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H.R. 3763—THE CORPORATE AND AUDITING

ACCOUNTABILITY, RESPONSIBILITY AND

TRANSPARENCY ACT OF 2002

HEARINGS

BEFORE THE

COMMITTEE ON

FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

MARCH 13, 20; APRIL 9, 2002

Printed for the use of the Committee on Financial Services

Serial No. 107–60

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa

MARGE ROUKEMA, New Jersey, Vice Chair

DOUG BEREUTER, Nebraska

RICHARD H. BAKER, Louisiana

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

PETER T. KING, New York

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

ROBERT W. NEY, Ohio

BOB BARR, Georgia

SUE W. KELLY, New York

RON PAUL, Texas

PAUL E. GILLMOR, Ohio

CHRISTOPHER COX, California

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

STEVEN C. LATOURETTE, Ohio

DONALD A. MANZULLO, Illinois

WALTER B. JONES, North Carolina

DOUG OSE, California

JUDY BIGGERT, Illinois

MARK GREEN, Wisconsin

PATRICK J. TOOMEY, Pennsylvania

CHRISTOPHER SHAYS, Connecticut

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

GARY G. MILLER, California

ERIC CANTOR, Virginia

FELIX J. GRUCCI, JR., New York

MELISSA A. HART, Pennsylvania

SHELLEY MOORE CAPITO, West Virginia

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

PATRICK J. TIBERI, Ohio

JOHN J. LAFALCE, New York

BARNEY FRANK, Massachusetts

PAUL E. KANJORSKI, Pennsylvania

MAXINE WATERS, California

CAROLYN B. MALONEY, New York

LUIS V. GUTIERREZ, Illinois

NYDIA M. VELA ́ ZQUEZ, New York

MELVIN L. WATT, North Carolina

GARY L. ACKERMAN, New York

KEN BENTSEN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

JULIA CARSON, Indiana

BRAD SHERMAN, California

MAX SANDLIN, Texas

GREGORY W. MEEKS, New York

BARBARA LEE, California

FRANK MASCARA, Pennsylvania

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

HAROLD E. FORD JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missouri

STEVE ISRAEL, New York

MIKE ROSS, Arizona

BERNARD SANDERS, Vermont

Terry Haines, Chief Counsel and Staff Director

(III)

C O N T E N T S

Page

Hearing held on:

March 13, 2002 ................................................................................................. 1

March 20, 2002 ................................................................................................. 66

April 9, 2002 ..................................................................................................... 125

Appendix:

March 13, 2002 ................................................................................................. 175

March 20, 2002 ................................................................................................. 295

April 9, 2002 ..................................................................................................... 417

WITNESSES

WEDNESDAY, MARCH 13, 2002

Glassman, James K., Resident Fellow, American Enterprise Institute .............. 12

Hills, Hon. Roderick M., Former Chairman, Securities and Exchange Commission ........................................................................................................................ 47

Lackritz, Marc E., President, Securities Industry Association ............................ 8

Melancon, Barry, President and CEO, American Institute of Certified Public

Accountants .......................................................................................................... 10

Roper, Barbara, Director of Investor Protection, Comsumer Federation of

America ................................................................................................................. 49

Turner, Lynn, Director, Center for Quality Financial Reporting ........................ 50

White, Ted, Director, Corporate Governance, California Public Employees’

Retirement System ............................................................................................... 14

APPENDIX

Prepared statements:

Oxley, Hon. Michael G. .................................................................................... 176

Gillmor, Hon. Paul E. ....................................................................................... 182

Carson, Hon. Julia ............................................................................................ 178

Jones, Hon. Stephanie ...................................................................................... 180

Royce, Hon. Ed .................................................................................................. 183

Glassman, James K. ......................................................................................... 210

Hills, Hon. Roderick M. .................................................................................... 254

Lackritz, Marc E. .............................................................................................. 184

Melancon, Barry ............................................................................................... 199

Roper, Barbara ................................................................................................. 266

Turner, Lynn ..................................................................................................... 274

White, Ted (with attachment) ......................................................................... 226

WITNESSES

WEDNESDAY, MARCH 20, 2002

Clapman, Peter C., Senior Vice President and Chief Counsel, Corporate

Governance, TIAA-CREF ..................................................................................... 107

DelRaso, Joseph V., Esq., Partner, Pepper Hamilton, LLP ................................. 101

Jasinowski, Jerry J., President, National Association of Manufacturers ........... 106

Livingston, Philip B., President and CEO, Financial Executives International 104

McCall, Hon. H. Carl, Comptroller, State of New York, Office of the State

Comptroller ........................................................................................................... 96

Pitt, Hon. Harvey L., Chairman, U.S. Securities and Exchange Commission ... 69

Raines, Franklin D., Chairman and CEO, Fannie Mae; Chairman, Corporate

Governance Task Force of the Business Roundtable ........................................ 98

Page

IV

APPENDIX

Prepared statements:

Oxley, Hon. Michael G. .................................................................................... 296

Gillmor, Hon. Paul E. ....................................................................................... 298

Jones, Hon. Stephanie T. ................................................................................. 299

Royce, Hon. Ed .................................................................................................. 301

Clapman, Peter C. ............................................................................................ 397

DelRaso, Joseph V. ........................................................................................... 360

Jasinowski, Jerry J. ......................................................................................... 388

Livingston, Philip B. (with attachment) ......................................................... 365

McCall, Hon. H. Carl ........................................................................................ 316

Pitt, Hon. Harvey L. ......................................................................................... 302

Raines, Franklin D. (with attachments) ......................................................... 320

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Maloney, Hon. Carolyn:

Hon. Eugene A. Ludwig, former Comptroller of the Currency, speech,

February 15, 2002 ......................................................................................... 413

Raines, Franklin D.:

The Business Roundtable statement on the Corporate and Auditing Accountability, Responsibility and Transparency Act of 2002 ...................... 351

Department of the Treasury’s Peter R. Fisher, Under Secretary for Domestic

Finance, prepared statement .............................................................................. 409

WITNESSES

WEDNESDAY, APRIL 9, 2002

Breeden, Hon. Richard C., former Chairman, Securities and Exchange Commission, Richard C. Breeden & Company .......................................................... 137

Langevoort, Prof. Donald C., Georgetown University Law Center ...................... 140

Silvers, Damon A., Associate General Counsel, AFL-CIO ................................... 141

Walker, Hon. David M., Comptroller General of the United States, U.S.

General Accounting Office ................................................................................... 135

APPENDIX

Prepared statements:

Gillmor, Hon. Paul E. ....................................................................................... 418

Jones, Hon. Stephanie T. ................................................................................. 419

Breeden, Hon. Richard C. ................................................................................ 454

Langevoort, Prof. Donald C. ............................................................................ 482

Silvers, Damon A. ............................................................................................. 492

Walker, Hon. David M. .................................................................................... 422

(1)

H.R. 3763—THE CORPORATE AND AUDITING

ACCOUNTABILITY, RESPONSIBILITY AND

TRANSPARENCY ACT OF 2002

WEDNESDAY, MARCH 13, 2002

U.S. HOUSE OF REPRESENTATIVES,

COMMITTEE ON FINANCIAL SERVICES,

Washington, DC.

The committee met, pursuant to call, at 10:00 a.m. in room 2128,

Rayburn House Office Building, Hon. Michael G. Oxley, [chairman

of the committee], presiding.

Present: Chairman Oxley; Representatives Roukema, Bereuter,

Baker, Lucas, Ney, Kelly, Weldon, Biggert, Shays, Cantor, Grucci,

Hart, Capito, Rogers, Tiberi, Royce, Gillmor, Ose, Green, LaFalce,

Waters, Sanders, C. Maloney of New York, Watt, Sherman, Lee,

Inslee, Jones of Ohio, Kanjorski, Moloney of Connecticut, Lucas of

Kentucky, Clay, Israel, and Roso.

Chairman OXLEY. Good morning and welcome to the committee’s

first legislative hearing on the Corporate and Auditing Accountability, Responsibility and Transparency Act of 2002 or CARTA.

This legislation makes important changes in the accounting profession, in the way public companies report their financial results, and

the manner in which investors access their information. These

issues are among the most serious in our jurisdiction. They have

percolated for some time. Now, the bankruptcies of Enron, Global

Crossing, and others have pushed them to the forefront.

Hearings held in this committee over the past few months have

demonstrated yet again the need for modernizing our financial reporting and disclosure system. Also, it is clear that we must have

strong oversight of the accounting profession. There should be no

question that the Federal securities laws need to be updated to ensure that investors have access to transparent, and meaningful information concerning public companies. Enhancing the public’s

faith in financial statements is absolutely critical. They serve as

the bedrock of our capital markets.

Our legislation, CARTA, addresses these fundamental issues by

strengthening our markets in a very careful way. We avoided the

temptation some apparently feel to blanket market participants in

a sea of red tape. This legislation creates an entirely new oversight

regime for public accountants, requiring accountants to be rigorously reviewed to ensure that they meet the highest standards of

competence, independence, and ethical conduct.

CARTA also recognizes the need for corporate leaders to act responsibly and holds them accountable if they fail to do so. The legVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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islation makes important improvements in the area of corporate

transparency, requiring that company’s disclose to investors important company news on a real time basis. It also directs the SEC

to require companies to disclose the use of off-balance sheet transactions.

CARTA’s provisions are designed to increase public confidence in

the U.S. capital markets. It is important that they remain the

world’s most efficient means of promoting economic growth and

providing retirement security.

President Bush recently announced the 10 Point Plan to improve

corporate responsibility and protect America’s shareholders. I am

pleased that the plan’s core principles, providing better information

to investors, making corporate officers more accountable, and developing a stronger more independent audit system are embodied in

our legislation.

I look forward to continuing our close collaboration with the Administration on this vital capital markets issue.

I also would like to mention Fed Chairman Alan Greenspan’s recent testimony before this committee. Discussing the implications

of the Enron collapse, Chairman Greenspan noted that it has already sparked a very significant shift toward more corporate transparency and more responsible corporate governance practices.

While it does not in my view obviate the need for Government action, the market’s self-correcting mechanism certainly does underscore the danger of overreacting to the Enron matter.

I am pleased that CARTA reflects Chairman Greenspan’s support for more transparent financial reporting and for strengthening

the independence of the audit.

I want to thank all the Members of this committee for working

so diligently on this important legislation. Let me also thank all of

our witnesses in advance for their important participation here this

morning.

I turn now to Ranking Member LaFalce for his opening statement.

[The prepared statement of Hon. Michael G. Oxley can be found

on page 176 in the appendix.]

Mr. LAFALCE. Thank you very much, Mr. Chairman. I ask unanimous consent that the entirety of my opening statement be included in the record.

Chairman OXLEY. Without objection, all the Members opening

statements will be made part of the record.

Mr. LAFALCE. I thank you. Our committee assumed jurisdiction

over securities and insurance for the first time in January of 2001.

And the Chairman has indicated that he is concerned that we not

overreact to the problem. Well, I think that that is a reasonable

concern. But I think that it is also true that we under reacted to

the problem historically and that was a much greater concern. At

the beginning of 2001, I began talking about the problem of earnings manipulation. That is when we assumed jurisdiction. The

SEC, as you know, was tripling the number of mandated restatements, which was at least some indication that something might

well be wrong.

And there was too much of an incentive it seemed to me within

corporate America, particularly because of the compensation mechVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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anisms that have evolved over the years, for earnings manipulation, for revenue recognition when it should not be recognized, for

channel stuffing, cookie jar reserves, and so forth, and so forth.

Very often, unchecked by the board of directors for one reason or

another, because of a policy passivity that may have existed at too

many boards, because of the same stock options to a lesser extent

to be sure that corporate officers, their chief desire is not a better

product or a better service, but market capitalization, to drive capitalization.

And then enter the accounting profession that was responsible to

the public as a public fiduciary for auditing these companies and

making sure that the books by the CFO and the CEO, and so forth,

and the audit committees were done right. And there was a difficulty there. They too had evolved over the years so that in a good

many respects they would make more money through consulting

than through auditing. But also independent of that they just had

obviously a vested interest in being retained and then staying retained by the firm because it was an employer/employee relationship and you want to make the client happy so you have this tension.

And then enter Wall Street. Wall Street got into an attitude of

stock hype, there is actually no question about it. Certainly the

number of recommendations went down precipitously from what it

previously had been. And then too we witnesses a number of blatant conflicts that existed.

Now nobody was paying attention in this committee when we

were considering the SEC fee reduction bill, I said what we should

be considering in the first instance is not a 2 or 3 percent increase

in the SEC budget, but a 200 or 300 percent increase in the SEC

budget, because of what is going on. And I made the same argument before the Rules Committee, and I made the same argument

on the floor of the House. But nobody was paying attention until

Enron. And then when Enron happened, people started paying attention.

Now, the Chairman is correct, we ought not to overreact, but we

ought to act. And we have to find that balance, what is the right

way. We ought to keep that pendulum. But we want good action,

strong action.

To restore confidence in the integrity of our markets, I think we

have to do at least the following. Enact legislation that will address

the serious deficiencies in our current system. Now, I have recently

introduced a bill, the Chairman had called a hearing on his bill,

but there is at least one other bill. There are many other bills actually. And there are good ideas in all of them. We have to sort

through them and try to come to some consensus. I hope we can

do that. If we don’t, we will just vote them up or vote them down,

not bill by bill, but issue by issue.

We should at least consider these particular proposals. The appropriate separate of audit and consulting functions; the concept of

auditor rotation; and other proposals that address the relationship

of the auditor to its audit client. We must also provide for meaningful oversight of the audit profession. And that means a strong and

credible regulator. And you have to have individuals who are on

this board, whatever it is going to be, that will instill some conVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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fidence in the investing public and restore the concept of integrity

to the accounting profession that is so richly deserved over the

years. We must reform the functioning of audit committees and the

boards of directors of public companies to ensure that independent

directors are truly independent and that auditors are working for

the shareholders, not for the management. And I think we need to

reconsider liability issues. Did we go a bit too far in 1995 and

1998? I think we need to reopen that issue, not in toto, but at least

in part.

I said early last year, and Lynn Turner, the Chief Accountant of

the SEC at that time, said that what we have witnessed so far was

just the tip of the iceberg. I am afraid that what we witnessed so

far too is still the tip of the iceberg, that there is a lot more out

there. Now I know that corporate officers and board of directors

and accountants are much more zealous today than they were in

October and November and earlier, but I think that having good

legislation will enhance that.

Second, and this is something that I think we can now agree on,

and I will finish up, I called for the 200 to 300 percent increase

in the SEC budget. I certainly called for pay parity, and the Chairman and I are going to team up I am sure with Mr. Baker and Mr.

Kanjorski and push the Administration and the Congress to give

the SEC the resources that it so desperately needs to do the job

that all America wants it to do.

I thank the Chairman.

Chairman OXLEY. The gentleman’s time has expired. The Chair

now recognizes the Chairman of the Capital Market Subcommittee,

the gentleman from Louisiana, Mr. Baker.

Mr. BAKER. Thank you, Mr. Chairman. I want to commend you

for the hearing and start by putting what I believe is our mutual

perspective about this problem on the record. By and large, day to

day, most professionals engaged in the business of running corporations, auditing corporations, analyzing corporations, and reporting

on corporations are doing the best job in the most professional capacity they know how to achieve those ends for the benefit of all

stockholders, including shareholders.

And the problems we are addressing today, I do not believe are

systemic or a condemnation of the business free-enterprise system

in the United States. I do believe that the rules now written some

60-70 years ago, are inadequate in light of the technological change

and the speed with which business is conducted, but it is apparent

to me that most individuals who are here today to testify are coming with helpful suggestions in how they believe we can improve

the legislation before us. But generally, everyone agrees we are on

track. We have not missed it. It is time to act. Every stakeholder

wants these issues resolved. We want to ensure investor and public

confidence in the credibility of our markets. And it is in our mutual

economic interest to see that occurs as quickly as possible.

To that end, I want to point out, Mr. Chairman, that you took

decisive action with regard to suggestions for treatment of analyst

conduct, together with the regulators and members of the profession, and announced mandatory, not voluntary, changes that

should be implemented which is now subject to public comment.

And they were sweeping in their effects. Research departments

5

may not be subject to supervision or control of the investment

banking department. The subject company may not approve prior

reports prior to distribution. The firm may not tie compensation to

specific investment banking practices. A firm must disclose if the

analysts receive compensation based upon the firm’s investment

banking revenues and establish certain quiet periods. No analyst

may purchase or receive an issuer’s securities prior to an initial

public offering. No analyst may trade securities issued by the company the analyst follows for a period beginning 30 calendar days.

And it goes on. A firm must disclose in research reports and an analyst must disclose in public appearances if they have a financial

interest in the securities of the company. A firm must disclose in

research reports and in public appearances whether or not the firm

or its affiliates beneficially own 1 percent of any class of common

equity securities of the subject company. And it goes on.

The point being that these are mandatory changes in analyst

conduct subject to penalties up to and including disbarment from

practice, which will, I believe, significantly alter the method and

manner in which analyst reports are issued and the public can

view the information contained therein.

The legislation before us here today is similar in its effect. I had

suggested that we analyze the consequences of having exchangebased engagement of audits. There has been any number of suggestions to radically alter the relationships between audits and their

corporations. And on reflection and consultation with the SEC and

many others who have expert opinion, I believe the bill before us,

with perhaps slight modification here or there, is an excellent vehicle for appropriate reform in light of the circumstance we face.

Just examine the GAO’s own report. I think they make two excellent statements that are worth repeating this morning. One is

go carefully. We are engaged in discussions that affect the entire

capital markets of this Nation and consequently internationally

have some significant potential for repercussions if we get it wrong.

And, second, that we need to make it clear that the financial

statement belongs to the shareholder. I was somewhat taken aback

when the CEO of Andersen Consulting said in response to a question before our hearing, ‘‘To whom does the financial statement belong?’’ He said, ‘‘To management and the shareholder.’’ Management 101, the financial statement should reflect accurate financial

condition of the corporation based upon management’s performance

for the shareholder. Once we return to that, and we ensure that

there is independence in the preparation of that audit statement,

and that we enable a good auditor to do good work despite what

management might choose for them to report, the consequences for

our capital markets, the auditor, the shareholder, and everyone

will be greatly enhanced.

I think you have got it right, Mr. Chairman. I think this is an

excellent start. Perhaps there is a change to be made here or there,

but in the overall picture and the risk we would take by going further faster, I think it is not warranted in light of the circumstances

we face, and I commend you for calling this hearing.

Chairman OXLEY. The gentleman’s time has expired. We now

turn to our distinguished panel. And let me introduce them. Mr.

Marc E. Lackritz.

6

Mr. SANDERS. Mr. Chairman, will others be allowed to make

opening statements?

Chairman OXLEY. Just the Ranking Member and the subcommittee.

Mr. SANDERS. We were told otherwise.

Mr. SHERMAN. That is not what we were told by staff by the way.

Chairman OXLEY. Staff informs me that you are correct. The gentleman from Vermont, Mr. Sanders.

Mr. SANDERS. Thank you very much, Mr. Chairman. And thank

you and Mr. LaFalce for holding this important hearing. I find myself in agreement with the Chairman and Mr. LaFalce and Mr.

Baker, but I would go further than they, because I think we have

a very, very serious problem, which the United States Congress has

got to address.

Let me just for a moment do a Dave Letterman Top 10, if I

might, in terms of failed audits. This suggests that while Enron

has gotten all of the publicity, the problem is a lot deeper than

Enron.

One: Arthur Andersen and Enron. We all know that.

Number two: KPMG failed in its audit of Rite-Aid causing a $800

million loss in stock value after recalculation of profits.

Number three: Arthur Andersen failed in its audit of Sunbeam,

causing a $1.2 billion loss in stock value after the recalculation of

profits.

Four: PriceWaterhouseCoopers failed in its audit of Micro Strategy, resulting in a $10.4 billion loss in stock value after their recalculation of profits.

Five: Arthur Andersen failed in its audit of Waste Management,

resulting in a loss of $900 million in stock value after their recalculation of profits.

Six: Arthur Andersen failed in its audit of McKessen HBOC, resulting in a $7.9 billion loss in stock value.

Seven: Ernst & Young failed in its audit of Cendant, resulting in

a loss of $11.3 billion in stock value.

Eight: KPMG failed in its audit of Greentree, resulting in a loss

of $1.1 billion in stock value.

Nine: while Global Crossing executives cashed in on some $1.3

billion in Global Crossing stock, Arthur Andersen’s failed audit of

this company has caused many of their employees to lose their entire life savings.

Ten: Arthur Andersen failed in its audit of the Baptist Foundation of Arizona.

The point is, Mr. Chairman, we have a serious problem. And I

think, Mr. Chairman, we need a serious solution. Mr. LaFalce

touched on the inherent conflict of interest between those who consult for the company, and that is kind of obvious and I would hope

that most of us would want to end that practice immediately. Mr.

LaFalce also touched upon the employer-employee relationship. If

you are working for a company and you are getting paid well by

that company, are you going to go up to that company and say: ‘‘By

the way, you are cooking the books and you are ripping off the

stockowners of your company.’’ Apparently, many of the large auditing firms are not prepared to do that.

7

So it seems to me that at the very least we need to significantly

beef up the SEC, but, in fact, we may want to go a lot further than

that. When people invest in the stock market, when people who

represent pension funds, who are representing the retirement savings of millions of American workers are investing in a company,

they have the right to know that the books are being honestly kept.

And, unfortunately, that has not been in many cases the record up

to today.

So I think we are going to need some very bold solutions to this

very serious problem.

Thank you, Mr. Chairman.

Chairman OXLEY. The gentleman’s time has expired. There are

other opening statements. The gentleman from California, Mr.

Sherman, is recognized for 3 minutes.

Mr. SHERMAN. Thank you, Mr. Chairman. We need not only to

be concerned with the culture of the business world, which I don’t

think we can change, but rather design strong rules and clear rules

rather than simply rely on adding more ethics courses to business

school curricula.

We ought to look at the scope of service that auditing firms provide. But keep in mind, if Arthur Andersen had just been an auditing firm, they would have collected only $25 million from Enron,

not $50 or $52. But they would have been a firm of half the size.

And if our concern is the size of the fee having an effect on the

auditor and the auditor’s judgment, we ought to perhaps limit the

total fee for all services provided to 150 percent of the audit fee so

that some incidental services could be provided.

We ought to look at the structure of accounting firms to ensure

that the technical review department always makes the final decision. That is not what happened with Arthur Andersen, which unlike the other Big Five firms, decided to have the decisions made

in Houston in effect by the sales partner.

We need to have minimum capitalization requirements so that if

you sue an accounting firm, you don’t collect absolutely nothing.

You can’t drive in most States without liability insurance, but you

can practice accounting and be responsible for trillions of dollars in

market reliance without adequate malpractice insurance or adequate capitalization.

If we are going to rotate auditors, perhaps we also ought to give

them tenure as well. Because if you are in the first year of what

is a maximum of 5 or 10 years of auditing a firm, you are subject

to pressure from the client, loosen your accounting interpretations

or you may lose your last 9 years of a contract. If instead these

were 6 or 10-year contracts, auditors would be free without financial pressure to be able to make the judgment decisions.

The SEC should have been here asking us to quadruple their

budget or double their budget. Instead the SEC was not even reading Enron’s financial statements. If tiny companies, going public for

the first time, get a review of their filings by the SEC and have

to answer questions and make their documents clear and complete,

certainly we should require the same kind of scrutiny of the thousand largest firms in America.

We ought to have the FASB come before us, Mr. Chairman, to

talk about how the accounting standards were so loose that people

8

at Arthur Andersen and Enron could convince themselves that they

were even close to compliance. And we ought to hear more from institutional investors, who frankly I think have under investigated

in their Washington presence. When it comes to reducing capital

gains, we have thousands of lobbyists. When it comes to other

things that would help investors, we tend not to hear from them

nearly as loudly.

I yield back.

Chairman OXLEY. The gentleman’s time has expired. Are there

further opening statements?

Now, I turn to our distinguished panel. The gentleman, Mr. Marc

Lackritz, president of the Securities Industry Association; Mr.

Barry C. Melancon, president and CEO, American Institute of Certified Public Accountants; Mr. James Glassman, resident fellow of

the American Enterprise Institute; and Mr. Ted White, director of

Corporate Governance, California Public Employees’ Retirement

System.

Gentlemen, welcome to all of you. And Mr. Lackritz, we will

begin with you.

STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES

INDUSTRY ASSOCIATION;

Mr. LACKRITZ. Thank you, Mr. Chairman.

Mr. Chairman, Congressman LaFalce, and Members of the committee, I am pleased to testify before you today on H.R. 3763. We

commend you, Mr. Chairman, and Members of the committee for

your ongoing efforts to ensure that investors will continue to be

well served and well protected.

SIA is deeply concerned about the implosion of Enron and the

corrosive effect this event is having on the public’s trust and confidence in our country’s corporations and financial markets. Public

trust and confidence is the bedrock of our financial system, the core

asset underlying why our financial markets are the envy of the

world.

Although Enron’s collapse appears to be a massive failure in the

accuracy of information that flowed into the marketplace, the securities industry’s regulatory structure remains fundamentally

strong. Although we are still learning the full story behind Enron’s

collapse, we strongly support responsible reforms that will ensure

that financial information, the lifeblood of our markets, is honest,

accurate, and easily accessible.

SIA welcomes the reforms in pension laws announced by the Administration in February. We support, for example, prohibiting insiders from selling their securities during a blackout period, requiring prior notice of blackout periods, and the concept of permitting

participants to sell company stock in their 401K plan after a reasonable period.

We also encourage the Senate to follow the House’s lead in passing legislation to allow retirement plan administrators to provide

individual financial advice to employee participants. Giving investors greater access to information will help them make more informed decisions about their retirement accounts.

SIA also supports full funding of pay parity for the Securities

and Exchange Commission’s professional staff. The SEC has been

9

a tough, effective cop on the beat. We have been profoundly troubled by the huge turnover in experienced staff that the SEC has

suffered in recent years. Congress should fund pay parity and increase the agency’s funding to ensure that the SEC has the staff

and resources it needs to be an effective regulator.

SIA believes that H.R. 3763 includes a number of important improvements to the current regulatory system. The bill sets up a

strong statutory framework for public oversight of the independent

audit function. It is a sensible, appropriate reaction to the shadow

the Enron debacle has cast on the current performance of outside

auditors.

We also support giving the SEC authority to prosecute senior executives of a public company that willfully mislead an independent

auditor. Although the SEC already has strong authority in this

area, the committee should consider President Bush’s proposal to

grant the SEC the statutory authority to require senior executives

to disgorge bonuses and other incentive-based forms of compensation in cases of accounting restatements resulting from misconduct.

Although SIA generally supports H.R. 3763’s provisions for more

timely and better disclosure of corporate information, we note that

the SEC has already announced its intention to act in this area,

we believe that the best action here is to provide the SEC with the

flexibility to make the necessary judgments about the timing and

content of required disclosures.

Similarly, the bill’s provisions to improve transparency in financial statements generally overlap with the recent SEC statement to

issuers regarding certain disclosures. Since those disclosures have

just been mandated, we believe it is premature to legislate at this

time in this area.

Our written statement includes additional recommendations, Mr.

Chairman, for improving corporate disclosures. Further, special

purpose entities play a critical role in a number of important financial markets, especially in the case of securitization programs. Regulatory or legislative actions should be considered carefully in light

of the significant adverse impact upon financial markets that might

result from inappropriate restrictions on SPEs.

Finally, SIA supports the provisions directing the SEC to conduct

a study of any final SRO rules regarding conflicts of interest by equity analysts. SIA developed a set of best practices for research a

year ago that we believe have been very useful and constructive.

The NASD and the New York Stock Exchange have recently proposed regulations in this area. And while we have some serious

issues with some aspects of these proposals, we support their overall goal.

SIA believes our system of securities regulation and corporate

disclosure is second to none. Our financial markets are envied

worldwide for their efficiency and integrity, and we now have the

opportunity to develop sensible, responsible reforms that will improve the markets for everyone.

Certainly Enron has brought us a new set of challenges to address. We look forward, Mr. Chairman, to working with you, the

SEC, and the Administration to develop a reasonable measured response to those challenges.

Thank you very much.

10

[The prepared statement of Marc E. Lackritz can be found on

page 184 in the appendix.]

Chairman OXLEY. Thank you, Mr. Lackritz.

Mr. Melancon.

STATEMENT OF BARRY C. MELANCON, PRESIDENT AND CEO,

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Mr. MELANCON. Thank you, Mr. Chairman. Chairman Oxley,

Ranking Member LaFalce, and Members of the committee, I am

Barry Melancon, a CPA and president and CEO of the American

Institute of Certified Public Accountants. I am here today on behalf

of the 350,000 members of the AICPA and for the almost 1,000

firms that perform audits for public registrants and 45,000 firms

that service small business throughout America.

CPAs across this country and the Members of this committee

share a common goal, to restore faith in the financial reporting system and reassure investors that they have access to the most upto-date, relevant, and accurate financial information.

Our profession has a long history of dedication of maintaining

and improving the quality of financial disclosures. We require it,

investors demand it, and the strength of our financial markets depends upon it. We take that responsibility very serious, and we

have zero tolerance for those who break the rules.

I would like to be clear: We support meaningful change, because

thoughtful improvements are needed. But we all should be wary of

proposals that can lead to unintended consequences. We ask that

this committee and Congress evaluate legislative proposals with an

eye to a straightforward public interest test, a test that asks four

important questions:

Will it help investors make informed investment decisions?

Will it enhance audit quality and the quality of financial reporting?

Will it increase confidence in the capital markets, our financial

reporting system, and the accounting profession?

Will it be good for America’s financial markets and economic

growth?

We support a robust private-sector regulatory body for auditors

of public companies dominated by members who are not accountants, with SEC oversight, and a clear charter to undertake professional discipline and quality review. A highly effective disciplinary

and quality review body will alleviate the need for individual prescriptive proposals.

Audit quality is another issue that I would like to discuss today.

New and more complicated financial instruments and the speed

and complex nature of business transactions has significantly increased the challenges facing auditors. The competency and experience needed to conduct today’s audit are vastly broader than they

were just even a few years ago. And those requirements will be

ever more far-reaching in years to come.

I would like to take a moment here to discuss the very real risk

that broad proposals that restrict services provided to audit clients,

whether intended or not, could lead to a profession comprised of

firms that provide narrowly defined audit services and little else.

This will have unfortunate, unintended consequences. The ripple

11

effect of such action could hurt businesses of all sizes and all communities. Such statutory restrictions will substitute informed and

reasoned decisionmaking by companies in their audit committees

with Government fiat.

Next, the issue of corporate governance. We should all recognize

that the financial reporting process is a complex system of checks

and balances that begins with the creation of the financial statement by the company. To enhance this first step in the process, the

audit committee should also have the sole authority to approve the

company’s financial statements and require business disclosures in

the annual report and other public documents. And the audit committee should be responsible for the hiring and firing of the company’s auditor. Equally important, it should be composed of outside

directors with auditing, accounting, or financial experience.

We hope that policymakers recognize that it would be harmful to

cast a dark cloud over all services outside the statutory audit by

establishing a negative presumption that an auditor cannot be

independent if any such services are provided to an audit client

even if that presumption could be overridden by an audit committee’s affirmative action.

Mandatory rotation of audit firms has been proven to increase

the potential for fraud. The COSA study of financial statement

fraud shows that client fraud is three times more likely in the first

2 years of a client-auditor relationship. Safeguards are already in

place. All firms that conduct audits for publicly traded companies

are currently required to take the lead engagement partner off engagements after 7 years for a period of at least 2 years. Finally,

I must mention that at one time Canada, Greece, Spain, and Italy

all required mandatory audit firm rotation in one form or another.

Three of those four countries subsequently dropped the requirement. In short, given the known risk, why follow these failed experiments.

On another note, it is ludicrous to suggest that accountants are

off the liability hook. One simply has to read the newspaper today

to see that the opposite is true. The past few years have seen

record numbers of lawsuits and record settlements from accounting

firms.

And now to the reforms that the AICPA has advocated for many

years.

Chairman OXLEY. Can you sum up, Mr. Melancon.

Mr. MELANCON. Yes, sir. Reforms in our 70 year old financial

system. The current system is no longer adequate in the information age. Efforts to modernize business reporting must be accelerated.

On behalf of the CPAs around the country, I thank you for the

opportunity to present our views today and commend the committee for what we trust will be a thoughtful approach to these important and complex issues.

[The prepared statement of Barry C. Melancon can be found on

page 199 in the appendix.]

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STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW,

AMERICAN ENTERPRISE INSTITUTE

Mr. GLASSMAN. you, Mr. Chairman. Mr. Chairman and Members

of the committee, thank you for inviting me to testify today. My

name is James K. Glassman. I am a Resident Fellow with the

American Enterprise Institute and host of techcentralstation.com.

Since 1993, I have been writing regularly on investing for a broad

audience. I am a financial columnist for The Washington Post. My

second book, ‘‘The Secret Code of the Superior Investor,’’ was published in January.

I believe that my usefulness to this committee lies in my understanding of what makes small investors tick and of the consequences of financial policies on the economy and markets. In the

current over-heated atmosphere, H.R. 3763 is admirably levelheaded, especially in comparison with the Comprehensive Investor

Protection Act. Still, some of the bill’s provisions are troubling.

Rather than protecting investors, these provisions may harm them.

First, understand that investors do a remarkable job protecting

themselves. Investors reward good corporate citizens with higher

stock prices and they punish miscreants with lower. Recent academic research confirms this fact, as I show in my written statement. Investors have their own unwritten set of rules and when

companies violate them, the retribution is swift. Investors do not

tolerate lying. In Enron’s case, as soon as it became clear that the

firm had deceived them, investors entered a verdict of guilty and

applied ‘‘capital’’ punishment. They didn’t wait for a trial. They

didn’t wait for an SEC investigation. Similarly, clients of Arthur

Andersen, Enron’s accounting firm, did not wait for an indictment

or a Government report. Delta Airlines, Merck & Company,

Freddie Mac, among others, fired Andersen as their auditor. In addition, of course, Enron and Andersen executives face possible

criminal penalties.

In the face of such a ferocious reaction, why is Congress considering at least 30 pieces of legislation in the Enron matter? Congress has played an important role in exposing the details of the

scandal to the public and in calling the participants to account publicly. This committee deserves particular praise. But much of the

legislation itself is unproductive at best.

Let me comment briefly. Auditor independence: H.R. 3763 would

bar accounting firms from providing clients with both external

audit services and financial information services or internal audit

services. The CIPA goes further. Both approaches are harmful to

investors.

First, Zoe Palmrose and Ralph Saul show in an extensive article

in the winter issue of Regulation, which I would like to enter into

the record, the issue of auditor independence has been extensively

studied with almost no empirical evidence of abuse. The theory put

forth by advocates of independence rules is that companies use the

high fees involved in contracts for non-audit services in order to

bribe accounting firms to produce deceptive audits that favor the

company. But Enron actually paid low non-audit fees relative to its

audit fees. And why should forbidding non-audit work solve the

problem? After all it is just as easy to bribe accountants, if you believe this theory, directly. Just pump up the fees for audit work.

13

While evildoers lurk in the corporate world as well as outside it,

the main reason that respected companies use the same firms for

audit and non-audit is not that this combination provides some

kind of nefarious leverage, but that it makes sense economically in

an age of high technology. Forcing this highly artificial separation

will add expenses, lower profits, and inevitably lower stock prices,

and that hurts investors. It does not help them.

Increasing the complexity of accounting rules: You should understand that the complex nature of American corporations means

that every loophole cannot be plugged, every possible deception and

distortion cannot be remedied with a new rule. The answer is not

more numbers and legalese, but more leeway for auditors and corporate executives to explain the truth health of a company, along

with strict accountability from companies and auditors.

So what should be done? Well, I strongly agree with Section 4

of H.R. 3763, which requires officers and directors to disclose sales

of company stock to the SEC within two days after the transaction.

I would go further and say that this information should be contemporaneous. I also concur with blackout provisions and with stricter

laws against companies interfering with audits.

Another remedy, which is beyond the scope of this committee, is

this: Cash dividends are the clearest, most transparent evidence of

corporate profits. An investor who sees dividends increasing every

year can properly have confidence in a company. But dividends are

taxed twice and mainly as a result fewer public companies now pay

dividends ever in history. Ending double taxation of dividends

would increase pay-outs and vastly increase investor confidence.

Repealing litigation reform: Congress, in 1995, overrode President Clinton’s veto of the Private Securities Litigation Reform Act,

a bill that scaled back the excesses involved in often frivolous securities fraud cases brought by a small group of politically generous

plaintiffs’ lawyers. Now some in Congress have decided that these

moderate reforms were responsible for the Enron excesses. In fact,

the law does not prevent such lawsuits. Cendant, for example, settled the class action lawsuit after the new law for $2.8 billion. And

its former auditor, Ernst & Young, settled another suit for $335

million. Attorneys could have sued Enron earlier and they are certainly suing Enron and its auditor, Arthur Andersen, today.

Repealing this reform would not protect shareholders. It would

hurt them by forcing their companies to make payments of tribute

and distracting executives who should be focusing on managing

their firm. Indeed, in my opinion, the bar should be raised higher

to deter more frivolous suits.

After the Enron scandal entered full public consciousness in December, the media carried stories claiming that as a result investors were losing faith in the stock market in general. Instead, while

investors have certainly become much more vigilant, to their credit

they have not responded by dumping shares across the board. In

fact, in January 2002, according to the Investment Company Institute, investors added $20 billion more to equity mutual funds than

they took out, the largest such net gain in many months.

Chairman OXLEY. If you could sum up.

Mr. GLASSMAN. Yes, sir. I do have to mention something. I was

not aware that CalPERS was going to be testifying today, but let

14

me say this. For this discipline that I have talked about, the discipline involved with investors enacting retribution against Enron

and other firms, for it to work, investors must act responsibly. Unfortunately, that is not always the case. The New York Times reported on February 5th that while the large California Public Pension Fund, CalPERS, was alerted to the abuses at Enron, in December 2000, 9 months before the company started to announce to

write-offs, was alerted to these abuses, executives ‘‘did not confront

Enron’s board,’’ or ‘‘publicize its concerns.’’ Instead it continued to

profit from dubious partnerships like Jedi.

Instead of concocting new laws, this committee should use its

bully pulpit to exhort accountants, corporations, and pension funds

to act responsibly. Finally, in times of scandal, emotions run high.

And the urge to rush in with legislative remedies is understandable, but it should be resisted. Parts of H.R. 3763 are admirable,

but market discipline and current criminal and civil laws provide

powerful remedies and protections against another Enron already.

Thank you, Mr. Chairman and Members of the committee.

[The prepared statement of James K. Glassman can be found on

page 183 in the appendix.]

Chairman OXLEY. Thank you, Mr. Glassman.

Mr. White.

STATEMENT OF TED WHITE, DIRECTOR OF CORPORATE GOVERNANCE, CALIFORNIA PUBLIC EMPLOYEES’ RETIREMENT

SYSTEM

Mr. WHITE. Thank you. Chairman Oxley, Ranking Member LaFalce, and distinguished Members of the committee, I am Ted

White. I am the Director of Corporate Governance for the California Public Employees’ Retirement System or CalPERS. On behalf of the CalPERS’ board and myself, I would like to thank you

for the opportunity to testify today regarding issues that are of

such importance to our capital markets.

CalPERS is the largest public pension system in the world, with

approximately $155 billion in assets. We represent over 1.2 million

members. Over $67 billion of our assets are invested in the U.S.

stock market alone.

CalPERS has long been a vocal, leading advocate for effective

corporate governance. We strongly believe that as owners of the

companies we invest in, shareholders have a right and a duty to

attempt to hold management and boards of directors accountable

for their performance. The concepts of accountability and transparency have long been recognized as the cornerstones of a successful corporate governance model. Unfortunately, the events of the

last few months have demonstrated all too clearly that basic ethics,

something that we may have all taken for granted, must also be

a concern for today’s investors.

With this background, I would like to focus on two key legislative

issues, auditor independence and audit industry oversight and several regulatory matters.

CalPERS was pleased to see both Chairman Oxley’s bill and

Ranking Member LaFalce’s bill include provisions on these important topics. Thank you both for recognizing the need for Congress

to address these issues.

15

On the issue of auditor independence, CalPERS believes there is

currently a crisis of confidence with the accounting industry. The

independence of the auditor must be beyond reproach. Investors

must be able to trust when an auditor says the books are accurate,

then they are accurate. The Enron/Andersen situation, as well as

many others, have prompted this erosion in investor confidence due

in large part to the very obvious conflicts that exist when an auditor is simultaneously receiving fees for non-audit work. How can

investors trust the discretion that is inherent in audit work while

the auditor may be influenced by the desire to keep a well-paying

client happy.

We understand that there is much debate over when to draw the

line between audit and non-audit services. As one investor,

CalPERS believes that there should be a bright line ban on external auditors providing consulting work or internal audit services to

audit clients. A firm should be an auditor or a consultant, but

never the same for the same client.

CalPERS is also advocating a system of mandatory auditor rotation of company external auditors. We have suggested a 5 to 7-year

limit. Although we recognize there is a cost inherent in this proposal, we believe the cost is far outweighed by the benefits, benefits

that can bring a fresh perspective and renewed investor confidence

in the industry.

I would note for your reference that CalPERS is mandatorily required to rotate its auditor every 5 years. And while this is not

easy for a financial institution of our size and complexity, we do

it nonetheless.

Turning to the oversight of the accounting industry, we again applaud the efforts of this committee, SEC Chairman Pitt, and President Bush for identifying the need to strengthen the oversight of

auditors and accountants. We believe it is time to update the oversight of this industry.

To achieve a goal of rebuilding the market’s confidence, we must

create an effective oversight body. To be effective, we believe that

the oversight body should be created with the following principles

in mind. It must represent the interests of end-users. The governing body should be dominated by independent public members.

It should have a stable and independent funding source. It should

have the power to effectively oversee the industry, which means

conduct investigations and discipline. And it must have standard

setting capability. We also believe that while the SEC should oversee this new entity, the creation, its charter, and its scope of authority at a minimum must be established by Congress.

We recognize that the current forms of the Oxley bill, as well as

the LaFalce bill, contains several elements that are consistent with

CalPERS existing reform package and we appreciate that you are

addressing these issues. For example, requirements on auditor

independence, mandatory auditor rotation, revolving door provisions, requirements that the auditor be hired by the auditor committee, provisions related to director independence, and the creation of the oversight body with a secure funding service, investigative and disciplinary power, and the ability to set standards.

Finally, CalPERS would like to express our strong desire that

pay parity for the SEC staff be fully funded by Congress this year.

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In conclusion, CalPERS is pleased that the Members of this committee are taking such a thoughtful and constructive approach to

addressing the financial reporting issues stemming from the Enron

collapse. We believe Congress must play an important role in helping restore investor confidence by improving auditor independence,

enhancing accounting industry oversight, providing regulators with

the power and resources to effectively regulate the industries, and

encourage interested market participants to assist them when practical.

Thank you. And I would be pleased to answer any questions.

[The prepared statement of Ted White can be found on page 226

in the appendix.]

Chairman OXLEY. Thank you, Mr. White and thanks to all of our

panel.

Let me begin by asking Mr. Lackritz, and this was also mentioned by Mr. Glassman, there have been media reports and

sources from the trial bar that the Securities Litigation Reform Act

of 1995 has reduced the number of shareholders’ suits or the average settlement amount. Would you care to comment on the numbers as they are reflected today after passage of that Act?

Mr. LACKRITZ. Yes, I would be happy to, Mr. Chairman. In fact,

the number of lawsuits that have been filed in the 4 years since

the Act became effective have actually gone up, and gone up proportionately, to the number of suits that were filed actually before

the Act was passed. And in addition the average settlement

amount has actually gone up, so that indicates that the quality of

the lawsuits that have been filed have probably improved significantly. And the purpose of the Act, which is to deter abusive practices by lawyers that didn’t have any clients, is being served quite

well. And I think that the examples that Jim Glassman cited are

further evidence that the law is actually working very much as it

was intended to work.

Chairman OXLEY. Thank you. Mr. Glassman, you had indicated

even that you would have perhaps gone further in the pursuit of

limiting those frivolous lawsuits. Is that correct?

Mr. GLASSMAN. Yes, sir. I think that when you talk to people in

Silicon Valley today, these lawsuits, the threat of these lawsuits is

hanging over their heads. The notion that just because the stock

price has declined, somebody did something wrong, which by the

way is the wrong signal always to send to investors, they have to

understand that stock prices do decline and they need to protect

themselves against that, I think in part has put a chill on that industry and distracted many of its executives. And it is not a good

thing. But certainly when companies like Cendant do the things

that Cendant has done, they ought to be punished for it in the

courts and perhaps in criminal activities.

Chairman OXLEY. I thought your comments were most appropriate. And I am speaking now to Mr. Glassman, particularly in

view of Chairman Greenspan’s comments that the markets have a

remarkable way of making corrections, punishing wrongdoers and

the like. One of the biggest fears that I have frankly, and it was

expressed by you and Mr. Melancon, at least obliquely, is what

would be worst, doing nothing, that is the Congress, or overreacting and passing overly restrictive legislation? I obviously know

17

your answer, Mr. Glassman. Let me ask Mr. Melancon what his

perception of that is?

Mr. MELANCON. Mr. Chairman, I would certainly agree with you

that in effect Congress has done something through its bully pulpit,

through these hearings, and a whole host of others that have

caused changes to occur, due diligence to occur, a greater awareness by everybody involved in the process. And that is a positive

thing and that is an indication, as Mr. Glassman has said, of the

marketplace’s unique capabilities in our economy to be responsive.

With that as a basis, if you are asking me specifically on would

it be better to have far-reaching unintended consequences through

legislation or no legislation, I think our economy would be better

served because it has responded to your activities and others with

the more restrained approach because the unintended consequences could be extraordinarily negative.

Chairman OXLEY. One of the things you learn after being around

here awhile is that sometimes laws are forever, or at least seemingly so. It took us 70 years to repeal Glass-Steagle and some of

us have the wounds to prove it. That is, when the Congress enacts

even bad legislation, it tends to take us a long time for it to correct.

And clearly the intent of our legislation was to provide a broad

framework for corrective action, but essentially to allow the regulators and to allow the market to work this out.

Mr. Greenspan even indicated that he thought, even at this early

going, that 50 percent of the problems inherent with the Enron debacle have already been dealt with. And in my discussions with

CEOs from various industries, it also leads me to think that that

is happening. Clearly, the actions taken by a number of boards recently regarding Andersen, by Andersen hiring Paul Volcker, by

Volcker’s announcement just recently, all would indicate that there

is a heightened awareness of corporate responsibility. There is

heightened awareness of auditor independence and their need to

provide an accurate and fair audit.

And there is indeed, obviously, the need with the changes taking

place in technology for virtually instantaneous information to be

placed before the investing public. Mr. Glassman, for example,

thought 2 days was perhaps too slow, that it ought to be instantaneous, maybe we ought to look at that. Maybe there are some other

issues that can be brought up. But, I have to say the more I discuss

these issues with people in the private sector, the more I am convinced that we have to tread very carefully in this arena.

I thank you, and my time is just about up. Let me recognize my

good friend from New York, Mr. LaFalce.

Mr. LAFALCE. Thank you, Mr. Chairman. And of course we must

always act deliberately and carefully, but we must act. And we

must not act with timidity. And we must act in the public interest

as opposed to listening primarily to the voices of the private special

interests. Discerning the difference between the two is often difficult.

I am struck by a number of comments that have been made. Mr.

Lackritz praised the 1995, 1998 legislation, saying that number

one, lawsuits have gone up. Number two, settlement dollar

amounts have gone up. Number three, the quality of the lawsuit

has gone up. And that the intention of the Congress has worked.

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I didn’t know that the intention of the Congress was to increase the

number of lawsuits, increase the settlements. Some people said it

was indeed to the contrary. Some people who authored the legislation of 1995, 1998 may actually have wanted to see the number of

lawsuits gone down, may have actually wanted to see the settlement figures go down. But that is I supposed historical perspective.

There has also been quite a bit of talk too about the markets will

punish the wrongdoers. The markets will make corrections. Well,

there is a certain amount of truth in that. But to what extent will

the markets, number one, obtain redress for the victims of wrongdoing. And, number two, to what extent will the working of the

marketplace in and of itself prevent future difficulties, future earnings manipulations?

That is where I think that you do need—in order to make the

market work, you do need a good system of laws and a good system

of regulation. That is the whole concept of law and regulation, to

make the market work. We have a good public capital market, the

public can invest on it. But I don’t think we can rely on the concept

of buyer beware, which is if I were to summarize Mr. Glassman’s

testimony in two words, which would be very unfair, Mr. Glassman, because you were thousands of times more nuanced than

that, but basically it sounds to me as if you are saying, ‘‘Let the

buyer beware.’’ And we have to go beyond that. Now how far beyond that, we need to discuss and debate.

Clearly, the accounting industry has come in with its own proposals. Clearly, there have been countless recommendations from

corporate America for corporate governance changes. Clearly, the

securities industry, the regulator, the NASD, has come in with

some changes. They are good as far as they go. Other major securities firms have gone even further, and maybe that is the best practice and maybe we should codify the best practice. This is what we

certainly need to debate.

But I don’t think it is good to just put our head in the sand and

say the marketplace is going to take care of it and to warn us all

about overreacting. I have not seen too many individuals so far

who have been overreacting. And I don’t think when the comptroller for the State of New York, for example, calls for mandatory

rotation, when the former controller of the city of New York calls

for mandatory rotation, when one of the former chairmen, at least

one, of the SEC calls for that concept, that is something that

should be considered seriously. When the Chairman of the Capital

Markets Subcommittee does not call for mandatory rotation, but

calls for at least a consideration of the concept of the exchanges

being responsible for the determination of the auditors, that is

something that merits very, very serious consideration.

And I look forward to working with the Chairman, maybe his

idea is better. It ought to be on the table. When CalPERS can rotate its auditors every 5 years, that shows it can be done. When

companies fire one auditor and hire another, as they have been

doing the past several weeks, it shows it can be done. And it is

done hopefully to improve things. It is done for a whole slew of reasons even though they may have been satisfied with the auditing,

they think it is necessary to restore investor confidence, which is

a good value in and of itself too that should be weighed along with

19

whatever learning difficulties there might be. So if we have problems, learning difficulties, whether it is a new Congressman,

whether it is a new chief of staff, and so forth, that goes with the

territory, but it should not create a paralysis on our part.

I thank the Chair.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from Louisiana, Mr. Baker.

Mr. BAKER. Thank you, Mr. Chairman.

Mr. White, in reviewing your testimony, I found it very helpful

in this sense, that you obviously manage a system that is financially significant, with a significant responsibility for a large number of people’s retirement futures. In your remarks you talk about

the adequacy of the audit committee construction and point out

that having only one member possess financial literacy skills is not

sufficient. I agree with you and think that the provision in the underlying legislation that allows for public members to be part of the

regulatory body is an advisable thing, but only if we can assure

that the appointment of these individuals to this incredibly important responsibility have financial literacy as an asset. I think it

goes beyond the ability just to read the financial statement itself.

I think it creates an environment where there is much more likely

to be independence in making judgments because you then understand what the facts are saying.

And that really gets to one of the principal concerns I have about

whatever system we adopt, to what extent is there assurance that

when the auditor is within the structure, doing the work that is required at the direction of the audit committee, the audit team has

to engage with management to understand what is going on almost

always. Based on Mr. Melancon’s comment that fraud is most likely

to occur when an auditor is new to the business structure.

At the same time, I don’t know on how many occasions that the

audit team is asked by the audit committee has management asked

you to modify, alter, change, in any way indicate that the financial

report you are presenting to us was inaccurate and have a responsibility for that auditor to disclose what relationships may have occurred with management beyond the normal due diligence required

to prepare the financials?

Is that a customary practice in your view?

Mr. WHITE. That is a good question. First, your opening comments about the applicability of how we feel about the role of the

audit committee and the expertise there and the expertise needed

on the oversight body I think are excellent points. What we would

stress on the oversight body is that the independence of those

members is of extreme importance, along side with their expertise

and that they will obviously hire audit staff that would carry out

the reviews and you would need a greater level of expertise at that

level.

Your question about the role of the audit committee, it would be

our strong desire that chairmen of audit committees and audit

committee members would hold the audit firm’s feet to the fire on

exactly those issues. I have no statistics to represent to you how

often that happens. In my conversations with audit committees and

audit committee chairmen, I think it is a mixed bag of how well

they fill that role. One of the things that we have learned out of

20

this is we are going to put additional pressure on audit committees

to do exactly the types of things that you mentioned right there.

It is one of the reasons that we want the audit committee to have

the absolute responsibility to hire and fire the auditors and to approve any non-audit services, whether there be a ban or come from

another angle.

Mr. BAKER. Thank you. Mr. Glassman, I always respect your defense of free enterprise and generally are right there with you on

most of these observations. One point that I think needs to be

made in the current environment though is that short-term earnings pressures on corporate management are enormous. And if you

don’t beat the street numbers by a little, something is wrong. And

if you invest for the long-term profitability of a corporation’s life at

the expense of the short-term quarterly report, you enter that category called fired.

I think we need to incentivize in some method a way for management to look to the long term, not to the short-term quarterly report. One of the ideas was to indicate where a no-cost option is exercised by an executive and through manipulations of reports helps

to bump the stock price up, either by whisper numbers or whatever

is out there that can be done accordingly. And subsequent, in some

time period, 3, 4, 5, 6 months, there is a restatement of earnings.

Today, the individual profits greatly while the shareholders take

the hit for that write-down of value.

Is there any kind of scenario, if it is a no-cost option, give back

of profits in that environment, is there anything we can do to lock

down and incentivize executives to return to the old fashioned way

of making product?

Mr. GLASSMAN. I agree that that is a big problem. And I know

that Chairman Greenspan said the same thing. I believe, and I say

this in my written testimony, that one step that can be taken is,

in fact, to expense options immediately, the majority of options. I

know that is a controversial issue. I know that there are especially

technology companies that say this would be terrible for them. I

don’t believe that. I understand their concerns. But I think that

would go a long way toward addressing exactly what you are talking about. In other words, there is no reason why there should not

be a level playing field between options and cash compensation so

that companies are making economic decisions about how compensation should be awarded to executives. And I think that that

is a step that I would take.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from Vermont, Mr. Sanders.

Mr. SANDERS. Thank you, Mr. Chairman. The issue that we are

discussing is really not very complicated. And the issue is if somebody invests in the stock market or Mr. White helps invest billions

and billions of dollars representing workers in the stock market, do

they have a right to know that the financial reports that they are

reading, talking about the conditions of the company are accurate

and who is going to help us determine that. That is the issue.

I think the evidence is pretty clear that we cannot simply trust

the industry or the accountants under the present scenario to provide us with that information.

21

I would like to ask Mr. Melancon a question. Mr. Melancon,

while the AICPA has the power to discipline auditing firms and

their employees for ethical and legal infractions, my understanding

or my observation is that it does not seem to be doing that job.

Now I read a little while ago 10 instances of where the top five auditing firms screwed up. Can you tell me the kind of punishment

that your organization levied on any of them? You said in your report, as I understand it, we have zero tolerance for those who

break the rules. Now tell the American people exactly how you

have sanctioned Arthur Andersen and the other companies for repeated violations of the rules, and, in fact, in situations where they

were sued for huge sums of money and, in fact, even fined by the

SEC. Now tell us what the self-governing regulatory body did in

terms of sanctions to those companies?

Mr. MELANCON. Congressman, we discipline hundreds of CPAs

each year. In addition to that, I think as you talk about moving to

different types of bodies, there are obviously issues of individual

due process rights that come into play. And clearly we have supported an enhancement to the disciplinary process that has been

talked about because there are some weaknesses in private sector

bodies being able to discipline primarily concerns in the liability

areas, and so forth.

However——

Mr. SANDERS. Excuse me, Mr. Melancon, may I ask you this. In

the last 25 years, has your public oversight board once sanctioned

a major accounting firm, one time in the last 25 years?

Mr. MELANCON. The public oversight board oversees peer reviews. There have been firms in the top 20 firms in this country

that have gotten modified reports, yes.

Mr. SANDERS. In the top five?

Mr. MELANCON. The firms in the top five have had——

Mr. SANDERS. Who account for a huge amount of the volume.

Mr. MELANCON. There have been individuals that have been

sanctioned in the Big Five, yes, sir.

Mr. SANDERS. In the last 25 years?

Mr. MELANCON. Yes, sir.

Mr. SANDERS. Can you tell me who they are?

Mr. MELANCON. I cannot tell you who they are right now. We

will be glad to provide you that information.

Mr. SANDERS. My understanding, and I stand to be corrected, is

that, in fact, in the last 25 years of existence your supposed regulatory board has never once sanctioned a major accounting firm.

Mr. MELANCON. There has been disciplinary action against members of the Big Five absolutely in that 25-year period. And in addition to that, Congressman, we have a system that——

Mr. SANDERS. Can you describe what—my understanding of that

may mean retraining of auditors. Fines? How much have they been

fined?

Mr. MELANCON. We do not have the power to fine, Congressman.

Mr. SANDERS. You don’t have the power. What do you do, do you

re-train? Do you slap them on the wrist? Do you give them a talking to? What do you do?

Mr. MELANCON. We publicly, in an egregious situation, they are

publicly dismissed from the AICPA, which would——

22

Mr. SANDERS. Any of the Big Five publicly dismissed from the

AICPA?

Mr. MELANCON. Individual members have been, yes, sir.

Mr. SANDERS. Top members? Mr. Chairman, I would say——

Mr. MELANCON. Partners have, yes.

Mr. SANDERS. Mr. Chairman, I would say that here is a situation, some people talk let the industry regulate itself. You don’t

need Government to play a role to protect investors or pension

funds. I would give an example, I would just simply say that the

record is fairly clear that the self-established regulatory group, the

AICPA, has not done the job that is necessary. And in fact, whether we like it or not, the Government is going to have to play a

much stronger role to protect American investors.

I yield back, Mr. Chairman.

Chairman OXLEY. The gentleman yields back.

The gentlelady from New Jersey, Mrs. Roukema.

Mrs. ROUKEMA. Thank you, Mr. Chairman. I, unfortunately, did

not hear all your testimony, but I have reviewed some of it. And

I do have a question for Mr. Lackritz. If I understand his testimony, I believe he said, ‘‘We believe that as part of the effort to

improve disclosure, it would be beneficial to look at the earnings

estimates that firms release.’’

Could you elaborate a little bit more and with more specificity

with respect to how this proposed legislation would deal with that

issue?

Mr. LACKRITZ. Sure, I would be happy to. The issue here is how

to improve the quality of the information in the marketplace. And

while the legislation for example would accelerate reporting requirements that are necessary under SEC regulation, the really

relevant and important reporting comes with the earnings releases

that happen about 21 days after the end of the quarter, not statements to regulators. What we were suggesting was that there

might be a means of suggesting a best practices for releasing earnings estimates into the marketplace that would provide a common

set of practices for firms to follow in addition to the regulatory requirements.

Mrs. ROUKEMA. Well, does this legislation adequately deal with

that subject or how would you suggest that we would refine it and

close any potential loophole there?

Mr. LACKRITZ. We were suggesting that it might go further than

it did and that is why the suggestion was in there.

Mrs. ROUKEMA. Well, if you have anything more that you would

contribute with a specific proposal as to how we would do that, I

would be more than happy to accommodate you and work with you.

Mr. LACKRITZ. Great.

Mrs. ROUKEMA. In defining that. And I must say that I do look

to the SEC for leadership here.

I thank the Chairman.

Chairman OXLEY. The gentlelady’s time has expired.

The gentleman from Washington, Mr. Inslee.

Mr. INSLEE. Thank you, Mr. Chair. From my neck of the woods,

the CPAs are people of integrity and the people I know have acted

very professional. And yet since the Enron collapse, when I have

been thinking about how the accounting industry is structured,

23

where you essentially have one team paying the referee and the

referee being able to go to work for one of the teams afterwards at

a good salary, and the referee being sort of working in tandem with

just one team like the Harlem Globetrotters for 30 years, it is really amazing to me that we have done as well as we can. So this has

been a real eye-opener for me in the Enron situation.

And one thing I think that many of us are considering are how

to gain the independence that we need from auditors while not

having unnecessary dysfunctions in their services, and that is what

I think all of us are looking for.

Mr. Melancon, I was really struck by your testimony. I read your

testimony. I don’t know if you said this verbally, but you had something that really caught my eye. You said that, ‘‘Lower paid, less

skilled accountants may staff audit-only firms, harming the ability

of lead audit partners to go toe to toe with the modern corporate

financial executive.’’

And the reason it struck me is that what I think you posited

there is that we need auditors who can go toe to toe with their clients, if you will, which is a difficult thing to do when the client is

paying you to go toe to toe with the client. But we need, because

we are unwilling to have the market pay for the auditing services,

we are all sort of agreed that we are going to continue the situation

where the client pays the service, and that has obvious huge problems for an auditor to go toe to toe with the guy who is paying him.

And it seems to me we need to look for ways to reduce the disinclination to go toe to toe like that.

Now in your testimony you told us that some auditing firms now

have rules about rotation of lead auditors internally, that that is

a rule. And I assume if you rotate a lead auditor, you would have

the same difficulty of getting up the knowledge bank as you would

if we imposed this rotational requirement. I just wondered should

we look at those differently somehow, if internally companies impose the rotational requirement for their lead auditors, it is a much

greater problem to have a rotational requirement for the firm itself.

And don’t exactly the same reasons to impose a rotational requirement for lead auditor, shouldn’t those same reasons exist for a firm

in itself?

Mr. MELANCON. Congressman, the requirement for rotating a

lead auditor is a profession-wide requirement. It is not a company

requirement. It is, in fact, a requirement that we have put on the

profession.

And on your sort of dilemma issue that you raised, that is why

the audit committee is particularly important in the process, because the audit committee is the buffer if you will in that environment that you described in the pay.

When you look at an audit engagement, there is a team of people, these are multi-national companies in large part today, there

are literally hundreds and hundreds of people involved in learning

curves and understanding the business complexities. To rotate that

whole team of people actually creates a greater risk from an audit

quality perspective. The fact of the matter is is that by changing

the lead partner, which is a requirement again as I said of the

firm, of the profession, we are trying to have, and through standard

setting in the past, have tried to set up a system that approaches

24

the appropriate balance. And that is really—and you sort of described it and captured that very well, it is the appropriate balance

in all of these issues. And so the system that we have in place is

we try to extract the best of knowledge of the enterprise, knowledge of the details, so that the quality of auditing is good, with requirements to take some different look from a lead audit perspective.

We also have a series of requirements if, in fact, someone goes

to work for an engagement that requires the audit—for a client

that the auditor take certain steps.

So it really is all about balance, Congressman.

Mr. INSLEE. So what do you think of this analogy of the referee

situation. I think it would be unhealthy if NBA referees had the

possibility of going to work for management of one of the teams

they are refereeing in, it seems to me that that is an unhealthy situation. But that is the situation we have now for auditors.

And I understand part of your testimony that that decreases the

attraction of the profession a little bit, to think that you now are

less able if you do the auditing function to go to work with management. But how can we tell our constituents that we have got this

increased level of trust in the profession if we continue to allow the

referees to go to work for the people they are refereeing the next

Monday morning after they finish the audit? Isn’t that a major

issue here in trust?

Mr. MELANCON. Congressman, there are series of issues associated with that. There are requirements to discuss that issue with

the audit committee. There are requirements where a person would

go to work for an audit client, if it is during the audit engagement,

that the work that that person did to be re-done by someone else.

There is a requirement that if, in fact, a person goes to work in

an important position in the client, that someone not associated

previously with that audit team review the work of that person and

review that work to make sure that there is a completely different

look and so that there is no, the concerns that you are articulating

or the closeness issues that are taken care of from that perspective.

And in addition to that, if a person is a member of an audit team

and is even offered employment from—not even if he takes it, but

if he is offered employment from a client, he is required to be removed from that audit team.

Chairman OXLEY. The gentleman’s time has expired.

Mr. INSLEE. Just one more comment, if I may. I want to thank

a lot of your members for helping us. I have been talking to a lot

of your members and they have been very good in helping us understand these issues. I just want to pass that on to you.

Thank you.

Mr. MELANCON. Thank you, Congressman.

Chairman OXLEY. The gentle lady from New York, Ms. Kelly.

Mrs. KELLY. Thank you, Mr. Chairman.

Mr. Melancon, could you please tell me—and give me the correct

pronunciation of your name?

Mr. MELANCON. It is Melancon. Congressman Baker had it right

because we both have those Louisiana ties.

Mrs. KELLY. Thank you very much, Mr. Melancon. I would like

to ask you a question. In your testimony, you talk about your oppoVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
25

sition to a cooling off period. We in Congress have one here as do

a lot of the Hill staffers. I am curious about why you don’t see any

conflict of interest for businesses wrongly influencing audits by offering better jobs with the company. You seem to be opposed to

that cooling off period. I wonder if you would talk about that a bit.

Mr. MELANCON. Interestingly, Congressman, in the past we have

articulated concerns in that particular area as a profession. The

Independent Standards Board, which was made up of people, 50

percent who were not associated with the profession at all, spent

a lot of time just in the last couple of years focusing on this particular issue. And the conclusion that was reached was that a series of safeguards was the best way to balance that particular environment, some of the safeguards that I just articulated that require

discussions with audit committees, that require work that that person was involved with being reviewed by someone else in the firm

that didn’t have anything to do with that particular person and the

audit team to ensure that the work is being done correctly. And the

conclusion was reached through a very deliberative process, with

public exposure and a tremendous amount of non-profession involvement in the issue that the right answer was, in fact, a series

of safeguards to produce the appropriate balance.

The other thing that I just might mention on this particular

issue is that the movement of individuals into corporate America,

if we look at that history over the last 40 or 50 years, has had a

tremendous positive influence on the quality of financial reporting.

If we compare corporate America’s internal capabilities today

versus decades ago, we have a much better situation in this country because of movement that is supported in that area.

But the safeguards are very, very important. And Congressman

Baker’s questions about audit committees, I think there is an audit

committee role when that particular situation does occur to ensure

the protection from the shareholder perspective.

Mrs. KELLY. Thank you. I still find it curious that we are held

to such strong restrictions here on Capital Hill and the business

community doesn’t feel any compunction—well, even though you

are talking about your safeguards, you feel that you can get around

that. I hope it works better than the Chinese Walls that are written into some areas.

I would like to talk to Mr. Glassman a minute. You talked about

the fact that you agreed with parts of H.R. 3763, but you think it

is too regulatory and it sends the wrong message to the investors.

What do you see as the wrong message here? Do you think it is

going to hurt the investment for small investors?

Mr. GLASSMAN. First of all, I think there are two points where

small investors are concerned. Number one, as I said earlier, I

think it adds unnecessary costs when you essentially tell really

some of the best corporations in America—there are 8,000, I think

that is the most recent number, listed companies on the three

major exchanges, certainly there have been abuses by some of

them. But the vast majority of excellent companies, companies like

IBM, McDonald’s, Exxon-Mobil use the same company for audit

work and non-audit work, and there is a reason for that. It is the

most efficient way to do it. These companies are very well run.

They are looking toward efficiency. So you add in cost.

26

The second thing, and I think this is maybe more important, the

signal that Congress has frequently sent to investors, not just in

this area, but in some hearings about analysts is that look, if stock

prices go down, somebody is at fault. Somebody, some crook is taking your money away. That is not the way the stock market works.

In 22 years out of the last 76, the stock market has declined. It

goes up. It goes down. What investors need to be told is the market

is extremely risky in the short term. You need to hold diversified

portfolios. You need to hold them for the long term. And to have

them feel that Congress is going to take care of everything, that

there is going to be a law that is going to be passed so that this

stock is not going to go down anymore, that is just the wrong signal. While, as you said, I do agree that there are some steps that

ought to be taken, and I think there are parts of this bill that I

admire.

Chairman OXLEY. The gentlelady’s time has expired.

The gentleman from North Carolina, Mr. Watt.

Mr. WATT. Thank you, Mr. Chairman. I appreciate your calling

this hearing. It has been enlightening and informative. I just had

a couple of comments and maybe one or two questions.

I guess we are all kind of seeking a framework to evaluate what

has happened, and we all do that from our individual backgrounds

and experiences. In my experience of 22 years of practicing law before I came here and working in the trenches beside accountants,

representing small businesses, and seeing them do consulting and/

or auditing and accounting more than perhaps auditing for those

businesses is that there has been a very strong sense of professionalism among both lawyers and accountants. So I have been

kind of wrestling on where I come down on this, whether we should

be heavy-handed and overreacting or whether we should be letting

the market take some of this into account.

It seemed to me that auditors over the years and accountants

over the years have had an even greater responsibility to be independent of the people, the companies for which they are doing work

even than lawyers. Yet there has always been a very, very strict

conflicts of interest set of standards that apply to lawyers in their

relationships with clients and others.

I am wondering, Mr. Melancon, I blow it even worse—I think it

is spelled wrong on our sheets is the problem.

[Laughter.]

Mr. MELANCON. It is just pronounced wrong.

Mr. WATT. Well, maybe it is pronounced wrong. Well, I certainly

just pronounced it wrong.

Do you think that the existing conflicts of interest and/or other

rules in place in your profession are strong enough, the existing set

that are out there, strong enough to allow consulting and accounting and auditing to peacefully co-exist without any kind of further

regulation or do you think there is something that needs to be done

to adjust that?

Mr. MELANCON. First off, Congressman, thank you for the kind

comments about the members of our profession that you have

worked with over the years, and I would agree with your assessment from that standpoint. There are 350,000 members of our proVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
27

fession, men and women doing the right thing in small businesses

and large businesses every day.

Mr. WATT. Don’t take too much of my time to brag about them.

I gave them as much of my time to do that——

Mr. MELANCON. Thank you, Congressman.

Mr. WATT. As I wanted to.

Mr. MELANCON. I will move to the answer to your question.

The fact of the matter is that there are significant rules in place

to protect that environment. We only need to look at the existing

situation to understand that if, in fact, a CPA treads on their reputation, that the horrendous results that can occur. And the thing

that they have to protect is their reputation. And so there is a

more——

Mr. WATT. You know I kind of expected you to say that. I think

the thing that I am having trouble reconciling, and I think Mr.

Glassman probably pointed it out more than anything else, it is

hard for me to be saying that we should let the market control accounting practices at the same time we seem to be ratcheting up

our oversight and rules and laws related to the legal profession.

And so this whole—I mean, it seems to me that what Mr. Glassman is saying is—and I mean this in the kindest way, not in a negative way—almost duplicitous. That we should be ratcheting up the

standards that are at play in the legal profession, but we should

be letting the market kind of control what is happening in the accounting profession.

And so if he could just respond to that.

Mr. GLASSMAN. Well, in the first place, I am not aware of any

PRO that governs the legal profession. I do think however that conflict of interest is a serious problem. There is no doubt about that.

The set-up with CPAs and corporations presents a conflict of interest. The question is how do you constrain it? I think it is very well

constrained by the marketplace where investors say if you guys are

fooling around, we are not going to invest in this company.

And let me just give you an analogy, because it is a business that

I know about and that is journalism. In 1992, according to a survey

by The Freedom Foundation, 89 percent of journalists who were

the chiefs of their bureaus in Washington voted for Bill Clinton for

president, 9 percent voted for George Bush. But I can tell you that

100 percent of those journalists will tell you that they are unbiased, that they put that particular interest aside in their professional lives. And I would say for the majority of them that is true.

And they are constrained by the public. That if their bias shows,

people are not going to read their newspapers. People are not going

to believe them.

Mr. WATT. In drawing a parallel between voting for some Member of Congress or the President and the responsibilities, the professional responsibilities that accountants have to shareholders and

businesses, I think that is——

Mr. GLASSMAN. I am saying that professionals in all walks of life

are torn by conflicts, as are you. I am sure you have personal interests, but you have also obligations to your constituents. And you

are constrained by what your constituents see of your behavior

here. Same thing with investors. I don’t think we necessarily need

rules on rotation. For example, CalPERS can tell companies, ‘‘We

28

are not going to invest in you unless you rotate your auditors.’’ So

those are the kinds of—I think those are much more effective constraints.

Chairman OXLEY. The gentleman’s time has expired.

The gentlelady from Illinois, Ms. Biggert.

Ms. BIGGERT. Thank you, Mr. Chairman. I am sorry to have

missed the testimony, but I still have a couple of questions that I

would like to ask.

One of the issues that came up in one of the hearings recently

was the fact—there was a discussion of whether audits now always

have to be unqualified or whether an auditing firm can give a

qualified opinion. I know that in the past they could. But it was

stated, I think on the other side of the aisle. I don’t know whoever

can answer that, I would appreciate it.

Mr. MELANCON. Certainly there can be qualifications to an audit

report today. I think that comment was probably related to where

there is a qualified opinion, there is any gradation of a qualified

opinion. And so I think that was where it is. But there are qualifications available.

Mr. GLASSMAN. Could I just comment on that briefly?

Ms. BIGGERT. Yes.

Mr. GLASSMAN. This is what I was trying to drive at in part of

my testimony. I really think that audit firms should be freer to tell

people, tell investors in clear English what is going on with a company. For example, I think Andersen could have said, if it believed

that these books were sound, that everything here is on the up and

up. However, investors should be aware that there are hundreds of

special purpose entities out there, that here are the liabilities. That

is the obligation of accountants. And I think frankly that they have

failed in that obligation. But part of the reason they fail is the

structure, the incredibly complicated structure of the GAAP system. In fact, if it were loosened and more judgment were involved,

but also more accountability, the system would work better.

Ms. BIGGERT. And I think that that is what I was driving at in

asking that question. And it seems that there is—they want to

make it appear the best and even if it is qualified, there still isn’t

any statements on that. So I would agree with you.

The other question I have is talking about real time disclosures.

And it is my understanding that when officers now sell stock or

purchase—particularly selling their stock, but purchasing, that the

newspapers do carry that. And I guess I would ask this of Mr.

Glassman.

Mr. GLASSMAN. Yes, the way that the current system works is

that smart CEOs who want to conceal their sales can time it in

such a way that it doesn’t appear for 40 days. And I think there

is no reason on earth for that. I think that sales and purchases of

stock by insiders are an important market signal that investors

should know about. And they should know about it the instant that

it occurs. And I think the technology is there for that happen. And

it should happen.

Ms. BIGGERT. In the paper, but certainly there has never been

any education to the public or to anyone that this is an important

item that maybe as an investor they should be watching for.

29

Mr. GLASSMAN. Well, there are services that provide this information. It can be overrated as an item. There are hundreds or

thousands of little items that go into making decisions about investments. And I think that is one of them. It is not dispositive.

It doesn’t mean that because someone has sold stock as an insider

that there is something terrible going on with the company. But

that is a piece of information that people should be able to take

into account. Right now, frankly, they can’t.

Ms. BIGGERT. So you would agree with the bill then, that it

should be immediate disclosure?

Mr. GLASSMAN. Right, what I say in my testimony is actually

that the disclosure should be faster. The bill allows essentially 2

days for the information to get to the public, I think it should be

2 minutes.

Ms. BIGGERT. And then as far as the restrictions on selling stock,

the selling in the blackout period for officers should be the same

as the employees, the restrictions?

Mr. GLASSMAN. I agree with the blackout period in the interest

of fairness, even though I understand that there is a difference between assets held in the 401K plan and assets held outside the

plan by executives. But I think this is a hardship, if you want to

call it that, that executives of corporations should endure in the interest of fairness. So, yes, I think there should be a blackout period

for them too.

Ms. BIGGERT. OK, thank you. Thank you, Madam Chairwoman.

Mrs. ROUKEMA. I thank you. Now, Mr. Kanjorski.

Mr. KANJORSKI. We seem to be talking around the issue in terms

of what transparency and accountability will do.

First and foremost, I will tell you what I am disturbed about. If

you look at the Enron situation, it seems that because of the accounting system that was established, there was not a clear disclosure of all of these risky transactions that were happening. Then,

we see that the pension fund was heavily invested in its own stock.

401Ks particularly were heavily invested by the employees. But

also, when you look across the country, we have the pension funds,

throughout the States, the public pension funds and the private

pension funds, that were heavily directed to one stock. So the loss

factors, it seemed as a result of the Enron collapse, fell upon people

who were not in control of their investments. Their investments

were basically being made by investment companies on Wall

Street. These companies were deriving profits from the transactions on commission basis as opposed to having anything at risk.

They had nothing to lose, and they could only gain by the transactions.

As we move toward democratic capitalism, and that is what we

are talking about, we have to recognize, I think, a couple of factors.

One, a lot of these people do not directly control their investments.

They are controlled by ‘‘specialists’’ who reside on Wall Street. Second, they are not the best informed investors in the world. Now,

unless we develop a system that guarantees that we are either

going to educate our investors, and that is a large mass of new investors, and we are going to give them some capacity to directly

control their investments, they are at risk of these people that did

not exercise diligence. These people were the 14 out of 15 analysts

30

that were calling for purchasing Enron’s stock up to a week before

the collapse. It is ridiculous. All of us are shocked.

Now, it seems to me that the accounting profession and the accounting firm clearly did not follow principles and rules of accounting to account for all these risky transactions on the book. If they

did, they wrote it in such a way, in such language, that not even

the best Wall Street analyst could penetrate the language to understand the risk. So clearly, if we do not do something there, this is

going to continue in the future.

On the other hand, we run the risk of passing legislation very

quickly, and then getting the unintended response. I understand

we are hell-bent on getting this legislation passed by Memorial

Day, which is shocking to me, because I do not think we know the

extent of the problem here.

So maybe any one of the four of you can tell us what you think,

or tell me what you think this problem really is at this point and

whether or not the Congress of the United States is so able, that

it should be able to act in 2 or 3 weeks to solve the problem?

Mr. GLASSMAN. Let me respond quickly. I agree with you that

this Congress should not be hellbent on finding a solution, because

we really do not even know all the facts in this case. They are just

not out yet.

But I just want to comment very quickly on one of the things you

said that I completely agree with, and I am glad that you brought

it up, Congressman, and that is this issue of investor education,

which I have devoted a good deal of my professional life to. The

fact is that 50 percent of Americans now own stock. It is going to

be 60, 70, 80 percent within a few years. And that is good. That

is good. However, many of them really do not understand the basics of investing. And I really think that if there is a role, a major

role for Congress here is in making sure that investors do have

that base in education. Now in most cases they are going to have

to trust professionals to make these decisions, these investing decisions for them. And most of the time professionals do a good job,

but they do need that base of education.

And that to me is one of the most important factors that has

come out of this Enron case, how little people still understand

about the basics, such as diversification. That is the way to protect

yourself against an Enron.

Mr. KANJORSKI. Yes?

Mr. Lackritz. Mr. Kanjorski, I would like to respond to your

question too. I think that it is very important to get this right rather than necessarily getting it fast. That being said, I think there

are a number of provisions in this legislation that obviously are

going to help to improve the quality of information in the marketplace, and the real issue here is how to improve that quality of information, because that is what everything else stems from.

And then to go on with the other point that Jim Glassman raised

with respect to investor education, I think that is something that

both the private sector and our association is engaged in in a big

way. We are launching an investor education website next month

that will draw together the best of class investment advice, objective investment advice, because there is nothing that is being sold

31

on this site. It is going to be made available throughout the country.

And so I think that along those lines, I think some of the responses we are making go to that question that you have raised as

well.

Mr. WHITE. From our organization, I would be the first to say

that we do not want to see overreaction either. We are one of the

groups with significant assets at risk in the financial markets. We

care more about how they work than any other group. But what

I would submit to you is that the issues that are on the table and

all the current forms of legislation and SEC Chairman Pitt’s proposal and President Bush are not at all overreaction. These issues

are not brand new. They have been on the table for years. The

issue of auditor oversight and the issue of auditor independence are

things that have been fully debated in the public.

We are an end-user of this, and we are completely convinced that

the measures that are being debated are absolutely essential to the

capital markets and to our protection as an investor.

Mr. KANJORSKI. I am not sure I understand. You think we should

adopt immediately, before Memorial Day, the Bush solutions and

then go home?

Mr. WHITE. No, I am not saying that that should be a deadline.

But what I am saying is that the issue of overreaction is one that

we just simply do not agree with. These issues are all real. And,

yes, let’s take the time to debate them and discuss them, but I

think the comments toward overreaction are more geared toward

slowing down the process so real reform does not take place.

Mr. KANJORSKI. Do you really think that the Congress——

Mrs. ROUKEMA. Excuse me, excuse me. The 5 minutes are up,

but will you let the last panelist respond to your first question. I

do not think you have time for another question.

Mr. MELANCON. Thank you, ma’am. Just a couple of quick points.

I think, Congressman, the overreaction or the unintended consequences is something you should be concerned about, because it

has a dire concern to us in the financial market system. As to the

education of people, this Congress enacted a tax-free benefit to educating employees on investment advice, which was a good first step

in this education activity. And if you had to focus on one thing that

was important to changing this whole environment, that is a financial reporting model that is not rooted in the 1930s, but is commensurate with the world that exists today.

Mrs. ROUKEMA. I thank you.

Congressman Shays.

Mr. SHAYS. Thank you, Madam Chairwoman. I would like to ask

Mr. White some questions and preface my statement by the fact

that in our previous hearings and going over the Powers Report,

Enron clearly is a story of a tremendous amount of greed. And no

profession looks good. The accountants do not look good. The lawyers do not look good. The analysts do not look good. The bankers

do not look good. And the investors do not look good either, particularly even your organization frankly.

And I want to ask you about the special purpose entities and

why you invested in them?

32

Mr. WHITE. First off, I am not the best person at CalPERS to answer those questions. I will gladly answer what I can and if you

want further detail, I will be more than happy to respond in writing at a later date.

The two private equity deals that CalPERS did with Enron were

fundamentally different in their nature than the partnerships that

got Enron ultimately into trouble. And I would note to you that

CalPERS declined to invest in those relationships after the fundamentals of the investment proposal changed. Why there is

criticism——

Mr. SHAYS. Well, you invested in Jedi One and you invested in

Jedi Two. And Jedi Two was basically determined to be somewhat

illegal, wasn’t it?

Mr. WHITE. I do not believe that is accurate, no.

Mr. SHAYS. Do you have any expertise to be able to respond to

us on these issues? What expertise are you bringing here?

Mr. WHITE. My role is—I am the Director of Corporate Governance. The private equity unit in CalPERS is an asset class that is

headed by a senior investment officer. And those questions——

Mr. SHAYS. The reason why I thought you were here was that

basically you were a major player with Enron. Isn’t that true?

Didn’t you invest almost $300 million in the first one. And almost

$500 million in the second?

Mr. WHITE. Correct.

Mr. SHAYS. And what brought Enron down was the fact that

these special purpose entities were basically hiding their liabilities

and over-inflating their income. Isn’t that true?

Mr. WHITE. Well, the two partnerships that CalPERS invested

in, number one, did not have the conflicts of interest that the later

partnerships, which CalPERS did not invest in had. There is a fundamental difference in that. Our organization was not interested in

participating in those, because we did not like——

Mr. SHAYS. Were you an investor in the company besides having

these special purpose entities?

Mr. WHITE. Correct. We hold common stock in Enron as well

as——

Mr. SHAYS. So you had common stock and yet you were part of

an operation, all these special purpose entities basically enabled

the company to get into the fix they were in. And when they had

to disclose Jedi Two, they basically were disclosing a tremendous

amount of liabilities that nobody knew. That is what basically

brought the company down. And that was your investment.

Mr. Glassman, do you have any comment on this?

Mr. GLASSMAN. Yes, because I think actually the worst thing

that CalPERS did, which the New York Times revealed on February 5th, and I mentioned in my oral statement, is that when it

was alerted about the nature of another one of these special purpose entities by its advisors in December 2000, it declined to invest

in it. As Mr. White said, it did decline. But then it did not live up

to what I think is its moral and public responsibility to bring the

matter before the board of Enron. And more important I think

what I would have done at CalPERS, I would have brought it to

the attention of the American investing public.

Mr. SHAYS. Let me ask why——

33

Mr. GLASSMAN. And if that had been done, we may have learned

about this whole Enron situation at least 9 months before we

ended up learning about it.

Mr. SHAYS. Why wasn’t that done, Mr. White?

Mr. WHITE. Again, personally I was not even on staff at the time

that that happened. But while it is true CalPERS is a leading governance organization, and we pride ourselves on being an active,

involved owner, we cannot read the tea leaves. We do not have a

crystal ball. While there may have been a conflict at Enron, it was

impossible for anybody to forecast that those conflicts would mushroom into the types of relationships and become what is apparently

fraud at Enron.

Mr. SHAYS. See, I have a different theory and unfortunately, you

are not—you are saying you are not capable of answering. My theory is that basically you were making such a great return on the

first 22 percent and then you were making 62 percent on an

annualized basis, that you all basically were part of the problem

like everyone else. You were part of the whole thing on greed. It

would seem to me that anyone who is making 62 percent says,

‘‘Hey, why is this happening?’’ And when they start to ask the

questions, they learn. In your case, you learned and then your organization remained silent.

Mr. WHITE. No, sir, our organization did not invest. The types of

returns that we made on the partnerships——

Mr. SHAYS. Did you invest in Jedi two?

Mr. WHITE. Correct.

Mr. SHAYS. Isn’t it true that you had an annualized gain through

June of 2001 of 62 percent?

Mr. WHITE. I believe that is accurate.

Mr. SHAYS. OK. I mean, when you are getting that kind of return, it should tell you a lot of things. And one of the things it tells

you is maybe this is not happening in a way that is credible.

Mr. WHITE. Well, if I may respond? If your theory about our decisions were driven only by greed were correct, then those returns

would have led us to invest in the next partnerships, yet we did

not.

Mr. SHAYS. No, I think by then people were aware of what was

going on. I think by then people knew that this was a house of

cards that was about to collapse.

Mr. WHITE. I think to the contrary, Enron was only beginning to

form all of the partnerships that had the terrible conflicts of interest that led to the problems, at that point in time. You remember

this 1996, 1997 era. So at that point in time, Enron was not even

forming those partnerships.

Mr. SHAYS. My time is up.

Mrs. ROUKEMA. All right, thank you.

Mr. Sherman.

Mr. SHERMAN. Thank you, Madam Chairwoman. I am glad we

are doing something, hopefully not by Easter, but by the Fourth of

July. And what we should do is not mere window dressing. We cannot just use the bully pulpit of this committee to urge Wall Street

to all join hands and sing Kumbayah or community values are better than greed. Nor can we scream, ‘‘Caveat Emptor’’ at the investing public.

34

I hope very much that we do not introduce ‘‘judgment’’ into Generally Accepted Accounting Principles to the point where two identical companies will be issuing wildly different financial statements

based on the different styles of the auditors that they select, nor

can we analogize the conflicts of interest faced by an auditor, by

that faced by a journalist who might happen to vote for Al Gore.

The difference between the local journalist on the one hand and

David Duncan of Arthur Andersen on the other is $52 million. Now

if there was any journalist getting $52 million for himself or his

publication, then perhaps that would be an equivalent conflict of

interest.

I hope that if we rotate, we will also look at providing tenure to

auditors. Otherwise if you have a chance of being the auditor for

8 years, but you can get fired after 1, then perhaps Ken Lay will

be able to convince you to go a little easy on which special purpose

entities you consolidate.

Mr. Melancon.

Mr. MELANCON. Melancon.

Mr. SHERMAN. Melancon. On the wall of my office is the AICPA

certificate. I hope our colleagues recognize that you are a voluntary

organization like the ABA. Many CPAs choose not to pay you dues.

The worst you could do to a CPA is throw him out and then he

saves the dues. Really the worst you can do though is publish rules

that if we violate, some lawyer can sue us. And it is your rulemaking, not your ability to discipline members who after all do not

really want to pay your dues anyway that is key.

I think you are wise to bring up the fact that we need not only

untainted judgment, which is the focus of these hearings, but

smart investigators. And those two are in conflict. A smart investigator would love to be involved in the internal auditing because he

would learn more about the company or the accountants would

learn more about the company. But then they would get a fee

which might taint their judgment. Likewise, rotation may reduce

the tainted judgment, but might prevent the audit from being as

effective as it would be because you are in a learning curve the

first year of an audit. So I would hope that we would make sure

that auditors remain good investigators as well as do everything

we can to prevent them from having tainted judgment.

I would like to focus on one area where I think the AICPA——

Mrs. ROUKEMA. Excuse me, Mr. Sherman. I do not know that you

realize that a vote has been called. So do you want to continue this

or do you want to recess—do the two votes on the floor and then

return because your time is almost out?

Mr. SHERMAN. Why don’t I continue and then we can go vote.

Mrs. ROUKEMA. Go ahead.

Mr. SHERMAN. The one area where I think the AICPA screwed

up is in allowing Arthur Andersen to adopt a structure where the

technical review department did not have final authority over

whether Arthur Andersen signed the financial statements. And

that is like having a situation where the life insurance agent decides whether to insure me for $10 million despite a little heart

flutter rather than the underwriter back at the home office. What

we I would hope, and I would like to know if you are planning to

do this soon, adopt an ethics rule that every member of the AICPA

35

must vote within their firm to demand that it is the technical review department that makes the decision as to whether to sign the

audited financial statement. Otherwise we are going to be in a situation where the guy whose chief job is to go golfing with Ken Lay

is the guy that makes all the decisions as to whether Arthur Andersen’s name appears at the bottom of the audit report.

I would like you to respond.

Mr. MELANCON. Congressman, first off, I appreciate the fact that

you have the AICPA certificate. And I understand your point on

that control issue. And I think it is one that is very important for

us to take a look at. It would be in the issue of quality control. It

would be in the standards in the SEC PS just from a technical

standpoint. And I am sure that we will, in fact, take a look at that.

Mr. SHERMAN. Well, I am sure you are going to look at it. I hope

that you will call me a month from today and tell me that you have

decided to change what is a glaring hole in the ethics rules that

you have control over.

Mr. MELANCON. Thank you, Congressman. I would also say, I

would agree with you on the issue of discipline and that is why we

have supported, as I think you have, the notion of an enhanced capability of discipline that actually is beyond the way you described

it from that standpoint.

Mrs. ROUKEMA. I think we are going to have to recess now because the bells have rung. I would just ask the Members to please

return promptly so that we can continue and conclude with this

panel.

Pardon me?

Mrs. MALONEY. Can you tell me who the next questioner is,

please?

Mrs. ROUKEMA. Dr. Weldon on our side and you will follow that.

Mrs. MALONEY. Very good, I will rush.

Mrs. ROUKEMA. You are the second one after the recess. All

right, we will be back shortly.

[Recess.]

Chairman OXLEY. [Presiding] Come to order. And the Chair

would recognize the gentleman from New York, Mr. Grucci.

Mr. GRUCCI. Thank you, Mr. Chairman. At the risk of destroying

your name once more, would it be OK if I called you Barry?

Mr. MELANCON. That would be great, Congressman.

Mr. GRUCCI. Thank you for that. You had in your testimony earlier talked about the ability of industry to self-police itself. And I

concur that industry can do a good job of doing that. And you

talked about some of the issues that took place, some notices in

files and people being expelled, and so forth. If I was a business

and I wanted to know about an accounting firm that I was thinking

about putting on to give me the types of information and look over

my books, and contacted your operation, if indeed there was a sanction against them, would I be able to access that information?

Mr. MELANCON. You would be able to access the results of their

peer review report and discipline is typically on an individual basis,

however, Congressman.

But it is important to make one point on this that I didn’t get

to make on the other, and it is along the lines of your questioning.

One of the advantages that we have—and we support enhanced

36

discipline and an enhanced regulatory body for discipline. So we

are not opposed to that. But one of the advantages that we have

is that if a auditor, a partner, a public company auditor is alleged

to have done something wrong, we do not have to—by rule we do

not wait until the culmination of the investigation. We can require

the firm, and we do today, require the firm to take that person off

of audits. They have a choice. They can take the person off audits.

They can fire the person. Or they can build an infrastructure

around the person to protect the public in effect without going

through the whole due process system that would be in a normal

Government environment. That is a public protection point. It is an

advantage that we have. Now we have some disadvantages as well.

Mr. GRUCCI. But, I guess what I am trying to get to is that I

would be able to determine as a business owner that a firm that

I was thinking about hiring indeed had some issues that were

being addressed by a peer review board of some sort. What kind

of an effect do you think that that would have?

Mr. MELANCON. You could get their peer review report and something called their letter of comments, which is sort of like management suggestions and you could have dialogue with the firm as to

what are they doing to fix those letter of comments, if they have

any, and you could reach a conclusion from that standpoint. All

45,000 firms in the country go through a peer review.

Mr. GRUCCI. And I would suspect that they don’t look forward to

those types of peer reviews because it could have a chilling effect

on their business?

Mr. MELANCON. Congressman, firms, first off, invest millions and

millions and millions of dollars in their systems of quality control

to avoid failing that process, which is a part of the constant improving process that is in place in our profession, because failing

that process is like putting a gun to your head.

Mr. GRUCCI. Thank you. I would like to move to Mr. White if I

may. You represented a pension fund that has $150 billion, and I

don’t know how much of it was invested in any single company. I

do not wish to drag up the Enron issue. But what I do wish to ask

you is when you are about to invest parts of your pension fund in

either a company or in a construction project or whatever you may

be investing in for the purposes of getting a return back for the retirees. What process do you go through to make that determination? When I make an investment, basically because it is such a

small investment on my part, it is a gut hunch. Do I think that

investment is going to do well or not? I would think that you would

do more than just a gut hunch when you put millions upon millions

of dollars of retirees’ pensions at risk. Could you bring me through

the process that leads you to your investment decisions?

Mr. WHITE. Certainly. The bulk of our assets, approximately twothirds, are invested through what we call an index strategy, it is

a passive strategy. You will find that many large institutions use

that because it is a cost-effective way for us to get equity exposure

to the market. We also invest through active strategies through

both internal programs and through external programs. We also

have private equity partnerships. We also have a real estate program. You will see a huge distinction between how institutional investors put money out on an index strategy versus an active stratVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00044 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
37

egy. For the index, if companies are included in the index, by and

large we are going to hold them.

Mr. GRUCCI. Let me try asking this another way, because I am

not sure I made myself clear to you. When you invest the money,

is there a criteria that you go through? Is there a checklist that you

go down? Is there some kind of thought process other than, yes, I

know that project, it sounds like a good one. I think I will put some

money in building a shopping center or building offices or investing

into a corporation. What do you do to ensure in your own minds

that you have made the right decision in investing in that product?

Mr. WHITE. OK, let me just get to the distinction quicker then.

Through our active strategies, we do a high level of due diligence,

that includes the real estate program. It includes the private equity

program. And it includes the active investments on the public market side. Our external managers that operate on our behalf, as well

as our internal managers, do due diligence on company specific.

This is fundamental research on the things that you are asking

about, whether or not we feel that a company is under valued or

overvalued.

On the index strategy, again which is the bulk of our assets, we

are buying the market index. It is an efficient way to get exposure

to the markets. But what it does is it gives us companies in our

portfolios that you may not pick through an active strategy, companies that are weak. It is one of the reasons that CalPERS has such

an active corporate governance program, is because our size necessitates that we have broad equity exposure. We simply could not

in a cost-effective way make active decisions for a portfolio of our

size.

Mr. GRUCCI. Thank you and I assume my time has expired.

Thank you, Mr. Chairman.

Chairman OXLEY. Thank you, Mr. Grucci.

Mrs. Jones.

Mrs. JONES. Thank you, Mr. Chairman. When you are doing, Mr.

White, your active strategy, what do you use—let me be just real

straight. You rely on an audit to make your decision about a company, whether you are going to invest in them, don’t you, sir?

Mr. WHITE. Yes, ma’am, we do.

Mrs. JONES. Thank you. Let me turn to Mr. Glassman. Mr.

Glassman, tell me what is the American Enterprise Institute, sir?

Mr. GLASSMAN. The American Enterprise Institute is a thinktank started about 50 or 60 years ago. They have 150 people who

work there. A think-tank is——

Mrs. JONES. I know what a think-tank is.

Mr. GLASSMAN. OK.

Mrs. JONES. Thanks. Mr. Glassman, what is your area of specialty at the Enterprise Institute?

Mr. GLASSMAN. Economics, finance, markets, although I have

wide-ranging interests, including education and health care as

well.

Mrs. JONES. OK, but you are here based on your economics and

finance background today, is that correct?

Mr. GLASSMAN. I think I am mainly here because I have for

many years written a column about investing that is syndicated, it

is in The Washington Post.

38

Mrs. JONES. Simple answer, Mr. Glassman, you are here because

of your background or experience in this area. I only have 5 minutes. I can’t give you a chance to do all you would like to do.

Mr. GLASSMAN. Yes, yes.

Mrs. JONES. OK, now, would you say that as a result of the regulations of the SEC that accountants have a place in the process of

investment that few other professionals have?

Mr. GLASSMAN. Yes.

Mrs. JONES. And as result of that, that puts a greater burden

upon auditors to be highly ethical in their conduct and forthcoming

in the work that they do on behalf of companies. Is that a fair

statement?

Mr. GLASSMAN. I think it puts a great burden on them, greater

than corporate executives.

Mrs. JONES. Well, let me finish. Greater than any other profession that is not required by the SEC?

Mr. GLASSMAN. Quite frankly, I think corporate executive boards

of directors have enormous responsibility.

Mrs. JONES. I was not talking—listen to my question.

Mr. GLASSMAN. Probably greater than accountants.

Mrs. JONES. Mr. Glassman, listen, my question was with regard

to accountant——

Mr. GLASSMAN. Right.

Mrs. JONES. Professionals dealing with companies, they have an

unusual placement by the SEC, greater than any other professional, I mean a lawyer, I am not talking about the people in the

business. I am talking about professionals that are hired by the

company. You don’t have to have——

Mr. GLASSMAN. I don’t necessarily agree with that, but there certainly is a great burden.

Mrs. JONES. Well, let me ask you this question. You don’t have

to have a lawyer to allow people to invest in your company, do you,

sir?

Mr. GLASSMAN. I think it would be a good—I can’t imagine——

Mrs. JONES. I didn’t say whether it is a good idea, but you are

not required by the SEC to have a lawyer?

Mr. GLASSMAN. I guess not.

Mrs. JONES. And you are not required to have a doctor?

Mr. GLASSMAN. No.

Mrs. JONES. And you are not required to have a psychologist?

Mr. GLASSMAN. Right.

Mrs. JONES. But you are required to have an accountant who is

to do the audit. Is that a fair statement?

Mr. GLASSMAN. Correct.

Mrs. JONES. I say that to get to the point that you are saying

that we ought to allow the industry to regulate—the market regulation to require—to do compliance in this area, is that a fair statement?

Mr. GLASSMAN. No, it is not a fair statement. I think that investors apply—you can call it the market if you want to think about

it as——

Mrs. JONES. I got that word from you. I wrote a quote, but if

you——

39

Mr. GLASSMAN. The investors and the market apply a tremendous discipline to corporations to behave correctly.

Mrs. JONES. Who applies the discipline to the auditors?

Mr. GLASSMAN. To the auditors? Well, let’s put it this way. Arthur Andersen has just been accused of doing some terrible things

regarding Enron. It has been fired by some of the biggest corporations in America.

Mrs. JONES. But what does that do for—since you all are beating

up on CalPERS, claiming they made so much money, what does

that do for the other smaller public employment retirement systems that lost money as a result of the reports or audits done by

Arthur Andersen that were not factual?

Mr. GLASSMAN. There is no doubt that among the 8,000 listed

companies in America some of them misbehave. Now actually Mr.

White just said something important about indexing. Enron——

Mrs. JONES. My question is, what does that do for the poor people who lost their money as a result of the misrepresentation of Arthur Andersen?

Mr. GLASSMAN. Well, I have to say that the nature of the stock

market is that you sometimes lose money. And you sometimes

make money. Dell Computer was up by 7,800 percent.

Mrs. JONES. OK, that is enough.

Mr. GLASSMAN. You don’t have to turn that money back.

Mrs. JONES. Let me go back to this. That maybe the nature of

the stock market that you sometimes lose money and sometimes

make money.

Mr. GLASSMAN. Correct.

Mrs. JONES. But when you invest in the stock market, you invest

knowing the financial situation of the company, whether you win

or lose, and you chose to win or lose based on that knowledge.

And I will be done, Mr. Chairman.

Mr. GLASSMAN. Oh, can I respond? Absolutely.

Mrs. JONES. Oh, I want you to respond, sir.

Mr. GLASSMAN. Absolutely, Congresswoman. I think that that is

true. You either make money or lose money. In the case of

Enron——

Mrs. JONES. You said you make money or lose money. My statement is you make money or lose money and you invest based on

the knowledge you have on the financial condition of the company.

Is that fair?

Mr. GLASSMAN. There is no doubt about that and that is why we

are here today. Enron misrepresented its financial statements. It

is dead as a company. Capital punishment has been inflicted on it

before it was ever indicted, before Congress did anything, before

anybody did anything. And that is probably true as well——

Mrs. JONES. But what we are trying to do here today——

Mr. GLASSMAN. Because of Arthur Andersen.

Mrs. JONES. Is figure out how we never find ourselves in that situation again.

Mr. GLASSMAN. I realize that.

Mrs. JONES. And the position that I am trying to get is that you

have auditors who have a position better than anybody else in the

investment world and therefore there has to be a greater obligation

on them to represent the truth.

40

And I yield the balance of my time. Thank you.

Chairman OXLEY. Thank you, Ms. Jones.

Mr. Cantor.

Mr. CANTOR. Thank you, Mr. Chairman. I would like to ask Mr.

Glassman, in your testimony I think it is fair to say, and if not,

please correct me, that while you agree with parts of the bill, H.R.

3763, you contend it might be too regulatory in its approach and

sends the wrong message to investors. Can you respond to that assertion and perhaps offer some suggestions if that is your position?

Mr. GLASSMAN. Well, it is my position. I think there are certain

things that should be done that I outlined in my oral testimony

and my written testimony. I think there should be a blackout period. I think there should be stricter accountability. I think there

should be contemporaneous reporting by executives when they buy

or sell stocks. But I worry about for example the notion that Congress should decide the functions that auditors perform within a

company. There is a good reason why corporations, the biggest and

best corporations in America, corporations completely beyond reproach, and I mentioned some of them earlier, companies like

Exxon-Mobil and IBM and McDonald’s, and I don’t want to leave

anybody out, there is a reason that they pay more in proportional

sense for non-audit services than audit services because they think

they are getting good value. And when you come in and decide that

this not the way that they should be doing business, it causes them

to incur extra costs, reduces their efficiency, and diminishes their

profits and therefore their value to shareholders. So I think that

is a big problem.

And the second problem is something I alluded to earlier, which

is that we are telling—in hearings like this sometimes people get

the wrong message, investors get the wrong message. And the message is that the reason that stock prices go down is there are all

these crooks around who are out to make money and do things in

nefarious ways and that is why you, the poor shareholder, is losing

money. That is not why people lose money in the stock market in

most cases. The reason they lose money is because stocks do not

go straight up. They never have. About one out of every 3 or 4

years, the market as a whole goes down. And I think it is very important that investors, that Americans understand that and structure their portfolios accordingly. So that is basically my point.

Mr. CANTOR. Can you talk about and address the issue of repealing litigation reform and say that it would not help shareholders.

Can you try and address that as well?

Mr. GLASSMAN. Well, I just, you know, despite litigation reform,

there have been many, many cases filed, actions taken, I cited in

my testimony the Cendant case in which Cendant paid $2.8 billion

to settle a shareholder’s suit. The accounting firm that was involved paid $330 million. Lots of money has been spent to settle

suits since this law was passed. And some in Congress are pointing

to this law as a reason for the Enron scandal itself, and I am just

saying that it is not and I don’t think that law needs to be revised.

And I think if anything, the bar ought to be raised, because the law

still makes it so easy to sue companies that really are not doing

anything wrong in many cases. In some cases they are, and I think

it is good that they are sued and they ought to pay for it. However,

41

it does distract executives and causes money that shareholders—

shareholder assets get paid out in these lawsuits. It hurts shareholders.

Mr. CANTOR. Thank you, Mr. Chairman. I yield back.

Chairman OXLEY. Ms. Waters.

Ms. WATERS. Thank you very much.

Mr. White from CalPERS, how much did we lose with our Enron

investments in California?

Mr. WHITE. At CalPERS, I can speak for CalPERS, we still have

assets at risk. As it stands right now, we have total losses based

on the book value of approximately $9 million. But we still have

private equity assets that are what I would say at risk. We do not

know how much of that we will be able to recover.

Ms. WATERS. Thank you very much. I have a million questions

I could ask, but I chose to use this time to distinguish between the

thinking of American Enterprise Institute as represented here by

Mr. Glassman and the more conservative thought in America politically. I am a Democrat. I am a liberal Democrat. I believe in the

body of law that we have developed in this Nation to protect consumers. I do not take the position that they ought to know better.

They ought to be smart enough. We have consumer law that is developed in so many ways. For example, maybe people should know

the difference between bad meat and good meat. But we do not

leave it to them. We have meat inspections. Maybe people should

know how to protect themselves against dirty water. But we have

laws to ensure that we have clean water. Maybe people should

know the difference between big banks and financial institutions

that do predatory lending and all of that and insurance companies,

but we do not just leave it to them. We believe that Government

has a role in helping to protect the least of these or the average

consumer. And perhaps we should not have any building and safety

laws, because people ought to know when they contract with someone to build a building, that they are just going to do the right

thing.

That is where you and I differ. That is the difference between

your conservative thought and my more liberal thought. We believe

that Government must play an important role in protecting consumers. And when we find that Government is intruding unnecessarily, we should stand up for that also.

To assume that somehow because Enron has been caught and it

is going to have to pay a price that the market is working fine and

we should not worry about having to come up with new law by

which to deal with the problems that have surfaced. However, how

many people have to be hurt? You talk about the biggest and the

best corporations in America. Enron was considered the biggest

and the best. It even got an award for being the best. Enron enjoyed close relationships with the President of the United States

and Members of Congress and they gave out lots of money. They

were all at the best parties. They said the right things. It was considered one of the biggest and the best.

If you are saying do not get involved in creating new law or getting overly involved in this because it is all right now, they are

going to be punished, what do you say to the pensioners who had

their life savings in that 401K that was managed by Enron that

42

helped to make them feel comfortable in putting their funds into

the company stock? What do you say to the person who had no

more than $300,000 or $400,000 to live with for the rest of their

lives once they retired? Don’t worry. Don’t worry. If another company does something bad, we will catch them. The marketplace will

work.

No, the political difference and the philosophy that is so different

here is that some of us no matter what you say about the fact that

they will have to pay a price, we come at this differently and we

say we should not allow people to get harmed time and time again,

because eventually the thieves will get caught and the big corporations may come down. Just do not bother with trying to create a

body of law that will prevent it.

Well, I want you to know we disagree with you, Mr. Glassman.

And we do not think for one minute that the fact that Enron is

going to have to pay a price that that is enough. We think that we

should use the power that the people have given us to legislate, to

prevent this kind of catastrophe from ever happening again.

And so instead of asking you a question, I just want to help people to understand the difference in your thinking and someone like

me, my thinking. And probably conservatives versus so-called liberals. We are people who believe that Government must play a role

in protecting folks. If you say don’t they know they should diversify, don’t they know that the stock market is cyclical and that it

changes and they should be aware of that, no, we do not take it

for granted that they know. And that is why we are going to protect social security from being privatized and leaving retirees out

there at the mercy of the suede shoe boys who would take their

money and do whatever at the time they can do with it and leave

them penniless.

So without having any questions to you, I hope that the students

around the country are listening to this so that we can help them

to understand the difference between the conservative thought that

comes out of the American Enterprise Institute and the thought of

us liberals about consumerism and how we use our role in Congress to protect folks who some people think ought to know better,

but maybe they don’t.

Thank you very much.

Chairman OXLEY. The gentlelady’s time has expired. And I would

like to start a short second round, and say to a great extent there

are elements of Ms. Waters’ comments with which I agree. Just because a corporation is large, just because it has been successful,

just because it is well regarded does not necessarily mean that it

is not subject to failure nor criticism nor that regulatory changes

are in order. I would welcome her participation with regard to the

GSEs in that regard.

I would also say that——

Ms. WATERS. You got it.

Chairman OXLEY. I would also say that despite the fact we suffered great loss on 9–11 and that we have suffered another great

loss with the demise of a Fortune 50 corporation, that the markets

have remained extraordinarily responsive and appropriately balanced to these difficult times. Investors, although guardedly, are

43

still investing their money in the greatest capitalist system in the

world and our profiting from it.

Now should we prohibit the blue suede shoe guys from getting

involved in the pension funds of social security is another issue.

Should we relegate the American taxpayer to a 2.3 percent rate of

return simply because we do not want to allow them inside the corporate boardroom? I don’t think so. There is balance here to be obtained. I think the balance is appropriate oversight to catch the

wrongdoers and create an environment in which there are penalties for inappropriate, unprofessional, irresponsible behavior. And

I also agree that the rules of 1930 do not fit 2002 and they need

to be revisited, rewritten, and made appropriately responsive for

the environment in which we find ourselves.

I do not however think it is advisable to have the Unite States

postal system making corporate decisions for the rest of the world.

And that the role for Government, from a conservative perspective,

is to get out of the way and let free markets make appropriate decisions to provide for a competitive environment where you have the

most number of products provided at the cheapest price so that

consumers can make the best choice for their families and not be

told by the Government they are too stupid to make their own investments.

Somewhere between the chasm that has been created by Ms. Waters and myself there is an appropriate balance that I hope this

committee will reach. And for all those students who are listening

here today, I hope they take a well-advised approach in looking at

both the alternatives presented in the committee today.

Thank you very much.

Mr. LaFalce.

Mr. LAFALCE. Mr. Chairman, may I just point out between the

extreme that you pose and the extreme that Ms. Waters pose is my

middle ground bill.

[Laughter.]

And I am glad in trying to reach common ground you have now

endorsed it. At least that is one spin that I could put at it.

Just a few comments, because I do want to get on to the second

panel and when I am Chairman we will only have one panel per

day for a hearing so they don’t have to stick around forever and

lose all the members. I don’t know when that day is going to come,

but if it does.

Let me just make a few points. Mr. Lackritz, and we go back a

long time, and I have the highest regard for you and your profession. But if I were to single out anybody where we need to focus,

it is the securities analysts. And I do not mean that in a punitive

sense at all. But we have got to improve the quality of analysis.

And you have got to work on some mechanisms to compensate analysts based upon the quality of their research. And there has got

to be much better peer review and we have got to withstand the

pressure to get on a bandwagon and hype stocks. And you and your

organization and the NASD are better equipped to do that than the

Congress, but that is a heavy, heavy responsibility and you have

to be really zealous in going after it. And we will try to watch over

your shoulder and assist you in that effort, OK. Sure.

44

Mr. LACKRITZ. Mr. LaFalce, I think we agree with what you said

and I think given the hearings that Congressman Baker initiated

last year and the process that he initiated——

Mr. LAFALCE. Yes, his hearings were terrific.

Mr. LACKRITZ. We have made a lot of strides.

Mr. LAFALCE. And you have made strides. You have made

strides. We cannot undo the damage, but we can try to prevent future damage.

And speaking of undoing the damage, Mr. Glassman, you point

out the settlements. The difficulty is most of those settlements

have been for pennies on the dollars that have been lost because

of the wrongdoing. And I am not talking about honest—I am talking about the wrongdoing. And so the individuals who have aggrieved have not been made whole even when there has been a successful lawsuit and a so-called settlement. And we want to prevent

that, especially given the evolution of people’s financial habits and

corporate habits. What do I mean? Well, 20 or 30 years or so ago,

if you were fortunate enough to have a pension plan, you had twothirds probability of having a defined benefit plan. Today, a smaller

percentage of Americans have pension plans and of those who do,

two-thirds are in defined contributions. And a corollary of that and

an outgrowth of that in part has been the fact that only a small

handful of Americans invested in their publicly traded securities

decades ago, today a good preponderance do. So an awful lot more

people have an awful lot more of their wealth in the markets, and

we need to be more zealous and our laws have to be better, our regulation and our oversight needs to be better.

It is going to be difficult to make the people whole. They have

been injured. I don’t know that we can, but we have to try to prevent other people from being injured in the future.

And Mr. Melancon.

Mr. MELANCON. Melancon.

Mr. LAFALCE. Melancon. I am very concerned about a number of

things. I do not want the accounting profession to take an unfair

wrap, but clearly there have been some inappropriate actions, negligence, recklessness, and you have to see this in perspective. There

are an awful lot of accounting firms. There is a Big Five right now

and then thousands of others that are much smaller and they

range from $1 billion dollar to $100,000 accounting firms in revenues. And I know you are responsible for them all. I don’t want to

see an Arthur Andersen go under. They have got 85,000 employees.

I spent money with the chairman of the board of Eastman Kodak,

which has so many employees in my district, well, Eastman Kodak

is far smaller than Arthur Andersen. That is how big Arthur Andersen is. And I don’t want to see a Big Five go to a big four because I don’t think the country would be well-served. I like when

we had a big eight. I don’t think we are going to be able to revisit

those days. But I am very worried, if you only have four or five

that could do the major corporations in any event, those that are

global in nature, and increasingly even small companies are global

in nature, you have some real problems in the marketplace because

you don’t have the type of competition that you do need.

And so we need to do something, with all due deference to the

99 percent of accountants who are always doing the very, very best

45

they can, that small percentage can wreak havoc with the marketplace. And while the marketplace may correct, the damage done by

that 1 percent is not self-corrective and it does not prevent future

abuses. So we need to work together. And I just don’t think will

ever be able to rely on accountants watching accountants again. I

just don’t think that is going to sell to either Democrats or Republicans. I could be mistaken.

I think we need a stronger oversight board. We can argue about

who should be on that oversight board. My preference is to have

representatives of investors and institutional investors such as private employees pension funds, public employee pension funds,

Council of Institutional Investors because I think they are more

likely to be zealous in overseeing it. And that is probably the most,

single most important provision within my bill or maybe anybody’s

bill I think to restore confidence and integrity in the markets.

With respect to each of the other provisions, we will dialogue on

them. I thank you.

Chairman OXLEY. Thank you, Mr. LaFalce. I would like to express appreciation to the panelists for their participation and helpful remarks today, particularly you, Mr. Melancon, for the many

names that you were called during the course of the day. But as

I have explained your good humor to other Members, guys from

Louisiana are accustomed to being called a lot of things.

To all of the panelists, our appreciation. I would like to have the

second panel.

I am sorry, I did not know you had an interest.

Mrs. Tubbs Jones.

Mrs. JONES. Thank you, Mr. Chairman. I have a couple of questions. Well, I am going to ask a question and then make a quick

statement.

Mr. Lackritz, what is your position with regard to the provision

that would limit—put a 4-year limitation on the use of an auditor

for purposes of preparing an audit?

Mr. LACKRITZ. You mean the term limits?

Mrs. JONES. Yes.

Mr. LACKRITZ. On auditors?

Mrs. JONES. Yes, like the people running for public office, yes.

Mr. LACKRITZ. We have not taken a specific position on that provision. What we are concerned about primarily is improving the

quality of the information and so we don’t have a specific position

on that.

Mrs. JONES. Mr. Glassman, what is your position?

Mr. GLASSMAN. I am against term limits in all their forms, including for Members of Congress.

Mrs. JONES. What do you that think term limits will do in terms

of the support or the ability of an auditor to do his or her job?

Mr. GLASSMAN. I think it will add to confusion if there is a term

limit. I just do not see the necessity for it. I think companies can

do a very good job on their own deciding how long the tenure of

their accounting firm ought to be.

Mrs. JONES. Knowing the public’s discomfort with auditors right

now, let me put this question to Mr. Melancon, even if you do not

support the term limits, sir, what do you do to increase the public’s

confidence in your profession?

46

Mr. MELANCON. Well, first off, public confidence is critically important and I would agree with your focus in that area. We have

supported a board that has greater capabilities in enforcement and

in quality control areas so we would support that. We think that

that would be a very positive step.

The problem with rotation, ma’am, is that as Mr. LaFalce just

pointed out, there are huge capacity issues and there are going to

be disruption issues. And if you are looking at 17,000 public companies on an annual basis, 3,400 or so would be changing auditors,

there would be a tremendous inefficiency to mandate that.

CalPERS has a situation where they voluntarily do that. They

want to do that. That is part of their corporate governance. That

is part of the free market system. And we think that audit committees ought to review that relationship. And the other thing that I

would say is that we have supported is that the audit committee,

representing the shareholders, ought to be the one that hires and

fires the auditor.

Mrs. JONES. Let me close with this, Mr. Chairman. I had an opportunity about 2 weeks ago to speak to a class at the Wutherhead

School of Management at Case Western Reserve University. These

were first year students working on their Master’s degrees and

they were just full of questioning about what is Congress going to

do about Enron and so forth and so on. I went through some of the

things that were being presented. But what I tried to weigh upon

each and every one of those students, and I call upon each of you

when you give testimony, is to help young people in every profession to understand the importance of character and good worth and

loyalty and all the things that I don’t care how much regulation we

do in any of our professions we are not going to take care of.

I feel obligated as Member of Congress sent here by the people

of the City of Cleveland and the surrounding communities to put

forth some legislation that will deal with some of the issues that

Enron brought forward. But I am constantly trying to say, and I

come from having been a judge, an elected prosecutor, I serve on

the Ethics Committee, I have done a lot of things like that, to say

we have got to teach young people what it means to have character

and honor. And if you don’t do it, I don’t know who else will. Those

of you sitting in the profession.

I yield the balance of my time, Mr. Chairman. And I thank each

of you for coming here this afternoon.

Chairman OXLEY. Again, I thank you gentlemen and appreciate

your participation. The record will remain open if other Members

have additional questions as a follow-up.

Thank you very much.

And we do appreciate your patience in participating in this important hearing. We have the Honorable Roderick M. Hills, former

Chairman of the Securities and Exchange Commission; Ms. Barbara Roper, Director of Investor Protection, Consumer Federation

of America; and Mr. Lynn Turner, Director, Center for Quality for

Financial Reporting.

Welcome. Please proceed. Your statements will be incorporated

as part of the record. Feel free to summarize.

And, Mr. Hills, we are glad to have you with us today, sir.

47

STATEMENT OF HON. RODERICK M. HILLS, FORMER

CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION

Mr. HILLS. Thank you, Mr. Chairman and Mr. LaFalce.

It should be clear that the accounting embarrassments of Waste

Management, Enron, Global Crossing, to name a few, means that

we have serious weaknesses in our accounting profession and in

our regulatory system. We have had them before. In the middle

1970s, the Securities and Exchange Commission compelled 400-

plus companies to disclose that they had bribed foreign officials or

made questionable payments to them. At that time, the SEC stimulated the New York Stock Exchange to require outside audit committees as a condition of listing. We strengthened the responsibilities of auditors and we required internal controls for the first time.

As we deal with the weaknesses in the system, I would hope that

we could build upon the foundation laid back then.

What are the weaknesses?

First, the overall system, as many have said, is very old, it is almost 70 years old. Almost anything 70 years old gets a little

creaky. It needs a major overhaul.

Second, it has become increasingly clear that some audit partners are not going to be able to consistently resist the management

pressures to allow questionable accounting policies or incomplete financial statements.

And, finally, the audit committees of far too many boards are just

not exercising the authority that has been given them.

H.R. 3763 has the prospect of making significant improvements

in all three areas.

Criticism of the regulatory system really has two aspects. The

audit has become a commodity. The CEO sees no value added. The

accountants compete on the basis of price, not on quality. Auditors

are not chosen for their judgment. They have become rule checkers

and we have too many rules. They have allowed the implication

that if something is not prohibited, it is therefore permitted.

The traditional auditor statement says: ‘‘In our opinion, the financial statements prepared by management fairly present in all

material respects the financial position of the company.’’ That suggests judgment. That is not what they mean. What they mean is

we have found no material violation of the laws.

Section 6 of the bill would cause both management and auditors

to use considerable judgment in deciding what the key accounting

principles are that affect the financial position of the company,

whether for good or for bad.

Let me turn briefly to FASB, the Financial Accounting Standards

Board.

Paul Brown of the accounting department of NYU summed up

the role of FASB pretty well. He said, ‘‘It is an old adage of a FASB

rule. It takes 4 years to write it. It takes 4 minutes for an astute

investment banker to get around it.’’ The proposed bill does not

deal specifically with FASB, and I would suggest the committee

may wish to put in Section 9 that somebody review it.

Turning to the profession. In addition to its other problems, the

accounting profession is not able to get the talent that it needs.

Twenty years ago, some 25 percent more people were entering the

profession. Twenty years ago the leading business schools, StanVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00055 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
48

ford, Wharton, Michigan, sent a substantial percentage of their

graduates to the accounting profession. They do not go there anymore. And yet today, the Big Five are hiring far more people than

they hired before.

This difficulty of finding top-notch personnel, the difficulty of

finding a precise rule to deal with an ingenious corporate structure

designed by Wall Street, and perhaps above all, the pressing financial need to keep a client. Too often, as I said before, it allows a

questionable accounting policy to slip by.

Section 3 of the bill will provide some deterrent to zealous management people to try to influence the auditors. But auditors will

not have the freedom unless the freedom is given to them, the independence is given to them by the audit committees.

Section 2 of the bill restricts the ability of auditors to provide

some services to their audit clients. To the extent that it deals with

financial system design, I think it is constructive. I do believe however that an absolute prohibition against the internal audit is both

unwise and unpractical. I have set forth in my written statement

some reasons for that.

The SEC rules now permit an external auditor to do 40 percent

of the internal audit. As long as there is a strong independent

audit function, it seems to me that the SEC rule is better than an

absolute ban.

The audit committee. The primary responsibility of the audit

committee is to protect the auditor. Unfortunately, CEOs too often

appoint the members to the board and therefore decide who is

going to be on the audit committee and selects the chair of the

audit committee. The audit committee members seldom ask the

auditors if there is a better way to make the financial presentation

that has been designed by the company. In other words, is there

a better way to do it?

The audit committee seldom plays any role of significance in the

selection either of the auditors or the selection of the audit partner.

In short, they seldom establish themselves as the party in charge

of the audit, and they do not establish themselves as the party in

charge of retaining the auditor.

Section 9 of the bill asked the President’s working group to decide whether or not the Commission should establish the duties of

the audit committee. I think that is appropriate. But I suggest that

the committee may wish to be a bit more specific about what the

responsibilities of the audit committee should be.

After 25 years, I think the audit committee deserves a legal status. It has been ambiguous. I suggest first of all that the SEC by

a simple speech could say that the failure to have a competent,

independent audit committee constitutes a material weakness in

the internal controls of the company. That status would be obtained if the SEC would say it.

The SEC could also make clear, as could this committee, that the

failure to have an independent nominating committee is absolutely

necessary to having an independent audit committee. Who is going

to put the members on the committee? Who is going to select the

chair? Who is going to evaluate their performance?

And, finally, the SEC can make it clear and this committee can

make it clear that the audit committee’s single most important

49

task is to make the auditor believe that its retention depends solely

upon the discretion of the audit committee.

In conclusion, Mr. Chairman, the Enron debacle is emblematic of

weaknesses in the regulatory system. Andersen is in the headlines,

but they all have the same problem. Andersen and the other firms

are not blameless, but they are not entirely to blame. The profession has real problems because of a system that they cannot

change by themselves.

Thank you very much.

[The prepared statement of Hon. Roderick M. Hills can be found

on page 210 in the appendix.]

Mr. BAKER. [Presiding] Thank you, Mr. Hills.

At this time I would like to recognize Ms. Barbara Roper, Director of Investor Protection, Consumer Federation of America. Welcome.

STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR

PROTECTION, CONSUMER FEDERATION OF AMERICA

Ms. ROPER. Thank you. I would like to thank the committee for

inviting me to testify today. I am testifying on behalf of both Consumer Federation of America and Consumer’s Union.

Because of the central importance of the outside audit in keeping

company managers honest, our organizations believe the two most

important things Congress can and must do to restore investor confidence in the reliability of corporate disclosures is to first and foremost restore real independence to the independent audit and second to provide effective oversight of auditors.

This legislation tackles both of those issues and for that reason

we congratulate you. However, because it fails to deal adequately

with the central issue of auditor independence and because it does

not do enough to guarantee the effectiveness and independence of

the regulatory body it creates, H.R. 3763 does not provide the comprehensive strong reforms that we believe the current crisis demands.

Because of time limits I am going to focus exclusively on these

two aspects of the bill in my oral testimony. My written testimony

discusses the broader provisions of the legislation.

Unless the auditor is independent, unless he or she is free of

bias, brings an appropriate level of professional skepticism to the

task and feels free to challenge management decisions, the audit

has no more value than if the company were allowed to certify its

own books. Unfortunately, in recent years auditors have been unwilling to adopt the total independence that this essential watchdog function demands.

To increase auditor independence, this legislation directs the

SEC to adopt a rule prohibiting auditors from providing internal

audit and financial information system design and implementation

to their audit clients. In doing so, it simply codifies steps that the

major accounting firms have said they plan to adopt voluntarily.

While there is certainly a benefit to having these restrictions written into the rule book to prevent backsliding once attention has

turned elsewhere, we believe more is needed. Specifically, we support a broad ban on the provision of non-audit services to audit clients. Certain services could be exempt on a case by case basis, but

50

only if they benefit investors and only if they are directly and separately approved by the audit committee of the board.

Furthermore, we believe Congress must look beyond the issue of

consulting services in dealing with auditor independence. After all

the lack of independence starts with the fact that auditors are

hired, paid, and fired by the audit client. This gives them considerable potential influence over the audit. We believe one way to limit

that influence is to require mandatory periodic rotation of auditors.

The basic reasoning behind this approach is that it is far easier for

an auditor to challenge management and risk losing an audit client

if they know the audit engagement is only temporary.

Another problem that in our view clearly needs to be addressed

is the revolving door that all too often exists between auditors and

their audit clients. And that is why we also support a cooling off

period for auditors before they could seek or accept employment at

an audit client.

While Congressman LaFalce’s bill, H.R. 3818, does not ban all

non-audit services, it contains most of what we believe is necessary

to restore a reasonable level of independence to the independent

audit.

H.R. 3763 is, in our view, stronger on the issue of auditor oversight than it is on auditor independence. At its heart is a requirement that all accountants who audit publicly traded companies belong to a newly created professional regulatory body with oversight

and investigatory powers. We believe that an independent regulator subject to SEC oversight could significantly improve the regulation of the accounting industry. To do so however it must be completely independent of the accounting industry, be adequately funded, have extensive rulemaking and standard setting authority and

be endowed with strong investigative and enforcement powers.

The bill takes important steps in this direction. Unfortunately,

much of the language in H.R. 3763 is simply too vague to ensure

that these essential standards for effective oversight will be met.

The Enron collapse has understandably shaken investor confidence in the safeguards our financial system provides to keep

company management honest. Only a comprehensive package of reforms with strong auditor independence and oversight at its heart

will restore that confidence. If it were strengthened in these key

areas, H.R. 3763 could provide the framework for meaningful reform. Without these changes, many of which can be found in H.R.

3818, fundamental problems will persist and investor distrust of

corporate disclosures will remain.

Once again, I want to thank you for inviting me to appear today.

[The prepared statement of Barbara Roper can be found on page

266 in the appendix.]

Mr. BAKER. Thank you.

The Chair now recognizes Mr. Lynn Turner, Director of the Center for Quality Financial Reporting. Welcome.

STATEMENT OF LYNN TURNER, DIRECTOR, CENTER FOR

QUALITY FINANCIAL REPORTING

Mr. TURNER. I would like to thank Chairman Oxley and Congressman LaFalce and Members of the committee, including the

one remaining Member of the committee, for inviting me here to

51

speak today. My comments today do draw upon my past experience

as an auditor, a business executive, a regulator and an educator.

I commend Chairman Oxley, Ranking Member LaFalce, and Congressmen Baker and Kanjorski for their respective efforts in raising red flags with respect to leaks in our system before Enron

struck the iceberg. But now that we have a sunken ship, we need

to ensure adequate reforms are made in a timely fashion to protect

investors. After tens if not hundreds of billions in losses, we must

stop the damage to capital markets and investors.

As described in further detail in my written statement, reforms

set forth in the proposed legislation and the following testimony

will be even more critical if the Big Five turn into the Final Four.

It is in the best interest of both the business community and the

profession if Andersen continues as a separate firm. If we end up

with just four firms and there is another disaster, our current system of public audits will quite frankly no longer be a viable system.

American investors will then rightly ask Congress why was it not

fixed after Enron?

The independent and oversight committee of Andersen chaired

by former Federal Reserve Chairman Paul Volcker has said the

problems facing accountants today are profession wide and not just

an Andersen issue. I agree with their conclusion. Those changes

made by Andersen and/or the oversight board should receive serious consideration by the committee.

H.R. 3763 does encompass some of the changes that will enhance

the current financial disclosure system. But as I will describe later,

there are additional reforms required that are addressed in Congressman LaFalce’s bill, H.R. 3818, that need to be enacted. While

I may quibble with certain sections or have minor quibbles with

certain sections, I think it—that bill has my wholehearted support

and I think it will move things along a long way.

Key elements of H.R. 3763 include:

The establishment of a public regulatory oversight board for the

accounting profession under the oversight of the SEC, making it

unlawful for company executives or directors to willfully and improperly influence, coerce, manipulate or mislead the auditor; requiring more timely disclosure of financial information provided all

investors receive such information consistent with the current requirements of Regulation FD; and real time electronic disclosure of

insider transactions.

Certain improvements to H.R. 3763, many of which are set forth

in Congressman LaFalce’s bill, would provide greater protection for

the investing public. These improvements include:

Providing the PRO with greater authority and powers along the

lines of what are outlined in my written testimony, including a

public board, as Congressman LaFalce earlier described, made up

of members from the public; enhancing auditors’ independence by

including all the original provisions of the SEC’s rule proposal

rather than just those the accounting firms have already quite

frankly agreed to. There should be both mandatory retention and

mandatory rotation of auditors.

Modifying the bill to require the SEC—or modifying the bill to

require the SEC to modify its rules in the event that FASB does

not complete the task in a timely manner. I strongly oppose conVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00059 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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gressional influence over and legislation of accounting standards. It

has directly contributed to less transparency in accounting for

stock options and some of the problems we have today.

Adding a statutory requirement that CEOs and CFOs provide a

statement to their shareholders vouching for the full and fair disclosure of a company’s public disclosures and consistent with legislation previously enacted by this committee, Section 36 of the Federal Deposit Insurance Corporation Improvement Act of 1991 include a report on management’s responsibility for internal controls

and laws and regulations and the effectiveness of those controls accompanied by an independent accountant’s report provide the necessary appropriations for the SEC, including a provision for adequate staffing and technology resources to undertake the mandated

review requirements. In that regard, I strongly support the funding

and risk rating system proposed in H.R. 3818, enhancing the independence and oversight of corporate boards.

In general, I believe the PRO proposed in H.R. 3763, while a step

in the right direction, does not advance the ball sufficiently down

the court to score. As my dad always taught me, if something is

worth doing, it is worth doing right the first time.

Let me close by noting that many of the issues being debated

today are not new. They were raised again and again during congressional hearings in the 1970s and in the 1980s.

[The prepared statement of Lynn Turner can be found on page

274 in the appendix.]

Mr. BAKER. Thank you, Mr. Turner.

Mr. Hills, I would like to address the first question to you. In

view of your extensive experience not only as Chairman of the

SEC, but your extensive board experience, can you tell the committee a little bit about what you view the role of the audit committee should be in specificity? What makes a good audit committee and what should they be doing?

Mr. HILLS. They should initially take charge of the audit and

that is a simple thing to do. If the auditors know that you are in

charge, they will know it. The audit committee should be in charge

of the fee negotiations. In my experience of seeing any audit committee for the first time and hearing of other audit committees,

they often think their highest role is to reduce the audit fee by 5

percent. They seldom ask what could you do if we gave you

$100,000 more?

Let me just speak quickly about the subject of independence. We

all talk about objective independence. That is one dimension. But

the auditor independence has three dimensions. Objective independence means how many times do you play golf with the CEO?

And that is easy to determine. The second dimension is the audit

committee has to understand for itself what it needs to know about

the company. You cannot just sit there passively and hear what is

told you. You need to go out. Whether you call it financial expertise

or commonsense, you need to figure out what you need to understand that company. And that takes a second dimension.

And, third, you have got to confer that independence upon the

auditor. They have to know that you are in charge of their fee.

They have to know that you will be there to mediate the disputes.

They need to know that they have to come to you first.

53

Let me give you an example. At Waste Management we wrote off $3.5 billion in 6 months. The audit committee had not seen a management letter in 5 years, and yet the auditors had given the management a treaty of 12 items, 12 significant items, you have got to

change those things. Nobody told the audit committee. Well, who

do you blame? I think you cannot understand fully the fragility of

the auditor, who is about 55 years of age. If he loses that account,

he is out of there. And so the most important thing for the audit

committee is to confer that independence upon the auditor.

Mr. BAKER. Ms. Roper, I would like to ask you to turn again to

this issue of auditor independence, and I think that we are in

agreement that Congress should not politicize and legislate accounting standards. But when you get to talking about standards

of independence, I believe that you have suggested that Congress

get involved in that area beyond what even the SEC has recommended. And so can you explain to the committee, this difference in your opinion on these two issues?

Ms. ROPER. The only reason to have an audit and to impose that

expense on companies is if it is independent. If it is not independent, it does not serve its mandated function to provide outside

expertise. And we believe that people respond to financial incentives. And in the area of audits right now we have the worst possible combination. We have financial incentives that at least up to

a point favor doing the wrong thing. The money is in consulting.

The glamor is in consultant. If you are too tough on the audit, you

could lose the consulting contract. If you are too tough on the audit,

you could lose the audit fee and not this year’s audit fee but, because of the low turnover, an endless stream of future audit fees.

And so we have, as I say, financial incentives that benefit the

firm if they do the wrong thing, and we have no real regulatory

oversight to punish them in those instances. We think regulation

only works effectively when the financial incentives are not stacked

too strongly against it. But if you have a system of regulation that

is imposed on a system where the financial incentives work the

other way, that regulators are always swimming upstream, always

cleaning up messes after they have been made.

And our view on auditor independence derives from the Supreme

Court’s statement that the public watchdog function that auditors

perform demands total independence. And so if we are going to

have a law that mandates that the audit be conducted, and if its

only value is independence, then I think it is absolutely appropriate for the laws to specify what it takes to be independent. And

I think it is necessary because the necessary has not accepted that

responsibility that goes with performing that function.

In the area of writing accounting rules, we have decided, rightly

or wrongly, to delegate that to a provide standard-setting body.

And we believe that more needs to be done to enhance the independence of that body as well, because our experience has taught

us in following some of the rules that they put forward that if they

contemplate a rule that will be opposed by big business and will

also be opposed by the accounting firms, they know they have years

of opposition in front of them and that those constituents will go

to Members of Congress and that they will in turn face threats to

their role as a private standard-setting body.

54

And so we do believe that that process should be politicized, not

that Members of Congress don’t have an absolutely appropriate

way to play in commenting on rules if they have a direct interest

in them, but that a group cannot maintain its independence if it

feels that its very existence as a standards-setting body will be

threatened if it does anything controversial. And I think you have

to look at one of the reasons we do not have comprehensive rules

on special purpose entities is that FASB knew that if they tackled

that issue, that they would be running into even more opposition

than they have run into on their rules on hedging practices or stock

options disclosures.

So if we are concerned that we do not have adequate rules in this

area, I think we have to look at some of the reasons why we don’t

have those adequate rules. And I think the lack of a guaranteed

independence for FASB is one of the reasons.

Mr. BAKER. Thank you, Ms. Roper.

Now, Ranking Member LaFalce.

Mr. LAFALCE. Thank you, Mr. Chairman.

Mr. BAKER. It is nice to be a Chairman after just a year.

Mr. LAFALCE. Again, let me apologize to the three of you. Mr.

Turner, you came from Colorado. Ms. Roper, Colorado also?

Ms. ROPER. Also Colorado.

Mr. LAFALCE. And, Mr. Hills, where are you?

Mr. HILLS. Just up the street.

Mr. LAFALCE. Just up the street, OK. You came a long distance

and spent a lot of time to testify. It is regrettable that we have almost no Members here, and so they won’t hear the benefit of your

comments, because each of the three of you, I think, had some really terrific comments to make about the issues. That is why, again,

I would exhort at our future hearings we have one panel. What

happened here today was not only predictable, but virtually certain, that is you would have an empty House. And we won’t correct

that. We need some structural changes too in the way we do business and one of them is just one panel per day.

Having said that, I hope the Chair will give me a little latitude

since we have so few Members here.

Mr. BAKER. Latitude granted.

Mr. LAFALCE. OK, thanks. Let’s try to take the issues one at a

time. Let’s first go to the corporate officers themselves. And then

from the corporate officers, let’s go to the board of directors and the

audit committee in particular and then let’s go to the auditing firm.

And if you want to, we can go to the credit rating agencies. But

I am just not sure what we should or shouldn’t do there. I certainly

want to focus on the securities analysts and see what we should

do.

How do we get to the corporate officers to make sure that they

do not engage in earnings manipulation in order to increase market

capitalization in order to make big bucks on their stock options?

Mr. HILLS. I will be a broken record, Mr. LaFalce. The only way

you deal with that, first of all, you have to have the capacity to

punish them, and I certainly support the notion that the SEC

should have an effective way to ‘‘disbar’’ them. I thought the existing law was sufficient, but Chairman Pitt thinks he would like

some more help, and I think he should get it.

55

If you don’t have somebody speaking up for the auditors and

speaking up for the financial statements, the chairman will run the

company, the chairman of the company.

Mr. LAFALCE. My experience, which is extremely limited, has

been the chairman or the CEO runs everything. They pick members for the board who are already friendly to them or who will be

friendly to them. They pick auditors who are or will be. And then

they nurture that relationship so that it almost becomes like a familial relationship where you can’t tell on a family member.

Mr. HILLS. Well, it is not quite as bad as it used to be or I

wouldn’t have been on the last eight boards. It is better. It really

is better. But, again, it is to me an oxymoron, you cannot have an

independent audit committee unless you have an independent

nominating committee. And that happens more and more. Now it

happens that Enron did have an independent nominating committee.

Mr. LAFALCE. We don’t have to legislate that. That is something

that is within the power of the SEC to promulgate by rule, correct?

Mr. HILLS. You bet. You bet.

Mr. LAFALCE. OK, good. Is this something you have discussed

with Harvey?

Mr. HILLS. You bet.

Mr. LAFALCE. Please continue.

Mr. HILLS. Well, it is that function, it is that capacity to have—

it is the capacity of an independent board. Are there seven to nine

people coming to hear the chairman as a panel or have they coalesced into a body that has the capacity to make decisions.

Mr. LAFALCE. They almost need a staff of their own then too, because in my experience on boards, you come and you do not even

know what the agenda is before until the night before maybe you

get something in the mail and then you probably don’t have time

to read it by the time you get it. And then the CEO or the chairman, whoever it is, goes over the agenda and sort of tells you. You

pretty much rely on the chairman of each of the committees within

the board to tell you what is going on within their committee. And

then you find out that their committee didn’t even meet, that they

did everything by phone. And so the members of that particular

committee who are supposed to be responsive to the full board usually don’t even know what went on within their own committee.

Mr. HILLS. There is a staff available. The chairman of the audit

committee, all he has to do is have one lunch a year with the CEO

of the audit firm, the audit partner and spend a day or an afternoon. I have been chairman of nine audit committees, and that is

how you start out. You sit down and go away to their place, spend

the day with them and make sure he understands you are in

charge. There is your staff.

Mr. TURNER. Congressman LaFalce, I think it takes a number of

things to drive at the question that you are asking about. For starters, I think President Bush’s and Secretary O’Neill’s notion of dealing with the executives, forcing them to write a statement to their

shareholders acknowledging their responsibility for those financial

statements and ensuring that they are thoroughly presented I

think is an excellent idea. I certainly support that notion along

with——

56

Mr. LAFALCE. But, I don’t think that Mr. Lay or Schilling would

have had any qualms about writing such a letter or statement. So

I don’t know whether that is adequate.

Mr. TURNER. In and of itself, no, I think you not only have to

deal with the executives, you have to deal with the board and audit

committee so I come at it from a number of angles. I think that

is a very good thing, and I strongly support what they have done

there. I strongly support that some of the things that former Chairman Hills has stated. I would definitely make it a requirement that

the audit committee hire, fire, and really oversee directly the audit.

Right now in practice the bottom line is the auditors are dealing

directly with management. I have been there myself as an audit

partner in one of these firms.

Mr. LAFALCE. What about banning auditors from working for the

corporate employer for a certain period of time, a year or two, because it seems to me that very frequently an auditor will be encouraged by his firm, maybe take an early retirement, go to work

for the company and that will just deepen the relationship between

the auditing firm and the company. And of course if an auditor is

contemplating future employment as an individual with the firm,

the less zealous that auditor is likely to be about the public fiduciary responsibilities. So I have got a 2-year ban on employment if

you have audited a firm. What do you think about that?

Mr. TURNER. I will actually speak from personal experience. I

was a partner at Coopers, certainly one of the big six at the time

and actually went to work for my audit client. Obviously, it was

permitted, but it was not a good situation. And I think some of the

things that you highlight, if I go back and look at it. First of all,

the company had other very fine qualified CFOs that were in the

search that they could have picked from. You have always got in

the back of you mind the point you just made about would you cut

them a deal or not if you had a difficult issue, because you know

if you are getting into a fight with them, they are not likely to hire

you.

But at the same time when you get across on the other side and

you get down to the audit time and here are all these people that

you have known for many, many years and now you are in charge,

if you will, as the CFO, it just leaves you with a queasy thing. It

would be like when I was at the Commission, if I had been involved

with an investigation of a situation like Enron and then walked out

the door and then right the next day I was back in trying to influence the SEC about the outcome. The Government has put in prohibitions against that. And having gone through that process, and

had some of those concerns in the back of my mind, I strongly

think the 2-year cooling off period is very good.

And a number of years ago, it was either the chairman of the Big

Five firms, the Big Six at that time, or the board of directors of the

AICPA recommended a 2-year cooling-off period too. So I think it

is an excellent idea.

Mr. LAFALCE. They recommended it?

Mr. TURNER. Yes, they recommended——

Mr. LAFALCE. What happened to the recommendation?

Mr. TURNER. It never went anyplace.

Mr. LAFALCE. That is the difficulty when something is volitional.

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Mr. TURNER. It is still a recommendation.

Mr. LAFALCE. It was a recommendation to themselves, correct?

Mr. TURNER. Yes.

Mr. LAFALCE. Yes, OK.

Chairman OXLEY. The gentleman’s time has expired. The gentleman from Louisiana, Mr. Baker.

Mr. BAKER. Thank you, Mr. Chairman. I wanted to compliment

you, Ms. Roper, on the content of the Federation’s analysis of the

legislation. Obviously, there are points where you feel that modification is warranted, but on balance the approach seems to be one

which has merit. And I think that is very helpful in the discussion

we are having. At the request of the Chairman, we are going to

have a number of hearings in the subcommittee over the coming

weeks to receive suggestive criticisms and potential modifications

to the bill before we would go to a full committee mark up. But I

think it is appropriate to say based on all we have heard today,

that we have got it pretty close and we are on the right track. And

there are elements that need to be addressed, but we are certainly

acting appropriately given the circumstances we face.

And to any who choose to respond, I think to a great extent

many are looking at the problem as if we only have bad audit and

bad audit individuals within a company where we have perhaps

questionable management or maybe OK management. What troubles me, and I don’t have a good sense of how we resolve this, is

if you have a good auditor who is in a company where you have

clearly badly motivated management. And where does that auditor

go short of resigning from service to get assistance in balancing the

act within the influence of management. If you have an independent audit team, that goes away. If you don’t have good management, you are not likely to have an independent audit team.

If there were disputes as to the construction, oh let’s say of an

SPE, and whether it would be beneficial to shareholders or not.

And the audit team said we think this ought to be disclosed, because it is not in the shareholder interest. And there was a dispute.

How does that resolve today? Mr. Hills, is there a SEC phone number you call and say ‘‘I’ve got a problem, come help me’’?

Mr. HILLS. Well, if you believe as I do that the failure to have

a strong independent audit committee is a material weakness to

the internal controls, the auditors have no right to take the assignment unless they first determine that there is such an independent

audit committee. I think that is the law, but I cannot get anybody

to say it.

Mr. BAKER. But assuming for the moment that that is the law

and it is not an independent situation after you arrive on the

scene, ought there not be a place where you could go and get an

advisory opinion privately, not on the record, so that if later you

were dismissed or if the management chooses not to abide by your

recommendation that there is a methodology for protection of that

audit team?

Mr. HILLS. Yes, I said in my written statement that the PRO

that the bill provides for is an ideal place for the auditor to go and

say, ‘‘I have this account, but I don’t have an independent audit

committee. Would you look into it?’’

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We try to do that once in a while with the New York Stock Exchange and they are willing, but they do not have the capacity to

do that. So the ability to go to something like the PRO that is proposed in the bill to say, ‘‘I have got a problem here,’’ is a tremendous assistance and I very strongly support that.

Mr. BAKER. And then with regard to corporate governance, one

of the concerns I have is manipulation of revenue or the hiding of

debt intentionally by management in the face of a non-cost option

being exercised to drive up share price, retirement is in sight, and

then 6, 7, 10 months later there is a restatement of earnings and

the shareholder takes it and the individual who benefited from the

precipitous increase in value does not have to give the money back.

What about the advisability of some time period during which

there is a disgorgement required and the difficulty is markets are

volatile. You could have good management making good judgments,

exercises the option in good faith as part of the employment contract and have these same circumstances develop.

Where are the equities in that argument, Mr. Hills?

Mr. HILLS. Well, the law is pretty clear if we can find people that

are capable of enforcing it. And this again is a function of corporate

governance. I can give you the example of Waste Management

where many things like that happened, there is the right of the

company to sue the former officers that did it. There is a shareholder derivative cases. The law is there.

Mr. BAKER. But, in that case we are talking evidentiary process,

a court determination, the fellow is gone, the money is tied up with

his lawyers. If there were an automatic clock, and then it would

be maybe a hearing process, my thought was let the executive come

in and make his case.

Mr. HILLS. Well, you have something called the bill of attainder

and that is difficult. We have a legal system—I think you could

spruce it up. I think it would not be wrong to have a specific procedure for the independent committee to decide that he is subject to

it. That would give a road map for a lawsuit. You could make the

lawsuit easier. I would be very reluctant to give up the notion that

somebody could take substantial sums of money away from somebody without due process. You could make the due process faster

or specific, but I think it is—and you could give the SEC the capacity to make the first decision as long as it was a subject of judicial

review.

Mr. BAKER. I don’t dispute that. The problem is that with the

speed with which transactions are closed and the volume of dollars

involved and the ability for individuals who chose to do so to move

assets out of the reach of even the Government’s control. I think

we have a problem that is not appropriately responsive when given

a judicial remedy.

Mr. HILLS. It is hard, but give the SEC a little more capacity.

They have a judicial system. They have an administrative body.

The SEC could have the right to come in and declare, you could

have an automatic injunction relief that would be subject to judicial

review. There are a lot of things you can do with the system you

have.

Mr. BAKER. Thank you. My time has expired.

Chairman OXLEY. The gentleman’s time has expired. Thank you.

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Let me conclude, and I apologize for being out of the room, but

I did want to first welcome all of you and we certainly appreciate

your concern. It is always difficult on the second panel. But your

testimony has been excellent and we have appreciated your being

here.

I want to, first of all, probe generally where—given what we are

faced with now in light of Enron and Global Crossing and other accounting issues that are in front of us in the legislation that we

have, as well as the proposed regulations, where each one of you

see the accounting, the Big Five/Four maybe accounting firms over

the next 10 years, given your best judgment as to where you see

these large companies going, where they resemble anything like

they are today. What is your best guess, Mr. Hills, on where that

might go?

Mr. HILLS. I think the most serious problem facing the country

is the failure or the fact that we could lose our accounting profession as we know it. It is deteriorating. It has deteriorated as I said

earlier. The caliber of people going into it no where near match

what they were 20 years ago. We have a real responsibility to get

them back into the profession. So it is a danger. As I said before,

partly it is because the whole audit process has become a commodity. There is no quality involved in the securing of an audit assignment. So we have a basic responsibility to put judgment back

into it, to bring people into it, to get the MBAs from the better

business schools, among others, to come into the profession. I

would say the accounting profession is in danger.

Chairman OXLEY. And where are those MBAs going now if they

are not going into accounting?

Mr. HILLS. Well, they go to consulting firms. They go to investment banking. They even go to law school sometimes, unfortunately. They have other places to go and they are not being pulled

in. Russ Palmer, some of you know, was the great dean of the

Wharton School. He had long before that been the chairman of

Touche Ross. Twenty-three percent of his graduates were going to

the accounting profession when he was the dean. In the last 2 or

3 years, not one went.

Chairman OXLEY. Ms. Roper, do you think it is important that

we have a strong public accounting firm, say five or whatever number large, multi-faceted accounting firms in existence, or do you

think it ought to be shrunk considerably?

Ms. ROPER. We generally do not think concentration in industries

benefits consumers, although it is not clear in this area that they

compete on the basis of benefits to investors. But we do not look

to shrink the accounting industry. And since the first place that

shrinkage would likely occur would be with Arthur Andersen, I

have to say there is the potential with the Volcker Commission for

Andersen to emerge from this if it can survive as something of a

model company. And we do not want to see Andersen destroyed by

the current situation.

I do not claim any particular talent for predicting the future. And

it seems to me that there are too many factors in question right

now to be able to look into the future with any accuracy. We do

not know what you will decide to do about auditor independence.

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sight, although as we have said we see real progress being made

here.

I think it is absolutely essential that we have strong independent

accounting firms performing public audits. One of the things that

has changed—we have had scandals in the past, one of the things

that has changed since the 1970s and 1980s, when we had previous

major accounting scandals is that most people did not invest then,

and today most households do. And they invest primarily to save

for retirement.

And there was a statement earlier that seemed to imply that this

bill was designed to send the message to investors that it is Congress’ job to protect them from stocks going down. It seems to me

that this bill is designed, and Congressman LaFalce’s bill, are designed to ensure that investors get accurate information so they

can determine for themselves whether the stocks should go up or

down and that they should not—it is not enough that Enron is now

being punished when for years its stock was artificially elevated

based on misinformation. And so we believe that if you take the

steps toward really enhancing auditor independence, enhancing

auditor oversight, doing a broad range of other things that we did

not talk about today to improve the quality of disclosure, that you

will significantly improve the ability of investors to make informed

decisions based on accurate information instead of hype.

Chairman OXLEY. Mr. Turner, are you good at predicting the future?

Mr. TURNER. Oh, I am right up there with you.

Chairman OXLEY. I will look at your brackets for the NCAA if

you are.

Mr. TURNER. I do believe the markets will drive where the firms

go to some degree. And I think the markets are already reacting

to that. In fact, there is evidence that the firms are already reacting to it. And just 2 years ago, we had a unique bonding arrangement with the firms when I was at the SEC over the auditor independence rules and they were not willing to give up a few things

that they are now. Now that the markets have turned around and

said we do not want you doing certain things, they are moving

more in that direction. And I think, in fact, that what we will see

in the future is the firms to some degree, not because of themselves, because I do not think they would ever do it on their own,

but because the markets and the fact that now we have one out

of ever two million American investors in the market, 60 percent

higher than just 10 years ago, the investors are raising up after

Enron, Global Crossing, and all the others and saying we want

some independent auditors, I think it is going to drive them there.

Financially, that may actually leave them even stronger in some

respects than what they have been for the last 10 years. Probably

make them stronger, it takes them back about 30 years ago when

70 percent of the fees were just audit, they were principally audit

and tax. In fact, if you go back to the mid-1970s, there was only

probably 5 to 10 percent in each of the firms that were in consulting, and financially they did very, very well at the time.

When you look at the gross margins, and as my resume says, I

have run one of these business units, the gross margin on the audit

practice, and this came out in our public hearings as well, is actuVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00068 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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ally higher than the margin that you make on the consultant. It

has just been that consulting has grown at a much more rapid rate

than the auditing, but that was because the economy was good. As

the economy turns down now, the consulting won’t be as important

to them, the auditing will. Given that financial side of it plus what

I think the market is demanding, as we have seen, and seen from

the audit committees, I think they are going to step back from

being consulting firms to becoming much more of an audit firm

than they have been in the past, market driven. And certainly I

would encourage the committee to take more steps in that direction

to protect the franchise.

Chairman OXLEY. Thank you. My time has expired.

The gentleman from New York had a couple of extra questions

before we close.

Mr. LAFALCE. Yes, first, just a brief comment. We focus an awful

lot on accounting firms and the audit, but most investors do not

have the vaguest idea of what that audit was, would not be able

to read it if it was put in front of them, and could not interpret

it, and that is why it is so important that we not lose sight of the

securities analyst because so often the investor, and the less sophisticated the more this is true, relies primarily on the recommendations of the Wall Street analysts, and they have got to do

a much better job. They have just missed too much for one reason

or another, to the point where you could say some of their analysis

has been grossly negligent or reckless with disregard for reality.

But I believe, Ms. Roper and Mr. Turner, you are familiar with

both Chairman Oxley’s bill and my bill. Mr. Hills, I am not sure

if you are familiar with my bill.

Mr. HILLS. I am not.

Mr. LAFALCE. Pardon?

Mr. HILLS. I am not. I have been in Singapore all week.

Mr. LAFALCE. OK, well, to the extent that any of you are familiar

there are similarities and then there are some clear differences too.

And we are going to be airing those differences I am sure during

the course of mark-up, which we anticipate will be after Easter.

Ms. Roper and Mr. Turner, since you are familiar with both,

what do you think are some of the salient differences and why do

you favor with respect to each of those differences one version over

another?

Ms. ROPER. OK, on the issue of auditor independence, as I said,

we believe that we need a broad ban on consulting services. And

while your legislation does not go quite as far as perhaps we would,

its provisions to go back to the original SEC rule proposal language

on the whole range of non-audit services we think is very important, because although at the time the attention was focused primarily on the questions of internal audit and financial system design, all of those areas were weakened in the final rule. We think

it is very important that once you define a list, once you have decided that you are going to take the approach of defining a list of

services that are prohibited, that that list not be set in stone. And

so we favor the idea that the SEC would have ongoing responsibility to review services that are provided to determine whether

they create independence problems for the auditors and to do that

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according to the set of principles that were included in the SEC

rule proposal.

We also believe very strongly that the auditor should be hired directly by the audit committee and that if we are going to allow any

non-audit services to be provided, that they should be directly and

specifically approved by the audit committee in keeping with the

idea that we need the board rather than the management to be

controlling these decisions.

And in addition we believe that mandatory periodic rotation of

auditors helps to reduce the inherent conflict of interest that exists

when the auditor is hired and fired by the audit company and that

an auditor who is looking at the—because of the low turnover in

the firm, an auditor is looking at a 20, 30, 50 year engagement

with that audit client has way more to lose than one who risks losing 2 years of audit fees because they are near the end of the term

of their rotation.

I mean, we are not married to a single idea of how long that

term would be. You have to balance the cost of the learning curve

at the start of the audit with the benefit that we think it provides

independence, but we do think that that is an approach that deserves attention. We are willing to look at other options as well to

deal with that issue, but we think that is a credible solution to that

problem.

And, on auditor independence, if you look at the constant flow of

personnel from Andersen to Enron, or from Andersen to Waste

Management, where you had at Waste Management, since 1971, no

chief financial officer or chief accounting officer who did not come

from the auditor, I think that creates a climate in which the outside auditors are viewed as just another part of the corporate community, and that that kind of intimacy is not conducive to true

independence. And so we also strongly support the cooling off period for auditors.

Mr. LAFALCE. Mr. Turner, and also could you include any comments you might have about litigation reform efforts and where at

least my bill would address that?

Mr. TURNER. I would be happy to. As far as the PRO goes, which

both of them have, which is actually excellent, I think in your bill

it is a much stronger SRO in that just in terms of the ability to

compel testimony and document production, which is I think very

important. It is probably more public—not only in public in terms

of what it can do as it comes out of a disciplinary action, but also

in terms of the board makeup itself.

In the area of auditor independence, I would echo what has just

been said by Ms. Roper. Going further I think is needed at this

point in time than what has just been mandated there, especially

in light of what we have seen in a number of cases that have come

out since we did our rulemaking. We have got Waste Management

behind us now. We have got Enron behind us. Global Crossing. I

think those all beg out for a much stronger independence standard.

On mandatory rotation, I certainly, having been an auditor, understand the concerns of the profession. But if you do a mandatory

rotation, for example, once every 7 years, the additional cost is not

going to be great. If you say the average audit for the 10,000 to

12,000 public companies is about 2,000 hours, real cost is going to

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be in the first year. On average, you provide about a third additional hour in the first year. So over a 7-year time period, you

would go from about 14,000 hours up to about 14,600, 14,700

hours. And in light of the losses that investors have incurred, that

is a drop in the bucket.

And the issues with first year audits, there are also indications

with the top 10 list that Congressman Sanders pointed out, there

is probably much greater losses and exposure there in the continuing relationship the market has shown and the losses have

shown, much greater damage and much greater exposure to problems if you don’t have the mandatory rotation provision billed in.

And they talked about Greece and Italy and some of the other

countries, I don’t know if I would use them as a model.

On the litigation issue, I certainly would urge the committee not

to go back and undo the PSLRA. I have served as an expert witness, in fact, for some of the accounting firms and being a partner

myself, there was too much ambulance chasing quite frankly, and

so I would not go back and roll that out.

But I think there is a reasoned approach to dealing with that

today. These are not all frivolous litigation. In fact, most of the

cases have got some validity to them that are being brought. I

think that is one of the benefits that we have got out at the

PSLRA, the fact that there has been an increase in litigation, just

the increase itself does not mean anything unless you turn around

and look at it. There has not been as much increase against the

accounting firms, if you actually go in and dig into the numbers.

But what the surveys do show is that, in fact, the incidence of financial misstatement wrongdoing has increased significantly.

Given that, I would expect that there would be an increase in the

amount of litigation. I think the PSLRA has avoided frivolous litigation, but perhaps swung—you heard the accounting firms talk

about ‘‘unintended consequences,’’ maybe one of the unintended

consequences of that bill was it swung way too far to one side. And

I think we need to bring it back into the middle and perhaps the

best way to do that would be to undo the Central Bank case and

bring back aiding and abetting.

Mr. HILLS. May I make one comment, Mr. LaFalce? As an alternative to mandatory rotation, the notion that every 3 years the

audit committee has the specific responsibility with independent

consultants to analyze the performance of the auditors and must

affirmatively decide it is in the best interest of the company to retain them, that keeps authority and responsibility in the audit

committee. The mandatory rotation for all practical purposes takes

total responsibility away from the audit committee. They no longer

have any role to play.

Mr. LAFALCE. I understand where you are coming from Mr. Hills,

but the difficulty with that is I remember my days in the Army

when you had to be rated, if you were not rated in the top 1 or

2 percentile, you were really doing terribly. And I am afraid that

it might become automatic.

Mr. Hills, I have no idea where you stand on the issue of overturning the Central case and once again permitting lawsuits based

upon aiding and abetting liability. Do you have a judgment on

that? It seems to me that the accounting profession is likely, if they

64

only have proportional liability rather than joint and several, and

most especially if they are not subject to private litigation from an

aggrieved party for aiding and abetting, they are much more likely

to be lax in their standards. What are your thoughts on that? And

I shouldn’t ask the question unless I know the answer and here I

don’t know the answer so I am proceeding at my own peril.

Mr. HILLS. If you look at the 16 committees I have served on, a

whole lot of those audit firms paid a whole lot of money to settle

the claims that we brought. And I would say to you that the punishment of the courts is really quite severe. In the Waste Management case, in the Enron case, the monies offered by, you cannot

hardly think they could offer much more money.

So something works. What works is conferring independence.

What works is a good independent audit committee. I say bolster

them. Give them the authority to do their job and you will have

a much better climate.

Mr. LAFALCE. Thank you.

Chairman OXLEY. The gentleman’s time has expired.

Let me just close if I can, Mr. Hills. What role does Congress

play in this? That is, there was some concern expressed in the first

panel with trying to many I guess put a one-size-fits-all solution to

auditor independence and so I am wondering exactly what we need

to do? I am concerned that if we do so, that we step in, we almost

federalize the auditing profession and I have some real concerns

about that. Do you share those concerns? And if you do, shouldn’t

the auditing committees, as you indicated, and the SEC step in and

deal with these issues?

Mr. HILLS. I think your Section 9 is an extraordinarily good way

to go about this. The SEC will respond very strongly to that kind

of request. The SEC can do most of the things you want. They can

require for example that the audit committee affirmatively decide

whether to retain the auditors. They can decide whether or not

there must be an independent nominating committee. They can decide those things if you push them to do it or you can legislate. I

do believe that we have gone a long time in a limbo. The audit

committee reached a certain pinnacle, maybe 10, 15, 20 years ago

and it stayed there, and we have not pushed them over to that last

part. I think this committee can do it. I think the Senate Banking

Committee can do it because the Commission will be responsive. It

may take a little bit of legislation, but I think a little bit of legislation will provoke a wonderful response.

Two things the SEC has done since September. One they said

the auditors must propel the directors to understand the alternative ways to understand the financial papers. That is a big

change.

The second thing happened just 3 weeks ago when the chief enforcement officer or the chief accounting officer of the enforcement

division, said, ‘‘By the way, the fact that you satisfy all the rules

does not mean that you are not violating the laws if it is not overall

fair.’’ Those are huge differences.

Now, when I was a kid, I thought those were the laws. But they

said it again and this committee can tell them well done and make

sure he does mean it.

65

Mr. LAFALCE. Anything wrong with that 30 year old case that

has been rediscovered and codifying that into law?

Mr. HILLS. I think that is a good idea.

Mr. LAFALCE. Thanks.

Mr. HILLS. I mean. I think there is a place for a push, a barb,

if you will.

Mr. LAFALCE. Yes.

Chairman OXLEY. We thank you so much for your patience and

excellent testimony and response to a myriad of questions from the

committee.

And with that the hearing stands adjourned.

[Whereupon, at 2:10 p.m., the hearing was adjourned.]

66

H.R. 3763—THE CORPORATE AND AUDITING

ACCOUNTABILITY, RESPONSIBILITY AND

TRANSPARENCY ACT OF 2002

WEDNESDAY, MARCH 20, 2002

U.S. HOUSE OF REPRESENTATIVES,

COMMITTEE ON FINANCIAL SERVICES,

Washington, DC.

The committee met, pursuant to call, at 10:00 a.m., in room

2128, Rayburn House Office Building, Hon. Michael G. Oxley,

[chairman of the committee], presiding.

Present: Chairman Oxley; Representatives Roukema, Baker,

Royce, Ney, Kelly, Gillmor, Weldon, Ryun, Ose, Shays, Cantor,

Hart, Ferguson, Rogers, Tiberi, LaFalce, Kanjorski, C. Maloney of

New York, Bentsen, J. Maloney of Connecticut, Hooley, Carson,

Sherman, Meeks, Inslee, Schakowsky, Moore, Capuano, Ford, K.

Lucas of Kentucky, Crowley, and Israel.

Chairman OXLEY. The hearing will come to order. Good morning

and welcome to the committee’s second legislative hearing on the

Corporate and Auditing Accountability Responsibility and Transparency Act of 2002, or CARTA.

Last week, the committee held its first hearing on CARTA. We

heard from a diverse panel of witnesses, including former SEC officials and representatives from the securities industry, a leading

consumer organization and the accounting profession. The testimony was very instructive. Our witnesses represented a broad

spectrum of views about the securities markets and the role of Government in protecting investors. Some of the witnesses said that

CARTA regulates too much. Others said not enough. Clearly we

must be on to something that is reasonable.

CARTA was carefully crafted to strengthen the oversight of the

accountants who audit public companies without federalizing the

accounting profession. The legislation requires companies to give

investors accurate and immediate access to important company information without drowning issues in red tape, and the bill would

make it a crime for company officials to mislead auditors, ensuring

both that corporate officers act responsibly and that auditors can

do their jobs effectively.

CARTA encourages business leadership by prompting executives

to act in the best interests of shareholders. It requires greater

transparency and prevents insiders from benefiting when their employees cannot.

Today’s witnesses will further eliminate the important issues

that face the committee as we seek to reassure investors in the

strength of America’s capital markets. Already the committee has

held extensive hearings in the wake of the Enron bankruptcy.

Going as far back as December of last year, the Financial Services

Committee has held hearings on the Enron collapse to ensure we

fulfill our obligation to protect investors. Our hearings have revealed that while some bad actors may seek to take advantage of

67

investors, ultimately the laws in the marketplace will catch up

with them.

No one should doubt that America remains the best place to invest not only for the ability of our workers and the ingenuity of our

entrepreneurs, but also because America does not tolerate cheats.

CARTA represents our further efforts to strengthen America’s capital markets so that they may remain healthy and vital, and I look

forward to the testimony of our witnesses.

I now recognize the Ranking Member, Mr. LaFalce, for an opening statement.

[The prepared statement of Hon. Michael G. Oxley can be found

on page 296 in the appendix.]

Mr. LAFALCE. Thank you very much, Mr. Chairman. As we continue our consideration of legislation to address the serious systemic weaknesses that have undermined confidence in financial reporting and in our capital markets, I think it is useful to reflect

on some of the testimony we have heard thus far.

One witness warned last week that we should not overreact to

the failure of Enron. If Enron were an isolated instance it would

be one thing. But unfortunately, it is not. The use of deceptive accounting practices to paint a false picture of a company’s financial

health has become much too common at some of our largest companies.

Enron is no longer even the most recent major failure linked to

accounting concerns. SEC and Justice investigations into the failure of Global Crossing have again raised the specter of another

major United States company using accounting practices to hide its

true condition.

The safeguards intended to protect investors have been overwhelmed by the temptations for companies to either cheat or overstate or obscure financial disclosure, largely to improve short-term

results and meet analyst or investor expectations and therefore enhance market capitalization.

Virtually all of our witnesses last week spoke of the need for

auditors to be willing to stand up to management and for audit

committees to take real responsibilities for audits and auditors. To

do this, I believe that we must fundamentally alter the relationship

of the auditor to its client and we must strengthen the functioning

of audit committees and we must provide meaningful and ongoing

oversight of the auditing profession. Auditors and audit committees

should be the first line of defense in protecting investors, and our

task in these hearings is to determine how we can best restore the

vitality of these critical investor safeguards.

Equally important, we must ensure that the restoration is permanent and not merely evolutional and therefore most likely a

temporary response to the headlines of the day. We should not delude ourselves into believing that the market will provide a lasting

solution to the issues we have identified.

Now I have introduced legislation that seeks to do exactly that,

the Comprehensive Investor Protection Act, CIPA. The measures

included in CIPA on auditor independent, corporate governance

and oversight of the audit profession have been strongly endorsed

by both consumer and institutional investor groups. The auditor

independence requirements of my bill are comparable to auditing

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standards adopted by the General Accounting Office and proposed

by New York State Comptroller Carl McCall, who will be testifying

before us this morning. They were crafted after the very closest

consultation with many outstanding individuals, including,

amongst others, the former chief accountant of the SEC, Lynn

Turner.

I look forward to working with Chairman Oxley, Members of this

committee and you, Chairman Pitt, as we seek to find a legislative

response that will help to restore confidence in the financial reporting system on which our markets rely.

Chairman OXLEY. Gentleman’s time has expired.

The gentleman from Louisiana, Mr. Baker.

Mr. BAKER. Thank you, Mr. Chairman. I commend you for calling

this hearing with regard to the important reforms contained in

CARTA. I certainly want to point out the work that has already

been done with regard to the reform of endless conduct with Chairman Pitt and the exchanges under Chairman Oxley’s leadership,

and I do believe that the provisions contained in the underlying bill

with regard to audit reform are significant, important and I think

timely for the committee to pursue.

My focus today will be more toward the issue of corporate governance and how we can incentivize those who are in managerial

responsibility to manage for the long term. It appears that the

events of Enron would indicate there was manipulation of corporate assets for the benefit of enhancing executive compensation,

and it is not a unique, but very troublesome problem in the business world today that management is under extraordinary pressure

to beat short-term quarterly earnings estimates in order to maintain their positions in the particular corporation they manage, all

to the disadvantage of the long-term shareholder interest and corporate growth. I think we should explore with all diligence any

remedies that would incentivize management to work for the long

haul and not to manipulate the stock price, for example, that would

enable them to exercise no cost options that then results perhaps

in a few weeks later a restatement of earnings all to the shareholders’ detriment with no downside risk for the executive. I think

we should at least explore disgorgement as a result of these events

or any other mechanism that would make it clear to management

that short-term manipulation of values to enhance one’s own compensation is unacceptable behavior in today’s world.

Given the complexity of very large corporations and the difficulty

that the common investor has in understanding the true financial

condition, the executives find themselves in a very advantageous

position with no liabilities for this performance.

I commend you, Mr. Chairman, for your work and I look forward

to engaging the witnesses today in pursuit of remedies for the public interest and for the working families. Thank you.

Chairman OXLEY. The gentleman’s time has expired.

The Chair would observe that we have a vote on the floor, and

I would like to recognize the gentleman from California for a brief

opening statement, and the Chair would recess the committee for

two votes on the House floor and return immediately. Gentleman

from California.

69

Mr. SHERMAN. Mr. Chairman, we have got a lot to do. There is

a lot of talk about how the fees for non-audit services are significant. We ought to be looking at the amount of those fees rather

than the particular services rendered. Even tax services can pose

a conflict of interest as you plan to set up 100 Cayman Island corporations and then accrue a tax liability to determine whether

those corporations are going to succeed in avoiding Federal income

tax.

We need clear accounting principles. We need a structure of our

auditing firms so the technical review department makes the final

decision with all the information, not the engagement partner

whose chief job it is to go golfing with Ken Lay.

Finally at the SEC, I wish that you had read the Enron financial

statements and those of the top thousand corporations in America

with the same care that you read the little $15 million and $10

million IPOs that I was involved in long ago where you made sure

that the filings for those small offerings were clear and complete,

but the Enron financial statements clearly did not meet that standard.

Thank you very much.

Chairman OXLEY. Gentleman’s time has expired.

The Chair would now declare a recess for a vote, and then we

will be pleased to hear from the Chairman of the SEC.

[Recess.]

Chairman OXLEY. The hearing will come to order. We are pleased

to welcome back once again to the committee the distinguished

Chairman of the Securities and Exchange Commission, Harvey

Pitt. Mr. Pitt, it is good to have you back again and it has been

a real pleasure to work with you through some very difficult issues

over the last several months, and I want you to know that the

Chair, and I am sure I speak for all the Members, appreciate your

diligence and hard work and positive attitude as we work through

some very difficult issues. So welcome and good to have you back.

STATEMENT OF HON. HARVEY L. PITT, CHAIRMAN, U.S.

SECURITIES AND EXCHANGE COMMISSION

Mr. PITT. Thank you, Mr. Chairman, and it is a pleasure to be

back. Mr. Chairman, Congressman LaFalce, Chairman Baker,

Members of the committee, I am pleased to be here to discuss H.R.

3763, the Corporate and Auditing Accountability Responsibility and

Transparency Act of 2002. As you will recall, on February 4 of this

year, I testified before Chairman Baker, Congressman Kanjorski,

and Members of the Subcommittee on Capital Markets about possible solutions to problems arising in the wake of the Enron implosion. The leadership and Members of this committee have worked

diligently since then to explore the substantive issues at stake and

to develop well thought out reform proposals intended to help restore confidence in the integrity of our financial markets.

Mr. Chairman, I would like to commend the leadership you have

shown, and I would like to commend the efforts of Ranking Member LaFalce as well as Chairman Baker and Congressman Kanjorski and all the Members of the committee. These are difficult

issues. These are difficult times, and your leadership has been remarkable. We appreciate the opportunity to work with you and

70

your staffs on many ideas in your legislative proposals, and we look

forward to our continuing cooperation. Whether by legislation, regulation or some combination of legislation and regulation, we will

work with you to make our Nation’s Federal securities laws more

responsive to the current day needs of investors.

I also want to say how very much the entire Commission and its

staff appreciate your support for funding pay parity and for your

concern for our agency’s resources at this especially critical time.

The past several months have tested the mettle and resiliency of

our markets and the investing public’s confidence. With the events

of September 11, Enron’s bankruptcy and last week’s indictment of

Arthur Andersen, we have all witnessed how critical our capital

markets are to the country’s strength, security and spirit.

In the aftermath of Enron’s meltdown, our staff is investigating

whether violations of Federal securities laws occurred and, if so,

who perpetrated them. Until that investigation is completed, we

cannot address the specific conduct of Enron and those involved

with it or the activities under investigation. The public can be confident, however, that our Enforcement Division is conducting a

thorough investigation and that we will address any and all wrongdoing and wrongdoers swiftly and completely.

Even prior to Enron, we were working to make disclosures and

financial reports more meaningful and intelligible to average investors. Investors are entitled to the best regulatory system possible.

To reassure investors and restore their confidence, we must address flaws in our current disclosure and accounting systems that

languished unaddressed for many years.

The Commission intends to reexamine our rules and regulations

in light of Enron. There are fundamental longstanding flaws in our

system. Now they are on the table. No one yet knows what the

final answers are or should be. But, at the end of this process, we

will have taken the best system of corporate disclosure, regulation

of the accounting profession and fidelity to fiduciary duties by corporate managers and directors, and made that system even better.

In the President’s State of the Union address, he appropriately

demanded ‘‘stricter accounting standards and tougher disclosure requirements’’ to hold corporate America more accountable to employees and shareholders and to hold them to the highest standard of

conduct. We share and embrace these principles and are firmly

committed to achieving them.

We can achieve needed improvements by improving standards

and our regulations in three principal areas. First, disclosure by

public companies must be truly informative and timely. Second,

oversight of accountants and the accounting profession must be

strengthened, and accounting principles that underlie financial disclosure must be made more relevant and timely. Third, corporate

governance must strengthen the resolve of honest managers and directors who oversee management’s actions and make them more responsive to the public’s expectations and interests.

The Commission already has statutory authority to adopt rules

to implement virtually all of the President’s program as well as

other improvements necessary to address systemic problems

brought to light by Enron’s collapse. We will work closely with you

to ensure that the regulatory framework we ultimately propose acVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00078 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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commodates your views of what is appropriate and in the public interest.

We have endeavored to move forward as quickly as we responsibly can on these issues. First, in cautionary advice on December

4 of last year, we gave guidance on the appropriate use of, and limits on, pro forma financials. In further cautionary guidance on December 12, we set forth initial requirements and guidance on the

obligations of public companies to disclose critical accounting principles.

On December 21, we announced our Division of Corporation Finance would monitor annual reports submitted by all Fortune 500

companies in 2002. This initiative significantly refocuses and improves our review program for financial and non-financial disclosures made by public companies.

On January 17, we announced our preliminary concept of a new

private sector regulatory body to oversee the accounting profession.

On January 22, we identified issues in Management’s Discussion

and Analysis to be addressed in 2001 fiscal year end reports regarding off balance sheet financing arrangements.

On February 4, the securities industry and its self-regulators,

acting under the leadership of Chairmen Oxley and Baker as well

as Ranking Members LaFalce and Kanjorski, announced proposed

rules to create more transparency for analyst recommendations.

On February 13, we announced proposals to address aspects of

corporate disclosure meeting improvements. On the same day, we

called upon the New York Stock Exchange and Nasdaq to look at

specific components of corporate governance. And just this past

Monday, in response to the Andersen indictment, we released orders and temporary rules to assure a continuing and orderly flow

of information to investors and the U.S. capital markets.

In addition, over the past several months, we have been seeking

input broadly, from all concerned on both corporate disclosure and

auditor regulation. To that end, we held roundtables on March 4th

in New York and March 6th in Washington, with distinguished

business executives, lawyers, accountants, academics, regulators,

and public interest representatives. We have scheduled our next

roundtable for April 4th in Chicago, and plan to hold additional

roundtables in the next 2 months. This May, we will hold our first

ever ‘‘investor summit’’ to solicit additional investor input.

Congress, however, must make the final judgment whether legislation is necessary or appropriate. We intend to continue working

with Members in both Houses and on both sides of the aisle regarding legislation. We will continue these efforts and will commit to

implementing any legislative changes Congress ultimately believes

are necessary.

Last month, Chairman Oxley and subcommittee Chairman Baker

introduced H.R. 3763. This proposed legislation addresses many of

the key issues facing our capital markets today, most notably, creating a statutory public regulatory organization to oversee the public accounting profession. In my formal testimony, I have addressed

some of the key aspects of this proposed legislation and I do ask

that my formal testimony be included in the record in its entirety.

Chairman OXLEY. Without objection.

72

Mr. PITT. Thank you. For present purposes let me offer a brief

overview on my comments on this legislation.

First, given our existing authority, combined with Section 12 of

the bill, we believe that this legislation would give us ample authority to enforce the bill’s directives, if enacted.

Second, the proposed public regulatory organization the bill mandates and our proposals for a public accountability board share

many common attributes and characteristics.

Third, if legislation is enacted, the key is giving us both the authority and flexibility to ensure comprehensive and effective regulation of accountants and accounting.

Fourth, the Commission shares the bill’s underlying philosophy

of holding auditors to the highest standards of independence, competence and ethics. We think it unwise to cast solutions to issues

of auditor independence in legislative stone, but we do agree with

the bill’s fundamental precept that auditor independence is a critical issue which requires constant attention.

Fifth, the Commission embraces the bill’s core concept that financial disclosures must be timelier, more comprehensive, more relevant and provide greater transparency.

Sixth, we agree with the bill’s concept that the Commission,

through its staff, must significantly expand its review of financial

and non-financial disclosures. We must also try to use our resources more effectively by targeting our reviews at the most important areas of disclosure at any given point in time.

Seventh, the bill requires us to perform or participate in several

studies that we believe would shed light on possible additional reforms. We support each of these initiatives, and yesterday the

Commission voted to commence a formal inquiry of rating agencies

and their regulation.

Finally, a companion bill increases our authorized funding. We

have identified current needs and have worked with OMB to reach

common ground. OMB supports our additional request for 100 additional personnel. It does not as yet support appropriating funds

for pay parity in fiscal 2003. We hope to persuade OMB to fulfill

the implicit promise of pay parity once the legislation authorizing

pay parity was enacted into law.

Mr. Chairman, Congressman LaFalce, Chairman Baker, Members of the committee, I thank you for the opportunity to testify

today, and I am pleased to try to respond to any questions the committee may have.

[The prepared statement of Hon. Harvey L. Pitt can be found on

page 302 in the appendix.]

Chairman OXLEY. Thank you, Mr. Chairman, and let me first indicate we will help you on a bipartisan basis on your issue on pay

parity with OMB. This Congress spoke very clearly on the pay parity issue along with the SEC fees legislation that were contained

therein, and we want to be equal partners with you on convincing

our friends at OMB and the Administration that pay parity is the

law of the land and that we have a firm commitment to that ideal

and we are going to continue on that best effort.

And let me also congratulate you on a number of initiatives within the SEC and working with our committee. It is frustrating somewhat, I am sure it is to you, that many of these initiatives go relVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00080 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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atively unnoticed in the popular press while high profile hearings

get most of the attention, but I have to tell you I think I share that

with the other Members of the committee. We understand the hard

work it takes to undertake these initiatives. And clearly the news

conference we had with you along with Mr. LaFalce and Mr. Kanjorski and Mr. Baker on the analyst issue was a good example, I

think, of what we can do when we work together, and I want to

thank you for all of your help in that area and many others.

Let me begin the questioning, Mr. Chairman, with a question

that was raised last week. One of our witnesses testified that the

market incentives for responsible corporate governance and accurate accounting are incredibly powerful. How would you characterize the practices of post-Enron America from your viewpoint?

Mr. PITT. My belief is that the response in the post-Enron era

has been all that one could hope for in terms of articulation of commitments to fiduciary obligations and companies reexamining the

qualities of their disclosure. We have had an upsurge of companies

coming to us asking for advice and assistance on a number of these

issues. That doesn’t, in my view, obviate the need either for legislation like yours and Mr. Baker’s or further regulatory work. But I

do believe that the market has now created very powerful incentives for people to do the right thing, and, with the proper legal

framework, we can ensure everyone that that fidelity won’t be

short lived.

Chairman OXLEY. That is an excellent point, and it is the goal

of our legislation, as you know, to provide for more timely disclosure, more transparency, not necessarily more difficult rules and

regulations, but indeed to allow the great forces of the marketplace

to work effectively based on those concepts of early disclosure and

transparency, and we thank you for your support in that regard.

Let me ask you, what is the relationship, if any, between the Private Securities Litigation Reform Act of 1995 and the ability of investors to recover for actual fraud?

Mr. PITT. In my view, the Private Securities Litigation Reform

Act, which was a bipartisan effort, reflected sound approaches to

the problems it was designed to deal with. We have taken a look

at the statistics since the adoption of the Act in 1995. In fact, there

has been no diminution in the number of class actions that have

been brought on average in the 7 years since it was enacted, and

the average value of settlements has increased. In point of fact, by

encouraging large institutions to take more of a role to ferret out

the frivolous from the meaningful, I think we are seeing a better

use of the class action mechanism, and in my view those who suggest that the Private Securities Litigation Reform Act is somehow

responsible for any aspect of what we see in Enron, or any of the

other high profile matters, are very much mistaken.

Chairman OXLEY. We have had some witnesses and other commentators to say that there is a real danger if Congress tries to

create audit only firms. What kind of ideas do you have in that regard?

Mr. PITT. This is a subject that I think is very critical, and you

are correct to hone in on the significance of that. In my view, there

is no direct correlation between consulting work and auditing failures, but there is a problem with respect to the independence of

74

auditors. Independence is the bedrock on which the accounting profession was founded and all steps have to be taken to strengthen

it.

My concern is that, if we go to the absolute separation that some

people are proposing, over the next 5 years the quality of audits

will diminish, not improve. It stands to reason that if accounting

firms doing audits only engage in auditing, they don’t become more

independent, they become more dependent on their audit work. To

me the problem is twofold. On the first hand, and the most important aspect, are those on the immediate firing line: the engagement

partners and all of those who do the audit work. Those people must

scrupulously adhere to independence notions. In my view, cross

selling compensation to those people, that is, enabling them to sell

other services, is absolutely inconsistent with the notion of independence.

On the other hand, you have the firms as a whole. Most people

have tried to deal with this issue as if it were a firm wide issue

and not as if it were the engagement partner and engagement

team’s problems. For the firm, the issue is to provide appropriate

incentives and sanctions if the firms do not properly supervise

those people who are on the engagement front line.

So, it is a twofold problem, but most people have looked away

from the individual audit partners and have looked at it as if it

were a firm wide problem.

In addition, one other point—and I apologize for going on, but

this is a very critical subject. If we take away much of the expertise

that auditing firms have developed, for example, in the tax area,

they will not be competent to perform audits. Getting into the

issues of tax work enables auditors to have a clear sense of where

the company is and how the issues can be handled.

Chairman OXLEY. The Chair’s time has expired.

The gentleman from New York, Mr. LaFalce.

Mr. LAFALCE. Thank you very much. Since you were just discussing the separation of the auditing and the consulting function

and you mentioned taxation in particular, in my bill I call for a

separation, but not a complete separation, same way as people can

advocate a separation between church and state, but we have never

had a complete separation within the United States. And I specifically would exempt the tax function.

Now, Chairman Levitt did articulate a rule, and I supported it

at the time although many others in the Congress generally opposed it. What is the status of that rule right now and where do

you agree or disagree with the former Chairman of the SEC, Mr.

Levitt.

Mr. PITT. I appreciate that question, because again I think it

goes to the heart of this issue. Eighteen months ago, the Commission adopted its independence rule, and at that point Chairman

Levitt said, and I am quoting this from memory, but I have the

exact quotes: ‘‘the rule we put in place today is better than an absolute ban.’’ I happen to agree with him. I don’t think 18 months

has been a sufficient time for us to allow the rule to take effect.

Mr. LAFALCE. How did that rule compare with his original proposal, which was not an absolute ban?

75

Mr. PITT. Exactly. He did not have an absolute ban. My view is

that——

Mr. LAFALCE. My question is how did the rule that was promulgated 18 months ago compare with his original rule? Was it watered down significantly, somewhat, not at all?

Mr. PITT. No. What I am saying is I have read some people say

that the rules were watered down. Chairman Levitt’s comment,

with which I fully agree, was not that the rules were watered

down, but that they were better than the absolute ban.

Mr. LAFALCE. No. You originally said that he said they were better than an absolute ban. You did not originally say that he said

that they weren’t watered down. And so are you now saying that

he also said that the rules that were promulgated were not watered

down from his original proposal?

Mr. PITT. I will tell you this. I have looked at, I think, every

statement I can get through computerized research and at no time

did I hear Chairman Levitt suggest, because I don’t think he believed it nor do I believe he should have, that the rules were watered down. There was a process of discussion and analysis with

accounting firms, but eventually the rule that he enacted he

thought was much better than what he had originally proposed,

which was an absolute ban.

Mr. LAFALCE. One of your predecessors other than Mr. Levitt,

Mr. Hill, argued last week before this committee, and you were his

General Counsel when he was Chairman, that we should confer on

audit committees a more formal legal status. He argued that the

SEC should make it clear the failure to maintain an independent

auditing committee constitutes a material weakness in a company’s

internal controls.

My first question is do you agree with that?

He also recommended that independent directors should be nominated by an independent nominating company rather than by the

CEO or chairman of a company and that this was in the program

of the SEC. Do you agree with that? Two specific recommendations

of your former Chairman, and do you agree or disagree?

Mr. PITT. It would be hard for me to question former Chairman

Hill’s judgment since you are right, I did serve as General Counsel

during his tenure. But my view is that, if you do not have a validly

constructed and operating audit committee, that that is a material

weakness. I believe that former Chairman Hill——

Mr. LAFALCE. Well, is it necessary for you to promulgate a rule

to that effect to make that operative?

Mr. PITT. No. I don’t believe——

Mr. LAFALCE. He suggested that it was.

Mr. PITT. I think what I read him to say and certainly what he

has said in private discussions and communications with me is that

the Commission should make that point loud and clear. I think I

have just done that.

Mr. LAFALCE. Could you explain that more explicitly in some

writing somewhere because the response to my question is one

thing. But something a bit more formal in writing would carry a

bit more weight, I believe. So I would be anxious to see that.

And now to the second question regarding his recommendation

for an independent nominating committee or the board of directors

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as opposed to taking the recommendations of the Chairman or

President or CEO.

Mr. PITT. I believe that those suggestions are quite constructive.

And as you may be aware and as I indicated in my opening statement, we have asked both the New York Stock Exchange and

Nasdaq to come forward with corporate governance standards.

Mr. LAFALCE. Which they can do or which you can do, correct?

Mr. PITT. I believe they can do that, yes.

Mr. LAFALCE. And you can also too, can you not?

Mr. PITT. I believe we can do that. I believe it raises some significant questions, and indeed there is an opinion in the DC. Circuit,

the Business Roundtable rule, that suggests that the Commission

has some limitations on its authority.

Mr. LAFALCE. I would suspect you disagree with that, do you

not?

Mr. PITT. I don’t agree with the decision.

Mr. LAFALCE. I thought so. You think you have the plenary authority. I thought you would.

Chairman OXLEY. Gentleman’s time has expired.

The gentleman from Louisiana, Mr. Baker.

Mr. BAKER. Thank you, Mr. Chairman.

Chairman Pitt, when CEO Berardino appeared before the committee he responded to a question from me as to the ownership

issue of the financial statement in that it belonged jointly to management and shareholders. I was a bit taken aback by that view.

Recently the GAO has issued a significant report in which one of

the recommendations of that report is to statutorily define that the

financial statement should reflect the financial condition of the corporation for the shareholders’ evaluation and not be the subject of

managerial influence or control. Would it be of help to the Commission if there was a provision of law that made it clear that the financial statements should be prepared to reflect accurate financial

condition of the corporation for the benefit of shareholders?

Mr. PITT. The law already provides that, and I would be concerned such a provision actually would create an implication that

the law does not require that.

Mr. BAKER. Terrific.

With regard to incentives, it appears that there are significant

conflicts, whether it is an audit firm which is consulting and is

paid $50 million in the aggregate or whether it is simply a $50 million dollar audit. There are 50 million reasons in both cases to be

influenced. Likewise, for management to manipulate earnings, revenue streams, obfuscate debt, the consequence of which is to increase stock values. It is all too often the case that part of the employment contract incorporates no cost options which are obviously

intended. If you do well and manage the company properly, those

options become more valuable, you exercise them. But then subsequently if there is a restatement of earnings within some shortterm period, the shareholder takes the consequences of that loss

while the executive is able to retain those proceeds. I don’t know

the appropriate remedy, but in both cases are there incentives that

could be considered by this committee for inclusion in the mark,

which would cause one to invest for the long term, not for the benefit of the quarterly report, and are there further incentives that

77

might be provided for the audit side of the function, for example,

a cooling off period, where if you are the principal audit firm engaged by a corporation, that you could not be employed by that corporation in an executive capacity for some period of time after you

conduct the audit, traditionally known as a cooling off period? With

regard to either of those, do you have recommendations or could

you make those at some future point to us?

Mr. PITT. I do. With respect to incentives, I could not agree more

with you that there is a need to make sure that management’s incentives align with shareholders’ interests. Just last week, we

brought a case that is a bit unusual for the Commission in which

we have sought to have a former CEO of a public company disgorge

his compensation in stock options and bonuses because the appearance of profitability was an illusion. I believe that the Commission

has to be much more aggressive in targeting misconduct. And

where serious misconduct has occurred, I think one incentive or

sanction has to be removing any benefits and making certain that

benefits are seen as a long-term proposition and not as a shortterm.

The other thing, and this is a place where we do need legislation,

is that I believe that the Commission should be given administrative authority to bar officers and directors of public companies who

commit violations of the Federal securities laws from serving as officers and directors. We can do that in the securities industry. The

banking agencies can do it with banks. I believe we should be able

to do it with public corporations, obviously subject to review.

Mr. BAKER. Let me jump in with one quick statement. Finally,

with regard to our whole accounting system, although we are taking important steps with the bill, as to the overall system we have

today, which tends to be historic in nature, reporting activities 90

days old, we need to look more thoroughly over the long term toward real-time forward disclosure as opposed to the regular FD approach, which appears in retrospect not to have worked very well

at all. If reg FD was intended to provide the investing public with

a thorough understanding of the markets, it would appear given recent circumstance that it has been a failure at best and we have

a long-term project ahead of us to reconstruct our whole accounting

methodology to give investors real-time information that is helpful

to the forward direction of the company. My time has expired.

Mr. PITT. One of the propositions in the bill I support that you

and Chairman Oxley have authored is the notion of moving to more

current disclosure. My concern about regulation FD, which I share

in terms of the remarks you made, is that you can satisfy the rule

by saying nothing to anyone. We are proposing affirmative disclosure requirements, and I think that solves the concerns that the

former Chairman had about selective disclosure, but does so in a

way about informing the market rather than keep information

away from the market.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from California.

Mr. SHERMAN. Thank you. Let me first suggest something that

I think you could probably do next week and might not be terribly

controversial, and that is to require that every audit report filed

with the SEC be signed by the head of the technical review departVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00085 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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ment within the accounting firm after seeing all the information

and that we not have a circumstance where the final decisionmaker

as to whether Arthur Andersen’s signature appears at the bottom

of a report is made by the billing partner, the engaging partner,

the golfing partner, but is instead made by someone whose loyalty

is to the firm as a whole and who is selected on the basis of the

technical expertise. Can you do that next week?

Mr. PITT. I don’t know if we can do it next week. But I will say

this, we are very much in favor of the concept you are articulating,

which is that in order to make sure that firms apply their supervisory responsibilities, the national technical office be assigned to

every audit and not leave the final decision in the hands of the engagement partner. We think that would produce even better audits

than we presently have, and most firms I think are doing that.

Mr. SHERMAN. There was one Big Five firm that wasn’t.

Mr. PITT. You are right.

Mr. SHERMAN. The SEC under the Chairman’s bill will be reviewing, I believe, the top 500 firms when they file their accounting

statements with you, reviewing them I hope as you review initial

public offerings by small firms. I hope I have that right. But can

you provide us with how much money you will need to do an outstanding job of reviewing either the 500 most important financial

statements or the Fortune 1,000 or the top 5,000 and would it be

necessary to increase your budget by 50 percent or 100 percent so

that we get the same kind of review process there as I commented

earlier I was used to with smaller companies? Obviously you can’t

plan your budget on the back of that envelope in front of you, but

if you could submit that for the record so that we know? And can

you also comment now, do you have the independence as the head

of an independent agency to come to Congress and say I need my

budget doubled or are you under the thumb of OMB and under the

thumb of those looking at the macro-budget situation from the Administration?

Mr. PITT. I would like to assure you that, with the exception of

my four children and my wife, I am under the thumb of no one.

I will say this, that we have had a very positive and constructive

working relationship with OMB. We have differences of view and

at my confirmation hearing I stated under oath that I will always

come back to Congress and inform you whenever there were differences of view if Congress wanted to know what we had asked

for.

Our major difference with OMB only relates to funding pay parity for 2003. And, because I believe we have a good relationship

with them, I believe that we will ultimately prevail, although I am

an optimist by nature.

Mr. SHERMAN. You may disagree on that one point, and that is

how much your existing people get paid. You seem to comment favorably on the idea of the SEC at least reading and demanding

clarification of the financial statements filed with you. That is a lot

of additional work. The President doesn’t have a penny in his budget to allow you to do that work. I assume that all your people are

working hard now and that they don’t have free time. So I would

hope that you would submit to us something that I guess would be

your second potential difference with the Administration, and that

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is how much you would need to carry out either the kind of review

that I believe the Chairman’s bill calls for and I am asking you also

to expand that, not from 500 firms, but to 1,000 and then 5,000.

Mr. PITT. May I just say this. When we testified before the Senate Commerce Committee on March 7, I had indicated that in order

to deal with the incredible vigor with which we are approaching financial fraud cases and to deal with our review of Fortune 500 filings we need 100 additional people. OMB supported that, and indeed, after our testimony, my understanding is that they asked

whether, rather than waiting until 2003, we would prefer to have

it immediately, which, of course, we would. I do want you to understand what the relationship is.

I also believe that the Commission is not a separate government.

I believe the SEC has to be part of an overall government and it

is my view that we are under an obligation to respect the fact that

there are a lot of budget priorities.

With regard to the point you make about how many more people

we would need, I do think one point is critical to stress. My hope

had been that I would have taken the first couple of months in office and done a thorough assessment of how many people I thought

we needed, whether there were efficiencies. A funny thing happened to me on the way to the Commission. And we are now dealing with our third crisis, and so I haven’t had the time. This week

we will be announcing, however, a 4-month in-depth internal review of our deployment of resources and with an effort to figuring

out before 2004 budget time what our actual needs are, and we are

devoting substantial attention to that. But you should be aware,

and this is the one concern I have, there is not enough money and

there aren’t enough people to give you the kind of guarantee that

I think we all would like to have. And so there are always tradeoffs.

But, one thing we did the minute Enron hit was to redeploy our

assets in the Corporation Finance Division to review Fortune 500

filings. And one of the things that we want to do with the additional 100 people is to hire risk management specialists who will

direct us to look for places where the greatest likelihood is that

problems will arise. I think that will help us strategically.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from Ohio, Mr. Ney.

Mr. NEY. Mr. Pitt, can you give your view on how accounting

firms maintain their independence of their auditors when members

of their firm work for years with the same company? And what I

am trying to get at, the question I had asked in the earlier hearing

a few weeks ago, I raised the issue about how Andersen employees

were intertwined with Enron and were actually mistaken for Enron

employees. They even went as far as to wear Enron golf shirts and

went on Enron retreats and some of the people thought they were

Enron employees.

Could you tell us, in your opinion, if the reforms proposed in

H.R. 3763, whether the reforms you suggest will ensure independence of future auditors, not just with golf shirts, but——

Mr. PITT. I believe they will, because both H.R. 3763 and the

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trol and the independence of public accounting firms. One concern

I have is that we not write something in stone, because if we put

it in stone today we may discover tomorrow that it creates a different problem, and that I would like to avoid. But I believe both

the legislation and our proposal would respond to that concern of

yours, which I think is a legitimate concern.

Mr. NEY. And still have flexibility.

Mr. PITT. Yes, we would have flexibility.

Mr. NEY. The other thing, Mr. Chairman, is it possible for a company to meet the GAAP standards and still provide a full, fair and

complete picture of a company’s financial condition? If so, would

the bill improve the standards to solve that problem?

Mr. PITT. I believe that it is possible and it has happened that

companies may comply literally with GAAP and still have financial

statements that may prove misleading. About 40 years ago—actually less than that, but almost 40 years ago, Judge Friendly in the

Second Circuit in the U.S. Against Simon case rejected as a defense

the notion that financial statements were done in accordance with

GAAP and therefore the accountants could not be held criminally

liable. He held just the opposite.

Judge Stanley Sporkin in the Lincoln Savings case held the same

thing, that you can still create a misleading impression. Notwithstanding that, we think there is a strong need to change the way

accounting principles are adopted and the way accountants look at

those principles. The current set of principles facilitate a check the

box mentality. That is something that we believe has got to be

changed.

We want professionals as well as management to ask themselves,

if I were an investor, does this disclosure tell me everything that

I would want to know. And the fact that it may comply with GAAP

is only one issue. If it still creates a misleading impression, it

should not be satisfactory to anyone.

Mr. NEY. Does it tell you everything you need to know and also

in a timely manner, also information gets there obviously as quick

as it can?

Mr. PITT. Absolutely.

Mr. NEY. One other thing, if updating the accounting standards

has been lengthy and arduous, which I think we all agree in recent

years that task has been tough, do you think the reforms that we

are discussing today can change that?

Mr. PITT. I am sorry, can they change——

Mr. NEY. It has been a lengthy process to update accounting

standards. Do you think that the reforms we are discussing today

will change that process, open it up, or is it still going to be a

lengthy and arduous task and possibly should be?

Mr. PITT. I believe that, both under our proposal and this legislation, we could improve the way accounting standards are articulated. The FASB, which presents a full-time reflection on accounting principles, is a wonderful concept. Its implementation however,

is troublesome. First, its funding is not truly independent, because

it is voluntary, and we believe it needs to be mandatory. Second,

we think that the Commission in the past has been lax in overseeing what the FASB has been doing, how quickly they do it and

what matters they attend to.

81

One of the most important subjects in accounting is revenue recognition. For 27 years, there has not been a statement of principle

on revenue recognition. So I believe the Commission has to have

clear authority to direct the FASB to respond to questions.

And finally, I believe accounting principles have to be principled

and not Tax Code formulated. They have to be designed to make

use of professional experience and knowledge without giving people

such a detailed approach that all they do is check the boxes. At the

same time, they have to be promulgated rapidly. The notion of taking 5 or 10 years or, as I said, 27 years, with respect to revenue

recognition just doesn’t cut it, and it has been allowed to go on way

too long.

Chairman OXLEY. Gentleman’s time has expired.

Gentleman from Massachusetts, Mr. Capuano.

Mr. CAPUANO. Thank you, Mr. Chairman.

Thank you, Mr. Pitt. Before I ask you questions, I just want to

make sure you note that the budget that is on the floor today, in

the Budget Committee, an amendment to fund pay parity this year

was voted down. Mr. Moore made the motion and it was voted

down along party lines, just as a little footnote. So your difference

is not just with OMB, but with Members of Congress as well.

I guess I need to go back about a month or so ago, and this is

the first time you have appeared before this committee. Mr.

Berardino testified at the same table. And during my questioning

he made a comment that I found a little shocking, because I suggested every auditor has an opportunity, if they differ with what

a client wants to do, to either add a comment to the audit report

or qualify that audit report, which is a kiss of death on many levels. And his reaction was something along the lines, well, we can’t

do that under GAAP, which I found a bit shocking. And at some

point if you could clarify my understanding of that, because I am

still under the impression that any auditor can either add a comment at the least or qualify that audit report any time they find

a client kind of crossing the line or not doing something within the

four square of what they need to do.

Mr. PITT. Let me say that the concept that you articulate is one

that I embrace, which is I believe that auditors have to have the

responsibility as well as the backbone to question and take issue

with management’s selection of auditing principles or their application. Whether or not current law permits a qualified opinion, which

is generally given under certain circumstances, may be a more

technical question, but as your question suggests, we shouldn’t be

interested in technicalities. That is one of the reasons why we have

proposed and will be implementing the rule which requires companies to identify their critical accounting policies, explain what

would have happened if they had chosen different policies and also

discuss what assumptions they made and what would have happened if they had operated under different assumptions. We believe

that is going to get us to the place that you want to be and, as I

say, I support the notion that we have to have accountants reflect

independent judgment on the financials they review.

Mr. CAPUANO. And the other thing I suggested to him is in the

final analysis even if you feel hamstrung you can always walk

away from the client, which in this particular case I think in the

82

final analysis is going to be proven to have been less expensive

walking away from a $100 million client than what is going to end

up happening. But we will let history be the judge of that.

And that leads me to the next question and some of my concerns

on both the bills that are filed before us is on proper influence. Arthur Andersen was my auditor when I was the mayor of my city,

and one of the ways they kept me from doing some things I wanted

to do to make the city look good on the books is if you do that we

are going to have a qualified report. If you do that, OK, fine. My

job was to make the city look as best it could in front of investors,

as is the job of anybody else.

So my concern in some of the language that is used in this improper influence, what is the line that I can’t cross. My job is to

push. The auditor’s job is to say that is enough, you can’t cross this

line. And my concern with some of these languages, improper influence, what does that mean? I understand if I say I got a picture

of you and your girlfriend, that is improper influence. But for me

to say I want to go here, I want to report this in this manner and

don’t you think you should count this revenue, under some of this

language I am a little concerned that could be considered improper

influence. And as we go through these bills, I would like you and

your people to kind of keep that in mind, because I don’t want this

committee doing something that I don’t think we really want to do.

Mr. PITT. Let me again say I share with you the underlying principles that your question implicitly raises. Both the bill and the

Commission’s proposal would set up an independent body that

would be reviewing the quality of audits, not just providing discipline when something has gone wrong, but reviewing every major

accounting firm on a yearly basis. Unfortunately, the present mechanism, the public oversight board which had been in effect for 25

years, was dramatically flawed. It wasn’t given the powers and authority it needed. Under the proposal that we have raised and

under the bill, you have a body that would effectively go through

quality review and have the power to strip an audit firm of a client

if it found that the audits were not of the highest quality. We believe that will create exactly the kind of incentive that you want

to see occur.

Mr. CAPUANO. Though my time is out, I would like to add a footnote. If and when that is the way we end up, I would hope that

such action on your behalf would be somehow publicly notified. If

it is a private thing in the back of a room and nobody knows you

did it, it really won’t accomplish much.

Mr. PITT. Let me say that discipline in secret does not achieve

its purpose. When we take disciplinary action, when the stock exchanges and the NASD take disciplinary action, we publicize it.

The public has a right to know if people have not lived up to appropriate standards.

Mr. CAPUANO. Thank you, Mr. Chairman.

Chairman OXLEY. The gentleman from Connecticut, Mr. Shays.

Mr. SHAYS. Thank you, Mr. Chairman.

Mr. Pitt, thank you for being here. I have a number of questions.

Let me begin by saying, by asking this question. Some have told

this committee that there is a danger in creating audit-only firms.

Do you agree or disagree?

83

Mr. PITT. I agree completely with that. I think it is a simplistic

solution to a complicated problem. And it will produce worse audits

than we presently have. I believe that, as I have said earlier in response to I think a question from Chairman Oxley, that the problem is a twofold problem. One is with the engagement team, where

they must have absolute scrupulous impartiality and independence,

and then at the firm level, there has to be incentivization to make

sure that the firm enforces the right supervisory techniques.

Unfortunately, this issue with a total separation would only deal

with the firm-wide question and not deal with the real problems

here.

Mr. SHAYS. Let me get to another question. A witness on our

next panel has taken the position he supports mandatory audit

firm rotation, and what is your position on that?

Mr. PITT. My view is that mandatory audit rotation would write

in stone a process that could prove detrimental. I believe that when

an audit firm is not living up to the highest standards, then a disciplinary body should require mandatory rotation of that client. But

I don’t believe that setting in stone a rote process of a new auditor

every 7 years is beneficial. There are a number of reasons for that.

Mr. SHAYS. Let me get to that later in the 5 minutes that I have.

In the Oxley-Baker bill, which I am a cosponsor of, is there any

new authority that you would like to see in the bill that is not in

the bill now?

Mr. PITT. The principal authority that we would like to see included is our ability administratively to bar someone from serving

as an officer or director of a company if we find that they have engaged in egregious misconduct.

Mr. SHAYS. Is that the primary addition?

Mr. PITT. That is the principal one.

Mr. SHAYS. Would you send that to this committee, suggested

powers that you want that aren’t in the bill? Let us know what

they are.

Mr. PITT. Well, there are——

Mr. SHAYS. In writing.

Mr. PITT. Yes, I would be happy to do that.

Mr. SHAYS. In 1992, the SEC, the Treasury and the Federal Reserve in a joint report recommended legislation to repeal the GSE’s

exemption from the Federal securities law. As you know, Fannie

Mae and Freddie Mac are the only two publicly traded firms that

aren’t. Does the SEC still adhere to the Commission’s 1992 report?

Mr. PITT. We have not changed our general position, but we have

focused on it again. I will say that in this day and age I believe

transparency has to be the order of the day. To the extent that the

exemptions permit anything less than transparency, which I believe is the case, I believe at least that portion has to be removed.

Frankly, I could care less whether the GSEs pay registration fees

or things of that nature. But I do believe that disclosure is critical

for the GSEs as well as for other public companies.

Mr. SHAYS. You say it fairly strongly. But in your statement

where you say comprehensive information is the lifeblood of strong

and vibrant markets, our system and the global markets supporting that system require accurate, complete and timely disclosure of financial and other information. The current system of FedVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00091 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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eral securities regulation is premised on a full and fair disclosure

of this information. Companies choosing to access the public capital

markets must provide material information about their financial

results and conditions, businesses, securities and risks associated

with investments in those securities. Could I use this as a strong

support in some cases of such disclosure?

Mr. PITT. Yes.

Mr. SHAYS. Thank you. I yield back, Mr. Chairman.

Chairman OXLEY. The gentleman yields back.

The gentleman from Texas, Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Chairman Pitt, I have a few questions for you. I want to talk for

a second about the audit firms. Under the MSRB, isn’t there a rule

for auditing firms that audit the books of issuers of debt of public

entities, cities, states, whatever, that during that period of time

those firms can’t conduct other services for that issuer? And you

may not know off the top of your head, but I just wonder if we already have some experience.

I understand your concern about complete separations and bans,

but what I don’t know, is there something wrong if we are already

doing it, is there something wrong with saying if you are going to

audit one firm, you can’t consult with them, but you can consult

with everybody else? If you have 17,000 public companies, there is

plenty of business to go around.

Mr. PITT. Let me say that neither the MSRB nor anyone else, to

my knowledge, has thus far taken the position that a firm may

only do audits as a way of business. What a firm can or should be

allowed to do for an individual client is a very real issue. And there

can be conflicts, for example, where the other services would involve the auditor in reviewing its own work. That would be a situation clearly where auditors shouldn’t be allowed to undertake those

particular functions for a client. What I was addressing, and what

I continue to urge upon this committee, is the notion that stripping

down accounting firms so that the only thing they do is audits will

produce worse audits in the future than we presently have.

Mr. BENTSEN. I agree with that. I guess what I am saying is just

on a client-by-client basis, you know, the number one can do the

audit, the number two can do the other consulting business.

Whether or not there is merit in that, in saying you just can’t do

both when one is say a public issuer.

Mr. PITT. The problem with any generalization is that somebody

will always find circumstances to create problems, and the tax area

is a good one. If accounting firms provide tax services to audit clients, they will be far more familiar with the company they are auditing and they will be developing the kind of expertise that is critical to do a qualified audit. So my view is that if a particular function creates the possibility of a lack of independence, it should not

be allowed. But I don’t think we should have an absolute ban.

Mr. BENTSEN. Let me go to the public regulatory organization because I am curious about that. I think it is generally—I think it

is a good idea. I am curious about exactly how you would envision

it working and the ideas of setting principles or guidelines for auditing firms to meet which the Commission would have oversight

over both the drafting of those principles and the enforcement of

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those principles, if I understand your testimony correctly. Are we

heading down a path where basically the Commission would be

overseeing the quality of audits and in effect you would have to be

giving an opinion just like you give a qualified tax opinion for an

issuance of debt or securities, that you would be giving a qualified

opinion that the audit meets the standards as established by the

PRO? And that may be where we want to go. I just don’t know.

What do you envision how this ultimately will come out?

Mr. PITT. I think what we have in mind is somewhat different

from that. What we have in mind is having a vigorous body that

both can discipline individual accountants as well as whole accounting firms or offices of accounting firms, that can do quality

control review to make sure that, even if there hasn’t been a violation, the standards are the highest, a body that can enforce ethical

requirements and that can enforce existing auditing standards.

With respect to accounting principles, my view is that I would

leave that in the FASB. But in both cases, what I think is critical

is that the Commission has to provide meaningful oversight. And

I think over the last several years the Commission has not provided meaningful oversight to those functions, and that is something that we are pledged to change.

Mr. BENTSEN. So this would be a form of registration for—any

auditing firm of a public company that is going to have a registered

issuance would then have to meet the principles and would be subject to greater oversight than what is under existing law or rule by

the Commission?

Mr. PITT. Any firm that wanted to be an auditor of public statements by public companies would have to belong to the PAB, as we

call it, or the PRO, as the Oxley-Baker bill refers to it. And they

would have to adhere to all of the standards, and they would have

to be subject to discipline, and they would have to be subject to all

of the rules and requirements of that organization. That is what we

believe is a necessary approach to restore public confidence in the

accounting profession.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from California, Mr. Royce.

Mr. ROYCE. Thank you, Mr. Chairman.

Thank you, Chairman Pitt. Let me ask you if you envision any

practical way of ensuring that the board of directors for public

traded companies are held accountable in their duty of directing

management with a view toward optimizing company performance

and increasing shareholder wealth. One of the things you talked

about was specifically giving the SEC the ability to bar anyone who

was engaged in egregious conduct. I agree with that. But looking

at it from the incentive side for a minute, are there any changes

that the Federal Government can make to its best practices recommendations in regard to board member selection and in regard

to remuneration that would incentivize members to pursue the interests of the stockholders themselves rather than the interests of

management?

Mr. PITT. I think you will hear about that on the next panel,

among others from Mr. Livingston, who is with Financial Executives International. At our request FEI reviewed its existing code

of ethics, which I thought was excellent when it was promulgated,

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to see whether there ought to be some changes, and indeed they

have recommended a change in that. And, in addition, they have

taken a position on 12 critical issues relating to this entire aftermath of Enron.

I believe that corporate officers and directors have to be held to

much higher standards. The question is how those standards are

articulated. If they can be articulated even through the stock exchanges’ listing standards, or through such codes of ethics as the

FEI has proposed to me, that is a very sensible way of getting to

the right result. And I think that it would provide a real incentive,

particularly if we have the power to effectively sanction people who

don’t live up to those highest standards.

Mr. ROYCE. We talked about incentives. Let’s talk about deterrence then. Short of having those involved in egregious conduct

simply barred, which is a good idea, what are some of the other

tools that the SEC would use or how would you envision other

sanctions on those corporate leaders who do not act responsibly?

Mr. PITT. Well, one of the things that we have discussed here,

but I think is worth mentioning again in response to your question

is the notion that whatever incentives corporate officers and directors receive for performance should be honestly earned. So, if officers and directors have been compensated either by stock options

or salaries or bonuses for producing results that turn out to be

shams, they should have to give back every penny that they took

from the shareholders. That is another thing that we are proposing, and, as I said, last week we filed a case in which we have

sought that against a former CEO of a public company.

Mr. ROYCE. Do you feel at this point in this legislation are you

crafting language that would give the SEC that ability?

Mr. PITT. Well, on the removal of unearned incentives, I believe

that all the authority that is needed exists. When we go into court,

we can ask the courts to provide that relief. Obviously if the courts

don’t agree with our case or for whatever reason they think it is

not an appropriate remedy, we are not going to get it. But that system has worked quite well.

Mr. ROYCE. We would certainly with legislative intent in this bill

amplify that and state that it is Congress’ desire that you do have

these powers, which you are now exercising or attempting to exercise in the Enron case, but just to clarify those powers to further

assist in your court proceedings. I think that would be a wise policy.

Mr. PITT. I think that would be helpful.

Mr. ROYCE. I will be happy to follow up with you on that language if you could assist me in developing the language that you

think would be most effective toward that end. And I thank you

very much. I thank the Chairman of the committee.

Chairman OXLEY. The gentleman’s time has expired.

The Chair now recognizes the gentleman from New York, Mr.

Meeks.

Mr. MEEKS. Thank you, Mr. Chairman.

Chairman Pitt, let me ask, the regulatory structure that you advocate for the auditing profession would move quality review and

discipline to an organization controlled by public members rather

than accountants. And it leaves the standards that the auditors

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must meet subject to the rules of the industry control organizations. Wouldn’t it make more sense to have the same entities set

standards and enforce those standards, you know, at one body as

opposed to having two separate?

Mr. PITT. I think that is a suggestion that is worthy of consideration. My own view is the difficulty isn’t with the ethical standards

that have been promulgated. The difficulty is with the adherence

to those standards and the enforcement of those standards. If we

had reason to believe that the ethical standards were lacking in

some way, then I think your point would be very well taken. At the

present time it seems to me to be a problem of enforcement, not

of standard-setting.

Mr. MEEKS. Let me ask this question, then. I believe in your testimony earlier you said that the—it was too early to tell if the auditor independent rules that were in place in the year 2000 needed

to be amended. As a result of the additional corporate disclosure

required under those rules, we have already learned that some

companies are paying the auditors as much as 30 times more in

fees for non-auditing services as they do for auditing services. Auditing services have been turned into a loss lender to enable firms

to get contracts for non-offered services. Do you think that it is appropriate for them to make so much more consulting?

Mr. PITT. I don’t really feel that the question should focus on

whether that is appropriate or not. The question that I think those

facts suggest is whether or not that situation could give rise to a

lack of independence. That is what is implicit in the question. I

have to say it is always possible that at some level, fees could create problems. But I think that there are ways to deal with that

issue. I don’t think, for example, that you and I sitting down together—I know you and I could reach agreement—but I don’t think

that, if you and I sat down together and said, fine, you can only

make 50 percent of your revenues from consulting, that that would

necessarily produce better audits.

In fact, I think if you look at the history of some of the failures

in the 1960s and 1970s, long before consulting was a factor, you

will find that we had some enormous audit failures. And they had

nothing to do with the consulting fees.

My concern is that we should be sensitive to the problem of

where the fees are coming from, how much auditors are earning.

But I don’t feel that there is a right number or amount of fees.

What I think is there is a right way to conduct an audit and there

is a right way to discipline auditors who don’t meet the highest

standards. That is what is critical.

Mr. MEEKS. Finally, it caught my attention also you mentioned

your concerns about the time period to roll out FASB standards

and what they should be based on. Do you believe the adoption of

standards based on a simple majority would be better than what

is now instituted, the super majority, especially when you consider

there are only seven members on the board?

Mr. PITT. My answer is unequivocally ‘‘yes.’’ And the reason is

that we simply can’t afford to wait. There is very little unanimity

on anything, any issue of the day. What we need are principles

that are sound, that are overseen by the SEC to make sure that

they are in the interest of shareholders and that they promote full

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disclosure. But a reduction of the size of FASB, which has been

proposed to five, and then having principles adopted by a 3-to–2

vote seems to me to be perfectly sufficient. This body operates by

standard majority. It is the way the Senate operates. And I think

it is appropriate for the FASB as well.

Mr. MEEKS. Thank you, Mr. Chairman.

Chairman OXLEY. The gentleman’s time has expired. If I could

just follow up briefly. Is it your understanding that the Commission, the SEC, could overturn any decision made by FASB?

Mr. PITT. Absolutely.

Chairman OXLEY. Thank you.

The gentleman from Virginia.

Mr. CANTOR. Thank you, Mr. Chairman.

Mr. Chairman, I just have a question concerning the Private Security Litigation Reform Act of 1995, and there has been some, I

guess, renewed vigor around discussing sort of the impact of that

Act and opposed to the Enron situation that we are in. I was just

curious about your thoughts on the relationship between the Act

and the ability of investors to receive any kind of results for actual

fraud under the Act and then if you think there was or is a relationship with the Act and the Enron collapse.

Mr. PITT. Let me say first that, if I thought that the Act in any

way created the possibility that we might have more failures, I

would be back here urging you to reconsider aspects of that legislation. As I have said repeatedly, I don’t think any issue can be off

the table. We have checked with a number of entities, independent

entities, that keep statistics, including one run by Professor

Grundfest at Stanford. The statistics that have been reported to us

show that the number of class action suits has remained constant,

may even be a little bit larger, but that the amount of awards has

increased significantly. If anything, I believe that the legislation on

private securities litigation has actually strengthened bona fide

cases while weeding out those cases that are frivolous and that

simply seek to take advantage of a downturn in the market.

In my view, there is absolutely no connection that has been

shown between the collapse of Enron and the Private Security Litigation Reform Act. Absolutely none.

Mr. CANTOR. Thank you very much. Yield back, Mr. Chairman.

Chairman OXLEY. The gentleman yields back.

The Chair now recognizes the gentlelady from New York, Mrs.

Maloney.

Mrs. MALONEY. Welcome, Mr. Pitt. And I commend you and some

of the initial steps that the accounting and security industries have

take in recent weeks to eliminate conflicts of interest. And I represent many employees in the accounting business, and for the

most part the vast majority of these professionals are hard working

and honest people. Yet I very much support the Oxley bill and the

LaFalce bill and really the statement of the accounting firms themselves that we should separate accounting and consulting and create a strong public regulator for accounting. And many of our members have stated that you could do consulting for other firms, but

at least separate it, as former Chairman Levitt advocated so

strongly, to put a firewall between auditing and consulting, and I

think this should be the first step. Even the consulting firms and

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auditing firms themselves have called for this and say they are

doing it voluntarily. So we should put the statutory strength behind it.

You mentioned that there is a difficulty in enforcement and a

number of professionals have come forward with an idea to ensure

that accounting firms do their jobs correctly without heavy Government interference. And what do you think of the proposal that the

SEC could require that all publicly traded companies hire a second

auditing company to review its books every 3 years? That would be

built-in oversight without heavy governmental interference.

Mr. PITT. The difficulty with that suggestion, which I believe is

well motivated, is that there are only five major accounting firms.

And my concern is that would create a taxation on investors effectively that wouldn’t produce the results you want. I think the goal

is right.

Mrs. MALONEY. A taxation on investors and accounting firms?

Mr. PITT. Because both accounting firms would charge fees. If

you just take the Enron situation for example, it has been reported

that Andersen received $25 million for its audit. So if you brought

in a second firm, we have now upped it to $50 million. Somebody

is going to have to pay that.

Mrs. MALONEY. We are talking about rotating every 3 years.

Mr. PITT. You are talking about rotation. I apologize. I misunderstood. I am in favor of rotation where it has been shown that an

accounting firm has not lived up to the highest standards of auditing professionalism.

Mrs. MALONEY. But, it is difficult to see if you are living up to

the highest standards of auditing professionalism. Enron was believed to be a model of a well run company up to months before

it failed. And I find it tremendously troubling that Enron’s techniques that duped the public were blessed by one of the world’s

most prominent accounting firms. And it is equally troubling that

Enron is not an isolated case. It is by far the largest and most spectacular of several failures and near failures over the past several

years, but they all had the same elements.

So in many ways I see the Enron scandal, debacle, as the 9/11

for the financial industry that we need to do something about it.

They were condoning what has been alleged to be fraudulent accounting practices by one of our top accounting terms. So if you rotated it, it wouldn’t cost more money and it would build in competition and build in oversight without increasing bureaucracy

which——

Mr. PITT. My concern on that is there have been studies, the

Cohen Commission, the Treadway Commission and others, which

have shown that a large percentage of financial frauds occur in the

first 2 years of an audit-client relationship. I believe that any per

se mandatory rule removes flexibility from our society, and what

it might produce are worse audits rather than better audits. You

would have audit firms that weren’t as familiar with the companies

they were auditing and would be more susceptible to not catching

fraud than they would otherwise.

My view is that, if we establish a public accountability board, as

we have proposed, which would do quality control review, not just

where there has been a breakdown, but would do quality control

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review every year for the major firms, we would hopefully make

certain that firms were providing the best quality services. And, if

they failed to do that, they would lose their clients. The client

would be automatically removed.

Mrs. MALONEY. But we have a case before us and other similar

cases that took a tremendous toll on middle and lower income company employees that were left impoverished while politically connected insiders at the top walked away with millions. And the

practice was condoned by one of our best accounting firms, or was

considered to be one of our best accounting firms. So I feel that we

need to do something and the Oxley and LaFalce bill certainly get

us going in the right direction.

Chairman OXLEY. The gentlelady’s time has expired.

Mrs. MALONEY. May I please respond to his study and request

permission to place into the record another study that was cited in

Business Week recently that showed that companies that use their

auditors as consultants tend to manage earnings, including moving

debt of the books into partnerships, the MIT, Michigan State and

Stanford study that demonstrates that this practice is widespread

and cites that steps need to be taken statutorily.

Chairman OXLEY. Without objection. The gentlelady’s time has

expired.

[The following information was subsequently furnished by Hon.

Carolyn B. Maloney for the hearing record.

The gentlelady from New Jersey, Mrs. Roukema.

Mrs. ROUKEMA. I am sorry, Mr. Pitt, that I was not here for your

testimony and I unfortunately could not be here for all the questioning, because I was in a markup in another committee. But I

read with great interest the Business Week article which features

an article called ‘‘The Reluctant Reformer,’’ and they identified

Harvey Pitt. Do you know him as the rereluctant reformer? It did

raise some questions in my mind, and I wonder whether you have

already responded to these in one form or another. But, for example, where you were asked a few questions and gave an answer, I

have a question mark beside a number of them, particularly, and

I think this will bear repeating even if you have gone over it, because I think it is essential and the core of the issue before us. And

the question was posed to you do you still oppose a rule that bans

a firm from doing audits and consulting work for the same company?

I know previously you had opposed any such rule. Your answer

here is not quite explicit. Could you give us a precise answer as to

your recommendations about audits and consulting firms from the

same company. Because I believe they have to be separated. And

I think our legislation indicates that requires that.

Mr. PITT. Let me——

Mrs. ROUKEMA. Or should, anyway.

Mr. PITT. Two things. First of all, those who know me know that

I am seldom right, but never in doubt. There is nothing reluctant

about me so ever.

Mrs. ROUKEMA. You sound like quite a few people I know in Government.

Mr. PITT. And secondly, reform is something I pledged to do

when I came in. With respect to your question, do I believe that

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there are certain combinations of certain consulting activities that

can create a conflict for accounting firms? Yes, and those should

not be permitted. What I don’t believe is prudent is an absolute

separation of accounting from consulting, that is to provide that a

firm may only do auditing work. That, I believe, would be a mistake.

Mrs. ROUKEMA. Can you explain that? Because it sounds to me

as though you are endorsing the great potential for conflict of interest here.

Mr. PITT. Not at all. And, if I thought there were any potential

for that, I would move swiftly to prevent it. My view is this: That

restricting firms solely to audit work will deprive those firms of the

ability to produce more revenues that will help them do better

training of their auditors; second, it will deprive them of critical

knowledge that would be useful for auditors to have when performing an audit; and third, it will create——

Mrs. ROUKEMA. Excuse me. That was your answer here. But it

does not address the question of the conflicts of interest. How do

you protect again the conflict of interest potential?

Mr. PITT. I have said that there are certain types of consulting

work that inherently create the potential for conflicts, such as an

auditor reviewing his or her own work, and auditors effectively acting in a management or a managerial capacity. Those things have

to be wholly prohibited.

I have also said that the SEC 18 months ago, under my predecessor, adopted a series of rules to define what could be done and

what could not be done. And I believe that those rules should be

given a fair chance to see whether they solve the problem or not.

What I am opposed to are the proposals that have been made by

some that a firm that does auditing cannot do anything else for

anyone. That is something I am totally opposed to at this point.

Mrs. ROUKEMA. Thank you very much.

Chairman OXLEY. The gentlelady’s time has expired. Let me

point out to the committee we have two votes on the floor. I would

like to get through the Members who are here for questioning. And

let’s begin with the gentlelady from Oregon, Ms. Hooley.

Ms. HOOLEY. Thank you very much. Mr. Pitt, thank you for coming today. I want to make sure that we are all on the same wave

length, and as we look at all of these issues that we are all here

to protect the investors. Is that a common goal?

Mr. PITT. It absolutely is.

Ms. HOOLEY. OK. To something that one of the other Members,

Mr. Sherman, talked about, do you pay enough money to your auditors to be able to hire well qualified auditors in your department?

Mr. PITT. I am sorry?

Ms. HOOLEY. Are the salaries of your auditors enough to hire

well qualified auditors?

Mr. PITT. I think at the present time the salaries are not enough,

and I think that there is a need for improvement. If you are talking

about the private sector, my own view is that——

Ms. HOOLEY. I am talking about within the SEC.

Mr. PITT. We have steadfastly urged the passage of pay parity,

and funding for it. Since we don’t have that funding for 2003, I believe that our people do not make enough money.

92

Ms. HOOLEY. Let me just give you an example of a friend of mine

who has worked for a couple of different CPA firms, large ones.

One of the things that—comments she made to me recently was,

you know, in all of these large companies they pay—this is the

starting point for everyone. This is their training. This is where

they put their newest, most lowest paid employees is out on auditing to sort of earn their way. What are we doing—a company can

do that. They can do whatever they want. But what are we doing

to make sure that we hold those companies to some standard so in

fact they are not putting their least experienced out on the auditing road?

Mr. PITT. Well, that to me is one of the gaps in the existing set

of regulations, including the Public Oversight Board. In my view,

it is absolutely critical that people be appropriately trained as well

as sensitized to both legal requirements and ethical requirements

in the accounting firms, and then that there be diligent review by

an independent body to make sure that firms live up to those

standards.

At the present time I don’t believe that that is happening. That

is why we have proposed a public accountability board, and Chairman Oxley and Chairman Baker have proposed a public regulatory

organization.

Ms. HOOLEY. Let me mention one other comment that another

person made, and she was doing some temporary work at a company who I won’t name. And she said half the people that worked

in that financial department had all come from the auditing firm.

And she said I can guarantee you when the auditing firm they

came in, they knew one another and they said they were never

going to get a very tough audit. And she said, and they knew all

the people working for this company got paid more than they got

paid as the auditors because they were the lowest paid. Do you

ever hear any comments about that? Is that common or——

Mr. PITT. I do.

M. HOOLEY. Again, how does that protect the investor?

Mr. PITT. I am concerned about the so-called private sector revolving door problem. I think it is a legitimate issue, and one that

requires some attention. My big concern is that, for middle and

smaller size companies, it may not be possible for them to attract

from a wider pool of talent. And my only concern is making certain

that before we adopt any restrictions—and I think there is a need

for some guidance here, and some guidelines—but, before we adopt

an absolute restriction, we make sure that smaller firms are not

somehow being disadvantaged. But the issue is a fair one.

Chairman OXLEY. The gentlelady’s time has expired.

The gentleman from Pennsylvania, Mr. Kanjorski.

Mr. KANJORSKI. Thank you, Mr. Chairman.

Mr. Pitt, am I to assume that you are opposed to term limits?

I mean, it seems to me limiting an auditor’s ability to stay with a

corporation to a certain number of years is very analogous to term

limits of Members of Congress. I think that was a very popular,

easy solution in the early 1990s that has since faded. I expect that

you favor or are opposed to term limits in that regard, as you are

for the auditors. Is that correct?

93

Mr. PITT. Well, let me say that I don’t think that there is a direct

correlation between term limits on politicians and term limits on

auditors.

Mr. KANJORSKI. So you would like us to have term limits, but not

the auditors?

Mr. PITT. I haven’t said that. I just said that the—I think the

issues——

Mr. KANJORSKI. I am opposed to term limits. I was using the

analogy to say it seems to me the problem is the electorate. The

electorate, in this case, is the shareholders in the corporation. They

are the ones that elect the board. The board is to proceed using due

diligence to protect their interests. They are allowed to make mistakes, I guess. They are allowed to hire foolish or fraudulent auditors, as members of the electorate are able to elect foolish or fraudulent Members of Congress.

Mr. PITT. Although that hasn’t happened yet, to my knowledge.

Mr. KANJORSKI. No, that never happens, right?

I am a little worried about this rush to decision and structuring

a lot of rules to accomplish what appears to be a lot of good purposes, but in the end, could result in great damage to the system.

So, when people come up with these definite rules, it concerns me.

What is the next thing? Well, are we going to term-limit lawyers?

Can we have a law firm representing a corporation for only 4

years? That is ridiculous. They are hiring professionals. The relationship is of such a nature that you do not want to have someone

telling you that you can not hire your auditor or lawyer. Those are

the people you have the most trust in. They in turn have the professional responsibility to perform to the highest standards.

In between there, we have a board of directors, or governors, to

oversee and be sure that these professionals protect the interest of

the shareholders. If the shareholders find they do not do that, they

can kick them out. The only problem is, it ends up Enron occurs

before there is any value in the shareholders having a meeting.

The one area that I——

Mr. PITT. I share your concern about destroying what is good

about our system. That is a very real concern.

Mr. KANJORSKI. I will hope that you will constantly remind us

up here to not be overly rambunctious in what we do, but try to

act deliberately and deliberatively, and hopefully take our time on

this.

It seems to me—of course, I am just a simple lawyer from Pennsylvania—but it is awfully complicated stuff. I do not know how

many of our graduate professors up here are fully aware of what

the ramifications may be consistent with the speed by which we

seem to be moving.

But, there is something you said earlier in your testimony that

I just wanted to correct. We have an opportunity here to assert

that the New York Times made a fatal error when they reported

on February 3, 2002, you are reported here as saying: ‘‘Now some

in the group’’—and this is referring to the people that supported

the change of the law in 1995, like Senator Dodd—‘‘have been having second thoughts about their opposition to the tougher accounting rules. Others, like Harvey L. Pitt, the Chairman of the SecuriVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00101 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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ties and Exchange Commission, say they are beginning to rethink

the wisdom of some provisions of the 1995 law.’’

You were obviously misquoted in that article.

Mr. PITT. No, I believe the reporter who wrote that is very careful, and quoted me accurately, at least on that proposition. I think

nothing is off the table. I believe that people have legitimately

raised an issue about the PSLRA and therefore I thought it was

appropriate to start collecting statistics and look at the issue. What

I have found thus far leads me to believe that the Act has actually

served its purposes and is not responsible for Enron. But I believe

that we have to be open to changes in any aspect of our system in

light of what we have seen in Enron.

Chairman OXLEY. The gentleman’s time has expired.

The gentleman from Tennessee, to wrap things up.

Mr. FORD. Briefly. Thank you, Chairman Pitt. I know we are

fresh out of time here. When we had Mr. Barandino before the

committee, we talked a little bit about his announcement, I guess,

and some of the other accounting firms—and forgive me of not

going through all the pleasantries, you are great, I am glad to see

you here and all those things. We will do that another time—but

that they would no longer offer financial information systems designed for implementation to their audit clients. My friend Chairman Oxley’s bill would prohibit auditors from offering these services to audit clients as well as internal audit services. This is probably a good start. But there a whole range of business consulting

and other services that can and do create the possibility, at least

the appearance, of conflict of interest.

How significant are financial information systems consulting and

internal audit services to the non-auditing revenue collected by accounting firms? And, two, what other areas of consulting business

do you believe could pose these conflicts of interest? And in interest

of time, that we have two bills up here, Mr. LaFalce and Mr. Oxley,

and I hope we work everything out, but in Mr. LaFalce’s version

he has a provision that would require accountants to preserve

records and documents relating to audits for 7 years after the audit

is completed. I am not going to be facetious and say do you think

that could have helped to at least expose some of the challenges

and problems involved with Enron. Obviously probably it would

have. But shouldn’t we have a clear standard for recordkeeping, I

guess, is the larger and broader question that is obvious to this

committee and Congress will soon address. I know we have a vote.

I wanted to talk a little faster than my part of the country expects

me to. So if you could answer that, I would appreciate it.

Mr. PITT. A broader standard as to what might constitute a conflict?

Mr. FORD. I was speaking to the 7-year mandate for recordkeeping, number one, and do we need a clear standard. And, yes,

could you extrapolate clear standard even on conflicts of interest.

I didn’t ask it that way, but that may be a better way of framing

it.

Mr. PITT. Let me make a few observations on that, if I might.

First, before Enron reared its head, I had given a speech in which

I said that the Commission would not tolerate people who come in

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and lie to us in investigations, people who obstruct investigations

or destroy documents.

Without commenting on the particular Enron situation, destruction of documents cannot be condoned, because once somebody gets

away with it, everybody will try to get away with it and the system

falls apart. So I have very, very strong views on document destruction and obstructing an investigation.

As to how long records ought to be kept, in my view, some rational period may be useful. And with computers, now there is an ability to store information electronically that may enable them to be

archived so that we have access to it even after 7 years. But I believe that auditors should, and I believe they generally do try to,

maintain records that reflect what audit practices they went

through in conducting a particular audit for 5, 7 or 10 years after

the audit is completed. Not everything that gets generated in the

course of an audit needs to be retained.

Chairman OXLEY. The gentleman’s time has expired. I thank you

for the time. The Chair would note that Under Secretary Peter

Fisher has submitted written testimony for this hearing. I would

like to thank the Treasury Department. Without objection, Secretary Fisher’s testimony will be entered into the record.

Mr. Pitt, thank you, Mr. Chairman, for your appearance today.

And the committee will reconvene at 1:00.

[The information can be found on page 409 in the appendix.]

[Recess.]

Chairman OXLEY. The hearing will reconvene. Here comes the

Ranking Member.

Let me introduce the panel. Let me introduce our distinguished

panel: Mr. Franklin D. Raines, Chairman and CEO of Fannie Mae,

on behalf of the Business Roundtable; Mr. H. Carl McCall, Comptroller, State of New York, Office of State Comptroller; Mr. Joseph

V. DelRaso, Partner, Pepper Hamilton, LLP; Mr. Philip B. Livingston, President and CEO of Financial Executives International; Mr.

Jerry Jasinowski, President of National Association of Manufacturers; and Mr. Peter C. Clapman, Senior Vice President and Chief

Counsel of Corporate Governance TIAA-CREF. Gentlemen, thank

you all for appearing and your willingness to appear here today.

Let me yield to the gentleman from New York.

Mr. LAFALCE. I too would like to welcome every member of the

panel. And so many of you I know so well: Mr. Raines with whom

I have had a long working relationship before his days at Fannie

Mae and the Administration; Mr. DelRaso with whom I have

worked over the years through the auspices of the National Italian

American Foundation; Mr. Jasinowski, going back 20, 30 years

now; but most of all, I want to welcome Mr. Carl McCall, the

Comptroller of the State of New York. Again, Carl has been one of

the most outstanding public servants it has been my pleasure to

know, whether it was a State senator, whether it was as a United

States Ambassador, whether it was as a Commissioner, whether it

was in the private sector as a leading vice president of one of the

major financial institutions in the world, and he has been elected

to statewide office in the State of New York by overwhelming margins on two separate occasions. And one of his distinctions, among

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many, he is also a member of the board of directors of the New

York Stock Exchange.

So, not to slight the other members of the panel, but I just don’t

know you quite as well. Thank you, Mr. Chairman.

Chairman OXLEY. Thank you. All you New Yorkers stick together, I notice that. I understand Mr. McCall has some issues and

has to get back to New York, and I appreciate that.

Let us begin with Mr. McCall.

STATEMENT OF H. CARL McCALL, COMPTROLLER, STATE OF

NEW YORK, OFFICE OF THE STATE COMPTROLLER

Mr. MCCALL. Thank you, Mr. Oxley. As I said in my prepared

remarks, I had a note here that I am to start off by saying good

morning. I guess that is not now appropriate, but thank you for

this opportunity. And, unfortunately, I do have to go back to New

York, but I hope I can stay for some of the questions.

Chairman OXLEY. Mr. Raines is shaking his head because he has

been on several second panels. So good afternoon.

Mr. MCCALL. I want to thank the Ranking Member, Congressman LaFalce, for all he has done, and I appreciate the long relationship I have had with him and to all the Members of the committee.

I want to thank you for giving me this opportunity to address

issues of corporate accountability and investor confidence. In the

past few months, Americans have learned that the integrity of the

financial markets and, in fact, the economic well-being of our country depend on these issues.

I commend this committee for holding a hearing. It is essential

that we have a national discussion on these issues. I assure you

our future depends on it. We need action at the Federal level to

prevent another Enron in the future.

I applaud my good friend, Congressman LaFalce, for his leadership in introducing the Comprehensive Investor Protection Act of

2002. As comptroller of the State of New York, I serve as the sole

trustee of the State’s $112 billion Common Retirement Fund, the

pension fund for nearly 1 million New York State and local government employees and retirees. The fund owned nearly 4 million

shares of Enron through its index portfolio and active managers

prior to the company’s catastrophic downfall. Our losses are expected to exceed $58 million.

While our fund is strong enough to absorb the financial blow inflicted by this corporate collapse, we are deeply shaken by the lack

of diligent oversight by the independent auditors, board of directors, rating agencies and analysts on whom investors rely.

And we are not alone. In fact, I believe that the loss of investor

confidence is the most devastating effect of the corporate collapse

experience over the last several months. And if we don’t restore

that confidence quickly and completely, the consequences will be

immeasurable.

The bill before the committee today, the Corporate and Auditing

Accountability Responsibility and Transparency Act of 2002, offers

measures for enhanced auditor oversight. However, this is no time

for small steps. I believe additional standards are necessary to enVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00104 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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sure the restoration of investors’ confidence in auditors and their

findings.

The Comprehensive Investor Protection Act that Congressman

LaFalce introduced goes much further toward that goal. I urge the

committee to consider a legislative compromise that includes some

form of the provisions included in the Comprehensive Investor Protection Act that would correct what is currently a failed regulatory

structure. I am speaking in particular of provisions that align with

recommendations I have made as New York State comptroller.

Let me explain. First we need standards to make auditors more

independent from the companies they audit. I submitted proposals

to the Securities and Exchange Commission and to the Big Five auditing firms and called on companies to take three steps:

One, prohibit auditors from providing non-audit services to audit

clients except under limited circumstances.

Two, limit audit relationships to a maximum of 7 years.

Three, restrict auditors from accepting employment with clients

for 2 years following work on an audit.

In short, auditor independence is critical to long-term shareholder value and confidence. That is why I supported the SEC’s

proposed revision of auditor independence requirements in 2000.

And that is why I submitted these proposals, and that is why I

pushed for change in my various roles as a public official.

I have introduced legislation that would require all New York

State agencies to adopt these standards in their relationships with

auditing firms. In addition, I issued an executive order to implement these standards in the Office of the State Comptroller. I believe these are important steps toward achieving meaningful auditor independence.

But we can’t achieve comprehensive reform on a State-by-State

basis. We also need a national effort. For this reason, the provisions in the Comprehensive Investor Protection Act that promote

auditor independence are extremely important. As a shareholder, I

have adopted a proxy voting policy to oppose the appointment of

any auditor that also performs non-audit services to the company.

I also sent a letter to the Common Retirement Fund’s 50 largest

portfolio companies, explaining our proposed standards and requesting information about how long companies have retained their

current auditor.

As comptroller, I can take these steps at the Common Retirement

Fund, and I can encourage my counterparts around the country to

do likewise, but it is essential that we hear from Washington on

these matters. It is essential to know that our legislators share our

commitment to investor protection.

The work of this committee sends a vital signal to all investors.

To ensure that I continue to develop appropriate proposals to increase investor protection, I have also created a panel of advisors

who will focus specifically on measures that enhance board independence and corporate accountability and minimize conflicts of interest in the marketplace. As a last resort, I have also taken legal

action against Enron. I have filed a notice of joinder in United

States District Court for the Southern District of Texas in support

of a legal application to freeze the assets of directors and execuVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00105 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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tives who may have benefited from stock sales based on information that was not available to other shareholders.

I applaud this committee for seeking input from a variety of

sources, especially from the private sector. As a member of the

board of the New York Stock Exchange, I serve as co-chairman of

a recently created Committee on Corporate Accountability and Listing Standards. The committee will review corporate governance

and shareholder accountability issues such as the composition of

corporate boards and committees, disclosure requirements and the

role of independent audit committees. The committee will also consider new listing standards that will have a profound impact on the

marketplace.

In closing, I would like to say that I am acutely aware of my fiduciary responsibility to the retirees and hard-working people of

New York State. Their ability to enjoy an economically secure retirement depends on the faithful and prudent investments of the

Common Retirement Fund. In 9 years as comptroller, I have never

heard from as many members of the pension systems as I have in

the past few months. They are nervous and frightened and beginning to question the rationality of equity markets generally. This

is not an encouraging sign for the marketplace. We must restore

their confidence, each of us, fiduciaries, legislators and regulators.

We all have a role to play.

I thank you for your reasoned and constructive approach to the

important issues before us. I look forward to working together with

you to restore investor confidence and ensure the long-term viability of the American marketplace.

Again, I thank you, Chairman Oxley, Ranking Member LaFalce,

and Members of the committee for allowing me to testify today.

[The prepared statement of H. Carl McCall can be found on page

302 in the appendix.]

Chairman OXLEY. Thank you, Mr. McCall. And feel free to stay

as long as you possibly can. Hopefully we can get to questions before you have to leave.

Now I am pleased to go back to regular order and introduce the

gentleman, Mr. Raines.

STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CEO,

FANNIE MAE; CHAIRMAN, CORPORATE GOVERNANCE TASK

FORCE, THE BUSINESS ROUNDTABLE

Mr. RAINES. Thank you, Chairman Oxley, and thank you, Ranking Member LaFalce and Members of the committee. My name is

Franklin Raines and I am Chairman and CEO of Fannie Mae. I am

here today as Chairman of the Corporate Governance Task Force

of the Business Roundtable, and I appreciate the opportunity to express the views of the Business Roundtable with respect to the

topic of today’s hearing.

Before I do that, Mr. Chairman, let me take this opportunity to

recognize the foresight and leadership of this committee in raising

and addressing issues of financial institution safety, soundness,

and transparency, well before the collapse of Enron brought these

issues to national attention. Let me recognize your leadership and

that of Ranking Member LaFalce, subcommittee Chairman Baker,

and subcommittee Ranking Member Kanjorski, for your consistent

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and strong leadership over the years on issues of corporate responsibility, transparency and market discipline.

The Business Roundtable is recognized as an authoritative voice

on matters affecting America’s business corporations and, as such,

has a keen interest in corporate governance. Indeed, as leaders of

some of our Nation’s largest businesses, the Roundtable has the

strongest interest in corporate governance practices that secure the

confidence of shareholders, employers, policymakers, and other constituencies.

The Roundtable has been involved in corporate governance issues

since 1978. In 1997, we published our statement on corporate governance, which suggests best practices regarding matters including

the functions of the board of directors, board structure and operations, and shareholders’ meetings. We are pleased with the number of large corporations that have adopted these practices.

In light of recent events, the Roundtable is reviewing its 1997

statement regarding corporate governance, and we expect to issue

a new statement on this subject later this spring. The Business

Roundtable has prepared a detailed analysis of H.R. 3763, and with

your permission I would like to submit that analysis for the record.

[The following information was subsequently furnished by Franklin D. Raines for the hearing record.]

Chairman OXLEY. Without objection.

Mr. RAINES. This afternoon I would like to summarize what the

Business Roundtable believes should be the guiding principles of

corporate governance. The Business Roundtable has issued a public

statement regarding the issues related to the bankruptcy of Enron,

in which we expressed our view of Enron’s collapse and a set of

principles we believe should guide the discussion of proposed

changes, practices, regulations and laws.

With respect to Enron, the Business Roundtable believes that a

number of the actions and behaviors revealed in the report of the

special committee of the Enron Board of Directors, which contributed to the collapse of the company, are unacceptable. The Powers

report describes a pervasive breakdown in the norms of ethical behavior, corporate governance, and corporate responsibility to internal and external stakeholders. The Enron situation appears at this

point to derive fundamentally from a massive breach of trust.

We understand why the American people are stunned and outraged by the failure of corporate leadership and governance at

Enron. It is wholly irresponsible and unacceptable for corporate

leaders to say they did not know, or suggest it was not their duty

to know about the operations and activities of their company, particularly when it comes to risks that threaten the fundamental viability of their company.

The success of the American free enterprise system follows from

the merger of corporate responsibility with individual responsibility, and the Business Roundtable believes that responsibility

starts at the top.

The United States has the best corporate governance, financial

reporting, and securities market systems in the world. These systems work because of the adoption of best practices by public companies within a framework of laws and regulations.

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The collapse of the Enron Corporation is a profound and troubling exception to the overall record of success. Other less dramatic

exceptions may also exist among the thousands of United States

public corporations, but there are exceptions in systems that have

generally worked very well.

In light of the public interest and issue drawing out of the Enron

situation, we thought it would be useful to articulate a set of guiding principles of corporate governance:

First, the paramount duty of the board of directors of a public

corporation is to select and oversee competent and ethical management to run the company on a day-to-day basis.

Second, it is the responsibility of management to operate the

company in a competent and ethical manner. Senior management

is expected to know how the company earns its income and what

risks the company is undertaking in the course of carrying out its

business. Management should never put personal interests ahead

of or in conflict with the interest of the company.

Third, it is the responsibility of management under the oversight

of the board and its audit committee to produce financial statements that fairly present the financial condition of the company

and to make sufficient disclosures to investors to permit them to

assess the business and financial soundness of the company.

Fourth, it is the responsibility of the board and its audit committee to engage an independent auditing firm to audit the financial statements prepared by management and to issue an opinion

on these statements based on generally accepted accounting principles. The board, its audit committee, and management must be

vigilant to ensure that the corporation or its employees do not take

any actions that compromise the independence of the independent

auditing firm.

Fifth, it is the responsibility of the independent auditing firm to

ensure it is in fact independent, is without conflict of interest, employs highly competent staff and carries out its work in accordance

with generally accepted auditing standards. It is also the responsibility of the independent accounting firm to inform the board,

through its audit committee, of any concerns it may have about the

appropriateness and quality of significant accounting treatments,

business transactions, and about any weaknesses in internal control systems. The firm should do so in a forthright manner and on

a timely basis, whether or not management has communicated to

the board or audit committee on the same matters.

Six, the company has a responsibility to deal with its employees

in a fair and equitable manner. Employee benefit plans, once established, should be operated in a manner that is fair and equitable

to all employees. These responsibilities and others are critical to

the functioning of the modern public corporation. No law or regulation alone can be a substitute for the voluntary adherence to these

principles by corporate directors and management and by the accounting firms retained to serve American corporations.

Several thoughtful proposals have been offered to create new regulations or laws to deal with what appear to be breaches of trust

and failure of responsibility at Enron. Two weeks ago, the President announced his plan to improve corporate governance. The

President’s personal involvement in seeking reform is welcome and

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underscores just how fundamental ethical and responsible corporate governance is to the health of the American economy.

Chairman Oxley, you and Mr. Baker have put forth a number of

laudable proposals to improve corporate governance we are considering today, as has Mr. LaFalce and others. Some legislation and

regulatory changes are necessary and advisable. The Business

Roundtable worked closely with policymakers to help ensure that

any necessary changes to laws and regulations are effective and efficient, taking care that our responses to the unusual circumstances presented by Enron do not inhibit U.S. Public corporations’ ability to compete, create jobs, and generate economic

growth.

Mr. Chairman, that concludes my statement, and on behalf of the

Business Roundtable and its member companies, thank you for the

opportunity to participate in today’s hearing.

[The prepared statement of Franklin D. Raines can be found on

page 320 in the appendix.]

Chairman OXLEY. Thank you Mr. Raines.

And I now call on Mr. Joseph V. DelRaso.

STATEMENT OF JOSEPH V. DelRASO, PARTNER, PEPPER

HAMILTON, LLP

Mr. DELRASO. Good afternoon, Chairman Oxley, Ranking Member LaFalce, and distinguished Members of the committee. Thank

you for this opportunity to present my views on H.R. 3763, legislation which I believe will do much to restore the faith of investors

in the way in which public companies report their financial results.

I commend the committee for its level-headed and responsible approach, especially at a time when many pundits and commentators

are generating more heat than light on these important issues.

I am a partner in the law firm of Pepper Hamilton in Philadelphia. My practice focuses on corporate and securities matters, particularly on matters arising under the Investment Company Act of

1940 and the Investment Advisors Act of 1940. I served as an attorney advisor with the Securities and Exchange Commission in

the 1980s, and I serve as a member of the board of directors of both

public and private companies and non-profit institutions.

Having experience on the regulatory side as a lawyer in private

practice and as a corporate board member, I believe I offer the committee an important perspective on the practical effect of key aspects of this legislation. Because this committee has already heard

a wealth of testimony on auditor oversight provisions, I will focus

my comments on other sections, particularly the transparency of

corporate disclosure provisions of section 6, corporate governance

provisions of section 9, and accredited rating agencies of section 11.

Each of these sections, the committee should ensure that studies

and activities undertaken do not attempt to fix things that are not

broken.

Federal Reserve Board Chairman Alan Greenspan in his earlier

testimony to this committee noted a pronounced move toward more

transparent reporting and improved corporate governance practices

in the wake of the Enron collapse. As Chairman Oxley said at the

committee’s hearings last week, while Government may still need

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to take action, that action should not stifle the ability and initiative

of the financial markets to self-correct.

In my practice as a lawyer, the vast majority of boards of directors, especially those of publicly held companies that I represent,

take their responsibilities very seriously. In the last few years in

particular, I am sure even more so now in the post-Enron and postGlobal Crossing world, independent directors have become increasingly aggressive in acting as watchdogs over their respective shareholders’ interests.

Audit committees have already been required to adopt charters

governing their operations.

But perhaps they even need more guidance in this area. And I

concur with some of the remarks earlier today that the stock exchanges and the other self-regulatory organizations may look into

other areas with regard to adopting rules to help guide audit companies in their role as the watchdogs on the financial side of the

shop.

Whether or not these policies and procedures are aggressively enforced, obviously, vary from company to company. On the one hand,

given the proclivity of the plaintiffs’ bar to act as a self-appointed

protector of shareholder interests, even the most diligent board of

directors is constantly checking itself to avoid costly unnecessary

litigation. This serves as an important catalyst for directors instituting improved corporate governance policies and procedures.

This also points to the need for appropriate government action to

craft legislation and implement rules that are clearly understood

and not easily manipulated.

Appropriate implementation and enforcement is just as critical

as the legislative effort. Again, while the actions of the plaintiffs’

bar keep directors and officers focused and diligent, the appropriate

deterrent is and always and will be government enforcement and

prosecution. The spectre of criminal sanctions and incarceration for

the most egregious behavior or civil fines and sanctions for other

transgressions serves the public interest much more sensibly than

allowing certain members of the bar to extract their self-imposed

penalties from companies in the form of their sometimes very large

contingency fees. A more direct distribution of funds to compensate

victims of corporate malfeasance, or fines that are used to further

bolster Government enforcement efforts might be preferable, and

indeed are just plain common sense in some circumstances. Any effort to roll back securities litigation reform may make business

only more expensive by increasing insurance costs and the like and

still produce inferior results.

Again, we heard studies undertaken by the SEC that point to the

fact that the plaintiffs’ bar is alive and well and still impacting the

markets. On the other hand, prosecutorial judgment most times is

a markedly more effective approach to handling some of these problems rather than ‘‘strike suit’’ targeting.

Below the board level, the President’s Working Group, referred

to in section 9, should examine how the financial markets can deter

managers and other employees from interfering or influencing

third-party professionals, whether they be auditors, rating agencies, and other parties that are relied upon in one way or another

to put their imprimatur on corporate actions.

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From a practical perspective, any additional Government overlay

from either a statutory or regulatory standpoint might further

dampen the enthusiasm of qualified people to serve as independent

directors. On the other hand, appropriate sanctions for inappropriate behavior would be welcome. The overwhelming majority of

independent directors has been and continue to be good corporate

citizens, dedicated to discharging their duties to protect shareholder interests.

Further initiatives, including personal liability expenses, except

in the most egregious cases of willful and wanton misconduct, and

other erroneous regulatory sanctions or requirements may merely

serve to deter good individuals from accepting positions as independent directors.

Finally, corporate governance ties in with the provisions in section 6 regarding the need for improved transparency of corporate

disclosures. Boards should be able to discern from transparent reporting the correct state of affairs. There should be little excuse for

a well-informed board of directors to fail or be victimized by obfuscation and financial high-jinks constructed as off-balance-sheet

transactions and other clever financial tricks. Uniform standards of

financial reporting will not only sustain a level playing field, but

will uphold the integrity of the process.

I applaud the work of this committee in seeking improved transparency, for without it, the efficient functioning of our financial

markets may be impeded. Financial investors expect to see, and

will demand more than ever, quality of earnings that can be reported via clear and concise accounting standards consistently applied. This is especially true in dealing with non-exchange traded

financial instruments and other instruments that are not readily

tracked in public markets. This legislation, I believe, will put the

‘‘fair’’ back in fair-value accounting.

Finally, with regard to credit agencies, I believe many of the

issues I noted regarding the corporate governance procedures also

apply in this field, particularly the overwhelming need to avoid

conflicts of interest. This again is essential to the efficient operation of our financial markets. Just as a ‘‘seal of approval’’ is expected by the auditor certification accompanying audited financial

results, the grade awarded by rating agencies will only be worth

the strength and integrity of the name behind it.

Finally, Mr. Chairman Oxley and Ranking Member LaFalce, I

would like to thank you again for this opportunity to testify today

on this important piece of legislation. The dark cloud of Enron and

Global Crossing, while obviously dire to investors, employees, and

those most immediately affected, may have some element of a silver lining if, as I believe, it serves as a wake-up call to responsible

independent directors and corporate officers and if it provides the

Congress the impetus to enact some long-needed reforms to ensure

responsible reporting of corporate financial results.

[The prepared statement of Joseph V. DelRaso can be found on

page 360 in the appendix.]

Chairman OXLEY. Thank you.

And I recognize Mr. Livingston.

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STATEMENT OF PHILIP B. LIVINGSTON, PRESIDENT AND CEO,

FINANCIAL EXECUTIVES INTERNATIONAL

Mr. LIVINGSTON. Thank you, Chairman Oxley and Ranking Member LaFalce. I am here today to represent FEI and its strong support for H.R. 3763 and the leadership of this committee. As Chairman Pitt kindly recognized this morning, the FEI released its own

recommendations for improving financial management, financial

reporting, and corporate governance. These recommendations dovetail nicely with H.R. 3763.

Financial officers know that good corporate control requires

broad frontline defense mechanisms to prevent problems. As a result, that is where our suggestions begin. Our most important recommendation is that all senior financial officers adhere to a special

code of ethical conduct. We recommend that this bill include an additional provision calling upon the SEC to work with the stock exchanges to develop a requirement that senior financial officers of

all public companies adhere to a code of ethical conduct similar to

that in use by FEI members today. We believe adherence to such

a code is a crucially important cornerstone of sound management,

appropriate atonement at the top, and successful fiduciary stewardship.

In order to reinforce management and board awareness in the

maintenance of a strong ethical climate, we strongly recommend

that all senior financial officers annually sign such a code and deliver it to their board. I will tell you that one of our leading CFOs

has required all of his company’s 3,000 financial professionals

worldwide to sign such a code and deliver it back to their corporate

headquarters.

Unfortunately, the Enron case once again demonstrates the need

to improve audit committees. Three years ago, the Blue Ribbon

Panel on Audit Committee Effectiveness called for all audit committee members to be financially literate and for each committee

to have at least one financial expert. Unfortunately, the criteria for

meeting the standard was set so low that no real change or addition to audit committee personnel actually occurred in the time

leading up to Enron’s demise.

We must get on with truly raising the bar and adding real expertise to audit committees. We need Congress and the stock exchanges and the SEC to act on this matter. The stock exchanges

should be required to write tougher standards into their listing

agreements. Explicit experience in financial reporting must be required of such experts.

FEI is also proposing recommendations as to the issue of auditor

independence. As recently as last year, I testified before the Senate

Banking Committee in opposition to former Chairman Levin’s proposal to split audit and non-audit services provided by accounting

firms. I tell you, it is still my strong personal opinion that consulting services do not corrupt the integrity of independent audits.

The truth, in my view, is exactly the opposite. Consulting projects

enable the auditor to get out of the accounting department and

learn about the intricacies of the business and, in the end, conduct

a more effective audit.

However, the accounting profession is suffering from a postEnron crisis of confidence. Therefore, certain restrictions should

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now be imposed on non-audit services supplied by the independent

audit. They should no longer provide clients with internal audit

services or consulting on computer systems used for accounting. We

strongly believe that tax services should be allowed, as well as acquisition due diligence, audits of employee benefit plans, and other

statutory audits. We do strongly recommend that audit committees

approve all large non-audit services provided by the auditor.

I also want to address the controversial issue of stock option accounting. Unfortunately, the current crisis has encouraged some to

attempt opportunistic initiatives to advance narrow and

unconstructive agendas with little regard for the important matters

in front of us. These very tactics were too often employed over the

last 10 years and are at the core of many of our problems.

Unusable accounting standards and dysfunctional financial statements result from processes and regulatory environments unable to

recognize the real problems, yet set out to achieve narrow politicalor governance-related objectives.

Stock option accounting is such a case. This debate has a long

and acrimonious history between shareholder activists, enraged by

cases of excessive executive compensation, and the corporate preparers of financial statements that find employees’ stock options as

hard to accurately measure as an Enron energy contract or put

agreement to sell broadband capacity. A charge to the income

statement for stock options is the Trojan horse in the battle over

governance controls of options and executive compensation.

When recently asked about the ongoing accounting debate, Sarah

Teslik, the CEO of the Council of Institutional Investors, was

quoted as saying: ‘‘If we can’t get the vote on these things, then we

have to punish them on the balance sheet.’’ Her comments reflect

the reality of the issue. It is about the practices and the quantities

of option grants, not the quality of the income statement.

A real reform would be for shareholders to approve all stock option plans and therefore control abusive levels of shareholder dilution in the few cases that it occurs. Because of the intense controversy around this subject, Congress can do a great service by

mandating shareholder approval of employee stock option plans,

and we urge you to act.

Briefly, FEI would like to add its continuing support for the Private Securities Litigation Reform Act. The PSLRA is working today

and there is no need to change or modify the current law. Enron’s

employees and shareholders will not be hindered by the PSLRA in

seeking restitution of their losses. Now is the time for real reform,

not opportunistic grabs of narrow agenda items.

FEI also recommends that we increase the SEC’s budget and

that a significant portion of the additional funds be earmarked for

attracting new high-caliber professional staff. Further, FEI supports the creation of a new regulatory organization for the auditing

profession. We believe it is important to clarify that the two-thirds

members specified as ‘‘not members of the accounting profession’’

be further defined as individuals who are not currently practicing

CPAs, but do have extensive education and experience in financial

management of public companies, auditing, or accounting.

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That concludes my remarks, and I would like to thank the Chairman and the Members of the committee for allowing FEI this opportunity.

[The prepared statement of Philip B. Livingston can be found on

page 365 in the appendix.]

Chairman OXLEY. Thank you.

Our next witness is Mr. Jerry Jasinowski. I was so used to having you testify in the committee across the hall, and we are facing

in different directions from the past, but I think this year you

made an appearance before our committee. Welcome. And it is good

to see you again and particularly under these circumstances.

STATEMENT OF JERRY J. JASINOWSKI, PRESIDENT, NATIONAL

ASSOCIATION OF MANUFACTURERS

Mr. JASINOWSKI. Thank you very much, Chairman Oxley, for

your leadership on this, and allowing us to testify before this committee.

With 14,000 manufacturing companies, both large and small, we

are a user of the auditing information and a producer of the auditing and financial information, and so have a particularly unique

perspective on this and have thought very carefully about it. Although we have not concluded all of our decisions on it, we certainly feel that your bill 3763 is a good framework.

I want to acknowledge, Congressman LaFalce, also our longstanding relationship, and we look forward to working with you in

terms of the legislation you propose.

In our press release, Mr. Chairman, we put the emphasis on best

practices and enforcement, and suggest that we have a very good

system in this country which has been badly damaged by Enron,

Andersen, and other misjudgments which Frank Raines has articulated rather well, and I would associate myself with his remarks.

Our 14,000 members are outraged by what appear to be certain

transgressions on the part of both companies and auditors, and feel

that the bulk of our membership are absolutely opposed to anything like that and strongly want to affirm the need for honest and

complete information. In fact, as we indicate in the statement—

which I would like included in the record—information is critical

to our capital markets, and I think without it, we will not be able

to have the growth and productivity that we so badly need.

Let me make five points. And the first point is to stress your bill

H.R. 3763, although we do not yet endorse it, we certainly feel it

provides the framework for the kind of reform—thoughtful balanced reform, that we need.

Disclosure beyond GAPP is important in getting better information, public regulatory oversight, as you suggest, is the kind of

thing that we think is important in the legislative area.

Having said that, we really put a lot of emphasis in our testimony on best practices and the need for the private sector to further improve the quality of the information that they have—and

not just the auditor, but also the companies. We do have the best

system in the world. But as Chairman Pitt said, we can make it

a lot better. And I think there are many ways in which we can.

At the heart of that, of course, is strengthening the audit committee and strengthening the oversight of the management, having

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a more independent board, focusing on such matters as the critical

accounting policies and practices that have come out of the SEC,

and other matters where we think a good system could be made

much better if, in fact, it is fully employed. I think the tone of

much of your bill puts the emphasis on that and we would want

to associate ourselves with that.

And we think we have an obligation, Mr. Chairman, to speak out

to our own members and say look, we know most of you are doing

a fine job, but not everybody is, and you can do better; and we will

certainly encourage that within our own membership.

As I said, I thought that Chairman Pitt was very helpful in

terms of his proactive emphasis on enforcement, information and

clarity. We think we ought to be very tough with wrongdoers. People make mistakes, they ought to pay. And it is important that society generally, the SEC, and the Congress assure that that happens.

Having said that, there may be some opportunities for legislative

reform, as you suggest, in your bill and beyond that. Certainly the

public regulatory organization to oversee accounting standards, as

you suggest, is something that we think merits careful consideration. Also, it might surprise some, but we think it is important to

increase the funding for the SEC in order to have the kind of education, clear information, and enforcement that they need. We cannot expect to get this job done if we do not have adequate resources

there, and we support that.

I am sure there are other measures as these hearings continue,

and in the market session we will support legislatively. But again

let me repeat, we don’t think there needs to be a whole set of new

laws. There is an enormous set of good laws on the books that,

with proper enforcement and good action on the part of the companies, will lead us to improve this system as it now stands.

We think it is, finally, important not to take on some measures

which will do real harm; that is, to produce a lot of new legislation,

new liabilities, try to reinvent the wheel. This committee, your own

leadership, Congressman LaFalce, and the SEC have been working

on this for some time. The Enron-Andersen affairs require us to redouble our efforts, to strengthen our laws in some cases, but let us

not try to reinvent the wheel. Certainly we don’t need new liability

provisions for the most part, and we ought to avoid increases in

costs.

Having said that, again, I think it is important for us in the private sector to take responsibility to further improve our own management and implementation of the accounting provisions.

Thank you, Mr. Chairman.

[The prepared statement of Jerry Jasinowski can be found on

page 388 in the appendix.]

Chairman OXLEY. Thank you, Mr. Jasinowski.

Mr. Clapman.

STATEMENT OF PETER C. CLAPMAN, SENIOR VICE PRESIDENT

AND CHIEF COUNSEL, CORPORATE GOVERNANCE, TIAA-CREF.

Mr. CLAPMAN. Thank you. Thank you, Chairman Oxley, Ranking

Member LaFalce, and Members of the committee. I am Peter

Clapman. I am speaking from an investor and shareholder perspecVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00115 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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tive on the issues of the day. I will be talking not only about the

accounting regulation issues, but the board of corporate governance

issues as well.

TIAA-CREF has a fiduciary responsibility to over 2–1/2 million

members of our pension system, which is the largest pension system in the world. We have approximately $275 billion under management. I also chair the most prestigious global corporate governance organization in the world, and I must say that the Enron episode has had a real detrimental effect on the reputation of the

United States and corporate governance.

TIAA-CREF has been a leader in corporate governance. We are

convinced that our initiatives to better corporate governance will

produce better returns for our pension participants and shareholders. We also believe that it is our responsibility to monitor the

managements of our portfolio companies and hold them accountable. Good corporate governance depends critically on the performance of the board of directors and, in particular, its most important

board committees: compensation committee, auditing committee

and nominating committee. If the board is not independent, if the

directors lack the proper qualifications, and if the directors do not

pay sufficient time and attention to fulfill this role, an Enron is not

only possible, but it is also likely. Are there other Enrons out

there? We can hope that there are not, but prudently cannot trust

that will be the case without reforms.

And I will now address some of the needed corporate governance

reforms and how I suggest they best be accomplished. One area

that must be addressed involves the conflicts within the key professions. Too often accountants and lawyers, ostensibly representing

the company, in fact wind up representing only its senior management. Such conflicts were at the heart of the problems of Enron.

The professional organizations themselves have a key role and

must do a better job through education and discipline to minimize

these abuses. The regulation of the accounting profession demands

change, and already excellent proposals have been made.

TIAA-CREF CEO John Biggs has urged, among other things,

that companies assure the integrity of the auditing process by not

giving the same audit firm that does its audits, consulting work.

We are not advocating the split of auditing and consultant work for

the organization, but that each company should be conscious of this

potential issue of conflict and split its auditing and consulting work

on that basis, and also by periodically rotating the auditing firm

or at least considering such action.

He also proposed that an independent board oversee the accounting profession, with its own funding source, and with the legal authority to enforce rules and impose sanctions for wrongdoing.

But on a broader scope, a related corporate governance reform

needed for more accurate financial reporting is on the subject of executive compensation, particularly affecting the use of stock options. The reforms needed are twofold: require that the cost of options be reflected in the financial statements; and, two, require

shareholder approval for dilution of option plans, introducing greater accountability in this most important area of executive compensation. Stock options are overused and abused, with the accounting rules largely to blame for this problem. The true cost of

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fixed-price options escape the earnings statement, encouraging this

overuse and abuse. This structural failure of corporate governance

must be addressed.

The National Stock Exchange as the New York Stock Exchange

and Nasdaq must be an important engine for needed reform. The

exchanges, however, have dual objective organizations. While they

must regulate companies and brokers in the public interest, as

businesses they also seek listings from the very companies they

must regulate. To the credit of Chairman Harvey Pitt, the SEC has

already requested that the exchanges evaluate which corporate

governance reforms are necessary. The exchanges must respond by

imposing stronger standards of director independence, requiring

shareholder approval of all material, equity plans promoting education of directors, and implementing more stringent policies to ferret out conflicts of interest. If the exchanges fail to act, the SEC,

using its regulatory powers and persuasive influence, should press

for needed reforms.

The education of directors is a major concern. Directors on audit

committees only recently had to meet a standard of financial literacy; literally, to have the ability to understand a financial statement. Directors on compensation committees often do not take a

proactive role on behalf of their company, because they lack an understanding of compensation issues and do not obtain independent

consultants when needed. The abuse and overuse of stock options

results from inadequate performance of many compensation committees and the board as a whole.

What is the role for Congress? It is not clear to me how many

new laws are needed. But as a minimum, your oversight role is

critical. At some point, memories of Enron will fade as other issues

take center stage, but the corporate governance problems that I

have highlighted, and are highlighted by the Enron experience,

should be fixed.

I have outlined a number of corporate governance issues in

which I believe reforms are both necessary and possible:

One, dealing with the conflicts among the professionals.

Two, better regulation of the accounting profession.

Three, reforms in the area of executive compensation, particularly in the area of stock options, and to require shareholder approval.

And in the role of the stock exchanges, to deal with issues in the

public interest and recognize their responsibility there.

And, finally, the education of directors.

You may be sure TIAA-CREF is an organization that will continue to press for these reforms. We hope the current widespread

public interest in such issues will provide focus and impetus for

such reforms.

Thank you very much.

[The prepared statement of Peter C. Clapman can be found on

page 397 in the appendix.]

Chairman OXLEY. Thank you Mr. Clapman.

Let me begin by asking Mr. Raines, what role corporate management plays in assuring that audit firms are independent, and how

is it similar or different to the role of the audit committee itself?

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Mr. RAINES. As we stated in our principles, it is not only the obligation of the auditor to be independent, but it is also the obligation

of both management and the board to not take any steps that

would compromise its independence. And that means from the

management standpoint, that management should not ask the

auditors to undertake activities that may be inconsistent with their

role as independent auditors, and must ensure that the practices

with regard to the personnel of the auditors and to the provision

of information needed for the auditors to do their work are consistent with the auditor’s independence.

Sometimes it is easiest, if you have a task and you have a professional firm working for you, to simply use the firm who is there

and use a different department of that firm. But that easy path can

lead to independence questions. If, for example, you used the consulting arm of an auditor to create your financial systems, and

then the auditors then have to audit those systems, that can impinge on the independence of the auditors. So it is in part management’s job to not even suggest to the auditors that they put themselves into positions that may create independence concerns.

Chairman OXLEY. Mr. DelRaso, you mentioned that Congress

should be careful in trying to fix things that aren’t broken. What

proposals specifically are you concerned about?

Mr. DELRASO. I think the CARTA legislation has done a pretty

good job of addressing the problems without going too far. But I am

still concerned about two areas in particular: one, the groundswell

that may be developing in terms of rolling back the reforms made

on securities litigation; and, number two, I think in the area of

auditor independence, Congress should take a careful look at the

real role of the modern-day accounting firm and the services they

provide across the board, audit and consulting.

We have seen the worst in these recent cases. I represent a number of companies that deal in the global markets, and I think a little more work may have to be done to take a look at the role of

these firms in the non-audit areas, especially overseas. When global companies are setting up subsidiary operations and other types

of international functions, the auditing firm is the law firm in that

jurisdiction and it provides other areas of advice and, quite frankly,

it is the best source of that advice in that particular market. And

at the same time, that firm also has the institutional knowledge of

a particular client.

There are, I think, a number of functions that really aren’t necessarily in as deep a conflict as we believe.

Chairman OXLEY. I don’t know whether you were here for Mr.

Pitt’s testimony, Chairman Pitt, but I think you and he share the

same concerns that perhaps I do as well; that is, we would be very

careful about putting things in stone, as Chairman Pitt said, because it is much more difficult to extricate ourselves from a bad decision. Better it be left for the most part to the private sector, and

indeed to regulators.

Let me ask, Mr. Jasinowski, Chairman Greenspan testified a

couple of weeks ago to this committee and, in response to a question, seemed to indicate that in many cases, the marketplace is the

best way of disciplining unwanted behavior. What do you think

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your members would fear the most, Government reprisals or market reprisals?

Mr. JASINOWSKI. I think the market reprisals are already taking

place, Mr. Chairman, as you know, and I don’t think there is a

company in my membership which isn’t reviewing all of its procedures to be absolutely sure they are not only sound, but they are

made stronger. And I think the markets, the equity markets, have

also reacted already. So we don’t have any choice about the private

markets except within running our own companies, where we do

have a choice, and I think we are going to do a lot better there.

I think the biggest concern is that people are going to try to create a whole new legislative, regulatory, liability system to go after

some particular transgressions. And I think one of the reasons why

your particular legislation is appealing is that you respond legislatively, you set up a framework to use the SEC, you try to involve

the private sector, and at the same time, you have punitive actions

if they are necessary.

I think you have got to have a balance. You have got to have perspective. That is what all our members are really looking for, and

we are concerned that Congress may overreact.

Chairman OXLEY. Mr. Livingston, while I may share your philosophical opinion regarding the division of labor between accounting

and consulting, the fact is that several of the accounting firms have

already indicated that it is their desire as the corporation or partnership to divide those. Some would say that we need to make sure

that maintains, by passing a law that would forever divide those

functions. What is your reaction to that?

Mr. LIVINGSTON. I think it would be a great role for the new

oversight body that we are talking about for the accounting profession. And the main reason it would be a great role for that body

is because there are many, many nuances. And our group, while it

feels strongly about continuing to get tax services from the auditor,

because most of that work is compliance work, it is related to the

tax return and ties into all the work they do on the audit, there

are areas in tax preparation, tax advisory, that might be good for

this oversight body to be concerned about; tax structurings and tax

shelters that have been in the news, and where there are contingency fees and tax savings. And that just illustrates the kind of nuances that an oversight body could react much more quickly to in

a more focused manner.

Chairman OXLEY. Thank you. My time has expired.

The gentleman from New York, Mr. LaFalce.

Mr. LAFALCE. I think everybody agrees we need to have some

type of oversight board, correct? So I guess the question is, what

powers should it have and who should serve on it? Now, with respect to powers, does anybody doubt that they have should have

their own independent investigatory powers, that they should have

their own ability to subpoena, to promulgate standards, and see to

its enforcement, adequate staff resources to do the job? Does anybody have any quarrel with any of those concepts?

Mr. Jasinowski, do you have a quarrel with those concepts?

Mr. JASINOWSKI. I do in the sense that it is not clear what the

relationship is to the SEC in that whole articulation.

Mr. LAFALCE. It surely would be subject to the SEC.

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Mr. JASINOWSKI. I think as long as the SEC is the one who has

the determination with respect to investigation.

Mr. LAFALCE. I assure you, anything coming out of this committee will absolutely ensure that the board is subject to the jurisdiction of the SEC, which is subject exclusively to the jurisdiction

of this committee.

Having said that, the question is, who is going to be on it? We

know that Charlie Boucher resigned when he heard of the appointment of certain individuals to a new board created by Mr. Pitt. We

know yesterday that Charlie Boucher said that the new board

should consist exclusively of public members. And I don’t know we

have to go that far.

Suppose we put in legislation that the SEC’s appointive power of

members of the board should be based upon recommendations

made by certain institutional investors; that TIAA-CREF should

make certain recommendations; that the Council of Institutional

Investors should make certain recommendations; that private employees’ pension plans and public employees’ pension plans should

make certain recommendations. A slate of candidates could then be

decided upon by the SEC.

How does that sound to you, Mr. Jasinowski, because it is important who is on it. Mr. Boucher would have rejected out of hand

those individuals that Mr. Pitt wanted.

Mr. JASINOWSKI. You have a lot of shareholders here, like you,

Congressman LaFalce, and employers are some of those. Management, auditors, pension funds.

Mr. LAFALCE. We want to check the employers, because it is the

employers that are the CEOs with the stock options, the CFOs

with the stock options that are the first line of defense against

earnings management or manipulation. Then it gets to the audit

committee who very often also has the same stock options, perhaps

not in the same quantity, and very often have a policy of passivity

that permeates the board. And so we need to check that. And it is

my judgment that the best check is to have at least a majority of

members coming from individuals representative of these pension

funds’ institutional investor groups.

It is not unreasonable in any event?

Mr. JASINOWSKI. No.

Mr. LAFALCE. Thank you. Let us go to the next issue. Is there

anybody here who thinks we should permit auditors to immediately

leave the audit firm and become an employee of the firm that they

were auditing? Don’t you think we ought to have some ban on the

time period? Wouldn’t that be a good thing to put in the legislation?

How about you, Mr. Raines?

Mr. RAINES. We believe there ought to be a period of time when

someone who worked on the audit is not eligible for employment.

Mr. LAFALCE. OK, good. Anybody who disagrees with that concept? We can accept that.

Mr. LIVINGSTON. That ought to be a company-driven thing, a policy adopted by the companies. And I don’t think you should legislate.

Mr. LAFALCE. You can say it, and I would strongly disagree with

it, because the problem is that 90 percent of the companies you

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don’t have to worry about would adopt it, and the 10 percent that

you might have to worry about wouldn’t adopt it. And that is why

you have laws. Most people don’t murder, but you have laws

against murder. Publicly traded corporations, if we are talking

about publicly traded corporations—and we are not talking about

private corporations, Mr. Livingston—publicly traded corporations

subject to—invested by public at large.

Let us go on to some other issues. Mr. Jasinowski, you were very

worried about adopting new laws dealing with grievances in the securities markets. What about a return to old laws? Would you consider that? I mean, you are opposed to new laws. What about return to old laws?

Mr. JASINOWSKI. We are not opposed to new laws.

Mr. LAFALCE. Let me focus in particular. What provisions in the

1995 Securities Litigation Act were so important that you think

they are so wonderful that they shouldn’t be changed? What was

done in the 1995 legislation that reformed or changed securities

litigation that was so important that you think it should not be revisited? Would you please explain that?

Mr. JASINOWSKI. I think in general——

Mr. LAFALCE. Not in general, in specific.

Mr. JASINOWSKI. I don’t see any reason we ought to be changing

that law.

Mr. LAFALCE. What did it do that it should not be changed?

What did it do specifically that is so good that we shouldn’t change

it?

Mr. JASINOWSKI. I am not in a position——

Mr. LAFALCE. All right. Thank you. OK, good. I know you came

out strongly.

Mr. JASINOWSKI. Again, it is not altogether new laws; I didn’t say

we ought to go back and change that particular law.

Mr. LAFALCE. That is the law you said should not be changed,

but it was enacted in 1995. And I want to know what did it do that

was so good that it ought not to be changed? And I have a nonresponse. But I understand that this is an institutional response as

opposed to a specific response. Is there any problem with making

sure that it is the audit committee that has the responsibility for

the hiring and the firing of the auditor? Is that a good idea?

Mr. JASINOWSKI. Congressman LaFalce, I particularly like that

aspect of your legislation, and I think having an independent nominating committee making a decision about the audit committee and

establishing in-house as independent an audit committee as you

can have is a very good idea. Whether or not you need to codify

it in legislation I don’t know, but I think it’s something we ought

to be striving for.

Mr. CLAPMAN. You made the point that the audit committee

should have the right to hire and fire the accountant. I think that

is embedded currently in the law. Whether it is followed in practice

is a different issue. But it does tie into——

Mr. LAFALCE. What if we make it a material breach if they do

not?

Mr. CLAPMAN. I think it already is.

Mr. LAFALCE. Well, then, there is not an awful lot of material

breaches, I would suggest, that have not been——

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Mr. CLAPMAN. That is true. There is a tie-in to the consultant aspect of what the audit firm does and why we take the position that

we do.

Mr. LAFALCE. Speaking of the consultant, we do not say that certain firms have to be auditors and can’t be consultants. We say

they can’t be the auditor and consultant for the same employer.

They could be a consultant for some other employers and still retain all that capacity. And, of course, I do think certain types of

consulting such as tax should be allowed for the same employer.

Mr. CLAPMAN. But there is an aspect of that point that goes to

the heart of your question, and that is that the consulting services

typically will not be retained by the audit committee. Typically, the

consulting services are obtained by the management of the company. And that is where the potential conflict comes about: How

does that firm view their loyalties? Do they view their loyalties to

the audit committee and the shareholders, or do they owe their loyalties to the senior management of the company? And that is the

effect of having large-scale consulting services by the same firm

that does the audit being hired by management, and how the audit

firm then assesses where their bread is buttered.

Mr. BAKER. [Presiding.] We will come back for another round.

Mr. RAINES. If I could differ. My experience is different than

that. Audit committees typically are, in fact, shown the entire

workload by the audit firm, whether or not it is audit-related or

consulting, and it is the responsibility of the audit committee to supervise that entire relationship; and in the firms that I am aware,

where best practices would include the audit committee supervising

the entire relationship, regardless of the scope of services.

But on the scope of services issue, I would urge the committee

to make, as you are thinking about the legislation, to not fall into

these definitions of audit, audit-related, and consulting, because

they are in many ways very false distinctions. Some of the auditrelated are in fact audits of the pension plan, and they are indistinguishable from audits of the financial statements. So I think most

people would believe having the same auditor doing auditing is not

a problem.

On the other hand, there are some things that are called ‘‘consulting’’ that look a lot like what you think an auditor should do,

such as looking and verifying information that is going to be used

for securities offerings. So, rather than using these broad definitions, I think it is far better to try to come up with something that

says things that are consistent with the attestation role of an auditor, where they are not to do broad-gauge management consulting,

but to provide assurance to third parties that something is accurate. And I think that is far better than these distinctions that are

currently being used, because I think they really confuse what it

is that the auditors are doing.

Mr. LAFALCE. I think if you look at Mr. Levitt’s recommendations, they were about an inch or two thick. And clearly, it would

be the job of the SEC to articulate regulations. We have separation

between church and state, but very often there must, of necessity,

be a merger of the two. It is absolutely impossible to have a complete separation.

Mr. BAKER. The gentleman’s time has expired.

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Mr. Raines, I want to pursue this line you just initiated with regard to the manner in which the Congress should act. And I sense

from a number of the other members of the panel that with regard

to the Congress being able to circumscribe current business practice by certain definition and thereby preclude inappropriate conduct in years to come, all of you are very bright people who can

construct a business model that would meet whatever rule Congress comes up with, and that we should address principles of governance and then empower the SEC to enforce those principles

where they don’t already have the authority to act—which I believe

they do have authority to act.

To that end, I think it was inappropriate for Enron officials to

have exercised no-cost options when, at the same time, constrained

employees may have been prohibited at different intervals from

acting on the exercise of their own stock options. And if there had

been a subsequent accounting, there certainly would have been a

restatement brought about which would have caused shareholders,

if they had been a viable corporation still standing, to take significant loss while the executives earned significant compensation during that same environment.

Is it your understanding that participants generally in the

Roundtable, as a matter of business ethics, have in place today

some prohibition on those generalizations that I have described? Or

how can we construct rules that encourage long-term earnings

growth versus short-term profit and the extreme pressures that I

understand management faces?

Mr. RAINES. I think you outlined the core problem, and let me

give you my perspective on that. For example, in our statement

with regard to the treatment of employees and treating them fairly,

I think it would be entirely appropriate for Congress to say that

one of the tests of fair treatment under the pension laws is that

the fair treatment would go to questions of when can individuals

trade or not trade. That is a broad principle that doesn’t go to the

Enron case, that says in this particular instance, here is what the

rules can be. And then the Labor Department, as necessary, can

begin to elaborate on how that might apply.

But we don’t believe there should be special treatment for one set

of employees of the corporation versus another as to when they

have access to the market. And most companies have tried to hold

any such periods to be very small. But I think it would not be unreasonable for that specification to be there, because it establishes

a principle without establishing exactly how it should be done for

all times; because, you know, 20 years ago we didn’t have 401Ks.

And 20 years from now we may have something different that is

in place.

But, I think the broad principle that employees should be treated

similarly in the implementation of these plans and should not be

disadvantaged vis-a-vis other employees in the exercise of their

rights to purchase or sell stock, I think is a broad principle that

would make an enormous amount of sense.

Mr. BAKER. Do shareholders generally today, as members of the

Roundtable, have the authority to approve or disapprove option

plans?

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Mr. RAINES. The vast majority of option plans are presented to

the shareholders for approval; not all, but the vast majority of the

plans are presented to shareholders for their approval, and they

are not always approved. Indeed, a number of the shareholder activist groups have taken very strong positions with regard to the

size of these plans, and many corporations go to great efforts to

comply with the views of these shareholder activist groups when

they put their plans together.

Mr. BAKER. I have suggested, as one incentive to preclude manipulation of stock value, exercising no-cost option with a subsequent

restatement of earnings, to require disgorgement within a certain

time period of the restatement occurring if there is a finding by the

SEC of manipulation of stock price. And the reason for that mechanism as opposed to the litigation route is the SEC can act while

there are still resources available to act upon, where if we rely on

litigation under Section 10(b)(5), it could be years. What is your reaction to that general line of thought?

Mr. RAINES. Mine? With regard to disgorgement, the SEC does

have authority now to undertake that. And in cases where there

has been wrongdoing that leads to a misstatement of the information given to the public that has a material impact on the stock,

I don’t believe it is unreasonable at all for the SEC to pursue

disgorgement among the senior management of the proceeds from

options that would have occurred under those circumstances. I

think you are going to have to define who was covered and what

the circumstances will be. But as you described the situation, that

would be a prime case in which the SEC should take action.

Mr. BAKER. As a general matter for the panel, does anyone dispute the observation that the financial statement should be an accurate reporting of corporate financial condition for the shareholder, and that it is not the property of the management? Does

anyone dispute that particular view? Because we had the CEO of

a significant accounting firm indicate it was a joint property of

management and the shareholder, and I found that to be a bit distressing that that conflict would be publicly acknowledged by a

CEO of an auditing corporation.

Did you want to comment?

Mr. CLAPMAN. Yes, I did. I just wanted to add to the response

of Mr. Raines to your question about whether shareholders have

the right to approve stock options. I think the vast majority of the

companies within the Business Roundtable do present their stock

option plans for shareholder approval, but we have been tracking

this and there are, increasingly, companies adopting plans without

shareholder approval. So if you want to look at the direction, without some reforms in this area, the direction is toward more plans

being put into effect without shareholder approval at the current

time.

Mr. BAKER. I am sure we may come back to a second round, but

Mr. LaFalce wanted to get 15 seconds.

Mr. LAFALCE. Mr. Chairman, pursuant to rule 11 of the Rules of

the House and rule 3 of the rules of our committee, I would like

to have an additional day of hearings on the matters related to

comprehensive reforms and, most particularly, both Mr. Oxley’s bill

and my bill so we can see the best merits of each.

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Mr. BAKER. I thank the gentleman.

Mrs. Maloney.

Mrs. MALONEY. Thank you, Mr. Chairman, and welcome to all

the panelists.

I would like to ask Mr. Raines, we currently have five big accounting firms, and with the indictment of Andersen there is a possibility that we may soon be down to four; and doesn’t the fact that

only four auditors will be reviewing the financial statements of

America’s largest companies require that the industry regulator be

a stronger public entity than those that have been proposed by the

SEC? Could you comment on what the impact may be with only

four firms?

Mr. RAINES. Well, I think that it is a bad thing that we might

face the prospect of having only four major accounting firms in the

United States. There are other accountings firms other than these

current five. But I think the reduction in the number of accounting

firms is not a good thing. I think competition in that market is a

good thing. I think having multiple firms is a good thing. And that

is a matter of concern, and I hope that is taken into account in future years as firms look to merge or otherwise reduce the number

of competitors.

With regard to an oversight body, I agree wholeheartedly that it

needs to be a strong body and needs to be one with the power to

actually investigate and the power to actually come to conclusions

and to make determinations that might include penalties. And you

ought to have on it those people who can both instill confidence in

the public, but also those people who have some knowledge of the

profession and the work to be able to come to decisions.

But it should not be a body that is nearly honorific. It ought to

have the ability to not only discipline, but also to look at the quality control procedures within accounting firms to ensure that they

are working to become better and they are becoming better at what

they do; because I believe the biggest impact they could have is not

on the penalty side, but it is in quality control. It is ensuring they

are hiring good people and they are training them and they have

systems of conflict of interest in place; that they are enforcing their

own internal rules, in fact, and actually going to look and review

periodic audits and see if those audits meet standards. I think that

kind of approach from an oversight body can have a tremendous effect on the quality of audits.

Mrs. MALONEY. There were two questions that have been asked

by the prior panel by members of this company. One was rotating

auditors, your feeling on that. And another of, say, every 3 years

having an auditor come in and look at the audit. And what is your

response to those two proposals?

Mr. RAINES. In terms of the rotation of auditors, there are instances, and particularly in public bodies, that do require rotation.

The concern that you have is that in the first year and last year

of the audit, you may not have the same quality of the audit that

you were looking for. I believe the SEC’s evidence is that more

frauds occur in the first year of a new audit relationship than in

any other time. So I believe the members of the Roundtable would

say it ought to be on a case-by-case basis.

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In our company we have adopted the practice now of essentially

requiring a de novo review of our auditor each year where we

would have the same process we would have as though we were

doing a new audit selection, where they have to present their credentials and identify their quality control and all the aspects to

make a determination should they continue to be the auditor in the

next year. And I think that practice can take the place of an automatic rotation, as a rule.

Mrs. MALONEY. With the proposal having, say every third year,

another auditor review the work.

Mr. RAINES. Well, currently there is a process in the auditing

profession of having another firm come and do a review. But this

is a relatively private process in which the SEC is informed of the

results, but it is a relatively private process. I personally believe

that that is a process that should be overseen by the new oversight

body, and that these reviews are used as a way to improve audits,

not only to say how did this one firm do, but what did you learn

in this case, in this type of a firm, or this type of an industry, and

let other people know so that if they run into the same problems,

they will know how to go about handling them.

We don’t have a good enough feedback loop so people are learning about what went right and what went wrong in audits. If you

have someone come in every 3 years to review the entire audit,

that is a massive undertaking for multinational companies that

may be in 100 different countries, that to go replicate that audit

would be a massive undertaking. I think it would be impractical.

But I do believe having these periodic quality reviews, taking random audits and really thoroughly looking at them, could be a very

important learning tool.

Mrs. MALONEY. Last week, former SEC Chairman Robert Hills

suggested before this committee that audit committees should be

given more formal legal status and that independent directors

should be nominated by an independent nominating committee

rather than by the CEO or chairman of a company. And what is

your view of these suggestions?

Mr. RAINES. At least my experience since last fall is that audit

committees have quite a status now within corporations. I think

our general view would be that designating a particular committee

as being independent of the board itself is not a good idea. Committees are just subsets of the boards. Audit committees should be

populated by independent directors. And all committee assignments should be made, in our view, through a nominating committee, and that no one person——

Mrs. MALONEY. An independent nominating committee?

Mr. RAINES. Nominating committee of the board.

Mrs. MALONEY. But most board members are appointed by the

CEO, so then you would have the CEO control.

Mr. RAINES. I don’t believe the Chairman was really talking

about a nominating committee that was independent of the board.

I believe he meant an independent committee made up of independent board members. So it would be the nominating committee

within the board that would be approving that. That is the practice

of the corporations that I am familiar with personally in any event.

Certainly the CEO is likely to have ideas, but I also know that very

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often that the CEO’s ideas don’t prevail in well-managed companies

and that the nominating company ultimately has responsibility of

picking both committee Members and members of the board.

Mrs. MALONEY. There has been some suggestion after the Enron

debacle that there is a massive hole in our financial services regulatory system for entities like Enron, entities like Enron that act

as financial services companies, but do not fit the current regulatory scheme. And do you believe that simply the reporting requirements for public companies to the SEC is regulation enough

for these companies? In many cases, banks are very heavily regulated. And in many cases, these entities like Enron are larger than

the banks in practicing formal banking practices. So either the

bank shouldn’t be regulated or possibly these entities should be

regulated.

Mr. BAKER. That will be your last question, because your time

has expired.

Mr. RAINES. I think you have raised an important issue. We have

been talking here about the regulation of financial disclosures. But

you are talking about as important, if not more important, safety

and soundness regulation. Enron could have disclosed much of this

and still have been unsound. And the rise of financial institutions

who are not subject to safety and soundness regulation is a matter

of concern, because just as surely as a large regulated financial

company could cause concerns in the economy and concerns with

other investors, you could have that same concern arise with a financial company that does not have a safety and soundness regulator.

So I think it is important to keep in mind that we need to have

appropriate disclosure, but also we need appropriate safety and

soundness regulation to ensure that our financial institutions are

contributing to a sound economy and not putting our economy in

danger.

Mrs. MALONEY. With Enron, do you think there is a gaping hole

for these type of entities? Should there be some type of regulation?

Mr. RAINES. I believe that that is an issue that ought to be given

very careful regulation. Enron was becoming a financial company.

It had no safety and soundness regulation or oversight of any kind.

And where we see very large companies becoming financial institutions without safety and soundness regulations, I think that is a

concern.

Mr. BAKER. Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman. I want to go back to

a comment you had a few moments ago and this whole issue of

whether or not you preclude an auditor from providing other services. And I agree that you don’t want to get caught up in the minutia of saying, well, it can’t be this or that, and I understand there

is some synergy between tax return preparation and auditing.

But you raise an interesting point which I was trying to raise

earlier today with Mr. Pitt; and that is, there are certain things

that auditors provide that are verification oriented for investors.

And it would seem to me, and again I recall—you may recall from

your prior experience—I seem to recall there was an MSRB rule or

other rule that precluded auditors from providing other verification

numbers in the same issuance that was being done.

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Now, I may be wrong about that, but it does seem to me that

is really what we are trying to get at. And I would be curious and,

Mr. Livingston, I would like your comments, because you talked a

little bit about this in your testimony, whether or not if we proscribe something a little more broadly in the way that Mr. Raines

discussed it, that that would be an acceptable form of separating

out, saying if you are going to be providing auditing for public companies and even tax return preparation that you can’t—at least in

the same issuance of a registered issuance—provide other forms of

verification. Because I think our concern is not just that there is

perhaps padding of other accounts in order to get a more favorable

audit, but I think our other concern in the case of Andersen was

that they were providing qualified opinions and verification for offbalance-sheet financing which, had they put all the pieces all together, they very likely would have said perhaps it wasn’t being

properly disclosed.

Mr. RAINES. I may not have been clear, but let me try to answer

that. It has been 20 years since I looked at any MSRB rules. I

think in my experience in dealing with entities, both entities in financial trouble and entities that are financially strong, is that the

auditing firm often is the only consistent source of information.

And well done, they require that numbers in one place match up

with numbers in another place. And it is a very valuable service

that they provide and they typically are very loath to sign off on

anything that they haven’t had a chance to verify what the source

of the information was.

And that is something we don’t want to discourage companies

from having; having someone who sees all the numbers, so you

don’t have a case where companies can show part of the numbers

to one audit firm and another set of numbers to another audit firm

and no one ever compares the two.

So I think you want to try to have your verification things in one

place. But I think what you don’t want to do is take the person who

is doing verification and then have them doing fundamentally different things that will get them off of what their particular expertise is and into this.

There was an unfortunate phase in the auditing profession where

they stopped looking at themselves as auditors and assurance firms

and got into being full-scale multipurpose professional services

firms. And I think that was a mistake, and I think most of the auditing firms are correcting that mistake now. But I do believe that

there is importance in having one firm that looks at all the numbers when you are verifying and making representations to the

public, so you don’t have things falling between the cracks.

Mr. LIVINGSTON. I would comment, a couple of years ago when

we did pass the—the SEC enacted those rules they extended the

list of services that auditors should not do, which resulted in a

product on which they might end up relying upon. And the problem

is, is that it gets—that is a good list of things that they shouldn’t

prepare the books and then audit the books or build receivable systems and then audit receivable systems.

But the problem gets into when a company is doing very complex

transactions and they show the transactions to the auditor. And I

think in the Enron case, the auditor may have gotten too involved

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in the actual design and then auditing the transactions. It takes

ethical conduct and professional standards at the local level to regulate that gray area.

Mr. BENTSEN. And I think that was the problematic situation

with respect to Enron.

Let me ask you one other question, Mr. Livingston. In your testimony, you briefly referenced the need that your organization is

calling for to review FASB and their rules. Can you expand upon

that a little bit?

Mr. LIVINGSTON. Yeah. We have gotten into a bad circumstance

in accounting standards over the last 10 years, and we have had

accounting standards like FASB 133 which is accounting for derivatives, which is 850 pages long and is unusable by the most sophisticated local audit partners out in the field. There are a handful of people in the world that know how to apply this accounting

standard. And that is the unfortunate circumstance we have gotten

ourselves into.

We have gone too far in getting away from principle-based accounting standards. In this Enron and accounting for derivatives,

FASB 133 has exposed the need to have a new process, a new

mind-set, principle-based accounting standards that get back to

substance of reform.

When I learned accounting and I studied for the CPA exam,

there was one principle called ‘‘substance of reform’’ that we have

lost in the last 10 years. Form over substance has taken over. And

it is an unfortunate lesson, but I think the lesson has been learned

and I think we are heading toward faster standard setting that are

principle-based, that get back to substance of reform.

Mr. BENTSEN. You sound like the architects have taken over

FASB, but I always thought of FASB as being more of an accounting-based institution, as it was. And you say it doesn’t work in its

current form.

Mr. BAKER. That has to be your last question.

Mr. LIVINGSTON. It has gotten too focused on narrow problems

and not prioritized. It hasn’t kept pace with the modernization of

technology and hasn’t thought about financial reporting as much as

here is a problem and we are going to swarm in and spend a lot

of time on that. The consolidations project, we spent a lot of time

on that. There were many of us that encouraged the FASB to break

up the consolidations project, which they worked for 20 years on,

and break it up and focus on the SPE issue. And a lot of people

said that. And they couldn’t step back and divorce themselves of

the other part of the consolidations project. They wouldn’t let that

go and focus on SBEs.

And that is part of the whole problem that has been going on for

the last 10 years. I think we have a new mind-set and a new attitude, and I think we will get to the right place.

Mr. BAKER. The gentleman’s time has expired.

Mr. Royce.

Mr. ROYCE. Thank you, Mr. Chairman. I was going to ask Mr.

Frank Raines of Fannie Mae, a lot of what we talked about today,

one of the things we have focused on is compensation structure and

making sure that when you have got a board of directors that you

are increasing their independence and that you are ensuring that

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the interests of the shareholder are being represented there on the

board and not the interests of management. And I was going to

ask, how does Fannie Mae compensate its own board of directors

and its audit committee, with an eye toward that specific objective?

Mr. RAINES. Well, it has been our philosophy for quite some time

not to concentrate the compensation of our directors or of our management using only one tool, so we use a variety of tools. Our board

is compensated through an annual retainer, meeting fees, and then

they also have stock options. And the idea there is to have their

focus not just on what is happening this year, but also the longerterm interest of the shareholders.

Similarly for our executives, we compensate with a combination

of salary, bonus that is focused on 1 year’s performance. In some

cases we have focused on 3 years of performance and then options,

which is for the longer term. So we don’t have any one focus. And,

indeed, we provide a disincentive to try to move the stock in the

short run, because if stock then goes down, you will disadvantage

your compensation which is not going to be paid to you for 3 or 4

or 5 years. So we found that a mix gives us the right balance, that

no one tool does the job, but also you don’t overweight toward one

thing or another.

Mr. ROYCE. You know, if there is a best practices approach to

this, what would be gained or lost by requiring all publicly traded

companies to submit to a structure—or do you think that is feasible?

Mr. RAINES. I think you can suggest best practice, but I don’t

know that any of us are smart enough to think that something is

going to work in all of these different companies. The companies

really all have different personalities and different circumstances.

So I would be loath to say that I would know that our structure

would be perfect for everyone. But I do think that in the compensation philosophy, these are the kinds of things that should be looked

at. And, indeed, now the SEC requires that in proxy statements

there be a report from the compensation committee stating the philosophy. And if investors believe strongly in one philosophy or another, that is their opportunity to communicate that to the company. And I think that process has worked for other kinds of reforms, including holding down the number of options so as not to

dilute the interest of the shareholders.

Mr. ROYCE. One other question I was going to ask. How does

Fannie Mae report management trades that occur in the company?

How do you report those to the marketplace and what timeframe

do you report those management trades in company stock?

Mr. RAINES. Fannie Mae is a non-SEC registrant. It doesn’t report or use the forms of the SEC. But we have had an insider trading compliance program for many years which prohibits executives

from trading at all, except during an open period, and that open

period only occurs after we have reported our earnings for the

quarter. So we only permit very limited windows. All trading done

during that period has to be reported to the company, which is

then—all the trading is reviewed by our counsel and reviewed by

our regulator.

We have, though, taken note of the proposals that Chairman Pitt

has suggested on contemporaneous reporting of these trades. And

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so we intend starting next month to provide contemporaneous reporting. So within several days of the trades, we will post on our

websites all trades by all insiders of the companies. And I believe

that will make us one of the first companies to, in fact, implement

the idea that Chairman Pitt has put forward.

Mr. ROYCE. I think that is a good move, and I would hope all corporations follow suit with the SEC’s suggestion there. And, frankly,

I think having that reported in real-time will do a lot to end the

abuse there. But I thank you for answering those questions.

Mr. BAKER. Ms. Carson.

Ms. CARSON. Thank you very much Mr. Chairman. Let me assure you, gentlemen, that I come here with no preconceived notion

in terms of what we need to do. What I seek personally are quality

control, disclosure, consumer confidence and integrity, business

ethics, fairness, understand what constitutes wrongdoing and how

the shareholder and then the stakeholders are protected throughout the process.

And I would also hasten to add that I think it is very troublesome that an institution like Arthur Andersen, who has for years

been one of the premier accounting firms in this country, has had

to go down based on the acts of a few bad apples in a bushel. I am

not one who believes you need to throw the bushel out.

I have two quick questions, one of Mr. Raines in terms of on behalf of the Roundtable. You said it is the responsibility of management under the oversight of the board and its audit committee to

produce financial statements that fairly present the financial condition of the company and make sufficient disclosures to investors to

permit them to access the financial and business soundness of the

company.

Can such responsibility be legislated by the United States Congress? I just sent back my shareholder proxy yesterday, and always

check yeah. Want to know if you want these people to be on the

board, yeah; do you want this kind of committee. It doesn’t make

to me any difference because I trust the company.

I don’t know how in the world Congress can legislate all these

things. And additionally, because I know we have a vote on, there

was an article in the Wall Street Journal, Mr. Chairman, that

talked about Enron, and that is why we are here, this one company. Information was that servicing Enron’s derivatives, trading

may have been used to mask weaknesses in the company’s other

businesses such as fiber optic bandwidth, retail gas and power, and

water systems.

Can any of you gentlemen tell me how we can as a Congress ensure that all of these lists of sundry outside entities under one big

umbrella can be regulated and audited so that the stockholders and

the shareholders will know fully well what the condition of a company is?

Those were two questions. If you don’t have time to answer, you

can write me, because I know we have a vote on.

Mr. BAKER. Let me suggest Mr. Sherman has a remark, and if

you will work with me here, we have an end in sight; because if

you don’t, we are going to have to come back after a 20-minute

delay. And hopefully that will encourage a prompt and courteous

response to Mr. Sherman’s inquiries.

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And thank you, Ms. Carson, for your comments. We are asking

for a direct written response, Ms. Carson.

Mr. SHERMAN. Thank you. I first want to comment that I hope

that we move toward the most thorough rules with all the identifiable loopholes plugged, rather than just announce that we want to

be principles-based.

I would point out that the form over substance principle is part

of the rule now, and we never raised that, and it was completely

insufficient. I think if we all sing patriotic songs and rededicate

ourselves to form over substance, that might work for a year or

two. But eventually the people who come to head the aggressive

firms will be the aggressive financial managers, and the firms that

are selling for 25 times reported earnings will be the aggressive

firms, and maybe it will be the aggressive firms that claim that

they are not aggressive.

And I am an old tax guy and I can just imagine what would happen if we went to a principles-based tax system. And keep in mind,

the Tax Code and FASB regulations are doing the same things.

There are two different systems for determining what your net income is. And if we just urged taxpayers to pay their fair share and

relied on principles rather than the most definitive rules, we would

have a lot larger deficit than we have now.

I wish I could ask a question, but you would have to stay for another 20 minutes. What I hope that we do is have a third day of

hearings and invite those who represent investors to be here. One

of the things that I think is one of the problems in this Enron situation is that those who represent investors, mutual funds, pensions, are not represented in Washington given the degree of their

importance to our economy, and that most of the people who have

come before us are issuers of financial statements, not those who

read them with an interested eye. And I look forward to a third day

of hearing, but not a 1 minute of questioning.

Mr. BAKER. I want to thank each of the witnesses for their appearance today, and I want to say a word, Mr. Livingston. I appreciate some of the recommendations your organization has made in

the testimony today. The Chairman would want me to encourage

you, in the days that remain before the committee would proceed

to markup of this important bill, that you forward any recommendations or suggestions based on the exchanges you heard

today. We have a significantly important task ahead of us, and we

need all the best minds we can get to succeed.

Thank you for your testimony and our hearing is adjourned.

[Whereupon, at 2:45 p.m., the hearing was adjourned.]

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H.R. 3763, THE CORPORATE AND AUDITING

ACCOUNTABILITY, RESPONSIBILITY AND

TRANSPARENCY ACT OF 2002

TUESDAY, APRIL 9, 2002

U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON FINANCIAL SERVICES,

Washington, DC.

The committee met, pursuant to call, at 2:05 p.m., in room 2128,

Rayburn House Office Building, Hon. Mike Ferguson presiding.

Present: Chairman Ferguson; Representatives Roukema, Baker,

Gillmor, Cantor, Ryun, Biggert, Rogers, LaFalce, Kanjorski, Watt,

Bentsen, Carson, Sherman, Inslee, Shakowsky, Capuano, Hinojosa,

Israel, Maloney of New York, Meeks, and Maloney of Connecticut.

Chairman FERGUSON. The hearing is called to order.

Today, the Committee meets for the third day of hearings on

H.R. 3763, the Corporate and Auditing Accountability, Responsibility and Transparency Act. Today’s hearing is being held at the

request of the Minority.

The Chair now recognizes himself for a brief opening statement.

Good afternoon. Welcome to the Committee’s third legislative

hearing.

Last December, this Committee, which oversees the financial and

capital markets, held the first congressional hearing on the Enron

collapse and its impact on investors and employees in the financial

markets. When the Committee set out to investigate the Enron collapse, we had several clear goals in mind.

First, we wanted to make sure the Congress now knew how the

biggest corporate collapse in American history occurred.

Second, we wanted to work toward restoring the confidence of investors in accounting, regulators and the rules governing our markets.

Third, we wanted to formulate an appropriate response that

would ensure that the free market system and the regulatory system that underpins it emerged stronger as a result of our work.

The American people deserve to know the facts directly and to

hear them specifically from those most directly involved. I commend Chairman Oxley for working closely with major investigators,

the Justice Department, the SEC and Enron and Andersen’s internal teams to achieve these goals.

The introduction of the Corporate and Auditing Accountability,

Responsibility and Transparency Act, or CARTA, represents the

culmination of this process. It has allowed us to move forward and

investigate comprehensive and practical solutions that will undoubtedly strengthen the overall financial system.

The past few legislative hearings have been very constructive.

We have heard from a diverse group of witnesses representing a

broad spectrum of views regarding the securities market and the

Government’s role in protecting investors. The distinct difference is

in the testimony of these individuals, including former SEC officials and representatives from the securities industry, a leading

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consumer organization and the accounting industry have confirmed

that the Committee has taken the necessary steps to improve the

current regulatory system through CARTA.

CARTA is clearly the product of a multitude of views and months

of work by the Committee to improve the public’s confidence in the

capital markets and to strengthen the overall financial system in

the most appropriate manner. CARTA is effective because it gets

to the heart of these foundational issues that will prevent future

Enrons without drowning businesses in a sea of red tape. It is important that this legislation avoids the temptation to overreact and

legislate in a manner that will cripple the entire business community.

In fact, Federal Reserve Chairman Alan Greenspan has testified

that the Enron collapse has already generated a significant shift in

corporate transparency and responsibility, highlighting the market’s ability to self-correct. Overlegislating would be counterproductive and make it impossible for the markets to function properly.

Despite these concerns, there is no dispute that Congress must

be involved in some capacity to ensure that the free market will

emerge stronger than ever. America needs a strong, vibrant and

healthy accounting industry to keep companies financially sound

and to provide investors with solid information. CARTA was carefully crafted by Members of Congress to provide our current system

with this base without overstepping our boundaries in a way that

could ultimately have a negative impact on the world’s strongest

markets.

CARTA rightfully establishes new firewalls and increased oversight to ensure independent reviews and avoid conflicts. It establishes a new public regulatory body under the SEC with strong

oversight authority and prohibits firms from offering certain controversial consulting services to companies they are also auditing.

This legislation also requires accountants who audit financial

statements of publicly traded companies to be federally certified by

the public regulatory organization and highlights the concept of

corporate responsibility by requiring companies to ensure their accountants are in good standing.

The oversight board has the authority to discipline individuals

who violate securities laws or breach standards of ethics or independence.

Investors of all types rely on accurate and accessible information

to make their financial decisions. In the Enron debacle, thousands

of investors were deprived much-needed resources to make sound

investment decisions. It is an outrage that any company would prohibit its employees from selling their stock within their retirement

plans, while at the same time its executives were selling millions

of dollars of stock because they were privy to more up-to-date information.

This legislation meets our responsibility to shareholders and employees of publicly traded companies who deserve to know more

and know it in real-time about a company’s financial well-being. It

also fittingly prohibits corporate executives from buying or selling

company stock when 401(k) plan participants are unable to buy or

sell securities.

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We have a moral obligation to ensure that safeguards are established to prevent the disasters of this magnitude in the future.

CARTA correctly holds corporate America more accountable to the

employees and shareholders through stricter accounting standards

and stiffer disclosure requirements.

But legislating should not be the end of Congress’s role in addressing these issues. The collapse of Enron represents a combination of irresponsible actions on the part of decisionmakers with

knowledge of the company’s financial well-being and a meltdown of

the financial safeguards used to identify problems at a stage when

corrective action might still be taken.

We must work directly with the private sector to instill a spirit

of corporate responsibility by challenging America’s business leaders to meet the highest standards of ethics and responsibilities to

their employees and shareholders.

There have been dozens of legislative measures introduced by

both sides of the aisle to address these issues. It is time to put partisan squabbling aside and to move forward with practical solutions

that will actually help. These hearings have helped the Committee

assess the effectiveness of CARTA in preventing future accounting

and stock irregularities in publicly traded companies. However, to

ensure that no questions are left unanswered, Chairman Oxley has

agreed to this final hearing before we move forward with the consideration of CARTA.

I want to thank the witnesses for their attendance, and at this

time I would like to yield to the distinguished Ranking Member,

the gentleman from New York, Mr. LaFalce.

Mr. LAFALCE. Thank you very much, Mr. Chairman.

Let me put this in perspective. In your opening statement, you

just said that the Chairman has agreed to this hearing. This is a

hearing which we demanded as a matter of right under the rules

of the House and the rules of the Committee. The timing for it was

set over the recess for 2 o’clock today, a day when the Congress

does not begin voting until 6:30. If we didn’t demand our rights,

we would have just proceeded to a markup on Thursday with but

2 days of hearings.

So you have said it is time to put partisan squabbling aside.

What does that mean, that we should just discuss and vote upon

exclusively the bill that was prepared by the Republican staff to

the Chairman of the Committee without Democratic input? That is

not putting partisan squabbling aside. That is just saying ‘‘succumb

to our will.’’ So let us not kid ourselves or kid the public as to is

going on here.

The Minority Members of this Committee wanted today’s hearing

out of a concern that we mark up legislation as soon as Thursday

on issues facing our securities markets without giving adequate

consideration to many aspects of the legislative proposals before us.

There are many aspects of the legislative proposal before us in

which no one has testified, much less haven’t had a diversity of testimony. And there have been significant developments.

On Monday, you all read in the New York Times, the Washington

Post, and so forth, about the role of investment banks that has

been added to the Enron lawsuit. We have not explored that. That

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is certainly within the jurisdiction of our Committee. It is an important issue to which we have given no consideration.

Today, you read in the New York Times and the Washington Post

and the Wall Street Journal, and so forth, about the action of the

Attorney General of the State of New York with respect to securities firms who were violating their own rules, flagrantly. These are

allegations, but he was able to obtain a court order.

Under any circumstances, though, these come within the jurisdiction and concern of our Committee; and before we mark up legislation, we should give attention to those issues.

It is clear to me that this should not be the last hearing before

we go to markup. It seems to me there would be a rush of judgment, and the judgment should be a very partisan one. That is, go

along with the bill prepared by the majority staff ab initio.

Well, there is consensus on certain things. There is a consensus

that we need a new public oversight body for the accounting profession, but there is not a consensus on the attributes such a regulator must have to be credible and effective, and there has been no

conversation between the Democrats and the Republicans, at least

as far as I am concerned, on this issue.

For example, my bill explicitly establishes the powers and duties

of the new regulator, while H.R. 3763 leaves these matters exclusively to the SEC rulemaking, effectively leaving these rules up for

jump ball, totally up to the SEC.

Now, certainly the SEC must make rules and they must have a

certain amount of discretion, but I think, given what we have seen,

we ought to have certain legislative powers that are clearly established. And that is a serious issue. I think that the new regulator

should have the authority to set quality standards rather than just

enforcing industry standards and should have clear disciplinary

and investigative powers. And that is not in the Chairman’s mark,

and it is in my bill.

We need a discussion of that issue. What should the legislation

have? Should the legislation establish the clear disciplinary and investigative powers of the regulatory body?

Auditor independence. We have barely scratched the surface in

considering that issue. We have not discussed the services that create conflicts for the auditor or measures to give the audit committee authority to determine the non-audit services the auditor

should provide. Other corporate governance reforms that would enhance the functioning of the audit committee and are inextricably

linked to auditor dependence. As the Enron collapse made sure, we

also must ensure that the independent directors of our public companies are truly independent.

Now, my bill includes these provisions. They deserve further discussion. They have not been discussed before our Committee.

The Committee has given little consideration to the role of the

securities analysts in the Enron collapse. My bill would do more to

reduce the conflicts that cause analysts to look the other way when

companies present rosy but misleading pictures of financial health.

As the New York State Attorney General said yesterday in bringing action against Merrill Lynch, such actions jeopardize the integrity of our securities marketplace, and we should examine that

issue fully.

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Finally, we must consider the need to enhance the ability of private litigants to enforce the securities laws, particularly with respect to aiding and abetting by accountants and other professionals. We restored the ability of the SEC to bring aiding and

abetting actions in 1995, and we should consider restoring the ability of private litigants to do the same, and we have had no hearing

devoted to that extremely important issue.

Further, I am pleased to announce that today I introduced another bill, a bill that would give legislative substance and real teeth

to meritorious portions of President Bush’s 10-point plan on corporate disclosure and accountability. The Corporate Responsibility

Act of 2002 requires disgorgement of incentive compensation and

certification of financial statements and allows the SEC to administratively bar unfit officers and directors from serving in public companies.

There is much to be done. I look forward to working with Chairman Oxley and all of the Members of the Committee to bring about

a strong legislative response. I think we need additional time and

hearings and consultation and conversations and compromise in

order to bring that about, and I thank the Chair.

Chairman FERGUSON. The gentleman’s time is expired.

The gentlelady from Illinois, Mrs. Biggert, you are recognized for

an opening statement for 5 minutes.

Mrs. BIGGERT. Thank you very much, Mr. Chairman.

Mr. Chairman, this morning hundreds of Andersen employees in

my district rolled out of bed with a simple question on their minds.

When I return home tonight, will I still have a job? If I do make

it through the day, will my job be there at the end of the week or

the month? Sadly, for many of them, the answer will likely be no.

Through absolutely no fault of their own, they will be looking for

employment elsewhere. As Andersen finalizes plans to cut its workforce, my thoughts and prayers are with the more than 500 Andersen employees in my district and the thousands more across the

Nation who had nothing whatsoever to do with the case at hand,

but nonetheless are feeling the aftershocks.

We can debate privately or publicly the end result of the actions

taken over the past months and how actions can lead to unintended consequences. As one Andersen employee from my district

asked in a letter to me last week, if one out of our 535 Congressman and Senators gets in trouble, should you all be fired? The

short answer is no; and yet it is true that, to a certain extent, we

all lose public confidence when one Member abuses his or her office. It is not right, and it is not fair, but it is what happens.

I think everyone can agree that change is needed in the accounting industry, and I think several good proposals are on the table.

We must, however, strike the right balance to ensure that the decisions we make in the coming days will help solve the problems at

hand without creating those unintended consequences down the

road.

H.R. 3763 is an important step in the right direction. With this

legislation, we will avoid any more blanket charges against groups

of accountants and instead punish the particular accountants at

fault. H.R. 3763 provides more immediate and closer scrutiny of

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the accounting profession in general and specific accountants in

particular.

I should add that, at the same time, there is much more that the

accounting industry must do. They should not wait for Congress to

point them in the right direction.

A good place to start is with the recommendations of former Federal Reserve Board Chairman Paul A. Volcker. I commend the efforts that he has made to begin to restore some of the credibility

that is much needed in the accounting profession.

I look forward to hearing from the witnesses today and thank

you very much and yield back the balance of my time.

Chairman FERGUSON. The gentlelady yields back.

The gentleman from California, Mr. Sherman, is recognized for

5 minutes for an opening statement.

Mr. SHERMAN. Thank you very much.

It is good that we are having these hearings. It is unfortunate

who is not here. We have those very many organizations who don’t

get fees as investment bankers, but do control trillions of dollars

of capital—professional investors, mutual funds, pension advisers—

who have been, I think, underrepresented in the overall process before Enron and even after Enron in giving us guidance as to what

information they need and what steps need to be taken so that

they can rely on that information.

CARTA I think is a good bill, but it is less than the minimum

we should do, and I think our constituents will be unimpressed

with those Members of this Committee who vote for final passage

of CARTA, but vote against the amendments necessary to make it

a strong enough and meaningful enough piece of legislation.

Alan Greenspan is correct when he points out that there has

been a shift in business culture so that the greatest abuses of the

past will not be repeated in the immediate future, but that is only

the immediate future. The pressures that created the atmosphere

of 2001 will return within a few years. The hottest executives at

the hottest companies will be those reporting the hottest growth in

their earnings and reporting the lowest liabilities. We need to legislate, not just rely upon what I fear is a short-term change in the

business culture.

There are three amendments I am certain to offer to this bill.

The first is to tell the SEC they have to read the financial statements of the 2,000 largest companies every year, and then when

they find something that is incomplete or confusing, they will then

demand that additional material be filed. The request or demand

for additional information will be immediately public. The material

filed in response would be made immediately available to the public, and this is an answer to the fact that an awful lot of what is

in those Enron financial statements isn’t false. It is just unintelligible. Not unintelligible to the uninitiated. Unintelligible to anyone.

The SEC doesn’t read the financial statements filed by the big companies. They only read financial statements filed by the small companies. That has got to stop. And by the small companies, I mean

the IPOs.

Second, Arthur Andersen was the one of the Big Five—then Big

Five—that had its salespeople, the people in charge of selling more

services to Enron and collecting the fee, the engagement partner,

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in final control of whether to sign the audit opinion. The other Big

Four accounting firms—or the other of the Big Five—put their

quality and technical review people in charge of making that final

decision. We should not leave it to the accounting firms to structure themselves any way they want. The people insulated from the

sales decision and who are steeped in accounting literature need to

make the final decision.

Finally, Mr. Chairman, recently Arthur Andersen indicated that, while it had offered over $700 million to settle, it was now cutting

its offer to only $300 million because, oops, they don’t have any

capital. We need a minimum capital requirement for accounting

firms of at least half a year’s audit fees. Right now, Arthur Andersen is saying they don’t have any money to pay those damaged by

their inaction, and we cannot tell accounting firms that they can

go practice virtually without malpractice insurance, with virtually

no capital and then, if they make a mistake, the investors get nothing.

There are two other issues. One is that if we are going——

Chairman FERGUSON. If the gentleman could just wrap up here.

Mr. SHERMAN. OK.

Chairman FERGUSON. We are past expired.

Mr. SHERMAN. My time is expired. Let me simply say that those

who don’t learn from history are doomed to repeat it, and those

who do not pass legislation triggered by recent history are doomed

to see those same mistakes repeated.

Chairman FERGUSON. The gentleman’s time is expired.

The Chair recognizes the gentleman from Louisiana, the distinguished Chairman of the Subcommittee on Capital Markets, Mr.

Baker.

Mr. BAKER. Thank you, Mr. Chairman.

I think in the aftermath of the demise of one of the largest corporations in American enterprise it would be inappropriate for us

to rely on additional lengthy studies or, worse yet, lengthy investigations with a failure to act. It would be really unacceptable consequences for the market as well as individual investors, and if we

start in good faith today and act quickly, I can suggest to you that

the congressional process will require a very long and tortuous

path before we all wind up in the Rose Garden and exchange good

wishes. So moving quickly at this juncture is not ill-advised. I

think it is highly appropriate, especially in light of the fact the

SEC, FASB, the GAO, the SROs and many other outside observers

all have strongly held opinions about the directions we should be

taking, coming to the consensus those elements will be enhanced

by the legislative process. And I think it entirely appropriate for us

to proceed.

I am particularly pleased with the panel of witnesses we have

here today, to get their insights on the remedies appropriate in

light of the consequences we face and to quickly implement not

only their recommendations, but the 10-point plan outlined by the

President, which I think was responsive to our current difficulty.

In fact, there are too many employees today watching every

morning the fund balance in their 401Ks erode. Where retirement

plans were certain, now we are thinking about second careers. The

consequences of this are enormous not just for the individual emVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00139 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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ployee, but for capital formation itself. The enhanced volatility in

market performance is directly related to the fear that there is an

undisclosed liability or inappropriate revenue stream that is not

creating a correct and accurate picture of true financial condition.

We all agree, disclosure, transparency and consequences for those

who fail to comply by the rules. I think how we construct those

rules are the difficult aspect, but as to the principles underlying

the resolution of this terrible difficulty, I think we are in agreement, and we should move forward.

Thank you, Mr. Chairman.

Chairman FERGUSON. The Chair recognizes the gentleman from

North Carolina, Mr. Watt, for an opening statement, 5 minutes.

Mr. WATT. Thank you, Mr. Chairman. I hope I don’t take 5 minutes, but sometimes we don’t know how long these things will take.

I, during the consideration of the Gramm-Leech-Bliley bill, was

accused of being one of the few Members of the Committee who actually read the bill, and I have to confess that I have made the

same mistake again, this time over the break. I have actually been

reading these bills, and I want to start by saying something complimentary about the Chairman’s bill. It clearly moves in the right

direction. It would be a substantial improvement over nothing, and

I think we should keep that in mind, but I hope that this hearing

today and the markup itself, if we are going immediately to a

markup, will result in a deliberation about improvements or revisions that can be made to the bill to make it stronger.

I think there are a number of instances in which I would prefer

to have stronger language, stronger provisions in a number of respects. The Chairman’s bill punts just a whole panoply of issues to

the Securities and Exchange Commission or other bodies. Maybe

some of that is necessary and desirable to get more information

and input over time, but I think there are some basic principles

that the legislative process has already agreed upon or should

agree upon to put into the bill before we punt the rest of it to the

SEC for further study.

The way to get there can be one of two ways. We can either do

it by discussions off the record outside the context of a markup, or

we can have a very, very protracted markup. Because, as many of

you remember in the Gramm-Leech-Bliley process, there will be a

number of amendments to be debated and considered. If we don’t

have the opportunity to put those amendments into the process,

have some discussion about them before we get to the markup,

then I think this markup is going to be a lot longer than perhaps

is being contemplated at this point.

So one of the things I particularly feel strongly about is that

there is a very important role for private litigants to enforce rights

in this context. We can’t give responsibility solely to the SEC and

say you have got absolute authority to do this, and if you don’t do

it, then nobody is going to have the authority to do it. Our whole

accountability system in this country is based on the rights of individuals to hold corporations and other individuals accountable

when they feel like they have been wronged. So, at a minimum, we

need to put some of those provisions in the bill to provide for private litigants to protect their own rights, and that I think is a hallmark of the way our system should work.

133

I appreciate the gentleman bearing with me, and I will yield

back the balance.

Chairman FERGUSON. The gentleman has, in fact, used the balance of his time.

The Chair recognizes the gentlelady from Illinois, Ms.

Schakowsky, for an opening statement for 5 minutes.

Ms. SCHAKOWSKY. Thank you.

I want to thank the Chairman and particularly Ranking Member

LaFalce for his leadership in assembling these witnesses here

today that I think will make a very important contribution to the

ultimate legislation, and I want to associate myself with the concern expressed by my colleague from Illinois for the Andersen employees who have, through no fault of their own, lost their jobs. For

this reason, as well as many others, it is important that we do act

in order to prevent those kinds of layoffs and to protect investors

and pension holders from conflicts of interest and from corporate

greed.

We all know that, if not for Enron’s collapse, we would almost

certainly not be considering these important matters today. I am

concerned that some want to characterize the Enron collapse as

just a case of one bad actor in the marketplace. I disagree with

that interpretation, as I think do most people on this Committee,

and that is why we are considering legislation. Because Enron’s

collapse does have systemic causes. Corporate boards of directors,

Wall Street analysts and the Big Five accounting firms all have an

economic incentive to provide biased analysis of large profitable

companies.

Enron used its political ties to persuade the Government to carry

out its business plan. Just take a look at California. President

Bush, his regulators and congressional Republicans who opposed

price caps for consumers, while Enron manipulated the market,

causing the energy crisis. Enron had incredible access to the White

House. President Bush received over $736,000 throughout his career as an elected official. Vice President Cheney had at least six

meetings with Enron officials while drafting the Administration’s

national energy plan. Enron’s economic and political power effectively muted people who were skeptical of the company’s economic

stability. Enron is not an isolated case, and this is not only a business scandal, but I am afraid it is also a political scandal.

The fact of the matter is we do not have the laws and procedures

in place to protect common investors. If we don’t take swift action,

I have little doubt that corporate executives’ greed and deception

will victimize more people.

Simply relying on free market dogma will not suffice. Employees

and pension managers must be involved in corporate decisionmaking. Boards that are dominated by corporate executives are inherently flawed.

Enron’s collapse had a significant impact on working families. In

the case of Enron, hard-working people lost their life savings, while

Enron’s executives gained millions. It is estimated that Illinois’

State pension fund lost $25 million. That means that hard-working

teachers, police officers and firefighters who worked for the public

good may not be able to enjoy their hard-earned retirement, and

that I don’t think is what public servants deserve for their future.

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Of course, I agree that we must proceed in a careful and deliberate manner, but we must proceed. That is why I am a proud cosponsor of the Comprehensive Investor Protection Act, and I look

forward to making sure that, as we move to the markup, that critical provision of that bill will be included in any measure that

passes out of this Committee. This legislation will help protect investors and workers in the future.

I thank Congressman LaFalce for his efforts on this legislation.

We have the responsibility to enact significant reforms. I look forward to hearing the witnesses’ testimony today, and I yield back.

Thank you.

Chairman FERGUSON. The time of the gentlelady is expired.

The gentleman from Texas, Mr. Hinojosa, for 5 minutes for an

opening statement.

Mr. HINOJOSA. Thank you, Mr. Chairman.

I want to say that I come from Texas. I have travelled throughout my district, and that is the first thing that our constituents

want to know, just what are the members of the financial services

going to do with regard to the losses that they have experienced,

and I am looking forward to listening to the witnesses today so

that, as we go through the markup, that we can make intelligent

decisions and come up with a national policy that is going to protect not only the investors, but protect employees of Andersen and

companies like Andersen who have lost their jobs as a result of

somebody at the top who made decisions that obviously were incorrect and very damaging.

I look forward to listening to the facts that the witnesses are

going to present, because I am very interested in both of the bills

presented by Chairman Oxley and our Ranking Member that I

think is much more comprehensive and one that is, in my opinion,

going to be necessary to consider and give every opportunity to

pass through this Committee so that it can go down to the whole

Congress. Mr. LaFalce, I commend you for the comprehensiveness

of the bill that you have given us to consider, and I yield back the

balance of my time.

Chairman FERGUSON. The gentleman yields back.

The gentleman from New York, Mr. Israel, for 5 minutes for an

opening statement.

Mr. ISRAEL. Thank you, Mr. Chairman.

I also spent a considerable amount of time in the last 2-and-ahalf weeks travelling throughout my district and hearing from constituents who routinely asked what we are going to do to ensure

the integrity of investments; and I want to commend the Ranking

Member, Mr. LaFalce, for the work that he has done on his bill.

I also commend our Chairman for his work.

Ultimately, it is my hope to support legislation that has a number of features: number one, that provides the strongest oversight

protections; number two, that facilitates transparency; number

three, that ensures accountability; and, finally, that ensures an

even standard among investors and management.

I look forward to working with my colleagues on the Committee

to these ends, and I yield back the balance of my time.

Chairman FERGUSON. The gentleman yields back.

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The Chair sees no other Members seeking time for an opening

statement.

The Committee will now hear testimony from our panel of witnesses. We thank the witnesses for their patience and for their

presence here today. They are, from the Chair’s left to right, the

Honorable David Walker, Comptroller General of the United

States, U.S. General Accounting Office; the Honorable Richard

Breeden, former Chairman of the SEC, now with Richard C.

Breeden and Co.; Professor Donald Langevoort from the Georgetown University Law Center; and Mr. Damon Silvers, Associate

General Counsel of the AFL-CIO.

Mr. Walker, you are invited to give your testimony. You have 5

minutes. Thank you for being here.

STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER GENERAL OF THE UNITED STATES, U.S. GENERAL ACCOUNTING

OFFICE

Mr. WALKER. Thank you, Mr. Chairman, Members of the Committee.

With your permission, I would like the entire statement to be entered into the record.

Chairman FERGUSON. Without objection, so ordered.

Mr. WALKER. Thank you. I will now summarize that statement.

I appreciate the opportunity to share our perspectives on a range

of issues emanating from the sudden and largely unexpected bankruptcy of Enron Corporation and financial-related activities relating to several other large corporations.

As the Committee knows, GAO has conducted an extensive

amount of work dealing with the accounting profession and has

issued a number of reports over several years. More recently, in

order to assist the Congress in framing needed reforms, on February 25th, 2002, we convened a forum on corporate governance,

transparency and accountability to discuss a variety of systemic

issues. On March 5, 2002, we issued highlights of the forum meeting which, Mr. Chairman, we will make available for the record if

you so desire.

As you requested, my comments today will primarily focus on

oversight of the accounting profession and related auditor independence and corporate governance issues raised by Enron’s failure.

The issues raised by Enron’s failure are multi-facetted, involving

many different problems and players with various roles and responsibilities. In that respect, needed changes to the Government’s

role should vary depending upon the specific nature and magnitude

of the problem. Specifically, the Government’s role can range from

direct intervention to encouraging certain non-governmental and

private sector entities to take certain steps designed to enhance

trust and better protect the public interest.

With regard to the possibility of a new oversight body, the issues

of fragmentation, ineffective communication and limitations on disciplines surrounding the accounting profession’s self-regulatory system strongly suggests that the current self-regulatory system is not

adequate in effectively protecting the public’s interest, particularly

in the auditing area. We believe these are structural weaknesses

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that require congressional action. Specifically, we believe that the

Congress should create an independent statutory Federal Government body to oversee financial audits of public companies.

The functions of the new independent body should include:

Establishing professional standards dealing with auditing standards, including standards for attestation and review engagements,

independence standards, and quality control standards, for both

public accounting firms and key members of those firms who audit

public companies.

Second, inspecting public accounting firms for compliance with

applicable professional records and standards;

And investigating and disciplining public accounting firms and/

or individual auditors of public accounting firms who do not comply

with applicable professional standards.

This new body should be independent from, but should closely coordinate with the SEC in connection with matters of mutual interest.

There are alternative models which we would be more than

happy to discuss if you so desire.

In addition, we believe that the issues concerning accounting

standard-setting can be addressed by the SEC working more closely with the FASB, rather than putting that function under the new

body.

The new body should be created by statute as an independent

Federal Government body. The new body should have resources of

funding independent from the accounting profession. For accountability, we believe the new body should report annually to the Congress and the public on the full range of its activities, including setting professional standards, inspections of public accounting firms

and related disciplinary activities. The Congress may wish to have

GAO review and report on the performance of the new body after

the first year of its operations and periodically thereafter.

We believe that the effectiveness of boards of directors and committees including their working relationship with management of

public companies can be enhanced by the SEC working with the

stock exchanges to enhance certain other listing requirements for

public companies.

We also believe that the issues surrounding the financial reporting model can effectively be addressed by the SEC in conjunction

with the FASB without statutorily changing the standard-setting

process. However, we do believe that more active and ongoing

interaction between the SEC and the FASB is needed in order to

facilitate a mutual understanding of priorities for standard setting,

realistic goals for achieving expectations and timely actions when

expectations are not met.

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

staff vacancies. We believe it is important for the SEC to be provided with the necessary resources to effectively discharge its current and any increased responsibilities that the Congress may wish

to give it.

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Finally, we believe the SEC should be directed to report annually

to the Congress on certain matters that I outline in my testimony.

In closing, Mr. Chairman and Members of the Committee, the

United States has the largest and most respected capital markets

in the world. Our capital markets have long enjoyed a reputation

of integrity that promotes investor confidence. However, this longstanding reputation is now being challenged by certain parties.

Today, I have discussed our suggestions to assist the Congress in

crafting needed reforms. We strongly believe that an independent

Federal Government body created by statute to regulate audits of

public companies is needed in order to better protect the public’s

interest. However, currently we do not believe that it is necessary

or appropriate for the Government to assume direct responsibility

for other key areas, such as generally accepted accounting principles or corporate governance requirements. We do, however, believe that Congress should provide the SEC with direction to address certain related issues.

In the end, no matter what system exists, bad actors will do bad

things with bad results. We must, however, strive to take steps to

minimize the number of such situations and to hold any violators

of the system fully accountable for their actions. Thank you, Mr.

Chairman.

[The prepared statement of Hon. David M. Walker can be found

on page 422 in the appendix.]

Chairman FERGUSON. Thank you, Mr. Walker.

I would ask the witnesses to do your best to stay within the 5-

minute time constraint, something that we all up here have enough

difficulty doing on our own. Thanks very much.

Mr. Breeden, 5 minutes.

STATEMENT OF HON. RICHARD C. BREEDEN, FORMER CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, RICHARD

C. BREEDEN & CO.

Mr. BREEDEN. Thank you, Mr. Chairman, Ranking Member LaFalce, Members of the Committee. It is a great pleasure to have

the opportunity to testify before you today at your request to discuss the provisions of H.R. 3763 and H.R. 3818, as well as to address various issues raised by the Committee arising out of the

tragic and disturbing events at Enron.

I had the great privilege of serving as Chairman of the Securities

and Exchange Commission back when dinosaurs roamed the earth.

It was an era in which we were successful in passing several major

pieces of legislation, both when I was in the White House, the savings and loan reform legislation and the Market Reform Act and

Securities Enforcement Remedies Enhancement Act of 1990. And

both in our legislation and the work of the Commission in that era,

I had the great pleasure of working with both sides of the aisle in

Congress.

It has been a great tradition in the area of financial services regulation and particularly in the areas governed by the SEC of bipartisanship, and it is a good thing to see you working together to try

and address these problems. It is important that that tradition of

bipartisan cooperation remain the prevailing spirit in this area.

138

At the outset, I would like to congratulate all the Members and

the staff of the Committee for the fine work you have done in developing legislative proposals to respond to the weaknesses in our

current system that this situation has brought to light. Both bills

contain many sensible provisions that should enhance our extremely good system and make it more resistent to problems in the

future. Both bills follow generally similar principles and demonstrate many areas of common agreement. This is particularly apparent in the provisions of both bills concerning a new approach to

oversight for the accounting profession, enhancements to the quality and speed of disclosure and enhancing healthy practices in corporate governance.

While H.R. 3818 goes beyond the provisions of H.R. 3763 in a

number of areas, it appears clear to me that there is good common

ground in the two bills and plenty of room to craft a bill that is

reasoned and measured. Certainly the President has shown leadership in this area as well, and with Presidential leadership in both

Houses of Congress and both parties considering these issues, there

is plenty of room to try and craft a bill that would reflect a consensus approach to these issues.

Of course, some have said the market has already fixed all of the

problems of Enron, and with that I respectfully disagree. There is

no question the market has reacted to the events at Enron. Boards

of directors and audit committees are more sensitive and wary

about conflicts and overstatements of income. Many people have

learned more about SPEs than they ever thought they would learn

in their life in recent weeks, and I doubt if many boards will be

suspending corporate codes of conduct and conduct standards any

time soon.

Hopefully, auditors at other firms realize both the importance of

sharing concerns with the audit committee, rather than keeping silent about major issues and alternatives, and investors are exacting a price from companies where they perceive a higher level of

accounting risk and lower levels of transparency. These are all very

healthy and welcome developments.

While improvements have been made, market responses can be

short-lived, and many memories can be too short. Unfortunately,

companies that don’t need the reforms often adopt the better practices, but companies that pose the greatest risk to investors may

not change their policies at all.

There are many issues involved in the Enron-Andersen case that

cannot be solved entirely by market, and there is not any reason

we should be reluctant to admit where our system has weaknesses

we should address.

The system for oversight and discipline of the performance of

audit firms and their personnel is one area that would benefit from

a legislative change. Our previous system of peer review and selfregulation of certain types of issues through the Public Oversight

Board did not work. The SEC needs at least some additional resources to allow it to handle the volume of financial fraud cases it

should be pursuing, as well as providing more frequent review of

filings by high cap and widely held issuers.

Legal standards today for disciplining accountants and their

firms for audit failures are subject to more litigation than is desirVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00146 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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able. Certain enhanced types of remedies such as stronger officer

and director bars and disgorgement authority to recover profits on

sales of stock by insiders prior to a bankruptcy would be desirable.

Standards need to be set regarding consulting services by audit

firms for audit clients, and the system for developing and interpreting accounting principles through the FASB needs to be improved.

These and other modest steps can complement market disciplines

and help restore balance and confidence to our system. None of

these steps need involve excessive regulation or interference with

healthy market developments.

In drafting the specific bill, we should not stake all on trying to

do too much, and we should not allow ourselves to do too little. We

have to make sure, for starters, that existing law is vigorously enforced, because much of the Enron-Andersen case involves violations of existing laws. Beyond that, you have identified a number

of reasoned and careful steps that will enhance the qualities of the

existing system.

My written testimony responds to a number of questions from

the Committee, and I would be happy to discuss any of those questions further, and I would only like to very, very briefly summarize

my views on the establishment of a new oversight body for the accounting profession.

Both bills contain provisions concerning establishment of a new

oversight body. In my testimony I urge you not to create a new governmental body, but rather to reinforce the role of the SEC in dealing with such issues. Whatever body is created and whatever its

exact mission, any such group should be a private sector entity

with oversight by the SEC. We should not repeat now the mistake

that was made when the CFTC was created that set us on a course

of endless competition of jurisdiction between Government bodies

with closely paralleled missions.

The SEC is there. It has the history, the culture and the tradition and the tools for dealing with these kind of problems; and it

should be the body that then provides oversight to an effective selfregulatory organization, along the lines of the NASD or the New

York Stock Exchange. There the organizations have strong staffs,

a good record of promoting healthy ethics and law enforcement,

while not creating additional Government bodies.

Again, thank you very much for having me, and I commend the

strong efforts of both parties to date in seeking to build legislation

that can command broad-based support. Our disclosure and accounting system has stayed viable over the years because we have

not been afraid to learn from major problems and to change some

of the rules of the game. In my judgment, this case demands a reasoned and measured response, but a response nonetheless. Thank

you.

[The prepared statement of Hon. Richard C. Breeden can be

found on page 454 in the appendix.]

Chairman FERGUSON. Thank you very much.

Professor Langevoort, you are recognized for 5 minutes for an

opening statement.

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STATEMENT OF PROFESSOR DONALD C. LANGEVOORT,

GEORGETOWN UNIVERSITY LAW CENTER

Mr. LANGEVOORT. Thank you, Mr. Chairman, and let me try and

be very brief.

The last few months have brought public attention to bear on the

seriousness of a problem—that economic forces have increased the

temptation and techniques many companies’ executives face to be

dishonest with the investing public and that these temptations and

techniques have translated into an unacceptable level of corporate

fraud, mismanagement and concealment.

My invitation here today is not to address all of the possible reforms that could come from this but, rather, touch on private securities litigation as one touchstone for reform; and I will try to be

very, very brief by focusing my oral remarks, as opposed to my

written testimony, on the two reforms that I consider most important and indeed whose merits to me are beyond doubt.

First, restoring a system in which those who aid and abet securities fraud become liable to the victims. When the Supreme Court

in 1994 eliminated aiding and abetting and private rights of action,

it didn’t do so on policy grounds or through careful legal reasoning.

Rather, it said, as a matter of statutory construction, that job is for

Congress, not the courts. I urge you today to take up the court’s

invitation and respond accordingly.

It is very difficult to argue that somebody who provides substantial assistance to a securities fraud shouldn’t have to compensate

the victim. The common law has for centuries imposed that liability. Congress has recognized that aiding and abetting is a Federal

crime and in 1995 gave the SEC specific authority to proceed in

that direction. It is clearly wrongful. Why then wouldn’t you make

the aider and abetter compensate the victim? The answer, we are

told, is fear of litigation abuse, that these kinds of claims can be

abused.

Now, I have to confess, I am one of those people who takes litigation abuse seriously. I think Congress in 1995 acted appropriately

in addressing the issues, even if I don’t agree with all of the specific outcomes. But litigation abuse and its fear is no excuse for

saying that somebody who provides the brains, the talent, often the

motivation behind a fraud should avoid responsibility to the victims simply because their appearance is not made visible to the investing public, and sadly that is the state of the law that we have

today. Those to whom the fraud is not attributed and who are not

identified to the investing public have grounds to avoid liability.

It seems to me clear that we ought to change that rule in the

name of common sense, without regard to debate about the statistics of whether the incidence of private securities litigation has

gone up or down. It simply makes sense to impose liability on those

people.

Second, the other reform I want to address in my oral testimony

is redressing the rather foolish statute of limitations that we have

today for private securities actions. The Supreme Court once again

gave us this rule, again as a matter simply that since Congress

hadn’t done anything about it since 1934, who are we to impose a

different standard? The result is that we have in private securities

litigation a rule that was adopted in 1934 before Rule 10b-5 exVerDate 11-MAY-2000 12:20 Sep 17, 2002 Jkt 000000 PO 00000 Frm 00148 Fmt 6633 Sfmt 6633 C:\DOCS\78501.TXT HBANK1 PsN: HBANK1
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isted, before class actions existed, before the depth of our securities

markets and its breadth could have been imagined. It is silly to assume that a rule adopted then should be the rule adopted today

simply a result of history.

That rule that actions have to be brought within 1 year after notice is much too short today to develop a complex, well-grounded

lawsuit. And, even worse, the rule that if somebody can hide the

fraud for 3 years they get away completely simply as a result of

their success is also something that makes no sense in our highly

complicated, highly complex financial markets.

Now, I make no claims that these two reforms or the others that

I address in my written testimony would prevent the next Enron,

would change things dramatically, but they are very important

first steps, very important pieces of the puzzle that we ought to

take as we begin to address the problem.

Thank you.

[The prepared statement of Prof. Donald C. Langevoort can be

found on page 482 in the appendix.]

Chairman FERGUSON. Thank you very much.

Mr. Silvers, 5 minutes for your testimony. Thank you for being

here.

STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL

COUNSEL, AFL-CIO

Mr. SILVERS. Thank you and good afternoon, Mr. Chairman, and

Ranking Member LaFalce.

On behalf of the AFL-CIO 65 member unions and our 13 million

working family members, I want to thank the Committee for the

opportunity to appear here today.

The collapse of Enron and similar events at Global Crossing,

Waste Management and other public companies are a window into

a set of pervasive conflicts of interest that defeat the purposes of

corporate governance and threaten the retirement security of

America’s working families.

This Committee has heard in prior hearings from those who

would still have you believe what Enron used to preach in this

town, that unregulated markets will solve all problems if they are

just left alone. Now that may be the view from the K Street offices

of the people who do the heavy lifting for the audit firms here in

Washington, but it is not how things look for thousands of working

families in Houston and Portland, Oregon, and Rochester, New

York, and clearly in Chicago who have lost their jobs or their retirement savings and their health care because they believed what

they were told by their employers, by their employers’ accountants

and the analysts that interpreted the accountants’ numbers.

H.R. 3813, the aptly named Comprehensive Investor Protection

Act of 2002, is the most comprehensive legislation introduced in

this Congress in response to the conflicts of interest in the capital

markets and in the boardrooms of America’s public companies.

Let me briefly review the areas where Congress needs to act to

protect investors, the provisions of H.R. 3818 that respond to that

need, and the key differences between H.R. 3818 and H.R. 3763,

which the Chairman discussed in his opening remarks.

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First, public company boards need strong, independent directors,

so investors need complete disclosure of all the ties that exist between the board members, the company and company management. H.R. 3818 requires just that, while 3673 has no such requirement. This higher standard of independence should be the relevant

standard for measuring the independence of company auditor and

compensation committees.

Furthermore, shareholders should have access to management’s

proxy not just for shareholder proposals on a handful of subjects,

but for director candidates, independent director candidates. We

urge these corporate governance provisions be added into any reform package this Committee takes up.

The second area in need of reform is the practice of public accounting. Here again H.R. 3818 takes the right approach to auditor

independence by giving the SEC the authority to ban a wide range

of consulting by auditors and requiring that the audit committee or

the full board of directors of a company approve in advance the

provision of consulting services by the company’s audit firm that

are still allowed by the SEC.

In contrast, H.R. 3673 bars only certain types of consulting and

would allow the sorts of consulting that led to the most egregious

abuses at Enron by Arthur Andersen to continue.

The next issue is auditor oversight. Former SEC Chair Arthur

Levitt has outlined in testimony before the Senate Governmental

Affairs Committee what we believe are the key characteristics of a

much-needed auditor oversight body: members independent of the

Big Five, full investigative and disciplinary powers, and independent funding. H.R. 3818 creates a public accounting regulatory

board that meets these tests. H.R. 3763’s provisions do not meet

these tests.

Then there are the Wall Street analysts. H.R. 3818 requires the

SEC to ban analyst compensation tied to investment banking performance. The Majority’s bill goes no further than requiring a

study.

All these reforms, though, are of little benefit if there is no enforcement. The Ranking Member’s bill provides both adequate resources to fund pay parity for the SEC and to expand the Commission’s oversight and enforcement activity. The Majority’s bill has no

such provision.

Finally I want to address the ultimate accountability measures

available to shareholders: recourse to the courts. As Professor

Langevoort has mentioned, the restoration of investors’ right to sue

those who aid and abet securities fraud is a vital and important

step that must be taken immediately. I would add, in addition to

the statute of limitations issue, that the restoration of joint and

several liability is critical in cases where the wrongdoers start filing for bankruptcy. These provisions are included in H.R. 3818 and

not in the Majority’s bill.

In conclusion, H.R. 3818 gets at the heart of the problem of conflicts of interest, whereas H.R. 3763, the Majority’s bill, leaves untouched the central conflicts of interest, conflicts of interest that

brought us Enron and will no doubt continue to cause losses to

workers’ retirement savings if not addressed. At the heart of what

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tions. These solutions will no doubt offend powerful interests, but

they will protect America’s working families. H.R. 3818 contains

within it these necessary solutions and has the AFL-CIO’s strong

support.

The AFL-CIO is grateful for the opportunity to share our views

with the Committee on these bills and welcomes the opportunity to

continue to work with the Committee as you move forward in addressing these important issues. Thank you.

[The prepared statement of Damon A. Silvers can be found on

page 492 in the appendix.]

Chairman FERGUSON. Thank you very much to all of our witnesses. We appreciate your presence here and lending of your insights and expertise to some of the very important matters before

the Committee particularly regarding this legislation.

We are now going to be begin our question period. Each Member

will be allotted 5 minutes to ask questions of the witnesses. I would

like to begin the question period by yielding to the distinguished

subcommittee Chairman of the Capital Market Subcommittee Mr.

Baker.

Mr. BAKER. Thank you, Mr. Chairman, for that courtesy. I do appreciate it very much.

Mr. Walker, I noted in your written testimony reference to the

fact that the audit clients should have clearly an understanding

that he has a primary responsibility to the shareholders. I recall

having read in the earlier report also another line which indicated

it should be made statutorily clear that the financial statement is

the property of the shareholder.

In testimony before this Committee Mr. Berardino, the former

CEO of Andersen, in response to a question from me indicated that

the financial statement was the property of management and the

shareholder, which I thought flew in the face of Accounting 101 in

that the audit committee’s engagement of the audit team is to prepare an accurate and true picture of the financial condition for the

shareholder. Although the financial data must be arrived at in consultation with management to understand the true operations of

the business plan, management should not be involved in the alteration, manipulation or intimidation of the preparation of the numbers as the audit team sees them in light of this responsibility. Is

that an accurate reflection of your understanding?

Mr. WALKER. My understanding, Mr. Baker, is that first the

board of directors work for the shareholders. Second, under the current literature, management is responsible for the financial statements, but the financial statements are for shareholders and other

stakeholders.

I personally believe that one of the real keys that has to be focused on here is determining who is the client and who are the parties that are representing the client. I would assert that when you

are talking about an audit, when you are talking about related financial reporting associated with that audit, that the client should

be the shareholders and other stakeholders who are relying upon

that information. But their representatives should be the audit

committee, which would be an independent body that is part of the

board which should be responsible for hiring the auditors. The

audit committee should assume additional responsibility above and

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beyond what it has right now in order to ensure that there is a convergence of interests between the board, which is supposed to be

working for the shareholders, and the independent auditors, who

should be working for the shareholders, but in addition to that,

should serve a broader public interest.

Mr. BAKER. If I may, let me take that as a long yes, because I

have a follow-up. There is inherently a conflict between the management’s interest to enhance stock performance, thereby enhancing their own remuneration, perhaps at the expense of the shareholder in unfortunate cases. To disincentivize that type of manipulative conduct in relation to the preparation of the statement,

would it be advisable for us to consider making the CEO personally

responsible and liable for the accurate preparation of the financial

statement? I know there is clearly a responsibility, but do we need

to make that more clear?

I will jump to the next one while you are rolling that one around

because I would like Mr. Breeden to comment as well.

To go perhaps further, it has been represented that there are

cases in which management, through collusive efforts of many,

have enhanced appearances of the corporation to increase the value

of stock, exercise no cost options granted as a part of their employment arrangement, and then subsequently have a restatement of

earnings so that the shareholder takes the net effect of loss, and

the executive remains enriched through that manipulative process.

For example, in that case, should we authorize the SEC to make

inquiries into matters of that sort and be given the rules and authority to take appropriate action including disgorgement, so if

there is a downturn as a result of manipulative bookkeeping, that

there are consequences for the corporate executive?

I make these comments in light of Chairman Greenspan’s remarks and others’ who have encouraged us to find ways to

disincentivize short-term earnings pressures and long-term corporate asset growth. Would either of you comment, please?

Mr. WALKER. There are several things in my testimony where I

talk about things that I think the SEC should be required to look

into in order to provide better checks and balances, and to better

protect not only the shareholders’ interests or the public’s interests.

They include the composition of the board, the composition of the

key committees on the board, and providing additional transparency and checks and balances, again the kind of actions you are

talking about.

Right now management does have a responsibility to sign a management representation letter in conjunction with an audit, and

they are supposed to make certain assertions that to the best of

their knowledge and belief, that certain things are true and correct.

I think that could be an area that you may want to have whichever

body that you decide should be responsible for the auditing area for

better protecting the public interest to take a look at that and determine whether or not additional steps should be necessary.

Mr. BREEDEN. Congressman, it is nice to see you. I would only

add, number one, on your question of the financials themselves, financial statements have to be prepared by management. The starting point is—the only correction to what you said, the auditors are

not engaged to prepare the financials. That is management’s duty

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and responsibility. The auditors are there then to check those financials and test them, and that check-and-balance system is at

the heart of how we go about preparing financial reports.

I think absolutely CEOs should be responsible for what is in the

financial statements. I think they are legally today already. The

system today, however, provides also full indemnification from the

company as well as insurance if they have any liabilities. So you

have liabilities.

Mr. BAKER. With your due diligence, I know time has expired, I

just want to emphasize that one point in the event there is an allegation against the corporate CEO for misrepresentation of material

elements of the preparation of the financials, the corporate attorney defends the CEO, where the shareholder has to fund the personal litigation expense out of their pocket. My point is should

there be a down side where it is defined after appropriate inquiry

that the manipulation that did, in fact, occur, there was a loss incurred, should not the CEO then out of his own pocket have some

liability which does not now today exist?

Mr. BREEDEN. I think your point of there being a down side is

important. I think the President’s messages have emphasized that.

Chairman Pitt’s remarks have emphasized that. My own testimony

suggests that we do need to do more in the disgorgement area.

I am particularly worried about the situation where an executive

may be selling, in Gary Winnick’s case in Global Crossing, $750

million worth of stock on the eve of bankruptcy and whether or not

you should trigger it by a restatement. I think Congress should

consider whether stock sales within a certain period of time of the

company going into bankruptcy, whether the profits from those

sales by senior officers shouldn’t be recaptured into the bankruptcy

estate.

Mr. BAKER. I have much more, but I am way out of time. Thank

you very much.

Mr. CANTOR. [Presiding.] The Chair now recognizes Ranking

Member LaFalce.

Mr. LAFALCE. Thank you very much.

Today, I introduced a bill to give legislative teeth to a number

of the recommendations that President Bush called for: Number

one, with respect to disgorgement of bonuses and other incentive

compensation for either false or misleading statements or other

misconduct; number two, requiring the CEO and CFO to personally

vouch for and certify to the veracity, fairness of their company’s

public disclosures, including their financial statements and certification that certain internal control procedures are in place; and

third, enhancing the ability of the SEC to bring an enforcement

case prohibiting a person from acting as an officer or director of a

public company by lowering the standard. Right now the standard

is substantial unfitness. We would simply eliminate the word ‘‘substantial.’’

It may be unfair to ask you to comment on a bill that you have

not been asked to testify on at this juncture, but it would be fair,

I think, to ask you to submit a letter to the Committee giving your

views on that bill once you have had time to consider it, hopefully

before markup on Thursday.

OK. Now to go on.

146

Mr. Walker, you have indicated, I believe, correct me if I am

wrong, that a new oversight body for the auditing profession is necessary; that it should have the authority to establish professional

standards for the auditors of public companies; that this new regulatory organization should be able to set independence standards;

that the new regulator should be able to charge annual fees to public companies as a means of financing itself. Is that basically correct?

Mr. WALKER. That is true. Our recommendation——

Mr. LAFALCE. You find those provisions in H.R. 3818, I would assume, and not in the other bill.

Mr. WALKER. I would find——

Mr. LAFALCE. Wherever they are found, would you favor them?

Mr. WALKER. Some of the provisions are in H.R. 3818.

Mr. LAFALCE. Why do you think they are important?

Mr. WALKER. My personal view is that we should not have direct

Government intervention unless we believe that it is called for. If

there are other bodies which Government could encourage to take

the right steps, we should first try to do that. If they fail to act,

direct Government intervention should be considered.

I think the area where direct Government intervention is necessary is in the auditing area. I do not believe that you are going

to achieve the objective of best protecting the public’s interests

without more direct Government involvement dealing with the

independence setting for auditors of public companies, the quality

assurance procedures associated with those auditors, the disciplinary process associated with those firms and the individual members, and certain other matters laid out in our testimony.

Mr. LAFALCE. I appreciate that. Both Mr. Oxley and I believe

that we do need a new auditing body. The question is what power

should it have. It certainly should have at least those powers and

maybe more. It is something that Mr. Breeden suggested, subject

to compromise, we can talk about. But another question is who

should be on that board? And that is a very important question.

And I have said that the SEC should appoint them, but from lists

that were submitted from certain type of organizations such as

pension plans of private employees, pension plans of public employees, and so forth. Otherwise you might have a situation where you

have Mr. Pitt appointing a board that Mr. Boucher would look at

and say, this is so bad I am resigning, which is exactly what happened.

So do you have any thoughts as to the type of individual that

should be on that board? Do we leave it totally to the discretion of

the SEC, or do we put some language in the legislation which tries

to make sure that the individuals on that board will be interested

first and foremost and exclusively in the protection of investors?

Mr. WALKER. My personal view is there should be some standards for the individuals who would be appointed to the board. I

would note in your bill, Mr. LaFalce, there is one provision in there

that I think may raise a constitutionality issue, and that is——

Mr. LAFALCE. I will take that one out, whatever it is.

Mr. WALKER. It is the one that talks about the Comptroller General being part of the appointment process. The Comptroller General can make recommendations.

147

Mr. LAFALCE. You don’t want it, you don’t get it. You are out.

Mr. Breeden, you described two concerns with the non-audit

services that auditors currently provide to audit clients, one specific service that creates conflicts for the auditor, and, two, the volume of non-audit fees in relation to audit fees. Does either bill address it adequately, more adequately? Are both inadequate? Do you

have a preferred approach other than the approach in either of the

two bills?

Mr. BREEDEN. Congressman, I think both bills have made a very

good start looking at what is—I tried to—in my usual excessively

wordy way, I tried to in my testimony show that there are some

real complexities in that issue. It is hard to just say no consulting

at all, because things like tax services are not pure audit, but

would rob the audit of its vitality if you took them away.

Mr. LAFALCE. Which I specifically say should not be done.

Mr. BREEDEN. Neither bill takes the tax services away, although

some of the proposals in the marketplace have done that. I think

they would do significant damage if you went that far.

Consulting on internal controls is something I used to do in the

3 years I spent at Coopers & Lybrand, and I think that it contributes to the quality of audits. So I think that we need to identify

any cases where the auditors are, in essence, auditing themselves.

If they have built a data system that is the system used for financial reporting, if they are doing something in the consulting side

that their own auditors are supposed to go and audit, it is unreasonable to expect that they will give the same level of diligence

that they would if an independent person had done that. The magnitude of all the whole shebang is too much; then you also have

distortion.

Mr. CANTOR. The gentleman’s time has expired.

Mr. WALKER. Real quickly, Mr. Chairman, can I?

In my testimony we recommend that the Committee consider a

principles-and-safeguards-based approach that we have already

promulgated for Federal entities and entities that receive Federal

funds. As you know, Mr. LaFalce, the GAO actually promulgates

auditing standards for Federal entities and entities that receive

Federal funds. We believe that that guidance would be helpful in

considering what should be done with regard to public companies.

Thank you.

Mr. CANTOR. The Chair thanks the gentleman.

At this time the Chair would like to address for a moment Mr.

Breeden. I take it you are familiar with Chairman Greenspan’s remarks when he addressed this Committee several months ago.

While he was here, he expressed a concern that Congress could go

too far in overregulating the capital markets in response to the

issues at hand. Can you comment on that? What do you make of

those concerns?

Mr. BREEDEN. Well, I think any time you have a scandal of this

kind that has touched so many people and caused such widespread

losses, and between the losses to investors in Enron and the losses

to Andersen employees and so on, there is an enormous amount of

damage here. And so I think Chairman Greenspan was—as many

others have done—noting a concern that Congress be careful in responding to events that naturally cause outrage on the part of good

148

people everywhere, that we not go too far in fashioning a legislative

response, and I agree with that sentiment.

At the same time I also believe that there are some areas that

have been exposed in this overall situation that would benefit from

legislative changes, that we not do too much, but we not do too little. I think actually that Mr. Oxley’s legislation together with Mr.

LaFalce’s legislation, both bills here attempt to—and one goes further than the other, but maybe something in between is an area

where people can coalesce around. It is important not to go too far,

but I think there are some areas where real change needs to be

made.

Mr. CANTOR. Mr. Walker, can you respond to those concerns?

Mr. WALKER. Yes. As I said in my statement, you should only

have direct Government intervention where you believe that the

problem cannot be effectively addressed by other parties. In that

regard, we believe the greatest need is in the auditing area, and

what we are recommending is that there be a qualified, independent and adequately resourced body to be able to assume those

responsibilities rather than the Congress trying to get into the details, trying to make those decisions through legislation. I think

that is critical in order to make sure that you don’t over react, that

you have a balancing of interests.

As you know, Chairman Greenspan has also said that he believes

that additional action is necessary in certain areas such as in the

auditing area and has expressed some concerns about current accounting and reporting with regard to certain types of compensation arrangements.

Mr. CANTOR. Thank you.

If I could turn to Mr. Silvers for a moment. In 2000, former SEC

Chair Levitt proposed auditor independence rules targeting 10 consulting services for prohibition, the final SEC rule prohibiting

seven of these services. Another was dropped because it was

deemed unworkable. The Oxley bill bans the other two. The LaFalce bill bans all 10. Again, seven are already prohibited under

the current rules. Isn’t this provision redundant?

Mr. SILVERS. I am sorry, sir, which provision do you think is redundant?

Mr. CANTOR. The Oxley bill bans the other 2, but the LaFalce

comes in and bans all 10, while 7 are already prohibited by the

rules as they exist now.

Mr. SILVERS. My understanding from reading the bills, Mr.

Chairman, is that Mr. LaFalce’s bill provides the Commission with

the authority to take a look at a practice such as that which occurred at Enron where Arthur Andersen participated in structuring

SPEs and then came back, and partly did so, I believe, under the

rubric of tax consulting. Certainly they could have done so under

the rubric of tax consulting. They structured the SPEs and came

back and audited the SPEs and generated a $5 million fee for doing

so.

The challenge of this problem of conflict of interest is that the

Commission needs to have the authority to draw these fine lines,

and the Chairman’s bill simply does not give the Commission the

clear authority and direction to do that. Mr. LaFalce’s bill does

that. The difference, frankly, is that under the Chairman’s bill, if

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a firm was to feel that it made sense for them economically to go

and do what Arthur Andersen did at Enron, there really would be

no reason per se under the Chairman’s bill that they couldn’t do

that, whereas Mr. LaFalce’s bill clearly directs the Commission to

promulgate rules under that conduct. I don’t believe that distinction is by any means redundant, as you would suggest.

Mr. CANTOR. Mr. Breeden, if I could turn to you in an attempt

to elicit a response about the potential redundancy in one of the

bills that attempts to address the rules that are already in place.

Mr. BREEDEN. Mr. Chairman, I have not looked in detail at the

language of the Commission’s current rules compared to the bill to

see whether they are completely overlapping or whether there are

gaps there. I could do so afterwards and send you a letter about

it, but I really haven’t done so, and so I can’t tell you whether they

are fully redundant or not.

Mr. CANTOR. It would be appreciated. Thank you.

Mr. LAFALCE. Would the gentleman like me to give an answer?

Number one, they are not fully redundant at all because there were

carve-outs within the rule. Number two, if the worst sin in redundancy is that codification into law of regulations, I will accept that

sin.

Mr. CANTOR. The Chair thanks the gentleman.

The Chair now recognizes Mr. Kanjorski.

Mr. KANJORSKI. All of the testimony in the pending bills makes

certain presumptions that, one, we know the full extent of the

Enron disaster, and also obviously in regard to its accounting firm,

Arthur Andersen, with its $25 million in auditing fees and $27 million in consulting fees. I would like to know whether these were

overcharges, whether the work performed was unethical or improper, and if it was, to what extent. Are any of you aware of any

studies that have analyzed what work was done, how competent

the work was, and whether or not, in fact, any of it was improperly

done?

Mr. WALKER. I am not aware of a study. I am also aware of the

fact that Arthur Andersen at least was performing certain internal

audit services that would be banned under both of these bills,

which I think is noteworthy.

Mr. BREEDEN. Congressman, I am not aware of any studies, but $52 million in fees combined for auditing and consulting is an enormous fee. That would put—Enron’s payments to Andersen clearly

would have had to have been among the top of not only Andersen’s

clients, but any accounting firm’s clients.

Mr. SILVERS. Mr. Kanjorski, I would make two points in response

to your question. One is the conflict that was alluded to in response

to the Chairman’s questions is discussed on page 5 of the Powers

Report and gone into in some detail later on in the report in terms

of the specific conflicts that were at work here. I would add that

prior to the appearance of the Powers Report, that both Andersen

and Enron made some efforts to conceal from Congress in several

different committees, including this one, the extent of those conflicts, but the Powers Report itself documents them quite adequately.

I could also say that although that fee is very large, it is very

interesting that the multiple of the consulting fee in relationship

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to the audit fee at Enron was not even close to the high end. There

have been several surveys of the ratios that the SEC’s recent disclosure rules have divulged to us of these ratios in other major public companies which I would be happy to provide to the Committee.

I would know one sticks in my mind, which is Motorola, which had

a board overlap with Enron until very recently. Motorola was 16-

to-1, the ratio of consulting fees to audit fees.

Mr. KANJORSKI. The consulting fees were 16 times more than the

audit?

Mr. SILVERS. Precisely.

Mr. KANJORSKI. So maybe Andersen undercharged?

Mr. SILVERS. Perhaps you could raise that with them.

Mr. KANJORSKI. The reason for that question is, obviously, that

the Congress is going to act. Whenever anything happens in our society, we either pass a law or we form a commission. Obviously, we

are not going to be able to form a commission to address this problem, so we are going to pass a law.

I am a little worried about the unintended consequences of what

we may be passing. I am not absolutely certain that the Congress

has the clarity of either the Enron problem, if it represents an endemic problem, and just how endemic that problem is, or whether

or not we are in a position to move this legislation through as

quickly as we seem to be. Should we take more deliberative time?

Do any of you see some great risk to our economic system if we

take a couple of more months in resolving this problem, or do we

have to do this before Memorial Day because it fits into the political schedule?

Mr. SILVERS. I am the only person willing to take a risk on this

proposition. Obviously I think the people that I represent here

would like Congress very much to take action in this session. I

would defer to the wisdom of the Committee as to what precise calendar that requires. It seems to me that the more important question is are you going to take the right direction or not.

I think, Mr. Kanjorski, your questions get at one issue in which

I am not sure that this Committee is heading in the right direction.

It would be better to take the time to get it right than to do something that won’t protect America’s working families against a future Enron.

Mr. KANJORSKI. I tend to agree, too. That question is structured

along the idea that we have 17,000-plus public corporations. It

would seem to me they do not all fall into Enron’s category. Anything we do will also cause additional expenses for those corporations and to the Government in order to police the law we are enacting. I am just worried: are we going to do what sometimes we

have done in other Congressional actions? We could just end up

just ignoring the cost and the burden to struggling companies that

have to get equity and have to get out there. They have not done

anything, but they will have to comply with all these rules and regulations at great expense to the company and ultimately to the

shareholders, and maybe actually put their long-term success in

jeopardy.

What I am thinking, is whether or not we should put a tier operation into effect with any bill and look at only the top 1,000 or

5,000 corporations. But all 17,000 of these companies? We initially

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did that with all banks when we enacted CRA. To a large extent,

it was my experience that we initially put unusual burdens on

small community banks to go through the legal work and expense

to comply with CRA. Before we changed the law, I visited banks

that were spending a sixth of their income on legal and accounting

fees to prove compliance with CRA—little banks that could not

exist outside of their community. So, anything they were doing,

they were complying with CRA.

Yes?

Mr. CANTOR. Will Mr. Walker answer the question, then the gentleman’s time has expired.

Mr. WALKER. I think in the final analysis it is better to get it

right rather than do it fast, but I think there is a need for some

expeditious attention to the critical area, especially in connection

with the auditing area. Obviously, as you know, Mr. Kanjorski, this

is the beginning of the legislative process on this side of the Hill,

and the Senate has to act as well. There are a lot of things that

have to happen before this will get finalized.

We do recommend in our approach that it is important to have

qualified, independent and adequately resourced bodies deal with

a lot of the details. The Congress may want to ask for those bodies

to look at certain issues and to make sure, for example, that in the

area of independence that they consider a principles-and-safeguardbased approach, that they can look at certain services in particular

as to whether or not they should be allowed, and if so, under what

circumstances. I think if you take that approach where you are

making sure you have a qualified, independent, adequately

resourced body, you are providing that body with the power to do

what needs to be done, you are providing it some guidance, but not

getting too detailed with regard to how much you are prescribing

legislatively, that might be a reasonable balance because, after all,

markets evolve over time. What you say today may not be appropriate tomorrow. So some other body has to be empowered to deal

with changes over time.

Mr. KANJORSKI. Thank you, Mr. Chairman.

Mr. CANTOR. The Chair recognizes Mr. Rogers from Michigan.

Mr. ROGERS. Thank you, Mr. Chairman.

I am going to take maybe a bit of a different direction. One of

the concerns I have is in this whole episode, we have been—we

being Congress—in a hurry to find a villain, and I am not sure exactly we have identified the crime yet. I was hoping to ask Mr.

Breeden, one of the things I am concerned about is that we are trying to treat this with a pill rather than laser surgery. I am not so

sure that laser surgery isn’t the order of the day here. We have a

real possibility here to cause some real problems for lots of folks,

UAW members and you name it out there, families who are investing more and more in 401K plans all across the United States. And

sometimes just questioning the company’s accounting practices by

any official entity can be devastating to the stock of that particular

company. We haven’t done any investor in the United States any

good if we do that maliciously or at least without good intent.

I want you to help me understand how we can make the corrective actions I think we all know we have to make here, certainly

for transparency, without jeopardizing investor confidence. And

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those families out there who are working very hard every day, they

send their money into their mutual funds knowing that that is

what they are going to retire on, and they are counting on all of

us, those here in Congress as well as you, auditors, regulators and

those in the business community, to make sure that there is honesty and true brokering going on out there in those companies.

Mr. BREEDEN. Congressman, I think both you and Congressman

Kanjorski raise similar, in a way, concerns and good points. One

of the best things we have been able to accomplish over the last

couple decades is to foster a broader participation in our capital

market, and as my colleague here from the AFL-CIO points out, we

have working men and women through pension plans, we have investors through mutual funds and directly to the tens of millions,

and that has been a wonderful accomplishment.

So we have as a Nation a great deal at stake in protecting the

confidence those people have that our markets work with honesty

and integrity, and they can believe the numbers they look at and

that they make investment decisions on, and that this is a huge

system with 17,000 public companies, and in fixing it a couple

things are apparent. Number one, we have to be careful that we

don’t go too far, we don’t fall into the law of unintended consequences when we try to fix one problem that we create another

one, that we don’t go too broadly and don’t create excessive costs,

as the Congressman is mentioning, in CRA, which is a very real

risk.

We need to start with what we have, which is the world’s finest

system. It is not perfect. It has some flaws. No system designed by

human beings and run by human beings is ever going to be perfect.

But I genuinely believe, notwithstanding Enron, that the U.S. accounting and disclosure system is the best in the world. So let’s not

throw the baby out with the bath water. Let’s start with what we

have and look to see how can we build on that. If there are gaps

here and there that we need to address, then let’s do it.

I think that now on the question of investor confidence, I don’t

think there is—I am not aware of a situation where anyone has

maliciously questioned people’s financials, but certainly the market

itself should raise questions about companies that have very aggressive accounting practices. We certainly have seen that postEnron with aggressive selling against Tyco and other stocks that

are perceived to have some accounting issues. I think those market

disciplines are very healthy. In fact, I wish we had more of them,

not that people should do it based on rumor or fear, but that a

healthy skepticism looking hard at what numbers companies are

reporting and making sure that investors do their homework to

worry about the risk that they may be undertaking.

So this whole area is one in which it is extremely complex, and

we have to be extremely careful that we don’t get things out of balance. But at the same time I think it is clear that we can do things

to speed up disclosure and make disclosure more comprehensive.

For 40 percent of the assets of Enron to be hidden off the books

was unacceptable. That is disclosure? That is a joke. It shouldn’t

have happened. The parties responsible should have known there

was—whether or not it was proper accounting, it was lousy disclosure.

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And so we need to look starting at the Commission, but also here

at Congress, are there things we can do to make disclosure faster

and make it more comprehensive? Can we have better information

about executive stock sales? That is very important to individual

investors across the country. They know enough to know—they

may not understand an SPE, but they know if the CEO is bailing

out of the stock, they don’t want to be investing themselves at the

very same time the top guys are getting out. So speeding up those

disclosures is another healthy thing.

Making sure that auditors don’t sell their integrity. We can’t station an SEC enforcement agent at the shoulder of every accounting

professional, but at the top trying to make sure that the system encourages quality auditing, and that the firms themselves realize

how important their public trust is, and the strong efforts they

themselves need to make to do a good job.

So there are a lot of things where I think we can make some improvements that are consistent with our traditions and consistent

with our systems and make it a little better.

Mr. CANTOR. The Chair thanks the gentleman.

The Chair recognizes Mrs. Maloney.

Mrs. MALONEY. I thank the Chairman and the Ranking Member

and all of the panelists.

I am sure all of you are aware that today Andersen announced

they are laying off 7,000 of their employees and that this represents a quarter of their total employees. And furthermore, the

long-term viability of the company is truly in question. And as I

have said many times before, the overwhelming majority of the

professionals in the industry are hard-working and honest and

have a great respect for the title ‘‘certified public accountant.’’

I am concerned, quite frankly, about some of these employees,

many of whom are my constituents. I would like to ask Mr.

Breeden from what you know, do you think it is appropriate for the

Justice Department to have targeted the whole of Andersen, or

should we allow the Volcker plan to go forward and have it put in

place and go after a limited number of employees known to have

been involved in the Enron audit? Do you have feelings on this?

Mr. BREEDEN. Congresswoman, thank you. The Andersen situation is a very sad one. It is certainly one that is regrettable on

many different planes, and I certainly hope that anything possible

that Paul Volcker or anyone else can do to stabilize the firm and

allow it to survive and then worry in the future about rebuilding,

I wish it every possible success.

On the other hand, we used to have debates when I was in the

White House working on financial services about whether banks

were too big to fail, and I don’t believe Arthur Andersen is too big

to fail, and I don’t believe any of the other Big Four are too big

to fail. If they ever got that notion in their head that they somehow

have carried their monopoly on auditing and the oligarchy that exists in competition in this world that no one could bring an action

against them if they broke the law, then that would be a mistake.

We went through Watergate to prove that the President of the

United States is not above the law. I think that the general counsel

and the CEO and other staff members of Arthur Andersen are also

not above the law.

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I don’t take a position on whether or not the Justice Department

has the—we can only know when a trial takes place and we see

what evidence the Justice Department has. But in my experience

working with the Department of Justice in law enforcement over

many years, they don’t indict people or firms capriciously. They do

it on the basis of a very sober and careful calculation of whether

they have the evidence of wrongdoing, and it is a responsible act.

I think some of the people worrying about the consequences for

Andersen should be asking the question about isn’t it sad that Andersen’s management engaged in the acts that led to the permanent injunction in Waste Management; that Andersen’s management tolerated massive destruction of documents on the eve of Government investigation; that chimpanzees could know that the documents at Enron were going to be subpoenaed high and low by every

Government agency and private litigants all over the place, and if

you destroy documents, you may be affecting the rights of the University of California to recover against Enron executives or others,

and in that context destroying documents is wrong.

And so it is a tough issue, because nobody likes to see what is

happening to other people at Andersen, and yet Andersen finds

itself where it is largely through its own actions.

Mrs. MALONEY. You mentioned earlier, Mr. Breeden, that we

should have faster and fuller disclosure, and one area that really

isn’t disclosed now except by consent or individual choice is the

code of ethics for the board of directors or the code of ethics for

firms. Do you think it would be helpful that the code of ethics was

printed in the annual report, and if the board of directors took the

unusual step of overriding the code of ethics of their board, that it

be reported to the SEC and printed in the annual report?

As you know, in Enron, as reported in press accounts, the board

of directors voted to overturn their own code of ethics to allow their

CFO Mr. Fastow to head these special SPEs. So I was wondering

when I called for fuller disclosure, would this be an area that you

think might be helpful to the investor, to the general public?

Mr. BREEDEN. Yes, Congresswoman, I think very much so. In

fact, in both testimony on the Senate side and in this testimony,

I did say I believe that any time a board acts to suspend the corporate code of ethics, that not only publication in the annual report

is way too slow, they should have to file an 8(k), do it within 10

days anyway, but almost immediate disclosure should be made. I

think corporate codes of ethics should be at least posted on their

website. It might add quite a few pages to the annual report, but

I think somewhere it should be noted.

I did call for disclosure in the proxy statement or in some other

vehicle for the board to set forth its policies on conflicts among senior executives. The conflicts in Enron at the CFO level were among

the most dangerous possible things that a corporation could do, because the outside auditors and the audit committee and the full

board all are looking at numbers provided by a CFO. So if the CFO

has got a personal financial reason to give distorted numbers, it

can defeat simultaneously the ability of the board, the audit committee and the outside auditors to check up on that. It is the one

vital spot where—it is the hub and the spokes of the wheel. So any

conflicts involving a CFO should be, in my judgment, prohibited

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under State law, and there should be required to be immediate disclosure if a company goes down that road, which hopefully they will

not.

Mr. CANTOR. The gentlelady’s time has expired.

The Chair now recognizes Chairman Baker.

Mr. BAKER. Thank you, Mr. Chairman.

Mr. CANTOR. He was assuming the time of the Chair who was

here before I was. So this is on his own time.

Mr. Chairman.

Mr. BAKER. Thank you very much for clarifying. Don’t want to

misrepresent my account here.

In the earlier round, Mr. Breeden, we talked about disgorgement

and insider trading prohibitions, bailing out on stock the night before the bankruptcy filing. We talked about clarity in the liability

for the CEO for the preparation of the financials. There are other

elements that I think I would like to get your comment on. One is

the subject of a cooling-off period where the auditor is the principal

engaged as an outside auditor for company X; upon retirement immediately goes to work for that company as the chief financial officer. There are prohibitions which apply to Members of Congress,

for example, in what we can do in post-congressional life. Do you

look at that in an advisable way? Is that something we should consider?

Mr. BREEDEN. Yes, sir, I believe that you should. I remember

back in my days at the Commission, we had the then infamous

Lincoln Savings collapse. An awful lot of people were hurt in that.

That was another case where this CFO that was in place at Lincoln

Savings had come over from the outside auditor, which means the

people who audit his work the very next year are all the people

who used to be his subordinates at the audit firm.

So without knowing exactly how it should be done, I think cooling-off periods are healthy and is something that would probably

make sense.

Mr. BAKER. As to structure on all of these, it is my thought to

authorize, mandate the SEC to study and implement rules governing these points raised by the Congress as a policy matter. I

think it may be difficult and take us years to get a plan that is

enforceable and not disruptive to markets if we do the specifics, but

at least to have a goal within 6 months, a year for the SEC and

staff to determine the most appropriate manner for prohibiting

whatever is an unreasonable corporate practice.

Audit committee and their ability to do their work. Provisions for

independent counsel. In other words, not having to rely on internal

corporate officials to do the work for the audit committee. It’s difficult if you have a CFO who is conflicted, but if you are really trying to do the job on the audit committee, and you are asking the

guys who are employed by the corporation, isn’t that equally troubling?

Mr. BREEDEN. I serve on three audit committees, and I chair two

of them. I can’t imagine anybody telling us—and I don’t think it

is just me—I can’t imagine anyone saying to an audit committee

that they can’t hire outside counsel. The board can do what it

wants. The problem is that—it is a little bit of a chicken-and-egg

situation. One of the problems in both Waste Management and

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Enron was that the auditors never said boo to the audit committee.

They knew there were problems and didn’t bring the audit committee into the loop. So they were, in many respects, oblivious or

appeared to be ignorant to many of the issues that might have

caused them to go and hire outside counsel, but they have to know

that they need it.

Mr. BAKER. That was my point is that rather than making it a

permissible activity to do it, is that a mandatory obligation to construct your audit analysis based on outside counsel?

Mr. BREEDEN. I think we have enough make work acts for lawyers, but I wouldn’t require it, but I think certainly as a matter of

good corporate practice and maybe through listing standards it is

something that can be encouraged. Certainly any audit committee

has to have the right to speak to independent counsel and independent financial advisors if they believe they need the advice.

Mr. BAKER. Lastly, with regard to stock option plans, shouldn’t

that require shareholder approval?

Mr. BREEDEN. I believe so.

Mr. BAKER. And there is one other piece of work may I compliment you on. In 1992, there was a report issued by the SEC, and

it also supports a statement of Chairman Pitt before the Committee just before the Easter recess relative to the reporting to the

SEC by the GSEs. As I recall it, your work at that time indicated

it was advisable policy for the GSEs to file as all other Fortune 500

companies do in compliance with SEC standards. Is that still your

view?

Mr. BREEDEN. Congressman, I don’t remember that specific report. I seem to remember getting the tar beat out of me by folks

at the time over that issue. I haven’t looked at it since then. So

with respect, I will just stay out of that hornet’s nest.

Mr. BAKER. If your bruises haven’t gone away, I can assure you

that the report contains that information, because I have the

bruises myself.

Mr. BREEDEN. One of the great things about being in the private

sector as opposed to being in Government service is you can duck

a few of the fastballs that you have to go ahead and stand at the

plate when you are in Government.

Mr. BAKER. I commend you for your bravery while on duty.

Mr. CANTOR. The Chair now recognizes the gentleman from

North Carolina, Mr. Watt.

Mr. WATT. Thank you, Mr. Chairman.

I want to start by applauding the testimony of Professor

Langevoort. I may not be pronouncing his name right. His testimony has gone unnoticed in the question-and-answer period, but

he should know that as far as I am concerned, it is among the most

important testimony that has been given here today. In my opening

statement I emphasized the importance of allowing individuals to

hold people accountable and corporations accountable in addition to

Government bodies, and your testimony seems to me to be consistent with that.

First of all, we have to reestablish the legal standard that makes

other parties have legal liability to anybody, and then we have got

to give individual people who are damaged by those activities the

right to take up their own private litigation and enforce those

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rights, and in some cases that may result in less Government bureaucracy. I keep having trouble convincing my Republican counterparts of that, but they may come around.

The problem is that—and I am certainly going to try to pursue

this in the course of this markup—the problem I have already identified, however, is that the rules of germaneness in the legislative

context are probably more rigorous than the rules of evidence in

the evidentiary context. If we start with the Chairman’s bill, I am

not sure we can craft an amendment that gets that on the table

for discussion and debate, so I am not going to spend a lot of time

asking you questions about it. But I did want you to know that

what you said did not go unnoticed by at least one Member of this

Committee.

Mr. LANGEVOORT. Thank you. I was actually happy not to get all

the fastballs.

Mr. WATT. Now I want to go to another issue that I am trying

to resolve or reconcile, the differences between Mr. Walker and Mr.

Breeden, and try to figure out which one of them I agree with

more. As I understand it, Mr. Breeden—no, I am sorry, as I understand it, Mr. Walker thinks that we ought to have another Federal

board of some kind in addition to FASB and the SEC. We ought

to have some third agency. And as I understand Mr. Breeden’s testimony, he rigorously disagrees with that. I would like for the two

of you to try to reconcile, if they are reconcilable, your views on

that issue. I tend, I think, to come down more on Mr. Breeden’s

side than Mr. Walker’s side, I believe.

It is coincidental that right across the hall here where I am on

the Judiciary also, as you may have gathered by my legal bent

here, we are debating whether to break up the INS into about five

or six different parts on the theory that if you break it up, it will

all of a sudden become more efficient even if you keep the same

people and the same rules and regulations and everything. It

seems to me that one approach we might be using is trying to

make the SEC and FASB more efficient rather than creating another institution in the process.

So let me hear from Mr. Walker first. Then I want to ask another question. I will give Mr. Breeden equal time to defend his position.

Mr. WALKER. Mr. Watt, right now you have one Federal Government entity involved, and that is the Securities and Exchange

Commission. As you know, the FASB is not a Federal Government

entity, it is a self-regulatory body.

Mr. WATT. But wouldn’t this bill put those kind of agencies kind

of under the jurisdiction, supervision of the SEC?

Mr. WALKER. What we were proposing at GAO is that the SEC

has more than enough to say grace over right now. Some can

debate——

Mr. WATT. One way to solve that is to add some more people.

Mr. WALKER. That is one issue. Mr. Watt, we are saying that the

area of most acute need for intervention is in the auditing area.

The SEC is already overtaxed as it relates to enforcing the securities laws and dealing with significant accounting and reporting

issues that have to be dealt with.

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There are many people on this Committee and others in Congress who believe that the CFTC ought to be merged with the SEC.

So the point is there are a lot of things that the SEC has to do

right now.

Our view is that you could have an independent entity within the

SEC. You could have a body within the SEC that would have Presidential appointees with Senate confirmation who have the authority to make final decisions with regard to certain auditing activities, but would allow them to be able to coordinate as appropriate

with the SEC on accounting issues and on securities regulation. We

think that is possible to be able to do that, but one of the concerns

that we have is that the auditing area is the one that we think

there is the most need and there needs to be appropriate accountability to the Congress, and we don’t know that you get appropriate

accountability to the Congress unless you have the parties responsible and reportable to the Congress.

Furthermore, we question whether or not the commission members and their staff can effectively discharge these additional responsibilities because they are already having difficulty dealing

with their current responsibilities.

Mr. CANTOR. The gentleman’s time is expired. Thank you.

Mr. BREEDEN. Mr. Chairman, if I could have the liberty of responding to this, because I think it really is a pivotal issue.

Mr. CANTOR. Without objection.

Mr. BREEDEN. Thank you very much. I, of course, have boundless

regard for GAO and its analytic capabilities. This is a matter that

is a matter of principle and philosophy, I suppose, but I could not

feel more strongly about it than I—and Mr. Watt, I appreciate your

asking the question and giving me a chance to give you my side

of things.

For about 68 years now, the SEC has been the Federal agency

with responsibility for overseeing the accounting profession. It has

a long history. It has a long culture and a long tradition of being

able to put the public interest first to have an effective enforcement

program. I do not think there is any wrongdoer out there, be it corporate, individual or a partnership, that the SEC and its history

would not tackle. It has built up a long history there without fear

or favor of any person, irrespective of party, irrespective of any

other factor, and to say that, well, that is very nice, but they are

awfully busy doing some other things, we should put it aside and

start all over again and build a brand new agency that has no history, no culture, no existing staff, nothing. We are going to start

from the beginning and build it all up, and 10 or 15 years from

now it will have experience and culture and tradition, and we are

going to hope at that time it is going to do a better job than the

agency that for 68 years has done a great job for America’s investors.

Now the Commission is starved for resources and has been underfunded since 1934, and I would appreciate the efforts of many

Members of Congress to expand its staff so that we could keep pace

with growth in the markets, and that is an ongoing problem today.

But I really think that there is not a need for another Federal

agency.

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Now I agree with a great deal of what Mr. Walker has said in

terms of the importance of integrity and independence and good

powers, and all of those things can be in a body like the NASD that

would be a subsidiary, private sector organization, out doing a lot

of work, doing a lot of enforcement, bringing all those fine qualities

to bear, but reporting up through the existing Government agency

so we don’t lose the benefit of nearly 70 years of public service.

Mr. CANTOR. Thank you.

The Chair now recognizes Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Let me thank my colleague from North Carolina, because I wanted to be the devil’s advocate on that, but he is much more eloquent

than I am, and I agree with his line of reasoning, and I think it

is problematic.

I think, Mr. Breeden, you are right on point that what we are

talking about doing now is starting over from scratch to create a

new agency, and I guess—that John is correct. Redundancy is not

necessarily a sin, but what I keep coming back to is does not the

commission already have a tremendous amount of authority in this

area? And perhaps the commission should be under some attack for

not necessarily exercising that authority, and perhaps the commission can argue that they have been underfunded and haven’t had

the resources, but it seems to me—I have always been under the

impression that the commission had this authority. You yourselves

stated that, in fact, audited financials are—in fact, the financials

themselves are prepared by the public company as a function under

the 1934 Act, and then audited and given a blessing by the auditor,

but in fact they are all compelled by securities law in the first

place, and it is the commission that governs securities law. And so

I think that your point is right or—your line—of reasoning is right

on point.

I furthermore think that now we are talking about in the GAO—

and I don’t think John’s bill goes this way or Mike’s bill goes this

way, necessarily, but the idea of registration of auditing firms with

this new authority. And the next question is, which I have asked

with other panels, are we going to have to have qualified opinions

with an audit that is given, for each audit that is given, that it

meets certain standards? And do we know exactly where we are

going in setting the standards?

But let me ask—I want to move on to some other points. Everyone talks about the need of sort of a division of labor between audit

and non-audit services, and I do not disagree with that, but we

have a number of lists that are out there, what ought to be precluded or prohibited, and what ought not to be prohibited. Are we

better off trying to write in the statute what services can be provided and what services cannot be provided, or are we better off

providing the commission, if that is the route we go, or whoever the

ultimate authority is—and again, I would argue that it is the commission—with the same authority that we have done in banking

law, for instance, to say something that creates the appearance of

a conflict and leave it up to the rulemaking bodies to determine

what is appropriate and what is not appropriate? Would we be better off than providing a list? Either one or all.

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Mr. BREEDEN. Congressman, I think the question of what is a

permissible service is a very important one. Certainly at a minimum, if it were left to an agency, there would have to be some

guidelines and standards of what should the policy be here, and I

think Congress has an important role to play in trying to answer

that. You know, in my mind, if Arthur Andersen had not done one

penny’s worth of consulting work for Enron, the exact same problem would have happened. We are in part discussing a red herring

here, because the audit fee that Andersen was collecting from

Enron was more than big enough to correct the behavior and create

all the pressure, whether or not they were also on top of that getting consulting fees. And so let us don’t kid ourselves that if we

forced the people to get out of all consulting, these pressures on

independence are not going to go away. In some ways they get

worse, because if you have said that the entire firm is dependent

on nothing but the audit fee, then the CFO who can threaten to

take away the audit fee has even more leverage over the auditor

than not.

So, on the other hand, we want the public to understand that

audit opinions cannot be bought and the audit relationship ought

to be the primary focus, and as one of the other witnesses pointed

out, we have now seen some cases where companies have many

multiples, the consulting fees, as the audit fee.

So what should the policy be? And if Congress sets out standards, whether it is conflict or specific types of risk, yes, then you

could give the jobs of drawing the lines to an agency.

Mr. BENTSEN. My time is coming up and I want to follow up with

two other points. Mr. Breeden——

Mr. LAFALCE. Mr. Walker, is——

Mr. CANTOR. The gentleman’s time is expiring.

Mr. BENTSEN. Well, I do not think it is expired, because it is——

Mr. CANTOR. I said ‘‘is expiring.’’ Yes, you are correct.

Mr. BENTSEN. I would like to hear from Mr. Walker, but I do

want to ask one other thing of Mr. Breeden. An issue was raised

with respect to Enron that goes back to some of the law and rule

changes in the 1980s with respect to insider trading as we know

it, not sales by insiders and sort of the Chinese wall that was established between underwriting and sales and trading, and some

have raised the question that the unintended consequence of that

was that deals that were being structured, primarily private placement deals that were being structured for Enron that had the effect of diluting stock value and taking debt off balance sheet while

increasing the leverage of the company, had the brokerage side

known that, they may well not have made a market in their public

securities. Is that an unintended consequence, and is there a way

to address that in going back to that 1980s law, or was that just

something we have to live with?

Mr. BREEDEN. The whole idea of Chinese walls is to deliberately

deprive certain parts of an organization of information that is possessed by other parts, and so assuming that that information is

valuable, it is almost always the case, for example, that the investment banking side of a firm might know that a tender offer is

going to happen or that there might be an LBO going to—something is going to happen to change the capital structure that would

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cause your brokers to either recommend the stock or not recommend it and you consciously and deliberately say we cannot

allow that information to be used, because only the customers of

that firm would have that information. It is not out in the broad

marketplace. So I think Chinese walls are not perfect, and they do

have the effect that you mentioned in particular cases, but they

also prevent essentially institutionalized insider trading that would

happen if knowledge from the banking side can filter over into one

group of brokers, but not everybody else in the rest of the marketplace.

Mr. BENTSEN. But under—and if——

Mr. CANTOR. The gentleman’s time is expired.

Mr. BENTSEN. With the indulgence of the Chair. Under things

such as Reg FD and others, when deals are being structured that

are increasingly leveraging the company to the detriment of the

public shareholders, should the underwriting side be dutybound to

disclose that? And I understand the original intent, why you would

put the Chinese wall in. It made perfect sense. But now you have

the reverse effect occurring. Or is that just an unintended consequence we have to live with?

Mr. CANTOR. Mr. Breeden, if you can expedite your answer, as

the gentleman’s time is expired.

Mr. BREEDEN. Always a problem. I guess I would just say I think

that is worth taking a look at, in the context of what we have seen

in this case, and see if there are not ways we can mitigate those

negative effects.

Mr. BENTSEN. Thank you. Thank you, Mr. Chairman.

Mr. CANTOR. The Chair now recognizes Mr. Sherman.

Mr. SHERMAN. Mr. Chairman, thank you. Let me make sure I

anger virtually everyone in the room with at least a couple of quick

points. First, as we praise the SEC, let us remember that that is

the Government agency responsible for our capital markets, and we

have just had the largest capital markets failure in history. And

while we focus on an accounting industry that is about to go down

from the Big Five down to the Big Four, we should remember that

we could have an SEC rule that no one firm can audit more than

15 percent of the publicly reporting issuers and force the breakup

of the Big Four and do something that has kind of a catchy title,

the Big Eight. To us old guys, that has a catchy title. And I do not

have time for oral responses, but I hope our panel would respond

on whether having only 4 accounting firms auditing publicly traded

companies is a good idea for our capital markets.

It has been pointed out that management prepares these financial statements and the auditor just expresses an opinion on them.

We should point out that what auditors do is demand changes to

those financial statements which management can implement or

not implement. The reason I make this point is that there has been

a lot of talk of criminalizing speech, that is to say, prohibiting the

‘‘undue influence of management on the auditors.’’ And what worries me is that that is just a pejorative vagueness for talking, and

that if we are going to criminalize some discussions between auditors and management, we ought to figure out how financial statements are going to be created or who is going to decide which talking is necessary and which is criminal.

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Shifting to a question to Messers. Langevoort and Silvers, you

folks have pointed out the importance of private litigation, which

is the only economic incentive auditors have to do a good job and

to stand up to that other economic incentive they have to do whatever Ken Lay wants them to do. The one concern I have is back

in those old days, these accounting firms were general partnerships. Everybody was liable for whatever the accounting firm was

liable for. All multithousands of partners and an awful lot of assets. Now they are all limited liability companies. Does it make any

sense to allow lawsuits against accounting firms unless we have a

requirement that they have malpractice insurance or malpractice

reserves or some other capital? And should that capital requirement be set at one half a year’s audit fees or at some other level?

Mr. LANGEVOORT. Certainly you need to address the question of

whether there is money. I think we have yet to learn what the protective shield of limited liability partnership or limited liability

company is, but you are absolutely right. If the deterrent effect is

going to be there, there has to be some way of reaching the wealth

generated by performing the services and capturing that.

Mr. SHERMAN. I am not so much thinking of this as a hammer

that is going to take away the house of every partner of Arthur Andersen, so much as a compensation fund. If we are going to tell

people they can sue because they have been harmed, they ought to

be able to recover something, and I would point out that the

amount being offered by Arthur Andersen now is just 6 years’ fees

to one client.

Mr. LANGEVOORT. I do not disagree with that, but I would keep

the club and the hammer there, too.

Mr. SHERMAN. Shifting to the scope of service, there is discussion

of making a laundry list, perhaps 10 items, that auditors are not

allowed to do. But the main impetus for this is to say, well, maybe

$25 million in fees is a necessary evil if you are going to have privately paid-for audits, but $52 million is way too much. Do we need

just a laundry list of services not to be provided, or do we need a

rule that says your total non-audit fee cannot exceed, say, 50 percent, 80 percent, 100 percent of your total audit fee? The ratio was

commented on by, I believe, Mr. Silvers, should there be a requirement that that ratio not exceed 50 percent or 100 percent?

Mr. SILVERS. I think that the issue here really is, as you mentioned, with the laundry list, that it is possible to evade the intention, which is to end the conflict, by the change in practices within

the marketplace. Our view is, is that what you need here is a—and

I believe one of the witnesses—one of my co-panelists spoke to this

earlier. You need a statutory mandate to the commission, right,

that in general bars consulting services, allows for consulting services that are intrinsic to the audit function, all right, and gives the

commission the discretion to sort out as the marketplace and practices change which are which. Right?

Mr. SHERMAN. But if, say, tax services are an integral part of the

traditional accounting function or auditing function, is it acceptable

to have a million dollar audit fee in a $3 million tax fee?

Mr. SILVERS. Well, I think there are two answers to that. One

is, as I said earlier, there are tax services and there are tax services that are preparing the audit. Then there is structuring the

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partnership designed to keep everything off the books. They are

very different and that is why you need the commission to have

this discretion. But to answer your question directly, the question

of the ratio, it seems to me that if we have got the general rule

right and the SEC is complying with the intent of Congress here,

that you would never see a situation in which audit firms exceeded

by multiples, right, consulting fee—audit fees exceeded by multiples consulting fees. Thus the kind of measure you are suggesting

might be a—I think what Mr. LaFalce referred to as a helpful redundancy.

I think, though, that what really is critical here is, is that the

Commission be given both the discretion and the clear direction.

Mr. SHERMAN. I would point out that the commission——

Mr. CANTOR. The gentleman’s time has expired.

Mr. SHERMAN.——has for the last 50-plus years—I believe my

time is expired.

Mr. CANTOR. Thank you, gentlemen.

The Chair now recognizes Mr. LaFalce.

Mr. LAFALCE. I thank the Chair very much.

Mr. Silvers, we have not really spent too much time considering

the issue of mandatory rotation of auditors, and I might say that

all of my accounting provisions or auditing provisions were discussed at great length with the former chief accountant to the SEC,

Mr. Lynn Turner. As you know, in my bill, I would say that you

could have an audit for a 4-year period, and it could be renewed.

It could be renewed basically if you have got the Good Housekeeping Seal of Approval of the SEC for an additional 4-year period. But then that would be it. I think that might well ensure for

8 years of good audits and then another auditor could come in and

say what a great job the previous auditor did or point out where

there is need for improvement.

No, what are your thoughts on that concept? It seems to me that

that concept is even more important, or at least equally as important, as the separation of the auditing and non-auditing functions.

Mr. SILVERS. Yes. I would very much agree with your characterization of that language. I think that—and the AFL-CIO has proposed a rulemaking petition to the SEC that the SEC put such a

requirement in place by rulemaking. I think that the critical issue

here again goes to what Chairman Greenwood was talking about,

which is the sort of confluence of forces that are at work to compromise the audit. All right? And one of the most important is this

sense of cash flows in perpetuity that come from keeping a client

happy, and the way in which there is a kind of melding of the audit

firm and the staff of the people they are auditing. I think that

Chairman Baker made some reference to his concern about that

earlier in this hearing. Both the firm rotation and the prohibition

on individuals flipping over that Chairman Baker alluded to would

get at that.

Mr. LAFALCE. Well, prohibition and flipping over and cooling-off

period is a provision of my bill.

Mr. SILVERS. I left that to you to say.

Mr. LAFALCE. OK. And you favor that.

Mr. SILVERS. Absolutely.

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Mr. LAFALCE. Let me just ask the other gentlemen. On the issue

of the cooling-off period, I have a 2-year time period wherein the

chief auditors of a particular company could not then be employed

by that company. Would you favor that, Mr. Walker, Mr. Breeden?

Mr. WALKER. I think the issue of a cooling-off period needs to be

looked at. Some changes are necessary. I think you have to recognize that there are ways to potentially get around that. While it

is not appropriate for them to serve in the CFO position, some of

the things that Chairman Breeden has talked about, you also can

hire people as consultants, and they are not employees, and the

question is, what are they doing. So I think you have to recognize

and look at substance over form and make sure you are accomplishing the objective.

Mr. BREEDEN. Congressman, as I said earlier, I think the cooling

off is an important principle. Without looking at the specifics of

how to do it—for example, I would let a company hire someone

from their audit team to come in and have another position in the

company for 2 years without being CFO. I think the real risk

comes when the CFO is dealing with his or her own former staff

over at the audit team, and I——

Mr. LAFALCE. Let us not kid ourselves. Some accounting firms

have a policy of encouraging early retirement, creating incentives

for early retirement, so that you do become the CFO of the company that you have been auditing, and you cement the relationship, the tie between the firm and your former auditing firm. We

have got to deal with that problem in some way.

Now we can always point out, well, this is not crossed right or

that T is not dotted right, but there is a fundamental problem. And

let us cure the problem. If we do it imperfectly, well, then we can

correct it, but let us deal with the very imperfect problem that exists. Let me go on, though, because I have so many other questions

I want to ask.

Mr. Langevoort, you have been neglected and I do not want to

neglect you any more, because Mr. Watt was talking about what

he considers to be so important. But that is one of the most important provisions of our bill. We specifically would give legislative

sanction to aiding and abetting liability for accountants and other

professionals, and we specifically alter the statute of limitations.

Now there has been some confusion. Everybody says you ought

not to change the 1995 Securities Reform Act or the 1998 Securities Reform Act. Do either of those provisions change the 1995 or

1998 Securities Reform Act?

Mr. LANGEVOORT. No, and thank you for the softball question.

Mr. LAFALCE. See, everybody here is under the impression that

we are undoing what is done in 1995 and 1998.

Mr. LANGEVOORT. These two changes would carry out things that

predate the 1995 legislation and that the SEC has endorsed previously. They are compelling as a matter of public policy.

Mr. LAFALCE. And yet witness after witness from industry comes

in and says, oh, you cannot do this, because you would be undoing

the 1995 and 1998 legislation, and they really do not know that it

has nothing to do with the 1995 and 1998 legislation.

Mr. CANTOR. The gentleman’s time is expired. The Chair is going

to yield himself time for an additional round of questions.

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Mr. Breeden, I would like to ask you on the question of rotating

audits, do you feel that there will be an increased quality of audit

if a company is required under all circumstances to replace its

auditors every 4, every 8 years? Do you really feel there will be an

increase in quality of audits, given the subsequent increase and expense the company will incur?

Mr. BREEDEN. Mr. Chairman, in my testimony I said that I do

not personally favor mandatory rotation because I think rotation in

some cases would be a benefit, and in other cases would be a disadvantage. In a very complex company, it takes a number of years

to get up to speed and really understanding where the risks in that

company are, and if you rotate—and particularly if you rotate

every 4 or 5 years, I think you would have periods of time, blackout

periods, almost, where the auditors are getting up to speed. That

could be overcome. People could spend more money to throw more

people at getting up to speed faster, but in general I think that is

something as a requirement that goes farther than we need.

What I would like to see us do is to move more to a system

where auditors are engaged for a 3 or 4-year period, not for a 1-

year period, and that at the end of that time, the audit committee

has to go out for proposal and at least hear what the other firms

propose and how they would structure the audit and how many

hours they think should be involved, and then leave it to the audit

committee to make a decision on whether that firm should be retained or whether you should rotate.

Mr. CANTOR. I would respond and ask you what value would it

be for there to be an imposition and to require going out for bid

again under all circumstances, because that, too, does take time,

and obviously someone participating in a response to a bid will not

have the knowledge of the company the way that an existing auditor will have, and is that the best way? Are we really gaining some

safeguards there?

Mr. BREEDEN. I am not sure I understand the question. You are

saying what value is there in going out for proposal?

Mr. CANTOR. Just for going out’s sake.

Mr. BREEDEN. Well, I would not require that as a matter of legislation. But I think as a matter of audit committee good practice,

that every few years you should put your periscope up above the

surface of the ocean and take a look around and see what other options are out there. I think the audit committee—I wrote on this

subject in the Wall Street Journal a week or so ago. The audit committee needs to become more active than has been traditional, and

we have been moving in that direction for the last 10 or 20 years.

We keep—through the exchanges they keep encouraging better literacy, higher quality membership on audit committees. They are

positioned to be a check-and-balance on the CFO, but we cannot expect audit committees to attract good people, and you want them

to have the responsibility, and yet put them in a straitjacket and

say, well, the law itself tells you what you have to do and not do.

So I would leave some of these questions to the audit committee.

Mr. CANTOR. Thank you.

The Chair now recognizes Mr. LaFalce.

Mr. LAFALCE. Well, thank you very much. I do think that there

are a number of threshold questions that are important. First of

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all, we ought to not lose sight of the fact that it is more than accounting and auditing that we have to be concerned about. We had

problems with corporate officers. We had problems with boards of

directors. We had problems with the auditing firms. We had problems with the rating agencies. We had problems with the securities

firms and their analysis. We had problems with the law firms and

probably an awful lot of others, too. What I am fearful of is that—

or not fearful, that we are going to overreact. Industry is too

strong, too powerful, too influential. Let us not kid ourselves. It is

going to be tough to get anything at all passed that is meaningful,

that is more than cosmetic. Our problem is not overreacting. Our

problem is underreacting, coming in with a cosmetic. And let us not

kid ourselves. If we don’t understand that, we do not understand

the governmental process as it really works, as opposed to you

know how it is supposed to work.

I want to go into some differences between the bills, and I really—it is not a question of his bill, my bill or anything like that, but

I want these issues to be addressed. I would like for there to be

dialogue between us. There has been no dialogue. Before we have

a markup. I make a public call for an opportunity to have dialogue,

private dialogue, on these issues that we can come to some compromise on them. But I would like at least a public comment on

some things that are new.

To the extent that you have knowledge, and you probably do not

have too much knowledge other than newspaper knowledge, but

please give me your thoughts about it.

The lawsuit against Enron has been expanded to include a number of the investment banks, about 10 or so. What is the theory of

liability there? It is not just lending. I think it is more than lending. It is some type of active participation. Is it more than aiding

and abetting?

And then also some people think that aiding and abetting in an

action brought by the SEC simply requires a show of negligence,

and I think the standard is substantially higher than that. I would

like some explanation on that. And then also the Attorney General

of the State of New York has obtained a court order. I am not exactly sure what the order says or does, but it was against Merrill

Lynch, apparently—and, again, only speaking now from what I

know about it from the newspaper—for making recommendations

that are contrary to opinions that were expressed by an overwhelming percentage of the analysts of the firms in their e-mail

conversations. Who wants to swing at that one?

Mr. LANGEVOORT. Let me start with what I think was the first

question. With respect to the pending lawsuit against a variety of

participants in Enron, I have not read the 500-and-whatever-page

complaint so I cannot address the specifics.

Going back to my testimony, the uphill battle plaintiffs have is

in trying to trace a way in which the investor banker’s involvement

was more than just behind-the-scenes assistance. It tries to do that

by saying the investment banks used their analyst conduits to

speak directly to the market. That is more than assistance. There

may have been some participation in preparation of documentation

that made it into the hands of the investing public. Those are all

possibilities, but I guess my bottom line concern is that is really

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an unfair burden to put on the plaintiffs, if what you are really

complaining about was that the bankers were the brains in some

respect behind all of this.

Second, with respect to aiding and abetting——

Mr. LAFALCE. One of the difficulties I have is we have not examined that before our Committee. We have not examined what the

nature of the law is that would cover and what the nature of the

law should be to cover them, and that could be a large part of the

problem. I do not say that it is.

Mr. SILVERS. Congressman, I am not familiar with the complaint,

obviously, as it has been amended, but I am a little familiar with

some of the transactions that may be part of the complaint. There

have been—and because there has been litigation both in the bankruptcy court and in the Southern District of New York around

some of these banking transactions, and essentially what some of

that litigation seems to show—and there are traditional opinions

backing up what I am about to say—is that in at least the case of

JPMorgan Chase, that company engaged in what was treated as a

market derivative transaction, but in effect was a loan to Enron,

because it was a loan paired with two energy derivatives contracts

which essentially canceled each other out, and in one case they

both ran through—JPMorgan Chase subsidiaries based in the Island of Jersey off the United Kingdom, which is an offshore bank

haven, and the result of that transaction was that Enron got a billion dollar loan, did not show up on Enron’s balance sheet.

Mr. LAFALCE. The whole issue of derivatives and the regulation

of derivatives is very important, because the industry officials that

engage in derivatives have said, well, these are counterparties who

are so sophisticated that there need not be any type of regulation

for them at least, and yet there are innocent people who are not

parties to those actions that can suffer serious consequences, and

then that is an issue smack dab before the jurisdiction of our Committee which we have not looked into.

Mr. CANTOR. If the gentleman will expedite his answer. The gentleman’s time has expired.

Mr. LAFALCE. Well, I want to take another round.

Mr. SILVERS. Just to conclude, that transaction, unless some particular facts have arisen, that would—Chase directly communicated

that transaction to Enron investors. That transaction will not be

litigable because of this aiding and abetting issue. But, nonetheless, as you point out, real people were very badly hurt here. I

spent some time with some of them in Houston on Friday, and

those people have no—if it is merely aiding and abetting, those

people have no cause of action.

Ironically enough, Chase Manhattan Bank, though, is acting on

their behalf on the creditors committee of Enron and depriving

those same people their severance money, while they see if they

can bob and weave out of the liability generated by these transactions. It is really scandalous, frankly.

Mr. LAFALCE. Mr. Chairman, I know my time is expired, but Mr.

Langevoort did not respond, did not have the opportunity to respond to the question of the standards that have to be met in aiding and abetting liability, whether it is negligence or something

considerably greater than negligence.

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Mr. LANGEVOORT. Congress made absolutely clear when it restored the SEC’s aiding and abetting authority that intentional

misconduct was the standard, and that is clearly the law with respect to aiding and abetting generally.

Mr. LAFALCE. And, therefore, if we extend aiding and abetting liability to private litigation, we would adopt the same standard, and

so you would have to prove intent.

Mr. LANGEVOORT. The bill 3813 would mirror the standard for intent in private securities.

Mr. LAFALCE. It need not, but——

Mr. LANGEVOORT. Yes. That is correct.

Mr. CANTOR. The Chair yields to himself this time for an additional question. Mr. Breeden, in your written testimony, you unequivocally state that you would not support any steps to restore

joint and several liability, aiding and abetting liability and other

measures. Can you speak just sort of briefly to the adequacy of the

remedies available under the 1995 Act?

Mr. BREEDEN. The 1995 Act was discussed earlier. I guess the

only thing I would add to the 1995 Act was this same issue of

whether aiding and abetting should be—whether Central Bank

should be overturned was before the Congress in the 1995 Act. The

Congress in that legislation could have done so, and it did not. The

absence of action rather than the actuality of action was part of

what Congress ended up doing there.

My own view is that we have struck a balance in the private litigation area, and there will always be cases that will cause us to

say we should give more rights of action, but there are also—that

opens the door, in my opinion—and I respect the differences from

others on this point, but I believe it does open the door to abusive

litigation, and the costs of that are very, very real, not only to the

economy and to businesses, but to shareholders, too, who pay the

ultimate cost of that whole process.

Mr. LAFALCE. Mr. Chairman, if I can just follow up with the

question with Mr. Breeden on that point.

Mr. CANTOR. If he can just finish his response and I will yield

back to you for plenty more time.

Mr. BREEDEN. I guess my view would be twofold. One, in the context of this legislation of trying to do something positive and meaningful to respond to the Enron situation, I think if we refight the

battle of litigation reform all over, as part of it I think it will make

the chances of doing anything constructive here much lower and,

therefore, I would not like to see that happen, because I think

there are some improvements that should be made and there are

a lot of good things in your bill that ought to be done.

Second, even if it were not a question of tactics and timing, I do

not substantively favor the expansion of the rights as has been described.

Mr. CANTOR. Thank you very much.

The Chair now recognizes Mr. LaFalce.

Mr. LAFALCE. Mr. Breeden, I just do not know how any person,

unless they have a philosophic disposition, that says individuals

should not be able to go into a court of law to obtain redress for

a wrong, can say that if an individual or a firm has intentionally

aided and abetted in false or misleading statements, that they

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should not be able to be held liable. You know, it is absolutely beyond the capacity of the SEC on its own to go after all of those instances when it is done. They have got a paltry record on this in

the past. The FTC, which has the ability to go into court—and you

can’t go into court if you are an individual—has come into Congress

and said, restore the right of an individual who has been aggrieved,

because it is wildly beyond our capacity to bring lawsuits where

lawsuits are necessary to be brought.

And, Mr. Breeden, I understand the philosophic mind that just

wants to cut back—for example, the mind of this Administration.

They want a terrorism insurance bill, but only if it is coupled with

the cutback of an individual’s right to go after individuals who may

have participated in that terrorism and caused injury.

Well, having said that, let me just say that that is one issue

where you and I have profound differences on, and I hope that the

Congress, at least this Committee, will be given the opportunity to

consider that as you—and not confuse it with undoing the 1995 or

the 1998 legislation which simply did not address those issues. And

I will not be offering the joint and several. I will be offering the

aiding and abetting and I will be offering the statute of limitations

and I will be offering them separately so that we can have discrete

issues before us.

Now, going back to the issue of mandatory rotation, Mr. Silvers,

you favor it—I do not know that you have an opinion one way or

the other, Mr. Langevoort. Mr. Breeden, you have said you opposed

it. Mr. Walker, you said you certainly think it should be on the

table for study. Is that fair enough?

Mr. WALKER. We are saying two things. One, more things need

to be done on key personnel on the engagement and that the other

issue should be studied. I have some personal concerns about mandatory rotation of audit firms.

Mr. LAFALCE. Well, I brought this up with Mr. Lynn Turner, the

former chief accountant, who favors rotation, and he said to me, let

me tell you, he says, I used to be one of the Big Five, he says, and

mandatory rotation of the chief partner just does not work. He says

no partner is going to go in and replace another partner and blow

the whistle on the other partner and say everything he did was

wrong. He says it does not work. If you are going to get to the

heart of it, you are going to have to go to mandatory rotation.

Now he may be right and he may be wrong, but my recommendation in the bill is not without significant authoritative support. But

let us assume we should not do that. Now, Mr. Breeden, you have

said, well, what we ought to do is have audit committees, consider

hiring audit firms for maybe a 3 or 4-year period and then consider

other audit firms, too. Maybe submit proposals.

Well, the only thing is, if we do not mandate that, how do we

get at the bad guys rather than the good guys? Won’t we have a

situation where the good guys are the ones who are going to do

that and the bad guys are the ones who will not do it voluntarily?

And that is the problem with volunteerism.

Now you would have the SEC do it, but, look it, you have sang

the praises of the SEC. The problem is the SEC has deferred almost 100 percent over the years to the SROs. They have had almost no watchdog role over the SROs, whether it is the securities

170

industry, and most especially the accounting industry. They have

been silent.

Mr. BREEDEN. Congressman, on the issue of rotation, while I do

not personally favor mandatory rotation, it is an extreme step, and

I do not think we are necessarily sure that applied to 17,000 companies in this country, that it would be a good idea.

On the other hand, my idea of having a 3 or 4-year engagement

could lend itself to having a statute that said that beyond, say, one

initial term and two renewals, that specific standards and findings

might have to be made by the audit committee in order to pick the

incumbent and keep going. You could encourage and the commission itself could encourage through proxy rule its audit committee—require the audit committee to say why after a dozen years

or so, but some—pick some number, why they did not consider—

or did they consider rotation. If so, why did not they do it. There

are ways you can put a little pressure on to make sure people do

look hard at the question. Would it serve the shareholders’ interest

to rotate.

Mr. LAFALCE. Mr. Walker.

Mr. WALKER. As far as the interest of full and fair disclosure, I

am a CPA and practiced for a number of years; and, number two,

I have been with two of the Big Five firms and I know how things

work; and, number three, I think if you look at the issue of rotation

of the key personnel, right now the rules are not adequate. You

could have an individual or a person who was serving as engagement manager, then engagement partner, then the second partner,

so they can end up being on the engagement for many, many years

in a row.

Mr. LAFALCE. You mean the SEC, having the power to change

that since their existence, has not?

Mr. BREEDEN. Congressman, I think this is an excellent issue,

though, that pointed out why the proposal of both Mr. Oxley and

yourself, both bills call for a body here to be created that would

begin to resolve some of these issues, and I think you have put

your finger on this is one of the number of such——

Mr. LAFALCE. That is why I wanted to have this hearing, because we have not discussed this issue, and I would love to discuss

it, and I would love to reach a compromise short of legislatively

mandating rotation, if it is a good compromise.

Mr. CANTOR. The gentleman’s time is expired, and Mr. Sherman

is in wait.

Mr. WALKER. One quick thing, Mr. Chairman, please. I think one

of the things you have to be concerned about is if you are looking

at the public interest, I think you have to be concerned with how

many firms are there that can perform the service. I think the

number of firms does matter.

Mr. LAFALCE. That is an important issue, too. Now are there not

a lot of auditing and accounting firms below the Big Five that really could do much more work than they presently do.

Mr. WALKER. They could do more work, except when you are

dealing with highly complex and global enterprises.

Mr. LAFALCE. But an awful lot of the publicly traded companies—what are there, about 17,000?

Mr. WALKER. They do not fit this——

171

Mr. LAFALCE. They can do it for—we have got to be able to encourage—I had a chairman of an accounting firm in my office today

saying I favor mandatory rotation. It is the only way we are going

to be able to get a piece of the action.

Mr. WALKER. I understand. It depends where you sit. Number

one, the number of firms that are qualified to do the work is important. Number two, we need to be concerned with firm quality and

related internal quality assurance procedures. And number three,

the quality of the people is key.

One of the concerns that I have about mandatory rotation is that

could end up putting more pressure on price, and the last thing you

want to do is create a further commoditization of the audit business, especially if you are going to end up taking a way a lot of

non-audit services, because in the end you have got to have a viable economic model, and if you do not have a viable economic

model, you are not going to attract and retain quality people.

Mr. LAFALCE. It is a pittance and——

Mr. CANTOR. The gentleman’s time has expired and the Chair is

going to recognize Mr. Sherman.

Mr. SHERMAN. Thank you, Mr. Chairman, for giving me a chance

to combine my third, fourth and fifth round questions into one

block.

One of the witnesses mentioned Jersey Island, and of course we

have also seen a lot of Enron activity in the Cayman Islands. I

commend this Committee and the Ranking Member and the Chair

for having these hearings on Enron and responding, but the Ways

and Means Committee is strangely silent. There are two sets of accounting games that were played by Enron. One, to cheat the

shareholders; the other, to cheat the United States Government

and all taxpayers.

Now, the first is a little bit more apparent, because the victims

are there. The employees, everybody who held stock at Enron, and

in a way every stockholder in every company in the country, because I am convinced the market would be several hundred points

higher if everybody didn’t have to factor into their investment decisions the fact that the company that they invest in has a number

of risks, including the risk that they might be the next Enron.

The hidden cost and victims of the accounting games, the trips

to Cayman Islands that had nothing to do with snorkeling, are the

taxpayers, the citizens of the country, everyone who depends upon

Government, our efforts to combat world terrorism, and it is not

just Enron, but hundreds of companies that have each established

dozens of subsidiaries in the Cayman Islands, in Jersey Island, in

Barbados, in the other tax havens, and I would call upon our sister

committee to be as vigorous as this committee has been. We have

to defend investors. They have to defend citizens.

But shifting to our responsibility and the scope of the outside

auditor, the whole problem arises, because financial reporting is

the only game where the umpire is paid by one of the teams. And

that means under the current system if you say no, we will not

give you an unqualified opinion, you are not just giving up this

year’s audit fee, you are giving up this year’s consulting fee. And

you are not just giving up this year’s auditing and consulting fee,

172

but those fees could continue for ten or 20 or 30 years into the future.

Now one thing that I do not think will solve the problem right

away—and I used to work for one of what we call the Little Six

accounting firms—as long as investors, as they have, always demanded from the big companies they buy stock in that are widely

traded that a Big Five, Big Eight, Big Four firm be the auditor, I

do not know a way to break that up just with rotation. I think you

would end up rotating among the Big Four, which may have some

advantages and disadvantages. I think if you want smaller firms,

we would have to break up the firms we have got now, because I

do not think Horwath is going to be able to stand up and say, we

audited General Motors or we audited even Pacific Gas and Electric, and you should buy their stock, or at least rely on our financial statements to decide whether or not to buy the stock.

We then focus, though, on that financial relationship that an accounting firm has with its clients, and one thing that Mr. Silvers

and I were talking about is the non-audit fee. And the question

there is whether you can just list a number of different services

and say, OK, from time to time we will change the list and we will

prevent the client from having too much clout with the accountant

because we will always have a list of prohibited services or limited

services that prevent the client’s total fee package from being too

important to the accounting firm, and I wonder whether that is

even possible without the backstop that I have suggested Mr. Silvers referred to as a perhaps useful redundancy. And I would like

the members of the panel to comment. Is there any way you could

list some services, but not other services and not have a situation

where the client’s total fees to the accountant might possibly be as

large or larger than the audit fee? Can we do this by enumeration,

or must we do it by ratio?

Mr. WALKER. My personal view is—and as our testimony states—

you may want to have certain principles that you say that under

no circumstances can the auditor violate certain principles, which

are clearly articulated.

Second, you may want to have certain safeguards to make sure

that people are not auditing their own work, either firms or people

within the firm. You should delegate to an independent qualified

authoritative body which is able to make the tough decisions on

what should and should not be allowed based upon changing market conditions. I think it is difficult to establish any particular level

to say that merely because non-audit fees exceed a certain number,

that there is a problem per se.

Mr. SHERMAN. So if I can interrupt, let us say it was thought to

be acceptable that an accounting firm also provide executive recruitment. You are not auditing your own work, except to the extent that——

Mr. CANTOR. The gentleman’s time is expired. If we can expedite

the answer.

Mr. SHERMAN. I didn’t even get through to the question. So I

would withdraw it.

Mr. CANTOR. The gentleman may proceed.

Mr. SHERMAN. If we—whatever the allowable service is, say executive recruitment, is there—if it makes sense to allow a little bit

173

of it, can you allow so much of it that the accounting firm is receiving more from those services than from the auditing fee?

Mr. WALKER. Under the approach that we have taken under generally accepted Government auditing standards, which is outlined

in my testimony, we say there are certain things you cannot do irrespective of the comments involved. There are other things that

you should be able to do, but certain safeguards must be met, and

we do not propose any arbitrary dollar or percentage limit. We also

think that the audit committee should end up being more actively

involved in reviewing and approving certain types of services.

Mr. SHERMAN. I believe my time is expired.

Mr. CANTOR. Thank you.

Mr. LAFALCE. Yes. I just want to thank the panel very, very

much. I think this has been very constructive and helpful. I just

wish there were more Members from both sides of the aisle who

could have listened to the issues that were discussed by both of

you.

Also, Mr. Breeden, I do want to say that it was a pleasure working with you in the Bush Administration when representatives of

the Administration used to talk with Democratic Members of the

House. That is not the case. I used to virtually live with representatives from the Treasury Department and from the White House

in those days, maybe because we were in the majority then and

they used to talk with us. That is why I developed such a close

working relationship, not only with you, but with the President

himself and so many of his cabinet officials. That is missing in

Bush 2, and it is a sad—I am sad that it is missing. Thank you.

Mr. BREEDEN. Congressman, can I only say and just respond and

say it was a great pleasure working with you then and all of the

Members of—some of the Members who are still on the Committee

here, that I really think the savings and loan legislation was an opportunity—a great challenge faced by the country, and you played

a tremendous leadership role then and it was a great pleasure. I

have never forgotten working with you.

Mr. LAFALCE. Well, let me say this, that one of the difficulties—

probably, in my judgment, the biggest difficulty—is that there was

a cutback in examiners and in regulators for our savings and loan

in the mid-1980s. I think that was the single greatest contributing

factor. In the beginning of 2001, when our Committee assumed jurisdiction, I pointed out that the biggest shortcoming in Government today was the inadequacy of resources at the SEC, and I

called at the beginning of 2001 for another 2 or 3 percent increase,

but a 200 or 300 percent increase in the resources of the SEC. I

was at least figuratively laughed at in calling for such a huge increase.

Now that Enron has happened, at least the President has called

for a 6 percent increase in his budget. But that is not good enough.

Mr. CANTOR. The Chair would also like to express his thanks,

and members of the panel, for your indulgence and patience. The

hearing now stands adjourned.

[Whereupon, at 4:52 p.m., the hearing was adjourned.]

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March 13, 2002

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April 9, 2002

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