Segment 1 Of 3 Next Hearing Segment(2)
SPEAKERS CONTENTS INSERTS
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H.R. 3763THE CORPORATE AND AUDITING
ACCOUNTABILITY, RESPONSIBILITY AND
TRANSPARENCY ACT OF 2002
WEDNESDAY, MARCH 13, 2002
U.S. House of Representatives,
Committee on Financial Services,
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.
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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 legislation 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.
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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.
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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 mechanisms 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.
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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.
Page 6 PREV PAGE TOP OF DOC Segment 1 Of 3 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 confidence 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.
Page 7 PREV PAGE TOP OF DOC Segment 1 Of 3 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 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.
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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 exchange-based 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.
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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.
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.
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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.
Page 11 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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.
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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.
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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 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.
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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.
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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 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.
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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.
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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.
[The prepared statement of Marc E. Lackritz can be found on page 184 in the appendix.]
Chairman OXLEY. Thank you, Mr. Lackritz.
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.
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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 up-to-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.
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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 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.
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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.
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[The prepared statement of Barry C. Melancon can be found on page 199 in the appendix.]
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 level-headed, 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.
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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.
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.
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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.
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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 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.
Page 25 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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.
Page 26 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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.
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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.
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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.
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.
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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.
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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 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.
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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. 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.
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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 needin 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.
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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 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.
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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 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.
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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.
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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.
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?
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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.
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.
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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 whatmy 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?
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Mr. MELANCON. We publicly, in an egregious situation, they are publicly dismissed from the AICPA, which would
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.
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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.
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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, 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.
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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.
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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 the appropriate balance. And that is reallyand 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 auditfor 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.
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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 fromnot 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.
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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 meand 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 opposition 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.
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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 compunctionwell, 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 Americathere 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.
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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.
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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 worseI think it is spelled wrong on our sheets is the problem.
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 profession, men and women doing the right thing in small businesses and large businesses every day.
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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 wholeI mean, it seems to me that what Mr. Glassman is saying isand I mean this in the kindest way, not in a negative wayalmost 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.
Page 50 PREV PAGE TOP OF DOC Segment 1 Of 3 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 are not going to invest in you unless you rotate your auditors.'' So those are the kinds ofI think those are much more effective constraints.
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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 factthere 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.
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Ms. BIGGERT. And I think that that is what I was driving at in asking that question. And it seems that there isthey 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 purchaseparticularly 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.
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.
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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.
Page 54 PREV PAGE TOP OF DOC Segment 1 Of 3 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 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.
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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.
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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 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.
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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.
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Mrs. ROUKEMA. I thank you.
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?
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?
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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 isI 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
Page 60 PREV PAGE TOP OF DOC Segment 1 Of 3 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
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.
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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 notyou 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.
Page 62 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
Page 63 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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. Melancon.
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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 recessdo 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.
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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 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.
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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.
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.
Chairman OXLEY. [Presiding] Come to order. And the Chair would recognize the gentleman from New York, Mr. Grucci.
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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 haveand we support enhanced 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 toby 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.
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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?
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Mr. WHITE. Certainly. The bulk of our assets, approximately two-thirds, 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 strategy. 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.
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Mr. GRUCCI. Thank you and I assume my time has expired. Thank you, Mr. Chairman.
Chairman OXLEY. Thank you, Mr. Grucci.
Mrs. JONES. Thank you, Mr. Chairman. When you are doing, Mr. White, your active strategy, what do you uselet 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 think-tank 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.
Page 71 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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.
Page 72 PREV PAGE TOP OF DOC Segment 1 Of 3 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 talkinglisten 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
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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 goodI 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?
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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 regulatethe market regulation to requireto do compliance in this area, is that a fair statement?
Mr. GLASSMAN. No, it is not a fair statement. I think that investors applyyou 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
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 forsince 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?
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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.
Page 76 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
Page 77 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
And I yield the balance of my time. Thank you.
Chairman OXLEY. Thank you, Ms. Jones.
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.
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And the second problem is something I alluded to earlier, which is that we are tellingin 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, it does distract executives and causes money that shareholdersshareholder assets get paid out in these lawsuits. It hurts shareholders.
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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.
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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 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.
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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.
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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 911 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 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.
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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. Chairman, may I just point out between the extreme that you pose and the extreme that Ms. Waters pose is my middle ground bill.
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.
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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 honestI 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 two-thirds 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.
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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 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.
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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.
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Mr. Lackritz, what is your position with regard to the provision that would limitput 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?
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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?
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.
Page 89 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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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.
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.
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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.
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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, Stanford, 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.
Page 93 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
Page 94 PREV PAGE TOP OF DOC Segment 1 Of 3 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 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.
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[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.
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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 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.
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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.
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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 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.
Page 99 PREV PAGE TOP OF DOC Segment 1 Of 3 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 itthat 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.
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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 SECor 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 congressional 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.
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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?
Page 102 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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?
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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.
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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?
Page 105 PREV PAGE TOP OF DOC Segment 1 Of 3 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.
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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.
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.
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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 haveit 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.
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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
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.
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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.
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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.
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.
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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''?
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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?''
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.
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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 systemI 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 isand 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.
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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.
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 wheregiven 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.
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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. And we do not know what you will decide to do about auditor oversight, although as we have said we see real progress being made here.
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I think it is absolutely essential that we have strong independent accounting firms performing public audits. One of the things that has changedwe 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 notit 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.
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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 actually 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.
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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.
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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 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 thebecause 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.
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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 publicnot 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.
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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 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 swungyou 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.
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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 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.
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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.
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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.
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.
Page 125 PREV PAGE TOP OF DOC Segment 1 Of 3 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.]
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