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H.R. 3763—THE CORPORATE AND AUDITING ACCOUNTABILITY, RESPONSIBILITY AND TRANSPARENCY ACT OF 2002
WEDNESDAY, MARCH 20, 2002
U.S. House of Representatives,
Committee on Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. Michael G. Oxley, [chairman of the committee], presiding.
Present: Chairman Oxley; Representatives Roukema, Baker, Royce, Ney, Kelly, Gillmor, Weldon, Ryun, Ose, Shays, Cantor, Hart, Ferguson, Rogers, Tiberi, LaFalce, Kanjorski, C. Maloney of New York, Bentsen, J. Maloney of Connecticut, Hooley, Carson, Sherman, Meeks, Inslee, Schakowsky, Moore, Capuano, Ford, K. Lucas of Kentucky, Crowley, and Israel.
Chairman OXLEY. The hearing will come to order. Good morning and welcome to the committee's second legislative hearing on the Corporate and Auditing Accountability Responsibility and Transparency Act of 2002, or CARTA.
Last week, the committee held its first hearing on CARTA. We heard from a diverse panel of witnesses, including former SEC officials and representatives from the securities industry, a leading consumer organization and the accounting profession. The testimony was very instructive. Our witnesses represented a broad spectrum of views about the securities markets and the role of Government in protecting investors. Some of the witnesses said that CARTA regulates too much. Others said not enough. Clearly we must be on to something that is reasonable.
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CARTA was carefully crafted to strengthen the oversight of the accountants who audit public companies without federalizing the accounting profession. The legislation requires companies to give investors accurate and immediate access to important company information without drowning issues in red tape, and the bill would make it a crime for company officials to mislead auditors, ensuring both that corporate officers act responsibly and that auditors can do their jobs effectively.
CARTA encourages business leadership by prompting executives to act in the best interests of shareholders. It requires greater transparency and prevents insiders from benefiting when their employees cannot.
Today's witnesses will further eliminate the important issues that face the committee as we seek to reassure investors in the strength of America's capital markets. Already the committee has held extensive hearings in the wake of the Enron bankruptcy. Going as far back as December of last year, the Financial Services Committee has held hearings on the Enron collapse to ensure we fulfill our obligation to protect investors. Our hearings have revealed that while some bad actors may seek to take advantage of investors, ultimately the laws in the marketplace will catch up with them.
No one should doubt that America remains the best place to invest not only for the ability of our workers and the ingenuity of our entrepreneurs, but also because America does not tolerate cheats. CARTA represents our further efforts to strengthen America's capital markets so that they may remain healthy and vital, and I look forward to the testimony of our witnesses.
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I now recognize the Ranking Member, Mr. LaFalce, for an opening statement.
[The prepared statement of Hon. Michael G. Oxley can be found on page 296 in the appendix.]
Mr. LAFALCE. Thank you very much, Mr. Chairman. As we continue our consideration of legislation to address the serious systemic weaknesses that have undermined confidence in financial reporting and in our capital markets, I think it is useful to reflect on some of the testimony we have heard thus far.
One witness warned last week that we should not overreact to the failure of Enron. If Enron were an isolated instance it would be one thing. But unfortunately, it is not. The use of deceptive accounting practices to paint a false picture of a company's financial health has become much too common at some of our largest companies.
Enron is no longer even the most recent major failure linked to accounting concerns. SEC and Justice investigations into the failure of Global Crossing have again raised the specter of another major United States company using accounting practices to hide its true condition.
The safeguards intended to protect investors have been overwhelmed by the temptations for companies to either cheat or overstate or obscure financial disclosure, largely to improve short-term results and meet analyst or investor expectations and therefore enhance market capitalization.
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Virtually all of our witnesses last week spoke of the need for auditors to be willing to stand up to management and for audit committees to take real responsibilities for audits and auditors. To do this, I believe that we must fundamentally alter the relationship of the auditor to its client and we must strengthen the functioning of audit committees and we must provide meaningful and ongoing oversight of the auditing profession. Auditors and audit committees should be the first line of defense in protecting investors, and our task in these hearings is to determine how we can best restore the vitality of these critical investor safeguards.
Equally important, we must ensure that the restoration is permanent and not merely evolutional and therefore most likely a temporary response to the headlines of the day. We should not delude ourselves into believing that the market will provide a lasting solution to the issues we have identified.
Now I have introduced legislation that seeks to do exactly that, the Comprehensive Investor Protection Act, CIPA. The measures included in CIPA on auditor independent, corporate governance and oversight of the audit profession have been strongly endorsed by both consumer and institutional investor groups. The auditor independence requirements of my bill are comparable to auditing standards adopted by the General Accounting Office and proposed by New York State Comptroller Carl McCall, who will be testifying before us this morning. They were crafted after the very closest consultation with many outstanding individuals, including, amongst others, the former chief accountant of the SEC, Lynn Turner.
I look forward to working with Chairman Oxley, Members of this committee and you, Chairman Pitt, as we seek to find a legislative response that will help to restore confidence in the financial reporting system on which our markets rely.
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Chairman OXLEY. Gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman. I commend you for calling this hearing with regard to the important reforms contained in CARTA. I certainly want to point out the work that has already been done with regard to the reform of endless conduct with Chairman Pitt and the exchanges under Chairman Oxley's leadership, and I do believe that the provisions contained in the underlying bill with regard to audit reform are significant, important and I think timely for the committee to pursue.
My focus today will be more toward the issue of corporate governance and how we can incentivize those who are in managerial responsibility to manage for the long term. It appears that the events of Enron would indicate there was manipulation of corporate assets for the benefit of enhancing executive compensation, and it is not a unique, but very troublesome problem in the business world today that management is under extraordinary pressure to beat short-term quarterly earnings estimates in order to maintain their positions in the particular corporation they manage, all to the disadvantage of the long-term shareholder interest and corporate growth. I think we should explore with all diligence any remedies that would incentivize management to work for the long haul and not to manipulate the stock price, for example, that would enable them to exercise no cost options that then results perhaps in a few weeks later a restatement of earnings all to the shareholders' detriment with no downside risk for the executive. I think we should at least explore disgorgement as a result of these events or any other mechanism that would make it clear to management that short-term manipulation of values to enhance one's own compensation is unacceptable behavior in today's world.
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Given the complexity of very large corporations and the difficulty that the common investor has in understanding the true financial condition, the executives find themselves in a very advantageous position with no liabilities for this performance.
I commend you, Mr. Chairman, for your work and I look forward to engaging the witnesses today in pursuit of remedies for the public interest and for the working families. Thank you.
Chairman OXLEY. The gentleman's time has expired.
The Chair would observe that we have a vote on the floor, and I would like to recognize the gentleman from California for a brief opening statement, and the Chair would recess the committee for two votes on the House floor and return immediately. Gentleman from California.
Mr. SHERMAN. Mr. Chairman, we have got a lot to do. There is a lot of talk about how the fees for non-audit services are significant. We ought to be looking at the amount of those fees rather than the particular services rendered. Even tax services can pose a conflict of interest as you plan to set up 100 Cayman Island corporations and then accrue a tax liability to determine whether those corporations are going to succeed in avoiding Federal income tax.
We need clear accounting principles. We need a structure of our auditing firms so the technical review department makes the final decision with all the information, not the engagement partner whose chief job it is to go golfing with Ken Lay.
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Finally at the SEC, I wish that you had read the Enron financial statements and those of the top thousand corporations in America with the same care that you read the little $15 million and $10 million IPOs that I was involved in long ago where you made sure that the filings for those small offerings were clear and complete, but the Enron financial statements clearly did not meet that standard.
Thank you very much.
Chairman OXLEY. Gentleman's time has expired.
The Chair would now declare a recess for a vote, and then we will be pleased to hear from the Chairman of the SEC.
[Recess.]
Chairman OXLEY. The hearing will come to order. We are pleased to welcome back once again to the committee the distinguished Chairman of the Securities and Exchange Commission, Harvey Pitt. Mr. Pitt, it is good to have you back again and it has been a real pleasure to work with you through some very difficult issues over the last several months, and I want you to know that the Chair, and I am sure I speak for all the Members, appreciate your diligence and hard work and positive attitude as we work through some very difficult issues. So welcome and good to have you back.
STATEMENT OF HON. HARVEY L. PITT, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
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Mr. PITT. Thank you, Mr. Chairman, and it is a pleasure to be back. Mr. Chairman, Congressman LaFalce, Chairman Baker, Members of the committee, I am pleased to be here to discuss H.R. 3763, the Corporate and Auditing Accountability Responsibility and Transparency Act of 2002. As you will recall, on February 4 of this year, I testified before Chairman Baker, Congressman Kanjorski, and Members of the Subcommittee on Capital Markets about possible solutions to problems arising in the wake of the Enron implosion. The leadership and Members of this committee have worked diligently since then to explore the substantive issues at stake and to develop well thought out reform proposals intended to help restore confidence in the integrity of our financial markets.
Mr. Chairman, I would like to commend the leadership you have shown, and I would like to commend the efforts of Ranking Member LaFalce as well as Chairman Baker and Congressman Kanjorski and all the Members of the committee. These are difficult issues. These are difficult times, and your leadership has been remarkable. We appreciate the opportunity to work with you and your staffs on many ideas in your legislative proposals, and we look forward to our continuing cooperation. Whether by legislation, regulation or some combination of legislation and regulation, we will work with you to make our Nation's Federal securities laws more responsive to the current day needs of investors.
I also want to say how very much the entire Commission and its staff appreciate your support for funding pay parity and for your concern for our agency's resources at this especially critical time.
The past several months have tested the mettle and resiliency of our markets and the investing public's confidence. With the events of September 11, Enron's bankruptcy and last week's indictment of Arthur Andersen, we have all witnessed how critical our capital markets are to the country's strength, security and spirit.
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In the aftermath of Enron's meltdown, our staff is investigating whether violations of Federal securities laws occurred and, if so, who perpetrated them. Until that investigation is completed, we cannot address the specific conduct of Enron and those involved with it or the activities under investigation. The public can be confident, however, that our Enforcement Division is conducting a thorough investigation and that we will address any and all wrongdoing and wrongdoers swiftly and completely.
Even prior to Enron, we were working to make disclosures and financial reports more meaningful and intelligible to average investors. Investors are entitled to the best regulatory system possible. To reassure investors and restore their confidence, we must address flaws in our current disclosure and accounting systems that languished unaddressed for many years.
The Commission intends to reexamine our rules and regulations in light of Enron. There are fundamental longstanding flaws in our system. Now they are on the table. No one yet knows what the final answers are or should be. But, at the end of this process, we will have taken the best system of corporate disclosure, regulation of the accounting profession and fidelity to fiduciary duties by corporate managers and directors, and made that system even better.
In the President's State of the Union address, he appropriately demanded ''stricter accounting standards and tougher disclosure requirements'' to hold corporate America more accountable to employees and shareholders and to hold them to the highest standard of conduct. We share and embrace these principles and are firmly committed to achieving them.
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We can achieve needed improvements by improving standards and our regulations in three principal areas. First, disclosure by public companies must be truly informative and timely. Second, oversight of accountants and the accounting profession must be strengthened, and accounting principles that underlie financial disclosure must be made more relevant and timely. Third, corporate governance must strengthen the resolve of honest managers and directors who oversee management's actions and make them more responsive to the public's expectations and interests.
The Commission already has statutory authority to adopt rules to implement virtually all of the President's program as well as other improvements necessary to address systemic problems brought to light by Enron's collapse. We will work closely with you to ensure that the regulatory framework we ultimately propose accommodates your views of what is appropriate and in the public interest.
We have endeavored to move forward as quickly as we responsibly can on these issues. First, in cautionary advice on December 4 of last year, we gave guidance on the appropriate use of, and limits on, pro forma financials. In further cautionary guidance on December 12, we set forth initial requirements and guidance on the obligations of public companies to disclose critical accounting principles.
On December 21, we announced our Division of Corporation Finance would monitor annual reports submitted by all Fortune 500 companies in 2002. This initiative significantly refocuses and improves our review program for financial and non-financial disclosures made by public companies.
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On January 17, we announced our preliminary concept of a new private sector regulatory body to oversee the accounting profession. On January 22, we identified issues in Management's Discussion and Analysis to be addressed in 2001 fiscal year end reports regarding off balance sheet financing arrangements.
On February 4, the securities industry and its self-regulators, acting under the leadership of Chairmen Oxley and Baker as well as Ranking Members LaFalce and Kanjorski, announced proposed rules to create more transparency for analyst recommendations.
On February 13, we announced proposals to address aspects of corporate disclosure meeting improvements. On the same day, we called upon the New York Stock Exchange and Nasdaq to look at specific components of corporate governance. And just this past Monday, in response to the Andersen indictment, we released orders and temporary rules to assure a continuing and orderly flow of information to investors and the U.S. capital markets.
In addition, over the past several months, we have been seeking input broadly, from all concerned on both corporate disclosure and auditor regulation. To that end, we held roundtables on March 4th in New York and March 6th in Washington, with distinguished business executives, lawyers, accountants, academics, regulators, and public interest representatives. We have scheduled our next roundtable for April 4th in Chicago, and plan to hold additional roundtables in the next 2 months. This May, we will hold our first ever ''investor summit'' to solicit additional investor input.
Congress, however, must make the final judgment whether legislation is necessary or appropriate. We intend to continue working with Members in both Houses and on both sides of the aisle regarding legislation. We will continue these efforts and will commit to implementing any legislative changes Congress ultimately believes are necessary.
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Last month, Chairman Oxley and subcommittee Chairman Baker introduced H.R. 3763. This proposed legislation addresses many of the key issues facing our capital markets today, most notably, creating a statutory public regulatory organization to oversee the public accounting profession. In my formal testimony, I have addressed some of the key aspects of this proposed legislation and I do ask that my formal testimony be included in the record in its entirety.
Chairman OXLEY. Without objection.
Mr. PITT. Thank you. For present purposes let me offer a brief overview on my comments on this legislation.
First, given our existing authority, combined with Section 12 of the bill, we believe that this legislation would give us ample authority to enforce the bill's directives, if enacted.
Second, the proposed public regulatory organization the bill mandates and our proposals for a public accountability board share many common attributes and characteristics.
Third, if legislation is enacted, the key is giving us both the authority and flexibility to ensure comprehensive and effective regulation of accountants and accounting.
Fourth, the Commission shares the bill's underlying philosophy of holding auditors to the highest standards of independence, competence and ethics. We think it unwise to cast solutions to issues of auditor independence in legislative stone, but we do agree with the bill's fundamental precept that auditor independence is a critical issue which requires constant attention.
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Fifth, the Commission embraces the bill's core concept that financial disclosures must be timelier, more comprehensive, more relevant and provide greater transparency.
Sixth, we agree with the bill's concept that the Commission, through its staff, must significantly expand its review of financial and non-financial disclosures. We must also try to use our resources more effectively by targeting our reviews at the most important areas of disclosure at any given point in time.
Seventh, the bill requires us to perform or participate in several studies that we believe would shed light on possible additional reforms. We support each of these initiatives, and yesterday the Commission voted to commence a formal inquiry of rating agencies and their regulation.
Finally, a companion bill increases our authorized funding. We have identified current needs and have worked with OMB to reach common ground. OMB supports our additional request for 100 additional personnel. It does not as yet support appropriating funds for pay parity in fiscal 2003. We hope to persuade OMB to fulfill the implicit promise of pay parity once the legislation authorizing pay parity was enacted into law.
Mr. Chairman, Congressman LaFalce, Chairman Baker, Members of the committee, I thank you for the opportunity to testify today, and I am pleased to try to respond to any questions the committee may have.
[The prepared statement of Hon. Harvey L. Pitt can be found on page 302 in the appendix.]
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Chairman OXLEY. Thank you, Mr. Chairman, and let me first indicate we will help you on a bipartisan basis on your issue on pay parity with OMB. This Congress spoke very clearly on the pay parity issue along with the SEC fees legislation that were contained therein, and we want to be equal partners with you on convincing our friends at OMB and the Administration that pay parity is the law of the land and that we have a firm commitment to that ideal and we are going to continue on that best effort.
And let me also congratulate you on a number of initiatives within the SEC and working with our committee. It is frustrating somewhat, I am sure it is to you, that many of these initiatives go relatively unnoticed in the popular press while high profile hearings get most of the attention, but I have to tell you I think I share that with the other Members of the committee. We understand the hard work it takes to undertake these initiatives. And clearly the news conference we had with you along with Mr. LaFalce and Mr. Kanjorski and Mr. Baker on the analyst issue was a good example, I think, of what we can do when we work together, and I want to thank you for all of your help in that area and many others.
Let me begin the questioning, Mr. Chairman, with a question that was raised last week. One of our witnesses testified that the market incentives for responsible corporate governance and accurate accounting are incredibly powerful. How would you characterize the practices of post-Enron America from your viewpoint?
Mr. PITT. My belief is that the response in the post-Enron era has been all that one could hope for in terms of articulation of commitments to fiduciary obligations and companies reexamining the qualities of their disclosure. We have had an upsurge of companies coming to us asking for advice and assistance on a number of these issues. That doesn't, in my view, obviate the need either for legislation like yours and Mr. Baker's or further regulatory work. But I do believe that the market has now created very powerful incentives for people to do the right thing, and, with the proper legal framework, we can ensure everyone that that fidelity won't be short lived.
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Chairman OXLEY. That is an excellent point, and it is the goal of our legislation, as you know, to provide for more timely disclosure, more transparency, not necessarily more difficult rules and regulations, but indeed to allow the great forces of the marketplace to work effectively based on those concepts of early disclosure and transparency, and we thank you for your support in that regard.
Let me ask you, what is the relationship, if any, between the Private Securities Litigation Reform Act of 1995 and the ability of investors to recover for actual fraud?
Mr. PITT. In my view, the Private Securities Litigation Reform Act, which was a bipartisan effort, reflected sound approaches to the problems it was designed to deal with. We have taken a look at the statistics since the adoption of the Act in 1995. In fact, there has been no diminution in the number of class actions that have been brought on average in the 7 years since it was enacted, and the average value of settlements has increased. In point of fact, by encouraging large institutions to take more of a role to ferret out the frivolous from the meaningful, I think we are seeing a better use of the class action mechanism, and in my view those who suggest that the Private Securities Litigation Reform Act is somehow responsible for any aspect of what we see in Enron, or any of the other high profile matters, are very much mistaken.
Chairman OXLEY. We have had some witnesses and other commentators to say that there is a real danger if Congress tries to create audit only firms. What kind of ideas do you have in that regard?
Mr. PITT. This is a subject that I think is very critical, and you are correct to hone in on the significance of that. In my view, there is no direct correlation between consulting work and auditing failures, but there is a problem with respect to the independence of auditors. Independence is the bedrock on which the accounting profession was founded and all steps have to be taken to strengthen it.
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My concern is that, if we go to the absolute separation that some people are proposing, over the next 5 years the quality of audits will diminish, not improve. It stands to reason that if accounting firms doing audits only engage in auditing, they don't become more independent, they become more dependent on their audit work. To me the problem is twofold. On the first hand, and the most important aspect, are those on the immediate firing line: the engagement partners and all of those who do the audit work. Those people must scrupulously adhere to independence notions. In my view, cross selling compensation to those people, that is, enabling them to sell other services, is absolutely inconsistent with the notion of independence.
On the other hand, you have the firms as a whole. Most people have tried to deal with this issue as if it were a firm wide issue and not as if it were the engagement partner and engagement team's problems. For the firm, the issue is to provide appropriate incentives and sanctions if the firms do not properly supervise those people who are on the engagement front line.
So, it is a twofold problem, but most people have looked away from the individual audit partners and have looked at it as if it were a firm wide problem.
In addition, one other point—and I apologize for going on, but this is a very critical subject. If we take away much of the expertise that auditing firms have developed, for example, in the tax area, they will not be competent to perform audits. Getting into the issues of tax work enables auditors to have a clear sense of where the company is and how the issues can be handled.
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Chairman OXLEY. The Chair's time has expired.
The gentleman from New York, Mr. LaFalce.
Mr. LAFALCE. Thank you very much. Since you were just discussing the separation of the auditing and the consulting function and you mentioned taxation in particular, in my bill I call for a separation, but not a complete separation, same way as people can advocate a separation between church and state, but we have never had a complete separation within the United States. And I specifically would exempt the tax function.
Now, Chairman Levitt did articulate a rule, and I supported it at the time although many others in the Congress generally opposed it. What is the status of that rule right now and where do you agree or disagree with the former Chairman of the SEC, Mr. Levitt.
Mr. PITT. I appreciate that question, because again I think it goes to the heart of this issue. Eighteen months ago, the Commission adopted its independence rule, and at that point Chairman Levitt said, and I am quoting this from memory, but I have the exact quotes: ''the rule we put in place today is better than an absolute ban.'' I happen to agree with him. I don't think 18 months has been a sufficient time for us to allow the rule to take effect.
Mr. LAFALCE. How did that rule compare with his original proposal, which was not an absolute ban?
Mr. PITT. Exactly. He did not have an absolute ban. My view is that——
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Mr. LAFALCE. My question is how did the rule that was promulgated 18 months ago compare with his original rule? Was it watered down significantly, somewhat, not at all?
Mr. PITT. No. What I am saying is I have read some people say that the rules were watered down. Chairman Levitt's comment, with which I fully agree, was not that the rules were watered down, but that they were better than the absolute ban.
Mr. LAFALCE. No. You originally said that he said they were better than an absolute ban. You did not originally say that he said that they weren't watered down. And so are you now saying that he also said that the rules that were promulgated were not watered down from his original proposal?
Mr. PITT. I will tell you this. I have looked at, I think, every statement I can get through computerized research and at no time did I hear Chairman Levitt suggest, because I don't think he believed it nor do I believe he should have, that the rules were watered down. There was a process of discussion and analysis with accounting firms, but eventually the rule that he enacted he thought was much better than what he had originally proposed, which was an absolute ban.
Mr. LAFALCE. One of your predecessors other than Mr. Levitt, Mr. Hill, argued last week before this committee, and you were his General Counsel when he was Chairman, that we should confer on audit committees a more formal legal status. He argued that the SEC should make it clear the failure to maintain an independent auditing committee constitutes a material weakness in a company's internal controls.
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My first question is do you agree with that?
He also recommended that independent directors should be nominated by an independent nominating company rather than by the CEO or chairman of a company and that this was in the program of the SEC. Do you agree with that? Two specific recommendations of your former Chairman, and do you agree or disagree?
Mr. PITT. It would be hard for me to question former Chairman Hill's judgment since you are right, I did serve as General Counsel during his tenure. But my view is that, if you do not have a validly constructed and operating audit committee, that that is a material weakness. I believe that former Chairman Hill——
Mr. LAFALCE. Well, is it necessary for you to promulgate a rule to that effect to make that operative?
Mr. PITT. No. I don't believe——
Mr. LAFALCE. He suggested that it was.
Mr. PITT. I think what I read him to say and certainly what he has said in private discussions and communications with me is that the Commission should make that point loud and clear. I think I have just done that.
Mr. LAFALCE. Could you explain that more explicitly in some writing somewhere because the response to my question is one thing. But something a bit more formal in writing would carry a bit more weight, I believe. So I would be anxious to see that.
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And now to the second question regarding his recommendation for an independent nominating committee or the board of directors as opposed to taking the recommendations of the Chairman or President or CEO.
Mr. PITT. I believe that those suggestions are quite constructive. And as you may be aware and as I indicated in my opening statement, we have asked both the New York Stock Exchange and Nasdaq to come forward with corporate governance standards.
Mr. LAFALCE. Which they can do or which you can do, correct?
Mr. PITT. I believe they can do that, yes.
Mr. LAFALCE. And you can also too, can you not?
Mr. PITT. I believe we can do that. I believe it raises some significant questions, and indeed there is an opinion in the DC. Circuit, the Business Roundtable rule, that suggests that the Commission has some limitations on its authority.
Mr. LAFALCE. I would suspect you disagree with that, do you not?
Mr. PITT. I don't agree with the decision.
Mr. LAFALCE. I thought so. You think you have the plenary authority. I thought you would.
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Chairman OXLEY. Gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
Chairman Pitt, when CEO Berardino appeared before the committee he responded to a question from me as to the ownership issue of the financial statement in that it belonged jointly to management and shareholders. I was a bit taken aback by that view. Recently the GAO has issued a significant report in which one of the recommendations of that report is to statutorily define that the financial statement should reflect the financial condition of the corporation for the shareholders' evaluation and not be the subject of managerial influence or control. Would it be of help to the Commission if there was a provision of law that made it clear that the financial statements should be prepared to reflect accurate financial condition of the corporation for the benefit of shareholders?
Mr. PITT. The law already provides that, and I would be concerned such a provision actually would create an implication that the law does not require that.
Mr. BAKER. Terrific.
With regard to incentives, it appears that there are significant conflicts, whether it is an audit firm which is consulting and is paid $50 million in the aggregate or whether it is simply a $50 million dollar audit. There are 50 million reasons in both cases to be influenced. Likewise, for management to manipulate earnings, revenue streams, obfuscate debt, the consequence of which is to increase stock values. It is all too often the case that part of the employment contract incorporates no cost options which are obviously intended. If you do well and manage the company properly, those options become more valuable, you exercise them. But then subsequently if there is a restatement of earnings within some short-term period, the shareholder takes the consequences of that loss while the executive is able to retain those proceeds. I don't know the appropriate remedy, but in both cases are there incentives that could be considered by this committee for inclusion in the mark, which would cause one to invest for the long term, not for the benefit of the quarterly report, and are there further incentives that might be provided for the audit side of the function, for example, a cooling off period, where if you are the principal audit firm engaged by a corporation, that you could not be employed by that corporation in an executive capacity for some period of time after you conduct the audit, traditionally known as a cooling off period? With regard to either of those, do you have recommendations or could you make those at some future point to us?
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Mr. PITT. I do. With respect to incentives, I could not agree more with you that there is a need to make sure that management's incentives align with shareholders' interests. Just last week, we brought a case that is a bit unusual for the Commission in which we have sought to have a former CEO of a public company disgorge his compensation in stock options and bonuses because the appearance of profitability was an illusion. I believe that the Commission has to be much more aggressive in targeting misconduct. And where serious misconduct has occurred, I think one incentive or sanction has to be removing any benefits and making certain that benefits are seen as a long-term proposition and not as a short-term.
The other thing, and this is a place where we do need legislation, is that I believe that the Commission should be given administrative authority to bar officers and directors of public companies who commit violations of the Federal securities laws from serving as officers and directors. We can do that in the securities industry. The banking agencies can do it with banks. I believe we should be able to do it with public corporations, obviously subject to review.
Mr. BAKER. Let me jump in with one quick statement. Finally, with regard to our whole accounting system, although we are taking important steps with the bill, as to the overall system we have today, which tends to be historic in nature, reporting activities 90 days old, we need to look more thoroughly over the long term toward real-time forward disclosure as opposed to the regular FD approach, which appears in retrospect not to have worked very well at all. If reg FD was intended to provide the investing public with a thorough understanding of the markets, it would appear given recent circumstance that it has been a failure at best and we have a long-term project ahead of us to reconstruct our whole accounting methodology to give investors real-time information that is helpful to the forward direction of the company. My time has expired.
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Mr. PITT. One of the propositions in the bill I support that you and Chairman Oxley have authored is the notion of moving to more current disclosure. My concern about regulation FD, which I share in terms of the remarks you made, is that you can satisfy the rule by saying nothing to anyone. We are proposing affirmative disclosure requirements, and I think that solves the concerns that the former Chairman had about selective disclosure, but does so in a way about informing the market rather than keep information away from the market.
Chairman OXLEY. The gentleman's time has expired.
The gentleman from California.
Mr. SHERMAN. Thank you. Let me first suggest something that I think you could probably do next week and might not be terribly controversial, and that is to require that every audit report filed with the SEC be signed by the head of the technical review department within the accounting firm after seeing all the information and that we not have a circumstance where the final decisionmaker as to whether Arthur Andersen's signature appears at the bottom of a report is made by the billing partner, the engaging partner, the golfing partner, but is instead made by someone whose loyalty is to the firm as a whole and who is selected on the basis of the technical expertise. Can you do that next week?
Mr. PITT. I don't know if we can do it next week. But I will say this, we are very much in favor of the concept you are articulating, which is that in order to make sure that firms apply their supervisory responsibilities, the national technical office be assigned to every audit and not leave the final decision in the hands of the engagement partner. We think that would produce even better audits than we presently have, and most firms I think are doing that.
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Mr. SHERMAN. There was one Big Five firm that wasn't.
Mr. PITT. You are right.
Mr. SHERMAN. The SEC under the Chairman's bill will be reviewing, I believe, the top 500 firms when they file their accounting statements with you, reviewing them I hope as you review initial public offerings by small firms. I hope I have that right. But can you provide us with how much money you will need to do an outstanding job of reviewing either the 500 most important financial statements or the Fortune 1,000 or the top 5,000 and would it be necessary to increase your budget by 50 percent or 100 percent so that we get the same kind of review process there as I commented earlier I was used to with smaller companies? Obviously you can't plan your budget on the back of that envelope in front of you, but if you could submit that for the record so that we know? And can you also comment now, do you have the independence as the head of an independent agency to come to Congress and say I need my budget doubled or are you under the thumb of OMB and under the thumb of those looking at the macro-budget situation from the Administration?
Mr. PITT. I would like to assure you that, with the exception of my four children and my wife, I am under the thumb of no one. I will say this, that we have had a very positive and constructive working relationship with OMB. We have differences of view and at my confirmation hearing I stated under oath that I will always come back to Congress and inform you whenever there were differences of view if Congress wanted to know what we had asked for.
Our major difference with OMB only relates to funding pay parity for 2003. And, because I believe we have a good relationship with them, I believe that we will ultimately prevail, although I am an optimist by nature.
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Mr. SHERMAN. You may disagree on that one point, and that is how much your existing people get paid. You seem to comment favorably on the idea of the SEC at least reading and demanding clarification of the financial statements filed with you. That is a lot of additional work. The President doesn't have a penny in his budget to allow you to do that work. I assume that all your people are working hard now and that they don't have free time. So I would hope that you would submit to us something that I guess would be your second potential difference with the Administration, and that is how much you would need to carry out either the kind of review that I believe the Chairman's bill calls for and I am asking you also to expand that, not from 500 firms, but to 1,000 and then 5,000.
Mr. PITT. May I just say this. When we testified before the Senate Commerce Committee on March 7, I had indicated that in order to deal with the incredible vigor with which we are approaching financial fraud cases and to deal with our review of Fortune 500 filings we need 100 additional people. OMB supported that, and indeed, after our testimony, my understanding is that they asked whether, rather than waiting until 2003, we would prefer to have it immediately, which, of course, we would. I do want you to understand what the relationship is.
I also believe that the Commission is not a separate government. I believe the SEC has to be part of an overall government and it is my view that we are under an obligation to respect the fact that there are a lot of budget priorities.
With regard to the point you make about how many more people we would need, I do think one point is critical to stress. My hope had been that I would have taken the first couple of months in office and done a thorough assessment of how many people I thought we needed, whether there were efficiencies. A funny thing happened to me on the way to the Commission. And we are now dealing with our third crisis, and so I haven't had the time. This week we will be announcing, however, a 4-month in-depth internal review of our deployment of resources and with an effort to figuring out before 2004 budget time what our actual needs are, and we are devoting substantial attention to that. But you should be aware, and this is the one concern I have, there is not enough money and there aren't enough people to give you the kind of guarantee that I think we all would like to have. And so there are always tradeoffs.
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But, one thing we did the minute Enron hit was to redeploy our assets in the Corporation Finance Division to review Fortune 500 filings. And one of the things that we want to do with the additional 100 people is to hire risk management specialists who will direct us to look for places where the greatest likelihood is that problems will arise. I think that will help us strategically.
Chairman OXLEY. The gentleman's time has expired.
The gentleman from Ohio, Mr. Ney.
Mr. NEY. Mr. Pitt, can you give your view on how accounting firms maintain their independence of their auditors when members of their firm work for years with the same company? And what I am trying to get at, the question I had asked in the earlier hearing a few weeks ago, I raised the issue about how Andersen employees were intertwined with Enron and were actually mistaken for Enron employees. They even went as far as to wear Enron golf shirts and went on Enron retreats and some of the people thought they were Enron employees.
Could you tell us, in your opinion, if the reforms proposed in H.R. 3763, whether the reforms you suggest will ensure independence of future auditors, not just with golf shirts, but——
Mr. PITT. I believe they will, because both H.R. 3763 and the proposition that the Commission has put forth are designed to create a board that exclusively deals with the ethics, the quality control and the independence of public accounting firms. One concern I have is that we not write something in stone, because if we put it in stone today we may discover tomorrow that it creates a different problem, and that I would like to avoid. But I believe both the legislation and our proposal would respond to that concern of yours, which I think is a legitimate concern.
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Mr. NEY. And still have flexibility.
Mr. PITT. Yes, we would have flexibility.
Mr. NEY. The other thing, Mr. Chairman, is it possible for a company to meet the GAAP standards and still provide a full, fair and complete picture of a company's financial condition? If so, would the bill improve the standards to solve that problem?
Mr. PITT. I believe that it is possible and it has happened that companies may comply literally with GAAP and still have financial statements that may prove misleading. About 40 years ago—actually less than that, but almost 40 years ago, Judge Friendly in the Second Circuit in the U.S. Against Simon case rejected as a defense the notion that financial statements were done in accordance with GAAP and therefore the accountants could not be held criminally liable. He held just the opposite.
Judge Stanley Sporkin in the Lincoln Savings case held the same thing, that you can still create a misleading impression. Notwithstanding that, we think there is a strong need to change the way accounting principles are adopted and the way accountants look at those principles. The current set of principles facilitate a check the box mentality. That is something that we believe has got to be changed.
We want professionals as well as management to ask themselves, if I were an investor, does this disclosure tell me everything that I would want to know. And the fact that it may comply with GAAP is only one issue. If it still creates a misleading impression, it should not be satisfactory to anyone.
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Mr. NEY. Does it tell you everything you need to know and also in a timely manner, also information gets there obviously as quick as it can?
Mr. PITT. Absolutely.
Mr. NEY. One other thing, if updating the accounting standards has been lengthy and arduous, which I think we all agree in recent years that task has been tough, do you think the reforms that we are discussing today can change that?
Mr. PITT. I am sorry, can they change——
Mr. NEY. It has been a lengthy process to update accounting standards. Do you think that the reforms we are discussing today will change that process, open it up, or is it still going to be a lengthy and arduous task and possibly should be?
Mr. PITT. I believe that, both under our proposal and this legislation, we could improve the way accounting standards are articulated. The FASB, which presents a full-time reflection on accounting principles, is a wonderful concept. Its implementation however, is troublesome. First, its funding is not truly independent, because it is voluntary, and we believe it needs to be mandatory. Second, we think that the Commission in the past has been lax in overseeing what the FASB has been doing, how quickly they do it and what matters they attend to.
One of the most important subjects in accounting is revenue recognition. For 27 years, there has not been a statement of principle on revenue recognition. So I believe the Commission has to have clear authority to direct the FASB to respond to questions.
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And finally, I believe accounting principles have to be principled and not Tax Code formulated. They have to be designed to make use of professional experience and knowledge without giving people such a detailed approach that all they do is check the boxes. At the same time, they have to be promulgated rapidly. The notion of taking 5 or 10 years or, as I said, 27 years, with respect to revenue recognition just doesn't cut it, and it has been allowed to go on way too long.
Chairman OXLEY. Gentleman's time has expired.
Gentleman from Massachusetts, Mr. Capuano.
Mr. CAPUANO. Thank you, Mr. Chairman.
Thank you, Mr. Pitt. Before I ask you questions, I just want to make sure you note that the budget that is on the floor today, in the Budget Committee, an amendment to fund pay parity this year was voted down. Mr. Moore made the motion and it was voted down along party lines, just as a little footnote. So your difference is not just with OMB, but with Members of Congress as well.
I guess I need to go back about a month or so ago, and this is the first time you have appeared before this committee. Mr. Berardino testified at the same table. And during my questioning he made a comment that I found a little shocking, because I suggested every auditor has an opportunity, if they differ with what a client wants to do, to either add a comment to the audit report or qualify that audit report, which is a kiss of death on many levels. And his reaction was something along the lines, well, we can't do that under GAAP, which I found a bit shocking. And at some point if you could clarify my understanding of that, because I am still under the impression that any auditor can either add a comment at the least or qualify that audit report any time they find a client kind of crossing the line or not doing something within the four square of what they need to do.
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Mr. PITT. Let me say that the concept that you articulate is one that I embrace, which is I believe that auditors have to have the responsibility as well as the backbone to question and take issue with management's selection of auditing principles or their application. Whether or not current law permits a qualified opinion, which is generally given under certain circumstances, may be a more technical question, but as your question suggests, we shouldn't be interested in technicalities. That is one of the reasons why we have proposed and will be implementing the rule which requires companies to identify their critical accounting policies, explain what would have happened if they had chosen different policies and also discuss what assumptions they made and what would have happened if they had operated under different assumptions. We believe that is going to get us to the place that you want to be and, as I say, I support the notion that we have to have accountants reflect independent judgment on the financials they review.
Mr. CAPUANO. And the other thing I suggested to him is in the final analysis even if you feel hamstrung you can always walk away from the client, which in this particular case I think in the final analysis is going to be proven to have been less expensive walking away from a $100 million client than what is going to end up happening. But we will let history be the judge of that.
And that leads me to the next question and some of my concerns on both the bills that are filed before us is on proper influence. Arthur Andersen was my auditor when I was the mayor of my city, and one of the ways they kept me from doing some things I wanted to do to make the city look good on the books is if you do that we are going to have a qualified report. If you do that, OK, fine. My job was to make the city look as best it could in front of investors, as is the job of anybody else.
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So my concern in some of the language that is used in this improper influence, what is the line that I can't cross. My job is to push. The auditor's job is to say that is enough, you can't cross this line. And my concern with some of these languages, improper influence, what does that mean? I understand if I say I got a picture of you and your girlfriend, that is improper influence. But for me to say I want to go here, I want to report this in this manner and don't you think you should count this revenue, under some of this language I am a little concerned that could be considered improper influence. And as we go through these bills, I would like you and your people to kind of keep that in mind, because I don't want this committee doing something that I don't think we really want to do.
Mr. PITT. Let me again say I share with you the underlying principles that your question implicitly raises. Both the bill and the Commission's proposal would set up an independent body that would be reviewing the quality of audits, not just providing discipline when something has gone wrong, but reviewing every major accounting firm on a yearly basis. Unfortunately, the present mechanism, the public oversight board which had been in effect for 25 years, was dramatically flawed. It wasn't given the powers and authority it needed. Under the proposal that we have raised and under the bill, you have a body that would effectively go through quality review and have the power to strip an audit firm of a client if it found that the audits were not of the highest quality. We believe that will create exactly the kind of incentive that you want to see occur.
Mr. CAPUANO. Though my time is out, I would like to add a footnote. If and when that is the way we end up, I would hope that such action on your behalf would be somehow publicly notified. If it is a private thing in the back of a room and nobody knows you did it, it really won't accomplish much.
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Mr. PITT. Let me say that discipline in secret does not achieve its purpose. When we take disciplinary action, when the stock exchanges and the NASD take disciplinary action, we publicize it. The public has a right to know if people have not lived up to appropriate standards.
Mr. CAPUANO. Thank you, Mr. Chairman.
Chairman OXLEY. The gentleman from Connecticut, Mr. Shays.
Mr. SHAYS. Thank you, Mr. Chairman.
Mr. Pitt, thank you for being here. I have a number of questions. Let me begin by saying, by asking this question. Some have told this committee that there is a danger in creating audit-only firms. Do you agree or disagree?
Mr. PITT. I agree completely with that. I think it is a simplistic solution to a complicated problem. And it will produce worse audits than we presently have. I believe that, as I have said earlier in response to I think a question from Chairman Oxley, that the problem is a twofold problem. One is with the engagement team, where they must have absolute scrupulous impartiality and independence, and then at the firm level, there has to be incentivization to make sure that the firm enforces the right supervisory techniques.
Unfortunately, this issue with a total separation would only deal with the firm-wide question and not deal with the real problems here.
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Mr. SHAYS. Let me get to another question. A witness on our next panel has taken the position he supports mandatory audit firm rotation, and what is your position on that?
Mr. PITT. My view is that mandatory audit rotation would write in stone a process that could prove detrimental. I believe that when an audit firm is not living up to the highest standards, then a disciplinary body should require mandatory rotation of that client. But I don't believe that setting in stone a rote process of a new auditor every 7 years is beneficial. There are a number of reasons for that.
Mr. SHAYS. Let me get to that later in the 5 minutes that I have. In the Oxley-Baker bill, which I am a cosponsor of, is there any new authority that you would like to see in the bill that is not in the bill now?
Mr. PITT. The principal authority that we would like to see included is our ability administratively to bar someone from serving as an officer or director of a company if we find that they have engaged in egregious misconduct.
Mr. SHAYS. Is that the primary addition?
Mr. PITT. That is the principal one.
Mr. SHAYS. Would you send that to this committee, suggested powers that you want that aren't in the bill? Let us know what they are.
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Mr. PITT. Well, there are——
Mr. SHAYS. In writing.
Mr. PITT. Yes, I would be happy to do that.
Mr. SHAYS. In 1992, the SEC, the Treasury and the Federal Reserve in a joint report recommended legislation to repeal the GSE's exemption from the Federal securities law. As you know, Fannie Mae and Freddie Mac are the only two publicly traded firms that aren't. Does the SEC still adhere to the Commission's 1992 report?
Mr. PITT. We have not changed our general position, but we have focused on it again. I will say that in this day and age I believe transparency has to be the order of the day. To the extent that the exemptions permit anything less than transparency, which I believe is the case, I believe at least that portion has to be removed. Frankly, I could care less whether the GSEs pay registration fees or things of that nature. But I do believe that disclosure is critical for the GSEs as well as for other public companies.
Mr. SHAYS. You say it fairly strongly. But in your statement where you say comprehensive information is the lifeblood of strong and vibrant markets, our system and the global markets supporting that system require accurate, complete and timely disclosure of financial and other information. The current system of Federal securities regulation is premised on a full and fair disclosure of this information. Companies choosing to access the public capital markets must provide material information about their financial results and conditions, businesses, securities and risks associated with investments in those securities. Could I use this as a strong support in some cases of such disclosure?
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Mr. PITT. Yes.
Mr. SHAYS. Thank you. I yield back, Mr. Chairman.
Chairman OXLEY. The gentleman yields back.
The gentleman from Texas, Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman Pitt, I have a few questions for you. I want to talk for a second about the audit firms. Under the MSRB, isn't there a rule for auditing firms that audit the books of issuers of debt of public entities, cities, states, whatever, that during that period of time those firms can't conduct other services for that issuer? And you may not know off the top of your head, but I just wonder if we already have some experience.
I understand your concern about complete separations and bans, but what I don't know, is there something wrong if we are already doing it, is there something wrong with saying if you are going to audit one firm, you can't consult with them, but you can consult with everybody else? If you have 17,000 public companies, there is plenty of business to go around.
Mr. PITT. Let me say that neither the MSRB nor anyone else, to my knowledge, has thus far taken the position that a firm may only do audits as a way of business. What a firm can or should be allowed to do for an individual client is a very real issue. And there can be conflicts, for example, where the other services would involve the auditor in reviewing its own work. That would be a situation clearly where auditors shouldn't be allowed to undertake those particular functions for a client. What I was addressing, and what I continue to urge upon this committee, is the notion that stripping down accounting firms so that the only thing they do is audits will produce worse audits in the future than we presently have.
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Mr. BENTSEN. I agree with that. I guess what I am saying is just on a client-by-client basis, you know, the number one can do the audit, the number two can do the other consulting business. Whether or not there is merit in that, in saying you just can't do both when one is say a public issuer.
Mr. PITT. The problem with any generalization is that somebody will always find circumstances to create problems, and the tax area is a good one. If accounting firms provide tax services to audit clients, they will be far more familiar with the company they are auditing and they will be developing the kind of expertise that is critical to do a qualified audit. So my view is that if a particular function creates the possibility of a lack of independence, it should not be allowed. But I don't think we should have an absolute ban.
Mr. BENTSEN. Let me go to the public regulatory organization because I am curious about that. I think it is generally—I think it is a good idea. I am curious about exactly how you would envision it working and the ideas of setting principles or guidelines for auditing firms to meet which the Commission would have oversight over both the drafting of those principles and the enforcement of those principles, if I understand your testimony correctly. Are we heading down a path where basically the Commission would be overseeing the quality of audits and in effect you would have to be giving an opinion just like you give a qualified tax opinion for an issuance of debt or securities, that you would be giving a qualified opinion that the audit meets the standards as established by the PRO? And that may be where we want to go. I just don't know. What do you envision how this ultimately will come out?
Mr. PITT. I think what we have in mind is somewhat different from that. What we have in mind is having a vigorous body that both can discipline individual accountants as well as whole accounting firms or offices of accounting firms, that can do quality control review to make sure that, even if there hasn't been a violation, the standards are the highest, a body that can enforce ethical requirements and that can enforce existing auditing standards.
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With respect to accounting principles, my view is that I would leave that in the FASB. But in both cases, what I think is critical is that the Commission has to provide meaningful oversight. And I think over the last several years the Commission has not provided meaningful oversight to those functions, and that is something that we are pledged to change.
Mr. BENTSEN. So this would be a form of registration for—any auditing firm of a public company that is going to have a registered issuance would then have to meet the principles and would be subject to greater oversight than what is under existing law or rule by the Commission?
Mr. PITT. Any firm that wanted to be an auditor of public statements by public companies would have to belong to the PAB, as we call it, or the PRO, as the Oxley-Baker bill refers to it. And they would have to adhere to all of the standards, and they would have to be subject to discipline, and they would have to be subject to all of the rules and requirements of that organization. That is what we believe is a necessary approach to restore public confidence in the accounting profession.
Chairman OXLEY. The gentleman's time has expired.
The gentleman from California, Mr. Royce.
Mr. ROYCE. Thank you, Mr. Chairman.
Thank you, Chairman Pitt. Let me ask you if you envision any practical way of ensuring that the board of directors for public traded companies are held accountable in their duty of directing management with a view toward optimizing company performance and increasing shareholder wealth. One of the things you talked about was specifically giving the SEC the ability to bar anyone who was engaged in egregious conduct. I agree with that. But looking at it from the incentive side for a minute, are there any changes that the Federal Government can make to its best practices recommendations in regard to board member selection and in regard to remuneration that would incentivize members to pursue the interests of the stockholders themselves rather than the interests of management?
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Mr. PITT. I think you will hear about that on the next panel, among others from Mr. Livingston, who is with Financial Executives International. At our request FEI reviewed its existing code of ethics, which I thought was excellent when it was promulgated, to see whether there ought to be some changes, and indeed they have recommended a change in that. And, in addition, they have taken a position on 12 critical issues relating to this entire aftermath of Enron.
I believe that corporate officers and directors have to be held to much higher standards. The question is how those standards are articulated. If they can be articulated even through the stock exchanges' listing standards, or through such codes of ethics as the FEI has proposed to me, that is a very sensible way of getting to the right result. And I think that it would provide a real incentive, particularly if we have the power to effectively sanction people who don't live up to those highest standards.
Mr. ROYCE. We talked about incentives. Let's talk about deterrence then. Short of having those involved in egregious conduct simply barred, which is a good idea, what are some of the other tools that the SEC would use or how would you envision other sanctions on those corporate leaders who do not act responsibly?
Mr. PITT. Well, one of the things that we have discussed here, but I think is worth mentioning again in response to your question is the notion that whatever incentives corporate officers and directors receive for performance should be honestly earned. So, if officers and directors have been compensated either by stock options or salaries or bonuses for producing results that turn out to be shams, they should have to give back every penny that they took from the shareholders. That is another thing that we are proposing, and, as I said, last week we filed a case in which we have sought that against a former CEO of a public company.
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Mr. ROYCE. Do you feel at this point in this legislation are you crafting language that would give the SEC that ability?
Mr. PITT. Well, on the removal of unearned incentives, I believe that all the authority that is needed exists. When we go into court, we can ask the courts to provide that relief. Obviously if the courts don't agree with our case or for whatever reason they think it is not an appropriate remedy, we are not going to get it. But that system has worked quite well.
Mr. ROYCE. We would certainly with legislative intent in this bill amplify that and state that it is Congress' desire that you do have these powers, which you are now exercising or attempting to exercise in the Enron case, but just to clarify those powers to further assist in your court proceedings. I think that would be a wise policy.
Mr. PITT. I think that would be helpful.
Mr. ROYCE. I will be happy to follow up with you on that language if you could assist me in developing the language that you think would be most effective toward that end. And I thank you very much. I thank the Chairman of the committee.
Chairman OXLEY. The gentleman's time has expired.
The Chair now recognizes the gentleman from New York, Mr. Meeks.
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Mr. MEEKS. Thank you, Mr. Chairman.
Chairman Pitt, let me ask, the regulatory structure that you advocate for the auditing profession would move quality review and discipline to an organization controlled by public members rather than accountants. And it leaves the standards that the auditors must meet subject to the rules of the industry control organizations. Wouldn't it make more sense to have the same entities set standards and enforce those standards, you know, at one body as opposed to having two separate?
Mr. PITT. I think that is a suggestion that is worthy of consideration. My own view is the difficulty isn't with the ethical standards that have been promulgated. The difficulty is with the adherence to those standards and the enforcement of those standards. If we had reason to believe that the ethical standards were lacking in some way, then I think your point would be very well taken. At the present time it seems to me to be a problem of enforcement, not of standard-setting.
Mr. MEEKS. Let me ask this question, then. I believe in your testimony earlier you said that the—it was too early to tell if the auditor independent rules that were in place in the year 2000 needed to be amended. As a result of the additional corporate disclosure required under those rules, we have already learned that some companies are paying the auditors as much as 30 times more in fees for non-auditing services as they do for auditing services. Auditing services have been turned into a loss lender to enable firms to get contracts for non-offered services. Do you think that it is appropriate for them to make so much more consulting?
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Mr. PITT. I don't really feel that the question should focus on whether that is appropriate or not. The question that I think those facts suggest is whether or not that situation could give rise to a lack of independence. That is what is implicit in the question. I have to say it is always possible that at some level, fees could create problems. But I think that there are ways to deal with that issue. I don't think, for example, that you and I sitting down together—I know you and I could reach agreement—but I don't think that, if you and I sat down together and said, fine, you can only make 50 percent of your revenues from consulting, that that would necessarily produce better audits.
In fact, I think if you look at the history of some of the failures in the 1960s and 1970s, long before consulting was a factor, you will find that we had some enormous audit failures. And they had nothing to do with the consulting fees.
My concern is that we should be sensitive to the problem of where the fees are coming from, how much auditors are earning. But I don't feel that there is a right number or amount of fees. What I think is there is a right way to conduct an audit and there is a right way to discipline auditors who don't meet the highest standards. That is what is critical.
Mr. MEEKS. Finally, it caught my attention also you mentioned your concerns about the time period to roll out FASB standards and what they should be based on. Do you believe the adoption of standards based on a simple majority would be better than what is now instituted, the super majority, especially when you consider there are only seven members on the board?
Mr. PITT. My answer is unequivocally ''yes.'' And the reason is that we simply can't afford to wait. There is very little unanimity on anything, any issue of the day. What we need are principles that are sound, that are overseen by the SEC to make sure that they are in the interest of shareholders and that they promote full disclosure. But a reduction of the size of FASB, which has been proposed to five, and then having principles adopted by a 3-to–2 vote seems to me to be perfectly sufficient. This body operates by standard majority. It is the way the Senate operates. And I think it is appropriate for the FASB as well.
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Mr. MEEKS. Thank you, Mr. Chairman.
Chairman OXLEY. The gentleman's time has expired. If I could just follow up briefly. Is it your understanding that the Commission, the SEC, could overturn any decision made by FASB?
Mr. PITT. Absolutely.
Chairman OXLEY. Thank you.
The gentleman from Virginia.
Mr. CANTOR. Thank you, Mr. Chairman.
Mr. Chairman, I just have a question concerning the Private Security Litigation Reform Act of 1995, and there has been some, I guess, renewed vigor around discussing sort of the impact of that Act and opposed to the Enron situation that we are in. I was just curious about your thoughts on the relationship between the Act and the ability of investors to receive any kind of results for actual fraud under the Act and then if you think there was or is a relationship with the Act and the Enron collapse.
Mr. PITT. Let me say first that, if I thought that the Act in any way created the possibility that we might have more failures, I would be back here urging you to reconsider aspects of that legislation. As I have said repeatedly, I don't think any issue can be off the table. We have checked with a number of entities, independent entities, that keep statistics, including one run by Professor Grundfest at Stanford. The statistics that have been reported to us show that the number of class action suits has remained constant, may even be a little bit larger, but that the amount of awards has increased significantly. If anything, I believe that the legislation on private securities litigation has actually strengthened bona fide cases while weeding out those cases that are frivolous and that simply seek to take advantage of a downturn in the market.
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In my view, there is absolutely no connection that has been shown between the collapse of Enron and the Private Security Litigation Reform Act. Absolutely none.
Mr. CANTOR. Thank you very much. Yield back, Mr. Chairman.
Chairman OXLEY. The gentleman yields back.
The Chair now recognizes the gentlelady from New York, Mrs. Maloney.
Mrs. MALONEY. Welcome, Mr. Pitt. And I commend you and some of the initial steps that the accounting and security industries have take in recent weeks to eliminate conflicts of interest. And I represent many employees in the accounting business, and for the most part the vast majority of these professionals are hard working and honest people. Yet I very much support the Oxley bill and the LaFalce bill and really the statement of the accounting firms themselves that we should separate accounting and consulting and create a strong public regulator for accounting. And many of our members have stated that you could do consulting for other firms, but at least separate it, as former Chairman Levitt advocated so strongly, to put a firewall between auditing and consulting, and I think this should be the first step. Even the consulting firms and auditing firms themselves have called for this and say they are doing it voluntarily. So we should put the statutory strength behind it.
You mentioned that there is a difficulty in enforcement and a number of professionals have come forward with an idea to ensure that accounting firms do their jobs correctly without heavy Government interference. And what do you think of the proposal that the SEC could require that all publicly traded companies hire a second auditing company to review its books every 3 years? That would be built-in oversight without heavy governmental interference.
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Mr. PITT. The difficulty with that suggestion, which I believe is well motivated, is that there are only five major accounting firms. And my concern is that would create a taxation on investors effectively that wouldn't produce the results you want. I think the goal is right.
Mrs. MALONEY. A taxation on investors and accounting firms?
Mr. PITT. Because both accounting firms would charge fees. If you just take the Enron situation for example, it has been reported that Andersen received $25 million for its audit. So if you brought in a second firm, we have now upped it to $50 million. Somebody is going to have to pay that.
Mrs. MALONEY. We are talking about rotating every 3 years.
Mr. PITT. You are talking about rotation. I apologize. I misunderstood. I am in favor of rotation where it has been shown that an accounting firm has not lived up to the highest standards of auditing professionalism.
Mrs. MALONEY. But, it is difficult to see if you are living up to the highest standards of auditing professionalism. Enron was believed to be a model of a well run company up to months before it failed. And I find it tremendously troubling that Enron's techniques that duped the public were blessed by one of the world's most prominent accounting firms. And it is equally troubling that Enron is not an isolated case. It is by far the largest and most spectacular of several failures and near failures over the past several years, but they all had the same elements.
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So in many ways I see the Enron scandal, debacle, as the 9/11 for the financial industry that we need to do something about it. They were condoning what has been alleged to be fraudulent accounting practices by one of our top accounting terms. So if you rotated it, it wouldn't cost more money and it would build in competition and build in oversight without increasing bureaucracy which——
Mr. PITT. My concern on that is there have been studies, the Cohen Commission, the Treadway Commission and others, which have shown that a large percentage of financial frauds occur in the first 2 years of an audit-client relationship. I believe that any per se mandatory rule removes flexibility from our society, and what it might produce are worse audits rather than better audits. You would have audit firms that weren't as familiar with the companies they were auditing and would be more susceptible to not catching fraud than they would otherwise.
My view is that, if we establish a public accountability board, as we have proposed, which would do quality control review, not just where there has been a breakdown, but would do quality control review every year for the major firms, we would hopefully make certain that firms were providing the best quality services. And, if they failed to do that, they would lose their clients. The client would be automatically removed.
Mrs. MALONEY. But we have a case before us and other similar cases that took a tremendous toll on middle and lower income company employees that were left impoverished while politically connected insiders at the top walked away with millions. And the practice was condoned by one of our best accounting firms, or was considered to be one of our best accounting firms. So I feel that we need to do something and the Oxley and LaFalce bill certainly get us going in the right direction.
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Chairman OXLEY. The gentlelady's time has expired.
Mrs. MALONEY. May I please respond to his study and request permission to place into the record another study that was cited in Business Week recently that showed that companies that use their auditors as consultants tend to manage earnings, including moving debt of the books into partnerships, the MIT, Michigan State and Stanford study that demonstrates that this practice is widespread and cites that steps need to be taken statutorily.
Chairman OXLEY. Without objection. The gentlelady's time has expired.
[The following information was subsequently furnished by Hon. Carolyn B. Maloney for the hearing record.
The gentlelady from New Jersey, Mrs. Roukema.
Mrs. ROUKEMA. I am sorry, Mr. Pitt, that I was not here for your testimony and I unfortunately could not be here for all the questioning, because I was in a markup in another committee. But I read with great interest the Business Week article which features an article called ''The Reluctant Reformer,'' and they identified Harvey Pitt. Do you know him as the rereluctant reformer? It did raise some questions in my mind, and I wonder whether you have already responded to these in one form or another. But, for example, where you were asked a few questions and gave an answer, I have a question mark beside a number of them, particularly, and I think this will bear repeating even if you have gone over it, because I think it is essential and the core of the issue before us. And the question was posed to you do you still oppose a rule that bans a firm from doing audits and consulting work for the same company?
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I know previously you had opposed any such rule. Your answer here is not quite explicit. Could you give us a precise answer as to your recommendations about audits and consulting firms from the same company. Because I believe they have to be separated. And I think our legislation indicates that requires that.
Mr. PITT. Let me——
Mrs. ROUKEMA. Or should, anyway.
Mr. PITT. Two things. First of all, those who know me know that I am seldom right, but never in doubt. There is nothing reluctant about me so ever.
Mrs. ROUKEMA. You sound like quite a few people I know in Government.
Mr. PITT. And secondly, reform is something I pledged to do when I came in. With respect to your question, do I believe that there are certain combinations of certain consulting activities that can create a conflict for accounting firms? Yes, and those should not be permitted. What I don't believe is prudent is an absolute separation of accounting from consulting, that is to provide that a firm may only do auditing work. That, I believe, would be a mistake.
Mrs. ROUKEMA. Can you explain that? Because it sounds to me as though you are endorsing the great potential for conflict of interest here.
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Mr. PITT. Not at all. And, if I thought there were any potential for that, I would move swiftly to prevent it. My view is this: That restricting firms solely to audit work will deprive those firms of the ability to produce more revenues that will help them do better training of their auditors; second, it will deprive them of critical knowledge that would be useful for auditors to have when performing an audit; and third, it will create——
Mrs. ROUKEMA. Excuse me. That was your answer here. But it does not address the question of the conflicts of interest. How do you protect again the conflict of interest potential?
Mr. PITT. I have said that there are certain types of consulting work that inherently create the potential for conflicts, such as an auditor reviewing his or her own work, and auditors effectively acting in a management or a managerial capacity. Those things have to be wholly prohibited.
I have also said that the SEC 18 months ago, under my predecessor, adopted a series of rules to define what could be done and what could not be done. And I believe that those rules should be given a fair chance to see whether they solve the problem or not.
What I am opposed to are the proposals that have been made by some that a firm that does auditing cannot do anything else for anyone. That is something I am totally opposed to at this point.
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Mrs. ROUKEMA. Thank you very much.
Chairman OXLEY. The gentlelady's time has expired. Let me point out to the committee we have two votes on the floor. I would like to get through the Members who are here for questioning. And let's begin with the gentlelady from Oregon, Ms. Hooley.
Ms. HOOLEY. Thank you very much. Mr. Pitt, thank you for coming today. I want to make sure that we are all on the same wave length, and as we look at all of these issues that we are all here to protect the investors. Is that a common goal?
Mr. PITT. It absolutely is.
Ms. HOOLEY. OK. To something that one of the other Members, Mr. Sherman, talked about, do you pay enough money to your auditors to be able to hire well qualified auditors in your department?
Mr. PITT. I am sorry?
Ms. HOOLEY. Are the salaries of your auditors enough to hire well qualified auditors?
Mr. PITT. I think at the present time the salaries are not enough, and I think that there is a need for improvement. If you are talking about the private sector, my own view is that——
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Ms. HOOLEY. I am talking about within the SEC.
Mr. PITT. We have steadfastly urged the passage of pay parity, and funding for it. Since we don't have that funding for 2003, I believe that our people do not make enough money.
Ms. HOOLEY. Let me just give you an example of a friend of mine who has worked for a couple of different CPA firms, large ones. One of the things that—comments she made to me recently was, you know, in all of these large companies they pay—this is the starting point for everyone. This is their training. This is where they put their newest, most lowest paid employees is out on auditing to sort of earn their way. What are we doing—a company can do that. They can do whatever they want. But what are we doing to make sure that we hold those companies to some standard so in fact they are not putting their least experienced out on the auditing road?
Mr. PITT. Well, that to me is one of the gaps in the existing set of regulations, including the Public Oversight Board. In my view, it is absolutely critical that people be appropriately trained as well as sensitized to both legal requirements and ethical requirements in the accounting firms, and then that there be diligent review by an independent body to make sure that firms live up to those standards.
At the present time I don't believe that that is happening. That is why we have proposed a public accountability board, and Chairman Oxley and Chairman Baker have proposed a public regulatory organization.
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Ms. HOOLEY. Let me mention one other comment that another person made, and she was doing some temporary work at a company who I won't name. And she said half the people that worked in that financial department had all come from the auditing firm. And she said I can guarantee you when the auditing firm they came in, they knew one another and they said they were never going to get a very tough audit. And she said, and they knew all the people working for this company got paid more than they got paid as the auditors because they were the lowest paid. Do you ever hear any comments about that? Is that common or——
Mr. PITT. I do.
M. HOOLEY. Again, how does that protect the investor?
Mr. PITT. I am concerned about the so-called private sector revolving door problem. I think it is a legitimate issue, and one that requires some attention. My big concern is that, for middle and smaller size companies, it may not be possible for them to attract from a wider pool of talent. And my only concern is making certain that before we adopt any restrictions—and I think there is a need for some guidance here, and some guidelines—but, before we adopt an absolute restriction, we make sure that smaller firms are not somehow being disadvantaged. But the issue is a fair one.
Chairman OXLEY. The gentlelady's time has expired.
The gentleman from Pennsylvania, Mr. Kanjorski.
Mr. KANJORSKI. Thank you, Mr. Chairman.
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Mr. Pitt, am I to assume that you are opposed to term limits? I mean, it seems to me limiting an auditor's ability to stay with a corporation to a certain number of years is very analogous to term limits of Members of Congress. I think that was a very popular, easy solution in the early 1990s that has since faded. I expect that you favor or are opposed to term limits in that regard, as you are for the auditors. Is that correct?
Mr. PITT. Well, let me say that I don't think that there is a direct correlation between term limits on politicians and term limits on auditors.
Mr. KANJORSKI. So you would like us to have term limits, but not the auditors?
Mr. PITT. I haven't said that. I just said that the—I think the issues——
Mr. KANJORSKI. I am opposed to term limits. I was using the analogy to say it seems to me the problem is the electorate. The electorate, in this case, is the shareholders in the corporation. They are the ones that elect the board. The board is to proceed using due diligence to protect their interests. They are allowed to make mistakes, I guess. They are allowed to hire foolish or fraudulent auditors, as members of the electorate are able to elect foolish or fraudulent Members of Congress.
Mr. PITT. Although that hasn't happened yet, to my knowledge.
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Mr. KANJORSKI. No, that never happens, right?
I am a little worried about this rush to decision and structuring a lot of rules to accomplish what appears to be a lot of good purposes, but in the end, could result in great damage to the system. So, when people come up with these definite rules, it concerns me. What is the next thing? Well, are we going to term-limit lawyers? Can we have a law firm representing a corporation for only 4 years? That is ridiculous. They are hiring professionals. The relationship is of such a nature that you do not want to have someone telling you that you can not hire your auditor or lawyer. Those are the people you have the most trust in. They in turn have the professional responsibility to perform to the highest standards.
In between there, we have a board of directors, or governors, to oversee and be sure that these professionals protect the interest of the shareholders. If the shareholders find they do not do that, they can kick them out. The only problem is, it ends up Enron occurs before there is any value in the shareholders having a meeting.
The one area that I——
Mr. PITT. I share your concern about destroying what is good about our system. That is a very real concern.
Mr. KANJORSKI. I will hope that you will constantly remind us up here to not be overly rambunctious in what we do, but try to act deliberately and deliberatively, and hopefully take our time on this.
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It seems to me—of course, I am just a simple lawyer from Pennsylvania—but it is awfully complicated stuff. I do not know how many of our graduate professors up here are fully aware of what the ramifications may be consistent with the speed by which we seem to be moving.
But, there is something you said earlier in your testimony that I just wanted to correct. We have an opportunity here to assert that the New York Times made a fatal error when they reported on February 3, 2002, you are reported here as saying: ''Now some in the group''—and this is referring to the people that supported the change of the law in 1995, like Senator Dodd—''have been having second thoughts about their opposition to the tougher accounting rules. Others, like Harvey L. Pitt, the Chairman of the Securities and Exchange Commission, say they are beginning to rethink the wisdom of some provisions of the 1995 law.''
You were obviously misquoted in that article.
Mr. PITT. No, I believe the reporter who wrote that is very careful, and quoted me accurately, at least on that proposition. I think nothing is off the table. I believe that people have legitimately raised an issue about the PSLRA and therefore I thought it was appropriate to start collecting statistics and look at the issue. What I have found thus far leads me to believe that the Act has actually served its purposes and is not responsible for Enron. But I believe that we have to be open to changes in any aspect of our system in light of what we have seen in Enron.
Chairman OXLEY. The gentleman's time has expired.
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The gentleman from Tennessee, to wrap things up.
Mr. FORD. Briefly. Thank you, Chairman Pitt. I know we are fresh out of time here. When we had Mr. Barandino before the committee, we talked a little bit about his announcement, I guess, and some of the other accounting firms—and forgive me of not going through all the pleasantries, you are great, I am glad to see you here and all those things. We will do that another time—but that they would no longer offer financial information systems designed for implementation to their audit clients. My friend Chairman Oxley's bill would prohibit auditors from offering these services to audit clients as well as internal audit services. This is probably a good start. But there a whole range of business consulting and other services that can and do create the possibility, at least the appearance, of conflict of interest.
How significant are financial information systems consulting and internal audit services to the non-auditing revenue collected by accounting firms? And, two, what other areas of consulting business do you believe could pose these conflicts of interest? And in interest of time, that we have two bills up here, Mr. LaFalce and Mr. Oxley, and I hope we work everything out, but in Mr. LaFalce's version he has a provision that would require accountants to preserve records and documents relating to audits for 7 years after the audit is completed. I am not going to be facetious and say do you think that could have helped to at least expose some of the challenges and problems involved with Enron. Obviously probably it would have. But shouldn't we have a clear standard for recordkeeping, I guess, is the larger and broader question that is obvious to this committee and Congress will soon address. I know we have a vote. I wanted to talk a little faster than my part of the country expects me to. So if you could answer that, I would appreciate it.
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Mr. PITT. A broader standard as to what might constitute a conflict?
Mr. FORD. I was speaking to the 7-year mandate for recordkeeping, number one, and do we need a clear standard. And, yes, could you extrapolate clear standard even on conflicts of interest. I didn't ask it that way, but that may be a better way of framing it.
Mr. PITT. Let me make a few observations on that, if I might. First, before Enron reared its head, I had given a speech in which I said that the Commission would not tolerate people who come in and lie to us in investigations, people who obstruct investigations or destroy documents.
Without commenting on the particular Enron situation, destruction of documents cannot be condoned, because once somebody gets away with it, everybody will try to get away with it and the system falls apart. So I have very, very strong views on document destruction and obstructing an investigation.
As to how long records ought to be kept, in my view, some rational period may be useful. And with computers, now there is an ability to store information electronically that may enable them to be archived so that we have access to it even after 7 years. But I believe that auditors should, and I believe they generally do try to, maintain records that reflect what audit practices they went through in conducting a particular audit for 5, 7 or 10 years after the audit is completed. Not everything that gets generated in the course of an audit needs to be retained.
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Chairman OXLEY. The gentleman's time has expired. I thank you for the time. The Chair would note that Under Secretary Peter Fisher has submitted written testimony for this hearing. I would like to thank the Treasury Department. Without objection, Secretary Fisher's testimony will be entered into the record.
Mr. Pitt, thank you, Mr. Chairman, for your appearance today. And the committee will reconvene at 1:00.
[The information can be found on page 409 in the appendix.]
[Recess.]
Chairman OXLEY. The hearing will reconvene. Here comes the Ranking Member.
Let me introduce the panel. Let me introduce our distinguished panel: Mr. Franklin D. Raines, Chairman and CEO of Fannie Mae, on behalf of the Business Roundtable; Mr. H. Carl McCall, Comptroller, State of New York, Office of State Comptroller; Mr. Joseph V. DelRaso, Partner, Pepper Hamilton, LLP; Mr. Philip B. Livingston, President and CEO of Financial Executives International; Mr. Jerry Jasinowski, President of National Association of Manufacturers; and Mr. Peter C. Clapman, Senior Vice President and Chief Counsel of Corporate Governance TIAA-CREF. Gentlemen, thank you all for appearing and your willingness to appear here today. Let me yield to the gentleman from New York.
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Mr. LAFALCE. I too would like to welcome every member of the panel. And so many of you I know so well: Mr. Raines with whom I have had a long working relationship before his days at Fannie Mae and the Administration; Mr. DelRaso with whom I have worked over the years through the auspices of the National Italian American Foundation; Mr. Jasinowski, going back 20, 30 years now; but most of all, I want to welcome Mr. Carl McCall, the Comptroller of the State of New York. Again, Carl has been one of the most outstanding public servants it has been my pleasure to know, whether it was a State senator, whether it was as a United States Ambassador, whether it was as a Commissioner, whether it was in the private sector as a leading vice president of one of the major financial institutions in the world, and he has been elected to statewide office in the State of New York by overwhelming margins on two separate occasions. And one of his distinctions, among many, he is also a member of the board of directors of the New York Stock Exchange.
So, not to slight the other members of the panel, but I just don't know you quite as well. Thank you, Mr. Chairman.
Chairman OXLEY. Thank you. All you New Yorkers stick together, I notice that. I understand Mr. McCall has some issues and has to get back to New York, and I appreciate that.
Let us begin with Mr. McCall.
STATEMENT OF H. CARL McCALL, COMPTROLLER, STATE OF NEW YORK, OFFICE OF THE STATE COMPTROLLER
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Mr. MCCALL. Thank you, Mr. Oxley. As I said in my prepared remarks, I had a note here that I am to start off by saying good morning. I guess that is not now appropriate, but thank you for this opportunity. And, unfortunately, I do have to go back to New York, but I hope I can stay for some of the questions.
Chairman OXLEY. Mr. Raines is shaking his head because he has been on several second panels. So good afternoon.
Mr. MCCALL. I want to thank the Ranking Member, Congressman LaFalce, for all he has done, and I appreciate the long relationship I have had with him and to all the Members of the committee.
I want to thank you for giving me this opportunity to address issues of corporate accountability and investor confidence. In the past few months, Americans have learned that the integrity of the financial markets and, in fact, the economic well-being of our country depend on these issues.
I commend this committee for holding a hearing. It is essential that we have a national discussion on these issues. I assure you our future depends on it. We need action at the Federal level to prevent another Enron in the future.
I applaud my good friend, Congressman LaFalce, for his leadership in introducing the Comprehensive Investor Protection Act of 2002. As comptroller of the State of New York, I serve as the sole trustee of the State's $112 billion Common Retirement Fund, the pension fund for nearly 1 million New York State and local government employees and retirees. The fund owned nearly 4 million shares of Enron through its index portfolio and active managers prior to the company's catastrophic downfall. Our losses are expected to exceed $58 million.
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While our fund is strong enough to absorb the financial blow inflicted by this corporate collapse, we are deeply shaken by the lack of diligent oversight by the independent auditors, board of directors, rating agencies and analysts on whom investors rely.
And we are not alone. In fact, I believe that the loss of investor confidence is the most devastating effect of the corporate collapse experience over the last several months. And if we don't restore that confidence quickly and completely, the consequences will be immeasurable.
The bill before the committee today, the Corporate and Auditing Accountability Responsibility and Transparency Act of 2002, offers measures for enhanced auditor oversight. However, this is no time for small steps. I believe additional standards are necessary to ensure the restoration of investors' confidence in auditors and their findings.
The Comprehensive Investor Protection Act that Congressman LaFalce introduced goes much further toward that goal. I urge the committee to consider a legislative compromise that includes some form of the provisions included in the Comprehensive Investor Protection Act that would correct what is currently a failed regulatory structure. I am speaking in particular of provisions that align with recommendations I have made as New York State comptroller.
Let me explain. First we need standards to make auditors more independent from the companies they audit. I submitted proposals to the Securities and Exchange Commission and to the Big Five auditing firms and called on companies to take three steps:
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One, prohibit auditors from providing non-audit services to audit clients except under limited circumstances.
Two, limit audit relationships to a maximum of 7 years.
Three, restrict auditors from accepting employment with clients for 2 years following work on an audit.
In short, auditor independence is critical to long-term shareholder value and confidence. That is why I supported the SEC's proposed revision of auditor independence requirements in 2000. And that is why I submitted these proposals, and that is why I pushed for change in my various roles as a public official.
I have introduced legislation that would require all New York State agencies to adopt these standards in their relationships with auditing firms. In addition, I issued an executive order to implement these standards in the Office of the State Comptroller. I believe these are important steps toward achieving meaningful auditor independence.
But we can't achieve comprehensive reform on a State-by-State basis. We also need a national effort. For this reason, the provisions in the Comprehensive Investor Protection Act that promote auditor independence are extremely important. As a shareholder, I have adopted a proxy voting policy to oppose the appointment of any auditor that also performs non-audit services to the company. I also sent a letter to the Common Retirement Fund's 50 largest portfolio companies, explaining our proposed standards and requesting information about how long companies have retained their current auditor.
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As comptroller, I can take these steps at the Common Retirement Fund, and I can encourage my counterparts around the country to do likewise, but it is essential that we hear from Washington on these matters. It is essential to know that our legislators share our commitment to investor protection.
The work of this committee sends a vital signal to all investors. To ensure that I continue to develop appropriate proposals to increase investor protection, I have also created a panel of advisors who will focus specifically on measures that enhance board independence and corporate accountability and minimize conflicts of interest in the marketplace. As a last resort, I have also taken legal action against Enron. I have filed a notice of joinder in United States District Court for the Southern District of Texas in support of a legal application to freeze the assets of directors and executives who may have benefited from stock sales based on information that was not available to other shareholders.
I applaud this committee for seeking input from a variety of sources, especially from the private sector. As a member of the board of the New York Stock Exchange, I serve as co-chairman of a recently created Committee on Corporate Accountability and Listing Standards. The committee will review corporate governance and shareholder accountability issues such as the composition of corporate boards and committees, disclosure requirements and the role of independent audit committees. The committee will also consider new listing standards that will have a profound impact on the marketplace.
In closing, I would like to say that I am acutely aware of my fiduciary responsibility to the retirees and hard-working people of New York State. Their ability to enjoy an economically secure retirement depends on the faithful and prudent investments of the Common Retirement Fund. In 9 years as comptroller, I have never heard from as many members of the pension systems as I have in the past few months. They are nervous and frightened and beginning to question the rationality of equity markets generally. This is not an encouraging sign for the marketplace. We must restore their confidence, each of us, fiduciaries, legislators and regulators. We all have a role to play.
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I thank you for your reasoned and constructive approach to the important issues before us. I look forward to working together with you to restore investor confidence and ensure the long-term viability of the American marketplace.
Again, I thank you, Chairman Oxley, Ranking Member LaFalce, and Members of the committee for allowing me to testify today.
[The prepared statement of H. Carl McCall can be found on page 302 in the appendix.]
Chairman OXLEY. Thank you, Mr. McCall. And feel free to stay as long as you possibly can. Hopefully we can get to questions before you have to leave.
Now I am pleased to go back to regular order and introduce the gentleman, Mr. Raines.
STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CEO, FANNIE MAE; CHAIRMAN, CORPORATE GOVERNANCE TASK FORCE, THE BUSINESS ROUNDTABLE
Mr. RAINES. Thank you, Chairman Oxley, and thank you, Ranking Member LaFalce and Members of the committee. My name is Franklin Raines and I am Chairman and CEO of Fannie Mae. I am here today as Chairman of the Corporate Governance Task Force of the Business Roundtable, and I appreciate the opportunity to express the views of the Business Roundtable with respect to the topic of today's hearing.
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Before I do that, Mr. Chairman, let me take this opportunity to recognize the foresight and leadership of this committee in raising and addressing issues of financial institution safety, soundness, and transparency, well before the collapse of Enron brought these issues to national attention. Let me recognize your leadership and that of Ranking Member LaFalce, subcommittee Chairman Baker, and subcommittee Ranking Member Kanjorski, for your consistent and strong leadership over the years on issues of corporate responsibility, transparency and market discipline.
The Business Roundtable is recognized as an authoritative voice on matters affecting America's business corporations and, as such, has a keen interest in corporate governance. Indeed, as leaders of some of our Nation's largest businesses, the Roundtable has the strongest interest in corporate governance practices that secure the confidence of shareholders, employers, policymakers, and other constituencies.
The Roundtable has been involved in corporate governance issues since 1978. In 1997, we published our statement on corporate governance, which suggests best practices regarding matters including the functions of the board of directors, board structure and operations, and shareholders' meetings. We are pleased with the number of large corporations that have adopted these practices.
In light of recent events, the Roundtable is reviewing its 1997 statement regarding corporate governance, and we expect to issue a new statement on this subject later this spring. The Business Roundtable has prepared a detailed analysis of H.R. 3763, and with your permission I would like to submit that analysis for the record.
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[The following information was subsequently furnished by Franklin D. Raines for the hearing record.]
Chairman OXLEY. Without objection.
Mr. RAINES. This afternoon I would like to summarize what the Business Roundtable believes should be the guiding principles of corporate governance. The Business Roundtable has issued a public statement regarding the issues related to the bankruptcy of Enron, in which we expressed our view of Enron's collapse and a set of principles we believe should guide the discussion of proposed changes, practices, regulations and laws.
With respect to Enron, the Business Roundtable believes that a number of the actions and behaviors revealed in the report of the special committee of the Enron Board of Directors, which contributed to the collapse of the company, are unacceptable. The Powers report describes a pervasive breakdown in the norms of ethical behavior, corporate governance, and corporate responsibility to internal and external stakeholders. The Enron situation appears at this point to derive fundamentally from a massive breach of trust.
We understand why the American people are stunned and outraged by the failure of corporate leadership and governance at Enron. It is wholly irresponsible and unacceptable for corporate leaders to say they did not know, or suggest it was not their duty to know about the operations and activities of their company, particularly when it comes to risks that threaten the fundamental viability of their company.
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The success of the American free enterprise system follows from the merger of corporate responsibility with individual responsibility, and the Business Roundtable believes that responsibility starts at the top.
The United States has the best corporate governance, financial reporting, and securities market systems in the world. These systems work because of the adoption of best practices by public companies within a framework of laws and regulations.
The collapse of the Enron Corporation is a profound and troubling exception to the overall record of success. Other less dramatic exceptions may also exist among the thousands of United States public corporations, but there are exceptions in systems that have generally worked very well.
In light of the public interest and issue drawing out of the Enron situation, we thought it would be useful to articulate a set of guiding principles of corporate governance:
First, the paramount duty of the board of directors of a public corporation is to select and oversee competent and ethical management to run the company on a day-to-day basis.
Second, it is the responsibility of management to operate the company in a competent and ethical manner. Senior management is expected to know how the company earns its income and what risks the company is undertaking in the course of carrying out its business. Management should never put personal interests ahead of or in conflict with the interest of the company.
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Third, it is the responsibility of management under the oversight of the board and its audit committee to produce financial statements that fairly present the financial condition of the company and to make sufficient disclosures to investors to permit them to assess the business and financial soundness of the company.
Fourth, it is the responsibility of the board and its audit committee to engage an independent auditing firm to audit the financial statements prepared by management and to issue an opinion on these statements based on generally accepted accounting principles. The board, its audit committee, and management must be vigilant to ensure that the corporation or its employees do not take any actions that compromise the independence of the independent auditing firm.
Fifth, it is the responsibility of the independent auditing firm to ensure it is in fact independent, is without conflict of interest, employs highly competent staff and carries out its work in accordance with generally accepted auditing standards. It is also the responsibility of the independent accounting firm to inform the board, through its audit committee, of any concerns it may have about the appropriateness and quality of significant accounting treatments, business transactions, and about any weaknesses in internal control systems. The firm should do so in a forthright manner and on a timely basis, whether or not management has communicated to the board or audit committee on the same matters.
Six, the company has a responsibility to deal with its employees in a fair and equitable manner. Employee benefit plans, once established, should be operated in a manner that is fair and equitable to all employees. These responsibilities and others are critical to the functioning of the modern public corporation. No law or regulation alone can be a substitute for the voluntary adherence to these principles by corporate directors and management and by the accounting firms retained to serve American corporations.
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Several thoughtful proposals have been offered to create new regulations or laws to deal with what appear to be breaches of trust and failure of responsibility at Enron. Two weeks ago, the President announced his plan to improve corporate governance. The President's personal involvement in seeking reform is welcome and underscores just how fundamental ethical and responsible corporate governance is to the health of the American economy.
Chairman Oxley, you and Mr. Baker have put forth a number of laudable proposals to improve corporate governance we are considering today, as has Mr. LaFalce and others. Some legislation and regulatory changes are necessary and advisable. The Business Roundtable worked closely with policymakers to help ensure that any necessary changes to laws and regulations are effective and efficient, taking care that our responses to the unusual circumstances presented by Enron do not inhibit U.S. Public corporations' ability to compete, create jobs, and generate economic growth.
Mr. Chairman, that concludes my statement, and on behalf of the Business Roundtable and its member companies, thank you for the opportunity to participate in today's hearing.
[The prepared statement of Franklin D. Raines can be found on page 320 in the appendix.]
Chairman OXLEY. Thank you Mr. Raines.
And I now call on Mr. Joseph V. DelRaso.
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STATEMENT OF JOSEPH V. DelRASO, PARTNER, PEPPER HAMILTON, LLP
Mr. DELRASO. Good afternoon, Chairman Oxley, Ranking Member LaFalce, and distinguished Members of the committee. Thank you for this opportunity to present my views on H.R. 3763, legislation which I believe will do much to restore the faith of investors in the way in which public companies report their financial results.
I commend the committee for its level-headed and responsible approach, especially at a time when many pundits and commentators are generating more heat than light on these important issues.
I am a partner in the law firm of Pepper Hamilton in Philadelphia. My practice focuses on corporate and securities matters, particularly on matters arising under the Investment Company Act of 1940 and the Investment Advisors Act of 1940. I served as an attorney advisor with the Securities and Exchange Commission in the 1980s, and I serve as a member of the board of directors of both public and private companies and non-profit institutions.
Having experience on the regulatory side as a lawyer in private practice and as a corporate board member, I believe I offer the committee an important perspective on the practical effect of key aspects of this legislation. Because this committee has already heard a wealth of testimony on auditor oversight provisions, I will focus my comments on other sections, particularly the transparency of corporate disclosure provisions of section 6, corporate governance provisions of section 9, and accredited rating agencies of section 11. Each of these sections, the committee should ensure that studies and activities undertaken do not attempt to fix things that are not broken.
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Federal Reserve Board Chairman Alan Greenspan in his earlier testimony to this committee noted a pronounced move toward more transparent reporting and improved corporate governance practices in the wake of the Enron collapse. As Chairman Oxley said at the committee's hearings last week, while Government may still need to take action, that action should not stifle the ability and initiative of the financial markets to self-correct.
In my practice as a lawyer, the vast majority of boards of directors, especially those of publicly held companies that I represent, take their responsibilities very seriously. In the last few years in particular, I am sure even more so now in the post-Enron and post-Global Crossing world, independent directors have become increasingly aggressive in acting as watchdogs over their respective shareholders' interests.
Audit committees have already been required to adopt charters governing their operations.
But perhaps they even need more guidance in this area. And I concur with some of the remarks earlier today that the stock exchanges and the other self-regulatory organizations may look into other areas with regard to adopting rules to help guide audit companies in their role as the watchdogs on the financial side of the shop.
Whether or not these policies and procedures are aggressively enforced, obviously, vary from company to company. On the one hand, given the proclivity of the plaintiffs' bar to act as a self-appointed protector of shareholder interests, even the most diligent board of directors is constantly checking itself to avoid costly unnecessary litigation. This serves as an important catalyst for directors instituting improved corporate governance policies and procedures.
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This also points to the need for appropriate government action to craft legislation and implement rules that are clearly understood and not easily manipulated.
Appropriate implementation and enforcement is just as critical as the legislative effort. Again, while the actions of the plaintiffs' bar keep directors and officers focused and diligent, the appropriate deterrent is and always and will be government enforcement and prosecution. The spectre of criminal sanctions and incarceration for the most egregious behavior or civil fines and sanctions for other transgressions serves the public interest much more sensibly than allowing certain members of the bar to extract their self-imposed penalties from companies in the form of their sometimes very large contingency fees. A more direct distribution of funds to compensate victims of corporate malfeasance, or fines that are used to further bolster Government enforcement efforts might be preferable, and indeed are just plain common sense in some circumstances. Any effort to roll back securities litigation reform may make business only more expensive by increasing insurance costs and the like and still produce inferior results.
Again, we heard studies undertaken by the SEC that point to the fact that the plaintiffs' bar is alive and well and still impacting the markets. On the other hand, prosecutorial judgment most times is a markedly more effective approach to handling some of these problems rather than ''strike suit'' targeting.
Below the board level, the President's Working Group, referred to in section 9, should examine how the financial markets can deter managers and other employees from interfering or influencing third-party professionals, whether they be auditors, rating agencies, and other parties that are relied upon in one way or another to put their imprimatur on corporate actions.
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From a practical perspective, any additional Government overlay from either a statutory or regulatory standpoint might further dampen the enthusiasm of qualified people to serve as independent directors. On the other hand, appropriate sanctions for inappropriate behavior would be welcome. The overwhelming majority of independent directors has been and continue to be good corporate citizens, dedicated to discharging their duties to protect shareholder interests.
Further initiatives, including personal liability expenses, except in the most egregious cases of willful and wanton misconduct, and other erroneous regulatory sanctions or requirements may merely serve to deter good individuals from accepting positions as independent directors.
Finally, corporate governance ties in with the provisions in section 6 regarding the need for improved transparency of corporate disclosures. Boards should be able to discern from transparent reporting the correct state of affairs. There should be little excuse for a well-informed board of directors to fail or be victimized by obfuscation and financial high-jinks constructed as off-balance-sheet transactions and other clever financial tricks. Uniform standards of financial reporting will not only sustain a level playing field, but will uphold the integrity of the process.
I applaud the work of this committee in seeking improved transparency, for without it, the efficient functioning of our financial markets may be impeded. Financial investors expect to see, and will demand more than ever, quality of earnings that can be reported via clear and concise accounting standards consistently applied. This is especially true in dealing with non-exchange traded financial instruments and other instruments that are not readily tracked in public markets. This legislation, I believe, will put the ''fair'' back in fair-value accounting.
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Finally, with regard to credit agencies, I believe many of the issues I noted regarding the corporate governance procedures also apply in this field, particularly the overwhelming need to avoid conflicts of interest. This again is essential to the efficient operation of our financial markets. Just as a ''seal of approval'' is expected by the auditor certification accompanying audited financial results, the grade awarded by rating agencies will only be worth the strength and integrity of the name behind it.
Finally, Mr. Chairman Oxley and Ranking Member LaFalce, I would like to thank you again for this opportunity to testify today on this important piece of legislation. The dark cloud of Enron and Global Crossing, while obviously dire to investors, employees, and those most immediately affected, may have some element of a silver lining if, as I believe, it serves as a wake-up call to responsible independent directors and corporate officers and if it provides the Congress the impetus to enact some long-needed reforms to ensure responsible reporting of corporate financial results.
[The prepared statement of Joseph V. DelRaso can be found on page 360 in the appendix.]
Chairman OXLEY. Thank you.
And I recognize Mr. Livingston.
STATEMENT OF PHILIP B. LIVINGSTON, PRESIDENT AND CEO, FINANCIAL EXECUTIVES INTERNATIONAL
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Mr. LIVINGSTON. Thank you, Chairman Oxley and Ranking Member LaFalce. I am here today to represent FEI and its strong support for H.R. 3763 and the leadership of this committee. As Chairman Pitt kindly recognized this morning, the FEI released its own recommendations for improving financial management, financial reporting, and corporate governance. These recommendations dovetail nicely with H.R. 3763.
Financial officers know that good corporate control requires broad frontline defense mechanisms to prevent problems. As a result, that is where our suggestions begin. Our most important recommendation is that all senior financial officers adhere to a special code of ethical conduct. We recommend that this bill include an additional provision calling upon the SEC to work with the stock exchanges to develop a requirement that senior financial officers of all public companies adhere to a code of ethical conduct similar to that in use by FEI members today. We believe adherence to such a code is a crucially important cornerstone of sound management, appropriate atonement at the top, and successful fiduciary stewardship.
In order to reinforce management and board awareness in the maintenance of a strong ethical climate, we strongly recommend that all senior financial officers annually sign such a code and deliver it to their board. I will tell you that one of our leading CFOs has required all of his company's 3,000 financial professionals worldwide to sign such a code and deliver it back to their corporate headquarters.
Unfortunately, the Enron case once again demonstrates the need to improve audit committees. Three years ago, the Blue Ribbon Panel on Audit Committee Effectiveness called for all audit committee members to be financially literate and for each committee to have at least one financial expert. Unfortunately, the criteria for meeting the standard was set so low that no real change or addition to audit committee personnel actually occurred in the time leading up to Enron's demise.
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We must get on with truly raising the bar and adding real expertise to audit committees. We need Congress and the stock exchanges and the SEC to act on this matter. The stock exchanges should be required to write tougher standards into their listing agreements. Explicit experience in financial reporting must be required of such experts.
FEI is also proposing recommendations as to the issue of auditor independence. As recently as last year, I testified before the Senate Banking Committee in opposition to former Chairman Levin's proposal to split audit and non-audit services provided by accounting firms. I tell you, it is still my strong personal opinion that consulting services do not corrupt the integrity of independent audits. The truth, in my view, is exactly the opposite. Consulting projects enable the auditor to get out of the accounting department and learn about the intricacies of the business and, in the end, conduct a more effective audit.
However, the accounting profession is suffering from a post-Enron crisis of confidence. Therefore, certain restrictions should now be imposed on non-audit services supplied by the independent audit. They should no longer provide clients with internal audit services or consulting on computer systems used for accounting. We strongly believe that tax services should be allowed, as well as acquisition due diligence, audits of employee benefit plans, and other statutory audits. We do strongly recommend that audit committees approve all large non-audit services provided by the auditor.
I also want to address the controversial issue of stock option accounting. Unfortunately, the current crisis has encouraged some to attempt opportunistic initiatives to advance narrow and unconstructive agendas with little regard for the important matters in front of us. These very tactics were too often employed over the last 10 years and are at the core of many of our problems.
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Unusable accounting standards and dysfunctional financial statements result from processes and regulatory environments unable to recognize the real problems, yet set out to achieve narrow political-or governance-related objectives.
Stock option accounting is such a case. This debate has a long and acrimonious history between shareholder activists, enraged by cases of excessive executive compensation, and the corporate preparers of financial statements that find employees' stock options as hard to accurately measure as an Enron energy contract or put agreement to sell broadband capacity. A charge to the income statement for stock options is the Trojan horse in the battle over governance controls of options and executive compensation.
When recently asked about the ongoing accounting debate, Sarah Teslik, the CEO of the Council of Institutional Investors, was quoted as saying: ''If we can't get the vote on these things, then we have to punish them on the balance sheet.'' Her comments reflect the reality of the issue. It is about the practices and the quantities of option grants, not the quality of the income statement.
A real reform would be for shareholders to approve all stock option plans and therefore control abusive levels of shareholder dilution in the few cases that it occurs. Because of the intense controversy around this subject, Congress can do a great service by mandating shareholder approval of employee stock option plans, and we urge you to act.
Briefly, FEI would like to add its continuing support for the Private Securities Litigation Reform Act. The PSLRA is working today and there is no need to change or modify the current law. Enron's employees and shareholders will not be hindered by the PSLRA in seeking restitution of their losses. Now is the time for real reform, not opportunistic grabs of narrow agenda items.
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FEI also recommends that we increase the SEC's budget and that a significant portion of the additional funds be earmarked for attracting new high-caliber professional staff. Further, FEI supports the creation of a new regulatory organization for the auditing profession. We believe it is important to clarify that the two-thirds members specified as ''not members of the accounting profession'' be further defined as individuals who are not currently practicing CPAs, but do have extensive education and experience in financial management of public companies, auditing, or accounting.
That concludes my remarks, and I would like to thank the Chairman and the Members of the committee for allowing FEI this opportunity.
[The prepared statement of Philip B. Livingston can be found on page 365 in the appendix.]
Chairman OXLEY. Thank you.
Our next witness is Mr. Jerry Jasinowski. I was so used to having you testify in the committee across the hall, and we are facing in different directions from the past, but I think this year you made an appearance before our committee. Welcome. And it is good to see you again and particularly under these circumstances.
STATEMENT OF JERRY J. JASINOWSKI, PRESIDENT, NATIONAL ASSOCIATION OF MANUFACTURERS
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Mr. JASINOWSKI. Thank you very much, Chairman Oxley, for your leadership on this, and allowing us to testify before this committee.
With 14,000 manufacturing companies, both large and small, we are a user of the auditing information and a producer of the auditing and financial information, and so have a particularly unique perspective on this and have thought very carefully about it. Although we have not concluded all of our decisions on it, we certainly feel that your bill 3763 is a good framework.
I want to acknowledge, Congressman LaFalce, also our longstanding relationship, and we look forward to working with you in terms of the legislation you propose.
In our press release, Mr. Chairman, we put the emphasis on best practices and enforcement, and suggest that we have a very good system in this country which has been badly damaged by Enron, Andersen, and other misjudgments which Frank Raines has articulated rather well, and I would associate myself with his remarks.
Our 14,000 members are outraged by what appear to be certain transgressions on the part of both companies and auditors, and feel that the bulk of our membership are absolutely opposed to anything like that and strongly want to affirm the need for honest and complete information. In fact, as we indicate in the statement—which I would like included in the record—information is critical to our capital markets, and I think without it, we will not be able to have the growth and productivity that we so badly need.
Let me make five points. And the first point is to stress your bill H.R. 3763, although we do not yet endorse it, we certainly feel it provides the framework for the kind of reform—thoughtful balanced reform, that we need.
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Disclosure beyond GAPP is important in getting better information, public regulatory oversight, as you suggest, is the kind of thing that we think is important in the legislative area.
Having said that, we really put a lot of emphasis in our testimony on best practices and the need for the private sector to further improve the quality of the information that they have—and not just the auditor, but also the companies. We do have the best system in the world. But as Chairman Pitt said, we can make it a lot better. And I think there are many ways in which we can.
At the heart of that, of course, is strengthening the audit committee and strengthening the oversight of the management, having a more independent board, focusing on such matters as the critical accounting policies and practices that have come out of the SEC, and other matters where we think a good system could be made much better if, in fact, it is fully employed. I think the tone of much of your bill puts the emphasis on that and we would want to associate ourselves with that.
And we think we have an obligation, Mr. Chairman, to speak out to our own members and say look, we know most of you are doing a fine job, but not everybody is, and you can do better; and we will certainly encourage that within our own membership.
As I said, I thought that Chairman Pitt was very helpful in terms of his proactive emphasis on enforcement, information and clarity. We think we ought to be very tough with wrongdoers. People make mistakes, they ought to pay. And it is important that society generally, the SEC, and the Congress assure that that happens.
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Having said that, there may be some opportunities for legislative reform, as you suggest, in your bill and beyond that. Certainly the public regulatory organization to oversee accounting standards, as you suggest, is something that we think merits careful consideration. Also, it might surprise some, but we think it is important to increase the funding for the SEC in order to have the kind of education, clear information, and enforcement that they need. We cannot expect to get this job done if we do not have adequate resources there, and we support that.
I am sure there are other measures as these hearings continue, and in the market session we will support legislatively. But again let me repeat, we don't think there needs to be a whole set of new laws. There is an enormous set of good laws on the books that, with proper enforcement and good action on the part of the companies, will lead us to improve this system as it now stands.
We think it is, finally, important not to take on some measures which will do real harm; that is, to produce a lot of new legislation, new liabilities, try to reinvent the wheel. This committee, your own leadership, Congressman LaFalce, and the SEC have been working on this for some time. The Enron-Andersen affairs require us to redouble our efforts, to strengthen our laws in some cases, but let us not try to reinvent the wheel. Certainly we don't need new liability provisions for the most part, and we ought to avoid increases in costs.
Having said that, again, I think it is important for us in the private sector to take responsibility to further improve our own management and implementation of the accounting provisions.
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Thank you, Mr. Chairman.
[The prepared statement of Jerry Jasinowski can be found on page 388 in the appendix.]
Chairman OXLEY. Thank you, Mr. Jasinowski.
Mr. Clapman.
STATEMENT OF PETER C. CLAPMAN, SENIOR VICE PRESIDENT AND CHIEF COUNSEL, CORPORATE GOVERNANCE, TIAA-CREF.
Mr. CLAPMAN. Thank you. Thank you, Chairman Oxley, Ranking Member LaFalce, and Members of the committee. I am Peter Clapman. I am speaking from an investor and shareholder perspective on the issues of the day. I will be talking not only about the accounting regulation issues, but the board of corporate governance issues as well.
TIAA-CREF has a fiduciary responsibility to over 2–1/2 million members of our pension system, which is the largest pension system in the world. We have approximately $275 billion under management. I also chair the most prestigious global corporate governance organization in the world, and I must say that the Enron episode has had a real detrimental effect on the reputation of the United States and corporate governance.
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TIAA-CREF has been a leader in corporate governance. We are convinced that our initiatives to better corporate governance will produce better returns for our pension participants and shareholders. We also believe that it is our responsibility to monitor the managements of our portfolio companies and hold them accountable. Good corporate governance depends critically on the performance of the board of directors and, in particular, its most important board committees: compensation committee, auditing committee and nominating committee. If the board is not independent, if the directors lack the proper qualifications, and if the directors do not pay sufficient time and attention to fulfill this role, an Enron is not only possible, but it is also likely. Are there other Enrons out there? We can hope that there are not, but prudently cannot trust that will be the case without reforms.
And I will now address some of the needed corporate governance reforms and how I suggest they best be accomplished. One area that must be addressed involves the conflicts within the key professions. Too often accountants and lawyers, ostensibly representing the company, in fact wind up representing only its senior management. Such conflicts were at the heart of the problems of Enron.
The professional organizations themselves have a key role and must do a better job through education and discipline to minimize these abuses. The regulation of the accounting profession demands change, and already excellent proposals have been made.
TIAA-CREF CEO John Biggs has urged, among other things, that companies assure the integrity of the auditing process by not giving the same audit firm that does its audits, consulting work. We are not advocating the split of auditing and consultant work for the organization, but that each company should be conscious of this potential issue of conflict and split its auditing and consulting work on that basis, and also by periodically rotating the auditing firm or at least considering such action.
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He also proposed that an independent board oversee the accounting profession, with its own funding source, and with the legal authority to enforce rules and impose sanctions for wrongdoing.
But on a broader scope, a related corporate governance reform needed for more accurate financial reporting is on the subject of executive compensation, particularly affecting the use of stock options. The reforms needed are twofold: require that the cost of options be reflected in the financial statements; and, two, require shareholder approval for dilution of option plans, introducing greater accountability in this most important area of executive compensation. Stock options are overused and abused, with the accounting rules largely to blame for this problem. The true cost of fixed-price options escape the earnings statement, encouraging this overuse and abuse. This structural failure of corporate governance must be addressed.
The National Stock Exchange as the New York Stock Exchange and Nasdaq must be an important engine for needed reform. The exchanges, however, have dual objective organizations. While they must regulate companies and brokers in the public interest, as businesses they also seek listings from the very companies they must regulate. To the credit of Chairman Harvey Pitt, the SEC has already requested that the exchanges evaluate which corporate governance reforms are necessary. The exchanges must respond by imposing stronger standards of director independence, requiring shareholder approval of all material, equity plans promoting education of directors, and implementing more stringent policies to ferret out conflicts of interest. If the exchanges fail to act, the SEC, using its regulatory powers and persuasive influence, should press for needed reforms.
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The education of directors is a major concern. Directors on audit committees only recently had to meet a standard of financial literacy; literally, to have the ability to understand a financial statement. Directors on compensation committees often do not take a proactive role on behalf of their company, because they lack an understanding of compensation issues and do not obtain independent consultants when needed. The abuse and overuse of stock options results from inadequate performance of many compensation committees and the board as a whole.
What is the role for Congress? It is not clear to me how many new laws are needed. But as a minimum, your oversight role is critical. At some point, memories of Enron will fade as other issues take center stage, but the corporate governance problems that I have highlighted, and are highlighted by the Enron experience, should be fixed.
I have outlined a number of corporate governance issues in which I believe reforms are both necessary and possible:
One, dealing with the conflicts among the professionals.
Two, better regulation of the accounting profession.
Three, reforms in the area of executive compensation, particularly in the area of stock options, and to require shareholder approval.
And in the role of the stock exchanges, to deal with issues in the public interest and recognize their responsibility there.
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And, finally, the education of directors.
You may be sure TIAA-CREF is an organization that will continue to press for these reforms. We hope the current widespread public interest in such issues will provide focus and impetus for such reforms.
Thank you very much.
[The prepared statement of Peter C. Clapman can be found on page 397 in the appendix.]
Chairman OXLEY. Thank you Mr. Clapman.
Let me begin by asking Mr. Raines, what role corporate management plays in assuring that audit firms are independent, and how is it similar or different to the role of the audit committee itself?
Mr. RAINES. As we stated in our principles, it is not only the obligation of the auditor to be independent, but it is also the obligation of both management and the board to not take any steps that would compromise its independence. And that means from the management standpoint, that management should not ask the auditors to undertake activities that may be inconsistent with their role as independent auditors, and must ensure that the practices with regard to the personnel of the auditors and to the provision of information needed for the auditors to do their work are consistent with the auditor's independence.
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Sometimes it is easiest, if you have a task and you have a professional firm working for you, to simply use the firm who is there and use a different department of that firm. But that easy path can lead to independence questions. If, for example, you used the consulting arm of an auditor to create your financial systems, and then the auditors then have to audit those systems, that can impinge on the independence of the auditors. So it is in part management's job to not even suggest to the auditors that they put themselves into positions that may create independence concerns.
Chairman OXLEY. Mr. DelRaso, you mentioned that Congress should be careful in trying to fix things that aren't broken. What proposals specifically are you concerned about?
Mr. DELRASO. I think the CARTA legislation has done a pretty good job of addressing the problems without going too far. But I am still concerned about two areas in particular: one, the groundswell that may be developing in terms of rolling back the reforms made on securities litigation; and, number two, I think in the area of auditor independence, Congress should take a careful look at the real role of the modern-day accounting firm and the services they provide across the board, audit and consulting.
We have seen the worst in these recent cases. I represent a number of companies that deal in the global markets, and I think a little more work may have to be done to take a look at the role of these firms in the non-audit areas, especially overseas. When global companies are setting up subsidiary operations and other types of international functions, the auditing firm is the law firm in that jurisdiction and it provides other areas of advice and, quite frankly, it is the best source of that advice in that particular market. And at the same time, that firm also has the institutional knowledge of a particular client.
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There are, I think, a number of functions that really aren't necessarily in as deep a conflict as we believe.
Chairman OXLEY. I don't know whether you were here for Mr. Pitt's testimony, Chairman Pitt, but I think you and he share the same concerns that perhaps I do as well; that is, we would be very careful about putting things in stone, as Chairman Pitt said, because it is much more difficult to extricate ourselves from a bad decision. Better it be left for the most part to the private sector, and indeed to regulators.
Let me ask, Mr. Jasinowski, Chairman Greenspan testified a couple of weeks ago to this committee and, in response to a question, seemed to indicate that in many cases, the marketplace is the best way of disciplining unwanted behavior. What do you think your members would fear the most, Government reprisals or market reprisals?
Mr. JASINOWSKI. I think the market reprisals are already taking place, Mr. Chairman, as you know, and I don't think there is a company in my membership which isn't reviewing all of its procedures to be absolutely sure they are not only sound, but they are made stronger. And I think the markets, the equity markets, have also reacted already. So we don't have any choice about the private markets except within running our own companies, where we do have a choice, and I think we are going to do a lot better there.
I think the biggest concern is that people are going to try to create a whole new legislative, regulatory, liability system to go after some particular transgressions. And I think one of the reasons why your particular legislation is appealing is that you respond legislatively, you set up a framework to use the SEC, you try to involve the private sector, and at the same time, you have punitive actions if they are necessary.
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I think you have got to have a balance. You have got to have perspective. That is what all our members are really looking for, and we are concerned that Congress may overreact.
Chairman OXLEY. Mr. Livingston, while I may share your philosophical opinion regarding the division of labor between accounting and consulting, the fact is that several of the accounting firms have already indicated that it is their desire as the corporation or partnership to divide those. Some would say that we need to make sure that maintains, by passing a law that would forever divide those functions. What is your reaction to that?
Mr. LIVINGSTON. I think it would be a great role for the new oversight body that we are talking about for the accounting profession. And the main reason it would be a great role for that body is because there are many, many nuances. And our group, while it feels strongly about continuing to get tax services from the auditor, because most of that work is compliance work, it is related to the tax return and ties into all the work they do on the audit, there are areas in tax preparation, tax advisory, that might be good for this oversight body to be concerned about; tax structurings and tax shelters that have been in the news, and where there are contingency fees and tax savings. And that just illustrates the kind of nuances that an oversight body could react much more quickly to in a more focused manner.
Chairman OXLEY. Thank you. My time has expired.
The gentleman from New York, Mr. LaFalce.
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Mr. LAFALCE. I think everybody agrees we need to have some type of oversight board, correct? So I guess the question is, what powers should it have and who should serve on it? Now, with respect to powers, does anybody doubt that they have should have their own independent investigatory powers, that they should have their own ability to subpoena, to promulgate standards, and see to its enforcement, adequate staff resources to do the job? Does anybody have any quarrel with any of those concepts?
Mr. Jasinowski, do you have a quarrel with those concepts?
Mr. JASINOWSKI. I do in the sense that it is not clear what the relationship is to the SEC in that whole articulation.
Mr. LAFALCE. It surely would be subject to the SEC.
Mr. JASINOWSKI. I think as long as the SEC is the one who has the determination with respect to investigation.
Mr. LAFALCE. I assure you, anything coming out of this committee will absolutely ensure that the board is subject to the jurisdiction of the SEC, which is subject exclusively to the jurisdiction of this committee.
Having said that, the question is, who is going to be on it? We know that Charlie Boucher resigned when he heard of the appointment of certain individuals to a new board created by Mr. Pitt. We know yesterday that Charlie Boucher said that the new board should consist exclusively of public members. And I don't know we have to go that far.
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Suppose we put in legislation that the SEC's appointive power of members of the board should be based upon recommendations made by certain institutional investors; that TIAA-CREF should make certain recommendations; that the Council of Institutional Investors should make certain recommendations; that private employees' pension plans and public employees' pension plans should make certain recommendations. A slate of candidates could then be decided upon by the SEC.
How does that sound to you, Mr. Jasinowski, because it is important who is on it. Mr. Boucher would have rejected out of hand those individuals that Mr. Pitt wanted.
Mr. JASINOWSKI. You have a lot of shareholders here, like you, Congressman LaFalce, and employers are some of those. Management, auditors, pension funds.
Mr. LAFALCE. We want to check the employers, because it is the employers that are the CEOs with the stock options, the CFOs with the stock options that are the first line of defense against earnings management or manipulation. Then it gets to the audit committee who very often also has the same stock options, perhaps not in the same quantity, and very often have a policy of passivity that permeates the board. And so we need to check that. And it is my judgment that the best check is to have at least a majority of members coming from individuals representative of these pension funds' institutional investor groups.
It is not unreasonable in any event?
Mr. JASINOWSKI. No.
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Mr. LAFALCE. Thank you. Let us go to the next issue. Is there anybody here who thinks we should permit auditors to immediately leave the audit firm and become an employee of the firm that they were auditing? Don't you think we ought to have some ban on the time period? Wouldn't that be a good thing to put in the legislation?
How about you, Mr. Raines?
Mr. RAINES. We believe there ought to be a period of time when someone who worked on the audit is not eligible for employment.
Mr. LAFALCE. OK, good. Anybody who disagrees with that concept? We can accept that.
Mr. LIVINGSTON. That ought to be a company-driven thing, a policy adopted by the companies. And I don't think you should legislate.
Mr. LAFALCE. You can say it, and I would strongly disagree with it, because the problem is that 90 percent of the companies you don't have to worry about would adopt it, and the 10 percent that you might have to worry about wouldn't adopt it. And that is why you have laws. Most people don't murder, but you have laws against murder. Publicly traded corporations, if we are talking about publicly traded corporations—and we are not talking about private corporations, Mr. Livingston—publicly traded corporations subject to—invested by public at large.
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Let us go on to some other issues. Mr. Jasinowski, you were very worried about adopting new laws dealing with grievances in the securities markets. What about a return to old laws? Would you consider that? I mean, you are opposed to new laws. What about return to old laws?
Mr. JASINOWSKI. We are not opposed to new laws.
Mr. LAFALCE. Let me focus in particular. What provisions in the 1995 Securities Litigation Act were so important that you think they are so wonderful that they shouldn't be changed? What was done in the 1995 legislation that reformed or changed securities litigation that was so important that you think it should not be revisited? Would you please explain that?
Mr. JASINOWSKI. I think in general——
Mr. LAFALCE. Not in general, in specific.
Mr. JASINOWSKI. I don't see any reason we ought to be changing that law.
Mr. LAFALCE. What did it do that it should not be changed? What did it do specifically that is so good that we shouldn't change it?
Mr. JASINOWSKI. I am not in a position——
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Mr. LAFALCE. All right. Thank you. OK, good. I know you came out strongly.
Mr. JASINOWSKI. Again, it is not altogether new laws; I didn't say we ought to go back and change that particular law.
Mr. LAFALCE. That is the law you said should not be changed, but it was enacted in 1995. And I want to know what did it do that was so good that it ought not to be changed? And I have a non-response. But I understand that this is an institutional response as opposed to a specific response. Is there any problem with making sure that it is the audit committee that has the responsibility for the hiring and the firing of the auditor? Is that a good idea?
Mr. JASINOWSKI. Congressman LaFalce, I particularly like that aspect of your legislation, and I think having an independent nominating committee making a decision about the audit committee and establishing in-house as independent an audit committee as you can have is a very good idea. Whether or not you need to codify it in legislation I don't know, but I think it's something we ought to be striving for.
Mr. CLAPMAN. You made the point that the audit committee should have the right to hire and fire the accountant. I think that is embedded currently in the law. Whether it is followed in practice is a different issue. But it does tie into——
Mr. LAFALCE. What if we make it a material breach if they do not?
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Mr. CLAPMAN. I think it already is.
Mr. LAFALCE. Well, then, there is not an awful lot of material breaches, I would suggest, that have not been——
Mr. CLAPMAN. That is true. There is a tie-in to the consultant aspect of what the audit firm does and why we take the position that we do.
Mr. LAFALCE. Speaking of the consultant, we do not say that certain firms have to be auditors and can't be consultants. We say they can't be the auditor and consultant for the same employer. They could be a consultant for some other employers and still retain all that capacity. And, of course, I do think certain types of consulting such as tax should be allowed for the same employer.
Mr. CLAPMAN. But there is an aspect of that point that goes to the heart of your question, and that is that the consulting services typically will not be retained by the audit committee. Typically, the consulting services are obtained by the management of the company. And that is where the potential conflict comes about: How does that firm view their loyalties? Do they view their loyalties to the audit committee and the shareholders, or do they owe their loyalties to the senior management of the company? And that is the effect of having large-scale consulting services by the same firm that does the audit being hired by management, and how the audit firm then assesses where their bread is buttered.
Mr. BAKER. [Presiding.] We will come back for another round.
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Mr. RAINES. If I could differ. My experience is different than that. Audit committees typically are, in fact, shown the entire workload by the audit firm, whether or not it is audit-related or consulting, and it is the responsibility of the audit committee to supervise that entire relationship; and in the firms that I am aware, where best practices would include the audit committee supervising the entire relationship, regardless of the scope of services.
But on the scope of services issue, I would urge the committee to make, as you are thinking about the legislation, to not fall into these definitions of audit, audit-related, and consulting, because they are in many ways very false distinctions. Some of the audit-related are in fact audits of the pension plan, and they are indistinguishable from audits of the financial statements. So I think most people would believe having the same auditor doing auditing is not a problem.
On the other hand, there are some things that are called ''consulting'' that look a lot like what you think an auditor should do, such as looking and verifying information that is going to be used for securities offerings. So, rather than using these broad definitions, I think it is far better to try to come up with something that says things that are consistent with the attestation role of an auditor, where they are not to do broad-gauge management consulting, but to provide assurance to third parties that something is accurate. And I think that is far better than these distinctions that are currently being used, because I think they really confuse what it is that the auditors are doing.
Mr. LAFALCE. I think if you look at Mr. Levitt's recommendations, they were about an inch or two thick. And clearly, it would be the job of the SEC to articulate regulations. We have separation between church and state, but very often there must, of necessity, be a merger of the two. It is absolutely impossible to have a complete separation.
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Mr. BAKER. The gentleman's time has expired.
Mr. Raines, I want to pursue this line you just initiated with regard to the manner in which the Congress should act. And I sense from a number of the other members of the panel that with regard to the Congress being able to circumscribe current business practice by certain definition and thereby preclude inappropriate conduct in years to come, all of you are very bright people who can construct a business model that would meet whatever rule Congress comes up with, and that we should address principles of governance and then empower the SEC to enforce those principles where they don't already have the authority to act—which I believe they do have authority to act.
To that end, I think it was inappropriate for Enron officials to have exercised no-cost options when, at the same time, constrained employees may have been prohibited at different intervals from acting on the exercise of their own stock options. And if there had been a subsequent accounting, there certainly would have been a restatement brought about which would have caused shareholders, if they had been a viable corporation still standing, to take significant loss while the executives earned significant compensation during that same environment.
Is it your understanding that participants generally in the Roundtable, as a matter of business ethics, have in place today some prohibition on those generalizations that I have described? Or how can we construct rules that encourage long-term earnings growth versus short-term profit and the extreme pressures that I understand management faces?
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Mr. RAINES. I think you outlined the core problem, and let me give you my perspective on that. For example, in our statement with regard to the treatment of employees and treating them fairly, I think it would be entirely appropriate for Congress to say that one of the tests of fair treatment under the pension laws is that the fair treatment would go to questions of when can individuals trade or not trade. That is a broad principle that doesn't go to the Enron case, that says in this particular instance, here is what the rules can be. And then the Labor Department, as necessary, can begin to elaborate on how that might apply.
But we don't believe there should be special treatment for one set of employees of the corporation versus another as to when they have access to the market. And most companies have tried to hold any such periods to be very small. But I think it would not be unreasonable for that specification to be there, because it establishes a principle without establishing exactly how it should be done for all times; because, you know, 20 years ago we didn't have 401Ks. And 20 years from now we may have something different that is in place.
But, I think the broad principle that employees should be treated similarly in the implementation of these plans and should not be disadvantaged vis-a-vis other employees in the exercise of their rights to purchase or sell stock, I think is a broad principle that would make an enormous amount of sense.
Mr. BAKER. Do shareholders generally today, as members of the Roundtable, have the authority to approve or disapprove option plans?
Mr. RAINES. The vast majority of option plans are presented to the shareholders for approval; not all, but the vast majority of the plans are presented to shareholders for their approval, and they are not always approved. Indeed, a number of the shareholder activist groups have taken very strong positions with regard to the size of these plans, and many corporations go to great efforts to comply with the views of these shareholder activist groups when they put their plans together.
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Mr. BAKER. I have suggested, as one incentive to preclude manipulation of stock value, exercising no-cost option with a subsequent restatement of earnings, to require disgorgement within a certain time period of the restatement occurring if there is a finding by the SEC of manipulation of stock price. And the reason for that mechanism as opposed to the litigation route is the SEC can act while there are still resources available to act upon, where if we rely on litigation under Section 10(b)(5), it could be years. What is your reaction to that general line of thought?
Mr. RAINES. Mine? With regard to disgorgement, the SEC does have authority now to undertake that. And in cases where there has been wrongdoing that leads to a misstatement of the information given to the public that has a material impact on the stock, I don't believe it is unreasonable at all for the SEC to pursue disgorgement among the senior management of the proceeds from options that would have occurred under those circumstances. I think you are going to have to define who was covered and what the circumstances will be. But as you described the situation, that would be a prime case in which the SEC should take action.
Mr. BAKER. As a general matter for the panel, does anyone dispute the observation that the financial statement should be an accurate reporting of corporate financial condition for the shareholder, and that it is not the property of the management? Does anyone dispute that particular view? Because we had the CEO of a significant accounting firm indicate it was a joint property of management and the shareholder, and I found that to be a bit distressing that that conflict would be publicly acknowledged by a CEO of an auditing corporation.
Did you want to comment?
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Mr. CLAPMAN. Yes, I did. I just wanted to add to the response of Mr. Raines to your question about whether shareholders have the right to approve stock options. I think the vast majority of the companies within the Business Roundtable do present their stock option plans for shareholder approval, but we have been tracking this and there are, increasingly, companies adopting plans without shareholder approval. So if you want to look at the direction, without some reforms in this area, the direction is toward more plans being put into effect without shareholder approval at the current time.
Mr. BAKER. I am sure we may come back to a second round, but Mr. LaFalce wanted to get 15 seconds.
Mr. LAFALCE. Mr. Chairman, pursuant to rule 11 of the Rules of the House and rule 3 of the rules of our committee, I would like to have an additional day of hearings on the matters related to comprehensive reforms and, most particularly, both Mr. Oxley's bill and my bill so we can see the best merits of each.
Mr. BAKER. I thank the gentleman.
Mrs. Maloney.
Mrs. MALONEY. Thank you, Mr. Chairman, and welcome to all the panelists.
I would like to ask Mr. Raines, we currently have five big accounting firms, and with the indictment of Andersen there is a possibility that we may soon be down to four; and doesn't the fact that only four auditors will be reviewing the financial statements of America's largest companies require that the industry regulator be a stronger public entity than those that have been proposed by the SEC? Could you comment on what the impact may be with only four firms?
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Mr. RAINES. Well, I think that it is a bad thing that we might face the prospect of having only four major accounting firms in the United States. There are other accountings firms other than these current five. But I think the reduction in the number of accounting firms is not a good thing. I think competition in that market is a good thing. I think having multiple firms is a good thing. And that is a matter of concern, and I hope that is taken into account in future years as firms look to merge or otherwise reduce the number of competitors.
With regard to an oversight body, I agree wholeheartedly that it needs to be a strong body and needs to be one with the power to actually investigate and the power to actually come to conclusions and to make determinations that might include penalties. And you ought to have on it those people who can both instill confidence in the public, but also those people who have some knowledge of the profession and the work to be able to come to decisions.
But it should not be a body that is nearly honorific. It ought to have the ability to not only discipline, but also to look at the quality control procedures within accounting firms to ensure that they are working to become better and they are becoming better at what they do; because I believe the biggest impact they could have is not on the penalty side, but it is in quality control. It is ensuring they are hiring good people and they are training them and they have systems of conflict of interest in place; that they are enforcing their own internal rules, in fact, and actually going to look and review periodic audits and see if those audits meet standards. I think that kind of approach from an oversight body can have a tremendous effect on the quality of audits.
Mrs. MALONEY. There were two questions that have been asked by the prior panel by members of this company. One was rotating auditors, your feeling on that. And another of, say, every 3 years having an auditor come in and look at the audit. And what is your response to those two proposals?
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Mr. RAINES. In terms of the rotation of auditors, there are instances, and particularly in public bodies, that do require rotation. The concern that you have is that in the first year and last year of the audit, you may not have the same quality of the audit that you were looking for. I believe the SEC's evidence is that more frauds occur in the first year of a new audit relationship than in any other time. So I believe the members of the Roundtable would say it ought to be on a case-by-case basis.
In our company we have adopted the practice now of essentially requiring a de novo review of our auditor each year where we would have the same process we would have as though we were doing a new audit selection, where they have to present their credentials and identify their quality control and all the aspects to make a determination should they continue to be the auditor in the next year. And I think that practice can take the place of an automatic rotation, as a rule.
Mrs. MALONEY. With the proposal having, say every third year, another auditor review the work.
Mr. RAINES. Well, currently there is a process in the auditing profession of having another firm come and do a review. But this is a relatively private process in which the SEC is informed of the results, but it is a relatively private process. I personally believe that that is a process that should be overseen by the new oversight body, and that these reviews are used as a way to improve audits, not only to say how did this one firm do, but what did you learn in this case, in this type of a firm, or this type of an industry, and let other people know so that if they run into the same problems, they will know how to go about handling them.
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We don't have a good enough feedback loop so people are learning about what went right and what went wrong in audits. If you have someone come in every 3 years to review the entire audit, that is a massive undertaking for multinational companies that may be in 100 different countries, that to go replicate that audit would be a massive undertaking. I think it would be impractical. But I do believe having these periodic quality reviews, taking random audits and really thoroughly looking at them, could be a very important learning tool.
Mrs. MALONEY. Last week, former SEC Chairman Robert Hills suggested before this committee that audit committees should be given more formal legal status and that independent directors should be nominated by an independent nominating committee rather than by the CEO or chairman of a company. And what is your view of these suggestions?
Mr. RAINES. At least my experience since last fall is that audit committees have quite a status now within corporations. I think our general view would be that designating a particular committee as being independent of the board itself is not a good idea. Committees are just subsets of the boards. Audit committees should be populated by independent directors. And all committee assignments should be made, in our view, through a nominating committee, and that no one person——
Mrs. MALONEY. An independent nominating committee?
Mr. RAINES. Nominating committee of the board.
Mrs. MALONEY. But most board members are appointed by the CEO, so then you would have the CEO control.
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Mr. RAINES. I don't believe the Chairman was really talking about a nominating committee that was independent of the board. I believe he meant an independent committee made up of independent board members. So it would be the nominating committee within the board that would be approving that. That is the practice of the corporations that I am familiar with personally in any event. Certainly the CEO is likely to have ideas, but I also know that very often that the CEO's ideas don't prevail in well-managed companies and that the nominating company ultimately has responsibility of picking both committee Members and members of the board.
Mrs. MALONEY. There has been some suggestion after the Enron debacle that there is a massive hole in our financial services regulatory system for entities like Enron, entities like Enron that act as financial services companies, but do not fit the current regulatory scheme. And do you believe that simply the reporting requirements for public companies to the SEC is regulation enough for these companies? In many cases, banks are very heavily regulated. And in many cases, these entities like Enron are larger than the banks in practicing formal banking practices. So either the bank shouldn't be regulated or possibly these entities should be regulated.
Mr. BAKER. That will be your last question, because your time has expired.
Mr. RAINES. I think you have raised an important issue. We have been talking here about the regulation of financial disclosures. But you are talking about as important, if not more important, safety and soundness regulation. Enron could have disclosed much of this and still have been unsound. And the rise of financial institutions who are not subject to safety and soundness regulation is a matter of concern, because just as surely as a large regulated financial company could cause concerns in the economy and concerns with other investors, you could have that same concern arise with a financial company that does not have a safety and soundness regulator.
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So I think it is important to keep in mind that we need to have appropriate disclosure, but also we need appropriate safety and soundness regulation to ensure that our financial institutions are contributing to a sound economy and not putting our economy in danger.
Mrs. MALONEY. With Enron, do you think there is a gaping hole for these type of entities? Should there be some type of regulation?
Mr. RAINES. I believe that that is an issue that ought to be given very careful regulation. Enron was becoming a financial company. It had no safety and soundness regulation or oversight of any kind. And where we see very large companies becoming financial institutions without safety and soundness regulations, I think that is a concern.
Mr. BAKER. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman. I want to go back to a comment you had a few moments ago and this whole issue of whether or not you preclude an auditor from providing other services. And I agree that you don't want to get caught up in the minutia of saying, well, it can't be this or that, and I understand there is some synergy between tax return preparation and auditing.
But you raise an interesting point which I was trying to raise earlier today with Mr. Pitt; and that is, there are certain things that auditors provide that are verification oriented for investors. And it would seem to me, and again I recall—you may recall from your prior experience—I seem to recall there was an MSRB rule or other rule that precluded auditors from providing other verification numbers in the same issuance that was being done.
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Now, I may be wrong about that, but it does seem to me that is really what we are trying to get at. And I would be curious and, Mr. Livingston, I would like your comments, because you talked a little bit about this in your testimony, whether or not if we proscribe something a little more broadly in the way that Mr. Raines discussed it, that that would be an acceptable form of separating out, saying if you are going to be providing auditing for public companies and even tax return preparation that you can't—at least in the same issuance of a registered issuance—provide other forms of verification. Because I think our concern is not just that there is perhaps padding of other accounts in order to get a more favorable audit, but I think our other concern in the case of Andersen was that they were providing qualified opinions and verification for off-balance-sheet financing which, had they put all the pieces all together, they very likely would have said perhaps it wasn't being properly disclosed.
Mr. RAINES. I may not have been clear, but let me try to answer that. It has been 20 years since I looked at any MSRB rules. I think in my experience in dealing with entities, both entities in financial trouble and entities that are financially strong, is that the auditing firm often is the only consistent source of information. And well done, they require that numbers in one place match up with numbers in another place. And it is a very valuable service that they provide and they typically are very loath to sign off on anything that they haven't had a chance to verify what the source of the information was.
And that is something we don't want to discourage companies from having; having someone who sees all the numbers, so you don't have a case where companies can show part of the numbers to one audit firm and another set of numbers to another audit firm and no one ever compares the two.
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So I think you want to try to have your verification things in one place. But I think what you don't want to do is take the person who is doing verification and then have them doing fundamentally different things that will get them off of what their particular expertise is and into this.
There was an unfortunate phase in the auditing profession where they stopped looking at themselves as auditors and assurance firms and got into being full-scale multipurpose professional services firms. And I think that was a mistake, and I think most of the auditing firms are correcting that mistake now. But I do believe that there is importance in having one firm that looks at all the numbers when you are verifying and making representations to the public, so you don't have things falling between the cracks.
Mr. LIVINGSTON. I would comment, a couple of years ago when we did pass the—the SEC enacted those rules they extended the list of services that auditors should not do, which resulted in a product on which they might end up relying upon. And the problem is, is that it gets—that is a good list of things that they shouldn't prepare the books and then audit the books or build receivable systems and then audit receivable systems.
But the problem gets into when a company is doing very complex transactions and they show the transactions to the auditor. And I think in the Enron case, the auditor may have gotten too involved in the actual design and then auditing the transactions. It takes ethical conduct and professional standards at the local level to regulate that gray area.
Mr. BENTSEN. And I think that was the problematic situation with respect to Enron.
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Let me ask you one other question, Mr. Livingston. In your testimony, you briefly referenced the need that your organization is calling for to review FASB and their rules. Can you expand upon that a little bit?
Mr. LIVINGSTON. Yeah. We have gotten into a bad circumstance in accounting standards over the last 10 years, and we have had accounting standards like FASB 133 which is accounting for derivatives, which is 850 pages long and is unusable by the most sophisticated local audit partners out in the field. There are a handful of people in the world that know how to apply this accounting standard. And that is the unfortunate circumstance we have gotten ourselves into.
We have gone too far in getting away from principle-based accounting standards. In this Enron and accounting for derivatives, FASB 133 has exposed the need to have a new process, a new mind-set, principle-based accounting standards that get back to substance of reform.
When I learned accounting and I studied for the CPA exam, there was one principle called ''substance of reform'' that we have lost in the last 10 years. Form over substance has taken over. And it is an unfortunate lesson, but I think the lesson has been learned and I think we are heading toward faster standard setting that are principle-based, that get back to substance of reform.
Mr. BENTSEN. You sound like the architects have taken over FASB, but I always thought of FASB as being more of an accounting-based institution, as it was. And you say it doesn't work in its current form.
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Mr. BAKER. That has to be your last question.
Mr. LIVINGSTON. It has gotten too focused on narrow problems and not prioritized. It hasn't kept pace with the modernization of technology and hasn't thought about financial reporting as much as here is a problem and we are going to swarm in and spend a lot of time on that. The consolidations project, we spent a lot of time on that. There were many of us that encouraged the FASB to break up the consolidations project, which they worked for 20 years on, and break it up and focus on the SPE issue. And a lot of people said that. And they couldn't step back and divorce themselves of the other part of the consolidations project. They wouldn't let that go and focus on SBEs.
And that is part of the whole problem that has been going on for the last 10 years. I think we have a new mind-set and a new attitude, and I think we will get to the right place.
Mr. BAKER. The gentleman's time has expired.
Mr. Royce.
Mr. ROYCE. Thank you, Mr. Chairman. I was going to ask Mr. Frank Raines of Fannie Mae, a lot of what we talked about today, one of the things we have focused on is compensation structure and making sure that when you have got a board of directors that you are increasing their independence and that you are ensuring that the interests of the shareholder are being represented there on the board and not the interests of management. And I was going to ask, how does Fannie Mae compensate its own board of directors and its audit committee, with an eye toward that specific objective?
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Mr. RAINES. Well, it has been our philosophy for quite some time not to concentrate the compensation of our directors or of our management using only one tool, so we use a variety of tools. Our board is compensated through an annual retainer, meeting fees, and then they also have stock options. And the idea there is to have their focus not just on what is happening this year, but also the longer-term interest of the shareholders.
Similarly for our executives, we compensate with a combination of salary, bonus that is focused on 1 year's performance. In some cases we have focused on 3 years of performance and then options, which is for the longer term. So we don't have any one focus. And, indeed, we provide a disincentive to try to move the stock in the short run, because if stock then goes down, you will disadvantage your compensation which is not going to be paid to you for 3 or 4 or 5 years. So we found that a mix gives us the right balance, that no one tool does the job, but also you don't overweight toward one thing or another.
Mr. ROYCE. You know, if there is a best practices approach to this, what would be gained or lost by requiring all publicly traded companies to submit to a structure—or do you think that is feasible?
Mr. RAINES. I think you can suggest best practice, but I don't know that any of us are smart enough to think that something is going to work in all of these different companies. The companies really all have different personalities and different circumstances. So I would be loath to say that I would know that our structure would be perfect for everyone. But I do think that in the compensation philosophy, these are the kinds of things that should be looked at. And, indeed, now the SEC requires that in proxy statements there be a report from the compensation committee stating the philosophy. And if investors believe strongly in one philosophy or another, that is their opportunity to communicate that to the company. And I think that process has worked for other kinds of reforms, including holding down the number of options so as not to dilute the interest of the shareholders.
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Mr. ROYCE. One other question I was going to ask. How does Fannie Mae report management trades that occur in the company? How do you report those to the marketplace and what timeframe do you report those management trades in company stock?
Mr. RAINES. Fannie Mae is a non-SEC registrant. It doesn't report or use the forms of the SEC. But we have had an insider trading compliance program for many years which prohibits executives from trading at all, except during an open period, and that open period only occurs after we have reported our earnings for the quarter. So we only permit very limited windows. All trading done during that period has to be reported to the company, which is then—all the trading is reviewed by our counsel and reviewed by our regulator.
We have, though, taken note of the proposals that Chairman Pitt has suggested on contemporaneous reporting of these trades. And so we intend starting next month to provide contemporaneous reporting. So within several days of the trades, we will post on our websites all trades by all insiders of the companies. And I believe that will make us one of the first companies to, in fact, implement the idea that Chairman Pitt has put forward.
Mr. ROYCE. I think that is a good move, and I would hope all corporations follow suit with the SEC's suggestion there. And, frankly, I think having that reported in real-time will do a lot to end the abuse there. But I thank you for answering those questions.
Mr. BAKER. Ms. Carson.
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Ms. CARSON. Thank you very much Mr. Chairman. Let me assure you, gentlemen, that I come here with no preconceived notion in terms of what we need to do. What I seek personally are quality control, disclosure, consumer confidence and integrity, business ethics, fairness, understand what constitutes wrongdoing and how the shareholder and then the stakeholders are protected throughout the process.
And I would also hasten to add that I think it is very troublesome that an institution like Arthur Andersen, who has for years been one of the premier accounting firms in this country, has had to go down based on the acts of a few bad apples in a bushel. I am not one who believes you need to throw the bushel out.
I have two quick questions, one of Mr. Raines in terms of on behalf of the Roundtable. You said it is the responsibility of management under the oversight of the board and its audit committee to produce financial statements that fairly present the financial condition of the company and make sufficient disclosures to investors to permit them to access the financial and business soundness of the company.
Can such responsibility be legislated by the United States Congress? I just sent back my shareholder proxy yesterday, and always check yeah. Want to know if you want these people to be on the board, yeah; do you want this kind of committee. It doesn't make to me any difference because I trust the company.
I don't know how in the world Congress can legislate all these things. And additionally, because I know we have a vote on, there was an article in the Wall Street Journal, Mr. Chairman, that talked about Enron, and that is why we are here, this one company. Information was that servicing Enron's derivatives, trading may have been used to mask weaknesses in the company's other businesses such as fiber optic bandwidth, retail gas and power, and water systems.
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Can any of you gentlemen tell me how we can as a Congress ensure that all of these lists of sundry outside entities under one big umbrella can be regulated and audited so that the stockholders and the shareholders will know fully well what the condition of a company is?
Those were two questions. If you don't have time to answer, you can write me, because I know we have a vote on.
Mr. BAKER. Let me suggest Mr. Sherman has a remark, and if you will work with me here, we have an end in sight; because if you don't, we are going to have to come back after a 20-minute delay. And hopefully that will encourage a prompt and courteous response to Mr. Sherman's inquiries.
And thank you, Ms. Carson, for your comments. We are asking for a direct written response, Ms. Carson.
Mr. SHERMAN. Thank you. I first want to comment that I hope that we move toward the most thorough rules with all the identifiable loopholes plugged, rather than just announce that we want to be principles-based.
I would point out that the form over substance principle is part of the rule now, and we never raised that, and it was completely insufficient. I think if we all sing patriotic songs and rededicate ourselves to form over substance, that might work for a year or two. But eventually the people who come to head the aggressive firms will be the aggressive financial managers, and the firms that are selling for 25 times reported earnings will be the aggressive firms, and maybe it will be the aggressive firms that claim that they are not aggressive.
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And I am an old tax guy and I can just imagine what would happen if we went to a principles-based tax system. And keep in mind, the Tax Code and FASB regulations are doing the same things. There are two different systems for determining what your net income is. And if we just urged taxpayers to pay their fair share and relied on principles rather than the most definitive rules, we would have a lot larger deficit than we have now.
I wish I could ask a question, but you would have to stay for another 20 minutes. What I hope that we do is have a third day of hearings and invite those who represent investors to be here. One of the things that I think is one of the problems in this Enron situation is that those who represent investors, mutual funds, pensions, are not represented in Washington given the degree of their importance to our economy, and that most of the people who have come before us are issuers of financial statements, not those who read them with an interested eye. And I look forward to a third day of hearing, but not a 1 minute of questioning.
Mr. BAKER. I want to thank each of the witnesses for their appearance today, and I want to say a word, Mr. Livingston. I appreciate some of the recommendations your organization has made in the testimony today. The Chairman would want me to encourage you, in the days that remain before the committee would proceed to markup of this important bill, that you forward any recommendations or suggestions based on the exchanges you heard today. We have a significantly important task ahead of us, and we need all the best minds we can get to succeed.
Thank you for your testimony and our hearing is adjourned.
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[Whereupon, at 2:45 p.m., the hearing was adjourned.]
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