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SARBANES-OXLEY: TWO YEARS OF
MARKET AND INVESTOR RECOVERY
Thursday, July 22, 2004
U.S. House of Representatives,
Committee on Financial Services,
The committee met, pursuant to call, at 10:04 a.m., in Room 2128, Rayburn House Office Building, Hon. Michael Oxley [chairman of the committee] presiding.
Present: Representatives Oxley, Baker, Bachus, Castle, Kelly, Ryun, Biggert, Fosella, Capito, Tiberi, Feeney, Hensarling, Waters, Maloney, Velazquez, Watt, Hooley, Lee, Inslee, Hinojosa, Lucas of Kentucky, Clay, Matheson, Miller of North Carolina, Davis, and Bell.
The CHAIRMAN. [Presiding.] The committee will come to order.
It has been 2 years since the Congress passed and President Bush signed the most sweeping corporate reform law in our nation's history. The Sarbanes-Oxley Act of 2002 was designed to curb accounting fraud, make financial statements more transparent and understandable, and hold company executives and directors accountable. I am pleased to say that the early returns are in and they are positive.
We all know that no law will stop certain determined bad actors from violating the trust of shareholders. Indeed, if that were shareholders we would have passed such legislation a long time ago. But Congress can establish incentives and disincentives for certain behavior. It does have the ability and the obligation to establish a baseline of professional conduct for American business. If these minimum standards are not met, Congress can help ensure that there will be swift, certain and severe punishment.
Page 2 PREV PAGE TOP OF DOC Sarbanes-Oxley was passed during a period in which a majority of Americans had lost faith in the pillars of corporate life: company executives, public accountants, investment bankers, stock and bond analysts, and attorneys. This mistrust, I would point out, was well founded. Too many failed to act ethically. Indeed, we have learned that many violated criminal laws and will serve time in prison. Sadly, it was more than a few bad apples.
That is the climate in which Sarbanes-Oxley was debated and passed. Remarkably, considering the overheated political environment at the time, it is measured and responsible legislation. Many of its provisions require companies to do things that they were already doing or should have been doing. As companies find that certain mandates like the internal control standard are particularly costly, maybe that is because they were deficient in that particular area.
Numerous parts of the act appear to be working extremely well. Certifications of company financials by chief executives and finance chiefs, independent and empowered audit committees, officer and director bars, and the FAIR fund have all had a very powerful and positive impact, to cite just a few provisions.
Are there increased costs? Yes. Do the benefits of improved financial reporting, more active and engaged boards and trusted markets outweigh these added costs? I believe yes. But do not take my word for it. Recent surveys indicate that a majority of corporate directors believe the act has had a positive impact on their companies and boards. That is not to say that this is a perfect statute. It certainly is not. No legislation ever is, or at least none have been in my two decades here in Washington. But it does appear to be working quite well and for that we should be very proud.
I look forward to hearing from our distinguished panel today. We have heard from many of you before and we obviously like what we have heard because we have invited you back. Welcome.
Page 3 PREV PAGE TOP OF DOC I now look to other members for an opening statement. Are there other members seeking an opening statement? The gentleman from Alabama.
[The prepared statement of Hon. Michael G. Oxley can be found on page 44 in the appendix.]
Mr. BACHUS. Mr. Chairman, I do not have an opening statement.
The CHAIRMAN. We will turn then to our distinguished panel. Let me introduce them, from my left to right: Mr. James H. Quigley, chief executive officer of Deloitte & Touche; Mr. Mitchell H. Caplan, chief executive officer of E*TRADE Financial Corporation; the Honorable Roderick M. Hills, former SEC Chairman and White House Counsel, welcome back; Mr. Joseph V. Del Raso, partner of Pepper Hamilton, LLP; and Mr. Richard L. Trumka, secretary-treasurer, AFL-CIO.
Gentleman, to all of you we are in your debt for appearing today and giving us a good review 2 years later of the Sarbanes-Oxley legislation. Mr. Quigley, we will begin with you.
STATEMENT OF JAMES H. QUIGLEY, CEO, DELOITTE & TOUCHE
Mr. QUIGLEY. Thank you, Mr. Chairman and members of the House Committee on Financial Services.
I am pleased with the opportunity to appear before you on behalf of the partners of Deloitte. Deloitte has 30,000 people in the U.S. and we audit more than 20 percent of the Fortune 1000 companies. I have served in several roles in our audit practice and have first-hand experience on many levels, including as a lead audit partner responsible for signing the firm's name.
As the CEO, I interact with our largest clients and attend approximately 40 audit committee meetings per year, including two this week. I will provide my perspective and insight from the frontline. Sarbanes-Oxley is having a positive impact on the financial reporting process at public companies. I believe the risk of fraudulent financial reporting has been reduced.
Page 4 PREV PAGE TOP OF DOC The effectiveness of financial reporting requires management, audit committees and auditors each to perform their essential role. The requirements in the act are directed to each participant. Management has strengthened their process in part to support the certifications by CEOs and CFOs of the financial disclosures. In addition, disclosure committees have been put in place and they are working effectively each quarter to improve the transparency and completeness of the financial disclosures. And the internal control documentation and related processes which have attracted significant attention when discussions of cost occur is also having a positive impact. It has led to broader acceptance of the responsibility for controls. Line management no longer defers solely to the controller or the internal audit department with respect to controls. This is progress.
Audit committee effectiveness has also improved dramatically. We have seen many well-intentioned efforts to improve audit committee performance, 15 years ago, the Treadway Commission report and more recently the Blue Ribbon Panel. But I observed many audit committees viewed those best practices as good ideas for someone else. The force of law through Sarbanes-Oxley has made it different this time. I see and feel the difference.
The number of meetings is up by 50 percent. The duration of the meetings has also increased by 50 percent, fundamentally doubling the amount of time that audit committees are spending in overseeing the financial reporting process. Members are better informed. They are better prepared and they better understand their essential role. They ask focused, probing questions. Prior to the act, the audit committee chairman would rarely call the lead audit partner in between meetings or in preparation for an upcoming meeting. Since the act over the past 2 years, this has become a very common practice.
Auditors are also stepping up. They have embraced both the letter and the spirit of this new law. We are working more effectively with audit committees and our new regulator the PCAOB. We have built our capacity to handle the Section 404 attestation requirements. At Deloitte, the number of internal control and systems assurance specialists in our firm have been increased by 20 percent and we have provided extensive training to each of our assurance professionals.
Page 5 PREV PAGE TOP OF DOC With respect to cost-benefits, some are honestly questioning whether the benefits exceed the costs. Most questions point at the Section 404 requirements. I believe we need to work through a full cycle of implementation before we revisit the standards, the law or the regulations related to Sarbanes-Oxley and then, after we have made our way through that first full cycle of implementation and have all of those learnings under our belt, we can again revisit and ask if changes are needed.
I believe in the cost-benefit question we need to view this in the spirit of the market cap of each of the registrants. Based on a recent survey by FEI that indicates the average cost of compliance, both costs that will be incurred by the registrant as well as costs that they will pay to the auditor, will average about $5 million per member of the S&P 500. When you view that cost in relation to the market capitalization of that group of companies, it is a very, very, very tiny fraction of 1 percent, .03 of 1 percent of the market cap. When we think about the opportunity that we have to reduce the risk of fraudulent financial reporting, I believe that is a cost that is well paid.
Separate from Sarbanes-Oxley, the SEC issued a rule to shorten the number of days between a company's fiscal year end and the filing of its annual report, from 90 days in 2002 to 75 days in 2003 and to 60 days for 2004. This plan for accelerated filing requirements was conceived before section 404 was enacted. Having to address both these new and significant requirements in the same year is very challenging and will put unusual pressure on all parties concerned that could impact the quality of financial reporting, the audit, and the internal control assessments. Frankly, it might also increase further these costs.
Next week, we will recommend in a letter to the SEC that it delay by 1 year the acceleration to the 60-day filing requirement, making it applicable for 2005 annual reports. This would allow companies and auditors an additional 2 weeks this year to focus on these significant new internal control requirements of the act.
Page 6 PREV PAGE TOP OF DOC Let me conclude. We are making progress, and I believe anytime you assess the impact of a change as sweeping as Sarbanes-Oxley, it is as important to consider the direction you are moving, as well as assess where we are. The risk of fraudulent financial reporting has been reduced by the actions taken to implement the act by management, by audit committees, by the PCAOB, by auditors. I believe it is time to absorb this massive change represented by Sarbanes-Oxley. Let's sustain our commitment to restore investor confidence and avoid future legislation, regulation, or scope of services limitations.
Costly, yes, but I believe these are costs that registrants should be willing to pay in return for the privilege of being the stewards of the public's money.
Thank you, Mr. Chairman.
[The prepared statement of James H. Quigley can be found on page 111 in the appendix.]
The CHAIRMAN. Thank you, Mr. Quigley.
STATEMENT OF MITCHELL H. CAPLAN, CEO, E*TRADE FINANCIAL CORPORATION
Mr. CAPLAN. Good morning. I am Mitchell Caplan, CEO of E*TRADE Financial. We are a leading provider of online, personalized and fully integrated financial services, including investing, banking, lending, planning and advice. A key tenet of our business strategy is to use our proprietary technology and the Internet to deliver an integrated, personalized and value-added financial services experience to all our customers.
I would like to thank Chairman Oxley and the committee for inviting us to share our company's experience with the implementation of the Sarbanes-Oxley Act as your committee examines the law's effectiveness since its enactment 2 year ago. Our experience with this law has clearly been a positive one. At the time this committee was debating the legislation, which became known as Sarbanes-Oxley, E*TRADE Financial was confronted with a serious corporate governance issue.
Page 7 PREV PAGE TOP OF DOC Our former CEO had taken an $80 million pay package amidst a number of unfolding corporate scandals. This excessive compensation package was frankly a surprise to many in the company and revealed flaws in our corporate governance policies and structure. Trust is especially important for the customers and shareholders of financial services companies. This breach of trust for us was a call to action. In 2003, the board of directors aggressively put in place changes to restore the confidence of our employees, our customers, our investors and our analysts. With the resignation of our former CEO, E*TRADE's board of directors took action to address those issues.
The board first separated the titles of chairman and CEO. It brought on four new members to our board of directors. We revamped entirely the audit and compensation committees of the board. We eliminated interlocking directors. We rationalized executive pay. We added a chief risk officer to our management team. We greatly enhanced the internal control processes by establishing additional checks and balances in compliance with Sarbanes-Oxley's Section 404, and we rotated our auditors.
When I assumed the role of CEO, we clearly had lost the confidence of both the investment community and our employees. While excessive executive compensation was the obvious problem, it drove the company to recast the composition and structure of the board and to realign incentives by focusing on rewarding actions that add value to our shareholders.
Today, after working to adhere to the strict guidelines of corporate governance, we have restored investor confidence and investor trust. We have been able to refocus on our core strength, providing innovative products and technology to self-directed investors.
Our implementation of Sarbanes-Oxley 404 has progressed very well, although the process has not been painless. The value we have received from documentation and testing has reinforced management's understanding of accountability for processes and financial reporting across the entire company. It has helped us identify where those processes were deficient or inadequate, and we have designed the necessary improvements to correct those inadequacies.
Page 8 PREV PAGE TOP OF DOC E*TRADE commends the committee for reviewing the Sarbanes-Oxley Act. We would urge you to resist any wholesale changes to the law. No one can fully predict the consequences of a new law until enough time has passed to determine whether it is working as Congress intended. Our management team and our board strongly believe that good corporate governance is a key contributor to shareholder value. The time and effort our management and board has taken to comply with Sarbanes-Oxley has fostered a vigorous, yet healthy internal debate over the company's direction and how to deliver innovative products to our customers, further adding value to our shareholders.
The changes we have implemented reflect the company's transition from a dot com organization into today a mature financial services business. It allows us to focus once again on our business of bringing the best new innovative products and technology to our customers, such as our rebate program for 12b-1 fees and our mortgage on the move product.
Thank you for the opportunity to testify. I would be happy to answer any questions.
[The prepared statement of Mitchell H. Caplan can be found on page 49 in the appendix.]
The CHAIRMAN. Thank you, Mr. Caplan.
Mr. Hills, welcome back.
STATEMENT OF HON. RODERICK M. HILLS, FORMER SEC CHAIRMAN AND WHITE HOUSE COUNSEL
Mr. HILLS. Thank you, Mr. Chairman and members of the committee.
I would like to offer you the perspective of spending 32 years working with 18 audit committees and chairing 10 of them. I suppose the first thing I would say is that as the Enron scandal fades from memory, it is fairly natural that a whole lot of complaints about the act might spring up. It costs too much, say many people. Thousands of honorably run companies should not have to bear the burden caused by a dozen bad companies. Board members and audit committee members have been forced to do much more than they can do. And by the way, some say the public did not really demand this legislation anyway.
Page 9 PREV PAGE TOP OF DOC The fact is that something was badly broken and it needed fixing. A corporate system, a system of corporate governance that was crafted by the SEC back in the middle 1970s had run out of gas. Back then, there were hundreds of American companies, U.S.-based companies that had off-the-books bank accounts, secret bank accounts where monies were disbursed without oversight. Much of that money was used to pay bribes.
The SEC took three steps. It mandated internal controls. It required external auditors to bring anything of a suspicious nature to the attention of somebody independent of suspicion, and persuaded the New York Stock Exchange to require independent audit committees.
Why did that run out of gas? Well, today a quarter of a century later, we have a knowledge-based economy whose assets are determined in large part by the judgments, the assumptions, the estimates made by management, with some oversight by the auditors. It is not the bricks and mortar economy of the past, where historical costs were used to fix those values. So management today has had much greater discretion in fixing the values used in their financial statements.
As management became more innovative in developing their values, the FASB, the Financial Accounting Standards Board, created ever more complex accounting standards and even more complex interpretations of those standards. Accountants to some degree became rule-checkers and to a large extent the basic audit became a commodity. The growing maze of rules became a magnet for the fertile minds of lawyers, bankers and consultants who created these complex corporate structures that wended their way through the maze of rules, satisfying maybe the letter of the rules, but certainly not the spirit.
Audit committees were passive during that period. Auditors did not sit down with the audit committees and explain the alternatives that were available to management in constructing a financial statement. The audit committees did not play a meaningful role in selecting the auditor or selecting the engagement partner, or in fixing the audit fees except in those rare occasions where they suggested the fee be lowered by 5 percent.
Page 10 PREV PAGE TOP OF DOC They did not, in short, take charge of the audit. The auditors for the most part knew that and did not expect to be protected from management were they to begin disagreeing with the estimates, assumptions and judgments made by management. A substantial number of companies took advantage of those circumstances and intentionally manipulated their financial statements. An even larger number, probably acting in good faith, regularly presented a more optimistic view of their financial statement than a realistic appraisal would have called for, simply because the rules allowed them to be that optimistic.
So the question is, will the Sarbanes-Oxley Act fix that? In one sense, the act really rejuvenated the three ideas of the SEC in the middle 1970s. Section 404 surely puts strength into the notion that there must be internal controls. The Public Company Accounting Oversight Board puts enormous teeth into the notion that the auditors have a responsibility to come forward when something is wrong, when something is suspicious. Of course, the act institutionalizes the independent audit committee that was created by the New York Stock Exchange.
It has already had a substantial benefit. Auditors now sit down with the audit committees and say, by the way, here are the other alternatives that were available to management. The audit committee really must take a look at those alternatives and conclude that the way management did it was fair. If the act had been in place, I sincerely believe that Enron and Waste Management, two serious cases, would never have occurred.
In addition, the act says in no uncertain terms the audit committee is responsible for the hiring and the firing of the auditors. It has already had a substantial impact. For one thing, the chief financial officers do not get asked to play golf by the engagement partner anymore.
Will 404 cost too much? The danger here is that companies will treat 404 as a kind of compliance tax, a word used by Ernst & Young in a publication recently, a bureaucratic requirement of no practical value. Just as too many companies have treated the audit as a commodity, 404 can be an expensive appendage if companies do not understand that it can be used and have positive effects. Ernst & Young recently noted that there are a number of companies that believe their investments in rule 404 can have a meaningful return on that investment. That is my experience and that is the experience of the several chief accounting officers with whom I have spoken in the last couple of weeks. The point is that companies can realize substantial value of the 404 effort if they utilize it as a management tool.
Page 11 PREV PAGE TOP OF DOC The most persistent and legitimate complaint about 404 relates to timing. A lot of companies just did not understand the degree of change that was necessary. When they came to understand it, they could not find the talent in the accounting firms needed to complete it. The SEC I hope will give consideration to this problem and where important and necessary, give some extension. That is an issue that I think should be of particular interest to this committee. The problem, of course, is particularly severe with respect to the smaller companies.
Is the burden on directors too great? As Mr. Quigley said, the audit committee members certainly must better understand their responsibility, their job. They have to spend more time at it with more meetings. But the notion that some impossible burden has been created is just not correct. Audit committees need to establish firm control over the external and internal auditors. They have to select their candidates and they have to take charge of the fee negotiations. In particular, they must pay far more attention to the selection, retention and compensation of the internal auditor. If they take those steps, they will have a large, competent and experienced staff that will keep them well informed of all their responsibilities as members of the audit committee.
One final comment, concern has been expressed, particularly by Peter Wallison of the American Enterprise Institute. He expresses a fear that the SEC and the PCAOB will use the act to insist upon strict adherence to existing accounting standards and will therefore preserve that maze of rules that contributed to the accounting problems of recent years. I hope not. Both agencies should take note of the growing body of thought today that seeks fewer accounting rules and more judgment to be used in the constructing of financial statements.
I have attached to my testimony a copy of a report done by an unusually experienced group of professionals with respect to the accounting profession called the Future of the Accounting Profession. It discusses this problem at length and then it endorses a theme the Chairman may have heard me use before, expressed by Economist magazine, that warns us not to continue to rely upon the brittle illusion of accounting exactitude which tends to collapse in periods of economic strain. I very much hope that this committee would accept that theme.
Page 12 PREV PAGE TOP OF DOC Thank you.
[The prepared statement of Hon. Roderick M. Hills can be found on page 67 in the appendix.]
The CHAIRMAN. Thank you, Mr. Hills.
Mr. Del Raso, welcome back to the committee. I think you were here 2 years ago.
STATEMENT OF JOSEPH DEL V. RASO, PARTNER, PEPPER HAMILTON LLP
Mr. DEL RASO. Yes, I was. Thank you.
Good morning, Chairman Oxley and distinguished members of the committee. Thank you for this opportunity to present my views on the impact of the Sarbanes-Oxley Act over the last 2 years.
I am Joseph Del Raso, a partner in the law firm of Pepper Hamilton, LLP. My practice focuses on corporate and securities matters, particularly matters related to securities regulation. I served as an attorney-adviser with the Securities and Exchange Commission in the 1980s and I have served as a member of the board of directors of both public and private companies. 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 the Sarbanes-Oxley Act over the last 2 years.
Overall, I believe the impact has been a positive one. While there are costs, in some cases material costs, and occasionally perceived regulatory overkill associated with the implementation of the act, it has done much to restore the faith of investors in the way in which public companies operate and report financial results.
Just as importantly, it has helped give directors and corporate officers the tool they need to meet their obligations and be accountable to shareholders. I commend the committee for its levelheaded and responsible approach to this act.
Page 13 PREV PAGE TOP OF DOC On the topic of positive changes. I would first like to address the positive impact of the Sarbanes-Oxley Act on domestic issuers. The act has increased the awareness of the need for corporate accountability and transparency and given greater attention to best practices in corporate governance. It has prompted procedures to establish internal controls to ensure compliance. It has highlighted the need to take prompt remedial action when problems are uncovered in order to reassure the global markets of the safety and integrity of our capital markets in those issuers who access them.
It has increased the protection of shareholder interests, thereby increasing shareholder confidence. It has highlighted the need for improved risk management and should produce the long-term effect of mitigating the costs of insurance, indemnities and potentially large awards, including punitive damages and governmental fines for systemic failure of the corporate entity. It has increased attention to the need for accountability directly to shareholders in matters of corporate governance.
On the topic of costs and the perception of regulatory overkill, the implementation of the Sarbanes-Oxley Act has not entirely been a bed of roses for some. The costs of compliance often can be burdensome. Reviewing internal financial controls, improving those mechanisms when necessary, and ensuring that the processes are well documented is time consuming and costly, in some cases, costing companies millions of dollars and thousands of hours annually. However, I believe that what corporate officers and directors need to keep in mind is that the cost of compliance is not nearly as burdensome as the cost of failing to comply.
What was at risk in 2002? What this act was designed to prevent was the threatened loss of confidence by investors throughout the world in our capital markets. That loss of confidence does not just affect companies with poor corporate governance or negligent or outright criminal leadership. Good companies as well as bad and millions of investors suffer the consequences when people lose faith in how companies operate and result their results.
Page 14 PREV PAGE TOP OF DOC I look at the costs associated with compliance as a necessary and prudent investment in the long-term stability and success of our capital markets. However, we must be careful not to stifle entrepreneurship and capital formation for emerging businesses. The initiatives of the SEC in the early 1980s to adopt rules to allow smaller companies's access to the public capital markets produced very positive outcomes. Some may argue that smaller issuers may not be suited for public ownership if they cannot afford the cost of Sarbanes-Oxley compliance. But that is not the appropriate focus. We should always encourage small businesses to grow and not overburden them with intrusive regulation.
On the other hand, we have learned that an environment of careless behavior and lack of respect for both the investor and the government's oversight and regulation produces nothing but financial and societal losses. We must balance the need for entrepreneurial freedom and reasonable government oversight, and for that reason it may be necessary to revisit and fine-tune this legislation from time to time.
I urge this committee as it examines future regulatory actions to be careful not to overburden the average issuer with overzealous enforcement and unreasonable intervention, to not pile on with additional regulations that make compliance more difficult, that are simply not practical. Further regulatory action should be adopted only after a thorough analysis shows that the benefits of the new regulations outweigh the risks that will make compliance overly burdensome on the average issuer.
Overzealous regulatory action and enforcement can also poison the atmosphere between regulators and industry and stifle the discipline and sense of cooperation between the government and those it regulates. The vast majority of corporate officers and directors act ethically and take their fiduciary responsibilities seriously and will welcome legislation, regulation and guidance that helps them meet their obligations to shareholders. However, when the regulators and the regulated find themselves in a constant adversarial atmosphere, the spirit of compliance and good corporate citizenship may erode into one of combat mentality. Operating in that environment is not consistent with our democratic traditions of creativity and free enterprise.
Page 15 PREV PAGE TOP OF DOC In the area of corporate governance, the impact of Sarbanes-Oxley has been profound. Independent directors are exercising their responsibilities and paying much more attention to detail. I can tell you from personal experience that board meetings are longer and have much broader agendas. Audit committees are meeting more frequently and are increasing the number of executive sessions with auditors. Special committees, especially those charged with internal investigations, are moving very quickly when troubling matters surface. No longer are independent directors satisfied with the assurances of management that everything is in order, or worse, sweeping corporate problems under the rug.
The act has also increased shareholder activism. In general, this may be viewed as a good thing. Boards need to be careful not to confuse, though, the political and social agendas of shareholder initiatives with their obligations to meet the goals of the majority of shareholders and to adhere to best practices.
Impact on global markets. I would like to particularly note that the impact of the Sarbanes-Oxley Act on the global financial markets. When first enacted into law, this legislation was met with some trepidation by foreign issuers. In speaking with foreign diplomats and issuers, I was impressed with their positive reaction to the responses of our regulators in this area. The SEC in particular worked quickly and effectively to harmonize the effective compliance with the special concerns of foreign issuers.
I had the opportunity last March to organize a symposium related to this topic in Italy at the American University of Rome. The participants included high-level securities regulators and issuers from several foreign countries. The consensus of the participants was to America's credit, when faced with the severity of a crisis such as the corporate scandals of 2002, we are quick to react and remedy situations. The swiftness both in prosecution and in legislation reassured the global markets that America was serious about protecting the interests of all investors.
Page 16 PREV PAGE TOP OF DOC It is also interesting to note that issuers who sought to bypass their Sarbanes-Oxley responsibilities by listing on foreign exchanges have not been able to find much relief. For example, regulatory requirements for listing companies on the exchange in London have also been intensified.
Long-term effects. Returning for a moment to the cost of compliance, I would offer one more comment. I view the cost of implementing compliance systems as similar to that of installing fire protection systems in buildings. While it may be cheaper to build an office building without sprinklers, in the long run the increased costs of insurance would likely outweigh the initial savings. More to the point, if a fire starts to smolder, it can either be quickly extinguished with little loss when the alarm is tripped if the building is so equipped with an effective fire protection system, or ignite into a raging inferno that consumes the entire edifice. The corporate entity is no different. Early detection and action is obviously preferred to the risk of a catastrophic loss.
I have also noticed an increased interest in developing programs to educate officers and directors. Professional firms, and more importantly academic institutions, have already designed and offered to support corporate directors and executives in these areas.
In conclusion, Mr. Chairman and distinguished members of this committee, thank you again for the opportunity to testify on the impact of this important piece of legislation. Much of the commentary after the passage of the act called it the most sweeping securities reform since the passage of the exchange acts of 70 years ago. I believe that is true. No law can completely prevent scandals such as the collapse of Enron, WorldCom and Global Crossing. In the end, you cannot legislate personal character and morality. But I strongly believe that the Sarbanes-Oxley Act has reduced the risk of such scandals. Like many corporate officers, directors and professionals, they may not agree with or like every aspect of this legislation, but if it continues to have the desired effect, the ongoing restoration of public confidence in the capital markets, then the Sarbanes-Oxley Act has indeed met its objectives.
Page 17 PREV PAGE TOP OF DOC [The prepared statement of Joseph V. Del Raso can be found on page 61 in the appendix.]
The CHAIRMAN. Thank you, Mr. Del Raso.
STATEMENT OF RICHARD L. TRUMKA, SECRETARY-TREASURER, AFL-CIO
Mr. TRUMKA. Good morning, Mr. Chairman and members of the committee.
Two years after its enactment, the Sarbanes-Oxley Act remains an outstanding example of government acting in the public interest. While the work of reform remains unfinished, America's retirement savings are substantially more secure today because of Sarbanes-Oxley. Both Houses of Congress and both sides of the aisle have reason to be proud of this act.
Working families's retirement security is, in large part, dependent on the integrity of our capital markets. We estimate that union members' pension funds lost over $35 billion in Enron and WorldCom alone. But for those with the bad luck to work directly for those companies and other problem companies, the consequences were far more serious: lost jobs, lost health care, and for many the complete loss of their 401(k) retirement savings invested at the urging of their employer in what ultimately became worthless company stock.
So we are particularly pleased that the Sarbanes-Oxley Act addressed many of the systematic issues that we had urged this committee and the SEC to address in our December 2001 testimony on Enron's collapse, issues like auditor and director independence. But the success of Sarbanes-Oxley stems not only from its specific provisions, but also from the tone it set and the message that it sent. Since its enactment, the act has been impressively augmented by the work of the SEC, the Public Company Accounting Oversight Board that the act created, the New York Stock Exchange and the NASDAQ and the work of state attorneys general, most notably Eliot Spitzer of New York.
Page 18 PREV PAGE TOP OF DOC Equally important, the message was heard in corporate boardrooms across the country. In the two proxy seasons since the act's enactment, investors themselves have pushed companies to have truly independent boards to rein in executive pay and to manage their audit process more effectively. The AFL-CIO is very proud of the role that unions and worker pension funds have played in the efforts by sponsoring over 360 such proposals, 48 of which received majority votes at company annual meetings.
Of course, Sarbanes-Oxley has its critics. Some companies seem unhappy with the act's requirement in Section 404 that companies strengthen their internal controls. There is no question that compliance with Sarbanes-Oxley imposes costs on American business. But there is ample evidence that these costs are far less than the alternative costs of more Enrons and WorldComs, evidence cited in more detail in my written testimony.
Recently, Senator Sarbanes noted that the job is not done. One could conclude this simply by looking at the data on the one issue of financial statement integrity. Last year, a record 206 public companies revised their annual financial statements according to preliminary figures compiled by the Hudson Consulting Group. And PCAOB Board Chairman William McDonough announced last month that his examiners are still finding significant problems with auditor compliance.
But there is a deeper sense in which corporate reform is an unfinished task, Mr. Chairman. We believe the underlying causes of the corporate governance crisis lie in the weakness of corporate boards and the short-term orientation of public company CEOs. As long as CEOs completely dominate the selection process for company directors, we simply will not see at problem companies the kind of vigorous independent boards that we need and that Sarbanes-Oxley called for.
The SEC has proposed to address this problem by giving long-term investors with a substantial stake in public companies the right to have their board nominees included on management's proxy. The commission's proposed rule on proxy access is an example of real bipartisan leadership. It has received more public comment than any other proposal in the commission's history, over 14,000 comments, with the overwhelming majority supporting the Commission's rule.
Page 19 PREV PAGE TOP OF DOC Second, investors still have inadequate disclosure of the facts on executive pay and the financial impact of that pay on the companies that award it. The most important step in this area is the proposal by the Financial Accounting Standards Board for mandatory stock option expensing. Executive stock options reward short-term decision-making and, as Enron painfully demonstrated, encourage stock price manipulation through creative and even fraudulent accounting. They should not be subsidized by dishonest accounting rules. Yet we believe, in our opinion, the House bill that passed on Tuesday truly attacks the integrity of our financial accounting system.
It appears that the battle against option expensing is being waged on behalf of CEOs with option mega-grants who frankly want to hide the true costs of their compensation from their shareholders and would-be investors. According to SEC filings, the CEOs of the 11 public companies who are the members of the International Employee Stock Option Coalition hold on paper a combined $977 million in unexercised stock options. The CEOs are going against the express wishes of their shareholders. In 2003, a majority of shareholders at 30 companies voted for stock option expensing. So far this year, shareholders at Hewlett-Packard, Intel, PeopleSoft and Texas Instruments have done the same. Clearly, as reform efforts get closer to the heart of what is going wrong in the corporate governance system, resistance from the CEO community will intensify.
However, only by truly creating transparency and accountability in the boardroom can the underlying dynamics that brought us Enron and WorldCom be addressed and the purposes of Sarbanes-Oxley be fulfilled.
Let me conclude, Mr. Chairman, by expressing my deepest appreciation to the committee on behalf of the working families of the AFL-CIO for not only inviting the AFL-CIO to appear today, but for the actions you have taken in making the pensions of America's working people more secure.
Page 20 PREV PAGE TOP OF DOC Thank you, Mr. Chairman.
[The prepared statement of Richard L. Trumka can be found on page 137 in the appendix.]
The CHAIRMAN. Thank you, Mr. Trumka. I do not often get that kind of praise from the AFL-CIO. We are recording this.
Before I begin the questions, I just want to comment. This is almost the 2-year anniversary now of passage and signing of the Sarbanes-Oxley Act. A lot of folks in this room truly made it happen. This was a classic example, I think, of bipartisan legislation where we faced up to a very severe loss of confidence in our capital markets, something that I had not seen certainly in my lifetime. Our committee was the first committee to hold a hearing on the Enron situation. That was back in December of 2001. That process began with a bill that we introduced early the next year, 2002, that we called the Corporate Accountability and Responsibility and Transparency Act, CARTA.
Ultimately, that was the vehicle that this committee ultimately passed out by a better than three-to-one margin, and then took to the floor a few weeks later with virtually the same success on the floor, with over a three-to-one margin, which I think made all of us on the committee quite proud. I want to say to my colleagues that were participants in that it was one of the best experiences I have had as a legislator here in my 23 years. I think all of us who had a part in that can look back with a great deal of pride. All of you gentlemen were quite praiseworthy and we really do appreciate it. It was, I think, in the best tradition of legislating and hopefully doing it right.
Let me begin with Mr. Hills, who has been here before, and he has been Chairman of the SEC. He has been around the block. He served on boards. We could not have a better witness than Rod Hills. I get a lot of questions, particularly regarding 404 and the costs. The questioner is always careful to couch it in rather benign terms, but the fact is that there are, particularly among smaller and medium-size companies some concerns about costs. I have had some very interesting discussions with corporate CEOs who at least have entertained the thought of going private. Some actually have, although I think it is a relatively small number, about the same number probably of European companies that threatened to de-list after passage of the act.
Page 21 PREV PAGE TOP OF DOC Let me ask you this. Did we give enough flexibility to the PCAOB and the SEC to try to ameliorate some of those costs with small-and medium-size companies? Or is that something that perhaps we need to study further?
Mr. HILLS. Mr. Chairman, I believe that there is enough flexibility. Just as we have to learn how the act works, we have to learn what the flexibility is. There are a couple of issues that could be dealt with. There is a particularly sore point between the requirement that the external audit attest to the efficacy of the work done internally. In a sense, there is a feeling that you have to do it twice. So the company gets an external consultant, usually one of the big four. They already have a big four company as an external auditor, and then they have the internal auditor do the work. So there is a hesitancy in these organizations to give the attestation that people want.
My own sense is that it is working out, that the external auditors are relaxing a little bit and see that the internal auditors are doing a pretty good job in creating systems. I do think that when we finish this season, that it may be possible for the PCAOB to see that some relaxation is possible. I am really quite convinced that more and more companies are understanding this can be a management tool.
I have watched the headlines, as you have, from some of the more prominent critics of the act. I have called their chief financial officers to say, well, is it really as bad as your CEO said? On most occasions, I have found that the audit committee of that company has been told by the chief financial officer, well, there are some problems with it, but there really are very positive aspects to 404.
So the question is a good one. I think that this committee should ask it. I am quite confident that both Chairman Donaldson and Chairman McDonough both understand that there may be some flexibility, some adjustment needed. But I am quite satisfied there is the capacity to do that.
Page 22 PREV PAGE TOP OF DOC The CHAIRMAN. Thank you.
I would like to ask each one of you to comment if you would like. One of the provisions that was added in the other body that was retained in the conference report, which I had some real concerns about, was the whole issue of corporate loans and how they would be addressed. I have heard some legitimate criticisms about that particular provision, how difficult it is in terms of moving expenses for officers of the corporation, that kind of thing, insurance coverage and everything. Is that a legitimate concern? If so, are there ways that we can deal with that problem to make it work?
I think everybody understood the reason for that provision being added in the Senate because it was during the WorldCom meltdown, and this committee had a hearing with Bernie Ebbers and the top people from WorldCom, who took the Fifth, so they were not much help. But the fact is that in this case Bernie Ebbers had gotten a $400 million loan from the board and the amendment that was offered by Senator Schumer I think was going at that issue, that abuse, which is understandable. My sense is it might have gone beyond just that, and included a lot more in that. I just wonder if we could start with Mr. Quigley and just go down the panel as to what kind of reaction you have.
Mr. QUIGLEY. I think that perhaps that is one example where we want to try to swing the pendulum, moving from do not loan $450 million to Bernie Ebbers, to do not loan anyone a penny for any purpose, perhaps is going too far. There are legitimate business purposes where you are trying to relocate an executive and it is very customary to be able to provide some form of an advance to pay the costs associated with that relocation, which is then repaid by the executive at the time that the relocation is completed.
But I think some moderation with respect to that provision would be prudent, and it would facilitate business in the ordinary course. I think we can still have prohibited the abusive practices that that provision was intended to shut down.
Page 23 PREV PAGE TOP OF DOC The CHAIRMAN. Thank you.
Mr. CAPLAN. Mr. Chairman, I would tell you at the time that Sarbanes-Oxley was passed, our company was dealing with that. We had an extraordinary number of loans outstanding to our executives for a variety of reasons. We have chosen to actually shut down the process entirely. We are of the view that it is just not appropriate and that, frankly, if we need to recruit somebody who needs compensation for the move, we pay it like we would pay for anybody else. It is part of their compensation and we report it accordingly. So we are actually quite comfortable with it. I think it is easier to adhere going forward to not have any of these loans.
Mr. HILLS. I think there are probably two or three different problems here. One is that understandably law firms give very broad opinions about what you can and cannot do, and law firms are very careful never to be wrong, so I do believe they have pulled the noose too tight. Company credit cards are now coming under fire because the theory is that if I have taken a trip and charged it on my credit card, I might have had my suit pressed. The hotel bill may have been legitimate, but my suit press was an advance or a loan. So some of that can be taken care of just by, I would think, the SEC's general counsel could issue a few statements and you could get there.
I am in agreement with Mr. Caplan's comment. In 1970, I became the accidental chairman of Republic Pictures. The first thing I found was that the stock had gone from $80 to $2. The top five executives of the company had borrowed over $8 million from the bank for themselves using their stock as collateral. That was just the practice throughout America, that you got to be rich, you got your stock blown up pretty high, you borrowed money against it, the collateral was the stock, and the bank that loaned the company money loaned you the money. And it was a disaster.
Page 24 PREV PAGE TOP OF DOC So saying you cannot do it is a pretty good rule. Chances are that if a year from now the chances are that it will sort out and there may be very well something that this Congress should do to open it up a little bit. But right now, I think it is sweating out some very serious problems.
Mr. DEL RASO. As the lawyer speaking, we are very careful about the opinions we give out. I would say that anecdotally you will hear a lot of these stories, but the example we used at our firm was, if you are traveling on business and you watch pay-for-view, which is not reimbursable, you have taken an impermissible loan from the company. That is where the pendulum I think may have swung too far.
But I think the real core of the problem was the example of the employee relocation. Reasonable and customary expenses of operating the corporation that either if expensed out as compensation or advanced as a loan, were much different than its senior executives using the company's bank lines as their margin account. The problem developed with large fortunes being built up in the company's stock, a reluctance to realize those gains either to pay tax or to not depress the value of the stock in the market, and ultimately leverage works well when it is working, and it is catastrophic when it does not.
I think that is where the idea of some type of safe harbor guidance Q&A from the SEC would help to distinguish appropriate, and especially, I do not want to call them de minimus, but more in the ordinary course of loans for a broader group of employees than just, again, using the company's bank account as your own margin account for your stock holdings.
Mr. TRUMKA. Yes, Mr. Chairman, we support the existing rule. First of all, we think that there is no way to start policing exceptions to the rule as they start coming up. They may be well intentioned at the beginning, but they quickly get out of hand. We think that corporate reform is only starting to take root right now, and it would send the wrong message to change that provision at this time.
Page 25 PREV PAGE TOP OF DOC The CHAIRMAN. Thank you. My time has long expired. We appreciate your patience.
We are going to recognize the members in order of appearance. The first questioner is the gentleman from Texas, Mr. Bell.
Mr. BELL. Thank you very much, Mr. Chairman. I greatly appreciate the testimony offered here today, coming from Houston which offered the world the poster child for bad corporate behavior. Obviously, we were glad to see the legislation and I am glad to hear what you all had to say about it today, in that it seems to be having a positive effect.
I do think going forward you have to look at it and see if there is any room for change and look at perhaps some of the negative effects. One thing that I have heard, and Mr. Del Raso I will start with you, and perhaps you have either from clients or from your own personal experience, some smaller corporations, some smaller businesses having difficulty finding qualified people to now serve on boards because of the heightened liability and the fears associated with that increased liability. I am curious as to whether you have heard anything like that, and if you believe that it is a problem that needs to be addressed.
Mr. DEL RASO. It was especially a concern with the passage of the legislation. I think it still is a concern because qualified individuals who would be willing to take a corporate board directorship are going to be a lot more careful about where they want to get involved. The downside to that is if you have a situation where an emerging business is seeking public access to the markets, new technology initiatives or what have you, are these people who really should serve there, too, as the stewards of the corporation going to be willing to step up and take that risk? Because as we all know, the chances for a problem in the smaller startup companies traditionally were thought to outweigh those of the larger, more seasoned companies. In a number of areas we were proven wrong, though, in the last few years because some very large perceived deep companies had their problems.
Page 26 PREV PAGE TOP OF DOC So I think that that is a problem. But the one thing I would point out is, again, we need the long-term approach. I think we are seeing now a swing in insurance rates for director and officer liability insurance, which was just reported in the last couple of weeks. From a risk management underwriting standpoint, I think the more these best practices and these safeguards are in place, we may find that with the perception that the catastrophic litigation occurs, those losses, either in derivative suits against the directors directly are actions that could really damage the corporation. We may find that this legislation may mitigate that, and you will see then a return of people more willing to step up to those positions.
Mr. BELL. Mr. Hills, do you have any thoughts on that?
Mr. HILLS. I do. It is an extremely good question. For about 60 years or so, directors were brought on board for their resumes, not their knowledge. What has happened in these recent years, both because of Sarbanes-Oxley and because the New York Stock Exchange has stepped up to the question of governance committees is that corporate boards are trying to decide what they need on a board. All of a sudden, the incentives of our capitalistic world work, all the headhunting firms have hired all kinds of people, but look much deeper for candidates.
What you have now is a way better quality of person being considered for boards, not people you may have read about in a headline, but scientists, doctors, professors who have real experience. So you have a growing body of people with the background that should be on these boards. It is an adjustment, as Mr. Del Raso said. We are going through an adjustment period, but there is a body of people coming forward as candidates for boards way better and way bigger than we have ever seen before.
Mr. BELL. And a willingness to serve by those individuals?
Mr. HILLS. Yes. I have, sadly, had more trouble with companies than anybody would ever want to have, and I still see a willingness to step up. If quality is wanted on a board, people of quality will go on the board.
Page 27 PREV PAGE TOP OF DOC Mr. BELL. So some of the individuals who may be refusing to serve would be of a lesser quality in some instances?
Mr. HILLS. I think this. I get asked a lot about whether they should go on a board. My answer is, who chose you? If there is an intelligent governance committee that is really working the problem to find a competent board, then it is a way better board to serve on. If you are there at the whim of the CEO, even a good CEO who played golf last weekend with somebody and would like that person on the board, then it is probably not a good board to serve on.
Mr. BELL. Mr. Quigley, I was going to ask you. In a recent poll, a slim majority of CPAs said management is more accountable because of Sarbanes-Oxley, but less than a quarter said shareholders are getting better information. Moreover, less than 10 percent said investors are making better decisions. In your opinion, why are the positive effects of Sarbanes-Oxley apparently not trickling down to those it was intended to protect in that particular instance?
Mr. QUIGLEY. I did not hear when you said ''more than.'' I just did not pick up your question exactly. If you would please, just one more time?
Mr. BELL. Less than 10 percent said investors are making better decisions, and then only a slim majority of CPAs said management is more accountable because of Sarbanes-Oxley.
Mr. QUIGLEY. With respect to the majority about management being more accountable, I certainly would be strongly with that majority because I have watched the behavior change as the certification process has unfolded. I have watched how CEOs act. I have watched how those cascading representations move through the organization. I truly believe that management broadly, very, very deep in the organizations, understands the importance of transparent financial disclosures and those financial results. It is no longer the purview solely of financial management. I think that is very positive.
Page 28 PREV PAGE TOP OF DOC In terms of the quality of investor decisions, I just do not have a comment on that element of the survey. I think the transparency and the completeness of the financial disclosures that are available to investors to consider as they make their investment decisions, it is absolutely there for them to take advantage of. If they choose not to, I cannot comment on that.
Mr. BELL. Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman's time has expired.
The gentleman from Alabama, Mr. Bachus.
Mr. BACHUS. Thank you, Mr. Chairman.
Mr. Chairman, my first question, well really I want to make a comment to Mr. Quigley. I want to commend the entire public accounting profession. I believe that public accounting has been really at the forefront of restoring public confidence in corporate governance and investor confidence in financial statements, in auditor independence and in internal controls. I would say that in response to that survey, I think that among knowledgeable people in the financial community, they believe that things are working much better.
So my question is this. In your statement you talked about the PCAOB's oversight of public accounting. Have you had your inspection thus far?
Mr. QUIGLEY. First of all, as I mentioned in the testimony, the PCAOB is the new regulator for the accounting profession. After 100 years of self-regulation, we now have a new regulator. Last year, Deloitte along with the other big four firms voluntarily submitted to a preliminary inspection. We did that without it being required, even though we had just simply registered as a public accounting firm under the act. We were not at that point required to submit to that initial inspection. We, along with the other big four firms, voluntarily submitted to this preliminary initial inspection.
Mr. BACHUS. How did that inspection process work?
Page 29 PREV PAGE TOP OF DOC Mr. QUIGLEY. I believe it was healthy and helpful in terms of the visibility throughout our firm that our regulator was inspecting our performance on some selected engagements. We are in the process right now of reviewing a draft report from those initial preliminary investigations. Again, I think we are absolutely committed to improving audit quality. I think we are making progress and I believe that our new regulator, the PCAOB, is a very important catalyst in helping us continue to take these steps forward.
Mr. BACHUS. So I take it that the inspection process was, in your opinion, effective?
Mr. QUIGLEY. I think it was constructive and helpful and supplemented the existing internal inspection that we have ongoing every year within our firm. Now our first formal required inspection is currently under way. I have had my interview as the inspectors were reviewing and meeting with me, to assess the tone at the top of our organization. Again, I think they are an important, constructive catalyst to help hold us accountable and to continue our efforts at sustained improvements in audit quality.
Mr. BACHUS. If there anything about them that you would change?
Mr. QUIGLEY. I think it is just too early to tell right now at this point. I really believe and feel strongly that we have a shared responsibility to strengthen investor confidence and to improve trust and confidence that our capital markets require in order for them to be effective. I think there are obligations of the regulated, the accounting profession, and obligations of the regulator to work collaboratively with that goal in mind, improved trust and confidence. I think we are in the right direction right now.
Mr. BACHUS. Okay.
Mr. Caplan, E*TRADE has extensively revamped its board structures, as you indicated. Has it been more difficult to find acceptable board members since Sarbanes-Oxley was enacted?
Page 30 PREV PAGE TOP OF DOC Mr. CAPLAN. In fact, it has been easier. As a matter of course at the time at which we were revamping our board, quite frankly I had concerns about our ability to get really qualified new board members because of everything we had been through. Although we had no issues whatsoever from either a financial reporting or accounting irregularities perspective, we certainly had a lot of notoriety with respect to executive compensation.
As we went through the process, the board worked very diligently on trying to determine who was missing from a skill set and what we needed to really round out the board exactly, as had been described before. In that process when we went out to look, we were able to find 40 qualified candidates. In fact, when we began we thought we would only add two new board members. As a result, we added four because there were so many really qualified candidates.
Mr. BACHUS. Okay.
Mr. Trumka, there is a recent Harris poll of investors that said almost 60 percent, 59 percent found Sarbanes-Oxley would help them safeguard their investments. Actually, 57 percent of investors say they are unlikely to invest in a company not in compliance with the act. Is that basically your experience?
Mr. TRUMKA. We are finding more and more investors looking to Sarbanes-Oxley as a guideline as the minimum that they do for investment. So the answer is yes, and I think you will see that percentage increase. Shareholders at existing companies are urging that, and many of the private companies that are not subject to Sarbanes-Oxley are now adopting it voluntarily. We think it made foreign investors, it makes things more transparent and more likely that, for instance, pensions funds that do their investing are likely to realize a gain and protect their beneficiaries.
Mr. BACHUS. Okay, thank you.
Mr. TRUMKA. Thank you, sir.
The CHAIRMAN. The gentleman's time has expired.
Page 31 PREV PAGE TOP OF DOC The gentlelady from Oregon, Ms. Hooley.
Ms. HOOLEY OF OREGON. Thank you, Mr. Chair. I have a couple of questions.
We have just heard from Representative Bell that said 10 percent of investors feel they have more information as a result of Sarbanes-Oxley. That is not a very high percentage. Mr. Caplan, what other information might be useful for investors so that would not be terribly burdensome on companies? And what can all of us do to improve transparency in disclosure?
Mr. CAPLAN. One of the things that we were challenged with as we began to go about improving corporate governance was a perception in the marketplace with both our investors and our analysts that we were not as transparent as we could be. So we have taken it upon ourselves not only in dealing with how we report in ours Q's and our A's, but also we do monthly reporting as to a lot of our key metrics in our business. When we do our quarter reporting as a public company, we have attached now our press release in terms of the information. It is about a half a page and we have about nine pages of additional information that we attach, really outlining all of the key drivers of our business and how we are succeeding or doing, both on a quarter-over-quarter basis and year-over-year basis.
So I think it really is incumbent upon companies today to ensure that investors are getting timely information about the key drivers of their business and the success or failure thereof.
Ms. HOOLEY OF OREGON. I think it is really important that we make sure that investors have confidence in the companies. I do not think you can give them too much information. We need to raise that confidence level still now.
Mr. CAPLAN. I agree.
Ms. HOOLEY OF OREGON. Mr. Quigley, what is your assessment of the future of the accounting profession? Has Sarbanes-Oxley changed that perception as a profession? Are you having success in recruiting people to the profession that have the kind of depth that we all count on in the accounting profession?
Page 32 PREV PAGE TOP OF DOC Mr. QUIGLEY. First of all, I am very optimistic about our future. I believe Sarbanes-Oxley has contributed in a very constructive way to the relationship that we enjoy with our key clients, and especially as has been discussed, this new client, the audit committee. We are finding on campuses very, very qualified candidates looking forward to the challenge of a career in public accounting and the increased visibility that the act has brought has contributed in a positive way to the quality of the students that are attracted to the profession, and I believe the career opportunities that we can provide for them. So we continue to be successful competing in the marketplace for experienced hires and also competing on campuses for the very best students.
Ms. HOOLEY OF OREGON. Thank you.
Mr. Hills, I understand that a number of the provisions of the Sarbanes-Oxley Act are similar to requirements that are already applicable to banks. Are there increased compliance requirements for banks because of these dual layers of requirements? Are there significant costs associated with that requirement? And the second part of the question, many banks are not publicly held and therefore not subject to many of the Sarbanes-Oxley requirements. Are the bank regulators imposing those requirements on private banks?
Mr. HILLS. I can quickly tell you know more than I know.
The bank examiner's role is a different role than we have historically had in the publicly traded industries. I do not know anything significant by reason of Sarbanes-Oxley has affected that relationship. I think the question you raise, though, is kind of interesting both because of its own background and because of the nature of the Public Company Accounting Oversight Board. The Chairman Bill McDonough, was the President of the New York Fed. I think he is approaching the job not unlike the manner in which bank examiners approach the job, by going to the accounting firms and by looking at the high-risk audits to try to find the problems before they erupt, and in one sense of the word substitute prior examination for later enforcement.
Page 33 PREV PAGE TOP OF DOC So having now ducked the question, I will leave it to somebody else to tell you just exactly what is happening.
Ms. HOOLEY OF OREGON. Mr. Del Raso?
Mr. HILLS. I would like to add one more thing, though.
Ms. HOOLEY OF OREGON. Yes?
Mr. HILLS. In my written testimony, I added this report called The Future of the Accounting Profession. I surely would like more people to read it and I hope Mr. Quigley has read it. There is much to be said for the future of the accounting profession.
Ms. HOOLEY OF OREGON. Good.
Mr. Del Raso, do you have anything to add to the question that I just asked?
Mr. DEL RASO. I would say that your observation, comparing the requirements for bank regulatory oversight at the governmental level, there are some similarities, but not all. When you work in the field of financial regulation, whether it is banks, investment companies, broker-dealer operations, you have much more of an aggressive government regulatory scheme within which they operate. Especially with banks, the review goes to safety and soundness, whereas general corporate issuers under our securities laws, both in the sale of and the secondary market trading of the securities, was mostly, it not primarily driving by a disclosure regimen. I think what happened was, when there was a failure of transparency, the disclosure failed, and that is what really impinged the markets.
I do not think you really want to jump into a situation where you include industries that may not require the same level and type of regulation as others. But on the other hand, if you are out from under that very strict and careful regulation, then the mandate in this legislation is, if you are only in a disclosure regimen, make sure that transparency works.
Page 34 PREV PAGE TOP OF DOC The CHAIRMAN. The gentlelady's time has expired.
Ms. HOOLEY OF OREGON. Thank you.
The CHAIRMAN. The gentlelady from Illinois, Ms. Biggert.
Mrs. BIGGERT. Thank you, Mr. Chairman.
My first question is for Mr. Hills. Do you see any perception or feeling in the corporate community that the improved practices of companies, like more frequent and lengthier meetings of the audit committees, are just a temporary effect and soon that the companies and their directors will let down their guard?
Mr. HILLS. I think here is always a possibility that people get bored sometimes with doing the same thing every year. But I think we have created a dynamic with the combination of not only the revitalization of the audit committee, but the extraordinary role now played by the governance nominating committees. This is a real change. We hope that 27 years later that audit committees will do now what Sarbanes-Oxley has told them to do. But the nominating committee and the governance committee is an extraordinarily vital forum. It will keep people on their feet.
I think we are in good shape. There is a problem that people have mentioned, and that is with all these directors with all this new authority to do stuff with respect to compensation and governance, will they start exercising that with respect to the management of the business? Will they butt in where they really should butt out? That is a problem.
As I say, if you sit down and all of a sudden you are really a powerful person with respect to the outside auditors and the compensation, you are hiring the compensation guy and you are hiring the outside auditors, the temptation is to go in and talk about the engineers and how to design something. So there is a bridge that still has to be crossed properly.
Mrs. BIGGERT. It would be kind of like education, where we all think we know more than we do because we have been parents and been in school. Thank you.
Page 35 PREV PAGE TOP OF DOC Mr. Del Raso, have there been complaints about the increase in insurance costs? I think you have said something about that, particularly for directors and officers insurance. You state in your testimony that one of the long-term effects of the act is that these costs, along with those of indemnity and fines will decrease. Can you elaborate a little bit more on that? I think it is a point that is not usually brought up in that matter.
Mr. DEL RASO. There was a real spike in premium costs, especially for business lines related to director and officer liability coverage issues and the like. Now, I think what we are going to see, in fact we even see some signs of it now that may be abating. The interesting thing about that is, too, I think from a risk-management standpoint, the more this legislation, is in effect, and again since insurance is written on experience, the experience shows that the system is working and the losses are not occurring, then the premiums will adjust accordingly.
Quite interestingly, I was approached by the dean of a prominent Philadelphia-area business school who asked for some advice on structuring an academy for directors. He was going to start the program. I said one of the things he should really do is consult with the insurance industry because I think that if you actually have a formal program of continuing education for directors and they have an academic program for maintaining close touch with best practices, you may even find from an underwriting standpoint insurers will look at the broader picture of how that whole interplay takes place.
Mrs. BIGGERT. Thank you.
Mr. Caplan, in your testimony you have something about the signing of the certificates regarding internal controls and what your company does. Could you talk a little bit about what your senior management does for the certification? My other question is, could other companies be able to do what E*TRADE does?
Mr. CAPLAN. Within the last year-and-a-half, we have actually put a couple of procedures in place. The first thing we did was we internally built our own financial disclosure committee. It has as its members the most senior of our financial employees in terms of the accounting department, as well as the internal audit department. So before every certification, that group meets independently to review all of the numbers and all of the reporting.
Page 36 PREV PAGE TOP OF DOC Immediately thereafter, there is a meeting of the entire senior-level leadership team. At that meeting, we ask each of the senior leaders of the company who represent different business units to attest to their numbers as well, given the comfort that they have reviewed the numbers, as well as their corresponding financial partner in the company. And then only as a result of doing all of that do we actually then attest or sign, both myself as the CEO and also the CFO.
What is interesting is that at that attestation process or certification process, we make it very clear to everybody in the finance department, as well as all the leaders of the company that they can or should consult with anybody in the organization, whether it is outside as the audit committee, whether it is our general counsel, whether it is our internal auditor, if they have any concerns whatsoever.
The other thing that we have done is we have engaged an outside third party company to allow us, and have then broadcast it throughout the entire organization pretty regularly, that if any employee in our company is concerned in any way about anything going on from a financial perspective, they should call that number. It is totally anonymous and then gets reported to the audit committee. I think as a result of that, it has greatly enhanced the level of not only accountability, but also a willingness and an understanding that if there is a concern, they should speak up and express it.
The CHAIRMAN. The gentlelady's time has expired.
Mrs. BIGGERT. Thank you.
The CHAIRMAN. The gentleman from North Carolina, Mr. Watt.
Mr. WATT. Thank you, Mr. Chairman.
Let me first thank the Chair for convening this hearing. As one who voted for the Sarbanes-Oxley bill out of committee, on the floor, and participated in the conference committee, it is always good to hear favorable results of something that we did. We do not get a chance to do that very often. I think sometimes we can also overdo patting ourselves on the back. I would like to raise a couple of questions that may be a little more forward-looking than patting ourselves on the back about how successful we have been in this legislation.
Page 37 PREV PAGE TOP OF DOC Mr. Caplan and Mr. Trumka put their finger, or at least mentioned in their testimony, an issue that I think by public perception at least is a major, major concern, and that is rationalized executive pay, as Mr. Caplan referred to it, or excessive executive compensation. Most of my constituents when I talk to them liken, it is kind of a visceral response, but it is a public perception at least that athletes are overpaid and corporate executives are overpaid, and something needs to be done about that.
So one question I would have, and I am going to pose both of these questions and then make you all go at them, whoever wants to address them. In your assessment, is there still a problem of irrational executive pay or excessive executive compensation? Is there some way to get a handle on this without doing it legislatively? Or is there some way to get a handle on it legislatively? That would be one question that I have, looking forward. Not that I am advocating anything, I would just like to get your perception about it.
Second, obviously everybody on this panel thinks that Sarbanes-Oxley has been exceedingly successful in a number of areas. I would like for the panel members to identify additional steps beyond Sarbanes-Oxley, either legislatively or from a regulatory perspective, that we should be talking about, not necessarily implementing. But if you were to identify one thing that you perceive to be either still a public perception problem, by public perception, or a real problem that is still in play in this whole corporate governance or accounting process, what would that one problem still be? What ought this committee be talking about or thinking about or having hearings about going forward to try to address that one problem that you would identify?
I will start with Mr. Trumka, since Mr. Quigley has been on the hot seat a lot today.
Mr. TRUMKA. Thank you, sir. My answer succinctly to, is the excessive executive compensation problem still around? The answer is yes. It continues to grow. If you look at the CEO pay, it is still not long-term performance-based. It is still based on things like stock options. That, I think, is one of the reasons why we still need something done with expensing those stock options and reining in that pay, because once it becomes transparent, plus accountable
Page 38 PREV PAGE TOP OF DOC Mr. WATT. Be quick, if you can. I know these are two tough questions.
Mr. TRUMKA. The second thing, if you asked me for one thing, I would say for long-term significant shareholders to have the right to nominate directors on management's proxy. The only way you get an independent board is for people to know on that board that there were two routes to get there: one by management, and then if you do a good job by the shareholders, the other one is if you do not do a good job, from the shareholders themselves.
Mr. WATT. Mr. Del Raso?
Mr. DEL RASO. I would be very careful about legislation that tries to regulate executive compensation. I think the call went out after the problems in 2002. I can tell you that compensation committees of boards are paying very careful attention to compensation. I think we should let this legislation ride out longer. I think you are going to see that the long-term effects of it are going to be quite beneficial. But when the government gets in the business of regulating executive compensation, I think that is a slippery slope that we have to be really careful about.
In the area also of expensing options, even though I do have a degree in accounting, I never practiced the way Mr. Quigley did, one question I have is and I think that has confronted a number of those of us who sit in the board room as opposed to the accounting experts, at a time when we are looking for clarity and transparency, I think the idea of attempting to expense an option when you are really trying to deal with a future value could be problematic without a very complex set of rules attached to it.
Mr. HILLS. The compensation committee, which is also new in 2 years, has come to believe I think almost universally that it must have its own consultant, and that that consultant cannot really work for management. That is going to have a leavening effect, whether it is enough or not, I cannot tell you. There are enough speeches going on. There can be more speeches. Chairman Donaldson, Chairman McDonough, Chairman Oxley, all can make note of the fact that pay should be for performance. So we need a bully pulpit and we need the compensation committees to work.
Page 39 PREV PAGE TOP OF DOC What should we do next? I will just keeping pushing my Future of the Accounting Profession. If you read that, you will see some thoughts that I would love to have any or all parts of this committee be interested in that subject.
Mr. CAPLAN. Although it is hard for me to comment outside of my experience directly at our own company, I will tell you that certainly I have seen dramatic changes with respect to the board and specifically the compensation committee and how they look at executive pay. Very quickly, I will tell you in the past when we had our problem, the executive pay was set entirely by the compensation committee and the full board was unaware of it. Today, not only do all the leaders of the company deal with the compensation committee, but also the full board approves and endorses everything related to me and understands it.
I would agree very much with Mr. Hills that the compensation committees are now looking for outside consultants. They are looking for guidance. They are taking their job very seriously. I think both management and comp committees at well-run companies are understanding it should be performance-linked.
The change, I would tell you that it is probably most imperative, and I think it is happening anyway on its own, is that you need to rotate directors. At a certain age, directors need to leave. At a certain point in time, if they have been on the board long enough, they can become stale in terms of their efficacy. I think it is important to constantly get new talent.
Mr. HILLS. Not age-related.
Mr. CAPLAN. No.
Mr. HILLS. Thank you.
Mr. CAPLAN. No, age in terms of performance.
Mr. QUIGLEY. I would just very briefly say, I believe in the free market system and I believe in the transparency of the executive compensation that is there. I think shareholders have the opportunity to vote with their feet if they do not like the practices that they see. I think the governance processes are becoming increasingly effective, as has been stated. I think we ought to sustain that process.
Page 40 PREV PAGE TOP OF DOC When I look forward for that future issue, one issue that I think needs more airing is just simply the enormous cost on our economy, certainly the enormous cost on our profession of the explosion of all of the litigation that is out there on every issue. That has an enormous cost and an enormous drag on this economy.
The CHAIRMAN. The gentleman's time has expired.
Mr. WATT. Mr. Chairman, I know my time is over, but I did want to make it clear that most of my constituents think that members of Congress are overpaid, too. So it is just not athletes and corporate executives. I did want to add that.
The CHAIRMAN. That will be noted.
You must be talking about your own constituents.
The gentleman from the first state.
Mr. CASTLE. Thank you, Mr. Chairman. If I am going to be overpaid, I would rather be overpaid like an athlete, rather than like a member of Congress, but that is all a different story.
I think this is a great panel. I say ''great panels'' when panels agree with what I am thinking, regardless of what you said, which is the case here. I am one who believes that Sarbanes-Oxley is extraordinarily important, and it may be an inconvenience, I am sure it is an inconvenience and expense for that matter to corporations in America, but the clarity and transparency that we have gotten from that makes it in my judgment abundantly worthwhile. I praise it greatly.
I did hesitate a little bit on praising the panel, though, after Mr. Caplan's comment about the age-related circumstances of directors, because that can be translated to members of Congress as well. I am starting to get a little edgy about that. So I would just as soon keep that discussion down.
Page 41 PREV PAGE TOP OF DOC Actually, I would like to go back to Mr. Caplan because in his written testimony he struck a chord with something I have introduced and am concerned about, which is a little bit different, Mr. Chairman, than the subject of the hearing directly, but it pertains. It pertains to what corporations are doing, and that is 12b-1 fees. It is something which actually until we prepared for this, I did not know about, that E*TRADE is doing, which is a 12b-1 fee rebate program. I have introduced legislation to eliminate 12b-1 fees for closed funds. If I thought I could get away with it, I would eliminate all 12b-1 fees, to be candid, but I do not think anybody would consider that right now, so I am trying to do it on a more limited basis.
I think by the fact that E*TRADE is doing this, it shows that perhaps there is not a need for this. I think most of us here know that 12b-1 fees are in lieu basically of sales commissions. They were never structured to be that to begin with. They were put into place at a time when more advertising was needed for mutual funds. Now I think they are being used in a way that was unintended. I think it is frankly a burden to the shareholders. I think it comes to close to $10 billion a year now or something of that nature.
So I am very pleased that you are doing this. But I understand that a number of the mutual fund companies you deal with have also dropped you, I guess, or listing E*TRADE as a result of that, which also bothers me somewhat. I would like your comments on the program in general, why you did it, why some are staying with it, why some are dropping out of it. I hope this is an area that evolves and gets changed over the next two or three years.
Mr. CAPLAN. I think we agree with you very much. One of the things that we were quite pleased about is that in this past quarter, in the past three months we were able to give $1 million back to our customers in connection with the 12b-1 rebate. The premise, as I stated in my earlier comments, for E*TRADE and its core tenet was always just using technology to have a lower cost, and taking a significant portion of that cost savings in its operation and putting it back in the hands of customers, and trying to evolve itself as a customer champion.
Page 42 PREV PAGE TOP OF DOC Earlier this year, we thought one of the interesting and dynamic ways to do that was to look at the fact that we have a lower cost platform and take those 12b-1 fees that we would be paid as a distributor and put 50 percent back in the hands of customers. We were actually quite hopeful when we did it that it would spur competition, and that you would see other distributors thinking about how they wanted to distribute, and really compete head-to-head with us.
Mr. CASTLE. Has that happened?
Mr. CAPLAN. In fact, we are a little disappointed that it has not. It is one of the things that has been most interesting about our core business, for example, on the brokerage side. As you have seen with online brokers, it has spurred competition and you have seen prices come down. To date, anecdotally I guess, we are disappointed because as we have had some fund families withdraw, we are hearing that they may feel pressured from other distributors. I think that disappoints us. We would be much happier if in fact there was a healthy competition out there which benefited each of us as businesses, as well as certainly the customers, by putting money back in their pockets.
To your point, it is about $6 billion a year, and we would love to be able to give $3 billion back. So that has been our premise.
Mr. CASTLE. Good. Do you do this with any funds? I mean, do you do it with closed funds as well as still open funds? You do not distinguish between the two?
Mr. CAPLAN. No, we do not. Our view is that we are just operating as the intermediary, as a platform.
Mr. CASTLE. Good.
I will just close with this. I feel very strongly that if you look at mutual funds, and I think it is over 50 percent of Americans now are someway or another involved with mutual funds, there are just huge cost aspects to it. To the extent that anybody, be it a distributor of the mutual fund itself, the holders of mutual funds can somehow interact in such a way that we can diminish these costs are even eliminate some of these costs which are unnecessary, and perhaps first just understanding them. Who really understands what a 12b-1 fee is? They see it and they do not even know what the heck it is. To the extent that we can do that and still allow all the businesses to be profitable, my judgment is that the American investor is going to be far better off.
Page 43 PREV PAGE TOP OF DOC So I wish you luck and success with this. Frankly, I hope all of your competitors imitate you because I think in the long term it is going to benefit the people who need to be benefited, and those are the shareholders and mutual funds in America.
With that, I yield back, Mr. Chairman.
The CHAIRMAN. The gentleman's time has expired.
The gentlelady from California, Ms. Waters.
Ms. WATERS. Thank you very much, Mr. Chairman.
I am very appreciative for this hearing. I, too, am very proud of the bipartisan effort that we displayed in this committee as we passed Sarbanes-Oxley. I like the discussion. We are beginning to have some transparency. I think there needs to be a lot more.
I want to ask Mr. Caplan, who indicated that they had taken some steps to help with transparency. You mentioned better composition of board members. What do you mean by that?
Mr. CAPLAN. One of the things that we did for the first time, really and it was spurred on very much by Sarbanes-Oxley, was instead of just taking for granted the board and who was on it, we stepped back and really did an assessment of the strengths and weaknesses of every board member. By way of example, as I said in my comments, we completely transformed our audit committee, our nominating and corporate governance committee, and our compensation committee.
In the process of adding new directors, we really looked for what skill sets were missing and assessed what we needed. I think very much as Mr. Hills said, rather than looking for names out there, we were looking for skill sets. We were looking for people who were interested, who were dedicated, who understood the time commitments. Our board meetings have gone from what would have been as quick as a half-a-day every quarter, to 3 days a quarter now. Last year, we did, including committee meetings, 39 different meetings. So it is an understanding on the part of all of our board members that it is a significant time commitment. We looked for those board members who wanted to give it and also had skill sets that we viewed were missing.
Page 44 PREV PAGE TOP OF DOC Ms. WATERS. As you know, there are some of us who have been involved at one time or another in trying to diversify America's boards of directors. I still think that it is a problem. It is not to place anyone in any uncomfortable position, but even as I look out among you today, I walk into this room committee meeting after committee meeting, and I just do not see the diversity represented, really, that is synonymous with what America is all about.
What can we do in dealing with the selection of board members of the various boards of companies in this country to diversify them, to get more women, to get more people of color? I think that if boards are to have the kind of input and expertise that is needed, that this diversity is very important. What can be done?
Mr. CAPLAN. I can tell you that when we looked to add new directors, that was one of the key criteria for us. As we were interviewing directors, not only did we look at specific skill sets, but we recognized that we had no African Americans and we had no women on our board and we added both. The view was exactly what you are expressing. There is a diversity of thought and a diversity of opinion which can only help us as we think about how we want to build out our business.
I would certainly encourage all other companies to do the same thing. I think it is imperative. Again, when you were asking before, when I was asked before about what could change, I think as you see turnover, the problem is there is sometimes just not enough turnover on boards, you will see more of a focus. I know on our board it is a topic of conversation as we look at those board members who will in turn retire, what are we looking for, and part of that is diversity.
Ms. WATERS. Would you agree with me that it is not difficult to find women and people of color who have expertise, who have the desire, who have the time, all that is required to serve? That is not a problem, is it?
Page 45 PREV PAGE TOP OF DOC Mr. CAPLAN. I would agree with you completely. When we identified, as I said in my earlier comments, 40 different candidates who were both capable from a skill set and interested in dedicating the time, we had many choices that were both women, as well as African American.
Ms. WATERS. Any of our other panelists have any thoughts about this discussion that I am having with Mr. Caplan about how to diversify boards? What do you do with the power that you have, Mr. Trumka, to encourage boards to diversify?
Mr. TRUMKA. We are very, very cognizant of that in everything we do. We try to diversify more both along racial and gender lines as well. I think one of the things we can do, although Sarbanes-Oxley did not mandate this, the experts now say that it takes about 250 hours per year per board that you sit on. You hit the nail I think right on the head. People with the skill sets and the time, that are willing to do this, we need to make more training available for those people with the expertise and to develop that pool. We are trying to do that.
On one board that I sit on, we have quarterly training for board members, but we opened that training to anybody else who wants to come in as well. I think that is one thing we could do, but also using just our moral suasion as leaders to demand that there be better diversity, and that America is more reflected not only in the streets, but in the boardrooms of America's corporations, and quite frankly, America's unions.
Ms. WATERS. Unanimous consent for 30 more seconds, Mr. Chairman.
The CHAIRMAN. Without objection.
Ms. WATERS. I would like to hear from each of our panelists whether or not you think there is a need to diversify and that absolutely it can be done.
Mr. QUIGLEY. I would encourage you to continue to speak about this very, very real issue. I will say on our own board we have four women, and on our executive committee we have two African Americans, one Latino and then two women. I believe, it is a critical business issue for us because I want everyone in our organization to be able to look up and see someone who looks like them. And then and only then can we become the kind of firm that I want us to be.
Page 46 PREV PAGE TOP OF DOC Ms. WATERS. Thank you. Anyone else?
Mr. HILLS. I think we can take some comfort from what has happened in the last 25, 26 years. I think we can have some hope that the authority now in the nominating committees of boards, as distinguished from the CEO, will make a big difference. I think if you look on almost every single large consumer company board, you will find African Americans and women. In my own family, my wife sits on more boards than I do, so I am safe.
Ms. WATERS. Thank you very much, Mr. Chairman.
The CHAIRMAN. The gentlelady's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
I want to speak again to the task you accomplished with Chairman Sarbanes in a very difficult timed environment to come to conclusions that I think have ultimately shown to be a very wise direction for not only corporate governance, but for investors and our general economic recovery.
Mr. Quigley, I want to just pose a question for your later written response, not today because time is so limited. There has been a great deal of controversy circling the question of auditor independence, scope of service and tax consulting, particularly in creation of taxation opportunities. Can you at some point send me just what Deloitte has propounded as to its own internal policy with regard to that matter going forward?
Mr. Trumka, I listened very attentively, but when you got to page six of your testimony, particularly attentively as to your comment about the stock option expense bill passed by the House. You go on page six to say, it is encouraged that overuse for executive compensation, contributing to widening gaps between executives and ordinary workers, the House is bent again, not just the first time, again, on subverting the integrity of our financial accounting system by giving runaway CEO pay less special legislative protection. This battle is being waged on behalf of CEOs who frankly want to hide the true cost. You then cite, according to SEC filings, which is a required disclosure, the amount of $977 million in unexercised options, the fact that is required to be disclosed, the fact that it is required to be disclosed today in footnotes makes it evident to anyone who chooses to find out they can get that knowledge.
Page 47 PREV PAGE TOP OF DOC But there is clearly a misread or a no-read of the bill. The bill requires executives to expense. It does not exempt them. In fact, what we are attempting to preserve is the right of employees's ability to participate in broad-based stock option plans. You go on to say a majority of the shareholders at 30 companies voted in favor of expensing. The bill not only preserves, but makes an express declaration that anyone who so chooses, board shareholders or otherwise, the company may be required to expense.
In light of this, I thought it particularly ironic in where my original line of questioning was going with Mr. Caplan, and I have to be brief, relative to E*TRADE's reforms. I noted on page four that you cite that the board had to adopt a requirement that any compensation for its chief executive officer must be approved by the entire board of directors. I found that very enlightening that in today's corporate world that the board may not know what their own CEO is earning in direct compensation.
I, for the purposes of the record, would just only make the point that I would very much appreciate receiving the corporate governance model relative to CEO compensation and other matters that you think appropriate for the committee to be made aware of in going forward, because Mr. Everett from Alabama has proposed a reform for my attention relative to pension plan approvals that I found of some interest.
I think this swirls in the bigger question that maybe was raised by Mr. Watt. We should not be legislating necessarily, but I think the bright focus of examination does a great deal to bring about responsible governance. To the extent you can help us with that effort, I would be most appreciative.
Finally, Mr. Hills, I am very taken by your testimony, and particularly the area where you are discussing non-financial metric disclosure and the analysis of current GAAP standards giving us a retrospective historical analysis, and not much of a forward-looking view about where the company is going. For example, if you know that there were 10,000 units sold in the last quarter at whatever price, but you did not know from customer satisfaction surveys that 8,000 of them were returned for refund, which piece of information might be more helpful in knowing what is going on at that corporation.
Page 48 PREV PAGE TOP OF DOC You did say, however, that you did not think disclosure of nonfinancial metrics ought to be necessarily a function of required disclosure. I want to get your thoughts where the FDIC is now engaged in a project known as expensible business reporting language, with about 300 banks. Next year, we will roll it out to all 8,000 insured depositories if it works, the idea being we are getting away from beating the street every 90 days with earnings expectations, taking the pressure off the CEO-CFO by having hopefully more real-time, material fact disclosure of things that shareholders should know in a timeframe in which they should know it, as opposed to the arbitrary, beat the street pressure that I think was an inordinate contributor to the problems we now face in trying to rein in through Sarbanes-Oxley.
Can you give me a quick view on that because I am just about out of time?
Mr. HILLS. The demand for more information is pretty clear. The problem is that the buying community, the buy-side analysts and the sell-side analysts, are not causing it to happen. As you have seen from this book, the need to have more nonfinancial disclosure and the need to recognize the so-called brittle illusion that the financial disclosure has is not as helpful as you think it is. Those two things seem to be coming together. There is quite an important committee going on now which I think Paul Volcker, he is not the chairman of it, but it is to develop more incentives for nonfinancial disclosure.
The passage of Sarbanes-Oxley and the role of the audit committee and the obligation now of the auditor to tell the audit committee, hey, the management could have done it differently, they could have said something differently, all of a sudden people understand that we are dealing with ranges of numbers, not precise numbers. The idea that you can have the profits of the company go up by 1 percent every quarter for 50 companies, I think the world now understood that that is ridiculous. It did not happen.
Mr. BAKER. Thank you.
Mr. Chairman, just unanimous consent request, Mr. Everett asked that I insert into the record his statement regarding his proposal on compensation.
Page 49 PREV PAGE TOP OF DOC The CHAIRMAN. Without objection.
The gentleman from Alabama, Mr. Davis.
Mr. DAVIS. Thank you, Mr. Chairman.
Let me try to pose three sets of questions for you all, and get you to give fairly succinct answers to them. The first one I would direct to Mr. Caplan and Mr. Hills. It deals with the level of knowledge or intent that is required for a CEO to be liable under Sarbanes-Oxley. Let me get first of all your answer to the question, what do you understand the level of mens rea to be, the level of knowledge to be? Is it sufficient if a CEO signs a financial statement and the statement is false, for that CEO to be liable? Or what is the extra level that is required? Does it have to be a willful disregard standard? That seems to be something that is not 100 percent clear, and we have had so few prosecutions that we have not yet developed a good answer to that.
The follow-up to that, if you feel that the standard is one that is something other than knowledge, if it something other than the usual criminal standard, is that problematic? Is there a discomfort level that we have or should have with holding CEOs liable unless we can show deliberate disregard or willfulness on their parts? This is the first set of questions.
The second one, Mr. Del Raso, I would direct to you. There was a period of time last year when the SEC was considering a new set of regulations involving attorneys. There was a lot of talk about a noisy withdrawal requirement. As you and the other lawyers in the room know, in the overwhelming class of cases around this country attorneys have very little leeway to get out of cases even permissively. Attorneys are able to get out of cases if there is a possibility of imminent physical harm or if a lawyer has knowledge of imminent wrongdoing.
As I understood what the SEC was contemplating, there was some consideration that if an attorney became aware of corporate misconduct, that there was actually not just as permission to get out of the case, but an affirmative duty to withdraw in some instances. As a lawyer, that struck me as a radical change from the normal rule of special responsibility. Can you briefly comment on that?
Page 50 PREV PAGE TOP OF DOC The final set of questions would be to Mr. Hills and Mr. Del Raso. It deals with the sentencing guidelines. We know because of the recent decision that the guidelines are very much in flux right now. We do not know what will eventually come about. But one of the things that was worked in the Sarbanes-Oxley, as I understand it, is a dramatic ratcheting-up of the penalties and the collapse of any distinction between theft and between fraud. As I understand the guidelines right now, pre-Blakely, if a wrongdoer causes a certain amount of loss, whether or not he or she receives any direct financial benefit from it, it is treated the same as if he or she had received benefit. Are we comfortable with collapsing fraud and theft together? Does it create problems either in terms of getting plea bargains efficiently? Or does it create some broader problem if we dramatically ratchet-up the sentences for people who are not financially benefiting themselves from the fraud?
Those are the three sets of questions. The first would be to Mr. Hills and Mr. Caplan.
Mr. HILLS. The standard for Sarbanes-Oxley compliance with respect to signing the document, the principal change, which is so important, is that the CEO cannot win simply if he says, I did not know anything about it. He has to be bloody certain that that company has done everything possible to uncover the problem. That is what 404 does also. He has to make certain that every possible effort has been made to surface problems with it.
So if he sits there and says, I did not know anything about it, and he does not have a compliance situation in place, he is in trouble. I think that is the way to look at that part. I am sure somebody else is going to answer the second question.
Mr. DAVIS. Mr. Caplan, do you have anything to add to that?
Mr. CAPLAN. I would agree completely. I think that Sarbanes-Oxley has worked quite effectively in terms of its intent. There is very little doubt in my mind that in certifying either on my behalf as a CEO or the CFO, there really is an understanding of the severity that is intended when you certify, whether it is quarterly or whether it is with respect to 404. I would tell you that it is impossible, particularly the larger the organization gets, to know everything that is going on at all times. But the duty to investigate, as Mr. Hills has said, is dramatically escalated. The amount of work that goes into the processes I described earlier, whether it is quarterly or with respect to 404, has really transformed the way companies are looking at these checks and balances.
Page 51 PREV PAGE TOP OF DOC Mr. DAVIS. Mr. Del Raso, can you comment on the attorney issues?
Mr. DEL RASO. Sure. One of the more discussed aspects of Sarbanes-Oxley was the notion of the responsibility of the attorney, this concept of reporting up and then reporting out. The responsibility of reporting up at the attorney level inside the corporation is one that was a little easier to deal with. But the idea that if you are not listened to and then reporting out, as you know, the American Bar Association and even some states really took opposite positions from what was required in the act. They are issues that I think were very troubling to a number of practitioners at the time, but I think we are working our way through them.
I would recommend to you one of my partners was actually appointed by the court to be the special SEC examiner in the Spiegel case last year. A large part of that report deals with the role of the attorneys in reporting. That was probably one of the last major cases before the enactment of legislation that dealt with these issues.
Mr. DAVIS. Can you just quickly comment on the fraud-theft issue?
Mr. DEL RASO. I think that is one that really does require attention. I am sure you are referring to the Dynegy case and maybe the sentence that was imposed there, big distinction between outright fraud or negligent responsibility in the chain of command in the certification process, and really quite frankly weighing and balancing the societal effects again, too. I mentioned even in my testimony, one of my concerns is that outside of the framework of the legislation, when you get to regulatory enforcement, if you have prosecutorial misjudgment and in discretion, you could really start then to have a deleterious effect on this legislation if it is not properly enforced.
The CHAIRMAN. The gentleman's time has expired.
Page 52 PREV PAGE TOP OF DOC The gentleman from Texas, Mr. Hensarling.
Mr. HENSARLING. Thank you, Mr. Chairman.
I have long since been convinced of the absolute necessary and profound benefits of Sarbanes-Oxley and what it means to the protection of our free market system. But let me take my limited time to focus on what some may perceive as the cost or risk and unintended consequences of the legislation.
Obviously, the subject of corporate board independence, independent members of the board, is discussed often these days. Sarbanes-Oxley has required that the audit committee be comprised totally of independent members. If we look at what I think my colleague from Houston described as the poster child for corporate malfeasance, Enron, I am told that 86 percent of their board was independent and had a dozen non-employee outsiders. This included four CEOs, four academics, and the board was chaired by an accounting professor from the Stanford Business School.
Just for the sake of argument, I am told Berkshire Hathaway would not pass anybody's test of having an independent board, yet I do not believe they have had a hint of corporate scandal, and except for 4 years out of 40, they have always beat the S&P 500.
So my question really focuses on where theory meets empiricism. The question is, with our limited history, what do we know about the impact of having independent members and what that means to corporate governance? Why don't we start with you, Mr. Quigley.
Mr. QUIGLEY. I believe that we need independent directors, but we also need audit committee effectiveness, understanding and executing their effective role. If it is an audit committee composed on the golf course, the likelihood of it being effective is much, much lower.
Mr. HENSARLING. Mr. Hills, how about you?
Mr. HILLS. Independence does not at all guarantee quality. I think if you go back to 1976 and just see the impact on corporate America by simply having an audit committee be required, so you had three independent people on the board at least, it has had a substantial impact. But independence is not enough. You need to have a sufficiently independent quality on every board to deal with those matters that need that independent quality. I do not see anything wrong with having employees on the board. It is a matter that each company is not the same.
Page 53 PREV PAGE TOP OF DOC But if the background for the question is, can we carry the independence question too far, of course we can. I think if we stay with the principle that every board needs a sufficiently independent quality to deal with those things that need that independence, then we are fine. At Berkshire Hathaway, the board is a very good example. They do have a substantial independent quality on that board.
Mr. HENSARLING. I have a lot of different studies crossing my desk. I am never quite sure of their reliability or their methodology. But I saw a Wall Street Journal article that dates back to about a year-and-a-half ago saying that since the advent of Sarbanes-Oxley, D&O insurance has quadrupled. I have seen another study saying that the cost of going public for mid-size companies has now doubled. Directors's fees have doubled. Accounting, audit and legal fees have doubled.
Again, I am uncertain of the methodology and reliability of these reports, but I am curious about the hard data out there on the cost of compliance. More specifically, what does that mean as far as companies making their decision to go public, not to go public, and the impact of that on job and wealth creation? Do you have any hard data on what these actual costs may be and how CEOs and boards are deciding on the decision of going public? Again, why don't we start with you, Mr. Quigley.
Mr. QUIGLEY. I view the cost of Sarbanes-Oxley compliance as a new element of the cost of capital. It is an issue that management must evaluate as they look at their various financing alternatives for their growth plans. I believe that in return for the privilege of becoming the steward of the public's money, if that is in fact the vehicle you use to finance your growth plans, you have to be willing to step up and pay these costs that go with that stewardship responsibility.
There is lots of liquidity in private equity. There is lots of liquidity in banks and insurance companies to finance growth plans through private transactions if you do not want to pay the cost of participating in the public markets.
Page 54 PREV PAGE TOP OF DOC Mr. HENSARLING. I see my time is just about to run out. Perhaps other answers could be submitted in writing. I had one other question. I saw a particularly critical report from a study from the Cato Institute on Sarbanes-Oxley that says it has so many ambiguities and contradictions that companies are faced with draconian punishments for vaguely defined offenses, which is somewhat following up on my colleague Mr. Artur Davis' line of questioning. I was just curious to know to what extent do you see ambiguities and contradictions that need to be addressed in the legislation? Having said that, I see I am out of time, Mr. Chairman, so those answers will have to wait for a later time.
The CHAIRMAN. I would have the witnesses respond, if anybody has a particular response. Mr. Del Raso?
Mr. DEL RASO. As the lawyer, I would tell you that this is not really a lot different than any other regulatory or legislative act that we work with. We have had the securities laws around for all these years, and Mr. Hills knows this all too well. That is why you have a system in place where you deal with the regulators. You either request positions from them, either in interpretive letters or through rulemaking, or you come back to the legislative side and ask for changes.
But I think what you are finding here is every day that passes since the act went into effect, the questions are probably a little more easily answered. There was a lot of work that was done in the very beginning. So I think that you will never get to ground zero with respect to having no issues or no questions with regard to any type in either the legislative or regulatory framework you are working in.
The CHAIRMAN. Thank you.
The gentlelady from New York.
Mrs. MALONEY. Thank you.
Mr. McDonough in testimony before this committee brought up the idea that possibly we should have two standards, one for larger companies and one for smaller companies for the enforcement of Sarbanes-Oxley. Many smaller companies are complaining that the burden is too great for them. I would like a response in writing to that.
Page 55 PREV PAGE TOP OF DOC But in my brief time, I would like to focus on something that Mr. Trumka brought up in his testimony and ask the other witnesses to comment on it further. We made a promise in Sarbanes-Oxley, but broke it this week on the floor. That promise was our promise to insist that companies tell investors the truth about their financial status. We said that we would insist on transparency and that we would empower the SEC to enforce that promise.
Yet just 2 days ago, the House passed legislation that has the exact opposite purpose and effect. H.R. 3574, the stock options bill, walks away from our commitment to investors. It walks away from our commitment to independent standard setting, in the interest of a few companies that do not want to show investors the true cost of their stock options that they pay their employees. The bill passed the House overwhelmingly, despite the opposition from every single financial luminary from Alan Greenspan, who reiterated his opposition to the bill yesterday literally in this room before the committee in a hearing, to Arthur Levitt, to Warren Buffett, to John Bogel, to Bill Donaldson, John Snow, all four big accounting firms and many others.
Today, it is getting slammed in the financial press precisely because that bill violates the premise of Sarbanes-Oxley. I request permission to place that article in the official record of this committee.
The CHAIRMAN. Without objection.
Mrs. MALONEY. I deeply believe, and I have really been extremely upset about this vote, that Sarbanes-Oxley is the most important and significant corporate governance bill that Congress has passed since the 1934 act. Like the 1934 act, it was a necessary response to a grave situation in order to restore investor confidence.
Although we have made some improvement, we have some unfinished business. My main question to the panel today is, do you believe that the principle of independent standard setting and SEC oversight was a critical part of Sarbanes-Oxley, and I would say the 1934 act? And if so, how much damage did we do with the stock options bill? On this precise point, I had an amendment which likewise failed on the floor, which merely reinstated the authority that the SEC has had since 1934 to override rules if they see fraud or the public interest jeopardized. That failed on the floor.
Page 56 PREV PAGE TOP OF DOC So I invite all the panelists to answer. I would like to start with Mr. Trumka and Mr. Hills, since he is a former chair of the SEC, and then of course the big four, Deloitte Touche, and everyone if you would like. Thank you.
Mr. TRUMKA. My testimony, I think you have just reiterated most of my written testimony. We think it sends the absolute wrong message at this time. We think it paints a roadmap for CEOs that want to cover and prevent investors and would-be investors from knowing what the real costs of their salary is, and what the real costs to the corporations are, and allows them to hide it.
The bill that was passed only purports to make the top five people report those expenses. The other people at the bottom, it pretends like it does not exist, so it is intellectually incompatible. Then it does something that I think is the world's greatest fiction. It says that stocks are nonvolatile. If anybody believes that stocks are nonvolatile, I have some beachfront property in southwestern Pennsylvania that I would sell them.
We think it has done tremendous damage and we think it sends the wrong message. It says to CEOs that if you put on a big enough effort, you can overturn all the good and the momentum that has been built up by Sarbanes-Oxley and in fact reverse what the experts in the field say is necessary.
The CHAIRMAN. The gentlelady's time has expired. We would ask for just some brief responses to the gentlelady's question. We are going to have votes momentarily on the floor of the House and I would like to complete the hearing.
Mrs. MALONEY. Mr. Hills?
Mr. HILLS. Of course, it has not done any damage yet. I am very much in favor of independent standards. I am very much in favor of allowing information in, not keeping it out. The fight over options pricing is in many respects a sad fight. The information in a balance sheet in the 10Ks tells any analyst worth his salt how many options are there and what it costs. The question is, why not put it in the profit-and-loss statement? It should be in the profit-loss statement because everything else is in there.
Page 57 PREV PAGE TOP OF DOC The issue is how do you treat the profit-and-loss statement. I will just go back to the quote I gave you at the end of my testimony, and that is this constant reliance upon the brittle illusion of accounting exactitude. The problem is that by throwing it in there, too many analysts are going to take more from it than they should, and therefore much of the industry does not want it in there. My own view is that the world has wised up to the fact that whether it is in or not is not going to make much difference because the analysts now do understand that stock options have a cost.
So I am in favor of it. I am sorry there is such a fight about it.
Mr. QUIGLEY. Congresswoman, I would just quickly comment that I, along with the other three CEOs of the big four firms, signed the letter that you referenced. I support fully private sector standard setting and believe it is one of the factors that has made our capital markets the envy of the world.
The CHAIRMAN. The gentleman from Ohio, Mr. Tiberi.
Mr. TIBERI. Mr. Del Raso, we have heard since the passage of Sarbanes-Oxley from some different public companies complaining about the legislation. You have counseled foreign companies. You have traveled overseas. What are you telling them? Can you give us the state of foreign affairs right now with respect to this issue?
Mr. DEL RASO. I think when the legislation first passed, there was some real concern and trepidation about the fact that the foreign issuers, especially larger ones, thought it was intrusive. Why should they have to comply? Well, if they want to access our capital markets, that is a cost of doing business here, but more importantly it was to stabilize global markets because we are such a large player.
I think, though, in the light of some of their own scandals that came home to roost in their countries, most notably just in the last year or so, the Parmalat scandal in Italy and some others, they are even more keenly aware of what we were faced with and the importance of this type of legislation. If you do take a look at what has happened overseas, they will in their legal process set up their own investigation and prosecution. I do hear from the diplomats or even the foreign business executives, than they do envy our system because it works much more efficiently and fairly than their inquisitorial systems which in some countries are worse.
Page 58 PREV PAGE TOP OF DOC Mr. TIBERI. Thank you.
Mr. Quigley, in your testimony you stated that a final human resources aspect of Sarbanes-Oxley that is worthy of note is the increased personal risk that our partners and professionals perceive about our profession. The stress creates long-term impact on the ability to attract and retain people.
In addition to that statement, are you concerned about the future of the your industry, with that issue and the issue of the increase of liability that you face and your partners face?
Mr. QUIGLEY. It is the single biggest cloud associated with the future of the profession. I, though, am very optimistic about that future and believe we will find a way to try to manage our way through that. I hope one day we can have meaningful securities law and other tort reform that can take that very, very large cloud off the horizon.
Fifteen cents of every audit dollar that we collect is required for litigation, claims and insurance costs. That is an enormous cost on our business, on our operation, and frankly does reflect somewhat the burden that our partners feel associated with this aspect of practicing public accounting.
Mr. TIBERI. Mr. Chairman, I yield back my time.
The CHAIRMAN. The gentleman yields back.
The gentleman from Staten Island.
Mr. FOSSELLA. Thank you, Mr. Chairman. Welcome and thank you to the panel. I thank you, Mr. Chairman, being the last, I know I get unlimited amount of time to ask questions. I appreciate that as always.
The CHAIRMAN. Yes, we always play that game.
Mr. FOSSELLA. I thank the panel, and especially welcome Mr. Caplan in moving so aggressively at E*TRADE and doing the right thing. And my friend Mr. Quigley, thank you for coming and offering as always insightful testimony.
Page 59 PREV PAGE TOP OF DOC Briefly following up on what Mr. Tiberi just talked about, and that is, to what degree, if at all, should we be concerned with the flow of capital from foreign countries? For example, I know John Thain, who is the CEO of the New York Stock Exchange, has argued that some of the new governance requirements may scare some of the foreign firms. I think he has indicated that the number of IPOs have been down relative to prior years. Whereas the head of NASDAQ has said there should not be concern, or more to the point, has not slowed down the IPO pipeline.
Just out of curiosity, why is there a disconnect? Is it because, as has just been indicated, that now these nations are going to their own problems, so therefore we should not lower our standards until they raise theirs? I was wondering if you can offer anything on that.
Secondly, from Mr. Quigley, a two-prong question. One, in your testimony you seem concerned about the new requirements, the shortening of filing time, as opposed to the concern regarding internal control assessments and attestations. I guess as you say, you are concerned about the quality of financial reporting, again not intended, but that could be in place. And next week, you are going to offer to the SEC that that extension on the filing deadline be delayed by a year.
If you can shed some light on why you think that is a concern and why that should be modified. I will just leave it at that. So for the first question, if someone can chime in.
Mr. CAPLAN. I would say it is probably not the first and it will not be the last time you will have a difference of opinion between NASDAQ, Mr. Greifeld and Mr. Thain with respect to the New York Stock Exchange. Having lived first-hand some of the issues around governance, I would tell you that certainly our view is that corporate governance really should have no boundaries. Watching first-hand in the part of our business that deals with equity trading, the importance of investor confidence and the return of that investor confidence, nothing should be allowed to shake that.
Page 60 PREV PAGE TOP OF DOC I think if you do not extend it to companies who want to access capital in the United States, regardless of where they are abroad, you really pose too great a risk, because if ultimately there is a problem, it will shake investor confidence again. I have watched the behavior of our customers in these last 2 years. One of the things that is interesting is that we sent a survey out to our customers about a year after Sarbanes-Oxley was enacted, and asked them were they more willing in light of general governance to trade. There was a 37 or 38 percent increase as a result of that.
So generally speaking, I think you are seeing the recovery in the marketplace due to what is happening economically, but I also think you are beginning to see a rebound in confidence. I really feel confident that we should not allow anything to shake that. If somebody wants to access capital in the United States, it is the cost of doing business.
Mr. QUIGLEY. Just to comment quickly with respect to the Sarbanes-Oxley 404 and its impact with respect to the accelerated filers, as we shorten that filing period to 60 days, I do not know how many, but some registrants are going to find as we get towards the end of February an enormous pressure. I believe that additional 2 weeks could be valuable to the registrants, to the auditors and could contribute to the quality of reporting this year. Accelerating from 75 to 60 days and overlaying the internal control reporting are two very significant changes that were not contemplated at the time the initial accelerated dates were put in place by the SEC. That is why we are going to recommend deferring for 1 year.
Mr. FOSSELLA. Just finally, Mr. Quigley, are there any State provisions that in your opinion conflict with Sarbanes-Oxley? If so, is this a problem?
Mr. QUIGLEY. There are States that are talking about broadening the application of Sarbanes-Oxley provisions to other than public companies. There are some States that are also debating whether they need their version of Sarbanes-Oxley. I am concerned about the complexity and the cost that continuing to layer additional levels of regulation on top of this through the States would not be a good move at this juncture.
Page 61 PREV PAGE TOP OF DOC Mr. FOSSELLA. Okay. Thank you, Mr. Chairman.
Thank you, gentlemen.
The CHAIRMAN. The Chair wants to thank all of you profusely for what has been an excellent tutorial and review of the Sarbanes-Oxley Act. I think it was an opportunity for all of us to talk about the highlights and perhaps some of the changes ultimately that we need to make, though it has never been perfect legislation. For that, we are most appreciative of your candor and your expertise.
The committee stands adjourned.
[Whereupon, at 12:21 p.m., the committee was adjourned.]