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H.R. 3763, THE CORPORATE AND AUDITING
ACCOUNTABILITY, RESPONSIBILITY AND
TRANSPARENCY ACT OF 2002
TUESDAY, APRIL 9, 2002
U.S. House of Representatives,
Committee on Financial Services,
Washington, DC.
The committee met, pursuant to call, at 2:05 p.m., in room 2128, Rayburn House Office Building, Hon. Mike Ferguson presiding.
Present: Chairman Ferguson; Representatives Roukema, Baker, Gillmor, Cantor, Ryun, Biggert, Rogers, LaFalce, Kanjorski, Watt, Bentsen, Carson, Sherman, Inslee, Shakowsky, Capuano, Hinojosa, Israel, Maloney of New York, Meeks, and Maloney of Connecticut.
Chairman FERGUSON. The hearing is called to order.
Today, the Committee meets for the third day of hearings on H.R. 3763, the Corporate and Auditing Accountability, Responsibility and Transparency Act. Today's hearing is being held at the request of the Minority.
The Chair now recognizes himself for a brief opening statement.
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Good afternoon. Welcome to the Committee's third legislative hearing.
Last December, this Committee, which oversees the financial and capital markets, held the first congressional hearing on the Enron collapse and its impact on investors and employees in the financial markets. When the Committee set out to investigate the Enron collapse, we had several clear goals in mind.
First, we wanted to make sure the Congress now knew how the biggest corporate collapse in American history occurred.
Second, we wanted to work toward restoring the confidence of investors in accounting, regulators and the rules governing our markets.
Third, we wanted to formulate an appropriate response that would ensure that the free market system and the regulatory system that underpins it emerged stronger as a result of our work.
The American people deserve to know the facts directly and to hear them specifically from those most directly involved. I commend Chairman Oxley for working closely with major investigators, the Justice Department, the SEC and Enron and Andersen's internal teams to achieve these goals.
The introduction of the Corporate and Auditing Accountability, Responsibility and Transparency Act, or CARTA, represents the culmination of this process. It has allowed us to move forward and investigate comprehensive and practical solutions that will undoubtedly strengthen the overall financial system.
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The past few legislative hearings have been very constructive. We have heard from a diverse group of witnesses representing a broad spectrum of views regarding the securities market and the Government's role in protecting investors. The distinct difference is in the testimony of these individuals, including former SEC officials and representatives from the securities industry, a leading consumer organization and the accounting industry have confirmed that the Committee has taken the necessary steps to improve the current regulatory system through CARTA.
CARTA is clearly the product of a multitude of views and months of work by the Committee to improve the public's confidence in the capital markets and to strengthen the overall financial system in the most appropriate manner. CARTA is effective because it gets to the heart of these foundational issues that will prevent future Enrons without drowning businesses in a sea of red tape. It is important that this legislation avoids the temptation to overreact and legislate in a manner that will cripple the entire business community.
In fact, Federal Reserve Chairman Alan Greenspan has testified that the Enron collapse has already generated a significant shift in corporate transparency and responsibility, highlighting the market's ability to self-correct. Overlegislating would be counterproductive and make it impossible for the markets to function properly.
Despite these concerns, there is no dispute that Congress must be involved in some capacity to ensure that the free market will emerge stronger than ever. America needs a strong, vibrant and healthy accounting industry to keep companies financially sound and to provide investors with solid information. CARTA was carefully crafted by Members of Congress to provide our current system with this base without overstepping our boundaries in a way that could ultimately have a negative impact on the world's strongest markets.
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CARTA rightfully establishes new firewalls and increased oversight to ensure independent reviews and avoid conflicts. It establishes a new public regulatory body under the SEC with strong oversight authority and prohibits firms from offering certain controversial consulting services to companies they are also auditing.
This legislation also requires accountants who audit financial statements of publicly traded companies to be federally certified by the public regulatory organization and highlights the concept of corporate responsibility by requiring companies to ensure their accountants are in good standing.
The oversight board has the authority to discipline individuals who violate securities laws or breach standards of ethics or independence.
Investors of all types rely on accurate and accessible information to make their financial decisions. In the Enron debacle, thousands of investors were deprived much-needed resources to make sound investment decisions. It is an outrage that any company would prohibit its employees from selling their stock within their retirement plans, while at the same time its executives were selling millions of dollars of stock because they were privy to more up-to-date information.
This legislation meets our responsibility to shareholders and employees of publicly traded companies who deserve to know more and know it in real-time about a company's financial well-being. It also fittingly prohibits corporate executives from buying or selling company stock when 401(k) plan participants are unable to buy or sell securities.
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We have a moral obligation to ensure that safeguards are established to prevent the disasters of this magnitude in the future. CARTA correctly holds corporate America more accountable to the employees and shareholders through stricter accounting standards and stiffer disclosure requirements.
But legislating should not be the end of Congress's role in addressing these issues. The collapse of Enron represents a combination of irresponsible actions on the part of decisionmakers with knowledge of the company's financial well-being and a meltdown of the financial safeguards used to identify problems at a stage when corrective action might still be taken.
We must work directly with the private sector to instill a spirit of corporate responsibility by challenging America's business leaders to meet the highest standards of ethics and responsibilities to their employees and shareholders.
There have been dozens of legislative measures introduced by both sides of the aisle to address these issues. It is time to put partisan squabbling aside and to move forward with practical solutions that will actually help. These hearings have helped the Committee assess the effectiveness of CARTA in preventing future accounting and stock irregularities in publicly traded companies. However, to ensure that no questions are left unanswered, Chairman Oxley has agreed to this final hearing before we move forward with the consideration of CARTA.
I want to thank the witnesses for their attendance, and at this time I would like to yield to the distinguished Ranking Member, the gentleman from New York, Mr. LaFalce.
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Mr. LAFALCE. Thank you very much, Mr. Chairman.
Let me put this in perspective. In your opening statement, you just said that the Chairman has agreed to this hearing. This is a hearing which we demanded as a matter of right under the rules of the House and the rules of the Committee. The timing for it was set over the recess for 2 o'clock today, a day when the Congress does not begin voting until 6:30. If we didn't demand our rights, we would have just proceeded to a markup on Thursday with but 2 days of hearings.
So you have said it is time to put partisan squabbling aside. What does that mean, that we should just discuss and vote upon exclusively the bill that was prepared by the Republican staff to the Chairman of the Committee without Democratic input? That is not putting partisan squabbling aside. That is just saying ''succumb to our will.'' So let us not kid ourselves or kid the public as to is going on here.
The Minority Members of this Committee wanted today's hearing out of a concern that we mark up legislation as soon as Thursday on issues facing our securities markets without giving adequate consideration to many aspects of the legislative proposals before us. There are many aspects of the legislative proposal before us in which no one has testified, much less haven't had a diversity of testimony. And there have been significant developments.
On Monday, you all read in the New York Times, the Washington Post, and so forth, about the role of investment banks that has been added to the Enron lawsuit. We have not explored that. That is certainly within the jurisdiction of our Committee. It is an important issue to which we have given no consideration.
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Today, you read in the New York Times and the Washington Post and the Wall Street Journal, and so forth, about the action of the Attorney General of the State of New York with respect to securities firms who were violating their own rules, flagrantly. These are allegations, but he was able to obtain a court order.
Under any circumstances, though, these come within the jurisdiction and concern of our Committee; and before we mark up legislation, we should give attention to those issues.
It is clear to me that this should not be the last hearing before we go to markup. It seems to me there would be a rush of judgment, and the judgment should be a very partisan one. That is, go along with the bill prepared by the majority staff ab initio.
Well, there is consensus on certain things. There is a consensus that we need a new public oversight body for the accounting profession, but there is not a consensus on the attributes such a regulator must have to be credible and effective, and there has been no conversation between the Democrats and the Republicans, at least as far as I am concerned, on this issue.
For example, my bill explicitly establishes the powers and duties of the new regulator, while H.R. 3763 leaves these matters exclusively to the SEC rulemaking, effectively leaving these rules up for jump ball, totally up to the SEC.
Now, certainly the SEC must make rules and they must have a certain amount of discretion, but I think, given what we have seen, we ought to have certain legislative powers that are clearly established. And that is a serious issue. I think that the new regulator should have the authority to set quality standards rather than just enforcing industry standards and should have clear disciplinary and investigative powers. And that is not in the Chairman's mark, and it is in my bill.
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We need a discussion of that issue. What should the legislation have? Should the legislation establish the clear disciplinary and investigative powers of the regulatory body?
Auditor independence. We have barely scratched the surface in considering that issue. We have not discussed the services that create conflicts for the auditor or measures to give the audit committee authority to determine the non-audit services the auditor should provide. Other corporate governance reforms that would enhance the functioning of the audit committee and are inextricably linked to auditor dependence. As the Enron collapse made sure, we also must ensure that the independent directors of our public companies are truly independent.
Now, my bill includes these provisions. They deserve further discussion. They have not been discussed before our Committee.
The Committee has given little consideration to the role of the securities analysts in the Enron collapse. My bill would do more to reduce the conflicts that cause analysts to look the other way when companies present rosy but misleading pictures of financial health.
As the New York State Attorney General said yesterday in bringing action against Merrill Lynch, such actions jeopardize the integrity of our securities marketplace, and we should examine that issue fully.
Finally, we must consider the need to enhance the ability of private litigants to enforce the securities laws, particularly with respect to aiding and abetting by accountants and other professionals. We restored the ability of the SEC to bring aiding and abetting actions in 1995, and we should consider restoring the ability of private litigants to do the same, and we have had no hearing devoted to that extremely important issue.
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Further, I am pleased to announce that today I introduced another bill, a bill that would give legislative substance and real teeth to meritorious portions of President Bush's 10-point plan on corporate disclosure and accountability. The Corporate Responsibility Act of 2002 requires disgorgement of incentive compensation and certification of financial statements and allows the SEC to administratively bar unfit officers and directors from serving in public companies.
There is much to be done. I look forward to working with Chairman Oxley and all of the Members of the Committee to bring about a strong legislative response. I think we need additional time and hearings and consultation and conversations and compromise in order to bring that about, and I thank the Chair.
Chairman FERGUSON. The gentleman's time is expired.
The gentlelady from Illinois, Mrs. Biggert, you are recognized for an opening statement for 5 minutes.
Mrs. BIGGERT. Thank you very much, Mr. Chairman.
Mr. Chairman, this morning hundreds of Andersen employees in my district rolled out of bed with a simple question on their minds. When I return home tonight, will I still have a job? If I do make it through the day, will my job be there at the end of the week or the month? Sadly, for many of them, the answer will likely be no. Through absolutely no fault of their own, they will be looking for employment elsewhere. As Andersen finalizes plans to cut its workforce, my thoughts and prayers are with the more than 500 Andersen employees in my district and the thousands more across the Nation who had nothing whatsoever to do with the case at hand, but nonetheless are feeling the aftershocks.
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We can debate privately or publicly the end result of the actions taken over the past months and how actions can lead to unintended consequences. As one Andersen employee from my district asked in a letter to me last week, if one out of our 535 Congressman and Senators gets in trouble, should you all be fired? The short answer is no; and yet it is true that, to a certain extent, we all lose public confidence when one Member abuses his or her office. It is not right, and it is not fair, but it is what happens.
I think everyone can agree that change is needed in the accounting industry, and I think several good proposals are on the table. We must, however, strike the right balance to ensure that the decisions we make in the coming days will help solve the problems at hand without creating those unintended consequences down the road.
H.R. 3763 is an important step in the right direction. With this legislation, we will avoid any more blanket charges against groups of accountants and instead punish the particular accountants at fault. H.R. 3763 provides more immediate and closer scrutiny of the accounting profession in general and specific accountants in particular.
I should add that, at the same time, there is much more that the accounting industry must do. They should not wait for Congress to point them in the right direction.
A good place to start is with the recommendations of former Federal Reserve Board Chairman Paul A. Volcker. I commend the efforts that he has made to begin to restore some of the credibility that is much needed in the accounting profession.
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I look forward to hearing from the witnesses today and thank you very much and yield back the balance of my time.
Chairman FERGUSON. The gentlelady yields back.
The gentleman from California, Mr. Sherman, is recognized for 5 minutes for an opening statement.
Mr. SHERMAN. Thank you very much.
It is good that we are having these hearings. It is unfortunate who is not here. We have those very many organizations who don't get fees as investment bankers, but do control trillions of dollars of capital—professional investors, mutual funds, pension advisers—who have been, I think, underrepresented in the overall process before Enron and even after Enron in giving us guidance as to what information they need and what steps need to be taken so that they can rely on that information.
CARTA I think is a good bill, but it is less than the minimum we should do, and I think our constituents will be unimpressed with those Members of this Committee who vote for final passage of CARTA, but vote against the amendments necessary to make it a strong enough and meaningful enough piece of legislation.
Alan Greenspan is correct when he points out that there has been a shift in business culture so that the greatest abuses of the past will not be repeated in the immediate future, but that is only the immediate future. The pressures that created the atmosphere of 2001 will return within a few years. The hottest executives at the hottest companies will be those reporting the hottest growth in their earnings and reporting the lowest liabilities. We need to legislate, not just rely upon what I fear is a short-term change in the business culture.
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There are three amendments I am certain to offer to this bill.
The first is to tell the SEC they have to read the financial statements of the 2,000 largest companies every year, and then when they find something that is incomplete or confusing, they will then demand that additional material be filed. The request or demand for additional information will be immediately public. The material filed in response would be made immediately available to the public, and this is an answer to the fact that an awful lot of what is in those Enron financial statements isn't false. It is just unintelligible. Not unintelligible to the uninitiated. Unintelligible to anyone. The SEC doesn't read the financial statements filed by the big companies. They only read financial statements filed by the small companies. That has got to stop. And by the small companies, I mean the IPOs.
Second, Arthur Andersen was the one of the Big Five—then Big Five—that had its salespeople, the people in charge of selling more services to Enron and collecting the fee, the engagement partner, in final control of whether to sign the audit opinion. The other Big Four accounting firms—or the other of the Big Five—put their quality and technical review people in charge of making that final decision. We should not leave it to the accounting firms to structure themselves any way they want. The people insulated from the sales decision and who are steeped in accounting literature need to make the final decision.
Finally, Mr. Chairman, recently Arthur Andersen indicated that, while it had offered over $700 million to settle, it was now cutting its offer to only $300 million because, oops, they don't have any capital. We need a minimum capital requirement for accounting firms of at least half a year's audit fees. Right now, Arthur Andersen is saying they don't have any money to pay those damaged by their inaction, and we cannot tell accounting firms that they can go practice virtually without malpractice insurance, with virtually no capital and then, if they make a mistake, the investors get nothing.
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There are two other issues. One is that if we are going——
Chairman FERGUSON. If the gentleman could just wrap up here.
Mr. SHERMAN. OK.
Chairman FERGUSON. We are past expired.
Mr. SHERMAN. My time is expired. Let me simply say that those who don't learn from history are doomed to repeat it, and those who do not pass legislation triggered by recent history are doomed to see those same mistakes repeated.
Chairman FERGUSON. The gentleman's time is expired.
The Chair recognizes the gentleman from Louisiana, the distinguished Chairman of the Subcommittee on Capital Markets, Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
I think in the aftermath of the demise of one of the largest corporations in American enterprise it would be inappropriate for us to rely on additional lengthy studies or, worse yet, lengthy investigations with a failure to act. It would be really unacceptable consequences for the market as well as individual investors, and if we start in good faith today and act quickly, I can suggest to you that the congressional process will require a very long and tortuous path before we all wind up in the Rose Garden and exchange good wishes. So moving quickly at this juncture is not ill-advised. I think it is highly appropriate, especially in light of the fact the SEC, FASB, the GAO, the SROs and many other outside observers all have strongly held opinions about the directions we should be taking, coming to the consensus those elements will be enhanced by the legislative process. And I think it entirely appropriate for us to proceed.
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I am particularly pleased with the panel of witnesses we have here today, to get their insights on the remedies appropriate in light of the consequences we face and to quickly implement not only their recommendations, but the 10-point plan outlined by the President, which I think was responsive to our current difficulty.
In fact, there are too many employees today watching every morning the fund balance in their 401Ks erode. Where retirement plans were certain, now we are thinking about second careers. The consequences of this are enormous not just for the individual employee, but for capital formation itself. The enhanced volatility in market performance is directly related to the fear that there is an undisclosed liability or inappropriate revenue stream that is not creating a correct and accurate picture of true financial condition. We all agree, disclosure, transparency and consequences for those who fail to comply by the rules. I think how we construct those rules are the difficult aspect, but as to the principles underlying the resolution of this terrible difficulty, I think we are in agreement, and we should move forward.
Thank you, Mr. Chairman.
Chairman FERGUSON. The Chair recognizes the gentleman from North Carolina, Mr. Watt, for an opening statement, 5 minutes.
Mr. WATT. Thank you, Mr. Chairman. I hope I don't take 5 minutes, but sometimes we don't know how long these things will take.
I, during the consideration of the Gramm-Leech-Bliley bill, was accused of being one of the few Members of the Committee who actually read the bill, and I have to confess that I have made the same mistake again, this time over the break. I have actually been reading these bills, and I want to start by saying something complimentary about the Chairman's bill. It clearly moves in the right direction. It would be a substantial improvement over nothing, and I think we should keep that in mind, but I hope that this hearing today and the markup itself, if we are going immediately to a markup, will result in a deliberation about improvements or revisions that can be made to the bill to make it stronger.
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I think there are a number of instances in which I would prefer to have stronger language, stronger provisions in a number of respects. The Chairman's bill punts just a whole panoply of issues to the Securities and Exchange Commission or other bodies. Maybe some of that is necessary and desirable to get more information and input over time, but I think there are some basic principles that the legislative process has already agreed upon or should agree upon to put into the bill before we punt the rest of it to the SEC for further study.
The way to get there can be one of two ways. We can either do it by discussions off the record outside the context of a markup, or we can have a very, very protracted markup. Because, as many of you remember in the Gramm-Leech-Bliley process, there will be a number of amendments to be debated and considered. If we don't have the opportunity to put those amendments into the process, have some discussion about them before we get to the markup, then I think this markup is going to be a lot longer than perhaps is being contemplated at this point.
So one of the things I particularly feel strongly about is that there is a very important role for private litigants to enforce rights in this context. We can't give responsibility solely to the SEC and say you have got absolute authority to do this, and if you don't do it, then nobody is going to have the authority to do it. Our whole accountability system in this country is based on the rights of individuals to hold corporations and other individuals accountable when they feel like they have been wronged. So, at a minimum, we need to put some of those provisions in the bill to provide for private litigants to protect their own rights, and that I think is a hallmark of the way our system should work.
I appreciate the gentleman bearing with me, and I will yield back the balance.
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Chairman FERGUSON. The gentleman has, in fact, used the balance of his time.
The Chair recognizes the gentlelady from Illinois, Ms. Schakowsky, for an opening statement for 5 minutes.
Ms. SCHAKOWSKY. Thank you.
I want to thank the Chairman and particularly Ranking Member LaFalce for his leadership in assembling these witnesses here today that I think will make a very important contribution to the ultimate legislation, and I want to associate myself with the concern expressed by my colleague from Illinois for the Andersen employees who have, through no fault of their own, lost their jobs. For this reason, as well as many others, it is important that we do act in order to prevent those kinds of layoffs and to protect investors and pension holders from conflicts of interest and from corporate greed.
We all know that, if not for Enron's collapse, we would almost certainly not be considering these important matters today. I am concerned that some want to characterize the Enron collapse as just a case of one bad actor in the marketplace. I disagree with that interpretation, as I think do most people on this Committee, and that is why we are considering legislation. Because Enron's collapse does have systemic causes. Corporate boards of directors, Wall Street analysts and the Big Five accounting firms all have an economic incentive to provide biased analysis of large profitable companies.
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Enron used its political ties to persuade the Government to carry out its business plan. Just take a look at California. President Bush, his regulators and congressional Republicans who opposed price caps for consumers, while Enron manipulated the market, causing the energy crisis. Enron had incredible access to the White House. President Bush received over $736,000 throughout his career as an elected official. Vice President Cheney had at least six meetings with Enron officials while drafting the Administration's national energy plan. Enron's economic and political power effectively muted people who were skeptical of the company's economic stability. Enron is not an isolated case, and this is not only a business scandal, but I am afraid it is also a political scandal.
The fact of the matter is we do not have the laws and procedures in place to protect common investors. If we don't take swift action, I have little doubt that corporate executives' greed and deception will victimize more people.
Simply relying on free market dogma will not suffice. Employees and pension managers must be involved in corporate decisionmaking. Boards that are dominated by corporate executives are inherently flawed.
Enron's collapse had a significant impact on working families. In the case of Enron, hard-working people lost their life savings, while Enron's executives gained millions. It is estimated that Illinois' State pension fund lost $25 million. That means that hard-working teachers, police officers and firefighters who worked for the public good may not be able to enjoy their hard-earned retirement, and that I don't think is what public servants deserve for their future.
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Of course, I agree that we must proceed in a careful and deliberate manner, but we must proceed. That is why I am a proud cosponsor of the Comprehensive Investor Protection Act, and I look forward to making sure that, as we move to the markup, that critical provision of that bill will be included in any measure that passes out of this Committee. This legislation will help protect investors and workers in the future.
I thank Congressman LaFalce for his efforts on this legislation. We have the responsibility to enact significant reforms. I look forward to hearing the witnesses' testimony today, and I yield back. Thank you.
Chairman FERGUSON. The time of the gentlelady is expired.
The gentleman from Texas, Mr. Hinojosa, for 5 minutes for an opening statement.
Mr. HINOJOSA. Thank you, Mr. Chairman.
I want to say that I come from Texas. I have travelled throughout my district, and that is the first thing that our constituents want to know, just what are the members of the financial services going to do with regard to the losses that they have experienced, and I am looking forward to listening to the witnesses today so that, as we go through the markup, that we can make intelligent decisions and come up with a national policy that is going to protect not only the investors, but protect employees of Andersen and companies like Andersen who have lost their jobs as a result of somebody at the top who made decisions that obviously were incorrect and very damaging.
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I look forward to listening to the facts that the witnesses are going to present, because I am very interested in both of the bills presented by Chairman Oxley and our Ranking Member that I think is much more comprehensive and one that is, in my opinion, going to be necessary to consider and give every opportunity to pass through this Committee so that it can go down to the whole Congress. Mr. LaFalce, I commend you for the comprehensiveness of the bill that you have given us to consider, and I yield back the balance of my time.
Chairman FERGUSON. The gentleman yields back.
The gentleman from New York, Mr. Israel, for 5 minutes for an opening statement.
Mr. ISRAEL. Thank you, Mr. Chairman.
I also spent a considerable amount of time in the last 2-and-a-half weeks travelling throughout my district and hearing from constituents who routinely asked what we are going to do to ensure the integrity of investments; and I want to commend the Ranking Member, Mr. LaFalce, for the work that he has done on his bill. I also commend our Chairman for his work.
Ultimately, it is my hope to support legislation that has a number of features: number one, that provides the strongest oversight protections; number two, that facilitates transparency; number three, that ensures accountability; and, finally, that ensures an even standard among investors and management.
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I look forward to working with my colleagues on the Committee to these ends, and I yield back the balance of my time.
Chairman FERGUSON. The gentleman yields back.
The Chair sees no other Members seeking time for an opening statement.
The Committee will now hear testimony from our panel of witnesses. We thank the witnesses for their patience and for their presence here today. They are, from the Chair's left to right, the Honorable David Walker, Comptroller General of the United States, U.S. General Accounting Office; the Honorable Richard Breeden, former Chairman of the SEC, now with Richard C. Breeden and Co.; Professor Donald Langevoort from the Georgetown University Law Center; and Mr. Damon Silvers, Associate General Counsel of the AFL-CIO.
Mr. Walker, you are invited to give your testimony. You have 5 minutes. Thank you for being here.
STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER GENERAL OF THE UNITED STATES, U.S. GENERAL ACCOUNTING OFFICE
Mr. WALKER. Thank you, Mr. Chairman, Members of the Committee.
With your permission, I would like the entire statement to be entered into the record.
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Chairman FERGUSON. Without objection, so ordered.
Mr. WALKER. Thank you. I will now summarize that statement.
I appreciate the opportunity to share our perspectives on a range of issues emanating from the sudden and largely unexpected bankruptcy of Enron Corporation and financial-related activities relating to several other large corporations.
As the Committee knows, GAO has conducted an extensive amount of work dealing with the accounting profession and has issued a number of reports over several years. More recently, in order to assist the Congress in framing needed reforms, on February 25th, 2002, we convened a forum on corporate governance, transparency and accountability to discuss a variety of systemic issues. On March 5, 2002, we issued highlights of the forum meeting which, Mr. Chairman, we will make available for the record if you so desire.
As you requested, my comments today will primarily focus on oversight of the accounting profession and related auditor independence and corporate governance issues raised by Enron's failure.
The issues raised by Enron's failure are multi-facetted, involving many different problems and players with various roles and responsibilities. In that respect, needed changes to the Government's role should vary depending upon the specific nature and magnitude of the problem. Specifically, the Government's role can range from direct intervention to encouraging certain non-governmental and private sector entities to take certain steps designed to enhance trust and better protect the public interest.
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With regard to the possibility of a new oversight body, the issues of fragmentation, ineffective communication and limitations on disciplines surrounding the accounting profession's self-regulatory system strongly suggests that the current self-regulatory system is not adequate in effectively protecting the public's interest, particularly in the auditing area. We believe these are structural weaknesses that require congressional action. Specifically, we believe that the Congress should create an independent statutory Federal Government body to oversee financial audits of public companies.
The functions of the new independent body should include:
Establishing professional standards dealing with auditing standards, including standards for attestation and review engagements, independence standards, and quality control standards, for both public accounting firms and key members of those firms who audit public companies.
Second, inspecting public accounting firms for compliance with applicable professional records and standards;
And investigating and disciplining public accounting firms and/or individual auditors of public accounting firms who do not comply with applicable professional standards.
This new body should be independent from, but should closely coordinate with the SEC in connection with matters of mutual interest.
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There are alternative models which we would be more than happy to discuss if you so desire.
In addition, we believe that the issues concerning accounting standard-setting can be addressed by the SEC working more closely with the FASB, rather than putting that function under the new body.
The new body should be created by statute as an independent Federal Government body. The new body should have resources of funding independent from the accounting profession. For accountability, we believe the new body should report annually to the Congress and the public on the full range of its activities, including setting professional standards, inspections of public accounting firms and related disciplinary activities. The Congress may wish to have GAO review and report on the performance of the new body after the first year of its operations and periodically thereafter.
We believe that the effectiveness of boards of directors and committees including their working relationship with management of public companies can be enhanced by the SEC working with the stock exchanges to enhance certain other listing requirements for public companies.
We also believe that the issues surrounding the financial reporting model can effectively be addressed by the SEC in conjunction with the FASB without statutorily changing the standard-setting process. However, we do believe that more active and ongoing interaction between the SEC and the FASB is needed in order to facilitate a mutual understanding of priorities for standard setting, realistic goals for achieving expectations and timely actions when expectations are not met.
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Over the last decade, securities markets have experienced unprecedented growth and change. At the same time, the SEC has been faced with an ever-increasing workload and ongoing human capital challenges, most notably high staff turnover and numerous staff vacancies. We believe it is important for the SEC to be provided with the necessary resources to effectively discharge its current and any increased responsibilities that the Congress may wish to give it.
Finally, we believe the SEC should be directed to report annually to the Congress on certain matters that I outline in my testimony.
In closing, Mr. Chairman and Members of the Committee, the United States has the largest and most respected capital markets in the world. Our capital markets have long enjoyed a reputation of integrity that promotes investor confidence. However, this long-standing reputation is now being challenged by certain parties.
Today, I have discussed our suggestions to assist the Congress in crafting needed reforms. We strongly believe that an independent Federal Government body created by statute to regulate audits of public companies is needed in order to better protect the public's interest. However, currently we do not believe that it is necessary or appropriate for the Government to assume direct responsibility for other key areas, such as generally accepted accounting principles or corporate governance requirements. We do, however, believe that Congress should provide the SEC with direction to address certain related issues.
In the end, no matter what system exists, bad actors will do bad things with bad results. We must, however, strive to take steps to minimize the number of such situations and to hold any violators of the system fully accountable for their actions. Thank you, Mr. Chairman.
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[The prepared statement of Hon. David M. Walker can be found on page 422 in the appendix.]
Chairman FERGUSON. Thank you, Mr. Walker.
I would ask the witnesses to do your best to stay within the 5-minute time constraint, something that we all up here have enough difficulty doing on our own. Thanks very much.
Mr. Breeden, 5 minutes.
STATEMENT OF HON. RICHARD C. BREEDEN, FORMER CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, RICHARD C. BREEDEN & CO.
Mr. BREEDEN. Thank you, Mr. Chairman, Ranking Member LaFalce, Members of the Committee. It is a great pleasure to have the opportunity to testify before you today at your request to discuss the provisions of H.R. 3763 and H.R. 3818, as well as to address various issues raised by the Committee arising out of the tragic and disturbing events at Enron.
I had the great privilege of serving as Chairman of the Securities and Exchange Commission back when dinosaurs roamed the earth. It was an era in which we were successful in passing several major pieces of legislation, both when I was in the White House, the savings and loan reform legislation and the Market Reform Act and Securities Enforcement Remedies Enhancement Act of 1990. And both in our legislation and the work of the Commission in that era, I had the great pleasure of working with both sides of the aisle in Congress.
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It has been a great tradition in the area of financial services regulation and particularly in the areas governed by the SEC of bipartisanship, and it is a good thing to see you working together to try and address these problems. It is important that that tradition of bipartisan cooperation remain the prevailing spirit in this area.
At the outset, I would like to congratulate all the Members and the staff of the Committee for the fine work you have done in developing legislative proposals to respond to the weaknesses in our current system that this situation has brought to light. Both bills contain many sensible provisions that should enhance our extremely good system and make it more resistent to problems in the future. Both bills follow generally similar principles and demonstrate many areas of common agreement. This is particularly apparent in the provisions of both bills concerning a new approach to oversight for the accounting profession, enhancements to the quality and speed of disclosure and enhancing healthy practices in corporate governance.
While H.R. 3818 goes beyond the provisions of H.R. 3763 in a number of areas, it appears clear to me that there is good common ground in the two bills and plenty of room to craft a bill that is reasoned and measured. Certainly the President has shown leadership in this area as well, and with Presidential leadership in both Houses of Congress and both parties considering these issues, there is plenty of room to try and craft a bill that would reflect a consensus approach to these issues.
Of course, some have said the market has already fixed all of the problems of Enron, and with that I respectfully disagree. There is no question the market has reacted to the events at Enron. Boards of directors and audit committees are more sensitive and wary about conflicts and overstatements of income. Many people have learned more about SPEs than they ever thought they would learn in their life in recent weeks, and I doubt if many boards will be suspending corporate codes of conduct and conduct standards any time soon.
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Hopefully, auditors at other firms realize both the importance of sharing concerns with the audit committee, rather than keeping silent about major issues and alternatives, and investors are exacting a price from companies where they perceive a higher level of accounting risk and lower levels of transparency. These are all very healthy and welcome developments.
While improvements have been made, market responses can be short-lived, and many memories can be too short. Unfortunately, companies that don't need the reforms often adopt the better practices, but companies that pose the greatest risk to investors may not change their policies at all.
There are many issues involved in the Enron-Andersen case that cannot be solved entirely by market, and there is not any reason we should be reluctant to admit where our system has weaknesses we should address.
The system for oversight and discipline of the performance of audit firms and their personnel is one area that would benefit from a legislative change. Our previous system of peer review and self-regulation of certain types of issues through the Public Oversight Board did not work. The SEC needs at least some additional resources to allow it to handle the volume of financial fraud cases it should be pursuing, as well as providing more frequent review of filings by high cap and widely held issuers.
Legal standards today for disciplining accountants and their firms for audit failures are subject to more litigation than is desirable. Certain enhanced types of remedies such as stronger officer and director bars and disgorgement authority to recover profits on sales of stock by insiders prior to a bankruptcy would be desirable. Standards need to be set regarding consulting services by audit firms for audit clients, and the system for developing and interpreting accounting principles through the FASB needs to be improved.
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These and other modest steps can complement market disciplines and help restore balance and confidence to our system. None of these steps need involve excessive regulation or interference with healthy market developments.
In drafting the specific bill, we should not stake all on trying to do too much, and we should not allow ourselves to do too little. We have to make sure, for starters, that existing law is vigorously enforced, because much of the Enron-Andersen case involves violations of existing laws. Beyond that, you have identified a number of reasoned and careful steps that will enhance the qualities of the existing system.
My written testimony responds to a number of questions from the Committee, and I would be happy to discuss any of those questions further, and I would only like to very, very briefly summarize my views on the establishment of a new oversight body for the accounting profession.
Both bills contain provisions concerning establishment of a new oversight body. In my testimony I urge you not to create a new governmental body, but rather to reinforce the role of the SEC in dealing with such issues. Whatever body is created and whatever its exact mission, any such group should be a private sector entity with oversight by the SEC. We should not repeat now the mistake that was made when the CFTC was created that set us on a course of endless competition of jurisdiction between Government bodies with closely paralleled missions.
The SEC is there. It has the history, the culture and the tradition and the tools for dealing with these kind of problems; and it should be the body that then provides oversight to an effective self-regulatory organization, along the lines of the NASD or the New York Stock Exchange. There the organizations have strong staffs, a good record of promoting healthy ethics and law enforcement, while not creating additional Government bodies.
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Again, thank you very much for having me, and I commend the strong efforts of both parties to date in seeking to build legislation that can command broad-based support. Our disclosure and accounting system has stayed viable over the years because we have not been afraid to learn from major problems and to change some of the rules of the game. In my judgment, this case demands a reasoned and measured response, but a response nonetheless. Thank you.
[The prepared statement of Hon. Richard C. Breeden can be found on page 454 in the appendix.]
Chairman FERGUSON. Thank you very much.
Professor Langevoort, you are recognized for 5 minutes for an opening statement.
STATEMENT OF PROFESSOR DONALD C. LANGEVOORT, GEORGETOWN UNIVERSITY LAW CENTER
Mr. LANGEVOORT. Thank you, Mr. Chairman, and let me try and be very brief.
The last few months have brought public attention to bear on the seriousness of a problem—that economic forces have increased the temptation and techniques many companies' executives face to be dishonest with the investing public and that these temptations and techniques have translated into an unacceptable level of corporate fraud, mismanagement and concealment.
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My invitation here today is not to address all of the possible reforms that could come from this but, rather, touch on private securities litigation as one touchstone for reform; and I will try to be very, very brief by focusing my oral remarks, as opposed to my written testimony, on the two reforms that I consider most important and indeed whose merits to me are beyond doubt.
First, restoring a system in which those who aid and abet securities fraud become liable to the victims. When the Supreme Court in 1994 eliminated aiding and abetting and private rights of action, it didn't do so on policy grounds or through careful legal reasoning. Rather, it said, as a matter of statutory construction, that job is for Congress, not the courts. I urge you today to take up the court's invitation and respond accordingly.
It is very difficult to argue that somebody who provides substantial assistance to a securities fraud shouldn't have to compensate the victim. The common law has for centuries imposed that liability. Congress has recognized that aiding and abetting is a Federal crime and in 1995 gave the SEC specific authority to proceed in that direction. It is clearly wrongful. Why then wouldn't you make the aider and abetter compensate the victim? The answer, we are told, is fear of litigation abuse, that these kinds of claims can be abused.
Now, I have to confess, I am one of those people who takes litigation abuse seriously. I think Congress in 1995 acted appropriately in addressing the issues, even if I don't agree with all of the specific outcomes. But litigation abuse and its fear is no excuse for saying that somebody who provides the brains, the talent, often the motivation behind a fraud should avoid responsibility to the victims simply because their appearance is not made visible to the investing public, and sadly that is the state of the law that we have today. Those to whom the fraud is not attributed and who are not identified to the investing public have grounds to avoid liability.
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It seems to me clear that we ought to change that rule in the name of common sense, without regard to debate about the statistics of whether the incidence of private securities litigation has gone up or down. It simply makes sense to impose liability on those people.
Second, the other reform I want to address in my oral testimony is redressing the rather foolish statute of limitations that we have today for private securities actions. The Supreme Court once again gave us this rule, again as a matter simply that since Congress hadn't done anything about it since 1934, who are we to impose a different standard? The result is that we have in private securities litigation a rule that was adopted in 1934 before Rule 10b-5 existed, before class actions existed, before the depth of our securities markets and its breadth could have been imagined. It is silly to assume that a rule adopted then should be the rule adopted today simply a result of history.
That rule that actions have to be brought within 1 year after notice is much too short today to develop a complex, well-grounded lawsuit. And, even worse, the rule that if somebody can hide the fraud for 3 years they get away completely simply as a result of their success is also something that makes no sense in our highly complicated, highly complex financial markets.
Now, I make no claims that these two reforms or the others that I address in my written testimony would prevent the next Enron, would change things dramatically, but they are very important first steps, very important pieces of the puzzle that we ought to take as we begin to address the problem.
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Thank you.
[The prepared statement of Prof. Donald C. Langevoort can be found on page 482 in the appendix.]
Chairman FERGUSON. Thank you very much.
Mr. Silvers, 5 minutes for your testimony. Thank you for being here.
STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, AFL-CIO
Mr. SILVERS. Thank you and good afternoon, Mr. Chairman, and Ranking Member LaFalce.
On behalf of the AFL-CIO 65 member unions and our 13 million working family members, I want to thank the Committee for the opportunity to appear here today.
The collapse of Enron and similar events at Global Crossing, Waste Management and other public companies are a window into a set of pervasive conflicts of interest that defeat the purposes of corporate governance and threaten the retirement security of America's working families.
This Committee has heard in prior hearings from those who would still have you believe what Enron used to preach in this town, that unregulated markets will solve all problems if they are just left alone. Now that may be the view from the K Street offices of the people who do the heavy lifting for the audit firms here in Washington, but it is not how things look for thousands of working families in Houston and Portland, Oregon, and Rochester, New York, and clearly in Chicago who have lost their jobs or their retirement savings and their health care because they believed what they were told by their employers, by their employers' accountants and the analysts that interpreted the accountants' numbers.
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H.R. 3813, the aptly named Comprehensive Investor Protection Act of 2002, is the most comprehensive legislation introduced in this Congress in response to the conflicts of interest in the capital markets and in the boardrooms of America's public companies.
Let me briefly review the areas where Congress needs to act to protect investors, the provisions of H.R. 3818 that respond to that need, and the key differences between H.R. 3818 and H.R. 3763, which the Chairman discussed in his opening remarks.
First, public company boards need strong, independent directors, so investors need complete disclosure of all the ties that exist between the board members, the company and company management. H.R. 3818 requires just that, while 3673 has no such requirement. This higher standard of independence should be the relevant standard for measuring the independence of company auditor and compensation committees.
Furthermore, shareholders should have access to management's proxy not just for shareholder proposals on a handful of subjects, but for director candidates, independent director candidates. We urge these corporate governance provisions be added into any reform package this Committee takes up.
The second area in need of reform is the practice of public accounting. Here again H.R. 3818 takes the right approach to auditor independence by giving the SEC the authority to ban a wide range of consulting by auditors and requiring that the audit committee or the full board of directors of a company approve in advance the provision of consulting services by the company's audit firm that are still allowed by the SEC.
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In contrast, H.R. 3673 bars only certain types of consulting and would allow the sorts of consulting that led to the most egregious abuses at Enron by Arthur Andersen to continue.
The next issue is auditor oversight. Former SEC Chair Arthur Levitt has outlined in testimony before the Senate Governmental Affairs Committee what we believe are the key characteristics of a much-needed auditor oversight body: members independent of the Big Five, full investigative and disciplinary powers, and independent funding. H.R. 3818 creates a public accounting regulatory board that meets these tests. H.R. 3763's provisions do not meet these tests.
Then there are the Wall Street analysts. H.R. 3818 requires the SEC to ban analyst compensation tied to investment banking performance. The Majority's bill goes no further than requiring a study.
All these reforms, though, are of little benefit if there is no enforcement. The Ranking Member's bill provides both adequate resources to fund pay parity for the SEC and to expand the Commission's oversight and enforcement activity. The Majority's bill has no such provision.
Finally I want to address the ultimate accountability measures available to shareholders: recourse to the courts. As Professor Langevoort has mentioned, the restoration of investors' right to sue those who aid and abet securities fraud is a vital and important step that must be taken immediately. I would add, in addition to the statute of limitations issue, that the restoration of joint and several liability is critical in cases where the wrongdoers start filing for bankruptcy. These provisions are included in H.R. 3818 and not in the Majority's bill.
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In conclusion, H.R. 3818 gets at the heart of the problem of conflicts of interest, whereas H.R. 3763, the Majority's bill, leaves untouched the central conflicts of interest, conflicts of interest that brought us Enron and will no doubt continue to cause losses to workers' retirement savings if not addressed. At the heart of what happened at Enron are systemic problems that need systemic solutions. These solutions will no doubt offend powerful interests, but they will protect America's working families. H.R. 3818 contains within it these necessary solutions and has the AFL-CIO's strong support.
The AFL-CIO is grateful for the opportunity to share our views with the Committee on these bills and welcomes the opportunity to continue to work with the Committee as you move forward in addressing these important issues. Thank you.
[The prepared statement of Damon A. Silvers can be found on page 492 in the appendix.]
Chairman FERGUSON. Thank you very much to all of our witnesses. We appreciate your presence here and lending of your insights and expertise to some of the very important matters before the Committee particularly regarding this legislation.
We are now going to be begin our question period. Each Member will be allotted 5 minutes to ask questions of the witnesses. I would like to begin the question period by yielding to the distinguished subcommittee Chairman of the Capital Market Subcommittee Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman, for that courtesy. I do appreciate it very much.
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Mr. Walker, I noted in your written testimony reference to the fact that the audit clients should have clearly an understanding that he has a primary responsibility to the shareholders. I recall having read in the earlier report also another line which indicated it should be made statutorily clear that the financial statement is the property of the shareholder.
In testimony before this Committee Mr. Berardino, the former CEO of Andersen, in response to a question from me indicated that the financial statement was the property of management and the shareholder, which I thought flew in the face of Accounting 101 in that the audit committee's engagement of the audit team is to prepare an accurate and true picture of the financial condition for the shareholder. Although the financial data must be arrived at in consultation with management to understand the true operations of the business plan, management should not be involved in the alteration, manipulation or intimidation of the preparation of the numbers as the audit team sees them in light of this responsibility. Is that an accurate reflection of your understanding?
Mr. WALKER. My understanding, Mr. Baker, is that first the board of directors work for the shareholders. Second, under the current literature, management is responsible for the financial statements, but the financial statements are for shareholders and other stakeholders.
I personally believe that one of the real keys that has to be focused on here is determining who is the client and who are the parties that are representing the client. I would assert that when you are talking about an audit, when you are talking about related financial reporting associated with that audit, that the client should be the shareholders and other stakeholders who are relying upon that information. But their representatives should be the audit committee, which would be an independent body that is part of the board which should be responsible for hiring the auditors. The audit committee should assume additional responsibility above and beyond what it has right now in order to ensure that there is a convergence of interests between the board, which is supposed to be working for the shareholders, and the independent auditors, who should be working for the shareholders, but in addition to that, should serve a broader public interest.
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Mr. BAKER. If I may, let me take that as a long yes, because I have a follow-up. There is inherently a conflict between the management's interest to enhance stock performance, thereby enhancing their own remuneration, perhaps at the expense of the shareholder in unfortunate cases. To disincentivize that type of manipulative conduct in relation to the preparation of the statement, would it be advisable for us to consider making the CEO personally responsible and liable for the accurate preparation of the financial statement? I know there is clearly a responsibility, but do we need to make that more clear?
I will jump to the next one while you are rolling that one around because I would like Mr. Breeden to comment as well.
To go perhaps further, it has been represented that there are cases in which management, through collusive efforts of many, have enhanced appearances of the corporation to increase the value of stock, exercise no cost options granted as a part of their employment arrangement, and then subsequently have a restatement of earnings so that the shareholder takes the net effect of loss, and the executive remains enriched through that manipulative process. For example, in that case, should we authorize the SEC to make inquiries into matters of that sort and be given the rules and authority to take appropriate action including disgorgement, so if there is a downturn as a result of manipulative bookkeeping, that there are consequences for the corporate executive?
I make these comments in light of Chairman Greenspan's remarks and others' who have encouraged us to find ways to disincentivize short-term earnings pressures and long-term corporate asset growth. Would either of you comment, please?
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Mr. WALKER. There are several things in my testimony where I talk about things that I think the SEC should be required to look into in order to provide better checks and balances, and to better protect not only the shareholders' interests or the public's interests. They include the composition of the board, the composition of the key committees on the board, and providing additional transparency and checks and balances, again the kind of actions you are talking about.
Right now management does have a responsibility to sign a management representation letter in conjunction with an audit, and they are supposed to make certain assertions that to the best of their knowledge and belief, that certain things are true and correct. I think that could be an area that you may want to have whichever body that you decide should be responsible for the auditing area for better protecting the public interest to take a look at that and determine whether or not additional steps should be necessary.
Mr. BREEDEN. Congressman, it is nice to see you. I would only add, number one, on your question of the financials themselves, financial statements have to be prepared by management. The starting point is—the only correction to what you said, the auditors are not engaged to prepare the financials. That is management's duty and responsibility. The auditors are there then to check those financials and test them, and that check-and-balance system is at the heart of how we go about preparing financial reports.
I think absolutely CEOs should be responsible for what is in the financial statements. I think they are legally today already. The system today, however, provides also full indemnification from the company as well as insurance if they have any liabilities. So you have liabilities.
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Mr. BAKER. With your due diligence, I know time has expired, I just want to emphasize that one point in the event there is an allegation against the corporate CEO for misrepresentation of material elements of the preparation of the financials, the corporate attorney defends the CEO, where the shareholder has to fund the personal litigation expense out of their pocket. My point is should there be a down side where it is defined after appropriate inquiry that the manipulation that did, in fact, occur, there was a loss incurred, should not the CEO then out of his own pocket have some liability which does not now today exist?
Mr. BREEDEN. I think your point of there being a down side is important. I think the President's messages have emphasized that. Chairman Pitt's remarks have emphasized that. My own testimony suggests that we do need to do more in the disgorgement area.
I am particularly worried about the situation where an executive may be selling, in Gary Winnick's case in Global Crossing, $750 million worth of stock on the eve of bankruptcy and whether or not you should trigger it by a restatement. I think Congress should consider whether stock sales within a certain period of time of the company going into bankruptcy, whether the profits from those sales by senior officers shouldn't be recaptured into the bankruptcy estate.
Mr. BAKER. I have much more, but I am way out of time. Thank you very much.
Mr. CANTOR. [Presiding.] The Chair now recognizes Ranking Member LaFalce.
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Mr. LAFALCE. Thank you very much.
Today, I introduced a bill to give legislative teeth to a number of the recommendations that President Bush called for: Number one, with respect to disgorgement of bonuses and other incentive compensation for either false or misleading statements or other misconduct; number two, requiring the CEO and CFO to personally vouch for and certify to the veracity, fairness of their company's public disclosures, including their financial statements and certification that certain internal control procedures are in place; and third, enhancing the ability of the SEC to bring an enforcement case prohibiting a person from acting as an officer or director of a public company by lowering the standard. Right now the standard is substantial unfitness. We would simply eliminate the word ''substantial.''
It may be unfair to ask you to comment on a bill that you have not been asked to testify on at this juncture, but it would be fair, I think, to ask you to submit a letter to the Committee giving your views on that bill once you have had time to consider it, hopefully before markup on Thursday.
OK. Now to go on.
Mr. Walker, you have indicated, I believe, correct me if I am wrong, that a new oversight body for the auditing profession is necessary; that it should have the authority to establish professional standards for the auditors of public companies; that this new regulatory organization should be able to set independence standards; that the new regulator should be able to charge annual fees to public companies as a means of financing itself. Is that basically correct?
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Mr. WALKER. That is true. Our recommendation——
Mr. LAFALCE. You find those provisions in H.R. 3818, I would assume, and not in the other bill.
Mr. WALKER. I would find——
Mr. LAFALCE. Wherever they are found, would you favor them?
Mr. WALKER. Some of the provisions are in H.R. 3818.
Mr. LAFALCE. Why do you think they are important?
Mr. WALKER. My personal view is that we should not have direct Government intervention unless we believe that it is called for. If there are other bodies which Government could encourage to take the right steps, we should first try to do that. If they fail to act, direct Government intervention should be considered.
I think the area where direct Government intervention is necessary is in the auditing area. I do not believe that you are going to achieve the objective of best protecting the public's interests without more direct Government involvement dealing with the independence setting for auditors of public companies, the quality assurance procedures associated with those auditors, the disciplinary process associated with those firms and the individual members, and certain other matters laid out in our testimony.
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Mr. LAFALCE. I appreciate that. Both Mr. Oxley and I believe that we do need a new auditing body. The question is what power should it have. It certainly should have at least those powers and maybe more. It is something that Mr. Breeden suggested, subject to compromise, we can talk about. But another question is who should be on that board? And that is a very important question. And I have said that the SEC should appoint them, but from lists that were submitted from certain type of organizations such as pension plans of private employees, pension plans of public employees, and so forth. Otherwise you might have a situation where you have Mr. Pitt appointing a board that Mr. Boucher would look at and say, this is so bad I am resigning, which is exactly what happened.
So do you have any thoughts as to the type of individual that should be on that board? Do we leave it totally to the discretion of the SEC, or do we put some language in the legislation which tries to make sure that the individuals on that board will be interested first and foremost and exclusively in the protection of investors?
Mr. WALKER. My personal view is there should be some standards for the individuals who would be appointed to the board. I would note in your bill, Mr. LaFalce, there is one provision in there that I think may raise a constitutionality issue, and that is——
Mr. LAFALCE. I will take that one out, whatever it is.
Mr. WALKER. It is the one that talks about the Comptroller General being part of the appointment process. The Comptroller General can make recommendations.
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Mr. LAFALCE. You don't want it, you don't get it. You are out.
Mr. Breeden, you described two concerns with the non-audit services that auditors currently provide to audit clients, one specific service that creates conflicts for the auditor, and, two, the volume of non-audit fees in relation to audit fees. Does either bill address it adequately, more adequately? Are both inadequate? Do you have a preferred approach other than the approach in either of the two bills?
Mr. BREEDEN. Congressman, I think both bills have made a very good start looking at what is—I tried to—in my usual excessively wordy way, I tried to in my testimony show that there are some real complexities in that issue. It is hard to just say no consulting at all, because things like tax services are not pure audit, but would rob the audit of its vitality if you took them away.
Mr. LAFALCE. Which I specifically say should not be done.
Mr. BREEDEN. Neither bill takes the tax services away, although some of the proposals in the marketplace have done that. I think they would do significant damage if you went that far.
Consulting on internal controls is something I used to do in the 3 years I spent at Coopers & Lybrand, and I think that it contributes to the quality of audits. So I think that we need to identify any cases where the auditors are, in essence, auditing themselves. If they have built a data system that is the system used for financial reporting, if they are doing something in the consulting side that their own auditors are supposed to go and audit, it is unreasonable to expect that they will give the same level of diligence that they would if an independent person had done that. The magnitude of all the whole shebang is too much; then you also have distortion.
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Mr. CANTOR. The gentleman's time has expired.
Mr. WALKER. Real quickly, Mr. Chairman, can I?
In my testimony we recommend that the Committee consider a principles-and-safeguards-based approach that we have already promulgated for Federal entities and entities that receive Federal funds. As you know, Mr. LaFalce, the GAO actually promulgates auditing standards for Federal entities and entities that receive Federal funds. We believe that that guidance would be helpful in considering what should be done with regard to public companies. Thank you.
Mr. CANTOR. The Chair thanks the gentleman.
At this time the Chair would like to address for a moment Mr. Breeden. I take it you are familiar with Chairman Greenspan's remarks when he addressed this Committee several months ago. While he was here, he expressed a concern that Congress could go too far in overregulating the capital markets in response to the issues at hand. Can you comment on that? What do you make of those concerns?
Mr. BREEDEN. Well, I think any time you have a scandal of this kind that has touched so many people and caused such widespread losses, and between the losses to investors in Enron and the losses to Andersen employees and so on, there is an enormous amount of damage here. And so I think Chairman Greenspan was—as many others have done—noting a concern that Congress be careful in responding to events that naturally cause outrage on the part of good people everywhere, that we not go too far in fashioning a legislative response, and I agree with that sentiment.
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At the same time I also believe that there are some areas that have been exposed in this overall situation that would benefit from legislative changes, that we not do too much, but we not do too little. I think actually that Mr. Oxley's legislation together with Mr. LaFalce's legislation, both bills here attempt to—and one goes further than the other, but maybe something in between is an area where people can coalesce around. It is important not to go too far, but I think there are some areas where real change needs to be made.
Mr. CANTOR. Mr. Walker, can you respond to those concerns?
Mr. WALKER. Yes. As I said in my statement, you should only have direct Government intervention where you believe that the problem cannot be effectively addressed by other parties. In that regard, we believe the greatest need is in the auditing area, and what we are recommending is that there be a qualified, independent and adequately resourced body to be able to assume those responsibilities rather than the Congress trying to get into the details, trying to make those decisions through legislation. I think that is critical in order to make sure that you don't over react, that you have a balancing of interests.
As you know, Chairman Greenspan has also said that he believes that additional action is necessary in certain areas such as in the auditing area and has expressed some concerns about current accounting and reporting with regard to certain types of compensation arrangements.
Mr. CANTOR. Thank you.
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If I could turn to Mr. Silvers for a moment. In 2000, former SEC Chair Levitt proposed auditor independence rules targeting 10 consulting services for prohibition, the final SEC rule prohibiting seven of these services. Another was dropped because it was deemed unworkable. The Oxley bill bans the other two. The LaFalce bill bans all 10. Again, seven are already prohibited under the current rules. Isn't this provision redundant?
Mr. SILVERS. I am sorry, sir, which provision do you think is redundant?
Mr. CANTOR. The Oxley bill bans the other 2, but the LaFalce comes in and bans all 10, while 7 are already prohibited by the rules as they exist now.
Mr. SILVERS. My understanding from reading the bills, Mr. Chairman, is that Mr. LaFalce's bill provides the Commission with the authority to take a look at a practice such as that which occurred at Enron where Arthur Andersen participated in structuring SPEs and then came back, and partly did so, I believe, under the rubric of tax consulting. Certainly they could have done so under the rubric of tax consulting. They structured the SPEs and came back and audited the SPEs and generated a $5 million fee for doing so.
The challenge of this problem of conflict of interest is that the Commission needs to have the authority to draw these fine lines, and the Chairman's bill simply does not give the Commission the clear authority and direction to do that. Mr. LaFalce's bill does that. The difference, frankly, is that under the Chairman's bill, if a firm was to feel that it made sense for them economically to go and do what Arthur Andersen did at Enron, there really would be no reason per se under the Chairman's bill that they couldn't do that, whereas Mr. LaFalce's bill clearly directs the Commission to promulgate rules under that conduct. I don't believe that distinction is by any means redundant, as you would suggest.
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Mr. CANTOR. Mr. Breeden, if I could turn to you in an attempt to elicit a response about the potential redundancy in one of the bills that attempts to address the rules that are already in place.
Mr. BREEDEN. Mr. Chairman, I have not looked in detail at the language of the Commission's current rules compared to the bill to see whether they are completely overlapping or whether there are gaps there. I could do so afterwards and send you a letter about it, but I really haven't done so, and so I can't tell you whether they are fully redundant or not.
Mr. CANTOR. It would be appreciated. Thank you.
Mr. LAFALCE. Would the gentleman like me to give an answer? Number one, they are not fully redundant at all because there were carve-outs within the rule. Number two, if the worst sin in redundancy is that codification into law of regulations, I will accept that sin.
Mr. CANTOR. The Chair thanks the gentleman.
The Chair now recognizes Mr. Kanjorski.
Mr. KANJORSKI. All of the testimony in the pending bills makes certain presumptions that, one, we know the full extent of the Enron disaster, and also obviously in regard to its accounting firm, Arthur Andersen, with its $25 million in auditing fees and $27 million in consulting fees. I would like to know whether these were overcharges, whether the work performed was unethical or improper, and if it was, to what extent. Are any of you aware of any studies that have analyzed what work was done, how competent the work was, and whether or not, in fact, any of it was improperly done?
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Mr. WALKER. I am not aware of a study. I am also aware of the fact that Arthur Andersen at least was performing certain internal audit services that would be banned under both of these bills, which I think is noteworthy.
Mr. BREEDEN. Congressman, I am not aware of any studies, but $52 million in fees combined for auditing and consulting is an enormous fee. That would put—Enron's payments to Andersen clearly would have had to have been among the top of not only Andersen's clients, but any accounting firm's clients.
Mr. SILVERS. Mr. Kanjorski, I would make two points in response to your question. One is the conflict that was alluded to in response to the Chairman's questions is discussed on page 5 of the Powers Report and gone into in some detail later on in the report in terms of the specific conflicts that were at work here. I would add that prior to the appearance of the Powers Report, that both Andersen and Enron made some efforts to conceal from Congress in several different committees, including this one, the extent of those conflicts, but the Powers Report itself documents them quite adequately.
I could also say that although that fee is very large, it is very interesting that the multiple of the consulting fee in relationship to the audit fee at Enron was not even close to the high end. There have been several surveys of the ratios that the SEC's recent disclosure rules have divulged to us of these ratios in other major public companies which I would be happy to provide to the Committee. I would know one sticks in my mind, which is Motorola, which had a board overlap with Enron until very recently. Motorola was 16-to-1, the ratio of consulting fees to audit fees.
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Mr. KANJORSKI. The consulting fees were 16 times more than the audit?
Mr. SILVERS. Precisely.
Mr. KANJORSKI. So maybe Andersen undercharged?
Mr. SILVERS. Perhaps you could raise that with them.
Mr. KANJORSKI. The reason for that question is, obviously, that the Congress is going to act. Whenever anything happens in our society, we either pass a law or we form a commission. Obviously, we are not going to be able to form a commission to address this problem, so we are going to pass a law.
I am a little worried about the unintended consequences of what we may be passing. I am not absolutely certain that the Congress has the clarity of either the Enron problem, if it represents an endemic problem, and just how endemic that problem is, or whether or not we are in a position to move this legislation through as quickly as we seem to be. Should we take more deliberative time? Do any of you see some great risk to our economic system if we take a couple of more months in resolving this problem, or do we have to do this before Memorial Day because it fits into the political schedule?
Mr. SILVERS. I am the only person willing to take a risk on this proposition. Obviously I think the people that I represent here would like Congress very much to take action in this session. I would defer to the wisdom of the Committee as to what precise calendar that requires. It seems to me that the more important question is are you going to take the right direction or not.
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I think, Mr. Kanjorski, your questions get at one issue in which I am not sure that this Committee is heading in the right direction. It would be better to take the time to get it right than to do something that won't protect America's working families against a future Enron.
Mr. KANJORSKI. I tend to agree, too. That question is structured along the idea that we have 17,000-plus public corporations. It would seem to me they do not all fall into Enron's category. Anything we do will also cause additional expenses for those corporations and to the Government in order to police the law we are enacting. I am just worried: are we going to do what sometimes we have done in other Congressional actions? We could just end up just ignoring the cost and the burden to struggling companies that have to get equity and have to get out there. They have not done anything, but they will have to comply with all these rules and regulations at great expense to the company and ultimately to the shareholders, and maybe actually put their long-term success in jeopardy.
What I am thinking, is whether or not we should put a tier operation into effect with any bill and look at only the top 1,000 or 5,000 corporations. But all 17,000 of these companies? We initially did that with all banks when we enacted CRA. To a large extent, it was my experience that we initially put unusual burdens on small community banks to go through the legal work and expense to comply with CRA. Before we changed the law, I visited banks that were spending a sixth of their income on legal and accounting fees to prove compliance with CRA—little banks that could not exist outside of their community. So, anything they were doing, they were complying with CRA.
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Yes?
Mr. CANTOR. Will Mr. Walker answer the question, then the gentleman's time has expired.
Mr. WALKER. I think in the final analysis it is better to get it right rather than do it fast, but I think there is a need for some expeditious attention to the critical area, especially in connection with the auditing area. Obviously, as you know, Mr. Kanjorski, this is the beginning of the legislative process on this side of the Hill, and the Senate has to act as well. There are a lot of things that have to happen before this will get finalized.
We do recommend in our approach that it is important to have qualified, independent and adequately resourced bodies deal with a lot of the details. The Congress may want to ask for those bodies to look at certain issues and to make sure, for example, that in the area of independence that they consider a principles-and-safeguard-based approach, that they can look at certain services in particular as to whether or not they should be allowed, and if so, under what circumstances. I think if you take that approach where you are making sure you have a qualified, independent, adequately resourced body, you are providing that body with the power to do what needs to be done, you are providing it some guidance, but not getting too detailed with regard to how much you are prescribing legislatively, that might be a reasonable balance because, after all, markets evolve over time. What you say today may not be appropriate tomorrow. So some other body has to be empowered to deal with changes over time.
Mr. KANJORSKI. Thank you, Mr. Chairman.
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Mr. CANTOR. The Chair recognizes Mr. Rogers from Michigan.
Mr. ROGERS. Thank you, Mr. Chairman.
I am going to take maybe a bit of a different direction. One of the concerns I have is in this whole episode, we have been—we being Congress—in a hurry to find a villain, and I am not sure exactly we have identified the crime yet. I was hoping to ask Mr. Breeden, one of the things I am concerned about is that we are trying to treat this with a pill rather than laser surgery. I am not so sure that laser surgery isn't the order of the day here. We have a real possibility here to cause some real problems for lots of folks, UAW members and you name it out there, families who are investing more and more in 401K plans all across the United States. And sometimes just questioning the company's accounting practices by any official entity can be devastating to the stock of that particular company. We haven't done any investor in the United States any good if we do that maliciously or at least without good intent.
I want you to help me understand how we can make the corrective actions I think we all know we have to make here, certainly for transparency, without jeopardizing investor confidence. And those families out there who are working very hard every day, they send their money into their mutual funds knowing that that is what they are going to retire on, and they are counting on all of us, those here in Congress as well as you, auditors, regulators and those in the business community, to make sure that there is honesty and true brokering going on out there in those companies.
Mr. BREEDEN. Congressman, I think both you and Congressman Kanjorski raise similar, in a way, concerns and good points. One of the best things we have been able to accomplish over the last couple decades is to foster a broader participation in our capital market, and as my colleague here from the AFL-CIO points out, we have working men and women through pension plans, we have investors through mutual funds and directly to the tens of millions, and that has been a wonderful accomplishment.
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So we have as a Nation a great deal at stake in protecting the confidence those people have that our markets work with honesty and integrity, and they can believe the numbers they look at and that they make investment decisions on, and that this is a huge system with 17,000 public companies, and in fixing it a couple things are apparent. Number one, we have to be careful that we don't go too far, we don't fall into the law of unintended consequences when we try to fix one problem that we create another one, that we don't go too broadly and don't create excessive costs, as the Congressman is mentioning, in CRA, which is a very real risk.
We need to start with what we have, which is the world's finest system. It is not perfect. It has some flaws. No system designed by human beings and run by human beings is ever going to be perfect. But I genuinely believe, notwithstanding Enron, that the U.S. accounting and disclosure system is the best in the world. So let's not throw the baby out with the bath water. Let's start with what we have and look to see how can we build on that. If there are gaps here and there that we need to address, then let's do it.
I think that now on the question of investor confidence, I don't think there is—I am not aware of a situation where anyone has maliciously questioned people's financials, but certainly the market itself should raise questions about companies that have very aggressive accounting practices. We certainly have seen that post-Enron with aggressive selling against Tyco and other stocks that are perceived to have some accounting issues. I think those market disciplines are very healthy. In fact, I wish we had more of them, not that people should do it based on rumor or fear, but that a healthy skepticism looking hard at what numbers companies are reporting and making sure that investors do their homework to worry about the risk that they may be undertaking.
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So this whole area is one in which it is extremely complex, and we have to be extremely careful that we don't get things out of balance. But at the same time I think it is clear that we can do things to speed up disclosure and make disclosure more comprehensive. For 40 percent of the assets of Enron to be hidden off the books was unacceptable. That is disclosure? That is a joke. It shouldn't have happened. The parties responsible should have known there was—whether or not it was proper accounting, it was lousy disclosure.
And so we need to look starting at the Commission, but also here at Congress, are there things we can do to make disclosure faster and make it more comprehensive? Can we have better information about executive stock sales? That is very important to individual investors across the country. They know enough to know—they may not understand an SPE, but they know if the CEO is bailing out of the stock, they don't want to be investing themselves at the very same time the top guys are getting out. So speeding up those disclosures is another healthy thing.
Making sure that auditors don't sell their integrity. We can't station an SEC enforcement agent at the shoulder of every accounting professional, but at the top trying to make sure that the system encourages quality auditing, and that the firms themselves realize how important their public trust is, and the strong efforts they themselves need to make to do a good job.
So there are a lot of things where I think we can make some improvements that are consistent with our traditions and consistent with our systems and make it a little better.
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Mr. CANTOR. The Chair thanks the gentleman.
The Chair recognizes Mrs. Maloney.
Mrs. MALONEY. I thank the Chairman and the Ranking Member and all of the panelists.
I am sure all of you are aware that today Andersen announced they are laying off 7,000 of their employees and that this represents a quarter of their total employees. And furthermore, the long-term viability of the company is truly in question. And as I have said many times before, the overwhelming majority of the professionals in the industry are hard-working and honest and have a great respect for the title ''certified public accountant.''
I am concerned, quite frankly, about some of these employees, many of whom are my constituents. I would like to ask Mr. Breeden from what you know, do you think it is appropriate for the Justice Department to have targeted the whole of Andersen, or should we allow the Volcker plan to go forward and have it put in place and go after a limited number of employees known to have been involved in the Enron audit? Do you have feelings on this?
Mr. BREEDEN. Congresswoman, thank you. The Andersen situation is a very sad one. It is certainly one that is regrettable on many different planes, and I certainly hope that anything possible that Paul Volcker or anyone else can do to stabilize the firm and allow it to survive and then worry in the future about rebuilding, I wish it every possible success.
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On the other hand, we used to have debates when I was in the White House working on financial services about whether banks were too big to fail, and I don't believe Arthur Andersen is too big to fail, and I don't believe any of the other Big Four are too big to fail. If they ever got that notion in their head that they somehow have carried their monopoly on auditing and the oligarchy that exists in competition in this world that no one could bring an action against them if they broke the law, then that would be a mistake. We went through Watergate to prove that the President of the United States is not above the law. I think that the general counsel and the CEO and other staff members of Arthur Andersen are also not above the law.
I don't take a position on whether or not the Justice Department has the—we can only know when a trial takes place and we see what evidence the Justice Department has. But in my experience working with the Department of Justice in law enforcement over many years, they don't indict people or firms capriciously. They do it on the basis of a very sober and careful calculation of whether they have the evidence of wrongdoing, and it is a responsible act.
I think some of the people worrying about the consequences for Andersen should be asking the question about isn't it sad that Andersen's management engaged in the acts that led to the permanent injunction in Waste Management; that Andersen's management tolerated massive destruction of documents on the eve of Government investigation; that chimpanzees could know that the documents at Enron were going to be subpoenaed high and low by every Government agency and private litigants all over the place, and if you destroy documents, you may be affecting the rights of the University of California to recover against Enron executives or others, and in that context destroying documents is wrong.
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And so it is a tough issue, because nobody likes to see what is happening to other people at Andersen, and yet Andersen finds itself where it is largely through its own actions.
Mrs. MALONEY. You mentioned earlier, Mr. Breeden, that we should have faster and fuller disclosure, and one area that really isn't disclosed now except by consent or individual choice is the code of ethics for the board of directors or the code of ethics for firms. Do you think it would be helpful that the code of ethics was printed in the annual report, and if the board of directors took the unusual step of overriding the code of ethics of their board, that it be reported to the SEC and printed in the annual report?
As you know, in Enron, as reported in press accounts, the board of directors voted to overturn their own code of ethics to allow their CFO Mr. Fastow to head these special SPEs. So I was wondering when I called for fuller disclosure, would this be an area that you think might be helpful to the investor, to the general public?
Mr. BREEDEN. Yes, Congresswoman, I think very much so. In fact, in both testimony on the Senate side and in this testimony, I did say I believe that any time a board acts to suspend the corporate code of ethics, that not only publication in the annual report is way too slow, they should have to file an 8(k), do it within 10 days anyway, but almost immediate disclosure should be made. I think corporate codes of ethics should be at least posted on their website. It might add quite a few pages to the annual report, but I think somewhere it should be noted.
I did call for disclosure in the proxy statement or in some other vehicle for the board to set forth its policies on conflicts among senior executives. The conflicts in Enron at the CFO level were among the most dangerous possible things that a corporation could do, because the outside auditors and the audit committee and the full board all are looking at numbers provided by a CFO. So if the CFO has got a personal financial reason to give distorted numbers, it can defeat simultaneously the ability of the board, the audit committee and the outside auditors to check up on that. It is the one vital spot where—it is the hub and the spokes of the wheel. So any conflicts involving a CFO should be, in my judgment, prohibited under State law, and there should be required to be immediate disclosure if a company goes down that road, which hopefully they will not.
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Mr. CANTOR. The gentlelady's time has expired.
The Chair now recognizes Chairman Baker.
Mr. BAKER. Thank you, Mr. Chairman.
Mr. CANTOR. He was assuming the time of the Chair who was here before I was. So this is on his own time.
Mr. Chairman.
Mr. BAKER. Thank you very much for clarifying. Don't want to misrepresent my account here.
In the earlier round, Mr. Breeden, we talked about disgorgement and insider trading prohibitions, bailing out on stock the night before the bankruptcy filing. We talked about clarity in the liability for the CEO for the preparation of the financials. There are other elements that I think I would like to get your comment on. One is the subject of a cooling-off period where the auditor is the principal engaged as an outside auditor for company X; upon retirement immediately goes to work for that company as the chief financial officer. There are prohibitions which apply to Members of Congress, for example, in what we can do in post-congressional life. Do you look at that in an advisable way? Is that something we should consider?
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Mr. BREEDEN. Yes, sir, I believe that you should. I remember back in my days at the Commission, we had the then infamous Lincoln Savings collapse. An awful lot of people were hurt in that. That was another case where this CFO that was in place at Lincoln Savings had come over from the outside auditor, which means the people who audit his work the very next year are all the people who used to be his subordinates at the audit firm.
So without knowing exactly how it should be done, I think cooling-off periods are healthy and is something that would probably make sense.
Mr. BAKER. As to structure on all of these, it is my thought to authorize, mandate the SEC to study and implement rules governing these points raised by the Congress as a policy matter. I think it may be difficult and take us years to get a plan that is enforceable and not disruptive to markets if we do the specifics, but at least to have a goal within 6 months, a year for the SEC and staff to determine the most appropriate manner for prohibiting whatever is an unreasonable corporate practice.
Audit committee and their ability to do their work. Provisions for independent counsel. In other words, not having to rely on internal corporate officials to do the work for the audit committee. It's difficult if you have a CFO who is conflicted, but if you are really trying to do the job on the audit committee, and you are asking the guys who are employed by the corporation, isn't that equally troubling?
Mr. BREEDEN. I serve on three audit committees, and I chair two of them. I can't imagine anybody telling us—and I don't think it is just me—I can't imagine anyone saying to an audit committee that they can't hire outside counsel. The board can do what it wants. The problem is that—it is a little bit of a chicken-and-egg situation. One of the problems in both Waste Management and Enron was that the auditors never said boo to the audit committee. They knew there were problems and didn't bring the audit committee into the loop. So they were, in many respects, oblivious or appeared to be ignorant to many of the issues that might have caused them to go and hire outside counsel, but they have to know that they need it.
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Mr. BAKER. That was my point is that rather than making it a permissible activity to do it, is that a mandatory obligation to construct your audit analysis based on outside counsel?
Mr. BREEDEN. I think we have enough make work acts for lawyers, but I wouldn't require it, but I think certainly as a matter of good corporate practice and maybe through listing standards it is something that can be encouraged. Certainly any audit committee has to have the right to speak to independent counsel and independent financial advisors if they believe they need the advice.
Mr. BAKER. Lastly, with regard to stock option plans, shouldn't that require shareholder approval?
Mr. BREEDEN. I believe so.
Mr. BAKER. And there is one other piece of work may I compliment you on. In 1992, there was a report issued by the SEC, and it also supports a statement of Chairman Pitt before the Committee just before the Easter recess relative to the reporting to the SEC by the GSEs. As I recall it, your work at that time indicated it was advisable policy for the GSEs to file as all other Fortune 500 companies do in compliance with SEC standards. Is that still your view?
Mr. BREEDEN. Congressman, I don't remember that specific report. I seem to remember getting the tar beat out of me by folks at the time over that issue. I haven't looked at it since then. So with respect, I will just stay out of that hornet's nest.
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Mr. BAKER. If your bruises haven't gone away, I can assure you that the report contains that information, because I have the bruises myself.
Mr. BREEDEN. One of the great things about being in the private sector as opposed to being in Government service is you can duck a few of the fastballs that you have to go ahead and stand at the plate when you are in Government.
Mr. BAKER. I commend you for your bravery while on duty.
Mr. CANTOR. The Chair now recognizes the gentleman from North Carolina, Mr. Watt.
Mr. WATT. Thank you, Mr. Chairman.
I want to start by applauding the testimony of Professor Langevoort. I may not be pronouncing his name right. His testimony has gone unnoticed in the question-and-answer period, but he should know that as far as I am concerned, it is among the most important testimony that has been given here today. In my opening statement I emphasized the importance of allowing individuals to hold people accountable and corporations accountable in addition to Government bodies, and your testimony seems to me to be consistent with that.
First of all, we have to reestablish the legal standard that makes other parties have legal liability to anybody, and then we have got to give individual people who are damaged by those activities the right to take up their own private litigation and enforce those rights, and in some cases that may result in less Government bureaucracy. I keep having trouble convincing my Republican counterparts of that, but they may come around.
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The problem is that—and I am certainly going to try to pursue this in the course of this markup—the problem I have already identified, however, is that the rules of germaneness in the legislative context are probably more rigorous than the rules of evidence in the evidentiary context. If we start with the Chairman's bill, I am not sure we can craft an amendment that gets that on the table for discussion and debate, so I am not going to spend a lot of time asking you questions about it. But I did want you to know that what you said did not go unnoticed by at least one Member of this Committee.
Mr. LANGEVOORT. Thank you. I was actually happy not to get all the fastballs.
Mr. WATT. Now I want to go to another issue that I am trying to resolve or reconcile, the differences between Mr. Walker and Mr. Breeden, and try to figure out which one of them I agree with more. As I understand it, Mr. Breeden—no, I am sorry, as I understand it, Mr. Walker thinks that we ought to have another Federal board of some kind in addition to FASB and the SEC. We ought to have some third agency. And as I understand Mr. Breeden's testimony, he rigorously disagrees with that. I would like for the two of you to try to reconcile, if they are reconcilable, your views on that issue. I tend, I think, to come down more on Mr. Breeden's side than Mr. Walker's side, I believe.
It is coincidental that right across the hall here where I am on the Judiciary also, as you may have gathered by my legal bent here, we are debating whether to break up the INS into about five or six different parts on the theory that if you break it up, it will all of a sudden become more efficient even if you keep the same people and the same rules and regulations and everything. It seems to me that one approach we might be using is trying to make the SEC and FASB more efficient rather than creating another institution in the process.
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So let me hear from Mr. Walker first. Then I want to ask another question. I will give Mr. Breeden equal time to defend his position.
Mr. WALKER. Mr. Watt, right now you have one Federal Government entity involved, and that is the Securities and Exchange Commission. As you know, the FASB is not a Federal Government entity, it is a self-regulatory body.
Mr. WATT. But wouldn't this bill put those kind of agencies kind of under the jurisdiction, supervision of the SEC?
Mr. WALKER. What we were proposing at GAO is that the SEC has more than enough to say grace over right now. Some can debate——
Mr. WATT. One way to solve that is to add some more people.
Mr. WALKER. That is one issue. Mr. Watt, we are saying that the area of most acute need for intervention is in the auditing area. The SEC is already overtaxed as it relates to enforcing the securities laws and dealing with significant accounting and reporting issues that have to be dealt with.
There are many people on this Committee and others in Congress who believe that the CFTC ought to be merged with the SEC. So the point is there are a lot of things that the SEC has to do right now.
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Our view is that you could have an independent entity within the SEC. You could have a body within the SEC that would have Presidential appointees with Senate confirmation who have the authority to make final decisions with regard to certain auditing activities, but would allow them to be able to coordinate as appropriate with the SEC on accounting issues and on securities regulation. We think that is possible to be able to do that, but one of the concerns that we have is that the auditing area is the one that we think there is the most need and there needs to be appropriate accountability to the Congress, and we don't know that you get appropriate accountability to the Congress unless you have the parties responsible and reportable to the Congress.
Furthermore, we question whether or not the commission members and their staff can effectively discharge these additional responsibilities because they are already having difficulty dealing with their current responsibilities.
Mr. CANTOR. The gentleman's time is expired. Thank you.
Mr. BREEDEN. Mr. Chairman, if I could have the liberty of responding to this, because I think it really is a pivotal issue.
Mr. CANTOR. Without objection.
Mr. BREEDEN. Thank you very much. I, of course, have boundless regard for GAO and its analytic capabilities. This is a matter that is a matter of principle and philosophy, I suppose, but I could not feel more strongly about it than I—and Mr. Watt, I appreciate your asking the question and giving me a chance to give you my side of things.
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For about 68 years now, the SEC has been the Federal agency with responsibility for overseeing the accounting profession. It has a long history. It has a long culture and a long tradition of being able to put the public interest first to have an effective enforcement program. I do not think there is any wrongdoer out there, be it corporate, individual or a partnership, that the SEC and its history would not tackle. It has built up a long history there without fear or favor of any person, irrespective of party, irrespective of any other factor, and to say that, well, that is very nice, but they are awfully busy doing some other things, we should put it aside and start all over again and build a brand new agency that has no history, no culture, no existing staff, nothing. We are going to start from the beginning and build it all up, and 10 or 15 years from now it will have experience and culture and tradition, and we are going to hope at that time it is going to do a better job than the agency that for 68 years has done a great job for America's investors.
Now the Commission is starved for resources and has been underfunded since 1934, and I would appreciate the efforts of many Members of Congress to expand its staff so that we could keep pace with growth in the markets, and that is an ongoing problem today. But I really think that there is not a need for another Federal agency.
Now I agree with a great deal of what Mr. Walker has said in terms of the importance of integrity and independence and good powers, and all of those things can be in a body like the NASD that would be a subsidiary, private sector organization, out doing a lot of work, doing a lot of enforcement, bringing all those fine qualities to bear, but reporting up through the existing Government agency so we don't lose the benefit of nearly 70 years of public service.
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Mr. CANTOR. Thank you.
The Chair now recognizes Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Let me thank my colleague from North Carolina, because I wanted to be the devil's advocate on that, but he is much more eloquent than I am, and I agree with his line of reasoning, and I think it is problematic.
I think, Mr. Breeden, you are right on point that what we are talking about doing now is starting over from scratch to create a new agency, and I guess—that John is correct. Redundancy is not necessarily a sin, but what I keep coming back to is does not the commission already have a tremendous amount of authority in this area? And perhaps the commission should be under some attack for not necessarily exercising that authority, and perhaps the commission can argue that they have been underfunded and haven't had the resources, but it seems to me—I have always been under the impression that the commission had this authority. You yourselves stated that, in fact, audited financials are—in fact, the financials themselves are prepared by the public company as a function under the 1934 Act, and then audited and given a blessing by the auditor, but in fact they are all compelled by securities law in the first place, and it is the commission that governs securities law. And so I think that your point is right or—your line—of reasoning is right on point.
I furthermore think that now we are talking about in the GAO—and I don't think John's bill goes this way or Mike's bill goes this way, necessarily, but the idea of registration of auditing firms with this new authority. And the next question is, which I have asked with other panels, are we going to have to have qualified opinions with an audit that is given, for each audit that is given, that it meets certain standards? And do we know exactly where we are going in setting the standards?
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But let me ask—I want to move on to some other points. Everyone talks about the need of sort of a division of labor between audit and non-audit services, and I do not disagree with that, but we have a number of lists that are out there, what ought to be precluded or prohibited, and what ought not to be prohibited. Are we better off trying to write in the statute what services can be provided and what services cannot be provided, or are we better off providing the commission, if that is the route we go, or whoever the ultimate authority is—and again, I would argue that it is the commission—with the same authority that we have done in banking law, for instance, to say something that creates the appearance of a conflict and leave it up to the rulemaking bodies to determine what is appropriate and what is not appropriate? Would we be better off than providing a list? Either one or all.
Mr. BREEDEN. Congressman, I think the question of what is a permissible service is a very important one. Certainly at a minimum, if it were left to an agency, there would have to be some guidelines and standards of what should the policy be here, and I think Congress has an important role to play in trying to answer that. You know, in my mind, if Arthur Andersen had not done one penny's worth of consulting work for Enron, the exact same problem would have happened. We are in part discussing a red herring here, because the audit fee that Andersen was collecting from Enron was more than big enough to correct the behavior and create all the pressure, whether or not they were also on top of that getting consulting fees. And so let us don't kid ourselves that if we forced the people to get out of all consulting, these pressures on independence are not going to go away. In some ways they get worse, because if you have said that the entire firm is dependent on nothing but the audit fee, then the CFO who can threaten to take away the audit fee has even more leverage over the auditor than not.
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So, on the other hand, we want the public to understand that audit opinions cannot be bought and the audit relationship ought to be the primary focus, and as one of the other witnesses pointed out, we have now seen some cases where companies have many multiples, the consulting fees, as the audit fee.
So what should the policy be? And if Congress sets out standards, whether it is conflict or specific types of risk, yes, then you could give the jobs of drawing the lines to an agency.
Mr. BENTSEN. My time is coming up and I want to follow up with two other points. Mr. Breeden——
Mr. LAFALCE. Mr. Walker, is——
Mr. CANTOR. The gentleman's time is expiring.
Mr. BENTSEN. Well, I do not think it is expired, because it is——
Mr. CANTOR. I said ''is expiring.'' Yes, you are correct.
Mr. BENTSEN. I would like to hear from Mr. Walker, but I do want to ask one other thing of Mr. Breeden. An issue was raised with respect to Enron that goes back to some of the law and rule changes in the 1980s with respect to insider trading as we know it, not sales by insiders and sort of the Chinese wall that was established between underwriting and sales and trading, and some have raised the question that the unintended consequence of that was that deals that were being structured, primarily private placement deals that were being structured for Enron that had the effect of diluting stock value and taking debt off balance sheet while increasing the leverage of the company, had the brokerage side known that, they may well not have made a market in their public securities. Is that an unintended consequence, and is there a way to address that in going back to that 1980s law, or was that just something we have to live with?
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Mr. BREEDEN. The whole idea of Chinese walls is to deliberately deprive certain parts of an organization of information that is possessed by other parts, and so assuming that that information is valuable, it is almost always the case, for example, that the investment banking side of a firm might know that a tender offer is going to happen or that there might be an LBO going to—something is going to happen to change the capital structure that would cause your brokers to either recommend the stock or not recommend it and you consciously and deliberately say we cannot allow that information to be used, because only the customers of that firm would have that information. It is not out in the broad marketplace. So I think Chinese walls are not perfect, and they do have the effect that you mentioned in particular cases, but they also prevent essentially institutionalized insider trading that would happen if knowledge from the banking side can filter over into one group of brokers, but not everybody else in the rest of the marketplace.
Mr. BENTSEN. But under—and if——
Mr. CANTOR. The gentleman's time is expired.
Mr. BENTSEN. With the indulgence of the Chair. Under things such as Reg FD and others, when deals are being structured that are increasingly leveraging the company to the detriment of the public shareholders, should the underwriting side be dutybound to disclose that? And I understand the original intent, why you would put the Chinese wall in. It made perfect sense. But now you have the reverse effect occurring. Or is that just an unintended consequence we have to live with?
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Mr. CANTOR. Mr. Breeden, if you can expedite your answer, as the gentleman's time is expired.
Mr. BREEDEN. Always a problem. I guess I would just say I think that is worth taking a look at, in the context of what we have seen in this case, and see if there are not ways we can mitigate those negative effects.
Mr. BENTSEN. Thank you. Thank you, Mr. Chairman.
Mr. CANTOR. The Chair now recognizes Mr. Sherman.
Mr. SHERMAN. Mr. Chairman, thank you. Let me make sure I anger virtually everyone in the room with at least a couple of quick points. First, as we praise the SEC, let us remember that that is the Government agency responsible for our capital markets, and we have just had the largest capital markets failure in history. And while we focus on an accounting industry that is about to go down from the Big Five down to the Big Four, we should remember that we could have an SEC rule that no one firm can audit more than 15 percent of the publicly reporting issuers and force the breakup of the Big Four and do something that has kind of a catchy title, the Big Eight. To us old guys, that has a catchy title. And I do not have time for oral responses, but I hope our panel would respond on whether having only 4 accounting firms auditing publicly traded companies is a good idea for our capital markets.
It has been pointed out that management prepares these financial statements and the auditor just expresses an opinion on them. We should point out that what auditors do is demand changes to those financial statements which management can implement or not implement. The reason I make this point is that there has been a lot of talk of criminalizing speech, that is to say, prohibiting the ''undue influence of management on the auditors.'' And what worries me is that that is just a pejorative vagueness for talking, and that if we are going to criminalize some discussions between auditors and management, we ought to figure out how financial statements are going to be created or who is going to decide which talking is necessary and which is criminal.
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Shifting to a question to Messers. Langevoort and Silvers, you folks have pointed out the importance of private litigation, which is the only economic incentive auditors have to do a good job and to stand up to that other economic incentive they have to do whatever Ken Lay wants them to do. The one concern I have is back in those old days, these accounting firms were general partnerships. Everybody was liable for whatever the accounting firm was liable for. All multithousands of partners and an awful lot of assets. Now they are all limited liability companies. Does it make any sense to allow lawsuits against accounting firms unless we have a requirement that they have malpractice insurance or malpractice reserves or some other capital? And should that capital requirement be set at one half a year's audit fees or at some other level?
Mr. LANGEVOORT. Certainly you need to address the question of whether there is money. I think we have yet to learn what the protective shield of limited liability partnership or limited liability company is, but you are absolutely right. If the deterrent effect is going to be there, there has to be some way of reaching the wealth generated by performing the services and capturing that.
Mr. SHERMAN. I am not so much thinking of this as a hammer that is going to take away the house of every partner of Arthur Andersen, so much as a compensation fund. If we are going to tell people they can sue because they have been harmed, they ought to be able to recover something, and I would point out that the amount being offered by Arthur Andersen now is just 6 years' fees to one client.
Mr. LANGEVOORT. I do not disagree with that, but I would keep the club and the hammer there, too.
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Mr. SHERMAN. Shifting to the scope of service, there is discussion of making a laundry list, perhaps 10 items, that auditors are not allowed to do. But the main impetus for this is to say, well, maybe $25 million in fees is a necessary evil if you are going to have privately paid-for audits, but $52 million is way too much. Do we need just a laundry list of services not to be provided, or do we need a rule that says your total non-audit fee cannot exceed, say, 50 percent, 80 percent, 100 percent of your total audit fee? The ratio was commented on by, I believe, Mr. Silvers, should there be a requirement that that ratio not exceed 50 percent or 100 percent?
Mr. SILVERS. I think that the issue here really is, as you mentioned, with the laundry list, that it is possible to evade the intention, which is to end the conflict, by the change in practices within the marketplace. Our view is, is that what you need here is a—and I believe one of the witnesses—one of my co-panelists spoke to this earlier. You need a statutory mandate to the commission, right, that in general bars consulting services, allows for consulting services that are intrinsic to the audit function, all right, and gives the commission the discretion to sort out as the marketplace and practices change which are which. Right?
Mr. SHERMAN. But if, say, tax services are an integral part of the traditional accounting function or auditing function, is it acceptable to have a million dollar audit fee in a $3 million tax fee?
Mr. SILVERS. Well, I think there are two answers to that. One is, as I said earlier, there are tax services and there are tax services that are preparing the audit. Then there is structuring the partnership designed to keep everything off the books. They are very different and that is why you need the commission to have this discretion. But to answer your question directly, the question of the ratio, it seems to me that if we have got the general rule right and the SEC is complying with the intent of Congress here, that you would never see a situation in which audit firms exceeded by multiples, right, consulting fee—audit fees exceeded by multiples consulting fees. Thus the kind of measure you are suggesting might be a—I think what Mr. LaFalce referred to as a helpful redundancy.
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I think, though, that what really is critical here is, is that the Commission be given both the discretion and the clear direction.
Mr. SHERMAN. I would point out that the commission——
Mr. CANTOR. The gentleman's time has expired.
Mr. SHERMAN.——has for the last 50-plus years—I believe my time is expired.
Mr. CANTOR. Thank you, gentlemen.
The Chair now recognizes Mr. LaFalce.
Mr. LAFALCE. I thank the Chair very much.
Mr. Silvers, we have not really spent too much time considering the issue of mandatory rotation of auditors, and I might say that all of my accounting provisions or auditing provisions were discussed at great length with the former chief accountant to the SEC, Mr. Lynn Turner. As you know, in my bill, I would say that you could have an audit for a 4-year period, and it could be renewed. It could be renewed basically if you have got the Good Housekeeping Seal of Approval of the SEC for an additional 4-year period. But then that would be it. I think that might well ensure for 8 years of good audits and then another auditor could come in and say what a great job the previous auditor did or point out where there is need for improvement.
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No, what are your thoughts on that concept? It seems to me that that concept is even more important, or at least equally as important, as the separation of the auditing and non-auditing functions.
Mr. SILVERS. Yes. I would very much agree with your characterization of that language. I think that—and the AFL-CIO has proposed a rulemaking petition to the SEC that the SEC put such a requirement in place by rulemaking. I think that the critical issue here again goes to what Chairman Greenwood was talking about, which is the sort of confluence of forces that are at work to compromise the audit. All right? And one of the most important is this sense of cash flows in perpetuity that come from keeping a client happy, and the way in which there is a kind of melding of the audit firm and the staff of the people they are auditing. I think that Chairman Baker made some reference to his concern about that earlier in this hearing. Both the firm rotation and the prohibition on individuals flipping over that Chairman Baker alluded to would get at that.
Mr. LAFALCE. Well, prohibition and flipping over and cooling-off period is a provision of my bill.
Mr. SILVERS. I left that to you to say.
Mr. LAFALCE. OK. And you favor that.
Mr. SILVERS. Absolutely.
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Mr. LAFALCE. Let me just ask the other gentlemen. On the issue of the cooling-off period, I have a 2-year time period wherein the chief auditors of a particular company could not then be employed by that company. Would you favor that, Mr. Walker, Mr. Breeden?
Mr. WALKER. I think the issue of a cooling-off period needs to be looked at. Some changes are necessary. I think you have to recognize that there are ways to potentially get around that. While it is not appropriate for them to serve in the CFO position, some of the things that Chairman Breeden has talked about, you also can hire people as consultants, and they are not employees, and the question is, what are they doing. So I think you have to recognize and look at substance over form and make sure you are accomplishing the objective.
Mr. BREEDEN. Congressman, as I said earlier, I think the cooling off is an important principle. Without looking at the specifics of how to do it—for example, I would let a company hire someone from their audit team to come in and have another position in the company for 2 years without being CFO. I think the real risk comes when the CFO is dealing with his or her own former staff over at the audit team, and I——
Mr. LAFALCE. Let us not kid ourselves. Some accounting firms have a policy of encouraging early retirement, creating incentives for early retirement, so that you do become the CFO of the company that you have been auditing, and you cement the relationship, the tie between the firm and your former auditing firm. We have got to deal with that problem in some way.
Now we can always point out, well, this is not crossed right or that T is not dotted right, but there is a fundamental problem. And let us cure the problem. If we do it imperfectly, well, then we can correct it, but let us deal with the very imperfect problem that exists. Let me go on, though, because I have so many other questions I want to ask.
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Mr. Langevoort, you have been neglected and I do not want to neglect you any more, because Mr. Watt was talking about what he considers to be so important. But that is one of the most important provisions of our bill. We specifically would give legislative sanction to aiding and abetting liability for accountants and other professionals, and we specifically alter the statute of limitations.
Now there has been some confusion. Everybody says you ought not to change the 1995 Securities Reform Act or the 1998 Securities Reform Act. Do either of those provisions change the 1995 or 1998 Securities Reform Act?
Mr. LANGEVOORT. No, and thank you for the softball question.
Mr. LAFALCE. See, everybody here is under the impression that we are undoing what is done in 1995 and 1998.
Mr. LANGEVOORT. These two changes would carry out things that predate the 1995 legislation and that the SEC has endorsed previously. They are compelling as a matter of public policy.
Mr. LAFALCE. And yet witness after witness from industry comes in and says, oh, you cannot do this, because you would be undoing the 1995 and 1998 legislation, and they really do not know that it has nothing to do with the 1995 and 1998 legislation.
Mr. CANTOR. The gentleman's time is expired. The Chair is going to yield himself time for an additional round of questions.
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Mr. Breeden, I would like to ask you on the question of rotating audits, do you feel that there will be an increased quality of audit if a company is required under all circumstances to replace its auditors every 4, every 8 years? Do you really feel there will be an increase in quality of audits, given the subsequent increase and expense the company will incur?
Mr. BREEDEN. Mr. Chairman, in my testimony I said that I do not personally favor mandatory rotation because I think rotation in some cases would be a benefit, and in other cases would be a disadvantage. In a very complex company, it takes a number of years to get up to speed and really understanding where the risks in that company are, and if you rotate—and particularly if you rotate every 4 or 5 years, I think you would have periods of time, blackout periods, almost, where the auditors are getting up to speed. That could be overcome. People could spend more money to throw more people at getting up to speed faster, but in general I think that is something as a requirement that goes farther than we need.
What I would like to see us do is to move more to a system where auditors are engaged for a 3 or 4-year period, not for a 1-year period, and that at the end of that time, the audit committee has to go out for proposal and at least hear what the other firms propose and how they would structure the audit and how many hours they think should be involved, and then leave it to the audit committee to make a decision on whether that firm should be retained or whether you should rotate.
Mr. CANTOR. I would respond and ask you what value would it be for there to be an imposition and to require going out for bid again under all circumstances, because that, too, does take time, and obviously someone participating in a response to a bid will not have the knowledge of the company the way that an existing auditor will have, and is that the best way? Are we really gaining some safeguards there?
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Mr. BREEDEN. I am not sure I understand the question. You are saying what value is there in going out for proposal?
Mr. CANTOR. Just for going out's sake.
Mr. BREEDEN. Well, I would not require that as a matter of legislation. But I think as a matter of audit committee good practice, that every few years you should put your periscope up above the surface of the ocean and take a look around and see what other options are out there. I think the audit committee—I wrote on this subject in the Wall Street Journal a week or so ago. The audit committee needs to become more active than has been traditional, and we have been moving in that direction for the last 10 or 20 years. We keep—through the exchanges they keep encouraging better literacy, higher quality membership on audit committees. They are positioned to be a check-and-balance on the CFO, but we cannot expect audit committees to attract good people, and you want them to have the responsibility, and yet put them in a straitjacket and say, well, the law itself tells you what you have to do and not do.
So I would leave some of these questions to the audit committee.
Mr. CANTOR. Thank you.
The Chair now recognizes Mr. LaFalce.
Mr. LAFALCE. Well, thank you very much. I do think that there are a number of threshold questions that are important. First of all, we ought to not lose sight of the fact that it is more than accounting and auditing that we have to be concerned about. We had problems with corporate officers. We had problems with boards of directors. We had problems with the auditing firms. We had problems with the rating agencies. We had problems with the securities firms and their analysis. We had problems with the law firms and probably an awful lot of others, too. What I am fearful of is that—or not fearful, that we are going to overreact. Industry is too strong, too powerful, too influential. Let us not kid ourselves. It is going to be tough to get anything at all passed that is meaningful, that is more than cosmetic. Our problem is not overreacting. Our problem is underreacting, coming in with a cosmetic. And let us not kid ourselves. If we don't understand that, we do not understand the governmental process as it really works, as opposed to you know how it is supposed to work.
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I want to go into some differences between the bills, and I really—it is not a question of his bill, my bill or anything like that, but I want these issues to be addressed. I would like for there to be dialogue between us. There has been no dialogue. Before we have a markup. I make a public call for an opportunity to have dialogue, private dialogue, on these issues that we can come to some compromise on them. But I would like at least a public comment on some things that are new.
To the extent that you have knowledge, and you probably do not have too much knowledge other than newspaper knowledge, but please give me your thoughts about it.
The lawsuit against Enron has been expanded to include a number of the investment banks, about 10 or so. What is the theory of liability there? It is not just lending. I think it is more than lending. It is some type of active participation. Is it more than aiding and abetting?
And then also some people think that aiding and abetting in an action brought by the SEC simply requires a show of negligence, and I think the standard is substantially higher than that. I would like some explanation on that. And then also the Attorney General of the State of New York has obtained a court order. I am not exactly sure what the order says or does, but it was against Merrill Lynch, apparently—and, again, only speaking now from what I know about it from the newspaper—for making recommendations that are contrary to opinions that were expressed by an overwhelming percentage of the analysts of the firms in their e-mail conversations. Who wants to swing at that one?
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Mr. LANGEVOORT. Let me start with what I think was the first question. With respect to the pending lawsuit against a variety of participants in Enron, I have not read the 500-and-whatever-page complaint so I cannot address the specifics.
Going back to my testimony, the uphill battle plaintiffs have is in trying to trace a way in which the investor banker's involvement was more than just behind-the-scenes assistance. It tries to do that by saying the investment banks used their analyst conduits to speak directly to the market. That is more than assistance. There may have been some participation in preparation of documentation that made it into the hands of the investing public. Those are all possibilities, but I guess my bottom line concern is that is really an unfair burden to put on the plaintiffs, if what you are really complaining about was that the bankers were the brains in some respect behind all of this.
Second, with respect to aiding and abetting——
Mr. LAFALCE. One of the difficulties I have is we have not examined that before our Committee. We have not examined what the nature of the law is that would cover and what the nature of the law should be to cover them, and that could be a large part of the problem. I do not say that it is.
Mr. SILVERS. Congressman, I am not familiar with the complaint, obviously, as it has been amended, but I am a little familiar with some of the transactions that may be part of the complaint. There have been—and because there has been litigation both in the bankruptcy court and in the Southern District of New York around some of these banking transactions, and essentially what some of that litigation seems to show—and there are traditional opinions backing up what I am about to say—is that in at least the case of JPMorgan Chase, that company engaged in what was treated as a market derivative transaction, but in effect was a loan to Enron, because it was a loan paired with two energy derivatives contracts which essentially canceled each other out, and in one case they both ran through—JPMorgan Chase subsidiaries based in the Island of Jersey off the United Kingdom, which is an offshore bank haven, and the result of that transaction was that Enron got a billion dollar loan, did not show up on Enron's balance sheet.
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Mr. LAFALCE. The whole issue of derivatives and the regulation of derivatives is very important, because the industry officials that engage in derivatives have said, well, these are counterparties who are so sophisticated that there need not be any type of regulation for them at least, and yet there are innocent people who are not parties to those actions that can suffer serious consequences, and then that is an issue smack dab before the jurisdiction of our Committee which we have not looked into.
Mr. CANTOR. If the gentleman will expedite his answer. The gentleman's time has expired.
Mr. LAFALCE. Well, I want to take another round.
Mr. SILVERS. Just to conclude, that transaction, unless some particular facts have arisen, that would—Chase directly communicated that transaction to Enron investors. That transaction will not be litigable because of this aiding and abetting issue. But, nonetheless, as you point out, real people were very badly hurt here. I spent some time with some of them in Houston on Friday, and those people have no—if it is merely aiding and abetting, those people have no cause of action.
Ironically enough, Chase Manhattan Bank, though, is acting on their behalf on the creditors committee of Enron and depriving those same people their severance money, while they see if they can bob and weave out of the liability generated by these transactions. It is really scandalous, frankly.
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Mr. LAFALCE. Mr. Chairman, I know my time is expired, but Mr. Langevoort did not respond, did not have the opportunity to respond to the question of the standards that have to be met in aiding and abetting liability, whether it is negligence or something considerably greater than negligence.
Mr. LANGEVOORT. Congress made absolutely clear when it restored the SEC's aiding and abetting authority that intentional misconduct was the standard, and that is clearly the law with respect to aiding and abetting generally.
Mr. LAFALCE. And, therefore, if we extend aiding and abetting liability to private litigation, we would adopt the same standard, and so you would have to prove intent.
Mr. LANGEVOORT. The bill 3813 would mirror the standard for intent in private securities.
Mr. LAFALCE. It need not, but——
Mr. LANGEVOORT. Yes. That is correct.
Mr. CANTOR. The Chair yields to himself this time for an additional question. Mr. Breeden, in your written testimony, you unequivocally state that you would not support any steps to restore joint and several liability, aiding and abetting liability and other measures. Can you speak just sort of briefly to the adequacy of the remedies available under the 1995 Act?
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Mr. BREEDEN. The 1995 Act was discussed earlier. I guess the only thing I would add to the 1995 Act was this same issue of whether aiding and abetting should be—whether Central Bank should be overturned was before the Congress in the 1995 Act. The Congress in that legislation could have done so, and it did not. The absence of action rather than the actuality of action was part of what Congress ended up doing there.
My own view is that we have struck a balance in the private litigation area, and there will always be cases that will cause us to say we should give more rights of action, but there are also—that opens the door, in my opinion—and I respect the differences from others on this point, but I believe it does open the door to abusive litigation, and the costs of that are very, very real, not only to the economy and to businesses, but to shareholders, too, who pay the ultimate cost of that whole process.
Mr. LAFALCE. Mr. Chairman, if I can just follow up with the question with Mr. Breeden on that point.
Mr. CANTOR. If he can just finish his response and I will yield back to you for plenty more time.
Mr. BREEDEN. I guess my view would be twofold. One, in the context of this legislation of trying to do something positive and meaningful to respond to the Enron situation, I think if we refight the battle of litigation reform all over, as part of it I think it will make the chances of doing anything constructive here much lower and, therefore, I would not like to see that happen, because I think there are some improvements that should be made and there are a lot of good things in your bill that ought to be done.
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Second, even if it were not a question of tactics and timing, I do not substantively favor the expansion of the rights as has been described.
Mr. CANTOR. Thank you very much.
The Chair now recognizes Mr. LaFalce.
Mr. LAFALCE. Mr. Breeden, I just do not know how any person, unless they have a philosophic disposition, that says individuals should not be able to go into a court of law to obtain redress for a wrong, can say that if an individual or a firm has intentionally aided and abetted in false or misleading statements, that they should not be able to be held liable. You know, it is absolutely beyond the capacity of the SEC on its own to go after all of those instances when it is done. They have got a paltry record on this in the past. The FTC, which has the ability to go into court—and you can't go into court if you are an individual—has come into Congress and said, restore the right of an individual who has been aggrieved, because it is wildly beyond our capacity to bring lawsuits where lawsuits are necessary to be brought.
And, Mr. Breeden, I understand the philosophic mind that just wants to cut back—for example, the mind of this Administration. They want a terrorism insurance bill, but only if it is coupled with the cutback of an individual's right to go after individuals who may have participated in that terrorism and caused injury.
Well, having said that, let me just say that that is one issue where you and I have profound differences on, and I hope that the Congress, at least this Committee, will be given the opportunity to consider that as you—and not confuse it with undoing the 1995 or the 1998 legislation which simply did not address those issues. And I will not be offering the joint and several. I will be offering the aiding and abetting and I will be offering the statute of limitations and I will be offering them separately so that we can have discrete issues before us.
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Now, going back to the issue of mandatory rotation, Mr. Silvers, you favor it—I do not know that you have an opinion one way or the other, Mr. Langevoort. Mr. Breeden, you have said you opposed it. Mr. Walker, you said you certainly think it should be on the table for study. Is that fair enough?
Mr. WALKER. We are saying two things. One, more things need to be done on key personnel on the engagement and that the other issue should be studied. I have some personal concerns about mandatory rotation of audit firms.
Mr. LAFALCE. Well, I brought this up with Mr. Lynn Turner, the former chief accountant, who favors rotation, and he said to me, let me tell you, he says, I used to be one of the Big Five, he says, and mandatory rotation of the chief partner just does not work. He says no partner is going to go in and replace another partner and blow the whistle on the other partner and say everything he did was wrong. He says it does not work. If you are going to get to the heart of it, you are going to have to go to mandatory rotation.
Now he may be right and he may be wrong, but my recommendation in the bill is not without significant authoritative support. But let us assume we should not do that. Now, Mr. Breeden, you have said, well, what we ought to do is have audit committees, consider hiring audit firms for maybe a 3 or 4-year period and then consider other audit firms, too. Maybe submit proposals.
Well, the only thing is, if we do not mandate that, how do we get at the bad guys rather than the good guys? Won't we have a situation where the good guys are the ones who are going to do that and the bad guys are the ones who will not do it voluntarily? And that is the problem with volunteerism.
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Now you would have the SEC do it, but, look it, you have sang the praises of the SEC. The problem is the SEC has deferred almost 100 percent over the years to the SROs. They have had almost no watchdog role over the SROs, whether it is the securities industry, and most especially the accounting industry. They have been silent.
Mr. BREEDEN. Congressman, on the issue of rotation, while I do not personally favor mandatory rotation, it is an extreme step, and I do not think we are necessarily sure that applied to 17,000 companies in this country, that it would be a good idea.
On the other hand, my idea of having a 3 or 4-year engagement could lend itself to having a statute that said that beyond, say, one initial term and two renewals, that specific standards and findings might have to be made by the audit committee in order to pick the incumbent and keep going. You could encourage and the commission itself could encourage through proxy rule its audit committee—require the audit committee to say why after a dozen years or so, but some—pick some number, why they did not consider—or did they consider rotation. If so, why did not they do it. There are ways you can put a little pressure on to make sure people do look hard at the question. Would it serve the shareholders' interest to rotate.
Mr. LAFALCE. Mr. Walker.
Mr. WALKER. As far as the interest of full and fair disclosure, I am a CPA and practiced for a number of years; and, number two, I have been with two of the Big Five firms and I know how things work; and, number three, I think if you look at the issue of rotation of the key personnel, right now the rules are not adequate. You could have an individual or a person who was serving as engagement manager, then engagement partner, then the second partner, so they can end up being on the engagement for many, many years in a row.
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Mr. LAFALCE. You mean the SEC, having the power to change that since their existence, has not?
Mr. BREEDEN. Congressman, I think this is an excellent issue, though, that pointed out why the proposal of both Mr. Oxley and yourself, both bills call for a body here to be created that would begin to resolve some of these issues, and I think you have put your finger on this is one of the number of such——
Mr. LAFALCE. That is why I wanted to have this hearing, because we have not discussed this issue, and I would love to discuss it, and I would love to reach a compromise short of legislatively mandating rotation, if it is a good compromise.
Mr. CANTOR. The gentleman's time is expired, and Mr. Sherman is in wait.
Mr. WALKER. One quick thing, Mr. Chairman, please. I think one of the things you have to be concerned about is if you are looking at the public interest, I think you have to be concerned with how many firms are there that can perform the service. I think the number of firms does matter.
Mr. LAFALCE. That is an important issue, too. Now are there not a lot of auditing and accounting firms below the Big Five that really could do much more work than they presently do.
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Mr. WALKER. They could do more work, except when you are dealing with highly complex and global enterprises.
Mr. LAFALCE. But an awful lot of the publicly traded companies—what are there, about 17,000?
Mr. WALKER. They do not fit this——
Mr. LAFALCE. They can do it for—we have got to be able to encourage—I had a chairman of an accounting firm in my office today saying I favor mandatory rotation. It is the only way we are going to be able to get a piece of the action.
Mr. WALKER. I understand. It depends where you sit. Number one, the number of firms that are qualified to do the work is important. Number two, we need to be concerned with firm quality and related internal quality assurance procedures. And number three, the quality of the people is key.
One of the concerns that I have about mandatory rotation is that could end up putting more pressure on price, and the last thing you want to do is create a further commoditization of the audit business, especially if you are going to end up taking a way a lot of non-audit services, because in the end you have got to have a viable economic model, and if you do not have a viable economic model, you are not going to attract and retain quality people.
Mr. LAFALCE. It is a pittance and——
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Mr. CANTOR. The gentleman's time has expired and the Chair is going to recognize Mr. Sherman.
Mr. SHERMAN. Thank you, Mr. Chairman, for giving me a chance to combine my third, fourth and fifth round questions into one block.
One of the witnesses mentioned Jersey Island, and of course we have also seen a lot of Enron activity in the Cayman Islands. I commend this Committee and the Ranking Member and the Chair for having these hearings on Enron and responding, but the Ways and Means Committee is strangely silent. There are two sets of accounting games that were played by Enron. One, to cheat the shareholders; the other, to cheat the United States Government and all taxpayers.
Now, the first is a little bit more apparent, because the victims are there. The employees, everybody who held stock at Enron, and in a way every stockholder in every company in the country, because I am convinced the market would be several hundred points higher if everybody didn't have to factor into their investment decisions the fact that the company that they invest in has a number of risks, including the risk that they might be the next Enron.
The hidden cost and victims of the accounting games, the trips to Cayman Islands that had nothing to do with snorkeling, are the taxpayers, the citizens of the country, everyone who depends upon Government, our efforts to combat world terrorism, and it is not just Enron, but hundreds of companies that have each established dozens of subsidiaries in the Cayman Islands, in Jersey Island, in Barbados, in the other tax havens, and I would call upon our sister committee to be as vigorous as this committee has been. We have to defend investors. They have to defend citizens.
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But shifting to our responsibility and the scope of the outside auditor, the whole problem arises, because financial reporting is the only game where the umpire is paid by one of the teams. And that means under the current system if you say no, we will not give you an unqualified opinion, you are not just giving up this year's audit fee, you are giving up this year's consulting fee. And you are not just giving up this year's auditing and consulting fee, but those fees could continue for ten or 20 or 30 years into the future.
Now one thing that I do not think will solve the problem right away—and I used to work for one of what we call the Little Six accounting firms—as long as investors, as they have, always demanded from the big companies they buy stock in that are widely traded that a Big Five, Big Eight, Big Four firm be the auditor, I do not know a way to break that up just with rotation. I think you would end up rotating among the Big Four, which may have some advantages and disadvantages. I think if you want smaller firms, we would have to break up the firms we have got now, because I do not think Horwath is going to be able to stand up and say, we audited General Motors or we audited even Pacific Gas and Electric, and you should buy their stock, or at least rely on our financial statements to decide whether or not to buy the stock.
We then focus, though, on that financial relationship that an accounting firm has with its clients, and one thing that Mr. Silvers and I were talking about is the non-audit fee. And the question there is whether you can just list a number of different services and say, OK, from time to time we will change the list and we will prevent the client from having too much clout with the accountant because we will always have a list of prohibited services or limited services that prevent the client's total fee package from being too important to the accounting firm, and I wonder whether that is even possible without the backstop that I have suggested Mr. Silvers referred to as a perhaps useful redundancy. And I would like the members of the panel to comment. Is there any way you could list some services, but not other services and not have a situation where the client's total fees to the accountant might possibly be as large or larger than the audit fee? Can we do this by enumeration, or must we do it by ratio?
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Mr. WALKER. My personal view is—and as our testimony states—you may want to have certain principles that you say that under no circumstances can the auditor violate certain principles, which are clearly articulated.
Second, you may want to have certain safeguards to make sure that people are not auditing their own work, either firms or people within the firm. You should delegate to an independent qualified authoritative body which is able to make the tough decisions on what should and should not be allowed based upon changing market conditions. I think it is difficult to establish any particular level to say that merely because non-audit fees exceed a certain number, that there is a problem per se.
Mr. SHERMAN. So if I can interrupt, let us say it was thought to be acceptable that an accounting firm also provide executive recruitment. You are not auditing your own work, except to the extent that——
Mr. CANTOR. The gentleman's time is expired. If we can expedite the answer.
Mr. SHERMAN. I didn't even get through to the question. So I would withdraw it.
Mr. CANTOR. The gentleman may proceed.
Mr. SHERMAN. If we—whatever the allowable service is, say executive recruitment, is there—if it makes sense to allow a little bit of it, can you allow so much of it that the accounting firm is receiving more from those services than from the auditing fee?
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Mr. WALKER. Under the approach that we have taken under generally accepted Government auditing standards, which is outlined in my testimony, we say there are certain things you cannot do irrespective of the comments involved. There are other things that you should be able to do, but certain safeguards must be met, and we do not propose any arbitrary dollar or percentage limit. We also think that the audit committee should end up being more actively involved in reviewing and approving certain types of services.
Mr. SHERMAN. I believe my time is expired.
Mr. CANTOR. Thank you.
Mr. LAFALCE. Yes. I just want to thank the panel very, very much. I think this has been very constructive and helpful. I just wish there were more Members from both sides of the aisle who could have listened to the issues that were discussed by both of you.
Also, Mr. Breeden, I do want to say that it was a pleasure working with you in the Bush Administration when representatives of the Administration used to talk with Democratic Members of the House. That is not the case. I used to virtually live with representatives from the Treasury Department and from the White House in those days, maybe because we were in the majority then and they used to talk with us. That is why I developed such a close working relationship, not only with you, but with the President himself and so many of his cabinet officials. That is missing in Bush 2, and it is a sad—I am sad that it is missing. Thank you.
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Mr. BREEDEN. Congressman, can I only say and just respond and say it was a great pleasure working with you then and all of the Members of—some of the Members who are still on the Committee here, that I really think the savings and loan legislation was an opportunity—a great challenge faced by the country, and you played a tremendous leadership role then and it was a great pleasure. I have never forgotten working with you.
Mr. LAFALCE. Well, let me say this, that one of the difficulties—probably, in my judgment, the biggest difficulty—is that there was a cutback in examiners and in regulators for our savings and loan in the mid-1980s. I think that was the single greatest contributing factor. In the beginning of 2001, when our Committee assumed jurisdiction, I pointed out that the biggest shortcoming in Government today was the inadequacy of resources at the SEC, and I called at the beginning of 2001 for another 2 or 3 percent increase, but a 200 or 300 percent increase in the resources of the SEC. I was at least figuratively laughed at in calling for such a huge increase.
Now that Enron has happened, at least the President has called for a 6 percent increase in his budget. But that is not good enough.
Mr. CANTOR. The Chair would also like to express his thanks, and members of the panel, for your indulgence and patience. The hearing now stands adjourned.
[Whereupon, at 4:52 p.m., the hearing was adjourned.]