Hearing Testimony:
Auditor Independence

UNITED STATES SECURITIES & EXCHANGE COMMISSION
HEARING ON AUDITOR INDEPENDENCE
Wednesday, September 13, 2000
8:45 a.m.

PUBLIC HEARING
ON
PROPOSED AUDITOR INDEPENDENCE RULES

Securities and Exchange Commission
Pace University
New York, New York
Wednesday, September 13, 2000 8:45 a.m.

Before:

ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner

Also Present:

JONATHAN G. KATZ, Secretary
DAVID M. BECKER, General Counsel
LYNNE E. TURNER, Chief Accountant

Opening Statements by the Chairman and Commissioners

ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner

MORNING SESSION

Panel 1

LAURENCE H. MEYER, Governor
Board of Governors of the Federal
Reserve System

Panel 2:

BEVIS LONGSTRETH, former Partner
Debevoise & Plimpton

Panel 3:

GARY M. PFEIFFER, Chief Financial Officer
E.I. DuPont DeNemours and Company

Panel 4:

KAYLA J. GILLAN, General Counsel
California Public Employeees'
Retirement System

Panel 5:

JACQUELINE K. WAGNER, Chairman of the Board
of Directors
The Institute of Internal Auditors

AFTERNOON SESSION

Panel 1:

TOM GARDNER, Co-Founder
The Motley Fool, Inc.

Panel 2:

DOMENICK J. ESPOSITO, Chief Executive Officer
Grant Thornton LLP

Panel 3:

ROBERT M. MORGENTHAU, District Attorney
County of New York

Panel 4:

JAY W. EISENHOFER, Grant & Eisenhofer, PA

Panel 5:

JOHN GUINAN

Panel 6:

ROBERT FOX, CPA
New York State Board for Public Accountancy

Panel 7:

GRAHAM WARD, President
Institute of Chartered accountants in England and Wales

Panel 8:

THOMAS C. DeFAZIO, Executive Vice
President & Chief Financial Officer
VirtualCom Incorporated

Panel 9:

RAJIB DOOGAR, Visiting Assistant Professor
Department of Accountancy

P R O C E E D I N G S

CHAIRMAN LEVITT: I'd like to welcome everybody to this second public hearing, the Commission's proposal to modify the rules governing the auditor independence. Can we have it quiet, please?

Today we will hear from a broad array of market participants, investors, institutional investors, lawyers, academics, state, federal and foreign regulators, corporate management and accountants. Accountants for the small firms as well as the Big Five.

The independence of the accounting profession is vitally important to all of these parties, and a broad public dialogue can only be good for the profession and ultimately our markets.

Since the Commission proposed this rule-making in late June, we've received over 700 comment letters in response to testify at our hearing. It's been completely strong. We take seriously our obligation to give everyone an equal voice in this process.

Some in the profession have asked for additional time to make a presentation to the Commission. We obviously realize that these ruleproposals would affect directly the major firms and we're happy to honor their requests. The Commission intends to make additional time available to these presentations on September 21st at the Commission.

I'd like to thank Pace University for their hospitality today, and I look forward once again to an informative day.

Before I introduce the first panel, I would ask the Commissioners if they have any opening comments.

Commissioner Hunt?

COMMISSIONER HUNT: I just want to join you and my colleagues, Mr. Chairman, in welcoming everybody to this second day of hearings. This is, as you said, a critically important issue that's been around for a long time.

As you also said, we want to give everybody a chance to speak who wants to speak who has something relevant to say.

I don't know how much time it's going to take, how many more days it's going to take to get everybody in the world to speak, but take as much time as is necessary, so then, thank you.

CHAIRMAN LEVITT: Commissioner Carey?

COMMISSIONER CAREY: Thank you, Mr.Chairman. I want to thank all the witnesses who are appearing here today and the witnesses who appeared in Washington.

It is a crucial step in informing the Commission's decision-making process on this very important issue.

I also want to single out staff for having put so many hours into this series of field hearings, and I look forward to today's testimony.

COMMISSIONER UNGER: Thank you, Mr. Chairman.

I join my colleagues in welcoming the witnesses, and I look forward to building a record that we are looking so hard to build on this important issue, and I really look forward to and hope that the witnesses today, if you're here, could focus on the practical implications of the rule, because I think that's something for the proposal that we really need to hear something about, and that's sometimes the hardest judgment to make when you're attempting to change some things such as this, so I look forward to hearing the testimony and it's going to be a long but informative day.

Thank you.

Panel 1 (Morning)

CHAIRMAN LEVITT: First panel, we have twodistinguished presenters, Dr. Laurence Meyer, Governor of the Federal Reserve System. Dr. Meyer is recognized as one of the nation's leading economists having received numerous awards for his conmetric forecasting and the author of numerous articles and a textbook on macroeconomic modelling, and our good friend, Paul Volcker, former chairman of the Federal Reserve Board from 1979 to 1987.

Following nearly 30 years of service, Paul is currently the chairman of James D. Wolfson Incorporated, a Wall Street investment firm, and is Frederick Schultz professor of economic policy at Princeton University, his alma mater.

Gentlemen, Dr. Meyer.

DR. MEYER: Thank you. Chairman Levitt and Commissioners, thank you for the opportunity to speak at today's hearing on rules governing auditor independence that have been proposed by the Commission.

The principal concern of the Federal Reserve is the efficiency and stability of financial markets. By extension, we take a keen interest in issues that underpin the functioning of markets, because information is a key support for financial markets.

The Board has long believed that highquality accounting standards and disclosure requirements are essential to the efficient, rational allocation of capital.

For the banking industry, we believe high standards aid market discipline, and good management. Banking regulators find such standards helpful in meeting their responsibility for supervising safety and soundness among financial institutions.

Independence enhances two important aspects of financial reporting. A setting of accounting standards and enforcing conformance with these standards.

Both the SEC and the accounting profession have important roles in fostering independence. Accounting standards have improved markedly as a result of steps taken over the years to strengthen independence.

High quality accounting standards, however, can potentially be nullified if there is a perception that auditors lack independence and objectivity in their enforcement role.

In my testimony this morning, I will focus on one aspect of the SEC proposal, the prohibition of outsourcing the internal audit function to the firm's external auditor.

We strongly support this aspect of the proposal. This reflects the importance to be attached to both the external audit and the internal audit, as critical checks on banking organizations' risk management and internal controls.

As regulators of banks, the Federal Reserve is very interested in external audits of institutions it supervises. Large banks are required by statute to have an external audit.

Recognizing the value of an external audit, we encouraged small institutions to engage public accountants. External audits give us greater assurance of the integrity of the financial information we receive.

In addition, we believe that banking organizations benefit from an outside opinion of the quality of their financial reports, and assessment of their internal controls.

Moreover, our ability to supervise institutions is enhanced by competent and objective external audits. We have been very wary since the trend began of internal audit outsourcing.

Our concerns are twofold. The potential to blur the accountability of bank directors and management for internal controls and diminishedeffectiveness in the internal audit's ability to monitor controls.

In 1997, the Federal Banking agencies issued a policy statement that serves as a framework for the internal audit function and related outsourcing arrangements.

On outsourcing, the policy seeks foremost to warn management and directors that outsourcing the internal audit does not in any way relieve them of the responsibility for internal controls.

Institutions can delegate the technical work, but not oversight and accountability.

The policy does not prohibit all outsourcing, because efficiencies can be gained and specialized talent brought to bear.

These arrangements must be carefully structured so as not to weaken overall the processes for identifying and fixing internal control deficiencies. The banking agencies considered prohibiting a bank's external auditors from acting as an outsourcing vendor, because we were concerned about the effect such arrangements could have on external auditor independence.

As we finalized our guidance, we decided such a prohibition was premature.

The banking agencies were reluctant to set a standard different from other industries, which of course are not subject to our safety and soundness policies.

Second, we believe the issue is more properly addressed by the SEC, who has broader jurisdiction over the auditing profession.

We ultimately chose instead to have our examiners monitor arrangements among supervised institutions and evaluate auditor independence case by case, and to encourage individual organizations to consider looking for firms other than their external auditors.

The SEC proposed rule would not eliminate outsourcing in its entirety or prohibit public accountants from offering all internal audit services.

Instead, it would exclude the external auditor from performing internal audit services for the same client. There may be efficiencies in providing internal and external audits, since the work can serve a dual purpose of inspecting internal controls and expressing an opinion about the financial statements.

These efficiencies, however, may come at the cost of the external auditor's appearance of independence. Our view is that auditor independence is more valuable than these asserted efficiencies.

We are pleased the SEC is addressing this issue on a cross-industry basis. From our perspective as a banking supervisor, we support the SEC's proposal to limit the external auditor's role in the internal audit function of its clients.

Thank you.

CHAIRMAN LEVITT: Thank you very much.

Paul Volcker.

MR. VOLCKER: Thank you, Mr. Chairman, I have done a lot of testifying in my day. This is the first time before the SEC, and I am particularly conscious of the importance of full disclosure and accuracy, and I have to tell you the SEC must have an old prospectus of my current activities, because I'm no longer with Wolfson. It doesn't exist and I no longer teach in Princeton, but I am very conscious and interested in this subject.

COMMISSIONER CAREY: You're still tall.

MR. VOLCKER: I still talk. I don't think I'm senile.

COMMISSIONER CAREY: No, I said tall.

MR. VOLCKER: I am not obviously an accountant, auditor, I am not a professional in thatsense, but I have been a consumer in various guise of my career, and have a great interest in the importance of the accuracy and reliability of accounting statements, and as I point out in the statement that I gave to the Commission, this is important, not just for the United States, it's important for the world, this globalized world and we are very fond of preaching the Americanized approach towards accounting and auditing to everyone else.

And I think that makes it particularly incumbent upon us to maintain the highest standards.

I have great admiration for the work that auditors do. I view it with admiration, but sometimes with frustration, because I think there is evidence that we fall short of what we preach and standards that we should uphold too frequently.

Part of that, I think, is the sheer complications of the present world and global world, and certainly the complications of financial markets.

I read about the Morgan Chase prospective merger in the paper this morning. Knowing I was coming down here, one of the things that occurred to me was still another challenge for the auditors to keep track of such a large, complex institution involving so many different businesses and people andcontrol systems and all the rest.

So there's a constant emphasis on making sure that the auditing profession, among other things, I think has ample revenues and training and all the rest, but what you're addressing in your proposal I think is kind of a philosophical point, a point of principal that raises a question of whether there is an insidious bias or lack of objectivity in accounting by the way accounting firms are organized.

There's more than one source of a conflict of interest, but I do think you have put your finger on an important conflict of interest that is real and not just a conflict in perception, and that is the increasing amount of activity, resources, revenues, profits, that accounting firms are seeing and consulting services unrelated to their auditing responsibilities, which inevitably raises the danger of insidiously, maybe unconsciously biasing the attentiveness, discipline, that they applied to the auditing statements of the company, the accounting statements of the company when they are looking to that same company for large revenues and other directions of activity.

I am very aware that this has become enough of a problem in practice, enough of a conflict withinfirms, that there is a strong tendency to provide the consulting and auditing practices, and in that sense, my understanding of what you're trying to do is to introduce a regulation that in fact reinforces what many of the firms are doing anyway, and doing it in a way that makes the borderline clear and more effective, and I think that is a correct approach and I support what you are trying to do.

I am also conscious particularly in recent days of the number of accounting and auditing friends that have told me your particular proposals are sometimes difficult to interpret. Sometimes they may be more sweeping than they need to be.

We certainly need to pay close attention as to their practical application, so while supporting the general thrust, I do agree with what Commissioner Unger just said, and I'm sure the Commission and its staff is alert to anyway, the purpose of these hearings, the purpose of this review is to make sure that in the final application of the rules and regulations about separating auditing from other activities within the accounting firms, legitimate concerns about the details can be reviewed to see whether they are in fact legitimate, but I certainly urge you to go ahead and put this in practical, final,effective form.

CHAIRMAN LEVITT: Thank you very much. I am deeply grateful, all of us are, for your distinguished presence here. I might ask you several questions.

Mr. Volcker, you made clear that as guardian of the public trust, the obligation should be to the shareholders.

Given the growth in the auditing service in providing a broad range of services to clients, are you concerned that with the meltdown in emerging economies, that the preservation of the status quo in this area might send the wrong message internationally?

MR. VOLCKER: Well, I certainly think the kind of action you're proposing will send the right message internationally, but this is supportive of all that we've been saying in terms of the kind of accounting practices that ought to be common around the world, and the United States has an image of being in the forefront in that effort, and that may sometimes be exaggerated, frankly.

We have problems there, too, but I certainly think that what you're trying to do is consistent with the image and the policy that we are proclaiming.

In that sense, the absence of action Isuppose would be reversed.

CHAIRMAN LEVITT: Do you share Dr. Meyer's concerns about the outsourcing of the internal audit on the part of banks, particularly smaller banks?

MR. VOLCKER: I certainly share his concern that you can't have the outside auditor reviewing its own internal audit. That seems to be quite obvious.

This issue about whether there should be any outsourcing of the internal audit at all is one I have not thought about deeply.

I know that when we, when I was chairman, there was still a question of whether banks had to be audited, and they are, of course, examined and many of the banks complain that it would be very costly and they didn't have the resources for decent internal auditing efforts, so maybe in some cases there are justifications for outsourcing an internal audit, but I certainly do not think that changes the need for an objective outside audit.

CHAIRMAN LEVITT: The critics of this proposal focused most directly and dismissed the notion of perception as being relevant. I know Dr. Meyer touched on this, but I would appreciate both of your comments with respect to the importance of perception, both domestic and internationally.

MR. VOLCKER: Well, that I can tell you, I have a paragraph in my statement about this, and I know people say, well, it's just a perception and it's wrong.

I don't think it is just a perception. It's a reality. The perception is there because there is a real conflict of interest. You cannot avoid all conflicts of interest, but this is a clear, evident, growing conflict of interest, given the relative revenues and profits from the consulting practice, and a conflict of interest is there.

How much it affects the audit, of course, is an elusive, difficult subject, but since the conflict is there, I think it is a kind of black and white issue that ought to be ruled on.

CHAIRMAN LEVITT: Dr. Meyer?

DR. MEYER: Even the perception of a problem undermines investor confidence in data and it also reduces the reliabilities that the supervisors can have in the investment firms and may therefore encourage the duplications, the burdens, as the supervisors do more work, because they don't believe they can count upon or aren't convinced they can count upon the reliability of external auditors.

I think if the perception didn't have anybasis in reality, it would not necessarily last very long, so there has to be some interconnection between them, but the perception is an important one.

CHAIRMAN LEVITT: I think there are some areas in our society where perception becomes the ultimate reality. I suspect this is probably one of them.

To what extent, Dr. Meyer, do you think that banking organizations today are outsourcing their internal audits and is this an increasing trend?

DR. MEYER: Yes, well we, since the 1997 effort and guidance, we've been doing ongoing monitoring, and we actually did a survey in the summer of '99, and we found out that for large bank holding companies with assets in excess of five billion, about a fifth of them outsource internal audit functions and about a fifth of state member banks do.

About half of these cases, the outsourcing is to the external auditor of the firm, so it is, now, you can decide whether or not that 10 percent is small or large, it's a significant number, it is something that has been growing over time as well, it has particularly been growing since about 1996.

The fact that we did this survey is a reflection of our ongoing concern and the necessitythat we feel to monitor this, and to talk to our examiners and see what level of concern they have about the practice, and they indicated some level of concern and some concern about the competence of the internal audit function when it does get outsourced to the external audit, so it is an issue.

CHAIRMAN LEVITT: Has the Board considered implementing their own regulations in this regard?

DR. MEYER: We did very much consider that in 1997, but we decided at that point to do it on a case-by-case basis and handle it through monitoring, mainly because we were reluctant to set a standard on major accounting and auditing issues that was different from other industries, partly in deference to the SEC, who has broader jurisdiction and authority in these areas.

We think our patience is being sort of rewarded by your turning to this issue, and we think this is something which will be very helpful to us.

CHAIRMAN LEVITT: Mr. Hunt?

COMMISSIONER HUNT: Again, thank you for appearing, gentlemen.

Dr. Meyer, do you think there's any difference in the outsourcing of the internal audit to the outside auditing firm and vis-a-vis to anotherauditing firm?

DR. MEYER: I think there is a difference, but there is some common issues as well.

We think it's a problem to outsource to anybody. I mean, there is that issue, because it sort of develops a mindset that the managers and directors of the bank can transfer responsibility for risk management to an outside vendor, and whether that transference is to the firm's external auditor or to some other external firm may not be that important.

Now, we think that there's -- that the problem is compounded when you're outsourcing to the external auditor, because then you get the potential of conflicts of interest, lack of independence in the external audit, and I think that's a much worse outcome, so we think that the prohibition on the outsourcing to the external auditor is justified.

On the other hand, we're still going to have ongoing monitoring whenever there's outsourcing to any vendor, for the reasons that I indicated.

COMMISSIONER HUNT: Because you think that it might allow the officers and directors to appear to advocate their responsibility for risk management?

DR. MEYER: I think there are sort of two issues here.

One is that mindset that's created that they had somehow transferred that responsibility and focused less on it, and that's certainly not a mindset that we want in banking organizations.

But in addition, our experience with outsourcing is that while you might think that the whole purpose of this is to increase the competence of the internal audit, the result seems to be just the reverse.

It's a very cumbersome process to have that internal audit carried out by some external firm. It's not constantly around, walking around, seeing what's going on in the ground and having that familiarity with the operations of the firm.

And that's a problem whether it's outsourced to the external auditor or some other auditor.

COMMISSIONER HUNT: Well, your last comment raises an interesting question that was raised in our first day of hearings, which is that some accounting firms indicate that when they do consulting work for their auditing clients, they become so much more familiar with their clients, that in fact the existence of the nonauditing work makes for a better audit.

DR. MEYER: Of course, this is not an issueof nonaudit work. This is audit work on both sides, but it seems to me in this case the world is still a trade-off. Okay, we appreciate that.

That's not an argument that I would completely dismiss out of hand. There's some justification, there's some duplication, there are some synergies involved here.

I don't dismiss that argument, but in a world of trade-offs, you have to weigh the lack of the conflict of interest and the implications of external auditors reviewing their own work, the potential deterioration, the competence of internal audit and the transfer of responsibility for internal risk management, and it seems to me that from our perspective it's not really a close call, that the costs are just too high.

COMMISSIONER HUNT: Thank you.

Mr. Volcker, you mentioned that there's a concern that the auditing firms have ample revenues to enable them to perform their auditing function, particularly in light of the mega mergers of today, such as the one announced in the paper this morning, a fast-growing part of the revenues of the auditing firm is from this nonauditing consulting business.

How do you envision them making up for thatlost revenue if the firms are divided and they cannot do the consulting work for the audit clients?

MR. VOLCKER: Well, they obviously don't have to make up for the lost revenue in terms of compensating all the employees that are involved in the consulting side of the business. That should be the bulk of those revenues.

But I do think it may put some pressure on companies to make sure that they are willing to compensate their straightforward auditors devoted towards the audit and not other services adequately to provide a reasonable attractiveness of that profession, and I think that is happening and will happen.

I think there is enough work to be done in auditing, and all these complexities show the professional, technical talent that is needed these days and that needs to be compensated.

COMMISSIONER HUNT: Thank you both.

CHAIRMAN LEVITT: Commissioner Carey?

COMMISSIONER CAREY: Thank you, Mr. Chairman.

Chairman Volcker, there's a point you touched on that has been repeated by many critics of the proposal, which is the issue of compensation andthe issue of the type of experience you get to have if you go to work at an accounting firm, and they, their assertion is that they cannot continue to make the audit experience or the auditing profession an attractive one and be able to retain and attract talented young people without giving them the ability to do some consulting work and that's a, it's for me a regrettable state of affairs, but what would you say to that?

MR. VOLCKER: Well, I suspect that many of the traditional professions are feeling under some pressure from the lure of Wall Street incomes, and the dot com world, and I suspect the Federal Reserve feels that, and auditing firms feel it. It is a fact of life.

I don't think you cure that problem by creating a conflict of interest in your own firm.

Those high-priced people have obviously created a lot of turmoil in the accounting firms by all the contests of who is going to receive all the revenue and how is it shared and they've ended up in something short of armed conflict, I guess.

But considerable conflict, quite obviously in some of these accounting firms doesn't strike me as very healthy in terms of the auditing practice.

The reason I mention this compensation thing, it's clear they do have talented people, there are lots of challenges in auditing these days by all these technical complications and companies, encouraged I'm sure by SEC surveillance are going to have to be willing to pay for straightforward auditing and a job which is adequate.

I've had enough experience with banks and other companies that I have been involved with that when they get in trouble, the auditing function certainly becomes more important, and they're willing to pay a somewhat higher fee to make sure they're adequately audited, because they realize the enormous expense of lack of sufficient diligence and independence when they get in trouble.

COMMISSIONER CAREY: I just want to say I share your view as well as Commissioner Unger, about the practical applications of this effort, and the need to be mindful of unintended consequences.

MR. VOLCKER: Part of the problem if you were talking about it, as I view it, conflicts in the auditing profession, is the way they're paid in the United States. You're not taking on that particular problem, but it obviously exists.

COMMISSIONER CAREY: Do you mean crossselling?

MR. VOLCKER: No, I mean the fact that a firm makes a bargain with an auditor, and there is competition among auditors, and one of the criteria for choosing an auditor may be trying to do it as cheaply as possible. It's just inherent in the situation, you're not dealing with that at this point, and I don't know how to deal with it, I haven't got any advice for you, but it is a problem.

CHAIRMAN LEVITT: One of the ways that other industries that have that conflict deal with the problem is by having an effective self-regulating organization.

Unfortunately, up to now the profession lacks that oversight discipline.

COMMISSIONER CAREY: No further questions, thank you.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: Thank you.

Chairman Volcker, you talk in your testimony or mention in your testimony a sense that auditors aren't challenging management enough and that may be one of the causes --

MR. VOLCKER: In some instances.

COMMISSIONER UNGER: Right, and that one ofthe causes of the failures could be the conflict between the management and auditing services.

Do you think there are other things that we should be looking at or other areas?

MR. VOLCKER: Other areas of conflict?

COMMISSIONER UNGER: Other areas.

One of the areas of failure or lack of diligence is because of this conflict.

Could you think of any other motivations?

MR. VOLCKER: There's always a human problem, not entirely the way that they're compensated, you audit a company, you become familiar with their problems, you become familiar with their management, you become psychologically part of management in some sense that's a danger, you shouldn't.

An auditor always has to resist that temptation. It's very insidious, but it's part of human nature.

I think all you can do is try to build some areas of principle. What you're trying to do here is to minimize, put it the other way, maximize a sense of independence of the auditor.

COMMISSIONER UNGER: It's interesting, because Dr. Meyer's testimony talks about how theofficers and directors should be more accountable, and that outsourcing impedes that, and yours says that the accountants aren't challenging the management enough, so I guess we need to find the right balance between the company challenging the auditors and the auditors challenging the company, so that you do have the integrity of the financial reporting system.

How do we do that?

MR. VOLCKER: With difficulty.

COMMISSIONER UNGER: Apparently.

MR. VOLCKER: Obviously there is no magic answer to these things. You don't want antagonistic relationships obviously between the auditors and the management either.

All you can do is draw some broad principles, count on the profession and there's a lot of reasons to count on the integrity of the auditors, but what's happened here is a relatively new development. There's heavy emphasis on consulting.

It didn't exist before automation, I guess, in the electronic age, anything to the same extent. I just think there's enough evidence within the firms themselves, that this has run into a problem to make it timely that you try to draw this line.

COMMISSIONER UNGER: Interesting you shouldraise that, because in the first day of hearings, I think when we asked, or I asked what the revenue of nonaudit income was, it's about 60, 50 to 70 percent, depending on the firm, and another question I have is, do you think that our proposal could drive firms out of the business of auditing and wholly into the business of consulting?

MR. VOLCKER: Well, some people might choose that route, but there's going to be a need for auditors because you're going to need audited statements, and the fewer people that offer that service, the price will go up.

Maybe it should go up, but I think you will reach a balance where the auditors are adequately compensated for doing what they do, and given complications of today's world, probably cost more than it used to cost, relatively speaking, if they're going to do a good job.

This as a result of to some degree increasing the costs of audits, I don't think that that is any way a reflection on the value of this proposal.

COMMISSIONER UNGER: Thank you.

CHAIRMAN LEVITT: Thank you very much, gentlemen, for really superb testimony. Thank you fortaking your time to be with us this morning.

Panel 2 (Morning)

The next panel will include D. Bevis Longstreth, who served an SEC Commissioner from 1981 to 1984, is a retired as partner from the law firm of Debevoise and Plimpton. Mr. Longstreth recently served as a member of the Panel of Audit Effectiveness that issued its final report on August 31, 2000.

Mr. David A. Brown, chairman of the Ontario Securities Commission, and a former senior corporate law partner at Davis Ward & Beck for nearly 28 years.

Finally, my long-time friend, mentor and associate, John C. Whitehead, former deputy Secretary of State, retired co-chairman and senior partner of Goldman Sachs & Company, and Mr. Whitehead most recently co-chaired the Blue Ribbon Panel to Improve Corporate Audit Committees and his recommendations have been implemented by the New York Stock Exchange, NASDAQ, the SEC and the accounting profession.

Mr. Longstreth.

MR. LONGSTRETH: I'm very grateful for this opportunity to testify.

I want to first, having followed this closely, I want to first congratulate the Commission and particularly its chairman for the vision and boldness embedded in the release and the rules it'sproposing.

To many it may seem strange that boldness and even personal courage may be required for the SEC to propose such an obviously praise-worthy rule, but yet I'm convinced that's exactly what it took to propose the rule and that plenty more of the same is going to be called for to adopt it and implement it.

This battle, and I think it is clearly a battle, pits a legally created monopoly dominated by five global accounting firms against the SEC.

Some of these firms representing solely their private business interests, reject further restrictions on the free play of those interests, as with many businesses.

The SEC acting upon the need for greater independence, a need long recognized by virtually every group that considered the issue, and there have been many, has proposed a rule to meet this need.

Given the sharpness of debate and the transparency of private versus public interest, there is more at stake than just the independence o auditors.

The independence of the SEC itself is being challenged.

As the accounting firms do all they can onCapital Hill and throughout the business community, to bring pressure, political and other kinds of pressure to bear against a proposal that in my opinion cannot be defeated by argument on the merits.

As the New York Times put it in an editorial supporting the Commission, "The SEC has proposed nothing Draconian, only common sense rules to make sure that outside auditors perform and appear to perform independent audits."

In the tumult of the moment, leaders of the accounting profession seem to have forgotten their origins as a profession granted rights and reciprocal duties to perform a vital public service.

Although affected by the public interest as much as any public utility, the profession seems to want freedom from serious oversight or constraint. It won't wash, not in a country where check and balance is king.

Before I turn to the proposal itself, let me also congratulate the SEC staff led by Lynn Turner in turning out such a thoughtful, well-considered and thorough set of proposed rules.

The details are always important and in this release there are no lack of them. And not all of those details I claim to have digested, but therelease is good on explanation and inviting of scrutiny, comment and ideas for improvement.

Overall, I'm a strong supporter of these rules and I'm going to limit my comments to the area of nonaudit services.

After a lot of thought, I've concluded that an exclusionary rule for nonaudit services is the best approach in addressing the independence problem.

This rule would have limited exceptions. Rather than repeat the case for an exclusionary rule here, I have attached to my written testimony the statement in the support of this kind of rule contained in the Report and Recommendations of the Panel on Audit Effectiveness.

This statement was written and supported by some panel members of which I was one, of whom I was one. The proposed rule takes a more complicated approach in seeking to prohibit only certain types of nonaudit services, those considered to be especially threatening to independence.

I have one major comment.

Under the proposal, an impermissible nonaudit service is one that meets one or more of four governing principles. These principles declare an accountant not independent if during the period ofaudit engagement the accountant has a mutual or conflicting interest with the audit client, audits the accountant's own work, functions as management or an employee or acts as an advocate for the client.

The list of nonaudit services determined by the Commission to be impermissible under these principles is extensive and the principles by which the litmus test is informed are sound.

Nonetheless, I think the approach is seriously incomplete, because it ignores a principle as important and arguably more important than the four listed above.

This principle is the auditor's vulnerability to economic pressure from audit clients.

The governing principles do not address this risk at all.

As the release acknowledges, as auditing becomes a smaller percentage of a firm's business with its audit clients, the auditor becomes increasingly vulnerable to economic pressures from those clients.

But it is not only the magnitude of nonaudit service fees that creates the problem. It is the fact that a conflict of interest, which you heard at a previous panel, a conflict of interest arises from the provision of virtually any kind of nonaudit service toan audit client.

This conflict derives from the fact that in performing these two kinds of services, the audit firm is really serving two kinds of clients.

Management in the case of nonaudit services, which typically are commissioned by and performed for management, and the audit committee in the case of the audit, which now is by rule commissioned by the audit committee and performed for that committee for shareholders and public investors at large.

And here I'm talking only about good professionals, not venal ones, but these are good professionals trying to serve two masters, the firm is a fiduciary in respect of each of these two very distinct client groups, duty bound to serve with undivided loyalty.

It is obvious and a matter of common experience that in serving these different clients, the firm will be regularly subject to conflicts of interest. These conflicts tear at the heart of independence, which is the freedom to exercise undivided loyalty to the audit committee and the investing public.

Where other loyalties tug for recognition, and they come from those in a position to enlarge orshrink one's book of business, the freedom necessary to meet one's professional responsibilities as an auditor is curtailed and sometimes it becomes eliminated all together.

Now, the proposed rule in addressing disqualifying financial and business relationships between an accountant and its audit client, declares an accountant to lack independence for even small investments in the client or any direct business relationship with that client.

One can imagine many financial and business relationships with an audit client that would, by these definitions, render an accountant not independent, yet be insignificant to the firm when compared to the revenues, past, present and future, generated and expected to be generated from nonaudit services performed for that client.

Yet the financial and business relationship of nonaudit services is given a complete pass in the proposed rule.

My point is not to suggest that the finely textured concerns over the independence impairing effects of various financial and business relationships are misplaced.

They reflect legitimate, albeit immeasurableconcerns, but they pale in significance when compared to the potential for impairment that comes from a financial and business stake that an audit firm will still be allowed to develop in an audit client through provision of permissible nonaudit services.

One of the premises on which the exclusionary rule argued for in the panel's report was based is the superiority of a clean rule over a complex finely textured one.

The problems of interpretation, misunderstanding, avoidance and even evasion, now so commonplace within the tax thickets of our land grow large as the complexity and detail of the rule increase.

Here, as in most cases, effectiveness is best achieved through simplicity.

Thank you.

CHAIRMAN LEVITT: Mr. Brown?

MR. BROWN: Thank you, Chairman.

I am pleased to have the opportunity to present the perspective of another North American securities regulator on the important issue of auditor independence.

I thought I would highlight a couple of the key points made in my written submission, elaborate onone or two of them and then hopefully leave some time for questions at the end.

A key element of the Ontario Securities Commission's legislated mandate is to foster a fair and efficient capital market and confidence in that capital market.

In recent months, we've seen a growing erosion of public confidence in the reliability of the audited financial statement.

We are told that sophisticated investors and analysts now place far less reliance on audited statements, preferring instead to develop their own independent views of a company's prospects.

But the resources necessary to conduct such exercises are far beyond the average investor.

Although the reasons for this erosion in confidence in the audited statement are likely complex, I believe that a significant factor is the loss of the confidence in the auditor as a figure sufficiently independent of company management.

Auditor independence is a significant concern to the OSC for the same reason that it is a concern in the United States.

The investing public must have confidence in the auditor's ability to exercise objective andindependent judgment in difficult situations.

Objectivity is fundamental to the integrity of the external audit. The auditor must avoid both real and perceived impediments to his or her ability to say no to management.

Anything that dilutes either the reality or the perception of objectivity undermines the whole system.

In Canada, for example, the rules of professional conduct for auditors require that they avoid any situation that impairs professional judgment or objectivity, or in the view of a reasonable observer would impair professional judgment or objectivity.

Thus in the Canadian rules, the reality and the perception of independence are given equal prominence.

And so the importance of the perception of auditor independence and objectivity cannot be overstated.

Audited financial statements are the cornerstone of our disclosure system, and the public has come to place a large measure of reliance on them in part because of the credibility lent by the report of an independent auditor.

This is particularly important in the context of Canadian accounting standards, which place great reliance on a framework of sound principles rather than the more detailed and specific rules commonly found in the U.S. GAAP.

The inevitable scope for auditors to create a necessary judgment increases the need for independence both in fact and appearance.

As public confidence in the role of independent auditors erodes, investors will be less inclined to rely on audited financial statements and will continue to seek other sources of information in which they believe they can have greater confidence.

Unfortunately, no matter what steps we take as regulators, we can never know with certainty that an auditor will be prepared to say no under pressure.

The reality of independence is difficult, if not impossible. Perceptions of independence, therefore, become almost equal to reality in importance.

When it comes to perceptions, I am concerned that consulting relationships and audit responsibilities can be seen as fundamentally at odds with each other.

In most circumstances, consultants are hiredby management of the corporation.

Management works on an ongoing frequent basis with consultants, determining their assignments, critiquing their work, reaching agreement on recommendations and approving their fees.

The result can be a relationship of consultant loyalty, a commonality of interests and potentially an element of financial dependence.

Firms may become beholden to their clients in areas that are far more lucrative than the basic audit functions. I am concerned that the audit may become little more than a loss leader, as accounting firms leverage the audit relationship to cross-sell higher margin services.

In these circumstances, it seems only natural for shareholders to question whether they can have confidence in the audit when it is carried out by a firm that spends much of the year taking direction from the same managers they are supposed to scrutinize.

A second issue involves the evolving structures of the accounting firms themselves, and I'm referring to the interrelationships within the accounting firms between the audit and the consulting practices.

As accounting firms have become large, multi-disciplinary businesses, and audits have become comparatively less lucrative, it seems likely that auditors will less frequently play the lead role in the partnership.

This has two effects: First, the partners from other divisions of the firm are more likely to be driving the partnership and making strategic decisions about client relationships.

And second, if this trend continues, firms will continue to have difficulty recruiting new talent for the audit department, particularly if new recruits get a sense that other areas of the firm are more highly valued by firm management.

Much has been said in the course of this debate about the difficulty of recruiting on the audit side of the firms, and I think that's a very real issue, but I think the issue is clearly exacerbated by the messages being telegraphed to young recruits, and that is that there's a faster partnership track on the consulting side.

For more than a year the OSC has publicly raised concerns about the issue of auditor independence.

We have discussed our concerns withindividual firms and the profession's regulatory associations, and we've challenged them to find a solution that addresses these issues.

So far the industry has not produced a proposal for consideration.

Although we've not begun to frame a regulatory solution, it has become increasingly evident in Canada that some form of regulatory involvement in a solution will be essential.

Since most of Canada's large public accounting firms are affiliated with major U.S. firms, the SEC's auditor independence rules will likely shape the corporate governance structure and the codes of conduct of their Canadian counterparts.

Therefore, we are following the SEC's proposals with great interest and will formulate our regulatory response based partly on your experience.

There's one further issue, Mr. Chairman, that I would like to raise.

I suspect that our regulatory counterparts in most of the other developed countries are following a similar process to ours, and I know that you, Chairman Levitt, and Commissioner Hunt have been leading a discussion on these issues with our colleagues in IOSCO.

I believe it's important to build an international consensus on a sound approach to these important issues which are not unique to North American capital markets.

This is particularly important because of the extent of direct and indirect participation of foreign companies in U.S. capital markets.

Independence standards established by the SEC will have significant implications in other countries.

It's also important to identify structural differences in the profession in other countries.

I have recently been aware of a potentially significant feature of the Canadian business model that perhaps is different in the U.S.

In Canada, the accounting firms provide the major portion of the bankruptcy and insolvency services.

This is a historical relationship the firms have by their own rules of professional practice not been permitted obviously to offer these services to audit clients, but they have not been prevented from offering those services where other clients of the firms perhaps are creditors, and this is particularly important in Canada because the major banks, there areonly a few major banks and a few firms, so all of the firms have banks as their clients.

The accounting firms then provide trustees in bankruptcy, receiverships and monitors for the courts in the insolvency relationship.

My understanding of your potential proposed rules is that this may affect the way in which the profession is evolved in Canada.

Having just become aware of these issues a few days ago, I haven't fully gotten my mind around them, but our staff would be quite willing to work with yours to explore these further and I suspect that there are other issues that we may find evolving.

So, Mr. Chairman, we strongly support the initiative that the SEC is taking. We believe that a regulatory solution is necessary, and we will be following with interest and likely adopting many of your proposals.

Thank you.

CHAIRMAN LEVITT: Thank you, Mr. Brown.

Mr. Whitehead.

MR. WHITEHEAD: Thank you very much, Mr. Chairman, for allowing me to be here today to speak my views on this important issue. I don't have prepared testimony, but I would just like to make some off-the-cuff remarks.

I feel as if I've been dealing with these issues all my life. It was in 1947 that I started to work at Goldman Sachs, more than fifty years ago, where I was involved in their investment banking activities.

During 37 years there, I was co-chairman of Goldman Sachs the last ten years, and during that period, I was on the boards of about a dozen companies, not all at the same time, and I think I was on the audit committee and often chairman of the audit committees of probably all of those boards.

I was also chairman of the Securities Industry Association, and during that period, and on the board of the New York Stock Exchange, and I was one of the founding members of the Financial Accounting Foundation which was organized back, I don't remember how many years ago, to establish the FASB and appoint the original members of the FASB.

And as you said, most recently, I was co-chairman of the Blue Ribbon Commission that studied the functioning of the audit committee, so I feel as if I have some credentials to have opinions on the subject.

I am a big defender of our capital markets. I think they're unique, and I think that they have never been as strong or as deep or as liquid as they are today.

I think a great deal of credit for this remarkable continued prosperity without interruption that the country is now having is very largely a function of the wonderful capital markets, which permit our corporations to raise capital for growth in unheard-of amounts, both equity capital and debt capital; which permit our new companies and growing companies to raise money more quickly than has ever been possible in the past.

Indeed sometimes it would seem maybe even too quickly, but they're a wonderful engine of our great prosperity in this country and very important to protect and maintain without interruption.

Financial statements are at the very heart of our capital markets. They're the basis for analyzing investments. Investors have every right to be able to depend absolutely on the integrity of the financial statements that are available to them, and if that integrity in any way falls under suspicion, then the capital markets will surely suffer if investors feel they cannot rely absolutely on the integrity of those financial statements.

The development of advisory income by the accounting firms, and particularly the leading accounting firms in recent years, has thrown some suspicion on their independence as auditors, as you know, and I believe it's reached the point where the separation of the functions is really essential.

Now, I think it's most unfortunate that the raising of these issues somehow casts some kind of aspersion on the integrity of accounting firms.

I know of no profession that has a higher level of integrity than the accounting profession.

They are, but the suspicion that's cast on them as a result of the growing fees in relation to the fees received for the auditing function does begin to cast doubt on a very honorable group of firms, and I have searched my mind for other ways to do it than the separation that you are proposing.

I find no other way to remove that growing suspicion, and I think it's important that that be done and I hope you stick to the rules.

I would make one other point to those accounting firms that have feared that these rules will upset their businesses in a major way and they can lose very substantial amounts of revenue.

I don't think that's the case. For everydollar of revenue that an accounting firm needs to give up as a result of these rules, some other firm will also be giving up just as much, and the opportunities to add new clients for their advisory services is also there for clients for which they are not the auditor.

I do not believe there will be any net reduction of fees to accounting firms on an industry-wide basis, and the better firms that have the best reputation for ability in these advisory areas will I think have a chance to grow rapidly by taking on more new business than they lose.

So I would urge the accounting firms to take that attitude and develop a means of growing as a result of these rules, and not necessarily of seeing their business shrink back.

So I think the rules are not as bad as it might look at first analysis, but I think there's no other way to assure the continued integrity of financial statements and the continued success of these wonderful capital markets that we now have here.

Thank you.

CHAIRMAN LEVITT: Mr. Longstreth, you mentioned the fact that accounting firms in fighting for freedom from serious oversight or constraint arerepresenting their private business interests.

What we've heard from the firms is that consulting services make for a better audit.

How do you view that argument?

MR. LONGSTRETH: Well, I think I've heard that, too, a number of times during our panel discussions, and I can't argue that it isn't the case in some circumstances.

In some circumstances, it may be strongly the case and in others a slight improvement. These are immeasurables, but it's just entirely plausible and sounds correct that the more you know the company, the more, the better you're equipped, let's say, to serve the company.

Now, this would apply equally well to independent directors, and John's Blue Ribbon committee issued a report, an excellent report that's been widely implemented, I think by now, in which it concluded that independent directors to be independent and to serve on the audit committee as independent directors must derive no compensation from the company other than their director's fees.

It's perfectly obvious to me and I think to anyone who thinks about it, that an independent director who had contractual relationships with thatcompany, that made the director intimately familiar with the operations of the company, could be arguably a better independent director.

He would know more or she would know more about the company, and yet that argument, if it was made, was rejected in the interests of assuring that an independent director serving on the audit committee had no connections to the company other than the director's fee, and I think the point is there are trade-offs, as I think the Honorable Mr. Meyer said earlier, or Paul Volcker said or they both said, there are trade-offs, and in this case, there is a trade-off.

So I wouldn't argue against the point, I would just say the point pales in significance to the need to shore up the independence.

CHAIRMAN LEVITT: When you were a member of the Commission, did you deal with this issue?

MR. LONGSTRETH: You're trying to embarrass me.

I have said that the worst decision I made, the worst decision I am today aware of that I made as a Commissioner was to vote to essentially repeal the disclosure rule which was put into effect, I think by the Williams Commission, requiring disclosure in theproxy statement of nonaudit services.

And if I knew now what I knew -- I mean, if I knew then what I know now, I would not have voted that way.

I think the arguments for repeal were lightweight and wrong, and I think we might not be in the position we're now in if that rule had persisted.

However, I do not, I strongly think that disclosure is an inadequate tool today to deal with this problem.

CHAIRMAN LEVITT: You were a member of the O'Malley Panel on Audit Effectiveness, and the opponents of this rule continually quote from that group's report to show that we really should not adopt any restrictions on audit services.

You mentioned that you were among the members of the panel that had a different view. I wonder if you could briefly tell me how the O'Malley group approached this issue?

MR. LONGSTRETH: We approached the issue first by debating whether independence was relevant to audit effectiveness at the outset.

It was put on the agenda after vigorous debate. It then became a subject of continuing vigorous debate as to whether nonaudit services posed a problem ornot, and the -- I think the most powerful argument that one keeps hearing about this subject is that from those who do not want any restriction; is that there are no smoking guns.

I mean, we don't have a major case revealing that nonaudit services caused an auditor to effect a bad audit or to indulge management in something that was really not right under auditing principles and accounting principles.

But there was plenty of debate over that, and we ended up with basically two points of view, and Mr. O'Malley I think as chairman took the decision which was supported by the panel, to lay out the two arguments in the panel report, and those two arguments are laid out in the report, and people can judge for themselves.

Those who are opposing your rule and quoting the report must be very selective in their choice of argument.

CHAIRMAN LEVITT: Mr. Brown, you mentioned professional expertise, and some in the profession contend that without being able to provide internal audit outsourcing or IT design, auditors won't be able to perform high quality audits.

I suspect you disagree with that line ofthought?

MR. BROWN: I do, Chairman.

Those who take the position that the audit is of higher quality where they are also doing other consulting services, are also quick to say, however, that in circumstances where they're not doing other consulting services, the audit is not inferior.

I suspect they're right on both counts, because I think what has to happen is the scope of the audit when they're not performing other consulting services may have to be greater than it otherwise would be, but I think the audit firms do that, and so I think it's an issue of cost, not of quality of the audit.

CHAIRMAN LEVITT: Your remarks concerning the likelihood of some kind of self-regulatory mechanism to be created by the industry is not very high, and you, you know, I found that over the years the profession has been reluctant to address this issue, and I wonder if you have any views on why you think that is, self-regulation works so effectively in other areas of the financial community.

MR. BROWN: I'm not sure that it's a reluctance to address the issue. I think the issue has been addressed, is being addressed, but I thinkthere's an inability for the profession itself to find answers, and I think that's for a couple of reasons.

The strongest is that the very business models that they themselves have developed see them pouring vast resources into the consulting side of the business. I think they believe that that's where most of the growth potential goes, where it's coming from, although I'm pleased to see that some of the firms now are talking about expansion of the assurance services and there may be some hope there that some of the pressures from the business model will change.

I also think that they're being pressured internally. I think that companies and perhaps audit committees have done a disservice to themselves in the past by forcing audit fees down.

There haven't been the same pressures on the consulting fees, and so I think that the consulting revenues have been more lucrative on a per person hour basis.

So I think that the firms, frankly, will be unable to solve the problem because of those pressures, and that it will be up to us as regulators to have a large role in that solution.

CHAIRMAN LEVITT: Mr. Whitehead, you were chairman of the Blue Ribbon Panel on CorporateGovernance, and there was a lot of skepticism at that time as to whether a nonregulatory approach, at least insofar as the panel was concerned, would do at all, and this was followed up by action by the various SROs, and my own observation and those of my fellow Commissioners has been that the dialogue raised by your panel has created nothing short of a cultural change on the part of audit committees.

I cannot tell you how many audit committees I've heard from personally who have said that the Blue Ribbon Panel has made their jobs much easier, and that it's empowered them.

How would you view our rule proposal in terms of helping audit committees to do their job even better?

MR. WHITEHEAD: I think it would help audit committees do their job better.

I think it would help auditing firms do their job better, too. I'm sure that every one of the auditing firms, at least both those that favor the new rule and those that are opposed to it, recognize that there is here a growing problem, and they're searching for ways internally to help.

I think this will push them in the right direction at a time when the problem is getting worserather than better, as these consulting fees continue to grow proportionate to the growth in the auditing fees.

CHAIRMAN LEVITT: Thank you.

Commissioner Hunt.

COMMISSIONER HUNT: Thank all of you, gentlemen, for being with us today.

Commissioner Longstreth, or former Commissioner Longstreth, I'm sure you're glad to be a former Commissioner and not having to sit with us all day today.

COMMISSIONER UNGER: You're not staying?

COMMISSIONER HUNT: You mentioned in your testimony that you were concerned about, and your written statement submitted for the record as well, that some of the battle over this issue may be eroding the independence of the Commission.

Do you think that's actually going to happen?

MR. LONGSTRETH: No, I don't. I mean, that's a --because of the, I'm aware of the extent to which a major effort by the firms has been undertaken.

I've been, I don't know how many lawyers are left in Washington who aren't working in one way or another.

I have this on hearsay, not direct evidence, but I have it from some highly placed sources, so I recognize there's a battle going on, and it seems to me that as many people have said, including The New York Times, but as the gentlemen who preceded us, the distinguished gentlemen on this panel, I mean, this is not, this need not be a big deal.

As Mr. Whitehead points out, which is a simple and brilliant observation, there's no shrinkage of the business.

For every audit client that you have to cease serving, there's one other client opened up for you, and the percentage of business today, the genie is not yet out of the bottle, but it's coming out of the bottle, and the question is whether the SEC will be able to withstand, in my view, anyway, I'm putting myself in your shoes, will withstand the heat that will come from many different places to make sure the genie doesn't get out.

By "genie," I mean that there is only about 70, well, for the Big 5, 75 percent of the SEC clients do not use their auditors for nonaudit services, but that percentage is shrinking. It went down from 80 percent a few years ago, so there is a trend and it's probably a powerful trend, so that's all.

COMMISSIONER HUNT: Well, you know the argument on the other side of course, which is there's synergism here and it leads to better audits and all the rest of it, that the Chairman, mentioned a few minutes ago.

I guess none of us know the definitive answer to that question at this point in time, but I think the conflicting views at this point are clearly understood.

Again, thank you for coming.

COMMISSIONER HUNT: Chairman Brown, you mentioned that you see an erosion of confidence in auditors.

Some of the comments we have received from our proposal are to the effect that professional analysts don't necessarily use the audited statements anymore.

I think you mentioned this, but are using new technologies, audited statements or documents are using new methodologies to evaluate the work and prospective work of companies.

If that's the case, and I suppose it is, do you think that makes our concerns about auditor independence any less important?

MR. BROWN: Commissioner Hunt, no, I don't.

As I said, I think that the reasons for the erosion of confidence are complex.

I clearly think one of the reasons relates to the diminishing independence of the auditors, and I think that the approach of the analysts is quite different, depending on the type of company, whether it's a so-called new economy company or old economy company, whether historical financial statements give a better or not as good a picture.

So I think there are a number of reasons. But we have been told, and I believe just from my own observation, that the independence issue is very much part of that trend.

COMMISSIONER HUNT: You mentioned our work in IOSCO, and as you know better than I, until now we've been focused on adjusting and adapting a set of standards for cross border uses, but I agree with you that we ought to in IOSCO give some attention to these independence issues now, and I'm sure we will, under your brilliant leadership of the Technical Committee.

MR. BROWN: Thank you.

COMMISSIONER HUNT: Mr. Whitehead, this was mentioned in our earlier hearing, too, that the way to solve the problem is to do audit work for audit clients, and consulting work for your competitor'saudit clients and you well know that the answer or response of some of the firms is that doesn't allow us to do as good an audit as if we were doing the audit work and consulting work.

MR. WHITEHEAD: Yes, I think there is probably something to that view, but I think the disadvantages of a firm doing both are greater than the advantages that come, and I think that the disadvantages of the lack of familiarity with the details of the company's business systems should be no handicap to an auditor in doing his professional job.

I must say that I appreciate, if I were the auditing partner, the partner of a leading accounting firm responsible for relationships with a company client for which I was doing the auditing work for, say, a million dollars, and doing $5 million of other services for that company, and there arose a disagreement between me and the chief financial officer about the treatment of some matter, accounting treatment of some matter in the company's business, I would be hard put to it, and I would feel some pressure to help my firm continue to maintain this relationship and keep those consulting contracts.

And that puts the auditor in a difficult position, and I'm sure every partner of everyaccounting firm that does both functions has felt the pressure of that decision.

I think it's better to remove the pressure, and as I tried to point out earlier, I don't believe an accounting firm necessarily loses business on a net basis as a result of this change.

They just do different kinds of businesses with different clients.

COMMISSIONER HUNT: I think we all have a perception that that kind of pressure is real and existing and growing, and obviously we have to find a way to solve it.

So thank you all for your opinion.

CHAIRMAN LEVITT: Commissioner Carey?

COMMISSIONER CAREY: Thank you, Mr. Chairman.

Commissioner Longstreth, I just want to say that if each of us up here had to defend each and every vote we've taken, I think we'd all find some stinkers.

COMMISSIONER UNGER: Speak for yourself.

COMMISSIONER CAREY: But I want to say we'll view your thoughts and your enlightened views on these matters in toto, but I want to thank you for your testimony.

I want to ask a question of Mr. Whitehead. Holman Jenkins is a columnist for the Wall Street Journal editorial page, which as a Democrat I don't often find myself agreeing with, but at the time of the PWC case he came out with the observation that if you have one firm with 8,100 violations, does that say more about the people or about the rules?

And I want to ask you, and I think there's much in this rule that addresses exactly that type of concern, but having run an organization as large and complex, with as many competing interests as Goldman Sachs, how do you -- as these firms get more and more complex and there are more intersections of interests, how do you address that?

MR. WHITEHEAD: Well, it's a good question and it would take a long answer, and I'm not sure I have it.

I'm glad I'm not running Goldman Sachs today, because it is much more complicated and much larger. It was easy in my day, and it's certainly not at all easy today, and with the steady stream of mergers of financial institutions, and of accounting firms, I think it's going to get more and more difficult.

I think it further argues for theimplementation of this kind of rule, that you have to give industries some guidelines, and I think that's the function of the SEC.

I think micromanagement of rules, and you have some rules that I would consider to be micromanagement, are not constructive and probably should be reviewed and maybe changed, but the guidelines of the principles behind these rules are the important things that will help accounting firms treat everybody, all the accounting firms equally, so that the competition within the industry will continue to remain and I think that's a healthy thing.

So I think the greater complexity of the industries now affect capital markets does make it more difficult, but that these, this kind of rule, these kinds of rules will be constructive in helping them run their firms more effectively.

COMMISSIONER CAREY: Thank you.

CHAIRMAN LEVITT: Commissioner Unger?

COMMISSIONER UNGER: Thank you, Mr. Chairman.

I wanted to follow up briefly on what Mr. Whitehead and Commissioner Hunt were talking about in terms of the synergies of the business between the auditing and nonauditing or consulting services.

Thinking about what you've said and that business will just move to another firm, and you will just pick up the other auditing clients, but I have a feeling it's just not so simple, because if that were the case, then why would the accounting firms be concerned about this loss or potential shift in business, not a loss in business.

Don't you think there's something more to it in the so-called maybe marketing of providing these services to your clients, in that there's a greater efficiency of the firm providing you with these consulting services, we already know a lot about you because we perform the audit, therefore it's just another step in our relationship and we can do it cheaper or more efficiently than competitors X, Y and Z and could the industry be concerned in fact if there is a prohibition on consulting and auditing being provided by the same firm, that there will be a whole new industry that springs up that is not an accounting firm, that has nothing to do with the auditing functions of that particular client, and that that's the real competitive issue, not that it will go to another firm and that they'll all share the auditing clients of each other in terms of providing consulting businesses, but that there will be a whole new sectorof the business that grows up in the economy.

MR. WHITEHEAD: That whole new industry already exists in a variety of forms.

Consulting services on these issues are available from a lot more than the accounting industry itself already and the accounting industry in effect is competing with the management consulting industry, with investment banking who are supplying now a variety of consulting services, so there's loads of competition, but I think my point would be that if an accounting firm really performs excellent services, better than others, that it need not fear losing some business as a result of the new regulations, because it will be able to take on more than it loses.

And I think this will be upsetting because it will be a period of transition in which they will be meeting new clients for their consulting services, and losing old clients for their consulting services and there will be a shuffling of personnel and management within each of these organizations which of course is disruptive, but when it's all over, some firms will come out better and some firms will come out worse, but the net result on the industry will not be negative.

COMMISSIONER UNGER: But they will have tocompete more on the strength of the services as opposed to the synergies achieved by providing both services.

MR. WHITEHEAD: I find it very dangerous that an accounting firm would be arguing that because we are your auditor, you really ought to do this advisory stuff with us and not with McKinsey. I don't think that's happening very much.

COMMISSIONER UNGER: But then what is the competitive issue, then? Why aren't people going to McKinsey more than they are to their own auditor?

MR. WHITEHEAD: They each have their own sales organizations and they each perform somewhat different functions. It would be a complex question.

COMMISSIONER UNGER: Very diplomatic answer.

MR. LONGSTRETH: Could I try, just add one footnote to this discussion.

Your numbers in the release are impressive. You mentioned the 75 percent.

In other words, 75 percent of the audit clients do not use their auditor for any services that are not related to the audit, and yet over the past six or seven years, the growth rate among the Big Five for nonaudit services is 26 percent, far exceeding the growth rate in audit services.

So the business, I mean, there is a business there and it's growing very rapidly, and it has nothing to do with the audit client.

COMMISSIONER UNGER: The other question I wanted to ask, and I think probably all of you are able to answer it, is the, improving the audit committee's role, strengthening the audit committee's role.

Is this conflict something that the audit committee could do more about?

MR. WHITEHEAD: Yes, I think this is a subject that the audit committee can certainly do something about, but I think the audit committee, too, is likely to welcome this change.

The company will have to find other purveyors of these advisory services, if that's the part of the business that the auditing firm decides to give up, or they will have to find other auditors, but I think the auditing committee is certainly concerned about the appearance, or possible appearance of a conflict of interest.

I'd like to make a comment, if I may, on outsourcing of internal auditing functions, which I heard discussed in your earlier panel.

I've always believed that internal auditingis the function of management.

It's not the function of some kind of separate thing; that management should be responsible for managing, for auditing its functions internally.

It's a legitimate function of management, but the internal auditing staff and the internal auditor should be made to feel by the audit committee and the Board that if he uncovers something which seems to be a serious problem, that he then is expected to report to the board of directors through the audit committee, through the chairman of the audit committee immediately, and not feel bound to only report to the chief financial officer.

So that there is, the Board has a function here in the audit committee, in insuring the integrity of the internal auditing process, but I think the management should pick and choose the people that are on their staff and not rely on an outside firm.

COMMISSIONER UNGER: Thank you.

COMMISSIONER HUNT: I have a follow-up question to you, Mr. Whitehead.

Given your experience on audit committees for many corporations -- I'm sorry, did you want to say something?

COMMISSIONER UNGER: My question was for Mr.Whitehead. I didn't mean for the rest of you to --

MR. BROWN: I was just going to add a brief point to Commissioner Unger's question.

I've been told by the chair of one of our major multinational corporations that it's the loneliest job in the world, and I think it takes a very strong, confident personality as the chair of the audit committee, to be able to understand and if necessary push back on some of the relationships that have grown up between the auditors or the accounting firm and management of the company.

So I believe that there is a stronger role for the audit committee to perform, and the recommendations of the Blue Ribbon Panel that have now been adopted at in the U.S. and that we're looking at in Canada will give them added strength and hopefully added confidence, but I don't think that we can stop there and ask the audit committee to solve this problem by themselves.

I do think that we need a regulatory solution.

MR. LONGSTRETH: Can I add two points to that?

I'm the chair of an audit committee of a large public company, and I've tried, I've thoughthard about the independence issue of necessity because of the panel's work and I've tried to talk to the auditor, have the committee talk to the auditors about independence.

It's extremely difficult for an audit committee to challenge the independence of the auditor.

You end up, basically, it's a challenge of the integrity of the auditor, and that's a very uncomfortable thing to be talking about, but the -- so that's point one.

It's not realistic to say, are you sure you're independent? How do we know you're independent?

That's a very difficult dialogue to contemplate.

The next point I'd like to make --

COMMISSIONER UNGER: That's the dialogue we're having.

MR. LONGSTRETH: The audit committee is essentially blind to this question and has to rely on the auditor itself to explore the question, and you cannot expect the auditor to determine its own independence.

So there is, I think it would be, while Iagree there's been an enormous shift, cultural shift, very positive one as a result of John's Blue Ribbon Committee recommendations, it simply is not enough to assure that the job can be done, in my view, for those two reasons, and the others that have just been set out.

COMMISSIONER UNGER: Thank you.

CHAIRMAN LEVITT: Thank you very much for a superb presentation.

We have fallen somewhat behind schedule, so I would ask succeeding witnesses and my fellow Commissioners to be concise in our questioning and concise in the presentation and to try to stay on target.

Panel 3 (Morning)

The next panel is reflective of what I believe is a very subtle but important change that is taking place as a result of this debate and a result of this dialogue, and that is that some of the best companies in America are thinking more about this issue than they ever have before, and some of the best audit committees are beginning to focus on this.

We have two witnesses, I've spoken to the chief executive officers that each of them represent, but in their own right, Gary Pfeiffer and Judy Lewent are among the most distinguished financial people inAmerica today.

Gary Pfeiffer represents E.I. DuPont. He joined the company in 1974, he holds a Bachelor of Arts degree in political science, an MBA from William and Mary in Virginia.

And Judy Lewent is chief financial officer of Merck, responsible for financial and corporate development functions.

Prior to that, she was vice president and CFO responsible for financial functions of the Merck Foundation.

We are honored to have your companies represented by two of the most distinguished financial officers in America today.

Gary, could you be the lead off?

MR. PFEIFFER: Thank you, sir.

I appreciate the opportunity to share my views as the CFO of DuPont on this important issue.

In the brief introductory remarks, I'd like to make three points.

First is we are in agreement with the intent of the proposal to reinforce the integrity of financial reporting by insuring the independence of external auditors.

Second, we agree fully that both the realityand the appearance of independence are very important parts of the proposal's intent, and that we believe independence in this area is best regulated with a rigorous oversight process by audit committees operating from a principle-based set of guidelines.

Before I expand on these three points, let me acknowledge up front that we are a firm that in 1999 requested and received substantial nonaudit services from our independent accountant.

Shortly I'll cover how we did so and maintained both the reality and appearance of independence.

Let me describe how these nonaudit services came about. I think that may be instructive in the application of the guidelines.

Several years ago, DuPont outsourced the administration of our employee benefit plans to both employees and pensioners to Coopers & Lybrand.

Subsequently, PriceWaterhouse, our independent auditor, merged with Coopers & Lybrand and suddenly the number or amount of nonaudit services performed by our external auditor doubled on that merger because of Cooper's work that they had done before the merger.

The second piece is that in 1998 to 1999,DuPont had some very substantial mergers and acquisitions and divestitures in our portfolio of businesses totalling more than $40 billion during that period.

We turned to our external auditors during this time for audit and attestation services and due diligence work.

We turned to them because they knew our businesses, they knew our values and we could count on their professionalism and their objectivity.

With this background, let me go back to where I started. The integrity of financial statements is extremely important to DuPont.

We at DuPont are both a preparer of financial statements and a user of financial statements.

Our life is clearly significantly easier when our investors and our prospective lenders have a high credibility in the integrity of our financial statements, but our life is also significantly easier if we can have the same credibility in the integrity of the financial statements to the customers to whom we extend billions of dollars in trade credit terms and in the statements of the companies in which our $18 billion pension fund invests. Confidence of theindependence of the external auditor helps build independence and integrity.

At DuPont, we strive for the appearance and the reality of independence of the auditor and that depends on our boards and our committees operating within the context of the Blue Ribbon panel. The audit committee sets the policy and the parameters for independence.

I, as chief financial officer, am accountable to execute within those policies and parameters as is our independent auditor, and the audit committee is then accountable to make sure that we both do our job.

The process that we use internally is supported by regular reviews of the audit committee, written reports on audit and nonaudit services, routine meetings between the audit committee and management without the independent auditor and routine meetings between the audit committee and the independent auditor without management.

All parties within this process take independence very, very seriously.

Within this control process, we are in full agreement of the four governing principles that the Commission is proposing.

We would recommend that the complexity of today's business world suggests that those four principles might be of better use as guidelines for audit committees and management and independent auditors rather than rules.

Pragmatism and materiality we would suggest need to be considerations in the audit committee's decision to insure the reality and appearance of decisions are maintained without compromising quality and effectiveness.

Let me give you a few examples from DuPont's perspective. First, we believe that internal audit work and external audit work are something of a continuum.

Where the exact line is drawn between the risk models of the independent auditor and the internal audit group is best set, we believe, by the audit committee annually as they review the scope of the important work of both those organizations.

Second, we believe it is appropriate and useful and effective to engage external auditors to insure that appropriate financial controls are embedded in information systems as those systems are developed by others, whether they be developed by company personnel or other consultants.

We would suggest that the audit committee can best determine how the independent auditor can best do that maintaining their independence and their separateness from the development of the system.

Third, we believe that using external auditors in financial due diligence in mergers and acquisitions is an effective assistant to management and the Board and is a service to shareholders.

We have found that in these engagements the professionalism and the objectivity that our external auditors bring support their role as advocate for shareholders and the Board.

Finally, we agree that shareholders should be made aware and need to know about the audit and nonaudit fees an independent auditor is paid by the company.

We have voluntarily disclosed these amounts since 1992. We would suggest the proposed exposure rule in its level of materiality would be overlong for a company like ours and could disclose some competitively sensitive information.

We would suggest a reasonable materiality test would be appropriate.

Let me close my remarks by stating we fully support the intent of the proposed rules.

Independence in reality and in appearance is very important to us both as a preparer of and a user of financial statements and financial reporting, and we believe that the four principles are excellent.

It would be most excellently used by the audit committees in its guidance in their rigorous oversight to insure the intent and purpose of full and complete independence of external auditors.

Thank you very much.

CHAIRMAN LEVITT: Ms. Lewent.

MS. LEWENT: Good morning. I do appreciate the Commission's offering Merck the opportunity to participate in these hearings on auditor independence.

My comments will primarily describe Merck's approach towards our auditors which is designed with a view to maintain an independent perspective while evaluating our financial statements. I will focus primarily on the principles and practices associated with the use of nonaudit services provided by our audit firm.

The approach which Merck developed more than twenty years ago, discourages the use of nonaudit services by our audit firm, but preserves the flexibility to use those services in the limited instances where the use of such services is clearlywarranted.

In general, the auditor's role is to act as a third-party provider of assurance on the overall prior presentation of a company's financial statements.

Clearly, it is necessary for the auditors to be independent.

Their unbiased guardianship helps assure the financial statement and provides solid footing for investor statements.

It is critical for the management and the public to have full faith in the integrity of those statements.

The perception of auditor independence is vitally important to that faith and is an important element of a sound financial reporting framework and efficient capital markets.

We are all aware of the difficulties in ascertaining whether certain auditor activities such as providing nonaudit services to audit clients, has in fact impaired auditor's objectivity and fairness in performing audits.

The answer is unclear in light of the vast number of particular circumstances in which the question can be considered.

There may be circumstances, however, where there is increased risk that independence could become impaired.

Even more likely, an outsider could perceive particular situations as impairing an auditor's independence.

We therefore manage the auditor/client relationship based on a set of principles and practices designed to minimize this risk.

A number of elements comprise a solid framework of independence. Some are exercised solely by the audit firm and others by client management.

Audit firms, for example, regularly participate in self-evaluation and peer review programs in which an auditor's work is scrutinized by other auditors inside and outside the firm.

Through some programs an audit firm can see shortcomings in its processes including adherence to independence and other professional standards.

At Merck, specific practices have been put in place over the years to reinforce our auditor independence.

First, consistent with common practice, the outside auditor has full access to the audit committee or the board of directors.

Second, Merck has established a practice of rotating its lead auditor every five years, two years before the AICPA practice rules would require.

It is also customary for us, for the partner to not have served on the Merck audit and in other capacities when assuming the role of the lead partner.

We believe these practices strike an appropriate balance between continuity and objectivity.

Third, based on a belief that our auditors should not provide nonaudit services except in limited circumstances, a rigorous evaluation process determines when to engage the external auditor for nonaudit services.

The standard for selecting our audit firm for nonaudit services is based on our auditors demonstrating superior expertise when compared to another provider and providing that service at a competitive cost.

The audit committee of Merck's board of directors must then approve each such request to use our outside audit firm for nonaudit services.

If the proposed services could impact the audit committee's view of auditor independence then it is obligated to deny this request for services relatedto the audit function, but outside the scope of the audit such as due diligence services or compliance audits, approval by our corporate controller is required.

To date, this process has resulted in the use of our audit firm for nonaudit services only in limited circumstances, and all of these processes have not been a burden to Merck in terms of fees or quality of results.

Management judgment is a key element of this approach.

Let me share an example of where we have used our auditors for nonaudit services.

Merck will occasionally engage the expertise of our auditors Arthur Andersen to support a compliance audit that is the responsibility of our internal audit function.

While our internal audit function is viewed as an important management responsibility, there are circumstances where it is appropriate to supplement their work with resources from our auditors.

For example, in Brazil, Korea, Japan and some other locations, we have used Arthur Andersen auditors with relevant language skills to support Merck auditors charged with completing the audit.

The framework Merck has in place to help preserve the fact and appearance of auditor independence is appropriate for our company and has not affected the quality of audit service we expect and have received from our audit firm.

Over the years of service, as our auditor, we have depended heavily on Arthur Andersen's competence, integrity and advice to insure that Merck prepares and presents high quality financial statements.

We will continue to rely on high quality audit professionals to provide that assurance in the years ahead and would favor a regulatory environment which serves to continually strengthen the expertise of the audit profession.

We believe the approach towards auditor independence that Merck developed many years ago with its focus on audit partner rotation and very limited use of nonaudit services is effective in addressing potential issues of independence.

Clear principles and a practice of evaluating each use of nonaudit services against a rigorous standard are the underpinnings of our management in this issue.

We have concerns about the potential resultsof a process which would substitute a detailed set of rules and regulations for Merck management and audit committee oversight.

Again, thank you for the opportunity to address the Commission.

CHAIRMAN LEVITT: I'd like to thank both of you, and observe that your CEOs and the audit committees are among the most noble and constructive in America and are representative of the kinds of companies that really care about the public interest.

In that connection, I'd like to ask both of you the question as to the argument made against this proposal that perceptions really don't count very much.

Certainly, your CEOs and the actions of your audit committees would suggest they have a different view of that, but I'd like to hear from you what you believe the attitudes of your CEOs and audit committees are with respect to perception in this arena.

MS. LEWENT: I think others before us made some excellent comments.

I guess I would only add that across the board, I know how DuPont feels as well as Merck that one's reputation is sacrosanct and your actions haveto make sure that perceptions are supported by reality, so that any violation of any, any potential jeopardy, you put that knowledge of the credibility of, let's say, independence in this case, is not worth, is really not worth the risk, and it's very hard to repair those perceptions once they develop, so we feel that taking these kinds of procedures and putting them in place, allows us to eliminate any potential risk that a perception might exist in that regard.

CHAIRMAN LEVITT: And you do think it appropriate for the Commission to address this issue of perception?

MS. LEWENT: I absolutely do.

MR. PFEIFFER: I would just add, Mr. Chairman, that in this area, I would agree with Judy that perception is reality in this area, because what we're talking about is the sense of integrity in the field, that they have when they read the statements.

CHAIRMAN LEVITT: What do you think the impact of the Commission's rule proposal will be upon the work of your audit committees?

Do you believe this will reinforce a practice that apparently has been in place for some time and may spread it to other audit committees thatperhaps have not focused on these issues?

MR. PFEIFFER: I think that the intent of the rule and the four principles will certainly reinforce the work and strengthen the framework within which our office exercises its accounting work.

As I mentioned in my remarks, I think using those principles as guidelines for the audit committee's pragmatic judgments will support their work.

I do have some concern about them having imposed upon them the administration of a very detailed set of rules.

CHAIRMAN LEVITT: Ms. Lewent?

MS. LEWENT: I guess I really don't have very much to add to what Gary said, except that we really do practice policies that are, I would say, quite representative of the rules that you're proposing.

I think that would only serve to reinforce what the committee practices are, and I guess our only concern is about the complexity that some of the specifics might present.

CHAIRMAN LEVITT: Commissioner Hunt?

COMMISSIONER HUNT: Thank you both for appearing before us.

Mr. Pfeiffer, do I understand from your remarks that you think the present rule is too detailed?

MR. PFEIFFER: Yes, sir, I do. I think the complexity of business models that large companies operate in around the world and across dozens and dozens of different businesses and industries is best measured and metered by guidelines and principles that audit committees who are independent of management, and rigorous management process, I think I've described this morning and Judy has tried to describe, are the best way to do that.

COMMISSIONER HUNT: Do you agree with that?

MS. LEWENT: I would add a perspective on the complexity and detail of rules, you've often appreciated when any of us attempt to lay out and anticipate any eventuality, it's a daunting thing.

That's one concern.

The other thing is we do live in a fast-changing environment. So I think not just the situation we live in today, but having something that is evergreen in reality, I think is a reality.

CHAIRMAN LEVITT: Commissioner Carey?

COMMISSIONER CAREY: I'd like to ask a question that was raised in your testimony.

How does Merck determine whether the nonauditor services are unavailable from another provider?

MS. LEWENT: I always put things out for competitive bid, so we would never take just a proposal from our own audit firm in any instance.

COMMISSIONER CAREY: So is it driven by price, is that what you're saying?

MS. LEWENT: What I'm saying is it's a combination.

Clearly you have to look at both aspects of stewardship, so we have to take cost into consideration, but the primary driver would be quality of service.

Some have particular superior capability, and it's really that standard that our own audit firm would have to demonstrate clearly superior capability to another competitor to cross that hurdle to have us engage them.

COMMISSIONER CAREY: All those lines, how can it be determined that nonauditor services are materially more cost effective if provided by the auditor?

And couldn't cost effective nonaudit services still impair independence?

MS. LEWENT: Could you just elaborate on the question, just so I appreciate --

COMMISSIONER CAREY: Isn't it possible that cost effective nonaudit services still pose a threat to independence?

MS. LEWENT: I guess what I was trying to say in my comments, that cost was one element, but clearly, our standard is basically we will not use our audit firm for nonaudit services until both expertise and cost come into play or demonstrate clear superiority, so I think it's pretty high standards.

So this is not a cost-driven exercise.

COMMISSIONER CAREY: That's what I was trying to get at.

Thank you very much.

CHAIRMAN LEVITT: Commissioner Unger?

COMMISSIONER UNGER: You set that question up for me perfectly, because I wanted to ask, how many times in making that determination do you end up using the auditor?

MS. LEWENT: Rare would be a fair word to use. Very rare.

COMMISSIONER UNGER: How would you qualify rare?

MS. LEWENT: Now you get into definitionissues.

COMMISSIONER UNGER: Percentage-wise.

MS. LEWENT: Well, by that I meant in terms of definition, just being clear, if I sweep up say due diligence services, in other words, taking the broadest definition of nonaudit services, so again, not even talking about issues like information systems and things like that, but just the broadest definition, our use would run under 10 percent.

COMMISSIONER UNGER: And what percentage would that be, then, of the total revenue or outgoing revenue to the firm's --

COMMISSIONER HUNT: Expenditure.

COMMISSIONER UNGER: -- expenditure, thank you.

So 10 percent would be nonaudit services and what percentage of the money you pay, I guess, to accountants or to the firm would that represent?

MS. LEWENT: Oh, I'm sorry. We don't usually get into the specific numbers, but just at sort of competitive levels, I'm just saying that of the total fees we pay to Andersen, basically less than 10 percent of those go for nonaudit, any kind of nonaudit service.

COMMISSIONER UNGER: Oh, thank you. I thinkit sounded, and I apologize, I missed most of your testimony, but it sounds like you have in place very effective measures to determine the independence of the auditors, yet you still think that the SEC should put into place specific rules.

Why is that?

MS. LEWENT: I guess some of the spirit of at least my comments were that we have been well served by some guiding principles, and that it's that we support you in terms of the mission and intent of what the SEC is about here.

The concerns we raised would be the implementation of those principles and the choice between having those guiding principles and allowing management and the audit committee to execute on those within those parameters versus having sort of a very detailed list to operate from.

CHAIRMAN LEVITT: I gather you would support the notion that the ultimate proposal taking cognizance of a number of commentators who were concerned with the complexity of some of the guiding principles, for instance, and their breadth, if they were narrowed and simplified, as the process of rule-making and the reason for these hearings would suggest, that you would be supportive of such afocused approach?

MS. LEWENT: I think that's very much in the spirit of the comments.

For example, I'd also reference the Blue Ribbon committee that was discussed earlier as a good model for that, because that really was a very positive process and gave audit committees a lot of guiding principles to operate under and I think it's been very effective.

CHAIRMAN LEVITT: And the ultimate finding of that panel was the result of very focused rule making by the Commission, which I would expect would be a process similar to one to be employed by this Commission.

COMMISSIONER UNGER: Thank you very much.

CHAIRMAN LEVITT: Thank you very much, both of you.

Panel 4 (Morning)

The next panel includes Kayla Gillan, general counsel of the California Public Employees' Retirement System, Alan P. Cleveland, legal counsel to the New Hampshire Retirement System, and Ralph Whitworth, managing member of the Relational Investors, a private investment manager specializing in strategic block investment in publicly traded U.S. companies.

Ms. Gillan?

MS. GILLAN: Thank you. I am honored to be here today, to represent the views of the California Public Employees' Retirement System, also known by the acronym CalPERS.

CalPERS is the largest public retirement system in the United States with assets exceeding over $175 billion, and while this asset size may be somewhat impressive, I may never leave California without mentioning the purpose of this money, and that is to secure the retirement of the over 1.2 million people who depend on our system to pay the retirement and the disability, both for themselves and for their families and its need to protect the financial security of our members and their families that brings us here today.

First let me clearly state for the record that CalPERS is not in the accounting industry and we profess no expertise in that field.

CalPERS is, however, one of the largest and most significant and sophisticated investors in the financial markets both within and without the U.S.

Although we are also a significant large customer of accounting and consulting services in our own operation, I come to you today to reflect ourinvestor role and our key interest in the integrity of the markets in which we participate.

It is for this reason CalPERS applauds the efforts of your Commission, Chairman Levitt, in your bringing this complex issue to public awareness.

We are aware of the high visibility as well as the high number of comments that the hearings have produced, and CalPERS appreciates the opportunity to provide its perspective.

I have read much public testimony submitted thus far and I will not duplicate what others have had to say, so for the sake of time I would just like to leave three points for you today.

The first, this rule-making effort is necessary. It seems universally accepted that an independent audit committee is an essential feature of a fully accountable corporate governance structure.

This Commission's most recent work regarding audit committee independence and disclosure has cemented this principle.

It's also well accepted that an independent audit is necessary for the committee to perform its function and we're here today because there is such a vast difference of opinion among providers, users and ultimate beneficiaries of the audit as to whatindependence means.

Recognizing the increasing complexity of the accounting business model, it's CalPERS' view that well-defined standards, principles and rules must be adopted, and while we support the work of the Independence Standards Board only, this Commission has the authority and the effective ability to weigh the competing public interests that are represented in this area and reach conclusions about the best way to protect shareholders and the integrity of the financial markets.

We know that some have suggested this rule-making is not necessary because of a lack of empirical data precisely linking each of the independence issues identified in the proposal to some financial harm to the company or its investors.

A decade ago, this was also said about much of what has been well accepted by this time in the corporate governance arena.

The concept that an auditor who has a greater financial incentive to please management than to criticize it will tend to find ways to avoid negative comment is intuitive and obvious.

I can offer some anecdotal evidence.

As part of CalPERS' own investmentoperations through our corporate governance program, we annually identify those few select companies that are the poorest performers within our over 1,500 U.S. companies and we use screens that look for the conveyance of poor performance with regard to stock performance, economic value added, and corporate governance practices.

At least during the past two years when CalPERS ourselves have been focussing on audit standards and auditor independence in each of these companies that we've identified as having the biggest problems with regard to performance, they've also had problems with regard to the quality of their financial statements and a seemingly meek auditor.

This is not proof that the poor performance was the result of the nonindependent auditors, but it certainly feeds into the investment community's concern about this issue.

It's not only the reality of biased auditing, but also the perception that a biased practice is possible that erodes investor confidence.

The second point.

The SEC should look to but not be limited by the ISB independence standards.

We've noted some testimony before youalready that the ISP standards in some respects provide even greater independence in areas of employment with audit clients and financial and family relationships, and we would urge you to look at those and seek to include them in your own proposal.

Third, the SEC should consider simplifying its proposal and drawing a bright line test. No nonaudit services to an audit client.

And in this comment, we join with the statement that you previously received from Mr. John Biggs, chairman and chief executive officer of TIAA-CREFF.

The nature of prescriptive lists such as those included in the current proposal is to invite the creative to find ways of escape.

As an attorney, much of what I do and my colleagues do every day is to find ways not to be covered by legal restrictions.

We in the bar have trained to do this and we do it quite well.

The current proposal I fear would benefit the attorney community through increased fees but at the cost of investor confidence.

A clear, simple and bright line standard will avoid this tendency, and moreover I have notheard anyone suggest that there is some absence of qualified and cost effective alternatives to the auditor performing nonaudit consulting services to the same client.

Thank you for your attention in allowing CalPERS to be before you today and we will be submitting written comment and I'll be happy to answer questions.

CHAIRMAN LEVITT: Thank you very much, Ms. Gillan.

I would note that you took the red eye to be with us this morning, and we are deeply, deeply appreciative.

CalPERS has long stood for doing what's right for individual investors. They've been a beacon in terms of leadership on difficult issues, and we take very seriously your interest and your commitment.

Alan Cleveland, on behalf of the New Hampshire Retirement System.

MR. CLEVELAND: Thank you, Commissioner.

The New Hampshire Retirement System is happy to be here. Ours is a retirement system on the east coast just under 500,000 in assets, 70 percent invested in domestic securities. However, those assets are absolutely critical, and what will fund thepension benefits of over 50,000 fire, police, teachers and public workers in the state of New Hampshire.

These monies are vitally important to us.

Ours, as most funds, is a trustee plan in that it is governed by future principal.

Often we hear comments about institutional investors. It sounds very antiseptic and one has a vision of high-rise buildings and blank facades.

In point of fact, these should probably be more accurately described as fiduciary investors, because approximately 55 percent heads up today of public securities are invested by public pension funds in this country.

These are fiduciary governed funds, and for that reason auditor independence is especially important.

The promise of the pension benefits of these funds very much depends on the integrity, transparency and accountability of the publicly traded companies in which our members are invested.

The trustees of pension funds have an undivided fiduciary duty to their beneficiaries.

They must act solely in the interests of the beneficiaries of these funds in the investment of trust assets, so again the trustees of approximately55 percent of these publicly, as holders of these publicly traded companies are fiduciarily governed and invest as fiduciaries under precepts of loyalty.

For that reason, they are particularly sensitive to the independence and loyalty of the auditors in which those companies invest.

Like the fiduciaries, we have a duty to the lenders and shareholders of the company i.e., the fiduciary lenders of the governance. This undivided fidelity to the investor can only be satisfied if the auditors are independent of company management.

We regard the concurrent performance by the company's external auditor of nonauditor services at the direction and under the control of management to be inherently corrosive and fundamentally incompatible with the duty of independence and fidelity owed by the auditor to the investing public.

We find unpersuasive the proposition that consulting and other nonaudit services provided by the auditor will not impair his or her independence.

To accept that proposition asks the investing public and particularly the fiduciaries of public pension funds and private pension funds to suspend just plain common sense and the lessons of life experience to enable the accounting firms topursue additional business opportunities in connection with the engagement.

For the trustees of pension funds to describe their duties of loyalty and prudence in holding the stock and debt of publicly traded companies, the auditors of those companies are necessarily relied upon to discharge their duties of fidelity and independence to the investing public.

Again, we fully concur in a prophylactic rule of strict independence as proposed by the Commission.

The appearance issue, okay, much has been discussed about appearances. It simply misses the point to argue as some do in opposition to the proposed rule that there is no empirical evidence proving a demonstrable loss of auditor independence in providing management consulting and other nonaudit services.

Independence, of course, is essentially a state of mind.

Trustees of pension funds are very familiar with the notion of independence. They are keenly sensitive to the notion of duty of undivided loyalty to their beneficiaries and they expect no less from the external auditors of the companies in which theyinvest.

Appearance counts a great deal in matters of trust. Not fidelity alone, but the appearance of independence is necessary for the relationship. The burden of preserving the implicitness of that trust falls wholly on the fiduciary. Any competing relationship that reasonably casts a shadow over the auditor's independence and felicity to the investing public is per se improper.

Stated simply, an auditor to be truly independent needs to be a person whose audit engagement constitutes his only connection to the company.

Again, another issue that has been touched upon often this morning is the auditing committee.

We will submit that it is impossible in the real world for an audit committee to impose a standard of independence with respect to the company's auditors if in point of fact the Commission is unable to affirm this rule of independence.

The auditing committee is properly charged to control the external independent auditor.

However, if that auditor or auditing firm in point of fact looks to management for the bulk of their fees and services, there's no means by which theauditing committee could control that external auditor. It undermines corporate governance and external controls of the company to expect the audit committee to compete with management.

So again, in conclusion, the investing public and creditors will look first and foremost to the independent auditor process to gain the assurance and confidence in the reliability of financial statements as prerequisite in holding of securities.

We applaud and confirm and concur and hope that the Commission stands by and in fact finalizes its proposed rule of independent accountants.

Thank you very much.

CHAIRMAN LEVITT: Thank you very much.

Mr. Whitworth?

MR. WHITWORTH: Thank you, Chairman Levitt, and members of the Commission, for giving me the opportunity to testify before you.

I commend you for holding these hearings, and for the related proposed rule-making, the effort flows logically and necessarily from your earlier commendable work on audit committees, and your staff's work on the phenomenon of managed earnings.

I come to you today as a member of five public company boards beyond my role as managing member of relational investors. Four of those are New York Stock Exchange companies, one of which I am the chairman of the board.

I also chair an audit committee of one of those boards as well as chairing compensation committees and nominating committees. Hopefully I can bring some of that practical experience to bear here as well.

As others have, I will summarize my testimony and the body of it has been submitted to your staff to be included in the record.

It's been said before, but I think it's worth restating, that auditor independence goes to the very essence of our capital markets, and it's linked inextricably to the efficiencies of our capitalist system.

I absolutely believe after having traveled some of the world and spent the last fifteen years in corporate America that we do have the very best system in the world of financial reporting.

It's not the envy of the world, though, as many other features of our system are.

In fact, there are many companies that I've spoken to their officers that say gee, we would just love to be listed in America and avail ourselves ofour capital markets, but we just can't swallow your audit requirements and your financial reporting requirements.

Well, I think that is very good and I'm very proud of our system for that, and I'm proud of you in your effort to maintain that integrity and the strength of our system, because I think it goes to our cost of capital and the vigor of our economy, so there's much broader, there's a very broad public interest at work here today.

We've heard a lot about perceptions, whether that's important or not. That's a very simple thing for me to conclude, because I go straight to the annual report, and I see that the auditor's letter in the annual report every year is titled, "Report of the independent auditor."

I also note that on the proxy statement of most companies every year, there's a line where they ask the shareholders to approve the independent auditors, so I think beyond that, it goes without saying that someone in corporate America believes that the perception of independence is important.

The problem is that both of those statements should have a giant asterisk next to them for many companies, because unbeknownst to the investors whoare reading them, there may be financial and economic interests between independent auditor and the company that may threaten that independence.

Now, I've long subscribed to Justice Brandeis' quote that sunlight is the best of disinfectants and that's generally been my approach as I have reviewed proposed rules from your body, but I think in this case that that just does not suffice.

I think both the fact and appearance of auditor independence is essential. And coming from a perspective where I have a strong bias towards unfettered markets, I think this is one area when balancing th