CHAIRMAN LEVITT: Good morning. I want to thank all of you for being here. Today is the third of four public hearings the Commission is holding on proposed rules to ensure greater independence of America's auditors.

These forums, I believe, are a crucial part of the open and comprehensive dialogue that is so important to our rule-making process. Only through such discussions can we craft meaningful and effective rules that serve the profession and this country's investors today as well as during the decades to come.

I look forward to hearing the important views and candid remarks of each of you testifying. I thank you for your participation here today. This is an issue, in my judgment, which has enormous meaning and impact for American investors.

Commissioner Hunt.

COMMISSIONER HUNT: Thank you, Mr. Chairman. Again, good morning, ladies and gentlemen. Thank all of you for taking time out of your busy schedules to be with us today.

As Chairman said, this is the third, I guess, of four days, three and a half days of public hearings we're going to have on this crucial issue. This issue has been around for a very, very long time.

There are strongly held views on both sides, sincerely held views on both sides. But like the Chairman, all of us, we look forward to hearing all of your valuable testimony. And again, thank you for coming.

Panel 1 (Morning)

CHAIRMAN LEVITT: The first panel features Senator Howard Metzenbaum, a man of enormous public spirit, enterprise, and energy who well represented the state of Ohio in the Senate for 19 years; Bill Patterson, the director of the AFL/CIO Office of Investment; and Frank Torres, the legislative counsel for the Washington office of the Consumers Union.

Senator Metzenbaum.

SEN. METZENBAUM: Thank you, Mr. Chairman. I appear before you today in my capacity as Chairman of the Consumer Federation of America, a non-profit consumer advocacy organization. I also have the privilege of speaking for two other consumer organizations, Consumer Action and Public Citizen, on whose board I also sit.

Our organizations, which together represent tens of millions of individual consumers, have a strong interest in investor protection issues related to auditor independence.

Our nation's current prosperity and future financial security are tied up as never before in our financial markets. For that reason, whether they know it or not, Americans are enormously dependent on independent auditors, both to the ensure the reliability of the information they use to make individual investment decisions and to ensure the efficiency of the marketplace in assigning value to stocks.

Stock prices are simply the response of buyers and sellers to information about public companies. Some of the most important information investors rely on is contained in companies' financial statements.

It is the auditors' job to ensure that these financial statements are prepared according to Generally Accepted Accounting Principles and therefore are reasonably reliable.

Day in and day out auditors must make decisions; in other words, to write off or capitalize a purchase, to depreciate over 5, 10 or 20 years, to write off or capitalize new program development, training programs, developmental efforts, and so much more.

The faith that the markets place in the pronouncement of auditors is founded on the auditors' independence. If auditors' independence is called into question, then the reliability of the financial statements of public companies is also called into question.

There's no doubt about it. Auditors today are less independent than they were just a decade ago. Having transformed themselves into multi-disciplinary professional service firms, the nation's biggest accounting firms now get more revenue from non-audit services than from their core business of auditing, and the disparity is growing rapidly.

Of particular concern for auditor independence is the recent and rapid increase in the marketing of non-audit services to audit clients. Can anyone reasonably argue that there isn't a conflict when an auditing firm is simultaneously trying to sell the audit client on a multi-million dollar consulting contract?

All the more so if the consulting contract stands to produce far greater profits for the company than the audit.

The fact that some auditors, perhaps even most, may not succumb to the pressure because of a commitment to professional independence, that's not the point. The point is that practices such as these raise serious questions about the independence of the audit. That is bad for investors, bad for the financial markets and bad for the reputation of the auditing profession.

Critics, including leaders within the accounting profession, have raised questions about the adequacy of existing independence standards for decades, particularly in light of the growing provision by auditors of non-audit services.

The Commission has studied the question for years. Chairman Levitt and his fellow Commissioners are to be congratulated for recognizing that the time has come to act.

The rule proposed is based on a simple and appropriate premise. Markets hate uncertainty, and the actual state of mind of the auditor can rarely, if ever, be known. In that context, the appearance, just the mere appearance -- good morning, Mr. Commissioner -- the appearance of a conflict of interest in an auditor can be as damaging as an actual conflict.

Therefore, practices that would seem to a reasonable, informed person to create a conflict of interest just are not acceptable. From there, the rule proposal offers four fundamental principles that govern determinations of independence. It then specifies a number of services an auditor might offer that would create an unacceptable conflict of interest if provided to an audit client.

In light of the degree to which the proposed rule simply codifies and brings clarity to existing Commission interpretations and to standards recognized by the industry, it may seem surprising that it is met with such violent opposition from some in the accounting profession, too many in the accounting profession, I might say.

This becomes less surprising, however, when you look at how dependent some of these firms have become on revenue from non-audit services. These opponents have built their case around four key arguments none of which holds water.

First, they claim auditors gain crucial knowledge about the firms they audit when they also serve those firms in other capacities. Armed with that knowledge, they are able to perform better audits.

While we agree that, in a perfect world, more detailed knowledge of an audit client should result in a better audit, this is far from a perfect world. In some instances, the auditor may ignore the conflict and produce a better, more informed audit. In other instances, the auditor may succumb to the conflict and compromise the quality of the audit. In every instance, the reliability of the audit will be subject to question by reason of the conflict.

Secondly, audit firms will be unable to attract to specialists in areas such as information technology if they aren't able to market consulting services to audit clients. Although it may not be as interesting and attractive as consulting, auditing is still a well respected, very well compensated profession.

It is therefore unlikely to suffer a dearth of talented experts any time soon. But even if you accept the questionable argument that the lure of consulting is necessary to attract the best experts, the proposed rule does nothing to prevent audit firms from attracting top talent.

After all, firms will still be free to offer those experts ample opportunities to use their skills in consulting for non-audit clients.

Third point, audit firms would be force to sell their consulting units. When they then rehire the same consultants to assist in the audit, they would have no control over their compliance with independence standards.

This argument starts with a false assumption --that the rule will force auditors to sell their consulting units -- and builds to a faulty conclusion. While a clean break between audit firms and consulting firms may be an attractive prospect, there is nothing in this rule proposal that would force that outcome.

In fact, though it has won them no thanks from the rule's opponents, the SEC has not proposed to simply ban auditors from providing non-audit services. The proposed rule fully preserves auditors' ability to provide non-audit services to non-audit clients. It even reserves the ability of auditors to provide audit clients with some non-audit services that the Commission believes would not unduly compromise auditor independence.

Having started from a phony premise -- that consulting units will have to be sold -- the opponents now attempt to throw scorn on the proposal by claiming that those firms will likely simply turn around and hire the same consultants as outside experts to assist them in the audit.

Only now, the argument goes, they won't have any control over the experts' independence. The result, they imply, is more questions about independence, not fewer.

This ignores the fact that the expert who is assisting in an audit of his or her own work or the firm's work for the audit client is hardly independent, regardless of whether he or she meets all other tests for independence.

It also assumes that auditors will have no ability to write conditions about independence into their contracts with outside experts.

Finally, it ignores the fundamental conflict that exists when a firm is simultaneously auditing a client and competing for a consulting contract from that client. Such a situation creates the very real danger that the client will pressure the auditor to lighten up in its scrutiny of the firm's accounting if it wants a shot at the potentially more profitable consulting contract.

When the bulk of the audit firm's revenues come from non-audit services, the pressure to go easy might not come just from the audit client.

Finally, and this is offered as the real clincher, opponents note that the SEC can offer no proof that an audit has ever been compromised by the provision of non-audit services to the audit client, and, therefore, the rule is unjustified.

As more than one person has noted, independence is a state of mind, and no one can see with absolute certainty into another person's mind. Therefore, unless the compromised auditor is careless enough to leave a paper trail or guilty enough to come forward with a confession, the SEC may never prove that a bad audit resulted from a lack of independence.

If absolute proof is missing, however, there are plenty of cases that raise questions in a reasonable observer's mind. Massive audit failures at Cendant and Sunbeam, Microstrategy and Waste Management, to name just a few of the most prominent recent examples, have all raised questions of whether consulting ties or incentive compensation for cross-selling consulting services may have compromised the audit.

Unless the practice of serving audit clients in due all capacities is checked, those questions will only grow. The rule is needed to eliminate this growing uncertainty about auditor reliability in the face of eroding independence.

As a parallel effort to defeat the rule, opponents have attempted to slow it down, hoping, presumably, for a more favorable political climate after the November elections. "What's the rush?" they ask. But a more compelling question is, why wait?

A problem has been identified. It has been carefully studied by the Commission and numerous outside experts. A measured and well thought out proposal has been put forward. Ample opportunity for comment and debate is being provided. It is time to act. Speaking for consumers across the country, we urge the Commission to move forward expeditiously with this important rule proposal.

I thank you, Mr. Chairman and I commend you,

Mr. Chairman, and the other members of the Commission for taking on this challenging issue at this point. I hope that you will see fit to move expeditiously and that there will be no delay.

And I, for one, say that if there is any effort in the congressional halls to put a stop or halt to your efforts between now and the end of the session, I know I and other consumer groups will be on the alert to see that such a provision not be inserted in any bills.

CHAIRMAN LEVITT: Thank you very much. Mr. Patterson.

MR. PATTERSON: Good morning, Commissioner Levitt -- I mean Commissioner Hunt, Chairman Levitt. My name is Bill Patterson. I am the director of the Office of Investment for the AFL/CIO, I want to address the impact this rule-making has on the huge amount of worker savings that are held either directly by pension funds or in 401(k) plans, stock plans.

Workers are beneficiaries of approximately 7 trillion in retirement assets through pension funds, 401(k)s, stock ownership plans. In total, these plans own approximately 25 percent of the equity of American corporations.

Members of AFL/CIO unions are the beneficiaries of over 2.5 trillion in assets subject to collective bargaining, including more than 400 billion in union-sponsored multi-employer pension plans.

While some plans are among the largest institutional investors in the country, most union-sponsored plans are much smaller, and, of course, many workers, both union members and non-union members are investors on their own behalf.

And it's on behalf of this huge amount of worker savings that I want to take up my comments. The AFL/CIO supports the proposed rules on auditor independence, and again I want to commend the work of Commissioner Hunt, Commissioner Carey and Arthur Levitt in bringing us this far in the process today on this issue.

In my comments, my initial comments, I want to join Howard Metzenbaum in focusing on one of the more controversial aspects, the prohibition of certain non-audit services to audit clients, since that's what's generating the most controversy.

The argument in favor of stricter rules limiting the provision of non-audit services to audit clients is clear and, to me, compelling. Unlike other functions for which a firm may turn to an outside provider, the audit also serves a public constituency.

Without the auditor, there would simply be no way for investors to know if the financial information provided by public corporations is trustworthy. This gatekeeper function keeps the auditor quite different from other providers of financial services.

The vast majority of audits I'm confident are carried out according to the highest and strictest professional standards, but the danger of an auditor placing a higher priority on maintaining a relationship with a client than on assuring the quality of the client's financial reporting is indeed a real one.

This danger is especially serious when the value of consulting and other services provided by the auditor exceeds, perhaps by a wide margin, the income a firm receives from the audit function itself.

A number of non-audit services provided under this proposal create clear conflicts with the audit function. If an auditor is providing valuation services to an audit client, for instance, this places it in the situation of having to critically assess and perhaps even challenge its own work.

Here I'd like to emphasize a point which has been made by a number of commentators, but I believe it bears repeating, and that is that the perception of auditor independence as well as the reality is what matters.

The strengths of the U.S. market rests more on any single factor on investor confidence. It is not enough that the auditors offer an objective assessment of the firm's financial statements. It must be absolutely beyond a doubt that their assessment is objective.

Now, we at the AFL/CIO have criticisms of the U.S. financial markets, but this is one area we are wholehearted defenders of those markets. It's the area of transparency and accountability.

And in terms of providing dependable information to investors, the U.S. is second to none, and it is an issue of equal concern, whether it's a small regionally based pension plan or to the large pension plans TIAA-CREF and CALPERS, all of these pivot around transparency and accountability.

Again, what matters is confidence or perceptions. The U.S. today is the beneficiary of an enormous in-flow of foreign capital, and this in-flow is of immense value to our economy. It is a reflection of the confidence foreign investors have in the integrity of the U.S. markets.

And to maintain this confidence to assure investors, U.S. and foreign, that the statements by which they make their decisions on can be trusted beyond a shadow of a doubt, this should be worth a good deal from the point of view of the broad public interest.

Much is made of the synergies between the audit function and the role of management consultant. However, it is unclear to us if any of these synergies are free from unacceptable conflicts which we are discussing today.

Additionally, I should also point out that the extent of these conflicts is not at all clear. The Big Five accounting firms are divided on how great a difficulty a ban on non-audit service would create for them as auditors. Two of them have already spun off their consulting firms, a clear judgment on the limited value of these synergies.

The former CEO of Deloitte & Touche has testified here recently and took a similarly skeptical view of the value to the audit of consulting and non-consulting audit services and has decided in favor of the new rule.

According to earlier testimony before this committee at least three-quarters of audit clients' purpose no other services from their auditors.

Now, this is a very competitive business, and if it is possible to run an auditing business without providing non-audit services to the same client -- and clearly it is --the benefits of combining audit and non-audit services simply cannot be that great; otherwise, why would we find any firm or any issues foregoing these benefits.

There are two issues I'd like to address next. First is the audit committee itself. Some opponents of the new rule suggest that while there may be, in some cases, a perception that auditors are not fully independent, this rule is not the way to address those perceptions.

Clearly, the only case where the auditor would come under pressure to overlook inappropriate or misleading fraudulent reporting would be the firm's own commitment to full and accurate disclosure where it was lacking.

So if something needs to be done, the argument goes, it is to strengthen the institutions within the firm that ensure the accurate reporting, particularly the audit committee itself, perhaps by requiring it be composed only of outside board members.

Now, I should make it clear that this proposal is unacceptable to our institution, the AFL/CIO. We have long been in favor of a larger and stronger role for independent directors and specifically suggested that only outsiders should sit on the audit committee. However, we don't think this should be a substitute for the current rule.

The argument's logic would suggest that there is no need for outside auditors in the first place, but there will always be companies, for whatever reason or at some point, do not wish -- they do not wish to issue accurate financial statements. And that is why we have auditors in the first place, as a second line of defense for investors.

Second, it would not address the perception issue.

CHAIRMAN LEVITT: Mr. Patterson, we're really running low on time. If I could ask you to submit your testimony and kind of wind up.

MR. PATTERSON: All right. Let me just conclude, then.

We believe that the proposed changes to the auditor independent rules by extending the range of financial business employment relationships are deemed to create conflicts of interest and will ensure auditors are genuinely independent, and we are fully in support of the rule-making here today.

CHAIRMAN LEVITT: Thank you very much. I'm very sorry to have to curtail that. But we have such a full schedule, and witnesses are waiting to testify.

Mr. Torres.

MR. TORRES: Good morning, Mr. Chairman, Commissioners. I'll try to be very succinct. On behalf of Consumers Union, thank you for the opportunity to appear before the Commission today. Of course, it is always an honor to be on a panel with the ultimate consumer advocate, Senator Metzenbaum, and we agree wholeheartedly with his testimony as well with the comments of Mr. Patterson.

Consumers Union supports your efforts to ensure that audits are the result of a credible and independent process. Technological advancements, a good economy and a host of other factors has spurred more consumers to put their money in financial markets than ever before.

Consumers who may have never thought about investing before are banking on Wall Street. While your proposal talks about protecting investors, in today's environment, what you're really talking about is protecting consumers.

Consumers have a variety of investment information sources at their disposal. The value of that information, however, is based, in part, on its reliability. A reliable audit can be a critical resource for both existing shareholders and potential investors to use in making rational decisions about where to put their hard-earned money.

The increasing amount of non-audit consulting work undertaken by audit firms raises concerns, especially where the audit and consulting work are done for the same company. Conflicts of interest, either real or perceived could lead to the appearance of impropriety and erode consumers' trust not only in the audit process but, perhaps more critically, consumers' confidence in the financial markets themselves.

It is crucial that there be no doubt as to the motivations of the firm preparing the audit. Consumers assume that an independent audit is just that, independent. Consumers shouldn't have to worry that the outcome of an audit was influenced by the relationship between the audit firm and the company being audited.

If consumers have reason to question the voracity of the information contained in an audit, the audit itself may be of little more real value than information from an unknown or unreliable source from the internet.

And if the audit firm ends up in the position of auditing its own work, it is difficult to see how this is any different than allowing the company to audit itself.

And there is another cause for concern. To the extent that audits are used by bank examiners and other regulators for purposes of determining the safety and soundness of the banking system, the credibility of those audits takes on increased significance.

Consumers Union shares the concerns raised by both the Comptroller of the Currency and Federal Reserve Board member Lawrence Meyers in his testimony just last week. Now, the Comptroller stated that an effective audit process is an essential component of risk management for the banking industry.

The audit is becoming more critical as banks expand into new products, services and technologies. Most importantly, he noted, is that the audit contributes to safe and sound banking operations. Because these institutions are taxpayer-backed, it is ultimately the American consumer, the taxpayer, who would wind up paying for any missteps here. The audit takes on a huge significance in this regard.

Consumers Union appreciates this opportunity to comment on the Commission's proposal to take steps to ensure that actions that compromise independence are curtailed. As Senator Metzenbaum has said, why wait?

Consumers Union will work with the Consumer Federation of America and other consumer groups in strongly opposing any congressional action to stall the Commission's efforts in this area. Thank you.

CHAIRMAN LEVITT: Thank you very much. Commissioner Hunt.

COMMISSIONER HUNT: Again, I want to thank all of you for being with us this morning. Senator, I think you well summarized the arguments for and against our proposed rule. We may make some modifications.

I'm not sure we will necessarily, but I deeply, personally deeply appreciate the testimony of all three of you and look forward to working with you as we go forward to craft a useful and beneficial rule for investors. So thank you for appearing.

CHAIRMAN LEVITT: Commissioner Carey.

COMMISSIONER CAREY: Mr. Patterson, it could be said that you represent more investors than any witness who has appeared before us. I just wanted to ask if you feel that the rule as proposed is something that would inure to the benefit of the AFL's investors, their ability to have confidence in the investment decisions made by the portfolio managers you hire.

MR. PATTERSON: We strongly believe that this is the appropriate way to address the potential conflicts of interest of audit committees. What anchors our support here is, as we've seen, several companies, Cendant and Sunbeam, engage in widespread auditor reform, and many portfolios of our pension funds have suffered because of this.

So we believe this is a very concrete exercise and believe this is a very important measure that directly benefits the pension fund savings of employees as well as the individual savings of workers.

COMMISSIONER CAREY: I'd love to ask you about Social Security privatization, but that will have to wait for another day. Senator Metzenbaum, let me say that the Senate has not been the same since you left the chamber.

I want to ask you, as a policy maker and a lawmaker,do you think that sound policy can be made on the basis of qualitative evidence, which is mostly what exists here, and not any empirical evidence or what our opponents have called the smoking gun?

SEN. METZENBAUM: I think it can be very well argued and persuasively on the basis of qualitative evidence. I think, as a matter of fact, it's almost self-evident in this particular case that there is an obvious conflict that exists.

And unfortunately, the conflict weighs heavily against independence rather than in favor of independence. So I would just say that I think the members of the Commission, each of you, in his or her own right, is entitled to really a tremendous vote of confidence, besides a vote of thanks for moving in this direction.

To me, it's just amazing that the issue has not been taken up publicly previously, whether by the SEC or some other body had spoken out against it, governmental body or otherwise. It's just so wrong on its face that it's reassuring that government -- people say government doesn't work, but, in this instance, I think government is working and working very well for the American consumer, for the American people.

COMMISSIONER CAREY: Well, I thank you for that, particularly because it's my belief that the American consumer has no greater champion than you.

COMMISSIONER CAREY: Thank you very much.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: I apologize for missing some of the testimony. However, I did have a chance to read it. So I guess I would start by asking Senator Metzenbaum do you have a sense from your constituents, the investors, that they are focused on the issue of auditor independence and that they sense that there's a problem or systemic issue with respect --

SEN. METZENBAUM: I'm not sure I got that question. COMMISSIONER UNGER: Well, I wasn't done with it. Which part?

SEN. METZENBAUM: Well, you asked if I had a problem, and I'm frank to admit I don't think I have the world's greatest hearing.

COMMISSIONER UNGER: Okay. Alright, well, I'll talk more directly into the microphone.

SEN. METZENBAUM: Thank you.

COMMISSIONER UNGER: What I'm asking is whether you have a sense from your membership, your constituents, not your old constituents but your new ones, about whether people are having, perhaps, a lack of faith in the financial statements of public companies? Whether there's a sense that they understand what we're talking about today?

SEN. METZENBAUM: Not overall. There isn't a general pervasive attitude of a lack of faith that they're not getting straight answers, but every so often something comes on the horizon that causes the investor and American consumer to say, "Hey, what goes here?" And it is those instances that cause a deep hurt.

Now, with a market such as we experienced in recent years, that doesn't become as much of an irritant. It doesn't become as much of a problem because they're isolated instances.

But let there be a big problem in the market, and then let some of these instances come about, and I think you'd have a large cry, "Hey, where has the SEC been? Where has the government been? Why hasn't something been done?"

And that's the reason I think it's so much to your credit that the SEC is contemplating acting on this issue before that kind of scandal develops, because there's no question about it that there have been some scandalous situations. I mentioned some of the corporations in my testimony.

But I think the confidence is still there, but it's an upbeat market. Let that market fall rather rapidly, and then let's find some defalcations with respect to the accounting procedures, and I think that you'd find really sort of a revolutionary attitude on the part of the American people.

COMMISSIONER UNGER: Mr. Torres, how about you?

MR. TORRES: I would have to agree with what Senator Metzenbaum has said. I think American consumers, from my experience, don't like the idea that they might get had, and they're investing -- a lot of people are relying on their own resourcefulness to find out information.

And the thought is -- one example in somebody else's testimony was it's like allowing high school seniors to grade their own college board exams and use that as a determination as to whether or not they get into good colleges or not, and would we have faith and confidence in them that they would do the right thing.

And I think, probably -- you know, that's one of the better analogies I've heard as far as this process goes. So while there might not be the smoking gun, there are some examples of this issue, kind of, creeping up, and if we want to encourage consumers to invest more and have some independent, reliable piece of information that they can use, then we need to keep the process independent.

COMMISSIONER UNGER: I did like the analogy of grading your own exams. However, I think that maybe that analogy goes a little too far because I'm not sure that investors really look at the financial statements themselves. It's more of what impact does it have on the companies of the marketplace and how that information is absorbed into the marketplace generally, which goes to my question to you, Mr. Patterson.

What is it that you look at in terms of what your investment decisions on behalf of the AFL/CIO, and what do you see in terms of the financial statements, if anything?

MR. PATTERSON: The auditor statements are part of what our fund professionals routinely review to make investment decisions. The integrity of these statements are very important.

Now, the individual investor, I think their interest in the process is really catalyzed again around these high-profile irregularities like Cendant, Sunbeam, Lucent and Waste Management. I think these are warning shots to investors that this is a problem that has to be addressed. So I would agree with my co-panelists here that we're looking at -- we think this is a very important measure to take in the event of the market not going just sideways but maybe even a downturn.

COMMISSIONER UNGER: And you think it's an overall confidence in the marketplace, or is this specific confidence in a company's financial statement?

MR. PATTERSON: I don't think you can separate them. I think that these are an important measure of investor confidence. The integrity of these statements are integral to just the overall confidence that investors, particularly small investors, place in the marketplace.

COMMISSIONER UNGER: Thank you.

CHAIRMAN LEVITT: I thank all of you for your testimony. I think if there is a common theme that I've heard it's that the consumer interest in this issue is something of great importance, and that while consumers may not be intimately involved in complex financial analysis they have taken for granted one of the most precious elements of our markets and the element that gives the greatest amount of confidence to America's markets, and that is the sanctity of the numbers.

And while there are not consumers outside the Commission clamoring for independence of auditors, believe me, when we have an instance of a Cendant or a Sunbeam or any of those or if there is any compromise of the audit, the sense of despair and the sense of disillusionment might have an impact that goes far beyond the immediacy of the issue.

I greatly appreciate your appearance today.

Panel 2 (Morning)

The next witness I'm really pleased to welcome to the Commission this morning is Richard Blumenthal, the 23rd Attorney General of the State of Connecticut. He was first elected in 1990, re-elected in 1994, and then re-elected to an unprecedented third term in 1998.

I think of all the attorney generals throughout the United States none has been more fearless, more effective and a more tireless advocate for consumers, the environment, children and the civil rights of Connecticut's children.

And it's a great honor for us to welcome you here this morning.

MR. BLUMENTHAL: Thank you, Mr. Chairman, and members of the Commission. I very much appreciate that, I'm afraid, somewhat overly excessively generous introduction, but I will take it and repeat it. I do thank you for that introduction and also for the opportunity to be with you today on an issue of supreme importance to the consumers of my state and the entire nation.

And I want to thank you, Mr. Chairman, for your courage and leadership and other members of the Commission in tackling an issue that is enormously complex, difficult to explain to the general public but profoundly significant, particularly at this point in our history.

And with your permission, Mr. Chairman, I'm going to very briefly summarize the points I have to make in the interest of time rather than reading my testimony.

For all the reasons that have been stated this morning already and that have been set forth to you in the two days of hearings that you've had so far and the speeches that have been given by you, Mr. Chairman, and other statements made by members of the Commission,the independencee of this auditing function is tremendously important and really ought to be guaranteed in good times. As Senator Metzenbaum said, we need to fix the roof while the sun is shining.

We will not find a great human cry. There will be no clamoring when the stock market returns are as good as they are now among the general public because of the complexity of this kind of function.

But I think that the general public does have now a confidence and a reason for confidence that they do take for granted, and we have seen in Connecticut instances of that confidence being betrayed.

I provided details in my testimony of one instance in particular involving Arthur Andersen and its involvement in the Colonial Realty investments where Arthur Andersen Consulting was performing various non-auditing functions for this investment group involved in preparing and assembling real estate designs and plans, even involved in helping to brief sales representatives for Colonial Realty, who then aided in recruiting investors, going with those sales representatives as members of the auditing team; in other words, performing even at that time, which was back in the 1990s various non-auditing functions at the same time as Arthur Andersen auditors were giving their seal of approval to the numbers that other Arthur Andersen employees had been involved in helping to prepare.

The net result of these 18 syndications and most particularly of the Constitution Plaza investments was that thousands of Connecticut investors lost their life savings, and these were not people who could afford to lose those savings. They counted on them for their retirements, for their children's college education.

They were blue collar people from Waterbury and the Hartford area who literally sacrificed their life savings as a result, and the result, of course, was investigation by my office and the Board of Accountancy, eventually the payment of a $3.5 million fine which was very, very large for Connecticut and for those days, and he repayment of $2.5 million in the fees that had been paid to Arthur Andersen.

There were criminal prosecutions. There were civil lawsuits, but the investors were never made whole. They never got back in full the savings that they had invested.

So I offer that as an instance of how the current system is inadequate to deal with this problem, but I think it also goes to the question that you asked, Commissioner Carey, of the smoking gun.

How do we know there's a problem? How do we deal with the point that inevitably is made by the other side that there has been no proven need for this change in rules?

And the problem is that when the need is proven very often the examples are so egregious that the opponents of this rule change can say, "Well, there are other laws to deal with it."

Because the problem of enforcement, as you well know as members of this Commission, that wrongdoing has to be detected. It has to be proved, and in this kind of area the evidence is very, very difficult to adduce.

And so very often what we have is simply the position of the audit management partner compromised because he or she becomes a marketer for the firm, and there may never be a judgment call that can be termed absolutely wrong or egregious but nonetheless goes over the line and is compromised as a result of that person being an advocate and a seller for the firm.

I hope that other AGs, other attorneys general across the country would join in this effort. I've spoken to a number of them. They're very interested. I think that like the public in general the complex and difficult nature of the subject matter may be an obstacle to overcome in enlisting broader support, but I am hopeful that a number of them will join this cause.

And from the standpoint of process, as I listened to questions that were posed to Senator Metzenbaum, I think this Commission is the place to do these rules. It shouldn't be Congress. This Commission has the expertise,the experience, the accountability to provide the kind of guidance that traditionally it has done.

And so I hope there will be no movement in Congress to in any way impede or impair your effort, but I would certainly add my voice to Senator Metzenbaum's and hope to mobilize other public sentiment in the event that there is.

CHAIRMAN LEVITT: Thank you very much. That story about Colonial Realty in which we had some involvement, and as a Connecticut resident I am aware of that as instructive as to what's at stake in the Commission's proposal.

You mention that Colonial paid its auditor $2.5 million for its audit and consulting work. Do you recall, by any chance, how much of that sum was for consulting and how much was for auditing?

MR. BLUMENTHAL: I do recall that a major share, I think, in fact, in the range of one half of the amount -- but I can verify that figure for you -- was for consulting rather than auditing.

CHAIRMAN LEVITT: When your office looked into Colonial, did you learn about pressure that consulting fees generated on employees to provide a favorable audit?

MR. BLUMENTHAL: The consulting fees became a source of very substantial pressure. Of course, there were also gifts to the auditors. There were family relationships that compromised the independence of Arthur Andersen in that instance, but the prospect of the business became a very important factor.

The effort of Arthur Andersen to broaden and increase its involvement with Colonial Realty, its potential future involvement drove a lot of its involvement with Colonial Realty.

CHAIRMAN LEVITT: Would you be able to submit your report on that case to the public comment file for our rule-making?

MR. BLUMENTHAL: Absolutely. I'd be delighted. I brought a copy of the executive summary, but I will have a full copy sent right away.

CHAIRMAN LEVITT: That would be great. I think we would be interested in hearing from other attorneys general about their views on this subject.

Commissioner Hunt.

COMMISSIONER HUNT: Thank you, Mr. Chairman. I want to join the Chairman in thanking you, Mr. Blumenthal, for testifying. I think that your idea of getting other attorneys general to testify or to contribute to these hearings is a very useful idea. I hope we can somehow arrange that.

Unfortunately, you're not the only one who has had a Colonial Realty in your state, so the experience of other attorneys general might be very useful. And I, like the Chairman, I would be very interested in seeing the file of your investigation of that matter.

I don't think we need to wait for a smoking gun in order to move in this difficult area, but I think it's useful to have evidence on our side to show that it has occurred and so we're not -- though we don't have a smoking gun we're not blowing smoke. So thank you very much.

CHAIRMAN LEVITT: Commissioner Carey.

COMMISSIONER CAREY: I want to join my colleagues and thank you for coming to Washington and for providing such a compelling illustration of why steps to ensure auditor independence are necessary. And I would also encourage you to spread the word among your fellow attorneys general to act in the manner you have today.

MR. BLUMENTHAL: Thank you.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: Well, I join my colleagues in their compliments. I find your testimony very interesting. And I guess you surpass the Chairman in longevity in terms of number of terms served. Arthur has one to go.

My question is I guess in the overall case, and I don't think we want to spend a lot of time talking about the specifics, especially if you're going to give us a report, but one thing I've been curious in all of this, is is it one or two particular things that are so obvious in terms of the compromises to the audits by the relationship of the audit and consulting work done by the same firm and individuals, or is it just very subtle because there are so many issues involved in an audit that require discretion?

And, a little bit of discretion in favor of the client can go a long way, and cumulatively, perhaps, that's really where the compromise comes in, or is it just a couple of really stark examples?

MR. BLUMENTHAL: Well, I have to confess, first of all, I make no claim of expertise in this area. As I once told a court of appeals, I'm just a country lawyer from Connecticut. But I think what's most troubling is the shift in the balance of the kind of work done from, I think it was, 37 percent of the work in 1977 was auditing work by these firms now to only 30 percent. And by the same token, the rate of growth in auditing fees, I think it's 9 percent a year since 1993; whereas, the consulting work has been 23 percent in terms of year-by-year growth.

So I think to put it in sort of common sense terms, the dog and the tail have become out of proportion. The tail is now the auditing work. The dog is more and more the consulting work, and so there is more pressure on the auditor, even the best intentioned auditor, to use that discretion, tremendous discretion.

COMMISSIONER UNGER: But what about when you considerer that 80 percent of the firms revenues are coming from non-audit clients, that, in fact, they're really only providing consulting services to 20 percent of the clients that they also audit?

And when you look at the fact that they're getting 70 percent, some, of their revenues from consulting you say, "Oh, my gosh. That's unreal," but then, when you say, well, "it's only 20 percent of their auditing clients," then I don't know where the rest of it is coming from, I guess non-audit clients, but then you have to, sort of, step back and wonder specifically what is the issue in terms of the compromising.

And I do believe that there is an inherent conflict in the relationship, but I'm just wondering how it manifests itself in terms of the financial statements.

MR. BLUMENTHAL: Well, I think that's a very good point and a legitimate one, but I would answer it this way: Having been in a firm, in a law firm, and having talked to some of my friends and having some exposure to the world of accounting I don't think those dollars are any less attractive simply because they're 20 percent of the total revenue.

I think those clients that represent 20 percent of the income of an accounting firm are every bit as precious and important as the other dollars and particularly the auditing partners who are involved in those accounts.

Their careers, their lives, are on the line. And their position has to be seen in terms of their everyday judgments, the pressures on them to cross market, the mergers and acquisitions, the pension services, the other kind of work and what are the informal or less visible kinds of pressures that come into play.

I was trying to do a better job of the analogy of the grader of the exams. And I think the analogy really is that the person taking the exam is paying the teacher grading the exam to prepare that person specifically for the exam.

COMMISSIONER UNGER: I thought maybe to pay them to grade the exam.

MR. BLUMENTHAL: Well that's even better. But I do think that that number is an important one the 80/20, but in terms of the outlook I think the work is still important.

COMMISSIONER UNGER: Thank you very much.

CHAIRMAN LEVITT: Thank you. When I think of public service, I can think of no better example of someone who has given his life to the public interest not just for your own advancement but for causes that are so valuable to our society. We're honored by your presence. We're honored by your interest in this issue. On behalf of consumers and on behalf of the Commission, I want to thank you.

MR. BLUMENTHAL: I'm deeply grateful for those comments, particularly from someone like yourself who has devoted so much of your life to public service and other members of this Commission who are doing such a great job here. And I hope that this cause is one that I can help you to advance. Thank you very much.

CHAIRMAN LEVITT: Thank you.

Panel 3 (Morning)

The next panel is William D. Travis, the Managing Partner of McGladrey & Pullen; and Wayne Kolins, National Director of Assurance, BDO Seidman. Mr. Kolins.

MR. KOLINS: Good morning. Thank you for giving my firm the opportunity to testify in this very important matter. My name is Wayne Kolins. I'm national director of assurance for BDO Seidman.

Our business consists overwhelmingly of assurance and tax services, and our clients are mainly middle market companies. I will focus my remarks on a few of the concerns which will be contained in our comment letter. These include the disproportionately adverse impact of the proposed rules on middle market and smaller accounting firms and the provision of tax services by auditors.

Before I explain these concerns I want to express my firm's support of your efforts to maintain and enhance the focus on the public interest by all participants in the financial reporting process.

We also support the Commission's effort to modernize the investment and employment relationship rules and encourage you to move forward with that aspect of the proposed rules in concert with the ISB.

We recommend, however, that the Commission bifurcate the rule proposal and let the ISB adopt a conceptual framework that provides more clear guidance than do the proposed four principles.

The four principles would adversely affect middle market and smaller firms and their audit clients because those clients generally have less in-house expertise and are thus more likely to turn to their outside auditors for advice.

However, those auditors may be unwilling to provide this advice, even on issues such as the application of complex accounting standards, that would raise questions about whether they're auditing their own work or serving as an employee of or advocate for the client.

If firms like ours can't provide that type of advice, our clients may do without the advice or turn to other more costly consultants, if any are available. In these cases, the company and its shareholders would be adversely affected.

The proposed definition of affiliate of an accounting firm would also have a disproportionately adverse impact on firms like ours because it's imprecise an appears to capture more relationships than we believe the Commission intends to cover.

For example, some accounting firms like BDO have strategic alliances with other autonomous accounting firms that are intended to provide the alliance members with access to accounting, tax, audit methodology and training expertise. These alliances enhance audit quality and benefit the shareholders of the alliance firms' clients as well as the firms themselves.

It appears, however, that an accounting firm that's a member of an alliance, and perhaps certain of its partners and employees, would have to be independent of the public clients of the other members of the alliance, even if the accounting firm has no control over those other members.

Requiring BDO and its other alliance members to monitor the relationships and investments of each other would be extremely complex, expensive and time-consuming, assuming that we could monitor them at all.

The alliance members don't control each other, and, therefore, we may have significant problems obtaining the necessary information.

Also, any terminations of strategic alliances resulting from the adoption of the proposed definition could trigger severe contractual penalties along with other costs. This should be considered by the Commission in its cost-benefit analysis of the proposed rules.

As an alternative to the proposed definition we recommend that the Commission consider using a control test. This would enable accounting firms to comply with the independence rules and still enter into appropriate and necessary strategic relationships.

On a positive note, we strongly support the exclusion of tax related services from the list of prohibited non-audit services. Smaller companies particularly need to be able to obtain tax related services from their outside auditors because they often lack the internal expertise to handle sophisticated tax issues.

We're concerned, however, that certain statements in the release and the four principles themselves may suggest that certain tax services adversely affect independence.

For example, the release states that the Commission's decision to exclude tax services from the list of prohibited services was based only on its evaluation of traditional tax return preparation.

The advocacy and auditing your own work principles also cast doubt on the acceptability of certain types of tax services. In contrast to one of the four principles, tax ethics standards actually require service providers to play an advocacy role.

However, this duty is counterbalanced in the ethics standards by a duty to the tax system itself. These standards and established enforcement mechanisms provide the needed protection for shareholders.

To avoid potential confusion, we recommend that the Commission revise the rule proposal to specifically permit the provision of tax related services. Without this clarification public clients may believe that they must retain a new tax service provider, increasing their costs of necessary services, to the detriment of shareholders, and precluding them from receiving the services from the best informed practitioner.

Now I'd like to turn to the recently adopted audit committee rules. These initiatives have great potential to strengthen this critical element of the financial reporting system.

We commend the Commission for its leadership role in this process. Because of its enhanced role, the audit committee is in the best position to consider all the facts relating to possible independence issues, including the existence of effective safeguards.

The urge the Commission to allow these multi-faceted initiatives to realize their full impact before adopting rules relating to non-audit services.

Throughout BDO's history we have emphasized integrity, trust, professionalism and independence.These values are an integral part of our culture. Like the Commission, BDO is dedicated to serving the public interest.

In that regard, we are committed to working with all the participants in the financial reporting process to strengthen the ethical fabric of our markets. Thank you.

CHAIRMAN LEVITT: Thank you very much. Mr. Travis.

MR. TRAVIS: Thank you. I've been a member of the public accounting profession for 25 years. McGladrey & Pullen is a firm -- one of the eight largest firms in the U.S. We're focused on mid-sized and emerging growth companies.

We appreciate the opportunity to provide testimony on the proposal, and we're supportive of the undertaking to modernize the independence ruse. We also appreciate the efforts of the SEC on this and other very important initiatives this past year.

There are many positive elements of the proposal; for example, establishing broad guidelines to provide a foundation for and simplified understanding of independence and also addressing the overly-burdensome restrictions on investment employment relationships.

Let me take a couple minutes and just highlight some items from our written testimony to save on time. Item No., working together. I'm very proud to be a CPA. It's a profession known for technical competency, personal integrity and objectivity, and I do know that the SEC and the profession have a mutual commitment to excellence and the public interest.

However, I believe there has been way too much negativity surrounding this debate from both sides which will ultimately lead to nothing more than wounded egos and hard feelings.

As a result, we suggest that the SEC and the profession work together with the ISB to address the input, identify the issues and to refine the proposal.

Item No. 2, the general standard. I'd like to talk about the definition of appearance. We certainly agree that appearance is an important element of independence along with the facts surrounding the issues.

We believe that the proposals should define who is capable of a fair and objective assessment of the appearance of independence. This requires both a reasonable understanding of the facts and the rules of independence.

We also believe that we need an organization with a balanced objective view to assess complex situations like the ISB. We also disagree with the advocacy principle. We believe mid-sized and emerging growth companies need and expect advocacy from their audit firm within reasonable bounds of professional integrity and objectivity.

These companies are faced with limited resource in terms of dollars and in terms of experience and expertise. They consistently rely on the input and counsel from their experienced and trusted audit and tax advisors.

We believe strongly that advocacy is acceptable and manageable within reasonable parameters.

Item No. 3, investments by the audit client in the audit firm. The proposed rule relates to direct investments by the audit client or its affiliates in the audit firm or its affiliates.

We suggest the rule include provisions to cure unintentional violations on a timely basis. For one thing, the auditor has limited ability to prevent and detect such violations by the client before they occur.

Second of all, it could lead -- the auditors could be faced with the extreme situation of a real or threatened intentional violation by a disgruntled client to pressure the auditor to do things they don't want to do.

We also suggest that the investment by audit client proposal consider materiality of these investments. We suggest you incorporate the concepts of ability to influence or control under this rule. It would be very difficult to cost-effectively identify and monitor immaterial investments since many are held in street names or investment funds.

Our logic is the potential influence on the auditor in the absence of control or significant influence is really no greater than the client pressure that results from outstanding audit fees or the threat to put an engagement out for bid.

Also, we strongly believe the audit committee process with improved communications and relationships between the audit firm and the audit committee should help for any attempts by management to unduly influence the audit firm.

Lastly, under investments by the audit client, we agree with the proposed rule which excludes audit client management and board members from the investment prohibition. We don't believe such investments by these individuals adversely impact auditor judgment nor create a mutuality of interest. The auditor certainly doesn't audit the value of those holdings. We recognize this is a change in the SEC's position, and we agree with this direction.

Number 4, scope of services. Obviously, a tough topic with strong views on both sides. We certainly understand the SEC's concerns and reasoning on this issue.

We believe the rule proposal needs to better consider the basic personal characteristics of the overwhelming majority of professionals who become auditors. They're involved in the profession for much more than financial gain. They have very high personal integrity. They take their professional responsibility to the public very seriously. And they would never sacrifice audit quality or their reputation.

We suggest that the scope of services proposal be given greater time for research and analysis, not to slow down, keep moving very quickly, but let's make sure we have all the facts before we make significant change.

I strongly believe the profession is willing to address problems supported by factual evidence and market demands. We also want to make sure -- consider the following: the potential magnitude of these rule changes on the public interest and on the profession is significant, particularly for mid-size and emerging growth companies.

We suggest you take the time to assess the impact of the audit committee changes which we fully support. We believe those changes should help in this area. In our view, let's move quickly, but let's get the data to do it right the first time.

We do disagree with certain prohibitions; for example, services that are oriented towards developing a system that management would approve and operate. Certain IT systems and HR systems are really done at the behest of management. They operate it. They approve it. It's their number. We believe this is significantly different than an actuarial number which the auditor would create.

We're concerned about the internal audit service prohibition. We agree certain of these services are a concern. However, the AICPA's ethics interpretation on extended audit and internal audit out sourcing seems quite clear, so we would like the proposal to be more specific on what components of internal audit out sourcing are a problem. We also disagree with any direction that would result or prevent the auditor from helping the client improve their business. As I said, emerging growth and mid-size companies need this help. In particular, tax services, as Wayne mentioned, are a critical issue.

As an aside, we trust that other regulatory organizations will carefully weigh the service restrictions proposed by the SEC on public companies before applying them to non-public companies.

Item 5 -- and I'll be done in a minute. Definition is unintentionally too broad and will include firms outside the audit firm's ability to control or significantly influence. This will add significant cost to tracking and monitoring independence compliance for no apparent benefit to the auditor -- or to the public. I'm sorry.

Thank you for allowing me to present our thoughts. I ask that you consider them in the spirit of the public comment process. I think we're all interested in the same thing, protecting the public interest and the health of the capital markets as well as the audit profession. Let's work together to address these issues. Thank you.

CHAIRMAN LEVITT: Thank you very much, Mr. Travis. I greatly appreciate the spirit that characterized your testimony, and I greatly appreciate your mention of the public interest.

The accountants of America are a superb and wonderful and honorable profession, and I think all the Commissioners feel that way. I wish that more emphasis had been placed upon the public interest, because the accountants that audit publicly owned companies have received a government franchise, and the public interest is a very important consideration. And your mention of that I find singularly important.

I think what you are asking for is reasonable in that it calls for balance, and I think that's the way the Commission intends to approach these proposals.

You talk very reasonably about a proposal about the investment of audit clients and their auditor. That is a complex issue, and I think we have to approach that with great circumspection. I think as this proposal develops your concern about providing tax services also will be taken note of.

And we, too, recognize that materiality is difficult to administer. I think if more of the leaders in the profession were willing to work as constructively as you we could avoid the negativity that I think both of us lament. I've done all that I can to engage in a dialogue with the profession. I've had constructive talks with some leaders in the industry like you, but others have rebuffed this, and I wonder how we can reduce that negativity and work more constructively.

MR. TRAVIS: Thank you. I think we just have to decide it's the answer that's important and that to work together in the public interest to assess all the facts, to assess the public interest, gaining all the intelligence we can and come up with good answers that, in the long term, will be for the good of the public interest, the profession and the Commission.

CHAIRMAN LEVITT: Mr. Kolins, your point about the four principles has been expressed to us before. I think all of us recognize the importance of those principles, and probably there would be very little argument about the philosophic background for those principles.

Do you think it might be useful as guidance if we remove them from the rule and modified them?

MR. KOLINS: Yes, I do. I think if we characterized -- the four principles were characterized as ideals or goals, something to aim for, something the people can get their arms around, I think that could serve a much more useful purpose rather than having it in a proposal which would then result in a service that is really good for the company, good for the shareholders somehow inadvertently tripping over that particular rule.

CHAIRMAN LEVITT: You mentioned concerns about the definition of "affiliate." Could you suggest ways that we could change the definition that would address your concerns but still protect against relationships that might tend to impair independence?

MR. KOLINS: Well, certainly one of control is one that we have suggested in our comment letter.

CHAIRMAN LEVITT: How would that work? How would that control test work?

MR. KOLINS: Well, control could be control the way "control" is defined under the accounting standards, the ability to control the operation of a particular company. It could be not necessarily ownership interest of a majority of the quo but ability to control the operations of the company would certainly be a threshold that would, obviously, in my view, come within that definition.

Whether there's an absolutely large economic interest that the accounting firm has in the other entity's ongoing activities, particularly with respect to the client that's being served, that could be another test.

CHAIRMAN LEVITT: Why don't you think that our rule would result in a reshuffling among the consulting practices of accounting firms?

MR. KOLINS: Well, the reshuffling argument is an interesting one, particularly when we're dealing with medium and smaller accounting firms.

If a medium-sized accounting firm had to give up an audit client, that medium-sized accounting firm may not necessarily be the beneficiary of a non-audit client of another accounting firm that had to give up its non-audit services because the client may be more apt to go to a more well-recognized name. So the reshuffling argument, I think, will not necessarily work out for the medium or smaller accounting firms.

CHAIRMAN LEVITT: Do you think that audit clients will move their business to non-accounting audit clients rather than to accountants who aren't their auditors? Is this because the opportunity for cross-selling by auditors would be lost?

MR. KOLINS: I think that they may go to other accounting firms but I think more well known accounting firms.

CHAIRMAN LEVITT: I might say to both of you that having started any number of small businesses and believing in the importance of medium and small businesses in terms of job creation in this country you're probably the most vital element of the whole universe of the accounting profession, and I am sincerely concerned about your well-being, your thinking, which is too easily lost in issues that appear to be of greater concern to the larger firms.

Commissioner Hunt.

COMMISSIONER HUNT: I want to thank both of you for appearing. I particularly appreciate the spirit of your testimony. It's a little different from the spirit of some testimony we've heard from members of the profession, in my judgment, in earlier sessions of these hearings.

I think your comments were thoughtful. Mr. Kolins, I appreciate your comments on the alliances and affiliates. I think that's something that we have to look at. I appreciate your thoughts on what the provision of tax services might do to small and medium-size clients and the necessity for the auditing firm perhaps providing those services to those size clients.

And Mr. Travis, again, I appreciate the spirit. I want you to know that we very much want to work with the profession. We are in this together. I personally -- I don't think any of us up here desire a hostile relationship with the profession.

This is a complicated issue. It has been with us a long time, and I hope we can move expeditiously but not too rapidly to fashion a satisfactory conclusion.

Let me ask both of you do you think that these proposed rules in their present form would negatively impact medium or small-size auditing firms more than large firms?

MR. KOLINS: Yes, I do. I think because of the nature of the clients that we deal with, as I mentioned, most of our clients look to us for advice, sophisticated tax advice, business advice, advice in terms of evaluating the competence of a prospective employee, which would seem to be precluded by the rules.

I think it's these types of clients that we deal with would have a tendency to run afoul of those elements of the rule.

CHAIRMAN LEVITT: Well, if that were addressed in some way, you'd be more comfortable with it, I gather.

MR. KOLINS: Yes.

MR. TRAVIS: I would echo Wayne's comments, and I would also add that I would be very concerned about the application of these rules to non-public companies because I believe the users of the financial statements are substantially different in their ability to have dialogue with the client about the financial statements and the issues surrounding the financial statements.

And to blindly apply these rules would cause medium and small-size CPA firms great concern because it is the relationship of trust and respect, and the competency of the auditor that drives the ability to help these companies grow and prosper.

CHAIRMAN LEVITT: Well, you don't think that there should necessarily be different standards for private companies, though, do you?

MR. TRAVIS: Well, there are today.

CHAIRMAN LEVITT: That's an interesting argument.

COMMISSIONER HUNT: I also think that your comments about -- frankly, I hadn't thought of this side of the audit client investing in the audit firm. I mean, I think we have been focusing on the members of the auditing firm investing in the client, or the client's securities and what kind of conflicts of interest that might create.

But I think that the other side of the coin is a valuable point you raise, and I thank you both for the spirit and the thoughtfulness of your comments this morning.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: I'm going to borrow Mr. Blumenthal's line and tell you, I'm just a country regulator, and I wonder if you could indulge me with some of the more practical aspects of your business and how it works.

For example, for each of you, what percentage of your revenue is from auditing, as opposed to consulting as we sit here today?

MR. KOLINS: For us, accounting and auditing is about half. If you include tax, it's about 85 percent accounting, auditing and tax services.

COMMISSIONER UNGER: Mr. Travis?

MR. TRAVIS: You can get the exact numbers from the AICPA annual report, but I would say our numbers are very close to that as well.

COMMISSIONER UNGER: So substantially most of your revenue is from auditing?

MR. TRAVIS: More importantly, substantial --

COMMISSIONER UNGER: And accounting.

MR. TRAVIS: More importantly, substantial chunks of our profit are from the audit practice. It's not a loss leader. Let's put it that way. It's a very profitable part of our business.

COMMISSIONER UNGER: Have you ever offered a loss leader -- I guess that's the official term -- but a sort of discounted audit fee in exchange for or in hopes of obtaining consulting business?

MR. TRAVIS: I think every time you propose on an engagement that involves competition, you try to package the service in accordance with the needs of the company that's looking for the proposal. Then you try to price the service according to those needs. So I don't believe we wholeheartedly go out and offer audit services for free. We don't go out and have audit sales. But we do look at the competition and what the market will bear in terms of pricing our services.

MR. KOLINS: To the extent that firms do do that, do low-ball a fee, I would love it if somehow -- and I know you have to deal with the FTC, probably, but somehow if the Commission could come up with a rule against low-balling and make it work -- I think Texas has something that's akin to that -- I think that would be helpful.

COMMISSIONER UNGER: Something that wouldn't resemble price fixing.

MR. KOLINS: Yes. Exactly. That's the problem.

COMMISSIONER UNGER: I was listening to the Chairman's question to you, and I think I didn't catch the whole question or answer. What percentage of your client base is public companies versus private companies?

MR. TRAVIS: I don't know the answer to that off the top of my head, but I'd say it's about 15 percent of our revenues.

COMMISSIONER UNGER: Private or public?

MR. TRAVIS: Public.

COMMISSIONER UNGER: Public.

MR. KOLINS: It's about the same for us.

COMMISSIONER UNGER: So do you think there are -- I guess, to follow on what the Chairman was talking about, do you think there are different incentives or conflicts inherent in a relationship with a client that is a public company?

MR. TRAVIS: Well, I think the public company independence rules are built around or trying to be built around the public interest. I think a private company has a different set of users in the financial statements.

And it's much like the rules on projections on forecast. If you have the ability to have a dialogue as a banker with a client about what's going on in those financials, I think it creates a different fact pattern than an investor in ABC Company on the New York Stock Exchange.

I have no ability to contact those folks and understand the details of the financial statements. I think that's different. Would I like to see a common set of rules? If we can get to a great answer for both sides, yes. But I think the facts of public versus private entities has to be considered in the debate.

COMMISSIONER UNGER: Mr. Kolins.

MR. KOLINS: I share those views. There is also an additional disincentive in the public arena, and that is the threat of litigation is just so much more. I think that's a countervailing influence in terms of maintaining independence.

COMMISSIONER UNGER: Well, if you have a mix of client base, though, the way you both do, is that confusing, or would that be confusing to have two different standards?

MR. KOLINS: Yes. The more standards you have that aim at the same goal the more confusing it is. There should be ultimately one set of standards.

MR. TRAVIS: I would respond to that by saying our independence and conflict of interest rules for the firm as a whole and the individuals in the firm are much more restrictive than either the AICPA standards or the SEC standards, so it doesn't create a problem for us.

COMMISSIONER UNGER: What was I going to ask you? I don't remember what I was going to follow-up on, so I'll have to get back to you on that. But the other question I had wanted to ask was when you do provide consulting services do you provide them to the same clients that you're auditing?

MR. TRAVIS: Again, I don't know the exact mix, but I would say that from what I know approximately 50 percent of our audit and tax client base are also buyers of consulting services. So 50 percent of the consulting revenues come from non-audit and tax client base.

COMMISSIONER UNGER: And how does it work personnel-wise? Do you use the same individuals who are --this is the synergy question. Do you use the same individuals on the audit that you use on the consulting work?

MR. TRAVIS: Depends on the engagement. The more sophisticated and complex the consulting engagement the more specialists you have to engage in the process.

So generally speaking, for complex IT engagements, complex HR engagements we would use specialists, as opposed to generalists or auditors for those services. The clients are becoming more and more interested in specialists to help them, as opposed to generalist information.

COMMISSIONER UNGER: And how much specialists do you have working at the firm?

MR. TRAVIS: I have no idea.

COMMISSIONER UNGER: Mr. Kolins?

MR. KOLINS: I'm not sure. It's probably a couple hundred, I would imagine.

COMMISSIONER UNGER: The same question with respect to providing --

MR. KOLINS: Yeah. The more technical the area becomes the more highly specialized people need to be, and that will only increase in the future. And there is a very close relationship, because the audit partners on the engagement team are working on an audit engagement because most of our consulting work is for non-audit clients.

But to the extent there is an audit engagement, the audit partner is very concerned that his client is being well served. So the audit partner knows what's going on on that consulting engagement, so there is a sharing of information.

COMMISSIONER UNGER: So the confidence that you were talking about, confidence and trust in your auditor, is it with respect -- maybe I should just ask it open-ended. What is the confidence and trust in, in the knowledge of your company or personal relationships?

MR. TRAVIS: Well, I think the entrepreneurial CEO owner is very discriminative on who they will listen to for advice, and the audit partner has to prove their worth in terms of value of integrity, value of business advice and value of professional competency.

COMMISSIONER UNGER: Well, when you put it in that context, my dad was an entrepreneur, so it's very rare for them to listen to anyone.

MR. TRAVIS: You said that.

COMMISSIONER UNGER: Speaking from my limited personal experience. And I did remember what it was I wanted to ask you before. That is, who are the users of the financial statements that you prepare for the private companies? Mostly sophisticated members of the industry.

MR. TRAVIS: Typically, the entrepreneur would have maybe a venture capitalist who is very sophisticated, a banker who is very sophisticated and their stockholder group. And that is really the audience that the financials go to. Occasionally, vendors and suppliers will ask for financial statements, but they, too, have the ability to have dialogue with the client about those financial statements.

COMMISSIONER UNGER: Is there anything you wanted to add?

MR. KOLINS: Same group.

COMMISSIONER UNGER: Okay. Thank you both. I very much appreciate that education.

MR. KOLINS: You're welcome.

MR. TRAVIS: Thank you very much.

MR. TURNER: You're in, kind of, a unique situation because McGladrey did sell part of its practice to H&R Block.

With respect to what you kept, is the tax advice now being given by the H&R Block side or by McGladrey's side, and did McGladrey retain and do you currently have an IT consulting practice, and, if so, what portion of your revenues are coming from the IT practice are going into the design and implementation systems?

MR. TRAVIS: The IT practice, Lynn, was part of what was sold to an affiliate of Block, so the consulting practice is owned in entirety by Block. You don't have the time to be bored by the complexities of the tax side of the agreement, but some of the tax side went to Block -- and the public accounting aspects side remain in the CPA firm partnership. I don't know the particulars. I can get you the information.

COMMISSIONER CAREY: That would be helpful. But the IT consulting prohibition that is in the proposed rule wouldn't affect you, then, because it is in the H&R Block side of the business.

MR. TRAVIS: Well, no. I think it would, because, as you know through our discussions, when we tried to set up this new structure we do view the two organizations together in terms of independence issues. So I think the answer is it would affect us, and we are interested in the outcome, we're trying to abide by the rules of the game as you and I define them.

CHAIRMAN LEVITT: Thank you very much.

Panel 4 (Morning)

The next panel is Wanda Lorenz, litigation support consultant for Lane Gorman Trubitt; and Howard Schilit, President of the Center for Financial Research & Analysis. Ms. Lorenz.

MS. LORENZ: Good morning, Chairman Levitt and the Commissioners. I am really honored to be here today and to be able to present my views.

I'm not going to read my testimony. I know you're running short on time, and there are some things I would like to emphasize. So with your permission, I'll just, kind of, jump right into the things I would like to emphasize.

As far as these proposed rules, which I do commend you all on, I believe it is a bold step you've taken, and it's a hard step for to you take. I understand that.

My comments go to one, the four basic principles. While I agree with them, I believe that they are overly broad right now. I serve on the rules and enforcement committees of the state board. And I usually look at something in terms of can it be interpreted so that there will be an enforcement process that's effective. You can apply it to the real world. I believe they need some tweaking in that area.

For example, the first principle, mutual or conflicting interest has a lot of rules behind it, including business relationships. It goes fairly far out. If somehow you could at least get in the general rule, take a look at those again. I believe mutual or conflicting interests, not all of them create an independence problem, and so perhaps things that would cause or have the appearance of causing an auditor to render an opinion or do work inconsistent with the matter they have found.

The second and third principle relate to when someone audits their own work. I think it relates to crossing over that line when you're truly acting equivalent to management. I don't believe that out on an audit, when we have to prepare journal entries for the client, or we sometimes have to help a client with footnotes on a new accounting principles, that that is going to circumscribe our integrity and independence.

And then the fourth principle, I share the views of my colleagues that in the advocacy area I think it should exclude the traditional type services that we've done for years and I think are a service to our clients, and I do not believe it impairs our independence.

Other concerns I have are some of the others have had, the definition of "affiliate." We also belong to peer groups that are totally autonomous firms. There's no cross-ownership or cross-control, but we do share ideas, and we have meetings and exchange literature, exchange a lot of different things, just a kind of a brainstorming session.

And I believe that pulling us into an affiliate process would be clearly unworkable and would hurt certainly smaller firms like ours.

I didn't preface it by saying our firm is local, single-office local firm in Dallas with 110 people, and that gives us a great advantage to be able to belong to alliances like that where we can, if our client needs someone in the UK or something, we can recommend someone and know about that firm.

There are a couple of areas where I believe it would impair, and that is if two firms get together and jointly perform an audit, then I would believe they would have to be independent at least with respect to that client. Or, as in the case of some of the affiliations who not only allow but even would like for you to present your report on the affiliation's letterhead, that would be a different story. But the rank and file alliances that are autonomous I think should not be pulled into that.

I also am concerned about the affiliation as it's applied to leasing of employees. I can see where that could be a problem in some instances, but a lot of us, with the shortage of professionals may lease or at least hire some employees on a temporary basis to help with audits during the busy season, and it would be -- I think create a large problem if you're getting someone from AccounTemps and the whole of AccounTemps has to be independent of your client base.

Certainly, those people you've hired have to be independent to the client base they're working on, but I don't believe the fact that they stay on the job for the duration of the audit is going to compromise the audit as long as they are, and I don't believe that the people that you're leasing them from has to have that same type of independence.

Another comment is that I would encourage you to look at the chain of command. I think it's overly broad when it tries to pull in any person who -- and I think the key word is "may" review or determine, or influence performance appraisal.

I think that people -- staff works for a lot of different managers and partners, and they may work on a lot of different jobs even in separate cities, and all of those people will probably do an evaluation and will probably deal with things that might tend to influence that person's salary, but I don't think even if Manager A talked to Manager B and said, "I didn't have a very good experience with that person on my job," I think that may make Manager B cautious about that person and supervise them more, but I don't see where it compromises the audit independence-wise, even though they are evaluating that person, effectively.

And then finally, my two favorite things, I guess, that really aren't in your rules but I believe that have brought us to where we are is that I believe that peer review, as it was envisioned, does not have the teeth it should have.

I think that we could deal with peer review in some way that it could be used better. The rules as they stand have us look at a lot of things at the peer review process but don't particularly allow the peer reviewers to look at things in a way that would superimpose their judgment over the other firm's judgment.

I can't believe that some of the things I've seen that have been talked about here today in the litigation process were not pulled in the peer review in those firms. If it had teeth -- and I'm not looking for it to have teeth -- to the extent that it's not remedial, I believe it could be remedial if it were designed to look at actually somewhat how the work was performed and look at the independence of the client and the auditor.

And we ought to be able to work through that process with a CPA firm before it gets to the level of the courts and the level of the SEC as far as enforcement.

And finally, I do believe it goes to the problems that exist today especially with respect to publicly-held companies related to fee negotiation.

From what I've seen of -- someone alluded to the pressures on the partners that had these audits. Certainly, there is that pressure, pressure on them to sell -- pressure on them to retain the client, pressure on them to build fees. I have seen the fee process negotiated down to where I looked at it and wondered why did that auditor take that risk for that low a fee for maybe a 60 percent realization over and over and over again.

Usually, it involves somewhere along the way, they are picking up additional services with that client, but we become like a shopkeeper in a bazaar. They will take a lower fee in a lot of instances in the hopes of being able to do more lucrative work.

As a whole, clients don't argue with you about doing consulting services. They're seen as value-added; whereas, the audits are not seen as value-added as the consulting services.

I would like -- probably what I've said is not particularly practical, but there could be some kind of a fund that the clients pay into and somebody totally independent looks at hiring the auditor so you put that fire wall between the auditor and client so you don't have -- I like whoever alluded to the fact that you would be paying the teacher to grade the report, so you could get away from that process.

Having said that I wished there would be a fund, I don't know how feasible that is, but I do know that we've been talking here today a lot about things like General Motors and Cendant, and things like that, the large clients. There are a lot of smaller SEC clients that not only does people like our firm do, and McGladrey, and the Big Five do them as well.

I don't agree with everyone that the audit committee rules will catch all that. We've had clients that -- we had a client filed with the American Stock Exchange whose audit committee consisted of one of the officers, the counsel for the company and a shareholder. That is definitely not independent, and if it were independent, it would still probably be influenced because that is a small client empowerment. It's the same kind of thing.

So I don't think that audit committee is a cure-all except in maybe the very big companies. We're dealing with people with new IPOs. We're dealing with people whose audit committees are not independent and who, even if they are, like I said, I don't think it would be effective.

We've got to look at some way to deal with that as well as the fee negotiation issue. The fee negotiation issue I think is the genesis of a lot of the problems we're seeing. It wouldn't be so important to everybody to go out and get the consulting work if we could make the same thing.

CHAIRMAN LEVITT: Thank you very much. Mr. Schilit.

MR. SCHILIT: Thank you. I am truly honored to have the opportunity to address the Commission today, and I applaud you, Mr. Chairman, for this initiative and just the work you've done over recent years with the new staff accounting bulletins last year. It has given our organization quite a bit of work.

There are three parts to my brief testimony. One, I want to tell a little bit about my background, both academic and professional, some observations of the problems, not just over the last year, but this issue of auditor independence over the last 25 years.

And I know Professor Briloff is going to be testifying tomorrow, and you could go back into the 1960s and read some of the warnings about the problem way back when the amount of fees from non-audit services was tiny.

And the third part of my testimony is a proposed solution which is much broader than simply creating new standards and rules for audit independence.

CHAIRMAN LEVITT: If you can accomplish all that in the time allotted to you.

MR. SCHILIT: I will try to do that in five minutes.

CHAIRMAN LEVITT: Okay.

MR. SCHILIT: Twenty years ago, while a doctoral student, I wrote a dissertation which was entitled, "An Empirical Study of Auditors' Independence," and I interviewed several hundred auditors.

And my conclusions sadly at that time were that auditors in general lacked familiarity with the then standards and norms of audit independence and, frankly, they were very vocal in their disagreement over any of those restrictions. That should have been a warning.

Over the next 15 years or so I embarked on an academic career and came very close to the SEC -- in fact, spending many days in the public reference room reading your enforcement releases, wonderful source of information, and it really moved me in such a way to begin going back and studying some of the major accounting debacles in the last generation or two.

And I began writing articles for academics and others, and, in '93, wrote a book which was entitled, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

And in the last seven years I have been working as an independent publisher of research for over 2,000 institutional investors -- again, warning them of various signs of problems, accounting problems, and the like.

My observations of the problems today, again looking at this 20-year period, is that things have gotten considerably worse, and I'm not just talking about the issue of audit independence, whether you can prove it, whether it's an appearance.

The problem is too many botched audits. An auditor is not learning from that. The second observation is that auditors in general have shown little interest in cooperating with initiatives to reduce auditor's concern and have become very adamant in their defiance, which I think is unfortunate. My proposed solution is three-fold, and the first one is what you're embarking on, and that is to tighten and simplify the rules and come up with rules and standards that are clear and are enforceable.

The second and perhaps more important is for the profession itself with the guidance of the Commission is to really step up the training. I think the reason why we have the accounting debacle, in large part, is that the auditors don't really understand the transactions.

In fact, as recently as yesterday there was a press release of a restatement on a company we had written two warnings on in the last year.

The third step, in addition to the clear rules and much better training is the SEC has enforcement responsibilities, and when there are clear signs that the auditors have been involved in a botched audit the Commission, I believe, should take some very substantial steps, whether it's prohibiting that CPA firm from engaging in any new SEC registrant in that industry, perhaps, for the next three to six months.

It has to be a penalty that hurts their pocketbook, that gets their attention to saying we will learn from these audit failures, and we will ensure that our staff will not be involved in these problems in the future.

I thank you for this opportunity, and I'll be happy to answer whatever questions.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: I'm curious, Ms. Lorenz, what do you do as a litigation consultant? What is your interaction with the companies?

MS. LORENZ: I primarily work in areas of GAAP and GAAS, either contract disputes, securities litigation, professional liability on occasion, but it has primarily been on the plaintiff's side.

COMMISSIONER UNGER: What does that mean? Are you a lawyer?

MS. LORENZ: Pardon me?

COMMISSIONER UNGER: Are you a lawyer?

MS. LORENZ: No. I'm an accountant.

COMMISSIONER UNGER: Consulting in terms of your expertise?

MS. LORENZ: Yes, interpreting areas of auditing standards and auditing principles.

COMMISSIONER UNGER: Only in the context of litigation, though?

MS. LORENZ: As a litigation consultant, yes, in the context of litigation vis-a-vis securities problems, failed audits, things like that.

COMMISSIONER UNGER: So if a company gets sued, they call on you to help them defend the suit? I honestly don't know. I'm asking --

MS. LORENZ: You can either defend, or you can be on the opposite side, the plaintiff's side. You can do either one. I have done primarily plaintiff's work.

COMMISSIONER UNGER: I was interested in what you were talking about in terms of what you called the lost leader engagement, the negotiation, the fees that the accounting firm charges to its clients, the bazaar type, "bazaar" with the "aa" type of negotiation.

What has been your experience with respect to those types of arrangements? And how have they, sort of, entered into the litigation context, if at all?

MS. LORENZ: Well, I've seen them enter into the litigation context by just observing that the fees were --you would like to have 100 percent recognition of your fees, and even on a fee that was probably a bit low for the work, you see 60 percent, 50 percent recognition, and it is generally -- there usually are some other services involved that I think help him make that up.

We have a rule in Texas -- I think someone else alluded to it -- that it would be good -- I think, the idea about a panel choosing the auditors probably would be nice but is not practical. But we have a rule in Texas that says you cannot perform an audit for below your cost, and we define "cost."

COMMISSIONER UNGER: So in seeing these types of negotiated fees, are you seeing them in the context of a conflict or analysis of a conflict between -- for the accountant providing that and consulting services?

MS. LORENZ: The accountant, I think, looks at a client as a -- in some instances, as a way to build a business and build more practice and do more work with that client. I'm not saying that's wrong, but I believe sometimes the audit and the intentions of the audit and the attempt to meet budget suffers.

COMMISSIONER UNGER: I assume you're seeing this in the context of litigation, and there is litigation for audit failures.

MS. LORENZ: I am seeing it sometimes there. I'm seeing it from the perspective of my own firm when firms I know with much higher rates than ours undercut us for a job. So I know it happens.

COMMISSIONER UNGER: So not much attention to the audit in what way? Not as much resources --

MS. LORENZ: In the litigation sense, not as much time spent in certain areas, not as much maybe higher partner time spent, those kind of things. It would be hard to name them all for you.

COMMISSIONER UNGER: Well, I'm questioning whether it's an issue of devoting sufficient resources or whether the relationship then evolves into one of providing consulting services, and there's, perhaps, a compromise in that regard.

MS. LORENZ: I think, generally, it's a way to get the relationship to evolve into other areas when it's done. If you're just going to perform the audit, you would like to get your full rates. Everyone is looking for more business. I believe that happens, yes.

COMMISSIONER UNGER: Thank you. Mr. Schilit, you had talked about the lack of independence and the lack of knowledge of the independence rules. I think you said that's more substantial today than 20 years ago?

MR. SCHILIT: I don't have any empirical evidence of testing today's auditors, but I think more than just the lack of knowledge of what those rules are, it's just a defiance of them and lack of the public interest in -- you should not be engaged in activities selling your audit client's product and have to look at a rule book to see whether or not there's a thou shalt not.

I think common sense should indicate that if you become an advocate selling your client's product, then you should not be auditing that client.

COMMISSIONER UNGER: And you're basing this on what?

MR. SCHILIT: I'm basing it on the recent disclosure with Microstrategy, the consulting relationship. In fact, listening to the previous panel I was surprised to learn that the people who are actually doing the audit were the ones who were involved doing the consulting work as well, in many cases, as opposed to having a completely separate team. That surprised me that the same person is wearing two different hats.

COMMISSIONER UNGER: Which is the issue. When you did your study 20 years ago, what type of constituency or what type of cross-section of accountants did you reach out to?

MR. SCHILIT: Large firms, small firms, medium size. All three groups were represented.

COMMISSIONER UNGER: Okay. I think that's it for now. Thank you very much.

CHAIRMAN LEVITT: Mr. Schilit, how can you suggest a better way for us to engage the accounting profession? We've met with a resistance to change and improvement not just during my tenure at the SEC but in talking to four of my predecessor chairs, they have experienced precisely the same problem.

MR. SCHILIT: That's certainly an enormous problem. Let's go to the second part of my solution, and that's to create rules that they have to have training -- for example, the big accounting failures in the last year. There should be evidence provided to the Commission that the lessons --case studies from those audit failures should be as well known to accountants as people who go to law school and study case studies from classic cases years ago.

So I think the track should be to encourage and to ensure compliance that the auditors are learning lessons from these past debacles. That's the only way you get smarter, by going back and know what happened at Equity Funding, and National Study Marketing, et cetera, et cetera. And I believe the auditors out there in the field are completely clueless about those lessons.

CHAIRMAN LEVITT: Well, I think that may be part of it. Also, looking at other industries and the way they approach the natural tension that exists between a regulator and regulated, in some instances, there is an awareness that a compromise to the integrity of any of them is a compromise to the integrity of all of them.

In some instances, there is an organization that represents them that is kind of a balance wheel and a way that the present organization representing the industry appears unable or unwilling to accept, and perhaps a truly independent POB -- I mean truly independent -- might offer a bridge that could be constructive.

MR. SCHILIT: I hope that indeed does come to fruition.

CHAIRMAN LEVITT: Thank you very much.

Panel 5 (Morning)

The next two witnesses will be Jim Schiro, the chief executive officer of Price Waterhouse and Phil Laskawy, the chairman and chief executive officer of Ernst & Young.

I would say that as I introduce these witnesses, your recognition of the issues, the complexity of the issues and your long-standing commitment to work toward constructive solutions of not just the independence issue, but the role of the Public Oversight Board and the role of the FASB and all of the very difficult issues that we face collectively, that the spirit that you have brought to these discussions and your willingness to engage in a dialogue makes our job much more fulfilling, and speaking for the Commission we appreciate that.

Mr. Schiro.

MR. SCHIRO: Thank you, Mr. Chairman. My name is Jim Schiro, I'm the CEO of PricewaterhouseCoopers, and I would like to begin by commending Chairman Levitt and the Commission for initiating this critical dialogue.

The SEC is providing appropriate and necessary leadership to help us achieve our shared objective in this rule-making process, safeguarding and improving the quality, significance and reliability of information upon which the investing public relies.

However, if we are to reach that goal, we must refocus this discussion, on reassessing the role of the audit and accounting firm in the 21st Century. We must resist the temptation to try to fashion rules that anticipate every conceivable future conflict or concern.

We have a larger mission to build upon the intellectual core of the profession, allowing it to grow and innovate to meet developing investor needs. Who knows what new assurance services will be demanded a decade from now or even a year from now.

Our challenge is to create a set of guidelines that will enable the profession to thrive and change. Let me quickly illustrate. As you well know, many, many technology stocks plummeted in March and April, decimating the portfolios of countless investors.

The reassessment of the technology sector has little to do with audited financial information. And that's my point. This profession's core mission must continue to be to protect investors and the public interest, an especially important role in times of dynamic change and economic transformation.

Yet, audited financial statements, which are the traditional heart of this profession, do not measure the very assets upon which today's companies are often valued. As a result, investors have little guidance in making investment decisions, leaving them at greater risk.

We need to create not merely a new set of rules but a new accounting and auditing model that reflects a whole host of factors upon which investors increasingly rely.

Investors want to know more about intangibles such as the potency of a company's market strategy or the value of its intellectual capital. They want to know whether companies are pursuing sustainable development, respecting human rights or addressing the global digital divide, the technology disparity that threatens to widen the inequity between the world's haves and have nots.

A decade ago, even a couple of years ago, most investors formed economic judgment, based solely on historical financial information. Today, a more complex set of factors has an effect on value. To make decisions in this environment, reliable, contemporaneous information supplied by a trusted and objective third party is increasingly necessary.

The future role of my profession is still being defined. The objectives have not changed. To provide assurance and to protect the public interest. The key is to recognize that new challenges driven by emerging technologies and innovative ways of doing business are arising every day.

And that brings me to the SEC's proposed rules. I'm here today on behalf of PricewaterhouseCoopers to contribute to the creation of rules that safeguard the public interest and allow the profession to adapt to the evolving needs of the capital markets, our clients and the public.

The right rules will ensure that this profession continues to be highly attractive to first rate people, professionals with strong character who posses highly sophisticated analytical skills, technological and interpersonal skills.

Make no mistake, the calibre of our people rather than the comprehensiveness of rules will be the investors' best protection. Our goal should be to ensure that the profession has an abundance of trained people with an objective mindset supported by firms appropriately focused on audit and assurance.

Over the past many months I've consistently said in testimony and in public statements that the profession needs to engage regulators on a global basis to address the challenges that now face us.

There has been too much rhetoric and too little reasoning owing to the mistrust that recently has arisen in the relationship between the profession and the SEC. It's time to reclaim that mutual respect and trust.

We are in a period of rapid change, and thus great risk should we fail to respond. The need for constructive dialogue is acute. There has been a lot of criticism of the current proposed rules.

I too, have had some disagreements with them, and I've made that clear to the SEC and to my partners. I believe, however, that dialogue and discussion is the route to a reasoned solution.

Therefore, my firm has been engaging the Commission staff, and we found them open to our ideas and interested in discussing the future of the profession. The time for action is at hand.

We're in the midst of a global information revolution as momentous as the agriculture or industrial revolution of the past. This is a revolution that moves at internet speed, and so we don't have years or even months to adapt to its demands.

Our profession and our people need clarity now. The financial markets, our clients and our industry cannot afford to wait. We have discussed these specific proposals with the SEC. We have submitted jointly with Ernst & Young proposed language to the staff for a new rule that we believe would meet the Commission's objectives and under which we could provide the services we anticipate that our clients will require in the 21st Century, information assurance services.

If the Commission is prepared to adopt rules along these lines, we will support them. Let me begin with the scope of services rule concerning financial information systems, because this is the core issue in the rule-making proposal.

We would support restrictions of the types of consulting services accounting firms provide, including internal audit outsourcing, because we believe that changing marketet forces are making it increasingly difficult for firms to provide these services alongside their assurance practices.

We made a decision which I announced a year ago to divest PricewaterhouseCoopers of its management consulting practice. We believe that our business has matured and developed a broader array of services.

We have become two distinct organizations under one roof. Each has a different mission. For one, the end game has been financial market integrity. For it, investor protection, objectivity and independence are crucial.

For the other, having a direct interest in client success is mandatory. These differences lead quite naturally to the evolution of very different cultures and very different business models.

The restructuring plan will allow each of our businesses to grow and prosper. PWC will continue to be the world's largest audit and accounting firm, and I am confident that we will be able to offer our people exciting and challenging careers.

The notion that we will not be able to conduct quality audits without an IT consulting practice is simply wrong. Let me summarize our views on four additional issues. Personal rules. The SEC has done well in addressing the need to modernize the archaic personal independence rules to reflect today's social and business realities. We have alerted the staff to a few areas that appear to have some unintended consequences.

Principles. The Commission has proposed broad governing principles. We would urge against writing these principles into the rules. By doing so, they would almost certainly become inflexible edicts rather than helpful guidelines.

Instead of assisting us in navigating an uncertain future, the principles would likely impair our ability to cope with changing investor demands.

Affiliate rules. We agree with the Commission that certain affiliations with audit clients pose independence concerns. However, other affiliations help the profession provide assurance on the increasingly wide array of information on which the investor relies.

Disclosure rules. We have always believed that transparency and sunshine are the most effective means of overseeing the profession. We have nothing to hide from clients, investors or regulators, and therefore, we would support disclosure of all aggregate audit fees and aggregate non-audit fees.

In crafting new rules, it is important to remember that currently we have three very important safeguards: audit committees, the Independence Standards Board and the Oversight Board.

These three oversight bodies are ideally positioned to determine whether auditors are engaged in practices that threaten their independence. We need to give them room to work.

Recently, a Blue Ribbon Committee on Improving Corporate Audit Effectiveness of corporate audit committees established at the behest of the Chairman Levitt, and on which I served, noted the importance of audit committees and strengthened the role they now play in the audit process.

The ISB on which I also serve is already deeply involved in independence standard-setting. I believe that given the degree of public representation on the board it is the best place to set future independence standards and resolve independence issues.

I would encourage the SEC to expressly acknowledge and respect the ISB's continuing role, and I recommend further bolstering the ISB's credibility by adding another member from the public to create a clear majority of public members.

Finally, we all agree on the need for a robust POB that will monitor the quality of the audit. I encourage others in the profession to join PricewaterhouseCoopers in supporting the POB's new charter.

Before I close, I want to caution that rules that work in this country and that protect our capital markets might not fit neatly in cultures elsewhere. The requirements and expectations of other countries must be taken into consideration in creating rules with global implications.

My travels throughout the world have impressed upon me our profession's awesome responsibility to a wide range of new stakeholders emerging in this global economy. These stakeholders have increasingly complex assurance needs.

They are seeking not merely traditional financial information but also accurate and objective information about a wide array of concerns, including how companies comply with standards of corporate responsibility.

We cannot know in what way the audit profession will need to reconfigure itself to ensure a continuing essential role as an objective trusted third party. What we do know is that a new era demands new thinking.

This rule-making process has broad implications for the global economy, and I'm confident that working together we're equal to the task of devising rules that will protect the public interest today and in the decades to come.

Thank you.

CHAIRMAN LEVITT: Thank you. Mr. Laskawy.

MR. LASKAWY: Mr. Chairman, Commissioners, I want to thank you for inviting me to appear before you today on this vitally important rule proposal.

As you know, Ernst & Young is one of the Big Five accounting firms in the United States. We have more than 23,000 partners and employees in the U.S., and increasingly we are a globally integrated firm with members of Ernst & Young International having offices in 689 cities around the world.

Integrity and independence are, of course, the cornerstones of the accounting profession. The SEC's independence rule release discusses this fact at some length and also discusses the unique and important role that the accounting profession plays in the nation's securities markets.

E&Y understands that role. We acknowledge that we have a unique relationship to public investors who rely on us as vital gatekeepers to the public security markets and who count on us to perform our audits well and effectively.

There is another relationship, another unique relationship, that was not discussed in the SEC's release, and it also warrants a few words. It is the relationship between the accounting profession and the Commission.

Unlike broker dealers, investment advisers, investment companies, stock exchanges or other central players in the capital markets, accounting firms are not entities over which the Commission has direct regulatory powers.

But in my view, we work more closely with the Commission and the staff in the development and application of rules and principles that are essential to the integrity of our nation's financial markets than does any other sector of the economy.

We do so through the FASB and other self-regulatory activities, through meetings with the staff to discuss difficult or unusual accounting issues through countless interchanges during the SEC staff review of our clients' SEC filings and through many other channels, both formal and informal.

This public/private sector relationship has had occasional rocky moments, but I believe it has worked very well for more than half a century, and it has worked well for one specific reason. Our primary goal and the Commission's primary goal is exactly the same.

Like the Commission, we want to make sure that our clients' financial statements are as accurate as possible in accordance with Generally Accepted Accounting Principles. And we want public investors to be completely certain of the integrity and independence of the accountants who audit those financial statements.

Thus, the appearance of independence is perhaps as important as is actual independence. In this regard, we have supported the SEC proposal on enhancing the POB. I believe that it is in the public's and the profession's best interests to have independence oversight over the profession.

For the same reason, I also support having a majority of public members on the Independence Standards Board. Both of these relationships, the one we have and the investing public and the one that we traditionally have had with the Commission, were the principal reasons for my firm's decision last May to express support for the concept of an SEC independence rule.

I've grown increasingly concerned during the past several years that the heightened scrutiny of auditor independence has had a negative impact in the marketplace. Increasingly, audit clients are troubled by the uncertainty surrounding the independence rules and questioning and denying our ability to offer a range of services that the SEC would agree do not -- do not -- present independence concerns.

I have, in other words, been concerned that the appearance that auditors lack independence could undermine our relationship with the investing public, and I was also hopeful that a rule could help us restore some civility between the relationship between the profession and the SEC.

It is unfortunate that the Commission's attempt to promulgate an independence rule has actually led less civility and has increased the tension between the profession and the Commission. I do not agree with the approach taken by others in the profession, including the AICPA, in making harsh attacks against the Commission and in trying to stonewall the Commission's efforts.

In fact, I am quite troubled that the AICPA, which has an obligation to represent all of its members, would take sides in a fashion that can only weaken public confidence in the accounting profession.

I have always believed that the profession can and should work to reach a reasonable solution with the Commission, one that would best serve the public interest.

Thus, although I do have concerns about certain aspects of the Commission's rule proposal and I have stated those concerns publicly, we decided several weeks ago to meet with the Commission staff to discuss these matters.

Together with the representatives from PricewaterhouseCoopers we have conveyed to the staff our conception of a rule that best furthers the public interest. The issues in this rule-making will affect millions of investors, tens of thousands of professional careers and thousands of public companies, and they are very, very complicated issues.

Accordingly, we wanted to make sure that the staff had a chance to listen carefully to our concernsMy colleagues and I at E&Y have been greatly impressed by the dedication and time commitment the staff has displayed throughout the comment period and have been particularly impressed at how seriously the staff has taken its commitment to the protection of public investors.

And the staff's receptiveness to our concerns is an example of precisely what I just discussed, the positive and productive relationships that has traditional existed between members of the accounting profession and the Commission.

In conveying our comments, we have told the staff that, in our view, an independence rule could accomplish three important objectives.

First, the rule might address an issue that has long needed attention, the financial relationship and investment restrictions governing the profession and audit clients. In many respects, the current rules are both outdated and irrational.

This is particularly true with respect to spousal employment and restrictions on the participation by spouses and employee stock compensation programs.

Second, a rule might clarify what is and what is not allowed with respect to non-audit services for SEC attest clients. In that regard, a rule might properly address the two activities that, obviously, have raised the most public concern; namely, information systems consulting a internal audit outsourcing.

Third, a rule could clarify certain relationships and affiliations that an audit firm can have. Increasingly, partnerships, joint ventures, minority investments, cross-licensing, customer alliances and other cooperative arrangements are key requirements for our clients' existence in the global marketplace, and it is important that we, too, be able to have such relationships not, of course, with audit clients but with entities that are not audit clients.

After discussing these matters with the staff, we and PWC have proposed our own independence rule. We have given an initial copy to the staff, which I understand has been placed in the public record, and we'll attach our final version in our comment letter.

We ask the Commission to consider our proposal carefully and ultimately to adopt our proposed modification to the final rule. Our approach would address most of the issues that were raised in the Commission's rule proposal, but, at the same time, it would protect our ability to serve the needs of our audit clients in a fast-changing and global marketplace.

I want to discuss two aspects of the proposal that have been at the heart of the independence controversy and have received the most attention during the Commission's recent public hearings; namely, information systems consulting and internal audit outsourcing. Our proposal would restrict the provision of both these services to audit clients.

First, information systems or management consulting. We recently sold our practice in this area. We did so for a variety of reasons, but one reason certainly was that although we did not believe independence was actually impaired by this service, we could understand that particularly with the large fees that sometimes are involved an appearance problem could be present.

I might note that now that we have sold this practice we have not discovered that we are somehow enfeebled, unable to perform effective audits or to mai

Hearing Testimony:Auditor Independence

UNITED STATES SECURITIES & EXCHANGE COMMISSION HEARING ON AUDITOR INDEPENDENCE Wednesday, September 20, 2000 9:00 a.m.

P R O C E E D I N G S

Panel 1 (Morning)

Panel 2 (Morning)

Panel 3 (Morning)

Panel 4 (Morning)

Panel 5 (Morning)

Hearing Testimony:
Auditor Independence

UNITED STATES SECURITIES & EXCHANGE COMMISSION
HEARING ON AUDITOR INDEPENDENCE
Wednesday, September 20, 2000
9:00 a.m.