Roundtable Discussion on Financial Disclosure and Auditor Oversight
Tuesday, March 6, 2002
Securities and Exchange Commission
Panel 1: Improving Financial Statement Disclosure
Moderator, James Cheek, Partner, Bass, Berry & Sims
Panel 2: Assuring Adequate Oversight of Auditing Function
Moderator, Judge Stanley Sporkin (Ret.), Partner, Weil, Gotshal & Manges
Panel 1: Improving Financial Statement Disclosure
Chairman Pitt: Good morning everyone, and welcome. This is the second of a series of round tables that the Securities and Exchange Commission has organized in order to get vital input on issues relating to financial disclosure, and accountant regulation. We are very, very fortunate to have a panel of experts, who have generously given of their time to assist us.
Our purpose, at least from the Commission's perspective, is to listen, not to speak, to hear, not to communicate any notions we may have, but to learn. And so with that, I'd like to turn it over to our chairman, Jim Cheek.
Mr. Cheek: Thank you, Mr. Chairman. Welcome to, as Harvey mentioned, the second roundtable on improving financial and related disclosure. We on this round table very much appreciate the opportunity provided by the Commission and the staff to address these issues, which are so critical to our capital markets. Our markets, of course, are some of the most respected and most liquid in the world, and much of that respect and resulting liquidity has been based on the reputation that our markets operate fairly, and that our disclosure and financial reporting system is the best in the world.
Even before Enron, there were cracks in the investing public's confidence that our current system was working. The challenges of earnings management cases have been well documented. The series of high profile financial fraud cases involving cases such as Sunbeam, Waste Management, Cendant, are also equally notorious. There has been in the last two years a dramatic increase in the number of financial restatements, something that was fairly rare in previous years.
All of these suggest that even before Enron, as chairman Pitt has observed, our system of financial and related disclosure is old, it's outdated, it neither provides timely or current information, nor does it provide clear and understandable financial disclosure. The financial disclosure has become complex, it's become lengthy, and impenetrable. Enron, of course, has been highly notorious, and in very visible ways has acted as a catalyst, which demands reform, and reform is indeed critical if the confidence in our capital markets is to be maintained.
Many efforts are underway to provide answers to this dilemma, and one can only hope that the law of unintended consequences in the reactions to Enron does not come into play. Knee-jerk, publicity-gathering responses are not the answer. Thoughtful, measured responses, balancing the needs of our economic system, its capital markets, the investing world, and the users of our financial disclosure system are the answers. Our goal today is to offer views, from different perspectives, of the issues and initiatives that are designed to improve our system of financial and related disclosures.
We are very fortunate today to have an experienced panel from different segments of the users of our financial disclosure system. On my far right well, I should say, on my far right, Commissioner Hunt will perhaps be with us later in the morning, but Phil Livingston, to my far right, is our representative of the financial executives world. He's CEO of Financial Executives Institute.
And next to him is Lou Thompson, who represents the investor relations world, as the CEO and president of the National Investor Relations Institute. The chairman, well-known to all. Rich Carbone is our representative of the executive world. He is the current CEO of Prudential Financial. CFO, sorry. And he has been under the tutelage of Warren Buffet, having previously been at Solomon, also having served as an accountant in his early days at Pricewaterhouse. And then next to Rich is Ray Groves, who is representing some of the corporate world today, but certainly has a lengthy experience in the accounting world, having been the CEO of Ernst & Young for many years, and very active in the accounting profession. He currently serves as president of Marsh, Inc.
And I'm the token securities lawyer, and hopefully won't interfere with the real world surrounding me here, but yes? Oh, I'm sorry, Commissioner Glassman. Excuse me. I apologize. We're delighted to have Commissioner Glassman with us this morning to my far left.
As a preliminary matter, I would like to note that, while the SEC has set forth a number of initiatives, which we will discuss today, and Congress has pending many bills to address the financial disclosure system, I would observe that the market demand for high quality, transparent financial reporting is already at work. The market is clearly penalizing, in some cases perhaps unfairly, public companies whose accounting practices are opaque and questionable, and not reflective of business realities. Major public companies have been reacting to this market pressure.
General Electric has spoken about providing more detailed information about specific businesses in its GE Capital subsidiary. IBM is going to provide more detailed information regarding financial income, intellectual property income, gains from sales of assets, which historically had not been presented separately. Companies like Krispy Kreme have announced policies of abandoning synthetic lease accounting policies. Cendant has put on its web page off balance sheet items.
These would not have happened except for the market reaction, and demand for transparent financial information. A number of other companies throughout America are, in fact, scrubbing their numbers as the year-end audit process concludes. I have noticed in my own practice that audit committees are, in fact, considerably more proactive, and sensitive to the process that they are engaged in, and to their oversight functions. There are much longer meetings. There are much more detailed meetings. There are much more adversarial processes that are being engaged in, to test the integrity and the openness of the financial reporting system.
The accounting profession itself has applied more stringent, and more specific review processes in connection with their audits, and are reporting in greater detail to audit committees. I make this point because, even without regulatory, and perhaps legislative solutions, the marketplace does work in this country, and the marketplace and the heat it has generated has caused change.
Now, that is not to say that there does not need to be further regulatory, and perhaps legislative action. We all know heat disappears, and risk of old practices emerge in the lack of heat. And the focus of our discussion today is on those areas where that action is needed, where it is happening, and where it may happen.
I thought I would tee this up in a way that focused on what I believe to be the three target goals of improvements in our financial reporting process, and I call on the three T's. The timeliness of information to the marketplace, the transparency of that information being presented to that marketplace, and the transformation of the process by which that information is created and communicated. And I thought I would start with our panel discussion with the for T of timeliness.
The old system that we're all used to is a system that has mandated, periodic disclosure, predominantly through the filing of 10-Qs and 10-Ks, with mandated items are the designed format of information to be provided to the investment community. That is enhanced by voluntary disclosure, through press releases, and through investment analyst conferences, and other communications that conform to the regulation FD the Commission adopted in recent times.
The old system suffers because the mandated disclosure is often stale. It comes late in the game. Press releases generally always precede the mandated disclosure. The information is out there. Conference calls have been held. The mandated disclosure, the periodic disclosure, is almost an afterthought in the actual real-world disclosure process.
The new system. How should the new system perform in light of the existing demands, and the existing technology that's available to communicate information? The new system should be designed I am offering this for comment to the panel to produce more real-time disclosure, more current disclosure. The chairman articulated this way before Enron really hit the media in the style in which it has hit.
And the market demands this type of information. If you just look at CNBC, CNNFN, Bloomberg, Yahoo, the Securities Sleuth web page, the chat rooms. All of these are instantaneous type of communication devices that are out there that investors are looking at, and calculating into their investment decisions.
The SEC, in an effort to provide more timely and current disclosure, has recently proposed rules which would advance the filing date of 10-Qs from 45 days after the end of the quarter, to 30 days, and the filing of 10-Ks from 90 days after the end of the fiscal year to 60 days after the fiscal year.
In addition, the Commission has proposed that form 8-K's be filed on a more timely basis, no later than two business days after the event, in some cases one business day. And they expanded significantly the list of specific items that are required to be filed on an 8-K. Coupling that with modern technology, the Commission has proposed that those filings be instantaneously be put on a corporate company web page. The first question that I would like to address and Phil, perhaps I'll throw it your way first is, in terms of the providing this information on a more accelerated time basis, is there a danger that the process becomes so pressurized, that reflective presentation is not capable of being made, and the audit committees' participation, particularly, is not as complete as it might be if you had a longer time period? Do you find, in your community of financial executives, any resistance to this, as occurred when the aircraft carrier release came out, and a number of comment letters came back very, very opposed to this accelerated time schedule? Or do you think it will work?
Mr. Livingston: Jim, I think it will work. And I think when you get as I've done, when you get financial officers behind closed doors, without the lawyers present, they'll tell you that they can do it, and they're very close to doing it as it stands today. You know, in general, we need to modernize our financial reporting system in a big way.
And in that vein, Enron offers a huge opportunity to all of us involved in the system to do it. And so when we talked about this, and we talked very specifically about it last week, there's very strong, and almost unanimous support, at least in our community, for the 60-day 10-K requirement. There's a little bit of concern about the 30-day requirement, but you know, in general, it's going to it is going to take some reengineering.
But it is our companies, if you think about the fact that this these timeline standards have been in existence for over 30 years. And if you think about the technology, and the process reengineering that's gone on in companies out there over the 30 of those 30 years, it's almost silly that we haven't modernized along this time frame. So I think there is support for it.
I think there is also tremendous benefit from the recent proposal to speed up the reporting of insider transactions. Why we didn't get to that point 10 years ago, 5 years ago is beyond me too. I think that that will be another tremendous benefit to investors, to know, very quickly, when corporate insiders, who know more about anything that's going on in their company, what they're doing with their investments.
Mr. Cheek: Rich, as CFO, do you have any particular concern about being able to thoughtfully meet these deadlines?
Mr. Carbone: Let me make a couple of comments. I think the 60 days on 10-K is doable, because when a company closes its books at the year-end, they do a lot of analysis with the data, and the problem with shortening the time frame is, you may get more data and less analysis. And I think the analysis that the company does on its performance is critical.
What does a company do? They compare its their results to prior periods. They compare it to what they expected, their plan. They compare it to their own company trends, a series of prior periods. And most importantly, they compare it to the competition, they've got to wait for the competition to come out. They've got to wait for industry analysts to publish some reports about what has gone on in their specific industry.
So I think the investor is best served when the company they invest in is contrasted against the rest of the industry for a similar investment, a similar investment risk. And so that 30-day one on 10-Q, that does trouble me. When I think about disclosure, and how it's always having to be refreshed, when we would go through a 10-Q, we'd think about all the stuff that we disclose in form 10-K as we write our 10-Q. And 30 days could be tight, given all of the steps you want to go through when you release your quarterly earnings.
Mr. Cheek: Roy, you serve now on a number of boards and, of course, with your expertise have been selected for the audit committees on a number of those boards. >From an audit committee perspective, the audit committee has an obligation to review the 10-Q prior to its filing. Many audit committees actually review press releases before they are issued on quarterly earnings. Does the timeline trouble you at all in terms of that process?
Mr. Groves: I think, with the larger companies, particularly probably the ones that Rich and Phil are speaking of, who have large staffs, and have wonderful systems, it would be not a major challenge. And I think they can get the information to the audit committee in time for them to have the review. As you say, all the ones I serve on do the press releases. They don't wait for the 10-Q.
But I would think, if history is repeating itself, the medium-size and smaller companies who do not have the staff, and perhaps do not have as extensive a system as the larger companies do, they may well be pressed in trying to get even some of the more basic data, even not even having industry data, Rich. I think that could be a challenge.
I think the emphasis probably should be on quality first, and timeliness second, because certainly the press releases always precede, or seem to always usually precede the Q's and the K's. And it's maybe it's the depth and the quality that's included in some of those releases maybe needs to be challenged, or enhanced as not as opposed to, but in addition to looking at the timeliness of looking at the Q and the K.
Mr. Cheek: Let me follow up on that point, and address this to you, Lou. One of the things that has troubled me about our mandated periodic disclosure system, and regardless of whether it's 45 days or 90 days I mean, 45 days or 30 days, or 90 days or 60 days, is that it's still information that's put into the marketplace that is after the fact of the system of actual disclosure that the market professionals are using in connection with their analysts' reports, in connection with their investment decisions.
What drives that today is, in fact, the press release process, and the conference call process that follows the press release in most public companies. And my question, Lou, is, one from an independent review point of view, and the user of the information by the investment community, is the 10-K, 10-Q process more of the liability completion-of- information process, and the real meaningful information derived out of press releases, and conference calls?
And if so, is not an idea that the Commission should consider enhancing the obligatory nature of the press release format, requiring press releases in quarterly earnings context, and annual earnings reporting to include summary analysis data, and information that would be part of the public filing on the web page, part of a public filing in an 8-K, and really putting all of the information that often finds its way through the investment community through conference calls and follow-on one-on-one telephone conversations, and so forth, out there before the Q and the K? Is that a useful paradigm to think about?
Mr. Thompson: Well, Jim, I think clearly in today's environment, the internet gives companies great power to communicate with the investors, and we were particularly pleased to see the SEC propose in its current disclosure rules that companies put their filings on their web site simultaneously with reporting them to EDGAR.
We did a survey last week, an online survey of 406 of our 2,400 companies represented by our membership. 89 percent said they would have no significant problem doing this, and the others were really more technical problems than anything, that could be overcome. And we think this is a giant step forward by the SEC in recognizing the power of the internet as a means for communicating with investor information on a real-time basis.
You know, what we're basically about here, one of our jobs in investor relations is really to do the things that minimize risk for investors, and we can do that by providing investors full, fair, and underline timely access to corporate information, to help them better understand the companies they're invested in. And we believe the companies should help investors understand how a company makes money, and that needs to be laid out in plain English. It could be done under your concept of a summary statement of the MD&A, for example.
Much of today's disclosure is impenetrable. Investors are forced to wade through complex footnotes that are often difficult to understand. We can do better than that. And I think the idea of right now, 92 percent of our members do conference calls. Virtually all of them now webcast those calls for full access. 84 percent that put out earnings guidance are putting that guidance in the earnings release, and then they discuss it in the conference call. And all of this is done as soon as the company gets its numbers together, and well before the filings.
Mr. Cheek: Rich, I'd like to ask you, in terms of what we've been discussing, as you know, there's a bill pending in Congress that's become the Oxley bill, that includes rulemaking authority to be granted to the Commission, to provide rapid and, essentially, contemporaneous disclosure, a concept that reminds me of a banner flowing under the company's web page, in which there is a constant update, quality of information.
From that point to the suggestion that I made about using a press release format in a more mandated way, of communicating information earlier, in advance of the more detailed information that would be included in the Q and the K, does that cause you concern, from either a liability point of view, or from a competitive position point of view, in your capacity as an executive officer of a public company?
Mr. Carbone: I don't think so. Let me make a few overriding statements first. Your thinking that the 10-K is the completion of the liability process, and the filling it in of the blanks form is very accurate. And the analysis process, and many of the research reports that the investor uses are long out before 10-K is filed.
I think the press release and the quarterly statistical supplement we call it the QFS, the quarterly financial supplement I think those things contain the information that a professional investor, a professional analyst, a securities analyst can use, load into their models to analyze the company.
It's not clear to me that the individual investor that doesn't use an advisor, or doesn't have a discretionary account can take that information, and fit that into their investment philosophy. I think the other point you make around 8-K I think the expansion of the list of stuff that you've got to report through form 8-K is also crucial. I think that gets to the timeliness.
Also within 8-K, we should remove some of the materiality concepts, and leave the form to be, these are the things you need to talk about when and if they happen, within the number of days or hours that you need to report them on. And not leave the materiality out, in the filing of form 10-K.
Mr. Cheek: Let me just focus on some of the expanded list of 8-K items, and particularly in the context of, say, competitive putting yourself at a competitive disadvantage. One of the items is that you must report any loss or gain of a material customer or contract within two business days of that event. Another is, any event that could trigger acceleration of any contingent or direct obligation. Another is that any material change in an accounting estimate needs to be reflected.
Do those is that the right balance? Are those the right focus points? Is that the right set of does it need to be that specific, in terms of the information flow? Or are you better, instead of having a checklist of specific items, to have a general mandate in connection with material events, as the New York Stock Exchange requires there be mandated public disclosure through press release format, with analysis attached to it?
Mr. Carbone: Yeah. The latter gets to the liability point, because you put the entire onus of judgment on management, and then you have the look-back, because with the look-back is, several quarters down the road, several reporting periods down the road, you fail to disclose something that management was required to, by their judgment, to disclose in an 8-K.
Nothing troubled me on the expanded list, with the exception of the change in estimates, because the change in estimates, again, they occur throughout a 90-day reporting period, as additional information and additional analysis occurs. So while you might have a belief that you need a change in estimate, or particularly in my industry, you have to have actuarial reserves for life, you have actuarial reserves for casualty.
These estimates are better refined over a longer time frame, rather than contemporaneous, one day, where things happen. "We think we've got a change in estimate." To report that on form 8-K, I think, is a bit premature, and we'd be filing 8-K's to frequently to help the investor.
Mr. Cheek: Phil, do you have a reaction?
Mr. Livingston: I wanted to comment on customers. I think that's a troubling area. And the other two that you mentioned, I think, are fine. But we talked about customers the other day. Most businesses lose 20 percent of their customers every year, and grow their business anyway, by building new customers, or expanding existing customers. So I think to have to file an 8-K every time you lose a material customer is going to be a big problem, and a real competitive concern to companies, you know.
A company that is super dependent on one customer, or only has five customers, and loses one, you know, I can see that making a case for that needing to be a disclosure, but a business that's got a whole lot of customers that they'll rebuild it.
And then what defines a loss of a customer? If you have $100,000,000 of business with a customer and you're only going to do 10 next year, is that a loss of a customer? I think that's a troublesome area to wade into.
Mr. Cheek: Just on that point, it struck me that the disclosure item is simply framed in terms of the loss of a material customer. What's really important is what the impact of that loss is. And each of those items are item-specific events. And it seems to me that the better, and more informative, and more transparent focus needs to be on the implications of the event on the company's business, and real business reality.
Lou, a lot of your folks are in the business of spinning that reality. Does it trouble you if we had a system where, rather than reporting events, you need to report a transparent analysis of the business reality of the impact of the event?
Mr. Thompson: Well, again, I think the answer to that is yes. And I think what we're again, we surveyed our members on that particular question, and we asked them, "Do you anticipate any problems if required to submit a form 8-K for any of the items listed above?" And again, 83 percent said, "No." Now, hopefully they read the list of items. But I think what we're really talking about here, Jim and I'd kind of like to go back to your earlier question about using the news release, using means of informal disclosure, the company's website, and so on.
What investors really need to understand and you know, I realize the MD&A has a certain legal process that one has to go through, and there are liabilities for the various things but what companies really need to do is to explain, again, what are the key factors that management believes are the most important in driving that company's business.
Now, there may be arguments that, well, that reveals competitive information, but I had a Harvard business school professor tell me last Friday, on the issue of competitive information, that that argument is way overblown today. They should understand what the significant trends are that can impact the company's performance going forward. Other key factors that affect the company's business, both on a historical and prospective basis.
And when these companies notice a significant change in one or more of these factors, then they should consider, on a current basis, disclosing that information broadly to investors. News release, it can be furnished through 8-K item 9 of an 8-K. Put it up on the company website. This kind of information is contemporaneous, and it shouldn't necessarily wait for the quarterly reporting.
Mr. Cheek: Well, I want to follow up on your point, and particularly on the substantive content of the information being disseminated. But one last point I'd like to hear some feedback on the panel about is in terms of timeliness, my first T. One of the concerns, I think quite rightly, that the Commission has is, assuring that the information that is disseminated gets disseminated as broadly as possible, and to as many investors as possible.
And I listened to the Monday discussion, and Dick Grasso at the New York Stock Exchange made the point several times that the process needs to be geared for the average individual investor in main street America. And I wonder about that in today's world, and the way most people invest their dollars.
Sure, there are over 50 percent of America that has their investment portfolio in the market, but most of those people are investing through collective investment funds. Either mutual funds, or through investment advisors that are individual advisors associated with managed money. And I wonder whether the old theory, which exists today still, that the information has to get mailed to every shareholder, or the information has to get to every shareholder, is still the right premise to go from.
Or is the better premise that, if the marketplace absorbs this information the marketplace, the market professional absorbs this information and that is really the driving factor of market capitalizations and values, and that information gets disseminated through that process, if the focal point of actual delivery to the individual investor in main street is really the right focal point.
But the better focal point being to streamline the disclosures that are out there on an equally available basis, but take those disclosures that have history occurred in one-on-one conferences, and buy-side institutional analysts discussions, and the conference call worlds that really aren't, despite FD, all that filtered out through the entire investment community, and hit the investment knowledge base that way.
Ray, do you have any reaction to that?
Mr. Groves: I think, Jim, you trigger in my mind a thought that I've proposed several years ago, in that I think if we are going to go to the average investor, and maintain that as a hallmark of the disclosure system, then I think we have to look toward some kind of a two-tiered system, where financial disclosures and financial information is summarized, challenging though that may be, and that for the investment advisors and the professionals who need all the information, and more than they're getting today, that that be available in a second tier.
Because the quantity of information, which is going to get just more and more, of all the things that we're talking about here today nothing is going to reduce anything, it's only going to increase the amount of disclosure, the amount of paper, the amount of the pages on your website, and there are still going to be only 24 hours in each day to look at this information. And people aren't going to spend a high percentage of those 24 hours, even if it's more readily accessible. That would cut down the time, because you can get a hold of it faster. But the information we're talking about adding to the information that's done today, in terms of off balance sheet entities, and clearer disclosure of debt arrangements, clearer disclosure of various kinds of revenue estimates that are made.
All that information takes time, not only to prepare, which we talked about in the timeliness, but it takes time to absorb. The reader, the investor takes time to think about that. What does it mean? Compare it to maybe what other companies are doing.
We have to find, I think, if we're going to keep adding, and never subtracting from the disclosure model, some kind of a summary approach with a second tier, with all this all the information, and more, available for those who have the time, and maybe have the job, to use it. The Commission tried that in '95, and didn't get much support for it, but maybe in today's environment it would be different.
Mr. Cheek: One of the dissemination techniques that clearly is contemplated by the Commission in its releases is the use of the company's web page. Rich, from your perspective again, is there any do you have liability concerns that surround the use of the web page as a principal communication device. Web pages of many companies have all kinds of product information, all kinds of company information that may not be as completely massaged as the legal documents that get filed with the Commission.
Mr. Carbone: Clearly, the safe harbor if the safe harbor rules were expanded somewhat, I think the companies' web pages could be more useful. But I also think they're ongoing disclosures could be more useful. And management would be willing to step up more, and give forward-looking trends. The investor today is looking for growth, I think, and the equity analyst looks for companies what they're going to do in the future, and not so much what they've done in the past.
To get there, I think the Commission should consider some expansion of safe harbor. But you hit upon another point, Jim. If you look at 10-K and you look at the average research report on a company, the average research report on a company is much richer, and much more helpful to an investor to make that investment decision than either form 10-K or 10-Q.
Again, those research reports. It might make more sense to make them more publicly available, get broader dissemination of all research reports written by the capital markets folks on a company to the individual investor. The professional investor already has them all.
Mr. Cheek: Then you are really sliding into my area of concern. There is the risk that is a legal risk associated with that, that has emerged out of several judicial decisions that are talking about the adoption theory, and the entanglement theory of companies blessing reports when they are able to, when they send them out, even, without any commentary.
But I think all of that actually can be lawyered through, in a way that minimizes that exposure. It has to be thoughtfully done. The expansion of the safe harbor opportunities to encourage that, I think, is something that should be considered. And I believe, however, that that is a 21st century way that the disclosure world can get adequately disseminated, and investors informed.
I'd like to move now to the second T of my three T's, the transparency of information. And under this T, I include a lot of the substantive issues that some of the panel have mentioned already. I think most of you recognize, from the commentary so far, that our old system our current system depends on several component parts for adequate dissemination and disclosure of substantive information.
It depends on the generally accepted accounting principles process being applied to a set of financial statements prepared by management. It depends on a management's discussion and analysis associated with those financial statements, and the management's discussion and analysis, I know, is now 15 years old.
And the initial concept release cautioned all issuers about using boilerplate language, and not presenting meaningful and clear information with respect to the analytics associated with the financial statements that are connected to the MD&A. I will challenge that in a moment. It also depends on a complex set of specific rules, as the environment within which our accounting profession and our issuing public companies exist today. So complex that a number of companies have felt compelled to adopt financial information that they believe more adequately reflects the business realities of that company.
That pro forma financial information is, in today's world, not consistently constructed. The pro forma information has been the subject of a Commission release and enforcement action. And the use of it, however, is a tool that modern public companies have had, to communicate what they believe to be operating realities, some would say, "spin" of their operating realities to the street. But it is a tool that shows the complexity of GAAP, and in some cases the opaqueness of GAAP in terms of how it presents economic realities.
In terms of the current practice of MD&As, it is a very lawyered section. There's an awful lot of what's called, "elevator music" in it. This went up, this went down. It, in many cases, is a markup from a previous quarter, or a previous year-end. And there's very little information. To key into what Lou suggested, there's very little information currently that is the key value drivers, and risk management drivers of the business. It lacks real transparency and meaning, and I think that the admonition in the original concept release of 15 years ago is worth repeating again, because I think the practice has fallen into a complacency that cannot be tolerated anymore.
The new approach, which has been encouraged by a number of, "statements" from the Commission, and commentary by the Commission and others with respect to GAAP, I think there's a lot of debate now that is taking place as to whether the complex rule-specific character of GAAP presentations is really the right approach, and whether there is a more generalized, conceptual approach that would enable accountants to be able to deal with creative accounting tactics that are often used for financial statement presentation purposes.
The second aspect of the financial statement presentation that is a reminder that the Commission has put forth, and chairman Pitt has spoken about, is the fact that case law and, indeed, Commission regulation, says that even if you prepare statements in accordance with generally accepted accounting principles, they have to fairly present the financial condition and financial risk of the company.
That fair presentation notion is a notion that has been buried in the complexity of GAAP presentation. The Commission has proposed specific MD&A changes, including a discussion of critical accounting policies that are determined with the interaction of management, auditors, and the audit committee. They have also demanded specific analysis, enhanced disclosure of certain selected problem areas that particularly flowed out of the Enron factual situation.
The goal here and I'd like to open the discussion here is to have the eyes of the management be presented to the investing public. Warren Buffet, in Monday's comments, said, I think, what is very telling, and a right approach, conceptually, to take with respect to the disclosure process. What he wants to know is, what a CEO of a business that he has a major investment in would tell him in a one-on-one type of conversation about how that business is doing.
And how you get that information base into a public arena that has litigation associated with it, that has competitive aspects associated with that disclosure, is the challenge, I think, for those formulating policy dealing with financial statement regulation.
I discussed with the panelists earlier a concept that I thought maybe made some sense, in terms of those concerns, as well as providing more meaningful information, which I'll throw out for discussion. And that is that, as you know, in prospectuses, there are summary boxes at the beginning of prospectuses that highlight significant and important facts that the investment bankers and the company want to emphasize to the potential investors. Indeed, many people have suggested nobody gets beyond the box.
And one of the things that concerns me in the focus on critical accounting policies, and specific event-related items in MD&A presentation, is that it doesn't really deal with the trend concept, the driving factors of financial performance, the expected change in those factors, the critical risk factors affecting future performance, and how one goes about managing those risks.
And it seems to me those are very important matters that the investing public should be aware of. And one way of doing that, I think, that could be useful is to provide an executive summary at the beginning of an MD&A discussion that talks about the financial performance historically, in the context of what drove that performance, and prospectively in the context of what factors may change in the future that will affect that trend that is reflected in the historical performance.
And equally, the critical risk factors that may affect the business and how the company is going about managing that business. Phil, I'll ask you whether you have any reaction to that type of structure.
Mr. Livingston: Well, I like the idea in concept, and I think it could be tied in Rich made a great point about how investors worry about the future. When you're an executive, and you sit with your investors and talk to them, 90 percent of the questions they ask about are about the future. They don't ask about the footnotes and the past, they talk about the future.
So if it could tie in the discussion of what happened in this past year, and the implications for the future, or maybe even a discussion of the forecast in the upcoming period, which a lot of companies are making available themselves now, that might be productive.
I would warn that what we've done over the last 10 or 15 years to get where we are, we just piled on disclosure on top of disclosure. If you're just piling on another layer of disclosure requirements, I don't see how that helps anymore than all the all the other disclosures we've tried to pile we've piled on over the last 10 years. So the spirit is right, getting like Warren Buffet said, he said, "MD&A is useless" in the corresponding round table on Monday. And I agree with him. It's boilerplate, and it doesn't get to the key points that investors are concerned about, and it doesn't get to the key things that the management team is working on.
But what we're really trying to do is, get to quality in the disclosure, and that's where we've got to get out of this boilerplate, legalese kind of mentality. I think that technology solves a lot of these problems, I really do.
And I think that a lot of the data, a lot of the and Rich even mentioned this too, that there is a lot they provide a lot of other supplemental we provide a lot of supplementary data to analysts in other fact books, and other forums. And a lot of key performance indicators are already out there, and we need to pull them together in web-based reporting, and measure what's being used, and enhance what's being used, and get rid of what's not being used. I think technology has a huge role to play in reforming our disclosure system.
Mr. Cheek: Lou, this is right down the middle of your plate, whet you talked about value drivers. And how do you think those drivers can be adequately communicated to the investing public?
Mr. Thompson: Well, Jim, I like very much the idea of a two-tier system kind of a summary. Although I do recall back in the mid '80s when GM came to the SEC and said, "Can we write a summary annual report, and just mail out the 10-K," and the SEC, as I recall, said, "No problem." They did that, I think, once, maybe twice. But the reason the summary didn't fly was that the analysts and institutional investors were very critical of a summary report. They wanted to see it all in the glossy annual typical annual report.
We're in a different environment today, I think, and you could put the kind of summary you're talking about not only in the MD&A, but put it up on the company's web site, have investors be able to link to the more detailed information if they want it. Clearly, going back to your earlier question about who are we communicating with today. Well, obviously, the institutions drive the market, but the individual is very important component of that, even though, by size, they may not be all that significant. By number they are, but not necessarily by holding and influence.
But they should have access to that information to the degree that they wish. And having it in a summary form, and containing the things that you're talking about here, I think, could be very, very helpful to them, and I think that's a concept that we could certainly consider.
Mr. Cheek: Rich, do you have an observation.
Mr. Carbone: I think it's very fair to think about the current disclosures as being compartmentalized. Ray wrote an article a few years ago about that, that when you get through the footnotes, and the disclosure around liquidity, and the disclosure around capital, and you finish reading either the 10-K or the annual report, you don't get a holistic view of the company and you certainly don't get a view of where the trends are taking the company. I think a letter up front, a disclosure up front, by the management, the senior management not necessarily just the CEO by the management of the businesses about the company, where the company is headed, what the things are that the company is relying on in the future in order to achieve its earnings projections would be a wonderful thing to have going forward. I think to get there you're going to have to expand the safe harbor rules.
Mr. Cheek: And what about the competitive aspects? Lou indicates he has some academic support for the notion that that's well overblown, in terms of laying out in front of the public business plans, strategies, and driving forces behind value that is expected to be created in the future. Do you have any
Mr. Carbone: I think there's so much information out there about companies in research reports. We all read everyone else's research reports. It we all rely on much of the same economic outcomes in the future, in order to be in order to meet our earnings targets. I don't think it's terribly competitively disadvantaging us would terribly disadvantage us.
Mr. Cheek: Ray, I know you're the originator of the two-tiered system theory that dates back to 1994, and really, I guess, was based on a system that the U.K. had developed in the early '90s.
Mr. Groves: Well, I would just say, welcome. Welcome, to summary information. I think it's a healthy discipline. It's not easy to summarize a complex company and the things they do. And probably the first couple of attempts wouldn't be reaping any rewards for literature. But nevertheless, I think it is a good discipline. I think companies would get better at it as they kept doing it. And the talent is within it, perhaps just not the practice of putting it in that form.
I think these the SEC's release on critical accounting issues well, you have to decide which ones are critical. And you know, that's an effort to do. But certainly, back in other days when I was an auditor, before we issued a report, we said, "What are the major issues? What were the judgments? What were the subjectivities that people had to go through?" And let's make sure we concentrate some time on those one, and maybe eight items. There may be three items. And let's make sure we really understand those, and the impact on the financials.
And so I think anything like that would be very serving well-served to the investing public if they could be if they would have those things pointed out to them, so that they think about those things also, when they think about that investment.
Mr. Cheek: Yeah. I think really the key and I'd like Phil to address this, as well but the key is, what information you're really going to focus on. And to me, critical accounting policies is really a very useful focus, and I've been through audit committees already in which the hours of discussion have been extended dramatically by having a detailed presentation about those critical accounting policies. But I wonder if that's the right focus. If the better focus isn't the critical driving factors underlying the financial condition and financial risks of the company.
Mr. Carbone: I think, Jim, you hit a point that's kind of hot in the marketplace right now, but that companies are kind of struggling with defining how they should respond to this critical accounting policies disclosure. The spirit is right, and it's the right direction, but companies, some companies are just regurgitating their accounting policies in this discussion, and that's not the spirit.
The spirit of the requirement was to get at the key items, as you're talking about. Where did you make key estimates? Where did the application of a key accounting policy make a big difference in the year that you just reported? And that's what I think the Commission was trying to get at when they required this asked for this disclosure. But I don't think that's what's happening out there in the field right now.
I think let me make one point. We're talking a lot about principal. We had a good discussion about this with our CFOs and controllers last week. A good discussion about the application using more of a principals-based approach, to get back to substance in the financial statements, and the financial disclosure is what we've got to do. And we agree with that. That a principal-based approach is right. But more examples are from the Commission, from the FASB, from the accounting firm. More examples of exactly what you're we're trying to get at is what's needed to get to use that principal-based approach.
And let me make just one quick comment on the I think the use of the term, "two-tier approach" is a little I think Ray was way ahead of his time 8 or 10 years ago when he wrote the article about disclosure overload, and the uselessness of footnotes in MD&A. I mean, he was writing about in '94, Ray? I don't know what it was. '94 or '92. You were dead on a long time ago.
But I don't think we need a two-tier system. I think technology allows us to have one system where people can go as deep as they want, and we don't need to ingrain this notion of a two-tier system. That's just a point I wanted to make.
Mr. Cheek: Well, let me get back to the focus on critical accounting policies. The point I'm trying to make is that that is constrained by the financials. I mean, that's linked to the financial statements itself. Often, the real driving forces behind a business aren't really contained in those financial statements. They're intangibles, they're developmental aspects, they're contractual relationships.
I mean, what's really driving the business is sometimes very difficult to ascertain through financial statement analysis.
Mr. Thompson: Jim, I think you hit on a very, very key point here. And really, when company officials sit down with the institutional investors and have a discussion about the business, the kinds of things that you're talking about what drives value? What are the value drivers? What are the critical things that management is most concerned about? a lot of times that discussion goes into the realm of intangible assets and nonfinancial information.
I mean, the accounting professor Baruk Lev at the Stern School recently said that five out of every six dollars of market value of the average S&P 500 company cannot be found in the financials. And he and others have been working on this whole area of trying to identify these nonfinancial factors, and they're getting pretty good at it.
I think what's lacking out there is some kind of a structure for voluntarily disclosing this information, but we're in the process of working on that, with some outside help. And I think this is something that we really need to think about in this whole disclosure regimen, and it goes beyond the financial statements.
Mr. Livingston: Jim, could I comment on that?
Mr. Cheek: Sure.
Mr. Livingston: I think we you know, the financial statement should have pretty precise in fact, a much more precise statement of purpose. I think part of what's happened over the last 10 years is that we've tried to achieve too many purposes with the financial statements. The financial statements ought to be about helping the investor understand cash flow last year, and the implications for cash flow in the upcoming periods, and the company's financial position. That should be the essence.
But when you try to encompass too many objectives, as we've done, in my opinion, in the financial statements, you end up with the situation that we have today, which is opaque, not meaningful. I don't think the purpose of the financial statements is to help you understand whether a certain pharmaceutical drug in the early stage of testing is going to be successful or not.
There's a whole bunch of other market data and information sources that smart investors use to get that date. So I actually think we need to be more focused in the what are we trying to achieve with the financial statements.
Mr. Cheek: One of the criticisms directed toward financial statements and MD&As relates to the complex legalese and accountingese with which they're written. The Commission several years ago had an initiative to convert prospectus language to plain English. And particularly us lawyers types struggled with that concept. And the effort, however, I think, has produced clearer and more intelligible disclosures in those documents.
Can accounting, Ray, be reduced to plain English? Can you articulate these complex notions? And the second question I'd like for you to comment on, Ray, is the issue of whether accounting principals have become too rule-specific, too checklist-oriented, and therefore, provide the opportunity for creative notions, and products that fall just outside the rules, and aren't respected in terms of the conceptual underpinnings of the rule.
Mr. Groves: Well, going in LIFO order, I think the I think there
Mr. Cheek: Conservative accounting treatment.
Mr. Livingston: Jokes are prohibited.
Mr. Groves: It wasn't a joke.
Mr. Groves: I have the feeling, you know, that they've been too rule-specific. On the other hand, that's been a response to the marketplace. You know, the marketplace has said, "we'd like these very unique items to be addressed each time." And I don't think accounting will ever be able to keep up with the inventiveness of investment bankers, and so I think they're probably going to trail it, even in the specific area. I think that the specificness probably still has to be maintained, but there needs to be a much healthier recognition of something you said just a bit ago, Jim, and that is, recognition that sometimes you get so buried in so many specifics that you lose sight of the forest.
And there should be a requirement to step back and say, "Do we have" at the end of all this "Do we have fair presentation? Are we both measuring the things that really happened in a fair way? And are we disclosing them in a way through the MD&A and the footnotes that's going to tell somebody how we got to these decisions?" And I think the latter one, the stepping back, has not had its place in the sun at all. There is a rather obscure rule that says that it may be, in a rare case, that following GAAP would not produce a fair presentation, but that's not been looked at, or relied upon, or, let's say, initiated for a long time. And we probably need to change the nature of that admonition to a way that it becomes just part of the process of putting out financial reports, both for management, as well as for those who are reporting on them.
So in your first one, can accountants? Sure they can. They can talk plain language. You have to beat on them a little bit to do it. But we used to talk about $5,000 footnotes. And it's probably with inflation, that they're a lot higher now, but you know, there isn't any pride that accountants should take in trying to make things lengthy, and going down every little detail, but explaining what the purpose is. After all, the purpose of accounting is to take thousands or millions of transactions, put them into a summarized form so somebody can make a decision. I mean, it's not a complex task. It's complex getting there, but not a complex purpose. And we just lose sight of it sometimes. So I think accountants need the discipline of having to talk in plain language also.
Mr. Cheek: The notion of fair presentation is one that has a great ring of motherhood and apple pie about it, in the sense that everybody should be for a fairly presented set of financial statements. From the lawyering perspective, we all recognize fair presentation is a standard that most likely will be determined in hindsight in the light of events that may not have been anticipated or fully focused on at the time that the financial statements were prepared.
Is there a capability to provide some parameters of guidance, with respect to fair presentation matters, where issues arise outside of GAAP that might be information that would be material to understanding the financial condition or financial risks of the company? Is that something, Ray, that could be done, should be done?
Mr. Groves: I think it should be done. We have yet to see whether it can be done. I was interested to hear the work that Lou had said that was going on, in trying to produce, and disclose, and report on some of the "nonfinancial" factors that really have so much to do with the value of a company. I think there's no quick solution to that, but I think it's certainly the direction that we can and should go. Mr. Cheek: Lou, do you have any further thoughts on that?
Mr. Thompson: Well, if I could, you brought up pro forma earnings. As you know, the FEI and NIRI went together last April to put together some guidelines. We now believe that investors should get the GAAP information first in their news release. And then if a company feels a need to provide pro forma information to help the analysts or investors look at a company on a more consistent quarter-to-quarter basis, than that pro forma disclosure should be secondary in the news release.
We did a survey of 233 third quarter earnings releases last year. 133 57 percent used pro forma information. 13 of the companies didn't pass our guidelines. But we think that this should be strengthened, and put the GAAP information out there first.
We also recommend that companies that have these off balance sheet businesses disclose that information to investors in an aggregated form. And companies should consider broadly disseminating that information, preferably in a news release posted on the company's web site, furnished under an 8-K. But that disclosure should include the business purpose of these investments, what the current or special charges were recorded to set up that entity, contingent liabilities, if any, and what the impact would be on the earnings if they were consolidated.
We also believe, as the SEC proposed, that companies should report these insider transactions on a current basis. But there should also be current reporting of material compensation actions, such as annual option grants, instead of waiting for the annual proxy to be published.
And lastly, that companies should have formal window periods that govern when insiders may buy and sell securities, and the dates of those windows should be published, so investors know when they are. And I think these kind of suggestions would aid in the area of transparency that we're talking about today.
Mr. Cheek: Phil?
Mr. Livingston: Just one point. NIRI and FEI did put those pro forma guidance, but I think the things you just ticked off are NIRI recent additions, kind of, to that. But I would the issue of pro forma is a hot topic, and we did our two organizations took the financial professionals and the investor relations professionals went together and tried to put out a best practices. And we have.
But and I'll just speak for myself this is not a position FEI is taking yet, but we recommended in that guidance that companies provide a table that reconciles their pro forma numbers to their GAAP numbers. And companies are doing that in a narrative kind of way. But I think we need a table. I think investors from my talking to investors, investors will be finally they'll be okay with the use of pro formas, if we give them a clear table that shows the reconciling items from pro forma to GAAP basis.
And I think that we suggested that it be done in our guidance, but we didn't say it absolutely should be done. But personally, I think that would be a major improvement in the process right now.
Mr. Cheek: My observation, from reviewing a number of pro forma and financial presentations, is that there is a clear lack of consistency. Even though you have these guidelines out there, there are those that clearly create their pro forma information to try to articulate to the analyst community the reality of their businesses from their point of view of maximizing their value. And I think that it is one item that, while your guidelines are very useful in terms of providing guideposts, that the Commission may want to take some look at, in terms of providing interpretive advice, or guidance, or a regulatory action.
Mr. Livingston: Good examples.
Mr. Groves: Jim, I would just echo what Phil said. I think that it should be mandated reconciliation to the GAAP statements, and I think that would really serve investors well. I am certainly a proponent of pro forma information when it clearly explains what happened during the year, when something material that did not happen in a prior year, or an unusual or a change in accounting, or whatever it may be. I think those are very useful.
But sometimes over the last few years, some things I've read in just narrative form have rather offended me, by just the lack of completeness to them.
Mr. Cheek: Rich?
Mr. Thompson: And we too are in favor of pro forma when it serves that purpose. I'm not suggesting that, but we're just suggesting that it may be well for them to express their GAAP earnings first, even though GAAP may have its deficiencies as a system, but until something better comes along, that's where we think it should be.
Mr. Cheek: Would there be any usefulness in having commentary as to why the company believes that the GAAP isn't the right approach to understanding their financial business?
Mr. Thompson: Well, as I said earlier, the call for pro forma has also come from the analyst community, to aid them in looking at companies on a more consistent quarter-to-quarter basis, taking out the nonrecurring items. But sometimes nonrecurring becoming reoccurring, and that presents a problem also.
Mr. Livingston: Jim, it's a mutual effort. The companies and the analysts have jointly created this.
Mr. Thompson: Exactly.
Mr. Livingston: I mean, you could just put out your GAAP numbers, and then describe some items that happened in the quarter, and then the analysts will then pro forma your numbers for you. So it happens both but it's very much a mutual problem, that I think a tabular reconciliation would go a long way to making all parties satisfied.
Mr. Cheek: That's one set of perspectives that differ. The GAAP financial statements and the pro forma financial statements. There are others that differ out there, as well. For example, the tax accounting that is applicable to the company often is different than the GAAP accounting. And the most evident issue there is the deductibility of option expense, which is not captured on GAAP financial statements.
Is there any merit in having, as some have proposed to, that if you deduct it in the tax arena, you must reflect it in your financial statements? Is there a methodology where one has a reconciliation of that and, therefore, inform the public more definitively about the expense component of that?
Mr. Livingston: Are you asking me?
Mr. Cheek: Yes.
Mr. Livingston: That sounds like a hot-seat question for me. You know, what you have to recognize is that the tax system is built upon public policy. The tax system is not built to give an investor fair and full disclosure of a company's financial position. It is built on tax policy. The fact that the federal government decides to give corporations deductions for nonqualifying stock options, but then tax it at the individual level, and tax that gain at a much higher rate personal rate that's a tax there are all kinds of tax policy questions.
You know, if you flip it over, and you say, well, for book purposes, you force companies to write off in-process R&D. Well, on the tax side, you don't give them a deduction for that. If you did, if you synced all these things up, we'd have a gigantic mess. So you really have to recognize that the tax system is written for a whole different purpose than fair the objectives that I talked about earlier for the financial statements.
I do think there are some interesting, smart investors. Look, I was talking to some investors yesterday. They look to that tax note. They want to know, is the company paying cash taxes. If the company is showing book profits for five years, but in that whole time hasn't had any taxable income, they're very suspicious of the and that's a good piece of information. So there is some value to the disclosure, but I don't think it's practically possible to sync up, or meaningful to sync up the systems.
Mr. Cheek: Well, there's been a lot of public rhetoric in both Congress and elsewhere about the option issue, and indeed there have been business publications that have produced tables that show what GAAP earnings were reported as, and what GAAP earnings would be if you deducted the compensation expense associated with the options. Is that relevant information at all?
Mr. Livingston: Jim, in the footnotes today, we measure.
Mr. Cheek: Right.
Mr. Livingston: We pro forma net income, and we pro forma EPS in the footnotes to the financial statements. I can tell you it's not used. CFO's don't get questions about that data. That data is meaningless, because the methods we have just like in the Enron case, the Enron case highlights a very important issue in accounting today, and that's fair value accounting, and mark-to-market accounting. The things that aren't actively traded on an exchange, or in a very liquid market are very difficult to value. And stock options that have incredible restrictions on them, and aren't actively traded are very difficult to value.
And in general, we don't things that are difficult to value, we don't measure them. We don't put them in the financial statements, is the bottom line. So I think this stock options is more of a governance issue. And what we're FEI is trying to work actively to get shareholders the ability to vote on all stock options plans, and that's where we'll need to move on this front.
The other thing I wanted to say is that we do have diluted stock options are included in EPS. Everybody ignores this, but when you have if you have in-the-money stock options, you have to add those shares into the outstanding shares, and that goes into EPS. So it is in the income statement.
Mr. Cheek: Rich, do you have any thoughts about that?
Mr. Carbone: I have to agree with Phil. I don't think we should be expensing that the value to the individual of the stock option. There are several reasons. One is, it's going to be out of period. It's not going to relate to the period it was issued. It may not come in the money until the very end. And then what did you do, you take the entire charge in one period when it comes in the money.
And Phil's other point is, it dampens the growth in earnings per share, and that growth in earnings per share is what's most important to the investor.
Mr. Cheek: Let me ask you, Rich, another observation that same have made is that one of the most important driving, planning tools of a business are the budgets created internally, and the incentives created internally that are bonus-driven incentives, or performance-based incentives. And oftentimes, the variances of budget versus actual results are the subject of significant board discussion.
Is there a manner by which that could be disclosed in a meaningful way, that helps an investor understand what the driving challenges are for the business going forward?
Mr. Carbone: Well, again I hate to keep repeating the safe harbor expansion needs. In order to give more forward-looking information, and a plan, a two-year a one-year plan or a two-year plan, depending upon the company's planning cycle maybe more is critical to an investor, but it's also volatile, and not necessarily a sure thing. It's certainly not a sure thing.
If the safe harbor rules were expanded, I think it would benefit both the company and the investor for management to disclose what it is relying on in the next year, the next two years, the next three years, in order to meet its earnings targets. Not necessarily give out those exact plans, but indicate what margins were necessary, what sales were necessary, what national trends if it's a domestic company, or global trends in a global company that the company was relying on in order to have earnings growth and ROE growth, and maintain its ROE.
Mr. Cheek: I think the key to that is, as you suggest, to make sure that those are done responsibility, with reasonably based assumptions and presentations, and reasonable protections surrounding those disclosures if that is the actual fact.
Let me ask another question to you, Lou. Some companies produce mid quarter reports. This isn't by any means a prevalent practice today, but some companies have as a practice of issuing mid quarter reports that reflect the current trends of the business, and the expectations that are associated with their previous commentary, in terms of either projected ranges of earnings, or in their contemplated business plans.
Do you see that as a useful device? Is that something that should be considered in a more global way?
Mr. Thompson: Well, it's actually last year it was a lot more prevalent than one might expect. I think roughly half of the of our members put out mid quarter reports. And a number of them also webcast those, their conference calls surrounding those reports. Because you know, basically under Reg FD, anytime you're dealing with earnings guidance, you're dealing with that in a fully public way in a public forum.
It also goes back to the issue of a duty to update. And while the lawyers may argue over whether that duty to update is as solid in case law as, perhaps, a duty to correct information, we believe, and we've said in our standards of practice, that it's both good business and good investor relations to update these material changes, particularly in guidance, in earnings guidance.
Now, I realize that there are some firms that say to their clients, "Put your numbers out, put your guidance out, and then just go silent for the rest of the quarter." But isn't there a problem if you're leaving material guidance out there that is changed in a material way, where investors are looking at that earlier guidance, maybe making investment decisions on that earlier guidance, when you know full well that it's changed in a material way. And I think this is one of the things that's driving companies to do these updates in mid quarter.
Mr. Cheek: Even if you don't have guidance, isn't the reality in many businesses that two months into a quarter, there's a pretty good sense of the direction of that quarter, in terms of how it's going to meet expectations that have been created in former disclosures?
Mr. Thompson: Well, you know, I think that varies a lot by the company and by the industry. I would say that, certainly, in a number of instances, companies by mid quarter have a pretty good sense. The problem we have and this is one of the things, I think, that kind of generated some of these mid quarter reports was some, I'm not sure you can call it guidance, but was in some discussions coming out from some SEC officials, indicating that much after mid quarter, you had a good sense of where things were. And if anything changed, then you had an obligation to say something. Or you could not confirm your earlier guidance in a one-on-one discussion with an analyst, without doing that publicly.
We think it should be more company-specific and fact-specific. I mean, companies even as big as IBM don't have the kind of numbers until late in the quarter to say where they are in that quarter with any assurance, in terms of putting out a news release that has enough facts in it about where your are, to avoid putting something out that leaves a lot of black holes, and a lot of room for speculation.
Mr. Cheek: I do think that is a weakness that exists in terms of both mid quarter reports, and a disclosure system that is the banner disclosure system that is constantly running across the company's web page. That businesses are not static. They're very dynamic organizations. Their financial business moves forward in ways that are not able to be captured in a single snapshot.
And I think that to have the overarching duty to have continuous rapidly, simultaneously, contemporaneously, whatever the words were disclosure is a very difficult system to really be informative, because I think the disclosures would be so riddled with caveats, and with careful language, that their meaning would be dissipated. Rich, do you have any reaction to any of that?
Mr. Carbone: I absolutely agree. I think you could confuse the marketplace if, in mid quarter, you report on the quarter. I guess you could report on the two months, but now we're talking about reporting more frequently, as opposed to updating quarterly results. I actually think quarterly reporting is the appropriate period to report.
I think the timeliness of it is also okay. I think management needs to speak more to the drivers of their earnings in each period, discuss how those drivers played out in the period and affected those earnings, and how they expect them to play out in the future. And if things change in the quarter, I still think management I still think it's worthwhile waiting to the end of the reporting period, but then link back, and describe what went different than what was expected when you have all the information.
Mr. Cheek: Phil?
Mr. Livingston: I think that those performance indicators, or those drivers, and those trend data, you know, if we could get to a if the exchange could give some kind of guideline guidance, a broad principal, again, to establish that companies should disclose these kinds of things. And maybe it's in the website.
Maybe if the 10-K or 10-Q tells people where this is, it forces them to disclose that they either have it or not, and where it is in the website. And if then companies begin to pull it together, all the stuff that they're currently already disclosing, I think over time we would it would grow, and it would get enhanced, and get focused, and actually add to the disclosure base that we're trying to more current, more of the drivers, more relevant reporting.
Mr. Cheek: Let me ask one last question in this section of the T's, which is that some, contrary to the two-tier system that we've been discussing, suggest that a lot of the current disclosure requirements are not useful at all, and that there would be positive impact on the clarity and transparency of the most relevant information if the SEC and the FASB attempted to weed out some of the disclosures that add length without adding value.
And some examples have been given with respect to employee benefit obligations, and even the tax section as being part of that irrelevant literature. From your point of view, Phil, is that a useful exercise to engage in?
Mr. Livingston: You know, if I had my druthers, I think I'd throw out the whole if we could rewrite the world, I'd throw out all the accounting standards, and all the disclosure rules, and start over, start afresh with a clean slate and clean and thinking about technology, and what investors really need. I don't think that's not practical. I also think, in the short-term, in the environment we're in, reducing disclosure is not going to go over with investors right now, and we need more investor confidence.
I think that the way to achieve this is and I've said this before to get our financial reporting on the web, and measure what is watched, and what is used. We can measure. You can do that through technology. We can break our financial statements up, and measure exactly which data items are used, and then get rid of the items that aren't used, and enhance the items that are used heavily.
And I think cash flow reporting, for instance, is one that is used very heavily, and we could expand disclosure around cash flow reporting. So I think technology is I think we have to start measuring what is used.
The problem in the dialogue between users and standard setters is that users always want more. Analysts always say they want more, more, more, more, more, and there's no looking back at what we've put into the pile, and thinning it out. There's no willingness to do that.
Mr. Carbone: I was just going to say more is not necessarily better.
Mr. Cheek: Rich, do you think that what Phil just articulated is achievable, from your point of view of creating that information?
Mr. Carbone: No, I don't. And Phil's caveat at the end of what he said, that he didn't think it was practical. There's too much stuff already embedded in the world today to report the way we report. But also, I disagree with it at the root-cause level. And let's take the pension footnote, or the tax footnote.
Take the pension footnote. It's a pretty routine footnote disclosure, but inside of it, as we've seen in the last year or two, we have companies reporting pension income. Now, if you didn't have the pension footnote, to look at that noncash earnings generator for companies and it's significant in a lot of companies today.
So I think footnotes are important, and the ones we have today. I wouldn't necessarily throw any of them out. I'm sure there's an exception here or there. But the funny part about them is that from time to time they come back into play as being really important, such as today, the pension footnote and that pension income that many companies are recording, if you know where to look.
Mr. Cheek: Ray, you're experienced over many years, from both the accounting side, and now on the board side at reviewing financial statement information. What observations would you have that reflect on better disclosure? More disclosure? Less disclosure? More focused disclosure?
Mr. Groves: Well, the concept of a two-tiered disclosure probably means different things to different people. I think the way it was being promoted several years ago was not at all to reduce the quantity of disclosure, but just to where it was located. That was prior to the wide use of technology, and Phil points out that exists today, and will exist even more so in the future.
But the idea of actually either just critical items, or summarizing a few highlights of the pension, rather than two solid pages of 2,500 words, but just get a couple of critical things. What was the expense, or income, as you point out, for the year? And what's the unfunded obligation? And all the other actuarial information, et cetera, that piles onto the annual report could be in the second tier of information.
So I didn't mean to suggest, and I don't think many other users meant to suggest we were going to remove anything, because that does seem to flow against the tide. But it's how it's located so people can use it, so you don't have to plow through thousands of words to get to the key items that you're interested in.
And if you're interested in more, then maybe through a hyperlink or something you could get just that information, if that's what you wanted, and you could probably then do the compare that with 10 other companies, and see what they're doing in that area. So I guess it's we're talking somewhat more mechanics in what I was saying than, perhaps, substance.
It would be wonderful if you could do it. Phil first said it, if you could start with a clean slate, and not just add it to what we had. But that doesn't seem, as he said, very practical right now. It's still something we should leave on the table though.
Mr. Cheek: Okay. Unless anyone has anything further on that T, I'd like to move to the next T of my trio, which is the transformation of the process by which financial disclosure information is produced and monitored and overseen.
The current and the old system had three components to it. One, management generated financial statements, auditors audited financial statements, and audit committees oversaw the process of financial reporting. It was not a cozy relationship, but it was a balanced relationship, in which parties felt comfortable with the process, until the last couple of years.
And obviously, now with more intense media focus, regulatory focus, Congressional focus on responsibilities, each of those parties, everybody has a heightened degree of angst and sensitivity about the process of producing financial information.
And I'd like to engage in some discussion about some of the proposals that have been put forth in trying to enhance the checks and balances that are inherent in those parties providing oversight and production of the financial system. And I'd like to start, really, Rich, with the executive side of the ledger.
The obvious beginning of financial reporting systems is within a corporate structure, headed by a chief financial officer, often in many companies with an internal audit process that's associated with that. There has been a suggestion that one way of assuring more credible and transparent, and accurate financial information is to heighten the stakes of the game for the executives involved in that process.
Commissioner Hunt has left, but Commissioner Hunt in a speech at SEC Speaks suggested that there be a significant monetary penalty that would be imposed on any CEO or CFO that was associated with inaccurate books and records.
As you know, the secretary has articulated a view that one remedy for some of the abuses is to lower the standard of liability for executive officers, as well as directors, from recklessness or intentional conduct, to mere negligent conduct. Do these would these things help?
And I want to get to Phil, and talk about his code of conduct that he has for executives in your position. But first, I'd like your thoughts about whether, if those things came to pass, would you be submitting your resignation, or would you be more heightened in your responsibility?
Mr. Carbone: I would do neither. I think today you know, we have some current situations that have happened, that have caused this to come to light, but I think most financial offices and most chairmen try to abide by the rules day in and day out. I think if the marketplace upped the ante and their risk in it, they'd still execute their duties the way they execute their duties.
I did have one thought on this, and I had this thought back in December, and that was, should the financial officers of a company the chief financial officer and the controller should they actually have stock in the company? And that's a question. I have wrestled with the answer. I think not. I think that's really an outlandish statement at this point, but I don't think the chief financial officer and the controller's compensation should be tied to the stock price.
But again, in executing my duties, or and the chairman and the rest of the management, I think everyone will behave, and 99 percent of American executives and CFOs, and controllers, and other financial officers behave in the same.
Mr. Cheek: Let me ask you this. There has been a lot of media discussion about some of the executives that have been involved in some of the financial fraud situations. Senior executives, CEO executives, claiming that they weren't accountants, they didn't know what was going on down there.
The suggestion of secretary O'Neil was that if you impose this higher potential liability, those CEOs would pay more attention. And I couple that with Warren Buffet's suggestion at the roundtable on Monday that the CEO really ought to be the chief disclosure officer of the company, and have the ultimate responsibility for assuring that the disclosures were accurately presenting the financial condition and financial risks of the company.
Mr. Carbone: Yeah, I think that's a full-time job. I think it's the full-time job of the chief financial officer and the controller. Probably more the controller than the CFO, but if somebody has to step into that role as being the chief disclosure officer, it's going to have to be the CFO. The CEO has to run the company. He has to pay attention to the businesses. He has to pay attention to the competition. And he has to pay attention to his investors.
Mr. Cheek: Do you have any and then I'm going to ask Phil to comment on all of these, as well as the FEI's code of conduct but do you have any sense about the impact of the presentation of financial statements, and the audit of those financial statements if the CFO is an alumnus of the independent auditor?
Mr. Carbone: I do. We I think the as an alumnus, as an I am an alumnus of Pricewaterhouse when it years and years ago, and Pricewaterhouse are our auditors. I think it's a matter of time. I think it's the distance between when the alumnus was an auditor on the engagement. And the level.
I certainly think perhaps partners and senior managers there would have to be a long curing period before they would move into the role of the controller, or the chief financial officer of the company.
Mr. Cheek: Phil, tell us a little bit about what's going on. I understand the code of conduct is under review. And how do you think you will approach it?
Mr. Livingston: Let me preface it by saying that these over and over again, we find when these failures happen, they are an ethical and moral failure on the front line amongst the management team. And I think recent cases bear that out. One issue that I'd love to hear the panel's comments on is, we haven't had good enough, or strong enough prosecution of some of these failures over the last 10 years, frankly. I mean, we've got a whole existing set of criminal and civil procedures, but if somebody makes $600 million and they pay a $300-million fine, it's la de da.
I had an investor say to me yesterday, a big portfolio manager say, "You know, he's out playing golf with my money, and he's still out there." So we've got to have we really do, in our group, and financial officers, you know, it's one or two percent of the culprits that cause us a whole lot of pain. And we have to using a little street talk we have to hang em high when this stuff happens.
And so that the if somebody's sitting there and the rewards on the upside are huge, and the downside is not that not great enough, they're going to some, without ethical or moral backbone are going to roll the dice too aggressively. So we do have to make the penalties tougher in the bad cases. I'm not sure. In fact, I'm not for secretary O'Neil's reducing the standards. I think that's a tough one.
But if you'll indulge me for give me one minute on our every member of FEI, all the financial officers have to sign a code of ethical conduct. And Chairman Pitt suggested we review it in light of what happened in Enron, and make sure that it's still applicable.
And I can our work is still open on this, but I can tell you the one interesting thing you might be interested to know, Chairman Pitt, is that we're going to add a really, the code was very good as stated, and I'll read a piece of it here to you in a second, but we're going to add a section that says the chief financial officer has an additional special duty to promote ethical conduct within the company, to go further. Not just ethical conduct for himself, but it's about the tone at the top, it's about the tone and the culture at the company. And the financial officers have a special duty to promote a good tone, good ethical conduct.
But I'm going to just read you a few sections from the code, and think just think about Enron as I read this. "Senior financial officers hold an important and elevated role in corporate governance. While members of the management team are uniquely capable and in power to assure that all stakeholders' interests are appropriately balanced, protected, and preserved."
And then down in the code there are two key points of the code that I'll read to you. And just think about what went on. "All members of FEI will act with honesty, integrity, avoiding actual or apparent conflicts of interest in personal and professional relationships." That's the first bullet in the code of ethical conduct, number one.
And the second one is, "to provide constituents with information that is accurate, complete, objective, and relevant." I think both of those those are the two top points in our code of ethical conduct, and a little adherence to that in some of these cases would be good. I'll tell you that we're going to I'll just wrap up by saying, FEI is in the process of putting together a set of reform proposals. One of our top reform proposals we don't it's not that they should all join FEI. That's not what it's about.
But we think all financial officers should sign a specialized code of ethical conduct like this. This one, if they want to, or modify this one. They should sign it, and give it to their audit committees.
Mr. Cheek: Yeah, Lou?
Mr. Thompson: The NERI board of directors next week, at our meeting in Houston and it wasn't necessarily planned that way but will be approving a new code of ethics, and it's going to be put very much like the FEI's. "And I will," da, da, da, da, da. And it addresses a number of the same issues. We think this is very important.
If I could make one suggestion with regard to the from the executive side. One suggestion that we have is that the SEC may want to examine this section called, in the 10-K, "management responsibility for financial reporting," and consider whether that should cover all of the written disclosures, whether it should be required instead of optional, as it currently is, and perhaps whether it would require management to formally affirm on a quarterly basis, instead of annually, that its disclosure is complete and current.
And as a final thought, it goes to the role of the board of directors in protecting their shareholders' interest. But whoever has responsibility for investor relations, whether it's a CFO doing it in a small company, or the person with that title, the senior person perhaps should be required, just as a company's internal auditor is, to meet with an independent committee of the board to report directly on what the investment community, institutional and individual, are saying about the company.
I've heard people who are directors who don't see all the analyst reports that are coming into the companies. And it seems to us that this would be a good early warning for boards if there is trouble out there, because our people are going to hear it first.
Mr. Cheek: Well, there are several points you made, which I think are quite good, and deserve further discussion. One on the content of the management report that's associated with the periodic filings, and whether the management, the CEO and the CFO particularly, should be required to sign and file an expanded sort of affirmation of due diligence with respect to the completeness and correctness of the information. Rich, do you think that would be useful? Or it would just create more potential liability?
Mr. Carbone: I don't think it would create any more liability. I don't think it would be particularly useful. The principal officer, the chairman of the board, the CEO, and the controller all sign the 10-K. I think the liability already exists.
Mr. Cheek: Yeah, I agree with you. There is statutory liability associated with the principal executive officers and the board that stand behind the 10-K. However, the others have suggested that there's a useful focus and discipline associated with the process of signing a specific instrument that as opposed to a signature page of a 10-K, which gets passed around the board room.
Mr. Livingston: Jim, could I comment?
Mr. Cheek: Yeah.
Mr. Livingston: Because we've long supported mandatory inclusion of the management responsibility report. And I don't know exactly what the numbers are, but I would estimate that about 70 percent of the S&P 500 already include a management responsibility report, but it would be a good step, I think, to require it. And too many CEOs down on the smaller companies don't particularly understand that it's their set of financials. They're responsible for the control environment, and they're responsible for the ultimate production of the financial statements. Too many of them lay off the responsibility on the auditor, and they think it's the auditor's responsibility, and it's not, it's the management team's responsibility.
Mr. Cheek: Let's focus a minute on the audit committee's responsibilities. And Ray, as a member of audit committees, I'd like for you to think about a couple of issues in connection with the enhanced focus on audit committee roles of overseeing financial statements, and the amount of time that might be required to really, in depth understand the areas of the financial statements that reflect risk, or prospective financial condition problems.
Should audit committees consider in this new world, because of those time demands, and the necessity of drilling down, perhaps more deeply than historically had been done, particularly with respect to critical accounting policies, engaging other professionals, risk management professionals, forensic accountants, or selected accounting advisors that would assist the audit committee in its work, and help it in a way that provides a greater degree of independent review than perhaps is given in the context of current practice?
Mr. Groves: Well, certainly, your first initial point about time requirements, they are increasing, and I think that needs to be acknowledged, that whatever the time frame of a typical audit committee structure during the year, if it's four meetings at one or two hours each, we shouldn't kid ourselves that we're going to add more responsibility, or more in depth examination of various items in the same time frame. And if you just acknowledge it, that we'll have to spend more time, and I think the people will be willing to do that.
As to whether there should be yet further outside parties come in, I would leave that on a case-by-case basis. I mean, I think there perhaps some, and, I would think, a minority number of companies where that might be useful, that once a year you bring in somebody with a particular expertise. But the majority of companies that I'm familiar with and that's not the majority of companies I don't believe that would be necessary.
I think additional time on the part of the audit committee and, obviously, more preparation by management, by internal auditors and by external auditors to recognize the different environment that we're in today, should handle most of the situations. But I believe most charters that I've seen published in the proxy statements, as they started to do last year, indicate that the audit committee has the perfect right to bring is such experts as they think may be necessary to assist them in what they're doing.
So I think most of the occasions or mostcompanies have that authority at this point, probably use it infrequently, and maybe in today's environment they may find more occasions, but I don't think there will be a large number.
Mr. Cheek: One process that, at least in my experience, has not been used, but is being revisited, is a process that permits the auditors to review MD&A, and provide comments and cold comfort with respect to the information in that, in accordance with SSA-8. Do you think that there ought to be consideration to there being more of an audit function with respect to MD&A discussions? And would you believe that the review under SSA-8 is sufficient to provide enough of a review to give you a balanced perspective about the accuracy of that information?
Mr. Groves: I think what I've seen in the limited number of cases that I'm involved in, is that there has been more time spent by everybody in the MD&A. It's to, for the most part, I think, the advantage of the investors, because I think the quality, as well as the quantity, has improved. But I don't know that we have to go I don't think that's been a problem.
I think we'll see in this reporting season if, in fact, that becomes more burdensome, or more time-consuming than we already see it is, in which case then maybe it has to go to maybe a lengthier report that's more comprehensive than exists today. But I would rather let's see this reporting season go through, and see what comes from it.
Mr. Cheek: One other issue that I wanted to focus on is the role of the internal audit function in the corporate reporting process. That is not a highly visible role, from the public's point of view. There's not any internal audit or report that goes out in connection with the financial information. Internal auditors do report to the audit committees, and in a number of cases have information that's particularly critical with respect to financial risk.
Should there be an internal audit report that is associated with public information?
Mr. Livingston: To put it softly, if we want to kill the effectiveness of it, yeah, let's make it an external you know, great companies have great internal audit functions. And the reasons they're great is, they're independent. And the things that companies are most worried about, they send their internal auditor off to work on these things, and protect their control environments, and check these things out.
And I think if we had external reporting of what the internal auditor was doing, I think that would really diminish it. And, I would kind of add, a pile-on a little bit of the auditing of MD&A. MD&A is almost useless now. If we want to make it completely 100 percent useless, let's audit it, and force it to be so sterile, and very, very accurate. Very, very accurate, useless information.
Audience Participant: Mr. Chairman, what about taking a question from the floor now?
Chairman Pitt: Our purpose here is to get through the discussion.
Mr. Cheek: I think if you have a question, you can come after we are completed, and we'll be glad to address it. It will be at noon.
There have been a lot of issues audit committees are considering with respect to the auditor audit-client relationship. Ray, would you have observations about the providing of nonaudit services to audit clients?
Mr. Groves: Yes, I have some thoughts on that. I don't want to take away from Judge Sporkin's panel this afternoon, but I think the definition of nonaudit services has been one that's been fairly flexible. The SEC's requirements that went in last year put in even the statutory audits for European entities and pension plan audits that you really have to do as part of the service, as nonaudit services, so there are some things classified as nonaudit that are very audit-related. And at least when I became a CPA, I had to answer tax questions. So once, for a while, I was actually giving tax advice. And so I think that's certainly okay.
I testified two years ago that chairman Levitt had that I thought that he was onto to separate these huge IT businesses away from the audit business, and that the providing internal audit services, other than maybe filling it when somebody was missing or something, on some minor way, was the way to go. So for the most part, that was what was proposed, but did not reach the final stage of regulation I supported. So depending on the definition of nonaudit, there are things that I agree are better separated, but there are things that are called nonaudit today, that I think belong with that service.
Mr. Cheek: And I'd like to ask one further question, which is the suggestion that has been included in the legislation and others, about the banning of audit firms after a period of year in terms of mandatory rotation. Do you have any view about that as to whether that's a good policy for an audit committee to adopt?
Mr. Groves: I probably have stronger views on that. I don't think that's a good policy, because just going on some boards myself, it takes a while to learn a company, and learn about what a company does. And back when I was practicing as an accountant, certainly the new engagements were challenging,. They were difficult, because there was just so much to learn in a period of time before you had to report on the statement. So I think there's a vulnerability on the early stage, and probably a vulnerability on the latter stage.
Sometimes it helps put it in perspective if you take that same suggestion and apply it somewhere else. I mean, if we were going to suggest rotating boards of directors, you know, you start to get the perspective of, does that make sense? Is it really adding to the process. I don't think you can legislate integrity, and I think we need integrity, and I think we have to get it in the ways that we're accustomed to getting it.
Mr. Livingston: Jim, I would just add on to that. I don't think auditor rotation is it would decrease the effectiveness of the auditors, not increase it. I do think that a good audit committee, a good proactive audit committee may, as they look at it and they may be at a time where the business is fairly stable, and the risk is not so high, and they may think that it would be good for promoting the independence of the auditors that they should change it out. And so I think good auditors I think audit committees are going to start thinking about their role in ensuring the independence of the auditors, as a result of what went on. And that could be their proactive rotation, at a time that's appropriate, maybe when the partner is changing, maybe when the business is pretty stable and things are okay, that would be helpful.
Mr. Cheek: I want to pick up on one point that Lou made, and then I'm going to ask each of the panelists for their opportunity to sum up their thoughts about financial disclosure reform. Lou mentioned the prospect of investor relations reporting to the audit committee, and providing the information that is communicated to the analyst community. I think that's a really first rate idea.
But in addition to that, I think that there is an obligation now of audit committees to understand exactly what commentary exists out there with respect to the financial statements of a company. And management needs to proactively provide that to them, whether through the investor relations group or otherwise.
There is an awful lot of analytical commentary that is in the media today, and in the forces of market communications that exist out there, that are critical of accounting policies. Audit committees ought to be aware of those, and have discussions about those with their auditors and management. So with that, Lou, I'll ask you to start some, and then Phil, and go down that way.
Mr. Thompson: Okay. Well, I think we've got really a wonderful opportunity at this point in time to take a whole look at the content issue that we've been discussing today, and in our various worlds, carry on that discussion to see how we can make better the content of what we're providing to investors. Clearly, we have the technological means today to deliver information on a real-time basis.
Before the internet came along, and even now, very few individual investors had a wire service terminal in their home, but now they, in effect, have that with the internet. And so we've got the means to deliver. I think the content issue, though, is highly important, and if we could kind of start with a clean sheet of music, so to speak, and examine that, I think it would be a tremendous idea. And we will certainly do our part in carrying on the discussion in our various forums.
Mr. Cheek: Thank you, Phil.
Mr. Livingston: I'll just try to tick off. We've talked quite a bit about some of these points, but I think we do collectively need to improve the quality of financial reporting disclosure. And we've got some great case studies to learn from here. But it is quality, not quantity, that I think needs to be worked on.
I encourage the SEC to work on key performance indicators, and give examples of the kind of thing they want to have. I encourage them to make this on a voluntary basis at first, but ask companies to disclose whether or not they are doing that. I think that will have the effect of making many companies do that on a voluntary basis, and it will be more useful. I don't think you can define key performance indicators. You need to let companies and industries define that in a competitive manner.
I think we need to move to more web-based reporting. I've probably talked about that too much. I think we need to move toward greater emphasis on cash flow reporting. If you talk to a good CFO controller, they say you can't mask the lack of earnings in the cash flow statement. The cash flow statement needs to be more emphasized, better measures of EBITDA, cash flow per share, cash flow from operations. More emphasis on cash flow.
I think we need to get back to principal-based accounting standards and principal-based SEC rules, with examples that emphasize substance over form. I think we need to recognize that our investors are interested in the future more than the past, and we need to incorporate that into our disclosure model. And I think, as Rich has said many times, we need to provide stronger safe harbor for key performance indicators, and other futuristic kind of measures that would enhance investor knowledge.
Mr. Cheek: Rich?
Mr. Carbone: Management is responsible for explaining the results of their company to their investors. I think that today we stand behind, a bit, the rules of MD&A, and the rules of the footnotes. I think if we have a little more room in safe harbor, management can do a much better job of explaining the profit dynamics of a business, both what went on during the year, and prospectively.
But again, we need a little bit more room in the safe harbor to get there, and not just sticking behind the cookbook.
Mr. Cheek: Final word, Ray?
Mr. Groves: Again, I would applaud all the efforts that have either been suggested, or already pronounced by the Commission. To summarize, to focus on the critical areas, the subjective areas, the things that really make material differences in the financial statements.
And then, hopefully, look again at making that the first tier of information, and the extra information that's not required for those material judgments into a second tier, yet to be defined as to the location of that. And I certainly applaud the work on pro forma information. And I would like to see a reconciliation to GAAP mandatory.
Mr. Cheek: Thank you. I'd like to thank each of the panelists, and I thank Commissioner Glassman for being with us, and Mr. Chairman, we appreciate the opportunity to chat about these issues, and hope you found it of use.
Chairman Pitt: Well, I very much want to thank Jim and the panelists for devoting their time, and giving us the benefit of their ideas. We're going to take a break until 2 o'clock, and then we will reconvene with a panel on auditor regulation. Thank you all.
(Whereupon, at 12:00 p.m., a luncheon recess was taken.)
Panel 2: Assuring Adequate Oversight of Auditing Function
Chairman Pitt: This afternoon, we have a panel discussing the regulation of auditors, and we're very pleased to have the Honorable Stanley Sporkin to lead our discussion. So Stan, we'll turn it over to you.
Judge Sporkin: Well, good afternoon Chairman, and Madam Commissioner. I first, obviously, want to commend the chairman and the Commission for holding these extremely important sessions. What people, I think, forget is that the accounting profession is key to this nation's financial reporting system.
This is not like the airline security system, where Congress says one day, "Well, we're going to have federal airport security people." I think is it fair to say that Congress is not going to mandate a system of federal auditors. So that the point is, the system is here, and we've got to deal with it.
And today we've assembled this panel to discuss how we're going to what is going to be the oversight of this system, and for in connection with that, we've assembled the following people. I see that Mr. Glauber has arrived, and we're ready to go.
Let me just introduce the panel. Mr. Neil Lerner is a partner at KPMG, and chairman of its ethics committee, and the ethics committee of the Institute of Chartered Accountants in England, and also in Wales. That's impressive. Mr. Lerner joined KPMG in 1968, and has worked on a wide range of clients, specializing particularly in the aerospace and defense and electricity sectors. He now heads up risk management, and practice protection for Europe, the Middle East, and Africa.
Mr. White is currently director, corporate governance for the California Public Employees Retirement System, known as CALPERS. He is responsible for its focus list program, and proxy voting. He also oversees the managed corporate governance strategy, which currently constitutes a combination of extension managers, and internal management, with a total of approximately $3 billion allocated.
Formerly, Mr. White was an investment officer in the California state treasurer's office, and was a deputy state controller under treasure Matt Fong. For three years Mr. White represented treasurer Fong on the board of administration of CALPERS and the California State Teachers Retirement System. And don't ask me what CALSTERS. Oh, I guess CALSTERS, CALPERS. All right.
Mr. Robert Glauber. He became the chairman and chief executive officer of the National Association of Securities Dealers in September of 2001. The NASD is the securities industry's largest self-regulatory body, the regulator of the NASDAQ stock market, and the parent of the American Stock Exchange.
Mr. Glauber served as undersecretary of the treasury for finance from 1989 to 1992. Prior to that, he was a professor of finance at the Harvard Business School. After leaving the Treasury, he was a lecturer at Harvard's Kennedy School of Government. In 1987, he served as executive director of the task force on market mechanisms known as the famous Brady Commission. Mr. Robert Glauber received his BA from Harvard in economics, and his doctorate from Harvard Business School. So it's doctor Glauber. He joined the school faculty in 1964, specializing in corporate finance and investment banking. In his last years on the business school faculty, he was faculty chairman of the school's advanced management program for senior executives.
Now, where is Mr. Macey's here? Oh, right here? All right. It's right where it should be. Professor John Macey. He graduated from Harvard in 1977, and then went to the other law school at Yale in 1982. He was a law clerk to the very famous Henry J. Friendly, who is becoming famous again because of the chairman who keeps quoting from Judge Friendly's opinions. Judge Friendly was one of the great jurists of all time. He is the J. Duport White professor of law at Cornell Law School. He's on the legal advisory committee of the New York Stock Exchange, and he has an honorary doctorate from the Stockholm School of Economics.
Now, gentlemen, let's see what we're going to do here. Remember, Mr. Chairman, how you used to help me when we used to do cases together, but he knows me now. All right. Now, let me the one thing that I was I'm instructed is, not to get controversial, so I'm not going to get controversial, and I'm going to make a nice I'm going to quote from a professor William Sternberg, who had this to say in a book he wrote in 1992.
He said, "Nor did the new securities laws of 1933 and 34 provide the money to pay the auditors. So companies hired and paid their own watchdogs, a situation that has been likened to authors being able to pick their own book reviewers. To use another analogy, imagine if the meat you buy at the supermarket were inspected not by the U.S. Department of Agriculture, but by private inspection firms hired by the meatpackers.
"Suppose these private defined their task as determining whether the cows are being slaughtered in accordance with generally accepted meat packing principals, or GAMP. Suppose further that if an inspector happened upon a blatant violation of GAMP, he would be obliged to report it not to the grocery or consumers, but to the management of the meatpacking company that hired him to do the inspections. If management disagreed with the assessment, the inspector would have to decide whether to see things management's way or to walk off the job, allowing another inspection firm to pick up the business."
Now, Mr. Sternberg says, "That may sound like a complicated recipe for allowing a lot of rotten meat to make its way to the market, but it is approximately the system that has evolved for inspecting the financial statements of this nation's major corporations. Like any system premised on biting the hand that feeds it, this one hasn't worked very well." And that's what he says.
Now, what we're going to do is, I want to get here and ask each of these gentlemen a few questions here. First of all, Mr. Lerner, how would you define the problem? And what are we trying to fix in this oversight of the accounting profession?
Mr. Lerner: Okay. What I think we need is, the public should have real confidence that their interest is being looked after in the mechanism for regulating the profession, and disciplining the members of the profession, setting professional standards. All of those. They want to know that the way that this is done is going to look after their interests, and not just the interests of the body of the individuals who practice in that profession.
Judge Sporkin: Well, Mr. White, how would you go about fixing the problem?
Mr. White: At this point, I would suggest that we focus on some key principals that would address the identified problem. In this case, I think what the key points might be is, what does it take to restore public confidence in the industry?
And I would suggest some of the key tenets be independent oversight would be a board that consisted of independent members with solely independent funding, with the authority to set standards, and the authority to enforce those standards, and that those key principals should be something we focus on today.
Judge Sporkin: So you think we do need an oversight board; is that correct?
Mr. Lerner: Correct.
Judge Sporkin: Mr. Glauber, you are the world's greatest expert in self-regulatory bodies. Do you think we need a self-regulatory organization here in the accounting profession?
Mr. Glauber: Well, I want to thank you, Judge Sporkin, both for those kind comments, and for comparing the NASD to a private detection inspecting meat. I guess my answer is that, properly structured, I think we can better rely on a private sector regulator than on the government. And let me, if I can just take a minute, explain why.
First of all, a private sector regulator can get funding, which I think won't be available to the SEC. And, of course, the issue of funding has been something of which the SEC has spoken recently and, I think, quite properly. Second of all, it can attract a professional staff of examiners, lawyers, administrators, that are independent and competitively paid. It can keep abreast with the industry if the industry changes. And it can tap the private expertise of the marketplace in a way that sometimes the government finds difficult.
But I don't think in any sense that there need be a choice. The NASD, which is an SRO private sector regulator, a self-regulatory organization I think, has accomplished all these things, and, I think, has done the job in a credible way.
But it isn't purely outside the vision of the government. Our regulator is the SEC. And so it isn't a choice of private sector versus the government. There is a layer of private sector regulation between the government and the industry, but it, of course, is under the watchful eye and oversight of the government, of the SEC.
The other piece of it, if I could just add, that is important is what was said just a minute ago. That this private sector has to be structured correctly. It has to be assuredly funded. It has to have a governance structure that will ensure independence. It has to have enforcement with teeth. It has to incorporate under one roof. The important elements of rulemaking, of examination, of enforcement, of registration. And then, of course, it has to have the proper oversight of the government.
Judge Sporkin: Now, Professor Macey, he's helped you already in the question I was going to ask you, and that is, what should this self-regulatory body look like, how would it be organized, how is it going to be staffed, and how would it be funded?
Professor Macey: Okay. Well, I want to narrow our understanding of what a self-regulatory organization is. I don't think that a pure self-regulatory body is going to work for the accounting profession.
I think that, as Chairman Pitt's suggestion of having a public accountability board suggests, the idea is that we have to move away from a pure self-regulatory model like one observes in the legal profession, in which the profession truly polices itself internally. That's been, I think, frankly, tried and failed in accounting. So we need people from the outside.
That is to say, this idea of having a dominant, if not exclusive representation on this board from outside the accounting profession is a good idea. And the reason for that is because we've had a lot of experience nowadays with self-regulatory organizations in a wide variety of contexts. Sometimes they work, and sometimes they don't.
Where they work is where the profession has that's being self-regulated, if you will, has a very large stake in improving the way the public perceives the profession, and that the SRO can bring its technical expertise, and experience, and knowledge to bear on making investments in kind of reputation.
The downside of SROs is that then you get this problem of "cartelization," and of perpetuating old, and perhaps and norms that may serve the profession better than the public. Frankly, for a variety of reasons we can maybe get into with respect to oversight of the accounting profession, the accounting profession, for public companies in the United States is not particularly competitive.
The model is a lot more like dealing with public utilities than it is like dealing with a sort of textbook microeconomic competitive industry. And that's why I think this idea of a public accounting accountability board as a regulatory model makes more sense.
With respect to staffing and oversight, clearly, this has to be under the watchful eye of the Securities and Exchange Commission, and it has to have some kind of stable, independent funding. I don't think anybody would disagree with that. Probably some sort of tax on audits, or something of that nature.
Judge Sporkin: Let us talk about what we have on the table now as the Chairman Pitt proposal. He has proposed a private sector regulatory body that would be independent of the accounting profession, and would have two primary components; discipline and quality control.
The new body would be dominated by public membership. The SEC would decide whether the conduct should be pursued as violations of law. The SEC will handle the other violations. The body would be empowered to perform investigations, bring discipline proceedings, publicize results, restrict individuals and firms from auditing public companies. They would proceed expeditiously. The SEC would have oversight.
In the quality control area, they would reform the current peer review process. That would avoid firm-on-firm review. They would replace the firm-on-firm review with periodic auditing of the quality and competence of the accounting firms. The existence of a permanent quality control staff consisting of knowledgeable people who are not affiliated with any accounting firm. The staff should be deployed and overseen by the new publicly dominated body and its staff.
Now, Dr. Glauber, would you agree with that kind of a setup? Do you think that is consistent with the SEC model?
Mr. Glauber: Yeah. I think, broadly speaking, that is very consistent with the model I've outlined, which in turn is taken from the experience of the NASD. So I think the answer is yes.
Judge Sporkin: Well, there are differences between this and the NASD. I don't think that Chairman Pitt's proposal would in any way require qualification examinations. Whereas you do, right? In other words, you wouldn't have a series 7 account.
Mr. Glauber: Absolutely.
Judge Sporkin: You would or you wouldn't?
Mr. Glauber: I wouldn't have a series 7 account, and I could imagine qualification examinations for a higher level of specialization within the industry, perhaps. But not entry-level qualification.
Judge Sporkin: So in other words but you're going to go instead of the whole nine yards, you're going to go about six of them, right?
Mr. Glauber: Well, less than nine.
Judge Sporkin: Less than nine. And you would do it by exception; is that correct? In other words, even though the person gets into the palace that, obviously, if that person doesn't conform, then you would be able to discipline that person, and actually exclude him from being an accountant doing audits of public companies. Is that right?
Mr. Glauber: Absolutely. As I said at the beginning, I think there has to be enforcement mechanisms with teeth, and one of them is exclusion from the organization. And I assume what we're talking about is an organization whose membership which would be a prerequisite to doing accounting for a publicly traded firm.
Judge Sporkin: Mr. Lerner, you have familiarity with the English system, and since England is our father country, we've got to follow what you do at times. Now, what is it that you have that we should be using over here? And how does it conform to the Pitt proposal?
Mr. Lerner: Well, it bears a remarkable similarity to the Pitt proposals. What we have is a foundation which is entirely composed of people independent of the profession, and that foundation acts as the link between the public interest and the various bodies that comprise the regulatory framework. Those bodies are a review board that is responsible for the whole of the system. Again, entirely composed of nonaccountants. The foundation nominate
Judge Sporkin: Composed of accountants or nonaccountants?
Mr. Lerner: Nonaccountants. Entirely of nonaccountants. Underneath that, you have an ethics and standards board, with a majority of nonaccountants. You have an investigation and discipline board, with a majority of nonaccountants. And you have an auditing practices board, again with a majority of nonaccountants.
Judge Sporkin: What do these nonaccountants do?
Mr. Lerner: Make sure that the public they're there, as I said at the beginning that what was important in here is, the public could be comforted that their interest was being protected in all of this. Judge Sporkin: I know, but how do we train nonaccountants to be nonaccountants? I mean, if somebody's going to look and see if an accountant has done something right, you know, it would be like sending my grandmother in to determine whether a doctor has performed the surgery correctly. But you got to have somebody.
Mr. Lerner: Okay. Let me extend the analogy. The guys who are actually go and do the investigations, they'll be accountants. The guys who are going to go around the firms every year, and do the investigations and are going to replace the firm-on-firm peer review are going to be qualified accountants.
But the people who sit at the top say, "Now, do we think the way that that duty has been discharged really fits the public interest, or is this yet another attempt by the profession to, effectively, avoid public scrutiny"?
Judge Sporkin: I see. Let me ask you, Mr. White, you are here representing investors. CALPERS is known as one of the biggest funds in the whole United States. It might be the biggest. Is that right?
Mr. White: Probably.
Judge Sporkin: Yeah, you've probably got the biggest. Okay. Now, you need to be satisfied, don't you, that you've got a system here that is going to protect your interest, right?
Mr. White: Correct.
Judge Sporkin: Are you satisfied with the well, which system are you satisfied with, the British system that uses the nonaccountants, or the Pitt system that would use some accountants?
Mr. White: Well, I think there may be a fine balance between the two. Mr. Lerner is correct, in that at the oversight level the individuals that sit on the board need to have some accountability to the end users. They do not have to be accountants to have that accountability. And because they're not accountants, that doesn't mean they can't understand the issues. And the professional staff that would be under this board is where you're going to need probably deeper levels of expertise. But the key tenet that you should focus on here, if this is going to be an effective oversight body, is that it has to have that degree of independence. Without it, this becomes really kind of
Mr. Lerner: It becomes self-regulation again.
Judge Sporkin: Professor Macey, how would you select? Let's say we're using the Chairman Pitts proposal, how would you select the how would you bring the board into existence?
Professor Macey: I would bring the board into existence the way that other public oversight boards would be formed. In other words, what I would do with the public accountability board is, have some nomination process within the Commission maybe, or generated by the chief accountant's office, and then vetted through the Commission.
Judge Sporkin: So in other words, you would have the Commission select the oversight board; is that correct?
Professor Macey: I would view that as superior to having the board selected from within the accounting profession, yes.
Judge Sporkin: Any other possibilities that anybody can think of here? Go ahead, doctor.
Mr. Glauber: Well, first, am I correct, the Chairman's proposal doesn't envision a board that is dominated by accountants at all, does it?
Judge Sporkin: That's right.
Mr. Glauber: I mean, the board would, in fact, have only a minority of accountants, if at all. So I'm not sure that, in terms of the board composition, there's much dispute over that. I think all of us, as I've heard, would support the idea of, at most, a minority of accountants on the board, and that the board be public members, or drawn from other "public" defined however we define them.
Judge Sporkin: Yeah. And I think the Pitt proposal, I think, mentioned a number. I mean, it could be any number, but what is a good number? How many do you have on your board? You have a couple boards.
Mr. Glauber: Well, we do, but I'll spare you that. Normally we have about 20, and we have a majority that we designate as public. My bet is that if this board were formed of truly public people, as well as maybe issuers, and maybe some broker/dealers, there would be a small minority that would be accountants added to that. So that gives you an idea, in terms of the question.
Judge Sporkin: All right. What is an ideal complement? You don't like 20 is too much, right? I mean, I can't get you to admit that 20 is too much, because you'll get in trouble, and I don't want to get anybody in trouble here today.
Mr. Glauber: Thank you.
Judge Sporkin: I can get myself, but that's all right. I'll leave everybody else out of it. But you would not what is an ideal board here? Mr. White, what is an ideal board? What size? Let's see if we can get down to nuts and bolts here. We're going to get this thing
Mr. White: We actually shy away from a specific number. We look for an ideal size to be between 6 and 16.
Judge Sporkin: 6 and 16.
Mr. White: Which is a wide range, you know, certainly. But I think you're getting to the real point here, which was sort of the definition of what makes a public member. And there's certainly nothing wrong with some representation from constituencies, whether it be the accounting industry, but as long as the public member is defined correctly, and the independence is defined, and they're in a majority, then you've got your end result. You've solved that problem.
Judge Sporkin: Well, wait a second. We have the SEC, and it has five members. Can we use five? Would that be too little? Too few? Six is no good, because you need an odd number in case you have a tie, right? So you want to get it odd. So it's either going to be five or three or seven or
Mr. White: I think the right way to look at it is to see who the constituencies are who you think should be represented. The public interest is a very convenient single word, but the public interest is actually a number of difficult constituents. There are your sorts of people. There's other uses. There's the small investors. The NASD. You need to look at all the constituencies, and then to see the number of people you should have, in order to give a fair representation.
Judge Sporkin: What kind of constituencies are we talking about? Are accountants fungible? One size fits all? Or do we have constituencies so in other words, the accountants but you were talking about investors, right?
Mr. White: I'm talking about
Judge Sporkin: So CALPERS should have the CALPERS seat? Is that right?
Mr. White: No.
Judge Sporkin: No?
Mr. White: No, no, no.
Judge Sporkin: What?
Mr. White: I'm getting into domestic politics here, which I mustn't do.
Judge Sporkin: Well, it's fun being overseas. I can get into British politics and nothing will happen to me. But I don't know a whole lot about British politics. But go ahead.
Mr. White: Can I just make one other point? I think it's important that when you've chosen these people, and when they come to the body, they then leave their passports at home. They've got to act in the genuine public interest, and if you happen to be a CALPERS representative, you must forget that when you're actually there. You are trying to represent the whole public.
Judge Sporkin: All right. Should we have unions pension funds represented on this board?
Mr. White: Yeah.
Judge Sporkin: Is that right?
Mr. White: I would say so.
Judge Sporkin: All right. We're talking about now and I'm trying to build a consensus here. You think the SEC ought to be given in other words, we're talking about a statutory organization in which the SEC would be giving the ability to appoint these members, and then there would be a term of years? Is that correct?
Mr. White: Yes.
Judge Sporkin: What's a good term?
Mr. White: Five years? Staggered board?
Unidentified Speaker: Yes.
Judge Sporkin: A staggered board. Five years. Look, it's going to look a little bit like the SEC now, right?
Mr. Glauber: Can I come back?
Judge Sporkin: Sure, go ahead.
Mr. Glauber: The question of who appoints them. I think, to get it off the ground, the SEC should appoint them. I'm not sure that that needs to be perpetuated. I think that a fully independent, that is, completely staffed by public members, a nominating committee process, could work perfectly well.
Judge Sporkin: So in other words, once you get that initial board, that the organization itself could then perpetuate itself. Is that what you're saying?
Mr. Glauber: Again, all is under the SEC's oversight.
Judge Sporkin: I'll find out what that means in a second. But I'm not saying I disagree with you. I think you come out with a very good idea here. Your idea is, get the SEC out of the appointment process once because that makes it political, whether you realize it or not. But you say, get them out of it, and then what we'll do is, make it self-perpetuating by having a nominating committee. And that nominating committee would then nominate successors; is that correct?
Mr. Glauber: That's my suggestion.
Judge Sporkin: Is that the way the NASD works?
Mr. Glauber: That is indeed the way the NASD works.
Judge Sporkin: It does work? In other words, you don't allow the members themselves to elect people; is that right?
Mr. Glauber: The nominating committee nominates, the members elect. But again, we are an SRO, and what we're talking about here is a private sector, or independent regulator. I don't think anybody here has suggested it would be a self-regulatory body.
Judge Sporkin: All right. So what would happen here is that the SEC would appoint, the board then would have a nominating committee, which would then bring nominees for their successors, and then the SEC would have oversight, which would be like the members. And therefore, the SEC could veto a person who was put up. Is that the way it would work?
Mr. Glauber: I think, for some range of reasons, yes.
Judge Sporkin: Professor Macey, what do you think of that system? That looks like we're really making progress.
Professor Macey: Well, the problem with using the NASD template is that there's a group of public they're a group of constituents at the NASD who can vote on the directors that are nominated by the board.
Judge Sporkin: Right.
Professor Macey: I'm unaware of what the
Judge Sporkin: The SEC will be voting on that.
Professor Macey: What the membership would be in this public board.
Judge Sporkin: The SEC. It would be the SEC.
Professor Macey: So the idea would be, we'd just replace my idea of having the SEC's office of the chief accountant nominate these people, and having them nominate themselves, and then having the Commission
Judge Sporkin: Right.
Professor Macey: That would be fine with me.
Judge Sporkin: I don't think you would want to put any staff member in that position. I think the Commission is controlled by the Commission, and I think that so all right. So that would be it. So that gets the politics out of it. It allows this thing to be recycled. What about term limits, doctor?
Mr. Glauber: I like term limits. I don't know whether it
Judge Sporkin: Do you have them on the
Mr. Glauber: Yeah, we have two we have a three-year term on the board, and you can have two three-year terms.
Judge Sporkin: Two three-year terms.
Mr. Glauber: Yeah. I don't know whether it's one five-year or two three-year. I like term limits.
Judge Sporkin: Mr. White, are you convinced that that would you be happy with term limits?
Mr. White: Actually, I would like to back up just one step, if I could, to reopen the last wound on nominating committee. We have a lot of experience with nominating committees with the companies we invest in, and overall, it's not a process that we feel works incredibly well. And it's not that you're removing politics, you're just changing the politics. So that's something that needs to be debated further.
Judge Sporkin: But you're going to have a Pitt Commission, or a Commission like the Pitt Commission, that's going to veto it if they don't like who they put up.
Mr. White: Yeah. That's not the same as having the nominating.
Judge Sporkin: Would we give the Commission any other powers over this board? What do you think, folks? What do you think, doctor Glauber? Would you give them any more power? Other than the fact that they could then veto the people that are sent up to be the people that run it?
Mr. Glauber: I think I'd give the Commission the kind of powers that they have over the NASD. We have to file our rules with the Commission. Absolutely.
Judge Sporkin: In other words, if you've got to suffer with them, somebody else ought to suffer with them.
Mr. Glauber: Well, no. I think that
Judge Sporkin: You don't want anybody else to get a free ride here. All right.
Mr. Glauber: No. Well, I'm going to make a profound statement, but I think it's a fine system. We're very happy with the SEC.
Judge Sporkin: Boy, you're really buttering up to the chairman today.
Mr. Glauber: Yeah, absolutely.
Judge Sporkin: Has he got anything pending there before you?
Mr. Glauber: We always have something pending before him. Are you kidding? No, but I think that that is the proper relationship. I think the SEC should have oversight over the rules. The rules should be
Judge Sporkin: They would have oversight over the rules. There would be no question about it. I'm looking at the composition of the
Mr. Glauber: I'm sorry.
Judge Sporkin: What about that, professor. What do you think? Should they have anything more? Could they not only have a negative I mean, a veto power, but could they have a positive power of saying, "You can't do so and so, but you got to take White or Macey."
Professor Macey: Well, my view of this is, to start with first principals, whatever this organization is, is going to have some sort of charter, which will define what exactly it is that it does. And it might be, it seems to me the way to begin would be to look at precisely what this organization would do.
Judge Sporkin: We're going to get to that.
Professor Macey: And then we'll figure out which aspects of that function will have varying degrees of SEC oversight.
Judge Sporkin: Are you one of these professors, on the one hand and on the other hand, and never give your students any answers to answer. I got to get answers here. I'm a judge. Or I used to be a judge. But I would get answers.
Professor Macey: Well, you tell me what this organization does, and I'll tell you what the SEC should do with respect to oversight.
Judge Sporkin: We are. We'll get it out, but
Professor Macey: I'll give you all the answers you want.
Judge Sporkin: But I need to get the organization component first, and then we'll get back to it. But on the organization, the SEC would have a veto power, it would have oversight over its rules. Let me ask this to you, Professor Macey, could the SEC does the SEC need legislation to set up the Glauber model? Or would you or can it do it could a creative lawyer do it without legislation?
Mr. Glauber: I think, the latter. I think, a creative lawyer.
Judge Sporkin: Could do it without legislation? And so Chairman Pitt could put this in tomorrow, if we get him this program designed here today?
Mr. Glauber: Pretty much.
Professor Macey: I think no one would disagree with you. He's the very model of a creative lawyer.
Judge Sporkin: Okay. Now, you say it can be done. I'm getting answers now. Okay. That's what I've asked for. Now what I want to know is, how do you do it? I mean, you gave me the bottom line, but now give me the thing that goes in. How would you do it without legislation?
Professor Macey: Rulemaking.
Judge Sporkin: Rulemaking under what provision of the law would you use?
Mr. Glauber: Well, you've got to get my lawyer here. What part of the Securities Act?
Judge Sporkin: Anybody figure that one out? You think that there could be a rule that would establish this organization?
Mr. Glauber: Sure.
Judge Sporkin: And who would fund it?
Mr. Glauber: Well, let's but on the rule, I mean, as I understand it and I'm now practicing without a license but as I understand it, the SEC could control what auditors are permitted to file reports that it would accept.
Judge Sporkin: Yes.
Mr. Glauber: And it would be under that authority that it would create it.
Judge Sporkin: In other words, under 13(a) of the Exchange Act, the SEC would put out a rule that says that they would accept no reports from companies unless the auditor belongs to the well, we've got to give it a name. Can we get a name for it? Belongs to the
Mr. Glauber: Public accountability board. We've got a name.
Judge Sporkin: Yes. I'm sorry. We do have a name.
Mr. Glauber: We have a name.
Judge Sporkin: Unless they belong to something called the PAB. You're the lawyer here. Well, I am too, but I'm not going to practice today. Go ahead.
Professor Macey: We're already there, in the sense that the SEC has power to define auditor independence. And we say that, in order to audit a public company, the auditing firm has to have has to be independent. And I'm of the view that the auditor independence rules are not operating very well at the moment in the U.S., because the auditor independence rules focus too much on the percentage of an accounting firm's total billing that come from particular clients, which I think, as we've seen in recent days, doesn't really reflect very well the real danger of kind of capture by the audit client of the audit firm.
And so I think the idea of this public accountability board is designed to make sure that the accounting profession is able to be sufficiently independent of its engagement clients.
Judge Sporkin: Now, how are you going to where's the who Mr. White, you're the man with all the money. How are you going to fund this group? Are you going to put in some money from CALPERS? How much are you going to pledge I'm going to this is going to be like a fundraising operation. How much are you pledging to this organization.
Mr. White: First, I was not told to bring the checkbook. The funding source, I think, is a critical element, and I think we would tend to favor above all else that the funding needs to be independent of both Congressional budget-setting procedures, and of the industry's ability to tinker with it. You know, what it ends up being, I don't know if we have that kind of detail answer yet.
But perhaps the way the SEC is funded on charges on registrants, or something like that. As long as it is a dedicated source, and it cannot be tinkered with. It's in stone. Then you've got to what you want, which is the independence of the funding source.
Judge Sporkin: Mr. Lerner, how is it done in the U.K.
Mr. Lerner: In the U.K.? This is probably the least satisfactory aspect of the whole system in the U.K. is, it's funded entirely by the profession. And I couldn't recommend that as a
Judge Sporkin: You would not recommend that?
Mr. Lerner: No. But you need but the funding needs to be flexible enough, so it because it's got to be able to respond to changes in demand. There will be things that happen in one year that require extra funding. And so a funding that's tied to just so much per registrant won't give that flexibility.
Judge Sporkin: Well, Mr. White, should investors institutional investors be able to pony up some money?
Mr. White: Sure. All the users of the statement should be willing to pony up some money, but how do you get around how do you charge each user? 25 cents every time you bring it down from the internet? That's probably a
Judge Sporkin: So you would say that the users I mean, the institutional investors should pay. You would say that how about the audit firms? Should they should it be is there a tax on each audit?
Mr. White: I think some proportion of the funding from the audit firms is appropriate.
Judge Sporkin: Right.
Mr. White: But only a proportion.
Judge Sporkin: So we're really getting some groups in here now. We've got the audit firms. We've got the institutional investors. How about the small investor? How do we charge the small investors? Yeah, go ahead, Mr. Glauber.
Mr. Glauber: I'd look four places. I'd look first to issuers, because issuers if I can just step back. The premise, I think, for the funding. It ought to be people who have a self-interest in making the system work. And the first ones that have a self-interest in making it work are the issuers. The issuers want the accountants to have a good name.
Look what happened after the Enron thing blew up. IBM has its stock selloff because people are worried about IBM's reports. Issuers, users, the institutional investors. I think broker/dealers have an interest in making certain that the markets have integrity. And so they should be participants.
Judge Sporkin: What about your organization, self-regulatory? Should the NYSC and the NASD or NASDAQ. Not the NASD, but NASDAQ have to pony up some money?
Mr. Glauber: Well, I'd reach through that and talk about the constituents, which are the broker/dealers.
Judge Sporkin: In other words, you would go right through the self-regulatory bodies, and go right to their users?
Mr. Glauber: And again, the reason is that they have an interest in seeing this cleaned up.
Judge Sporkin: Yes.
Mr. Glauber: And the final place I would look is the one you just mentioned, which is the accountants. There are going to be examinations of accountants. At a minimum, they should pay fees for those examinations.
Judge Sporkin: And how about the fines that they collect? Should that money go to fund it?
Mr. Glauber: Well, we collect fines, and we use those fines to develop our technology, and to do our job better.
Judge Sporkin: Now, Professor Macey, as a professor of law, would you find that somewhat problematic, because of the fact that there might be an inspiration to go out and sue people to get money, so you could benefit yourself? Is there a problem there? Professor Macey: Well, obviously, there's that kind of red flag, but that's why we would have SEC oversight. That left unfettered, this would be something very worrisome, but under the structure we're envisioning of SEC oversight, I think it wouldn't be a big problem.
Judge Sporkin: All right. Let's find out now what it is we want this organization to do. I don't know whether we've got it all organized. I know we got it we know where the sources of the funds are going to come from, but we don't know how we're going to impose those I mean, how we're going to reach those folks, unless perhaps and I'll go back for a second, doctor Glauber except maybe we do have to go to the NASDAQ. Not your organization, but your sister organization. And go to the NYSE and say, "Hey look, you know, you've got the deep pockets. You come forth and put in the money."
Mr. Glauber: You could. You could do it that way. But I think the real question is, if you do it that way, you're reaching through to the people who pay into those organizations. You could do it.
Judge Sporkin: No, but the only point is, I think you could get a ready source of money.
Mr. Glauber: Yeah, there's money there.
Judge Sporkin: You don't have to go back and pass a law, and people complain, and things of that kind. All right. Now let's see what it is that we're going to have this organization do. We've got to get back to Professor Macey's question. He wants to know what this organization is going to do. Then he'll know how it's going to be organized. We've done it a little differently, but let's see what we're going to do. What is it that you would like this organization to do, Mr. White? What would you like this organization that we're setting up to oversee the accounting profession do?
Mr. White: Well, again, broadly defined is you want an effective oversight body, which doesn't exist right now. So what do you need to have that happen? They need to have the ability to set auditing standards. They need to have the ability to enforce those standards. You know, they need to have the funding source, and the independence so they can accomplish those goals without being tinkered with. And you've accomplished what you want here. You want an oversight body.
Judge Sporkin: Mr. Lerner, is that going to
Mr. White: You've got to
Judge Sporkin: Wait just one second. Mr. Lerner, is that going to take away from FASB if you say they're going to set standards?
Mr. Lerner: They set auditing standards, but rather than accounting standards. You could have a debate about whether the accounting standards should be in this or not. And I think you could have a lively debate.
I think there are arguments for bringing accounting standards in under this overall umbrella. What you were talking about, Ted, was auditing standards. It also needs to be able to look at independence issues. And it need to just overall be responsible for discipline within the profession.
Judge Sporkin: What accounting standards would they enforce, if they're not going to make the accounting standards?
Mr. Lerner: Well, all audits in order for an audit to be a GAAS audit, the audit accounts need to comply with GAAP.
Judge Sporkin: So in other words, you would say you would have FASB be where it is. Is that correct?
Mr. Lerner: No, I'm neutral.
Judge Sporkin: Mr. Lerner, how is anybody neutral in FASB? You either like it you don't like it. Mr. Lerner: Now, that's the difference between where it sits in the organization and what the content of the rules are.
Judge Sporkin: All right. Well, doctor Glauber, what would you do there? Would you want this organization to have set accounting principals, as well as auditing standards? Or one or the other? Or maybe something else?
Mr. Glauber: Well, the first thing the major categories are registration of the members and their records. Second of all, some rule setting. And we can talk about what rule setting. Third, examination. And fourth, enforcement. Under the rulemaking, I think, clearly, what you want is rulemaking that deals with quality control and conduct, both of the way audits are performed, of the quality of the accounts, of the issues of auditor independence. All of those.
And then you can debate whether or not you put actual accounting principals, FASB, underneath.
Judge Sporkin: But what would your suggestion be?
Mr. Glauber: I'm perfectly happy to see it stay out, and I'll tell you why.
Judge Sporkin: Yeah, go ahead.
Mr. Glauber: It is fundamentally different. I look, again, at us as a model. Our rulemaking goes over a broad range of issues, but it doesn't go to the kind of fundamental principals that GAAP is. And furthermore, the FASB is presently under the oversight of the SEC, so it isn't a question of bringing it under the oversight of a new body.
Having said that, I mean, you could also argue it should go in. So I think there are plausible arguments on both sides. But I'd be comfortable taking that piece of the rulemaking out.
Judge Sporkin: Well, you have in your organization you have two situations. One where you enforce your own rules.
Mr. Glauber: Yep.
Judge Sporkin: Right. And you also enforce other people's rules.
Mr. Glauber: Absolutely.
Judge Sporkin: Such as the municipal rule
Mr. Glauber: Yes, we do. Such as the SEC's rules.
Judge Sporkin: And the SEC's rules. Now, when you're enforcing somebody else's rules, who makes that interpretation as to what they mean?
Mr. Glauber: That's a very good question. I believe we make the interpretation in consultation with the rulemaking body, but I would
Judge Sporkin: Well, in a disciplinary proceeding, you don't have that luxury to go and say, "Hey, what do you mean by this rule?"
Mr. Glauber: No. Listen
Judge Sporkin: I mean, you can't go up and say upstairs and say, "Someone tell me, what does that rule mean?"
Mr. Glauber: It's a fair question. And that's why I think, in general, you want rulemaking and enforcement under the same roof. In the case of setting generally accepted accounting principals, I don't think that issue gets to the question you just asked. In other words, you could have those set somewhere else. The question is, whether or not the audit is performed in accordance with them, but not whether the rule
Mr. Lerner: But of course, in order to find out where the audit has been performed, you have to, effectively, interpret the rule.
Mr. Glauber: That's fair.
Mr. Lerner: So you need the expertise. In your body of people, you need the expertise who are able to say, "Was this a GAAP audit? Was it a GAAS audit?" You need to
Mr. Glauber: Right.
Mr. Lerner: When you can't when you're conducting a disciplinary inquiry, you need to have all that expertise.
Judge Sporkin: Well, where do you think it should be? In the enforcement arm group? Or outside the group?
Mr. Lerner: I think it should be in.
Judge Sporkin: In?
Mr. Lerner: Yeah.
Judge Sporkin: In other words, you think this organization should be making its own rules that it enforces. Is that what you're saying?
Mr. Lerner: No.
Mr. Glauber: You didn't mean to say FASB should be in.
Mr. Lerner: No. I would have this body also being responsible for oversight over the FASB process.
Judge Sporkin: I see. That's interesting. Professor Macey
Mr. Lerner: We don't in the U.K.
Judge Sporkin: You know what it is to interpret rules and laws, and courts every day interpret laws that they don't make, right? Because they're not the Congress of the United States.
Professor Macey: Right.
Judge Sporkin: Do you see any problem in who in where this thing should come out? Should this new organization be interpreting its own laws? Or does it matter whether the laws are being made, or the rules are being made by an outside body?
Professor Macey: No. I don't think it matters. I think more importantly would be I think we're running the danger of defining the nature of what this board will be doing a little too narrowly. That is to say, if it's going to be successful, I think it's going to have to be involved in a more elevated way, or in a way that deals with structural problems of the relationship between accounting firms and their clients, rather than just sort of coming in ex post.
I think it's a great idea, for example, as you've mentioned before, to have this organization serve a kind of function of looking at failed audits, and coming in and sort of trying to do an autopsy, and see what went wrong. I think that's an enormously valuable role that this organization could play. But I don't think it goes nearly far enough. Nor does simply having enforcement powers of looking at bad calls by auditing firms, and dealing with that.
I'd see this organization it would go beyond that in a couple of ways. Number one, it is drafting guidelines and this would relate to public companies more than accounting firms to deal with the process of audit selection. To have an organization like this, if it really had integrity, could deal with these vexing issues like, should the chairman and the CEO function in a public company be combined, where the chairman in picking the audit committee.
Similarly, the question of who picks the outside auditor. Is it going to be the audit committee of the firm, or is there going to be management? That these kind of structural issues, I think, would be useful for the public accountability board.
And finally, the most important issue is issues relate to the discharge of the audit function. That is to say, under what circumstances can this public accounting board be successful in allowing accountants to be able to fire their auditors without that accountant ruining his or her career. And once we're at that we're sort of back to that stage with respect to the relationship between the big accounting firms and their public audit clients, then I think this public accounting board will have been successful.
And I'm absolutely certain that we don't accomplish that simply by splitting off the consulting and the internal bookkeeping functions, as we're doing. I think that we're going to have to go significantly beyond that.
Judge Sporkin: Wait, wait. You've now taken me from the East coast to the West coast.
Professor Macey: Round trip.
Judge Sporkin: It's been a pretty heady one. But what you're saying here is, if I heard you correctly, that you would have this board supplant the state of Delaware, in determining internal rules as to how corporations should functionality. Is that what you're saying?
Professor Macey: Well, it's an interesting question. Purely as an academic matter, one could wonder whether or not recent events have accomplished a sort of de facto overruling of business roundtable against SEC, but if you look at pronouncements coming out of, say, the Treasury Security O'Neil's office, or editorials and the like, you know, this idea of having corporate governance standards generated by the states is something that no one is talking about. And the idea that I think that there's a great deal of appetite for
Judge Sporkin: This is not the Professor Macey I used to know. When did you have this transformation?
Professor Macey: No, no. I'm simply I'm not saying what should be, Stanley, I'm simply saying what is. I'm just describing the world we live in post whatever date you want to say, that right now
Judge Sporkin: Chicago doesn't exist anymore, huh?
Professor Macey: The citadel has been significantly shaken by recent events.
Judge Sporkin: Well, I'm glad to see all right. No, but these are very, very serious issues here now. I mean, we're taking on now, with this board we're not only taking on the accounting profession, and others like it, but we're taking on the great state of Delaware. And people don't mess with Delaware too easily around here.
But you're really saying that this board that the chairman has come up and has brought before us here today, that you would have this organization really define certain corporate governance standards. Which I think is a I don't know, I haven't thought about it, but that's terrific thinking.
Professor Macey: Let me just jump in and say that already, as we all know, there we have corporate governance standards being promulgated simultaneously by the New York Stock Exchange, and the other exchanges in NASD, as well as states. And so this is a peaceful coexistence that's been going on for a very long time. In fact, the New York Stock Exchange was promulgating corporate governance standards long before Delaware was.
Judge Sporkin: Right.
Professor Macey: And we're just you know, we're
Judge Sporkin: Wait. What do you mean, "long before Delaware"? Now, Delaware has been in existence before the New York Stock Exchange.
Professor Macey: Right, but Delaware did not
Judge Sporkin: At least my history tells me that.
Professor Macey: Your history is right, but Delaware did not emerge from the womb promulgating corporate governance standards, the New York Stock Exchange did.
Judge Sporkin: Wait a second. Mr. White, do you understand what Professor Macey is saying? And you like it.
Mr. White: Yeah. Actually, I think what he's touched on that is accurate is that the audit committee has a role here. And what we have to realize is that
Judge Sporkin: The audit committee is going to be determining corporate governance?
Mr. White: Sure. And there's other parties that have an interest here, and have some say or some oversight. It doesn't have to be necessarily this body. We as investors have a role in asking our audit committee members to take certain responsibilities on. The exchanges have they already have policies on what audit committees should look like, and what they should do. And maybe we should look at those. It's not there's not one answer.
Judge Sporkin: So who would you want to defined your corporate governance standards? Would you want the Pitt board? Or would you want the New York Stock Exchange? And it wouldn't be the NASD. It would be NASDAQ, wouldn't it be?
Mr. Glauber: Right.
Judge Sporkin: The NASDAQ would do that. But they don't have the machinery to do it, you have the machinery.
Mr. Glauber: I could get them in.
Judge Sporkin: In other words, you'd have to lend it. They'd have to borrow it from you.
Mr. Glauber: We'll lend it.
Judge Sporkin: You'll lend it to them. All right.
Mr. Livingston: If you believe that you can't do a good audit without good corporate governance, which is what I believe, then corporate governance properly falls within
Judge Sporkin: Well, wait. Here's what I'm going to try to get us out of a murky area here. We're saying that we're not going to rely on Delaware anymore. We've got now this new board that we're going to establish. We also have the New York Stock Exchange and we have NASDAQ. Where do we want to put it, Mr. White?
Mr. White: Well, I mean, again what we have to realize is that we all have a role. We can't leave the responsibility with this body, and then go to sleep. As investors, we have to continue to police whether or not it's doing a good job. The oversight body has its role. The state of Delaware may have a role in cases where legislation is appropriate to fix problems. At the federal level there may be a role. We're all in this together, and we can't
Judge Sporkin: What would how where do you see your role as representing investors? You won't want to have a vote on this board, will you?
Mr. White: No.
Judge Sporkin: So you'll just have to use your feet.
Mr. White: Well, in certain proposals that I know that are floating around the legislature, public pension systems may nominate people for consideration. That's one role we may have. But we certainly have a role as an active owner in companies. And we have our own corporate governance standards that we try to hold companies to. And that's what we try to fulfill.
Judge Sporkin: All right. So we haven't resolved I'm sorry, doctor, go ahead.
Mr. Glauber: No, I think you're right. We haven't resolved it. I think it's an interesting idea. My bet is that there are now a number of avenues through which corporate governance could be influenced. This new body we're bringing into being is going to have a lot to do. I'm not sure, as good an idea as interesting an idea as it is, that we need to saddle it with this added responsibility.
Judge Sporkin: You think it would have enough to do without getting involved in this; is that correct?
Mr. Glauber: Yeah. I mean, I'd make a list of the rules that it is going to have to make.
Judge Sporkin: All right. Let's get some
Mr. Glauber: And it's a pretty long list.
Judge Sporkin: Well, give me the short list.
Mr. Glauber: Well, it's going to have to be rules on conduct and quality control. How audits are conducted. The question of the type of field work, double reviews. All the things that are part of so-called GAAS.
It's going to have to be the whole set of issues on auditor independence, stock ownership by auditors. Consulting activities. It's going to have to be the whole issue of conduct of actual audits. And that's a long list, even if you whether you put the FASB or not under it. If you put the FASB under it, then it's even a longer list.
Judge Sporkin: Let me look at some of these rules now. Auditor independence, you would give them a clean slate on that? Or do you have your ideas?
Mr. Glauber: Well, I have my ideas, but I think that ought to be a focus of the rulemaking of this organization. They're going to have to deal with just where you draw the consulting line. I mean, that's a complicated issue that you're carving out.
Judge Sporkin: All right. Let me ask you, Mr. White, what do you think of rotation of auditors?
Mr. White: We support it.
Judge Sporkin: You support rotation. Do you have any and you would allow the board to make that determination? Is that correct?
Mr. White: Our perspective is that and I want to be careful to let you know that we have considered that there are costs involved with rotating the auditors, and it's not an easy answer, but at the end of day, what we have come to the conclusion is that it's worth that cost to get some fresh perspective.
I don't know exactly what the right number of years or time is. I suspect it's between five and seven, is probably a very nice balance between the pros and cons of doing that.
Mr. Lerner: Could I just chip in?
Judge Sporkin: Absolutely. I was going to come to you next, so go ahead and you tell me.
Mr. Lerner: It's interesting that a number of countries have tried rotation of auditors and abandoned it, because the hoped for improvement in quality didn't happen. The increased cost did. And that country that still has it the only, I think, OECD country that has it at the moment is Italy, and Italy is not exactly a beacon of high audit quality. Now, there may be other reasons, of course.
Mr. White: Yeah. And I don't know that rotating auditors is the only answer, but we think it's part of it.
Judge Sporkin: Mr. Lerner, why don't you do you see any negative in rotating auditors?
Mr. Lerner: Yeah. I think one there's two distinct negatives. One is evidence that problems that occur in the early years of audits when the audit team aren't fully familiar with the systems and with the environment. And with rotation, you have more early years.
Judge Sporkin: Let me ask you this. Doesn't, at some point, if you don't have some form of rotation, aren't don't you lose your independence?
Mr. Lerner: No, because you rotate the partners, so there's always a fresh pair of eyes.
Judge Sporkin: So in other words, you would call it a mini rotation, not a maxi rotation.
Mr. Lerner: Correct.
Judge Sporkin: You would rotate the auditors well, why isn't that going to suffer from the same problem of rotating the whole audit firm?
Mr. Lerner: Because you don't rotate you don't lose the whole body of knowledge. You bring in one new person, who can put a fresh perspective on the issue.
Judge Sporkin: You have a staggered rotation?
Mr. Lerner: No, you don't. You have the body of knowledge, which is the corporate body of knowledge in the audit firm, remains there. But a new partner comes to lead the team, and can review the judgments that have been made by his predecessor.
Judge Sporkin: Do you allow clients to determine who shall the auditor be able to veto who an auditor is going to be on the account?
Mr. Lerner: You absolutely shouldn't, but I suspect in practice it has happened.
Judge Sporkin: It has happened?
Mr. Lerner: But you absolutely shouldn't. And that enables me to just add one other thing that this board needs to look at. It needs to look at remuneration policies for partners, so that you get the right drivers, you get incentives for doing good quality work, for taking the tough decisions. You get penalties for making bad decisions.
Judge Sporkin: Professor Macey what do you think?
Professor Macey: I just want to make two a lot of this ground on auditor rotation has been covered, but I do want to make two points about it. One, fundamentally, is, I think we should take a step back and just admit to ourselves that things have to be really bad before we start talking about the idea of rotating auditors. That is to say that basically what we're saying is that the system is really pathologically broken in such a way that we, essentially, have to sort of nationalize the system.
And the second thing I want to mention is that, to my way of thinking, the problem with auditor rotation is not necessarily the sort of learning curve point that was mentioned before. It's the idea that structurally, if you go to an auditor rotation system, what you're doing is, going even more in the direction of treating auditors like public utilities.
You're taking competition out of the system, because no matter how bad a job an auditing firm does, eventually, like musical chairs, its time is going to come when it gets the new audit assignment, irrespective of competitive factors, and quality.
So I like the focus on auditor rotation, simply because it gives recognition to the fact, which I agree with, that there's something seriously wrong with the sort of competitive equilibrium that exists between auditing firms and audit clients.
But I think that this particular solution is going to be way is going to make the disease way significantly worse. So I share the concerns of the people who are in favor of audit capture. I just don't think that's the right prescription for the problem.
Judge Sporkin: You would be against it?
Professor Macey: Yeah, I'm against it.
Judge Sporkin: Doctor Glauber?
Mr. Glauber: I guess I have nothing useful to add.
Judge Sporkin: You don't on your you have auditors, I assume, at the NASD, right?
Mr. Glauber: Oh, absolutely.
Judge Sporkin: So you don't rotate. Is that it? Or you do rotate?
Mr. Glauber: We do not rotate as a regular course. I mean, we have changed auditors, but we don't rotate.
Judge Sporkin: Oh, you have changed auditors.
Mr. Glauber: We have, yes.
Judge Sporkin: But you don't do it on a regular basis.
Mr. Glauber: Correct.
Judge Sporkin: Mr. White, what do you do?
Mr. White: Yeah, a couple points. Yeah, we do.
Judge Sporkin: You rotate?
Mr. White: As an organization we do.
Judge Sporkin: How do you do it?
Mr. White: I think we rotate every five years currently. But a couple points, to follow up from earlier. The issue of whether or not there's more mistakes made earlier in the audit, I think those studies probably fail to take into account what is of the other side of the ledger, which is the benefits that you gain from having somebody new come in and take a look at it. So maybe there are a couple more mistakes, but maybe there is five places where you had a net benefit, which is hard to measure.
And then as far as the competitive factor, this may actually make it more competitive, I think. And if there's an issue with declining quality of audit from the short-termer's attitude near the end of a rotation, that is exactly what the public oversight board is supposed to do. So I think it addresses one of the key drawbacks. And again, we recognize that this is a resource issue.
This will cost more to bring people up to the learning curve. Our answer to that is, net net it's worth it.
Mr. Lerner: What it does mean is that however good a quality of audit you do over five years, you still get rotated off. So there's no reward at all for doing good quality work.
Mr. White: Yeah, and it's not a perfect answer.
Professor Macey: Two really quick points on this. One is, I would not be so adamant about being opposed to auditor rotation if there were 40 big five accounting firms, so that the idea of rotating wouldn't raise these sorts of problems.
Judge Sporkin: You've got to watch him, he slips one in there. 40 big five, huh?
Professor Macey: The other thing I would say well, the math's a little hard there, I will admit. But the other thing I would say is that it wouldn't it would be something that I think SEC would be well served to think about creatively are ways of dealing with or changing the auditor independence rules to open up the universe of firms that would be qualified to audit a public company.
Because I certainly you know, the ideas the idea that one of these big five accounting firms is better suited than a much smaller firm, because it is the fees from that particular client are such a small percentage of the total revenue, completely loses sight of the economic reality that on the audit engagement team, unfortunately, in recent situations one has observed that the sort of care and feeding of that client is what's critical to the career of the particular audit engagement partner.
And if that's going to be if that's the world we live in, then even a small or a medium-sized firm could audit a big client.
Judge Sporkin: Let me ask you this question. Let's talk about what this group would do. Mr. Lerner, as you see it, and as it works in the United Kingdom, what happens? This group goes out and audits the auditors?
Mr. Lerner: Yes. Every firm every major firm - that's the 20 largest firms are visited every year, and the remainder of the firms are visited on a rotational basis. And they test the firm's quality controls, and reperform some of the firms own check. S
Judge Sporkin: And do they bring disciplinary actions?
Mr. Lerner: The disciplinary in our model the disciplinary actions as a result of any findings are brought by this separate disciplinary board.
Judge Sporkin: Is it a public proceeding, or a private proceeding?
Mr. Lerner: It's a private proceeding, but the findings are public. And the findings can be vicious. The fines are very large, potentially. And of course, also the ability to remove individuals' livelihood by striking them off.
Judge Sporkin: Do you have qualification standards in this group? In other words, do you have to become a how do you become a member of this group that we're talking about?
Mr. Lerner: That group is nominated by the same public interest body that nominates the
Judge Sporkin: I mean, say I'm a chartered accountant, am I subject to your board?
Mr. Lerner: Absolutely.
Judge Sporkin: And how do I become subject to your board? Do I become a member of it, or what?
Mr. Lerner: You have to be a member. You have to be a chartered accountant to practice.
Judge Sporkin: I see.
Mr. Lerner: And once you become a chartered accountant, you're subject to the disciplinary apparatus.
Judge Sporkin: Now, does the disciplinary apparatus go to the individual accountant, or does it go to the firm, or both?
Mr. Lerner: Both. Fines on them both and, potentially, a firm could have its license taken away, as well as an individual.
Judge Sporkin: And is there a board that tries these cases? Is there a hearing? Do you have a hearing?
Mr. Lerner: Yeah, yeah. It's a tribunal system in private, but with legal representation.
Judge Sporkin: And is that is there any appeal from that board to any other body?
Mr. Lerner: Yes, there's an appeal process, but still in private.
Judge Sporkin: And where does it go? Who is it a court? Does it get into the court system at some point?
Mr. Lerner: We've managed to keep it out of the courts so far.
Judge Sporkin: You've kept it out. You keep it out of the court system?
Mr. Lerner: Yes. Whether that will I mean, whether somebody would be able to get judicial review for a decision they don't like, I don't know. Nobody's tried it yet.
Judge Sporkin: How many cases do they bring in a year?
Mr. Lerner: Probably 20.
Judge Sporkin: 20 proceedings?
Mr. Lerner: But probably only one or two is are very major ones.
Judge Sporkin: Yeah. Two major ones? And those would be against the whole accounting firm?
Mr. Lerner: Yeah. and the individual.
Judge Sporkin: When you bring your action against at accounting firm, what is the theory for bringing them in. When do you determine to bring an accounting firm in, versus just the individuals?
Mr. Lerner: It's the inevitable practice to bring the accounting firm in, because the belief is that individuals in accounting firms do not make decisions on their own.
Judge Sporkin: Yes. So that you're saying that the presumption is that every time you find a violation, you would bring the accounting firm in? Is that correct?
Mr. Lerner: Yes.
Judge Sporkin: On what's called responde superior?
Mr. Lerner: Yes.
Judge Sporkin: And what do you think of that model?
Professor Macey: I find a lot to like about it. I think it's a nice a good template.
Judge Sporkin: And it's consistent with the proposal we're doing here, Dr. Glauber?
Mr. Glauber: It's very consistent with the procedures at the NASD, up and down the line. There are a couple of elements that I would add to it as perhaps a part of it.
Judge Sporkin: Right.
Mr. Glauber: One is transparency, to make the results public. And the other is to do it quickly.
Judge Sporkin: And do you do it publicly or private?
Mr. Glauber: We make the result public.
Judge Sporkin: But it's the proceeding is private?
Mr. Glauber: The hearing is private, but the results are public.
Judge Sporkin: All right.
Mr. Lerner: Doing it quickly is easier said than done.
Mr. Glauber: Oh, I understand that, because sometimes we don't do ours very quickly either, but I think we should well, in particular, I'm talking about a present aspect of the disciplinary process under the AICPA, which is to await the completion of private suits.
Judge Sporkin: That's a good issue. All right. Let's get into that one. Where do we stand on that one there. What do you
Mr. Lerner: We don't wait. We don't wait. We are determined to start the process expeditiously, although it may not finish until the private suits are finished. Therefore, there's no ability of the litigants to control that.
Judge Sporkin: How long has this organization been in existence?
Mr. Lerner: Only a couple of years.
Judge Sporkin: Yeah. Is that that used to be the process over there. But you and Dr. Glauber, what you say that you have a concern about the private action going on at the same time?
Mr. Glauber: I don't have a no, I have a concern on waiting for the completion of the private action before instituting the action of this organization.
Judge Sporkin: You would not wait?
Mr. Glauber: I would not wait.
Judge Sporkin: Now, what about should the SEC seek some kind of immunity for these whatever action you take, so that it cannot be used against the firm in a litigation?
Mr. Glauber: Well, I think that's an interesting question, and I guess I'm not going to comment on it. I do think there is an issue of protection, protecting the information that is produced as part of this proceeding.
Judge Sporkin: You think that should be protected?
Mr. Glauber: I generally think it should be private.
Judge Sporkin: And the private litigants should not get a hold of that.
Mr. Glauber: Yeah, I think so.
Judge Sporkin: What do you think, Professor?
Professor Macey: I think that a great not all, but a lot of the problems that we're trying to fix are a function of the fact that the accounting profession, particularly the big accounting firms in the United States, which used to be driven by a kind of competitive model, are now being driven by a litigation model, so that what they do is designed not to benefit clients or investors so much as to engage in risk management.
Frankly, one of the ironies about the recent situation with respect to Enron and Arthur Andersen is that I think that when the history of all of this is written, a lot of the actions that were taken with respect to the accounting treatment were done with found their origins in the desire to avoid litigation. And I think it's led to a diminution in the quality of audit services.
Judge Sporkin: Well, are you concerned that you could have all these facts gathered in one place, and that the litigants would not be able to get access to it? Would that bother you at all?
Professor Macey: If that's the only way that this board can function, then I think that you know, the gain it's worth it. I mean, it wouldn't be any worse than the current system, where there is no such board generating this sort of information.
There would one thing we can say about this country is, we're rich in discovery devices in litigation, that my it's very difficult for me to muster a great deal of sympathy for the ability of the plaintiff's bar to lack of ability to get at this information, when there are so many other sources of information.
Judge Sporkin: Well, but don't you have a isn't there an ethical problem with the lawyers who are defending the firms here, who have access to this information? The plaintiffs do not have access to the information. Don't you see an ethical issue there?
Professor Macey: No.
Judge Sporkin: You don't see an ethical issue?
Professor Macey: In every litigation, the defendant's lawyers have access I mean, the defendant's lawyers are dealing with the defendants.
Judge Sporkin: Yeah, but when there is a duty or responsibility to make representations in court, which used to come before me, where someone cannot walk away from facts that the lawyer knows, right?
Professor Macey: Right.
Judge Sporkin: So you got problems there. Mr. White, what do you think? Do you want the system to be private or public?
Mr. White: You mean, in regards to the investigation?
Judge Sporkin: Well, no. In regards to the hearing that takes place, and where all the facts are laid out.
Mr. White: The one thing I'd be certain about is, ultimately, the decision has to be public. I would kind of look to the SEC's current procedures, maybe for some examples of how where how does that work, and where problems might be.
Judge Sporkin: Well, the SEC is all public, unless for some which I don't think they do anymore, it would be private, but it's all public in the SEC. The SEC operates
Mr. White: Once a charge is made correctly.
Judge Sporkin: What?
Mr. White: Once a charge is made, it's a public
Judge Sporkin: Right.
Mr. White: Correct?
Judge Sporkin: Not the investigation, right.
Mr. White: Right. So maybe there's a distinction to make there. You know, again I think this is a pretty complicated issue for you want this to be an independent body that's charged with oversight of the industry. They're going to have to have some way to conduct investigations without being torn apart by the plaintiff's attorneys.
Judge Sporkin: How about Mr. Lerner, what do you think? Private? Public?
Mr. Lerner: I believe it would be private, but I think it will be impossible to get the profession to buy into this, if the information is going to be laid out for the plaintiff's attorneys.
Judge Sporkin: What do you think about an issue of reparations to be paid to an accounting firm that is discharged because the firm is doing the right thing? Has that been floated around? That idea?
Mr. Lerner: No. No.
Judge Sporkin: Why do you laugh at that?
Mr. Lerner: Well, that's a good idea. You see, it's actually a good idea.
Judge Sporkin: Oh, okay.
Mr. Lerner: But it's an issue of funding.
Judge Sporkin: Yeah.
Mr. Lerner: A firm might spend millions of pounds in defending itself, and if that has got to come out of the funding of the body, it just increases the
Judge Sporkin: No, I don't mean the body, I'm talking about the well, I mean, the body would make a rule that says that if a firm, because it does its job and walks away from an audit, that it should receive reparations of maybe one- or two-year audit fees.
Mr. Lerner: My answer to that is, it gains in terms of its reputation, it gains immeasurably. It doesn't need anything more than that. And in the current environment, to walk away would gain so much in reputation, they don't need monetary.
Judge Sporkin: Oh, you don't think they would need the reparations
Mr. Lerner: No.
Judge Sporkin: Would you be against reparations?
Mr. Lerner: Who would pay them?
Judge Sporkin: The company that fires the audit that shouldn't have fired the auditor. I mean, that would be clearly that would be the and it would be a rule that would be issued by the board.
Mr. Lerner: But the auditors are fired for so many reasons, other than an issue of quality.
Judge Sporkin: But there would be a determination made by the but as to whether they are filed whether it was retaliation. Does anybody what do you think, folks? Nobody? It's going to die like a lead balloon? Nobody likes reparations?
Professor Macey: Well, I wish it were the case that audit firms really are firing clients, in order to enhance their own reputation. This, incidentally coming back to Judge Sporkin's point about the death of the Chicago school is the textbook economic model of how audit firms are supposed to work. They make a huge reputation investment in reputation, such that any minor gain they have from playing around with the books, or helping with a funny audit would be minor compared to the loss in reputation. And again, that model works great in a world in which there's genuinely vigorous competition among accounting firms. And the problem is, the industry is simply too concentrated now for that really to work.
I want I mean, I throw this out as a question. I genuinely don't know the answer, but kind of one way to kind of test this hypothesis is that under your idea, Mr. Lerner, there are reputational differences among the big five accounting firms.
Putting aside the recent unpleasantness with respect to Arthur Andersen, if we took the remaining four and did a survey, do you think there would really be, among CFOs, for example, of public companies, there would be strong tiering in which somebody's any of these firms has really successfully separated itself from the pact, with respect to so again, the idea is that, I think, unfortunately, we don't live the real world does not has not produced a marketplace where there is sufficiently vigorous competition among these audit firms.
Mr. Lerner: I don't agree. From the inside it feels a fiercely competitive marketplace.
Judge Sporkin: Well, what I was just suggesting, if a firm does its job, and it gets fired because it did its job, then maybe the rule that the so-called this new Commission, the PAB, then would have the say that we can give reparations to a firm that's been improperly discharged, or discharged for an improper reason. Let me ask you this question, Dr. Glauber?
Mr. Glauber: Yes sir.
Judge Sporkin: You one of the great things about your organization, and the SEC is that you have specific rules on supervision. And you require entities to have in place supervisory models.
Mr. Glauber: Right.
Judge Sporkin: And you even can bring actions against firms, where the supervisory model has broken down.
Mr. Glauber: Yes.
Judge Sporkin: And on that alone, right?
Mr. Glauber: Failure to supervise, sure.
Judge Sporkin: Right. Now, should there be a similar failure-to-supervise rule as part of the of this of the PAB? Should they have a failure-to-supervise?
Mr. Glauber: Yeah. I mean, generically I think that would be part of the quality control rulemaking. Absolutely. I think the model, or the similarity is quite correctly drawn.
Judge Sporkin: And you think that's in important rule?
Mr. Glauber: I think it is a very important rule.
Judge Sporkin: And would that take the place of responde superior? What do you think?
Mr. Glauber: I don't even know what you're talking about.
Judge Sporkin: I know. Okay.
Mr. Glauber: That's a different language.
Judge Sporkin: All right. It's the law. It's lawyer language, and I apologize, doctor. The responde superior says that the superior the
Mr. Glauber: Principal.
Judge Sporkin: The principal is held responsible for the acts of agencies.
Mr. Glauber: I guessed it.
Judge Sporkin: Which is an easier standard to hold accountable than the supervisory, which would say, only responsible where supervision has failed.
Mr. Glauber: Right. And you could direct it right at the supervisory process, and the supervisor.
Judge Sporkin: Right.
Mr. Glauber: Yeah. I believe in that model.
Professor Macey: I think the SEC model and at the risk of grossly oversimplifying is the idea that there's an expectation that firms have supervisory systems in place.
Judge Sporkin: Right.
Professor Macey: And this does not abrogate the system of vicarious liability or responde et superior. What it does is, it says excuse my crude characterization that if you don't have an adequate supervisory system in place as a firm, you're going to be in much even worse trouble than you're in under traditional
Judge Sporkin: Well, that's the sentencing guidelines. But as I look through the SEC rules, the SEC, I think, has a supervisory provision in the insider trading, and it has one, I think, in the books and records provision. But I don't know if it has adopted the NASD model overall. You have a much broader model.
Mr. Glauber: Well, I think we have a broad model.
Judge Sporkin: Now, I agree with you, Professor Macey. I think the SEC can still charge that, because it does enforce, at times, NASD rules. But and the SEC usually operates on what I call belt and suspenders. They can do both respondeat superior, as well as that as supervision.
But one of the rules that the SEC might consider, even without the new organization, is whether making the supervisory provision overall, with respect to the entire operation of not only registrants, broker/dealers, but maybe as with respect to issuers. And I don't know about accountants, but I mean, why don't we go all the way. We'll go for the
Mr. Glauber: But as a matter of general philosophy, as I understand it, the SEC has delegated to us most of the conduct rules, and indeed, I think that is a sensible handoff, so that when we came to issues dealing with analyst conflict and analyst independence, the SEC delegated to us, subject to their supervision, obviously, the job of writing rules to do with that kind of conduct or ethical behavior. And I think that's an appropriate handoff. And I would expect the same kind of handoff here.
Judge Sporkin: You have a rule, for example, that talks about just and equitable principals of trade.
Mr. Glauber: Sure.
Judge Sporkin: Which the SEC does not have, and I don't know what they how they would be able to administer it, but you have administered that.
Mr. Glauber: Well, and by writing, indeed, beyond that, certain detailed rules of what constitutes but having that as a backup.
Judge Sporkin: Now, let's talk about inspection powers. There's no problem that this group will have with the power to inspect these broker/dealers, right, Mr. Lerner?
Mr. Lerner: Accountants.
Judge Sporkin: Accountants. I'm sorry.
Mr. Lerner: I'm flattered to be confused. No. No. I mean, I think if the profession believes that the public has a legitimate interest in the oversight of the profession, then it must accept that there must be a power to
Judge Sporkin: All right. Let's get to the next question. Should it have subpoena power? Why is there silence? You don't have subpoena power, do you?
Mr. Glauber: Well, it was going to start off by saying, we don't. But we do, I think, achieve the necessary investigations by agreement with our members that they will open their books to us as a
Judge Sporkin: But suppose you need third-party information, or suppose you need information from the issuer. What do you think, Professor? Would you give this group subpoena power? And if you did do it, then you probably would need legislation, right?
Mr. Glauber: Legislation. Yeah.
Professor Macey: I think that with respect to this powers of inspection, that like the NYSE and the NASD, the subpoenas should be run through the Securities and Exchange Commission. I think that having a private, or even semi-private body having that sort of power, I think, is
Judge Sporkin: Well, let's see. How would the power go? With respect to accountants, you would require them to go to the SEC to get a subpoena to bring in the accountants?
Mr. Lerner: The PAB.
Professor Macey: The PAB.
Judge Sporkin: Yeah. Well, we've got do we have a division here?
Mr. Lerner: No, because I think the accountants, by agreeing to join this structure, agree to make their books
Judge Sporkin: That's the NASD model.
Mr. Glauber: Yeah. I don't think the accountants are the problem. It's one you raised. It's the third-party
Judge Sporkin: But I'm asking, how do you enforce yours, doctor? What did you do if somebody refuses you don't have subpoena power. If somebody refuses to provide you with information a member what, do you just lift the license?
Mr. Glauber: Yeah. Well, it's even better than that. They sign an agreement as part of joining us, that they will make it available.
Judge Sporkin: Right.
Mr. Glauber: So we don't even have to threaten them. They're already agreed to make that information available.
Judge Sporkin: But suppose they don't.
Mr. Glauber: You just lift the license.
Judge Sporkin: You just lift the license?
Mr. Glauber: I can't tell you of a case in which we've had to do that, but I think that would be our policy.
Judge Sporkin: All right. But should this we're designing something from scratch. This is like my wife that's doing the remodeling. She says she's designing it from scratch. So I don't know whether she's going to get everything that's that good, but I remember the last time I did this, I got into trouble with her.
But that's let me ask you this, if we're designing something from scratch, why shouldn't should we should, ideally, they have subpoena power to be able to get into third parties' information?
Mr. Glauber: Well, that's the issue for the third party.
Judge Sporkin: In other words, the issue let's assume it's a blown audit, and your group, Mr. Lerner, wants to make the case, and they need that information.
Mr. Glauber: Well, you could get it without subpoena power.
Judge Sporkin: By asking for it.
Mr. Glauber: Well, no. But you could get it as a condition of the audit, that the third party sign an agreement that they'll make their papers available.
Judge Sporkin: Wait a second. You're not a lawyer?
Mr. Glauber: No.
Judge Sporkin: Well, you're a God damn good one, whatever it is.
Mr. Glauber: I take that as a complement, although
Judge Sporkin: It is a complement.
Mr. Glauber: Thank you.
Judge Sporkin: I want to explore that, because I hadn't thought about it. You're saying that the agreement that you would require that the PAB would require, would require an accountant to get their contract with the issuer that they audit that they would agree to turn over their records to the PAB. Is that right? Does that work?
Mr. Glauber: Sure.
Judge Sporkin: Terrific.
Mr. Glauber: Just lucky. I'm not going any further.
Judge Sporkin: You hit a home run. It's spring training, and you already batted one out. What do you think, Mr. Lerner?
Mr. Lerner: Yep. No, I agree. I agree.
Judge Sporkin: Mr. White, you're silent. What do you think?
Mr. White: Yeah, I mean, maybe in either case, I think in order to be an effective oversight body, it has to have the ability to get the records. I don't see that much downside in giving the body the ability to subpoena records, if it gets the same end result.
Judge Sporkin: But Dr. Glauber, one thing. They might be able to get the records from the entity. They might not be able to get the testimony, though, from the individuals, which they might need.
Mr. Glauber: Okay. I'll believe you if you say so.
Judge Sporkin: Well, I mean,
Mr. Glauber: No, I understand what you're saying, of course.
Judge Sporkin: Your agreement can go so far.
Mr. Glauber: Sure. I understand. It might be an imperfect substitute for subpoena power.
Judge Sporkin: Okay. Now let us get to the issue of when on enforcement, when are we going to have the organization, the PAB do it, and when are we going to have the SEC do it? Now, Dr. Glauber, you have that problem with not the problem, but you have that dichotomy with the SEC right now. Is it clear? Are you like the Justice Department and the Trade Commission, and you know which cases you're going to do you have an agreement?
Mr. Glauber: It isn't clear, but we cooperate and we seem to work it out. And sometimes we move and the SEC doesn't. Sometimes we do it cooperatively, jointly.
Judge Sporkin: There's no piling on?
Mr. Glauber: I don't believe there's piling on. We just did one jointly this year with a large firm, and issued large fines as part of it. I think it works. I think it can be worked out without any
Judge Sporkin: Well, should there be I think under the Pitt proposal that we talked about, he makes a distinction between legal violations and violations of ethical standards.
Mr. Glauber: Yeah, and that, as I said earlier, has guided the rulemaking, for example, in general. You've raised one particular kind of rule, supervision. And I think it's the quality control conduct issues that have been left to the SROs, and properly so.
But there are cases where the SEC has involved itself in conduct. This particular case which dealt with IPO allocations, the SEC was involved, we were involved. And we both issued fines.
Judge Sporkin: Yeah. But do you think there ought to be a clearer demarcation between when you have when the PAB should move in, and when the SEC should move in?
Mr. Glauber: It's an interesting question. My sense is and I don't have the sweep of history to call on but my sense is that the relationship has worked okay in this case, and that we haven't stumbled over each other very well.
Judge Sporkin: Professor Macey?
Professor Macey: I think that I don't foresee this as being a huge problem. One area where it is slightly more complicated than in the NASD situation is where you have this board not just looking at an accounting firm violations, but also looking at the issuer.
And I guess my instinct, having not thought it about that much, is that situations like that probably should be dealt with by the SEC. They move outside the realm of auditor ethics, and auditor conduct. And that just as a jurisdictional matter, this board should probably limit itself to dealing with audit firms.
Judge Sporkin: Should the SEC be precluded from taking action where it finds a violation, but it's part of a bigger violation? Should they stop and say, "We'll send this part to the board, and we'll handle the rest"?
Professor Macey: No. I think there are some things this organization ought to do, that the SEC really doesn't do, or is not oriented to doing. One of them would be, for example I don't know if this happens in the U.K., but something that seems to me, in light of the increasing complexity of transactions, would be, issuing advisory opinions on difficult audit issues for firms. I think that could be some kind of value added.
And in addition to that, with respect to ethical rules, something that I think is a deficiency right now in the way that accounting is practiced, is that there is never any inquiry made by accountants about whether a transaction is advisable from a business perspective, even if it's properly accounted for.
In other words, if all the accountants worry about, as far as I can tell, is whether a particular transaction is properly accounted for, and they don't seem to mind if there's no business purpose for the transaction. Or even if the business purpose of the transaction is simply to move debt off of the balance sheet, for example. And that doesn't seem to me to be a particularly satisfactory state of affairs.
And I would think that a role that this public accountability board could play would be to try to motivate audit firms into making those sort of deeper inquiries when they're doing audits.
Judge Sporkin: Mr. Lerner, what do you think?
Mr. Lerner: Right. What I think you're describing is a feature of accounting standards, and not auditing. It's the accounting standards that need to be got right, so that you look at substance over form of transactions. Once you look at substance over form, then you, effectively, get where the professor wants to get. And the accounting will follow the substance and not the form.
Judge Sporkin: But that's something that the if the if we have FASB, that's a FASB issue.
Mr. Lerner: Absolutely. It's a FASB issue.
Judge Sporkin: That's not a PAB. All right. Let me ask you this question. Aiding and abetting. Should that be a standard that the board should allow for violative conduct? Should they should aiding and abetting be considered a violation? What do you think?
Mr. Lerner: Help me with the phrase, "aiding and abetting"?
Judge Sporkin: That is where the accountant is not a principal violator, but it aids and abets in the violation of the issuer.
Mr. Lerner: Oh, absolutely.
Judge Sporkin: Absolutely?
Mr. Lerner: Absolutely.
Judge Sporkin: You understand that right now, that's the accountants are not responsible for aiding and abetting. There's a Supreme Court case that says they're not responsible. You would change that.
Mr. Lerner: Well, I would regard that as I disciplinary matter.
Judge Sporkin: Mr. White?
Mr. White: I agree.
Judge Sporkin: What do you think, John?
Professor Macey: Within the purview of this public accounting accountability board, this would certainly be within their jurisdiction to do it.
Judge Sporkin: Well, the SEC has the right.
Chairman Pitt: Right.
Judge Sporkin: The SEC has been given the right under statute.
Chairman Pitt: Well, I'd do it through rulemaking, but sure.
Judge Sporkin: You'd do it. But you have it in your
Chairman Pitt: Yeah.
Judge Sporkin: All right. So aiding and abetting we take care of. What about inspections by this board of this is a little different than the subpoena power, but the inspections of issuers. Should and this might be this case this issue might go a little bit broader than what we're talking about today, but it's one that has come up. And that is, should somebody have the ability to inspect an issuer, as opposed to going in only for where there's a suspicion of a violation, and the SEC has an auditor investigation? What do you think?
Professor Macey: If it's necessary in order to monitor the accountants, then it seems to me that you know, the idea is I don't understand
Judge Sporkin: Would you give this power to the SEC?
Professor Macey: To monitor the issuers for what purpose?
Judge Sporkin: Well, just like they have for example, if it's a broker/dealer, you inspect, right? Orthe SEC inspects. Or the New York Stock Exchange inspects, right? But nobody inspects normally regular issuers.
UNIDENTIFIED: We certainly don't.
Judge Sporkin: Do you understand, John, what I'm saying?
Professor Macey: Yeah, yeah.
Mr. Lerner: So you mean, on a random basis, without any evidence that there is
Judge Sporkin: It's like the IRS comes in.
Mr. Lerner: Yeah. That's an issue of resource, isn't it? There's a resource issue there.
Judge Sporkin: But the SEC can do it by all right. Let me ask you this way.
Mr. Glauber: Can I ask?
Judge Sporkin: Sure, go ahead.
Mr. Glauber: I'll just ask a question. We've been talking about inspection, and action. Could I raise the issue of immunity for these for this board?
Judge Sporkin: Sure. That's a good issue. I'm sorry. That's a good issue. Should the board have immunity from being sued?
Mr. Glauber: We do, because of the Maloney Act, I believe.
Judge Sporkin: Quasi governmental?
Mr. Glauber: Yeah.
Judge Sporkin: And that issue is now before the isn't that issue now before the court in New York, I think? It might be before the court of appeals. I think that the New York Stock Exchange was recently
Mr. Glauber: Second circuit.
Judge Sporkin: Yeah. Which was one of the chairman's cases. It was great. He won for the New York Stock Exchange. You did get immunity. And I don't I read something that somehow it's there's but I think that's the last word.
Mr. Glauber: Okay.
Judge Sporkin: They should be given immunity.
Mr. Glauber: Well, I'm happy we have it.
Judge Sporkin: Well, at least quasi immunity. But let me ask you this question. We have what's known as a national safety National Transportation Safety Board. And one thing that board does is, after there is a debacle or a tragedy, they go right in and find out what happened. Now, should this board, this PAB, have that as one of its responsibilities.
Mr. Glauber: Yeah, I think so. You might call it autopsies of failed audits, or something like that.
Judge Sporkin: Well, that doesn't sound good.
Mr. Glauber: Sorry.
Judge Sporkin: We have to get a better name for that than that.
Mr. Glauber: Okay. I yield on naming. But I think, in general, yes.
Judge Sporkin: But do you do that?
Mr. Glauber: Do we do that? I'm not sure. I'm trying to get the equivalent.
Judge Sporkin: Well, I'll give you an example. Recently I think you had a situation with one of your members, where the well, I guess it goes to the real-time business that the SEC that the chairman is talking about. I guess he's trying to work that out. But for example, you had recently a case where it's alleged that a broker walked away with a lot of money.
Mr. Glauber: Right.
Judge Sporkin: You'll go in immediately on that.
Mr. Glauber: Yeah.
Judge Sporkin: But you will go in for the purpose of taking action against that person. Will you go in immediately? Or what will you do?
Mr. Glauber: I believe we would go in immediately. And we would go
Judge Sporkin: Yeah. Well, where would you go? When you say you would go in immediately, where would you go? You've got to go somewhere.
Mr. Glauber: Into the firm.
Judge Sporkin: Huh?
Mr. Glauber: Into the firm.
Judge Sporkin: Yeah. You would go into the firm, and then what would you do? You would have problems unless you went you don't have the authority to go to court.
Mr. Glauber: Right.
Judge Sporkin: So you'd have to go so this gentleman's company, right? His agency.
Mr. Glauber: Well, to go into court, yes.
Judge Sporkin: Yes.
Mr. Glauber: So we'd have no criminal
Judge Sporkin: No. Well, this wouldn't be criminal, this would be you've got to preserve the money, you've got to
Mr. Glauber: Oh, I'm sorry. I'm sorry.
Judge Sporkin: Well, how would we get that authority to this board?
Mr. Glauber: Is that I thought what you were talking about is, doing a diagnosis of a failed audit
Judge Sporkin: Right. I was trying to use the analogy.
Mr. Glauber: And you're trying to understand it. I guess as a diagnosis of a failed audit, yes, I would give this board the authority, and charge them to do that.
Judge Sporkin: In other words, that would be a routine function?
Mr. Glauber: I would make it so.
Mr. Lerner: One of its most important functions.
Mr. Glauber: I would make it so, yeah.
Judge Sporkin: In other words, a case and again, I'm not trying to get into Enron, but a case like Enron
Mr. Lerner: Routinely in the U.K., any company that fails, the investigation and disciplinary board will investigate the accountants. However culpable or nonculpable they ultimately turn out to be, they would be investigated if there's a corporate failure. Absolutely routine.
Professor Macey: You would think there's a tremendous amount to be learned from the failure.
Mr. Lerner: There usually is. There usually is.
Mr. Glauber: And the analogy, I think, is just right, to the National Transportation Safety Board, or whatever.
Professor Macey: Do they generate a public report after this
Mr. Lerner: No, they don't. It's the same basis, I'm afraid. There's a private public and a public finding. So there is a system whereby a government department creates a public report called DTI inspection, and that is very, very detailed, very interesting, but takes many years to appear, and is of somewhat limited value by the time it does appear.
But these private reports are available for us in the Institute to research, and to try to learn the generic lessons from failures, in terms of improving auditing standards. So we can look across all of the reports, and say, "Well, what does this tell us about what should be done to auditing standards?"
Judge Sporkin: Now, what type of what we're doing is we're putting in this system of oversight. Now, should there be some benefits that go to the accounting profession for setting up this board of supervision? And by that I mean, should they get some get out of jail passes, so to speak? I mean, I'm using that in other words, should they get some liability limitations because of this operation? What do you think?
Mr. Lerner: I believe them to be separate issues. I think liability and discipline are separate issues. Liability reform is
Judge Sporkin: But don't we need the accounting profession?
Mr. Lerner: You do.
Judge Sporkin: And particularly I mean, we need it, right?
Mr. Lerner: Yes.
Judge Sporkin: And are we doing anything in the public good if we
Mr. Lerner: Yes, you are.
Judge Sporkin: Take somebody well, you've got a competitor there. But if you take somebody and want to and you take a good firm, and you want to throw it out of business, and then you're going to be down to four, or three, or two.
Mr. Lerner: Okay. I mean, it would clearly have to be the most extreme situation where you felt you had to take the firm's license away.
Judge Sporkin: Right.
Mr. Lerner: You might have intermediate steps before that. You might ban them from taking on new clients for a period of six months or a year.
Judge Sporkin: You mean, either have the electric chair or slow death, right? Either starve them, or you give them the last mean and you take it away at that point.
Mr. Lerner: But I think there is a
Judge Sporkin: What I'm saying is, should we is you say that liability should be apart from what the PAB does; is that right?
Mr. Lerner: Yes.
Judge Sporkin: And that the liability should be well, isn't liability a form of discipline and enforcement?
Mr. Lerner: It is a form of discipline, but it's a rather crude weapon.
Judge Sporkin: But should that be taken into account when you are issuing sanctions?
Mr. Lerner: They've suffered enough already.
Judge Sporkin: That's the one. That's the argument you get.
Mr. Lerner: I think that liability is a civil matter, and this is a public interest matter. And I think it's quite difficult. Liability will compensate somebody else who has suffered a wrong. This is in order to to put in place in order to ensure that the public interest is
Judge Sporkin: What we ought to do is send all our auditors to get trained in the United Kingdom. That's a heck of a tune you're singing there.
Mr. Lerner: But the benefit from the
Mr. Glauber: But it's sensible. The purpose of this is to protect the markets, and to make to give integrity to the markets. And I think that ought to be obtained.
Mr. Lerner: And the benefit for the profession in all this is a restoration, to the extent that confidence has declined, a restoration of that confidence. And that's an enormous benefit.
Judge Sporkin: Professor, do you want to chime in? Should private litigation be considered a part of the disciplinary process?
Professor Macey: With respect to certainly, I think that the people who are members of this board should, like their counterparts at the NASD and the NYSE, and the SEC, for that matter, have some amount of immunity.
Judge Sporkin: No, we're not talking about immunity. The issue we're talking about here is, whether the firm should get some benefit from the fact that they paid a big litigation sum?
Professor Macey: You mean, should this sort of count against the damages they'd have to private matters?
Judge Sporkin: Right.
Professor Macey: Well, if the my short answer is no. And the reason two things on that. Number one is that, with respect to the narrow confines of the question, there's whenever an auditor messes up in a you know, say, intentionally, or there's real wrongdoing, there really are going to be two separate harms. One is the harm to the particular private parties who depended on that audit.
Judge Sporkin: Right.
Professor Macey: And then there's a general public harm that's suffered, as we are observing, from the lack of public confidence in the markets. So each of the the PAB could be the fine could be viewed as dealing with that latter sort of harm, and you have the private remedy.
This is all assuming the premise, which is that this private remedy is actually reasonably well tailored to combating wrongdoing. And I think that that's a real open question. That on the one hand, there's a problem of going after innocent people, innocent firms because they're deep pockets, and missing other wrongdoers who are not as attractive targets.
So the whole area of private liability and sanctions is very tricky, and not at all obvious that it's very well tailored to actually serving the purpose for which it's intended.
Judge Sporkin: Let me ask you this, there's one of the rules that I that's been bandied around here. Time out. Should there be a time-out period from when an auditor is auditing a client, and then switches from the client I mean, switches from the auditing firm to the client? Mr. Lerner?
Mr. Lerner: In a simple answer, yes, I believe that the rules need to be tightened up in that area, but you can't apply the same rules to the most junior employee on the team, as a senior partner. But for senior partners who are going to move across to the account which they have worked on, I believe a cooling off period is an important element of, again, bolstering public confidence in the process.
Judge Sporkin: How long a period?
Mr. Lerner: I think I hope that two years would be sufficient to distance them from because the probability is that they've found another job in the meantime, and they won't go straight
Judge Sporkin: All right. And that would be a rule that the board would put in effect; is that correct? That's the kind of rule?
Mr. Lerner: If we're going to give the board responsibility for auditor independence, then that indeed is an important part of auditor independence, along with remuneration policies for partners, and
Judge Sporkin: I see. All right. Now, let's let me go to the role here, and let's see if we can't button this up a little bit. You know, it's interesting here. I was just I can't take lose the opportunity, but an opinion that a judge wrote back in 1990, the judge said that, in discussing when an auditor left the firm and went to work for the an auditor left the accounting firm, and went to work for the firm.
And this judge wrote that, in a footnote 23 the chairman likes footnotes it says, "It would seem that some cooling off period, perhaps one to two years, would not be unreasonable for a senior official when an audit can be employed by the client." And we won't we can't say who the judge that wrote that, can we?
Mr. Lerner: Somehow I don't think that will be necessary.
Judge Sporkin: I can take the fifth amendment, can't I? All right. Even I can take it. Now, let's get to the question of the role of the New York Stock Exchange versus and the NASD, as it fits into this PAB. Where do we see that role?
Mr. Glauber: Well, I think the role of the New York Stock Exchange, and maybe NASDAQ, can deal with a lot of the corporate governance issues. And we talked about that earlier. I think on the issues that we've been talking about of behavior and conduct of the profession, the accounting profession, the PAB ought to have the role that we've begun to outline for it.
Judge Sporkin: Yes. But the we talked about the self-regulatory body, the NYSE and the NASDAQ as the professor talked about their getting involved in corporate governance.
Mr. Glauber: Right. And I think that's sensible.
Judge Sporkin: Now, if we want to do something now, don't they have the ability to immediately do something in this regard, as opposed to, at least the SEC would have to take some time to look through the rules, to find out where they're going to get the power that you suggested that they have. So that takes time to look through those rules. There are a lot of rules.
Mr. Glauber: Well, I think on that issue of speed and I think you're quite right to focus us on it which I think it's very important that something be done, and done very soon.
Judge Sporkin: Well, could the New York Stock Exchange well, let's take NASDAQ, you're closer to the NASDAQ. Could NASDAQ establish a group that would be like the PAB?
Mr. Glauber: Well, they could. And so could the New York Stock Exchange.
Judge Sporkin: Yeah, I know. I don't want to I'm not going to give them
Mr. Glauber: But I'm worried about doing it that way.
Judge Sporkin: Why?
Mr. Glauber: Because you might get two different groups, with two different sets of rules. Or you'd have
Judge Sporkin: Well, the SEC could see to that, because they've got to approve the rules.
Mr. Glauber: Well, we have this problem in the rules we do, where oftentimes the New York Stock Exchange and the NASDAQ SROs produce different rules. Indeed, it's the exception when we produce the same rule.
Judge Sporkin: There's a plus here, isn't there? And the plus is that if one size doesn't fit all one of the problems you're going to have with a lot of rules is that there are some little shnooky companies down there that don't that just can't have these rules. In other words, they don't have even three directors to be a I mean, independent directors to be on an audit committee.
Mr. Glauber: Yeah, sure.
Judge Sporkin: So at least if you have the main NASDAQ board and the New York Stock Exchange, you at least have size - companies of size that can really meet these requirements.
Mr. Glauber: Oh, I think, again, when we're talking about corporate governance, I think that kind of flexibility makes a great deal of sense.
Judge Sporkin: Right.
Mr. Glauber: So you're talking about rules for the accounting profession.
Judge Sporkin: Right.
Mr. Glauber: There, I think speed is important. I think the SEC could do it really quite quickly, a lot of this, by rule.
Judge Sporkin: Well, I mean, you think I have you might be right. And you might be a better lawyer than I am. But the point is that I don't see it that easy for the SEC, although the chairman's sitting right here. But I do see it fairly easy for the self-regulatory bodies to do it.
Mr. Glauber: And again, they I think they could, and perhaps should, do more on the corporate governance front. I would be uncomfortable to see them do, through their rulemaking, through their rulemaking for listed companies, which is, I take it, what you're talking about, try and invent this kind of process. And I would be worried, again, about two different processes being invented
Judge Sporkin: Well, but the SEC can do that. That rule would have to go to the SEC for approval. What do you think?
Professor Macey: I think it's very unrealistic. I think a good we have a good model for this in history, which is when the New York Stock Exchange had this its one-share-one-vote requirement, and which I thought was a kind of a for a lot of reasons, had a lot of merit.
The New York Stock Exchange was put under tremendous pressure, because a lot of listed firms decided they didn't like the rule, and they were going to simply risk the New York Stock Exchange's sanction, which comes in the form of delisting, as and refuse to comply with the rule.
So the problem I think you'd have is if one of these, either the NASD or the New York Stock Exchange, decided unilaterally that it was going to do something like this public accountability board, any the precise issuers that you would most want to catch by this would avoid the rule simply by migrating to an alternative trading venue.
Judge Sporkin: Where are they going to find one? If you lose the NASDAQ, are they going to go overseas? Or go unlisted?
Mr. Glauber: Probably unlisted. Or go to the bulletin board.
Judge Sporkin: I mean, could you see Microsoft with a bulletin board?
Professor Macey: No, but they could get but if you have differences
Mr. Glauber: No, and I'm being facetious.
Professor Macey: If you have differences in these rules, though, between the NYSE and the NASDAQ, you create regulatory arbitrage.
Judge Sporkin: But you wouldn't have that, because the SEC would make sure that they weren't different.
Professor Macey: That's happened before.
Mr. Glauber: All right. If speed is an issue, I think and I think speed is an issue, I think that the SEC could
Judge Sporkin: Well, again I think 13(a) might be stretching it a little bit, but I'm not going to I'll have to wait for the chairman to give me that assignment to find the rule that you've got. I haven't found it yet, but it might be there. Well, listen, there's one thing I always pride myself on, and that is to end these proceedings before can get up and ask a question.
Audience Participant: Now you are starting. We have been good. Stanley, there is one thing you have not talked about. The conflict of interest of directors of corporations who are members of the audit committee. For instance, if a chairman of the audit committee of a certain corporation is also president of a University which exchanges major contributions from this corporation.
Naturally, if they don't get the figures they want to the chairman, than what is the solution to this? That was the conflict of interest. And otherwise, the chairman could and that way, get the figures they want to.
Chairman Pitt: I'm going to exercise the prerogatives of the chair. I want to thank Judge Sporkin. I want to thank all of the members of the committee, the panel, the roundtable. This has been a very enlightening discussion, and we appreciate your willingness to assist us on it.
So thank you. And the Commission will be scheduling several additional roundtables, and we will let the public know about those when they're set up. Thank you very much. (Whereupon, the discussion was concluded.)