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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the Investment Company Institute
2002 Securities Law Developments Conference


Commissioner Paul S. Atkins

U.S. Securities and Exchange Commission

Washington, D.C.
December 9, 2002

Good afternoon. It is a privilege for me to speak to you today, and I'd like to thank Matt Fink, Craig Tyle, the ICI's board of governors and its membership for inviting me today.

Once upon a time I was a young lawyer in New York and cut my teeth setting up new UITs and closed-end funds. Then, a few years later, I came to the SEC in the chairman's office and had the opportunity to work directly with the Division of Investment Management. During that time, I spent countless hours working on 1940 Act issues and developed a great appreciation for the ICI and the mutual fund industry. In particular, I appreciated your insightful comments on rule proposals and other initiatives. You have been of great assistance to the SEC and our regulatory process.

As much as I'd like to speak in detail with you today regarding the intricacies of "fund of funds" or the 1940 Act's "affiliated transactions" provisions, my guess is it would be best to avoid such topics during a luncheon speech! Nevertheless, maybe I can help get you some CLE credits. And, of course, before discussing such topics, I must note that my comments here today are my own, and do not necessarily reflect the views of the Commission.

This has been an extraordinary and tumultuous year for investors and the financial services industry, as well as for the SEC itself. While I have not seen a poll on this subject, I would bet that a very high percentage of Americans today know about the Securities and Exchange Commission. I was stunned recently when an airport security man in Atlanta saw "SEC" on my laptop and asked me if I worked at the Securities and Exchange Commission or with the South Eastern Conference -- a year or so ago, I'm certain he would have assumed I worked for the football conference. In fact, when I was at the SEC ten years ago, the SEC was so far off of the radar screen that even a surprising number of government workers to whom I would introduce myself would not clue in to the initials "SEC." They would think FCC or FTC or even FEC and - believe it or not - not know that the SEC is a government agency.

Investors have experienced the end of "irrational exuberance" in the stock market, seen on television corporate heads and accountants do the "perp walk," and wondered whether they can trust numbers from corporations and advice from Wall Street. In the past few months, the SEC has been in the unaccustomed position of being at the center of a campaign of those who wanted to make the series of recent corporate audit failures an issue to attack the Administration in an election year. Politicians of all stripes began to focus on the SEC, especially in the context of what some saw as a referendum on the President. I hope now that the mid-term elections are over, the unprecedented, year-long, ferocious political storm over a usually non-political agency has ended.

Public Accounting Profession

We all know of the spectacular corporate failures that have confronted investors because of bad accounting practices. A report issued by the General Accounting Office in October presents some startling statistics in this area, including that one out of every ten listed public companies restated its earnings during the last five years. These restatements, along with the litany of accounting problems that you well know - Enron, Worldcom, Adelphia, Tyco, Global Crossing, etc. - are probably why a recent Gallup poll cited 70% of U.S. investors saying that corporate accounting issues are hurting investment climate, quote, "a lot."

The cause of these restatements is the subject of debate. Some say that the accounting firms either were not aware of the particular issue causing the restatement or were not hard-nosed enough with their clients when matters are rather small and not material. When the issue does become material, the auditor realizes that the accounting is not right and forces a change. Others say that the SEC is at least partly the cause because the SEC's staff in recent years have been more aggressive in announcing changes to their preferred accounting treatment of various issues - such as in-process R&D - without notice and comment, so that companies have had to make more significant shifts in their treatment to align with the staff's new interpretation.

Well, with respect to the SEC actions on substance and process, we can and will make the necessary changes. As for the portion of the scandals that can be attributed to the accounting profession itself, I believe that the problems can be summed up into two general areas: (1) a culture that has fostered audit relationships that are too cozy with clients; and (2) professional leadership - namely the AICPA - that has seemed rather reluctant to embrace a self-regulatory system with any meaningful oversight or ability to impose substantive penalties. In fact, the system that currently exists was established with pressure from Congress and the SEC in the wake of large audit failures in the 1970s.

Coziness of the Profession

The public accounting profession largely can trace its rise to the wake of the 1929 stock market crash. First, the New York Stock Exchange adopted a listing requirement for all companies to have an independent audit. It had been best practice before that, instigated mainly by foreign investors who had lost money in the railroad boom in the U.S. in the 1800s, to have audited financial statements. Then, in the Securities Act of 1933, Congress essentially codified this stock exchange rule for all public companies.

During the past 15-20 years, the largest accounting firms have arguably lost sight of their primary function - the performance of independent audits - in favor of attempting to become full-service professional organizations. Some observers charge that in doing so, the profession has participated in commoditizing and debasing its flagship product - the audit. Many investors and issuers seem not to pay attention to the audit until things go wrong, perhaps because the numbers are essentially historical - the audit figures are out of date the day they are published.

I have heard many anecdotes from accountants of a tendency by some audit committees and corporate management to try to get the cheapest audit. In response to this "squeeze," the accountant might reduce the scope of the audit to work within the lower budget. To get the same job done with a lesser scope, the accountant might rely more on the company's own work and representations, without the traditional amount of testing and verifying. All of this could lead to greater potential for financial misstatements to go undetected - or even worse, to be wittingly or unwittingly acquiesced to by the auditor.

I don't mean to engage in endless speculation here. Still, many have noted that the very fact that the corporation pays the auditor and can fire the auditor is an inherent challenge to an auditor's independent outlook. Completely severing that remunerative relationship would require nationalizing the accounting profession, which is clearly unthinkable, although in the heyday of the New Deal some members of Congress actually discussed it. Here, I'll note that Sarbanes-Oxley took a great remedial step in this area by making it crystal clear that the auditors work for the audit committee, not for corporate management. Thus, independent directors representing shareholders' interests are now clearly in charge of this vital relationship.

Practices that the accounting profession has permitted have also served to undermine auditor independence. For example, some firms have calculated at least part of an auditor's compensation based upon his level of cross-selling of non-audit services to the audit client. Is an auditor really going to challenge aggressive accounting treatment regarding a particular financial product structured and sold by that auditor's partners in another part of the same firm? This is the "auditing your own work" that the independence rules seek to avoid.

Further, audit staff, especially in relatively smaller offices, sometimes "grow up" with their clients - that is, people on the audit engagement can spend years working for the same client, starting as a staff accountant and growing to the level of partner. In addition, the accounting personnel of companies frequently comprise persons who previously conducted the external audits for those companies. All of these factors can give investors the impression that the accounting profession in some spectacular cases has failed to stand up to management and has appeared to lose its objectivity.

We have to acknowledge that all but an extremely small percentage of accountants are honest, hard-working, well-intentioned professionals. It is also extremely difficult for an auditor to detect fraud committed by its client: persons intent on embezzling funds are likely capable of hiding such frauds from their auditor.

Nevertheless, some failures on the part of auditors cannot be simply attributed to slick and fraudulent corporate managers. It is one thing for a company to "cook the books" by fraudulently inflating revenue through phony sales or inventing phantom inventory. Frauds like this may be extremely difficult for an auditor to detect if the management crook is clever. But, some of the recent accounting scandals have involved a different kind of activity - companies asserting aggressive interpretations of GAAP to justify financial statement treatment, such as capitalization of expenses or so-called "true sales" of assets to off-balance sheet entities to remove debt from the balance sheet. These cases have involved not undetected fraud, but apparent acquiescence of the auditors in the accounting treatment or interpretation, sometimes when the auditors' colleagues have helped to structure the underlying transaction and formulate the case for the aggressive accounting treatment. In these situations, it could be argued that compromised independence led to a compromised audit.

Lack of Oversight

Morality and ethics cannot be legislated into existence. A professional organization like the AICPA should take active steps to recognize these sorts of situations and establish standards that help professionals in the field deal with the situations that they encounter. The accounting firms themselves also have a responsibility to establish appropriate cultures among their personnel, starting with the tone at the top. Firms need to structure their compensation systems to incentivize quality work and reward individuals for making difficult decisions - like telling the client "No" - rather than for selling consulting services.

Historically, the accounting profession has relied primarily upon self-regulation. While I certainly prefer the self-regulation of professions - rather than imposed governmental regulation - self-regulation must have teeth. The current situation overseen by the AICPA has no teeth: I am not aware of any major accounting firm failing a peer review. Essentially, the profession has lacked any meaningful review or disciplinary process.

Sarbanes-Oxley and the Accounting Profession

It is precisely because of the lack of leadership on the part of the AICPA that the recently established Accounting Oversight Board is so important. It will fill the role that the AICPA allowed to languish. The Oversight Board will meet the need of a strong investigatory and disciplinary body over the profession to encourage quality work and ethics. Nothing can substitute for a strong, effective cop on the beat with a big billy club who is not afraid to wield it. Accordingly, I strongly support and fully endorse the new Oversight Board.

In addition to the establishment of the Oversight Board, Sarbanes-Oxley also requires that the SEC adopt certain rules regarding the independence of auditors. We recently proposed these rules, which are intended to address a number of the issues related to the coziness of the accounting profession with its clients. For example, among other things, the proposed rules will require rotation of all engagement partners working on significant areas of the audit. The rules will also include a one-year cooling-off period before members of an audit engagement team can join an audit client in certain management positions.

These proposals are subject to comment, and I am looking forward to reviewing the comments, especially regarding practicability and effect on small companies.

We also proposed some revised rules dealing with non-audit services offered to public companies by their auditors. Congress in Sarbanes-Oxley endorsed the SEC's rules in this area. Our proposed rules clarify and enhance the rulemaking that was undertaken a few years ago, which is consistent with the intent of Congress to codify the SEC's current auditor independence rules. For example, legal services (in the United States at least) and management services provided to audit clients are clearly inappropriate, but accounting firms could continue to provide a broad range of tax services. Our Chief Accountant has argued that providing these tax services is essential for a competent audit. The essential standard boils down to preventing an auditor from being in an awkward position when he cannot simply say "No."

All of these rules -- which are essentially ethical obligations -- should have and could have been adopted by the accounting profession long ago. Further, the profession should have and could have established its own strong system of peer review and discipline - which it failed to do. Accordingly, Congress called upon us to act, and I believe that the Oversight Board and the proposed rules will go a long way toward restoring objectivity to this profession.

I should take a moment to contrast - since I am talking to a room filled mainly by lawyers - the reaction of the AICPA to the SEC's independence effort a few years ago with the ABA's reaction to our proposed rules, required by Sarbanes-Oxley, regarding corporate lawyers who practice before the SEC. This includes the very controversial "noisy withdrawal" if a lawyer perceives lack of an appropriate response to a potential fraud. While arguing strenuously against this proposal, the ABA has pointed out how it is taking steps to address these situations via ethical standards. Would many provisions of Sarbanes-Oxley have been necessary if the accounting profession had adopted a similar approach in the past?

Application to Fund Industry

At this point you might be wondering whether I mixed up a speech to a bunch of accountants with a speech to a bunch of lawyers from the fund industry. Well, the roots of the Sarbanes-Oxley Act are key to understanding where we are today and why the provisions of the Act are written the way they are.

In large part, the enactment of Sarbanes-Oxley was the result of a profession's failure to act. That failure and the crises that ensued have great collateral consequences on other industries, including the fund industry, which has largely operated for over sixty years without major scandal.

Crises - especially of the financial variety - have yielded a legislative reaction many times in our past. Professor Robert Higgs wrote a book a few years ago called Crisis and Leviathan. He traces very effectively how government's command-and-control system of resource allocation has expanded as a result of crises. When the government responds to an insistent but ill-defined public demand that it "do something" about a crisis, it is able to expand its power at the expense of the private-sector's cost-revealing market system. He reviews a number of crises in our history - some financial, some military - and reveals how the market sector has given way in those cases.

Thus, this demand to "do something" in times of crisis often yields incongruous regulatory results. Congress has acted and included the fund industry in a number of the provisions of Sarbanes-Oxley. Some have argued that Congress gave little thought to how the provisions could affect this industry. As a result, we at the SEC have been left to struggle with how to implement numerous portions of the Act within the regulatory structure of the '40 Act.

As I noticed from your schedule, you will be discussing these requirements in depth tomorrow afternoon, so I will not spend time listing them now.

It is apparent from the nature of these requirements, and the text of Sarbanes-Oxley itself, that the drafters of the legislation clearly had conventional, operating companies in mind. However, many provisions of Sarbanes-Oxley capture investment companies through the definition of the term "issuer," which generally encompasses companies that file reports under sections 13(a) or 15(d) of the Securities Exchange Act of 1934.

This definition has left us with the task of trying to fit a square peg into a round hole. The ICI's comments have pointed out a number of places where the Sarbanes-Oxley requirements do not mesh with investment companies. For example, section 407 of Sarbanes-Oxley requires disclosures of whether a Fund's audit committee includes a "financial expert." However, as your letters have reminded us, historically funds' financial statements have not been complicated due to the fact that fund assets consist almost exclusively of investment securities that are marked to market daily.

We also found quite a challenge to fit the financial statement certification requirements under Sarbanes-Oxley to an investment company's reporting obligations. Sarbanes-Oxley requires CEOs and CFOs to certify annual reports based on their knowledge. The semi-annual report that a fund files is on Form N-SAR, which is a fill-in-the-blank, census-type form designed primarily for the SEC staff's use in administering its compliance program and in rulemaking. But, Form N-SAR doesn't have any financial statements. Complicating this requirement even further is that not all investment companies are required to file periodic forms.

I can imagine that many of you might be thinking to yourselves: Why are we being subjected to these regulations at all? We are not Enron, WorldCom or any other operating company whose failure led to the passage of Sarbanes-Oxley.

I believe that one reason why the mutual fund industry has avoided the scandals plaguing other industries stems from the simple, fundamental properties of fund management: (1) limitations on affiliated transactions, (2) daily market valuations, (3) oversight of funds by independent boards to eliminate conflicts of interest and prevent abuses, and (4) no taxpayer guarantees like the banking industry has. With the new regulations under Sarbanes-Oxley, you may perceive yourselves as being hit twice as hard as operating companies. In fact, investment companies are, in a sense, the victims -- the loss of confidence in the markets from the corporate scandals has caused investors to take their money out of funds. Why are funds being forced to pay the price for a problem they didn't cause?

I would like to use the remainder of my time to try to answer this question, to explain why we have included funds in our implementation of the relevant requirements set forth in Sarbanes-Oxley, and to offer a few suggestions as to why these requirements will serve to benefit the investment management industry.

Because most registered investment companies are not traded on an exchange, and their financial statements do not raise the same issues that those of operating companies do, as we move toward adopting final rules under Sarbanes-Oxley, we will try to balance concerns raised by commenters and the real-world situation with what we can divine as Congressional intent.

The corporate governance issues raised by Sarbanes-Oxley are critical to investment companies. Investors need to believe that auditors of public companies are without conflict, ethical, and acting in the best interests of shareholders, that corporate officers are honest and have the best interests of their companies and stockholders in mind, that boards are actively guarding their interests and that financial reports issued by public companies present a clear and accurate picture of the financial health of those companies.

Mutual funds are the vehicles that connect millions of Americans to the securities markets. Codes of ethics are just as relevant to registered investment companies and their investment advisers as to operating companies. The same applies to mutual funds standing behind their financial statements. In this vein, the banking regulators have urged banks and the other financial institutions they oversee to adopt many of the requirements of Sarbanes-Oxley as best practices.

Our joint challenge, for the benefit of investors who ultimately bear the burden of increased regulation through fees, is to work together to ensure that the provisions of Sarbanes-Oxley regarding investment companies are implemented in balanced ways, without imposing unnecessary costs on fund shareholders. In this regard, although Sarbanes-Oxley in many cases is a difficult fit for funds, the goal has been to apply the provisions of the Act in creative and appropriate ways for funds, while furthering the intent of the Act.

For example, when we implemented section 302 of Sarbanes-Oxley requiring the principal executive and financial officers to certify the information contained in a fund's N-SAR, we also proposed a new form, form N-CSR, to better implement the intent of the Act. While I always retain a concern that new forms may simply impose additional burdens upon issuers, Congress intended the certification requirement to improve the quality of the disclosure that a company provides about its financial condition in its periodic reports to investors. Since shareholder reports are the primary means by which funds provide financial statements to investors, funds would file on Form N-CSR copies of required shareholder reports, information about the fund's internal controls and procedures, and the certifications of its principal executive and financial officers.

Mutual funds have a lot to gain through this increased scrutiny of corporate governance. When investors' confidence increases, they will return to the markets. And when they do, history shows that the vehicles they will use will be mutual funds. As institutional investors, funds have a stake in ensuring that we implement these regulations in the right way with respect to the companies in which they invest.

One last point I would like to mention is that Sarbanes-Oxley not only affects investment companies, public companies and other financial institutions, but it also imposes a whole new set of responsibilities on the SEC. As a matter of fact, if you take a look at us, you might feel better. Sarbanes-Oxley requires the SEC to review the disclosure documents of each issuer at least every three years. With 98,000 filings in 2001, this amounts to about 1100 filings per SEC accountant each year. Although Sarbanes-Oxley grants a substantial percent increase in the SEC's budget, these funds have not yet been appropriated. Regardless of this new money and increased staff, in a post-Enron world and with this increased mandate from Congress, we will certainly have to have a wholesale review and restructuring of our own systems and procedures to make sure that we will do a more effective job for the investor and taxpayer.


The events of this past year have made the bolstering of investor confidence a vital regulatory goal. President Bush and Congress played their part - they provided the impetus for renewed focus on accountability of accountants and emphasis on corporate responsibility. Our role is to implement these laws as we have been directed to do, while avoiding additional requirements that impose unnecessary costs or burdens beyond the law's intent. This is where you come in. I urge you to continue to provide us with your comments on a comprehensive and timely basis, which I realize is becoming more demanding as we shorten our comment periods to comply with Sarbanes-Oxley's tight implementing deadlines. In this way, we can work towards fulfilling the mandate Congress has given us to the best of our ability.

I thank you again for inviting me to speak here today. Now, I would be more than happy to take any questions you may have.



Modified: 12/11/2002