Public Statement by SEC Chairman:
Remarks at the Winter Bench and Bar Conference of the Federal Bar Council
Chairman Harvey L. Pitt
U.S. Securities and Exchange Commission
February 19, 2002
These remarks reflect solely the personal views of Mr. Pitt, and do not necessarily reflect the views of the Commission, the individual members of the Commission, or its Staff.
One reason I readily accepted the President's gracious invitation to Chair the Securities and Exchange Commission was the prospect of finally settling down to a job where I could sit for hours at my desk undisturbed, and quietly contemplate arcane issues regarding nuances of the federal securities laws and help define public policy. I thought I was entering an ivory tower of sorts, where good thoughts and creative ideas would be rewarded both here and in heaven! As I'm sure even those of you who do not regularly follow the travails of the federal securities laws know, it hasn't quite worked out that way so far, at least here. It's mercifully too soon to make judgments about other locales.
I was viewing life in those rose-colored hues when I accepted Judge Rakoff's flattering invitation last August to join distinguished members of the judiciary and the bar at this conference and offer some modest observations on a topic of my choosing. Now, I don't want to mislead you. I learned, from years of practicing law with Judge Jed, that he and my mother had one very strong trait in common the appearance of a choice is never what it seems! I may have been told I had a choice of topics, but I knew it was only a matter of time before I'd be told what my choice was!
My familiarity with the good Judge also taught me he is nothing if not thorough. And so, I received several calls from him, asking what I would talk about today. Early on, I thought we agreed I would talk about the government's obligations when it files an amicus brief. But, last week, as I sat in my office, thinking about my speech and reading an early draft, Judge Rakoff called and asked again, for what proved to be the final time, about my speech topic.
When I reiterated our previously agreed upon topic the ethical and professional obligations that apply when government agencies act as amici, I sensed Judge Rakoff was unconvinced. "Is that your final answer?" he asked, as if he were a quiz show host. "Yes," I replied. Then he asked, "Don't you think you have something hotter to talk about?" I told him this audience wouldn't be interested in all that headline stuff, and would really like hearing about government brief-writing obligations, but the Judge cut to the quick, as he is so adept at doing: "Don't you think you should talk about Enron?" To the uninitiated, this might have sounded like a question. But I know a judicial decree when I hear one! So I will save the topic of amicus briefs for another occasion, and offer some perspectives on a few of the lessons to be learned from the Enron debacle.
The tragedy that Enron reflects is breathtaking in its scope and reach. The large number of people callously injured is shocking. And, the implications of Enron are incredibly broad and far-reaching. Since I believe business, law and accounting classes will spend entire semesters, if not full academic years, analyzing the issues raised by Enron in the coming years, I will offer only a cursory overview of some of Enron's implications in the time allotted. But, I hope you will not assume from my truncated remarks that the problem is limited, or easy to identify, much less susceptible of simple solutions quickly implemented. Nothing could be further from the truth.
Let me start by observing that there are two major facets to the Enron situation figuring out who perpetrated this awful tragedy (along with what to do to them), and finding ways to minimize the likelihood that things like this will recur. As to the former, our Enforcement Staff is investigating to find out if there have been violations of the federal securities laws, and by whom. Until their investigation is complete, we cannot fairly assign blame. But, our Enforcement Division is conducting a thorough investigation, and we will deal aggressively with any wrongdoing and wrongdoers.
The second major facet figuring out how to minimize chances that something like this will recur -- is more complicated. An integral element of this inquiry is whether Enron resulted from bad behavior by bad people, or from systemic flaws needing repair. I'll leave the first half of the equation bad people and bad acts to our investigators, and focus solely on whether we have systemic flaws. Even before the Enron tragedy, we were alerting all who would listen that our system showed signs of age, and needed significant improvements. Enron makes even more apparent the immediate need for necessary changes in our system.
This is not to say that fraud lurks behind every public company's financial statements. Our financial reporting and disclosure system has been, and still is, the best in the world. That does not mean it cannot be improved; it can. And it surely does not mean that we can, will, or should, tolerate more Enrons; we won't. But, as long as investors are given full, fair and comprehensible disclosure, and read and think before they buy or sell securities, the existing system will continue to serve them. Implosions like Enron require us to reassess how our system is functioning and, more critically, to learn how to improve it.
Not all problems can, or should, be cured with regulations or legislation. For example, for both lawyers and auditors in the aftermath of Enron, there are serious ethical issues to consider and address. Put simply, the core issue is: who does a lawyer or an accountant represent when a corporation retains him or her? The answers for both professions are similar, but the analysis is dramatically different.
Lawyers are paid, and are professionally obligated, to advocate legitimate views and interests of their clients, with emphasis on the word "legitimate." This is a decidedly different function from the one auditors perform. Nonetheless, Enron teaches it is inappropriate for corporate lawyers to assist clients in finding ways to evade legal requirements, or disserve the public interest, even if those results can be achieved in a manner arguably within the literal letter of the law. Corporate lawyers represent the corporation and its shareholders, even though management may hire or fire them; they must be satisfied that objectives management asks them to pursue truly are intended to, and do, further the interests of the company and its shareholders. And, they need to ward against conflicts arising between management and the company's shareholders; if such conflicts arise, corporate lawyers must avoid lending assistance to any action that could harm shareholders. In sum, corporate attorneys should serve corporate constituencies in all they say and do; they should not use their skills primarily to serve the interests of corporate managers, even if the goals of those managers can be harmonized with the best interests of the corporation and its shareholders.
Confidence in our capital markets cannot be maintained if the public believes everything is a game to enable corporations to rely on lawyers and other professionals, who in turn rely on a literal reading of the law or governing principles. That, in my view, is a major flaw in our system that Enron has exposed. Government, or at least government acting alone, should not be expected to solve this problem. It must be solved by professionals who are faithful to their professional obligations. The notion lawyers too often adopt is, if it's technically legal, it must be ok! Helping a company fall within very literal legal prescriptions, even when doing so flies in the face of what the particular legal prescriptions were obviously intended to accomplish, endangers public confidence, and is surely ill advised.
The issues are different for accountants. We start from the proposition that accountants engaged in auditing, unlike lawyers, are not, and may not act as, advocates for their clients; they are professionals whose function is to give the investing public greater confidence that a company's financial reports are reliable, and truthfully prepared. Some would try to make accountants guarantors of the accuracy of corporate reports. But, even the most dutiful accountant could not assume that level of obligation. Years of experience teach that it is difficult, and often impossible, to discover frauds perpetrated with management collusion.
The fact that no one can guarantee that fraud has not been perpetrated does not mean, however, that we cannot, or should not, improve the level and quality of audits. The Auditing Standards Board recently approved an exposure draft on revised standards for fraud detection. This is a timely and a positive development; one that needs to be finalized promptly. Auditing firms also should put their collective heads together to figure out better ways to structure audits so that their personnel can better detect fraud. At present, the firms largely act unilaterally; acting in concert would ensure that greater resources could be applied to the problem more effectively, and would have the not insignificant side benefit of demonstrating accounting firms really do care about improving the safeguards our system offers investors.
Other accounting problems do not just reflect situations where auditors got out-foxed, or colluded with management. Present-day accounting standards are cumbersome and offer far too detailed prescriptive requirements for companies and their accountants to follow. That approach, by necessity, encourages accountants to "check the boxes" that is, to read accounting principles narrowly, to ascertain whether there is technical compliance with applicable accounting principles.
But the first principle should always be the one Judge Henry Friendly articulated four decades ago in the Lybrand Ross criminal case, US v. Simon. There, in rejecting the auditors' claim that criminal charges were foreclosed because the financial statements literally complied with GAAP, Judge Friendly held that, if literal compliance with GAAP creates a fraudulent or materially misleading impression in the minds of shareholders, the accountants could, and would, be held criminally liable.
Judge Friendly's decision came at a time when unlike the situation today accounting standards were more often based on broad principles, and their objectives were stated unequivocally. The standard for accounting for the cost of inventories is a good example it provides, along with other broad principles, that overhead must be included in the cost of inventories, no matter how determined. In the 49 years since that standard was promulgated exactly one interpretation has been needed, and that was way back in 1974! And, I am unaware of any recent enforcement cases involving inventory accounting. These are the kind of standards we need for all accounting principles. In moving to that system, we must remain concerned about fair presentation, and there must be enough certainty to avoid unfair liability for good faith efforts to follow standards articulated more clearly.
That is why we are advocating fundamental and far-reaching changes in the Financial Accounting Standards Board. We seek to move toward a principles-based set of accounting standards. The SEC must play an active and aggressive oversight role vis-à-vis FASB. This means the SEC must have greater influence over FASB's agenda, and should be able to require FASB to address critical subjects and promulgate standards in a short time frame, rather than the years it currently takes for principles to be announced. It also means adding disclosure to explain the impact on financial reports of key accounting principles and decisions.
Similarly, every profession needs diligent and vigorous oversight and quality control. Accountants are no exception. To address this need, we are proposing a private-sector regulatory body, predominantly comprised of persons unaffiliated with the accounting profession. Funds for this body would come from involuntary assessments imposed on all who benefit from the services audits of public companies provide. And, a meaningful regulatory system requires vigorous enforcement and investigative powers, backed up by the SEC's own enforcement powers. A system like this should have been in place years ago. We intend to put it in place as quickly as possible.
We also need to ensure that auditors and accounting firms do their jobs as they were intended to be done. Our disclosure system depends on it. And yet, long before Enron's collapse, it was painfully clear that the accounting profession had experienced an enormous brain drain; the numbers of new graduates seeking to enter accounting, especially those at the top of their classes, were diminishing rapidly. The current environment with its scrutiny and criticism of accountants is unlikely to create a groundswell of interest on the part of top graduates to become auditors. Quality, quantity, competence and ethics have been, and still are, the key issues for the profession. We intend to deal with those issues, and help transform and elevate the performance of the profession. The profession we envision with better fraud detection, accounting standards and oversight will be vibrant and attractive to smart young people.
Recent events also have underscored the need for public companies to have a strong commitment to full disclosure and compliance with all regulatory regimes to which their companies are subject. While no set of rules can stop venal actors determined to put personal interests ahead of those of the companies they manage, there are a number of ways current corporate governance standards can be improved to strengthen the resolve of honest managers and the directors who oversee management's actions. Toward that end, we have asked the FEI to review its model code of conduct for corporate directors, to see if recent events suggest improvements in that model. Concurrently, we have asked the NYSE and Nasdaq to review their listing agreements, to see whether new obligations for corporate officers and directors can be articulated to enhance the security investors feel, and the reliance they place, on corporate oversight.
We are at work on numerous other initiatives to improve and modernize our current disclosure and regulatory system. These initiatives include the following:
- A "current" disclosure system. Investors need current information, not just periodic disclosures, along with clear requirements for public companies to make affirmative disclosures of, and to provide updates to, unquestionably material information in real time. As we announced last week, we want investors to have an accurate and current view of the posture of their company, as seen through the eyes of management. We are also proposing to expedite the filing of existing periodic reports.
- Public company disclosure of significant current "trend" and "evaluative" data. Providing current trend and evaluative data would enable investors to assess a company's evolving financial posture. It would also preclude "wooden" approaches to disclosure, and encourage evaluative disclosures that begin where line item and GAAP disclosures end. This information, upon which corporate executives and bankers already base critical decisions, can be presented without confusing or misleading investors, prejudicing legitimate corporate interests or exposing companies to unfair assertions of liability.
- Clear and informative financial statements. Investors, and employees concerned with preserving and increasing their savings and retirement funds deserve comprehensive financial reports they can easily and quickly interpret and understand.
- Conscientious identification and assessment of critical accounting principles. Public companies should be required to identify the most critical accounting principles upon which a company's financial status depends, and which involve the most complex, subjective, or ambiguous assessments. Investors should be told, concisely and clearly, how these principles are applied, as well as information about a range of possible effects in differing applications of these principles.
- Ensuring those entrusted with the important public responsibility of auditing public companies are single-minded in their devotion to the public interest, and not subject to conflicts that might confuse or divert them. Those who perform audits must be truly independent and in particular must not be subject to the conflict of increasing their own compensation at the risk of ensuring the public's protection. Their fidelity to the cause of full, fair and understandable financial reporting must be ironclad and unequivocal.
- More meaningful investor protection by audit committees. Audit Committees must be proactive, not merely reactive, to ensure the quality and integrity of corporate financial reports. Especially critical is the need to improve interaction between audit committee members and senior management and outside auditors. Audit Committees must understand why critical accounting principles were chosen, how they were applied, and have a basis to believe the end result fairly presents the company's actual status.
- Analyst recommendations predicated on financial data they have deciphered and interpreted. Two weeks ago, the securities industry and its self-regulators announced proposed rules to create more transparency for analyst recommendations. Responding to a directive from the House Financial Services Committee and the SEC, these proposed rules appear to go a long way toward addressing concerns about conflicts of interest. Once these proposals are formally filed with us, we will invite public comments, and then proceed expeditiously to review the proposals and comments.
As I noted, last week we announced our intent to propose changes in corporate disclosure rules as the first in a series of steps designed to improve our financial reporting and disclosure system. The proposed rules would require companies to report additional critical information on a current basis and in a complete manner, such as transactions by company insiders, critical accounting policies, and changes in rating agency decisions. While these proposed rules would only be a first step, they will provide the most dramatic and significant improvements in our disclosure system in at least two decades, and they can be implemented quickly while other more sweeping proposals are considered. We anticipate proposing further comprehensive reform proposals covering financial reporting and disclosure requirements, accounting standard setting, regulation of the auditing process and profession and corporate governance. We will be working on our own and together with Congress, the President's Working Group, companies, investor groups and other interested participants on our regulatory agenda.
The SEC does not have a monopoly on wisdom, nor do we have definitive answers to all the problems highlighted by Enron's collapse. We do have an undeniable obligation to think about the issues, search for answers, lead constructive debate, and move quickly on behalf of investors to try to prevent future Enrons. We must consider the issues, put forward the most responsible proposals we can, and engage in a dialogue with all parties willing to participate. That is the process we have begun, and we are committed to following through promptly on this process by taking all necessary steps to reassure the public and preserve confidence in our disclosure and financial reporting process. No one yet knows the final answers. But at the end of the process we must, and we will, have a better system that instills justifiable confidence in investors.