Public Statement by SEC Chairman:
Remarks at the SEC Speaks Conference
Chairman Harvey L. Pitt
U.S. Securities and Exchange Commission
February 22, 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.
Thank you, Annette and Paul, for that flattering introduction. I appreciate your faithful rendition of the introduction, just as I prepared it! Gosh, it's fun to be the Chairman!
Let me add my own welcome to all of you. This year's conference is the thirtieth edition of the "SEC Speaks." Conceived by the late Al Sommer, Alan Levenson, and PLI's Mary Mule', the premise was that once a year SEC Senior Staff and Commissioners would assemble to discuss issues of current importance. Members of the private bar, accounting firms and others affected by Commission pronouncements, actions and even inaction, could learn of late-breaking developments, as well as mingle and exchange ideas with the Staff.
In 1972, I was a young member of the Commission's Senior Staff, Chief Counsel of the then new Division of Market Regulation. It was one of my first public speeches, and I'm pretty sure my performance was not noteworthy, which was precisely the result I hoped for. We talked about institutional exchange membership, Chinese walls, and a host of other arcane and esoteric topics, at the old Hyatt Regency Hotel on New Jersey Avenue.
In many ways, the program was like a school "show and tell" presentation. To a large extent, it still is. We open our doors once a year and let professionals practicing before us know what we are doing and thinking. My last appearance on a panel at the SEC Speaks was in 1979, my first year in private practice. I can honestly say, after nearly a quarter century interregnum, it is great to be "back home" both at the SEC, and at this SEC Speaks program. I learned to be a lawyer at the SEC, and I never stopped caring about the agency, its missions and its employees.
As you all surely know, the SEC is an extraordinary agency, filled with talented people driven by intense dedication to our multiple missions. Many of you in the audience perhaps a majority are SEC alums; you know what I mean when I say that departing Staff always carry a bit of the Commission with them. While this is my first SEC Speaks since rejoining the SEC, it is the last year Lyn Oliensis will shepherd the program, and all of us, through the well-defined paces and rituals. We will miss you, Lyn. We all offer you special thanks for organizing a wonderful conference, year after year.
I've only been back at the Commission since September, but a few things have happened since then. First, we had the 9/11 terrorist attacks. Then we turned our attention to the conflicts confronted by securities analysts. While those efforts were ongoing, we were faced with the sudden and unexpected collapse of Enron. These were not the events I had expected would mark the beginning of my Chairmanship. But you don't get to choose the circumstances that prevail when you enter the game; you simply must play the hand you're dealt.
Crises like these require us to reassess how our system functions for us; they also require us to assess how we function in our system. Every crisis engenders one of two possible reactions there are those who seek to solve the problems, and then, unfortunately, there are those who seek to take advantage of them. The Commission doesn't have a choice we must solve the problems, and swiftly, because the success of our capital markets, which most of us took for granted prior to September 11th, but no longer do, depends on solutions we craft.
At present, there are many different forums in which solutions to the current crisis are being considered. We are pledged to work with any and all legitimate forums to achieve the best solutions. But, as efforts proceed in Congress, and as solutions are debated in the press, the Commission cannot wait. We must act. If legislation fails, or takes too long for passage and enactment, we would be faulted for not taking steps to minimize the likelihood of another Enron. We have announced an ambitious program of rulemaking and constructive overhaul of our present system. But that is not all that needs to be done.
For both lawyers and accountants, there are serious professional and ethical issues to consider and address. Accountants have recently joined lawyers as popular bashees. But, bashing professions is not good for anyone. It's time for all of us to step back and re-examine what it means to be a professional.
If you listen carefully to those who address the subject of accounting and accountants, you will note that some people refer to the accounting profession, while others refer to the accounting industry. This is not accidental, but it is significant. Nearly four decades ago, Robert Roy and James MacNeill, in their seminal work, "Horizons for a Profession," pointed out the prerequisites for designating accounting as a profession:
The most important and significant aspects of a CPA's services to his [or her] clients and to the public cannot be defined as knowledge, nor even as experience, but must be described by more elusive terms: wisdom, perception, imagination, circumspection, judgment, integrity.
When to speak out, when to be silent, how to say or write that which is necessary but awkward, courage to face up to the need for doing so, talent to be firm yet diplomatic, imagination to see beneath and beyond the surface, perceptivity not only for what has happened but also for what may happen, constancy in ethical behavior, sagacity to avoid errors of omission as well as those of commission: these and other attributes like them are qualities, not definable as knowledge but inherent in individuals. Without them a CPA can be nothing more than a technician, regardless of the scope of his [or her] knowledge; possessing these attributes plus requisite knowledge, [a CPA] is a professional.1
I do not doubt that accounting is, should be, and must be treated as, a profession; but that requires its members to act, in all respects, in a manner consonant with professionalism; if not, the public and the profession's critics will rightly consider it an industry. Recently, especially with the proliferation of the Internet, the number of laypersons who have some knowledge of the professions whether accounting, law or medicine has grown exponentially. And professionals are being challenged. Are we using our specialized knowledge in appropriate ways? What is our ethos, or code of ethics? Are we disciplining ourselves?
A core issue arising in Enron's wake is enhancing existing and planned legal standards with ethical and competency standards, for lawyers, accountants, directors and others. The public cannot be served if professionals who serve as gatekeepers merely follow the letter of the law, but not necessarily its spirit. We need to move away from wooden, rigid, literalism, and encourage all upon whom the present system depends to adopt a bias in favor of the needs of the investing public.
And, because the goal is to provide coverage that is broader than mere illegality, the government should not undertake to establish directly standards of professional ethics and competency. On the other hand, the government has to ensure that appropriate standards of ethics and competency are in fact established, and then rigorously implemented and enforced.
Viewed from the public's perspective, the central question 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, experience 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. Again, the establishment and enforcement of professional ethics, especially for lawyers, is not a function the federal government should embrace. It can be done by professional organizations, working cooperatively with the SEC and other interested governmental bodies.
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. Professionals who are faithful to their professional obligations must solve it. The notion lawyers too often adopt is, if it's technically legal, it must be ok! But lawyers are not mere technicians. We are professionals and our judgment is key. 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. Like lawyers, auditors have professional responsibilities. 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 54 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 Financial Executives International 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 New York Stock Exchange 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.
The role of audit committees and outside directors must be strengthened. We are hopeful that, working together with the exchanges, we will be able to craft a set of responsible guidance for directors and senior officers to follow.
One of the other elements that we are looking into is how to make corporate officers and directors more responsive to the public's expectations and interest. We think the best way to do that is a two-fold approach: first, make certain that officers and directors have a clear understanding of what their roles should be, and second, to apply serious consequences to those who do not live up to their fiduciary obligations. We are proposing to Congress that we be given the power to bar egregious officers and directors from serving in similar capacities for any public company.
We also need to focus on tailoring the remedies we are able to seek to fit the needs of investors. Our culture over the past decade has been to foster a short-term perspective of corporate performance. Managers and directors are rewarded for short-term performance, but there is a lack of emphasis on promoting long-term fundamental value in our corporations. Compensation especially in the form of stock options can align management's interests with those of the shareholders, but not if management can profit from illusory short-term gains, but not suffer the consequences of subsequent restatements, the way the public does.
We are at work on numerous other initiatives to improve and modernize our current disclosure and regulatory system. We anticipate proposing 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.
Although this conference is called the SEC Speaks, let me assure you that we're listening too. We welcome your ideas, your concerns, your constructive criticisms, and your guidance. Many of the projects we plan to pursue will not be well executed without your active participation. This May, the Commission will hold its first ever "Investor Summit," to solicit investor input on the policy issues that confront us as we begin reforming our disclosure and financial reporting process. We are also holding a series of Roundtables to discuss significant issues regarding our ideas for reform and the suggestions of others. It is incumbent on the SEC to consider the issues, put forward the most responsible proposal it can, and engage in dialogue with all parties willing to participate. That is the process we have begun, and to which we are committed.
For my part, we hope to inspire each of you to be the best professionals you can be. This is a difficult, but exciting time at the Commission, and we want all who interact with us to feel our excitement, participate in our proposed changes, and help steer us on the right course if you think we may have strayed. We also welcome any and all innovative ideas for change or improvements that you may have thought about and want to see us consider. We eagerly anticipate working with you to make sure that both you and we discharge our obligations prudently, generously and in the spirit with which the federal securities laws were adopted.
1 Robert H. Roy and James H. MacNeill, Horizons for a Profession (1967) at 1 (emphasis in original).