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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the Harvard Club

Remarks by

Commissioner Norman S. Johnson

U.S. Securities and Exchange Commission

at the Harvard Club
New York, NY

April 29, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its members or employees. The views expressed herein are those of Commissioner Johnson and do not necessarily reflect the views of the Commission or its staff.

Good afternoon. I’d like to thank the Directors Roundtable, and Jack Friedman in particular, for inviting me to speak today. I spoke at a Directors Roundtable event here at the Harvard Club a year-and-a-half ago and it’s very much my pleasure to be here again. Of course, my remarks here today are strictly my own and do not necessarily reflect the views of the Commission, other Commissioners or the staff.

Since I was last here, much has happened, but I’d like to talk today about a subject that has received a particular amount of attention in the last six months -- the problem of "earnings management." For those unfamiliar with this term and the SEC’s recent initiatives in this area, "earnings management" refers to the practice of companies misapplying accounting principles in order to report artificially "smoothed" earnings.

For many of you, the topic of "earnings management" probably brings to mind some of the recent, high-profile accounting scandals that have received so much attention. The newspapers of late seem to be full of stories of major companies that have been forced to restate their financial results -- at times accompanied by revelations that some members of the company’s management have been engaged in accounting fraud. While these situations attract most of the attention, the SEC is concerned about more than cases of outright, deliberate fraud. The Commission is also concerned about companies that -- while perhaps not engaging in an out-and-out, intentional fraud -- have shown a disturbing willingness to stretch or "fudge" the numbers, particularly when it’s necessary to meet analysts’ earnings targets. Some of these companies have even intentionally misapplied GAAP in their financial reporting -- apparently believing that this passes legal muster because the differences are quote "not material" unquote. In a speech last September at the NYU Center for Law and Business, Chairman Levitt described this as a "gray area between legitimacy and outright fraud, . . . where the accounting is perverted; where managers are cutting corners; and where earnings reports reflect the desires of management rather than the underlying financial performance of the company."

Now, I’m sure the first question on some of your minds is "Why is the SEC so concerned about this problem?" Our economy continues to perform at a remarkable pace. Just a few weeks ago, the Dow broke the 10,000 mark -- a figure unimaginable even a few years ago. Corporations continue to report record profits. The bull market is nearly a decade old. In light of the economy’s impressive run, I know there are those who would say "If it ain’t broke, don’t fix it."

But I believe there is a real problem that needs to be fixed. And it’s not just the SEC’s opinion that earnings management is an increasingly serious problem. In his most recent letter to Berkshire Hathaway shareholders, Warren Buffett commented that "a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street’s desires." In fact, Mr. Buffett went so far as to describe what he sees as many executives’ lack of respect for accurate financial reporting as a "business disgrace."

These are strong words and I want to be clear about what I see as the scope of the problem. Certainly, I do not believe that most companies engage in deliberate fraud. I have always believed that most corporate officers and directors take seriously their regulatory responsibilities and their fiduciary duties to shareholders. Even after my years at the SEC, I continue to believe this.

But having seen the misconduct leading to some of the enforcement cases we’ve brought during that time, I can assure you that there are some who are willing to cut corners. And when respected figures like Warren Buffett begin to speak in such strong terms, it is time that all members of the financial community take notice and think about what can be done to fix things.

Today, I am glad to report that something is being done about the practice of earnings management. The SEC has made this a top priority. So far, what’s been most noticeable is the increased emphasis on accounting fraud in our enforcement program. As I’m sure many of you are aware, the Commission’s Director of Enforcement, Dick Walker, has announced that 1999 will be the "Year of the Accountant" at the Commission. Obviously, no profession wants to receive this sort of attention from our enforcement division. So far, the SEC has brought several high profile enforcement cases based on fraudulent financial reporting. Confidentiality requirements restrict my ability to discuss matters that the Commission has not publicly announced, but our enforcement division has indicated that it will continue to focus on accountants and on accounting fraud in its investigations.

Although I strongly disagree with some of the means chosen by my colleagues to respond to accounting abuses -- in particular the Commission’s use of Rule 102(e) of our Rules of Practice as an enforcement weapon against accountants -- I do support the Commission’s underlying efforts to maintain the quality of financial reporting. Unfortunately, this sometimes results in accountants and auditors being charged with violations of the federal securities laws. In bringing such cases, I believe it is critical that we not unfairly blame professionals just because we disagree with their advice after the fact. Nonetheless, one’s status as an accountant or auditor does not by itself confer any immunity under the federal securities laws.

While our enforcement program has received the most attention so far, I’d like to focus today on another aspect of the SEC’s earnings management initiative -- one that should be of particular interest to corporate directors and the attorneys who counsel those directors. As part of his September speech, Chairman Levitt announced that he had called on the New York Stock Exchange and the NASD to develop recommendations for strengthening board audit committees.

This initiative is based on a simple premise -- good corporate governance contributes to reliable financial reporting. All board members, of course, owe fiduciary duties to the company’s shareholders. As fiduciaries, audit committee members stand in the shareholders’ shoes in overseeing the quality and integrity of the company’s financial reporting. The goal of the audit committee initiative is to create informed and effective audit committees that can monitor the financial reporting process to prevent the types of "earnings management" and outright fraud that have caught the attention of our enforcement division.

Shortly after the Chairman’s speech, the New York Stock Exchange and the NASD announced the formation of a "blue ribbon" panel on improving the effectiveness of audit committees. This distinguished group was charged with a difficult task. The Blue Ribbon Committee was asked to "develop a series of far-ranging recommendations intended to empower audit committees and function as the ultimate guardian of investor interests and corporate accountability." And they were asked to do so in 90 days.

I’m pleased to report that the Blue Ribbon Committee has met the ambitious agenda set for it. In early February, the committee issued a 71-page report on "Improving the Effectiveness of Corporate Audit Committees." In preparing this report, the committee received input from a wide range of sources through a public hearing and a request for written comments. Representatives of more than 25 different financial and accounting organizations responded.

The report sets forth 10 recommendations that fall into three categories:

The first group would strengthen the independence and effectiveness of the board members chosen to serve on audit committees. The Committee recommended amending the New York Stock Exchange and the NASD’s listing requirements to impose certain requirements on the composition of board audit committees. Specifically, the larger listed companies would be required to have an audit committee composed of at least three members. All members of the audit committee would also have to be "independent" from the company’s management under a new, stronger definition of "independence." In addition, all members of the audit committee would have to be what the report calls "financially literate" -- meaning they have the ability to understand fundamental financial statements. And at least one member of the audit committee would have to have "accounting or related financial management expertise."

The second set of recommendations would require the audit committees of listed companies to adopt a formal written charter detailing the scope of their responsibilities. The Blue Ribbon Committee also recommended that the SEC require reporting companies to make disclosures in the proxy statement for their annual shareholder meeting about the audit committee’s activities and whether the audit committee has a charter. The Blue Ribbon Committee also recommended that the Commission create a "safe harbor" for these disclosures.

Finally, the third group of recommendations attempt to create more dialogue and accountability between the audit committee, management and the outside auditors. Included in this group is a recommendation to give the audit committee authority to select and, when appropriate, replace the outside auditor. The Blue Ribbon Committee also recommended amending GAAS to require the outside auditor to discuss with the audit committee the quality, not just the acceptability, of the accounting principles used in the company’s financial reporting. The Committee also recommended that the SEC require a reporting company’s outside auditors to conduct interim reviews of the company’s quarterly financial reporting.

The Blue Ribbon Committee’s report is lengthy and some of the recommendations are quite detailed. Rest assured, I will not further interrupt your lunch by going over each of the ten recommendations in detail. However, I would encourage all of you with an interest in these issues to read the report in full. You can find it online at both the New York Stock Exchange's and the NASD's websites.

I do want to discuss one recommendation by the Blue Ribbon Committee that I believe is particularly important. One of the audit committee’s primary tasks is monitoring the independence of the company’s auditors. An auditor’s independence from his or her client lies at the core of the auditing profession’s standards and is crucial to a reliable financial reporting process. Auditors of public companies owe their preeminent loyalty to the company’s shareholders and to public investors generally, not to their audit clients.

A number of the Commission’s recent enforcement cases for financial fraud have raised questions regarding the independence of the auditors involved. As I have explained in a previous speech, I fear that many of these independence problems may be rooted in the organizational changes that have taken place in the accounting profession over the last several years, including, most notably, the growth of accounting firms’ consulting practices. I am also concerned about the recent efforts of some accounting firms to expand into the practice of law -- a development that I believe has troubling implications for auditor independence.

In light of my concerns, I was pleased to see that the Blue Ribbon Committee included at least one recommendation designed to bolster the audit committee’s role in monitoring the independence of the company’s auditor. This recommendation would require the audit committees of all listed companies to receive from the outside auditor a statement detailing all relationships between the auditor and the company that might affect the auditor’s independence. The audit committee would also be responsible for engaging in a dialogue with the auditor about any such relationships and for taking, or recommending that the full board take, any appropriate action to ensure the independence of the auditor.

This recommendation builds on a standard recently adopted by the Independence Standards Board or ISB -- a group under the leadership of William Allen, a former Chancellor of the Delaware Court of Chancery. Under this new standard, which takes effect in July, an accounting firm must annually give written notice to its client's audit committee of any relationship that may reasonably be thought to bear on the auditor’s independence. For instance, this might include consulting work performed for the company or employment of former auditors at the company. The accounting firm must also annually discuss the auditor’s independence with the audit committee.

The Blue Ribbon Committee’s recommendation -- working in tandem with the ISB’s new rule -- is intended to focus both accounting firms and audit committees on the various factors that may affect the auditor’s independence. The rules also create an opportunity for the audit committee to explore independence issues with the outside auditor and, when necessary, with the full board. Of course, many audit committee members will not be lawyers or accountants and cannot be expected to learn all the intricacies of the existing auditor independence rules, which are quite complex. Instead, this recommendation is merely intended to create an opportunity for the audit committee members -- using the good judgment, practical experience and sound instincts for which they were chosen to serve on the board -- to ask the auditor hard questions about their independence.

Before I conclude, I also want to mention another issue that is a particular concern of mine. Throughout my tenure at the SEC, I have tried to be sensitive to the effects of our rulemaking on small businesses. As a practicing lawyer, I had the privilege of representing a number of small businesses. Based on my experience, I have learned that rules that make sense for a Fortune 500 company may not always make sense for a start-up.

In light of my concerns, I took note of the fact that some of the Blue Ribbon Committee’s recommendations are limited to larger, public companies. Specifically, the committee’s recommendations concerning the composition of audit committees only apply to listed companies with a market capitalization of at least $200 million -- or a more appropriate measure as determined by the New York Stock Exchange and the NASD. The recommendations would maintain the status quo for smaller companies.

I know that some have speculated that the SEC may want to expand the Blue Ribbon Committee’s recommendations to include smaller companies. While I don’t want to prejudge any issue that may come before the Commission, I certainly would want to proceed with caution before taking any such step. Some of the Blue Ribbon Committee’s recommendations -- such as the requirements that companies have at least three audit committee members who are independent from management and one member who has a background in accounting or corporate finance -- may not be practical for some small companies. I look forward to examining this issue in more detail as any rulemaking goes forward.

The Blue Ribbon Committee has produced far-reaching recommendations with important consequences for all public companies, particularly those listed on the New York Stock Exchange or Nasdaq. At the same time, much work remains to be done before any rules are put in place. I know that the Commission’s staff in the Division of Corporation Finance -- under the able leadership of Brian Lane -- are hard at work on the recommendations for rulemaking addressed to the Commission. And I trust that the New York Stock Exchange, the NASD and the AICPA are working on the recommendations addressed to them as well. Once the New York Stock Exchange, the NASD and the Commission have prepared any proposed rules, they will have to be published for notice-and-comment which will ensure that all interested parties have a chance to be heard.

I welcome the Blue Ribbon Committee’s recommendations and I am hopeful that the groundwork has been laid for a genuine improvement in corporate governance. In this "Year of the Accountant" at the SEC, it is my hope that these improvements can lead to more effective board oversight of the financial reporting process and, in turn, more reliable and accurate financial reports.

Thank you.