Congressional Committee Report for Accounting Reform Bill

[4] The bill also requires steps to enhance the direct responsibility of senior corporate management for financial reporting and for the quality of financial disclosures made by public companies. The bill establishes clear statutory rules to limit, and expose to public view, possible conflicts of interest affecting securities analysts. Finally, the bill authorizes substantially higher funding for the Securities and Exchange Commission.

[6] On February 12, 2002, the Committee heard from a panel of five former Chairmen of the Securities and Exchange Commission: Roderick M. Hills, Chairman, 1975-77; Harold M. Williams, Chairman, 1977-81; David Ruder, Chairman, 1987-89; Richard C. Breeden, Chairman, 1989-93; and Arthur Levitt, Jr., Chairman, 1993- 2000.¹

[7] On February 14, 2002, Paul Volcker, Chairman of the Trustees of the International Accounting Standards Committee, and former Chairman of the Board of Governors of the Federal Reserve System, and Sir David Tweedie, Chairman of the International Accounting Standards Board, and former Chairman of the United Kingdom's Accounting Standards Board, appeared before the Committee to discuss "International Accounting Standards and Necessary Reforms to Improve Financial Reporting."

[8] On February 26, 2002, a panel of three former Chief Accountants of the Securities and Exchange Commission and a former Chairman of the Financial Accounting Standards Board testified on "Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles." The witnesses were Walter P. Schuetze, Chief Accountant, 1992-95; Michael H. Sutton, Chief Accountant, 1995-98; Lynn E. Turner, Chief Accountant, 1998-2001; and Dennis R. Beresford, Chairman, Financial Accounting Standards Board, 1987-97.

[9] On February 27, 2002, the Committee heard testimony on "Corporate Governance" from John H. Biggs, Chairman, President, and Chief Executive Officer, Teachers' Insurance and Annuity Association -- College Retirement Equities Fund (TIAA-CREF), and former member of the Public Oversight Board; and Ira M. Millstein, Senior Partner, Weil, Gotshal & Manges LLP, and Co-Chair of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees.

[10] On March 5, 2002, the Committee heard from David M. Walker, Comptroller General of the United States; as well as Robert Glauber, Chairman and Chief Executive Officer, National Association of Securities Dealers, Inc., and former Under Secretary for Finance, Department of Treasury, under President Bush (1989-1992); Joel Seligman, Dean and Ethan A. H. Shepley University Professor, Washington University School of Law; and John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School.

[11] On March 6, 2002, the Committee heard testimony on "Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles" from Shaun O'Malley, Chairman, 2000 Public Oversight Board Panel on Audit Effectiveness, and former Chairman, Price Waterhouse LLP; Lee Seidler, Deputy Chairman, 1978 American Institute of Certified Public Accountants ("AICPA") Commission on Auditors' Responsibilities, and Managing Director Emeritus, Bear Stearns & Co.; Arthur R. Wyatt, former President, American Accounting Association, and Professor of Accountancy Emeritus, University of Illinois; Abraham Briloff, Emanuel Saxe Distinguished Professor Emeritus, Baruch College, City University of New York; and Bevis Longstreth, Member, 2000 Public Oversight Board Panel on Audit Effectiveness, and former Commissioner, Securities and Exchange Commission (1981-84).

[12] On March 14, 2002, the Committee heard from representatives of the accounting industry, the American Enterprise Institute, and The Brookings Institution. The witnesses were James G. Castellano, Chairman, AICPA, and Managing Partner, Rubin, Brown, Gornstein & Co. LLP; James S. Gerson, Chairman, Auditing Standards Board, AICPA, and Partner, PricewaterhouseCoopers LLP; William Balhoff, Chairman, AICPA Private Company Practice Section; Olivia F. Kirtley, former Chair, AICPA; James E. Copeland, Jr., Chief Executive Officer, Deloitte & Touche LLP; Peter J. Wallison, Resident Fellow and Co-Director, Financial Deregulation Project, American Enterprise Institute; and Robert E. Litan, Director, Economic Studies Program, The Brookings Institution.

[13] On March 19, 2002, the Committee heard from two members of the recently-disbanded Public Oversight Board ("P.O.B"): Charles A. Bowsher, former Comptroller General of the United States, who was the P.O.B 's Chairman; and Aulana L. Peters, former Commissioner, Securities and Exchange Commission (1984-88), who was a member of the P.O.B; as well as from L. William Seidman, former Chairman, Federal Deposit Insurance Corporation and Resolution Trust Corporation, and former Partner, Seidman & Seidman; John C. Whitehead, former Co-Chairman, Goldman Sachs & Co., Co-Chair of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, and former Deputy Secretary of State (1985-89); and Michael Mayo, Managing Director, Prudential Securities, Inc.

[14] On March 20, 2002, the Committee heard from a variety of interested parties including Thomas A. Bowman, President and Chief Executive Officer, Association for Investment Management and Research; Howard M. Metzenbaum, Chairman, Consumer Federation of America, and former U.S. Senator; Damon Silvers, Associate General Counsel, AFL-CIO; and Sarah Teslik, Executive Director, Council of Institutional Investors.

[15] On March 21, 2002, the Committee heard testimony from Harvey L. Pitt, Chairman, Securities and Exchange Commission.

[17] The new Board may, subject to review by the Securities and Exchange Commission (the "SEC" or the "Commission"), establish, adopt, or modify auditing, quality control, ethics, and independence standards for public company audits, inspect accounting firms, investigate potential violations of applicable rules relating to audits, and impose sanctions if those violations are established. The Board will have authority only with respect to audits of public companies. It has no jurisdiction over the work of accountants in auditing other companies.

[18] The Board will bring together various issues and responsibilities that have in the past been subject to what one Committee witness characterized as "a bewildering array of monitoring groups"² under the auspices of the accounting profession. As Shaun O'Malley, Chairman of the 2000 Panel on Audit Effectiveness (and former Chairman of Price Waterhouse LLP), explained to the Committee in greater detail:

[20] The concerns of the Committee extend beyond immediate allegations of wrongdoing, to the fundamental principles on which the functioning of free markets and the protection of investors are based. Each of the country's federal securities laws -- the 1933, 1934, 1935, and 1940 Acts -- requires comprehensive financial statements that must be prepared, in the words of the Securities Act of 1933, by "an independent public or certified accountant."⁷ Professor Benjamin Graham's seminal textbook for securities analysts explains why:

[21] The successful operation of the Board depends upon its independence and professionalism. The Board will have five members, each of whom must have a demonstrated commitment to the interests of investors, as well as an understanding of the financial disclosures required of public companies, and the responsibilities for those disclosures, under the federal securities laws. Three members of the Board will have a general background, and two members will have an accountancy background.¹⁰ (The Board's Chairperson may have an accountancy background, but if so, he or she may not have been a practicing accountant for at least five years prior to appointment to the Board.)

[22] Board members are to be appointed by the SEC after consultation with the Federal Reserve Board and the Department of the Treasury. They will serve full-time, for five-year (staggered) terms, with a two-term limit. To further assure their independence, Board members may engage in no other business activities of any nature, or receive any payments from any accounting firms (except for standard retirement payments) or other persons. In addition, former Board members will be subject to a one-year "cooling off" period at the end of their Board service, during which time they may not work for an accounting firm registered with the Board.

[23] It is essential that the Board have a strong, well- trained, and experienced staff, of sufficient size to carry out its responsibilities. A number of witnesses emphasized, for example, that inspections must no longer be left to "peer reviews" of one accounting firm by another. ¹¹ The bill makes it plain, as the Committee intends, that the Board is to provide for staff salaries that are fully competitive with those for comparable private-sector self-regulatory, accounting, technical, supervisory, or related staff or management positions.¹²

[24] Prompt Action is Essential . The Committee believes that the new oversight arrangements must come into effect quickly. The SEC is to appoint the initial Board within three months of the bill's enactment, so that the Board can take the steps necessary to begin its operation within six months of its appointment, and the registration of accounting firms (below) can be completed within six months after the Board begins operation.

B. Registration of accounting firms

[25] Accounting firms that audit public companies must register with the Board, no later than six months after the SEC determines that the Board is ready to begin operation. It is unlawful for a firm that has not registered to continue to audit public companies.

[26] Conditioning eligibility to audit public companies on registration with the Board is the linchpin of the Board's authority. Suspension or revocation of registration renders a firm unable to continue its public company audit practice.

[27] As part of its registration process, each accounting firm must execute a consent to comply with any requests, within the Board's authority, for documents or testimony made in the course of the Board's operation. The firm must also agree to obtain (and ultimately, if necessary, to enforce) similar consents from the firm's partners and employees, who are subject to the Board's investigative and disciplinary jurisdiction.

[28] Certain necessary information is to accompany the registration materials (including a list of the firm's accountants who perform public company audits), and the Board will determine within 45 days of receipt whether an application is complete and the applicant can be registered. Basic registration information is to be public, but each accounting firm may protect from public disclosure information that it reasonably identifies as proprietary or that is otherwise protected by law. Each registrant is to file a report annually to update the required information.

[29] The Board is to assess a registration fee, and an annual fee, to recover the costs of processing and reviewing applications and annual reports.

C. Auditing, quality control, ethics, and independence standards and rules

[30] The bill requires the Board to establish or adopt auditing, quality control, and ethics standards for the audit of public companies. The Committee has concluded that the Board's plenary authority in this area is essential for the Board's effective operation, a position taken during the hearings by a number of witnesses, including former SEC Chairman Levitt, former Comptroller General Bowsher, and former FDIC Chairman Seidman (himself once a principal of a substantial accounting firm).¹³

[31] The Board's standard-setting authority, however, is neither intended nor structured to exclude practicing accountants from participation in the standard-setting process. The Board may adopt as part of its rules (and modify as appropriate for that purpose, at the time of adoption or thereafter), any portion of a statement of auditing, quality control, or ethics standards that meets the bill's statutory tests and that is proposed (i) by a professional group of accountants (designated by a rule of the Board for that purpose), or (ii) by one or more advisory groups of practicing accountants or other interested parties convened by the Board. (Pre-existing standards of designated professional groups of accountants may be adopted during the Board's transitional period.) The Board is to cooperate on an ongoing basis with the designated professional groups of accountants noted above, with its own advisory groups, and with other interested groups (and the accounting profession and the investing public at large), in examining the need for changes in any standards subject to Board authority. It is to recommend issues for inclusion on the agendas of these groups, take other steps to facilitate the standard-setting process, and respond in a timely fashion to requests for changes in the standards. Finally, rules are open to comment by accountants and any other interested persons in a public process before they are approved either by the Board or, ultimately, by the SEC. Many of these provisions were suggested by Senator Enzi.

[32] Particular Standards Required by the Bill . Although the Board's power to establish or adopt auditing and related standards extends to the full range of those standards, the bill specifies certain provisions that must be part of the standards. These include (i) preparation, and maintenance for at least seven years, by public company auditors of audit work papers and related information in sufficient detail to support each audit's conclusions, (ii) "second partner" review and approval of each public company audit report and its issuance, and (iii) inclusion in each audit report of a description of the auditor's testing of the public company's systems for compliance with the requirements of section 13(b)(2) of the Securities Exchange Act and of the company's controls over its receipts and expenditures, together with specific notation of any significant defects or material noncompliance of which the auditor should know on the basis of such testing. In addition, the quality control standards adopted by the Board must address an accounting firm's monitoring of ethics and independence; internal and external consulting on audit issues; audit supervision; hiring, development, and advancement of audit personnel; acceptance and continuance of engagements; and internal inspection.

[33] Auditor Independence. The Board is also authorized to issue rules to implement the provisions of title II of the bill relating to auditor independence. That authority is discussed in greater detail in connection with title II, below.

D. Inspections of registered accounting firms

[34] Virtually every witness who addressed the details of auditor oversight agreed on the critical need for a regular and comprehensive review, by an independent body of inspectors, of each audit firm's compliance with audit standards and procedures. A program of inspections is essential to identify problems in firm procedures, training, and "culture" before those problems can produce audit failures that trigger large investor losses and threaten confidence in the capital markets.¹⁴

[35] The Board is to inspect the operations of each registered accounting firm, in order to assess compliance of that firm, and of its partners and employees, with the new statute, the Board's rules, and professional accounting standards. Initially, firms that audit more than 100 public companies are to be inspected each year, and firms that audit 100 or fewer public companies are to be inspected at least every three years. The Board is given the power to adjust these inspection schedules if it finds different schedules to be consistent with the bill's purposes, the protection of investors, and the public interest.

[36] During an inspection, the Board is to review particular audit engagements (that it selects) of a firm and the firm's general quality control systems and policies, as well as to perform such other testing of the firm's audit, supervisory, and quality control procedures as is necessary or appropriate. The Board is specifically given authority to require firms to retain their records for inspection purposes regardless of whether retention of those records is otherwise required.

[37] After each inspection, the Board will prepare an inspection report, which will be available for comment in draft form by the firm under inspection. Quality control defects found by the Board may be disposed of simply by corrective action, but specific violations identified during inspections may form the basis for a more formal investigation or disciplinary action by the Board and are to be reported, if appropriate, to the SEC and relevant state accountancy boards; final inspection reports are to be sent to the SEC and relevant state accountancy boards in any event. The reports will also be made public, subject to appropriate protection of confidential or proprietary information. However, firms will be given 12 months to correct defects in their quality control systems, to the satisfaction of the Board, before portions of the reports dealing with those defects are added to the public record.¹⁵

E. Investigations and disciplinary proceedings

[38] Committee witnesses stressed that the Board must possess investigative and disciplinary authority. Arthur Levitt, who served as Chairman of the SEC during most of the 1990s, told the Committee that:

[39] The Board's rules are to prescribe fair investigative and disciplinary procedures. It may, under those rules, require testimony or the production of audit work papers and other documents from (and may inspect the records of) registered firms or their associated persons, and it may suspend or revoke the registration of a firm, or suspend or bar from further association with a firm an "associated person," for non-cooperation with a Board investigation, subject to review of that action by the SEC.¹⁸

[40] Committee witnesses also emphasized that information gathered by Board investigators should be "privileged from outsiders" during the investigative process. Under the bill, any information gathered in the course of an investigation is to be confidential and privileged for all purposes (including civil discovery), unless and until particular information is presented in connection with a public proceeding. However, the Board may disclose investigative information, if it determines that such disclosure is "necessary to accomplish the purposes of the Act or to protect investors," to the SEC, any federal financial supervisor (if the investigation pertains to an institution under the latter's supervision), the Attorney General, and, with the SEC's permission, to state attorneys general, in connection with criminal investigations, or state accountancy boards. (The Board may also refer an investigation to the SEC or other agencies to which disclosure of information is permitted.)

[41] A full range of sanctions is available if the Board finds that a registered firm (or its partners or employees) has violated one or more of the rules within the Board's investigative jurisdiction. Potential sanctions include revocation or suspension of an accounting firm's registration, or of the ability of particular individuals to remain associated with that firm or become associated with any other registered accounting firm (effectively barring the subject of the sanction from participating in audits of public companies), substantial civil money penalties, 19 required professional education or training, and censure; the breadth of these sanctions is intended to encourage flexible and appropriate action, designed to correct if possible. The Board's ability to suspend or bar an associated person from the auditing of public companies, and its ability to impose civil money penalties above a certain amount, is limited to situations involving intentional, knowing, or reckless conduct, or repeated negligent conduct.

[42] An important provision of the bill permits the Board to impose sanctions upon a registered accounting firm for failure reasonably to supervise a partner or employee who is found to have violated applicable rules. The terms for liability for failure to supervise are similar to those that apply to broker-dealers under section 15(b)( 4) of the Securities Exchange Act of 1934; they permit an accounting firm to defend itself from supervisory liability by showing that its internal control procedures were reasonable and were operating fully in the situation at issue.

[43] The Board's determination that a violation has occurred and that a sanction should be imposed may be appealed to the Commission (as described below). Disciplinary sanctions must be reported to the Commission, appropriate state or foreign boards of accountancy, and the public (once any stay of enforcement pending appeal has been lifted).

F. Foreign public accounting firms

[44] Companies that sell shares to U.S. investors, and are subject to the federal securities laws, can be organized and operate in any part of the world. Their financial statements are not necessarily audited by U.S. accounting firms, and the Committee believes that there should be no difference in treatment of a public company's auditors under the bill simply because of a particular auditor's place of operation. Otherwise, a significant loophole in the protection offered U.S. investors would be built into the statutory system.

[45] Thus, accounting firms organized under the laws of countries other than the United States that issue audit reports for public companies subject to the U.S. securities laws are covered by the bill in the same manner as domestic accounting firms, subject to the exemptive authority of both the Board and the SEC. (Registration under the bill will not in itself provide a basis for subjecting a foreign accounting firm to U.S. jurisdiction other than with respect to controversies between such a firm and the Board.) The Board is also authorized to determine that other foreign accounting firms play a sufficiently substantial role in the preparation and furnishing of such reports for particular issuers that their coverage under the bill is necessary or appropriate to protect investors and the public interest.

[46] Finally, the bill sets terms for the production in the United States by a foreign public accounting firm of its audit work papers, for any audit in which the foreign accounting firm issues an opinion or otherwise performs material services upon which an accounting firm registered under the bill relies in issuing all or part of a public company audit report. The foreign firm is deemed, by performing such work, to have consented to production, and the domestic accounting firm that relies on the foreign accounting firm's work must have secured, as a condition of its reliance, the foreign firm's agreement to the production.

G. SEC oversight of the Board

[47] The Board is subject to SEC oversight and review to assure that the Board's policies are consistent with the administration of the federal securities laws, and to protect the rights of accounting firms and individuals subject to the Board's jurisdiction. Oversight also allows the public an important forum for commenting on Board rules relating to auditing, quality control, and related standards.

[48] The rules for SEC oversight of the Board are generally the same as those that apply to SEC oversight of the National Association of Securities Dealers, under section 19 of the Securities Exchange Act. Thus, the Board's proposed rules will be filed with the SEC and published by the SEC for public comment; SEC approval is necessary in most cases before rules of the Board take effect, and the SEC may itself abrogate or amend Board rules (as well as disapprove proposed Board rules). (Transitional rules are to be separately approved by the SEC at the time of the SEC's determination that the Board is ready to begin operation.) Disciplinary sanctions imposed by the Board are subject to SEC review and may be canceled or modified (or in some cases enhanced) by the SEC. The SEC can relieve the Board of any responsibility to enforce any provision of the bill, or censure or limit operations of the Board, or remove a Board member, for cause. Finally, the bill makes clear that any violations of its terms will constitute a violation of the Securities Exchange Act itself for purposes of the SEC's enforcement (including injunctive and cease- and-desist) authority under that Act, so that the SEC may proceed under the bill's provisions directly if appropriate.

H. Accounting principles

[49] Since 1973, the SEC has generally required public companies operating in the United States to prepare their financial statements in accordance with "principles, standards, and practices" promulgated by the Financial Accounting Standards Board (the "FASB") in the absence of specific SEC pronouncements on particular accounting questions.²⁰ The bill seeks to formalize the SEC's reliance on the FASB and, as discussed below, to strengthen the independence of the FASB by assuring its funding and eliminating any need for it to seek contributions from accounting firms or companies whose financial statements must conform to FASB's rules. Thus, the bill amends the Securities Act of 1933 specifically to allow the SEC to recognize as "generally accepted" (for securities law purposes) accounting principles established by a private entity that is funded as outlined in the bill (described below) and that has adopted procedures (including acting by majority vote) to ensure prompt consideration of necessary changes to the body of accounting principles.

[50] An important issue presented to the Committee was the potential difference between an accounting regime that contains detailed rules for the treatment of particular items, and a regime that simply outlines general concepts (or "principles") to be applied to particular items. Witnesses noted the possibility that the overly-detailed approach of U.S. standard-setters may have delayed updating of necessary guidance and at the same time drawn the focus of auditors away from the overriding principle that a set of financial statements, taken as a whole, must fairly and completely reflect the economic results and operations of the company being audited. To allow more careful consideration of the differences between various formulations of accounting standards, the bill requires the Commission to conduct a study, within 12 months, of the adoption by the U.S. financial reporting system of a principlesbased accounting system.

I. Funding

[51] The Committee's witnesses overwhelmingly agreed that both the Board and the FASB required guaranteed sources of funding, in order to protect their independence. Several witnesses testified to the problems various attempts at oversight of auditors had encountered when voluntary funding was withheld. With respect to the FASB, Michael Sutton, a former SEC Chief Accountant, testified to the Committee that "[t]o restore confidence in our standards setters, we should take immediate steps to secure independent funding for the FASB -- funding that does not depend on contributions from constituents that have a stake in the outcome of the process."²¹

[52] Under the bill, public companies are required to pay "accounting support fees" to support the annual budgets of the Board and the FASB. (The Board's budget will be subject to approval by the SEC.) Amounts payable by public companies to either body will generally be allocated among those companies based on relative average annual monthly market capitalization for the 12 months prior to the year to which the support fee relates; both the Board and the FASB are permitted to differentiate among various classes of public companies in allocating fees.

[54] The statutory independent audit requirement has two sides. It grants a franchise to the nation's public accountants -- their services, and only their services, and certification, must be secured before an issuer of securities can go to market, have the securities listed on the nation's stock exchanges, or comply with the reporting requirements of the securities laws. This is a source of significant private benefit to the public accountants.

[55] But the franchise is conditional. It comes in return for the CPA's assumption of a public duty and obligation. As a unanimous Supreme Court noted nearly 20 years ago: "In certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility. * * * [That auditor] owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust." United States v. Arthur Young, 465 U.S. 805, 817-18 (1984) (emphasis added).

[56] Richard Breeden, Chairman of the SEC from 1989-93, put it succinctly in testimony before the Committee:

[58] According to the SEC, 55 percent of the average revenue of the big five accounting firms came from accounting and auditing services in 1988. Twenty-two percent of the average revenue came from management consulting services. By 1999, those figures had fallen to 31 percent for accounting and auditing services, and risen to 50 percent for management consulting services. Recent data reported to the SEC showed on average public accounting firms' non-audit fees comprised 73 percent of their total fees, or $2.69 in non-audit fees for every $1.00 in audit fees. At the same time, the frequency of financial restatements by public companies has dramatically increased. From 1990-97, the number of public company financial restatements averaged 49 per year, but jumped to an average of 150 per year in 1999 and 2000.

[59] For these reasons, the bill includes a number of provisions directed to the issue of auditor independence.

A. Services outside the scope of practice of auditors

[60] A number of the witnesses who testified before the Committee during the course of the hearings, as well as other informed observers, argued that the growth in the non-audit consulting business done by the large accounting firms for their audit clients has so compromised the independence of the audits that a complete prohibition is required on the provision of consulting services by accounting firms to their audit clients.

[61] Perhaps the strongest advocates of this view have been the managers of large pension funds who are entrusted with people's retirement savings. James E. Burton, Chief Executive Officer of the California Public Employees' Retirement System (CalPERS), which manages pension and health benefits for more than 1.3 million members with aggregate holdings totaling almost $150 billion, has stated: "We believe that the inherent conflicts created when an external auditor is simultaneously receiving fees from a company for non-audit work cannot be remedied by anything less than a brightline ban. An accounting firm should be an auditor or a consultant, but not both to the same client."²³

[62] John Biggs is Chairman of Teachers Insurance and Annuity Association -- College Retirement Equities Fund (TIAA-CREF), the largest private pension system in the world providing pensions and other financial products to the education and research community. TIAA-CREF manages approximately $275 billion in pension assets for over 2 million participants. Mr. Biggs has stated:

[65] The Committee considered adopting a complete prohibition on non-audit services by accounting firms for their audit clients, but instead decided on a somewhat more flexible approach. The approach adopted by the Committee is supported by former Comptroller General Bowsher, former SEC Chairman Arthur Levitt, and former Federal Reserve Board Chairman Paul Volcker.²⁸

[66] The bill provides that it shall be unlawful for a public accounting firm registered with the Board which performs an audit for a public company to provide, contemporaneously with the audit, the following non-audit services:

[68] The need for this provision was clearly stated by David M. Walker, Comptroller General of the United States, in a statement he released on June 18, in which he said:

[70] The intention of this provision is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients because their doing so creates a fundamental conflict of interest for the accounting firms. The list is based on simple principles. An accounting firm, in order to be independent of its audit client, should not audit its own work, which would be involved in providing bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal audit outsourcing services to an audit client. The accounting firm should not function as part of management or as an employee of the audit client, which would be required if the accounting firm provides human resources services such as recruiting, hiring, and designing compensation packages for the officers, directors, and managers of an audit client. The accounting firm should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings, or serving as a broker-dealer, investment adviser, or investment banker to an audit client, which places the auditor in the role of promoting a client's stock or other interests.

[71] The accounting industry itself has announced voluntarily that it will not provide two of these non-audit services -- internal audit services and financial information systems design and implementation -- to public company audit clients because of the conflicts they present. The other prohibited non-audit services also pose clear conflicts of interest for accounting firms when provided for audit clients. For example, in its oversight hearing earlier this year on the failure of Superior Bank, FSB, in Hinsdale, Illinois, the Committee learned first-hand the risks associated with allowing accounting firms to audit their own work.³⁰ In that case, the accounting firm audited and certified a valuation of risky residual assets calculated according to a methodology it had provided as a consultant. The valuation was excessive and led to the failure of the institution.

[72] The Board is given authority to make case-by-case exemptions in instances where the Board believes an exemption is in the public interest and consistent with the protection of investors. Further, no limitations are placed on accounting firms in providing non-audit services to public companies that they do not audit or to any private companies. The purpose is to assure the independence of the audit, not to put an end to the provision of non-audit services by accounting firms.

[73] In summary, the bill adopts a strong, balanced approach to assure that in return for the significant private benefits conferred on accounting firms by our securities laws, they maintain their independence from the companies they audit and fulfill their "public trust."

B. Audit committee pre-approval of audit and non-audit services

[74] The legislation requires that audit services, as well as non-audit services other than those proscribed by the bill, must be pre-approved by the audit committee of the public company's board of directors. The Committee heard testimony on the role that the audit committee of a public company should play in connection with the engagement of an auditor to provide audit and non-audit services contemporaneously. Michael Sutton, former Chief Accountant of the SEC, said, "Whatever non-audit services might be permitted, I think they should be permitted only with the approval of the audit committee."³¹ Former SEC Commissioner Bevis Longstreth told the Committee:

[76] The bill does not require the audit committee to make a particular finding in order to pre-approve an activity. The members of the audit committee shall vote consistent with the standards they determine to be appropriate in light of their fiduciary responsibilities and such other considerations they deem to be relevant.

[77] The audit committee must pre-approve a non-audit service before it commences. The audit committee may pre-approve at any time in advance of the activity. For example, an audit committee may grant pre-approval at its March meeting for a non-audit service that would begin in August. However, the Commission or the Board under its general authority may specify a maximum period of time in advance of which the approval may not be granted, such as, for example, requiring the pre-approval to be granted no earlier than one year prior to the commencement of the service.

[78] The bill does not limit the number of non-audit services that the audit committee may pre-approve at one meeting or occasion. The Committee intends, however, that each non-audit service be specifically identified in order to be approved by the audit committee. The Committee does not intend for the statutory requirement to be satisfied by an audit committee voting, for example, to permit "any service that management determines appropriate for the auditor to perform "or" all non-audit services permissible under law."

[79] The Committee has chosen to offer audit committees a delegation option in their administration of the pre-approval requirement. The bill permits the audit committee to delegate to one or more of its members (who are members of the board of directors) the authority to pre-approve non-audit services. After a delegated member has granted a pre-approval, he or she is required to report the decision at the next meeting of the full audit committee. This delegation of authority may be useful where, for example, the audit committee is asked to determine whether or not to permit the issuer's auditor to perform a new non-audit service within a short period of time.

[80] The Committee has taken into account the atypical circumstance where an auditor is providing to the issuer a service that was anticipated to be an audit service within the scope of the engagement, but is later discovered to be a non-audit service. The bill provides that the pre-approval requirement is waived with respect to a nonaudit service if: (1) the service was not recognized by the issuer at the time of the audit engagement to be a non-audit service, (2) the aggregate amount paid for all services described in (1) is not more than 5 percent of the total amount of revenues paid by the issuer to the auditor, and (3) the service is promptly brought to the attention of the audit committee, and (4) the audit committee approves the activity prior to the conclusion of the audit. This post-approval may be granted by the entire audit committee or by one or more audit committee members (who are members of the board of directors) to whom authority to grant such approvals has been delegated by the audit committee. This flexibility was suggested by Senator Enzi.

[81] The bill requires that the audit committee approvals be disclosed to investors in periodic reports filed with the Commission.

[82] The bill specifically notes that audit services "may entail providing comfort letters in connection with securities underwriting" in order to make clear that providing such a comfort letter is an audit service.

C. Audit partner rotation

[83] The Committee heard testimony from numerous witnesses on whether, in order to maintain the objectivity of its audits, an issuer should be required to rotate its audit firm after a number of consecutive years. For example, former SEC Chairman Arthur Levitt proposed "that serious consideration be given to requiring companies to change their audit firm -- not just the partners -- every 5-7 years to ensure that fresh and skeptical eyes are always looking at the numbers."³³ Former SEC Chairman Harold Williams recommended a requirement that issuers "[h]ire auditors with a fixed term with no right to terminate for five or seven years."³⁴ John Whitehead, former Co-Chairman, Goldman Sachs & Co., recommended requiring "[t]erm limits of 8 to 10 years."³⁵ Lynn Turner, former SEC Chief Accountant, recommended requiring "mandatory rotation (5 to 7 years)."³⁶

[84] Other witnesses felt that accounting firm rotation could be disruptive to the issuer and that the costs of mandatory rotation might outweigh the benefits. Former SEC Chairman Rod Hills said that "[f]orcing a change of auditors can only lower the quality of audits and increase their costs."³⁷ Shaun O'Malley, Chairman, 2000 Public Oversight Board Panel on Audit Effectiveness, said that "forcing issuers to change auditors every few years * * * would undermine audit effectiveness."³⁸

[85] The Committee determined that the possibility of requiring audit firm rotation merits further study. The bill directs the U.S. General Accounting Office ("GAO") to analyze the merits and potential effects of requiring mandatory rotation of auditors, and to report its analysis to Congress within one year.

[86] While the bill does not require issuers to rotate their accounting firms, the Committee recognizes the strong benefits that accrue for the issuer and its shareholders when a new accountant "with fresh and skeptical eyes" evaluates the issuer periodically. Accordingly, the bill requires a registered public accounting firm to rotate its lead partner and its review partner on audits so that neither role is performed by the same accountant for the same issuer for more than five consecutive years.³⁹

D. Disclosures of accounting issues.

[87] The Committee believes that it is important for the audit committee to be aware of key assumptions underlying a company's financial statements and of disagreements that the auditor has with management. The audit committee should be informed in a timely manner of such disagreements, so that it can independently review them and intervene if it chooses to do so in order to assure the integrity of the audit.

[88] Accordingly, the bill requires a registered independent public accounting firm performing an audit for a public company to report in a timely manner to that company's audit committee (1) the critical accounting policies and practices to be used; (2) all alternative treatments of financial information within GAAP (generally accepted accounting principles) that have been discussed with management; (3) any accounting disagreements between the auditor and management; and (4) other material written communications between the auditor and management.

E. Cooling off period

[89] The Committee received extensive testimony on whether to impose a cooling off period between an accountant's employment by an auditor and his or her employment by an issuer. Several witnesses advocated this requirement, in order to enhance the integrity of an audit. Former Comptroller General Bowsher recommended to the Committee that "[e]ngagement and other partners who are associated with an audit should be prohibited from taking employment with the affected firm until a two-year 'cooling off' period has expired."⁴⁰ Lynn Turner, former SEC Chief Accountant, said, "Cooling off periods should last two years. Close the door between the audit firm, its partners and employees, and the company being audited."⁴¹ Other witnesses also gave testimony that "the revolving door between audit firms and their audit clients" should be closed by enacting a cooling off period. James E. Copeland, Jr., Chief Executive Officer, Deloitte & Touche LLP, opposed a cooling off period because of concerns that it would "impose unwarranted costs on the public, the client and the profession."⁴²

[90] The Committee considered various options, including imposing a cooling off period of one, two, or three years, and applying a cooling off period to all employees who worked for the auditor, regardless of whether they worked on the audit of a particular issuer and regardless of the position they would take with that issuer, or applying a cooling off period only to certain groups of employees.

[91] The Committee decided to impose a one-year cooling off period that would apply to an employee of the accounting firm who worked on the issuer's audit and subsequently seeks to be employed by that issuer in a senior management capacity. Thus, the bill provides that an accounting firm may not provide audit services for a public company if that company's chief executive officer, controller, chief financial officer, chief accounting officer, or other individual serving in an equivalent position, was employed by the accounting firm during the one year before the start of the audit services. The cooling off period does not take effect if the CEO or other senior official worked for the auditor but did not work on the issuer's audit or if a member of the audit team is hired by the issuer for a position other than CEO, CFO, controller, chief accounting officer, or an equivalent position. However, if an issuer hires an accountant from the audit team as its CEO, for example, it would be required to change auditors.

F. The bill does not create state regulatory standards

[92] Titles I and II are designed to apply only to accounting firms that audit public companies. They are not designed to apply to audits of private companies. Nonetheless, some have raised the concern that the bill could lead state regulatory authorities to impose similar requirements for audits of private companies.

[93] The bill indicates clearly that Congress does not intend that state regulatory authorities should find this Act controlling in their regulation of non-registered accountants. The bill states that it is the intention of the Act that, in supervising non-registered accounting firms, state regulatory authorities should make an independent determination of the proper standards, and should not presume the standards applied by the Board under this bill to be applicable to small-and medium-sized non-registered accounting firms. Senators Hagel and Enzi proposed this provision.

[95] Recent events have highlighted the failure of companies' internal audit committees to properly police their auditors and have raised awareness of the need for strong, competent audit committees with real authority. Several witnesses suggested that the Committee make changes in the role of audit committees in order to enhance the audit process. In response, under the bill, the SEC must draft rules directing national securities exchanges and associations to require listed companies to comply with a number of enumerated provisions regarding audit committees. The Committee believes that the bill's approach to strengthening audit committees will help avoid future auditing breakdowns.

[96] The bill also contains a number of provisions aimed at corporate management. Defects in procedures for monitoring financial results and controls have been blamed for recent corporate failures. The bill therefore requires CEOs and CFOs to certify their companies' financial reports, outlaws fraud and deception by managers in the auditing process, prevents CEOs and CFOs from benefitting from profits they receive as a result of misstatements of their company's financials, and facilitates the imposition of judicial bars against officers and directors who have violated the securities laws. Finally, title III includes a provision intended to prevent employees from being required to hold company stock in their retirement accounts while officers and directors are free to sell their shares.

A. Issuer audit committees

[97] Oversight of Auditors. Witnesses at the Committee's hearings suggested that the auditing process may be compromised when auditors view their main responsibility as serving the company's management rather than its full board of directors or its audit committee. For this reason, the bill requires audit committees to be directly responsible for the appointment, compensation, and oversight of the work of auditors, and requires auditors to report directly to the audit committee.

[98] Many witnesses testified as to the importance of these provisions. In particular, witnesses believed that the hiring and firing of the auditor should be the exclusive province of the audit committee. A number of witnesses emphasized that "audit committees [should] be solely responsible for the retention of accounting firms and be responsible for the fees paid to them."⁴³ Sarah Teslik, Executive Director of the Council of Institutional Investors, told the Committee that" perhaps [the] single first step [Congress] should take to increase auditor independence is to require a listing standard [of the national securities exchanges and associations] that the audit committee of the board hire and fire the auditors," the approach taken by the bill.⁴⁴ Additional witnesses who supported making the audit committee responsible for hiring and firing the auditors included: Robert E. Litan, Director of the Economic Studies Program of The Brookings Institution; Damon Silvers, Associate General Counsel of the AFL-CIO; and former U.S. Comptroller General Bowsher.⁴⁵

[99] Audit Committee Member Independence. Many recent failures have been attributed to close ties between audit committee members and management. In 1998-99, the NYSE and Nasdaq sponsored the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. The Blue Ribbon Committee, chaired by Committee witnesses Ira Millstein and John Whitehead, made a number of recommendations to enhance audit procedures and effectiveness, including recommendations to increase the independence of audit committee members. Mr. Millstein and Mr. Whitehead, as well as Blue Ribbon Committee member John Biggs, testified at the hearings in support of adoption of the Blue Ribbon Committee's recommendations.⁴⁶ Consistent with their recommendations, the bill enhances audit committee independence by barring audit committee members from accepting consulting fees or being affiliated persons of the issuer or the issuer's subsidiaries other than in the member's capacity as a member of the board of directors or any board committee.

[100] The audit committee independence provisions were supported by a number of witnesses in addition to Messrs. Millstein, Whitehead, and Biggs. Former SEC Chairman Arthur Levitt testified that "as a listing condition, stock exchanges should require at least a majority of company boards to meet a strict definition of independence," including barring audit committee members from accepting consulting fees from the company.⁴⁷ Former SEC Chairman Roderick M. Hills and Washington University School of Law Dean Seligman also recommended that Congress require that companies have independent audit committees.⁴⁸ Former Senator Howard Metzenbaum, the Chairman of Consumer Federation of America, testified that lack of independence frequently leads audit committees to have a "fealty to the management that an audit committee shouldn't have."⁴⁹

[101] Additional Audit Committee Responsibilities. The bill contains several additional provisions regarding audit committees. The bill requires audit committees to have in place procedures to receive and address complaints regarding accounting, internal control, or auditing issues. Further, the bill includes an amendment by Senator Stabenow providing protection for corporate "whistleblowers" by specifying that audit committees must establish procedures for employees' anonymous submission of concerns regarding accounting or auditing matters.

[102] The bill also requires public companies to provide their audit committees with authority and funding to engage independent counsel and other advisers as they determine necessary in order to carry out their duties. Comptroller General Walker agreed that audit committee members must be "adequately resourced," suggesting that audit committee members "may need their own staff."⁵⁰

[103] In light of recent events, the Committee believes that these audit committee provisions should be codified in the securities laws in order to help rectify auditing misconduct and to enhance the effectiveness of audit committee oversight of public company audits.

B. Corporate responsibility for financial reports

[104] The Committee believes that management should be held responsible for the financial representations of their companies. The bill therefore clearly establishes that CEOs and CFOs are responsible for the presentation of material in their company's financial reports. Under one of the recommendations put forward by the President on March 7, "CEOs would personally attest each quarter that the financial statements and company disclosures accurately and fairly disclose the information of which the CEO is aware that a reasonable investor should have to make an informed investment decision." In effect the bill adopts this proposal, in an approach developed with Senator Miller, by requiring CEOs and CFOs to certify, in periodic reports containing financial statements filed with the Commission pursuant to section 13(a) or 15(d) of the Exchange Act, the appropriateness of financial statements and disclosures contained therein, and that those financials and disclosures fairly present the company's operations and financial condition.

[105] These provisions reflect the Committee's concern regarding the reliability of companies' audited financial statements. In his testimony before the Committee, former SEC Chairman Breeden recognized that there is "growing doubt about whether audited financial statements are believable."⁵¹ Council of Institutional Investors Executive Director Sarah Teslik echoed this concern in testifying that "CEOs, audit committee members and outside auditors" should be required to "sign the financials as true and accurate."⁵²

C. Prohibited influence

[106] Numerous witnesses testifying before the Committee, including Shaun O'Malley, Chair of the 2000 Public Oversight Board Panel on Audit Effectiveness, and Sarah Teslik, Council of Institutional Investors Executive Director, were concerned with addressing fraud and misconduct in the audit process.⁵³ In response, title III of the bill makes it unlawful for any officer or director of an issuer, or person acting under the direction thereof, to fraudulently influence, coerce, manipulate, or mislead any accountant engaged in preparing an audit of that issuer, for the purpose of rendering the audit report misleading. The Commission is provided with exclusive authority to enforce this section. The bill establishes a 90-day deadline for proposed rules or regulations by the Commission under this section, and a 270-day deadline for final rules or regulations.

D. Forfeiture of bonuses and profits

[107] Recent events have raised concern about management benefitting from unsound financial statements, many of which ultimately result in corporate restatements. The President has recommended that "CEOs or other officers should not be allowed to profit from erroneous financial statements," and that "CEO bonuses and other incentive-based forms of compensation [sh]ould be disgorged in cases of accounting restatement and misconduct."

[108] Title III includes provisions designed to prevent CEOs or CFOs from making large profits by selling company stock, or receiving company bonuses, while management is misleading the public and regulators about the poor health of the company. The bill requires that in the case of accounting restatements that result from material non-compliance with SEC financial reporting requirements, CEOs and CFOs must disgorge bonuses and other incentive-based compensation and profits on stock sales, if the non-compliance results from misconduct. The required disgorgement applies to amounts received for the 12 months after the first public issuance or filing of a financial document embodying such financial reporting requirement. Under this section, the SEC may exempt any person from this requirement as it deems necessary and appropriate.

E. Officer and director bars and penalties

[109] Title III also includes several measures affecting officers and directors who have violated the securities laws. The staff of the Commission indicated to the Committee staff that when enforcement proceedings are brought under the securities laws, courts in some cases have been reluctant to impose prospective bars against violators serving as officers or directors of companies. The bill would facilitate not only the SEC's prevention of individuals who have violated the securities laws from serving as officers and directors, but also the imposition of penalties on violators of securities laws.

[110] Currently, it must be proved that an officer or director has both violated the securities laws, and has shown "substantial unfitness" to serve before a bar can be imposed. The Commission has argued that the "substantial unfitness" standard for imposing bars is inordinately high, causing courts to refrain from imposing bars even in cases of egregious misconduct. The proposed bill rectifies this deficiency by modifying the standard governing imposition of officer and director bars from "substantial unfitness" to "unfitness."

[111] These provisions also reflect the President's recommendation that "CEOs or other officers who clearly abuse their power should lose their right to serve in any corporate leadership positions."

[112] The Commission has also suggested that it should be allowed to obtain additional relief in enforcement cases. For a securities law violation, currently an individual may be ordered to disgorge funds that he or she received "as a result of the violation." Rather than limiting disgorgement to these gains, the bill will permit courts to impose any equitable relief necessary or appropriate to protect, and mitigate harm to, investors.

F. Prohibition on insider trades during pension fund blackout periods

[113] As former SEC Chairman Breeden observed, "The spectacle of corporate insiders plundering their own companies or selling their stock quietly in advance of a looming collapse has awakened a sense of revulsion among investors who were left with worthless stock."⁵⁴ In some cases, officers and directors have profited by selling off large portions of company stock during a time when employees were prevented from selling company stock in their section 401(k) retirement plans. To address this problem, the bill prohibits key individuals from engaging in transactions involving any equity security of the issuer during a "blackout" period when at least half of the issuer's individual account plan participants are not permitted to purchase, sell, or otherwise transfer their interest in that equity security. Upon Senator Miller's recommendation, this section applies to directors and executive officers in order to ensure that the prohibition is limited to individuals in policy- making positions.

[114] The bill provides added protection for participants in retirement plans by requiring that they be provided with written notice at least 30 days before a blackout period. Two exceptions to the 30day notice are provided in response to Senator Enzi's recommendations. First, an exception is allowed in cases where a deferral of the blackout period to comply with the 30-day notice requirement would violate ERISA provisions that require fiduciaries to act exclusively on behalf of participants, and those that require trustees to act prudently, in their decisions regarding plan assets. Second, an exception may be provided where the inability to provide the notice is due to unforeseeable events or circumstances beyond the reasonable control of the plan administrator.

[115] The Committee is concerned that without the provisions of title III, our financial markets will witness numerous corporate restatements in the future. The Committee believes that title III incorporates needed reforms that will enhance corporate responsibility among public companies.

A. Accounting adjustments

[117] The bill requires that financial statements filed with the Commission reflect the material adjustments under GAAP that have been identified by the auditor.

B. Off-balance sheet transactions

[118] Former SEC Chairman Richard Breeden testified, after the problems of Enron Corp. and its special purpose entities, on the need for "enhance[d] disclosure of 'off-balance sheet' transactions and debt."⁵⁵ To address this need, the bill requires annual and quarterly reports filed with the SEC to disclose all material off- balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.

C. Pro-forma financial disclosures

[119] Thomas A. Bowman, President and CEO of the Association for Investment Management and Research (AIMR), testified before the Committee on his concerns about the use of pro forma disclosures:

[120] The Committee seeks to address problems attendant to pro forma financial disclosures by requiring the SEC to promulgate rules requiring that issuers publish pro forma data with a reconciliation to comparable financial data calculated according to GAAP and in a way that is not misleading and does not contain untrue statements. The reconciliation presumes, and would require, the issuer to publish financial data calculated according to GAAP at the same time as it publishes pro forma data. This should enable investors to, at the least, simultaneously compare the pro forma financial data with the same types of financial disclosures (e. g., earnings) calculated according to GAAP for the comparable reporting period.

[121] The Committee recognizes from the recent experience of Enron Corp. and other public companies the need for additional types of disclosures. The Committee supports public and private efforts that result in greater quality, clarity, and completeness in the disclosures made by public companies.

D. Enhanced disclosures of loans

[122] Enron Corp. and other corporations have made loans to directors and executive officers totaling many millions of dollars.⁵⁹ Many of these insider loans are disclosed to investors in the annual proxy materials months after they occur.

[123] In his testimony, former SEC Chairman Richard Breeden recommended that "immediate 8-K disclosure" of insider loans be required.⁶⁰

[124] The Committee is aware that investors are concerned about loans to insiders and want to know this information promptly after the loans are made in order to better inform their investment decisions. The bill requires an issuer in its current reports to disclose within seven days, or such other time period determined to be appropriate by the SEC, all loans, except credit card loans, made by the issuer and its affiliates to any director or executive officer, specifying amounts paid and balances owed on such obligations and any conflicts of interest, as defined by the SEC. The Committee created an exemption from reporting for credit card loans made by the issuer to a director or executive officer in the ordinary course of the issuer's consumer credit business, of a type generally made available by the issuer to the public on market terms. The bill gives the SEC the flexibility to shorten the period to less than seven days or extend it to more than seven days if it deems appropriate.

[125] These provisions will result in information about insider loans and other conflicts of interest being disclosed in a timely manner so investors can consider such data in making their investment decisions.

E. Disclosures of transactions involving management

[126] The Committee received testimony that insiders should be required to report their transactions in the stock of their companies more promptly. Ira Millstein, Senior Partner, Weil, Gotshal & Manges LLP and Co-Chair of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, testified that, "SEC rules should be amended to mandate prompt disclosure of transactions between the corporation (or its affiliates) and members of senior management, directors or controlling shareholders."⁶¹ Former Comptroller General Bowsher echoed this objective when he testified: "To discourage conflicts of interest involving public corporations, Congress should amend the Securities Exchange Act of 1934 to require more meaningful and timely disclosure of related party transactions among officers, directors, or other affiliated persons and the public corporation."⁶²

[127] At present, Section 16(a) of the Exchange Act requires insiders to report trades by the tenth day of the month following the month in which the transaction was executed. The Committee recognizes that some investors find trades by insiders to be probative of whether investing in a company is desirable and feel that, in today's markets, the current deadline imposed by Section 16(a) allows too long a delay in reporting.

[128] The bill would amend Section 16(a) to require directors, officers and 10 percent equity holders to report their purchases and sales of securities more promptly, that is, by the end of the second day following the transaction or such other time established by the SEC where the two-day period is not feasible. The purpose is to make available to investors information about insider transactions more promptly so they can make better informed investment decisions.

F. Management assessment of internal controls

[129] The Committee heard testimony from former Comptroller General Bowsher, who recommended:

[131] In addition, the company's auditor must report on and attest to management's assessment of the company's internal controls. In requiring the registered public accounting firm preparing the audit report to attest to and report on management's assessment of internal controls, the Committee does not intend that the auditor's evaluation be the subject of a separate engagement or the basis for increased charges or fees. High quality audits typically incorporate extensive internal control testing. The Committee intends that the auditor's assessment of the issuer's system of internal controls should be considered to be a core responsibility of the auditor and an integral part of the audit report.

G. Exemptions for investment companies

[132] The bill exempts investment companies from certain disclosure requirements. The Committee feels that the objectives of those disclosure sections are adequately addressed by existing Federal securities laws and the rules thereunder affecting investment companies.

[133] For example, Section 17(a) of the Investment Company Act of 1940 and Rule 17j-1 thereunder prohibit affiliated persons of an investment company from borrowing money or other property from, or selling or buying securities or other property to or from the investment company, or any company that the investment company controls. Investment company officials therefore would not have any insider loans to report, as would be required under the bill.

H. Code of ethics for senior financial officers

[134] The problems surrounding Enron Corp. and other public companies raise concerns about the ethical standards of corporations and their senior financial managers. The Committee believes that investors have a legitimate interest in knowing whether a public company holds its financial officers to certain ethical standards in their financial dealings. The bill requires issuers to disclose whether or not they have adopted a code of ethics for senior financial officers and, if not, why not. This section was recommended by Senator Corzine.

I. Disclosure of audit committee financial expert

[135] As discussed above, the Committee received testimony about the important role played by the audit committee in corporate governance. The Committee believes the effectiveness of the audit committee depends in part on its members' knowledge of and experience in auditing and financial matters. Investors may find it relevant in making their investment decisions whether an issuer's audit committee has at least one member who has relevant, sophisticated financial expertise with which to discharge his or her duties.

[136] The bill requires the SEC to adopt rules requiring issuers to disclose whether their audit committees include among their members at least one "financial expert." In defining "financial expert," the SEC shall consider whether a person understands GAAP and financial statements, has experience preparing or auditing financial statements, has experience with internal accounting controls, and understands audit committee functions.

[138] The Committee heard testimony from Thomas A. Bowman, President and CEO of the Association for Investment Management and Research, who said, "Clearly, the erosion of investor confidence in the independence and objectivity of 'Wall Street' research reports and recommendations * * * could seriously harm the reputation of the entire investment profession."⁶⁴ He added, "Only if the investing public believes that the information available to them is fair, accurate, and transparent can they have confidence in the integrity of the financial markets and the investment professionals who serve them."⁶⁵ He explained how "some Wall Street firms may pressure their analysts to issue favorable research on current or prospective investment-banking clients" and that investors who receive recommendations" may not be aware of the pressures on Wall Street analysts."⁶⁶ Former SEC Chairman Richard Breeden suggested as a goal that Congress "[i]mprove independence of stock analyst recommendations," explaining that "[a]nalyst recommendations should be driven by analysis and fundamentals, not the pursuit of investment banking business for their firms."⁶⁷

[139] The Attorney General of the State of New York, Eliot Spitzer, in a letter to Chairman Sarbanes, stated, "Problems in this area have existed for several years and recently appear to have grown worse."⁶⁸ In his office's extensive investigation of analyst recommendations, he said he has found that "research reports and stock ratings of companies that were potential banking clients of [a major broker-dealer] were often distorted to assist the firm in obtaining and retaining investment banking business. One management document we obtained actually acknowledged the conflict and its results, stating: 'We are off base on how we rate stocks and how much we bend over backwards to accommodate banking, etc. 'We believe that the lack of research independence from investment banking likely extends to other firms as well."⁶⁹

[140] The Committee feels that it is critical to restore investor confidence in this area. The bill is intended to prevent certain pressures on analysts which could compromise their objectivity and to provide disclosure to investors of certain conflicts of interest that can also influence the objectivity of the analyst in preparing a research report.

[141] The Committee received testimony specifically demonstrating that conflicts of interest distort securities analysts' recommendations. Professor John Coffee of Columbia Law School told the Committee of a number of studies that sought to assess the impact of conflicts of interest on the objectivity of securities analysts' recommendations:

[143] Chinese Walls. Dean Joel Seligman recommended addressing "whether investment banks have adequately maintained 'Chinese walls' between retail brokerage and underwriting and whether, more fundamentally, securities firms that underwrite should be separated from retail brokerage."⁷¹ The bill creates new Section 15A(n)(1)(C) of the Securities Exchange Act of 1934, which mandates rules "to establish structural and institutional safeguards within registered brokers or dealers to assure that securities analysts are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision."

[144] Blackout Periods. Professor Coffee cited abuses involving the so-called "Booster Shot" and recommended that research reports not be issued during certain periods. He testified:

[146] Services Provided. Mr. Bowman recommended disclosure of "the nature of the relationship or services provided" by an analyst's firm to the subject company.⁷³ The bill requires disclosure of the types of services provided.

[147] Supervision by Investment Bankers and Disclosure of Investment Banking Relationships. Michael Mayo, Managing Director of Prudential Securities, recommended that Congress "[t]ake actions to minimize the interference of investment bankers with the job of research analysts "and" [d]isclose investment banking relationships to investors."⁷⁴ The bill prohibits the pre-publication clearance of research or recommendations by investment banking or other staff not directly responsible for investment research and requires disclosure of whether the issuer is or has recently been a client of the analyst's firm, and if so, the services provided.

[148] Lynn Turner, former SEC Chief Accountant, testified: "As long as the investment-banking arm of Wall Street has influence over the work of the research analysts or their compensation, analysts will not be able to provide independent research."⁷⁵ The bill requires the creation of rules that limit the supervision and compensatory evaluation of research personnel to officials who are not engaged in investment banking activities.

[149] Compensation from the Subject Firm to the Broker and Deal-Based Analyst Pay. Mr. Mayo raised the concern, "Does the retail investor know that the brokerage firm pitching shares is also earning investment banking fees from the company?" and also recommended that the Congress "eliminate deal-based incentive pay" for research analysts.⁷⁶ The bill requires disclosure of whether any compensation has been received by the broker-dealer from the issuer, subject to such exemptions as the Commission may determine necessary and appropriate to prevent disclosure of material non-public information regarding specific potential future investment banking transactions of such issuer, as is appropriate in the public interest and consistent with the protection of investors. The bill, while not eliminating deal-based pay, requires disclosure of whether the analyst received compensation based on an affiliate's investment banking revenues from the subject of any research report.

[150] Retaliation. The Committee heard testimony about the serious problem of retaliation against analysts who wrote negative research reports. Professor Coffee testified, "In self- reporting studies, securities analysts report that they are frequently pressured to make positive buy recommendations or at least to temper negative opinions."⁷⁷ He added, "According to one survey, 61% of all analysts have experienced retaliation -- threats of dismissal, salary reduction, etc. -- as the result of negative research reports. Clearly, negative research reports (and ratings reductions) are hazardous to an analyst's career. Congress could either adopt, or instruct the NASD to adopt, an anti-retaliation rule: no analyst should be fired, demoted, or economically penalized for issuing a negative report, downgrading a rating, or reducing an earnings, price, or similar target."⁷⁸

[151] Eliot Spitzer, Attorney General of the State of New York, concluded that the analyst conflict regulations put forth by the self-regulatory organizations "fall short of what should be legislated in this area [because], [f] or example, the regulations fail to address the problem of intimidation or retaliation against analysts who publish unfavorable research about a company."⁷⁹

[152] The bill requires rules to be promulgated to protect securities analysts from retaliation or intimidation because of negative, or otherwise unfavorable, research reports, subject to the proviso that such rules may not limit a broker-dealer from disciplining a securities analyst in accordance with firm policies and procedures for causes other than writing such a research report.

[153] Professor Coffee recommended that a no-retaliation rule should:

[155] Additional Analyst Issues. The Committee heard testimony about various additional concerns and recommendations to prevent analyst conflicts of interest and otherwise enhance investor protection, some of which are discussed below.

[156] Professor Coffee recommended "A No-Selling Rule." He testified:

[158] Mr. Bowman recommended disclosure of "[i]nvestment holdings of Wall Street analysts, their immediate families, the Wall Street firm's management and the firms themselves" as well as disclosure of "[m]aterial gifts received by the analyst from either the subject company or the Wall Street firm's investment-banking or corporate finance department."⁸³

[159] Mr. Bowman explained the need for greater explanatory information about analysts' rating systems. He said that "rating systems need to be overhauled so that investors can better understand how ratings are determined and compare ratings across firms. Ratings must be concise, clear, and easily understood by the average investor "and he recommended disclosures of" where and how to obtain information about the firm's rating system."⁸⁴ He also said that "Wall Street analysts and their firms should also be required to update or re-confirm their recommendations on a timely and regular basis, and more frequently in periods of high market volatility.

[160] They should be required to issue a "final" report when coverage is being discontinued and provide a reason for discontinuance. Quietly and unobtrusively discontinuing coverage or moving to a "not rated" category, i.e., a "closet" sell, does not serve investors' interests."⁸⁵

[161] The Committee also heard testimony about the intimidation of analysts by issuers. Mr. Bowman testified that:

[163] While the bill does not specifically identify remedies to these situations, it authorizes the Commission, or a registered securities association or exchange at the Commission's direction, to create rules to address such other issues as it determines appropriate and to require such other disclosures of conflicts of interest that are material to investors, research analysts, or the broker or dealer as it deems appropriate. The Commission, and the association and exchanges, should consider the issues noted above as they adopt other rules necessary and appropriate to protect investors in the area of analyst recommendations. The prohibition of specific activities identified in title V is not an exhaustive solution to the analyst conflicts problem, and the Committee expects the Commission and the self-regulatory organizations to use their authority to apply such additional rules as they deem appropriate.

[164] The bill requires that rules be adopted within one year. Existing rules that satisfy the requirements of the bill do not have to be reproposed or readopted. Existing rules that do not contradict the bill or that impose requirements that are not imposed by the bill do not have to be withdrawn or reproposed. For example, self- regulatory organization rules that require disclosure of statistics regarding analyst ratings or of the securities holdings of an analyst's family members in a subject company are not adversely affected by this bill.

[165] It should be noted that title V of the bill creates a new Section 15A(n)(B), (C) and (D) of the Exchange Act, which requires disclosure of simply "affirmative" or "negative" in response to "whether" an event has occurred. Further, Section 15A(n)(C) requires a description of the types of services provided, rather than a list of all specific services. This requirement is to enable the investor to assess whether the relationship is likely to influence the objectivity of the subjective portions of the research report.

[166] The new Section 15A(n)(B) of the Exchange Act created by the bill authorizes the Commission to grant exemptions to prevent disclosure of material non-public information about specific future investment banking revenues. In determining whether to grant an exemption, the Commission should take into account the importance that Congress places on providing investors with this information for making investment decisions and the likelihood that stating an affirmative response would divulge material non-public information that would be understood by investors, particularly in light of the size and complexity of the brokerage firm. For example, a complex brokerage firm which has received money from an issuer may be far less likely to disclose material nonpublic information simply by responding "yes," and therefore not merit an exception, than a small firm that only is engaged to find buyers for an issuer and has received compensation.

[167] The Committee heard testimony from authorities which stated that the rules set forth by self-regulatory organizations are inadequate to address the analyst conflicts of interest issue. Former SEC Chairman Arthur Levitt testified, "we must better expose Wall Street analysts' conflicts of interest * * * the New York Stock Exchange and the National Association of Securities Dealers [rulemaking] * * * is not enough."⁸⁸ Also, Attorney General Spitzer stated "the proposed regulations by the National Association of Securities Dealers and the New York Stock Exchange fall short of what should be legislated in this area."⁸⁹ The Committee feels that while the NYSE and NASD rules will improve the quality of analysts' stock recommendations, title V is needed to address analyst conflicts and to strengthen investor protection.

[169] SEC Authorization. Witnesses before the Committee testified consistently and strongly that the SEC needs additional resources in order to effectively carry out its mission and protect investors. John Whitehead, former Co-Chairman, Goldman Sachs & Co., testified: "I think the SEC is under-funded and has been for some years. When you consider the seriousness [to] the system of just one Enron, it's dangerous to fool around with relatively small increases in budgets that the SEC asks for."⁹⁰ David Walker, U.S. Comptroller General, testified, "[T]he SEC's ability to fulfill its mission has become increasingly strained due in part to imbalances between the SEC's workload (such as filings, complaints, inquiries, investigations, examinations and inspections) and staff resources * * *. Over the last decade, securities markets have experienced unprecedented growth and change * * *. At the same time, the SEC has been faced with an ever-increasing workload and ongoing human capital challenges, most notably high staff turnover and numerous vacancies."⁹¹

[170] Former SEC Chairmen Roderick Hills, Harold Williams, Richard Breeden, and Arthur Levitt all supported increasing the SEC's resources.⁹² Chairman Breeden recommended that Congress "[s]trengthen the SEC's resources through expanded budget authority (offset by increased user fees), immediate and continuing funding of pay parity provisions, and addition of 200 new accounting positions."⁹³

[171] Professor John Coffee testified, "I think you're hearing from all of us that the SEC is resource-constrained and I think the less visible casualty of that are the offices such as the office of the chief accountant, where you can't really measure the output until a scandal like Enron comes along."⁹⁴

[172] The Committee also received and considered the General Accounting Office report, "SEC OPERATIONS: Increased Workload Creates Challenges," March 5, 2002 (GAO-02-302). GAO found that industry officials said "the SEC's limited staff resources have resulted in substantial delays in SEC regulatory and oversight processes, which hampers competition and reduces market efficiencies. In addition, they said information technology issues need additional funding, and SEC needs more expertise to keep pace with rapidly changing financial markets. Finally, the officials said that SEC's reliance on a small number of seasoned staff to do the majority of the routine work does not allow those staff to adequately deal with emerging issues."

[173] The bill authorizes an appropriation of $776,000,000 for the SEC for fiscal year 2003. This includes:

[175] The bill codifies the authority of the SEC in 17 CFR 210.102(e) to censure or deny, temporarily or permanently, the privilege of appearing or practicing before it to any person found by the SEC after notice and opportunity for hearing: (i) not to possess the requisite qualifications to represent others, (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct, or (iii) to have willfully violated, or willfully aided and abetted the violation of, any provision of the federal securities laws or the rules and regulations thereunder.

[176] Penny Stock Bar. Under current law, the penny stock bar is available only in administrative proceedings. However, the Commission frequently brings cases involving serious microcap or penny stock fraud in federal district court in order to obtain injunctive relief. In such a case, if the Commission also wishes to obtain a penny stock bar, it must bring a separate administrative proceeding, typically after the district court case is concluded. The Commission would be able to obtain all necessary relief more efficiently if the district courts had the authority to order penny stock bars.

[177] The bill authorizes federal courts to impose penny stock bars, or conditionally or unconditionally and temporarily or permanently prohibit a person from participating in a penny stock offering. The Commission has requested this authority in order to deal more swiftly with penny stock fraud.

[178] Qualifications of Associated Persons of Brokers and Dealers. The SEC staff has advised the Committee that in recent years, there has been a growing perception that fraud artists are able to exploit gaps in federal and state regulatory systems and to move from one sector of the financial services industry to another without sufficient impediment. The SEC lacks the enforcement authority to bar individuals from coming into the securities industry who have been found by other financial regulators to have engaged in fraudulent, deceptive, or dishonest conduct in other financial industries. The bill gives the SEC this power. In order to reduce the migration of fraud perpetrators into the securities industry, the bill authorizes the Commission to bar from the securities industry persons who have been suspended or barred by a state securities, banking, or insurance regulator because of fraudulent, manipulative, or deceptive conduct. The Commission requested this authority.

[180] Historically, the accounting industry has been consolidating into fewer large accounting firms. James E. Copeland, CPA and Chief Executive Officer, Deloitte & Touche, testified, "I've been on record since the last spate of proposed mergers saying that I thought the further consolidation of our industry would not be in the public's interest."⁹⁷

[181] The bill, in a section authored by Senator Akaka, directs the Comptroller General, in consultation with the SEC, similar regulatory agencies of the other G-7 nations, and the Department of Justice, to conduct a study identifying the factors that have led to the consolidation of public accounting firms since 1989, the impact of such consolidation, and solutions to any problems caused by such consolidation. The study shall also examine the problems faced by businesses as a result of limited competition among public accounting firms, and consider whether federal or state regulations impede competition among public accounting firms. A report is to be submitted to the Senate Banking Committee and the House Financial Services Committee within one year of enactment of this legislation.

[182] The Federal regulation of credit-rating bureaus was raised at the hearing of March 21, 2002. The bill, in a section authored by Senator Bunning, directs the SEC to conduct a study of the role of credit rating agencies in the operation of the securities market, including an examination of the role of credit rating agencies in the evaluation of issuers, the importance of that role to investors, any impediments to the rating agencies' accurate appraisal of issuers, any barriers to entry into the business of acting as a credit rating agency, measures to improve the dissemination of information about issuers when credit rating agencies announce credit ratings, and any conflicts of interest in the operation of credit rating agencies. A report is to be submitted to the President, the Senate Banking Committee, and the House Financial Services Committee within 180 days of enactment.

Section 2. Definitions

[183] Section 2 contains a set of definitions of terms that are used in the bill.

1. An "appropriate state regulatory authority" is a state authority responsible for licensing or other regulation of the practice of accounting in a state that has jurisdiction over an accounting firm or its personnel in connection with a particular matter.

2. An "audit" is an examination of the financial statements of an issuer by an independent public accounting firm, in accordance with rules of the new accounting oversight board or the SEC, for the purpose of expressing an opinion on those statements. This definition should be read in connection with the definitions of "issuer" and "audit report," below.

3. An "audit committee" is a committee of an issuer's board of directors created to oversee the accounting and financial reporting processes and audits of the financial statements of the issuer.

4. An "audit report" is a document, prepared following an audit performed for purposes of an issuer's compliance with the federal securities laws, in which a public accounting firm sets forth its opinion regarding a financial statement, report, or other document, or asserts that no such opinion can be expressed.

5. The "Board" is the Public Company Accounting Oversight Board established by section 101 of the bill.

6. The "Commission" is the U.S. Securities and Exchange Commission.

7. An "issuer" is a company that issues or proposes to issue securities, if the securities are registered under section 12 of the Securities Exchange Act of 1934, or if the company is required to file reports with the SEC under section 15(d) of the Securities Exchange Act (or will be required to file those reports at the end of the fiscal year in which a registration statement for the issuer's securities has become effective under the Securities Act of 1933).

8. "Non-audit services" are professional services provided to an issuer by an accounting firm registered with the Board, other than those required to be provided in connection with an audit or other review of the issuer's financial statements.

9. A "person associated with a public accounting firm" is a proprietor, partner, shareholder, principal, or an accountant or other professional employee of a public accounting firm, or any independent contractor or entity that shares in compensation or profits, or that participates on behalf of the firm in an activity, in connection with preparation or issuance of an audit report.

10. "Professional standards" include (i) accounting principles established by the standard-setting body recognized under the bill or prescribed or recognized by the SEC that are relevant to particular audit reports or accounting firm quality control systems, and (ii) auditing standards, standards for attestation engagements, quality control policy, ethical and competency standards, and independence standards that relate to the preparation of audit reports and are established or adopted by the Board or SEC.

11. A "public accounting firm" includes a proprietorship or entity engaged in the practice of public accounting or preparing or issuing audit reports. To the extent the new oversight board designates in its rules, the term can also include an associated person of an accounting firm.

12. A "registered public accounting firm" is a firm that registers with the new oversight board, as required by section 102 of the bill.

13. The "rules of the Board" include both the formal bylaws and rules adopted by the new oversight board (subject to action of the SEC under section 107 of the bill) and stated policies, practices, and interpretations of the board that the SEC deems to be rules of the board.

14. The term "security" has the same meaning as in section 3(a) of the Securities Exchange Act.

15. The term "securities laws" has the meaning given that term in section 3(a)(47) of the Securities Exchange Act, and includes the SEC's rules, regulations and orders. (Section 2(b), in a conforming amendment, makes the bill a part of the section 3(a)(47) definition.)

16. A "State" includes any state of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, and any other U.S. territory or possession.

Section 3. Commission rules and enforcement

[184] Section 3 generally gives the Securities and Exchange Commission (the "Commission" or the "SEC") authority to promulgate rules consistent with the Act and provides that a violation of the Act, or of any rule of the Commission or of the new Public Company Accounting Oversight Board created by title I of the Act, will be treated for all purposes as a violation of the Securities Exchange Act of 1934 and the rules thereunder; similarly, the new Board will be treated as if it were a self-regulatory organization under the 1934 Act for purposes of the Commission's investigative and enforcement authority. It should be emphasized that the new Board's own authority is limited to the work of accountants in auditing public companies; the Board has no jurisdiction with respect to the work of accountants in performing audits of other companies.

[185] Section 3 thus confirms that the Commission will have the authority to enforce the Act directly. Section 3 also makes clear that nothing in the Act or the rules of the new Board limits the Commission's own authority over accounting firms and their personnel, or accounting, auditing, independence, or other standards relating to auditors' reports.

[186] Section 101 creates a new Public Company Accounting Oversight Board (the "Board"). The Board will oversee the auditing of companies that are subject to the federal securities laws ( i.e., companies ("public companies "or" issuers") that have chosen to sell stock or debt instruments to public investors). Accounting firms that perform audits of public companies must register with the Board, and the Board will possess authority, subject to action by the Commission, to (i) set auditing, quality control, ethics, and independence standards (the latter supplementing statutory provisions on that subject), with respect to audits of the financial statements of public companies, (ii) inspect accounting firms' audit operations with respect to public companies, (iii) investigate potential violations by the firms or their partners or employees of the Act, the Board's rules, related provisions of the securities laws (and the Commission's rules), and professional accounting and conduct standards, and (iv) impose sanctions for violations. Again, the Board's authority in these areas is focused on, and limited to, the audit of public companies; it has nojurisdiction over accountants performing other audits. The Board is to submit an annual report of its activities to the Commission, which in turn is to send a copy to the House Committee on Financial Services and the Senate Committee on Banking, Housing, and Urban Affairs within 30 days of receipt.

[187] Legally, the Board will be a private nonprofit corporation subject to the District of Columbia Nonprofit Corporation Act. The Board will not be an agency or establishment of the United States. It is explicitly given authority to set compensation for its employees at levels comparable to similar positions in the private sector.

[188] Membership. Section 101(e) provides that the Board will have five members. The initial Board will be appointed by the Commission, after consultation with the Federal Reserve Board and the Department of the Treasury, within 90 days of the date of enactment; vacancies will be filled by the Commission after similar consultations. Board members will serve full-time, for five-year (staggered) terms, with a two-term limit. All Board members must have an understanding of the responsibilities for and the nature of the financial disclosures and accountants' responsibilities required by the securities laws. Three members of the Board will have a general background, and two members will have an accountancy background; the Board's Chairperson may be one of the two Board members with an accountancy background, but if so, he or she may not have been a practicing accountant for at least five years prior to appointment to the Board. Internal Board standard of conduct rules must include a one-year ban on practice before the Board (or before the Commission, with respect to Board-related matters) for former Board members and appropriate "cooling off" periods (not to exceed one year) for former Board staff.

[189] The initial Board's first task will be to hire staff, propose or adopt its first sets of rules and generally bring the organization into operational existence, so that the Commission can make a determination, required under section 101(d) within 270 days of enactment, that the Board possesses the capacity to carry out its responsibilities and enforce compliance with title I of the Act.

Section 102. Registration with the Board

[190] The Commission's determination that the Board can begin to exercise its authority starts the running of a 180-day period within which each public accounting firm that prepares or issues audit reports for public companies must register with the Board. At the end of the 180-day period it will become unlawful for an unregistered accounting firm to audit a public company. (Again, lack of registration will have no effect on an accounting firm's ability to perform any other sort of work.) An application for registration must include information about the identity of the public companies for which an accounting firm currently or during the previous year performs or has performed audit work, certain current financial information about the accounting firm itself, a statement of the firm's quality control policies for its accounting and auditing practice, a list of the firm's accountants who participate in public company audits, and information about pending civil, criminal, or disciplinary actions, and client-auditor disputes, relating to the firm's audits of public companies. The application must also include a consent to compliance with any requests for documents or testimony, within the Board's authority, made to the registrant in the course of the Board's operation and an agreement to obtain and if necessary to enforce similar consents from the firm's partners and employees who participate in public company audits. Registered accounting firms will be required to report changes in this information to the Board annually (or more frequently if the Board so requires).

[191] Information submitted to the Board as part of each application will be made available to the public, subject to limitations to protect the confidentiality of proprietary, personal, and other information for which such protection is necessary or required by law. In particular, information "reasonably identified by [the registrant] as proprietary information" will be withheld from disclosure.

[192] The Board is authorized by section 102(f) to impose a registration fee and an annual fee on each registrant, to cover the cost of processing and reviewing applications and annual reports.

Section 103. Auditing, quality control, and independence standards and rules

[193] Section 103 requires the Board to establish auditing, quality control, and ethical standards, as required by the Act or the rules of the Commission or necessary or appropriate in the public interest or for the protection of investors, to be used by registered accounting firms in the preparation of audit reports for public companies. The Board is also to adopt rules to implement the provisions on the independence of public company auditors contained in title II of the Act.

[194] The Board's rules specifically must require (i) preparation and maintenance for 7 years by public company auditors of audit work papers and related information in sufficient detail to support each audit's conclusions, (ii) "second partner" review and approval of each public company audit report and its issuance, and (iii) inclusion in each audit report of a description of the auditor's testing of the public company's systems for compliance with the requirements of section 13(b)(2) of the Securities Exchange Act and of the company's controls over its receipts and expenditures, together with specific notation of any significant defects or material noncompliance of which the auditor should know on the basis of such testing.

[195] Section 103 also specifies the subjects that the quality control standards adopted by the Board must address. These are: monitoring of ethics and independence; internal and external consulting on audit issues; audit supervision; hiring, development, and advancement of audit personnel; acceptance and continuance of engagements; and internal inspection.

[196] The Board may adopt as part of its rules (and modify as appropriate for that purpose, at the time of adoption or thereafter), any portion of a statement of auditing, quality control, or ethics standards that meet the statutory test prepared (i) by a professional group of accountants designated by a rule of the Board for that purpose, or (ii) by one or more advisory groups convened by the Board. (Pre-existing standards of designated professional groups of accountants that may be adopted during the Board's nine-month transitional period are to be separately approved by the Commission at the time of the Commission's determination (pursuant to section 101(d), noted above) that the Board is ready to begin operation.)

[197] The Board will convene advisory groups of practicing accountants and other experts, as well as representatives of other interested groups (subject to appropriate conflict of interest rules), to make recommendations concerning, or propose drafts of, the content of any required standards for public company auditors.

[198] The Board is to cooperate on an ongoing basis with both the designated professional groups of accountants noted above, and with its own advisory groups, in examining the need for changes in any standards subject to Board authority. The Board is to recommend issues for inclusion on the agendas of these groups, and take other steps to facilitate the standard-setting process, and it is to respond in a timely fashion to requests for changes in the standards over which the Board has authority.

[199] Finally, the Board is to include a summary of the results of its standard-setting responsibilities in each of its annual reports. Each summary must include a discussion of the Board's work with any designated professional group of accountants or advisory group, as well as the Board's pending agenda for future standard- setting projects.

Section 104. Inspections of registered public accounting firms

[200] Section 104 outlines the duty of the staff of the Board to undertake annual inspections of registered public accounting firms that prepare audit reports for more than 100 public companies, and triennial inspections of firms that prepare audit reports for 100 or fewer public companies, to assess the degree of compliance by those firms with the Act, the rules of the Board, and professional standards relating to audits of public companies. (The inspection cycles for different-sized accounting firms may be subsequently changed by the Board.) The Board is to (i) identify in the course of each inspection any act, practice, or omission by the firm or its partners or employees revealed by the inspection that may violate the Act, the Board's or related Commission rules, the firm's own quality control policies, or professional standards, (ii) report any such finding, if appropriate, to the Commission and each state accountancy board with jurisdiction over the matter, and (iii) commence a formal investigation or take any appropriate disciplinary action with respect to the violation.

[201] The scope of each inspection will include both particular audit and review engagements (which may include engagements that are otherwise the subject of ongoing controversy between the accounting firm under inspection and third parties), selected solely by the Board, as well as a review of each firm's quality control system and its compliance with professional standards relating to audit reports for public companies. The term "professional standards" means, for purposes of title I and the Board's authorization, (i) generally accepted accounting principles, (ii) auditing standards, standards for attestation engagements and quality control policies, and ethical and competency standards that the Board adopts, and (iii) independence standards that the Board adopts to implement title II of the Act.

[202] The rules of the Board are to provide a procedure for review and comment on a draft inspection report by the firm inspected; the text of any comment by the firm on a draft inspection report is to be attached, with appropriate redactions to protect confidential information, to the final report. That report is to be sent to the Commission and the appropriate state board of accountancy and made available to the public (subject, again, to protection of confidential and proprietary information). Portions of an inspection report which deal with criticisms of or potential defects in the quality control systems of a firm will not be made public if the defects are addressed to the satisfaction of the Board within 12 months of the date of the report. In certain cases interim Commission review of certain inspection-related disputes is available.

Section 105. Investigations and disciplinary proceedings

[203] Section 105 outlines the investigative and disciplinary authority of the Board over firms that audit public companies and partners and employees of these firms.

[204] Investigations. Section 105(a) authorizes the Board to investigate any act or practice by a registered accounting firm, or its partners or employees, that may violate the Act, the Board's rules, professional standards, and the portion of the securities laws and SEC rules that relate to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto. The Board may require testimony or production of documents or information, or inspect documents or information, in the possession of any registered public accounting firm or its partners or employees. The Board's investigative activities and any information gathered in the course of an investigation are to be confidential and privileged for all purposes (including civil discovery), unless and until particular information is presented in connection with a public proceeding. The Board may refer investigations to the Commission, any other federal functional regulator (in the case of an investigation relating to the audit of an institution subject to the jurisdiction of such functional regulator), and, at the direction of the Commission, to the Attorney General, state attorneys general in connection with any criminal investigation, or appropriate state boards of accountancy, and may share information derived from investigations with the same parties, but only if the Board determines that such disclosure is "necessary to accomplish the purposes of the Act or to protect investors." The Board's investigators are granted civil immunity for their activities during an investigation to the same extent that a federal investigator would enjoy such immunity.

[205] Disciplinary proceedings. Section 105(b) authorizes the Board to impose a full range of sanctions if it finds that a registered firm, or its partners or employees, have engaged in any act or practice that violates the Act, the Board's rules, professional standards, or the portion of the securities laws (and SEC rules) relating to audits of public companies. Potential sanctions include revocation or suspension of the registration of an accounting firm, or of the ability of particular individuals to remain associated with that firm or become associated with any other registered accounting firm (effectively barring the subject of the sanction from participating in audits of public companies), substantial civil money penalties, required professional education or training, or censure; the Board's ability to suspend or bar an associated person from the auditing of public companies, and the Board's ability to impose civil money penalties above a certain amount, is limited to situations involving intentional, knowing, or reckless conduct, or repeated negligent conduct. The Board may also impose sanctions upon a registered accounting firm for failure reasonably to supervise a partner or employee (in terms similar to those that apply to broker-dealers under section 15(b)(4) of the Securities Exchange Act of 1934, which permit the firm to defend by showing that its internal control procedures were reasonable and were operating fully in the case at issue).

[206] The Board's rules must set out fully the procedural requirements for disciplinary proceedings. Disciplinary sanctions finally imposed must be reported to the Commission, appropriate state or foreign boards of accountancy, and the public (once any stay of enforcement pending appeal has been lifted). Any sanction may be appealed to the Commission under the provisions of section 107(c) (described below).

[207] Fines imposed by the Board are to be used to fund a scholarship program for students in undergraduate or graduate programs in accounting.

Section 106. Foreign public accounting firms

[208] Section 106 provides that accounting firms organized under the laws of countries other than the United States that issue audit reports for public companies subject to the U.S. securities laws are covered by the Act in the same manner as domestic accounting firms, subject to the exemptive authority of both the Board and the Commission. (Registration under the Act will not in itself provide a basis for subjecting a foreign accounting firm to U.S. jurisdiction other than with respect to controversies between such a firm and the Board.) The Board is authorized to determine that other foreign accounting firms play a sufficiently substantial role in the preparation and furnishing of such reports for particular issuers that their coverage under the Act is necessary or appropriate, in light of the purposes of the Act and in the public interest or for the protection of investors.

[209] Section 106 also sets terms for the production in the United States by a foreign public accounting firm of its audit work papers, for any audit in which the foreign accounting firm issues an opinion or otherwise performs material services upon which an accounting firm registered under the Act relies in issuing all or part of an audit report for a public company.

Section 107. Commission oversight of the Board

[210] Section 107 makes the Board generally subject to the same degree of control by the Commission as the National Association of Securities Dealers or the New York Stock Exchange. Section 107(b) provides that the Board's proposed rules must be filed with the Commission and published by the Commission for public comment. No Board rule may take effect without Commission approval (except in limited situations), and the Commission retains the power not only to disapprove, but to abrogate or amend, any rules of the Board. Section 107(c) incorporates the provisions of section 19(d)( 2) and (e)(1) of the Securities Exchange Act of 1934 to give the Commission full authority to review, modify, or cancel any disciplinary sanction imposed by the Board (including any sanction imposed for failure to comply with a demand for testimony or documents in the course of a Board investigation), either upon the Commission's own motion or on the motion of an aggrieved party. (The Commission may, in some cases, also review registration-or inspection-related disputes.) Finally, the Commission possesses authority to limit the authority and activities, or to censure, or even to remove members, of the Board itself, if the Commission finds that the Board, or a particular member, has violated, is unable to comply with, or has failed to enforce compliance with the Act, the Board's or the Commission's rules, or the securities laws, has failed to enforce compliance with professional standards, or, in the case of a particular Board member, has willfully abused his or her authority.

Section 108. Accounting standards

[211] Section 108 amends section 19 of the Securities Act of 1933 specifically to allow the Commission to recognize as "generally accepted" (for securities law purposes) accounting principles established by a standard-setting body that meets certain criteria. First, the body must be a private entity and be funded by public companies in the same manner as the Board (provided in section 109 of the Act), and it must have adopted procedures, including acting by majority vote, to ensure prompt consideration of necessary changes to the body of accounting principles. Second, the Commission must determine that the standard-setting body has the ability to assist the Commission, because the standard-setting body has proved able to improve the accuracy and effectiveness of financial reporting and the protection of investors. Any such standard-setting body must report annually to the Commission. Finally, section 108 requires the Commission to conduct a study of the adoption by the U.S. financial reporting system of a principles-based accounting system.

Section 109. Funding

[212] Section 109 provides that the Board and the accounting principles standard-setting body recognized under section 108 of title I are to be funded by an "accounting support fee." (The Board's budget, but not the budget of the standard-setting body, is to be subject to approval by the Commission.) In the case of both the Board and the standard-setting body, the annual support fee is to be assessed against each public company. Amounts payable by public companies to either body will generally be allocated among those companies based on relative average annual monthly market capitalization for the 12 months prior to the year to which the support fee relates; both the Board and the standard-setting body are permitted to differentiate among various classes of public companies, as necessary or appropriate, in allocating fees. Fees are to be collected in such manner as is deemed appropriate in each case.

[213] The Act restricts a registered public accounting firm in the nonaudit services it may provide to its audit clients that are public companies in order to preserve the firm's independence. The Act specifies eight categories of activities that an auditor may not provide to a public company that is its audit client. These include: (1) bookkeeping or other services related to the accounting records or financial statements of the issuer; (2) financial information systems design and implementation consulting services; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit services; (6) any management or human resources function; (7) broker, dealer, investment adviser, or investment banking services; and (8) legal services and expert services unrelated to the auditing service. In addition, the Public Company Accounting Oversight Board may determine that any other non-audit service is prohibited. The Board has the authority to grant exemptions on a case-by-case basis to the extent necessary or appropriate in the public interest and consistent with the protection of investors, subject to SEC review. A registered public accounting firm would be permitted to perform for a public company audit client any other non-audit service, including tax services, that the public company's Audit Committee preapproves in accordance with the requirements adopted in Section 202.

[214] The Act would not affect the services that a registered public accounting firm provides to non-public companies or to public companies that are not its audit clients. Thus, a firm could provide any consulting service to any public company for which it does not provide audit services as well as to any non-public company.

Section 202. Pre-approval requirements

[215] The Audit Committee of a public company must pre-approve all the services, both audit and non-audit, provided to that company by a registered public accounting firm. The public company is required to disclose the Audit Committee's approvals of non-audit services to shareholders in SEC filings. The pre-approval requirement is waived if an auditor provides a service that was not recognized to be a non-audit service at the time of the engagement and if the aggregate amount of all such non-audit services is 5% or less of total auditor fees and such services are promptly brought to the attention of the Audit Committee and approved by the Audit Committee prior to the completion of the audit. Approval may be made by one or more members of the Audit Committee, to whom such authority has been delegated. The decisions of any delegated member to pre-approve an activity shall be presented to the full Audit Committee at each of its meetings.

Section 203. Audit partner rotation

[216] A registered public accounting firm must rotate its lead partner and review partner on its audits of a public company so that no partner performs an audit on the same issuer as a lead partner or review partner for more than five consecutive years.

Section 204. Auditor report to Audit Committees

[217] A registered independent public accounting firm performing an audit for a public company will timely report to that company's Audit Committee the critical accounting policies and practices to be used and all alternative treatments of financial information within GAAP that have been discussed with management, any accounting disagreements between the auditor and management and other material written communications between the auditor and management.

Section 205. Conforming amendments

Section 206. Conflicts of interest

[218] An accounting firm may not provide audit services for a public company if that company's chief executive officer, controller, chief financial officer, chief accounting officer, or other individual serving in an equivalent position, was employed by the accounting firm and worked on the audit of the public company during the one year before the start of the audit services.

Section 207. Study of mandatory rotation of registered public accounting firms

[219] The GAO will study the potential effects of requiring the mandatory rotation of registered public accounting firms and report to Congress within one year.

Section 208. Commission authority

[220] A registered independent public accounting firm must comply with the restrictions in sections 201-204 and 206 in order to perform an audit for a public company.

Section 209. Considerations by appropriate state regulatory authorities

[221] It is the intent of this Act that in supervising non- registered accounting firms, state regulatory authorities should make an independent determination of the proper standards, and should not presume the standards applied by the Board under this Act to be applicable to small-and medium-sized non-registered accounting firms.

[222] The Exchange Act is amended to require the SEC to draft rules directing national securities exchanges and national securities associations to require listed companies to make Audit Committees responsible for the appointment, compensation, and oversight of the work of auditors and to require auditors to report directly to the Audit Committee. The amendments also: bar Audit Committee members from accepting consulting fees or being affiliated persons of the issuer or the issuer's subsidiaries other than in the member's capacity as a member of the board of directors or any board committee; require Audit Committees to have in place procedures to receive and address complaints regarding accounting, internal control or auditing issues; require Audit Committees to establish procedures for employees' anonymous submission of concerns regarding accounting or auditing matters; and require public companies to provide their Audit Committees with authority and funding to engage independent counsel and other advisers as they determine necessary.

Section 302. Corporate responsibility for financial reports

[223] CEOs and CFOs must certify, in periodic reports containing financial statements filed with the Commission pursuant to section 13(a) or 15(d) of the Exchange Act, the appropriateness of financial statements and disclosures contained therein, and that those financials and disclosures fairly present the company's operations and financial condition.

Section 303. Prohibited influence

[224] It is unlawful for any officer, director, or person acting under their direction to fraudulently influence, coerce, manipulate, or mislead any accountant engaged in preparing an audit report, for the purpose of rendering the audit report misleading.

Section 304. Forfeiture of certain bonuses and profits

[225] In the case of accounting restatements that result from material non-compliance with SEC financial reporting requirements, CEOs and CFOs must disgorge bonuses and other incentive-based compensation and profits on stock sales, if the non-compliance results from misconduct. The required disgorgement applies to the 12 months after the first public issuance or filing of a financial document embodying such financial reporting requirement. The SEC may exempt any person from this requirement as it deems necessary and appropriate.

Section 305. Officer and director bars and penalties

[226] The sanction of barring securities law violators from serving as officers or directors of public companies is strengthened by modifying the standard that governs judicial imposition of officer and director bars. In addition, courts may impose any equitable relief necessary or appropriate to protect, and mitigate harm to, investors.

Section 306. Insider trades during pension fund blackout periods prohibited

[227] Directors and executive officers are prohibited from engaging in transactions involving any equity security of the issuer during a "blackout" period when at least half of the issuer's individual account plan participants are not permitted to purchase, sell or otherwise transfer their interest in that equity security. No blackout period may take effect until at least 30 days after written notice of the blackout is provided by the plan administrator to the participants or beneficiaries. Exceptions to the 30-day notice are allowed in cases: (1) where a deferral of the blackout period would violate ERISA fiduciary provisions; or (2) where the inability to provide the notice is due to unforeseeable events or circumstances beyond the reasonable control of the plan administrator.

[228] A public company in periodic reports filed with the SEC will present: (1) disclosures of financial information that reflect all material correcting adjustments that have been identified by the auditor in accordance with GAAP and (2) the material off-balance sheet transactions, arrangements, obligations, and other relationships of the issuer with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.

[229] Issuers that disseminate "pro forma" financial information in their filings with the SEC, press releases or other public disclosures must present pro forma data in a manner that does not contain an untrue statement or omit to state a material fact necessary in order to make the information, in light of the circumstances under which it is presented, not misleading, and that reconciles it with the issuer's financial condition under GAAP.

Section 402. Enhanced disclosures of loans

[230] An issuer in its current reports must disclose within 7 days, or such other time period determined to be appropriate by the SEC: (A) all loans, except credit card loans, made by the issuer and its affiliates to any executive officer or director, specifying amounts paid and balances owed on such obligations and (B) any conflicts of interest, as defined by the SEC.

Section 403. Disclosures of transactions involving management

[231] Section 16(a) of the Exchange Act is amended to require directors, officers and 10% equity holders to report their purchases and sales of securities more promptly, by the end of the second day following the transaction or such other time established by the SEC in any case in which the two-day period is not feasible.

Section 404. Management assessment of internal controls

[232] Annual reports filed with the SEC must be accompanied by a statement by the management of its responsibility for creating and maintaining adequate internal controls. Management must also present its assessment of the effectiveness of those controls. In addition, the company's auditor must report on and attest to management's assessment of the company's internal controls. Such attestation shall not be the subject of a separate engagement.

Section 405. Exemption

[233] Investment companies are exempted from the disclosure requirements of sections 401, 402 and 404.

Section 406. Code of ethics for senior financial officers

[234] Issuers are required to disclose whether or not they have adopted a code of ethics for senior financial officers, and if not, the reason therefor.

Section 407. Audit Committee financial expert

[235] The SEC is required to adopt rules to require issuers to disclose whether their Audit Committees include among their members at least one "financial expert." In defining "financial expert," the SEC shall consider whether a person understands GAAP and financial statements, has experience preparing or auditing financials, has experience with internal accounting controls, and understands Audit Committee functions.

[236] The Act requires the Commission, or upon the authorization and direction of the Commission, a registered securities association or national securities exchange, within one year to adopt rules designed to address conflicts of interest facing securities analysts. The rules will (A) foster greater public confidence in securities research and protect the objectivity and independence of stock analysts who publish research intended for the public by (i) prohibiting the pre-publication clearance of such research or recommendations by investment banking or other staff not directly responsible for investment research, (ii) limiting the supervision and compensatory evaluation of such research personnel to officials who are not engaged in investment banking activities, and (iii) protecting securities analysts from retaliation or threats of retaliation by investment banking staff because of negative or otherwise unfavorable research reports that might adversely affect investment banking relations with the issuer described in the report, provided that the rules shall not limit the authority of a broker or dealer to discipline a securities analyst for causes other than such report in accordance with the firm's policies and procedures, (B) define periods during which broker-dealers who participate in a public offering of securities as underwriters or dealers shall not publish research or recommendations about the securities of the issuer, (C) establish structural and institutional safeguards within broker-dealers to assure that securities analysts preparing research reports are separated by appropriate informational partitions from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision, and (D) address such other issues as the SEC or the SROs deem appropriate.

[237] The Act also requires the Commission, or upon the direction of the Commission, a registered securities association or national securities exchange, to adopt rules requiring disclosures about conflicts of interest in reports and public appearances. These disclosures include (A) the extent to which the analyst holds securities in the issuer, (B) whether compensation has been received from the issuer, subject to such exemptions as the Commission may determine appropriate and necessary to prevent disclosure of material non-public information regarding specific potential future investment banking transactions as is appropriate in the public interest and consistent with investor protection, (C) whether the issuer is or has recently been a client of the analyst's firm, and if so, the types of services provided, (D) whether the analyst received compensation based on an affiliate's investment banking revenues, and (E) such other disclosures as the SEC or the SROs deem appropriate. The regulator would have the authority to amend its rules.

[238] There is authorized an appropriation of $776,000,000 for the SEC for fiscal year 2003, of which: $102,700,000 would fund the pay parity of salary and benefits for SEC employees, as authorized in the Investor and Capital Markets Fee Relief Act (P.L. 107-123); $108,400,000 would fund information technology, security enhancements, and recovery and mitigation activities in light of the terrorist attacks of September 11, 2001; and $98,000,000 would fund at least 200 more professionals to oversee auditors and auditing services, and additional staff to improve SEC investigative and disciplinary efforts and strengthen the SEC's oversight and regulation of market participants and of issuer disclosure, securities markets and investment companies.

Section 602. Appearance and practice before the SEC

[239] The SEC is authorized to censure or deny, temporarily or permanently, the privilege of appearing or practicing before it to any person found by the SEC after notice and opportunity for hearing: (i) not to possess the requisite qualifications to represent others, (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct, or (iii) to have willfully violated, or willfully aided and abetted the violation of any provision of the federal securities laws or the rules and regulations thereunder. This codifies Section 102(e) of the SEC's Rules of Practice.

Section 603. Federal court authority to impose penny stock bars

[240] Federal courts are authorized to conditionally or unconditionally and temporarily or permanently prohibit a person from participating in a penny stock offering.

Section 604. Qualifications of associated persons of brokers and dealers

[241] The SEC is authorized to bar from the securities industry persons who have been suspended or barred by a state securities, banking or insurance regulator because of fraudulent, manipulative or deceptive conduct.

[242] The Comptroller General, in consultation with the SEC, similar regulatory agencies of the other G-7 nations, and the Department of Justice, is to conduct a study identifying the factors that have led to the consolidation of public accounting firms since 1989, the impact of such consolidation, and solutions to any problems caused by such consolidation. The study shall also examine the problems faced by businesses as a result of limited competition among public accounting firms, and consider whether federal or state regulations impede competition among public accounting firms. A report is to be submitted to the Senate Banking Committee and the House Financial Services Committee within one year of enactment.

Section 702. Commission study and report regarding credit rating agencies

[243] The SEC is to conduct a study of the role of credit rating agencies in the operation of the securities market, including an examination of the role of credit rating agencies in the evaluation of issuers, the importance of that role to investors, any impediments to the rating agencies' accurate appraisal of issuers, any barriers to entry into the business of acting as a credit rating agency, measures to improve the dissemination of information about issuers when credit rating agencies announce credit ratings, and any conflicts of interest in the operation of credit rating agencies. A report is to be submitted to the President, the Senate Banking Committee, and the House Financial Services Committee within 180 days of enactment.

[246] The bill make structural changes in various aspects of the federal securities laws. Titles I through IV and portions of title VI affect the auditing of public companies and financial disclosures by those companies and their managers. Title V affects conflicts of interest by employees of broker-dealers who issue research reports dealing with particular companies or industries.

[247] There are, according to the SEC, approximately 16,500 public companies subject to the federal securities laws.⁹⁸ Fewer than 15 percent of the nation's accounting firms audit any public companies, and only 20 firms have more than 30 audit clients.⁹⁹ There are perhaps 75-100 registered broker- dealers that issue research reports of the type dealt with in title V, and perhaps as many as 5000 analysts who prepare those research reports.

[248] The bill establishes a comprehensive framework to modernize and reform the oversight of public company auditing, improve quality and transparency in financial reporting by those companies, and strengthen the independence of auditors. It promotes competition among service providers, enhances accurate investor decision-making throughout the capital markets, and seeks to correct shortcomings that have threatened the reputation of those markets for integrity.

[249] The legislation should have little additional impact upon the privacy of particular individuals. Information and documents held by the Public Company Accounting Oversight Board created by the bill are generally confidential and privileged until made public in connection with a particular public enforcement proceeding. Corporate managers and others affected by the bill are already subject to extensive reporting requirements under the federal securities laws.

[250] Specific rules issued by the SEC under various provisions of the bill will contain their own regulatory and paperwork estimates, as required by applicable law. Otherwise, it is difficult to measure, at this time, the extent to which the bill would impose additional costs beyond those described in the CBO estimate, below. In addition, the bill's net regulatory impact upon the economy can be positive, especially as its terms operate to reduce crises in corporate management and value of the sort the economy is now witnessing. Finally, the immediate regulatory impact of the bill must be weighed against the continuing serious adverse economic impact on investors, the markets, and the national economy of the failure of existing regulatory arrangements and the decline in investor confidence, here and abroad, that this failure has generated. For all of these reasons, the Committee has determined that more extensive compliance with rule XXVI(11)(b) than that contained above is impracticable.

Chairman, Committee on Banking, Housing, and Urban Affairs,

U.S. Senate, Washington, DC.

DEAR MR. CHAIRMAN : The Congressional Budget Office has prepared the enclosed cost estimate for the Public Company Accounting Reform and Investor Protection Act of 2002.

If you wish further details on this estimate, we will be pleased to provide them. The CBO staff contacts are Ken Johnson (for federal costs), Greg Waring (for the state and local impact), and Paige Piper/Bach (for the private-sector impact).

[252] Summary: The bill would establish two new organizations -- the Public Company Accounting Oversight Board (Oversight Board) to regulate the accounting industry and the Standard-Setting Body to write national standards for accounting practices. The activities of these organizations would be overseen by the Securities and Exchange Commission (SEC). In addition, the bill would authorize the appropriation of $776 million in 2003 for the SEC's activities. Under the bill, both the SEC and the Oversight Board could assess civil penalties for violations of the bill's provisions. Any civil penalties collected by the Oversight Board would be spent on a scholarship program for accounting students. The bill also would require the General Accounting Office (GAO) to complete two studies of the accounting industry within one year of enactment.

[253] Based on information from the SEC, CBO estimates that implementing this bill would cost about $787 million over the 2003- 2007 period, assuming the appropriation of the necessary amounts. Under current law, the SEC's discretionary costs are offset by fees the agency collects from securities markets. Enactment of the bill would not change the amount of fees expected to be collected in the future. Assuming the continued collection of the regulatory fees assessed by the SEC, the commission would collect $1.3 billion in fees in 2003, and its net outlays would be ¥ $621 million in that year. The two GAO studies also would cost an estimated $1 million in 2003, subject to the availability of appropriated funds. CBO estimates that the bill would have effects on revenues and direct spending, but that the net effect of those changes would be negligible each year. Because the bill would affect revenues and direct spending, pay-as-you-go procedures would apply.

[254] The bill contains an intergovernmental mandate as defined in the Unfunded Mandates Reform Act (UMRA), but CBO estimates that complying with that mandate would result in no costs to state, local, or tribal governments. Therefore, the threshold established by UMRA ($ 58 million in 2002, adjusted annually for inflation) would not be exceeded.

[255] The bill would impose several private-sector mandates, as defined by UMRA, on certain accounting firms, companies that issue registered securities, officers and directors of those companies, investment banking firms, and securities analysts. CBO cannot determine whether the direct cost of those mandates would exceed the annual threshold set by UMRA for private-sector mandates ($ 115 million in 2002, adjusted annually for inflation). The mandate costs are difficult to estimate because (1) we do not have sufficient information to estimate the cost of prohibiting insider trading during blackout periods when investment activity is restricted; (2) the cost to comply with several of the mandates would depend on rules soon to be prescribed by the SEC under current authority; and (3) the cost to comply with several of the mandates would depend on rules that would be prescribed by the SEC under the bill.

[256] Estimated cost to the Federal Government: The estimated budgetary impact of the bill is shown in the following table. The costs of this legislation would fall within budget functions 370 (commerce and housing credit -- for the SEC) and 800 (general government-for GAO).

                                fiscal year, in millions of dollars --

[257] For this estimate, CBO assumes that the bill will be enacted by the end of fiscal year 2002. Assuming appropriation of the necessary funds, CBO estimates that implementing the bill would cost the SEC about $787 million and GAO about $1 million during the 2003- 2007 period. We estimate that the bill also would affect both revenues and direct spending, but that the net impact of those effects would be negligible for each year.

[258] The SEC is typically funded through fees the agency collects for registrations, transactions, and mergers of securities. Under current law, the fee rates are determined periodically by the SEC, and they are collected only to the extent provided in advance in appropriations acts. These fees are classified in the budget as offsets to the SEC's discretionary spending.

Spending subject to appropriation

[259] The bill would authorize the appropriation of $776 million for all SEC activities in 2003. Of this amount, the bill would earmark $103 million for higher salaries for SEC employees, $108 million for security and information technology enhancements needed by the agency after the September 11th attacks, and $98 million for additional staff to monitor audit services. Based on the agency's historical spending patterns, CBO estimates that implementing this provision would result in gross outlays of about $592 million in 2003 and $768 million over the 2003-2004 period, assuming the appropriation of the necessary amounts. Adding these amounts to CBO's projections for fee collections in 2003, we estimate that the SEC's net spending would be ¥ $621 million in that year.

[260] The bill also would require the SEC to review any sanctions or rules proposed by the Oversight Board. CBO estimates that the cost of these activities would be roughly comparable to the SEC's oversight of national securities exchanges and associations. Based on information from the SEC about the cost of such oversight, CBO estimates that the SEC would require about 40 staff members, at a cost of about $5 million a year, to review the rules and sanctions proposed by the new Oversight Board. Any amounts the SEC would spend to oversee accounting practices under the bill would be subject to the availability of appropriated funds.

[261] Under the bill, GAO would complete two reports to the Congress on the accounting industry within one year of enactment. Based on information from GAO, CBO estimates that conducting these two studies would cost the agency about $1 million in 2003, subject to the availability of appropriated funds.

Revenues and direct spending

[262] CBO estimates that implementing this bill also would affect direct spending and revenues. The effects would result from the bill's provisions creating an Oversight Board and a Standard- Setting Body to oversee the accounting industry and from provisions relating to civil penalties.

[263] Costs of Creating the Oversight Board and Standard- Setting Body. The bill would require that annual financial reports filed by public companies under the securities laws must be audited by an accountant who is deemed qualified to do so by a new organization called the Public Company Accounting Oversight Board. CBO expects this provision would give the Oversight Board substantial authority to regulate and control entry into the accounting industry, thus exercising the sovereign power of the federal government. The fact that the board's rules, sanctions, funding sources, and annual budget would be approved by the SEC indicate a significant level of federal control over the board's operations and funding. For these reasons, CBO would consider the board's spending and the fees it would collect under the bill from public companies and accounting firms as part of the federal budget (even though the bill states it would not be part of the government).

[264] The bill also would require the SEC to designate an organization called the Standard-Setting Body to write national standards for accounting practices. Under current law, all annual financial statements filed by public companies must comply with such standards. The bill also would mandate that the Standard-Setting body assess fees on public companies using a formula that would be approved by the SEC, thereby giving the federal government control over the Standard-Setting Body's funding. Therefore CBO also would consider this body's collections and spending a part of the federal budget (even though the bill states it would be organized as a private entity).

[265] CBO expects that operating the Oversight Board, when fully implemented, would cost at least as much as similar activities that are now performed by the Public Oversight Board (POB) and the Independence Standards Board, and through peer reviews administered by the American Institute of Certified Public Accountants (AICPA). Before they recently disbanded, the POB and the Independence Standards Board spent about $8 million a year. The peer reviews administered by AICPA are conducted by other accounting firms. Based on information from AICPA, CBO estimates that these reviews could cost the Oversight Board at least $50 million a year. Similarly, CBO expects that the annual costs of the Standard-Setting Board would approach the $20 million spent each year by the Federal Accounting Standards Board (FASB), which performs standard-setting duties today.

[266] Under the bill, the Oversight Board and the Standard- Setting Body would assess fees on the public to cover their costs. CBO expects that the net effect of the two organizations' collections and spending under this bill would not be significant in any year. Whether such collections would be categorized in the budget as revenues or offsetting receipts is uncertain because we do not know how the organizations would assess those fees.

[267] Civil Penalties. The bill also would authorize the SEC and the Oversight Board to enforce the bill's provisions with civil penalties. Such penalties are recorded in the budget as governmental receipts (revenues). Based on information from the SEC, CBO estimates that these provisions would increase revenues by less than $500,000 a year.

[268] Under the bill, any civil penalties collected by the Oversight Board would be spent on scholarships for accounting students in undergraduate or graduate programs. Because the amounts spent would equal the penalties collected by the accounting board, CBO estimates that the increase in direct spending also would be less than $500,000 per year.

[269] Pay-as-you-go considerations: The Balanced Budget and Emergency Deficit Control Act sets up pay-as-you-go procedures for legislation affecting direct spending or receipts. CBO estimates that the net pay-as-you-go effects of this bill would be insignificant for each year.

[270] Estimated impact on state, local, and tribal governments: Because it would preempt state authority to license or regulate the Public Company Accounting Oversight Board as a nonprofit corporation, the bill contains an intergovernmental mandate as defined in UMRA. CBO estimates that this preemption would not affect state budgets because, while it would limit the application of state law towards the board, it would not impose a duty on states that would result in additional spending. Therefore, the threshold established by UMRA ($ 58 million, in 2002, adjusted annually for inflation) would not be exceeded. The remaining provisions of the bill contain no intergovernmental mandates and would impose no costs on state, local, or tribal governments.

Estimated impact on the private sector

[271] The bill would impose private-sector mandates, as defined by UMRA, on certain accounting firms, companies that issue registered securities, officers and directors of those companies, investment banking firms, and securities analysts. CBO cannot determine whether the direct cost of those mandates would exceed the annual threshold set by UMRA fro private-sector mandates ($ 115 million in 2002, adjusted annually for inflation). The mandate costs are difficult to estimate because (1) we do not have sufficient information to estimate the cost of prohibiting insider trading during blackout periods when investment activity is restricted; (2) the cost to comply with several of the mandates would depend on rules soon to be prescribed by the SEC under current authority; and (3) the cost to comply with several of the mandates would depend on rules that would be prescribed by the SEC under the bill.

Regulation of accounting firms

[272] Under the bill, a registered public accounting firm would be:

• Subject to a system of review by the Public Company Accounting Oversight Board to be established under the bill;

• Prohibited from offering both audit and certain non-audit consulting services (designing or implementing financial information systems or providing internal audit services); and

• Required to retain all audit work papers for at least seven years.

• Sponsors a transitional private entity that reviews independent accountants:

• Has voluntarily stopped offering both audit and such non audit consulting services; and

• Retains financial statement working papers and records for seven years.

[275] The bill would require an accounting firm to obtain a second review of audit reports from another auditor within the firm, and test and express an opinion on certain internal controls of public companies. The cost to obtain a second review and provide an opinion on compliance by a company would depend on rules to be prescribed by the SEC. Since the regulations have not been established, CBO cannot estimate the cost to comply with those mandates.

Registration and accounting support fees

[276] The bill would require that the new Oversight Board and a designated Standard-Setting Body be independently funded by public companies. Based on information from the SEC, CBO estimates the annual cost of operating the oversight board and the standard-setting body would be approximately $80 million. The bill would require those organizations to levy fees on registered public accounting firms and an annual accounting support fee on issuers of securities. Currently, the accounting industry is self-regulated and voluntarily provides the funding for the regulatory organization, including peer reviews. According to the SEC and the industry, the cost of oversight and review required by the bill are similar to the costs now voluntarily incurred by the industry. Therefore the incremental cost to the private sector would be small.

Auditor independence

[277] Section 203 of the bill would prohibit the lead and review partners of an accounting firm from providing audit services for the same company for more than five consecutive years. Based on information from the AICPA, CBO estimates that the direct cost to rotate lead and review partners would be minimal.

[278] Section 206 would prohibit an accounting firm from providing audit services for a public company if that company's chief executive officer, financial officer, controller, or other equivalent position was employed by the accounting firm during the year before the start of the audit services. Based on information from the AICPA, CBO anticipates that some firms would lose business that other accounting firms would gain. Therefore, CBO estimates that total direct cost to the accounting industry would be negligible.

Corporate responsibility

[279] The bill contains provisions that would require greater corporate responsibility for financial reports. The cost of complying with those requirements would depend on rules that the SEC has agreed to propose, but not yet promulgated. Therefore, CBO cannot estimate the direct costs of complying with the following mandates:

• Section 301 would require the audit committee of a corporate board to be responsible for the appointment, compensation, and oversight of the work of their auditors. This section also would prohibit national securities exchanges and associations from listing companies that do not comply with certain audit committee standards.

• Section 302 would require chief executive officers and chief financial officers of public companies to certify the appropriateness of their company's periodic reports and to ascertain that the financial reports fairly reflect the operations and conditions of their companies.

[280] Section 306 would prohibit certain owners and officers of a company from selling equity securities issued by that company during periods (called "blackout" periods) when participants in the retirement plan are restricted in their ability to direct investments. Such periods may occur for administrative reasons -- for example, when a plan changes recordkeepers. This restriction would increase the financial exposure of affected owners and officers and, thus, could impose a cost on them. CBO does not have sufficient information to estimate the amount of that cost.

Enhanced financial information disclosure

[281] Section 403 would require officers and directors of companies that issue securities and certain owners of such securities to disclose to the SEC any insider trading by a certain time. According to the SEC, insider trading disclosure is currently required to be reported to the SEC by the tenth day following the month in which the trade occurred. Thus, CBO estimates that the cost of providing such information on an expedited basis would be small.

[282] The bill also contains provisions that require increased disclosure of financial information. The cost of complying with those requirements would depend on rules that the SEC has agreed to propose, but not yet promulgated. Therefore, SEC cannot estimate the direct costs of complying with the following mandates:

• Under Title IV, the SEC would prescribe rules that would require companies that issue securities to report loans to insiders within a certain time period, to disclose material off balance sheet transactions and conflicts, and present pro forma data in a manner that is not misleading in periodic financial reports to the SEC.

• Section 404 would require a company and the company's auditor to attest to the company's internal control procedures in their annual reports. Public companies also would be required to disclose whether they have adopted a code of ethics for senior financial officers, and whether their audit committee has among its members a "financial expert."

[283] Section 501 would require the SEC or a registered securities association or exchange to adopt rules to prohibit certain conflicts within investment banking firms that could compromise securities analysts' independence and to require security analysts to disclose other potential conflicts. The cost of prohibiting certain conflicts and disclosing additional information would depend on rules to be prescribed by the SEC or the directed authority. CBO does not have sufficient information to estimate the cost to comply with those mandates.

[284] Previous CBO Estimate: On April 26, 2002, CBO transmitted a cost estimate for H. R. 3763, the Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, as passed by the House of Representatives on April 24, 2002. H. R. 3763 would require the SEC to oversee a new board that would regulate the accounting industry and to accelerate its review of annual reports filed by public companies. CBO estimated that implementing H. R. 3763 would cost about $150 million over the 2003-2007 period, assuming the appropriation of the necessary amounts. Because of provisions that would create new civil penalties and a new accounting board that CBO considered part of the federal budget, CBO estimated that H. R. 3763 also would cause revenues and direct spending to rise to insignificant net amounts for each year.

[285] For H. R. 3763, CBO identified similar private-sector mandates on accountants, companies that issue registered securities, officers and directors of those companies, and certain owners of the securities. CBO could not determine whether the total direct cost of those mandates would exceed the annual threshold established by UMRA for private-sector mandates as we did not have sufficient information to estimate the cost of prohibiting insider trading during blackout periods when investment activity is restricted.

[286] Estimate prepared by: Federal costs: Ken Johnson; impact on state, local and tribal governments: Greg Waring; impact on the private sector: Paige Piper/Bach.

[287] Estimate approved by: Peter H. Fontaine, Deputy Assistant Director for Budget Analysis.

[289] First of all though, it would be hard to overestimate the importance of maintaining our system of private setting of accounting standards through the Financial Accounting Standards Board (FASB). Neither Congress nor any other agency of the government should be in the business of setting accounting standards. A bad accounting standard set by an independent board is better than a good standard set by Congress. But we do need to establish a stable, reliable funding mechanism for FASB.

[290] With regard to legislation, the reported bill is better today than the bill as first proposed, yet the fundamental problems of the original bill remain. We should pass a bill that sets up an independent ethics supervisory board that will oversee and enforce the highest standards of ethics in public accounting. This board should be given power to determine what are conflicts of interest and to make determinations on questions of auditor independence. It should also be independently funded by a source that is committed to the purpose of funding that activity, and the funding source should be reliable.

[291] Yet, even though some flexibility has been added, the structure of the bill is still troubling. If we are going to create this independent panel, we should create one in which we can place our confidence, allowing the panel, for example, to set the standards as to what represents a conflict of interest. While it is tempting to vote on these things and to set out in government writ for all time what we mean and what we want, if we are trying to make this board powerful, why would we want to prejudge what the panel is going to decide? There is a fundamental difference between having the board make decisions or having Congress make them.

[292] When Congress prejudges the board's activities, we eliminate the flexibility that the board will need to apply statutory principles to the variety of circumstances that appear in the real world. The one-size-fits-all approach of the bill cripples the ability of the board to adjust to differences in situations among companies -- particularly to distinguish between large and small companies -- as well as to stay up to date with changes that occur over time.

[293] This will be particularly hard on smaller companies. While the legislation allows for exceptions to its ban on auditors providing companies with additional services, these exceptions can only be obtained on a case-by-case basis. It is the smaller companies who routinely obtain a number of services from their auditor and who can least afford to pay for a second or third auditing firm to provide these additional services. These smaller business will be most likely to need the exemptions. But the smaller the company, the less likely it will be able to afford the legal services to get its needed exemptions from the new board. This is not a small problem, as the bill would impose its new regulatory requirements on 17,000 companies -- the vast majority of which are small businesses -- all across the country.

[294] It may be easy to envision requiring that General Motors have six different accounting firms to comply with the conflict of interest rules. But it stretches reason and good judgment to legislate those same standards for Joe Green and Son Motor Repair of Texarkana. We should trust the board that we create and let them look at the feasibility for large and small companies, ask them to look at the benefits to shareholders, the integrity of the financial system and long term growth prospects. It is easy to envision that they might end up with standards that would be differentiated based on the size of accounting firms and the size of the businesses that are affected. We would preserve flexibility in doing this. One-size-fits- all will hurt a lot of shareholders and the businesses in which they have invested. And heaping unnecessary costs on struggling small enterprises, it will hurt the economy.

[295] The point is, when you start setting out in law what auditing standards are, what the conflict of interest standard is, and the many other specific mandates in the bill, you eliminate flexibility, you eliminate the ability of the board to learn what works and what does not work, and you eliminate the ability of the board to differentiate between General Motors and Joe Green and Son, Incorporated. In the process of setting up a strong, independent board we have largely done our work. We ought not to be doing the board's work after that.

[296] In addition, before this legislation becomes law, the concerns of constitutional experts with regard to the appointment, regulatory powers, and taxing authority of this new supervisory board will need to be resolved.

[298] A wave of new regulations and legislative proposals have been introduced to protect America's investors against corporate abuses. The securities' self-regulatory organizations (SROs), the Securities and Exchange Commission (SEC), the White House, and Congress are all working on different approaches with the same goal -- to ensure executives are providing accurate and reliable information to the public.

[299] However, any approach must also be sensitive to the fact that auditors are a critical element in assuring the quality of a financial statement. Legislation that does not provide adequate liability protections for auditing firms will decrease the already minimal number of companies which can audit and evaluate complex and fast-growing companies. Without a competitive auditing industry, consumers may, at the end of the day, experience less reliable financial statements.

[300] I believe this legislation, as reported by the Senate Banking Committee, will provide a disincentive for small accounting firms to continue to audit publicly traded companies. These small accounting firms may only audit a relatively few public companies, and my fear is that this legislation would increase their liability exponentially, thus the firms would decide to cease offering services to public companies. With current litigation downsizing an already limited number of accounting firms, we cannot allow additional regulations to drive more firms from offering auditing services to public companies.

[301] The legislation also places a negative presumption on any approval of non-prohibited consulting services. Legislation should not mandate to audit committees that all consulting services are inherently conflicted. Audit committees should be left to make their own determination as to what services provided by their auditing companies is in the best interest of their shareholders.

[302] I also have concerns that the setting of auditing standards will be taken out of the hands of accountants. Auditing standards are complicated and detailed and the setting of them requires the knowledge and expertise of individuals who understand and work in the field of accounting. I am hesitant to allow a Board, of which the majority must be non-accountants, to establish the standards under which accountants operate.

[303] I continue to support reform of the accounting industry and will continue to work toward that goal with this legislation. I, however, will work to change aspects of the bill which I believe will impose severe unintended and unnecessary consequences on the accounting industry and their clients.

² Testimony of John H. Biggs, Chairman, President and CEO, Teachers' Insurance and Annuity Association -- College Retirement Equities Fund (TIAA-CREF), and former member of the Public Oversight Board, before the Committee on February 27, 2002.

³ Testimony of Shaun O'Malley, Chairman, 2000 Public Oversight Board Panel on Audit Effectiveness, and former Chairman, Price Waterhouse LLP, before the Committee on March 6, 2002.

⁴ Testimony of Paul Volcker, Chairman of the Trustees of the International Accounting Standards Committee, and former Chairman of the Board of Governors of the Federal Reserve System, before the Committee on February 14, 2002.

⁵ The Public Oversight Board was created in 1977 as part of self-regulatory efforts by the accounting industry. In January 2002, the P.O.B voted unanimously to disband, in "recognition of the obstacles to achieving this goal [i.e., effective self-regulation] which have been encountered in recent years, and given the proposal of the SEC in consultation with the AICPA and the SEC Practice Section Executive Committee, without input from the Public Oversight Board, to reorganize the self-regulatory structure. * * *" Resolution of the Public Oversight Board, January 20, 2002. Available at http://www.publicoversightboard.org/about.htm.

⁶ Testimony of Charles A. Bowsher, Chairman, Public Oversight Board, and former Comptroller General of the United States, before the Committee on March 29, 2002; testimony of Aulana L. Peters, Member, Public Oversight Board and former Commissioner, Securities and Exchange Commission (1984-88), before the Committee on March 19, 2002; Biggs Testimony, February 27, 2002.

⁷ Schedule A(25) of the Securities Act of 1933, 15 U.S.C. § 77(aa)(25) (emphasis added); see also section 13(a)(2) of the Securities Exchange Act of 1934, 15 U.S.C. § 78m(a)(2), section 14 of the Public Utility Holding Company Act of 1935, at U.S.C. § 79n, and section 30(g) of the Investment Company Act of 1940, 15 U.S.C. § 80a-29(g).

⁸ Graham, Dodd, and Cottle, Security Analysis, 108 (4th ed., 1962).

⁹ Testimony of Lee Seidler, former partner, Bear Stearns & Co. and Deputy Chair of the 1978 Commission on Auditors' Responsibilities, before the Committee on March 6, 2002.

¹⁰ Senator Enzi suggested that the bill require, not merely permit, that two Board members have an accountancy background.

¹¹ Testimony of Harold M. Williams, former SEC Chairman (1977-81), before the Committee on February 12, 2002; Biggs Testimony, February 27, 2002; testimony of Joel Seligman, Dean and Ethan A. H. Shepley University Professor, Washington University School of Law, before the Committee on March 5, 2002; testimony of Bevis Longstreth, Member, 2000 Public Oversight Board Panel on Audit Effectiveness, and former Commissioner, Securities and Exchange Com mission (1981-84), before the Committee on March 6, 2002; cf. testimony of Robert Glauber, Chairman and Chief Executive Officer, National Association of Securities Dealers, Inc., and former Under Secretary for Finance, Department of Treasury, under President Bush (1989-1992), before the Committee on March 5, 2002.

¹² The Board itself will be a corporation created under the D. C. Nonprofit Corporation Act. It will be neither an agency nor establishment of the federal government, and its members and employees are not to be deemed to be federal officers or employees by reason of their Board service.

¹³ Testimony of Arthur Levitt, former SEC Chairman (1993-2000), before the Committee on February 12, 2002; Bowsher Testimony, March 19, 2002; testimony of L. William Seidman, former Chairman, Federal Deposit Insurance Corporation and Resolution Trust Corporation, and former partner, Seidman & Seidman, before the Committee on March 19, 2002.

¹⁴ See, e.g., Ruder Testimony, February 12, 2002; Seligman Testimony, March 5, 2002; Seidler Testimony, March 6, 2002.

¹⁵ The bill creates a right to interim SEC review of certain inspection-related disputes.

¹⁶ Levitt Testimony, February 12, 2002.

¹⁷ Glauber Testimony, March 5, 2002. John Biggs said simply: "Accounting firms must know that they cannot refuse to open their books or prevent their staff from cooperating with this new agency." Biggs Testimony, February 27, 2002.

¹⁸ The Board may request, but not require, the testimony of, or production of documents, in the possession of any other person (for example, an audit firm's client). Its rules may provide for procedures to seek issuance of a subpoena from the SEC to any person.

¹⁹ Fines imposed by the Board are to be used to fund a scholarship program for students in undergraduate or graduate programs in accounting.

²⁰ Accounting Series Release No. 150, 3 SEC Dock. 275 (1973).

²¹ Testimony of Michael Sutton, former SEC Chief Accountant (1995-98), before the Committee on February 26, 2002.

²² Testimony of Richard Breeden, former SEC Chairman (1989-93), before the Committee on February 12, 2002.

²³ Letter from James E. Burton, Chief Executive Officer, California Public Employees' Retirement System (CalPERS), to Chairman Paul S. Sarbanes, June 26, 2002.

²⁴ Letter from John H. Biggs, Chairman, President and CEO, Teachers' Insurance and Annuity Association -- College Retirement Equities Fund (TIAA-CREF), to Chairman Paul S. Sarbanes, June 28, 2002.

²⁵ Testimony of John C. Whitehead, former Co-Chairman, Goldman Sachs & Co., and former Deputy Secretary of State, before the Committee on March 19, 2002.

²⁶ Testimony of Walter P. Schuetze, former SEC Chief Accountant (1992-95), before the Committee on February 26, 2002.

²⁷ Williams Testimony, February 12, 2002.

²⁸ Bowsher Testimony, March 19, 2002; Levitt Testimony, February 12, 2002; Volcker Testimony, February 14, 2002.

²⁹ Statement of David Walker, Comptroller General of the United States, June 18, 2002.

³⁰ "Analysis of the Failure of Superior Bank, FSB, Hinsdale, Illinois," Hearing before the Senate Committee on Banking, Housing, and Urban Affairs, February 7, 2002.

³¹ Sutton Testimony, February 26, 2002.

³² Longstreth Testimony, March 6, 2002.

³³ Levitt Testimony, on February 12, 2002.

³⁴ Williams Testimony, February 12, 2002.

³⁵ Whitehead Testimony, March 19, 2002.

³⁶ Testimony of Lynn Turner, former SEC Chief Accountant (1998-2001), before the Committee on February 26, 2002.

³⁷ Testimony of Roderick M. Hills, former SEC Chairman (1975-77), before the Committee on February 12, 2002.

³⁸ O'Malley Testimony, March 6, 2002.

³⁹ The "lead" partner is the partner who is in charge of the audit engagement. The "review" partner refers to the outside partner brought in to review the work done by the lead partner and the audit team.

⁴⁰ Bowsher Testimony, March 19, 2002.

⁴¹ Turner Testimony, February 26, 2002.

⁴² Testimony of James E. Copeland, Jr., Chief Executive Officer, Deloitte & Touche LLP, before the Committee on March 14, 2002.

⁴³See, e.g. , Seligman Testimony, March 5, 2002.

⁴⁴ Testimony of Sarah Teslik, Executive Director, Council of Institutional Investors, before the Committee on March 20, 2002.

⁴⁵ Testimony of Robert E. Litan, Director, Economic Studies Program, The Brookings Institution, before the Committee on March 14, 2002; testimony of Damon Silvers, Associate General Counsel, AFL-CIO, before the Committee on March 20, 2002; Bowsher Testimony, March 19, 2002.

⁴⁶ Testimony of Ira Millstein, Senior Partner, Weil, Gotshal & Manges LLP, before the Committee on February 27, 2002; Whitehead Testimony, March 19, 2002; Biggs Testimony, February 27, 2002.

⁴⁷ Levitt Testimony, February 12, 2002.

⁴⁸ Hills Testimony, February 12, 2002; Seligman Testimony, March 5, 2002.

⁴⁹ Testimony of Howard M. Metzenbaum, Chairman, Consumer Federation of America, and former U.S. Senator, before the Committee on March 20, 2002.

⁵⁰ Testimony of David Walker, Comptroller General of the United States, before the Committee on March 5, 2002.

⁵¹ Breeden Testimony, on February 12, 2002.

⁵² Teslik Testimony, March 20, 2002.

⁵³ O'Malley Testimony, March 6, 2002; Teslik Testimony, March 20, 2002.

⁵⁴ Breeden Testimony, on February 12, 2002.

⁵⁵ Breeden Testimony, February 12, 2002.

⁵⁶ Testimony of Thomas A. Bowman, President and Chief Executive Officer, Association for Investment Management and Research, before the Committee on March 20, 2002.

⁵⁷ Volcker Testimony, February 14, 2002.

⁵⁸ Seligman Testimony, March 5, 2002.

⁵⁹ For example:

Two of Enron's top officials who were also board members -- Kenneth Lay and Jeffery Skilling -- received personal loans from Enron. Mr. Lay received more than $70 million in cash during one 12- month period and repaid the loan with his own Enron stock. Wall Street Journal (May 3, 2002).

WorldCom's board extended its former chief executive, Bernard Ebbers, a personal loan of $366.5 million. Richard Waters, Pressure Forces Ebbers to Leave WorldCom, Financial Times (May 1, 2002).

Adelphia Communications made $3.1 billion in off-balance sheet loans to its founder, John Rigas, reportedly without the knowledge of its shareholders or board. Richard Waters, Rigas Agrees to Give Up Adelphia, Financial Times (May 24, 2002).

In April, Qwest revealed in its proxy statement that it lent $4 million to President and COO Afshin Mohebbi. It was reported that a portion of the loan will be used to pay the premium on his life insurance policy. Jim Seymour, Nacchio Dip: Qwest CEO Delays His Pay Raise, TheStreet.com (April 9, 2002).

Global Crossing Ltd. eliminated or substantially reduced the terms of $18 million worth of personal loans the company made to two of its top executives in the months before the telecommunications company filed for bankruptcy protection, regulatory filings show. Elizabeth Douglass, Global Eased Loan Terms Compensation: The firm forgave or reduced advances to executives in the months before its Chapter 11 filing, L.A. Times (February 7, 2002).

AES Corp., a power producer, granted $1.5 million personal loans to both its chief financial officer and an executive vice president in October to prevent them from being forced to immediately sell company shares due to margin calls. AES Makes Loans To Two Executives To Cover Margin Calls, Wall Street Journal (March 26, 2002).

⁶⁰ Breeden Testimony, February 12, 2002.

⁶¹ Millstein Testimony, February 27, 2002.

⁶² Bowsher Testimony, March 19, 2002.

⁶³ Bowsher Testimony, March 19, 2002.

⁶⁴ Bowman Testimony, March 20, 2002.

⁶⁵ Bowman Testimony, March 20, 2002.

⁶⁶ Bowman Testimony, March 20, 2002.

⁶⁷ Breeden Testimony, February 12, 2002.

⁶⁸ Letter from Eliot Spitzer, Attorney General of the State of New York, to Chairman Paul S. Sarbanes, June 5, 2002.

⁶⁹ Spitzer Letter, June 5, 2002.

⁷⁰ Testimony of John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School, before the Committee on March 5, 2002 (internal citations omitted).

⁷¹ Seligman Testimony, March 5, 2002.

⁷² Coffee Testimony, March 5, 2002 (internal citations omitted).

⁷³ Bowman Testimony, March 20, 2002.

⁷⁴ Testimony of Michael Mayo, Managing Director, Prudential Securities, Inc., before the Committee on March 19, 2002.

⁷⁵ Turner Testimony, February 26, 2002.

⁷⁶ Mayo Testimony, March 19, 2002.

⁷⁷ Coffee Testimony, March 5, 2002.

⁷⁸ Coffee Testimony, March 5, 2002 (internal citations omitted).

⁷⁹ Spitzer Letter, June 5, 2002.

⁸⁰ Coffee Testimony, March 5, 2002.

⁸¹ Coffee Testimony, March 5, 2002.

⁸² Seligman Testimony, March 5, 2002.

⁸³ Bowman Testimony, March 20, 2002.

⁸⁴ Bowman Testimony, March 20, 2002.

⁸⁵ Bowman Testimony, March 20, 2002.

⁸⁶ Bowman Testimony, March 20, 2002.

⁸⁷ Mayo Testimony, March 19, 2002.

⁸⁸ Levitt Testimony, on February 12, 2002.

⁸⁹ Spitzer Letter, June 5, 2002.

⁹⁰ Whitehead Testimony, March 19, 2002.

⁹¹ Walker Testimony, March 5, 2002.

⁹² Hills Testimony, February 12, 2002; Williams Testimony, February 12, 2002; Breeden Testimony, February 12, 2002; Levitt Testimony, February 12, 2002.

⁹³ Breeden Testimony, February 12, 2002.

⁹⁴ Coffee Testimony, March 5, 2002.

⁹⁵ Coffee Testimony, March 5, 2002.

⁹⁶ Turner Testimony, February 26, 2002.

⁹⁷ Copeland Testimony, March 14, 2002.

⁹⁸ SEC budget testimony for FY 2003 gives the number as over 17,000, Testimony Concerning Appropriations for Fiscal 2003 by Harvey L. Pitt, Chairman, U.S. Securities & Exchange Commission, before the Subcommittee on Commerce, Justice, State, and the Judiciary, Committee on Appropriations, United States House of Representatives, April 17, 2002, while SEC Release 33-8109 gives the number as 16,242, SEC Release 33-8109 (Proposed Rule: Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process), http://www.sec.gov/rules/proposed/33-8109. htm at 71.

⁹⁹ See Proposed SEC Release 33-8109 at footnote 111, page 111.