[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
THE IMPACT OF THE SARBANES-OXLEY ACT
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
APRIL 21, 2005
__________
Printed for the use of the Committee on Financial Services
Serial No. 109-21
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North HAROLD E. FORD, Jr., Tennessee
Carolina RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
VITO FOSSELLA, New York STEVE ISRAEL, New York
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio JOE BACA, California
MARK R. KENNEDY, Minnesota JIM MATHESON, Utah
TOM FEENEY, Florida STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina AL GREEN, Texas
KATHERINE HARRIS, Florida EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK,
Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina
Robert U. Foster, III, Staff Director
C O N T E N T S
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Page
Hearing held on:
April 21, 2005............................................... 1
Appendix:
April 21, 2005............................................... 35
WITNESSES
Thursday, April 21, 2005
Donaldson, Hon. William H., Chairman, Securities and Exchange
Commission..................................................... 7
McDonough, William J., Chairman, Public Company Accounting
Oversight Board................................................ 10
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 36
Hinojosa, Hon. Ruben......................................... 38
Hooley, Hon. Darlene......................................... 40
Kanjorski, Hon. Paul E....................................... 41
Donaldson, Hon. William H.................................... 43
McDonough, William J......................................... 62
Additional Material Submitted for the Record
Frank, Hon. Barney:
Equity Group Investments, L.L.C., prepared statement......... 88
Tiberi, Hon. Patrick J.:
American Bankers Association, prepared statement............. 90
McDonough, William J.:
Written response to questions from Hon. Joseph Crowley....... 122
Written response to questions from Hon. Vito Fossella........ 105
Written response to questions from Hon. Ruben Hinojosa....... 113
Written response to questions from Hon. Deborah Pryce........ 121
Written response to questions from Hon. Nydia M. Velazquez... 107
Donaldson, Hon. William H.:
Written response to questions from Hon. Ginny Brown-Waite.... 128
Written response to questions from Hon. Joseph Crowley....... 133
Written response to questions from Hon. Ruben Hinojosa....... 113
Written response to questions from Hon. Dennis Moore......... 141
Written response to questions from Hon. Deborah Pryce........ 125
Written response to questions from Hon. Patrick J. Tiberi.... 126
Written response to questions from Hon. Nydia M. Velazquez... 132
THE IMPACT OF THE SARBANES-OXLEY ACT
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Thursday, April 21, 2005
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The Committee met, pursuant to call, at 10:05 a.m., in Room
2128, Rayburn House Office Building, Hon. Michael G. Oxley
[chairman of the committee] Presiding.
Present: Representatives Oxley, Leach, Baker, Bachus,
Royce, Tiberi, Kennedy, Feeney, Hensarling, Brown-Waite,
Barrett of South Carolina, Neugebauer, Price of Georgia,
Fitzpatrick, McHenry, Frank, Kanjorski, Waters, Sanders,
Maloney, Gutierrez, Velzquez, Watt, Hooley, Sherman, Meeks,
Lee, Moore of Kansas, Capuano, Crowley, Israel, Baca, Matheson,
Miller of North Carolina, Scott, Green, Cleaver, Bean,
Wasserman Schultz, and Moore of Wisconsin.
The Chairman. The Committee will come to order. Pursuant to
Rule 3(f)(2) of the rules of the Committee of Financial
Services for the 109th Congress, the Chair announces he will
limit recognition for opening statements to the Chair and
Ranking Minority Member of the full Committee and the Chair and
Ranking Minority Member of the Subcommittee on Capital Markets,
Insurance and Government-Sponsored Enterprises, or their
respective designees, not to exceed 16 minutes evenly divided
between the majority and minority. The prepared statements of
all members will be included in the record. The Chair
recognizes himself for an opening statement.
Good morning. And today we meet to discuss the impact of
the Sarbanes-Oxley Act of 2002. The Committee will hear from
the two regulators, Chairmen Donaldson and McDonough, charged
with implementing key provisions of the Act. We welcome both of
you back to the Committee and look forward to hearing your
views on the benefits, and the costs of Sarbanes-Oxley,
affectionately known as SOX.
Although the legislation was passed less than 3 years ago,
the benefits to investors and the capital markets have already
been quite dramatic. Not entirely measurable in all areas, but
dramatic nonetheless. The primary purpose of the Act was to
restore investor faith in the reliability of corporate
financial reporting. In this regard, the Act has been an
unmitigated success. The audit process has clearly been
strengthened. Now subject to rigorous oversight and precluded
from offering certain non-audit services to audit clients,
accountants have refocused on the audit, achieved, greater
independence from their clients, and are insisting with
success, on more transparent financial reporting.
Replacing decades of ineffectual industry self-regulation,
the Public Company Accounting Oversight Board conducts
inspections of all registered accounting firms--annually for
the largest firms--and has the authority to investigate and
discipline accountants and firms that violate Board rules, SEC
rules, or securities laws. This oversight by the PCAOB has
served and will continue to serve, in my opinion, as an
effective deterrent to unethical and illegal conduct.
Oversight of management activities by corporate boards has
been significantly improved. Directors, particularly audit
committee members, are more engaged, more informed, and more
independent of management and working harder. Corporate
leaders, subject to stiffer criminal penalties and greater
director oversight, are focused on the financial statement like
never before. The certification provisions have been
successful. Financial statements are more reliable today than
they were before the Act was passed.
Does this mean that Sarbanes-Oxley will eliminate fraud
altogether? Of course not. No legislation can deliver such a
benefit. But we are reducing the opportunities for fraud,
making fraud more difficult to commit, and holding accountable
those who break the law.
The most famous, or infamous, section of the Act, of
course, is section Section 404. Nothing is more central to
sound financial reporting than the strong internal controls
contemplated by Sarbanes-Oxley. I may have heard a complaint or
two about the costs, but the benefits have not been disputed.
And make no mistake, the costs associated with section Section
404 are higher than anyone expected. That is a cause for
concern, and I am particularly sensitive to any undue burden on
small and mid-sized companies whose compliance costs are a
higher percentage of total revenues.
The question then becomes, can we achieve the unquestioned
benefits of strong internal controls at a more reasonable cost.
I believe we can and that we will. For starters, there seems to
be a consensus that Section 404 costs will be reduced by as
much as one-half next year, due to the fact that systems will
be in place and documentation will be completed. I am
encouraged by Chairman McDonough's recent comments about costs
and his announcement that additional implementation guidance is
forthcoming.
The PCAOB standard instructs auditors to exercise
professional judgment when performing the attestation required
by the statute. Upcoming Board inspections will seek to
determine whether a one-size-fits-all approach is being used on
some audit engagements. We would also like to commend Chairman
Donaldson for his leadership in this area. The Commission has
rightly given small companies and foreign companies a delay in
complying with Section 404. The Chairman has also organized a
useful roundtable discussion on Section 404 to hear concerns
from a broad spectrum of market participants and assembled an
advisory committee of smaller public companies.
And, finally, I am pleased that there is a consensus, or
close to one, on the question of whether legislative
modifications are necessary. Congress, regulators, accountants,
issuers, and other interested parties generally agree that, to
the extent changes are necessary, they can be done within the
regulatory framework.
I look forward to the testimony, and I yield to the
gentleman from Massachusetts for an opening statement.
Mr. Frank. Thank you, Mr. Chairman.
I think it is time for us to address a very important issue
involving corporate governance, and it is a matter of
increasing expense, significantly increasing expense to
corporations, and an expense which I do not believe is
justified by value given. That is, I agree with some of the
critics who think that we are facing a situation in which
corporations, public corporations, in particular large ones,
are spending far more than they should on something for which
they do not get sufficient value and which in fact impinges on
the shareholders. I am talking about executive compensation.
Executive compensation is increasingly out of control. I
have put up some charts here--actually, I haven't put them up;
some very nice people who work for me have put them up at my
request, and I appreciate it.
That chart compares what CEOs are doing compared to
shareholders. The blue line is CEOs, the red line is
shareholders. To the extent that that correlates to red States
and blue States, it was unintentional, but it is not a bad mix,
as a matter of fact. The enormous increase percentage-wise in
CEO compensation is compared to what shareholders are getting.
That is, CEO compensation goes up substantially when the S&P
index goes down.
The next chart. This one compares the pay of CEO to the
average worker from 1980 to 2003. We have a ratio of 42 to 1 in
1980, we have a ratio of 500 to 1 today.
In the next chart, lest people think I am talking here
merely about envy, because I think we are talking about a
serious social and economic problem. The compensation that is
rapidly increasing for the people who run corporations has
become macro-economically significant. This chart shows the
percentage of company profits that are paid to the top 5
executives in the Fortune 500 companies. It was 4.8 percent in
1993, it was 10.3 percent in 2003, the last year for which we
have gotten figures. When you are talking about that
significant an increase, you are getting into things that
affect performance. And I should say that I raise that in the
context of this hearing for two reasons: One, we are told that
the compliance costs with section Section 404 Sarbanes-Oxley
are a significant drag on corporations. Well, not compared to
the money they pay the top people. Now, if it were necessary to
pay these people this amount of money to get them to run the
corporations, then of course we wouldn't have a problem. I
think the evidence is overwhelming that CEOs are compensated
far beyond, on the whole, what would be economically justified.
And I want to acknowledge here that I am drawing on work
done by Professors Lucian, Bebchuk, and Jesse Freed, and the
book that they have published on the subject, and also articles
by Professor Bebchuk and Professor Yaneff Grinstein. It is very
clear from their studies, it is clear as we see this, there are
very few constraints on what the CEOs get. The boards of
directors--and this is the second reason I mention this. It is
relevant to corporate governance. Some of the corporate leaders
have told us that they feel terribly beleaguered that they have
been put upon by that unlikely combination, Sarbanes and Oxley;
that they have, in fact, had imposed on them staggering burdens
which interfere with their ability to function. Well, I think
it is very clear that at least in one area of some importance
to them, setting their own salaries, Sarbanes and Oxley might
as well be Donald and Daisy Duck, because nobody lays a glove
on these people when it comes to setting their own salaries,
and I think that this is something that we have to address.
We are in a difficult period in America today. We have
growth going forward at a reasonable level, but inequality is a
concomitant to that growth. Employment growth has stagnated to
some extent. As I noted when Secretary Snow testified, in 2004,
the President's Council of Economic Advisors said that we would
get 325,000 jobs a month in this current growth.
This year's Council of Economic Advisors' report
unheraldedly projected 175,000. I asked Mr. Snow, he said,
well, the chairman of the Council of Economic Advisors' went
back to Harvard; he couldn't fully explain it. The trouble is,
he took 150,000 jobs a month with him back to Harvard. Things
must be going very well in Cambridge.
But we have this problem of a slowdown in job growth. We
have a problem even more so of wages stagnating. And for CEOs
to be enjoying skyrocketing compensation which becomes
statistically significant, 10 percent to the profits in 2003,
at a time when wages also are stagnating, that causes a series
of problems politically and socially.
So as we look at the questions of corporate governance, I
hope we will look at this. Because I believe that Sarbanes-
Oxley has worked well. I think with the distinguished
leadership of these two gentlemen, we are going to be able to
make some adjustments that would be appropriate, as is always
to be expected when you do something new. But the agenda for
corporate governance should be, what do we do next? Not, how do
we go backwards? Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired. The
gentleman from Louisiana, Mr. Baker.
Mr. Baker. I thank the Chairman, and wish to first
acknowledge his good work and that of Senator Sarbanes in a
time of business corporate governance of which few of us are
proud, and that strong action was required and strong action
was taken.
I don't think there is any question that the implementation
of Sarbanes-Oxley has brought to the corporate board room an
awareness of their professional responsibilities and
appropriate accountability for actions which are not consistent
with the highest of standards. I do believe that there are
elements to Sarbanes-Oxley, which have enhanced business
function, and I think that on one aspect there is a tangible
element to the implementation of Sarbanes-Oxley directly
beneficial to shareholders.
Since the passage of the Fair Fund in Sarbanes-Oxley, I am
advised to date there have been in excess of $5 billion
recouped from those who have engaged in fraudulent conduct for
the benefit of shareholders directly. To my knowledge, this is
the first time a program has been implemented to use government
resources to recoup losses for shareholder benefit without the
necessity of going to the trial bar. It is exceedingly
successful, and some questioned its validity at the outset
saying it would only amount to a small pizza for most
shareholders. I would suggest modestly that a $5 billion pizza
would be something to behold.
On the other hand, no legislation of this magnitude can
possibly be implemented without flaw. And I do believe the
chairman's comments with regard to the cost of implementation
and compliance of section Section 404 is something that
warrants further study by the Committee, and action that might
necessarily require legislative effort.
Specifically, with regard to the PCAOB's methodology for
assessing cost for the audit function, it is a statutory
requirement that the PCAOB would not have the regulatory
authority to visit should it even choose to do so. But I would
certainly like to hear from the experts if there is an
alternate methodology other than market cap, which might be
more appropriate. It would seem to me, were there corporate
misdoings and the market would respond by a runoff of market
cap, that the subsequent assessment resulting from that audit
would then be unnecessarily adversely impacted. So it might be
an area where this Congress should act if the professionals
tell us it is warranted.
And, finally, with regard to the issue of corporate
governance and that of executive compensation, I thought for a
moment we were talking only about Fannie and Freddie. If they
were pulled from the pile, it might bring the bell curve back
in more in normal range. I recall just in bonuses only there
were $245 million paid out in a 5-year period on which the
financials cannot be relied that the earnings per share were
indeed accurate. I share the concern about corporate abuse, but
think we should go slowly in areas where the United States
Congress really has no business.
Mr. Chairman, I compliment you on good work and yield back.
The Chairman. The gentleman yields back. The gentleman from
Pennsylvania, Mr. Kanjorski.
Mr. Kanjorski. Mr. Chairman, nearly 3 years ago after a
surge of corporate and accounting scandals we adopted the
Sarbanes-Oxley Act. As you know, I was intimately involved in
every stage of the law's development from the first
congressional hearing on the collapse of Enron through the
final meeting of our bicameral conference committee. We are
meeting today to review the effects of this historic law on our
capital markets. In general, I believe that the landmark
legislation has strengthened responsibility and enhanced
investor confidence. In recent months, the Public Company
Accounting Oversight Board and the Securities Exchange
Commission have continued to pursue an ambitious agenda as they
have worked to implement the reforms that Congress mandated.
Today's hearing will help us to better appreciate their
hard work in turning this functional statutory outline into an
active regulatory system. It will also help us to understand
the progress that we have made in bolstering investor
confidence, restoring the integrity of financial statements,
and rebuilding trust in our securities markets. Since the enact
of Sarbanes-Oxley Act, we have also heard regular complaints
from some about the cost of complying with the law. Most
recently the statutes' provisions regarding internal control
audits have become the subject of considerable public debate. I
would therefore like to focus my comments this morning on this
area of the law.
We designed section Section 404 to require public traded
companies and their auditors to assess internal controls, which
is a firm's policies, practices, systems, and procedures to
prevent abuse, protect against fraud, and ensure proper
accounting. This section of the law requires companies to
report their material weaknesses and their internal controls
and work to fix these problems before financial reporting
failures occur. As a result of this mandate, public
corporations are decreasing their risk of future shareholder
losses.
Section 404 is another important benefit. It is helping
corporate executives to better understand the financial
reporting shortcomings within their companies, allowing them to
recognize the nature of the problems earlier and adopt reforms
and account procedures expeditiously. Such internal analysis by
a company and external verification by an outside auditor is
also helping to provide important assurances to the chief
executive and financial officers of public companies who now
must sign statements attesting to the accuracy and veracity of
their financial statements under section 302 of the very same
law.
Today, we are fortunate to once again have before us the
leaders of the Securities Exchange Commission and the Public
Company Accounting Oversight Board. In their comments. I hope
they will examine the implementation of and complaints
regarding section Section 404. I know that both organizations
have been diligently working to address these concerns,
particularly by conducting outreach, holding forums, and
providing assistance in these matters.
It is my hope that both organizations will continue with
these efforts, particularly for the smaller issuers that will
have disproportionate costs in implementing these well-
intentioned reforms. I know that the Public Company Accounting
Oversight Board intends to issue next month additional guidance
in these matters. I expect that such guidance will maintain the
spirit of the reforms that Congress envisioned but offer
auditors greater flexibility in tailoring their examinations of
internal controls to match the size and complexity of the kind.
Such guidance should also help to improve the effectiveness of
the law.
In closing, Mr. Chairman, we cannot and should not remove
the risks associated with investing. Our capital markets work
well because of that risk. We should, however, ensure that
every corporation plays by the rules; that all investors have
access to reliable information needed to make prudent
decisions; and that each party who violates our securities laws
is held accountable. As the Securities and Exchange Commission
and the Public Company Accounting Oversight Board work to
achieve these objectives, it is appropriate for us to review
their progress. Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 41 in the appendix.]
The Chairman. The gentleman yields back.
We now turn to our distinguished witnesses today. And,
again, gentlemen, thank you for once again appearing before the
Committee. We have always appreciated your information that you
bring the Committee and your hard work as dedicated public
servants in dealing with some very tough issues.
And, Chairman Donaldson, we will begin with you.
STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES
AND EXCHANGE COMMISSION
Mr. Donaldson. Thank you. Chairman Oxley, Ranking Member
Frank, and members of the Committee, thanks for inviting me to
testify on behalf of the Securities and Exchange Commission
concerning the implementation of the Sarbanes-Oxley Act of
2002.
A little over 2 years ago when I became chairman of the
Commission, the headlines were still dominated by reports of
financial fraud, lapses, and audit, corporate governance
responsibilities, and intentional manipulation of accounting
rules. Congress acted swiftly in the face of this breakdown by
enacting the Sarbanes-Oxley Act which called for the most
significant reforms affecting our capital markets since the
Securities Exchange Act of 1934.
Since enactment, the Act has affected dramatic change
across corporate America and beyond and is helping to
reestablish investor confidence and the integrity of corporate
disclosures and financial reporting. Your strong support of the
Act, along with the support of your counterparts in the Senate
demonstrates Congress's demonstration to ensuring the integrity
and vitality of our markets.
Before turning to the particular provisions of Sarbanes-
Oxley Act, I want to start by saying that I am pleased to be
testifying today alongside of Bill McDonough, the chairman of
the Public Company Accounting Oversight Board. While he will
testify more fully on the board's activities, I can assure you
that the PCAOB has developed as a respected and effective
organization under Chairman McDonough's leadership, and that
Chairman McDonough has personally been instrumental in helping
to forge the close bond between our organizations.
The goals of Sarbanes-Oxley are far reaching, and aim to
restore investor confidence in and ensure the integrity of the
markets. Consequently, reforms in the Act address nearly every
aspect of the Act in our Nation's capital markets. The Act
called on the Commission to undertake nearly 20 rulemakings and
studies. The Act also set ambitious deadlines for the
Commission and, in most cases, required us to implement the
final rule speedily.
The Commission has completed the required rulemaking under
the Act, having considered the thousands of letters of public
comment that we received. The Nation's largest companies,
comprising more than 95 percent of U.S. market capitalization,
are now fully subject to the regulatory requirements of the
Sarbanes-Oxley act. Just as the SOX Act was a landmark piece of
legislation for Congress, the successful implementation of that
legislation will be seen as a watershed in the history of the
Commission.
Given the scope and the scale of the task Congress placed
before us, I am pleased to report that, with the dedication and
hard work of our staff, the Commission's overall discharge of
its rulemaking responsibility has been exceptionally on the
mark in fulfilling the Act's objectives while avoiding
unnecessary problems. Collectively, these accomplishments
should have an enormous positive impact on the management and
governance of U.S. public companies in the decades ahead, and
they will safeguard the fundamental imperative that our markets
be characterized by levels of investor confidence and
participation that are second to none.
Although most of the Act's benefits have been accomplished
without substantial expense for market participants, we should
not minimize the cost to public companies and their investors
of achieving the full measure of the Act's objectives. In
particular, the internal control reporting and auditing
requirements which companies are dealing with for the first
time have required significant outlays of time and expense. The
short-term costs to improve internal control over financial
reporting are, in my view, best seen as an investment, because
over the long term, these improvements will result in
structurally sounder corporate practices and more reliable
financial reporting.
While these critical goals now firmly in view call to roll
back or weaken Sarbanes-Oxley generally as a result of concern
over the cost of internal control reporting are, in my
judgment, unjustified. At the same time, the Commission and the
PCAOB must be sensitive to the need to recalibrate and adjust
our rules and guidance to avoid unnecessary costs or unintended
consequences. To this end, the Commission and the PCAOB will
remain committed to the implementation of the Act in the most
efficient and effective way.
I would like to review briefly a few specific
accomplishments. A central focus of Sarbanes-Oxley was to
enhance the integrity of the audit process. We believe the new
rules have already had a beneficial effect in strengthening the
integrity of the independent audit. We have also seen that
audit committees are taking their responsibility seriously, and
they are much more sensitive to auditor independence issues.
The Act has strengthened our ability to enforce the Federal
securities laws. One of the toughest challenges facing the
Commission has been recovering and, when appropriate, returning
funds to injured investors. The Act gave the Commission two
powerful tools to help meet this challenge: The fair funds
provision, and the authority to seek a temporary freeze on
extraordinary payments by an issuer. Before the Act, by law all
civil penalties were paid into the U.S. Treasury. Now, the
Commission has authority in certain circumstances to use civil
penalties to help compensate injured investors. The Commission
has authorized fair funds in over 100 cases with a total value
of over $5.4 billion for anticipated distribution to harmed
investors.
Another objective of the Act was to improve executive
responsibility and, quote, the tone at the top of public
companies, a key theme that dates back to President Bush's 10-
point plan of March 2002. Among the government's reform,
Sarbanes-Oxley called on us to institute, the CEO and CFO
certification provisions that perhaps have perhaps had the
greatest immediate impact by reinforcing executive
responsibility for the financial reporting process of public
companies. While CEOs and CFOs already had responsibility for
company disclosures in the filings in question, the
certification requirements have focused their attention on the
completeness and accuracy of disclosure in new and very
important ways.
Complementing the focus on executive responsibility, the
Act takes several important steps toward improving disclosure
in the old financial reporting process. Accurate and reliable
financial reporting is the bedrock of our disclosure-based
system of Securities' regulation. Investor confidence and the
reliability of information in a company's filings with the SEC
is fundamental to the vibrancy of our markets. The Commission
has adopted a number of reforms in this area to implement the
Act. Although each of the reforms is important in its own
right, the reform that has drawn the most attention recently is
section Section 404's requirement that management and external
auditors report on the effectiveness of a company's internal
control over financial reporting. As I have said on other
occasions, I believe the requirements of section Section 404
may have the greatest long-term potential to improve financial
reporting by companies. Much of the recent discussion about
Section 404 has focused on the costs of implementation. There
is no doubt costs have been higher than we and public companies
anticipated, though I believe it important to note that a
substantial portion of the cost may reflect initial startup
expenses as many companies for the first time conducted a
systemic review and documentation of their internal controls.
In this regard, a number of commentators have suggested
that costs in the second and subsequent years will decrease
significantly. Nevertheless, we are monitoring the costs of
section Section 404 implementation closely to ensure that its
benefits are achieved in the most sensible way. We have
actively sought feedback about our first-year experiences in
implementing section Section 404 requirements in order to
determine if commission rules and the PCAOB standards are
operating as intended.
Just last week, we held a public roundtable to review the
first-year experience with implementation of the internal
control requirements. We are paying particular attention to the
impact on smaller companies, and our new advisory committee on
smaller public companies held its first meeting last week also.
Based on this feedback, we are now evaluating ways to make the
process more efficient and effective while preserving its
benefits. We are closely coordinating with the PCAOB, and I
have instructed our staff to consider as quickly as possible
how we could improve the guidance available to management and
auditors in order to fine-tune the process. While we can and
will do more on the subject of section Section 404. Any
reflection upon the scandals that gave rise to the Sarbanes-
Oxley Act will reveal the enormous costs to investors of corner
cutting and internal controls.
As I have said before, I believe that the time, energy, and
expense that companies are now investing in their internal
controls will earn a handsome return in the years to come.
I have covered our activities under the Sarbanes-Oxley in
greater detail in my prepared statement for the Committee, and
I, of course, would be happy to elaborate further this morning.
Before concluding, however, I would offer my own observation
that the real key to achieving the great potential of the
Sarbanes-Oxley Act lies not with the Commission or the PCAOB,
but with the dedicated and serious efforts of American
businesses and their managers who probably have the most to
gain from preserving the reputation of our markets as the best
place in the world for investment capital.
A wise man once remarked that capital will always go where
it is welcomed and stay where it is well treated. I believe
that a company that recognizes the true benefits of the Act in
strengthening our capital markets will have no trouble seeing
that effective compliance with Sarbanes-Oxley, doing the right
thing is not only in the best interests of its investors but
the long-term interests of the company itself.
In conclusion, let me thank you again for your leadership
and vital support in reestablishing and strengthening investor
confidence in the integrity of our nation's capital markets.
And, of course, I would be happy to answer any of your
questions. Thank you.
[The prepared statement of Hon. William H. Donaldson can be
found on page 43 in the appendix.]
The Chairman. Thank you, Chairman Donaldson.
And Chairman McDonough, again, welcome back.
STATEMENT OF WILLIAM J. McDONOUGH, CHAIRMAN, PUBLIC COMPANY
ACCOUNTING OVERSIGHT BOARD
Mr. McDonough. Thank you, Chairman Oxley, Ranking Member
Frank, and members of the Committee. I am pleased to appear
before you today and once again to be appearing with my friend
Bill Donaldson. The President and the Senate brought him to
Washington. He brought me here, and most days I am grateful,
including today.
With the Sarbanes-Oxley Act, the Congress took a giant step
toward restoring investor confidence in financial reporting and
auditing. The Act did not merely create a regulatory
environment conducive to investor protection, it also reflected
the powerful demand of the American people for fairness and
honesty in the U.S. markets. I would like to commend this
committee under Chairman Oxley's leadership both for its work
in passing Sarbanes-Oxley and for its continued stewardship of
our markets on behalf of American investors. It is the faith of
those investors that fuels the growth and competitiveness of
our economy.
In response to the people's demand, the Sarbanes-Oxley Act
created the Public Company Accounting Oversight Board to
oversee the auditors of public companies and bolster investor
confidence in public company financial statements. The Act
provides a great deal of regulatory flexibility so that we can
meet new challenges as they develop. Today, the PCAOB is well
on its way to maintaining a continuous program of auditor
oversight. The PCAOB staff numbers 319 in 8 cities, of whom 138
are inspectors. By the end of 2005, we expect to have
approximately 450 staff, and of those 219 will be inspectors.
Our main growth area is in the experienced accountants who
inspect the accounting firms that are registered with the
PCAOB. Our goal is to inspect roughly 300 accounting firms per
year.
Our highest priority at this time is the continued
implementation of our standard for auditing companies' internal
control over financial reporting. Section 404 of the Sarbanes-
Oxley Act requires public companies annually to provide
investors an assessment of the quality of their internal
control over financial reporting accompanied by an auditor's
attestation on the same subject.
In the simplest terms, internal control provides reasonable
assurance that the financial data being collected by a company
provide meaningful and reliable information that can be used to
produce accurate financial statements. With such assurance
about internal control, investors can have much more confidence
in the reliability of the corporate financial statement.
Now, although the term internal control over financial
reporting has only recently entered our common parlance,
internal control is a familiar concept to most auditors who are
required, under existing standards, at least to gain a basic
understanding of internal control, as part of the financial
statement audit. Companies have been required to have internal
control over their accounting since Congress enacted the
Foreign Corrupt Practices Act in 1977.
However, the Sarbanes-Oxley Act's requirements took the
responsibility of management and auditors to a different level.
Today, under PCAOB Auditing Standard Number 2, auditors of
public companies must not only obtain an understanding of
internal control, but they must also examine its design and
operation in order to reap the most benefit and to make the
overall audit process as efficient as possible.
We designed our standard around an integrated model. An
integrated audit combines an audit of internal control over
financial reporting with the audit of the financial statements.
We believe this approach both enhances the overall reliability
of company financial statements and is cost effective. Given
the tight deadlines for 2004 implementation, however, many
auditors were unable to fully integrate their work. This
problem should be corrected for 2005, which should bring costs
down considerably.
Many companies have already reaped benefits from the
internal control reporting process. For example, 74 percent of
222 financial executives recently surveyed reported that their
companies benefited from compliance with the Act. Of those, 33
percent said that compliance lessened the risk of financial
fraud. By identifying weaknesses before financial reporting
failures occur, these companies are reducing the risk of a
future loss of shareholder value.
Although the benefits of enhanced internal control to
investor confidence are potentially great, there have been
concerns about the associated costs. Through our inspections of
registered accounting firms, we will assess whether auditors
implement new standards appropriately and effectively.
Meanwhile, we have carefully monitored implementation of our
internal control standard and on occasion have issued
additional guidance to promote a consistent rational approach.
Some have charged that auditors are implementing Auditing
Standard Number 2 with a check-the-box mentality that focuses
on minutia unlikely to affect the financial statements. Our
guidance emphasizes that the focus should be on what is
material to the financial statements, not on the trivial.
Auditing Standard Number 2 expressly permits auditors
considerable flexibility to rely on the work of others,
including internal auditors, to complete some of the more
detailed, time consuming tasks.
In addition, some smaller companies have charged that they
are disproportionately burdened because auditors are not
tailoring their audit procedures to the nature and complexity
of the client. Smaller, less complex businesses typically need
less complex controls. Our guidance continues to reflect that
view.
Another area of concern for us is the misconception that
companies may no longer look to their auditors for advice on
difficult accounting issues. Auditors have long advised public
companies on accounting issues and on internal control matters,
and Auditing Standard Number 2 does not preclude that kind of
advice and discussion.
We are working to help auditors better understand our views
on this matter so that they will have the confidence we won't
second-guess their reasonable judgments on this area. Last
week, we participated in the SEC's Roundtable on Internal
Control to explore additional implementation questions. And
there I pledged that the PCAOB would issue more guidance on May
16th, including guidance that explains the top-down approach
encouraged by auditing standard 2, and more clearly describes
how the auditor's assessment of risk affects the amount of work
that must be done to comply with the standard.
Although public attention on the work of the PCAOB has
recently focused most intensely on section Section 404, the
longer term effects of our work will be the product of our
inspections and our other oversight activities. PCAOB oversight
is causing a profound shift in the character of public company
auditing. We have seen changes in auditors' attitudes toward
their accountability. The old system relied primarily on
enforcement tools after a problem had already occurred. The
risk that an auditor's errors would come to the attention of
regulators was too often not sufficient to motivate auditors to
take the tough stance necessary to head off potential
misstatements in financial reports.
Under the new system, auditors understand that their work
is much more likely to be reviewed by the PCAOB's inspectors.
Last year, our inspectors reviewed portions of more than 500
audits performed by the largest 8 firms. Our inspectors have
identified and encouraged appropriate resolution of numerous
accounting and auditing problems that will improve the
reliability of financial statements.
Now, 2 years of inspecting the audits of the big four
accounting firms has done nothing to shake my view that these
firms operating at their best are capable of the highest
quality auditing, and it has also done nothing to shake my
view, Mr. Chairman, that the Congress, this committee led by
you, acted wisely in creating independent oversight of the
profession to help move firms in the direction of consistently
operating at their best.
I cannot say, and I do not believe that you would expect to
hear that after only two inspection cycles we have identified
and uprooted all the causes of auditing failures, nor would it
be prudent to assume that the repercussions of pre-Sarbanes-
Oxley failures are behind the firms. But we have plainly made a
start that amply vindicates the decision that Congress and this
committee made in creating the inspection process.
Over time, I believe this process is the most promising
means we have available for protecting firms from their own
failures due to audit risks and ultimately restoring investor
confidence in the reliability of audits.
In addition to the eight largest U.S. firms, we also
oversee more than 900 small U.S. audit firms and more than 550
foreign firms. Early on, some expressed concern that the Act
might pose a barrier to small firms' ability to compete for
public company audit clients. However, a number of small firms
have actually increased the number of public companies that
they audit. As for our oversight of non-U.S. accounting firms,
we have used the flexibility afforded us in the Act to develop
a framework that relies on cooperation with local country
regulators.
Over the past 18 months we have engaged in a constructive
dialogue with relevant regulators in certain key non-U.S.
jurisdictions. As I speak, PCAOB inspectors are sitting side by
side with inspectors from the Canadian Public Accountability
Board, reviewing the work of the Canadian firms that audit U.S.
public companies. We are also far along in working out similar
arrangements with the United Kingdom, Australia, France, and
Japan. With our counterparts, we hope to do what we can to
reduce overall risk to investors in securities markets
throughout the world.
Mr. Chairman, I am happy to answer any questions.
[The prepared statement of William J. McDonough can be
found on page 62 in the appendix.]
The Chairman. Thank you, Mr. Chairman. And thanks to both
of you. And particularly, I want to publicly acknowledge and
appreciate your sincere efforts to follow the intent of the
Act. I think too many times we, as policymakers, legislators
pass legislation only to see it totally misinterpreted at the
regulatory level much to our disgust. In this case, it is clear
from the beginning that both of you gentlemen and the people
that you work with have made it a point to follow the dictates
of what the Congress passed in the Act and to make it as
flexible as possible.
I have to say that I guess all of us would do things
differently and certainly in the context of the legislating
during that white-hot period of corporate scandal. In looking
back on it, I think to give you some more flexibility probably
would have been the right thing to do. But having said that, I
think there--and from the feedback we get from the roundtable
discussions that you both participated in last week, a very
positive way of getting to what all of us in the Congress
wanted to do was restore investor confidence and make it work,
and to that I want to publicly thank both of you.
Let me describe Section 404, and ask you, Chairman
McDonough, that it appears to me that maybe most of the cost of
the implementation in Section 404 was at least partially due to
some deferred maintenance in the internal controls system
already existent. Is that a fair assessment?
Mr. McDonough. I think it is, Mr. Chairman. It varies with
the company. Some of the companies which have very complex
internal financial structures already had very good internal
control, probably had to do some documentation improvement of
them. For medium and small-sized firms, very frequently the
internal control is existent, but was kind of in the head of
the guy who ran the place, and therefore there is deferred
maintenance in actually establishing written documentation of
what the controls are.
Some of these controls are not very exotic; it is making
sure that you are actually reconciling the bank statements with
your cash book to make sure your cash account is right.
A lot of this is very straightforward stuff. And I think
that in the second year, a lot of companies will find that they
have done the deferred maintenance and their internal costs
should come down significantly. And we are making it very clear
to the auditors that we expect their costs to come down, that
there should not be unnecessary work. We also have to be
careful at the same time that auditors really have to be
working hard to make sure that they are protecting investors'
rights. It is a very, very fine balance both for them and for
us overseeing them.
The Chairman. What is your assessment, Chairman McDonough,
on the claim that auditors are engaging in perhaps defensive
auditing, too conservative of auditing because of the potential
threat of litigation? And, in addition, what are your views on
whether we ought to look for ways to reduce potential liability
particularly in light of the fact that we now have four
accounting firms doing about 99 percent of the accounting? And
lastly, is there the opportunity or the possibility of some of
the mid-level or regional auditing firms to ultimately become
one of the top nationwide auditing firms?
Mr. McDonough. I think there is no question that auditing
firms of all sizes, given the Sarbanes-Oxley Act arising out of
scandals, that people are running very concerned about the
threat of litigation either by civil suits against them or by
the criminal authorities at either the Federal or State levels.
Human beings, what we are, if you are scared, you tend to
act very defensively. And I think there is no question that
there is a certain amount of this defensive posturing, which is
taking place.
Whether or not there should be a limitation on liability
for accounting firms is a very tough balancing act. On one
side, you would say the positive is that it would make the
firms less concerned, less scared, and therefore, they would
use their judgment more effectively. On the other hand, they
ought to do that anyway. And, therefore, I think that when and
if the Congress in its wisdom should decide to provide limited
liability, I would support it. In the meantime, we will proceed
on the basis that the accountants should be doing their jobs
properly anyway.
On the very complex issue of whether there will be a number
5 adding to hopefully the big four remaining alive and well,
the Government Accountability Office, as required by the
Sarbanes-Oxley Act, did a study and came, I think we would all
agree, to the conclusion that it is not very likely that any
firm in the number 5, 6, 7, or 8 position, or even something
which is completely unlikely to happen, that all 4 of them
would get together, it would still be a relatively small number
5. What I think should happen is that there are issuers--
community banks come to mind--who use very large accounting
firms because somehow they think that that is something that
maybe their regulators or the rating agencies would like.
And it really seems to me, to be very direct, Mr. Chairman,
much more appropriate that they use an accounting firm more
appropriate to their size. Therefore, I would like to see the
numbers 5 through 8, and then the smaller accounting firms
grow, become healthier and stronger, but I don't think we can
hold out a realistic likelihood that that will result in
another firm anywhere near the size of the big four.
The Chairman. But you do think that the market can work,
that, given time, we can have a leveling; that is, some of
our--and I think it is a good point on the community banks, for
example; it clearly would be much, and a lot cheaper probably,
too, to engage with the mid-sized firms.
Mr. McDonough. I think the market should evolve in a way
that will have stronger accounting firms right through the size
structure, and that is very much to be desired.
The Chairman. Thank you.
Chairman Donaldson, one of the contributions in the
conference committee was the addition of the Fair Fund;
Chairman Baker offered the amendment during the conference that
created this fair fund. And I know you testified that there
were $5.4 billion--that is with a B--in that fund. And of
course that fund comes from fines and disgorgements for cases
that the SEC undertakes. Could you give us a little more detail
on how that fund is working and whether, in fact, it needs any
kind of amendments at our level? Or can the SEC take care of
some of the potential problems with regulatory means?
Mr. Donaldson. Thank you. I think that, as I said, there is
a large amount of money that has been designated for the Fair
Funds. I think that the--
The Chairman. If I could interject. That is less than,
what, less than 3 years?
Mr. Donaldson. Right.
The Chairman. And it has grown to 5.4 billion, which I
guess--there is no way to predict, I guess, by any of us how
that fund would grow. But, anyway, I interjected. Go ahead and
continue.
Mr. Donaldson. It is a tremendous benefit that we can now
convey to harmed shareholders. The actual distribution of the
money is a complicated process. Basically, it requires
retroactive reconstruction, if you will, of records as to who
the harmed shareholders were at a particular period of time. I
think you can see how complicated that gets. Fortunately, now,
as we have moved ahead we are able to put the costs of doing
that off on the companies that we have fined. In other words,
we didn't do that at the beginning. We now have the authority
to do that, so that the actual cost of this retrofitting is
being borne in addition to the original--or built into the
penalty to the company.
The Chairman. I see. And are we talking in this case in
terms of harmed investors? What is the universe? There are
thousands, tens of thousands, millions?
Mr. Donaldson. Millions.
The Chairman. Millions.
Mr. Donaldson. Yes. If you add it all up, millions.
The Chairman. Okay.
Mr. Donaldson. And, again, it is a very difficult exercise
to identify the exact period, if you will, where the
malfeasance took place.
The Chairman. I understand.
Mr. Donaldson. And within that to the intellectual exercise
of determining who got hurt.
The Chairman. Thank you.
Mr. Donaldson. But we are making great progress. I think
our administrators of the Fair Funds are getting more and more
experienced in doing this.
The Chairman. Thank you.
The gentleman from Massachusetts.
Mr. Frank. To begin, to both the chairmen, we talked about
this a little bit before. I think Mr. Donaldson had some
reference to it. There was a troubling article in The
Washington Post earlier this week by David Brown suggesting
that the interpretation of accounting rules regarding when you
could give yourself credit for receiving revenue were
interfering with the ability of the government to stockpile
pediatric vaccines. And it did seem to me that this was
something that, if it were a real problem, we could solve. And
maybe it wasn't a real problem. Although obviously, somebody
interpreted it that way. And as you know, I wrote to both of
you and asked if there was anything that needed to be done in
terms of regulation or legislation to clear that up, but I
assumed it was something we could do quickly.
So I would be interested, you said you had a chance to look
at that, Mr. Donaldson. Did you have some response on that?
Mr. Donaldson. Sure. Of course, I read The Washington Post
article as did all of our people in charge. The basic thrust of
that article, as you know, that many manufacturers have decided
to stop participating in part because they may not recognize
revenue when vaccines are placed in the stockpile. We are
concerned, but I am also concerned that it may be slightly more
complicated than just an accounting problem. It is not clear to
us that the accounting is the real issue as opposed to perhaps
the business economics of the existing program.
But we certainly don't want to be an obstacle. We will sit
down with any drug company that comes to us to see if we can
work this out. There may be other ways to deal with the
problem. For example, the contract with the government could
perhaps be restructured to handle a particular problem. But we
are willing and will sit down with any drug company and try to
work through their particular problem.
Mr. Frank. Thank you. And let me urge people, any drug
company that has said that, and also to the people at the
Department of Health and Human Services, if they get that
answer, let us have them come and talk to you. And if a change
is needed, we can do that. I had my own sense that maybe
accounting was being used as an excuse for something else. But
people may be erring on the side of being extra cautious, and I
understand that. But I appreciate that, and I would hope we
could get this one resolved fairly quickly. I don't see any
kind of obstacle, if people are getting the money, there isn't
a problem.
I have spoken to others here, I have spoken to Henry Waxman
who has been very involved in all this. And I appreciate what
you are saying. I would hope that we could all follow up now
and that the companies involved--I am going to ask HHS to make
sure that the companies involved are in touch with you and your
people. And I would hope we could get this one resolved pretty
quickly. I am encouraged by what you say.
Now, back on the subject of compensation. And I know, I
guess there was some reference to whether or not this was
really all Fannie Mae and Freddie Mac's fault. I guess, if it
rains tomorrow, we will complain to them, too, and send to them
for the umbrellas. But, in fact, we are talking about billions
of dollars in compensation, so, in fact, their presence perhaps
it would make no significant difference. A couple of questions
here about that. Because they do go with the accounting. One of
the--I am very much persuaded by the very extensive work that
is done by the Professors Bedrick and Freed and Grinstein and
others that mechanisms for--that CEO pay is largely self-
determined. That there are ineffective constraints, and it does
look like, if you hire a consulting company, you get more
money, because the consulting companies, not wanting to annoy
the people who decide whether or not to hire them, tend to give
them more.
And there is also this apparent view on a corporation that
if you are not paying your CEO above the average, then you must
have a below average CEO. And, as everybody tries to get
continuously above average, that, in and of itself, is a
significant inflationary factor. It is the opposite of where I
go with regard to businesses in general in America.
Actually, it is an interesting economic rule, that we have
every business in America operating on a constantly downward
sloping playing field. That is, every business in America that
has ever testified on a committee where I have been sitting has
announced that they are on an unlevel playing field and that
the competitors have an advantage. And it is striking to me
that the universe consists entirely of companies that are at a
disadvantage to other companies. I mean, I have never met a
company that was at an advantage to any other.
They should get a prize if they come forward. But the main
check on executive compensation that gets too high, that it is
unrelated to performance, that simply becomes an economic
problem, the main constraint is publicity.
Mr. Frank. In that case, let me ask you, Mr. McDonough, one
of the suggestions we have had in the law of unintended
consequences, Congress passed a law a few years ago that said
if you pay the executive a salary that was way disproportionate
to the average worker, that wasn't deductible. And we have
encouraged people to get into other forms of compensation not
covered by that. And particularly one of these we are told--
well, there are two that trouble me.
One is pension arrangements, and those involved in Fannie
Mae. The pension arrangements--we had the CEO of Fannie Mae at
the time tell us that if there were accounting problems, he
would be accountable. At least I thought that is what he said.
Apparently, he said his benefits would be uncountable. I didn't
hear him right. And they consisted of what seemed to me to be
widely excessive pension benefits.
You have the jurisdiction. What is the transparency of
pension benefits? I think we are running into a little problem.
And let me ask you, Mr. Donaldson, too. When we have these
pension arrangements that kick in--and I appreciate the extra
time, and I will try to wrap it up--but this combines with what
I think is a perverse incentive effect. We have had a couple of
mergers in Boston lately where very successful major
enterprises in Boston sold themselves to other enterprises.
But, in both cases, the CEOs made well over $100 million solely
because of the sale, and that can't be irrelevant. It cannot be
that the ability to make over $100 million has no effect on
whether or not you make the sale, but it shouldn't be by any
rational economic standards. And the problem is that those tie
in, because very often the benefits are triggered by that kind
of a sale.
Let me ask both of you, finally, of the extent to which
current accounting rules make all of the compensation
arrangements, including the contingent ones in case of sale,
fully transparent and is that something that maybe we could
give some more attention to.
Mr. Donaldson. Let me try to give you an answer on that
over the short haul and over the long haul.
Over the short haul, I think the first step in the whole
issue of executive compensation should be based and addressed
by the independence of the compensation committee. As mandated
in Sarbanes-Oxley, as instituted by the stock exchange, we now
have independent compensation committees, number one.
Number two is those committees have the authority to hire
the outside experts themselves, as opposed to corporate
management hiring the compensation advisors. Now the Committees
can bring in their own advisors and give those advisors the
instructions they want to give them.
Beyond that, I believe there needs to be a fundamental
change in the management or rather the boards' and the
compensation committee's understanding of exactly what
performance is, exactly what are we rewarding people for.
My own view on that is that we are way over too far onto
the earnings per share and quarterly results and the numerical
measures, if you will, of success in a corporation as opposed
to the qualitative judgments on what is good performance, what
do you mean by that, over what period of time, quality of
products, et cetera, et cetera, et cetera.
Now, having said that, we are taking steps now to increase
the transparency of the total compensation package. Alan Beller
in our Corporation Finance Division is hard at work now in
developing a better way of displaying what the total
compensation package is. And, again, you have to be a forensic
accountant practically to understand in a current disclosure
document exactly what the total package is that a corporate
executive is getting in terms of not only salary, bonus and so
forth, but post-employment bonuses, benefits and so forth. We
will come up with a way of displaying this that we hope that
will open the whole process up to the sunlight.
Beyond that, I think it is important to note that we have
felt that it was not the SEC's role to dictate compensation
measures. It is our role to make each company disclose exactly
what they are doing. And of course, I believe--and this is a
longer answer than you wanted--I believe that sunlight will
have its effect.
Mr. Frank. It is very much the answer I wanted. I agree
with you. This is not a case for us to act, but make sure the
information is there.
Mr. McDonough.
Mr. McDonough. As you may remember, Mr. Frank, I think I
was the first public official to speak out describing the
excessive compensation when I was honored to give the
anniversary of 9/11 speech at Trinity church at the foot of
Wall Street.
Mr. Frank. Your survival has emboldened me.
Mr. McDonough. It is a matter of considerable concern to me
because I live in some fear that since, in addition to your
cogent remarks on the subject, I always describe the present
level of executive compensation as morally outrageous, which I
think it is, I think there is no question that none of us can
figure out a way that you could have a law or a regulation that
would control executive compensation. My friends at the SEC
bringing it out more into the sunshine will help, but mainly
what we need is the leadership of the American business
community, for to get it through its head that the
responsibility that they have to the American people as members
of a single society is that this level of executive
compensation is nuts. It has no economic theory behind it
except one called greed, and it is time for it to get changed.
The Chairman. Gentleman's time has expired.
The gentleman from Louisiana, Mr. Baker.
Mr. Baker. I thank the chairman.
I wish to commend you both for taking on the administration
of this Act in an aggressive and appropriate manner. I think it
has brought about a heightened level of responsibility by those
who govern public corporations.
I do share the view that the compensation matter is one
that should be brought to public light and we should examine
ways to make sure the shareholders fully understand the scope
of packages, but I think that is as far as one can comfortably
go until some person within either of your organizations
figures out a logical way to provide a remedy. However, there
are elements to this that I think are pervasive in the system.
CEOs and CFOs have a great responsibility to meet or beat
the street every 90 days; and if they don't, they are fired. I
think that is an insidious force in perverting compliance with
the accounting rules and perhaps making ill-advised business
judgments.
If someone spends the money on Section 404 compliance
because the law requires it and people are going to look, did
that cause us a hit on our earnings, and the only defense you
will have is the law made me do it, if by contrast you had
spent the same amount of money on internal data processing in
order to facilitate that knowledge and not be required by law
and take a hit, he would perhaps be in some trouble. We have to
incent corporate America to invest for the long haul, just like
we try to incent our individual constituents to invest in the
markets for decades not days; and I think that is an overhaul
task of some immense proportion.
With regard to Section 404 compliance, Chairman Donaldson,
there is another way I would like to come at the problem of
cost, particularly for moderate to small business enterprises,
not necessarily changing the compliance requirements of Section
404 but rather the trigger that brings you into compliance with
Sarbanes-Oxley in the first place.
As I understand it, it is a shareholder number or an asset
size that brings you into the pot; and that shareholder number
is fairly small, at least in my view. Is there any review
ongoing as to whether those thresholds which trigger the
compliance, because that is the group from which we get the
largest complaint, that the compliance costs versus their
operating budget is out of whack? Is that an approach that
might merit some consideration?
Mr. Donaldson. As a result of our concern on just that, we
formed the Small Business Advisory Committee. That is made up
of sitting CEOs and accountants and everybody that is involved
in this issue, and they met last week. It is an outstanding
committee.
One of the first agenda items for them has been the
definition of what is a small business, how do you define. We
have had traditional market cap numbers, if you will, but those
are misleading in terms of a true definition of what we are
talking about when we talk about a small business. And I think
you will see, as a result of the work they are doing and their
advice to us, we will come up with some better definitions than
we have now.
Mr. Baker. I don't expect a response this morning, your
answer to the chairman on the Fair Fund administration to
identify for us any operational concerns that going forward we
might address and some more detailed status of the operations
of the Fair Fund administration today. It would be helpful.
Thank you for your good work.
Chairman McDonough, I want to jump quickly, going forward,
the Section 404 compliance issue, I understand that May 16 of
this year there will be additional guidance issued. Is it
inappropriate to ask where we might be going or is that
something that should be subject to later disclosure?
Mr. McDonough. Here is what we are working on first, Mr.
Chairman. On May 16, we will come out with all the guidance we
can possibly bring to bear on telling auditors it is not a one-
size-fits-all, you are supposed to use judgment.
When the people in the issuing companies say, here is the
internal controls we have in mind, what do you think, you are
not supposed to say, I can't talk about that, but, rather, that
there be a relationship between the auditor, very much with the
audit committee involved and the issuer that is for the benefit
of the growth in our society.
We have a Standing Advisory Group on our audit standards
which meets on June 8 and 9. That entire meeting will be
dedicated to additional thinking on guidance we bring to bear.
The more we can get down to the nuts and bolts so we can tell
people, here is the way to go about doing it, we can reach a
point where we say here is a checklist--
Mr. Baker. One of the little elements in the list, would
that also apply to the subject of audit independence and tax
advice?
Mr. McDonough. We have a proposed rule. The comment period
has ended. We have, I believe, 1,200 pages of comment; and I
would hope that say within the next month we will be able to
finalize that rule. Then it goes the SEC, and they put it out.
Essentially, what we have in that rule, which I believe
strongly in, we want to get auditors out of the business of
giving tax advice of how you can pay, you know, take a little
risk and pay less tax to Uncle Sam. That is terrible. They
never should have been doing that, and we forbid it in this
proposed rule.
We also tell them they can't do the individual tax returns
for senior executives, especially in the line of financial
reporting.
The other, more traditional work that audit firms have done
for their issuers, we believe they should be allowed to
continue to do. It is much more cost efficient for the issuer,
and I think it is just a better way of trying to get as much
cost benefit thinking as we can into the American economy and,
at the same time, carry out the clear mandates of Sarbanes-
Oxley.
The Chairman. Gentleman's time has expired.
Gentleman from Pennsylvania.
Mr. Kanjorski. Thank you, Mr. Chairman.
Gentlemen, let me congratulate you on your operations thus
far. I can assure--I don't know if I can speak for all the
members of the Committee, but I sleep a lot better knowing that
both of you are there. You have taken on a tremendous task, and
you have been terribly successful to date. So we don't have a
tendency to congratulate you as nearly as often.
I am going to take the opportunity to get into two little
areas that are really off the record. One is going back to the
vaccine question. I have the largest manufacturer of injectable
vaccines in my district, Sanofi pasteur. We have been working
closely with HHS and the Securities and Exchange Commission;
and I would appreciate, Mr. Donaldson, if you could reach down
in your organization--and I don't want to put you on the spot
to discuss it, but in the omnibus bill we had required a study
to be completed by HHS in 90 days, and that has expired on
March 15, and that study is not completed by HHS since they did
not communicate with your organization until sometime in the
middle of February. Just superficially, it appears there may be
a tennis match of where the ball is and in whose court.
I think it demands high-level executive talent to make sure
that we resolve this issue. Because we are completing, one, to
maintain these manufacturers in the United States; and, two, we
certainly want to encourage inventories. If there is some
accounting problem or it is a contract problem, I really don't
care. I am interested in making sure we have the stockpile. So
if you could attend to that.
Now the second thing, and I bring it up with a lack of
knowledge with all the ramifications, but yesterday we had the
announcement of the possible privatization of the New York
Stock Exchange. Quite frankly, I am very concerned, first and
foremost, that the institution existed so well as a not-for-
profit organization now moving into the realm of a for-profit
corporation--certainly they have the right to do that and may
be the right thing to do. It may enhance the equity action of
the whole country, and that may be good.
I am concerned about two things, the self-regulatory
organization of the exchange--it seems to me both the Congress
and the SEC have some work to do here, and I don't want to put
you on the spot because I am sure we are going to be passing on
this transaction. But as you are passing on this transaction, I
would hope that you would listen to some of these concerns and
think about it.
The second concern, which I had detailed discussions with
the leadership of the exchange on, is my concern of the
national security issue, which I think privatization has not
taken into consideration. Now we have for the first time the
capacity of foreign corporations or foreign countries being the
equity owners of the largest equity market in the United
States; and if for some perverse reason profit was not their
motive but in fact some devious purpose to accomplish some end,
they would have in their vital control 80 percent of the equity
of this economy at their disposal.
Under normal circumstances, the SEC is a reactive
organization to pass on what has happened. But suddenly now,
with little investment, maybe a half a million or a billion
dollars, a foreign power or combo could control the largest
equity market in the United States and not worry about their
investment but be more worried about the advantages of
attacking us economically. They could utilize this exchange for
horrendous purposes.
When I look at the normal protections that we have against
subversion in our economy, profit has so much to do with
keeping people on the correct road. But when you have the
opportunity with little amount of equity to extraordinarily
impact or affect an economy as large as that of the United
States, this is sort--I don't know what protection--
I know other exchanges have gone into privatization. I have
raised that issue with them. They usually look at me and say,
well, we never really thought of that. And they will say, we
will know who owns this. But we all know you could own huge
amounts of equity in this country in blind trusts or
unidentifiable trusts. It is going to be very difficult to
pierce this veil and get the transparency.
It seems to me with the hook of self-regulatory control
under the auspices of the Securities and Exchange Commission
you may have the ability to structure something here and
invariably have to work for Congress to establish wherever that
regulatory organization will--ultimately may be. But certainly
to examine that we are not at a national security risk here,
not that it would happen now under the present administration
of the exchange or even with countries, but some devious
character out there sitting in some foreign land with an awful
lot of oil money--I didn't mean that--could think about having
a real impact on the American economy in a very cheap way, a
lot less expensive than nuclear weaponry. So if you would pay
attention that, I would appreciate it. And within the
constraints of a regulator, if you would like to give us any of
your feelings on that matter, I would appreciate it.
Mr. Donaldson. Let me begin by saying that I don't and
cannot comment on the specifics of the proposal as was just put
forward, since it will ultimately come under our jurisdiction,
but let me try to answer a couple of your questions.
First of all, on the SRO issue and the whole regulatory
side of the exchanges, we have been, as you know, concerned by
trying to isolate the regulatory side of the exchanges from the
business side, if you will, and we have had a proposal out
there for comment, if you will, on just how in the future the
regulatory aspect of exchange organization can be isolated from
the business aspect.
In the case of New York Stock Exchange, they have a model
that has the regulatory side under the purview of independent
directors and totally out of the chain of command, if you will.
So we have been very concerned with that problem.
We have also been concerned with how the financing of the
independent regulatory oversight would take place, the
precedents, if you will, of the revenues of the exchange going
to the regulatory side.
As far as the national security aspect, again, we have been
thinking about this, and we have been working on it. Because it
seemed to us that it was inevitable that the issue of public
ownership was going to become more and more in the public view.
Obviously, the NASDAQ situation is publicly held now; and we
have been concerned about the constraints that we can put on,
the reassurances we can put on the overall structure to make
sure that what you just talked about doesn't happen. We will be
incorporating in our--and, again, I am not referring to the
present situation--we will be incorporating in our SRO
governance standards our conclusions, if you will, on just how
to do that.
I might also say that the competition now between the
marketplaces is happening just as it should. We have increased
competition between the markets and the bringing together, if
you will, of the New York Stock Exchange and the new structure
illustrates that competition. It also illustrates the rising
importance of electronic execution, if you will.
It also brings forward, in my view, the importance of our
recent national market system rulings in terms of individual
investor protection. It is very important as we move toward
electronic trading that we protect the individual investor, and
it is very important that we have rules that are consistent
across the marketplace. That is why that was such an important
part of Reg NMS, the extension of the rules to not only the New
York Stock Exchange but NASDAQ.
The Chairman. Gentleman's time has expired.
The gentleman from Alabama.
Mr. Bachus. I thank the Chairman.
Before I go into a more general line of questioning, I have
got a bank-related question I want to ask Chairman McDonough.
Some audit firms are beginning to require dispute resolution
provisions in their engagement letters with the companies they
audit, and these provisions prohibit the companies from suing
the auditing firm. They require arbitration; and, even more
importantly to me, they require the location of those
arbitration proceedings. I know the banks have expressed
concerns to us and also I think the bank regulators are
concerned about possible safety and soundness issues related to
this. Has the oversight board focused on this issue and have
you had conversations with the bank regulators?
Mr. McDonough. Mr. Bachus, my understanding is that the SEC
has taken a position that when an accountant enters into an
indemnity agreement with its audit client that provides the
accountant immunity from liability it can jeopardize the
accountant's independence. Now, under Sarbanes-Oxley, we now
share responsibility for auditor independence with the SEC. We
have--at the staff level, but also in our case involving me
personally, we have been in discussions at the SEC and the
PCAOB with the Federal banking regulators on this issue; and I
think I can speak for all of us involved in these discussions
by saying we are all concerned about that practice. We
understand that the bank regulators intend to issue guidance on
this issue in the near future, which I certainly like to see.
We will monitor that practice very, very closely.
Mr. Bachus. I want to focus on the bigger issues. Of the
2,500 companies that filed by March, 8 percent of them reported
material weaknesses in their internal controls. I think that
alone tells you that Section 404 was necessary and validates
the legislation and the need for internal control audits and
reports. I think--I hope you agree that will result in a more
accurate reporting and enhanced investor confidence. I know
that one or two of my colleagues have said these are just a few
bad apples, but 8 percent is a pretty surprising figure. Would
you all agree?
Mr. Donaldson. I think it is an important statistic, and it
illustrates the positive impact that the whole Section 404
approach takes. I do believe in our conversations with
corporate executives that many of them, after they get done
complaining about the costs, talk about the improved management
oversight they have now and welcome this exercise they have
gone through to identify their own weaknesses. So I think it
has been positive.
Mr. Bachus. Let me say this, and I wanted to say that
first, that I think that it is necessary. I think it is
positive. I think it has led to better confidence by investors,
more accurate reporting.
That being said, I think the main concern expressed on
Sarbanes-Oxley is focused on Section 404; and I think the main
criticism has been on the disproportionate costs to the smaller
firms. One figure I saw was that the cost of these internal
audit reports to companies of over $5 billion in revenue was
$0.06 out of every dollar. But to companies of $100 million in
revenue, the cost was $2.50, which is obviously
disproportionate. I have read estimates I think from the
oversight board and others that that cost ought to drop about
50 percent in the second year.
Having said that, and I know you have forms--and a lot of
the criticism is the duplication between the internal audits
and external audits, maybe extending the deadlines. I think
another criticism is the need for risk-based audits.
Would you like to comment on maybe ways we can lessen the
costs on these smaller firms?
Mr. McDonough. I think it is absolutely essential that we
do so.
I was a central banker five times longer than I have been
an audit overseer, so maybe it is the central banker in me that
says small- and medium-sized companies create all the increase
in jobs in our economy. They are absolutely vital to the
functioning of the American economy and therefore serve the
interests of our people. There is no question that there are
ways to reduce the cost. The use of the work of others was put
right into our auditing standards.
You may recall when I was here a year ago I said that we
invented that cost benefit, thinking it isn't, in fact, in the
statute, and Chairman Oxley was nice enough to say that he was
glad that we had done so.
I think we are going to be able to say that in our May 16
guidance, that the audit plan should indicate exactly what work
needs to be done. That has to be more thoughtfully done by the
auditor, figure out how much work can be done by the work of
others, especially reward a good internal audit capability by
taking more advantage of it. At the end of the day, the auditor
has to say, I know enough by my own work to be able to make a
judgment.
But taking advantage of the work of others is certainly, in
my view, encouraged and, heaven knows, not precluded. We will
then continue to work throughout--well, for the indefinite
future. But we want to work at it really fast, because the more
guidance we get out quicker, the more we improve the 2005 audit
season so that some of this unnecessary expense that took place
in the last year won't be repeated. Will we get beat out all of
the unnecessary expense in 2005? I hope so, but I doubt it.
So this is going to be a project where we have to keep
working with the audit firms. That is why our inspections are
so valuable. We made it very clear to the auditors that, yes,
we would be critical if you didn't do enough work on internal
control, but we will also be critical if we have the view that
you did too much. Whether it is inspired by fear, as has been
suggested earlier in my answer to the chairman, or even if it
is a less attractive motivation, which is to run up the hours
and the fees, we have to get a much better cost benefit
equation into this necessary work to protect investors.
Mr. Donaldson. Could I add two comments to that?
Number one, I think on the smaller end of the scale,
because of the delay and that coming under the implementation,
if you will, there has been a learning curve out there as a
result of what is going on to date. That learning curve is not
only in the companies themselves but with the auditors
themselves. I think we will see a natural improvement in the
efficiency of the process simply having been through it once.
The Chairman. Gentleman's time has expired.
The gentleman from Illinois, Mr. Gutierrez.
Mr. Gutierrez. Thank you very much, Mr. Chairman.
Chairman McDonough, in response to Ranking Member Frank,
you referenced your previous remarks where you predicted that
Congress would take action to rein in executive pay; and you
also called the gap in pay between executives and workers,
quote, grossly immoral. You said, quote, the American dream is
in danger. The loss of confidence in private sector leaders by
the American people can be restored only if we convince them
once again that the private sector at the top is not a closed
club of people guided by their own selfishness and agreed,
unquote. I thank you for that insightful observation, Mr.
Chairman.
As you know, my colleague, Mr. Frank, began and indicated
that the first step regarding these obscene salary packages
should involve clear disclosure so the shareholders and the
public can follow the trail and discover the total compensation
packages of these CEOs. I think the real solution is that
shareholders should be able to directly decide their CEO's pay
package. After all, it is their money footing the bill. What
would you think, Mr. Chairman, of this type of proposal where
there would be a direct linkage between shareholders and
determining the package, pay package of a CEO?
Mr. McDonough. Well, Congressman Gutierrez, you will recall
that I am a native of Chicago, so thank you. I do stand by
those remarks that you quoted for me.
Actually, the shareholders do direct the compensation,
because the directors of the company are supposed to represent
the shareholders. I think if we say that shareholders are not
being well protected if CEO compensation is too high that we
have to say that the directors of public companies--not all
public companies, some public companies--are actually improving
their situation by coming up with a methodology which you and I
and any other member of the American society can look at and
say, well, that makes sense.
But in many, many other cases, you look at the methodology
and, essentially, it is what the Ranking Minority Member
described as, you bring in an executive compensation consultant
and the executive compensation consultant says, no, McDonough,
you are a genius because you hired me. Of course, that is why
he knows I am a genius; and, therefore, you should be in the
top quartile of executive compensation and we will compare you
just by chance with a group of companies that happen to pay a
lot. That actually is what was happening. That is not a
caricature, but, unfortunately, that is the truth. That
shouldn't be happening if the directors of public companies are
doing their jobs properly.
Mr. Gutierrez. In the instances--because you are from
Chicago, I thought you were going to give me that answer and go
back to the board of directors. So I am happy that we are on
the same page.
Having said that, then what about the shareholders being
able to veto a mistake made by the board of directors in terms
of an excessive package of wages? Let us say the board of
directors does something and the shareholders feel, God, look
at all that money. What do you think of that instance? A veto
process? They don't like it. Is there a procedure in which they
should be able to get involved?
In order to seriously address the issue of competence,
because as you and Mr. Donaldson have expressed, we are
beginning to make inroads after the lack of competence which
ensued at the end of the last decade and the beginning of this
one, but there are still stories that may continue to unfold.
And as you declared, and I agree with you totally and I am
happy you stand by those words, grossly immoral. What do you
think of that?
Mr. McDonough. I would be really trampling on the turf if I
answered that question of my colleague and friend, Mr.
Donaldson, because it has to do with the governance of
corporations, which is the SEC area.
I will make the comment, at the present time, a shareholder
only has one choice, and that is to sell the shares. That
doesn't impress me as the only choice that ought to be
available.
Mr. Gutierrez. I will take that as an answer.
I would like to ask a question of Chairman Donaldson. You
were quoted in Forbes magazine in 2003 where you referred to a,
quote, disconnect between executive compensation and
performance. You expressed fear that the business was slow to
heed the public's outrage, quote. In my view--this is Chairman
Donaldson--such cynicism is a major threat to the long-term
growth and health of our economy.
You added, without the confidence and participation of
mainstream America--I thought that was the shareholders--our
markets cannot resume their rightful and necessary place as the
engine of American prosperity, end quote.
Company directors must create, according to Mr. Donaldson's
quote in the Forbes magazine, a corporate culture based on a
philosophy of high ethical standards and accountability. And
you said this culture must be engrained in the company's moral
DNA, following up on Mr. McDonough talking about morality.
Obviously, there is a serious ethical moral question, as
both of you have been so widely quoted about the morality or
lack of morality. However, you have CEOs like Robert
Allbritton, who presided over Riggs Bank, an institution that
systemically failed to comply with Bank Secrecy Act
requirements and facilitated transactions for General Pinochet
for years before these actions were finally acknowledged by the
regulator, the OCC. In addition to his generous salary and
sizeable stock options, which he exercised just before his
resignation as chairman, earning him $5.7 million in a single
day, here is somebody who violated the OCC, and we will let
them continue to look at the things.
The Chairman. Gentleman's time has expired. Could we hear
the answer?
Mr. Gutierrez. Could you just speak to that issue
momentarily before the chairman cuts you off?
Mr. Donaldson. Well, I think that the issue of compensation
has to do--as I tried to say earlier, has to do with an
appraisal of what good management is and what effect that has
on the performance of the company; and I think it needs to be
measured over a longer period of time than is currently there.
I think there is a danger that if we somehow do not reward
really good performance with really good rewards--and I believe
the marketplace must be the determination of that, and that
comes from a complete disclosure of just what these rewards
are, and then the shareholders can make their own judgment as
to whether the rewards they are getting in the marketplace are
being fairly compensated. I think the problem is that there are
rewards that are not disclosed and if disclosed would excite
some shareholders.
Mr. Gutierrez. Thank you very much. If I could submit some
questions in writing to the two chairmen.
The Chairman. The Gentleman from Texas.
Mr. Hensarling. Thank you, Mr. Chairman. Let me add my
voice to the chorus of those congratulating you for your
leadership on Sarbanes-Oxley, a critical piece of legislation
at a critical time in our Nation's history. Clearly, accounting
firms and executives are held to higher standards, and we have
our financial controls strengthened and more transparency, and
investor confidence is up. Clearly, that is all the good.
But sometimes when I hear from constituents about the
application of Sarbanes-Oxley, it reminds me of some of these
miracle drugs we see advertised on TV: Take the green pill. It
is 97 percent effective, but side effects include premature
baldness, bad breath and nausea. I think to some extent in my 5
minutes I could say that Sarbanes-Oxley is 97 percent effective
in curing what ails us, and I want to spend a little time
talking about some of these possible side effects.
I represent a Dallas, Texas, based congressional district;
and I have seen an uptick in small public companies deciding to
go private. Just a couple of examples.
A company named Bestway, a rent-to-own company, they had a
net income of $366,000 last year, and they spent almost
$600,000 on their Section 404 compliance, and they decided to
go private.
Calloways, which is a nursery, had a $4.3 million loss in
'03, $113,000 profit in '04, and they are saying that they have
to spend an extra half a million dollars a year to meet all the
public filing requirements. They have decided to go private as
well.
I have a twofold question. Number one, do you have any
evidence that this is a trend that increasingly small public
companies are choosing to go private because of the compliance
costs? And if you do see a trend, what are the implications to
the investor community and the economy? Chairman Donaldson?
Mr. Donaldson. First of all, I think you have to put it in
context relative to the numbers of small companies or relative
to the number of companies out there. Those that have gone
private are quite small. Nonetheless, they are more than they
were in the past.
I think you have to relate that to the public ownership
boom, if you will, that took place during the escalating
markets in the 1990s. There are a number of companies who never
should have gone public, who were not ready for it and were not
ready to accept the burdens of public ownership. There are
obligations for liquidity and capital raising that comes from
public ownership. There are burdens of regulation.
Having said that, it is, I believe a natural process here
where there are going to be some companies who are going to
decide that the burdens and responsibilities are too great and
would rather be a private company. And I think for the great
majority of companies, there has been--the very reason for
Sarbanes-Oxley, there has been inadequate attention to the
expenses, the justified expenses of being public.
Mr. Hensarling. You don't necessarily see a trend, but if
you do see a trend you don't see a worrisome trend?
Mr. Donaldson. I see an increase in companies going
private. I think the rhetoric is a little ahead of the actual
numbers. I mean, the numbers are very small relative to the
thousands of companies that are public.
Mr. Hensarling. Continuing to focus on the burden on
smaller public companies, you get a lot of studies and
anecdotal evidence crossing your desk. I happened to pick up a
USA Today the other day flying back to Dallas, and they just
mentioned a few companies. Priority Health Care, a pharmacy
distributor, has 491 percent higher audit fees. Aaron Marantz,
audit-related fees up 287 percent. A lumber company, Daletech
Timber, 243 percent rise in their audit fees.
Do you have some way to get your arms around all this as
far as the size of magnitude, as far as the cost compliance for
these smaller companies? Do you have any studies that you
believe are valid and worthy of bringing to our attention?
Mr. Donaldson. We are very concerned about the small
company end of the economy. Obviously, that is the engine of
growth in our economy, has been and will continue to be. We are
very concerned about any sort of disadvantages that come from a
one-size-fits-all application of Sarbanes-Oxley, and that is
why we formed this advisory committee. And we are going to pay
particular attention to smaller companies and the burdens on
smaller companies, we are concerned about it and we are
concerned about seeing if we can't cut away some of the chaff,
if you will, in terms of the implementation of Sarbanes-Oxley.
The Chairman. Gentleman's time has expired.
The gentleman from Georgia, Mr. Scott.
Mr. Scott. Thank you, Mr. Chairman.
First, to you, Chairman Donaldson, I would like to ask you
about the New York Stock Exchange and their move of going
public. Is it your opinion it is a good move? I think from your
earlier comments I think you were saying it would promote
greater choice. Transparency might be better for faster
transactions. Is that a fair assessment?
Mr. Donaldson. Again, I am reluctant to comment publicly
since we do have to pass, if you will, ultimately on the stock
exchange proposal.
Let me say two things. Number one is that I believe the
proposal is reflective of the increasing competition between
markets; and I think that is very healthy. It is very healthy
not only domestically but as we emerge in a world order, if you
will, to make the U.S. markets even more competitive on a
worldwide basis.
Mr. Scott. Let me ask you this. Now it has gone public, it
comes under the purview of Sarbanes-Oxley. How do you feel that
Sarbanes-Oxley would fall into this? Particularly given the
past recent culture of the New York Stock Exchange, the recent
scandals, the recent settlement of the $257 million, of the
cheating of investors, some of the fallout from the Glasgow
situation, how do you feel Sarbanes-Oxley will fit into this?
How do you envision that?
Mr. Donaldson. Clearly, in terms of the independence of the
regulatory oversight at the New York Stock Exchange, I think a
significant improvement has been made. You are referring now to
things that happened before the structure was changed, the
fines that we have given, and I would say that we have been
very tough in enforcement.
Mr. Scott. The culture has improved.
Mr. Donaldson. And I believe the structure now and the
personnel that has been brought in on the regulatory side is
just what the SRO concept of oversight is all about.
Mr. Scott. Mr. McDonough, let me go to you; and,
incidentally, I want to thank you for stopping by my office. I
thought we had a delightful visit.
I want to talk about Section 404. Recently,
PriceWaterhouse, KPMG and Ernst & Ernst and I think it was
Deloitte Touche did a study, a survey, and in that survey it
came out that there was an average uniform cost of $7.8 million
for compliance with Section 404 and that the bulk of this was
one-time costs. Do you have any breakdown on what these one-
time costs were?
Secondly, it appears to be quite a bit. Do you foresee the
costs or expenses going down?
Mr. McDonough. Yes, Congressman Scott, I think they will go
down. How much they go down will vary a lot by company. If the
company had a lot of deferred maintenance, if they had to
document internal controls, that was very expensive. That
should be a one-time expense, and then they would have a big
drop from year to year. If you had a company that had better-
developed internal controls, the past year's costs would be
lower and, therefore, the likelihood of a big drop would be
less.
I think what we have to do--these conglomerate numbers are
all very interesting, but they don't tell you much. You have to
go in company by company and auditor by auditor and really see
if they have the level of internal controls that really make
sense for the nature of the issuing company. Some of them, in
my view, clearly have more bells and whistles than they need,
and that expense is inappropriate.
There is no question that there is enough anecdotal
evidence to figure out that some of the auditors have been
overdoing it and how much work that they have required. We
wished through the guidance through our standards group and
then through our inspection process to make sure that that
conduct gets improved as well.
Here is one where I think that you really go at it issuer
by issuer and audit engagement by audit engagement and try to
drive down the unnecessary cost. We still have to protect the
investors. That is what Sarbanes-Oxley is all about. But we
have to do it where it is most cost effective with the special
concern for the small- and medium-sized companies, that they
are not spending money that they really don't need to be
spending.
The Chairman. The gentleman's time has expired.
The gentleman from South Carolina.
Mr. Barrett of South Carolina. Thank you, Mr. Chairman.
Thank you, gentlemen, for being here today. Travel light
and hit hard.
Got two questions, real quick. Let us turn our attention to
Section 404, the SEC-issued guidance to the accounting industry
on certain treatment of the lease accounting practices. I have
gotten several letters. I have gotten one from the Retail
Leaders Industry Association, the National Restaurant
Association, even the Chamber. They have expressed concern that
retroactively applying these interpretations could have a
tremendous adverse effect on the economy. Why did SEC insist on
the interpretation being applied retroactively in the ninth
inning for the form 10-K?
Mr. Donaldson. On February 7, our chief accountant issued a
response to the AICPA in which he clarified the staff's
understanding regarding several lease accounting practices that
were not compliant with pre-existing and long-standing
accounting rules. These issues were initially identified by a
few companies and their auditors who had already concluded
without our staff involvement that certain leases had been
accounted for in error based upon long-standing GAAP
accounting.
So, basically, the restatement raises the issue of whether
a material weakness in internal controls exists for Section 404
reporting. The issue of whether a restatement constitutes a
material weakness in a particular instance is a matter to be
resolved through discussions between a company's management and
its auditors. It would be very difficult for us to
categorically conclude that a particular type of restatement is
never a material weakness. But the issue here was us trying to
face up to this inconsistency as quickly as we could,
particularly as the Section 404 compliance measures were
coming.
Mr. Barrett of South Carolina. I guess this leads into my
second question. When you are talking about material weakness,
due to some of the timings on these things, a lot of these
companies are having reports written about them that they do
have material weakness. My question is, how do I separate a
company like that from the Enrons out there that have some
serious material weaknesses? How do I differentiate between
those two?
Mr. Donaldson. Well, I think--and Chairman McDonough may
want to answer this. I think the material weakness is an
accounting concept, and it is something that must be arrived at
with the accounting profession according to auditing standards.
Beyond that, I mean, it is a matter of some judgment here as
between the auditors and the company itself and the company's
financial officials. I think the real issue here is the
correction of the material weaknesses; and, again, I think we
are going to see corrections coming quite rapidly.
Did you want to add to that.
Mr. McDonough. The decision of whether something is a
significant deficiency or material weakness has to be done case
by case.
Let us assume that the decision is made by the issuer and
the auditor it is a material weakness. The important thing is
that there be disclosure, disclosure, disclosure, disclosure.
Say exactly what happened, why it happened, what you plan to do
about it; and then the auditor should also opine that, yes, we
think that it is fixable in this way.
We have just brought out a proposed standard, Congressman,
that would say that if in the course of the year following a
fiscal year in which an issuer has a material weakness the
issuer says, I fixed the material weakness, and the issuer
says, but I think I better get my auditor to agree with me, we
are creating a methodology through a new rule that will
establish how the auditor goes about that.
In the real world, there are material weaknesses and
material weaknesses. Some of them would probably make any
sensible investor say, this is not a good company to be
investing in. Others you would say, okay, they made a mistake,
they admit it, and they are saying how they are going to fix
it, and I have confidence they will fix it.
The interesting thing is the securities market, if you
watch the stock market performance, some companies come out and
state a material weakness of the kind I described and explain
it well; stock market reaction is not detectable. On the other
hand, if they say that they have serious problems, the stock
market reaction is indeed predictable; it is down. I think it
is an indication that markets work.
Mr. Donaldson. As a former security analyst, one man's or
woman's material weakness may not be another's. There is an
accounting concept here, and then there is the marketplace. As
Chairman McDonough says, the marketplace will evaluate whether
an accountant's concept of material weakness is really
significant; and that will play out in the price of the stock.
The Chairman. Gentleman's time has expired.
Gentleman from New York, Mr. Meeks.
Mr. Meeks. Thank you, Mr. Chairman.
First, I want to thank Chairman McDonough for taking the
time to visit me in my office and establishing a relationship
when he first became the chairman of PCAOB; and I want to thank
you and your staff for arranging to have a meeting in your
offices, particularly Mary Hamlick. I want to thank you also
for your frankness and your testimony, a frankness that is not
often heard at this committee today.
Let me ask you a couple of quick questions, given that I
have heard the bells.
Mr. McDonough, in response to Chairman Oxley a short while
ago, you mentioned that more firms could be involved in
auditing if more issuers used auditing firms that match their
size instead of large firms. I was wondering, is there a way
that regulators or Congress can encourage this to happen?
Because one of my thoughts was there is only four firms that
are doing all of the auditing and to increase the number of
firms that are involved here, do you think there is any way
that we could encourage this to happen?
Mr. McDonough. I think we are actually doing it in this
dialogue and the one I had earlier with the chairman.
I think when the chairman of the PCAOB says that a smaller-
sized company or a community bank really ought to have an
auditor that is more appropriate to its size, that rather says
to that community bank or small company, well, if the chairman
of the PCAOB and Congressman Meeks agree that that is
appropriate, it kind of tells them it is okay. It isn't
necessary to have some big fancy auditing firm if it really
doesn't make a whole lot of sense for you.
Mr. McDonough. So I think that we are both using the bully
pulpit to get that message across.
Another thing I think that these smaller firms can do, and
this is a conversation we had with that very nice group that
came to see us at your arrangement. We want, because we think
it is most cost efficient, that you have an audit, which is an
audit of both the financial statement and of internal controls.
But a lot of companies actually need expert advice in
establishing internal controls, and that is something that a
smaller auditing firm could develop a real expertise at and be
able to get a nice flow of income by being an expert adviser on
people getting up good internal control mechanisms. And we at
that meeting, and now, I am really encouraging that
development.
Mr. Meeks. What about, do you think they would bring down
the cost of Section 404 by having the primary auditor
subcontract out to smaller firms? Do you think that that would
be a possibility, or do you believe that the regs are written
in such a way that subcontractor joint ventures are not viable?
Mr. McDonough. I don't think that would work. I was just
turning to Laura Phillips, whom we call Miss Internal Control,
and is my expert on this subject. The integrated audit we think
is really the way to go, and therefore to subcontract part of
the work, I just don't think it works. That is why I like the
idea better that the issue were, say, if we really need some
help in designing the internal controls, first of all, they
ought to hire another firm. Their auditor shouldn't do that
because you destroy independence in the process. So I think
that is how we can bring some new business to the smaller firm
as an expert adviser on the creation of internal controls.
Now, I do recognize that that is probably a one-time
proposition, but at least it brings them into the picture in as
constructive a way as I think I can figure out.
Mr. Meeks. Let me just ask this question. What are your
thoughts on mandatory auditor rotation? And should the SEC or
PCAOB have the authority to demand a change in auditors for a
company where they suspect the relationship may be too cozy or
where certain legal violations may have occurred?
Mr. McDonough. I believe that the SEC could order an issue
or two to change audit firms. So they have that authority. The
larger question, should we have a general requirement for
rotation of audit firms, unfortunately, I don't think it works
because if you look at the large number of larger companies
that deal with one of the big four audit firms, they would have
a real problem in moving to one of the others because of the
independence issue as we currently define it. If they have used
one of the other three firms--and the chances are pretty high
they have probably used all three of them for some kind of a
consulting project, that new firm to which they might think of
moving would flunk the independence test. It is one of the
reasons that, since we have only four very large firms, I have
a sincere continuing belief that we continue to have four very
large firms and that no accident will come along which would
present us with the enormous public policy challenge of what
would we do if we had three.
The Chairman. The gentleman's time has expired.
The Chair would indicate that because we have three 15-
minute votes pending on the floor of the House, which is
somewhat unprecedented, at least lately, and I have also been
informed that we would have to pay Mr. McDonough overtime--
Since you are paid by the taxpayers as I am, we would still
retain the same amount of pay, but Mr. McDonough is in a
different category. Having said that, we will plan to adjourn
the hearing.
Let me first thank both of you again for an excellent
hearing and excellent contributions, as usual, and indicate
that some members may have additional questions for the panel
which they may wish to submit in writing. Without objection,
the hearing record will remain open for 30 days for members to
submit written questions to those witnesses and to place their
responses in the record. And, without objection, correspondence
from the American Bankers Association regarding the
implementation of the Sarbanes-Oxley Act will be made part of
the record.
[The following information can be found on page 90 in the
appendix.]
The Chairman. No further business coming before the
Committee, the Committee stands adjourned.
[Whereupon, at 12:05 p.m., the Committee was adjourned.]
A P P E N D I X
April 21, 2005
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