Hearing on "Accounting and Investor Protection Issues Raised
by Enron and Other Public Companies."

Good morning, Mr. Chairman, Senator Gramm and members of the Committee. My name is Howard M. Metzenbaum and I now serve as Chairman of the Consumer Federation of America (CFA). CFA is a non-profit association of some 300 pro-consumer organizations, with a combined membership of over 50 million Americans. I appreciate your invitation to offer my comments on this very important issue. I am especially pleased to appear before my old friend and colleague, Chairman Sarbanes.

I spent my career in the U.S. Senate working to prevent corporations from running roughshod over the rights of consumers and workers. I have to tell you that I have never seen a more appalling example of heartless, unfettered corporate greed than in the Enron debacle. This company lied to their investors, lied to their employees, hid crucial information about their finances and tried to improperly influence government officials. And in criminally indicting Enron's auditing firm, Arthur Andersen, the Department of Justice has said that it believes that Andersen was a party to this massive deception.

How could this energy giant have gone from number seven on the Fortune 500 to bankruptcy court almost overnight? The answer, of course, is that it didn't. The problems that ultimately brought Enron down were a long time in the making. They were simply hidden from investors' eyes. That revelation has prompted an even more pressing question, since it has broader implications for investors in all publicly traded companies: Given all the safeguards in our system designed to ensure investors receive full and fair disclosure, how could Enron have succeeded for so long in presenting a false picture of financial health? The disturbing answer is that, in this case as in others, all the safeguards designed to protect investors failed, and failed miserably.

1) The rules that dictate what information companies have to disclose and how they have to disclose it failed to produce an accurate picture of Enron's finances, even where the company complied with the rules.

2) The corporate board that is supposed to supervise management failed to ask the tough questions, challenge questionable practices, or require more transparent disclosure.

3) The auditors, whose job it is to certify that financial disclosures are not only prepared according to the rules but present an accurate picture of company finances, signed off on financial statements that clearly failed that test.

4) The Securities and Exchange Commission, which also has responsibility for reviewing corporate disclosures, had not reviewed the energy giants complex financial statements since 1997.

5) The credit ratings agencies and securities analysts -- outside experts that investors rely on to analyze all the available information and provide an independent assessment of the company's credit- or invest-worthiness -- did not provide any advance warning of possible trouble.

In short, the real story out of the Enron disaster, at least for policymakers, is not that its corporate managers went to great lengths to hide the company's indebtedness and artificially inflate its earnings. Our system was designed with just that sort of behavior in mind. The real story is that all the safeguards that we rely on to keep corporate executives honest failed. Clearly, key parts of the system are broken, and it is Congress's job to fix them. Only a comprehensive package of strong reforms will do the job.

I. Restore value and integrity to the independent audit.

The most important thing Congress can do is restore value to the independent audit. To accomplish this, it must enhance auditor independence, provide effective regulatory oversight of accountants, and restore the threat of private litigation as a strong deterrent to wrong-doing.

A. Make the "independent" audit truly independent.

1. The independent audit has never been more important.

The whole point of requiring public companies to obtain an independent audit is to ensure that outside experts have reviewed the company books and determined that they not only comply with the letter of accounting rules but also present a fair and accurate picture of the company's finances. Auditors have profited handsomely over the years from performing this important public watchdog function. Unless the auditor is free of bias, brings an appropriate level of professional skepticism to the task, and feels free to challenge management decisions, however, the audit has no more value than if the company were allowed to certify its own books.

The independent audit is arguably more important today than it has been at any time since the requirement was first imposed in the 1930s. More than half of all American households today invest in public companies, either directly or though mutual funds. They do so primarily to save for retirement. As a result, their financial well-being later in life is dependent on the integrity of our financial markets.

At the same time, corporations today are under great pressure to keep their stock prices on a smooth upward trajectory. As one writer has noted:

"No longer is a higher stock price simply desirable, it is often essential, because stocks have become a vital way for companies to run their businesses. The growing use of stock to make acquisitions and to guarantee the debt of off-the-books partnerships means, as with Enron, that the entire partnership edifice can come crashing down with the fall of the underlying stock that props up the system. And the growing use of the stock market as a place for companies to raise capital means a high stock price can be the difference between failure and success." ⁽¹⁾

Corporate managers have a strong incentive to manage their earnings in order to present the picture of steadily rising profitability that Wall Street rewards. And, as the Enron case clearly illustrates, murky accounting rules that rely on numerous subjective judgments make it easier than it should be to construct a false picture of financial health. The Enron case also makes it abundantly clear that an auditor whose independence is compromised may be all too willing to sign off on financial statements that conceal, rather than reveal, the company's true financial state.

Finally, Enron's dramatic collapse, and Arthur Andersen's obvious complicity, have shaken public confidence in the reliability of companies' financial statements. That adds an unhealthy element of uncertainty to financial markets. As the SEC noted when it proposed its auditor independence rules in 2000: "Investors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance that the financial information disclosed by issuers is reliable. Independent auditors play a key role in providing that assurance."

2. Many factors undermine auditor independence.

Because of the central importance of the outside audit in upholding the integrity of our system of financial disclosure, the Supreme Court has stated that this "public watchdog function demands that the accountant maintain total independence from the client at all times." Unfortunately, accountants have shown virtually no real willingness to accept the responsibility for maintaining their independence that goes with the privilege of performing audits.

Since the mid-1990s, most of the big firms have dramatically increased their sales of consulting and other non-audit services to their audit clients, despite the clear conflict of interest that this creates. Today, virtually all big companies receive both audit and non-audit services from their accountants, and they typically pay between two and three times as much for the non-audit services as they do for the audit itself. In some cases, the disparity between audit and non-audit fees is far greater. Furthermore, consulting services increasingly drive the profitability of accounting firms. If an auditor's tough questioning of management were to threaten its more profitable consulting arrangement, that auditor might expect to face tough questioning of his own from higher ups at the firm.

Other factors also undermine auditor independence. The lack of independence starts with the fact that auditors are hired, paid, and fired by the audit client. This basic conflict is exacerbated by the general lack of client turnover. Auditors may reasonably expect to keep the same client for 20, 30, even 50 years. These long relationships make it that much harder for the auditor to challenge management aggressively, not only because of the friendships that are likely to develop between auditors and company management, but also because they risk losing this seemingly endless stream of future audit revenues if their tough questioning causes them to lose the client.

Another problem that clearly needs to be addressed is the revolving door that all too often exists between auditors an their audit clients. This was true at Enron, it was true at Waste Management, and it is a common feature in many failed audits. A constant flow of personnel from the auditor to the audit client helps to create an environment in which external auditors are viewed as just another part of the corporate family. Such intimacy is not conducive to true independence.

3. Comprehensive reforms will be needed to restore auditor independence.

The only way to provide complete independence to the outside audit is to take it out of the private sector. Rep. Kucinich has introduced legislation (H.R. 3795) that would create a Federal Bureau of Auditing in the SEC, and CFA has endorsed that legislation. But other less radical approaches could significantly enhance auditor independence while leaving it in the private sector. Some have suggested, for example, making the exchanges responsible for hiring accounting firms to audit the companies that trade there. The idea behind this approach is that it would minimize the company's financial leverage over the auditor, and that auditors would as a result be more likely to perceive themselves as working for investors, rather than for the audited company. This is an intriguing suggestion that we believe deserves further exploration.

Another idea that has gained some high-powered and highly credible backers is the idea of requiring periodic mandatory rotation of auditors. An audit firm that knows it has a limited term of engagement has significantly less to lose by challenging management than one that expects to retain the client indefinitely. This approach has costs as well, in the form of the learning curve at the start of an audit rotation. However, such costs can be minimized by setting a sufficiently long rotation period of five to seven years. Because such an approach would significantly enhance auditor independence, we believe the benefits far outweigh the costs.

This mandatory rotation of auditors should be combined with a broad ban on provision of non-audit services to audit clients. Certain services could be exempt, on a case-by-case basis, if it is shown that these services are closely related to the audit, directly enhance the quality of the audit, benefit investors, and create negligible conflicts of interest for the audit firm. If any such non-audit services are permitted, they should have to be directly and separately approved by the audit committee of the board. Finally, to close the revolving door between audit firms and their audit clients, there should be a two to three year cooling off period after their involvement in the audit has ended during which members of the audit team would be prohibited from seeking or accepting employment with a former audit client.

A strong package of reforms along this line would restore real integrity and value to the independent audit. That, in turn, should go a long way toward restoring investor confidence in the reliability of corporate disclosures.

B. Provide effective regulatory oversight of accountants.

If auditors face numerous pressures to sign off on questionable accounting practices, they face relatively little fear of sanctions if they do. Although a variety of groups including the SEC, state accountancy boards, and the AICPA all have power to discipline auditing firms and their employees for ethical and legal infractions, even serious violations typically receive little more than a hand slap.

1. The current "regulatory" system is under-funded, ineffective, and captive of the industry.

In theory, the real authority over auditors lies with the SEC. It has the power to bar individuals and firms from auditing publicly traded companies. It also has authority to impose potentially substantial fines. In reality, however, the agency does not routinely review how auditors perform their audits, and instead delegates that responsibility to the AICPA and its Public Oversight Board. Furthermore, according to past agency officials, the SEC only has the resources to tackle the very worst cases of alleged accounting abuse, and it typically settles even those cases without an admission of wrongdoing. It took no action, for example, against a former Arthur Andersen managing partner whom the SEC said had allowed persistent misstatements on Waste Management's financial reports to go uncorrected. ⁽²⁾ Similarly, a PricewaterhouseCoopers partner ordered by the SEC in 1999 to cease and desist violating securities laws didn't even lose his position as lead partner on the audit in question. ⁽³⁾

The AICPA sets audit standards, oversees through its affiliated Public Oversight Board a peer review system to determine compliance with those standards, and has disciplinary authority over its members for violations. According to former SEC chief accountant Lynn Turner, however, the audit standards adopted by AICPA are "so general that, as a practical matter, it's difficult to hold anyone accountable for not following them." ⁽⁴⁾ The POB, ⁽⁵⁾ which is responsible for overseeing the industry's peer review system and other ethics investigations, is notable for having never sanctioned a major accounting firm in its 25 years of existence, even when peer reviews have uncovered serious short-comings in a firm's audit procedures. ⁽⁶⁾ Furthermore, the POB can't act against a firm without the AICPA's cooperation. In one case where, at the SEC's prompting, the POB did attempt to investigate possible stock-ownership violations at the major firms, the AICPA refused funding for and cooperation with the investigation, which as a result went nowhere. ⁽⁷⁾

Even if they had the will to act, the AICPA and POB are also hampered by a severe lack of investigative authority. They cannot subpoena evidence, for example, and as a result are forced to rely on the public record in building a case. If the SEC settles a case confidentially, with neither a public ruling nor an admission of guilt, there is no public record the AICPA or POB can rely on in bringing its own enforcement actions. Where the AICPA does act, its maximum sanction is expulsion from the organization, which can have serious consequences, but does not prevent the individual from continuing to practice.

In reality, however, AICPA has shown itself to be a reluctant regulator. According to a Washington Post investigation, the AICPA took disciplinary action in fewer than a fifth of the cases in which the SEC imposed sanctions over the past decade. Even when AICPA determined that SEC-sanctioned accountants had committed violations, they closed the vast majority of ethics cases without disciplinary action or public disclosure. ⁽⁸⁾ The disciplinary action AICPA was most likely to take, according to the Post investigation, was issuing a confidential letter directing the offender to undergo additional training. Ethics committee member Dave Cotton has reported seeing "ethical lapses that resulted in millions of dollars of losses get punished with as little as 16 hours of continuing education." ⁽⁹⁾

2. A complete overhaul of the system is needed.

Some policymakers, including SEC Chairman Harvey Pitt and several members of Congress, have recommended creation of an independent regulatory organization for accountants. Others have argued that the SEC should be given enhanced responsibilities in this area. Regardless of which approach is adopted, it is clear that improved oversight is needed. The following are some principles that must be incorporated in any such plan.

a. It must be independent of the accounting industry.

As one former SEC official observed to Business Week, "The accounting profession is very creative at taking over every group that's ever tried to rein it in." ⁽¹⁰⁾ For a self-regulatory organization to have any credibility, therefore, its independence must be unassailable. At a minimum, a super majority of board members must have no ties whatsoever to the accounting industry, and they must be subject to conflict of interest rules that prohibit ties to the industry for a significant period after they leave the board. Just as important, funding for the organization must be totally free from threat by industry members. The AICPA and the Big Five firms have shown their willingness to use strong arm tactics to head off potentially embarrassing investigations in the past. They must have no such hold over any SRO that is created to provide enhanced oversight in the wake of the Enron-Andersen disaster.

Because of the tendency of self-regulatory organizations to identify with the industries they regulate, rather than the public, CFA has generally favored direct government oversight over the SRO approach. In this case, that would take the form of direct SEC regulatory oversight of accountants. However, such an approach does not offer a perfect solution. The accounting industry has shown itself to be more than capable of influencing SEC actions, the most recent example being the industry's ability to force the agency to back off the toughest components of its proposed auditor independence rules by lining up members of Congress to intervene.

b. It must be adequately funded.

Whether the SEC or an SRO assumes responsibility for rulemaking, inspections, investigations, and disciplinary actions against auditors, the effort must be generously funded. Because the SEC's budget has for two decades failed to keep pace with the growth in its workload, the SEC today is severely under-funded. By passing SEC fee-reduction legislation last year without first raising the agency's budget to an appropriate level, Congress increased the likelihood that the agency will continue to be hampered by a shortage of funds in the future. The president's proposed FY 2003 budget for the agency includes no significant increase in funding, not even enough to fund the pay parity provisions enacted last year. This raises serious concerns about the willingness of Congress and the administration to adequately fund enhanced SEC oversight of auditors without robbing other high priority agency activities. One of the most favorable aspects of a proposal the create an independent regulatory body (provided it is unassailably independent) is that it offers the opportunity to ensure both adequate funding and the higher pay scales that make it easier to attract top investigation and enforcement staff.

c. It must have rule-making authority.

Chairman Pitt's SRO proposal appears to anticipate leaving authority for developing auditing standards with the AICPA. This is unacceptable. Rules on how to conduct audits clearly need to be strengthened and clarified. That is the job of an independent regulator, not an industry trade association. Either the SEC or an SRO operating under SEC supervision must be given authority to set both auditing and quality control standards. The AICPA, as a trade association, should have no government-recognized role in the regulatory process.

d. It must have strong investigative and enforcement authority.

If oversight of accountants is delegated to an SRO, that SRO must have the ability to conduct routine, thorough inspections of audit firms to determine their compliance with auditing standards. It also must have extensive powers to conduct timely investigations of suspected abuses, including the power to subpoena witnesses and records from both auditors and the public companies they audit. And it must have the ability to impose meaningful penalties for violations.

It has also been suggested that, in cases where companies are forced to restate their earnings, a team of forensic accountants be dispatched immediately to investigate. ⁽¹¹⁾ At the end of their investigation, they would issue a public report on what went wrong and what is being done to correct the problem. Possible recommendations might include revisions to accounting rules, revisions to auditing standards, changes in audit practices at the firm under investigation, etc. The SRO would then have authority to ensure that those changes were made. We believe this offers a good model for appropriate corrective action where problems are exposed either at a particular firm or in the system more generally.

C. Reform private litigation laws to provide a real deterrent to wrong-doing.

Private litigation has long been viewed as an important supplement to regulation, since the threat of having to pay significant financial damages provides an incentive to comply with even poorly enforced laws. In 1995, however, Congress passed the Private Securities Litigation Reform Act, which significantly reduced auditors' liability in cases of securities fraud. ⁽¹²⁾ It did so, both by making it more difficult to bring a case against accountants and by reducing their financial exposure where they are found to have contributed to fraud.

It is not enough, in a securities fraud lawsuit, to show that an auditor made a materially false statement. You must also show that the auditor acted with an intent to defraud or a reckless disregard for the truth or accuracy of the statement. PSLRA set pleading standards with regard to state of mind that create a Catch 22 for plaintiffs' attorneys. They must present detailed facts showing the defendant acted with requisite state of mind, and they must do this before they gain access through discovery to the documents they need to establish state of mind. If plaintiffs can't meet the pleading standards, the case is dismissed.

In addition to making it more difficult for securities fraud victims to bring private lawsuits against accountants, PSLRA reduced accountants' liability when they are found to have contributed to fraud. The primary way it accomplished this was by replacing joint and several liability with a system of proportionate liability. Thus, accountants who are found to have contributed to securities fraud no longer have to fear being forced to pay the full amount of any damages awarded should the primary perpetrator be bankrupt. Under proportionate liability, the culpable accountant cannot be forced to pay more than their proportionate share of damages. As a result, according noted securities law expert Professor John C. Coffee, Jr., accountants will rarely be forced to may more than 25 percent of the losses. ⁽¹³⁾

PSLRA was also notable for what it didn't do. It failed to extend the federal law's very short statute of limitations for securities fraud of no more than three years from the time of the wrongdoing. This rewards those who are able to cover up their fraud for the relatively short period of three years and guarantees, for example, that some claims against Enron and Andersen will be time-barred. PSLRA also failed to restore aiding and abetting liability under securities fraud laws, which the Supreme Court's 1994 Central Bank of Denver decision eliminated as a potential cause of action. Thus, accountants can only be sued as primary perpetrators of securities fraud, not for their role in aiding and abetting that fraud.

The result is that the threat of private lawsuits now poses a diminished deterrent to accounting fraud. Restoring reasonable liability for culpable accountants should be part of any overall reform plan. This should include provisions: to enable plaintiffs to gain access to documents through discovery before having to meet the heightened pleading standards regarding state of mind; to restore joint and several liability where the defendant recklessly violated securities laws and the primary wrong-doer is bankrupt; to restore aiding and abetting liability for those who contribute to fraud but are not the primary culprit; and to extend the statute of limitations for securities fraud lawsuits.

II. The independent audit must be backed up by an aggressive, fully funded SEC.

In the wake of Enron's collapse, many have asked, "where was the SEC?" Given the SEC's responsibility for reviewing public company's financial disclosures, why had the agency not detected the company's problematic accounting earlier? One answer is that the SEC had not reviewed Enron's financial disclosures since 1997. The reason is that the agency is so understaffed it is only able to review a small percentage of filings each year.

This committee recently heard testimony from the head of General Accounting Office on the devastating effect that under-funding is having on the SEC's ability to perform its assigned tasks. The recent GAO report that formed the basis for that testimony looks at the growth in workload at the agency since the start of the 1990s, and documents the degree to which funding has failed to keep pace. It tells only half the story. The real damage to SEC funding occurred before the period covered by the report, in the 1980s, when staffing stayed virtually flat while the industry experienced dramatic growth.

In 1980, for example, there were just over 8,000 publicly traded companies filing annual reports, according to a report commissioned in 1988 by the Securities Subcomittee of this committee, ⁽¹⁴⁾ and there were 710 new registration statements filed. Excluding the staff for electronic filing and information services, 420 staff years were devoted to disclosure matters. As a result, the agency was able to review all transactional filings.

In 2000, the number of staff years devoted to full disclosure (again excluding the staff for electronic filing and information services), had dropped to 356, according to the SEC's analysis of the president's proposed FY 2002 budget. As a result of diminished staffing, dramatic growth in the number of publicly traded companies, and increased workload associated with review of initial offerings, "the percentage of all corporate filings that received a full review, a full financial review, or were just monitored for specific disclosure items" decreased to about eight percent in 2000, according to the GAO report. Because of a dramatic drop-off in the number of IPOs in 2001, the SEC was able to complete "full or full financial reviews of about 16 percent, or 2,280 of 14,060 annual reports filed" last year, the GAO report found.

Among the financial statements that was passed over for review because of this staffing shortfall were the financial statements for Enron from 1998, 1999, and 2000. Although it is impossible to know whether more regular, more thorough reviews would have nipped the accounting problems at Enron in the bud, it is reasonable to think they might have. Certainly, it is irresponsible to so grossly under-fund the federal regulators that they can't hope to fulfill the important responsibilities assigned to them.

Last year, Congress had a historic opportunity to fix this problem. A decision was made not to use SEC-generated fees to fund other areas of the government. As a result, the agency no longer had to compete with other federal priorities in justifying its budget. Instead of taking that opportunity to dramatically boost agency funding, Congress approved a budget that required additional staffing cuts and passed legislation to reduce agency imposed fees to reflect that inadequate budget. Members of this committee fought to provide a funding boost, but those efforts were ultimately unsuccessful.

The collapse of Enron has focused new attention on the issue of SEC funding. Because of Enron, most of that attention is focused on staffing issues related to full disclosure and enforcement. These are important priorities that certainly need a funding boost, but similar trends have affected all areas of SEC responsibility. Think of what has happened in that time in the area of mutual funds or financial planning since the beginning of the 1980s. Think of how many more households are now participants in the markets and thus vulnerable to wrongdoing. The GAO report commissioned by this committee has helped to make the case for across-the-board significant funding increases for the SEC. That case is even more powerful when the numbers from the 1980s are taken into account. Members of this committee must make a priority of undoing the damage of last year's fee reduction legislation and providing a budget for the SEC that is commensurate with its responsibilities.

III. Study credit ratings agencies to determine why they failed to provide an earlier warning of problems.

Another troubling aspect of the Enron collapse is the failure of credit rating agencies to provide an early warning of trouble. In fact, both Moody's and Standard & Poor's still had Enron at investment grade until just five days before it filed for bankruptcy. According to a Bloomberg News account, Moody's had decided to downgrade Enron to junk in early November, but backed down in response to lobbying from Dynegy, which was then negotiating a takeover of Enron, and its bankers. ⁽¹⁵⁾ Although this raises serious questions about the objectivity of the ratings, it is unclear that an earlier downgrade would have changed things for investors. A credit rating is not just an isolated measure of a company's financial health. A downgrade may not just reflect the company's worsening financial status, it can trigger further financial woes, as it did for Enron.

We strongly encourage this committee to conduct a further study of this issue to assess whether the operations of credit ratings agencies are adequate to ensure accurate ratings and, if not, what should be done to enhance the quality of ratings. That study should examine the extent to which recently announced changes by the ratings agencies are likely to provide the desired improvement. It should also examine whether lack of competition in the industry is contributing to the problem. We expect that a thorough review will identify areas in need of additional reform.

IV. Study measures to address securities analyst conflicts of interest to determine whether additional protections are needed.

Credit ratings agencies were not alone in missing the warning signs. In early November, after the SEC had already announced it was looking into Enron's partnership transactions, ten of fifteen analysts who followed Enron still rated it as a "buy" or "strong buy." One reason, as the analysts are quick to point out, is that they were not getting good information from Enron's financial statements. Another is that Enron was apparently actively and intentionally misleading analysts about activity on its trading floor, for example.

However, this offers only a limited explanation. Red flags were there for those who were looking. And many now looking back -- albeit with the benefit of 20-20 hindsight -- have been able to point out obvious danger signs. These included wide discrepancies between the company's reported earnings and its retained earnings, negative cash flow of $2.56 billion in 2000 once proceeds from asset sales and other one-time activities not part of its core business were deducted, and actual revenues on energy trading that were a mere fraction of those that accounting rules let the company claim. ⁽¹⁶⁾ Surely it is analysts' job to look for just such clues and to probe deeper than the surface of company disclosures.

Another reason analysts may have missed these signs is that they simply weren't looking. After all, negative reports don't attract investment banking business, and Enron was clearly seen as a huge potential source of such deals. Since investment banking business is far more profitable than the retail sales business for large Wall Street firms, it is hardly surprising that those firms use their research arms to support their investment banking business. In the process, their research has become so compromised by conflicts of interest that it has no real credibility.

Recently, new rules have been proposed to address analyst conflicts of interest. They do so by attempting to limit the investment banking department's influence over research, limit analysts' investments in pre-IPO shares of companies in the industry they cover, limiting their purchase or sale of securities during a window of time around the release of a new research report, and prohibiting trades against their own recommendations, and requiring better disclosure of conflicts. We view this as a very positive step in the right direction, and will be commenting on the rules as they move through the approval process. However, we believe more should be done in several areas, including banning compensation for analysts that is tied in any way to investment banking profits, improving the clarity and relevance of required disclosures, and extending disclosure to recommendations by sales representatives to retail clients based on the company's research. We encourage this committee to further study this issue to determine whether additional steps to enhance analyst independence may be necessary.

V. Protect FASB's independence.

In the wake of Enron's collapse, Arthur Andersen has tried to blame inadequate accounting rules -- rather than its own poor performance as auditor -- for Enron's less-than-transparent financial disclosures. This ignores the fact that Enron's financial statements have been shown to contain several violations of existing rules. ⁽¹⁷⁾ It also ignores Andersen's responsibility as auditor to ensure not just that Enron's disclosures complied with the letter of existing rules, but also that they presented an accurate picture of Enron's overall financial status. However, this is not an either-or proposition. It is in fact the case that Andersen failed in its responsibility as auditor and existing accounting rules are inadequate.

One reason is the inability of the Financial Accounting Standards Board to produce strong rules in a timely fashion when faced with entrenched opposition from large corporations and accounting firms. It is difficult to criticize FASB for moving too slowly on improved accounting rules governing special purpose entities, for example, when their past efforts to pass similarly controversial rules -- regarding pooling of interest accounting for mergers, derivatives disclosures, and accounting for stock options -- have met strong resistance, not just from business, but also from members of Congress.

Something needs to be done to enhance FASB's independence. This is a difficult issue to tackle, since FASB is a private entity not subject to government oversight. We applaud Senators Dodd and Corzine for tackling this issue in their recently introduced legislation. We believe the approach they have outlined -- by giving the SEC greater say in FASB's agenda and by guaranteeing an independent funding source for FASB -- offers the possibility of real progress. In addition, certain members of Congress must recognize that they have played a key role in undermining FASB's independence in the past and should refrain from interfering inappropriately in the future.

VI. Improve corporate governance standards.

Enron's independent board members, and particularly the board audit committee, have come in for considerable criticism for authorizing some of the company's more controversial partnership deals and for failing to ensure clear, accurate financial disclosures. While it may be unrealistic to suppose that board audit committees will ever be equipped to closely scrutinize and challenge the outside auditor's work, steps can and should be taken to enhance the independence and expertise of independent board members. This committee could play a valuable role by examining what additional steps are needed to improve corporate governance practices.

As a first step, exchanges must be pressed to adopt tough standards for determining the independence of board members and to require that a majority of board members for listed companies meet these standards. ⁽¹⁸⁾ A starting point should be the 1999 recommendations of an SEC-appointed blue ribbon commission. Among other things, that commission recommended that all audit committee members be financially sophisticated independent board members, and that at least one member have expertise in accounting or financial management. ⁽¹⁹⁾

Unfortunately, those standards have never been fully embraced by the major exchanges. Under its listing rules, for example, the New York Stock Exchange permits directors on the company payroll to serve on the audit committee, along with former employees and their families after a three-year cooling off period, and board members with significant business relationships with the company, if the board determines those ties won't interfere with the board member's judgment. ⁽²⁰⁾ If the exchanges fail to act voluntarily to improve board member independence standards, Congress and the SEC should call them to account.

VII. Conclusion

The collapse of Enron has provided a clarion call for reform. It has exposed gaping holes in the investor protections we rely on to keep corporate managers honest. Enron is not unique. These same shortcomings apply to all publicly traded companies. We are fortunate that so many company managers have remained committed to providing clear, accurate disclosures to investors. But we cannot rely exclusively on their integrity. We need a system that works even when company managers are greedy and overly aggressive. Congress can repair the gaps in the current system. It is of paramount importance that you do so.

Notes:

^1. "Deciphering the Black Box: Many Accounting Practices, Not Just Enron's, Are Hard to Penetrate," by Steve Liesman, Wall Street Journal, January 23, 2002, pg. C1+.

^2. Ibid.

^3. Ibid.

^4. "After Enron, New Doubts About Auditors," by David Hilzenrath, Washington Post, December 5, 2001, pg. A01.

^5. The POB recently voted itself out of existence in protest over SEC Chairman Harvey Pitt's proposal to create a new self-regulatory body for the accounting industry.

^6. "Peer Pressure: SEC Saw Accounting Flaw," by Jonathan Weil and Scot J. Paltrow, Wall Street Journal, January 25, 2002, pg. C1.

^7. The case is described both in a May 12, 2000 letter from Rep. John Dingell (D-MI) to the SEC Chairman Arthur Levitt and in a May 22, 2000 Business Week editorial, "Why the Auditors Need Auditing."

^8. Ibid.

^9. "CPAs (and I'm One) Can Reverse Their Losses," by Dave Cotton, Washington Post, January 27, 2002, Op Ed.

^10. "Accounting in Crisis," by Nanette Byrnes with Mike McNamee, Diane Brady, Louis Lavelle, Christopher Palmeri, and bureau reports, Business Week, January 28, 2002, pg. 44-48.

^11. "Auditors Face Scant Discipline, Review Process Lacks Resources, Coordination, Will," by David S. Hilzenrath, Washington Post, December 6, 2001, pg. A01.

^12. PSLRA also all but guaranteed that Enron's victims will receive mere pennies on the dollar in any recovery.

^13. "The Enron Debacle and Gatekeeper Liability: Why Would the Gatekeepers Remain Silent?" Professor John C. Coffee, Jr., Adolf Berle Professor of Law, Columbia University Law School, testimony before the Senate Committee on Commerce, Science and Transportation, December 18, 2001.

^14. Self-Funding Study, prepared by the Office of the Executive Director of the U.S. Securities and Exchange Committee, submitted in partial response to the request of the Securities Subcommittee of the Senate Committee on Banking, Housing and Urban Affairs (S. Rpt. 100-105), December 20, 1988.

^15. "Moody's Enron Rating Shows Lack of Independence," Mark Gilbert, Bloomberg News, November 15, 2001.

^16. "How 287 Turned Into 7: Lessons in Fuzzy Math," by Gretchen Morgenson, New York Times, January 20, 2002, Section 3, page 1.

^17. In his January 24, 2002 testimony before the Senate Committee on Governmental Affairs, former SEC chief accountant Lynn Turner outlined four areas of noncompliance with existing rules.

^18. In his January 24, 2002 testimony before the Committee on Governmental Affairs of the U.S. Senate, former SEC Chairman Arthur Levitt said independent board members should be precluded from receiving consulting fees, using corporate aircraft without reimbursement, accepting support of director-connected philanthropies, "or other seductions."

^19. "Accounting in Crisis," by Nanette Byrnes with Mike McNamee, Diane Brady, Louis Lavell, Christopher Palmeri, and bureau reports, Business Week, January 28, 2002, pg. 44-48.

^20. Ibid.

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