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

We are all Enron exhausted, so I’ll start with the bottom line.

Accountants sign off on financials that trick investors because we let them. CEOs pay themselves hundreds of millions of dollars, even when they bankrupt their companies, because we let them. Boards look the other way because we let them.

There are almost no consequences for individuals who commit corporate crimes. There are almost no consequences for board members, CEOs, auditors, analysts, rating agencies and government employees who fail to do their jobs. Even honest people start behaving badly when there are no consequences. Especially when the reward is hundreds of millions of dollars.

This is not an Enron issue. Enron is already old news—questions about Global Crossing, PNC, WorldCom and A.C.L.N. all post-date it.

People will behave badly to get great wealth if the stock exchanges don’t stop them. If the SEC doesn’t deter them. If FASB and the AICPA enable them. If prosecutors rarely go after them. And if you legislate loopholes.

The causes of this problem are not recent. Frauds are bigger and more frequent because the laws that were passed 65 years ago to protect shareholders have been steadily worn down by special interests. Indeed, our laws now protect executives, accountants and financial wheeler/dealers at shareholders’ expense instead of the other way round. We are reaping the harvest of this multi-decade legal hijacking now.

Great civilizations in history crumble when special interests take control of government machinery and use it for their benefit. I am well aware that these special interests are applying heavy pressure to each of you right now. If history is any guide, you will give in. I am begging you not to. The fact that we’ve had a good run of it the past 200 years doesn’t mean we will in the future unless you reverse this erosion average Americans’ protections.

What most urgently has to be done? Let’s start with the auditors.

Right now we allow managers to pick and pay people to bless their work. If fifth graders picked their teachers, fifth graders would get As. People invariably act in their self interest.

Not only that. We allow auditors and managers to write accounting and auditing standards. If fifth graders wrote grading standards, all fifth graders would pass. People invariably act in their self interest. So who can be surprised that we have loophole-ridden, outdated standards that permit amazing things—what is permissible under current standards is more amazing than what is not.

Not only that. We allow auditors to fund and run their own professional oversight. You all know better than that. No profession self polices effectively. People invariably act in their self interest.

What should you pass? Legislation that aligns auditors’ interests with shareholders’ and that stops aligning auditors’ interests with the managers whose numbers they review. Unless it is in auditors’ financial interest to protect shareholders, it won’t happen reliably enough. You also need legislation that keeps oversight and enforcement power free of undue influence by auditors and issuers.

Specifically: One. Require the board audit committee, not the managers, to hire the auditors. This is critical. Two. Fix FASB’s and the AICPA’s accounting and audit standard-setting systems with guaranteed funding and better accountability to investors—current accounting principles gave Enron crater-size loopholes. In other words fix the system for setting accounting and auditing standards, not just a couple of the worst products of the current systems. Three. Require CEOs, audit committee members and outside auditors to sign the financials as true and accurate—just like you and I sign our tax returns. (You think twice, don’t you, when you sign?) Four. Remove non-trivial conflicts of interest—conflicts affect behavior. And five. Come down hard on individuals—not just companies—who break the law. If you merely fine audit companies for fraud, you simply increase a company’s cost of doing business. Anderson settled case after case, wrote checks and moved on.

Relying on peoples’ honor or professionalism will not work. Chinese walls never work. Independent bodies don’t remain independent long. Unless you harness self interest as the legislative motivator, you will keep getting misleading financials.

But auditors are only partly to blame for this mess. If your legislation focuses mostly on audit reform, it will be ineffective.

It is not the auditor’s job to oversee the company. It is not the auditor’s job to detect fraud, absent certain red flags. It is not the auditor’s job to prevent self dealing or make business decisions. It is not the auditor’s job to set the tone at the top and say it is wrong to lend a rich CEO 341 million dollars. It is not the auditor’s job to create secure jobs and shareholder value. These are jobs for managers and boards.

Why have so many boards allowed terrible things to happen? Let me ask you this: if your staffers had absolute power to remove you from office, would you discipline them if they were stealing? Our system allows executives to pick the boards who are supposed to police them. So, although boards are supposed to represent shareholders, they don’t. You participate in real elections so you care about your constituency. We shareholders should be so lucky.

Fixing this fundamental misalignment is more important to fraud prevention than auditor independence because a board’s responsibilities are more critical to a company’s health. Yet current laws, rather than helping shareholders keep companies accountable, do the opposite. I’ll give you a few examples.

1. If a shareholder buys a mere 5% of a company’s stock, he/she has to file forms as if the government is tracking a pedophile rather than an owner. The only way a shareholder can avoid this is to file a form promising to be passive. I’m not making this up. So shareholders without expensive form-filing lawyers have to promise to remain inert. Large pension funds that might otherwise be willing to pressure a troubled company, and who do not seek control, remain inert rather than filing burdensome forms that bring litigation risks with them. These requirements should be reworked.
2. The government tells us what issues we can and cannot bring up with our own employees—company executives. The SEC decides what issues shareholders can raise for a shareholder vote. Have any of you read these rules? They take almost every issue a shareholder ought to want to raise off the table:

--We cannot ask about anything that is "ordinary business"—which covers almost everything we should care about.

--We can’t ask about anything that is extraordinary business either if an issue affects only a small part of the company.

--We cannot ask about the thing we should most want to ask about—the election of the company’s actual board. I’m still not kidding.

Many of the problems at Enron would be off limits for shareholders to raise under current rules.

Worse, the SEC is free to, and often does, change its interpretations of these rules, without warning or recourse, so we don’t know from one year to the next what we can ask.

3. When the SEC does allow a shareholder to raise an issue for a vote, it requires the shareholder to send someone to the annual meeting, even though few companies require their own directors to attend and most shareholders vote by proxy and not in person. If the shareholder’s rep isn’t there, the company can cancel the vote. So if you are disabled, have a job, are not rich or can’t travel, forget it.
4. As if this isn’t enough, companies can, and do, move their annual meetings to hard-to-reach places, even foreign countries, so shareholders can’t get there. Annual meetings of major US companies have been held in Russia—or in towns without airports in Alabama on Friday afternoons before holidays. I’m not kidding.
5. Managers can call off a shareholder vote on election day if they see they are losing. (Though a Council member sued a company over this recently and more or less won.) Can you imagine if a US Senator could do this—people would howl.
6. If a shareholder wins a majority of votes cast for its proposal, companies can, with few exceptions, ignore the vote. Most do. Some companies ignore majority shareholder votes even when an issue passes year after year. This makes the shareholder franchise a joke.
7. Shareholders used to get to vote once a year on directors. But this year AT&T and Comcast have agreed to bar shareholders from voting again on the board of the new company until 2005.
8. Some shareholder ballot items are rigged. The New York Stock Exchange allows brokers to stuff ballot boxes and vote for management when shareholders with broker accounts don’t vote. Most shareholders don’t know this. Studies show this throws important votes. The SEC and NYSE ignore our pleas to fix this.

On this subject, I would caution you not to put the New York Stock Exchange in charge of any investor protections. The NYSE is a private sector corporation. It gets money from corporate executives—listing fees. Never expect private-sector bodies to act against those who fund them—they won’t do it. Not surprisingly, the NYSE has, in my opinion, consistently used its government powers to harm investors and protect managers, not the other way round. In my opinion, anyone who assigns investor protections to the NYSE doesn’t want to protect investors. Democracies were designed to avoid precisely the problems we see over and over in this guild-like, government-protected, reportedly highly profitable franchise.

So, if you do want to make a real difference, what legislation do you pass?

We need better and immediate information about companies’ executive compensation practices and directors’ and CEOs’ buying, selling, borrowing and hedging activities. And we need better ways to control this compensation—votes on all stock option plans and an ability to put up board candidates if existing boards are giving away the shop. Fraudulently calculated pay needs to be returned.

Why is all this so important? Because if we cannot control our employees’ compensation, even honest people will gradually pay themselves more and more. It is happening all over. Power corrupts. In extreme cases companies become Ponzi schemes. Executives siphon money out in mega option grants and companies crash.

There is a reason that nearly a quarter of major-company CEOs get their companies to give them huge loans--loans as high as a third of a billion dollars to one person. There is a reason these loans are often forgiven, subsidized and/or used to hide CEO stock dumping. When shareholders’ hands are tied behind their backs and key information stays secret, or stays secret until it is useless, executives get more and more generous with themselves. They do it because they can.

If you curb executive compensation abuse, frauds become less profitable to fraudsters. Money is the main motivator. Focus on it.

Neither the SEC nor the NYSE has used the powers they already have to address this problem adequately; if it doesn’t come from you, it won’t happen.

What else? Senator Nelson’s bill gets at many of the issues I’ve raised today. It requires that companies disclose directors’ conflicts better—something we asked the SEC to do years ago but which just sits over there. In fraud after fraud we discover undisclosed director conflicts. There is no excuse for hiding this critical information.

Nelson’s bill also gets at board independence effectively because it uses a real-world definition of independence, not a weak definition, like those used by the NYSE and some companies.

At our meeting next week Council members will be discussing legislative language that would make it easier for shareholders to put director candidates on the company’s proxy and get issues on company ballots. Why do you let companies ignore our majority votes? Why does the NYSE throw shareholder votes by letting brokers, who are not shareholders, vote? Shareholders will keep markets clean, at no government expense, if only you’d let us by removing our handcuffs.

Corporate governance should be at the heart of this debate, not at the periphery. Structures to stop frauds in the first place, rather than efforts to catch them when they arrive in auditors’ hands, should be the starting point. Better information is useless without ways to act on it. We need both.

Finally, enforcement. There is too little enforcement and too much of it targets companies and not human wrongdoers. Five years from now when this hubbub is history and you are an auditor or a director being pressed privately by management to go along with a fraud, will you be more deterred by the thought that your company may be fined or by the thought you may go to jail?

When you punish companies, you punish innocent shareholders, the victims. I am therefore very pleased by the enforcement proposals in the Leahy, Daschle bill. Fraudsters will do anything you let them. Please stop letting them. And please do not go for mid-level scapegoats. Those who get the big bucks need to shoulder the responsibility. A CEO or a director going to jail would be a corporate governance shot heard round the world.

The Council is a not-for-profit association of large institutional shareholders. It includes corporate pension funds, government pension funds, labor funds, endowments, international pension funds, entities such as the World Bank and TIAA-CREF, money managers and financial institutions. Its members manage over two trillion dollars and represent millions of beneficiaries, employees and voters. The Council is funded solely by members’ dues. It is non-partisan. It addresses investment issues exclusively.

The Council’s policies and copies of its letters and rulemakings on subjects mentioned here are available from its office. 202.822.0800 or michelle@cii.org

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