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Interview: arthur levitt

Chairman of the SEC from 1993 to 2000, Levitt says the Enron scandal is "symptomatic of a breakdown of the ethical values of business over a period of perhaps 20 years." He is very critical of what he calls "accounting hocus-pocus" or how companies have become more creative in their interpretations of accounting standards. In this interview, he describes the political heat he took during the three big accounting battles of the 1990s, and calls for an independent agency with subpoena power to oversee the accounting industry. This interview was conducted by FRONTLINE correspondent Hedrick Smith on March 12, 2002.

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Mr. Levitt, what's the significance of the Enron scandal and collapse for the markets as a whole? Is this just a group of bad guys who broke the law maybe in one company? Or is this symptomatic of something larger?

I think the Enron scandal is symptomatic of something much broader than Enron. I think it's symptomatic of a breakdown of the ethical values of business over a period of perhaps 20 years, a gradual erosion of business ethics that brought us to an Enron, but might very well bring us to a whole host of Enrons as we move down the road.

How do you account for that? Is that the go-go 1990s? Or Wall Street pressure?

... Part of it, I believe, is a function of a bull market, which made every decision appear to be absolutely the right decision. Part of it is a function of the complexity of new instruments that are available to create investments -- derivative products, options, instruments -- which were never available before.

The Enron scandal has conveyed to the American investor that he cant have confidence in the traditional gatekeepers that protect Americas markets.

Part of it, I think, is a function of the greed factor that's involved. American business is extraordinarily competitive. And if Company A and B are moving close to the line in a given tax treatment, are given business devices, Company C, D, and E can't be very far behind.

By "close to the line," do you mean the law? What's permissible?

Exactly. And what we have seen happening is companies have become more and more creative in terms of the way they present their numbers to the public. Their interpretation of what accounting standards are has become more and more creative, rather than using the numbers the way they really were intended to be used -- as a means of telling investors about the health of a particular company.

In your speeches, you talk about "the numbers game." Just in laymen's terms, what's "the numbers game?"

The numbers game represents the effort of managements to take the earnings of the company and paint them in the most creative light possible.

You mean the most positive?

To try to persuade investors that the company is in a lot better shape than it really is; to take out of the numbers certain factors which would have lowered the earnings as far as investors were concerned; to deal with something that companies now call "pro forma numbers," rather than the numbers as they really are. What are pro forma numbers? They are numbers the way management hopes the company has done and will do, rather than giving the picture as the company did.

Well, wait a second. The picture you're painting is something, I think, that most ordinary investors really don't understand; maybe the pros do, isn't that right? I always thought there are costs, and there's income. You put your books together, and that's it. But you're suggesting there's a lot of leeway here.

That's absolutely right. I think because of the different ways that companies can use financing techniques to present their earnings, the different interpretations of accounting standards, and because of the more than cozy relationship which has developed between the accountants who are supposed to be the gatekeepers of the numbers insofar as investors are concerned, those numbers had become less trustworthy than they had always been in the past.

"Less trustworthy," because they don't represent economic reality?

That's exactly right. They are less trustworthy because very often they depart from economic reality. They represent hopes; they represent wishes. They don't very often represent the picture as it really is. They program earnings in a way that investors believe that a company which has sold a product but hasn't been paid for it can book those earnings as if they had been paid. Companies, on the other hand, may very well be booking earnings on products that can be returned. ...

Let's take two or three quick examples. ... When you talk about creative accounting, what kinds of things do you mean?

Creative accounting, I think, is easily symbolized by taking a look at two recent scandals: Sunbeam and Enron.

In the case of Sunbeam, the company had booked earnings on products that really hadn't been sold, or products that were sold and could be returned subsequently. So they really weren't earnings.

The case of Enron was even more creative. The investment bankers came to Enron and said, "Look, we can really create a structure which will hide your obligations from the general public by creating subsidiaries. Those subsidiaries will borrow, and those borrowings, under our interpretation of the accounting rules, will not flow up to the parent."

So they don't show up on Enron's financial statement?

Exactly. So Enron showed a financial statement that was a great deal healthier than, in fact, it really was, because of this creative device to hide the obligations of the parent in subsidiary corporations.

You made this speech up in New York, which I was rereading this morning. You use these terms: "Abuses, trickery, and accounting hocus-pocus." Are things that bad?

I think they are. I think that the seduction of the boards of companies that are intended to protect investors ... the nexus between the accounting firms and the corporations, and the aggressive attitudes of CFOs and CEOs has created a pattern of deception that has created a situation which has eroded public confidence in the sanctity of the numbers which is the basis of our markets today.

Without public confidence, our markets are no better than any in the world. The only reason our markets are so superior is because the public has had confidence in the sanctity of the numbers, in the way the numbers have been produced, because they believed in what corporate America was saying to them. Enron and Sunbeam and a number of other recent accounting scandals have severely eroded that confidence.

When you look at Enron, when you look at Sunbeam, when you look at Waste Management, when you look at a series of these scandals, what's the heart of the matter? What's at stake here?

What is so serious about these recent scandals, in my judgment, is that it goes to the heart of America's markets, of our financial system, which, in my judgment, is public confidence. If investors lose confidence in the reliability of numbers that are presented to them, our markets will suffer grievously.

The reason that our markets are so vastly superior to any others in the world is because we have a pattern of full and fair disclosure. If investors can no longer believe in the sanctity of the numbers that are reported to them, they're going to extract a penalty from those markets. It will be more difficult to raise money. It will be more difficult to maintain public interest in our markets. The source of capital will dry up. It will have very severe economic and political consequences.

So if I understand you correctly, what you're saying is that Enron, Sunbeam, Waste Management, these companies that have misstated, overstated their earnings, are playing with fire, in terms of the whole integrity, honesty, openness and trustworthiness of our markets?

I think our markets have already suffered a very serious blow. And whether they recover from that, whether they can restore the kind of public confidence that is essential to America's markets, depends on how our policymakers deal with these issues. ...

It's stunning to see that in the last three years of the 1990s there was something like 400 corporations that had to restate their earnings or their net worth. Talk about that for a moment. What does this mean?

I think what's going on, again, is a function of the competitiveness of American business. If a company sees three other companies dealing with an accounting treatment in a fairly aggressive way, they're going to try to deal with it even more aggressively.

Now, what's the control point? The control point should be the accountants that provide the bookkeeping for the company. It should be the board, and particularly the audit committee of the company, which should make certain that those numbers are an accurate reflection of what the company is doing. It should be the standard setters who establish the standards by which the company reports its earnings.

And then ultimately it should be a function of the regulator, the SEC, which oversees the production of these numbers in these statements, and ultimately must come down hard on corporations that are playing games with their reported earnings.

But why are they playing games? What's driving them?

What's driving them is the price of their stock. What's driving them is the desire to see to it that, quarter by quarter, their earnings reach levels of a penny or two or three more than the quarter before that, so that analysts will deal with it in the most favorable way.

There is an obsession with short-term earnings and short-term results, and our stock markets reflect that obsession. A drop of one or two pennies per quarter in earnings that vary from expectations can result in a 30 percent decline in the price of the stock, virtually overnight. ...

So the Wall Street expectations game, in your opinion, is what's driving companies and accountants to go maybe over the line or at least up to the line?

We've developed a short-term culture in American business, where executives have become obsessed with the selling price of their stock. They drive earnings in whatever way they possibly can to meet the expectations of analysts, rather than presenting a picture that is totally accurate. ...

You make it sound as though accounting hocus-pocus is going on quite broadly.

There is much too much accounting hocus-pocus. I would not say that every American company practices this. It's a matter of degree. Many companies do practice accounting hocus-pocus. And accounting standards are insufficiently clear to make that argument hard and fast, so companies will argue the point as to whether their treatment is fair or not fair.

You mentioned the term "conflict of interest" before. Talk a minute about the conflicts of interest. Are there conflicts of interest of accounting firms? Of investment banks? Of the bond-rating agencies? Of the lawyers who advise corporations?

Yes. I think the Enron story was a story, not just of the failure of the accounting firm but also the traditional gatekeepers: the board, the audit committee, the lawyers, the investment bankers, the rating agencies. All of them had a part in this.

Take the rating agencies, for instance. They deferred downgrading Enron, pending a merger which they knew very well might never have taken place.

Take the investment bankers, who developed the elaborate scheme that Enron used to hide the obligations of the parent company in subsidiaries. That didn't come out of the blue; that was a scheme concocted between the investment bankers and the chief financial officer of Enron.

Take the accounting firm that Enron was the most important audit client that they had, and Enron was also the largest consulting client that they had -- a client that paid them over a million dollars a week in fees. In my judgment, that accounting firm was compromised. Their audit was compromised. Putting aside any fraudulent activity that may have been part of this, they were clearly compromised by the nexus of consulting with auditing.

Take the lawyers that were paid vast fees. I think here you have a very interesting case where the American Bar Association prevents lawyers from revealing financial fraud of clients to regulators. And here we had a case in point where a major client of the law firm was obviously involved in practices that may well proved to have been fraudulent, and they didn't blow the whistle.

And [take] the analysts, who were claiming that Enron was a buy even after this story had broken and Enron had declared bankruptcy. These are analysts that were being paid by investment bankers that were receiving large fees from Enron for performing a variety of services. How independent could their research have been? And what could an investor have expected from an analyst who was recommending the purchase of Enron, while at the same time his employer was receiving millions of dollars in fees from that company? How likely was it that the analysts would tell it as it was? Very unlikely, in my judgment.

Let's go back to the whole idea of auditing, which I gather comes out of the Securities Exchange Act of 1933, 1934. What's the job given by law to auditors? Whom are the auditors supposed to serve?

... America's auditors were given a franchise by the Securities Acts of 1933 and 1934 to provide the public with accurate audited statements of companies that were public companies or about to become public companies. And their mission, the reason for all of that, was to protect the public investor from financial fraud.

When you look at the accounting profession today in the wake of the Enron, Waste Management, Sunbeam, and lots of other scandals, who are they working for? The public? Or somebody else?

I think up until now, there was a real question as to whether auditors represented the public as they should have, or represented the companies that paid them for audits and paid them even more for consulting services. They clearly had a conflict of interest, and some of them abused the public that they were supposed to protect.

If you take Waste Management for instance, Waste Management paid a $48 million annual auditing fee. Who are they working for?

You could make the point that, by virtue of the fact that the auditors are paid for by the company, that no audit is totally clean. I think our society really functions based upon balancing interests. It's one thing for a company to pay their auditor. But that auditor has its reputation at stake in every audit that it does. The payment for the audit is an anticipated fee in the same way that paying a lawyer his legal charges, in the same way that any service is paid for.

It's when the auditor goes beyond that and it is paid vast sums of money for consulting that I believe the audit becomes compromised. We're used to paying audit fees, they're fairly standard. And we've had a competitive environment for it.

But you've also seen an inflation in audit fees. If you start looking at some of the audit fees, and particularly the audit fees of companies that got in trouble, they're paying enormous audit fees -- $20 million, $25 million, $48 million. I mean, those are huge fees.

... Actually, audit fees in terms of hours put in it by a given accounting firm have gone down through the years. But what has happened is that we have fewer accounting firms today that are capable of providing world-class audits for companies that have international operations. The ordinary pressure that would come from competition from what were the Big Ten firms has moved down to the Big Five firms and may well be the Big Four firms very shortly.

But talk about the pressures in that environment where you've got so few firms. What's the pressure on Andersen's engagement partner in Houston who's dealing with Enron? What's the corporate pressure? Is it to do the toughest possible audit he could do? Or "Don't lose the Enron business, it's a big account."

I think clearly the Enron business was the motivating factor with the Houston office. Accounting firms today, their corporate set-up is such that they have separate fiefdoms all over the world. Most of them lack the kind of central control that will keep an office that depends so exclusively upon a client as large as Enron from doing virtually anything that Enron wanted them to do.

You talked about these conflict of interests. Let's bring it right down to a practical situation. You're the Andersen representative in Houston and you're dealing with Enron, both the consulting business at Enron and the auditing business at Enron. What are the pressures on you?

There are enormous pressures on the senior officer of Andersen in the Houston office whose major account, probably his only account, is Enron. The control factor there has to be a responsible board of directors, and particularly an audit committee which is sensitive to the responsibility of providing a clean, accurate statement for investors. But clearly the motivation of that local office, if left to its own devices, is to make Enron happy, rather than to keep the investors well informed. ...

You talk about conflicts of interest with the Enron board. What do you mean?

I'm talking about a board where certain members received consulting fees that were above and beyond their regular directors' fees. I'm talking about a board where some members received charitable contributions from Enron to their own institutions. I'm talking about a board that had the use of corporate aircraft. And it was a board that, in my mind, was defined by a culture of seduction characteristic of many American boards.

Seduction by whom?

Seduction by management. A board that became so comfortable with the perks offered by management, and the relationship with management became more collegial, more fraternal. It lacked the kind of skepticism that I believe America's boards should manifest in terms of protecting investors' interests.

This was a board that, I believe, was far more supportive of management than they were of shareholders. The balance between their responsibilities was skewed seriously toward management, and that created much of the problem that eventually developed. ...

If you look at the statistics of more than 400 firms having to restate their values, do you have any idea how much the ordinary investors lost?

The restatement of earnings has cost America's investors in recent years in excess of $60 billion. That's an enormous amount of money. Now how did it come about? Why suddenly has all of this money evaporated from investor interest? I think it's come about through a variety of reasons.

I think corporate America has exaggerated their earnings, and they've been called to task by U.S. regulators causing them to restate those earnings. I think that the process of setting accounting standards has been imprecise and has been impacted by political pressure, so that the standards which would ordinarily be cut and dry and absolutely clear, in terms of what companies can do or can't do, have become vague and fuzzy. ...

And the third reason for restated earnings has been that the accounting firms that should have prevented the earnings from being presented the way they were simply didn't blow the whistle.

OK. Andersen is in a lot of trouble. Andersen cropped up on Global Crossing, on Enron, on Sunbeam, on Waste Management, on some others. Is Andersen a weaker firm than the other big accounting firms? Or is this typical of the accounting profession?

I don't personally believe that Andersen is any worse than any of the other firms. I can't speak to fraud, because we don't know the dimensions of that at this point. But in terms of how they deal with their clients, I think the kinds of problems Andersen has had, have developed and will develop in other firms in probably precisely the same way. ...

Is it going to be adequate to let the accounting firms do their own restructuring and their own reforms? Or are outside reforms going to be necessary?

Whether it's adequate to have the firms do their own reforms, I think, depends on the issue of perception as well as reality. As long as the American public perceives that they can't rely on America's accountants because those accountants have a conflict of interest, that speaks for itself. So I don't think that we can rely upon the firms themselves to do the job.

I think we need an oversight body to oversee the accounting firms in a way that gives them subpoena power. And that means legislative action. I don't think the firms can do it by themselves. I don't think the SEC can do it by themselves. I think the SEC cannot do the job that I think is necessary to restore public confidence today.

Because?

Because I believe we need an independent agency that consists of people of impeccable credentials that can oversee the accounting firms, that has subpoena power to go after not only the accounting firms, but also their clients, to assure the public that audits are being conducted fairly. And in those instances where audits are being compromised, that there is a mechanism for providing immediate relief in the form of sanctions against those accounting firms.

That doesn't exist today. There is no real mechanism aside from what the SEC can do, and that process takes an extended period of time.

It looks from the outside to somebody's who's trying to understand the situation that the accounting industry is essentially regulated by itself -- that various organizations that are supposed to do the oversight are, in effect, composed of people from the accounting industry. They're not outsiders. [It is] so unlike the aviation industry or some other industries where you actually have regulators that are appointed, they have official power, they have subpoena power. So has self-regulation worked, or failed?

There is no self-regulation that is working in the accounting industry today. There simply is no effective self-regulation. The SEC lacks the resources on their own to regulate this industry.

I think we need the same thing with the accounting industry that we have with the securities industry. That's a combination of self-regulation, which in the securities industry is represented by the stock exchanges, private rights of action which you do have the legal profession being able to sue accounting firms for malfeasance and the enforcement efforts of the SEC.

What you lack here is self-regulation that you have in other regulated activities. And without self-regulation, you cannot assure the public that this profession is being run effectively and cleanly and in their interest. ...

What's the importance of the Enron scandal for the American investor and for the American economy?

The Enron scandal has conveyed to the American investor that he can't have confidence in the traditional gatekeepers that protect America's markets. He can't have confidence in the auditor that presented him with the statements. He can't have confidence in the standard-setter that created standards which were so fuzzy that Enron was able to hide the obligations of the parent in subsidiaries. You can't have confidence in investment bankers, in the lawyers for the company. You can't have confidence in the rating agencies that should have given him a clear picture of what Enron's obligations were.

So what you're saying is Enron is not unique? It's a signal that the integrity and honesty of the American markets have been damaged?

I think Enron is symptomatic of something that's going on in a lot of American companies where there has been, in my judgment, an erosion in the culture of integrity that was so significant a part of America's corporate structure up until recent years.

But why has there been this erosion?

I think a large part of it is due to a runaway bull market, where virtually any corporate decision turned out to be right, any investment decision turned out to be a winner; where corporate executives believe that they were almost omnipotent; that the role of the investor became less significant as companies turned out quarter after quarter of increased earnings; where we had a culture of analysts who were treated like rock stars; where the media extolled the analysts and the financial commentators who took over the mindset of America's investors in recent years.

But in retrospect, a lot of that almost looks like a false bubble.

It was a bubble. It was clearly a bubble, and it was clearly false in many aspects. The description of the new paradigm, where even senior government officials would talk about the new paradigm, represented a change that few Americans can realize or appreciate.

Well, in my judgment, the bottom-line earnings are the same in the new paradigm or the old paradigm. And where Silicon Valley feels that they should be treated differently than smokestack companies in America, I sharply disagree with that. That's led us into the kinds of problems where the bubble of Silicon Valley has burst, and billions of dollars had been lost by investors. The new paradigm, in my judgment, is a myth that has covered up a variety of financial techniques which have been deceptive. ...

You use the phrase "accounting hocus-pocus." What does that mean?

Accounting hocus-pocus represents the efforts of corporations to color their earnings in a way which will cast them in the best possible light; hiding from investors certain aspects of those earnings which may have made investing less attractive at that point in time; using devices such as taking earnings in a quarter in which they wanted them to be taken, rather than the quarter in which they were actually earned; booking earnings that were not really earnings, such as products that were sold but which could be returned and represented potential liabilities, products which hadn't even been developed and booking the earnings on those products in advance of development; losing sight of tax obligations or other commitments, leases that weren't truly leases that could have been cancelled.

All of these devices were aggressive efforts on the part of management to display hopes and expectations to investors, rather than the reality of what the companies were actually booking and actually doing and actually experiencing.

How do we, the ordinary investors, find out about this? How do we understand it?

I think there are certain telltale signs. I think reading the financial statement's terribly important, asking questions about footnotes.

But how many ordinary investors have the time to read footnotes, particularly footnotes that are deliberately constructed in complicated language? I mean, as a practical matter, who can we count on as ordinary investors?

I think we should be able to count on the audit committees of boards of directors to protect us as investors. We should be able to count on a regulator such as the SEC for overseeing corporate America and the accounting profession. We should be able to exercise our rights of private action by bringing suit against the fraudulent presentation of numbers. We should be able to count on the laws of this country and the efforts of U.S. legislators to help protect us. ...

You mentioned a whole bunch of people. Were there any others that could protect?

Yes. Yes, there were others. There was the standard setter, the FASB [Financial Accounting Standards Board], which for 15 years tried to establish a standard that would have kept Enron from hiding the obligations of itself in subsidiary operations. And they didn't do it. They fell down on the job.

Because?

They didn't do it because they were pressured by the corporation and other corporations from coming up with a standard that was effective, because they were funded by the very corporations for which they are setting standards. They didn't do it because Congress brought pressure on them to go easy on the business community.

Let's talk about FASB. Let's go back to the early 1990s and the fight over stock options. Why is it important for me, as an ordinary investor, to have a good rule on stock options?

Stock options are an obligation of the company to give an ownership of that company in the form of stock to employees of the company. That is a clear obligation of the company.

The argument made by the standard setter then was to have the company put that down on the balance sheet as an expense item, that it is a cost to the company. Corporate America went ballistic at that time. I probably spent a third of my time talking to corporate officers who felt that the SEC should prevent the standard setter from expensing the cost of stock options.

Because?

Because that would, in their judgment, lower their earnings. It would cause them not to give stock options to employees and to executives. And the argument they made was that they couldn't hire people, they couldn't get good executives, and that the whole future of their company was put in jeopardy by the expensing of stock options.

Isn't there something to that argument? In the 1990s Silicon Valley was saying essentially you're going to kill the golden goose. What do you say?

I don't buy that argument one single bit. Stock options have been a useful device. They're part of the culture of American business. That's not going to disappear overnight. If it takes a stock option to induce an employee or an executive to come to a company and that stock option has to be represented as a cost on the balance sheet, in my judgment, America's executives are going to pay that price. It is not the end of stock options. It is not the end of entrepreneurship in America. In my judgment, that is a specious argument, and I don't buy it.

So FASB has come up with this new rule. What happened?

When I came to the SEC, this new FASB rule to expense stock options had galvanized the American business community and brought literally hundreds of CEOs to my office in Washington to urge me to prevent the FASB from going ahead with this proposal. ...

But what happened during the course of this fierce debate and dialogue was that the Congress changed, and Newt Gingrich brought to power a group of congresspeople who were determined to keep FASB from enacting this rule proposal. My concern was that if Congress put through a law that muzzled FASB, that would kill independent standard setting. So I went to FASB at that time, and I urged them not to go ahead with the rule proposal.

It was probably the single biggest mistake I made in my years at the SEC, because this was during the first four months of the so-called Gingrich Revolution. The country has swung far to the right. What I didn't realize is, as we got to the summer of that year, the country had begun the swing back to the center again where it always gets. The likelihood of congressional action to muzzle FASB, I believe, was very remote.

But what did Gingrich actually do? Did Gingrich get in touch with you? Did they write a letter? What happened?

Gingrich spoke about this issue. He didn't talk to me directly. But he spoke about the issue a number of times. This was clearly on his agenda.

You've been talking a lot about distortions of reality. Is the failure to expense stock options a distortion? Does that distort company income?

Yes. Investors should care deeply about expensing stock options, because those options represent a distortion of the earnings of the company. Right now, options are treated as a footnote, but that's not good enough. Those options represent a claim on the company, and a claim that may very well and has been exercised.

So what you're saying is stock options are a cost of doing business that businesses don't show their shareholders?

Stock options are a cost of doing business that is not clear to many American investors.

[Prior to the Gingrich Revolution, what happened in the Senate regarding the FASB rule?]

The Senate passed a [resolution] about the proposal of the standard setter to expense stock options. Why did they do it? There was no question in my mind that campaign contributions played the determinative role in that Senate activity. Corporate America waged the most aggressive lobbying campaign I think that they had ever put together on behalf of this issue. And the Congress was responsive to that.

You have Sen. Joe Lieberman of Connecticut leading the charge. Why?

I don't know. I honestly don't know. Sen. Lieberman is my own home senator, and I have great regard and respect for him. I've spoken to him about this issue a number of times. And I simply do not understand where he's coming from.

What were his arguments?

The arguments were the arguments being used by the business community: that this was a break on entrepreneurship; that this would keep companies from being able to hire good people; that this would destroy companies; that this would distort their earnings. All the arguments used by the business community were the ones set forth by Senator Lieberman in his opposition. ...

Let's move on to 1995. You have tort law reform, private securities litigation reform. This was something that the accounting industry, by its own account, was interested in getting done since 1991. Was there a legitimate reason for changing the securities litigation laws?

The securities litigation laws resulted from the perception that a lot of litigation had become spurious, mischievous, that it was created by trial lawyers to generate vast sums of money for themselves and very little money for investors. And there was some truth to that argument at that time. But it was a question of how far the reform would go.

The initial bill called for a "loser pays" determination. In other words, someone who brought a suit who lost would have to pay for that litigation. Now that would have been terribly unfair to poor people who couldn't afford that possible liability. And it's something that I opposed strenuously.

There were aspects of the litigation reform bill that I think were fair and were constructive, such as combining all the litigation in one format rather than have 15 different lawyers representing 15 different plaintiffs to have a lead plaintiff. ...

Looking back on it now from experience, what was the impact of that bill? Was it good or was it bad from the ordinary investor's standpoint?

In my judgment, the impact of that bill was relatively moderate. It was a push that it didn't curtail a great deal of litigation. It didn't really hurt investors except in one possible way. Part and parcel of that bill changed the obligation of accountants from being a total obligation -- that any one partner had a total obligation for the liabilities of his other partners -- to a proportionate liability that exists today. That limited the liability of accountants. Whether that was fair or not I think is debatable. But clearly that had an impact on the responsiveness accountants would have to the responsibility of protecting investors.

Wait a minute. You mean by loosening the pressures on accountants in terms of lawsuits, they were less deterred from questionable behavior? What do you mean?

You could have argued that, by loosening the pressure on accountants, they may have become less diligent in terms of their responsibilities than they might otherwise have been. That was the one negative that you could have drawn from the securities litigation reform.

In April 2000, you proposed reforming the accounting industry. What happened? What was the industry's reaction?

The number of cases of financial fraud that we were seeing at the commission had absolutely exploded. Managed earnings became the regular way of going rather than the exception. So I went to the leaders of the Big Five accounting firms. And I said that we have got to change the rules, and that means the conflicts that exist have got to be eliminated.

Two of the firms, Ernst & Young and Price Waterhouse, said that they would try to work with us on trying to change those rules. Three of the firms, KPMG, Deloitte, and Arthur Andersen, at a private meeting that we had, said, "We're going to war with you. This will kill our business. We're going to fight you tooth and nail. And we'll fight you in the Congress and we'll fight you in the courts."

And that began a nine-month saga of public hearings, because I felt the public interest was involved in this. We held public hearings in different parts of the country, had witnesses, and an enormous lobbying campaign went along parallel with our efforts to bring this to the public's attention.

Lobbying campaign on your part? On the industry's part?

No, on the industry's part. They hired no fewer than seven lobbying firms to represent them on the Hill. I spent probably over half my time in my final months at the SEC on Capitol Hill, responding to queries from members of Congress, talking to congressional committees, trying to explain why this is a matter of national economic interest. ...

What kind of clout does the accounting industry have on Capitol Hill?

I guess I learned over coming months that they had enormous clout; that their contributions to members of Congress who never thought about an accounting issue or an accountant and suddenly picked up the cudgels for the profession; where my own congressman was led into the belief that this was an effort that might have been worthwhile and signed on to a letter which he later retracted on the floor of the Congress; where a close friend of mine who I'd climbed eight mountains in Colorado with while he was head of the Outward Bound School signed on to another letter that he later retracted on the floor of the Congress.

This was a broad-ranging campaign that was well-financed, well-structured, and extremely vigorously fought.

Well, speaking of letters, I have a letter that you got in April. What is this letter?

This is a letter from the overseers of the SEC, the congressional committee that oversees the SEC that has a chokehold on the existence of the SEC, that can block SEC funding, that can block SEC rulemaking, that can create a constant pressure in terms of hearings and challenges and public statements, that can absolutely make life miserable for the commission.

And here are the three leaders, Tom Bliley, the chairman, Mike Oxley, the head of the subcommittee, and Billy Tauzin, the chairman of another subcommittee, were directing me to go slow on this issue, to go through a process. And this is, I guess it's a five- or six-page letter, asking for the kinds of responses that tied the agency up for weeks and weeks to answer questions that were intended to really stand in the way of the rulemaking that we had in mind.

So look at the bottom of page four. I think it's the just before the signatures and read that last. They asked you a slew of questions. And then what do they say?

"Please respond to these questions two weeks from the date of receipt of this letter. These responses will help to determine if hearings on the SEC's oversight of the accounting profession are warranted."

How do you interpret that?

That was a threat. A hearing is intended to either embarrass or humiliate the recipient of a letter such as this. That was a clear and blatant threat on an independent agency.

A shot across your bow?

Without a question.

So what'd you do?

We responded to their questions. The hearings were held. We responded to those questions. And it was just part of this process.

So they followed through? So they kept the heat on you, is that correct?

Oh, absolutely.

How would you describe it?

They kept the heat on me by telephone calls, by letters, by congressional hearings, and ultimately by threatening the funding of the agency by threatening its very existence. I mean, we were at that point struggling with this same committee to see to it that the employees of the SEC received the same compensation as other financial regulators. At the time, we were getting about a third less than employees for the Federal Reserve Board and other banking entities. And certain members of this committee suggested to me that getting that pay parity was out of the question while we were proceeding with this issue. So we were really being held, well, an attempt was made to hold us captive. ...

What were they talking about? People talking about putting a rider on an appropriations bill?

No. That was a separate issue. They were talking about two issues. One, they would not help us get pay parity for our employees.

Secondly, as we got down toward the end of the congressional session the threats were made, "Arthur, if you go ahead with this proposal, it is likely that a rider will be placed upon your appropriations bill, which says that the SEC will not be funded if they proceed with the issue of auditor independence." They also threatened that they would put a rider on which would prevent us from dealing with auditor independence for a period of at least six months, by which time they knew I was going to leave the commission.

Who made that threat?

A variety of members of Congress called me, told me this in private meetings, said that they weren't going to do it, but they knew others who were going to do it.

So you're talking about Congressman Bliley or Tauzin or Oxley?

Congressmen Bliley, Tauzin, and Oxley never suggested that they would present the rider, but they mentioned to me a number of times, "Arthur, you will face a rider if you proceed with this action. Try to work out something with the accountants."

So they're not saying "I'm going to do it." They're saying, "Somebody's going to do it, look out."

Exactly.

What about in the Senate? Phil Gramm was head of the banking committee. Any dealings with him?

Phil Gramm said, "Arthur, if you proceed with this rulemaking, you are likely to face a rider in the final moments of this Congress." He did say that he would do everything he could to prevent that from happening. He said that he opposed legislative slight of hand to interfere with the rulemaking process. ...

So where was the heat? Was there heat coming from the Senate? And if so, from where?

Yes, there was a lot of heat coming from the Senate. It came principally from the Senate Banking Committee. A shot across our bow came from a letter sent to me by the Senate Banking Committee members that included Rod Grams, Evan Bayh, Sen. Phil Gramm, Charles Schumer, Mike Crapo, Rick Santorum, Chuck Hagel, Jim Bunning, Wayne Allard, and Senator Robert Bennett. They were clearly opposed to this rulemaking.

But were they threatening your funding as well?

The letter didn't threaten the funding. The letter clearly said, "There's no need for this. You're not being thoughtful about it. You haven't established a smoking gun. Why proceed in this precipitous way?"

This was not a threat to our funding. But when a U.S. senator who is a member of a key committee that oversees your agency authors a letter of this kind -- particularly when the chairman of the committee is a signer of such a letter at the close of a legislative session in which your appropriations is about to be decided -- the implicit threat is fairly obvious. ...

So all through this thing, what's going on? Are they trying to scare you? Intimidate you? Force you to back down?

All through this thing, the effort was obvious to try to intimidate the commission into backing away from a very important rulemaking proposal. They said to us in my private meetings, "Arthur, where's the smoking gun? There's no need to get into this issue. You haven't shown us anything other than perception."

And I said to them, "Public confidence is a question of perception. And if I had nothing other than perception, it would be enough to go ahead with this rulemaking. But you want to see the smoking gun, I'll have a private, off-the-record hearing for you, in which we will present to your members of your committee at the commission cases that we are contemplating bringing which will represent the smoking gun which I hope will change your mind."

We invited them to the commission, and they came. We went through a whole variety of financial fraud cases we were about to bring including Waste Management. They left the hearing, and they didn't say that they were misled and heard nothing. But they didn't come away and say, "We've changed our minds." Clearly, we gave them the smoking gun.

Nevertheless, they proceeded with letters, with calls, with veiled threats.

... You testified this year, 2002, before some of these same people. Did the issue of the smoking gun come again? What did you say?

I went back and testified before the Senate Banking Committee once again. And during the course of that hearing, Sen. Robert Bennett of Utah, who had vigorously opposed the rulemaking last year, mentioned to me that during his business career, he had employed his auditor to do consulting work and that represented a cost saving to him, and wouldn't I recognize this as an efficiency?

And I said, "Senator, no, I really wouldn't. Another auditor could do it just as efficiently, and it would cost you no more. But more significantly than that, I called to your attention during a private hearing we had last year the smoking gun that you had asked about and that smoking gun was Waste Management and other companies we talked about. But the gun exploded and that explosion, of course, was Enron."

And Senator Bennett didn't respond to that query.

So now you've got your smoking gun. What did you do about this rule in the end? Did the congressional pressure get to you? Did you run out of time? What happened?

Toward the end of the congressional session, the three warring firms approached me. First one firm approached me and then the others came to the table. And they asked for a compromise. It's a compromise that I probably would not have made today. It's a compromise that I would not have made, had I not been threatened so aggressively with congressional action. It was a compromise that a number of members of Congress and the Senate said that I should accept, or they personally would not be responsible for the results. And that compromise was to take IT off the table.

IT? Information Technology?

As a result of this pressure, we modified the rule to not prevent the firms from doing Information Technology as we had wanted to do, but rather asking them to disclose the fact that they were doing Information Technology and to expose that to the audit committees of the companies for whom they were doing it. And that was a compromise that I would not make today that I agreed to at the time.

So a rule was promulgated?

We eventually agreed to a compromised rule, which called for corporations to bring to their audit committees any consulting contracts that they had made with their auditor.

But you had a divided accounting profession. As you said out of the Big Five, three were against you, two were willing to work [with] you; the small firms weren't tied in.

Yes.

Aren't you really saying that, in the end, it's the political clout? It's the ability to go over your head?

Yes, I clearly am. What I didn't say was that today American business goes directly to the Congress. A few years ago, they'd stop at the regulator if they had a problem and talk to them. Now, they go right to their congressman. And the congressman writes me a letter. And I even had a congressman say to me, "Arthur, don't pay too much attention to this letter. I have to write it because I'm getting pressure from some fanatic."

In the end, what drove this process?

In the end, this process was driven by the very effective lobbying efforts of both the accounting profession and certain elements of the business community that went to the Congress and persuaded them that this was a rule that was worth opposing. ...

Did you ever hear from Ken Lay at Enron about controversial accounting issues?

Ken Lay wrote me a letter during the debate over the issue of auditor independence, urging me not to proceed with this rulemaking, because his relationship with his accountant, Arthur Andersen, had been such that consulting was terribly important to the well being of Enron.

So Ken Lay didn't want that broken up -- that relationship with Andersen?

No, he did not.

What was your reaction?

My reaction was that this was one of a battery of letters that we had received from clients of the firms that were making war against the commission. And I treated it as such. ...

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