(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Levitt Calls For Oversight Body, Better Governance

In testimony before the Senate Governmental Affairs Committee, former SEC Chairman Arthur Levitt urged the establishment of a "truly independent" oversight body with the power to set auditing standards, discipline accountants and conduct timely investigations that cannot be deferred for any reason. To preserve its integrity, he continued, this organization cannot in any way be funded by the accounting profession. Echoing this call, former SEC Chief Accountant Lynn Turner said that an effective independent regulatory oversight body for the accounting profession must have the following critical elements:

• It must be conducted by an adequately funded organization;

• Its members must be drawn from the public rather than the profession;

• It must have the ability to investigate and discipline those who fail to follow the rules;

• It must have the power to establish auditing and quality control standards that serve the interests of investors as opposed to the interest of the profession; and

• It must inspect the work of auditors on an ongoing basis to ensure they have made investors their number one priority.

Analyst Conflicts of Interest

The Enron collapse did not occur in a vacuum, testified Mr. Levitt, but rather against the backdrop of an "obsessive zeal" by too many companies to project greater earnings from year to year. In his view, this has lead to a culture in which companies bend to the pressures of Wall Street analysts rather than to the reality of numbers, where analysts overlook dubious accounting practices, where auditors are more occupied with selling other services than detecting potential problems, and where directors are more concerned about not offending management than with protecting shareholders.

Reform must begin by exposing Wall Street analysts' conflicts of interest, said the former chairman, who added that in early December, with Enron trading at 75 cents a share, 12 of the 17 analysts who covered the company rated the stock either a hold or buy. Two years ago, Mr. Levitt asked the NYSE and NASD to require investment banks and their analysts to disclose all financial relationships with the companies they rate.

That still not finalized rulemaking should go further, emphasized Mr. Levitt, and mandate that analysts disclose how their compensation is affected by their firm's investment banking relationships. In addition, Wall Street's major firms must take immediate steps to reform how analysts are compensated. As long as analysts are paid based on banking deals they generate, he reasoned, there will "always be a cloud" over what they say. He further recommended that analysts not be allowed to trade the stock of any company for which they have issued a recommendation in the last thirty days.

Directors and Audit Committees

Turning to corporate governance issues, the former chairman urged stock exchanges to require as a listing condition that company boards contain at least a majority of independent directors. A strict definition of independence should be used that would preclude, for example, consulting fees, use of corporate aircraft without reimbursement, and support of director-connected philanthropies. In Enron's case, he noted, at least three "so-called independent board members would have been disqualified under this test of independence."

Auditor Independence

Finally, he urged reformers to recognize that the accounting profession's independence has been compromised. He recommends a prohibition on the same auditor designing or installing information technology systems and performing the internal audit. Auditors should also be barred from consulting on how to structure transactions, such as the kinds of special purpose entities that Enron engaged in.

Mr. Levitt also called on audit committees to pre-approve all other consulting contracts with the audit firm. Such approval should be rarely granted, he emphasized, and only when the audit committee decides that a consulting contract is in the shareholders' best interests. Finally, he said that companies should be required to change their audit firm every five to seven years to ensure that "fresh and skeptical eyes are always looking at the numbers."

Failure to Comply with Existing Rules

While fully recognizing that financial accounting rules should be improved to provide greater transparency, former SEC Chief Accountant Lynn Turner told the committee that any accounting standard is meaningless unless fully complied with and enforced through a rigorous and independent audit. In this context, he noted that, under the existing rules, Enron's financial statements should have presented a much clearer picture than they did when first presented to investors.

Based on SEC filings the company made last November, he identified four instances of noncompliance with existing rules. While Enron has correctly been described as a business failure, reasoned the former official, it was also a failure that the audited numbers did not report the true economic condition of the company in an accurate and timely manner to investors.

• The first error involved the company issuing approximately $1.2 billion of its stock and in return receiving back a note receivable. SEC and FASB accounting rules that have existed for over fifteen years prohibit a company from counting stock that has not been paid for as equity on its balance sheet.

• The second error, involving materiality, occurred when the company failed to book audit adjustments decreasing income by $51 million or 48.6% of the reported net income of $105 million in 1997. The company and its auditor rationalized why such a large number would not be considered important information to investors. As a result, in 1999, an SEC staff accounting bulletin reiterated the rules on materiality and, in Mr. Turner's view, following the SAB will prevent future abuses.

• The third error involves the company failing to include in its financial statements partnerships it had established for specific structured transactions. Enron's special purpose entities did not meet the test for adequate capitalization under accounting guidelines that have been in existence since 1991, observed the former SEC official.

• The fourth question involves the adequacy of the disclosures of the transactions Enron entered into with related parties. In 1982, the FASB adopted SFAS No. 57, which is a broad general standard requiring a company to disclose 1) the nature of the relationships it has entered into, 2) a description of the transaction, 3) the dollar amount of the transaction impacting the income statement and 4) the amounts due to or from the related party and how they are to be settled. The former chief accountant pointed out that the description and discussion of related party transactions are in significantly greater detail in Enron's November 2001 filings than had previously been disclosed.