(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.)

SEC Chairman Pitt Testifies on House Enron Reform Bill

Recent testimony before the House Financial Services Committee revealed qualified SEC support for the post-Enron reform package being advanced by Chairman Michael Oxley and other House leaders. The Corporate and Auditing Accountability, Responsibility and Transparency Act, H.R.3763, addresses many of the key issues facing the capital markets today. Of particular note, the bill would create a statutory public regulatory organization to oversee the accounting profession.

According to SEC Chairman Harvey L. Pitt, the bill would establish a public regulatory organization, or PRO, to review and discipline accountants who certify financial statements filed with the Commission. He noted that the Commission is proposing "private sector" regulation, not "self" regulation. Self-regulation implies that the accounting profession would regulate itself, he said, and the SEC is suggesting regulation by the private sector, but not by the profession. The SEC believes that it is necessary to create a new, private sector, independent body that can direct periodic reviews of accounting firms' quality controls for their accounting and auditing practices and discipline auditors for incompetent and unethical conduct.

In his view, the proposed PRO in the CARTA legislation shares many characteristics that the Commission believes are necessary for effective private-sector regulation of the accounting profession. It is critical to separate discussion of the regulatory model from the issue of whether there is a need for legislation. While legislation is not required to establish private sector regulation with SEC oversight, noted the chairman, if Congress determines that legislation is desirable, he pledged the SEC's assistance to that process.

The SEC and the CARTA bill share many key elements. The board of the PRO would include some members of the accounting profession, but the overwhelming majority of members would be unaffiliated with the profession, providing a level of independence that the Commission considers critical for effective oversight. Further assuring the PRO's independence, CARTA requires that the PRO function on a self-funded basis, and not rely solely on fees from the accounting profession. The SEC believes these structural measures will go a long way to addressing concerns with the accounting profession's previous self-regulatory scheme.

One aspect of the bill's PRO that could be enhanced, testified Mr. Pitt, is its provisions on SEC oversight. If such a body is established by legislation, in addition to mandating that the Commission pre-approve the PRO's rules and granting the Commission the authority to amend those rules, several other oversight features could be added. For instance, the chairman suggested that the PRO and all of its records should be subject to discretionary examination by SEC staff. The Commission should also have the authority to direct the PRO to conduct special projects, such as a special review of a firm's quality control system. In addition, the Commission should have the authority to approve the PRO's budget and to approve the selection of individuals to the PRO.

Auditor Independence

CARTA would stipulate that a public accountant not be considered independent of its audit client if it provides that client with financial information system design or implementation, or internal audit services. Specifically, the bill directs the Commission to revise its auditor independence regulations as they relate to these two non-audit service.

Mr. Pitt noted that the Commission's approach to auditor independence, with rules adopted less than 18 months ago, should be tested by practical application over a reasonable period of time. If problems are empirically shown to exist in this area, any needed reforms can be tailored to address the precise problems uncovered. Some of the restrictions on non-audit services adopted in the SEC's auditor independence rules have not yet taken effect, he continued, due to phase-in provisions.

The SEC believes that limiting those services that create an inherent conflict with auditing, barring inappropriate compensation mechanisms (such as compensation for cross-selling services) and penalizing firms whose aggregate and individual audit performance is substandard are more likely to prevent audit failures than the suggestion that the SEC increase the reliance of all audit firms on their audit clients.

Improper Influence on Audits

The bill would make it unlawful for officers and directors to improperly influence or mislead any accountant engaged in auditing the company's financial statements for the purpose of rendering the statements materially misleading. The bill grants the Commission exclusive civil enforcement authority over this provision. Mr. Pitt pointed out that the SEC has long recognized that the auditor must not be misled in the course of an audit. The SEC already has the authority to sanction any such improper conduct. In addition to the general anti-fraud sections of the federal securities laws, which could apply based upon the specific facts and circumstances, Section 13(b)2 of the Exchange Act, and Rule 13b2-2 thereunder, prohibit making materially false or misleading statements to auditors, and Section 20(c) of the Exchange Act prohibits obstruction of the making or filing of any required report with the Commission.

Real Time Disclosure

The SEC strongly supports CARTA's call for "real time" disclosure of information concerning the issuer's financial condition and operations. In addition, CARTA would require that any disclosure concerning any sale of securities by company insiders would have to be made electronically to the Commission before the end of the following business day, and would subsequently have to be made available to the public, electronically, by the Commission. In this regard, said Chairman Pitt, the SEC recognizes the need to require corporate insiders to make public their trading activities more quickly than current law requires. Under current law, which dates back to 1934, the principal provision covering reporting by insiders calls for filing by the tenth day of the month after the month when the trading occurred. While that may have been good enough in 1934, he emphasized, "it is not nearly good enough today."

With regard to oversight, CARTA would require the Commission to set minimum periodic review requirements to ensure that the periodic reports of the largest issuers will be subject to a regular and thorough review. The SEC would report annually to Congress on its compliance with this requirement. While the SEC agrees with the concept that it must significantly expand its review of financial and non-financial disclosures, Mr. Pitt said that circumscribing these periodic reviews through legislation could be "impractical or counterproductive."

Announcing the timing and criteria of SEC reviews through legislation would be "troublesome," continued the chairman, and would reduce the Commission's flexibility as well as putting issuers on notice regarding the timing and scope of SEC reviews. He emphasized that the Commission should have the flexibility to focus on areas that could shift as it identifies matters calling for in-depth scrutiny.

Accounting Standards

Finally, Mr. Pitt described current accounting standards as cumbersome and governed by an approach that encourages accountants to "check the boxes" to ascertain whether there is technical compliance with applicable accounting principles. The SEC seeks to move toward a principles-based set of accounting standards, said the chairman, where mere compliance with technical prescriptions is neither sufficient nor the objective.

Accounting standards should be set by the private sector, he continued, but subject to vigorous SEC oversight. Presently, the standard-setting authority resides in the Financial Accounting Standards Board, explained Mr. Pitt, but FASB's standards govern financial statements only because the Commission has chosen to accept those standards as authoritative. He declared that the SEC will exercise its authority to ensure that FASB's agenda is responsive to issues facing investors and accountants and is completed on a timely basis.