Former Securities & Exchange Commission Chairman Arthur Levitt Jr. spent most of his seven-plus years in office fighting a pitched battle against the accounting industry. In an upcoming book, written with Paula Dwyer, deputy manager of BusinessWeek's Washington bureau, Levitt reveals the many twists and turns in his attempts to rein in what he saw as an out-of-control profession. While Levitt won only half the battle by the time he left office in early 2001, the fall of Enron Corp. (ENRNQ) and other corporate failures led Congress to adopt the rest of his agenda in the Sarbanes-Oxley Act of 2002. Here's an excerpt from Take on the Street: What Wall Street and Corporate America Don't Want You to Know. What You Can Do to Fight Back:
When I arrived at the Securities & Exchange Commission in mid-1993, I found nearly all of Corporate America lined up against the "gnomes of Norwalk," otherwise known as the Financial Accounting Standards Board. The controversy raged over whether companies should treat stock options as an expense against earnings on their income statements, just as they treat salaries, bonuses, and other forms of compensation. Corporations insisted they should not, since no money actually flowed from company coffers. The FASB, the independent, private-sector body located in Norwalk, Conn., that sets accounting standards, said they should. To the FASB, options had real value to their owners, and involved real costs to shareholders. In June, 1993, it voted unanimously to seek comment on a rule that would make companies put a fair value on their stock option grants and record that number as an expense.
Corporate lobbyists, outraged by the FASB's perfidy, persuaded Congress to hold hearings. The pressure from Silicon Valley's high-tech companies, whose lack of revenues and weak profits made cash compensation difficult, was intense. Even the Clinton administration opposed the rule.
Senator Joe Lieberman, the Connecticut Democrat who would become Al Gore's running mate in 2000, led the charge. He introduced legislation to bar the SEC from enforcing the rule. In addition, Lieberman wanted to strip the FASB of authority by requiring the SEC to ratify each of its decisions, in effect relegating private-sector standards to mere recommendations.
Lieberman didn't stop there. He also sponsored a Senate resolution that declared the FASB proposal a cockamamie idea that would have "grave consequences for America's entrepreneurs." Joining him were numerous Republicans and a smaller group of so-called New Democrats who prided themselves for their pro-business positions, especially toward Silicon Valley, the fount of large campaign contributions. By saying that stock options were essential to one particular segment of the economy, they were arguing, in effect, that transparent financial statements should be secondary to other political and economic goals.
While Lieberman's bill did not pass, his resolution did--by an overwhelming 88-9. Though it was nonbinding, it was an unmistakable signal that Lieberman had the votes to stop the FASB if it pushed ahead. I, too, was lobbied hard. In my first few months in Washington, I spent about one-third of my time being threatened and cajoled by legions of business people. I recall a discussion with Home Depot (HD) Chairman Bernard Marcus, who became increasingly animated throughout our meeting, at the end of which he warned: "This will be a terrible blow to the free enterprise system. It will make it impossible to start up new businesses."
Such arguments did not sway me. Politics did, however. The controversy dragged on through the November, 1994, elections, which put the Republicans in charge of the House of Representatives and vaulted Newt Gingrich, the conservative lawmaker from Georgia, into the Speaker's chair. I concluded that the rule would not survive in this atmosphere. I also worried that disgruntled companies would press Congress to end the FASB's role as a standard-setter. To me, that would have been worse than going without the stock option rule.
At a December, 1994, meeting with FASB members in Norwalk, I urged them to retreat. I warned that if they adopted the new standard, the SEC would not enforce it. The FASB soon backed down in favor of the current, weaker rule that requires companies to disclose stock option grants in the footnotes to income statements. In retrospect, I was wrong. I know the FASB would have stuck to its guns had I not pushed it to surrender. I consider this my biggest mistake as SEC chairman.
But I also learned my biggest lesson from this back-channel brawl: Accounting firms were passive when it came to standing up for investor interests. It wasn't surprising that CFOs would fight for standards that let them understate expenses and exaggerate profits. But I was shocked when I saw how the auditors behaved. They failed to rally to the cause of investors and instead supported the demands of corporate clients. They had become advocates. I would forever look upon the accounting profession differently after this episode.
The use of stock options soon mushroomed, in large part because lax accounting encouraged them. By 2001, some 80% of management compensation was in the form of stock options. But instead of aligning employees' interests with shareholders', options gave executives an incentive to use accounting tricks to boost the share price on which their compensation depended.
Over the next several years, a succession of SEC chief accountants--Walter Schuetze, Mike Sutton, and Lynn Turner--would warn me that they were seeing a marked increase in corporate numbers games. The most common trick was to push ordinary expenses into the category of one-time or nonrecurring costs. Then companies would add these expenses back into their earnings and call the result "pro forma" earnings. To be GAAP [generally accepted accounting principles]-compliant for SEC filings, these so-called unusual expenses were properly subtracted from earnings. But many analysts and investors didn't bother to read filings made four to six weeks later. It was old news by then.
We began to see a pattern. Corporations were playing with their earnings calculations until they arrived at the best possible number. Earnings press releases revealed only the good news. Auditors, increasingly captive of their clients, would give them the clean audits they wanted, despite lots of chicanery.
Consulting fees--for everything from information technology design and installation to management compensation advice and merger analysis--were pouring into accounting firms. Audit fees made up 70% of accounting firm revenues in 1976 but only 31% in 1998.
Auditors are supposed to be like the umpire in a baseball game and call 'em like they see 'em. But it was clear that the auditors would do nothing to jeopardize their chief source of income. Some auditors were even performing internal audits for companies, making them part of the very control systems producing the financial statements that they later audited. They were passing judgment on their own work. And within the auditing profession itself, there was no watchdog willing to discipline unethical conduct.
It wasn't just a case of a few bad apples, either. Blue-chip companies with sterling reputations were manipulating their numbers in misleading ways. From 1997 through 2000, 700 companies would find flaws in past financial statements and restate their earnings. By comparison, only three companies restated in 1981. These came at a tremendous cost to investors, who would lose hundreds of billions of dollars in market value.
In a speech at New York University on Sept. 28, 1998, called "The Numbers Game," I laid out a plan. I said that the SEC would insist on auditor independence and, through enforcement actions if necessary, require that companies adhere to the letter and spirit of GAAP.
Earlier, we proposed that the SEC and the AICPA [American Institute of Certified Public Accountants] together establish a new body to set auditor independence standards. It took a year of frustrating negotiations, but the AICPA and the largest accounting firms begrudgingly went along with the formation of an Independence Standards Board (ISB). Harvey Pitt, my successor as SEC chairman, represented the accounting industry in these talks as a partner in the law firm of Fried, Frank, Harris, Shriver & Jacobson. The ISB's purpose: develop national independence standards. My fervent hope was that the ISB would help me stop the growth of consulting from compromising audits.
But I was to learn that every step forward by the accounting industry was followed by a giant step backward. The AICPA commissioned a lengthy white paper, presented at the ISB's first meeting in 1997, that questioned the need for national standards. Instead, it suggested that the ISB outline broad principles, and each firm customize its own rules. There would be no enforcement: Individual auditors would determine if they were in compliance. The paper also argued that firms should be able to perform almost any service provided some safeguards were in place. Indeed, the document advocated the expansion of nonaudit services as a means of improving audit quality.
The white paper's lead author was the very same Harvey Pitt who helped us create the ISB. Even after becoming SEC chairman, Pitt continued to hold the view that the growth of consulting does not interfere with auditor independence. To him, the solution is more frequent disclosure. Because GAAP is backward-looking, he argues, quarterly filings produce an out-of-date snapshot rather than a real-time window. I believe more disclosure would be an important step, but the most critical need is to get companies to comply with the letter and spirit of GAAP.
It soon became clear that the AICPA had gone along with the ISB's creation because it believed it could control the group. Over the next two years, the ISB would get bogged down in endless discussions over where to draw the line on independence. The SEC would have to take matters into its own hands.
In the winter of 1997, an anonymous letter arrived at the SEC's Southeast Regional Office in Miami. It would greatly improve the hand we were holding. The letter alleged that audit staff in the Tampa office of Coopers & Lybrand owned stock in the companies they were auditing. If true, this was a violation of independence rules if ever there was one.
While we were investigating, Coopers merged with Price Waterhouse to form PricewaterhouseCoopers (PwC), reducing the Big Six accounting firms to the Big Five. But the merger also exacerbated the stock ownership problem that our whistle-blower had reported. After the merger, Coopers partners and staff had to divest shares they owned in companies audited by Price Waterhouse, and vice versa. Some of the required divestitures, however, never took place. At the SEC's insistence, PwC hired a special counsel to conduct an internal investigation.
The results shocked us. The investigation uncovered an incredible 8,000 violations, involving half the firm's partners. Some were serious infractions. The heads of major PwC divisions and top managers in charge of enforcing the conflict-of-interest rules owned stock in audit clients. Even PwC Chief Executive James Schiro owned forbidden stock. We now had irrefutable evidence of independence violations by the largest of the Big Five, giving the SEC the right to reject PwC client filings. Had the SEC taken that step, PwC almost certainly would have been fired by hundreds of companies. With that possibility hanging over it, PwC was unusually cooperative when it came time for the SEC to regulate.
That day had arrived. In mid-2000, the stock market had reached dizzying heights, and the corporate numbers game had grown more brazen. The ISB was proving to be a dead end, and the accounting industry was using all its political and financial clout to fight us.
We invited the three most recalcitrant accounting firm CEOs to discuss our plans to issue new rules. But the three--KPMG Chairman Stephen Butler, Arthur Andersen CEO Robert Grafton, and Deloitte & Touche CEO James Copeland--refused to see us anywhere but on their own premises. We agreed to convene at Deloitte & Touche's midtown Manhattan office on June 20. There, the leaders said they would never go along with rules that might limit the kinds of consulting services they could perform for audit clients. When I asked them to help us arrive at a solution, they said little and yielded even less. Arthur Andersen's Bob Grafton warned: "Arthur, if you go ahead with this, it will be war." They had drawn a clear line in the sand.
We issued proposed rules a week later. They did not ban auditors from doing all consulting work for their audit clients, but they did severely limit such activities. For example, if an accounting firm designed and installed a financial information system, it could not audit the numbers that such customized software produced. After all, what auditor would alienate both his own firm and his client by pointing out flaws in a multimillion-dollar software program that his firm designed?
The proposal also said that any accountant who acted as a company's internal auditor could not also be the public auditor. Other verboten areas included designing compensation systems, acting in an advocacy role, as by giving legal advice or lobbying, providing bookkeeping services, conducting appraisals, recruiting or evaluating employees, and giving investment advice.
The firms accused us of issuing last-gasp regulations at the end of the Clinton Administration. This baffled me. For the past six years, I barely had a conversation with accounting industry leaders in which I did not press them to act on independence. More substantively, they argued that the SEC had not proven that any auditor had compromised an audit because of a consulting contract.
This "no smoking gun" argument was harder to fight. No auditor would ever admit that he allowed bad numbers to save a consulting relationship. The no-smoking-gun argument worked wonders on Capitol Hill. Members of Congress parroted it back to us in letters, phone calls, and personal visits. Within a month, I received negative letters from 46 members of Congress, including two-thirds of the Senate Banking Committee's securities subcommittee. Even normally pro-consumer Democrats, such as Evan Bayh of Indiana and Oregon's Ron Wyden, opposed the rule. Pennsylvania Republican Rick Santorum and others asked me to postpone a final vote on the rule until 2001. The aim, of course, was to wait for a possible George W. Bush Administration, which would almost certainly nix the proposal.
The accountants also opened the campaign contribution spigot. The Big Five firms, individual partners, and the AICPA pumped gobs of money into the election coffers of Congressional candidates and the Bush campaign. Altogether, they gave $14.5 million in the 2000 election cycle, according to the Center for Responsive Politics, a nonpartisan research group. The center lists the industry as No. 27 in total contributions, out of 122 sectors it ranks. That puts accountants above the defense industry but below telecoms.
Boy, did those donations get results. Not only could the AICPA get lawmakers to contact me on demand, it also persuaded the Senate Banking Committee's securities subcommittee to hold a hearing; its chairman, Minnesota Republican Rod Grams, had received $60,000 from the industry. (He would lose his reelection bid that November.)
Accounting firms also got their clients to weigh in. In a September, 2000, letter, Enron Chairman Kenneth L. Lay said that Enron's use of Arthur Andersen as both internal and external auditor was "valuable to the investing public...given the risks and complexities of Enron's business...."
Around this time, I received an ominous phone call from Senate Banking Committee Chairman Phil Gramm, who opposed the rule but who had a finely tuned sense of fair play. The Texas Republican warned me that his GOP colleague, Alabama's Richard Shelby, was preparing an "appropriations rider" to our funding bill that would bar the agency from spending taxpayer funds to enforce the rule. A similar rider was in the works on the House side. Gramm advised me to cut a deal with the accountants, or else the riders would pass.
Alarmed, I called Senator Trent Lott, then majority leader, at home. I pleaded with the Mississippi Republican not to let this important issue be resolved by dead-of-night appropriations riders. "No matter what you think about the issue," I said, "the process should be aboveboard." I told him that such publications as The New York Times, Washington Post, and BusinessWeek had all endorsed the rule. "Well, Arthur," Lott said, "I'm not familiar with what you're proposing to do, but if those liberal publications are in favor of it, then I'm against it."
Never before had the SEC faced such a threat to its independence. The possibility of a drawn-out legal challenge also gave me pause. We had no choice but to compromise. This is when Joseph Berardino, a managing partner of Arthur Andersen, played a crucial role. Berardino, who later briefly served as Arthur Andersen CEO until the Enron scandal forced his resignation, broke ranks with KPMG and Deloitte & Touche, unbeknownst to both. For weeks he worked with SEC General Counsel David Becker to craft a compromise.
At the same time, Becker, chief accountant Turner, and I began an intense game of three-dimensional chess as we tried to shape what that compromise would look like. We weren't just negotiating with the accountants, either. Certain GOP members of Congress, notably Representative Billy Tauzin of Louisiana, had taken a keen interest in the talks, and called several times a day to make suggestions.
The proposed ban on computer-systems consulting was far and away the most difficult part of the rule. Information technology (IT) was the largest and fastest-growing service accountants were selling. We scrambled for an alternative and settled on a requirement that public companies disclose in their proxy statements the amount they pay their audit firms for consulting services, with IT broken out separately. This way, investors could judge for themselves if an auditor was truly independent. Berardino said he thought he could sell this compromise to his colleagues.
We also had to wrestle with whether auditors could perform internal audits. The proposal called for an outright ban, but we were willing to accept that no company could rely on its independent auditor for more than 40% of internal audit services. Once again, Berardino got KPMG, Arthur Andersen, and Deloitte to agree.
There was one more sticky issue. The Big Five objected to the part of the proposal that said an auditor must be independent in fact and appearance. This meant that an auditor could be found in violation of independence rules if a "reasonable investor" looked at a set of circumstances and concluded that an auditor was incapable of acting without bias. No auditor, then, could hide behind the lack of direct evidence, such as a remark to a colleague, to escape punishment. As you can imagine, the Big Five balked.
In early November, we met with the firm leaders at the SEC for a showdown. I described the major points in our package and said: "Take it or leave it." In hindsight, hubris was not the best approach. But we had already given up much ground and could not retreat further. The firms caucused among themselves for 45 minutes and came back with a "no, thanks." A key point of disagreement: the independence in fact and appearance standard. The meeting ended badly.
The next morning, Berardino, who had been traveling in Europe, called Becker and asked, "What the hell happened? I thought we had everything worked out?" Luckily, Berardino got the talks going again, and spent the next 48 hours playing diplomat. He was willing to split with KPMG over the appearance issue, as was Deloitte & Touche. With those two joining Ernst & Young and PwC, we had four out of five on board on the appearance standard.
But Ernst & Young CEO Phil Laskawy balked at the last minute. He wanted the SEC to ban computer consulting, having just sold his IT unit to Cap Gemini Group in anticipation of such a ban. This was ironic, since Laskawy had been the most enlightened of the Big Five leaders. In a phone call with Laskawy and his top management, his general counsel argued against the proposal. Frustrated, I yelled at his counsel to be quiet and demanded an answer from Laskawy: "Do I have your support or not?" He was silent for a few nerve-wracking seconds, then said he felt it was in the best interest of the profession to get a deal done. Finally, we had everyone's vote.
The final rules, adopted on Nov. 15, 2000, gave up considerable ground by allowing auditors to perform up to 40% of a company's internal audit work and an unlimited amount of it consulting. But once companies began disclosing the amount of nonaudit services their auditors provide, shareholders could see what all the hullabaloo was about: S&P 500 companies had paid their auditors $3.7 billion for nonaudit services in 2000 alone--more than three times the $1.2 billion in audit fees.
In October, 2001, eight months after I left the SEC, Enron blew up. I never imagined a failure on the scale of Enron. The industry's "no smoking gun" claim now seems ludicrous. It is in the embarrassing position of having to explain Enron's demise, Arthur Andersen's disintegration, and the record $10 million fine that Xerox paid, without admitting or denying guilt for overstating revenues by more than $2 billion.
That's just for starters. By mid-2002, the SEC had opened investigations into alleged accounting shenanigans at conglomerate Tyco International (TYC), cable-TV company Adelphia Communications (ADELQ), long-distance provider WorldCom (WCOEQ), and dozens of others. And the Sarbanes-Oxley Act, signed by President Bush on July 30, 2002, finally achieves what we set out to do and bans most forms of consulting for audit clients. It also creates a new accounting oversight board in place of the AICPA.
Sometimes it takes a crisis to convince the world that the status quo has to change. If there's a silver lining in the past year's corporate accounting disasters, it's that an issue as mundane as auditor independence, which nearly consumed us at the SEC, has finally caught the public's imagination.
From Take on the Street: What Wall Street and Corporate America Don't Want You to Know. What You Can Do to Fight Back by Arthur Levitt with Paula Dwyer. Copyright 2002 by Arthur Levitt. Excerpted by permission of Random House, Inc.