The Reluctant Reformer
Faced with rising public disgust over the Enron scandal and a seemingly endless string of corporate bookkeeping investigations, Administration economic advisers spent much of the winter huddled in crisis meetings. The key question: How can a fiercely anti-regulation White House restore confidence in Corporate America's accounting and governance without choking off the innovation and flexibility that underpin the world's most efficient financial system?
On Mar. 7, President George W. Bush gave his answer to a chorus of lawmakers clamoring for tough new laws: Let Harvey do it. The Harvey in question is Harvey L. Pitt, the savvy 57-year-old lawyer Bush tapped to head the Securities & Exchange Commission. A brilliant conservative who made his name representing the nation's financial powerhouses, Pitt was selected as an antidote to his prickly predecessor, Arthur Levitt Jr., a combative champion of small investors and scourge of accountants and Wall Street. Pitt's original vision for the SEC: Let sweet reason, self-policing, and voluntary compliance supplant Levitt's confrontational reign.
Enron Corp.'s rapid collapse, a rash of corporations restating their earnings, and a wave of corporate insiders selling out just before their stocks cratered: All these overwhelmed that game plan and thrust Pitt into the unexpected role of reluctant reformer. Granted sweeping powers by the White House, he now has the Herculean task of cleaning up a mess that has been accumulating for years--an alarming erosion in the honesty and reliability of financial information about companies, data on which America's markets depend. Companies have played numbers games with increasing abandon--exaggerating profits, understating debts, hiding costs--and indulgent auditors have O.K.'d it all, for fear of losing juicy consulting contracts with their clients. Overblown earnings inflated the bonuses of corporate insiders, many of whom reaped big profits cashing in stock options ahead of earnings restatements. Meanwhile, investors were left clueless about what was really going on inside once-admired outfits such as Enron.
In Bush's vision, the newly empowered Pitt will be part cop and part missionary, determined to restore the Investor Class's faith in what the President calls "the ownership culture." Shape up those see-no-evil accountants? The SEC will crack the whip, Bush insisted in his Mar. 7 speech. Deal with the ill-gotten gains of serial financial finaglers? The SEC will get CEOs' attention by confiscating bonuses and stock-option profits. Direct management to tell shareholders of important deals quickly and fully? A piece of cake for Pitt & Co. "Today, I call upon the Securities & Exchange Commission to take action," said Bush. "Reform should improve investor confidence and help our economy to flourish and grow."
But Pitt's mandate is to fix the problems by using existing rules, heading off tough legislation at all costs. He's caught in a three-way squeeze by congressional Democrats and investor advocates, who think he's a wimp; financial-industry giants, who will brand him a turncoat if he resorts to punitive measures; and hard-core conservatives, who think any institutional response to the Enron mess will slow economic growth. As these forces play out, the last thing Bush wants is a wide-ranging reform bill from the Hill that he hates but cannot veto because it would make him look soft on Enron, the biggest corporate backer of his political career. Most reforms "can be done by executive action through the Securities & Exchange Commission and the Treasury," insists White House political guru Karl Rove, who is guiding Bush's response to the Enron saga. "If we can solve much of the problem [without new legislation], so much the better."
Portly, bearded, and given to talking in dense phrases--the man practically speaks in footnotes--Pitt is comfortable with that approach. His belief in the power of markets to correct faults is almost religious. He openly decries the urge to legislate of such leading liberals as Senators Jon S. Corzine (D-N.J.) and Christopher J. Dodd (D-Conn.). "Not every problem," Pitt says, "requires a new statute or a new rule". Instead, he is pushing a free-market agenda: a four-pronged offensive that relies on stronger enforcement, stepped-up penalties for corporate miscreants, quicker and clearer financial disclosure, and structural reform of auditing.
As a first step, Pitt has ordered the enforcement of existing accounting rules, nearly tripling the number of SEC probes into company books. The troubled telecommunications industry is bearing the brunt of this scrutiny, with bankrupt Global Crossing and outfits such as Qwest Communications and WorldCom in the crosshairs. And he's operating behind the scenes to nip potential crises in the bud: When questions about IBM's accounting for asset sales threatened to send the stock into the tank in February, SEC accountants quickly persuaded Big Blue to quit using those transactions to bolster earnings. "Harvey operates by talking to people and achieving consensus rather than wielding a big stick," says former SEC Chairman David S. Ruder, now a law professor at Northwestern University.
Meanwhile, Pitt has embraced Treasury Secretary Paul H. O'Neill's call to make CEOs personally liable for financial performance. He helped spike O'Neill's most sweeping proposal--making it easier to sue execs and directors--but came back with some stiff penalties that could dissuade top officers from playing numbers games. "Harvey likes to say that you have to listen to both the words and the music," says Paul Gonson, a longtime top SEC lawyer now at Kirkpatrick & Lockhart. "For corporate executives, his music is saying, `We're getting much tougher."'
But Pitt has struck some sour notes. His preference for quiet diplomacy over noisy activism led to a major blunder with his first response to the Enron collapse, a plan for a new review board to oversee and discipline auditors. As the spot- light fell on Arthur Andersen LLP's auditing failures at Enron, Pitt met with the American Institute of Certified Public Accountants and its top members. They all knew him well: Pitt and his former law firm, Fried Frank Harris Shriver & Jacobson, had represented the trade group and each of the Big Five at one time or another. Together, they hammered out a deal to take auditor discipline out of the hands of the AICPA and vest it in a new group, later dubbed the Public Accountability Board, with a majority of investor and business representatives and a minority of accountants.
Pitt was about to let Capitol Hill in on his plan in mid-January when details leaked to BusinessWeek and The Washington Post. His hurried announcement ruffled feathers on the Hill and among accounting overseers. The Public Oversight Board, a five-member group that Levitt charged with reviewing the quality of Big Five audits, disbanded in protest. Pitt's proposed board is widely viewed as weak. It would lack subpoena power to produce evidence. And by allowing even a minority of accountants on the board, Pitt risks repeating history and letting it get taken over by the industry. But Pitt stuck to his guns, with White House support, even in the face of bipartisan demands for a tougher stance. "Political skills and luck are two of the most important things an SEC chairman can have," observes a former top Democratic SEC official. "So far, Harvey is falling short on both."
All the same, he may win one victory that eluded several of his predecessors: persuading Congress to boost the SEC's budget. Plagued by low pay, mission creep, and sagging morale, the agency has long needed more money. Though Bush said on Mar. 13 he's still not inclined to give it, Congress' General Accounting Office thinks otherwise. In a Mar. 5 report, it found the SEC's workload has grown by 80% since 1993, while staffing has been stagnant. Pitt asked the Hill for $558 million for next year--an extra $91 million, or six times the $15 million that Bush's budget office approved. "We need those resources if we are to restore the public's full confidence in our capital markets," he told the Senate Appropriations Committee.
Pitt was right on both counts: The SEC needs reinforcements, and it needs to rebuild public confidence. But how much faith should members of the Investor Class have that Pitt will do the job of reining in corporate offenders--and those who help them?
Before Enron blew up into a corporate ethics fiasco, Pitt made millions representing top financial-industry players. So Democrats, eager to prolong Bush's discomfort over Enron's demise, are quick to suggest that Pitt's background makes him a poor candidate to lead an ethics crusade. Pitt "is a man of unquestioned character," says Corzine, a former Wall Streeter. But "on policy, he's toeing the Administration's line with relatively weak initiatives."
A chorus of pension-fund managers and shareholder-rights advocates agrees. They fear the Administration will rob them of their best chance in decades to overhaul corporate boards. "Pitt wants to have the appearance of action to hide the fact that he's not doing anything serious," asserts Sarah Teslik, president of the Council of Institutional Investors, an activist group of pension and mutual funds.
Pitt's supporters say skeptics are missing a key point: Pitt's devotion to the SEC and its central role in ensuring the integrity of U.S. capital markets. Born in Brooklyn, N.Y., to immigrant parents, Pitt believes that "the SEC plays an incredibly important role in overseeing the markets that enable millions to achieve a piece of the American dream." With a freshly minted law degree from St. John's University, Pitt joined the SEC in 1968. He headed a major study on the rising clout of institutional investors, then was tapped as executive assistant to the late SEC Chairman Ray Garrett Jr. In 1975, Garrett named the 30-year-old Pitt the agency's youngest-ever general counsel. In that job, Pitt got acquainted with accounting abuses. He and then-Enforcement Director Stanley Sporkin launched the mid-1970s crackdown on cooked books and faulty internal controls at such companies as United Brands and Lockheed. "We brought 20 cases against the Big Eight accounting firms," Sporkin recalls. "Harvey was in on every one of them."
Pitt left in 1978 to become a partner in the Washington office of Fried Frank. There, he became the go-to guy for anyone in trouble on financial issues--the New York Stock Exchange, Merrill Lynch, America Online, and, according to his ethics filing, 109 other clients with civil, criminal, or policy problems with the SEC.
Even as a private lawyer, Pitt helped the SEC crack big cases. In the 1986 Drexel Burnham Lambert insider-trading scandal, Pitt put enforcers on to two of the prime suspects--Drexel broker Dennis B. Levine and junk-bond king Michael R. Milken--as he negotiated plea bargains for his clients, Switzerland's Bank Leu and arbitrageur Ivan F. Boesky. Sure, the deals helped his clients, but the episodes show that Pitt "is firmly committed to the view that people who abuse securities markets should be punished," says Cornell University law professor Jonathan R. Macey.
Back at the SEC--earning a fraction of his $3 million annual pay at Fried Frank--Pitt is setting a stiff pace for his staff. Still, he finds time to make homemade Oreo ice cream at school events for his young son and daughter. Friends say he's a voracious reader, and his nightstand tilts to the right: Recent books by William Safire and Peggy Noonan are among his favorites. Pitt is currently reading Theodore Rex, Edmund Morris' biography of a GOP President faced with massive abuses of corporate power.
It could be instructive. History shows that even doctrinaire conservatives can get religion when the markets are roiled by scandal. Case in point: the go-go '80s. When Milken and Boesky burst into the headlines, the SEC was headed by a throw-out-the-regs Republican, John Shad. But that didn't keep the SEC from demonstrating its resolve with a wave of prosecutions that cooled inside dealing.
When it came to Enron, the enforcement response was a no-brainer: In October, as soon as the Houston-based energy-trading giant disclosed huge third-quarter losses, the SEC launched an investigation. Enforcement Director Stephen M. Cutler quickly asked the three then-sitting commissioners to grant him subpoena power. Pitt weighed his own conflict--he had represented Andersen--against the fact that if he didn't participate, the SEC wouldn't have a quorum. He joined in a unanimous vote to back Cutler. Since then, Pitt has not been involved in the Enron probe. That has quieted critics, though some still say he should have fully and formally recused himself. More significantly, he has ordered Cutler to step up examinations of other companies' books, drafting accountants from other SEC divisions to speed up cases.
On the second front--tightening financial disclosure--Pitt has zeroed in on the weaknesses that let Enron build its house of cards. Take Enron's abuse of murky accounting rules to create off-the-books partnerships that hide the company's debt. Pitt has chewed out the Financial Accounting Standards Board for failing to fix the rules. But he's not waiting for FASB action: Starting with annual reports for 2001, companies must tell investors which bookkeeping judgments have the biggest impact on reported profits. Under SEC "guidance"--soon to be backed by formal rules--CEOs will have to spell out the key risks their businesses face in the "management discussion and analysis" section of the reports. "[Those] have always been a pretty rote exercise," says SEC Chief Accountant Robert K. Herdman, a former Ernst & Young International vice-chairman. "This year, we're hearing that lots of companies are taking out a clean sheet of paper."
New SEC rules will speed other information, too. On Pitt's advice, Bush is calling for a 48-hour deadline for reporting major insider stock sales or purchases--tightening today's rules, under which reports can take months. Pitt has also ordered up rules requiring companies to report immediately on a range of events, including some, like waivers of ethics rules or creation of off-balance-sheet financing vehicles, that figured prominently in Enron's collapse.
Pitt came to the SEC prepared to overhaul financial reporting--and for that effort, Enron has been a blessing in disguise. "The current crisis finally demonstrates in absolutely clear relief that our disclosure system doesn't work as well as it should," says Alan L. Beller, a securities lawyer Pitt tapped as director of corporation finance and senior counselor. These early steps will feed into a more sweeping overhaul of financial statements that will let companies use Internet technology to give investors data that are both broader and better focused than today's impenetrable financial statements.
Another top Pitt priority--streamlining rules to make it easier to raise capital and to help retail investors get in on a broader range of stock issues--has been delegated for now to newly appointed Commissioner Cynthia A. Glassman, an economist who came to the SEC from Ernst & Young. "The goal is to make sure that our rules are relevant, effective, and efficient in the markets of the 21st century," Glassman says.
But right now, coping with Enron fallout is Job One. The SEC has already attacked the rich pay that Enron is bestowing on its new CEO, corporate turnaround expert Stephen F. Cooper. On Mar. 13, the SEC filed its first suit seeking repayment of stock options earned when an executive at chemical company IGI Inc. allegedly inflated profits. "We are going to go after compensation packages whenever we think the facts show disservice to the shareholders," Pitt says. Such threats "will make a lot of CEOs sit up and take notice," says Philip B. Livingston, CEO of Financial Executives International, which represents top execs.
To make them stick, the SEC will need some creative legal work. Now, it can ask a federal court to bar egregious offenders from taking new jobs as officers or directors, where they can play around with shareholder money. Pitt's enforcers have stepped up those requests and are hoping to make an example of Albert "Chainsaw Al" Dunlap, who's fighting SEC charges that he defrauded Sunbeam Corp. shareholders. Judges have been stingy, in enforcement chief Cutler's view, in granting the SEC's requests. In his plan, Bush asks Congress to amend its 1990 law to give disbarment power directly to the SEC--the only element of his 10-point corporate-accountability plan that requires new legislation.
The Hill, however, may want to do more on accounting issues. Bush's plan wouldn't do much to limit the conflict created when the same accounting firm consults for a company that it audits. Bush would ban auditors only from performing internal auditing--checking corporate controls for hiring, say, or purchasing. Any other restrictions would be left to Pitt, who maintains that Levitt's big push in 2000 to split consulting from auditing was misguided. Pitt doesn't believe consulting has to be in conflict with auditing and fears a separation would scare bright people away from accounting. "My concern is that if some [congressional] proposals go through, in the next five years we will have far worse audits than we have now," says Pitt.
That view doesn't prevail on the Hill. The Senate is likely to pass a ban on all consulting, except tax work, by audit firms. The bill might also close the revolving door between auditors and the executive suite, forcing any company that hires an audit partner as a chief financial officer to switch auditing firms for at least two years. The House GOP leaders may water down those provisions. But Congress is ahead of Pitt on reforming accounting.
Can Pitt get in front of the reform parade and silence the skeptics? On three of his four core agenda items--enforcement, cracking down on CEOs, and improving financial disclosure--his proposals are indeed ahead of the pack. So far, though, Pitt is getting little credit. In part, that's because of his style: While the SEC chief knows the technical and legal role of the commission from the inside out, he hasn't yet grasped the vital importance of the chairman's bully pulpit. Pitt is never likely to become another Levitt--but he can make his positions clearer. Most tellingly, he hasn't done what any good pol does at the start of a campaign: Define himself before his opponents do it for him. Pitt could make a case that his measures will protect the Investor Class--and make investing easier as well. But he hasn't.
If Pitt takes on that challenge, he must shake the perception that he's a mouthpiece for the White House. His gushing embrace of Bush's plan only feeds the idea that he's a halfhearted reformer. Pitt can easily put some distance between himself and the White House by accepting that Congress can play a role in giving his reforms teeth. That means listening to Democrats, some of whose ideas--like the Mar. 12 proposal from Senator Patrick Leahy (D-Vt.) to create a new class of securities crimes--merit serious attention.
Pitt must also make a clean break with his old clients. When Enron turned accountants' conflicts into front-page news, it exposed an incestuous system in which the guardians of financial statements were allowed to police themselves. Pitt persuaded the accountants to let a few outsiders in on disciplinary decisions--and he thinks that's a major triumph. But it's hardly enough. He needs to push for a tougher discipline board, and work with Congress to win it. And as for splitting auditing from consulting, he should embrace the Big Five's agreement to end their most lucrative form of consulting--installing big computer systems--for audit clients.
Few SEC chiefs have come into office with the qualifications Pitt brings. He knows both the agency and the industries it regulates intimately. In a quarter-century of representing financial-fraud defendants he has been exposed to nearly every known form of chicanery. The Reluctant Reformer has enormous potential to end the epidemic of financial abuse plaguing Corporate America. And when it comes to getting things done, there's a chance that Pitt's conciliatory style could achieve much more than Levitt's saber-rattling.
Will this historic moment in American business produce a historic reformer? Or will Pitt succumb to the pressures--from his party, from Wall Street, and from his own ideology--and devote himself to little more than calming the troubled political waters around his President? Super-lawyer Pitt likes to say that since he took the helm at the SEC, he now works for "the most wonderful client of all--the American investor." It's time for him to deliver for that client as he has for so many others before.
By Mike McNamee and Amy Borrus in Washington, with David Henry in New York