u.S.Securities and Exchange CommissionWashington,D. C. 20549 (202) 272-2650

THE TREADWAY COMMISSION REPORT:TWO YEARS LATER

Prepared for the

[N]@\'!;\Yl~[R1@~@~~@

sixteenth Annual Securities Regulation InstituteThe University of california, San Diego

January 26, 1989

Joseph A. GrundfestCommissioner, U.S. Securities & Exchange Commission

andMax Berueffy, Esq.

Counsel to commissioner Joseph A. Grundfest

The views expressed herein are those of the authors and donot necessarily represent those of the Commission, othercommissioners, or the Commission staff.

THE TREADWAY COMMISSION REPORT:TWO YEARS LATER

I. THE TREADWAY COMMISSIONThe National Commission on Fraudulent Financial Reportingwas established in June 1985. Usually referred to by thename of its chairman, former SEC Commissioner James C.Treadway, Jr., the "Treadway Commission" was jointlysponsored and funded by five private accountingorganizations: the American Institute of CertifiedPublic Accountants (AICPA), the American AccountingAssociation (AAA), the Financial Executive Institute(FEI), the Institute of Internal Auditors (IIA), and theNational Association of Accountants (NAA).The early and mid-1980's saw such spectacular failuresas Drysd~le Government Securities, Washington PublicPower Supply System, Baldwin-united Corp., and E.S.M.Government Securities. Congressional hearings into thecauses for these failures focused upon whether they couldhave been avoided by, among other things, better auditpractice. See,~, Hearings on SEC Oversight.Authorization. and Other Matters Before the Subcommitteeon Telecommunications. Consumer Protection. and Financeof the House Committee on Energy and Commerce, 99thCong., 1st Sess. 2, 85-90 (Mar. 21, 1985). See generally"The Internal Auditor's Role In Deterring, Detecting andReporting of Financial Frauds," Remarks of David S.Ruder, Chairman, SEC, Before the Institute of InternalAuditors' Business Issues and Audit Conference,Washington, D.C. (April 25, 1988) at 1 (hereinafter citedas Ruder, "The Internal Auditor's Role"): Tougher RoleUrged for Firms' AUditors, Wash. Post, Oct. 22, 1986, atG-2.: Daily Report for Executives (BNA) at S-23, Jan. 20,1987.The Treadway Commission was formed amidst this climate ofscrutiny. The mission it defined for itself was "toidentify causal factors that can lead to fraudulentfinancial reporting and steps to reduce its incidence."Report of the National Commission on FraudulentFinancial Reporting (October 1987) at 1 (hereinaftercited as Treadway Report). In October 1987, the TreadwayCommission issued its final report presenting itsfindings, conclusions, and recommendations.A. Definition of "Fraudulent Financial Reporting." For

purposes of its study and report, the TreadwayCommission defined "fraudulent financial reporting"as "intentional or reckless conduct, whether act oromission, that results in materially misleading

financial statements." Treadway Report at 2. TheCommission pointed out that fraudulent financialreporting can take many forms, including"deliberate distortion of corporate records, such asinventory count tags," or "falsified transactions,such as fictitious sales or orders," or"misapplication of accounting principles." Id.

B. The Treadway Commission's Objectives. As set forthin its Report, the Treadway Commission had threemajor objectives:"1. Consider the extent to which acts of fraudulentfinancial reporting undermine the integrity offinancial reporting; the forces and theopportunities, environmental, institutional, orindividual, that may contribute to these acts; theextent to which fraudulent financial reporting canbe prevented or deterred and to which it can bedetected sooner after occurrence; the extent, ifany, to which incidents of this type of fraud may bethe product of a decline in professionalism ofcorporate financial officers and internal auditors;and the extent, if any, to which the regUlatory andlaw enforcement environment unwittingly may havetolerated or contributed to the occurrence of thistype of fraud."2. Examine the role of the independent pUblicaccountant in detecting fraud, focusing particularlyon whether the detection of fraudulent financialreporting has been neglected or inSUfficientlyfocused on and whether the ability of theindependent pUblic accountant to detect such fraudcan be enhanced, and consider whether changes inaUditing standards or procedures--internal andexternal--would reduce the extent of fraudulentfinancial reporting."3. Identify attributes of corporate structure thatmay contribute to acts of fraudulent financialreporting or to the failure to detect such actspromptly." Treadway Report at 2.

C. The Treadway Commission's Recommendations--Generally. The Treadway Report recognized thatimprovement in the prevention and detection offraudulent financial reporting involves action inall areas, by many persons and entities. Accord-ingly, the Report's recommendations are directedtoward three groups: pUblic companies, independentpUblic accountants, and the SEC.

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1. Recommendations for the Public Company.Recognizing that "[p]revention and detection offraudulent financial reporting must start withthe entity that prepares financial reports,"the first focus of the Treadway Commission'srecommendations is the public company. Therecommendations for pUblic companies deal with(1) the tone set by top management, (2) theinternal accounting and audit function, (3) theaudit committee, (4) management and auditcommittee reports, (5) the practice of seekingsecond opinions from independent publicaccountants, and (6) quarterly reporting.Treadway Report at 11, 31-48.

2. Recommendations for the Independent PublicAccountant. The Treadway Report also notedthat the independent public accountant plays a"crucial" role in detecting and deterringfinancial reporting. To improve theeffectiveness of the independent pUblicaccountant, the Treadway Commission recommendedchanges in auditing standards, in proceduresthat enhance audit quality, in the independentpUblic accountant's communications about his orher role, and in the process of settingauditing standards. Treadway Report at 12, 49-62.

3. Recommendations for the SEC and Others toImprove the Regulatory and Legal Environment.The Treadway Commission also suggested thatimprovement could be made in the area ofdeterring fraudulent financial reporting.Treadway Report at 14. The Report'srecommendations for increased deterrenceinvolve new SEC sanctions, greater criminalprosecution, improved regulation of the pUblicaccounting profession, adequate SEC resources,improved federal regUlation of financialinstitutions, and improved oversight by stateboards of accountancy. The Treadway Commissionalso made two final recommendations inconnection with the perceived insurance andliability crises. LQ. at 14, 63-78.In addition to these recommendations directedto participants in the financial reportingprocess, the Treadway Commission acknowledgedthe role that education can play in "providingknowledge, skills, and ethical values that

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potentially may help prevent, detect, and deterfraudulent financial reporting." Accordingly,the Report recommended changes in business andaccounting curricula, professional certifica-tion examinations, and continuing professionaleducation in order to encourage initiativestoward that end. Treadway Report at 15, 79-86.

D. General Observations on the Treadway Report byMembers of the securities and Exchange Commission.In general, the SEC has applauded the TreadwayCommission's Report as "an important contribution tothe efforts of the [SEC] and others" in theirefforts to consider methods to improve financialreporting by pUblic companies. See Hearings beforethe Subcommittee on Oversight and Investigations ofthe House Committee on Energy and Commerceconcerning the Recommendations of the NationalCommission on Fraudulent Financial Reporting, 100thCong., 2nd Sess. (May 2, 1988) (statement of David S.RUder, Chairman, SEC) (hereinafter cited as SECTestimony (May 2, 1988». In addition, theindividual members of the SEC have made separateremarks regarding the Treadway recommendations.1. Chairman Ruder. Chairman Ruder's individual

statements with respect to the work of theTreadway Commission have generally tracked theviews set forth in the SEC's May 2, 1988testimony. He believes that the TreadwayReport provides "a number of constructivecomments that may contribute to an improvedfinancial reporting climate." Ruder, "TheInternal Auditors' Role," supra p. 1, at 6; seealso "Concerning The Report Of The NationalCommission on Fraudulent Financial Reporting,"Remarks of David S. Ruder, Chairman, SEC,Before the 7th Annual SEC and FinancialReporting Institue Conference, Los Angeles,California (May 10, 1988).

2. Commissioner Cox. In a recent address,Commissioner Cox observed that "the Treadwayrecommendations that, if implemented, wouldhave the greatest impact on reducing fraudulentfinancial reporting are basically hortatorystatements directed to corporate managers andare not calls for regulatory action." "TheTreadway Report--Any Results Yet?", Remarks byCommissioner Cox to the Annual Meeting of SECReviewing Partners Committee of Peat MarwickMain & Co., Washington, D.C. (Dec. 7, 1988) at

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1 (hereinafter cited as "Cox Speech").Commissioner Cox stated the SEC has a"relatively "minor role to play in addressing'the reforms proposed by Treadway." Id. In hisview, the relative importance of the SEC'srole is "reflected by its response over thepast year--one that has exhibited a lack ofurgency and has included the rejection ofcertain Treadway recommendations." Id.Commissioner Cox also emphasized the need forcareful cost-benefit analysis of the Treadwayrecommendations, and notes that the TreadwayReport is "candid in stating that companieswould incur considerable costs in implementingits recommendations, and that costs would beespecially significant for smaller, newlypUblic companies." Id. Unfortunately, asCommissioner Cox observed, generalizationsabout the costs of not implementing theTreadway recommendations are "too vagu(~," andinvolve considerations such as "investorconfidence" that are "highly sUbjective andinherently unquantifiable." Id. at 1-2.

3. Commissioner Grundfest. Commissioner Grundfestviews the Treadway Report as addressingproblems in optimal quality control and inoptimal deterrence. Because of the highprobabilistic component in the audit procedure,some incidence of audit failure may beinevitable absent costs far out of proportionto the benefits that complete elimination ofsuch failures might bring. From a socialperspective, economic well-being is maximizedwhen the social marginal cost of punitivemeasures equals the marginal social benefits.Absolute elimination of all possibilities ofaudit failure is thus too extreme a positionbecause it would require marginal costs inexcess of benefits. Moreover, because thecosts and benefits of specific Treadwayrecommendations can differ dramatically fromcompany to company--most notably by increasingcosts for smaller firms without generatingcommensurate social benefits--CommissionerGrundfest recommends that policymakers avoid"pounding square pegs into round holes" byforcing all companies to comply withstandardized requirements, regardless of theirspecific circumstances. Commissioner Grundfestinstead recommends strategies that permit

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greater flexibility, recognize the implicationsof differential compliance costs, and applyappropriate sanctions in order to induceoptimal levels of compliance. See,~,Easterbrook & Fischel, Optimal Damages inSecurities Cases, 52 U. Chi. L. Rev. 611(1985), for a discussion of an optimaldeterrence approach to securities lawenforcement that carries over well to many ofthe situations addressed in the TreadwayReport.

4. Commissioner Fleischman. In an addressdelivered last fall, Commissioner Fleischmanstated that the Treadway Report's emphasis onlithe tone at the top" should be "trumpeted fromthe financial rooftops" because, in calling onfinancial executives "to set the tone byidentifying and understanding the factors thatcan lead to fraudulent financial reporting andby assessing the risk of fraudulent reportingthat those factors create * * * ," it puts theprimary responsibility for proper reportingexactly where it belongs. "GreatExpectations," Address to the FinancialExecutives Institute, New York City, at 6(Oct. 31, 1988). In his view, "if thetone * * * is professional, the likelihood offraudulent reporting is minimized." Id. at 7.Commissioner Fleischman believes that nomeasures of legislation or governmentregulation can do more to prevent financialfraud than ethos of honesty in management--fromthe top down:

[Y]ou as financial executives can"help establish [a control] environ-ment where open communication isexpected, accepted, and protected. .

" Each of you expects no less ofyourself, and your audit committee,your company's shareholders, yourCEO, the SEC and the oversightcommittees of Congress also expect noless of you. And I do believe thatthe obligations inherent in thatexpectation are coupled withassurances that regulatory policiesfocussed on protecting the integrityof the financial reporting process,and thereby on safeguarding the

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fairness and efficiency of the pUblicsecurities markets, have been, areand will be applied in such a manneras to credit your professionalefforts in that regard. Id.

5. Commissioner Schapiro. Commissioner Schapirojoined the SEC on December 5, 1988, and has asyet expressed no views regarding the TreadwayCommission or any of its recommendations.

II. THE TREADWAY COMMISSION'S RECOMMENDATIONS FOR THE SECAND THE SEC'S RESPONSEOf the forty-nine specific recommendations made by theTreadway Commission, thirteen require rulemaking by theSecurities and Exchange Commission, or legislativeaction. This section of the outline sets forth each ofthese recommendations, the Treadway Commission's reasonsfor each recommendation, the SEC's response, the reasonsfor that response, and the basis for any dissentsexpressed by members of the Commission. In summary form,the recommendations involve:

1. A requirement that publicly traded firms haveindependent audit committees;

2. A requirement that a management reportaddressing responsibility for financia~statements and controls accompany the 1ssuer'sannual report;

3. A requirement that an audit committee letterdescribing the committee's activities accompanythe annual report;

4. A requirement that any change in auditors beaccompanied by disclosure of material auditingissues that arose during three years precedingthe change;

5. A requirement that independent accountantsreview quarterly financial data prior torelease;

6. A suggestion that the SEC seek legislativeauthority to impose civil money penalties ininjunctive and administrative proceedings;

7. A suggestion that the SEC seek legislativeauthority to issue cease and desist orders;

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8. A suggestion that the Commission seek specificlegislative authority to bar or suspendcorporate officers and directors;

9. A suggestion that the commission affirmativelypromote increased criminal prosecutions offraudulent reporting cases through greatercooperation with criminal enforcement agencies;

10. A requirement that all auditors of publiclytraded firms be members of organizations withSEC approved peer review functions;

11. A suggestion that the SEC take enforcementaction against firms that fail to correctdeficiencies identified in peer reviews (peerreview enforcement);

12. A suggestion that the SEC's budget beincreased; and

13. A suggestion that the SEC reconsider its policyagainst indemnification of independentdirectors.

A. Mandatory Independent Audit Committees1. Recommendation. "The board of directors of all

public companies should be required by SEC ruleto establish audit committees composed solelyof independent directors." Treadway Report at40.

2. Treadway Commission's Rationale. Auditcommittees composed of independent directorswould enhance the board of directors' abilityto carry out its responsibility to oversee topmanagement, which is primarily responsible fora company's financial reporting. The TreadwayCommission's research indicated that the auditcommittee's assessment of the independence ofthe pUblic accountant and its review of theadequacy of, and compliance with, internalaccounting controls contribute significantly tothe integrity of the financial reportingprocess. For example, the Report noted onestudy which found that, while 85% of all publiccompanies have audit committees, a signifi-cantly smaller percentage (69%) of the publiccompanies involved in the fraudulent financialreporting cases brought by the SEC from 1981 to

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1986 had audit committees. Treadway Report at40.

The Treadway Commission recognized thedifficulties that smaller, newly publiccompanies may have in attracting qualifiedindependent directors. The Report thereforerecommends that, although the rule should applyregardless of the company's size, the SECshould be able to exempt a company from theaudit committee rule if the company candemonstrate that it is unable, after a diligentattempt, to attract independent directors andhas instituted procedures and controls that arethe functional equivalent of an auditcommittee. rd. at 41.

3. The SEC Response. On December 7, 1988, the SECsent letters to the NASD and all stockexchanges, except the New York Stock Exchange(which already requires all listed domesticcompanies to maintain independent auditcommittees), urging these self-regulatoryorganizations ("SROs") to consider upgradingand expanding their listing and quotationstandards relating to audit committees.

4. Reasons for the SEC's Response. The Commissionunanimously rejected the specific Treadwayrecommendation that the Commission, by rule,require independent audit committees. ChairmanRuder and Commissioners Peters and Fleischman,however, supported a letter to the SROs urgingthem to upgrade their listing standards, whileCommissioners Cox and Grundfest, for separatereasons, opposed sending such a letter.a. The Majority's Decision. The SEC decided

not to propose a rule mandating independentaudit committees, but rather to urge theSROs to consider upgrading their quotationand listing standards with respect to suchcommittees. The SEC's letters to the SROsexplained that:

[t]he Commission believes that theSROs' experience, particularlywith respect to corporate listingstandards, puts [them] in aposition to exercise flexibilityin the formulation and implemen-tation of new audit committee

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standards. This flexibilitywould, for example, enable you toformulate appropriate independencestandards for audit committeemembers and to determine theextent to which it is feasible torequire audit committees to becomposed of independent directors.In addition, SROs are wellequipped to consider whether anexemption, in whole or in part,from audit committee requirementsshould be available for smallercompanies.

b. The Dissent. Commissioners Cox andGrundfest dissented from the majority'sdecision. Commissioner Cox, whilerecognizing that "audit committeeB are oftenbeneficial," has expressed the viE!w that theSEC should not "use its authority andinfluence over the securities self-regulatory organizations as a 'back-door'for regulating indirectly corporategovernance matters that have traditionallybeen the province of state law, and that arearguably beyond the agency's ability toregulate directly." Cox Speech, suprap, 5, at 2.

Commissioner Grundfest objected to theletter because of concern that pressure tocreate independent audit committees was notnecessarily the most efficient means toachieve the desired result. Increasedfinancial and other penalties for fraudulentreports would create a greater incentive tocomply with the law and simultaneouslyprovide for valuable corporate flexibilityin determining the most cost-effective meansof compliance. Thus, Commissioner Grundfestargued that the Commission should focus onestablishing appropriate incentives forcompliance and thereafter allow companiessubstantial flexibility in determining themethods they would use to improve thequality of their financial reports.See SEC to Ask Congress for Power to Imposecivil Monetary Fines, 20 Sec. Reg. & L. Rep.(BNA) 636 (April 29, 1988).

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c. Note: Prior SEC Support for AuditCommittees. As early as 1940, the SECendorsed the formation of audit committeescomposed of non-officer directors with theresponsibilities of selecting, for theboard's approval, the company's outsideauditors and of specifying the terms of theoutside auditors' engagement. Exchange ActReI. No. 2707 (Dec. 5, 1940). In 1972, theSEC advocated that all pUblicly heldcompanies establish audit committeescomposed of outside directors, for thepurpose of promoting reliability infinancial reporting. Securities Act ReI.No. 5237 (Mar. 23, 1972). Subsequently, byletter to NYSE Chairman William Batten datedMay 11, 1976, Chairman Roderick M. Hillssuggested that the Exchange revise itslisting policies to encourage corporation toestablish independent audit committees. TheSEC has also endorsed the creation ofindependent audit committees in occasionalreports to Congress. See Report of theSecurities and Exchange Commission onQuestionable and Illegal Corporate Paymentsand Practices, Senate Committee on Banking,Housing and Urban Affairs, 94th Cong., 2ndSess., 67-69 (Committee Print 1976);Securities and Exchange Commission Reportto Congress on the Accounting Professionand the Commission's Oversight Role,Subcomm. on Governmental Efficiency and theDistrict of Columbia of the SenateCommittee on Governmental Affairs, 95thCong., 2nd Sess., 96-107, 145-48 (CommitteePrint 1978); Staff Report on CorporateAccountability, Senate Committee on Banking,Housing and Urban Affairs, 96th Cong., 2ndSess., 486-510 (Committee Print 1980).

B. Management Report1. Recommendation. -All public companies should be

required by SEC rule to include in their annualreports to stockholders management reports signedby the chief executive officer and the chiefaccounting officer and/or the chief financialofficer. The management report should acknow-ledge management's responsibilities for thefinancial statements and internal control,discuss how these responsibilities werefulfilled, and provide management's assessment

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of the effectiveness of the company's internalcontrols." Treadway Report at 44.

2. Treadway Commission's Rationale. Managementreports, tailored to a company's individualcircumstances, would improve communication tofinancial statement users regarding the nature offinancial information and the processes thatsurround its preparation and presentation.Management's opinion on internal control issignificant because the internal control systemprovides the basis for the preparation offinancial statements, and the overall system ofaccountability. The signatures of the CEO andthe CFO and/or CAO would underscore their rolesin, and responsibilities for, the financialaccounting process. Treadway Report at 45.Despite the support of several private sectororganizations, such as the FEI and AICPA, asignificant number of pUblic companies do notinclude management reports in their annualreports to stockholders. Id.

3. The SEC Response. On April 27, 1988, the SECunanimously agreed with the staff's recom-mendation to propose for comment a rule thatwould require issuers to include a report bymanagement similar to the report recommended bythe Treadway Commission annual reports on Form10-K and annual reports to security holders. Seegenerally SEC Testimony (May 2, 1988), supra p.4, at 10-14. The SEC's proposed rule requiringthat registrants include a report of management'sresponsibilities in Forms 10-K and N-SAR andannual reports to security holders was pUblishedfor comment on August 2, 1988. See SecuritiesAct ReI. No. 6789, 41 S.E.C. Dkt. 681 (Aug. 2,1988). The staff is currently reviewing thecomment letters received.Proposed Item 703 (a) to Regulation S-K wouldrequire a description of management's responsi-bilities for the preparation of the registrant'sfinancial statements, the determination of theestimates and jUdgments used therein, and thepreparation of other financial informationincluded in a document containing the regis-trant's financial statements. Proposed Item703(b) would require a description or statementof management's responsibilities for establishingand maintaining a system of internal control over

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financial reporting. It would also require anassessment, as of the registrant's most recentfiscal year end, of the effectiveness of theregistrant's system of internal control thatencompasses material matters. Finally, manage-ment would be required to state how it hasresponded to the recommendations of the auditorsconcerning the company's internal control.

4. Reasons for the SEC's Response. The SEC has longemphasized the importance of effective systemsfor internal control of the financial reportingprocess. See Accounting Series ReI. No. 278(June 6, 1980), 45 Fed. Reg. 40134. In itsrelease proposing that management repor~s berequired, the SEC reaffirmed its view that "someassurance concerning the existence of aneffective system is important to investors."Securities Act ReI. No. 6789, 41 S.E.C. Dkt. at681. The SEC believes that management reportswill provide evidence that senior management hasattended to preparation of reliable financialinformation and to the internal control system,thus reflecting the "tone at the top, II which theTreadway Commission characterized as lithe mostimportant factor contributing to the integrity ofthe financial reporting process." TreadwayReport at 11. However, the proposed rule willnot increase management's existing responsibilityfor the preparation of financial information, butmerely require management to acknowledge thatresponsibility. Id.The SEC also believes that additional b~nefitswill flow from the auditor's increased involve-ment with internal controls, coupled with theauditor's responsibility to read and considerother information, such as the proposedmanagement report, included in a documentcontaining audited financial statements. Id.The SEC's proposal should not, however,significantly enlarge the scope of the auditor'sreview in accordance with Generally AcceptedAuditing Standards ("GAAS").Because of the auditor's review in accordancewith Statement on Auditing Standards ("SAS") 8,A.U. Sec. 550, the auditor will be associatedwith the report on the company's internalcontrols. Under a newly adopted auditingstandard, SAS 55, auditors must gain an

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understanding of a company's internal controlstructure in all audits, regardless of whetherthey intend to rely on controls in conducting theaudit. Another new standard, SAS 60, requiresthat auditors communicate to management and theaudit committee significant deficiencies in thedesign or operation of the internal controlstructure, including material weaknesses thatcome to the auditor's attention during and auditof the financial statements. Pursuant to SAS 8,auditors must read any management reportincluded in an annual report and inform thecompany of anything therein that the auditorconcludes is materially inconsistent with thefinancial statements or a material misstatementof fact. Thus, an auditor's review of disclosurein accordance with SAS 8 would include a reviewof any management statement regarding itsresponse to the auditor's recommendations forinternal control. See SEC Testimony (May 2,1988), supra p. 4, at 12; see generally thediscussion of the role of independent accountantin the SEC's Proposing Release, 41 S.E.C. Dkt. at684-85.In light of the existing responsibilities ofmanagement in the financial reporting process,and the auditors standards promulgated under SAS8, 55 and 60, the recommended management reportappeared to have relatively low marginal cost.Note: The SEC's 1979 Proposal. In 1979, the SECproposed rules that would have required thatForms 10-K and annual reports to shareholderscontain a statement of management's opinion as towhether the systems of internal accountingcontrol of the company and its subsidiariesprovides the reasonable assurances, required bythe Foreign Corrupt Practices Act ("FCPA"), thataccurate books and records are maintained andthat assets are safeguarded. The proposal wouldhave also required that an independent accountantexamine and report on the management statement.The proposal was withdrawn in 1980 followingcriticism concerning the close correlationbetween disclosure of management's opinion oninternal control and compliance (or the lack ofcompliance) with the internal accounting controlprovisions of the FCPA. See SEC Testimony (May2, 1988), supra p. 4, at 13; see also SecuritiesAct ReI. No. 6789, 41 S.E.C. Dkt. at 685-86.Many commentators suggested that the proposal

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was apparently intended not to give stockholdersuseful information, but rather to establish theexistence of violations of the FCPA forenforcement purposes. 41 S.E.C Dkt. at 686;Treadway Report at 45. The commentators alsoobjected to the impact the rule might have on therole of the auditor in examining companies'internal controls. SEC Testimony (May 2, 1988),supra p. 4, at 13-14.The SEC believes that, by emphasizing amateriality standard, its new proposal for amanagement report would avoid several of theobjections to the earlier proposal. 19. Inaddition, the new proposal would not require theauditors to do more than they are currentlyrequired to do under present generally acceptedauditing standards. Id. at 14.

C. Audit Committee Chairman's Letter1.

2.

3.

4.

Recommendation. "All public companies should berequired by SEC rule to include in their annualreports to stockholders a letter signed by thechairman of the audit committee describing thecommittee's responsibilities and activitiesduring the year." Treadway Report at 46.Treadway Commission's Rationale. The auditcommittee Chairman's letter would make the roleof the audit committee more visible and wouldmore effectively communicate to investors thecommittee's role. The Treadway Commission'sresearch also indicated a need to reinforce theaudit committee members' awareness and acceptanceof the importance of their responsibilities.Although certain contents of the suggested auditcommittee letter duplicate existing proxystatement disclosures, the Treadway Commissionbelieved such a letter would provide moreflexible and illuminating disclosure than mostproxy statements do at present. Treadway Reportat 46.The SEC Response. The SEC unanimously concludedthat an audit committee chairman's letter is notneeded. SEC Testimony (May 2, 1988), supra p. 4,at 15-16.Reasons for the SEC Response. Most companieswith actively traded securities have auditcommittees as a result of the NYSE's listing

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requirements and the corporate governancestandards imposed by the NASD on companies withOTC securities designated as National MarketSystem securities. Companies that have asecurity registered under section 12 of theExchange Act, if they solicit proxies, arecurrently subject to SEC proxy rules requiringdisclosure concerning the existence of the auditcommittee's functions. As noted, the TreadwayCommission acknowledges that certain informationin the proposed audit committee letter wouldduplicate existing proxy statement disclosures.The SEC therefore believes that the proposedaudit committee letter would not provideinvestors with significant additicnalinformation and is thus unnecessary. SECTestimony (May 2, 1988), supra p. 4, at 15-16.

D. Seeking A Second Opinion1. Recommendation. -When a public company changes

independent public accountants, it should berequired by SEC rule to disclose the nature ofany material accounting or auditing issuediscussed with both its old and new auditorduring the three-year Period preceding thechange.- Treadway Report at 47.

2. Treadway Commission's Rationale. This is thesecond of two recommendations the TreadwayCommission made regarding the practice of seekinga second opinion regarding accounting issues.The first recommendation is that "managementshould advise the audit committee when it seeks asecond opinion on a significant accountingissue." Treadway Report at 47. The TreadwayCommission expressly acknowledged thatlegitimate differences of opinion in financialreporting can arise. Id. However, the TreadwayCommission noted that when a company decides toseek an opinion from a different accounting firm,"commercial pressures are introduced into theprocess of resolving the financial reportingissue. Recent cases have shown that thesecommercial pressures sometimes lead to fraudulentfinancial reporting." Id. ThUS, althoughmanagement may, and sometimes should, seek asecond opinion, management should discuss theissue with the audit committee and explain whythe particular accounting treatment was chosen.Id.

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The Treadway Commission's second recommendationin this area is an SEC rule requiring certaindisclosures in the event the company changesindependent pUblic accountants "[a]s a furtherdeterrent to possible fraudulent financialreporting." Id. Although the TreadwayCommission did not specifically articulate howsuch disclosures would deter fraudulent financialreporting, the inclusion of this recommendationwith the discussion of the process of seekingsecond opinions suggests that the TreadwayCommission saw the same types of "commercialpressures" as affecting the decision to seek anew accounting firm.

3. The SEC Response. The SEC has effectivelyimplemented this recommendation. In a publicmeeting on April 7, 1988, the SEC votedunanimously to amend Regulation S-K, Form 8-K,and Schedule 14A regarding disclosure bycompanies of changes in independent accountantsand potential opinion shopping situations.Financial Reporting ReI. No. 31 (Apr. 12, 1988);40 S.E.C. Dkt. 1140 (Apr. 26, 1988).In addition to adopting rules related topotential opinion shopping situations, the SECalso voted unanimously to propose for commentamendments to Regulation S-K which wouldaccelerate the timing for filing Forms 8-Krelating to changes in accountants andresignations of directors. Sec. Act ReI. No.6767 (Apr. 12, 1988); 40 S.E.C. Dkt. 1147 (Apr.26, 1988).

4. Reasons for the SEC's Response. The SEC adoptedits new disclosure requirements "[i]n order toprovide increased pUblic disclosure of possibleopinion shopping situations * * *." 40 S.E.C.Dkt. at 1143. The SEC's release recognized thatcompanies may change auditors at theirdiscretion. Id. However, when a new auditor isengaged, that auditor must possess the integrity,objectivity, and independence required by thestandards of the profession and the SEC. IS. Asthe SEC's release explained,

The auditor must, at all times,maintain a "healthy skepticism" toensure that a review of a client'saccounting treatment is fair andimpartial. The willingness of an

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auditor to support a proposedaccounting treatment that is intendedto accomplish the registrant'sreporting objectives, even though thattreatment might frustrate reliablereporting, indicates that there may bea lack of such skepticism andindependence on the part of theauditor. The search for such anauditor by management may indicate aneffort by management to avoid therequirement for an independentexamination of the registrant'sfinancial statements. Engaging anaccountant under such circumstances isgenerally referred to as "opinionshopping." Id.a. Disclosure of Disagreements and

Reportable Events. The SEC's rulescontinue to require that a companydisclose disagreements and certainreportable events involving a formerauditor. The revisions to these rulesrequire new disclosures concerningconsultations between the company andthe newly-engaged accountant thatoccurred during the two full fiscalyears and any sUbsequent interim periodpreceding the accountant's engagement,if those conSUltations:(1) were or should have been sUbject

to SAS No. 50, which sets forthguidelines for pUblic accountantswhen the accountant is preparinga proposal to obtain a new accountor when preparing reports orgiving advice on the applicationof accounting principles to actualor hypothetical transactions: or,

(2) concerned the sUbject matter of adisagreement or a reportable eventwith the former accountant.

b. Note Regarding Definitions. The term"disagreement" includes any differenceof opinion between a registrant and itsindependent accountant concerning anymatter of accounting principle orpractice, financial statement

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disclosure, or aUditing scope orprocedure, which if not resolved to thesatisfaction of the former accountantwould have caused the accountant tomake reference to the matter in itsreport. Instruction to Item 304,Regulation S-K; see also Securities ActReI. 6766, 40 S.E.C. Dkt. at 1141-42.A "reportable event" is similar to adisagreement in that it involves asituation where the position ofmanagement may be considered to begenerally at odds with that of theaccountant. However, a reportableevent does not require that there be anexpress difference of opinion, but istriggered when the accountant advises aregistrant of certain concerns. Underthe adopted rules, reportable eventsinclude instances where the auditor hasadvised the registrant that theinternal controls necessary for theregistrant to develop reliablefinancial statements do not exist;where the accountant has advised theregistrant that it is no longer ableto rely on management's representationsor be associated with the registrant'sfinancial statements; where theaccountant has advised the registrantof the need significantly to expandthe scope of its audit; and where theaccountant has advised the registrantof unresolved issues that theaccountant has concluded materiallyimpact the fairness or reliability ofcurrent or past financial statements oraudit reports.The amendments adopted by the SECdiffer slightly from the Treadwayrecommendation in three respects.First, the Treadway recommendationwould require disclosure only of thoseissues discussed with both the old andnew accountants. Because a companyordinarily would have discussions withits former accountant concerning anymatter discussed with the newaccountant, the SEC believed thisdifference would have little practical

19

effect. SEC Testimony (May 2, 1988),supra p. 4, at 20.Second, the Treadway recommendationwould require disclosure of discussionsconcerning any material accounting oraUditing issue. The SEC's proposedrules would have required the samedisclosures. Commentators on the SEC'sproposal were concerned that such arequirement would result in voluminousdisclosure that would not highlight theareas of most concern to investors.In response to those concerns, the SECadopted rules requiring disclosure ofthose consultations that would mostlikely be relied upon by companies(i.e., which are given the circum-stances described in SAS 50), and thathave been the sUbject of contentionbetween the company and the formeraccountant. Id. at 20.Third, the SEC's rules provide fordisclosure of potential opinionshopping situations during the twofiscal years preceding the accountant'sengagement, while the Treadwayrecommendation would require disclosureduring the three-year period precedingthe change in accountants. Because theSEC's rule will normally cover acompany's three most recent aUdits, theSEC did not believe this difference tobe significant. Id. at 20-21.

E. Timely Review of Quarterly Financial Data1. Recommendation. -The SEC should require

independent public accountants to reviewquarterly financial data of all public companiesbefore release to the public.- Treadway Reportat 53.

2. Treadway Commission's Rationale. Investors relyon, and react quickly to, quarterly results.However, under existing SEC rules, quarterlyfinancial information is not audited or reviewedby an independent auditor prior to its pUblicrelease. The Treadway Commission believes thatpUblic accountant's timely involvement withquarterly financial data would improve the

20

reliability of quarterly reporting and increasethe likelihood of preventing or detectingfraudulent financial reporting. The review ofquarterly financial data before pUblic releaseassures investors of more frequent review of thereporting practices of pUblic companies by anindependent and objective party. The Reportnotes the increasing frequency and highpercentage of fourth-quarter write-offs (nearly2/3 of total dollar value, based on a sample of1,088 companies from 1980-85). Id. at 53-54.The Treadway Commission recommends a "limited"review, as described in existing ASB guidelines,rather than an aUdit. A review differs from anaudit in the degree of evidence the independentpUblic accountant must obtain to support thefinancial information, and in the degree ofassurance a user may place on such information.14. at 53. A review is not designed to expressan opinion on the financial information. Ittherefore requires significantly less supportingevidence than an audit. Treadway Report at 53.

3. The SEC's Response. On October 25, 1988, the SECapproved the issuance of a concept releasesoliciting comment on timely review of interimfinancial information. The release is expectedto be issued shortly. Commissioner Fleischmandissented from this Commission decision.

4. Reasons for the SEC's Response. As the TreadwayCommission noted in its Report, the SEC currentlyrequires larger, more widely traded publiccompanies to include selected quarterly data intheir annual financial statements. Pursuant toItem 302(a) of Regulation S-K, these quarterlydata must be reviewed, but not aUdited, inaccordance with GAAS. The SEC has also indicatedits belief that "all registrants would find ituseful and prudent to have independent publicaccountants review quarterly financial data on atimely basis * * *." Codification of FinancialReporting policies section 304.01.The SEC's concept release will presumably solicitcomment on the costs of implementing the Treadwayrecommendation vis a vis any additional benefitsof disclosure in addition to that required underexisting SEC disclosure rules in this area. SeeSEC Testimony (May 2, 1988), supra p. 4, at 23;Cox Speech, supra p. 5, at 4, ("To me, the

21

comments from independent accountants on thecosts and benefits of timely review will beparticularly important in determining whataction, if any, should be taken.lI)

F. civil Money Penalties1. Recommendation. -The SEC should have the

authority to impose civil aoney penalties inadministrative proceedings [including Rule 2(e)proceedings] and to seek civil money penaltiesfrom a court directly in an injunctiveproceeding.- Treadway Report at 65.

2. Treadway Commission's Rationale. Except forcases SUbject to the Insider Trading SanctionsAct, Pub. L. No. 98-376, 98 stat. 1264 (codifiedas amended at 15 U.S.C. Sec. 78c, 780, 78t, 78u,and 78ff), the SEC lacks the ability to imposecivil money penalties. The SEC thus lacks theflexibility and breadth of response in dealingwith such violations that the CFTC and the SROshave in seeking or imposing monetary penaltiesfor violations of the laws and/or rules undertheir respective jurisdictions. Treadway Reportat 65.

The Treadway Commission believes that theauthority to impose fines would enable the SEC tocalibrate the penalties imposed on perpetratorsof fraudulent financial reports, by imposingheavy fines, in addition to other sanctions, foregregious violations, and imposing smaller finesin lieu of excessively harsh sanctions forviolations at the other end of the spectrum. Id.The Treadway Commission also noted that the SEChas settled some enforcement actions involvingancillary relief in the form of disgorgement ofthe value of compensation received based onfraudulently reported earnings or profits. Inthe Treadway Commission's view, the authority forsuch relief is SUbject to debate if it is viewedas punitive rather than remedial. Expressstatutory fining authority would remove any doubtas to the validity of such relief. Deprivingperpetrators of fraudulent financial reporting ofany ill-gotten gains would also help maintainpUblic confidence in the integrity of thefinancial reporting process. IQ.

22

3. The SEC Response. On September 28, 1988, the SECtransmitted to Congress its legislative proposalentitled the "Securities Law Enforcement RemediesAct of 1988." This proposed legislation wouldamend the Securities Act, the Securities ExchangeAct, the Investment Company Act, and the Invest-ment Advisers Act to authorize the assessment ofcivil money penalties in administrative and civilproceedings under these Acts. CommissionerFleischman dissented from the SEC's decision topropose this legislation. See infra p. 24.

Note: The 'proposed legislation would alsopermit the SEC and the courts to suspend orbar violators of these Acts from serving asan officer or director of any company thatfiles reports with the SEC, and would addviolations of Section 16(a) of theSecurities Exchange Act to the bases forinstituting administrative proceedings underSection 15(c) (4) of that Act.

Although Congress has taken no action on theSEC's proposed legislation, Section 3 of theInsider Trading and Securities Fraud EnforcementAct, Pub. L. No. 100-704 (Nov. 19, 1988), directsthe SEC to submit to Congress, within 60 days ofenactment, "any recommendations the [SEC)considers appropriate with respect to theextension of the [SEC's] authority to seek civilpenalties or impose administrative fines forviolations other than [insider trading]." As ofthe date this outline was submitted, the SEC hadnot submitted those recommendations.

4. Reasons for the SEC's Response. The SECsupported the recommendation to seek legislativeauthority for civil monetary penalties for muchthe same reasons cited in the TreadwayCommission's Report. In its transmittal letterto Congress, the SEC noted the following factorsthat it considered in determining to seek thisauthority.a. Penalties Against Issuers. In May 1988,

the SEC endorsed further examination ofwhether civil penalties should be imposedagainst corporate issuers under .circumstances where shareholders w~ll bearthe costs of the penalty. SEC Testimony(May 2, 1988), supra p. 4, at 24.

23

Subsequently, on September 28, 1988, theSEC proposed the authority to impose or seeka court order imposing civil penaltiesagainst issuers for several reasons. First,the proposed legislation would not requirethe SEC to seek penalties from an issuer.Rather, the SEC would be permitted toproceed against the appropriate individualoffenders acting for a corporate issuer,rather than against the issuer itself. TheSEC has stated that, as a matter ofenforcement policy, it will seek civil moneypenalties against issuers only where theviolation resulted in an improper economicbenefit to shareholders. Moreover, the SEChas indicated that it would not seekpenalties against registered investmentcompanies because, as with other expensesincurred by investment companies, thesefines would simply be passed on to theirshareholders. Memorandum of Securities andExchange Commission in Support of theSecurities Law Enforcement Remedies Act of1988 (Sept. 28, 1988) at 4-5 (hereinaftercited as SEC Memorandum on Remedies Act).

b. Rule 2(e) Proceedings. The SEC determinednot to seek authority to impose penaltiesin Rule 2(e) proceedings, as recommended bythe Treadway Commission. In the SEC'sview, Rule 2(e) proceedings are designed toprotect the integrity of its proceedings,and the sanctions imposed should be limitedto those necessary to meet that end, such assuspensions or bars from appearing beforethe SEC. As the SEC noted, "[p]aying apenalty will not make a professional fit topractice before the Commission. Rather,penalties serve enforcement goals ofpunishing past misconduct and deterringfuture misconduct." SEC Memorandum onRemedies Act, supra, at 7.

Commissioner Fleischman's Dissent. At an openmeeting held on April 27, 1988, CommissionerFleischman dissented from the SEC's decision toseek authority to impose or to seek civilmonetary penalties because he feared that theagency, if given that authority, would use itregularly and inflexibly, without regard to themerits of each particular case.

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G. Cease and Desist Orders1. Recommendation. "The SEC should have

authority to issue a cease and desistit finds a securities law violation."Report at 65.

theorder when

Treadway

2. Treadway Commission's Rationale. Cease anddesist authority would provide the SEC withgreater flexibility in tailoring remedies to thecircumstances of a particular case. Byproviding a "milder" alternative to an injunctiveaction, cease and desist authority would assistthe pUblic in distinguishing degrees of culpa-bility. In addition, although not as strong asanction as a civil injunction, cease and desistauthority would provide a degree of deterrencein situations in which the SEC might lackevidence of a likelihood of future violations, orin which the SEC hesitates to pursue injunctiverelief because the side-effects of an injunctionseem too harsh and therefore inappropriate.Treadway Report at 66.

3. SEC Response. The SEC unanimously concluded thatlegislation providing cease and desist authorityis not necessary. However, to expand theremedies available for additional types ofreporting violations that may not warrant aninjunctive action, the SEC's proposed SecuritiesLaw Enforcement Remedies Act of 1988 would addviolations of section 16(a) of the SecuritiesExchange Act (requiring officers, directors, andten percent beneficial owners to report purchasesof their company's stock) to the bases forinstituting administrative proceedings undersection 15(c) (4) of that Act. See SEC Memorandumon Remedies Act, supra p. 24, at 2-3.

4. Reasons for the SEC's Response. The SECconcluded that the need for an enforcement remedythat is "milder" than an injunction is satisfiedin most financial fraud cases by Exchange Actsection 15(c) (4), which authorizes the Commissionto issue an order requiring any person found,after notice and opportunity for hearing, to haveviolated or to have been a cause of a violationof Exchange Act sections 12, 13, 14, 15(d), orthe rules thereunder, to comply with the violatedprovisions. Id.

25

In order to increase the range of cases in whichthis remedy is available, the SEC has proposedthat the scope of section 15(c) (4) be expanded toencompass violations of section 16(a) of theExchange Act and the rules thereunder, thusproviding the SEC with an administrative remedyto address additional types of reportingviolations that may not warrant an injunction.Commissioner Fleischman's Dissent. At the SEC'sopen meeting on April 27, 1988, CommissionerFleischman dissented from the SEC's decision toexpand the scope of section 15(c) (4) because hewas of the view that the agency's enforcementauthority was already sufficient.

H. Bars or Suspensions from serving as Corporate Officeror Director1. Recommendation. "The SEC should seek explicit

statutory authority to bar or suspend corporateofficers and directors involved in fraudulentfinancial reporting from future service in thatcapacity in a public company." Treadway Reportat 66.

2. Treadway Commission's Rationale. The authorityto bar or suspend corporate officers anddirectors would provide a sanction when theCommission's disclosure rules regarding priorenforcement actions and the other collateraleffects of an injunction would not serve assufficient deterrents to future involvement infraudulent financial reporting. Thisrecommendation would afford the SEC greaterflexibility in its enforcement actions and wouldstiffen sanctions against individual offenderswho commit egregious and/or repeated violations.The Commission's limited use of this remedy todate has taken place in the context of settledcases and its authority to impose such bars orsuspension has been the subject of extensivelegal debate. Treadway Report at 66.

3. The SEC's Response. The SEC's proposed"Securities Law Enforcement Remedies Act of 1988"would give the SEC the express authority toimpose, or seek a court order imposing, a bar orsuspension prohibiting violators from serving asofficers or directors of "any issuer that has aclass of securities registered pursuant tosection 12 of the Securities Exchange Act * * *

26

I.

or that is required to file reports pursuant to[Section 15(d)] of such Act."

4. Reasons for the SEC's Response. As a form ofancillary relief in SEC injunctive actions, theSEC has successfully obtained court ordersbarring or suspending individuals from serving asofficers or directors of a pUblic company.Nevertheless, the SEC recommended legislationgiving the Commission and the courts expressauthority to impose such bars and suspensions soas to remove any doubts about the propriety ofthis remedy, which has been obtained in SECinjunctive actions by consent. See SECMemorandum on Remedies Act, supra p. 24, at 3.Commissioner Cox's Views. Commissioner Cox hasstated that although he supports seekingstatutory authority to bar officers anddirectors, he does not support the imposition ofsuch bars under existing law. He believes that,absent express statutory authority, "the betterview is that Congress intended that investorswould rely on disclosure [of past securitieslaws violations, see Regulation S-K, Item 401] toprotect themselves from officers and directorswho have violated the securities laws." CoxSpeech, supra p. 5, at 6.

Increased Criminal Prosecution.1. Recommendation. Criminal prosecution of

fraudulent reporting cases should become a higherpriority. The SEC should conduct an affirmativeprogram to promote increased criminal prosecutionof fraudulent financial reporting cases byeducating and assisting government officials withcriminal prosecution powers." Treadway Reportat 67.

2. Treadway Commission's Rationale. A basic premiseof the Treadway Report is that fraudulentfinancial reporting is a significant problemrequiring more attention from many constitu-encies, inclUding regulatory and law enforcementagencies. SEC civil and administrativeproceedings alone cannot provide the degree ofdeterrence that is needed to protect againstfraudulent financial reporting. Treadway Reportat 67-68.

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3. The SEC's Response. In an effort to enhancecooperation among agencies responsible forcriminal enforcement, officials from the SEC,CFTC, FBI, IRS, and the united States PostalInspection Service met on March 29, 1988, withrepresentatives of the North American SecuritiesAdministrators Association, the NationalAssociation of Attorneys General, and severalself-regulatory organizations. The purpose ofthis meeting was to consider formation of aSecurities and Commodities Fraud Working Group.During this meeting, a framework for furthercommunication was established so that theagencies could discuss enforcement priorities,improvements in current systems of informationexchange, and initiatives to improve enforcementin the areas regulated by the participatingagencies. SEC Testimony (May 2, 1988), suprap. 4, at 29-30.

4. Reasons for the SEC's Response. As the SECindicated in its testimony before theSubcommittee on Oversight of the House Energy andCommerce Committee on May 2, 1988, "[t]heCommission supports criminal prosecution ofoffenses involving fraudulent financial reportingand, accordingly, conducts an active program toassist and educate officials with criminalenforcement responsibilities." SEC Testimony(May 2, 1988), supra p. 4, at 29. The meeting onMarch 29, 1988 was just one of a number ofprograms in which the SEC participates tocoordinate enforcement activities by the variousfederal and state administrators charged withthis responsibility.As noted in the Treadway Report, the Commissionmaintains an active liaison with criminalenforcement authorities, provides access toinvestigative files, and provides expertassistance on a case-by-case basis. See TreadwayReport at 68. In some instances, Commissionstaff members are assigned to assist in criminalinvestigations and trials. Each year, theDivision of Enforcement and members from theDepartment of Justice and United StatesAttorney's Offices participate in cooperativeenforcement training programs. SEC Testimony,supra p. 4, at 29.

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J. Professional Organization Membership1. Recommendation. RThe SEC should require all

public accounting firms that audit publiccompanies to be members of a professionalorganization that has peer review and independentoversight functions and is approved by the SEC,such as that specified by the SECPS of theAICPA's Division for CPA Firms.R TreadwayReport at 71.

2. Treadway Commission Rationale. Mandatory member-ship in a quality assurance program is necessaryfor effective regUlation of the accountingprofession and to implement the securities laws.The quality of audit practice is related directlyto the prevention, detection, and deterrence offraudulent financial reporting. TreadwayCommission research claimed to find anunacceptably higher incidence of failure todetect fraudulent financial reporting byaccountants that were not members of the SECPS.Mandatory membership in a quality assuranceprogram is essential to ensure that independentaccountants have the requisite qualifications toaudit and opine on companies' financialstatements. Treadway Report at 72.

3. The SEC's Response. On April 1, 1987, the SECproposed for pUblic comment a rule that wouldamend the RegUlation S-X definition of"certified" financial statements to require thatsuch financial statements be examined by anindependent accountant who has undergone anobjective review by other independent accountantswithin three years preceding the date of thecompletion of the examination. Securities ActReI. No. 6695 (Apr. 1, 1987), 37 S.E.C. Dkt. 1825(Apr. 14, 1987).

The Commission's proposal would provide that anaccountant may satisfy this "peer review"requirement by (1) undergoing a peer review underthe auspices of an acceptable peer revieworganization ("PRO"), or (2) by havinq its reviewsupervised directly by the Commission. A PROwould be required to supervise peer reviewsperformed under its auspices to ensure that theyare conducted in accordance with standardsproposed in the :ule. ,PROS ~ould be,su~ject t~Commission overs1ght, 1nclud1ng Comm1SS1on reV1ew

29

of peer review workpapers. Accountants choosingnot to participate in a peer review programunder the auspices of a PRO would select a peerreviewer meeting requirements specified in therule. The Commission staff would perform thesupervisory functions otherwise performed by aPRO.The Commission staff is reviewing the commentletters received and preparing a recommendationwith respect to this proposal.

4. Reasons for the SEC's Response. The SEC'srelease proposing mandatory peer review noted itslong support of the concept "as a way ofproviding added assurance to investors,creditors and clients that an accountant isconsistently complying with professionalstandards. II 37 S.E.C. Dkt. at 1827. Althoughrecognizing that peer review cannot identify allfactors affecting the quality of an accountant'spractice and prevent all audit failures, the SECbelieves that lIundergoing a peer reviewreinforces an accountant's commitment to themaintenance of adequate audit quality controls.1I

lQ. at 1829. The SEC noted its staff'sfavorable experience with quality controlreviews performed pursuant to settlement of itsenforcement actions and in overseeing the peerreview program of the SECPS. The SEC alsoobserved the strong support for peer reviewprograms among diverse private and governmentalbodies such as the AICPA, the Treadway Commis-sion, the "Big Eight" accounting firms, theHouse Committee on Government operations, and theRural Electrification Administration. Id. at1827.The SEC has broad authority to establish theform, content and requirements for financialstatements required to be filed under the federalsecurities laws, inclUding requiring independentaudits of registrants, defining technical andaccounting terms, prescribing the reports andinformation to be filed, and prescribing the formin which information is set forth and the methodsto be followed in the preparation of reports. Inaddition, the SEC has general authority to makesuch rules and regUlations as may be necessary toimplement the provisions of the securities laws.See ide at 1827-28, and citations includedtherein. Because peer review would benefit

30

investors b¥ improving the disclosure process,the SEC bel1eves that its proposed rule isreasonably related to implementing the provisionsof the securities laws. 19. at 1828.Separate Views of Commissioner[sl Cox.Commissioner Cox has indicated that he hasdoubts about whether the SEC's peer reviewproposal "is justified, from either a cost-benefit or a legal standpoint." In his view,"requiring membership in a group which purportsto confer net benefits on its members iscounter-intuitive, and that an organization thatimposes quality control and practice standards onits members should stand or fallon its merits."Cox Speech, supra p. 5, at 4. He also questionsthe SEC'S authority to mandate peer reviewpursuant to its power to define "certified"financial statements. Id.

K. Enforcement1. Recommendation. "The SEC should take enforcement

action when a public accounting firm fails toremedy deficiencies cited by the publicaccounting professional's quality assuranceprogram." Treadway Report at 72.

2. Treadway Commission's Rationale. The publicaccounting profession's quality assurance effortsrequire credible enforcement with meaningfUlsanctions. The SEC should provide this function,and can do so within its existing regulatory andenforcement framework. Implicit in an SEC rulerequiring membership in a professional qualityassurance program is compliance with thatprograms's standards and requirements. Thus, thefailure to remedy cited deficiencies wouldconstitute violation of an SEC rule. TreadwayReport at 72.Under SEC Rule 2(e) the SEC may discipline aprofessional who practices before the agency ifthat person is found "not possess the requisitequalifications to represent others." A findingof noncompliance with the requirements of thepUblic accounting profession's quality assuranceprogram would constitute a lack of "therequisite qualification to represent others"within the meaning of SEC Rule 2(e). A Rule 2(e)proceeding allows the SEC to impose a meaningfUlsanction: temporary or permanent denial of the

31

privilege of performing audits of pUbliccompanies for the inclusion of an audit report inpublic disclosure documents. I9. at 73.

3. The SEC's Response. The SEC has said that if itspeer review proposal is adopted, the SEC may beable to examine, in an administrative proceeding,an accounting firm's failure to remedydeficiencies cited in a peer review and itseligibility to provide certified financialstatements. See SEC Testimony (May 2, 1988),supra p. 4, at 33-34.

4. The Reasons for the SEC's Response. The failureto implement measures to address peer reviewdeficiencies would not, in itself, violate thesecurities laws. The SEC therefore has noexpress statutory authority to take enforcementaction based on an accounting firm's failure toremedy such deficiencies. Moreover, under GAAS,an accountant need not participate in a peerreview program or remedy particular deficienciescited by such a program. SEC Testimony (May 2,1988), supra p. 4, at 33-34.However, SAS 25 indicates that, in order tocomply with generally accepted aUditingstandards, a firm of independent accountantsshould establish quality control policies andprocedures to provide it with reasonableassurance of conforming with those standards inits aUditing engagements. The failure to remedydeficiencies cited in a peer review may indicatethat a firm has failed to establish the qualitycontrol policies and procedures required by SAS50. If adopted, the SEC's peer review proposalwould permit the SEC to examine an accountingfirm's failure to remedy deficiencies cited in apeer review and to determine in an administrativeproceeding the firm's continued eligibility toprovide certified financial statements. Id.

L. SEC Resources1. Recommendation. RThe SEC must be given adequate

resources to perform existing and additionalfunctions that help prevent, detect, and deterfraudulent financial rePOrting.R TreadwayReport at 73.

2. Treadway Commission's Rationale.resources should be adequate for

32

The SEC'seffective

performance of its existing functions as well asthe new functions recommended by the TreadwayCommission. Adequate SEC resources for itsenforcement of the pUblic accounting profession'squality assurance standard would obviate the needfor an ultimately more costly SRO for theprofession. Treadway Report at 73.The sheer volume of new issues and otherpressures has inevitably led to a reduction inthe Commission's review of filings. Adequateresources should extend beyond funding to salaryand grade-level mechanisms that would enable theSEC to attract and retain highly qualifiedpersonnel. Id.

3. The SEC's Response. The SEC's 1989 budgetrequest of $160.9 million represented anincrease of $25.7 million over the SEC's 1988appropriation. The actual SEC appropriation for1989 was $142.6 million. See Pub. L. No. 100-459 (Oct. 1, 1988).In December 1988, the SEC submitted to Congress astudy prepared by the SEC's Office of theExecutive Director. The SEC staff's studyrecommends that the SEC be given authority to:a.

b.

c.

d.

e.

set staff salaries that would take intoaccount competitive salary differentials andwould provide regional pay differentials;offer retention bonuses to professionalstaff based on performance;fill 100 positions at compensation up toLevel IV of the executive pay scale forhighly qualified lawyers, accountants, orother professionals for specific cases orprogram management;develop and implement pay bands forclassifying professional and support staffpositions: and,lease space itself and obtain exemptionsfrom GSA space management regulations inorder to meet specialized SEC spacerequirements.

33

Because these proposals would involve asubstantial cost to the agency, the staff's studyoffers options for increased funding. The firstoption involves separate Congressional considera-tion of the SEC's bUdget re~est. The second andthird options present choices which utilize arevolving account or fund account that would takethe SEC off-budget. Under the second option, theOMB and Congressional authorization andappropriation committees would retain theircurrent roles over the agency's budget. Thethird option would establish a permanent SECtrust-revolving fund outside the traditionalappropriation process. using this approach, theSEC would request authorization for expendituresfrom the trust-revolving fund through biennialrequests to the oversight committee. Theunderstanding is that any funding optionemploying the agency's fee collections wouldresult in reduced payments to the General Fund ofthe Treasury.The SEC expects to consider the staff's study,and make its own recommendations to Congressshortly.

4. Reasons for the SEC's Response. In response toextensive testimony that the SEC lacks sufficientoverall resources and faces difficulty inrecruiting and retaining the top quality staffnecessary for effective regUlation, the Securi-ties Subcommittee of the Senate Committee onBanking, Housing and Urban Affairs directed theSEC to study the possibility of transforming theagency from appropriated to self-funded status.See Senate Rep. No. 100-105, 100th Cong., 2ndSess. (JUly 9, 1987). The SEC staff submittedits self-funding study in partial response to theSubcommittee's direction.

M. Reconsidering Corporate Indemnification1. Recommendation. -The SEC should reconsider its

long-standing position, insofar as it applies toindependent directors, that the corporateindemnification of officers and directors forliabilities that arise under the Securities Actof 1933 is against public policy and thereforeunenforceable.- Treadway Report at 77.

34

2. The Treadway Commission's Rationale. Independentdirectors are necessary components of aneffective audit committee, which in turn is akey to preventing fraudulent financial reporting.The perceived liability crisis and thedifficulties in obtaining directors' andofficers' insurance make it more difficult torecruit qualified independent directors. Iflimited indemnification, particularly ofindependent directors, is permitted, it may beeasier to attract and retain directors qualifiedto serve on audit committees. Thus, the benefitsof permitting such indemnification may outweighthe public policy concerns underlying the SEC'straditional position. Treadway Report at 77-78.

3. The SEC's Response. The SEC believes that nochange in its position is warranted. SECTestimony (May 2, 1988), supra p. 4, at 36.

4. Reasons for the SEC's Response. Historically,the SEC has taken the position thatindemnification of officers, directors, orcontrol persons of an issuer from liabilityarising under the Securities Act is againstpUblic policy and is, therefore, unenforceable.See Securities Act ReI. No. 3791 (May 27, 1957)The SEC believes that, where the Securities Actimposes monetary liability on individuals,Congress did not intend that those liabilities betransferred to the pUblic shareholders of theissuer by means of indemnification. If indemni-fication were permitted, pUblic investors--whoare victimized by false statements in securitiesAct registration statements--would bear thecosts of injuries caused by false filings. Thiswould nullify the liability provisions of theSecurities Act. SEC Testimony (May 2, 1988),supra p. 4, at 36-37.Courts that have considered this matter haveagreed with the SEC's position, and have refusedto enforce indemnification agreements as contraryto pUblic policy. In Globus v. Law ResearchService, Inc., 418 F. 2d 1276 (2d Circ. 1969),cert. denied, 397 U.S. 913 (1970), the court heldthat it would be "against the public policyembodied in the federal securities legislation"for an underwriter who had actual knowledge ofmisstatements contained in a Regulation Aoffering circular to obtain indemnification. Thecourt limited its decision to circumstances where

35

the "has committed a sin graver than ordinarynegligence." Id. at 1288. See also Heiser Corp.v. Ross, 601 F. 2d 330 (7th Cir. 1979) (recklessconduct under Section 10(b) and rule 10b-5precludes indemnification). other courts,however, have refused to permit indemnificationfor liability arising as a result of negligentconduct. ~,~, Laventhol, Krekstein,Horwath & Horwath v. Horwitch, 637 F. 2d 672 (9thCir. 1980), cert. denied, 452 U.S. 963 (1981);Odette v. Shears on , Hammill & Co., Inc., 394 F.Supp. 946 (S.O.N.Y. 1975); SEC Testimony(May 2, 1988), supra p. 4, at 36.

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