Remarks of Richard Walker before the AICPA Washington, D.C., December 8, 1998 Good morning. I'm Richard Walker, the Commission's Enforcement Director. Like Walter, my remarks represent my own views and not necessarily the views of the Commission or other members of the staff. At this point in the program, you're probably wondering to yourselves whose bright idea it was to invite not just the Chairman of the SEC, but the Commission's Chief Accountant, the Chief Accountant of the Division of Enforcement, and, yes, even the Director of Enforcement. Surely this is not the type of gathering likely to generate holiday cheer for accountants. You've heard our Chairman give a rather sobering assessment of the practice of earnings management. You've also heard our Chief Accountant talk about the need to increase the level of professionalism in public accounting and financial management. And you've heard Walter Schuetze talk about some of the accounting issues we're dealing with on the enforcement side -- "the dark side of accounting" as Walter aptly describes the problems. It's not as though you've heard a lot of good news over the course of the morning. And now, of course, it's my turn. I'd like to pick up where Walter left off. Unfortunately, this is not going to be the old "good cop/bad cop" routine -- I agree wholeheartedly with Walter's comments. As Walter has correctly noted, we have not seen anything new in terms of financial fraud at the SEC. What alarms me is that we're seeing more of it, in larger amounts and in companies where we would have expected controls to be tight. I have witnessed enough accounting restatements during my first 7 months as Enforcement Director to last a career. This is not an instance of the SEC crying wolf. Studies support our perception that accounting fraud is on the rise. Former SEC Commissioner Joe Grundfest, now a Professor at Stanford Law School, runs a website tracking securities class action lawsuits. A visit to the site this past Friday shows that 500 companies have been named in federal class actions during the last three years. It also shows that accounting fraud was alleged in a whopping 59% of the cases. Now, whatever you may think about using class action statistics to support the conclusion that there has been an increase in accounting fraud, I submit to you that the evidence is quite strong. While I was SEC General Counsel, my Office prepared a Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995. We found that of the 105 securities class actions filed in 1996, 43 percent contained allegations of accounting irregularities. This compared to about 33 percent in earlier years. Folks, we have a problem. And we must all work together to do something about it -- quickly. As the Commission has long said, accurate financial reporting is the bedrock of our capital markets. Financial statements are one of the primary sources of information that help shape informed investment decisions. And I don't need to tell you how important a role you play in helping to assure compliance with reporting requirements. Your role in preserving the reputation of our markets as the fairest, most transparent in the world is even more important in an environment where there is uncertainty and instability in some corners of the globe. We must all do our part to make sure that our markets remain vibrant and their integrity unquestioned. I'm here today to tell you some of the ways I plan on going about this. Admittedly, as Enforcement Director, some of what I have to say may come as strong medicine. Before we can discuss how to tackle the problem of accounting fraud in the marketplace, we should take a minute to identify some of the causes of the problem. As our Chairman has observed, this bull market can be unforgiving to an issuer who fails to meet analysts' forecasts. We've reached a point where the market will hammer a company's stock if the company misses an analyst's estimate by even _ as Walter might say _ one newly minted copper penny. Executive compensation structures have also put greater emphasis on the company's bottom line. Incentive pay, including stock options, is on the rise. One recent study shows that shares allocated for stock incentive plans at the 200 largest U.S. companies have nearly doubled this decade -- growing from 6.9 percent of total shares outstanding in 1989 to 13.2 percent this year. In addition, most corporate executives only get cash bonuses if corporate earnings reach some pre-set target level. I'm not criticizing incentive pay which, in fact, has many benefits. Rather, I'm saying it provides added pressure on management to reach certain earnings levels. The pressure to meet analyst's estimates and compensation benchmarks have both operated to increase the temptation to fiddle with the numbers. I am also concerned as to whether members of the accounting profession may have become more complacent about financial reporting as a result of legislative and judicial reforms taking place over the past several years. The first break came in 1994 with the Supreme Court's decision in Central Bank. That milestone decision held that there can be no liability in a private action for aiding and abetting a securities fraud. This closed the courthouse door on the theory used most often to charge accountants and auditors. The next year, 1995, Congress passed landmark legislation -- the Private Securities Litigation Reform Act. The provisions of that Act, including heightened pleading standards and proportionate, as opposed to joint and several, liability, gave accountants even greater comfort that they would not be exposed to the threat of runaway verdicts in frivolous securities fraud suits. The Reform Act's heightened pleading standards have pitted the SEC and the AICPA against each other on an issue of enormous importance. A number of district court decisions interpreting the Act's pleading standards have called into question the continued vitality of recklessness as a basis for pleading and proving fraud. The ability to charge a defendant who acted recklessly with a securities fraud violation goes to the core of investor confidence in our markets. It is also a cornerstone of the Commission's jurisprudence. We have long argued that this standard is needed to protect investors and the securities markets from fraudulent conduct by those who turn a blind eye to wrongdoing. A higher standard would lessen the incentives for issuers, as well as accountants and auditors, to conduct a full inquiry into potentially troublesome areas. This would threaten the disclosure process that has made our markets a model for nations around the world. The AICPA filed an amicus brief with the Ninth Circuit last year in the Silicon Graphics case arguing that recklessness does not suffice to impose liability. I know the brief was filed out of concern that the industry was subject to abusive securities litigation. And I am sympathetic to this concern. Strike suits have no place in our legal system. However, in today's climate with the rise in financial fraud, I question whether you sent the right message by arguing for immunity for reckless misconduct. After all, the threshold for a finding of recklessness is quite high _ it requires a showing of an "extreme departure from the standards of ordinary care." And most courts have held that violations of GAAP, without more, are not sufficient to establish liability. Quite frankly, I believe it's difficult to take the position that when an accountant engages in conduct that is an extreme departure from the standards of ordinary care _ conduct that clearly violates your own professional standards _ that the accountant should not be held accountable to investors who suffer losses as a result. The debate over recklessness aside, the accounting profession scored another victory with the passage of further reform legislation two months ago. The Uniform Standards Act of 1998, which the Commission supported, makes federal law the law of the land by preempting securities class actions based on more liberal state laws. Proponents of the law, including the AICPA (which provided Senate testimony) argued that it was necessary to prevent a migration of frivolous litigation to state courts. Based on the foregoing, I think you'd have to agree that in terms of beneficial changes to the federal securities laws, the `90s have been banner years for your profession. You are no longer threatened with being dragged into private lawsuits as aiders and abettors. You are no longer exposed to joint and several liability unless you "knowingly" commit a violation. The heightened pleading standards under the Reform Act have made it easier for you to obtain dismissal of a complaint when you are sued. And you no longer need to worry about being named simultaneously in both federal and state class actions. The reforms I've mentioned have had bite. Our Report to the President found that accountants were being named much less frequently in securities class actions. We found that accountants were named as defendants in only 6 of the 105 class actions filed during 1996. By contrast, prior statistics for the years 1990 to 1992 show that accountants were named in roughly 175 suits each year, although this number is not limited to class actions. I do not stand here today as an opponent of these reforms that have helped to reduce your exposure to unwarranted litigation. In fact, I personally worked closely with the Congress to facilitate passage of the Uniform Standards legislation. In many respects, however, while your exposure has been lessened by these reforms, our responsibilities for policing the markets have increased. We've all seen the same alarming headlines over the period these reforms have taken place that raise questions about the current health of financial reporting. For example, look at the October 5, 1998 edition of Business Week. There, you'll see a story titled, "Where are the Accountants?" with a sub-headline reading, "Why auditors end up missing so many danger signs." Every case involving an accounting fraud raises a host of difficult questions. Let me share with you my enforcement philosophy in this type of case. The first and most obvious question we ask in every case is who is responsible? At the center of every fraud, there is decision-maker who directed the activity _ whether it be to recognize income that does not exist, to establish a reserve without justification, or otherwise to falsify financial results. In every financial fraud there is also someone who actually carried out the direction by making false entries or engaging in other fraudulent conduct. Sometimes, the director and the perpetrator of a fraud are one and the same. More often, there are multiple persons involved with differing levels of culpability. Every day, we must make decisions about how high up and how low down the organizational chart we should go in apportioning blame. A second question we ask in every case is what is the responsibility of management? Did management know of the wrongdoing, or worse, direct it? If not, was management reckless in not knowing that the corporate piggy bank was missing, say, a couple hundred million dollars of reported income? And what about the audit committee? What level of review and scrutiny did that committee bring to the company's financial reporting? Finally, to borrow from my predecessor, Judge Stanley Sporkin, we ask the same question he did in the Lincoln Savings and Loan case: "Where were the professionals? -- both the in- house and outside accountants?" The importance of this inquiry is highlighted by a recent press account of a case involving auditors who, according to the press, failed to question an increase in electric blanket sales in the summer and an increase in the sale of barbecue grills in the winter. Combating financial fraud is my number one priority. We will bring maximum resources to bear on this problem. I have impressed upon my enforcement staff of over 800 nationwide my desire to see greater focus placed on financial fraud cases. The evidence of our commitment to attacking financial fraud will be forthcoming soon. Too much depends upon the integrity of the financial reporting process to allow this kind of activity to escape anything other than the strongest response. In each financial fraud investigation, we will take a close look at all participants in the reporting process, including, of course, the accountants and auditors. During the balance of my time, I'd like to talk about the tools available to address misconduct by accountants and auditors. Over the years, most of the focus on proceedings involving accountants has been on our Rule of Practice 102(e). As you know, the rule allows the Commission to censure, suspend, or bar professionals from practicing before it. We have always taken the position that Rule 102 (e) is not intended to be an "additional weapon" in our enforcement arsenal. Rather, it is meant to protect our processes from those who are not competent to practice before us. Courts have uniformly held that we have the authority to promulgate the rule. The rule allows us to discipline an accountant who lacks the requisite qualifications to represent others, has violated the law, is lacking in character or integrity, or has engaged in unethical or improper professional conduct. A discussion of Rule 102(e) is timely because just two weeks ago, on November 25, a material amendment to the rule took effect, clarifying what constitutes "improper professional conduct." The amendment was prompted by the D.C. Circuit Court of Appeal's decision in the Checkosky case. The Court rebuked the Commission for not clearly articulating the standard underlying this prong of the Rule. The amendment makes clear that "improper professional conduct" means one of three things: ú First, intentional or knowing conduct, including recklessness, that results in a violation of applicable professional standards; ú Second, a single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted; and ú Third, what I call "serial negligence" - repeated instances of unreasonable conduct, each violating professional standards, that indicates an overall lack of competence. The second prong of the amended rule has generated the most discussion. During the comment process, some argued that a rule imposing professional discipline for a single instance of highly unreasonable conduct goes too far; others claimed it doesn't go far enough. Some have even suggested that the Rule can be interpreted to mean that it is ok for an accountant to act unreasonably, so long as the accountant doesn't act "highly" unreasonably, and that it's even alright to act highly unreasonably where heightened scrutiny is not required. It would be a mistake to read Rule 102(e) in this manner. First, as our release adopting the amendments to Rule 102(e) makes clear, the rule addresses only professional conduct that threatens the Commission's processes; it "was not intended to cover all forms of professional misconduct" - misconduct that may harm the public. The adoption of a "highly unreasonable" standard in the rule amendments reflects the Commission's conclusion that "a single judgment error, even if unreasonable when made, may not indicate a lack of competence to practice before the Commission." At the same time, the Commission made it quite clear that it does not accept nor condone unreasonable, or negligent, accounting or auditing errors that undermine accurate financial reporting. And neither should you. If any of you have any lingering doubts about the consequences of engaging in highly unreasonable, or even unreasonable, conduct, let me remind you that we have ample statutory authority, separate and distinct from our Rule 102(e), to sanction negligent violations of the federal securities laws. For proof of this fact, you need look no further than the proceeding we brought on May 22 of this year against two partners of a Big Five accounting firm in connection with accounting advice they rendered to Spectrum Information Technologies, Inc. While the case is ongoing and I cannot, therefore, comment on the facts _ in fact, the administrative proceeding began this Monday _ I can tell you that we charged the accountants under Exchange Act Section 21C with "causing" Spectrum's accounting violations. Administrative law judges have held that a cease and desist order may issue under Section 21C upon a showing of negligence.1 I hope I've persuaded you that there is no safe harbor for negligent conduct. It goes without saying that we also have ample remedies to deal with more egregious violations. For those who act knowingly, intentionally, or recklessly, we will bring an injunctive action in district court alleging violations of our general antifraud provision, Section 10(b). The reforms I discussed earlier, applicable to private 10(b) actions, are not applicable to Commission law enforcement actions. By its express terms, the Reform Act's pleading standards do not apply in SEC actions. The Reform Act also confirmed that the Commission has the authority to prosecute aiders and abettors. *** I've not held any punches this morning in giving you a frank and candid assessment of some of my concerns. In fact, I believe we've all given you a lot of food for thought over the course of the morning. I want to leave you, however, on a positive note. I do not want you to conclude from my remarks that I am unsympathetic to the enormous challenges you face or that I do not appreciate the fact that every day you put your good names and reputations on the line in helping to safeguard our financial reporting process. The vast majority of you do so with honor and integrity. I have the greatest respect for the work that you do and the vitally important role you play. I call upon you, however, in the face of an alarming rise in financial fraud, to not relax your guard, to not hesitate to ask the tough questions of your clients and to not shy away from the truth. And remember the lessons that Judge Sporkin taught us in the Lincoln Savings case: [A]n accountant must not blindly apply accounting conventions without reviewing the transaction to determine whether it makes any economic sense and without first finding that the transaction is realistic and has economic substance that would justify the booking of the transaction that occurred. Moreover, [an accountant] should be particularly skeptical of any transaction where the audit trail is woefully lacking and the audited entity has failed to comply with the record keeping requirements established by a federal regulatory body. Last Friday during a Wells meeting a lawyer for whom I have great respect, who was representing a CFO of a large company, told me, "If you think what my client did constitutes fraud, then every Fortune 500 company is engaged in fraud." I certainly don't believe that to be the case. And I urge you never to accept as a justification for an accounting decision a claim that "everybody's doing it." At the end of the day, your efforts will be measured not so much by whether we agree with you on difficult judgment calls that are not subject to scientific measure, but rather, by whether you've made a diligent good faith effort _ a real effort _ to reach the right result. Thank you. _______________________________ 1See, e.g., In the Matter of Jeffrey Steinberg, 1998 LEXIS 2079 (Sept. 11, 1998).