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Harvey Pitt, who announced his resignation in November after 15 tumultuous months as chairman of the Securities and Exchange Commission, already has been written off as an embarrassment and a mistake. Amid the post-mortems, no one seems to have noticed that his prescriptions for the securities industry were and are cogent. In fact, at a juncture when investor anger and political self-promotion dominate the agenda for securities law reform, Pitt’s ideas are more timely than ever. Pitt’s regulatory philosophy, as set forth in a series of speeches and interviews earlier this year, rests on the unwelcome truth that law is a very limited tool for enforcing proper standards of business conduct. Pitt began from the premise that “businesses have cultures,” and disasters such as Enron “have their roots in a cultural pathology.” Therefore, he argued, an effective regulatory policy must rely on a variety of incentives to improve and maintain ethical and competency standards. This is as true for corporate officers and directors as it is for accountants, lawyers, and other professionals. PITT’S PHILOSOPHY In Pitt’s view, the commands and punishments of the law play a role, but not a dominant one. Business culture, like any culture, tends to coarsen with regulation, as the letter of the law supplants internal motivations such as loyalty and pride. “Confidence in our capital markets cannot be maintained,” Pitt argued, “if the public believes everything is a game to enable corporations to rely on lawyers and other professionals, who in turn rely on a literal reading of the law or governing principles.” Because the imposition of law can be ineffective and even counterproductive, Pitt reasoned that it is a mistake to expect “government acting alone” to solve the crises posed by Enron and other scandals. Pitt’s message of cautious reform, to be accomplished other than at the point of a sword, wasn’t what the Street (or the politicians and talking heads who flatter it) wanted to hear. Pitt learned the hard way that a bear market is no time for intelligent securities law reform — as the ponderous Sarbanes-Oxley legislation passed in July makes all too clear. To the extent Pitt’s views weren’t ignored, they were dismissed as apologetics for his former (and presumably future) clients in the securities industry and corporate America. Pitt didn’t help matters when, toward the end of his tenure, he found religion and desperately began sounding more like a prosecutor than the guardian of the nation’s securities markets. Yet the wisdom of Pitt’s ideas stands out, especially in the two problem areas that haunted him most: accounting practices for the audit of public companies and the protection of securities analysts from conflicts of interest. Pitt’s approach to the accounting profession had two facets. The first was “private-sector regulation” of the audit process, by a board appointed by the SEC and entrusted with disciplinary powers. The second was SEC involvement in the promulgation of accounting standards in order to foster a return to “principles-based accounting.” Both of these important proposals were incorporated in the Sarbanes-Oxley law. But Pitt has never received the credit he deserves for formulating them. As to the new disciplinary board, many critics persist in the paranoid view that allowing a minority of its members to be certified public accountants — as Pitt successfully recommended to Congress — is a sellout to the accounting lobby, rather than a way of providing the board with necessary expertise. Pitt’s proposal for accounting reform, on the other hand, has drawn little notice even though Pitt thought it crucial. The current myopic “check the boxes” tendency in auditing, he believed, led to the accounting abuses in Enron. Accounting rules are an arcane subject not reducible to sound bites or demagogic appeals. Yet Pitt, to his credit, insisted that these rules must be tackled as part of the ethical and educational reform of the accounting profession. Pitt gave short shrift, however, to the most highly touted proposal for accounting reform, which would prohibit auditing firms from also performing consulting and other non-audit work for their clients. The rationale for the proposal is that strict separation will strengthen auditor independence. Pitt’s disagreement, in the teeth of a campaign by former SEC Chairman Arthur Levitt and other media favorites, was both courageous and wise. NO MAGIC BULLET In characteristic fashion, Pitt cautioned against searching for a legislative magic bullet for the complex problem of independence of auditors. Pitt made the common sense point that accountants offering only auditing services still would have to juggle their responsibilities to the public and their loyalty to the client. “Auditors face an obvious conflict from the moment they get paid by their clients. That’s basic life,” he said. In 2001, it should be noted, Arthur Andersen received $25 million from Enron for auditing services and another $27 million for consulting work. It’s hard to believe that the spines of Enron’s auditors would have been stiffened if $27 million worth of business, rather than $52 million, had been at stake. In fact, as Pitt observed, “audit only” accounting firms might grow more dependent on their large audit clients than firms that have diverse sources of revenue. Pitt’s preference was to target specific services and billing arrangements that put pressure directly on auditors, as well as to take steps to improve auditor training and morale. But his more flexible approach was largely rejected in Sarbanes-Oxley. At the same time that the Enron/Arthur Andersen debacle placed Pitt permanently on the defensive on one front, New York Attorney General Eliot Spitzer’s high-profile investigations of securities analysts had the same impact on another. The crux of the regulatory problem here is that analysts employed by investment banks are inherently compromised — caught between the companies that hire the banks to sell their securities and the individual investors whom the analysts advise to buy them — because their salaries and research costs are necessarily paid out of banking revenues. The only way to resolve the tension would be to spin off research entirely, which would mean much less research, and at high prices, for retail investors. A less ambitious, more sensible approach would be to implement procedures for managing the conflicts and disclosing them to the investing public. The SEC adopted such an approach last May, approving rules that prohibit investment banking departments from supervising analysts, bar banks from tying analyst compensation to banking transactions, and require disclosure to investors of banking services provided to the subjects of the bank’s research. Under the new rules, the underlying conflict in the analysts’ position remains. But, as The Economist put it, “the recommendations of any analyst who is paid a small fortune by his bank should always be regarded with suspicion. No amount of structural changes, lawsuits or compensation funds can beat this simple advice.” UNAPPRECIATED REALISM Needless to say, the SEC’s realism wasn’t appreciated by Spitzer, who immediately called the new rules a “fig leaf.” Similarly, Sarah Teslik of the Council of Institutional Investors fumed that same month that Pitt’s refusal to seek a complete separation of analysts and investment bankers was a failure of leadership. In a telling analogy, she likened Pitt to the “kids on bicycles” who follow in the wake of a parade. A few weeks later, Spitzer announced a settlement with Merrill Lynch that mandates reforms similar to the SEC’s rules. Yet Spitzer still hasn’t stopped. His recent proposals for a global solution to analysts’ conflict (made jointly with a now chastened SEC) include one requiring the largest brokerage firms and investment banks to contribute as much as $1 billion over five years to subsidize research by independent companies to be selected by a government panel. Should such a proposal be adopted, Pitt’s disclosure-oriented reforms would be superseded by an intrusive and clumsy bureaucratic apparatus. If there’s a silver lining here, it’s that Pitt’s departure might mean his ideas finally receive a measure of objective consideration. Fairly and unfairly, for reasons within his control and beyond it, the greatest impediment to appreciating his regulatory philosophy had become Harvey Pitt himself. Kevin J. O’Brien is a litigation partner in the New York office of Swidler Berlin Shereff Friedman. A former federal prosecutor, he practices in the areas of white collar criminal defense and securities litigation.

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