It is an honor and a pleasure to be here in Brazil to speak with you about the remarkable changes in the nature and character of the world’s capital markets we have witnessed in the last five years. Among the many changes, perhaps the most far-reaching is that investors have in many ways broken down national borders to find opportunities all over the world, through mutual funds that target opportunities in other countries, through shares or depository receipts of foreign companies traded on their local markets, and most recently even through direct investment in shares listed on markets in other countries.
I am particularly excited to observe first-hand Brazil’s initiative to compete for capital on the basis high quality financial reporting on its newest exchange. Indeed, the Novo Mercado’s use of high quality financial reporting standards to improve pricing and liquidity sends a message to markets and companies around the world that investors value robust and reliable financial reporting.
Today, I would like to describe for you some of the changes that have taken place in U.S. capital markets, beginning with some of the root causes of the devastating loss of investor confidence that led to the creation of the PCAOB, touching on several important reforms, and ending with a look at where we are today. Before I go further, however, I must note that the views I express today are my own, and not necessarily those of the other Board members or staff.
I. Stresses on Investor Confidence in U.S. Markets Were Building for Years Before the Revelations of Fraudulent Reporting by Some of Our Largest Companies.
The most obvious cause of the loss of investor confidence in the United States earlier this decade was the revelation of massive financial reporting frauds at some of the largest U.S. public companies. As astounding as the frauds themselves, though, was the exposure of numerous stress fractures in the underlying foundation of U.S. capital markets. Investors – both U.S. and non-U.S. – had confidence in the U.S. markets because they were understood to be based on fairly distributed, robust and reliable information upon which they could make their decisions whether to buy or sell interests in the companies that traded on those markets. This confidence made U.S. markets the most liquid, and the most cost-efficient for both investors and companies, in the world. When the frauds were disclosed – not just one, but one after another after another – investors questioned whether indeed U.S. markets did ensure fairly distributed, robust and reliable information, and having lost confidence in the answer to this question, swiftly cut off their previously free and reliable flow of capital.
Where were the fractures in the system? The sad fact is that there were numerous fractures, some of which we are only now beginning to see. Some, such as the IPO allocation process and, most recently revealed, corporate managements’ stock option granting practices, ran to the fairness of the system. Others, such as weaknesses in companies’ internal control over financial reporting and weaknesses in audits, ran to the reliability of the financial reports that are the lifeblood of system.
A. Audits Became Perceived to be Compliance Obligations as Opposed to the Linchpin of Reliable Financial Reporting.
Weaknesses in auditing did not happen overnight. Rather, they were the result of several years of pressure. In the years leading up to the Enron and WorldCom scandals, companies and auditors gradually began to treat auditing as a compliance exercise with little intrinsic value. Meanwhile, many audit firms found they could parlay the client relationships developed through providing services into lucrative, discretionary contracts to provide a seemingly limitless range of consulting services, and thus substantially increase the overall profitability of client relationships. These consulting services often involved engagements that were bigger, longer-term, and more leveraged from a staffing perspective, and that presented significantly lower risks than audit engagements.
Accountants who were successful in leveraging existing audit engagements into engagements to provide consulting services were encouraged in and rewarded for their efforts. Indeed, some audit plans – that is, the portion of the audit in which auditors critically evaluate risks of financial reporting errors and design a plan to identify and address any such errors – came to include studies of what kinds of additional services a client might need. Accounting firms began competing for audit engagements on the basis of price and fixed-fee commitments, notwithstanding the significantly higher risk of that work, on the theory that the more lucrative non-audit services would outweigh the disadvantage of doing so. Inevitably, the pressure on auditors to improve margins in this environment led to reduction of audit effort.
In this environment, some accountants shifted their own focuses from auditing to those other services, and many accountants even left the accounting profession entirely to apply their skills to the burgeoning consulting industry. The number of college graduates entering the auditing profession also declined, reflecting in my view the general perception that auditing was a tedious and largely unimportant compliance function. While each of these developments might have started as a hairline fracture, over time, they contributed to a lack of preparedness by U.S. capital markets for managing the explosive growth in equity investment in the late 1990s.
B. Weaknesses in Controls over Corporate Accounting and Reporting Allowed Managers Free Reign to Manipulate Results as Reported to Investors.
At the same time, corporate reporting faced its own weaknesses. Although U.S. companies have been required to have internal control over their accounting since the U.S. Congress enacted the Foreign Corrupt Practices Act in 1977, even by the 1990s many companies had failed to establish or maintain effective controls. I’m not talking about controls over the minute details of insignificant accounts. I’m talking about controls that would ensure integrity in the preparation of the overall financial statements by preventing management from hiding material changes to the financial statements.
Absent such controls, as a number of high-profile cases revealed years later, senior corporate managers were able to – and some did – manipulate official reported financial results to make them look better than they were. Indeed, in at least one high-profile case, senior U.S. managers appear to have manipulated corporate results by changing the accounts of a Brazilian subsidiary. As the U.S. Securities and Exchange Commission charged in a consented action filed against Xerox Corporation in 2002, as early as 1995 top U.S. managers at Xerox regularly directed that financial reports from its Brazilian operations be changed to reflect different revenue trends than applicable accounting standards would have required. Corporate managers also used their ability to change detailed accounts at subsidiaries in Mexico and Europe to prevent the company’s investors from knowing the company’s true operating performance.
Weakened by these fractures and others, the financial reporting framework as we knew it collapsed beginning in late 2001 with what appeared to the investing public to be a spontaneous implosion of two of the United States’ larges companies – Enron and WorldCom – and one of the world’s premier accounting firms, the venerable Arthur Andersen.
II. The Sarbanes-Oxley Reforms are Designed to Restore the Reliability of Audited Financial Statements as a Basis on which Investors Can Make Informed Decisions
I know I need not describe for you how the scandals led to the passage of the Sarbanes-Oxley Act. No matter where you were on the globe in 2002, if you were involved in the financial markets you were acutely aware. What I would like to discuss with you today, though, is the new paradigm that has shifted the balance of power from corporate managers, many of whom formerly had near absolute authority over both their companies’ financial reporting processes as well as their auditors, to audit committees, who now have renewed mandates and new tools to demand and ensure robust and reliable financial reporting.
A. Auditors Are Now Hired and Overseen by Independent Audit Committees, Instead of Corporate Management.
Because you’ve asked me to touch on the topic of audit firm rotation given what I understand is an initiative in Brazil to consider the topic, let me start by describing how auditor selection occurs in the United States today.
1. Sarbanes-Oxley Makes Audit Committees Responsible for Auditor Selection, Compensation and Oversight and Requires Periodic Audit Partner Rotation.
Sarbanes-Oxley did not require audit firm rotation, in part because in the Congress’s view the legislative record did not provide clear evidence that rotation would prevent the kinds of problems that led to the crisis in 2001. Instead, the Act did three things.
First, it required companies to establish audit committees comprised of independent directors and made those independent audit committees “directly responsible for the appointment, compensation, and oversight” of the companies’ auditors. Formerly, in the United States, company management – typically a company’s CFO – hired and, importantly, had the authority to fire the auditor.
The wrath of CFOs was not a theoretical threat. For example, in the Xerox case I mentioned earlier, one of the charges that the SEC’s complaint levied against the company was that “when the engagement partner for the outside auditor challenged several of Xerox's non-GAAP accounting practices, Xerox's senior management told the audit firm that they wanted a new engagement partner assigned to its account. [And t]he audit firm complied.” Today, an independent audit committee would provide a serious impediment to such a dismissal.
Second, Sarbanes-Oxley prohibited audit firms from providing audit services to an audit client if the lead or coordinating audit partner, or the partner responsible for reviewing the audit, has provided audit services to that client for the previous five years. This is, in effect, a requirement that audit partners rotate off audits after five years to provide for a new team to take a “fresh look” at the audit client’s financial reporting process and accounting principles.
Of course, to the extent an audit firm has already signed-off on a questionable accounting method, incentives not to disagree with the firm’s, or one’s partners’, earlier positions still exist. I’m not aware of any empirical evidence on behavioral patterns before and after the new rule, but there is evidence that U.S. companies are restating prior period financial statements at a significantly greater rate than in the past. Many of these restatements are attributed to errors identified in companies’ and auditors’ examination of the effectiveness of internal controls, but they tend to show that engagement partners and firms are not inclined to let errors continue unaddressed once they are identified. Indeed, the number of restatements by U.S. companies in 2005 reached a record level. Approximately 1 in 12 public companies restated their financial statements in 2005 to correct material errors. While troubling that this number of material errors in U.S. companies’ financial statements still exist, it is, at the same time, a positive sign that, working with their auditors, U.S. companies are getting their accounting on the right path.
Finally, the Sarbanes-Oxley Act also required the Comptroller General of the United States to conduct a study of the potential effects of requiring the mandatory rotation of audit firms. The Comptroller General did so, and in November 2003 published a report opining that “mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality.” Importantly, the report also found that, in order to be effective in their role in enhancing auditor independence and audit quality, “audit committees need to have access to adequate resources, including their own budgets, to be able to operate with the independence necessary to effectively perform their responsibilities under the Sarbanes-Oxley Act.”
2. In Practice, There Has Been Considerable Audit Firm Turnover in the United States.
In the four years since the Sarbanes-Oxley Act was passed, even without mandatory audit firm rotation, there has been considerable change in how audit firms and audit clients pair up. For one thing, 1,085 public company audit clients of Arthur Andersen – which, in 2001, was the fourth largest U.S. accounting firm – switched auditors when or shortly before the firm was indicted by the U.S. federal government in connection with its destruction of Enron audit records. Separately, from 2003 to 2005, in the United States approximately one-third of all public companies changed accounting firms. In 2005 alone, 1,430 – or approximately 11 percent of – U.S. public companies switched their auditors.
It’s difficult to say whether audit firm changes are overall enhancing auditor independence or audit quality. In the United States, unless there is an accounting disagreement between a company and its auditor or some other reportable condition exists, the company is not required to disclose the reason for the change. Further, not all of these changes reflect decisions by audit committees at all. In fact, recently some audit firms have resigned from clients because of resource constraints.
Nevertheless, audit committees in the United States today do play an important role in considering whether to continue to retain the company’s audit firm every year, and some have even adopted policies of engaging in an in-depth comparison of options on a fairly regular basis. At those times, an effective audit committee can weigh the risk of fostering complacency by the company’s auditor against the risk of losing the auditor’s in-depth knowledge of the company’s business and its financial reporting system.
B. Audit Committees Have New Tools to Oversee the Financial Reporting Process in a Meaningful Way.
Audit committees’ authority to hire, oversee, and if necessary, fire, auditors provides audit committees much more than just the ability to make sure auditors approach their work with a “fresh look.” Rather, it frees auditors from the grip of management and establishes a tone for their relationship with the audit committee that is conducive to open, forthright, and robust discussion.
Under the Sarbanes-Oxley Act, the implementing rules of the SEC and the U.S. exchanges, and audit committees’ own charters, there are, of course, a number of specific matters audit committees must handle, including establishing a mechanism for receiving and addressing complaints or anonymous information about the company’s accounting, and approving any non-audit services that may be performed by the company’s audit firm, among other things. In addition, audit committees play a key role in establishing and monitoring companies’ internal control over financial reporting.
These explicit requirements can help audit committees maintain a level of awareness about their respective companies’ financial reporting processes and risks that positions them well to examine with the outside auditors the quality, not just the acceptability, of the companies’ accounting and disclosures, as well as the effectiveness of the companies’ internal control over financial reporting. After all, this examination – this close dialogue between a company’s audit committee and its auditors – is one of the key solutions, or strategies if you will, for avoiding the breaches in the fairness and reliability of a company’s financial reporting that can so damage investor confidence.
III. Over Time, Quality of Financial Reporting Will Prove to be an Important Driver of Competition in and between Markets.
Weaknesses in financial reporting were not unique to companies and auditors based in the United States.
The U.S. SEC has brought numerous cases against non-U.S. companies whose shares are traded on U.S. markets and non-U.S. auditors who audit those companies. For instance, one spectacular case involved an IPO by a London-based company known as AremisSoft, at the height of the tech boom in 1999. During AremisSoft’s two-and-a-half years as a public company, it engaged in a number of fraudulent practices to make it appear to be a sprawling international software company, including by booking fake sales and accounts receivable and overstating earnings in two Cyprus-based subsidiaries. During that period, disappointingly, the company’s U.K. auditors issued unqualified reports on its financial statements, even though it later turned out that only a small fraction of reported revenues were real and that close to one-third of the company’s cash lay in the personal bank account of one of its co-chairmen and co-CEOs.
Self-interest and deception are indeed global problems. What was unique to U.S. markets was their unparalleled reputation for robust and fair disclosure, transparency and accountability. This reputational advantage translated into real dollars for companies seeking access to capital, in the form of a premium on IPO pricing as well as sustained liquidity.
Today, some in the United States complain that burdensome regulation has discouraged companies from tapping U.S. capital markets. In support of this argument, they point to circumstantial evidence such as the number of large new IPOs choosing to list on non-U.S. markets as well as the growth in the London Stock Exchange’s Alternative Investment Market for smaller companies, but it’s not clear to me that this is the case.
First, I understand the greatest costs companies listing in the U.S. face are not compliance costs but rather are underwriting fees. One recent study has estimated that underwriting fees consume 6.5 to 7 percent of IPO receipts in the U.S., compared to 3 to 4 percent in Europe.
Moreover, it’s not clear to me that there is any evidence that the costs of starting and maintaining a listing on a U.S. market exceed the premium companies enjoy on such a market. Rather, the facts appear to confirm the continued attraction of U.S. markets to companies, because of the significant valuation premium for companies that can meet the requirements of U.S. listings. Indeed, seven out of the 29 U.S. companies that have listed on the LSE’s AIM have a dual-listing or otherwise trade on a U.S. market. As the Head of Nasdaq’s International Listings office has said, “The key reasons companies are still coming to the U.S. remain the same. International listing activity is still driven by U.S. valuations.”
The New York Stock Exchange has estimated this valuation premium at 30 percent, which is consistent with recent empirical research documenting statistically and economically significant differences in the cost of equity capital between countries. Specifically, after controlling for traditional measures of risk and differences between countries, a December 2005 study by two Wharton professors found that companies from countries with more extensive disclosure requirements, stronger securities regulation, and stricter enforcement mechanisms, have a significantly lower cost of capital.
To be sure, though, stock exchanges’ marketing efforts have become global, and companies around the world now enjoy listing options not available even in the recent past. For example, the top five IPOs in 2005 were privatizations of state-owned entities in China and France. Not surprisingly, those companies listed on the local Hong Kong and Euronext markets, respectively. Notwithstanding the significant valuation premium in the U.S., there are political, cultural and other influences on such companies to list locally and I expect they will continue. In any event, it is questionable that sacrificing disclosure and governance quality requirements could attract these companies, although it does pose the very real risk of significantly reducing the U.S. valuation premium for all other companies listing in the U.S.
Short-termism – or making a decision based on a short-term perspective – is a disease that can affect companies as well as investors. For a while, some companies and investors may find markets with lax requirements attractive. However, I am confident that over time the lustre of that attraction will fade, because long-term investors depend on robust and reliable financial reporting.
In the meantime, other markets, like the Novo Mercado here in Brazil, are beginning to offer meaningful investor protections too. Now, that kind of competition on the basis of quality may indeed lure investors to new markets. I believe this is a positive development that regulators everywhere should support, though, because whatever happens it’s a race that investors will win.
 See Economist, “New Wave for the Novo Mercado; Brazilian IPOs,” Feb. 25, 2006.
 The number of U.S. accounting graduates (bachelor level) has declined or been flat in every year in the period 1991 through 2002, except 1994 (up 7 percent) and 2001 (up 2 percent). In 1999, 2000 and 2002 there were significant declines of 21 percent, 10 percent, and 8 percent, respectively. See AICPA, The Supply of Accounting Graduates and the Demand for Public Accounting Recruits – 2005 , at 4.
 See Complaint Against Xerox Corp. (April 11, 2002), available here ("In most cases, application of ROE was a ‘top-side’ adjustment directed by corporate headquarters. Operating units allocated lease cash flows . . . according to long-established procedures. Before the financial results were reported publicly, Xerox's regional headquarters, using data supplied by corporate, recalculated these allocations to insure that Xerox's financing operations realized no more than a 15 percent return, regardless of its own capital or administrative costs or the interest rates paid by the customer to lease a copier. Initially, use of the ROE formula was limited to the United States and to Xerox Brazil, where the formula was implemented by at least 1995. As the pressure to meet earnings targets grew, and competition made selling copiers more difficult, ROE was expanded to Xerox Europe in 1998."). Xerox agreed to settle the SEC's complaint by consenting to the entry of an injunction by a federal district court in New York.
 See Complaint Against Xerox Corp., at 1.
 Sarbanes-Oxley Act , Section 301. The blueprint for this requirement lay in the 1999 recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, established by the SEC, the New York Stock Exchange, and the National Association of Securities Dealers, in response to concerns expressed about the adequacy of the oversight of the audit process. The Committee recommended, among other things, that audit committee charters be required to specify that the outside auditor is ultimately accountable to the board of directors and the audit committee, as representatives of shareholders, and that these shareholder representatives have the ultimate authority and responsibility to select, evaluate, and where appropriate, replace the outside auditor. The bases for this recommendation were that (1) in most companies at the time, management selected or recommended auditors and changes in auditors, negotiated fees, and monitored the audit, and “[c]onsequently, the outside auditors typically develop over time close relationships with management,” and (2) “the expanding role of outside auditors, particularly in providing non-audit services, ha[d] further entwined the relationship of management and the outside auditors.” Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, at 30, available here.
 See Complaint Against Xerox Corp., at 18.
 Sarbanes-Oxley Act , Section 203. In addition, the U.S. SEC has adopted certain rules implementing the Act’s audit partner rotation requirement, which among other things establish that a partner who is required to rotate off an audit engagement may not rotate back onto the engagement for another five years. See 17 C.F.R § 210.2-01(c)(6).
 “While the number of public companies announcing financial restatements from 2002 through September 2005 rose from 3.7 percent to 6.8 percent, restatement announcements identified grew about 67 percent over this period. Industry observers noted that increased restatements were an expected byproduct of the greater focus on the quality of financial reporting by company management, audit committees, external auditors, and regulators.” U.S. General Accounting Office, Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities (GAO-06-678, July 2006) .
 See Glass Lewis & Co., Getting it Wrong the First Time, March 2, 2006, at 1.
 Sarbanes-Oxley Act, Section 207.
 U.S. General Accounting Office, Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation (GAO-04-216, November 2003) . The report also suggested that the SEC and the PCAOB continue to monitor and evaluate the effectiveness of existing requirements for enhancing auditor independence and audit quality.
 Id. at 9.
 U.S. General Accounting Office, Public Accounting Firms: Mandated Study on Consolidation and Competition (GAO-03-864, July 2003) , at 101.
 See Glass Lewis, Mum’s the Word, Yellow Card Trend Alert (July 27, 2006).
 See Jean, Sheryl, Overwhelmed Accounting Firms Focus on Big Client, Leaving Smaller Ones Behind, St. Paul Pioneer Press, Oct. 19, 2004.
 For example, in its 2000 Form 10-K, AremisSoft reported $97.5 million in revenue from its two Cyprus-based subsidiaries, which comprised 80% of its reported $123.6 million in consolidated revenue. The SEC later determined that, together, the two subsidiaries contributed only $1.7 million in revenue for the year. See Order Instituting Public Administrative and Cease-and-Desist Proceedings in re PKF, et al., SEC Release No. 33-8675, at 4 (April 12, 2006).
 See Oxera Consulting Ltd., The Cost of Capital: An International Comparison (June 2006) , at 4.
 Remarks of Charlotte Crosswell, Head of International Listings, NASDAQ, printed in Ernst & Young, Accelerated Growth: Global IPO Trends 2006, at 24.
 Remarks of Noreen Culhane, Executive Vice President, Global Corporate Client Group, New York Stock Exchange, id. at 26 (An “underlying motivation for most companies listing in the U.S. is the valuation premium (average 30 percent) that accrues as a result of adhering to high standards of governance.”).
 Hail, Luzi and Leuz, Christian, International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?, Journal of Accounting Research (June 2006). Leuz and Hail estimated the cost of capital from 1992 to 2001 for several thousand companies from 40 countries.