instances in industry of promises without action that I do not believe you should leave to the accounting profession these important issues of public trust and confidence. Inherently, what you are dealing with is the Government versus private interest.

I doubt you could get the Securities Exchange Acts passed today. The lobbyists for private interests are much more sophisticated than 40 years ago and would see to it that the SEC would be toothless. Fortunately, passing these laws is not the issue. The issue is enforcing them. This committee should see to it that the laws are enforced. With a few exceptions, that is all I am advocating.

The law was set up for that purpose because, for years and years before its enactment, improper accounting and reporting had been going on and it came to the point in 1932 and 1933 when public pressure made it clear that reform was necessary. A Congress was elected that fully agreed with what President Roosevelt was trying to do. In my opinion, our situation today is just about as bad except that it has been covered up by custom and by legal gimmicks. What was wrong then has become customary and legal now.

I have tried to give you a frank answer.

Senator PERCY. There are two other points. One is an intriguing idea. It is a problem I couldn't come up with an answer to and I didn't. That is, when an independent accounting firm does get too tough with a company, the tendency of management might be to change them. If they had it already paid, the management would only have an influence on it but they couldn't control it. You have said there ought to be some sort of compensation to carry them over. How would you collect funds for that?

Let's say a company was threatened and lost an account because they really held their feet to the fire and they went in and audited and said the personal expense accounts of all the top management had to go and got mad and threw them out. How would we collect the money to have a fund of that kind? Because it may well be a very creative, helpful idea.

Admiral RICKOVER. 1 made two recommendations to deal with the problem of audit independence. The first was that there should be a system of reparation so that an auditing firm would be compensated if it lost a client for failure to carry out the client's desires. The second was that there should be a requirement for mandatory rotation of auditors after 5 years, during which time the accounting firm could not be dismissed by a company except for improprieties or personal incompetence, and then only after an SEC hearing. What I had in mind with regard to the reparation agreement was something like a 5-year contract between the company and its auditors which would provide for a termination payment or severance pay in the event that the company elected to discharge the audit firm for reasons other than improprieties or incompetence. I do not think that there would be any need to set up a public or private fund to finance such agreements since each company would be responsible for the costs of the termination or reparation agreement in the event that the company elected to discharge the audit firm for reasons other than improprieties or incompetence. I do not think that there would be any need to set up a public or private fund to finance such agreements since each company would be responsible for the costs of the termination or reparation agreement in the event that the company elected to discharge the auditor.

In effect, reparation would put some teeth into the 5-year commitment of a company to its accounting firm and would provide some real sanctions to the SEC's current requirements for a company to disclose the circumstances under which an audit firm is discharged. I am sympathetic to the efforts being made by the SEC to force disclosure in these circumstances. For example, the SEC requires that it be advised in a public filing by the company of the reasons for a change in audit firm. This is a good step but I would go further since, as a realist, I suspect that there are times when both the company and the audit firm gloss over the real reasons for their parting.

Another thought you may wish to consider in connection with my proposal for mandatory rotation is to require that there be an overlap in time between the old and new auditing firms. For example, perhaps it would be appropriate for the SEC to mandate both the old and new auditing be retained in the 5th year of the mandatory period. This would help overcome the reservations of some that mandatory rotation would diminish the quality of audit service. This, of course, would cost money but I suspect that the investment would be well worth it in terms of public confidence in the system.

Senator PERCY. What if we said once SEC comes in that they could suspend a dismissal of an order, for instance, and until an investigation was made as to

whether or not the auditor's position is valid or not? If they are valid, you can't fire an employee, if it is a civil rights situation.

Admiral RICKOVER. I agree with that.

Senator PERCY. So there might be a whole situation where you could go into to protect companies or auditing firms who did get tough with a company and hold them harmless while an investigation was made by an outside source. Admiral RICKÓVER. Yes, sir.

My testimony is not intended as an omnibus thing which has all wisdom in it. My whole purpose today is to cause some people to think and realize in plain terms what is actually going on. My job is to report that the Augean stables are dirty. It is not my job to clean them out. I am the messenger and I am reporting. Have I done a fair job in reporting the situation, sir? Senator PERCY. Yes.

Admiral RICKOVER. That is all I came here to do. I am sure people with your experience and your wisdom will generate some ideas on what I have said. You may find completely, entirely different solutions.

Senator PERCY. I was delighted to see how hard you came down on outside auditing committees. I think that is absolutely essential that you have the auditors selected by outside directors, not by management.

You commend the New York Stock Exchange, but I have a quarrel with the stock exchange that they would permit a director to be classified as an outside director who is the commercial banker, investment banker, the lawyer who is collecting thousands of dollars, sometimes millions of dollars from the management. I think they must be beholden to the management in this sense, and I don't think they can be considered an outside director.

Would you concur with that?

Admiral RICKOVER. I agree with you entirely. The qualifications of outside directors and in turn the composition of audit committees should exclude those such as bankers and lawyers who have personal interest in the company. Some companies choose their so-called outside directors for reasons not related to the quality of service they can perform. Frequently, an outside director is some guy with a name who gets $5,000 or $10,000 a year for attending two or three meetings and then the company uses his name. And in order to stand good with the public. companies now get minorities and women as outside directors. Next they will have hermaphrodites, I am sure.

During my testimony at hearings held by your Subcommittee on May 26, 1977, Senator Percy requested that I apprise your Subcommittee of my views with respect to 13 recommendations included in the prepared statement of Admiral H. G. Rickover. Admiral Rickover's recommendations deal with actions that should be taken by the Securities and Exchange Commission (SEC) to more closely monitor and review the work of public accounting firms. Two of the recommendations are addressed to the responsibilities of the Cost Accounting Standards Board (CASB).

In my prepared statement before your Subcommittee, I indicated that the current approach to setting accounting Standards in the private sector is appropriate, particularly if it is coupled with close oversight and review by the SEC. Recommendations made by Admiral Rickover are entirely compatible with this view, although it is not entirely clear that the SEC has the authority to go as far as the Admiral would like the Commission to go in monitoring and regulating the independence of public accounting firms. I understand that the General Counsel of the SEC has submitted a memorandum to your Subcommittee dealing with the statutory authority of the SEC to implement each of the specific recommendations contained in the testimony by Admiral Rickover. That memorandum spells out some of the actions that have been taken or are being considered by the Commission and also describes some reservations that the SEC General Counsel has concerning the Commission's authority to carry out certain of the recommendations made by the Admiral. We have nothing further to add to the views expressed by the General Counsel of the SEC.

Admira? Rickover recommends that "Congress should maintain oversight of the composition and operation of the CASB to insure that it carries out the intent of Congress." Public Law 91-379, the basic legislation of the

CASB, makes specific provision for congressional review of individual Standards, rules, or regulations promulgated by the CASB. The legislation provides that such Standards, rules, or regulations shall become effective if the two Houses of the Congress do not pass a concurrent resolution disapproving of a promulgation within 60 legislative days following transmittal of the promulgation to the Congress. In addition, the Senate Committee on Banking, Housing and Urban Affairs and the House Committee on Banking, Currency, and Housing maintain close surveillance over the operations of the CASB. Both Committees have held hearings on Board operations in the past. Further, Senator William Proxmire has recently advised us that the Joint Committee on Defense Production has tentatively scheduled oversight hearings concerning the CASB which he expects will be held within the next two months. We believe the Congress is maintaining appropriate oversight of the operations of the CASB, and we believe we have been carrying out the intent of the Congress.

Admiral Rickover also recommends that "the CASB should be required to abandon its proposal to liberalize the criteria by which contractors are exempt from its requirements and devote its efforts to issuing needed Standards for cost accounting under Government contracts." The recent proposal by the Board to modify application of its rules, regulations, and Standards to certain categories of contractors and contracts is based on the provisions of Section 719 (h) (2) of the Defense Production Act of 1950, as amended, which authorizes the Board to prescribe rules and regulations exempting from Cost Accounting Standards classes or categories of contractors or subcontractors on the basis of the size of contracts involved or otherwise if the Board deems the exemption appropriate and consistent with the purposes sought to be achieved by the cited legislation. The Board's proposed changes to Cost Accounting Standards contract coverage are still under consideration.

As I indicated during my testimony on May 26, we have received more than 130 sets of comments on that proposal from interested parties, and we are analyzing and considering the comments. After analysis of these comments, the Board expects to be prepared to make decisions on the proposed exemptions during July and should be in a position to transmit any new regulations to the Congress early in August for the 60 days of congressional review. Please be assured that during the time that the Board has been studying the exemption question, it has in no way reduced its efforts in developing Standards needed in accounting for the cost of negotiated Government contracts. Our research efforts leading to the development of Standards on 13 additional subjects are continuing. The subjects under consideration were briefly described in an appendix to my prepared statement of May 26.

I trust that this letter is responsive to the request of Senator Percy during the hearings on May 26. If you desire any additional information, please let us know.

In your testimony of 26 May to this subcommittee,
you made several recommendations for action by the
Securities and Exchange Commission in connection with
public accounting. You further observed that in your
opinion the SEC had the authority under existing legisla-
tion to do much of what you advocated. At the hearings,
I requested that the SEC specifically report to the sub-
committee on whether the SEC has statutory authority to
implement your recommendations. The Commission addres-
sed these issues in its testimony before the subcommit-
tee on 13 June.

It would be of great assistance to the subcommittee to receive your views on the positions taken by the SEC. Your views on these matters will be incorporated in the record of the subcommittee's hearings on accounting.

Very truly yours,