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CONCLUSIONS

To sum up, auditors cannot practice their calling without being exposed to pressures on their integrity and objectivity. To define and proscribe all such situations would be impracticable.

The pressures that accompany normal relationships with clients are offset by powerful countervailing restraints. These include the possibility of legal liability, professional discipline involving revocation of the right to practice, loss of reputation and the inculcated resistance of a professional to any infringement upon his basic objectivity and integrity.

In deciding which types of relationships should be prohibited, both the magnitude of the threat posed by a relationship and the force of countervailing pressures have to be weighed. Such judgments should be based on whether reasonable men, having knowledge of all the facts and taking into consideration normal strength of character and normal behavior under the circumstances, would conclude that a particular relationship would pose an unacceptable threat to an auditor's objectivity or integrity.

The profession has applied these criteria in establishing its prohibitions of relationships between auditors and their clients. It believes that those prohibitions are being scrupulously observed and are adequate to assure the independence of auditors.

The profession has also taken steps to minimize the pressures on auditors by urging the establishment of corporate audit committees and assisting in the development of reporting requirements on changes in auditors. Safeguards to assure a high level of performance have also been imposed by adopting and carrying on extensive quality control review programs and requiring continuing professional education by practitioners.

In short, the profession is doing all that can reasonably be expected to assure that a high level of independence is maintained by auditors. However, no procedures or system of constraints, whether self-imposed or invoked by government, can provide a guarantee of zero defects.

Even though there have been failures in the performance of auditors they have been minuscule in number in relation to the overall volume of audits performed, When failures have occurred they have rarely involved impairment of objectivity or integrity. In almost all instances, audit judgments were found to be faulty in the light of hindsight, audit procedures were not effectively applied or generally accepted accounting principles had not been sufficiently narrowed to deal appropriately with new forms of business transactions. None of these shortcomings would have been cured by the rotation of auditors, restrictions on the scope of services of auditors, different methods of appointment or remuneration of auditors or transfer of the audit function to a governmental body.

The problems that have been encountered are to a large extent inherent in the difficulties in accounting for and reporting in a highly condensed format on the operations of large complex corporate structures. Impairment of the independence of auditors is not a principal or fundamental cause of the few shortcomings that have been encountered in audited financial statements. Auditors have, overall, displayed a remarkable degree of objectivity and integrity in fulfilling their role and are likely to do so in the future without changes in the present system of constraints.

Mr. CUNNINGHAM. We will recess until the chairman returns and then continue with two witnesses until the Sergeant at Arms appears to close down the hearing. Thank you.

Recess. ]
Senator HARTKE. The committee will come to order.

The next witness will be Mr. Richard Cyert, the president of Carnegie-Mellon University, Pittsburgh, Pa.

STATEMENT OF RICHARD M. CYERT, PRESIDENT, CARNEGIE

MELLON UNIVERSITY, PITTSBURGH, PA. Dr. CYERT. Good morning, Senator.

What I would like to do is just briefly indicate the points in my statement which has been submitted and a little of my background.

"Then I would like to answer any questions you have.

My background has been economics. I have concentrated on microeconomics and I have been particularly concerned with decisionmaking within the business firm.

Since I have been president of the Carnegie-Mellon University, which has been for the last 4 years—and prior to that I was dean of the business school—I have accepted several directorships so that I feel I know the corporation from the outside and from the inside.

In my statement what I have done is talk about the whole question of governance, which deals with the relationship of a board of directors to the chief executive officer and to the stockholders of the corporation in general, and, secondly, I have discussed the problem of antitrust.

I would be prepared to answer questions from you on either of these areas or any of the other areas that are of interest to you.

Senator HARTKE. Do you consider that there are, at the present time, what you call corporate violations of the law?

Mr. CYERT. Well, I would say this: What is happening within corporations is that a number of incidents are surfacing because of the general sensitivity and concern.

These are incidents generally which top management would have great difficulty in ever discovering. There are relationships where the company may be selling through an agent in a South American country and it turns out that that agent, who is not even an employee of the company, has been taking some of the funds which the company has been paying him, which are completely reasonable in terms of an agent's fee, and it turns out they discover he has been bribing some people in that South American government.

He is a native of that country. That is a violation in the way that the corporation views it.

At the top management level, I think the violation question has to be answered "no," that there is no known kind of violating going on, and there is a great sensitivity to this whole area.

Senator HARTKE. Let me give you a specific.
What about the Gulf Oil thing?
You said "no known".

Mr. CYERT. Well, the Gulf Oil situation, I just do not believe there are other situations like that Gulf Oil situation going on at this time.

Senator HARTKE. I don't want to go into specifics. I think generally speaking I would feel there is. You say that on critical subjects such as the supplying of energy that we should have neither more competition or more government involvement.

Is that right?

You say we should increasingly rely on the ability of businessmen to behave like statesmen.

Mr. CyErt. That is right.

Senator ILARTKE. What are the incentives for them to behave like statesmen?

Mr. CYERT. Well, I think, first, the board itself is a factor in this in that they are—most boards, and particularly those with a fair number of outside directors are critical of behavior of chief executives, who seem to be self-seeking or exhibiting behavior that would smack of illegality.

I think the chief executives themselves are professionals in the same sense I am talking about most of them now—in the same sense that most physicians are.

Just as physicians and other professionals have self-regulating and self-auditing bodies, I think that is the kind of development that has to be increased in the whole business area.

Now, I don't think at the moment, however, that we need just to rely on that, because I do believe for critical things like pricing of products, like investment in new areas, that competition does exist in a very strong fashion in our economy despite the fact that we may have markets where there are only three or four firms which economists refer to as oligopolies.

There is a lot of evidence that has been developing in the economic sector to indicate that oligopolies are extremely competitive, and that it is not a question of these companies somehow getting together and setting prices and making huge profits. They are competing.

So, I think my long-run hope is that we can develop among top executives and I think educational institutions play a role in this much more of an attitude that stimulates ethical standards among this group so they will be behaving in the way that I describe as statemanlike, which means taking the best aspects of society.

Senator HARTKE. Is the sum and substance of what you are saying, then, that there really is no problem?

Mr. CYERT. No. I don't mean to be Pollyannaish about it.

I do think we have a number of things we have to be concerned about. I think business firms are concerned about them and are in the process of doing something about them.

We have heard some of them today. The audit committee, a concept which has been developing among boards of directors, is a very healthy thing.

These committees are made up of outside directors, and are very tough. I am on several of them.

We have given instructions to the auditors that they are to come directly to us with anything that smacks of any illegal activity.

We question them hard on the possibilities of their having uncovered such things, and we go over their audit program before they audit, so that there is, I would say, a growing control through the outside directors and through sensitivity of directors because of some of the events that have happened, and in particular the Gulf Oil situation.

Senator HARTKE. Would you feel that in any case there would be a justification for a public board of directors to be appointed to these corporations!

Mr. CYERT. I personally do not.

The reason I think not is that I think the board of directors has a particular kind of relationship with the management.

It has to be involved in the decisionmaking process at particular levels of the corporation. It is an important part of that decisionmaking process.

The directors do not sit there only as auditors. They are also decisionmakers. Therefore, there has to be effort to understand the operation.

There has to be a basis of working with the management at the same time that it is recognized that ultimately the board holds the authority to hire or fire that chief executive officer.

To put someone in from the outside, I think you run the risk of really having an individual that is not a person who works—who can work well with the rest.

You see, for instance, I am in some sense a kind of risky member from this standpoint. I come in with no need, no obligations.

I am not obligated in any way to the management. I am, and consider myself, an outside director representing the public, but I also am able, because of my background, to know something about the way the firm operates.

I push for improvements in the management; for example, in the way certain decisions are made.

I think that kind of process, more firms are looking for directors of that kind, is the way that we want to go. After 2 or 3 years, if one still sees that these kinds of developments have not really increased, then maybe one has to take another hard look at the whole situation.

I do believe there are trends now that are self-correcting.

Senator HARTKE. Do you see any situations in which that part of society which is affected as a result of corporate action should have a director, such as labor?

Mr. CYERT. Well, this is an item that I know has received a lot of discussion and, as you pointed out, in Germany in particular, they have this.

The Yugoslavs have had something like this for a long time.

I would say, again, I don't think that that should be forced on a corporation. I think there will be some corporations that are going to move in this direction on their own.

I think the danger of having particular directors of that kind is that sometimes long-run interests, which are crucial for the corporation, are sacrificed for short-term interests.

For example, in Yugoslavia, where this is done, there is a great problem in terms of getting enough investment in the corporations.

They really do have corporations in Yugoslavia. The danger is that the labor members want everything paid out, and little invested, because that is to their own self-interests.

These are dangers.

Senator HARTKE. Let me ask you: In other words, what you are saying is that you can rely upon what you call self-discipline; is that right? Mr. CYERT. Among Senator HARTKE. On the board of directors? Mr. CYERT. I think there is a great deal of that, yes.

Mr. HARTKE. Can we rely upon that to create this statesmen like attitude that you are talking about?

Mr. CYERT. Let me say this: In terms of the boards that I am on, I would say unequivocally yes.

I don't know, obviously, all the other boards in that much detail. It is my strong feeling that the environment in which we are operating now is reinforcing that attitude, and that there is increasingly on boards a strong element of this kind of self-discipline.

We mentioned the Gulf thing. I would go back to that. The notion that it was the Mellon family that somehow threw out the management is an incorrect point.

I know that the Wall Street Journal had such a story. I happen to know the members of that board well. I happen to know the whole situation.

It was really two outside directors, both from academic life, who were the crucial people.

Senator HARTKE. All right. Thank you, sir. I appreciate your coming.

[The statement follows:]

STATEMENT OF RICHARD M. CYERT

SOCIAL AND ECONOMIC RIGHTS AND DUTIES OF CORPORATIONS A number of interesting questions about corporations are being raised by this committee and several other groups in the society. Generally, the questioning of the structure of our economy and the organizational form of our basic business unit, the corporation, have been stimulated by books. These books have been written by lawyers, economists, professors of business administration and concerned citizens. The books have been stimulated by the recession, by environmental prob. lems, and by disclosures on illegal payments. Historically, criticisms arise during periods of economic transition, more generally when the economy is in recession, and the tendency is generally to recommend radical reform. Frequently, the reforms suggested have no relationship to the problem. It is like recommending open heart surgery for the cure of the common cold. Nevertheless, it is only through criticism that any system is stimulated to improve even though the critics may be ignorant of the real problems and speak in the form of falsehoods and half-truths. I am reminded of the student demonstrations of the sixties. The demonstrations were almost always based on symptoms rather than basic ills and never proposed fundamental solutions of importance. Today, however, uni. versities and students are probably better off, in part at least, because of the almost random disruptions of the last decade. I have every confidence that the same situation will prevail in the case of our economic system and the corporation. Nature of the Economic System

One of the critical characteristics of our economic system and our society is its decentralized nature. The question of centralization and decentralization of decision-making power is a question of perpetual concern to organization theorists who tend to concentrate their analysis on the individual organization. But the same issues that are relevant for individual organizations are relevant for a whole system, such as our economy. There are some technical questions that affect the degree of centralization or decentralization such as the source of information for decision making and the size and cost of indivisible resources, but for the most part the most important questions revolve around incentives. Every organization must be concerned with developing a structure that will stimulate the members of the organization to exert their maximum effort and to become committed to the organization so that each of them behaves as through the business was owned by him or her. The more decentralized the unit, no matter how large the total organization, the greater the tendency for such behavior. The difference between the operations of the Post Office and General Motors, can, in my view, be traced to this point. I would point to the same basic point to explain the contrast between the undeniably magnificent performance of the American economy over the years and the Russian system.

One reason we have been able to maintain a decentralized system is that we have organized our economic activity so that the decisions on the use of our resources is governed by the people of the country through dollar votes in the market, with the exception of those resources taken by the government through the tax system. Those who may complain that the market system does not work well because of some characteristic of the income distribution can work to change that distribution (which can be done easily through the negative income tax) but should not condemn the system. Similarly, those who excoriate the corporation for not taking the cost of some form of polluting into account should be after Congress or their state legislatures to modify the tax system appropriately. Taxes negative and positive rather than regulation is the way to modify the system when

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