Roundtables on Auditor Independence and Attorney Conduct
December 17, 2002
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C.
Chairman Pitt: Good afternoon. It is my pleasure to welcome you to the roundtable discussion on the international impact of our proposed rules.
Today's session is focused on auditor independence and attorney conduct, subjects of rules required to be promulgated under the Sarbanes-Oxley Act, and those rules must be promulgated by January 26.
Sarbanes-Oxley was adopted a mere four and a half months ago and in implementing the Act, the Securities and Exchange Commission must be faithful to both the letter and the spirit of the law.
We are aware of and concerned about the potential impact of the Act on both U.S. and non-U.S. entities. We organized these interactive roundtables because input on the cross-border effect of these rules is critical.
We're delighted to have so many participants from the international community today, and I very much appreciate the fact that many of you have traveled quite a ways to participate, especially so close to the holidays. So a special thank you for that.
The Sarbanes-Oxley Act generally makes no distinction between U.S. issuers and foreign private issuers listed in the United States.
This did not occur inadvertently. As a result, the Act raises sovereignty concerns and concerns about the potential duplication of reforms that are underway outside the U.S.
I want to make it clear that I view the U.S. as but one participant in the world is global markets. We don't believe that we have all the answers or the only answers to the problems that led to the passage to the Sarbanes-Oxley Act.
In implementing the Act, we want and need to maintain U.S. markets as an attractive environment for foreign issuers, while, at the same time, fulfilling our investor protection mandate and that of our Congress.
Your input is crucial to help us implement the Act to balance the goals of the Act with the regulatory approaches of your jurisdictions that are meant to achieve the same goals. We hope that you will use this roundtable forum as an opportunity to provide us with constructive advice on specific examples of where your approaches address the same investor protection concerns and where there may be direct conflicts with your laws.
We are also looking for suggestions on how to resolve conflicts about foreign legal requirements in Sarbanes-Oxley. This kind of meaningful input relayed to us as we proceed with our rulemaking.
While our final rules may not accommodate all of the concerns that are raised, rest assured that we will carefully listen to and evaluate them and we will attempt to accommodate as many concerns as we believe we lawfully and pragmatically should.
Now I want to turn this over to Ethiopis Tafara, who is the Acting Director of our Office of International Affairs and has labored mightily with the staff to put together this program on very short notice.
Before I do that, I do want to say again thank you to all of you for being here today. Ethiopis?
Mr. Tafara: Thank you, Chairman Pitt. Good morning. I'm Ethiopis Tafara, the Acting Director of the SEC's Office of International Affairs.
Thank you for taking the time to be here today to discuss the international implications of the SEC's proposed rules on auditor independence.
Although the passage of the Sarbanes-Oxley Act was prompted by corporate failures in the United States, we know the issues it raises are being addressed by markets around the world.
We are cognizant of the fact that the SEC is not alone in its effort to restore investor confidence. Lawmakers and regulators in many jurisdictions, often with the input and support of the private sector, are working hard toward this end globally, and evidence of these efforts is easily visible.
To name just a few, the European Commission has commissioned a working group of high-level company law experts to examine a variety of corporate governance issues with the goal of possibly developing an EU action plan on company law.
The Japanese Financial Services Agency has announced a securities market reform program focusing on a broad range of issues involving issuers, market intermediaries, and investors.
I know Canada is revisiting its regulatory scheme in light of the recent corporate failures and that the Brazilian Securities Commission a short while ago published its recommendations on good corporate governance practices.
At the multilateral level, IOSCO recently released principles on disclosure, auditor independence, and auditor oversight that are to serve as guidelines for securities regulators contemplating reform in these areas.
As we proceed with today's discussion on the SEC's proposed rule on auditor independence, we are mindful of the reform being undertaken in many jurisdictions. We look forward to learning about conflicts that the SEC rule may create for foreign audit firms subject to opposing home country requirements, as well as the ways in which foreign regulatory schemes may address, in alternative fashion, the same problems the Sarbanes-Oxley Act is intended to remedy.
This morning's panel on auditor independence rules, which are aimed at enhancing the independence of accountants that audit and review financial statements and prepare active station reports filed with the Commission, will be moderated by Jackson Day, the Acting Chief Accountant, and Sam Burke, the Associate Chief Accountant.
In terms of the format for today's discussions, we expect to raise for discussion questions posed in the SEC's proposing release and provide a brief opportunity for participants to address specific questions.
We ask that your remarks be brief so that we can accommodate as many speakers as possible and provide time for interaction among the participants and the SEC Commissioners and staff.
Due to previous commitments, Commissioner Roel Campos regrets that he will be late to today's proceedings. He has asked that I extend his welcome and appreciation to each of you for your participation in the roundtable.
He is keenly interested in the issues and looks forward to the discussion.
With that, I would like to turn it over to Jackson. Thank you.
Mr. Day: Thank you, Ethiopis. Good morning. Again, my name is Jackson Day and I am the Acting Chief Accountant of the SEC. I also serve as Chairman of IOSCO's Standing Committee 1 on Accounting, Auditing and Disclosure.
Today is important because independence in both fact and appearance is the backbone of the credibility of auditing and an essential component to investor confidence in our markets.
Mechanically, to implement the requirements of the Sarbanes-Oxley Act, the Commission must enter into rule- making, a process that has already begun.
Our goal today is to discuss the issues at a technical level so that the Commission and the staff will have the necessary information to make good decisions during the weeks and days ahead.
If we stray from this goal, I may politely nudge you just a little to get back to the questions at hand so that we can make best use of our time.
Now, on to a few housekeeping matters. I will open the dialogue in each discussion topic and then turn it over to the panelists for comments and perspective. I ask that everyone try to stay focused, constructive, and on topic.
If you wish to speak, consistent with international protocol, kindly turn your name card on end and I will call on you in order. If you can't wait, just give me a signal and I will call on you out of order.
We will be taking a ten-minute break at 10:20 and we must wrap up by noon, so I have to limit the number of comments on any given subject.
So let's go ahead and get started, and let me review the agenda.
I think what we'd like to do would be to start out and try to talk about legal services and rotation, prior to break, and then, after break, we'll move on to audit committee administration, bookkeeping evaluation, transition disclosures, and then I'm going to save 15 minutes at the end just for general comments and other comments that participants may make.
So if everybody is agreeable, let's go ahead and get started. First, let's talk about legal services.
Under the existing rules, with respect to providing legal services, an auditor is deemed to lack independence when he or she provides legal services to an audit client under circumstances in which the person providing the service must be admitted to practice before the courts of the U.S. jurisdiction.
Now, the proposed rule will extend this provision to foreign audit and legal firms. Thus, the proposed rules would apply to foreign and U.S. accounting firms and legal practices equally, minimizing and possibly eliminating the instances where legal services are provided by the auditor to an audit client.
So rather than go on and talk more in detail, let's go ahead and get started. Some of the questions might be: are there particular legal services that should be exempted; how we could draft a rule that could take into account all the cross-border issues; and we could also discuss should there actually just be an exception for legal services provided in foreign jurisdictions.
So with that said, let's get started. Maybe to start up, I know, John, you have some comments. Mr. Grewe, would you like to kick it off?
Mr. Grewe: Thank you. I really wanted to pick up from the references in this section and elsewhere in your proposal related to taxation services.
We in the UK were very interested to see the comments in your proposals on taxation services, given that we are actively thinking about it in the UK, and, of course, Sarbanes-Oxley specifically refers to taxation services as a form of non-audit services it thinks should be allowed.
From the UK Government's perspective, we do think that taxation services can raise significant issues of auditor independence. That is not in the area of low margin compliance work, but, if anywhere, with the higher margin in tax planning services, where the recommendations can depend on changes to business structures on one hand or on a particular accounting treatment.
That said, we don't think this is straightforward. It is really quite an important part. It's an area where the proposals go beyond Sarbanes-Oxley.
We need to find a way forward which points up the areas of real concern without having significant side effects which impact on the structure of the profession and on the quality of the audit, particularly outside the United States.
So in the sense we are surprised in some ways to see that you are seeking to introduce rules in a very short time scale which go beyond the Sarbanes-Oxley requirements, and we think there is a danger that rules developed in this way in a such a short time scale will either be slightly misjudged or will not be well understood outside the United States, I think there's an important point about clarity, even in the UK, let alone in countries that are divided not by a common language, but by a different language.
We find the reference, I think, in this part on taxation services for the role of the audit committee somewhat confusing. Like you, we certainly come toward, I think, later on, as well. We see the audit committee as having a key role in approving the purchase of non-audit services.
At the time, we believe a clear steer to the audit committee that they should think very hard indeed about taxation services would be tantamount to a ban. I think no audit committee in the UK would contemplate it.
So I think it's an area where we would prefer not to follow through the principles-based approach. Be sure that the audit committee understands the threat to independence in this area and can then decide whether it feels comfortable with that.
I won't go on and comment more specifically on the legal services aspect. I think that's an important point.
Thank you very much.
Mr. Day: Thank you very much. I think you made some important points there and maybe others would like to comment. Mr. White?
Mr. White: Thank you. Generally, the perspective I would like to bring, as a U.S. institutional investor, is that we have been through a period of time in the U.S. markets where we have learned some lessons and they have been harsh lessons.
At the center of that and one of the things that we as an organization have focused on in our reform efforts is the level of independence of the audit.
We can talk service by service about what might impede independence and what might not, but overarching all of that, what we have come to the conclusion is it's the client relationship that is what you need to be after.
The auditor should be an auditor exclusively. That has been our goal through our support of Sarbanes-Oxley and through all the reform efforts, but it's the client relationship that you need to be concerned about.
In some respect, it doesn't matter whether or not they are providing legal services or lawn care. If they need to protect the client relationship, it has the potential of impeding their independence and objectivity, and that should be the goal here.
With some sensitivities to all the differences that we face in international investing, we should be after the client relationship to ensure that investors throughout the world, that the auditor can provide an independent opinion.
Mr. Day: Questions? I know a number of the rest of you also had comments on legal services. I've got a list here, I can go in order, but if somebody wants to volunteer. Mr. Knorr?
Mr. Knorr: Thank you. The SEC states that the scope of prohibited services should be judged against three basic principles.
There is, first, an auditor cannot audit his own work or her own work; an auditor cannot function as part of the management; and an auditor cannot serve in an advocacy role for the client.
Violating these principles is considered to impair an auditor's independence. In Europe and, in particular, in Germany, the first and second principles, which is auditing your own work or functioning as a manager, have long been part of our requirements for auditor independence and, therefore, auditors in Germany comply fully with these two principles.
But, however, given the differences between the German and the American legal environments, we do not agree that a German auditor acting in an advocacy role for audit clients in Germany would impair their auditor's independence by itself.
The role of a lawyer and the rules of conduct vary very much from one legal environment to another. So the threat of advocacy is seen differently.
I would like to use the German example, which I know best, to show this, but I believe that a similar view applies in member states in other European countries, as well.
Compared to the American legal system, the role of lawyers as client advocates within the German legal system is based on the fundamental different conception of client advocacy. Client advocacy by lawyers in the American legal system emphasizes that a lawyer's core professional obligation is to advance clients' interests within applicable regulatory and ethical requirements.
In other words, an American lawyer is generally obligated to undertake whatever lawful and ethical means necessary to assist in the furtherance of the client's cause or endeavor, may not act against interest of the client once an engagement has been accepted.
Consequently, in the U.S. economy, interests, economic interests of a lawyer may be more closely aligned with that of the client in the German legal system.
Contingency fees represent a prime example of such an alignment of economic interests between the lawyer and his or her client.
In our legal system, as in many European countries, based rather on civil than common law, the role of a legal advisor may different significantly from that in the U.S.
In Germany, a lawyer is considered to be an independent organ within the legal system in which a lawyer is required to advise his client objectively, without identifying himself or herself with economic or other interests of the client.
Consequently, contingency fee arrangements are expressly forbidden in Germany. In fact, the basis for the remuneration of lawyers in Germany is a feel scale, independent from the results of the work.
By not aligning the interests of a client's legal advisor with that of the client through the prohibition of contingency fee arrangements, in Germany, a lawyer is considered by the public not to be just a representative of a particular client, but is viewed as an objective advisor.
The questions raised by the SEC demonstrate that the SEC is to have noted that for historical and cultural reasons. Other countries have an understanding of the role of legal advice which differs from that in the U.S.
Hence, the question as to whether the provision of legal services to acting in an advocacy role for an audit client impairs an auditor's independence can only be assessed by examining the legal framework within which that auditor operates or legal advice is provided.
From a European point of view, the provision of legal services does not a priori impact the independence of the statutory auditor to the extent that the auditor does not audit his or her own work, nor assumes management functions.
In Germany, the independence of an auditor is considered to be impaired only if the results of his or her legal advice have direct impact upon the contents or presentation of the financial statement.
The conclusion in this respect will be, therefore, that legal services in foreign jurisdictions should not be prohibited generally unless they have a direct impact on the contents of presentation of the financial statements.
Since the activities described as expert services in the proposed rule would, for the most part, be considered legal services under German law, it should be stressed, again, from the German perspective, those providing such services may not identify themselves with the interests of their clients.
The German lawyer, or wirtschaftsprufer, we refer to them, a public auditor, must act as an independent advisor of the client. Pursuant to Article 43 of the law regulating the wirtschaftsprufer profession in Germany, a wirtschaftsprufer acting as an advisor or a consultant, is legally required to provide advice in an impartial manner.
Consequently, the American understanding of expert services appears to differ fundamentally from the European, and in particular of the German understanding of such services.
I have, finally, to mention tax services, as well, because that's a large proportion of advisory service, in connection with legal services. Please let me explain this.
In Germany, as in other countries, tax services are defined as legal service. The law does not distinguish between preparation of tax returns, tax compliance, tax planning, and other services.
The authority to perform such services is given equally to lawyers, tax advisors and accountants in public practice. A ban on legal work in the German sense would, therefore, prohibit any tax service. That was, as I understand it, not the intention of the Sarbanes-Oxley Act.
Pursuant to Section 201 of the Sarbanes-Oxley Act, accounting firms are not prohibited from providing tax services to their audit clients. The audit committee of the client must pre-approve provision of tax services by an auditor, and, therefore, it appears that American law does not intend to prohibit tax services in general.
In view of the German legal environment, we believe that tax services in Germany are even more deserving of such special status as is in the papers of the Sarbanes-Oxley Act.
Thus, unlike in the U.S., in Germany, tax consultancy may only be provided by professions specially licensed - - as I said earlier, lawyers, tax advisors, and wirtschaftsprufer, accountants.
In the provisions of these types of tax consulting services, the wirtschaftsprufer has the same rights as the other professions. Both of these two professions, steuerberater, tax advisors, and wirtschaftsprufer, must pass national government examination in tax law.
Both are required to maintain their independence of the client. In particular, neither profession is permitted to engage in any commercial business activities.
The provision of tax advice is expressly regulated by institute. Furthermore, generally, there is substantial connection between the commercial financial statements that are required under the German commercial code and the financial statements that are required to be prepared for tax purposes.
The intensity of this connection exceeds the length between U.S. debt financial statements and tax information prepared under the tax code in the U.S.
Mr. Day: If I could ask just a couple of questions. I think you've laid out a number of important issues right there and it seems that I think I've seen some of this in some of the other letters, too, and in the feedback, that to some extent, we have differences because of how we define things and what words that we use in the language.
I think your example of tax versus legal, the description of advocacy are good examples.
I think one of the things we want to walk away with here is I think from a Commission perspective, I think what they are after is to hear what some of the issues are.
From the staff perspective, we have to actually put the document together and we're looking for how-to's. So I have a question with regard to how-to's.
Are you suggesting that and I think, Mr. Grewe, this interchange with what you were suggesting, too, that we be more principles-based and descriptive of the principles. So that way we can attempt to take a model that can be applied throughout the world more consistently and deal with those issues.
Mr. Knorr: I think a principles approach, with a definition which is clearer than it is at the moment, I mean, legal services is an American definition. It might be clear to you, but not clear to other legal environments and participants of other constituencies, could be a way of dealing with it, and the principles approach has the appealing difference that it can react to whatever the definition or the construction in other countries is.
By example, want it to show that there are differences in the perspective and the basis where you start from, not in the goal.
I mean, we want to achieve independence of the auditors as well as you will, but there are some differences.
And if I might go on just for a couple of seconds to explain a second difference which is not in the principles approach and the definitions, but is in the actual performance of tax services, which is different.
As I set the link between the financial statements in the U.S. GAAP sense and prepared for the tax authorities is very much more linked. So to separate it from each other would damage it in another way than it would in the U.S., because under the so-called governing principles, commercial financial statements are the legal basis of the progression of the financial statements for tax purposes.
Furthermore, under the converse governing principle, the tax treatment of specific financial statement items may govern their treatment for accounting purposes. And the intensity of this link is also demonstrated by the fact that both the short auditor's report and the long form auditor's report issued by the wirtschaftsprufer from a client's financial statements must both be submitted to the tax authorities and they use it and if misstatements in the financial statements lead to an unfounded determination of the tax base, the wirtschaftsprufer may become liable to the tax authorities for such misstatements.
So in material things, there is a so close link to it in German law and German practice that a separation of the two services will be harmful to the client, because then he had to do things twice and have two different people to have to learn all the knowledge about the firm, data, et cetera, and that's a second reason for thinking differently and coming back to the principles approach.
Mr. Day: Commissioner, did you have some questions?
Commissioner Goldschmid: I did. A comment, first. U.S. and Germany may be closer than it seems, although the legal systems are different and even the educational systems are different for lawyers.
But in the U.S., in these business areas, there are very few contingency fees and though our codes of ethics talk about advocacy, they also talk about professorial judgment and detachment, much as the Germans would.
But even assuming they are closer than it seems, the question, the larger question for me is it is possible for other nations to make different value judgments. Say, lawyers and accountants together is not as dangerous as the U.S. thinks.
Assuming that is true, how should we deal with those kinds of reasonable judgments even though they may be different than our own at home?
Mr. Day: Mr. Lerner?
Mr. Lerner: Perhaps I could just take up your question, Commissioner. I think the answer is to apply those three principles that the SEC enshrined in the commentary on tax tools, such as legal services, those principles being not to audit your own work, not to stand in the shoes of management, and not to act as an advocate in the sense that you used the word advocate.
I think if you adopt that principles-based approach to both tax and legal services, you will have found a solution to the problem of what auditors can do that will transcend global boundaries, and we think those principles are an excellent way of dealing with these difficult definitional issues.
Commissioner Goldschmid: How would you apply those principles? I take it you don't want them applied in terms of a per se prohibition.
Mr. Lerner: Correct. We would say that those services, whether they come under a broad heading of legal services or a broad heading of tax services, should be permissible for an auditor to provide or his associated legal firm.
Of course, it's important to remember that these services we're talking about are generally not provided by the audit firm. They are provided by separate, but associated legal firms.
That if they did not result in the auditor or the associated firm auditing their own work or standing in the shoes of management or acting as an advocate, in your terms, then the associated law firm would be permitted to provide those services to those clients who audit clients of the associated audit firm.
Mr. Day: Mr. Matsuo, I think you were wanting to make some comments.
Mr. Matsuo: Thank you very much. In the Japanese case, its legal services are provided by the law firms and the lawyers, not the audit firms. Regarding tax services, we have a tax accountant system and they are providing tax services.
Under the Japanese law, even at present, our audit firms are prohibited from providing tax accounting services. So that regarding this legal services issue, Japan has no serious issue.
But rather than taking advantage of this opportunity, I would like to make more of a general comment. Today's conference is held in very good timing in the sense that today in the Japanese Times, the Subcommittee of the Financial System Council established the Financial Services Agency of Japan.
This subcommittee is on the regulations of certified public accountants and that subcommittee issued a report for the comprehensive reform of the certified public accountant and audit firm system in Japan, and this report includes various proposals regarding the auditor or the enhancement of the auditor, a further strain of the auditor independence, taking serious consideration of the international developments over the IOSCO reports or the Sarbanes-Oxley Act.
So that we are not satisfied with the present situation and we would further enhance our system and meet the bill for the revision of the certified public accountant law in Japan in the next regular session of the Diet in next year.
Our efforts show that that the Japanese audit firms are subject to the Japanese legal auditor independence regulations and as I said earlier, this regulation would be further enhanced.
I think and we believe that the strength of the regulations, which apparently we achieve equivalent purposes expected by the Sarbanes-Oxley Act and the proposed new rule, the proposed rule issued by the SEC, and we believe so, therefore, that it is not necessary to make the Japanese audit firms subject to the related prohibition of the Sarbanes-Oxley Act and the proposed rule.
Section 202 or 204, from Section 201 to 205 of the Sarbanes-Oxley Act, deals with the registered public accountant firms and we have been requesting of the SEC to exempt, make appropriate exemption for the Japanese from these prohibitions to Japanese audit firms.
So we respectfully request the SEC to provide appropriate exemptions to the Japanese audit firms from the prohibition of the Sarbanes-Oxley Act and proposed rule regarding auditor independence, together with appropriate exemption from Section 106 of the Sarbanes-Oxley Act.
But what I would like to reiterate again here is that these issues, it's not limited to the United States, but, also, as the Chairman or Mr. Tafara pointed out, it's a global issue.
So that the real root, make assertive efforts to enhance our system. So the Sarbanes-Oxley Act and our efforts in Japan have common purposes together.
Thank you very much.
Mr. Day: Mr. Wright?
Mr. Wright: Thank you very much, Chairman. Let me say straight away how much we in the European Commission value this roundtable today.
I think it might be helpful for Commissioners to understand just a little about how we approach this in the European Commission. We have adopted, in April of this year, a principles-based statutory auditor independence recommendation.
Now, at the heart of this is a simple statement. At the heart of this is and it deals with all audit situations, that the statutory audit has the primary responsibility not to carry out an audit if there are any fiscal business or other relationships between him and the client, including the auditor provision of non-audit services that would compromise his independence.
So this is a global all-inclusive approach. The auditor, under our recommendation, which is now being applied in all our member states or 15 member states of the European Union, soon, next year, to be 25, auditors have to demonstrate their independence, document the threats and safeguard responses, have up-front discussions with governance bodies on independence issues, make declarations in writing to governance bodies, such as audit committees, where they exist in Europe, but none of the services provided have compromised independence, and make detailed public disclosure of audit and non-audit fees.
So our recommendation shapes and looks at the same objectives as the Sarbanes-Oxley Act in a different way, on a principles-based way, and I think the all encompassing, comprehensive principles-based approach that we have put forward is something that we think covers all situations.
Mr. Day: Thank you. I just have one question with regard to your proposal or, I mean, to the discussion you just outlined there.
I think I heard that the evaluations are performed by the auditors. Maybe if you could just elaborate a little bit on the thinking there. I think that's a little bit different than what we have here in the U.S. and we'd be interested in other participants' reactions, as well.
Mr. Wright: That is quite right. We put the primary responsibility on the auditor profession. It requires people to have trained for many years. It's an old profession. We believe that auditors are responsible and should be responsible, with those various sub-parts that I have outlined to you.
So the responsibility in the first place is on the auditor under our recommendation and our principles-based system.
Mr. Day: Mr. White, I think you had a question.
Mr. White: If I could. If I could ask Mr. Knorr, I was wanting just a little more clarity on your last point in regards to the legal portion of the audit firm providing what sounded to me like an opinion on portions of the audit and how would you reconcile it.
That looks like a potential conflict to me. But then broader than that is how do you respond to what I would portray to you as a concern from U.S. investors as the overall client relationship and, again, whether or not that law portion of it, if truly independent, is fine, but there is still a client relationship and is that an ongoing type of relationship that could last for years and years and years that could give you the perception at least that they need to drive that relationship as much as they do.
Then I was interested in Mr. Wright's comments, and if you could kind of reconcile how your standing in Germany would be with what the EU is proposing.
Mr. Knorr: What I wanted to say is that to our opinion, defined legal work or legal service in itself does not impair the independence, but it comes under every principle that principally decides whether it should be impaired or not and a very close relationship of the legal services can have the same result as any other close relationship which can lead to the impairment of independence, not because it's legal work, because it creates the link between the auditor and the firm.
So I would like to return not to a defined service, which is impairing the independence, but principles under which any service impairs the independence.
Mr. White: So you would agree with our concern over the client relationship, then.
Mr. Knorr: That is one of the general principles.
Mr. Lerner: Would you just articulate that concern a bit more clearly? Because I don't think we probably clearly understood the concern you were articulating and we need to understand that before we can address it.
Mr. White: In regards to the client relationship?
Mr. Lerner: Yes.
Mr. White: We perceive as part of really the root of the problem that we've had here in the United States, particularly in regards to the independence of the audit, that those individuals that were engaged with each of the companies, and you could name the ones that we've had high profile problems with, have had to deal with more than just their role as an auditor.
They need to keep the client happy and in order to do that, they can't rock the boat. That's the root of the problem, in our opinion, is that those auditors cannot behave in a manner that is completely objective.
They cannot raise a flag and say this is wrong, because they will threaten the revenue that their firm receives with other business, which could be quite substantial.
It's that relationship that we are deeply concerned about. Again, it doesn't really matter what the service is. I think I tend to agree with what you said that the legal service in itself doesn't make the difference. It's the client relationship. You have to separate that.
Mr. Day: So just to summarize, it's the magnitude of services other than audit services. Once they get to be too big, there's a concern about loss of objectivity.
Mr. White: Right.
Mr. Day: Commissioner, did you have a question? And then Mr. Delespaul.
Commissioner Goldschmid: I do. On some level, before Sarbanes-Oxley, we operated, at least in some areas, on a principles, without using terminology, threats and safeguards level. We left room for flexibility as to how auditing was going to be done and told the auditing firms building in safeguards, in effect.
Congress has concluded that didn't work very well in the context of what happened in this country and for us the question is how much of it and how should we think about this when it comes to foreign firms.
Congress has clearly told us now, almost unanimously, there are nine categories that you must not allow this kind of consulting to take place.
So what we're suffering with is how much of this should be extended elsewhere.
Mr. Day: Good point. Mr. Delespaul?
Mr. Delespaul: Well, I'm not sure I can answer that question, but I can give an illustration of what Mr. Wright said concerning the case of France.
The French regulatory authority has been concerned with the question of independence of auditors for a long time and we have, in the past 13 years, two specific task forces reflecting on that question, producing reports, one in 1993, one in 1997, and we helped setup with the profession with a professional body, a special committee in charge of ethics and independence, dealing with specific cases.
And until now, we solve, we try to solve these questions only on the basis of principles. The principle is quite simple. Whatever type of services rendered either by the auditor or by a related provider of services, member of the same network, for instance, or of the related company, is supposed, is considered as a possible impairment of his independence.
But we do not fix precise wording on type of services. This for two reasons. The first one is that in some cases, our law requires the statutory auditor to produce specific valuation reports and it is considered as part of his mission in the auditing of the financial statements.
It is an additional value, an improvement in the quality of his audit, and this is required by law. So we cannot decide that it will be strictly and forever forbidden. First of all.
Secondly, we consider that it is probably much more efficient to have the definition of the principle relying on the responsibility of the auditors themselves, of the profession on the basis of a code of conduct and ethic rules which are closely monitored by the profession and by the regulatory authorities.
And since we are preparing a new bill, which will be presented to parliament next spring or early next year, and which will make the COB disappear into another institution, there are rules relating to independence of auditor, but the rule that is the present draft of the text doesn't define precisely services. It just mentions that it is strictly forbidden to the auditor to provide any type of service, recommendation, advice and so on, which would be contrary to the rules of ethics approved by the profession, and, of course, these rules are under monitoring by the authorities.
Mr. Day: Mr. Clarke, do you have a comment?
Mr. Clarke: In connection with legal services, we have set three criteria. The first one, any consulting audit service provided by a firm must not be reviewed by the same entity or a related party.
Second, a service must not have an influence on the financial result of a financial statement of the client. This is an additional criteria to the three criteria set in the document.
The third one is a firm cannot advocate the client. Using this concept, we have found a specific list of legal services which could be permitted. For example, legal advice oriented to serve matters related with the relations, to the extent it does not affect financial certs, review of legal documents, review of contract and its implementation, presentations before the regulatory authorities.
These are just examples. Perhaps the most interesting thing is when you apply the concept of the principles, you are still going to find examples of legal services which could be provided, without lessening the principles.
I would suggest, in terms of providing independence of the auditors in relation to any service, you have to set a cap, a specific cap in terms of the total auditor independence in relation to specific issues. Perhaps that is up front to set an independence rule in specific terms.
Mr. Day: Thank you. I'm hearing, I think, one prevailing comment here is that a principles approach is very helpful in getting across barriers of language and cultures, et cetera, so that we need to focus on striking the right balance to the extent that we can in light of kind of some of the directions that we got from Sarbanes-Oxley.
I see we have a couple more comments, and then I think it will be time that we move on to our next topic of partner rotation, in order to stay on schedule and get a little input on all the topics.
Do you want to make any last comments?
Mr. Lerner: Thank you. I think just to make some further comments on what is meant by legal services, because I think this has given rise to a great deal of the difficulty that we're facing around this table.
What the legal service is differs enormously from country to country and in attempting to enshrine within your definitions something that must be provided by the particular bar of an individual territory will result not in what you're looking for, which is consistency for application around the world, but rather genuine and widespread inconsistency, because the bar rules around the world vary so much as to what a legal service is and what it isn't.
And there are many services that are provided by our associated legal firms that are pure advisory services and which would be permitted under the Sarbanes-Oxley rules to be provided in the United States without literal hindrance.
It just happens that as a matter of tradition and history, those types of advisory services which are far removed from the type of adversarial advocacy services, litigation services that you may have in mind when you're thinking about legal services, that trying to bring them all under a single heading would just not work in terms of the definitional differences around the world.
And that is why I think we need to go back to a principles approach that says if these three vital principles which we absolutely endorse called advocacy, management, are not offended, then this service should be permitted, whether it be provided by an associated legal firm or whether it be provided by some other entity in the network.
Mr. Day: Thank you.
Mr. Lerner: Thank you. If I may go back to the point that David Wright made about what happens and what we've been doing in Europe, but also to give a sort of perspective from the UK on some of these issues, to add to what colleagues from France and Germany have said.
I think it is helpful to offer comments to understand the detailed questions you raise on auditor independence, to understand a little bit of the context and further understand the UK's concern.
The UK, I mention not really as an ad, but just to say I think we have the second largest number of foreign private issuers after Canada in the U.S. market. I think roughly half of the foreign issuers from Europe are UK companies.
So needless to say, there has been a very keen interest in the UK on the impact of Sarbanes-Oxley both on UK companies and on UK audit firms.
In our view, there are certainly equivalent systems of regulation in the UK and, in some respects, stronger, and, certainly, in some respects, more tested than you are attempting to introduce in the U.S.
I think one important point to bear in mind is that equivalence, of course, does not mean that things are exactly the same and we have had some examples of how things are different here.
I should just mention what we're doing in the UK, like in a number of countries that have been mentioned, is to review very much our arrangements and requirements and we are, in many ways, not grateful for what happened initially in the U.S., but grateful for, in a sense, the opportunity that has given to actually look at these things, particularly with a view to strengthening the systems of oversight and regulation.
I think what we are doing at the governmental level in the UK at the moment is to look carefully at that balance, long historical balance between professional self regulation, to which David Wright referred, on the one hand, which is already subject in the UK to careful external oversight, and a system of entirely external regulation.
And on auditor independence, to bring it more precisely to that, at present in the UK, the requirements are indeed set by the professional bodies, subject to an external agenda-setting role, and subject to satisfying the government that this is an effective way of ensuring independence.
But one thing that we are looking at, though the results of the ministerial group won't be out until the end of January, is whether, in fact, there are standards for auditor independence that we're discussing today should be set independently over the professional accountancy bodies, as indeed, in the UK, is already the case for accounting and auditing standards.
Perhaps just to say what are the key messages we think for the U.S. and how you approach this in the context of today's meeting. We hope that you and, indeed, the PCAOB, in a slightly different part of the forest, will contemplate recognizing equivalent arrangements in other jurisdictions and that equivalency is not seen in such a narrow way that only one route is a possible route; in other words, the term is used, but not really followed through.
We have talked quite a lot about the principles-based approach, that's one point I wanted to make, without laboring it. Certainly, we remain convinced that it can provide a stronger and more challenging agenda for the auditors in a system that is based very heavily on detailed rules, which seems to require yet more rules, and I think in an international environment it becomes yet even more complicated.
So whilst there are lots of references, very helpful in many ways, to principles in your document and I think we have said they are principles with which everyone agrees, we need really a true principles-based approach which takes up further.
I worry of principles always being that it's the soft options. I think enforcement is important and with that, it is not a soft option.
I think it is also important in the U.S. to remember that were you to simply impose a U.S. regime on foreign audit firms, it is not automatically that just because it's the same regime in the sense it seems bearing not sense.
I think there are two reasons for that. First of all, rules written in the U.S., in a sense, do not travel always very well. They may be appropriate and relevant in the U.S., but by the time they reach another country, they just don't work as well. They are developed with a particular environment, the size of country, and they're probably, in many ways, easier for the UK than many other countries, because we have a lot of things in common, but I think you have to bear that in mind.
Secondly, the audit firms in other jurisdictions are already likely to be subject to an extensive system of regulation, certainly true in the UK, and we do have to be aware that the foreign audit firm is not one subject to the disadvantages of double regulation, of overlapping, possibly contradictory requirements.
I know you're well seized of that. I think it is an important point. It's not only, taken in the whole, poor regulation, but it is certainly wasteful and costly.
Mr. Day: Okay.
Mr. Lerner: One very final point and I will keep quiet.
We would hope that against this background, we recognize what Chairman Pitt said at the beginning about your need to work with the spirit and the letter of Sarbanes- Oxley. We would hope that there is scope for the SEC to encourage your legislators in Congress, which I think is necessary for domestic reasons in any event, to look to correct the faults.
Nobody is suggesting for a moment that it's misguided legislation overall, but I think there are inevitably in the need to bring it about some specific weaknesses and faults.
I hope in doing so, to encourage legislators here to look more closely than was possible in July when we were all running around muddling the UK on this, as well as on Capitol Hill, to look more carefully at how this all looks through the eyes of a non-U.S. registrant or an audit firm.
Thank you very much.
Mr. Day: Thank you. Commissioners, any last comments? If not, I think we will move on to rotation.
Mr. Day: Okay. The Sarbanes-Oxley Act clearly specifies that the lead audit partner and reviewing partner should serve on an engagement in that capacity no more than five consecutive years.
The Commission's proposal clarified the five-year rotation requirement specified in the Act as with regard to that, we've made a determination that at least for purposes of the proposal, that those requirements ought to apply to all partners that are significantly involved and that there ought to be a five-year time out period.
I think really what we're after there is trying to strike a good balance from the fresh look notion that is provided by rotating the auditors, along with the knowledge that you gain from years of working on the client and to get the right balance.
So I would like to open that up and seek out some input to see whether or not we're getting that right balance. You want to kick us off?
Mr. Muter: Thank you. Thank you for the invitation to speak at this roundtable. We appreciate your interest and attention to the specific issues for foreign entities raised by the proposals.
The comments I am making are from my perspective and experience as a partner in a major accounting firm outside the U.S. One of my responsibility as leader of the Canadian professional practice is oversight responsibility in our firm for compliance with the independence standards, including those of the SEC.
The comments I am making will not be addressing issues which are also relevant to domestic issuers and auditors. These will be addressed in subsequent submissions in response to your request for comments and proposals.
Also, my comments are necessarily somewhat preliminary, given the brief time available to study this complex material. And I'm not proposing any specific solutions, but only identifying for your consideration issues which may have a significantly different effect outside the U.S. than within it.
I think it would be useful for me to note, as well, how important these SEC rules are on Canadian capital markets. More than 50 percent by market capitalization of the trading of Canadian company securities on the Toronto Stock Exchange is in securities which are also listed in the U.S., which are, therefore, also SEC registrants.
The number of Canadian SEC registrants is about four times that of the next large group, the UK, and, in addition, given the proximity and large amount of trade between Canada and the U.S., there are a large number of Canadian subsidiary public companies.
That's the background.
In terms of the specific issue of partner rotation, we agree with the concept of partner rotation as it relates to the partners involved in the key accounting and auditing decisions. Some Canadian firms have, in fact, adopted a rotation policy for the audit engagement leader across their entire Canadian public company client base, without any regulatory or professional requirement to do so.
Our concern, however, is that the rotation rules, as proposed, could have a significant negative effect on audit quality. Our specific issues relate to the time permitted for transition to the new rules and to extending mandatory rotation beyond the engagement partner and concurring partner.
The specific reasons for our concerns include looking at this from an external perspective, requirement for knowledge of U.S. GAAS and GAAP, the impact on our own plans to introduce a rotation requirement in Canada, language issues, geographic considerations, regulatory requirements, and industry specialization, and I will speak briefly on each of those.
The U.S. GAAS and GAAP requirements, their expertise, partners working on SEC registered clients should be skilled in U.S. accounting principles and U.S. auditing standards, as well as domestic accounting principles and standards.
The availability of partners with these skills is more limited outside the U.S. than domestically.
Secondly, impact on plans to introduce a rotation requirement for Canadian public companies. Just prior to the Sarbanes-Oxley Act, Canadian standard-setters proposed introduction of a rotation requirement for all public companies in Canada.
This means all non-SEC public companies will be moving from a no rotation requirement, or many of them will be, to a perhaps five year rotation requirement, at the same time as a change from seven to five years and extending the mandatory rotation beyond the engagement partner for SEC clients is being implemented.
An immediate effective date for a five-year SEC limitation and extended mandatory rotation could delay the previously announced plans we have in Canada to implement a rotation standard, because it may not be feasible to introduce our own requirements and the proposed SEC rules at the same time.
Language issues. Canada is officially a bilingual country, but most of our partners and staff do not have a French language capability. From a legal and practical perspective, we are required to operate in French with a number of our clients, some of which are SEC registrants.
Some of these clients operate in specialized industries or regulated industries. We need a reasonable transition period in order to identify, train, and possibly relocate persons with appropriate language skills in order to deal with these situations.
Geographic considerations. As the proposal indicates, the rotation requirements could cause some firms to have to relocate partners. The large firms are not immune from this.
In fact, the relocations could be significant given the nature of the Canadian market and industry concentration. Our clients are disbursed across offices that are individually separated by several hundred miles and, in some cases, several thousand miles.
The offices serving SEC registrant clients are spread across Canada and not all have other partners available with the necessary skills to quickly take on new responsibility without some reasonable transition period.
I would add that although many of our offices have closer proximity to U.S. offices than other Canadian offices, regulatory and licensing requirements restrict the use of U.S. partners from practicing public accounting in Canada unless they become licensed in Canada.
Common regulatory requirements. A number of our clients are governed by legislation applicable to various types of financial institutions, including banks, trust companies, investment dealers, et cetera.
The governing legislation generally requires that the engagement partner have a minimum of five years experience at a senior level auditing these types of entities.
This presents us with a very difficult matrix to accommodate when our role requires a minimum, our rule requires a minimum amount of industry experience and another rule provides that there be a maximum amount of time on the engagement.
Industry specialty, last but not least. An quality audit requires specialized industry knowledge, which may not be available in-depth in certain cities in performing audits of SEC clients.
I would add that mandatory rotation beyond the group audit is particularly difficult if it extends beyond the engagement partner and concurring partner.
Two examples I would raise. First, smaller offices looking after subsidiary audits where there may be few partners with expertise in U.S. GAAS and GAAP, and, second, in larger offices where tax or perhaps computer audit expertise is required to assist the engagement team in conducting a quality audit.
Also, the current practice of assigning younger partners to be responsible for subsidiaries to develop the U.S. GAAP and GAAS skills before taking over responsibility for the parent could be restricted by the proposed rules because they would not be eligible to move on to the parent company because of the rotation requirement.
Mr. Day: I guess if I could interrupt you here. There seems to be a common theme to the points that you're making, and that is the fresh look is a good idea, the first couple partners is a good idea, but once you get beyond that, there is another factor that you've got to, I guess, balance, as well, and that is competency because of limited resources.
Mr. Muter: I think that's exactly right. It's audit quality. It's the skill and expertise that needs to be brought to bear in an audit and the fact that an audit requires specialty skills to be done properly.
Mr. Day: I think just to make an observation, I think that was a point of concern that got raised and debated in our own discussions when we sent out the proposal, and that's why you see the flurry of questions in there.
Also, there is even an alternative described in there, and that is if someone else came in and performed other procedures, could that be some sort of check and balance and provide some alternatives, as well, and it's described in the context of are there some forensic audit procedures performed by another firm periodically, would that help with this fresh look notion.
Mr. Muter: My thought would be we did not understand how that would enhance either auditor independence or the quality of financial reporting. So as I say, we haven't studied it in detail, but we did not see that one as particularly useful in addressing this particular problem.
Mr. Day: I brought that up because I wanted to make sure that people understood the context of what we were after there.
The question is could we reduce the amount of rotation that we propose if, in fact, somebody else was coming in and taking some sort of second look, and then there is, of course, the follow-on question, well, what kind of second look might they be taking, and I think the forensic got put on the table largely because we have this gap, I think, of expectation differences between investors and what actually happens with regard to fraud detection.
So that's kind of the context and, hopefully, as you all study the proposal, you can keep that in mind, and if you have additional comments.
We're a little bit limited on time. Maybe Mr. Sun would like to make some comments.
Mr. Sun: Yes. Thank you. I share the views just expressed by Bob, but let me augment that from an Asian perspective.
We certainly support the practice of partner rotation as a safeguard against the familiarity threat. However, the proposed rules are an extension of the rotation rules that cut across those of many national regulators, and these extensions will pose real problems for many in Asia, and let me offer a few comments.
It is a time to build audit quality, especially in Asia, and quality audits require, on the part of the auditor, an in-depth understanding of the business, the structure, systems, controls, and the people of companies, and this understanding is acquired and deepened over time.
Quality audits also require the auditor to exercise seasoned judgments. This very valuable attribute is also built on time and experience. Such knowledge and experience cannot be replaced or obtained instantaneously. It takes time to build quality, and there are not enough resources in Asia.
Asia comprises countries, a full range of countries varying from various stages of economic development. Countries like Japan, Hong Kong, and Singapore are the more advanced stage, where there are other countries, like Indonesia, Thailand, China, they are certainly in the developing stage.
And these countries cannot train qualified accountants fast enough to compliment the country's economic development, let alone qualified accountants who are knowledgeable of U.S. accounting and auditing rules.
Take a country like China. It did not have an independent audit profession as recent as a decade ago, and China currently has one CPA to 13,000 people, compared to, in the U.S., one CPA to roughly less than a 1,000 people, or Hong Kong, where one CPA for roughly over 2,000 people.
So the major accounting firms, in collaboration with the National Accounting Institute in China, are training accountants en masse to take on the accounting and to take on the mind set and the skill set necessary to perform independent audits in accordance with national requirements, as well as international standards.
At present, there are just not enough partners in country who are bilingual and have the local knowledge and the knowledge of U.S. GAAP and GAAS to go around, and there are not enough specialists.
Additionally, any rotation should be restricted to the lead partner and independent review partner on the engagement, specialists in areas such as EDP, derivatives, actuarial, should not be required to be rotated, as these expertise are even more limited in Asia.
Also, a reasonable transitional period is needed given the shortage of necessary resources in Asia.
The third point is that the existing rotation rule is difficult enough. As is, the current seven-year rotation rule is already difficult enough to handle.
A five-year rotation rule makes it even more difficult. The primary purpose of the auditors in many Asian countries is to perform audits using local country GAAP and GAAS. Many countries have only a few partners with the necessary U.S. GAAP and GAAS expertise to handle audits of foreign registrants or significant subsidiaries of U.S. domestic registrants.
They are stretched to the limit now. Rotating these partners will require more involvement from partners outside the country who are not familiar with the language, custom, and local issues.
Audit partners climb a steep learning curve during the first two years on the new account. They learn about the business, the structure, the systems, the controls of the company. They have spent the time to know the people.
Audit partners get to know the ins and outs of the company after serving on the account for two or three years and if they are rotated out after five years and replaced by another team totally unfamiliar with the company, it begs the question of whether it is absolutely necessary, especially for subsidiaries whose audit teamwork and judgment are subject to the scrutiny of the group lead and review partners.
The last point I want to make is that the extended time out rule will negatively affect audit quality in Asia. The more often partners are rotated, the less knowledgeable they become, especially in many Asian countries which do not have many significant players in key industries and thus not enough major clients to build up a coherent body of knowledge.
Although this deficiency is at present somewhat compensated by having the knowledge expert or experts serve an area instead of any single location, the extended time out rule will likely pose further restrictions and cause experience and expertise to dissipate due to the lack of exercise.
In an age where knowledge is counted as a nation's invaluable wealth, such squandering of knowledge and experience is bad economics.
It is, therefore, important to strike a balance and ensure that the measures that seek to bolster auditors' independence will not foster auditors' ignorance, and that we do not place the threat of familiarity with the threat of unfamiliarity, for such initiative would heighten the risk of audit failure.
The proposed rule of extending the time out period to five years will make it extremely difficult, if not impossible for audit firms, especially those in Asia, to build and retain the wealth of knowledge which is so necessary for ensuring quality audits.
So in summary, the SEC proposals on audit rotation in the present form will not work in many Asian countries without affecting audit quality.
Mr. Day: Thank you. Okay. Now I'm going to change the rules here midstream, because we do have limitations on time.
We heard a couple of concerns that have been fairly consistent with regard to resources, competency. As to not belabor the point, are there others who maybe would have that sort of thought that we ought to focus on these issues as we make decisions?
If we can get a nod or two. My sense is, by looking around the room, that that's an area that we need to think carefully about as we move forward.
Commissioner, did you have a question?
Commissioner Goldschmid: Yes, I did. If we accept this concern about certainly the partners, the concurrent partner and the audit partner, you both mentioned reasonable transition period.
Would you define reasonable? What would you need?
Mr. Muter: That's hard to say. In other words, I would be reluctant to respond to that immediately, other than to say that it is a complex issue when you're focusing on many clients, many skill sets, different offices, and it is something that I think can be best done in an organized way rather than in a way that's disruptive to delivering the quality audit procedures.
Commissioner Goldschmid: But if we start at the period, the five or seven years, for instance, from the date our proposal went into effect, that would give you lots of planning time.
Mr. Muter: Absolutely. Sure.
Commissioner Goldschmid: That would work perfectly well, I take it.
Mr. Muter: Yes.
Mr. Day: Mr. Pena, did you want to make a couple of comments?
Mr. Pena: I wanted to, obviously, just raise two points or basically two suggestions. The situation in Latin America is as critical probably as it is in Asia.
It's even made worse in aspects because the movement of people across borders is almost impossible.
But there are certain aspects of the rules that probably could help the problem. One is, obviously, and I'm not talking so much about registrants, I mean, registrants, the rules have been there for years. We have been rotating over seven and five. The number is highly debatable, but not the place to debate that, and the lead partner and the lead audit partner and the concurring partner have been rotating in the past and they will continue to be rotated.
That is not the major problem. It is a problem, but it is a solvable problem.
The fact is the definition of extending that beyond that aspect. For Latin America, though we do have a number of significant registrants, the issue raises much more importantly on subsidiaries. Most U.S. companies have a significant amount of subsidiaries in many countries and the definition, as currently related to, takes the lowest definition of material applicable to subsidiaries.
The SEC has different levels of materiality for different types of disclosures or requirements relating to subsidiaries and affiliates.
The ten percent rules probably would extend this rule to an enormous amount of subsidiaries, because ten percent of income, revenues or income or of assets will go to more than just ten subsidiaries. It will go to several, could well go into as many as a hundred, which creates an enormous amount of people, and I think that is not the intent of this. It is the real big, significant subsidiaries.
One suggestion would possibly be to adopt one of the higher levels of materiality that the Commission has already deemed suitable for other purposes for this purpose, too, maybe the 40 or 30 percent rule.
The other is to seriously consider whether reconsider whether extending it to non-audit partners, who are the ones who actually take the responsibility for the audit and are, therefore, the ones whose independence will most effectively be impaired by familiarity, taking it beyond those will create an enormous problem.
We have very few SEC trained partners. It takes a long time to take someone who is already qualified in another country and train him or her in U.S. rules.
It is almost impossible, and we have a lot less tax partners or other specialists, and that creates another problem and I don't think adds significantly to the independence problem.
Mr. Day: Thank you. We've got just a few more minutes. There's a few people who want to speak. I would ask that we try to limit our comments to incremental ideas that we'd say would generally be consistent, but I think Mr. White has a question.
Mr. White: I just want to state for the record that I'll disagree with the comments made earlier that there's a significant detrimental impact to the rotation of the partners from their knowledge base. I would think that that is actually additive and positive over time.
But the one thing I would like to stress for the industry here is that as an investor, we've engaged with many of the audit firms here in the states with this debate countless times. The one thing I would like to stress is that as investors, we are okay with raising the economics of the audit.
We recognize that needs to happen and it's worth it to us. The audit is extremely important to us. We rely on you extensively.
What we've been saying these months is that we need the audit to be independent and if that costs more money, so be it. It's worth it.
Mr. Day: Mr. Wright?
Mr. Wright: Thank you very much, Chairman. On a slightly different issue, but I think I would like to make it clear that from a European perspective, we have in our recommendation a seven-year lead partner rotation requirement in our recommendation.
So as this recommendation is being implemented by our member states, international law and professional codes of ethics, we have here the potential and perhaps probability of divergence between our recommendation, our approach in Europe and the proposed SEC rule.
In our view, on this issue of time difference for rotation, five years or seven years, quite frankly, no one has the wisdom of Solomon. There's no absolute truth on what determines non-independence, whether it should be five years, seven years, or, as my Belgian friends would say, "coupe le trois, un, deux," make it six, or perhaps 5.3.
So we think here there is judgment on both sides of the Atlantic which are perfectly reasonable, and that really leads me to say that our view is that the timing differences or these potential timing differences, as far as we are concerned, the proposed SEC rule and our recommendation on seven years, we believe them to be broadly equivalent and provide a broadly equivalent level of protection of auditor independence, and we would like this to be recognized in your final rulemaking.
On the question of scope, the extension of the scope that you are proposing here be on the key audit partner responsible for the group audit we believe could have far- reaching practical consequences because it requires a rotation of auditors of subsidiaries in other jurisdictions of auditors not responsible for the group audit, and it's not clear to us what risk is mitigated by the proposed increase in scope.
So we would urge you, from our perspective, to stay on the original drafting of the Sarbanes-Oxley Act, which is in line with our recommendation. If we can do that and recognize equivalence on time differences on this issue, we might have common ground.
Mr. Day: Thank you. Mr. Matsuo?
Mr. Matsuo: Thank you very much. I think that what is important is to make a right balance between the purpose of the Act, namely, to foster high quality audit by periodic fresh look and promote investor confidence.
Considering the international developments in this area, the report I mentioned before by the Subcommittee of the Financial System Council in Japan issued today, made a proposal on this concept of the auditor rotation.
The report made, for the first time, the legal requirement for the auditor rotation in engagement partners and the report says that the partner over an audit firm will be prohibited from engaging in auditing of a corporation over a certain consecutive period, such as seven years or five years, and there shall be time out periods, such as two years.
So we will decide the details, for example, what kind of time out period from now on, but we have a serious concern especially in the time out period, because we think that the main purpose is to make a periodic fresh look by other partners.
So for this purpose, the five year requirement, time out requirement, it goes too far. As mentioned in the proposal by our subcommittee, for example, two years is enough for achieving this fresh look purpose and, at the same time, the purpose of promoting investor confidence.
I reiterate again that audit firms in Japan are subject to our auditor independence regulations and we think that our regulations are equivalent of the regulations under the Sarbanes-Oxley Act.
So that appropriate exemption is necessary for Japanese audit firms in this respect.
Mr. Day: Mr. Delespaul?
Mr. Delespaul: Thank you. Well, this, again, is a point where we have given some reflections before.
The initial reflections in the reports I mentioned earlier said that there should be a rotation and the duration should be seven to nine years. That was initially eight or nine years ago, considering the necessary balance between the qualification and good knowledge of the audited firm and the necessity to avoid links which might be considered with time as impairing the independence of the auditor.
Maybe I should mention that France is among the countries where, for listed companies, we have a system of double auditing. We have auditors from two different audit firms legally signing the audit of the financial statements.
The new law, in preparation, will organize these sort of different rotation between these two auditors so that the duration of their mandates do not cover a period of more than three years. I mean, they will act together on the same company for no more than three years, knowing that in our legal system, because the audit is legally required, the mandate given to the auditor is for a period of six years.
As far as the rotation is concerned, which we are implementing now, is a principle of a rotation of seven years. The new law introduces a six year period. In all terms, it will not be consequent with the five years time fixed by the Sarbanes-Oxley Act.
But we do agree that a rotation of the key partner signing the audit is a necessity, but please don't fix it on a duration which would raise questions internationally.
Mr. Day: I think one last comment and then we'll take a break.
Mr. Grewe: Very briefly. I won't go over ground that's been covered. Just to say that we have yet another variation as to where we have ended up in the UK, having thought about this very carefully.
I think we have now a requirement for lead audit partner rotation of five years and then seven years for a wider group of partners involved in the audit. That, I think, goes beyond Sarbanes-Oxley and beyond somewhat the European Union recommendation, but not as far as your proposals being discussed today.
This has been looked at closely by ministers in the UK and that's where we have concluded the balance of advantage rights. We agree it's a question of judgment and of striking the right balance.
And we do have some other concerns over audit quality, that if you go too far down this route and make succession planning more and more difficult, it would be a shame where, as a regulator, having the interest of audit quality, if we were to conclude in the long term that requirements from somewhere else were actually to impact adversely on audit quality in the UK, I think we would find that a bit galling for those companies.
I don't say we'd come to that, but there is no quite right answer, but that's where we are in the UK.
Mr. Day: Thank you. I think these are some very good and helpful comments for us and something that we can look to and consider. I want to thank everybody.
We are running about ten minutes behind. So how about we try to keep the break as short as possible, no more than ten minutes. See you back at 20 til.
(A brief recess was taken.)
Mr. Day: We're going to get started. I'm going to outline what I'd like to cover in this session.
I'd like to begin talking about audit committees, bookkeeping evaluation services, then transition and talk a little bit about disclosures, and then leave some time around 11:45 for general comments.
So that's kind of the plan. We're about ten minutes behind schedule, but that is perfectly fine. I would observe that I think many of these discussions we've already started.
So with that said, I think as we go through the remaining comments, to the extent and this probably most applies to me, that we can kind of get to the point and, in addition, be careful, I mean, to the extent that you can just reiterate previous comments, so do that.
So with that said, let's turn to audit committees. I think the proposals would require that audit committees pre-approve all permissible non-audit services and our audit review or attest engagements required under the securities law.
With the acknowledgment of the fact that corporate governance is structured very internationally, the rule proposal requires an audit committee or its foreign equivalent approve broadly the provision of audit review and attest services by the auditor to issuers and their subsidiaries.
The whole goal of this guidance around audit committees is to have somebody independent be looking after the auditors and have the auditors report to them, not management, with the idea of improving the objectivity.
So with that said, maybe we can go ahead and open it up with comments. Who wants to go first?
Mr. Day: That leaves me with the option of picking. Mr. Wright, do you want to get it started?
Mr. Wright: Thank you, Chairman. Let me begin by saying that we do see here the potential for conflicts between our approach and member states law with these rather corporate governance-related elements which will emerge or could emerge from the SEC rules.
There is no general EU or member state legal requirement to have an audit committee at the moment, let alone rules on the functioning of audit committees in the European Union.
We have, as you know, collective board responsibility in certain of our member states. We have obligatory employee representation on boards in our member states.
So I have to say that it makes it very difficult for EU companies to comply with audit committee preapproval requirements of the Sarbanes-Oxley Act, and this is also true for U.S. listed EU companies, as well as private issuers from the European Union.
Mr. Day: Can I ask a question about employer representation?
Mr. Wright: Could I just continue and then perhaps respond?
Having said that, Chairman, our recommendation does recognize, and I said this earlier, the importance of the involvement of the involvement of audit clients, governance bodies, to ensure auditor independence. We clearly recognize, in our approach, that auditor independence is much too important to be left solely to auditors.
So auditors do discuss, under our recommendation, discuss with governance bodies, on independence issues of whatever form they take.
Against the governance body, of course, in the European Union can be the supervisory board, independent directors, or audit committees.
Our recommendation requires at least an annual, but always before the acceptance or renewal of the audit engagement that the auditor discloses in writing audit fees and non-audit fees. That's another point we might come onto later.
Also, the auditor should confirm in writing to the governance body that nothing compromises independence. As you recall, this is at the heart of our principles-based approach.
Moreover, the auditor should seek to discuss these matters with the governance body and we believe that this involvement is an important and sufficient general safeguard to ensure auditor independence.
To conclude, briefly here, detailed audit committee requirements will conflict with present EU and member state legislation. Our recommendation requires up front involvement of the governance body and a written declaration by the auditor of compliance with independence requirements.
So we would like the SEC to recognize that by requiring involvement of the governance body, our recommendation is equivalent to the preapproval process by audit committees proposed by your Sarbanes Oxley Act and by the SEC rules.
So we believe we have broadly equivalent approaches, in effect.
Mr. Day: One question that I am interested in, I think, with regard to the employee representation, because I think that's a very broad issue, at least throughout Europe, is that person generally from management or is it more of a rank and file employee, so to speak?
Mr. Wright: Well, Mr. Knorr, on my right, would know the German system much better than I do, but this, in my view, generally tends to be representatives of trade unions, employees as a whole.
Perhaps he would like, through you, Chair, to perhaps add some more detail to that.
Mr. Knorr: You are quite right. It's usually a representative of the trade union selected by the employees, not by management.
Mr. Day: Mr. Delespaul?
Mr. Delespaul: Well, for more or less philosophical reasons, in France we have decided that rules concerning the corporate governance shouldn't be ascribed in the law and there is no legal definition of the audit committee.
Concerning the auditor and the engagement of the auditor, the choice is prepared by the board and the proposal is made to the general assembly of the shareholders, and that's one of the decisions of the general assembly of the shareholders.
In the new law, we will precise that, saying that when giving such advice or recommendation for the engagement of the auditor, the board decision should exclude those members of the board who are linked directly or indirectly to the management, either because they are in the management of the company or because they may be related to the management of the parent company.
But above from that, we don't foresee any legal definition of an audit committee and for that reason, there will be a conflict in the rules because we don't have such structure in our legal requirements.
Mr. Day: Sam, did you have a question before we move on?
Mr. Burke: One quick question for Mr. Wright. Recognizing that the requirements in the European community may not require that audit committees exist, I just wanted to ask you one question in light of the proposals and draw really a distinction in the proposals for independence versus the proposals that may be forthcoming related to audit committees, as required by the Act, which would be Section 301 of the Act.
The independence rules say that the audit committee should engage the auditor to provide audit and non-audit services and where an audit committee doesn't exist, the full board of directors should do so.
Recognizing that there aren't audit committee requirements, per se, in the European community, how would these requirements conflict or this particular requirement conflict with the requirements in your jurisdictions?
Mr. Wright: As I said, the governance body, under our recommendation, can be the supervisory board, the independent directors, so there would be a good synergy there, or an audit committee.
The issue of audit committees is certainly a subject that we're not putting to bed and forgetting about. We intend next year, early next year to come forward with further policy thinking in the audit area and certainly this issue will be one of those we will be looking at.
Ethics is another. Oversight is another. So we are, if I can convince you, very active and very interested in all these points and I agree with you that there would seem to be some synergy between Section 301 and what we have as a governance body definition.
Mr. Day: Commissioner, do you have a question?
Commissioner Goldschmid: Yes, I do. Assuming we can work out the audit committee or its equivalent, and so we can take account of where there is participation and co- determination and such, do I hear relative common ground that the idea of a disinterested approval of consulting work for auditing forms or the idea of at least the equivalent of the audit committee retaining, evaluating, and, if necessary, firing the auditors are something that there would be no great problem on once we've had this kind of body established?
Mr. Day: I saw a few nods yes. I didn't see any objections. Anybody?
Commissioner Goldschmid: That is very helpful.
Mr. Day: Mr. Matsuo, I think you're next.
Mr. Matsuo: Well, I broadly agree with Mr. Wright from the European Commission. I think that the corporate governance system is different jurisdiction by jurisdiction.
For example, in the Japanese case, shareholders meeting will appoint or dismiss external auditing firms, but on the other hand, we have an enhanced corporate governance system in Japan for many times since early 19th, and we also have the division form of the corporate governance system, namely, our commercial code, which sets out the corporate governance system in Japan, twice recently.
And from April next year, large corporations, such as the corporations listed in the New York Stock Exchange or NASDAQ, have the option of two corporate governance systems.
One option is the Board of Corporate Statutory Auditors, which is a separate body from the board of directors. The other option is a committee system, including establishment of the nomination committee, audit committee, and compensation committee.
What is important is that the large corporation is free to choose between these two systems and it is essential from the government point of view to maintain corporations' choice of freedom.
Our law, Section 202 and Section 204 of the Sarbanes-Oxley Act specifically provide the requirement of preapproval for non-audit services by the audit committee and the submission of auditor report to the audit committee.
Our commercial code and the related law, that does not specifically have such a concrete provision, but we have a general provision in our law and the law says that audit firms are required to submit audit reports to the Board of Corporate Statutory Auditors or audit committee.
In addition, both corporate statutory auditors and the audit committee have strong powers for auditing affairs of the corporation.
So we believe that the Japanese corporate governance system provides a governance structure that is equivalent to the one provided by the corporate governance system contemplated by the provisions relating to the audit committee regarding the auditor independence issue.
So that I hope that Securities and Exchange Commission of the United States will have consideration of the corporate governance systems, different corporate governance systems of foreign countries.
Thank you very much.
Mr. Day: A couple more comments on audit committees and then we'll try to move on to bookkeeping.
I'm hearing a general consensus, though, I think, that, A, we need to take into consideration equivalent forums and there ought to be something like an audit committee or some independent body that is hiring, firing, and retaining the auditors. Pretty good response.
Mr. Clarke: Thank you. I want to stress the point that it is important to recognize concept or institutional roles. For example, companies have a director of committees, but the director of committees comprise functions related to audit committees and compensation committees. Therefore, to apply the law, the Sarbanes-Oxley law, it is easier to take into account concept or institutional local and state in the law. Otherwise, it will be contradictory with local regulation.
The same point in relation to the concept of independence. In the case of the companies, and I say it's the case of most Latin American companies, the concept of independence is in relation to the controller, because the controller used to own a large amount of shares, 50 percent, for example, and not in relation to the management.
But the concept is in line, because the management is put by the controller, not by the Latin American countries. So the point is exactly the same. It's important to take into account local and specific concepts in the countries.
The other specific points in the Sarbanes-Oxley law could be included in the function of this kind of director committee.
Thank you very much.
Mr. Day: Thank you. Mr. Grewe?
Mr. Grewe: Thank you, Chairman. First, I should just say that my ministers have made very clear that they do believe that independent audit committees have a key role to play in this whole area of auditor independence. Indeed, the whole thing is seen very much as part of a package with the rules on auditors, the rules on audit committees, enforcement of those, all having to work together. I think that's an important point.
The way in which ministers' assets were taken forward was for a group to look at our corporate governance codes in the UK, which have been, I think, a powerful force over the last ten years for developing corporate governance, and that work is going on now and will report very shortly. I would expect a lot of it to fit very well with the general tenor of the discussion this morning and indeed the proposals.
I think in the UK, we will stop short of making this a legal requirement for audit committees, with satisfactory responsibilities.
I question whether that is actually critical to anything internationally, because I think, by and large, the systems will be there.
One very brief comment on the substance of the point you raise in the paper for this meeting, which is about the nature of preapproval, not a very sophisticated point really, but I think it would be a shame if there were requirements set in place which were very inflexible in the way it operated in practice and actually resulted in outcomes which just went against common sense, that you couldn't do something because you couldn't get an audit committee together and it was really something very minor that raised no problems.
So I think in terms of the paper, there are two options to discuss. I think the second was really much to be favored over the first.
Finally, just slightly to correct a small point and I think one that is probably not going to cause a lot of problems in practice, we talked about conflicts with the law.
One conflict there is, I hope, a technical one between the UK law and Sarbanes-Oxley, is that in the UK, it is the shareholders who formally appoint the auditors.
At present, that is the matter of practice. I think more likely to be on the recommendation from management or the directors than from independent directors or the audit committee, but that is in practice, we would expect that recommendation to come in certainly in listed companies from audit committees, as a matter of practice, and we'd very much hope that where you go on this will accommodate that variation.
I think it's a point of principle for our company law in there.
Mr. Day: Okay. Any last comments on audit committees? If not, what I would like to do would be to talk about both bookkeeping and appraisal and valuation services together.
The reason being is in both cases they tend to flop up against a similar principle, and that's acting as management.
Under bookkeeping, under existing SEC rules, and auditors' independence is impaired if the auditor provides bookkeeping services to an audit client, except in limited situations, such as an emergency or where their services are provided in a foreign jurisdiction and certain conditions are met.
The proposed rules eliminate the limited situations where bookkeeping may be provided, again, because of the management issue, and, also, the issue of auditing your own work.
With regard to appraisal or valuation services, under the Commission's current independence rule, an accountant is deemed to lack independence when providing appraisal or valuation services, fairness opinions or contribution kinds for audit clients.
However, the current rules contain certain exemptions that are eliminated in the proposal. This is an issue that we have worked a lot with everyone on and particularly in relationship to the contribution in kind reports, where certain foreign jurisdictions make it a requirement that auditors do those.
So maybe we could try to, I think, focus on those two issues together and we certainly look forward to your input.
Who would like to start off? Mr. Sun?
Mr. Sun: Frankly, we weren't actually sure as to why the Commission decided to do away with the limited situations where bookkeeping services may be provided. We support the idea that we don't want the auditors to be auditing the books of companies that they have prepared, but certainly in the Asia-Pacific, there are many smaller size subsidiaries of U.S. domestic issuers or registrants or U.S. companies, such as sales office and the small sales outpost locations where initially the company sends a few employees to those locations to primarily start up a marketing and sales operation, and where they want to establish a beach front at those locations.
It really is expedient for them to actually engage the audit firm in those foreign jurisdictions to assist them in doing the back office, including some bookkeeping services, and that's really generally on a very temporary basis.
And over time, as these operations grow in size, they would actually employ their own employees to do their own bookkeeping. So it's really certainly very temporary.
Then, additionally, in many jurisdictions in Asia, because of this really statutory audit requirement, there is a requirement to then have those accounts audited by the audit firm, but really the primary interest on the part of these companies is actually to have some bookkeeping functions so that they can actually better communicate and have better information flow with the head office.
So it is against this background that companies usually engage in these bookkeeping services and they are generally very immaterial to the overall audit fees earned by the auditors on a worldwide basis.
So we are a bit unsure as to why the Commission decided it wants to actually eliminate this and one can also argue that perhaps with the auditors actually doing the books on a temporary basis, that actually presents a better quality when it comes to financial reporting, and these are, generally, again, very limited and small scale.
Mr. Day: In response to your question, Sam, correct me if I'm wrong here, but this is an area in which we received a lot of input from the Sarbanes-Oxley Act both in specificity, as well as in the notion of the principles.
So I think that is why it's a sensitive area that we're going to have to give a lot of thought to.
Mr. Burke: Just to clarify my understanding of your comments, are the situations that you are describing ones where there does not exist another firm to perform the out-sourcing services?
Mr. Sun: Exist in other firms.
Mr. Burke: If you're in the jurisdiction and there is a requirement or a need for services to be out-sourced and you look to a firm, are there other alternatives than just the auditor in those locations or are you implying that the out-sourcing is needed from the auditor because there are not other alternatives?
Mr. Sun: It varies from jurisdiction to jurisdiction in Asia, but generally, because the one stop shop concept, basically, you have the marketing, the person in charge, basically, primarily interested in the marketing and the sales activities and they really don't want to waste the time, so to speak, in talking to two sets of accountants.
So it's really done for expediency, I recognize, but that helps them to focus in whatever they do. And having then to split into different sets of service providers could create some inconvenience and particularly these type of services usually are not done on a long term basis, maybe a year or two at most.
Mr. Day: Mr. Lerner?
Mr. Lerner: We certainly agree that bookkeeping and valuation services will often fall foul of the fundamental principles of acting as management and, also, fall foul of the self-review threat, but there will be circumstances where this isn't the case and we'd like the Commission to give careful thought to that.
What I would like to do is just to broaden out the debate a little bit on that lines to some other normal services, in particular, tax. Tax, we believe, is different from non-audit services because of the involvement of the tax authorities and the courts in determining tax payments.
We believe that this represents a very important safeguard and that combined with the fact that tax usually involves the application of a specific set of rules means that there are important safeguards, and that's why we believe that rules in this area, which would mean that businesses wouldn't be able to or wouldn't wish to use their auditors for tax services, tax advice, would be a very detrimental step.
The negative aspects would be that the corporation would no longer have the opportunity of getting high quality tax advice. It would deprive the tax authorities of the benefit that they have of auditors overseeing the tax returns, and, also, we feel that splitting tax work and audit work would increase the risk of irregularities.
It's interesting that a feature of the scandals in the United Kingdom in the '90s, beginning of the '90s, Maxwell one of those most notorious, was the desire to spread the work around different firms so that nobody had the oversight of what was going on and ultimately to restrict the ability to provide tax services to audit clients would result in the tax part of the practices splitting off and going elsewhere, and this would really result in reduced audit quality.
So we do believe that tax is a special aspect of non-audit services and one where the auditors should be allowed to play their full part, particularly making representations in the tax court, as they are required to in many jurisdictions, formalizing tax strategies to minimize tax obligations, and potentially providing tax opinions, which, again, is required in many jurisdictions.
So we would urge the Commission to bear all these facts and particularly these safeguards in mind when finally developing their rules.
Mr. Day: Mr. White, did you have a question?
Mr. White: Just a quick comment.
Mr. Day: Okay,
Mr. White: I agree actually with the first part of Mr. Lerner's comments. We would tend to agree that tax form preparation and some of the tax services are sort of natural extensions of the audit.
I would disagree when it comes to the formulation of tax strategy. I think that kind of borders on where the auditor then will need to resign on the results of their own advice to the company.
Then on the bookkeeping, appraisal and valuation services, it's pretty cut and dried, from our perspective. Those are not audit services and should not be allowed from an independent auditor. Pretty cut and dried for us.
Mr. Day: I guess maybe if I could just kind of test the group here. I think those are probably the key issues we need to focus on with regard to tax services. I guess, unless I hear differently, what I would like to do would be to focus a little more specifically going forward here on some of the appraisal and valuation services and get an opportunity to get some input there, as well.
Mr. Wright: Thank you very much, Chairman. Perhaps I can give you our perspective on both the bookkeeping and the contribution in kind issues.
First of all, on the bookkeeping, I think this is one where our recommendation on statutory auditors' independence prohibits the provision of any bookkeeping and financial preparation services provided by the auditor in cases where the audit client is a public interest entity. By that, we mean that includes listed companies.
So we feel there are very few differences, fortunately, here with the proposed SEC rule.
Our recommendation would allow auditors to be involved in the preparation of financial statements in cases of emergency, but we recognize and we understand you intend to close off that possibility.
But I think in general, in bookkeeping, we have fewer problems than some of the others we have been talking about this morning.
On question two, are there certain types of appraisal or valuation services or instances that do not raise auditor independence concerns, as far as we are concerned, the answer is yes to that.
Valuation services that are immaterial, I underline the word immaterial, or do not involve a high degree of subjectivity in the valuation, in our view, fall into that category. For example, where the audit clients provide primary support for the valuations or actuarial services if the audit client takes responsibility, provided the audit client takes responsibility for all significant assumptions. This is included in our recommendation.
Question three, should the Commission provide an exemption for such services provided to a firm, a private issuer by its accountant, where local law requires such services, the answer, from our perspective, is yes.
All our member states have, on the basis of our second and third company directive international law provisions that require a statutory auditor to provide an independent expert report on valuations prepared by management or other valuers, and this applies, I am informed, to something like three million limited liability companies in EU.
Because this is an assurance and your terminology would be attestation service, all member states allow the statutory auditor to provide these assurance services. So we require a statutory auditor to provide an independent expert report and it can be the statutory auditor.
Fourth question, the Commission staff, when providing interpretations and so forth, should the Commission's rule provide that similar practices or arrangements be permitted, we believe, from our perspective, that the SEC proposed rule should be modified to allow contribution in kind assurance services by EU auditors under EU company law.
Alternatively, we suggest that you might consider no action letters for EU audit firms. So those are our views on the bookkeeping and contribution in kind questions.
Mr. Day: I think with regard to valuations, that is always a challenging issue for us and I think there is some comfort when somebody other than the auditor does the initial valuation and then the auditor takes yet a second look.
Do others have similar experiences?
Mr. Delespaul: I mentioned it earlier. There are cases where, by law, the statutory authority is required to present some sort of valuation reports as part of its audit mission.
Mr. Day: Other points?
Mr. Day: Moving right along. How about we talk a little bit about transition? We've already moved into that issue a little bit with regard to rotation.
One of the issues that we have here is the Act, in and of itself, I think, provides for some pretty dramatic change with regard to auditor independence. In addition to that, I think the Commission has taken the opportunity to propose some additional requirements that it thought kind of made sense in the circumstance at least to air out, as well. So there's going to be quite a bit to do.
Generally, these things go into effect upon adoption, sometimes with a short waiting period and when it shows up in the Federal Register, but for all practical purposes, basically, upon adoption.
But at the same time, we want to allow for an orderly transition, because that can often be as critical as immediately putting a rule into effect to achieve a new and, I think, mainly in this case, an enhanced objective.
So this question is if there are areas of transition that we need to be particularly sensitive to and if you do have some areas identified and you have any suggestions, I'm sure we'd be happy to hear those and we'll go from there. Mr. Lerner:?
Mr. Lerner: Thank you. I think that rotation, partner rotation requirements are the area where the transitional rules will be most important to ensuring that we retain audit quality whilst acknowledging your desire to toughen up the rules in this area.
The change from the seven years, which has been in pretty general application around the globe on the major firms, to five years does require careful handling.
I think perhaps the best way of summarizing my thoughts here is to explain what we have done in the UK in order to handle effectively the same transition from seven down to five.
This compromise between maintaining quality, toughening the requirements, was hammered out in discussions between the profession and government and I, therefore, put it forward as having some substance, and that is to allow effectively those engagement partners and other partners, in your terminology, the concurring partner, who are already in office to serve out the remainder of the seven years that they would have been allowed under the old rules.
The new person who then comes in would be subject to the five year rule, because succession planning is in place on that seven year basis, and I think succession planning is really, really important.
So that would give firms time to plan to bring up the right partner, the right knowledge, the right background into play and then put the new rules into place.
Mr. Day: Thank you. Other comments? Linda, do you have any specific comments?
Ms. Griggs: Yes, Jack. I'm here representing the Transition Oversight Staff, which is in the process of completing reviews of the independence quality control systems of the four largest firms in this country.
That report should be completed by the end of this week.
In the course of performing those reviews, the Transition Oversight Staff has had the opportunity to look at the quality control systems quite significantly and I think based on their review, it is fair to say that the effective date of the requirement in the SEC's current rule for the foreign offices or the foreign accounting firms to have quality control systems that comply with Rule 201(d), to the extent they audit, review or attest more than 500 clients, may need to be revisited if the rule is changed as you have proposed.
In that regard, I might speak to just a couple of the elements of the quality control systems that I think will be implicated.
The quality control system, the elements of a quality control system are identified in 201(d) and among those are systems to be sure that non-audit services are considered.
Now, at this point, none of the quality control systems of the U.S. firms keep a restricted list by subsidiary, the restricted entity list that the large firms use today to identify independence problems, include the names of all of the audit clients plus all of the names of any subsidiaries or affiliates of those audit clients that have issued securities.
So where you talk about non-audit services provided to subsidiaries, as has been brought up on numerous occasions this morning, there is no list that somebody can go to to identify whether that particular subsidiary is a subsidiary of a U.S. audit client.
Instead, the quality control system in this country is heavily reliant upon the identification of SEC registrant relationships by the engagement partners, by other people involved in the engagement.
So there would be an enormous educational process required upon adoption of the SEC's rules to be sure that engagement partners around the country understand these new prohibitions of non-audit services. They can't go to a handy-dandy list and find out whether the particular company for which they might be doing the service is an SEC client.
So I think in the area of non-audit services, a heavy educational process will be required, which I think, if you gave some additional time, a transition period could certainly be accomplished, but I think it will take an enormous amount of time.
Your immediate effectiveness requirement, Jack, would impose a problem for this educational process.
The role of the engagement partner is also particularly important in identifying conflicts resulting from members of the engagement team going with audit clients, or not even just members of the engagement team, partners of an accounting firm going with an audit client.
Today it's easier to identify those moves from the audit relationship or from the auditing firm to the audit client when they are direct, but just think of the obstacles when it's a former member of the firm going to the audit client.
Again, there are no good systems in existence today. It is heavily reliant upon the role played by the partners involved, the engagement persons involved.
So I think the educational process, again, would take some time to be sure that everybody around the world were sensitive to that particular rule change.
I think the other issue that you need to deal with with quality control systems is that our systems are heavily reliant the systems of the four largest firms in this country are heavily reliant upon the tone at the top, the culture of the persons who have to comply with these systems.
These systems today require reporting of investments in securities. They require annual certifications. That culture of reporting is not one that is necessarily shared around the country.
So, again, the educational process would be critical in order for the firms to have this quality control system that meets the objectives of 201(d).
Moreover, in some countries, it is actually against the law for persons to request access to tax returns and a key feature of our control systems here in this country is that there is an audit of the reporting mechanism to be sure that investments and investment securities are not made in audit clients.
So to the extent there are laws that prohibit access to tax returns, that would be an issue. Perhaps persons from the other countries could address that better than I can, but that is something that the Transition Oversight Staff became aware of as a part of their reviews.
Finally, many of these offices around the country may not, in fact, be involved with any SEC audit client. So, therefore, imposing the quality control systems to every office of the four largest firms or associated offices of the four largest firms in this country around the world could be an enormous burden on these offices if they have no audit clients or they're only involved in maybe ten percent of their operations.
Imposing this reporting process on all of the partners and managers of the office, imposing the annual certification is very difficult and would require training.
So I guess our recommendation would be that you provide a transition period before there needs to be full compliance with the 201(d) definitions of quality control systems, which, of course, are a safe harbor, but the firms would want to be able to rely on that safe harbor.
Mr. Day: A question maybe for you, maybe for others in the group. I guess one alternative that the firms might have when they are auditing compliance with independence would be simply to have the partners agree voluntarily to provide the information, but there has to be a compulsion factor and presumptively that can be built into the partnership agreements.
Any idea if that's possible and if so, how long it would take?
Ms. Griggs: I have no idea how long it would take. My guess is that, just having been involved, to a certain extent, in the review process of these quality control systems, it is an enormous undertaking that firms go through yearly in order to get the annual certifications to monitor the reporting.
So if you're going to every single partner and manager and trying to get them to agree to participate in this process, my guess is there are thousands and thousands of people they would have to go to.
Mr. Day: Mr. Pena?
Mr. Pena: Again, answering your direct question and something that Ms. Griggs raised. Yes, it is possible perhaps that you can write things into partnership agreements, although the independence rules also apply to managers and other staff.
It would probably be illegal in most countries to write violations of the privacy laws into contract. We have had a lot of problems, especially with the European privacy laws, which are very strict. They are very, very difficult to overcome.
In either case, redrafting and getting the necessary approvals on partnership agreements does not happen overnight.
The other issue that you raised was in relation to the cooling off period between again, I know it's in the law, so it's very difficult to get around it and I can see ways of putting it into partnership agreements, but in other countries, it is totally illegal for an employer to restrict the limits of choice of an employee to change his job.
In Chile, where I've lived for the last 20 years, there's been numerous court cases that have said this is unconstitutional and it has been thrown out.
So it seems strange to penalize a firm and a company, but penalize a firm for actions taken by third parties which it cannot control, and I don't know an answer to that one.
But if an employee, say, a senior accountant, goes to a registrant to be their chief accountant, which, in Latin America, is seen as actually a very positive way, because they would not be able to get qualified staff otherwise, we have this restriction and the firm can do nothing about it other than resign the engagement, and that does not seem to be the thrust of what we're talking about here.
I have no idea how you get around the law on that one, but there may be ways to do it. But it is unconstitutional, at least in Chile, and it has been proved in the courts to be unconstitutional. We can't write it into their employment contract and I would suspect the same thing will happen in Europe with the confidentiality and privacy laws.
Mr. Day: Mr. Wright?
Mr. Wright: Chairman, I have some general comments on transition. Would you like to take them now?
Mr. Day: Absolutely.
Mr. Wright: My first point is that transitional arrangements may be helpful in some areas, but I think we have to bear in mind that hopefully in today's discussion we have convinced all of us here that there are different approaches to the same question, a point John Grewe made earlier on, different cultures, different approaches, we hope very much that will taken into account.
Also, we have tried to show equivalence. We have tried to show that our measures in Europe are broadly equivalent to many of the questions we have been talking about this morning, and equivalence would imply, if you accept equivalence, we don't need transition. We need other forms of relief.
I say this from a European perspective in the context of a developing European capital market which we are working very hard to construct by 2005. We believe we're making progress. We believe that is something of massive interest to the United States, and, also, that we will be coming forward, as I said earlier, with new legislation in these areas, in certain of these areas next year.
The final point I would like to make is a question of proportionality. Proportionality is an important criteria in European Union policy-making and data I receive suggests that the share volume of EU located companies traded on the New York Stock Exchange adds up to precisely 2.8 percent of total trading volume. That's 80 hours.
So I think it is important, as well, when you decide what should be transitory and what should be other forms of relief that this proportionality point I've just made is taken into account.
Those are general points on transition, Chairman. Thank you.
Mr. Day: Thank you. I think it's important to recognize that our goal here today is to, as we set out, learn about all the different points and areas of consideration and I assure you that we are going to go back and take these matters seriously and think through and try to make the best decisions that we believe are most appropriate.
The reason that we ask about transition is we only get one shot at this. So we want to take into account all the implications up front. Just to elaborate a little bit.
Other issues with regard to transition? Mr. Matsuo.
Mr. Matsuo: Well, I will not speak on the other issues, but what I would like to say is I broadly agree, again, with Mr. Wright from the European Commission, that we believe that our Japanese system on auditor independence and corporate governance system is equivalent, which will achieve the same purpose as the Sarbanes-Oxley Act.
Based on this thinking, I respectfully request SEC to take appropriate action reflecting our thinking.
Mr. Day: Thank you, sir. Seeing really no more comments on transition, why don't we talk about disclosures a little bit, and then we'll open it up.
Under the newly proposed requirements, we'd make some modifications to our existing disclosure requirements, which are the three or four buckets of information that you've got to provide.
The purpose of doing that is to provide some additional disclosure in certain cases, and other cases, such as with regard to IT, if, in fact, you're going to be providing that to clients, even in some sort of limited basis, it doesn't seem really necessary to continue the disclosure.
So from a GAAP perspective, we are trying to, I guess, all in all, make the disclosures line up better with the latest version of the rules, as well as provide a little more detail.
Comments? I think this is one that might be pretty easy to get general consensus. Disclosure is usually a pretty good thing and something that we can deal with probably relatively easily across jurisdictions.
Mr. White: Just briefly. I'll kind of second that statement. As a user of the financial statements, the disclosure that we're going to get is very important to us. It helps us make an evaluation as to how companies are using the auditors.
So, for one, the investor community is going to be quite supportive.
In the disclosure area, though, there are going to be exceptions, which clearly the SEC staff is going to need to work through that pretty carefully in cases where there are expanded disclosure about why there are exceptions and what the differences are in the reconciliation, as well.
Mr. Day: Mr. Delespaul?
Mr. Delespaul: This wouldn't be a problem for us. There is a recent regulation which is going exactly along the same line, with requirements for disclosure on the auditors' fees and additional fees, but not only to the auditor, but for related services by the network, which is important to us.
So these regulation hasn't been published yet, so it's not applicable, but it should be applicable very soon.
Of course, that relates to the fees. Considering what I said earlier about the audit committee, we would have a problem with the requirement on disclosure on audit committee.
Mr. Day: I think, at these point, what I would like to do would be just to open up the table for any last general comments before lunch. Would you like to go first, Mr. Matsuo?
Mr. Matsuo: Well, I would just like to introduce that measures to be taken with regard to disclosure of the fees. Yesterday the Subcommittee of the Financial System Council issued the report for the enhancement of disclosure and that report includes that the part of the disclosure of the governance related information in the annual report and registration statement, the example that the report says indicated that disclosure of the audit fees to the audit firms, it has two compositions.
One is fees for attestation of audit and the other fees.
Thank you very much.
Mr. Day: Mr. White?
Mr. White: Thanks. Only briefly just to say thank you to the Chairman and the Commissioners for the opportunity to participate today. This is truly helpful for us to get the perspectives of the international community and hopefully our perspectives weigh in as well.
There is one issue that's of a little bit of concern to us. It's my understanding that the London Stock Exchange is kind of taking advantage of the opportunity here to somewhat market itself as the lowest common denominator, in a sense, using the lower governance standards as an attractive to get companies to list there.
I think that is a potential disaster, something that the SEC needs to weigh in its considerations. We understand the level of the challenge that faces you, but we don't want to put a race to the bottom here.
Mr. Lerner: I must respond to that. There is absolutely no question of the London Stock Exchange marketing itself, as I think you've read a very unfortunate and badly drafted press article.
I read the same one. I absolutely assure you that the London Stock Exchange intends to continue to market itself on the basis of the best governance standards of the world, absolutely no evidence to support the fact that it's acting to the contrary. So you can rest assured.
Mr. White: Good, because it's a deep concern.
Mr. Wright: And I understand why it was a deep concern. The London Stock Exchange has had experience of corporate disasters going back well before Worldcom and Enron. Much of the work that we did on auditor independence and the reason that we can stand up proud this morning in front of you and talk about auditor independence is because of what we learned from Maxwell, et cetera, in the beginning of the '90s and the guys who run the London Stock Exchange have got Maxwell written absolutely on their brains.
Actually, they would know more which to go back and market themselves as somewhere easy to come and raise capital with the prospect that that would give rise to a second Maxwell. Absolutely not.
Mr. White: That's good. One of the things that has concerned us in some of our participation in panels and events internationally is that there has been a little bit of taking of pleasure from the international community in what we've been through here in the U.S.
I understand that to a small degree, but I also hope that the lessons get learned globally.
Mr. Wright: Absolutely. We would take no pleasure in this because we have been through it ourselves and we know how absolutely painful it is, but it does, I hope, make you realize that we have learned the lessons and there's more than one way of learning the lessons from these corporate disasters and that they have equal validity.
Mr. White: We do.
Mr. Day: Thank you. Commissioner?
Commissioner Goldschmid: I was just going to add that all of us I think want the highest quality disclosure and governance in general.
We understand that there is more than one way to get there, but on the other hand, concerns about U.S. issuers and private foreign companies here, we've got to be concerned that we give U.S. investors the protection that they're used to and know.
On the other hand, you can hear in all of us a concern about trying to accommodate, trying to understand, trying to work out equivalence where we can, and this has been a very helpful session.
I really do appreciate all of you coming and giving your views.
Mr. Day: Mr. Grewe?
Mr. Grewe: Just commenting very briefly to Mr. Lerner:'s comment in relation to the London Stock Exchange, though also making clear I'm not in the right part of government for regulating them.
But a point, just in case there is any confusion, of course, the supervisory authority for London markets is now the Financial Services Authority, as the UK listing authority, I think I would prefer to say one of the more respected regulators in the world.
When the stock exchange deneutralized in London, then it became essentially like a private sector organization. I haven't seen the article, but I think just in case the wrong impression is being given around the table.
Mr. Day: Chairman Pitt, would you like to interject?
Chairman Pitt: I think this has been an exceedingly helpful discussion. One of the things that has sort of gone unstated, in addition to globalizing the nature of capital raising and corporate activities, has been the fact that there's, by and large, a small number of professional firms which use the same name in different countries and when investors look at a certification of financial statements, it is one thing to say that, for example, a foreign issuer may be subject to different standards, but it is another thing, I think, to say that firms that market themselves as unified have disparate standards.
That is not an issue that I think we have discussed here, in part, because and I think that's appropriate, in part, because here we haven't, in the Sarbanes-Oxley applications, dealt with that issue.
But I would urge my colleagues around the table to focus on this, because as we have moved to have the IASB and the FASB converge on principles of accounting, I think it is also critical for the regulators, in particular, but also the firms to look into the question of what the impact will be on investors who will, in the ordinary course, under current rules, get no disclosure, but a firm that looks as if it's the same firm, that they're used to seeing in the United States, may be subject to different standards.
That I think is an issue that Sarbanes-Oxley didn't deal with, but it's definitely an issue that I think the world community has to focus on.
Mr. Day: Linda?
Ms. Griggs: Just an observation. The convergence of accounting and auditing standards has been going at quite a clip, but there has been relatively little, if no effort at convergence or independence standards.
So this is perhaps why this is such a difficult area for all the people around the table.
Mr. Day: Mr. Wright?
Mr. Wright: Thank you, Chairman. First of all, let me repeat again what I said at the beginning. We support the general objectives of Sarbanes-Oxley. We believe restoring confidence in financial markets is vital.
We have seen estimates of the damage that corporate governance scandals are doing to our economies and the damage in one economy today in global markets ripples across to others, and we in Europe have suffered that, as well.
We believe, just as the Chairman has said, that it is extremely important to converge our regulatory principles upstream and not be in situations where we have to deal with regulatory repair, which is much more difficult.
We particularly welcome this roundtable today. We hope there will be more.
As you know, as the SEC knows, we have in the European Union seven major concerns with the application of Sarbanes-Oxley. So we obviously hope there will be a proliferation of these excellent discussions.
One area of our debate today which seemed to me less clear was the debate on tax. There seemed to be a rather ambiguous discussion. It seems to me that real clarity is needed here and, again, we would plead for a principles based system.
A final comment, and this is no way intended to be any sort of criticism of the process, because we understand the deadlines that are being imposed on you, but please also have a little sympathy for the similar deadlines that are imposed on us, because we have a swathe of rules coming out almost by the day and one month to respond, and, to be quite frank, we find this a little difficult and, frankly, a little too short given the seriousness of the issues at stake, but we understand the political constraints you have.
Mr. Day: Chairman Pitt?
Chairman Pitt: I think that Mr. Wright's last point is an excellent one. We are, in part, not just a regulatory agency, but a law enforcement agency. So it behooves us to obey the law, as well as to enforce it.
The existence of these deadlines has created exactly the difficulties that you've alluded to. It may not present much comfort, but I think one should not look at the adoption of rules as the end of a process, but rather the beginning of a process.
So even if we do not fully respond to some of the concerns, that doesn't mean that the opportunity to keep the dialogue open and to consider how particular requirements may impact foreign entities ends.
To me, I think this effort today is the kind of effort that we need to engage in on a consistent and regular basis, but I hope, however difficult it is, we get the benefit of comments, because we really do want the international community's views and I encourage people even after the rules are adopted to keep the dialogue open, because we will be responsive.
Mr. Day: One last comment from Mr. Matsuo. One more comment and then I think we're going to have to wrap up.
Mr. Matsuo: Thank you very much. I greatly appreciate that the Securities and Exchange Commission provides a viable opportunity today for a foreign regulator and association to have expressed our views on the issues of the auditor independence and other opportunities.
We sincerely hope that SEC will give us other opportunity for such a kind of roundtable opportunity.
As a securities regulator of Japan, we have the smooth function of the securities market is a very utmost important thing. In this sense, we have a common agenda and common objectives with the SEC and the other securities regulators in the world.
So as the Chairman said, we would also like to continue our dialogues with the SEC.
Thank you very much.
Mr. Day: Mr. Delespaul.
Mr. Delespaul: Just a word. To be very frank, the way the issues were treated today were not so easy for us to react on, because it's a very analytical process, which, of course, takes into consideration the fact that you have to draft rules and you have to know what to put in the rules.
This is very, very analytical and we have assisted more if we knew a bit more about the way you intend to implement this and to enforce these rules.
So if there have to be further discussions, probably it will be better to have a more gravel approach, showing the difficulties in the implementation, based also on the possible interaction between the regulators in the different countries.
Mr. Day: Thank you. Well, I guess, at this point, I think it's time that we wrap up. I'll make a final comment and then ask if Ethiopis and the Chairman would like to make a final comment, as well.
I think this has been a terrific day for us, a lot of good input, a lot of things to work with as we work through the proposal and figuring out where to go from here with regard to the rules. When I say us, I'm recognizing the members of the Office of the Chief Accountant here, Sam Burke and Bob Burns.
So thank you very much. Ethiopis?
Mr. Tafara: Thanks, Jack. I don't think I have much to add to that. I want to thank all the participants for coming and for their contribution.
This has been highly instructive for us. I expect that our hope at least is that the process whereby you prepared for this was instructive to you as to the difficulties and the issues and the challenges that we face.
I'm hoping that this will result in something that is satisfactory from our perspective and from your perspective, as well.
Housekeeping matters. Those of you who are here for the attorney conduct session, which is to take place this afternoon, if you could please check out with Sean Horowitz, he has some materials that he needs to give to you.
Otherwise, we are free to break and to go to lunch. Thank you.
(Whereupon, a luncheon recess was taken.)
Chairman Pitt: Good afternoon. This afternoon's subject I suspect will be much less controversial. With that, unless, Ethiopis, you have some remarks, you can turn it over to Giovanni Prezioso, our General Counsel.
Mr. Tafara: I think we can go ahead and turn it over to Giovanni.
Mr. Prezioso: Good afternoon. Thank you all for participating in this afternoon's roundtable to discuss the impact of the Commission's proposed professional conduct rules on non-U.S. attorneys and issuers under Section 307 of Sarbanes-Oxley.
As I think everyone here knows, under Section 307, Congress directed the Commission to issue rules, and I will quote for a moment, "in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers."
Congress went on to say that those rules must include a requirement for an attorney to report evidence of certain material violations of law up the ladder to responsible individuals within the issuer.
The legislative history of Section 307 does not provide detailed guidance regarding the range of attorneys to whom the Commission's rules should apply. Congress did use, however, the term "appearing and practicing," which is a term that has some historical significance and interpretative history under the Commission's existing Rule 102(e) governing sanctions on lawyers and other processionals who have business before the Commission.
In the November release proposing the Commission's rules under Section 307, the Commission recognized that the Congressional mandate raised a number of questions regarding the application of these new professional conduct regulations to non-U.S. attorneys appearing and practicing before the Commission, as well as for non-U.S. issuers more generally.
Thus, the Commission specifically sought comment on a number of those issues and today we have an opportunity to hear directly from many affected parties whose views I believe can be helpful to all of us here at the Commission in trying to address those questions.
We are going to ask participants today to provide us with their views on a number of the specific questions raised in the release. I am hoping that participants will assist us in this discussion in identifying specific problems that the proposed rules could raise, in particular, in non- U.S. jurisdictions.
Even more importantly, I hope that participants will engage in a constructive dialogue today and I'm sure that people will, based on the informal discussions I've had just at lunch and leading up to this, in developing rules that will appropriately take into account both the concerns of the non-U.S. community, but also the interests of U.S. investors and the mandate of Congress on the Sarbanes-Oxley Act.
With those thoughts in mind, I would actually like to just jump into the first of the questions that we have on our list. Ethiopis is holding up a sign.
Mr. Tafara: Just to let you know the one request we have received from people listening to us via the webcast is that you identify yourself at the start of your remarks. They're having a little trouble following who is speaking. So if you could do that, please, that would be extremely helpful.
Mr. Prezioso: This is Giovanni Prezioso, for those on the web.
The first question and I'm hoping to do be doing a lot of listening today rather than talking. The first question on the list is the definition of appearing and practicing before the Commission.
The Commission's release asked a number of questions about whether that term, appearing and practicing, should include attorneys who may be involved in the preparation of documents for use in a foreign jurisdiction where those documents might subsequently be used by others for filing before the Commission.
More generally, the question arises of when should non-U.S. attorneys be viewed as appearing and practicing before the Commission and whether there should be modifications to the definition of appearing and practicing for attorneys in that situation.
I understand that a number of folks have volunteered to speak to this topic. First on my list is Stephen Revell. Perhaps you would want to kick us off.
Mr. Revell: Thank you. Stephen Revell, representing the Section of Business Law of the International Bar Association.
Certainly, one of the concerns we have generally in terms of leaping in and answering questions, such as the definition of appearing and practicing, is, I think, twofold.
One, I am certainly not and most of the members I represent are not U.S. lawyers. So I hesitate slightly.
Having said that, I think the second and more important issue is there are some bigger issues than just the definition of appearing and practicing.
I think if one were to constrain that definition to have a more meaningful involvement with the filing, which might be one way that one could go with that definition, one is still left, I think, with two very difficult issues from the perspective of a U.S. lawyer, one being the conflicts that these rules would give rise to in terms of our own bar rules, and I know we will come on to that.
But on commenting on this definition, we can't lose sight of that.
Secondly, and, again, a very fundamental issue from the non-U.S. lawyer's perspective is that the test we're meant to apply in terms of a violation is, and I believe it is intended to be a violation of U.S. law, whether it's U.S. securities law, state or federal, or a similar violation, or a breach of fiduciary duty, and, again, the standard given is common law.
So the concern we have is that the very test we're being asked to apply, even if we alter the definition of appearing and practicing, is one that we're not necessarily competent to apply.
Mr. Prezioso: Perhaps, not in order here, but perhaps you're next physically, Damon, would you want to speak a little bit to the question of appearing and practicing and follow up a bit on that?
Mr. Silvers: I have been asked to try to represent the views of the U.S. investors. I'm Damon Silvers, for the webcast. I'm Associate General Counsel of the AFL-CIO. I'm here in relation to the roughly $5 trillion in assets invested on behalf of union members in the United States.
I think our general view, and I believe it is the view of institutional investors beyond labor funds, is that we think that there are unavoidably, in the nature of the statutory process, and as Giovanni made reference to, the unfortunate paucity of legislative history in this area, which is, in certain ways, good.
I mean, it gives the Commission, I think, the flexibility to deal with these issues in a serious way relatively with the kind of space that generally Congress feels that the Commission needs to have to get these questions right.
But there is unavoidably some tension with a variety of bar rules, statutes, regulatory structures in other jurisdictions.
The scope of practice issue, in our view, needs to be an attempt needs to be made to draw a line between the preparation of documents which are fundamentally driven by other jurisdictions and other jurisdictions' securities law, corporate law, and the moment at which those documents become consciously incorporated into a securities filing under United States law.
That seems to us to be the critical juncture. We think it would be overreaching, in a sense, to interpret the Sarbanes-Oxley Act in such a way that someone practicing law in a foreign jurisdiction, preparing a document for purposes, to that person's mind, exclusively under that jurisdiction, would somehow find themselves ensnared in U.S. law unknowingly. We think that would be inappropriate.
However, the person involved consciously and intentionally, in a U.S. in the process of preparing a filing under United States securities laws, should come under, in our view, some should come under the ambit of this Sarbanes-Oxley.
Now, the question is, which I think goes to the previous speaker's questions, which is then these broader issues arise, which is how can we harmonize, to use a word that I think some of our European friends are familiar with, how can we harmonize the way in which we interpret Sarbanes- Oxley with various legal ethics regimes in place in other jurisdictions, that attorneys involved in preparing documents under U.S. securities law will have to be will be subject to.
I would just make one comment about that and I think it's a specific comment, but I hope the spirit is understood to apply more broadly.
The statute specifically states violations of securities or the duty to report violations of securities law and violations of fiduciary duty.
Now, one could say, I suppose, one could conclude that since these are references to U.S. law, that, for example, an attorney for an issuer incorporated in a non-U.S. jurisdiction would be incapable of violating fiduciary duty under U.S. law, that the meaning of the statute does not reach to fiduciary duty, as that duty is understood even in other common law countries, let alone the equivalent concepts in German law or French law or Japanese law.
We think that would be a bit narrow minded, that approach. However, there needs to be an approach which recognizes that there are differences here that are more than foreign and we should not in any way construe the statute so as to make it impossible for practitioners, for overseas practitioners to participate in securities filings in the United States.
Mr. Prezioso: Picking up on each of your comments, particularly with reference to the point of appearing and practicing, I sensed actually some commonality of expression in the threshold issue of what I think Stephen Revell described as meaningful involvement and what you described in slightly different words.
It would be interesting to me to hear from each of you and from others where you think that line might be. I take it you don't think that line starts where somebody has prepared a contract under the non-U.S. law that then is incorporated in a filing with the Commission would be picked up.
I'll ask the question the other way. If we think that is something that wouldn't be covered, what do we think would be covered, in your mind, each of your minds?
Mr. Revell: I think if one could build something around the idea of active participation in preparing the filing, then I think one could get to a level of involvement where you could then investigate what standards need to attach to that individual.
But I find it difficult commenting on that in isolation because I don't know what tests are meant to apply. So for instance, if I am actively involved, and let's assume we pass that test, what do you, the SEC, expect me, as a non- U.S. lawyer, to what standard do you expect me to meet.
Am I meant to know the U.S. securities laws so that I can screen violation or am I meant to screen violation only in connection with the laws on England and Wales?
Mr. Prezioso: I do want to come to that point, but I want to stick for a minute on the involvement, because one of the issues, for example, to take a specific point that is in the rule as proposed, is an issue of when a lawyer advises an issuer not to make a filing with the Commission or that no filing is required.
What is your view in that context, if you've got a view in that context, as to whether that could constitute meaningful participation insofar as ultimately it would preclude the filing from occurring in an extreme case?
Mr. Revell: I could see why the SEC would want to ask that.
Mr. Silvers: I will say that I will take on at least one example of what I think is covered. A counsel for a registrant who is involved in preparing, for example, a glossy annual report, in the context where they know that that report will be included in, say, a 20-F filing, and this is an ongoing to an ongoing registrant, it's all very clear that this is going to happen.
It would strike me that that person that that process is one that should be covered under umbrella. There is no question that that document is going to turn up in the U.S. securities filing. Everyone knows it. It's really integral to it.
I view that as being the sort of thing that should be covered.
The question you raised about advising the client either to make a filing or not to make a filing under U.S. securities laws, it's even clearer. I don't think you could come to a more clear example of what should be covered.
Mr. Prezioso: Let me try to get some of the thoughts of other folks who want to speak to this. Bob?
Mr. Mundheim: I think if I were constructing a way to narrow the reach, I think I would talk about significant responsibility for an issuer's preparing documents transmitted in compliance and that are intended to comply with the U.S. securities laws, maybe advising on legal compliance with the securities laws.
All of those cases, people are presumed to have some ind of familiarity with the U.S. securities laws and if they've got doubts, they will reach out to people who are more expert and rely on their judgments.
But I think it is important. I think, on the one hand, it is very understandable that your definition in the proposed rule for appearing and practice is very, very wide- reaching, because you want to establish the authority.
I don't think that you have to reach the limits of your authority in triggering particular responsibilities under the rules, and I would urge you not to do that.
One of the principles that you might apply is not constructing traps for the unweary and the lawyer, whether it's foreign or U.S., who is given a piece of a document to review, for example, a real estate description, an antitrust description, in my view, would typically fall as in a trap for the unwary, and realize that he is within the ambit or she is within the ambit of Sarbanes-Oxley.
I think by narrowing the definition, you create one other advantage. I don't think that you want to create any greater disparities in the rules governing U.S. lawyers and foreign lawyers than you absolutely are driven to do, because, as was mentioned in this morning's discussion, that could very well create some frameworks in which people advertise or market their services, which I do not think would be very helpful.
Mr. Prezioso: Bob, let me ask you a follow-up question on the suggestion you were making about significant responsibility for preparing documents that will be transmitted to the Commission.
Along the spectrum of participation, as I think we all have seen at times, disclosure documents may be reviewed by a number of lawyers expert in different areas, even in the domestic context, from the tax folks to the ERISA folks.
In the international context, where there may be disclosures that are keyed off of either litigation matters occurring outside of the United States, regulatory matters relevant to the issuer outside of the United States, where counsel, who is expert in those matters, is involved, how would you envision the kind of test you were describing playing out?
Mr. Mundheim: I think, as my first cut at it, I would take people who have the senior responsibility for the appropriateness of the document being filed. I don't really know that you have to go much below that line.
Mr. Prezioso: And thus your thought is there actually would be someone who either would be designated or would be somehow construed to have the principal responsibility for the preparation of the document.
Mr. Mundheim: I think that is certainly one way you could go at it. I don't know that it need be one person, but it does seem to me it is realistically a small group and usually somebody does bear the overall responsibility.
Mr. Prezioso: Let me get some thoughts, because I know there are two other folks that wanted to speak to this issue in reaction both to Bob's suggestion and to some of the other suggestions we have had. I don't know whether Thomas Joyce wants to begin to speak to that.
Before you start, did you want to ask Bob a question?
Chairman Pitt: If I can. Bob, did I understand you correctly to say that whatever the appropriate limits are for domestic attorneys, you think that, by and large, the same standards should apply overseas, as well as here? Assuming we get the right standards.
Mr. Mundheim: I said if you have a narrow enough standard, then I think you need not have a disparity and I think that to the extent that you have disparities in treatment, that is not without its consequences, and I think the Commission should bear those consequences in mind.
Commissioner Goldschmid: Let me push you further on that.
Mr. Mundheim: I want to tell you, it's very unusual for me, as an academic, to have to answer questions.
Commissioner Goldschmid: It's nice to be able to turn the tables on these academics.
Why shouldn't we have a narrower net in this foreign context, with the uncertainty and limited knowledge of foreign law, for foreign lawyers in terms of U.S. law, as compared to U.S. lawyers, where we can put extra burdens.
Clearly, they will understand certainty is there and we may want, particularly in reporting up, to put that emphasis in a heavy way.
Mr. Mundheim: I would like to come back at an appropriate time and talk about reporting up, where I think there is a different and more effective way to achieve that.
I can understand that the trap for certain foreign lawyers may, given the hypotheticals, be a bigger trap than it is for a U.S. lawyer and I think that is true, but basically I think you ought to have as one of the factors in your final rule-making to keep the disparity as narrow as you can.
Mr. Prezioso: Let me actually pick up on this theme a bit more. It is something you were going to talk about anyway, I think, which is when we think about this question and from the perspective that I think Bob is raising it, one of the issues that occurs to me, and it's sort of the next topic on our agenda, is how some of this will play out when you have U.S. and non-U.S. admitted lawyers practicing side by side in multinational law firms.
In part, I take your suggestion, Bob, as having some application in that context, as well. Since I know Mr. Joyce was going to be speaking about both of these topics, maybe you can jump in and tie those two together.
Mr. Joyce: On the first topic, six London based law firms filed a letter with you at lunchtime that and if you want to take on a difficult task, try to get six London based law firms to agree on anything.
We took a fairly technical approach to appearing and practicing and simply asked that rather than saying what was the activity that constituted appearing, we said that people whose involvement was tangential or incidental should be excluded, and we enumerated three or four things that we think are tangential.
The clearest one perhaps is drafting a contract that happens to be included as an exhibit, that without changing the inclusive part of the rule, that we have a carve out.
With regard to practicing in a multi-jurisdictional law firm, I have non-technical thoughts. I think everyone in the room is sort of aware, but I think it is worth recounting that in the course of the '90s, the practice of U.S. securities laws had spread abroad enormously, so that there are at least hundreds, maybe more than a thousand active U.S. securities lawyers in London, Paris, Milan, Hong Kong, all of whom are trying to do the job that I think the securities bar uniquely has done for 70 years, and that's actually get people to comply with the law, transmit the learning down to the clients in a way that they can understand it, particularly with foreign clients, so they can figure out how to comply.
And it is important, I think, that in drafting the Rule 205, that the Commission not get in the way of the effectiveness, the continued effectiveness of that group and its bar.
We don't know quite how to make it work and, frankly, I have met now two or three times with an internal risk management group in the firm, trying to anticipate what we might do depending on what the Commission does, and it is difficult.
We haven't figured out all of the problems, but some of the problems have to do with communication; that if the rules are drafted in certain ways, we may find that the simple answer is not to talk to the Americans; that the flow of information from the client to the lawyers may certainly be interrupted and the flow of communication within our firms.
We think that it shouldn't make any difference whether a firm is U.S. based or based outside the United States, although, obviously, as is the case with Freshfields, you have eight U.S. securities partners and 492 others, there are difficulties that don't exist in a firm like Sullivan & Cromwell, where almost everybody is at least generally familiar with the securities laws.
Other big Wall Street firms are closer to our model than Sullivan & Cromwell, but everybody knows what the spectrum is.
We ask in this letter that I referred to for a safe harbor for foreign lawyers who consult with U.S. lawyers, so that if a foreign lawyer is genuinely concerned or just simply doesn't know what to do, if he consults with one of his U.S. colleagues, we think that ought to give him protection, because if the rule applies to him, he often cannot comply without somebody's help.
Dually qualified lawyers and U.S. lawyers practicing abroad may need some kind of Commission exemption, qualified or not, from noisy withdrawal because of the problem of conflicts with foreign law that I know we're going to discuss a little further down the agenda.
Alternatively, and some of the relevant people are in the room, they may be able to get exemptions or partial exemptions from the law societies in the places where they practice.
But this is a process that is going to take a long time to figure out and I guess we are asking in our letter for the Commission to delay the adoption of noisy withdrawal until some of those problems can be sorted out.
Mr. Prezioso: Let me pick up on the please.
Mr. Lawrence: My name is Lawrence, Allan Lawrence. I represent the Law Society of Upper Canada, Ontario.
We are a regulator, as is the SEC. So that we perhaps look on this from a slightly different point of view. But surely in any corporate practice today, there has got to be a point person. There has got to be somebody who pulls the whole thing together.
There has got to be somebody who is responsible for those actions. Now, is there anything wrong with the SEC having a requirement? You're doing it, you want to do it in the accountancy field as far as certification of accounts are concerned.
Is there anything wrong with requiring a person or a small group of people to be responsible for the documentation and the material that goes into the SEC?
I would see nothing wrong with that. There may be a different way in which this can be crafted, but that is certainly one way.
There is no question that the SEC has spread the net far too widely in this thing. I think we're all agreed on that, I hope we're all agreed on that, so that it's got to be narrowed.
Well, I think what we're also doing here is avoiding the question of what happens in a case where there has been a misstatement, something said, something printed, something certified that is incorrect.
For the SEC to come along now and advocate that they, and perhaps the SEC alone, should be the judge of that matter as far as the discipline is concerned, the remedy for doing it, I just want to point out that as another regulatory body, and there are other regulatory bodies represented here, as well, we think that our discipline procedures are far more severe than anything the SEC can come up with.
We really have the power of life or death, or almost, over practicing lawyers in Ontario, and not just lawyers who represent public issuers. All corporate lawyers fall under our domain and sometimes there are as many abuses, if not more so, in the private sector, private corporate sector as there are in the public corporate sector.
But the SEC cannot disbar a lawyer in Ontario. You may prevent that lawyer from appearing before the SEC, but you can't disbar him.
Now, in the public interest, if the situation is bad enough, surely you want to remove that person, in the public interest, from ever practicing anywhere again. If that happens, as I say, the SEC cannot disbar a lawyer.
In Ontario, our own Securities Commission cannot disbar a lawyer. Our courts, our Canadian courts cannot disbar a lawyer.
The only regulatory body that can really shoot the boots off somebody who should not be there, in the public interest is the Law Society of Upper Canada. We are the regulatory body and we have a string of these regulatory bodies right across our country.
Therefore, surely we should be reaching for a lot greater cooperative effort. Once we have defined what the rules should be, we are certainly open, we are desirous of having a very warm, close, cooperative relationship with our own Securities Commission and with the American Securities Commission.
So we want to root these people out perhaps more than you do because we can it's a bad name for the practicing lawyers in our province and in our country.
So as I say, I think in this discussion, even if we do come up with these standards, we are avoiding the remedy and I would like to see us get on to the remedy sometime.
Mr. Prezioso: Well, I think it would be good to talk about the remedies. I think I didn't expect anyone to be arguing that our remedies were insufficiently tough in this particular context, but it just shows that you need to have these discussions to your all points of view.
I want to pick up on the point you made about a particular lawyer assuming the responsibility, and then come back to the remedies issue, because I think it is an important point and I think I can't speak for the Commission, but I'm pretty confident that everyone in the Commission is strongly committed to cooperative efforts with all regulators who are, in many cases, in a more primary situation vis-a-vis particular problems or wrongdoers.
I know I personally feel strongly that that is an important part of what we do with the attorneys here at the Commission.
On the issue of a person who is principally responsible, I heard two interesting thoughts coming through and I would like to get your thoughts and of others which have been raising that, which is, on the one hand, there is a notion that we could carve out people whose involvement is, as I think you described it, incidental or that isn't meaningful, to use the phrase we had earlier, and Bob had a different phrasing.
But I want to distinguish that just slightly, if I've got it correctly, from the notion of a safe harbor that I heard being described in the sort of six firm letter, because I think they are slightly different in formulation and I think they've got a significantly different implication from a policy perspective.
Let me just try to lay that out and get people's thoughts. On the one hand, if the Commission's rule were to exclude a category of people whose involvement was incidental, even though they did work on it, it might have the incentive effect of saying keep your distance from participating in any of these filings, keep information away from the U.S. lawyers, because so long as your involvement is incidental, you will not be covered by the rules, the U.S. lawyer will never have the information who is covered by the rules, or the designated lawyer, whoever that may be.
The safe harbor idea I understood a little differently, which is you get protection under the safe harbor by actually going to the lawyer who is qualified and is taking the active role and entrusting information to that person, where, in other words, the incentives would be actually to share information rather than to guard them jealously apart from the u.S. lawyer.
I would be interested if you see that same distinction between your suggestion and some of the other suggestions here and maybe you want to go ahead.
Mr. Joyce: I think that's actually a very good point. I think there is merit in excluding people whose involvement is truly incidental in any case because it's just not necessary to cover them.
But I'd just point out a couple of other things that situations that we foresee in a multi-jurisdictional firm where the safe harbor would probably help.
One is the classic situation where the client is incorporated in some European country. The responsible partner is advising, say, on the necessity of disclosing merger negotiations.
The client is listed in New York, and the U.S. partner is not giving the advice. The U.S. partner's technical view is being sought. The responsible partner for the client packages the advice together with home country considerations and maybe third country considerations, if there is another capital market involved.
So the American partner actually is not present when the advice is delivered and may not know what the advice is that's delivered, although he should if the law firm is working as it should.
Then the client makes a decision based on a whole lot of considerations.
If, in the judgment of the U.S. person, the wrong result has been achieved, he doesn't really know whether there has been a material violation. He knows his advice wasn't followed, but there may be facts that he wasn't familiar with.
Then just to elaborate a little bit, if you get to the situation where the American partner is convinced there has been a material violation or unless there is something that he doesn't know, there are all sorts of access questions involved in implementing up the ladder, because it could be quite possibly the case in some of our continental clients that the American partner doesn't know anybody at the client.
So everything that drives people together and forces information into the head of the guy that has to make the decision is helpful, but I'm not sure, particularly when you get to the final point of noisy withdrawal, whether or not it's going to help.
We concluded that noisy withdrawal decisions would have to be made at the very top of the firm, because there was no way, in a mixed firm, that we could continue to be corporate counsel if the American partners were effecting a noisy withdrawal, even if the client is incorporated, obviously, in a European country.
But there are significant difficulties that we just haven't been able to think through.
Mr. Prezioso: I know that Jose Visoso wanted to speak to some of the issues in multi-national firms, and maybe this is a place where you could share some of your thoughts and pick up on some of these theme.
Mr. Visoso: Yes. I'm going to try to take it from our point of view of what would happen in Mexico. There would be basically three difficulties in applying this proposed Rule 205.
The first difficulty would arise from the fact that certain provisions are contrary to what Mexican law provides. This is the case of the noisy withdrawal, which requires an attorney to breach his confidentiality obligations under Mexican law.
According to different provisions, but mainly to Article 36 of the professions law, an attorney must maintain in strict confidence the matters entrusted to him or her, except for the reports which may be required to be filed under applicable law, where foreign law would not be included in this concept of applicable law.
This concept would also be regulated by the codes of ethics of the Mexican Bar Association and this would require the client confidentiality and would only allow a client withdrawal under certain specific circumstances.
The second difficulty would arise from the fact that it may be not possible for a non-U.S. lawyer, in this case, a Mexican lawyer, to determine whether or not, under the laws of the United States, his work product may be included in SEC filed material.
This may be come even more complex if the work product is not securities related.
We understand the definition of appearing and practicing before the Commission would even cover a non-U.S. lawyer working in a document governed by Mexican law for a local transaction, which, under the U.S. securities laws, has to be included as an exhibit to a filing with the Commission, although such attorney may have no knowledge of U.S. securities laws or does not participate in the filing with the Commission.
The third difficulty would be to determine whether or not a client has breached any U.S. securities law, a fiduciary duty or a similar law.
In our specific case, nearly all of our attorneys are only qualified to practice in Mexico and all of us advise our clients only as to Mexican law.
Therefore, we are not in a position to assess what are the U.S. securities laws, requirements, or the case law addressing the standards of materiality or reasonability, and we cannot be expected to determine where there has been a violation of the securities law or a breach of a fiduciary duty recognized by common law or any similar law.
Mr. Prezioso: Let me follow up on the second of those points, the issue of the non-U.S. lawyer who may not be able to tell whether his or her work product is being filed with the SEC.
We have had a discussion of a number of potential approaches to that different phrasing of the concept. Do you have particular thoughts about how one might articulate a standard that would accommodate the concern that you're addressing, but also would help the Commission's processes in the interest of investors in the U.S.?
Mr. Visoso: Yes. I was going to maybe one of the extreme cases. Of course, there are very there may be some scenarios where it is clear that there is a direct involvement in a securities related document, for example, preparing a 20-F or a document that one knows that has to be filed.
So in our view, that may be subject to liability or to the sanctions provided by the securities laws. But it has to be, in our view, a direct participation or a direct action which the lawyer has knowledge will be used for purposes of the filing with the SEC.
Mr. Prezioso: Please.
Mr. Fish: My name is John Fish. I'm the President of the Council to the Bars of the European Union, the EEA, and certain other observer countries.
I'm looking at these issues principally from the point of view of bars and bars regulation. It would seem to me that leaving aside any question of the enforcability of these provisions, the issues which we would be concerned with and which we will talk about a little later, in any event, noisy withdrawal and reporting up the ladder, would be the extent to which our members could be caught peripherally by the provisions.
I accept that in the securities field, there will be many lawyers, whether U.S. or non-U.S., who will be very familiar with the obligations, but I think our concern would be that a lawyer, a European lawyer who was preparing documentation, that mightn't be terribly familiar with the requirements of the SEC, and I think there is certain weight to that when we look at the violations that we're talking about.
There's material violation, breach of a fiduciary duty or similar violation, and by way of example, a fiduciary duty, I think I'm correct in saying it would be a relatively novel concept, as far as civil law jurisdictions are concerned, very much a common law concept.
So I would see that in relation to those particular areas, there could be difficulties.
I think I'm attracted to the suggestion that the objective here may be to narrow down the criteria so that we can reach a point where one might say there is a degree of equivalence applicable, in which case it becomes a much more understandable concept, but that still leaves, and we will, I'm sure, be talking about it shortly, regarding how bars and law societies could deal with misconduct issues which were directly related to SEC rules.
Mr. Prezioso: Just to be clear on that. Your thought as to how one might address the concern of particularly a multi-national law firm, where there are lawyers working side by side, some of whom are U.S. admitted, some are not, where the matters are a hybrid, and I think that is one of the difficult scenarios we've been talking about, where would your approach bring you on that sort of question and how would you envision dealing with that sort of situation?
Mr. Fish: I appreciate the difficulty and there may be others who are better qualified to comment on the multi-national concept, but we would probably approach it from the point of the individual lawyer's responsibilities within that organization.
So it is not so much a question of the fact that his partners may be involved in SEC, it would be the individual concerned.
I think one other point we would make is that a distinction could be made between lawyers who are admitted, European lawyers who are admitted to practice in the United States and, indeed, lawyers who practice in the United States, under the foreign legal consultant rules, I think a distinction could be made between them and lawyers who are resident outside the United States, but who happen, through their professional career and activities, to be preparing documents which might then be used subsequently in an SEC filing.
Commissioner Goldschmid: Giovanni, one quick one. How should we create in-house lawyers in these narrowing scenarios?
Ms. Hook: Alison Hook, from the Law Society of England and Wales. We are the regulatory body for about a 100,000 lawyers in England and Wales and, indeed, around the world, and about 24,000 of those are in-house lawyers.
So whilst I am not an in-house lawyer and can't promise to have captured every point, I would say that in our discussions with in-house lawyers, they are very attracted by the sort of safe harbor concept that Tom was talking about earlier, because in their view, most of the work that they would do, they would either do through outside counsel, if they were actually going to be doing something quite complicated.
If they were doing something fairly routine, like a 20-F, for example, they would expect to still nonetheless use a U.S. attorney or take a view from a U.S. attorney.
Commissioner Goldschmid: Safe harbor includes reporting any problems to that attorney, I take it.
Ms. Hook: The whole noisy withdrawal thing, I think we need
Commissioner Goldschmid: Let's leave that side, but let's keep it within the chain at this point.
Ms. Hook: Yes. Well, they would expect to report any problems to the board that they came across and, indeed, we have a rule in our rule book, which I know, again, is something we will come back to, but we have a specific rule which says that an in-house lawyer, a senior in-house lawyer must have access to the board and must seek that in the terms of his contract.
So we would think either the board or the safe harbor through the U.S. attorney should deal with that problem.
Mr. Prezioso: Just to focus on the safe harbor for a minute, because I think this question of in-house attorneys is a good one for us to turn to right now.
One question I'm trying to tease out, and I think this may have been where your follow-up question was going, is there are two ways that one at least can envision this safe harbor working.
One is where a person who is not admitted in the U.S. only interacts with the U.S. system via a U.S. qualified lawyer or person subject to our rules. That person is excluded from coverage because they choose to work through that lawyer.
Another approach, and I don't know if this is where you were going, but I'll ask the question in any event, is whether there is a separate requirement that says and when you become aware of violations, you must go to the U.S. lawyer.
On that front, I think we may still have some of these questions, but how do you know it's a violation, in the first instance, but I want to just see if your views differ on the two strains there.
Ms. Hook: I think that's why we did come back to this issue, which, again, is something that all the lawyers that I've spoken to in England and Wales do have this problem, how would we know that this is a violation of U.S. securities law, and that's why we consult a U.S. attorney and why we go through a U.S. attorney.
Mr. Prezioso: I think, Damon, you wanted to say something.
Mr. Silvers: I think that investors in the United States are very sympathetic, I think, with the concern that Bob Mundheim raised several iterations back about the competitive effect of creating too much of a gap here.
I think our bottom line and most serious concern about this whole process is that it would inadvertently undermine the larger purposes of the Act as it affects U.S. securities markets and U.S. corporate governance.
Our second concern, although a pretty important one, is that this be worked out in a fashion that the markets continue to function and that the United States remains a place where companies around the world wish to list their securities.
For that reason, I think that this question of getting the not creating a huge incentive to either shut down interaction with U.S. markets or to move the legal oversight process outside substantially, substantially outside of the range of the Act is a great concern to us.
Along those lines, in the discussion of the safe harbor, I find interesting and worthy of exploring the concept that counsel exclusively practicing in a foreign jurisdiction, in certain circumstances, might be able to have a safe harbor for their that's tied into their interaction with U.S. counsel.
I think that's an interesting idea. I'm very troubled by the notion that there ought to be exemptions for anyone practicing law within U.S. jurisdictions if they happen to be doing so physically in a foreign jurisdiction.
I particularly feel very strongly that anyone who is in a position to issue an opinion about a filing or an aspect of a filing under U.S. law should have no exemption at all, no safe harbor at all from the Act. I think that's a central concern here.
I think doing anything otherwise would open up a what's that thing Ross Perot used to say, you'd hear a giant sucking sound if you did that. The flow of securities law representation to people with licenses to practice law in the United States, with apartments in Paris, would be immediate.
And although I'm sympathetic to that as a way of life, I think that it would undermine the Act fundamentally. So very much against that.
But I think the other idea is worth exploring. It's the sort of thing that might yield to a practical outcome.
Mr. Mundheim: I wanted to address Commissioner Goldschmid's question relating to in-house lawyers. I thought it was interesting that he put it in terms of in- house lawyers, because in thinking about this panel, one of the things I was forced to read was, for example, that a French in-house lawyer has to resign from the bar because a French lawyer may not be employed by a commercial establishment.
In Japan, most of the people who serve in-house legal functions, as we tend to think about them, are not lawyers. They're not members of the bar.
And it really makes one think about why do we focus on the nexus to lawyers when we're thinking about bringing information to the right level in the corporation.
I think that you can do a great deal for that fundamental purpose by leaning on the corporate governance side of these questions, just as Mr. Lawrence was suggesting to you, and saying that a company that's listed in the U.S. markets has got to articulate its expectations with respect to how to develop information and to have procedures for getting that flow of information to the right level, because that is the critical point in the so-called up the ladder exercise.
Then you're really not limiting yourself to lawyers. You're really having the corporation decide how within its particular structure it can best promote and encourage that result, which is where you want to be at the end of the day.
Commissioner Goldschmid: But, Bob, here is the conceptual problem. One, we do require reporting up of others, accountants and others. Congress was very specific on 307 that they want lawyers to take on this obligation, and that is very hard for us to move from if we take the Chairman's very good phrasing of the intent and the spirit of Sarbanes-Oxley.
Mr. Mundheim: No, no. I'm not saying that those two things are mutually exclusive. But I think you get much further towards your goal by thinking about this issue from the corporate governance process. It's really much broader and I think can be much more effective.
Lawyers will get swept up in it and lawyers will continue to have the obligations that they have as members of the bar, whether it's the New York State Bar or whether it's the Paris Bar.
Mr. Prezioso: Picking up on this, it's an interesting question I think that you've got us focused on.
At one level, one could view this as potentially a problem of under-inclusiveness in the rule as proposed in the sense that it focuses on a definition of an attorney that's keyed off of someone being admitted or licensed to practice in a particular jurisdiction.
If I understood correctly the description of the French law, which is consistent with my past recollections, what I've heard in that and, in fact, in other continental jurisdictions, as well, I hear you partly saying the in-house lawyers, as we see them, are actually not admitted or licensed to practice in any jurisdiction and thus might not be covered by a rule that uses the terminology of the proposal.
Let me just start to make sure I've got that right.
Mr. Mundheim: Not in any, but in some jurisdictions.
Mr. Prezioso: In following up on your notion of the corporate governance side of this, how would you imagine that the Commission could try to achieve some of the same objectives that we have been talking about here from the corporate governance side?
Let me just throw out one possibility to get your reaction. I'm sure there are others.
If the Commission took the position that the general counsel of every issuer, as defined in the statute, which would include, obviously, all the companies that are making the requisite filings here, as someone who is covered by the Commission's rules and went the step of imposing on the general counsel a set of obligations to create internal reporting processes on an ongoing or other basis, is that the kind of vision that you have as to how one might address this from the corporate governance side or are you thinking more a board level kind of question of coming at it from the non- lawyer perspective?
Mr. Mundheim: I think it is more effective when it comes from the board, because it then and the CEO, because it then reflects the ethos of the company.
I understand the narrower approach of running it through the general counsel, but I think you want to get as much high level corporate support for this, because then it will work better.
Chairman Pitt: What do you mean when you say that "it" comes from the board? What is the "it" that we are referring to?
Mr. Mundheim: It would be a statement which could be in your code of ethics. It could be in your bylaws, where you set up your various committees. You could say we're going to have a compliance committee and the compliance committee is, at a minimum, going to set forth expectations about how compliance is going to be effected, is going to oversee the creation of procedures.
So it seems to me you can run that kind of a track.
Chairman Pitt: The only concern I have, and maybe I'm not fully comprehending where you would go, is it seems to me there are two discreet segments to the issues that the specific provision 307 of Sarbanes-Oxley deals with.
Lawyers who have knowledge or should have knowledge that something may be wrong and that a significant violation of law may well have occurred. The second aspect is who has the obligation to do what once that has occurred.
The reason why I think Section 307 pinpoints lawyers or people who are acting in a legal capacity or rendering legal advice is because by the very nature of their functions, they may well learn of certain things that ought to cause a red flag to go up.
That part, it seems to me, cannot be delegated to a more amorphous concept of corporate governance. It seems to me that the whole rational of 307 was to impose a specific obligation on corporate lawyers who become aware or should have become aware of certain types of information to then do something with the information.
The second half of it, I would think you are entirely right, the problems that people are concerned about dissipate if the obligations with respect to reporting and disclosure and resolution are handled from a corporate governance aspect.
I don't know if you are making that same distinction.
Mr. Mundheim: I think you are absolutely right that the second helps discharge I mean, will inevitably end up making it easier to discharge the first set of obligations.
Part of my thought really came from the fact that if you look at the proposed rule, while it imposes obligations on lawyers which doesn't pick up people who perform legal functions in some corporations, it also imposes responsibility on people who are not functioning as lawyers, an investment banker with a law degree, and says we're going to impose responsibilities on you as if you were in a lawyer- client relationship in your corporate job.
So it began to make me wonder what's the intellectual basis on which the Commission was proceeding and made me look around for one that would pick up the banker, the non-lawyer, in-house person, pick up the compliance people who will learn a lot about the possible law violations, pick up the CFO and his staff or her staff who may also become aware of the kind of disclosure obligations or the kind of facts that you are concerned get up to the right level in the corporation.
I'm not saying if you adopt the corporate governance part, you abandon the dictate of 307. I'm saying the job becomes much easier and I would encourage you to, for a variety of reasons, pursue the corporate governance part.
Mr. Prezioso: I think Mr. Kawamura wanted to speak to this issue.
Mr. Kawamura: Thank you. I came from Japan. I am representing the bar of Japan. We have introduced a very big report of lawyer education system and we are vigorously pursuing to increase the supply of legal human resources to the business. But still a very small number.
Also, the public companies in Japan have legal officers, in-house counsels, but most of them are not qualified lawyers, so not a member of the bar, no discipline as we have.
Some of the public corporations may not do not have the legal officers at all and so we have a very different culture and system of the corporate governance in Japan.
Our corporate governance system is changing and probably catching up with the other advanced countries like you.
The point is if you introduce these new regulations, you have to be very flexible and practical has to how to apply the rules. The present framework is extremely rigid and extremely inflexible and simply these rules may put the Japanese lawyers into some difficult situation.
By putting the Japanese lawyers into the difficult situation, you may probably destroy an important part of the market in the international arena.
So I would very much like to urge you to give very special attention to the difference of the international market.
I would like to make one point. We have a great respect to the functions of the United States Securities and Exchange Commission is doing. You were created in the difficult time of a great recession, the very early part of last century.
We have similar difficulties now. So your leadership is extremely important, but you must be very, very practical to apply your rules to the international market.
If you destroy the confidence or function of foreign bars, you lose a core body of your business.
So unfortunately, I don't have an alternative proposal today for that, but we should be well, the bars, we should be given more time to make up a very flexible, practical alternative to your proposals, which are applicable to all the countries in the world.
Chairman Pitt: One thing that might be very helpful, and I can understand why you may not have a solution. If you said you did, you'd be inundated immediately. But one factual matter would be to understand pragmatically how you see the potential conflict arising, for example, between responsibilities of a Japanese lawyer that would be inconsistent with things the lawyer might be required to do if the rules were adopted in the way that, as you put it, the inflexible way that you see them presently being structured.
Mr. Kawamura: Well, the present proposal of your rules are absolutely inconsistent with our rules. We have a very strict obligation of confidentiality, as provided by the Japanese law, that is a statutory requirement, and we also have rules of ethics which requires the lawyers to hold the confidentiality.
If we have a breach of either of them or both, we have serious penalties. The Japanese Bar has the primary absolute power to penalize the member who is in breach of these obligations.
So no Japanese lawyer could infringe the confidentiality rules. Our confidentiality rules are very similar to what my Mexican colleague explained about Mexican rules and once the Japanese lawyer has a contradictory conflict of obligations, they will not follow and once they don't follow, your rules will have a difficulty to enforce against the Japanese Bar members.
I could not understand how you could enforce the functions you provided in the rules against the Japanese lawyers. Once you do not enforce your sanctions against the Japanese infringer, you will lose the authority, power of the rules.
So, again, I would urge you to be very careful to make up such conflicting rules.
Mr. Chairman, I would like to add one more thing. We have a very strict confidentiality rule, but we have also different rules which require the member of the bar to take appropriate action if he becomes aware of any illegal engagement things in dealing with the day by day business.
In other words, it is not so explicit as yours, but a kind of up the ladder obligation is recognized by the Japanese rules.
So probably the difference between ours may not be terribly large, so we may probably find out some common mutually understandable solutions if we take time to find out the solutions.
Chairman Pitt: I would just ask one more factual question. If the rule only dealt with internal reporting, that is, reporting by the lawyer inside the company, but didn't deal with reporting outside the company, would that obviate some of the confidentiality problems or would you still see difficulties in the Japanese law?
Mr. Kawamura: If the two things are separated, I think it is quite possible that the Japanese Bar rules may give endorsement of the requirements set forth by the U.S. rules.
This is just, of course, my personal interpretation, but it is quite possible.
Mr. Lawrence: On that point, I must say that as far as Ontario is concerned, as we like to think Ontario has the financial center for the whole of the country, that may be disputed, but in any event, we like to think that.
We have had a commentary on our rules which governed all Ontario lawyers since pre-Enron, pre-Worldcom, pre-Arthur Andersen, and there was absolutely no objection from the Ontario regulator of lawyers if an up the ladder reporting requirement was put into place here.
As a matter of fact, we'd take it as a bit of compliment. You're following our lead.
Chairman Pitt: We can always learn.
Mr. Lawrence: Can't we all.
Mr. Fish: I think for the sake of completeness, it would be worth saying something about the position in continental Europe. In many ways, it reflects the position in Japan, where the obligation of confidentiality is one imposed by law on the lawyer.
So it's known as the professional secret and he can't break that professional secret without maybe some change in the law, and that is to be distinguished between the common law concept of attorney-client privilege, which is the right of the client.
So there is a sharp distinction between the two and certainly we take the view in the CCBE that the current proposal which would require the outside lawyer to withdraw from the case to inform the authorities of any professional considerations and also to disaffirm the particular provision contained in the filing.
We would regard that as tantamount to a breach of the confidentiality rule. So we are faced with that particular issue at a European level.
In terms of the up the ladder, the position would generally seem to be, and I do emphasize generally, because we, too, would need to have time to check this out with the myriad of bars and law societies within the European Union and within the CCBE, but generally it would appear that it would be regarded as an ethical duty of the lawyer to report up the ladder to the highest level.
For me, coming from a common law jurisdiction, that is a fairly self-evident concept. I can't say for a certainty that that applies across the board at a European level. There may be nuances of difference, but I believe it is the general position.
Mr. Prezioso: I understand I've been ignoring folks to my left.
Mr. Revell: I would just like to really echo the comments of Mr. Kawamura from the Japanese perspective, really from a total global perspective, which is certainly the one I think today is trying to bring to this issue, and I think two or three comments that flow from Mr. Kawamura's comments.
One is I think the foreign legal community feels itself has been sort of found guilty without trial. Rules are being imposed upon it without a very clear understanding of what we've done wrong and what we might be able to do as international lawyers to meet the concerns that the SEC have.
As Mr. Kawamura gave an example, and I think there were several other examples around the world, there are rules in place in many countries that go towards the objectives that the SEC is trying to meet.
Certainly, for us as commentators on the rules, to try and garner what the local rules might be in a 30 day comment period is, with the greatest respect, unrealistic. We just cannot do that.
Therefore, certainly one central, simply on the IBA's comments, has been give us some time to go away and work out what rules already exist that go a long way towards meeting the goals that the SEC have and are mandated to have under 307 and let us explain to you what protections are already in place and discuss meaningful extensions of those where appropriate.
Certainly, I think nobody I've talked to has any particular problem with the concept of up the ladder. Indeed, many of us feel we're already under clear responsibilities in that regard.
Certainly, noisy withdrawal raises a lot of difficult issues, issues that you yourself accept in the rules. So in the rules, from our perspective, you've let Americans off the hook.
You said, "Don't worry, guys. We're imposing this rule on you, but we'll let you off the hook as a breach of client confidentiality."
You can't do that for us, so you're imposing and forcing us to breach our own client confidentiality rules, but having no power to let us off the hook.
So our argument is you shouldn't put us on the hook in the first place, because you can't get us off of it. That's not to say we don't support some of the goals that you have, but what we would like to do is to take those goals away, and certainly from the section on business laws, perspective in the IBA, to see how we could work with you to make those rules work better, and Mr. Kawamura's points of good rules that are not only observed and enforceable, I think, should be one of the critical goals of the SEC.
Chairman Pitt: I would just like to repeat something I said at this morning's session. We are operating under time constraints that are not of our own choosing and because, in addition to our regulatory responsibilities, we also enforce the law, we have an obligation, I believe, to obey the law, which means that we need to complete our rule making within the time frame.
I think this session is very valuable to helping us understand where conflicts are and how we can parse the issues, but I also want to stress that even if we don't even attempting to make accommodations, don't go all the way that various jurisdictions think we should go, that's not the end of the process.
The rulemaking doesn't end with the adoption of the rules, particularly in an area as complicated as this, and it would be my hope that there would be a continuing dialogue so that you will have the time to look at issues and even where we may, in your view, have gone too far, and I hope there won't be any instances of that, there will still be a chance to influence how we deal with those issues.
Mr. Silvers: I had one comment about the question of sort of who had the reporting obligation that arose. Then I want to turn for a moment to where we just were in terms of the apparent conflict around the noisy withdrawal question.
I just wanted to raise a concern that I had forgotten to do in my last comment, which was that there's been some suggestion that one way of dealing with some of these problems is to create a sort of a point person within a firm that would be the person on whom the burdens of Sarbanes-Oxley and the rules would fall upon and that the reporting of others in the firm would be channeled to that person.
This I think has some appeal as a general concept, seems to simplify some of these problems, particularly in the multi-jurisdictional firms, different partners operating under different schemes, pick one person, that person clearly is under our scheme and let them carry it away.
What concerns me about this is that one of the visions that at least I have in my mind in terms of what this rule is designed to accomplish is tied up with the fact, at least in the United States, I don't know if this is true everywhere, but that the is that every lawyer in a firm working on a particular matter has a separate and independent duty to the client corporation, a duty that does not run through the partner of their firm, but runs directly to that corporation.
In my own mind, and this is a product of my own personal experience, a vision I have is that lowly associate, churning their way through endless due diligence, that and coming up on something that just doesn't jive with what is being discussed in the drafting room.
It is important, I think, from the investor protection perspective that that associate have a clear individual duty to act on that information if they are convinced that it genuinely is represents a violation of law, and that that duty does not merely run to the partner of their firm, but to their client.
So it concerns me that in looking for more practical ways of dealing with this, with these problems, that we might perhaps inadvertently damage that particular form of investor protection, which I think many investors were familiar with the process by which securities filings are drafted.
I have a great deal of concern for it. It's that person who often has the information that noone else has and needs to be integrated into the process.
I would come to this question of noisy withdrawal. As I said earlier, I think that the investment community recognizes that there is an issue here. It's a serious one that needs to be harmonized.
The Commission cannot be in the position of demanding that individuals do the impossible. I will say in the Commission's defense here that there is statutory language and it's very clear. It says attorneys appearing and practicing before the Commission in any way in the representation of issuers, and the Commission has to live with that language, and I think and similarly the Commission has to live with their deadlines.
I'm sympathetic to the difficulties that those deadlines create.
But I would say a point about this that I'm curious about, which is the focus of many of the people who have commented, particularly from the civil law regime perspective, is that the notion of disclosing the notion of repudiating a particular aspect of their work as part of the noisy withdrawal is a clear violation of the duty of confidentiality under those regimes.
I'm curious whether someone could tell me whether, in their particular regimes, whether particular countries of the European community or Japan or elsewhere it would be the case that a resignation, just pure and simple, would be a violation of that duty.
It seems to me impossible, in a sense, to resign in secret. You have to inform those who you are representing your client in front of that you have resigned. So I wonder at what level here in terms of noisy withdrawal does, in fact, the clear conflict, in your view, kick in.
Is it the act of resigning? Would it be the act of resigning while letting someone know, probably the marketplace, that you are resigning pursuant to a requirement of some kind? Does that trigger, in your view, the conflict or is it, in fact, the resignation with the specific repudiation that triggers the conflict?
I would just be interested to know what people's answers would be to that.
Ms. Hook: I'm going to comment because what I want to say follows on from what a lot of other people have already said. If we're going to have a break, I would rather get it over and done with now rather than afterwards.
A number of people have talked about rules and the Law Society of England and Wales has a lot of rules. In fact, I brought the rule book with me so you can see that we have quite a lot of rules.
These are simply the procedural rules, in addition to, obviously, the rules that govern us through common law.
The original question that I think we were addressing in this part of the discussion was about where are the conflicts.
Well, in addition to the rules that govern solicitors in England and Wales, we also have overseas practice rules which take into account specific requirements that arise from practicing in other people's jurisdictions.
Now, this is where this may not be a popular thing to say, but I come back to the issue that came up earlier about appearing and practicing, because to our minds, the definition that is in the proposed rule for appearing and practicing actually breaches Rule 1 of the solicitor's overseas practice rules, which basically have the effect of limiting or applying local rules and whether made by law or by local bodies such as the SEC to those solicitors who are either practicing in that jurisdiction or who are dual qualified.
So we would actually have a problem with the suggestion as posed by Damon Silvers earlier of what happens if you have a lawyer in Paris who has a U.S. practicing certificate. That's great. They can get exemption from that.
This is why, for us, unless the definition of appearing and practicing is drawn so narrowly that we can actually say these people are really genuinely appearing and practicing in front of the SEC, we would have difficulty judging that those people weren't breaching Rule 1 of our solicitor's overseas practice rules.
The other question that is a real conflict for us is noisy withdrawal, and that, again, chimes in with what a number of others have said, particularly on confidentiality.
We have a rule which is in Chapter 16 which says disclosure of a client's confidences which is unauthorized by a client or by law could lead to disciplinary proceedings against a solicitor and render a solicitor liable in certain circumstances to a civil action by the client arising as of misuse of client information, and that basically leads us back again to Stephen's point about really, for us, there are even if we are to narrow the appearing and practicing definition to those who are genuinely appearing and practicing, noisy withdrawal still causes a problem which has to be resolved for us in some way, because even if we were to say, "Well, look, guys, we think the SEC's doing what they have truly been given by Sarbanes-Oxley the right to do," even though it doesn't mention noisy withdrawal in the law itself, we would still then be there would still you could imagine the consequences or the possibility either of the client feeling that they actually would challenge either us or challenge us and the lawyer concerned on our interpretation of whether we thought this actually lay within the vires of the SEC.
So that is a problem for us, whereas reporting up the ladder is not a problem. What we would generally expect to happen under circumstances in which something similar to the kind of things the SEC are trying to capture here is that we would expect a lawyer, a solicitor who came across something that looks very sort of suspicious to report up the ladder.
If, having reported up the ladder, they were not satisfied with the response they were getting, we would expect them to withdraw.
Now, what we wouldn't expect them to do and what there is no cover for them to do is to disaffirm any of the documentation. So quite how where that fits in with what Damon was talking about and where the borderline is exactly drawn is perhaps slightly unclear.
But I just wanted to mention those specific rules before we got off the question of where are the specific conflicts.
Mr. Prezioso: I think this topic of specific conflicts merits additional discussion, but I do think that I was given the discretion from Ethiopis to call a break about halfway through. I think that folks may want to take ten minutes now to just get up and stretch their legs, and perhaps we can come back to this when we get back, say, in about ten minutes.
(A brief recess was taken.)
Mr. Tafara: If we could get started. I think we have about hour, at this point, left before we have to break for the day.
Giovanni, it's in your hands.
Mr. Prezioso: Thanks, all, and welcome back. I would like to pick up again on the topic of potential conflicts with foreign statutes and explore in greater depth the contours of some of those conflicts and to work through the distinctions between how those conflicts might arise.
I think we have heard differently in the context of up the ladder verus noisy withdrawal, as well as the distinctions between inside and outside lawyers, and make sure we have heard from everyone on that topic and that we really do focus carefully on the scope of the conflict, whether it is entirely due to rules governing disclosure of client confidences, whether there are restrictions on resignation if it is not noisy, whether there are other types of restrictions that might be inconsistent with the proposal if applied to lawyers admitted outside the United States, as well as potentially the U.S. lawyers physically resident in other jurisdictions, which is a point that during the break Alan Beller was reminding me of.
Does anyone want to kick us off on this? I can call on names, but I see a volunteer.
Mr. Lawrence: Just before we get into that, I think on behalf of the foreign lawyers, really we have been deficient in not saying at the very beginning how much we appreciate the opportunity of coming here today and to have you listening to our beefs and complaints.
From our point of view, this is very welcome and we simply do appreciate the opportunity to speak to you.
If I can just go off into the wild blue yonder here just for a moment. We do appreciate, of course, that the bottom line in all of this is to attempt to re-establish the credibility of the capital market system, if not in North America rather, if not in the world, then certainly in North America.
There is another aspect of all of this, as well, though, that I'm sure the Commissioners themselves will be appreciative of, and that is that more and more we're in a global community, more and more it's a global economy, more and more this is the responsibility of all of us, regulators, practitioners, and everyone else involved to eventually come up with a standardization, a uniformity of rules and regulations in the public interest to protect the investor, and especially the small investor, right around the world.
I think we all appreciate that and we all appreciate that this is another impetus and motivation in this whole thing.
Again, if I can echo the words of our Japanese friend, that this has got to, therefore, impel us all to be very, very cautious not only in what we say, but what we do, because that secondary purpose is going to be defeated if any one of us, and I'm speaking now as a regulator, any one of us goes off half cocked in any way with something that is extreme that the rest of the world looks upon with disdain or disfavor or as impossible to achieve.
That, of course, brings us back to the noisy withdrawal. I said to you that we have an up the ladder provision in Ontario and the intimation as a matter of fact, the actual wording of the commentary is that it may be necessary if there is no adequate response to the lawyers' complaints about the activities or inactivities of his corporate client, it may be necessary, therefore, for that lawyer to withdraw his services.
Now, there is a real rule certainly in the Ontario Securities Commission and certainly I think in the SEC's, as well, that if there is a change in that representation, if there is a withdrawal, then it is incumbent that that withdrawal be notified to the Commission.
So what are we talking about? Are we saying that a quiet withdrawal is okay, but a noisy withdrawal is not okay? Does a withdrawal have to have the code words applied to it that the SEC has indicated may be necessary? I don't know. I would like to hear some of those answers.
But from our point of view, our Commission has to be notified if there is a change in solicitors, in lawyers.
Mr. Prezioso: So the rule is, in fact, that whenever the lawyers are either fired or withdraw, that there is a notice obligation to the Commission.
Mr. Lawrence: There is an obligation to inform the Commission of that, yes.
Mr. Prezioso: On the issuer?
Mr. Lawrence: On the issuer, yes.
Mr. Prezioso: In other words, more analogous to the situation here with accountants, by and large.
Mr. Lawrence: Yes. But why the code words? Somebody can withdraw from representing an issuer for a thousand and one reasons. There's no question about that. Why does there have to be code words? If the code words are included, then we feel that that is an infringement of client confidentiality because it will immediately bring the regulator in running to find out why.
Mr. Prezioso: Why do you require the notice to the Commission if the purpose I would have thought the reason for notice is, in fact, to alert the Commission to an event that might merit further inquiry.
Mr. Lawrence: Oh, no. I can think of, as I'm sure you can, many, many reasons why a lawyer or a law firm would resign from acting for a client. It happens every day and every way.
Mr. Prezioso: Absolutely. And I was just raising a question of why reporting is required if there's dispute over fees. There still is a reporting requirement to the Commission in your case.
Mr. Lawrence: Well, I assume the reporting requirement is there so that the regulator then knows who they're dealing with as far as the new person is concerned. Presumably, it's not only a resignation. It's an appointment of somebody else.
Commissioner Goldschmid: How would you handle this? Assume the ugly situation of financial fraud. The lawyer has gone up the chain of command, which is largely common ground here in terms of up the ladder.
Nothing has happened. What do you do with the next lawyer? You resign quietly. New lawyer his hired who doesn't know about the fraud. Do you have any obligations to that new lawyer?
Mr. Lawrence: I don't know.
Mr. Prezioso: I know that Commissioner Campos has a question.
Commissioner Campos: It is clear that one of the largest conflicts that we've got has to do with, just to say the obvious, but just to sort of say to set the groundwork, is this noisy withdrawal, this reporting of material evidence of wrongdoing, and how it impacts the local laws of the jurisdiction.
Certainly, the U.S. has had similar rules having to do with protection of client confidences. The SEC was not unmindful of that. Obviously, this is part of the greatest item that we have been in terms of coming up with a proposal and looking at various ways of doing it, dealing with our own jurisdictions and the basic premise of protecting client confidentiality was foremost in our staff's mind and also with the Commissioners that participated in all this.
We came up with one practical approach which maybe doesn't solve everything, but I'm just curious to see what the members here from the various home jurisdictions would think about it.
That is something that doesn't seem to have gotten a lot of attention, to my surprise, and that's our concept of the qualified legal compliance committee.
The idea here is that the lawyer, and we can I'm leaving the notion of who the lawyer is and the idea of how we define practicing before, because I think those are all areas that we can work on, but let's say whoever the lawyer is who is in the practice of and whether that lawyer is from a foreign jurisdiction and working through a U.S. lawyer, nonetheless, he is practicing.
If that lawyer discovers or suspects that there is material evidence of wrongdoing, such as we defined it, then that lawyer, instead of going up the ladder the way we've been talking about, can report directly to a qualified legal compliance committee, which consists of members of the board who are set up to do this sort of work and includes a member of the audit committee to make sure that we've got cross- fertilization, as it were.
The committee then is required to notify the general counsel and to notify the CEO of the company. All three of those elements, the committee, the CEO, the GC, the general counsel have now got the problem in their lap. It is now incumbent on the three to investigate, to explore, to do whatever is required to resolve this evidence of wrongdoing.
Now, keep in mind, this keeps this report in-house. The client is the corporation, shall we say. It hasn't gone outside the corporation at this particular point.
So there is no noisy withdrawal, there's no report yet to the regulatory authorities, the SEC, and the lawyer essentially, as far as we have worked our rules, is essentially done. It's somebody else's problem at this point.
I have referred to at various groups that I have spoken to as the lawyer's one stop shopping. Essentially, monitoring, so on and so forth, you're done. You've kicked it up to within the corporation and now the company with those three elements by the way, if there is no resolution, if all three are not satisfied, the committee, the GC and the CEO, one of them ultimately has to report it out.
But one would presume that the three would essentially come up with the right resolution to this problem. So I'm just wondering why that see, and this goes to Bob Mundheim's earlier comment about governance.
This seemed to me to be a very genius approach to bringing in governance and bringing in the requirements of up the ladder.
Couldn't we have a regime that works like that in various in our other jurisdictions and why then does that create the disclosure of confidence if it stays within the company?
Mr. Revell: I think that's a great question and it's also a very good solution. I think, though, what it does underscore is the SEC needs to focus on how that solution can be made to work in jurisdictions other than the U.S.
In many jurisdictions, there is no culture of board committees. There is only the board. In many companies, it would be, in SEC defined terms, independent directors, even though there are directors fulfilling independent functions.
In some companies, there isn't an audit committee, so you can't have a member of that committee on the QLCC. So there are structural barriers to creating a QLCC.
Having said that, consistent with your approach will be to say if the lawyer reports to the board with all those elements, then he should similarly be off the hook, because I agree entirely with your analysis. What the SEC needs to do in the proposal is adapt that to make it work for foreign lawyers and indeed that would be, if you like, a perfect escape route for the lawyer, as you describe it.
Mr. Silvers: I was thinking, based on what Mr. Lawrence said, of a sort of elaboration of what you were just suggesting. And I don't know whether this works or not, but it strikes me that one way we might be able one way the Commission might be able to address this problem without creating the sort of loophole that concerns us and other investors is through sort of a slight of hand, in a sense, which is that the place where the conflict seems to arise with noisy withdrawal is between the attorney and their obligations under the jurisdiction where they practice.
One way of fixing that might be to require that the attorney goes through the reporting up the ladder, as you say, and it wouldn't have to be, I think, necessarily to the qualified legal compliance committee. I mean, it could be to the board or to the CEO or whoever that may be.
If the attorney reaches a point at which the attorney is convinced that the matter is not being adequately addressed and that an aspect of the company's filings with the Commission is in breach of the securities law, that the attorney must resign, must withdraw, but a silent withdrawal, however, only silent with respect to the public.
The attorney must notify the client they are withdrawing because they believe a breach has occurred, they believe a particular document is incorrect or in violation in a specific fashion, and that that information has to be conveyed to the client.
From what I heard today, I don't think that violates anyone's rules of practice, that such an obligation would fall upon the attorney in relation to their client.
But the next step would be that the client would have an obligation under our rules to disclose that information to its shareholders.
Mr. Prezioso: To whom?
Mr. Silvers: To the shareholders.
Mr. Prezioso: Presumably through a filing with the Commission.
Mr. Silvers: Through a filing with the Commission.
Mr. Prezioso: Along the lines of what Mr. Lawrence was suggesting.
Mr. Silvers: Exactly. And that that obligation would fall upon the client. If the client doesn't wish to do that, they can find other places to have their securities traded.
Commissioner Campos: Just to clarify what you're talking about. This is in the event that after reporting it to the board or whatever mechanism we have that's like our QLCC, there is no satisfactory activity.
Mr. Silvers: Of course. It's corrected. There's not an issue. The counsel doesn't have to resign, there's no withdrawal.
Commissioner Campos: But there may be a disagreement. In other words, the committee may get into it, may come up with solutions that the lawyer may not think go far enough, but nonetheless a lawyer wouldn't be substituting his judgment or her judgment.
Mr. Silvers: I think what I am suggesting is that if a circumstance arose in which, under the Commission's current proposal, would necessitate a noisy withdrawal, which it has been represented here would create a violation of the legal practice codes of a variety of foreign countries, that in that circumstance, what the Commission ought to say is that the attorney's obligation is simply to disclose to the client to resign, and to disclose to the client the reasons for their resignation.
But the obligation to make the noise would then fall on the client, who is not subject to these legal ethics codes that seem to be creating the problem.
Commissioner Campos: It is the client, the privilege to waive.
Mr. Silvers: And if the client chooses not to waive the privilege, then they have committed a separate and independent breach of our securities laws and would have to suffer the consequences.
Mr. Lawrence: The privilege is the client's in any event. It's not the lawyers.
Mr. Silvers: That's the centerpiece of what I'm suggesting. Now, I think the question here is really whether or not and I don't know the answer to this, but I think that it's something the Commission should think about in contemplating this problem as a whole.
The question is whether or not really the central thought of Section 307 and the central thought of the Commission in its rule-making proposal implementing 307 is the thought that really that the company that is going to pursue a course of action that an attorney feels clearly violates the law is very unlikely to disclose that their attorney has told them that they are violating the law and is resigning.
We can't really trust them to do that, and, therefore, what I am suggesting is an inadequate solution. I don't know the answer to that question. It seems to me one worth some thought.
Commissioner Campos: Just to sort of finish the thought. In the regime that we proposed, as the SEC, and it's in our proposal, we believe there is a check and balance, as such, in the three parts that we described.
You have a board committee, independent directors. You have two of the major officers of the company working this out.
So to the extent that we continue to believe that that is an appropriate solution, then the idea would be to find some sort of equivalent process in a foreign corporation or a foreign company that provides that same degree of competence that the right decision is going to be made.
Mr. Silvers: My guess would be that it's a very rare publicly traded entity in any jurisdiction which, when presented with a bright line situation, such as a withdrawal of counsel pursuant to SEC regs under Section 307 and laid out in that fashion, it's a very rare company that would then put that in the trash can and hope nobody found it.
I think even Enron would probably have disclosed that.
Mr. Prezioso: Let me pursue this idea and test just one point, because I want to make sure we've got a correct assumption, which is implicit in what you were saying, Damon, and I think this is important.
I also have taken from the conversation that at least to the knowledge of people here at the table, there would not be a problem under the laws applicable to counsel in other jurisdictions with an approach of the type that Damon suggested.
In other words, resigning and resigning pursuant to a particularized form of notice that then would apply the additional obligations on the issuer.
But let me just make sure we have agreement around the table that that is not inconsistent with what people here are familiar with.
Ms. Hook: If I could just say I think one of the kind of conceptual difficulties I'm having in thinking through it, and I think it's clearly an improvement on what is in the proposed rule, is that it kind of changes the role of the lawyer.
In our context, in our world, the lawyer is not the policeman and we would expect the lawyer to be working with the client throughout and explaining to the client and trying, where there are problems with potential conflicts, insofar as they actually know about them, which is back to the other question.
So this idea that they should withdraw and notify the client is a bit strange, because we would want them to talk and keep talking to the client right up to the point where there was really no other alternative other than to withdraw.
So I think what I'm saying is that on the face of it, I think this seems, under English rules, to be better, we would normally hope that actually having reported up the ladder to the board, that that is sufficient that that nothing needs to go beyond that.
Mr. Prezioso: And where is, as best one can describe it, is the point today, because where the noisy withdrawal provision is keyed off of now is that the lawyer has become aware of a material violation and, in addition, believes that there is a substantial likelihood of injury, in effect, to third parties, to investors.
In other words, there is substantial ongoing fraud. Would that not be a sufficient basis to require a lawyer to withdraw if the client were made aware of a substantial ongoing fraud and refused to address it?
Ms. Hook: I think one thing which we would also like to see included in the rules is something which requires would require the lawyer to sit down with the client at the beginning and explain that, and that's where maybe actually having something which suggested that there would be an obligation on the issuer to notify if that was indeed what happened, would have an equivalent effect, because we would certainly it would still be a breach of our rules even withdrawing if it had not originally been explained to the client that in the event of a breach of the law, the attorney would actually have to withdraw.
Mr. Lawrence: Surely the difference here is whether you're requiring the lawyer to report it or not. If the privilege, if the confidential information privilege concept belongs to the client, then surely it should be the client that has to report, not the lawyer.
Surely, by requiring a disaffirmation of the documentation that went before by the lawyer, you're making the lawyer the gatekeeper and that then destroys the confidence between the client and the lawyer.
Surely, it is the client's responsibility.
Mr. Prezioso: Is the client the gatekeeper?
Mr. Lawrence: But the very fact that the lawyer is attempting to withdraw is obviously I mean, that's the lever that the lawyer has.
No capital issuer is going to be jeopardize the reputation and the image of that corporation. Surely to goodness, if the lawyer is saying, wait a minute, there's something wrong here, we don't think this is right and in the absence of your explanation, we're going to withdraw, and, yes, you're turning the client into the gatekeeper. Why not?
Commissioner Campos: I don't think that squares with the history and the recent history, but that's not but we don't need to go there.
Right now we have on the table, I think, an idea in which essentially the lawyer reports to an internal company body and we have what we did in our proposal for our jurisdiction. We have what Damon and the others are suggesting.
We're talking here about the requirement of reporting and explaining to the client, that would be pretty part and parcel of any taking it up, as it were.
So that doesn't appear to me, from what I'm hearing, to be a violation of any confidence rule in any particular home jurisdiction.
Mr. Lawrence: I think that's right. I think that's right, as long as it's within the client corporation.
Commissioner Campos: Right. So we don't need to deal right now, because this is a different proposal about disaffirming. We're talking whether that, maybe in combination with a quiet withdrawal, if it turns out that the reporting entity of the corporation doesn't do anything, then what's left for the lawyer to do other than essentially to maybe do at least a quiet withdrawal.
Mr. Lawrence: But surely we've got to worry about what happens when the lawyer does not get a satisfactory explanation after these negotiations, after this reporting up the ladder and whatnot, what does the lawyer what is the lawyer's responsibility at that stage.
We're saying as long as his responsibility is reporting up the ladder, then the onus then is on the client, surely, not on the lawyer.
Mr. Prezioso: Let me get a couple other voices in here. Mr. Fish.
Mr. Fish: I was just going to say it's a very seductive argument and sometimes with seduction you have to think twice about it. It may be a case that you when an idea as novel as that one is put on the table, that we do need the time to think it through and consider what impact it might have in relation to I'm thinking particularly of civil law lawyers where the obligation of the profession secret is an obligation, as I said earlier, that rests upon the lawyer and he faces criminal charges if he breaches it.
But leaving that aside for the minute, I presume what would be at the base of idea is that having gone through the lawyer's duty of reporting to his client his concerns about a violation, having gone through the process of pointing out the facts of life to the client and where he's going wrong, and the client refuses to do anything about it, then are you suggesting, by law, the lawyer would be obliged to withdraw and file a notice of some kind with some authority and then there would be an obligation by law on the client to account and set out the reasons why the lawyer
Mr. Prezioso: Jut to be clear, I think the proposal was to require a notice to the client, not with an authority, and then to require the client to notify the authority. I don't know if that I'm sorry to interrupt you, but I think that is what we had on the table.
Mr. Fish: Well, it throws another element in the mix that if, in fact, the lawyer, having a question, would be following the line of thought I have suggested, not supporting, but only suggested, that if the lawyer was obliged to notify the world at large that he had resigned, without setting out why, would that not set off a train of events which would bring out the reason why he did so?
And the question in that scenario is does that account is that a breach of confidentiality, is it a breach of the professional secret, needs to be examined.
Mr. Prezioso: I think Alan want so to speak and we'll come back to you.
Mr. Beller: There is a question at the end of this, but let me try to position it. I think a lot of what we have been hearing the last five minutes or so, I think the idea, as Commissioner Campos expressed it I think very well, and it does relate to something that Bob Mundheim has been talking about, if you have a corporate governance structure, and I don't know if it's a QLCC or it's a whatever, that has sufficient independence from management that it can we're willing, as a regulatory matter, to rely on it to do the right thing.
I think what Commissioner Campos was saying, I don't want to put words in your mouth, but where does that leave you with respect to what you get from noisy withdrawal if you have that structure.
Somebody said recent evidence suggests that that kind of an idea may not be enough, but, again, I think what the ABA task force has been struggling with is come up with a corporate governance structure that makes it enough.
The problem is you can't rely on management to turn itself in, but you might be able to, you should be able to rely on a sufficiently independent structure to do the right thing, which is I think what Stephen Revell was saying.
It's not necessarily the QLCC. The same structure doesn't necessarily work in all jurisdictions.
Then the other idea on the table was, well, and if that doesn't work, then you have the notion of what we're calling a quiet withdrawal. You tell the company you are withdrawing and you leave it to the company to make the very difficult but you leave it to that independent body within the company to make that difficult decision as to whether or not they're right or the lawyer is right.
And what the secrecy statutes are telling us is that in a lot of jurisdictions, the law says it can't be the lawyer's judgment.
Mr. Prezioso: And I think the residual question I was hearing I'm sorry.
Mr. Beller:I guess the question I had was and maybe somebody put it on the table, does that structure first of all, does the up the ladder to a sufficiently independent body violate the laws of any jurisdiction? I mean, I don't know. That it seems to me is a question one has to think about very hard.
You've got some independent group. It doesn't in the United States, I am quite confident, but that's the only place I'm quite confident.
Secondly, does the quiet withdrawal violate restrictions in any jurisdiction. I heard a little bit of a notion that maybe it does in England unless you lay a sufficient groundwork for doing so.
Again, it wouldn't in the United States, but we're here to talk about the international context. Does that kind of withdrawal raise issues in other jurisdictions? Giovanni, you have another
Mr. Prezioso: I have a variant, but I'll let Damon go ahead.
Mr. Silvers: I want to clarify what I was saying earlier, because I think there are different concepts floating out here and I want to make sure at least mine is understood.
I think investors care a great deal about the noisy withdrawal portion of the Commission's proposal. Again, I think all the international ramifications of that have not been fully thought out.
But the basic concept is very important to us because I think there is a fundamental skepticism about ultimately, in bad cases, the ability of corporate governance systems to, within the board-CEO loop, adequately address the worst situations and that it's very important that there be a channel of communication outside that loop when that loop is fundamentally compromised.
That I think sort of goes to this question of whether corporate governance processes are sufficient and I think there is sort of a sense that although it's very good to have independent processes, that there needs to be a backstop for the most egregious situations.
That goes for a number of different situations, but one of them is the attorney is the question of what should attorneys do.
What I was suggesting was and I'll say a second point. It's our view that the process of implementing Sarbanes-Oxley should not be a process by which American style corporate governance is forced upon jurisdictions with different corporate governance systems. I think our markets have been quite successful over the years at being able to provide a source of capital and a source of liquidity to companies that are incorporated in a variety of jurisdictions with a variety of governance systems.
There may be certain common safeguards we wish to have in all these systems, but we're not interested in forcing everyone to be exactly like us.
Now, that being said, what I was suggesting is this. That let's say let's assume that there is no qualified legal compliance committee; that, for whatever reason, the company chooses not to have one, that they can't have one because of the corporate governance of the country in which it's incorporated in, the way that its corporate law works.
Assuming that there is no such committee, my proposal was that the Commission consider at least this idea, that where a counsel, such as a corporation, has gone through a process of consultation with the company, tried to persuade of the error of its ways, gone up the chain command and failed, that at the end of the day, counsel is convinced that the corporation is pursuing a course of conduct that violates U.S. securities laws or if we get this other sort of hornet's next sorted out, the fiduciary duty aspect of it, but let's just talk about securities laws, make it simple.
They're convinced they violated U.S. securities laws. They're certain of it. What do they do then?
The proposal the Commission has currently is that they make a noisy withdrawal. My proposal is that they make a silent withdrawal, meaning that they silent with respect to the outside world, that they communicate to the company, to whatever the appropriate decision-making body is in the under that company's corporate law, that they are resigning and that they are resigning because the corporation is violating because X document, in the way it's drafted, violates U.S. securities laws and that they have an obligation to do so pursuant to Section 307 of Sarbanes- Oxley.
They send this letter to the company. So that in a sense, that is a silent withdrawal, because it is silent with respect to the world outside the company, the attorney-client relationship.
But that then the Commission have a separate rule or a separate subsection of this rule, I'll leave it to those who know these things best to figure out exactly how you draft this, but the point being that that rule says that the issuer is not supposed to, well, what do we think, what should we do, that the issuer has an absolute obligation to immediately file that letter with the Securities and Exchange Commission, the letter they received from their attorney.
If they choose not to do so, and it's their right as a client under the laws of their jurisdiction, I suppose, not to do so, then they've violated the U.S. securities laws.
I suppose you could create some system by which they could withdraw from the U.S. securities markets if they feel strongly about it, but the point being that it's only a silent withdrawal with respect to the attitude of the attorney.
In practice, it is a noisy withdrawal, because the company has an obligation to make it known. That's my concept.
And what I'm curious about is, is this workable in terms of the ends of Sarbanes-Oxley, A, and, B, does a system like that violate anyone's legal ethics codes, assuming that before anything like this happens, the attorney has done everything they possibly can to get their client to comply and to understand what the consequences of not complying would be and to solicit reasons from the company as to why, in fact, what they're doing is legal, because that is obviously part of that process.
Mr. Prezioso: I think Mike wants to speak to this.
Mr. Eisenberg: I think one of the problems that we face in connection with drafting this is that things are not always so clear. If you go to the company's board and counsel is convinced that what he has drawn up and that which has been filed with the Commission is false and fraudulent, the board calls in special counsel.
They review it and they say, "Oh, no, this is not a violation of the securities laws," and the board goes along with that view.
What is missing from the mix here is that counsel is convinced that that which he has drawn and which has been filed with the Commission or that which he's structured is false and misleading, he then silently withdraws.
The next question and I think there is general agreement that he can do that.
The next question is does he have an obligation to withdraw the documents which he has filed knowing that, in his view, they are false.
If someone else, new counsel wants to substitute their opinion that this is all okay, the company may be able to rely on that, but is there not some obligation, some obligation as a member of the bar and as representing the company from which he is withdrawing not only to silently withdraw after he has told the company and tried to persuade them and do all the things that we've discussed, that if they still persist, to say, "Well, you cannot use my opinion in connection with this offering."
Mr. Prezioso: Bob, are you going to try to walk into that or answer a different question?
Mr. Mundheim: Mike started out by saying you drafted a document or assisted in the drafting of a document and then he switched to you rendered an opinion, and I think that switch makes all the difference in the world.
There is a rule in every U.S. state and I suspect in most of our countries situated around the table that a lawyer cannot assist in the commission of a crime and if you assist by keeping an opinion on file, that's a major issue, but you don't need noisy withdrawal.
That goes to a very simple old principle.
Commissioner Goldschmid: Let's test that one in foreign jurisdictions. Make it the clear case that there's a fraudulent document, your firm let it go in without realizing it, you know. Can you withdraw that document in other jurisdictions?
Does anyone have a jurisdiction where you couldn't do that?
Ms. Hook: We certainly have no rule requiring it.
Commissioner Goldschmid: How about if it's permissive?
Ms. Hook: Our rules generally are not permissive.
Commissioner Goldschmid: Does that mean you couldn't withdraw it?
Ms. Hook: My interpretation of the fact that we don't have a rule requiring is that we would not.
Commissioner Goldschmid: You would not be able to.
Ms. Hook: Not be able to.
Mr. Eisenberg:Just adopt the Canadian rule.
Mr. Prezioso: What would the Japanese do?
Mr. Kawamura: Required withdrawal could be probably possible if the counsel's discretion dictates that way. But under the Japanese rules, the things must be determined from counsel's best discretion.
In some cases, counsel should not withdraw and should take some action to cure the situation by some way other than just up the ladder.
So our rules rest on more freedom for the judgment of the counsel.
Commissioner Goldschmid: But if you knew it was a fraudulent document that had been filed, could you take that document, withdraw that document in Japan in terms of the lawyer's discretion?
Mr. Kawamura: If there is a fraudulent document and if that is going to be submitted to some authority, including the United States Securities and Exchange Commission, that he should do something to prevent that, but the withdrawal is not a full action available for him.
Mr. Prezioso: Just in terms of doing something to prevent that, just so I've got it straight, would the counsel be permitted to go to the authority with whom the document was filed and say "I withdraw that document as fraudulent?"
Mr. Kawamura: It's a difficult question, but probably the counsel should talk to the management to ask the management to withdraw that document.
Mr. Prezioso: But it would not be clear that the counsel could actually independently seek to withdraw the document.
Mr. Kawamura: Not clear to me at this moment.
Mr. Prezioso: That's fair. We're moving quickly from proposal to proposal. I think Commissioner Campos would like to speak.
Commissioner Campos: Again, because I would like to walk away with a working premise that might get us a long way in the various jurisdictions. I would like to follow up on Damon's last point, which is if we don't have an equivalent of a QLCC and we have a lawyer who interacts with management to indicate a problem and ultimately finds a situation in which the problem is not resolved and the problem may be a materially inaccurate statement or it could be something else, it could be an act of fraud, then we're at the situation as to what does a lawyer do and how do we comply with the laws of confidentiality within each of the home jurisdictions.
I think we've got pretty much agreement that the concept of a silent or a quiet withdrawal is okay as far as that goes, because we're not going out to the public.
So now the issue is what more does that lawyer do or what more is that lawyer obligated to do.
What we looked at was that the lawyer, obviously, then reports to the management and says, "I have a problem and this is a violation of 307," or words to that effect, and where it was left was that the company then or the idea was that the SEC would put some rules upon the company's obligation at that point, but the lawyer himself or herself isn't the one that's necessarily reporting out.
We're trying to free the lawyer from being the reporter, the whistle blower, if you will, which ends up causing all this conflict with the rules of confidences and confidentiality.
Therefore, what if then we had a rule upon the company, and it seems to me we have to have some range of options for the company, because if we specifically require the company to report to the Commission, then it seems to me that under the interpretation of home jurisdiction and rules of confidentiality, if a lawyer knows that a certain action is going to result in reporting out by the company, then I don't think we're outside the reporting out in the requirement of violating the confidences.
So, therefore, if we give the company a range of options to cure, which would include, one, reporting to the situation to the regulator, in this case, the SEC; two, withdrawing the violative document and dealing with it in whichever way the company needed to, because after all, the company at that point is the one that's making the representations to the regulator; three, another potential, disclosure to the shareholders, which we talked about earlier; and, any other curing that the company at that point I'm using the company broadly was willing to take the risk would solve it.
If I guess there were five law firms that were ready to line up and opine that the outside lawyer who started all this was wrong and the company was willing to take its chances with the regulator later, I suppose we should probably allow that. At least that might be one situation.
It seems to me that kind of a regime of the lawyer has done his or her duty, we have, by regulation, required the company to cure, in some way, and it's not for certain that the reporting by the lawyer is going to cause a disclosure of confidences, it's up to the company to ultimately find the right curing and take its chances with the regulator in terms of whether the law is being violated.
Would something that like that work?
Mr. Revell: I think we might be back to seduction again. Again, I like that process, but I think the danger, particularly for foreign companies, is we're drawing too sharp a divide between those companies that have a QLCC and those that don't.
Taking Damon's logic to its logical conclusion, you should say that a QLCC isn't enough because if you report to the QLCC and the lawyer is still very concerned, he ought to, taking your logic to the extreme, ought to then do something that notifies that concern to the public, because after all, we know that there are independent directors and members of audit committee that can be seen to be too close to management.
So you could see a QLCC not really meeting the full independence test and, therefore, falling foul of Damon's ultimate concern.
However, the SEC, rightly, in my view, has proposed a QLCC structure that seeks to protect the lawyers. I think it would be unfair to foreign registrants to force them into a much more exposed position for themselves and for their lawyers merely because the local rules, laws and culture doesn't enable them to create a QLCC.
Ultimately, as Bob made the point at the outset, this is a question of good corporate governance. So why isn't the board as a whole a good enough cipher for a QLCC when you haven't got one?
The lawyer goes to the full board and says, "I'm out of here for the following reasons," and then leave it to the board to make the decision.
Ultimately, it's the board's documents before the authorities in those circumstances.
Commissioner Campos: I don't see a conflict in what you're suggesting and what I suggested. I used the euphemism the company, but what is the company, not the board or not the governing structure. Ultimately, somebody has to make the decision as to what is the appropriate reaction, curing of a problem, at least that their outside counsel thinks is a problem.
Mr. Lawrence: As long as it's not the CEO.
Commissioner Campos: Well, I think we have corporate structures in which we have boards, various different types of boards, but I don't know of any
Mr. Lawrence: If it's a case where there's a greedy top management, for instance, then nothing wrong with the lawyer reporting to the compensation committee. If it's a fiddling of the books, then there is nothing wrong with reporting to the audit committee, providing the compensation committee and the audit committee are set up in the proper way.
Commissioner Goldschmid: I think that's the inside on the QLCC. If it is something reported up in management that's willing to change it, you never have to go further.
The problem is management is dug in either corruptly or with judgment or whatever else and then the idea of the QLCC was supposed to be get a dispassionate independent view so in case this really is a judgment that can be made, you're getting it from a disinterested group.
Picking that up, I think the analogy here would be, at most, that you would go to the independent members of the board, if there were such things, so that, again, you have this dispassionate independent review from management if we were looking for some kind of equivalent for the QLCC.
Mr. Revell: Again, though, I think that is difficult in many jurisdictions. I mean, the supervisory board in a German situation is seen by many to be a good independent body, but I don't know that it would necessarily meet the independence tests of the SEC for a QLCC in the sense it's made up of
Commissioner Campos: You clearly have lots of issues in terms of the governance and the numbers of independent directors and what's appropriate for audit committees. We want all independent directors on an audit committee in most jurisdictions, and most have them, a majority.
Yes. All those are issues, obviously, but here let's focus on how to solve the confidentiality requirement for lawyers.
It seems like at least we have a concept that in theory would work. I'm not hearing any violent objections. Then so the issue frankly, our details are, yes, the independent directors, as a portion of the board, that's really deemed to be the ones who would make the decision, is it the entire board, is it the two boards.
Yes. Those are all things that are interesting, but essentially it seems to me we have the makings of a concept here that we can work with perhaps that can get us a long way there.
Mr. Prezioso: And because we're starting to run out of time, I want to see if we can turn just a little bit, in connection with this, if others don't object, we can keep exploring this, but I think there are two related points that come out of this that I heard implicit.
One is the question that some folks touched on earlier, but I don't think the discussion was complete, I didn't sense, on the issue of the scope of the requirement.
In the case of a non-U.S. lawyer, the question arises what sort of legal violations are covered.
I know folks raised the issue that a lot of non- U.S. lawyers don't know U.S. law. On the other hand, presumably, they do know the law of the jurisdiction where they are admitted.
And one question I guess I'd like to hear a little more on is if one develops an approach that assumes that some kind of up the ladder process works, that assumes that, as Commissioner Campos suggests, the corporate governance issues here, while subtle, are potentially resolvable, what is the correct triggering standard for a non-U.S. lawyer.
Commissioner Campos: Could you explain more as to?
Mr. Prezioso: As to both commencing going up the ladder and the withdrawal. Is it triggered only by violations of U.S. securities laws and U.S. fiduciary obligations? What is the definition of similar violation?
Again, this was an issue raised earlier in our conversation and because we have just a little time left and it is very important, I want to make sure we have everyone's thoughts.
Mr. Joyce: I am a U.S. lawyer and I think the material violation standard ought to be limited to U.S. law. I think that for the Commission to begin to require people to follow its procedures with respect to all the laws of the world, with trepidation, I say is a very broad extension of its customary activities.
But the logical other position that it ought to be just any law, which I thought about quite a lot before I came to the conclusion that I just expressed, is it at least puts the foreign lawyer in the area where he is an expert, but I think the foreign lawyer who has a worry should go to a U.S. lawyer.
Mr. Prezioso: Mr. Kawamura.
Mr. Kawamura: Yes. There are a number of Japanese lawyers who have been admitted in the United States, but who are not practicing the U.S. law at all. We call it paper drivers.
It is very good things to carry, although they don't use the license so well.
They are really concerned about this new regulation, simply because of this paper license, they may be liable actually to the regulations.
I think and probably the Japanese Bar thinks that the Japanese lawyers should simply follow and observe the Japanese regulations and Japanese standard of fiduciary duties and should not be bound by the U.S. regulations and U.S. standard of fiduciary duties, because it is impossible to follow.
Mr. Beller: I guess I would just ask, would that apply where the Japanese lawyer was, in fact, giving U.S. legal advice or practicing U.S. law?
Mr. Kawamura: He is not a paper driver, so he's a different category.
Mr. Beller: But how would you distinguish?
Mr. Kawamura: If he is actually practicing U.S. law, he is competent and he has a good moral, ethical reason to follow U.S. standard of the fiduciary duties. My personal view.
Mr. Prezioso: Let me just test the suggestion that it should only be U.S. law in the following sense. If this is an investor driven, investor protection driven regulation that we're talking about and a, say, French lawyer or a Japanese lawyer knows of a violation of local law, which, in fact, is material in the sense defined in the rule, namely, it is something that investors would like to know about that will cost the company X million pick your favorite currency, why is it that that shouldn't be a triggering event for purposes of what this regulation and statute are trying to achieve?
Mr. Silvers: I think this is really the nub of this question. The way in which violations of foreign law will interact with U.S. law and will amount to a violation of U.S. law is really what this comes down to.
I think it's easy to say, well, we won't this clearly doesn't apply to a violation of foreign law that has no relevance to U.S. laws, but, unfortunately, in most cases, a violation, a material violation of foreign law will have a will turn into a violation of U.S. law if not disclosed.
So these things end up merging and I think investors want to know about that sort of thing and would want this to apply to that sort of circumstance, which I think then feeds naturally into the question of the interaction between the foreign attorney who has the knowledge of whether or not the company is complying in the material fashion with foreign law and what we think this discussion has brought out, the attorney who is licensed to practice in a U.S. jurisdiction, who is going to be the gatekeeper on the question of U.S. securities law.
And how you treat that is going to have implications for what that interaction looks like and the extent to which information is shared.
I think investors' view is that we're not I think it's unreasonable to require the SEC to reach out and gather up every possible violation of every possible legal code in the world, but to the extent that those violations then become violations of U.S. law, you have to deal with that. Otherwise, you have essentially gutted this with respect to foreign issuers.
I'm going to abuse the privilege of having the floor for a moment, though, because I think there was a mischaracterization in the last discussion that I wanted to clarify, because I think the people who I'm supposed to be representing here would be very upset if I didn't.
Investors I think believe that if the company has hired counsel on a securities matter, the company has confidence in, and that counsel comes to the conclusion that the company is violating the securities laws, that counsel, whose relationship begins with trust and confidence with the CEO, if that counsel moves to that position and that those circumstances are uncorrected, we want to know and we do not want the possibility that the company could go and find more compliant counsel to be the basis for us not finding out that he original counsel that the company originally had confidence in became convinced that the company was violating the law.
I cannot imagine a more material fact. And the fact that other sort of more other more compliant folks are out there does not change that fact.
So we feel very strongly about that and I think in this discussion, it's given me the sense that that can be done consistently with the bar codes that have been discussed, the various legal ethics codes that have been discussed here in foreign jurisdictions.
It may cut very harshly against the culture of legal practice in those countries, but I think that's kind of tough, frankly.
Mr. Prezioso: I think we might have time for one more person if anyone wants to offer any thoughts either addressed or not.
Mr. Revell: Just hanging on to should it be U.S. law or broader. I think if it is only U.S. law and, as Tom said, that would inevitably involve a U.S. lawyer, then you don't need this rule to apply to foreign lawyers.
You've achieved your goals. So I think you need to come off the fence on this very basic issue as to what violations are you talking about and then follow that through to the different groups of attorneys, because you can't make it broader than U.S. law and impose that test, in my view, on U.S. lawyers.
You say within the proposal you cannot expect lawyers to deal with issues they don't know about. You can't expect U.S. lawyers to deal with foreign laws. You can't expect non-U.S. lawyers to deal with the U.S. law.
It's that somewhat contradictory kernel that I think you've got to address.
Mr. Prezioso: I think as Dan points out, we have an interesting interrelation here because many violations of non-U.S. law can, in fact, constitute material violations of the U.S. securities laws.
So it is hard to talk about one without the other.
I think that given the time, I would like to thank everyone for what I found a very useful and constructive discussion. Many of you had to come in from very far and I think all of you made an excellent contribution and I know I greatly appreciate the efforts that led to this discussion today.
(Whereupon, at 5:04 p.m., the meeting was concluded.)