Speech by SEC Staff:
|The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Becker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.|
On November 15, 2000, the Securities and Exhange Commission voted to approve revisions to the Commission's rules on auditor independence.1 The revised rules took effect on February 5, 2001, and while a few of the rules are not yet fully phased in, the staff at the Commission has been working throughout the winter with registrants and their auditors to address the practical aspects of implementing the new rules. The newly required disclosure for proxy statements will be included in the filings for the upcoming proxy season, and we know that management, outside auditors and corporate audit committees are all taking seriously their obligations as participants and partners in the effort to ensure the integrity of financial statements.
The SEC's auditor independence rulemaking has been called "one of the nastiest regulatory fights Washington has seen in years."2 As we look back on the auditor independence rulemaking, it is tempting to concentrate on the noise. The threats of litigation; the congressional hearing; the earnest and sometimes strident declamations in the SEC's public hearings; and the persistent media buzz as the process moved from April through November.
From the noise one would have thought that this was a mud-wrestling exhibition rather than a serious exercise of public policy-making. It was the SEC versus the accounting profession -- white hats against black hats, although, to be sure, who were the good guys and who were the bad depended on your point of view. And, of course, after the rule was adopted, much of the focus was on who won, rather than on how the public was served.
I thought it would be useful to give you some perspective as to how the process looked from the vantage point of some on the SEC staff. I stress, of course, that the views I am about to express are mine alone and are not necessarily those of the Commission or of any Commissioner or of any member of the SEC staff other than myself. The rulemaking process was, to be sure, extremely arduous; for almost all of us, it was the hardest project we had undertaken in our professional lives. But the contest metaphor misses the point; our goal was never simply to win a battle.
In brief summary, the Commission modernized its rules for determining whether an auditor is independent in light of investments by auditors or their family members in audit clients, employment relationships between auditors or their family members and audit clients, and the scope of services provided by audit firms to their audit clients. Under the new rules, significantly more audit firm employees and their family members are able to hold investments in audit clients without impairing the auditor's independence. The amendments also shrank the circle of family and former firm personnel whose employment relationships with the audit client impair an auditor's independence. These parts of the new rules were, by and large, uncontroversial though quite important.
More famously, the new rules address the scope of permissible non-audit services that can be provided to audit clients. The rules set forth a general principle of independence and a nonexhaustive list of non-audit services that, if provided by an auditor to its audit client, impair the auditor's independence. The Commission's rules also now require most public companies to disclose in their annual proxy statements the amount of fees paid to the principal auditor for each of auditing, information technology consulting, and other services. The new rules also require audit committees to disclose if they have considered whether the principal accountant's provision of non-audit services is compatible with maintaining the accountant's independence.3
There are some significant differences between the rules as proposed and the final rules. The proposed rules, for example, would have prohibited audit firms from providing most information systems consulting services to their audit clients. In the area of proxy disclosure, the proposed rules would have required registrants to disclose each professional service provided by the registrant's principal independent public accountant, if the fees exceeded $50,000 or 10 percent of the audit fee, whichever was less.4 Neither of those proposed provisions was retained in the final rulemaking. The differences between the proposed rules and the ones finally adopted, as is generally known, arose in large measure from an extended dialogue between the Commission staff, various segments of the accounting profession, and users of the financial statements. As such, they reflect the consensus that the Commission sought to achieve. These differences have also, however, raised the question whether the Commission won or lost the war.
The answer is that the "war" was a sideshow; what counts is whether the new rules serve the public interest. They emphatically do.
The rules arose from the combined vision, energy, and persistence of then Chairman Arthur Levitt, and Lynn Turner, the Commission's Chief Accountant. They were often accused of being extremely unreasonable on the subject of auditor independence. In fact, they were not; but history is rarely made by reasonable people. Chairman Levitt's and Mr. Turner's unreasonable insistence on investor protection and the highest standards of professional integrity accomplished what others thought was impossible. The rules as they were adopted are their lasting tribute.
And besides, they were not especially unreasonable. The Commission never believed that the public interest would be best served by going to war and defeating the accounting profession. To be sure, the Commission and the profession have from time to time clashed about independence issues; and in the past few years the debate over independence - particularly issues of the scope of services that may be provided by a truly independent auditor - has been at times intense and occasionally acrimonious. Feelings on the issue have been intense and, in truth, on occasion personal.
But going into the rulemaking, and throughout the process, the Commission believed that over the long term it could not accomplish its mission without the vigorous participation of the accounting profession. Of course, we understand that the instruments of coercion at the government's disposal - rules, the bully pulpit, public opinion, and the occasional enforcement action - can stimulate obedience. But obedience alone is not sufficient to sustain the vital partnership between the Commission and the profession. While we were prepared to accept sullen acquiescence if we had to, we would have viewed it as a poor second to consensus.
Years ago, when the Second Circuit upheld the Commission's authority to discipline accountants,5 it did so on the basis that honest professionals are essential for the Commission to discharge its regulatory mission, and that Commission disciplinary authority was necessary to protect the Commission's processes. The Court emphasized that
The role of the accounting and legal professions in implementing the objectives of the disclosure policy has increased in importance as the number and complexity of securities transactions has increased. By the very nature of its operations, the Commission, with its small staff and limited resources, cannot possibly examine, with the degree of close scrutiny required for full disclosure, each of the many financial statements which are filed. Recognizing this, the Commission necessarily must rely heavily on both the accounting and legal professions to perform their tasks diligently and responsibly. 6
Twenty years later, the Commission's reliance on the professions is no less. As Chairman Levitt testified before the House of Representatives, "The SEC is able to handle its broad mandate with a small staff by regulating, to a large extent, through a public-private partnership."7
Also, the Commission has enormous respect for the accounting profession and for the good it does for investors. We had no wish to undermine the esteem in which the profession is rightly held. That would not have benefited the public.
Simply put, the public needs the accounting profession; and the Commission needs the profession to assist it in its job of protecting investors. And over the long term, professional norms - truly believed by the profession - are the greatest influence on professional behavior. In our view, an outcome that was viewed as completely imposed from without, instead of being embraced (even if reluctantly) by the profession, stood a significant chance of being ignored by the ordinary accountant. From the beginning, then, our preferred outcome was to reach consensus.
The Commission strove for consensus with the accounting profession even though the Commission was well prepared to continue the battle and overwhelmingly likely to prevail. In the staff's view, the Commission was in an extremely strong position. From the outset, we had been threatened with litigation.8 The day before the open Commission meeting at which the new rule was adopted, the Street.com proclaimed that "[w]hen Arthur Levitt gathers other members of the Securities and Exchange Commission . . . to decide how much to rein in the accounting industry, he'll be up against some awfully formidable legal foes."9 At one point, Big Five accounting firms that opposed the rulemaking had retained much of the heart and brains of what turned out to be the Bush election-dispute legal team and the Gore election-dispute legal team.10 Our would-be opponents spoke openly about attacking any final rules through legislative action as well.11
We were prepared for litigation, which we regarded as inevitable in the absence of consensus. The final rules and the accompanying release were written with litigation in mind. We thought we would prevail in any challenge to our rules, though we understood that litigation brings with it certain irreducible risks. We believed that our rules were a reasonable response to matters within our peculiar expertise and that we were likely to receive significant deference from the courts.
We also believed that litigation would be enormously costly to the potential litigants. Public and strident opposition to the rulemaking already had been harmful to the profession as a whole12 and boards of public companies had been noticeably more skeptical about awarding large consulting projects to their outside auditors. The calculus for particular accounting firms varied. Some of the Big Five accounting firms appeared unlikely to litigate over the rules. Accordingly, any firm suing us would have to bear a significant competitive cost. Any firm that did not join a lawsuit would, in competition for auditing clients, undoubtedly tell potential clients that the litigating entities were regarded as rogue firms, and that as a result their financial statements would be greeted more skeptically by the SEC and perhaps even by the investing public. That any such statements would have been unfounded is beside the point. Competitors would have made them, and clients might have been influenced by them.13 In all, we believed ourselves ready for litigation and in a better position to sustain a contest if one ensued.
By November 15, when the final rules were adopted, we were not overly worried about congressional action. Over the summer and early fall, some members of Congress had made clear their opposition to the rulemaking. In addition, some of the Big Five firms tried hard to persuade Congress to attach to our appropriations legislation a rider that would have prevented us from enforcing new auditor independence rules. We fought these efforts vigorously because we believed in our proposals and, more importantly, in order to preserve the long-standing independence of the Commission.
By early November, it seemed clear to us that those firms that had sought an appropriations rider had brought every available resource to bear without success. By the time the Commission considered adopting the final rule, we believed that the threat of congressional intervention had receded to the point that the Commission, in our view, was free to pursue the public interest as it saw it.
We had several goals in pursuit of the public interest as we began the rulemaking process. I believe we accomplished them.
1. We wanted to affect how people think about auditor independence. More than anything else, this rulemaking was about attitudes. As we regularly repeated, independence is about a state of mind.14 We embarked upon the rulemaking because of serious doubts over whether the existence of that state of mind could be taken for granted. To place our doubts in a broader perspective, for better or worse, in recent decades there has been a sea change in fundamental attitudes among professionals. It is not an issue of ethics or morals; it just appears that many professionals are more likely to see themselves as purely economic actors than would have been the case a generation ago. "Professionalism" - meaning non-economic motivation - by no means has vanished; but managed care, the law firm that is a transient alliance rather than a life-long partnership, and the multi-service accounting firm all bespeak an increase in the relative importance among professionals of purely economic motivation. For the accounting profession, the pressures to get - and go along with - clients have never been greater. The Commission's concern, as stated in the proposing release, is that increasingly auditors had come to see themselves not so much as skeptics to be convinced as providers of a type of consulting services that enables management to achieve corporate goals.15 Here is how one Big Five firm describes its audit service on its website:
It goes beyond the traditional audit by allowing the client service team to work with management in order to gain an understanding of the clients' business risks and controls and to help the client generate new insights about performance improvement opportunities.
Through BMP, [the auditor] gains a better understanding of the environment in which clients operate, allowing us to enhance management's ability to assess where risks are located and how they can be mitigated. By taking an industry-specific, top-down look at an organization, our firm is equipped to understand a client's strategic objectives, the risks a client faces in relation to those objectives and the controls established by management to respond to the risks.16
The Commission hoped that its rulemaking would bring these changes to the forefront of the consciousness of the accounting profession, the corporate community, and the investing public. The profession turned out to be, perhaps unwittingly, our best ally. Fierce opposition coming from certain quarters of the profession generated an unprecedented degree of public attention to these issues. Our hearings and the number and intensity of the public comments to our proposal served the same purpose.
A consequence of the rulemaking process is that our independence rules, and the underlying professional values they were designed to protect, at least for a time interest not only a few propeller-headed experts at the Commission and within the profession. The process cast light on the issues and provoked debate inside and outside the accounting profession by people who had not before examined the issues.
We do not know if the rulemaking process has led members of the profession to look at independence differently and whether it has had a significant impact on evolving professional attitudes. We do know for a certainty that it has raised consciousness from the boardrooms to the chat rooms.
2. We wanted to relieve professionals of the burden of outmoded rules concerning financial and employment relationships with audit clients. We wanted to free professionals whose independence was highly unlikely to be compromised from the unnecessary burden of complying with complicated investment and employment rules, applicable to them and their families, that were adopted long before the advent of huge multinational accounting firms and before two working spouses became commonplace.17 These amendments to the rules - most of the text of the rules - are highly deregulatory and were adopted without substantial change from the original proposals.
3. We wanted to add clarity to the rules. The federal securities laws require, or in some places authorize the Commission to require,18 that financial statements filed with the Commission be audited by "independent" accountants. "Independence" is hardly a self-defining term. Section 2-01(b) of the Commission's Regulation S-X sets forth the Commission's basic independence rule. Before the recent amendments the rule itself was rather brief. It was, and to an extent remains, supplemented by a series of Commission releases that were collected together in the Codification of Financial Reporting Releases, referred to by those who follow these things simply as "the Codification."
Talmud scholars will recognize the Codification. The Codification includes broad declarations of principle, precise proscriptions, and commentary on a variety of hypothetical situations. The interpretations collected in the Codification were issued initially at different times, provoked by varying exigencies. Some commentators have raised questions about the Codification's status as law, though it certainly reflects interpretations by the Commission as to how it would apply the law to a variety of situations. Beyond the Codification, our interpretations of the independence rules consist of no-action letters and what can only be called accounting lore - an informal oral tradition of recollections of conversations among accountants, both inside and outside the Commission, as to what auditor independence means.
While the Commission prescribes independence standards for the auditors of public registrants, we do not, of course, have a monopoly on the subject. Many if not all of the states, which are charged with licensing accountants, have their own rules on independence as do state professional organizations. The national accounting professional association, the AICPA, long ago recognized the importance of independence19 and likewise has its own independence rules for its membership.20 And of course, the Independence Standards Board, which was formed through the cooperative action of the Commission and the AICPA in 1997, has been specifically charged with addressing auditor independence issues and has promulgated several standards pertaining to auditor independence.21
The Commission's new auditor independence rules bring together and reconcile, to some degree, these various approaches to the question of independence. Registrants, outside accountants and the investing public are all better served by the Commission having studied the issue closely and put down its prescriptions, informed as they are by prolific input from all quarters, in a clearer and more consolidated form.
4. We wanted to confront serious questions raised by dramatic expansions in scope of services. As the Commission's Chief Accountant Lynn Turner noted early in the rulemaking process, there were longstanding concerns that some auditors lacked independence from their public company audit clients, particularly because of the growth in scope of services.22 Auditing firms had become multi-service professional firms, and the largest accounting firms also had (and still have) large consulting practices. There was, however, no consensus on the solution to the concern about this change in the profession. For example, the Panel on Audit Effectiveness (the "O'Malley Panel") addressed the effect on independence of providing non-audit services to an audit client. The O'Malley Panel Report concluded, however, by making "no recommendation regarding an exclusionary rule" because "[p]anel members have two distinct viewpoints on this question."23
With the goal of stimulating the dialogue towards that elusive consensus, the Commission issued its proposing release on June 27, 2000. We proposed one approach, but the release also expressly contemplated a number of alternatives. In a speech at the New York University Center for Law and Business, former Chairman Levitt had presaged this open-mindedness when he remarked
There are at least three possible ways to address these potential conflicts. Many in the profession once sought to establish broad "principles" of independence. Alternatively, greater public disclosure of the types and amounts of services offered could be required. Or, certain services considered inconsistent with an independent public audit could be prohibited. Each of these alternatives, as one might expect, has both advantages and drawbacks.24
For the Commission, the proposing release for the auditor independence rulemaking marked the official opening of the dialogue; the Commission was not drawing a line in the dust and daring the world to try to cross it. To be sure, the proposals reflected sincere thinking of the Commission and its staff, but we were also keenly aware that a final rule would rely upon contributions from the affected parties - accountants, registrants and the public - if it was to be fair and if it was to be effective. As the Chairman had suggested, we knew there was no easy or obvious answer.25 And as we had hoped, we learned a great deal as a result of the comment process.
For those who are not steeped in the subject, it should be pointed out that, as an intellectual exercise alone, prescribing useful auditor independence rules is an extraordinarily complex and challenging task. Once one leaves the domain of comfortable generality, the issues devolve into complexities, contradictions, and conflicting values. Making policy in this area is all the more daunting because the unavoidable absence of meaningful data requires the policymaker to rely on judgment more than calculation. Our experience is that, as a general matter, the public comment process is enormously useful. Here, it was especially so because of the range and intensity of reasonably held views. By the end of the comment process, we concluded that wisdom lay in capitalizing on the intelligence and attentiveness of investors and corporate boards of directors. The final rules leave many decisions about consulting services in the hands of companies and their boards but require disclosure of the financial dimensions of those decisions and about whether audit committees have considered the effect on auditor independence of the decisions the company had made. In so doing, we believed we had struck a fair balance that would both protect auditor independence, and therefore the integrity of financial statements, and help ensure that the attention to the issues that our rulemaking had fostered would not wane.
Because we had come to see information technology consulting as a particular problem, we decided on measures intended to underscore client responsibilities for those projects. In light of the nature of the potential conflict caused by information technology consulting, our rules also set forth special disclosure requirements for this category of non-audit services. The final rules do not, however, impose an outright ban on the provision of information technology services by a company's independent auditor. The departure from the proposal is but one clear example of many cases where the final rules reflected the decision to rely on the continuing attention by the diverse group of parties -accountants, registrants, and investors - who have a stake in the independence of auditors. Consistent with the Commission's general approach, the treatment of information technology consulting relies not insignificantly on the judgment of public company directors and investors.
We are pleased that the final rules incorporate ideas that came from the regulated and that they rely more on audit committees and investors using their own judgment than the proposed rules did. Because the process was open and because some good ideas came from all quarters, the final rules are better than what was proposed.
That the profession accepted the rules is an independently good thing. As the Second Circuit observed over 20 years ago in the Touche Ross opinion,26 the SEC cannot monitor every corporate registrant, nor can we monitor every auditor. The efficacy of our rules in significant measure depends on the good faith of those to whom they apply. So we truly welcomed the reconciliation with the major accounting firms over these issues.
The auditor independence rulemaking process was, to be sure, not just a cordial search for truth. Billions of dollars potentially were at stake, and the players - legitimately and lawfully - used all the persuasive powers at their disposal. But at the end of the day, the parties reached consensus where the public and private interests converged. That is why the new rules are good ones. There will be future chapters. As the public securities markets and the accounting profession continue their evolution, the Commission's rules will change as well. The SEC will remain prominent on the independence landscape, and there remains much to be done.
|1||See Commission Approves Auditor Independence and Market Structure Rules, November 15, 2000, available at http://www.sec.gov/news/headlines/audmarkt.htm.|
|2||"How Levitt Won the Accounting Wars," Business Week, November 27, 2000, p. 60.|
|3||See SEC Release Nos. 33-7919; 34-43602; 35-27279; IC-24744; IA-1911; FR-56; File No. S7-13-00, 65 FR 76008, available at http://www.sec.gov/rules/final/33-7919.htm (hereinafter Final Release).|
|4||See SEC Release Nos. 33-7870; 34-42994; 35-27193; IC-24549; IA-1884; File No. S7-13-00, June 30, 2000, 65 FR 43148, available at http://www.sec.gov/rules/proposed/34-42994.htm (hereinafter Proposing Release).|
|5||SEC v. Touche Ross, 609 F.2d 570 (2d Cir. 1979).|
|6||Id. at 580-81.|
|7||Testimony of Chairman Arthur Levitt Concerning the Commission's Authorization Request for Fiscal Year 1997 Before the Subcommittee on Telecommunications and Finance, Committee on Commerce, U.S. House of Representatives, February 28, 1996, available at http://www.sec.gov/news/testimony/testarchive/1996/spch086.txt.|
|8||See "SEC Calls For Rules To Curb Consulting By Auditing Firms," Wall Street Journal, June 28, 2000, C19; see also "S.E.C. Proposes Stricter Accounting Rules," New York Times, June 28, 2000, C1 (noting efforts by some in profession to enlist Congressional opposition to proposed rulemaking).|
|9||"Heavy Hitters Lined Up Against SEC's Limits on Accounting Industry," TheStreet.com, November 14, 2000, available at . http://www.thestreet.com/markets/marketfeatures/1173126.html.|
|10||As a footnote to history, future historians may wonder how the course of American electoral history might have been changed if, when the call came from the campaigns, these lawyers had been occupied litigating over the Commission's auditor independence rules.|
|11||See "Small Firms Urged to Back Independence in Auditing," New York Times, September 19, 2000, C2 ("Besides testifying against the proposal before the S.E.C., [the AICPA] has sought to rouse Congressional opposition and threatened to take the S.E.C. to court over any rule that it approved"); see also "SEC, in Surprise to Accounting Firms, Sets Vote on Conflict-of-Interest Rules," Wall Street Journal, November 7, 2000, A4 (commenting on activities to stymie adoption of final rules through legislative intervention).|
|12||Cf. Testimony of James J. Schiro, Chief Executive Officer, PricewaterhouseCoopers, LLP, before the Securities and Exhange Commission, September 21, 2000 (commenting on need to rebuild trust between the profession and the SEC), available at http://www.sec.gov/rules/proposed/s71300/testimony/schiro1.htm.|
|13||Throughout the struggles over the independence rules, the Commission dealt with the profession in other areas as if it were business as usual. The Commission entirely respects the right of any members of the public to challenge a regulatory action that they believe is beyond the agency's authority or otherwise in violation of the law.|
|14||See, e.g., Chairman Arthur Levitt, Renewing the Covenant With Investors, May 12, 2000, available at http://www.sec.gov/news/speech/spch370.htm.|
|15||Proposing Release, supra note 4, 65 FR 43148, 43154 ("Our concern is not just that an auditor will give in to a client. It is that, as auditors become involved in a broad array of business arrangements with their clients, they come to be seen by themselves, their firms, their clients, and investors less as exacting, skeptical professionals who must be satisfied before signing off on the financial statements, and more like any other service vendor who must satisfy the client to make the sale.").|
|16||http://www.us.kpmg.com/services/content.asp?l1id=10&l2id=10 (emphasis added.)|
|17||See Proposing Release, supra note 4, 65 FR 43148, 43149; Final Release, supra note 3 at 76029; see also SEC News Supplement: Remarks by Chairman Arthur Levitt at the Open Meeting on Proposals To Modernize Auditor Independence Rules, available at http://www.sec.gov/news/extra/audalvt.htm.|
|18||See, e.g., Item 26 of Schedule A under the Securities Act of 1933; Section 12(b)(1)(J) of the Securities Exchange Act of 1934; Section 13(a)(2) of the Securities Exchange Act of 1934; Section 314(a) of the Trust Indenture Act of 1939.|
|19||In 1947, the AICPA recognized that "Independence, both historically and philosophically, is the foundation of the public accounting profession and upon its maintenance depends the profession's strength and its stature." The Panel on Audit Effectiveness Report and Recommendations, August 31, 2000, p. 109 (hereinafter The O'Malley Panel Report) (quoting John L. Carey, The Rise of the Accounting Profession: To Responsibility and Authority, 1937-1969 (New York, 1970), p. 182).|
|20||See AICPA Code of Professional Conduct and the Statement on Standards for Consulting; AICPA SAS No. 1, AU § 220.01-02; see also AICPA Plain English Guide to Independence, available at http://www.aicpa.org/members/div/ethics/plaineng.htm.|
|21||See Testimony of William T. Allen, Chair, Independence Standards Board, Before the Securities and Exhange Commission, July 26, 2000, available at http://www.sec.gov/rules/proposed/s71300/testimony/allen2.htm.|
|22||See "S.E.C. Proposes Stricter Accounting Rules," supra note 8 ("This is the first time there has ever been a rule proposal on the scope of services these firms provide,' said Lynn Turner, the S.E.C.'s Chief Accountant. People have wondered whether that growing scope related to some of the major audit failures we have seen.'")|
|23||The O'Malley Panel Report, supra note 19, §§ 5.27, 5.25.|
|24||Renewing the Covenant with Investors, supra note 14.|
|25||See also Lynn E. Turner, Remarks to the Panel on Audit Effectiveness, July 10, 2000, available at http://www.sec.gov/news/speech/spch391.htm (identifying independence as "difficult" issue and remarking that "As everyone realizes, it can be a difficult and emotionally charged subject").|
|26||Supra note 5.|
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