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Proposed Rule:
Revision of the Commission's Auditor Independence Requirements

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release Nos. 33-7870; 34-42994; 35-27193; IC-24549; IA-1884; File No. S7-13-00]

RIN 3235-AH91

Revision of the Commission's Auditor Independence Requirements

AGENCY: Securities and Exchange Commission

ACTION: Proposed rule

SUMMARY: The Securities and Exchange Commission ("SEC" or "Commission") is soliciting comment on proposed rule amendments regarding auditor independence. The proposals modernize the Commission's requirements by providing governing principles 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. The proposals would, among other things, significantly reduce the number of audit firm employees and their family members whose investments in audit clients are attributed to the auditor. They would also identify certain non-audit services that, if provided to an audit client, would impair an auditor's independence. The scope of services proposals would not extend to services provided to non-audit clients. The proposals also would provide a limited exception for accounting firms that have certain quality controls and satisfy other conditions. Finally, the proposals would require companies to disclose in their annual proxy statements certain information about, among other things, non-audit services provided by their auditors during the last fiscal year.

DATES: Comments are due on or before September 25, 2000.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Comments also may be submitted electronically at the following e-mail address: rule-comments@sec.gov. Comment letters should refer to File No. S7-13-00; this file number should be included on the subject line if e-mail is used. All comment letters received will be available for public inspection and copying in the Commission's Public Reference Room at the same address. Electronically submitted comments will be posted on the Commission's internet web site (http://www.sec.gov).¹

FOR FURTHER INFORMATION CONTACT: John M. Morrissey, Deputy Chief Accountant, or W. Scott Bayless, Associate Chief Accountant, Office of the Chief Accountant, at (202) 942-4400, or with respect to questions about investment companies, John S. Capone, Chief Accountant, Division of Investment Management, at (202) 942-0590, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-1103.

SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to Rule 2-01 of Regulation S-X² and Item 9 of Schedule 14A³ under the Securities Exchange Act of 1934 (the "Exchange Act").⁴

I. Executive Summary

Independent auditors have an important public trust.⁵ Every day, millions of people invest their savings in our securities markets in reliance on financial statements prepared by public companies and audited by independent auditors.⁶ These auditors, using Generally Accepted Auditing Standards ("GAAS"), examine issuers' financial statements and issue opinions about whether the financial statements, taken as a whole, are fairly presented in conformity with Generally Accepted Accounting Principles ("GAAP"). While an auditor's opinion does not guarantee the accuracy of financial statements, it furnishes investors with critical assurance that the financial statements have been subjected to a rigorous examination by an impartial and skilled professional and that investors can therefore rely on them. Providing that assurance to the public is the auditor's over-arching duty.⁷

Investors must be able to put their faith in issuers' financial statements. If investors do not believe that the auditor is truly independent from the issuer, they will derive little confidence from the auditor's opinion and will be far less likely to invest in the issuer's securities. Fostering investor confidence, therefore, requires not only that auditors actually be independent of their audit clients, but also that reasonable investors perceive them to be independent.

One of our missions is to promote investor confidence in the reliability and integrity of issuers' financial statements. To promote investor confidence, we must ensure that our auditor independence requirements remain relevant, effective, and fair in light of significant changes in the profession, structural reorganizations of accounting firms, and demographic changes in society. Some of the important developments in each of these areas since we last amended our auditor independence requirements in 1983⁸ include the following:

firms are becoming primarily business advisory service firms as they increase the number, revenues from, and types of non-audit services provided to audit clients,
firms and their audit clients are entering into an increasing number of business relationships, such as strategic alliances, co-marketing arrangements, and joint ventures,
firms are divesting significant portions of their consulting practices or restructuring their organizations,
firms are offering ownership of parts of their practices to the public, including audit clients,
firms are in need of increased capital to finance the growth of consulting practices, new technology, training, and large unfunded pension obligations,
firms have merged, resulting in increased firm size, both domestically and internationally,
firms have expanded into international networks, affiliating and marketing under a common name,
non-CPA financial service firms have acquired accounting firms, and the acquirors previously have not been subject to the profession's independence, auditing, or quality control standards,
firms' professional staffs have become more mobile, and geographical location has become less important due to advances in telecommunications and internet services, and
audit clients are hiring an increasing number of firm partners, professional staff, and their spouses for high level management positions.

Having considered these and other developments and their effect on auditor independence, we are proposing rule amendments. The proposals start from the premise that investor confidence in auditor independence turns on whether auditors are in fact independent and appear to be independent. To strengthen the basis for that confidence, the proposals focus on those who can influence a particular audit. The proposals articulate four principles that would govern our determination of whether an accountant is independent of its audit client. Specifically, the proposals provide that an accountant is not independent whenever, during the audit and professional engagement period, the accountant: (i) has a mutual or conflicting interest with the audit client, (ii) audits the accountant's own work, (iii) functions as management or an employee of the audit client, or (iv) acts as an advocate for the audit client.

The proposals then describe certain relationships which, when considered in light of these principles, render an accountant not independent of an audit client. The relationships addressed by the proposals include, among others, the financial and employment relationships between auditors (or their family members) and audit clients, and relationships between auditors and audit clients where the auditors provide certain non-audit services to their audit clients.

Financial and Employment Relationships. Current requirements attribute to an auditor ownership of shares held by widely dispersed audit firm personnel and their families. In light of some of the developments described above, these rules may unnecessarily restrict investment and employment opportunities available to firm personnel and their families. The proposals shrink significantly the circle of firm personnel whose investments are imputed to the auditor. They also shrink the circle of family members and former firm personnel whose employment impairs an auditor's independence.

Non-Audit Services. We have become increasingly concerned that the dramatic increase in the nature, number, and monetary value of non-audit services that accounting firms provide to audit clients may affect their independence. Accordingly, the proposals specify certain non-audit services that, if provided by an accounting firm to an audit client, impair an auditor's independence in light of the four governing principles.

For example, the proposals provide that an accounting firm would not be independent from an audit client to which the firm provides valuation and appraisal services. Some accounting firms provide these services to audit clients,⁹ even though the firm's auditors must independently question the value of the appraised asset in auditing the audit client's financial statements. As such, the auditor may have participated actively in the process of developing asset values that are reported to investors in financial statements. The auditor then is required to challenge those same numbers during the audit. In this dual role as auditor and consultant, the accountant both oversees and answers to management, raising serious conflict of interest questions. Will the auditor be diligent and objective in reviewing the accounting firm's valuation work? If, during the audit, the auditor identifies a problem with the valuation or appraisal, will that auditor bring the problem to management's attention? Perhaps more important, even if the auditor made unbiased decisions, would investors believe that the auditor had been objective?¹⁰

The proposals do not extend to all non-audit services provided to audit clients. Not all non-audit services pose the same risk to independence. The proposals reflect what we believe to be a reasonable differentiation among various non-audit services, as well as our preference for narrowly drawn rules.

Quality Controls. Accounting firms and the public benefit when firms have effective quality controls that ensure the independence of audit professionals. These controls protect the public and the firms, on whose audits the public relies. Public companies benefit as well, since they are able to access capital at a lower cost through our capital markets. Therefore, for accounting firms that have certain quality controls, we are proposing a limited exception from the independence rules for certain independence failures that are cured promptly after discovery. This exception should encourage firms to institute controls to ensure the independence of the firm's personnel.

Disclosure of Non-Audit Services. Investors should have enough information to enable them to evaluate the independence of a company's auditors. The proposed rules would bring the benefits of sunlight to the auditor independence area by requiring companies to disclose in their annual proxy statements certain information about, among other things, the non-audit services provided by their auditors and the participation of leased personnel in performing the company's annual audit.

II. The Need to Preserve Auditor Independence

A. The Securities Laws Give Independent Auditors A Vital Mission and Responsibility

Capital formation depends on the willingness of investors to invest in the securities of public companies. Investors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance that the financial information disclosed by issuers is reliable.¹¹ Independent auditors play a key role in providing that assurance. Auditors follow specified procedures set forth in GAAS and express their opinion on whether the financial statements, taken as a whole, fairly reflect the financial position, results of operations, and cash flows of the company.¹² Based on the independent auditor's opinion, investors have reason to believe that financial statements are materially accurate, fair, and complete.

The federal securities laws, to a significant extent, make independent auditors "gatekeepers" to the public securities markets.¹³ These laws require, or permit us to require, financial information filed with us to be certified (or audited) by independent public accountants.¹⁴ Without an opinion from an independent auditor, the company cannot satisfy the statutory and regulatory requirements for audited financial statements and cannot sell its securities to the public.¹⁵ The auditor is the only professional that a company must engage before making a public offering of securities and the only professional charged with the duty to act and report independently from management. Because it is the issuer's responsibility to file independently audited financial statements, if the auditor is not independent, the issuer's filings are deficient under the securities laws.

In the fiscal year ended September 30, 1999, 13,460 public companies filed annual reports with the Commission. In the same period, the aggregate dollar volume for public offerings filed with the Commission was $2.1 trillion. While our staff reviews a great many filings, it is not able to review in detail all of the financial statements filed with us. We therefore must rely heavily on the accounting profession to be primarily responsible for the integrity of the large volume of financial information that forms the cornerstone of our full disclosure system.¹⁶

In creating this system, Congress granted the accounting profession an important public trust. Congress considered creating a corps of government auditors to review and audit companies' financial statements. Congress also considered mandating federal licensing of auditors. Instead, Congress entrusted the accounting profession with the responsibility of auditing the financial statements of companies registered with the SEC.¹⁷ In so doing, Congress gave the accounting profession both an enormously valuable franchise and a bedrock public responsibility.¹⁸

The Supreme Court has underscored the significant and unique role of the auditor. In United States v. Arthur Young & Co.,¹⁹ the Court considered whether to extend to auditors certain confidentiality protections available to legal counsel representing a client and preparing for trial. The Court refused to extend the protections, citing principally the differences between the roles of counsel and auditor. A lawyer, the Court noted, is a confidential advisor and advocate with a duty to present the client's case in the most favorable light. In contrast, the Court stated that the "independent certified public accountant performs a different role. By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client ... [and] owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public."²⁰ According to the Court, "This `public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust."²¹ The Court's words largely echoed those of Congress,²² the Commission,²³ and the accounting profession.²⁴

B. Independence in Fact and Appearance

To fulfill the important role assigned to the auditor, the auditor must approach each audit with professional skepticism and must have a willingness and freedom to decide issues in an unbiased and objective manner, even when the auditor's decisions may be against the interests of management of an audit client. According to a 1947 statement by the accounting profession, "The independent auditor is under a responsibility peculiar to his profession to maintain strict independence of attitude and judgment in planning and conducting his examination and in expressing his opinion on financial statements."²⁵ Further, the AICPA's SAS No. 1 requires that "in all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor...he must be without bias with respect to the client."²⁶

Because a principal purpose of auditor independence is to provide assurance to investors, the accounting profession has long required independence not only in fact but also in appearance. SAS No. 1 states, "Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence."²⁷ Accordingly, "Independent auditors should not only be independent in fact; they should avoid situations that may lead outsiders to doubt their independence."²⁸

The 1979 Report of the Public Oversight Board ("POB") echoes the point, noting that the appearance of independence is itself "a key ingredient to the value of the audit function, since users of audit reports must be able to rely on the independent auditor. If they perceive that there is a lack of independence, whether or not such a deficiency exists, much of that value is lost."²⁹ The Supreme Court made the same point in the Arthur Young decision:

The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries. It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional. . . . If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.³⁰

Auditor independence involves assumptions about human behavior that cannot be easily verified.³¹ While conflicts of interest are easily described, their actual impact on the "objectivity" of particular auditors can never be precisely known, because "objectivity," as the AICPA's professional standards note, "is a state of mind."³²

For this reason, the appearance standard serves an important legal purpose. It supplements an inquiry into the auditor's actual, subjective state of mind with an objective test: whether reasonable persons, knowing all relevant circumstances, would perceive that an auditor is independent. As the words connote, the appearance standard confines the inquiry into what is apparent and does not require an inquiry into the auditor's actual state of mind. The appearance standard, it should be stressed, is not a matter of "public relations." It does not require the auditor to guess how persons with only a superficial understanding of the relevant facts would view his or her actions. Appearance is measured only with respect to reasonable persons knowing all the relevant facts and circumstances.

Independence rules also must be prophylactic.³³ Auditor independence requires auditors "to be alert to a number of rather subtle influences... [T]here is a considerable range of individual abilities within the profession; some accountants are strong enough and alert enough to control themselves under the most adverse and perhaps even the most subtle influences; others are not so fortunate."³⁴ Our task in this area is to identify and address the influences that reasonably could be expected to pose an unacceptable risk that an auditor would lose his or her objectivity or that reasonable persons would perceive a loss of objectivity.

C. The New Business Environment Calls for Modernized Rules

In recent years, there have been significant demographic changes, changes in the accounting profession, and changes in the business environment that have affected accounting firms. Some of the more significant changes that have drawn attention to our auditor independence requirements include the increase in dual-career families, an ever-increasing mobility among professionals, a broadening international presence of accounting firms, and the growth and profitability of non-audit services offered by accounting firms to audit clients. These changes have led us to re-evaluate whether our auditor independence requirements remain effective, relevant, and fair.

1. Financial and Employment Relationships

We propose to update the requirements regarding financial and employment relationships between auditors or their family members and audit clients.³⁵ The existing requirements, among other things, attribute to the auditor investments of the relatives of the auditor "in varying degrees depending on the closeness of the [family] relationship,"³⁶ regardless of the amount of the holdings. They also attribute to auditors the investments of all partners and many professional employees in the accounting firm, as well as their families. The existing attribution rules may be too restrictive, since traditional family structures have changed, family members are more dispersed, there is increased mobility of professional employees, and accounting firms themselves are expanding around the globe. Accordingly, our proposals narrow many of these requirements, while protecting investor confidence in the reliability of financial information.

The proposals similarly narrow existing restrictions on the employment of auditors' family members, former audit firm employees, and former audit client employees who leave companies to work in audit firms. For example, with respect to employment restrictions on auditor's relatives, the proposals liberalize our existing position in several significant respects. First, the proposals reduce the pool of people within audit firms whose independence is required for an independent audit. Second, the proposals identify specific positions, namely those in which a person is in a position to or does influence the audit client's financial records, that would impair an auditor's independence if held by the auditor's relative. Finally, under the proposals, only positions at an audit client held by the auditor's "close family members" affect the auditor's independence. These proposals liberalize our current position and the ISB's position as reflected in its recent Invitation to Comment.³⁷

2. Scope of Services

(a) A Historical Perspective on the Provision of Non-Audit Services. In the 1970s, Congress seriously considered limiting the services independent public accountants could provide that were not directly related to accounting, even though at that time non-audit services did not constitute a large percentage of audit firms' businesses.³⁸ Although Congress did not take action, in 1979, the Chairman of the POB warned the public about dangers arising from the growth of non-audit services:

The [POB] believes that there is possibility of damage to the profession and the users of the profession's services in an uncontrolled expansion of MAS to audit clients. Investors and others need a public accounting profession that performs its primary function of auditing financial statements with both the fact and the appearance of competence and independence. Developments which detract from this will surely damage the professional status of CPA firms and lead to suspicions and doubts that will be detrimental to the continued reliance of the public upon the profession without further and more drastic governmental intrusion.³⁹

Our staff considered these issues in a 1994 Staff Report.⁴⁰ The Staff Report noted that much of the growth in non-audit services until then could be attributed to services provided to parties other than audit clients.⁴¹ Accordingly, the Staff Report concluded that no change in our rules or the federal securities laws was warranted at that time, but the staff promised to "continue to be alert to the development of problems of independence that may be caused by [non-audit services]."⁴² The staff has kept a watchful eye on these matters.

Other industry observers also have followed developments in this area. After the Staff Report, there were at least three significant studies by the private sector and one by the General Accounting Office ("GAO"). These studies emphasized the continuing public concern regarding the objectivity and independence of auditors, particularly in light of the expansion of consulting and other non-audit services for audit clients. The Advisory Panel on Auditor Independence (also known as the Kirk Panel), in its September 1994 report, described the trend toward non-audit services as "worrisome," because:

[g]rowing reliance on nonaudit services has the potential to compromise the objectivity or independence of the auditor by diverting firm leadership away from the public responsibility associated with the independent audit function, by allocating disproportionate resources to other lines of business within the firm, and by seeing the audit function as necessary just to get the benefit of being considered objective and to serve as an entree to sell other services....⁴³

Similarly, the AICPA Special Committee on Financial Reporting (also known as the Jenkins Committee), in its 1994 report, found that users of financial statements believed that non-audit service relationships could "erode auditor independence." The Report noted:

[Users] also are concerned that auditors may accept audit engagements at marginal profits to obtain more profitable consulting engagements. Those arrangements could motivate auditors to reduce the amount of audit work and to be reluctant to irritate management to protect the consulting relationship.⁴⁴

Two years later, in 1996, GAO completed a thorough review of the accounting profession. In its report, GAO noted:

GAO . . . believes that questions of auditor independence will probably continue as long as the existing auditor/client relationship continues. This concern over auditor independence may become larger as accounting firms move to provide new services that go beyond traditional services. The accounting profession needs to be attentive to the concerns over independence in considering the appropriateness of new services to ensure that independence is not impaired and the auditor's traditional values of being objective and skeptical are not diminished.⁴⁵

Most recently, in 1999, Earnscliffe conducted interviews to assess the perceptions of different audiences about auditor independence. In conclusion, Earnscliffe reported that, "Most [interviewees] felt that the evolution of accounting firms to multi-disciplinary business service consultancies represents a challenge to the ability of auditors to maintain the reality and the perception of independence...."⁴⁶

Taken together, these studies suggest that important constituencies see a connection between the business scope of accounting firms and auditor independence.

(b) Recent Developments. The menu of services offered by the firms to audit clients has grown dramatically and continues to grow.⁴⁷ Attached to this release, for commenters' convenience, is a list of services that auditors provide to their audit and non-audit clients.⁴⁸ Companies appear to be turning to their auditors for performance of their internal audit, pension, financial, administrative, sales, data processing, and marketing functions, among others.⁴⁹

U.S. revenues for management advisory and similar services⁵⁰ for the five largest public accounting firms amounted to more than $15 billion in 1999, based on amounts calculated from data published in the Public Accounting Report.⁵¹ Revenues for these service lines are now estimated to constitute half of the total revenues for these firms.⁵² In contrast, these service lines provided only 13 percent of total revenues in 1981.⁵³ From 1993 to 1999, the average annual growth rate for revenues from management advisory and similar services has been 26 percent; comparable growth rates have been 9 percent for audit, and 13 percent for tax services.⁵⁴

For the largest firms, the growth in management advisory and similar services involves both audit clients and non-audit clients. For the largest public accounting firms, MAS fees from audit clients have increased significantly over the past two decades. In 1984, only one percent of audit clients of the eight largest public accounting firms paid MAS fees that exceeded the audit fee.⁵⁵ The percent of Big 5 audit clients that paid MAS fees in excess of audit fees did not exceed 1.5 percent until 1997.⁵⁶ In 1999, 4.6 percent of Big 5 audit clients paid MAS fees in excess of audit fees,⁵⁷ an increase of over 200% in two years. For the five largest public accounting firms, MAS fees received from audit clients amounted to ten percent of all revenues in 1999.⁵⁸ Almost three-fourths of audit clients purchased no MAS from their auditors in 1999. This means that purchases of MAS services by one-fourth of firm's audit clients account for ten percent of all firm revenues.⁵⁹ In addition, the magnitude of MAS fees received from SEC registrants appears to distinguish the five largest accounting firms from other firms. The MAS fees received by the approximately 800 accounting firms with 1,000 or fewer SEC registrants as audit clients represent approximately one percent or less of total fees on average.⁶⁰

Certain transactions raise questions about auditor independence. Some smaller firms are consolidating their audit practices and seeking public investors in the resulting company.⁶¹ Other firms are entering into agreements to sell all of their assets except their audit practices to established financial services companies. As part of these agreements, the financial services companies also hire the employees of the accounting firm, and then lease back the majority or all of the assets and audit personnel to the "shell" audit firm. These lease arrangements allow the financial service firm to pay the professional staff for "nonprofessional" services for the corporate organization as well as professional attest services rendered for the audit firm.⁶²

In February 2000, Ernst & Young announced that it would sell its management-consulting business to Cap Gemini Group SA, a large and publicly-traded computer services company headquartered in France.⁶³ KPMG recently split off its consulting business into a separate corporation (KPMG Consulting, Inc.), sold preferred stock convertible to between 18.2% and 19.9% of its outstanding stock to Cisco Corporation, and announced its intention to sell additional shares to the public in an initial public offering.⁶⁴ PricewaterhouseCoopers has publicly announced its intention to re-structure its audit and consulting businesses along similar lines.⁶⁵

Under certain circumstances, these transactions could lead to violations of the independence rules, since the financial interests and relationships of the newly formed consulting entities would be imputed to the auditing firms. At a minimum, these transactions could raise serious public policy issues by creating relationships between firms and shareholders, strategic investors, and companies providing services to audit clients. In the case of Ernst & Young, our Chief Accountant, by no-action letter, stated that the Office of the Chief Accountant would not assert that Ernst & Young's independence from an audit client has been impaired solely because that audit client is also a client of, enters into a business relationship with, or is invested in by Cap Gemini. That no-action relief was based on, among other things, Ernst & Young's representations that: (1) following the initial sale to Cap Gemini, Ernst & Young's equity interest would be reduced to zero within five years, (2) Ernst & Young would play no role in the corporate governance of the consulting company, and (3) Ernst & Young would not have any co-marketing arrangements with the new entity.⁶⁶

(c) How Non-Audit Services Can Affect Auditor Independence. The dramatic expansion of non-audit services may fundamentally alter the relationships between auditors and their audit clients in two principal ways. First, as auditing becomes an ever-smaller portion of a firm's business with its audit clients, auditors become increasingly vulnerable to economic pressures from audit clients. Second, certain non-audit services, by their very nature, raise independence issues. These concerns, described more fully below, have led us to consider whether our rules should limit - or even completely bar - an auditor's provision of non-audit services to audit clients.

(i) Auditor Vulnerability to Economic Pressure From Audit Clients. Large non-audit engagements⁶⁷ may make it harder for auditors to be objective when examining their client's financial statements. Under any circumstances, it can be difficult for an auditor to make a judgment that works against the audit client's interest. Where making that judgment may imperil a range of service engagements of the firm, of which the audit is a fairly small part, it may be unrealistic to expect that an auditor can ignore completely what the firm stands to lose by the auditor's action.

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.⁶⁸

An expanded menu of relationships with an audit client may also give rise to a mutuality of interest between the auditor and client. This would be a significant concern in any era, but it may be especially important in an era when many ventures go quickly from start-up to apparent success to failure. For example, an audit firm may agree to perform the audit of a start-up company for fees significantly below market rates for a few years, in anticipation of "recouping" such an investment in the client through a subsequent initial public offering or performance of consulting services.

We also have concerns about the effect on an accounting firm's internal culture when the firm is trying to be an audit client's vendor of choice. As non-audit services become more important to a firm, that firm may care less about auditing and more about expanding its service lines. The factors that drive a high quality audit, including the core values of the auditing profession, may diminish in importance to the firm, as will the influence of those firm members who exemplified those core values in their own professional careers.

There appears to be growing public concern about audit firms' increasing provision of various non-audit services, and skepticism that firm safeguards adequately protect the fact and appearance of independence. Earnscliffe reports that auditors, audit committee chairs, chief executive officers, analysts, and regulators all, to some degree, recognize the independence risks posed by multifaceted relationships between auditors and their audit clients.⁶⁹ A majority of the Earnscliffe respondents felt that internal firm safeguards "might ultimately be insufficient to sustain confidence in the independence of auditors." According to the Report, those respondents

. . . felt that the judgement of observers would turn on how the financial incentives and penalties were organized: if it appeared that a firm had more upside in bending to a client's pressures, then internal processes would only be of limited value. Not everyone felt that this was the perception today, rather they were offering the view that internal firm safeguards had limited prophylactic value if the scrutiny were to become more punishing.⁷⁰

(ii) Independence Issues Inherent in the Nature of Certain Non-audit Services. Providing certain non-audit services to an audit client can lead an audit firm to have a mutual or conflicting interest with the client, audit its own work, advocate a position for the client, or function as an employee or management of the client.⁷¹ Auditor independence concerns arise, for example, when a company hires its audit firm to perform valuations of in-process research and development.⁷² When an auditor in effect, even if not in form, makes decisions for management, he or she functions as a member of the management team and may develop a "mutuality of interest" with the audit client. After all, a "consultant ...will be judged by the ultimate usefulness of his advice in bringing success to management's efforts. He has had a hand in shaping managerial decisions and will be judged by management on the same basis that the management itself will be judged. How then can he claim to be completely independent?"⁷³ The consultant is accountable to management, in contrast to the auditor, who must "acknowledge[] no master but the public."⁷⁴

(d) Measuring Independence Impairments. Some argue that no empirical evidence justifies our concerns. They argue that there is no evidence that providing non-audit services in general - much less particular types of non-audit services - leads to false financial reporting. Without this evidence, the argument goes, the Commission should not take steps to protect auditor independence.

It is common sense, however, and confirmed by studies, that a person's decision changes when he or she has a stake in the outcome of that decision.⁷⁵ Furthermore, common sense dictates that the more someone - including an auditor - has at stake, the more likely his or her decision is to be affected.

Studies cannot always confirm what common sense makes clear. Except where an auditor accepts a payment to look the other way,⁷⁶ is found to have participated in a fraudulent scheme,⁷⁷ or admits to being biased, it is largely impossible to observe an auditor's state of mind or know whether an auditor's mind is "objective." It is even harder to measure the impact a particular financial arrangement has on the auditor's state of mind. And it is similarly impossible to tie a questionable state of mind to a wrong judgment, a failure to notice something important, a failure to seek important evidential matter, a failure to challenge a management assertion, or a failure to consider the quality - not just the acceptability - of a company's financial reporting.⁷⁸ This is particularly true because auditing misjudgments may often go unnoticed.⁷⁹ As the POB noted, "Specific evidence of loss of independence through MAS, a so-called smoking gun, is not likely to be available even if there is such a loss."⁸⁰

Whatever the effect of non-audit service relationships on an auditor's conduct, there can be little question about the effect of these impairments on investor confidence. Gradual decreases in investor confidence may not be measurable, but their cumulative economic impact could not be more palpable. Investor confidence in the integrity of publicly available financial information is the cornerstone of our securities markets. That confidence is hard won and easily lost, and the Commission must act to protect it.

(e) Whether to Prohibit All Non-Audit Services. In developing these proposals, we considered whether independence is impaired whenever an auditor provides any non-audit service to an audit client, or whether certain non-audit services do not impair independence. We have tentatively concluded, pending public comment, that the better approach is to permit some significant non-audit services, though several factors weigh in favor of a blanket ban.

Prohibiting only some non-audit services does not address the increasing vulnerability of auditors to their audit clients and the corresponding link between the financial health of auditors and their clients. These concerns do not turn on the nature of the non-audit service involved, but arise simply because of the growing interdependence of auditor and client.

In addition, distinguishing between permissible and impermissible types of services raises difficult questions about services that do not fall squarely into precise categories. These questions will get only harder in the future as firms move to provide new and unforeseen services.

Finally, an approach that tries to distinguish between permissible and impermissible types of services depends heavily upon daily interpretations by the very firms the rules are intended to affect. In light of the powerful economic interests at stake, there is serious question whether it is fair or reasonable to expect accounting firms to evaluate the impact of new services on their own impartiality.

Despite these doubts, we believe that the measured approach we propose - establishing basic principles for evaluating any non-audit services' impact on independence, and identifying specific services that are plainly incompatible with independence - protects investor confidence in the audit process while allowing auditors to provide those services that are not reasonably viewed as creating a bias in the auditor. Our goal is to preclude non-audit services only to the extent necessary to protect the integrity and independence of the audit function. Of course, therefore, the proposals do not extend to services provided to non-audit clients.

3. Quality Controls

As accounting firms become more global and their business relationships with their audit clients become more complex, the need for quality controls to address independence becomes more apparent. Without strong quality controls, it may be difficult or impossible for an accounting firm to understand whether its independence may be impaired. For example, firms need quality controls to track whether the firm, or any covered person in the firm, has any direct investment in an audit client.

Our staff has stated that certain firms, particularly larger firms with public company clients, may lack sufficient worldwide quality controls.⁸¹ The staff has urged certain firms to review existing quality controls and ensure that particular areas are covered.⁸² Moreover, designing and implementing quality controls is not a one-time responsibility. We encourage accounting firms to continue to invest in state-of-the-art systems that can identify conflicts at an early stage to ensure a swift response. The speed of the response to a conflict, or potential conflict, is important to maintain public confidence in the self-regulatory process and the effectiveness of quality controls.⁸³

We understand that many firms are already designing and implementing quality controls. We recently announced a voluntary compliance program, in which the Big 5 accounting firms agreed to report past violations of auditor independence rules.⁸⁴ In connection with the program, the firms also have agreed to design and implement quality controls specified by our Chief Accountant and have the POB issue public reports on the results of their efforts. The rules we propose today are intended to encourage firms to design and implement effective quality controls to address independence. Toward that end, the rules contain a limited exception for firms that have appropriate quality controls and meet other conditions.

4. Proxy Disclosure

From 1978 to 1982, we required companies to disclose in their proxy statements all non-audit services provided by their auditors.⁸⁵ We also required companies to include a statement of the percentage of the fees for all non-audit services compared to total audit fees, the percentage of the fee for each non-audit service compared to total audit fees, and a statement whether each non-audit service was considered and approved by the audit committee of the board of directors or by the board itself.⁸⁶

In connection with the disclosure requirement, we published an interpretive release⁸⁷ describing certain factors that independent accountants, audit committees, boards of directors, and managements should consider in determining whether a company's independent accountant should be engaged to perform non-audit services. These factors included the auditor's dependence on non-audit fees, the possibility of the auditor supplanting management's role in making corporate decisions, the possibility of creating a situation where an auditor may be required to review its own work, and the relation of the non-audit activity to accounting and auditing skills.

Although our concerns regarding the provision of consulting and other non-audit services remained unchanged, we later determined to rescind the formal interpretive release⁸⁸ and the proxy disclosure requirement.⁸⁹ Among other reasons, our review of proxy disclosures convinced us that accounting firms were not providing extensive non-audit services to their audit clients. Our review of the 1979 and 1980 proxy disclosures of approximately 1,200 registrants showed that fees paid by audit clients for non-audit services generally constituted a relatively small fraction of registrants' audit fees.⁹⁰ In addition, we noted that, even without the proxy disclosure requirement, investors had access to useful data concerning the relative levels of audit and non-audit services provided by firms to their audit clients. In particular, we noted that summarized information regarding the relationship between MAS and audit fees was provided to the SECPS by member firms and was publicly available. We also concluded that the efforts of audit committees and the accounting profession to monitor firms' provision of non-audit services generally had been effective.

As discussed above, however, in recent years there has been a dramatic growth in the number of non-audit services provided to audit clients and the magnitude of fees paid for non-audit services.⁹¹ Moreover, there may be less information available to investors about these services since the SECPS has stopped publishing information about audit firms' provision of non-audit services. Further, information provided by the SECPS describes the mix of services provided by an accounting firm to all of its clients, while an investor generally is primarily interested in the services provided to an individual company. This information is not currently available.

Under circumstances where investors have less information about a matter that has become more important, we believe a disclosure requirement may once again prove useful to investors. Accordingly, we propose to reinstate a requirement that companies include in their proxy statements certain disclosures about non-audit services provided by their auditors during the last fiscal year. As we did while the requirement was in effect twenty years ago, we expect that both we and investors will learn from these disclosures and that they will have an impact on audit committees, investors, and accounting firms.⁹² Disclosure may be particularly effective now that investors have unprecedented access to information about companies in which they invest. We believe that investors should have access to information regarding the company's auditors when making investment decisions and when voting to elect, approve, or ratify the selection of, the accounting firm as the principal auditor of a company's financial statements.

We also believe that audit committees, as well as management, should engage in active discussions of independence issues with the outside auditors. According to the Blue Ribbon Report, "If the audit committee is to effectively accomplish its task of overseeing the financial reporting process, it must rely, in part, on the work, guidance and judgment of the outside auditor. Integral to this reliance is the requirement that the outside auditors perform their service without being affected by economic or other interests that would call into question their objectivity and, accordingly, the reliability of their attestation."⁹³

Recently, the ISB adopted ISB Standard No. 1, which requires each auditor to disclose in writing to its client's audit committee, all relationships between the auditor and the company that, in the auditor's judgment,⁹⁴ reasonably may be thought to bear on independence, and to discuss the auditor's independence with the audit committee.⁹⁵ Furthermore, we recently adopted new disclosure rules regarding audit committees and auditor reviews of interim financial information, in response to recommendations made by the Blue Ribbon Committee.⁹⁶ These new rules require that companies include in their proxy statements reports of their audit committees that state whether, among other things, the audit committees have received the written disclosures and the letter from the independent auditors required by ISB Standard No. 1,⁹⁷ and discussed with the auditors the auditors' independence. Our new requirements, and the new requirements of the ISB, the New York Stock Exchange, the National Association of Securities Dealers, Inc. and the American Stock Exchange⁹⁸ should encourage auditors, audit committees, and management to have robust and probing discussion of all issues that might affect investors' views of the auditor's independence.

D. The Need for a More Accessible Auditor Independence Framework

Currently, our auditor independence requirements are found in various Commission rules and interpretations. These have been supplemented over the years by staff letters, staff reports, and ethics rulings by the accounting profession.⁹⁹ Current Rule 2-01 of Regulation S-X sets forth the circumstances under which we will not recognize an accountant as independent.¹⁰⁰ Because Rule 2-01 does not address particular factual situations, we and our staff have issued interpretations of Rule 2-01 in response to public companies' questions about particular situations.¹⁰¹ The proposed revisions to Rule 2-01 would consolidate and make more accessible the standards for auditor independence under the federal securities laws, reemphasize its importance, and provide a comprehensive framework for evaluating auditor independence. The proposed proxy disclosures, if adopted, should add to the body of knowledge regarding the provision of non-audit services.

The new rules should also assist the ISB in its work. In FRR No. 50,¹⁰² we stated that we would look to the ISB to provide leadership in improving auditor independence requirements and in establishing and maintaining a body of independence standards applicable to auditors of public companies.¹⁰³ In the same manner, we previously have endorsed the establishment of the Financial Accounting Standards Board ("FASB").¹⁰⁴ Among other things, the ISB sets standards and its staff answers day-to-day inquiries regarding the application of our auditor independence requirements to specific situations confronting auditors and their clients.

The ISB has requested more guidance from us. For example, the ISB noted in ISB Standard No. 2,¹⁰⁵ the standard would not take effect until the SEC revises its rules on independence. Accordingly, our proposals and the attendant modifications to the Codification, if adopted, would enhance the ability of the ISB to make its standards effective. In addition, by providing a comprehensive framework, the new rules, if adopted, should assist the ISB in making future decisions regarding auditor independence matters.¹⁰⁶

III. Discussion of Proposed Rules

A. Qualifications of Accountants

Section 2-01(a) would remain unchanged and require that in order to practice before the Commission an auditor must be in good standing and entitled to practice in the state of the auditor's residence or principal office. This requirement has existed since the Federal Trade Commission first adopted rules under the 1933 Act.¹⁰⁷ It acknowledges our deference to the states for the licensing of public and certified public accountants.

B. The General Standard for Auditor Independence

Proposed rule 2-01(b) sets forth the basic test of an auditor's independence. Under that test, we will not recognize as independent an accountant who, with respect to an audit client, is not, or would not be perceived by reasonable investors to be, capable of exercising objective and impartial judgment on all issues encompassed within the auditor's engagement.¹⁰⁸ The general standard in paragraph (b) recognizes that an auditor must be independent in fact and appearance. Appearance is measured by reference to reasonable investors knowing all the relevant circumstances. As noted above,¹⁰⁹ independence in fact and the appearance of independence are inseparable.

To make the general standard more specific, paragraph (b) identifies four governing principles for determining when an auditor is not independent. The four principles incorporate situations that we believe reasonable investors would agree impair an auditor's independence. They are when the auditor:

has a mutual or conflicting interest with the audit client,¹¹⁰
audits the accountant's own work,¹¹¹
functions as management or an employee of the audit client,¹¹² or
acts as an advocate for the audit client.¹¹³

We believe these four basic principles provide a framework for analyzing auditor independence issues, in that actions inconsistent with one or more of these principles would result in a lack of auditor independence. We apply these principles in the remainder of the rules.

We request comment on the general standard and the four proposed principles. Do these four principles appropriately address the concept of auditor independence? If not, why not? Please describe any alternative formulation and why it is preferable. Some believe a basic principle of auditor independence is that the auditor will not subordinate his or her judgment to others.¹¹⁴ Should this be included in the proposed principles? Are there additional principles that should be included, and, if so, what are they, and do they reflect an impairment of independence?

Should the concept of mutual or conflicting interests be limited to economic interests? Would that limitation reach areas such as employment of close family members by an audit client? What forms of activities engaged in by accountants involve auditing their own work? What forms of activities constitute advocacy? Are there situations in which an auditor may act as an advocate for the audit client that would not impair the auditor's independence? If so, what are these, and why would they not impair independence? For instance, the principle regarding advocacy is not intended to prevent the accounting firm from explaining or defending (in court, if necessary) its work in an audit. Should that principle be modified to make that explicit? If so, how? Should accounting firms be permitted to lobby for an audit client before Congress, state legislatures, regulatory agencies, or other similar bodies?

C. Specific Applications of the Independence Standard

Proposed rule 2-01(c) ties the general standard and four principles of paragraph (b) to specific applications.¹¹⁵ It provides that an accountant is not independent under the standard of paragraph (b) if, during the audit and professional engagement period, the accountant has any of the financial, employment or business relationships with, provides certain non-audit services to, or receives a contingent fee from, the accountant's audit client or an affiliate of the audit client, as specified in paragraphs (c)(1) through (c)(5), or otherwise does not comply with the standard of paragraph (b). Paragraphs (c)(1) through (c)(5) address separately situations in which an accountant is not independent of an audit client because of: (i) a financial relationship, (ii) an employment relationship, (iii) a business relationship, (iv) the provision of non-audit services, or (v) the receipt of contingent fees.¹¹⁶

While paragraph (c) specifies a number of the relationships and other situations that might impair an auditor's independence, this list is not exhaustive. We cannot foresee all situations in which an auditor might lack independence. Accordingly, paragraph (c) includes a catch-all reference to any other situation in which an accountant "otherwise does not comply with the standard of paragraph (b) of this section."¹¹⁷

Auditor independence is more than a requirement imposed by the federal securities laws. Accountants have both a professional and ethical duty to remain independent of their audit clients,¹¹⁸ including an obligation to "avoid situations that may lead outsiders to doubt their independence."¹¹⁹ Accordingly, accountants may have to take steps to remain independent even if the steps are not specified in proposed rule 2-01.

In certain situations, the best course may be for the accountant to ask to be removed from the audit engagement. Neither we nor the profession's standards-setters can foresee every business or employment relationship, or investment that could affect the hundreds of decisions that an auditor must make during the course of an audit. On occasion, there may be a relationship, apart from those contemplated by any standard or rule, that has an important meaning to an individual accountant and could create, or be viewed as creating, a conflict with the accountant's duty to investors.¹²⁰ We therefore encourage accountants to seek to recuse themselves from any review, audit, or attest engagement if reasonable investors would view the accountant's ability to exercise objective and impartial judgment as compromised by any personal, financial, or business relationship, whether or not specifically discussed in the Commission's, the ISB's, or the profession's rules.

Paragraphs (b) and (c) require the accountant to be independent "during the audit and professional engagement period."¹²¹ This term is defined in proposed rule 2-01(f)(6) to mean the period covered by any financial statements being audited or reviewed, and the period during which the auditor is engaged either to review or audit financial statements or to prepare a report filed with us, including at the date of the audit report.¹²² The use of the word "during" in paragraphs (b) and (c) is intended to make clear that an accountant will lack independence if, for example, he or she is independent at the outset of the engagement but acquires a financial interest in the audit client during the engagement.

1. Financial Relationships

Proposed rule 2-01(c)(1) sets forth the general rule regarding financial relationships that impair independence and is substantially similar to current Rule 2-01(b). Both state that a direct or material indirect financial interest in an audit client will impair an auditor's independence with respect to that audit client. The remainder of paragraph (c) of the proposed rule provides a non-exclusive list of relationships in which an accountant has a direct or material indirect financial interest in an audit client and is, therefore, not independent. Accountants should not assume that financial interests not specifically described in (c)(i) through (c)(iv) do not impair independence.

(a) Investment in audit client. Proposed rule 2-01(c)(1)(i) provides that an accountant is not independent with respect to an audit client if the accounting firm, any covered person in the firm, or any immediate family member of any covered person has any direct investment in the audit client or in an affiliate of the audit client. Under current rules, the "direct financial interest" requirement prevents all partners in an accounting firm, all managers in the office performing the audit, and all persons on the engagement team, from having any financial interest in the audit client. This approach was intended to give effect to the principle of loyalty that the firm and all of its employees owe to public investors. It is based on the belief that the public generally perceives a firm as one entity in which individuals may have equal access to confidential client information, shared confidences, and common personal and financial interests.

Under the proposal, as under the current rules, the accounting firm (including its affiliates, such as its pension plan) cannot have a direct investment in an audit client and remain independent of that audit client. The proposal otherwise increases significantly the group of persons within the firm who can invest in an audit client without impairing the auditor's independence. Under proposed paragraph (c)(1)(i), the group of persons who cannot invest is limited to "covered persons in the firm" and their immediate family members. As explained in greater detail below, we define "covered persons" in proposed rule 2-01(f)(13) to include the "audit engagement team," those in the "chain of command," all other partners, principals, shareholders, or professional employees providing any professional service to the audit client or its affiliate, and any other partner, principal, or shareholder in an "office" that participates in a significant portion of the audit.¹²³ The proposal, like the current rule, would attribute all investments by a covered person's "immediate family members" -- that is, the covered person's spouse, spousal equivalent, and dependents -- to the covered person.¹²⁴

Paragraph (c)(1)(i)(A) applies to any direct investment in an audit client "such as stocks, bonds, notes, options, or other securities." As the language of the rule makes clear, this is not an exclusive list of all covered ownership interests. In addition, as under current law, the rule cannot be avoided through indirect means. For instance, an accountant who cannot have a direct investment in the audit client by virtue of being a covered person in the firm, may not hold the investment through a corporation or as a member of an investment club.¹²⁵

Under paragraph (c)(1)(i)(A), a direct investment in an affiliate of an audit client would be treated the same as an investment in the audit client. "Affiliate of the audit client" is defined in proposed rule 2-01(f)(5) to mean an entity that has significant influence over the audit client, or over which the audit client has significant influence.¹²⁶ Our concern is that, in both cases, there is a melding of financial interests and managerial functions of the entity and the audit client such that one can influence the accounting policies and financial transactions of the other. Once an audit client can exercise "significant influence" over the operating or financial policies of an entity, then under GAAP,¹²⁷ information from the financial statements of that entity will be reflected in the financial statements of the audit client. Similarly, if an entity can exercise influence over the audit client, information from the audit client's financial statements will be reflected in the entity's financial statements. In this case, the revenues and income of the audit client would directly affect the earnings of the entity in which the accountant has an investment.

Proposed rule 2-01(c)(1)(i)(A) applies only to a limited class of people, namely an accounting firm, as well as covered persons in the firm and members of their immediate families. Proposed rule 2-01(c)(1)(i)(B) applies to a larger class of people, including an accounting firm's partners, principals, shareholders, professional employees, and their immediate family members, the close family members of covered persons in the firm,¹²⁸ and any "group" of the foregoing persons.¹²⁹ Under proposed rule 2-01(c)(1)(i)(B), an accountant is not independent with respect to an audit client when any such person or group holds more than five percent of an audit client's outstanding voting securities or otherwise controls the audit client. We selected the five percent level, in part, because it triggers a separate filing with the Commission,¹³⁰ and therefore, in certain circumstances, the accountant will have an independent means of knowing the status of those persons' investments.

Proposed rule 2-01(c)(1)(i)(C) is a specialized application of the direct financial interest rule. It provides that an accountant is not independent when the accounting firm, any covered person in the firm, or any covered person's immediate family member serves as voting trustee of a trust or executor of an estate containing the securities of an audit client. In these positions, the firm or person typically makes investment decisions, or participates in making investment decisions, concerning the securities of the audit client. In this role, the firm or person typically has a fiduciary duty to preserve or maximize the value of the assets. We believe that this warrants treating the trustee or executor's interest as a direct financial interest in the audit client and deeming the auditor's independence impaired.

Proposed rule 2-01(c)(1)(i)(D) covers material indirect investments in an audit client. It describes the circumstances in which independence is impaired because of investments by the accounting firm, any covered person in the firm, any immediate family member of a covered person, or any group of these people in: (i) non-client entities that have an investment in an audit client ("non-client investors"), or (ii) companies in which an audit client also has invested ("common investees"). The current rule generally recognizes that these investments create a mutuality of interest if the auditor or the audit client owns more than five percent of the entity's equity securities.¹³¹

In both the "non-client investor" and "common investee" scenarios, an intermediary is placed between the auditor and the audit client. In one case, the auditor has invested in an entity that, in turn, has invested in the audit client. In the other, the auditor and the audit client are linked through a mutual financial interest in seeing their common investment grow and prosper. Because these financial ties are indirect, we believe that use of a materiality threshold continues to be appropriate. Accordingly, under the proposed rule, accounting firms, covered persons, and covered persons' immediate families can own up to five percent of an entity that invests in an audit client or of an investee in which an audit client also invests.¹³²

It should be remembered, however, that should the "non-client investor" or the "common investee" become an affiliate of the audit client, then as described under paragraph (A) regarding direct investments, the auditor may not have any investment in the intermediary entity. For example, assume auditor A invests in non-client company B, which owns an equity interest in audit client C. A may own up to five percent of the equity of B without impairing its independence from C, provided B does not "significantly influence" or is not "significantly influenced" by C. As discussed above, if such significant influence exists, then B is an affiliate of C and, under paragraph (A) regarding direct investments, A may not invest in B without impairing its independence from C. Similarly, assume auditor A invests in non-client company Z, and audit client C also invests in company Z. A may own up to five percent of the equity of company Z without impairing its independence from C, provided Z does not "significantly influence" or is not "significantly influenced" by C.

Proposed rule 2-01(c)(1)(i)(D) does not make a distinction for an indirect investment in an audit client by an auditor through an investment company. As a result, an auditor would not be independent if the auditor owns more than 5% of the outstanding stock of an investment company and the investment company holds an investment in an audit client.¹³³ The proposed rule, however, does not impose a limit on the portion of an investee company's (including an investment company's) assets that may be invested in the audit client, assuming the auditor owns less than five percent of the investee company and the investee is not an affiliate of the audit client. For example, an operating company or an investment company (Company A) could have a significant portion of its assets invested in Company B, and an auditor could own up to five percent of Company A's stock and audit Company B, so long as B is not an affiliate of A.

We considered limiting the portion of an investee company's assets that could be invested in an audit client without impairing auditor independence. We request comment on whether there should be a limit on the portion of an investee's total assets that can be invested in an audit client without independence being impaired in addition to, or in place of, the proposed indirect investment test. If so, where should the limit be set? Would a 10% percent or 25% level be appropriate?

If we use that approach, should the rule for registered investment companies turn on their diversification status?¹³⁴ Limitations on material indirect investments in an audit client may be difficult for auditors to apply in practice when they invest in an investment company. Auditors have no easy way to determine how much of an investment company's assets are invested in an audit client or how much of an issuer's securities are owned by an investment company because many investment companies' portfolios change frequently. Because funds are required to disclose their diversification status in their registration statements, accountants could easily determine, by looking at a fund's registration statement, whether an investment in the fund by the accounting firm, a covered person in the firm or such person's immediate family might impair an accountant's independence under the rule. Should we permit an investment in any registered investment company that is "diversified" under the ICA, provided it is not part of the same investment company complex as an audit client?¹³⁵ Would this be one way to prevent inadvertent violations of the independence rules?

We solicit comment on all aspects of the financial interest rules in paragraph (c)(1)(i). In particular, would reasonable investors be concerned that investments of the sort described in this section would impair an auditor's independence? Should the restrictions on financial ownership interests apply to all partners (but not their immediate family or employees of the firm) of an audit firm, as the partners represent the partnership?

Is the five percent threshold for financial interest in an audit client by persons who do not influence the audit appropriate? For example, would reasonable investors perceive a firm's independence to be impaired if a partner or employee in an office that did not work on the audit, held four percent of the audit client? If the five percent threshold is not appropriate, what threshold is appropriate, and which individuals should be subject to the restriction?

Furthermore, is it appropriate to base the determination, as we do, on ownership of five percent or more of a company's equity securities? Should we be more specific and indicate whether to account for common and preferred shares, and voting and non-voting shares? If so, what types of shares should be included (i.e., voting shares only)? If the determination depends on ownership of outstanding voting shares, should all shares, regardless of the number of votes different classes of shares have, count the same?

Would reasonable investors perceive an accountant's independence to be impaired if any partner, shareholder, or professional employee of the accountant's firm has an investment in an audit client that is more than five percent of the individual's net worth, even if it represents less than five percent of the ownership of the audit client's equity securities?

Suppose that ABC Accounting Firm audits XYZ Corp. Partner A is a covered person in the firm for the XYZ audit. In the following situations, would a reasonable investor be concerned about the independence of the auditor:

(i) A grandchild of Partner A owns more than five percent of the equity of XYZ Corp;

(ii) Partner A's siblings each own four percent of the equity of XYZ Corp. The siblings do not act together in their investment activities in such a way as to constitute a group under the proposed definition of group;

(iii) Partner A's brother-in-law owns ten percent of the equity of XYZ Corp;

(iv) Partner A's sister-in-law owns 20 percent of the equity of XYZ Corp; or

(v) Five partners of ABC Accounting Firm, none of whom are covered persons and not acting as a "group," each own four percent of the equity of XYZ Corp.

Are there other persons whose investment in the XYZ Corp. may cause concern regarding the independence of Partner A?

We solicit comment on all aspects of the proposals regarding investments in audit clients in paragraph (c)(1)(i)(D). Do investments in an intermediary affect the auditor's independence when the intermediary has an investment in an audit client that an auditor could not have directly without impairing the auditor's independence? If the auditor has an investment greater than five percent in the intermediary, but the intermediary has an investment in the audit client that is less than five percent of the audit client, is the auditor's independence impaired? What if the intermediary's investment is less than five percent of the audit client but material to the auditor or intermediary?

Suppose that the pension fund of ABC Accounting Firm has a 4.9 percent ownership of DEF Corp. DEF is not an audit client of ABC. DEF in turn has a substantial investment in XYZ Corp., an audit client of ABC. DEF and XYZ are not affiliates. Would a reasonable investor perceive that the accountant's independence was impaired? Is five percent an appropriate threshold? Would a lower threshold enhance investor confidence in auditor independence? The proposed rule on material indirect investments includes investments by the accounting firm, any covered person in the firm or any of his or her immediate family members, or any group of such persons. Should other persons be included?

Suppose that the pension fund of ABC Accounting Firm has a 4.9 percent ownership of DEF Corp. DEF is not an audit client of ABC. XYZ Corp., an audit client of ABC, has a substantial investment in DEF, but XYZ and DEF are not affiliates. Would reasonable investors perceive that the accountant's independence was impaired? The proposed rule includes investments by the accounting firm, any covered person in the firm or any of his or her immediate family members, or any group of such persons. Should other persons be included? Are there any investments that you believe would impair an auditor's independence that the proposed rules permit? If so, what are they, and why do they raise independence concerns?

(b) Other financial interests. Proposed rule 2-01(c)(1)(ii) describes other financial interests of an auditor that would impair an auditor's independence with respect to an audit client because they create a debtor-creditor relationship or other commingling of the financial interests of the auditor and the audit client. In some situations (e.g., bank deposits or insurance), the continued viability of the audit client may be necessary for protection of the auditor's own assets or for the auditor to receive a benefit (e.g., insurance claim). These situations reasonably may be viewed as creating a self-interest that competes with the auditor's obligation to serve only investors' interests. We discuss several of these situations here.

(i) Loans/debtor-creditor relationships. The proposals provide that the accountant will not be independent when the accounting firm, or any covered person in the accounting firm, or any of the covered person's immediate family members has any loan (including any margin loan) to or from an audit client, the officers of an audit client or an affiliate of an audit client, the directors of an audit client or an affiliate of an audit client, or record or beneficial owners of more than five percent of the equity securities of an audit client or its affiliate. We considered adding to the proposal the AICPA's Ethics Ruling on loans to or from audit clients.¹³⁶ The ruling indicates that any loan would impair the auditor's independence, unless the loan was from a financial institution; acquired in accordance with that institution's normal lending procedures, terms and requirements; kept current as to all its terms; and, was: (1) an automobile loan or lease collateralized by the automobile; (2) a loan on the cash surrender value of an insurance policy; (3) a "passbook loan" collateralized by cash deposits at the same institution; or (4) credit cards or cash advances on checking accounts with an aggregate balance not paid of less than $5,000. We are proposing a more liberal approach since our proposal sets the credit card balance threshold at $10,000, permits a mortgage loan not obtained during the period of the audit or professional engagement, and because, unlike the AICPA ruling, the proposed rule covers only the relatively small group of entities and people that could influence the audit.

We solicit comment on our approach to loans. Should we expand the rule to cover close family members as opposed to just immediate family members? For example, would a $1,000,000 home loan from an audit client to the auditor's brother-in-law be perceived as affecting the independence of the audit partner? Does the answer change if the loan is unsecured? Are there other categories of loans that should be excluded, similar to car loans? Are there circumstances under which a loan to or from an audit client would not impair an auditor's independence?

(ii) Savings and checking accounts. The proposals provide that an accountant will not be independent when the accounting firm, or any covered person in the accounting firm, or any of the covered person's immediate family members has any savings or checking account at a bank or savings and loan that is an audit client or its affiliate, if the account has a balance that exceeds the amount insured by the Federal Deposit Insurance Corporation ("FDIC"). Would reasonable investors perceive an accountant's independence to be impaired if an accountant or the accountant's immediate family member has any savings or checking account at an audit client or the audit client's affiliate? Would an accountant's independence be impaired if a covered person maintained a balance in a non-federally insured bank that is an audit client? Are there other institutions that are similar to a bank or savings and loan that should be included? Are any of the risks to independence mitigated by depository insurance similar to that provided by the FDIC? Why or why not? Would the financial condition of the bank or other depository institution affect reasonable investors' perceptions?

(iii) Broker-dealer accounts. The proposals provide that an accountant will not be independent when the accounting firm, or any covered person in the accounting firm, or any of the covered person's immediate family members has any brokerage or similar account maintained with a broker-dealer that is an audit client or an affiliate of an audit client if any such accounts include any asset other than cash or securities (within the meaning of "security" provided in the Securities Investor Protection Act ("SIPA")), or where the value of the assets in the accounts exceeds the amount that is subject to a Securities Investor Protection Corporation ("SIPC") advance for those accounts, under Section 9 of SIPA. Our proposal is rooted in a concern that, to the extent that the assets of an accountant (or covered persons or their family members) in a broker-dealer account are exposed to loss in the event of the broker-dealer's financial failure, the accountant has an interest in the financial condition of the broker-dealer.

When an accounting firm, a covered person, or a covered person's immediate family member maintains such accounts at an audit client, would reasonable investors perceive that auditor independence is impaired? Should covered persons be considered not independent if they have an account with a broker-dealer that is an audit client, regardless of whether the assets in the account are subject to a SIPC advance? Are there better ways to identify broker-dealer accounts that impair an auditor's independence? For example, the proposal's provision on loans and debtor-creditor relationships provides that a margin loan impairs an auditor's independence. Should the provision concerning broker-dealer accounts state that maintaining a margin account with a broker-dealer impairs an auditor's independence as to that broker-dealer, whether or not any margin debt exists? Are there other types of accounts that might be maintained with a broker-dealer that the rule should specifically identify as impairments to independence? If so, what types of accounts, and why do they impair, or appear to impair, independence?

Should the rule specifically address short positions, or the writing of options, in an account with a broker-dealer? If so, should the rule provide that those types of accounts, when held by the accounting firm, any covered person in the firm, or such person's immediate family member, impair independence as to the broker-dealer with whom the account is maintained?

Is it impractical for accountants (and covered persons and family members) to monitor whether the assets in their broker-dealer accounts are within the amounts subject to a SIPC advance? Are there preferable alternative formulations that would accomplish the goal of deeming independence to be impaired only in those situations where the accounts include assets that are exposed to loss in the event the broker-dealer fails? Or is that goal too narrow? Should the rule impose additional limits on accounts even though the assets in the accounts stay within the amounts subject to a SIPC advance? For example, an auditor might control several different types of accounts, each of which qualify for SIPC coverage. Should the rule impose some limit on the number or total assets of such accounts with a broker-dealer audit client? What should those limits be, and why?

Would it be preferable to provide that independence is impaired as to any broker-dealer audit client with whom the accountant (or covered person or covered person's family member) maintains any account, regardless of whether the account's assets are within the limits subject to a SIPC advance?

In addition to SIPC protection, broker-dealers sometimes purchase insurance from private insurers to protect customer assets. Should the rule take that type of insurance into account? If so, how?

(iv) Futures commission merchant accounts. The proposals provide that the accountant will not be independent when the accounting firm, or any covered person in the accounting firm, or any covered person's immediate family member has any futures, commodity, or similar account maintained with a futures commission merchant ("FCM") that is an audit client or an affiliate of the audit client. This proposal is rooted in a concern that, to the extent that the assets of an accountant (or covered persons or their family members) in an FCM account are exposed to loss in the event of the FCM's financial failure, the accountant has an interest in the financial condition of the FCM. We solicit comment on whether maintaining such accounts could impair, or would appear to reasonable investors to impair, an auditor's independence. Are there different types of FCM accounts or different types of assets maintained in FCM accounts that should be distinguished from each other for purposes of determining auditor independence? What distinctions should be made? Are there conditions under which an accountant (or covered person or covered person's family member) could maintain an account with an FCM but have no interest in the financial condition of the FCM? If so, what are those conditions? How, if at all, should the rule take those conditions into account?

(v) Credit cards. We are proposing that credit card balances of $10,000 or less owed by a firm, a covered person, or any covered person's immediate family member to an audit client or its affiliate, not be deemed to impair an auditor's independence.¹³⁷ We do not believe that a relatively minor credit card balance would create or appear to create a mutuality or conflict of interest with the lender-audit client. Furthermore, a strict prohibition of such accounts might unnecessarily affect a firm's ability to assign staff to provide short-term technical advice to the audit engagement team. Would reasonable investors perceive an accountant's independence to be impaired if a covered person held a credit card balance in excess of $10,000 with a lender that is an audit client? Is $10,000 an appropriate limit?

(vi) Insurance products. Proposed rule 2-01(c)(1)(ii)(F) provides that an auditor's independence is impaired whenever the accounting firm, any covered person in the firm, or any immediate family member of a covered person holds any individual insurance policy originally issued by an insurer that is an audit client or an affiliate of an audit client. Additionally, under the proposed rule, an auditor's independence is impaired if the audit firm obtains professional liability coverage from an audit client or its affiliate. Holding these policies creates a mutual interest in the continuing viability of the insurer.

We solicit comment on whether an accountant's independence is impaired, and on whether reasonable investors would perceive an accountant's independence to be impaired, if the accountant or a member of the accountant's immediate family originated an individual insurance policy with an insurance company that is an audit client or an affiliate of an audit client. Should the proposed rule cover all insurance policies, or be limited, such as to life insurance policies? Would an accounting firm's independence be impaired if the accounting firm acquired from an audit client insurance such as (i) insurance for litigation or indemnification losses, (ii) group health, or (iii) group life insurance policies? Should an accounting firm be permitted to purchase professional liability coverage through an audit client?

(vii) Investment companies. Proposed rule 2-01(c)(1)(ii)(G) sets forth the rule for investment by accounting firms, covered persons and covered persons' immediate family members in an investment company or a related entity. The proposed rule provides that an auditor is not independent if the auditor invests in any entity in an investment company complex if the audit client is also an entity included in that investment company complex. Proposed rule 2-01(f)(16) defines "investment company complex" as an investment company and its investment adviser or, if the company is a unit investment trust, its sponsor; any entity controlled by, under common control with, or controlling the investment adviser or sponsor, such as the distributor, administrator or transfer agent; and any investment company or an entity that would be an investment company but for the exclusions provided by section 3(c) of the ICA¹³⁸ that is advised by the same adviser or a related adviser, or sponsored by the same sponsor or related sponsor.

Proposed rule 2-01(c)(1)(ii)(G) makes clear that when an audit client is part of an investment company complex, the accountant must be independent of each entity in the complex. The proposed rule follows ISB Standard No. 2 on this point. Under ISB Standard No. 2, the firm and those in the firm who are in a position to influence an audit must be independent from each fund in the fund complex and each entity in the fund complex in order to be independent with respect to any fund or entity in the complex.¹³⁹

In addition to the requirement that the auditor have no investment in any entity in the investment company complex, the auditor also must be independent with respect to its other relationships with entities within the complex. For example, an auditor could not be a director for an entity within an investment company complex while auditing an entity in the complex.

Should we follow the standard of ISB Standard No. 2 that an accountant must be independent of the entire investment company complex to be independent of any entity in that complex? Is this standard sufficiently clear and capable of implementation? If not, what modifications are needed? Does this standard have implications outside the area of investments (e.g., employment relationships, business relationships, or the provision of non-audit services) that go beyond what is necessary to safeguard independence?

Are there certain complex capital structures, such as master/feeder or fund of funds, that require specific clarification as to an auditor's independence when the auditor audits one or more entities in that structure? Are there any unique implications of applying the proposed independence rules to investment companies, investment advisers, sponsors of unit investment trusts, and affiliated or unaffiliated service providers? If so, what are they and how should they be addressed?

(c) Exceptions. Proposed rule 2-01(c)(1)(iii) would provide two limited exceptions to the financial relationship rules. These exceptions recognize that there are situations in which an accountant, by virtue of being given a gift of or inheriting a financial interest from a third party, or because the accounting firm has taken on a new audit client, may lack independence solely because of events beyond the accountant's control. In these circumstances, and provided the financial interest is promptly disposed of or the financial relationship is promptly terminated, we believe that reasonable investors would not necessarily perceive the accountant to be incapable of exercising objective and impartial judgment.

(i) Inheritance and gift. Proposed rule 2-01(c)(1)(iii)(A) provides that an accountant's independence will not be impaired if any person acquires a financial interest through an unsolicited gift or inheritance that would cause the accountant to be not independent under (c)(1)(i) or (c)(1)(ii), and the financial interest is disposed of as soon as practicable, but no longer than 30 days after the person has the right to dispose of such interest. We solicit comment on all aspects of the gift and inheritance exception. Does the exception capture all situations in which a person subject to the financial relationship rules might enter into a restricted financial relationship and yet not give rise to any independence concerns? Are there situations in which an accounting firm might have no option but to receive its fee in its audit client's stock as a result of a court settlement? If so, should there be an exception for these situations, and how would such an exception work? Does the rule provide affected persons with adequate means to "cure" the lack of independence? For example, should the rule expressly allow a covered person to recuse himself or herself from an engagement or the chain of command rather than disposing of the financial interest?

Would an accountant's independence be impaired if the covered person was restricted from disposing of the financial interest for an extended period? For example, suppose XYZ Corp. is the audit client of ABC Accounting Firm. Partner A is a covered person in the firm. Partner A becomes the beneficiary of a testamentary trust fund that includes $2 million in equity securities of XYZ Corp. This amount constitutes 40 percent of the amount of the trust, and 30 percent of Partner A's net worth. The terms of the trust fund prohibit disposing of the XYZ investment for a period of five years. Would a reasonable investor perceive ABC's independence to be impaired?

Assume the same facts as above, except that the securities are received directly by Partner A. Would placing those securities in a "blind trust" remedy the independence question? Can an individual be impartial if he or she knows what securities are held in the blind trust?

(ii) New audit engagement. Proposed rule 2-01(c)(1)(iii)(B) is designed to allow accounting firms to bid for and accept new audit engagements, even if a person has a financial interest that would cause the accountant to be not independent under the financial relationship rules. This exception is available to an accountant so long as the accountant did not audit the client's financial statements for the immediately preceding fiscal year, and the accountant was independent before the earlier of either accepting the engagement to provide audit, review, or attest services to the audit client; or commencing any audit, review, or attest procedures (including planning the audit of the client's financial statements).

The new audit engagement exception of proposed rule 2-01(c)(1)(iii)(B) is necessary because an auditor must be independent, not only during the period of the auditor's engagement, but also during the period covered by any financial statements being audited or reviewed.¹⁴⁰ Because of an existing financial relationship between an accounting firm or one of its employees and a company (that is not an audit client), an accounting firm may not be able to bid for or accept an audit engagement from the company without this exception. For example, where a firm's pension plan or a covered person in the firm owns the stock of a potential audit client during the period of the financial statements to be audited or reviewed, the accounting firm could not compete for the audit engagement but for this exception. This exception allows firms to bid for and accept engagements in these circumstances, provided they are otherwise independent of the audit client and they become independent of the audit client under the financial relationship rules before accepting the engagement or beginning any audit, review, or attest procedures.

We solicit comment on all aspects of the new audit engagement exception. Will the exception, as a practical matter, allow accounting firms to bid for and accept new audit engagements when they become available? Is the exception appropriate even though the auditor's independence would otherwise be considered impaired? Should the exception also extend to employment relationships, business relationships, or the provision of non-audit services? Does the existence of an employment relationship or the provision of non-audit services during the period covered by the financial statements raise independence concerns that cannot be "cured" before beginning the engagement in the same way that a financial relationship during this period can?

(d) Audit Clients' Financial Relationships. Proposed rule 2-01(c)(1)(iv) provides that an accountant is not independent when its audit client has invested, or otherwise has a financial interest in the accounting firm or an affiliate of the accounting firm.

(i) Investments by the audit client in the auditor. Under proposed rule 2-01(c)(1)(iv)(A), an accountant's independence is impaired with respect to an audit client when the audit client or an affiliate of an audit client has, or has agreed to acquire, any direct investment in the accounting firm or its affiliate, whether in the form of stocks, bonds, notes, options, or other securities. This impairment occurs primarily for two reasons.

First, the accountant may be placed in the position of auditing the value of the securities of the accounting firm or its affiliates that are reflected as an asset in the financial statements of the audit client. This could result when an auditor in an accounting firm whose shares are held by the audit client must value the shares of that accounting firm held by the audit client for purposes of including that valuation in the audited financial statements.

Second, the accountant reasonably may be assumed to have a mutuality of financial interest with the owners of the firm and of the firm's affiliates, including an audit client-shareholder. The audit firm, as management, will be responsible to its shareholders, and one of the shareholders may be an audit client. Thus, there may be situations where a shareholder-audit client is in a position to influence the accountant because the accountant would owe a fiduciary responsibility to that audit client-shareholder and would be accountable to that audit client for the accounting firm's activities.¹⁴¹ For example, an audit client-shareholder is legally entitled to receive certain notices, invoke "dissenters' rights," and nominate candidates for directors under most state corporation laws. Consequently, an accountant, as management, would have fiduciary obligations to an audit client-shareholder who, acting alone or in combination with other shareholders, may be in a position to exercise some measure of influence over the accountant.

Are there other situations in which an audit client could have a financial interest in the accounting firm that would impair independence? For example, would a reasonable investor perceive an accountant's independence to be impaired if the audit client's CEO held a substantial investment in the accounting firm? Would it make a difference if the investment was significant to the CEO's net worth? Should there be a maximum allowable investment by audit clients in their auditors? If so, what should the threshold be? Does it matter if the investment is material to the investor or one of its affiliates?

(ii) Underwriting. Few transactions are as significant to the financial health of a company, including an accounting firm, as the sale of its securities, whether in private or public offerings. In an offering, an underwriter either buys and then resells a company's securities or receives a commission for selling the services. In either circumstance, were an audit client to act as underwriter of an accounting firm's or its affiliate's securities, the audit client would assume the role of advocate or seller of the accounting firm's securities. Moreover, depending on the terms of the underwriting, the underwriter could for a time become a significant shareholder of the accounting firm. There also may be indemnification agreements that place the underwriter and auditor in adversarial positions.

Relying on an audit client to sell the accounting firm's securities plainly impairs independence. The accounting firm would have a direct interest in ensuring the underwriter's viability and credibility, either of which could be damaged as the result of an audit. Moreover, the auditor would have a clear incentive not to displease an audit client to which it had entrusted a critical financial transaction. Similar conflicts of interest may arise if an audit client or an affiliate of an audit client performs other financial services for an accounting firm or its affiliates, such as making a market in the accounting firm's or its affiliate's securities or issuing an analyst report concerning the securities of the accounting firm or its affiliate.

We request comment on whether we have addressed all situations in which the independence concerns arise because the audit client or its affiliate performs a financial service for the accounting firm or an affiliate? Are there financial services that an audit client or its affiliate could provide to its auditors or the accounting firm or its affiliate that would not raise these concerns? For example, would reasonable investors perceive an accountant's independence to be impaired if an audit client or an affiliate of an audit client made a market in the securities of the accounting firm or prepared and issued research reports on the accounting firm?

2. Employment Relationships

Proposed rule 2-01(c)(2) sets forth the employment relationships that impair an auditor's independence. This paragraph is based on the premise that when an accountant is either employed by an audit client, or has a close relative or former colleague employed in certain positions at an audit client, the accountant might not be capable of exercising the objective and impartial judgment that is the hallmark of independence.

As with the financial relationships provision, paragraph (c)(2) sets forth the general standard that an accountant is not independent if the accountant has an employment relationship with an audit client or an affiliate of an audit client. The proposed rule then provides a non-exclusive list of relationships that are inconsistent with the general rule of paragraph (c)(2). Again, accountants should not assume that all employment relationships not specifically described in (c)(2)(i) through (c)(2)(iv) do not impair independence. All non-specified employment relationships are subject to the general test of paragraphs (b) and (c)(2).

(a) Employment at audit client of accountant. Proposed rule 2-01(c)(2)(i) continues the principle set forth in current Rule 2-01(b) that to be independent, neither the accountant nor any member of his or her firm can be a director, officer, or employee of an audit client. The paragraph therefore provides that an accountant is not independent if any current partner, principal, shareholder, or professional employee of the accounting firm is employed by the audit client or an affiliate of an audit client, or serves as a member of the board of directors or similar management or governing body of the audit client or an affiliate of the audit client. In the most basic sense, the accountant cannot be employed by his or her audit client and be independent.

(b) Employment at audit client of certain relatives of accountant. Proposed rule 2-01(c)(2)(ii) specifies the family members of the auditor whose employment in certain positions by an audit client or its affiliate will impair the auditor's independence. For the employment category, the interests and relationships of a covered person's close family members -- that is, the covered person's spouse, spousal equivalent, dependents, parents, nondependent children, and siblings -- are attributed to the covered person in the firm. This stands in contrast to the investment category, where only the interests of the covered person's immediate family members (i.e., spouse, spousal equivalent, and dependents) are attributed to the covered person. We believe this distinction is justified because, while some close family members' investments may not be known to a covered person, the place and nature of such family members' employment should be obvious, and thus may affect the covered person's objectivity and impartiality.

We do not consider an audit client's employment of even a close family member, however, to impair an auditor's independence unless that family member is in a position to, or does, influence the preparers or the contents of the accounting records or financial statements of the audit client or its affiliate. The proposed rule uses the defined term "accounting or financial reporting oversight role" to describe the persons in this group. The term is defined in proposed rule 2-01(f)(3). To reduce uncertainty, the definition lists those positions that generally carry with them the type of influence about which we are concerned. These positions include: a member of the audit client's board of directors (or similar management or governing body), chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, vice president of marketing, or any equivalent position.

The proposed rule eliminates the so-called "five hundred mile rule." Under that rule, when a family member has an interest in or relationship with an audit client, consideration is given to whether the geographic separation of that family member from both the person in the firm and the conduct of the audit lessens the negative impact of that interest or relationship on the auditor's independence.¹⁴² When an auditor's relative is not geographically distanced from the auditor and the audit, the auditor and his or her relatives are said to be in "closely linked business communities" and the auditor's independence is deemed to be impaired. However, considering whether family members are in "closely linked business communities" no longer seems relevant in today's world of instantaneous international communications and global securities markets. Accordingly, the proposal dispenses with this test of auditor independence.

We solicit comment on all aspects of proposed rule 2-01(c)(2)(ii). Does the proposal use an appropriate definition of what constitutes close family members whose employment by an audit client results in an impairment of an auditor's independence? If not, how should it be revised? Should the definition of close family member be expanded to include extended family relationships, such as in-laws? Would reasonable investors perceive an accountant's independence to be impaired if the audit client's CEO was the brother-in-law of a covered person? Would employment by an audit client of friends, neighbors, or other persons having emotional or financial ties with covered persons, but not within the definition of close family member, impair an accountant's independence?

Would reasonable investors perceive an accountant's independence to be impaired if a close family member of a covered person were employed by an audit client in a capacity that did not enable the family member to influence the preparers or contents of the accounting records or financial statements of the audit client or its affiliates? The ISB has suggested that independence is impaired if an immediate family member of a person on the audit engagement team is employed by the audit client in any position, or if a close family member holds a "key position" at an audit client.¹⁴³ Is the ISB's stricter position with respect to immediate family members necessary to ensure an auditor's independence?

Is the definition of the positions that may enable employees to influence the accounting records appropriate? Would independence be impaired by other employment positions held by close family members with an audit client, such as vice president of human resources, assistant controller, or manager of internal audit?

(c) Employment at audit client of former employee of accounting firm. Proposed rule 2-01(c)(2)(iii) describes the circumstances under which an auditor's independence will be impaired by an audit client's employment of a former partner, shareholder, principal, or professional employee of the accounting firm. When these persons retire or resign from accounting firms, it is not unusual for them to join the management of former audit clients or to become members of their boards of directors. Registrants and their shareholders may benefit from the former partner's accounting and financial reporting expertise. Investors and the public in general also may benefit when individuals on the board or in management can work effectively with the auditors, members of the audit committee, and management to provide informative financial statements and reports.

When these persons, however, assume positions with the firm's audit client and also remain linked in some fashion to the accounting firm, they could be in a position to influence the content of the audit client's accounting records and financial statements on the one hand, or the conduct of the audit, on the other. This is particularly true when the individual, while at the accounting firm, was in some way associated with the audit of the client. The perceived close association between a member of the board of directors or of senior management¹⁴⁴ may create the impression of a mutuality of interest.¹⁴⁵

As accounting firm partners leave their firms and accept management positions with former audit clients, some have questioned whether these individuals compromised their independence in order to secure positions with audit clients.¹⁴⁶ Others have questioned the continuing personal relationships between the former partner and the individuals at the firm who audit the client's financial statements.¹⁴⁷ There is also the risk that the former partner's familiarity with the firm's audit process and the audit partners and employees of the firm will enable him or her to alter the outcome of the audit.¹⁴⁸

As with the current requirements, the proposed rule recognizes that an auditor's independence with respect to an audit client may be impaired when former partners, shareholders, principals, or professional employees of the firm are employed in an accounting or financial reporting oversight role at the firm's audit client or an affiliate of the audit client. We are also proposing, however, that independence will not be impaired if certain steps are taken to disassociate the individual from the firm. Under the proposed rules, the former partner, shareholder, principal, or professional employee must not: (i) influence the firm's operations or financial policies, (ii) have a capital balance in the firm, or (iii) have a financial arrangement with the firm, other than a fully-funded, fixed payment retirement account.

The rule provides that, under certain conditions, use of a "rabbi trust" as a mechanism to make fixed retirement payments to a former partner or employee of the accounting firm would not impair an auditor's independence.¹⁴⁹ Specifically, under the proposed rule, use of a "rabbi trust" does not impair an auditor's independence as long as the amount owed to the individual is immaterial to the firm, the payments from the trust are fixed as to time and amount, and the chances of the firm entering bankruptcy or insolvency are remote.

We request comment on our approach in (c)(2)(iii). Should a former partner now employed by the audit client, be permitted to retain financial ties to the audit firm without impairing the independence of the auditor? What if the financial ties are material to the former auditor but not to the firm? Would reasonable investors perceive an accountant's independence to be impaired if a former employee of the accounting firm, who continued to hold a 401(k) investment with the accounting firm, became employed by the audit client? Does it matter if the former partner's position at the audit client is not one in which he or she will have influence over the company's audit, accounting records, or financial statements?

If an audit partner or other professional employee leaves an accounting firm and joins the audit client during the course of an audit, does this impair the accounting firm's independence? Should the rule depend on whether the person leaving the accounting firm is a senior partner within the firm, an audit manager with management responsibilities for the audit, or non-managerial audit staff?

Should we require a mandatory "cooling off" period for former partners and professional staff of an audit firm who join an audit client? Should registrants have to disclose on a timely basis if they hire a partner or other senior audit professional assigned to the company's audit.¹⁵⁰ If so, where should the disclosure appear?

(d) Employment at accounting firm of former employee of audit client. Proposed rule 2-01(c)(2)(iv) describes the circumstances under which employment of a former officer, director, or employee of an audit client or its affiliate as a partner, principal, or shareholder of the accounting firm will impair an auditor's independence. This provision, in a sense, mirrors the restrictions on employment by an audit client of former partners or employees of an accounting firm.

When the employee of an audit client joins an accounting firm, the independence rules must ensure that the former employee is not in a position to influence the audit of his or her former employer.¹⁵¹ Participating in that audit might require the former employee to audit his or her own work. Accordingly, the rule provides that independence is impaired unless the former employee does not participate in and is not in a position to influence the audit of the financial statements of the audit client or its affiliate for any period during which he or she was employed by or associated with that audit client or its affiliate.

We solicit comment on whether additional or other procedures should be implemented when a former employee of an audit client joins the accounting firm? If so, what should they be? Should the rule also apply to professional employees of the accounting firm?

3. Business Relationships

Proposed rule 2-01(c)(3) describes the business relationships that impair an auditor's independence from an audit client. It continues the Codification's current standard that an auditor's independence with respect to an audit client is impaired when the accounting firm, or a covered person in the firm, has a direct or material indirect business relationship with an audit client, an affiliate of an audit client, or either of their officers, directors, or shareholders holding five percent or more of the audit client's equity securities.¹⁵² As is true today, under proposed rule 2-01(c)(3), an accountant's independence is not impaired solely because the accountant has a business relationship with the audit client in which the accountant provides professional services to the audit client except for those specified in rule 2-01(c)(4) or acts as "a consumer in the ordinary course of business."

Because of recurring issues in this area, we have attempted to set forth in proposed rule 2-01(f)(11) a workable definition of "consumer in the ordinary course of business." In general, an accountant acts as a "consumer in the ordinary course of business" when the accountant buys "routine" products or services on the same terms and conditions that are available to the seller's other customers or clients.¹⁵³ An accountant is not acting as a "consumer" if it resells the client's products or services. Likewise, a purchase is not "in the ordinary course of business," nor is the product "routine," if it is significant to the firm or its employees. For example, an over-the-counter purchase of office supplies at customary prices would be considered in the ordinary course of business. Purchasing items other than on normal, customary terms, or acting as an agent, value-added reseller, or marketer of the client's products, however, would not be acting as a consumer in the ordinary course of business.

We considered whether to address each business relationship that would impair an auditor's independence. Because there are vast, varied, and constantly shifting types of business relationships, we determined not to attempt to identify all such business relationships. We have retained, however, a number of the examples currently found in the Codification to provide guidance on permissible and impermissible business relationships.¹⁵⁴

We solicit comment on all aspects of paragraph (c)(3). Is the definition of "consumer in the ordinary course of business" appropriate? If not, how should it be modified? Should an auditor be allowed to resell its audit client's products? For example, should an auditor be allowed to act as a reseller of a client's software products to other clients of the auditor? Would the answer change if the sales to the auditor exceed some percentage of the client's revenues such as ten percent?