September 6, 2000
Mr. Jonathan G. Katz
U.S. Securities & Exchange Commission
450 Fifth Street NW
Washington, DC 20549
Re: Revision of the Commission's Auditor Independence Requirements
(SEC File No. S7-13-00)
I write to offer the Commission my thoughts and comments on the proposed rule. I am neither an audit practitioner whose reactions to the proposal are tempered by the possible impact of the changes on my livelihood, nor am I a pure academic who deals principally with the abstract theory of what might be ethically ideal to have in place. I offer the Commission my comments from the perspective of a sixteen-year experienced former regulator who, after ten years of service as an accountant in Corp Fin, went on to administer the present auditor independence rules for three different Chief Accountants while serving as an Assistant Chief Accountant in the Office of the Chief Accountant from 1990 to 1996. I therefore think that I have a better than reasonably mature and informed understanding of what is needed to make the independence rules work for the betterment and protection of investors.
I am both a CPA and a Certified Fraud Examiner, currently practicing accounting consultancy and litigation support in private practice for Ten Eyck Associates, Inc., managing the firm's office here in Washington, DC. I would be quick to repeat the disclaimer that I remember making many times while speaking as a staff member of the Commission - that the comments I make in this letter are mine and mine alone, and that they do not necessarily reflect the opinions of any or all my partners, or the firm itself. I should also, in full candor, enter into the record that certain of the firm's clients have involvement in one or the other of the specific proposals in the rule, and for that reason I will endeavor not to address the specifics of matters that relate to them. I do, however, think that the Commission and the process generally, would benefit from hearing a more generic view about the proposed rule from a commentator with my background, and I am pleased to offer it.
For the reasons that I will explain more fully in the letter, I believe that the Commission ought not to approve the proposal in its present form. While there may be a demonstrable need to address what has been since my days on the staff the subject of some legitimate concern, I believe that the proposal in its present form is simply too complex and too detailed to achieve what ought to be the primary goal of any such undertaking - to produce an understandable benchmark by which auditors the investing community (and not simply the SEC staff) can better understand auditor independence.
The proposed rule attempts to legislate morality, which is never an easy undertaking. But I would suggest that if the Ten Commandments were to have taken 20 stone tablets and 5,000 words to communicate their gist, they never would have gained any common understanding or acceptance. That is the essential problem with the current proposal. It simply reads like a cook-book to specifically proscribe some forms of conduct that exist today and that the staff finds troubling. A better approach in my opinion would be to propose something less explicitly descriptive, and I therefore favor broader principles.
I also believe that a neutral but experienced reading of the proposed new Rule 2.01 leaves one with the impression that it was drafted almost exclusively with the major accounting firms (and their clients) in mind. The commissioners would do well to remember that something on the order of 20% to 25% of SEC registrants are audited by non-Big 5 firms, and that the proposed rules should contemplate those smaller practices as well. In my opinion, and as I will illustrate in some specific comments below, the proposed rule is presently somewhat defective in that regard.
In addition, the proposal moves decidedly away from many of the suggestions made by the Independence Standards Board, and it ignores the long-standing principle upon which the federal securities laws are based - that disclosure will allow intelligent market-making. The ISB's initial standard requiring candid discussion between auditor and client to explain and discuss independence would be rendered less meaningful if the question is already obviated by rule. I would suggest to you that if the Commission is truly supportive of the ISB, it needs to allow that body to gain some aura of authority. This will not be achieved by countermanding it or making its pronouncements appear to lose authority.
Seeking approval of a rule change as sweeping as this, in the extremely short time frame being contemplated, is unprecedented in the distinguished 66 year history of the Commission, and it isn't warranted by current conditions. The Commission ought not to ask respondents for their answers and reactions to over 300 questions while simultaneously proposing its own language for final rules. The Commission is certainly aware that the Office of the Chief Accountant had a concepts release ready for issuance ten years ago (when the current Chief Accountant was just a Professional Accounting Fellow!). That release was never published because the Commission did not see its need. The Commission told Congress as recently as five years ago that no changes to auditor independence rules were needed, and yet now it proposes within a 75-day period to expand a simple 400 hundred word, 3-paragraph rule into a new one with six layers of sub-paragraphs and that runs for over 4,200 words. This is simply not a well-conceived or credible regulatory process.
The proposed rule is transparent in its attempt to loosen existing rules in some areas of concern while proposing to tighten others, forming a joint package that simultaneously entices and restricts. I will address the four principles in the proposal, and then each of the three major areas, stating my concerns and suggestions, and close with some suggestions.
The Four Principles
In general, I favor an enumeration of basic principles as an alternative to the specificity that continues later on in the proposal.
With several of the proposed principles, I also find no fault. Auditing one's own work is hardly ever seen as resulting in independence. Functioning as management or as an employee is likewise obstructive of independently concluding about management's work product.
While I am a firm proponent of the view that those who audit should not be affiliated in any way with providing legal services that provide advocacy, the Commission has long accepted the practice of tax advocacy as being one that does not impair independence, so the excessively broad language of the fourth principle is troubling to me, and not on good theoretical ground. Moreover, the staff itself frequently demands advocacy by auditors in its own discussions with registrants, at least occasionally refusing to even schedule meetings with registrants unless they are accompanied by their auditors who it will expect to explain why certain accounting or reporting is acceptable. The staff has historically required letters from auditors when clients change accounting principles, asserting that the change is to an accounting principle that is considered "preferable". How can this not be seen as "advocacy"? The present wording in the proposal is too broad here, and it's not well enough grounded in practice to be workable.
However, I have my most serious reservations about the first principle. While it expresses a well sounding and presumably unquestionable concept, I would agree with other commentators that virtually all interests between a client and its auditors are either mutual or conflicting. To postulate that the only relationship between auditor and client is an independent one is simply naïve. An unpaid bill is a conflicting interest - and no one pays for an audit in advance. In fact, payments are frequently and generally made on an ongoing basis as work progresses. Is this not a mutual interest - that I am paid and that you receive the results of my work? Doesn't the auditor have an interest in seeing that he gets paid? How about those situations where client and auditor are named together in litigation? Are not their interests generally "mutual" in that situation? There is a need for more preciseness in the language here.
In many ways, the suggestions in this section of the proposal are thoughts that have been too long in coming. Personally, I share the reservations that were expressed by Mike Cook (and other senior partners of accounting firms) in the early round of hearings - that the present proscription against such ownership is so bedrock to long-time CPAs that it ought not to be tinkered with. However, I also have to agree that despite the absence of empirical research to support such a conclusion, I would venture to guess that virtually no one in America would believe, for example, that a non-engagement related Deloitte & Touche partner in, working say the Miami office and who is not affiliated in any way with the General Motors audit, would taint the firm's independence by his or her ownership of a single share of GM stock - but that is what the current rules specify.
It is probably wise to pause and remember why the current rule was established. The original auditing entities of the 1930s and 40s were true partnerships - organizations in which the firm's overall profits were divided among all partners in some agreed upon measure. As such, each partner in the firm had some personal economic stake in the conduct and outcome of every audit of the firm. This time has long since passed. It is commonly understood that modern auditing entities - the large ones anyway - divide profits more like corporations, basing compensation decisions on local office revenues and profitability and not simply an allocation of firm-wide results. As such, the fact-based dimension of the basic "financial interests" concern in such entities has ceased to be a reality in many, particularly larger firms.
Although the subject of familial financial interest ownership is made somewhat more complicated by the societal expansion of working spouses and new forms of retirement plans, a continued proscription against the holding of any financial interests in clients is often meaningless and unnecessary.
I say "often" because a serious failing of the proposed rule is that it proposes to open such ownership relatively indiscriminately, which is a serious mistake.
The commissioners should remember that many of the smaller-through-mid-size firms retain the true partnership formula for dividing firm profits. As such, it would be inappropriate for the Commission to permit them to enjoy the loosening of the present financial interest rule with the one presently proposed in Rule 2.02 (c)(1)(i). I believe, and I think that investors would also believe, that in any case in which a partner or other professional's net worth or current earnings is directly impacted by a client's fees, he or she should not be permitted to directly own its securities (even if he or she is not a "covered person", as defined in the proposed rule)
If the new, permissive rule were to contemplate only the major firms, it arguably would be fine. Unfortunately, there are still numerous auditing practitioners, auditing mostly smaller public companies, whose compensation is still derived from a firm profiting splitting model, and the new rules make no exception for such firms, essentially allowing partners to hold financial interests in clients as long as they do not participate in the "line of authority" over the audit or work in the office participating in a "significant portion" of the audit. (By the way, who determines what a "significant" part of the audit would mean?). Hence, for a two-office firm with three or four partners who share economic profits of the firm, the rule in its present form would allow two partners to own a client's securities while ownership by the other two partners (engagement and concurring partner) would be proscribed. This is foolish, and will raise questions in the minds of investors. It needs to be fixed.
I suggest that, even with respect to larger firms, a better measure for allowing financial interests might be whether the value of the interest held is greater than some level. Investors would not be expected to believe that "independent" judgment is affected by insignificant holdings. Let's just set the bar rather low.
In addition, the proposed rule needs greater clarity with respect to some definitions. For example, "spousal equivalent" is not a defined term in the rule. In discussions on this subject, I have heard a view expressed that this is intended to cover co-habitant relationships. Others say it means same-sex unions. Some wonder if it means both. I am probably in a decided minority that questions how wise it is to go here with specificity. There are plenty of spousal relationships (including hostile separations) that are not close enough to warrant any holdings to be a problem. However, there are many engaged couples whose non-CPA member would not be covered by these rules, but whose relationship is closer than that which may exist in many marriages. In fact, there are many "relationships" that are not covered by the rule (either the present or the proposed rule) that may well be sufficiently intense that ownership of financial interests should not be permitted. Examples may be godchildren or next door neighbors. Not including such relationships is probably flawed if the goal of the rule is towards a view of who may be "seen" to affect independence.
I think that a better approach would be to have the rule against holding financial interests in clients pertain to all relatives (and others) of the auditor that would be reasonably construed by disinterested parties as being individuals whose financial welfare is of concern to the auditor. This is probably one area in which specificity is probably not well served. If the staff were to discover such an inappropriate holding, then the burden (properly) should be on it to be able to convince a trier of fact of that inappropriate concern.
On another point, proposed Rule 2.10 (c)(1)(iv)(A) says that an auditor's independence would be considered impaired if a client has any direct investment in the firm or its affiliate whether in the form of stocks, bonds, notes options, or other securities". "Affiliate" is defined in Rule 2.01 (f)(4)(D) in a way that could be interpreted to include the firm's bank as an affiliate - wouldn't a loan from such an institution be such a "direct business relationship?" (Note that "business relationship" and "direct investment" are not defined terms in 2.01(f)). This concept needs repair as well.
This is another area that has seen vast societal change in the sixty some odd years over which the staff has interpreted the present rule. Aside from the confusion that the Commission's adoption of its proposed rule would cause by being at odds with what the ISB has just issued, the general subject area is appropriate for rule-making.
In my time on the staff, I was frequently confronted by practitioners who sought to get relief from the staff's present positions, arguing that "society has changed", that "being separated by geographical distance does not mean as much anymore". While I understood the argument, I did not and do not agree with it.
The fact that more spouses work today (and thus that there are more individuals in potential position to be hired into a job that conflicts with the firm's independence) does not obviate the simple intrinsic concern that simply being there is a problem. Things do not become right simply because they become more common. If in 1935 it would have been troubling that a partner's sister-in-law was a controller at a client, how is it less troubling today simply because there are increased numbers of people who could find themselves in that position? I simply cannot accept that argument, and neither should you.
My experience tells me that each of these situations needs to be evaluated on its facts - and that broad rule-making on the subject is only likely to create even more problems and more appearance difficulties. The public could be little expected to accept such relationships as not impairing impartiality and independence.
Also, although I am admittedly in a small and potentially unpopular minority, I continue to be troubled by the practice of audit firm personnel leaving the firm to accept financial positions with public clients. While I agree that there is frequently some "benefit" to the client in such cases, I question whether that benefit is outweighed by the almost certain continuing close relationship between that former employee and those former co-workers who may be still engaged in the audit. I also wonder if that "benefit" is the right measure for the rule, or whether what is at issue is whether the shareholder/investor is benefited by the practice.
I would remind the Commission that it believes with respect to its staff that leaves to work with registrants, that a simple notification requirement by which the Commission is informed of such representation is considered sufficient. At certain, more senior staff levels, a "two-year out" rule prevents such representation. These kinds of disclosure requirements could easily be ported over to employment associations between former auditors and public clients.
The proposal in this regard is not so much an attempt to define the concept of, or the requirements for independence, as it is an attempt to change the way in which those who audit conduct their businesses. It makes parties and people who are not licensed to practice public accounting suddenly subject to SEC rule. One must ask whether this is practical, desirable, feasible or enforceable.
I believe that serving a client as auditor, while also providing services that generate fees several times as large for non-audit work is generally not desirable. I do not necessarily believe that the optimal solution to that problem is to constrain the form of how an audit firm chooses to practice its profession, and for that reason I am troubled by both the tone, the extent, and the content of the restrictions envisioned in the proposed rule. I think a more workable rule would create meaningful disclosure, perhaps even in the audit report itself that will hold the practice out to a greater level of public scrutiny and consideration.
There was never, in my opinion, a very good reason to repeal in ASR 264 (1979) the earlier (ASR 250) instituted requirement for public disclosure of the monetary level of such information. I believe that had such information continued to be available in public filings, on a client-by-client basis, with specificity as to what non-audit work was being provided by the firm in exchange for what amounts, the growth that we have seen take place in this regard would likely never have occurred. I believe that if an audit firm had to tell investors that it had collected five or ten times the amount of its audit fee in non-audit services, reasonable investors would long ago have started to ask how that impacted (or may have impacted) on the objectivity of the audit decision-making process. And they would have been valid questions.
To the extent that a firm has reached a conclusion that such an imbalance of services does not or has not had an adverse impact on its independence and objectivity, and it can explain that decision satisfactorily to the company's audit committee (as it is now required to do by IAS #1), I believe that such a decision, coupled with public disclosure is sufficient to address the present problem. Perhaps I am unreasonably persuaded by my faith in disclosure, but if so, that is a by-product of having worked 16 years on the staff. If the Commission wants or needs more assurance, I'd suggest instituting a requirement for the Audit Committee to disclose to investors what it was told in the meeting with the firm that is contemplated by the ISB Standard - what convinced it that such disparate fees were not a problem. Outlawing the very provision of such services is regulatory overkill at this point in time.
Finally, I also urge the Commissioners to pretty carefully consider the explanations by the major accounting firms about the viability of how they can recruit and hire talented individuals if they are forced to tell them in the recruitment that they will be limited to conducting audit-only services. In today's world, this is simply not feasible. An auditor who detects a system weakness should be both capable and motivated to repair that weakness. Proscribing systems related work would prevent this.
Broad Philosophical Issues
In its consideration of the proposed rule, I would also urge the Commission to be mindful of the "health of the firm" arguments that have been put forth by the larger accounting firms. I would include in this consideration the increasing adoption by many states of the "150 hour rule" requiring aspiring licensees to undergo essentially a fifth year of undergraduate study as a condition for CPA licensing - meaning a year more of tuition and one year delay in reaching financially productive employment. Ironically, this requirement, which was based on the exponentially expanding base of accounting standards that need to be learned, is now serving to dissuade many of the colleges' best students from becoming accounting majors.
While I may agree that the ethical necessities of assuring audit independence should not be held hostage to such requirements, it certainly is appropriate to at least consider their impact on recruiting the best talent to auditing. I urge each of the commissioners to discuss with prominent business school academics the evolution of who chooses accounting as a major in our business schools. I understand that as recently as twenty or thirty years ago the "best and the brightest" fought to major in accounting. But I also understand that today, this is no longer true - that the students do not view either the "ticky checky" work of an auditor or the long-term benefit of doing such work to benefit his or her career sufficient to justify choosing auditing as a starting assignment out of school. As such, the auditing firms are no longer getting the best minds coming from our business schools. If the Commission's actions proposed here make the auditing profession even slightly less attractive to the best students, that will not be good regulation.
I would also point out what I think are some disturbing findings in the Phase II report of the Earnscliffe study of independence for the ISB, published in July 2000. The report indicates that discussions with eight "focus groups' of investors produced relatively unanimous results (good), but that also indicated that (bad) "the information focused on in deciding buying opportunities did not include audited financial statements", and that while these investors had a "high level of trust in financial information today", "the trust is not based on any shared understanding of the safeguards that help ensure the reliability of financial reporting".
The report states that "...(m)ost people had only scant impressions of how audits were conducted", and "the tendency was to guess that it involved time-consuming detailed checking of facts and figures" - demonstrably not what twenty-first century auditing is about at all.
Moreover, Earnscliffe says that such investors have an innate trust that institutional and large investors know more about such things than they do, and that the retail investor trusts them to carry that ball. The report states that "..(t)he annual report of public companies is not a particularly widely used component, and audited financial statements seem even less widely consumed, among the retail investor community".
I think that these are sobering realizations which are likely to (and should) place into some question the innately accepted significance of the "independently audited financial statements" as a factor in investment decisions. While this likely would not have been the case twenty years ago, it is certainly seems to be so today.
An alternative standard
I believe that at least for discussion purposes, an appropriate and workable standard of auditor independence would be that:
"An auditor or firm should not have or be burdened by relationships that ("suggest" / "lead to" / "create") a view that audit decisions may be compromised or other than objectively made. These conditions exist whenever:
Certainly this list could be supplemented.
Considerations of Disclosure
Based on my years on the staff, I have considerable confidence that a well-informed marketplace, if it is told about them with candor, can factor the impact of non-audit services on audit independence. I therefore do not hold the belief it should be necessary to issue a rule totally proscribing those services.
To the extent that there are firms like Pfizer that elect not to buy such non-audit services from its independent auditor, should not the market then attribute a greater sense of reliance on its audited results than on those of a competitor who does not ascribe to that policy (assuming the market knows that fact)? The Commission's entire argument about the importance of independence rests on the assumption that this is so.
I will probably now render myself completely anathema to my former colleagues in the Office of the Chief Accountant by suggesting that both Earnscliffe and current developments in the market support the thought that would have been unthinkable 20 or 30 years ago - that the credential that may be more important to investors today than auditor independence is some form of technical expertise.
One must ask if the market would prefer an examination and opinion by a well-resourced and highly technically capable Big 5 firm that is not independent, or would it prefer to have an examination and opinion of a less well-resourced and less technically qualified firm doing only auditing and whose independence is unquestioned? This is a troubling dilemma, but one on whose answer the decision as to this proposed rule may well rest.
The Commission must ask itself, particularly in light of the Earnscliffe effort, "who is the investor that needs to be protected by the enactment of the proposed rule". If the investing dynamic present in the market today is that the small, private retail investor neither reads nor relies on audited financial statements, but instead depends on the larger institutions to be aware of them and the process of how they are prepared and audited, is it not logical to assume that the protections should be formulated with the larger, analyst community in mind?
Is it not also logical then to assume that, armed with sufficiently well disclosed information, these larger investors and analysts would be able to appropriately factor hypothetical or perceived potential impediments or impairments to independence into their evaluation of the information with which they are provided?
An audit firm whose non-audit revenues for a client (including corporate tax work and personal tax work for officers and employees) exceeds it audit revenues by some factor (say, two or three times) should be required to disclose that fact, perhaps even in its audit opinion. To the extent that the firm has determined that such an imbalance does not or has not had an adverse impact on its independence, it is already required (by ISB Standard #1) to discuss that fact with the Audit Committee and to convince that body about the correctness of that belief.
For now, I personally believe this would be sufficient to address the existing problem. Perhaps the Commission might consider instituting a requirement that the Audit Committee publicly disclose in a filed report what it was told about independence by the firm (something it is not presently required to do), and then explain to investors how the committee reached a conclusion that the independence requirement of federal securities regulations was not compromised.
Outlawing the provision of such services by auditing firms, at least at this point in time, in my opinion is draconian, needlessly risky to the health of audit firms, not justified by observed problems in practice, and would be regulatory overkill.
Like the Commission, I believe that it is important to have meaningful regulation on this subject, but I believe that the present proposal, however well-intended it may be, is an over-reactive and restrictive response that simply needs more deliberate and thoughtful review before being enacted. To some extent, because the staff has historically not chosen to seek out and litigate the kind of violation that this proposed rule pre-supposes currently exists, it has a somewhat weak platform from which to suggest a need for it.
Ten years ago, when I began work in this area, I probably would have argued that being independent is like being pregnant - you either are or aren't. There are no degrees of comparison. Maturity and experience brings me to a realization that this is perhaps too black and white a way to deal with this issue - at least in the abstract. While absolutism may be a valid measure with respect to appearance in "fact", it is flawed in the study of "appearance". I think that the Commission should be commended for proposing to raise the bar in Regulation S-X by introducing the notion of appearance, because it will result in more careful thought being given to that aspect. But I do not think that it is possible to capsulize in a federal rule what will and will not impair the appearance of independence. No one sees into the mind of the person performing the audit. Substituting the judgment of even a well-meaning staff person for that of the "reasonable investor" is a risky proposition because the judgment of a regulator is always to reject and not to accept.
In any event, this is an important enough subject not to rush to judgment. Change here should be at a glacial pace, not a rocket pace. The staff and the Commissioners should be concerned with what I think are validly expressed concerns about how, if firms are to be limited to only auditing, they will be able to attract bright and talented individuals into the noble and vital profession of auditing. A regulatory effort that impedes that process even slightly is not one that will advance the interests of investors, and should therefore be re-considered.
I thank you for your attention to my views, and although I will not be available to appear before the Commission on either of the remaining planned public hearing dates because of previously arranged international travel, I would be happy to respond either before September 11th or after September 26th to any questions by any Commissioner on what is contained herein.
Roy T. Van Brunt, CPA, CFE