Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-13-00, Proposed Revision of the Commission's Auditor Independence Requirements
Dear Mr. Katz:
I am writing on behalf of Teachers Insurance and Annuity Association and College Retirement Equities Fund (TIAA-CREF) to comment on the Securities and Exchange Commission's proposed revision of auditor independence requirements. My comments amplify those delivered by TIAA-CREF Chairman and CEO John Biggs to the Commission in testimony on July 26, 2000.
TIAA is a non-profit stock life insurance company. Its companion organization, CREF, is a non-profit corporation registered with the Commission as an investment company. Together, through the issuance of fixed and variable annuity certificates, TIAA-CREF is the principal retirement system for the nation´s higher education and research communities. TIAA-CREF, which also offers a series of retail and institutional mutual funds, manages more than $300 billion in assets.
As an investor, we rely on the financial statements issued by stock issuers, borrowers and entrepreneurs. Our analysts necessarily assume those statements have been audited by an independent, disinterested and professional outside auditor, and most of the time that assumption is correct. But we are concerned both about recent serious audit failures, as well as about more subtle distortions that may arise because of the potential business conflicts of auditors whose firms provide substantial and profitable non-audit services to clients.
In TIAA-CREF's own operations, we maintain a strict view of professional independence. As Mr. Biggs said in his testimony to the Commission:
When we need professional services in management consulting, we hire someone other than our auditors to do the job. For example, we bring in the consulting arm of a different accounting firm, or perhaps someone totally unrelated to the accounting profession. Our Board Audit Committee faces no questions on our accountants' independence. Committee members never wonder whether our auditors are receiving so much in consulting revenue that they dare not challenge management.The Commission's Proposal
TIAA-CREF applauds the Commission for this much-needed initiative on auditor independence. We strongly support the central thrusts of the proposed rules. It makes sense to modernize the rules for investments imputed to the auditor for purposes of preventing investment conflicts. The current stock ownership rules are excessive given the proliferation of dual-career couples and the large size and extended work forces of the larger accounting firms. We also appreciate and support the Commission proposals on disclosure and on quality controls.
On the central and perhaps most controversial questions--those related to provision of non-audit services--the Commission has set forth a compromise approach that has important advantages, certainly over the existing rules. However, in this area we urge the Commission to adopt a simpler and more far-reaching approach that would prohibit a public accounting firm from auditing any company for which it simultaneously provides other services.
In the Release, the Commission invites comment on this approach as an alternative to the rule proposed by the Commission.1 We believe this complete break between audit and non-audit services provided to a given issuer would be much simpler than the Commission's approach, and would give investors increased confidence that auditors are acting without bias and with complete objectivity and independence.
The rule as proposed by the Commission, based on four general principles for assessing independence, is aimed at preventing audit firms from providing services to audit clients that are plainly incompatible with independence.2 The proposed rule is both potentially too narrow and too complicated. The proposed rule focuses in particular on services that result in the audit firm essentially reviewing its own work ("self-review"), and those that directly or indirectly put the auditor in the role of playing management. It would not necessarily deal directly with the vulnerability of audit firms to pressure from clients for general consulting work the firms may provide. This general risk is separate from the risk arising from inherent characteristics of certain non-audit services.
Moreover, as the Commission itself suggests in the Release, the proposed rule could lead to difficult judgments about permissible and impermissible types of services. As the Commission says, "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."3 Moreover, it is not realistic to expect the board audit committee to fully identify independence problems that may exist, and to always challenge an auditor's judgment on whether independence has been compromised where such a problem has not been acknowledged by the auditor. In summary, the SEC's approach could engender tortured and difficult-to-evaluate efforts by firms to evade the restrictions, and might reward firms that are most willing to stretch the envelope of what is allowed.
Our favored outcome--a "bright line" rule prohibiting any non-audit services to audit clients--would not prevent an audit firm from engaging in consulting of all types with business entities other than its audit clients. Such consulting services can be profitable and can sustain a broad breadth of knowledge within the auditing firm. We see no reason why being closed out of perhaps 20 percent or 30 percent of the market for such services (that is, the auditing clients of a particular large firm) should prove to be disabling to the consulting business of those firms, unless the entrée provided by the auditing work is the key to business success, which would be deeply disturbing from an independence standpoint.
While we think a complete prohibition on non-audit services to audit clients makes the most sense, we believe a better compromise solution than that proposed by the Commission has been identified by members of the Panel on Audit Effectiveness (the "O'Malley Panel") of the Public Oversight Board. We refer to what these Panel members call an "exclusionary rule" that would, with very limited exceptions, exclude audit firms and their affiliates from providing management services to audit clients "that do not directly advance the interests of investors in objective and reliable financial reports on the stewardship of management."4
The exclusionary rule would bar, with very limited exceptions, the provision of non-audit services to an audit client by either:
(a) the audit firm itself or (b) any firm affiliated with the audit firm, whether by reason of a control relationship or strategic or other business alliance or other arrangement that gives the audit firm or its partners a financial stake in the provision of non-audit services to such audit client by such other firm.5Work involved in performing an audit "and other work that is integral to the function of an audit" would not be barred by this rule, leading to some of the fine line-drawing that also would be involved in the Commission's proposal. However, the logic by which decisions would be made is much stronger under the exclusionary rule, leaving less discretion to the accounting firms and to regulators. Moreover, the exclusionary rule would prescribe a set of procedures for use of the exception that would provide considerable reassurance to users of financial statements.6
The O'Malley panel members supporting the exclusionary rule sensibly suggest that the "touchstone" for deciding whether a service should be excluded is "whether the service is rendered principally to the client's audit committee, acting on behalf of investors, to facilitate, or improve the quality of, the audit and the financial reporting process rather than being rendered principally to provide assistance to management in the performance of its duties."7
Indeed, this is the heart of the problem; the "audit and consulting" firm really is serving two different sets of clients. This point seems to be missed by critics of new limitations on auditor consulting for clients. The auditors as auditors owe their duty to shareholders and their representatives on the board of directors, particularly on the audit committee, and to other outsiders who rely on audited financials to, for example, lend to the company. The client for management consulting services is management. As O'Malley Panel members supportive of an exclusionary rule state:
The [audit] firm is a fiduciary in respect to each of these client groups, duty-bound to serve with undivided loyalty. It is obvious that in serving these different clients the firm is subject to conflicts of interest that tear at the fragile fabric of loyalty owed to one client or the other. And it is equally obvious that the existence of dual loyalties creates a serious appearance problem, regardless of whether, in particular cases, the fabric actually tears apart or not.8The Commission's proposal on non-audit services is a third-best solution, in our view. Aside from vulnerabilities in the framework of that approach, the four principles suggested for defining relationships that compromise independence, while sound in and of themselves, miss a crucial issue. That issue, as we suggest above, is that general provision of consulting services of any type, even those that would be acceptable under terms of the rule, pose a conflict of interest. Should the commission adhere to its proposed framework, we would endorse the suggestion made by former SEC Commissioner Bevis Longstreth of a fifth principle stipulating that non-audit services impair independence when aggregate fees for those services exceed a certain percentage of the audit fee.9 Appropriate levels for such a rule may be in the range of 10 percent to 25 percent.
Disclosure: We strongly support disclosure of non-audit services and fees that are provided by a firm's auditor in the proxy statement. This disclosure is important under any of the possible frameworks outlined in the Commission's proposal, except perhaps for our own approach which would simply prohibit provision of non-audit services to audit clients.
While we do not believe that disclosure in and of itself is adequate to deal with the independence problems involved here, shareholders have a right to know about relationships that may compromise the independence of audits on which they rely. The level of detail suggested by the Release appears to us to be appropriate, particularly if the Commission adheres to its proposed framework for considering non-audit services.
As a shareholder, we frequently are asked to vote to approve the auditors of our portfolio companies. Information on provision of non-audit services, were such information available, would be important in informing our vote. This is a reason why such disclosure should be made in the proxy statement, rather the 10-K or other documents, which are not always available when we cast our votes. We note that summary information is required in the United Kingdom, which helps inform voting there on proxy proposals to approve auditors.
As noted above, we support the Commission's proposal to narrow and streamline rules governing investments by auditors or their family members in audit clients. These rules play an important role in protecting investors, but they are excessively broad in an era of dual-income families and extended firms with many employees not in the line of authority who have no involvement with the audit of a particular company. However, we do have concern that the suggested 5 percent threshold for investment by the audit firm or its covered persons in so-called "common investees" may be too high. Similarly, the 5 percent threshold for ownership in an entity that owns an interest in the audit client seems too high, given the significant scale and influence that such a position entails. We would suggest either lower thresholds (such as 1 percent) or a straight dollar threshold.
As with the investment rule, we endorse the narrowing of employment relationships presumed to compromise independence, as set forth in the proposal.
We also strongly support the ban on contingent fee relationships, which clearly are inappropriate as recognized by current ethics rules of the American Institute of Certified Public Accountants. Given the growth in consulting and non-audit services, and the increase in creative forms of fees for consulting work, it makes sense to codify the principle that acceptance of contingent fees compromises independence.
Finally, within the context of the Commission's proposal, we support the limited exception on independence violations for accounting firms that maintain certain quality controls and satisfy certain conditions, since inadvertent independence violations may occur from time to time. We support the suggestion of the Investment Company Institute that the Commission consider a similar limited exception for audit client issuers, to protect issuers from being unduly penalized for auditors' missteps.
We thank the Commission for this opportunity to comment on this important proposal. We hope these comments are helpful. If it is useful, we would be happy to meet with Commission officials to discuss our views further. Please do not hesitate to contact me.
Peter C. Clapman
Senior Vice President and Chief Counsel, Investments
730 Third Avenue
New York, NY 10017-3206
1See Section 3(D)(2).
2The four principles are that the firm "(1) has a mutual or conflicting interest with a client; (2) audits the accountants own work; (3) functions as management or an employee of the audit client; or (4) acts as an advocate for the audit client."
4See the Public Oversight Board Panel on Audit Effectiveness, Report and Recommendations ("O'Malley Report"), August 31, 2000, Section 5.32, p. 118.
5O'Malley Report, Section 5.32, p. 118.
6Use of the exception would require (1) a finding by the client's audit committee of special circumstances that make it obvious the best interests of the company and its shareholders will be served by retaining its audit firm or affiliate to render such non-audit service, and that no other vendor of such service can serve those interests as well; (2) submission of a written copy of the finding to the SEC and the POB; and (3) disclosure in the next proxy statement of the amount paid and expected to be paid for such service. See O'Malley Report, Section 5.38, p. 119.
7O'Malley Report, Section 5.36. The exclusionary rule (or "Non-Audit Services Rule") as advocated by some members of the O'Malley panel would have the SEC provide general guidelines on this issue to the Independence Standards Board, which would be charged with writing detailed rules of implementation, and which would be expected to evolve over time.
8O'Malley Report, Section 5.39, pp. 119-120.
9Testimony by Bevis Longstreth before the Securities and Exchange Commission, Hearing on Auditor Independence, September 13, 2000.