Ernst and Young
787 Seventh Avenue
New York, New York 10019
Phone: 212 773 3000
September 25, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: SEC File No. S7-13-00: Proposed Revision of the Commission's Auditor Independence Requirements
Dear Mr. Katz:
Ernst & Young LLP ("Ernst & Young" or "E&Y") respectfully submits this comment letter on the Securities and Exchange Commission's Proposed Revision of the Commission's Auditor Independence Requirements (the "Rule" or the "Rule Proposal").
I. Background and Summary of Position
A. Background on Ernst & Young
Ernst & Young, one of the "Big Five" accounting firms, has more than 23,000 partners and employees in the United States. E&Y is the auditor for 23% of the Fortune 500 companies and 21% of the Fortune 1000 companies in the U.S. Many of E&Y's clients have significant worldwide operations, and E&Y serves those clients through its affiliates outside of the U.S. Members of Ernst & Young International, which is an umbrella organization for E&Y firms throughout the world, have offices in 689 cities in more than 130 countries.
Last May, Ernst & Young completed a significant transaction, divesting itself of its management consulting practice.1 Ernst & Young did so by selling its practice to Cap Gemini, SA, an international consulting firm headquartered in Paris, France. This was an enormous transaction, resulting in the separation from E&Y of almost 7,000 partners and employees, or approximately 23% of E&Y's entire workforce. As discussed below, this transaction has considerable relevance to the SEC's proposal.
B. Our General Views on the Independence Issue
1. As an initial matter, we share the Commission's goal of promulgating an independence rule that would, among other things, ameliorate concerns about the appearance of independence. Integrity, and its auditor independence cornerstone, is the essence of the accounting profession. The Commission's rulemaking release (the "Release") discusses this fact at considerable length, and also discusses the unique and important role that the accounting profession has in this nation's securities markets. E&Y fully understands that role. We acknowledge that we have a unique relationship to public investors, who rely on us as vital "gatekeepers" to the public securities markets and count on us to perform our audits well and effectively. Accordingly, to the extent that there are concerns about auditor independence, we believe that the Commission appropriately should address those concerns through rulemaking.
In taking this position, we want to make clear our view that there is not now, nor has there previously been, any indication of actual independence impairments caused by
the provision of non-audit services to audit clients. In our experience, auditors perform their tasks with diligence and integrity, and a firm's performance of consulting services for an audit client does not affect the judgments of the firm or the audit engagement team as to the proper application of accounting or auditing principles. The risks to the reputations of the firm and the individual accountant; the liability exposure; the possibility of SEC-imposed or other sanctions; and the inhibitions imposed by conscience, training, supervisory review, peer pressure and experience are, taken together, monumental restraints on any inclination to sacrifice audit quality in favor of consulting fees. Nevertheless, we acknowledge that the appearance of independence is almost as important as is actual independence. If there is an appearance issue, and if it is undermining our credibility with the investing public and our productive relationship with this Commission, then we believe it properly should be addressed through rulemaking.
There are two principal areas that require attention in an independence rule. First, the existing rules governing investments by auditors in audit clients and the employment of relatives by audit clients are very much outdated. This is particularly true with respect to spousal employment and the restrictions on the participation by spouses - including spouses who have employment positions that are permissible under the independence rules - in employee stock compensation programs.
Second, the Commission might properly address the appearance problem that stems from the provision of large-fee non-audit services. As Philip A. Laskawy, the Chairman of Ernst & Young, stated in a letter sent to Chairman Levitt on May 9, 2000, the Commission might promulgate a rule that would restrict certain non-audit services currently being provided, in particular, management or information systems consulting, and full-scope internal audit outsourcing. We would support restrictions because of the concerns that have been expressed about the appearance of non-independence in connection with these activities.
As witnesses at the SEC's hearings on independence have testified, information systems or management consulting can generate fees that are many times the amount of the audit fee. Clearly, this disproportionality may generate an appearance problem. And while we believe that full-scope internal audit outsourcing actually can improve the quality of a client's financial statements, we also would agree that, because of a potential appearance concern, this service might be restricted. However, as we discuss further below, providing outsourcing services in specific areas, such as computer auditing, or helping to fill in certain gaps in a client's internal audit department, should not be prohibited.
Because we are supportive of an appropriate independence rule, we have, as the public rulemaking record discloses, engaged in a number of discussions with senior members of the SEC Staff about the precise parameters of such a rule. Together with partners from the accounting firm of PricewaterhouseCoopers, we have made suggestions to the Staff of what an alternative rule might look like. We have appreciated the opportunity to share our views with senior Commission Staff members. We believe that discussions on these important issues, which will affect millions of investors, tens of thousands of professional careers, and thousands of public companies, are the appropriate means of achieving a practical and effective independence rule.
Accordingly, we do not take issue with all of the aspects of the SEC's proposal in this comment letter; we do not challenge the SEC's authority to promulgate an independence rule; and we do not attempt to answer every question that is posed in the Release. Generating the hundreds of pages necessary to fully address all of these areas is, in our view, not a productive endeavor. Rather, we address the issues that we consider to be most significant. In addition, we are attaching to this letter a red-lined version of the Rule Proposal that reflects suggestions we already have made to the Staff (see Attachment A).2
2. It is important to stress at the outset that our alternative proposal attempts to satisfy the Commission's concerns about the appearance of independence. At the same time, our proposal would provide the accounting profession with the flexibility and means to deal with the global and technological challenges of the 21st century.
The investing public relies heavily on the integrity of financial statements and on the independence and objectivity of the auditor. In order to ensure that that trust is not misplaced, auditing firms must be able to attract the best and the brightest graduates of our universities; must be able to tap the specialized knowledge and resources of persons who are not a part of the firm's core accounting and auditing practice; and must be financially able to commit the resources necessary to keep pace with the astonishing technological changes in today's economy.
Accordingly, a major element of our suggested approach reflects our need to be able to maintain strategic relationships with entities that are not audit clients but that provide us with access to necessary goods and services. The modifications would allow us to grow in order to meet developing technological and global demands. We fully appreciate the Commission's objective that rules be in place to prevent accounting firms from engaging indirectly in activities that they are prohibited from doing directly. But we believe the current rules and professional guidance are largely adequate for this purpose, and we urge the Commission not to adopt the broad, restrictive definitions contained in the Rule Proposal.
3. We are in this letter making one particularly significant assumption - that tax consulting services will not be affected in any way by the final Rule. We strongly urge that the Commission make this point clear in the Adopting Release.
The Release does state that the Rule does not cover "tax-related services" because such services are "unique." Release, 65 Fed. Reg. 43148, 43172 (2000) (to be codified at 17 C.F.R. pts. 210 & 240) (proposed July 12, 2000). But the Release further refers to the permitted "tax-related services" as "traditional tax preparation services," which are only a small component of "tax-related services." Id. at 43172. Further clouding the issue, the Release asks for comment on whether "providing tax opinions, including tax opinions for tax shelters, to an audit client . . . would appear to reasonable investors to impair an auditor's independence." Id. at 43171, 43173. Thus, the Release does not clearly establish that all tax-related consulting services may be performed for audit clients.
There are many reasons why tax advisory and compliance services should be exempted from the restrictions on non-audit services. These services have been performed for many decades, since well before enactment of the federal securities laws. These are very large practices, and any SEC-imposed restriction would cause enormous disruption to thousands of client relationships and the livelihoods of tens of thousands of tax practitioners throughout the world. Moreover, tax advice and compliance work is subject to regulatory examination and scrutiny by tax authorities, and misconduct in this area can lead to legal and financial penalties. Accordingly, we urge the Commission to state clearly in the Adopting Release that tax services are not affected by the Rule.
II. Specific Concerns
A. Proposed Principles
The Commission has proposed to include in the Rule four principles that, according to the Release, are intended to "govern our determination of whether an accountant is independent of its audit client." Release, 65 Fed. Reg. at 43149. The Rule (paragraph 2-01(b)) would 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." Release, 65 Fed. Reg. at 43190.
We believe that legally enforceable "principles" should not be included in the text of the Rule itself. We are not opposed to the SEC's setting forth principles that might guide the profession in dealing with independence questions; indeed, we have supported the efforts of the Independence Standards Board ("ISB") in this regard. But we believe that including the principles in the text of the Rule itself will foster confusion rather than clarity because the principles are not applicable to many situations faced by accountants and thus the principles cannot meaningfully serve as more than guideposts to be considered in the context of particular facts and circumstances.
Accordingly, the Commission might reasonably describe these principles in a Preamble or Preliminary Note, separate from the Rule itself. The Commission could state that the principles helped guide the Commission in its development of the Rule, and that the Commission expects the profession to refer to them in its future consideration of independence issues. Such a statement could be useful to the ISB and the profession generally in dealing with independence issues.
B. Rules Relating to "Affiliates" of Accounting Firms and Audit Clients, "Business Relationships," "Material Indirect Investments," and Investments in the Auditor by Audit Clients
1. The Importance of Alliances
Alliances, partnerships, joint ventures, minority investments, cross-licensing, and other cooperative arrangements between and among entities are becoming key requirements for continued existence in the global marketplace. The trend toward greater collaboration and "strategic relationships" is expected to be a critical part of the fabric of doing business in the evolving, connected economy. It is vital that accounting firms be permitted to have such arrangements.
Alliances can cover a broad array of relationships including: collaborative transactional relationships; customer alliances; strategic sourcing arrangements; strategic integration arrangements; strategic partnerships; equity joint ventures; spin-out/spin-in joint ventures; supplier relationships; and other arrangements. One recent study showed that alliances now account for 26% of Fortune 500 revenue, up from 11% five years ago.3 And the projected value of alliances is 30 to 50 trillion dollars within five years.4
The accounting profession is not exempt from the transformations taking place in today's business environment. The profession must keep pace with the rapid changes, developments and opportunities presented by the dynamics of changing service models, or risk being rendered technologically obsolete. This is particularly true in view of the rapid globalization of the world's economy.
Alliances provide several specific benefits, both to the profession and to audit clients. First, alliances provide access to capital that can fuel further investment in our audit capabilities, thereby contributing to the long-term improvement of the audit. This is vitally important, particularly as the audit line of business continues to mature at the same time that technological investments become both more costly and more necessary.
Second, alliances provide access to skilled personnel. Our profession faces a crisis in finding and developing the next generation of audit professionals. While our talented audit professionals are world-class and realize the value of their role in providing assurance to the public, the evidence is undeniable: there will be a shortage of qualified audit professionals in the coming years. This year has ushered in the smallest pool of college graduates of accounting programs in more than a decade.
Some universities have seen enrollment in accounting programs drop more than 50% in the last 9 years and a 23% drop in the last 4 years.5 The number of first-time CPA exam-takers has fallen 13% since 1992. Many students perceive auditing as unexciting. Business students are flocking to other business curricula, favoring the challenges and opportunities afforded by other disciplines.
The shortage of upcoming qualified labor to support future generations of audit work will force firms to work smarter, work more efficiently, and rely more heavily on technology and tools that make marginal substitutions of technology for labor. This erosion of emerging talent requires our firm and other firms to seek out those alternatives, and to partner with innovators who are creating the next generation of tools and technology to meet the profession's demand for audit capability. By entering into alliances with entities that have different structures, risk tolerances and compensation abilities, our firm can access talented individuals who choose not to work directly for our firm or for auditing firms in general. In other words, alliances provide us with the supplemental skill sets and labor that we are unable to obtain on our own.
Third, by entering into alliances, we are able to leverage our own knowledge base and skill set. We have thousands of highly skilled accountants, tax specialists, actuaries, economists, and others, and we need to be able to make sure that their talents and their thousands of combined years of higher education and specialized training are tapped to the maximum. This brings benefits that extend well beyond our own firm.
Here is one example. In May of this year, Ernst & Young announced plans to launch a joint venture with E*Trade that will provide personal financial counseling to E*Trade customers. If successful, this venture will enable investors to integrate their online banking and trading electronically with their financial planning. As a result, Ernst & Young will make its tax and financial counseling expertise available to a vastly greater number of people, because our services may have been too expensive or too inaccessible to many E*Trade customers. The end result: individuals, many of them middle-income, can better plan for their retirement, for college education for their children, and for their long-term needs.
Fourth, alliances allow for efficiency in operations, as they allow for services to be provided and received at a preferential or reduced price. It is not likely that the costs of conducting an audit will decrease, but otherwise skyrocketing costs can be held to pricing levels that allow for reasonable returns on capital to the auditing firms.
New technologies continue to evolve that facilitate efficient examination of clients' records, data and processes. Without unrestricted availability to such technologies, audit teams will be forced to use procedures that may not be best-in-class, or will be forced to pay premiums for the right to use such tools, which will increase the cost of audits - ultimately borne by clients and their shareholders.
In the past few years, Ernst & Young and other Big Five firms have invested hundreds of millions of dollars to purchase state-of-the-art computers for each staff member. Training and software development costs added millions more. However, the creators of leading-edge technologies are able to command significant premiums for needed tools and applications. Alliances allow for quicker access to tools and adoption of emerging technologies, at affordable prices.
2. Our Proposal
Five areas of the Rule Proposal would directly affect an accounting firm's ability to make investments in, provide services to, or enter into strategic alliances or have other business relationships with other entities. These are the definitions of "affiliates" of the accounting firm (Release, 65 Fed. Reg. at 43193, paragraph 2-01(f)(4)), "affiliates" of the audit client (id., paragraph 2-01(f)(5)), the restriction on business relationships (id. at 43191, paragraph 2-01(c)(3)), the limitation on material indirect investments (id. at 43190, paragraph 2-01(c)(1)(i)(D)), and the rules relating to investments in accounting firm affiliates by audit clients (id. at 43191, paragraph 2-01(c)(1)(iv)(A)). The SEC's proposals in these areas are extremely broad and would make it impossible for an accounting firm to have the types of alliances or investments we have just described. Our proposal, at Attachment A, would allow for appropriate alliances and investments in other entities.
First, the proposal would preserve the status quo by adopting the "control" test in Regulation S-X for the definition of affiliates of audit clients (that is, "controlling, controlled by, or under common control with").6 The proposal would impose separate restrictions on investments in audit client affiliates (as distinguished from business relationships with or non-audit services provided by audit client affiliates), consistent with existing rules. 7
Second, as for material indirect investments, our proposal (paragraph 2-01(c)(1)(i)(D)) would codify existing restrictions and, consistent with the ISB's deliberations, impose further limits by clarifying that if the accountant controls the intermediary or its investment activities then the investments by the intermediary are considered direct investments by the accountant.
Third, business relationships, under the SEC's proposal, would reach much further than the existing rules. This is largely because of the broad "affiliate" rules noted above, but also because of a proposed change from the existing provision in the Codification at § 602.02.g ("Business Relationships"). The Codification prohibits direct and material indirect business relationships with persons associated with the audit client "in a decision-making capacity," such as "substantial stockholders." Because of the "decision-making" and "substantial" requirements of this provision, we and other firms use the "significant influence" test of APB 18. The SEC's Rule Proposal would reduce
that test to 5%, thereby greatly expanding the universe of venture capital firms with which we could not have any business relationships. We have proposed using the existing rules (particularly since, in the vast majority of cases, these types of investments in start-up companies by venture capital firms are immaterial to the venture capitalist).
Finally, the SEC's Rule Proposal would prohibit an audit client from investing in an accounting firm or its affiliate. This is certainly an appropriate restriction as a general matter, but there may be situations in which an accounting firm establishes an affiliate, or spins off an existing division, that provides no accounting and no auditing services. Limited, immaterial investments by an audit client in the affiliate or spin-off might properly be permitted under those circumstances; we have proposed appropriate language.8
C. Non-audit services
As noted above, we would support a rule that prohibits the non-audit services that have caused virtually all of the public concern about auditor independence, that is, information systems consulting and full-scope internal audit outsourcing. As to other non-audit services, some are currently prohibited by the AICPA or by the AICPA SEC Practice Section rules, and, as a matter of consistency and ease of reference, it strikes us as reasonable that the Commission might incorporate those restrictions into its own independence rule. However, assuming the Commission does promulgate such a rule, it is important that the precise service that is being prohibited be defined properly, and, unless there is a strong rationale for change, that existing exceptions to these prohibitions be maintained. We point out below where the Rule Proposal should be modified to make it more consistent with existing restrictions.
1. The proposed prohibition on bookkeeping services is as follows:
"Bookkeeping or other services related to the audit client's accounting records or financial statements. Any service involving:
(1) Maintaining or preparing the audit client's or an affiliate of the audit client's accounting records;
(2) Preparing the audit client's or an affiliate of the audit client's financial statements; or
(3) Generating financial information to be disclosed by the audit client or an affiliate of the audit client to the public."
Release, 65 Fed. Reg. at 43192.
The Release states that "[c]urrently, an auditor's independence is impaired if the auditor provides bookkeeping services to an audit client or an audit client's affiliate," and that the Rule Proposal "continues that position." Id. at 43168. While this is largely correct, the Rule Proposal defines bookkeeping not only as "maintaining or preparing" the client's accounting records or "preparing" the client's financial statements, but also as "generating financial information to be disclosed by the audit client or an affiliate of the audit client to the public." Id. at 43192. There is no current prohibition on "generating financial information to be disclosed by the audit client . . . to the public." Auditors frequently perform activities that might be viewed as "generating" financial information, and it is often necessary for the audit firm to be involved in the production of data and evaluations of numbers that ultimately are disclosed to the public. For example, auditors have historically assisted clients in computing tax provisions used in financial statements and frequently propose adjusting journal entries. This type of work might fit within the meaning of "generating financial information," but these activities have traditionally been done without any suggestion of an independence impairment, and it clearly is in the public interest to allow them to continue.
Moreover, the proposed definition does not include current exceptions under the Codification (§ 602.02.c) for bookkeeping in "emergency" situations and for foreign subsidiaries in certain instances. Both of these exceptions are sensible from a public policy standpoint. We have incorporated the existing exceptions into our proposal at Attachment A.9
2. The management consulting proposal would prohibit:
"Financial information systems design and implementation. Designing or implementing a hardware or software system used to generate information that is significant to the audit client's financial statements taken as a whole, not including services an accountant performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls."
Release, 65 Fed. Reg. at 43192.
As noted previously, Ernst & Young recently sold its information systems consulting, or management consulting, practice to Cap Gemini. We did so for a range of business reasons, but one factor was our view that large systems engineering projects can cost millions of dollars, oftentimes a large multiple of the audit fee. We can understand how such services could create an appearance that independence might be impaired and why, therefore, an SEC prohibition might be warranted. Accordingly, although we have some suggested changes in the rule (see Attachment A), we support the rationale for the SEC's proposal.10
We acknowledge that some other major accounting firms have not yet divested themselves of their management consulting practices. One of the arguments heard on this topic is that a management consulting practice is necessary for an accounting firm adequately to perform financial statement audits. Although our experience in this area is only a few months old, we have not found any indication that our ability to provide audit services to our existing clients, or our ability to attract new clients, has been impaired by the fact that we no longer have a management consulting practice. If we had believed that a large management consulting practice was necessary for the conduct of an effective audit, we would not have sold our practice. We maintain the necessary cadre of specialized professionals and experts within the firm upon whom the audit personnel can call for assistance, and we are confident of our ability to use these experts to work in tandem with our auditors.
3. The proposed rule on appraisals is as follows:
"Appraisal or valuation services, fairness opinions, or contribution-in-kind reports. Any appraisal or valuation service for an audit client or an affiliate of an audit client, or any service involving a fairness opinion or contribution-in-kind report where it is reasonably likely that, in performing an audit in accordance with generally accepted auditing standards, the results will be audited by the accountant."
Release, 65 Fed. Reg. at 43192.
We generally agree with the proposed Rule, which is largely consistent with existing rules. There are, however, certain exceptions to the prohibitions. These exceptions have been set forth in an ISB Discussion Memorandum, DM 99-3 (September 19, 1999), "Appraisal and Valuation Services." We would support a restriction assuming that the exceptions are included in the Rule. (See Attachment A).
The proposal's reference to contribution-in-kind reports raises a separate issue. It is common practice in many countries, most notably those within the European Union, for a company's auditor to issue contribution-in-kind reports as the independent expert where it is the task of the expert to review the valuations of third parties in order to protect shareholders and other stakeholders by providing them with an opinion on the adequacy of the valuations (e.g., required by EU Company Law under Articles 10 and 27 of the 2nd Company Law Directive and Articles 10 and 23 of the 3rd Company Law Directive). The regulators and auditors in these jurisdictions consider the service to be an attest function that does not raise independence concerns. They also do not consider this to be a service where it is reasonably likely that, in performing an audit of the company's financial statements, the accountant will be auditing the results of a valuation service performed by the accountant. Accordingly, the Commission, based on consultation with the European Commission, should determine that the services furnished by the accountant when fulfilling the requirements of the 2nd and 3rd Directives are not valuation services such that the results will be audited by the accountant as part of the examination of the client's financial statements. The Commission also should not preclude auditors in jurisdictions outside the United States from issuing such reports as independent experts as required by law when it is recognized and accepted by regulators in the other jurisdictions that the accountant serves as the independent expert for this purpose.11
A final observation: the Release states that the Commission is not prohibiting these services "for non-financial or tax purposes where the results of the valuation do not have a direct impact on the financial statements," (Release, 65 Fed. Reg. at 43169) but this statement is not included in the Rule text. To avoid any confusion, we recommend that the text of the Rule itself include this statement.
4. The prohibition on actuarial services is as follows:
"Actuarial services. Any advisory service involving the determination of policy reserves and related accounts for the audit client or an affiliate of an audit client, unless the audit client or its affiliate uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities."
Release, 65 Fed. Reg. at 43192.
The Release notes that the "SECPS already prohibits member accounting firms from providing certain actuarial services." Id. at 43169. While this is correct, the Rule Proposal does not include a number of items that are included in paragraph 6 of Appendix A of the SEC Practice Section membership requirements as exceptions from the general rule. Those exceptions reflect the profession's best thinking on this issue, and we urge the Commission to retain these exceptions (which are set forth in our proposal at Attachment A).
In addition, the SEC Practice Section prohibits actuarial services in connection with insurance company policy reserves, but does not prohibit actuarial services for other types of companies. The reason is that the actuarial function is basic to the operation and management of an insurance company. Our proposal would maintain the existing distinction.
5. The proposal on internal audit outsourcing provides:
"Internal audit outsourcing. Internal audit services for an audit client or an affiliate of an audit client, not including nonrecurring evaluations of discrete items or programs and operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements."
Release, 65 Fed. Reg. at 43192.
We agree that full-scope internal audit outsourcing might properly be prohibited, but we believe that the proposed restriction should be modified.
In our view, full-scope internal audit outsourcing actually can improve the quality and efficiency of the audit, and independence is not affected. In fact, not that long ago most companies did not have internal audit departments and the audit firm performed more extensive audit procedures. However, we understand that, in the eyes of some, full-scope internal audit outsourcing raises an appearance problem. It would be a mistake, however, for the Commission to prohibit all outsourcing, including smaller-scale activities that have been performed for many years without raising an independence issue. Providing outsourcing services in specific areas or locations, such as computer auditing or work at a company's foreign operation, should not be prohibited. And these less far-reaching activities clearly can improve the quality of the client's financial statements.
Accordingly, we have proposed in Attachment A that accounting firms be permitted to perform internal audit services to the extent these services do not exceed 40% of the client's overall internal auditing activities.
6. The "management functions" proposal is as follows:
"Management functions. Acting, temporarily or permanently, as a director, officer, or employee of an audit client or an affiliate of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client or affiliate of the audit client."
Release, 65 Fed. Reg. at 43192.
This proposal reflects existing practices, and we have no objection to it.
7. The "human resources" consulting proposal is as follows:
"Human resources. Recruiting, hiring, or designing compensation packages for officers, directors, or managers of the audit client or an affiliate of the audit client; advising about the audit client's or affiliate of the audit client's management or organizational structure; developing employee evaluation programs; or conducting psychological or other formal testing of employees."
Release, 65 Fed. Reg. at 43192.
The Release states that this proposed restriction is "consistent with" existing SEC Practice Section rules (id. at 43171, n.171), but, in fact, it differs in significant ways. We have two principal concerns.
First, the proposal would prevent the auditor from "design[ing] compensation packages" for corporate officers. Id. at 43171. This activity is frequently or largely tax-driven, and it is permitted under existing rules. See SEC Practice Section rules (Appendix A, "Executive Recruiting Services," SECPS Membership Requirements). We do not believe such work should be prohibited, as it merely entails advice to the client about compensation issues based on the size of the company, the nature of the business, and similar criteria. We, of course, make no decisions for the client in this area; the work is solely advisory.
Second, audit firms obtain a detailed knowledge of the client's requirements and the business issues surrounding those requirements, and they can perform a service to their clients if they can comment on potential candidates or staff; this is explicitly acknowledged in the SECPS membership requirements. Indeed, audit committees expect to hear the auditors' views on the quality and capabilities of the client's accounting staff. Our proposal, which would permit these activities, is included at Attachment A.12
8. The "broker-dealer" restriction is proposed as follows:
"Broker-dealer, investment adviser, or investment banking services. Acting as a securities professional, such as a broker-dealer, promoter, underwriter, analyst of the audit client's or an affiliate of the audit client's securities, investment adviser, or in any capacity recommending the purchase or sale of an audit client's or an affiliate of an audit client's securities, or designing the audit client or an affiliate of the audit client's system to comply with broker-dealer or investment adviser regulations."
Release, 65 Fed. Reg. at 43192.
The Codification (§ 602.02.e.iii) states that "concurrent engagement as a broker-dealer is incompatible with the practice of public accounting." The text of the Rule Proposal, however, raises several concerns that the Codification does not.
First, unlike the existing rule, the Rule Proposal uses several terms - "investment adviser," "investment banking services," "securities professional," "promoter," "underwriter," and securities "analyst" - whose meaning and significance is either unclear or too broad. For instance, "investment banking services," "securities professional," and securities "analyst" are not defined terms in the securities laws. The use of these words will cause confusion, and we recommend that the proposal be limited to broker-dealer, promoter and underwriter work, which is the current rule.
Second, the proposed restriction on work as an "investment adviser" would make it impossible for us to maintain our existing personal financial counseling practice. We operate this practice pursuant to a no-action letter, Arthur Andersen & Co., SEC No-Action Letter, July 8, 1994 (1994 SEC No-Act LEXIS 617), and we registered an investment adviser - Ernst & Young Investment Advisers LLP - with the Commission. Among other things, EYIA provides asset allocation recommendations to clients, identifies categories of mutual funds that satisfy a client's investment objectives and other criteria, and provides the client with a list of two or more mutual funds in each category from which the client may choose. If the client wants more specialized advice, EYIA will also provide a list of two or more money managers that meet certain criteria. EYIA does not make any recommendations as to any other specific types of securities. It is a highly circumscribed practice, used mostly by individuals to plan for retirement, education, and other expenses. Further details on these activities are set forth in EYIA's Form ADV, filed with the Commission.13
Third, we are concerned that, because of the way that the proposal is worded, it would reach services that we perform for non-audit clients, as well as for audit clients. The Rule should make clear that it only restricts broker-dealer work performed for an audit client, just as all of the other proposed restrictions on non-audit services only apply to work performed for audit clients.
9. The SEC's restriction on "legal services" is as follows:
"Legal services. Providing any service to an audit client or an affiliate of an audit client that, in the jurisdiction in which the service is provided, could be provided only by someone licensed to practice law."
Release, 65 Fed. Reg. at 43192.
Legal services for audit clients by U.S. lawyers are currently prohibited by the SEC, and the practice of law by accounting firms is prohibited under state bar rules. The Commission's proposal, however, would change existing practice by prohibiting non-U.S. law practices associated with Ernst & Young from being allowed to continue providing foreign legal services (i.e., legal services involving non-U.S. law), pursuant to guidelines they are now following. These non-U.S. Ernst & Young affiliates practice solely foreign law, as to which restrictions on legal practice are quite different from those in the U.S. Our proposal, at Attachment A, would address this issue.
10. The proposed restriction on "expert services" is as follows:
"Expert services. Rendering or supporting expert opinions for an audit client or an affiliate of an audit client in legal, administrative, or regulatory filings or proceedings."
Release, 65 Fed. Reg. at 43192.
This proposal is contrary to existing rules. The proposal seems to be based on the premise that the expert serves as an "advocate" for his or her client. The AICPA standards, however, make clear that the expert is not an advocate, but rather is an objective analyst and presenter of specialized information. ET § 191.203 provides:
A member serving as an expert witness does not serve as an advocate but as someone with specialized knowledge, training, and experience in a particular area who should arrive at and present positions objectively.
Likewise, the AICPA has instructed:
When acting as an expert witness, CPAs need to make clear to the attorney and client that the CPA's role is not to become the client's advocate. Client advocacy is a proper role for lawyers, but not for CPAs who will provide expert testimony. The CPA's role is to form an objective professional opinion based on either facts or hypotheses. As expert witnesses, CPAs need to maintain objectivity at all times in a litigation services assignment.
Consulting Services Special Report 93-4: Providing Litigation Services (70/120.02). See also AICPA Code of Professional Conduct Rule 102.
Moreover, preventing the client's accountants from providing expert services would be detrimental to the client and its investors for numerous reasons. The auditor is typically familiar with the client's key information and accounting systems, financial records and personnel of the client, and this familiarity can be critically important on assignments, which frequently can be time sensitive. For example, engagements can include investigations of potential, suspected, or actual fraud; investigation of and response to electronic security breaches/computer hackers; evaluation of financial terms and defenses in a hostile takeover context; evaluation of insurance disaster claims; and work on other time sensitive regulatory issues. If a client is required to look elsewhere than its auditor for an expert in these areas, the service is almost certain to be provided less efficiently and effectively. Accordingly, because expert services are not currently prohibited and do not cause any independence impairment - in fact or in appearance - we recommend that the restriction on expert services be dropped from the Rule.
D. Personal Independence Requirements
As a general matter, we believe that the Commission's proposed changes to the financial investment and employment rules would be an enormous improvement over the existing rules in this area. As Chairman Levitt himself recognized in his speech at the New York University School of Law on May 10, 2000,14 the current rules severely penalize accountants whose spouses work outside the home. In many respects, the current rules are outdated and even irrational. Although we applaud the Commission's efforts, we have a number of specific concerns. Because these issues are highly technical, we have set forth our specific concerns in Attachment B.
The Rule Proposal (Release, 65 Fed. Reg. at 43191, paragraph 2-01(c)(ii)(F)) would prohibit an accounting firm from obtaining professional liability insurance from an audit client. According to the Release, the SEC believes this restriction is necessary because an insurance policy is believed to create a debtor-creditor relationship or other commingling of the financial interests of the auditor and audit client, and the continued viability of the audit client insurance company may be necessary for the auditor to receive a financial benefit in the form of a claim payment.
Because of the rather unusual nature of the Big Five insurance programs, these concerns are unwarranted. Our professional liability coverage, like that of the other major accounting firms, is obtained through globally syndicated policies that involve numerous insurers. Because of these complex syndications, it is exceedingly unlikely that any one insurer's participation could affect the judgment of an auditor. This is true for many reasons, including the fact that a line auditor is unlikely even to know about the audit firm's insurance arrangements and, even if he or she does know, the roster of insurers, and the layers on which they participate, change every year, making information about any one particular year of extremely limited value.
Moreover, the practical implications of the Commission's proposal counsel strongly against its adoption. If the Rule Proposal were adopted, either of two things would happen: Big Five audit firms would not be able to purchase adequate professional indemnity insurance coverage, or the major insurance companies that provide this coverage would no longer be able to obtain an audit from a Big Five audit firm. This is because there is a small number of major global insurers - only three or four - who have the financial capacity and insurance expertise to participate in a lead role to provide professional indemnity insurance coverage on a global basis to the Big Five firms. All of those insurance companies also have a Big Five auditor and most provide coverage for at least four of the Big Five firms. The number of insurers prepared to lead Big Five syndicated insurance groups, and the number of insurers who can participate in those groups, is extremely limited because of the complicated nature of evaluating and pricing the Big Five liability risks and because of the high levels of exposure.15
As the Commission is presumably aware, we and other major accounting firms continue to face massive liability risks. It might be thought that passage of the Private Securities Litigation Reform Act of 1995 largely ameliorated those risks, but this would be wholly inaccurate. The risks are real. We urge the Commission not to preclude us from obtaining adequate insurance coverage.
F. Contingent Fees
The Rule Proposal (Release, 65 Fed. Reg. at 43192, paragraph 2-01(c)(5)) provides for the first time a Commission rule addressing directly, and prohibiting an auditor from receiving, contingent fees from an audit client. Although the SEC discussion of the Rule Proposal draws heavily on the existing AICPA guidance, specifically Ethics Rule 302, "Contingent Fees," it departs from that rule in several respects. If the SEC believes it is necessary to address contingent fees as part of its independence rules, the Commission should take the benefit of the many years of experience the profession has had with AICPA Rule 302 and adopt that rule, including its exceptions, as its contingent fee rule.
As proposed, the Rule would prohibit fee arrangements that are not genuinely "contingent fees" because they are not contingent on any specific findings or outcome.
As the leading treatise in this area points out, a restriction on contingent fees, such as the existing AICPA rule, is not
"intended to mean that a CPA's fees must always be based on inflexible per diem rates. In deciding what to charge for his work he may properly consider such factors as the following: the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the engagement properly; the customary charges by certified public accountants for similar services; the amounts involved in the transactions to which the accountant's work relates, and the extent of benefit to the client resulting from the accountant's services; the character of the employment, whether casual or for an established and constant client."
John Carey & William Doherty, Ethical Standards of the Accounting Profession, 143 (1996).
In short, we urge the SEC, if it believes there is a necessity for it to have its own contingent fee rule as part of the independence rules, to adopt AICPA Rule 302 in its entirety and not prohibit fee arrangements that are based on factors such as the timeliness of completion of a project and are not contingent on any specific finding or outcome. Our proposal, at Attachment A, reflects the existing AICPA rule.
G. Proxy Disclosure
In addition to the specific prohibitions on non-audit services set forth in the Rule Proposal, the Commission is proposing to require that companies make detailed disclosure of non-audit services and fees in their annual proxy statement. Most significantly, the proposal would require disclosure of "each professional service" (Release, 65 Fed. Reg. at 43176) provided by the company's auditing firm (unless the fee for the services was less than $50,000 or 10% of the annual audit fee) and the fees for each such service; a statement as to whether the audit committee approved the service before it was rendered and "considered the possible effect of the service on the principal accountant's independence" (id. at 43194); and disclosure of the aggregate fee for the audit and quarterly reviews of the company's financial statements. We have several observations.
First, in view of the specific prohibitions on non-audit services, we believe that such detailed disclosures are unnecessary. The disclosures would actually be more confusing than helpful to investors, because the disclosures would relate to services that do not cause an independence impairment. As is required by ISB 1, the company's audit committee will presumably have considered the information disclosed in the proxy statement in considering the independence of the auditors.
Second, the Rule Proposal could require the disclosure of confidential information that could competitively disadvantage the registrant. For example, an accounting firm might be retained to participate in due diligence relating to a possible acquisition. That information might be non-public, and its disclosure might well conflict with legal or professional rules of confidentiality.
Third, the proposal emphasizes the need for approval by the audit committee of any engagement for non-audit services, but many audit committees do not meet more than three or four times a year, making this an impractical concept.
Fourth, and particularly important, the Release says that the disclosure rule that is being proposed is like that in the United Kingdom (e.g., Release, 65 Fed. Reg. at 43186, "The disclosure of non-audit services provided by a company's auditor is intended to allow investors to judge for themselves whether they believe that a particular service affects the independence of the audit. Such disclosures have been provided in the United Kingdom for several years."). In fact, the rule in the U.K. only requires disclosure of the total of audit fees and the total of non-audit fees, and it does not require any specific disclosure of the nature of the non-audit service or the specific fees relating to that service. This disclosure is much more limited than what the Commission has proposed. We have set forth in Attachment A a rule that follows the tradition established in the U.K.16
H. Transition Rules
The proposed Rule includes a transition provision, but it provides a transition period only for the prohibitions on non-audit services. We have proposed a broader rule. Our proposal would also give firms a two-year transition period to exit from the provision of non-audit services that would be prohibited by the new Rule. In addition, our proposal would provide for grandfathering of loans, insurance products, and employment relationships that would prohibited by the new Rule but are not prohibited by the existing rules.
The Commission is proposing to delete interpretations in the Codification that are reflected in, or that have been superseded by, the new Rule. At the same time, the Commission is proposing to leave items that "may continue to be useful in situations not specifically or definitively addressed in the proposed rule." Release, 65 Fed. Reg. at 43182. Because the Rule Proposal is intended to clarify the existing independence restrictions, the Commission should ensure that matters covered by the Rule are deleted from the Codification and should not add substantial additional material to the Codification (as is proposed at 65 Fed. Reg. 43190).
For the foregoing reasons, we urge the Commission to adopt the alternative rule proposal set forth in Attachment A.
Ernst & Young LLP
Proposed Revised Independence Rule
§ 210.2-01 Qualifications of accountants
(a)* * *
The Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or would not be perceived by reasonable persons, with knowledge of all relevant facts and circumstances, to be capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement. In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the Commission.
An accountant is not independent under the standard of paragraph (b) of this section if, during the audit and professional engagement period, the accountant has any of the financial, employment or business relationships with, provides any of the non-audit services to, or receives a contingent fee from, the accountant's audit client as specified in paragraphs (c)(1) through (c)(5) of this section.
(1) Financial relationships
An accountant is not independent if the accountant has a direct financial interest or a material indirect financial interest in the accountant's audit client, such as the financial relationships specified in this paragraph (c)(1).
(i) Investment in audit client
An accountant is not independent when:
(A) The accounting firm, any covered person in the firm, or any of his or her immediate family members has any direct investment in an audit client, such as stocks, bonds, notes, options, or other securities.
(B) Any partner, principal, shareholder (hereinafter referred to as partner), or professional employee of the accounting firm, any of his or her immediate family members, or any group of the above persons has filed a Schedule 13D or 13G with the Commission indicating beneficial ownership of more than five percent of an audit client's equity securities, or controls an audit client, or a close family member other than an immediate family member of a partner has control of an audit client.
(C) The accounting firm, any covered person in the firm, or any of his or her immediate family members, serves as voting trustee of a trust or executor of an estate containing the securities of an audit client.
(D) The accounting firm, any covered person in the firm, any of his or her immediate family members, or any group of the above persons has any material indirect investment in an audit client.
The term "indirect investment" means an investment in one or more audit clients through a non-client intermediary, such as a mutual fund or unit investment trust, unless:
(i) The holder of an interest in the intermediary has control over that entity or its investment activities, in which case the investment in the audit client is considered to be direct; or
(ii) The intermediary has an investment in the audit client that amounts to 20% or more of its total investments at the time of investment, in which case the investment in the audit client is considered to be direct.
The materiality of an indirect investment is measured on a flow-through basis - i.e., as if the holder's prorata share of the intermediary's underlying investments belong to the holder. Materiality is based on the accounting firm's net worth or the combined net worth of a covered person and his or her immediate family members.
(i) The accounting firm, any covered person in the firm or any of his or her immediate family members has any direct or material indirect investment in a non-audit client where an audit client has the ability to exercise significant influence (as defined by generally accepted accounting principles) over the non-audit client and the audit client's investment in the non-audit client is material to the audit client; or
(ii) the accounting firm, any covered person in the firm or any of his or her immediate family members has any direct or material indirect investment (A) in a non-audit client where the non-audit client has the ability to exercise significant influence over the audit client and the non-audit client's investment in the audit client is material to the non-audit client; or (B) that would enable the firm, any covered person or any of his or her immediate family members to exercise significant influence over a non-audit client if the non-audit client has significant influence over the audit client.
(ii) Other financial interests in audit client.
(A) An accountant is not independent when the accounting firm, any member of the audit engagement team, or any of his or her immediate family members has:
(1) Loans/debtor-creditor relationship
Any loan (including any margin loan) to or from an audit client, or an audit client's officers, directors, or stockholders who have the ability to exercise significant influence over the audit client, except for the following loans obtained from a financial institution under its normal lending procedures, terms and requirements:
(a) Automobile loans and leases collateralized by the automobile;
(b) Loans fully collateralized by the cash surrender value of an insurance policy;
(c) Loans fully collateralized by cash deposits at the same financial institution; and
(d) A mortgage loan collateralized by the accountant's primary residence provided the loan was not obtained while the borrower was a member of the audit engagement team or an immediate family member of a member of the audit engagement team.
(2) Savings and checking accounts
Any savings, checking or similar account at a bank, savings and loan or similar institution that is an audit client, if the account has a balance that exceeds the amount insured by the Federal Deposit Insurance Corporation or any similar insurer except that a firm account may have an uninsured balance provided that the firm has concluded that the likelihood of the bank, savings and loan, or similar institution experiencing financial difficulties is remote.
(3) Broker-dealer accounts
Any brokerage or similar accounts maintained with a broker-dealer that is an audit client, if:
(a) Any such accounts include any asset other than cash or securities (within the meaning of "security" provided in the Securities Investor Protection Act); or
(b) The value of 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 the Securities Investor Protection Act.
(4) Futures commission merchant accounts
Any futures, commodity, or similar account maintained with a futures commission merchant that is an audit client.
(5) Credit cards
Any aggregate outstanding credit card balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and any available grace period.
(B) Insurance Products: An accounting firm is not independent when any member of the audit engagement team, or any of his or her immediate family members, has any individual policy issued by an audit client that is obtained by the accountant, or by his or her immediate family member, while the accountant is a member of the audit engagement team. Previously obtained policies will not impair independence provided that the likelihood of the insurance company becoming insolvent is remote. Such policies may be renewed and coverage increased if done pursuant to the pre-existing contractual terms of the policy.
(C) Investment companies: An accounting firm is not independent where the firm, any covered person, or any of his or her immediate family members have any investment in any entity that is part of an investment company complex if the audit client is also part of thesame complex and if the audit client is an investee it is material to the non-client investor or if the audit client is an investor the non-client investee is material to the audit client investor, except as follows: (i) When the audit client is the investment advisor or sponsor of a unit investment trust, members of the audit engagement team and their immediate family members may not invest in non-client funds or unit investment trusts advised or sponsored by the audit client notwithstanding that such funds or trusts are not deemed to be material to the audit client; (ii) when the audit client(s) is an investment company or unit investment trust advised or sponsored by a non-client advisor or sponsor, members of the audit engagement team and their immediate family members may not invest in the non-audit client advisor or sponsor, or in funds or trusts advised or sponsored by the same advisor or sponsor, notwithstanding that such funds or trusts are not deemed to be material to the audit client.
Notwithstanding paragraphs (c)(1)(i) and (c)(1)(ii) of this section, the accountant will not be deemed not independent if:
(A) Inheritance and gift
Any person acquires a financial interest through an unsolicited gift or inheritance that would cause an accountant to be not independent under paragraphs (c)(1)(i) or (c)(1)(ii) of this section, 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 the financial interest.
(B) New audit engagement
Any person has a financial interest that would cause an accountant to be not independent under paragraphs (c)(1)(i) or (c)(1)(ii) of this section, and:
(1) The accountant did not audit the client's financial statements for the immediately preceding fiscal year; and
(2) The accountant is independent under paragraphs (c)(1)(i) and (c)(1)(ii) of this section before the earlier of:
(i) Signing an initial engagement letter to provide audit, review, or attest services to the audit client; or
(ii) Commencing any audit, review or attest procedures (including planning the audit of the client's financial statements).
(C) Inadvertent Violations Where Firm Has Quality Controls in Place
An accounting firm's independence will not be impaired solely because a covered person in the firm is not independent of an audit client provided:
(1) The covered person did not know of the circumstances giving rise to the lack of independence;
(2) The covered person's lack of independence was corrected promptly under the relevant circumstances after the covered person or accounting firm became aware of it; and
(3) The accounting firm has a quality control system in place that provides reasonable assurance, taking into account the size, and nature of the accounting firm's practice, that the accounting firm and its employees do not lack independence. For an accounting firm that annually provides audit, review, or attest services to more than 500 companies with a class of securities registered with the Commission under section 12 of the Securities Exchange Act of 1934, a quality control system will not provide such reasonable assurance unless it has at least the following features:
(i) Written independence policies and procedures;
(ii) With respect to partners and managers, an automated system to identify their financial relationships (i.e., investments in securities) that might impair the accountant's independence;
(iii) With respect to all professionals, a system that provides information about entities that require independence;
(iv) An annual or on-going firm-wide training program about auditor independence;
(v) An annual internal inspection and testing program to monitor adherence to independence requirements;
(vi) Notification to all firm members, officers, directors, and employees of the name and title of the member of senior management responsible for compliance with auditor independence requirements;
(vii) Written policies and procedures requiring all partners and all covered persons to report promptly to the firm when they are engaged in employment negotiations with an audit client, and requiring the firm to remove immediately any such professional from that audit client's engagement and to review promptly all work the professional performed related to that audit client's engagement; and
(viii) A disciplinary mechanism to ensure compliance with this section.
[New language needed re: Not applicable if system is prohibited in foreign jurisdiction based on privacy or confidentiality concerns.]
(iv) Audit clients' financial relationships
An accountant is not independent when:
(A) Investment by the audit client in the auditor
An audit client has, or has agreed to acquire any direct investment in the accounting firm or its affiliate, such as stocks, bonds, notes, options, or other securities, except that as to accounting firm affiliates that do not provide any accounting or auditing services, independence is not impaired by investments that are not material to the audit client, but in no event may such direct investments exceed ten percent of the outstanding shares of the accounting firm affiliate.
(B) The accounting firm engages an audit client to act as an underwriter with respect to securities issued by the accounting firm .
(2) Employment relationships
An accountant is not independent if the accountant has an employment relationship with an audit client as follows :
(i) Employment at audit client of accountant
A current partner or professional employee of the accounting firm is employed by the audit client or serves as a member of the board of directors or similar management or governing body of the audit client.
(ii) Employment at audit client of certain relatives of accountant; Employee Benefit Plans and Compensation Programs
(A) A member of the audit engagement team has (i) a close family member, other than an immediate family member, who has a known material (to both the relative and the professional) investment in the audit client, or (ii) a close family member who is in an accounting or financial reporting oversight role at the audit client, or was in such a role during any period covered by the audit for which the accountant is a member of the engagement team;
(B) A partner who is in a position to influence the audit has a close family member who is in an accounting or financial reporting oversight role at the audit client, or was in such a role during any period covered by an audit that the partner is in a position to influence;
(C) Notwithstanding the provisions of (c)(1)(i) above, immediate family members of covered persons who are not precluded under this paragraph from having an employment relationship with the audit client may fully participate in the client's employee compensation programs, including receiving stock, stock options, and restricted stock and participate in stock purchase plans, 401(k) plans, etc., provided they are not immediate family members of a member of the audit engagement team. When the immediate family member is no longer employed by the client and there are no restrictions that preclude the disposition of the investments obtained as a result of participation in the employee compensation program, such investments must be disposed of within ninety days of termination of employment or the cessation of restrictions whichever is later, if the person is still a close family member of a covered person in the firm.
(iii) Employment at audit client of former employee of accounting firm
A former partner, shareholder, principal, or professional employee of an accounting firm becomes associated with an audit client unless the individual:
(A) Does not influence the accounting firm's operations or financial policies;
(B) Has no capital balances in the accounting firm; and
(C) Has no financial arrangement with the accounting firm other than one providing for regular payment of a fixed dollar amount (which is not dependent on the revenues, profits, or earnings of the firm) which is immaterial to the firm. For individuals who: (1) within five years of disassociation from the firm are employed by an audit client in a position that is required to be disclosed in the client's proxy statement or annual report filed with the Commission, or (2) become non-employee directors of an audit client with which they were closely associated (i.e., a member of the audit engagement team or in a position to influence the audit) within two years of such close association, such payments must be made pursuant to a fully funded retirement plan, rabbi trust, or similar vehicle.
(iv) Employment at accounting firm of former employee of audit client
A former officer, director, or employee of an audit client becomes a partner of the accounting firm, unless the individual does not participate in, and is not in a position to influence, the audit of the financial statements of the audit client covering any period during which he or she was employed by or associated with that audit client.
(3) Business relationships
(a) An accountant is not independent if the accounting firm or any covered person in the firm has any direct or material indirect business relationship
(i) with an audit client,
(ii) with an audit client's officers, directors, or a substantial stockholder, or
(iii) with an entity over which the audit client has significant influence but not control, and the effect of the business relationship is material to the audit firm or to the audit client.
(b) The relationships described in this paragraph do not include a relationship in which the accounting firm or covered person in the firm provides professional services or is a consumer in the ordinary course of business.
(4) Non-audit services
An accountant is not independent when the accountant provides the following non-audit services to an audit client.
(A) Bookkeeping or other services related to the audit client's accounting records or financial statements
Any service involving:
(1) Maintaining or preparing the audit client's accounting records;
(2) Preparing the audit client's financial statements that are filed with the Commission; or
(3) Preparing or originating source data underlying the client's financial statements.
Notwithstanding the above, the accountant may assist the client in emergency or other unusual situations provided the accountant does not make any managerial decisions. The accountant may perform certain limited services for foreign subsidiaries, divisions, branches or offices of the client provided
(i) the services are limited, routine, or ministerial;
(ii) it is impractical for the client entity to make other arrangements;
(iii) the services relate to accounting entries that are not material to the consolidated financial statements;
(iv) the services performed are consistent with local professional ethics rules; and
(v) the fees for all such services collectively (for the entire group of companies) do not exceed the greater of 1% of the consolidated audit fee or $10,000.
(B) Financial Information Systems
Designing or implementing a hardware or software system that aggregates source data underlying the financial statements and generates information that is significant to the audit client's financial statements taken as a whole, not including services an accountant performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls.
(C) Appraisal or valuation services and fairness opinions
Any appraisal or valuation service or any service involving a fairness opinion that is not required by law to be rendered by an independent expert (including the statutory auditor when recognized and accepted by regulators in the concerned jurisdiction) where it is reasonably likely that, the results of the valuation would be material to the financial statements, or, in performing an audit in accordance with generally accepted auditing standards, the results will be audited by the accountant. This prohibition does not apply: (1) when a firm valuation expert reviews and reports on the work of the audit client or a specialist, employed or engaged by the client, and the audit client or specialist provides the primary support for the balance recorded in the client's financial statements; (2) to situations where firm actuaries value a client's pension, other post-employment benefit, or similar liabilities as long as the assumptions and data are provided by the audit client; (3) to valuations performed in the context of the planning and implementation of a tax-planning strategy or for tax compliance purposes; or (4) to valuations for non-financial purposes where the results of the valuation do not have a direct impact on the financial statements.
(D) Actuarial services
Any actuarial service involving the determination of insurance company policy reserves and related accounts, unless the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities. This restriction does not include:
(i) Assisting management to develop appropriate methods, assumptions, and amounts for policy and loss reserves and other actuarial items presented in financial reports based on the company's historical experience, current practice, and future plans.
(ii) Assisting management in the conversion of financial statements from a statutory basis to one conforming with generally accepted accounting principles.
(iii) Analyzing actuarial considerations and alternatives in federal income tax planning.
(iv) Assisting management in the financial analyses of various matters such as proposed new policies, new markets, business acquisitions, and reinsurance needs.
(E) Operation of the internal audit function or department
Internal audit services for an audit client, except that the accountant may provide services to supplement the audit client's internal audit functions by performing evaluations in discrete areas, such as computer auditing, or in certain geographic locations, provided that the accountant conducts no more than 40% of the audit client's internal audit activities. Nothing in this paragraph (i) precludes the auditor from performing extended audit procedures during the period under audit in order to comply with generally accepted auditing standards (for example, when the registrant does not have an internal audit department), or (ii) restricts operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements.
(F) Management functions
Acting, temporarily or permanently, as a director, officer, or employee of an audit client or performing any decision-making, supervisory, or ongoing monitoring function
(G) Executive Recruitment
Searching for or seeking out prospective candidates for managerial, executive, or director positions; engaging in psychological testing, or other formal testing or evaluation programs; undertaking reference checks of prospective candidates for an executive or director position; acting as a negotiator on the client's behalf, in determining position, status or title, compensation, fringe benefits, or other conditions of employment; or recommending or advising the client to hire a specific candidate for a specific job (except that an accounting firm may, upon request by the client, interview candidates and advise the client on the candidate's competence for financial accounting, administrative, or control positions).
(H) Broker-dealer services
Acting as a broker-dealer, promoter, or underwriter on behalf of an audit client.
(I) Legal services
Providing any service to an audit client under circumstances in which the person providing the service must be admitted to practice before the courts of a U.S. jurisdiction.
(5) Contingent fees.
(A) An accountant is not independent if the accountant provides any service to an audit client for a contingent fee, or receives a contingent fee from an audit client.
(B) Except as stated in the next sentence, a contingent fee is a fee established for the performance of any service pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such service. Solely for the purposes of this rule, fees are not regarded as being contingent if fixed by courts or other public authorities, or, in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies. Fees may vary depending, for example, on the complexity of services rendered.
To the extent the matters covered by (c)(1) through (4) above were not previously prohibited by published rules and guidelines of the Commission or those of the accounting profession in the United States, these rules should be complied with no later than two years from the effective date of this section, except that foreign firms that practice as sister accounting firms are not required to comply with subsections (3)(ii) and (3)(iv) of (C)(1)(iii)(B) above ("Inadvertent Violations Where Firm Has Quality Controls in Place") for a period of three years from the effective date of this section in order for the exception set forth in (c)(2)(iii)(B) to be applicable. Loans, insurance products, and employment relationships in existence on the effective date of this section that are prohibited by these rules, but were not prohibited by previous rules, are grandfathered. The requirement in (c)(2)(iii) to settle financial arrangements with former professionals applies to situations that arise after the effective date of this section.
(f) Definitions of terms.
For purposes of this section:
means a certified public accountant or public accountant performing services in connection with an engagement for which independence is required. References to the accountant include any accounting firm with which the accountant is affiliated.
(2) Accounting firm
means the organization (whether it is a sole proprietorship, incorporated association, partnership, corporation, limited liability company, limited liability partnership, or other legal entity) that is engaged in the practice of public accounting or furnishing accountant's reports with respect to financial statements, reports, or other documents filed with the Commission, and all departments, divisions, parents, subsidiaries, and affiliates of the accounting firm, including its pension, retirement, investment or similar plans.
(3) Accounting or financial reporting oversight role
means that the person is a member of the 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, or any equivalent position.
(4) Affiliate of the audit client
means an entity that has control over the audit client, or over which the audit client has control, or which is under common control with the audit client.
(5) Audit and professional engagement period
means the period of the engagement to audit or review the client's financial statements to be filed with the Commission (the "professional engagement period"). The professional engagement period:
(i) Begins when the accountant starts to perform professional services requiring independence pursuant to this section 2-01 provided that the accountant was fully compliant with section 2-01 in the conduct of the audit of the most recent fiscal period, and was not connected with the client as a promoter, underwriter, and voting trustee, or as a director, or officer, or in any capacity equivalent to that of a member of management during any period covered by any financial statements being audited or reviewed (the "audit period")'; and
(ii) Ends when the client notifies the accountant that the accountant is dismissed, or the accountant notifies the client that it is no longer that accountant's audit client.
(6) Audit client
means the entity whose financial statements or other information is being audited, reviewed, or attested and any affiliates of such entity, except with respect to the application of (c)(1)(i), it means the entity whose financial statements or other information is being audited, reviewed, or attested and any material affiliates of such entity.
(7) Audit engagement team
means all partners, principals, shareholders, and professional employees participating in an audit, review, or attestation engagement of an audit or attest client, including those conducting concurring or second partner reviews.
(8) Position to influence
means all persons who: a) supervise or have direct management responsibility for the audit, including at all successively senior levels through the firm's chief executive, b) evaluate the performance or recommend the compensation of the audit engagement partner, c) provide technical consultation to, quality control or other oversight of the audit, or d) are partners or managerial employees who provide ten or more hours of non-audit services to the client.
(9) Close family members
means a person's spouse, spousal equivalent, parent, dependent, nondependent child, and sibling.
(10) Covered persons in the firm
means the following partners and employees of an accounting firm:
(i) The "audit engagement team;"
(ii) Those in a "position to influence" the audit; and
(iii) Any other partner, principal, or shareholder from an office of the accounting firm in which the lead audit engagement partner primarily practices in connection with the audit.
means when two or more persons act together for the purposes of acquiring, holding, voting, or disposing of securities of a registrant.
(12) Immediate family members
means a person's spouse, spousal equivalent, and dependents.
(13) Investment Company Complex(i) "Investment company complex" includes:
(A) An investment company and its investment adviser or sponsor;
(B) Any entity controlled by, under common control with or controlling the investment adviser or sponsor in paragraph (f)(16)(A) of this section; or
(C) Any investment company or entity that would be an investment company but for the exclusions provided by section 3(c) of the Investment Company Act of 1940 (15 U.S.C. § 80a-3(c)) that has an investment adviser or sponsor included in this definition by either paragraphs (f)(16)(A) or (f)(16)(B) of this section.
(ii) An investment adviser, for purposes of this definition, does not include a sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser.
(iii) Sponsor, for purposes of this definition, is an entity that establishes a unit investment trust.
(14) Office means a distinct sub-group within an accounting firm, whether distinguished along geographic or practice lines.
(15) Rabbi trust means an irrevocable trust whose assets are not accessible to the accounting firm until all benefit obligations have been met, but are subject to the claims of creditors in bankruptcy or insolvency.
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934
3. The authority citation for Part 240 continues to read, in part, as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
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4. By amending § 240.14a-101 to add paragraph (e) to Item 9 to read as follows:
§ 240.14a-101 Schedule 14A Information required in proxy statement.
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Item 9. Independent public accountants. * * *
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(e)(1) Disclose (i) the aggregate fees for the audit of the registrant's financial statements for the fiscal year most recently completed, for reviews of the financial statements included in the registrant's Forms 10-Q, and for other services related to registration statements and reports filed with the Commission; and (ii) the aggregate fees for all non-audit services provided during the fiscal year most recently completed.
Personal Independence Rule Proposals
We have the following specific comments on the section of the rule dealing with personal investments and employment restrictions.
1. Definition of "Covered Persons": We agree with the concept of "covered persons," and we agree with the proposed definition and inclusion of "immediate family members." Release, 65 Fed. Reg. 43148, 43194 (2000) (to be codified at 17 C.F.R. pts. 210 & 240) (proposed July 12, 2000). We believe, however, that the Commission should adopt definitions of "audit engagement team" and "those in a position to influence the audit," as set forth in the June 19, 2000 draft of an exposure draft prepared by the Independence Standards Board, "Financial Interests of the Auditor in, and Family Relationships Between, the Auditor and the Audit Client." The ISB's definitions provide a more appropriate way to target those individuals that should be restricted. We have reflected those alterations in the proposed rule text at Attachment A.
In addition, one aspect of the SEC's proposed definition of "a covered person" is that it would include partners who are not on the engagement team but who work in an office that participates in a "significant portion of the audit." Such non-involved partners are not in a position to influence the audit, and the inclusion of such professionals would be inconsistent with the streamlining purpose of the rule revisions. Moreover, in some cases there could be hundreds of such partners who would be covered, because the audit of a large client could involve many offices. Further, this proposal would be extremely difficult to implement. One can easily identify the audit engagement team, and those in a position to influence the audit (subject to our comments below) are a fairly limited group. It would, however, be difficult to determine the appropriate office subgroup and also to determine whether an office participates in a "significant portion" of the audit, particularly since that determination can vary from year to year. Thus, we urge that the "covered persons" definition only include partners from the office in which the lead audit engagement partner primarily practices in connection with the audit. This would appropriately limit the number of affected individuals by targeting those who are most likely to have contact with the key player in the audit, that is, the engagement partner.
We also do not support the proposed "chain of command" element of the covered person definitions because it focuses on persons who "may review, determine, or influence the performance appraisal or compensation of `any' member of the audit engagement team." Release, 65 Fed. Reg. at 43193. This approach could include many hundreds (or thousands) of additional people (particularly since professionals work on a number of different audits during the year), and it, too, would be extremely difficult to implement. More importantly, it would not target those who would actually be in a position to influence the audit. Thus, we would limit these individuals - whom we refer to in our proposal as persons in a "position to influence" rather than persons in the "chain of command" - to persons who a) supervise or have direct management responsibility for the audit, including at all successively senior levels through the firm's chief executive, b) evaluate the performance or recommend the compensation of the audit engagement partner, c) provide technical consultation to, quality control or other oversight of the audit, or d) are partners or managerial employees who provide ten or more hours of non-audit services to the client.
2. Investments in Audit Clients: The Rule (Release, 65 Fed. Reg. at 43190, paragraph 2-01(c)(1)(i)) prohibits certain investments in audit clients, both by the firm and certain persons at the firm. Certain observations apply to investments by individuals at the firm.
First, we agree with the basic restriction on direct investments in (i)(A). We also agree on the cap on investments by non-covered persons in (i)(B). While it is unlikely that a professional would own anywhere near 5% of an SEC audit client's equity securities, the Schedule 13D filing requirement does provide an objective measure of impairment. Consistent with the ISB's deliberations, however, we do not believe that the 5% cap should apply to parents, non-dependent children or siblings of covered persons but that such relatives of any partner should not control an SEC audit client.
We also agree with the restrictions on serving as voting trustee or executor in the Release, 65 Fed. Reg. at 43190, paragraph 2-01(c)(1)(i)(C).
3. Other financial interests in the audit client: Proposed paragraph 2-01(c)(1)(ii) of the Release, 65 Fed. Reg. at 43190, would restrict the firm and all covered persons with respect to loans, savings and checking accounts, broker-dealer accounts, futures commission merchant accounts, credit cards, insurance products and investment companies. While we agree with the scope of the restrictions on investments set forth in the Release, 65 Fed. Reg. at 43190, paragraph 2-01(c)(1)(i), we should note that these other financial interests for the most part have a more tenuous impact on independence, since they represent interests acquired as a consumer in the ordinary course of business.
The firm and the audit engagement team, but not those in a position to influence the audit, should be restricted with respect to loans, savings, checking, broker-dealer and futures commission merchant accounts, and credit cards. However, we would allow the firm to have an uninsured balance in a savings or checking account with a client bank (provided the bank is not in danger of experiencing financial difficulties). Otherwise, this restriction would effectively preclude the firm from using a client bank for normal business accounts (because of the size of our firm, we frequently have balances in accounts that exceed the $100,000 insured amount, even if only temporarily). We would also revise the loan restrictions to only preclude loans from non-client investors in the client if the investor can exercise "significant influence." Finally, we would revise the wording for credit cards to focus on the unpaid balance at the payment due date, consistent with AICPA rules.
With respect to products issued by insurance company audit clients, we would not restrict the firm's ability to obtain professional liability coverage. This is an important matter, which we have dealt with in our letter (see Section II.E). In addition, we would revise the restriction on the audit engagement team to reflect the ISB approach that focuses on "obtaining" insurance. Policies obtained prior to joining the audit engagement team could be retained provided the likelihood of the insurance company becoming insolvent is remote, and we would allow individuals to renew or increase coverage pursuant to terms of pre-existing policy since they may not be able to obtain other insurance due to age or health.
We believe the proposed restrictions on the firm and covered persons with respect to investment companies (Release, 65 Fed. Reg. at 43191, paragraph 2-01(c)(1)(ii)(G)) are appropriate except for two items: first, the restriction should include a materiality test (otherwise, the restrictions would apply fully even if the auditor audited only a small piece of a large financial services entity), and second, non-client fund and adviser prohibitions should apply only to the engagement team, where the greatest threat to independence exists.
4. Exceptions: Because the Commission proposes to require its independence rules to be applied during the "audit and professional engagement period," and because that term is defined in the Release, 65 Fed. Reg. at 43193, paragraph 2-01(f)(6) as including the "period covered by any financial statements being audited or reviewed," the Commission also proposes in paragraph 2-01(c)(1)(iii) (id. at 43191) to allow certain exceptions to the financial relationship rules in paragraphs 2-01(c)(1)(i) and (ii). Id. at 43190. We agree with the proposed exceptions for inheritance and gifts. We also agree with the proposed exception for new audit engagements except that we would reword the starting point in paragraph 2-01(c)(1)(iii)(B)(2)(i) (id. at 43191) (i.e., accepting the engagement) to be consistent with the starting point in paragraph 2-01(f)(6) (id. at 43193) (i.e., signing the initial engagement letter) to avoid confusion.17
The Commission also proposes in the Release, 65 Fed. Reg. at 43192, paragraph 2-01(d) to allow an exception to the requirements if "inadvertent error" conditions are met and the accountant has a quality control system in place that is substantially consistent with that required by the AICPA SEC Practice section. We propose to move this provision to the "exceptions" section of the rules since it logically belongs there; we deal with it separately below.
5. Employment Relationships: Proposed paragraph 2-01(c)(2)(i) (id. at 43191) would restrict any partner or professional employee from being an employee or on the board of an audit client. Proposed paragraph 2-01(c)(2)(iv) (id.) provides guidance on employees of the audit client joining the firm. These are consistent with current rules and we agree with them.
Proposed paragraph 2-01(c)(2)(ii) (id.) deals with employment at the audit client of certain relatives of the auditor, an area that has long been in need of modernization. Among other things, the proposal would effectively deal with the discriminatory impact that the existing rules and interpretations have on two-earner couples. This issue is increasingly causing negative consequences for both accounting professionals and firms. Equity incentive programs are becoming a routine part of employee compensation, and, together with volatile markets (which make it difficult to take advantage of even the limited materiality exception that allows spousal participation in some cases) and merger and acquisition activity, we and other firms are losing talented and experienced people. And, most troublesome, the careers of spouses of professionals are seriously disrupted when they have to change jobs, decline promotions, or forego or forfeit routine equity-based compensation such as stock options, restricted stock, or participation in 401(k) programs.
The SEC's proposal provides that a close family member (which includes immediate family plus other "certain relatives" - parents, non-dependent children and siblings - a definition with which we agree) of a covered person cannot be in an "accounting or financial reporting oversight role" ("AFROR"), or have been in an "AFROR" in any period covered by the audit.18 Although not stated in the Release, 65 Fed. Reg. at 43191, paragraph 2-01(c)(2)(ii), when read together with paragraph 2-01(c)(1)(i) (id. at 43190) the proposal would not allow spouses in non-AFROR positions to participate in employee stock compensation programs. Other close relatives, on the other hand, would have no limits on participation.
We support a tiered approach to this important issue, that is, an approach that would make a distinction between relatives of the audit engagement team, relatives of those in a position to influence the audit, and relatives of other covered persons. Under our approach, close family members of either persons on the audit engagement team or in a position to influence may not be in an AFROR, and close family members (other than immediate family members) of those on the audit engagement team may not have a known material (to both the relative and the professional) investment in the client.19 Except for immediate family members of the audit engagement team, immediate family members of covered persons who are not precluded from having an employment relationship may fully participate in employee compensation programs, such as stock options and purchase plans, 401(k) plans, and so on. However, when the immediate family member is no longer employed by the client and there are no restrictions that preclude the disposition of the investments obtained as a result of participation in the employee benefit plan, such investments must be disposed of within ninety days of termination of employment or the cessation of restrictions whichever is later, if the person is still an immediate family member of a covered person in the firm.
We believe this tiered approach - which places more stringent restrictions than the SEC has proposed on the audit engagement team, slightly less restrictions on those in a position to influence, and no restrictions on other covered persons (i.e., non-involved partners in the office in which the lead engagement partner primarily practices in connection with the audit) - appropriately addresses the different threats to independence.20
Proposed paragraph 2-01(c)(2)(iii) (id. at 43191) deals with firm professionals becoming associated with clients. Unlike current rules, the Rule Proposal makes no distinction between employees and non-employee directors. For professionals who join clients as employees we would track ISB 3, which contains a five-year sunset provision; for professionals who become non-employee directors (which ISB 3 does not cover), we would keep existing SEC staff guidelines in place, because they work well.
6. Inadvertent Violations and Quality Controls: The proposal provides that inadvertent violations of the personal financial interest and employment rules would not constitute an independence impairment under certain conditions. We believe that the proposal is a very sensible one, and we strongly support it. We would, however, suggest the following changes.
First, under the proposal, the inadvertent error exception is only available when the investment or employment restriction was not known to the auditor and the auditor was "reasonable in not knowing." Release, 65 Fed. Reg. at 43192. We recommend that this "reasonableness" limitation be deleted from the Rule. Because of the comprehensive rules and systems most accounting firms now have in place, it could certainly be contended in many instances that a person who purchases a prohibited security does so "unreasonably," meaning that he or she may have been careless in failing to check whether a security is on a prohibited list, or failing accurately to enter the name of the security in the database. Thus, the "reasonableness" exception would swallow the rule. In our view, as long as the person did not know about the restriction and - most importantly - corrected it promptly after learning of the restriction, a temporary, and arguably careless, but quickly remedied mistake in this area should not lead to the Draconian consequences of an independence impairment.21
Second, the inadvertent error exception is proposed to be available only where a firm has certain quality controls in place. While we support this proposal, we have been advised by our foreign firm affiliates that the financial relationship disclosure requirements might be prohibited by privacy laws in other jurisdictions, such as in Switzerland. There should be an appropriate exception for this.
Third, foreign firms will find it difficult to develop the quality control systems that are necessary in order for the inadvertent violation exception to be available. There needs to be a transition rule that allows the inadvertent violations exception to be applicable notwithstanding the lack of complete quality control systems in a non-U.S. accounting firm affiliate. We would suggest a three-year transition period.
1 By "management consulting," we mean the type of practice that would be prohibited by the "Financial information systems design and implementation" paragraph of the Rule Proposal - that is, large information systems consulting.
2 As to any of the matters raised by the Commission's proposal, we would of course be pleased to meet with the Commission or Staff or make any additional submissions that might be helpful to the Commission in its deliberations.
3 Andersen Consulting, 1999 Global Alliance Survey, reprinted in Association of Strategic Alliance Professionals, Best Practices Guidebook on Alliance Formation and Management 1 (1999).
4 Booz-Allen & Hamilton, Inc., The Allianced Enterprise: Breakout Strategy for the New Millennium, Executive Summary 1 (2000).
5 W. Steve Albrecht & Robert J. Sack, The Future of Accounting Education: Thinking About the 21st Century 22 (2000), citing AICPA, The Supply of Accounting Graduates and the Demand for Public Accounting Recruits (1997).
6 Our proposed alternative deletes the Commission's proposed "affiliate of the accounting firm" definition, which means that the existing control test in Regulation S-X would be applicable in this area as well. We concede, however, that the control test may not be stringent enough to satisfy the Commission's objectives. Thus, it might be appropriate to adopt a "significant influence" standard, rather than control, as to entities that provide prohibited non-audit services to audit clients. This is an issue that is clearly both complex and important, and we think that the best solution requires considerable additional dialogue between the Commission and the profession. We would be pleased to provide the assistance necessary to develop an appropriate rule.
7 Restrictions on investments in non-audit clients are currently contained in Section 602.02.b.iii of the Codification of Financial Reporting Policies ("the Codification"), "Interests in Nonclient Affiliates and Investee Companies;" AICPA Interpretation 101-8, "Effects on Independence of Financial Interest in Non-clients Having Investor or Investee Relationships with a Member's Client;" and AICPA Ethics Rule 106, "Investment in an Entity That Has Significant Influence Over an Audit Client." These restrictions are reflected in our proposed paragraph 2-01(c)(1)(i)(E).
8 If the Commission determines not to adopt our proposal, we would urge that there be no rule addressing this issue, thereby enabling firms and the Commission to address any situations on the basis of the particular facts and circumstances presented.
Also, at Release, 65 Fed. Reg. at 43191, paragraph 2-01(c)(1)(iv)(B), the Commission proposed to prohibit an audit client from acting as an underwriter for the auditor or performing "any service for the accounting firm related to underwriting, offering, making a market in, promoting or selling securities issued by the accounting firm" or issuing an "analyst report concerning the securities of the accounting firm." We agree that underwriting should be prohibited, but the auditor has no means of preventing others - audit clients or non-audit clients - from doing the other activities listed in the proposed Rule. Accordingly, we propose to limit the restriction to underwriting activities.
9 Our proposal would also clarify a relatively minor aspect of the Rule Proposal. In some situations, we may prepare an SEC registrant's financial statements that are not filed with the Commission, such as statutory financial statements. There is no reason to think that independence would be at issue in that situation, so our proposal would explicitly exempt it.
10 Our suggested changes in the wording of the information systems consulting restriction are intended to more clearly distinguish between large information systems engagements, which typically aggregate source data underlying the financial statements and generate information that is significant to the financial statements, and much narrower information systems work, which should not raise independence concerns.
11 We note that the language we have provided to address this issue, in Attachment A, differs somewhat from the language that was included in our September 19th draft submission to the Commission. The previous language provided an exception that would have allowed the statutory auditor to issue fairness opinions where the auditor is "required by law" to render this service. We have since been advised that only in Belgium, Sweden and Italy is the statutory auditor actually required by law to issue the fairness opinion; in other countries, the statutory auditor customarily serves as the statutorily-required "independent expert" for this purpose.
12 The SEC Practice Section rules prohibit one activity - "acting as a negotiator on the client's behalf . . . in determining position, status or title, compensation, fringe benefits, or other conditions of employment" - that, perhaps by inadvertence, the SEC's Rule Proposal omitted. We would maintain that prohibition.
13 EYIA does not have any assets under management, and accordingly does not satisfy the requirements for registration with the Commission (rather than with the states) under Section 203A of the Investment Advisers Act of 1940. However, SEC registration was permitted pursuant to a Commission exemptive order of July 8, 1997 (Rel. IA-1641).
14 Chairman Arthur Levitt, Renewing the Covenant with Investors, Address before the New York University School of Law Center for Law and Business (May 10, 2000).
15 We understand that Aon Corporation, an insurance broker that has provided brokering and advisory services to the Big Five firms for many years, is submitting a comment letter addressing these issues in more detail.
16 We have modified the U.K. rule slightly to fit the U.S. situation. In particular, the U.K. rule requires disclosure of audit fees, but we are proposing to require disclosure of the aggregate of audit fees, fees for quarterly reviews, and fees "for other services related to registration statements and reports filed with the Commission."
17 We also would revise the definition of "audit and professional engagement period" in the Release, 65 Fed. Reg. at 43193, paragraph 2-01(f)(6), to codify the Commission Staff's practice of only requiring the latest audited period in initial filings by foreign private issuers to be fully compliant with SEC independence rules, and to extend that practical accommodation to domestic IPO situations.
18 We support the concept of "AFROR," except that we believe that it is important to provide certainty as to the positions covered. (The Rule Proposal lists a number of positions as examples of AFROR positions). Also, we do not think that one of the positions included in the Commission's proposal - vice president of marketing - is reasonably considered to be an accounting or financial position.
19 We are recommending that the materiality of investments be measured with respect to both the relative and the firm professional. This is intended to address cases where an "other close family member" has an investment in a client which is material to the family member, but which is immaterial to the firm professional. For example, an adult child of the audit partner could have an investment in the audit client that is very material to the child, but is immaterial to the partner. In such a situation, even if the partner were aware of the investment, it would not affect his or her behavior.
20 As noted in the accompanying Comment Letter (page 19, n.11), we previously provided the Staff with a draft of our alternative rule proposal, dated September 19, 2000. That draft did not include all of the aspects of the "tiered" approach discussed above. Because we strongly believe that the "tiered" approach makes the most sense from a public policy standpoint, we have revised our proposal by deleting the words "or partner in a position to influence the audit" from the fifth line of (c)(2)(ii)(C).
21 Our proposal would require correction of the inadvertent violation promptly "under relevant circumstances." This is intended to reflect the disparate types of inadvertent violations. For example, an independent purchase of a share of stock of a proscribed entity can, and should, be remedied immediately. Other inadvertent violations might take longer to cure, such as a mistaken investment in an illiquid asset.