Outline of Testimony of William T. Allen
Securities and Exchange Commission
July 26, 2000
Re: Proposed Rule Making Respecting Auditor Independence
A. Chair of Independence Standards Board which was formed through the cooperative action of the SEC and the AICPA in 1997 and was authorized in February 1998 by SEC FRR 50 to establish standards that have prima facie validity. Other members of Board here with me - John Bogle, Robert Denham and Manuel Johnson. Each will briefly speak.
B. My background is as a judge (Chancellor, Delaware Court of Chancery 1985-97), Professor of Law and of Business (New York University 1997 - date) and as counsel or consultant to a law firm in New York (Wachtell, Lipton, Rosen & Katz).
C. Today I speak for myself and not the ISB institutionally........ Nor do I speak for any other institution with which I am proud to be affiliated professionally.
Auditor independence in fact and in appearance is a vital protection to capital market efficiency and thus to economic welfare in our capital market-centered brand of capitalism. On this I think there is universal agreement.
Evolution of the auditing profession into multi-service professional firms plainly gives rise to reasonable concerns that the integrity of financial data is being or may be adversely affected (or at the least markets may become suspicious of that fact and impose an additional discount for such risk).
The ISB was stablished in 1997 by the SEC and the AICPA to create principle-based standards for the determination of auditor independence. The Board is comprised of people of integrity and experience. Pursuant to agreement between the SEC and the SECPS, the ISB has been afforded sufficient resources to accomplish this task. While getting the infrastructure of the Board in place was time consuming at the outset, the ISB is making good progress and indeed is close to completion on its 4th and 5th major Standards at this time.
A short summary of its standard setting work:
1). Preparation of a conceptual framework for establishing standards of auditor independence. We see this task as important to achievement of a long-term goal of a coherent and effective system of standards. We retained two academics to act as our reporters and impaneled a Task Force of experts from within and without the accounting profession. That Task Force under Board oversight has almost completed its project after about two years of steady work. This has been a very large and time consuming effort, and we are now within several months of a final statement.
2) Address a series of problematic questions that appear to have fewer system-wide (or market efficiency) side-effects.
An additional strong reason to support this change in disclosure policy is that the ability of markets to price the risk associated with this information will permit financial economists to conduct studies of the existence of any risk premium associated with this information. Such information would be extremely helpful; if an informed market does not care about this information, the case for regulating these relationships is reduced. On the other hand if the market does care (i.e., firms that have auditors who perform substantial non-audit services are penalized by a higher average cost of capital) then the activity will to some extent be self-correcting.
Thus, especially in the absence of good social scientific data respecting the costs and benefits of the provision of non-audit services, it is arguable (and I believe) that disclosure is the optimal social policy.
That standard reflects the best judgment of a board comprising experienced individuals and a process that entailed wide public participation. This Commission authorized the ISB to undertake that work and I respectfully suggest that where the product of that process represents a reasonable and good faith balancing of appropriate factors in standard setting, the Commission should limit its options to accepting or rejecting an ISB Standard in toto.
Of course the SEC can and should reject a standard that in its judgment is not consistent with the public interest. But I suggest that it ought not to "second guess" specific judgments that are built into an ISB Standard. The SEC should accept or reject a standard. It is not reasonable to expect that senior professional people will continue to dedicate their time to this form of public service if the end result of the lengthy public deliberation process is in effect a proposal to the SEC Staff for modification. Attached is a brief summary of differences between ISB No. 3 and the Proposed Rule's treatment of the employment with audit clients.
The framework of the proposed rule is a first step at a conceptual framework, but it is just a first step. I agree that values or principles that form the premise for the proposed rule constitute significant threats to auditor independence. Advocacy, mutuality or conflict of interest, auditing one's own work and performing management functions for an audit client certainly are problematic for auditor independence. But these generalities need much more conceptual refinement before they can be useful guides to standard-setting independence determinations. What constitutes advocacy for example will often not be clear. Mutuality of interest too should be deemed a problem, but always? To the extent of every mutual interest? What about a passive investment in which an audit client also has a passive investment? Say limited partnership interests. This is a mutual interest, does it in all events prevent the auditor from being independent? What if these investments are material to both? Or financially material to neither? What are the factors that count in deciding when it might and when it doesn't ? The framework won't help people know.
Thus I tend not to share the optimistic view of the proposal, that its adoption would helpfully clarify the work of the ISB or at least to do so in a way that is consistent with careful, highly textured standard setting.
Independence Standards Board
Financial Interests of the Auditor in, and Family Relationships between,
the Auditor and the Audit Client
Comparison of the ISB's Proposed Standard and
the Recent SEC Rulemaking Proposal
The SEC proposals on financial interests and family relationships have the same general thrust as those in the ISB draft ED, including a major change in defining the individuals who need to be independent, intended to modernize the current rules. Specifically, both the SEC and ISB proposals dramatically reduce the number of individuals restricted under the "member" approach of the present rules. However, they differ in certain significant respects, including the following.
The SEC and ISB proposals would prohibit both those on the audit engagement and those in a position to influence the audit from owning any direct financial interest in the audit client. The SEC proposal, however, would include in that group all professionals providing non-audit services to an audit client from owning an investment in the client. In contrast, the ISB proposal would limit those professionals to partners and managers, on the basis that non-audit staff below those categories do not have influence on the audit and therefore need not be restricted.
On the other hand, the ISB proposal would prohibit a person on the audit from having an other close relative (parent, non-dependent child or sibling) from having an investment in the audit client that is material to both the auditor and the close relative, if the auditor knows about it. The SEC proposal does not cover this situation. The ISB believes that knowledge of such a material investment could impact the auditor's objectivity, and therefore prohibits it.
Investments in clients often are related to employment, and because employment of spouses has become much more frequent, impediments to such employment must be justified. In that spirit, the ISB concluded that although other partners in an office participating in the audit should not own client securities, that prohibition need not extend to employer-sponsored benefit plan investments of their immediate family members, given that their employment role also must be evaluated as acceptable. In this case, the threat from such stock ownership was considered minimal, but the inability to participate in the benefit plan would make such employment much less desirable. The SEC proposal has no such exemption.
Family Relationships - Employment
The SEC proposal would prohibit employment of immediate family members and close relatives in an accounting or financial reporting oversight role, and these restrictions would apply to all categories of "covered persons."
The ISB proposal applies restrictions based on whether the firm professional is on the audit or in a position to influence the audit, and whether the family member is an immediate versus an other close family member. For example, The ISB proposal would prohibit someone on the audit engagement from having an immediate family member employed in any position at the audit client. People frequently develop financial or emotional ties to their employer, and the desire to protect an immediate family member's employer (and his or her job) may affect the auditor's objectivity, whatever the relative's position at the client.
In addition the ISB proposal would prohibit both immediate family members and close relatives from being employed in a key policy-making position at the client, and would also restrict immediate family members from holding a sensitive financial position at the client. Restrictions are targeted to the risks to protect the auditor's independence, recognizing that overly restrictive rules impose costs that may exceed their benefits.
Finally, for other partners in a work office, where the ISB views the threats as generally being less strong, only specified senior positions are prohibited for immediate family members, and none are for other relatives. The SEC proposal, however, would continue to bar all the oversight role positions for both immediate and other close family members.
Independence Standards Board
Employment with Audit Clients
Comparison of the Provisions of ISB No. 3, Employment with Audit Clients,
and the Recent SEC Rulemaking Proposal
ISB No. 3, Employment with Audit Clients (the ISB standard), addresses the auditor independence concerns raised when audit firm professionals join firm audit clients. Briefly, these concerns are that:
The provisions of the SEC's rulemaking proposal (the SEC's proposal) dealing with the employment with audit client issues differ from the ISB's standard in several important aspects: