The New Hampshire Retirement System is in full support of the Revision of the Commission's Auditor Independence Requirements in the form of the Proposed Rule as published in Securities Act Release No. 7870 (June 30, 2000).
The New Hampshire Retirement System is a trusteed governmental pension plan presently covering about 52,000 members- fire, police, teacher, state and local public employees. The System operates for the exclusive purpose of providing legislated benefits to its members and their beneficiaries. These retirement benefits are funded by monthly contributions from the members' paychecks and from the public monies of over 300 of their employers. The System's board of trustees, the majority of whom are public employees and active members of the retirement plan they administer, currently invests and reinvests about $5 billion in fund assets received and held in trust solely in the interests of its members and beneficiaries.
The much greater part of the New Hampshire System's assets are invested in publicly-traded financial securities, purchased largely by member contributions taken directly from their paychecks. Those workers providing public services for their fellow citizens both earn and pay for their pensions, as do the taxpayers.
The promise of those pension benefits, however, is very much dependent on the integrity, transparency and accountability of the publicly traded companies in which their retirement savings are invested in trust.
Just as the trustees of pension funds have an undivided fiduciary duty of loyalty to their beneficiaries to act solely in their interests in the investment of trust assets, so too do the external auditors have a like fiduciary duty of loyalty to the lenders and shareholders of the companies they audit. This undivided fidelity to the investors can only be satisfied if the auditors are independent of company management.
The scrupulousness of auditor independence in the audit of public companies is not simply an ethical precept of the accounting profession, but also a legal mandate found by the United States Supreme Court to be dictated by sound public policy:
"The independent public accountant performing this special function owes allegiance to the to the corporation's creditors and stockholders, as well as the investing public. This public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust."(emphasis supplied). United State v Arthur Young, 465 U.S. 805, 817- 818 [1984].
We regard the concurrent performance by the company's external auditor of non-auditor services at the direction and under the control of management to be inherently corrosive and fundamentally incompatible with that duty of independence and fidelity owed by the auditor to the investing public. We find unpersuasive the proposition that consulting and other non-audit services provided by the auditor will not impair his or her independence. To accept the proposition asks the investing public to suspend common sense and the lessons of life experience to enable the accounting firm to pursue additional business opportunities in connection with the engagement.
Rather, Justice Cardozo's admonitions concerning the fiduciary duty of undivided loyalty owed by a trustee to the trust's beneficiaries have convergent application to the public company auditor's duty of independence and undivided fidelity to the investing public:
"Many forms of conduct, permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the "disintegrating erosion" of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd."
Meinhard v Salmon, 249 N.Y. 458, 464, 164 N.E. 545, 546 (1928).
To countenance consulting and other contemporaneous non-audit services would inevitably result in a "disintegrating erosion" of that fidelity and independence owed by auditors to the investors of publicly held companies. For the trustees of pension funds to discharge their duties of loyalty and prudence in holding the stock and debt of publicly traded companies, the auditors of those companies are necessarily relied upon to discharge their duties of fidelity and independence to the investing public. We therefore fully concur in the prophylactic rule of strict independence as proposed by the Commission.
It also simply misses the point to argue, as do some in criticism of the Commission's proposed rule, that there is as yet no "empirical evidence" proving a demonstrated loss of auditor independence in providing management consulting and other non-audit services. Such "independence" is essentially a state of mind, not easily proved or disproved. And so for auditors, no less than for trustees, "not honesty alone, but the punctilio of honor the most sensitive" is the governing standard. Appearance counts a great deal in matters of trust. Not fidelity alone but also the appearance of independence and loyalty is essential to the fiduciary relationship. The burden of preserving the implicitness of that trust falls wholly on the fiduciary. The beneficiary is not to be put to the proof, by "empirical evidence" or otherwise, that the "morals of the marketplace" are insufficient to assure the fiduciary's undivided loyalty. Likewise, any competing relationship that reasonably casts a shadow over the auditor's independence and felicity to the investing public is per se improper.
Stated simply, an auditor, to be truly independent, needs to be a person whose audit engagement constitutes its only connection to the company.
Lastly, it has been suggested that the Commission's proposed rule establishing standards of auditor independence is unnecessary-that the case-by-case evaluation of an auditor's independence should be left to the established audit committee of the company's board of directors.
Although it should indeed be the duty of the audit committee to protect and enhance the independence of the company auditor, we would add that the audit committee should make specific inquiry confirming the auditor's independence in accordance with the final rules of the Commission. (See Improving Audit Committee Performance: What Works Best, A Research Report Prepared by Price Waterhouse, Ch. 6 "Relationships with Internal Auditing, the Independent Accountant, and Management", published 1993 by The Institute of Internal Auditors Research Foundation). Best corporate governance practices and principles dictate that external auditors "should view the audit committee as their primary client" and "meet privately with the audit committee, on a periodic basis, without the presence of management or internal auditors". Report of the National Association of Corporate Directors Blue Ribbon Commission on Audit Committees: A Practical Guide, "Relationships" at p. 17, published 2000 by NACD. The audit committee should employ, review and evaluate the external auditor, and serve as its designated channel of communication with the company and board. See American Law Institute, Principles of Corporate Governance: Analysis and Recommendations, Sec. 3A.03, Functions and Powers of Audit Committees. But an audit committee needs proposed Rule 2-01 to perform those functions.
As a practical matter of corporate governance, it is difficult to see how a board's audit committee will be able to adequately discharge its charter to control the external auditor, or the likelihood of the external auditor to view the audit committee as the primary client independent of management, if that same accounting firm is dependent on company management for its non-audit consultancy. Such non-audit services would not only compromise the independence of the auditor, but effectively undermine the primacy of the audit committee in the company relationship with the auditors. Under such circumstances, it is unrealistic to expect the auditor to defer to the audit committee, rather than to management, as premised by best corporate governance practices. If the auditor is to have two masters, the audit committee will be in second place.
For now and in the foreseeable future, the independence and professionalism of the external auditor remains the first line of defense against that financial fraud involving publicly-held companies. It is a fact that the investing public and creditors still look first and foremost to the independent audit process to gain that assurance and confidence in the reliability of financial statements as prerequisite to holding the securities of publicly traded companies. The audit committees and boards of many if not most public companies are still too weakly positioned to be the sole arbiters of auditor independence. See Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies, a Reseach Report prepared by Mark S. Beasley, Joseph V. Carcello, and Dana R. Hermanson, published 1999 by the Committee of Sponsoring Organizations of the Treadway Commission. The Commission's rulemaking in defining what constitutes the requisite "independence" for external auditors is not only still required, but overdue, for the protection of the investing public.
In sum, the New Hampshire Retirement System supports the Commission's adoption of proposed Rule 2-01 in final form as submitted, and would be available for further discussion and testimony concerning it.