District Attorney Robert M. Morgenthau
U.S.Securities and Exchange Commission
September 13, 2000
I am grateful for this opportunity to testify on the subject of auditor independence and the Commission's proposed rules to ensure independence.
The importance of independently audited financial statements to the investing public cannot be overstated. In the past four years, my office has prosecuted more than 200 defendants in securities cases for bilking innocent investors of millions of dollars, in many instances defrauding gullible victims of their life-savings. In the great bulk of these cases investors lost money because they were fed inaccurate financial information and projections. Although these cases, by and large, involved dishonest securities brokers and not faulty audits, they illustrate the importance of investors' being able to base their decisions on reliable sources of information.
Chief among the repositories of reliable information, in our system of securities regulation, are the independently audited financial statements filed by public companies. These statements play a vital role in the country's and the world's economy. They not only serve to protect individual investors, but engender confidence in the securities markets, encourage investment and promote capital formation.
If misused, however, audited financial statements can do great damage. As the distinguished federal appellate judge, Henry Friendly, said, writing for the Second Circuit Court of Appeals in United States v. Benjamin, "In our complex society the accountant's certificate and the lawyer's opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar."
Like judges and public prosecutors, accounting firms, when they exercise the function of independent auditors, occupy positions of public trust. As the United States Supreme Court has said,
By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. . . . The "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.
Like judges and prosecutors, auditors exercising their public responsibilities must not only be independent, they must also be seen as independent. That is to say, they must avoid even the appearance of a conflict of interest.
It is not only the fact but also the appearance of independence that ensures, when a judge or prosecutor makes a decision in a controversial case, that the public will accept the results. That same appearance of independence is vital to the public acceptance of the integrity of the securities markets. The Commission's proposed rules, by limiting business interests that might compromise or appear to compromise an auditor's independent judgment, would serve an important public purpose.
My experience in law enforcement, eight and one-half years as United States Attorney for the Southern District of New York and 25 years as Manhattan District Attorney, has shown that accountants, like other professionals, are susceptible to the temptation to engage in questionable activities or exercise questionable judgment on behalf of a paying client. This happens, on occasion, even at the best firms.
For example, in 1996, the District Attorney's Office obtained convictions in a case involving the bribery of bank officers in connection with sales of Brazilian debt, transactions which earned about 6 million dollars for the defendants and their co-conspirators, most of it tax free thanks to the use of off-shore corporations and bank accounts.
In that case, the bribes were paid by a private debt trader through shell companies set up and managed in Antigua by one of the Big Five accounting firms. The illegal payments, which included bribes paid to a U.S. banker, to two bankers in the Florida agency of a Colombian bank, and to a banker in Amsterdam, were all arranged by employees of the accounting firm.
When my office approached the major accounting firm's office in New York for assistance, we got no help, only the explanation that the off-shore firm was not part of the same legal entity as its identical namesakes in New York and elsewhere in the world.
In another case that my office investigated, a bank, the client of a major accounting firm, had destroyed the original records of an improper $500 million transaction and created new, back-dated records misrepresenting the nature of the deal. Our investigators were surprised to learn that the accounting firm, despite being aware of the falsification, had issued a clean audit opinion, reporting no material weaknesses in the client's internal controls. Pressed for an explanation, the audit partner said that the destruction and falsification of records was not material because the client had made money on the transaction.
In that case, as in most cases, it was impossible to tell whether financial considerations played a role in the auditor's issuing the opinion he did. But this only underscores the need for a clear rule, limiting the occasions when financial opportunities or relationships might play an improper role in influencing an auditor.
As the Commission has reported, the range of non-audit services provided by accounting firms and the revenues generated by these services - more than $15 billion for the Big Five firm alone in 1999 - are considerable and growing. Also, relationships of accounting firms with investors and other businesses are becoming more common and more complex. The Commission is on the right track in seeking to prevent lucrative business activities and relationships from corrupting the critical audit function. It is also correct to require disclosure of any such matters that might materially bear on the auditor's independence.
To be sure, there are those who will see any proposed restrictions and disclosure requirements as unduly harmful to the economic interests of the accounting firms, deterring the most qualified and able people and firms from engaging in independent audit functions. This is an argument I have heard before.
In 1966, when I was United States Attorney, at a time when accountants and lawyers were virtually exempt from criminal prosecution for professional misdeeds, my office indicted two partners and a senior associate in a national accounting firm for conspiracy and mail fraud in connection with a false financial statement. The defendants were charged with, among other things, concealing the fact that the president of a client corporation had siphoned off $4 million from the corporation through an affiliated company.
The prosecution generated much criticism in the accounting profession; among the complaints was that the prosecution would deter the best and brightest from entering the profession. Even the chief accountant of the SEC at the time declined to testify as an expert for the prosecution in that case. Nonetheless, the defendants were convicted, and, I dare say, I do not think it harmed the fortunes of the accounting firms in anyway; if anything, it likely encouraged good people to join the profession, knowing that shady dealings would not be tolerated. The fact that the convicted accounting partners were pardoned by President Nixon, before they spent a day in prison, does not alter my judgment in this matter the least bit.
In any event, the appropriateness of the proposed independence rules cannot be measured solely against the bottom line on the balance sheets of the accounting firms. Ensuring the independence of auditors as they carry out their public responsibilities must be given paramount consideration.
In the investigation of fraud and other economic crimes, the trail of ill-gotten gains often leads prosecutors to off-shore jurisdictions that foster extreme secrecy in financial matters and which have virtually no laws or regulations restricting the pursuit of wealth. What distinguishes the United States from these jurisdictions is the transparency in financial dealings and the public confidence in our financial markets and institutions fostered by responsible regulation and oversight. The rules proposed by the Commission, by safeguarding the independence of auditors, will help preserve this vital distinction.
I realize that the stakes in this matter are high. The newspapers in recent days have reported ongoing discussions for the sale by one of the Big Five accounting firms of its management and information technology consulting practice for between $17 and $18 billion in cash and stock. I am certain the lobbying in the Congress and elsewhere against the proposed rules has been intense. I am confident, however, that the Commission under the leadership of Chairman Arthur Levitt has the wisdom and courage to adopt these rules.