A M E R I C A N F U N D S G R O U P
333 South Hope Street, Los Angeles, California 90071 * Telephone (213) 486-9200 * Fax (213) 486-9455
September 12, 2000
Via Electronic Mail
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
RE: Auditor Independence Requirements
Comment File No. S7-13-00
Dear Mr. Katz:
I appreciate the opportunity to provide this summary of my intended testimony on the Commission's proposed rule amendments regarding auditor independence. I fully support the Commission's goal of promoting investor confidence in the reliability and integrity of issuers' financial statements.
I am a Senior Vice President, Fund Business Management Group, of Capital Research and Management Company. I am currently responsible for providing fund accounting and financial reporting services to each of the mutual funds in The American Funds Group. This fund complex is among the nation's largest, with 29 funds representing more than $325 billion in assets and over 11 million shareholder accounts. Prior to joining Capital in 1998, I was an audit partner for over 20 years with a major accounting firm. I served as lead partner on audit engagements for a variety of clients within and outside of the mutual fund industry.
The views expressed below are strictly personal and do not represent the views of Capital Research and Management Company or my former partners at Deloitte & Touche LLP. They do, however, reflect my experience as an independent auditor and, more recently, as an audit client.
I believe that, in general, the Commission's efforts to modernize the rules pertaining to auditor's independence are a necessary and appropriate reaction to recent developments affecting the profession, including the growth of non-audit services, structural reorganizations among the firms, and changes in societal demographics. I commend the Commission and its staff for their substantial work on these important issues. As more fully explained later in my testimony, I would urge the Commission to consider carefully whether this is the appropriate time to adopt certain elements of the proposal relating to scope of services. This is a time of tremendous change in the accounting industry - and investors may benefit if adoption of some provisions is deferred. Mutual fund and operating company shareholders benefit when management decides to obtain professional expertise from external sources when it is more efficient than developing similar resources in-house. Ready access to such expertise has value to individual companies and the economy as a whole.
As you know, the proposed rule amendments are lengthy and fairly complex. Rather than attempt to provide comprehensive comments, I will focus on four areas of particular concern to me - financial relationships, scope of services, quality control standards and proxy disclosures. Following my remarks, I would be pleased to answer any questions you have for me regarding any aspect of this proposal.
Financial Relationships and Quality Control Standards
Modernization of the rules for determining auditor independence, particularly those addressing financial relationships, is quite appropriate for the mutual fund industry. The considerable expansion of the IRA and 401(k) markets in recent years has made investing in mutual funds commonplace. The consolidation of the independent accounting firms and the size of the firms have created many hardships for professional employees of the firms and their family members, particularly with respect to investing for retirement. I do not believe that revised, less restrictive rules for auditor investment in mutual funds will reduce investor confidence, especially if the audit firms can administer the rules in a clear-cut manner - and minimize inadvertent violations.
Less restrictive rules make sense in part due to the unique structure of the mutual fund industry and the considerable oversight that exists within it. There is already comprehensive regulation of the activities of mutual funds by the Commission and its staff. In addition, ongoing independent director oversight of fund operations (at the board level) and financial reporting (through the audit committees) contribute significantly to an environment where appropriate accounting standards are maintained. The structure of the industry, accounting practices and procedures within the industry, and the industry's relatively straightforward business model all argue for recognizing the special attributes of mutual funds when revising the rules governing auditor independence.
Proposed rule 2-01(c)(1)(i) provides that an accountant is not independent with respect to an audit client if the accounting firm, any "covered person" 1 in the firm, or any immediate family member of any covered person, has any direct investment in the audit client or in an affiliate of the audit client. Under current rules, the direct financial interest prohibition applies to all partners in the accounting firm, all managers in the office performing the audit, and all persons on the engagement team. Under the proposal, as under current rules, the accounting firm (including its affiliates, such as its pension plan) cannot have a direct investment in an audit client and remain independent.
The definition of "covered person" in the proposed rule has the effect of expanding the group of persons within the audit firm who can invest in an audit client without impairing the auditor's independence. Although I fully support the proposed expansion, I would like to emphasize the importance of the Commission also adopting the provisions of proposed rule 2-01(d) relative to quality controls. Audit clients need assurance that the audit firm's control procedures will preclude independence violations that could result in a determination by the Commission that the audit client's financial statements lack an independent certification.
If the proposed rules are adopted and the number of the audit firm's employees eligible to own client equity securities is expanded, audit firms will have to manage carefully the application of the rules within each office to ensure that their client assignments are adequately staffed. The accounting profession is known to have a relatively high turnover of employees below the partner level - which requires somewhat frequent changes to the staff serving particular client assignments. It may be more difficult for the firms to properly staff audit engagements if a greater proportion of the professional staff is not independent with respect to that client. This may be a tougher issue for those firms providing service to mutual funds due their popularity as an investment vehicle.
A potential difficulty may arise in situations requiring ad hoc consultation on technical or other client matters. The Commission has been presented with a number of views advocating the need to have the accounting firm's non-audit professionals available to provide assistance and expertise to the audit professionals. If the non-audit professionals have investments in audit clients, it will limit the firm's ability to call on their expertise - if to do so would bring them within the covered person definition. Professional personnel should be able to provide limited, technical assistance from time to time as long as they are not part of the regular audit engagement team. Access to a broad and deep talent pool is in everyone's interest, especially the audit client's.
Another potential issue for an accounting firm attempting to comply with the revised rules is defining persons in the "chain of command." For example, it is not clear that professional personnel that perform administrative functions involving compensation matters should be considered to be a "covered person." Although compensation issues are tied to an individual's overall performance, employees involved with the determination of specific compensation amounts may not have any role in providing or supervising professional services to the client.
Proposed rule 2-01(c)(1)(i)(D) applies to material indirect investments in an audit client. It sets forth the circumstances in which independence is impaired because of investments by the accounting firm, any covered person in the firm, any immediate family member of a covered person, or any group of these people in (i) non-client entities that have an investment in an audit client ("non-client investors") or (ii) companies in which an audit client also has invested ("common investees"). Under the proposed rule, accounting firms, covered persons and covered persons' immediate family members can own up to five percent of a non-client investor or of a common investee.
The proposed rule does not distinguish between different types of non-client investors (investment companies vs. operating companies). Similarly, the proposed rule does not distinguish between investments made in a common investee by an investment company/audit client vs. investments made by an operating company/audit client. I strongly urge the Commission to adopt a rule that draws such distinctions.
There are a number of reasons why investment companies, and in particular, those that are diversified under the Investment Company Act,2 should be treated differently. First, in my experience, neither shareholders nor outside auditors are in a position to influence a fund's investment activities.3 It is unrealistic to expect outside auditors to track (or predict) on an ongoing basis how much of a particular fund's assets are invested in an audit client or how much of an issuer's securities are owned by a fund, since portfolio holdings are reported only periodically through shareholder reports.
Further, pursuant to generally accepted accounting principles, fund portfolio investments are generally assigned current market values, rather than historical or book values, in determining the fund's net asset value and in reporting investment results. Thus, for open-end investment companies, it is a rough but fair assumption that current market values will determine at least 85%, and more often a much higher percentage, of a fund's daily share price.4
For diversified funds, applicable rules limit the fund's economic exposure to any given issuer. To qualify for beneficial tax treatment under the Internal Revenue Code, non-diversified funds must comply with similar, but less restrictive, requirements.5 Thus, the impact on an investment company of accounting policies and practices followed by a portfolio company (and as reflected in its financial statements) will be diluted both by the market's interpretation of the company's recent results and future prospects and by the mathematical effects of diversification.
In terms of the ability to influence management and accounting policies and practices of a commercial enterprise, in my judgment there is a tremendous difference between the essentially passive investments made by investment companies and the more active investments made by operating companies.
For all these reasons, accounting firms, covered persons and covered persons' immediate families should be permitted to invest in investment companies without restriction as to the amount invested or the composition of the fund's investment portfolio, so long as the fund is not part of the same complex as an audit client. Similarly, since there is no real opportunity for an auditor to influence materially the carrying value of an investment in an audit client, I believe there should be no restriction on the amount an investment company may invest in an audit client and still remain eligible for investment under these rules.
Failure to adopt rules that reflect the unique characteristics of investment companies is likely to result in a number of inadvertent independence violations that are of little or no consequence. In my judgment, it is highly unlikely that an investor would perceive there to be an appearance of lack of independence under these circumstances.
When the common investee is owned by an operating company, rather than an investment company, different accounting principles apply. Consolidation accounting principles govern whether an investment should be consolidated or accounted for by the equity method of accounting. It is quite possible for the value of the investee company (as reflected in its financial statements attested to by the auditor) to affect the value of the operating company (as reflected in its own financial statements). It is also common for an operating company parent to become involved in the management of, and financial reporting for, the subsidiary's operations.
I believe the proposed rule should be amended to preclude an indirect investment by a covered person in an audit client through an operating company, particularly if the business is required to consolidate or account for the audit client using the equity method of accounting. This generally occurs at a 20% or greater ownership level. Restriction of investments when these accounting principles apply is necessary to avoid a situation analogous to a covered person making a direct investment in an audit client. Although the proposed rule would allow such an investment, I do not believe that such a rule would impose an unrealistic burden on the auditor, as the proposed rule considerably narrows the number of audit personnel defined as covered persons. It may make sense to consider completely barring indirect investments in audit clients through operating companies. This would reduce the compliance burden for the audit firms and help minimize the number of inadvertent violations affecting audit clients.
Scope of Services
I do not believe that adoption of restrictions on the provision of non-audit services to audit clients that are not currently precluded by professional standards is appropriate at this time. The Commission has been presented with extensive and conflicting views on this part of the proposal. While the Commission should be commended for considering this matter, I believe that it could be a mistake to adopt prohibitive rules affecting scope of services at this time. Adoption of such rules would have a profound impact on the business of accounting firms and could potentially reduce the overall quality of audit services to the detriment of audit clients and their shareholders.
As the Commission has already heard in other testimony, adoption of prohibitive rules could have an adverse impact on the existing industry infrastructure (including the Independent Standards Board) established to resolve such matters. Furthermore, the adoption of these aspects of the proposal may be viewed, with hindsight, as premature. Many of the accounting firms are in a transition mode with respect to their consulting practices. Allowing them to find ways on their own to continue to provide quality audit services and attract and retain talented personnel without a consulting practice as we know it today could prove to be a reasoned and responsible response to these important changes.
If audit clients cannot use their audit firm to perform non-audit services, that also restricts their freedom of choice when seeking outside professional services. A business may decide that a particular accounting firm is being for both auditing and a special non-audit service. Companies have increasingly looked to their audit firm to help them with operational, regulatory and operational matters because of the caliber of their personnel and the depth of their industry knowledge. Precluding the use of the company's auditors for non-audit services may be particularly detrimental to companies that are in specialized industries - such as the mutual fund industry - where only a few audit firms dominate the practice and have the relevant expertise. Many mutual fund complexes utilize more than one audit firm for sound business reasons. This practice may compound the problem of finding non-audit professionals with desired industry knowledge.
I would like to make two additional points on this matter. First, the Commission and other bodies have made significant progress in increasing the effectiveness of independent boards of directors and fund audit committees. I believe these groups should be given the opportunity - if not the responsibility - to determine whether, in their judgment, the provision of non-audit services has the potential of diminishing the auditor's independence. At present, I am not aware that consideration has been given to the potential effectiveness of independent board and committee members to weigh in on this matter.
Second, much of the Commission's concern relates to "perceived" lack of independence when a company's auditor performs non-audit services. I believe that further research or fact gathering should be performed to assess the parameters of this issue. Thus far, the Commission has heard testimony from primarily current or former auditors, university professors and attorneys. Consequently, I believe that useful information could be obtained by determining whether this issue is important within one group directly impacted - professional investors. Although I have not made a formal study, I have not heard expressions of concern about provision of non-audit services from my colleagues who are investment professionals. I believe their focus is often on much more fundamental investment issues - particularly when they are making investment decisions involving issuers domiciled or operating outside of the United States.
As an interim measure, I would support additional disclosure requirements. This would provide information to the users of the audited financial statements and would also ensure the involvement of independent board and audit committee members. The Commission should also consider whether it would be more effective to place this new disclosure in the issuer's annual report, rather than the proxy statement.
* * * * *
I appreciate the opportunity to present my views on the Commission's auditor independence proposal. If you have any questions or need any additional information, please feel free to call the undersigned at (714) 671-7188.
Thomas M. Rowland
cc: Paul F. Roye
Director, Division of Investment Management
|1||The term "covered person" includes the "audit engagement team," those in the "chain of command," all other partners, principals, shareholders, or professional employees providing any professional service to the audit client or its affiliate, and any other partner, principal, or shareholder in an "office" that participates in a significant portion of the audit.|
|2||A diversified investment company, with respect to 75% of its total assets, may not invest more than 5% of its total assets in a single issuer and may not own more than 10% of the outstanding securities of a single issuer.|
|3||Importantly, a fund's investment activities are managed by the investment adviser in accordance with a written contract (and the fund's registration statement) and overseen by independent board members.|
|4||Under normal circumstances, open-end investment companies generally are limited to investing no more than 15% of their net assets in illiquid securities. Illiquid securities often lack readily available market prices and require fair valuation under the oversight of the fund's board. My experience has been that most funds rarely approach this limit. Although the existence of fund liabilities would affect the 85% figure, I believe the assertion remains valid for most funds.|
|5||An investment company will not be treated as a registered investment company ("RIC") under the Internal Revenue Code for any taxable year unless, at the close of each quarter, at least 50% of the value of an investment company's total assets are represented by (i) cash and cash items (including receivables), Government securities and securities of other RICs; and (ii) other securities, limited in respect of any one issuer to no more than 5% of the value of the RIC's assets and to not more than 10% of the outstanding voting securities of the issuer.|