January 15, 2003
Securities and Exchange Commission
Re: File No. S7-49-02-Strengthening the Commission's Requirements Regarding Auditor Independence
Ladies and Gentlemen:
We are submitting this letter in response to the request of the Securities and Exchange Commission (the "Commission") for comments on the Commission's proposed rules to implement Title II of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act").1 We appreciate the opportunity to comment on these proposed rules.
We want to preface our specific comments with several general observations about the Commission's requirements on auditor independence. These arise from our practice advising issuers and underwriters on these requirements, and especially from our familiarity with the concerns of foreign private issuers.
First, we believe that the Commission's rules should be clear enough on their face that they can be interpreted by issuers, underwriters and their advisers, and by auditors and regulators outside the United States. Many of these parties cannot be expected to consult the commentary contained in proposing and adopting releases, and they have no access to the lore arising from the interplay between the staff and the U.S. accounting profession. But it is critically important for all of them, and not just the independence specialists within the U.S. auditing firms, to be able to interpret the independence requirements, particularly since the practical stakes for them have increased with the rotation requirements and conflicts provisions under the Sarbanes-Oxley Act. This concern informs several of our specific comments below.
Second, the application of the independence rules to foreign private issuers raises special concerns that do not apply equally where domestic issuers are concerned. These concerns are not specific to the implementation of the Sarbanes-Oxley Act, but the Commission should consider them now and in future rulemaking and other actions on this subject. In particular:
In our view, these considerations suggest extra caution in rulemaking on independence where foreign private issuers are concerned.
I. Conflicts of Interest Resulting from Employment Relationships
A. The definition of "financial reporting oversight role" is too broad and should conform more closely to Section 206.
Section 206 of the Sarbanes-Oxley Act makes it unlawful for an accounting firm to audit an issuer's financial statements if the "chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position" for the issuer was employed by the accounting firm and participated in the audit of the issuer during a one-year period prior to the initiation of the audit.
In proposing rules under Section 206, the Commission has expanded the scope of the prohibition to cover any former accountant serving in a "financial reporting oversight role" for a former audit client. The proposed definition of "financial reporting oversight role" would cover any person who is "in a position to or does exercise influence over the contents of the financial statements or anyone who prepares them." The Commission noted in the Proposing Release that its definition is intended to be read broadly to cover not only persons who have input into a company's financial statements, but also those who prepare information related to the financial statements, such as MD&A.
We believe that this expansion of Section 206 is not justified, and we believe it could impose a significant burden on the employment practices of many companies. We agree that an accountant's independence may be impaired if a former member of an audit engagement team accepts a senior financial position at an audit client within a year after being on the engagement team. We do not believe, however, that the same concern exists where a former accountant accepts a mid-level or junior position at an audit client, because such a person is unlikely to influence decisions that are made in preparing the audit client's financial statements or MD&A. This would particularly burden foreign private issuers, because in many countries the pool of persons qualified to work on the preparation of financial statements and MD&A in English, and following U.S. practices, is very limited.
B. The Commission should correct the definition used in implementing Section 206.
Under Section 206 of the Sarbanes-Oxley Act, there is a conflict of interest if a specified employee of the audit client was employed by the accounting firm "and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit." The conflict of interest applies to a given audit unless that audit begins more than one year after the individual's last participation in auditing the client.
We suggest that the Commission revise paragraph (c)(2)(iii)(B) of Rule 2-01 of Regulation S-X to read in full as follows:
(B) With respect to a particular audit or review, a former partner, principal, shareholder, or professional employee of the accounting firm2 is in a financial reporting oversight role at an audit client, unless the individual was not a member of the audit engagement team of the audit client during the one-year period preceding the date that the accountant commenced audit procedures or review procedures.
In contrast, the Commission's proposed formulation of paragraph (c)(2)(iii)(B) can be read to make the conflict of interest permanent. The Commission's proposed provision includes the following language:
Audit procedures are deemed to have commenced at the earlier of:
(i) the date the accountant commenced the audit for the period covered by the financial statements that included the date of the initial employment of the audit engagement team member by the audit client; or
(ii) the date the accountant commenced review procedures for the period covered by the financial statements that included the initial employment of the audit engagement team member by the audit client.
For example, if a person last worked as a member of the audit engagement team in February 2001 and joined the audit client in a financial reporting oversight role in June 2001, audit procedures would be deemed to have commenced the date the accountant commenced the audit for "the period covered by the financial statements that included the date of the initial employment of the audit engagement team member by the audit client" - a period which will always be, in this example, fiscal year 2001. Reading the proposed rule literally, the former accountant would always have been a member of the audit engagement team during the one-year period preceding the date that audit procedures commenced (i.e., January 2002) because that date is defined by reference to the period in which the person last served on the audit engagement team.
A permanent prohibition is not what the Sarbanes-Oxley Act intended. There is no policy reason for it, absent the kind of ongoing relationship with the accounting firm that is addressed in paragraph (c)(2)(iii)(A) (existing paragraph (c)(2)(iii)). It is particularly unjustified if the former audit team member does not assume a financial reporting oversight role at the audit client for more than a year after leaving the accounting firm. If a junior member of the audit team joins the audit client in a junior capacity, as the proposed rule is drafted, the accounting firm will be disqualified if that individual ever assumes a financial reporting oversight role, even many years later.
II. Prohibited Non-audit Services
A. The provisions on valuation services should retain the existing exceptions.
Paragraph (c)(4)(iii) of Rule 2-01 covers appraisal or valuation services, fairness opinions, or contribution-in-kind reports. Subparagraph (B)-particularly items (1), (2) and (4)-clarifies the meaning of the prohibition in ways that are helpful, necessary and logical. The proposed amendments would eliminate subparagraph (B), but the Proposing Release, in discussing practices that do not violate paragraph (c)(4)(iii), paraphrases the existing exceptions. The end result will be extremely confusing: the rule is amended to eliminate reference to these practices, but the Commission states its view that they are permitted.
We suggest that the Commission retain the clarifications contained in subparagraph (B). We do not believe they are "categorical exceptions" of the kind the Commission has sought to eliminate from paragraph (c)(4) in response to Section 201 of the Sarbanes-Oxley Act.
B. The status of Italian contribution-in-kind reports should be clarified.
In adopting the amendments, the Commission should clearly state that the staff's existing position on certain contribution-in-kind reports required under Italian law survives the amendment of the rules. The reference to that position in note 38 of the Proposing Release is not clear enough, particularly since the express reference to contribution-in-kind reports is being added in these amendments.
The Commission should consider adopting a categorical exception for contribution-in-kind reports that are required under non-U.S. law to be provided by the statutory auditors. The policy balance reflected in the Italian letter is sound, but the letter addresses only one circumstance, and there are others under Italian law and there could be others in other jurisdictions. The goals of the Commission and the Act will be better served the more fully the Commission's policies are set forth in the rules, rather than in releases and no-action positions, because the rules themselves will be much better disseminated and understood among non-U.S. accountants, issuers and regulators.
C. The Commission should address the scope of permitted tax services.
We believe that there is significant doubt and confusion concerning the proper limits of the tax-related services independent auditors may provide. Companies should have sufficient guidance so that they can develop their own policies on the matter, and not just rely on the accounting firms to interpret the independence rules and to monitor their own compliance. The uncertainties concern such important matters as advising on tax-sensitive financial products and structures, and tax planning advice on matters that could have a material impact on the financial statements. Another area in which guidance would be appropriate is the provision of personal tax services to directors and executive officers.
The proposed rules and the Proposing Release do not clarify the subject. The Sarbanes-Oxley Act does not expressly require the Commission to address these uncertainties, and the Commission may consider that the timetable for adoption of the rules under Article II does not permit a full review of the issues. We would, however, urge the Commission not to delay in coming to grips with the scope of permitted tax services.
A. The rules should give issuers a choice between engaging forensic auditors periodically and having the audit partners on their engagement team subject to the rotation requirements.
The proposed rotation requirements for audit partners will be burdensome for many issuers - particularly foreign private issuers in jurisdictions with limited pools of qualified accountants and issuers in industries with specialized regulatory regimes and accounting principles. We believe the Commission can address these concerns and still achieve its objectives by permitting an issuer to obtain periodic forensic audits in lieu of rotating its audit partners. We agree with the suggestion in the Proposing Release that such forensic audits would encourage an issuer's principal accountant to maintain high standards of independence and professional care and would provide a check on the principal accountant's work that would be at least as effective as substituting another accountant from the same firm on the engagement team.
B. The Commission's rules should not extend the rotation requirements beyond the lead partner and the reviewing partner.
Section 203 of the Sarbanes-Oxley Act requires rotation of the lead partner and the reviewing partner. The Commission's proposed rotation requirements would apply to all members of the audit engagement team, and the Proposing Release comments on the breadth of the group that would be captured.
The Commission should reconsider its decision to go beyond the scope of the Sarbanes-Oxley Act in this respect. First, it will be difficult to interpret the scope of the proposed requirement. The Commission's comments appear to take a broader view of the audit engagement team than the language of the definition might suggest, and it may in particular be hard to determine whether technical experts or senior consulting partners are within the definition or not.3 Second, outside the United States our experience is that in particular countries the requisite technical expertise on issues arising under U.S. GAAP is not widely distributed at each auditing firm. Audit quality will not be well served by imposing rotation requirements on the local partners most familiar with U.S. GAAP and Commission practices.
IV. Audit Committee Pre-Approval
Section 202 of the Sarbanes-Oxley Act provides that the audit committee may delegate to one or more designated members of the audit committee who are independent directors the authority to grant pre-approval of audit or non-audit services. The Proposing Release refers to this option, but the proposed rules do not provide for it except in connection with the de minimis exception in paragraph (c)(7)(ii)(C) of Rule 2-01. Paragraph (c)(7) should provide expressly for the audit committee to delegate the power to pre-approve audit or non-audit services.
V. Expanded Disclosure
The references to a review of quarterly financial statements in a registrant's Form 10-Q should be removed from the proposed amendments to Form 20-F.
The Commission's proposed rules should not require companies to disclose the percentage of audit fees that were subject to the pre-approval requirements of each sub-paragraph of paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-X. The level of granularity imposed by such disclosure is unduly burdensome given its limited use to investors in evaluating an auditor's independence.
VI. Transition Periods
The Commission's proposed rules will require significant changes in the current practices of many reporting companies and their auditors, and the Commission should establish transition periods to allow for an orderly implementation of the final rules.
With respect to prohibited non-audit services, we recommend delaying effectiveness of the new rules for a period of at least six months following the adoption of final rules. A limited grandfathering provision should be available for specific assignments such as litigation expert services. While certain categories of prohibited services remain unchanged, the changes are significant with respect to actuarial services for non-insurance companies, legal services outside the United States and expert services. These changes will require some reporting companies to identify and hire new providers of services currently being provided by their auditors, and to implement such changes without a transition period would place an undue burden on these companies.
We recommend delaying effectiveness of the rules regarding conflicts of interest, audit partner rotation, audit committee pre-approval, required communications with audit committees and compensation at least until December 31, 2003. Companies should not be required to make and monitor these changes until the next audit cycle after the rules are final.
With respect to the enhanced disclosure rules, we recommend delaying implementation so that the new rules would apply, at the earliest, beginning with annual reports in respect of fiscal years ending on or after September 30, 2003. They should not apply to the annual reports that will be filed in the first half of 2003, because issuers will need to implement systems to collect the information. In addition, in the first year they apply, the enhanced disclosures should only be required for one year, so that issuers do not have to reconstruct data for periods before the publication of the rules.
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We thank you for the opportunity to comment on the Proposing Release. We would be happy to discuss with you our comments or any other matters you feel would be helpful in your review of the proposals. Please do not hesitate to contact Nicolas Grabar or Leslie N. Silverman in New York (212-225-2000) or Edward F. Greene in London (44-20-7614-2200) if you would like to discuss these matters further.