SEC Speech: Remarks at the Securities Regulation Institute (Norman S. Johnson)
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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the Securities Regulation Institute

by Commissioner Norman S. Johnson

U.S. Securities & Exchange Commission

San Diego, Calif.

January 27, 2000

I am pleased to be back at the Securities Regulation Institute – although a day late – to share the lectern with such a distinguished panel. I should note that I speak only for myself and not for the Commission or my fellow commissioners.

I have the utmost respect for the accounting profession and recognize the complex decisions facing practitioners. However, efforts to combat financial fraud and so-called "earnings management" became a top enforcement priority for the Commission in 1999. Indeed, 1999 came to be dubbed "the Year of the Accountant."

After hearing Lynn Turner and Dick Walker speak, it should be clear that our concerns about crooked and sloppy financial reporting did not evaporate on New Year's Day. Developments seem to have cast this year – 2000 – as the "Year of the Accountant II." During this sequel, I hope we will see further progress on auditor independence issues. One independence issue I'd like to discuss today involves the notion of "multidisciplinary practice."

Looking back on the 20th Century, it is evident that investors' growing faith in our capital markets was due in large measure to the perceived independence of auditors. One hundred years ago, a noted accountant wrote, "[a] public accountant acknowledges no master but the public." This premise remains an integral part of our securities laws today. Accountants must maintain strict independence from their audit clients.

Despite this long-standing requirement, we have seen increasing use of accounting fudges often called "earnings management." Auditors are supposed to uncover and frustrate management's use of accounting gimmicks. Why, then, have auditors let the public down in a number of highly publicized cases?

Some time ago, Chairman Levitt talked about a game of "nods and winks" between companies, auditors and analysts. This game is fueled in part by growing business relationships between auditors and their audit clients. It hardly seems accidental that financial fraud has increased at the same time non-audit services performed by accounting firms have proliferated and become more profitable.

The Commission has not hesitated to use its enforcement power where business and financial relationships threaten auditor independence. This morning, Dick Walker, our able enforcement director, discussed a number of recent SEC actions. In one case I found particularly troubling, we disciplined an attorney --who was also a CPA – for compromising his firm's independence by providing legal services to an audit client.

Auditor/lawyer independence is a very hot issue. I am sure you are all aware of the efforts by some accounting firms to expand into the area of legal services by creating "multidisciplinary practices" or "MDPs." In August 1998, the ABA appointed a Commission on Multidisciplinary Practice to study the implications of MDPs. In a controversial proposal, the ABA commission recommended relaxing professional restrictions to permit the same firm to offer legal, audit, consulting and other services. According to the ABA commission, these proposals would not change the legal profession's core values.

How can this be?

Under the ABA commission's proposals, MDPs could be managed by non-lawyers. To safeguard legal standards, MDPs controlled by non-lawyers would have to certify compliance with ethical and disciplinary rules to the highest court in their jurisdiction.

Shouldn't we be troubled by the impact non-lawyer management might have on lawyers' professional judgment? There is an old proverb "he who controls the purse controls all." Would certification to a state court change this reality?

As most of you know, the ABA's House of Delegates voted to continue the current limitations on MDPs pending further study. The ABA commission recently published an updated report on MDPs that tries to address some criticisms and solicits further comment. Additional discussion is scheduled for the ABA's mid-year meeting next month, in Dallas.

While I personally have grave concerns about MDPs, the SEC has taken no position on them per se. However, both SEC and AICPA rules prevent auditors from performing legal services for their SEC audit clients.

MDP- advocates argue that changing professional practices will breach traditional barriers between legal and audit services. For example:

  • Several major accounting and law firms have entered into "strategic alliances" involving referrals, but not fee sharing;

  • Ernst & Young recently announced that it would lend its name and start-up capital to a new law firm with which E&Y will jointly market services. However, partners in the new firm have represented that the law firm will not share fees with E&Y or provide legal services to E&Y's audit clients.

Proponents claim that the next logical step is MDPs that offer legal and audit services to the same client. However, isn't there an unbridgeable gap between the duties of attorneys and auditors? Unlike attorneys who must keep client matters confidential, auditors of public companies must publicly disclose their disagreements with management over questionable accounting practices. Moreover, a lawyer's advice often influences management decisions. In the MDP context, an auditor could then be reviewing decisions made or suggested by a lawyer-colleague.

A lawyer's mandate is advocacy while an auditor's mandate is objectivity. Interest in enhanced profits or cross-selling of services can't overcome this divide.

The SEC is not alone in recognizing the importance of this distinction. I am pleased to note that last month the ABA commission on MDPs determined that roles of auditor and attorney are incompatible under the securities laws. Moreover, the Supreme Court stated in the Arthur Young case that "the value of the audit function itself might be lost" by a blurring of the audit and attorney roles.

That's why I'm surprised by some elements of a recent discussion memorandum issued by the Independence Standards Board. The ISB was created to establish independence standards for auditors of public entities. The discussion memorandum seeks public comment on whether appropriate independence standards can be designed to allow audit firms to provide legal services to their SEC audit clients.

The ISB's memorandum gives five scenarios for independence. The first is the blanket prohibition now in place, while the fifth allows auditors to provide legal services to audit clients subject only to the requirement that the auditor not become "a de facto employee or officer of the client." In between are three scenarios that would limit legal services based on tests involving the degree of advocacy, magnitude or materiality of the services or use of safeguards such as "firewalls" and client waivers.

I realize that the ISB is trying to stimulate public debate on these issues. However, there are several suppositions that raise concern. The first is that attorneys and accountants are both advocates for their clients. While accountants may have taken on very limited advocacy roles in certain tax areas, their role in an audit is certainly not as an advocate. The second is that a materiality threshold can be set without at least the appearance that the auditor's independence has been compromised.

Finally, I question whether firewalls can really maintain the degree of independence required of auditors. What would investors make of audited financial statements containing legal opinions from the auditor's law partners? How would investors react if auditors failed to uncover or disclose problems known to the legal part of the same firm? Appearances alone may be enough to undermine investors' confidence.

Auditors have a special franchise under our securities laws. They are the only experts that public companies must hire. The value of this franchise would rapidly deteriorate if auditors became just another consultant to – or advocate for – their clients. The SEC will continue to enforce independence rules to maintain the public's confidence in our system of financial reporting.

My remarks today have focused on maintaining the integrity of the audit. As an SEC Commissioner, that is a logical focus for me. I would also like to express my personal view on the legal practice. In my experience, an independent lawyer serves as an important safeguard of our country's most cherished democratic ideals. We should resist the urge to accommodate commercial relationships by relaxing fundamental standards of confidentiality, conflicts and independence of action, so vital to the protection of our clients.

Thank you.