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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:

Commissioner Norman S. Johnson

U.S. Securities & Exchange Commission

Stamford, Connecticut

October 1, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its members or employees. The views expressed herein are those of Commissioner Johnson and do not necessarily reflect the views of the Commission or its staff.

Good afternoon. I'd like to thank the Corporate Bar for inviting me here today. I spoke at your "Afternoon with the SEC" event two years ago and it's very much my pleasure to be here again. Of course, my remarks today are strictly my own and do not necessarily reflect the views of the Commission, the other Commissioners or the staff.

Since I was last here, much has happened. In particular, in the last year the SEC has become increasingly focussed on the problem of "earnings management" – the practice of companies misapplying accounting principles in order to report enhanced or artificially "smoothed" earnings.

In a speech last September at the NYU Center for Law and Business, Chairman Levitt called for a number of steps to combat earnings management. Of these initiatives, what's received the most attention so far is the increased emphasis on accounting fraud in our enforcement program. In fact just earlier this week, the Commission announced the filing of 30 additional cases based on fraudulent financial reporting, bringing the total to 88 such cases in the last year. Our Director of Enforcement Dick Walker, who you will hear from later this afternoon, declared 1999 the "Year of the Accountant." Given the success of his efforts so far, I suspect that the end of the millennium will not stop the Enforcement Division from continuing to focus on accounting fraud investigations.

But in addition to increased enforcement attention, the Chairman in his NYU speech also announced several steps – by the SEC, by accounting standard-setters and by the private sector – to address the problem of earnings management. I am pleased to report that substantial progress has been made on several of these fronts.

  • First, in response to the recommendations of the Blue Ribbon Committee, the boards of the NASD, New York Stock Exchange and American Stock Exchange have recently approved proposed amendments to their listing rules concerning the composition and function of corporate audit committees. Now that the SROs have acted, the Commission will shortly be proposing rules to implement some of the Blue Ribbon Committee's other recommendations. The rules to be proposed by the Commission are generally intended to improve disclosure of audit committees' activities.

  • Second, our Office of Chief Accountant and Division of Corporation Finance issued a staff accounting bulletin on materiality. The staff's bulletin is intended to dispel any misconceptions that there is a set numerical threshold for materiality or that intentional accounting errors can be excused as immaterial. The staff accounting bulletin is a must read for all corporate counsel and I'm sure many of you are already grappling with the important issues it raises.
Harvey Goldschmid and Mike McAlevey, both of whom will be appearing on panels this afternoon, played key roles in these important initiatives.

These are vital issues for every public company and the attorneys who counsel them. Today, however, I'd like to focus on another aspect of the SEC's earnings management initiative – our efforts to maintain auditor independence. This topic may seem a bit academic from your perspective as practicing lawyers. While I'm sure that you all recognize that auditors must be independent from management when they review a company's financial statements, this is probably not an issue you encounter daily in your practices. But I believe that the principle of auditor independence is so crucial to the quality of financial reporting and faces such unprecedented threats, that it is a topic that deserves the attention of all who care about the financial reporting process, including all members of the securities bar.

An increasing number of the Commission's enforcement cases for financial fraud have raised questions regarding the independence of auditors. For instance, the Commission recently settled a case with an auditor who continued to audit a client while negotiating employment with the company at the same time. The Commission also recently settled a case against a large accounting firm in which several members of one of the firm's offices owned stock in companies that their office and other offices of the firm audited. Cases like these involving such basic violations of the auditor independence rules are troubling. I sincerely hope that the profession has learned from them, so that others do not commit similar missteps.

But preserving auditor independence is not just a matter of bringing enforcement actions when our rules are violated. I am also concerned that many of the independence problems we have seen are rooted in the dramatic organizational changes that have taken place in the accounting profession over the last several years driven by economic pressures. Auditing fees are no longer the primary revenue source for the largest accounting firms. And it seems like these firms are adding new businesses and services at breakneck speed. As used to this trend as I think I have become, I was still surprised to read recently about the plans of one of the Big Five's consulting affiliates to launch a so-called internet portal, which describes itself as a "network to help you [among other things] plan your next cruise or vacation . . . and update your wardrobe."

While I have been concerned about the structural changes in the accounting industry throughout my time at the Commission, I find a more recent development especially troubling – the efforts by accounting firms to expand into the legal services area. The accounting firms' earliest efforts have involved legal representation before the IRS. Recent press reports have indicated that the largest firms have also expanded into providing advice on structuring corporate transactions and benefit plans. Indeed, according to the New York State Bar Association, Ernst & Young now employs as many lawyers – about 2400 – as the law firms of Jones Day and Skadden Arps combined. In case anyone thinks this trend is not accelerating, consider that the NYU Law School's placement office estimates that 20% of its recent graduating classes have been hired by the Big Five.

In my opinion, these developments pose grave threats to the principle of auditor independence. An accountant-attorney relationship with a client simply cannot be reconciled with the appearance of independence, at the least. This principle has long been recognized by the Commission's independence rules which prohibit an auditor from certifying the financial statements of a client with which his firm has an attorney-client relationship. Our codification of financial reporting policies states: A legal counsel enters into a personal relationship with a client and is primarily concerned with the personal rights and interests of such client. An independent accountant is precluded from such a relationship under the securities acts because the role is inconsistent with the appearance of independence required of accountants in reporting to public investors. Auditors of public companies are watchdogs for the public they owe their preeminent loyalty to the shareholders and to investors generally, not to their audit clients. As the Supreme Court indicated in the Arthur Young case, independent audits enhance the credibility of financial information, and, as a consequence, have a paramount role in ensuring investor confidence in our capital markets. If an auditor's independence is impaired, even if in appearance only, investors may lose confidence in the quality of the financial information reported. Auditors must carefully guard their independence, and place investors' interests above all else. Otherwise, as the Supreme Court stated in Arthur Young: "If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost."

As for lawyers, their duties and obligations are quite different. Attorneys owe their primary allegiance to their private clients, whose interests they are ethically bound to protect. Attorneys have an ethical duty to represent zealously the interests of their private clients, and it is impossible to reconcile this role as private advocate with the duty accountants and auditors owe to the investing public.

The expansion of accounting firms into legal services is currently being reviewed and considered by two organizations and the Commission has taken forceful steps to make its views known to both groups.

The first group studying the issue is the Independence Standards Board or ISB. Under the leadership of William Allen, a renowned former Chancellor of the Delaware Court of Chancery, this independent, private-sector group has been charged with establishing independence standards applicable to audits of public companies in order to serve the public interest and to promote investor confidence in the securities markets. In January, our Chief Accountant Lynn Turner sent a strongly worded letter to the ISB concerning the independence issues raised by accounting firms expanding into legal services. In response, the ISB has formally placed legal services on its agenda and, I am told, will shortly issue a discussion memorandum on this topic for public comment.

Not surprisingly, the American Bar Association has also taken a keen interest in these developments. As I'm sure many of you are aware, the ABA last year formed a committee to determine what, if any, changes should be made to the ABA Model Rules of Professional Conduct as they relate to the performance of legal services as part of a so-called multidisciplinary practice or "MDP." To the surprise of many, this past June the Committee concluded that – and I quote – "with appropriate safeguards a lawyer can deliver legal services to the clients of an MDP without endangering the core values of the legal profession ... ."

The ABA's House of Delegates took up the Committee's recommendation at its August meeting in Atlanta. After spirited debate, the House chose to postpone indefinitely consideration of the Committee's recommendation. I understand that, in all likelihood, the Committee's recommendation will not be considered again until the ABA's next annual meeting, which will take place in New York in July 2000.

The ABA's debate naturally focussed on the ramifications of MDPs for the legal profession. Opponents of MDPs raised important concerns, including:

  • the effect of MDPs on the lawyer's exercise of independent professional judgment;

  • the effect of MDPs on the lawyer's duty of confidentiality to his or her client and the possible impairment of the attorney-client privilege in an MDP; and

  • the increased likelihood of conflicts of interest for lawyers working in MDPs.
Valid concerns have also been raised about the effect of MDPs on the bar's traditional commitment to providing pro bono services – a commitment that does not exist in many other professions. These are issues all lawyers – indeed, all interested in preserving our legal system – should be concerned about.

But, as incredibly important as these issues are, they relate only indirectly to the Commission's core concern of protecting investors. What is central to protecting investors, however, is preserving the credibility of financial reporting. Accordingly, the Commission's staff has tried to remind the ABA of the effect that MDPs would have on the accounting profession and its vital role as auditors of public companies.

Initially, Lynn Turner sent a letter to the Committee studying MDPs calling their attention to the auditor independence issues and advising that our Office of Chief Accountant "would consider a firm's independence from an SEC registrant to be impaired if that firm also provides legal advice to the registrant or its affiliates." More recently, Lynn Turner, Dick Walker and Harvey Goldschmid sent a letter to the President of the ABA to reiterate the obstacle the SEC's existing independence rules pose to MDPs. That letter concludes: "[A]s the House of Delegates considers the MDP Commission's report, all involved should realize that the SEC will continue vigorous enforcement of its rules on auditor independence and that, unless and until those rules are modified, those rules prohibit an auditor from certifying the financial statements of a client with which his firm also has an attorney-client relationship." In these matters, the staff has my full backing, and – I think it safe to say – the full backing of the Commission.

Weighed against the serious, adverse effects of MDPs on auditor independence, proponents of MDPs have mostly suggested that they satisfy their clients' desires for "one-stop shopping" and "comprehensive" solutions to their problems. I appreciate that, for many of you, one-stop shopping may sound convenient. And I can even imagine that some benefit might be provided in some situations by having all the professionals needed to solve a certain problem under one roof. But whatever incremental benefits MDPs might provide, those benefits must be weighed against the tremendous threats they pose. And these are threats not only to the value of the legal and auditing services your company receives, but also to the crucial role that auditors play in preserving investor's confidence in the integrity of the financial reporting process. The quality and transparency of the United States financial reporting system is one of the most important assets of our capital markets. I think that we need to carefully consider whether the purported justifications for MDPs are enough reason to rush in to something that could jeopardize values so important.

Let me conclude by urging all of you to make your views on this subject known to the ABA and the ISB. I realize that participating in the organized bar is not necessarily the first thing on most of your minds. But as a former state bar president and ABA delegate, I know that corporate counsel provide a valuable, distinct viewpoint on issues the bar is considering. I must say that I was gratified to see that in-house counsel for a Fortune 500 company spoke in opposition to MDPs before the ABA's House of Delegates.

Likewise, I imagine that to the extent you have time to follow the work of accounting standard-setters, you probably focus on FASB and some of their current projects. But, as important as those projects seem today, I believe that the ISB's forthcoming discussion memorandum on legal services has such far-reaching implications that it deserves our special attention. Moreover, as corporate counsel, I believe that you bring an important and unique viewpoint to auditor independence issues in particular. Corporations are not only preparers, but also significant users of corporate financial statements.

This country can be proud to have a financial reporting system – and a legal system – that are each the envy of the rest of the world. In my opinion, MDPs pose enough of a threat to both that we should all take a careful look at the issues involved before proceeding any further down this path.

*     *    *

Before I conclude, I want to address one subject that is not related to auditor independence, but that has been much in the news lately. As I'm sure you all know, Chairman Levitt delivered an important address on the structure of our securities markets last week.

I think the Chairman's speech provided a valuable service by raising a lot of the important issues that the Commission and the industry must address in this period of rapid change in our securities markets. In terms of the basic principles the Commission must be guided by in this process – ensuring that investors are protected, promoting competition, considering whether technology provides new ways to combine the benefits of competition and centrality – I entirely agree with the Chairman.

However, I do think it's important that people recognize that the Chairman's speech was a starting point for a discussion of these issues and not an expression of the Commission's conclusions. I, for one, certainly have not made up my mind about a number of the issues it raised, including the proper structure of the self-regulatory function in a world of for-profit exchanges. I think we need to do a lot more hard thinking – and listening to people in the industry – before we decide that some type of single, unified SRO makes sense.

Thank you.


Modified: 03/25/2005