AICPA Comment Letter
Table of Contents
THE AICPA AND AUDITOR INDEPENDENCE
SUMMARY OF OUR OVERARCHING CONCERNS
THE APPROPRIATE RULEMAKING STANDARDS
THE TWELVE OVERARCHING CONCERNS
September 25, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Revision of the Commission's Auditor Independence Requirements - SEC File No. S7-13-00
Members and Staff of the Commission:
The American Institute of Certified Public Accountants (the "AICPA") respectfully submits the following written comments on the proposed revisions by the Securities and Exchange Commission (the "SEC" or the "Commission") to its auditor independence requirements.1
The AICPA and Auditor Independence
The AICPA has always been deeply committed to auditor independence. It is a core value of the accounting profession. The reputation of all auditors depends on it. And, the public interest requires it.
The accounting profession has a proud, more than 100 year history, of working in the public interest to uphold auditor independence. All members of the AICPA providing services to audit clients are required to maintain independence from their audit clients, in accordance with a detailed and regularly updated set of independence rules, interpretations and ethics rulings.2 These requirements apply to members auditing public and non-public entities, and are enforced through a joint program of the AICPA and the state CPA societies.3
AICPA member firms that audit SEC registrants are also required to join the AICPA's SEC Practice Section (the "SECPS"), which has adopted quality control requirements designed to promote both audit quality and auditor independence. Through its Quality Control Inquiry Committee ("QCIC"), the SECPS reviews allegations of audit failure in cases involving publicly-traded companies. In addition, member firms of the SECPS have been required, for over two decades, to participate in a program of peer review for compliance with professional standards and guidelines, including independence requirements. The SEC has access to peer review working papers and quality control inquiry files. These reviews serve to identify lessons learned to improve the quality of future audits.
The AICPA is committed to an effective self-regulatory program that focuses on protecting the public interest by ensuring investors have reliable financial information and by enhancing the credibility of financial reporting through the audit. Without question, this self-regulatory system has been an integral part of the best financial reporting system in the world. The profession understands that the public's trust is hard-earned and easily lost.
The AICPA has initiated or supported numerous efforts over the years to strengthen the financial reporting system and the profession's independence requirements. As the U.S. General Accounting Office (the "GAO") observed in its 1996 report, "[t]he accounting profession has been responsive to concerns about audit quality" and has "instituted and strengthened monitoring and disciplinary mechanisms to improve audit quality."4 To that end, the AICPA has played a leadership role in connection with the formation of the Public Oversight Board (the "POB")5 and the Independence Standards Board (the "ISB").6 We have also actively supported the Commission's commendable initiatives to enhance and improve the performance of audit committees. The AICPA has also made important contributions to the work of the many bodies that have from time to time studied various issues relating to audit services, including the Cohen Commission,7 the Jenkins Committee,8 the Elliott Committee,9 the Kirk Panel10 and the O'Malley Panel.11
Focusing on the ISB, the AICPA was a party to the creation three years ago of this promising partnership between the SEC and the profession. We have funded it ever since. We are committed to its success. And, we are pleased that it has made much progress on several fronts.
The ISB has adopted, always by unanimous vote, standards mandating that auditors disclose to audit committees information that could have a bearing on auditor independence, addressing the difficult issue of the independence implications of audits involving investment company complexes and providing guidance on an auditor's employment with an audit client. In addition, the ISB has prepared exposure drafts proposing new standards on financial interests in audit clients, family relationships between personnel employed at accounting firms and client employees and appraisal and valuation services. Most importantly, as contemplated at the ISB's formation, substantial progress has been made in developing a new conceptual framework for auditor independence, the predicate for replacing the present rule-based system with one based on principles.12
As our actions have demonstrated, the AICPA is fully committed to a careful and thorough review of the rules governing auditor independence. We have a long track record of working, in cooperation with the SEC, to improve the effectiveness of these rules. Indeed, the SEC's own expressly stated position, over many years, has been to turn to the AICPA's independence standards for guidance absent a clear conflict with an SEC rule or interpretation.13 While we have differed with the Commission in many respects, and apparently continue to do so, on how best to achieve the objective of auditor independence, we believe the means, and the will, are present for the profession and the SEC to work together to serve the public interest in the highest quality of independent audits of public entities.
Summary Of Our Overarching Concerns
Having reaffirmed our commitment to auditor independence, and our desire to work together with the Commission in the public interest, however, we regret that we can neither support the proposed rule, nor recommend that our members do so. There are twelve overarching concerns which lead us to this conclusion:
Before reviewing each of these overarching concerns in more detail, it is important to consider the overall impact of the proposed rule. Contrary to assertions in the Proposing Release, the proposed rule would have the overall effect of curtailing drastically the ability of accounting firms to engage in activities other than audit and tax (and even some tax services could be proscribed). The interaction of four components of the proposal would lead to this result:
As a result of these components, the "net" adverse impact of the proposal on the profession's ability to continue to serve clients is substantially greater than the sum of the individual restrictions. By also proposing to apply four vague and open-ended general "governing principles," a catch-all provision that sets forth a "facts and circumstances" test, an elastic, appearance-based standard in determining independence questions, the proposed rule would assure widespread uncertainty about its true reach. Instead of providing guidance and clarity, the Commission and its Staff would have virtual blanket authority to decide in the future that any non-audit service or other relationship impairs independence, even services or relationships that had not previously been identified as posing any threat to independence. Given the uncertainties associated with the use of such terms, and the severe consequences attached to construing them more narrowly than the SEC might do in hindsight, audit clients would be dissuaded from retaining their audit firm for the provision of any non-audit services. The proposed broad proxy rule compounds this problem by casting a further shadow over engagement of the auditor to provide those non-audit services that are not prohibited outright.16 The chilling effect of a potential unfavorable determination by the SEC as to their auditor's independence - including having to retain new auditors at considerable expense and delay, or possibly even exposure to civil liability for engaging the auditor - coupled with the ambiguity inherent in the principles' broad scope, would lead many public registrants to take the "path of least resistance" and eschew all non-audit services from their audit firm and any of its "affiliates." From the perspective of the accounting firms, promulgation of the rule would force divestiture of their consulting practices to avoid the substantial loss of value attributable to the severe restrictions the rule would impose. Indeed, the Commission could hardly expect any other result.
We believe this result -- virtually mandating audit and tax-only accounting firms -- is not in the public interest. To the contrary, in this time of dynamic and dramatic change, the public interest is best served by allowing a variety of models to emerge so that the most effective, efficient and independence-enhancing approach is ultimately found.
The Appropriate Rulemaking Standards
Before providing the Commission with our analysis of the proposal, it is important to specify the standards applicable to this rulemaking.
It should go without saying that the Commission may act only pursuant to authority granted to it by Congress. While Congress has authorized the SEC to issue rules defining "technical, trade, accounting, and other terms" used in the federal securities laws,17 the Commission's power to define such terms is limited in several respects. In particular, rules adopted by the SEC under the Securities Act of 1933 (the "Securities Act") must be "necessary to carry out the provisions of" the Securities Act.18 Further, in promulgating rules under the Securities Exchange Act of 1934 (the "Exchange Act"), the SEC must act "consistently with the provisions and purposes of" the Exchange Act.19
Accordingly, while the Commission has authority to define independence, it can do so only in a manner "necessary" to carry out the SEC's responsibilities or "consistent" with the federal securities laws. In particular, the authority to regulate independence does not extend to empowering the Commission to regulate the accounting profession as such. To the contrary, the legislative history of the federal securities laws indicates that Congress understood that accountants were subject to regulation at the state level,20 turning down the opportunity to create a de facto federal licensing scheme for public accounting firms and rejecting a scheme whereby companies registered with the SEC would be audited by government auditors.21
Even where the Commission does have authority to promulgate rules applicable to accountants, it must give individuals and entities adequate notice of what does, and does not, constitute improper conduct. This requirement was articulated most recently in Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (Checkosky II), where the D.C. Circuit strongly criticized the Commission for failing to provide accountants with adequate notice of the standard for "improper professional conduct" under SEC Rule 2(e)(1)(ii). The Court stated:
However legitimate and, indeed, essential the Commission's concern about unreliable financial statements may be, it is no substitute for a clearly delineated standard. Instead, the Commission's statements come close to a self-proclaimed license to charge and prove improper professional conduct whenever it pleases, constrained only by its own discretion (combined, perhaps, with the standards of GAAS and GAAP). . . . Although [under the APA] we owe `substantial deference to an agency's interpretation of its own regulations' . . . we cannot defer to an agency when `we are at a loss to know what kind of standard it is applying or how it is applying that standard to this record.'22
Although various federal laws and/or provisions governing the rulemaking process are implicated by the Commission's rulemaking, three deserve particular attention: the Administrative Procedure Act (the "APA"),23 the Exchange Act,24 and Executive Order 12866.25 Together, they direct that the Commission undertake a thorough and substantive reasoned analysis of the relevant data bearing on economic, efficiency and competitive consequences of a proposed rule prior to its adoption. We address additional, relevant federal laws and requirements in Appendix A.
Under the APA as construed by the U.S. Supreme Court, the U.S. Court of Appeals for the D.C. Circuit and other courts, an "agency must examine the relevant data and articulate a satisfactory explanation for its action including a `rational connection between the facts found and the choice made.' "26 In the words of the Supreme Court,
Normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.27
Similarly, the D.C. Circuit has stated that "speculation is an inadequate replacement for the agency's duty to undertake an examination of the relevant data and reasoned analysis."28 Further, an agency must "come to grips with the obvious ramifications of its approach and address them in a reasoned fashion."29 The government body "must do more than simply ignore comments that challenge its assumptions and must come forward with some explanation that its view is based on some reasonable analysis."30
The Exchange Act requires the SEC, when engaged in rulemaking, to consider whether its proposed actions will promote efficiency, competition and capital formation and not impose a burden on competition which is neither necessary nor appropriate in furtherance of the statute.31 The legislative history of these provisions makes clear that Congress intended the SEC to undertake a thorough and substantive analysis of the economic and competitive consequences of proposed rules prior to their adoption. For example, a report from the House of Representatives Committee on Commerce indicates that Congress "expect[ed] that the Commission [would] engage in rigorous analysis pursuant to [Section 3(f)]" and that "[s]uch analysis [would] be necessary to the Congress in connection with the Congress' review of major rules pursuant to the terms of the Small Business Regulatory Enforcement Fairness Act of 1996."32
Finally, under Executive Order 12866, which sets forth principles for federal agencies to follow in adopting new or revised regulations, a federal agency engaging in a rulemaking must:
The Twelve Overarching Concerns
I. The Rulemaking Process Is Too Rushed For Informed Decision-Making That Serves the Public Interest
We have serious concerns with the process the Commission has adopted for consideration of this momentous rule proposal, especially in light of the requirements for rulemaking discussed above. In particular, the process is too abbreviated and too rushed for informed decision-making that serves the public interest. Perhaps the most dramatic example of this unseemly rush to regulate is the refusal to extend the abbreviated 75-day comment period, 39 even to allow for interested parties to reflect on the record created at the Commission's public hearings on the rulemaking. 40 Tellingly, parties have had just two business days since the last public hearing to submit their written comments within the deadline.
The fact that independence issues have been the subject of ongoing debate for decades is no reason to rush consideration of a massive new rule proposal not previously the subject of public debate and absent issuance of a concept release. Indeed, the SEC has inconsistently indicated that no changes were needed (in its 1994 Staff Report to Congress)41 and that a new principles-based approach developed by a new organization (in the 1997 creation of the ISB) was needed.42 Work on a conceptual framework for auditor independence by the ISB is nearing completion after two years of intensive effort. Now, the SEC has suddenly changed course once again. No reason is given in the Proposed Release for this about face. These factors are evidence also of a rush to regulate, not the deliberative process of informed rulemaking required of the SEC.
In reality, the 75-day comment period is simply inadequate to allow the profession and the public to comment meaningfully on regulatory alternatives the agency itself has not even addressed, to analyze the more than 400 questions the Proposing Release raises43 and otherwise provide the Commission with the comprehensive commentary a rule of this complexity and importance requires. While we have endeavored to comment on all aspects of the proposed rule, that has not been possible within the constrained period imposed by the Commission.
The truncated process the Commission has adopted cannot be justified in terms of urgency. The Earnscliffe Report, on which the proposing release places much emphasis, did not find any evidence of crisis - to the contrary, the Phase II study specifically found that the more survey respondents "became informed about current safeguards, the more confident they became in the independence of the auditor."44 The director of that study project was recently quoted as saying that "[t]here's a consensus that the system is functioning reasonably well" and there "is no groundswell of demand by either individual investors or executives for the prohibition-type approach favored by the SEC."45 And, the recent Penn, Schoen & Berland poll of 600 investors found that nine out of ten investors trusted the annual audit of the companies they invest in, as well as the companies' audit committees and boards of directors.46 There is no crisis of confidence in auditor independence or the quality of audited financial information.
In short, there is no reason to rush to regulate on this important issue. To the contrary, there is time to hear from all interested parties, to gather informed comments, to solicit the information needed and "to get it right." Regulation which is not fully informed cannot be in the public interest.
II. The Proposed Rule Would Cripple the Ability of Accounting Firms to Meet the Audit Needs of Investors and Audit Clients in the New Economy
It is, by now, a truism to say that we are in a period of fundamental economic change. No one is smart enough to predict what that will mean in terms of the needs of public companies for new attestation and other professional services and the abilities of accounting firms to meet those needs. No one is wise enough to identify with confidence those needs and abilities necessary to meet the challenges of the New Economy and to serve the public interest. The better part of wisdom, therefore, calls for caution, and even a sense of humility, as the Commission considers a rule which will shape the structure of the accounting profession well into the future. Under these circumstances, the Commission would be well advised to follow the maxim of the medical profession: "above all, do no harm." Again, this is not the time to rush to regulate based on a hastily developed and uninformed proposed rule.
There can be no question about the urgent need to reinvent the financial reporting model, which was embedded into the federal securities laws in the 1930s. The markets are telling us what we are doing now is not as relevant as it used to be. When Microsoft's audited financial statements reflect that its most valuable assets are, first, its investment portfolio and, next, the buildings which house its intellectual capital, something is critically wrong. The fact is that audited financial statements simply are not measuring what the markets value most, a shortcoming which has much to do with the high price-to-earnings (if any) ratios in New Economy companies.
The current financial reporting model is based on the assumption that profitability is driven by physical assets, like factories and machinery, and raw materials -- in other words, the tangible inputs needed to produce tangible products. But, the high-tech companies of the information age are driven by intangible inputs financial statements mainly ignore -- from patentable ideas to marketing concepts, process design, computer programs, know-how, brand names, work-force expertise and training, quality controls, executive strategy, and organizational mechanisms to generate both quality improvements and innovation. These are the "intangibles" valued by the market but largely missed by the current SEC-influenced accounting model. In short, there is a serious "gap" in GAAP.
The old financial reporting model needs to be reexamined from two perspectives:
That is why the AICPA has called for the Commission to issue a concept release on the development of new GAAP for the New Economy.47 Six years ago, the Jenkins Committee, the AICPA's Special Committee on Financial Reporting, proposed a way to capture the "intangibles" that drive profitability in the New Economy in a new "business reporting" model.48 Today, the need to reexamine what information is reported is even more urgent. If we fail to meet that need, our system of financial reporting will become irrelevant, with unpredictable consequences for our capital markets.
The second challenge is rethinking when information is reported. We need more timely disclosure. In the Internet age, quarterly and annual reports are becoming dinosaurs. Currently, the lack of a reporting model that reflects relevant information on a more continuous basis contributes to market uncertainties that can result in stock volatility and increased risks that raise the cost of capital.49 It also provides an insight into the behavior of Wall Street analysts and other market professionals who seek to obtain information from companies over and above what is reflected in their periodic filings. Real-time disclosure of relevant financial information on the Internet is clearly foreseeable.
Implementing a 21st Century business reporting model presents new and very difficult conceptual and practical challenges. Accountants will have to become experts in e-commerce and all forms of rapidly evolving information technology. They will need to understand how "new" businesses are run and how to evaluate "soft" business information. Accounting firms will need to employ even greater arrays of "heavy duty" statistical techniques to examine the integrity, quality and reliability of client-generated information. And, they will have growing needs for specialists to provide critical assurance support - professionals with skills sets honed in performance of sophisticated client work.
Adoption of the proposed rule would take the profession in exactly the wrong direction at the wrong time. Instead of fostering the growth of an accounting firm's capacity to understand and assess the value of a registrant's business as reflected in its publicly disseminated information, the proposal would thwart the firm's ability to engage in activities enabling it to:
The proposed rule, if adopted, would also go far to deny accounting firms the very resources they will require most to meet the challenges of "information age" accounting and reporting:
The profession is already experiencing considerable difficulty in its efforts to continue to attract the best and the brightest. If the Commission constricts opportunities for talented young men and women with the qualifications and drive to work with cutting-edge information technology, accounting firms will present less attractive career opportunities for top-quality graduates. Today the profession faces serious recruiting challenges.50 The challenges of the future cannot be met by imposing an "audit and tax-only" model on accounting firms - a model that has never accurately characterized the range of services offered by accounting firms and makes no sense today.
The accounting profession does not operate in a vacuum. The profession is no more immune than other businesses from the sweeping changes wrought by the New Economy. By participating in joint ventures, partnerships, minority investments, cooperative alliances and networks, accounting firms enhance their ability to keep abreast of the latest technological and business developments. Such relationships expand the range, geographical reach and depth of the firms' potential resource base, ranging from institutional and human skill sets and expertise, to research and development and exposure to new products, tools, methodologies and capital resources. These experiences, in turn, redound to the benefit of the firms' audit capabilities by, among other things: (1) providing additional insights into the business processes and industry dynamics that may apply to the companies they audit; (2) leading to new technologies that can be deployed in assurance and audit engagements; and, (3) supplying firms with additional sources of capital that can be invested in improving the audit and assurance function and attracting the "best and brightest" to auditing.51
Many of these same synergistic effects result from accounting firms providing consulting, as well as audit, services. By severely curtailing their ability to (1) enter into strategic business alliances and ventures, (2) make even immaterial strategic minority investments, and (3) provide non-audit services, the unprecedented broad reach of the Commission's preclusive proposed rule would effectively reverse, or at minimum seriously erode, accounting firms' progress toward improving the quality of their audit services and increasing their relevance in the New Economy. The proposal's "affiliate" definitions, which are central to understanding the effect of the proposal rule in this regard, are discussed in Section V.
Many members of Congress from both political parties have urged the Commission not to act on its current auditor independence proposals with respect to non-audit services, among other new limitations on auditors' activities, until it has made further progress toward understanding and addressing the ramifications and implications of these issues.52 We share the concerns of these lawmakers, both as to the process for consideration of the Commission's proposals and the substance of its approach.53 We believe that to restrict the range of audit firm activities before new models of corporate disclosure have evolved is a "cart-before-the-horse" exercise which is at best premature and at worst inimical to investor protection.
III. The Proposed Rule Would Perform Radical Surgery on the Accounting Profession Without Any Rational Basis
Given the drastic impact of the proposed rule, one would expect to find a substantial record of empirical studies establishing a correlation between audit failures and non-audit services, including findings to that effect in litigated cases, a large body of enforcement actions at least alleging such a connection or other evidence of harm. The fact is, there is no such record.
To the contrary,
Lacking any empirical support, the Proposing Release relies instead on "common sense" and the impossibility of observing "an auditor's state of mind" as a basis for the proposed new restrictions.63 But someone's assertion of what is "common sense" is not a substitute for reasoned decision-making, particularly where it is at least equally likely as a matter of common sense that if non-audit services were a factor in audit failure, someone - whether it be the SEC, the accounting profession, private securities counsel, the insurance industry, investors, audit clients or the academic community - would by now be able to demonstrate that was the case. No one has done so.
Similarly, the so-called problem of "penetrating the auditor's mind" does not explain the failure to demonstrate a link between non-audit services and audit failures. In many situations, the SEC and other law enforcement agencies successfully bring cases which turn upon a determination of a defendant's state of mind. Findings of impairment of independence in fact do not require mental telepathy on the part of the decision-maker. Instead, the fact finding process calls for the drawing of inferences from relevant factual information in a way which is both disciplined and accountable. The paucity of cases even alleging a casual connection between an impairment of independence and an audit-failure cannot be explained away.64 Surely, neither the SEC's resourceful Enforcement Division nor the ever-aggressive plaintiffs' bar would be deterred by such alleged difficulties if they had relevant evidence.
The published reports (not yet even allegations) of matters under investigation by the SEC that may raise such issues do not constitute meaningful evidence of such a link and could not have informed this proposed rulemaking. Similarly, the anecdotal evidence of supposed "smoking guns" is just that - anecdotal.65 On a more fundamental level, even if there were isolated cases in which non-audit services were found to be linked to audit failures - and there are none as of today - that would not establish a basis for reasoned decision-making, particularly in light of the draconian restrictions the proposed rule would impose.
Moreover, the Proposing Release simply ignores the powerful economic and other incentives to maintain auditor independence. In particular, an accounting firm that puts its independence at risk in any client engagement would imperil its most valuable asset -- its reputation for high quality audits for multiple clients.66 Audit relationships have large start-up costs, but when performed professionally, are an "evergreen" source of revenue for the accounting firm, year-in and year-out.67 Every one of these relationships, each representing an expected flow of revenue, would be put at risk by compromising audit integrity with respect to just one audit client.68 This means there is a significant incentive for the firm not only to uphold independence at a firm-wide level, but to ensure that there are safeguards in place to prevent individual auditors and consultants from behaving in a manner that is detrimental to independence.69 Whatever benefit may be thought to flow from such substandard conduct would pale in comparison with the potential loss of revenue from other audit clients.70
The economic stake in maintaining independence is reinforced by exposure to litigation. The suggestion that the Private Securities Litigation Reform Act of 1995,71 has resulted in a decline in litigation and, thus, reduced the incentive for accounting firms to maintain high professional standards is not borne out by the data.72 QCIC statistics show that following a temporary drop-off in 1996 and 1997, immediately after passage of the PSLRA, proceedings against SECPS members have risen again to the same levels as the period immediately preceding the enactment of the statute. 73
IV. The Proposed Rule Relies Too Heavily on an Inadequately Informed and Legally Inappropriate Appearance Standard
As discussed above, the federal securities laws require financial statements to be certified by an "independent public or certified public accountant,"74 and authorize the Commission to define "accounting, technical and trade terms" thereunder.75 The legislative history of these statutes establishes that Congress understood that the key attributes of an "independent" accountant were impartiality and objectivity (i.e., independence "in fact"), rather than the avoidance of relationships that might call his appearance of independence into question.76
In other contexts, the Supreme Court has rejected attempts to impose perception-based regulatory requirements without clear statutory authority, concluding that causal links involving perception are too remote to form the basis for regulatory action.77 In particular, the Supreme Court determined that calls for regulatory action under the National Environmental Policy Act based on psychological reactions to unrealized risks were too far removed from reality to justify or support such action, noting that, "[a] risk is, by definition, unrealized" and that "[r]isk is a pervasive element of modern life."78 The Court went on to explain that, if perception-based tests were encompassed within the statute, "[a]gencies would, at the very least, be obliged to expend considerable resources developing psychiatric expertise that is not otherwise relevant to their congressionally assigned functions . . . `we cannot attribute to Congress the intention to . . . open the door to such obvious incongruities and undesirable possibilities.' "79
None of these observations regarding the flaws in the SEC's proposals, of course, is intended to suggest that auditors should not be concerned with maintaining their reputation as objective and independent professionals. As our own current rules demonstrate, the AICPA has continually taken steps to enhance and safeguard the reputation of auditors for maintaining independence from their clients. But, where perception is relied upon as the predicate for sweeping governmental prohibitions, uninformed by any empirical analysis, undisciplined by any fact-finding process80 and not preceded by any sustained effort to determine whether disclosure to audit committees or investors would suffice to mitigate any potential appearance concerns, the resulting rule cannot be said to reflect reasoned decision-making.
As the release correctly states:
The appearance standard, it should be stressed, is not a matter of `public relations.' It does not require the auditor to guess how persons with only a superficial understanding of the relevant facts would view his or her actions. Appearance is measured only with respect to reasonable persons knowing all the relevant facts and circumstances.81
But no studies support the conclusion, and there is no basis for a "reasonable person" who understands the "relevant facts and circumstances", to perceive, that an accounting firm which performs services or has relationships restricted by the proposed rule would not be independent of its audit client. In this regard, the analysis of the Earnscliffe Report by a leading academic, Professor Gary Orren of Harvard University, concluded that the findings of the Earnscliffe Report do not support the representations made in the Proposing Release about the appearance issue. 82 Further, as the project director of the Earnscliffe Report has made clear, the study found that "[t]here's a consensus that the system is functioning reasonably well" and there "is no groundswell of demand by either individual investors or executives for the prohibition-type approach favored by the SEC." 83
Consistent with the Supreme Court's reluctance to interpret statutes to allow the imposition of perception-based regulatory requirements, the Phase II Earnscliffe Report actually reflects a sense of unease among those surveyed about relying on a perception standard to define the minimum requirements of independence. In particular, the report noted,
[a]lmost half of the sample offered the view that trying to meet a perception test could be limiting, burdensome and would impose unreasonable costs on accounting firms. Still others were concerned that the instinct to address perception issues might result in either excessive or ambiguous regulation of the profession.84
Similarly, the "reasonable investors" polled in the Phase II Earnscliffe Report attempted to place into perspective concepts about risk in connection with rulemaking. In summarizing reactions of the investor focus groups as a whole, the Phase II Earnscliffe Report noted,
Inherent in many of these comments was an acceptance of the fact of life that the relationship between the auditor and auditee could become corrupted, but that made it no different from a wide variety of other situations in which people place their trust everyday. In short, they were saying that they felt that the level of risk was modest, the track record was pretty good, and the checks and balances seemed to be appropriate and functioning reasonably well.85
While the Phase II Earnscliffe Report indicates that most survey respondents from the elite group recognized, as do the AICPA's own professional standards,86 that perception concerns should be addressed when they are based on an "objective standard of acceptable perception," the respondents also recognized that the most fundamental test of all remains reality.87
It is often said that appearance is reality. But, even if we know how something appears (which is not the case here), where reality and appearance are misaligned, the first recourse should be to inform and educate.88 After all, if people were afraid that tall buildings would topple over, we would not stop building them. We would inform people that their fears were unfounded. The Earnscliffe Report's finding that the more survey respondents "became informed about current safeguards, the more confident they became in the independence of the auditor" is very instructive in this connection.89 We urge the Commission to give it heed. Just as the SEC has fostered the concerns, or more accurately, the perception of concerns that it now perceives to exist, so too can the Commission contribute to aligning perception with reality - starting with informing the public of the findings of the POB's Panel on Audit Effectiveness that the audit process is fundamentally sound.90
The Proposing Release argues that the appearance test can be applied objectively, as compared with decisions about independence in fact which, supposedly, requires inquiring into the mind of the auditor.91 Just the opposite is the case. To determine whether independence has been impaired as a matter of fact requires drawing reasonable inferences based on facts found in an objective and transparent process. One must ask, however, how the Staff would know whether a particular service is perceived by a "reasonable" investor as impairing independence?92 Lacking information, the temptation for the Staff to rely on its own entirely subjective perception is overwhelming. We submit this uninformed approach is arbitrary and fraught with peril - not only for the Commission, but also for accounting firms and their clients - who are at risk that the SEC Staff will reject their audited financials. This risk to the client effectively rules out any prospect of an accounting firm's challenging the Staff's decision. We have here all the makings of unreviewable "eye of the beholder" discretion by the SEC Staff. Governmental power should not transform important aspirational goals into coercive rules unless rationally grounded in a foundation of supporting evidence.
V. The Proposed Rule Would Isolate Accounting Firms, Depriving Them of Relationships Critically Needed to Perform Effective Audits in the New Economy
As we have discussed, the New Economy is placing new demands on auditors. As their clients evolve ever more complex structures involving rapidly changing and increasingly sophisticated technology, accounting firms must keep pace, or the quality of audits inevitably will suffer. Cost considerations and constraints on the availability of talent rule out a go-it-alone strategy. As with other participants in the global economy, accounting firms must form a variety of relationships to gain access to expertise and technology. As noted above, however, the proposed rule would isolate accounting firms from virtually all such relationships.
This result follows from the provisions in the proposed rule which would treat any entity with which an accounting firm has virtually any commercially meaningful relationship as an "affiliate of the accounting firm," itself obligated to comply with all the SEC's independence requirements. Such an "affiliation" would arise from, among other things, the existence of investor/investee relationships at an equity threshold of as low as five percent, any investment by the accounting firm in any entity if the entity provides non-audit or other professional services to the firm's attest clients, any direct business relationship,93 the sharing of any revenue in a business venture, or being "publicly associated" with the entity by co-branding, the use of the accounting firm's name, cross-selling or co-management.
By defining an affiliate of the accounting firm in such an expansive manner, and thereby making the conduct and investments of such third parties attributable to the accounting firm -- regardless of whether the relationship is material to either party -- the rule would turn accounting firms into pariahs. Under the proposed rule, an accounting firm's independence could be impaired, for example, if any entity with which the accounting firm has any such relationship owned even one share of an audit client of the accounting firm or engaged in a variety of even immaterial business relationships with that audit client.
For example, if a software firm such as, for instance, Oracle, were to enter into a venture with an accounting firm (other than its own auditor) to assist in developing a new accounting software application, Oracle would become an "affiliate" of that accounting firm. Accordingly, to maintain its independence, the accounting firm would have to require Oracle to subject itself to all the attendant independence rules as if it were an accounting firm. In consequence, Oracle could not invest in any audit client of the accounting firm; Oracle could not provide any non-audit services (such as installing software) to any audit client of its accounting firm partner; and any other entity in which Oracle had a greater than five percent investment would be subject to the same restrictions, as that entity would also be considered an "affiliate" of the accounting firm. It is inconceivable that Oracle (or any similarly situated entity) would subject itself to such burdens.
In sum, faced with the choice of being treated as an accounting firm subject to compliance with the SEC's complex, stringent and highly intrusive independence regulations or foregoing any business relationship with any accounting firm, what rational entity would sign up? The Proposing Release offers no justification -- not even in terms of investor perceptions --for this draconian and entirely arbitrary result. And, we are aware of none.
The "affiliate" rule would do grave damage to smaller accounting firms. As the Commission is aware, a principle means by which many small and mid-sized firms improve their geographic reach and depth of expertise is by forming alliances or networks. The typical structure for such an arrangement does not involve cross ownership, or "control," by one alliance member over the other members, or over the alliance itself. In fact, no one member could be said to exert "significant influence" over the alliance, as that concept is understood in the accounting literature.94 However, the collaborative business activities of the typical alliance (cross referrals, shared marketing and the like) would result in alliance (or network) members being considered affiliates under the proposed rule.
If that were the case, any work for any audit client of any member of the alliance would be attributed to every other member of the alliance, notwithstanding the fact that no member of the alliance exercises control or even significant influence over any other members. But none of the members of the alliance would have the information about the other members necessary to comply with the rules, and the risk of disqualifying members from serving a client, because of the attribution of the activities of other alliance members, would be so great that alliances would have to be scrapped. As a result, competition and audit quality would suffer.
The definition of an "affiliate of the accounting firm" would diverge radically from common understanding of the meaning of an "affiliate," as generally defined in Regulation S-X, which contains the requirements applicable to the preparation of financial statements of SEC registrants, including standards related to the independence of their auditors. Specifically, Regulation S-X defines an affiliate as a person or entity that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with another person or entity.95 Regulation S-X, in turn, defines control as the direct or indirect power to "direct or cause the direction of the management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise."96 In applying the concept of "control," standards-setting organizations such as the FASB and the AICPA traditionally have looked to indicia such as the presence of a majority voting interest.97 Use of these concepts for attribution purposes makes sense in that one legitimately might view entities subject to such control as an "alter ego" of the controlled (or controlling) entity. However, to establish a supposedly insurmountable conflict of interest barrier, the proposed definition of "affiliate of the accounting firm" would find "control" in investor/investee relationships of as low as five percent (or lower, if the non-accountant investee provides any non-audit or other professional services to an accounting firm's audit clients), and also constitute as "affiliates" almost any other entity involved in a business relationship in which an accounting firm might engage, regardless of whether the relationship confers any authority on one party over the other party's internal management or policies, or is even material to either party.
The definition of an affiliate of an accounting firm diverges not only from the Commission's own longstanding concepts of "control," but also from the proposed definition of an "affiliate of an audit client," which turns on an entity's ability to exercise "significant influence" over an audit client, or vice versa, based on principles set forth in Accounting Principles Board Opinion No. 18 ("APB Opinion No. 18"). APB Opinion No. 18 establishes, among other things, a rebuttable presumption that the ability to exercise significant influence exists as a result of a 20% or greater equity interest.98 Other indicia of "significant influence" under APB Opinion No. 18 include board representation, participation in policy making processes, material intercompany transactions, interchange of managerial personnel or technological dependency.
Regardless of whether "significant influence" as opposed to "control" is a sufficient basis for attribution of third-party conduct in an auditor independence context, the proposed definition of an affiliate of an audit client at least sets a threshold that recognizes that not all business or investment relationships rise to a level that should warrant the imposition of extensive and highly restrictive regulations on parties other than the accounting firms. In contrast, the proposed definition of an affiliate of the accounting firm, among numerous other provisions described hereafter, spreads a net so broad that we can only conclude that it was intended to result in the total economic isolation of all firms auditing publicly-traded companies.
The low thresholds at which investments will result in imputed "affiliate" status, in combination with the proposed restrictions with respect to purported "material indirect investments," also will thwart the ability of accounting firms (not to mention a host of newly defined "affiliates") to make important strategic investments, even though such investments may be immaterial overall to the audit client and the accounting firm or affiliate in relation to their financial portfolios. Specifically, the proposed rule seeks to classify as a "material indirect investment" those situations, now perfectly lawful and ethical under rules of the profession, where an accounting firm (or its "affiliates") or certain personnel associated with the firm (as well as certain of their family members) individually or collectively own more than five percent of the equity of an entity that either has any equity interest in an audit client or in which the audit client owns any equity interest. For example, assume the audit client is General Motors. Any entity in which the accounting firm (or its "affiliates") has more than a five percent equity interest (regardless of how small the total value of the interest) could not hold one share of stock in GM without causing the accounting firm to violate the proposed rule.
These affiliation provisions go well beyond existing guidance. In particular, the SEC's existing Codification of Financial Reporting Policies (the "Codification"), which contains interpretive guidance with respect to the SEC's auditor independence rules, focuses on the materiality of indirect financial interests involving audit clients in relation to the net worth of the accountant and the audit client,99 as well as in relation to the total assets and the consolidated income from continuing operations of the audit client that has the direct investment relationship with the entity.100
As a result, the proposed revision would significantly expand an accounting firm's (and, arguably, its affiliates') investment restrictions. Classifying as a "material indirect investment" any equity investment above five percent in the investee by an accounting firm (or any of the other affected persons) where the investee also has an investment relationship with an audit client, without regard to the effect of the investment or the related financial interest on the financial positions of the respective parties involved, is simply unsupportable by logic or experience. The SEC's current guidance recognizes that not all equity investments by audit firms (or persons whose investments are attributable to an audit firm) above five percent in entities that, in turn, have investment relationships with audit clients of the firm, will impair auditor independence, so long as such indirect financial interests remain immaterial in relation to the criteria in the Codification. Under the SEC's proposed revisions, however, an accountant's independence could be impaired even if the investment relationship involving an audit client and a non-client investee consisted of a single share and the audit firm's equity investment in the investee represented a fraction of one percent of the audit firm's financial worth. It is difficult to imagine what possible threat to the auditor's independence conceivably might exist in such circumstances. None is identified in the Proposing Release.
In addition, the SEC has taken an overly broad view of the parties it would treat as equivalent to an "audit client" for purposes of applying its "business relationship" restriction. For example, under proposed rule 2-01(c)(3), an officer, director or more than five percent shareholder of an entity in which an audit client had only a 20% equity interest would be considered an "affiliate" of that audit client, and accordingly, the accounting firm (or its "affiliates") could not have any direct or material indirect business relationship with that person. In addition, proposed rule 2-01(c)(3) would preclude direct or material indirect business relationships between an accounting firm (or persons whose business relationships would be attributed to the accounting firm) and officers and directors of, and shareholders with greater than a five percent equity interest in, the audit client.101
In contrast, existing SEC interpretive guidance in Section 602.02.g. of the Codification extends only to "substantial" shareholders of the audit client.102 While Section 602.02.g. does not define the meaning of a "substantial" shareholder, in describing situations that fall under the business relationship rule, the only example included in the Codification that expressly uses the term concerns a common investment involving audit firm partners and a 22% shareholder of a prospective audit client of the audit firm.103 The fact that such an equity level exceeds the threshold at which a presumption arises that the holder exercises "significant influence" over the audit client under APB Opinion No. 18 (which is triggered by a 20% or more equity interest) provides at least some basis for treating such a party as a "substantial shareholder."104
Conversely, no basis is set forth in the proposed rule for designating an equity holder above five percent (or, precluding investments in excess of five percent in entities which have any investment relationship with audit clients, no matter how small) as a "substantial shareholder." Nor does the Proposing Release suggest that the Staff has considered (1) alternatives to the five percent threshold at which an equity holder would be considered a "substantial shareholder, " or (2) the implications of its proposed new application of the business relationship rule, even though it would subsume business relationships of audit firms or their "affiliates" (as broadly defined) with persons only remotely, at best, associated with an audit client (such as officers, directors or shareholders in excess of five percent of entities which in turn have a 20% investment relationship with an audit client). How would the accounting firm even know, at three levels removed from the actual audit client, that it is prohibited from dealing with that person?
Finally, the statement in the Proposing Release that the proposed business relationship rule "continues the Codification's current standard,"105 given that Section 602.02.g. contains no reference to affiliates of audit clients and makes reference to "substantial stockholders," not five percent or more equity holders, seems ill-founded at best.
VI. The Proposed Restrictions on Specific Non-Audit Services Would Significantly and Unnecessarily Expand Existing Restrictions
Under the Proposing Release, the Commission would promulgate rules specifically banning ten enumerated non-audit services. We believe that in the 21st Century, when regulators generally have abandoned the "command-and-control" philosophy,106 this is a misguided approach. With the support of the accounting profession and the Commission, the ISB has undertaken to create a conceptual framework with respect to standards setting for auditor independence, so that a uniform, principles-based approach to regulation in this area can be adopted, as opposed to the ad hoc treatment that has prevailed in the past. By focusing on the development of such a principled approach, the ISB has been making strides to ensure that the focus remains squarely on audit quality, not mere technical compliance with a "laundry list" of prohibitions.107
Our concern with the SEC's contrary approach is well illustrated by considering the proposed prohibition on internal audit outsourcing.108 The stated reason for its proposed restriction is based in part on its views that the performance of such services necessarily entails the abdication by the registrant of its management function.109 However, the AICPA Code, which sanctions the provision of these services, subjects auditors to detailed conditions designed to ensure that registrants' retain management responsibility over such services.110 If the SEC were to prohibit the performance of such extended audit services by auditors, the result could be that registrants would devote fewer resources to internal audits. In this regard, it is worth noting that there generally is no legal requirement that registrants even have an internal audit capacity.
The debate about "internal audit outsourcing" or "extended audit services" in reality is not about the scope of non-audit services an auditor may perform - it is a debate about the scope of the audit. Seen in that way, it is difficult to understand the objection to a broader audit scope, which can enrich the audit, extend the auditor's responsibility and corresponding liability, and provide greater comfort to the public as to the thoroughness of the audit, so long as management is not relieved of its internal control responsibility. Banking regulators have voiced a proper concern that the institutions which they regulate retain and appropriately carry out that responsibility.111 But that concern has to do with management's retention of its responsibilities - not the independence of the auditor. In other words, the issue of whether an institution should outsource certain activities should not be confused with the issue of auditor independence.
Similarly, we dispute the ban on auditors "[d]esigning or implementing a hardware or software system used to generate information that is significant to the audit client's financial statements taken as a whole," except for "services an accountant performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls."112 These services have been provided to audit clients for decades and have never been shown to impair audit effectiveness. In fact, the SEC previously have recognized that "[s]ystems design is a proper function for the qualified public accountant."113
We do not understand why the SEC now is changing its position on this topic in the absence of any evidence of a systemic problem. Moreover, the Proposing Release does not take into account the negative consequences that could flow from such a prohibition. For example, public registrants today can call on their auditors for assistance if, as is sometimes the case, they encounter difficulty meeting deadlines for the implementation of new financial systems for the start of a new fiscal year. Should problems in the financial information system be detected by auditors during the course of the audit, the audit could well be delayed longer under the proposed rules than otherwise due to the additional time required to retain and inform other service providers. As a result, the audit client would incur increased costs.
The Proposing Release ignores other important benefits of the auditor's providing design and implementation services. These services deepen the audit firm's knowledge of a registrant's financial systems, contributing to overall audit quality. They also serve to strengthen the registrants' financial information systems, enhancing the reliability of the financial information reported, which benefits investors.
The risk that an auditor would ignore his or her professional responsibility to point out financial inaccuracies or systems deficiencies in the event the system generated incorrect data is unsupported and remote. We would submit that the benefits of allowing audit firms to apply their expertise in making improvements to financial reporting systems far outweighs the entirely speculative (and less probable) risk associated with such services in the event that material errors occur in isolated instances.114
The ban on legal services is entirely unwarranted. As the Commission is aware, given current restrictions imposed by the U.S. legal profession, the ban will only affect legal service practices of foreign accounting firms. Such services have been provided to foreign registrants since the early 1990s, pursuant to the Commission's prior guidance. There is no basis now for the SEC to impose its model on the rest of the world, overriding the judgment of regulators in other nations at to what best serves the public interest in those jurisdictions. To the extent the Commission's process is driven by concerns over "appearance," there is certainly no reason to assume that the performance of legal services by a foreign accounting firm will have any cognizable effect on appearance in the United States.
Beyond our overall disagreement with the decision to enumerate the ten prohibited services, we note that the Proposing Release greatly understates the extent to which the proposed rule would further restrict the provision of non-audit services. Although the Proposing Release suggests that eight of the ten services that would be banned "already are deemed to impair an auditor's independence under existing rules of the Commission or the SEC Practice Section of the AICPA,"115 a closer review demonstrates that, in many instances, the proposed rule would broaden restrictions beyond their current boundaries. In particular, we are concerned by the pervasive absence of materiality exceptions found in the comparable provisions of the AICPA's guidance. For example, in prohibiting appraisal and valuation services, the Proposing Release would ban the valuation of immaterial assets allowed by the AICPA's code. No reason is given for this position. We address in greater detail the specific instances where the Proposing Release would expand current restrictions in Appendix B.
VII. The Rulemaking Is Not Supported By A Meaningful Cost-Benefit Analysis
As we have noted above, the Commission is required to conduct a "rigorous" cost-benefit analysis of the economic and competitive consequences of its rulemaking. Although the Proposing Release purports to address costs and benefits of the proposed rules, it fails entirely to consider the most significant impacts.
The Commission seeks comment on the costs and benefits of the proposed rule. But, assuming the existence of a problem warranting action by the SEC, it is the responsibility of the Commission, not interested parties, to evaluate in a substantive and meaningful manner the costs, benefits and effectiveness of various regulatory solutions in order to determine which course of action would be most appropriate. The Proposing Release is devoid of any such analyses.
For example, the SEC's discussion of whether the rule will promote efficiency, competition and capital formation, required by Section 3(f) of the Exchange Act, is limited to a single paragraph, including the following unsupported statements:
[w]e believe that the proposals will increase investor confidence in the integrity of the audit process and in the audited financial information that they use daily to make investment and voting decisions. This increased sense of confidence should promote market efficiency and capital formation.116
Yet, just a few pages earlier, the Proposing Release recognizes that such "beliefs" are nothing more than pure speculation, it can claim only that, "[I]f the proposals increase investor confidence in financial reporting and thereby encourage investment, they may facilitate capital formation."117 In fact, even this speculation is unwarranted, considering that the Phase II Earnscliffe Report suggests that the "reasonable investors" surveyed exhibited "no underlying sense of insecurity"118 about financial statements and expressed little interest in the topic of auditor independence generally.119
Even when the Release does attempt to consider empirical data, it fails to take into account all of the relevant issues and factors. For example, in discussing whether "knowledge spillovers" or synergies exist in performing both audit and non-audit services, the Proposing Release cites to three studies from the 1980s and early 1990s to support the statement that the existence of such benefits remains "inconclusive."120 The Proposing Release makes no reference, however, to the survey this year by the O'Malley Panel, which found that in one quarter of the audit engagements where non-audit services were provided by the audit firm, such services had a positive impact on the effectiveness of the audit.121 Rather than dismissing evidence that such benefits exist, the SEC should undertake to systematically investigate the extent to which benefits may exist, as Professor Rick Antle urged at the SEC's July 26, 2000 public hearing on the proposals.122
In addition, the cost-benefit analysis set out in the Proposing Release fails to address at all the implications of the proposed new definition of an affiliate of an accounting firm. The obvious compliance burdens are not even mentioned. The costs imposed on audit firms and the losses resulting from the deprivation of needed business relationships (with non-audit clients) are ignored. Nor does the discussion of this definition reflect any consideration of alternatives. For instance, no consideration is given to the materiality of the relationship or whether the relationship relates to activities involving an audit client or would enable either party to exercise any corrupting influence over the other. Yet, addressing these factors lie at the heart of determining whether any justification exists for the prohibitions which the proposed rule would impose.123
There are many other costs and/or benefits ignored by the Proposing Release. For example, the analysis: does not consider the impact of new restrictions on business relationships and material indirect investments; does not individually analyze the costs and benefits of each of the ten enumerated prohibitions on non-audit services; contains no analysis of the five "alternative" regulatory approaches; provides no analysis of the cost to the marketplace and the economy as a whole, including - as required by law - effects on of competitiveness, employment, productivity and investment,124 fails to consider the costs likely to result from decreased competition among providers of consulting services and turns a blind eye to the impact on small firms.
Accordingly, as the Chief Economist of the U.S. Senate Committee on Banking, Housing and Urban Affairs has recently written to the Commission's Chief Economist, the rulemaking should "revisit and improv[e]" the analysis "in order to allow the public and the Congress to weigh sufficiently the relative benefits and costs of this proposal."125 Specifically, Mr. Silvia offered five suggestions on how the Commission Staff could improve the cost-benefit analysis, which -- in the event the Commission decides to proceed any further with this rulemaking process -- we fully endorse. These include: (i) expanding the scope of review to account for the fact that the proposed rule is a "major" rule; (ii) "quantify[ing]" the cost-benefit analysis rather than expecting the public to bear this burden; (iii) comparing the cost-benefit analysis to a baseline estimate of conditions that would exist without the regulation; (iv) providing a cost-benefit analysis for the "next best alternative"; and (v) soliciting a peer review to garner "independent critical evaluation of the work product."126 We endorse this approach and call upon the Commission to examine the other costs and benefits identified above.
VIII. The Proposed Rule's Sweeping Approach Would Result in a Host of Adverse, Unintended Consequences
Given the circumstances under which the proposed rule has been put out for comment - including the failure of the Commission to first issue a "concept release," the lack of any meaningful cost-benefit analysis and the haste with which it was drafted - it is not surprising that many, serious adverse unintended consequences are likely to result. The most prominent of these consequences is addressed above - under the rule, accounting firms would not be able to function in the New Economy. Because of the short time we have had to analyze the rule proposal, we are not able to identify all of the other unintended consequences. However, the following outcomes, many of which we have discussed in detail elsewhere in this letter, are evident:
IX. The Proposing Release Gives Inadequate Attention to Alternatives
The Proposing Release gives scant, if any, attention to alternatives to its restrictive and sweeping changes. For example, the SEC's presentation of its four identified alternative approaches130 for addressing scope of services takes up less than a page-and-a-half of the 57-page Proposing Release and lacks any discussion of the comparable merits or costs and benefits of such proposals in comparison to the SEC's proposed rule. No consideration is given in this or any other section of the Release to whether (1) existing, recent reforms with respect to strengthening audit committee oversight of such services, or (2) the development or enhancement of safeguards (such as professional reviews in this area) adequately mitigate the risks to independence perceived by the SEC. Yet, in considering responses from financial officers interviewed for the report, Earnscliffe observed that, "[t]he majority favored rulemaking which stressed best practices over bright lines, fearing a tendency to put in place rules that were too narrow, restrictive, and ultimately counterproductive."131
Given that the Proposing Release devotes a scant thirteen paragraphs to its four "alternatives," one must ask whether the Commission intends to give them any serious consideration. If the Commission were really considering alternative approaches, each alternative would have been discussed in depth to provide the basis for informed public debate. Dedicating two or three paragraphs to each of the so-called "alternatives" and suggesting that they may be used as the basis for the Commission's ultimate rulemaking fails to provide adequate notice of the Commission's intent and is flatly inconsistent with the APA's notice-and-comment requirements. Under these circumstances, we are unable to offer substantive comment on these "alternatives."
X. The Proposed Rule Would Not Promote Clarity, But Rather Exacerbate Uncertainty and Confusion
The SEC's use of its four vague "governing principles," contrary to the claim made in the Proposing Release, can only lead to continued uncertainty and confusion as to the application of the auditor independence rules.
The breadth and ambiguity of the four proposed governing principles become readily apparent in attempting to interpret them (as our members would be required to do in the event the rule were adopted). Under two of the four principles, for example, an auditor's independence would be impaired if he/she "has a mutual or conflicting interest with the audit client" or "acts as an advocate" of the audit client.132 Clearly, these principles cannot be read literally, for to do so would lead to absurd results. But, if they are not to be read literally, then where is the line to be drawn (except wherever the Commission and its Staff decide after the fact)? Surely, for example, the Commission does not want to discourage auditors from expressing candid professional judgments in the course of an audit about the application of specific accounting principles - issues on which informed professionals might well disagree. Yet, using the sweeping terms contained in the governing principles, such activity might well be deemed to constitute an independence impairment, since an auditor could be viewed as having a "conflicting interest with the audit client" if they disagreed as to the application of specific accounting principles. Similarly, the auditor and its audit client ought to share a "mutual interest" in the integrity of the company's financial statements.
Likewise, would not tax services otherwise permitted by the rule involve a mutuality of interest in that the client wishes lawfully to reduce its tax obligations, and the auditor is assisting in achieving that objective? And, do not a variety of tax services involve advocacy for the client? What is wrong with an auditor advocating a client's position on an accounting or tax issue which, in his professional opinion, is absolutely right? And, how does the Staff, which is to make the decisions, know how any of this "appears" to a reasonable investor. Or, more to the point, how is the auditor to predict how the Staff would perceive this perception? The auditor would have to guess, how the Staff would guess, what the investor would guess on the point - a triple guess rendering it impossible for the auditor to know with any certainty that he/she is complying with the rule.
The other two "principles" are not really principles either, but inadequately articulated rules. Taken to the extreme, the concept of not "functioning as management"133 may be viewed as antithetical to the traditional practice of commenting in a "management letter" on management practices. Similarly, the proscription against any self review whatsoever could extend to such functions as the routine dialogue which occurs when the auditor comments on the drafting of a financial statement footnote, which management then alters.134
As a consequence, even widespread, traditional services that accountants long have provided receive no safe haven under the proposed rule. For example, notwithstanding the statement in the preamble in the Proposing Release, nothing in the proposed rule itself expressly excludes an accounting firm's "explaining or defending (in a court, if necessary) its work in an audit"135 from being construed as serving as an "advocate." In short, the open-ended text of the four principles provides no meaningful guidance as to the application of their terms in specific circumstances. 136
Similar problems exists with respect to the "quality controls" safe harbor the rule proposal seeks to impose.137 Since the SECPS already mandates specific "quality controls" which are subject to peer review, it is difficult to discern the basis for this new requirement which can only cause confusion and undermine the self regulation process.138
XI. The Proposed Disclosure Requirements Are, at the Very Least, Premature
The purpose and utility of the SEC's proposed disclosure requirements are also unclear. The proposal would, among other things, generally require public registrants to: (i) describe specifically each professional service provided by the accounting firm that serves as its auditor, if the fee is greater than $50,000 or ten percent of the fee for the audit of the annual financial statements, whichever is smaller, as well as disclosure of work performed on the audit by leased personnel, if their hours were greater than 50% of the total work on the audit,139 and (ii) indicate whether the company's audit committee or, where no such committee exists, board of directors approved the service and considered the effect that the provision of each disclosed service could have on the auditor's independence.140 As with several other aspects of the proposed rule, these new disclosure requirements are being contemplated in the absence of any meaningful analysis of whether they are warranted and would address the problem the SEC perceives, and without allowing existing reforms recently put into place an opportunity to work.
Just last year, the ISB, the SEC, the NYSE, the AMEX and the NASD adopted rules to enhance board oversight concerning auditor independence in the wake of recommendations by the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. In particular, in July 1999, the ISB adopted Standard No. 1, which requires written disclosure by auditors to audit committees of public registrants of all relationships between the company and its auditor that in the auditor's professional judgment may reasonably be thought to bear on independence.141 Subsequently, in December 1999, the Commission approved its own new rules and those of the self-regulatory organizations that required, among other things, discussions and oversight by a registrant's audit committee concerning the independence of the registrant's auditors.142 The SEC's rules also require that public registrants include a report of their audit committee in their proxy statements which states, among other things, that the audit committee has received disclosures regarding independence required by ISB Standard No. 1 and has discussed the auditors' independence with the external audit firm.143
These recent reforms represent appropriate and targeted disclosure measures with respect to issues relating to auditor independence. They ensure that audit committees will obtain the information they need and assume the responsibility for monitoring issues relating to their auditor's independence. Nevertheless, the proposal suggests that new, additional disclosure requirements are necessary to inform investors in connection with their investment decisions.144
As noted in testimony before the Commission at its July 26, 2000 hearing, investors rely not just on the integrity of the auditors themselves (in terms of whether there are any potential economic conflicts that could threaten the independence of an audit), but on the integrity of the accounting firms generally, in terms of whether they have appropriate safeguards to monitor and address any potential conflicts that may arise.145 Investors would not be accurately informed, however, if they are furnished with additional disclosures that may create an aura of potential conflicts without an accompanying discussion of related safeguards.146 If investors are not given the full picture, they cannot make their own cost-benefit analysis about the extent, if any, of any potential independence threat posed by the provision of a particular service versus the value to the company of the service.147 It is also hard to see what purpose would be served by the disclosure of leased personnel arrangements, or that investors would have an interest in such information.
When the Commission previously imposed additional proxy disclosure requirements, through regulations in effect between 1979 and 1982, it found that the information disclosed was "not generally of sufficient utility to investors to justify continuation of the disclosure requirement" and rescinded the requirement.148 The Proposing Release notes that the SEC has revisited these disclosure requirements and now once again believes that they are warranted due to (1) the fact that there is now less information available to investors since the SECPS has stopped publishing information about audit firms' provision of non-audit services and (2) the growth in the amount of non-audit services now provided by audit firms.149 But while it is true that non-audit services are more prominent now than in the 1970s and 1980s, as the Proposing Release also notes, only 25% of audit clients also receive non-audit services from their accounting firms.150
The Proposing Release also cites implementation of a disclosure system in the United Kingdom as the basis for such a system in the United States.151 But we question what conclusions could be drawn to date from such experiences. First, the United Kingdom's approach is vastly different from the proposed rule. It has few prohibitions and instead largely relies on disclosure to deter questionable practices. Second, we are unaware of any studies -- and the Proposing Release cites none -- of the U.K. system. So, we are in the dark on such basic issues as its effectiveness in promoting auditor independence and audit quality and enhancing the confidence of investors in audited financial information. Surely, the Commission would not be justified in emulating a system which is so fundamentally different than ours and without any information as to its performance.
The new regime of targeted disclosure to strengthen audit committees has only recently come into effect. The SEC and the ISB exercised leadership in bringing about these reforms and they are fully supported by the profession. The audit committee is clearly the right body in the corporate governance structure to evaluate the independence implications of procuring non-audit services from the company's auditor. They stand in the shoes of the shareholders, not management. While management may retain the audit firm to perform non-audit services (while the audit committee engages the same firm to perform the audit), the fact that any non-audit services performed will be reviewed by the audit committee should act as a deterrent to any potential abuse. Under these circumstances, it just makes sense to gain some experience by monitoring the performance of the new system before considering whether broader disclosure would be in the public interest.
XII. Rather Than Issue New Independence Rules, the Commission Should Focus its Energies on Updating our Financial Reporting Model to Meet the Needs of the 21st Century and Let the ISB Finish Its Work
As discussed, the present rulemaking is fatally flawed. Instead of pursuing this approach, the Commission should first turn its attention to the needs of investors in the New Economy for a revised financial reporting model. At the same time, the Commission should allow the ISB to complete the variety of important projects it currently has underway, so that each of the subjects of the Commission's current rulemaking can be more thoroughly evaluated and vetted, and the independence standards-setting process will be more informed.
In FRR 50, which recognized the ISB, the SEC stated that it expected that "the public interest [would] be served by having the ISB take the lead in establishing, maintaining, and improving auditor independence requirements; and that operation of the ISB [would] promote efficiency, competition, and capital formation."152 That expectation is as relevant today as it was then. The ISB's deliberative processes have provided for broad and open public participation, as it examines existing auditor independence requirements and current issues, and develops updated standards applicable to auditors of public companies. As discussed above, the ISB's work has already resulted in significant progress, including the adoption and implementation of three final standards153 and the review of several other independence topics. We are generally supportive of the SEC's treatment of the financial and employment relationship rules, in seeking to modernize them through this proposal. However, the proposal deviates from the approach taken by the ISB in certain respects, which we discuss in detail in Appendix B. As is made clear there, we believe the ISB formulation should be allowed to take effect in its entirety. Most importantly, as contemplated at the ISB's formation, substantial work has been done to develop a new conceptual framework for auditor independence, the predicate for replacing the present rule-based system with one which is based on principles.
There is no crisis requiring the SEC to act without benefit of the ISB's guidance. The ISB's conceptual framework project is key to the creation of the principles-based approach to auditor independence that the SEC and the AICPA just three years ago agreed to entrust to the ISB. But, if the proposed rule were adopted, with its dense thicket of prescriptions and prohibitions, this project would be moot. After all, what would be the point of developing a conceptual framework for a principles-based approach, when the SEC has just adopted a sweeping rule-based regulation which would crowd out any new framework? More broadly, the proposed rule would strip the ISB of its role as a primary standards-setter for auditor independence. Reduced to the task of interpreting the new rule, the ISB would find it impossible to attract and retain the same high quality of Board members and staff it has now.
The AICPA and its members fully support the work of the ISB and will continue to do so. Although we may not ultimately agree with every decision the ISB makes, we fully respect its process and are committed to complying with the standards it promulgates. If the Commission's approach reflects a concern with the pace of the ISB's processes or its commitment to its mission, the AICPA would be happy to work with the Commission to strengthen this promising private-public partnership initiative.
We submit the public interest is best served by allowing the ISB process to complete its work. We understood the public members of the ISB at the July 26, 2000 hearing to say the SEC should make the ultimate policy choices about non-audit services. If the ISB were allowed to complete its work, the SEC could do just that - but on the basis a fully developed principles-based framework. Meanwhile, if the current Commission is to have a legacy with respect to auditor independence, that legacy should be that it established and supported a strong ISB, and not that it short-circuited the ISB's deliberative work and imposed an ill-conceived and deeply flawed rule on the accounting profession and the public.
In sum, for all the reasons set forth above and in the attached appendices, we respectfully urge the Commission not to pursue its pending rulemaking approach. If the SEC nevertheless decides that the rulemaking should continue, the process should be revised to reflect a more deliberative approach. In particular, the Commission should issue a concept release and seek comments on:
Adopting such an approach would not result in undue delay. The complexity, scope and magnitude of these issues, not to mention the requirements of the APA, the federal securities laws and Executive Order 12866, all call for a deliberative approach to rulemaking. Again, we believe the appropriate course of action is for the Commission to discontinue this rulemaking and allow the ISB to complete its work on the conceptual framework. But, if the Commission determines to proceed, the AICPA respectfully submits that such a process would better serve the public interest in improving the rules on auditor independence.
On behalf of our membership, we respectfully submit these deeply held concerns for the Commission's careful consideration.
Very Truly Yours,
Richard I. Miller
General Counsel and Secretary
Barry C. Melancon
President and CEO
Robert K. Elliott
Appendix A: Additional Legal Deficiencies and Issues
Appendix B: Additional Comments Regarding Specific Items in the Proposing Release
Appendix C: Remarks Regarding the Questions Posed in the Proposing Release
|1||See Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 43,148 (proposed July 12, 2000) (to be codified at 17 C.F.R. pts. 210 and 240).|
|2||AICPA independence rules, interpretations and ethics rulings are attached as Exhibit 6.|
|3||In response to Commissioner Unger's question at the public hearing on September 21, we are pleased to provide the following information about our enforcement program. For the year ended December 31, 1999, 262 new investigations were opened and 273 investigations closed, with a total of 623 investigations open at year-end. See AICPA, Annual Report of Ethics Division Activity, The CPA Letter (April 2000) (For the year ended December 31, 1998, 302 investigations were opened, 296 were closed and 634 remained open at year end). The subject matter of these investigations goes beyond SEC audit-related issues. With respect to enforcement actions related to SEC actions, in the period January 1, 1991 through May 3, 2000, there were 347 cases which involved AICPA members. This reflects Accounting and Auditing Enforcement Releases ("AAERs") beginning with AAER 287 and ending with AAER 1256. The AICPA opened 226 cases with respect to these 347 AAERs. The difference in the count reflects the fact the SEC issues multiple AAERs relating to the same matter, or includes more than one person in an AAER. The AICPA opened a case on every AICPA member involved in an AAER. The Quality Control Inquiry Committee ("QCIC") is working toward a system where any SECPS member firm with a partner who is a subject of an ethics investigation will be given the choice, during the pendancy of the investigation, of dismissing the auditor, placing them on probation (and away from audits) or "double teaming" the audit. This enhanced procedure goes well beyond any current AICPA, or even SEC, sanction.|
|4||See GAO, The Accounting Profession - Major Issues: Progress and Concerns, at ch. 4, 92 (GAO/AIMD 96-98, Sept. 1996) [hereinafter GAO Report].|
|5||The POB is a five-member body founded in 1977 whose autonomy is assured as a result of its ability to appoint its own members, chairperson and staff and to set its own budget and operating procedures. Funded by dues paid by the AICPA's SECPS members, the POB consists primarily of non-accountants, with a broad spectrum of business, professional, regulatory and legislative experience.|
|6||The ISB was created in May 1997 following extensive discussions involving the SEC, the AICPA and the leading accounting firms. The ISB consists of eight members, comprised equally of members from the public and from the profession. In recognizing the establishment of the ISB in Financial Reporting Release No. 50, the SEC stated that it expected the public interest would be served "by having the ISB take the lead in establishing, maintaining, and improving auditor independence requirements," and that principles, standards, practices and interpretations issued by the ISB would be considered by the SEC as having "substantial authoritative support," so long as the SEC had not affirmatively disavowed them. See Financial Reporting Release No. 50, 7 Fed. Sec. L. Rep. (CCH) ¶ 72,450, at 62,308-62,309 (Feb. 18, 1998) [hereinafter FRR 50].|
|7||In 1974, the AICPA appointed the Commission on Auditors' Responsibilities (the "Cohen Commission"), an independent study group chaired by former SEC Chairman Manuel E. Cohen. The Commission was formed to consider and make recommendations with respect to the "gap" between what the public expected of auditors and what auditors reasonably could accomplish. See AICPA, The Commission on Auditors' Responsibilities: Report, Conclusions and Recommendations (1978) [hereinafter Cohen Commission Report].|
|8||The Special Committee on Financial Reporting (the "Jenkins Committee") was formed in April 1991 by the AICPA and charged with recommending "(1) the nature and extent of information that should be made available to others by management and (2) the extent to which auditors should report on the various elements of that information." See AICPA, Improving Business Reporting - A Customer Focus (a.k.a. The Jenkins Report) 1994, at Appendix IV (visited Aug. 18, 2000) <http://www.aicpa.org/members/div/acctstd/ ibr/appiv.htm> [hereinafter Jenkins Report].|
|9||The Special Committee on Assurance Services (the "Elliott Committee"), chaired by Robert K. Elliott, was created by the AICPA in 1994, to "analyze and report on the current state and future of the audit/assurance function and the trends shaping the audit/assurance environment." The Elliott Committee was also charged with investigating "the implications of potential changes in the audit/assurance function for independence, professional skills, and professional education." See AICPA, Charge to the AICPA Special Committee on Assurance Services, at 1 (visited Sept. 18, 2000) <www.aicpa.org/assurance/scas/about/charge.htm>.|
|10||The Advisory Panel on Auditor Independence (the "Kirk Panel"), chaired by Donald J. Kirk, a POB member and former Chairman of the Financial Accounting Standards Board ("FASB"), was appointed by the POB in 1994 as an advisory panel on auditor independence. The Kirk Panel was charged with determining whether "`the SECPS, the accounting profession or the SEC should take steps to better assure the independence of auditors and the integrity and objectivity of their judgments.'" See Donald J. Kirk & Arthur Siegel, Professional Issues: How Directors and Auditors Can Improve Corporate Governance, J. of Acct. 53 (Jan. 1996).|
|11||The Panel on Audit Effectiveness (the "O'Malley Panel"), chaired by Shaun F. O'Malley, former Chair of Price Waterhouse LLP, consists of eight members appointed by the POB in October 1998 at the request of SEC Chairman Arthur Levitt. The O'Malley Panel is charged with evaluating the performance of public company financial statement audits, assessing whether recent trends in audit practices were in the public interest. See The Panel on Audit Effectiveness, Report and Recommendations, at vii (Aug. 2000) [hereinafter "Panel on Audit Effectiveness"].|
|12||See Testimony of William T. Allen, Chair, ISB, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 4 (visited Sept. 25, 2000) <http://www.sec.gov/rules/proposed/s71300/testmony/allen2.htm>.|
|13||See, e.g., Hill, Barth and King, SEC No-Action Letter [1984 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,650 (May 18, 1984); Deloitte, Haskins & Sells, SEC No-Action Letter [1982-1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,398 (Jan. 14, 1983).|
|14||See 65 Fed. Reg. at 43,190.|
|15||See id. at 43,192-43,193.|
|16||See Testimony of Dan L. Goldwasser, Vedder, Price, Kaufman & Kammholz, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 112-113 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>.|
|17||See, e.g., Securities Exchange Act of 1934 § 3(b), 15 U.S.C. § 78c(b) (1994); Securities Act of 1933 § 19(a), 15 U.S.C. § 77s(a) (1994); Public Utility Holding Company Act of 1935 § 20(a), 15 U.S.C § 79t(a) (1994); Investment Company Act of 1940 § 38(a), 15 U.S.C. § 80a-37(a) (1994).|
|18||See Securities Act of 1933 § 19(a), 15 U.S.C. § 77s(a) (1994).|
|19||See Securities Exchange Act of 1934 § 3(b), 15 U.S.C. § 78c(b) (1994). Items 25 and 26 of the Instructions to Schedule A of the Securities Act require issuers to have balance sheets and profit and loss statements certified by "independent public accountants." See Securities Act of 1933, Item 25 and 26 of the Instructions to Schedule A, 15 U.S.C. § 77aa (1994). Similarly, the Exchange Act authorizes the Commission to require financial statements audited by an "independent public or certified public accountant." See, e.g., Securities Exchange Act of 1934 § 10A, 15 U.S.C. § 78j-1(a) (Supp. IV 1998).|
|20||See, e.g., Jeremy Wiesen, The Securities Acts and Independent Auditors: What Did Congress Intend?, Commission on Auditors' Responsibilities, Research Study No. 2, at 40 (1978).|
|21||See id. at 38-40.|
|22||See Checkosky II, 139 F.3d at 225.|
|23||See 5 U.S.C. § 551 et seq. (1994 & Supp. IV 1998).|
|24||See Securities Exchange Act of 1934, 15 U.S.C. § 78 et seq. (1994 & Supp. IV 1998).|
|25||See Exec. Order No. 12,866, 3 C.F.R. 638 (1994).|
|26||See Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mutual Auto. Ins. Co., 463 U.S. 29, 43 (1983) (finding an order of the National Highway Traffic Safety Administration rescinding motor vehicle passive restraint requirements to be arbitrary and capricious due to the agency's inadequate analysis, including, but not limited to, its failure to consider relevant factors and alternative approaches).|
|27||See id.; see also Urbina-Osejo v. INS, 124 F.3d 1314 (9th Cir. 1997) (remanding order of Board of Immigration Appeals on the basis that the Board did not consider relevant factors in its decision and conducted only a cursory review of other factors); Chemical Mfrs. Ass'n v. EPA, 28 F.3d 1259 (D.C. Cir. 1994) (finding an EPA rule arbitrary and capricious where the agency, among other things, inadequately addressed comments about the weaknesses of the model it used in classifying a material as a high risk pollutant, by responding in a "high-handed and conclusory manner," and using speculative factual assertions and unsupported positions); Horsehead Resource Dev. Co. v. Browner, 16 F.3d 1246 (D.C. Cir. 1994) (remanding part of an EPA rule where the agency relied on "pure speculation" in establishing its standard rather than undertaking an examination of the relevant data and engaging in reasoned analysis); Alltel Corp. v. FCC, 838 F.2d 551 (D.C. Cir. 1988) (identifying as arbitrary and capricious an order of the FCC where, among other things, the FCC failed to provide a "reasoned explanation" for its actions by not responding to challenges that questioned the relevancy of its propositions and offering little more than hypotheses and questionable assumptions regarding purported abuses instead of showing that purported abuses existed); National Parks and Conservation Ass'n v. Federal Aviation Administration, 998 F.2d 1523 (10th Cir. 1993) (reversing FAA order No. where the agency substituted its subjective evaluation of impact on the public for empirical evidence about the affected recreational users); Kenneth Culp Davis & Richard J. Pierce, Jr., Administrative Law Treatise § 7.4 (3d ed. 1994) (noting that an agency "must set forth the basis and purpose of [a] rule in a detailed statement, often several hundred pages long, in which the agency refers to the evidentiary basis for all factual predicates, explains its method of reasoning from factual predicates to the expected effects of the rule, relates the factual predicates and expected effects of the rule to each of the statutory goals or purposes the agency is required to further or to consider, responds to all major criticisms contained in the comments on its proposed rule, and explains why it has rejected at least some of the most plausible alternatives to the rule it has adopted").|
|28||See Horsehead Resource, 16 F.3d at 1269-70.|
|30||See Alltel, 838 F.2d at 558.|
|31||See Securities Exchange Act of 1934 § 3(f), 15 U.S.C. § 78c(f) (Supp. IV 1998); Securities Exchange Act of 1934 § 23(a)(2), 15 U.S.C § 78w(a)(2) (1994).|
|32||See H.R. Rep. No. 104-622 (1996), reprinted in 1996 U.S.C.C.A.N. 3877, 3901 (emphasis added). As discussed in our comments on the Congressional Review Act ("CRA") provisions of the Small Business Regulatory Enforcement Fairness Act of 1996 ("SBREFA") in Appendix A, the annual effect of the proposed rules' impact on the accounting profession, registered companies and the economy as a whole would significantly exceed $100 million and, therefore, as a "major rule," they could not take effect for at least 60 days from the date of their issuance. See also Letter from John Silvia, Chief Economist, U.S. Senate Comm. on Banking, Housing and Urban Affairs, to Mark Ready, Chief Economist, SEC, at 1 (Sept. 15, 2000) [hereinafter Silvia Letter] (stating that "[u]nquestionably [the proposed rule] is a `major' rule as defined by the Congressional Review Act (5 U.S.C. 804(2)) and Executive Order 12866").|
|33||See Exec. Order No. 12,866, at § 1(b)(1). In other contexts, Congress has also recognized the value of turning to the private sector, where practical, to assess public issues and attempt to resolve them. For example, the National Technology Transfer and Advancement Act, Public Law 104-113 (March 7, 1996) ("NTTAA") directs agencies to rely upon standards developed by voluntary, private sector consensus bodies, in lieu of government-based standards.|
|34||See id. at § 1(a).|
|35||See id. at § 1(b)(3).|
|36||See id. at § 1(b)(5), (6).|
|37||See id. at § 1(b)(5).|
|38||See id. at § 1(b)(8). The shortcomings of command-and-control regulation are discussed in detail in AICPA, Serving the Public Interest: A New Conceptual Framework for Auditor Independence, at 88-103 (Oct. 20, 1997) [hereinafter Serving the Public Interest] (Attached as Exhibit 4).|
|39||Seventy-five days is a short period compared to the time allowed for comment on other recent major SEC rulemaking proposals. For example, the recently adopted Regulation FD had a 120-day comment period. See Selective Disclosure and Insider Trading, 65 Fed. Reg. 51,715 (2000) (to be codified at 17 C.F.R. pts. 240, 243 and 249).|
|40||Notably, the Commission has yet to publish transcripts of the September 13, September 20 or September 21, 2000 hearings, including testimony by the AICPA.|
|41||See Office of Chief Accountant, SEC, Staff Report on Auditor Independence, at 1, 55 (March 1994). Nor has the Commission indicated otherwise in subsequent reports to Congress.|
|42||See FRR 50, 7 Fed. Sec. L. Rep. (CCH), at 62,307-62,308 (stating that "the Commission intends to look to a standard-setting body designated by the accounting profession - known as the Independence Standards Board ("ISB") - to provide leadership not only in improving current auditor independence requirements, but also in establishing and maintaining a body of independence standards applicable to the auditors of all Commission registrants").|
|43||See Discussion of the questions posed in the Proposing Release contained in Appendix C.|
|44||See Earnscliffe Research & Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity - Phase II, at 53 (July 2000) (emphasis added) [hereinafter Phase II Earnscliffe Report] (Attached as Exhibit 1). The latest survey conducted by Earnscliffe Research and Communications for the ISB refutes the notion that there is an emergency that necessitates precipitous action. After surveying a pool of 51 respondents comprised of CEOs, CFOs, audit committee chairpersons, analysts and audit partners (following a similar survey by Earnscliffe of 131 similar respondents in 1999), and conducting focus groups of individuals identified as "reasonable investors" based on their participation in the stock market, the Phase II Earnscliffe Report noted the absence in either pool of respondents of any "widespread, urgent anxiety" about impairments to independence and that they "were not agitating" for more protection. See id., at 52-53. Instead, the surveys conducted by Earnscliffe reflected overall confidence in the financial reporting structure, including overall confidence in the performance of auditors. See id. at 4-7.|
|45||See Neil Roland, SEC Audit - Independence Tack Seen Lacking CEO, Investor Support, Bloomberg News (Aug. 2, 2000).|
|46||See Penn, Schoen & Berland Associates, National Industry Survey, at 4 (Sept. 12, 2000) (Attached as Exhibit 2).|
|47||See Testimony of Robert K. Elliott, Chairman, AICPA, before the Senate Banking Committee, Subcommittee on Securities, Hearing on Adapting a 1930's Financial Reporting Model to the 21st Century - July 19, 2000 (visited Sept. 8, 2000) <http://www.senate.gov/ ~banking/00_007hrg/071900/elliott.htm>.|
|48||See Jenkins Report, at ch. 6, 32-33.|
|49|| As Steve Samek of Arthur Andersen LLP remarked before the Senate Securities Subcommittee during a July, 2000 hearing,
Because so many underlying sources of value are overlooked in the traditional measurement and reporting system, investors and analysts are compelled to apply a variety of less-than-exact analytical methods and `guesstimates' to value companies. Investors need to understand all of the sources of value and how well management exploits them. The increasing volatility in the daily highs and lows of the NASDAQ index demonstrates the need for better information about all the assets that matter.
See Testimony of Steve M. Samek, Partner, Arthur Andersen, before the Senate Banking Committee, Subcommittee on Securities, Hearing on Adapting a 1930's Financial Reporting Model to the 21st Century - July 19, 2000, at 5 (visited Sept. 8, 2000) <http://www.senate.gov/_banking/00_007hrg/071900 /samek.htm>; see also Testimony of Peter J. Wallison, Resident Fellow, American Enterprise Institute, before the Senate Banking Committee, Subcommittee on Securities, Hearing on Adapting a 1930's Financial Reporting Model to the 21st Century - July 19, 2000, at 3 (visited Aug. 15, 2000) <http://www.senate.gov/_banking/00_007hrg/071900/wallison.htm> (noting that modern developments "have made intangible assets the real drivers of company value, but this had happened before we have had an opportunity to develop the means to assess and communicate what these assets are actually worth" and that the "result is an increasing discrepancy between what financial statements are telling us and what the market sees - and hence more uncertainty, more volatility, higher than necessary capital costs, and less efficiency in the allocation of capital in our economy").
|50||University accounting departments are already having significant difficulties attracting students to their programs. See W. Steve Albrecht & Robert J. Sack, Accounting Education: Charting the Course through a Perilous Future, at 19 (Aug. 2000) (Attached as Exhibit 3). Practitioners attribute this decline, in particular, to the greater salary potential for other disciplines, such as information systems, and the perception that accounting is less rewarding and challenging than other fields. See id. at 25. A virtual ban on non-audit services, combined with a continuation of a financial reporting model embedded in the federal securities laws in the 1930s, will only exacerbate this trend.|
|51||See Remarks for Delivery by Philip A. Laskawy, Chairman, Ernst & Young LLP, to the American Accounting Association, The Global Marketplace, the "Connected" Economy, and the SEC's Auditor Independence Proposals (Aug. 15, 2000).|
|52||For example, several members of the Senate Banking Committee's Securities Subcommittee have asked the Commission to extend its comment period until early next year, noting that, "[a]t a time when our accounting standards will require significant modernization if they are to reflect value in today's economy, it is axiomatic that the accounting profession must retain the capacity to respond to these changes." See Letter from Rod Grams, Evan Bayh, Phil Gramm, Mike Crapo, Robert F. Bennett, Wayne Allard, Chuck Hagel & Rick Santorum, U.S. Senators, to Arthur Levitt, Chairman, SEC (July 28, 2000).|
|53||Several members of the U.S. House of Representatives stated in a letter to Chairman Levitt in July that, "[l]ending assurance to new species of company information in real time will surely require skills, methodologies, and technologies beyond those geared to the traditional audit of historical financial statements." See Letter from Ellen O. Tauscher, Jim Moran, Cal Dooley, Adam Smith, Peter Deutsch & Jim Maloney, Members of Congress, to Arthur Levitt, Chairman, SEC (July 18, 2000).|
|54|| See Testimony of Richard Walker, Dir. of Enforcement Div., SEC, Open Meeting on Proposals to Modernize Auditor Independence Rules (June 27, 2000) (acknowledging that the SEC has not found in an enforcement action to date that the provision of non-audit services led to an impairment of an auditor's independence). During his July 26, 2000 testimony before the Commission, Professor Douglas Carmichael cited the Westec case mentioned in the Cohen Commission Report as the one example of a case where "consulting practice has compromised audit independence." We disagree. In fact, Commission Chairman Manuel Cohen stated immediately before issuing the Report (and after considering Westec) that the Commission "found no evidence of the loss of independence in the performance of other [i.e., non-audit] services." See Manuel F. Cohen, Remarks on The Work Of The Commission On Auditors' Responsibilities - Mar. 8, 1977, at 9 (visited Sept. 22, 2000) <http://newman.baruch.cuny.edu/|
digital/saxe/saxe_1976/cohen_77.htm>. This is borne out by the Report itself which notes that Westec involved only an "alleg[ation]" that provision of non-audit services impaired independence. See Cohen Commission Report, at 97. Significantly, shortly after the final Report was issued, the SEC issued its May 31, 1978 Opinion and Order in the Westec matter, Ernst & Ernst, 14 SEC Docket (CCH) 1276 (1978), which drew no connection between provision of non-audit services and impairment of the auditors' independence.
|55||See GAO Report, at ch. 2, 41-42. To the extent studies have considered the issue of potential impairments to auditor independence, they do not support the radical measures proposed by the SEC. The GAO reviewed studies regarding auditor independence by groups including the Cohen Commission, the POB, the major accounting firms, the AICPA's Special Committee on Standards of Professional Conduct for Certified Public Accountants (the "Anderson Committee"), the Treadway Commission and the SEC Staff and concluded that "measures that would limit auditor services or mandate changing auditors are outweighed by the value of continuity in conducting audits and the value of traditional consulting services." See id. at 56. The Report stated that a more "reasonable" response would be to restructure the auditor/client relationship to bring the independent auditor into a more direct working relationship with the board of directors, and the audit committee in particular, so that additional oversight could be provided. See id. That is precisely the approach implemented by ISB Standard No. 1, see ISB Standard No. 1, Independence Discussions with Audit Committees (Jan. 1999), and by the rules recently adopted by the SEC, the New York Stock Exchange, the American Stock Exchange and the National Association of Securities Dealers, with respect to audit committees. See Audit Committee Disclosure, 64 Fed. Reg. 73,389 (1999) (to be codified at 17 C.F.R. pts. 210, 228, 229 and 240); Order Approving Proposed Rule Change by the New York Stock Exchange, Exchange Act Release No. 42233, 71 SEC Docket (CCH) 639 (Dec. 14, 1999); Order Approving Proposed Rule Change by the American Stock Exchange, Exchange Act Release No. 42232, 71 SEC Docket (CCH) 632 (Dec. 14, 1999); Order Approving Proposed Rule Change by the NASD, Exchange Act Release No. 42231, 71 SEC Docket (CCH) 624 (Dec. 14, 1999).|
|56||See Steven M.H. Wallman, The Future of Accounting, Part III: Reliability and Auditor Independence, 10 Acct. Horizons 76, 92 (Dec. 1996).|
|57||See id. at 79 n.5.|
|58||See Serving the Public Interest, at 12 (stating that the behavior of the insurance industry, an industry which has a major economic stake in auditor liability, refutes the theory that non-audit services are perceived to impair independence).|
|59||See Testimony of William T. Allen, Chair, ISB, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 85 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>.|
|60||See Panel on Audit Effectiveness, at 113.|
|62||See id. at ix.|
|63||See 65 Fed. Reg. at 43,155. There was a time when the Commission was willing to examine independence issues on a case-by-case basis and determine if a non-audit relationship between a firm and its client in fact impaired independence. See, e.g., Advanced Research Associates, Inc. 41 S.E.C. 579, 594 (1963) (noting that "business relationships in addition to the accountant-client relationship do not per se establish a lack of independence"); Red Bank Oil Co. 21 S.E.C. 695, 709 n.24 (1946) (characterizing evidence of various business relationships between an accounting firm and a registrant as "collateral facts"); A. Hollander & Son, Inc., 8 S.E.C. 586, 616 (1941) (observing that evidence of various business relationships between an accountant and the principal officers of an audit client "taken by itself, has little probative value, . . . but must be considered together with the facts heretofore discussed").|
|64||Data collected in 1997 on insurance claims made by the six largest U.S. accounting firms confirmed the absence of any increased liability exposure associated with the provision of non-audit services to audit clients. In a review conducted of a risk management database compiled by an insurance broker for the six firms, it was found that out of 610 insurance claims made, the accounting firm provided management advisory services in addition to audit services in only 24 cases. Lack of independence was alleged by plaintiffs in only five of the 24 cases and in only three of those five cases was it alleged that the provision of management advisory services contributed to the alleged breach of independence. See Serving the Public Interest, at 56.|
|65||See Testimony of Richard Blumenthal, Att'y Gen. of the State of Conn., before the SEC - September 20, 2000 (visited Sept. 22, 2000) <http://www.sec.gov/rules/proposed/s71300/testmony/blumentl.htm>; Testimony of Charles R. Drott, before the SEC - September 13, 2000 (visited Sept. 22, 2000) <http://www.sec.gov/rules/proposed/s71300/testmony/drott1.htm>; Testimony of Jay W. Eisenhofer, before the SEC - September 13, 2000 (visited Sept. 22, 2000) <http://www.sec.gov/rules/proposed/ s71300/testimony/eisenhofer.htm> . In the testimony of Messrs. Drott and Eisenhofer, no specifics of any case were discussed, due to confidentiality restrictions. While such "examples" deserve further examination, they do not form the basis for a rulemaking.|
|66||For a broader discussion of these issues, see Serving the Public Interest, at 58-88.|
|67||There is no empirical or logical basis for the view that the audit is a "loss leader" for consulting services. C.f. Testimony of Jack T. Ciesielski, R.G. Associates, Inc. and Publisher, The Analyst's Accounting Observer, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 78 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>. Given that three out of four audit clients purchased no management advisory services from their auditors in 1999, see 65 Fed. Reg. at 43,153, this would not be a rational course of action for accounting firms to maximize revenue. A more logical reason to price the initial audit as a so-called "loss leader" is the expectation of capturing a long-term, profitable audit relationship.|
|68||See The Law & Economics Consulting Group, Inc., An Economic Analysis of Auditor Independence for a Multi-client, Multi-service Public Accounting Firm, at 15 (Oct. 20, 1987), Appendix B to Serving the Public Interest ("Engaging in an institutional-level abrogation of independence would put the firm's entire stream of audit revenues at risk.").|
|69||See id. at 9-10.|
|70||See id. at 15.|
|71||Pub. L. No. 104-67 § 102, 109 Stat. 737, 15 U.S.C. §§ 77z-2, 78u-5 (Supp. IV 1998) ("PSLRA")|
|72||C.f. Testimony of John C. Coffee, Jr., Professor of Law, Columbia School of Management, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 28 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>.|
|73||See Serving the Public Interest at 82 which notes that exposure to liability and professional sanctions provides a complimentary deterrent to compromising independence.|
|74||See, e.g., Securities Exchange Act of 1934 § 10A, 15 U.S.C. § 78j-1(a) (Supp. IV 1998); Public Utility Holding Company Act of 1935 § 14, 15 U.S.C. § 79n (1994); Investment Company Act of 1940 § 30, 15 U.S.C. § 80a-29(e) (1994).|
|75||See, e.g., Securities Exchange Act of 1934 § 3(b), 15 U.S.C. § 78c(b) (1994), Securities Act of 1933 § 19(a), 15 U.S.C. § 77s(a) (1994); Public Utility Holding Company Act of 1935 § 20(a), 15 U.S.C § 79t(a) (1994); Investment Company Act of 1940 § 38(a), 15 U.S.C. § 80a-37(a) (1994).|
|76||See, e.g., 78 Cong. Rec. 8,300-01 (1934), 78 Cong. Rec. 8,496-97 (1934), Stock Exchange Practices Hearings before the Senate Committee on Banking and Currency, 73d Cong., 6990 (1934) (statement of Eugene E. Thompson, President of Associated Stock Exchanges), Securities Act, Hearings before the Senate Committee on Banking and Currency on S. 875, 73d Cong., 56-58 (1933) (discussing auditor independence in terms of whether the accountant is an employee of the registrant).|
|77||See Metropolitan Edison Co. v. People Against Nuclear Energy, 460 U.S. 766, 772-77 (1983).|
|78||See id. at 775.|
|79||See id. at 776.|
|80||See Orren Analysis on the need for empirical research on appearance at 5. See also Professor Orren's report "The Appearance Standard for Auditor Independence: What We Know and Should Know," October 20, 1997, which is attached as Appendix A to Serving the Public Interest.|
|81||See 65 Fed. Reg. at 43,151.|
|82||See Memorandum from Gary Orren, to AICPA, Analysis of Earnscliffe Report and SEC Rule Proposal (Sept. 19, 2000), at 1-2 [hereinafter Orren Analysis] (Attached as Exhibit 5). Professor Orren was critical of the methodology used by Earnscliffe, primarily because "some of its conclusions do not follow from the Report's own empirical findings." Id., at 2. Professor Orren also noted that "The Earnscliffe findings are consistent with most previous empirical studies of the impact of non-audit services on people's perceptions of auditor independence. . . . The bulk of available research indicates that the confidence of the investing public and other market participants in the independence of accounting firms has not been significantly impaired by the growth of non-audit services." Id. at 4.|
|83||See Neil Roland, SEC Audit - Independence Tack Seen Lacking CEO, Investor Support, Bloomberg News (Aug. 2, 2000).|
|84||See Phase II Earnscliffe Report, at 14.|
|85||See id. at 53.|
|86||See AICPA, Codification of Statements on Auditing Standards No. 1, AU § 220.01-03.|
|87||See Phase II Earnscliffe Report, at 14.|
|88||See Testimony of Rick Antle, at 24-25.|
|89||See Phase II Earnscliffe Report, at 53.|
|90||See Letter from Shaun F. O'Malley, Chair, Panel on Audit Effectiveness, to The Public Oversight Board and Other Interested Parties (Aug. 31, 2000), included in Panel on Audit Effectiveness Report.|
|91||See 65 Fed. Reg. at 43,151.|
|92||Although the Staff has not sought to do so, these questions concerning perception are not inherently unanswerable. Rather, as Professor Orren indicated "the measurement and analysis of perceptions is a 70-year old science grounded in solid academic disciplines (psychology, political science, and survey research) and rigorous professional practice." See Orren Analysis, at 3.|
|93||Although we believe the Commission did not so intend, proposed rule 2-01(f)(4)(i)(D) pertaining to the definition of an "affiliate of the accounting firm" might preclude accounting firms from using any professional service provider also used by any of its audit clients. Literally read, the proposed rule appears to provide that a public relations firm, software designer, professional consultant or university that has a direct business relationship with the audit firm and provides professional services to one of the firm's audit clients would become the firm's affiliate thereby, triggering the prohibition. Moreover, the "ordinary course of business exception" found elsewhere in the proposed rules, is omitted from the definition of "affiliate of the accounting firm," thereby making its application to "direct business relationships" unclear.|
|94||See Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (2000).|
|95||See 17 C.F.R. § 210.1-02(b) (1999). Rule 2-01 of Regulation S-X, which now sets forth the SEC's current independence requirement, makes no reference at all to an affiliate of an accounting firm, referring instead only to affiliates of a client of an accountant. It defines a "member" of an accountant's firm to include all partners, shareholders, and other principals of the firm, any professional employee involved in providing any professional service to a client, and any professional employee having managerial responsibilities and located in the engagement office or other office of the firm that participates in a significant portion of the audit. See id. § 210.2-01(b).|
|96||See id. § 210.1-02(g).|
|97||See FASB, Financial Accounting Standards Board Statement No. 94, at ¶ 2 (2000); AICPA Code, Interpretation 101-9 [ET § 101.11].|
|98||See APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, at ¶ 17 (2000).|
|99||In particular, in determining whether a "material indirect financial interest" exists by an accountant in an attest client (or its parents, subsidiaries or affiliates) that would impair an accountant's independence under Rule 2-01 currently, Section 602.02.b.i. of the Codification provides, in part, that "it is necessary to determine whether such financial interest is material. In this context, the materiality determination is made primarily with reference to the net worth of the accountant, his or her firm, and the net worth of the client." See Codification of Financial Reporting Policies § 602.02.b.i., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,258, at 62,886 (1998).|
|100||More specifically, in discussing situations involving an immaterial financial interest of an accountant in a nonclient investee of an audit client, Section 602.02.b.iii. states, in part, that, "[i]n general, an immaterial financial interest in a nonclient investee of a client company would not have an adverse effect on the independence of the auditor of the client/investor where the investor's investment in the investee does not exceed five percent of the investor's consolidated total assets and the investor's equity in the investee's income from continuing operations before income taxes does not exceed five percent of the investor's consolidated income from continuing operations before income taxes." See Codification of Financial Reporting Policies § 602.02.b.iii., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,260, at 62,887 (1998) (emphasis added). The Commission appears to have conflated the Codification's reasonable concern (in terms of materiality) over the impact on the investor with an investor's non-material five percent ownership interest in an investee.|
|101||See 65 Fed. Reg. at 43,191-43,192.|
|102||See Codification of Financial Reporting Policies § 602.02.g., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,272, at 62,905 (1998).|
|103||See Codification of Financial Reporting Policies § 602.02.g., example 8, 7 Fed. Sec. L. Rep. (CCH) ¶ 73,272, at 62,906 (1998).|
|104||See APB Opinion No. 18, at ¶ 17.|
|105||See 65 Fed Reg. at 43,167.|
|106||See Serving the Public Interest, at 89.|
|107||One of the key shortcomings of command-and-control regulation, as opposed to a principles-based threats- and-safeguards approach, is that it emphasizes technical compliance with particularized rules rather than the achievement of policy objectives or goals. A regulatory regime that stresses compliance with detailed, specific rules, over time, will require additional rules, in order to address new developments, or close off loopholes in existing rules. In this way, regulations beget more regulations, leading to a regime of detailed rules, developed through accretion, that becomes increasingly tangential to the original purpose of the regulations. For further discussion, see id. at 90-96. A principles-based, threats-and-safeguards approach has also been adopted in the European Union. See Testimony of the Fédération des Experts Comptables Européens (FEE), before the SEC, Hearing on Auditor Independence - Sept. 20, 2000 (stating that "FEE has developed a conceptual approach considering the different kinds of threats that arise with respect to statutory audit independence and objectivity and the possible safeguards, including prohibitions, to offset these threats").|
|108||See 65 Fed. Reg. at 43,192.|
|109||Id. at 43,170.|
|110||See AICPA Code, Interpretation 101-13 [ET § 101.15].|
|111||See Testimony of John D. Hawke, Jr., Comptroller of the Currency, before the SEC, Hearing on Auditor Independence - July 26, 2000 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>.|
|112||See 65 Fed. Reg. at 43,192.|
|113||See Accounting Series Release No. 126, 37 Fed. Reg. 14,294, 14,296 (July 19, 1972).|
|114||We view the nature and degree of the "self-review" associated with such financial information systems design and implementation as no different in kind than with respect to permitted systems work with respect to the design, assessment and implementation of accounting controls and risk management controls, which the SEC considered insufficient to warrant prohibiting.|
|115||See Memorandum from Lynn E. Turner, Chief Accountant, SEC, to Arthur Levitt, Chairman, SEC, at 2 (July 17, 2000) (attached to Letter from Chairman Levitt to Senator Evan Bayh, July 17, 2000).|
|116||See 65 Fed. Reg. at 43,189 (emphasis added). The Commission's failure to state why it believes such things makes meaningful public debate vastly more difficult. One can challenge poorly conducted studies or "junk science." But one is at something of a loss to challenge "beliefs" of a regulator solemnly handed down without any foundation.|
|117||See id. at 43,184 (emphasis added).|
|118||See Phase II Earnscliffe Report, at 53 ("The fact that auditors had reviewed the financials gave people comfort, but there was no underlying sense of insecurity, despite the fact that most people could name some high profile problem cases in recent years.").|
|119||See id. ("The more people became informed about current safeguards, the more confident they became in the independence of the auditor. They were open to the idea that more safeguards might be needed, but were not agitating for these, nor were they overly interested in being communicated to about these matters in the future.").|
|120||See 65 Fed. Reg. at 43,186.|
|121||See Panel on Audit Effectiveness, at 113. Disregarding credible evidence which disagrees with a regulator's preferred result is one hallmark of arbitrary and capricious action.|
|122||See Testimony of Rick Antle, Professor of Accounting, Yale School of Management, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 24-25 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm> (commenting on the synergies that could be lost if the SEC precluded the provision of such non-audit services to audit clients).|
|123||The Commission's press summaries of the proposed rules make no effort to acknowledge or convey the broad reach of this radical approach. See, e.g., Notice of Hearings, 65 Fed. Reg. 43,385 (2000). For example, the summaries make no reference to the definition of an "affiliate of the accounting firm." Nor does the release, by illustrations analogous to those in Appendix C to the Proposing Release, indicate how much of the economy might be affected by the broad sweep of the proposed prohibitions.|
|124||Such analysis is required by Congress with respect to a "major rule," which this clearly is. See SBREFA discussion in Appendix A.|
|125||See Silvia Letter, at 1.|
|126||See id. at 1-2.|
|127||See Panel on Audit Effectiveness, at ch. 5.|
|128||See Letter from Thomas J. Donahue, Chairman, U.S. Chamber of Commerce, to Arthur Levitt, Chairman, SEC (Aug. 7, 2000) (expressing concern about proposed rule, including that it would reduce competition, raise audit costs, increase consolidation among accounting firms, deprive accounting firms of the ability and/or incentive to innovate, force companies to dismiss auditors that have performed well and compel companies to accept their second choice firm for provision of non-audit services); see also Serving the Public Interest, at 68-79 (discussing the benefit of a broad scope of practices to audit quality, economies of scale and innovation).|
|129||See 65 Fed. Reg. at 43,187.|
|130||At least one of these alternatives would be even more restrictive than the proposed rule in that it would provide for a total ban on the provision of non-audit services to audit clients. Meanwhile, the alternatives do not include, waiting to see if the recent changes to audit committee responsibilities provide greater assurance of auditor independence and/or permitting the ISB to continue its standards-setting work.|
|131||See Phase II Earnscliffe Report, at 24; see also Serving the Public Interest, at 116 (suggesting that regulation of independence can best be achieved not through "command and control" directives, but rather by "call[ing] for the ISB to provide clear guidance regarding the core principles of independence, and then require firms to implement those principles through their own compliance codes, subject to ISB oversight").|
|132||See 65 Fed. Reg. at 43,190.|
|133||See 65 Fed. Reg. at 43,190.|
|135||See id. at 43,158.|
|136||The very vagueness of the proposed principles would pose significant questions of adequate notice and due process. See, e.g., Checkosky II, 139 F.3d at 224. As noted supra at § 1, the Commission was harshly criticized by the D.C. Circuit in Checkosky II for failing to give accountants adequate notice of the standard for "improper professional conduct" under SEC Rule 2(e)(1)(ii). See id.|
|137||See id. at 43,192.|
|138||This provision also raises questions about the Commission's authority, since it is not empowered to regulate the profession directly. See prior discussion of "The Appropriate Rulemaking Standards."|
|139||See 65 Fed. Reg. at 43,194.|
|141||See ISB Standard No. 1, Independence Discussions with Audit Committees (Jan. 1999).|
|142||See Audit Committee Disclosure, 64 Fed. Reg. 73,389 (1999) (to be codified at 17 C.F.R. pts. 210, 228, 229 and 240); Order Approving Proposed Rule Change by the New York Stock Exchange, Exchange Act Release No. 42233, 71 SEC Docket (CCH) 639 (Dec. 14, 1999); Order Approving Proposed Rule Change by the American Stock Exchange, Exchange Act Release No. 42232, 71 SEC Docket (CCH) 632 (Dec. 14, 1999); Order Approving Proposed Rule Change by the NASD, Exchange Act Release No. 42231, 71 SEC Docket (CCH) 624 (Dec. 14, 1999).|
|143||See 64 Fed. Reg. at 73,401.|
|144||See 65 Fed. Reg. at 43,156.|
|145||See Testimony of Dan L. Goldwasser, at 112.|
|148||See Accounting Series Release No. 304, 24 SEC Docket (CCH) 800 (Jan. 28, 1982).|
|149||See 65 Fed. Reg. at 43,156.|
|150||See id. at 43,185.|
|151||See id. at 43,177.|
|152||See FRR 50, 7 Fed. Sec. L. Rep. (CCH), at 62,308.|
|153||See ISB Standard No. 1, Independence Discussions with Audit Committees (Jan. 1999); ISB Standard No. 2, Certain Independence Implications of Audits of Mutual Funds and Related Entities (July 2000); ISB Standard No. 3, Employment with Audit Clients (July 2000).|