Appendix A

Additional Legal Deficiencies and Issues

Appendix A

Table of Contents

I. The Proposing Release Does Not Satisfy the Requirements of the Paperwork Reduction Act

II. The Proposing Release Does Not Satisfy the Requirements of the Regulatory Flexibility Act

III. In the Event the Commission Promulgates the Proposed Rule as Final, It Must Be Designated a "Major Rule" Pursuant to the Congressional Review Act

Appendix A

Additional Legal Deficiencies and Issues

As we have explained in our Comment Letter, the rulemaking thus far does not stand up to scrutiny under the Administrative Procedure Act (the "APA"), the federal securities laws and Executive Order 12866. The following additional legal deficiencies are presented by the rulemaking.

I. The Proposing Release Does Not Satisfy the Requirements of the Paperwork Reduction Act

The Paperwork Reduction Act requires each federal agency to (1) establish a process, independent of program responsibility, to evaluate proposed collections of information; (2) manage information resources to reduce information collection burdens on the public; and (3) ensure that the public has timely and equitable access to information products and services.1

As described in detail in an August 22, 2000 comment letter submitted to the Office of Management and Budget by the AICPA, jointly with Arthur Andersen LLP, Deloitte & Touche LLP and KPMG LLP, with respect to the proposed proxy requirements, the Proposing Release fails to meet the requirements of the Paperwork Reduction Act, particularly with respect to the burdens placed on the public, including accounting firms and SEC registrants.2 As explained in that Comment Letter, the Proposing Release would re-impose a proxy reporting requirement that the Commission has previously repudiated. Clearly, the Staff has dramatically underestimated the burden on registrants in collecting the information which would be required to be disclosed. For example, the analysis in the Proposing Release fails to consider the additional burden on registrants of analyzing and storing this type of information and of putting it in a reporting format.

In addition, ambiguities in the proposed proxy rule raise the possibility it might be construed to require proxy disclosure by registrants any time they enter into a relationship meeting the $50,000 or 10 percent of annual audit fee threshold not only with an accounting firm, but with any of its "affiliates," as that term is very broadly defined in the proposal. Proposed Item 9(e)(1) to Schedule 14A would require registrants to:

Describe each professional service provided during the most recent fiscal year by the independent public or certified public accountant (as defined in Article 2 of Regulation S-X, 17 CFR 210.2-1) that is the registrant's principal accountant.3

Although this language includes the parenthetical phrase "as defined in . . . 17 CFR 210.2-1," the proposed amendments to Rule 2-01 in fact include no definition of the terms "independent public or certified public accountant." Variations on these terms do appear within the definition of "accountant," which includes "a certified public accountant or public accountant performing services in connection with an engagement for which independence is required" and "any accounting firm with which the certified public accountant or public accountant is affiliated."4 In turn, the definition of "accounting firm" includes "affiliate[s] of accounting firms."

If the intent of the Staff in using the term "independent public or certified public accountant," rather than the terms "accountant" or "accounting firm," in the proxy rule is to limit the requirement to reporting relationships only with the firm providing the actual accounting services, then the misleading parenthetical referencing a phantom definition in 17 C.F.R. 210.2-1 should be deleted or modified, and the rule's intent in that regard expressly clarified.

Alternatively, if the Staff intends to include within the proxy reporting requirements non-audit relationships with "accountants," "accounting firms" and "affiliate[s] of the accounting firm," as those terms are defined in 17 C.F.R. 210.2-1, it clearly should have included within its Paperwork Reduction Act analysis a discussion of the substantial additional information-gathering and reporting burden that interpretation would impose on public registrants. If a registrant is required to identify not only the extent of its non-audit relationships with its auditing firm, but also to determine and disclose whether it has relationships with entities or persons including (but not limited to) any person or entity owning five percent or more of the accounting firm's securities, any person or entity of which five percent or more of the stock is owned by the accounting firm, any officer, director, partner, copartner or five percent shareholder of any such person or entity, or any person or entity that has a joint venture or other "shared benefit" relationship with the accounting firm, the recording and reporting burdens will be very substantial, both in the amount of additional time and resources needed to fulfill the proxy disclosure requirement and in the number of registrants that would have to make proxy disclosures.

The Proposing Release disregards these burdens. The Proposing Release states that "based on information provided to SECPS, approximately 75 percent of Commission registrants receive no non-audit services from the auditors of their financial statements and, accordingly, will not be required to make any disclosures under the proposed amendments."5 But, the "75 percent" figure, taken from Appendix B, Table 3 of the Proposing Release, certainly does not suggest that the data therein were compiled in light of the proposed broad new definitions of accountant and accounting firm. While it may include services provided by auditors as that term is commonly (and currently) understood, it apparently does not include registrants that receive non-audit services from "accounting firms" as that term is defined in the proposal.

Under the current securities laws, if a registrant receives non-audit services from a software company and the registrant's auditor also has an unrelated joint venture with that software company, the registrant would not consider the software company's services to be non-audit services provided by its auditor. Under the definitions contained in the proposed rule, however, the software company would be an "affiliate of an accounting firm," and thus be captured within the definition of "accounting firm." Accordingly, assuming the services by the software company meet one of the minimal 10% or $50,000 thresholds in the proxy rule, the registrant would henceforth have to report the provision of such services in its proxy statement. In the New Economy, where such relationships are commonplace, this new requirement will be extremely burdensome and will unreasonably and unnecessarily expand the number of registrants subject to the proposed new proxy disclosure requirement, as well as the activities on which they must report.

II. The Proposing Release Does Not Satisfy the Requirements of the Regulatory Flexibility Act

Under the Regulatory Flexibility Act ("RFA"), agencies are required to conduct and make available to the public an Initial Regulatory Flexibility Analysis ("IRFA") in connection with their proposed rulemakings.6 The purpose of an IRFA is to describe the impact of the proposed rule on small entities. It must contain, among other things, a description of how small entities will be affected by the reporting and other compliance requirements of the rule and a description of any significant alternatives to the proposed rule that would accomplish its objectives while minimizing any significant economic impact.7 While the Proposing Release notes that the SEC Staff has prepared an IRFA with regard to the proposed rule and describes the Staff's various findings, it is clear that the Staff has overlooked several aspects of the proposal's impact on small entities.

In the Proposing Release, the Staff indicates that the proposed rule would affect two primary groups, auditors and registrants.8 As explained in the Release, the IRFA states that the rule could, among other things, impact auditors in terms of investments, employment relationships, non-audit services and quality controls. With respect to investments and employment relationships, the Proposing Release correctly notes that the proposed rule relaxes some of these compliance requirements with respect to individual employees of audit firms and their families. However, the Release ignores the adverse effects of the proposed rule on smaller accounting firms.

For instance, as a result of the proposed imposition of lower thresholds on material indirect investments and the application of a new definition of "affiliate of the accounting firm," the proposed rule would restrict the ability of small firms to engage in investment or other business relationships with other firms. As explained in our Comment Letter, the new affiliate definition will also preclude small accounting firms from the opportunity, among other things, to participate in business ventures that provide capital and other resources, and to promote technological and other business advancements. In addition, small accounting firms no longer would appear to be able to join in alliances and networks with other accounting firms, since such firms would need to remain independent with respect to each others' attest clients (notwithstanding the narrow exception for sharing training facilities, technical knowledge, databases or billing facilities). The proposed rule would lead to further consolidation in the accounting profession, as more small firms merge or fail under the increased economic burdens the rule would impose.

The IRFA also does not adequately consider the impact of the proposed rule on small businesses that might want to partner with accounting firms for various purposes but would, for all practical purposes, be denied the opportunity to do so as a result of the imputation implications of the expansive affiliate definition. In addition, the IRFA does not consider the significant effect the proposed rule would have on small registrants who may rely on the specialized expertise of their accountants in a business area -- expertise, which enables the accounting firm to provide both audit and non-audit services to such registrants. Under the proposed rule, these small registrants would be either have to find new accountants to conduct their audits or find other means to fulfill their needs for the specialized non-audit services. In either case, these small registrants could incur considerable costs not considered by the IRFA. Indeed, the IRFA has taken no account of, nor attempted to quantify, the nationwide costs of the dislocations and disrupted relationships due to the game of "musical chairs" for non-audit services which even the Commission Staff concedes its proposed rule would initiate.

The proposed proxy disclosure rule also could impose significant additional reporting burdens on small registrants and accounting firms, since, among other things, as described in the Paperwork Reduction Act discussion above, the new requirements potentially encompass not just those non-audit services provided by the auditor but also by the auditor's affiliates. These burdens are also not adequately assessed in the IRFA.

Finally, the proposal also virtually ignores the RFA's requirement that an agency evaluate significant alternatives to its proposed rule that would minimize any significant impact on small entities. The Proposing Release states that the Staff considered some alternatives and then states that because the proposed rule should not have a significant economic impact on small entities, it did not make special provisions for small entities. By this conclusory statement, the Release completely skips the RFA's required analytical step of examining how potential alternatives to its proposed rule could minimize the economic impact on small entities. It merely asserts that such an examination is not warranted given the conclusions (demonstrated above to be erroneous, or at least incomplete) that small entities will not be harmed by the proposed rule.

III. In the Event the Commission Promulgates the Proposed Rule as Final, It Must Be Designated a "Major Rule" Pursuant to the Congressional Review Act

Pursuant to Chapter 8 of the APA, as added by the Congressional Review Act9 ("CRA") provisions of the Small Business Regulatory Enforcement Fairness Act of 1996 ("SBREFA"), an agency must inform the Office of Management and Budget ("OMB"), and the OMB must ultimately determine, if a rule is a "major rule," as that term is defined. Designation as a major rule means that the rule may not become effective for at least 60 days to enable the Congress adequate time to consider a joint resolution of disapproval. 5 U.S.C. §§ 801-802. The proposed rule, if promulgated in its current form, clearly must be designated a major rule.10

Under the CRA,11

The term "major rule" means any rule that the Administrator of the Office of Information and Regulatory Affairs of the Office of Management and Budget finds has resulted in or is likely to result in -

(A) an annual effect on the economy of $100,000,000 or more;

(B) a major increase in costs or prices for consumers, individual industries, Federal, State, or local government agencies, or geographic regions; or

(C) significant adverse effects on competition, employment, investment, productivity, innovation, or on the ability of United States-based enterprises to compete with foreign-based enterprises in domestic and export markets. 12

The rule as proposed by the Commission meet all of these criteria. The annual effect of these proposed rule's impact on the accounting profession, registered companies and the New Economy as a whole will significantly exceed $100 million.13 In addition, as our Comment Letter points out, the rule as proposed would have a significant effect on competition, employment, productivity and innovation, and will result in major increases in costs and prices for consumers of both accounting and consulting services.


1 See Paperwork Reduction Act of 1995, P.L. 104-13, § 2, 109 Stat. 173., 13 U.S.C § 91 (Supp. IV 1998).
2 See Comment Letter Regarding Proposed Revision of the Commission's Auditor Independence Requirements from Douglas R. Cox, Gibson, Dunn & Crutcher LLP, on behalf of Arthur Andersen LLP, Deloitte & Touche LLP, KPMG LLP and the American Institute of Certified Public Accountants, to Office of Management and Budget (Aug. 22, 2000). That letter is incorporated herein by reference.
3 See Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 43,148, 43,194 (proposed July 12, 2000) (to be codified at 17 C.F.R. pts. 210 and 240).
4 See id. at 43,193 (emphasis added).
5 See id. at 43,189.
6 See 5 U.S.C. § 603 (1994 & Supp. IV 1998).
7 See id.
8 See 65 Fed. Reg. at 43,187.
9 See 5 U.S.C. § 801 et seq. (Supp. IV 1998).
10 See the Silvia Letter discussed in our Comment Letter, which reaches this same conclusion.
11 The CRA makes "major rules" subject to a distinct Congressional review procedure, which the SEC's proposed rule clearly merit.
12 See 5 U.S.C. § 804(2) (Supp. IV 1998).
13 Note that the definition of a "major rule" refers to an "effect" of $100 million annually, not "costs." Thus, for example, all the effects of requiring registrants to obtain non-audit services from new providers, and all the effects of compelling small accounting firms to withdraw from networks and alliances, must be counted toward the $100 million. Since, according to Appendix B, Tables 1 and 4 in the Proposing Release, the Big Five firms alone had over $3.0 billion in MCS fees from "SEC clients" in 1999, the $100 million threshold will clearly be surpassed many times over.