September 25, 2000
VIA E-MAIL AND FIRST CLASS MAIL
Jonathan G. Katz, Esq., Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Auditor Independence Proposal
File No. S7-13-00
Dear Mr. Katz:
American Express Tax and Business Services ("TBS") is a provider of non-audit accounting, tax, and business advisory services and, through an alternative practice structure, is associated with a number of auditing firms serving the middle market. As a result, we are an interested party in this rulemaking and have strong views about the Commission's auditor independence proposal. We do not wish to add to the strident rhetoric coming from both the accounting industry and the Commission. We are concerned, however, that certain aspects of the proposed rule appear to be aimed precisely at our business model. The Commission's proposal acknowledges barely, and dismisses without analysis, the needs and realities of middle market accounting firms and their clients. Specifically, the rule will result in an impairment of independence of our associated auditing firms whenever their audit clients have any immaterial and inconsequential business interaction with American Express.
Some Preliminary Thoughts
We agree that, even if the objective evidence about audit quality were to the contrary, if the investing public believed that auditors' independence was compromised, some action would be appropriate to bolster confidence. The Commission's proposal presumes that the public is indeed skeptical about auditors, that the public is right, and that the only way to deal with such skepticism is a re-engineering of the accounting profession. We disagree with the Commission's assessment of the problem and with the Commission's proposed solutions.
The Commission's assessment and proposed solutions are unsupported by the authoritative studies on this subject. Indeed, despite the conclusions of any number of
independent inquiries that auditor independence and audit failure are unconnected, the Commission asserts the existence of such a connection and, even more insupportably, to support its position on auditor independence asserts that there is "growing public concern" regarding the objectivity of auditors. See Memorandum from Lynn Turner, Chief Accountant of the SEC, to Arthur Levitt, Chairman of the SEC at 1 (May 24, 2000). Even the Commission itself, when evaluating the massive and systemic violations of the existing auditor independence rules by PricewaterhouseCoopers (PwC), concluded that the integrity of the financial statements of the companies audited was not suspect and did not require re-auditing of any company's financial statements. Nor did it discipline any of the individuals involved. Yet, despite the lack of empirical evidence supporting the need for new, draconian restrictions on auditors, the Commission concludes that a new regulatory structure is necessary.
The harsh constraints on auditors' services and relationships embodied in the proposed rule and the accompanying rhetoric overshadow the fact that auditor independence is not an end in itself, but one facet of a regulatory system designed to insure that investors receive timely, accurate and reliable financial information. The proposal loses sight of, and we believe ultimately sacrifices, audit quality as the Commission's principal objective. Recent Commission enforcement actions highlight the disconnect between pronouncement of a crackdown on the audit profession and its enforcement actions. A cursory review of the Commission's recent releases in financial fraud cases reveals numerous stark examples of charges of financial fraud without any reference to audit quality. Rather than focusing on audit quality and the reasons behind audit failures, the Commission's proposal emphasizes the concept of independence in appearance and reflects an extraordinary effort to develop complex rules. Its focus simply misses the mark.
TBS's Alternative Practice Structure Responds to Market Demands
TBS's concern about the proposed rule centers around its threat to TBS's alternative practice structure. Our alternative practice structure responds to the needs of the middle market segment of the profession that seeks to maintain and build firms that can provide high-quality services in a changing environment. The proposed rule will lessen the ability of these firms to meet that challenge by preventing the growth of new accounting firm structures that offer the audit firms needed capital and career development opportunities for young professionals. We believe that this is bad policy not only because it directly affects TBS and others who wish to enter the field, but also because it will ultimately degrade the quality of financial information available to investors.
The accounting and auditing profession is changing and adapting to an evolving economy, a technology-driven marketplace, and a work force with new ideas and seemingly unlimited personal options, much as the Commission experiences in its own world of EDGAR and employee relations. Accounting firms, and especially middle market firms, are unquestionably under intense pressure to generate and attract capital. Many, we are told, encounter difficulty obtaining bank lines to meet operating expenses, let alone to meet expansion and modernization needs. The demise of many middle market firms, including several firms of national size and repute, and the consolidation of many others, including the "Big Eight" to the "Big Six" to the "Big Five," have been widely chronicled in business journals in recent years. Today, only two of the middle market firms of the 1960's still exist.
This trend supports the observation that many firms seek consolidation as a means of reducing costs and expanding access to capital. For the accounting profession to remain vibrant and meet its obligations to clients and to the public and for the accounting services market to thrive, accounting firms today must have access to capital for personnel, training, technology and operations. The new firm structures such as ours that have evolved in recent years are designed to assure that the profession has the capital necessary to survive in a competitive marketplace. Constraining audit firms to traditional structures and virtually prohibiting other business alliances and investments reduce their access to resources and weaken them. Financially weak firms cannot be relied upon to provide high quality, and independent, services.
Qualified, well-capitalized entrants to the profession should be encouraged, not discouraged. As recent experience suggests, middle market firms have it especially tough in competing for public audit clients and in providing the high level of professional competence that is demanded for public companies. Evolving alternative practice structures offer such firms and their partners an opportunity to level the playing field by providing access to expanded opportunities and services, not to mention access to capital to meet firm needs.
It is ironic that the Commission raises questions regarding improper appearance and auditor objectivity in virtually every relationship between auditors and audit clients except the fee-for-service model. To the extent that auditor independence is an issue, nothing in the proposed rule deals with the direct payment of fees to auditors by audit clients or the fact that audit firms compensate partners, at least in part, based on maintaining client relationships. To say, as does the Commission, that Congress authorized this "inherent conflict" is hardly responsive given the significance of the issue, and fails entirely to address partner compensation arrangements. In any event, every auditor deals every day with pressures from their audit clients far greater than any pressure based on any immaterial relationship an audit client may have with American Express.
Our Alternative Practice Structure Protects Independence in Fact and in Appearance
TBS's alternative practice structure effectively separates its non-audit tax and business advisory practice from the auditing function reserved to associated accounting firms ("Separate Practices") that are neither owned nor operated by TBS. TBS is not a licensed, public accounting firm. When it acquires an accounting firm, it acquires only the non-attest assets of the firm.
The Separate Practices continue to be owned and operated by their original CPA owners, who remain solely and totally responsible for the benefits and losses of the firm. In addition, each Separate Practice may admit or terminate members, and bills and collects for its own services, maintains separate books from TBS, and maintains its own professional liability insurance. The sale of an accounting firm's non-attest assets to TBS does not affect the remaining Separate Practice's internal organization, governance, or decision-making processes.
Each Separate Practice enters into an agreement with TBS that permits the Separate Practice, in its sole discretion, to lease staff and to receive administrative services from TBS. This is a non-exclusive arrangement; the Separate Practice retains the right to hire its own personnel or lease employees from any outside firm. If the Separate Practice does lease employees from TBS, the Separate Practice pays TBS at its standard hourly rates or at such other rate as negotiated between the parties, and reimburses TBS for out of pocket expenses incurred in connection with providing these services.
In sum, the essence of the relationship between TBS and the Separate Practice is "arm's length." All goods and services are provided at fair value and there is no implicit or explicit subsidy by TBS to the Separate Practice. The Separate Practice and its CPA owners bear all the risk and rewards of running a business enterprise. TBS does not control the Separate Practice or its professional audit judgments.
Of course, the Separate Practices, like all public accounting firms, must observe applicable independence requirements in their audit engagements. In addition, TBS has created a series of "protocols" or "prohibited relationships" that further define independence requirements in the context of the relationships that Separate Practice audit clients can have with American Express. These "protocols" or "prohibited relationships" were acknowledged by the New York State Department of Education in its agreement to allow a Separate Practice to operate in New York.
TBS believes that its alternative practice structure provides an organizational framework that enhances competition in the audit profession by providing capital for middle market firms to improve systems, training, compensation, and recruiting of auditors. The results are a strengthened profession and higher audit quality without compromising investor confidence or auditor independence in associated Separate Practices.
The Commission's Proposal Puts Middle Market Audit Firms in Jeopardy
Although several of the Big Five are, perhaps, the most vociferous opponents of the Commission's proposal, we believe that the proposal will have an even more drastic effect on middle market auditing firms. We are, frankly, astounded that the Commission would even propose so significant a restructuring of its rules without undertaking an economic analysis of the rule's impact on the affected parties.
We believe that the proposal will result in a major restructuring of the accounting profession by causing the divorce of consulting and auditing. The limitation on the services an audit firm may provide will, in turn, constrict the ability of audit firms to raise capital and attract capable financial professionals. In a time of unprecedented merger and consolidation activity in virtually all industries, including the financial services industry, large accounting firms may feel even more pressure to merge in order to maintain the resources and expertise needed to serve audit clients whose businesses have grown exponentially in both size and complexity. Small and mid-sized accounting firms will ultimately be forced to choose between providing auditing and other services to their clients, with some firms inevitably choosing the latter. This will further reduce the number of auditors from which companies may choose and increase the oligopoly of the largest audit firms. Application of the rule will, in effect, "squeeze out" the middle market accounting firm, leaving only the largest firms and "mom-and-pop" shops in its wake. This heightened power of the largest firms can only squelch competition in the industry. Decreased competition will increase the cost and degrade the quality of audit services.
Furthermore, unreasonable prohibitions on the services firms may provide will engender a dependent relationship between auditors and their clients. Such dependence threatens the exercise of independent judgment. Ultimately, financial dependence on audit clients for fees and job protection is a threat far greater to auditor independence than the possibility that immaterial corporate relationships audit clients may have with American Express will color audit judgments through fear of retaliatory action by corporate officials against individual auditors.
The Commission's Proposal Puts Audit Quality and Professionalism in Jeopardy
Contrary to the Commission's intentions and interests, the proposal we fear will undermine the profession and threaten audit quality. Recent SEC enforcement actions and SEC staff commentary suggest a decline in audit quality attributable, at least in part, to the use of young, inexperienced and inadequately trained and supervised staff accountants. Quality audits require not only objectivity, but also highly qualified and experienced professional auditors to do the work. This means that audit service providers must compete with consulting firms and other employers for talented accountants. Moreover, the specialized and rigorous nature of audit work requires a significant investment in training, technology and infrastructure. Without the ability to attract outside investment and provide the opportunities that flow from it, audit firms will inevitably attract less qualified accountants, suffer staff turnover that further endangers quality, struggle to provide adequate training, demand performance without providing the technology to accomplish it, and lack the wherewithal to provide a work environment conducive to producing quality results. Moreover, by substituting the need for ethical judgments by trained professionals with rigid, complex rules of conduct and byzantine definitions, the Commission's proposal diminishes the profession.
Many in the profession attest to, and newspapers chronicle, the enormous difficulty firms have in attracting and retaining talented young accountants. Indeed, the Commission has the same dilemma. Promising accountants, before or after joining a firm, are seduced by the glamour of alternative careers, higher compensation, and the opportunity to participate in the growth of an enterprise. Our experience and that of our associated accounting firms is that recruiting and retention of qualified personnel has improved markedly since acquisition by TBS. These firms are no longer regarded as "dead ends" by applicants and are able to offer young accountants security and attractive career opportunities. Indeed, today, middle-market firms are able to offer their clients the wide array of services they need and are able to offer young professionals the opportunity to do it all, or at least, try it all. The limitations on firm structure inherent in the Commission's recommendations simply restrict this ability and in turn, make public accounting a less attractive career than other available opportunities. This is especially true at a time when jobs are plentiful and recruiting and retaining talented professionals is so difficult. Even more important, a reduction in the number of talented young accountants entering the profession will ultimately adversely affect the quality of audits provided by the profession.
Modifications to the Proposed Rule Are Necessary
The challenge is to preserve independence while also permitting accounting firms to attract capital and personnel. The dramatic decline in the number of middle market firms in recent years suggests that they have it especially tough in competing for public audit clients and in providing the high level of professional competence that is demanded for public companies. Evolving practice structures offer such firms and their partners an opportunity to level the playing field by providing access to expanded opportunities and services, not to mention capital to meet firm needs.
The proposed rule cripples accounting firms -- and in particular middle-market firms -- by restricting a firm's ability to raise capital and attract personnel in two ways. First, it closes the door on expanded relationships between auditors and alternative sources of capital and business associations by treating affiliates of accounting firms as if they were the alter ego of the accounting firm. Thus, a non-accounting firm that enters into a relationship with an accounting firm risks jeopardizing the accounting firm's independence through its own insignificant business dealings with an audit client. Second, it limits the scope of services firms can provide to their clients.
The definition of "affiliate of an accounting firm" in the proposed rule effectively prohibits an accounting firm from entering into any business arrangement with any non-accounting entity or person because of the risk that ordinary course of business dealings of the non-accounting entity, remote from the audit process, will impair independence. Additionally, for TBS, it means that American Express and each of its numerous global subsidiaries and business partners will be subject to the same constraints as the Separate Practice that conducts the audit, no matter how remote, attenuated, or de minimus the business interaction. It also means that American Express officers, directors and five percent shareholders will have restrictions on their conduct.
It seems incredible that anyone seriously believes that the officers and managers of American Express entities far removed from TBS, who have no direct or indirect role in compensation or other decisions relating to partners of the Separate Practices or TBS employees leased to the Separate Practice, would have the motive or opportunity to influence the outcome of the audit of a client of a Separate Practice or that the investing public would perceive that there is a lack of independence. Does anyone really believe that a reasonable investor will perceive an independence problem if an audit client of a Separate Practice uses an American Express charge or credit card in the ordinary and regular course of its business? Does anyone believe that independence is tainted if audit clients of the Separate Practices use American Express travelers cheques, buy American Express mutual funds, or contract for American Express travel services if those services are immaterial, rendered on an arm's length basis, and are subject to usual and customary payment terms? We think not. Subjecting to auditor independence rules those American Express persons and entities that are totally removed from the audit process but that transact insignificant business with a Separate Practice audit client will only chill the ability of accounting firms to enter into alternative practice structures that enhance their ability to raise capital, attract qualified auditors and develop expertise necessary to conduct meaningful audits of complex, multifaceted corporations.
The Commission's proposed rule attempts to build a wall around the audit profession to insure that the auditors are not tainted. This wall, however, will prevent the flow of capital, information and personnel to the audit industry. It will prevent TBS and other providers of capital from entering the gates. It will preserve a dwindling pool of resources for an oligopoly of five or six firms and isolate a profession that needs vibrancy to meet the challenges of the modern business world. Ultimately, it will result in the eradication of the middle market firm.
Our Proposal Balances the Commission's Concerns and the Market's Needs
We believe it is possible to preserve independence in fact and in appearance with a rule that recognizes the critical distinctions between those who perform audit services or who are in a position to directly influence the auditor and those who are not in a position to do so. By creating a rule encompassing remote and tenuous relationships, irrespective of materiality, the Commission has trivialized the concept of independence and created a virtual minefield for auditors, audit clients and persons with whom they do business. At the core, independence is a state of mind, not a "Catch-22" for the unwary.
We understand why the Commission would be concerned about threats to independence by entities affiliated with audit firms. However, there must be a distinction between the relationships that are prohibited for an accounting firm and those that are prohibited for an affiliate of an accounting firm. The more remote the relationship between the auditor and the affiliate and the more immaterial the nature of the business interaction, the less any such relationship between the affiliate and an audit client impairs independence either in fact or appearance. This is equally true of restrictions on officers and managers of affiliates who do not have the ability to influence audit decisions.
We are mindful, however, that certain relationships between an accounting firm and a related entity may implicate independence concerns and require some restrictions as a prophylactic measure to give comfort to the investing public. Therefore, affiliates of the accounting firm should be subject to certain restrictions designed to bolster the confidence of the investing public and to insure that there are no economic or business interests that would, to a reasonable investor, appear to impair independence.
We therefore suggest the following changes to the proposed rule for audits of SEC registrants:
1. Remove the phrase "affiliate of the accounting firm" from the definition of accounting firm in Section 210.2-01(f)(2); and
2. Insert a new Section 210.2-01(d), and re-letter the remaining subsections, that states "An accountant is not independent under the standard of paragraph (b) of this section if, during the audit and professional engagement period, an affiliate of the accounting firm had any material relationship with an audit client of an affiliated accounting firm that the accounting firm would not be permitted to have or:
(1) performed any service that derogates from acceptance of full responsibility by the audit client for its financial statements;
(2) assumed management authority over an audit client, including but not limited to, consummating transactions, having physical or legal custody of assets, or exercising authority over its assets;
(3) made investment or business risk decisions for an audit client or accepted discretionary authority over an audit client's investments;
(4) made commercial loans to an audit client, but excluding credit and charge card relationships that are not material to either the lender or the borrower and are maintained in the ordinary course of business and in accordance with their terms, and also excluding fully secured, collateralized or insured financing for property or equipment maintained in the ordinary course of business and in accordance with their terms;
(5) performed any services requiring registration as a broker or dealer, except for the purchase and sale of securities in an account fully insured by SIPC and not involving investment discretion or the extension of credit; or
(6) prepared research reports on the investment merit of an audit client.
This proposal is generally consistent with the current AICPA rule and the Commission's own guidance. It allows materiality to be considered when determining whether the affiliate of the accounting firm and indirect supervisors of auditors can have certain relationships with audit clients and mirrors the Commission's use of materiality as a basis for determining accountant independence in the context of indirect financial relationships with audit clients. See Section 210.2-01(c)(1). The proposal simply recognizes, as the Commission itself recognized in Section 210.2-01(c)(1), that material relationships are more likely to impair independence than relationships that are not material.
Using materiality as the touchstone in evaluating relationships that may compromise or appear to compromise auditor independence shifts the focus of independence analysis away from inconsequential and remote financial and business relationships and concentrates on economic substance. Independence is truly threatened only in those situations where a party has the motive and opportunity to exert pressure on the auditor to compromise objective analysis of an audit client's financial condition.
The employment of Separate Practice partners by TBS does not change the analysis. Evaluating the impact of dual employment on independence with respect to a particular client requires analysis of the substance of the economic relationship between the affiliate of the accounting firm (TBS and American Express) and the audit client, as well the relationship between the affiliate of the accounting firm and the auditor. Where there is a material business or financial interest between the affiliate of the accounting firm and the audit client, independence would be impaired. In the absence of such interest, there is no reason for the affiliate of the accounting firm even to attempt to influence independent auditors who are also corporate employees, and it is preposterous to suggest an affiliate of the accounting firm would do so.
Restrictions would, of course, apply to direct supervisors of auditors. Pursuant to the rule as proposed, restrictions would apply to "covered persons in the firm," including persons in the "chain of command." Anyone with supervisory, management, quality control, compensation, or other oversight responsibility over either any member of the audit engagement team or over the conduct of the audit would be covered. Thus, restrictions would extend to supervisors of the dual employees and other persons who have the motive and opportunity to influence significantly the outcome of the audit. Managers of the affiliate of the accounting firm who are not performing functions directly or indirectly related to auditors have little or no ability to influence decisions by or related to those employees and should not be subject to restrictions.
Reasonable investors will not consider audit independence to be impaired in the absence of a material interest by the auditor or by an entity theoretically capable of exercising significant influence over the auditor or audit firm. This reasoning is confirmed by the comments of users of financial statements that responded to the Independence Standards Board's discussion memorandum on alternative practice structures. See Earnscliffe Research & Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditory Independence and Objectivity - Phase II (2000) at 37-39.
Moreover, the question of how users of financial statements will evaluate these relationships will not be left to the opinions and beliefs of the Commission or other commentators. Audit committees and users of financial statements will have the opportunity to assess whether these relationships affect auditor objectivity.
The requirements of the proposed rule for greater disclosure of the details about the affiliate's relationship with an audit client, though flawed in detail and in need of simplification, will also have a salutary affect on investor confidence. Disclosure of affiliate-audit client relationships will enable users of financial statements to evaluate for themselves the threats to auditor objectivity in any given non-prohibited relationship. The fundamental premise of securities law is that information is the best prophylactic against fraud and abuse. We see no reason to reach a different conclusion in the area of auditor independence.
The objective of the independence rules is to insure that users of financial statements have confidence in the integrity of the audit process. Although we question the need for any modification in the existing rules without substantial research into and analysis of the basic concepts of auditor independence, we recognize that the Commission believes otherwise. However, even assuming the need for revision at this time, the Commission's proposal goes too far and particularly so in the absence of both substantive research and economic analysis. We believe that our proposal appropriately balances the need for objectivity by auditors and the continued ability of the audit profession to attract capital and personnel to perform quality audits.
Andrew D. Cvitanov
President and Chief Executive Officer