Legal Office
P.O. Box 942707
Sacramento, CA 94229-2707
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September 25, 2000

Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549

VIA ELECTRONIC FILING (rule-comments@sec.gov)

Re: File No. S7-13-00

Dear Mr. Katz:

On behalf of the California Public Employees' Retirement System ("CalPERS"), I am pleased to submit this letter in response to the Commission's request for comments on proposed Auditor Independence rules ("Proposed Rules").

As you may know, CalPERS is the largest public retirement system in the nation, with assets of approximately $176 billion. Of this, approximately $98 billion is invested in the U.S. public markets. These funds provide retirement benefits to over 1.2 million current and retired California public servants, and their beneficiaries. Although CalPERS is also a significant customer of accounting and consulting services, we offer these comments primarily based upon our role as a significant long-term participant in the capital markets.

Because of this interest, CalPERS applauds the effort of the Commission, Chairman Levitt, and the SEC staff to raise public awareness of the issue of auditor independence. We are aware of the high level of visibility - and the high volume of comments - which the Proposed Rules have produced. CalPERS appreciates the opportunity to provide one more perspective.

1. This Rulemaking Effort is Necessary.

It seems universally accepted that an independent audit committee is an essential feature of a fully accountable corporate governance structure.1 The Commission's most recent work regarding audit committee independence and disclosure has cemented this principle.2 It is equally well accepted that an independent audit is necessary for the committee to perform its function.3 More pointedly, independent audits are critical to the efficiency and integrity of the capital markets. As the Commission noted in Release 33-7870,

Capital formation depends on the willingness of investors to invest in the securities of public companies. Investors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance that the financial information disclosed by issuers is reliable. Independent auditors play a key role in providing that assurance. . . Based on the independent auditor's opinion, investors have reason to believe that financial statements are materially accurate, fair, and complete. The federal securities laws, to a significant extent, make independent auditors "gatekeepers" to the public securities markets. . .

(Footnotes omitted.)

But, as the business model for the accounting industry has become more and more complex, concepts of "independence" have blurred. Recognizing this increasing complexity, it is CalPERS' view that well-defined standards, principles and rules must be adopted. While CalPERS supports the work of the Independence Standard Board ("ISB"), only this Commission has the legal authority and effective ability to weigh the competing public interests that are represented in this area and reach conclusions about the best way to protect shareowners and the integrity of the financial markets.

We note that some suggest that Rulemaking is unnecessary because of a lack of empirical data precisely linking each of the independence issues identified in the Proposed Rules with some financial harm to the company and its investors. A decade ago, this was also said about much of what has now been well established as good corporate governance practices.4 The concept that an auditor with a greater financial incentive to please corporate management than to criticize it will tend to find ways to avoid negative comment is intuitive and obvious.

As noted above, the principal purpose of auditor independence is to provide assurance to investors. Recognizing this, the accounting profession has long required independence not only in fact but also in appearance. SAS No. 1 states,

Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence.5

Accordingly, "[i]ndependent auditors should not only be independent in fact; they should avoid situations that may lead outsiders to doubt their independence."6

CalPERS can also offer anecdotal evidence in this regard. As part of CalPERS' own investment operations, the System annually identifies those few select companies that are the poorest performers within a portfolio of over 1,500 U.S. companies (using screens that look for the convergence of poor performance with regard to stock performance, Economic Value Added (EVA)©, and governance practices). At least during the past two years, many of these companies have had problems with the quality of their financial statements, or seemingly meek auditors. This is not "proof" that the poor performance is the result of non-independent auditors, but it certainly contributes to the investment community's concern about this issue. It is not only the reality of biased auditing, but also the perception that a biased practice is possible, that erodes investor confidence.

2. The SEC Should Look To, But Not Be Limited By, The ISB Independence Standards.

Where the ISB standards provide even greater independence, such as in the areas Employment with Audit Clients, and Financial and Family Relationships, the SEC should incorporate those into its own Rules. We are guided in this respect by the testimony that William T. Allen, Chair of the ISB, offered on July 26, 2000 (comments C and D).7

3. The SEC should consider simplifying its Proposal and drawing a bright-line Test: no non-audit services to an audit client.

In this comment, CalPERS joins with the Statement of John H. Biggs, Chairman and Chief Executive Officer of TIAA-CREF8: If a firm is providing audit services to a client, it should not simultaneously provide non-audit services. There is simply no shortage of firms - accounting and otherwise - available to provide public companies with non-audit services. We have heard many (primarily from within the accounting industry) contend that crossover services (a) cost the company less; (b) are more convenient to the company; and (c) enhance the quality of the accounting firm's professionals. Responding to each point from an investor's perspective:

(a) Decreased fees result from two possibilities: (1) the audit firm "low-balls" either its auditing fees or its consulting fees, for the purpose of cross-marketing other firm products, or (2) the audit firm has a familiarity with the company that a separate consulting firm would not have to duplicate. With regard to the first possibility: it is exactly this practice that raises questions of auditor objectivity, and it is exactly this practice that should be prohibited. With regard to the second possibility: CalPERS believes that any additional "familiarity" cost would be small and worth the added value of increased investor confidence.

(b) Convenience to the company is a question of timing. Although CalPERS recognizes that in some unique circumstances the company may require new consulting services on a very expedited bases, we also believe that these services can be obtained quickly when company management knows that it must. Again, there is a huge pool of available consultants, including all of the accounting firms that are not also retained as the company's auditor, that are capable of meeting this need. The competitive nature of this market ensures that necessary services are available even when required on an expedited basis.

(c) While it serves the investors' interests to have highly skilled and motivated audit professionals, CalPERS does not believe that independence should be the price paid. Moreover, under a bright-line test such as what we recommend, audit firm professionals will continue to be able to provide the full range of non-audit services - just not for their audit clients.

CalPERS prefers a simple standard to the specific application approach included in Proposed Rule 2-01(c). The very nature of "prescriptive lists" is to invite the creative to find ways of escape. Those in the legal profession are trained to find ways for their clients not to be covered by legal prescriptions. CalPERS is concerned that Proposed Rule 2-01(c) will benefit the legal community through increased work, but at the cost of investor confidence. A clear, simple and bright-line standard will avoid provide necessary .

Again, thank you for considering CalPERS views. Please contact me if you have further questions.


General Counsel

cc: Members, CalPERS Board of Administration

James E. Burton, CalPERS Chief Executive Officer


1 See, Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999) ("Blue Ribbon Report"); Report of the National Commission on Fraudulent Financial Reporting (Oct. 1987) (the "Treadway Report"); and Advisory Panel on Auditor Independence ("Kirk Panel"), Strengthening the Professionalism of the Independent Auditor, Report by the Oversight Board of the SEC Practice Section, American Institute of Certified Public Accountants ("AICPA") (Sept. 13, 1994) (the "Kirk Panel Report").

"Audit committees play a critical role in the financial reporting system by overseeing and monitoring management's and the independent auditors' participation in the financial reporting process." (SEC Release No. 34-41987.)

2 See January 31, 2000 amendments to Rule 10-01 of Regulation S-X; Item 310 of Regulation S-B; Item 7 of Schedule 14A3 under the Securities Exchange Act of 1934 ; and Item 302 of Regulation S-K. See also, new Item 306 of Regulation S-K6 and Item 306 of Regulation S-B-7. (SEC Release No. 34-42266.)

3 See Blue Ribbon Report, supra note 1, at 7. As noted, the Blue Ribbon Committee indicated that the audit committee, management, and the independent auditors form a "three-legged stool" that supports responsible financial disclosure and active and participatory oversight.

4 See, e.g., William B. Chandler III, On the Instructiveness of Insiders, Independents, and Institutional Investors, 67 U. Cin. L. Rev. 1083 (1999); Ira M. Millstein and Paul W. MacAvoy, The Active Board of Directors and Performance of the Large Publicly Traded Corporation, 98 Colum. L. Rev. 1283, (1998); National Association of Corporate Directors, Blue Ribbon Commission Report on Director Professionalism (1996); and Robert F. Felton, Jennifer van Heeckeren, and Alec Hudnut, Putting a Value on Board Governance, 4 The McKinsey Quarterly (1996).

5 AICPA SAS No. 1, AU § 220.03.

6 Id.

7 Filed at http://www.sec.gov/rules/proposed/s71300/testmony/allen2.htm.

8 Filed at http://www.sec.gov/rules/proposed/s71300/testmony/biggs1.htm.