October 12, 2000
VIA MAIL AND E-MAIL
Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-13-00
Dear Mr. Katz:
I am a Professor of Law and Co-Director of the Center for the Study of International Business Law at Brooklyn Law School and of Counsel to Kelley Drye & Warren LLP. I was a Commissioner of the SEC from 1977-80. I am serving on the audit committees of an SEC registered public company, a mutual financial services company, and a non-profit company. This letter represents my own views and not the views of any organization with which I am affiliated or any client.
Independence requirements for auditors should not be the stuff of politics. In my view the June 2000 release by the Securities and Exchange Commission (SEC) proposing revisions to the Commission's auditor independence requirements (Independence Release) is an unfortunate heavy-handed reaction to a self-regulatory failure. It has led to a political outcry that is likely to undermine the kind of consideration of this issue that should occur. For more than 25 years, the SEC has been lecturing to the accounting profession to develop mechanisms to ensure that non-audit services do not compromise auditor independence or the appearance of independence. During that time non-audit services have increased significantly at a time when the big accounting firms, which audit most large public companies, have shrunk in number to five. Further, accounting has become more of a business and less of a profession and is competing in the international marketplace for revenues, capital and personnel. The accounting profession has consistently argued that management accounting services (MAS) are beneficial to clients and should not be banned in the absence of demonstrated abuse or impairment of independence. Yet, there is agreement that some services are questionable. It is time for the accounting profession, rather than the SEC to pass appropriate prohibitions with respect to MAS and the SEC should then review and make appropriate, reasoned comment on this effort. However, I believe the SEC's rule proposals requiring disclosure of MAS by public companies are reasonable and should be adopted, with some modifications.
The SEC's Independence Release proposes rulemaking addressed to five areas. First, the SEC attempts to set forth four broad standards by which independence should be measured. These standards would be asserted in a rule that an accountant will not be recognized by the SEC as independent " whenever, during the audit and professional engagement period, the accountant: (1) Has a mutual or conflicting interest with the audit client; (2) Audits the accountant's own work; (3) Functions as management or an employee of the audit client; or (4) Acts as an advocate for the audit client." Although the articulation of these standards may be a reasonable effort to set forth general independence requirements, they are controversial insofar as the SEC proposes to interpret them so as to regulate, and in some respects to eliminate, the provision of non-audit services by auditors. Further, I agree with other commenters who have suggested that such standards should be developed by the Independence Standards Board (ISB), rather than the SEC.
The second aspect of the Independence Release is a proposed rewriting of current SEC requirements attributing to an auditor ownership of shares held and employment by widely dispersed audit firm personnel and their families. I have no comments regarding these rules. Another area of proposed rulemaking on which I have no comments is the provision of a limited exception from the independence rules when an accounting firm has effective quality controls, provided the lapses involved are cured promptly.
The next area to which the Independence Release is addressed is non-audit services. Finally, the Independence Release proposes certain disclosure rules with regard to the provision of non-audit services. I note that the SEC passed disclosure rules with regard to non-audit services when I was a Commissioner of the SEC, and thereafter the rules were rescinded.
The federal securities laws require, or permit the SEC to require, that financial information filed with the SEC be certified or audited by "independent" public accountants. Since "independence" in this context is a statutory term, the SEC has the general power to define it. However, just as the SEC generally has delegated the definition of generally accepted accounting principles to the accounting profession, it likewise has permitted the profession to develop generally accepted auditing standards, including regulations with regard to "independence." Nevertheless, the SEC has also adopted its own requirements with regard to independence.
In the 1970s, following the sensitive payments scandals and some high profile corporate failures, Congress considered limiting the services independent public accountants could provide. Congress was persuaded not to take action, in part, because the SEC adopted a rule that required disclosure about non-audit services in order to permit security holders to better evaluate registrants' relationships with independent accountants.1 This regulation required companies to disclose in proxy materials all non-audit engagements and the fees from such engagements as a percentage of the audit fee. It further required disclosure of whether the company's audit committee or board of directors approved such engagements prior to their commencement. The SEC did not propose rules to prescribe particular services because the Public Oversight Board (POB) of the AICPA's new self-regulatory organization, the SEC Practice Section of the Division for CPA firms (SECPS), was considering the issue of management advisory services performed by independent accountants. In March 1979, the POB published a report in which it endorsed public disclosure about non-audit services rather than the proscription of particular services, and recommended that independence be maintained through the peer review process. But the POB admonished members of the SECPS to exercise self-restraint and judgment before venturing into new non-audit services.2 The SEC did not feel that the POB Report adequately sensitized the profession to the potential deleterious effects non-audit services could have on accountants' independence and therefore issued ASR 264 which discussed factors that the SEC identified as relevant to an evaluation by accountants, audit committees, boards of directors and managements of whether performance by independent accounts of specific services could impair their independence, either in fact or appearance.
The accounting profession was unhappy with the SEC's disclosure rule and even more unhappy with the interpretations in ASR 264 and claimed these regulations caused confusion and effected an unwarranted curtailment of non-audit services. Accordingly, in 1981 the SEC withdrew ASR 2643 and rescinded the proxy disclosure requirement, asserting that summarized information regarding the relationship between management accounting services and audit fees was provided to the SECPS by member firms and was publicly available, and the efforts of audit committees and the accounting profession to monitor firms' provision of non-audit services generally had been effective. This reversal in SEC policy is unusual and difficult to explain, except politically. The SEC should be cautious in its current rulemaking proceeding so that this experience is not repeated.
Approximately three years ago, the SEC again turned to self-regulation to address auditor independence, in part because of the consolidation of the profession. It recognized the establishment of the ISB and indicated that, consistent with its continuing policy of looking to the private sector for leadership in establishing and improving accounting principles and auditing standards, the SEC intended to look to the ISB for leadership in establishing and improving auditor independence regulations applicable to auditors of financial statements filed with the SEC. The SEC analogized its recognition of the ISB to its recognition of and relationship with the Financial Accounting Standards Board.
Proposed Rule 210.2-01(c)(4) would render an accountant not independent when an account provides certain non-audit services to an audit client or an affiliate of an audit client. These services include the following: bookkeeping or other services relating to preparing accounting records or financial statements or financial information for public release; financial information systems design used to generate information significant to the audit as a whole, except for internal accounting and risk management controls; appraisal or valuation services, fairness opinions, or contribution in kind reports where it is reasonably likely that the results will be audited by the accountant; advisory services involving the primary determination of actuarial reserves; internal audit outsourcing (with some exceptions for nonrecurring evaluations); acting as a director, officer or employee of an audit client or affiliate or performing any decision-making, supervisory or ongoing monitoring functions; human resources MAS; broker-dealer, investment adviser, or investment banking services; legal services; and expert services.
The proposed rule would not affect tax-related services, on the rather curious ground that the Internal Revenue Service has the discretion to audit any tax return. The SEC also has the discretion to investigate any SEC filing. This is not a principled distinction, but a distinction based on the reality that public companies turn to their accountants for tax advice. But the SEC has not made clear precisely why some other MAS are likewise permitted and others are to be prohibited.
Like the proxy disclosure rule in effect from 1979-82, the proposed disclosure rule would require public companies to: (1) describe each professional service provided by its auditor, and (2) indicate whether the audit committee approved the service and considered the effect of the service on independence. Going beyond the earlier, rescinded requirement, the new proposed rule would require companies to disclose the fee paid for each non-audit service and the aggregate audit fee for the most recent fiscal year.
The SEC's reach with regard to MAS prohibitions would appear to exceed its grasp because accountants are a state regulated and self-regulated profession. Although the SEC has the authority to define the term "independence," and this is a broad authority, it is limited to those accountants who file audited financial statements with the SEC. The SEC's effort to control, and micromanage the structural growth and business directions of accounting firms at a time when the profession is experiencing great change globally seems contrary to the spirit of the federal-state split authority to regulate accountants and likely to undermine the fledging self-regulatory efforts of the ISB. Further, the SEC's real quarrel is with the Big 5. It should not be issuing detailed rules on MAS that will inevitably affect small and medium sized accounting firms. To the extent MAS and auditing are incompatible and not in the best interests of audit clients and investors, the Big 5 seem to be engaged in self-correcting steps. Arthur Anderson and its former consulting arm are completely separated. Ernst & Young and KPMG are in the process of spinning off their consulting businesses. There is no valid reason for the SEC not to wait for the outcome of this ongoing restructuring before issuing rules on MAS.
This is especially true of the SEC's proposal regarding the provision of legal services. Outside the United States accountants are engaged in multi-disciplinary practices, including the combination of law and accounting in the same firm and this combination is lawful. The U.S. bar has been engaged in thoughtful, lengthy and also heated consideration of the question of whether practicing lawyers can be employees or principals of accounting firms. The American Bar Association voted this summer for the status quo, but that will not end this debate. Personally, I believe the ban on multi-disciplinary practice is anti-competitive and raises antitrust questions that deserve some attention. But I also believe that if auditors and lawyers are in a combined firm, the lawyers should be deprived of their time hallowed privilege of confidentiality. Will clients wish to hire such auditor-lawyers? That is a good question, but it is hardly one for the SEC to decide, especially since it is a global issue. Acting as a lawyer and an accountant does not necessarily impair independence. Although lawyers act as advocates, they also have a professional obligation to exercise independent judgment Furthermore, many accountant-lawyers practice in the tax area, where the SEC is not proposing a ban on MAS. The judgments that must be brought to bear on many questions that arise in the course of an audit involving questions of law. An argument can be made that multidisciplinary practices in which transactional lawyers share information with audit partners and the audit committee could lead to improved financial disclosure.4
When it comes to the SEC's proposed rule on disclosure of MAS fees and practices I part company with critics of the SEC's proposals. While I believe marketplace and self-regulatory solutions to the MAS problem should take precedence over government imposed regulations, the marketplace cannot function to resolve these issues if public companies and investors are not fully informed. Mandating disclosure is the SEC's primary responsibility. The furor over the SEC's disclosure rules raises the suspicion that auditors have much to hide. If they really believe MAS benefits their clients, why should they be ashamed to make the facts public? Shareholders vote annually on the appointment of a company's independent auditors. The amount and nature of any MAS provided by an issuers' auditors is a significant fact for shareholders voting on such an appointment. The controversy over the SEC's MAS proposals highlights this significance. Since the ISB has no authority over public issuers or their audit committees, it is more appropriate for a disclosure rule to come from the SEC.
However, I believe the rules as proposed is too broad. Although a general description of each non-audit service provided is appropriate, it may not be necessary to disclose the exact fee for each service. What is important is the ratio of MAS fees to audit fees. Further, I disagree with disclosure that would force the audit committee to give prior approval to each engagement. This would prevent issuers from obtaining timely advice in certain circumstances. The audit committee should consider the ratio of MAS to audit fees on a periodic basis and when it determines an auditor's independence as is now required.
The SEC has correctly focussed on an important issue -- as the accounting profession and accounting firms change into giant conglomerates, under what circumstances do audit judgments become compromised so they are no longer independent? But the kind of detailed rulemaking proposed, banning some services and not others, is not the way to answer this question. It will involve the SEC in the kind of oversight of the accounting profession that it has over the securities industry, and that would be inappropriate. Disclosure of MAS by accountants for audit clients could, however, be a useful means to engage accountants, their clients and investors in a more useful analysis of the problems involved. Further, if accountants wish to fend off the kind of detailed regulation to which the SEC aspires, they will have to engage in more meaningful self-regulation than they have done in the past 25 years.
Roberta S. Karmel
|1||Securities Act Release No. 5869, 42 Fed. Reg. 53635 (Sept. 26, 1977).|
|2||Public Oversight Board Report, Scope of Services by CPA Firms (1979).|
|3||See Relationships Between Registrants and Independent Accountants, Securities Act Release No. 6341, 46 Fed. Reg. 43181 (Aug. 27, 1981).|
|4||See Peter C. Konstant, Breeding Better Watchdogs: Multidisciplinary Partnerships in Corporate Legal Practice, 84 Minn. L. Rev. 1213 (2000).|