BY E-MAIL AND BY HAND
September 27, 2000
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
Attn: Jonathan G. Katz, Secretary
Re: Securities Act Release No. 33-7870, (the "Release") File No. S7-13-00
On behalf of the Committees on Federal Regulation of Securities and Law and Accounting of the Section of Business Law, American Bar Association, we respectfully submit these comments on the Commission's proposed revision of the Commission's auditor independence requirements.
We appreciate the opportunity to comment on these most important proposals. We share the Commission's views of the importance to the confidence of investors of the assurance provided by a vigorous examination of financial statements by impartial and skilled professionals.
Various members of our Committees represent issuers, independent auditors, users of financial statements or plaintiffs and defendants in securities litigation, all of whom may have interests in the Commission's proposals. However, in preparing this comment letter we have endeavored to avoid reflecting the interest of any individual client or any particular group. In addition, the Commission's proposals have implications for multi-disciplinary practice issues, atopic of considerable concern for the legal profession. We have chosen not to address these in our comment letter. Rather, we have limited our comments to specific issues on which we believe we have professional expertise and experience, including the impact of the proposals on issuers and their audit committees and certain technical aspects of the proposals.
Drafts of this letter have been circulated for comment among members of our Committees and the officers of the Section of Business Law. A substantial majority of the members of the Committees who have commented on these drafts have indicated their general agreement with the views expressed in our letter. However, our letter does not express the official position of the American Bar Association, the Section of Business Law or the Committees, nor does it necessarily reflect the views of all of our members who have reviewed it.
Discussion
Guiding Principles
We believe that the Commission's four guiding principles of independence - (1) auditors should not have mutual or conflicting interests with their audit clients; (2) auditors should not audit their own audit work; (3) auditors should not function as client management or employees; and (4) auditors should not act as advocates for their audit clients - may be acceptable as aspirational goals, but will not be useful as rules for defining independence. This is because these principles do not provide sufficient guidance as to when the described activities impair auditor independence and, while laudatory goals, they would result in uncertainty as rules. In addition, if applied as immutable rules, they would interfere with the ability of companies to obtain quality accounting and related services, which ultimately would be disadvantageous to investors.
Economic and Employment Relationships
We generally support an effort to modernize independence rules governing investments by auditors or their family members and employment relationships between family members of auditors and audit clients. We have doubts, however, whether these rules should be established by the Commission, rather than by the Independence Standards Board. The Commission's adoption of rules dealing withthe same subject matter as rules proposed or adopted by the ISB may raise questions about the role and the priority of the ISB and its pronouncements. In this regard, we believe the Commission has failed to address adequately the role it envisions for the Independence Standards Board now and in the future.
Notwithstanding our concerns, we do not believe that adoption of these generally non-contraversial proposals should be delayed.
Non-Audit Services
With respect to the scope of services provided by auditors to their audit clients, we reluctantly have concluded that the Commission's proposals are premature and, perhaps, inadvisable.1 Moreover, we believe that the Commission's authority to define terms is a slender reed on which to erect a new structure for the accounting profession. The Commission has conceded that there is no empirical evidence of audit failures as the result of non-audit services provided to audit clients. In the absence of compelling evidence of a problem, those proposals represent an over-broad and premature reaction, which, as indicated under our discussion of the Commission's guiding principles, well could have a negative effect on audit effectiveness.2 Accordingly, we believe that the Commission's actions with respect to these proposals, no matter how well intended, could be more deleterious than beneficial to investors and the public interest.
Many of our members believe that those proposals are counter-productive as the audit process only affords the auditors with a limited chance of catching errors. The greater the audit firm's exposure to the client, the greater the chances of catching errors and being in a position to determine whether they are material to that client's financial statements.3
The Role of Audit Committees
We also are concerned that the Commission, in its proposals, has failed to address adequately the difficulties these proposals would create for audit committees. Many of our members believe that one of the most important issues under the Commission's proposals is their impact on audit committees.
From the perspective of an audit committee, these proposals, if adopted, will place audit committee members in the position of having to reach decisions on issues of independence as to which they will have no standards for gauging and will provide a basis for further liability exposure without necessarily providing a countervailing benefit. In short, these proposals may not result in better decision making by audit committees and, instead, may tend to discourage qualified persons from accepting audit committee positions. Moreover, we question the advisability of considering these proposals for adoption before at least one proxy season has occurred under the new audit committee disclosure rules. Those rules mandate that audit committees receive a report of the auditors regarding their independence consistent with Independent Standards Board Standard 1 and oversee the auditor's independence. Having just been adopted, these rules should be given a chance to operate.
The Commission has proposed an alternative which would require that an audit committee (1) to find that "special circumstances make it obvious that the best interests of the company and its shareholders will be served by retaining its audit firm or affiliate to render such non-audit service and that no other vendor of such service can serve those interests as well. . .", (2) to submit a written report of those findings to the Commission and the AICPA's Public Oversight Board, and (3) for the company to disclose those findings and the amount paid or expected tobe paid to the audit firm or affiliate for those non-audit services in the company's next proxy statement relating to the election of its directors. We believe that this is not an appropriate alternative. This alternative would place too great a burden on the members of the audit committee and could expose them to additional liability.
The audit committee will have (1) heard from the auditors (in line with the new audit committee rules) about the non-audit services provided by the auditors, (2) learned the auditors' conclusion that such services do not affect their independence, and (3) been told by the SEC that the type of services still allowed do not interfere with independence. In those circumstances, what is it that the audit committee is supposed to determine? In any event what resources would they have in order to make a determination beyond what they learned from the foregoing? An outside director group can't really be expected to go behind what they have learned from (1), (2) and (3) above and conclude that, in fact, the auditor is not independent.
Moreover, the Commission does not address the consequences to the company and the audit committee members if their judgment is challenged and found to be faulty.
If an audit committee makes reasonable inquiries and concludes that the Company's auditor is independent but the Commission or a Court later determines that the auditor, in fact, was not independent, must the company's historical financial statements audited by that auditor be reaudited by another auditor? How far back must the reaudit extend? We believe that the Commission should address these issues before it adopts its proposals and that it should consider a safe harbor that would provide that a reaudit is not required if the audit committee's conclusions as to the auditors' independence had a reasonable basis.
Other Initiatives
We believe that the Commission has not provided sufficient opportunities for a number of its previous initiatives and initiatives undertaken by the accounting profession to ameliorate the issues which the Commission seeks to address by this proposal. These prior initiatives could address independence issues in a more systematic and contemplative manner.
Independence Standards Board. The proposals will likely restrict the Independence Standards Board's ability to develop a coherent conceptual framework, thereby condemning the independence standards to being a tangled web of regulation with numerous inconsistencies.
The ISB was created at the Commission's initiative. However, the Commission's proposals, with respect to the scope of services of audit firms, if adopted, would preempt the ISB's consideration of these issues and the other issues that are the subject of the Commission's proposals. We believe that the ISB, with a restructured governance if that is believed to be necessary, should have the opportunity to address these issues under SEC oversight.
Audit Committee Initiatives. The Commission and, at the Commission's initiative, various self-regulatory organizations and the Auditing Standards Board have adopted rules to enhance the role of corporate audit committees in considering auditors independence issues independently from corporate management. These rules will not be fully operative until 2001. We believe that the Commission's proposed actions with respect to the scope of services are premature, without consideration and analysis of the impact these rules play in overseeing the audit process.
Public Oversight Board. It also has been suggested that the Public Oversight Board of the AICPA may have a greater role to play in overseeing the audit process. The Commission's actions would preempt thoughtful consideration of the role that the POB could play in this regard.
Panel on Audit Effectiveness. The Panel on Audit Effectiveness was established under the auspices of the POB, and at the Commission's request. The Panel has issued an exposure draft with numerous findings and recommendations to bolster the reliability and credibility of financial statement audits. The recommendations of the Panel with respect to the conduct of the audit and earnings management and fraud have been wholeheartedly supported by the Commission's Chairman.
We believe it is premature for the Commission to propose rules that could cause a restructuring of the accounting profession without providing an opportunity for the Panel's proposals to be considered by the profession, adopted to the extent appropriate and their impact on audit effectiveness analyzed in practice.
Accounting Firms. We note that several large accounting firms voluntarily have restructured their practices to eliminate or reduce certain of their non-audit services. For example, several of the major firms have sold or announced the sale of their consulting operations. Also, the Commission has agreed to accept voluntary submissions from accounting firms as to possible past non-compliance with independence rules. We believe that the Commission should provide the opportunity for these voluntary efforts to work and be analyzed in practice before it adopts a restructuring of an entire profession, with significant consequences for their clients and, in turn, the investing public.
Disclosure Proposals
We do not believe that disclosure about non-audit services, as proposed, is a meaningful approach, whether coupled with, or as an alternative to, complete or partial prohibition of non-audit services. We seriously doubt that investors would know what to do with this information. An auditor is either independent or not. Disclosure will not make an auditor who is not independent independent.
We also do not favor the Commission's proposals for detailed disclosure about non-audit services in proxy statements. We believe that this disclosure would not provide meaningful information to security holders, but rather engender confusion and add to the bulk of proxy statements. Nor would it help investors, or improve the audit process. In fact, the information will be of little use to investors and it is unlikely to have any impact on their investment decisions, since it will provide no useful information concerning the issuer. Perhaps more important, it will tend to undermine investor confidence in the financial reporting system, which is exactly what the Commission is trying to prevent.
If the Commission determines that certain non-audit services do not affect an auditor's independence, either in appearance or in fact, what is the purpose of providing disclosure about these services to security holders? The disclosure may suggest that the auditors are not independent in appearance. But, what can a security holders possibly do with this information? Do they totally disregard the Company's financial statements? Do they look at the financial statements with greater skepticism? If so, why should they? Do they vote against ratification of the board of directors' selection of the audit firm to audit the Company's financialstatement for the current year?4 Do they withhold her vote from the members of the audit committee standing for election as directors?
Presumably the Company's audit committee has considered the information disclosed in the proxy statement in considering the independence of the auditors and whether to engage them or to recommend their engagement for the current year. Should the security holders challenge the audit committee's judgment in this regard, if, under the Commission's rules, the auditors are independent in appearance and in fact?
Based on the proposed disclosure, security holders would be unable to determine whether the auditor is independent in fact. Is the purpose of the disclosure to provide the security holders a basis for arriving at some judgment as to whether the auditor is independent in appearance? This would be particularly troublesome in view of the discussion of "Independence in Fact and Appearance" in Section II.A of the Release and the reference in footnote 109 to the Release to independence in fact and independence in appearance being inseparable
Technical Comments on Disclosure Proposals.
The instruction to paragraph (e) of the proposed amendment to Item 9 of Schedule 14A requires a specific description of each professional service provided by the registrant's principal accountant to the registrant during the most recent fiscal year for which the fee was, is, or will be greater than the lesser of $50,000 or 10% of the audit fee. A disclosure of the fees for each service disclosed as well as fees for the annual audit and review of interim financial statements would be required. General categories, including "tax matters" or "management advisory services" would not be acceptable.
We would first observe that, as to services to be performed in the future at an hourly rate, the registrant may not be able to estimate the fee.
Second, the Commission should clarify whether the audit fee referred to in the rule is that for the current fiscal year or the most recent fiscal year.
More importantly, although the detailed breakdown of services to be required by the rule might be of some value to the audit committee, we do not believe that that amount of detail would be meaningful to security holders, particularly since all these services will be permissible under the Commission's auditor independence rules. Furthermore, identification of the particular services could involve sensitive confidential information, the disclosure of which could be injurious to the company. For example, disclosing employment of the accounting firm to assess the value of a claim as part of litigation strategy could give valuable information to the opposing party. Similarly, disclosure that the accounting firm did a rate analysis could result in premature speculation about regulatory strategy and potential rate increases.
The proposed rule also would require an indication whether each service disclosed was approved by the audit committee or the board of directors, if there was no audit committee, before it was rendered and that the committee or, the board considered the possible effect of the service on the principal accountant's independence. Since these services, in the Commission's view, do not affect the auditor's independence, we question the meaningfulness of this disclosure to security holders and the necessity of a determination by the audit committee or the board of directors.
However, if the Commission determines to adopt a requirement for disclosure about fees for non-audit services, we believe that the disclosure should be limited to the aggregate fees for the annual audit and the aggregate fees for non-audit services during the year subject to the audit.
Lack of "Safe Harbor". We further do not understand why the Commission has not proposed a safe harbor for this disclosure, similar to that for other audit committee related disclosures or why it has not addressed any issues as to any liability exposure of audit committee members as a result of this disclosure. If this requirement is adopted, we strongly urge that it be accompanied by a meaningful safe harbor rule protecting the issuer and the members of the audit committee from liability as the result of such disclosure.
Disclosure About "Leased" Employees. The proposed rule would require disclosure of the percentage of hours expended on the principal auditor's annual audit that were attributed to work performed by persons other than the principal accountant's full-time permanent employees, if that percentage was greater than 50%. We do not understand the purpose for the disclosure or how a securityholder would be expected to assess it. Either using "leased" employees is a permissible means to conduct an audit, or it is not and should be prohibited by the Commission. However, requiring this disclosure could be perceived by security holders or, indeed, even audit committee members, as an indication that the Commission believes using "leased" employees to a significant degree in an audit is improper in some manner and that the audit committee did not properly perform its duties by allowing it to occur.
Comparison to MD&A. The Commission in footnote 92 of Rel. No. 33-7870 states that "[t]$he effect of the proposed disclosure would be similar to disclosure of management's discussion and analysis of financial condition and results of operations." We see no such similarities. The MD&A permits investors to see, through managements' eyes, the reasons for historical results and the potential impact of known trends, events and uncertainties on future results, liquidity and financial positions. The proposed disclosure rules would provide no such analysis. Security holders, based on the Commission's proposed disclosure rules, could not possibly see through the eyes of the audit committee members, the subtleties of their determinations of the independence of their company's independent auditors.
Impact on Smaller Companies
We believe that the impact of these scope of services proposals could fall most heavily on smaller companies. Accordingly, if it determines to adopt these proposals, we urge the Commission to seriously consider modified rules to reduce the burdens of compliance on smaller companies.
The proposals could deter, if not preclude, a number of smaller public companies from obtaining the consulting help they need to permit their businesses to flourish. This is because in many cases the client will simply not appreciate the possibilities that exist for improving their operations, and their accountants will have no economic incentive to bring such matters to their attention. In fact, if the accounting firms do not possess the requisite capabilities, they may not even be aware of those possibilities themselves.
Definitions
We believe that certain of the definitions to be used with the proposed rules either are unworkable in practice or present other problems, particularly those of "materiality" and "affiliate of the accounting firm."
"Materiality". The proposed rules relating to investments use a "materiality" threshold, generally over a 5% equity interest in an entity, in determining whether an investment is permissible. This definition differs from that used in other Federal securities law contexts, including those used in Staff Accounting Bulletin No. 99, and could result in uncertainty and confusion. If the Commission determines that a bright line test is appropriate for these purposes, we would favor a much higher threshold, say 20%.
"Affiliate of the Accounting Firm." Proposed Rule 2-02(f) 4(i) defines the term "affiliate of the accounting firm" in terms of "control" relationships; but then further provides that a person with a direct or indirect ownership interest of 5% or more of the voting securities of an entity is an affiliate of that entity and the entity is an affiliate of the person and further extends that definition to include "affiliates" of those affiliates. Further, the proposed definition would include any entity with a direct ownership relationship with the auditor that also provides services to the audit client. We do not believe that, in all circumstances, a person with a 5% or more voting interest in an entity is a control person of the entity nor is the entity necessarily a controlled person. We believe that it is even more unlikely that the remote relationship of an "affiliate of an affiliate" creates a control relationship.
We also note that the proposed definition of "affiliate" differs from the current definition in Rule 1-02 of Regulation S-X, which is the more traditional general definition used under the Federal securities laws.
We suggest that the Commission should consider defining the economic interests that it believes affect an accountant's independence in terms other than "control" or "affiliation." In so doing, the Commission should not extend it rules to entities in which a person has a remote indirect (5% of 5%) interest.
"Affiliate of the Audit Client." The Commission would define this term to mean "an entity that has significant influence over the audit client, or over which the audit client has significant influence...." "Significant influence," a term whichis not defined in the proposed rules, is a much broader concept then "control" and will be difficult to deal with in practice. We are concerned that too many entities could become subject to the Commission's independence rules, if this definition is adopted.
Conclusion
While, we support efforts to modernize independence rules relating to investments and employment relationships, we oppose the Commission proposals with respect to the scope of services, particularly the specter of restrictions on tax-related services, and disclosure about non-audit services. We also believe that the Commission, if it determines to adopt these proposals, should address their impact on the ISB, audit committees and smaller issuers.
Members of our Committees would be pleased to meet with representatives of the Commission to discuss our comments.
Stanley Keller, Chair
Committee on Federal Regulation of Securities
Richard H. Rowe
Chair, Committee on Law and Accounting
Drafting Group:
David R. Baker
Dan L. Goldwasser
Richard E. Gutman
John J. Huber
Richard H. Rowe
James J. Winn, Jr.
cc: Honorable Arthur Levitt, Chairman
Honorable Isaac C. Hunt, Commissioner
Honorable Paul R. Cary, Commissioner
Honorable Laura S. Unger, Commissioner
David Becker, General Counsel
Lynn E. Turner, Chief Accountant
1 As noted above, we have not addressed issues relating to multi-disciplinary practice that may be involved in the Commission's proposals with respect to the prohibition on providing legal services to audit clients. However, the Commission has requested comments on auditors' tax-related services. We feel particularly strongly that tax-related services, which historically have not raised independence issues, should not be prohibited.
2 cf Section 5.25 of the Report and Recommendations of the Panel on Audit Effectiveness (Exposure Draft, May 31, 2000). In developing its Report, the Panel conducted "quasi" peer reviews of 126 audits of SEC registrants in 28 offices of the eight largest audit firms. In 37 engagements, services other then audit and tax services had been provided. The reviewers did not identify any instance in which non-audit services had a negative effect on audit effectiveness.
3 Some of our members also believe that the loss of consulting services will limit both the profitability and growth of accounting firms and thereby impair their ability to attract competent audit personnel.
4 We note that Delaware and other states do not require stockholder approval of the engagement of an auditor.