September 25, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Comments to Proposed Rulemaking, File No.: S7-13-00
Dear Mr. Katz:
On behalf of the independent law firm of McKee Nelson, Ernst & Young LLP ("McKee Nelson"), we welcome this opportunity to comment on the proposed revision of auditor independence requirements by the Securities and Exchange Commission ("SEC" or "Commission"). 65 Fed. Reg. 43148-43203 (July 12, 2000). Our comments specifically address those sections of the proposed rule that prohibit the provision of legal services to a client by a law firm affiliated with an accounting firm that audits the same client.
McKee Nelson is an independent law firm in a strategic alliance with the accounting firm of Ernst & Young. Let us provide a snapshot of our law firm and its relationship with Ernst & Young. We are a stand-alone partnership, in which all of our partners are lawyers, and none is a partner in any accounting firm. All lawyers in the firm are bound by, and adhere to, the legal rules of professional conduct. The law firm determines which clients to represent, screens for conflicts, and manages its own caseload. It takes direction only from its clients. Lawyers in the law firm make all hiring and partnership decisions, and manage the operation of the firm. We accept no referral fees from non-lawyers for referrals that we make, and we pay no referral fees for referrals that we receive. Our offices are self-contained, in a building located at 1150 18th Street, N.W., in Washington, D.C.
Our alliance with Ernst & Young involves joint marketing, cross-referrals and introductions, joint proposals, and joint efforts on discrete client engagements. This alliance is not exclusive: depending on the client´s needs, we work collaboratively with other accounting firms on client engagements, and refer work to professional services firms other than Ernst & Young. As the firm fully discloses, in its name, in its informational literature, on its letterhead, in its retainer letters, and whenever asked, the firm is in an alliance with the accounting firm of Ernst & Young.
Why are we in this alliance? The alliance provides us with access to diverse skills, tools, and technologies of the accounting firm that enable us to better understand the businesses of our clients and enhance the quality of our legal services. Ernst & Young clients seek legal services from McKee Nelson because they perceive significant benefits from the effective integration, coordination, and delivery of multiple services and competencies from a law firm allied with their accounting firm.
In the current regulatory environment, McKee Nelson and Ernst & Young do not, and cannot, share fees or profits. Accordingly, there can be no direct economifrom the alliance. The benefits arise from the firms´ abilities to coordinate marketing and service delivery to clients whose matters require legal services, as well as audit, tax, and other advisory services offered by Ernst & Young. Lawyers are not the only professionals seeking to deliver coordinated professional services with non-lawyers. Take physicians. Increasingly, physicians of many specialities B for example, internists, plastic surgeons, and dermatologistsB are teaming with nutritionists, physical therapists, nurse practitioners, and others, to offer integrated, health-related services. While professionals in each firm render separate statements to their clients, the client receives quality care from professionals who regularly work together and who have compatible philosophies and invest in and use common or compatible systems and equipment. These benefits of close, but nonexclusive, cooperation can be achieved without sharing profits or fees. The same is true about the law firm´s alliance with Ernst & Young.
In any successful alliance relationship, both firms in the alliance hold the view that client demand for coordinated services will benefit both firms and possibly expand the client base because of improved client satisfaction. The economic benefit is indirect: where one firm in the alliance recommends its strategic ally to a client and the client retains that firm, the referring firm hopes to obtain a similar referral at some point in the future, where appropriate for the client. As noted, the alliance between Ernst & Young and McKee Nelson is not exclusive, and on many matters clients retain only one firm in the alliance. Such client decisions have no adverse impact on the financial results of our law firm and plainly have no such impact on Ernst & Young. Even a large malpractice claim filed against one firm in the alliance has no adverse financial effect on the other.
In Part I, we discuss the proposed definition of "affiliate." The proposed definition of affiliate captures relationships not covered by existing regulations, and sweeps far more broadly than the definition utilized by Congress throughout the securities laws. As drafted, the proposed regulation would prohibit existing, independent law firms with an established client base, that regularly go to market with, and cross-refer business to, accounting firms, from providing legal services to audit clients of the accounting firms. We respectfully submit that Congress has not delegated to the SEC the authority to broadly define and regulate affiliates of accounting firms so as to prohibit such conduct. We further believe that the proposed definition of "affiliate of the accounting firm" lacks support in the law and in the facts.
In Part II of these comments, we discuss the proposal to ban affiliates of audit firms from providing legal services to audit clients. The Commission maintains that the differences in duties between lawyers and auditors could threaten the appearance of audit independence, and asserts that this potential threat justifies the prohibition. We explain that the different legal duties of lawyers and auditors do not conflict when the professionals practice in separately managed and controlled entities. Appearance-based threats to independence, such as when legal services are offered by a separate law firm that is independently managed and controlled, should be addressed by less restrictive means than a total prohibition on the performance of legal services. Flexibility is warranted, particularly in view of the client demand for, and satisfaction with, integrated professional services.
1. Regulation of Affiliates.
Commission lacks authority to expand Congressional definition of "affiliate". For the past 63 years, the SEC has regulated affiliates of accounting firms, which it has consistently defined as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with," a specified person or organization.1 The SEC´s authority to promulgate the proposed rule, and thus its power to define and regulate "affiliates" of accounting firms is based on five statutes passed by Congress.2 In each of these five statutes B the Public Utility Holding Company Act of 1935, the Investment Company Act of 1940, the Investment Advisors Act of 1940, and the Securities Acts of 1933 and 1934 B Congress adopted a control-based definition of "affiliate." For example, in the Public Utility Holding Company Act of 1935, the first time Congress defined "affiliate," it defined the term to reach any person or company that directly or indirectly owns, controls, or holds with power to vote, five percent or more of the outstanding voting securities of another company, or whose executive leadership overlaps.3 The Senate Committee on Interstate Commerce explained that it sought through this definition "to control certain transactions between companies which are not wholly independent of each other."4 Put another way, companies with looser connections than the ones set forth in the congressional definition of "affiliate" were, according to Congress, "wholly independent of each other."
Congress has repeatedly reaffirmed and reauthorized this definition of "affiliate." Starting with the Trust Indenture Act of 1939, Congress has incorporated this same definition of affiliate into other statutes, and has consistently set five percent of voting shares in whatever form as the threshold at which an affiliate relationship would attach.5 As Congress explained, in adopting the same control test in defining "affiliated" in the Investment Company Act of 1940, it sought to distinguish between individuals and organizations that are "independent" and those that are not.6 Congress has made clear that regulated entities and non-regulated entities that do not trigger the control test are free to lawfully conduct their business as they see fit.
The first two subsections of the proposed definition of "affiliate of the accounting firm" adhere to the long-standing congressional definition.7 However, the third, fourth, and fifth subsections enlarge expansively the definition of an affiliate to include:
This definition dramatically broadens the concept of "affiliate" beyond the scope of any of the five statutes on which the SEC premises its authority to promulgate the proposed rule. We respectfully suggest that the SEC is not free to so redefine the term "affiliate."
Congress has retained for itself the power to define affiliates, and has not delegated that power to the SEC. Over the decades, Congress has gradually modified the list of entities whose affiliates are subject to SEC control and inserted definitions of "affiliate" selectively.11 This practice has spanned the entire period of the SEC´s existence, and Congress has never indicated a willingness to give up its control in this area, nor has it ever adopted legislation granting the SEC power to define affiliates of independent auditors. The proposed rule makes clear that the SEC seeks to enlarge the congressional definition of "affiliate." The SEC lacks that authority, and must return to Congress to acquire it.12
Commission cannot use definitional authority to expand its jurisdiction. In the preamble to the proposed regulation, the SEC argues that it has implied powers to define certain entities and regulate them based on (1) the statutory command that certain financial statements be audited by "independent" accountants and (2) the SEC´s statutory authority to define "accounting, technical, and trade terms used in each Act."13 The SEC made a similar claim in 1985 when it asserted that it had the power to redefine the term "bank" to bring numerous banks within its jurisdiction for the first time in 50 years. The D.C. Circuit rejected this effort. American Bankers Ass´n v. SEC, 804 F.2d 739 (D.C. Cir. 1986). There, the Comptroller of the Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation interpreted the Glass-Steagall Act to allow banks to engage in brokerage services for nonbanking customers. The SEC responded with a new regulation that attempted to define banks as "broker dealers" and, as such, bring them under the Commission´s regulatory purview. The D.C. Circuit invalidated the regulation. It found that a "crucial problem with the SEC´s new rule defining ´bank,´ however, is that the 1934 Act already contains a definition of the term ´bank.´" Id. at 743-44. The Court held that the SEC "cannot use its definitional authority to expand its own jurisdiction" beyond what it has been given by Congress. Id. at 755.
Here, Congress has spoken to the precise question at issue repeatedly and explicitly. Congress has defined the meaning of the word "affiliate" in the securities laws, and the SEC lacks the power to extend its authority by re-writing terms adopted and defined by Congress.
Commission cannot use mission statement to expand its jurisdiction. The SEC makes no explicit claim that it has the statutory authority to redefine the term affiliate. Instead, it maintains that the proposed regulation of non-audit services B and thus presumably this expansive definition B is justified by (a) a "mission . . . to promote investor confidence in the reliability and integrity of issuers´ financial statements"; (b) "common sense . . . that a person´s decision changes when he or she has a stake in the outcome"; (c) two academic commentaries suggesting that an audit firm´s judgments are likely to be "unconsciously and powerfully biased" when it provides audit and non-audit services to the same client; and (d) industry reports showing that some insiders and regulators are concerned about possible breaches of auditor independence when one firm provides audit and non-audit services to the same client. 65 Fed. Reg. at 43148, 43152-53, 43154-55 & n.75. None of these justifications support an expansion of the proposed definition of affiliate.
The D.C. Circuit, in Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990), rejected a prior SEC effort to rely upon "immensely broad" agency mission statements to regulate proxy solicitations and rules adopted by SROs. In that case, the SEC maintained that the stated congressional goal of "fair corporate suffrage," set forth in ' 14 of the 1934 Act, empowered the Commission to adopt regulations to force SROs to control stock voting structures. The D.C. Circuit rejected the SEC´s claim. The Court found that "unless the legislative purpose is defined by reference to the means Congress selected, it can be framed at any level of generality B to improve the operation of capital markets, for instance." 905 F.2d at 410. The Court instructed the SEC that "it must turn to Congress" to obtain the authority to regulate SROs. Id. at 411. Here, the purported SEC effort to expand the entities covered by the affiliate rule cannot be justified solely by an assertion that regulation will serve a broad purpose of the securities laws. The Commission may only use the "means" intended by Congress and, as shown above, Congress has clearly defined, and so limited, the entities that can be regulated as "affiliates."
As to the second justification for the rule B common sense B that is not an area in which the SEC has any special expertise. The Supreme Court has made clear that agency judgments are entitled to deference only where those judgments "depend upon more than ordinary knowledge respecting the matters subject to agency regulation." Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc. 467 U.S. 837, 844 (1984). Indeed, "common sense" B speaking for the man in the street B is arguably the unique province of the elected members of Congress. Congress has determined that business relationships, to be regulated, should meet the threshold of five percent voting ownership or overlapping high-level leadership.14
The third and fourth justifications are based on sources that do not discuss affiliates of accounting firms. To the extent they have relevance, they are only arguments, not clear justifications for agency action. With respect to the academic commentaries suggesting that an auditor´s judgments could be biased when the same firm provides non-audit services, other equally respected academics have reached the contrary conclusion. For example, the Dean of the University of Chicago Law School, Daniel Fischel, has opined that audit independence would be strengthened in such circumstances because the enlarged base of business enjoyed by a firm offering multiple services will, "lower its incentive to compromise its reputation for independence on behalf of any individual client and risk losing its other existing and future clients."15
Similarly, investor opinion B the fourth justification for the proposed prohibitions B is divided on whether non-audit services could appear to threaten audit independence. A recent study of perceptions among the general public conducted by independent experts B professors of accounting at North Carolina State University B "indicated that nonaudit services had an incremental or positive influence on users´ perception of auditor independence and objectivity."16 Indeed, a recent survey conducted by the SEC-commissioned Independence Standards Board found that roughly half of the CEOs and CFOs interviewed reported that they retained their U.S. audit firms for non-audit work: "[t]hey reasoned that their auditors were better able to understand their needs, that they had a relationship that worked, and that the audit firm would be motivated to do a good job and charge reasonable fees, knowing the client was a long term, important relationship."17 Empirical research by the Panel on Audit Effectiveness suggests that these conclusions are well founded: the Panel´s reviewers, after studying the effect of non-audit services on auditor independence, found that in about one-quarter of the engagements where non-audit services were provided to audit clients, "those services had a positive impact on the effectiveness of the audit." And, notably, the reviewers "did not identify any instances in which providing non-audit services had a negative effect on audit effectiveness."18
In every other business relationship where affiliations are regulated by the securities laws B brokers, dealers, issuers, underwriters, and other market participants B these affiliations are defined by Congress in authorizing legislation to mean control, measured by either significant ownership (five percent or more) or overlapping leadership at the highest levels.19 There is no basis in law or fact for treating auditor affiliations any differently, including affiliations with lawyers and law firms.
Unintended Harms From Proposed Expansion of Affiliate Definition. The unprecedented expansion of the affiliate definition, which has no basis in existing SEC rules and regulations, would have costly and unintended consequences for law firms.20
In the last 20 years, there has been a revolutionary transformation of the U.S. economy from industrial to information-based. Global competition, complex business structures and transactions, innovative financial instruments and rapid technology changes have forced businesses here and abroad to improve their productivity and to reach customers effectively and efficiently. Competing in the global economy often involves tangled legal and non-legal elements, and businesses seek integrated, comprehensive solutions from teams of professional advisers in multiple competencies. These professionals B including lawyers, financial planners, accountants, investment advisers, and tax consultants B have diverse skills and expertise.
In the current regulatory environment in this country, lawyers cannot share fees, or partner with, non-lawyers. As a result, law firms regularly team with accounting firms to offer integrated, comprehensive consulting services, including legal, business advisory, tax, and audit services to clients. These teams are more than ad hoc arrangements. Law firms routinely work with the same accounting firms, and refer clients to them, and vice versa.21 Depending on the ethics rules of the state in which the referral is made, the lawyer may be able to be paid for making the referral,22 but cannot "give anything of value to a person for recommending the lawyer´s services."23 Such a cross-referral relationship could be deemed to be an undertaking that creates a "shared benefit" and, under the proposed rule, would convert the law firm into an affiliate of the accounting firm, pursuant to proposed ' 210.2-01(f)(4)(C).24
By the same token, the proposal to include as affiliates entities that cross-sell, or co-brand, with accounting firms would reach numerous established independent law firms across this country. American law firms have been quick to recognize the synergies of working with accounting firms and have established numerous relationships short of multi-disciplinary partnerships to provide better coordinated services to clients. These associations involve joint marketing, cross-referrals and introductions, joint proposals, and joint efforts on discrete client engagements. These teams can establish common methodologies to deal with an issue, and can generate stronger arguments, richer analysis, and sounder advice than professionals in any one firm. Because the firms are separate and independent, client confidences are not shared between the allied firms, except with the consent of the client, client accounting and financial records are separate, electronic and hard copy client files are maintained separately by each firm, and separate retainer letters, and bills for professional services, are sent by each firm. Professionals in each firm B lawyers in the law firm and accountants in the accounting firm B are governed by and comply with applicable ethics rules.
In these respects, McKee Nelson´s alliance with Ernst & Young is similar to numerous other alliances in place today between law firms and accounting firms. For example, one of the largest networks of independent law firms, Lex Mundi, has a number of law firm members that regularly go to market, and cross-sell services, with accounting firms.
Adoption of the affiliate definition proposed by the Commission will effectively halt the formation of any strategic alliances between law firms and accounting firms. Any law firm in such an arrangement would be required to "fire" long-standing clients that were also audit clients of the accounting firm because the law firm would be deemed to be part of the accounting firm. Lawyers in law firms would be required to follow audit independence rules which could conflict with governing legal ethics obligations.25
The SEC maintains that the proposed affiliate definition B of which three elements are entirely new and have no foundation in existing statutes or regulation B is needed to satisfy the concerns of a hypothetical "reasonable" investor. However, the proposed definition contains no limiting principle. Any "shared benefit" or any "cross-selling" creates an affiliation, and the entity, and all persons within it, are treated as part of the accounting firm, regardless of the amount of the benefit. This proposed approach is at odds with the approach previously taken by the SEC in connection with audit fees. In that instance, the SEC has asserted that audit independence can be impaired only where the audit client "make[s] up a significant part of the total income of the [CPA] firm."26 In the two reported cases addressing this issue, the SEC found audit independence impaired where the audit client accounted for 75%,27 and more than 30% of an audit firm´s income over several years.28
"Mutuality of interest" justification is unsupportable. The SEC further maintains that the proposed affiliate definition "attempts to capture those entities that are financially tied to or otherwise associated with the accounting firm enough to warrant being treated like the accounting firm for purposes of our independence requirements." 65 Fed. Reg. at 43178. The new elements of the affiliate relationship enumerated in parts (C), (D), and (E) of the proposed affiliate definition, according to the SEC, are added because such relationships create a "mutuality of interest" between the audit firm and the affiliated entity. Current ethics rules, in place in every American jurisdiction, prohibit lawyers from sharing fees with non-lawyers, or from entering into partnerships with non-lawyers. Similarly, ethics rules in many states prevent lawyers from receiving payments for referrals, or from paying money for referrals. Because of these bar rules, which are likely to remain for many years, there can be no direct economic mutuality of interests when a law firm and an accounting firm are in a strategic alliance.
We have previously discussed the strategic alliance between McKee Nelson and Ernst & Young. Because the bar rules prohibit profit and fee sharing, because McKee Nelson does not accept, and cannot pay, referral fees, and because the alliance is not exclusive, the loss of an engagement by one firm has no obvious or direct adverse impact on the other. An engagement that is unprofitable to one firm has no effect on the other firm, even when both firms are engaged to provide coordinated but separate services on the same matter. Put another way, the accounting firm cannot directly profit economically from the relationship between its strategic ally and its audit client, and such an affiliation therefore cannot impair independence in fact.
The proposed rule does not define "mutuality of interest" between the accounting firm and its affiliate. Under the Commission´s definition of affiliated entity, practically every business relationship between a law firm and an accounting firm creates a mutual interest that would cause the law firm to be regulated as part of the accounting firm. The D.C. Circuit has previously invalidated regulations by other agencies that contain no "intelligible principle" limiting that agency´s discretion to act.29
Moreover, the proposed effort to capture business relationships, set forth in sections (C), (D), and (E) of the proposed rule on the ground that such relationships create a mutuality of interest, is at odds with the definition of "mutuality of interest" that appears in another part of the proposed rule. Under proposed ' 210.2-01(c)(i)(D) a "mutuality of interest" will be found when an auditor and a client both invest in the same enterprise when the auditor owns more than five percent of the enterprise or the enterprise is subject to significant influence by the client.30 Likewise, the auditor may own up to five percent of an enterprise that owns a stake in the auditor´s client, as long as that enterprise does not exercise significant influence over the client.
"Mutuality of interest" cannot be defined to mean control and five percent ownership in one part of the proposed rule, and a far more expansive cross-referral, cross-selling business relationship in another part of the same rule.31
For all of these reasons, the Commission should abandon its proposal to dramatically expand the definition of affiliate, and should return to regulating as affiliates only those entities that fit the definition adopted by the Congress.
2. Legal Services. For the past several years, clients have increasingly sought integrated professional services, including legal services, because they perceive significant benefits from the effective integration, coordination, and delivery of multiple services and competencies. In a survey conducted last year, the Financial Times found that "[m]ore than half" of the senior executives at large corporate and financial institutions in the US and UK would use one firm to provide legal and audit services and "[a]mong US financial organisations this figure was 75 per cent."32 In our experience, clients want the option to retain affiliated firms to provide legal and audit services because they perceive that heightened coordination, teamwork and fully-considered strategic planning will result when auditors, lawyers, and other professionals regularly work together as a team and that they will receive better services at reduced costs. Clients are not the only beneficiaries of integrated services. Investors and capital markets also stand to gain when companies purchase audit and legal services from allied firms because there is a greater likelihood that critical issues will be recognized and addressed efficiently.33
Against these benefits is the concern articulated by the Commission that the differences in duties between lawyer and auditor could threaten the independence of an affiliated auditor. See 65 Fed. Reg. at 43172.34 In the Commission´s view, this concern outweighs any benefits to consumers and investors that flow from comprehensive, integrated services and justifies a total prohibition on legal services by law firm affiliates of accounting firms.
The Commission provides no empirical evidence that independence is actually impaired when a law firm affiliated with an audit firm provides legal services to an audit client of the audit firm. As we have discussed, independent U.S. law firms have, for a number of years, had alliances with accounting firms and have offered legal services to audit clients. We are aware of no evidence that audit independence has been actually impaired in this practice setting. The Commission´s concern arising from the provision of legal services by affiliated law firms is appearance-based. We respectfully submit that a less restrictive approach should mitigate or eliminate such perceived threats to independence.
The Commission first asserts that the lawyer´s duty of advocacy is in "fundamental conflict" with an auditor´s obligation to remain independent. 65 Fed. Reg. at 43172. The SEC has long maintained that one individual cannot offer legal and audit services to the same client. In re Greenspan, 1991 SEC LEXIS 1687 (Aug. 26, 1991). In recent years, the Office of the Chief Accountant of the Commission has taken the position that the SEC would find audit independence impaired where one firm provided legal and audit services to the same SEC registrant.35 For independence purposes, the SEC has viewed one firm as a single person, and has imputed the obligations and legal duties of one professional to all professionals in one firm.
We leave for others to debate the soundness of such imputation when different professionals practice in one firm. We address only the SEC´s proposal to impute duties from one set of professionals in a stand alone firm to a different set of professionals, governed by different ethics rules, in a separate firm. As we discussed previously, McKee Nelson is an independent, stand-alone law firm. Elements of its "separateness" include separate offices, separate management, separate clients, separate conflicts procedures, separate record keeping, separate equity ownership, and no fee or profit sharing with non-lawyers. Lawyers at McKee Nelson owe a duty to advocate zealously for their clients. That duty stops at the law firm: put another way, lawyers at McKee Nelson owe no legal duties under governing bar rules to zealously advocate for clients of Ernst & Young. Indeed, McKee Nelson properly represents clients adverse to Ernst & Young. No state accounting regulator has the authority to sanction lawyers at McKee Nelson when they decline to disclose privileged information in response to requests by an auditor of any law firm client. Conversely, the CPAs at Ernst & Young have a legal duty to be independent when performing audits, and their accounting licenses may be in jeopardy if their independence is compromised. No bar regulatory authority can discipline an auditor for a failure to adhere to legal ethics rules. At bottom, the auditor´s legal duty of independence cannot be compromised by the legal duties of anyone else, including lawyers, in a separate, stand alone firm.
The Commission´s discussion of advocacy conflates a legal duty with the general professional obligations of auditors and lawyers. All professional service providers B including lawyers and auditors B engage in advocacy for their clients. Advocacy simply involves recommending to a third party, a position or course of conduct to benefit the interests of a client. Auditors advocate on behalf of audit clients when they provide management letters at the conclusion of an audit. Apart from audit services, auditors historically have provided tax advisory services to audit clients, and these services plainly involve advocacy.36 The Commission recognizes that these tax advocacy services do not automatically impair audit independence B audit firms are permitted to provide these services under the proposed rule.37 There is nothing inherent in the nature of advocacy that actually impairs audit independence.
The issue involving advocacy, to the extent that there is an issue, appears to revolve around the Commission´s statement that the lawyer´s "near absolute" duty of confidentiality could appear to threaten the independence of an affiliated auditor. 65 Fed. Reg. at 43172. This statement flows from an assumption that a lawyer in an affiliated firm, in order to protect client confidentiality, would not disclose material information to the auditor. This potential threat exists today when the lawyer and auditor are in unaffiliated firms.38 Generally accepted auditing standards require the auditor to request from a client´s lawyers information respecting matters that may be material to the client´s financial statements. See AICPA Codification of Statements on Auditing Standards AU ' 337 ("Inquiry of a Client´s Lawyer Concerning Litigation, Claims, and Assessments"). Lawyers often have confidential or privileged information that may impact the client´s financial statements. Absent the consent of the client, the lawyer may not disclose such information to the auditor. Clients also understand that if auditors cannot get the information they need, regardless of the reason, the auditors will have no choice but to qualify their opinion, or resign from the engagement B options that cause most clients grave concerns because of the conclusions investors would draw. This issue does not change when the law firm is affiliated with the audit firm.39
Moreover, the lawyer´s duty to protect client confidences is understood by investors and the capital markets. Auditors today do not have automatic access to information protected by the attorney-client privilege. See AICPA Codification of Statements on Auditing Standards, AU '' 337.13, 9337.09 (SAS No. 12). Investors and the capital markets do not expect company auditors to know privileged information, and these expectations should not change when lawyers and auditors practice in allied firms.
The Commission´s appearance-based concerns should be addressed by less restrictive means than a total prohibition on the performance of legal services by law firms allied with audit firms, particularly in view of the client demand for, and satisfaction with, integrated services. As the Commission acknowledges, determination of whether independence may appear to be impaired turns on "whether reasonable persons, knowing all relevant circumstances, would perceive that an auditor is independent." That is, "[a]ppearance is measured only with respect to reasonable persons knowing all the relevant facts and circumstances." 65 Fed. Reg. at 43151. We concur with this approach. Appearance-based threats to independence arising from alliances between accounting firms and law firms can be remedied through full disclosure of the facts and circumstances of the alliance. Appropriate safeguards should mitigate, if not eliminate, perceived threats to audit independence. Affiliated firms should be required to make full disclosure of their relationship to potential clients, investors, and regulators. Clients seeking comprehensive, integrated services, including audit and legal services, can weigh the potential benefits of integrated services against the potential losses associated with a concern that audit independence may appear compromised, and determine whether to make a trade-off. For clients that are SEC registrants, audit committees and boards of directors are responsible for monitoring and determining whether company auditors are independent in fact and in appearance. They are required to take steps to ensure that the integrity of financial statements could be questioned because of legal services provided by law firms affiliated with the audit firm. Where non-audit services of affiliated firms, including legal services, are disclosed in the client´s proxy statements, the reasonable investor will have sufficient knowledge of all "relevant circumstances" to determine whether he is comfortable with the independence of the auditor. 65 Fed. Reg. at 43151.
A second safeguard to address and remedy appearance-based threats would be to prohibit certain types of legal services. For example, public advocacy by a law firm in highly visible, material litigation for audit clients of an allied accounting firm could give rise to appearance concerns, and such services could be prohibited. Conversely, appearance-based threats are not presented in negotiated transactions. In that practice setting, the client´s strategies and confidences are frequently shared with a team of outside advisors, including lawyers, tax advisors (which often come from the auditing firm), investment bankers, economists, and public relations specialists. The client´s auditor is often involved in financial due diligence. When the lawyer provides advice, based on communicated facts, that advice is almost always not privileged because it is virtually always shared with the client´s outside, nonlawyer advisors and, at times, with the party on the opposite side of the table. With respect to tax and business advisory services, the proposed rules permit audit firms to continue to provide such services to audit clients. See 65 Fed. Reg. at 43172. Such services could plainly be provided by lawyers in a law firm affiliated with the audit firm without triggering appearance-based independence concerns.
* * * * * *
We appreciate the opportunity to comment on this notice of proposed rulemaking. On behalf of the firm, I am sending a copy of this comment to the Commission by electronic mail.
William S. McKee
McKee Nelson, Ernst & Young LLP
1 See Rule 455, General Rules and Regulations under the Securities Act of 1933 (1937); Securities Act Release Nos. 1376 & 1378 (1937); 17 C.F.R. ' 210.1-02(b) (2000). The SEC also has used a second definition of "affiliate," which is drawn verbatim from the Public Utility Holding Company Act of 1935. 17 C.F.R. ' 256.01-9(c) (1939).
2 65 Fed. Reg. at 43150 n.14, 43190.
3 Public Utility Holding Company Act of 1935, 15 U.S.C. ' 79b(a)(11).
4 Senate Report No. 621 at 23 (May 13, 1935).
5 Trust Indenture Act of 1939, 15 U.S.C. ' 77kkk (incorporating Holding Company Act´s five percent threshold); Telecommunications Act of 1996, 15 U.S.C. ' 79z-5c(a)(1) (same);15 U.S.C. ' 79z-5a(a)(1) (same);15 U.S.C. ' 79z-5b(f)(2)(A) (same). See also Investment Company Act of 1940, 15 U.S.C. ' 80a-2(a)(3) ("affiliated person" subject to five percent threshold); Securities Acts Amendments of 1964, 78 Stat. 565, 565 (1964), 15 U.S.C. ' 78c(a)(19) (incorporating Investment Company Act´s five percent threshold into Exchange Act of 1934).
6 Senate Report No. 1775 at 14 (June 6, 1940); House Report No. 2639 at 14 (June 18, 1940).
7 Proposed ' 210.2-01(f)(4)(A), (B).
8 Proposed ' 210.2-01(f)(4)(C).
9 Proposed ' 210.2-01(f)(4)(D).
10 Proposed ' 210.2-01(f)(4)(E).
11 See note 5, supra; see also, e.g., Gramm-Leach-Bliley Financial Modernization Act, 113 Stat. 1338, 1405-06 (1998), 15 U.S.C. ' 78q(i)(5)(C) (adding affiliate of supervised investment bank holding companies to 1934 Act); Securities Litigation Uniform Standards Act, 112 Stat. 3227, 3229, 3232 (1998), 15 U.S.C. ' 77p(f)(1) ("affiliate of the issuer" for purposes of limitations on remedies under 1933 Act), 15 U.S.C. ' 78bb(f)(5)(A) (same under 1934 Act); Government Securities Act Amendments of 1993, 107 Stat. 2344, 2361 (1993), 15 U.S.C. ' 78n(h)(f)(ii) (adding affiliate of appraiser of limited partnership rollup to 1934 Act); Securities and Exchange Commission Authorization Act of 1987, 101 Stat. 1249, 1256 (1987), 15 U.S.C. ' 78o(b)(4)(C) (adding affiliate of investment company, bank, insurance company, any person required to be registered under the Commodity Exchange Act, and of foreign equivalents of the above, to the 1934 Act for purposes of broker/dealer registration); Securities Investor Protection Act Amendments of 1978, 92 Stat. 249, 249 (1978), 15 U.S.C. 78ccc(a)(2)(A)(i)(adding 1934 Act definition of affiliate, and including affiliates in definition of broker and dealer, for purposes of SIPC membership); Securities Acts Amendments of 1964, 78 Stat. 565, 565 (1964), 15 U.S.C. 78c(a)(19) (adopting Investment Company Act definition of "affiliated person" for 1934 Act).
12 Business Roundtable v. SEC, 905 F.2d 406, 411 (D.C. Cir. 1990).
13 65 Fed. Reg. at 43150 n.14.
14 Nor can the Commission argue that it is performing the traditional agency function of filling in a regulatory gap left by Congress (see Nationsbank, N.A. v. Variable Annuity Life Ins., 513 U.S. 251, 257 (1995)) where an affiliation involves less than five percent ownership and an absence of overlapping leadership but may threaten independence. To the contrary, Congress anticipated this concern in the Holding Company Act and the many other contexts in which Congress has elected to apply that Act´s definition of "affiliate." Thus, Congress has authorized the SEC to find affiliations in specific cases where the ownership and overlapping leadership tests are not met, but only after the SEC gives the parties notice and an opportunity to be heard, and then makes specific factual findings with respect to those particular parties. 15 U.S.C. ' 79b(a)(11).
15 Daniel R. Fischel, Multidisciplinary Practice, 55 Bus. Lawyer 951, 962 (2000).
16 J. Gregory Jenkins & Kathy Krawczyk, Perceptions of the Relationship Between Nonaudit Services and Auditor Independence at 10 (available at www.sec.gov/rules/proposed/ s713000/krawczy1.htm).
17 Earnscliffe Research & Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity (Nov. 1999) at 15.
18 The Panel on Audit Effectiveness, Report and Recommendations (Exposure Draft, May 31, 2000) at 103.
19 See notes 5, 6, and 11, supra.
20 The testimony of Thomas Gardner, co-founder of The Motley Fool, Inc., regarding the damage the proposed rule would inflict on the accounting sector is equally applicable to law firms: "the problem with untying the meaningful and existing commercial ties between auditing businesses and public corporations is that doing so would act as a strike against value creation for auditors. Any restriction, which in effect forces an auditor to scale back or sell its consulting business, will result in a loss of value. And that loss in value extends not just to executives at auditing companies, but throughout the entire industry. This sort of decline in the value of the auditing function would, no doubt, then repel the best certified public accountants from working as auditors. The net result of that would be a lower quality of auditing and, thus, an increased risk to market transparency." Testimony of Thomas M. Gardner Before the United States Securities and Exchange Commission On Sept. 13, 2000, at 4-5.
21 Alliances between law firms and accounting firms are not unique to those industries. In this global market, joint ventures, cross-selling, cross-licensing, and other collaborative arrangements are key to continued success in the market. A recent study showed that such affiliations account for more than one-quarter of Fortune 500 revenue, up dramatically from just five years ago.
22 See, e.g., Pennsylvania Bar Ass´n Ethics and Prof=l Responsibility Comm. Op. 98-12; Missouri Bar Office of Chief Disciplinary Counsel Op. 96-0124; Kansas Bar Ass´n Ethics Advisory Comm. Op. 95-18; Illinois State Bar Ass´n Advisory Op. on Prof=l Conduct 97-04; Connecticut Bar Ass´n Comm. on Prof=l Ethics Op. 97-36; State Bar of Utah Ethics Advisory Comm. Op. 99-07.
23 See ABA Model Rule of Professional Conduct 7.2(c), which has been adopted in virtually all U.S. jurisdictions.
24 Creation of an affiliate relationship through a "shared benefit" has far greater ramifications than just limiting cross-referral relationships. Take institutional charitable giving. Law firms and accounting firms are regularly called upon to sponsor charitable events and organizations. For example, the "Big Five" accounting firms, along with large Washington law firms, sponsor events at the Kennedy Center, or underwrite exhibits at the National Gallery of Art. Under the proposed definition of affiliate, all of these firms would become affiliates of the other simply by participating in the charity and obtaining the "shared benefit" of the charitable donation, and/or by appearing as a co-sponsor and commingling firm names and logos. Surely the SEC did not intend this absurd consequence.
25 Moreover, the proposed expanded affiliate definition, and the SEC´s concomitant regulation of lawyers in affiliated law firms, would encroach on established state regulatory regimes. Historically, state courts have regulated lawyers and, through lawyers, their law firms. Courts are resistant to "federalize" state regulatory authority, absent otherwise constitutional Congressional action. Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 479 (1977) ("Absent a clear indication of congressional intent, we are reluctant to federalize the substantial portion of the law of corporations that deals with transactions in securities, particularly where established state policies of corporate regulation would be overridden").
26 In re Tarnowsky, 1993 SEC LEXIS 1778, at *11-12 (July 15, 1993).
27 1993 SEC LEXIS at *11.
28 In re Wahl, 1991 SEC LEXIS 1915, at *5 (Sept. 30, 1991).
29 American Trucking Ass´ns v. EPA, 175 F.3d 1027, 1034 (D.C. Cir.), modified on other grounds, 195 F.3d 4, 6-7 (D.C. Cir. 1999) (requiring agency to spell out "intelligible principle" limiting its discretion), cert. granted, 120 S. Ct. 2003 & 2193 (2000).
30 65 Fed. Reg. at 43160 & n.131 (citing Codification ' 602.02.b.iii); id. at 43190 (proposed rule 210.2-01(c)(i)(D), "investment in audit client").
31 The only expert authority on which the SEC relies for its expansive definition of "mutuality of interest", R.K. Mautz & Hussein A. Sharaf, The Philosophy of Auditing 222 (1961), undercuts, rather than supports, its contention. For Messrs. Mautz and Sharaf, mutuality of interest raises independence concerns only when it is "significant." Id. at 222. They conclude that "[t]he case for the performance of management services by public accountants is a simple one and a strong one, . . . [while] [t]he case against . . . is neither so simple nor so strong." Id. at 218-19. The authors further observe that "[a]ny attempt to restrict the practice of public accounting firms to auditing or to other services, whether by rules of conduct or voluntary action . . . might well be the remedy that would kill rather than cure. We do not recommend it." Id. at 229. Indeed, the authors relied on by the SEC support the creation of affiliate relationships: "A second step, to be taken more leisurely, will separate partners into audit partners and others." Id.
32 Long arm of the law: The Big Five may be right that clients want them to move into legal services, Fin. Times (London), Sept. 9, 1999. Countries outside the United States have already recognized the benefits of combining legal and non-legal services in a single firm. Among other places, the United Kingdom, Canada, and Australia have all taken steps to allow partnerships between lawyers and non-lawyers. Updated Background and Informational Report and Request for Comments, ABA Commission on Multidisciplinary Practice 3 (Dec. 15, 1999) (available at www.abanet.org/cpr/febmdp.html).
33 Fischel, Multidisciplinary Practice, 55 Bus. Law. at 963; see also Letter from William R. Kinney, Jr., Professor, McCombs School of Business, University of Texas at Austin, to Jonathan G. Katz, Secretary, Securities and Exchange Commission 1 (Sept. 12, 2000) ("Proscribing [non-audit] services to audit clients would hamper development of the broad perspective auditors need to be able to recognize and protect investors´ interests in a period of rapid change and global competition").
34 Proposed ' 210.2-01(c)(4)(i) provides: "[e]ven if the audit client accepts ultimate responsibility for the work that is performed or decisions that are made, an accountant is not independent under the standard of paragraph (b) of this section when the accountant provides certain non-audit services to an audit client or an affiliate of an audit client, such as: . . . (I) Legal services. Providing any service to an audit client or an affiliate of an audit client that, in the jurisdiction in which the service is provided, could be provided only by someone licensed to practice law."
35 Norman S. Johnson, Commissoner, SEC, Remarks at the Practicing Law Institute´s SEC Speaks 3 (Feb. 26, 1999) (available at www.sec.gov/news/speeches/spch256.htm); see also 65 Fed. Reg. at 43172 n.179 (citing Letter from Lynn E. Turner, Chief Accountant, SEC, to Sherwin P. Simmons, Chair, Commission on Multidisciplinary Practice (Jan. 22, 1999)).
36 The AICPA Code of Professional Conduct B the chief source of an auditor´s ethical duties B recognizes that audit firms provide non-audit services involving client advocacy and rejects a bright line prohibition on such services. Where "there is some possibility that some requested professional services involving client advocacy may . . . pose an unacceptable risk of impairing the reputation of the member and his or her firm with respect to independence," the Code directs that "the member and the member´s firm should consider whether it is appropriate to perform the service." AICPA Code of Professional Conduct Interpretation 102-6 (ET ' 102.07) (emphasis added). The Code, in other words, does not require an accounting firm to refrain completely from providing services that require it to advocate for an audit client.
37 See 65 Fed. Reg. at 43172 ("[t]he proposed rule would not affect tax-related services provided by auditors to their audit clients").
38 At least one scholar very well versed in these issues B the Dean of the University of Chicago School of Law B has concluded that the potential threat that a lawyer would fail to communicate material information to the client´s auditor is less likely to occur when the lawyer and auditor are in affiliated firms than when they are in separate, unaffiliated firms. See Fischel, Multidisciplinary Practice, 55 Bus. Law. at 964.
39 This potential threat is further circumscribed by the ethical duties of lawyers to the public. Although lawyers have an ethical obligation to keep confidences, they may not assist their clients in hiding information from an auditor or from a public tribunal. Lawyers B like auditors B have a duty to the investing public not to misrepresent or omit material matters, as well as a duty to prevent their clients from doing so. See American Bar Association Statement of Policy Regarding Lawyers´ Responses to Auditors´ Requests for Information, in Auditor´s Letter Handbook 10 (ABA 1976) ("The lawyer has an obligation not knowingly to participate in any violation by the client of the disclosure requirements of the securities laws."). If a lawyer learns of problems that he believes should be disclosed to the auditor but the client refuses to make the disclosure, the lawyer may be required to resign from the engagement. See American Bar Association Statement of Policy Regarding Lawyers´ Responses to Auditors´ Requests for Information ("the lawyer also may be required under the Code of Professional Responsibility to resign his engagement if his advice concerning disclosures is disregarded by the client"); AICPA Codification of Statements on Auditing Standards, AU ' 337.11 (SAS No. 12).