Testimony of Professor John C. Coffee, Jr.
Adolf A. Berle Professor of Law
Before the
Securities and Exchange Commission
July 26, 2000

Gatekeepers and the Concept of Auditor Independence

As a non-accountant, I will humbly attempt to stay within my own turf and focus on the concept of auditor independence from a securities law perspective. Although I am supportive of the Commission's proposals, as articulated in Securities Act Release No. 7870 (June 30, 2000), I think that the concept can be more clearly defined and that the inevitable line drawing problems that the Commission faces should be more closely related to the fundamental concept that the Commission is seeking to articulate.

Early in Release 7870, the Commission notes that "the federal securities laws ... make independent auditors `gatekeepers' to the public securities markets." (2000 SEC LEXIS 1389, *11). Correct as this statement is, it is useful to spend a moment defining the "gatekeeper" concept. As used today, the term "gatekeeper" refers to a strategy for law enforcement which posits that it is sometimes easier and less costly to deter the agent than the principal.1 Because the corporation and its controlling officers and shareholders may anticipate substantial gains (or hope to avert substantial losses) from materially misleading disclosures, they are often not easily deterred. High penalties on the firm also fall on innocent shareholders. But outsiders, who expect only modest gains, have less incentive to acquiesce in fraud and thus are more easily deterred. To the extent that the cooperation or acquiescence of such an outside agent is legallymandated before a transaction can be consummated, such agents make the ideal gatekeeper.

By definition, then the ideal gatekeeper is an outside agent who combines three elements: (1) the agent's approval is legally mandated so that his or her non-acquiescence frustrates any attempted fraud and is a condition of the principal's continued access to the capital markets; (2) the outside agent faces a significant risk of liability for failure to detect and prevent an unlawful or non-complying transaction; and (3) the agent expects only modest gains from the principal for giving its approval. Such an agent who faces both legal liability and a loss of reputational capital that is greater than any economic gain derivable from acquiescence makes that ideal and incorruptible gatekeeper. No one -- not the attorney, the underwriter, the outside director or others who are also assigned legally mandated duties as external agents to the corporation -- fits this idealized definition more closely than the independent public accountant.

Yet, as the Commission notes in Release 7870, the world is changing. Much of the narrative in Release 7870 describes the ways in which the contemporary auditing firm has moved from providing a single service at relatively modest cost to becoming a multi-faceted vendor of business advisory services. Put bluntly, this means that the potential economic gains from acquiescence have grown. Yet, this is only half the story. The other side of the coin, less noted by Release 7870, is that the potential liabilities facing the auditor for acquiescence have also recently shrunk. The bottom line is that the margin between the expected costs and the expected benefits from shirking one's duty as a gatekeeper has been dangerously narrowed.

At least four developments have produced this reduced threat of legal liability for the auditorwho fails to perform its task as a corporate monitor:

(1) The Private Securities Litigation Reform Act of 1995 (the "PSLRA") erected substantial pleading barriers that particularly work to the advantage of the auditor because it is difficult to plead facts giving rise to a "strong inference of fraud" on the part of the auditor at the outset of the case; also, some Circuits have begun to require a showing closer to actual knowledge than to traditional recklessness in order to satisfy the requisite scienter requirement under Rule 10b-5.

(2) The PSLRA also substituted proportionate liability for joint and several liability as the normal standard of damages under the Securities Exchange Act of 1934, and this change works particularly to the advantage of auditors, who, even if culpable, are usually much less so than members of management.

(3) The Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), eliminated liability for aiding and abetting a securities law violation as a potential cause of action that an auditor could face in private litigation. This theory of liability had been the preferred weapon of the plaintiffs' bar in Rule 10b-5 litigation against accountants. Although the SEC has regained the right to sue for some "aiding and abetting" violations pursuant to the PSLRA, private parties have not.

(4) Although securities fraud litigation in state court came to be a substantial risk for accountants in the 1990's, that risk was effectively ended in 1998 by the passage of the Uniform Standards Act, which preempted assertions of state or common law based securities fraud actions both in state court and in federal court as well).

As a result, although litigation involving accounting irregularities remains common (and, by sometabulations, may even have increased since the PSLRA), accounting firms are rarely defendants in these suits. The bottom line is that the risk of litigation has substantially eroded in recent years - at least as that risk applies to the auditing firm.

I do not suggest that this reduction in liability risk for accountants is necessarily undesirable. Personally, I supported (and do support) the substitution of proportionate liability for joint and several liability. But an inevitable byproduct of this transition is a narrowing of the margin between the expected costs and the expected benefits to the auditor from deferring to the audit client's recurring desire to inflate revenues or suppress costs. Hence, the ideal gatekeeper is somewhat less incorruptible.

As a practical matter, there is little that the Commission can do as about the overall decline in the legal threats facing an auditing firm that misbehaves. But precisely for this reason, the Commission has correspondingly more reason to be concerned about the increased incentives to acquiesce in accounting irregularities that accompany the growth in non-audit services as a percentage of the total revenues of auditing firms. Thus, prophylactic limitations on the ability of auditing firms to market non-audit services to auditing clients makes sense -- less as the ideal regulatory tool than as the best available mechanism.

Against this backdrop, let me turn now to proposed Rule 2-01 and its most critical provisions, namely subparagraphs (c)(3) and (c)(4). Proposed Rule 2-01(c)(4) identifies certain "tainted" professional services that cannot be provide to an audit client without impairing the auditor's independence. Because it basically sets forth a laundry list of forbidden services, it is inherently both underinclusive and overinclusive. To be sure, there are certain common denominators linking theseforbidden services, and the paradigmatic problem seems to be that of self-grading: the accountant should not be reviewing its own work product. But not all the forbidden services share this characteristic to the same extent. For example, I find the "human resources" exclusion (i.e., proposed rule 2-01(c)(4)(i)(G)) somewhat overbroad. The auditing firm that prepares a standardized exam to determine if a client's employees properly understood certain regulatory rules (hypothetically, whether brokerage employees understand the NASD's requirements applicable to them) is not truly placing itself in a compromising position; nor does it have in my judgment a clear "interest in the success of the employees that the auditor has selected, tested or evaluated." (2000 SEC LEXIS 1389, * 154).

Conversely and more importantly, the list of forbidden professional services in proposed 2-01(c)(4) is very underinclusive. Ultimately, it does not matter what the particular service is, so long as the aggregate of these non-audit services produces income in excess of (and potentially a multiple of) the firm's auditing revenues from the audit client. Once the auditing firm sees the potential of increasing its revenues from the audit client by a multiple of its current billings, then it is the rational self-interest of the auditing firm to convert the partner or partners in charge of this client into effectively a vendor of advisory services and to compensate such partners in proportion to their success at cross-selling those services. This places both economic pressures on the auditing partner and also more subjective, psychological pressures to the extent that the partner's loyalty to his firm leads the partner to see maximizing these cross-selling opportunities and revenues as part of his or her duty to the firm. Ultimately, this can erode the auditing partner's professional independence.

Nor are these claims merely theoretical. Real world examples can be identified where such pressures appear to have been determinative. Professors Bazerman, Morgan and Lowenstein point tothe massive scandal at Phar-Mor, Inc., the largest drug store chain in the United States which went bankrupt in 1992. The audit partner of the "Big 5" accounting firm that handled the Phar-Mor account was, they suggest, "hungry for business because he had been passed over for additional profit sharing in 1988 for failing to sell enough of the firm's services." A year later, in 1989, he began selling non-audit services to close relatives of Phar-Mor's CEO, who ultimately went to prison for fraud. See Bazerman, Morgan, and Lowenstein, "The Impossibility of Auditor Independence," Sloan Management Review (Summer 1997) at p. 89. Such a relationship is exactly what Rule 2-01(c) intends to prevent. Having served as an expert witness in the Phar-Mor case for the outside director defendants, I am familiar with the facts of that case and also believe that the accountants were strangely passive and unquestioning, despite numerous flags and warning signals.

What response then is appropriate? I believe proposed Rule 2-01(c)(4) should use an additional aggregate test under which an auditor would not be independent of a particular audit client if its non-audit revenues from the client exceeded some percentage of the firm's auditing revenues from the same client. The precise percentage (whether it is 50% or 100%) is of secondary importance. This is because the real function of such a rule is to reduce the firm's expectation of non-audit revenue from an auditing client, thereby re-establishing the margin between expected costs and expected benefits that makes the gatekeeper incorruptible.

Put differently, today an auditing firm that has revenues from non-audit services equal to only 25% of its audit from a particular client may still anticipate future revenue growth from non-auditingservices that could vastly exceed its future growth in auditing revenues.2 At this point, even if the firm's audit revenues from the client currently exceed its non-audit revenues by a margin of 10 to 1, the same incentives arise, because it is the expectation of future revenue growth that makes the gatekeeper vulnerable to economic and psychological pressures. Hence, the key attraction of a rule that simply stated that revenues from non-audit services to a particular client may not exceed audit revenues is that it would place a clear ceiling on those expectations, thereby minimizing temptation.

If such a rule were adopted, it might also be possible to scale back some of the "tainted" categories in proposed rule 2-01(c)(4), where those categories do not involve clear conflicts or "self-grading." Nonetheless, I agree that the undesirability of an auditor reviewing its own firm's work product should be an independent basis for finding the auditor not to be independent. Thus, for example, the prohibition on "human resources" services in proposed rule 2-01(c)(4)(i)(G) is much less important (and could be deleted) if there were an aggregate limitation on non-auditing services.

By the same token, it is not clear to me that the Commission's asserted distinction between the prohibited professional services in paragraph (c)(4) of the proposed rule and tax services, which are permissible, truly holds up. The same problem of self-grading exists here also if the auditor realizes (or should realize) that a tax position recommended by (or even a tax shelter marketed by) the auditor's firm may have materially distorted the client's reported results. The incentive to be non-critical and look the other way is equally powerful in such a case, as in the case of valuation or bookkeeping services. But, rather than prohibit such tax services, which I recognize have long been provided byaccounting firms, it would be far easier to include them within a generalized basket and subject all such non-audit services to a ceiling equal to auditing services revenues (or some significant percentage thereof).

What would be the cost of such a rule? At most, it might cause some auditing firms to cease serving as an auditor to a potentially lucrative client in order to instead market non-auditing services to that client. But the harm or loss here seems minimal. In all likelihood, some Big Five firms that anticipated significant revenue growth from non-audit services for a particular client might abandon the auditing role and even exchange that role with another similarly situated "Big Five" (or similar) accounting firm. All that would be sacrificed here would be the opportunity to cross-sell the firm's services from a base as the client's auditor (and that is precisely what is dangerous).

I anticipate the reply from industry representatives, however, that performing such multiple roles is efficient and improves the quality of the audit services provided. Although critics have been quick to demand empirical proof and studies that justify the Commission's proposed rule, it is precisely this more speculative contention that the performance of non-audit services improves the quality of audit services that most needs empirical support. In any event, demands that the Commission not act until it could show that empirical studies justify its proposed reforms have been heard on every occasion that the Commission has addressed corporate governance issues since the Commission first persuaded the New York Stock Exchange to adopt a mandatory audit committee rule in the mid-1970's. Although I certainly favor empirical scholarship on corporate governance issues, it cannot be a precondition to the SEC action, because it is remarkably hard to conduct such studies in a manner that renders them relevant to rapidly changing current conditions. Only recently within the past two years have the firstempirical studies appeared that evaluate the impact of independent boards and directors -- more than 25 years after such reforms became standard.

To sum up, I support the thrust of proposed rule 2-01, but would recommend some simplification of rule 2-01(c)(4)'s proposed laundry list of forbidden professional services. The most important reform would be to impose an aggregate limitation on non-audit services whose ceiling would be set in relation to the auditing revenues from the client. Such a role would keep the auditing role paramount (at least for auditing clients) and would prevent auditing services from otherwise deteriorating into the loss leader by which a multi-service business advisory firm attracted and held its clients.


1 For an overview, see Kraakman, Corporate Liability Strategies and the Cost of Legal Controls, 93 Yale L.J. 857 (1984).
2 Indeed, as Release 7879 correctly notes, the rate of growth on non-auditing services has been explosive and has vastly outdistanced the growth in auditing revenues.