Testimony of Charles C. Cox, Lexecon Inc.
The U.S. Securities and Exchange Commission
September 20, 2000
Revision of the Commission's Auditor Independence Requirements

Mr. Chairman and Commissioners:

My name is Charles Cox. I am a Senior Vice President of Lexecon Inc., a consulting firm that specializes in the application of economics to a variety of legal and regulatory issues. I served as Commissioner of the U.S. Securities and Exchange Commission from 1983 to 1989. I was Acting Chairman of the SEC during 1987, and Chief Economist of the SEC from 1982 to 1983. Before joining the SEC, I was a professor in the Economics Department at Ohio State University and in the College of Business at Texas A&M. I served from 1990 to 1993 as Chairman of United Shareholders Association, a nonprofit, nationwide organization that advocated shareholder rights and management accountability to shareholders.

Thank you for giving me the opportunity to testify before you today about the revision of the Commission's auditor independence requirements. The proposed rule would, among other things, identify certain non-audit services that "if provided to an audit client, would impair an auditor's independence."1 I have been asked by Arthur Andersen, Deloitte & Touche, KPMG and the American Institute of Certified Public Accountants ("AICPA") to comment on these proposed amendments.


In my opinion, the SEC has failed to analyze the costs and benefits of its proposal, and the best analysis possible under the time constraints imposed by the SEC fails to support the proposal. It is also my opinion that the SEC could adopt a much less intrusive set of regulations that would address its concerns about auditor independence while allowing the competitive marketplace to determine the appropriate degree of separation between audit and consulting services.

There is No Evidence of a Problem or Benefits from the Proposed Rule

The SEC proposal represents a major change that would affect thousands of public companies in the United States, billions of dollars of consulting services and tens of thousands of consulting and auditing jobs. Yet the Commission fails to cite even a single piece of concrete evidence that a problem exists. Instead the Commission appeals to "common sense," arguing that "there can be little question about the effect of these impairments [from the provision of non-audit services] on investor confidence. Gradual decreases in investor confidence may not be measurable, but their cumulative economic impact could not be more palpable."2

This "evidence" cannot justify a sweeping regulatory change. First, "common sense" suggests that, while the U.S. securities markets may suffer from certain faults (possibly including "irrational exuberance"), they certainly do not suffer from a lack of investor confidence. On the contrary, the growth of consulting income at accounting firms has taken place during a period when participation in equities markets by individuals, both directly and through mutual funds, has reached new heights, and during a period when U.S. companies have been able to raise unparalleled quantities of new capital. There is simply no evidence that investors have lost confidence in U.S. equity markets.

The lack of investor concern about auditor independence should come as no surprise, because there is also no reliable evidence that consulting by accounting firms or their affiliates inhibits honest financial reporting by public companies or effective audits by accountants. The U.S. financial and legal systems provide powerful disincentives to fraud, including an aggressive enforcement program at the SEC and an extremely active and aggressive plaintiffs' bar.

The experience of other countries also fails to support the SEC's claim. While the U.S. and the U.K. both allow auditors to consult with their audit clients, such consulting is banned in certain other countries, including France, Italy and Japan. Yet it is widely believed that financial reporting in these markets is less transparent and satisfactory than financial reporting in the United States. And certainly equity markets in these countries play a less important role in corporate finance and attract less individual participation than does the U.S. market. Of course there are vast differences among these countries, but the fact remains that they provide no support for the SEC's view that consulting by the auditing firm has handicapped the U.S. market.

Evidence from the U.K. also fails to support the SEC's theory that restricting consulting activities by auditors would allow issuers "to attract capital at lower rates of return."3 For example, the U.K. imposes a reporting requirement as to consulting services purchased, and U.K. firms appear to purchase a higher percentage of consulting from their auditors than do U.S. firms. Again, there is simply no evidence that either firms or investors view this consulting for audit clients as a material conflict of interest.

Costs of the Proposed Rule Should Be Measured

The SEC does not even attempt to measure the costs of its proposal. Accounting firms have consistently built large and profitable consulting businesses. Such economic success does not occur at random - it follows from low costs and economic efficiencies. Furthermore, even when accounting firms have "spun off" parts of their consulting operations, they have typically kept substantial pieces of the business and have continued to act as "incubators" for new consulting operations. The kind of efficiencies that drive this repeated, consistent success can be expected to provide lower costs to customers, profits to the consultants, and career opportunities that help audit firms attract high-quality employees. These economic advantages would be eliminated or substantially reduced by the SEC proposal.

In addition, the SEC proposal could reduce the number of effective competitors providing audit and consulting services for a given public company. Many public companies employ multiple consultants. If firms are not allowed to purchase consulting services from their auditors, then a public firm in the market for a nationally recognized auditor might often find at least several of the five potential candidates unavailable. For example, if a major audit client currently uses three of the major five accounting firms as consultants, the proposed rule could effectively force the audit client to choose between the two remaining accounting firms for its auditor.

The SEC proposal also would create an ambiguous and open-ended regulatory framework that is likely to impose a large and complex regulatory burden. Ambiguous regulations - such as the proposal that accounting firms cannot implement a hardware or software system "that is or will be used to generate information that is significant to the audit client's financial statements as a whole" - create costs because firms must re-design their businesses to meet the requirements and must litigate the inevitable disputes. Because accounting firms earn billions of dollars from their consulting operations, ambiguous rules are likely to result in substantial costs of "avoidance" and litigation. The enormous resources spent by U.S. firms to minimize taxes provides a sobering example of the costs created by complex and ambiguous rules.

As has been widely documented by the economic literature, the greatest costs of regulation are often the "unintended consequences" of well-intentioned rules. In particular, regulation inevitably reduces the ability of businesses to adapt and change as their environment changes, since regulation rarely keeps pace with changes in technology and commerce. U.S. accounting firms presently have world-class technical and business skills and attract large numbers of highly qualified employees - in no small part because of their consulting activities. Regulations that suppress or handicap these advantages could easily have significant unintended consequences, both on audit quality and on the U.S. economy in general. Certainly the open-ended nature of the proposed regulations increases the likelihood of unintended consequences.

The SEC proposal reflects a "command-and-control" mindset that is both unnecessary and counterproductive. If investors displayed material concern over auditor independence, then firms would have an incentive to publicly announce policies of not hiring their auditors for consulting - since these policies would presumably give them easier access to capital markets. Furthermore, auditors might find it efficient to spin off all or most of their consulting businesses, since that would make them more attractive to their audit clients. In general, the market should find the "right" level of consulting by accounting firms. The regulatory process has no such self-correcting features.

Although I have not, in the time available, been able to estimate the likely costs that the proposed amendments will impose on the U.S. economy, the magnitude of these costs could be substantial. For example, if audit clients are forced to switch consultants by the proposed amendments, they will have to turn to higher-cost or lower-quality consultants. Suppose that these audit clients' consulting costs would go up by one to two percent as a result. Then because these firms paid about $3 billion in consulting fees to their auditors in 1999, these firms would have incurred additional costs of $30 to $60 million year in 1999. And if consulting continues to grow in importance, these costs would continue to increase in the future. Furthermore, if the proposed amendments raise the costs of an audit by one to two percent, total audit fees in the U.S. economy would increase by $90 to $180 million per year. Some portion, or all, of these costs would eventually by borne by shareholders.

Disclosure is a Less Costly Alternative

The SEC has not made a case for why any change is necessary, particularly in light of the recent enhancements in the involvement of corporate audit committees in safeguarding auditor independence. But the SEC plainly has failed to demonstrate the need to go any further than a disclosure approach. If the SEC feels compelled to impose new regulations, it could employ a disclosure approach, as does the United Kingdom, which requires firms to disclose the amount they spend to purchase consulting services from their auditors, but does not prohibit such purchases. U.S. securities regulation relies on a fundamental premise - that accurate disclosure and reporting will permit investors to reach efficient decisions. There is, thus, no justification to go forward with a command-and-control set of regulatory prohibitions.


1 65 Fed. Reg., 43,148.

2 65 Fed. Reg., 43,155.

3 65 Fed. Reg., 43,184.