Amsterdam, 20 September 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609.
Re: File No. S7-13-00, Proposed Auditor Independence Rule
Dear Mr. Katz,
I am a partner in Holland Van Gijzen Advocaten en Notarissen, a law firm based in the Netherlands. Since 1997, I am also chair of a group of international law practices associated with Ernst & Young International, which I shall refer to in this letter as the Law Practices. On behalf of my own firm and the Law Practices, I am very pleased to submit this comment letter in response to the Commission's proposed revision of its rules on auditor independence.
My law firm, Holland Van Gijzen, consists of more than 150 attorneys and civil law notaries with offices in major cities throughout the Netherlands. It is an independent law firm managed by its own partners. It also works on a regular basis with other firms that together comprise the Law Practices.
The relationship of the Law Practices to the Ernst & Young audit practice varies from country to country. In some countries, the law practice is closely integrated with the audit practice. In others, there is a more distant relationship. In still others, there are no managerial ties or sharing of revenues between the audit and law practices. If applicable the law practices are organized according to the regulation issued by a country's (region, canton, etc.) respective Law Society or Bar Association.
We are certain that the Commission will receive many comments on the proposed rule from interested parties within the United States. In this letter, we seek to focus on matters as to which my firm and the Law Practices may have a unique perspective.
Our Experience In Providing Legal Services to Audit Clients
As we understand it, the proposed rule would largely, if not completely, prohibit the provision of legal services by any of the Law Practices to a client .) and to affiliates of that client .) if the client is a registrant of the Commission and is audited by Ernst & Young. We thought it might be helpful to the Commission in evaluating the need for such a rule to consider the experiences that the Law Practices have had to date in providing legal services to audit clients.
There are few restrictions on the Law Practices', provision of legal services to Ernst & Young audit clients that are not registrants of the Commission. For most of our clients, there are no rules prohibiting or even restricting the provision of legal services. In some cases, certain types of legal work (such as representation in court) may be precluded, but most types of legal services may still be provided. Accordingly, the Law Practices perform a substantial amount of legal work for clients that are audit clients of Ernst & Young, but that do not have U.S.-registered securities.
To a more limited extent, the Law Practices also provide legal services to foreign subsidiaries and affiliates of audit clients of Ernst & Young that do have U.S. registered securities. They do so based on our understanding of guidance provided informally by the Commission's staff in 1994. Among other factors, the work must be routine or immaterial; it must not violate any other independence restriction; and it must be permitted by the laws of the foreign country in question.
The Law Practices have every incentive to be alert to instances in which there might be signs of incompatibility between our services and those of the Ernst & Young auditors. For us, this is a matter not only of the integrity of the markets but also of our own professional well-being. It would be to our own detriment for us to provide any services in a manner that would threaten the audit function. Among other factors, diminishing the value of an audit could only erode the value of our association with an organization of public accountants.
Although no precise count is available, it is fair to say that the Law Practices combined have provided legal services to hundreds, if not thousands, of Ernst & Young audit clients on many thousands of occasions. In all of these instances, despite being alert to the possibility of such a case, we are aware of no case in which the provision of legal services by a Law Practice has in any respect negatively affected the audit, or has even been accused of doing so. In particular, we are aware of:
We believe that this positive experience strongly supports the view that a prohibition on an audit firm or affiliate providing legal services to an audit client is unnecessary. At a minimum, it suggests that the Law Practices should be permitted to continue providing the same scope of legal services to Ernst & Young audit clients that they have heretofore provided without incident.
The Regulatory Approach in Other Countries
The Law Practices have experience with the auditor independence rules in many countries around the world. We find it interesting to note that, to our knowledge, no other country has found legal services, as a category, to be so wholly inconsistent with service as an auditor. We recognize that, in some countries, the role of the auditor or the nature of securities regulation is different than in the United States. In our experience, however, even those countries with securities markets, regulatory regimes, and auditor roles not unlike those in the United States have neither adopted nor proposed auditor independence rules that would prohibit the provision of legal services to audit clients.
A current regulatory initiative in the European Union may be particularly instructive. A working paper of the European Commission's Committee on Auditing addresses many of the same auditor independence concerns that are addressed by the Commission's proposed rule, including certain types of legal services. A comparison of the EU working paper with the Commission's proposed rule makes clear that the broad principles of objectivity and integrity, and of independence in fact and appearance, are the same in both documents. See Committee on Auditing Working Paper, Statutory Auditors., Independence in the EU: A Set of Fundamental Principles, § B.1. Where the documents differ is in how they propose to address these concerns. Although the approaches are similar in some respects, the EU approach places much emphasis on the establishment by each audit firm of an appropriate safeguarding system .) including written policies and procedures, monitoring by top-level professionals, and documentation requirements .) and rather less emphasis on prohibiting specific services. See EU Working Paper § B.4.2.2.
For instance, both the EU working paper and the proposed rule of the Commission recognize advocacy on behalf of a client in adversarial situations as a potential threat to independence. See EU Working Paper § B.3. However, the two documents deal with this potential threat in quite different ways. The Commission's proposed rule appears to impose a flat prohibition on any form of advocacy, although it does not give much definition to the term. It also completely prohibits the provision of any legal services, in part on the theory that all legal services inherently involve impermissible advocacy. The EU proposal, on the other hand, treats the advocacy threat to independence as just that .) a threat .) that the audit firm.,s safeguarding system must be prepared to address and mitigate. Only in the limited case of acting for the audit client in the resolution of a dispute involving matters that, in the aggregate, would be material to the client.,s financial statements, and which involve a significant degree of subjectivity, would the draft EU proposal impose a ban. In this case, the EU working paper notes that a self-review threat, as well as an advocacy threat, would exist. See Working Paper § C.7.2.5.
To us, the Commission's prohibitory .) and to our minds unnecessarily rigid .) approach is quite the opposite of what we would expect from the United States. Although the U.S. regulatory system is tough and effective, we typically find that it is more flexible, and places greater emphasis on self-regulation and market-based solutions, than the approach employed in many other countries. In this case, however, it seems to be the United States that is pursuing the inflexible .&big government.8 approach. This would be understandable if the approach being followed outside the United States was not working .) if there were some reason to believe that only a rigid, hard-line rule completely barring legal services would preserve the integrity of audits. However, we are aware of no reason to believe that. The Commission has not presented any evidence to support such a conclusion, and, as we noted above, we are aware of no such evidence from our own experience.
Although one may reasonably take action to prevent a problem from occurring, rather than acting only after a problem occurs, it does seems to us that the fact that the alleged problem being addressed has apparently never occurred is at least relevant to determining the reasonable approach to addressing the issue. It seems to us that the EU working paper.,s requirement of a safeguarding system, or some similar system of structural safeguards, would be more than sufficient to address any perceived threat to the integrity of audits.
Definition of Affiliate of the Accounting firm
We imagine that the concept of an .&affiliate.8 of an accounting firm will be the subject of much comment. We will briefly add our point of view.
As we read it, the proposed definition of .&affiliate.8 is far too broad or at least too vague. The relationship between a Law Practice and an Ernst & Young audit firm may include merely an agreement to share some costs for shared office space, reception and parking places. In some European cases we know of the relationship including an arm.,s length loan, which is -if applicable- fully disclosed to the country, region or canton.,s regulator (for auditors, for the legal profession or as the case may be the securities markets supervisor). We are not aware of any case where the repayment of the loan is materially dependent on work performed for audit clients. We do not think that these sorts of relationships should be enough to make a law practice into an .&affiliate.8.
We suggest that the concept of safeguarding systems, noted above in the discussion of the EU working paper, should be relevant to determining whether a law practice is an .&affiliate.8. Our experience indicates that the provision of combined services in an integrated MDP (where permitted by Law Society or Bar Association rules) or by an .&affiliated.8 firm does not preclude appropriate firewalls or "silos" of professional knowledge and confidentiality from being maintained. In my own practice in the Netherlands, e.g., we apply a Dutch Bar Association.,s rule whereby putatively shared knowledge can be contained within the law firm permitting it to act without being disqualified for a potential conflict of interest. Similar types of safeguards could be applied within a MDP or between .&affiliated.8 entities, trough appropriate systems to contain abd secure knowledge and to maintain confidentiality and privilege (as may be applicable and appropriate). During our visits to other law practices we always meet a large degree of structural separation, including separate management on professional issues, and to a large extent lawyers and auditors working in different buildings or at (secured) floors. We believe hat the EU working papers.,s requirement of a safeguarding system would properly address any perceived thread to the integrity of audits. .&Legal Services.8 as a Category
The proposed rule defines .&legal services.8 as those that .&in the jurisdiction in which the service is provided, could be provided only by someone licensed to practice law..8 If one must define .&legal services,.8 this is probably the only possible approach. Given the enormous differences from one country to another in what constitutes the practice of law, no single substantive definition would be possible. It should be recognized, however, that the definition would result in extremely wide variations from one country to another in what services may be provided by an audit firm or its affiliate.
In the United States, for instance, advice on tax matters may be offered by certified public accountants and others who are not lawyers. Thus, when applied to the United States, the proposed definition sensibly excludes tax matters from the definition of legal services. But in a number of non-US countries, tax advice may only be given by a lawyer. Thus, the result of the proposed definition would be that in some countries, audit firms (or their affiliates) would be permitted to handle tax matters, and in other countries, they would not.
Conversely, it is also the case that many services that, in the United States, can be provided only by a licensed lawyer are not restricted to licensed lawyers in other countries. In my home country of the Netherlands, for instance, a law degree alone, without a license, is sufficient to practice many areas of the law, including advising on a full range of legal matters, drafting transactional documents and smaller types of first level court cases (employment law; rent or lease real estate).
To us, these differences suggest that prohibiting .&legal services.8 as a category is not a sound approach, at least with respect to non-U.S. services. We cannot envision a reason why it would be good policy to permit an audit firm or affiliate to offer tax services in the United States but not in France, or to draft a real estate deed in Amsterdam but not in New York, merely because in each case the service in question happens to fall under the Commission's proposed definition.
We also believe that much of what might be considered .&legal services.8 does not involve any form of advocacy and poses no conceivable threat whatever to auditor independence. To take one example, we can conceive of no reason why advising a client on the proper interpretation of a law poses any greater threat than advising a client on the proper interpretation of an accounting standard .) something that auditors necessarily do every day.
The Auditor.,s Duty to the Public
The proposed rule suggests that there is an irreconcilable conflict between the auditor.,s duty to the public and the lawyer.,s duty to the client. We believe the conflict, if one exists at all, is purely theoretical. In our experience, such conflicts have not occurred in practice, nor do we expect that they will occur in the future. Proper disclosure to the public .) the job of the audi-tor .) is in a client.,s best legal interest as well. Moreover, lawyers are not permitted to assist their clients in committing a fraud on investors. Although we are not aware of any case we would in practice expect the auditor and the lawyer (at least in those jurisdictions where, notwithstanding an attorney-client relationship exists, the lawyers has a counterbalancing professional duty as an officer of the court) to go to the client to discuss the issue, and in the end they would (or are professionally obliged to) end the assignment with the client if the answer is unsatisfactory.
In addition, whether the lawyer and auditor have any connection with one another would seem to have no bearing on the amount of information that is available to the auditor. Is a lawyer has information that cannot be disclosed to the auditor, that will be the case whether or not the lawyer is associated with the auditor.
The Independence Standards Board
Before the Commission announced its proposed rule, we had been following with interest the consideration of legal services by the Independence Standards Board. The Board had issued a discussion memorandum and had received comments from the public on it. We understood that the next step was to be the preparation by the Board of a proposed rule that would again be circulated for public comment.
It had been our understanding that the Board had been created, with the support of the Com-mission, for the purpose of addressing precisely the type of independence issues that the Commission is now attempting to resolve for itself through the proposed rule. We are confused by this development. With respect to legal services, the Board was in the middle of a deliberate process .) informed by an international task force of accountants, lawyers and others representing many different perspectives .) that would presumably have led, at the end of a process, to a reasoned, carefully drafted, well supported rule concerning legal services. One of the matters being considered by the Board was the extent to which research might be helpful in formulating a rule on legal services. The Board had noted that .&the use of both original and archival research to facilitate the development of principles-based independence standards.8 was part of its mandate. See DM 99-4, Legal Services, Q8, at 24. It had asked for suggestions from the public on existing research, or new research that the Board could commission, that would be beneficial.
We do understand that the Commission has the authority to overrule the Board if it does not agree with its conclusions. However, we do not understand why the Commission found it necessary, with respect to legal services, to circumvent the Board.,s process altogether .) particularly when that process was already well underway. Especially given what appears to us to be the current lack of any evidence to support the Commission's rule, it would seem appropriate for the Commission to allow the Board to complete its process, including pursuing research, rather than preempting that process in midstream.
We appreciate very much the opportunity to submit our comments to the Commission. We would be very pleased to discuss our comments with the Commission or its staff.
Van Gijzen Holland