From: Bernard Wolfman [wolfman@law.harvard.edu] Sent: Wednesday, December 11, 2002 12:22 PM To: rule-comments@sec.gov Subject: File No. S7-49-02 The Commission's proposed amendments to existing auditor independence rules are commendable. They take steps designed to foster and secure auditor independence, but they can and they should go further than they do if the investing public is to be reasonably certain that auditors are independent, free of the conflict-of-interest that exists when auditors engage in non-audit activity, in so-called consulting. I have set forth below the short piece I published on this subject in U.S. Law Week on August 13, 2002 at p. 2083. It sets out problems that the Commission's proposals do not treat, and it recommends what the Commission might do if it is minded to assure auditor independence. To assure auditor independence the Commission must require that auditors of public companies stick to auditing, leaving consulting (including all tax services other than return preparation and compliance work) to others. The Big Four and many other public company auditors are not now independent. The Commission has the power and the obligation to require that they become so. The views expressed above and in the piece below are personal to Bernard Wolfman are not necessarily those of the Harvard Law School or Harvard University. "Sarbanes-Oxley' Needs Fixing By Bernard Wolfman "Bernard Wolfman is the Fessenden Professor of Law at Harvard Law School, where he teaches and writes on federal income taxation and on standards of tax practice. "On July 30, 2002, President Bush signed the Sarbanes-Oxley Act of 2002, a law designed in large part to assure the public that the certified financial reports of public companies are reliable. To do so it seeks to eliminate auditor conflict, an important goal that the Act will not achieve unless Congress amends it in two significant respects. "Although it should go without saying, and as recent shameful events remind us, the obligation of an auditor is to maintain a single focus, with a loyalty that is undivided. The auditor's service and fidelity must be dedicated to the public investor and not to the company it is auditing. To that end the Act prohibits an auditor from performing non-audit services for its audit clients. In listing the non-audit services that it covers, the Act includes "legal services and expert services unrelated to the audit," services that are often grouped under the term "consulting." The Act does, however, permit an auditor to provide tax services to its audit client if the company's audit committee gives its approval. The purpose of tax advice and tax planning in connection with a company's prospective transaction is, of course, to save it taxes. Frequently such consulting activity is successful, and it attains its objective legitimately, but at times it does so questionably or even illegitimately. The line between the questionable and the legitimate is sometimes clear, sometimes fuzzy. Tax Services Should Be Banned "Those who sell tax shelter plans to corporations do so for big dollars. When it can find them, the IRS will often have reason to disallow the shelters and will do so. Investors and prospective investors in those companies should be able to tell from looking at a company's financial statements whether the auditor thinks that the tax shelters in which the company has invested are vulnerable to IRS attack. If the auditor thinks so, it should make sure that the company's reserve for taxes is large enough to account for the additional taxes the company may have to pay if the IRS disallows the shelter. At the least, a footnote to the financials should note the prospect. No auditor who has sold a company a tax shelter or other tax minimization plan should audit that company because clearly the auditor would be conflicted. Either the auditor would have to indicate that the plan it sold the client was vulnerable or it would have to hide something from public investors that they need to know. Just as the prohibition of an auditor's rendering non-tax expert services to an audit client may not be waived by the audit committee, so the conflict posed by tax planning should not be subject to waiver. There is too much at stake to permit otherwise, and the Act should be amended promptly to correct this flaw. The amendment should not ban an auditor's tax services other than those involving transactional tax advice and planning, since there is no need to prohibit an auditor's preparation of tax returns or its performance of tax compliance work for its audit clients. Other Consulting Services Too "Although auditors are prohibited from performing non-audit services for audit clients, the Act allows them to do so for everyone else. At first blush this may sound reasonable, yet it is anything but. A serious problem lies in the fact that the Big Five accounting-consulting firms are dominant when it comes to the audit of public companies. The Big Five audit more than 90 percent of them. Moreover, all five sell essentially the same types of consulting services and products. Even those that proclaim that they have rid themselves of much of their consulting activity have retained all of their tax consulting. And so, for example, if Deloitte and Touche audits Coat Co. and sells a tax shelter plan to Hat Co., audited by KPMG, there would be no violation of the law. But to allow that result would be naive at best because Arthur Andersen or Ernst & Young or KPMG or PwC has sold Coat Co. a tax shelter similar in all major respects to the one that Deloitte sold to Hat Co. It would, therefore, be unlikely, indeed bizarre, for Deloitte to require Coat Co. to footnote the vulnerability of the plan it bought from, say, PwC, when Deloitte has been marketing the same kind of shelter to Hat Co. as well as to every other company that it does not audit. The reality is that conflict of interest is present whenever the auditor of a public company renders non-audit services to anyone, not just to its audit clients. "As enacted, Sarbanes-Oxley will fail to secure auditor independence, but a simple amendment will correct the failure. First, the amendment should include tax services (other than return preparation and compliance work) among the expert services that are prohibited to auditors, not permitting the prohibition to be waived by an audit committee, just as all the other expert services may not be waived. Second, the amendment should prohibit an auditor from performing non-audit services for anyone, not just for its audit clients, thereby requiring that auditors stick to their auditing." "Copyright © 2002 by The Bureau of National Affairs, Inc., Washington D.C." Bernard Wolfman Fessenden Professor of Law Harvard Law School Cambridge, MA 02138 Tel: (617) 495-4623 Fax: (617) 496-4002 ___________________________________________________________________________ From: Bernard Wolfman [wolfman@law.harvard.edu] Sent: Wednesday, December 11, 2002 3:01 PM To: rule-comments@sec.gov Subject: File No. S7-49-02 - follow up As a follow-up to my Comment submitted earlier today, I am setting forth below an excerpt from an email I received from a lawyer in a major Texas law firm after he read an earlier version of the piece I included in my Comment: "At XXXX, we have had experiences similar to those that you describe: a big five firm selling a "product" that looks identical to the product that the other big five firms are selling. In fact, some of our clients have seen presentations from one accounting firm and liked the product, but then contacted another one of the big five that they know to be cheaper and asked to see the same product. "Over the last several months, XXXX has been asked to review for clients several different products that the big five firms were selling. When we have raised issues (e.g., do the fast pay stock regulations apply to section 304 transactions), we have frequently heard the response "it is the firm's position that . . . ." This, I think, is precisely what you are referring to in your article. Every big five firm has a vested interest in the products that the others are selling, whether or not such firm is the firm that sold the product to the company it is auditing."