American Society of Corporate Secretaries
January 13, 2003
Jonathan G. Katz, Secretary
RE: File No. S7-49-02
Dear Mr. Katz:
On behalf of the American Society of Corporate Secretaries, Inc., I am pleased to have the opportunity to comment on "Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence," (the "Proposing Release"). The Society has over 3,800 members representing over 2,500 corporations in the United States and other countries.
The Society recognizes the Commission's objective of implementing the legislative mandate of Title II of the Sarbanes-Oxley Act of 2002 (the "Act"), and supports the Commission's goal of ensuring the confidence of companies, and their investors, in the independence and integrity of public accountants and auditors. Set forth below are suggestions that are intended to clarify the proposed requirements, and eliminate excess administrative burdens, while still supporting the purpose of the proposal.
Given the administrative and logistical changes that will be required in order to comply with several of the proposals, both on the part of companies and their auditors, we urge the Commission to consider reasonable transition periods. We believe that the Commission has the authority to adopt appropriate transition periods, even where it is directed under the Act to adopt final rules by January 26, 2003. Particularly with respect to the proposals on auditor rotation and disclosure of non-audit services pre-approval policies and procedures, as discussed below, we believe it is appropriate for these requirements to first apply to companies in their next fiscal year beginning on or after January 1, 2004. In addition, we recommend that the proposal requiring auditor communications about critical accounting policies and certain other matters should be delayed until the Public Company Accounting Oversight Board has developed standards for such communications. The implementation of reasonable transition periods is further supported by the language of Title II of the Act, which purports to apply the Act's provisions to "registered public accounting firms." Clearly, Congress contemplated that certain of the provisions would not apply until the Public Company Accounting Oversight Board has developed a registration system. Finally, as a result of other requirements of the Act, many companies are reconstituting the membership of their audit committees. We believe that the Commission should allow a reasonable time for these companies to first accomplish this challenging task.
Pre-Approval of Non-Audit Services
We support the Commission's proposal to break out audit fees into four categories, including two new categories. We believe that this approach is logical and will facilitate investors' understanding of the audit fee disclosure. However, not all companies currently have pre-approval policies and procedures in place. Those companies that do have such policies and procedures in place may not have maintained adequate records in the past to make the necessary distinctions to readily disclose the percentage of fees approved under the various approval categories, as contemplated by proposed Item 9(e)(5)(ii) of Schedule 14A. Accordingly, for transitional purposes, we urge the Commission to provide that the requirement to disclose the audit committee's policies and procedures for the approval of non-audit services first apply to filings made in the company's next fiscal year beginning on or after January 1, 2004. We further recommend that the disclosure regarding the percentage of fees approved under the various approval categories be effective with respect to one year of information in proxies for annual meetings to be held two years after the adoption date of the new requirement, and with respect to the two years of information, three years after the adoption date of the new requirement. We believe that a number of companies already track the amount of fees in the four separate categories, however, and can comply with that disclosure requirement for filings made within 30 or 45 days after the date on which the requirement is adopted.
As the Commission acknowledges, Section 202 of the Act includes a broad range of services within the ambit of "auditing services." In the text of the Proposing Release, the Commission states that its proposals consistently "anticipate that the audit committee may approve broadly the provision of audit, review and attest services...." (emphasis added). However, proposed Rule 2-01(c)(7)(i) of Regulation S-X does not, as drafted, reflect the grant of such broad approval. In particular, the proposed rules should provide that the determination of whether a service constitutes an audit service, a non-audit service which may be performed subject to the pre-approval requirements, or a non-audit service which is strictly prohibited shall be made pursuant to the good faith efforts of the audit committee, or those to whom pre-approval authority is delegated.
Similarly, while the Proposing Release provides some clarification of the nature of the policies and procedures that would satisfy proposed Rule 2-01(c)(7)(ii)(B), that guidance is not reflected in the proposed rule itself. The Proposing Release states that such policies and procedures should be "detailed as to the particular service and designed to safeguard the continued independence of the auditor." It is not apparent from the Proposing Release what the Commission envisions with policies and procedures that are "designed to safeguard the continued independence of the auditor." We suggest that the Commission revise proposed Rule 2-01(c)(7)(ii)(B) to give examples of policies and procedures that will satisfy the rule, such as procedures that specify minimum dollar amounts, or minimum percentage amounts as a portion of the auditors' revenues1, of individual and aggregate fees that would require specific pre-approval by the audit committee. Such policies and procedures could also specify types of services that are acceptable, and types of services for which pre-approval is not required, such as consents and comfort letters.
Consider the following scenario that is representative of the type of issues confronted frequently by audit committees. A company's compensation committee is holding an all-day session to consider compensation plan design. Its independent consultant suggests a change to the existing plan. While the compensation committee likes the new plan, it seeks an analysis of the tax impact of the proposed change. The independent consultant can only describe the impact generally, as he or she is not intimately familiar with the specific details of the company, such as its effective tax rate, its projected taxable income or its ability to take advantage of deductions. This situation clearly requires at least a brief consultation with the company's outside tax advisors. The compensation committee would like to approve the change on the day of its scheduled meeting, but the charter of the audit committee requires pre-approval by the full audit committee for such a non-audit service, as contemplated by the proposed rules. (Alternatively, if there were delegation to one person, it is easily conceivable that he or she would not be reachable to obtain pre-approval.) Convening the full audit committee under these circumstances would likely be impracticable.
In order to solve this logistical problem, we recommend that the proposed rules be revised to clearly permit an audit committee to pre-approve a set "blanket" dollar amount or percentage amount for specific types of services, such as permitted tax services in this example. The dollar or percentage amount could be expressed as an aggregate on an annual basis. Of course, the audit committee could use its discretion to approve such aggregate amounts for a shorter period, such as on a quarterly basis or for the period between audit committee meetings. The audit committee, also in its discretion, would have concluded that this amount would have no impact on the independent auditor's independence. At its subsequent meeting, the audit committee would receive a report detailing each permitted tax service performed under the "blanket" - in this case "consultation about the proposed cost of a change to the stock option plan in order to answer a request of the compensation committee in a timely fashion," and indicating the exact amount charged. We believe that such a "blanket" pre-approval is consistent with the responsibilities and discretion given to audit committees under the Act and other core corporate governance principles.
Finally, the Commission acknowledges that Section 202(i)(3) of the Act provides for the delegation of pre-approval responsibilities. Proposed Rule 2-01 does not, however, reflect this aspect of the statute, and we recommend that it be revised to expressly permit such delegation to an audit committee member. The availability of such delegation should not be viewed as diminishing the need for clear guidance on pre-approval procedures. Some audit committees, as a governance matter, prefer to deliberate pre-approvals as a committee rather than to delegate to one member the authority to make pre-approvals in between meetings. Even where the ability to pre-approve services has been delegated, the designated member is not always readily available to respond in a timely manner.
Identification of Permissible Non-Audit Services
We appreciate the inherent difficulty of making clear distinctions between permissible and impermissible non-audit services. We recommend, however, that the proposed rules be revised to incorporate or retain clearer and more detailed guidance, including, where clear rules cannot be established, safe harbors tied to a percentage of the audit fee. While we appreciate the relevance of the four principles discussed in the release (e.g., an auditor should not audit its own work), application of such principles can be overly subjective, and may lead to inconsistent applications by companies. The approach also may discourage regular, and appropriate, consultation between management and the outside auditors regarding the appropriate application of accounting principles, due to the inherent difficulty of determining which consultations are appropriate in the absence of objective standards.
As a general comment, we suggest an alternative overall approach that would, to the extent possible, further clarify the definitions of prohibited non-audit services under proposed Rule 2-01(c)(4), and then create an overall safe harbor or "basket" for other services that are not clearly prohibited up to an aggregate amount in fees of some percentage of the audit fee (e.g., 20%).
Traditional Non-Audit Services
In the Proposing Release, the Commission acknowledges the continued legitimacy of certain traditional non-audit services that have been provided for years without compromising auditor independence. These include traditional tax services, M&A due diligence, and tax-related consultation in connection with significant transactions. We urge the Commission to revise the proposed rules to more clearly reflect that position.
In its Proposing Release, for example, the Commission interprets Section 201(h) of the Act to permit "traditional" tax services, subject to audit committee pre-approval. Tax planning is a "traditional" tax service, and by definition tax planning involves the development of tax saving strategies, including advice in structuring business transactions. Yet, the Proposing Release states that the formulation of tax strategies designed to minimize a company's tax obligations and the representation of an audit client in a tax court may impair independence because it may require the accountant to audit his or her own work, become an advocate or assume a management function.
We recommend that the Commission continue to permit tax services, including development of tax strategies and representation in tax courts, subject to the pre-approval of the audit committee. The audit committee should be entitled to approve such a service so long as the fee involved, individually and together with all other fees for services other than audit, review, attestation and audit related, is not considered to adversely affect the accountant's independence. In this regard, we note that the proposed rules regarding remuneration of auditors would help to minimize potential issues of independence. For example, the Commission could require that the audit committee identify in its policies and procedures particular materiality thresholds, such as a specified relationship to the audit fee for the particular year and to the average audit fee over a specified period of years, that could not be exceeded for tax services that might involve representation in a tax court or the development of a tax strategy. Such an approach would permit the audit committee to consider the overall welfare of the company and its shareholders in choosing who best to perform tax services on its behalf. In this regard, we note that in certain non-U.S. jurisdictions, a company's audit firm may also constitute the highest quality alternative for tax services, including representation in tax court.
Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports
As noted by several participants in the December 17, 2002 roundtable, auditors in some foreign jurisdictions must provide these services to their audit clients. We therefore suggest that the SEC adopt a limited exception to this prohibition for instances where the auditors are required to perform such services pursuant to the laws of their home country.
Some participants in the December 17, 2002 roundtable also noted that tax services are often considered to be legal services or services that can only be provided by lawyers in foreign countries. We recommend that this paragraph of the proposed rule except tax services from the prohibition with the limitations discussed above.
We urge the Commission to reconsider eliminating the exception under current Rule 2-01(c)(4)(i)(B) for non-U.S. divisions or subsidiaries of an audit client, where, among other things, the services are limited, routine, and ministerial, it is impractical to make other arrangements, and the division or subsidiary is immaterial. For multinational companies with foreign divisions and subsidiaries, it is in some cases impractical, if not impossible, to obtain appropriate bookkeeping services in certain non-U.S. jurisdictions. In some non-U.S. jurisdictions, there may be only a handful of accountants with the necessary expertise in a given industry and U.S. GAAP, which expertise has become even more critical given the compressed filing timeframes. Very often, such experts work for a Big Four accounting firm. We are not aware of any instance in which application of the narrow current exception has undermined auditor independence.
We suggest that the Commission delete from the subtitle of proposed Rule 2-01(c)(4)(viii) the reference to "investment advisor, or investment banking services." While we acknowledge that the language was used in Section 201(a) of the Act, we do not understand to what specific or additional activity that portion of the subtitle refers, and the text under the heading does not provide an explanation. We are concerned that the subtitle will cause confusion, and note that the current rule does not include those references. The Commission may consider a different subtitle that better captures the policy reflected in the text of the rule, such as "Stock Promotion Activities." If the subtitle is retained, we urge the Commission to include in the adopting release the language in FR 56 regarding this area to provide guidance.
Audit Partner Rotation
While we support the proposed auditor rotation requirement, we recommend that the Commission limit its application to the lead partner and review partner as provided in Section 203 of the Act. We believe Congress likely made a careful legislative judgment when it limited the scope of Section 203 to those primary partners. Congress balanced the benefits of a rotation requirement for the two primary partners with the potential disruption and costs that could result from a broader requirement. Rotation of the two principal partners should adequately serve the policy goals of ensuring that the auditor take a "fresh look" every five years, as the new post-rotation lead and review partners would clearly have the authority and mandate to reevaluate prior approaches. It seems unlikely that a partner, principal or shareholder who does not have overall responsibility for the audit would be in a position to interfere with that reevaluation. If the Commission is concerned that in some cases there are more than two partners with ultimate management authority over the account, the rule could include a "catchall" that would cover other partners who function in a similar coordinating, review or supervisory capacity.
Application of the rule as proposed to all partners and principals will impose unnecessary costs on the audit client, while depriving the client of the auditor's institutional knowledge that other partners could provide over time. Additionally, rotation of peripheral partners could deprive the audit client of specialists who improve audit quality. Auditor rotation will directly impose costs on audit clients by virtue of the time that its employees will need to devote to educating new audit staff about the company and its operations. That cost will likely be excessive where the senior audit team is replaced, eliminating continuity of institutional knowledge on the part of the audit firm. In addition, some of the costs incurred by the auditor-such as the need to engage additional personnel-will likely be passed on to the audit client indirectly.
While we support the Commission's determination that an auditor rotated off an assignment after five years should remain off the assignment for a reasonable period, we believe that five years "off" is too long. We believe that two or three years "off" would adequately serve the Commission's policy goals, and would mitigate additional costs incurred by the auditing firm that may be passed on to the audit client.
While the Commission suggests that audit firms "stagger" their personnel so that the entire team does not rotate at the same time, upon effectiveness of the proposed rules, the firms will have to address engagement teams in place now. Even going forward, given factors such as turnover and the realities of specialization, the firms may have little flexibility in practice to rationalize the rotation of individual team members.
The proposed rotation requirements may have an especially adverse impact on companies in specialized industries where there are only a handful of issuers. In these circumstances, there are often few accountants who have the necessary expertise to serve as auditors, and our members are concerned that there simply may not be a sufficient number available to serve if the rotation requirements apply broadly as proposed.
The Commission requests comment on whether a forensic audit should be an alternative to, or supplement, the proposed rotation requirement. We strongly oppose introducing the concept of a forensic audit, as we believe that such a procedure is impractical due to the cost and time required to conduct such an audit.
If the Commission retains the proposed scope of the rotation proposal, we recommend that the rule define the term "principal," because there is no common definition of that term. It should clearly not reach persons, such as managers, who are merely employees, notwithstanding that some may share in profits via their bonus or similar arrangement.
Consolidated Public Subsidiaries
We believe that it would serve no purpose for a company to comply with proposed Rules 2-01(c)(7) and 2-07 if it is part of a consolidated group with a corporate parent that is already subject to those requirements. In such circumstances, the parent's audit committee should appropriately make judgments for the group concerning the administration of the audit engagement. Accordingly, we suggest that the Commission modify the definition of covered "issuers" under those proposed rules to make an exception for such subsidiaries, and make any other necessary adjustments to proposed amendments to Schedule 14A, Form 10-K, and other forms. We also urge the Commission to take this comment into consideration in adopting final rules to implement Section 301 of the Act.
Thank you for your consideration of our comments on this important matter. Please do not hesitate to contact the undersigned with any questions you may have.
cc (via e-mail): Susan Wolf (Chair, Securities Law Committee, ASCS)