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January 14, 2003 Via e-mail: rule-comments@sec.gov Jonathan G. Katz
Re: File No. S7-49-02 ("Strengthening the Commission's Requirements Regarding Auditor Independence") Dear Mr. Katz: This letter is submitted on behalf of the Committee on Federal Regulation of Securities and the Committee on Law and Accounting of the American Bar Association's Section of Business Law (the "Committees")* in response to the Commission's request for written comments on the above-referenced proposal to amend the Commission's auditor independence requirements (the "Proposal").1 The Commission issued the Proposal pursuant to Section 208(a) of the Sarbanes-Oxley Act of 2002 (the "Act"), which directs the Commission to issue, within 180 days after the Act's enactment, final regulations to carry out each of new subsections (g) through (l) of section 10A of the Securities Exchange Act of 1934 (the "Exchange Act"), as added by the Act. The comments expressed in this letter represent the views of the Committees only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committees. The Proposal, which in a number of respects goes significantly beyond the Act's requirements, would: --Revise the Commission's regulations related to the non-audit services that, if provided to an audit client, would be deemed to impair an accounting firm's independence; --Define the circumstances requiring pre-approval by an issuer's audit committee of audit and permissible non-audit services provided to the issuer (and, in the case of an investment company, its investment adviser and any entity controlling, controlled by, or under common control with the investment adviser) by its financial statement auditor; --Prohibit partners on the "audit engagement team" from providing audit services to the issuer (and, in the case of an investment company, any entity in the investment company complex) in such a capacity for more than five consecutive years; --Prohibit an accounting firm from auditing an audit client's financial statements if certain members of the audit client's management had been members of the accounting firm's audit engagement team within a one-year period preceding the commencement of audit procedures; --Define an accountant as not being independent from an audit client if any partner, principal or shareholder of the accounting firm who was a member of the engagement team received compensation based on any service, other than audit, review and attest services, provided or sold to that client; --Require additional disclosures to investors of information related to the audit and non-audit services provided by, and fees paid by the issuer (and, in the case of an investment company, its investment adviser and any entity controlling, controlled by, or under common control with the investment adviser) to, the auditor of the issuer's financial statements; and --Require that the auditor of an issuer's financial statements report certain matters to the issuer's audit committee, including "critical" accounting policies used by the issuer. Various members of our Committees represent issuers (including investment companies), accounting firms, and users of financial statements in connection with the Commission's rulemaking proposal, and some members represented clients in connection with the legislative activity that led to the Act. In preparing this comment letter, we have directed our comments to issues on which we have professional expertise. We also comment on the Commission's interpretation of the statutory mandate and legislative intent. In this connection, we have reviewed the language of the Act and the relevant legislative history and, with respect to some provisions, have confirmed our reading of that history with further discussions with drafters of relevant provisions of the Act.2 I. Overview The Proposal addresses the critical roles of independent auditors and audit committees in the financial reporting process. We support its broad goals and recognize the significant mandate Congress has given the Commission to adopt rules to carry out the Act's independence-related provisions. The Proposal, however, sweeps more broadly than the Act in a number of areas. In certain important respects, the Proposal appears to be at odds with the legislative history of the Act and, in other respects, the Proposal creates uncertainties and ambiguities that, if uncorrected, would threaten stated policy goals of Congress, impose significant new costs on issuers, and create potential new liabilities. The Proposal goes to the heart of the relationship between issuers and their auditors, and its broad sweep and lack of clarity is particularly troublesome in those provisions that must be interpreted by audit committees to guide their actions in overseeing that relationship. The mandatory deadlines imposed by the Act have created substantial pressure on the Commission and the staff to issue final rules just two weeks after the comment period closes -- a period hardly sufficient for careful reflection on the comments in light of the complexity and far-reaching nature of the Proposal. In a rulemaking of this scope, the Commission typically would establish a longer period for public comment and, perhaps more important, would allocate sufficient time for the Commission to consider and give proper weight to the comments received. In view of the limited time available to the Commission to meet its statutory rulemaking obligations under the Act, we believe the Commission should limit its rules to address only those issues required to be addressed by the Act by January 26, 2003. In this regard, we note that the new Public Company Accounting Oversight Board (the "Board") will have broad authority to regulate accounting firms that audit public companies, including with respect to independence issues. For example, the Board will have authority to expand the list of prohibited non-audit services, but not to provide exemptions (except on a case by case basis); thus, new scope of services restrictions that go beyond the current independence rules are not necessary at this time, unless specifically required by the Act. When the Board is operational and accounting firms are registered with it, the Commission and the Board can take the time necessary to consider whether the Proposal's more far-reaching restrictions are warranted. As we discuss in more detail below, we believe the Commission is taking on issues it simply does not have to address at this time, and it is not clear that there are investor protection benefits to offset the costs and confusion that will result from adoption of the Proposal in its current form. A more narrow focus, consistent with the Act's requirements, would enable the Commission to provide better guidance to those who must operate under the new rules going forward and would allow the Commission and the new Board to weigh carefully the need for additional rules, outside of the context of the tightly-drawn statutory rulemaking deadline. Moreover, a more narrow focus will give the Commission and the staff in the short time remaining the opportunity to refine and clarify, and then adopt in final form, rules clearly required under the Act. II. General Comments In this section, we provide general comments about each of the significant subjects addressed in the Proposal. In section III, we provide a more complete discussion of the Proposal's scope of services provisions. A. Prohibited Non-Audit Services We direct the major portion of our comments to the provisions on non-audit services. The Commission's most recent amendments to its auditor independence rules are just two years old.3 The comment process related to those rules produced 3000 comment letters and resulted in a number of changes in the rules as proposed. While some commentators believed the Commission should have imposed a broader or total ban on non-audit services provided by accounting firms to their audit clients, the Commission's final rule was broadly supported. Against this backdrop, Congress last year was presented with proposals for a total ban on accounting firms' provision of non-audit services to audit clients. Congress considered, and rejected, the "audit only" concept and chose to prohibit only a "limited list" of non-audit services, while expressly preserving the ability of accounting firms to provide tax services to their audit clients. As we read the legislative history, it appears that Congress largely endorsed the approach to non-audit services taken by the Commission in its current rule, subject to two additional restrictions: a new prohibition on "expert services"(left to be defined by the Commission); and a new requirement that audit committees pre-approve all audit and non-audit services provided by the issuer's auditor (presumably subject to the business judgment rule but, according to the relevant committee report, specifically not requiring particular findings by the audit committee in pre-approving a service).4 As discussed in more detail below, however, the Proposal appears to misconstrue and give undue weight to a portion of the legislative history of the Act in suggesting that Congress intended significantly greater restrictions on non-audit services than those set forth in the Commission's current rules and, specifically, that Congress intended to eliminate or sharply curtail the SEC's use of exemptive authority when implementing statutory prohibitions on non-audit services.5 Such an interpretation would vitiate the broad exemptive authority only recently granted to the Commission in Section 36 of the Exchange Act and would limit the Commission in exercising that authority to develop rational and tailored exceptions to general statutory terms.6 For example, the interpretation put forward in the Proposal would eliminate the Commission's ability to provide exceptions for services such as emergency bookkeeping -- which was never criticized by Congress and, as we read the legislative history, was never intended by Congress to be eliminated as an exception to the current independence rule. The Proposal also concludes that, in addition to the non-audit services specifically restricted by the Act, accounting firms and audit committees should evaluate services that are not prohibited by the Act against three "simple principles" in the relevant Senate committee report (the "Senate Report"),7 as well as a fourth principle described in the Preliminary Note to the Commission's current independence rule.8 As discussed below, we believe that, in doing so, the Proposal assigns undue weight to certain commentary in the legislative history and too little weight to the expressed intent of Congress that there be a "clear line around a limited list" of non-audit services that an accounting firm may not provide to its audit clients. Accordingly, while we agree that "simple principles" informed the non-audit services that Congress expressly acted to limit, we do not believe that it is either practical or consistent with the congressional goal of clarity for the Commission to suggest that audit committees must look beyond the language of the Act and its implementing rules and apply these general principles to every non-audit service, including those not prohibited by the Act. We therefore recommend deletion of the confusing language in the Proposal suggesting that audit committees must assess whether each and every service that is not specifically prohibited violates one or more of principles. We believe that the Commission, instead, should exercise its statutory authority to define terms used in the Act, as well as its exemptive authority, to provide the intended clarity as the scope of each prohibited non-audit service. As discussed below, we believe this approach is consistent with legislative intent that there be a "clear line" around services that are prohibited. Non-audit services that are not specifically prohibited then must be assessed by audit committees, subject to the their fiduciary responsibilities, and, if approved, subsequently disclosed in accordance with fee disclosure requirements that are designed to enhance investor understanding of non-audit services provided by a company's auditors. To the extent the Commission wishes to provide guidance on the factors audit committees might consider in connection with the pre-approval process, such guidance should be consistent with the Congressional goal of clarity. The treatment of tax services illustrates the considerable and -- in our view -- unnecessary ambiguities that would arise in practice under the Proposal's approach. The Act expressly states that an accounting firm may provide tax services to an audit client if the services are pre-approved by the audit committee. The Proposal similarly acknowledges that tax services are permissible but states that this statutory provision may be limited by basic principles alluded to in the legislative history, including the general principle of avoiding "advocacy" on behalf of an audit client, which could apply to virtually all communications made by an accountant to tax regulatory authorities or other parties in connection with an engagement. In view of the confusing and inconsistent language in the Proposal, we recommend that the Commission clarify that tax services are a permissible non-audit service under the Act if pre-approved by the audit committee. We emphasize that we believe the Act is clear on this point and that the Commission should not invoke legislative history to limit tax services expressly permitted by statute. If the Commission nevertheless chooses to do so because it believes specific tax services pose undue threats to independence, however, the Commission must draw a much clearer line around such services than it has done in the Proposal. We note that audit committees will continue to have an obligation to determine whether to approve a tax service, consistent with the standards they determine to be appropriate in light of their fiduciary responsibilities and other considerations they believe appropriate. Since it is our general view that the Commission has the authority and flexibility to, and should, adopt scope-of-services restrictions along the lines of those in its existing independence rule, we do not comment in detail on specific prohibited services, except for the new category of "expert services unrelated to the audit," which must be incorporated into the non-audit services provisions of the current rules and should be clearly defined in the rules.9 In particular, we believe the Proposal goes too far in describing the scope of prohibited expert services, by proposing to limit counsel's use of such services from the issuer's auditor. In addition, we recognize that Congress enacted the provisions of the Act relating to prohibited non-audit services after the largest accounting firms announced that they would not provide internal audit outsourcing and financial information systems design and implementation services to public company audit clients. Thus, while the Act does not require the Commission to eliminate the current rule's exceptions relating to these services, it is reasonable to assume that Congress believed the provision of these two services by accounting firms to audit clients would cease. With the exception of these two services, and with the addition of expert services to the list of non-audit services in the current rule (narrowed as we suggest in our more detailed comments below), we believe it would be consistent with the Act and its legislative history for the Commission to codify its existing definitions and exceptions relating to categories of non-audit services that appear in both the current independence rule and the Act. This would help streamline the Commission's work over the next several weeks and allow it to complete its work on rules required to be adopted by January 26, 2003. It also would assist compliance and permit audit committees to assess the various non-audit services based on understandings developed over the past two years' experience with the Commission's existing rules. B. Pre-Approval Procedures and Related Disclosure The Proposal's requirement for pre-approval of non-audit services performed by an investment company auditor on behalf of the investment company's investment adviser and the adviser's control affiliates significantly and unnecessarily expands the involvement of the investment company's audit committee in the affairs of its management company. It is not inconceivable, in this era of financial service conglomerates, for an investment adviser to share control with hundreds of other entities, and for the investment company activities to represent a tiny fraction of the conglomerate's overall business activities. To delay an affiliate's commencement of a non-audit engagement pending approval of a remote fund board's approval unduly burdens the engagement process with no commensurate regulatory benefit. The Commission has previously recognized this imbalance in the similar context of independence standards for counsel to fund directors.10 We recommend that the Commission require only the reporting to, and not pre-approval by, the investment company audit committee of non-audit services performed by its audit firm to control affiliates of its investment adviser. In general, the Commission's proposed rule and the accompanying commentary provide helpful flexibility and guidance for audit committees in pre-approving audit and non-audit services. We believe it is appropriate for the Commission to allow audit committees to exercise their responsibility to pre-approve non-audit services by establishing policies and procedures for pre-approval and permitting management, pursuant to those policies and procedures, to obtain permissible services from the issuer's auditor. By requiring separate disclosure of the non-audit services approved in this manner, however, the Proposal suggests that it may be a less favored method of pre-approval than other methods. We recommend the Commission omit the requirement for separate disclosure based on the method of audit committee approval. We also note that audit committees will be required to disclose the particular policies and procedures they employ for this purpose. We believe that many complex and varying judgments will be involved in the pre-approval process, and we doubt that disclosure of particular policies and procedures will provide meaningful information. We suggest instead that audit committees be required to disclose that the audit committee approved the specified services as required and in accordance with its policies and procedures. This approach would be consistent with the other disclosures required in the audit committee report under Item 306 of Regulation S-K. In any case, we urge the Commission to exercise restraint and not review the disclosures with a particular view of what the policies and procedures should be. C. Fee Disclosure The Commission has proposed to amend its current audit fee disclosure requirements to require disclosure of four categories of services: Audit Fees, Audit-Related Fees, Tax Fees, and All Other Fees. We generally support these enhanced disclosures, which we believe will be more meaningful to investors than the current three categories. However, we do have some comments that we believe will clarify those disclosure requirements. First, while the Commission has noted that fees for the review of interim financial statements would fall into the "Audit Fees" category, it is important to recognize that such reviews are not limited to interim financial statements included in Forms 10-Q and 10-QSB. Accountants also review interim financial statements included in Securities Act registration statements, including financial statements of foreign private issuers who are not required to file quarterly reports with the Commission. Accordingly, we recommend that the Audit Fees category include fees for reviews of any interim financial statements included in a registrant's filing under the Securities Act or the Exchange Act. Second, while we do not take issue with the proposal that issuers describe subcategories of audit-related and other fees, we suggest that, to avoid unnecessary detail, the Commission may wish to consider some de minimis threshold for those subcategories (for example, subcategories for which the fees in any year represent less than five per cent of the total fees for that category would be excluded). Subcategories of services the fees for which do not exceed such a threshold could be included in an "all other" subcategory. Third, we believe that the Commission should indicate how the hours expended by a specialist whose work the principal accountant relied on in accordance with GAAS are to be viewed in determining the percentage of hours expended in an audit by persons other than full-time, permanent employees of the registrant's principal accountant. D. Communications with the Audit Committee The Commission proposes to implement the timely reporting requirement of Section 204 of the Act, which, in large part, codifies similar GAAS requirements, by adopting Rule 2-07 of Regulation S-X. The proposed rule essentially tracks the language of Section 204, although it has modified the "timely" reporting requirement of that section to require the auditor to report to the audit committee before the filing of the audit report with the Commission. Also, the Commission has clarified that the auditor's report may be oral or written. We have no general objection to these proposed requirements. However, we note that only the requirement to report "other material written communications" has a materiality qualifier. The examples of current GAAS requirements included in Part II.G of the Release all are modified by terms such as "significant," "unusual," "particularly sensitive material" and "disagreements." We recognize that Section 204 does not use such modifiers as to "discussions" about alternative accounting treatments. However, we suggest that, since the term "discussed" is so indefinite, that unless there was a "disagreement" between the auditors and management, the auditor should only be required to report discussions that led to the initial adoption of, or change in, an accounting policy or treatment. We further note that proposed Rule 2-07(a)(1) would require that the auditor report to the audit committee "all critical accounting policies and practices to be used." However, the discussion in Part II.G.1 of the Release discusses both the "critical accounting policies," which were the subject of the Commission's cautionary advice in Rel. 33-8040, and "critical accounting estimates," which were the subject of the Commission's proposals in Rel. 33-8090. The Commission refers auditors to both releases in determining what types of matters should be communicated to the audit committee, although the rule speaks only in terms of "critical accounting policies," the term used in Section 204 of the Act. If the Commission intends to go beyond reporting "critical accounting policies" and also require reporting of "critical accounting estimates," it should so provide in the rule, particularly since the rule must be understood not only by auditors, but also by members of audit committees and their advisers. We believe that it also would be helpful for both auditors and members of audit committees if the Commission defined "critical accounting policies" (or "critical accounting estimates," if they are required to be reported) in Rule 2-07. This is particularly important given the confusion between the terms "critical accounting policies" and "critical accounting estimates" evidenced by the comment letters on the Commission's proposals for disclosure of critical accounting estimates. The definition should be consistent with the term used for purposes of MD&A disclosure, and the Commission may want to incorporate by reference the definition it ultimately determines to adopt for purposes of MD&A disclosure. E. Rotation By proposing to extend mandatory rotation to all partners on the "audit engagement team" for a five-year period, the Proposal goes beyond the statutory requirements and clearly expressed congressional intent. This is all the more problematic in the investment company context, where the Proposal would further prohibit all such partners from providing audit services to any entity in an "investment company complex," defined by Commission rules adopted in connection with a different regulatory goal.11 As we read the legislative history, Congress considered, and specifically rejected, audit firm rotation and required only that the lead and reviewing partner on an audit rotate off after having served in such a capacity for five years. The Act further provides for a study by the General Accounting Office (the "GAO") of the "potential effects of requiring mandatory rotation" of registered public accounting firms. In view of the significant potential costs to issuers of the broader partner rotation proposed by the Commission, the lack of specific transition relief in the release (and, therefore, no opportunity for informed comment on a range of possible transition proposals), the limited time within which to evaluate the effects of the proposal on smaller accounting firms and issuers, and the absence of information that could be derived from the statutorily-mandated study, we urge the Commission to defer its broader proposal and, instead, confine rules in this area to the requirement specified, and clearly intended, by Congress. A broader rotation requirement could be adopted, if considered warranted, after the issuance of the GAO report on firm rotation. In the meantime, it will be important for the Commission to develop workable transition rules for lead and reviewing partner rotation. By narrowing its focus, the Commission can spend the remaining time developing such transition rules. F. Employment Restrictions Section 206 of the Act calls for a one-year "cooling off" period before a former member of an audit engagement team can accept a position with an audit client as "chief executive officer, controller, chief financial officer, chief accounting officers, or other . . . equivalent position." The Proposal would go beyond this requirement by extending the cooling-off period to any former member of the audit team who accepted a "financial reporting oversight role" with an audit client. The Commission proposes to define that term to include all members of a company's board of directors, in addition to other members of a company's management not covered under Section 206 of the Act. The legislative history of the Act indicates that Congress specifically considered those senior management positions at an audit client to which a mandatory cooling-off period should apply. The relevant Senate Report states that the cooling-off period "does not take effect if . . . a member of the audit team is hired by the issuer for a position other than CEO, CFO, controller, chief accounting officer, or an equivalent position").12 Extending a cooling-off requirement to a broader range of positions imposes limits on the ability of issuers to recruit qualified board members and employees at a time when the need for financially knowledgeable individuals to serve in these positions has never been greater. We recommend that the Commission apply the cooling-off requirements in the manner intended by Congress. G. Partner Compensation Under the Proposal, an audit firm's independence from an audit client would be impaired if any partner, principal or shareholder on the audit engagement team is compensated "based on" the performance of, or procuring of, engagements with the client to provide products or services other than audit, review or attest services. While the proposing release indicates that the Commission's intent was to prohibit the direct compensation, through bonuses or other financial incentives, of audit partners for "cross-selling" non-audit services to their audit clients,13 the text of the Commission's proposed rule can be read as restricting any situation in which the compensation of a member of an audit engagement team reflects fees derived by his or her firm's performance of non-audit services for an audit client. We believe that it is appropriate for the Commission to focus on the particular threats to independence that may affect individual audit partners and that directly rewarding a partner on an audit engagement team for selling or promoting his or her firm's non-audit services to an audit client raises a legitimate independence concern. Indeed, we understand that many accounting firms prohibit such incentive-based programs. However, the Commission should clarify in the adopting release that the restrictions are intended to cover direct financial incentives to audit partners for cross-selling non-audit products or services to audit clients, but do not restrict partners from sharing in a firm's total revenues derived from audit and non-audit services provided to the firm's clients. III. Discussion of Scope of Non-Audit Services We discuss below the basis for our view that the Commission has the authority to, and should, adopt more limited changes in its rules relating to scope of non-audit services. We believe more limited changes are consistent with congressional intent and will assist audit committees in the exercise of their pre-approval responsibilities under the Act and implementing rules. A. Prohibited Non-Audit Services; Exceptions Subsection 201(a) of the Act states that it is unlawful for a registered public accounting firm to provide an issuer, contemporaneously with an audit, any non-audit service listed in that subsection, as well as any other service that the new Board determines by regulation is impermissible. The provision states that other non-audit services, including tax services, may be provided to an issuer that is an audit client only if its audit committee pre-approves the service in accordance with the Act and discloses the pre-approval in its periodic reports. On its face, the list of prohibited services in subsection 201(a) of the Act appears to have been drawn from the text of the Commission's current independence rule and an earlier version of the rule proposed in July 2000, which provided that the rendering of "expert services" to an audit client also would impair an accounting firm's independence. The hearing record of the Act confirms that the Commission's rule was the genesis of the list of prohibited services in the Act; we have further confirmed this through separate discussions with staff of the Senate Committee on Banking, Housing and Urban Affairs ("Senate Banking Committee"). The list of prohibited services, therefore, was not created by the Congress or any particular Senator or sponsor of the legislation, but instead was derived from the Commission's past rulemaking. The Act does not define the terms used in the list of prohibited services. The legislative record provides evidence that, as a result of a compromise between members of the Senate Banking Committee, the committee determined not to direct the Commission to write particular definitions or to constrain the Commission in its rulemaking under the Exchange Act.14 Subsection 201(b) of the Act does limit the authority of the new Board, which may exempt only on a "case by case" basis any person, issuer, public accounting firm, or transaction from the prohibitions on the provision of services, subject to a public interest test and review by the Commission. However, neither the Act nor the Senate Report states or implies that Congress limited, or intended to limit, the Commission's use of its exemptive authority, including its authority to adopt exemptions to the Act's prohibited non-audit services similar to those the Commission found appropriate in updating its independence rule just two years ago. The Proposal focuses on a narrow part of the legislative history as support for its conclusion that "[i]t seems clear that Congress did not intend to codify unchanged the current auditor independence rules as the Commission adopted them in November 2000."15 In support of this view, the Proposal refers to statements made in the Senate at the end of debate on the conference report on the Act by then Senate Banking Committee Chairman Sarbanes. Based on those statements, the Commission "assume[s] . . . that Congress intended the Commission to revise the existing rules, at a minimum, to eliminate categorical exceptions and exemptions."16 We do not believe, however, that Senator Sarbanes' comments, when viewed in their proper context, lead to or require the conclusion reached in the Proposal. Specifically, when the Sarbanes bill was considered by the Senate in early July 2002, the Senate Banking Committee's Ranking Republican, Senator Gramm, filed an amendment (which was never subject to a vote) to subsection 201(b) that would have granted the new Board the authority to exempt any person, issuer, or firm from the prohibition on services under the Act, based upon the small business nature of the person.17 Senator Gramm revisited this issue during the debate on the conference report on the Act, stating on the Senate floor, "I personally believe we should have given the board, with the agreement of the SEC, the ability to grant blanket waivers. . . ."18 Later in the debate, Senator Sarbanes commented on Senator Gramm's statements as follows: "Senator Gramm has suggested that the conference report should be changed to give the SEC or the Oversight Board authority to grant broad categorical exemptions from the list of non-audit services. . . . Such a change, in my view, would weaken [the objectives of the conference report.]"19 Although Senator Sarbanes' views concerning the SEC's exemptive authority were expressed as his own views, these remarks are quoted in the Proposal in support of the view that Congress, as a body, intended that the Commission's rules implementing the prohibited services provisions of the Act eliminate exemptions contained in the Commission's current independence rule.20 In interpreting statutory language and legislative intent, however, the Commission must look beyond the statements of any one member, even one who played as prominent a role crafting the legislation as Senator Sarbanes. The text of the Act reflects the intent of Congress and the compromises that led to the Act's passage. In our review of the legislative history of the Act, we found no proposal to limit the Commission's exemptive authority in this regard, other than the statement of views by Senator Sarbanes. It appears that the Commission's use of its exemptive authority was never at issue. Had Congress wished to provide such a limitation on the SEC's authority to grant exemptive relief, it could have done so expressly in Section 201(b) of the Act, which expressly limits the Board's exemptive authority. Certainly there is no reason to believe that Congress was not aware of the Commission's broad exemptive authority under section 36(a) of the Exchange Act, which Congress enacted just six years ago.21 This authority was strongly supported by then SEC Chairman Levitt and was viewed by the Commission and the private sector as essential in giving the Commission flexibility to administer its statutes. Indeed, the lawmaking process can be a blunt instrument, and it is critical that in crafting rules the Commission use its broad authority to define terms and grant exemptions to implement the statutes with the flexibility and the detail necessary to make them workable. Congress further recognized the need for the Commission to have broad authority in carrying out its statutes by giving the Commission general rulemaking authority in Section 3 of the Act. As noted earlier, the Commission's 2000 rulemaking resulted in 3000 comments, public hearings, and a lengthy comment period. In those rules, the Commission identified broad categories of non-audit services that could impair independence and then crafted definitions and exceptions to those rules that made them workable, consistent with core principles of auditor independence. We do not find any legislative history to suggest that Congress intended to eliminate the carefully crafted exceptions in the current rules. Accordingly, the Commission does not have to adopt the blunt approach suggested by its Proposal to eliminate all exceptions to the prohibited non-audit services, regardless of their previously recognized merits. B. The Commission's Proposed Application of "Simple Principles" The Proposal gives substantial weight to three "simple principles" of auditor independence that are discussed in one paragraph of the 65-page Senate Report and were repeated in statements on the floor of the Senate by then Chairman Sarbanes. For the reasons described below, we believe the Proposal gives undue weight to the discussion of these principles in the legislative history to the exclusion of other indicators of congressional intent. The principles identified in the Proposal in large part track three of the four principles set forth in the Preliminary Note to the Commission's current independence rule. These principles also appeared in the Commission's July 20000 proposal to amend its independence rules. At that time, the Commission proposed to include these principles in the text of the rule by providing that an accountant would not be independent if, during the audit and professional engagement period, the accountant:
In a September 27, 2000 letter to the Commission, we commented on the proposal as follows:
In addition to noting the practical difficulties that would arise if these principles were formally codified, our letter identified policy arguments against applying these principles as "immutable rules:"
Responding to these and similar comments, the Commission in its final rule moved these principles from the text of the rule to a Preliminary Note, stating,
The Proposal states that these "simple principles" should be applied by audit committees in further assessing permissible non-audit services (that is, services that are not identified as prohibited services in subsection 201(a) of the Act, including tax services which the Act expressly identifies as permissible). The release also states that the "simple principles" further reflect Congress' intent to eliminate exemptions to the rule. While the Senate Banking Committee and Senator Sarbanes found these principles useful in explaining the rationale for the prohibition on specified non-audit services, there is no evidence that Congress intended that this brief and general discussion in a portion of the legislative history should be used to narrow, condition or interpret the statutory terms or to limit non-audit services that are not prohibited under the statute. As noted earlier, the Senate Committee Report explains that Congress rejected proposals to ban all non-audit services and chose instead to draw a "clear line" around a "limited list" of services. The committee report explains that, other than this "limited" list, the Act permits issuers to obtain from their auditors other non-audit services, expressly including tax services, subject only to a requirement for pre-approval by the issuer's audit committee.26 We believe the Proposal's characterization of the general principles as a further limitation on permissible services would have the unintended effect of leaving audit committees to guess as to what services, as a matter of law, fall on one side of the line versus the other. Even though audit committees otherwise may believe that the services do not pose a threat to independence and provide other benefits, such ambiguities in the Commission's statements may lead audit committees to simply disapprove obtaining permissible and beneficial services from the issuer's auditor. This would undercut the congressional intent that there be only a "limited" list of prohibited services and that non-audit services other than those clearly prohibited be permitted, subject to audit committee pre-approval. We note that the weight that should be given to these principles by auditors or audit committees was not an issue debated by Congress. Instead, the Banking Committee Report states:
Had Congress wished to require audit committees to evaluate non-audit services not on the list of prohibited services using the "simple principles," it would have been a simple task to include those principles -- either in the Act or in the committee report -- as standards to be applied by audit committees. Congress did not do so. Thus, we believe the principles should be read as providing background context for the decision by Congress to limit certain specific categories of non-audit services, rather than held out as touchstones for audit committees in evaluating or defining non-audit services generally. Finally, we note that, in its 2000 rulemaking, the Commission identified similar principles as "guiding principles" and nevertheless reached the conclusion that the definitions and exemptions in its current independence rule were consistent with these principles. There is no reason to conclude that Congress, in discussing these general principles, intended that the Commission write implementing rules under the Act significantly different from the current rule. Congress legislated against the backdrop of the Commission's rules, and it is not logical to "assume", as does the Proposal, that Congress intended to "prohibit any service or scenario that reasonably could create one or more of the conflicts identified in the principles."28 C. Tax Services Section 201(a) of the Act provides, "A registered public accounting firm may engage in any non-audit service, including tax services, that is not described" in the list of prohibited non-audit services in that section. The analysis in the relevant Senate Report explains the provision as follows:
There has been considerable discussion about why the Act expressly provides that tax services are a permissible service, when the congressional purpose of drawing a line between prohibited services and "any non-audit service . . . that is not" prohibited could have been achieved if the phrase "including tax services" was never included in the provision. The logical explanation, which is supported by our recent discussions with the committee staff, is that Congress was simply following the approach taken by the Commission in its independence rule, which made it clear that issuers could continue to obtain tax services from their auditor. Indeed, the Commission was consistent in its position in proposing amendments to its independence rule in June 2000,30 as well as in adopting the final rule.31 Companies must be able to use their auditors to advise them of tax requirements, prepare tax returns, analyze and advise as to the appropriateness of tax accruals, assist in tax planning and advise on the tax consequences of proposed transactions, and assist them in responding to governmental tax audit inquiries. These services generally can be provided most efficiently by companies' auditors and have not been thought to raise independence issues. Both the Act and prior Commission rulemaking recognize the benefits of permitting these services to be provided by a company's auditors. The Proposal suggests, however, that the simple principles discussed in the legislative history should be applied to limit the statutory language permitting the provision of tax services and also suggests that a tax service may be a prohibited expert or legal service. We believe the better reading of the Act and its legislative history leads to the conclusion that the Act's drafters understood that the Commission already had applied the core principles in its 2000 rulemaking and found the provision of tax services not to impair independence. Congress itself, applying those same principles, identified certain services as "prohibited" but expressly permitted tax services. Indeed, while there were some suggestions in the hearings leading to the Act that Congress should prohibit accounting firms from providing "tax shelters" to audit clients, there is nothing in the Act or in the Senate Report that suggests that Congress decided to limit such services. In light of the Act and its legislative history, we do not believe the Commission should prohibit accounting firms from providing tax services to audit clients or require that audit committees engage in a methodology of applying the "principles" discussed in the legislative history in evaluating whether to approve tax services. We share the Commission's concerns about the potential for an auditor to promote aggressive tax shelter strategies to an audit client. Whether or not the Commission addresses the issue of tax shelters in its rules, we believe audit committees must carefully examine these and other services in fulfilling their statutory responsibilities to pre-approve all services obtained from the issuer's auditor. We believe this is consistent with the approach adopted by Congress to prohibit specified non-audit services and leave to the audit committee the determination, based on the specific circumstances, whether other non-audit services should be approved as in the best interests of the issuer, taking into account both the actuality and appearance of independence. However, if the Commission chooses to prohibit such services because it believes they pose undue threats to independence, the Commission must draw a much clearer line around such services than it has done in the Proposal. In view of the complexity of defining such services, expansion of the rule in this area may best be left to a later time. D. Expert Services The Act adds "expert services unrelated to the audit" to the list of non-audit services that, if provided to an audit client, are deemed to impair an accounting firm's independence. The Act's legislative history suggests that Congress was concerned about situations in which an auditor is perceived as acting as an "advocate of the audit client" in a "legal, administrative, or regulatory proceeding."32 In adding "expert services" to the list, Congress drew upon the Commission's July 2000 proposal, and the Commission's discussion of the term in that rulemaking likely provided the context within which Congress understood the term. We believe the Proposal goes too far in suggesting that an auditor's assistance to client's counsel in a proceeding should be a prohibited expert service. As the Commission correctly states, "legal counsel have an ethical duty to `represent a client zealously and diligently within the boarders of the law.'"33 Counsel should be able to utilize the client's auditor to provide information, technical advice, and forensic services that the auditor may be best positioned to provide, subject to pre-approval by the client's audit committee. Where counsel is drawing upon the auditor's specialized knowledge, experience and expertise in a non-testifying role in a legal, administrative or regulatory proceeding, there should be no doubt that it is counsel, and not the auditor, who is serving as the client's advocate. We recommend that the Commission narrow the relevant language in the release to permit counsel to continue to utilize a client's auditors in this manner, subject to audit committee pre-approval. We believe there is nothing in the legislative history of the Act to suggest that Congress intended to prohibit services of this nature. We also believe statements in the Proposal clarifying that an auditor may serve as a fact witness to its audit work for a client and that the auditor should be permitted to assist the client's audit committee without limitation provide helpful clarification and should be included in the adopting release as well. E. Legal Services We have chosen not to address the Proposal's specific limitations on legal services but make the following observations. The Proposal, like the Commission's current independence rules, has implications for multi-disciplinary practice issues, a topic of considerable concern for the legal profession. The Commission proposes to expand the limitation of legal services to prohibit offering services outside of the United States where the service is required by the jurisdiction to be performed only by a person licensed to practice law in the jurisdiction. We are not aware of anything in the legislative history of the Act suggesting that Congress was concerned about the current rule or wished the Commission to broaden its scope beyond the United States. We also understand that the Commission is sensitive to concerns that have been raised about the impact of the Proposal in view of differing legal requirements abroad. Therefore, we urge the Commission to defer expansion of its rules in this area and to work with regulators, issuers, and audit firms abroad to address particular independence concerns raised by the scope of the legal services restrictions in the current rule. * * * We appreciate the Commission's consideration of the Committee's comments. Members of the Committees would be pleased to meet with representatives of the Commission to discuss our comments.
Drafting Committee: Martha Cochran
cc: The Honorable Harvey L. Pitt
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