Sullivan & Cromwell LLP
125 Broad Street
New York, New York 10004-2498
January 10, 2003
VIA E-MAIL: email@example.com
Mr. Jonathan G. Katz,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20549-0609.
Re: Proposed Rules Relating to Auditor Independence
as Required by Section 208 of the
Sarbanes-Oxley Act of 2002 (File No. S7-49-02)
Dear Mr. Katz:
We are pleased to respond to Release No. 33-8154 (the "Proposing Release"), in which the Securities and Exchange Commission solicited comments on its proposed rules implementing the provisions of the Sarbanes-Oxley Act of 2002 (the "Act") relating to auditor independence.
We have set forth below aspects of the proposed rules that we believe, based on our review and on discussion with our clients, should be modified in order to promote the underlying statutory purposes of Title II of the Act.
We recognize that Section 208 of the Act requires the Commission to adopt rules relating to auditor independence and that these rules will have an enormous impact on both accounting firms and their audit clients. The proposed rules, however, significantly exceed the Act's requirements. In particular, we are concerned that the extent of the Commission's proposed requirements will have the unintended effect of limiting the supply of qualified auditors and thus ultimately diminishing audit quality. Accordingly, we encourage the Commission, in adopting final rules, to apply the requirements of the Act in a manner that does not unduly restrict the ability of issuers to engage and retain qualified accountants to perform necessary audit and non-audit services. A brief summary of certain of our comments follows:
- Given the extremely tight timetable proposed by the rules, the Commission should provide for appropriate grandfather provisions and transition periods to ensure smooth implementation of the independence rules.
- The Commission should defer proposals that exceed the requirements of the Act until they can be appropriately evaluated both on their own and in the context of pending proposals by the relevant securities exchanges (e.g., those relating to the formation and operation of audit committees) and rules required to be adopted by the Public Company Accounting Oversight Board (the "Board") (e.g., those relating to accountants' professional standards).
- The Commission should confirm that the three "basic principles" described in the Proposing Release as informing the scope of enumerated non-audit services are not self-executing.
- The rules should not attribute activity at, or services provided to, an entity in an investment company complex to other entities in that complex except in specific, limited circumstances.
Conflicts of Interest Resulting from Employment Relationships
- The rule should not apply to those positions in which the employee is overseen by a covered employee.
Services Outside the Scope of the Practice of Auditors
- The Commission should confirm that accountants may meaningfully assess and suggest improvements to an audit client's internal controls and procedures so long as the accountant's work is not the primary basis for the design and implementation of the client's internal control system.
- The Commission should permit auditors to provide the full range of tax services without requiring that these services separately be evaluated against either the specific list of prohibited services or the Commission's basic principles.
- The Commission should clarify that a non-audit service should be evaluated by reference to the category in which it most appropriately falls, rather than being separately evaluated under multiple categories.
- The "time-out" period should be no longer than two years.
Audit Committee Administration of the Engagement
- The Commission should provide that an audit committee may establish pre-approval policies and procedures for narrow categories of services so long as they appropriately detail the procedures to be followed.
- The Commission should not attempt to regulate internal compensation issues for partners at accounting firms by prohibiting compensation for permitted non-audit services.
- The Commission should clarify the types of services to be disclosed under the four categories set forth in the proposed rules.
Issues Relating to Non-U.S. Auditors and Audit Clients
- The Commission should defer application of the proposed rules to foreign audit firms until such time as the Commission, working together with the Board and appropriate international authorities, can determine how best to reconcile U.S. professional standards with similar standards applicable in foreign jurisdictions.
I. GENERAL COMMENTS
A. Given the Timeframe in Which Issuers and Accountants Must Comply with the Rules' Requirements, "Grandfather" Provisions and Transition Periods Are Necessary to Ensure Smooth Implementation of the Final Rules
The Proposing Release indicates that the proposed rules would be effective upon adoption of final rules, which we understand may, for some of the rules, be no later than January 26, 2003. The rules proposed in the Proposing Release, along with the numerous other rules proposed under the Act, mark a significant departure from current practice for issuers and accountants in many areas and will require them to implement numerous systems for recordkeeping, internal procedures and required disclosures, among others. All of these changes may take effect during what for most issuers is their normal year-end audit and reporting period. In addition, sanctions for violating the rules proposed under the Act may be severe, ranging from required re-audits, to fines and, perhaps, imprisonment. We agree with the Commission that certain of these rules are desirable to protect investors and to enhance the integrity of financial statements. However, we believe that investors will be ill-served by the rules if issuers and their independent accountants are not afforded sufficient time to develop and implement the systems that are required to comply with the rules, especially if certain of these systems may have to be in place by January 26, 2003. In addition, issuers and accountants will have to make these changes in an environment in which it may not be clear whether the enhanced systems will require further drastic overhaul to meet additional requirements that may be imposed by the Board. As noted below, we urge the Commission to consider the extremely tight timetable that it is imposing and to adopt transition periods and grandfather provisions to allow issuers and accountants to implement systems that will enable them to comply fully with the final rules.
"Grandfather" Provisions Are Needed. As proposed, the rules contain no provisions that would exempt employment relationships and services in existence on the effective date of the final rules. The lack of such grandfather provisions may mean that, virtually overnight, issuers will be faced with auditors that no longer are independent. This raises a number of concerns. First, issuers may already have contracted with accounting firms that audit their financial statements to provide certain non-audit services that no longer will be permitted under the final rules. Even if the accounting firm has not yet begun to provide that non-audit service, the issuer may have to break the contract for that non-audit service, and possibly compensate the accounting firm for that breach in order to avoid having to engage a new accounting firm to audit its financial statements. The alternative of engaging a new accounting firm to audit its financial statements for the previous fiscal year, moreover, is undesirable given that many issuers' fiscal years ended December 31, 2002 and the filing deadline for their annual reports will not give a new accounting firm sufficient time to learn about the issuer's business and financial background to perform a satisfactory audit. This would have the obvious effect of diminishing audit quality and ultimately harming investors.
In some instances, the proposed rules give issuers no viable alternatives to engaging new accounting firms to audit their financial statements. For example, if an issuer hired a former member of the audit engagement team to become the issuer's chief financial officer in May 2002 (well before even the passage of the Act) and audit procedures for fiscal year 2002 commenced in February 2002, under the proposed rules, the accounting firm may no longer be deemed independent, and the issuer would be forced to engage a new accounting firm to perform the 2002 audit. To the extent that the new rules, as proposed, may leave issuers with no alternative but to hire a new accounting firm to perform the previous fiscal year's audit within a very compressed time period, audit quality will be diminished and the aims of the Act thwarted. Therefore, we strongly urge the Commission to grandfather certain services and employment relationships in existence when the rules become effective, as discussed in more detail below.1
Transition Periods Are Needed. We also urge the Commission to provide for a reasonable transition period for application of the proposed rules. To the extent that many of these rules significantly will disrupt ongoing audit processes (e.g., partner rotation) or will require issuers to develop new procedures and systems to ensure auditor independence (e.g., audit committee pre-approval), issuers and accounting firms alike will need time to ensure that such systems and controls are working properly. If the Commission does not provide for such a transition period, entities likely will not be able to put in place effective and thoughtful systems by the rules' effective date, which ultimately will hurt investors.
Although we agree with the Commission that some of the proposed rules may be appropriate to bolster auditor independence, we believe that it is equally important that the implementation process run smoothly in order to protect accounting firms, audit clients and, most importantly, investors. Below we discuss the areas in which we believe that grandfather provisions and transition periods are particularly necessary:
Conflicts of Interest Resulting from Employment Relationships
- The final rule should grandfather employment relationships in existence on the effective date of the rule.
- To the extent that the final rule applies to more positions than the Act requires (e.g., members of the board of directors, personnel in a financial reporting or internal audit function), effectiveness should also be delayed for a reasonable period, e.g., at least six months, to permit accounting firms and issuers to educate their employees (especially those performing human resources functions) and establish systems to ensure that firms and issuers are alerted to potential independence issues relating to employment of former auditors.
Services Outside the Scope of the Practice of Auditors
- The final rules should grandfather contracts for the provision of services in existence on the effective date of the final rules.
- The Commission should also delay effectiveness of the changes to the rules prohibiting non-audit services until the Board is established and prepared to exercise its exemptive authority as provided in Section 201 of the Act. Section 201 enumerates the non-audit services that may not be provided to the audit client by a "registered public accounting firm". Section 201 also expressly grants the Board the authority, on a case by case basis, to exempt any person, issuer, public accounting firm or transaction from the prohibition of the provision of the enumerated services. Because Section 201 references services provided by registered public accounting firms and because it contemplates certain exemptions from the prohibition of the enumerated non-audit services, we believe that Congress did not intend Section 201 or the rules promulgated thereunder to take effect until a firm is registered with the Board and the Board is prepared to rule on requests for exemptions. Accordingly, we urge the Commission to coordinate the effectiveness of the rule relating to prohibited non-audit services with the schedule for establishing and organizing the operations of the Board so that it is established and able to consider requests for exemptions.2
- As discussed at the Commission's December 17, 2002 Roundtable on the International Impact of the Proposed Rules on Auditor Independence, the "clock" should start for the five-year period on the effective date of the final rule, thereby requiring the first set of rotations to occur five years later. If the Commission does not adopt this approach, we urge the Commission to at least provide for a two-year transition period, thereby requiring the first set of rotations to occur two years after the effective date of the rule.3 This two-year transition period would permit accounting firms to put in place a succession plan for those partners who must rotate off the audit engagement team and provide time for partners to pass along any institutional knowledge that they have acquired concerning the audit client. Such a transition period would ensure that the quality of the audit is not diminished as partners rotate on and off the audit engagement team.
Audit Committee Administration of the Engagement
- To avoid audit committees having to ratify engagements that already have begun, the final rule should exempt audit and non-audit services that currently are being provided and services that have not yet begun but for which the accounting firm has already been engaged.
- The Commission should provide for a reasonable transition period (e.g., at least six months) to enable audit committees to convene and develop processes and procedures to comply with the new rule. The proposed rule provides that audit committees may develop pre-approval policies and procedures as an alternative to pre-approving each non-audit service that the accounting firm provides. The Commission notes that these policies and procedures must be detailed as to each particular non-audit service. With such a standard, audit committees will have to consider carefully the scope of non-audit services that will be provided by the accounting firm and develop policies and procedures that are tailored to each particular service. To accomplish this task effectively will require time and, more likely than not, multiple audit committee meetings and discussions with management.
- If the Commission adopts a final rule in the compensation area (which is not required by the Act), the final rule should exempt arrangements that are in place on the effective date of the final rule.
- The Commission should, if it adopts a final rule, provide for a reasonable transition period to allow accounting firms to implement processes and procedures to ensure that partners are not directly compensated for non-audit services provided to an audit client.
Communication with Audit Committees
We urge the Commission to be mindful of the effect of its rules on audit committees. Under the Act and the proposed rules, audit committees are given an increased number of responsibilities and tasks that will require additional meetings that will be lengthier and require more advance preparation. These effects will be magnified as a result of accelerated filing deadlines and the increased responsibilities imposed under parallel rulemaking proposals by the various exchanges. Although we support the Commission's efforts to ensure that audit committees take an active role in ensuring auditor independence and the integrity of the issuer's financial statements, we caution the Commission that these increased burdens may become a significant deterrent preventing many qualified individuals from agreeing to serve on audit committees. This would undermine the fundamental goal of the Act to improve the quality of financial reporting. To help alleviate the burden on audit committees, we encourage the Commission not to expand the rules beyond the Act's requirements, to grandfather the services and relationships in existence on the effective date of the final rules and to provide for reasonable transition periods.
C. To the Extent that the Commission Is Concerned that the Final Rules Do Not Adequately Guard Independence, the Board May Implement Professional Standards to Cure Any Perceived Deficiencies
In many cases, particularly for proposals that significantly exceed the requirements of the Act and the expectations created by that legislation and those that affect significantly the operation of the audit committee or the internal operations of accounting firms, we urge the Commission to defer rulemaking until the proposals can be more fully reviewed and properly coordinated both with the proposals of the various securities exchanges on audit committee formation and operation and the formation and certification of the Board. These proposals include the significant expansion of the partner rotation requirements and related "time-out" period and the introduction of substantive regulation of internal compensation decisions at accounting firms.
As noted throughout this comment letter, we are concerned that the rules greatly exceed the requirements set forth in the Act and that the proposed rules' overbreadth ultimately will impair audit quality. However, we understand the Commission's concern that independence be guarded so as to protect investors. To the extent that the Commission believes that the proposed modifications to final rules may not ensure independence in all cases, we note that the Board has rulemaking authority under the Act (subject to oversight by the Commission) to adopt professional standards to ensure auditor independence and to protect the integrity of an issuer's financial statements. Accordingly, we urge the Commission to be mindful of the extreme time pressures it is placing on auditors and their audit clients, to adopt the rules required by the Act and to wait until the Board is established to determine whether further rulemaking is appropriate.
D. The Commission Should Avoid Further Diminishing the Already Limited Supply of Qualified Auditors by Unnecessarily Rendering Certain Auditors Not Independent or by Increasing Auditors' Liability to Such a Degree that They Will Be Deterred from Continuing in or Even Entering the Profession
As the Commission is aware, the supply of qualified auditors is limited, especially in cities outside major U.S. financial centers and in industries in which specialized knowledge is required to audit an issuer's financial statements. As we discuss in detail below, many of the proposed rules will have the direct or indirect effect of further limiting the supply of auditors, whether by implementing mandatory rotation or restricting the types of services that an auditor may provide. Such rules could have a number of adverse effects. To the extent that the supply of qualified auditors is limited and to the extent that accounting firms must implement additional procedures to ensure auditor independence, fees charged by accounting firms likely will increase, and may rise to a level that is unacceptable to some issuers. As a result, issuers may turn to smaller accounting firms, which could have the effect of diminishing the quality of the audit.
In addition, to the extent that individual accountants feel that the Act and related rules place too much liability on them and unduly restrain their professional growth, they may choose to exit the profession or not to enter the profession at all, which again will have the effect of limiting the supply of qualified auditors. Therefore, we encourage the Commission not to expand unnecessarily the rules' scope beyond the requirements of the Act in a way that will negatively impact the supply of auditors.
A number of the proposed rules distinguish between "audit" and "non-audit" services. Given that different requirements often apply depending upon which type of service is provided, we request that the Commission either define these terms or provide explicit guidance as to what types of services properly fit within each category. For example, would review of periodic reports or registration statements filed with the Commission constitute audit or non-audit services? Would consultation on a particular disclosure requirement be an audit service? Would comfort letters be audit services in all instances? Set forth below are a few examples of instances in which the proposed rules distinguish between audit and non-audit services:
- Partner Rotation: The proposed rule provides that after a partner has been on the audit engagement team in that capacity for five years, he or she may not provide audit services to the audit client for the next five years.
- Audit Committee Administration of the Engagement: The proposed rule requires that an audit committee pre-approve all audit services provided by the accountant. With respect to non-audit services, such services must either (1) be pre-approved, (2) be approved pursuant to pre-approval policies and procedures or (3) fall within a de minimis exception.
- Compensation: The proposed rule prohibits a partner on the audit engagement team from earning or receiving compensation based on the performance of, or procuring of, engagements with the audit client to provide any products or services other than audit or review services.
- Expanded Disclosure: The proposed rule requires issuers to disclose in each of four separate categories the fees paid for audit services, audit-related services, tax services and all other services. As discussed below, we believe that the Commission should clarify the difference between these four categories and reconcile these four categories to the audit service/non-audit service categories referenced in the partner rotation, pre-approval and compensation rules.
In addition to clarifying the difference between audit and non-audit services, for ease of application of the rules, we urge the Commission to confirm that such terms will apply uniformly throughout the auditor independence rules.
F. Because a Violation of the Proposed Rules Could Have a Significant Impact on Both Auditors and Their Audit Clients, the Scope of the Proposed Rules Should Be Clear
Under nearly all of the rules as proposed, a violation of the rules would impair auditor independence, which may require an audit client to have its financial statements re-audited. A violation would also constitute an unlawful act by the auditor. Because a violation would impact both the auditor and its audit client, it is important that the rules be clear as to what does and does not impair independence. In order to protect issuers from unwittingly violating the independence rules, the Commission should clearly identify those services and relationships that would impair independence. For example, and as discussed further below, the Commission should clarify the types of services that would be prohibited internal audit outsourcing activities and the types of financial rewards that would be prohibited under the compensation rule.
G. To the Extent that an Issuer May Not Have Control Over or Knowledge of an Auditor's Actions or Relationships, a Violation of the Proposed Rules Should Not Impair an Auditor's Independence
As discussed above, a violation of nearly all of the proposed rules under Title II would result in impairment of auditor independence, which greatly impacts not only the auditor but, more significantly, the audit client. Upon a finding of impaired independence, an audit client may have to have its financial statements re-audited. Given the significant effect of impaired independence on issuers, we recommend that the Commission remove those provisions regarding an auditor's actions or relationships over which an issuer may have little control and knowledge, such as the rule relating to audit partner compensation, from the independence rules. These provisions are more appropriately recast as professional standards to which an auditor may be subject under the rules to be adopted by the Board (subject to the Commission's oversight) pursuant to Section 102 of the Act rather than independence requirements that may unfairly penalize an audit client.
As the Commission notes in the Proposing Release, the list of prohibited non-audit services set forth in Section 201 of the Act is based on a set of three basic principles.4 According to the Commission, these principles are that an accounting firm should not (1) audit its own work, (2) function as part of management or as an employee of the audit client or (3) act as an advocate of the audit client. The basic principles are similar to the four factors set forth in the preliminary note to Rule 2-01 of Regulation S-X. As the preliminary note indicates, these four factors "are general guidance only and their application may depend on particular facts and circumstances." As is the case with the current four factors, we urge the Commission to clarify that the three basic principles will not be self-executing. We are concerned that the application of the principles without the benefit of the specificity of the enumerated prohibited services will create unnecessary uncertainty in application of the rules and potentially require any services to meet multiple hurdles to assure independence. We note that Congress specifically enumerated the non-audit services that it wished to prohibit, and indicated that the principles were the basis for its list of prohibited services, and did not separately require that the three basic principles be applied to otherwise permitted services.
We believe Congressional intent was clear in establishing that the statutory list of services in Section 201, as appropriately defined through Commission rulemaking, was intended to create a clear, objective and complete set of prohibited non-audit services.5 Applying a separate hurdle that requires an audit committee to test otherwise clearly permissible services against a set of vague principles is inconsistent with both the purpose and the plain language of the Act. The fundamental problem with the Commission's approach is illustrated by the Proposing Release's discussion of tax services. Under the proposal, tax services, which Congress specifically called out as permissible, would potentially have to be separately analyzed under each of the listed specific prohibited non-audit services to determine if the specific service may also arguably fit within one of those categories. Then, even assuming the service survives that gauntlet, the service also would have to be evaluated against the three (or four) general principles set out in the Proposing Release to determine if it implicates one of these. In most cases, an audit committee member will be likely to simply rule out the company's auditors from providing the service rather than accept this administrative burden (and the risk of being second-guessed) even if the auditor is clearly in the best position to provide the permitted service for the issuer.
I. The Commission Should Not Extend Certain Proposed Requirements of the Independence Rules to All of the Entities Within an Investment Company Complex
We are troubled by the scope of the proposed rules' application to investment companies. We believe that the historic approach in Regulation S-X of requiring that the auditors of an investment company be independent of each entity in the investment company complex of which it is a part has been beneficial to investment companies and their shareholders and generally should be preserved. However, we believe that extending the employment of former auditors, partner rotation or pre-approval of non-audit services proposals to all entities within an investment company complex as proposed and the five-year "time-out" period is neither necessary nor desirable and will adversely affect investment companies and their shareholders. These proposals, if adopted, will impose unreasonable burdens on investment companies and their audit committees and threaten the quality of audits performed for investment companies.6
The proposed rule relating to employment of former auditors would apply to employment with any entity in the investment company complex. As proposed, we believe that the rule is overly broad. We note that many entities, such as the transfer agent, may have no relationship with the investment company's financial statements, and therefore, prohibiting employment at such an entity would not further the Commission's goals. Accordingly, we urge the Commission to limit application of the rule to employment with the investment company issuer. To the extent that the Commission declines to follow this approach, we urge the Commission to limit application to the investment company issuer, the investment adviser and any entity that prepares financial statements on behalf of the investment company issuer.
The proposed rule relating to audit partner rotation would prohibit an audit partner from rotating between entities in the investment company complex. We urge the Commission to limit application of the rule to the engagement and review partners on the audit engagement team of an investment company issuer. Under this approach, an audit partner would be permitted, after serving on the audit engagement team of an investment company issuer for five years, to rotate to the audit engagement team of the investment adviser. Similarly, an audit partner would be permitted to rotate among service providers within the same complex.
We believe that the structure and nature of an investment company issuer will be sufficient to ensure independence without application of these "attribution rules". An investment company issuer has its own audit engagement team as well as its own audit committee. Requiring rotation of audit partners on that particular audit engagement team is sufficient to provide for a "fresh look" on the investment company issuer's financial statements. Requiring rotation of audit partners on audit engagement teams of other entities within the investment company complex would not serve to increase the "effectiveness" of the fresh look, as rotation of the lead and reviewing partner on the investment company issuer's audit engagement team results in rotation of those partners with the most direct relationship with the investment company's financial statements.
We are also concerned about the effect on the supply of auditors given the expertise that is required to audit investment companies. Audits of investment companies require an intimate knowledge of the Investment Company Act of 1940 and the rules promulgated thereunder, as well as certain specific provisions of the Internal Revenue Code, such as Subchapter M. This type of expertise is simply not available from the pool of auditors who ordinarily conduct audits of typical reporting companies. The combination of the broad rotation requirement and a five-year time-out period will particularly exacerbate the already limited supply of qualified auditors in the investment company context. Accordingly, we urge the Commission not to apply the partner rotation requirement beyond the investment company issuer. We believe our approach is justified by the Act and will satisfy the Commission's goal of providing a "fresh look" to the investment company's financial statements and accounting methods.
We also are deeply concerned about the scope of the proposed rule relating to pre-approval of non-audit services. The proposed rule would require an investment company issuer's audit committee to pre-approve non-audit services to be provided to the investment adviser and the investment adviser's affiliates that provide services to the investment company in addition to the investment company issuer itself. We propose that an investment company's audit committee only be required to pre-approve the non-audit services provided to that investment company issuer. Investment company issuers rarely, if ever, have control over the other entities within the investment company complex. To require an investment company issuer's audit committee to pre-approve all of the non-audit services provided to the non-investment company entities will unreasonably increase the burden on audit committees and potentially make it difficult for those entities to contract for necessary non-audit services. In many instances, investment companies are serviced by broad financial services providers that use accounting firms for a wide range of non-audit services. Requiring an investment company issuer's audit committee to pre-approve each such non-audit service (which under the proposed rules will presumptively not impair such auditor's independence) will not only increase the frequency with which the audit committees must meet to discuss such services but also will have the effect of delaying such assignments, as the service provider's own audit committee alone will not be able to approve the service. In addition, this requirement will require an unreasonably high level of expanded experience and expertise among investment company audit committee members. The approval process will be inefficient and will create little if any benefit to investors. In addition, the added administrative burden required by the proposed rule may cause accounting firms to withdraw from auditing investment company issuers, which would certainly impair audit quality as there are currently only a limited number of accounting firms and individual accountants with relevant experience that are willing to audit these issuers.
To the extent that the Commission is concerned that an investment company issuer's audit committee will be unable to determine whether an auditor is independent, we note that current auditing standards require that an auditor disclose to the audit committee "all relationships between the auditor and its related entities and the company and its related entities that in the auditor's professional judgment may reasonably be thought to bear on independence...."7 Therefore, current auditing standards already require an auditor to discuss any relationships that may affect the auditor's independence. Given that the Act only requires pre-approval for non-audit services provided to "issuers" and given the likely effect of the proposed rule on the quality of audits, we strongly urge the Commission not to go beyond the Act in this area.
II. CONFLICTS OF INTEREST RESULTING FROM EMPLOYMENT RELATIONSHIPS
A. The Proposed Definition of "Financial Reporting Oversight Role" Goes Beyond What Is Required by the Act and What Is Necessary to Fulfill the Act's Purpose
The proposed rule implementing Section 206 of the Act would prohibit a former member of the audit engagement team from being employed at the audit client in a "financial reporting oversight role" unless he or she was not a member of the audit engagement team during the one-year period preceding the date that audit procedures commenced. As discussed below, we are concerned that the proposed rule goes beyond the Act's requirements in a number of areas that will unnecessarily limit the pool of qualified accountants that issuers may employ and the number of employment positions that a former auditor may accept.
The proposed rule defines "financial reporting oversight role" to include members of the board of directors, chief executive officers, presidents, chief financial officers, chief operating officers, general counsels, chief accounting officers, controllers, directors of internal audits, directors of financial reporting, treasurers or any equivalent persons. In contrast, Section 206 of the Act applies only to those acting as chief executive officers, controllers, chief financial officers, chief accounting officers or any persons serving in an equivalent position for the issuer. As proposed, we believe that the rule is unnecessarily broad. In particular, we urge the Commission not to apply the rule to additional positions (1) that are defined broadly and may therefore not be easily identified or (2) that are overseen by covered positions.
We are concerned that with respect to some of the broader categories of employment positions listed in the proposed rule, such as directors of internal audit or directors of financial reporting, it may be difficult to determine whether a particular position is "equivalent" to such position. For example, would a position as Vice-President, Financial Reporting, fit that description, even if the individual operates three or four layers down in the management hierarchy and is overseen by individuals in two or three other covered positions? We note that the nature of a particular position may be especially difficult for an accounting firm to assess, as it will not necessarily know the role that the former auditor fills as an employee of the audit client. As noted above, clarity is especially important with respect to the independence rules in order to allow issuers and accounting firms to determine readily whether the firm is independent. Given the importance of clarity in this area and given that individuals in these types of positions generally are overseen by others in positions covered by the proposed rule, as discussed below, we do not believe that the rule should go beyond the Act with respect to these or "equivalent positions".
In addition, we believe that the Act is unnecessarily broad as it applies to positions that are overseen by other prohibited positions. We believe that Section 206 is designed to prevent a former member of the audit engagement team from assuming a position in which he or she will have substantial decision-making authority over material aspects of the issuer's financial statements. To the extent that the principal financial officer or principal accounting officer or other executive oversees employees in one of the enumerated positions such as the director of financial reporting, the primary executive acts as a backstop to guard against impaired independence and, accordingly, a rule covering both positions is unnecessarily broad. Therefore, we urge the Commission to eliminate from the final rule those positions (other than the principal executive officer, principal financial officer or principal accounting officer, as those terms are used in Regulation S-K) in which the employee is overseen by a covered employee.
B. The Rule Should Apply Only to the Issuer Audit Client and Any Significant Subsidiaries that Are Not Also Issuers
Unlike the Act, which applies only to employment with "issuers", as that term is defined in Section 10A(f) of the Exchange Act, the proposed rule would apply to employment with "audit clients". "Audit client" currently is defined in Rule 2-01 of Regulation S-X to include the entity whose financial statements or other information is being audited, reviewed or attested and any affiliates of the audit client, which would include certain of the issuer's subsidiaries. As proposed, the rule goes beyond the Act and beyond what is necessary to fulfill the Act's purpose.
We understand that Congress and the Commission are concerned that independence will be impaired when a former auditor has a close relationship with both the auditing firm and the issuer's financial statements. By applying the rule to an issuer and the issuer's subsidiaries, the proposed rule goes beyond what is necessary to ensure independence and also unnecessarily limits the employment opportunities of former auditors. To achieve the Commission's goal in this area while at the same time preserving the maximum number of employment opportunities available to former auditors and the maximum number of qualified candidates available for employment positions, the Commission should limit the rule's application to the issuer and significant subsidiaries that are not also issuers. We note that an issuer subsidiary is subject separately to the independence rules and reporting requirements, and as such, the applicable regulations serve to ensure that the subsidiary's auditors are independent. Therefore, little benefit would be added by prohibiting a member of the parent's audit team from accepting a covered position with the subsidiary, as the independence rules, as applied to "issuers", serve to protect from impaired independence. Similarly, a relationship with an insignificant subsidiary will not raise the independence risks that the Act seeks to address. In this manner, the proposal would not be unnecessarily broad and would protect investors, former auditors and issuers alike. If the Commission declines to follow this approach, we urge the Commission not to expand the rule beyond issuers and consolidated subsidiaries, so as to avoid application of the rule to "common control" affiliates.
C. The Proposed Rule Should Not Be Expanded to Apply to National Office Personnel Who Are Not Members of the Audit Engagement Team
The Commission has requested comment on whether the rule should cover national office personnel who would be excluded under the proposed rule. We understand that the Commission is concerned with independence issues arising when the former member of the audit engagement team has close ties with the other members of the audit engagement team and can "`by reason of his or her knowledge of and relationships with the audit firm, adversely influence the quality or effectiveness of the audit. . .'", as noted in the Proposing Release. We do not believe that such concerns are warranted in the instance of national office personnel who are not members of the audit engagement team.
We note that national office personnel in many accounting firms serve as a "check" on the independence of the audit engagement team. As the Commission is aware, the function of those in the "national office" is to answer specific accounting questions that may arise during the course of an audit, as well as to review financial statements to ensure adequate disclosure and compliance with auditing and financial reporting requirements. Accounting firms design the structure of the relationship between the national office, the regional auditors and the audit clients to ensure distance (and therefore independence) between the national office and the audit client. National office personnel rarely interact with the audit client and only infrequently interact with the members of the audit engagement team. These individuals will not have developed the types of relationships with the audit engagement team and the audit client about which the Act is concerned, and therefore should not be subject to the rule.
Section 206 of the Act provides for a reasonably straightforward one-year cooling-off period. The proposed rule complicates this by attempting to calculate the cooling-off period by counting backwards from the date "when the accountant began the current fiscal year's audit or when the accountant began review procedures necessary to conduct a timely review of the registrant's quarterly financial information associated with the current fiscal year." The Proposing Release goes on to caution issuers that "procedures associated with the planning of the engagement constitute commencement of an audit." For many issuers, however, the audit and planning process may be continuous or may commence at different times in different locations and it will be extremely difficult to pinpoint a commencement date with certainty. We suggest that the Commission adopt a safe harbor under which an audit for a particular year will be deemed not to have commenced prior to the filing of required financial statements for the previous fiscal year. We would also recommend a safe harbor to define when an individual should be considered to have been part of the "engagement team". This could, for example, be defined by the number of hours worked by an individual during the engagement period. This would, among other things, avoid unnecessarily "tainting" an individual who had rotated off the client engagement but provided some de minimis transitional services or responded to one-off questions during the audit, but was not substantially involved in the audit engagement.
III. SERVICES OUTSIDE THE SCOPE OF THE PRACTICE OF AUDITORS
A. Financial Information Systems Design and Implementation
The Commission Should Clarify that an Accountant May Assess and Make Suggestions for Improving the Design and Implementation of Financial Information Systems
Under the proposed rule, an accountant would be prohibited from (1) directly or indirectly, operating, or supervising the operation of, the audit client's information system or managing the audit client's local area network or (2) designing or implementing a hardware or software system that aggregates source data underlying the financial statements or generates information that is significant to the audit client's financial statements or other financial information systems taken as a whole. It is not clear from either the proposed rule or the Proposing Release whether an accountant would be prohibited from making suggestions about the design of the client's financial information systems where the audit client implements those suggestions. The Proposing Release discusses this distinction between designing a system and making suggestions for improvements to a system in the context of internal controls. However, it is unclear whether that distinction would apply here as well, and if so, to what extent an accountant would be able to make specific suggestions regarding design changes that later will be implemented by the audit client.
Given accountants' expertise in the area of financial reporting and the collection and processing of information that forms part of the financial statements, we urge the Commission to permit accountants to make detailed suggestions with respect to the design and implementation of financial information systems. To the extent that the Commission is concerned about auditor independence and "overreaching" in this area, the Commission can specify that an accountant is permitted to make such suggestions as long as the accountant's work is not the primary basis for the design and implementation of an issuer's financial information systems.
The Commission notes that whether a system is used to generate information that is "significant" to the audit client's financial statements may depend on the size of the engagement and requests comment on whether the magnitude as a percentage of either audit fees or total fees of the fees for such services makes a difference on whether performance of the service impairs independence. For reasons discussed below, we believe that the magnitude of the fees in relation to other fees should not be applied in determining whether a service relating to financial information systems design impairs independence.
The proposed rule already provides that certain services are prohibited where the information generated is significant to the audit client's financial statements as a whole. We believe that use of a "significance" threshold protects against an auditor auditing his or her own work. For example, if a particular piece of software designed by the auditor generates information that is related to a small part of the audit client's financial statements, the risk associated with an auditor auditing his or her own work also is small. Even if the auditor's independence vis-à-vis that small part is impaired by such a relationship, any harm from such impaired independence would be minimal, as the information being generated itself has a minimal relationship to the audit client's financial statements. In addition, such a threshold also protects against an auditor from functioning as part of management because if an auditor's work only insignificantly affects the financial statements, his or her role with the issuer vis-à-vis the financial statements necessarily will be marginal. Accordingly, we believe that the Commission should retain the "significance" threshold in the final rule.
B. Appraisal or Valuation Services, Fairness Opinions or Contribution-in-Kind Reports
The Commission notes in the Proposing Release that its staff, when providing interpretations of the application of the auditor independence rules to contribution-in-kind reports, has worked with foreign jurisdictions to accommodate the statutory requirements of those jurisdictions. The Commission requests comment on whether the rules should provide that similar practices or arrangements are permitted where contribution-in-kind reports are required by foreign statute. We note that this jurisdictional conflict is an ongoing issue for accountants and issuers alike and therefore, we strongly urge the Commission to provide for continuation of this practice in the final rule. By providing for this procedure directly in the final rule, the Commission will ensure that this policy will be respected in the future.
C. Internal Audit Outsourcing
The Commission Should Permit Accountants to Perform Nonrecurring Evaluations of Discrete Items or Programs and Operational Internal Audits that Are Unrelated to the Internal Accounting Controls, Financial Systems or Financial Statements
The proposed rule prohibits an accountant from providing any internal audit services related to the internal accounting controls, financial systems or financial statements for an audit client. The Proposing Release notes that this would not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function and would not include operational internal audits unrelated to the internal accounting controls, financial systems or financial statements. The Commission requests comment on whether both of these interpretations should be retained. We strongly believe that they should.
First, accountants are particularly skilled at these types of services and have a deep understanding of the audit client's internal controls and operations. Therefore, to perform discrete tasks or to perform certain operational audits will be much easier and less expensive if the accountant is already familiar with the client's internal operations. Second, by limiting the permitted services to discrete internal audit projects and to operational audits unrelated to the financial statements, the accountant is prevented from assuming a decision-making role within the audit client and does not run the risk of auditing his or her own work-two of the basic principles that underlie the prohibited non-audit services. Therefore, we urge the Commission to permit these types of services to be provided by the audit client's accounting firm.8
Under the current rules, an accountant may provide internal audit services to audit clients with less than $200 million in total assets, provided certain conditions are met. The proposed rule would eliminate this exemption. We share the Commission's concern, as noted in the Proposing Release, that small issuers may not have the capability or sufficient need to establish a full-time internal audit department. Many of these small businesses engage their auditing firms to provide certain internal audit services from time to time, which under the proposed rule, would be prohibited. If this practice is prohibited, small issuers may decide not to have such work done at all. Such a result would not be in the interests of investors.
Under the proposed rule, an accountant would be prohibited from acting, temporarily or permanently, as a director, officer or employee of an audit client, or performing any decision-making, supervisory or ongoing monitoring function for the audit client. The Proposing Release indicates that an auditor would be able to assess the effectiveness of internal controls and recommend improvements in the design and implementation of internal controls and risk management controls, but would not be able to design and implement such controls.
We request that the Commission clarify the differences between recommending improvements to the design of the internal controls that management subsequently implements and designing the internal controls. We can imagine a situation in which the accounting firm recommends a substantial number of improvements to an audit client's internal controls that are subsequently implemented by the audit client. Is there a point at which the scope of the suggested improvements is so great that the accounting firm has in fact designed such internal controls? We are concerned that as proposed, the rule would deter accounting firms from performing a comprehensive assessment of an audit client's internal controls. That is, to the extent that the accounting firm assesses an audit client's internal controls and makes a significant number of detailed suggestions that would improve those internal controls, that accounting firm may be concerned it could be viewed as providing a prohibited non-audit service.
On the other hand, if an accounting firm that is assessing an audit client's internal controls either identifies no significant problems or identifies significant problems but makes only very general suggestions for improvements that provide little guidance for implementation, that accounting firm may have greater assurance it will not be providing a prohibited service, but ultimately, the audit client will have a less effective internal control system.
As the Commission has stated, auditors are in an ideal position to identify weaknesses and recommend improvements in an issuer's internal controls. To prohibit or limit unduly these services reduces an important opportunity to improve the quality of issuers' internal controls. If anything, the Act and the Commission's efforts in implementation have sought to increase auditors' roles in assessing an issuer's internal control system. An assessment without the ability to make appropriate suggestions for improvement, however, would undermine the value of the assessment function and compromise the Commission's very significant efforts to improve internal controls.
Accordingly, we recommend that the Commission permit the accountant to suggest improvements and design ideas for the audit client's internal controls and procedures so long as the accountant's work is not the primary basis for the audit client's design and implementation of its internal controls. Under our proposal, the level of detail of the accountant's suggestions would be irrelevant provided that the audit client or an independent third party has ultimate responsibility for the design and implementation of the internal controls.
Under the proposed rule, an accountant would be prohibited from providing any service to an audit client that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided. The proposed rule expands the current rule by prohibiting legal services provided in any jurisdiction, including those outside of the United States. In light of the vastly differing legal systems throughout the world, we urge the Commission to adopt a final rule that reflects these differences.
As the Commission notes, there are some jurisdictions in which those performing certain accounting functions must be admitted to practice law before the court of a particular jurisdiction. In the event that a jurisdiction does require that such an individual who is performing accounting functions be admitted to practice law, we recommend that the Commission adopt the same type of policy that it currently has with respect to contribution-in-kind reports. That is, the Commission should coordinate with the relevant jurisdiction and the accounting firm and audit client to satisfy the jurisdiction's statutory requirements and the Commission's concern regarding independence. We urge the Commission to incorporate this procedure into the final rule.
Under the proposed rule, an accountant would be prohibited from providing expert opinions for an audit client in connection with legal, administrative or regulatory proceedings or acting as an advocate for an audit client in such proceedings. According to the Proposing Release, such prohibited services would include providing consultation and other services to an audit client's legal counsel in connection with litigation, administrative or regulatory proceedings.
We understand the Commission's concern that by providing assistance to an audit client's legal counsel, the accountant may indirectly be providing expert and advocacy services. However, we believe that an accountant may have factual background relating to the audit client that is useful to the audit client's legal counsel and that the accountant should be able to consult with legal counsel regarding any related questions that may arise. An accountant has unique knowledge about an audit client; to the extent that the audit client may not be able to communicate clearly with legal counsel in accounting-related areas, the accountant should be able to consult with legal counsel to an unlimited extent without being deemed to provide prohibited expert services.
We request, therefore, that the Commission clarify that the accountant may provide factual background and testimony in all contexts, and not just those instances in which the accountant acts as a "fact witness".
The Commission requests comment on whether an auditor should be permitted to serve as a non-testifying expert for an audit client in connection with a proceeding. We believe that an auditor should be able to perform such a function. We note that in instances in which the accountant serves as a non-testifying expert, the auditor essentially serves as an educational tool for the audit client and its legal counsel. A non-testifying expert does not appear in court and is not used to generate evidence. Therefore, the concerns relating to advocacy and the appearance of impropriety are greatly diminished. Accordingly, we urge the Commission to permit an auditor to act as a non-testifying expert where the auditor's work does not provide the basis for testimony by another expert.
As noted in the Proposing Release, Section 201 of the Act specifically contemplates that tax services are permitted non-audit services as long as such services are pre-approved by the audit committee. The Commission does not define "tax services" in the Proposing Release, instead stating that tax services can include a range of activities including the preparation of tax returns, tax compliance, tax planning, tax recovery and other tax-related services. Reviewing tax accruals, on the other hand, would be considered an "audit service", although tax-related.
The Commission notes that classifying a particular service as a "tax service" does not necessarily mean that the service is a permitted non-audit service. Instead, the accounting firm and the audit committee should consider, among other things, "whether the proposed non-audit service is an allowable tax service or constitutes a prohibited legal service or expert service." The Proposing Release goes on to state that the accounting firm and audit committee should be "mindful" of the three basic principles.
To ease application, the Commission should define tax services to include permitted and tax-related non-audit services. That is, rather than identifying a service as a "tax service" and then having to evaluate the service under the categories of prohibited non-audit services, an audit committee and accountant should be satisfied that, once the service is classified as a tax service, such service is permitted. This will add a great deal of certainty to the rule and will be easier for issuers and accountants to apply.9 If there is a service that the Commission believes is tax-related in nature, but more appropriately characterized as a prohibited legal service, the Commission should clarify in the final rules that such a service is a "legal service", rather than a "tax service" that is also a prohibited "legal service".
In defining "tax services", we strongly believe that the Commission should permit an accountant to be able to provide the full range of tax services, due to the accountant's expertise in the area. In the event that the accountant's tax positions are called in to question and the matter is heard in tax court or federal court, the accountant would not be permitted to represent his or her client in the matter, as this would be a clear violation of the prohibition against legal services. Therefore, the prohibition on legal services protects against situations in which an accountant may take a position on a novel tax issue and later have to defend the position and the audit client. Due to the prohibition on legal and expert services, the accountant will not be put in the position of acting as a testifying expert witness or advocating on behalf of the audit client. Instead, the accountant will merely be able to act as a fact witness to explain his or her work and his or her position on the particular issue.
The Commission gives as an example of prohibited "tax services" formulating tax strategies (e.g., tax shelters) that are designed to minimize the audit client's tax obligations (because the accountant may be required to audit his or her own work, become an advocate for the client's position on novel tax issues or assume a management function). We note, however, that in any instance in which the accountant is engaging in tax planning, preparation of returns or tax compliance, the accountant may be deemed to be engaged in an effort to minimize the client's tax obligations. We suspect, however, that audit clients would find any effort to the contrary troubling, to say the least. Accordingly, we urge the Commission not to prohibit services solely on the basis that they are designed to minimize tax obligations.
IV. PARTNER ROTATION
A. The Time-Out Period Is Unnecessarily Long and Will Greatly Limit the Supply of Qualified Auditors
Under the proposed rule implementing Section 203 of the Act, an accountant is not independent with respect to an audit client when an audit engagement team partner, principal or shareholder performs audit, review or attest services for that issuer or any significant subsidiaries, as a partner, principal or shareholder in each of the five previous fiscal years of the issuer or any significant subsidiaries and continues to serve as a partner, principal or shareholder on the audit engagement team. Following five consecutive years where audit, review or attest services have not been provided to that issuer or any significant subsidiaries by such individual, such individual again may perform audit, review or attest services for the audit client. The Commission requests comment on the length of the time-out period, which under the proposed rule would be five years. Although the Act does not specify the length of the time-out period, the proposed rule would greatly lengthen the current time-out period of two years that was established by the AICPA's SEC Practice Section.
We believe that the proposed length of the time-out period is unnecessary to meet the goals of the Act and will have a significant negative impact on the availability of qualified auditors. For example, if an audit client has a large number of audit partners on its audit engagement team and those partners are required to remain off the engagement team for five years, the audit client may "run out" of qualified audit partners at the accounting firm, especially if either the accounting firm is small or the audit client requires a significant number of partners with expertise in a specific area. Indeed, to the extent that the accounting firm "runs out" of qualified audit partners to serve on the audit engagement team, the audit client may have to rotate to a different accounting firm, with the rule thus resulting in a de facto mandatory audit firm rotation. By requiring the Comptroller General of the United States to study the possible effects of mandatory audit firm rotation, Section 207 of the Act specifically rejects such mandatory rotation. Therefore, to the extent that the length of the rotation period has an effect on the number of audit partners available to serve on audit engagement teams and leads to audit firm rotation, the proposed rule may conflict with the Act.
The Commission notes in the Proposing Release that a five-year time-out period will "ensure investors that there will be a periodic fresh look at the accounting and auditing issues confronting the company." The Proposing Release goes on to state that "[i]f a shorter `time-out' provision is used, investors might believe that partners merely would be placed in [a] secondary role for a year or two, only to resume the same roles that they previously occupied and to return to the prior engagement team's approach to the accounting and auditing issues." If the time-out period is five years, the Proposing Release notes that it will be more likely that a partner will move on to a different audit client rather than being held in abeyance. We do not believe that whether a partner remains in abeyance for two years or moves on to another audit client is relevant to the determination of whether there has been a "fresh look". Rather, the relevant inquiry should be whether the time-out period is long enough to permit the "new" audit partner to provide a "fresh look". We strongly believe that two audit cycles is a sufficiently long period for a new audit partner to provide a meaningful fresh look at the audit client's financial statements and would therefore serve the rule's purpose.
Because the supply of qualified auditors already is limited and because there are numerous audit clients that require specialists in a wide variety of areas, we are concerned that there are not enough qualified auditors to permit such a lengthy rotation period. Accordingly, we urge the Commission to retain the current two-year time-out period.
B. As Applied to All of the Partners on the Audit Engagement Team, the Proposed Rule Is Too Broad and Goes Beyond What Is Necessary to Ensure Auditor Independence
Unlike Section 203, which applies to the lead and reviewing partners, the proposed rule would require all of the partners who provide audit services to the issuer to rotate. As the Proposing Release notes, the proposed rule could apply even to tax partners in the event that they become involved in the audit. We strongly believe that the rule as proposed is too broad.
We understand the Commission's concern that audit partners not "grow up" on the audit engagement team and that from time to time a "fresh look" be put on the audit client's financial statements. However, we believe these goals can be accomplished by limiting the partners that are required to rotate to the lead and reviewing partners. The lead and reviewing partners have ultimate responsibility for the audit and are charged with ensuring that the other members of the audit engagement team are independent. In "signing off" on the audit report, the lead and reviewing partners are responsible for ensuring that each aspect of the audit was performed properly and in accordance with generally accepted auditing standards. Therefore, to the extent that the lead and reviewing partners review the entire audit process, a "fresh look" is put on that process each time the lead and reviewing partners rotate.
We believe that a rule requiring additional partners to rotate would impact severely the quality of the audit by limiting the supply of qualified partners and may result in de facto audit firm rotation. For example, if a particular audit client has a specific and unusual tax issue that arises each year during the audit process that requires the assistance of a tax partner, and if there is only one tax partner in the accounting firm that is qualified to handle the particular issue, the audit client may be forced to change accounting firms in order to receive advice on that particular issue. Alternatively, the accounting firm or the audit client may turn to another partner in the accounting firm who is not as qualified to assist on that particular issue, or may decide not to pursue the issue, in either event diminishing the quality of the audit. We are especially concerned about this result to the extent that the rule applies to tax partners and other partners with expertise in a specialized area.
For the reasons discussed above, we strongly urge the Commission not to go beyond the Act in this area and require rotation of only the lead and reviewing audit partners. To the extent that additional partners should be subject to some rotation requirement, the Board, in its development of professional standards, is the appropriate body to consider this issue.
C. As Applied to the Issuer and the Issuer's Significant Subsidiaries, the Proposed Rule Is Too Broad
The proposed rule goes beyond the Act, which applies to the lead and reviewing partner for only the issuer's audit engagement team, and applies to partners on the audit engagement team of the issuer and the issuer's significant subsidiaries. Under the proposed rule, therefore, an audit partner would be prohibited from serving on the audit engagement team of the issuer for five years and then rotating to the audit engagement team of an issuer's significant subsidiary.
We understand the Commission's concern that simply rotating to a related entity still may place an audit partner in a position of influence with respect to the audit of the issuer's financial statements. However, given that the partner in charge of auditing the issuer's financial statements will be a "new" partner, any concerns that the Commission may have about the old partner's ongoing influence and relationship to the issuer's financial statements will be counterbalanced by the new partner, who is putting a "fresh look" on the financial statements and accounting methods. We believe that the rule could be narrowed and apply only to parent issuers and any non-issuer subsidiaries. Subsidiaries that also are issuers are separately subject to the proposed independence rules as well as to reporting requirements. To apply the rotation rule to issuers and their issuer subsidiaries would be unnecessarily broad, as existing and proposed regulations serve to protect against impaired independence of such subsidiaries' auditors. Under this proposal, an auditor would be able to rotate off the parent's audit engagement team to the issuer subsidiary's audit engagement team. We believe that this approach more closely follows the Act (which applies to issuers), while at the same time satisfying the Commission's concern that an audit partner's influence not linger after he or she no longer is on the audit engagement team.
V. AUDIT COMMITTEE ADMINISTRATION OF THE ENGAGEMENT
A. The Commission Should Provide that an Audit Committee May Establish Pre-Approval Policies and Procedures for Narrow Categories of Services So Long as They Are Detailed with Respect to the Procedures to Be Followed
As an alternative to pre-approving a specific non-audit service, the proposed rule provides that an engagement with respect to a non-audit service may be entered into pursuant to pre-approval policies and procedures established by the audit committee of the issuer, provided that the audit committee is informed of each service. The Proposing Release states that such policies and procedures must be detailed as to the particular service and designed to safeguard the continued independence of the auditor.
We recommend that the Commission provide that rather than being detailed as to each particular non-audit service, such as due diligence for a specific contemplated acquisition or tax compliance services for a specific subsidiary, the policies and procedures may cover specified categories of services, such as due diligence for acquisitions or tax compliance services. If an audit committee is required to develop detailed procedures and policies for each particular service, we are concerned that audit committees will not be able to anticipate and provide procedures for each particular non-audit service that may be required and that this option will in practice become a requirement that each service be pre-approved.
If audit committees are required to pre-approve each specific non-audit service that an accounting firm provides, the audit committee will have to meet frequently and often with little or no advance notice, especially in the case of non-audit services that must be provided in emergency situations where no advance notice is possible. In many instances, the members of the audit committee, or the member to whom approval authority has been delegated, may be unavailable to pre-approve the service.10
The Commission should permit audit committees to develop policies and procedures that are tailored to specified categories of non-audit services rather than to particular non-audit services. To ensure that management is not given too much discretion over the engagement, the Commission can provide that the policies and procedures, although applying to categories of services rather than specific services, must be detailed so as to ensure that the audit committee, in developing such procedures, is in practice exercising a significant degree of control over management.
B. The Commission Should Expand the Pre-Approval Policies and Procedures Option to Allow for Approval of a Category of Services the Fees for Which Fall Below a Specified Level
In addition to permitting pre-approval policies and procedures to cover specified categories of services such as tax compliance, we urge the Commission specifically to confirm that a permitted category of services would include services the fees for which are below a specified dollar amount or percentage of total fees that are paid to the accounting firm over the course of a year. Under this proposal, an audit committee would have the option of adopting this policy as one of its pre-approval policies and procedures. By permitting audit committees to establish these types of pre-approval policies and procedures, the Commission would reduce the burden on audit committees, as audit committees would not have to develop particular pre-approval policies and procedures for each minor non-audit service that an accounting firm may provide.
C. The Commission Should Clarify the Timeframe in Which Audit Committees Must Be Informed of Engagements for Non-Audit Services Entered into Pursuant to Pre-Approval Policies and Procedures
The proposed rule provides that the audit committee must be "informed" of non-audit service engagements entered into pursuant to pre-approval policies and procedures. We recommend that the Commission clarify that this language means that management must inform the audit committee before the audit committee's next scheduled meeting, thereby coinciding with the requirement that members of the audit committee to whom approval authority has been delegated must inform the full audit committee of any decisions that the member makes at each scheduled meeting.
D. The Rule Should Not Require an Issuer to Pre-Approve Non-Audit Services Provided to Subsidiaries that Also Are Issuers or to Unconsolidated Subsidiaries
The proposed rule would require an issuer to approve non-audit services provided to an issuer or its subsidiaries. As applied to any subsidiary of the issuer, we believe that the rule is unnecessarily broad. In particular, we recommend that the rule not apply to non-audit services provided to subsidiaries that are issuers themselves or to unconsolidated subsidiaries. In the case of issuer subsidiaries, we note that the subsidiary's audit committee would be required to pre-approve the non-audit service itself, and to require multiple layers of review of the non-audit service would be unnecessarily duplicative and burdensome. The issuer subsidiary's audit committee is charged with ensuring an auditor's independence, and to the extent that the subsidiary's audit committee reviews the proposed service, we believe that such review is sufficient to guard against impaired independence. In the case of subsidiaries that may be controlled by another issuer, that particular issuer's audit committee already will be required to approve the service. We do not believe that the rule should have the effect of requiring multiple layers of approvals that possibly could lead to the effect of a particular audit committee having "veto power" over the provision of a non-audit service. We are especially concerned about this result in the context of a subsidiary over which the issuer does not have control. Accordingly, we urge the Commission to exclude from the proposed rule non-audit services provided to subsidiaries that also are issuers and unconsolidated subsidiaries, so as to avoid application to subsidiaries that are "common control" affiliates.
A. The Act Does Not Contemplate Commission Regulation of Compensation Matters and We Strongly Urge the Commission Not to Adopt the Proposed Rule Which is Not Necessary to Ensure Auditor Independence
Under the proposed rule, an accountant is not independent of an audit client if, at any point during the audit and professional engagement period, any partner, principal or shareholder who is a member of the audit engagement team earns or receives compensation based on the performance of, or procuring of, engagements with that audit client to provide any products or services other than audit, review or attest services. For the reasons discussed below, we strongly believe that the Commission should not adopt the proposed rule.
We first note that the proposed rule is not required by the Act. More significantly, however, we believe that the proposed rule is not necessary to ensure auditor independence. The proposed rule would effectively prohibit members of the audit engagement team from participating in the provision of any non-audit service, a prohibition that is contemplated neither in the Act nor in any specific discussion in the Proposing Release which itself appears to focus on marketing and sales activities by members of the audit engagement team. As noted in the Proposing Release, some accounting firms may offer their partners monetary incentives to sell non-audit services to audit clients. We understand that the Commission views such incentive programs as "inconsistent with the independence and objectivity of external auditors that is necessary for them to maintain, both in fact and in appearance." Although we agree with the Commission that it is important for auditors both to appear and in fact be independent, we do not agree that compensating professionals for providing non-audit services or procuring engagements for non-audit services that are expressly permitted under the Commission's rules and therefore recognized as not implicating independence, would impair or appear to impair independence. If the Commission's rules recognize that the accountant may perform the service without compromising independence, we do not see the reason for the Commission to seek to discourage accountants from performing these services by directly regulating internal compensation issues at accounting firms.
The Commission notes that the proposed rule should reinforce the position that "accountants at the partner level should be viewed as skilled professionals and not as conduits for the sale of non-audit services." We do not agree that performing valuable non-audit services for an audit client and receiving payment for such services, or being compensated for attracting an audit client to use the firm for non-audit services to be provided by another accountant in the accounting firm, would tarnish a partner's reputation as a "skilled professional". In many cases, of course, it is just the individual's reputation and status as a "skilled professional" that would induce the audit client to use the individual's firm for other related services. If the Commission is concerned with how an audit partner markets or "sells" non-audit services to an audit client, the Board can implement professional standards to ensure that such services are "sold" to audit clients in a way that does not impair the integrity of the profession.
B. If the Rule Is Retained, the Commission Should Limit the Prohibition to Direct Compensation
If the Commission declines to eliminate the rule entirely, we recommend that the Commission clarify that the rule applies only to direct compensation. Although the Commission provides as examples of prohibited compensation cash bonuses and other financial incentives to sell products or services, the Proposing Release also states that "`compensation'. . . would include any form of income or monetary benefit distributed to the partner, principal or shareholder." We are concerned that "compensation" could be interpreted by some to include a partner's share of the accounting firm's overall profits, meaning that firms would be required to set up complicated internal fee allocation arrangements to ensure that the audit partner received no "monetary benefit" attributable to the permitted non-audit service.
To the extent that the Commission is concerned about audit partners focusing more attention on selling non-audit services than on the audit as the result of a potential and specific monetary reward, we believe that the Commission's goal is not served by the proposed rule. A partner likely will not be encouraged to cross-sell a non-audit service any more than he or she will be encouraged to sell an audit service if the financial reward is an increase in firm profits that will be divided among the firm's partners and thus diluted by the time such partner receives his or her share. On the other hand, if the partner knows that he or she will receive a specific cash bonus as the result of cross-selling services related to due diligence in mergers and acquisitions, then he or she will be encouraged to focus his or her efforts on inducing the audit client to engage the firm for those services, rather than on increasing the firm's goodwill (the financial value of which would be shared among all of the firm's partners) by performing particularly well on an audit. Given that increased firm profits serve as a far less powerful incentive than cash bonuses, we urge the Commission to restrict the rule to direct compensation.
In addition to the fact that increased profits do not provide a specific incentive to cross-sell a non-audit service, it would be administratively difficult to ensure that profits derived from a particular non-audit service are not passed along to the partner on the audit client's engagement team. Under the proposed rule, an accounting firm first would have to determine whether any non-audit services were provided to an audit client during the fiscal period. Second, the firm would have to determine the exact amount of profit derived from that particular non-audit service, subtract that amount from the firm's overall profits, and pay the partner his or her share of such profits. These steps would have to be performed for each audit client and for each partner in the accounting firm, which would be extremely complicated, especially in a firm with a large number of partners and audit clients. Given the lack of a specific incentive to cross-sell non-audit services where the only reward is an increase in firm profits, we believe that the burdens of such a system would outweigh the benefits.
Accordingly, if the Commission adopts a final rule regarding audit partner compensation, the Commission should limit the prohibited compensation to "direct" compensation and exclude from the definition any compensation received through the partnership-wide division of profits. We believe this approach certainly is warranted, given that the Act does not even require such a rule.
C. The Commission Should Not Expand the Rule to Include Compensation for Managers, Supervisors and Staff Accountants
The proposed rule would apply to partners, principals and shareholders who are members of the audit engagement team. The Commission requests comment on whether the rule also should apply to managers, supervisors and staff accountants. For the reasons discussed below, we strongly believe that it should not.
Partners on the audit engagement team, and particularly the lead partner, are responsible for ensuring that the audit is conducted in accordance with generally accepted auditing standards and applicable law, and as a result, they must protect the independence of the members of the audit engagement team vis-à-vis the audit client. As the individuals who ultimately "sign-off" on the audit, audit partners provide sufficient protection on independence issues.
Applying the compensation rules to those below the partner level may also be problematic due to the type of compensation that such employees may traditionally receive. An accounting firm may compensate its professional employees supplementally based on the employees' and the firm's performance. We are concerned that if an employee receives supplemental compensation for performing well on due diligence for a specific business combination transaction (most likely a non-audit service), such compensation would be prohibited under the proposed rule. As another example, if the employee performed well on multiple projects for an audit client for which he or she was a member of the audit engagement team, some of which were non-audit services, part of that supplemental compensation may be prohibited under the proposed rule. If this is the case, it will be difficult to determine exactly what portion of the compensation may not be given to the employee. Given that the partners on the audit engagement team act as a "safety net" to guard against the effects of impaired independence, we do not believe that application of the proposed rule to the level of professional employees is either necessary or worth the burden that it would place on both accounting firms and employees who are non-partner members of the audit engagement team.
For the reasons discussed above, we urge the Commission not to expand the rule to apply to compensation given to accountants other than partners on the audit engagement team. We believe that the Commission's concerns are addressed by the structure of the audit engagement team itself, which places ultimate responsibility for the audit on the audit partners.
VII. COMMUNICATION WITH AUDIT COMMITTEES
A. The Commission Should Not Go Beyond the Act Regarding the Timing of the Required Communications Between the Accounting Firm and the Audit Committee
Under the proposed rule implementing Section 204 of the Act, a registered public accounting firm performing an audit must report to the audit committee (1) all critical accounting policies and practices to be used, (2) all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management and (3) other material written communications between the registered public accounting firm and management. The proposed rule specifies that such communications must be made prior to the filing of the audit report with the Commission.
With regards to the required timing of the communications, the proposed rule goes beyond the Act, which requires that such communications be "timely". In addition, as the Commission notes in the Proposing Release, generally accepted auditing standards state that such communications must occur on a timely basis and are not required to occur before the issuance of the auditor's report on the entity's financial statements. Generally accepted auditing standards note, however, that there may be instances in which such discussions, particularly those relating to the initial selection of significant accounting policies and audit adjustments, should occur prior to the filing of the audit report or in some instances much earlier.11 The timing of those communications is left to the auditor's judgment, thereby creating a flexible rule that is based on the particular nature of the discussions. Given the added burden placed on audit committees by the Act and given that many of these communications are, as described by current auditing standards, "incidental to the audit", we believe that the Commission should follow the Act in this area and require that the reports be "timely", thereby giving both audit committees and auditors flexibility in determining when such communications should be made.
The Proposing Release states that the communications may be oral or written. The Commission requests comment on whether such communications should be required to be written. For the same reasons discussed throughout this comment letter relating to added burdens placed on both accounting firms and audit committees, we believe that such communications should be permitted to be oral.
First, we note that the Act does not specify whether the communications must be oral or written (the Act only uses the term "report"); generally accepted auditing standards provide that such communications may be oral. Therefore, the Commission would be acting in conformity with the Act and generally accepted auditing standards if it were to permit such communications to be oral. Second, permitting oral communications gives accounting firms the flexibility of discussing issues at an audit committee meeting without first having to prepare a formal report. Third, we note that in some instances, oral communications may be more effective than written communications, as oral communications permit the audit committee to engage in an active and casual dialogue with the accounting firm regarding a particular issue. Although oral communications may be more informal, they permit more questions to be asked of auditors and allow for more efficient and more "real-time" dialogue. Accordingly, we urge the Commission to permit such communications to be oral.
VIII. EXPANDED DISCLOSURE
A. The Commission Should Confirm that the Required Proxy Statement and Annual Report Disclosure Satisfies the Disclosure Requirements of Section 202 of the Act
The proposed rule requires disclosure regarding fees paid to accounting firms for audit and non-audit services, the audit committee's pre-approval policies and procedures and the percentage of fees paid for services that were approved pursuant to each of the (1) pre-approval, (2) approval pursuant to pre-approval policies and procedures and (3) de minimis exception "options" that are available under the proposed rule implementing Section 202. We request that the Commission confirm that the disclosure required under the proposed rule will satisfy Section 202's requirements.
B. The Commission Should Clarify the Types of Services to Be Disclosed Under the Four Categories Set Forth in the Proposed Rules
We request that the Commission clarify what types of services must be disclosed in each of the "Audit Fees", "Audit-Related Fees" and "Tax Fees" categories. In particular, do the services that must be described in proxy statements under the category "Audit Fees" correspond to "audit services", as that term is used elsewhere in the proposed rules and the Proposing Release? Would services that must be described under "Audit-Related Fees" be characterized as non-audit services or would those be audit services as well? We request that the Commission clarify the types of services to be disclosed under these three categories.
In addition, we note that there are numerous areas in which a particular service could be disclosed under multiple categories. As an example, tax services provided in connection with due diligence for a potential business combination could, as the categories are described in the proposed rules and in the Proposing Release, be disclosed under "Audit-Related Fees" or "Tax Fees". Tax services provided in connection with an audit could be disclosed under "Audit Fees" or "Tax Fees". To the extent that there is overlap among the three specific categories, we request that the Commission provide guidance as to how such overlap should be treated.
The Commission requests comment on whether companies should be required to provide fee information in their quarterly reports. Given the annual nature of the audit process, we believe that disclosure on a quarterly basis will not be representative of the overall fees paid to accounting firms and will be of little benefit to investors. In addition, to the extent that registrants will have to collect this information and determine whether a particular service falls within one reporting period or another and within one category or another, registrants will have to spend time gathering and analyzing the information, which will be especially difficult given the accelerated filing deadlines. We believe that any benefits derived from the additional disclosure, which as discussed are minimal at best, will be greatly outweighed by the burdens of having to gather and process this additional information. Accordingly, we urge the Commission to require such disclosure on an annual basis.
D. We Recommend that the Commission Eliminate the Disclosure Regarding the Percentage of Fees Paid for Services that Were Approved Using Each of the Permitted Approval Methods
The proposed rule would require issuers to disclose in each of the "Audit-Related Fees", "Tax Fees" and "Other Fees" categories the percentage of fees paid for services that were approved using each of the (1) pre-approval, (2) approval pursuant to pre-approval policies and procedures and (3) de minimis exception "options". We strongly recommend that the Commission eliminate this requirement.
We note that the Commission specifically permits each of these approval policies and procedures to be used. By requiring issuers to disclose how frequently their audit committees use each of these options, the Commission is placing a "stigma" on the pre-approval policies and procedures option, thereby discouraging audit committees from using such option. As discussed above, allowing an audit committee to adopt pre-approval policies and procedures rather than requiring committees to pre-approve each non-audit service is necessary to alleviate some of the burden placed on audit committees by the Act and allows for non-audit services to be provided in emergency situations or in other situations in which the audit committee is not able to meet or the committee's delegate is not available. Because the proposed disclosure requirement may have the practical effect of eliminating the pre-approval policies and procedures option for audit committees, we strongly urge the Commission to eliminate this requirement.12
The Proposing Release notes that such disclosure "would provide insight into the extent to which the audit committee takes an active, direct role in considering each category of non-audit fee engagements." Although we appreciate the Commission's concern, we believe that these three options recognize that an audit committee can take an active role by directly pre-approving non-audit services or by developing detailed pre-approval policies and procedures for management to follow. By allowing an audit committee to use any of the three options, the proposed rule recognizes that a different level of involvement is appropriate in different situations, and that flexibility is desirable to permit audit committees to avoid meeting to approve each non-audit service. We strongly encourage the Commission to eliminate this disclosure, as it contradicts the Commission's proposed rule relating to approval procedures and provides little benefit to investors.
IX. ISSUES RELATING TO NON-U.S. AUDITORS AND AUDIT CLIENTS
The proposed rules would apply to U.S. and non-U.S. accounting firms and audit clients alike. In addition, we note that as proposed, the rules provide for no transition period with respect to effectiveness relating to non-U.S. accounting firms. As the Commission is aware, rules governing auditor independence issues differ drastically among various countries. Moreover, accounting firms in non-U.S. jurisdictions are often substantially smaller than their U.S. counterparts and have fewer qualified partners. We are concerned that the proposed rules will be extremely difficult, if not impossible, to comply with while at the same time complying with local independence and auditing standards. Certain of the Commission's proposed rules will conflict with local legal standards or rules designed to promote the integrity and independence of the audit and indeed, in certain of these instances, the local rule may be more rigorous than the Commission's proposed rule. We believe that to the extent that an accounting firm or an issuer is having difficulty applying the Commission's rules in the context of a local jurisdiction, the Commission, working together with the Board, is in an ideal position to determine how U.S. and non-U.S. professional standards should be reconciled. We note that in many instances, the Commission and the Board will have to develop policies that apply on a case by case or jurisdictional basis. We are concerned that if the independence rules take effect in January without a transitional period, neither the Commission nor the Board will be in a position to consider, or at least consider thoughtfully, these significant issues. Accordingly, we urge the Commission to defer application of the independence rules to foreign audit firms until such time as the Commission, working together with the Board and appropriate international bodies, is prepared to determine how best to reconcile U.S. professional standards with similar standards applicable in foreign jurisdictions.
B. The Commission Should Clarify that the Proposed Rules Do Not Impose New Auditor Independence Standards on MJDS Issuers
Under the current multi-jurisdictional disclosure system ("MJDS"), certain foreign disclosure documents are not subject to the Commission's independence standards.13 Although the proposed rules would not directly subject additional filings to the auditor independence rules, we are concerned that proposed Rule 10A-2, relating to violations of the independence rules by an auditor, would have the effect of indirectly subjecting such MJDS filings to the auditor independence rules. In particular, proposed Rule 10A-2 provides that a violation of certain of the auditor independence rules will constitute a violation of the Exchange Act on the part of the auditor. The proposed rule does not exempt auditors that audit financial statements to be included in these particular MJDS filings. Therefore, to the extent that an auditor does not comply with certain of the Commission's independence rules, even though such compliance specifically is not required by the applicable registration statement instructions, the auditor will be violating the Exchange Act, which most likely will have the effect of forcing the auditor to comply with the Commission's independence rules. To prevent what we believe is an unintended effect of the proposed rules, we urge the Commission to exempt from Rule 10A-2 accountants14 that are auditing financial statements of MJDS issuers that are included in filings for which independence is not required.
* * *
We appreciate the opportunity to comment to the Commission on the proposed rules, and would be happy to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to John T. Bostelman (212-558-3840), Robert E. Buckholz, Jr. (212-558-3876), David B. Harms (212-558-3882) or Scott D. Miller (650-461-5620).
Very truly yours,
SULLIVAN & CROMWELL LLP
cc: Giovanni P. Prezioso
Jackson M. Day
Acting Chief Accountant
Alan L. Beller
Director, Division of Corporation Finance
|1|| In implementing grandfather provisions and transition periods, the Commission should also adopt appropriate safe harbors to ensure that inadvertent or uncontrolled future developments do not unfairly compromise independence in circumstances in which the goals of the independence rules are not implicated. These would include transactions (e.g., mergers or acquisitions) in which a former audit engagement team member became employed by an audit client or an audit partner in a "time-out" period provided audit services for a company that became a subsidiary of the audit client as a result of the transaction. Similar safe harbors would be appropriate for partner compensation issues and pre-approval of non-audit services in instances where an issuer engages a new auditing firm that in the past provided non-audit services to that issuer.
|2|| We suggest that as part of the application process to become a "registered public accounting firm", firms be permitted to submit a detailed description of certain services they currently provide for which they request an exemption under Section 201. Under this process, the Board could review the firm's application and these requests for exemptions at the same time.
|3|| We note that under standards promulgated by the AICPA's SEC Practice Section, the required rotation period is seven years. Therefore, under current standards, if a lead partner has been on the audit engagement for five years as of the effective date of the final rule, such partner will have to rotate after two years regardless of whether the transition period is longer than two years.
|4|| The Commission notes that a fourth principle (an accounting firm should not be a promoter of the issuer's stock or other financial interests) was discussed on the floor of the Senate.
|5|| S. Rep. No. 107-205 at 17-18 (July 3, 2002) ("A registered public accounting firm may engage in any non-audit service, including tax services, that is not on the list for an audit client only if the activity is approved in advance by the audit committee of the issuer . . . . The intention . . . is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients because doing so creates a fundamental conflict of interest for accounting firms." (emphasis added)) See also H.R. Rep. No. 107-414 at 17 ("[I]t is appropriate to continue dealing with nonaudit services by having the Commission proscribe specific services rather than casting doubt on a broad range of nonaudit services.")
|6|| We note that many of the proposed rules (e.g., those relating to employment of former auditors, partner rotation and partner compensation) refer to services and relationships vis-à-vis "audit clients". Audit client is defined in Regulation S-X to include an audit client's affiliates, which in the case of an investment company would be "[e]ach entity in the investment company complex when the audit client is an entity that is part of an investment company complex." In a few other of the proposed rules (e.g., pre-approval of non-audit services), the rule would apply to investment companies, their investment advisers (not including a sub-adviser whose role is primarily portfolio management and is sub-contracted or overseen by another investment adviser) and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the registered investment company.
|7 || See Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees.
|8|| In addition, as we discuss in detail below, in interpreting the scope of prohibited internal audit outsourcing activities, we encourage the Commission to permit an audit client's auditors to suggest improvements and design ideas for the audit client's internal controls and procedures.
|9|| Although this concept is most obvious in the context of tax services, we urge the Commission to adopt the general position that a particular service should be evaluated by reference to the category in which it most appropriately falls. In this manner, if issuers appropriately characterize a particular service as falling within an exemption to legal services, for example, the service would not have to be evaluated separately under other non-audit services as well.
|10|| In addition, even if the delegate is available to approve such service, the delegate may be reluctant to make such a unilateral decision.
|11|| Statement on Auditing Standards No. 61.
|12|| We also note that the proposed de minimis exception applies to services not recognized at the time of the engagement to be non-audit services. To the extent that these types of services inherently are difficult to distinguish from audit services, it is unclear how it would be useful to investors to "single out" these services and further require issuers to separate them into one of three non-audit services categories.
|13|| For example, the instruction to Form F-7 specifies that the Commission's auditor independence rules do not apply to auditor reports filed on financial statements included in the registration statement on Form F-7.
|14|| We note that the Commission uses the term "auditor" in proposed Rule 10A-2. We request that the Commission clarify that such term has the same meaning as "accountant", as used in other of the proposed rules.