# Revision of the Commission's Auditor Independence Requirements

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URL: https://www.frixlaw.com/law-library/documents/fr%3A00-30244

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** December 5, 2000
- **Citation:** 65 FR 76008

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210 and 240
[Release Nos. 33-7919; 34-43602; 35-27279; IC-24744; IA-1911; FR-56; File No. S7-13-00]
RIN 3235-AH91
Revision of the Commission's Auditor Independence Requirements

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“SEC” or “Commission”) is adopting rule amendments regarding auditor independence. The amendments modernize the Commission's rules for determining whether an auditor is independent in light of investments by auditors or their family members in audit clients, employment relationships between auditors or their family members and audit clients, and the scope of services provided by audit firms to their audit clients. The amendments, among other things, significantly reduce the number of audit firm employees and their family members whose investments in audit clients are attributed to the auditor for purposes of determining the auditor's independence. The amendments shrink the circle of family and former firm personnel whose employment impairs an auditor's independence. They also identify certain non-audit services that, if provided by an auditor to public company audit clients, impair the auditor's independence. The scope of services provisions do not extend to services provided to non-audit clients. The final rules provide accounting firms with a limited exception from being deemed not independent for certain inadvertent independence impairments if they have quality controls and satisfy other conditions. Finally, the amendments require most public companies to disclose in their annual proxy statements certain information related to, among other things, the non-audit services provided by their auditor during the most recent fiscal year.

DATES:

Effective date:
February 5, 2001.

Compliance dates:

Transition Dates:
Until August 5, 2002, providing to an audit client the non-audit services set forth in § 210.2-01(c)(4)(iii) (appraisal or valuation services or fairness opinions) and § 210.2-01(c)(4)(v) (internal audit services) will not impair an accountant's independence with respect to the audit client if performing those services did not impair the accountant's independence under pre-existing requirements of the SEC, the Independence Standards Board, or the accounting profession in the United States. Until May 7, 2001, having the financial interests set forth in § 210.2-01(c)(1)(ii) or the employment relationships set forth in § 210.2-01(c)(2) will not impair an accountant's independence with respect to the audit client if having those financial interests or employment relationships did not impair the accountant's independence under pre-existing requirements of the SEC, the Independence Standards Board, or the accounting profession in the United States. Until December 31, 2002, § 210.2-01(d)(4) shall not apply to offices of the accounting firm located outside of the United States. Registrants must comply with the new proxy and information statement disclosure requirements for all proxy and information statements filed with the Commission after the effective date.

FOR FURTHER INFORMATION CONTACT:

John M. Morrissey, Deputy Chief Accountant, or Sam Burke, Assistant Chief Accountant, Office of the Chief Accountant, at (202) 942-4400, or with respect to questions about investment companies, John S. Capone, Chief Accountant, Division of Investment Management, at (202) 942-0590, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION:

The Commission today is adopting amendments to Rule 2-01 of Regulation S-X
1

and Item 9 of Schedule 14A
2

under the Securities Exchange Act of 1934 (the “Exchange Act”).
3

1
17 CFR 210.2-01.

2
17 CFR 240.14a-101.

3
15 U.S.C. § 78a
et seq.

I. Executive Summary

We are adopting amendments to our current rules regarding auditor independence.
4

The final rules advance our important policy goal of protecting the millions of people who invest their savings in our securities markets in reliance on financial statements that are prepared by public companies and other issuers and that, as required by Congress, are audited by independent auditors.
5

We believe the final rules strike a reasonable balance among commenters' differing views about the proposals while achieving our important public policy goals.
6

4
The amendments were proposed in Securities Act Release No. 7870 (June 30, 2000) (the “Proposing Release”) [65 FR 43148].

5
This release uses the terms “independent auditor,” “auditor,” “independent public accountant,” “accountant,” and “independent accountant” interchangeably to refer to any independent certified or independent public accountant who performs an audit of or reviews a public company's financial statements or whose report or opinion is filed with the Commission in accordance with the federal securities laws or the Commission's regulations.

6
In addition to soliciting comments in the Proposing Release, we held four days of public hearings (July 26, Sept. 13, Sept. 20, and Sept. 21). The public comments we received can be reviewed in our Public Reference Room at 450 Fifth Street, N.W., Washington, D.C., 20549, in File No. S7-13-00. Public comments submitted by electronic mail are on our website, www.sec.gov. The written testimony and transcripts from each of our public hearings (July 26, Sept. 13, Sept. 20, and Sept. 21) are available on our website. For purposes of this release, date references following the names of participants at our public hearings indicate the hearing date for which the participant submitted written testimony and/or appeared as a witness.

Independent auditors have an important public trust.
7

Investors must be able to rely on issuers' financial statements.
8

It is the auditor's opinion that furnishes investors with critical assurance that the financial statements have been subjected to a rigorous examination by an objective, impartial, and skilled professional, and that investors, therefore, can rely on them. If investors do not believe that an auditor is independent of a company, they will derive little confidence from the auditor's opinion and will be far less likely to invest in that public company's securities.
9

7
The profession's principles of professional conduct state, “Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.” American Institute of Certified Public Accountants (“AICPA”) Professional Standards: Code of Professional Conduct (“AICPA Code of Professional Conduct”), ET § 53.

8
Public companies and other public issuers and entities registered with us must have their annual financial statements audited by independent public accountants.
See, e.g.,
Items 25 and 26 of Schedule A to the Securities Act of 1933 (the “1933 Act”), 15 U.S.C. § 77aa(25) and (26), that expressly require that financial statements be audited by independent public or certified accountants.
See also infra
note 34.

9

See, e.g.,
Testimony of John Whitehead, retired Chairman, Goldman Sachs & Co. (Sept. 13, 2000) (“Financial statements are at the very heart of our capital markets. They're the basis for analyzing investments. Investors have every right to be able to depend absolutely on the integrity of the financial statements that are available to them, and if that integrity in any way falls under suspicion, then the capital markets will surely suffer if investors feel they cannot rely absolutely on the integrity of those financial statements.”).

One of our missions is to protect the reliability and integrity of the financial statements of public companies. To do so, and to promote investor confidence, we must ensure that our auditor independence requirements remain relevant, effective, and fair in light of significant changes in the profession, structural reorganizations of accounting firms, and demographic changes in

society.
10

There have been important developments in each of these areas since we last amended our auditor independence requirements in 1983.
11

10
As stated by Baxter Rice, President of the California Board of Accountancy, “[I]n this ever-revolving economy and business environment, it's important that we go back and take a look at these regulations and see whether they are really applicable, and whether or not what we do is going to in any way interfere with or is going to enhance auditor independence, including the public perception of auditor independence.” Testimony of Baxter Rice (Sept. 13, 2000).

11
Financial Reporting Release (“FRR”) No. 10 (Feb. 25, 1983).

More and more individual investors participate in our markets, either directly or through mutual funds, pension plans, and retirement plans. Nearly half of all American households are invested in the stock market.
12

As technology has advanced, investors increasingly have direct access to financial information, and they act decisively upon relatively small changes in an issuer's financial results. These and other market changes highlight the importance to the market and to investor confidence of financial information that has been audited by an auditor whose only master is the investing public.
13

12
In 1999, an estimated 48.2%, or 49.2 million, U.S. households owned equities either in mutual funds or individually, up from 19% in 1983. Investment Company Institute and Securities Industry Association, “Bull Market, Other Developments Fuel Growth in Equity Ownership” (available at www.sia.com/html/pr834.html.).

13

See, e.g.,
Testimony of Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of America (Sept. 20, 2000) (“Our nation's current prosperity and future financial security are tied up as never before in our financial markets. For that reason, whether they know it or not, Americans are enormously dependent on independent auditors, both to * * * ensure the reliability of the information they use to make individual investment decisions and to ensure the efficiency of the marketplace in assigning value to stocks.”); Testimony of Ralph Whitworth, Managing Member, Relational Investors LLC (Sept. 13, 2000) (“[A]uditor independence goes to the very essence of our capital markets, and it's linked inextricably to the efficiencies of our capitalist system.”).

As discussed in the Proposing Release and below, the accounting industry has been transformed by significant changes in the structure of the largest firms. Accounting firms have woven an increasingly complex web of business and financial relationships with their audit clients. The nature of the non-audit services that accounting firms provide to their audit clients has changed, and the revenues from these services have dramatically increased. In addition, there is more mobility of employees and an increase in dual-career families.

We proposed changes to our auditor independence requirements in response to these developments. As more fully discussed below, we are adopting rules, modified in response to almost 3,000 comment letters we received on our proposal, written and oral testimony from four days of public hearings (about 35 hours of testimony from almost 100 witnesses), academic studies, surveys and other professional literature.

The Independence Standard.
Independence generally is understood to refer to a mental state of objectivity and lack of bias.
14

The amendments retain this understanding of independence and provide a standard for ascertaining whether the auditor has the requisite state of mind. The first prong of the standard is direct evidence of the auditor's mental state: independence “in fact.” The second prong recognizes that generally mental states can be assessed only through observation of external facts; it thus provides that an auditor is not independent if a reasonable investor, with knowledge of all relevant facts and circumstances, would conclude that the auditor is not capable of exercising objective and impartial judgment. The proposed amendments to Rule 2-01 included in the rule four principles for determining whether an accountant is independent of its audit client. While some commenters supported our inclusion of the four principles in the rule,
15

others expressed concerns about the generality of these principles and raised questions concerning their application to particular circumstances.
16

In response, we have included the four principles instead in a Preliminary Note to Rule 2-01 as factors that the Commission will consider, in the first instance, when making independence determinations in accordance with the general independence standard in Rule 2-01(b).

14
See discussion in Proposing Release, Section II.B.

15

See, e.g.,
Written Testimony of Dennis Paul Spackman, Chairman, National Association of State Boards of Accountancy (Sept. 13, 2000) (The four principles “set a sensible baseline that is simply stated, easy to understand, useable, and square on the mark. They also serve as an exceptional foundation to the other elements of the proposed revision. * * * [T]hey can serve as a bright beacon giving much needed guidance to members of the profession * * *”); Written Testimony of Robert L. Ryan, Chief Financial Officer, Medtronic, Inc. (Sept. 20, 2000); Written Testimony of John C. Bogle, Member, Independence Standards Board (July 26, 2000).

16

See, e.g.,
Letter of Arthur Andersen LLP (Sept. 25, 2000) (“Arthur Andersen Letter”); Written Testimony of the New York Society of Certified Public Accountants (Sept. 13, 2000).

The amendments identify certain relationships that render an accountant not independent of an audit client under the standard in Rule 2-01(b). The relationships addressed include, among others, financial, employment, and business relationships between auditors and audit clients, and relationships between auditors and audit clients where the auditors provide certain non-audit services to their audit clients.

Financial and Employment Relationships.
Current requirements attribute to an auditor ownership of shares held by every partner in the auditor's firm, certain managerial employees, and their families. We believe that independence will be protected and the rules will be more workable by focusing on those persons who can influence the audit, instead of all partners in an accounting firm. Accordingly, we proposed to narrow significantly the application of these rules. Commenters generally supported our efforts to modernize the current rules because they restrict investment and employment opportunities available to firm personnel and their families in ways that may no longer be relevant or necessary for safeguarding auditor independence and investor confidence.
17

Not all commenters agreed with all aspects of the proposals.
18

We have modified the proposal in some respects, but the final rule, like the proposal, shrinks significantly the circle of firm personnel whose investments are imputed to the auditor. The rule also shrinks the circle of family members of auditors and former firm personnel whose employment with an audit client impairs the auditor's independence.

17

See, e.g.,
Letter of Ernst & Young LLP (Sept. 25, 2000) (“Ernst & Young Letter”); Written Testimony of James J. Schiro, Chief Executive Officer PricewaterhouseCoopers (Sept. 20, 2000); Written Testimony of the New York State Society of Certified Public Accountants (Sept. 13, 2000); Written Testimony of James E. Copeland, Chief Executive Officer, Deloitte & Touche LLP (Sept. 20, 2000); Arthur Andersen Letter.

18
Some commenters, for example, believed that the amendments went too far.
See, e.g.,
Written Testimony of J. Michael Cook, former Chairman and Chief Executive Officer, Deloitte & Touche (July 26, 2000) (supporting proposed rule changes in this area but stating that no partner in an accounting firm should have a financial interest in any of the firm's audit clients); Written Testimony of Ray J. Groves, former Chairman and CEO, Ernst & Young (July 26, 2000) (agreeing with proposals but stating preference to retain current proscription of direct investment in an audit client by all partners, principals, and shareholders of an accounting firm); Testimony of Paul B.W. Miller, Professor, University of Colorado at Colorado Springs (July 26, 2000) (“I want to direct my attention * * * to the ownership [provisions], and my language is plain. It simply says don't do it”); Written Testimony of Ronald Nielsen and Kathleen Chapman, Iowa Accountancy Examining Board (Sept. 20, 2000). While supporting the goals of the modernization, others provided suggestions to address their concerns about possible unintended consequences.
See, e.g.,
Ernst & Young Letter; Letter of PricewaterhouseCoopers LLP (Sept. 25, 2000) (“PricewaterhouseCoopers Letter”).

Non-Audit Services.
As we discuss below,
19

there has been growing concern on the part of the Commission and users of financial statements about the effects on independence when auditors provide both audit and non-audit services to their audit clients. Dramatic changes in the accounting profession and the types of services that auditors are providing to their audit clients, as well as increases in the absolute and relative size of the fees charged for non-audit services, have exacerbated these concerns. As the Panel on Audit Effectiveness (the “O'Malley Panel”) recently recognized, “The potential effect of non-audit services on auditor objectivity has long been an area of concern. That concern has been compounded in recent years by significant increases in the amounts of non-audit services provided by audit firms.”
20

19

See infra
Section III.C;
see also
Proposing Release, Section II.C.

20

The Panel on Audit Effectiveness: Report and Recommendations
(the “O'Malley Panel Report”), at ¶ 5.6 (Aug. 31, 2000). The Chairman of the Public Oversight Board (“POB”) similarly warned about the “uncontrolled expansion” of management advisory services to audit clients. Letter from John J. McCloy, Chairman, POB (former Chairman of the Board of Chase Manhattan Bank and former President of The World Bank), to Walter E. Hanson, Chairman, Executive Committee, SEC Practice Section (“SECPS”) (Mar. 9, 1979).

We considered a full range of alternatives to address these concerns. Our proposed amendments identified certain non-audit services that, when rendered to an audit client, impair auditor independence. The proposed restrictions on non-audit services generated more comments than any other aspect of the proposals. Some commenters agreed with our proposals.
21

Others believed that the proposals were not restrictive enough and recommended a total ban on all non-audit services provided by auditors to their audit clients.
22

Still other commenters opposed any Commission rule on non-audit services.
23

After careful consideration of the arguments on all sides, and for the reasons discussed below, we have determined not to adopt a total ban on non-audit services, despite the recommendations of some, and instead to identify certain non-audit services that, if provided to an audit client, render the auditor not independent of the audit client.

21

See, e.g.,
Testimony of Robert E. Denham, Member, Independence Standards Board (“ISB”) (July 26, 2000) (“I think [the proposals] represent a very thoughtful, rational, coherent set of proposals.”); Letter of Michael McDaniel (Aug. 14, 2000) (supporting SEC proposal and disagreeing with a Form Letter from the AICPA to its members (“AICPA Form Letter”) urging them to write to the SEC to oppose the scope of services proposal); Letter of Randie Burrell, CPA (Aug. 14, 2000) (same); Letter of Leland D. O'Neal, CPA (Aug. 15, 2000) (same); Letter of David A. Storhaug, CPA (Aug. 21, 2000) (same); Letter of Arthur Gross (Sept. 10, 2000); Letter of Kristian Holvoet (Sept. 8, 2000); Letter of Bettina B. Menzel (Sept. 9, 2000); Letter of Robert Hanseman (Sept. 10, 2000); Written Testimony of Thomas S. Goodkind, CPA (Sept. 13, 2000); Testimony of Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of America (Sept. 20, 2000); Written Testimony of Bill Patterson, Director, Office of Investments, AFL-CIO (Sept. 20, 2000); Written Testimony of Frank Torres, Consumers Union (Sept. 20, 2000); Testimony of Nimish Patel, Attorney, Pollet & Richardson (July 26, 2000).
See also
Senator George J. Mitchell (Ret.), “How to Keep Investor Confidence,” Editorial, Boston Globe, pg. A15 (Oct. 28, 2000) (“The commission's proposal is well-reasoned and appropriate. * * * [T]he commission should adopt this rule to protect investor confidence and strengthen the most vibrant financial market system in the world.”).

22

See, e.g.,
Written Testimony of Kayla J. Gillan, General Counsel, California Public Employees' Retirement System (“CalPERS”), which is the largest public retirement system in the United States with over 1.2 million participants (Sept. 13, 2000) (“The SEC should consider simplifying its Proposal and drawing a bright-line test: no non-audit services to an audit client.”); Written Testimony of John H. Biggs, Chairman and CEO of TIAA-CREF, which has 2.2 million participants (July 26, 2000) (“[I]ndependent public audit firms should not be the auditors of any company for which they simultaneously provide other services. It's that simple,”); Written Testimony of Alan P. Cleveland, the New Hampshire Retirement System, with 52,000 members (Sept. 13, 2000) (“We regard the concurrent performance by the company's external auditor of non-auditor services at the direction and under the control of management to be inherently corrosive and fundamentally incompatible with that duty of independence and fidelity owed by the auditor to the investing public”); Testimony of Jack Ciesielski, accounting analyst (July 26, 2000) (“I think the single best way to improve auditor independence and the appearance of auditor independence is to call for an exclusionary ban on non-audit services to audit clients.”); Letter of Carson L. Eddy, CPA, (Aug. 22, 2000) (“It is my opinion that the general public would be better served if Certified Public Accountants providing the attest function for a client were unable to do any other consulting work for that client, with the exception for the ability to prepare tax returns.”); Letter of William V. Allen, Jr., CPA (Aug. 22, 2000); Letter of Terry Guckes (Sept. 9, 2000); Letter of Art Koolwine (Sept. 8, 2000); Letter of Elliot M. Simon (Sept. 9, 2000); Letter of Melvin Schupack (Sept. 9, 2000); Letter of William Odendahl (Sept. 5, 2000).

23

See, e.g.,
Letter of the AICPA (Sept. 25, 2000) (“AICPA Letter”); Letter of KPMG (Sept. 25, 2000) (“KPMG Letter”); Letters of Robert Roy Ward, Chairman and Chief Executive Officer, Horne CPA Group (Sept. 20, 2000), Douglas R. Ream, CPA (undated), Jack W. Palmer (Sept. 9, 2000), Sherry Wilson, CPA (Aug. 28, 2000), and Nathaniel Boyle, CPA (Aug. 16, 2000) (each reiterating concerns expressed in the AICPA's Form Letter).

In response to public comments,
24

in several instances we have conformed the restrictions to the formulations set forth in the professional literature or otherwise modified the final rule to better describe, and in some cases narrow, the types of services restricted. For example, the final rule does not ban all valuation and appraisal services; its restrictions apply only where it is reasonably likely that the results of any valuation or appraisal, individually or in the aggregate, would be material to the financial statements, or where the results will be audited by the accountant. The rule also provides several exceptions from the restrictions, such as when the valuation is performed in the context of certain tax services, or the valuation is for non-financial purposes and the results of the valuation do not affect the financial statements. These changes are consistent with our approach to adopt only those regulations that we believe are necessary to preserve investor confidence in the independence of auditors and the financial statements they audit.

24

See, e.g.,
Ernst & Young Letter; PricewaterhouseCoopers Letter.

We recognize that not all non-audit services pose the same risk to independence. Accordingly, under the final rule, accountants will continue to be able to provide a wide variety of non-audit services to their audit clients. In addition, they of course will be able to provide any non-audit service to non-audit clients.

Quality Controls.
The quality controls of accounting firms play a significant role in helping to detect and prevent auditor independence problems. The final rule recognizes this role by providing accounting firms a limited exception from being deemed not independent for certain independence impairments that are cured promptly after discovery, provided that the firm has certain quality controls in place.

Disclosure of Non-Audit Services.
Finally, we continue to believe that disclosures that shed light on the independence of public companies' auditors assist investors in making investment and voting decisions. Accordingly, we proposed and are adopting requirements for disclosures that we believe will be useful to investors.
25

In response to commenters' concerns about the breadth of the proposed disclosure requirements,
26

however, we have modified them in the final rule.

25
Commenters generally agreed that disclosure would be useful to investors.
See, e.g.,
Written Testimony of James W. Barge, Vice President and Controller, Time Warner (Sept. 20, 2000); Letter of The Institute of Internal Auditors (Sept. 5, 2000); Written Testimony of Dennis Paul Spackman, Chairman of the National Association of State Boards of Accountancy (Sept. 13, 2000); Letter of Marsha Payne, President, Association of College & University Auditors (Sept. 25, 2000); Letter of Keith Johnson, Chief Legal Counsel, State of Wisconsin Board (Sept. 20, 2000); Letter of Peter C. Clapman, Senior Vice President and Chief Counsel, Investments, TIAA-CREF (Sept. 21, 2000).

26

See, e.g.,
Written Testimony of Clarence E. Lockett, Vice President and Corporate Controller, Johnson & Johnson (Sept. 20, 2000); Written Testimony of Philip A. Laskawy, Chairman, Ernst & Young LLP (Sept. 20, 2000).

II. Background

Our Proposing Release generated significant comment and broad debate. We received nearly 3,000 comment letters. In addition to soliciting comments in the Proposing Release, we held four days of public hearings, including one day in New York City, so that we could engage in a public dialogue with interested parties. At the hearings, we heard from almost 100 witnesses, representing investors, investment professionals, large and small public companies, the Big Five accounting firms, smaller accounting firms, the AICPA, banking regulators, consumer advocates, state accounting board officials, members of the Independence Standards Board (“ISB”), academics, and others.
27

In addition, the Subcommittee on Securities of the Senate Committee on Banking, Housing, and Urban Affairs held a hearing about our proposal.
28

27

See
written testimony and transcripts from each of our hearings.

28

A Proposal by the Securities and Exchange Commission to Modernize Its Rules That Govern the Independence of Accountants that Audit Public Companies, Before the Subcomm. On Securities of the Senate Comm. On Banking, Housing, and Urban Affairs,
95th Cong. 2d Sess. (Sept. 28, 2000).

We received thoughtful and constructive input from a broad spectrum of interested parties. That input helped us to understand better the sincere and strongly-held views on all sides and to shape final rule amendments that incorporate these views to the extent consistent with our public policy goals. As discussed specifically below, the final rule amendments, particularly those related to non-audit services, have been modified from the proposals.

Nevertheless, some commenters expressed concern that we have “rushed to regulate,”
29

and they asked that we take more time before addressing auditor independence issues generally, and especially the issues regarding the provision of non-audit services to audit clients. As many commenters noted, however, the issues presented by this rulemaking are not new,
30

and recent and accelerating changes in the accounting profession and in society have made resolution of these issues more pressing. For many years the profession has been discussing modernization of the financial and employment relationship rules, and the scope of services issue has been on the horizon even longer.
31

Many previous Commissions have studied these issues.
32

Against this backdrop, in light of the comments that our proposals generated, and informed by our experience and expertise in these matters, we believe that it is appropriate to act now.
33

29

See, e.g.,
Letter of KPMG; Written Testimony of Robert K. Elliott, Chairman, AICPA (Sept. 13, 2000) (“There is no reason * * * for a rush to judgment on these critical issues. We have the time to get it right, and the public is entitled to nothing less.”); Written Testimony of Barry Melancon, President and Chief Executive Officer, AICPA (Sept. 13, 2000); Letters of Richard W. Hammel, CPA (Sept. 25, 2000), Roland H. Flyge II, CPA (Sept. 23, 2000), and Daniel P. Naragon, CPA (Sept. 25, 2000) (each reiterating concerns expressed in the AICPA Form Letter).

30

See
Written Testimony of Bevis Longstreth, former SEC Commissioner and member of the Panel on Audit Effectiveness (Sept. 13, 2000) (“The SEC acting upon the need for greater independence, a need long recognized by virtually every group assigned the task of considering the issue (and there have been many), has proposed a rule to meet this need.”); Testimony of Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of America (Sept. 20, 2000); Written Testimony of Douglas Scrivner, General Counsel, Andersen Consulting (Sept. 20, 2000) (“This issue is not new. The issue has been debated within the profession and by others for over 20 years. The only thing that has changed, in my opinion, is that the risks to the system have increased.”); Written Testimony of Dennis Paul Spackman, Chairman of the National Association of State Boards of Accountancy (Sept. 13, 2000) (“[A]ction is needed. Indeed, I believe it is long over due. While further study may enhance the finer points of the issues, it would do nothing to resolve the larger concerns. They have been deliberated far too long.”); Testimony of Larry Gelfond, CPA, CVA, CFE, former President of the Colorado State Board of Accountancy (Sept. 13, 2000) (“I firmly believe the SEC is taking a correct position in this long debated area of concern to the profession.”).

31
Congress itself considered the issue of scope of services in the 1970s.
See Report on Improving the Accountability of Publicly Owned Corporations and Their Auditors, Subcomm. on Reports, Accounting and Management of the Senate Comm. on Governmental Affairs,
95th Cong., 1st Sess. (Comm. Print Nov. 1977).

32
In the late 1980s, for example, several of the large public accounting firms filed a petition with us seeking to enter into joint ventures, limited partnership agreements, and other similar arrangements with audit clients.
See
Letter from Jonathan G. Katz, Secretary, SEC, to Duane R. Kullberg, Arthur Andersen & Co. (Feb. 14, 1989) (denying the petition).

33

See Richard C. Breeden, Roderick M. Hills, David S. Ruder and Harold M. Williams
(former Chairmen of the SEC), Editorial, “Accounting for Conflicts,”
Wash. Post,
at A31 (July 21, 2000) (“This initiative is timely and necessary. * * * [T]he time has come to chart a surer path to preserving the all-important principle of auditor independence from commercial client relationships.”); James J. Schiro, Chief Executive Officer, PricewaterhouseCoopers LLP, “Auditor Independence: It's Time to Change the Rules,” Wall St. J. (Oct. 10, 2000) (“
New rules are needed now.
Working together, we can devise rules that will protect the public interest today and for decades to come. The need for change is upon us. Further delay will only prolong confusion at a time when greater clarity is needed.”) (emphasis in original); Written Testimony of Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of America (Sept. 20, 2000) (“[A] more compelling question is, why wait? * * * Speaking for consumers across the country, we urge the Commission to move forward expeditiously with this important rule proposal.”); Testimony of Professor John C. Coffee, Columbia University (July 26, 2000) (“Right now you have the appropriate moment because the vast majority of firms aren't purchasing dual services. If you wait ten years, that will change, and [it's] much harder to change an existing reality rather than an approaching change. So I think this is the time for action. * * *”); Testimony of J. Michael Cook, former Chairman and Chief Executive Officer, Deloitte & Touche (July 26, 2000) (“[T]he Commission's consideration of this issue at this time is both warranted and necessary. The status quo is not an acceptable answer.”); Written Testimony of Professor Curtis C. Verschoor, DePaul University (July 26, 2000) (stating that the question is “[n]ot why so fast, but what took so long?”); Letter of John S. Coppel, CPA, CFO, Electric Power Equipment Company (Aug. 16, 2000) (“I view this rule as a long overdue, greatly needed response to the practices now taking place within the profession.”).

III. There Is a Need for Commission Rulemaking

A. The Independence Requirement Serves Important Public Policy Goals

The federal securities laws require, or permit us to require, that financial information filed with us be certified or audited by “independent” public accountants.
34

To a significant extent, this makes independent auditors the “gatekeepers” to the public securities markets.
35

This statutory framework gives auditors both a valuable economic franchise and an important public trust. Within this statutory framework, the

independence requirement is vital to our securities markets.

34
For example, Items 25 and 26 of Schedule A to the Securities Act, 15 U.S.C. 77aa(25) and (26), and Section 17(e) of the Exchange Act, 15 U.S.C. 78q, expressly require that financial statements be audited by independent public or certified accountants. Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 78l and 78m, Sections 5(b)(H) and (I), 10(a)(1)(G), and 14 of the Public Utility Holding Company Act of 1935 (“PUHCA”), 15 U.S.C. 79e(b), 79j, and 79n, Sections 8(b)(5) and 30(e) and (g) of the Investment Company Act of 1940 (“ICA”), 15 U.S.C. 80a-8 and 80a-29, and Section 203(c)(1)(D) of the Investment Advisers Act of 1940 (“Advisers Act”), 15 U.S.C. 80b-3(c)(1), authorize the Commission to require the filing of financial statements that have been audited by independent accountants. Under this authority, the Commission has required that certain financial statements be audited by independent accountants.
See, e.g.,
Article 3 of Regulation S-X, 17 CFR 210.3-01,
et seq.
In addition, public companies must have their quarterly reports reviewed by independent accountants. Article 10 of Regulation S-X, 17 CFR 210.10-01(d) and Item 310(b) of Regulation S-B, 17 CFR 228.310(b). The federal securities laws also grant the Commission the authority to define the term “independent.” Section 19(a) of the Securities Act, 15 U.S.C. 77s(a), Section 3(b) of the Exchange Act, 15 U.S.C. 78c(b), Section 20(a) of PUHCA, 15 U.S.C. 79t(a), and Section 38(a) of the ICA, 15 U.S.C. § 80a-37(a), grant the Commission the authority to define accounting, technical, and trade terms used in each Act. Section 17 of the Exchange Act, 15 U.S.C. 78q, and Section 31 of the Investment Company Act, 15 U.S.C. 80a-30, grant the Commission authority to prescribe accounting principles to be used in the preparation of financial statements required.

35
Steven M. H. Wallman, “The Future of Accounting and Disclosure in an Evolving World: The Need for Dramatic Change,”
Accounting Horizons,
at 81 (Sept. 1995).

The independence requirement serves two related, but distinct, public policy goals. One goal is to foster high quality audits by minimizing the possibility that any external factors will influence an auditor's judgments. The auditor must approach each audit with professional skepticism and must have the capacity and the willingness to decide issues in an unbiased and objective manner, even when the auditor's decisions may be against the interests of management of the audit client or against the interests of the auditor's own accounting firm.

The other related goal is to promote investor confidence in the financial statements of public companies. Investor confidence in the integrity of publicly available financial information is the cornerstone of our securities markets. Capital formation depends on the willingness of investors to invest in the securities of public companies. Investors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance that the financial information disclosed by issuers is reliable.
36

The federal securities laws contemplate that that assurance will flow from knowledge that the financial information has been subjected to rigorous examination by competent and objective auditors.

36

See generally
Codification of Financial Reporting Policies (the “Codification”) § 601.01 (“An investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest.”). Use of the term “Codification” means the Codification that existed prior to the Commission's adoption of the rule amendments in this release. For a list of changes to the Codification resulting from the rule amendments, see
infra
Section IX.

The two goals—objective audits and investor confidence that the audits are objective—overlap substantially but are not identical. Because objectivity rarely can be observed directly, investor confidence in auditor independence rests in large measure on investor perception.
37

For this reason, the professional literature, such as the AICPA's Statement on Auditing Standards (SAS) No. 1, has long emphasized that auditors “should not only be independent in fact; they should also avoid situations that may lead outsiders to doubt their independence.”
38

The Supreme Court has emphasized the importance of the connection between investor confidence and the appearance of independence:

37

See, e.g.,
Testimony of Laurence H. Meyer, Governor, Board of Governors of the Federal Reserve System (Sept. 13, 2000) (“High quality accounting standards * * * can potentially be nullified if there is a perception that auditors lack independence and objectivity in their enforcement role * * * I think if the perception didn't have any basis in reality, it would not necessarily last very long, so there has to be some interconnection between them, but the perception is an important one.”); Testimony of David A. Brown, QC, Chair, Ontario Securities Commission (Sept. 13, 2000) (“The reality of independence is difficult, if not impossible. Perceptions of independence, therefore, become almost equal to reality in importance.”); Testimony of Kayla Gillan, General Counsel, CalPERS (Sept. 13, 2000) (“It's not only the reality of biased auditing, but also the perception that a biased practice is possible that erodes investor confidence.”).

38
AICPA SAS No. 1, AU § 220.03. As explained in SAS No. 1, “Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence.”
See also
Testimony of Robert K. Elliott, Chairman, AICPA (Sept. 13, 2000) (“[The AICPA] believe[s] that appearances are very important and capital markets require confidence in financial statements and audit reports, and the member firms of the AICPA are basing their business of auditing on their reputations, and that is heavily affected by appearance. There is no question about that. We are not disputing that appearance is important.”); Public Oversight Board (“POB”),
Scope of Services by CPA Firms
, at 27 (Mar. 1979) (“1979 POB Report”) (citing A. Arens and J. Loebbecke,
Auditing: An Integrated Approach
(Prentice-Hall 1976)) (“[The appearance of independence is] a key ingredient to the value of the audit function, since users of audit reports must be able to rely on the independent auditor. If they perceive that there is a lack of independence, whether or not such a deficiency exists, much of that value is lost.”); Earnscliffe Research and Communications (“Earnscliffe”),
Report to the United States Independence Board: Research into Perceptions of Auditor Independence and Objectivity—Phase II
, at 11 (July 2000) (“Earnscliffe II”) (“Perhaps the most overwhelming consensus was the belief that the perception of auditor independence is as critical to the integrity of the financial system, as is the reality.”).

The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries. It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional. . . . If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.
39

39

United States v. Arthur Young and Co.
, 465 U.S. 805, 819 n.15 (1984) (emphasis in original).
See also
Article IV of the AICPA's Standards of Professional Conduct, which provides, “Objectivity is a state of mind. * * * Independence precludes relationships that
may appear to impair a member's objectivity
. * * *” AICPA Code of Professional Conduct, ET § 55.01 (emphasis added). Elsewhere, the AICPA's SAS No. 1 states that auditors should “avoid situations that
may lead outsiders to doubt their independence
.” SAS No. 1, AU § 220.03 (emphasis added).

The Commission's independence requirements have always included consideration of investor perceptions.
40

Many foreign countries have similar requirements. A comparative analysis of the independence requirements of eleven countries concluded, “With the possible exception of Switzerland, most of the countries stress both the appearance and the fact of independence.”
41

In Canada, Rules of Professional Conduct require that the auditor be free of influence that would impair its judgment “or which, in the view of a reasonable observer, would impair * * * professional judgment or objectivity.”
42

David A. Brown, Chair of the Ontario Securities Commission, testified that the importance of the perception of auditor independence “cannot be overstated.”
43

40

See
Codification § 601.01.

41
Belverd E. Needles, Jr. (ed.)
Comparative International Accounting Standards
26 (1985) (comparing France, Netherlands, Switzerland, U.K., Germany, Jordan, Kuwait, Canada, Mexico, U.S., and Japan).

42
Institute of Chartered Accountants of Ontario, Rules of Professional Conduct Rule 204.1 (Objectivity: audit engagements);
see also
Institute of Chartered Accountants of British Columbia, Rules of Professional Conduct. Rule 204.1, Objectivity—Assurance and Specified Auditing Procedure Engagements.

43
Testimony of David A. Brown, QC, Chair, Ontario Securities Commission (Sept. 13, 2000). Principles in Hong Kong regarding the conduct of accountants provide that “a member must at all times perform his work objectively and impartially and free from influence by any consideration which might appear to be in conflict with this requirement.” Hong Kong Society of Accountants, Fundamental Principles ¶ 10 (revised April 1999). In addition, a Statement of Professional Ethics in that country provides that an auditor “should be, and be seen to be, free in each professional assignment he undertakes of any interest which might detract from objectivity.” Hong Kong Society of Accountants, Statement 1.203, Professional Ethics (Integrity, Objectivity and Independence) ¶ 2 (revised June 2000).

International organizations and standard setters also stress the appearance of independence. In its comment letter, the Federation of European Accountants stated, “In dealing with independence, one must address both: Independence of mind * * * and Independence in appearance, [i].e. the avoidance of facts and circumstances, which are so significant that an informed third party would question the statutory auditor's objectivity.”
44

Although the European Union has not defined independence for auditors, a Green Paper from 1996 provides, “In dealing with independence, it is necessary to address both independence in mind * * * and independence in appearance, i.e. the avoidance of facts and circumstances which are so significant that an informed third party would question the statutory auditor's objectivity.”
45

44
Letter of Helene Bon, President, Federation of European Accountants (Sept. 25, 2000).

45
In 1998, the European Parliament approved a resolution broadly supporting the Green Paper.

Green Paper,
The Role, The Position and the Liability of the Statutory Auditor Within the European Union
§ 4.8 (July 24, 1996), available at http://europa.eu.int. Communication from the Commission,
The Statutory Audit in the European Union: The Way Forward
(May 7, 1998), C143 8.05.1988-EN, available at http://europa.eu.int.

The concept of “appearance” as used in the final rule is not unbounded. “Appearance” as used in our operative legal standards is not a reference to what anyone might think under any circumstances. Rather, as explained below,
46

it is an objective test, keyed to the conclusions of reasonable investors with knowledge of all relevant facts and circumstances.

46

See infra
Section IV.C.

B. Recent Developments Have Brought the Independence Issues to the Forefront

The accounting industry is in the midst of dramatic transformation. Firms have merged, resulting in increased size, both domestically and internationally. They have expanded into international networks, affiliating and marketing under a common name. Increasingly, accounting firms are becoming multi-disciplinary service organizations and are entering into new types of business relationships with their audit clients. Accounting professionals have become more mobile, and geographic location of firm personnel has become less important due to advances in telecommunications. In addition, there are more dual-career families, and audit clients are increasingly hiring firm partners, professional staff, and their spouses for high level management positions.

In conjunction with these changes, accounting firms have expanded significantly the menu of services offered to their audit clients, and the list continues to grow.
47

Companies are turning to their auditors to perform their internal audit, pension, financial, administrative, sales, data processing, and marketing functions, among many others.
48

47
Some firms are seeking to provide expanded services through joint ventures with audit clients or their affiliates. As noted above, as early as 1988, large public accounting firms were looking to enter into joint ventures, limited partnership agreements, and other similar arrangements with audit clients.
See
Letter from Jonathan G. Katz to Duane R. Kullberg, Arthur Andersen & Co. (Feb. 14, 1989).

48

See
Proposing Release, App. A, for a list of services that auditors provide to their audit and non-audit clients. The list was prepared by the ISB.
See also
Beverly Gordon, “KPMG spies rapid growth in ‘shared services,' ”
Accounting Today
, at 12 (June 3, 1996); “KPMG Restructures to Reposition Outsourcing,”
Public Accounting Report
, at 1 (May 15, 1996); websites of Deloitte & Touche (http://www.deloitte.com) and KPMG (http://www.us.kpmg.com).

As we noted in the Proposing Release, U.S. revenues for management advisory and similar services
49

for the five largest public accounting firms (the “Big Five”) amounted to more than $15 billion in 1999.
50

Moreover, revenues for these service lines are now estimated to constitute half of the total revenues for these firms.
51

In contrast, these service lines provided only thirteen percent of total revenues in 1981.
52

From 1993 to 1999, the average annual growth rate for revenues from management advisory and similar services has been twenty-six percent; comparable growth rates have been nine percent for audit and thirteen percent for tax services.
53

49
Management advisory services (“MAS”) are a subset of non-audit services.

50

See
Proposing Release, Table 1 in Appendix B. The underlying data are derived from data in “Special Supplement: Annual Survey of National Accounting Firms—2000,”
Public Accounting Report
(Mar. 31, 2000), annual reports filed with the AICPA Division for CPA Firms by public accounting firms, and from reports prepared by the AICPA Division for CPA firms.

51

See
Proposing Release, Tables 1 and 2 in Appendix B.

52

See
Proposing Release, Table 2 in Appendix B.

53

See
Proposing Release, Table 1 in Appendix B.

For the largest firms, the growth in management advisory and similar services involves both audit clients and non-audit clients. For the largest public accounting firms, MAS fees from SEC audit clients have increased significantly over the past two decades. In 1984, only one percent of SEC audit clients of the eight largest public accounting firms paid MAS fees that exceeded the audit fee.
54

For the Big Five firms, the percentage of SEC audit clients that paid MAS fees in excess of audit fees did not exceed 1.5% until 1997.
55

In 1999, 4.6% of Big Five SEC audit clients paid MAS fees in excess of audit fees,
56

an increase of over 200% in two years. For the Big Five firms, average MAS fees received from SEC audit clients amounted to ten percent of all revenues in 1999.
57

Almost three-fourths of Big Five SEC audit clients purchased no MAS from their auditors in 1999. This means that purchases of MAS services by one-fourth of firms' SEC audit clients account for ten percent of all firm revenues.
58

54

See
Proposing Release, Table 3 in Appendix B.

55

Id.

56

Id.

57

See
Proposing Release, Table 4 in Appendix B.

58

See
Proposing Release, Table 3 in Appendix B. Taken together, the data from Tables 1, 3, and 4 indicate that in 1999 more than 12,700 clients of the five largest public accounting firms paid approximately $9.150 billion for accounting and auditing services.

Some smaller firms are consolidating their audit practices and seeking public investors in the resulting company.
59

Other firms are entering into agreements to sell all of their assets, except their audit practices, to established financial services companies. As part of these agreements, the financial services companies hire the employees, and in some cases the partners, of the accounting firm, and then lease back the majority or all of the assets and audit personnel to the “shell” audit firm. These lease arrangements allow the financial services firm to pay the professional staff for “nonprofessional” services for the corporate organization as well as professional attest services rendered for the audit firm.
60

59

See, e.g.,
Rick Telberg, “Anybody can do it! says small-firm consolidator,”
Accounting Today,
at 5 (Jan. 4-24, 1999).

60
“Done Deal: HRB acquires M&P for $240 million cash, pension obligation,”
Public Accounting Report,
at 1 (July 15, 1999); “Amex and Checkers Close The Deal,”
Public Accounting Report,
at 1 (Mar. 31, 1997).

Recently, Ernst & Young sold its management-consulting business to Cap Gemini Group SA, a large and publicly traded computer services company headquartered in France.
61

KPMG has sold an equity interest in KPMG Consulting to Cisco Corporation
62

and is in the process of registering additional shares in its consulting business to sell to the public in an initial public offering.
63

In addition, PricewaterhouseCoopers has publicly announced an intention to sell portions of its consulting businesses. Also, Grant Thornton recently sold its e-business consulting practice.
64

61
“Cap Gemini and Ernst & Young Have Agreed to Terms for the Acquisition of Ernst & Young Consulting” (Feb. 29, 2000) (press release of Ernst & Young).

62
As clarified by the amended S-1 filed by KPMG Consulting, Inc., in connection with the initial public offering, Cisco may sell up to about half of its stake in that entity.
See
KPMG Consulting, Inc., Form S-1, Amend. No. 3 (Sept. 25, 2000).

63

Id.

64
Albert B. Crenshaw, “Audit Firm Sells Consulting Unit,” Wash. Post, Oct. 26, 2000, at E2;
see also
news release at www.grantthornton.com/esannounce/index.html.

Simultaneous with this metamorphosis of the accounting profession, public companies have come under increasing pressure to meet earnings expectations. Observers suggest that this pressure has intensified in recent years, especially for companies operating in certain sectors of the economy.
65

The extent of the pressure

becomes apparent each time a company loses a significant percentage of its market capitalization after failing to meet analysts' expectations.
66

These intense pressures on companies lead to enhanced pressure on auditors to enable their clients to meet expectations.
67

65

See
Earnscliffe,
Report to the United States Independence Board: Research into Perceptions of Auditor Independence and Objectivity
(“Earnscliffe I”) at 16 (Nov. 1999) (finding increased pressure and threat of earnings management in the technology sector);
see also
Testimony of Jay W. Eisenhofer, Partner, Grant & Eisenhofer (Sept. 13, 2000) (“[I]n the current environment where

company stock prices are increasingly dependent on showing growth and on meeting or exceeding the expectations of Wall Street investment analysts [, e]ven one missed profit number can have a significant negative effect on stock price. This places great pressure on company executives to insure that each quarter the profits are in the expected range, regardless of whether the quarter has been as good as the analyst expected. In order to meet these expectations, we often find that corporations will sometimes make questionable assumptions.”).

66
Ann Grimes, “Former McKesson Officials are Charged,”
Wall St. J.
, at B6 (Sept. 29, 2000); Sarah Schafer and David S. Hilzenrath, “Orbital to Settle Shareholder Suit,”
Wash. Post,
at E1 (July 18, 2000); Paul Sweeney, “Accounting Fraud: Learning from the Wrongs,”
Fin. Exec.
(Sept./Oct. 2000); Mike McNamee, “Accounting Wars,”
Bus. Wk.,
157, 160 (Sept. 25, 2000); Bernard Condon, “Pick a Number, Any Number, Forbes (Mar. 23, 1998).

67

See
O'Malley Panel Report,
supra
note 20, ¶ 1.10 (“The growth in equity values over the past decade has introduced extreme pressures on management to achieve earnings, revenue or other targets. These pressures are exacerbated by the unforgiving nature of the equity markets as securities valuations are drastically adjusted downward whenever companies fail to meet ‘street’ expectations.* * * These pressures on management, in turn, translate into pressures on how auditors conduct audits and in their relationship with audit clients.”).

As discussed below, the changes in the accounting profession, combined with increasing pressures on companies, raise questions about auditor independence and investor confidence in the financial statements of public companies that those auditors audit. To respond to some of these questions, we proposed, and are now adopting, new rules relating to the financial and employment relationships independent auditors may have with their audit clients, business and financial relationships between accounting firms and audit clients, and the non-audit services that auditors can provide to audit clients without impairing their independence.

C. Independence Concerns Warrant Restrictions on the Scope of Services Provided to Audit Clients

The rules that we adopt today include provisions restricting the scope of services that an auditor may provide to an audit client without impairing the auditor's independence with respect to that client. The proposed restrictions on non-audit services generated most of the public comment on our proposals, both in written comment letters and in testimony provided during our public hearings. Commenters expressed a range of views from full support to staunch opposition.
68

68

See supra
notes 21-23.

After careful consideration of the arguments on various sides, we have determined that it is in the public interest for us to adopt certain restrictions on the provision of non-audit services to audit clients. We act on the basis of our evaluation of the potential impact of non-audit relationships on audit objectivity and also on the basis of indications that investor confidence is in fact affected by reasonable concerns about non-audit services compromising audit objectivity.

1. The Expansion of Non-Audit Service Relationships with Audit Clients Has Long Been Viewed as a Potential Threat to Auditor Independence

It has long been recognized that an unchecked expansion of non-audit relationships between auditors and their audit clients could affect both an auditor's objectivity and investor confidence in financial statements.
69

In the 1970s, Congress seriously considered limiting the types of non-audit services that independent auditors could provide. Even though non-audit services did not constitute a large percentage of audit firms' revenues at that time, and Congress ultimately determined not to take legislative action, the deliberations highlighted significant concerns bearing on the independence issue.
70

69

See
Proposing Release, Section II.C.2; O'Malley Panel Report,
supra
note 20, at App. D (chronicling the debate since 1957); The Commission on Auditors' Responsibilities,
Report, Conclusions and Recommendations
95-96 (1978).
See also infra
notes 92, 98 (citing recent studies).

70

Report on Improving the Accountability of Publicly Owned Corporations and Their Auditors, Subcomm. On Reports, Accounting and Management of the Senate Comm. on Governmental Affairs,
95th Cong., 1st Sess. (Comm. Print Nov. 1977). In the Report, the Subcommittee stated that it “agrees with the Cohen Commission and many others that the accounting profession must improve its procedures for assuring independence in view of the public's needs and expectations. Several activities of independent auditors have raised questions. Among them are public advocacy on behalf of a client, receiving gifts and discounts from clients, and maintaining relationships that detract from the appearance of arm's-length dealings with clients. Such activities are not appropriate.”
Id.
at 16. The Subcommittee also stated that “[t]he best policy . . . is to require that independent auditors of publicly owned corporations perform only services directly related to accounting. Non-accounting management services . . . should be discontinued.”
Id.
at 16-17. In a letter to Harold Williams, Chairman, SEC, Senator Thomas F. Eagleton, Chairman, Subcomm. on Governmental Efficiency and the District of Columbia, of the Senate Comm. on Governmental Affairs, recommended that “[t]here must be a requirement that independent auditors of publicly owned corporations perform only services directly related to accounting.” Letter from Senator Thomas F. Eagleton to Harold Williams (Apr. 6, 1978) (attached list of recommendations) (reprinted in
Securities and Exchange Commission Report to Congress on the Accounting Profession and the Commission's Oversight Role
(July 1978)).

These concerns gradually became the subject of increasing debate and study. In 1979, the then-Chairman of the POB expressed concern about the expansion of non-audit services to audit clients:

The [POB] believes that there is a possibility of damage to the profession and the users of the profession's services in an uncontrolled expansion of MAS [management advisory services] to audit clients. Investors and others need a public accounting profession that performs its primary function of auditing financial statements with both the fact and the appearance of competence and independence. Developments which detract from this will surely damage the professional status of CPA firms and lead to suspicions and doubts that will be detrimental to the continued reliance of the public upon the profession without further and more drastic governmental intrusion.
71

71
Letter from John J. McCloy, Chairman, POB (former Chairman of the Board of Chase Manhattan Bank and former President of The World Bank), to Walter E. Hanson, Chairman, Executive Committee, SECPS (Mar. 9, 1979).

A 1994 Report of the AICPA Special Committee on Financial Reporting noted that users of financial statements believed that non-audit service relationships could “erode auditor independence” and that those users were “concerned that auditors may accept audit engagements at marginal profits to obtain more profitable consulting engagements.”
72

A separate 1994 report of the Advisory Panel on Auditor Independence noted the increased basis for investor concerns, describing the trend toward non-audit services as “worrisome” because “[g]rowing reliance on nonaudit services has the potential to compromise the objectivity or independence of the auditor.”
73

72
Special Committee on Financial Reporting, AICPA,
Improving Business Reporting—A Customer Focus:

Meeting the Information Needs of Investors and Creditors,
at 104 (1994).

73
Advisory Panel on Auditor Independence,
Strengthening the Professionalism of the Independent Auditor: Report to the Public Oversight Board of the SEC Practice Section, AICPA,
at 9 (Sept. 13, 1994).

In 1994, the SEC staff also studied the issues and issued a Staff Report.
74

While concluding that no action was warranted at the time, the staff recognized the need “to be alert” to independence problems that may be

caused by auditors' provision of non-audit services.
75

A 1996 General Accounting Office (GAO) study predicted that the “concern over auditor independence may become larger as accounting firms move to provide new services that go beyond traditional services.”
76

74
Office of the Chief Accountant, SEC,
Staff Report on Auditor Independence
(Mar. 1994) (
“Staff Report”
). Between 1979 and 1981, public companies were required to disclose in their proxy statements certain information about non-audit services provided by their auditors.
See infra
Section IV.G. (discussing these disclosure requirements).

75

See Staff Report, supra
note 74, at 84; Proposing Release, notes 40-42.

76
GAO,
THE ACCOUNTING PROFESSION—Major Issues: Progress and Concerns,
at 8 (GAO/AIMD-96-98, Sept. 1996).

2. The Growth of Certain Non-Audit Services Jeopardizes Independence

A common theme running through the reports described above is concern that future expansion of non-audit services may make regulatory action necessary. We believe that the circumstances about which the Commission was warned are coming to pass. An auditor's interest in establishing or preserving a non-audit services relationship raises two types of independence concerns. First, the more the auditor has at stake in its dealings with the audit client, the greater the cost to the auditor should he or she displease the client, particularly when the non-audit services relationship has the potential to generate significant revenues on top of the audit relationship. Second, certain types of non-audit services, when provided by the auditor, create inherent conflicts that are incompatible with objectivity.

a.
Non-Audit Services Create Economic Incentives that May Inappropriately Influence the Audit.
As explained above and in the Proposing Release, the rapid rise in the growth of non-audit services has increased the economic incentives for the auditor to preserve a relationship with the audit client, thereby increasing the risk that the auditor will be less inclined to be objective.
77

Some commenters supported this analysis,
78

while others took issue with it.
79

The principal criticisms were: (i) the economic stake in the relationship with the audit client in fact had not materially increased and any such increase is offset by countervailing incentives on the auditor not to compromise his or her independence; and (ii) there is no proof that changing the mix of incentives has affected auditor behavior. We have considered each of these criticisms and address them below.

77

See supra
Section III.B.; Proposing Release, Section II.C.2(b).

78

See, e.g.,
Testimony of Kayla Gillan, General Counsel, CalPERS (Sept. 13, 2000) (“The concept that an auditor who has a greater financial incentive to please management than to criticize it will tend to find ways to avoid negative comment is intuitive and obvious.”); Letter of B. Raymond Dunham (“I understand that actual hard evidence may not be apparent on the surface. However, it becomes obvious that auditing judgment may be clouded when large sums of potential revenues are dependent upon an auditing decision from any firm that derives great revenues from consulting services to the same organizations it is responsible for auditing.* * * The separation of consulting and auditing is intuitive if a firm is to maintain independence in its auditing procedures.”); Letter of David T. DeMonte, CPA (“The conflict of interest potential is so patently obvious.”).

79

See, e.g.,
Testimony of Thomas C. DeFazio, Executive Vice President and Chief Financial Officer, VirtualCom, Inc. (Sept. 13, 2000) (“[T]he provision of non-audit services does not pressure the audit firms to look the other way.”); Testimony of Thomas M. Rowland, Senior Vice President, Fund Business Management Group, Capital Research & Management Co. (Sept. 20, 2000) (“[A]t no time during my career did I feel pressure from other partners in the firm * * * not to do the right thing.”).

(i)
The Mix of Economic Incentives Has Changed.
Commenters generally agreed that there has been enormous growth in non-audit services and in their importance to the firms that provide them. Several commenters took issue with whether this growth enhanced any potential conflict of interest. These commenters argued, in essence, that there has always been the potential for a conflict of interest, since the auditor is paid by the client.
80

They argue that because Congress adopted this arrangement in enacting the federal securities laws, by choosing the statutory independence requirement rather than creating a corps of government-paid auditors, Congress implicitly condoned these types of conflicts of interest.

80

See, e.g.,
Testimony of Robert K. Elliott, Chairman, AICPA (Sept. 21, 2000).

The argument proves too much; it assumes that because Congress permitted one form of potential conflict of interest, it intended to permit all forms. Taken to its logical conclusion, this argument, of course, would read the independence requirement out of the statute. If Congress believed that all conflicts were equal in kind or degree, it would not have required that auditors be independent. Congress apparently chose to tolerate a degree of potential conflict of interest rather than supplant the private auditing profession. Simply because Congress chose to tolerate an unavoidable degree of conflict inherent in the relationship between a private auditor and a paying client, it hardly follows that all conflicts of interest beyond the unavoidable minimum were approved by Congress or that the statutes express indifference to conflicts of interest.

A related argument is that, despite the rapid growth of services, the economic stakes have not really changed for the auditor. The argument is that, despite the growth of non-audit services generally, these services are rarely as significant to the auditor, from an economic standpoint, as maintaining the audit relationship.
81

Put another way, while non-audit services (excluding tax) account for as much as fifty percent of audit firm revenue, only ten percent of revenues come from providing these services to audit clients. But, as noted above, the trend of available data suggests a rapid increase in the provision of non-audit services to audit clients—in 1999, 4.6% of Big Five SEC audit clients paid MAS fees in excess of audit fees, an increase of over 200% in two years.

81

See, e.g.,
Letter of Financial Accounting Standards Committee, American Accounting Association (Oct. 12, 2000),

The increasing importance of non-audit services to accounting firms is further evidenced by suggestions that the audit has become merely a “commodity” and that the greater profit opportunities for auditors come from using audits as a platform from which to sell more lucrative non-audit services.
82

An AICPA practice aid entitled “Make Audits Pay: Leveraging the Audit Into Consulting Services” provides a step-by-step guide for auditors to become “business advisers” to their audit clients. The book quotes an AICPA officer as follows: “We see the greater viability of the CPA going forward as being a strategic business adviser, an information professional being viewed by the public as the person for solid big-picture business advice—applied to a broader information world instead of a financial information world.”
83

At the same time, the book acknowledges that “[t]he business adviser is a client advocate. The entire business adviser audit process is based on understanding the client's business from the owner's perspective and acting in the owner's best interest,”
84

which, of course, is contrary to the duty of the auditor to the public.

82

See
O'Malley Panel Report,
supra
note 20, ¶ 4.4 at 99 (“Focus group participants often indicated that not only clients, but also engagement partners and firm leaders, treat the audit negatively—as a commodity.”).

83
AICPA Practice Aid Series,
Make Audits Pay: Leveraging the Audit Into Consulting Services,
at 3 (1999).

84

Id.
at 24.

At our public hearings and in comment letters, we also heard a great deal about the “loss leader” phenomenon. When an auditor uses the audit as a loss leader, the auditor, in essence, “low-balls” the audit fee—even offering to perform it at a loss—in order to gain entry into and build a relationship with a potential client for

the firm's non-audit services.
85

Low-balling creates a variety of independence issues.
86

Use of audits as loss leaders to be made up for with more lucrative consulting contracts further suggests the growth in importance of non-audit services as compared to audits.
87

85

See, e.g.,
Letter of William S. Lerach, Milberg Weiss Bershad Hynes & Lerach LLP (Sept. 22, 2000) (“In some instances, public companies bid out auditing work demanding low bids, while indicating to the bidding firms that low auditing bids will be rewarded with lucrative consulting work”). Texas adopted a statutory provision to prevent the use of audits as loss leaders in order to protect small audit firms that could not compete in a market where audits were underpriced. Tex. Rev. Civ. Stat. art. 41a-1, § 20A (1994).
See also
Testimony of K. Michael Conaway, Presiding Officer, Texas State Board of Accountancy (Sept. 20, 2000) (explaining that the worry was that “big firms would predatory price their way into markets and * * * in effect, gain a competitive advantage over smaller firms that couldn't discount their work to the same extent”); Written Testimony of Wanda Lorenz, CPA, Lane Gorman Trubitt (Sept. 20, 2000) (“[M]ost of the problems that exist today can be tied to
fee negotiations
on audits * * *. Therefore the profession has accepted being bargained with like a shopkeeper in some bazaar in order to perform other more lucrative work.”) (emphasis in original).

86

See
Testimony of Larry Gelfond, CPA, CVA, CFE, former President of the Colorado State Board of Accountancy (Sept. 13, 2000) (“Audit failures occur because auditors become careless and in the oversight or reliance on something, they may be taking a shortcut. Clearly, where an audit is low bid, there is that concern.”).

87
Low-balling also sends a message to the auditor that the audit relationship is not as valuable as the consulting relationship.
See
Testimony of Roderick Hills, former Chairman, SEC (Sept. 20, 2000). Low-balling sends a message inside the audit firm as well. We are concerned that the shift in a firm's emphasis away from auditing and toward non-audit services causes, over time, a cultural shift within the firm. The factors that drive a high quality audit, including the core values of the auditing profession, may diminish in importance to the firm, as will the influence of those firm members who exemplified those core values in their own professional careers.

Changes in legal standards have also affected incentives. Professor John C. Coffee, Jr. testified that the legal constraints on accountants have loosened considerably in recent years, and as a result, there has been a significant decrease in the threat of liability. It has become much more difficult, and less worthwhile, for private plaintiffs to assert civil claims against auditors even in cases where the plaintiffs believe that an audit failure flowed from a lack of auditor independence.
88

He specifically described the following four significant developments in the law since 1994 that he believes have reduced the likelihood of success in private lawsuits against auditors: (i) the passage of the Private Securities Litigation Reform Act of 1995, which affected pleading standards and substituted proportionate liability for joint and several liability, which makes it less attractive to sue accountants “because even if you're successful you're only going to get a portion of the total liability assessed against them, and that may not justify the cost”; (ii) passage of the Securities Litigation Uniform Standards Act of 1998, which preempted certain state or common law claims in securities fraud actions against auditors in both state and federal court;
89

(iii) the Supreme Court's decision in Central Bank of Denver in 1994,
90

eliminating liability in private litigation for aiding and abetting a securities fraud violation, “which was the principal tool used to sue accountants by the plaintiff's bar”; and (iv) the elimination of the threat of treble damage liability as a result of amendment to the Racketeer Influenced and Corrupt Organization Act.
91

88
Testimony of Professor John C. Coffee, Jr., Columbia University (July 26, 2000) (“[T]he expected costs facing the accountant who might be []tempted to shirk his duties in order to please management have vastly declined in just the last five or six years.”);
see also
Written Testimony of Professor Coffee.

89
Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227 (codified in scattered sections of the U.S.C.) (requiring most private class actions alleging fraud in the sale of nationally traded securities to be based on federal law and brought in federal court).

90

Central Bank of Denver
v.
First Interstate Bank of Denver,
511 U.S. 164 (1994).

91
The Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737, amended 18 U.S.C. § 1964(c) to eliminate “fraud in the purchase or sale of securities” as a predicate act for RICO liability unless the defendant has been criminally convicted.

Professor Coffee summarized the effect of these developments by noting that while lawsuits involving accounting irregularities have actually increased since 1995, “those suits today rarely involve * * * the outside accountant, as a defendant, and when they do they're often very easily and quickly dismissed,” which would preclude relevant evidence from coming to light. In view of these developments in the law, he noted that an auditor today “faces greatly increased benefits through the existence of non-audit advisory services that are subject to the discretion of management, and it faces greatly reduced liabilities.”

In part because the risks of liability have changed, as described by Professor Coffee, we do not believe, as urged by at least one commenter,
92

that liability insurance premiums are a barometer of the extent to which non-audit services pose a risk to audit quality. Professional malpractice premiums reflect the risk that the liability insurer will have to fund a judgment or settlement imposing money damages on the auditor. This risk of liability is attributable to a variety of factors, only one of which is the risk of audit failure. The likelihood of audit failure, in turn, is attributable to many factors, only one of which is auditor independence. And auditor independence, in turn, can be threatened in numerous ways, only one of which is the provision of non-audit services. In assessing overall litigation risk, it is entirely possible, for example, that a liability insurer would conclude that an enhanced risk of misconduct is offset by a small probability of discovery, as well as a diminishing likelihood, owing to changes in the law, that even known misconduct would result in a judgment or settlement that the insurer would have to fund. Consequently, even if insurers were to provide auditors substantially the same professional malpractice coverage at approximately the same cost despite increases in their provision of non-audit services, that indicates at most that, from the insurers' perspective, overall litigation risks have not increased. Because there are numerous explanations as to why auditors' professional liability premiums might or might not increase, we are not persuaded that insurance premiums are a useful measure of the effect of non-audit services on auditor independence.

92
AICPA Letter (citing AICPA,
Serving the Public Interest: A New Conceptual Framework for Auditor Independence
(Oct. 20, 1997) (“AICPA White Paper”)). We note that the data relied on in the AICPA White Paper and referred to in the AICPA Letter was collected in 1997. As we discuss throughout this release, the magnitude of non-audit services has increased dramatically over the past several years.

(ii)
Changes in Incentives Are Likely to Affect Behavior.
In the Proposing Release, we discussed our concern that the enhanced incentive to perpetuate a client relationship involving non-audit services increases the so-called “self-serving bias” auditors experience in favor of an audit client. We heard during our public hearings from academics who have studied the “self-serving bias,” including in connection with the behavior of auditors. Two academics presented research tending to show that subtle but powerful psychological factors skew the perceptions and judgments of persons—including auditors—who have a stake in the outcome of those judgments.
93

Other

academics, by contrast, pointed out that the issue may be more complicated because, even where an auditor has some stake in an outcome, the auditor also has countervailing reputational interests,
94

and concerns about, for example, legal liability,
95

audit committee review,
96

and peer review.
97

93

See
Testimony of Professor Max H. Bazerman, Northwestern University (July 26, 2000); Testimony of Professor George F. Loewenstein, Carnegie Mellon Institute (July 26, 2000);
see also
Max H. Bazerman, Kimberly P. Morgan, and George F. Loewenstein, “The Impossibility of Auditor Independence,”
Sloan Management Review
at 91, 94 (Summer 1997) (reviewing empirical research showing that “[w]hen people are called on to make impartial judgments, those judgments are likely to be unconsciously and powerfully biased in a manner that is commensurate with the judge's self interest,” and concluding that, despite their best

intentions, “there is good reason to believe that auditors will unknowingly misrepresent facts and will unknowingly subordinate their judgment due to cognitive limitations”); Jesse D. Beeler and James E Hunton, “Contingent Economic Rents; Insidious Threats to Auditor Independence,” manuscript (2000).

94
Testimony of Don N. Kleinmuntz, Professor, University of Illinois at Urbana-Champaign (Sept. 21, 2000); Testimony of Urton Anderson, Professor, University of Texas at Austin (Sept. 21, 2000) (presenting results of research commissioned by Arthur Andersen, Deloitte & Touche, KPMG, and the AICPA);
see also
Testimony of Professor Rick Antle, Yale University (July 26, 2000) (researcher for the AICPA presenting personal views on data).

95

See supra
notes 88-91.

96

See infra
Section III.C.5.

97
At least one witness challenged the effectiveness of the current peer review system. She testified that, as enacted, peer review has no “teeth.” Testimony of Wanda Lorenz, CPA, Lane Gorman Trubitt, LLP (Sept. 20, 2000).

We do not question that there are influences on the auditor and an accounting firm beyond a “self-serving bias.” We accept also that firms have incentives to avoid situations that expose them to liability and reputational harm. But, again, the argument proves too much. Even with these disincentives, audit failures and impairments of independence occur.
98

Other studies tend to show that the reputational interests of the audit firm are not the same as the reputational interests of the audit engagement partner or the office of the partner that performs most of the work for an audit client. Specifically, these studies suggest that the audit engagement partner and the office have more to gain by, for example, acquiescing to the client's aggressive accounting treatment than they have to lose if it results in audit failure, particularly if the client engagement contributes substantially to the partner's income and the office's revenues. Reputational damage will be spread across the entire firm, whereas income from the client will be concentrated in the partner and the office out of which he or she works.
99

In addition, in a two-phase study commissioned by the ISB, Earnscliffe reported that “[m]ost believe that accounting firms today are not indifferent about their reputation for quality audits, but are more focused on raising the profile, reputation, and profitability of non-audit services.”
100

98

See, e.g., In the Matter of PricewaterhouseCoopers LLP,
AAER No. 1098 (Jan. 14, 1999).

99
W.R. Kinney, Jr., “Auditor Independence: Burdensome Constraint or Core Value?”
Accounting Horizons
(March 1999); G. Trompeter, “The effect of partner compensation schemes and generally accepting accounting principles on audit partner judgment,”
Auditing: A Journal of Practice and Theory
(Fall 1994); Paul M. Clikeman, “Auditor Independence: Continuing Controversy,”
Ohio CPA Journal
(Apr.-Jun. 1998).

100
Earnscliffe II,
supra
note 38, at 6. Interviewees included chief executive officers, chief financial officers and controllers, auditors, buy-side and sell-aside analysts, audit committee chairs, and regulators.

While we do not purport to resolve a debate among scholars, it is plain that there is ample basis to conclude that the more a person, including an auditor, has at stake in a judgment, the more likely his or her judgment is to be affected.
101

We stress that the influences that we are concerned with can be “extremely subtle,” as stated by the Comptroller of the Currency, John D. Hawke, in testimony supporting our proposal to restrict internal audit outsourcing.
102

Paul A. Volcker, the former Chairman of the Federal Reserve, in his testimony supporting our proposal, noted the real threat posed by the “insidious, hard-to-pin down, not clearly articulated or even consciously realized, influences on audit practices” that flow from non-audit relationships with audit clients.
103

101
The Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees noted with respect to independent directors that, even absent objective verification, “common sense dictates that a director without any financial, family, or other material personal ties to management is more likely to be able to evaluate objectively the propriety of management's accounting, internal control and reporting practices.” The Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the “Blue Ribbon Committee”),
Report and Recommendations,
at 22 (1999) (the “Blue Ribbon Report”). Copies of the Blue Ribbon Report are available at
www.nyse.com
or
www.nasd.com.

102
Written Testimony of John D. Hawke, Jr. (July 26, 2000).

103
Written Testimony of Paul A. Volcker (September 13, 2000). Aggregate economic incentives aside, non-audit services can have the effect of aligning the accountant's interests with those of management. When the accountant acts as a consultant, the accountant must answer to management, and a “consultant . . . will be judged by the ultimate usefulness of his advice in bringing success to management's efforts. He has had a hand in shaping managerial decisions and will be judged by management on the same basis that the management itself will be judged.” R.K. Mautz and Hussein A. Sharaf,
The Philosophy of Auditing
at 222 (Am. Acct. Ass'n 1961). As the auditor becomes increasingly involved with the audit client and its managers, the auditor is more likely to perceive himself as a part of the management team and place less emphasis on his or her primary loyalty to investors. In Earnscliffe I, Earnscliffe reported that many individuals interviewed believed that pressures on auditors have been increasing and are becoming problematic, and that “auditors are developing a stronger interest in their relationship with management, perhaps at the expense of their responsibilities to shareholders.” Earnscliffe I,
supra
note 65, at 9.

b.
Certain Non-Audit Services Inherently Impair Independence.
Our rule lists services that, regardless of the size of the fees they generate, place the auditor in a position inconsistent with the necessary objectivity. Bookkeeping services, for example, place the auditor in the position of later having to audit his or her own work and identify the auditor too closely with the enterprise under audit. It is asking too much of an auditor who keeps the financial books of an audit client to expect him or her to be able to audit those same records with an objective eye.

In much the same way, performing certain valuation services for the audit client is inconsistent with independence. An auditor who has appraised an important client asset at mid-year is less likely to question his or her own work at year-end. Similarly, an auditor who provides services in a way that is tantamount to accepting an appointment as an officer or employee of the audit client cannot be expected to be independent in auditing the financial consequences of management's decisions. And an auditor who has helped to negotiate the terms of employment for an audit client's chief financial officer is less likely to bring quickly to the audit committee questions about the new CFO's performance.

3. The Expansion of Non-Audit Service Relationships with Audit Clients Is Affecting Investor Confidence in the Independence of Auditors

Recent studies indicate that there is a growing disquiet among investors and other users of financial statements about auditor independence in light of the multi-faceted relationships between auditors and their audit clients. Recently, Earnscliffe found that most interviewees “felt that the evolution of accounting firms to multi-disciplinary business service consultancies represent[ed] a challenge to the ability of auditors to maintain the reality and the perception of independence.”
104

In Phase II of its study, Earnscliffe reported that interviewees generally had confidence in and are satisfied with the current standard of financial reporting in the U.S. Nonetheless, the study noted, “[m]ost [interviewees] felt that the risks of unfavorable perceptions of auditor independence are growing, due largely to the provision of non-audit services to auditees.”
105

104
Earnscliffe I,
supra
note 65, at 46 (Nov. 1999). The study also found that many individuals interviewed believed that “auditors are developing a stronger interest in their relationship with management, perhaps at the expense of their responsibilities to shareholders.”
Id.
at 9.

105
Earnscliffe II,
supra
note 38, at 5 (July 2000).

Though the O'Malley Panel did not reach consensus on whether changes to the independence rules are needed, over the past year it surveyed preparers and users of financial statements, auditors, regulators, academics, lawyers, and analysts about the provision of non-audit services, and heard from witnesses at the Panel's public hearings. The Panel found that,

[M]any people continue to be concerned—some very concerned—that the performance of non-audit services could impair independence, or that there is at least an appearance of the potential for impairment. Almost two-thirds of the respondents to the Panel's survey from outside the profession who addressed non-audit services expressed such concerns.
106

106
The O'Malley Panel Report,
supra
note 20, at ¶ 5.20.

In a June 2000 study, Brand Finance plc surveyed analysts and representatives of companies listed on the London Stock Exchange. Brand Finance reported,

Analysts are concerned that the acceptance of non-audit fees by auditors is likely to result in the independence of the audit being compromised. 94% of analysts stating an opinion believe that significant non-audit fees are likely to compromise audit independence. 76% of companies stating an opinion felt that auditor independence is likely to be compromised where significant non-audit fees are received from audit clients.
107

107
Brand Finance plc,
The future of audit—“Back to the Future,”
ch. 1 (June 2000).

Brand Finance also found that “83% of analysts who expressed an opinion believe objectivity is threatened even when the non-audit fee is less than the audit fee.”
108

108

Id.

In another recent survey, the Association for Investment Management and Research (“AIMR”) surveyed its members and certified financial analyst candidates regarding auditor independence issues. AIMR reported that “[p]otential threats to auditor independence, resulting from audit firms providing non-audit services to their audit clients [were] troublesome to many . . . respondents.”
109

109
Written Testimony of Mauricio Kohn, CFA, CMA, CFM, AIMR (Sept. 20, 2000) (submitting survey). AIMR is a global, non-profit organization of investment professionals.

A recent poll was conducted by Public Opinion Strategies
110

to determine, among other things, how the investing public views our proposed rules.
111

The results showed that eighty percent of investors surveyed favor (forty-nine percent strongly favor; thirty-two percent somewhat favor) an SEC rule that generally would require restrictions on the types of consulting services accounting firms can provide their audit clients,
112

and fifty-one percent thought the new rule was “very important” to protecting individual stock market investors.
113

As summarized by James C. Stadler of Duquesne University, “The results of our national poll indicate that average American investors, in fact, overwhelmingly support the need for some new rulemaking in this area.” He further stated, “The survey results confirm what most practitioners have felt for decades—that large consulting engagements for audit clients can raise serious concerns regarding audit independence.”
114

110
The results were published by the A.J. Palumbo School of Business Administration at Duquesne University (“Duquesne Poll”). PricewaterhouseCoopers provided funding for the poll.

111
The 800 adults had incomes greater than $50,000.

112
Duquesne Poll,
supra
note 110, Question 12.

113
Duquesne Poll,
supra
note 110, Question 13. The Poll also found that 37% of respondents thought the new rule was “somewhat important,” 6% thought it “not very important,” and 3% thought it “not at all important.”

114
Mr. Stadler is Dean of the John F. Donahue Graduate School of Business and the A.J. Palumbo School of Business Administration.

Witnesses at our public hearings and written comments on our proposed rules supplied additional indications that investor confidence in auditor independence is in fact being undermined by non-audit relationships between auditors and audit clients.
115

For example, representatives of TIAA-CREF, CalPERS, the New Hampshire Retirement System, and the AFL-CIO, organizations with responsibilities for the sound investment of hundreds of billions of dollars for the benefit of millions of participants, all came forward to express precisely that concern and to urge us to adopt the restrictions we proposed, or even more stringent restrictions.
116

115
For written comments,
see, e.g.,
Letter of Samuel Fleishman (Sept. 9, 2000) (“My confidence in the audits is greatly decreased by knowing that the same company is or could be doing consulting work for the company they are auditing.”); Letter of George R. Jensen (Sept. 8, 2000) (“Investors have a right to expect that sanctity [of the audit] as it is promised without having to wonder about the same firm monkeying with the audit to preserve or enhance their consulting business.”); Letter of Goran LindeOlsson (Sept. 9, 2000) (“The mere possibility that audits may not be 100% objective is reason enough to toughen the rules and keep accounting and consulting services separate.”); Letter of Vivian D. Kilgore Jr. (“No public confidence should be given to any report of any firm that engages in this practice.”); Letter of John Dossing (Sept. 10, 2000) (“Common sense tells me and other indivi[d]ual invest[o]rs this conflict of interests will lead to at the very least the appearance of conflict of interest. How can we trust any audits with the appearance of a conflict of interest. Why invest if we can't trust the figures presented to us in the financial statements?”).

116

See
Testimony of John H. Biggs, Chairman and CEO of TIAA-CREF (July 26, 2000); Testimony of Kayla J. Gillan, General Counsel, CalPERS (Sept. 13, 2000); Testimony of Alan P. Cleveland, New Hampshire Retirement System (Sept. 13, 2000); Testimony of Bill Patterson, Director, Office of Investment, AFL-CIO (Sept. 20, 2000).

Paul Volcker, former Chairman of the Federal Reserve Board, testified as follows about investors' perceptions of a conflict of interest when auditors provide non-audit services to audit clients:

The perception is there because there is a real conflict of interest. You cannot avoid all conflicts of interest, but this is a clear, evident, growing conflict of interest, given the relative revenues and profits from the consulting practice, and a conflict of interest is there.
117

117
Testimony of Paul A. Volcker (Sept. 13, 2000).

Richard Blumenthal, the Attorney General of Connecticut stated in his testimony before us, “The tough-minded questions and vigorous standards that the public has traditionally associated with the term “independent auditor” have been compromised by the interdependent business relationship between the auditors and the audited.”
118

Manuel H. Johnson, a public member of the ISB and the former Vice Chairman of the Federal Reserve Board, testified that,

118
Written Testimony of Richard Blumenthal (Sept. 20, 2000).

[T]he growing complexity of financial and economic relationships and the extent of non-audit services provided to audit clients by major accounting firms have significantly increased the perception and the potential for conflicts of interest and threatens the integrity of the independent audit function.
119

119
Testimony of Manuel H. Johnson (July 26, 2000).
See also
Testimony of William T. Allen, Chairman, ISB (July 26, 2000) (“[T]he evolution of the auditing profession into multi-service professional firms has given rise to reasonable concerns that the integrity of financial data is being or may be adversely affected or at least that markets may become suspicious of that fact and impose an additional risk premium.”).

At a Congressional subcommittee hearing regarding our proposals, John H. Biggs, Chairman, President, and Chief Executive Officer of TIAA-CREF, said,

The concern about auditor independence in the presence of substantial management consulting fees has been with us for years, and has caused much questioning and study in the profession. Investor uneasiness and suspicion of the quality of audited financial statements is growing rapidly along with the dramatic rise in the percentage of audit firm revenues that come from cross-sold services.
120

120
Written Testimony of John H. Biggs before the Subcommittee on Securities of the Senate

Committee on Banking, Housing and Urban Development (Sept. 28, 2000).

We recognize there are different views as to whether investor confidence is being undermined.
121

For example, in Phase I of its study, Earnscliffe reports “The vast majority of respondents believe that auditors are currently performing audits, which meet a high standard of objectivity and independence.”
122

In Phase II, Earnscliffe reports that with respect to the investing public surveyed, “Most had a high degree of confidence in the quality and reliability of the information that was available for them to use in making investment decisions.”
123

In addition, two professors from North Carolina State University submitted a study tending to suggest that “non-audit services had a positive influence on participants” perceptions of auditor independence, consistent with the contention that nonaudit services enhance auditor independence.”
124

Some commenters also cited a survey commissioned by the AICPA and conducted by Penn Schoen & Berland Associates,
125

which found that ninety-one percent of investors surveyed believe audited financial statements are credible.
126

121

See, e.g.,
Testimony of John Guinan, Partner, KPMG (Sept. 13, 2000) (“There's no fundamental unease within the marketplace on this subject.”); Testimony of Richard J. Stegemeier, Chairman Emeritus, Unocal Corp. (Sept. 13, 2000) (“I do not believe that [a clear and present danger to investors] exists.”).

122
Earnscliffe I,
supra
note 65, at 8.

123
Earnscliffe II,
supra
note 38, at 44. At the request of the AICPA, Gary Orren, a professor at the John F. Kennedy School of Government, reviewed and evaluated Earnscliffe I and II. Memorandum from Gary Orren to AICPA (Sept. 19, 2000). Mr. Orren concluded that the findings do not support our proposals, and that the studies were methodologically flawed. At the same time, he acknowledged that among the respondents in the studies, “[a] larger number, about half, thought that a perception problem might develop in the future,” that the majority of groups interviewed perceived a “slight appearance problem” today, that the respondents registered “mild misgivings” about the effects of non-audit services on independence, and that the respondents were “mildly worried” about a possible appearance problem in the future.
Id.
at 3, 4, and 7.

124
J. Gregory Jenkins and K. Krawczyk, North Carolina State University,
Perceptions of the Relationship Between Nonaudit Services and Auditor Independence,
manuscript (2000) (synopsis). In this study, the researchers interviewed 289 users of financial statements, including business professionals, graduate business students, and accounting professionals at Big Five firms and Non-Big Five firms.

125
Penn Schoen & Berland Associates, Inc.,
National Investors Survey
(Sept. 12, 2000) (“Penn Schoen Survey”).

126

Id.
at 4. What the Penn Schoen Survey did not report, but what we believe to be equally important, however, is that among all investors surveyed, only 54% said that they believe audited financial statements are “very credible,” 37% believe they are only “somewhat credible,” 5% believe they are “not credible,” and the remaining 3% do not know if they are credible.
See
Judith Burns, “Investors Unconcerned About Auditor Independence,”
Dow Jones New Service
(Sept. 12, 2000). We do not believe that investors or the accounting profession are well-served by a situation in which 37% of investors in a survey think public companies' audited financial statements are only “somewhat credible.” In addition, according to the Penn Schoen Survey, 23% of investors surveyed believed that regulators should play a bigger role than they do now in prohibiting accounting firms from offering a range of services (
id.
at 10) and 33% of investors surveyed disagreed that if our rules proposals were implemented audit firms will know less about the companies they audit and the quality of the audit will suffer (
id.
at 13).

We take seriously the indications of investor unease, along with indications that investor opinion may be divided. We focus on
degrees
of investor confidence, and we cannot take lightly suggestions that even a minority portion of the population is “mildly worried” about a possible appearance problem or that their confidence is being undermined.
127

We also take into account the durability of investor concerns. For decades there have been some who were troubled at the growth of non-audit services.
128

Those who were troubled remain troubled, only more so, and they have been joined by new voices from disparate quarters. We also consider whether the concerns that we hear will likely persist, or are merely transitory and unreasonable fears that inevitably will be allayed. In this instance, we believe that the indications of unease are reasonably based and thus likely to endure and increase, absent preventive action by the Commission.

127
Some have suggested that perception is not an appropriate basis for regulation.
See
AICPA White Paper, at App. A (paper by Gary Orren, “The Appearance Standard for Auditor Independence: What We Know and Should Know” (Oct. 20. 1997)). Others believe that “investor perceptions constitute an economically legitimate and theoretically sound basis for regulatory intervention.”
See, e.g.,
Written Testimony of Rajib Doogar (Sept. 20, 2000).

128

See supra
Section III.C.1;
see also
Arthur A. Schulte, Jr., “Compatibility of Management Consulting and Auditing,”
Accounting Rev.
586 (July 1965) (survey of four respondent groups—research and financial analysts of brokerage firms, commercial loan and trust officers of banks, investment officers of insurance companies, and investment officers of domestic mutual funds—indicated a third of all respondents believed that the provision of both audit and non-audit services was a conflict of interest); Abraham J. Briloff, “Old Myths and New Realities in Accountancy,”
Accounting Rev.
490-94 (July 1996) (finding that a significant number of academics, members of financial community, and accountants believed that an auditor's provision of management-advisory services detracted from the quality of the audit); Pierre L. Titard, “Independence and MAS—Opinions of Financial Statement Users,”
J. Accountancy
47 (July 1971) (finding that a significant number of parties who represented major investment concerns believed that an auditor's provision of management advisory services impaired auditor independence).

4. The Rules Are Appropriately Prophylactic

Some commenters and witnesses argue that there is “no empirical evidence to support the notion that providing non-audit services to audit clients has had any adverse effect on the quality of audits.”
129

This argument fails to take into account not only the extensive body of research and comments discussed above that document investor concerns, but also the extent to which our approach is, and must be, prophylactic. Moreover, as we explain below, the asserted absence of conclusive empirical evidence on this point is not particularly telling.

129
Letter of Deloitte & Touche (Sept. 25, 2000) (“Deloitte & Touche Letter”).

a.
The Commission's Independence Rules Must Be Prophylactic.
Our approach to auditor independence traditionally has been, as it must be, prophylactic. Independence rules are similar, though not identical, to conflict of interest rules. To minimize the risks of bias, the independence rules, like conflict of interest rules, proscribe certain relationships or circumstances, whether or not one can show that biased behavior inevitably results from the conflict.
130

The independence rules are preventive both because of the difficulty in proving the link from circumstance to state of mind, as discussed below, and because of the need to act in the public interest and protect investor confidence before it has been significantly undermined.

130
In this regard, our rule addresses potential conflicts in a way that is similar to rules regarding the conduct of federal judges. For example, § 455 of title 28 of the federal code provides that a federal judge is to disqualify himself (and may be disqualified by the appellate court) in any proceeding where the judge's “impartiality might reasonably be questioned.” 28 U.S.C. § 455(a). The courts have explained that “disqualification is required if a reasonable person who knew the circumstances would question the judge's impartiality, even though no actual bias or prejudice has been shown.”
Gray
v.
University of Arkansas,
883 F.2d 1394, 1398 (8th Cir. 1989).

The Commission's obligation to protect investors requires it to act before there has been a serious erosion of confidence in our nation's securities markets. Our view on this point is quite different from the suggestion from the CEO of an accounting firm that we should wait to adopt restrictions on non-audit services until there has been “a train wreck or a stockmarket crash.”
131

Our mission is not to pick up the pieces of such a “train wreck,” but to prevent one.

131
“The Ties That Bind Auditors,”
The Economist
at 63 (Aug. 12, 2000) (“Usually there is a train wreck or a stock market crash prompting this sort of radical legislation.”).

We have adopted other rules with a similar attentiveness to the need to sustain investor confidence in the public securities markets. For example, in our Order regarding rule changes by the Municipal Securities Rulemaking Board to address “pay to play” practices in the municipal securities market, we stated that the proposed rule changes were intended, among other things, “to bolster investor confidence in the integrity of the market by eliminating the opportunity for abuses in connection with the awarding of municipal securities business.”
132

Regulation FD provides another example of our acting to protect investor confidence.
133

There, our concern was, among other things, that “the practice of selective disclosure leads to a loss of investor confidence in the integrity of our capital markets.”
134

132
Notice of Proposed Rule Change by the Municipal Securities Rulemaking Board Relating to Political Contributions and Prohibitions on Municipal Securities Business, Exchange Act Release No. 33482 (Jan. 14, 1994) [59 FR 3389];
see also
“Exceptions to Rules 10b-6, 10b-7, and 10b-8 Under the Securities Exchange Act of 1934 for Distributions of Foreign Securities to Qualified Institutional Buyers, Securities Act Rel. No. 6999 (May 5, 1993) [58 FR 27686)] (“Rules 10b-6, 10b-7, and 10b-8 (‘Trading Rules’) are prophylactic in nature and designed to protect investors purchasing a security in a distribution from paying a price that has been artifically influenced (
i.e.
, raised or supported) by those persons who have the greatest incentive to engage in manipulative activity. Because the Trading Rules protect investors against artificial price movements, they promote the integrity of the pricing process and public confidence in the U.S. securities markets.”).

133
“Selective Disclosure and Insider Trading,” Release No. 33-7881 (Aug. 15, 2000) [65 FR 51715].

134

Id.

The courts have specifically rejected the need for proof of prior harm as an antecedent to government action designed to safeguard public confidence in the integrity of public actors and processes. For example, the court in
Blount
v.
Securities and Exchange Commission,
135

articulated this principle in the context of those rules limiting “pay to play” practices in the municipal securities markets, stating, “Although the record contains only allegations, no smoking gun is needed where, as here, the conflict of interest is apparent, the likelihood of stealth great, and the legislative purpose prophylactic.”
136

135
61 F.3d 938 (D.C. Cir. 1994).

136

Id.
at 945. Similarly, even in the First Amendment context of restrictions on campaign contributions, the Supreme Court has upheld the validity of prophylactic rules.
Nixon v. Shrink Missouri Government,
528 U.S. 377 (2000) (relying on the seminal case of
Buckley v. Valeo,
424 U.S. 1 (1976)).

In promulgating rules concerning auditor independence, we are making judgments about incremental probabilities. We must make judgments about the circumstances that render a loss of auditor objectivity more or less likely. “Objectivity” is not merely the absence of a conscious intention to skew audit results in a client's favor; it is a willingness to go without reluctance wherever the data lead. For us, the question is not whether an auditor who otherwise would be without bias will inevitably become biased and then intentionally disregard a false statement in a client's financial statements. We do not believe the appropriate benchmark for action is whether new rules are needed to make “bad” auditors good, malleable ones stronger, or sales-oriented ones focus solely on the audit. Rather, the actual issue is whether providing these services makes it unacceptably likely that there will be an effect on the auditor's judgment, whether or not the auditor is aware of it.

Similarly, our mandate to enhance investor confidence in our securities markets requires us to make judgments as to effects on degrees of confidence. Investor confidence in the securities markets arises from a multiplicity of sources. Investor confidence is currently high. We must consider not whether otherwise confident investors will lose confidence in our markets, but whether there is a significant enough probability that enough investors will lose enough confidence if we fail to act. In our judgment, the risk is present, and we should address it.

b.
The Commission Should Not Delay Action to Engage in Further Study.
In any event, the assertion that no empirical evidence conclusively links audit failures to non-audit services misses the point.
137

First, “audit quality,” which we seek to protect, is about more than just avoiding major audit failures or financial fraud. Auditing, we are often reminded, is not mechanical, but requires numerous subtle judgments.
138

It is important that these judgments be made fairly and objectively, whether or not they relate to matters that are material to the financial statements. As four previous SEC Chairmen stated,

137
The widespread perception among sophisticated members of the financial community that non-audit services are jeopardizing audit reliability at the very least suggests that there is in fact a problem. Moreover, at least one published study has found a statistical link between the provision of non-audit services and the frequency of audit qualifications. Graeme Wines, “Auditor Independence, Audit Qualifications and the Provision of Non-Audit Services: A Note,” 34
Acc. & Fin.
76 (May 1994). The author analyzed the audit reports put out between 1980 and 1989 by 76 companies publicly listed on the Australian Stock Exchange. He found that “the auditors of companies not receiving an audit qualification of any type over the period derived a significantly higher proportion of their remuneration from non-audit services fees than the auditors of companies receiving at least one audit qualification.”
Id.
at 76. While the author acknowledges that his research is by no means conclusive, it does corroborate the common-sense expectation that “auditors are less likely to qualify a given company's financials statements when higher levels of non-audit fees are derived.”
Id.
at 83.

138

See
Testimony of Robert L. Ryan, CFO, Medtronic, Inc. (Sept. 20, 2000) (“[T]o my mind one of the most sacred things in the whole audit process is judgment.* * * [T]here is so much judgment that goes into a financial statement and I want to feel that if I'm sitting across from a partner * * * that audit is the primary thing.* * *”).

Some will say that action now is premature or unwarranted. They argue that there's no harm unless you can directly tie a firm's nonaudit services to a failed audit. But this claim belies the environment in which many tough business decisions are made. It is rarely the black-and-white issues that an auditor faces. The danger lies in the gray area—where the pressure to bend to client interest is subtle, but no less deleterious.
139

139
Richard C. Breeden, Roderick M. Hills, David S. Ruder and Harold M. Williams, Editorial,
supra
note. 33.

The number of “audit failures” says nothing about misjudgments in the gray area.

“Audit failures” in all likelihood also demonstrate relatively little about the incidence of auditor error. An “audit failure,” as we use the term, refers to an instance in which the issuer's financial statements are materially misstated and in which the auditor either failed to discover the misstatement or acquiesced in the inclusion of the misstatement in the issuer's financial statements. The Commission is aware of only those audit failures it discovers or that are made public; presumably there are more. And, presumably, every error by an auditor does not lead to an audit failure. Moreover, audit failures arise from a multiplicity of causes, of which an impairment of independence is but one. To demand, as a predicate for Commission action, evidence that each loss of independence produces an audit failure is a bit like demanding proof that every violation of a fire safety code results in a catastrophic fire.
140

140

See, e.g.
, Written Testimony of J. Michael Cook former Chairman and Chief Executive Officer, Deloitte & Touche (July 26, 2000) (“I do not share the view that proof of such a linkage is the only appropriate basis for regulatory action. To the contrary, I believe the most independence rules today are the result of appearance-based rather than fact-based concerns. Further, I agree with the Commission that the absence of “proof” does not justify inaction, particularly when such evidence cannot be expected to be demonstrable.”); Paul B.W. Miller, Ph.D., CPA, Professor, University of Colorado at Colorado Springs, and Paul R. Bahnson, “The Spirit of Accounting” (draft column to appear in
Accounting Today,
submitted as Addendum to Written Testimony of Paul Miller (July 31, 2000) (“[A]udit failure is the wrong factor to consider.* * * The issue is not whether the auditor

can avoid catastrophic failure but whether the audit can increase the credibility of the statements enough to make investors perceive a lower risk of being misled.”); Testimony of Robert E. Denham, Member, ISB (July 26, 2000) (“[I]t's a mistake to focus too much on the cases of major audit failure and try to draw lessons from whether independence played a role in those.* * * [T]he better question for guiding the Commission * * * is what set of rules is more likely to produce better accounting, better financial reporting in the ordinary circumstances of the good companies.* * *”)

Second, the subtle influences that we are addressing are, by their nature, difficult to isolate and difficult to link to any particular action or consequence. The asserted lack of evidence isolating those influences and linking them to questionable audit judgments simply does not prove that an auditor's judgment is unlikely to be affected because of an auditor's economic interest in a non-audit relationship. Indeed, it is precisely because of the inherent difficulty in isolating a link between a questionable influence and a compromised audit that any resolution of this issue must rest on our informed judgment rather than mathematical certainty.

Except where an auditor accepts a payment to look the other way,
141

is found to have participated in a fraudulent scheme,
142

or admits to being biased, we cannot know with absolute certainty whether an auditor's mind is, or at the time of the audit was, “objective.” It is even harder to measure the impact that a particular financial arrangement with the audit client had on the auditor's state of mind.
143

Similarly, it is difficult to tie a questionable state of mind to a wrong judgment, a failure to notice something important, a failure to seek important evidential matter, a failure to challenge a management assertion, or a failure to consider the quality “ not just the acceptability “ of a company's financial reporting. As the POB noted, “Specific evidence of loss of independence through MAS [management advisory services], a so-called smoking gun, is not likely to be available even if there is such a loss.”
144

141

See, e.g., SEC
v.
Jose Gomez,
AAER No. 57 (May 8, 1985).

142

See, e.g., SEC
v.
Christopher Bagdasarian and Sam White,
AAER No. 825 (Sept. 26, 1996).

143
Article IV of the AICPA's Code of Professional Conduct provides, “Objectivity is a state of mind, a quality that lends value to a member's services. It is a distinguishing feature of the profession. The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interest. Independence precludes relationships that may appear to impair a member's objectivity in rendering attestation services.” AICPA Code of Professional Conduct, ET § 55.01.

144
1979 POB Report,
supra
note 38, at 34 n.103. As the POB noted, “[T]he Board recognizes that the nonexistence of such evidence does not necessarily mean that there have not been instances where independence may have been impaired. Not all situations where an auditor's objectivity is compromised will result in a lawsuit.”
Id.
at 35.

Testimony during our hearings provided informed, real-world perspectives bearing on the practical difficulty of establishing a conclusive link between non-audit service relationships and compromised audit judgments. Many who provided those perspectives nonetheless urged that we proceed with our rule.
145

145
While we considered testimony from our public hearings in evaluating the need for the rules as a matter of public policy, there was no fact finding with respect to particular cases and we have not reached any conclusions as to the presence or absence of securities law violations in cases discussed by witnesses.

Based on his thirty-three years of law enforcement experience and several cases involving unlawful and questionable conduct by auditors, Robert M. Morgenthau, the District Attorney for the County of New York, testified, “in most cases, it was impossible to tell whether financial considerations played a role in the auditor's issuing the opinion he did.”
146

In these instances, absent the sort of admission referenced above, we can look only to circumstantial evidence of influences or incentives affecting the auditor.
147

A number of plaintiffs' lawyers agreed that the hard evidence opponents of the proposals seek will be rare because even where the evidence does exist, it is unlikely that it will be made public. Charles Drott, a CPA and a forensic examiner, testified that “the only time these issues come to light

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A00-30244. Public record. Not legal advice.