My name is Bevis Longstreth. I am a retired partner of the New York law firm, Debevoise & Plimpton, where I spent the bulk of my professional career. From 1981 to 1984, I served as a Commissioner of the SEC, a post to which I was appointed twice by President Reagan. Recently, I served as a member of the Panel on Audit Effectiveness, which released its final Report and Recommendations in August, 2000. For five years following retirement from law practice, I taught a course on the regulation of financial institutions at the Columbia Law School.
I welcome this opportunity to address the Committee on the subject of reforming the audit profession. I am here because my professional experience and background give me some basis for contributing to your treatment of this urgent need for reform. I represent only myself, but in so doing, I hope to offer opinions that will resonate with other public investors in our nation’s securities markets.
I want to speak about the audit profession, a once proud profession now embattled and greatly in need of reform.
My thesis is simple. The profession needs reform in two major respects:
Despite the SEC’s adoption of Rule 2-01, the threat to an auditor’s independence from performing non-audit services allowed by the Rule remains palpable.
Despite the enlarged charter of the Public Oversight Board, until recently the most promising vehicle for achieving some limited improvement in self regulation, an effective system of self-regulation does not exist and can not be achieved without legislative reform. No greater proof of this fact could be found than the POB’s unanimous vote on January 20, 2002 to terminate its existence in reaction to the efforts of the profession’s trade association and the CEOs of the Big Five, in private meetings with the new Chairman of the SEC, to circumvent the POB by proposing still another voluntary oversight entity.
While the reforms I advocate offer no guarantee against audit failures, they should sharply reduce the size and number of these occurrences without impairing the ability of firms to prosper. Indeed, I believe that, without these reforms, the profession, which has been its own worst enemy, will continue to spiral downwards until legislation denies it the exclusive economic franchise on which its success was built from the beginnings of the securities laws in 1933 and 1934.
The Need for an Exclusionary Rule for Non-Audit Services
Arthur Levitt, with strong assistance from Lynn Turner, his Chief Accountant, showed boldness in their efforts to achieve a lasting solution to the vexing problem of independence. In the SEC’s Proposing Release, they invited comment on a simple rule excluding an auditor from providing non-audit services to audit clients. To many people away from the narrow corridor extending from the financial capital of the world that is still New York City to the separated powers of government in Washington, the idea that boldness, and even personal courage, would be required for a governmental powerhouse such as the SEC to propose such an obvious, and widely supported, rule is strange. Yet, I am positive that it took both boldness and courage to issue the Proposing Release. That’s because, by so doing, the SEC knowingly unleashed an unprecedented attack from those it was seeking to regulate, as it was charged by Congress to do, for the protection of the investing public and otherwise in the public interest. The ensuing battle, and it was clearly a battle, pitted a legally created monopoly, dominated by five global accounting firms, against the SEC. Three of the five, representing solely their private business interests, rejected any meaningful restrictions on the free play of those interests. Despite the profession’s multi-pronged assault, the SEC, acting upon the need for greater independence, a need long recognized by virtually every group that’s considered the issue (and there have been many), went ahead with its proposals, inviting comment and conducting four days of public hearing.
There were almost 3000 comment letters. One hundred witnesses testified for about 35 hours. The battle raged far beyond the frontlines at 450 5th Street N.W. Given the sharpness of the debate, and the transparency of the private vs. the public interest, there was more at stake in the outcome than just the independence of auditors. The independence of the SEC, itself, was being challenged as the accounting firms did all they could, on Capitol Hill and throughout the business and legal communities, to bring political pressure to bear against a proposal, the exclusionary rule, that could not be defeated by argument on the merits. At an informal meeting during the pendency of the rule proposal, involving representatives of the SEC and the POB, I was told by a veteran Washington insider that there wasn’t a significant law firm in DC that hadn’t been lined up by the profession to assist in its battle.
In the tumult of the moment, many leaders of the accounting profession -- and here I must say I am not including leadership of the POB --forgot their profession’s origins as one granted exclusive rights, and reciprocal duties, to perform a vital public service. Although affected by the public interest as much as, or more than, any public utility, these leaders were demanding freedom from serious oversight or constraint. From my vantage point as a member of the Panel on Audit Effectiveness who had a career of experience working closely with literally hundreds of responsible public accountants, I became increasingly convinced that the leadership of the profession was seriously, perhaps disastrously, disserving a worthy profession.
A rule on independence was adopted on November 21, 2000, shortly before Arthur Levitt’s term expired. The adopting release was 212 pages long. It was meticulously detailed. In that detail a careful reader can discern the parry and thrust of the battle that raged over each principle sought by the SEC and every word and sentence by which each surviving principle was to be expressed. I’m sure if Lynn Turner bared his back and shoulders, we would find more wounds than we could count, inflicted by a profession in the hands of hostile and short-sighted people.
The release acknowledges in several places that, in the SEC’s view, the final rule struck a reasonable balance among the commenters’ differing views. The release also claims the rule achieves the SEC’s important public policy goals. I wish these statements were true. But, it is my firm opinion they are not. There is a large gap between the sound policy goals sought by the SEC and the actual accomplishments that can realistically be anticipated by the rule. When the smoke had cleared, it was apparent to this observer that the profession had won the battle. Importantly, however, it was just one battle in a war the outcome of which, when it comes, sooner or later, will be different.
About the rule, let me be clear. I am not saying that, on balance, we would be better off without the rule. It is useful, despite its breath-taking complexity, which has proven very costly for the best intentioned issuers. I speak here as Co-Chair of the Audit Committee of a large public company that is continually struggling to understand the rules and assure that both it and its auditor are in compliance.
The rule is not even "half a loaf;" nonetheless, it is a step in the right direction. I say that for three reasons. First, because it was a bold and honorable battle hard fought by the SEC. In future battles this effort will count for a lot, despite the many compromises. Second, because the policy goals elaborated in both releases, and supported by abundant testimony and comment, provide a compelling foundation for carrying the battle forward in the halls of Congress, where, it has become clear, the fight must now be taken. And third, because the disclosure requirement is proving of particular use in focusing public attention, not to mention the attention of audit committees, on the amazing growth in non-audit fees paid to their auditors.
In thinking of the disclosure requirement, it is important to remember that the SEC in 1978, based on what it then saw as a growing amount of non-audit services being performed for audit clients, adopted a very similar disclosure rule, ARS 250, which was swiftly repealed in 1982 as the consequence of massive pressure from a profession that was beginning to be adversely impacted by disclosure. Since then, as we now know, non-audit services have increased exponentially.
So, what’s wrong with the rule? In many respects it can be criticized. I want only to address one big problem. The SEC adduced strong and abundant evidence in the rule-making process, as summarized in III(c)(2)(a) of the Adopting Release, that providing to one’s audit client non-audit services of any kind or kinds, if large enough in terms of fees paid, may impair independence. Despite this powerful predicate for rule-making, the rule adopted fails absolutely to address this concern.
The SEC describes the rule as implementing a "two-pronged" approach:
1. Requiring separate disclosure of audit fees, financial information-related service fees and other non-audit fees.
2. Prohibiting nine specific non-audit services believed by the SEC to be, by their very nature, incompatible with independence.
Economic incentives derived from non-audit work, no matter what their magnitude, were not defined as being, by their very nature, incompatible with independence. In failing to address this matter, the SEC ignored a mountain of persuasive argument.
This giant omission touches upon one of the two fictions that I am going to address. Fiction Number One is the claim that payment by an audit client to its auditor for consulting and other non-audit services, no matter how large, will never impair independence, that is, will never have an adverse effect on the quality of the audit or be seen to have such an effect in the eyes of the investing public.
It defies common sense to claim that large payments for non-audit services, which management could easily purchase, or threaten to purchase, from service providers other than its auditor, do not function as a powerful inducement to gain the auditor’s cooperation on how the numbers are presented.
Audit account partners are expected by their firms to establish close relationships with the managements they serve. They are expected to cross-market to management as full a range of non-audit services as possible. And, they are compensated by their firms on the basis, among others, of how much revenue they produce from their audit clients. Their stake in maximizing revenue from these clients through cross-marketing of non-audit services is as natural and compelling as any financial reward could be. To claim these incentives have no adverse impact on both the fact and appearance of independence is a fiction, pure and simple.
To be fair, I should point out that the rule contains a general standard, 2.01(b), that declares an accountant not independent if, in fact, or in the opinion of a fully informed, hypothetical "reasonable investor," the accountant is not capable of exercising objective and impartial judgment. Absent a "smoking gun," this "capability" test would seem to create a virtually insurmountable hurdle for the SEC.
The disclosure requirements of the rule, which enjoy the truth-eliciting feature of proxy rule sanctions for misstatements, have already illuminated the seriousness of the economic incentive problem. On average, for every dollar of audit fee paid, clients paid their auditors $2.69 in fees for non-audit services. In other words, non-audit fees represent, on average, 73% of total fees paid to auditors. This percentage is astoundingly large, even when one discounts it for lumping together audit-related services such as work on financials in registration statements. Of course, this is just the average. As The Washington Post reported in a June 13, 2001 editorial: "KPMG charged Motorola $39 million for auditing and $623 million for other services. Ernst & Young billed Sprint Corp. $2.5 million for auditing and $63.8 million for other services."
If Rule 2-01 with all of its promise and detail, allows non-audit service fees, as a percentage of total fees, to represent even a fraction of the 73% average that we now know prevailed on the eve of the rule’s adoption, the rule must be counted a failure. Given the compromises reached in defining the "terrible nine" services that may not be provided, I am afraid the percentage will not be substantially lessened by these so-called "bright line" exclusions. Of course, there remains the often powerful effects of disclosure on corporate behavior and, in this case, on the behavior of the audit committees.
Disclosure might encourage the growth of "best practices," as exemplified by TIAA/CREF, for example, which denies its auditor any non-audit business. Over some period of years, the rule’s disclosure could cause a growing number of audit committees to back away from using their auditors for any significant amounts of non-audit work.
But I wouldn’t bet on it. I fear Rule 2-01 will turn out to be the Maginot Line for Independence, crisscrossed with trenches, barbed wire and gun emplacements, all pointing in one direction only, capable at will of being thoroughly outflanked.
One indication of the rule’s failure in addressing the impact of large payments for non-audit services can be found in the way the Big Five presented it to their audit clients. I have been exposed to only one sample, which I fear may be illustrative of what others did, at least in oral presentations. Overall the message of this firm’s booklet on the rule, provided to audit committees and management of its audit clients, is that the rule changes almost nothing. In the sweep of its misleading characterization of what the SEC was seeking to accomplish, it leaves an informed reader amazed at the firm’s audacity. It carried Fiction Number One to a breathtaking extreme. I want you to hear only one statement taken from this document. It appears twice with only slight variations. Here’s one version:
"The real issue for audit committees is the nature of the work performed, not its cost. The rules do not indicate that fees of any magnitude alone impair independence. Nor did the SEC cite specific ratios of audit to non-audit fees as being "good" or "bad."
"Historically, the size of non-audit fees paid to an audit firm has been relevant to SEC independence considerations only to the extent that the total fees earned from one client represent a disproportionate percentage of the audit firm’s total revenues. SEC guidance on this point has established 15 percent of an audit firm’s total fees as a threshold of concern."
In 2001, the smallest of the Big Five’s total revenues was reported in The New York Times to have been more than $9 billion. Using the 15% "threshold of concern," a client could pay its Big Five auditor at least $1.35 billion dollars per year in non-audit fees before the audit committee , the SECor anyone else need trouble itself over independence. In practical terms, there was no limit.
How any professional firm, let alone a closely regulated firm of auditors, could so blatantly deceive its audit clients in this way defies common sense. For me, given the spirit of what the SEC was trying to accomplish by this rule-making, and the take-no-prisoners approach of the profession, the only plausible answer is that it’s a reflection of the contempt that a victor sometimes directs against the vanquished. For there was no question that the firms were victorious in beating back the SEC’s efforts at reform.
The Big Five firm that authored this statement surely knew that the 15% "threshold" came out of a 1994 no-action position taken by the Office of the Chief Accountant to address non-audit fees proposed to be paid to a very small auditor to allow that auditor to take on as a client its first SEC registrant. They know as well that this ruling was limited to its special facts and contained no suggestion of being an authoritative statement with regard to independence generally.
One basic problem with non-audit fees, which exists regardless of their magnitude but grows more serious as the fees grow larger, is conflict of interest. This conflict derives from the fact that, in performing both audit and non-audit services, the audit firm is serving two different sets of clients:
The audit firm is a fiduciary in respect to each of these two very distinct client groups, duty-bound to serve each with undivided loyalty. It is obvious, and a matter of common experience, that in serving these different clients the firm will be regularly subject to conflicts of interest. These conflicts tear at the heart of independence. What is independence? It is the absolute freedom to exercise undivided loyalty to the audit committee and the investing public. When other loyalties tug for recognition, and especially when they come from those in a position to enlarge or shrink one’s book of business, on which depends one’s partnership share, the freedom necessary to meet one’s professional responsibilities as an auditor is adversely affected.
Paul Volcker, in testimony on the rule, given in New York City on September 13, 2000, made the same point:
"The extent to which the conflict has in practice actually distorted auditing practice is contested. And surely, instances of overt and flagrant violations of auditing standards in return for contractual favors -- an auditing capital offense so to speak -- must be rare. But more insidious, hard-to-pin down, not clearly articulated or even consciously realized, influences on audit practices are another matter."
To highlight the size of the hole in the rule, consider that, in addressing disqualifying financial and business relationships between an accountant and its audit client, the rule declares in absolute terms that an audit firm lacks independence if there exists (a) any investment in the client, however small, by the firm or personnel involved in the audit, or (b) any direct business relationship with that client, however insignificant. Explicitly excluded from the term "business relationships," is the provision of non-audit services by the audit firm to its audit clients. Thus, one faces the absurdity of a rule that is absolute in banning financial and business relationships that are utterly inconsequential while appearing to allow any level of non-audit fees to be paid to the audit firm.
My point is not to suggest that the finely textured concerns of the SEC over the independence-impairing effects of various financial and business relationships are misplaced. They reflect legitimate, albeit immeasurable, concerns. But the important point is that they pale in significance when compared to the potential for impairment that comes from the financial and business stake that an audit firm, despite the rule, is still free to develop in an audit client through provision of a very wide variety of permitted non-audit services.
To plug this big hole, I suggest a simple exclusionary rule covering virtually all non-audit services, in place of the deeply complex, existing rule that I hope, by now, to have convinced you is ineffective.
This rule would define the category of services to be barred as including everything other than the work involved in performing an audit and other work that is integral to the function of the audit. In general, the touchstone for deciding whether a service other than the straight-forward audit itself should be excluded from non-audit services is whether the service is rendered principally to the client’s audit committee, acting on behalf of investors, to facilitate, or improve the quality of, the audit and the financial reporting process or is rendered principally to provide assistance to management in the performance of its duties.
This exclusionary rule could include a carefully circumscribed exception to permit certain types of non-audit services to be rendered by the audit firm to its client where special circumstances justify so doing. Use of such an exception should require at least the following:
The rule would be refined, administered and enforced by the legislatively empowered SRO that is the subject of my second recommendation for reform (discussed below).
The fundamental argument for exclusion is the avoidance of what amounts to a professional conflict of interest in serving two clients within one corporation. Beyond that, however, there are a number of other points to be made. I summarize them below:
1. Given the conflict of interest, it is not realistic to expect the firm, itself, to decide convincingly on its own independence. Given its self-interest in the outcome, the credibility of this process is highly suspect.
2. Nor is it feasible to expect independence to be assured by approval of the audit committee. It is impossible for that committee to identify when the problem exists. To challenge the auditor’s judgment on the matter is to challenge its integrity, something audit committees are not likely to do. Independence is a state of mind, necessary to maintain the skepticism and objectivity that long have been the hallmarks of the accounting profession. Being subjective and invisible, independence is not something an audit committee can apply any known litmus test to determine.
3. No one has suggested that the audit committee can be a substitute for clear rules where the problem of conflicts is most serious. Thus, for example, there is no suggestion that the audit committee be accorded discretion to assess independence despite the existence of financial or business interests between the audit firm and its client. Stock or other financial interests in one’s audit client, for example, have long been viewed as creating too clear a conflict of interest to become the subject of discretion, even if exercised by an audit committee composed only of outside directors. The need for an exclusionary rule is rooted in the same ground: prospective revenues from the provision of non-audit services, extending into the future, create precisely the kind of financial stake that produces a conflict of interest capable of impairing independence.
4. An exclusionary rule is easy to administer. It does not preclude an audit firm from engaging directly or through affiliates in non-audit services of any kind. All business entities other than its audit clients are available for business. Since the rule would apply to all audit firms, for each audit client put out of bounds for non-audit services, all the clients of other audit firms become available.
5. An exclusionary rule should correct the current system of compensation, which was found by the Panel on Audit Effectiveness to fail in giving adequate weight to performing the audit function with high levels of skill and professionalism. This situation adversely affects audit effectiveness. Success in cross-marketing an audit firm’s consulting services is a significant factor in the compensation system. The skills that make one successful in marketing non-audit services to management are not generally consistent with the professional demands on an auditor to be persistently skeptical, cautious and questioning in regard to management’s financial representa-tions. As long as the marketing of non-audit services by auditors to their audit clients is encouraged, expected and rewarded, there will exist a tension counterproductive to audit excellence. An exclusionary rule would eliminate both this tension and its harmful effects.
6. An exclusionary rule would be effective in rewarding those audit firms most sensitive to the independence issue and most scrupulous in seeking to avoid a real problem or even the appearance of a problem. Toothless exhortation and disclosure are pale green lights to those willing to sail close to the line, or cross over it. This situation has the perverse impact of hurting the competitive position of the most sensitive and scrupulous audit firms, and in time encourages even those firms to drop their guard and exploit the laxness in standards as well.
7. Independence is given important meaning in many analogous situations where potential conflicts, while not always certain to impair independence, nonetheless are prohibited in the interest of avoiding the problem. For example, consider the kind of independence necessary for a director to serve on an audit committee of a public corporation, The Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees determined that, for a director to be independent for that purpose, he or she must not accept compensation from the corporation for any service other than service as a director and committee member. The Blue Ribbon Committee noted that "… 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 common sense parallel to the auditor is both exact and compelling. Compensation for any service other than the audit threatens independence.
8. An exclusionary rule is a low cost premium on an important insurance policy for the whole profession, against governmental intervention to deny audit firms the right to do any non-audit work. In the Panel report we wrote, as of August 31, 2000, that "an exclusionary rule would go far toward eliminating the possibility of a major audit failure being linked to the influence of non-audit service business on the audit firm’s diligence and skepticism, an event that would provide a basis, and possibly the momentum, for some radical solution like a total ban." Enron could turn out to be the failure we were imagining.
The Need for A Legislatively Empowered Self-Regulatory Organization
The second fiction I wish to address is the profession’s three-fold claim that (1) it has the ability and motivation to regulate itself voluntarily, (2) it has done so effectively over the past several decades, and (3) therefore, there is no need for a legislatively empowered regulatory body led by persons independent of the profession.
The present form of self-regulation of the auditing profession reminds one of military music, or even, some might argue, corporate governance - - a classic oxymoron. Having looked closely at the system of governance within the auditing profession, I’m not prepared to be quite so simplistic. However, I am quite certain that the governance of this vitally important profession is in an entirely unsatisfactory state. Moreover, this is no trivial matter.
Overview of Governance. Today, governance is exercised from three sources:
1. State boards of accountancy, which have licensing powers.
2. The SEC, which exercises potentially broad powers over those who audit reporting issuers.
3. Private organizations of the profession, of which there are
at least seven important ones.
The profession claims that, through its various organizations, effective self-regulation is achieved. Having looked closely at this claim, I believe it to be false. What one sees is a bewildering maze of overlapping committees, panels and boards piled one on top of the other. They are characterized by complexity and ineffectiveness in matters of central importance to any effective system of self-regulation.
Among the short-comings of the present system are the following:
1. Lack of real public representation.
2. Lack of unified leadership over the seven organizations.
3. Lack of transparency.
4. Fuzzy and often over-lapping areas of responsibility.
5. Conflict between self-interest (as in the American Institute of Certified Public Accountants (AICPA), which is a trade organization parading as an SRO) and protection of the public interest.
6. Lack of any credible system for imposing discipline, a sine qua non for effectiveness.
7. Lack of assured funding.
8. Overall, lack of accountability to anyone.
Given its importance, a further word on discipline. Here’s all there is. The Quality Control Inquiry Committee of the SEC Practice Section of the AICPA (QCIC) is charged with investigating alleged audit failures involving SEC clients arising from litigation or regulatory investigations. However, it is only looking to see if there are deficiencies in the firm’s system of quality control. It is not involved in assessing guilt, innocence or liability of the firm or any individual. And its report is only prospective in its impact.
The Professional Ethics Executive Committee of the AICPA (PEEC) is charged with such responsibility for discipline as exists. It is supposed to pick up cases from the QCIC. However, out of alleged "fairness," at the firm’s request, the PEEC will automatically defer investigation until any litigation or regulatory proceeding has been completed, often many years later. This system results in long delays in investigation and, as a practical matter, renders the disciplinary function a nullity in almost all instances.
It was the Panel’s hope to recast the POB as the central overseer of self-regulation, with power and responsibility to effect changes necessary to make self-regulation effective. With a new and energetic chairman in Chuck Bowsher, this idea seemed achievable. As conceived by the Panel, the POB would have had these new elements:
1. Public members, independent of both the profession and the SEC, would constitute a majority of the board.
2. "Strings attached" funding would be provided by the profession in amounts sufficient to carry out the POB’s mission.
3. Absolute control over the nature of its work and the budget necessary to carry out that work.
4. Power to oversee all of the profession’s governance organizations.
5. Power of approval over appointments to the various organizations and over hiring, compensation, evaluation and promotion decisions by AICPA in respect of employees of key organizations.
6. Term limits for board members.
7. Nominating committee for selection of board members, composed of representatives of public and private institutions especially concerned with the quality of auditing and financial reporting.
8. Advisory council, composed similarly to the nominating committee, responsible for annually reviewing the work agenda for the POB.
The new charter for the POB was the result of heavy negotiation among the Big Five, the AICPA and the SEC. It fell short of the Panel’s recommendations in several important respects:
1. No POB approval over membership of governance organizations. Concurrence rights over Chairs.
2. No oversight over PEEC’s standard setting activities.
3. No nominating committee or transparency for POB board membership.
4. No oversight of staff of key governance organizations.
5. No power to change POB charter.
The POB believed it could work around its charter limitations by the threat of going public with disagreements. A whistle-blower technique. At the time I thought this a slim possibility. Making the POB the central, responsible and empowered regulator of the profession, which was the Panel’s goal and similarly the goal of the SEC under Chairman Levitt, was powerfully and effectively resisted by the AICPA. Again, the battle was waged. Again, the AICPA and the big firms asserted their immense power on behalf of unchecked self-interest. And again, the profession’s leaders came out on top.
However well intentioned Chuck Bowsher and his board might have been, and I know they were well intentioned, there was no way they could have achieved effective self-regulation of this profession under the POB’s charter as negotiated in 2000. Even if they had gotten all that the Panel advocated, it wouldn’t have worked. The reason is quite simple. Like many other businesses, the profession, and particularly its current leaders, apart from the POB, don’t want self-regulation. They want the shield of apparent self-regulation. But not anything close to the real thing.
Now, as you know, the POB members have all resigned in protest over the actions taken by the Big Five CEOs and the AICPA, in cooperation with the new SEC Chairman and in complete disregard of the Panel’s recommendations and the modest efforts taken so recently to strengthen the POB. The five members of the POB did, indeed, become whistle-blowers, having no other choice even in the face of a palpable crisis to the profession.
Whatever the explanation for the profession’s nearly suicidal attempt to evade the POB, which was the only plausible entity capable of some self-regulation, and whatever the SEC Chairman’s motives in lending support to this effort, it will not stand scrutiny. On the back of Enron, real reform must come at the legislative level. It must emerge from the lawmakers on Capitol Hill not only because the SEC appears unwilling to lead. In regard to an SRO, only legislation can arm an SRO with the necessary powers to do the job. A review of the essential elements common to all the existing SROs will explain why this is so. Here they are:
1. Creation by legislation or by governmental agency pursuant to legislation, with clear powers to write rules and conduct enforcement and disciplinary proceedings.
2. Supervision by government agency, including registration with that agency to operate as an SRO, agency approval of all rules adopted by the SRO and agency power to adopt rules for the SRO.
3. Power in the supervising agency to sanction the SRO for failure to perform its responsibilities, as, for example, failure to comply with its self-governance rules or to enforce the rules it imposes on those it has the chartered duty to regulate.
4. Requirement that all participants in the profession or industry being regulated (e.g., brokers and dealers) become subject to the SRO’s jurisdiction and powers.
It will be useful to examine further the workings of the NASD’s SRO, whose most important public duty is that of policing the rules of financial responsibility, professional conduct and technical proficiency. In carrying out this charge, the SRO is given essentially the same range of sanctions available to the SEC, which must be applied by the SRO in cases where a broker-dealer or its employees have violated the securities laws or SEC-enacted rules or the rules of the SRO. Of particular importance in achieving wide-spread compliance with the rules of professional conduct is the power of both the SEC and the SRO to discipline either or both the supervisory personnel and the firm for a failure to supervise employees who misbehave. To avoid sanction the firm must have in place procedures to deter and detect rule violations and a system for the effective implementa-tion of those procedures. It is hard to exaggerate the importance of this "duty to supervise" in respect of its prophylactic effects.
To facilitate speedy investigation by the SRO of alleged violations, and speedy judgment and imposition of sanctions where warranted, the SRO has one critically important tool that it uses to gain the cooperation of those it regulates, even those who are targets of an investigation. Its rules require each of its registered firms and individuals to turn over all requested documents and other information, and to appear and testify, in connection with an SRO investigation. Failure to cooperate in this way can result in expulsion from the industry. Courts have held the Fifth Amendment privilege against self-incrimination inapplicable to sanctions imposed by an SRO. Thus, as a practical matter, those regulated by the SRO, including the target of an investigation, must cooperate or lose their right to be in the industry.
As a result of being vested with law enforcement powers in combination with close supervision from a governmental agency, an SRO possesses three significant protections that typically are only enjoyed by governmental agencies in the exercise of enforcement powers. They are:
1. Immunity from suit.
2. Privilege from discovery of investigative files. It is important to note here that this privilege is generally understood to operate only during the investigation. This limitation holds for the SEC too.
3. Protection from antitrust violation for group boycott or other activity violative of antitrust principles.
These protections proceed from the fact, as reflected in Congressional committee reports, that an SRO is delegated law enforcement powers subject to supervision by the governmental agency from whence those powers came. Effectiveness compels the delegation of these protections as well.
From the foregoing brief summary of the common elements of an SRO, it can be seen that a private organization such as the POB, voluntarily organized by the accounting profession to self-regulate itself, cannot do the job, no matter how well-intentioned its leaders might be.
To reiterate: the SROs are effective because they are accountable to a governmental agency and derive from their relationship with that agency immunity from suit and important protections against discovery and antitrust laws, while at the same time preserving their private status enough to avoid the Fifth Amendment’s protections for those it regulates.
The inescapable conclusion from this analysis is that, unless and until a real, legislatively supported SRO is put in place to regulate the accounting profession, little, if any, progress toward an effective disciplinary system for accountants practicing before the SEC can be made, outside the SEC itself.
The need for the two reforms outlined above is not a trivial matter. To the contrary. I will use an analogue from Congressional history to measure this need. In the wake of the Great Depression, with the failure of an immense number of banks, and the huge losses to depositors, the Congress recognized that the public’s confidence in the country’s banking system had been badly shaken. Through hearings before the House and Senate, it became clear that the public’s earnings, when deposited in banks, had to be made safe, in fact, and the public had to be convinced of their safety. To meet this goal the Congress passed the Banking Act of 1933, creating the Federal Deposit Insurance Corporation and the system of deposit insurance we still enjoy.
Since 1933, as you all know, the public’s earnings have gradually migrated from the banking system to the capital markets: from bank deposits to money market mutual funds and, increasingly, to equities.
With this shift in how the public saves its earnings must come a shift by lawmakers in fashioning the kinds of protections these public investors need.
The Congress should not, of course, create a safety net to protect public investors in equities against any loss. To do that would be to do more harm to our system of capital formation than good.
But the Congress should act to insure that the system by which our corporations present their financial condition to the world is worthy of trust by the investing public. The auditors are the last line of defense against management’s inclination to fudge the numbers and, in recent years, with disturbing frequency, to present misleading and even false numbers.
Legislative action is needed now, because, with the growing number of audit failures in recent years, culminating (but not ending) with Enron, the public’s trust and confidence has again been badly shaken, just as in the Depression. However, this time the loss of confidence is by the public in its capacity as investors, not depositors, and its loss of trust and of confidence is directed at the reliability of financial statements certified by auditors.
I hope that the Enron hearings will convince Congress that the public’s trust in the auditing system must be restored by prompt and forceful legislative intervention, just as the public’s trust in the banking system was restored by forceful Congressional action in 1933.
The two reforms I have summarized will do the job. Other measures addressed to (1) matters of corporate governance, such as assuring punishment of officers and directors for dereliction of duty or conflict of interest, or (2) matters of conflict of interest involving securities analysts, may prove useful if carefully drafted after study and a weighing of costs against benefits. The time for reforming the auditing profession, however, is here and now.
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