Originally Published in Investment Services Advisor - February 2002
Auditor Accountability and Independence
The recent failure of Enron highlights the importance of initiatives to reform auditor independence and accountability. On January 17, 2002, SEC Chairman Harvey Pitt issued a statement regarding these initiatives and his vision of enhanced accountability. He stated that the SEC "cannot and in any event will not tolerate this pattern of growing restatements, audit failures, corporate failures and investor losses." Chairman Pitt stressed the need for participation from the profession. While only in the early stages of development, the proposed system is to have two main components: discipline and quality control.
With regard to the disciplinary aspect of the reforms, the SEC envisions a system:
- subject to a new body dominated by public membership, which is empowered to perform investigations, bring expeditious disciplinary proceedings subject to SEC oversight, publicize results, and restrict individuals and firms from auditing public companies; and
- in which the SEC determines whether conduct is pursued as violations of law (in which case the SEC would handle it), or pursued as violations of ethical and/or competence standards (in which case it would be handled by the private sector regulatory body).
With regard to quality control, Chairman Pitt stated that the current peer review process needs to be reformed to ensure more frequent monitoring of audit quality and competence. He advocates a permanent quality control staff, unaffiliated with any accounting firm, that is deployed by the new publicly dominated body.
Also on January 17, 2002, the SEC issued a Policy Statement: "Establishment and Improvement of Standards Related to Auditor Independence." The SEC stated that it would no longer look to the Independence Standards Board ("ISB"), a private sector body composed of members from the accounting profession and from the public, for leadership in establishing, improving and maintaining independence standards for auditors of registrants’ financial statements. The SEC believes that its new auditor independence regulations and disclosure requirements, adopted in November 2000, best assure auditor independence through SEC staff interpretation and enforcement.
In a January 23, 2002 speech, Chairman Pitt elaborated on his and the SEC’s recent pronouncements on the accounting profession. He stated that in his belief, private regulation presents major advantages, both in quality control and discipline, over governmental control of the accounting review process. He cited cost as a major reason for his opinion. Chairman Pitt also discussed the new proposed Public Accountability Board ("PAB"). The SEC envisions that the PAB would be funded, not by the accounting profession, but from others in the private sector.
SEC Abandoned Project Identifying Flaws in the Accounting Industry
According to a January 29, 2002 Wall Street Journal article, after Harvey Pitt was appointed Chairman of the SEC in August 2001, the SEC staff stopped work on a lengthy report detailing weaknesses in, among other things, the Big Five accounting firms’ peer review process. The draft SEC report revealed numerous cases where peer reviews did not uncover violations of auditing standards that were later discovered by the SEC staff in its reviews. The draft report also indicated that in many of the cases where violations were uncovered, the oversight committee in charge of disciplining such firms failed to take action.
The Wall Street Journal
article indicates that the SEC’s abandonment of the project means that the conclusions in the draft report likely differ from Chairman Pitt’s new plan to reform auditor monitoring as outlined in his statement issued on January 17, 2002. Before taking office in August, Mr. Pitt represented all of the Big Five firms, as well as the AICPA, and in 1997 he helped write a "white paper," on behalf of the AICPA, arguing against the SEC’s plans to limit the consulting work accounting firms could do for the companies they audit. More recent articles tie the termination of this project to the resignation of the SEC’s former Chief Accountant, Lynn Turner.Commission Guidance on Soft Dollar Practices
On December 28, 2001, the SEC issued interpretive guidance regarding the scope of Section 28(e) of the Securities Exchange Act of 1934. Section 28(e) provides a safe harbor to money managers who use the commission dollars of advised accounts to obtain research. Specifically, the SEC expanded its interpretation of the term "commission" for purposes of determining to what extent certain soft dollars fall within the Section 28(e) safe harbor.
Previously, the SEC had interpreted Section 28(e) to be available only for research and brokerage services obtained in relation to commissions paid to broker-dealers acting in an "agency" capacity. Consequently, the safe harbor available under Section 28(e) did not allow soft dollar credits in connection with trades executed by market makers in a "principal" capacity. NASDAQ requested that the SEC reconsider its interpretation of Section 28(e). The SEC responded by broadening its interpretation of "commission" for Section 28(e) purposes to include mark-ups, mark-downs, commission equivalents or other fees paid by managed accounts to a dealer for executing transactions where the fee and transaction price is fully and separately disclosed on the confirmation and the transaction is reported under conditions that provide independent and objective verification of the transaction price subject to self-regulatory organization oversight. As a result of the broadened definition, firms are now able to receive research in exchange for soft dollars for certain principal transactions.
In going forward under the SEC’s recent guidance, firms should be careful to review all disclosure regarding soft dollar practices. Depending on the manner in which the term "commission" is utilized in a firm’s disclosure and the wording of the disclosure in general, it may be unnecessary to update the disclosure regarding soft dollar payments to NASDAQ brokers.
SEC Agenda
In several speeches last fall, Chairman Pitt outlined his agenda for the SEC. These themes, listed below, have been echoed by senior SEC staffers at various securities law conferences:
- Better, more efficient use of technology by the SEC. Chairman Pitt wants the SEC to create a new position, Chief Technology Officer.
- "Real time enforcement." This initiative is already underway as indicated by the SEC’s institution of proceedings in November and December against several companies alleged to have made misleading public statements regarding anthrax. Chairman Pitt also has stated that the SEC intends to encourage registrants to self-report violations, self-correct the problem and self-remediate those injured by the violation.
- Codification of various no-action letters and exemptive orders that have been issued by the Division of Investment Management. That process has already started with the SEC’s proposed amendments to Rule 17a-8 and Rule 17f-4 (discussed below).
The Investment Services Advisor is published by the law firm of Vedder, Price, Kaufman & Kammholz. It is intended to keep our clients and interested parties generally informed on developments in the investment services industry. It is not a substitute for professional advice.
