Statement of Edmund Mierzwinski, Consumer Program Director, U.S. PIRG
Before the New York State Board for Public Accountancy Hearing To Discuss Recent Proposals To Enhance Auditor Independence and Public Protection in the Wake of Enron
Baruch College, New York City
May 16, 2002

Thank you for the opportunity to be here today. We appreciate the opportunity to testify and offer our views on how the New York State Board of Public Accountancy can respond to the urgent need to increase investor confidence "in the wake of Enron."

I am Edmund Mierzwinski, Consumer Program Director with the National Association of State Public Interest Research Groups, or U.S. PIRG. I am pleased to be here with Russ Haven, Legislative Counsel for NYPIRG. The state PIRGs are non-profit, non-partisan public interest advocacy organizations active around the country. Another of our members, California PIRG, works very closely with another witness today, Gail Hillebrand, Senior Counsel in Consumers Union's West Coast office, on Enron-related accounting reforms. The state PIRGs have also launched an Enron Watchdog campaign, with a 10-point platform of accounting, corporate governance and campaign finance reforms available at its Web site, www.enronwatchdog.org.

It is a great privilege for us to testify before you today along with your many other far more distinguished experts, including members of the O'Malley Panel on Audit Effectiveness of the Public Oversight Board (POB)-which developed over 200 important reforms you should also be considering, and including SEC Chairman Arthur Levitt's chief accountant, Lynn Turner, who worked with the Chairman on many reforms, including his efforts to enact a strong SEC auditor independence rule.

(1) State accountancy boards and legislatures have a critical role in the wake of Enron:

My primary message today is this: your work in New York is important. At the end of this Congressional session, due to the massive influence of the accounting and corporate lobbies, we're not sure Congress will do anything more than hold hearings and wring its hands over Enron and Arthur Andersen. So, just as Attorney General Spitzer is leading the SEC toward a solution to the analyst conflict problem, your board can lead Congress on the way to solving the accountant independence problem. California's legislature is also playing a critical role in this regard, as Gail Hillebrand has described.

In addition, for the record, we know of no federal preemption in any SEC rule or statute or case law that would prevent you from enacting the auditor independence rules you are considering. As the distinguished Justice Louis Brandeis said, "the states are the laboratories of democracy."

While I am sure the accounting industry lobbyists and witnesses today will try to convince you to wait for Congress to act, that would be a mistake. We cannot count on Congress. Already, the House has passed a weak, unsatisfactory accounting independence bill, HR 3763, while rejecting the efforts of New York State Representative John LaFalce, with his better proposal, HR 3818, to strengthen it. Consumer groups endorsed the LaFalce bill, although our optimal reforms (see Section (2), below are stronger). While the draft of the leading Senate bill, to be filed any day now by Banking Committee Chairman Paul Sarbanes, is better than what the House passed with HR 3763, it does not meet all of the tests we believe are necessary to guarantee auditor independence.

To better understand why we cannot rely on the Congress, here is a summary of what the House could have done and what the House did, in this excerpt from a letter from the Consumer Federation of America, Consumers Union and U.S. PIRG comparing the Oxley and LaFalce bills as they were considered in committee:

If New York, by board rule, or California, by legislation, enacts a better auditor independence proposal than what Congress does, we believe that the role your states play in the economy is so great that Congress or the SEC will then be forced to ratchet up their laws or rules. Even if they do not, we believe that firms auditing public companies will voluntarily comply with your stronger rules in their business nationwide, to ensure public confidence.

(2) We support the strongest possible rules prohibiting simultaneous provision of non-audit services to their clients, the strongest mandatory audit rotation rules and the longest cooling off period possible.

In your call for this public hearing, you asked witnesses to comment on each of these possible approaches. We recommend that your solution to the problem of ensuring auditor independence incorporate a combination of the three. We hope you find the comments below helpful.2

The whole point of requiring public companies to obtain an independent audit is to ensure that outside experts have reviewed the company books and determined that they not only comply with the letter of accounting rules but also present a fair and accurate picture of the company's finances. Auditors have profited handsomely over the years from performing this important public watchdog function. Unless the auditor is free of bias, brings an appropriate level of professional skepticism to the task, and feels free to challenge management decisions, however, the audit has no more value than if the company were allowed to certify its own books.

The independent audit is arguably more important today than it has been at any time since the requirement was first imposed in the 1930s. More than half of all American households today invest in public companies, either directly or though mutual funds. They do so primarily to save for retirement. As a result, their financial well-being later in life is dependent on the integrity of our financial markets.

(A) Mandatory periodic rotation: An audit firm that knows it has a limited term of engagement has significantly less to lose by challenging management than one that expects to retain the client indefinitely. This approach has costs as well, in the form of the learning curve at the start of an audit rotation. However, such costs can be minimized by setting a sufficiently long rotation period of five to seven years. Because such an approach would significantly enhance auditor independence, we believe the benefits far outweigh the costs.

(B) Broad Ban On Non-Audit Services: This mandatory rotation of auditors should be combined with a broad ban on provision of non-audit services to audit clients.

In enacting a ban, we urge a total ban, rather than relying on the kind of itemized list of banned services that the SEC proposed when it considered this issue in 2000. As the SEC noted at the time, an outright ban on auditors' providing non-audit services to audit clients offers a cleaner solution, since it attacks not just the particular conflicts associated with certain practices—such as conducting internal audits or performing valuations of in-process research and development—but also the substantial conflicts that arise as a result of the auditor's vulnerability to economic pressures from an audit client when other fees start to eclipse revenue from the audit itself. Furthermore, some services will inevitably fall between the cracks of even the best drafted rules. As a result, without a total ban, auditors will be responsible for determining on a day-to-day basis what services they can and cannot provide audit clients. Their unwillingness thus for to accept any responsibility for maintaining a professional level of independence clearly makes them unreliable arbiters of what services might create a conflict.

Finally, a total ban is essential to maintaining the auditor's independence of management. While the auditor is supposed to work for the audit committee of the board of directors, consultants work for company management. If an accounting firm has, or is seeking, a lucrative consulting contract from company managers, the auditor may come under enormous pressure within its own firm to please those company managers by signing off on questionable accounting practices. This is exactly the type of pressure that has been brought to bear on securities analysts, whose companies expect them to support investment banking operations with positive analysis. No attempt to erect firewalls—by requiring that auditors' consulting contracts be board approved, for example, or by prohibiting auditors from being paid based on their ability to cross-sell non-audit services, for example—is likely be effective in protecting the auditor from pressure if the firm has a large enough financial stake in the audit client.

After enacting a total ban, the board could then exempt certain services, on a case-by-case basis, if it is shown that these services are closely related to the audit, directly enhance the quality of the audit, benefit investors, and create negligible conflicts of interest for the audit firm. So, rather than describing certain services that cannot be provided, leaving a laundry list that can, you prescribe a narrow list of services that can be provided.

If any such non-audit services are permitted, they should have to be directly and separately approved by the audit committee of the board. Of course, this proposal would be manifestly strengthened if corporate governance rules are also improved, such that, first, rules defining independent directors are toughened, and, second, audit committees are then comprised only of truly independent directors who then face significant legal liability if they fail to adequately do their jobs. In addition, the state accountancy board should codify strict rules and continually review allowable non-audit services, to determine whether or not they pose independence problems, based on the four principles articulated in the SEC's Proposed Rule on Auditor Independence Requirements.3 As the proposed rule stated:

(3) Cooling off Period: Finally, to close the revolving door between audit firms and their audit clients, there should be a two to three year cooling off period after their involvement in the audit has ended during which members of the audit team would be prohibited from seeking or accepting employment with a former audit client. Most of the federal proposals on this are too weak or nonexistent. Your rule must go beyond a cooling off period only for the Chief financial officer or chief executive officer and must go at least two to three years. As the SEC found in its 2001 consent order with Arthur Andersen following the Waste Management debacle:

In this order, the SEC permanently enjoined Andersen from violating the SEC Act and imposed a civil penalty of $7 million.4

Again, we believe that each of these three potential reform "approaches" the board has identified work together and are interrelated. So, we also urge you to consider a rule so that any time a company hires a chief executive or chief financial officer who worked for their audit firm within the last three years, then that company should be required to rotate its auditors at that time, even if this period falls within the middle of a mandatory rotation cycle.

Conclusion

Nationally, consumer groups, including U.S. PIRG, the Consumer Federation of America and Consumers Union, allied with labor organizations led by the AFL-CIO, are urging the Congress to enact the strongest possible package of Enron-related reforms. The solution to the problem requires a mix of reforms. It requires that audit services be independent. It requires the establishment of meaningful accounting oversight boards with independent funding, and control by a majority of independent, public members. It requires adequate funding for the Securities and Exchange Commission and state accountancy boards. It requires real changes to corporate governance, so audit committees are made up only of truly independent members and decide on all key auditing questions. It requires a solution to the problem of securities analyst conflicts of interests and more.

Without leadership from state accounting boards and state legislatures, we do not believe Congress and the SEC will get the task done. We commend you for holding this hearing and look forward to working with you in the future.

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1 See full letter at www.enronwatchdog.org/newsroom/4_10_02.html

2 Much of our testimony today is developed in greater detail in the Consumer Federation of America's "White Paper on the Enron Collapse and the Need for Investor Reform" (February 2002) by Director of Investor Protection Barbara Roper www.consumerfed.org/enron_auditor_rpt.pdf . See also CFA's testimony to the Senate Banking Committee, by CFA Chairman Senator Howard Metzenbaum (ret.) on 20 March 2002, http://banking.senate.gov/02_03hrg/032002/metzenbm.htm Both the white paper and the testimony detail additional even stronger public policy solutions to the problem of auditor independence, such as requiring audits of publicly traded companies to be conducted by a new team of government-employed auditors in the SEC.

3 See the SEC's Proposed Rule Revising the Commission's Auditor Independence Requirements at www.sec.gov/rules/proposed/34-42994.htm. The final rule was weaker, following pressure from Congress and the accounting industry.

4 See "In the Matter of Arthur Andersen, 19 June 2001, www.sec.gov/litigation/admin/34-44444.htm

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