July 8, 2002

Re: Support Public Interest Amendments to Strengthen Audit Reform Legislation Not Special Interest Amendments to Weaken It

Dear Senator:

As the Senate takes up legislation this week to restore independence and integrity to the audits of public companies, the vote will provide a key test of members' willingness to stand up to special interests and adopt real reform. The integrity of the financial markets, the confidence of investors, and the health of the economy hang in the balance.

Despite that, the vote is far from a sure thing. Although the bill takes steps to improve auditor independence and oversight, it would not be enough in its current form to stop many of the accounting scandals we've seen in recent years and keep investors from losing billions. This is because the accounting industry succeeded in getting key investor protections weakened during committee mark-up.

The industry will be back this week with further amendments to gut the bill. While we do not know for certain whether any or all will be offered, or whether others will be offered in their place, we are aware of six amendments for which the accounting firms are seeking sponsors.

Oppose Amendments to Weaken the Bill

We urge members not to offer and, if they are offered, not to support amendments to:

• Further weaken the limits on non-audit services. The bill's key provision to promote auditor independence is aimed at restricting consulting-related conflicts of interest by prohibiting auditors from providing certain specified non-audit services to their audit clients. The bill gives teeth to this prohibition by classifying violations as unlawful acts. The major accounting firms, which have repeatedly violated existing independence requirements, are seeking to lessen the force of this prohibition by reclassifying violations as independence violations, which would likely carry reduced penalties. As a result, audit firms could be expected to engage in constant testing of the limits of what is permissible, undermining auditor independence and placing additional burdens on regulators to police these activities.

• Gut the pre-approval requirement for non-audit services. The bill supplements its limited ban on non-audit services with a requirement that audit committees pre-approve any non-audit services to be provided by the auditor. In doing so, it specifies procedures to be used in approving and disclosing such services. The accountants are seeking to replace these procedural requirements with an approach that could allow audit committees to adopt blanket policies and procedures for pre-approval that would not necessarily require specific review by the committee of services to be offered. The amendment would also replace the requirement that companies disclose in periodic reports what non-audit services have been approved with a meaningless requirement that the board's policies and procedures for approving such services be disclosed. This would make it more likely that audit committees would give superficial review to services that could undermine auditor independence while leaving investors with inadequate information with which to judge for themselves whether auditor independence has been compromised.

• Limit information to audit committees on critical accounting policies and practices. The bill attempts to improve corporate board oversight of audits by arming audit committees with better information with which to evaluate financial disclosures. It does so by requiring auditors to report to audit committees on all critical accounting policies and practices to be used, alternative treatments within generally accepted accounting principles that have been discussed with management, the ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the audit firm. Although the bill already limits the requirement to "critical" policies and practices, accountants are seeking to further limit its reach by adding a materiality standard. Given accountants' well-documented willingness to dismiss as immaterial discrepancies totaling tens of millions of dollars, and the fact that crucial accounting practices are often developed and implemented before the financial amounts involved have become material to the financial statements, this could be used as a justification for dramatically reducing the information provided to audit committees. The bill's existing limitation to critical accounting issues is more than adequate to prevent information overload.

• Weaken incentives for audit firms to provide adequate supervision of audits. The bill empowers its new regulatory board for auditors to sanction firms and firm managers for failing to provide adequate supervision of audits. This approach is well-tested in the securities industry, where it has been shown to have a real deterrent effect. It is based on a recognition that firms, not individual audit partners, set company policies and that some firms create a working environment that, at worst, encourages lax and unethical practices, or, at best, allows them to go undetected. At a time when corporations are being encouraged to take responsibility for their financial reporting, holding the management of audit firms accountable for ensuring high quality audits makes simple sense.

• Limit auditors' role in testing companies' internal accounting controls. The Private Securities Litigation Reform Act required auditors to adopt procedures "designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts." While this would seem to be the minimum investors should be able to expect from the independent audit, it is a responsibility that auditors have resisted. The bill would beef up this provision by requiring auditors to submit reports describing the scope of their testing of the company's system of internal accounting and their findings as a result of that testing. The accountants are seeking to eliminate this requirement, presumably because it would make it far more difficult for them to continue to evade their responsibility to adopt procedures designed to detect illegal acts.

• Undermine the deterrent effect of board sanctions. Having already succeeded in amending the bill in committee to all but ensure that board sanctions are hidden from public view until the statute of limitations for securities fraud has run, the accountants are seeking to further ensure that Board findings cannot be used in any prosecution, civil enforcement action, or private lawsuit. To that end, they are seeking to insert a specific statement in the bill that Board actions may not be treated as conclusive in subsequent lawsuits. Among other things, this would preclude use of Board findings by state accountancy boards, forcing them to start from scratch in bringing parallel actions against auditors. Since Board actions would often likely replace SEC actions once legislation is passed, and SEC actions are not subject to any such limitations, this would seriously undermine the effectiveness of the regulatory regime for auditors.

• Tie the hands of state regulators investigating securities analysts. The accountants are not alone in seeking special interest amendments to weaken the bill. Morgan Stanley has reportedly been shopping around its own blatantly self-seeking amendment to prevent state securities regulators from pursuing their investigation into abuses by securities analysts at major Wall Street firms. Investors have long benefited from the role state regulators have played in exposing Wall Street abuses. State regulators are unlikely to continue that role if they are deprived of the tools to conduct effective investigations and impose meaningful sanctions. Any amendment to restrict their enforcement authority should be rejected.

Support Amendments to Strengthen the Bill

Fending off these amendments is essential, but not sufficient. If the bill is to provide the broad reform needed to end the growing drumbeat of massive accounting scandals, its key provisions on auditor independence and auditor oversight must be strengthened. To that end, we urge members to offer or support amendments to:

• Guarantee the independence of the oversight board. The bill creates an independently funded new regulator for auditors of public companies with the extensive inspection, standard-setting, investigative, and enforcement authority necessary for effective regulatory oversight. Under the terms of the bill, however, which require that two members of the five-member board be accountants and set no standards for qualification as a "public" member, the independence of the governing board is in serious doubt.

• Strengthen the ban on non-audit services. Don't leave all-important decisions on the scope of the ban to the SEC. The prohibition on non-audit services in the bill now relies entirely on how the SEC would interpret those restrictions for its effectiveness. For the majority of services on the list already covered by watered down SEC rules, including internal audits and financial system design and implementation, there is nothing in the bill to prevent the SEC from declaring that the bill codifies existing narrow definitions. While the bill does add a few services, including expert services, not covered by existing rules, the SEC will be free to define those services in the most restrictive way possible. Given the current SEC Chairman's role as an accounting industry lobbyist in watering down existing auditor independence rules, and his oft-stated belief that there is no conflict between auditing and consulting for the same client, this is a very real concern.

• Require rotation of audit firms. For auditors to be independent, they must feel free to challenge management without fear of losing the audit engagement. In a field where relationships typically last for decades, however, auditors have too much to lose to truly be independent. In contrast, auditors who know they will lose the audit engagement in a few years anyway will be more willing to stand up to management and disallow overly aggressive accounting.

• Improve transparency of disciplinary actions and sanctions. The public is fed up with closed-door disciplinary procedures that produce weak settlements and do nothing to resolve lax or abusive practices. Provisions added to the bill during Committee markup require confidential treatment of board disciplinary actions unless the parties agree otherwise and of sanctions until all appeals have been withdrawn or exhausted. As a result, the SEC proposal now provides greater transparency to the disciplinary process than the Sarbanes bill. Furthermore, by virtually ensuring that these actions would be kept from the public view until the statute of limitations for securities fraud has run, the bill would make it more difficult for victims of auditor wrongdoing to receive compensation for their losses.

• Other possible amendments. We also support other strengthening amendments that may be offered to the bill, including: Sen. Patrick Leahy and Sen. John McCain's legislation to strengthen criminal penalties for corporate wrongdoing and lengthen the statute of limitations for securities fraud to two years from discovery but no more than five years from the wrongdoing; Sen. McCain and Sen. Carl Levin's legislation to require companies that claim stock options as an expense in tax filings to declare them on financial statements; Sen. Dianne Feinstein's proposal to restore federal oversight of the over-the-counter derivatives market; and an amendment to restore aiding and abetting liability in private securities fraud lawsuits.

The rising tide of massive accounting frauds has understandably and justifiably shaken investor confidence in the integrity of corporate leaders and the reliability of independent auditors. If Congress fails to pass meaningful reform, you risk an additional loss of public confidence in the willingness of their representatives to place their interests ahead of special interests and adopt real reforms.

The House has already failed the test, adopting a sham reform bill that would create a new regulator for auditors custom designed for industry control. While it has some good features, the SEC proposal has two fatal flaws—serious questions about the SEC's legal standing to impose certain of its requirements and an approach to creating the board through a voluntary application process that, like the House bill, all but guarantees industry capture of the new regulator it creates. The Senate bill offers the last chance to adopt the meaningful reforms that are essential to restoring investors' faith in the markets and citizens' faith in their legislative representatives. We urge you to support the strongest possible audit reform bill.

For more information, contact Travis Plunkett at the Consumer Federation of America at (202) 387-6121.

Sincerely,

Barbara Roper Director of Investor Protection Consumer Federation of America

Scott Harshbarger President Common Cause

Edmund Mierzwinski
Consumer Program Director
U.S. Public Interest Research Group