[Federal Register Volume 65, Number 134 (Wednesday, July 12, 2000)]
[Proposed Rules]
[Pages 43148-43203]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-17207]



[[Page 43147]]

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Part IV





Securities and Exchange Commission





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17 CFR Parts 210 and 240



Revision of the Commission's Auditor Independence Requirements; 
Proposed Rule

  Federal Register / Vol. 65, No. 134 / Wednesday, July 12, 2000 / 
Proposed Rules  

[[Page 43148]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release Nos. 33-7870; 34-42994; 35-27193; IC-24549; IA-1884; File No. 
S7-13-00]
RIN 3235-AH91


Revision of the Commission's Auditor Independence Requirements

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``SEC'' or 
``Commission'') is soliciting comment on proposed rule amendments 
regarding auditor independence. The proposals modernize the 
Commission's requirements by providing governing principles 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 proposals would, 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. They 
would also identify certain non-audit services that, if provided to an 
audit client, would impair an auditor's independence. The scope of 
services proposals would not extend to services provided to non-audit 
clients. The proposals also would provide a limited exception for 
accounting firms that have certain quality controls and satisfy other 
conditions. Finally, the proposals would require companies to disclose 
in their annual proxy statements certain information about, among other 
things, non-audit services provided by their auditors during the last 
fiscal year.

DATES: Comments should be received on or before September 25, 2000.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
NW., Washington, DC 20549-0609. Comments also may be submitted 
electronically at the following e-mail address: [email protected]. 
Comment letters should refer to File No. S7-13-00; this file number 
should be included on the subject line if e-mail is used. All comment 
letters received will be available for public inspection and copying in 
the Commission's Public Reference Room at the same address. 
Electronically submitted comments will be posted on the Commission's 
internet web site (http://www.sec.gov). \1\
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    \1\ We do not edit personal, identifying information, such as 
names or e-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: John M. Morrissey, Deputy Chief 
Accountant, or W. Scott Bayless, Associate 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 
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Commission, 450 Fifth Street, NW., Washington, DC 20549-1103.

SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to 
Rule 2-01 of Regulation S-X \2\ and Item 9 of Schedule 14A \3\ under 
the Securities Exchange Act of 1934 (the ``Exchange Act''). \4\
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    \2\ 17 CFR 210.2-01.
    \3\ 17 CFR 240.14a-101.
    \4\ 15 U.S.C. 78a et seq.
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I. Executive Summary

    Independent auditors have an important public trust.\5\ Every day, 
millions of people invest their savings in our securities markets in 
reliance on financial statements prepared by public companies and 
audited by independent auditors. \6\ These auditors, using Generally 
Accepted Auditing Standards (``GAAS''), examine issuers'; financial 
statements and issue opinions about whether the financial statements, 
taken as a whole, are fairly presented in conformity with Generally 
Accepted Accounting Principles (``GAAP''). While an auditor's opinion 
does not guarantee the accuracy of financial statements, it furnishes 
investors with critical assurance that the financial statements have 
been subjected to a rigorous examination by an impartial and skilled 
professional and that investors can therefore rely on them. Providing 
that assurance to the public is the auditor's over-arching duty. \7\
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    \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 account who performs an 
aduit 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\ Public companies 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 accounts. 
Public companies also must have their quarterly reports reviewed by 
independent accountants. See, e.g., Article 10 of Regulation S-X, 17 
CFR 210.10-01(d).
    \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 
Sec. 53.
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    Investors must be able to put their faith in issuers' financial 
statements. If investors do not believe that the auditor is truly 
independent from the issuer, they will derive little confidence from 
the auditor's opinion and will be far less likely to invest in the 
issuer's securities. Fostering investor confidence, therefore, requires 
not only that auditors actually be independent of their audit clients, 
but also that reasonable investors perceive them to be independent.
    One of our missions is to promote investor confidence in the 
reliability and integrity of issuers' financial statements. 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. Some of the 
important developments in each of these areas since we last amended our 
auditor independence requirements in 1983 \8\ include the following:
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    \8\ Financial Reporting Release (``FRR'') No. 10 (Feb. 25, 
1983).
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     Firms are becoming primarily business advisory service 
firms as they increase the number, revenues from, and types of non-
audit services provided to audit clients,
     Firms and their audit clients are entering into an 
increasing number of business relationships, such as strategic 
alliances, co-marketing arrangements, and joint ventures,
     Firms are divesting significant portions of their 
consulting practices or restructuring their organizations,
     Firms are offering ownership of parts of their practices 
to the public, including audit clients,
     Firms are in need of increased capital to finance the 
growth of consulting practices, new technology, training, and large 
unfunded pension obligations,
     Firms have merged, resulting in increased firm size, both 
domestically and internationally,
     Firms have expanded into international networks, 
affiliating and marketing under a common name,
     non-CPA financial service firms have acquired accounting 
firms, and the acquirors previously have not been

[[Page 43149]]

subject to the profession's independence, auditing, or quality control 
standards,
     Firms' professional staffs have become more mobile, and 
geographical location has become less important due to advances in 
telecommunications and internet services, and
     Audit clients are hiring an increasing number of firm 
partners, professional staff, and their spouses for high level 
management positions.
    Having considered these and other developments and their effect on 
auditor independence, we are proposing rule amendments. The proposals 
start from the premise that investor confidence in auditor independence 
turns on whether auditors are in fact independent and appear to be 
independent. To strengthen the basis for that confidence, the proposals 
focus on those who can influence a particular audit. The proposals 
articulate four principles that would govern our determination of 
whether an accountant is independent of its audit client. Specifically, 
the proposals provide that an accountant is not independent whenever, 
during the audit and professional engagement period, the accountant: 
(i) Has a mutual or conflicting interest with the audit client, (ii) 
audits the accountant's own work, (iii) functions as management or an 
employee of the audit client, or (iv) acts as an advocate for the audit 
client.
    The proposals then describe certain relationships which, when 
considered in light of these principles, render an accountant not 
independent of an audit client. The relationships addressed by the 
proposals include, among others, the financial and employment 
relationships between auditors (or their family members) 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 widely dispersed 
audit firm personnel and their families. In light of some of the 
developments described above, these rules may unnecessarily restrict 
investment and employment opportunities available to firm personnel and 
their families. The proposals shrink significantly the circle of firm 
personnel whose investments are imputed to the auditor. They also 
shrink the circle of family members and former firm personnel whose 
employment impairs an auditor's independence.
    Non-Audit Services. We have become increasingly concerned that the 
dramatic increase in the nature, number, and monetary value of non-
audit services that accounting firms provide to audit clients may 
affect their independence. Accordingly, the proposals specify certain 
non-audit services that, if provided by an accounting firm to an audit 
client, impair an auditor's independence in light of the four governing 
principles.
    For example, the proposals provide that an accounting firm would 
not be independent from an audit client to which the firm provides 
valuation and appraisal services. Some accounting firms provide these 
services to audit clients,\9\ even though the firm's auditors must 
independently question the value of the appraised asset in auditing the 
audit client's financial statements. As such, the auditor may have 
participated actively in the process of developing asset values that 
are reported to investors in financial statements. The auditor then is 
required to challenge those same numbers during the audit. In this dual 
role as auditor and consultant, the accountant both oversees and 
answers to management, raising serious conflict of interest questions. 
Will the auditor be diligent and objective in reviewing the accounting 
firm's valuation work? If, during the audit, the auditor identifies a 
problem with the valuation or appraisal, will that auditor bring the 
problem to management's attention? Perhaps more important, even if the 
auditor made unbiased decisions, would investors believe that the 
auditor had been objective? \10\
    The proposals do not extend to all non-audit services provided to 
audit clients. Not all non-audit services pose the same risk to 
independence. The proposals reflect what we believe to be a reasonable 
differentiation among various non-audit services, as well as our 
preference for narrowly drawn rules.
    Quality Controls. Accounting firms and the public benefit when 
firms have effective quality controls that ensure the independence of 
audit professionals. These controls protect the public and the firms, 
on whose audits the public relies. Public companies benefit as well, 
since they are able to access capital at a lower cost through our 
capital markets. Therefore, for accounting firms that have certain 
quality controls, we are proposing a limited exception from the 
independence rules for certain independence failures that are cured 
promptly after discovery. This exception should encourage firms to 
institute controls to ensure the independence of the firm's personnel.
    Disclosure of Non-Audit Services. Investors should have enough 
information to enable them to evaluate the independence of a company's 
auditors. The proposed rules would bring the benefits of sunlight to 
the auditor independence area by requiring companies to disclose in 
their annual proxy statements certain information about, among other 
things, the non-audit services provided by their auditors and the 
participation of leased personnel in performing the company's annual 
audit.

II. The Need To Preserve Auditor Independence

A. The Securities Laws Give Independent Auditors a Vital Mission and 
Responsibility

    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.\11\ Independent auditors play a key role in providing that 
assurance. Auditors follow specified procedures set forth in GAAS and 
express their opinion

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on whether the financial statements, taken as a whole, fairly reflect 
the financial position, results of operations, and cash flows of the 
company.\12\ Based on the independent auditor's opinion, investors have 
reason to believe that financial statements are materially accurate, 
fair, and complete.
    The federal securities laws, to a significant extent, make 
independent auditors ``gatekeepers'' to the public securities 
markets.\13\ These laws require, or permit us to require, financial 
information filed with us to be certified (or audited) by independent 
public accountants.\14\ Without an opinion from an independent auditor, 
the company cannot satisfy the statutory and regulatory requirements 
for audited financial statements and cannot sell its securities to the 
public.\15\ The auditor is the only professional that a company must 
engage before making a public offering of securities and the only 
professional charged with the duty to act and report independently from 
management. Because it is the issuer's responsibility to file 
independently audited financial statements, if the auditor is not 
independent, the issuer's filings are deficient under the securities 
laws.
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    \9\ See Independence Standards Board (``ISB''), ``Discussion 
Memorandum 99-3: Appraisal and Valuation Services,'' at 2-3 (Sept. 
1999). The ISB was formed in 1997 to establish auditor independence 
standards applicable to audit and other attestation reports that are 
filed with us. Copies of standards issued by the ISB can be obtained 
from the ISB's web site at www.cpaindependence.org.
    \10\ As Statement on Auditing Standards No. 1 states, ``. . . an 
independent auditor auditing a company of which he was also a 
director might be intellectually honest, but it is unlikely that the 
public would accept him as independent since he would be in effect 
auditing decisions which he had a part in making. Likewise, an 
auditor with a substantial financial interest in a company might be 
unbiased in expressing his opinion on the financial statements of 
the company, but the public would be reluctant to believe that he 
was unbiased.'' AICPA Codification of Statements on Auditing 
Standards (``SAS'') No. 1, AU Sec. 220.03. Indeed, a recent survey 
suggests that the complexity of the financial and business 
relationships between accounting firms and audit clients could 
diminish investors' confidence in the objectivity of auditors. In 
the 1999 study sponsored by the ISB, Earnscliffe Research & 
Communications found 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.'' See Earnscliffe Research & 
Communications (``Earnscliffe''), Report to the United States 
Independence Standards Board: Research into Perceptions of Auditor 
Independence and Objectivity, at 9 (Nov. 1999) (``Earnscliffe 
Report'').
    \11\ See generally Codification of Financial Reporting Policies 
(the ``Codification'') Sec. 601.01 (``[a]n 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'').
    \12\ The opinion of the auditor appears in a report that must 
include the word ``independent.'' See AICPA SAS No. 58, AU 
Sec. 508.08.
    \13\ 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).
    \14\ For example, Items 25 and 26 of Schedule A to the 1933 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 1933 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.
    \15\ ``An `unqualified opinion' states that the financial 
statements present fairly, in all material respects, the financial 
position, results of operations, and cash flows of the entity in 
conformity with generally accepted accounting principles.'' AICPA 
SAS No. 58, AU Sec. 508.10.
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    In the fiscal year ended September 30, 1999, 13,460 public 
companies filed annual reports with the Commission. In the same period, 
the aggregate dollar volume for public offerings filed with the 
Commission was $2.1 trillion. While our staff reviews a great many 
filings, it is not able to review in detail all of the financial 
statements filed with us. We therefore must rely heavily on the 
accounting profession to be primarily responsible for the integrity of 
the large volume of financial information that forms the cornerstone of 
our full disclosure system.\16\
    In creating this system, Congress granted the accounting profession 
an important public trust. Congress considered creating a corps of 
government auditors to review and audit companies' financial 
statements. Congress also considered mandating federal licensing of 
auditors. Instead, Congress entrusted the accounting profession with 
the responsibility of auditing the financial statements of companies 
registered with the SEC.\17\ In so doing, Congress gave the accounting 
profession both an enormously valuable franchise and a bedrock public 
responsibility.\18\
    The Supreme Court has underscored the significant and unique role 
of the auditor. In United States v. Arthur Young & Co.,\19\ the Court 
considered whether to extend to auditors certain confidentiality 
protections available to legal counsel representing a client and 
preparing for trial. The Court refused to extend the protections, 
citing principally the differences between the roles of counsel and 
auditor. A lawyer, the Court noted, is a confidential advisor and 
advocate with a duty to present the client's case in the most favorable 
light. In contrast, the Court stated that the ``independent certified 
public accountant performs a different role. By certifying the public 
reports that collectively depict a corporation's financial status, the 
independent auditor assumes a public responsibility transcending any 
employment relationship with the client * * * [and] owes ultimate 
allegiance to the corporation's creditors and stockholders, as well as 
to the investing public.'' \20\ According to the Court, ``This 'public 
watchdog' function demands that the accountant maintain total 
independence from the client at all times and requires complete 
fidelity to the public trust.'' \21\ The Court's words largely echoed 
those of Congress,\22\ the Commission,\23\ and the accounting 
profession.\24\

B. Independence in Fact and Appearance

    To fulfill the important role assigned to the auditor, the auditor 
must approach each audit with professional skepticism and must have a 
willingness and freedom to decide issues in an unbiased and objective 
manner, even when the auditor's decisions may be against the interests 
of management of

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an audit client. According to a 1947 statement by the accounting 
profession, ``The independent auditor is under a responsibility 
peculiar to his profession to maintain strict independence of attitude 
and judgment in planning and conducting his examination and in 
expressing his opinion on financial statements.'' \25\ Further, the 
AICPA's SAS No. 1 requires that ``in all matters relating to the 
assignment, an independence in mental attitude is to be maintained by 
the auditor * * * he must be without bias with respect to the client.'' 
\26\
    Because a principal purpose of auditor independence is to provide 
assurance to investors, the accounting profession has long required 
independence not only in fact but also in appearance. SAS No. 1 states, 
``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.'' \27\ Accordingly, ``Independent auditors should not 
only be independent in fact; they should avoid situations that may lead 
outsiders to doubt their independence.'' \28\
    The 1979 Report of the Public Oversight Board (``POB'') echoes the 
point, noting that the appearance of independence is itself ``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.'' \29\ The Supreme Court 
made the same point in the Arthur Young decision:

    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.\30\

    Auditor independence involves assumptions about human behavior that 
cannot be easily verified. \31\ While conflicts of interest are easily 
described, their actual impact on the ``objectivity'' of particular 
auditors can never be precisely known, because ``objectivity,'' as the 
AICPA's professional standards note, ``is a state of mind.'' \32\
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    \16\ This regulatory regime has been recognized by the courts. 
See, e.g., Touche Ross & Co. v. SEC, 609 F.2d 570, 580-81 (2d Cir. 
1979).
    \17\ Hearings on S. 875 Before the Senate Comm. on Banking and 
Currency, 73d Cong., 1st Sess. 55-60 (1933) (``1933 Senate 
Hearings''). During one hearing, Col. A. H. Carter, then president 
of the New York State Society of Certified Public Accountants, 
stressed the fact that outside accounting firms would be independent 
of management. During this discussion, Col. Carter, in 
differentiating between controllers employed by companies and 
independent accountants, stated, ``the public accountant audits the 
controller's accountant.'' Senator Barkley then asked, ``Who audits 
you?'' Col. Carter's oft-quoted reply was, ``Our conscience.'' Id. 
at 58.
    \18\ Payment of fees by the company to the auditor for 
performance of the audit and issuance of the auditor's opinion on 
the company's financial statements often is cited as a fundamental 
issue in the area of auditor independence. This fee structure was 
inherent in the decision by Congress in 1933 to have private sector 
auditors, rather than government employees, audit public companies. 
Id. Rather than being a reason for liberalization of the 
independence regulations, this payment structure should be a cause 
for exercising greater care by both companies and auditors in 
maintaining the auditor's independence. The National Association of 
Securities Dealers, Inc. (``NASD''), the New York Stock Exchange 
(``NYSE''), and the American Stock Exchange (``AMEX'') recently 
addressed this issue by changing their company listing standards to 
make it clear that the auditor is ultimately accountable to the 
board of directors and the audit committee, as opposed to 
management, and that the audit committee and the board of directors 
have the ultimate authority and responsibility to select, evaluate 
and, when appropriate, replace the auditor. See Order Approving 
Proposed Rule Change by the NASD, Exchange Act Rel. No. 42231, File 
No. SR-NASD-99-48 (Dec. 14, 1999); Order Approving Proposed Rule 
Change by the NYSE, Exchange Act Rel. No. 42233, File No. SR-NYSE-
99-39 (Dec. 14, 1999); and Order Approving Proposed Rule Change by 
the AMEX, Exchange Act Rel. No. 42232, File No. SR-Amex-99-38 (Dec. 
14, 1999).
    \19\ 465 U.S. 805 (1984).
    \20\ Id. at 817-18.
    \21\ Id. at 818.
    \22\ See, e.g., Subcomm. on Oversight and Investigations of the 
House Comm. on Interstate and Foreign Commerce, 94th Cong., 2d 
Sess., Federal Regulation and Regulatory Reform 35 (Subcomm. Print 
1976) (also known as the Moss Report).
    \23\ See, e.g., ``Relationships Between Registrants and 
Independent Accountants,'' Accounting Series Release (``ASR'') No. 
296 (Aug. 20, 1981). See also Office of the Chief Accountant of the 
U.S. Securities and Exchange Commission, Staff Report on Auditor 
Independence (Mar. 1994) (``Staff Report'') for a detailed 
discussion of: (1) The background and need for auditor independence, 
(2) the current rules and interpretations of the Commission, the 
AICPA, and other nations, and (3) recent and proposed changes in 
those rules and interpretations.
    \24\ See, e.g., AICPA SAS No. 1, AU Sec. 220.03.
    \25\ The Council of American Institute of Accountants adopted an 
official statement on independence that was published in The Journal 
of Accountancy in July 1947.
    \26\ AICPA SAS No. 1, AU Sec. 220.01-02.
    \27\ Id. at AU Sec. 220.03.
    \28\ Id.
    \29\ POB, Scope of Services by CPA Firms, at 27 (Mar. 1979) 
(``1979 POB Report'') (quoting A. Arens and J. Loebbecke, Auditing: 
An Integrated Approach (Prentice-Hall 1976)).
    \30\ Arthur Young, supra note 19, at 819 n.15 (emphasis in 
original).
    \31\ 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.
    \32\ 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 Sec. 55.01.
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    For this reason, the appearance standard serves an important legal 
purpose. It supplements an inquiry into the auditor's actual, 
subjective state of mind with an objective test: whether reasonable 
persons, knowing all relevant circumstances, would perceive that an 
auditor is independent. As the words connote, the appearance standard 
confines the inquiry into what is apparent and does not require an 
inquiry into the auditor's actual state of mind. The appearance 
standard, it should be stressed, is not a matter of ``public 
relations.'' It does not require the auditor to guess how persons with 
only a superficial understanding of the relevant facts would view his 
or her actions. Appearance is measured only with respect to reasonable 
persons knowing all the relevant facts and circumstances.
    Independence rules also must be prophylactic.\33\ Auditor 
independence requires auditors ``to be alert to a number of rather 
subtle influences. . . . [T]here is a considerable range of individual 
abilities within the profession; some accountants are strong enough and 
alert enough to control themselves under the most adverse and perhaps 
even the most subtle influences; others are not so fortunate.'' \34\ 
Our task in this area is to identify and address the influences that 
reasonably could be expected to pose an unacceptable risk that an 
auditor would lose his or her objectivity or that reasonable persons 
would perceive a loss of objectivity.

C. The New Business Environment Calls for Modernized Rules
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    \33\ Earnscliffe reports that ``[w]hile some believe that 
perceptions of the independence of auditors is already suffering 
some corrosion, more people take the view that damage is inevitable 
in the future if greater precautions are not taken to protect the 
perception of independence.'' Earnscliffe Report, supra note 10, at 
46.
    \34\ R. K. Mautz and Hussein A. Sharaf, The Philosophy of 
Auditing, at 223 (Am. Acct. Ass'n 1961).
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    In recent years, there have been significant demographic changes, 
changes in the accounting profession, and changes in the business 
environment that have affected accounting firms. Some of the more 
significant changes that have drawn attention to our auditor 
independence requirements include the increase in dual-career families, 
an ever-increasing mobility among professionals, a broadening 
international presence of accounting firms, and the growth and 
profitability of non-audit services offered by accounting firms to 
audit clients. These changes have led us to re-evaluate whether our 
auditor independence requirements remain effective, relevant, and fair.
1. Financial and Employment Relationships
    We propose to update the requirements regarding financial and 
employment relationships between auditors or their family members and 
audit clients.\35\ The existing requirements, among other things, 
attribute to the auditor investments of the relatives of the auditor 
``in varying degrees depending on the closeness of the [family] 
relationship,'' \36\ regardless of the amount of the holdings. They 
also attribute to auditors the investments of all partners and many 
professional employees in the accounting firm, as well as their 
families. The existing attribution rules may be too restrictive, since 
traditional family structures have changed, family members are more 
dispersed, there is increased mobility of professional employees, and 
accounting firms themselves are expanding around the globe. 
Accordingly, our proposals narrow many of these requirements,

[[Page 43152]]

while protecting investor confidence in the reliability of financial 
information.
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    \35\ See illustrations in Appendix C of how some of the proposed 
rules would apply. They are provided for illustrative purposes only 
and necessarily exclude certain important details set forth in the 
proposed rules.
    \36\ Codification Sec. 602.02.h.
---------------------------------------------------------------------------

    The proposals similarly narrow existing restrictions on the 
employment of auditors' family members, former audit firm employees, 
and former audit client employees who leave companies to work in audit 
firms. For example, with respect to employment restrictions on 
auditor's relatives, the proposals liberalize our existing position in 
several significant respects. First, the proposals reduce the pool of 
people within audit firms whose independence is required for an 
independent audit. Second, the proposals identify specific positions, 
namely those in which a person is in a position to or does influence 
the audit client's financial records, that would impair an auditor's 
independence if held by the auditor's relative. Finally, under the 
proposals, only positions at an audit client held by the auditor's 
``close family members'' affect the auditor's independence. These 
proposals liberalize our current position and the ISB's position as 
reflected in its recent Invitation to Comment.\37\
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    \37\ See ISB, ``Invitation to Comment 99-1: Family Relationships 
Between the Auditor and the Audit Client'' (July 1999).
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2. Scope of Services
    (a) A Historical Perspective on the Provision of Non-Audit 
Services. In the 1970s, Congress seriously considered limiting the 
services independent public accountants could provide that were not 
directly related to accounting, even though at that time non-audit 
services did not constitute a large percentage of audit firms' 
businesses.\38\ Although Congress did not take action, in 1979, the 
Chairman of the POB warned the public about dangers arising from the 
growth of non-audit services:
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    \38\ 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). 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 which 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, dated Apr. 6, 1978 (reprinted in 
Securities and Exchange Commission Report to Congress on the 
Accounting Profession and the Commission's Oversight Role (July 
1978)).
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    The [POB] believes that there is possibility of damage to the 
profession and the users of the profession's services in an 
uncontrolled expansion of MAS 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.\39\

    \39\ 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''), dated March 9, 1979, at 2.
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    Our staff considered these issues in a 1994 Staff Report.\40\ The 
Staff Report noted that much of the growth in non-audit services until 
then could be attributed to services provided to parties other than 
audit clients.\41\ Accordingly, the Staff Report concluded that no 
change in our rules or the federal securities laws was warranted at 
that time, but the staff promised to ``continue to be alert to the 
development of problems of independence that may be caused by [non-
audit services].''\42\ The staff has kept a watchful eye on these 
matters.
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    \40\ Staff Report, supra note 23, at 27-34. 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 II.C.4. (discussing these 
disclosure requirements). In the late 1980s, 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., 
dated Feb. 14, 1989 (denying the petition). In 1990, the staff 
stated that if certain conditions were met, it would not object to 
Arthur Andersen & Co.'s conclusion that certain business 
relationships between Andersen Consulting and audit clients of 
Arthur Andersen & Co. may be considered indirect business 
relationships. See Letter from Edmund Coulson, Chief Accountant, 
SEC, to Robert Mednick, Arthur Andersen & Co., dated June 20, 1990.
    \41\ Staff Report, supra note 23, at 33. See infra notes 47-67 
and accompanying text (showing dramatic increase in nature, number, 
and dollar amount of non-audit services provided to audit clients 
since the issuance of the Staff Report).
    \42\ Staff Report, supra note 23, at 34.
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    Other industry observers also have followed developments in this 
area. After the Staff Report, there were at least three significant 
studies by the private sector and one by the General Accounting Office 
(``GAO''). These studies emphasized the continuing public concern 
regarding the objectivity and independence of auditors, particularly in 
light of the expansion of consulting and other non-audit services for 
audit clients. The Advisory Panel on Auditor Independence (also known 
as the Kirk Panel), in its September 1994 report, described 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 by 
diverting firm leadership away from the public responsibility 
associated with the independent audit function, by allocating 
disproportionate resources to other lines of business within the 
firm, and by seeing the audit function as necessary just to get the 
benefit of being considered objective and to serve as an entree to 
sell other services. . . . \43\

    \43\ Advisory Panel on Auditor Independence, Report to the 
Public Oversight Board of the SEC Practice Section, AICPA: 
Strengthening the Professionalism of the Independent Auditor, at 9 
(Sept. 13, 1994).
---------------------------------------------------------------------------

    Similarly, the AICPA Special Committee on Financial Reporting (also 
known as the Jenkins Committee), in its 1994 report, found that users 
of financial statements believed that non-audit service relationships 
could ``erode auditor independence.'' The Report noted:

[Users] also are concerned that auditors may accept audit 
engagements at marginal profits to obtain more profitable consulting 
engagements. Those arrangements could motivate auditors to reduce 
the amount of audit work and to be reluctant to irritate management 
to protect the consulting relationship.\44\

    \44\ Special Committee on Financial Reporting, AICPA, Improving 
Business Reporting--A Customer Focus: Meeting the Information Needs 
of Investors and Creditors, at 104 (1994).

    Two years later, in 1996, GAO completed a thorough review of the 
---------------------------------------------------------------------------
accounting profession. In its report, GAO noted:

GAO . . . believes that questions of auditor independence will 
probably continue as long as the existing auditor/client 
relationship continues. This concern over auditor independence may 
become larger as accounting firms move to provide new services that 
go beyond traditional services. The accounting profession needs to 
be attentive to the concerns over independence in considering the 
appropriateness of new services to ensure that independence is not 
impaired and the auditor's traditional values of being objective and 
skeptical are not diminished.\45\

    \45\ GAO, The Accounting Profession--Major Issues: Progress and 
Concerns, at 8 (GAO/AIMD-96-98, Sept. 1996) (the ``GAO Report'').
---------------------------------------------------------------------------

    Most recently, in 1999, Earnscliffe conducted interviews to assess 
the perceptions of different audiences about

[[Page 43153]]

auditor independence. In conclusion, Earnscliffe reported that, ``Most 
[interviewees] felt that the evolution of accounting firms to multi-
disciplinary business service consultancies represents a challenge to 
the ability of auditors to maintain the reality and the perception of 
independence. . . .'' \46\
---------------------------------------------------------------------------

    \46\ Earnscliffe Report, supra note 10, at 46.
---------------------------------------------------------------------------

    Taken together, these studies suggest that important constituencies 
see a connection between the business scope of accounting firms and 
auditor independence.
    (b) Recent Developments. The menu of services offered by the firms 
to audit clients has grown dramatically and continues to grow. \47\ 
Attached to this release, for commenters' convenience, is a list of 
services that auditors provide to their audit and non-audit 
clients.\48\ Companies appear to be turning to their auditors for 
performance of their internal audit, pension, financial, 
administrative, sales, data processing, and marketing functions, among 
others.\49\
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    \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, supra note 40.
    \48\ See Appendix A. The list was prepared by the ISB. See ISB, 
``Discussion Memorandum 99-2: Evolving Forms of Firm Structure and 
Organization'' (Oct. 1999). Although the list is long, it is not 
comprehensive. Commentators may wish to review accounting firms' web 
sites and other sources for additional information about the 
services being provided by accounting firms.
    \49\ See, e.g., ``KPMG spies rapid growth in `shared 
services','' Accounting Today, at 12 (June 3-16, 1996); ``KPMG 
Restructures to Reposition Outsourcing,'' Public Accounting Report, 
at 1 (May 15, 1996).
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    U.S. revenues for management advisory and similar services \50\ for 
the five largest public accounting firms amounted to more than $15 
billion in 1999, based on amounts calculated from data published in the 
Public Accounting Report.\51\ Revenues for these service lines are now 
estimated to constitute half of the total revenues for these firms.\52\ 
In contrast, these service lines provided only 13 percent of total 
revenues in 1981.\53\ From 1993 to 1999, the average annual growth rate 
for revenues from management advisory and similar services has been 26 
percent; comparable growth rates have been 9 percent for audit, and 13 
percent for tax services.\54\
---------------------------------------------------------------------------

    \50\ Management advisory services (``MAS'') are a subset of non-
audit services.
    \51\ See Table 1 in Appendix B. The underlying data are reported 
in ``Special Supplement: Annual Survey of National Accounting 
Firms--2000,'' Public Accounting Report (Mar. 31, 2000).
    \52\ See Tables 1 and 2 in Appendix B.
    \53\ See Table 2 in Appendix B.
    \54\ See 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 audit clients have 
increased significantly over the past two decades. In 1984, only one 
percent of audit clients of the eight largest public accounting firms 
paid MAS fees that exceeded the audit fee.\55\ The percent of Big 5 
audit clients that paid MAS fees in excess of audit fees did not exceed 
1.5 percent until 1997.\56\ In 1999, 4.6 percent of Big 5 audit clients 
paid MAS fees in excess of audit fees,\57\ an increase of over 200% in 
two years. For the five largest public accounting firms, MAS fees 
received from audit clients amounted to ten percent of all revenues in 
1999.\58\ Almost three-fourths of audit clients purchased no MAS from 
their auditors in 1999. This means that purchases of MAS services by 
one-fourth of firm's audit clients account for ten percent of all firm 
revenues.\59\ In addition, the magnitude of MAS fees received from SEC 
registrants appears to distinguish the five largest accounting firms 
from other firms. The MAS fees received by the approximately 800 
accounting firms with 1,000 or fewer SEC registrants as audit clients 
represent approximately one percent or less of total fees on 
average.\60\
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    \55\ See Table 3 in Appendix B.
    \56\ See Table 3 in Appendix B.
    \57\ See Table 3 in Appendix B.
    \58\ See Table 4 in Appendix B.
    \59\ See 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. During that same 
period, approximately 3,300 of those companies that are SEC 
registrants paid approximately $3.062 billion for MAS and similar 
non-audit services.
    \60\ See Table 4 in Appendix B.
---------------------------------------------------------------------------

    Certain transactions raise questions about auditor independence. 
Some smaller firms are consolidating their audit practices and seeking 
public investors in the resulting company.\61\ 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 also hire the employees 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 service firm to pay the professional 
staff for ``nonprofessional'' services for the corporate organization 
as well as professional attest services rendered for the audit 
firm.\62\
---------------------------------------------------------------------------

    \61\ See, e.g., Rick Telberg, ``Anybody can do it! says small-
firm consolidator,'' Accounting Today, at 5 (Jan. 4-24, 1999).
    \62\ ``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).
---------------------------------------------------------------------------

    In February 2000, Ernst & Young announced that it would sell its 
management-consulting business to Cap Gemini Group SA, a large and 
publicly-traded computer services company headquartered in France.\63\ 
KPMG recently split off its consulting business into a separate 
corporation (KPMG Consulting, Inc.), sold preferred stock convertible 
to between 18.2% and 19.9% of its outstanding stock to Cisco 
Corporation, and announced its intention to sell additional shares to 
the public in an initial public offering.\64\ PricewaterhouseCoopers 
has publicly announced its intention to re-structure its audit and 
consulting businesses along similar lines.\65\
---------------------------------------------------------------------------

    \63\ ``Cap Gemini and Ernst & Young Have Agreed to Terms for the 
Acquisition of Ernst & Young Consulting'' (Feb. 29, 2000) (press 
release of Ernst & Young) (available at www.ey.com).
    \64\ KPMG Consulting, Inc., Form S-1, filed May 5, 2000.
    \65\ Diane B. Henriques, ``Auditing Firm Plans to Split Its 
Businesses,'' N.Y. Times, Feb. 18, 2000, at C8.
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    Under certain circumstances, these transactions could lead to 
violations of the independence rules, since the financial interests and 
relationships of the newly formed consulting entities would be imputed 
to the auditing firms. At a minimum, these transactions could raise 
serious public policy issues by creating relationships between firms 
and shareholders, strategic investors, and companies providing services 
to audit clients. In the case of Ernst & Young, our Chief Accountant, 
by no-action letter, stated that the Office of the Chief Accountant 
would not assert that Ernst & Young's independence from an audit client 
has been impaired solely because that audit client is also a client of, 
enters into a business relationship with, or is invested in by Cap 
Gemini. That no-action relief was based on, among other things, Ernst & 
Young's representations that: (1) Following the initial sale to Cap 
Gemini, Ernst & Young's equity interest would be reduced to zero within 
five years, (2) Ernst & Young would play no role in the corporate 
governance of the consulting company, and (3) Ernst & Young would

[[Page 43154]]

not have any co-marketing arrangements with the new entity.\66\
---------------------------------------------------------------------------

    \66\ Letter from Lynn E. Turner, Chief Accountant, SEC, to 
Kathryn A. Oberly, Esq., Ernst & Young, dated May 25, 2000 
(available at www.sec.gov).
---------------------------------------------------------------------------

    (c) How Non-Audit Services Can Affect Auditor Independence. The 
dramatic expansion of non-audit services may fundamentally alter the 
relationships between auditors and their audit clients in two principal 
ways. First, as auditing becomes an ever-smaller portion of a firm's 
business with its audit clients, auditors become increasingly 
vulnerable to economic pressures from audit clients. Second, certain 
non-audit services, by their very nature, raise independence issues. 
These concerns, described more fully below, have led us to consider 
whether our rules should limit--or even completely bar--an auditor's 
provision of non-audit services to audit clients.
    (i) Auditor Vulnerability to Economic Pressure From Audit Clients. 
Large non-audit engagements \67\ may make it harder for auditors to be 
objective when examining their client's financial statements. Under any 
circumstances, it can be difficult for an auditor to make a judgment 
that works against the audit client's interest. Where making that 
judgment may imperil a range of service engagements of the firm, of 
which the audit is a fairly small part, it may be unrealistic to expect 
that an auditor can ignore completely what the firm stands to lose by 
the auditor's action.
---------------------------------------------------------------------------

    \67\ In 1999, Big 5 accounting firms received higher fees for 
MAS and other consulting services than for audits from approximately 
600 audit clients. See Table 3 in Appendix B.
---------------------------------------------------------------------------

    Our concern is not just that an auditor will give in to a client. 
It is that, as auditors become involved in a broad array of business 
arrangements with their clients, they come to be seen by themselves, 
their firms, their clients, and investors less as exacting, skeptical 
professionals who must be satisfied before signing off on the financial 
statements, and more like any other service vendor who must satisfy the 
client to make the sale.\68\
---------------------------------------------------------------------------

    \68\ Earnscliffe reports, ``The large majority of interviewees 
in each segment (including auditors) have sensed that in recent 
years accounting firms have lost their preoccupation with audits, 
and become much more preoccupied with growing new areas of 
consulting revenue. Many felt that within firms, the psychic and 
financial rewards were tilted heavily towards the consulting side, 
and that auditors who wanted to be well compensated and respected by 
peers, needed to support the growth of non-audit functions. This 
perception was even shared by a fair number of auditors. . . .'' 
Earnscliffe Report, supra note 10, at 14.
    See also Statement of PricewaterhouseCoopers, ``In essence, we 
have become an organisation trying to follow two missions at the 
same time. One goal has been to assure financial market integrity 
and provide investor protection. The other has been to help clients 
succeed by guiding them through complex, large-scale business 
transformations. One goal demands objectivity and independence. The 
other demands a direct interest in our clients' success.'' Wall St. 
J., Feb. 22, 2000, at A17.
---------------------------------------------------------------------------

    An expanded menu of relationships with an audit client may also 
give rise to a mutuality of interest between the auditor and client. 
This would be a significant concern in any era, but it may be 
especially important in an era when many ventures go quickly from 
start-up to apparent success to failure. For example, an audit firm may 
agree to perform the audit of a start-up company for fees significantly 
below market rates for a few years, in anticipation of ``recouping'' 
such an investment in the client through a subsequent initial public 
offering or performance of consulting services.
    We also have concerns about the effect on an accounting firm's 
internal culture when the firm is trying to be an audit client's vendor 
of choice. As non-audit services become more important to a firm, that 
firm may care less about auditing and more about expanding its service 
lines. 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.
    There appears to be growing public concern about audit firms' 
increasing provision of various non-audit services, and skepticism that 
firm safeguards adequately protect the fact and appearance of 
independence. Earnscliffe reports that auditors, audit committee 
chairs, chief executive officers, analysts, and regulators all, to some 
degree, recognize the independence risks posed by multifaceted 
relationships between auditors and their audit clients.\69\ A majority 
of the Earnscliffe respondents felt that internal firm safeguards 
``might ultimately be insufficient to sustain confidence in the 
independence of auditors.'' According to the Report, those respondents
---------------------------------------------------------------------------

    \69\ Earnscliffe Report, supra note 10, at 28, 37-41.

. . . felt that the judgement of observers would turn on how the 
financial incentives and penalties were organized: if it appeared 
that a firm had more upside in bending to a client's pressures, then 
internal processes would only be of limited value. Not everyone felt 
that this was the perception today, rather they were offering the 
view that internal firm safeguards had limited prophylactic value if 
---------------------------------------------------------------------------
the scrutiny were to become more punishing.\70\

    \70\ Id. at 20. Regarding the lack of effective safeguards, see 
generally ``Report of the Internal Investigation of Independence 
Issues at PricewaterhouseCoopers LLP'' (Jan. 6, 2000) (available on 
our web site, www.sec.gov). See also Letters from Lynn Turner, Chief 
Accountant, SEC, to Michael Conway, Chairman, SECPS Executive 
Committee, dated Nov. 30, 1998 and May 1, 2000.
---------------------------------------------------------------------------

    (ii) Independence Issues Inherent in the Nature of Certain Non-
audit Services. Providing certain non-audit services to an audit client 
can lead an audit firm to have a mutual or conflicting interest with 
the client, audit its own work, advocate a position for the client, or 
function as an employee or management of the client.\71\ Auditor 
independence concerns arise, for example, when a company hires its 
audit firm to perform valuations of in-process research and 
development.\72\ When an auditor in effect, even if not in form, makes 
decisions for management, he or she functions as a member of the 
management team and may develop a ``mutuality of interest'' with the 
audit client. After all, 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. How then can he claim to be completely independent?'' \73\ 
The consultant is accountable to management, in contrast to the 
auditor, who must ``acknowledge[] no master but the public.'' \74\
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    \71\ See generally Paul M. Clikeman, ``Auditor Independence: 
Continuing Controversy,'' Ohio CPA J. (Apr.-June 1998); Mautz and 
Sharaf, supra note 34, at Ch. 8.
    \72\ See infra Section III.D.1.(b) (regarding the types of 
services that raise independence concerns).
    \73\ Mautz and H. Sharaf, supra note 34, at 222.
    \74\ Gary John Previts, The Scope of CPA Services 33 (John Wiley 
& Sons, 1985) (citing Charles Reckitt, The Public Accountant 
(Philadelphia 1900)).
---------------------------------------------------------------------------

    (d) Measuring Independence Impairments. Some argue that no 
empirical evidence justifies our concerns. They argue that there is no 
evidence that providing non-audit services in general--much less 
particular types of non-audit services--leads to false financial 
reporting. Without this evidence, the argument goes, the Commission 
should not take steps to protect auditor independence.
    It is common sense, however, and confirmed by studies, that a 
person's decision changes when he or she has a stake in the outcome of 
that decision. \75\

[[Page 43155]]

Furthermore, common sense dictates that the more someone--including an 
auditor--has at stake, the more likely his or her decision is to be 
affected.
---------------------------------------------------------------------------

    \75\ See Max H. Bazerman, Kimberly P. Morgan, and George F. 
Loewenstein, ``The Impossibility of Auditor Independence,'' Sloan 
Management Review, at 89-94 (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 selfinterest,'' 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''); see also Robert A 
Prentice, ``The SEC and MDP: Implications of the Self-Serving Bias 
for Independent Auditing,'' Ohio St. L.J. (Fall 2000) (forthcoming).
---------------------------------------------------------------------------

    Studies cannot always confirm what common sense makes clear. Except 
where an auditor accepts a payment to look the other way,\76\ is found 
to have participated in a fraudulent scheme,\77\ or admits to being 
biased, it is largely impossible to observe an auditor's state of mind 
or know whether an auditor's mind is ``objective.'' It is even harder 
to measure the impact a particular financial arrangement has on the 
auditor's state of mind. And it is similarly impossible 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.\78\ This is particularly true because auditing misjudgments 
may often go unnoticed.\79\ As the POB noted, ``Specific evidence of 
loss of independence through MAS, a so-called smoking gun, is not 
likely to be available even if there is such a loss.'' \80\
---------------------------------------------------------------------------

    \76\ See, e.g., SEC v. Jose Gomez, Accounting and Auditing 
Enforcement Release (``AAER'') No. 57 (May 8, 1985).
    \77\ See, e.g., SEC v. Christopher Bagdasarian and Sam White, 
AAER No. 825 (Sept. 26, 1996).
    \78\ See AICPA SAS No. 90, AU Sec. 380.11. Independence lapses 
perhaps are most likely to affect this gray area, where the answers 
are more a matter of judgment than of bright-line rule, and where 
judgments are out of the public view.
    \79\ Of course, all of these factors make it equally impossible 
to demonstrate empirically that an auditor's economic interests do 
not adversely affect the quality of the audit.
    \80\ 1979 POB Report, supra note 29, 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.
---------------------------------------------------------------------------

    Whatever the effect of non-audit service relationships on an 
auditor's conduct, there can be little question about the effect of 
these impairments on investor confidence. Gradual decreases in investor 
confidence may not be measurable, but their cumulative economic impact 
could not be more palpable. Investor confidence in the integrity of 
publicly available financial information is the cornerstone of our 
securities markets. That confidence is hard won and easily lost, and 
the Commission must act to protect it.
    (e) Whether to Prohibit All Non-Audit Services. In developing these 
proposals, we considered whether independence is impaired whenever an 
auditor provides any non-audit service to an audit client, or whether 
certain non-audit services do not impair independence. We have 
tentatively concluded, pending public comment, that the better approach 
is to permit some significant non-audit services, though several 
factors weigh in favor of a blanket ban.
    Prohibiting only some non-audit services does not address the 
increasing vulnerability of auditors to their audit clients and the 
corresponding link between the financial health of auditors and their 
clients. These concerns do not turn on the nature of the non-audit 
service involved, but arise simply because of the growing 
interdependence of auditor and client.
    In addition, distinguishing between permissible and impermissible 
types of services raises difficult questions about services that do not 
fall squarely into precise categories. These questions will get only 
harder in the future as firms move to provide new and unforeseen 
services.
    Finally, an approach that tries to distinguish between permissible 
and impermissible types of services depends heavily upon daily 
interpretations by the very firms the rules are intended to affect. In 
light of the powerful economic interests at stake, there is serious 
question whether it is fair or reasonable to expect accounting firms to 
evaluate the impact of new services on their own impartiality.
    Despite these doubts, we believe that the measured approach we 
propose--establishing basic principles for evaluating any non-audit 
services' impact on independence, and identifying specific services 
that are plainly incompatible with independence--protects investor 
confidence in the audit process while allowing auditors to provide 
those services that are not reasonably viewed as creating a bias in the 
auditor. Our goal is to preclude non-audit services only to the extent 
necessary to protect the integrity and independence of the audit 
function. Of course, therefore, the proposals do not extend to services 
provided to non-audit clients.
3. Quality Controls
    As accounting firms become more global and their business 
relationships with their audit clients become more complex, the need 
for quality controls to address independence becomes more apparent. 
Without strong quality controls, it may be difficult or impossible for 
an accounting firm to understand whether its independence may be 
impaired. For example, firms need quality controls to track whether the 
firm, or any covered person in the firm, has any direct investment in 
an audit client.
    Our staff has stated that certain firms, particularly larger firms 
with public company clients, may lack sufficient worldwide quality 
controls.\81\ The staff has urged certain firms to review existing 
quality controls and ensure that particular areas are covered.\82\ 
Moreover, designing and implementing quality controls is not a one-time 
responsibility. We encourage accounting firms to continue to invest in 
state-of-the-art systems that can identify conflicts at an early stage 
to ensure a swift response. The speed of the response to a conflict, or 
potential conflict, is important to maintain public confidence in the 
self-regulatory process and the effectiveness of quality controls.\83\
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    \81\ See Letter from Lynn Turner, Chief Accountant, SEC, to 
Charles Bowsher, Chairman, POB, dated Dec. 9, 1999; see, e.g., In 
the Matter of PricewaterhouseCoopers, LLP, AAER No. 1098 (Jan. 14, 
1999).
    \82\ See Letters from Lynn Turner, Chief Accountant, SEC, to 
Michael Conway, supra note 70.
    \83\ See id.
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    We understand that many firms are already designing and 
implementing quality controls. We recently announced a voluntary 
compliance program, in which the Big 5 accounting firms agreed to 
report past violations of auditor independence rules.\84\ In connection 
with the program, the firms also have agreed to design and implement 
quality controls specified by our Chief Accountant and have the POB 
issue public reports on the results of their efforts. The rules we 
propose today are intended to encourage firms to design and implement 
effective quality controls to address independence. Toward that end, 
the rules contain a limited exception for firms that have appropriate 
quality controls and meet other conditions.
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    \84\ SEC Press Release, ``All Big 5 Accounting Firms Agree to 
Participate in Voluntary Program to Address Independence Violations; 
Safe Harbor Provided for Certain Violations'' (June 7, 2000).
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4. Proxy Disclosure
    From 1978 to 1982, we required companies to disclose in their proxy 
statements all non-audit services provided by their auditors.\85\ We 
also required companies to include a statement of the percentage of the 
fees for all non-audit services compared to total audit fees, the 
percentage of the fee for each non-audit service compared to

[[Page 43156]]

total audit fees, and a statement whether each non-audit service was 
considered and approved by the audit committee of the board of 
directors or by the board itself.\86\
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    \85\ For a concise discussion of the Commission's previous 
rulemaking efforts in this area, see Staff Report, supra note 23, at 
27-34.
    \86\ ``Disclosure of Relationships with Independent Public 
Accountants,'' ASR No. 250 (June 29, 1978). Prior to the 
implementation of this disclosure requirement, a private commission 
established by the AICPA (The Commission on Auditor's 
Responsibilities, known as the ``Cohen Commission'') reviewed the 
performance of non-audit services by auditors. The Cohen Commission 
found that outside of executive search and placement services, there 
was no evidence that the performance of such services compromised 
auditor independence. In spite of this finding, the Cohen Commission 
urged the accounting profession to take steps to diminish the 
concerns of a ``significant minority'' and recommended that the 
performance of non-audit services be evaluated by audit committees 
or boards of directors, and that registrants or auditors 
appropriately disclose such services. The Commission on Auditors' 
Responsibilities, AICPA, Report, Conclusions, and Recommendations, 
at 100-04 (1978).
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    In connection with the disclosure requirement, we published an 
interpretive release \87\ describing certain factors that independent 
accountants, audit committees, boards of directors, and managements 
should consider in determining whether a company's independent 
accountant should be engaged to perform non-audit services. These 
factors included the auditor's dependence on non-audit fees, the 
possibility of the auditor supplanting management's role in making 
corporate decisions, the possibility of creating a situation where an 
auditor may be required to review its own work, and the relation of the 
non-audit activity to accounting and auditing skills.
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    \87\ ``Scope of Services by Independent Accountants,'' ASR No. 
264 (June 14, 1979).
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    Although our concerns regarding the provision of consulting and 
other non-audit services remained unchanged, we later determined to 
rescind the formal interpretive release \88\ and the proxy disclosure 
requirement.\89\ Among other reasons, our review of proxy disclosures 
convinced us that accounting firms were not providing extensive non-
audit services to their audit clients. Our review of the 1979 and 1980 
proxy disclosures of approximately 1,200 registrants showed that fees 
paid by audit clients for non-audit services generally constituted a 
relatively small fraction of registrants' audit fees.\90\ In addition, 
we noted that, even without the proxy disclosure requirement, investors 
had access to useful data concerning the relative levels of audit and 
non-audit services provided by firms to their audit clients. In 
particular, we noted that summarized information regarding the 
relationship between MAS and audit fees was provided to the SECPS by 
member firms and was publicly available. We also concluded that the 
efforts of audit committees and the accounting profession to monitor 
firms' provision of non-audit services generally had been effective.
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    \88\ In withdrawing the interpretive release, we reaffirmed our 
views regarding the need for caution in the provision of non-audit 
services:
    Although the Commission's views expressed in [the interpretive 
release] are unchanged and registrants and accountants must continue 
to carefully evaluate their relationships to ensure that the public 
maintains confidence in the integrity of financial reporting, the 
Commission is withdrawing that release because it may confuse 
independent accountants, audit committees and others who are trying 
to evaluate services performed or to be performed by the 
accountants. Moreover, the Commission believes it has achieved its 
objective in issuing [the interpretive release]. Accountants and 
their self-regulatory structure, audit committees, boards of 
directors and managements are aware of the Commission's views on 
accountants' independence and should be sensitive to the possible 
impact on independence of nonaudit services performed by 
accountants. The Commission believes it should be able to rely on 
these persons to ensure adequate consideration of the impact on 
accountants' independence of nonaudit services because they share 
the responsibility to assure that the public maintains confidence in 
the independence of accountants.
    ASR No. 296, supra note 23.
    \89\ ``Rescission of Certain Accounting Series Releases and 
Adoption of Amendments to Certain Rules of Regulation S-X Relating 
to Disclosure of Maturities of Long-Term Obligations,'' ASR No. 297 
(Aug. 20, 1981).
    \90\ ASR No. 296, supra note 23.
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    As discussed above, however, in recent years there has been a 
dramatic growth in the number of non-audit services provided to audit 
clients and the magnitude of fees paid for non-audit services.\91\ 
Moreover, there may be less information available to investors about 
these services since the SECPS has stopped publishing information about 
audit firms' provision of non-audit services. Further, information 
provided by the SECPS describes the mix of services provided by an 
accounting firm to all of its clients, while an investor generally is 
primarily interested in the services provided to an individual company. 
This information is not currently available.
---------------------------------------------------------------------------

    \91\ See supra Section II.C.; see also Appendix B.
---------------------------------------------------------------------------

    Under circumstances where investors have less information about a 
matter that has become more important, we believe a disclosure 
requirement may once again prove useful to investors. Accordingly, we 
propose to reinstate a requirement that companies include in their 
proxy statements certain disclosures about non-audit services provided 
by their auditors during the last fiscal year. As we did while the 
requirement was in effect twenty years ago, we expect that both we and 
investors will learn from these disclosures and that they will have an 
impact on audit committees, investors, and accounting firms.\92\ 
Disclosure may be particularly effective now that investors have 
unprecedented access to information about companies in which they 
invest. We believe that investors should have access to information 
regarding the company's auditors when making investment decisions and 
when voting to elect, approve, or ratify the selection of, the 
accounting firm as the principal auditor of a company's financial 
statements.
    We also believe that audit committees, as well as management, 
should engage in active discussions of independence issues with the 
outside auditors. According to the Blue Ribbon Report, ``If the audit 
committee is to effectively accomplish its task of overseeing the 
financial reporting process, it must rely, in part, on the work, 
guidance and judgment of the outside auditor. Integral to this reliance 
is the requirement that the outside auditors perform their service 
without being affected by economic or other interests that would call 
into question their objectivity and, accordingly, the reliability of 
their attestation.'' \93\
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    \92\ The effect of the proposed disclosure would be similar to 
disclosure of management's discussion and analysis of financial 
condition and results of operations. See Item 303 of Regulation S-K, 
17 CFR 229.303.
    \93\ Blue Ribbon Report, supra note 31, at 40.
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    Recently, the ISB adopted ISB Standard No. 1, which requires each 
auditor to disclose in writing to its client's audit committee, all 
relationships between the auditor and the company that, in the 
auditor's judgment,\94\ reasonably may be thought to bear on 
independence, and to discuss the auditor's independence with the audit 
committee.\95\ Furthermore, we recently adopted new disclosure rules 
regarding audit committees and auditor reviews of interim financial 
information, in response to recommendations made by the Blue Ribbon 
Committee.\96\ These new rules

[[Page 43157]]

require that companies include in their proxy statements reports of 
their audit committees that state whether, among other things, the 
audit committees have received the written disclosures and the letter 
from the independent auditors required by ISB Standard No. 1,\97\ and 
discussed with the auditors the auditors' independence. Our new 
requirements, and the new requirements of the ISB, the New York Stock 
Exchange, the National Association of Securities Dealers, Inc. and the 
American Stock Exchange \98\ should encourage auditors, audit 
committees, and management to have robust and probing discussion of all 
issues that might affect investors' views of the auditor's 
independence.
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    \94\ In a letter to the SECPS, ISB Chairman William Allen 
clarified the use of the auditor's judgment under the standard. He 
stated:
    [I]n asking itself whether a fact or relationship is material in 
this setting the auditor may not rely on its professional judgment 
that such fact or relationship does not constitute an impairment of 
independence. Rather the auditor is to ask, in its informed good 
faith view, whether the members of the audit committee who represent 
reasonable investors, would regard the fact in question as bearing 
upon the board's judgment of auditor independence.
    Letter from William T. Allen, Chairman, ISB, to Mr. Michael A. 
Conway, Chairman, Executive Committee, SECPS, dated Feb. 8, 1999. We 
believe that Chairman Allen's interpretation is appropriate.
    \95\ ISB Standard No. 1, ``Independence Discussions with Audit 
Committees'' (Jan. 1999).
    \96\ ``Audit Committee Disclosure,'' Exchange Act Rel. No. 42266 
(Dec. 22, 1999). Companies also should note the requirement to 
disclose interests and relationships with its auditors under Item 
509 of Regulation S-K, 17 CFR 229.509, and Item 509 of Regulation S-
B, 17 CFR 228.509.
    \97\ ISB Standard No. 1, supra note 95.
    \98\ Orders Approving Proposed Rule Changes by AMEX, NASD, and 
NYSE, supra note 18.
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D. The Need for a More Accessible Auditor Independence Framework

    Currently, our auditor independence requirements are found in 
various Commission rules and interpretations. These have been 
supplemented over the years by staff letters, staff reports, and ethics 
rulings by the accounting profession.\99\ Current Rule 2-01 of 
Regulation S-X sets forth the circumstances under which we will not 
recognize an accountant as independent.\100\ Because Rule 2-01 does not 
address particular factual situations, we and our staff have issued 
interpretations of Rule 2-01 in response to public companies' questions 
about particular situations.\101\ The proposed revisions to Rule 2-01 
would consolidate and make more accessible the standards for auditor 
independence under the federal securities laws, reemphasize its 
importance, and provide a comprehensive framework for evaluating 
auditor independence. The proposed proxy disclosures, if adopted, 
should add to the body of knowledge regarding the provision of non-
audit services.
---------------------------------------------------------------------------

    \99\ We have brought a number of enforcement cases in which we 
charged auditors with violations of the independence rules. See, 
e.g., In the Matter of Pricewaterhouse Coopers, LLP, AAER No. 1098 
(Jan. 14, 1999); In the Matter of Moore Stephens, et al., AAER No. 
1135 (May 19, 1999).
    \100\ Rule 2-01 states:
    (a) The Commission will not recognize any person as a certified 
public accountant who is not duly registered and in good standing as 
such under the laws of the place of his residence or principal 
office. The Commission will not recognize any person as a public 
accountant who is not in good standing and entitled to practice as 
such under the laws of the place of his residence or principal 
office.
    (b) The Commission will not recognize any certified public 
accountant or public accountant as independent who is not in fact 
independent. For example, an accountant will be considered not 
independent with respect to any person or any of its parents, its 
subsidiaries, or other affiliates (1) in which, during the period of 
his professional engagement to examine the financial statements 
being reported on or at the date of his report, he, his firm, or a 
member of his firm had, or was committed to acquire, any direct 
financial interest or any material indirect financial interest; (2) 
with which, during the period of his professional engagement to 
examine the financial statements being reported on, at the date of 
his report or during the period covered by the financial statements, 
he, his firm, or a member of his firm was connected as a promoter, 
underwriter, voting trustee, director, officer, or employee. A 
firm's independence will not be deemed to be affected adversely 
where a former officer or employee of a particular person is 
employed by or becomes a partner, shareholder or other principal in 
the firm and such individual has completely disassociated himself 
from the person and its affiliates and does not participate in 
auditing financial statements of the person or its affiliates 
covering any period of his employment by the person. For the 
purposes of Sec. 210.2-01(b), the term ``member'' means (i) all 
partners, shareholders, and other principals in the firm, (ii) any 
professional employee involved in providing any professional service 
to the person, its parents, subsidiaries, or other affiliates, and 
(iii) any professional employee having managerial responsibilities 
and located in the engagement office or other office of the firm 
which participates in a significant portion of the audit.
    (c) In determining whether an accountant may in fact be not 
independent with respect to a particular person, the Commission will 
give appropriate consideration to all relevant circumstances, 
including evidence bearing on all relationships between the 
accountant and that person or any affiliate thereof, and will not 
confine itself to the relationships existing in connection with the 
filing of reports with the Commission.
    17 CFR 210.2-01.*COM019*
    \101\ Many of the interpretations are reprinted in Section 600 
of the Codification. These interpretations include selected text 
from FRRs that explain the background, provide interpretive guidance 
for disclosure rules that promote auditor independence, and describe 
examples in which the staff and the Commission made a determination 
about a particular auditor's independence. Although the Commission 
updates the Codification to include the text from releases as rules 
are amended, the examples in the Codification have not been revised 
since 1983. See FRR No. 10, supra note 8. Since 1982, instead of 
waiting until there are a sufficient number of interpretations to 
warrant a Commission release that would amend the Codification, the 
Commission staff has placed its independence interpretive letters in 
a file where they are immediately available to the public. See FRR 
No. 33 (Oct. 17, 1988) and FRR No. 4 (Oct. 14, 1982).
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    The new rules should also assist the ISB in its work. In FRR No. 
50,\102\ we stated that we would look to the ISB to provide leadership 
in improving auditor independence requirements and in establishing and 
maintaining a body of independence standards applicable to auditors of 
public companies.\103\ In the same manner, we previously have endorsed 
the establishment of the Financial Accounting Standards Board 
(``FASB'').\104\ Among other things, the ISB sets standards and its 
staff answers day-to-day inquiries regarding the application of our 
auditor independence requirements to specific situations confronting 
auditors and their clients.
---------------------------------------------------------------------------

    \102\ FRR No. 50 (Feb. 18, 1998).
    \103\ In FRR No. 50, however, we said that we were not 
abdicating our responsibilities in this area and that our existing 
authority regarding auditor independence was not affected. ISB 
standards and interpretations do not take precedence over our 
regulations or interpretations. As a result, if an ISB standard 
conflicts in any way with our rules or interpretations, the ISB 
standard or interpretation does not take effect unless or until we 
amend our existing regulation. See FRR 50, at 7 n.10.
    \104\ See ASR No. 150 (Dec. 20, 1973) (recognizing establishment 
of the FASB); ASR No. 280 (Sept. 2, 1980) (commenting on FASB's role 
in establishing and improving accounting principles).
---------------------------------------------------------------------------

    The ISB has requested more guidance from us. For example, the ISB 
noted in ISB Standard No. 2,\105\ the standard would not take effect 
until the SEC revises its rules on independence. Accordingly, our 
proposals and the attendant modifications to the Codification, if 
adopted, would enhance the ability of the ISB to make its standards 
effective. In addition, by providing a comprehensive framework, the new 
rules, if adopted, should assist the ISB in making future decisions 
regarding auditor independence matters.\106\
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    \105\ ISB Standard No. 2, ``Certain Independence Implications of 
Audits of Mutual Funds and Related Entities,'' at 2 para. 5 (Dec. 
1999).
    \106\ See generally FRR No. 50, supra note 102 (regarding SEC's 
endorsement of ISB); ISB, ``Discussion Memorandum 00-1: A Conceptual 
Framework for Auditor Independence,'' at 1 (Feb. 2000) (regarding 
the purposes of a conceptual framework).
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III. Discussion of Proposed Rules

A. Qualifications of Accountants

    Section 2-01(a) would remain unchanged and require that in order to 
practice before the Commission an auditor must be in good standing and 
entitled to practice in the state of the auditor's residence or 
principal office. This requirement has existed since the Federal Trade 
Commission first adopted rules under the 1933 Act.\107\ It acknowledges 
our deference to the states for the licensing of public and certified 
public accountants.
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    \107\ Federal Trade Commission, Rules and Regulations Under the 
Securities Act of 1933, art. 14 (July 6, 1933).
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B. The General Standard for Auditor Independence

    Proposed rule 2-01(b) sets forth the basic test of an auditor's 
independence. Under that test, we will not recognize as independent an 
accountant who, with respect to an audit client, is not, or would not 
be perceived by reasonable investors to be, capable of exercising 
objective and impartial judgment on all

[[Page 43158]]

issues encompassed within the auditor's engagement.\108\ The general 
standard in paragraph (b) recognizes that an auditor must be 
independent in fact and appearance. Appearance is measured by reference 
to reasonable investors knowing all the relevant circumstances. As 
noted above,\109\ independence in fact and the appearance of 
independence are inseparable.
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    \108\ Cf. Staff Report, supra note 23, at 12-16. See also SEC, 
Tenth Annual Report of the Securities and Exchange Commission, at 
205-207 (1944), which states:
    [T]he Commission has found an accountant to be lacking in 
independence with respect to a particular registrant if the 
relationships which exist between the accountant and the client are 
such as to create a reasonable doubt as to whether the accountant 
will or can have an impartial and objective judgment on the 
questions confronting him.
    \109\ See supra Section II.B.
---------------------------------------------------------------------------

    To make the general standard more specific, paragraph (b) 
identifies four governing principles for determining when an auditor is 
not independent. The four principles incorporate situations that we 
believe reasonable investors would agree impair an auditor's 
independence. They are when the auditor:
     Has a mutual or conflicting interest with the audit 
client,\110\
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    \110\ See, e.g., Codification Secs. 601.01 & 601.04.
---------------------------------------------------------------------------

     Audits the accountant's own work,\111\
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    \111\ See, e.g., Codification Sec. 602.02.c.i.
---------------------------------------------------------------------------

     Functions as management or an employee of the audit 
client,\112\ or
---------------------------------------------------------------------------

    \112\ See, e.g., Rule 2-01(b), 17 CFR 210.2-01(b); Codification 
Sec. 602.02.d.
---------------------------------------------------------------------------

     Acts as an advocate for the audit client.\113\
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    \113\ See, e.g., Arthur Young, supra note 19, at 819 n.15 
(1984); Codification Secs. 602.02.e.i and ii.
---------------------------------------------------------------------------

    We believe these four basic principles provide a framework for 
analyzing auditor independence issues, in that actions inconsistent 
with one or more of these principles would result in a lack of auditor 
independence. We apply these principles in the remainder of the rules.
    We request comment on the general standard and the four proposed 
principles. Do these four principles appropriately address the concept 
of auditor independence? If not, why not? Please describe any 
alternative formulation and why it is preferable. Some believe a basic 
principle of auditor independence is that the auditor will not 
subordinate his or her judgment to others.\114\ Should this be included 
in the proposed principles? Are there additional principles that should 
be included, and, if so, what are they, and do they reflect an 
impairment of independence?
---------------------------------------------------------------------------

    \114\ See AICPA Code of Professional Conduct, ET Sec. 102.01 
(regarding integrity and objectivity).
---------------------------------------------------------------------------

    Should the concept of mutual or conflicting interests be limited to 
economic interests? Would that limitation reach areas such as 
employment of close family members by an audit client? What forms of 
activities engaged in by accountants involve auditing their own work? 
What forms of activities constitute advocacy? Are there situations in 
which an auditor may act as an advocate for the audit client that would 
not impair the auditor's independence? If so, what are these, and why 
would they not impair independence? For instance, the principle 
regarding advocacy is not intended to prevent the accounting firm from 
explaining or defending (in court, if necessary) its work in an audit. 
Should that principle be modified to make that explicit? If so, how? 
Should accounting firms be permitted to lobby for an audit client 
before Congress, state legislatures, regulatory agencies, or other 
similar bodies?

C. Specific Applications of the Independence Standard

    Proposed rule 2-01(c) ties the general standard and four principles 
of paragraph (b) to specific applications.\115\ It provides that an 
accountant is not independent under the standard of paragraph (b) if, 
during the audit and professional engagement period, the accountant has 
any of the financial, employment or business relationships with, 
provides certain non-audit services to, or receives a contingent fee 
from, the accountant's audit client or an affiliate of the audit 
client, as specified in paragraphs (c)(1) through (c)(5), or otherwise 
does not comply with the standard of paragraph (b). Paragraphs (c)(1) 
through (c)(5) address separately situations in which an accountant is 
not independent of an audit client because of: (i) A financial 
relationship, (ii) an employment relationship, (iii) a business 
relationship, (iv) the provision of non-audit services, or (v) the 
receipt of contingent fees.\116\
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    \115\ See illustrations in Appendix C, supra note 35.
    \116\ A number of the specified situations are based on examples 
in the current Codification and the AICPA and SESPS membership 
rules.
---------------------------------------------------------------------------

    While paragraph (c) specifies a number of the relationships and 
other situations that might impair an auditor's independence, this list 
is not exhaustive. We cannot foresee all situations in which an auditor 
might lack independence. Accordingly, paragraph (c) includes a catch-
all reference to any other situation in which an accountant ``otherwise 
does not comply with the standard of paragraph (b) of this section.'' 
\117\
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    \117\ We anticipate that the ISB and, when appropriate, our 
staff, will continue to implement and apply these principles to new 
and evolving transactions and events in the future.
---------------------------------------------------------------------------

    Auditor independence is more than a requirement imposed by the 
federal securities laws. Accountants have both a professional and 
ethical duty to remain independent of their audit clients,\118\ 
including an obligation to ``avoid situations that may lead outsiders 
to doubt their independence.'' \119\ Accordingly, accountants may have 
to take steps to remain independent even if the steps are not specified 
in proposed rule 2-01.
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    \118\ See AICPA SAS No. 1, AU Sec. 220.03; AICPA Code of 
Professional Conduct, ET Sec. 101. Of course, accountants also have 
to comply with applicable state law on independence. Id.
    \119\ AICPA SAS No. 1, AU Sec. 220.03.
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    In certain situations, the best course may be for the accountant to 
ask to be removed from the audit engagement. Neither we nor the 
profession's standards-setters can foresee every business or employment 
relationship, or investment that could affect the hundreds of decisions 
that an auditor must make during the course of an audit. On occasion, 
there may be a relationship, apart from those contemplated by any 
standard or rule, that has an important meaning to an individual 
accountant and could create, or be viewed as creating, a conflict with 
the accountant's duty to investors.\120\ We therefore encourage 
accountants to seek to recuse themselves from any review, audit, or 
attest engagement if reasonable investors would view the accountant's 
ability to exercise objective and impartial judgment as compromised by 
any personal, financial, or business relationship, whether or not 
specifically discussed in the Commission's, the ISB's, or the 
profession's rules.
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    \120\ Cf. AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202 (2d 
Cir. 2000) (noting ``E&Y's failure lay in the seeming 
spinelessness'' of the audit engagement partner and that ``[p]art of 
the problem was undoubtedly the close personal relationship 
between'' that partner and the company's chief executive officer, a 
former co-partner in the firm) (quoting 991 F. Supp. 234, 248 
(S.D.N.Y. 1997) (district court opinion)).
---------------------------------------------------------------------------

    Paragraphs (b) and (c) require the accountant to be independent 
``during the audit and professional engagement period.'' \121\ This 
term is defined in proposed rule 2-01(f)(6) to mean the period covered 
by any financial statements being audited or reviewed, and the period 
during which the auditor is engaged either to review or audit financial 
statements or to prepare a report filed with us, including at the

[[Page 43159]]

date of the audit report.\122\ The use of the word ``during'' in 
paragraphs (b) and (c) is intended to make clear that an accountant 
will lack independence if, for example, he or she is independent at the 
outset of the engagement but acquires a financial interest in the audit 
client during the engagement.
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    \121\ AICPA Code of Professional Conduct, ET Sec. 101.02 (as 
revised Feb. 28, 1998).
    \122\ Proposed rule 2-01(f)(6) states that the engagement period 
ends when the registrant or accountant notifies the Commission that 
the registrant is no longer the accountant's audit client. This 
notice typically would occur when the registrant files with the 
Commission a Form 8-K with disclosures under Item 4 ``Changes in 
Registrant's Certifying Accountant.'' In some cases, however, a Form 
8-K would not be required, such as when the registrant is a foreign 
private issuer or when the audited financial statements of a non-
reporting company are filed upon its acquisition by a public 
company. Notification to the Commission in these cases would occur 
by the filing of the next audited financial statements of the 
foreign private issuer or the successor corporation. Registrants or 
auditors in these situations, however, may provide earlier notice to 
the Commission on Form 6-K or other appropriate means.
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1. Financial Relationships
    Proposed rule 2-01(c)(1) sets forth the general rule regarding 
financial relationships that impair independence and is substantially 
similar to current Rule 2-01(b). Both state that a direct or material 
indirect financial interest in an audit client will impair an auditor's 
independence with respect to that audit client. The remainder of 
paragraph (c) of the proposed rule provides a non-exclusive list of 
relationships in which an accountant has a direct or material indirect 
financial interest in an audit client and is, therefore, not 
independent. Accountants should not assume that financial interests not 
specifically described in (c)(i) through (c)(iv) do not impair 
independence.
    (a) Investment in audit client. Proposed rule 2-01(c)(1)(i) 
provides that an accountant is not independent with respect to an audit 
client if the accounting firm, any covered person in the firm, or any 
immediate family member of any covered person has any direct investment 
in the audit client or in an affiliate of the audit client. Under 
current rules, the ``direct financial interest'' requirement prevents 
all partners in an accounting firm, all managers in the office 
performing the audit, and all persons on the engagement team, from 
having any financial interest in the audit client. This approach was 
intended to give effect to the principle of loyalty that the firm and 
all of its employees owe to public investors. It is based on the belief 
that the public generally perceives a firm as one entity in which 
individuals may have equal access to confidential client information, 
shared confidences, and common personal and financial interests.
    Under the proposal, as under the current rules, the accounting firm 
(including its affiliates, such as its pension plan) cannot have a 
direct investment in an audit client and remain independent of that 
audit client. The proposal otherwise increases significantly the group 
of persons within the firm who can invest in an audit client without 
impairing the auditor's independence. Under proposed paragraph 
(c)(1)(i), the group of persons who cannot invest is limited to 
``covered persons in the firm'' and their immediate family members. As 
explained in greater detail below, we define ``covered persons'' in 
proposed rule 2-01(f)(13) to include the ``audit engagement team,'' 
those in the ``chain of command,'' all other partners, principals, 
shareholders, or professional employees providing any professional 
service to the audit client or its affiliate, and any other partner, 
principal, or shareholder in an ``office'' that participates in a 
significant portion of the audit.\123\ The proposal, like the current 
rule, would attribute all investments by a covered person's ``immediate 
family members''--that is, the covered person's spouse, spousal 
equivalent, and dependents--to the covered person.\124\
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    \123\ See infra Section III.I.10, for a complete discussion of 
the term ``covered persons in the firm.''
    \124\ See infra Section III.I.11. for a complete discussion of 
the term ``immediate family members.''
---------------------------------------------------------------------------

    Paragraph (c)(1)(i)(A) applies to any direct investment in an audit 
client ``such as stocks, bonds, notes, options, or other securities.'' 
As the language of the rule makes clear, this is not an exclusive list 
of all covered ownership interests. In addition, as under current law, 
the rule cannot be avoided through indirect means. For instance, an 
accountant who cannot have a direct investment in the audit client by 
virtue of being a covered person in the firm, may not hold the 
investment through a corporation or as a member of an investment 
club.\125\
---------------------------------------------------------------------------

    \125\ Compare Codification Sec. 602.02.b.ii (Example 1); cf. 
infra Section III.C.1.(a). (regarding indirect investments).
---------------------------------------------------------------------------

    Under paragraph (c)(1)(i)(A), a direct investment in an affiliate 
of an audit client would be treated the same as an investment in the 
audit client. ``Affiliate of the audit client'' is defined in proposed 
rule 2-01(f)(5) to mean an entity that has significant influence over 
the audit client, or over which the audit client has significant 
influence.\126\ Our concern is that, in both cases, there is a melding 
of financial interests and managerial functions of the entity and the 
audit client such that one can influence the accounting policies and 
financial transactions of the other. Once an audit client can exercise 
``significant influence'' over the operating or financial policies of 
an entity, then under GAAP,\127\ information from the financial 
statements of that entity will be reflected in the financial statements 
of the audit client. Similarly, if an entity can exercise influence 
over the audit client, information from the audit client's financial 
statements will be reflected in the entity's financial statements. In 
this case, the revenues and income of the audit client would directly 
affect the earnings of the entity in which the accountant has an 
investment.
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    \126\ We recognize that this definition of affiliate is 
different from the current definition in Rule 1-02. We believe, 
however, that the revised definition is appropriate in the context 
of our proposals in this release.
    \127\ Accounting Principles Board (``APB'') Opinion No. 18, 
``The Equity Method of Accounting for Investments in Common Stock,'' 
at para. 17 (1971).
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    Proposed rule 2-01(c)(1)(i)(A) applies only to a limited class of 
people, namely an accounting firm, as well as covered persons in the 
firm and members of their immediate families. Proposed rule 2-
01(c)(1)(i)(B) applies to a larger class of people, including an 
accounting firm's partners, principals, shareholders, professional 
employees, and their immediate family members, the close family members 
of covered persons in the firm,\128\ and any ``group'' of the foregoing 
persons.\129\ Under proposed rule 2-01(c)(1)(i)(B), an accountant is 
not independent with respect to an audit client when any such person or 
group holds more than five percent of an audit client's outstanding 
voting securities or otherwise controls the audit client. We selected 
the five percent level, in part, because it triggers a separate filing 
with the Commission,\130\ and therefore, in certain circumstances, the 
accountant will have an independent means of knowing the status of 
those persons' investments.
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    \128\ See infra Section III.I.9. for a complete discussion of 
the term ``close family members''.
    \129\ ``Group'' is defined in proposed rule 2-01(f)(14) to mean 
when two or more persons act together for the purposes of acquiring, 
holding, voting, or disposing of securities of a registrant. This 
definition is based on Exchange Act Rule 13d-5(b)(1).
    \130\ Schedules 13D and 13G, 17 CFR 240.13d-1. Schedules 13D and 
13G are intended to alert the market to accumulations of a public 
company's securities that might indicate a potential change of 
control of the company.
---------------------------------------------------------------------------

    Proposed rule 2-01(c)(1)(i)(C) is a specialized application of the 
direct financial interest rule. It provides that an accountant is not 
independent when

[[Page 43160]]

the accounting firm, any covered person in the firm, or any covered 
person's immediate family member serves as voting trustee of a trust or 
executor of an estate containing the securities of an audit client. In 
these positions, the firm or person typically makes investment 
decisions, or participates in making investment decisions, concerning 
the securities of the audit client. In this role, the firm or person 
typically has a fiduciary duty to preserve or maximize the value of the 
assets. We believe that this warrants treating the trustee or 
executor's interest as a direct financial interest in the audit client 
and deeming the auditor's independence impaired.
    Proposed rule 2-01(c)(1)(i)(D) covers material indirect investments 
in an audit client. It describes the circumstances in which 
independence is impaired because of investments by the accounting firm, 
any covered person in the firm, any immediate family member of a 
covered person, or any group of these people in: (i) Non-client 
entities that have an investment in an audit client (``non-client 
investors''), or (ii) companies in which an audit client also has 
invested (``common investees''). The current rule generally recognizes 
that these investments create a mutuality of interest if the auditor or 
the audit client owns more than five percent of the entity's equity 
securities.\131\
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    \131\ Codification Sec. 602.02.b.iii. We have used the term 
``material'' in our proposed rules in the sense that it has been 
used in our current independence rules. See, e.g., ASR No. 79 (Apr. 
8, 1958). This should not be confused with the meaning of the term 
``material'' in other federal securities law contexts. See Staff 
Accounting Bulletin No. 99 (Aug. 13, 1999).
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    In both the ``non-client investor'' and ``common investee'' 
scenarios, an intermediary is placed between the auditor and the audit 
client. In one case, the auditor has invested in an entity that, in 
turn, has invested in the audit client. In the other, the auditor and 
the audit client are linked through a mutual financial interest in 
seeing their common investment grow and prosper. Because these 
financial ties are indirect, we believe that use of a materiality 
threshold continues to be appropriate. Accordingly, under the proposed 
rule, accounting firms, covered persons, and covered persons' immediate 
families can own up to five percent of an entity that invests in an 
audit client or of an investee in which an audit client also 
invests.\132\
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    \132\ Paragraph (c)(1)(i)(D)(1) and (2) refer to ``ownership'' 
of an entity. Ownership interest is determined based on the form of 
organization. For example, for a corporation, ownership is based on 
ownership of a class of voting securities. For a partnership, 
ownership is based on ownership of a partnership interest or unit.
---------------------------------------------------------------------------

    It should be remembered, however, that should the ``non-client 
investor'' or the ``common investee'' become an affiliate of the audit 
client, then as described under paragraph (A) regarding direct 
investments, the auditor may not have any investment in the 
intermediary entity. For example, assume auditor A invests in non-
client company B, which owns an equity interest in audit client C. A 
may own up to five percent of the equity of B without impairing its 
independence from C, provided B does not ``significantly influence'' or 
is not ``significantly influenced'' by C. As discussed above, if such 
significant influence exists, then B is an affiliate of C and, under 
paragraph (A) regarding direct investments, A may not invest in B 
without impairing its independence from C. Similarly, assume auditor A 
invests in non-client company Z, and audit client C also invests in 
company Z. A may own up to five percent of the equity of company Z 
without impairing its independence from C, provided Z does not 
``significantly influence'' or is not ``significantly influenced'' by 
C.
    Proposed rule 2-01(c)(1)(i)(D) does not make a distinction for an 
indirect investment in an audit client by an auditor through an 
investment company. As a result, an auditor would not be independent if 
the auditor owns more than 5% of the outstanding stock of an investment 
company and the investment company holds an investment in an audit 
client.\133\ The proposed rule, however, does not impose a limit on the 
portion of an investee company's (including an investment company's) 
assets that may be invested in the audit client, assuming the auditor 
owns less than five percent of the investee company and the investee is 
not an affiliate of the audit client. For example, an operating company 
or an investment company (Company A) could have a significant portion 
of its assets invested in Company B, and an auditor could own up to 
five percent of Company A's stock and audit Company B, so long as B is 
not an affiliate of A.
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    \133\ Also, an auditor would not be able to invest in an 
investment company if the investment company is an affiliate of the 
audit client. See proposed rule 2-01(c)(1)(i)(A).
---------------------------------------------------------------------------

    We considered limiting the portion of an investee company's assets 
that could be invested in an audit client without impairing auditor 
independence. We request comment on whether there should be a limit on 
the portion of an investee's total assets that can be invested in an 
audit client without independence being impaired in addition to, or in 
place of, the proposed indirect investment test. If so, where should 
the limit be set? Would a 10% or 25% level be appropriate?
    If we use that approach, should the rule for registered investment 
companies turn on their diversification status? \134\ Limitations on 
material indirect investments in an audit client may be difficult for 
auditors to apply in practice when they invest in an investment 
company. Auditors have no easy way to determine how much of an 
investment company's assets are invested in an audit client or how much 
of an issuer's securities are owned by an investment company because 
many investment companies' portfolios change frequently. Because funds 
are required to disclose their diversification status in their 
registration statements, accountants could easily determine, by looking 
at a fund's registration statement, whether an investment in the fund 
by the accounting firm, a covered person in the firm or such person's 
immediate family might impair an accountant's independence under the 
rule. Should we permit an investment in any registered investment 
company that is ``diversified'' under the ICA, provided it is not part 
of the same investment company complex as an audit client? \135\ Would 
this be one way to prevent inadvertent violations of the independence 
rules?
---------------------------------------------------------------------------

    \134\ Generally, a diversified management investment company is 
a company that with respect to 75% of its total assets may not 
invest more than 5% of its total assets in a single issuer and may 
not own more than 10% of the outstanding securities of a single 
issuer. See Section 5(b)(1) of the ICA, 15 U.S.C. 80a-5(b).
    \135\ See infra Section III.I.12. for a discussion of the 
``investment company complex'' definition.
---------------------------------------------------------------------------

    We solicit comment on all aspects of the financial interest rules 
in paragraph (c)(1)(i). In particular, would reasonable investors be 
concerned that investments of the sort described in this section would 
impair an auditor's independence? Should the restrictions on financial 
ownership interests apply to all partners (but not their immediate 
family or employees of the firm) of an audit firm, as the partners 
represent the partnership?
    Is the five percent threshold for financial interest in an audit 
client by persons who do not influence the audit appropriate? For 
example, would reasonable investors perceive a firm's independence to 
be impaired if a partner or employee in an office that did not work on 
the audit, held four percent of the audit client? If the five percent 
threshold is not appropriate, what threshold is appropriate, and which 
individuals should be subject to the restriction?

[[Page 43161]]

    Furthermore, is it appropriate to base the determination, as we do, 
on ownership of five percent or more of a company's equity securities? 
Should we be more specific and indicate whether to account for common 
and preferred shares, and voting and non-voting shares? If so, what 
types of shares should be included (i.e., voting shares only)? If the 
determination depends on ownership of outstanding voting shares, should 
all shares, regardless of the number of votes different classes of 
shares have, count the same?
    Would reasonable investors perceive an accountant's independence to 
be impaired if any partner, shareholder, or professional employee of 
the accountant's firm has an investment in an audit client that is more 
than five percent of the individual's net worth, even if it represents 
less than five percent of the ownership of the audit client's equity 
securities?
    Suppose that ABC Accounting Firm audits XYZ Corp. Partner A is a 
covered person in the firm for the XYZ audit. In the following 
situations, would a reasonable investor be concerned about the 
independence of the auditor:
    (i) A grandchild of Partner A owns more than five percent of the 
equity of XYZ Corp;
    (ii) Partner A's siblings each own four percent of the equity of 
XYZ Corp. The siblings do not act together in their investment 
activities in such a way as to constitute a group under the proposed 
definition of group;
    (iii) Partner A's brother-in-law owns ten percent of the equity of 
XYZ Corp;
    (iv) Partner A's sister-in-law owns 20 percent of the equity of XYZ 
Corp; or
    (v) Five partners of ABC Accounting Firm, none of whom are covered 
persons and not acting as a ``group,'' each own four percent of the 
equity of XYZ Corp.
    Are there other persons whose investment in the XYZ Corp. may cause 
concern regarding the independence of Partner A?
    We solicit comment on all aspects of the proposals regarding 
investments in audit clients in paragraph (c)(1)(i)(D). Do investments 
in an intermediary affect the auditor's independence when the 
intermediary has an investment in an audit client that an auditor could 
not have directly without impairing the auditor's independence? If the 
auditor has an investment greater than five percent in the 
intermediary, but the intermediary has an investment in the audit 
client that is less than five percent of the audit client, is the 
auditor's independence impaired? What if the intermediary's investment 
is less than five percent of the audit client but material to the 
auditor or intermediary?
    Suppose that the pension fund of ABC Accounting Firm has a 4.9 
percent ownership of DEF Corp. DEF is not an audit client of ABC. DEF 
in turn has a substantial investment in XYZ Corp., an audit client of 
ABC. DEF and XYZ are not affiliates. Would a reasonable investor 
perceive that the accountant's independence was impaired? Is five 
percent an appropriate threshold? Would a lower threshold enhance 
investor confidence in auditor independence? The proposed rule on 
material indirect investments includes investments by the accounting 
firm, any covered person in the firm or any of his or her immediate 
family members, or any group of such persons. Should other persons be 
included?
    Suppose that the pension fund of ABC Accounting Firm has a 4.9 
percent ownership of DEF Corp. DEF is not an audit client of ABC. XYZ 
Corp., an audit client of ABC, has a substantial investment in DEF, but 
XYZ and DEF are not affiliates. Would reasonable investors perceive 
that the accountant's independence was impaired? The proposed rule 
includes investments by the accounting firm, any covered person in the 
firm or any of his or her immediate family members, or any group of 
such persons. Should other persons be included? Are there any 
investments that you believe would impair an auditor's independence 
that the proposed rules permit? If so, what are they, and why do they 
raise independence concerns?
    (b) Other financial interests. Proposed rule 2-01(c)(1)(ii) 
describes other financial interests of an auditor that would impair an 
auditor's independence with respect to an audit client because they 
create a debtor-creditor relationship or other commingling of the 
financial interests of the auditor and the audit client. In some 
situations (e.g., bank deposits or insurance), the continued viability 
of the audit client may be necessary for protection of the auditor's 
own assets or for the auditor to receive a benefit (e.g., insurance 
claim). These situations reasonably may be viewed as creating a self-
interest that competes with the auditor's obligation to serve only 
investors' interests. We discuss several of these situations here.
    (i) Loans/debtor-creditor relationships. The proposals provide that 
the accountant will not be independent when the accounting firm, or any 
covered person in the accounting firm, or any of the covered person's 
immediate family members has any loan (including any margin loan) to or 
from an audit client, the officers of an audit client or an affiliate 
of an audit client, the directors of an audit client or an affiliate of 
an audit client, or record or beneficial owners of more than five 
percent of the equity securities of an audit client or its affiliate. 
We considered adding to the proposal the AICPA's Ethics Ruling on loans 
to or from audit clients.\136\ The ruling indicates that any loan would 
impair the auditor's independence, unless the loan was from a financial 
institution; acquired in accordance with that institution's normal 
lending procedures, terms and requirements; kept current as to all its 
terms; and, was: (1) An automobile loan or lease collateralized by the 
automobile; (2) a loan on the cash surrender value of an insurance 
policy; (3) a ``passbook loan'' collateralized by cash deposits at the 
same institution; or (4) credit cards or cash advances on checking 
accounts with an aggregate balance not paid of less than $5,000. We are 
proposing a more liberal approach since our proposal sets the credit 
card balance threshold at $10,000, permits a mortgage loan not obtained 
during the period of the audit or professional engagement, and because, 
unlike the AICPA ruling, the proposed rule covers only the relatively 
small group of entities and people that could influence the audit.
---------------------------------------------------------------------------

    \136\ See AICPA Code of Professional Conduct, ET Secs. 101.02, 
101.07 (Ethics Rulings 101-1-A-4, 101-5).
---------------------------------------------------------------------------

    We solicit comment on our approach to loans. Should we expand the 
rule to cover close family members as opposed to just immediate family 
members? For example, would a $1,000,000 home loan from an audit client 
to the auditor's brother-in-law be perceived as affecting the 
independence of the audit partner? Does the answer change if the loan 
is unsecured? Are there other categories of loans that should be 
excluded, similar to car loans? Are there circumstances under which a 
loan to or from an audit client would not impair an auditor's 
independence?
    (ii) Savings and checking accounts. The proposals provide that an 
accountant will not be independent when the accounting firm, or any 
covered person in the accounting firm, or any of the covered person's 
immediate family members has any savings or checking account at a bank 
or savings and loan that is an audit client or its affiliate, if the 
account has a balance that exceeds the amount insured by the Federal 
Deposit Insurance Corporation (``FDIC''). Would reasonable investors 
perceive an accountant's independence to be

[[Page 43162]]

impaired if an accountant or the accountant's immediate family member 
has any savings or checking account at an audit client or the audit 
client's affiliate? Would an accountant's independence be impaired if a 
covered person maintained a balance in a non-federally insured bank 
that is an audit client? Are there other institutions that are similar 
to a bank or savings and loan that should be included? Are any of the 
risks to independence mitigated by depository insurance similar to that 
provided by the FDIC? Why or why not? Would the financial condition of 
the bank or other depository institution affect reasonable investors' 
perceptions?
    (iii) Broker-dealer accounts. The proposals provide that an 
accountant will not be independent when the accounting firm, or any 
covered person in the accounting firm, or any of the covered person's 
immediate family members has any brokerage or similar account 
maintained with a broker-dealer that is an audit client or an affiliate 
of an audit client if any such accounts include any asset other than 
cash or securities (within the meaning of ``security'' provided in the 
Securities Investor Protection Act (``SIPA'')), or where the value of 
the assets in the accounts exceeds the amount that is subject to a 
Securities Investor Protection Corporation (``SIPC'') advance for those 
accounts, under Section 9 of SIPA. Our proposal is rooted in a concern 
that, to the extent that the assets of an accountant (or covered 
persons or their family members) in a broker-dealer account are exposed 
to loss in the event of the broker-dealer's financial failure, the 
accountant has an interest in the financial condition of the broker-
dealer.
    When an accounting firm, a covered person, or a covered person's 
immediate family member maintains such accounts at an audit client, 
would reasonable investors perceive that auditor independence is 
impaired? Should covered persons be considered not independent if they 
have an account with a broker-dealer that is an audit client, 
regardless of whether the assets in the account are subject to a SIPC 
advance? Are there better ways to identify broker-dealer accounts that 
impair an auditor's independence? For example, the proposal's provision 
on loans and debtor-creditor relationships provides that a margin loan 
impairs an auditor's independence. Should the provision concerning 
broker-dealer accounts state that maintaining a margin account with a 
broker-dealer impairs an auditor's independence as to that broker-
dealer, whether or not any margin debt exists? Are there other types of 
accounts that might be maintained with a broker-dealer that the rule 
should specifically identify as impairments to independence? If so, 
what types of accounts, and why do they impair, or appear to impair, 
independence?
    Should the rule specifically address short positions, or the 
writing of options, in an account with a broker-dealer? If so, should 
the rule provide that those types of accounts, when held by the 
accounting firm, any covered person in the firm, or such person's 
immediate family member, impair independence as to the broker-dealer 
with whom the account is maintained?
    Is it impractical for accountants (and covered persons and family 
members) to monitor whether the assets in their broker-dealer accounts 
are within the amounts subject to a SIPC advance? Are there preferable 
alternative formulations that would accomplish the goal of deeming 
independence to be impaired only in those situations where the accounts 
include assets that are exposed to loss in the event the broker-dealer 
fails? Or is that goal too narrow? Should the rule impose additional 
limits on accounts even though the assets in the accounts stay within 
the amounts subject to a SIPC advance? For example, an auditor might 
control several different types of accounts, each of which qualify for 
SIPC coverage. Should the rule impose some limit on the number or total 
assets of such accounts with a broker-dealer audit client? What should 
those limits be, and why?
    Would it be preferable to provide that independence is impaired as 
to any broker-dealer audit client with whom the accountant (or covered 
person or covered person's family member) maintains any account, 
regardless of whether the account's assets are within the limits 
subject to a SIPC advance?
    In addition to SIPC protection, broker-dealers sometimes purchase 
insurance from private insurers to protect customer assets. Should the 
rule take that type of insurance into account? If so, how?
    (iv) Futures commission merchant accounts. The proposals provide 
that the accountant will not be independent when the accounting firm, 
or any covered person in the accounting firm, or any covered person's 
immediate family member has any futures, commodity, or similar account 
maintained with a futures commission merchant (``FCM'') that is an 
audit client or an affiliate of the audit client. This proposal is 
rooted in a concern that, to the extent that the assets of an 
accountant (or covered persons or their family members) in an FCM 
account are exposed to loss in the event of the FCM's financial 
failure, the accountant has an interest in the financial condition of 
the FCM. We solicit comment on whether maintaining such accounts could 
impair, or would appear to reasonable investors to impair, an auditor's 
independence. Are there different types of FCM accounts or different 
types of assets maintained in FCM accounts that should be distinguished 
from each other for purposes of determining auditor independence? What 
distinctions should be made? Are there conditions under which an 
accountant (or covered person or covered person's family member) could 
maintain an account with an FCM but have no interest in the financial 
condition of the FCM? If so, what are those conditions? How, if at all, 
should the rule take those conditions into account?
    (v) Credit cards. We are proposing that credit card balances of 
$10,000 or less owed by a firm, a covered person, or any covered 
person's immediate family member to an audit client or its affiliate, 
not be deemed to impair an auditor's independence.\137\ We do not 
believe that a relatively minor credit card balance would create or 
appear to create a mutuality or conflict of interest with the lender-
audit client. Furthermore, a strict prohibition of such accounts might 
unnecessarily affect a firm's ability to assign staff to provide short-
term technical advice to the audit engagement team. Would reasonable 
investors perceive an accountant's independence to be impaired if a 
covered person held a credit card balance in excess of $10,000 with a 
lender that is an audit client? Is $10,000 an appropriate limit?
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    \137\ See proposed rule 2-01(c)(1)(ii)(E).
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    (vi) Insurance products. Proposed rule 2-01(c)(1)(ii)(F) provides 
that an auditor's independence is impaired whenever the accounting 
firm, any covered person in the firm, or any immediate family member of 
a covered person holds any individual insurance policy originally 
issued by an insurer that is an audit client or an affiliate of an 
audit client. Additionally, under the proposed rule, an auditor's 
independence is impaired if the audit firm obtains professional 
liability coverage from an audit client or its affiliate. Holding these 
policies creates a mutual interest in the continuing viability of the 
insurer.
    We solicit comment on whether an accountant's independence is 
impaired, and on whether reasonable investors would perceive an 
accountant's independence to be impaired, if the

[[Page 43163]]

accountant or a member of the accountant's immediate family originated 
an individual insurance policy with an insurance company that is an 
audit client or an affiliate of an audit client. Should the proposed 
rule cover all insurance policies, or be limited, such as to life 
insurance policies? Would an accounting firm's independence be impaired 
if the accounting firm acquired from an audit client insurance such as 
(i) insurance for litigation or indemnification losses, (ii) group 
health, or (iii) group life insurance policies? Should an accounting 
firm be permitted to purchase professional liability coverage through 
an audit client?
    (vii) Investment companies. Proposed rule 2-01(c)(1)(ii)(G) sets 
forth the rule for investment by accounting firms, covered persons and 
covered persons' immediate family members in an investment company or a 
related entity. The proposed rule provides that an auditor is not 
independent if the auditor invests in any entity in an investment 
company complex if the audit client is also an entity included in that 
investment company complex. Proposed rule 2-01(f)(16) defines 
``investment company complex'' as an investment company and its 
investment adviser or, if the company is a unit investment trust, its 
sponsor; any entity controlled by, under common control with, or 
controlling the investment adviser or sponsor, such as the distributor, 
administrator or transfer agent; and any investment company or an 
entity that would be an investment company but for the exclusions 
provided by section 3(c) of the ICA \138\ that is advised by the same 
adviser or a related adviser, or sponsored by the same sponsor or 
related sponsor.
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    \138\ Section 3(c) of the ICA excludes from the ICA certain 
companies that otherwise would be investment companies. 15 U.S.C. 
80a-3(c). These companies include, among others, hedge funds and 
real estate pools.
---------------------------------------------------------------------------

    Proposed rule 2-01(c)(1)(ii)(G) makes clear that when an audit 
client is part of an investment company complex, the accountant must be 
independent of each entity in the complex. The proposed rule follows 
ISB Standard No. 2 on this point. Under ISB Standard No. 2, the firm 
and those in the firm who are in a position to influence an audit must 
be independent from each fund in the fund complex and each entity in 
the fund complex in order to be independent with respect to any fund or 
entity in the complex.\139\
---------------------------------------------------------------------------

    \139\ ISB Standard No. 2, ``Certain Independence Implications of 
Audits of Mutual Funds and Related Entities,'' at para. 3 (Dec. 
1999).
---------------------------------------------------------------------------

    In addition to the requirement that the auditor have no investment 
in any entity in the investment company complex, the auditor also must 
be independent with respect to its other relationships with entities 
within the complex. For example, an auditor could not be a director for 
an entity within an investment company complex while auditing an entity 
in the complex.
    Should we follow the standard of ISB Standard No. 2 that an 
accountant must be independent of the entire investment company complex 
to be independent of any entity in that complex? Is this standard 
sufficiently clear and capable of implementation? If not, what 
modifications are needed? Does this standard have implications outside 
the area of investments (e.g., employment relationships, business 
relationships, or the provision of non-audit services) that go beyond 
what is necessary to safeguard independence?
    Are there certain complex capital structures, such as master/feeder 
or fund of funds, that require specific clarification as to an 
auditor's independence when the auditor audits one or more entities in 
that structure? Are there any unique implications of applying the 
proposed independence rules to investment companies, investment 
advisers, sponsors of unit investment trusts, and affiliated or 
unaffiliated service providers? If so, what are they and how should 
they be addressed?
    (c) Exceptions. Proposed rule 2-01(c)(1)(iii) would provide two 
limited exceptions to the financial relationship rules. These 
exceptions recognize that there are situations in which an accountant, 
by virtue of being given a gift of or inheriting a financial interest 
from a third party, or because the accounting firm has taken on a new 
audit client, may lack independence solely because of events beyond the 
accountant's control. In these circumstances, and provided the 
financial interest is promptly disposed of or the financial 
relationship is promptly terminated, we believe that reasonable 
investors would not necessarily perceive the accountant to be incapable 
of exercising objective and impartial judgment.
    (i) Inheritance and gift. Proposed rule 2-01(c)(1)(iii)(A) provides 
that an accountant's independence will not be impaired if any person 
acquires a financial interest through an unsolicited gift or 
inheritance that would cause the accountant to be not independent under 
(c)(1)(i) or (c)(1)(ii), and the financial interest is disposed of as 
soon as practicable, but no longer than 30 days after the person has 
the right to dispose of such interest. We solicit comment on all 
aspects of the gift and inheritance exception. Does the exception 
capture all situations in which a person subject to the financial 
relationship rules might enter into a restricted financial relationship 
and yet not give rise to any independence concerns? Are there 
situations in which an accounting firm might have no option but to 
receive its fee in its audit client's stock as a result of a court 
settlement? If so, should there be an exception for these situations, 
and how would such an exception work? Does the rule provide affected 
persons with adequate means to ``cure'' the lack of independence? For 
example, should the rule expressly allow a covered person to recuse 
himself or herself from an engagement or the chain of command rather 
than disposing of the financial interest?
    Would an accountant's independence be impaired if the covered 
person was restricted from disposing of the financial interest for an 
extended period? For example, suppose XYZ Corp. is the audit client of 
ABC Accounting Firm. Partner A is a covered person in the firm. Partner 
A becomes the beneficiary of a testamentary trust fund that includes $2 
million in equity securities of XYZ Corp. This amount constitutes 40 
percent of the amount of the trust, and 30 percent of Partner A's net 
worth. The terms of the trust fund prohibit disposing of the XYZ 
investment for a period of five years. Would a reasonable investor 
perceive ABC's independence to be impaired?
    Assume the same facts as above, except that the securities are 
received directly by Partner A. Would placing those securities in a 
``blind trust'' remedy the independence question? Can an individual be 
impartial if he or she knows what securities are held in the blind 
trust?
    (ii) New audit engagement. Proposed rule 2-01(c)(1)(iii)(B) is 
designed to allow accounting firms to bid for and accept new audit 
engagements, even if a person has a financial interest that would cause 
the accountant to be not independent under the financial relationship 
rules. This exception is available to an accountant so long as the 
accountant did not audit the client's financial statements for the 
immediately preceding fiscal year, and the accountant was independent 
before the earlier of either accepting the engagement to provide audit, 
review, or attest services to the audit client; or commencing any 
audit, review, or attest procedures (including planning the audit of 
the client's financial statements).

[[Page 43164]]

    The new audit engagement exception of proposed rule 2-
01(c)(1)(iii)(B) is necessary because an auditor must be independent, 
not only during the period of the auditor's engagement, but also during 
the period covered by any financial statements being audited or 
reviewed.\140\ Because of an existing financial relationship between an 
accounting firm or one of its employees and a company (that is not an 
audit client), an accounting firm may not be able to bid for or accept 
an audit engagement from the company without this exception. For 
example, where a firm's pension plan or a covered person in the firm 
owns the stock of a potential audit client during the period of the 
financial statements to be audited or reviewed, the accounting firm 
could not compete for the audit engagement but for this exception. This 
exception allows firms to bid for and accept engagements in these 
circumstances, provided they are otherwise independent of the audit 
client and they become independent of the audit client under the 
financial relationship rules before accepting the engagement or 
beginning any audit, review, or attest procedures.
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    \140\ See supra Section III.C.
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    We solicit comment on all aspects of the new audit engagement 
exception. Will the exception, as a practical matter, allow accounting 
firms to bid for and accept new audit engagements when they become 
available? Is the exception appropriate even though the auditor's 
independence would otherwise be considered impaired? Should the 
exception also extend to employment relationships, business 
relationships, or the provision of non-audit services? Does the 
existence of an employment relationship or the provision of non-audit 
services during the period covered by the financial statements raise 
independence concerns that cannot be ``cured'' before beginning the 
engagement in the same way that a financial relationship during this 
period can?
    (d) Audit Clients' Financial Relationships. Proposed rule 2-
01(c)(1)(iv) provides that an accountant is not independent when its 
audit client has invested, or otherwise has a financial interest in the 
accounting firm or an affiliate of the accounting firm.
    (i) Investments by the audit client in the auditor. Under proposed 
rule 2-01(c)(1)(iv)(A), an accountant's independence is impaired with 
respect to an audit client when the audit client or an affiliate of an 
audit client has, or has agreed to acquire, any direct investment in 
the accounting firm or its affiliate, whether in the form of stocks, 
bonds, notes, options, or other securities. This impairment occurs 
primarily for two reasons.
    First, the accountant may be placed in the position of auditing the 
value of the securities of the accounting firm or its affiliates that 
are reflected as an asset in the financial statements of the audit 
client. This could result when an auditor in an accounting firm whose 
shares are held by the audit client must value the shares of that 
accounting firm held by the audit client for purposes of including that 
valuation in the audited financial statements.
    Second, the accountant reasonably may be assumed to have a 
mutuality of financial interest with the owners of the firm and of the 
firm's affiliates, including an audit client-shareholder. The audit 
firm, as management, will be responsible to its shareholders, and one 
of the shareholders may be an audit client. Thus, there may be 
situations where a shareholder-audit client is in a position to 
influence the accountant because the accountant would owe a fiduciary 
responsibility to that audit client-shareholder and would be 
accountable to that audit client for the accounting firm's 
activities.\141\ For example, an audit client-shareholder is legally 
entitled to receive certain notices, invoke ``dissenters' rights,''and 
nominate candidates for directors under most state corporation laws. 
Consequently, an accountant, as management, would have fiduciary 
obligations to an audit client-shareholder who, acting alone or in 
combination with other shareholders, may be in a position to exercise 
some measure of influence over the accountant.
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    \141\ See Letter from POB to ISB, dated Jan. 12, 2000 
(``[p]ublic ownership in an audit firm or in its parent or in an 
entity that effectively has control of the audit firm would add 
another form of allegiance and accountability to those identified by 
the Supreme Court--a form of allegiance that in our opinion will be 
viewed as detracting from, if not conflicting with, the auditor's 
`public responsibility' '').
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    Are there other situations in which an audit client could have a 
financial interest in the accounting firm that would impair 
independence? For example, would a reasonable investor perceive an 
accountant's independence to be impaired if the audit client's CEO held 
a substantial investment in the accounting firm? Would it make a 
difference if the investment was significant to the CEO's net worth? 
Should there be a maximum allowable investment by audit clients in 
their auditors? If so, what should the threshold be? Does it matter if 
the investment is material to the investor or one of its affiliates?
    (ii) Underwriting. Few transactions are as significant to the 
financial health of a company, including an accounting firm, as the 
sale of its securities, whether in private or public offerings. In an 
offering, an underwriter either buys and then resells a company's 
securities or receives a commission for selling the services. In either 
circumstance, were an audit client to act as underwriter of an 
accounting firm's or its affiliate's securities, the audit client would 
assume the role of advocate or seller of the accounting firm's 
securities. Moreover, depending on the terms of the underwriting, the 
underwriter could for a time become a significant shareholder of the 
accounting firm. There also may be indemnification agreements that 
place the underwriter and auditor in adversarial positions.
    Relying on an audit client to sell the accounting firm's securities 
plainly impairs independence. The accounting firm would have a direct 
interest in ensuring the underwriter's viability and credibility, 
either of which could be damaged as the result of an audit. Moreover, 
the auditor would have a clear incentive not to displease an audit 
client to which it had entrusted a critical financial transaction. 
Similar conflicts of interest may arise if an audit client or an 
affiliate of an audit client performs other financial services for an 
accounting firm or its affiliates, such as making a market in the 
accounting firm's or its affiliate's securities or issuing an analyst 
report concerning the securities of the accounting firm or its 
affiliate.
    We request comment on whether we have addressed all situations in 
which the independence concerns arise because the audit client or its 
affiliate performs a financial service for the accounting firm or an 
affiliate? Are there financial services that an audit client or its 
affiliate could provide to its auditors or the accounting firm or its 
affiliate that would not raise these concerns? For example, would 
reasonable investors perceive an accountant's independence to be 
impaired if an audit client or an affiliate of an audit client made a 
market in the securities of the accounting firm or prepared and issued 
research reports on the accounting firm?
2. Employment Relationships
    Proposed rule 2-01(c)(2) sets forth the employment relationships 
that impair an auditor's independence. This paragraph is based on the 
premise that when an accountant is either employed by an audit client, 
or has a close relative

[[Page 43165]]

or former colleague employed in certain positions at an audit client, 
the accountant might not be capable of exercising the objective and 
impartial judgment that is the hallmark of independence.
    As with the financial relationships provision, paragraph (c)(2) 
sets forth the general standard that an accountant is not independent 
if the accountant has an employment relationship with an audit client 
or an affiliate of an audit client. The proposed rule then provides a 
non-exclusive list of relationships that are inconsistent with the 
general rule of paragraph (c)(2). Again, accountants should not assume 
that all employment relationships not specifically described in 
(c)(2)(i) through (c)(2)(iv) do not impair independence. All non-
specified employment relationships are subject to the general tests of 
paragraphs (b) and (c)(2).
    (a) Employment at audit client of accountant. Proposed rule 2-
01(c)(2)(i) continues the principle set forth in current Rule 2-01(b) 
that to be independent, neither the accountant nor any member of his or 
her firm can be a director, officer, or employee of an audit client. 
The paragraph therefore provides that an accountant is not independent 
if any current partner, principal, shareholder, or professional 
employee of the accounting firm is employed by the audit client or an 
affiliate of an audit client, or serves as a member of the board of 
directors or similar management or governing body of the audit client 
or an affiliate of the audit client. In the most basic sense, the 
accountant cannot be employed by his or her audit client and be 
independent.
    (b) Employment at audit client of certain relatives of accountant. 
Proposed rule 2-01(c)(2)(ii) specifies the family members of the 
auditor whose employment in certain positions by an audit client or its 
affiliate will impair the auditor's independence. For the employment 
category, the interests and relationships of a covered person's close 
family members--that is, the covered person's spouse, spousal 
equivalent, dependents, parents, nondependent children, and siblings--
are attributed to the covered person in the firm. This stands in 
contrast to the investment category, where only the interests of the 
covered person's immediate family members (i.e., spouse, spousal 
equivalent, and dependents) are attributed to the covered person. We 
believe this distinction is justified because, while some close family 
members' investments may not be known to a covered person, the place 
and nature of such family members' employment should be obvious, and 
thus may affect the covered person's objectivity and impartiality.
    We do not consider an audit client's employment of even a close 
family member, however, to impair an auditor's independence unless that 
family member is in a position to, or does, influence the preparers or 
the contents of the accounting records or financial statements of the 
audit client or its affiliate. The proposed rule uses the defined term 
``accounting or financial reporting oversight role'' to describe the 
persons in this group. The term is defined in proposed rule 2-01(f)(3). 
To reduce uncertainty, the definition lists those positions that 
generally carry with them the type of influence about which we are 
concerned. These positions include: a member of the audit client's 
board of directors (or similar management or governing body), chief 
executive officer, president, chief financial officer, chief operating 
officer, general counsel, chief accounting officer, controller, 
director of internal audit, director of financial reporting, treasurer, 
vice president of marketing, or any equivalent position.
    The proposed rule eliminates the so-called ``five hundred mile 
rule.'' Under that rule, when a family member has an interest in or 
relationship with an audit client, consideration is given to whether 
the geographic separation of that family member from both the person in 
the firm and the conduct of the audit lessens the negative impact of 
that interest or relationship on the auditor's independence.\142\ When 
an auditor's relative is not geographically distanced from the auditor 
and the audit, the auditor and his or her relatives are said to be in 
``closely linked business communities'' and the auditor's independence 
is deemed to be impaired. However, considering whether family members 
are in ``closely linked business communities'' no longer seems relevant 
in today's world of instantaneous international communications and 
global securities markets. Accordingly, the proposal dispenses with 
this test of auditor independence.
---------------------------------------------------------------------------

    \142\ See generally Codification Sec. 602.02.h.
---------------------------------------------------------------------------

    We solicit comment on all aspects of proposed rule 2-01(c)(2)(ii). 
Does the proposal use an appropriate definition of what constitutes 
close family members whose employment by an audit client results in an 
impairment of an auditor's independence? If not, how should it be 
revised? Should the definition of close family member be expanded to 
include extended family relationships, such as in-laws? Would 
reasonable investors perceive an accountant's independence to be 
impaired if the audit client's CEO was the brother-in-law of a covered 
person? Would employment by an audit client of friends, neighbors, or 
other persons having emotional or financial ties with covered persons, 
but not within the definition of close family member, impair an 
accountant's independence?
    Would reasonable investors perceive an accountant's independence to 
be impaired if a close family member of a covered person were employed 
by an audit client in a capacity that did not enable the family member 
to influence the preparers or contents of the accounting records or 
financial statements of the audit client or its affiliates? The ISB has 
suggested that independence is impaired if an immediate family member 
of a person on the audit engagement team is employed by the audit 
client in any position, or if a close family member holds a ``key 
position'' at an audit client.\143\ Is the ISB's stricter position with 
respect to immediate family members necessary to ensure an auditor's 
independence?
---------------------------------------------------------------------------

    \143\ ISB, Invitation to Comment 99-1, supra note 37, at 9.
---------------------------------------------------------------------------

    Is the definition of the positions that may enable employees to 
influence the accounting records appropriate? Would independence be 
impaired by other employment positions held by close family members 
with an audit client, such as vice president of human resources, 
assistant controller, or manager of internal audit?
    (c) Employment at audit client of former employee of accounting 
firm. Proposed rule 2-01(c)(2)(iii) describes the circumstances under 
which an auditor's independence will be impaired by an audit client's 
employment of a former partner, shareholder, principal, or professional 
employee of the accounting firm. When these persons retire or resign 
from accounting firms, it is not unusual for them to join the 
management of former audit clients or to become members of their boards 
of directors. Registrants and their shareholders may benefit from the 
former partner's accounting and financial reporting expertise. 
Investors and the public in general also may benefit when individuals 
on the board or in management can work effectively with the auditors, 
members of the audit committee, and management to provide informative 
financial statements and reports.
    When these persons, however, assume positions with the firm's audit 
client and also remain linked in some fashion to the accounting firm, 
they could be in a position to influence the content of the

[[Page 43166]]

audit client's accounting records and financial statements on the one 
hand, or the conduct of the audit, on the other. This is particularly 
true when the individual, while at the accounting firm, was in some way 
associated with the audit of the client. The perceived close 
association between a member of the board of directors or of senior 
management \144\ may create the impression of a mutuality of 
interest.\145\
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    \144\ See generally AUSA Life Ins. Co. v. Ernst & Young, supra 
note 120.
    \145\ See Auditing Standards Division, AICPA, ``Audit Risk 
Alert--1994, General Update on Economic, Accounting, and Auditing 
Matters,'' at 35 (1994).
    A few litigation cases suggest auditors need to be more cautious 
in dealing with former coworkers employed by a client. None of these 
cases involved collusion or an intentional lack of objectivity. 
Nevertheless, if a close relationship previously existed between the 
auditor and a former colleague now employed by a client, the auditor 
must guard against being too trusting in his or her acceptance of 
representations about the entity's financial statements. Otherwise, 
the auditor may rely too heavily on the word of a former associate, 
overlooking that a common interest no longer exists.
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    As accounting firm partners leave their firms and accept management 
positions with former audit clients, some have questioned whether these 
individuals compromised their independence in order to secure positions 
with audit clients.\146\ Others have questioned the continuing personal 
relationships between the former partner and the individuals at the 
firm who audit the client's financial statements.\147\ There is also 
the risk that the former partner's familiarity with the firm's audit 
process and the audit partners and employees of the firm will enable 
him or her to alter the outcome of the audit.\148\
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    \146\ See Paul M. Clikeman, ``Close revolving door between 
auditors, clients,'' Accounting Today, at 20 (July 8-28, 1996). Cf. 
In the Matter of Richard A. Knight, AAER No. 764 (Feb. 27, 1996) 
(individual allegedly learned of accounting misstatements while he 
was engagement partner for firm conducting audit and resigned to 
become registrant's executive vice president and chief financial 
officer).
    \147\ See, e.g., AUSA Life Ins. Co. v. Ernst & Young, supra note 
120; AICPA Board of Directors, Meeting the Financial Reporting Needs 
of the Future: A Public Commitment From the Public Accounting 
Profession, at 4 (June 1993) (``AICPA Board Report''); see also 
Staff Report, supra note 23, at 51-52; In addressing an example of 
this problem, the court in Lincoln S&L v. Wall, 743 F. Supp. 901, 
917 n.23 (D.D.C. 1990) wrote:
    Atchison, who was in charge of the Arthur Young audit of 
Lincoln, left Arthur Young to assume a high paying position with 
Lincoln. This certainly raises questions about Arthur Young's 
independence. Here a person in charge of the Lincoln audit resigned 
from the accounting firm and immediately became an employee of 
Lincoln. This practice of ``changing sides'' should certainly be 
examined by the accounting profession's standard setting authorities 
as to the impact such a practice has on an accountant's 
independence. It would seem that some ``cooling off period'' 
perhaps, one to two years, would not be unreasonable before a senior 
official on an audit can be employed by the client.
    \148\ In response to these and other concerns, the AICPA Board 
of Directors suggested in 1993 that we prohibit a public company 
from hiring the partner responsible for the audits of that company's 
financial statements for a minimum of one year after the partner 
ceases to serve that company. See AICPA Board Report, supra note 
147, at 4. Our staff has indicated, however, that, if implemented, 
this suggestion would take the form of the firm's independence being 
impaired for one year from the date the individual left the audit 
engagement, rather than as a prohibition on hiring the former 
partner. Staff Report, supra note 23, at 52 n.146. See also 
Committee of Sponsoring Organizations of the Treadway Commission 
(``COSO''), ``Fraudulent Financial Reporting: 1987-1997: An Analysis 
of U.S. Public Companies,'' at 21 (1999) (finding, with respect to 
companies where there was fraudulent financial reporting, that among 
44 companies for which there was information available on their 
CFO's background, 11 percent of the companies' CFOs had previous 
experience with the companies' audit firms immediately prior to 
joining the company).
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    As with the current requirements, the proposed rule recognizes that 
an auditor's independence with respect to an audit client may be 
impaired when former partners, shareholders, principals, or 
professional employees of the firm are employed in an accounting or 
financial reporting oversight role at the firm's audit client or an 
affiliate of the audit client. We are also proposing, however, that 
independence will not be impaired if certain steps are taken to 
disassociate the individual from the firm. Under the proposed rules, 
the former partner, shareholder, principal, or professional employee 
must not: (i) Influence the firm's operations or financial policies, 
(ii) have a capital balance in the firm, or (iii) have a financial 
arrangement with the firm, other than a fully-funded, fixed payment 
retirement account.
    The rule provides that, under certain conditions, use of a ``rabbi 
trust'' as a mechanism to make fixed retirement payments to a former 
partner or employee of the accounting firm would not impair an 
auditor's independence.\149\ Specifically, under the proposed rule, use 
of a ``rabbi trust'' does not impair an auditor's independence as long 
as the amount owed to the individual is immaterial to the firm, the 
payments from the trust are fixed as to time and amount, and the 
chances of the firm entering bankruptcy or insolvency are remote.
    We request comment on our approach in (c)(2)(iii). Should a former 
partner now employed by the audit client, be permitted to retain 
financial ties to the audit firm without impairing the independence of 
the auditor? What if the financial ties are material to the former 
auditor but not to the firm? Would reasonable investors perceive an 
accountant's independence to be impaired if a former employee of the 
accounting firm, who continued to hold a 401(k) investment with the 
accounting firm, became employed by the audit client? Does it matter if 
the former partner's position at the audit client is not one in which 
he or she will have influence over the company's audit, accounting 
records, or financial statements?
    If an audit partner or other professional employee leaves an 
accounting firm and joins the audit client during the course of an 
audit, does this impair the accounting firm's independence? Should the 
rule depend on whether the person leaving the accounting firm is a 
senior partner within the firm, an audit manager with management 
responsibilities for the audit, or non-managerial audit staff?
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    \149\ To avoid adverse tax consequences to the individual, 
accounting firms often settle their retirement obligations to former 
partners by fully funding a ``rabbi trust'' from which payments will 
be made to the individual. As defined by proposed rule 2-01(f)(18), 
a ``rabbi trust'' is an irrevocable trust whose assets are not 
available to the firm until all benefit obligations have been met 
but are subject to claims of the firm's creditors in bankruptcy or 
insolvency.
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    Should we require a mandatory ``cooling off'' period for former 
partners and professional staff of an audit firm who join an audit 
client? Should registrants have to disclose on a timely basis if they 
hire a partner or other senior audit professional assigned to the 
company's audit.\150\ If so, where should the disclosure appear?
---------------------------------------------------------------------------

    \150\ See Letter from Association for Investment Management and 
Research to Arthur Siegel, Executive Director, ISB, dated Feb. 29, 
2000, at 4 (``AIMR Letter'').
---------------------------------------------------------------------------

    (d) Employment at accounting firm of former employee of audit 
client. Proposed rule 2-01(c)(2)(iv) describes the circumstances under 
which employment of a former officer, director, or employee of an audit 
client or its affiliate as a partner, principal, or shareholder of the 
accounting firm will impair an auditor's independence. This provision, 
in a sense, mirrors the restrictions on employment by an audit client 
of former partners or employees of an accounting firm.
    When the employee of an audit client joins an accounting firm, the 
independence rules must ensure that the former employee is not in a 
position to influence the audit of his or her former employer.\151\ 
Participating in that

[[Page 43167]]

audit might require the former employee to audit his or her own work. 
Accordingly, the rule provides that independence is impaired unless the 
former employee does not participate in and is not in a position to 
influence the audit of the financial statements of the audit client or 
its affiliate for any period during which he or she was employed by or 
associated with that audit client or its affiliate.
---------------------------------------------------------------------------

    \151\ Of course, once an employee of an accounting firm, the 
person would also be subject to all other independence requirements 
applicable to other firm members. For example, if the former audit 
client employee becomes a covered person, he or she could have no 
financial interest in the audit client. See proposed rule 2-
01(c)(1)(i)(A).
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    We solicit comment on whether additional or other procedures should 
be implemented when a former employee of an audit client joins the 
accounting firm? If so, what should they be? Should the rule also apply 
to professional employees of the accounting firm?
3. Business Relationships
    Proposed rule 2-01(c)(3) describes the business relationships that 
impair an auditor's independence from an audit client. It continues the 
Codification's current standard that an auditor's independence with 
respect to an audit client is impaired when the accounting firm, or a 
covered person in the firm, has a direct or material indirect business 
relationship with an audit client, an affiliate of an audit client, or 
either of their officers, directors, or shareholders holding five 
percent or more of the audit client's equity securities.\152\ As is 
true today, under proposed rule 2-01(c)(3), an accountant's 
independence is not impaired solely because the accountant has a 
business relationship with the audit client in which the accountant 
provides professional services to the audit client except for those 
specified in rule 2-01(c)(4) or acts as ``a consumer in the ordinary 
course of business.''
---------------------------------------------------------------------------

    \152\ See Codification Sec. 602.02.g. As under the current 
business relationship standard, the term ``business relationships'' 
does not encompass sales of professional services by the accounting 
firm to a company.
---------------------------------------------------------------------------

    Because of recurring issues in this area, we have attempted to set 
forth in proposed rule 2-01(f)(11) a workable definition of ``consumer 
in the ordinary course of business.'' In general, an accountant acts as 
a ``consumer in the ordinary course of business'' when the accountant 
buys ``routine'' products or services on the same terms and conditions 
that are available to the seller's other customers or clients.\153\ An 
accountant is not acting as a ``consumer'' if it resells the client's 
products or services. Likewise, a purchase is not ``in the ordinary 
course of business,'' nor is the product ``routine,'' if it is 
significant to the firm or its employees. For example, an over-the-
counter purchase of office supplies at customary prices would be 
considered in the ordinary course of business. Purchasing items other 
than on normal, customary terms, or acting as an agent, value-added 
reseller, or marketer of the client's products, however, would not be 
acting as a consumer in the ordinary course of business.
---------------------------------------------------------------------------

    \153\ The definition of ``consumer in the ordinary course of 
business'' does not include situations in which an accountant sells, 
rather than purchases, the audit client's products or services.
---------------------------------------------------------------------------

    We considered whether to address each business relationship that 
would impair an auditor's independence. Because there are vast, varied, 
and constantly shifting types of business relationships, we determined 
not to attempt to identify all such business relationships. We have 
retained, however, a number of the examples currently found in the 
Codification to provide guidance on permissible and impermissible 
business relationships.\154\
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    \154\ See infra Section IX. relationships.\154\
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    We solicit comment on all aspects of paragraph (c)(3). Is the 
definition of ``consumer in the ordinary course of business'' 
appropriate? If not, how should it be modified? Should an auditor be 
allowed to resell its audit client's products? For example, should an 
auditor be allowed to act as a reseller of a client's software products 
to other clients of the auditor? Would the answer change if the sales 
to the auditor exceed some percentage of the client's revenues such as 
ten percent?
    Should an auditor be permitted to enter into any of the following 
types of business relationships with an audit client without impairing 
independence, and why or why not: (i) Strategic alliances such as joint 
marketing arrangements of the products or services of the audit client 
or auditor; (ii) joint ventures or other similar activities to develop 
or market new products or services; or (iii) prime/subcontractor 
relationships? Should any of these relationships be permitted if they 
do not result in the auditor and audit client sharing any revenues, 
costs or profits? Should any of these relationships be permitted if 
they do not result in any revenue, cost or profit sharing that is 
material to the audit partner, the audit firm, or the audit client?
    Are there other business relationships that impair independence 
that the rules do not cover? Should we retain the ``direct or material 
indirect business relationship'' formulation or are there other 
formulations that would provide additional or more precise guidance? 
Should we adopt rules addressing particular business relationships 
based on the examples of direct and material indirect business 
relationships in the Codification?
    In addition, we request comment on business relationships between 
other persons or entities related to the accountant that might affect 
the independence of the accountant. For example, suppose that XYZ 
Corp., an audit client of ABC Accounting Firm, manufactures coffee 
mugs. The spouse of Partner A, who is the partner in charge of the 
audit of XYZ, purchases coffee mugs from XYZ Corp., applies decorative 
logos, and sells the mugs to customers. The spouse purchases the mugs 
at a price that is below the normal selling price. Would a reasonable 
investor perceive that accountant's independence to be impaired?

D. Non-Audit Services

    Historically, accounting firms have provided consulting and other 
non-audit services to their audit clients.\155\ As noted elsewhere in 
this release, however, for many years consulting services for SEC 
registrants constituted a relatively minor portion of the firms' 
revenues.\156\ In recent years, firms have expanded the scope of 
services they offer to audit and other clients.\157\
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    \155\ The AICPA describes ``consulting services'' as follows:
    Consulting services differ fundamentally from the CPA's function 
of attesting to the assertions of other parties. In an attest 
service, the practitioner expresses a conclusion about the 
reliability of a written assertion that is the responsibility of 
another party, the asserter. In a consulting service, the 
practitioner develops the findings, conclusions, and recommendations 
presented. The nature and scope of work is determined solely by the 
agreement between the practitioner and the client. Generally, the 
work is performed only for the use and benefit of the client.
    AICPA Professional Standards: Consulting Services--Definitions 
and Standards, CS Sec. 100.02.
    \156\ See supra Section II.C; see also Appendix B.
    \157\ See Appendix A.
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    Current Rule 2-01 states that our independence requirements apply 
to ``any professional employee involved in providing [on behalf of an 
accounting firm] any professional service'' to an audit client. The 
current rule further states that in making independence determinations, 
we will consider ``all relevant circumstances, including evidence 
bearing on all relationships between the accountant and [the 
client].''\158\ Our independence requirements, therefore, apply to all 
persons at an accounting firm who provide non-audit services to audit 
clients, and we consider those services in making independence 
determinations. These principles remain unchanged in the rule proposal.
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    \158\ Rule 2-01(c).
---------------------------------------------------------------------------

    The proposed rules, like our current independence requirements, 
govern

[[Page 43168]]

non-audit services provided by an accountant to an audit client during 
the audit and professional engagement period. They do not govern non-
audit services when provided to persons other than audit clients. We 
request comment on this approach.
1. The Proposals
    (a) General Rule. Proposed rule 2-01(c)(4) states the general rule 
that an auditor's independence is impaired if providing services to an 
audit client or its affiliate is inconsistent with the standard in 
proposed rule 2-01(b). The rule is derived from current Rule 2-01 and 
our releases that have been incorporated into the Codification. 
Proposed rule 2-01(c)(4) identifies certain services that are 
incompatible with the principles set forth in proposed rule 2-01(b), 
even when the audit client, by contract or otherwise, accepts ultimate 
responsibility for the work performed or for any decision made.
    The rule does not provide an all-inclusive list of the services 
that are incompatible with proposed rule 2-01(b). Whether the provision 
of a non-audit service not specified in the proposed rule impairs an 
accountant's independence will be measured against the four general 
principles set forth in proposed rule 2-01(b). We request comment on 
whether there are any services listed in Appendix A that would raise 
independence concerns if provided by the accounting firm to the audit 
client? If so, what are they, and why do they raise independence 
concerns? Are there other non-audit services that are not on the list 
in Appendix A that raise independence concerns? If so, what are they, 
and why do they raise independence concerns?
    We request comment on whether, if you are a registrant, your 
company, board of directors, or audit committee have a policy or 
practice of not hiring your independent auditors to provide non-audit 
services, other than income tax services. We request comment from 
registrants about what non-audit services you hire your auditor to 
provide, other than tax services.
    We also request comment on whether allowing certain non-audit 
services to be provided to audit clients is a viable approach, or 
whether banning all non-audit services for audit clients is the only 
appropriate approach. Should such a ban exclude tax services?
    (b) Specific Non-Audit Services that Impair Independence.
    (i) Bookkeeping or other services related to the audit client's 
accounting records or financial statements. Currently, an auditor's 
independence is impaired if the auditor provides bookkeeping services 
to an audit client or an audit client's affiliate.\159\ Proposed rule 
2-01(c)(4)(i)(A) continues that position. When an accounting firm 
provides bookkeeping services for an audit client, the auditor auditing 
that client's financial information may be auditing his or her 
accounting firm's work. If, during an audit, an auditor must audit the 
bookkeeping work performed by his or her accounting firm, it is 
questionable that the auditor could, or that reasonable investors would 
believe that the auditor could, remain objective and impartial. If the 
auditor found an error in the bookkeeping, the auditor could well be 
under pressure not to raise the issue with the client, if raising the 
issue could jeopardize the firm's contract with the client for 
bookkeeping services.
    Because there may be bookkeeping tasks that do not involve 
financial information or that do not otherwise need to be considered in 
the audit, we have narrowed the definition to services involving 
maintaining or preparing the audit client's or its affiliate's 
accounting records or financial statements, or generating financial 
information to be disclosed by the audit client, or its affiliate, to 
the public.\160\
    We request comment on whether performing bookkeeping or preparing 
financial records or statements for an audit client would impair, or 
would appear to reasonable investors to impair, an auditor's 
independence. If not, why not? Should the definition of bookkeeping be 
further clarified? If so, how? Does the definition cover all the 
bookkeeping services that would impair an accountant's independence?
    (ii) Financial information systems design and implementation. Under 
the proposed rule, an accountant is not independent if the accountant 
designs or implements a hardware or software system that is or will be 
used to generate information that is significant to the audit client's 
financial statements taken as a whole. By ``significant'' we refer to 
information that is reasonably likely to be material to the financial 
statements of the audit client or its affiliate. Since materiality 
determinations cannot be made before financial statements are 
generated, the accounting firm by necessity will need to evaluate the 
general nature of the information rather than only system output during 
the period of the audit engagement. An accountant, for example, would 
not be independent of an audit client for which it designed an 
integrated Enterprise Resource Planning (ERP) system.\161\
    Designing or implementing systems affecting the financial 
statements may create a mutual interest between the client and the 
accountant in the success of that system, supplant a fundamental 
business function, or result in the accountant auditing his or her own 
work. For example, if an auditor designs and installs a computer system 
that generates the financial records, and that system generates 
incorrect data, the accountant is placed in a position of having to 
report on its own work. When an accountant audits the accountant's own 
work, investors may perceive that the accountant will be unwilling to 
challenge the integrity and efficacy of the client's financial or 
accounting information collection systems that the accountant designed 
or implemented.
    Our proposed rule would not, however, cover services in connection 
with the assessment, design, and implementation of internal accounting 
and risk management controls. Accountants often gain an understanding 
of their audit clients' systems of internal accounting controls. With 
this insight, auditors often become involved in diagnosing, assessing, 
and recommending to audit committees and management, ways in which 
their audit client's internal controls can be improved or strengthened. 
These services can be extremely valuable to companies, and they may 
also bring benefits to the performance of a quality audit, such as 
through increased knowledge of the audit client's business.
    At the same time, we recognize that when an auditor designs and 
implements its audit client's internal accounting and risk management 
control systems, some might believe that the auditor will lack 
objectivity if called upon to audit financial statements that are 
derived at least in part from data from those systems. Testing of these 
controls is often an integral part of any

[[Page 43169]]

audit of the financial statements of a company. Do such services result 
in the auditor auditing their own work? Would such services impair an 
auditor's independence if the auditor were required to issue an opinion 
on the effectiveness of the control systems that he or she designed or 
implemented?
    We believe there is relatively little reason for concern about an 
audit firm's work on hardware or software systems that are unrelated to 
the audit client's financial statements or accounting records. 
Accordingly, our proposed rule does not prohibit an accounting firm 
from providing such services for non-financial or tax purposes where 
the results of the valuation do not have a direct impact on the 
financial statements.
    We request comment on whether designing or implementing financial 
information systems poses a threat to an auditor's independence. Is an 
auditor's independence impaired when the auditor designs, selects or 
helps select, implements, or tests computer software and hardware 
systems that generate financial data used in or underlying the 
financial statements? Why or why not?
    Whether a system is used to generate information that is 
``significant'' to the audit client's financial statements may depend 
on the size of the engagement. Does the magnitude of the fees for such 
services make a difference? For example, if the auditor is hired to do 
a major new system design and implementation for which the fees will 
exceed the audit fee, is the auditor's independence impaired or would 
reasonable investors perceive the auditor's independence to be 
impaired? What if the consulting fees do not exceed the audit fee, but 
are significant in relation to the audit fee? What if the consulting 
fees are much larger than the audit fee?
    Is having the audit committee pre-approve these computer systems 
consulting arrangements sufficient to monitor and ensure the auditor's 
independence? Why or why not? Would disclosure of such an arrangement 
make a difference? Why or why not?
    Some believe that with the current pace of technological 
innovation, the quality of audits in the future will be even more 
dependent on internal controls over the electronic processing of 
information and data. If so, is auditor independence impaired if 
auditors are permitted to design and implement the systems that process 
the information and data, then audit these systems in the course of the 
audit engagement?
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    \159\ Codification Sec. 602.02.c.i.
    \160\ As noted in section 602.c.iii of the Codification, we 
determined not to raise questions of independence solely because a 
foreign office of, or a foreign firm associated with, a domestic 
accounting firm performs limited, routine, or ministerial 
bookkeeping services for a foreign division, subsidiary or investee 
of a domestic registrant which is a client of that firm. The 
Commission stated that a comparison of the fees for the bookkeeping 
services and the audit should provide a fair test for determining 
the significance of the work to the registrant and the accountant 
and, indirectly, the possible effect on the firm's independence. 
Accordingly, the Commission limited the fees for such services to 
the greater of $1,000 or one percent of the total audit fee for the 
registrant. The Commission continues to recognize the need for 
relief in this area and has therefore retained this section of the 
Codification.
    \161\ This includes designing or implementing such a system for 
an affiliate of the audit of client, if the system is used to 
generate information that is significant to the audit client's 
financial statements taken as a whole.
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    (iii) Appraisal or valuation services, fairness opinions, or 
contribution-in-kind reports. The proposals would provide that the 
auditor is not independent if the auditor provides appraisal or 
valuation services, fairness opinions or contribution-in-kind reports, 
\162\ where there is a reasonable likelihood that the results will be 
audited by the auditor. \163\ Appraisal and valuation services include 
any process of valuing assets, both tangible and intangible, or 
liabilities. They include valuing, among other things, in-process 
research and development, financial instruments, assets and liabilities 
acquired in a merger, and real estate. Fairness opinions and 
contribution-in-kind reports are opinions and reports in which the firm 
provides its opinion on the adequacy of consideration in a transaction. 
Providing these services to audit clients raises several auditor 
independence concerns. When it is time to audit the financial 
statements, the accountant could well end up reviewing his or her own 
work, including key assumptions or variables that underlie an entry in 
the financial statements. \164\ Also, where the appraisal methodology 
involves projection of future results of operations and cash flows, the 
accountant that prepares the projection could have a mutuality of 
interest with the client in attaining forecast results. The auditor may 
feel constrained by the valuation and appraisal issued by the firm, and 
as a result, the auditor may be unable to evaluate skeptically and 
without bias the accuracy of that valuation or appraisal. Our proposals 
do not prohibit an accounting firm from providing such services for 
non-financial (e.g., tax) purposes.
    We request comment on whether providing appraisal or valuation 
services and issuing fairness opinions or consideration-in-kind reports 
to audit clients would impair, or appear to reasonable investors to 
impair, an accountant's independence. Does providing valuation or 
appraisal services that are unrelated to the financial statements, such 
as for income tax purposes impair an accountant's independence?
    Some believe that providing valuations and appraisals does not 
impair the auditor's independence when the amounts involved are likely 
to be immaterial to the financial statements that later would be 
reviewed by the auditor. Should we provide an exception in our rule to 
cover this situation? If so, would the auditor/consultant be able to 
determine in advance of the valuation work being performed whether 
amounts may be material to the financial statements currently and in 
the future?
    Are there certain types of appraisal or valuation services, or 
certain instances in which they are provided, that do not raise auditor 
independence concerns? Are there circumstances in which an accounting 
firm may be required by law or regulation to provide such services, 
either in the United States or abroad? If so, please describe them. How 
should our rules address them?
    (iv) Actuarial services. The SECPS defines actuarial services to 
include: (i) assisting management to develop appropriate methods, 
assumptions, and amounts for policy and loss reserves presented in 
financial reports, based on the company's history, current practice and 
future plans; (ii) assisting management in the conversion of financial 
statements from a statutory basis to one in conformity with GAAP; (iii) 
analyzing actuarial considerations and alternatives in federal income 
tax planning; and (iv) assisting management in the financial analyses 
of various matters, such as proposed new policies and business 
acquisitions. \165\ Providing actuarial services may affect amounts 
reflected in an audit client's financial statements and result in an 
accountant auditing his or her own work.
    The proposals, therefore, provide that the accountant is not 
independent if the auditor provides any advisory service involving the 
determination of policy reserves and related accounts for the audit 
client or its affiliate, unless the audit client uses its own actuaries 
or third-party actuaries to provide management with the primary 
actuarial capabilities. The SECPS already prohibits member accounting 
firms from providing certain actuarial services.
    Does providing actuarial services to an audit client, such as the 
calculation of actuarial reserves or determining key actuarial 
assumptions, impair an auditor's independence? Sometimes auditors 
provide consulting services to their audit clients concerning employee 
benefit plans. While the consulting services may range from providing 
tax advice to complete development and ongoing administration of the 
plan and plan records, many of these services

[[Page 43170]]

require computation of future benefit levels. Does providing such 
services impair an auditor's independence with respect to the audit 
client or the audit of the plan?
    Auditors also sometimes prepare or assist an audit client in 
preparing its annual pension plan reports, from which the financial 
data are derived to be used in recording the appropriate pension plan 
information in the financial statements. Does providing this service 
for an audit client impair the independence of the auditor? Would the 
auditor's independence be impaired if management provided all of the 
significant data and key assumptions, and the auditor merely input 
these data into its computer model to generate the necessary 
information for the accounting records and financial statements?
    Are there certain circumstances under which an accountant can 
provide actuarial services to an audit client without impairing 
independence? Have we appropriately described the actuarial services 
that give rise to independence concerns?
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    \162\ Contribution-in-kind reports in certain foreign countries 
require the auditor to express an opinion on the fairness of a 
transaction, the value of a security, or the adequacy of 
consideration to shareholders.
    \163\ The ISB has identified threats to the independence of 
firms that perform appraisal and valuation services for audit 
clients. See ISB, Discussion Memorandum 99-3, supra note 9, at 7-9 
(Sept. 1999).
    \164\ See generally Codification Sec. 602.02.c.
    \165\ See SECPS, Organizational Structure and Functions of the 
SECPS of the AICPA Division for CPA Firms, at Sec. 1000.35 (June 
1997) (``SECPS Manual'').
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    (v) Internal audit outsourcing. The line between performing 
management functions and performing an audit is not always clear. Our 
staff has received numerous questions about where to draw this line in 
general, and where to draw this line with respect to ``internal audit 
outsourcing'' in particular. Companies ``outsource'' internal audit 
functions by contracting with an outside source to perform all or part 
of their audits of internal controls. As emphasized by the Committee of 
Sponsoring Organizations (``COSO''), internal auditors play an 
important role in evaluating and monitoring a company's internal 
control system.\166\ As a result, internal auditors are, in effect, 
part of a company's system of internal accounting control.
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    \166\ See also Committee of Sponsoring Organizations of the 
Treadway Commission (``COSO''), Internal Control--Integrated 
Framework, at 7 (1992) (the ``COSO Report'').
---------------------------------------------------------------------------

    Since the external auditor generally will rely, at least to some 
extent, on the internal control system when conducting the audit of the 
financial statements,\167\ the auditor would be relying on its own work 
performed as part of the internal controls and internal audit function. 
In essence, by outsourcing the internal audit function, the auditor 
assumes a responsibility of the company and becomes part of the 
company's control system, as opposed to providing consulting advice. 
Also, there may well be a mutuality of interest where management and 
the external auditor become partners in creating an internal control 
system and share the risk of loss if that system proves to be 
deficient.
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    \167\ AICPA SAS No. 55, AU Sec. 319 (effective for audits on or 
after Jan. 1, 1990).
---------------------------------------------------------------------------

    Proposed rule 2-01(c)(4)(i)(E) provides that an auditor is not 
independent when the auditor performs certain internal audit services 
for an audit client or an affiliate. This does not include nonrecurring 
evaluations of discrete items or programs that are not in substance the 
outsourcing of the internal audit function. It also does not include 
operational internal audits unrelated to the internal accounting 
controls, financial systems, or financial statements.
    In 1996, the Ethics Committee of the AICPA published a revised 
ruling concerning internal audit outsourcing.\168\ It states that AICPA 
members may perform ``extended audit services,'' including internal 
audit outsourcing services, provided the member or his or her firm does 
not act or appear to act in a capacity equivalent to a member of client 
management or as an employee. Under the ruling, an AICPA member may 
conduct ``separate evaluations'' of the effectiveness of a client's 
internal controls.\169\ The client, however, among other things, must 
designate a competent member of management to: (i) Be responsible for 
the internal audit function, (ii) determine the scope, risk, and 
frequency of internal audit activities, including those to be performed 
by the member, (iii) evaluate the findings and results arising from the 
internal audit activities, and (iv) evaluate the adequacy of the audit 
procedures performed and the findings resulting from performance of 
those procedures. The ruling also contains examples of activities that, 
if performed by the member, would be considered to impair that member's 
independence.\170\ The staff has interpreted the language of this 
ruling narrowly: if the performance of internal audit work entails any 
managerial or employee function, audit independence is adversely 
affected.
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    \168\ AICPA Code of Professional Conduct, ET Sec. 101.15 
(Omnibus Proposal of Professional Ethics Division Interpretations 
and Rulings (June 1996)).
    \169\ COSO Report, supra note 166, discussed what constitutes an 
acceptable internal control system. Monitoring, according to the 
report, has two parts: ongoing monitoring activities and separate 
evaluations. The first is a management function, and the second is 
not.
    ``Ongoing monitoring'' occurs in the course of operations, and 
includes regular management and supervisory activities. Id. at 3. 
Ongoing monitoring procedures are built into the normal recurring 
operations of an entity. Id. at 72. Separate evaluations, on the 
other hand, are not conducted on a continuing basis. The scope and 
frequency of separate evaluations depend primarily on management's 
assessments of the effectiveness of the ongoing monitoring 
procedures and the amount of information necessary for management to 
have reasonable assurance about the effectiveness of the internal 
control system. Id. at 3, 71.
    \170\ Supra note 168. These examples include the performance of 
ongoing monitoring activities that affect the execution of 
transactions or ensure that transactions are properly executed, 
accounted for, or both; and the performance of routine activities in 
connection with the client's operating or production processes that 
are equivalent to those of an ongoing compliance or quality control 
function.
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    The COSO Report defines certain tasks for management related to 
separate evaluations, including deciding on scope; analyzing control 
evaluation work by internal auditors; prioritizing high risk areas; 
considering the scope, time-frame, methodology, tools, input to be 
used, and means of reporting findings; reviewing findings; and ensuring 
follow-up actions are taken. Id. at 76.
    As noted above, the proposal does not follow the AICPA because we 
believe performing an internal audit function results in the auditor 
assuming a management function and, during the audit, relying on a 
system that the auditor has helped to establish or maintain. We solicit 
comment on whether internal outsourcing would impair, or would appear 
to reasonable investors to impair, an auditor's independence. Does it 
impair an auditor's independence if the auditor does not outsource the 
internal audit function of the audit client, but rather performs 
individual audit projects for the client? Would it impair the auditor's 
independence if the auditor performs only operational audits that are 
unrelated to the internal controls, financial systems, or financial 
statements?
    (vi) Management functions. Proposed rule 2-01(c)(4)(i)(F) provides 
that an accountant's independence is impaired with respect to an audit 
client for which the accountant acts, temporarily or permanently, as a 
director, officer, or employee of an audit client, or an affiliate of 
the audit client, or performs any decision-making, supervisory, or 
ongoing monitoring functions. This provision is consistent with the 
provisions of existing Rule 2-01(b).
    We request comment on whether there are circumstances under which 
an accounting firm can perform or assume management functions or 
responsibilities for an audit client without impairing independence?
    (vii) Human resources. Proposed rule 2-01(c)(4)(i)(G) provides that 
an auditor's independence is impaired with respect to an audit client 
when the

[[Page 43171]]

auditor recruits, hires, or designs compensation packages for, 
officers, directors, or managers of the audit client or its affiliate. 
Under the proposed rule, an auditor's independence also is impaired 
when the auditor advises an audit client about its or its affiliate's 
management or organizational structure, when it develops employee 
evaluation programs, or conducts psychological or other formal testing 
of employees.\171\
---------------------------------------------------------------------------

    \171\ This proposal is consistent with SECPS Manual 
Sec. 1000.35, supra note 165.
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    Assisting management in human resource selection or development 
places the auditor in the position of having an interest in the success 
of the employees that the auditor has selected, tested, or evaluated. 
Accordingly, an auditor may be reluctant to suggest the possibility 
that those employees failed to perform their jobs appropriately, or at 
least reasonable investors might perceive the auditor to be reluctant, 
because doing so would require the auditor to acknowledge shortcomings 
in its human resource service. The auditor would also have other 
incentives not to report such employees' ineffectiveness, including 
that the auditor would identify and be identified with the recruited 
employees.
    We request comment on whether providing human resource services 
would impair, or would appear to reasonable investors to impair, an 
auditor's independence. Are there any types of human resource and 
employee benefit services rendered that are included in Appendix A that 
do or do not impair an auditor's independence?
    Is an auditor's independence impaired when the accounting firm does 
an executive search for an audit client? Would an auditor's 
independence be impaired if the auditor provided personnel hiring 
assistance for only non-executive or non-financial personnel?
    Does it impair an auditor's independence if the auditor provides 
consultation with respect to the compensation arrangements of the 
company's executives? Is an auditor's independence impaired if the 
auditor outsources an audit client's human resource department or 
similar functions? Are there circumstances in which outsourcing these 
functions would not impair independence?
    (viii) Broker-dealer, investment adviser or investment banking 
services. The proposed rule provides that an accountant is not 
independent if the accountant acts as a securities professional for an 
audit client or an affiliate of the audit client. Examples include 
serving as a broker-dealer, promoter, underwriter, investment adviser, 
or analyst of the audit client's or an affiliate of the audit client's 
securities; designing the audit client's or its affiliate's system for 
compliance with broker-dealer or investment adviser regulations; or 
recommending the purchase or sale of securities issued by an audit 
client or its affiliate. Our existing regulations take note of the 
mutuality of interest created by providing services of this type.\172\ 
Selling--directly or indirectly--an audit client's securities is 
incompatible with the auditor's responsibility of assuring the public 
that the company's financial condition is fairly and accurately 
presented.
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    \172\ Rule 2-01(b), 17 CFR 210.2-01(b); Codification 
Sec. 602.02.e.iii. These regulations indicate that activities such 
as recommending securities, soliciting customers, and executing 
orders provide investors with sufficient reason to question the 
auditor's ability to be impartial and objective.
---------------------------------------------------------------------------

    We solicit comment on whether providing these services would 
impair, or would appear to reasonable investors to impair, an auditor's 
independence. Are there situations in which an accountant could serve 
as a promoter or underwriter of an audit client's or an affiliate of an 
audit client's securities without impairing independence?
    Broker-dealers often give advice and recommendations on investments 
and investment strategies. Investment advisers give similar advice. The 
value of that advice is measured principally by the performance of a 
customer's securities portfolio. When the customer is an audit client, 
the accountant has an interest in the value of the audit client's 
securities portfolio, even as the accountant values the portfolio as 
part of an audit.
    When an accountant, in any capacity, recommends to anyone 
(including non-audit clients) that they buy or sell the securities of 
an audit client or an affiliate of the audit client, the accountant has 
an interest in whether those recommendations were correct. That 
interest could affect the audit of the client whose securities, or 
whose affiliate's securities, were recommended. For example, if an 
auditor uncovers an accounting error in a client's financial 
statements, and the auditor had, in an investment adviser capacity, 
recommended that client's securities to investment clients, the auditor 
performing the audit may be reluctant to recommend changes to the 
client's financial statements if the changes could negatively affect 
the value of the securities recommended by the auditor to its 
investment adviser clients. We solicit comment on whether recommending 
the purchase or sale of the securities of an audit client or an 
affiliate of an audit client would impair, or would appear to 
reasonable investors to impair, an auditor's independence. Will there 
be an independence impairment if the accountant's broker-dealer 
customers or investment adviser customers hold substantial positions in 
audit client securities, even though the accountant did not recommend 
those securities? We request comment on whether acting as a broker-
dealer or an investment adviser for an audit client or an affiliate of 
an audit client would impair, or would appear to reasonable investors 
to impair, an auditor's independence.
    An accountant acting as a securities analyst for an audit client or 
an affiliate of an audit client has a mutuality of interest with the 
audit client. An analyst often prepares research reports that are used 
to promote or market the securities of their client. In addition, an 
auditor may be placed in a conflict if the audit results in the auditor 
obtaining information that casts doubt on the analyst's opinion. We 
solicit comment on whether serving as a securities analyst for an audit 
client's or an affiliate of an audit client's securities would impair, 
or would appear to reasonable investors to impair, an auditor's 
independence. Are there circumstances in which an accountant could act 
as a securities analyst for an audit client's or an affiliate of an 
audit client's securities without impairing independence?
    Independence issues also arise when an accountant designs an audit 
client's or an affiliate of an audit client's system for complying with 
broker-dealer or investment adviser regulations. To the extent that, 
during the performance of the audit, the auditor relies on the controls 
that are part of compliance systems designed by the accountant, the 
accountant will end up in the position of auditing its own work.
    We solicit comment on whether designing an audit client's or an 
affiliate of an audit client's system for compliance with broker-dealer 
or investment adviser regulations would impair, or would appear to 
reasonable investors to impair, an auditor's independence. If an 
accountant has an audit client who is a broker-dealer or an investment 
adviser, and the accountant designs the client's system for regulatory 
compliance, will the financial audit necessarily encompass reviewing or 
auditing any aspect of that system or its performance?
    We further solicit comment on the scope of the proposal. Are there 
other securities professional services that the

[[Page 43172]]

rule should expressly identify as impairing independence?
    (ix) Legal services. The proposed rule provides that an accountant 
is not independent of an audit client if the accountant provides any 
service to the audit client or its affiliates that, in the jurisdiction 
in which the service is provided, may be provided only by someone 
licensed to practice law. This proposal is consistent with current 
regulations, under which legal services are deemed to be incompatible 
with auditor independence.\173\ A lawyer's core professional obligation 
is to advance clients' interests. Rules of professional conduct require 
the lawyer to ``represent a client zealously and diligently within the 
bounds of the law.'' \174\ The lawyer must ``take whatever lawful and 
ethical measures are required to vindicate a client's cause or endeavor 
* * *. In the exercise of professional judgment, a lawyer should always 
act in a manner consistent with the best interests of the client.'' 
\175\ Unlike an auditor, a lawyer takes basic direction from the 
client. In addition, a lawyer has a near absolute duty to safeguard the 
confidences of his or her client.\176\ We have long maintained that an 
individual cannot be both a zealous legal advocate for management or 
the client-company, and maintain the objectivity and impartiality that 
are necessary for an audit. As noted above, the Supreme Court has 
agreed with our view. In Arthur Young, the Supreme Court emphasized, 
``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.'' \177\
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    \173\ Codification Sec. 602.02.e.ii.
    \174\ See, e.g., D.C. Rules of Professional Conduct, Rule 
1.3(a).
    \175\ Id. at cmts. 1, 5.
    \176\ Id. at Rule 1.6.
    \177\ Arthur Young, supra note 19, at 819-20 n.15.
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    We recently reiterated our views in a settled enforcement 
action.\178\ In addition, the staff wrote to the American Bar 
Association and to its Commission on Multidisciplinary Practices (``ABA 
Commission'') explaining the impairment of auditor independence that is 
created when a firm provides both audit and legal services to an entity 
required to file audited financial statements with the SEC.\179\ In its 
final report, the ABA Commission adopted this view. In discussing legal 
and attest services, the report states, ``The Commission explicitly 
recognizes their incompatibility. It does not believe that a single 
entity should be allowed to provide legal and audit services to the 
same client.'' \180\ We continue to believe that a fundamental conflict 
exists between the roles of an independent auditor and an 
attorney.\181\
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    \178\ In the Matter of Charles Falk, AAER No. 1134 (May 19, 
1999) (formally disciplining an attorney/accountant who gave legal 
advice to an audit client of another partner in his accounting 
firm).
    \179\ Letter from Harvey J. Goldschmid, Lynn E. Turner, and 
Richard H. Walker, SEC, to Philip S. Anderson, President, American 
Bar Association, dated July 12, 1999; Letter from Lynn E. Turner, 
Chief Accountant, SEC, to Sherwin P. Simmons, Chair, Commission on 
Multidisciplinary Practice, dated Jan. 22, 1999. Except with respect 
to the matter of auditor independence, we have not taken a position 
on the development of multidisciplinary practices.
    \180\ American Bar Association Commission on Multidisciplinary 
Practice, Report to the House of Delegates, at 5 (July 2000) 
(footnote omitted). The report is available at www.ABAnet.org/cpr/mdpfinalrep2000.html.
    \181\ See also ISB, ``Discussion Memorandum 99-4: Legal 
Services'' (Dec. 1999).
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    We request comment on whether providing legal services to an audit 
client or an affiliate of an audit client would impair, or would appear 
to reasonable investors to impair, an auditor's independence. Are there 
any particular legal services that should be exempted from the rule? 
Does making the rule's application depend upon the jurisdiction in 
which the service is provided leave the rule subject to any significant 
uncertainty, or pose the prospect of any significant complexity or 
unfairness? Should there be any exception for legal services provided 
in foreign jurisdictions? If so, why?
    (x) Expert services. The proposed rule states that an accountant's 
independence is impaired as to an audit client if the accountant 
renders or supports expert opinions for the audit client or an 
affiliate of the audit client in legal, administrative, or regulatory 
filings or proceedings (``expert services''). Clients retain experts to 
lend authority to their contentions in various proceedings by virtue of 
the expert's specialized knowledge and experience. The provision of 
expert services by the accountant creates, at the very least, the 
appearance that the accountant is acting as the client's advocate in 
pursuit of the client's interests. The appearance of advocacy (and the 
corresponding appearance of mutual interest) created by providing 
expert services is sufficient to deem the accountant's independence 
impaired.\182\ Our proposals would not prohibit an auditor from 
testifying as a fact witness to its audit work for a particular audit 
client. In those instances, the auditor is merely providing a factual 
account of what he or she observed and the judgments he or she made.
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    \182\ Existing auditor independence regulations recognize the 
problem posed by expert services. See Codification Secs. 601.01 & 
602.02.e. Moreover, in connection with its report on auditor 
independence, the GAO cited a congressional staff report issued in 
1977 that ``raised concerns involving situations where accountants 
testify before public bodies advocating positions that are favorable 
to their clients.'' GAO Report, supra note 45, at 47. That 
congressional study related to auditing firms' testimony before 
Congress on oil and gas pricing issues and stated, ``Conflicts of 
interest occur when 'Big Eight' firms influence governmental 
authorities on matters which affect their corporate clients.'' 
Subcomm. on Reports, Accounting and Management of the Senate Comm. 
on Government Operations, ``The Accounting Establishment: A Staff 
Study,'' 95th Cong., 1st Sess., Doc. No. 95-34, at 67 (1977).
---------------------------------------------------------------------------

    We solicit comment on whether providing expert services on behalf 
of an audit client or an affiliate of an audit client would impair, or 
would appear to reasonable investors to impair, an auditor's 
independence. Are there circumstances in which providing audit clients 
with expert services in legal, administrative, or regulatory filings or 
proceedings should not be deemed to impair independence? We also 
solicit comment on whether an auditor should be permitted to serve as a 
non-testifying expert for an audit client in connection with a 
proceeding in which the auditor's work does not provide a basis for 
testimony by an expert.
    An auditor may provide an audit client a written report or 
``opinion'' on the application of an accounting principle to a 
particular transaction in accordance with AU Sec. 625. Such advice aids 
the audit client in determining the appropriate accounting for a 
transaction. However, an auditor may also provide such an opinion that 
is not used primarily by the audit client in the preparation of its 
financial statements, but rather to market a product to third parties. 
Does it impair the independence of the auditor when it issues an 
opinion on the application of an accounting principle that is used 
primarily to market a product to third parties?
    (xi) Tax services. The proposed rule would not affect tax-related 
services provided by auditors to their audit clients. Tax services are 
unique, not only because there are detailed tax laws that must be 
consistently applied, but also because the Internal Revenue Service has 
discretion to audit any tax return. We do not think that the 
Congressional purpose for requiring independent audits is thwarted by 
an accountant providing traditional tax preparation services to an 
audit client or an affiliate of an audit client.
    We are considering whether special considerations apply when the 
auditor provides a tax opinion for the use of a third party in 
connection with a business transaction between the audit client and the 
third party. The tax opinion may be vital in the audit client's efforts 
to induce the third party

[[Page 43173]]

to enter into the transaction, particularly when the transaction is 
tax-driven. Under those circumstances, the auditor may be acting as an 
advocate for the audit client by actively promoting the client's 
interests.
    We request comment on whether providing tax opinions, including tax 
opinions for tax shelters, to an audit client or an affiliate of an 
audit client under the circumstances described above would impair, or 
would appear to reasonable investors to impair, an auditor's 
independence. Should the rules provide that independence is impaired 
whenever the auditor provides any tax opinion or any tax opinion that 
will affect the audit client's financial statements? Does rendering a 
tax opinion to an audit client affect an auditor's independence 
considering an auditor must reach an opinion that the financial 
statements taken as a whole, including the tax accounts, are fairly 
presented? Are there circumstances in which providing audit clients 
with tax opinions should not be deemed to impair independence? Are 
there other tax-related services that if provided to an audit client, 
would impair, or would appear to reasonable investors to impair, an 
auditor's independence?
2. Alternatives
    We are considering a number of alternatives concerning scope of 
services. We encourage public comment on each alternative. We may adopt 
a rule based on one or more of these alternatives instead of the 
proposed rule or in combination with the proposed rule.
    As discussed above, some have suggested that auditors should be 
prohibited from providing any non-audit service to audit clients.\183\ 
We are considering drawing this bright line. This approach may provide 
investors with the greatest assurance of an auditor's independence. 
Some believe that such an approach should contain an exception, 
referred to as an exclusionary rule, that would permit non-audit 
services to be provided if: (i) Before any non-audit service is 
rendered to the audit client, the client's audit committee finds that 
special circumstances make it obvious that the best interests of the 
company and its shareholders will be served by retaining its audit firm 
or affiliate to render such non-audit service and that no other vendor 
of such service can serve those interests as well; (ii) a written copy 
of that finding is submitted promptly to the SEC and POB; and (iii) the 
company discloses such finding by the audit committee and the amount 
paid and expected to be paid to the audit firm or affiliate for such 
service in the company's next proxy statement for the election of 
directors.\184\
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    \183\ See supra note 38; The Panel on Audit Effectiveness 
(``O'Malley Panel''), Report and Recommendations: Exposure Draft, at 
ch. 5, p. 9 (May 31, 2000) (``O'Malley Report''). A copy of the 
O'Malley Report is available at www.pobauditpanel.org.
    \184\ Id. at 10.
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    Is a complete break between audit and non-audit services necessary 
to give investors confidence that auditors will act without bias and 
with complete objectivity and independence? Would a complete break be 
useful for instilling such confidence in investors? Is the exclusionary 
rule a reasonable alternative to a prohibition on non-audit services? 
How should the exclusionary rule be modified?
    We are also considering whether the rules should identify services 
that would not impair an auditor's independence. These would include 
services that are a natural outgrowth of the audit process, by building 
on information learned, and analyses conducted, during the audit. 
Examples might include business risk assessments, tax services, 
actuarial valuations of pension and other post-employment benefits or 
similar liabilities, consulting on the client's internal controls, and 
similar services. If we pursue this alternative, we might also include 
a provision stating that these services would nevertheless impair 
independence if they involved the auditor in making management 
decisions, operating the client's internal controls or information 
systems, marketing the client's products, or sharing risks or rewards 
with the client. We solicit comment on this alternative.
    We are also considering whether the independence problems raised by 
expanded non-audit services can be avoided by structuring a firm to 
segregate its audit and non-audit businesses into separate autonomous 
units. Under this approach, the audit, income tax, and certain 
consulting practices, such as financial advisory and business risk 
management services, would be placed into an ``audit entity.'' 
Information and computer technology services, e-commerce, business 
process reengineering, strategic planning, and other remaining 
consulting practices would be placed into a separate ``consulting 
entity.'' Each entity would be managed by individuals not associated 
with the other entity. Both the audit entity and the consulting entity 
would be owned and to some extent governed by a common partnership or 
corporation (``holding entity''), whose board and management would be 
elected by the respective subsidiary entities. Partners of the audit 
entity and the consulting entity would own the holding entity.
    The holding entity board of directors could be structured to give 
either entity--or neither--a majority of representatives on the board. 
The holding entity would retain certain rights, including the right to 
approve significant transactions, investment, borrowings, or business 
alliances. The audit and consulting entities would enter into 
agreements not to compete with each other. In addition, the holding 
entity, the audit entity, and the consulting entity might share 
similar, but not identical names, such as ABC Global, ABC LLP, and ABC 
Consulting, respectively. Partners in the audit entity and consulting 
entity might market the other entity's services.
    In these arrangements, it is common that there would be some level 
of direct or indirect profit sharing between the audit and consulting 
entities. The amount of shared profits might depend on whether each met 
or fell below certain earnings targets. The impact of the profit 
sharing on an individual owner or partner in the audit or consulting 
entity would depend on his or her ownership interest in the respective 
entity. There could also be profit sharing between the audit entity and 
the consulting entity arising from investments made in other companies.
    We request comment on whether such a structure would create a 
sufficient ``firewall'' between the audit entity and the consulting 
entity such that the auditor's independence would not be impaired with 
respect to any services provided by the consulting entity. Are there 
other ways to construct a firewall that should prevent the consulting 
entity from being considered an affiliate of the audit entity for 
purposes of determining the audit entity's independence? Would the 
independence of the audit entity be impaired if the consulting entity 
entered into business relationships, such as strategic marketing 
alliances, with an audit client of the audit entity? Would the 
independence of the audit entity be impaired if it continued to provide 
consulting services that generated revenues or profits that were 
material to the audit entity? Would the independence of the audit 
entity be impaired if the consulting entity acquired either material or 
immaterial investments in clients of the audit entity? Would the audit 
entity's independence be impaired if clients of the audit entity 
invested in the consulting entity?

[[Page 43174]]

    We could require the audit entity and consulting entity to have 
completely separate management and financial operations, not to ``co-
brand'' or use similar names or logos, not to share more than a de 
minimis amount of revenues or earnings (no organization's or partner's 
earnings would change by more than three percent annually), not to have 
an equity interest in each other, and not to be contractually or 
otherwise obligated to refer clients to one another. We request comment 
on whether any or all of these requirements would suffice to prevent 
impairments to the audit entity's independence resulting from 
activities or relationships of the consulting entity.
    Under the auditing literature, an auditor is required to discuss 
matters that may affect the audit with personnel responsible for 
providing non-audit services to the client-company.\185\ Does this 
requirement prevent the use of firewalls? Are investors harmed if 
communications between the audit and consulting entities are hindered? 
If communication is not hindered and there would remain a free flow of 
information between the audit and consulting entities, should we 
require other measures to assure independence of the auditors? If we 
were to pursue this alternative, are there other conditions that should 
be considered?
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    \185\ AICPA SAS No. 22, AU Sec. 311.04b and AUI Sec. 9311.03.
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    We are also considering an alternative that would provide that non-
audit services impair independence only when the aggregate fees for 
those services surpass a certain level in relation to the audit fee. 
For example, we could adopt a rule stating that an auditor's 
independence would be impaired if the fees for all non-audit services 
(excluding tax services) during the most recent fiscal year, and the 
fiscal year in which the services would be provided, were or would be 
more than 25 percent of the fee for the audit of the client's financial 
statements. Does the size of the consulting fees relative to audit fees 
affect independence? Is the proposed fee comparison an appropriate 
measure by which to determine whether independence is impaired? If not, 
what level of non-audit service fees, relative to audit fees, should 
trigger an impairment of independence?
    We also solicit comment on whether not to preclude certain non-
audit services, but instead to require companies to disclose 
substantial information about all the non-audit services received from 
their auditors. Under this alternative, investors, and not regulators 
or other interested parties, would decide whether their perceptions of 
auditor independence were affected by the provision of non-audit 
services to audit clients. Is disclosure alone sufficient to preserve 
investor confidence in financial information? Can an impairment of 
auditor independence be avoided merely by disclosing it?
    Several of the largest accounting firms have announced that they 
have sold, or intend to sell, certain non-audit service lines. We 
solicit comments relating to those developments and their bearing on 
this proposed rule. Will the economic forces that gave rise to these 
transactions cause all or most major accounting firms to divest all or 
a portion of their consulting service lines? Will economic forces cause 
those accounting firms that have divested certain consulting service 
lines to create similar service lines in the future?
3. Transition
    We recognize that adoption of the proposed rules could require a 
registrant to decide between continuing to engage an auditing firm to 
audit its financial statements and continuing to engage that firm to 
provide certain non-audit services. It may not be feasible for the 
registrant and the auditor to cease all ongoing or scheduled non-audit 
engagements immediately. The company may need time to find a new 
provider of those services, to complete works in progress, and to 
provide for a smooth transition from one provider of services to 
another.
    As a result, we propose to include a transition period of two 
years. Under the proposal, for the two years following the effective 
date of the rule, providing the non-audit services set forth in 
subsection (c)(4)(i) to an audit client or an affiliate of an audit 
client will not impair an accountant's independence from the audit 
client, if the following holds true: (i) The non-audit services are 
performed pursuant to a written contract in effect on or before the 
effective date of this rule; and (ii) performing those services would 
not impair the auditor's independence under pre-existing requirements 
of the Commission, the ISB, or the U.S. accounting profession. We 
believe that two years provides a reasonable time period for the 
auditor and the audit client to make the necessary elections and 
conform to the new rules.
    We solicit comment on the proposed transition provisions. Do the 
proposed transition provisions allow an adequate period for 
implementation? Should the period be longer? If so, how long and why? 
Could the period reasonably be shorter? If so, what is the shortest 
transition period that we could reasonably adopt? Are there any 
conditions other than the two specified in the proposed rule that 
should be satisfied in order for the services specified in section 2-
01(c)(4)(i) not to impair independence during the transition period? 
Should the condition described in section (c)(4)(ii)(A)--that the non-
audit services performed during the transition period be pursuant to a 
written contract in effect on or before the effective date of the 
rule--require that the contract be in writing?

E. Contingent Fees

    Proposed rule 2-01(c)(5) provides that an accountant is not 
independent under the standard of paragraph (b) of the rule if the 
accountant provides any service to an audit client or an affiliate of 
an audit client for a contingent fee, or receives a contingent fee from 
an audit client or an affiliate of an audit client. Contingent fee 
arrangements will typically result in the auditor having a mutual 
interest with the client. If, for example, a firm arranged to receive 
an audit fee of $200,000, but half of that fee was contingent upon the 
audit client successfully completing an initial public offering within 
the following year, the auditor would have a mutual interest with the 
audit client in the success of the client's planned IPO, and in the 
continuing viability of the audit client. That mutuality of interest 
could influence the auditor's conduct of the audit.
    A ``value added'' fee may be another example of a contingent fee 
arrangement that presents independence problems. An accounting firm 
might arrange to provide a non-audit service to a client for a ``value 
added'' fee, meaning that the amount of the fee will depend upon the 
additional value, profit, or other benefit recognized by the client 
because of the non-audit service. For example, an audit may undertake a 
study of certain types of a client's expenditures in order to identify 
greater amounts of qualifying expenses that would result in greater 
income tax credits. Fees for such services might be based on a 
percentage of the tax credits generated, a base fee plus a percentage 
of tax credits generated over a pre-determined base amount, or a base 
fee plus a ``value added'' amount to be added to the base fee.
    The accounting firm will have an interest in a high valuation of 
the benefit to the client from the service that had been provided for a 
contingent fee. In the situation described above, the accounting firm's 
economic benefit will be greater if the tax credits are maximized, a 
position that is

[[Page 43175]]

inconsistent with an auditor who would have to act independently in 
assessing the accuracy of the impact on the income tax accounts and 
financial statements of the tax credits.
    Rule 302 of the profession's ethics rules states that an AICPA 
member may not receive a contingent fee for the performance of any 
service. The AICPA Rule further states:

    [A] contingent fee is a fee established for the performance of 
any service pursuant to an arrangement in which no fee will be 
charged unless a specified finding or result is attained, or in 
which the amount of the fee is otherwise dependent upon the finding 
or result of such service. Solely for purposes of this rule, fees 
are not regarded as being contingent if fixed by courts or other 
public authorities, or, in tax matters, if determined based on the 
results of judicial proceedings or the findings of governmental 
agencies.\186\

    Contingent fees are not specifically mentioned in our current 
regulations, though contingent fees are prohibited by the AICPA 
Rules.\187\ In view of the increase in consulting activities and 
business relationships among accounting firms, their affiliates, and 
SEC registrants, however, we believe that it is advisable to state 
explicitly in the proposed rule that receiving contingent fees from an 
audit client impairs the auditor's independence.\188\ Consistent with 
the AICPA Rule, however, our proposed definition of ``contingent 
fees,'' in proposed rule 2-01(f)(12), contains an exception for fees 
that are fixed by courts or by federal, state, or local governments.

    \186\ AICPA Code of Professional Conduct, ET Sec. 302.01.
    \187\ Under our current Codification, however, a contingent fee 
might constitute a financial interest in an audit client. For 
example, Codification Sec. 602.02.b.v. states in part:
    If fees for audit and other professional services are owed to an 
accountant for an extended period of time and become material in 
relation to the fee expected to be charged for a current audit, 
there may be a question concerning the accountant's independence 
with regard to the current audit because the accountant may appear 
to have a direct interest in the results of operations of the 
client. Generally, prior year audit and other unpaid fees should be 
paid before a current audit engagement is commenced in order for the 
accountant to be deemed independent with respect to the current 
audit. (Emphasis added.)
    \188\ The staff has become aware of an increasing number of 
situations where firms are sharing with their consulting clients the 
risk that the firm's advice will add value to the project or 
transaction. In such situations, the firms are paid through 
contingent fees or similar arrangements, or payments to the firm may 
be deferred until contemplated transactions occur or benefits from 
the project begin to be realized. If the consulting client is also 
an audit client, however, these payment mechanisms would be 
considered to be contingent fees and impair the firm's audit 
independence.
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    We solicit comment on whether contingent fee arrangements impair, 
or would appear to reasonable investors to impair, an auditor's 
independence. Are there circumstances in which, or particular types of 
services for which, a contingent fee arrangement would not impair 
independence?
    We also solicit comments on whether our proposed definition of 
contingent fees is adequate. For example, an auditor might charge an 
audit client fees for professional services priced significantly below 
market price with the expectation of higher fees in connection with or 
after a securities offering. Though these arrangements may involve no 
legal obligations between the parties, they could have the same effect. 
Should our definition of ``contingent fees'' include fees that are 
substantially below the fair market value of the services provided? Are 
there fee arrangements, such as commissions, that are not included 
within the proposed definition but that should be included because they 
would impair an auditor's independence? Should the exception for fees 
fixed by courts or public authorities be deleted?

F. Quality Controls

    Paragraph (d) of the proposed rules establishes a limited exception 
for accounting firms that maintain certain quality controls and satisfy 
certain conditions. We are proposing this exception to encourage 
accounting firms to adopt internal quality controls that ensure the 
independence of the firm's auditors. In addition, we are proposing this 
section so that accounting firms that have appropriate controls will 
not be deemed to lack independence when the particular auditor did not 
know, and was reasonable in not knowing, the circumstances giving rise 
to the impairment.
    Notwithstanding attempts to maintain independence, we recognize 
that situations may arise where an accountant's independence 
inadvertently becomes impaired. A covered person's independence may be 
impaired, for example, because his or her family member made an 
investment in an audit client and the covered person was not aware of 
the investment. We propose, therefore, that in certain situations an 
accounting firm's independence will not be impaired if: (i) The covered 
person did not know, and was reasonable in not knowing, the 
circumstances that gave rise to the lack of independence; \189\ (ii) 
the covered person's lack of independence was corrected promptly after 
the covered person or the accounting firm became aware of it; and (iii) 
the accounting firm maintains a quality control system that provides 
reasonable assurance that the accounting firm and its employees do not 
lack independence.
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    \189\ The exception does not apply to situations where the 
covered person was aware of the circumstances but did not know that 
the circumstances impaired the covered person's independence.
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    The third condition for the exception--a quality control system--is 
the first line of defense to guard against independence impairments 
with respect to a client. We understand that accounting firms vary 
significantly in size and in the nature of their practices, and we 
propose that the quality controls that the firm establishes be tailored 
to the firm's size and practice.
    Proposed rule 2-01(d)(3)(i)-(vii) describe the elements of a 
quality control system that large accounting firms that audit public 
companies must have in place to qualify for the limited exception.\190\ 
Many of these elements are set forth in a 1999 letter from our staff to 
the SECPS.\191\ In the letter, the staff noted that the requirements 
reflect procedures that many accounting firms are implementing or 
already following. While the proposed rules would require only large 
firms to incorporate these elements in their control systems to qualify 
for the limited exception, we encourage all firms to adopt them and 
note that, depending on firm size and the nature of its practice, some 
of these elements may be essential to a quality control system. We 
discuss those elements here.\192\
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    \190\ Under the proposed rule, these procedures apply to those 
firms that have as clients 500 or more companies that have a class 
of securities registered with us under Section 12 of the Exchange 
Act, 15 U.S.C. Sec. 78l.
    \191\ See Letters from Lynn Turner to Michael Conway, supra note 
70. The SECPS adopted independence quality control membership 
requirements in April 2000.
    \192\ The quality control policies and procedures would consist 
of policies and procedures for the accounting firm. Proposed rule 2-
01(d)(3)(i). Under the proposed rules, the term accounting firm 
includes affiliates of the firm. Proposed rule 2-01(f)(2). The 
definition of affiliate of the accounting firm would include, among 
other things, all persons and entities with which the firm is 
publicly associated by co-branding or using the firm's name, 
initials, or logo. Proposed rule 2-01(f)(4)(E). One effect of this 
provision, therefore, is that the term accounting firm would include 
all of the firm's affiliates worldwide. We expect that the written 
policies and procedures, therefore, would apply to the firm and its 
affiliates worldwide. See Letters from Lynn Turner to Michael 
Conway, supra note 70.
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1. Written Independence Policies and Procedures
    The largest firm's independence policies and procedures must be 
reduced to writing. We expect that the policies and procedures would be 
comprehensive and would cover all professionals in the accounting firm 
and

[[Page 43176]]

address all aspects of independence, including financial, employment, 
and business relationships, and fee arrangements.
2. Automated Systems
    Large firms must have automated systems to identify financial 
relationships that may impair independence. We expect that these 
systems would provide a reasonable basis for tracking audit clients and 
financial investments by firm professionals. We anticipate that large 
firms will employ a sophisticated electronic system updated on a 
regular basis that would allow employees to post their investments to 
the system, and that would maintain a list of employee holdings and 
check them against a current list of clients. We propose to require 
these systems track only financial relationships.
3. Training
    Large firm quality controls also must include annual or ongoing 
firm-wide training about auditor independence. This training should be 
designed to raise awareness and understanding of the applicable rules. 
Each professional in a large accounting firm should be able to 
demonstrate a minimum level of competence with respect to professional 
standards, legal requirements, and firm policies and procedures.
4. Internal Inspection and Testing
    An internal inspection and testing program to monitor adherence to 
independence requirements is an important part of quality controls. To 
qualify for the limited exception, large firms must monitor compliance 
by their firm, their firm partners and their firm professional 
employees with the applicable independence rules of the profession, 
standard setters, and other regulatory bodies. This would entail 
procedures to audit, on a test basis, the completeness and accuracy of 
information submitted by employees and partners, and information in a 
client investment database. We expect that firms would have policies, 
procedures, and controls to monitor the investments of the firm itself 
and its pension and retirement plans, and any business arrangements 
with firm clients. We encourage firms to monitor compliance with their 
own policies and procedures as well.
5. Notice of Names of Senior Management Responsible for Independence
    We also propose to require, with respect to large firms, that all 
firm members, officers, directors, and employees be notified of the 
name and title of the member of senior management responsible for 
compliance with the independence requirements. This would require firms 
to assign responsibility to members of senior management for ensuring 
compliance with the independence rules.
6. Prompt Reporting of Employment Negotiations
    A firm professional would not be independent if he or she were to 
audit a client while simultaneously negotiating employment with that 
client. The quality control system of a large firm, therefore, would 
contain written policies and procedures to require firm professionals 
to report promptly to the firm as soon as they begin employment 
negotiations with an audit client. The large firm also would have 
appropriate procedures in place to remove any such professional from 
that audit client's engagement immediately and to review that 
professional's work related to that client.
7. Disciplinary Mechanism
    Finally, we propose to require that large firms' quality control 
systems also have a disciplinary mechanism for enforcement.
    We request comment on whether these are the appropriate elements of 
an effective quality control system. Are there other quality controls 
that should be required? For example, are these quality controls 
sufficient to address all situations where the audit firm leases 
personnel? Under the proposed rules, these procedures apply to those 
firms that have as clients 500 or more companies registered with us 
under section 12 of the Exchange Act. Is 500 the appropriate number? Is 
there another test that we should use to determine which firms must 
adhere to these procedures to qualify for the exception? We request 
comment on whether these are the appropriate controls on which to 
condition the exception, or whether other conditions would be 
appropriate.
    The Big 5 firms are comprised of both U.S. and foreign members. 
Should these quality controls apply to both U.S. and the foreign firms? 
Do the foreign firms require a transitional or phase-in period? Should 
the exception also be provided to a firm that has adopted the specified 
quality controls, but did not know and was reasonable in not knowing 
that a partner or employee lacked independence, and the lack of 
independence was cured promptly after the firm became aware of it? 
Should the term ``promptly'' be defined in terms of a period of time?

G. ``All Relevant Circumstances''

    Proposed rule 2-01(e), reciting the standard currently found in 
current Rule 2-01(c), provides that we will look to all relevant 
circumstances in making independence determinations, including all 
relationships between the accountant and the audit client or its 
affiliates, and will not confine ourselves solely to the relationship 
between the audit client and the corporate entity whose name appears on 
the audit client's filing. Reasonable investors would consider all 
appropriate circumstances in evaluating an auditor's independence. 
Paragraph (e) of the proposed rule expresses this principle and makes 
clear that an independence determination cannot be based on an 
artificially limited set of the relevant facts.
    We solicit comment on paragraph (e). Does paragraph (e) adequately 
capture the relevant circumstances for making an independence 
determination? Are there other considerations that should be expressly 
mentioned in this paragraph?

H. Proxy Disclosure Requirement

    We are proposing to reinstate a proxy disclosure requirement. The 
proposed proxy disclosure requirement varies somewhat from the proxy 
disclosure requirement rescinded in 1982. Like the 1979-82 proxy 
disclosure requirement, the proposal would require companies to: (i) 
Describe specifically each professional service provided by its 
auditor, and (ii) indicate whether the company's audit committee or, 
where no such committee exists, board of directors approved the service 
and considered the effect that the provision of each disclosed service 
could have on the auditor's independence.\193\ We are proposing to 
require disclosure of the specific non-audit services provided by an 
auditor to an audit client because we believe that an investor needs 
the information to form a judgment about independence. We also believe 
that investors will be aided by disclosure as to whether the audit 
committee or board of directors considered this issue: Among other 
things, this information will enable investors to make judgments about 
whether their interests have been adequately considered by the audit

[[Page 43177]]

committee or whether the investors should make further inquiry.
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    \193\ The O'Malley Panel has recommended that audit committees 
pre-approve non-audit services that exceed a threshold determined by 
the committee. This recommendation is consistent with the 
recommendations of the Blue Ribbon Committee regarding auditors' 
services. The Panel set forth factors for audit committees to 
consider in determining the appropriateness of a service. See 
O'Malley Report, supra note 183, at ch. 5, pp. 7-8.
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    Unlike the earlier proxy disclosure requirement, the current 
proposal would require companies to disclose the fee paid for each non-
audit service and the aggregate audit fee for the most recent fiscal 
year. Additional disclosures would be required only if a company's 
auditor leased or otherwise acquired from another entity the 
professionals it needed to perform a majority of the audit of the 
company's financial statements.
1. Disclosure of Fees
    The proposal would generally require a company to disclose the fee 
paid for each non-audit service performed by its auditor and the fee 
charged for the annual audit. An exception to these general disclosure 
requirements is that issuers would not have to describe a non-audit 
service, nor disclose the fee for that service, if the fee was less 
than $50,000 or ten percent of the company's audit fee, whichever is 
smaller. We are proposing this exclusion to allow companies to avoid 
disclosure of de minimis items.
    Earnscliffe asked respondents in its survey whether disclosure 
could potentially improve auditor independence. ``A fair number of 
[respondents] advocated a requirement of full disclosure as a way to 
both deter an unhealthy relationship between auditor and client, and to 
inform investors of any risks related thereto.'' \194\ Like the 
respondents surveyed, we believe that disclosure could have a positive 
impact on auditor independence.
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    \194\ Earnscliffe Report, supra note 10, at 33.
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    We note that, in this area, the United Kingdom has long required 
disclosure of annual audit fees, and since 1989, it has required 
disclosure of fees for non-audit services provided by their auditors. 
``The [British] government believes that the publication of the 
existence of, and extent of, non-audit consultancy services provided to 
audit clients will enable shareholders, investors, and other parties to 
judge for themselves whether auditor independence is likely to be 
jeopardized.'' \195\
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    \195\ Michael Firth, ``The Provision of Nonaudit Services by 
Accounting Firms to their Audit Clients,'' Contemporary Accounting 
Research, at 6 (Summer 1997). Firth hypothesized that companies with 
potentially high agency costs (i.e., companies in which directors do 
not control management or which have a large amount of debt) would 
limit the non-audit services provided by their auditors because the 
appearance of a lack of auditor independence would increase their 
cost of capital. Firth's findings were consistent with his 
hypothesis.
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    We request comment on whether the disclosure requirement will be 
useful to investors and enhance auditor independence. Will disclosure 
impede the ability of audit client's to obtain valuable non-audit 
services or have any negative affect? We also request comment on 
whether the disclosure regarding the approval of the audit committee 
should be made by the audit committee in its report under Item 306 of 
Regulation S-K. Is the information required to be disclosed appropriate 
or should other information be required? Should we require companies to 
disclose separately the fee paid for tax services? For example, should 
we require companies to disclose fees by a range in which they fall? 
Would the disclosure of audit and non-audit fees be more appropriate in 
Form 10-K (for example, for all companies or for those companies that 
are not required to prepare proxy statements or information statements) 
or footnotes to the financial statements, as done in the U.K.?
    We further request comment on the exclusion for non-audit services 
that cost the lesser of $50,000 or ten percent of a company's annual 
audit fee. Should we set different levels for this de minimis 
exclusion? If so, what should these levels be? What is the appropriate 
scope of the exclusion? As proposed, the disclosure requirement applies 
only to the registrant. In the case of an investment company complex, 
should the rule extend beyond the registrant to require disclosure of 
all of the professional services that are provided to the investment 
company complex?
2. Leased Personnel
    Under the proposal, a company would have to disclose if its 
principal auditor leased or otherwise acquired from another entity the 
personnel it needed to perform a majority of the audit of the company's 
financial statements. This disclosure requirement responds to the 
recent move by accounting firms to sell their non-audit practices to 
financial services companies. Often in these transactions, the partners 
and employees become employees of the financial services firm. The 
accounting firm in essence becomes a ``shell'' that then leases assets, 
namely professional auditors, back from those companies to complete 
audit engagements. In such an arrangement, audit professionals become 
full-or part-time employees of the financial services company, but work 
on audit engagements for their former accounting firm. They receive 
compensation from the financial services firm and in some situations 
from the accounting firm.\196\ We believe that investors should be 
informed when individuals who have personal interests that may affect 
their objectivity are performing the bulk of the audit. \197\
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    \196\ The ISB cites threats to independence arising from these 
structures and identifies quality controls to ensure the 
independence of the auditors in these situations. See ISB, 
``Discussion Memorandum 99-2: Evolving Forms of Firm Structure and 
Organization,'' at 20 (Oct. 1999).
    \197\ AICPA SAS No. 1, AU Sec. 543 also sets forth guidance on 
when a principal auditor discloses and makes reference to another 
auditor who performs an audit of a component of the entity.
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    We request comment on the proposal to require disclosure when the 
principal audit firm signing the audit opinion uses personnel from 
another entity to perform a majority of the work on the audit 
engagement.

I. Definitions

    In this section of the release, we provide a more detailed 
explanation of those defined terms not discussed in the preceding 
sections. Proposed rule 2-01(f) provides definitions of certain terms 
used in rule 2-01. These definitions apply only to rule 2-01 and not to 
other sections of Regulation S-X. Rule 1-02 of Regulation S-X provides 
definitions of terms used in the remainder of Regulation S-X. Are the 
different scopes of the two sets of definitions sufficiently clear, or 
should we amend current Rule 1-02 to make it explicit?
1. ``Accountant''
    Proposed rule 2-01(f)(1) defines the term ``accountant.'' The 
proposed rules are written in terms of an accountant's independence 
from the audit client. The definition of ``accountant'' set forth in 
Rule 2-01(f) includes the accounting firm in which the auditor 
practices and, accordingly, makes clear that an individual accountant's 
lack of independence may be attributed to the firm.
2. ``Accounting Firm''
    Proposed rule 2-01(f)(2) is the first of several definitions that 
are used to describe the entities or groups whose actions may cause an 
accountant to lack independence. The ``accounting firm'' includes the 
organization (whether organized as a partnership, corporation, limited 
liability company, or otherwise) that is engaged in the practice of 
public accounting or furnishing accountant's reports with respect to 
financial statements, reports, or other documents filed with the 
Commission, and all of the firm's divisions, subsidiaries, and 
departments. The definition also includes all ``affiliates of the 
accounting firm,'' including its pension, retirement,

[[Page 43178]]

investment, or similar plans. The definition of ``affiliate of the 
accounting firm'' is discussed below.
    The ``accounting firm'' does not include individual partners or 
employees of the firm. For the purposes of these independence rules, we 
are proposing that a distinction be made between investments in which 
the ``accounting firm'' has the primary legal rights or obligations, 
and investments in which individual partners or employees have the 
primary legal rights or obligations.
3. ``Affiliate of the Accounting Firm''
    Proposed rule 2-01(f)(4) defines ``affiliate of the accounting 
firm.'' \198\ This definition attempts to capture those entities that 
are financially tied to or otherwise associated with the accounting 
firm enough to warrant being treated like the accounting firm for 
purposes of our independence requirements. While part of the definition 
draws on the definition of ``affiliate'' used in other areas of the 
securities laws, the definition is broader than those other provisions.
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    \198\ As noted above, the definitions used in the rest of 
Regulation S-X, including the definition of ``affiliate,'' would not 
apply to proposed Rule 2-01.
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    Proposed rule 2-01(f)(4)(i)(A) states that an ``affiliate of the 
accounting firm'' includes any person controlling, controlled by, or 
under common control with the firm, shareholders of more than five 
percent of the firm's voting securities (or similar interests entitling 
a person to vote), and entities five percent or more of whose 
securities (or similar interests entitling a person to vote) are owned 
by the firm. The rule also includes any officer, director, partner, or 
co-partner of any of the foregoing entities, or persons. This portion 
of the definition is based generally on the provisions in section 
2(a)(3) of the ICA \199\ and the definition of ``affiliate'' in 
Regulation S-X.\200\
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    \199\ 15 U.S.C. Sec. 80a-2(a)(3).
    \200\ 17 CFR 210.1-02(b). We request comment on whether all 
investments and relationships of an affiliate of an accounting firm, 
as described in the preceding paragraph should be attributed to the 
audit firm for purposes of evaluating its independence from its 
audit clients. Should the answer depend upon the percentage of the 
accounting firm's securities (or similar voting interests) that the 
affiliate owns? If the latter, at what percentage of ownership 
should we draw the line beyond which independence is impaired, and, 
accordingly, draw the line by which we define ``affiliate of the 
accounting firm?'' If the ``affiliate'' holding the ownership 
interest is an entity, should the definition of ``affiliate of the 
accounting firm'' also include any officer, director, partner, co-
partner or shareholder of more than five percent of the voting 
securities of that entity? Does the proposed definition identify all 
persons that should be considered affiliates for purposes of 
determining impairments to independence?
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    Paragraphs (C) through (F) of proposed rule 2-01(f)(4)(i) describe 
those who are ``affiliates of the accounting firm'' because they are 
business partners of the accounting firm. In general, these include 
certain: (i) Joint ventures in which the accounting firm participates, 
(ii) entities that provide non-audit services to the accounting firm's 
audit clients and with which the accounting firm has certain financial 
interests or relationships, and (iii) entities involved in ``leasing'' 
professional services to the accounting firm for their audits. The 
definition also includes all other entities with which the accounting 
firm is publicly associated in certain ways.\201\
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    \201\ There is also an exception from the definition of 
``affiliate of the accounting firm'' for certain persons or entities 
with which the accounting firm shares services, such as training or 
billing facilities. Proposed rule 2-01(f)(4)(ii).
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    The category of joint ventures and partnerships takes into account 
recent changes in accounting firms' structures and alliances with third 
parties. It generally would attribute to the auditor actions and 
interests of certain entities in joint ventures or partnerships in 
which the parties agree to share revenues, ownership interests, 
appreciation, or certain other shared economic benefits. The category 
is based on the notion that such agreements create a mutuality of 
interest between the auditor and its partner or shareholder because the 
revenue or profits accruing to each party depend, to some degree, on 
the efforts of each. Their interests are wedded.\202\ Accordingly, 
under the proposals, the business partner's relationships with or 
interests in the accounting firm's audit clients would be attributed to 
the auditor.
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    \202\ See generally, Letter from Jonathan G. Katz to Duane R. 
Kullberg, supra note 40, at 4.
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    The definition of ``affiliate of an accounting firm'' also includes 
any entity that provides non-audit services to an audit client, if the 
accounting firm has an equity interest in, shares revenues with, loans 
money to, or if any covered person has certain direct business 
relationships with, the consulting entity. Under these circumstances, 
the actions and investments of the consulting entity are fairly 
attributed to the accounting firm because the accounting firm's 
interest in the consulting entity creates a mutuality of interest in 
the promotion and success of the entity's consulting projects.
    The proposed definition of ``affiliate of the accounting firm'' 
also attributes to the auditor the actions and interests of persons 
``co-branding'' or using the same (or substantially the same) name or 
logo, cross-selling services, or using co-management. Where the auditor 
has taken steps to identify itself publicly with another person, the 
auditor shares, and will be perceived to share, a mutuality of interest 
with that other person.
    Would the relationships described in the preceding three paragraphs 
impair, or appear to reasonable investors to impair, an auditor's 
independence? Are there any that should be excluded from the definition 
of ``affiliate of the accounting firm'' for purposes of determining 
impairments to independence?
    The proposed definition of ``affiliate of the accounting firm'' 
also addresses the situation where full- or part-time employees of an 
entity other than the firm signing the audit report perform a majority 
of the audit engagement. The proposal provides that if an auditor 
``leases'' personnel from an entity to perform audit procedures or 
prepare reports to be filed with the Commission, and the ``leased'' 
personnel perform a majority of the hours worked on the engagement, 
then the actions and interests of the ``lessor,'' the lessor's board of 
directors, executive officers, persons with responsibility for 
management, quality control, or technical supervision over the leased 
personnel, and shareholders of five percent or more of the lessor's 
securities, are attributed to the audit firm. In these situations, we 
believe that this proposal strikes a balance between those entities and 
persons who reasonably could influence the auditor and the audit 
process, and those who may be associated with the lessor but have no 
real or perceived ability to influence the audit.
    Would the relationships described in the preceding paragraph 
impair, or appear to reasonable investors to impair, an auditor's 
independence? Does the answer depend upon the percentage of the hours 
worked on the engagement that are attributable to leased personnel? If 
so, where should the line be drawn and why?
    Finally, the proposed definition of ``affiliate of the accounting 
firm'' excludes persons whose sole business relationship with an 
accounting firm is to share certain services or facilities, such as a 
joint training facility or billing office, so long as neither the 
auditor nor the other person profits from the shared services. The 
latter restriction is necessary to assure that the auditor and audit 
client have not joined together in a profit-seeking venture.
    We seek comment on the proposed definition of ``affiliates of an 
accounting firm.'' Should persons or entities other

[[Page 43179]]

than those identified in the proposed rule be included as affiliates?
4. ``Affiliate of the Audit Client''
    Proposed rule 2-01(f)(5) defines ``affiliate of an audit client'' 
as any entity that has ``significant influence'' over the audit client, 
or any entity over which the audit client has significant influence. 
The definition thus makes clear that it covers both ``upstream'' and 
``downstream'' affiliates of the audit client, including the audit 
client's corporate parent and subsidiary.
    We use the term ``significant influence'' in the definition to 
signal that the ``affiliates of an audit client'' should be determined 
in light of the principles in Accounting Principles Board (``APB'') 
Opinion No. 18. \203\ APB No. 18 clarifies the term ``significant 
influence.'' This accounting literature recognizes that ``significant 
influence'' can be exercised in several ways: representation on the 
board of directors; participation in key policy decisions; material 
inter-company transactions; interchange of personnel; or other means. 
APB No. 18 also recognizes that an important consideration is the 
extent of the equity investment, particularly in relation to the 
concentration of other investments. In order to provide a reasonable 
degree of uniformity in application of this standard, the Board 
concluded that,
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    \203\ APB Opinion No. 18, ``The Equity Method of Accounting for 
Investments in Common Stock'' (Mar. 1971).

    [A]n investment (direct or indirect) of 20% or more of the 
voting stock of an investee should lead to a presumption that in the 
absence of evidence to the contrary an investor has the ability to 
exercise significant influence over an investee. Conversely, an 
investment of less than 20% of the voting stock of an investee 
should lead to a presumption that an investor does not have the 
ability to exercise significant influence unless such ability can be 
demonstrated.\204\
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    \204\ Id.para. 17.

    We believe that the ``significant influence'' test is appropriate 
because it results in the marriage of financial information between the 
audit client and the entity influenced by, or influencing, the 
financial or operating policies of the audit client, including those 
over which the audit client has control or that control the audit 
client. Should we, however, consider a different definition of an 
``affiliate of an audit client?'' What other test would be appropriate? 
Rather than using a test that sets a presumption of influence at an 
equity investment of 20%, is a different investment threshold more 
appropriate? Should it be higher or lower, and why?
5. ``Audit and Professional Engagement Period''
    The proposed definition of ``audit and professional engagement 
period'' uses language from current Rule 2-01(b) and indicates that the 
auditor must be independent during the period covered by any financial 
statements being audited or reviewed (the ``audit period''), and during 
the period that the auditor is engaged either to review or audit 
financial statements or to prepare a report (the ``professional 
engagement period''). The proposed definition also provides that the 
``professional engagement period'' begins when the auditor signs the 
initial engagement letter or begins review or audit procedures, 
whichever is earlier, and ends when the registrant or the accountant 
notifies the Commission that the registrant is no longer the 
accountant's audit client.
    The proposed definition makes clear that we agree with the 
``auditor of record'' notion described in AICPA Ethics Ruling 101-1. 
That ruling states:

    The period of a professional engagement starts when the [AICPA] 
member begins to perform any professional services requiring 
independence for an enterprise, lasts for the entire duration of the 
professional relationship, which could cover many periods, and ends 
with the formal or informal notification of the termination of the 
professional relationship either by the member, by the enterprise, 
or by the issuance of a report, whichever is later. Accordingly, the 
professional engagement does not end with the issuance of a report 
and recommence with the signing of the following year's 
engagement.\205\
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    \205\ AICPA Code of Professional Conduct, ETSec. 101.02.

    We solicit comment on the proposed definition. Does the proposed 
definition cover the appropriate period? Is the definition appropriate 
for all situations in which the professional engagement ends or do we 
need to provide an alternative definition for some types of 
registrants, such as foreign private issuers, or for certain types of 
engagements? Could this portion of the definition be made more specific 
by referring to Form 8-K or other Commission filings?
6. ``Audit Client''
    The term ``audit client'' is defined in proposed rule 2-01(f)(7) as 
the entity whose financial statements or other information is being 
audited, reviewed, or attested. This is how ``audit client'' is 
commonly used. Use of the term ``audit client'' in this rule in no way 
changes our position that the auditor ``owes ultimate allegiance to the 
corporation's creditors and stockholders, as well as to the investing 
public.'' \206\
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    \206\ Arthur Young, supra note 19, at 818.
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7. ``Audit Engagement Team''
    Proposed rule 2-01(f)(8) defines the term ``audit engagement 
team.'' The ``audit engagement team'' includes the people in the 
accounting firm that are obviously in a position to influence the 
audit. Members of the ``audit engagement team'' are included within the 
category of ``covered persons in the firm,'' which is the term used to 
indicate the persons in the firm subject to a number of the specific 
rules in paragraph (c) of proposed rule 2-01.
    The ``audit engagement team'' includes all partners, principals, 
shareholders, and professional employees participating in an audit, 
review, or attestation engagement of an audit client, including those 
conducting concurring or second partner reviews, and all persons who 
consult, formally or informally, with others on the audit engagement 
team during the audit, review, or attestation engagement regarding 
technical or industry-specific issues, transactions, or events.
    We solicit comment on this definition. Should any other persons be 
included on the audit engagement team? Should any of the persons 
included on the audit engagement team not be included?
    Could the definition's inclusion of persons consulted on an audit 
create a disincentive for an auditor to seek, or for others to provide, 
assistance on an audit, and thereby adversely affect the quality of the 
audit? Is there a realistic possibility that auditors will be impeded 
significantly in their efforts to secure expert consulting assistance 
because experts would have to terminate any interest in the audit 
client before consulting? For example, XYZ Corp is an audit client of 
ABC Accounting Firm. Industry Expert A, who is not otherwise a covered 
person in the firm with respect to XYZ Corp, holds an investment in XYZ 
Corp. Accountant B, who is a covered person, seeks the advice of 
Industry Expert A. A declines to offer advice because liquidation of 
the investment would create adverse tax consequences. In situations 
like this, are there likely to be other industry experts in the firm 
without investments in the audit client that the accountant could 
consult? Should the definition of covered persons be limited to assure 
that all appropriate expertise is available for every audit engagement?

[[Page 43180]]

8. ``Chain of Command''
    Proposed rule 2-01(f)(9) defines the term ``chain of command.'' 
This term is defined broadly to refer to the group of people in the 
accounting firm who, while not directly on the audit engagement team, 
are capable of influencing the audit process either through their 
oversight of the audit itself or through their influence over the 
members of the audit engagement team. Like the ``audit engagement 
team,'' persons in the ``chain of command'' are included as ``covered 
persons in the firm,'' and therefore are subject to a number of the 
specific rules in paragraph (c) of proposed rule 2-01.
    Under the proposed definition, the ``chain of command'' includes 
all persons having any supervisory, management, quality control, 
compensation, or other oversight responsibility over either any member 
of the audit engagement team or over the conduct of the audit. It also 
includes all partners and managers who may review, determine, or 
influence the performance appraisal or compensation of any member of 
the audit engagement team and any other person in a position to 
influence the audit engagement team's decisions during the conduct of 
the audit, review, or attestation engagement.
    We solicit comment on the definition. Should additional persons be 
included in the chain of command? Should prominent partners, principals 
or shareholders in the firm, such as a chairman, CEO, member of the 
governance board, office managing partner or managing partner of the 
national technical office always be considered to be in the chain of 
command? Should any of the persons included in the chain of command not 
be included? Specifically, is it appropriate to include managers in 
this group? Is the definition capable of being consistently applied 
under different accounting firms' management structures?
9. ``Close Family Members''
    Proposed rule 2-01(f)(10) defines ``close family members'' to mean 
a person's spouse, spousal equivalent, parent, dependent, nondependent 
child, and sibling. These terms should be understood in terms of 
contemporary family relationships. Accordingly, ``spouse'' means a 
husband or wife, whether by marriage or under common law; ``spousal 
equivalent'' means a cohabitant occupying a relationship generally 
equivalent to that of a spouse; ``parent'' means any biological, 
adoptive, or step parent; ``dependent'' means any person who received 
more than half of his or her support for the most recent calendar year 
from the relevant covered person; ``child'' means any person recognized 
by law as a child or step-child; and ``sibling'' means any person who 
has the same mother or father.
    ``Close family members'' includes the persons separately defined as 
``immediate family members'' (spouse, spousal equivalent, and 
dependent), and adds certain family members who may, as a general 
matter, be thought to have less regular, but not necessarily less 
close, contact with the covered person in question (parent, 
nondependent child, and sibling). One of our reasons for distinguishing 
the two groups is that the less immediate the family relationship to 
the covered person, the more substantial that family member's 
relationship to the audit client should be before we deem it to impair 
the auditor's independence.
    We considered whether we should follow this approach further and 
further into a covered person's family, making impairment depend upon 
increasingly substantial relationships to the audit client the further 
removed the family member is from the covered person. The proposed 
definition of ``close family members,'' for example, does not include 
in-laws.
    We solicit comment on the proposed definition of ``close family 
members.'' Should the definition include family members in addition to 
those proposed? Is the proposed definition too inclusive? Should we 
adopt some type of formula that would reach family members who are 
further removed from the covered person if those family members have 
substantial enough relationships to the audit client? How would such a 
formula work? Instead, are these situations appropriately handled under 
the general standards of paragraphs (b) and (c)(2) of the rule?
10. ``Covered Persons in the Firm''
    Proposed rule 2-01(f)(13) defines the term ``covered persons in the 
firm.'' The term includes four basic groups: (i) The ``audit engagement 
team;'' (ii) the audit engagement team's ``chain of command;'' (iii) 
any other professional employee of the accounting firm who is, or 
during the audit client's most recent fiscal year was, involved in 
providing any professional service to the audit client, its parents, 
subsidiaries, or other affiliates; and (iv) all other professional 
employees from an ``office'' of the accounting firm that participates 
in a significant portion of the audit.
    The ``audit engagement team'' and the ``chain of command'' are 
discussed above. We have also included as ``covered persons in the 
firm'' those professionals who provide consulting and non-audit 
services to the audit client. We did so because the auditing 
literature, quite appropriately, directs the audit engagement team to 
discuss certain matters with the firm personnel responsible for 
providing such services to that client. \207\
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    \207\ AICPA SAS No. 22, supra note 185.
---------------------------------------------------------------------------

    We have also included as ``covered persons in the firm'' all other 
professional employees from an ``office'' of the accounting firm that 
participates in a significant portion of the audit. (The definition of 
``office'' is separately discussed below.) We included these people 
because we believe they are generally in a position to influence the 
audit. They are the ones most likely to interact with the audit 
engagement team on substantive matters and to exert influence over the 
audit engagement team by virtue of their physical proximity to, or 
relatively frequent contact with, the audit engagement team.
    Nevertheless, under the proposal, an accounting firm employee in a 
distant part of the world, or even down the street, could own an audit 
client's securities, have a family member in a financial position at 
the client, or enter into a business relationship with a client without 
necessarily impairing the firm's independence from the audit client. We 
expect that many partners and employees who previously could not own 
securities issued by an audit client will be able to do so under the 
proposed rule. It should be noted that insider trading restrictions 
prohibit any partner, principal, shareholder, or employee of the firm, 
whether or not he or she performs any service for the client, from 
trading on any nonpublic information about that client. \208\
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    \208\ See ``Selective Disclosure and Insider Trading,'' 
Securities Act Rel. No. 7787 (Dec. 20, 1999). As discussed in 
footnote 109 of that release, an individual working at an accounting 
firm may be liable for insider trading for misappropriating 
information about a client, even if he or she did not perform 
services for that client.
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    We believe that the lines drawn in the proposed rule provide a 
reasonable balance between those who may and those who may not be able 
to influence the audit process for a particular client. In general, all 
those who may have a connection with, or directly or indirectly 
influence, the audit have been included.
    We solicit comment on the definition of ``covered persons in the 
firm.'' Are there other persons in the firm who should be included, 
such as all partners? Are there persons included in the definition who 
should not be

[[Page 43181]]

included? Is the concept of a ``significant portion of the audit'' 
sufficiently familiar to accountants to be a useful standard?
    A person who is not a covered person at the time an audit 
engagement begins may be consulted about the audit as the engagement 
progresses. Once consulted, that person becomes a member of the audit 
engagement team and, therefore, a covered person in the firm. That 
person must dispose of any financial interest in the audit client 
completely and irrevocably before participating in any discussion with 
another covered person concerning the audit engagement. The proposal 
would not allow the person consulted to participate in a discussion 
about the audit engagement and then ``cure'' an independence impairment 
by later disposing of his or her financial interest in the audit 
client.
    Likewise, a person may become a covered person by rotating on to an 
engagement or being promoted into the chain of command. In these 
situations, the person must also dispose of any financial interest in 
the audit client completely and irrevocably before becoming a covered 
person.
11. ``Immediate Family Members''
    Proposed rule 2-01(f)(15) defines ``immediate family members'' to 
mean a person's spouse, spousal equivalent, and dependent. These terms 
have the same meaning as they do in the definition of ``close family 
members.''
    ``Immediate family members'' is a narrower group than ``close 
family members.'' Again, part of our premise in distinguishing the two 
groups is that the less immediate the family relationship to the 
covered person, the more substantial that family member's relationship 
to the audit client should be before we deem it to impair the auditor's 
independence. By circumscribing the group of ``immediately family 
members,'' we mean to identify those persons who have such regular and 
close contact with a ``covered person,'' that it is fair, for 
independence purposes, to attribute to the covered person any financial 
and employment relationships that family member has with the audit 
client.
    We solicit comments on the definition of ``immediate family 
members.'' Should the definition include family members in addition to 
those proposed? Is the proposed definition too inclusive? Are there any 
qualifications that should be added to the definition, such as not 
including spouses who are separated from, and living apart from, the 
covered person?
12. ``Investment Company Complex''
    Proposed rule 2-01(f)(16) provides a definition of ``investment 
company complex'' that is loosely based on ISB Standard No. 2. ISB 
Standard No. 2 defines ``mutual fund complex'' to mean ``[t]he mutual 
fund operation in its entirety, including all the funds, plus the 
sponsor, its ultimate parent company, and their subsidiaries.'' \209\
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    \209\ ISB Standard No. 2, supra note 139.
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    Our proposed rule defines ``investment company complex'' to include 
an investment company and its investment adviser, or if the company is 
a unit investment trust, its sponsor; any entity controlled by, under 
common control with, or controlling the investment adviser or sponsor 
of a unit investment trust, such as a distributor, fund administrator, 
or transfer agent; and any investment company or an entity that would 
be an investment company but for the exclusions provided by section 
3(c) of the ICA and that is advised by the investment adviser or 
sponsored by the sponsor, or an entity that is controlled by, under 
common control with, or controlling the investment adviser or sponsor. 
The definition does not include sub-advisers whose role is primarily 
portfolio management and who provides services pursuant to a 
subcontract with, or are overseen by, an adviser in the complex. As 
proposed, an auditor generally would not be precluded from investing in 
other investment companies advised by an investment company audit 
client's sub-adviser. We request comment on whether the auditor of an 
investment company should be independent of other investment companies 
that have an adviser that is the sub-adviser of an audit client 
investment company. Sub-advisers are excluded only when their duties 
are limited to portfolio management. Should they be excluded only in 
this circumstance? Is the definition of sub-adviser clear and capable 
of implementation, or is another definition preferable?
    As proposed, the definition would require an auditor to be 
independent of all companies that would be investment companies but for 
the exclusions set forth in section 3(c) of the ICA. Should the auditor 
of an investment company be independent of all investment type products 
(i.e., hedge funds, venture capital funds, commodity pools, real-estate 
pools) offered by the adviser or sponsor of the investment company?
    The rule would preclude auditors of a unit investment trust from 
investing in other investment companies sponsored by the sponsor of the 
unit investment trust and any other entity in the same investment 
company complex. We have defined sponsor as the entity that establishes 
the unit investment trust. Is such a definition sufficiently clear and 
capable of implementation? If not, how should it be modified so as to 
be sufficiently clear?
    We solicit comment on the proposed definition of ``investment 
company complex.'' Does the definition include all entities that should 
be within the investment company complex? Does the definition include 
any entities that should not be included? For example, under the 
proposed rule, we focus on the integral role of an investment adviser 
in the investment company complex. But, for some fund groups, the 
principal underwriter or administrator plays a predominant role in 
organizing and managing the overall operations of the investment 
companies in the investment company complex. Should the auditors be 
independent of the administrator or principal underwriter? Should the 
auditors be independent of other fund groups who use the same principal 
underwriter or administrator?
13. ``Office''
    Proposed rule 2-01(f)(17) defines ``office'' to mean a distinct 
sub-group within an accounting firm, whether distinguished along 
geographic or practice lines. The term ``office'' is used in the rule 
to help delimit the persons who are considered ``covered persons'' and, 
therefore, plays a role in identifying those firm personnel who cannot 
have financial or employment relationships with a particular audit 
client or affiliate of an audit client without impairing the firm's 
independence.
    We give ``office'' a meaning that does more than merely refer to a 
distinct physical location where the firm's personnel work. By 
``office'' we mean to encompass any reasonably distinct sub-group 
within an accounting firm, whether constituted by formal organization 
or informal practice, where the personnel who make up the sub-group 
generally serve the same clients, work on the same matters, or work on 
the same categories of matters. In this sense, ``office'' may transcend 
physical boundaries, and it is possible that a firm may have a sub-
group that constitutes an ``office'' even though the personnel making 
up that sub-group are stationed at various places around the country or 
the world.
    At the same time, we intend for ``office'' also to include 
reference to a physical location. For this reason, ``office'' will 
generally include a distinct physical location where the firm's

[[Page 43182]]

personnel work. We recognize, however, that in some cases thousands of 
firm personnel may work at a single, large physical location, but 
physical divisions may nonetheless effectively isolate different sub-
groups of personnel from each other in ways that will warrant treating 
each sub-group as a separate ``office'' under the proposed definition.
    We solicit comments on the proposed definition of ``office.'' Does 
the definition provide a useful framework for identifying firm 
personnel who reasonably should be included within the definition of 
``covered persons?'' Is there an alternative definition that would 
better serve the objective of identifying persons firm-wide whose 
geographic or professional proximity to the firm's work for a 
particular audit client suggests that their financial or employment 
relationships with that audit client should be deemed to impair the 
firm's independence? Should ``office'' be defined more narrowly, such 
as by limiting it to persons who work in the same physical location? To 
the extent that the definition does include physical location, should 
``office'' be defined more strictly, by providing that all firm 
personnel working at the same physical or geographic location will, in 
all cases, constitute a single office?

J. Codification

    As previously discussed, the Commission's current auditor 
independence requirements are found in various rules and 
interpretations. Section 600 of the Codification provides 
interpretations and guidance not otherwise available in the current 
rule. The proposed rule attempts to articulate clearly situations and 
circumstances, such as financial relationships, employment 
relationships, and non-audit services that impair auditor independence. 
Accordingly, we are proposing to delete interpretations included in the 
Codification that are reflected in, or that have been superseded by, 
the proposed rule.\210\ The current Codification contains background 
information and interpretations that may continue to be useful in 
situations not specifically or definitively addressed in the proposed 
rule. Examples of these items concern business relationships, unpaid 
prior professional fees, indemnification by clients, and litigation.
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    \210\ The Codification in its entirety remains in effect until 
any final rule is adopted.
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    Should the background information and other relevant items included 
in the Codification be maintained in their current form? Are there 
additional items that should be modified? Are there items that are 
proposed to be deleted but should be maintained in the Codification?

IV. General Request for Comments

    We request comment on the proposals, other matters that may have an 
impact on the proposals, and your suggestions for additional changes. 
In addition, in considering whether to adopt rule amendments on auditor 
independence, the Commission will consider what effect, if any, its 
actions might have on the states and on state law. Specifically, the 
Commission will consider whether the rule amendments (i) could alter 
the relationships between federal and other authorities, (ii) require 
expenditures by state officials, or (iii) preempt state or local law. 
The Commission's rules affect only those auditors that perform audits 
for companies required to file financial statements and auditors' 
reports with the Commission, whereas state regulations often affect a 
much broader category of auditors and companies.
    The Commission's proposals are not intended to alter the 
relationship between federal and state authorities. In general, states 
have patterned their regulations after those of the AICPA or the 
National Association of State Boards of Accountancy. Many state 
independence regulations may be more permissive, in some respects, than 
the Commission's current regulations. These differences would continue 
under the proposals. The proposals do not require state officials to 
undertake licensing regimes or otherwise make any financial outlays. 
Furthermore, our proposals would not affect the ability of the states 
to adopt different regulation in those areas they currently regulate. 
We solicit comment on whether the proposals would affect specific state 
laws or require any expenditures by state officials. We also request 
comment on whether or how these proposals would alter the relationship 
between federal and state authorities.

V. Cost-Benefit Analysis

    We have identified certain costs and benefits of the proposals. We 
request comment on all aspects of this cost-benefit analysis, including 
identification of any additional costs or benefits of the proposed 
amendments. We encourage commenters to identify or supply relevant data 
concerning the costs or benefits of the proposed amendments.

A. Costs and Benefits of the Proposals Regarding Investments in and 
Employment Relationships With Audit Clients

    The proposals clarify and, in some cases, eliminate, certain 
existing regulations under which an accountant's independence is 
impaired by fellow accounting firm employees or their family members 
having an investment in or holding a position at an audit client. As 
explained above,\211\ changes in business practices and demographics, 
including an increase in dual-career families, may warrant a change in 
our auditor independence requirements to prevent them from 
unnecessarily restricting the employment and investment opportunities 
available to auditors and members of their families. To this end, the 
proposals take a more targeted approach and focus on those persons who 
are involved in or can influence an audit. In addition, the proposals 
create a limited exception for accounting firms that have quality 
controls that provide reasonable assurance of independence.
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    \211\ See supra Section II.
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1. Benefits
    We believe that our proposals on investment and employment 
restrictions provide several benefits. Eliminating certain investment 
and employment restrictions should benefit auditors and their families 
by permitting them a wider range of investment and employment 
opportunities. Currently, according to annual reports filed by 
accounting firms with the SECPS, the five largest audit firms employ 
approximately 115,000 professionals. Other public accounting firms that 
audit SEC registrants employ an estimated 5,000 to 25,000 professional 
staff. Our proposals would benefit these 120,000 to 140,000 accounting 
firm professional employees and their families by enabling them to 
invest in some public companies that, under the current rules, they 
cannot invest in without impairing the independence of the companies' 
auditors. In addition, under the proposals, unlike under current rules, 
family members of some audit firm employees could be employed by audit 
clients and their affiliates without impairing auditor independence.
    Expanding the set of investment opportunities available to auditors 
and their family members may increase the return they can earn on their 
investments and improve their ability to reduce risk through 
diversification. Similarly, expanding the set of employment 
opportunities available to

[[Page 43183]]

the family members of audit firm employees has the potential to 
increase their compensation. Finally, opening up the employment 
opportunities available to auditors and their family members increases 
their freedom of choice with respect to employment opportunities. This 
could improve the non-pecuniary, as well as financial, benefits of 
employment.
    We request comment on the estimate of the number of individuals who 
are likely to benefit from the proposed amendments. Is a better 
estimate available? Is it possible to estimate the annual benefits to 
these individuals from having a wider range of investment choices? Is 
it possible to estimate the benefits that these individuals may achieve 
on an annual basis because of a wider range of employment choices? 
Would eliminating investment and employment regulations provide other 
benefits to these individuals? Are there other individuals who would 
benefit from the proposals regarding investment and employment 
relationships?
    In addition to eliminating certain restrictions, the proposals 
clarify the independence requirements. Currently, these requirements 
are found in various Commission rules, Commission interpretations, 
staff letters and staff reports. The proposals consolidate the 
requirements. As a result, the proposals should provide clearer 
guidance to accountants and their families, issuers and their audit 
committees, regulators, courts, administrative law judges, and others. 
The proposals also put this guidance in an easily accessible format 
that should save these parties costs in ascertaining and complying with 
the regulations. Is it possible to quantify these benefits? Would 
additional parties be affected by the proposed clarification of our 
investment and employment restrictions?
    Finally, the proposals encourage, but do not require, accounting 
firms to establish quality control systems that provide reasonable 
assurance that they are complying with our auditor independence 
requirements. The proposals do so by providing that an accounting 
firm's independence will not be impaired solely because one of its 
employees does not comply with the independence rules if, among other 
things, the firm has adequate independence quality controls in place.
    GAAS already requires firms to have quality controls for their 
audit practices and refers auditors to the ``Statements on Quality 
Control Standards'' (``SQCS'') for guidance regarding the elements of 
those systems.\212\ SQCS No. 2 states that firms' controls should 
provide ``reasonable assurance that personnel maintain independence (in 
fact and in appearance) in all required circumstances, perform all 
professional responsibilities with integrity, and maintain objectivity 
in discharging professional responsibilities.'' \213\ In addition to 
requirements imposed by GAAS, public accounting firms that are SECPS 
members must comply with independence quality control membership 
requirements. Among other things, member firms with at least 7,500 
professionals must implement an electronic tracking system by no later 
than December 31, 2000.\214\ Our proposals, therefore, do not impose, 
even indirectly, a requirement for internal controls that does not 
already exist under GAAS and SECPS membership requirements.
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    \212\ AICPA SAS No. 25, AU Sec. 161, n. 1.
    \213\ AICPA Professional Standards: SQCS, QC Sec. 20.09.
    \214\ Letter from Michael A. Conway, Chairman, Executive 
Committee, SECPS, to the Managing Partners of SECPS Member Firms, 
dated April 2000 (available at www.aicpa.org).
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    The proposals, however, do clarify the GAAS requirement for firms 
with more than 500 SEC registrants as audit clients by identifying 
procedures that should be part of their quality control systems.\215\ 
This aspect of the proposals could benefit the largest public 
accounting firms by reducing uncertainty about the required minimum 
characteristics of any quality control system they institute.
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    \215\ The specified criteria for a quality control system only 
apply to the largest accounting firms. For other firms, the proposal 
states that a firm's quality control system should take into account 
the size and nature of the firm's practice. Again, this is in 
general conformity with GAAS, which states, ``The nature and extent 
of a firm's quality control policies and procedures depend on 
factors such as its size, the degree of operating autonomy allowed 
its personnel and its practice offices, the nature of its practice, 
its organization, and appropriate cost-benefit considerations.'' 
AICPA SAS 25, AU Sec. 161.02.
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    In addition, any public accounting firm implementing a quality 
control system in compliance with this limited exception should benefit 
because we would be narrowing the circumstances in which independence 
would be impaired. This aspect of the proposals also should provide 
investors with the assurance of improved quality control systems of any 
firms that implement them, and inform investors and others who rely on 
audited financial statements about the minimum characteristics of the 
quality control systems maintained by these accounting firms. This 
should reduce uncertainty among investors and increase investor 
confidence.
    What methods are available to estimate the benefits that these 
accounting firms would receive from the limited exception and the 
reduced uncertainty about the minimum characteristics required for 
quality control systems? What methods are available to estimate the 
benefits to investors and others because of enhanced assurance that 
firms possess quality controls with minimum characteristics described 
in this section? Are there other benefits arising from the proposed 
amendment?
    We request comment, including supporting data if available, on the 
benefits of the proposals regarding investment and employment 
relationships.
2. Costs
    Modification of our investment and employment restrictions may 
require accounting firms, their employees, or others to incur 
transaction costs, such as one-time costs to modify existing systems 
that monitor investments and employment relationships, and training 
costs to make all professional staff aware of the revised rules. Is it 
possible to estimate these costs? Are there additional costs that would 
be borne by any individual or entity other than those identified?
    As discussed above, the proposals provide an incentive--namely a 
limited exception from the auditor independence requirements--for 
accounting firms to establish quality controls. In the case of the 
largest firms, the proposals specify what we believe to be the minimum 
characteristics of these systems.\216\ For the largest firms, 
implementing such a quality control system would likely entail costs to 
enhance or alter the firm's existing system. Because seeking the 
limited exception is elective, such costs will be assumed voluntarily, 
if at all, by accounting firms that decide that the benefits of this 
limited exception outweigh the cost of any incremental changes that are 
necessary to make their quality control systems meet the proposals' 
standards.
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    \216\ Other public accounting firms would have the flexibility 
to adopt a system to comply with the proposed requirement in light 
of the nature and size of their practice.
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    In addition, to minimize costs, we have tailored these quality 
control proposals in recognition of current industry requirements and 
practices. As noted above, under GAAS and, where applicable, under 
SECPS membership requirements, accounting firms must have a system of 
quality controls, including policies and procedures, to

[[Page 43184]]

provide the firm with reasonable assurance that personnel maintain 
independence in all required circumstances.\217\ Moreover, it is 
prudent business practice to maintain reasonable quality controls.\218\ 
An accounting firm that chooses to upgrade its existing quality control 
system to comply with the limited exception should incur only the 
incremental costs of implementing any improvements beyond what is 
required by GAAS and SECPS membership requirements.
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    \217\ AICPA SQCS, QC Sec. 20; AICPA SAS No. 25, AU Sec. 161.
    \218\ Some firms are already developing or improving quality 
control systems. At least one Big 5 accounting firm has begun the 
process of installing a computerized tracking system that monitors 
employee investments. See Elizabeth MacDonald, ``Top Accounting 
Industry Group Sets Conflict-of-Interest Compliance Rules,'' Wall 
St. J., Feb. 2, 2000, at B2.
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    We seek comment, and supporting data if available, on these and any 
other costs of our investment and employment proposals, including the 
quality control proposals. Is it possible to quantify the initial costs 
accounting firms may incur to modify their quality control systems? Is 
it possible to quantify the incremental costs that may be incurred by 
the largest accounting firms that choose to put in place a quality 
control system that meets the specified criteria?

B. Costs and Benefits of Restricting Certain Non-Audit Services

    As more fully described above,\219\ there is increasing concern 
that the growth of non-audit services provided to audit clients affects 
the independence of auditors. If investors lose confidence in auditors' 
ability or willingness to provide an unbiased and impartial examination 
of companies' financial statements, then investors' trust in the 
reliability of publicly available financial information, and in the 
integrity of the securities markets, may be damaged.
---------------------------------------------------------------------------

    \219\ See supra Section II.C.
---------------------------------------------------------------------------

    Currently, accounting firms may not provide certain services to 
their audit clients without impairing their independence. Our proposals 
extend and clarify those restrictions by setting forth four basic 
principles that should be used to evaluate the effect of non-audit 
services on an auditor's independence, and by designating certain non-
audit services that, if performed by an auditor for an SEC registrant 
that is an audit client, impair the auditor's independence.
    Our proposals on the provision of non-audit services may affect 
four distinct groups: investors, issuers, public accounting firms, and 
other potential providers of non-audit services. The benefits and costs 
arising from the proposed amendments are examined for each group.
1. Benefits
    (a) Investors. For the reasons explained above, the Commission 
believes that the proposals will enhance auditor independence and 
thereby enhance the reliability and credibility of financial statements 
of public companies.\220\ We expect these benefits to inure primarily 
to investors who, if the proposals are adopted, should be able to 
review public companies' financial statements with greater assurance 
that reliance on the statements will lead to more informed investment 
decisions. We seek comment on whether it is possible to quantify the 
benefits of the proposals to investors, and if so, how.
---------------------------------------------------------------------------

    \220\ See supra Section III.D.1.
---------------------------------------------------------------------------

    (b) Issuers. Issuers may benefit from the proposed scope of 
services regulations in several respects. First, the proposals 
eliminate certain uncertainties as to when a registrant's auditor will 
not be recognized as independent. The proposals eliminate these 
uncertainties by setting forth not only four general principles by 
which to analyze non-audit services, but also by listing certain non-
audit services as incompatible with the concept of auditor 
independence. Accordingly, in the future, issuers can know that if 
their auditor provides any of the listed services, the auditor will not 
be independent for purposes of Commission filings.
    Second, if the proposals increase investor confidence in financial 
reporting and thereby encourage investment, they may facilitate capital 
formation. In such a scenario, issuers would be able to attract capital 
at lower rates of return, or in circumstances in which they currently 
cannot raise capital.
    Finally, the proposals may increase the utility of annual audits to 
issuers. For example, by requiring issuers to obtain certain 
information technology services, such as implementation of an 
accounting information system that is used to generate data significant 
to the financial statements as a whole, from a vendor other than their 
auditor, the proposals should result in someone other than the non-
audit services provider reviewing that system during the course of the 
audit. As a result, issuers may get an independent ``second opinion'' 
of the system from the audit. Furthermore, as a result of the 
proposals, issuers may avoid pressure from their auditors to purchase 
non-audit services.
    (c) Other Consulting Firms. Consulting firms that do not engage in 
public accounting also may benefit from the proposals. Such consulting 
firms may receive revenue from certain consulting engagements that, but 
for our proposals, would have gone to the client's auditor. Moreover, 
to the extent that a registrant's auditor has advantages in competing 
to provide consulting services to an audit client by virtue of the 
auditor's personal relationships with officers of the audit client or 
increased awareness of potential consulting engagements through 
proximity to an audit client, our proposals may improve competition in 
the market for the provision of consulting services. This improved 
competition could benefit any consulting firm with comparative 
advantages in providing the necessary non-audit services.\221\
---------------------------------------------------------------------------

    \221\ This would also benefit the issuers that contract for 
these non-audit services.
---------------------------------------------------------------------------

    (d) Public Accounting Firms. We anticipate that the proposals will 
confer two primary benefits on public accounting firms. First, the 
proposals should clarify what non-audit services may be provided to an 
audit client without jeopardizing auditor independence. Second, the 
proposals could improve competition in the market for the provision of 
non-audit services by public accounting firms. Because the restrictions 
on providing non-audit services to an audit client would apply equally 
to all accounting firms, the overall impact of the proposed 
restrictions may be to re-distribute the restricted non-audit services 
among the public accounting firms.\222\
---------------------------------------------------------------------------

    \222\ As noted above, some of this work may be re-distributed to 
consulting firms that do not engage in public accounting.
---------------------------------------------------------------------------

    In addition, as noted above, a registrant's auditor may have 
advantages in competing to provide non-audit services to its audit 
client that are not based on the auditor's skill or cost advantages in 
providing that service. To the extent that such advantages exist, the 
proposals may improve competition in the market for non-audit services. 
If a public accounting firm has a comparative skill or cost advantage 
in providing a particular non-audit service, that public accounting 
firm may benefit from any enhanced competition because its comparative 
advantage over other public accounting firms in providing that service 
would be more likely to lead to non-audit assignments from other public 
accounting firms' audit clients. Might these enhancements to

[[Page 43185]]

competition change the way accounting firms invest in various of their 
service lines? For example, might accounting firms begin to re-invest 
more heavily in their audit function?
    We request comment, including supporting data, on the benefits of 
the proposals.
2. Costs
    Our proposals on non-audit services may impose costs on issuers and 
public accounting firms. We request comment on whether these proposals 
may impose costs on other groups.
    (a) Issuers. The proposed amendments have the effect of restricting 
issuers from purchasing certain non-audit services from their auditors. 
Currently, the five largest public accounting firms audit approximately 
12,800 public companies. Other public accounting firms audit 
approximately 3,900 public companies. According to reports filed with 
the AICPA, of the 12,800 public companies audited by the so-called 
``Big 5,'' approximately 9,500 did not purchase any consulting services 
from their auditor in the most recently reported year. Of the 
approximately 3,900 registrants that are audited by other public 
accounting firms, approximately 3,100 did not purchase any consulting 
services from their auditor.
    For the 12,600 registrants that did not purchase any consulting 
services from their auditor, the proposed amendments would not have 
affected their purchase of non-audit services in the most recently 
reported year. In the future, however, these registrants could be 
affected by the proposals insofar as the proposals reduce their 
flexibility in the purchase of non-audit services.
    Of the approximately 4,100 registrants that were reported to have 
purchased non-audit services from their auditor, many may have 
purchased non-audit services that are not covered by the proposals. In 
the future, these issuers could continue to procure the same services 
from their auditor.
    Issuers that purchased from their auditor non-audit services that 
are covered by the proposals, however, will have to look to other 
professional services firms, including other public accounting firms, 
to provide these services in the future. The fact that many issuers 
currently purchase non-audit services from firms other than their 
auditor suggests that there is a competitive market for non-audit 
services. Therefore, issuers who are precluded by the proposals from 
purchasing such services from their auditor likely will be able to 
purchase these services from other vendors. These issuers may incur 
costs from having to use a separate vendor, including the possible loss 
of any synergistic benefits of having a single provider of both audit 
and non-audit services. For example, they may incur costs locating a 
new vendor and developing a business relationship with that vendor.
    We request comment on whether it is possible to quantify the costs 
arising from employing separate vendors for certain consulting 
services, and if so, how. We also request comment on the accuracy of 
the estimated number of issuers that would be affected by the proposed 
amendment. What percentage of SEC registrants use a competitive bidding 
process in selecting providers of non-audit services? What percentage 
``sole source'' non-audit assignments? For issuers that currently 
acquire from their auditor non-audit services that are prohibited by 
the proposals, what is the additional cost of using a competitive 
bidding process to acquire non-audit services? Are there any benefits 
to the issuer of employing such a process? Under our proposed rule, how 
often, if at all, would an issuer be unable to find a vendor other than 
their auditor to provide a covered non-audit service on a comparable 
basis?
    (b) Public Accounting Firms. Some public accounting firms provide a 
wide variety of services both to audit and non-audit clients. Our scope 
of services proposals are likely to affect these firms in several ways. 
The primary cost for these firms is that they individually may lose one 
source of revenue because they will no longer be able to sell certain 
non-audit services to their audit clients. Based on the accounting 
firms' SECPS reports, however, it appears that, on average, public 
accounting firms with fewer than 1,000 SEC registrants as clients earn 
less than 1% of their total fees from providing management consulting 
services to audit clients.\223\
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    \223\ Of course, these firms and other firms that do not 
currently earn any such revenues would be precluded from earning 
such revenues in the future from the covered non-audit services.
---------------------------------------------------------------------------

    The anticipated loss of revenue would primarily affect the Big 5 
firms. Some members of the Big 5 provide extensive non-audit services 
to their audit clients. However, at least two of the Big 5 have 
recently sold or taken steps to separate their consulting practice from 
their audit practice. And, at least one other Big 5 firm has announced 
its intention to separate its consulting and its audit practices. In 
addition, the SECPS reports of the Big 5 show that almost 75% of their 
audit clients that are SEC registrants purchased no management 
consulting services from their auditor. Accordingly, the proposals 
appear likely to impose significant costs only on those members of the 
Big 5 that do not plan to separate their audit and non-audit practices 
(or at least that portion of their non-audit practice that provides 
those non-audit services listed in proposed rule 2-01(c)(4)).\224\ Even 
then, because only about 25% of these firms' SEC audit clients buy non-
audit services from their auditors, the proposals will only impose 
costs with respect to, at most, 25% of these firms' client 
relationships.
---------------------------------------------------------------------------

    \224\ Public accounting firms that are separating their 
consulting practices would be affected if they subsequently 
determined to re-acquire or recreate consulting practices that 
included these listed services.
---------------------------------------------------------------------------

    In addition, because our proposals would affect all auditors, the 
overall impact of the proposed restrictions may be merely to 
redistribute certain non-audit services among public accounting 
firms.\225\ To the extent these services are only redistributed, there 
should be no net loss of revenue to public accounting firms as a whole.
---------------------------------------------------------------------------

    \225\ Of course, as noted above, some of the non-audit services 
now provided by auditors may be redistributed to consulting firms 
that are not engaged in public accounting.
---------------------------------------------------------------------------

    We request comment on these costs and our estimates of the number 
of accounting firms and issuers that will be affected. Is it possible 
to quantify these costs? Is there any reason to believe the costs in 
the form of lost revenue will not be offset by equal benefits to other 
public accounting firms and other consulting firms?
    A complete prohibition on accounting firms' providing any non-audit 
services could impose other, different costs on public accounting 
firms, such as depriving accounting firms of expertise they could have 
obtained from consulting activities that can be employed in audit 
engagements, preventing ``synergies'' from a better understanding of 
the client, and harming accounting firms' ability to recruit and retain 
employees. Our proposed rule does not ban accounting firms from 
providing all non-audit services, nor does it ban accounting firms from 
providing any non-audit services to entities other than their audit 
clients. It only adds certain non-audit services to those that 
accounting firms are already precluded from providing to a particular 
audit client if they wish to maintain independence from that audit 
client.
    Nonetheless, we have considered whether our proposals are likely to 
impose any of these other costs on public accounting firms. For 
example, we have considered that the provision

[[Page 43186]]

of non-audit services may enhance an auditor's expertise and thereby 
improve the efficiency or effectiveness of the audit. Our proposals 
would not preclude public accounting firms from developing or 
maintaining such expertise through consulting engagements, however. 
Under the proposals, public accounting firms could provide any non-
audit service to clients that are not audit clients as to which they 
must be independent under the federal securities laws, and thereby 
develop or maintain their expertise. Moreover, to the extent that the 
effect of the proposals is merely to redistribute the provision of non-
audit services among the public accounting firms, this redistribution 
may permit each of the firms to maintain its expertise in various of 
these services.
    We request comment on whether our proposals on non-audit services 
would impose costs on accounting firms or others because accountants 
would have diminished expertise. If so, is it possible to quantify 
these costs? We also request comment on what effect, if any, reducing 
the pool of clients to which accounting firms can sell certain non-
audit services will have on the firms' profit margins.
    Our proposals also may affect what some contend are synergies (or 
``knowledge spillovers'') that arise from providing non-audit services 
to an audit client. Research on enhanced efficiency or effectiveness of 
providing non-audit services to audit clients is inconclusive.\226\ 
Anecdotal evidence that argues against knowledge spillovers is found in 
the recent sale or proposed sale of the consulting divisions of several 
large public accounting firms. If efficient and effective audits 
require the expertise that can be most efficiently maintained through 
the provision of consulting services to audit clients, these firms 
would be unlikely to sell their consulting practices. Thus, the sale of 
these consulting practices, coupled with the results of previous 
research, provide evidence that is inconsistent with the existence of 
synergies that would be negatively affected by our proposed amendments.
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    \226\ Two studies in the 1980s documented that audit fees were 
generally greater, after controlling for other factors, for clients 
that also purchased nonaudit services from the same public 
accounting firm. See Zoe-Vonna Palmrose, ``The effect of nonaudit 
services on the pricing of audit services,'' Journal of Accounting 
Research, at 405-11 (Autumn 1986); Dan A. Simunic, ``Auditing, 
consulting, and auditor independence,'' Journal of Accounting 
Research, at 679-702 (Autumn 1984). The authors of these studies 
nonetheless concluded that this evidence was consistent with the 
hypothesis that the joint provision of audit and nonaudit services 
may give rise to ``knowledge spillovers'' (i.e. enhanced efficiency 
or effectiveness). More recent research documents that these higher 
fees are associated with increased audit effort (in labor hours). 
See Larry R. Davis, David N. Ricchiute, and Greg Trompeter, ``Audit 
Effort, Audit Fees, and the Provision of Nonaudit Services to Audit 
Clients,'' Accounting Review, at 135-50 (Jan. 1993). The results of 
the Davis et al. study therefore cast doubt on the knowledge 
spillover hypothesis.
---------------------------------------------------------------------------

    We seek comment on whether there are knowledge spillovers that 
would be lost under the proposals. If so, is there some means of 
quantifying this cost? Would knowledge spillovers be a concern for some 
or all of the non-audit services covered by our proposals? We also seek 
comment on whether there is evidence as to the mechanisms by which 
knowledge spillovers occur. For example, please provide an average of 
the number of hours billed on particular audit engagements by 
consulting personnel as a fraction of total audit hours and the number 
of hours of audit staff time billed for consulting services covered by 
the rule to an audit client of that staff member.
    Finally, some accounting firms have suggested that their recruiting 
and employee retention would be affected if they could not provide non-
audit services. According to this argument, employees or potential 
employees are more interested in joining accounting firms in which they 
will be able to engage in both audit and non-audit work, or at least 
have the option of engaging in both audit and non-audit work.
    We seek comment on whether our proposals impose a cost of this type 
on accounting firms. Do a significant number of accounting firm 
employees engage in both: (i) audit activities, and (ii) non-audit 
activities that are prohibited as a result of our proposal, as part of 
their work? Have a significant number of accounting firm employees 
shifted from providing audit services to providing non-audit services 
that are covered by these proposals? Do the proposals significantly 
reduce the non-audit work available to professional audit staff? If so, 
how? \227\
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    \227\ This argument also assumes that accounting firms will not 
be engaged in both audit and nonaudit work. Our proposals, of 
course, do not prevent accounting firms from continuing to provide 
any nonaudit services to companies other than their audit clients.
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C. Costs and Benefits of the Proposals to Add Disclosure Requirements

    Our proposals require public companies, under certain 
circumstances, to disclose information about the non-audit services 
provided by their auditor, the fees for those services, and the audit 
fee. The proposals also require public companies to disclose, when 
relevant, that more than 50% of the audit was performed by personnel 
who are full-or part-time employees of an entity other than the audit 
firm.
    The disclosure of non-audit services provided by a company's 
auditor is intended to allow investors to judge for themselves whether 
they believe that a particular service affects the independence of the 
auditor. Such disclosures have been provided in the United Kingdom for 
several years.
    The disclosure regarding the usage of leased personnel to perform 
an audit is intended to allow investors to know when personnel of an 
entity, other than the audit firm, performed a majority of the audit so 
that investors can consider the independence of the other entity. Under 
such circumstances, the independence of the other entity and its 
personnel may be as relevant--if not more relevant--to auditor 
independence than the independence of the auditor itself.
1. Benefits
    As discussed above,\228\ there is growing concern about the impact 
of non-audit services on auditors' independence. In addition, as noted 
above, while the SECPS collects information on non-audit and audit fees 
from its member firms, it no longer publishes this information. 
Accordingly, such information is not readily available to, or easily 
accessible by, the investing public. Further, this information provides 
a description of service line activities by the public accounting firm 
for all of its clients, rather than for each audit client.
---------------------------------------------------------------------------

    \228\ See supra Section II.C.
---------------------------------------------------------------------------

    The proposals would remedy this situation. The proposed disclosure 
related to non-audit services provided by auditors to audit clients 
would give investors insight into the full relationship between a 
company and its auditor. In so doing, the proposed disclosure would 
replace uncertainty about the nature and scope of such relationships 
with facts about the services provided by the auditor to the company. 
This information may help shareholders decide, among other things, how 
to vote their proxies in selecting or ratifying management's selection 
of an auditor.
    The disclosure regarding the auditor's use of another entity's 
employees to perform a majority of the audit work also provides 
important information to investors. Investors may need to know when a 
majority of the audit work is performed by persons who have financial, 
business, and personal interests in addition to, or different

[[Page 43187]]

from, persons employed by the auditor. This disclosure is significant 
because it reveals when the ``principal auditor'' (the auditor 
performing a majority of the audit work) is an entity other than the 
firm signing the audit opinion.
    We believe that the benefits of the proposed disclosure rules would 
include increased market efficiency due to improved information and 
transparency concerning the credibility and reliability of companies' 
financial disclosures. The value of these benefits is not readily 
quantifiable. We solicit comment, including supporting data if 
available, on the benefits of the proposed disclosure rule.
2. Costs
    We believe that the proposed disclosure rule will impose relatively 
minor reporting costs on issuers. Generally, information about auditor 
independence is readily available to registrants. One basis for that 
information is ISB Standard No. 1, which requires auditors to report 
certain independence issues to the audit committees of their audit 
client-registrants.\229\ In addition, the SECPS requires members to 
report annually to the audit committee, or similar body, the total fees 
received from the company for management advisory services during the 
year under audit, and a description of the types of such services 
rendered.\230\ As a result, companies should have ready access to the 
information on fees paid to their auditor for non-audit services. The 
proposed disclosure requirement would merely require issuers to pass 
certain of this information on to shareholders.
---------------------------------------------------------------------------

    \229\ ISB Standard No. 1, supra note 95. In addition, SAS No. 61 
provides additional guidance on topics that an auditor should 
discuss with the audit committee (or board of directors if there is 
no such committee) of each registrant. AICPA SAS No. 61, AU 
Sec. 380.
    \230\ SECPS Manual, supra note 165, at Sec. 1000.08(i).
---------------------------------------------------------------------------

    For purposes of the Paperwork Reduction Act, we have estimated that 
our proposed disclosure rules would, on an annual basis, impose 2,473 
additional burden hours on all Schedule 14A filers and 63 additional 
burden hours on all Schedule 14C filers, for an aggregate annual total 
of 2,536 additional burden hours.\231\ That estimate is based on 
current burden hour estimates and the staff's experience with such 
filings. We further estimate that approximately 75% of the extra burden 
hours, or 1,902 hours, will be expended by companies' internal staff, 
and the remaining 25%, or 634 hours, by outside professional help.\232\ 
These percentage estimates, which are based on current burden hour 
estimates and the staff's experience with such filings, reflect the 
time companies would spend preparing the additional disclosures in the 
proxy statement or information statement.
---------------------------------------------------------------------------

    \231\ Approximately 9,892 respondents file proxy statements 
under Schedule 14A and approximately 253 respondents file 
information statements under Schedule 14C. We based the number of 
entities that would complete and file each of the forms on the 
actual number of filers during the 1998 fiscal year.
    \232\ These assumptions are based on the staff's experience with 
these filings. We believe that a company's internal staff will 
typically carry most of the burden of preparing the proposed 
additional disclosures, and will consult with outside professionals 
only on specific issues that the company may periodically encounter 
in preparing the proxy statement or information statement.
---------------------------------------------------------------------------

    Assuming that the internal staff costs the company an average of 
about $85 per hour, the aggregate annual cost for internal staff 
assistance would amount to approximately $161,670. If we assume that 
the outside professional assistance would have an average cost of 
approximately $175 per hour, the aggregate annual paperwork cost would 
be approximately $110,950. The total annual costs would accordingly be 
about $272,620. We request comment on the reasonableness of these 
estimates and their underlying assumptions.
    In addition, as noted above, some issuers would have to disclose 
the percentage of hours expended on the engagement by ``leased'' 
employees. We currently lack information on the number of issuers that 
would be affected by the proposed disclosures on ``leased'' employees. 
We expect, however, that this disclosure will be required only in rare 
situations where the firm has sold its non-attest practice to a 
financial services company and is leasing back its employees. In these 
situations, former employees of the firm become full-or part-time 
employees of the financial services company and are ``leased'' back to 
the accounting firm to perform audit work. This disclosure should not 
require any additional recordkeeping by the firm because the amount of 
hours performed on an audit by the lessor and by the ``leased'' 
personnel should be readily available from the firm's billing records. 
This information also should be readily available to the registrant 
because of the communications requirements under ISB Standard No. 1, as 
discussed above.
    We seek comment on these and any other costs of the proposed 
disclosure rules. Are there any other potential costs we have not 
considered?

VI. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility Act 
Analysis (``IRFA'') in accordance with the Regulatory Flexibility 
Act,\233\ regarding the proposed amendments to Rule 2-01 of Regulation 
S-X and item 9 of Schedule 14A under the Exchange Act. The following 
summarizes the IRFA.
---------------------------------------------------------------------------

    \233\ 5 U.S.C. Sec. 603.
---------------------------------------------------------------------------

    As discussed in greater detail in the IRFA and in other sections of 
this release, there have been significant changes in accounting firms, 
changes in the business environment, and demographic changes since we 
last amended our requirements regarding the independence of auditors of 
financial statements filed with us. The IRFA notes that we are re-
evaluating whether our auditor independence requirements remain 
effective, relevant and fair. In this regard, we are proposing 
amendments to our current requirements to address investments by 
auditors or their family members in audit clients, employment of 
auditors' family members and former partners by audit clients, and the 
scope of services provided by audit firms to their SEC audit clients. 
The IRFA also discusses the proposed proxy disclosure requirements by 
public companies regarding non-audit services provided by their 
auditors.
    The IRFA sets forth the statutory authority for the proposed rules. 
It also discusses small entities subject to the rules.\234\ The IRFA 
states that approximately 2,500 Exchange Act reporting companies are 
small businesses and approximately 227 investment companies are small 
businesses. The IRFA also states that the Small Business Administration 
defines small business, for purposes of accounting firms, as those with 
under $6 million in annual revenues.\235\ We cannot estimate the number 
of firms with less than $6 million in revenues.
---------------------------------------------------------------------------

    \234\ For the purposes of this analysis, the Commission has 
defined ``small business'' in Securities Act Rule 157 as any entity 
whose total assets on the last day of its most recent fiscal year 
were $5 million or less and is engaged, or proposes to engage, in 
small business financing. 17 CFR 230.157. A registrant is considered 
to be engaged, or to propose to engage, in small business financing 
under this rule if it is conducting, or proposes to conduct, an 
offering of securities which does not exceed the dollar limitation 
prescribed by Section 3(b) of the Securities Act. 15 U.S.C. 77c(b). 
The Commission also has defined small business in Rule 0-10 of the 
Investment Company Act as an investment company that has assets of 
$50 million or less as of the end of its most recent fiscal year. 17 
CFR 270.0-10.
    \235\ 13 CFR 121.201.
---------------------------------------------------------------------------

    The IRFA indicates that the proposed rules would affect two primary 
groups, auditors and registrants. The IRFA states that the rules could 
potentially affect auditors in three areas: investments and

[[Page 43188]]

employment relationships; non-audit services; and quality controls. 
With regard to investments and employment relationships, the IRFA 
states that the proposed rules would liberalize certain restrictions on 
investments by, and employment opportunities available to, accountants 
and their families. In this sense, compliance requirements are being 
relaxed.
    With regard to non-audit services, the IRFA states that the vast 
majority of SEC registrants are audited by one of the Big Five firms, 
which clearly are not small entities. The IRFA explains that we have 
data regarding the approximately 776 accounting firms with fewer than 
20 SEC audit clients,\236\ which would tend to be smaller accounting 
firms. As the IRFA explains, we do not believe that the proposed 
amendments regarding consulting and non-audit services would have a 
significant impact on a substantial number of small accounting firms.
---------------------------------------------------------------------------

    \236\ ``Special Supplement: Annual Survey of National Accounting 
Firms--2000,'' Public Accounting Report (March 31, 2000); Annual 
Reports to SECPS, Annual reports filed with AICPA Division for CPA 
firms; SECPS Reports, Reports prepared by the AICPA Division for CPA 
firms.
---------------------------------------------------------------------------

    With regard to quality controls, the IRFA explains that the 
proposed rules establish a limited exception for accounting firms that 
institute certain quality controls and satisfy other conditions. The 
proposed rules, therefore, encourage, but do not require, accounting 
firms to adopt quality controls that ensure the independence of the 
firms' auditors. The IRFA explains that GAAS already require firms to 
have quality controls over their audit practices, and the standards 
refer to the SQCS for guidance regarding the elements of those 
systems.\237\
---------------------------------------------------------------------------

    \237\ AICPA SAS No. 25, AU Sec. 161 n.1.
---------------------------------------------------------------------------

    The proposals, however, clarify the GAAS requirement for the 
quality controls of firms with more than 500 SEC audit clients by 
setting forth certain procedures that should be part of their quality 
controls. For firms with fewer than 500 SEC audit clients, a firm's 
quality control system should take into account the size and nature of 
the firm's practice. For smaller firms, therefore, the proposals 
incorporate GAAS requirements, but do not add new requirements.
    The proposed proxy disclosure rule would require registrants to 
disclose certain information to shareholders regarding auditor 
independence and regarding fees for audit and non-audit services. The 
proposed rules also address situations where more than 50% of the audit 
is performed by personnel that are full or part-time employees of 
another entity.
    We do not believe that the proposed proxy disclosure requirement 
would have a significant impact on a substantial number of small 
entities. These requirements would apply to small businesses only if 
they are otherwise subject to the proxy rules. We estimate the number 
of those entities to be no more than 2,700, including 227 investment 
companies. The proposed disclosures relate to only one item on the 
proxy statement, and the information should be readily available to 
registrants because of the requirements of ISB Standard No. 1. Finally, 
the proposals provide an exclusion from the disclosure requirements for 
de minimis items.
    As explained in the IRFA, the Regulatory Flexibility Act directs us 
to consider significant alternatives that would accomplish the stated 
objective, while minimizing adverse impact on small entities. In that 
regard, we considered the following alternatives: (a) Differing 
compliance or reporting requirements that take into account the 
resources of small entities; (b) the clarification, consolidation or 
simplification of compliance and reporting requirements under the rule 
for small entities; (c) use of performance rather than design 
standards; and (d) an exemption from the coverage of the proposed 
amendments for small entities.
    As noted, because neither the proposals to modernize the 
independence rules for investments and employment relationships nor the 
proposed proxy disclosure requirements should have a significant 
economic impact on a substantial number of small entities, we did not 
make special provisions for small entities. Regarding the provision of 
non-audit services by accounting firms, including small accounting 
firms, we have, above, solicited comment on a number of alternative 
regulatory approaches. The IRFA states that because of the limited 
amount of non-audit services that small accounting firms provide to 
their SEC audit clients, we believe that the adoption of any of these 
alternatives would not have a significant impact on a substantial 
number of small businesses or small accounting firms.
    The IRFA explains that the use of performance rather than design 
standards or providing an exemption from the coverage of the proposed 
amendments for small entities are not viable because it is not possible 
to design performance standards that would carry out our statutory 
mandate and we believe investors receive a significant benefit from 
knowing that an independent professional has examined the financial 
statements of a registrant, including a small registrant, with 
skepticism.
    The IRFA includes information concerning the number of small 
entities that may be affected by the proposed amendments and the nature 
of the impact on those entities. We encourage the submission of 
comments with respect to any aspect of the IRFA. In particular, we seek 
comment on the number of small entities that would be affected by the 
proposed rules; the nature of the impact; how to quantify the number of 
small entities that would be affected; and how to quantify the impact 
of the proposed rules. Comment is specifically requested regarding the 
number of small accounting firms that might be affected by the proposed 
rules, and the effect, if any, that the proposed rules would have on 
those firms. Please describe the nature of any impact and provide 
empirical data supporting the extent of the impact. Such comments will 
be considered in the preparation of the Final Regulatory Flexibility 
Analysis, if the proposed amendments are adopted, and will be placed in 
the same public file as comments on the proposed amendments. A copy of 
the IRFA may be obtained by contacting Robert Burns, Chief Counsel, 
(202) 942-4400, at the Office of the Chief Accountant, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-1103.

VII. Paperwork Reduction Act

    Certain of the provisions in the proposed amendment to item 9 of 
Schedule 14A contain ``collection of information'' requirements within 
the meaning of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501 et 
seq.), and the Commission has submitted them to the Office of 
Management and Budget (OMB) for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. The collections of information are titled 
``Regulation 14A (Commission Rules 14a-1 through 14b-2 and Schedule 
14A)'' and ``Regulation 14C (Commission Rules 14c-1 through 14c-7 and 
Schedule 14C).'' An agency may not conduct or sponsor, and a person is 
not required to respond to, a collection of information unless it 
displays a currently valid control number.
    Regulation 14A (OMB Control No. 3235-0059) was adopted pursuant to 
section 14(a) of the Exchange Act \238\ and prescribes information that 
a company must include in its proxy statement to ensure that 
shareholders

[[Page 43189]]

are provided information that is material to their voting decisions. 
Regulation 14C (OMB Control No. 3235-0057) was adopted pursuant to 
section 14(c) of the Exchange Act \239\ and prescribes information that 
a company must include in an information statement when a shareholder 
vote is to be held but proxies are not being solicited. Schedule 14C 
refers to Schedule 14A for the disclosure requirements related to the 
company's independent accountants.
---------------------------------------------------------------------------

    \238\ 15 U.S.C. 78n(a).
    \239\ 15 U.S.C 78n(c).
---------------------------------------------------------------------------

    The proxy disclosure requirements in section 14 of the Exchange Act 
apply to those entities that have securities registered with the 
Commission under section 12 of that Act. The likely respondents, 
therefore, include entities with more than 500 shareholders and more 
than $10 million in assets (section 12(g)) \240\ and entities with 
securities listed on a national exchange (section 12(b)).\241\ 
Approximately 9,892 respondents file proxy statements under Schedule 
14A and approximately 253 respondents file information statements under 
Schedule 14C. We based the number of entities that would complete and 
file each of the forms on the actual number of filers during the 1998 
fiscal year.
---------------------------------------------------------------------------

    \240\ 15 U.S.C. 78l(g).
    \241\ 15 U.S.C. 78l(b).
---------------------------------------------------------------------------

    We estimate that the total reporting burden for Schedule 14A is 
179,144 hours, or approximately 18 hours per respondent. We estimate 
that the total reporting burden for Schedule 14C is 4,582 hours, or 
approximately 18 hours per respondent. These estimates include 
increases of 2,473 hours for Schedule 14A and 63 hours for Schedule 14C 
based on estimates that the proposed amendments will add one hour to 
the reporting burden of one-quarter of the respondents, and will not 
add to the burden of the other respondents. These increases are based 
on the fact that the information needed to make these disclosures 
should be readily available to the respondents and the fact that, based 
on information provided to the SECPS, approximately 75 percent of 
Commission registrants receive no non-audit services from the auditors 
of their financial statements and, accordingly, will not be required to 
make any disclosures under the proposed amendments.
    We believe the proposed disclosure will bolster confidence in the 
securities markets by informing investors about: (i) non-audit 
relationships between the auditor and the audit client, and (ii) 
situations in which a majority of the audit work is performed by 
employees of an entity other than the principal audit firm signing the 
audit opinion. As discussed in other sections of this release, there is 
growing concern about the impact of non-audit services on auditors' 
independence. The disclosure will bring the benefit of sunshine to non-
audit relationships and replace uncertainty about the nature and scope 
of such relationships with facts about the services provided by an 
auditor to each audit client. This information may be material to an 
investor's decision to vote on the selection or ratification of the 
auditor. The disclosure regarding the auditor's use of another entity's 
employees to perform a majority of the audit work also provides 
important information to investors. Investors may need to know when a 
majority of the audit work is performed by persons who have financial, 
business, and personal interests in addition to, or different from, 
persons employed directly by the auditor.
    Compliance with the disclosure requirements is mandatory if the 
audit client is subject to the proxy or information disclosure 
requirements and either (i) the audit client has received non-audit 
services from the auditor of its financial statements, or (ii) the 
auditor used employees of another entity to perform a majority of the 
audit work. There would be no mandatory retention period for the 
information disclosed, and responses to the disclosure requirements 
will not be kept confidential.
    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to: (i) Evaluate whether the proposed collection of 
information is necessary for the proper performance of the functions of 
the agency, including whether the information will have practical 
utility, (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information, (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected, and (iv) evaluate whether there are 
ways to minimize the burden of the collection of information on those 
who respond, including through the use of automated collection 
techniques or other forms of information technology.
    Persons submitting comments on the collection of information 
requirements should direct the comments to OMB, Attention: Desk Officer 
for the Securities and Exchange Commission, Office of Information and 
Regulatory Affairs, Washington, DC 20503, and send a copy to Jonathan 
G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth 
Street, NW., Washington, DC 20549, with reference to File No. S7-13-00. 
Requests for materials submitted to OMB by the Commission with regard 
to this collection of information should be in writing, refer to File 
No. S7-13-00, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services. OMB is required to make a decision concerning the collection 
of information between 30 and 60 days after publication of this 
release. Consequently, a comment to OMB is assured of having its full 
effect if OMB receives it within 30 days of publication.

VIII. Consideration of Impact on the Economy, Burden on 
Competition, and Promotion of Efficiency, Competition, and Capital 
Formation

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996,\242\ we are requesting information regarding the potential 
impact of the proposals on the economy on an annual basis. Commenters 
should provide empirical data to support their views.
---------------------------------------------------------------------------

    \242\ Pub. L. No. 104-121, tit. II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

    Section 23(a)(2) of the Exchange Act requires us, when adopting 
rules under the Exchange Act, to consider the anti-competitive effects 
of any rule it adopts.\243\ We expect that in some ways the proposals 
will increase competition by removing the accountant's competitive 
advantage in bidding on or otherwise obtaining non-audit work required 
by audit clients.\244\ We request comment on any anti-competitive 
effects of the proposals.
---------------------------------------------------------------------------

    \243\ 15 U.S.C. 78w(aa)(2).
    \244\ See supra Section V. for a discussion of this issue.
---------------------------------------------------------------------------

    In addition, Section 3(f) of the Exchange Act requires us, when 
engaging in rulemaking that requires us to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider whether the action will promote efficiency, competition, 
and capital formation.\245\ We believe that the proposals will increase 
investor confidence in the integrity of the audit process and in the 
audited financial information that they use daily to make investment 
and voting decisions. This increased sense of confidence should promote 
market efficiency and capital formation. The modernization of our rules 
should allow more accountants, and their families, to invest in a wider 
range of investment opportunities. According to information provided to 
the SECPS, over 100,000 individuals will have more freedom of choice in 
their financial investments.

[[Page 43190]]

This should increase the efficiency of the markets. We request comment 
on these matters.
---------------------------------------------------------------------------

    \245\ 15 U.S.C. Sec. 78c(f).
---------------------------------------------------------------------------

IX. Codification Update

    The ``Codification of Financial Reporting Policies'' announced in 
Financial Reporting Release No. 1 (April 15, 1982) is proposed to be 
amended as follows:
    1. By removing section 602.01.
    2. By removing section 602.02.a.
    3. By removing section 602.02.b.i.
    4. By removing section 602.02.b.ii to remove examples 2, 3, 4, 7, 
8, and 10, and redesignate examples 5, 6, and 9 as examples 2, 3, and 
4.
    5. By removing section 602.02.b.iii.
    6. By amending section 602.02.b.iv to remove the first three 
introductory paragraphs.
    7. By amending section 602.02.c.i to remove the last two 
paragraphs.
    8. By amending section 602.02.c.ii to remove examples 1, 2, 3, 4, 
5, 7, 8, and 9 and redesignate example 6 as example 1.
    9. By amending section 602.02.d to remove the two introductory 
paragraphs, remove examples 2, 3, 4, 5, 6, and 7, and redesignate 
example 8 as example 2.
    10. By removing section 602.02.e.ii.
    11. By removing section 602.02.e.iii.
    12. By amending section 602.02.f to remove the introductory 
paragraph, remove examples 1, 2, 3, 4, and 5, and redesignate examples 
6 and 7 as examples 1 and 2.
    13. By amending section 602.02.g to remove examples 5, 15, 18, 19, 
and 22 and remove examples 6, 7, 8, 9, 10, 11, 12, 13, 14, 16, 17, 20, 
21, 23, and 24 as examples 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 
17, 18, and 19, respectively.
    14. By removing section 602.02.h.
    15. By adding section 602.01, captioned ``Discussion of Rule 2-
01,'' to include the text in the adopting release that discusses the 
final rules, which, if the proposed rules are adopted, would be 
substantially similar to topic III of this release.
    16. By amending section 602.02 to redesignate sections 602.02.b.ii, 
602.02.b.iv, 602.02.b.v, 602.02.c.i, 602.02.c.ii, 602.02.c.iii, 
602.02.d, 602.02.e.i, 602.02.e.iv, 602.02.f, 602.02.g, 602.02.i.i, and 
602.02.i.ii as sections 602.02.a.i, 602.02.a.ii, 602.02.a.iii, 
602.02.b.i, 602.02.b.ii, 602.02.b.iii, 602.02.c, 602.02.d.i, 
602.02.d.ii, 602.02.e, 602.02.f, 602.02.g.i, and 602.02.g.ii, 
respectively.
    The Codification is a separate publication of the Commission. It 
will not be published in the Code of Federal Regulations.

X. Statutory Bases and Text of Amendments

    We are proposing amendments to Rule 2-01 of Regulation S-X and Item 
9 of Schedule 14A under the authority set forth in Schedule A and 
Sections 19 and 28 of the Securities Act, Sections 3, 10A, 12, 13, 14, 
17, 23 and 36 of the Exchange Act, Sections 5, 10, 14, and 20 of the 
Public Utility Holding Company Act of 1935, Sections 8, 30, and 38 of 
the Investment Company Act of 1940, and Sections 203 and 211 of the 
Investment Advisers Act of 1940.

List of Subjects

17 CFR Part 210

    Accountants, Accounting.

17 CFR Part 240

    Reporting and recordkeeping requirements, Securities.

Text of Amendments

    In accordance with the foregoing, Title 17, Chapter II of the Code 
of Federal Regulations is proposed to be amended as follows:

PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL 
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT 
COMPANY ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975

    1. The authority citation for Part 210 continues to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77aa(25), 
77aa(26), 78j-1, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d), 
79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-
37(a), unless otherwise noted.
    2. By amending Sec. 210.2-01 by revising paragraphs (b) and (c) and 
adding paragraphs (d), (e) and (f) to read as follows:


Sec. 210.2-01  Qualifications of accountants.

    (a) * * *
    (b) The Commission will not recognize an accountant as independent, 
with respect to an audit client, if the accountant is not, or would not 
be perceived by reasonable investors to be, capable of exercising 
objective and impartial judgment on all issues encompassed within the 
accountant's engagement. Under this standard, an accountant is not 
independent whenever, during the audit and professional engagement 
period, the accountant:
    (1) Has a mutual or conflicting interest with the audit client;
    (2) Audits the accountant's own work;
    (3) Functions as management or an employee of the audit client; or
    (4) Acts as an advocate for the audit client.
    (c) An accountant is not independent under the standard of 
paragraph (b) of this section if, during the audit and professional 
engagement period, the accountant has any of the financial, employment 
or business relationships with, provides any of the non-audit services 
to, or receives a contingent fee from, the accountant's audit client or 
an affiliate of the audit client, as specified in paragraphs (c)(1) 
through (c)(5) of this section, or otherwise does not comply with the 
standard of paragraph (b) of this section.
    (1) Financial relationships. An accountant is not independent under 
the standard of paragraph (b) of this section if the accountant has a 
direct financial interest or a material indirect financial interest in 
the accountant's audit client, such as the financial relationships 
specified in this paragraph (c)(1).
    (i) Investment in audit client. An accountant is not independent 
when:
    (A) The accounting firm, any covered person in the firm, or any of 
his or her immediate family members, has any direct investment in an 
audit client or an affiliate of an audit client, such as stocks, bonds, 
notes, options, or other securities.
    (B) Any partner, principal, shareholder, or professional employee 
of the accounting firm, any of his or her immediate family members, any 
close family member of a covered person in the firm, or any group of 
the above persons has filed a Schedule 13D or 13G with the Commission 
indicating beneficial ownership of more than five percent of an audit 
client's equity securities, or otherwise controls an audit client.
    (C) The accounting firm, any covered person in the firm, or any of 
his or her immediate family members, serves as voting trustee of a 
trust or executor of an estate containing the securities of an audit 
client.
    (D) The accounting firm, any covered person in the firm, any of his 
or her immediate family members, or any group of the above persons has 
any material indirect investment in an audit client, including:
    (1) Ownership of more than five percent of an entity that has an 
ownership interest in the audit client; or
    (2) Ownership of more than five percent of an entity of which the 
audit client has an ownership interest.
    (ii) Other financial interests in audit client. An accountant is 
not independent when the accounting firm,

[[Page 43191]]

any covered person in the firm, or any of his or her immediate family 
members has:
    (A) Loans/debtor-creditor relationship. Any loan (including any 
margin loan) to or from an audit client, an affiliate of an audit 
client, or an audit client's or an affiliate of an audit client's 
officers, directors, or record or beneficial owners of more than five 
percent of the audit client's or affiliate's equity securities, except 
for the following loans obtained from a financial institution under its 
normal lending procedures, terms and requirements:
    (1) Automobile loans and leases collateralized by the automobile;
    (2) Loans fully collateralized by the cash surrender value of an 
insurance policy;
    (3) Loans fully collateralized by cash deposits at the same 
financial institution; and
    (4) A mortgage loan collateralized by the accountant's primary 
residence provided the loan was not obtained while the borrower was a 
covered person in the firm or an immediate family member of a covered 
person in the firm.
    (B) Savings and checking accounts. Any savings, checking or similar 
account at a bank, savings and loan or similar institution that is an 
audit client or an affiliate of an audit client, if the account has a 
balance that exceeds the amount insured by the Federal Deposit 
Insurance Corporation or any similar insurer.
    (C) Broker-dealer accounts. Any brokerage or similar accounts 
maintained with a broker-dealer that is an audit client or an affiliate 
of the audit client, if:
    (1) Any such accounts include any asset other than cash or 
securities (within the meaning of ``security'' provided in the 
Securities Investor Protection Act); or
    (2) The value of assets in the accounts exceeds the amount that is 
subject to a Securities Investor Protection Corporation advance, for 
those accounts, under Section 9 of the Securities Investor Protection 
Act.
    (D) Futures commission merchant accounts. Any futures, commodity, 
or similar account maintained with a futures commission merchant that 
is an audit client or an affiliate of the audit client.
    (E) Credit cards. Any credit card balance in excess of $10,000 owed 
to a lender that is an audit client or an affiliate of an audit client.
    (F) Insurance products. Any individual policy or professional 
liability policy originally issued by an insurer that is an audit 
client or an affiliate of an audit client.
    (G) Investment companies. Any investment in any entity in an 
investment company complex if the audit client is also an entity in the 
same investment company complex. When the audit client is an entity 
that is part of an investment company complex, the accountant must be 
independent of each entity in the investment company complex.
    (iii) Exceptions. Notwithstanding paragraphs (c)(1)(i) and 
(c)(1)(ii) of this section, the accountant will not be deemed not 
independent if:
    (A) Inheritance and gift. Any person acquires a financial interest 
through an unsolicited gift or inheritance that would cause an 
accountant to be not independent under paragraphs (c)(1)(i) or 
(c)(1)(ii) of this section, and the financial interest is disposed of 
as soon as practicable, but no longer than 30 days after the person has 
the right to dispose of the financial interest.
    (B) New audit engagement. Any person has a financial interest that 
would cause an accountant to be not independent under paragraphs 
(c)(1)(i) or (c)(1)(ii) of this section, and:
    (1) The accountant did not audit the client's financial statements 
for the immediately preceding fiscal year; and
    (2) The accountant is independent under paragraphs (c)(1)(i) and 
(c)(1)(ii) of this section before the earlier of:
    (i) Accepting the engagement to provide audit, review, or attest 
services to the audit client; or
    (ii) Commencing any audit, review or attest procedures (including 
planning the audit of the client's financial statements).
    (iv) Audit clients' financial relationships. An accountant is not 
independent when:
    (A) Investments by the audit client in the auditor. An audit client 
or an affiliate of an audit client has, or has agreed to acquire, any 
direct investment in the accounting firm or its affiliate, such as 
stocks, bonds, notes, options, or other securities.
    (B) Underwriting. An audit client or an affiliate of an audit 
client, including a broker-dealer or other entity, performs any service 
for the accounting firm related to underwriting, offering, making a 
market in, marketing, promoting, or selling securities issued by the 
accounting firm, or issues an analyst report concerning the securities 
of the accounting firm.
    (2) Employment relationships. An accountant is not independent 
under the standard of paragraph (b) of this section if the accountant 
has an employment relationship with an audit client or an affiliate of 
an audit client, such as the employment relationships specified in this 
paragraph (c)(2). An accountant is not independent when:
    (i) Employment at audit client of accountant. A current partner, 
principal, shareholder, or professional employee of the accounting firm 
is employed by the audit client or an affiliate of an audit client or 
serves as a member of the board of directors or similar management or 
governing body of the audit client or an affiliate of the audit client.
    (ii) Employment at audit client of certain relatives of accountant. 
A close family member of a covered person in the firm is in an 
accounting or financial reporting oversight role at an audit client or 
an affiliate of an audit client, or was in such a role during any 
period covered by an audit for which the covered person in the firm is 
a covered person.
    (iii) Employment at audit client of former employee of accounting 
firm. A former partner, shareholder, principal, or professional 
employee of an accounting firm is in an accounting or financial 
reporting oversight role at an audit client or an affiliate of an audit 
client, unless the individual:
    (A) Does not influence the accounting firm's operations or 
financial policies;
    (B) Has no capital balances in the accounting firm; and
    (C) Has no financial arrangement with the accounting firm other 
than one providing for regular payment of a fixed dollar amount (which 
is not dependent on the revenues, profits, or earnings of the firm) 
pursuant to a fully funded retirement plan or rabbi trust.
    (iv) Employment at accounting firm of former employee of audit 
client. A former officer, director, or employee of an audit client or 
an affiliate of an audit client becomes a partner, shareholder, or 
principal of the accounting firm, unless the individual does not 
participate in, and is not in a position to influence, the audit of the 
financial statements of the audit client or an affiliate of the audit 
client covering any period during which he or she was employed by or 
associated with that audit client or an affiliate of the audit client.
    (3) Business relationships. An accountant is not independent under 
the standard of paragraph (b) of this section if the accounting firm or 
any covered person in the firm has any direct or material indirect 
business relationship with an audit client, an affiliate of an audit 
client, or with an audit client's or an affiliate of an audit client's 
officers, directors, or record or beneficial owners of more than five

[[Page 43192]]

percent of the audit client's or affiliate's equity securities. The 
relationships described in this paragraph do not include a relationship 
in which the accounting firm or covered person in the firm provides 
professional services or is a consumer in the ordinary course of 
business,
    (4) Non-audit services. (i) Even if the audit client accepts 
ultimate responsibility for the work that is performed or decisions 
that are made, an accountant is not independent under the standard of 
paragraph (b) of this section when the accountant provides certain non-
audit services to an audit client or an affiliate of an audit client, 
such as:
    (A) Bookkeeping or other services related to the audit client's 
accounting records or financial statements. Any service involving:
    (1) Maintaining or preparing the audit client's or an affiliate of 
the audit client's accounting records;
    (2) Preparing the audit client's or an affiliate of the audit 
client's financial statements; or
    (3) Generating financial information to be disclosed by the audit 
client or an affiliate of the audit client to the public.
    (B) Financial information systems design and implementation. 
Designing or implementing a hardware or software system used to 
generate information that is significant to the audit client's 
financial statements taken as a whole, not including services an 
accountant performs in connection with the assessment, design, and 
implementation of internal accounting controls and risk management 
controls.
    (C) Appraisal or valuation services, fairness opinions, or 
contribution-in-kind reports. Any appraisal or valuation service for an 
audit client or an affiliate of an audit client, or any service 
involving a fairness opinion or contribution-in-kind report where it is 
reasonably likely that, in performing an audit in accordance with 
generally accepted auditing standards, the results will be audited by 
the accountant.
    (D) Actuarial services. Any advisory service involving the 
determination of policy reserves and related accounts for the audit 
client or an affiliate of an audit client, unless the audit client or 
its affiliate uses its own actuaries or third-party actuaries to 
provide management with the primary actuarial capabilities.
    (E) Internal audit outsourcing. Internal audit services for an 
audit client or an affiliate of an audit client, not including 
nonrecurring evaluations of discrete items or programs and operational 
internal audits unrelated to the internal accounting controls, 
financial systems, or financial statements.
    (F) Management functions. Acting, temporarily or permanently, as a 
director, officer, or employee of an audit client or an affiliate of an 
audit client, or performing any decision-making, supervisory, or 
ongoing monitoring function for the audit client or affiliate of the 
audit client.
    (G) Human resources. Recruiting, hiring, or designing compensation 
packages for officers, directors, or managers of the audit client or an 
affiliate of the audit client; advising about the audit client's or 
affiliate of the audit client's management or organizational structure; 
developing employee evaluation programs; or conducting psychological or 
other formal testing of employees.
    (H) Broker-dealer, investment adviser, or investment banking 
services. Acting as a securities professional, such as a broker-dealer, 
promoter, underwriter, analyst of the audit client's or an affiliate of 
the audit client's securities, investment adviser, or in any capacity 
recommending the purchase or sale of an audit client's or an affiliate 
of an audit client's securities, or designing the audit client or an 
affiliate of the audit client's system to comply with broker-dealer or 
investment adviser regulations.
    (I) Legal services. Providing any service to an audit client or an 
affiliate of an audit client that, in the jurisdiction in which the 
service is provided, could be provided only by someone licensed to 
practice law.
    (J) Expert services. Rendering or supporting expert opinions for an 
audit client or an affiliate of an audit client in legal, 
administrative, or regulatory filings or proceedings.
    (ii) Transition. Until [insert date two years from the effective 
date of this section], providing to an audit client or an affiliate of 
an audit client the non-audit services set forth in paragraph (c)(4)(i) 
of this section will not impair an accountant's independence with 
respect to the audit client if:
    (A) The non-audit services are performed pursuant to a written 
contract in effect on or before [insert the effective date of this 
section]; and
    (B) Performing those services did not impair the auditor's 
independence under pre-existing requirements of the Commission, the 
Independence Standards Board, or the accounting profession in the 
United States.
    (5) Contingent fees. An accountant is not independent under the 
standard of paragraph (b) of this section if the accountant provides 
any service to an audit client or an affiliate of an audit client for a 
contingent fee, or receives a contingent fee from an audit client or an 
affiliate of an audit client.
    (d) Quality controls. An accounting firm's independence will not be 
impaired solely because a covered person in the firm is not independent 
of an audit client provided:
    (1) The covered person did not know, and was reasonable in not 
knowing, of the circumstances giving rise to the lack of independence;
    (2) The covered person's lack of independence was corrected 
promptly after the covered person or accounting firm became aware of 
it; and
    (3) The accounting firm has a quality control system in place that 
provides reasonable assurance, taking into account the size and nature 
of the accounting firm's practice, that the accounting firm and its 
employees do not lack independence. For an accounting firm that 
annually provides audit, review, or attest services to more than 500 
companies with a class of securities registered with the Commission 
under section 12 of the Securities Exchange Act of 1934, a quality 
control system will not provide such reasonable assurance unless it has 
at least the following features:
    (i) Written independence policies and procedures;
    (ii) An automated system to identify financial relationships that 
might impair the accountant's independence;
    (iii) An annual or on-going firm-wide training program about 
auditor independence;
    (iv) An annual internal inspection and testing program to monitor 
adherence to independence requirements;
    (v) Notification to all firm members, officers, directors, and 
employees of the name and title of the member of senior management 
responsible for compliance with auditor independence requirements;
    (vi) Written policies and procedures requiring all firm 
professionals to report promptly to the firm when they are engaged in 
employment negotiations with an audit client, and requiring the firm to 
remove immediately any such professional from that audit client's 
engagement and to review promptly all work the professional performed 
related to that audit client's engagement; and
    (vii) A disciplinary mechanism to ensure compliance with this 
section.
    (e) In determining whether an accountant is independent, the 
Commission will consider all relevant circumstances, including all 
relationships between the accountant and the audit client or the 
affiliates of the audit client, and not just those

[[Page 43193]]

relating to reports filed with the Commission.
    (f) Definitions of terms. For purposes of this section:
    (1) Accountant, as used in paragraphs (b) through (e) of this 
section, means a certified public accountant or public accountant 
performing services in connection with an engagement for which 
independence is required. References to the accountant include any 
accounting firm with which the certified public accountant or public 
accountant is affiliated.
    (2) Accounting firm means the organization (whether it is a sole 
proprietorship, incorporated association, partnership, corporation, 
limited liability company, limited liability partnership, or other 
legal entity) that is engaged in the practice of public accounting or 
furnishing accountant's reports with respect to financial statements, 
reports, or other documents filed with the Commission, and all 
departments, divisions, parents, subsidiaries, and affiliates of the 
accounting firm, including its pension, retirement, investment or 
similar plans.
    (3) Accounting or financial reporting oversight role means that the 
person is in a position to, or does influence the contents of the 
accounting records or financial statements or anyone who prepares them, 
such as when the person is a member of the board of directors or 
similar management or governing body, chief executive officer, 
president, chief financial officer, chief operating officer, general 
counsel, chief accounting officer, controller, director of internal 
audit, director of financial reporting, treasurer, vice president of 
marketing, or any equivalent position.
    (4) Affiliate of the accounting firm. (i) ``Affiliate of the 
accounting firm'' means:
    (A) Any person directly or indirectly controlling, controlled by, 
or under common control with the accounting firm, including:
    (1) Any person or entity directly or indirectly owning, 
controlling, or holding the power to vote five percent or more of the 
accounting firm's outstanding voting securities, partnership units, or 
other interest entitling a person to vote; and
    (2) Any person or entity five percent or more of whose outstanding 
voting securities, partnership units, or other interest entitling a 
person to vote are directly or indirectly owned, controlled, or held by 
the accounting firm;
    (B) Any officer, director, partner, copartner, or shareholder of 
more than five percent of the voting securities of a person described 
in paragraph (f)(4)(A) of this section;
    (C) Any joint venture, partnership, or other undertaking in which 
the accounting firm participates and in which the parties agree to any 
form of shared benefits, including any form of shared revenue, income, 
or equity appreciation;
    (D) Any entity that provides non-audit or other professional 
services to one or more of the accounting firm's audit clients, and in 
which the accounting firm has any equity interest in, has loaned funds 
to, or shares revenues with, or with which the accounting firm or any 
covered person in the firm has any direct business relationship;
    (E) All persons and entities with which the accounting firm is 
publicly associated by co-branding; using the accounting firm's name, 
initials, or logo; cross-selling services; or using co-management; and
    (F) If the accounting firm leases, or otherwise routinely acquires 
on a temporary or continuous basis, the services of personnel employed 
full- or part-time by another party (the ``lessor'') and the leased 
personnel perform a majority of the hours worked on the engagement or 
supporting the accountant's reports filed with the Commission, the 
lessor and the lessor's board of directors, executive officers, and all 
persons with management, supervisory, compensation, or other oversight 
responsibility for the leased personnel, and shareholders of five 
percent or more of the lessor's equity securities.
    (ii) ``Affiliate of the accounting firm'' does not include parties 
that share with an accounting firm training facilities, technical 
knowledge, databases, or billing facilities but that have no other 
business or financial relationship with the accounting firm, provided 
that the accounting firm pays a reasonably proportionate and fair share 
of the costs and expenses associated with such items, and the party 
charges all participants no more than the costs and expenses incurred 
to operate or maintain the shared facility or database.
    (5) Affiliate of the audit client means an entity that has 
significant influence over the audit client, or over which the audit 
client has significant influence, including the audit client's parent 
and subsidiary.
    (6) Audit and professional engagement period includes both:
    (i) The period covered by any financial statements being audited or 
reviewed (the ``audit period''); and
    (ii) The period of the engagement to audit or review the client's 
financial statements or to prepare a report filed with the Commission 
(the ``professional engagement period'').
    (A) The professional engagement period begins when the accountant 
either signs an initial engagement letter (or other agreement to review 
or audit a client's financial statements), or begins review or audit 
procedures, whichever is earlier; and
    (B) The professional engagement period ends when the client or the 
accountant notifies the Commission that the client is no longer that 
accountant's audit client.
    (7) Audit client means the entity whose financial statements or 
other information is being audited, reviewed, or attested.
    (8) Audit engagement team means all partners, principals, 
shareholders, and professional employees participating in an audit, 
review, or attestation engagement of an audit client, including those 
conducting concurring or second partner reviews and all persons who 
consult, formally or informally, with others on the audit engagement 
team during the audit, review, or attestation engagement regarding 
technical or industry-specific issues, transactions, or events.
    (9) Chain of command means all persons having any supervisory, 
management, quality control, compensation, or other oversight 
responsibility over either any member of the audit engagement team or 
over the conduct of the audit. The ``chain of command'' includes all 
partners, principals, shareholders, and managers who may review, 
determine, or influence the performance appraisal or compensation of 
any member of the audit engagement team and any other person in a 
position to influence the audit engagement team's decisions during the 
conduct of the audit, review, or attestation engagement.
    (10) Close family members means a person's spouse, spousal 
equivalent, parent, dependent, nondependent child, and sibling.
    (11) Consumer in the ordinary course of business means a purchaser 
of routine products or services on the same terms and conditions that 
are available to the seller's other customers or clients, as long as 
the purchaser does not resell the product or service or receive a 
commission or other fee for selling the product or service.
    (12) Contingent fee means any fee where payment, or the amount of 
the fee paid or due, is contingent, in whole or in part, on the result, 
including the value added, of any transaction or event, other than 
completion of the work or delivery of the product giving rise to the 
fee. A fee is not a ``contingent fee'' if it is fixed by a court or by 
any federal, state, or local governmental agency.

[[Page 43194]]

    (13) Covered persons in the firm means the following partners, 
principals, shareholders, and employees of an accounting firm:
    (i) The ``audit engagement team;''
    (ii) The ``chain of command;''
    (iii) Any other partner, principal, shareholder, or professional 
employee of the accounting firm who is, or during the audit client's 
most recent fiscal year was, involved in providing any professional 
service to the audit client or an affiliate of the audit client; and
    (iv) Any other partner, principal, or shareholder from an 
``office'' of the accounting firm that participates in a significant 
portion of the audit.
    (14) Group means when two or more persons act together for the 
purposes of acquiring, holding, voting, or disposing of securities of a 
registrant.
    (15) Immediate family members means a person's spouse, spousal 
equivalent, and dependent.
    (16) Investment company complex. (i) ``Investment company complex'' 
includes:
    (A) An investment company and its investment adviser or sponsor;
    (B) Any entity controlled by, under common control with or 
controlling the investment adviser or sponsor in paragraph (f)(16)(A) 
of this section; or
    (C) Any investment company or entity that would be an investment 
company but for the exclusions provided by section 3(c) of the 
Investment Company Act of 1940 (15 U.S.C. Sec. 80a-3(c)) that has an 
investment adviser or sponsor included in this definition by either 
paragraphs (f)(16)(A) or (f)(16)(B) of this section.
    (ii) An investment adviser, for purposes of this definition, does 
not include a sub-adviser whose role is primarily portfolio management 
and is subcontracted with or overseen by another investment adviser.
    (iii) Sponsor, for purposes of this definition, is an entity that 
establishes a unit investment trust.
    (17) Office means a distinct sub-group within an accounting firm, 
whether distinguished along geographic or practice lines.
    (18) Rabbi trust means an irrevocable trust whose assets are not 
accessible to the accounting firm until all benefit obligations have 
been met, but are subject to the claims of creditors in bankruptcy or 
insolvency.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    3. The authority citation for Part 240 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 
80b-11, unless otherwise noted.
* * * * *
    4. By amending Sec. 240.14a-101 to add paragraph (e) to Item 9 to 
read as follows:


Sec. 240.14a-101  Schedule 14A Information required in proxy statement.

* * * * *
    Item 9. Independent public accountants. * * *
* * * * *
    (e)(1) Describe each professional service provided during the most 
recent fiscal year by the independent public or certified public 
accountant (as defined in Article 2 of Regulation S-X, 17 CFR 210.2-01) 
that is the registrant's principal accountant. A service does not have 
to be disclosed if the fee for that service was, is, or will be less 
than the lesser of $50,000 or 10 percent of the fee for the audit of 
the registrant's annual financial statements.
    Instruction to paragraph (e)(1). Specifically describe each 
service. Broad general categories such as ``tax matters'' or 
``management advisory services'' or ``management consulting services'' 
are not sufficient.
    (2) Indicate whether, before each disclosed professional service 
was rendered, the audit committee of the board of directors, or if 
there is no such committee then the board of directors, approved the 
service and considered the possible effect of the service on the 
principal accountant's independence.
    (3) Disclose the fee for each disclosed professional service.
    (4) Disclose the aggregate fee for the audit of the registrant's 
financial statements for the fiscal year most recently completed and 
for the reviews of the financial statements included in the 
registrant's Forms 10-Q (17 CFR 249.308a) or 10-QSB (17 CFR 249.308b) 
for that fiscal year.
    (5) If greater than 50 percent, disclose the percentage of the 
hours expended on the principal auditor's engagement to audit the 
registrant's financial statements for the most recent fiscal year that 
were attributed to work performed by persons other than the principal 
accountant's full-time, permanent employees.
* * * * *

    By the Commission.

    Dated: June 30, 2000.
Margaret H. McFarland,
Deputy Secretary.

    Note: Appendices A, B, and C to the preamble will not appear in 
the Code of Federal Regulations.

Appendix A

Services Offered by Professional Accounting Firms

Accounting and Auditing Services

    1. Year-end audit. This may include assisting the client in 
calculating the amount of the income taxes owed, valuing stock 
options and other stock compensation arrangements under FAS 123, and 
drafting and typing up the financial statements.
    2. Review of interim (monthly, quarterly) financial statements.
    3. Compilation of financial statements.
    4. Bookkeeping services (some firms offer this as a computer 
bookkeeping service).
    5. Valuations of derivatives at fair market value for accounting 
purposes.
    6. Assistance in preparation of and review of filings with the 
SEC, including initial public offerings.
    7. Underwriter comfort letters for SEC and non-SEC filings.
    8. Audit of Management's Discussion and Analysis in SEC filings.
    9. Agreed upon procedures engagement (the client and auditor 
agree to procedures the auditor is to perform with respect to tasks 
such as testing a royalty arrangement or compliance with a loan 
agreement, and the auditor then issues a report on his or her 
findings).
    10. Audit or review of financial forecasts or projections. This 
includes such documents included in offering memoranda.
    11. Providing advice on how to interpret new accounting 
pronouncements, including providing sample journal entries.
    12. Audits of financial statements of pension plan financial 
statements.
    13. Director examinations of financial institutions.
    14. CPA WebTrust--an engagement to review the security of a 
company's website that is conducting electronic commerce over the 
internet.
    15. Assisting international companies in conforming their 
financial reporting to U.S. financial reporting practices (GAAP 
conversions).
    16. Technical opinions on accounting matters to clients of other 
accounting firms.

Business Controls

    1. Ethics and Responsible Business Practices--a service that 
helps clients address the sources of internal wrongdoing and 
eliminate barriers to responsible business practices.
    2. Evaluation, design and implementation of internal accounting 
and financial reporting controls, policies and procedures.
    3. Evaluation, design and implementation of management and 
business controls over various business functions such as management 
reporting systems, research and development, etc.
    4. Examinations of internal controls.

[[Page 43195]]

    5. Business Fraud and Investigation Services--helps companies 
identify, manage and minimize integrity risks, such as suspected 
management or alleged employee fraud.

Tax Services

    1. Preparation of federal and state individual income tax 
returns.
    2. Preparation of federal and state corporation tax returns.
    3. Individual and corporate tax planning (including federal, 
state, and local taxes).
    4. Personal financial planning for individuals including client 
employees and executives.
    5. Income tax planning for executives including employee 
compensation and benefit plans (see below).
    6. Investment planning.
    7. Programs for planning for college.
    8. Retirement planning programs.
    9. Estate planning including preparation of wills, trusts, etc.
    10. Representation of clients in tax negotiations and disputes 
with the IRS.
    11. Review of property tax assessments.
    12. Succession planning.
    13. Serve as or provide tax advice to executors and trustees.
    14. Tax credit reviews to determine maximum allowable credits 
(e.g., research and development credits).
    15. Trade and customs services--ensures compliance with trade 
laws and regulations while trying to avoid, reduce, or defer overall 
customs duties.
    16. Transfer pricing studies and evaluation, documentation, and 
modification of existing policies.
    17. Valuation services.
    18. VAT Services.

Financial Services

    1. Treasury management services including design, development 
and implementation of policies and procedures.
    2. Credit management services including design, development and 
implementation of credit policies and procedures.
    3. Design and structuring of financial instruments.
    4. Assisting investment banking firms with the design of 
financial instruments and financing transactions.
    5. Assistance with finding/identifying equity parties or 
financing parties.
    6. Identification and selection of banks.
    7. Assistance with or preparation of financing and loan 
applications.
    8. Loan review services.
    9. Regulatory advisory services.

Information Systems Technology

    1. Selection of new hardware and software systems. This may 
include activities such as performing a ``needs analysis,'' 
preparation of a request for proposals, and overseeing, assistance 
with, or performance of demonstrations.
    2. Implementation of new hardware and software systems. This may 
include:

 Full on-site team to perform all implementation services.
 Project administration of another consulting team.
 Development of necessary manual and computer control 
systems.
 Providing necessary computer programmers.
 Software design and programming.
 Ongoing support functions.

    3. Consulting on Y2K issues such as:

 Inventory of Y2K system problems.

 Development of Y2K remediation program.

    4. Development of IT management and/or strategic plans.
    5. Evaluation and selection of telephone systems.
    6. Business continuity planning and information security 
services.
    7. Application controls consulting.
    8. Electronic commerce services.
    9. Reporting on the processing of transactions by service 
organizations.

Employment Benefit Programs

    1. Designing and developing employee compensation programs 
including:
 Stock option programs.
 Retirement plans.
 Executive compensation arrangements.
 Deferred compensation and bonus arrangements.

Business Reengineering

    1. Benchmarking of best practices including business and 
financial reporting practices.
    2. Reengineering of business processes including:

 Manufacturing processes.
 Research and development processes.
 Review of spending levels (e.g., for general and 
administrative expenses).
 Plant layout design.

    3. Review of manual processes that feed into computerized 
information systems.
    4. Staff reduction programs.

Outsourcing

    Outsourcing of such client functions as:
    1. Information systems. This may include outsourcing the 
management or the entire data processing and information systems 
group.
    1. Internal audit function.
    2. Tax department.
    3. Office of the Chief Financial Officer.
    4. Accounting department.
    5. Human resource department.
    6. Risk management function.

Corporate Finance

    1. Deal due diligence.
    2. Candidate targeting.
    3. Preparation of offering memorandums.
    4. Lead advisor for private placements
    5. Merger transaction advice on:

 Structuring of transactions.
 Tax implementations.
 Sourcing capital.
 Preparation of pro forma financial statements and 
projections.
 Reengineering acquired businesses.
 Cost reduction and synergistic studies.

    6. Appraisal and valuation of targets assets, including 
receivables, inventories, property, plant and equipment, intangible 
assets and in-process research and development.
    7. Fairness opinions.
    8. In some foreign jurisdictions, the firms act as stock 
transfer agents.
    9. ``Turnaround'' business advisors.

Marketing and Distribution

    1. Evaluation of marketing and distribution channels.
    2. Development of marketing and distribution channel plans and 
consulting on the implementation of such plans.

Legal Services

    1. Corporate and commercial legal services to national and 
international companies worldwide.
    2. Assistance to law departments and general counsel to enhance 
and measure performance.

Litigation Support

    1. Case management.
    2. Expert accounting and financial reporting witnesses.
    3. Damages experts and witnesses.
    4. Environmental litigation experts.
    5. Securities litigation experts.
    6. Antitrust services.
    7. Construction disputes.
    8. Service of detailed data to provide cost-effective, proactive 
strategies and solutions to complex business disputes.

Other

    1. Government Contract Consulting--helps companies understand 
and address business risks associated with negotiating, contracting 
with, and performing under contracts for the sale of goods or 
services with U.S. federal, state, local and foreign governments.
    2. Advise government entities that are privatizing on 
commercialization, restructuring, competition, changing organization 
attitudes, customer satisfaction and policy adjustment; provides 
other grant-aided work in emerging markets.
    3. Real Estate--provides advice about increasing the 
profitability of real estate assets through the acquisition, 
development, management and disposition of single assets or 
portfolios of properties. Services also include strategic planning, 
consolidation studies, surplus property planning, valuations, and 
outsourcing consulting.
    4. Services for middle-sized companies--includes cash 
management, payroll needs, business relocation services, and 
shareholder meetings.
    5. Insolvency/executory services--acting as receivers, 
liquidators, bankruptcy trustees, or advisors to debtor or creditor 
groups.
    6. Specific services for health insurers and other health care 
organizations.
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BILLING CODE 8010-01-C

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Direct Investments in the Audit Client or an Affiliate of the Audit 
Client

    Section (c)(1)(i)(A) of the proposed rule states that an 
accountant is not independent when the Accounting Firm, any Covered 
Person in the firm or a member of the Immediate Family of a Covered 
Person in the firm has any direct investment in an ``Audit Client'' 
or an ``Affiliate of the Audit Client.'' Section (f)(5) of the 
proposed rule defines ``Affiliate of the Audit Client'' as an entity 
that has significant influence over the audit client, or over which 
the audit client has significant influence. Also, under APB No. 18 
as noted in the release, there is a presumption of significant 
influence where an entity owns 20% or more of an audit client or 
where the audit client owns 20% or more of an entity. For purposes 
of these examples, we assume that there are no other factors 
rebutting the presumption of significant influence under APB No. 18.
    Both and C own 20% or more of the Audit Client. In addition, the 
Audit Client owns 20% or more of E, which in turn owns 20% or more 
of F and G. The Audit Client also owns 20% of L which in turn owns 
20% or more of M and N. Finally the Audit Client owns more than 20% 
of J. Thus, in addition to being precluded from directly investing 
in A, the Accounting Firm, any Covered Person in the firm and the 
Immediate Families of Covered Persons in the firm would be precluded 
from directly investing in companies B, C, E, F, G, L, M, N, and J 
since these entities are affiliates of the audit client.
    With respect to D, I, H, and O there is no presumption of 
significant influence since D only owns 5% of the Audit Client and 
the Audit Client only owns 5% of I and the entities over which A has 
significant influence, E and L, only own 5% of H and O, 
respectively. Under APB No. 18, as noted in the release, there could 
be other indicia that would cause D's ownership of the audit Client 
or the Audit Client's ownership of 5% of I (as well as E's ownership 
of H or L's ownership of the Audit Client or the Audit Client's 
ownership of 5% of I (as well as E's ownership of H or L's ownership 
of O) to rise to the independence would be impaired by direct 
investments in those entities.
    J is an Affiliate of the Audit Client because the Audit Client 
owns more than 20% of J and thus has ``significant influence'' over 
J. However, K is not an Affiliate of the Audit Client because the 
Audit Client does not have ``significant influence'' over K and the 
accountant's independence would not be impaired by direct 
investments in K.
    Therefore, the Accounting Form, Covered Persons and the 
Immediate Families of Covered Persons would not be precluded from 
investing in D, I, H, O, and K. Investments in D, I, H, and O could 
not exceed 5% of the voting interests of these entities as described 
under ``Material Indirect Investment in an Audit Client or an 
Affiliate of the Audit Client'' below.

Investments Reportable on Schedule 13D or 13G or Otherwise Control the 
Audit Client

    Section (c)(1)(i)(B) of the proposed rule states that an 
accountant would not be independent if any partner, principal, 
shareholder, or professional employee of the accounting firm, any of 
his or her immediate family members, any close family member of a 
covered person in the firm, or any group of the above persons has 
filed a Schedule 13D or 13G with the Commission indicating record or 
beneficial ownership of more than five percent of an audit client's 
equity securities, or otherwise controls an audit client.
    As noted above, partners and professionals in the firm other 
than covered persons, and their immediate families and the close 
family members of covered persons would not be precluded from 
investing in the audit Client, A. Section (c)(1)(i)(B) of the 
proposed rule operates to, among other things, preclude 
professionals in the firm from acting as a group to control the 
audit client. Thus, the accountant would not be independent when any 
partner or professional in the firm other than a covered person, a 
member of their immediate family, or the close family member of a 
covered person filed a Schedule 13D or 13G (generally required for 
investments over 5%) with the Commission or otherwise controlled the 
Audit Client, A.

Material Indirect Investment in an Audit Client or an Affiliate of the 
Audit Client

    Section (c)(1)(i)(D) of the proposed rule states that an 
accountant would not be independent if the accounting firm, any 
covered person in the firm or the immediate family member of a 
covered person or any group of these persons owned more than 5% of 
an entity that has an ownership interest in the audit client or more 
than 5% of an entity of which the audit client has an ownership 
interest.
    Assuming that D, I, H, and O are not affiliates, the accounting 
firm, a covered person in the firm or the immediate family of a 
covered person or any group of these persons could own up to 5% of 
these entities without impairing independence since a 5% investment 
would be considered an immaterial indirect investment in the Audit 
Client, A.

Employment of Relatives of a Covered Person

    Section (c)(2)(ii) of the proposed rule states that an 
accountant will not be independent if a close family member of a 
covered person in the firm is in an accounting or financial 
reporting oversight role at an audit client or an affiliate of an 
audit client or was in such a role during any period covered by an 
audit for which the covered person in the firm is a covered person.
    As noted above, B, C, E, F, G, L, M, N, and J are affiliates of 
the audit client. Consequently, the accountant would not be 
independent when any close family member of a covered person in the 
firm was employed in accounting or financial reporting oversight 
role at the Audit Client A or the affiliates of the audit client, B, 
C, E, F, G, L, M, N, or J.
    Subject to the general standard, a close family member of a 
covered person could work in any position at D, I, H, O, or K since 
those entities are not affiliates of the audit client.

Non-Audit Services

    Section (c)(4)(i) of the proposed rule provides that an 
accountant will not be independent when the accountant provides 
certain non-audit services to an audit client or an affiliate of an 
audit client.
    Accordingly, the accountant would not be independent if the 
accounting firm provided any prohibited non-audit services to the 
Audit Client, A, or to any affiliate of the audit client including 
B, C, E, F, G, L, M, N, and J. Subject to the general standard, the 
firm would not be precluded from providing non-audit services to D, 
I, H, O, or K since these entities are not affiliates of the audit 
client.

[FR Doc. 00-17207 Filed 7-11-00; 8:45 am]
BILLING CODE 8010-01-P