[Federal Register Volume 65, Number 234 (Tuesday, December 5, 2000)]
[Rules and Regulations]
[Pages 76008-76090]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30244]



[[Page 76007]]

-----------------------------------------------------------------------

Part II





Securities and Exchange Commission





-----------------------------------------------------------------------



17 CFR Parts 210 and 240



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

  Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / 
Rules and Regulations  

[[Page 76008]]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release Nos. 33-7919; 34-43602; 35-27279; IC-24744; IA-1911; FR-56; 
File No. S7-13-00]
RIN 3235-AH91


Revision of the Commission's Auditor Independence Requirements

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

-----------------------------------------------------------------------

SUMMARY: The Securities and Exchange Commission (``SEC'' or 
``Commission'') is adopting rule amendments regarding auditor 
independence. The amendments modernize the Commission's rules 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 amendments, 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 for purposes 
of determining the auditor's independence. The amendments shrink the 
circle of family and former firm personnel whose employment impairs an 
auditor's independence. They also identify certain non-audit services 
that, if provided by an auditor to public company audit clients, impair 
the auditor's independence. The scope of services provisions do not 
extend to services provided to non-audit clients. The final rules 
provide accounting firms with a limited exception from being deemed not 
independent for certain inadvertent independence impairments if they 
have quality controls and satisfy other conditions. Finally, the 
amendments require most public companies to disclose in their annual 
proxy statements certain information related to, among other things, 
the non-audit services provided by their auditor during the most recent 
fiscal year.

DATES: Effective date: February 5, 2001.
    Compliance dates: Transition Dates: Until August 5, 2002, providing 
to an audit client the non-audit services set forth in Sec. 210.2-
01(c)(4)(iii) (appraisal or valuation services or fairness opinions) 
and Sec. 210.2-01(c)(4)(v) (internal audit services) will not impair an 
accountant's independence with respect to the audit client if 
performing those services did not impair the accountant's independence 
under pre-existing requirements of the SEC, the Independence Standards 
Board, or the accounting profession in the United States. Until May 7, 
2001, having the financial interests set forth in Sec. 210.2-
01(c)(1)(ii) or the employment relationships set forth in Sec. 210.2-
01(c)(2) will not impair an accountant's independence with respect to 
the audit client if having those financial interests or employment 
relationships did not impair the accountant's independence under pre-
existing requirements of the SEC, the Independence Standards Board, or 
the accounting profession in the United States. Until December 31, 
2002, Sec. 210.2-01(d)(4) shall not apply to offices of the accounting 
firm located outside of the United States. Registrants must comply with 
the new proxy and information statement disclosure requirements for all 
proxy and information statements filed with the Commission after the 
effective date.

FOR FURTHER INFORMATION CONTACT: John M. Morrissey, Deputy Chief 
Accountant, or Sam Burke, Assistant 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 
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Commission today is adopting amendments 
to Rule 2-01 of Regulation S-X \1\ and Item 9 of Schedule 14A \2\ under 
the Securities Exchange Act of 1934 (the ``Exchange Act'').\3\
---------------------------------------------------------------------------

    \1\ 17 CFR 210.2-01.
    \2\ 17 CFR 240.14a-101.
    \3\ 15 U.S.C. Sec. 78a et seq.
---------------------------------------------------------------------------

I. Executive Summary

    We are adopting amendments to our current rules regarding auditor 
independence.\4\ The final rules advance our important policy goal of 
protecting the millions of people who invest their savings in our 
securities markets in reliance on financial statements that are 
prepared by public companies and other issuers and that, as required by 
Congress, are audited by independent auditors.\5\ We believe the final 
rules strike a reasonable balance among commenters' differing views 
about the proposals while achieving our important public policy 
goals.\6\
---------------------------------------------------------------------------

    \4\ The amendments were proposed in Securities Act Release No. 
7870 (June 30, 2000) (the ``Proposing Release'') [65 FR 43148].
    \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 accountant who performs 
an audit 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\ In addition to soliciting comments in the Proposing Release, 
we held four days of public hearings (July 26, Sept. 13, Sept. 20, 
and Sept. 21). The public comments we received can be reviewed in 
our Public Reference Room at 450 Fifth Street, N.W., Washington, 
D.C., 20549, in File No. S7-13-00. Public comments submitted by 
electronic mail are on our website, www.sec.gov. The written 
testimony and transcripts from each of our public hearings (July 26, 
Sept. 13, Sept. 20, and Sept. 21) are available on our website. For 
purposes of this release, date references following the names of 
participants at our public hearings indicate the hearing date for 
which the participant submitted written testimony and/or appeared as 
a witness.
---------------------------------------------------------------------------

    Independent auditors have an important public trust.\7\ Investors 
must be able to rely on issuers' financial statements.\8\ It is the 
auditor's opinion that furnishes investors with critical assurance that 
the financial statements have been subjected to a rigorous examination 
by an objective, impartial, and skilled professional, and that 
investors, therefore, can rely on them. If investors do not believe 
that an auditor is independent of a company, they will derive little 
confidence from the auditor's opinion and will be far less likely to 
invest in that public company's securities.\9\
---------------------------------------------------------------------------

    \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.
    \8\ Public companies and other public issuers and entities 
registered with us 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. Sec. 77aa(25) and (26), that expressly require that 
financial statements be audited by independent public or certified 
accountants. See also infra note 34.
    \9\ See, e.g., Testimony of John Whitehead, retired Chairman, 
Goldman Sachs & Co. (Sept. 13, 2000) (``Financial statements are at 
the very heart of our capital markets. They're the basis for 
analyzing investments. Investors have every right to be able to 
depend absolutely on the integrity of the financial statements that 
are available to them, and if that integrity in any way falls under 
suspicion, then the capital markets will surely suffer if investors 
feel they cannot rely absolutely on the integrity of those financial 
statements.'').
---------------------------------------------------------------------------

    One of our missions is to protect the reliability and integrity of 
the financial statements of public companies. To do so, and 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

[[Page 76009]]

society.\10\ There have been important developments in each of these 
areas since we last amended our auditor independence requirements in 
1983.\11\
---------------------------------------------------------------------------

    \10\ As stated by Baxter Rice, President of the California Board 
of Accountancy, ``[I]n this ever-revolving economy and business 
environment, it's important that we go back and take a look at these 
regulations and see whether they are really applicable, and whether 
or not what we do is going to in any way interfere with or is going 
to enhance auditor independence, including the public perception of 
auditor independence.'' Testimony of Baxter Rice (Sept. 13, 2000).
    \11\ Financial Reporting Release (``FRR'') No. 10 (Feb. 25, 
1983).
---------------------------------------------------------------------------

    More and more individual investors participate in our markets, 
either directly or through mutual funds, pension plans, and retirement 
plans. Nearly half of all American households are invested in the stock 
market.\12\ As technology has advanced, investors increasingly have 
direct access to financial information, and they act decisively upon 
relatively small changes in an issuer's financial results. These and 
other market changes highlight the importance to the market and to 
investor confidence of financial information that has been audited by 
an auditor whose only master is the investing public.\13\
---------------------------------------------------------------------------

    \12\ In 1999, an estimated 48.2%, or 49.2 million, U.S. 
households owned equities either in mutual funds or individually, up 
from 19% in 1983. Investment Company Institute and Securities 
Industry Association, ``Bull Market, Other Developments Fuel Growth 
in Equity Ownership'' (available at www.sia.com/html/pr834.html.).
    \13\ See, e.g., Testimony of Senator Howard Metzenbaum (Ret.), 
Chairman, Consumer Federation of America (Sept. 20, 2000) (``Our 
nation's current prosperity and future financial security are tied 
up as never before in our financial markets. For that reason, 
whether they know it or not, Americans are enormously dependent on 
independent auditors, both to * * * ensure the reliability of the 
information they use to make individual investment decisions and to 
ensure the efficiency of the marketplace in assigning value to 
stocks.''); Testimony of Ralph Whitworth, Managing Member, 
Relational Investors LLC (Sept. 13, 2000) (``[A]uditor independence 
goes to the very essence of our capital markets, and it's linked 
inextricably to the efficiencies of our capitalist system.'').
---------------------------------------------------------------------------

    As discussed in the Proposing Release and below, the accounting 
industry has been transformed by significant changes in the structure 
of the largest firms. Accounting firms have woven an increasingly 
complex web of business and financial relationships with their audit 
clients. The nature of the non-audit services that accounting firms 
provide to their audit clients has changed, and the revenues from these 
services have dramatically increased. In addition, there is more 
mobility of employees and an increase in dual-career families.
    We proposed changes to our auditor independence requirements in 
response to these developments. As more fully discussed below, we are 
adopting rules, modified in response to almost 3,000 comment letters we 
received on our proposal, written and oral testimony from four days of 
public hearings (about 35 hours of testimony from almost 100 
witnesses), academic studies, surveys and other professional 
literature.
    The Independence Standard. Independence generally is understood to 
refer to a mental state of objectivity and lack of bias.\14\ The 
amendments retain this understanding of independence and provide a 
standard for ascertaining whether the auditor has the requisite state 
of mind. The first prong of the standard is direct evidence of the 
auditor's mental state: independence ``in fact.'' The second prong 
recognizes that generally mental states can be assessed only through 
observation of external facts; it thus provides that an auditor is not 
independent if a reasonable investor, with knowledge of all relevant 
facts and circumstances, would conclude that the auditor is not capable 
of exercising objective and impartial judgment. The proposed amendments 
to Rule 2-01 included in the rule four principles for determining 
whether an accountant is independent of its audit client. While some 
commenters supported our inclusion of the four principles in the 
rule,\15\ others expressed concerns about the generality of these 
principles and raised questions concerning their application to 
particular circumstances.\16\ In response, we have included the four 
principles instead in a Preliminary Note to Rule 2-01 as factors that 
the Commission will consider, in the first instance, when making 
independence determinations in accordance with the general independence 
standard in Rule 2-01(b).
---------------------------------------------------------------------------

    \14\ See discussion in Proposing Release, Section II.B.
    \15\ See, e.g., Written Testimony of Dennis Paul Spackman, 
Chairman, National Association of State Boards of Accountancy (Sept. 
13, 2000) (The four principles ``set a sensible baseline that is 
simply stated, easy to understand, useable, and square on the mark. 
They also serve as an exceptional foundation to the other elements 
of the proposed revision. * * * [T]hey can serve as a bright beacon 
giving much needed guidance to members of the profession * * *''); 
Written Testimony of Robert L. Ryan, Chief Financial Officer, 
Medtronic, Inc. (Sept. 20, 2000); Written Testimony of John C. 
Bogle, Member, Independence Standards Board (July 26, 2000).
    \16\ See, e.g., Letter of Arthur Andersen LLP (Sept. 25, 2000) 
(``Arthur Andersen Letter''); Written Testimony of the New York 
Society of Certified Public Accountants (Sept. 13, 2000).
---------------------------------------------------------------------------

    The amendments identify certain relationships that render an 
accountant not independent of an audit client under the standard in 
Rule 2-01(b). The relationships addressed include, among others, 
financial, employment, and business relationships between auditors 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 every partner in 
the auditor's firm, certain managerial employees, and their families. 
We believe that independence will be protected and the rules will be 
more workable by focusing on those persons who can influence the audit, 
instead of all partners in an accounting firm. Accordingly, we proposed 
to narrow significantly the application of these rules. Commenters 
generally supported our efforts to modernize the current rules because 
they restrict investment and employment opportunities available to firm 
personnel and their families in ways that may no longer be relevant or 
necessary for safeguarding auditor independence and investor 
confidence.\17\ Not all commenters agreed with all aspects of the 
proposals.\18\ We have modified the proposal in some respects, but the 
final rule, like the proposal, shrinks significantly the circle of firm 
personnel whose investments are imputed to the auditor. The rule also 
shrinks the circle of family members of auditors and former firm 
personnel whose employment with an audit client impairs the auditor's 
independence.
---------------------------------------------------------------------------

    \17\ See, e.g., Letter of Ernst & Young LLP (Sept. 25, 2000) 
(``Ernst & Young Letter''); Written Testimony of James J. Schiro, 
Chief Executive Officer PricewaterhouseCoopers (Sept. 20, 2000); 
Written Testimony of the New York State Society of Certified Public 
Accountants (Sept. 13, 2000); Written Testimony of James E. 
Copeland, Chief Executive Officer, Deloitte & Touche LLP (Sept. 20, 
2000); Arthur Andersen Letter.
    \18\ Some commenters, for example, believed that the amendments 
went too far. See, e.g., Written Testimony of J. Michael Cook, 
former Chairman and Chief Executive Officer, Deloitte & Touche (July 
26, 2000) (supporting proposed rule changes in this area but stating 
that no partner in an accounting firm should have a financial 
interest in any of the firm's audit clients); Written Testimony of 
Ray J. Groves, former Chairman and CEO, Ernst & Young (July 26, 
2000) (agreeing with proposals but stating preference to retain 
current proscription of direct investment in an audit client by all 
partners, principals, and shareholders of an accounting firm); 
Testimony of Paul B.W. Miller, Professor, University of Colorado at 
Colorado Springs (July 26, 2000) (``I want to direct my attention * 
* * to the ownership [provisions], and my language is plain. It 
simply says don't do it''); Written Testimony of Ronald Nielsen and 
Kathleen Chapman, Iowa Accountancy Examining Board (Sept. 20, 2000). 
While supporting the goals of the modernization, others provided 
suggestions to address their concerns about possible unintended 
consequences. See, e.g., Ernst & Young Letter; Letter of 
PricewaterhouseCoopers LLP (Sept. 25, 2000) 
(``PricewaterhouseCoopers Letter'').

---------------------------------------------------------------------------

[[Page 76010]]

    Non-Audit Services. As we discuss below,\19\ there has been growing 
concern on the part of the Commission and users of financial statements 
about the effects on independence when auditors provide both audit and 
non-audit services to their audit clients. Dramatic changes in the 
accounting profession and the types of services that auditors are 
providing to their audit clients, as well as increases in the absolute 
and relative size of the fees charged for non-audit services, have 
exacerbated these concerns. As the Panel on Audit Effectiveness (the 
``O'Malley Panel'') recently recognized, ``The potential effect of non-
audit services on auditor objectivity has long been an area of concern. 
That concern has been compounded in recent years by significant 
increases in the amounts of non-audit services provided by audit 
firms.'' \20\
---------------------------------------------------------------------------

    \19\ See infra Section III.C; see also Proposing Release, 
Section II.C.
    \20\ The Panel on Audit Effectiveness: Report and 
Recommendations (the ``O'Malley Panel Report''), at para. 5.6 (Aug. 
31, 2000). The Chairman of the Public Oversight Board (``POB'') 
similarly warned about the ``uncontrolled expansion'' of management 
advisory services to audit clients. 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'') 
(Mar. 9, 1979).
---------------------------------------------------------------------------

    We considered a full range of alternatives to address these 
concerns. Our proposed amendments identified certain non-audit services 
that, when rendered to an audit client, impair auditor independence. 
The proposed restrictions on non-audit services generated more comments 
than any other aspect of the proposals. Some commenters agreed with our 
proposals.\21\ Others believed that the proposals were not restrictive 
enough and recommended a total ban on all non-audit services provided 
by auditors to their audit clients.\22\ Still other commenters opposed 
any Commission rule on non-audit services.\23\ After careful 
consideration of the arguments on all sides, and for the reasons 
discussed below, we have determined not to adopt a total ban on non-
audit services, despite the recommendations of some, and instead to 
identify certain non-audit services that, if provided to an audit 
client, render the auditor not independent of the audit client.
---------------------------------------------------------------------------

    \21\ See, e.g., Testimony of Robert E. Denham, Member, 
Independence Standards Board (``ISB'') (July 26, 2000) (``I think 
[the proposals] represent a very thoughtful, rational, coherent set 
of proposals.''); Letter of Michael McDaniel (Aug. 14, 2000) 
(supporting SEC proposal and disagreeing with a Form Letter from the 
AICPA to its members (``AICPA Form Letter'') urging them to write to 
the SEC to oppose the scope of services proposal); Letter of Randie 
Burrell, CPA (Aug. 14, 2000) (same); Letter of Leland D. O'Neal, CPA 
(Aug. 15, 2000) (same); Letter of David A. Storhaug, CPA (Aug. 21, 
2000) (same); Letter of Arthur Gross (Sept. 10, 2000); Letter of 
Kristian Holvoet (Sept. 8, 2000); Letter of Bettina B. Menzel (Sept. 
9, 2000); Letter of Robert Hanseman (Sept. 10, 2000); Written 
Testimony of Thomas S. Goodkind, CPA (Sept. 13, 2000); Testimony of 
Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of 
America (Sept. 20, 2000); Written Testimony of Bill Patterson, 
Director, Office of Investments, AFL-CIO (Sept. 20, 2000); Written 
Testimony of Frank Torres, Consumers Union (Sept. 20, 2000); 
Testimony of Nimish Patel, Attorney, Pollet & Richardson (July 26, 
2000). See also Senator George J. Mitchell (Ret.), ``How to Keep 
Investor Confidence,'' Editorial, Boston Globe, pg. A15 (Oct. 28, 
2000) (``The commission's proposal is well-reasoned and appropriate. 
* * * [T]he commission should adopt this rule to protect investor 
confidence and strengthen the most vibrant financial market system 
in the world.'').
    \22\ See, e.g., Written Testimony of Kayla J. Gillan, General 
Counsel, California Public Employees' Retirement System 
(``CalPERS''), which is the largest public retirement system in the 
United States with over 1.2 million participants (Sept. 13, 2000) 
(``The SEC should consider simplifying its Proposal and drawing a 
bright-line test: no non-audit services to an audit client.''); 
Written Testimony of John H. Biggs, Chairman and CEO of TIAA-CREF, 
which has 2.2 million participants (July 26, 2000) (``[I]ndependent 
public audit firms should not be the auditors of any company for 
which they simultaneously provide other services. It's that 
simple,''); Written Testimony of Alan P. Cleveland, the New 
Hampshire Retirement System, with 52,000 members (Sept. 13, 2000) 
(``We regard the concurrent performance by the company's external 
auditor of non-auditor services at the direction and under the 
control of management to be inherently corrosive and fundamentally 
incompatible with that duty of independence and fidelity owed by the 
auditor to the investing public''); Testimony of Jack Ciesielski, 
accounting analyst (July 26, 2000) (``I think the single best way to 
improve auditor independence and the appearance of auditor 
independence is to call for an exclusionary ban on non-audit 
services to audit clients.''); Letter of Carson L. Eddy, CPA, (Aug. 
22, 2000) (``It is my opinion that the general public would be 
better served if Certified Public Accountants providing the attest 
function for a client were unable to do any other consulting work 
for that client, with the exception for the ability to prepare tax 
returns.''); Letter of William V. Allen, Jr., CPA (Aug. 22, 2000); 
Letter of Terry Guckes (Sept. 9, 2000); Letter of Art Koolwine 
(Sept. 8, 2000); Letter of Elliot M. Simon (Sept. 9, 2000); Letter 
of Melvin Schupack (Sept. 9, 2000); Letter of William Odendahl 
(Sept. 5, 2000).
    \23\ See, e.g., Letter of the AICPA (Sept. 25, 2000) (``AICPA 
Letter''); Letter of KPMG (Sept. 25, 2000) (``KPMG Letter''); 
Letters of Robert Roy Ward, Chairman and Chief Executive Officer, 
Horne CPA Group (Sept. 20, 2000), Douglas R. Ream, CPA (undated), 
Jack W. Palmer (Sept. 9, 2000), Sherry Wilson, CPA (Aug. 28, 2000), 
and Nathaniel Boyle, CPA (Aug. 16, 2000) (each reiterating concerns 
expressed in the AICPA's Form Letter).
---------------------------------------------------------------------------

    In response to public comments,\24\ in several instances we have 
conformed the restrictions to the formulations set forth in the 
professional literature or otherwise modified the final rule to better 
describe, and in some cases narrow, the types of services restricted. 
For example, the final rule does not ban all valuation and appraisal 
services; its restrictions apply only where it is reasonably likely 
that the results of any valuation or appraisal, individually or in the 
aggregate, would be material to the financial statements, or where the 
results will be audited by the accountant. The rule also provides 
several exceptions from the restrictions, such as when the valuation is 
performed in the context of certain tax services, or the valuation is 
for non-financial purposes and the results of the valuation do not 
affect the financial statements. These changes are consistent with our 
approach to adopt only those regulations that we believe are necessary 
to preserve investor confidence in the independence of auditors and the 
financial statements they audit.
---------------------------------------------------------------------------

    \24\ See, e.g., Ernst & Young Letter; PricewaterhouseCoopers 
Letter.
---------------------------------------------------------------------------

    We recognize that not all non-audit services pose the same risk to 
independence. Accordingly, under the final rule, accountants will 
continue to be able to provide a wide variety of non-audit services to 
their audit clients. In addition, they of course will be able to 
provide any non-audit service to non-audit clients.
    Quality Controls. The quality controls of accounting firms play a 
significant role in helping to detect and prevent auditor independence 
problems. The final rule recognizes this role by providing accounting 
firms a limited exception from being deemed not independent for certain 
independence impairments that are cured promptly after discovery, 
provided that the firm has certain quality controls in place.
    Disclosure of Non-Audit Services. Finally, we continue to believe 
that disclosures that shed light on the independence of public 
companies' auditors assist investors in making investment and voting 
decisions. Accordingly, we proposed and are adopting requirements for 
disclosures that we believe will be useful to investors.\25\ In 
response to commenters' concerns about the breadth of the proposed 
disclosure requirements,\26\

[[Page 76011]]

however, we have modified them in the final rule.
---------------------------------------------------------------------------

    \25\ Commenters generally agreed that disclosure would be useful 
to investors. See, e.g., Written Testimony of James W. Barge, Vice 
President and Controller, Time Warner (Sept. 20, 2000); Letter of 
The Institute of Internal Auditors (Sept. 5, 2000); Written 
Testimony of Dennis Paul Spackman, Chairman of the National 
Association of State Boards of Accountancy (Sept. 13, 2000); Letter 
of Marsha Payne, President, Association of College & University 
Auditors (Sept. 25, 2000); Letter of Keith Johnson, Chief Legal 
Counsel, State of Wisconsin Board (Sept. 20, 2000); Letter of Peter 
C. Clapman, Senior Vice President and Chief Counsel, Investments, 
TIAA-CREF (Sept. 21, 2000).
    \26\ See, e.g., Written Testimony of Clarence E. Lockett, Vice 
President and Corporate Controller, Johnson & Johnson (Sept. 20, 
2000); Written Testimony of Philip A. Laskawy, Chairman, Ernst & 
Young LLP (Sept. 20, 2000).
---------------------------------------------------------------------------

II. Background

    Our Proposing Release generated significant comment and broad 
debate. We received nearly 3,000 comment letters. In addition to 
soliciting comments in the Proposing Release, we held four days of 
public hearings, including one day in New York City, so that we could 
engage in a public dialogue with interested parties. At the hearings, 
we heard from almost 100 witnesses, representing investors, investment 
professionals, large and small public companies, the Big Five 
accounting firms, smaller accounting firms, the AICPA, banking 
regulators, consumer advocates, state accounting board officials, 
members of the Independence Standards Board (``ISB''), academics, and 
others.\27\ In addition, the Subcommittee on Securities of the Senate 
Committee on Banking, Housing, and Urban Affairs held a hearing about 
our proposal.\28\
---------------------------------------------------------------------------

    \27\ See written testimony and transcripts from each of our 
hearings.
    \28\ A Proposal by the Securities and Exchange Commission to 
Modernize Its Rules That Govern the Independence of Accountants that 
Audit Public Companies, Before the Subcomm. On Securities of the 
Senate Comm. On Banking, Housing, and Urban Affairs, 95th Cong. 2d 
Sess. (Sept. 28, 2000).
---------------------------------------------------------------------------

    We received thoughtful and constructive input from a broad spectrum 
of interested parties. That input helped us to understand better the 
sincere and strongly-held views on all sides and to shape final rule 
amendments that incorporate these views to the extent consistent with 
our public policy goals. As discussed specifically below, the final 
rule amendments, particularly those related to non-audit services, have 
been modified from the proposals.
    Nevertheless, some commenters expressed concern that we have 
``rushed to regulate,'' \29\ and they asked that we take more time 
before addressing auditor independence issues generally, and especially 
the issues regarding the provision of non-audit services to audit 
clients. As many commenters noted, however, the issues presented by 
this rulemaking are not new, \30\ and recent and accelerating changes 
in the accounting profession and in society have made resolution of 
these issues more pressing. For many years the profession has been 
discussing modernization of the financial and employment relationship 
rules, and the scope of services issue has been on the horizon even 
longer.\31\ Many previous Commissions have studied these issues.\32\ 
Against this backdrop, in light of the comments that our proposals 
generated, and informed by our experience and expertise in these 
matters, we believe that it is appropriate to act now.\33\
---------------------------------------------------------------------------

    \29\ See, e.g., Letter of KPMG; Written Testimony of Robert K. 
Elliott, Chairman, AICPA (Sept. 13, 2000) (``There is no reason * * 
* for a rush to judgment on these critical issues. We have the time 
to get it right, and the public is entitled to nothing less.''); 
Written Testimony of Barry Melancon, President and Chief Executive 
Officer, AICPA (Sept. 13, 2000); Letters of Richard W. Hammel, CPA 
(Sept. 25, 2000), Roland H. Flyge II, CPA (Sept. 23, 2000), and 
Daniel P. Naragon, CPA (Sept. 25, 2000) (each reiterating concerns 
expressed in the AICPA Form Letter).
    \30\ See Written Testimony of Bevis Longstreth, former SEC 
Commissioner and member of the Panel on Audit Effectiveness (Sept. 
13, 2000) (``The SEC acting upon the need for greater independence, 
a need long recognized by virtually every group assigned the task of 
considering the issue (and there have been many), has proposed a 
rule to meet this need.''); Testimony of Senator Howard Metzenbaum 
(Ret.), Chairman, Consumer Federation of America (Sept. 20, 2000); 
Written Testimony of Douglas Scrivner, General Counsel, Andersen 
Consulting (Sept. 20, 2000) (``This issue is not new. The issue has 
been debated within the profession and by others for over 20 years. 
The only thing that has changed, in my opinion, is that the risks to 
the system have increased.''); Written Testimony of Dennis Paul 
Spackman, Chairman of the National Association of State Boards of 
Accountancy (Sept. 13, 2000) (``[A]ction is needed. Indeed, I 
believe it is long over due. While further study may enhance the 
finer points of the issues, it would do nothing to resolve the 
larger concerns. They have been deliberated far too long.''); 
Testimony of Larry Gelfond, CPA, CVA, CFE, former President of the 
Colorado State Board of Accountancy (Sept. 13, 2000) (``I firmly 
believe the SEC is taking a correct position in this long debated 
area of concern to the profession.'').
    \31\ Congress itself considered the issue of scope of services 
in the 1970s. 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).
    \32\ In the late 1980s, for example, 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. (Feb. 
14, 1989) (denying the petition).
    \33\ See Richard C. Breeden, Roderick M. Hills, David S. Ruder 
and Harold M. Williams (former Chairmen of the SEC), Editorial, 
``Accounting for Conflicts,'' Wash. Post, at A31 (July 21, 2000) 
(``This initiative is timely and necessary. * * * [T]he time has 
come to chart a surer path to preserving the all-important principle 
of auditor independence from commercial client relationships.''); 
James J. Schiro, Chief Executive Officer, PricewaterhouseCoopers 
LLP, ``Auditor Independence: It's Time to Change the Rules,'' Wall 
St. J. (Oct. 10, 2000) (``New rules are needed now. Working 
together, we can devise rules that will protect the public interest 
today and for decades to come. The need for change is upon us. 
Further delay will only prolong confusion at a time when greater 
clarity is needed.'') (emphasis in original); Written Testimony of 
Senator Howard Metzenbaum (Ret.), Chairman, Consumer Federation of 
America (Sept. 20, 2000) (``[A] more compelling question is, why 
wait? * * * Speaking for consumers across the country, we urge the 
Commission to move forward expeditiously with this important rule 
proposal.''); Testimony of Professor John C. Coffee, Columbia 
University (July 26, 2000) (``Right now you have the appropriate 
moment because the vast majority of firms aren't purchasing dual 
services. If you wait ten years, that will change, and [it's] much 
harder to change an existing reality rather than an approaching 
change. So I think this is the time for action. * * *''); Testimony 
of J. Michael Cook, former Chairman and Chief Executive Officer, 
Deloitte & Touche (July 26, 2000) (``[T]he Commission's 
consideration of this issue at this time is both warranted and 
necessary. The status quo is not an acceptable answer.''); Written 
Testimony of Professor Curtis C. Verschoor, DePaul University (July 
26, 2000) (stating that the question is ``[n]ot why so fast, but 
what took so long?''); Letter of John S. Coppel, CPA, CFO, Electric 
Power Equipment Company (Aug. 16, 2000) (``I view this rule as a 
long overdue, greatly needed response to the practices now taking 
place within the profession.'').
---------------------------------------------------------------------------

III. There Is a Need for Commission Rulemaking

A. The Independence Requirement Serves Important Public Policy Goals

    The federal securities laws require, or permit us to require, that 
financial information filed with us be certified or audited by 
``independent'' public accountants.\34\ To a significant extent, this 
makes independent auditors the ``gatekeepers'' to the public securities 
markets.\35\ This statutory framework gives auditors both a valuable 
economic franchise and an important public trust. Within this statutory 
framework, the

[[Page 76012]]

independence requirement is vital to our securities markets.
---------------------------------------------------------------------------

    \34\ For example, Items 25 and 26 of Schedule A to the 
Securities 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 Securities 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. Sec. 80a-37(a), grant the Commission the authority to 
define accounting, technical, and trade terms used in each Act. 
Section 17 of the Exchange Act, 15 U.S.C. 78q, and Section 31 of the 
Investment Company Act, 15 U.S.C. 80a-30, grant the Commission 
authority to prescribe accounting principles to be used in the 
preparation of financial statements required.
    \35\ 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).
---------------------------------------------------------------------------

    The independence requirement serves two related, but distinct, 
public policy goals. One goal is to foster high quality audits by 
minimizing the possibility that any external factors will influence an 
auditor's judgments. The auditor must approach each audit with 
professional skepticism and must have the capacity and the willingness 
to decide issues in an unbiased and objective manner, even when the 
auditor's decisions may be against the interests of management of the 
audit client or against the interests of the auditor's own accounting 
firm.
    The other related goal is to promote investor confidence in the 
financial statements of public companies. Investor confidence in the 
integrity of publicly available financial information is the 
cornerstone of our securities markets. 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.\36\ The federal 
securities laws contemplate that that assurance will flow from 
knowledge that the financial information has been subjected to rigorous 
examination by competent and objective auditors.
---------------------------------------------------------------------------

    \36\ See generally Codification of Financial Reporting Policies 
(the ``Codification'') Sec. 601.01 (``An 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.''). 
Use of the term ``Codification'' means the Codification that existed 
prior to the Commission's adoption of the rule amendments in this 
release. For a list of changes to the Codification resulting from 
the rule amendments, see infra Section IX.
---------------------------------------------------------------------------

    The two goals--objective audits and investor confidence that the 
audits are objective--overlap substantially but are not identical. 
Because objectivity rarely can be observed directly, investor 
confidence in auditor independence rests in large measure on investor 
perception.\37\ For this reason, the professional literature, such as 
the AICPA's Statement on Auditing Standards (SAS) No. 1, has long 
emphasized that auditors ``should not only be independent in fact; they 
should also avoid situations that may lead outsiders to doubt their 
independence.'' \38\ The Supreme Court has emphasized the importance of 
the connection between investor confidence and the appearance of 
independence:
---------------------------------------------------------------------------

    \37\ See, e.g., Testimony of Laurence H. Meyer, Governor, Board 
of Governors of the Federal Reserve System (Sept. 13, 2000) (``High 
quality accounting standards * * * can potentially be nullified if 
there is a perception that auditors lack independence and 
objectivity in their enforcement role * * * I think if the 
perception didn't have any basis in reality, it would not 
necessarily last very long, so there has to be some interconnection 
between them, but the perception is an important one.''); Testimony 
of David A. Brown, QC, Chair, Ontario Securities Commission (Sept. 
13, 2000) (``The reality of independence is difficult, if not 
impossible. Perceptions of independence, therefore, become almost 
equal to reality in importance.''); Testimony of Kayla Gillan, 
General Counsel, CalPERS (Sept. 13, 2000) (``It's not only the 
reality of biased auditing, but also the perception that a biased 
practice is possible that erodes investor confidence.'').
    \38\ AICPA SAS No. 1, AU Sec. 220.03. As explained in SAS No. 1, 
``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.'' See also Testimony of Robert K. Elliott, 
Chairman, AICPA (Sept. 13, 2000) (``[The AICPA] believe[s] that 
appearances are very important and capital markets require 
confidence in financial statements and audit reports, and the member 
firms of the AICPA are basing their business of auditing on their 
reputations, and that is heavily affected by appearance. There is no 
question about that. We are not disputing that appearance is 
important.''); Public Oversight Board (``POB''), Scope of Services 
by CPA Firms, at 27 (Mar. 1979) (``1979 POB Report'') (citing A. 
Arens and J. Loebbecke, Auditing: An Integrated Approach (Prentice-
Hall 1976)) (``[The appearance of independence is] 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.''); Earnscliffe 
Research and Communications (``Earnscliffe''), Report to the United 
States Independence Board: Research into Perceptions of Auditor 
Independence and Objectivity--Phase II, at 11 (July 2000) 
(``Earnscliffe II'') (``Perhaps the most overwhelming consensus was 
the belief that the perception of auditor independence is as 
critical to the integrity of the financial system, as is the 
reality.'').

    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.\39\

    \39\ United States v. Arthur Young and Co., 465 U.S. 805, 819 
n.15 (1984) (emphasis in original). See also Article IV of the 
AICPA's Standards of Professional Conduct, which provides, 
``Objectivity is a state of mind. * * * Independence precludes 
relationships that may appear to impair a member's objectivity. * * 
*'' AICPA Code of Professional Conduct, ET Sec. 55.01 (emphasis 
added). Elsewhere, the AICPA's SAS No. 1 states that auditors should 
``avoid situations that may lead outsiders to doubt their 
independence.'' SAS No. 1, AU Sec. 220.03 (emphasis added).
---------------------------------------------------------------------------

    The Commission's independence requirements have always included 
consideration of investor perceptions.\40\ Many foreign countries have 
similar requirements. A comparative analysis of the independence 
requirements of eleven countries concluded, ``With the possible 
exception of Switzerland, most of the countries stress both the 
appearance and the fact of independence.'' \41\ In Canada, Rules of 
Professional Conduct require that the auditor be free of influence that 
would impair its judgment ``or which, in the view of a reasonable 
observer, would impair * * * professional judgment or objectivity.'' 
\42\ David A. Brown, Chair of the Ontario Securities Commission, 
testified that the importance of the perception of auditor independence 
``cannot be overstated.'' \43\
---------------------------------------------------------------------------

    \40\ See Codification Sec. 601.01.
    \41\ Belverd E. Needles, Jr. (ed.) Comparative International 
Accounting Standards 26 (1985) (comparing France, Netherlands, 
Switzerland, U.K., Germany, Jordan, Kuwait, Canada, Mexico, U.S., 
and Japan).
    \42\ Institute of Chartered Accountants of Ontario, Rules of 
Professional Conduct Rule 204.1 (Objectivity: audit engagements); 
see also Institute of Chartered Accountants of British Columbia, 
Rules of Professional Conduct. Rule 204.1, Objectivity--Assurance 
and Specified Auditing Procedure Engagements.
    \43\ Testimony of David A. Brown, QC, Chair, Ontario Securities 
Commission (Sept. 13, 2000). Principles in Hong Kong regarding the 
conduct of accountants provide that ``a member must at all times 
perform his work objectively and impartially and free from influence 
by any consideration which might appear to be in conflict with this 
requirement.'' Hong Kong Society of Accountants, Fundamental 
Principles para. 10 (revised April 1999). In addition, a Statement 
of Professional Ethics in that country provides that an auditor 
``should be, and be seen to be, free in each professional assignment 
he undertakes of any interest which might detract from 
objectivity.'' Hong Kong Society of Accountants, Statement 1.203, 
Professional Ethics (Integrity, Objectivity and Independence) para. 
2 (revised June 2000).
---------------------------------------------------------------------------

    International organizations and standard setters also stress the 
appearance of independence. In its comment letter, the Federation of 
European Accountants stated, ``In dealing with independence, one must 
address both: Independence of mind * * * and Independence in 
appearance, [i].e. the avoidance of facts and circumstances, which are 
so significant that an informed third party would question the 
statutory auditor's objectivity.'' \44\ Although the European Union has 
not defined independence for auditors, a Green Paper from 1996 
provides, ``In dealing with independence, it is necessary to address 
both independence in mind * * * and independence in appearance, i.e. 
the avoidance of facts and circumstances which are so significant that 
an informed third party would question the statutory auditor's 
objectivity.'' \45\
---------------------------------------------------------------------------

    \44\ Letter of Helene Bon, President, Federation of European 
Accountants (Sept. 25, 2000).
    \45\ In 1998, the European Parliament approved a resolution 
broadly supporting the Green Paper. Green Paper, The Role, The 
Position and the Liability of the Statutory Auditor Within the 
European Union Sec. 4.8 (July 24, 1996), available at http://europa.eu.int. Communication from the Commission, The Statutory 
Audit in the European Union: The Way Forward (May 7, 1998), C143 
8.05.1988-EN, available at http://europa.eu.int.

---------------------------------------------------------------------------

[[Page 76013]]

    The concept of ``appearance'' as used in the final rule is not 
unbounded. ``Appearance'' as used in our operative legal standards is 
not a reference to what anyone might think under any circumstances. 
Rather, as explained below,\46\ it is an objective test, keyed to the 
conclusions of reasonable investors with knowledge of all relevant 
facts and circumstances.
---------------------------------------------------------------------------

    \46\ See infra Section IV.C.
---------------------------------------------------------------------------

B. Recent Developments Have Brought the Independence Issues to the 
Forefront

    The accounting industry is in the midst of dramatic transformation. 
Firms have merged, resulting in increased size, both domestically and 
internationally. They have expanded into international networks, 
affiliating and marketing under a common name. Increasingly, accounting 
firms are becoming multi-disciplinary service organizations and are 
entering into new types of business relationships with their audit 
clients. Accounting professionals have become more mobile, and 
geographic location of firm personnel has become less important due to 
advances in telecommunications. In addition, there are more dual-career 
families, and audit clients are increasingly hiring firm partners, 
professional staff, and their spouses for high level management 
positions.
    In conjunction with these changes, accounting firms have expanded 
significantly the menu of services offered to their audit clients, and 
the list continues to grow.\47\ Companies are turning to their auditors 
to perform their internal audit, pension, financial, administrative, 
sales, data processing, and marketing functions, among many others.\48\
---------------------------------------------------------------------------

    \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, Arthur Andersen & Co. (Feb. 
14, 1989).
    \48\ See Proposing Release, App. A, for a list of services that 
auditors provide to their audit and non-audit clients. The list was 
prepared by the ISB. See also Beverly Gordon, ``KPMG spies rapid 
growth in `shared services,' '' Accounting Today, at 12 (June 3, 
1996); ``KPMG Restructures to Reposition Outsourcing,'' Public 
Accounting Report, at 1 (May 15, 1996); websites of Deloitte & 
Touche (http://www.deloitte.com) and KPMG (http://www.us.kpmg.com).
---------------------------------------------------------------------------

    As we noted in the Proposing Release, U.S. revenues for management 
advisory and similar services \49\ for the five largest public 
accounting firms (the ``Big Five'') amounted to more than $15 billion 
in 1999.\50\ Moreover, revenues for these service lines are now 
estimated to constitute half of the total revenues for these firms.\51\ 
In contrast, these service lines provided only thirteen percent of 
total revenues in 1981.\52\ From 1993 to 1999, the average annual 
growth rate for revenues from management advisory and similar services 
has been twenty-six percent; comparable growth rates have been nine 
percent for audit and thirteen percent for tax services.\53\
---------------------------------------------------------------------------

    \49\ Management advisory services (``MAS'') are a subset of non-
audit services.
    \50\ See Proposing Release, Table 1 in Appendix B. The 
underlying data are derived from data in ``Special Supplement: 
Annual Survey of National Accounting Firms--2000,'' Public 
Accounting Report (Mar. 31, 2000), annual reports filed with the 
AICPA Division for CPA Firms by public accounting firms, and from 
reports prepared by the AICPA Division for CPA firms.
    \51\ See Proposing Release, Tables 1 and 2 in Appendix B.
    \52\ See Proposing Release, Table 2 in Appendix B.
    \53\ See Proposing Release, 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 SEC audit clients 
have increased significantly over the past two decades. In 1984, only 
one percent of SEC audit clients of the eight largest public accounting 
firms paid MAS fees that exceeded the audit fee.\54\ For the Big Five 
firms, the percentage of SEC audit clients that paid MAS fees in excess 
of audit fees did not exceed 1.5% until 1997.\55\ In 1999, 4.6% of Big 
Five SEC audit clients paid MAS fees in excess of audit fees,\56\ an 
increase of over 200% in two years. For the Big Five firms, average MAS 
fees received from SEC audit clients amounted to ten percent of all 
revenues in 1999.\57\ Almost three-fourths of Big Five SEC audit 
clients purchased no MAS from their auditors in 1999. This means that 
purchases of MAS services by one-fourth of firms' SEC audit clients 
account for ten percent of all firm revenues.\58\
---------------------------------------------------------------------------

    \54\ See Proposing Release, Table 3 in Appendix B.
    \55\ Id.
    \56\ Id.
    \57\ See Proposing Release, Table 4 in Appendix B.
    \58\ See Proposing Release, 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.
---------------------------------------------------------------------------

    Some smaller firms are consolidating their audit practices and 
seeking public investors in the resulting company.\59\ 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 hire the 
employees, and in some cases the partners, 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 services firm to pay the professional staff for 
``nonprofessional'' services for the corporate organization as well as 
professional attest services rendered for the audit firm.\60\
---------------------------------------------------------------------------

    \59\ See, e.g., Rick Telberg, ``Anybody can do it! says small-
firm consolidator,'' Accounting Today, at 5 (Jan. 4-24, 1999).
    \60\ ``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).
---------------------------------------------------------------------------

    Recently, Ernst & Young sold its management-consulting business to 
Cap Gemini Group SA, a large and publicly traded computer services 
company headquartered in France.\61\ KPMG has sold an equity interest 
in KPMG Consulting to Cisco Corporation \62\ and is in the process of 
registering additional shares in its consulting business to sell to the 
public in an initial public offering.\63\ In addition, 
PricewaterhouseCoopers has publicly announced an intention to sell 
portions of its consulting businesses. Also, Grant Thornton recently 
sold its e-business consulting practice.\64\
---------------------------------------------------------------------------

    \61\ ``Cap Gemini and Ernst & Young Have Agreed to Terms for the 
Acquisition of Ernst & Young Consulting'' (Feb. 29, 2000) (press 
release of Ernst & Young).
    \62\ As clarified by the amended S-1 filed by KPMG Consulting, 
Inc., in connection with the initial public offering, Cisco may sell 
up to about half of its stake in that entity. See KPMG Consulting, 
Inc., Form S-1, Amend. No. 3 (Sept. 25, 2000).
    \63\ Id. 
    \64\ Albert B. Crenshaw, ``Audit Firm Sells Consulting Unit,'' 
Wash. Post, Oct. 26, 2000, at E2; see also news release at 
www.grantthornton.com/esannounce/index.html.
---------------------------------------------------------------------------

    Simultaneous with this metamorphosis of the accounting profession, 
public companies have come under increasing pressure to meet earnings 
expectations. Observers suggest that this pressure has intensified in 
recent years, especially for companies operating in certain sectors of 
the economy.\65\ The extent of the pressure

[[Page 76014]]

becomes apparent each time a company loses a significant percentage of 
its market capitalization after failing to meet analysts' 
expectations.\66\ These intense pressures on companies lead to enhanced 
pressure on auditors to enable their clients to meet expectations.\67\
---------------------------------------------------------------------------

    \65\ See Earnscliffe, Report to the United States Independence 
Board: Research into Perceptions of Auditor Independence and 
Objectivity (``Earnscliffe I'') at 16 (Nov. 1999) (finding increased 
pressure and threat of earnings management in the technology 
sector); see also Testimony of Jay W. Eisenhofer, Partner, Grant & 
Eisenhofer (Sept. 13, 2000) (``[I]n the current environment where 
company stock prices are increasingly dependent on showing growth 
and on meeting or exceeding the expectations of Wall Street 
investment analysts [, e]ven one missed profit number can have a 
significant negative effect on stock price. This places great 
pressure on company executives to insure that each quarter the 
profits are in the expected range, regardless of whether the quarter 
has been as good as the analyst expected. In order to meet these 
expectations, we often find that corporations will sometimes make 
questionable assumptions.'').
    \66\ Ann Grimes, ``Former McKesson Officials are Charged,'' Wall 
St. J., at B6 (Sept. 29, 2000); Sarah Schafer and David S. 
Hilzenrath, ``Orbital to Settle Shareholder Suit,'' Wash. Post, at 
E1 (July 18, 2000); Paul Sweeney, ``Accounting Fraud: Learning from 
the Wrongs,'' Fin. Exec. (Sept./Oct. 2000); Mike McNamee, 
``Accounting Wars,'' Bus. Wk., 157, 160 (Sept. 25, 2000); Bernard 
Condon, ``Pick a Number, Any Number, Forbes (Mar. 23, 1998).
    \67\ See O'Malley Panel Report, supra note 20, para. 1.10 (``The 
growth in equity values over the past decade has introduced extreme 
pressures on management to achieve earnings, revenue or other 
targets. These pressures are exacerbated by the unforgiving nature 
of the equity markets as securities valuations are drastically 
adjusted downward whenever companies fail to meet `street' 
expectations.* * * These pressures on management, in turn, translate 
into pressures on how auditors conduct audits and in their 
relationship with audit clients.'').
---------------------------------------------------------------------------

    As discussed below, the changes in the accounting profession, 
combined with increasing pressures on companies, raise questions about 
auditor independence and investor confidence in the financial 
statements of public companies that those auditors audit. To respond to 
some of these questions, we proposed, and are now adopting, new rules 
relating to the financial and employment relationships independent 
auditors may have with their audit clients, business and financial 
relationships between accounting firms and audit clients, and the non-
audit services that auditors can provide to audit clients without 
impairing their independence.

C. Independence Concerns Warrant Restrictions on the Scope of Services 
Provided to Audit Clients

    The rules that we adopt today include provisions restricting the 
scope of services that an auditor may provide to an audit client 
without impairing the auditor's independence with respect to that 
client. The proposed restrictions on non-audit services generated most 
of the public comment on our proposals, both in written comment letters 
and in testimony provided during our public hearings. Commenters 
expressed a range of views from full support to staunch opposition.\68\
---------------------------------------------------------------------------

    \68\ See supra notes 21-23.
---------------------------------------------------------------------------

    After careful consideration of the arguments on various sides, we 
have determined that it is in the public interest for us to adopt 
certain restrictions on the provision of non-audit services to audit 
clients. We act on the basis of our evaluation of the potential impact 
of non-audit relationships on audit objectivity and also on the basis 
of indications that investor confidence is in fact affected by 
reasonable concerns about non-audit services compromising audit 
objectivity.
1. The Expansion of Non-Audit Service Relationships with Audit Clients 
Has Long Been Viewed as a Potential Threat to Auditor Independence
    It has long been recognized that an unchecked expansion of non-
audit relationships between auditors and their audit clients could 
affect both an auditor's objectivity and investor confidence in 
financial statements.\69\ In the 1970s, Congress seriously considered 
limiting the types of non-audit services that independent auditors 
could provide. Even though non-audit services did not constitute a 
large percentage of audit firms' revenues at that time, and Congress 
ultimately determined not to take legislative action, the deliberations 
highlighted significant concerns bearing on the independence issue.\70\
---------------------------------------------------------------------------

    \69\ See Proposing Release, Section II.C.2; O'Malley Panel 
Report, supra note 20, at App. D (chronicling the debate since 
1957); The Commission on Auditors' Responsibilities, Report, 
Conclusions and Recommendations 95-96 (1978). See also infra notes 
92, 98 (citing recent studies).
    \70\ 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 that 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 (Apr. 6, 1978) (attached list of 
recommendations) (reprinted in Securities and Exchange Commission 
Report to Congress on the Accounting Profession and the Commission's 
Oversight Role (July 1978)).
---------------------------------------------------------------------------

    These concerns gradually became the subject of increasing debate 
and study. In 1979, the then-Chairman of the POB expressed concern 
about the expansion of non-audit services to audit clients:

    The [POB] believes that there is a possibility of damage to the 
profession and the users of the profession's services in an 
uncontrolled expansion of MAS [management advisory services] 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.\71\

    \71\ 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, 
SECPS (Mar. 9, 1979).
---------------------------------------------------------------------------

    A 1994 Report of the AICPA Special Committee on Financial Reporting 
noted that users of financial statements believed that non-audit 
service relationships could ``erode auditor independence'' and that 
those users were ``concerned that auditors may accept audit engagements 
at marginal profits to obtain more profitable consulting 
engagements.''\72\ A separate 1994 report of the Advisory Panel on 
Auditor Independence noted the increased basis for investor concerns, 
describing 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.'' \73\
---------------------------------------------------------------------------

    \72\ Special Committee on Financial Reporting, AICPA, Improving 
Business Reporting--A Customer Focus: Meeting the Information Needs 
of Investors and Creditors, at 104 (1994).
    \73\ Advisory Panel on Auditor Independence, Strengthening the 
Professionalism of the Independent Auditor: Report to the Public 
Oversight Board of the SEC Practice Section, AICPA, at 9 (Sept. 13, 
1994).
---------------------------------------------------------------------------

    In 1994, the SEC staff also studied the issues and issued a Staff 
Report.\74\ While concluding that no action was warranted at the time, 
the staff recognized the need ``to be alert'' to independence problems 
that may be

[[Page 76015]]

caused by auditors' provision of non-audit services.\75\ A 1996 General 
Accounting Office (GAO) study predicted that the ``concern over auditor 
independence may become larger as accounting firms move to provide new 
services that go beyond traditional services.'' \76\
---------------------------------------------------------------------------

    \74\ Office of the Chief Accountant, SEC, Staff Report on 
Auditor Independence (Mar. 1994) (``Staff Report''). 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 IV.G. (discussing these disclosure 
requirements).
    \75\ See Staff Report, supra note 74, at 84; Proposing Release, 
notes 40-42.
    \76\ GAO, THE ACCOUNTING PROFESSION--Major Issues: Progress and 
Concerns, at 8 (GAO/AIMD-96-98, Sept. 1996).
---------------------------------------------------------------------------

2. The Growth of Certain Non-Audit Services Jeopardizes Independence
    A common theme running through the reports described above is 
concern that future expansion of non-audit services may make regulatory 
action necessary. We believe that the circumstances about which the 
Commission was warned are coming to pass. An auditor's interest in 
establishing or preserving a non-audit services relationship raises two 
types of independence concerns. First, the more the auditor has at 
stake in its dealings with the audit client, the greater the cost to 
the auditor should he or she displease the client, particularly when 
the non-audit services relationship has the potential to generate 
significant revenues on top of the audit relationship. Second, certain 
types of non-audit services, when provided by the auditor, create 
inherent conflicts that are incompatible with objectivity.
    a. Non-Audit Services Create Economic Incentives that May 
Inappropriately Influence the Audit. As explained above and in the 
Proposing Release, the rapid rise in the growth of non-audit services 
has increased the economic incentives for the auditor to preserve a 
relationship with the audit client, thereby increasing the risk that 
the auditor will be less inclined to be objective.\77\ Some commenters 
supported this analysis,\78\ while others took issue with it.\79\ The 
principal criticisms were: (i) the economic stake in the relationship 
with the audit client in fact had not materially increased and any such 
increase is offset by countervailing incentives on the auditor not to 
compromise his or her independence; and (ii) there is no proof that 
changing the mix of incentives has affected auditor behavior. We have 
considered each of these criticisms and address them below.
---------------------------------------------------------------------------

    \77\ See supra Section III.B.; Proposing Release, Section 
II.C.2(b).
    \78\ See, e.g., Testimony of Kayla Gillan, General Counsel, 
CalPERS (Sept. 13, 2000) (``The concept that an auditor who has a 
greater financial incentive to please management than to criticize 
it will tend to find ways to avoid negative comment is intuitive and 
obvious.''); Letter of B. Raymond Dunham (``I understand that actual 
hard evidence may not be apparent on the surface. However, it 
becomes obvious that auditing judgment may be clouded when large 
sums of potential revenues are dependent upon an auditing decision 
from any firm that derives great revenues from consulting services 
to the same organizations it is responsible for auditing.* * * The 
separation of consulting and auditing is intuitive if a firm is to 
maintain independence in its auditing procedures.''); Letter of 
David T. DeMonte, CPA (``The conflict of interest potential is so 
patently obvious.'').
    \79\ See, e.g., Testimony of Thomas C. DeFazio, Executive Vice 
President and Chief Financial Officer, VirtualCom, Inc. (Sept. 13, 
2000) (``[T]he provision of non-audit services does not pressure the 
audit firms to look the other way.''); Testimony of Thomas M. 
Rowland, Senior Vice President, Fund Business Management Group, 
Capital Research & Management Co. (Sept. 20, 2000) (``[A]t no time 
during my career did I feel pressure from other partners in the firm 
* * * not to do the right thing.'').
---------------------------------------------------------------------------

    (i) The Mix of Economic Incentives Has Changed. Commenters 
generally agreed that there has been enormous growth in non-audit 
services and in their importance to the firms that provide them. 
Several commenters took issue with whether this growth enhanced any 
potential conflict of interest. These commenters argued, in essence, 
that there has always been the potential for a conflict of interest, 
since the auditor is paid by the client.\80\ They argue that because 
Congress adopted this arrangement in enacting the federal securities 
laws, by choosing the statutory independence requirement rather than 
creating a corps of government-paid auditors, Congress implicitly 
condoned these types of conflicts of interest.
---------------------------------------------------------------------------

    \80\ See, e.g., Testimony of Robert K. Elliott, Chairman, AICPA 
(Sept. 21, 2000).
---------------------------------------------------------------------------

    The argument proves too much; it assumes that because Congress 
permitted one form of potential conflict of interest, it intended to 
permit all forms. Taken to its logical conclusion, this argument, of 
course, would read the independence requirement out of the statute. If 
Congress believed that all conflicts were equal in kind or degree, it 
would not have required that auditors be independent. Congress 
apparently chose to tolerate a degree of potential conflict of interest 
rather than supplant the private auditing profession. Simply because 
Congress chose to tolerate an unavoidable degree of conflict inherent 
in the relationship between a private auditor and a paying client, it 
hardly follows that all conflicts of interest beyond the unavoidable 
minimum were approved by Congress or that the statutes express 
indifference to conflicts of interest.
    A related argument is that, despite the rapid growth of services, 
the economic stakes have not really changed for the auditor. The 
argument is that, despite the growth of non-audit services generally, 
these services are rarely as significant to the auditor, from an 
economic standpoint, as maintaining the audit relationship.\81\ Put 
another way, while non-audit services (excluding tax) account for as 
much as fifty percent of audit firm revenue, only ten percent of 
revenues come from providing these services to audit clients. But, as 
noted above, the trend of available data suggests a rapid increase in 
the provision of non-audit services to audit clients--in 1999, 4.6% of 
Big Five SEC audit clients paid MAS fees in excess of audit fees, an 
increase of over 200% in two years.
---------------------------------------------------------------------------

    \81\ See, e.g., Letter of Financial Accounting Standards 
Committee, American Accounting Association (Oct. 12, 2000),
---------------------------------------------------------------------------

    The increasing importance of non-audit services to accounting firms 
is further evidenced by suggestions that the audit has become merely a 
``commodity'' and that the greater profit opportunities for auditors 
come from using audits as a platform from which to sell more lucrative 
non-audit services.\82\ An AICPA practice aid entitled ``Make Audits 
Pay: Leveraging the Audit Into Consulting Services'' provides a step-
by-step guide for auditors to become ``business advisers'' to their 
audit clients. The book quotes an AICPA officer as follows: ``We see 
the greater viability of the CPA going forward as being a strategic 
business adviser, an information professional being viewed by the 
public as the person for solid big-picture business advice--applied to 
a broader information world instead of a financial information world.'' 
\83\ At the same time, the book acknowledges that ``[t]he business 
adviser is a client advocate. The entire business adviser audit process 
is based on understanding the client's business from the owner's 
perspective and acting in the owner's best interest,'' \84\ which, of 
course, is contrary to the duty of the auditor to the public.
---------------------------------------------------------------------------

    \82\ See O'Malley Panel Report, supra note 20, para. 4.4 at 99 
(``Focus group participants often indicated that not only clients, 
but also engagement partners and firm leaders, treat the audit 
negatively--as a commodity.'').
    \83\ AICPA Practice Aid Series, Make Audits Pay: Leveraging the 
Audit Into Consulting Services, at 3 (1999).
    \84\ Id. at 24.
---------------------------------------------------------------------------

    At our public hearings and in comment letters, we also heard a 
great deal about the ``loss leader'' phenomenon. When an auditor uses 
the audit as a loss leader, the auditor, in essence, ``low-balls'' the 
audit fee--even offering to perform it at a loss--in order to gain 
entry into and build a relationship with a potential client for

[[Page 76016]]

the firm's non-audit services.\85\ Low-balling creates a variety of 
independence issues.\86\ Use of audits as loss leaders to be made up 
for with more lucrative consulting contracts further suggests the 
growth in importance of non-audit services as compared to audits.\87\
---------------------------------------------------------------------------

    \85\ See, e.g., Letter of William S. Lerach, Milberg Weiss 
Bershad Hynes & Lerach LLP (Sept. 22, 2000) (``In some instances, 
public companies bid out auditing work demanding low bids, while 
indicating to the bidding firms that low auditing bids will be 
rewarded with lucrative consulting work''). Texas adopted a 
statutory provision to prevent the use of audits as loss leaders in 
order to protect small audit firms that could not compete in a 
market where audits were underpriced. Tex. Rev. Civ. Stat. art. 41a-
1, Sec. 20A (1994). See also Testimony of K. Michael Conaway, 
Presiding Officer, Texas State Board of Accountancy (Sept. 20, 2000) 
(explaining that the worry was that ``big firms would predatory 
price their way into markets and * * * in effect, gain a competitive 
advantage over smaller firms that couldn't discount their work to 
the same extent''); Written Testimony of Wanda Lorenz, CPA, Lane 
Gorman Trubitt (Sept. 20, 2000) (``[M]ost of the problems that exist 
today can be tied to fee negotiations on audits * * *. Therefore the 
profession has accepted being bargained with like a shopkeeper in 
some bazaar in order to perform other more lucrative work.'') 
(emphasis in original).
    \86\ See Testimony of Larry Gelfond, CPA, CVA, CFE, former 
President of the Colorado State Board of Accountancy (Sept. 13, 
2000) (``Audit failures occur because auditors become careless and 
in the oversight or reliance on something, they may be taking a 
shortcut. Clearly, where an audit is low bid, there is that 
concern.'').
    \87\ Low-balling also sends a message to the auditor that the 
audit relationship is not as valuable as the consulting 
relationship. See Testimony of Roderick Hills, former Chairman, SEC 
(Sept. 20, 2000). Low-balling sends a message inside the audit firm 
as well. We are concerned that the shift in a firm's emphasis away 
from auditing and toward non-audit services causes, over time, a 
cultural shift within the firm. 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.
---------------------------------------------------------------------------

    Changes in legal standards have also affected incentives. Professor 
John C. Coffee, Jr. testified that the legal constraints on accountants 
have loosened considerably in recent years, and as a result, there has 
been a significant decrease in the threat of liability. It has become 
much more difficult, and less worthwhile, for private plaintiffs to 
assert civil claims against auditors even in cases where the plaintiffs 
believe that an audit failure flowed from a lack of auditor 
independence.\88\ He specifically described the following four 
significant developments in the law since 1994 that he believes have 
reduced the likelihood of success in private lawsuits against auditors: 
(i) the passage of the Private Securities Litigation Reform Act of 
1995, which affected pleading standards and substituted proportionate 
liability for joint and several liability, which makes it less 
attractive to sue accountants ``because even if you're successful 
you're only going to get a portion of the total liability assessed 
against them, and that may not justify the cost''; (ii) passage of the 
Securities Litigation Uniform Standards Act of 1998, which preempted 
certain state or common law claims in securities fraud actions against 
auditors in both state and federal court; \89\ (iii) the Supreme 
Court's decision in Central Bank of Denver in 1994,\90\ eliminating 
liability in private litigation for aiding and abetting a securities 
fraud violation, ``which was the principal tool used to sue accountants 
by the plaintiff's bar''; and (iv) the elimination of the threat of 
treble damage liability as a result of amendment to the Racketeer 
Influenced and Corrupt Organization Act.\91\
---------------------------------------------------------------------------

    \88\ Testimony of Professor John C. Coffee, Jr., Columbia 
University (July 26, 2000) (``[T]he expected costs facing the 
accountant who might be []tempted to shirk his duties in order to 
please management have vastly declined in just the last five or six 
years.''); see also Written Testimony of Professor Coffee.
    \89\ Securities Litigation Uniform Standards Act of 1998, Pub. 
L. No. 105-353, 112 Stat. 3227 (codified in scattered sections of 
the U.S.C.) (requiring most private class actions alleging fraud in 
the sale of nationally traded securities to be based on federal law 
and brought in federal court).
    \90\ Central Bank of Denver v. First Interstate Bank of Denver, 
511 U.S. 164 (1994).
    \91\ The Private Securities Litigation Reform Act of 1995, Pub. 
L. No. 104-67, 109 Stat. 737, amended 18 U.S.C. Sec. 1964(c) to 
eliminate ``fraud in the purchase or sale of securities'' as a 
predicate act for RICO liability unless the defendant has been 
criminally convicted.
---------------------------------------------------------------------------

    Professor Coffee summarized the effect of these developments by 
noting that while lawsuits involving accounting irregularities have 
actually increased since 1995, ``those suits today rarely involve * * * 
the outside accountant, as a defendant, and when they do they're often 
very easily and quickly dismissed,'' which would preclude relevant 
evidence from coming to light. In view of these developments in the 
law, he noted that an auditor today ``faces greatly increased benefits 
through the existence of non-audit advisory services that are subject 
to the discretion of management, and it faces greatly reduced 
liabilities.''
    In part because the risks of liability have changed, as described 
by Professor Coffee, we do not believe, as urged by at least one 
commenter,\92\ that liability insurance premiums are a barometer of the 
extent to which non-audit services pose a risk to audit quality. 
Professional malpractice premiums reflect the risk that the liability 
insurer will have to fund a judgment or settlement imposing money 
damages on the auditor. This risk of liability is attributable to a 
variety of factors, only one of which is the risk of audit failure. The 
likelihood of audit failure, in turn, is attributable to many factors, 
only one of which is auditor independence. And auditor independence, in 
turn, can be threatened in numerous ways, only one of which is the 
provision of non-audit services. In assessing overall litigation risk, 
it is entirely possible, for example, that a liability insurer would 
conclude that an enhanced risk of misconduct is offset by a small 
probability of discovery, as well as a diminishing likelihood, owing to 
changes in the law, that even known misconduct would result in a 
judgment or settlement that the insurer would have to fund. 
Consequently, even if insurers were to provide auditors substantially 
the same professional malpractice coverage at approximately the same 
cost despite increases in their provision of non-audit services, that 
indicates at most that, from the insurers' perspective, overall 
litigation risks have not increased. Because there are numerous 
explanations as to why auditors' professional liability premiums might 
or might not increase, we are not persuaded that insurance premiums are 
a useful measure of the effect of non-audit services on auditor 
independence.
---------------------------------------------------------------------------

    \92\ AICPA Letter (citing AICPA, Serving the Public Interest: A 
New Conceptual Framework for Auditor Independence (Oct. 20, 1997) 
(``AICPA White Paper'')). We note that the data relied on in the 
AICPA White Paper and referred to in the AICPA Letter was collected 
in 1997. As we discuss throughout this release, the magnitude of 
non-audit services has increased dramatically over the past several 
years.
---------------------------------------------------------------------------

    (ii) Changes in Incentives Are Likely to Affect Behavior. In the 
Proposing Release, we discussed our concern that the enhanced incentive 
to perpetuate a client relationship involving non-audit services 
increases the so-called ``self-serving bias'' auditors experience in 
favor of an audit client. We heard during our public hearings from 
academics who have studied the ``self-serving bias,'' including in 
connection with the behavior of auditors. Two academics presented 
research tending to show that subtle but powerful psychological factors 
skew the perceptions and judgments of persons--including auditors--who 
have a stake in the outcome of those judgments.\93\ Other

[[Page 76017]]

academics, by contrast, pointed out that the issue may be more 
complicated because, even where an auditor has some stake in an 
outcome, the auditor also has countervailing reputational 
interests,\94\ and concerns about, for example, legal liability,\95\ 
audit committee review,\96\ and peer review.\97\
---------------------------------------------------------------------------

    \93\ See Testimony of Professor Max H. Bazerman, Northwestern 
University (July 26, 2000); Testimony of Professor George F. 
Loewenstein, Carnegie Mellon Institute (July 26, 2000); see also Max 
H. Bazerman, Kimberly P. Morgan, and George F. Loewenstein, ``The 
Impossibility of Auditor Independence,'' Sloan Management Review at 
91, 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 self interest,'' 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''); Jesse D. Beeler and James E Hunton, ``Contingent 
Economic Rents; Insidious Threats to Auditor Independence,'' 
manuscript (2000).
    \94\ Testimony of Don N. Kleinmuntz, Professor, University of 
Illinois at Urbana-Champaign (Sept. 21, 2000); Testimony of Urton 
Anderson, Professor, University of Texas at Austin (Sept. 21, 2000) 
(presenting results of research commissioned by Arthur Andersen, 
Deloitte & Touche, KPMG, and the AICPA); see also Testimony of 
Professor Rick Antle, Yale University (July 26, 2000) (researcher 
for the AICPA presenting personal views on data).
    \95\ See supra notes 88-91.
    \96\ See infra Section III.C.5.
    \97\ At least one witness challenged the effectiveness of the 
current peer review system. She testified that, as enacted, peer 
review has no ``teeth.'' Testimony of Wanda Lorenz, CPA, Lane Gorman 
Trubitt, LLP (Sept. 20, 2000).
---------------------------------------------------------------------------

    We do not question that there are influences on the auditor and an 
accounting firm beyond a ``self-serving bias.'' We accept also that 
firms have incentives to avoid situations that expose them to liability 
and reputational harm. But, again, the argument proves too much. Even 
with these disincentives, audit failures and impairments of 
independence occur.\98\ Other studies tend to show that the 
reputational interests of the audit firm are not the same as the 
reputational interests of the audit engagement partner or the office of 
the partner that performs most of the work for an audit client. 
Specifically, these studies suggest that the audit engagement partner 
and the office have more to gain by, for example, acquiescing to the 
client's aggressive accounting treatment than they have to lose if it 
results in audit failure, particularly if the client engagement 
contributes substantially to the partner's income and the office's 
revenues. Reputational damage will be spread across the entire firm, 
whereas income from the client will be concentrated in the partner and 
the office out of which he or she works.\99\ In addition, in a two-
phase study commissioned by the ISB, Earnscliffe reported that ``[m]ost 
believe that accounting firms today are not indifferent about their 
reputation for quality audits, but are more focused on raising the 
profile, reputation, and profitability of non-audit services.'' \100\
---------------------------------------------------------------------------

    \98\ See, e.g., In the Matter of PricewaterhouseCoopers LLP, 
AAER No. 1098 (Jan. 14, 1999).
    \99\ W.R. Kinney, Jr., ``Auditor Independence: Burdensome 
Constraint or Core Value?'' Accounting Horizons (March 1999); G. 
Trompeter, ``The effect of partner compensation schemes and 
generally accepting accounting principles on audit partner 
judgment,'' Auditing: A Journal of Practice and Theory (Fall 1994); 
Paul M. Clikeman, ``Auditor Independence: Continuing Controversy,'' 
Ohio CPA Journal (Apr.-Jun. 1998).
    \100\ Earnscliffe II, supra note 38, at 6. Interviewees included 
chief executive officers, chief financial officers and controllers, 
auditors, buy-side and sell-aside analysts, audit committee chairs, 
and regulators.
---------------------------------------------------------------------------

    While we do not purport to resolve a debate among scholars, it is 
plain that there is ample basis to conclude that the more a person, 
including an auditor, has at stake in a judgment, the more likely his 
or her judgment is to be affected.\101\ We stress that the influences 
that we are concerned with can be ``extremely subtle,'' as stated by 
the Comptroller of the Currency, John D. Hawke, in testimony supporting 
our proposal to restrict internal audit outsourcing.\102\ Paul A. 
Volcker, the former Chairman of the Federal Reserve, in his testimony 
supporting our proposal, noted the real threat posed by the 
``insidious, hard-to-pin down, not clearly articulated or even 
consciously realized, influences on audit practices'' that flow from 
non-audit relationships with audit clients.\103\
---------------------------------------------------------------------------

    \101\ 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.
    \102\ Written Testimony of John D. Hawke, Jr. (July 26, 2000).
    \103\ Written Testimony of Paul A. Volcker (September 13, 2000). 
Aggregate economic incentives aside, non-audit services can have the 
effect of aligning the accountant's interests with those of 
management. When the accountant acts as a consultant, the accountant 
must answer to management, and 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.'' R.K. Mautz and Hussein A. 
Sharaf, The Philosophy of Auditing at 222 (Am. Acct. Ass'n 1961). As 
the auditor becomes increasingly involved with the audit client and 
its managers, the auditor is more likely to perceive himself as a 
part of the management team and place less emphasis on his or her 
primary loyalty to investors. In Earnscliffe I, Earnscliffe reported 
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.'' Earnscliffe I, supra note 65, at 9.
---------------------------------------------------------------------------

    b. Certain Non-Audit Services Inherently Impair Independence. Our 
rule lists services that, regardless of the size of the fees they 
generate, place the auditor in a position inconsistent with the 
necessary objectivity. Bookkeeping services, for example, place the 
auditor in the position of later having to audit his or her own work 
and identify the auditor too closely with the enterprise under audit. 
It is asking too much of an auditor who keeps the financial books of an 
audit client to expect him or her to be able to audit those same 
records with an objective eye.
    In much the same way, performing certain valuation services for the 
audit client is inconsistent with independence. An auditor who has 
appraised an important client asset at mid-year is less likely to 
question his or her own work at year-end. Similarly, an auditor who 
provides services in a way that is tantamount to accepting an 
appointment as an officer or employee of the audit client cannot be 
expected to be independent in auditing the financial consequences of 
management's decisions. And an auditor who has helped to negotiate the 
terms of employment for an audit client's chief financial officer is 
less likely to bring quickly to the audit committee questions about the 
new CFO's performance.
3. The Expansion of Non-Audit Service Relationships with Audit Clients 
Is Affecting Investor Confidence in the Independence of Auditors
    Recent studies indicate that there is a growing disquiet among 
investors and other users of financial statements about auditor 
independence in light of the multi-faceted relationships between 
auditors and their audit clients. Recently, Earnscliffe found that most 
interviewees ``felt that the evolution of accounting firms to multi-
disciplinary business service consultancies represent[ed] a challenge 
to the ability of auditors to maintain the reality and the perception 
of independence.'' \104\ In Phase II of its study, Earnscliffe reported 
that interviewees generally had confidence in and are satisfied with 
the current standard of financial reporting in the U.S. Nonetheless, 
the study noted, ``[m]ost [interviewees] felt that the risks of 
unfavorable perceptions of auditor independence are growing, due 
largely to the provision of non-audit services to auditees.'' \105\
---------------------------------------------------------------------------

    \104\ Earnscliffe I, supra note 65, at 46 (Nov. 1999). The study 
also found that many individuals interviewed believed that 
``auditors are developing a stronger interest in their relationship 
with management, perhaps at the expense of their responsibilities to 
shareholders.'' Id. at 9.
    \105\ Earnscliffe II, supra note 38, at 5 (July 2000).

---------------------------------------------------------------------------

[[Page 76018]]

    Though the O'Malley Panel did not reach consensus on whether 
changes to the independence rules are needed, over the past year it 
surveyed preparers and users of financial statements, auditors, 
regulators, academics, lawyers, and analysts about the provision of 
non-audit services, and heard from witnesses at the Panel's public 
---------------------------------------------------------------------------
hearings. The Panel found that,

[M]any people continue to be concerned--some very concerned--that 
the performance of non-audit services could impair independence, or 
that there is at least an appearance of the potential for 
impairment. Almost two-thirds of the respondents to the Panel's 
survey from outside the profession who addressed non-audit services 
expressed such concerns.\106\
---------------------------------------------------------------------------

    \106\ The O'Malley Panel Report, supra note 20, at para. 5.20.
---------------------------------------------------------------------------

    In a June 2000 study, Brand Finance plc surveyed analysts and 
representatives of companies listed on the London Stock Exchange. Brand 
Finance reported,

Analysts are concerned that the acceptance of non-audit fees by 
auditors is likely to result in the independence of the audit being 
compromised. 94% of analysts stating an opinion believe that 
significant non-audit fees are likely to compromise audit 
independence. 76% of companies stating an opinion felt that auditor 
independence is likely to be compromised where significant non-audit 
fees are received from audit clients.\107\
---------------------------------------------------------------------------

    \107\ Brand Finance plc, The future of audit--``Back to the 
Future,'' ch. 1 (June 2000).

Brand Finance also found that ``83% of analysts who expressed an 
opinion believe objectivity is threatened even when the non-audit fee 
is less than the audit fee.'' \108\
---------------------------------------------------------------------------

    \108\ Id. 
---------------------------------------------------------------------------

    In another recent survey, the Association for Investment Management 
and Research (``AIMR'') surveyed its members and certified financial 
analyst candidates regarding auditor independence issues. AIMR reported 
that ``[p]otential threats to auditor independence, resulting from 
audit firms providing non-audit services to their audit clients [were] 
troublesome to many . . . respondents.'' \109\
---------------------------------------------------------------------------

    \109\ Written Testimony of Mauricio Kohn, CFA, CMA, CFM, AIMR 
(Sept. 20, 2000) (submitting survey). AIMR is a global, non-profit 
organization of investment professionals.
---------------------------------------------------------------------------

    A recent poll was conducted by Public Opinion Strategies \110\ to 
determine, among other things, how the investing public views our 
proposed rules.\111\ The results showed that eighty percent of 
investors surveyed favor (forty-nine percent strongly favor; thirty-two 
percent somewhat favor) an SEC rule that generally would require 
restrictions on the types of consulting services accounting firms can 
provide their audit clients, \112\ and fifty-one percent thought the 
new rule was ``very important'' to protecting individual stock market 
investors.\113\ As summarized by James C. Stadler of Duquesne 
University, ``The results of our national poll indicate that average 
American investors, in fact, overwhelmingly support the need for some 
new rulemaking in this area.'' He further stated, ``The survey results 
confirm what most practitioners have felt for decades--that large 
consulting engagements for audit clients can raise serious concerns 
regarding audit independence.'' \114\
---------------------------------------------------------------------------

    \110\ The results were published by the A.J. Palumbo School of 
Business Administration at Duquesne University (``Duquesne Poll''). 
PricewaterhouseCoopers provided funding for the poll.
    \111\ The 800 adults had incomes greater than $50,000.
    \112\ Duquesne Poll, supra note 110, Question 12.
    \113\ Duquesne Poll, supra note 110, Question 13. The Poll also 
found that 37% of respondents thought the new rule was ``somewhat 
important,'' 6% thought it ``not very important,'' and 3% thought it 
``not at all important.''
    \114\ Mr. Stadler is Dean of the John F. Donahue Graduate School 
of Business and the A.J. Palumbo School of Business Administration.
---------------------------------------------------------------------------

    Witnesses at our public hearings and written comments on our 
proposed rules supplied additional indications that investor confidence 
in auditor independence is in fact being undermined by non-audit 
relationships between auditors and audit clients.\115\ For example, 
representatives of TIAA-CREF, CalPERS, the New Hampshire Retirement 
System, and the AFL-CIO, organizations with responsibilities for the 
sound investment of hundreds of billions of dollars for the benefit of 
millions of participants, all came forward to express precisely that 
concern and to urge us to adopt the restrictions we proposed, or even 
more stringent restrictions.\116\
---------------------------------------------------------------------------

    \115\ For written comments, see, e.g., Letter of Samuel 
Fleishman (Sept. 9, 2000) (``My confidence in the audits is greatly 
decreased by knowing that the same company is or could be doing 
consulting work for the company they are auditing.''); Letter of 
George R. Jensen (Sept. 8, 2000) (``Investors have a right to expect 
that sanctity [of the audit] as it is promised without having to 
wonder about the same firm monkeying with the audit to preserve or 
enhance their consulting business.''); Letter of Goran LindeOlsson 
(Sept. 9, 2000) (``The mere possibility that audits may not be 100% 
objective is reason enough to toughen the rules and keep accounting 
and consulting services separate.''); Letter of Vivian D. Kilgore 
Jr. (``No public confidence should be given to any report of any 
firm that engages in this practice.''); Letter of John Dossing 
(Sept. 10, 2000) (``Common sense tells me and other indivi[d]ual 
invest[o]rs this conflict of interests will lead to at the very 
least the appearance of conflict of interest. How can we trust any 
audits with the appearance of a conflict of interest. Why invest if 
we can't trust the figures presented to us in the financial 
statements?'').
    \116\ See Testimony of John H. Biggs, Chairman and CEO of TIAA-
CREF (July 26, 2000); Testimony of Kayla J. Gillan, General Counsel, 
CalPERS (Sept. 13, 2000); Testimony of Alan P. Cleveland, New 
Hampshire Retirement System (Sept. 13, 2000); Testimony of Bill 
Patterson, Director, Office of Investment, AFL-CIO (Sept. 20, 2000).
---------------------------------------------------------------------------

    Paul Volcker, former Chairman of the Federal Reserve Board, 
testified as follows about investors' perceptions of a conflict of 
interest when auditors provide non-audit services to audit clients:

The perception is there because there is a real conflict of 
interest. You cannot avoid all conflicts of interest, but this is a 
clear, evident, growing conflict of interest, given the relative 
revenues and profits from the consulting practice, and a conflict of 
interest is there.\117\
---------------------------------------------------------------------------

    \117\ Testimony of Paul A. Volcker (Sept. 13, 2000).

Richard Blumenthal, the Attorney General of Connecticut stated in his 
testimony before us, ``The tough-minded questions and vigorous 
standards that the public has traditionally associated with the term 
``independent auditor'' have been compromised by the interdependent 
business relationship between the auditors and the audited.'' \118\ 
Manuel H. Johnson, a public member of the ISB and the former Vice 
---------------------------------------------------------------------------
Chairman of the Federal Reserve Board, testified that,

    \118\ Written Testimony of Richard Blumenthal (Sept. 20, 2000).
---------------------------------------------------------------------------

[T]he growing complexity of financial and economic relationships and 
the extent of non-audit services provided to audit clients by major 
accounting firms have significantly increased the perception and the 
potential for conflicts of interest and threatens the integrity of 
the independent audit function. \119\
---------------------------------------------------------------------------

    \119\ Testimony of Manuel H. Johnson (July 26, 2000). See also 
Testimony of William T. Allen, Chairman, ISB (July 26, 2000) 
(``[T]he evolution of the auditing profession into multi-service 
professional firms has given rise to reasonable concerns that the 
integrity of financial data is being or may be adversely affected or 
at least that markets may become suspicious of that fact and impose 
an additional risk premium.'').

    At a Congressional subcommittee hearing regarding our proposals, 
John H. Biggs, Chairman, President, and Chief Executive Officer of 
---------------------------------------------------------------------------
TIAA-CREF, said,

The concern about auditor independence in the presence of 
substantial management consulting fees has been with us for years, 
and has caused much questioning and study in the profession. 
Investor uneasiness and suspicion of the quality of audited 
financial statements is growing rapidly along with the dramatic rise 
in the percentage of audit firm revenues that come from cross-sold 
services.\120\

    \120\ Written Testimony of John H. Biggs before the Subcommittee 
on Securities of the Senate Committee on Banking, Housing and Urban 
Development (Sept. 28, 2000).

---------------------------------------------------------------------------

[[Page 76019]]

    We recognize there are different views as to whether investor 
confidence is being undermined.\121\ For example, in Phase I of its 
study, Earnscliffe reports ``The vast majority of respondents believe 
that auditors are currently performing audits, which meet a high 
standard of objectivity and independence.'' \122\ In Phase II, 
Earnscliffe reports that with respect to the investing public surveyed, 
``Most had a high degree of confidence in the quality and reliability 
of the information that was available for them to use in making 
investment decisions.'' \123\ In addition, two professors from North 
Carolina State University submitted a study tending to suggest that 
``non-audit services had a positive influence on participants'' 
perceptions of auditor independence, consistent with the contention 
that nonaudit services enhance auditor independence.'' \124\ Some 
commenters also cited a survey commissioned by the AICPA and conducted 
by Penn Schoen & Berland Associates,\125\ which found that ninety-one 
percent of investors surveyed believe audited financial statements are 
credible.\126\
---------------------------------------------------------------------------

    \121\ See, e.g., Testimony of John Guinan, Partner, KPMG (Sept. 
13, 2000) (``There's no fundamental unease within the marketplace on 
this subject.''); Testimony of Richard J. Stegemeier, Chairman 
Emeritus, Unocal Corp. (Sept. 13, 2000) (``I do not believe that [a 
clear and present danger to investors] exists.'').
    \122\ Earnscliffe I, supra note 65, at 8.
    \123\ Earnscliffe II, supra note 38, at 44. At the request of 
the AICPA, Gary Orren, a professor at the John F. Kennedy School of 
Government, reviewed and evaluated Earnscliffe I and II. Memorandum 
from Gary Orren to AICPA (Sept. 19, 2000). Mr. Orren concluded that 
the findings do not support our proposals, and that the studies were 
methodologically flawed. At the same time, he acknowledged that 
among the respondents in the studies, ``[a] larger number, about 
half, thought that a perception problem might develop in the 
future,'' that the majority of groups interviewed perceived a 
``slight appearance problem'' today, that the respondents registered 
``mild misgivings'' about the effects of non-audit services on 
independence, and that the respondents were ``mildly worried'' about 
a possible appearance problem in the future. Id. at 3, 4, and 7.
    \124\ J. Gregory Jenkins and K. Krawczyk, North Carolina State 
University, Perceptions of the Relationship Between Nonaudit 
Services and Auditor Independence, manuscript (2000) (synopsis). In 
this study, the researchers interviewed 289 users of financial 
statements, including business professionals, graduate business 
students, and accounting professionals at Big Five firms and Non-Big 
Five firms.
    \125\ Penn Schoen & Berland Associates, Inc., National Investors 
Survey (Sept. 12, 2000) (``Penn Schoen Survey'').
    \126\ Id. at 4. What the Penn Schoen Survey did not report, but 
what we believe to be equally important, however, is that among all 
investors surveyed, only 54% said that they believe audited 
financial statements are ``very credible,'' 37% believe they are 
only ``somewhat credible,'' 5% believe they are ``not credible,'' 
and the remaining 3% do not know if they are credible. See Judith 
Burns, ``Investors Unconcerned About Auditor Independence,'' Dow 
Jones New Service (Sept. 12, 2000). We do not believe that investors 
or the accounting profession are well-served by a situation in which 
37% of investors in a survey think public companies' audited 
financial statements are only ``somewhat credible.'' In addition, 
according to the Penn Schoen Survey, 23% of investors surveyed 
believed that regulators should play a bigger role than they do now 
in prohibiting accounting firms from offering a range of services 
(id. at 10) and 33% of investors surveyed disagreed that if our 
rules proposals were implemented audit firms will know less about 
the companies they audit and the quality of the audit will suffer 
(id. at 13).
---------------------------------------------------------------------------

    We take seriously the indications of investor unease, along with 
indications that investor opinion may be divided. We focus on degrees 
of investor confidence, and we cannot take lightly suggestions that 
even a minority portion of the population is ``mildly worried'' about a 
possible appearance problem or that their confidence is being 
undermined.\127\ We also take into account the durability of investor 
concerns. For decades there have been some who were troubled at the 
growth of non-audit services.\128\ Those who were troubled remain 
troubled, only more so, and they have been joined by new voices from 
disparate quarters. We also consider whether the concerns that we hear 
will likely persist, or are merely transitory and unreasonable fears 
that inevitably will be allayed. In this instance, we believe that the 
indications of unease are reasonably based and thus likely to endure 
and increase, absent preventive action by the Commission.
---------------------------------------------------------------------------

    \127\ Some have suggested that perception is not an appropriate 
basis for regulation. See AICPA White Paper, at App. A (paper by 
Gary Orren, ``The Appearance Standard for Auditor Independence: What 
We Know and Should Know'' (Oct. 20. 1997)). Others believe that 
``investor perceptions constitute an economically legitimate and 
theoretically sound basis for regulatory intervention.'' See, e.g., 
Written Testimony of Rajib Doogar (Sept. 20, 2000).
    \128\ See supra Section III.C.1; see also Arthur A. Schulte, 
Jr., ``Compatibility of Management Consulting and Auditing,'' 
Accounting Rev. 586 (July 1965) (survey of four respondent groups--
research and financial analysts of brokerage firms, commercial loan 
and trust officers of banks, investment officers of insurance 
companies, and investment officers of domestic mutual funds--
indicated a third of all respondents believed that the provision of 
both audit and non-audit services was a conflict of interest); 
Abraham J. Briloff, ``Old Myths and New Realities in Accountancy,'' 
Accounting Rev. 490-94 (July 1996) (finding that a significant 
number of academics, members of financial community, and accountants 
believed that an auditor's provision of management-advisory services 
detracted from the quality of the audit); Pierre L. Titard, 
``Independence and MAS--Opinions of Financial Statement Users,'' J. 
Accountancy 47 (July 1971) (finding that a significant number of 
parties who represented major investment concerns believed that an 
auditor's provision of management advisory services impaired auditor 
independence).
---------------------------------------------------------------------------

4. The Rules Are Appropriately Prophylactic
    Some commenters and witnesses argue that there is ``no empirical 
evidence to support the notion that providing non-audit services to 
audit clients has had any adverse effect on the quality of audits.'' 
\129\ This argument fails to take into account not only the extensive 
body of research and comments discussed above that document investor 
concerns, but also the extent to which our approach is, and must be, 
prophylactic. Moreover, as we explain below, the asserted absence of 
conclusive empirical evidence on this point is not particularly 
telling.
---------------------------------------------------------------------------

    \129\ Letter of Deloitte & Touche (Sept. 25, 2000) (``Deloitte & 
Touche Letter'').
---------------------------------------------------------------------------

    a. The Commission's Independence Rules Must Be Prophylactic. Our 
approach to auditor independence traditionally has been, as it must be, 
prophylactic. Independence rules are similar, though not identical, to 
conflict of interest rules. To minimize the risks of bias, the 
independence rules, like conflict of interest rules, proscribe certain 
relationships or circumstances, whether or not one can show that biased 
behavior inevitably results from the conflict.\130\ The independence 
rules are preventive both because of the difficulty in proving the link 
from circumstance to state of mind, as discussed below, and because of 
the need to act in the public interest and protect investor confidence 
before it has been significantly undermined.
---------------------------------------------------------------------------

    \130\ In this regard, our rule addresses potential conflicts in 
a way that is similar to rules regarding the conduct of federal 
judges. For example, Sec. 455 of title 28 of the federal code 
provides that a federal judge is to disqualify himself (and may be 
disqualified by the appellate court) in any proceeding where the 
judge's ``impartiality might reasonably be questioned.'' 28 U.S.C. 
Sec. 455(a). The courts have explained that ``disqualification is 
required if a reasonable person who knew the circumstances would 
question the judge's impartiality, even though no actual bias or 
prejudice has been shown.'' Gray v. University of Arkansas, 883 F.2d 
1394, 1398 (8th Cir. 1989).
---------------------------------------------------------------------------

    The Commission's obligation to protect investors requires it to act 
before there has been a serious erosion of confidence in our nation's 
securities markets. Our view on this point is quite different from the 
suggestion from the CEO of an accounting firm that we should wait to 
adopt restrictions on non-audit services until there has been ``a train 
wreck or a stockmarket crash.'' \131\ Our mission is not to pick up the 
pieces of such a ``train wreck,'' but to prevent one.
---------------------------------------------------------------------------

    \131\ ``The Ties That Bind Auditors,'' The Economist at 63 (Aug. 
12, 2000) (``Usually there is a train wreck or a stock market crash 
prompting this sort of radical legislation.'').

---------------------------------------------------------------------------

[[Page 76020]]

    We have adopted other rules with a similar attentiveness to the 
need to sustain investor confidence in the public securities markets. 
For example, in our Order regarding rule changes by the Municipal 
Securities Rulemaking Board to address ``pay to play'' practices in the 
municipal securities market, we stated that the proposed rule changes 
were intended, among other things, ``to bolster investor confidence in 
the integrity of the market by eliminating the opportunity for abuses 
in connection with the awarding of municipal securities 
business.''\132\ Regulation FD provides another example of our acting 
to protect investor confidence.\133\ There, our concern was, among 
other things, that ``the practice of selective disclosure leads to a 
loss of investor confidence in the integrity of our capital 
markets.''\134\
---------------------------------------------------------------------------

    \132\ Notice of Proposed Rule Change by the Municipal Securities 
Rulemaking Board Relating to Political Contributions and 
Prohibitions on Municipal Securities Business, Exchange Act Release 
No. 33482 (Jan. 14, 1994) [59 FR 3389]; see also ``Exceptions to 
Rules 10b-6, 10b-7, and 10b-8 Under the Securities Exchange Act of 
1934 for Distributions of Foreign Securities to Qualified 
Institutional Buyers, Securities Act Rel. No. 6999 (May 5, 1993) [58 
FR 27686)] (``Rules 10b-6, 10b-7, and 10b-8 (`Trading Rules') are 
prophylactic in nature and designed to protect investors purchasing 
a security in a distribution from paying a price that has been 
artifically influenced (i.e., raised or supported) by those persons 
who have the greatest incentive to engage in manipulative activity. 
Because the Trading Rules protect investors against artificial price 
movements, they promote the integrity of the pricing process and 
public confidence in the U.S. securities markets.'').
    \133\ ``Selective Disclosure and Insider Trading,'' Release No. 
33-7881 (Aug. 15, 2000) [65 FR 51715].
    \134\ Id.
---------------------------------------------------------------------------

    The courts have specifically rejected the need for proof of prior 
harm as an antecedent to government action designed to safeguard public 
confidence in the integrity of public actors and processes. For 
example, the court in Blount v. Securities and Exchange 
Commission,\135\ articulated this principle in the context of those 
rules limiting ``pay to play'' practices in the municipal securities 
markets, stating, ``Although the record contains only allegations, no 
smoking gun is needed where, as here, the conflict of interest is 
apparent, the likelihood of stealth great, and the legislative purpose 
prophylactic.''\136\
---------------------------------------------------------------------------

    \135\ 61 F.3d 938 (D.C. Cir. 1994).
    \136\ Id. at 945. Similarly, even in the First Amendment context 
of restrictions on campaign contributions, the Supreme Court has 
upheld the validity of prophylactic rules. Nixon v. Shrink Missouri 
Government, 528 U.S. 377 (2000) (relying on the seminal case of 
Buckley v. Valeo, 424 U.S. 1 (1976)).
---------------------------------------------------------------------------

    In promulgating rules concerning auditor independence, we are 
making judgments about incremental probabilities. We must make 
judgments about the circumstances that render a loss of auditor 
objectivity more or less likely. ``Objectivity'' is not merely the 
absence of a conscious intention to skew audit results in a client's 
favor; it is a willingness to go without reluctance wherever the data 
lead. For us, the question is not whether an auditor who otherwise 
would be without bias will inevitably become biased and then 
intentionally disregard a false statement in a client's financial 
statements. We do not believe the appropriate benchmark for action is 
whether new rules are needed to make ``bad'' auditors good, malleable 
ones stronger, or sales-oriented ones focus solely on the audit. 
Rather, the actual issue is whether providing these services makes it 
unacceptably likely that there will be an effect on the auditor's 
judgment, whether or not the auditor is aware of it.
    Similarly, our mandate to enhance investor confidence in our 
securities markets requires us to make judgments as to effects on 
degrees of confidence. Investor confidence in the securities markets 
arises from a multiplicity of sources. Investor confidence is currently 
high. We must consider not whether otherwise confident investors will 
lose confidence in our markets, but whether there is a significant 
enough probability that enough investors will lose enough confidence if 
we fail to act. In our judgment, the risk is present, and we should 
address it.
    b. The Commission Should Not Delay Action to Engage in Further 
Study. In any event, the assertion that no empirical evidence 
conclusively links audit failures to non-audit services misses the 
point.\137\ First, ``audit quality,'' which we seek to protect, is 
about more than just avoiding major audit failures or financial fraud. 
Auditing, we are often reminded, is not mechanical, but requires 
numerous subtle judgments.\138\ It is important that these judgments be 
made fairly and objectively, whether or not they relate to matters that 
are material to the financial statements. As four previous SEC Chairmen 
stated,
---------------------------------------------------------------------------

    \137\ The widespread perception among sophisticated members of 
the financial community that non-audit services are jeopardizing 
audit reliability at the very least suggests that there is in fact a 
problem. Moreover, at least one published study has found a 
statistical link between the provision of non-audit services and the 
frequency of audit qualifications. Graeme Wines, ``Auditor 
Independence, Audit Qualifications and the Provision of Non-Audit 
Services: A Note,'' 34 Acc. & Fin. 76 (May 1994). The author 
analyzed the audit reports put out between 1980 and 1989 by 76 
companies publicly listed on the Australian Stock Exchange. He found 
that ``the auditors of companies not receiving an audit 
qualification of any type over the period derived a significantly 
higher proportion of their remuneration from non-audit services fees 
than the auditors of companies receiving at least one audit 
qualification.'' Id. at 76. While the author acknowledges that his 
research is by no means conclusive, it does corroborate the common-
sense expectation that ``auditors are less likely to qualify a given 
company's financials statements when higher levels of non-audit fees 
are derived.'' Id. at 83.
    \138\ See Testimony of Robert L. Ryan, CFO, Medtronic, Inc. 
(Sept. 20, 2000) (``[T]o my mind one of the most sacred things in 
the whole audit process is judgment.* * * [T]here is so much 
judgment that goes into a financial statement and I want to feel 
that if I'm sitting across from a partner * * * that audit is the 
primary thing.* * *'').

Some will say that action now is premature or unwarranted. They 
argue that there's no harm unless you can directly tie a firm's 
nonaudit services to a failed audit. But this claim belies the 
environment in which many tough business decisions are made. It is 
rarely the black-and-white issues that an auditor faces. The danger 
lies in the gray area--where the pressure to bend to client interest 
---------------------------------------------------------------------------
is subtle, but no less deleterious.\139\

    \139\ Richard C. Breeden, Roderick M. Hills, David S. Ruder and 
Harold M. Williams, Editorial, supra note. 33.
---------------------------------------------------------------------------

    The number of ``audit failures'' says nothing about misjudgments in 
the gray area.
    ``Audit failures'' in all likelihood also demonstrate relatively 
little about the incidence of auditor error. An ``audit failure,'' as 
we use the term, refers to an instance in which the issuer's financial 
statements are materially misstated and in which the auditor either 
failed to discover the misstatement or acquiesced in the inclusion of 
the misstatement in the issuer's financial statements. The Commission 
is aware of only those audit failures it discovers or that are made 
public; presumably there are more. And, presumably, every error by an 
auditor does not lead to an audit failure. Moreover, audit failures 
arise from a multiplicity of causes, of which an impairment of 
independence is but one. To demand, as a predicate for Commission 
action, evidence that each loss of independence produces an audit 
failure is a bit like demanding proof that every violation of a fire 
safety code results in a catastrophic fire.\140\
---------------------------------------------------------------------------

    \140\ See, e.g., Written Testimony of J. Michael Cook former 
Chairman and Chief Executive Officer, Deloitte & Touche (July 26, 
2000) (``I do not share the view that proof of such a linkage is the 
only appropriate basis for regulatory action. To the contrary, I 
believe the most independence rules today are the result of 
appearance-based rather than fact-based concerns. Further, I agree 
with the Commission that the absence of ``proof'' does not justify 
inaction, particularly when such evidence cannot be expected to be 
demonstrable.''); Paul B.W. Miller, Ph.D., CPA, Professor, 
University of Colorado at Colorado Springs, and Paul R. Bahnson, 
``The Spirit of Accounting'' (draft column to appear in Accounting 
Today, submitted as Addendum to Written Testimony of Paul Miller 
(July 31, 2000) (``[A]udit failure is the wrong factor to consider.* 
* * The issue is not whether the auditor can avoid catastrophic 
failure but whether the audit can increase the credibility of the 
statements enough to make investors perceive a lower risk of being 
misled.''); Testimony of Robert E. Denham, Member, ISB (July 26, 
2000) (``[I]t's a mistake to focus too much on the cases of major 
audit failure and try to draw lessons from whether independence 
played a role in those.* * * [T]he better question for guiding the 
Commission * * * is what set of rules is more likely to produce 
better accounting, better financial reporting in the ordinary 
circumstances of the good companies.* * *'')

---------------------------------------------------------------------------

[[Page 76021]]

    Second, the subtle influences that we are addressing are, by their 
nature, difficult to isolate and difficult to link to any particular 
action or consequence. The asserted lack of evidence isolating those 
influences and linking them to questionable audit judgments simply does 
not prove that an auditor's judgment is unlikely to be affected because 
of an auditor's economic interest in a non-audit relationship. Indeed, 
it is precisely because of the inherent difficulty in isolating a link 
between a questionable influence and a compromised audit that any 
resolution of this issue must rest on our informed judgment rather than 
mathematical certainty.
    Except where an auditor accepts a payment to look the other 
way,\141\ is found to have participated in a fraudulent scheme,\142\ or 
admits to being biased, we cannot know with absolute certainty whether 
an auditor's mind is, or at the time of the audit was, ``objective.'' 
It is even harder to measure the impact that a particular financial 
arrangement with the audit client had on the auditor's state of 
mind.\143\ Similarly, it is difficult 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. As the POB 
noted, ``Specific evidence of loss of independence through MAS 
[management advisory services], a so-called smoking gun, is not likely 
to be available even if there is such a loss.''\144\
---------------------------------------------------------------------------

    \141\ See, e.g., SEC v. Jose Gomez, AAER No. 57 (May 8, 1985).
    \142\ See, e.g., SEC v. Christopher Bagdasarian and Sam White, 
AAER No. 825 (Sept. 26, 1996).
    \143\ 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.
    \144\ 1979 POB Report, supra note 38, 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.
---------------------------------------------------------------------------

    Testimony during our hearings provided informed, real-world 
perspectives bearing on the practical difficulty of establishing a 
conclusive link between non-audit service relationships and compromised 
audit judgments. Many who provided those perspectives nonetheless urged 
that we proceed with our rule.\145\
---------------------------------------------------------------------------

    \145\ While we considered testimony from our public hearings in 
evaluating the need for the rules as a matter of public policy, 
there was no fact finding with respect to particular cases and we 
have not reached any conclusions as to the presence or absence of 
securities law violations in cases discussed by witnesses.
---------------------------------------------------------------------------

    Based on his thirty-three years of law enforcement experience and 
several cases involving unlawful and questionable conduct by auditors, 
Robert M. Morgenthau, the District Attorney for the County of New York, 
testified, ``in most cases, it was impossible to tell whether financial 
considerations played a role in the auditor's issuing the opinion he 
did.''\146\ In these instances, absent the sort of admission referenced 
above, we can look only to circumstantial evidence of influences or 
incentives affecting the auditor.\147\ A number of plaintiffs' lawyers 
agreed that the hard evidence opponents of the proposals seek will be 
rare because even where the evidence does exist, it is unlikely that it 
will be made public. Charles Drott, a CPA and a forensic examiner, 
testified that ``the only time these issues come to light * * * is when 
there is significant litigation.* * * The accounting firm[s] [are] not 
sharing this information, and I don't know of any vehicle at the 
present time that requires them to do so.''\148\ Stuart Grant, an 
attorney who regularly represents institutional investors in securities 
litigation, stated that, based on his experience, he thought it 
unlikely that an auditor, like any party to a lawsuit, would ever 
concede that it made an accounting judgment in part to protect its 
consulting business.\149\ Jay W. Eisenhofer, Mr. Grant's partner, noted 
that even if a case involving independence allegations were to proceed 
to trial, any information relevant to the alleged violation that was 
produced in discovery likely would be protected from general disclosure 
by a confidentiality order.\150\
---------------------------------------------------------------------------

    \146\ Testimony of Robert M. Morgenthau (Sept. 13, 2000).
    \147\ See Testimony of Jay W. Eisenhofer, Partner, Grant & 
Eisenhofer (Sept. 13, 2000) (``It's always difficult to prove [that 
the auditor was influenced by large consulting fees] as a certainty, 
but what you're attempting to do is to use that information to 
demonstrate that the auditor had a motive that in combination with 
other facts that you're able to elicit demonstrates that the auditor 
at least recklessly disregarded its obligations, if not 
intentionally did so.'').
    \148\ Testimony of Charles R. Drott (Sept. 13, 2000).
    \149\ Testimony of Stuart Grant, Partner, Grant & Eisenhofer 
(Sept. 20, 2000). Mr. Grant testified at the request of his client, 
the Council of Institutional Investors, although he stated that he 
was expressing his own views.
    \150\ Testimony of Jay W. Eisenhofer (Sept. 13, 2000).
---------------------------------------------------------------------------

    While these witnesses and commenters said that, based on their 
experience, we should not expect to have an abundance of evidence 
showing a direct link between the provision of non-audit services and 
audit failures, others pointed to cases where they believed the 
connection was apparent.\151\ Richard Blumenthal, Attorney General of 
the State of Connecticut, described a matter investigated by his office 
which he believed did involve a significant audit failure linked to a 
loss of audit objectivity caused by the auditor's non-audit business 
relationship with the audit client. Mr. Blumenthal stated, 
``Connecticut residents have personally experienced the financial 
hardship occasioned by the loss of independence and objectivity in the 
accounting profession. * * * While investors eventually recovered a 
portion of their losses, many surely never recovered their faith in * * 
* the accounting profession.''\152\
---------------------------------------------------------------------------

    \151\ But see Testimony of Barry Melancon, President and Chief 
Executive Officer, AICPA (Sept. 21, 2000) (``Even if there was some 
isolated case[s] in which non-audit services were found to be linked 
to audit failures that would not establish a proper basis for the 
drastic action proposed by this rule.'').
    \152\ Written Testimony of Richard Blumenthal (Sept. 20, 2000).
---------------------------------------------------------------------------

    William S. Lerach, of Milberg Weiss Bershad Hynes & Lerach LLP, 
which represents investors in securities litigation, provided his 
perspective on this issue. He stated,

It has been asserted there is as yet no ``empirical evidence'' 
demonstrating a loss of auditor independence in providing consultant 
and other non-audit services. In fact, we know otherwise.

In prosecuting securities fraud cases against public companies and 
their auditors, we obtain access to internal corporate documents 
that are sealed from public view by confidentiality orders and are 
never made available to the Commission. Over the years, we have seen 
repeated instances where auditors are unable to maintain 
independence from their clients. Not infrequently, the lack of 
independence arises most directly from the fact that the auditing 
firm has substantial consulting relationships with the client `` 
relationships that are extremely lucrative `` much more lucrative 
than the auditing work.\153\
---------------------------------------------------------------------------

    \153\ Letter of William S. Lerach (Sept. 22, 2000). See also 
Letter of Britton Davis (Aug. 14, 2000) (``I have witnessed several 
instances of ``rolling over'' on issues that affected our clients, 
for no other reason than the apparent conflict sticking to our guns 
would have caused (thus threatening our revenue stream).''); see 
also Testimony of Charles R. Drott, CPA, CFA (Sept. 13, 2000) (``My 
overall conclusion * * * has been that in most of the cases that I 
have been involved in, meaning at least 50 cases that I have been 
involved in regarding audit failures, that the underlying cause of 
most of these situations was compromised auditor independence. This 
involved auditors auditing their own work, acting as advocates for 
their clients, entering into improper business relationships with 
their clients, and acting as management for their clients.'').


[[Page 76022]]


---------------------------------------------------------------------------

    Finally, we are also cognizant that concerns about the impact of 
non-audit services on independence have been steadily with us, and 
growing, during relatively prosperous times, and that any economic 
downturn may heighten concern over some of these issues. As one analyst 
stated during our public hearings,

If we're asking hard questions about independence and the appearance 
of independence now, won't our concerns be magnified during times of 
economic distress? It's not hard to imagine an economic environment 
where firms may be more prone to pushing the envelope of reliable 
accounting and reporting, and that's when you would want an auditing 
profession possessing unquestionable independence. If we have qualms 
about that independence now, it will be worse in an economic 
downturn, and that's when investor confidence may be tested on 
issues other than auditor independence.\154\
---------------------------------------------------------------------------

    \154\ Testimony of Jack T. Ciesielski, accounting analyst (July 
26, 2000).
---------------------------------------------------------------------------

5. Our Two-Pronged Approach Responds to Various Aspects of Auditor 
Independence
    As discussed above, some non-audit services, by their very nature, 
raise independence concerns because, for example, they place the 
auditor in the position of auditing his or her own work. We are 
otherwise concerned about non-audit services because of the overall 
economic incentives they create and because of the interdependence that 
develops between the auditor and the audit client in the course of the 
non-audit relationship.
    The greatest assurance of auditor independence would come from 
prohibiting auditors from providing any non-audit services to audit 
clients. We solicited comment on this approach, and some commenters 
strongly urged that we adopt such an exclusionary ban.\155\ That way, 
the auditor would never be placed in a conflict-of-interest position, 
nor would the auditor have any economic incentive, beyond continuation 
of the audit relationship, that might give rise to a biased attitude. 
We believe, however, that the better course is for us to eschew a 
single bright line and instead to draw a series of lines, based on our 
assessment of particular factual circumstances, understanding that 
identifying dangerous circumstances in this area is more a matter of 
informed judgment than measurement. We believe that the two-pronged 
approach we are taking in the final rules--requiring disclosure of the 
fees billed by the auditor for the audit, financial information systems 
design and implementation services, and other non-audit services, and 
identifying particular services that are incompatible with 
independence--best protects the audit process. Our approach also 
permits us to restrict non-audit services only to the extent necessary 
to protect the integrity and independence of the audit function. 
Accountants will continue to be able to provide a wide variety of non-
audit services to their audit clients. They also will be able to 
provide any non-audit service to non-audit clients.
---------------------------------------------------------------------------

    \155\ See supra note 22.
---------------------------------------------------------------------------

    Under the proxy disclosure rule being adopted, registrants will 
have to disclose, among other things, the aggregate fees billed for the 
audit in the most recent fiscal year, the aggregate fees billed for 
financial information systems design and implementation, and the 
aggregate fees billed for non-audit services performed by the auditor 
in the most recent fiscal year. In addition, companies must provide 
certain disclosures about their audit committee. Investors will be able 
to evaluate for themselves whether the proportion of fees for audit and 
non-audit services causes them to question the auditor's independence. 
As discussed above, 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.\156\ 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.\157\
---------------------------------------------------------------------------

    \156\ As discussed above and in the Proposing Release (Section 
II.C), there have been significant changes in the accounting 
profession and the provision of non-audit services since 1982, when 
we rescinded our previous proxy statement disclosure requirement 
regarding non-audit services. From 1978 to 1982, we required 
companies to include in their proxy statement disclosures about non-
audit services provided by their auditors, including the percentage 
of the fees for all non-audit services compared to total audit fees 
and the percentage of the fee for each non-audit service compared to 
total audit fees (``Disclosure of Relationships with Independent 
Public Accountants,'' ASR No. 250 (June 29, 1978)). Although our 
concerns about the provision of consulting and other non-audit 
services remained unchanged, we later determined to rescind the 
proxy disclosure requirement (``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)). Among other reasons, 
our review of proxy disclosures convinced us that accounting firms 
then, in contrast to now, were not providing extensive non-audit 
services to their audit clients. In addition, we noted that, even 
without the proxy statement requirement, investors had access to 
useful data provided to and made public by the SECPS. As discussed 
below, that data are no longer readily available.
    \157\ In particular, summarized information regarding the 
relationship between non-audit and audit fees is provided to the 
SECPS by its member firms. Until recently, the SECPS published 
aggregate information regarding the mix of services provided by an 
accounting firm to all of its clients. Investors, however, would be 
primarily interested in the receipt of non-audit services by the 
companies in which they invest.
---------------------------------------------------------------------------

    Surveys confirm that investors expect that the information that 
will be disclosed under the final rule will be useful in making 
investment decisions. In its Phase II study, Earnscliffe found that 
``[m]any advocate[] 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 to the relationship.\158\ In 
addition, the Penn Schoen Survey found that ``[n]ine in ten investors 
want to know if a company's auditor also provides other 
services.''\159\ Eighty-nine percent of respondents in that study said, 
``It would be important for shareholders to know if a company's auditor 
also provides consulting services to that company.''\160\
---------------------------------------------------------------------------

    \158\ Earnscliffe II, supra note 38 at 9.
    \159\ Penn Schoen Survey, supra note 125, at 15.
    \160\ Id.
---------------------------------------------------------------------------

    We considered a disclosure-only approach and solicited comment on 
that approach. Some commenters favored a disclosure-only approach to 
the independence issues created by auditors' provision of non-audit 
services.\161\ We, however, do not believe that such an approach is 
appropriate for several reasons. First, our federal securities laws 
require that auditors be independent, and we do not believe that 
disclosure can ``cure'' an impairment of independence.\162\ Second, as 
discussed above, by their very nature, certain non-audit services 
provided by auditors can affect an auditor's independence, regardless 
of whether investors are made aware of the provision of the services. 
As a representative of one of the largest pension funds commented, 
``While we do not believe that disclosure in and of itself is adequate 
to deal with the independence problems involved here, shareholders have 
a right

[[Page 76023]]

to know about relationships that may compromise the independence of 
audits on which they rely.''\163\
---------------------------------------------------------------------------

    \161\ See, e.g., Arthur Andersen Letter.
    \162\ Testimony of Jack Ciesielski, accounting analyst (July 26, 
2000).
    \163\ Letter of Peter C. Clapman, Senior Vice President and 
Chief Counsel, Investment, TIAA-CREF (Sept. 21, 2000).
---------------------------------------------------------------------------

6. The Final Rules Will Assist Audit Committees in Their Oversight Role
    Issuers and other registrants have strong incentives to promote 
auditor independence. It is their financial statements that an auditor 
examines. They have the legal responsibility to file the financial 
information with the Commission, as a condition to accessing the public 
securities markets, and it is their filings that are legally deficient 
if auditors who are not independent certify their financial statements.
    For most public companies, audit committees have become an 
essential means through which corporate boards of directors oversee the 
integrity of the company's financial reporting process, system of 
internal accounting control, and the financial statements themselves. 
Among other things, an audit committee serves as the board's principal 
interface with the company's auditors and facilitates communications 
between the company's board, its management, and its internal and 
independent auditors on significant accounting issues and policies.
    The Commission is an advocate of effective and independent audit 
committees. Most recently, the Commission and three major exchanges 
adopted important audit committee rules. The New York Stock Exchange, 
the National Association of Securities Dealers, Inc., and the American 
Stock Exchange changed their listing standards. These changes require 
listed companies to have independent audit committees, and require 
audit committees to play a significant role in overseeing the company's 
auditors.\164\
---------------------------------------------------------------------------

    \164\ The New York Stock Exchange (``NYSE''), National 
Association of Securities Dealers, Inc. (``NASD''), and the American 
Stock Exchange (``AMEX'') also changed 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).
---------------------------------------------------------------------------

    Also, we adopted new disclosure rules regarding audit committees 
and auditor reviews of interim financial information \165\ in response 
to recommendations of the Blue Ribbon Committee.\166\ Those rules 
require that companies include in their proxy statements reports of 
their audit committees that state whether, among other things, the 
audit committees received the written disclosures and the letter from 
the independent auditors required by ISB Standard No. 1,\167\ and 
discussed with the auditors the auditors' independence. ISB Standard 
No. 1 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, reasonably may be thought to bear on 
independence and to discuss the auditor's independence with the audit 
committee.\168\
---------------------------------------------------------------------------

    \165\ ``Audit Committee Disclosure,'' Exchange Act Rel. No. 
42266 (Dec. 22, 1999).
    \166\ In its report, the Blue Ribbon Committee noted that with 
respect to independent directors, 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.'' 
Blue Ribbon Report, supra note 101, at 22.
    \167\ ISB Standard No. 1, ``Independence Discussions with Audit 
Committees'' (Jan. 1999). Copies of standards issued by the ISB are 
available on the ISB's website at www.cpaindependence.org.
    \168\ 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 Michael A. 
Conway, Chairman, Executive Committee, SECPS (Feb. 8, 1999). We 
believe that Chairman Allen's interpretation is appropriate.
---------------------------------------------------------------------------

    The final rule supplements those required disclosures with an 
additional disclosure as to whether the issuer's audit committee ``has 
considered whether the provision of non-audit services] is compatible 
with maintaining the principal accountant's independence.'' The 
disclosure focuses particularly on non-audit services and requires 
disclosure of whether the audit committee itself has focused on the 
issue. We believe that our final rule, our new audit committee 
disclosure rules, and the new requirements of the NYSE, AMEX, NASD, and 
ISB should encourage auditors, audit committees, and management to 
conduct robust and probing discussion on all issues that might affect 
the auditor's independence. 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.''\169\
---------------------------------------------------------------------------

    \169\ Blue Ribbon Report, supra note 101, at 40.
---------------------------------------------------------------------------

    Our final rule does not impose any new legal requirements on audit 
committees.\170\ While the rule may serve to direct the attention of 
audit committees to the potential for independence issues arising from 
non-audit services, any action taken by audit committees will be 
business judgments. Nonetheless, the rule should help audit committees 
carry out their existing responsibilities by codifying the key legal 
requirements that may bear on audit committees' exercise of their 
business judgment.\171\ We believe that audit committees, as well as 
management, should engage in active discussions of independence-related 
issues with the outside auditors.\172\ As with discussions over the 
quality and acceptability of management's judgments, audit committees 
can be useful in considering whether assertions of independence rest on 
conservative or aggressive readings of the independence rules. 
Similarly, audit committees may wish to consider whether to adopt 
formal or informal policies concerning when or whether to engage the 
company's auditing firm to provide non-audit services.\173\
---------------------------------------------------------------------------

    \170\ See Testimony of Barry Melancon, President and Chief 
Executive Officer, AICPA (Sept. 21, 2000) (``[I]t's the audit firm's 
responsibility to determine that they are independent.* * * [T]he 
obligation is clearly on the auditor. The auditor cannot put that 
obligation off solely to the audit committee in any form or fashion. 
And even if the audit committee were to determine things were okay, 
the firm is still responsible to make an independent judgment that 
they are in fact independent.'')
    \171\ See Testimony of John Whitehead, former Chairman, Goldman 
Sachs & Co. (Sept. 13, 2000).
    \172\ See, e.g., Testimony of Robert L. Ryan, Chief Financial 
Officer, Medtronic, Inc. (Sept. 20, 2000) (``We believe that we 
should continue to require our audit committees, who are in the best 
position to evaluate independence, to play an active role in this 
assessment process as the proposed rule changes outline.'')
    \173\ Companies have differing approaches to hiring their 
auditors to provide non-audit services. For example, John H. Biggs 
testified that TIAA-CREF does not hire its auditors to provide non-
audit services (Testimony of John H. Biggs (July 26, 2000)), while 
Judy Lewent, Senior Vice President and CFO, Merck & Co., Inc., 
testified that her company employs a set of principles and practices 
for determining whether to hire their auditors to provide non-audit 
services, such as rotating its lead auditor every five years and 
requiring the audit committee to approve each request to use the 
outside audit firm for non-audit services. She noted that the 
company's process for such determinations has resulted in the use of 
their audit firm for non-audit services only in limited 
circumstances (Testimony of Judy Lewent (Sept. 13, 2000)).

---------------------------------------------------------------------------

[[Page 76024]]

    In this latter connection, we note that recently the O'Malley Panel 
recommended certain guiding factors for audit committees to consider in 
making business judgments about particular non-audit services. 
According to the O'Malley Panel, one guiding principle should be 
whether the ``service facilitates the performance of the audit, 
improves the client's financial reporting process, or is otherwise in 
the public interest.''\174\ Other matters to be considered are:
---------------------------------------------------------------------------

    \174\ O'Malley Panel Report, supra note 20, at para. 5.29.
---------------------------------------------------------------------------

     Whether the service is being performed principally for the 
audit committee.
     The effects of the service, if any, on audit effectiveness 
or on the quality and timeliness of the entity's financial reporting 
process.
     Whether the service would be performed by specialists 
(e.g., technology specialists) who ordinarily also provide recurring 
audit support.
     Whether the service would be performed by audit personnel 
and, if so, whether it will enhance their knowledge of the entity's 
business and operations.
     Whether the role of those performing the service (e.g., a 
role where neutrality, impartiality and auditor skepticism are likely 
to be subverted) would be inconsistent with the auditor's role.
     Whether the audit firm's personnel would be assuming a 
management role or creating a mutuality of interest with management.
     Whether the auditors, in effect, would be auditing their 
own numbers.
     Whether the project must be started and completed very 
quickly.
     Whether the audit firm has unique expertise in the 
service.
     The size of the fee(s) for the non-audit service(s).\175\
---------------------------------------------------------------------------

    \175\ Id. at 116-17.
---------------------------------------------------------------------------

    These factors expand upon the four factors in the Preliminary Note 
to Rule 2-01. Additionally, the O'Malley Panel recommends that audit 
committees pre-approve non-audit services that exceed a threshold 
determined by the committee. We believe that the O'Malley Panel 
recommendations represent a thoughtful and appropriate approach to 
these issues by audit committees, and we encourage audit committees to 
consider the Panel's recommendations.
    Some commenters suggested that the Commission and investors rely 
primarily on corporate audit committees to monitor and ensure auditor 
independence.\176\ Other commenters, however, including investor 
representatives, indicated that this approach, without more, was 
inadequate.\177\ While we welcome active oversight by audit committees 
with respect to auditor independence, we do not believe that this 
oversight obviates the need for the rule we adopt today. Audit 
committees bring business judgment to bear on the financial matters 
within their purview. Their purpose is not to set the independence 
standards for the profession, and we are not attempting to saddle them 
with that responsibility. On the other hand, we believe that the final 
rule facilitates the work of audit committees by establishing clear 
legal standards that audit committees can use as benchmarks against 
which to exercise business judgment.
---------------------------------------------------------------------------

    \176\ See, e.g., Testimony of Philip D. Ameen, Chair, Committee 
on Corporate Reporting, FEI-CRR (Sept. 20, 2000); Letter of Caroline 
Rook, Acxiom Corp. (Sept. 7, 2000); Letter of Allen J. Krowe, 
retired Vice Chairman, Texaco, Inc. (Sept. 5, 2000).
    \177\ See, e.g., Testimony of Bill Patterson, Director of the 
Office of Investment, AFL-CIO (Sept. 20, 2000).
---------------------------------------------------------------------------

7. The Final Rules Will Not Diminish Audit Quality
    Some commenters expressed concern that the proposed restrictions on 
non-audit services would hurt audit quality.\178\ These commenters 
assert that the auditor gains valuable knowledge about an audit 
client's business by providing non-audit services. The more the auditor 
knows about the client, these commenters assert, the higher the quality 
of the audit. These commenters further assert that accounting firms 
need broad technical skills to provide high quality audits and that the 
necessary array of skills can be acquired only if the accounting firm 
has a multidisciplinary practice. Finally, the commenters assert that 
the rules will affect accounting firms' ability to recruit and hire 
talented professionals, which in turn will lead to less capable 
professionals performing lower quality audits. We note that the rules 
we adopt today are significantly less restrictive than the proposed 
rules. We are adopting without substantial alteration restrictions that 
already appear in the professional literature with respect to the 
majority of the nine services that are covered by our rules. In any 
event, we are not persuaded by these arguments.
---------------------------------------------------------------------------

    \178\ See, e.g., AICPA Letter.
---------------------------------------------------------------------------

    a. Auditors Will Continue to Have the Expertise Necessary for 
Quality Audits. The suggestion that the more the auditor knows about 
the audit client, the better its capacity to audit, is flawed. It is an 
argument without limitation that takes no account of the negative 
impact on audit quality from an independence impairment. As the former 
Chief Accountant of the SEC explained several years ago, ``Arguments 
that more knowledge of the audit client increases the quality of the 
audit * * * taken to the extreme, would have the auditor keeping the 
books and preparing the financial statements. Once a firm has worked 
closely with a client to improve the client's operations or reporting 
systems, it would appear that the firm would have difficulty in 
providing a ``critical second look'' at those operations and 
systems,''\179\ as the investing public relies on the auditor to do.
---------------------------------------------------------------------------

    \179\ Letter from Michael H. Sutton, Chief Accountant, SEC to 
William T. Allen, Chairman, ISB (Dec. 11, 1997), at 6-7 (attaching 
SEC Staff Analysis of AICPA White Paper).
---------------------------------------------------------------------------

    In addition, the argument incorrectly assumes that all additions to 
an auditor's knowledge about the client's business are relevant to an 
audit. With respect to the full-scale non-audit practices of some 
firms, however, the O'Malley Panel said,

Audit firms' management consulting practices have expanded far 
beyond the skills required for audit support and the traditional 
areas related to financial planning and controls. For example, some 
firms now offer certain investment banking and legal services, 
outsourcing of a variety of corporate functions, strategic business 
planning and business process reengineering advice.\180\
---------------------------------------------------------------------------

    \180\ O'Malley Panel Report, supra note 20, at para. 5.11 But 
see Testimony of James E. Copeland, Chief Executive Officer of 
Deloitte & Touche (Sept. 20, 2000) (asserting that it is the overall 
competencies gained by providing non-audit services to audit clients 
and non-audit clients that improve the quality of audits).

    Further, the argument that the more an auditor knows about an audit 
client, the better the audit, assumes that knowledge gained by an 
accounting firm's consultants is inevitably transferred to the firm's 
auditors. We are skeptical about this claim. Some testified that there 
is no sharing of firm personnel between the consulting side and 
auditing side. The General Counsel of Andersen Consulting said, ``[I]n 
our experience there is no meaningful crossover of personnel between 
the audit divisions and these other business consulting functions. The 
skills necessary to perform high quality audits are vastly different 
from those needed to perform consulting services of the type covered by 
the rule.''\181\
---------------------------------------------------------------------------

    \181\ Written Testimony of Douglas Scrivner, General Counsel, 
Andersen Consulting (Sept. 20, 2000). Scrivner also is a former 
partner of Arthur Andersen. See also Testimony of Thomas Goodkind, 
CPA (Sept. 13, 2000) (``I have rarely seen [a transference of 
knowledge] occur in my experience.'')

---------------------------------------------------------------------------

[[Page 76025]]

    Available evidence suggests that even without the opportunity to 
provide non-audit services to audit clients, auditors will have the 
expertise to perform quality audits.\182\ First, under the final rules, 
auditors will be able to continue to provide non-audit services to non-
audit clients. They can gain the technical and other expertise that 
they believe they need by providing the non-audit services to all of 
their other clients who are not also audit clients. Second, the great 
majority of companies do not purchase any non-audit services from their 
auditors in any given year. In the most recent year for which data are 
available, approximately seventy-five percent of the public company 
clients of the Big Five accounting firms received no non-audit services 
from their auditor.\183\ This would mean that the financial statements 
of thousands of public companies were audited by firms who provided no 
non-audit services to them in that year. We do not believe that the 
lack of non-audit services resulted in inadequate audits of the 
financial statements of seventy-five percent of all public companies. 
As J. Michael Cook, former Chairman and Chief Executive Officer of 
Deloitte & Touche said, ``Some suggest that consulting services are 
essential to the performance of a quality audit. That assertion, in my 
opinion, is incorrect. The vast majority of all audits are for 
companies who purchase little or no consulting services from the audit 
firm, and those audits are of high quality and always have been.''\184\
---------------------------------------------------------------------------

    \182\ See Testimony of Stephen G. Butler, Chairman and Chief 
Executive Officer, KPMG (Sept. 21, 2000) (``[C]learly we don't 
believe that we will not be able to do a quality audit today in the 
structure that we have,'' with KPMG having incorporated its 
consulting business and prepare for an initial public offering of 
that business). Auditors of course have a professional obligation to 
have the expertise required to perform quality audits, and during 
the audit process, to gather all the evidence needed to evaluate, 
test, and render an opinion on the client's financial statements. 
See, e.g., General Standard No. 1 of Generally Accepted Auditing 
Standards (``GAAS'') (``The audit is to be performed by a person or 
persons having adequate technical training and proficiency as an 
auditor.''); Standards of Field Work No. 3 of GAAS (``Sufficient 
competent evidential matter is to be obtained through inspection, 
observation, inquiries, and confirmations to afford a reasonable 
basis for an opinion regarding the financial statements under 
audit.''). Au Sec. 150.02. Where auditors do not have the requisite 
expertise in house, they can hire others outside the firm to provide 
the skills needed. As observed by Jack Ciesielski, ``Auditors have 
always had to call in specialists when matters are outside their 
understanding.'' Testimony of Jack Ciesielski, accounting analyst 
(July 26, 2000). See also Testimony of John J. Costello, Senior 
Director of Litigation, Gursey, Schneider & Co., LLP (Sept. 20, 
2000) (``[I]n my experience over the years, many times have we had 
to go and get an independent consultant that was not part of the 
firm. * * * It is not something that's new. It's been there for a 
long time and could be done again.'').
    \183\ See Proposing Release, Table 3 in Appendix B.
    \184\ Written Testimony of J. Michael Cook, former Chairman and 
Chief Executive Officer, Deloitte & Touche (July 26, 2000). See also 
Written Testimony of Philip A. Laskawy, Chairman, Ernst & Young 
(Sept. 20, 2000) (``[T]he argument that you have to have 30,000 
consultants to do an audit is not real, it never was real, because * 
* * what percentage of clients are you doing consulting for and it 
is usually in the 20 to 30 percent range. So, the other 70 percent, 
I hope, are getting good audits.'').
---------------------------------------------------------------------------

    We also note that accounting firms that do not provide consulting 
can focus more readily on the audit function, which could in turn 
improve audits. As the Chairman of Ernst & Young said regarding his 
firm's recent sale of its consulting practice,

[N]ow that we have sold this practice, we have not discovered that 
we are somehow enfeebled, unable to perform effective audits or to 
maintain a top-notch audit and tax practice. In fact, we have found 
the opposite to be true: without a large consulting practice to 
manage, we are now more targeted and more focused on our core audit 
and tax business. * * * We have had a greater string of ``wins'' in 
obtaining new audit clients since we sold our management consulting 
practice than we have had at any time in recent history--four new 
Fortune 500 clients, including two Fortune 50 companies, just within 
the last six months.\185\
---------------------------------------------------------------------------

    \185\ Written Testimony of Philip A. Laskawy, Chairman, Ernst & 
Young (Sept. 20, 2000).

    Some commenters \186\ have cited the O'Malley Panel Report as 
evidence that the provision of non-audit services positively affects 
audit quality, reciting the statement from the Report that ``[o]n about 
a quarter of the engagements in which non-audit services had been 
provided * * * those services had a positive impact on the 
effectiveness of the audit.''\187\ It may well be that--independence 
concerns aside--providing certain non-audit services can be said to 
enhance the ``efficiency'' of the audit. But, as Laurence H. Meyer, a 
Governor of the Federal Reserve Board, said in support of our proposed 
restriction on internal audit outsourcing, ``auditor independence is 
more valuable than these asserted efficiencies.''\188\
---------------------------------------------------------------------------

    \186\ See, e.g., KPMG Letter; Deloitte & Touche Letter; Arthur 
Andersen Letter.
    \187\ O'Malley Panel Report, supra note 20, at para. 5.18. Some 
of the eight members of the Panel, however, issued a separate 
statement calling for an outright ban (with very limited exceptions) 
on auditors providing non-audit services to audit clients because of 
their belief in the ``central importance of independence to the 
profession of auditing in general, and to the effectiveness of the 
audit process in particular,'' and ``the severe and growing 
challenges to independence that the audit profession faces in the 
current environment.'' Id., para. 5.32.
    \188\ Written Testimony of Laurence H. Meyer (Sept. 13, 2000). 
Moreover, it has been suggested that these efficiencies can ``be 
partially appropriated as rents to the CPA firm supplier, and hence 
can themselves create a threat to independence.'' Dan A. Simunic, 
``Auditing, Consulting, and Auditor Independence,'' 22 J. Accounting 
Research 679, 681 (Autumn 1984).
---------------------------------------------------------------------------

    Furthermore, we are concerned that as non-audit services become 
more important, firms may care less about auditing and more about 
expanding their service lines, which itself may have a negative effect 
on audit quality.\189\ 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 
exemplify those core values.\190\ Equally important, the training and 
compensation that auditors receive may stress the importance of cross-
selling at the expense of auditing.\191\ The O'Malley Panel, for 
example, noted a sense that accounting firms ``treat the audit 
negatively--as a commodity.''\192\ The O'Malley Panel also agreed that, 
``[i]n their zeal to emphasize the array of services that CPAs offer, 
audit firms and the AICPA scarcely acknowledge auditing services in the 
public images that they portray. This serves to exacerbate the 
independence issue and to downplay

[[Page 76026]]

the importance of auditing.''\193\ This is a trend that we and the 
accounting profession alike must guard against because, as one 
commenter remarked, ``the value of [a CPA] license and the public's 
perception of that license is going to be diminished when it becomes 
another one of the alphabet soup titles that people in the various 
professions now use.''\194\
---------------------------------------------------------------------------

    \189\ E.g., Letter of Ronald J. Marek, CPA (Aug. 17, 2000) 
(``Over the past twenty to thirty years, the big accounting firms 
started placing a higher value on selling skills and less on being 
`a good accountant.' This change is appropriate if the goal is 
generating more fees. This change has resulted in a deterioration of 
audit quality.''); Letter of Mike McDaniel, CPA (Aug. 14, 2000) 
(``[T]he focus was sharper and firm operations had many fewer 
conflicts during the period when consulting services were not a 
central profit center for the Firms.'').
    \190\ See Testimony of Douglas Scrivner, General Counsel, 
Andersen Consulting (Sept. 20, 2000) (``What is necessary to 
maintain audit quality is a sustained focus and investment in the 
audit profession rather than in non-audit services in order to keep 
up with the complexity and sophistication of business in a rapidly 
changing environment.'').
    \191\ See, e.g., Letter of John L. Marty, CPA (Sept. 9, 2000) 
(``If the practice of `cross-selling' of services were constrained, 
it may cause a renewed emphasis on effective auditing and thereby, 
enhance the reliability of audited financial statements and protect 
the investing public.''); Testimony of Larry Gelfond, CPA, CVA, CFE, 
former President of the Colorado State Board of Accountancy (Sept. 
13, 2000) (``Partners are measured by the amount of business that 
they generate, the referrals that they bring in, and the jobs that 
they handle. Obviously, their ability to generate more fees has a 
direct relationship in many of these firms, including my own, to 
their compensation.''); Testimony of Wanda Lorenz, CPA, Lane Gorman 
Trubitt, LLP (Sept. 20, 2000) (acknowledging the ``pressure on 
[audit partners] to sell--pressure on them to retain the client, 
pressure on them to build fees'').
    \192\ O'Malley Panel Report, supra note 20, para. 4.4.
    \193\ O'Malley Panel Report, supra note 20, para. 5.23. See also 
Testimony of Jack Ciesielski, accounting analyst (July 26, 2000) 
(``[The] accounting profession * * * increasingly seeks to distance 
itself from the public image as auditor in favor of one that 
positions accountants in the public's collective mind as business 
enhancing consultants.'').
    \194\ Testimony of Robert Fox, Chair, New York State Board of 
Public Accountancy (Sept. 13, 2000).
---------------------------------------------------------------------------

    b. Many Factors Affect Firms' Recruiting Efforts. We take concerns 
about recruiting and retention very seriously. Nonetheless, we are 
skeptical about the claim that the capacity to offer non-audit services 
to audit clients is critical to the auditing profession's ability to 
recruit and retain talented professionals.
    Today's prosperity, with record lows in unemployment, has 
intensified the recruiting pressures on all sectors of the economy, not 
just the accounting profession.\195\ Enabling auditors to provide all 
types of non-audit services to audit clients is not likely to solve the 
auditor recruiting issues for the accounting firms. From 1993 to 1999, 
the average annual growth rate for revenues from management advisory 
and similar services was twenty-six percent.\196\ Over approximately 
the same time frame, according to data from the U.S. Census Bureau, the 
number of candidates sitting for the first time for the CPA exam 
dropped from 53,763 (1991) to 38,573 (1998),\197\ and the percentage of 
students majoring in accounting dropped from four percent of all 
graduates in 1990 to two percent in 2000.\198\ In other words, while 
accounting firms have been dramatically expanding their consulting 
practices, there has been a steady decline in certain indicators of 
interest in the accountancy profession as a career choice, and the 
firms have been hiring fewer accounting graduates.\199\
---------------------------------------------------------------------------

    \195\ See Testimony of Paul Volcker, former Chairman, Board of 
Governors of the Federal Reserve System (Sept. 13, 2000) (``I 
suspect that many of the traditional professions are feeling under 
some pressure from the lure of Wall Street incomes, and the dot com 
world, and I suspect the Federal Reserve feels that, and auditing 
firms feel it. It is a fact of life. I don't think you cure that 
problem by creating a conflict of interest in your own firm.'').
    \196\ See supra note 53.
    \197\ U.S. Census Bureau, Statistical Abstract of the United 
States: The National Data Book (119th ed. 1999).
    \198\ Taylor Research & Consulting Group Study (2000) 
(commissioned by the AICPA); see generally AICPA Letter (noting 
trend); see also Letter of W. Steve Albrecht, Professor and 
Associate Dean, Marriott School of Management, Brigham Young 
University (Aug. 29, 2000) (noting trends and expressing concern 
that the proposal regarding non-audit services would cause ``further 
and dramatic declines in the quality and quantity of students 
wanting to become accountants and auditors'' because the accounting 
field will be narrower).
    \199\ In the 1991-1992 academic school year, the firms hired 
22,520 graduates with bachelor and master degrees in accounting. In 
1995-1996, that number had fallen to 20,470. AICPA: Supply/Demand 
Study 1997 (``AICPA Supply/Demand Study'') presented to the O'Malley 
Panel (Aug. 31, 1999).
---------------------------------------------------------------------------

    According to some commenters, potential recruits have negative 
perceptions about the accounting profession, including that accounting 
work is unsatisfying and that accountants have no interaction with 
clients, and these perceptions must be overcome in order for the 
profession to attract the best and brightest students.\200\ By 
``selling'' the non-audit practice to recruits, the commenters suggest 
that they will be able to dispel negative perceptions of the auditing 
profession.
---------------------------------------------------------------------------

    \200\ See, e.g., Arthur Andersen Letter; KPMG Letter; Testimony 
of Joseph F. Berardino, Managing Partner, Assurance and Business 
Advisory Services, Arthur Andersen (Sept. 20, 2000).
---------------------------------------------------------------------------

    If a bar to successful recruiting is the perception that auditing 
is not especially rewarding, the profession must take some 
responsibility for creating it.\201\ As noted above, some firms 
increasingly regard the audit as a ``commodity,'' downplay its 
importance, and present themselves to the public as business advisors 
first and only incidentally as independent, objective auditors. If 
large multidisciplinary firms downplay to the general public the 
importance of auditing, they do little to dispel negative impressions 
of the auditing profession to the public or to potential recruits.\202\
---------------------------------------------------------------------------

    \201\ See Testimony of David A. Brown, QC, Chair, Ontario 
Securities Commission (Sept. 13, 2000) (``[F]irms will continue to 
have difficulty recruiting new talent for the audit department, 
particularly if new recruits get a sense that other areas of the 
firm are more highly valued by firm management. . . . I think [the 
difficulty of recruiting on the audit side is] a very real issue, 
but I think the issue is clearly exacerbated by the messages being 
telegraphed to young recruits, and that is that there's a faster 
partnership track on the consulting side.'').
    \202\ We also cannot overlook the extent to which the challenge 
of recruiting auditors partially may be a result of the firms' own 
business decisions. As the General Counsel of Andersen Consulting 
testified at our hearings, ``Some of the firms have diverted 
investment and resources out of the audit function and into non-
audit services, thereby reducing the attractiveness of the audit 
function as a career path.'' Testimony of Douglas Scrivner, General 
Counsel, Andersen Consulting (Sept. 20, 2000); Letter of John S. 
Coppel, CPA, CFO, Electric Power Equipment Company (Aug. 16, 2000) 
(``Promising young staff are exiting the audit area, the 
professions['] most important training ground, after a[ss]essing 
accurately, that career growth opportunities lie elsewhere within 
the practice.'').
---------------------------------------------------------------------------

    Moreover, the salaries of accountants, particularly in comparison 
to the salaries of consultants, may exacerbate recruiting problems. 
Dennis Spackman, Chairman of the National Association of State Boards 
of Accountancy, testified, ``[T]here is a disparity in what [the 
accounting firms] [a]re willing to pay somebody to come on to their 
consulting staff with what they're willing to pay for somebody to come 
on the audit staff.''\203\ In Mr. Spackman's view, the ``big salary 
differential'' gives incentives to recruits who are looking for a 
promising career path to work at a public accounting firm in the 
nonattest area, rather than the attest area.\204\ Publicly available 
statistical data support the conclusion that firms pay accounting 
recruits less than consulting recruits and that salaries for accounting 
recruits have increased at a significantly slower pace than starting 
salaries for consultants.\205\
---------------------------------------------------------------------------

    \203\ Testimony of Dennis Paul Spackman (Sept. 13, 2000).
    \204\ Id. (``The profession to a great extent is doing it to 
itself and it's doing it when it gives up audits in very competitive 
low ball kinds of bidding processes.''); see also Testimony of 
Thomas Goodkind, CPA (Sept. 13, 2000) (stating, in response to a 
question from Chairman Levitt about why the profession is having a 
hard time recruiting auditors, ``They're not offering enough 
money'').
    \205\ W. Steve Albrecht & Robert J. Sack, Accounting Education: 
Charting the Course Through a Perilous Future 9 (Aug. 2000).
---------------------------------------------------------------------------

    Undoubtedly, there are many factors contributing to the decline in 
interest in careers in the accounting profession.\206\ The O'Malley 
Panel noted a similar concern about the decline in the attractiveness 
of auditing as a career, identifying increased educational 
requirements, issues of compensation, heavy workloads and issues of 
family or lifestyle as contributing factors. In addition, the Panel 
noted that the decline
---------------------------------------------------------------------------

    \206\ Id. (showing that the number of accounting degrees awarded 
in the 1998-99 academic year declined 20% compared to those awarded 
in the 1995-96 academic year). There has been a general decline in 
students seeking bachelor degrees in business-related fields. See 
AICPA Supply Demand/Study 1997, supra note 199, which indicates that 
from 1992 to 1997, the number of students obtaining bachelor degrees 
in accounting declined by 14%, those obtaining finance degrees 
declined by 17%, those obtaining general business degrees declined 
by 8%, and those obtaining marketing degrees declined by 27%.

also has been influenced by the perception that alternative career 
opportunities are more exciting, challenging and rewarding than 
auditing.* * * The profession will need to restore the historic 
attractiveness of auditing as a profession and convince the ``best'' 
people that it offers excellent long-term career opportunities. To 
do so it will have to

[[Page 76027]]

lift the public perception of the profession to a higher plane and 
convincingly demonstrate the worth of the profession. This is an 
effort that will require a partnership among audit firms, 
professional societies and the academic community.\207\
---------------------------------------------------------------------------

    \207\ O'Malley Panel Report, supra note 20, Paras. 8.9, 8.10.

    Finally, our revised rules on investments may assist the accounting 
profession in addressing their difficulties in recruiting and retaining 
professionals. In particular, by, among other things, significantly 
shrinking the circle of accounting firm employees to whom restrictions 
on investments in audit clients apply, the final rules will allow more 
accountants to take greater advantage of investment opportunities, and 
therefore, may make the accounting profession more attractive.\208\
---------------------------------------------------------------------------

    \208\ See Written Testimony of Testimony of Jack Ciesielski, 
accounting analyst (July 26, 2000); ``Where Have All the Accountants 
Gone?'' Bus. Wk., at 203 (Mar. 27, 2000) (noting that in addition to 
competition from corporations and startups and increasing college 
requirements, ``also to blame, many are beginning to argue, are 
regulations that govern auditors' ability to invest in stocks,'' and 
that the firms ``are having a much harder time addressing the 
biggest retention problem they face today: regulatory restrictions 
on stock ownership.'').
---------------------------------------------------------------------------

    c.The Rules Need Not Lead to Restructurings. Some commenters said 
that our proposals, if adopted, would require accounting firms to 
restructure their business by, for example, spinning off their 
consulting practices.\209\ It was not, and is not, our intention to 
cause any firms to restructure. In any event, we remain skeptical of 
the claim that our rules will be the cause of wholesale restructuring 
of the accounting profession. Before we proposed these amendments, 
three of the Big Five firms had either consummated or announced their 
intention to enter into transactions that would separate their auditing 
and consulting practices,\210\ and other firms undertook restructurings 
while the proposals were pending. That suggests that reasons, apart 
from this rulemaking, prompted those business decisions. Indeed, one 
industry leader commented that his firm was splitting off its 
consulting business and ``it wasn't done for cultural reasons, it was 
done for different business reasons than that, and it certainly wasn't 
done for independence issues.''\211\
---------------------------------------------------------------------------

    \209\ See generally Deloitte & Touche Letter.
    \210\ See supra Section III.B.
    \211\ Testimony of Stephen G. Butler, Chief Executive Officer, 
KPMG LLP (Sept. 21, 2000).
---------------------------------------------------------------------------

    Moreover, while a few commenters asserted that accounting firms 
will sell their consulting practices if we adopt a final rule, they did 
not provide us with any basis beyond assertion for evaluating their 
comments. While it would have been preferable to have information 
describing the economic impact of the proposed rules upon them, these 
commenters have not elaborated on the claim.\212\
---------------------------------------------------------------------------

    \212\ Because we believed that it would have been useful to have 
additional data concerning the revenue mix of accounting firms, as 
well as the extent to which fees to audit clients for non-audit 
services exceed fees for audits, we solicited comment on revenue 
data. In addition, SEC Commissioner Isaac C. Hunt, Jr. informed the 
Big Five firms that these data would help the Commission in its 
deliberations. See Transcript of July 26 hearing for questions of 
Commissioner Isaac C. Hunt, Jr. posed to Joseph F. Berardino, 
Managing Partner, Assurance and Business Advisory Services, Arthur 
Andersen LLP, Robert R. Garland, National Managing Partner, 
Assurance & Advisory Services, Deloitte & Touche, and J. Terry 
Strange, Global Managing Partner, Audit, KPMG LLP (July 26, 2000); 
see also Letters from Commissioner Isaac C. Hunt, Jr. to Joseph F. 
Berardino, Robert R. Garland, and J. Terry Strange (Aug. 18, 2000) 
and Letters from Commissioner Isaac C. Hunt, Jr. to Kenton J. 
Sicchitano, Global Managing Partner--Independence and Regulatory 
Affairs, PricewaterhouseCoopers LLP, and Mr. Robert Herdman, Vice 
Chair--AABS Professional Practice, Ernst & Young (Sept. 14, 2000). 
Counsel to Arthur Andersen LLP, Deloitte & Touche LLP and KPMG LLP 
indicated that some of these data might be provided by mid-September 
(Letter from John F. Olson, Gibson, Dunn & Crutcher LLP to 
Commissioner Isaac C. Hunt, Jr. (Sept. 1, 2000). However, no data 
were submitted by any of the five firms.
---------------------------------------------------------------------------

    Without information supporting it, the argument that firms will 
sell off their consulting practices solely because they cannot provide 
certain consulting services to audit clients seems similarly 
questionable. As noted in the Proposing Release, while firms will be 
prevented from providing some consulting services to their audit 
clients, they will gain potential clients from other firms who are 
similarly situated.\213\ Even assuming some accounting firms will lose 
the ability to market their consulting services based on asserted 
synergies with their audit services, no other firm will be better 
situated. Every consulting firm, including non-accounting firms, will 
have to compete for consulting business on the same footing.
---------------------------------------------------------------------------

    \213\ See Albert B. Crenshaw, ``Breakup of Andersen Firm 
Approved,'' Wash. Post, at E3 (Aug. 8, 2000) (quoting former Arthur 
Andersen Chief Executive James Wadia).
---------------------------------------------------------------------------

8. The Final Rules Will Apply to Small Accounting Firms Only if They 
Have SEC Audit Clients
    The final rule applies only to public companies and other entities 
registered with the Commission or otherwise required to file audited 
financial statements with the Commission. It does not apply to audits 
of financial statements not required to be filed with us. Big Five 
firms audit the vast majority of the financial statements of public 
companies. Data from the SECPS public files indicate that, in 1999, 
non-Big Five firms earned less than one percent of their annual 
revenues from consulting services provided to public company audit 
clients.\214\ Consequently, we believe there will be only an incidental 
impact on accounting firms that provide audit and non-audit services 
principally to audit clients that are private companies not registered 
with the SEC.
---------------------------------------------------------------------------

    \214\ See Proposing Release, Table 4 in Appendix B.
---------------------------------------------------------------------------

    We received many letters from small accounting firms expressing 
strong support for our proposal,\215\ and the National Conference of 
CPA Practitioners, a national organization comprised of 1,200 member 
firms that represent 5,000 CPAs and service between 400,000 and 500,000 
small and medium sized business clients, similarly wrote to express 
support for the proposal.\216\ Indeed, some commenters pointed out that 
rather than harming the interests of the small practitioners, the rules 
could provide smaller firms with new business opportunities to provide 
non-audit services to companies that previously used their auditors to 
provide those services.\217\
---------------------------------------------------------------------------

    \215\ See, e.g., Letter of Joseph F. Simontacci, CPA (Aug. 14, 
2000); Letter of Leland D. O'Neal, CPA (Aug. 15, 2000); Letter of 
Danny M. Riddle, CPA (Aug. 16, 2000); Letter of Frank Chovanetz, CPA 
(Aug. 16, 2000).
    \216\ Letter of National Conference of CPA Practitioners (Sept. 
25, 2000).
    \217\ Testimony of Larry Gelfond, CPA, CVA, CFE, former 
President of the Colorado State Board of Accountancy (Sept. 13, 
2000); see also Letter of John Mitchell, CPA (Aug. 14, 2000).
---------------------------------------------------------------------------

    Some commenters expressed concern about a possible derivative 
effect of our rule amendments on smaller or regional accounting firms 
that provide audit and non-audit services solely or principally to 
private companies.\218\ The concern is that state boards of 
accountancy, which regulate and license certified public accountants, 
may adopt rules analogous to our own for all accountants in their 
jurisdiction without regard to whether the companies to which they 
provide non-audit services are public or private companies.\219\ This 
certainly is not our intention. Our concern throughout this rulemaking 
has been with investors in public companies and the public securities 
markets.
---------------------------------------------------------------------------

    \218\ See Testimony of Harold L. Monk, Jr., Chairman of the PCPS 
Executive Committee, AICPA (Sept. 21, 2000); Letter of Peter J. 
Hackett, Clark, Schaefer, Hackett & Co. (July 25, 2000); Letter of 
Frank P. Orlando (July 28, 2000); Letter of Michael L. Toms, York, 
Neel and Co. (Aug. 16, 2000).
    \219\ See, e.g., Testimony of Thomas J. Sadler, Past Chair, 
Washington State Board of Accountancy (Sept. 20, 2000); Letter of 
Mark A. Maurice, Chief Financial Officer, Avenir Group, Inc. (Aug. 
15, 2000); Letter of Allan W. Nietzke, CPA (Sept. 23, 2000); Letter 
of Steven F. Farrel, CPA, ABV Gaither Rutherford & Co. LLP (Sept. 
22, 2000); Letter of Honkamp Krueger and Co., P.C. (Sept. 22, 2000).

---------------------------------------------------------------------------

[[Page 76028]]

    As we noted in the Proposing Release, the proposals were not 
intended to ``alter the relationship between federal and state 
authorities'' or to ``affect the ability of the states to adopt 
different regulations in those areas they currently regulate.'' Though 
several state boards suggested that our rules would have a high degree 
of influence over their state regulations,\220\ other commenters 
pointed out that state boards of accountancy have a strong independent 
tradition.\221\ We fully expect that the state boards will continue 
their practice of exercising independent judgment in determining the 
extent to which our rules should be imported into what may be a 
different context.
---------------------------------------------------------------------------

    \220\ See, e.g., Letter of Baxter Rice, President, California 
Board of Accountancy (Sept. 25, 2000); Letter of James E. Houle, 
CPA, Chair, Oregon Board of Accountancy (Sept. 24, 2000).
    \221\ See, e.g., Testimony of K. Michael Conaway, Presiding 
Officer, Texas State Board of Public Accountancy (Sept. 20, 2000); 
Letter of William D. Baker, President, Arizona Board of Accountancy 
(Sept. 20, 2000).
---------------------------------------------------------------------------

9. The Rules Take Into Account the Work of the ISB
    During this rulemaking process, members of the ISB provided 
thoughtful and constructive comments and testimony.\222\ We appreciate 
their commitment and professionalism in pursuing their mandate, and 
their work laid the foundation for our rulemaking. Several commenters 
requested that we defer to the ISB \223\ with respect to financial and 
employment rules and scope of services rules,\224\ while others stated 
their belief that the Commission is the appropriate body to act, and 
that we should act now.\225\
---------------------------------------------------------------------------

    \222\ See Letter from Arthur Siegel, Executive Director, ISB 
(Aug. 31, 2000); Testimony of William T. Allen, John C. Bogle, 
Manuel H. Johnson, and Robert E. Denham (July 26, 2000).
    \223\ In this regard, we note that in FRR No. 50, we stated 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. See FRR No. 50 (Feb. 18, 
1998). In FRR No. 50, we also stated that ``[i]n view of the 
significance of auditor independence to investor confidence in the 
securities markets, the Commission also will review the operations 
of the ISB as necessary or appropriate and, within five years from 
the date the ISB was established, will evaluate whether this new 
independence framework serves the public interest and protects 
investors.'' Id. Some witnesses acknowledged that changes to the ISB 
structure, such as having a majority of public members, may benefit 
the process and enhance the public's perception of the Board as a 
body focused on the public interest and protecting investors. See, 
e.g., Testimony of William T. Allen, Chairman of the ISB (July 26, 
2000) (``[I]informally we have discussed whether or not it would be 
desirable to increase the public membership of the board to a 
majority. I don't think it would [change] the outcome of our 
deliberations, but I recommended that we consider doing that on the 
notion that it might help the perception of the world, thinking that 
perhaps we were compromising to get standards done.''); Testimony of 
Clarence Lockett, Vice President and Corporate Controller, Johnson & 
Johnson (Sept. 20, 2000) (``I believe that [having a majority of 
public members] would certainly go a long way in establishing that 
body in giving the appearance of greater independence from the 
profession of that body and its role in establishing 
independence.''); Testimony of Philip A. Laskawy, Chairman, Ernst & 
Young (Sept. 20, 2000); Written Testimony of James J. Schiro, 
Chairman and Chief Executive Officer, PricewaterhouseCoopers (Sept. 
20, 2000); Testimony of John J. Costello, Senior Director of 
Litigation, Gursey, Schneider & Co., LLP (Sept. 20, 2000); see also 
the Memorandum by Shaun O'Malley, Chair of the O'Malley Panel, to 
the O'Malley Panel, dated Aug. 31, 2000, identifying the expansion 
of the public representation on the ISB as a ``major 
recommendation'' of the Panel.
    \224\ See, e.g., KPMG Letter; AICPA Letter; Written Testimony of 
Philip D. Ameen, Philip B. Livingston, Roger W. Trupin, Financial 
Executives Institute (Sept. 20, 2000); Written Testimony of the New 
York State Society of Certified Public Accountants (Sept. 13, 2000).
    \225\ See, e.g., Letter of Kayla J. Gillan, General Counsel, 
CalPERS (Sept. 25, 2000) (``While CalPERS supports the work of the 
[ISB], only this Commission has the legal authority and effective 
ability to weigh the competing public interests that are represented 
in this area and reach conclusions about the best way to protect 
shareowners and the integrity of the financial markets.'').
---------------------------------------------------------------------------

    In crafting our rules, we were, and continue to be, mindful of the 
work of the ISB, and we give due regard to their requests for our 
guidance. For example, the ISB noted in ISB Standard No. 2 that the 
standard would not take effect until the SEC revises its rules on 
independence.\226\ Importantly, public members of the ISB have stated 
that the Commission is the appropriate body to take action with respect 
to the scope of services issues, and have requested that we do so. As 
William T. Allen, Chairman of the ISB, stated at our public hearings, 
the scope of services issue is ``not well-suited for a board of our 
character. It's really a public policy choice that the government needs 
to make, I think. And that's, I think the view of us all.''\227\ 
Similarly, Robert Denham, a public member of the ISB, stated, ``the 
Commission is uniquely well-suited to making the difficult public 
policy choices that are required to protect independence in an 
environment that has become increasingly complex.''\228\ Mr. Denham 
also stated,
---------------------------------------------------------------------------

    \226\ ISB Standard No. 2, ``Certain Independence Implications of 
Audits of Mutual Funds and Related Entities,'' para. 5 (Dec. 1999).
    \227\ Testimony of William T. Allen, Chairman, ISB (July 26, 
2000).
    \228\ Testimony of Robert E. Denham, Member, ISB (July 26, 
2000).

    As a public member of the ISB I have encouraged the Commission 
to exercise its authority in this area, because the Commission is 
the only entity able to balance and evaluate the difficult policy 
issues that are involved. I am comfortable that the rules proposed 
regarding scope of services represent a rational, coherent and 
thoughtful set of policies that will substantially improve 
---------------------------------------------------------------------------
protection for auditor independence.\229\

    Manuel H. Johnson, another public member of the ISB, stated, ``I do 
feel it's important the SEC undertake a new rulemaking not only to 
strengthen the standards and guidance of the ISB but also to directly 
address in a timely fashion the difficult policy issues surrounding the 
proper scope of services appropriate for accounting firms charged with 
the trust of performing independent audits.''\230\ We believe that 
these considerations, and our evaluation of the important public policy 
goals addressed by our rulemaking, require us to act.
---------------------------------------------------------------------------

    \229\ Written Testimony of Robert E. Denham (July 26, 2000).
    \230\ Testimony of Manuel H. Johnson, Member ISB (July 26, 
2000).
---------------------------------------------------------------------------

10. The Final Rules Encourage International Efforts in This Area
    Foreign companies increasingly seek to raise capital in the U.S. 
securities markets,\231\ and holdings by U.S. investors of foreign 
company securities have risen. With the increasing globalization of the 
markets, regulators worldwide have been re-examining current regulatory 
requirements applicable to cross-border offerings. We, and regulators 
around the world, have an interest in promoting high quality 
international accounting, auditing, and independence standards, while 
at the same time preserving or enhancing existing investor protections.
---------------------------------------------------------------------------

    \231\ During 1999, approximately 120 foreign companies from 26 
countries entered our markets for the first time. At year-end, there 
were over 1,200 foreign companies from 57 countries filing reports 
with us, and public offerings by foreign companies totaled over $244 
billion. SEC, Annual Report, at 76 (1999).
---------------------------------------------------------------------------

    We have been involved in and support efforts to raise the level and 
quality of information available to investors in connection with cross-
border flows of capital, consistent with our mandate to protect 
investors. We worked on a project in which the International Accounting 
Standards Committee (``IASC'') developed the principal components of a 
core set of international accounting standards. Earlier this year, the 
International Organization of Securities Commissions (``IOSCO'') \232\ 
announced that it completed its assessment of the IASC core set of 
standards, and recommended that its members allow multinational issuers 
to use the IASC standards, as supplemented by reconciliations,

[[Page 76029]]

disclosure and interpretation where necessary.\233\ In order to 
determine whether and under what conditions we should accept financial 
statements of foreign issuers using the IASC standards, earlier this 
year we issued a Concept Release on International Accounting Standards, 
seeking comment on the necessary elements of a high quality global 
financial reporting framework that also upholds the high quality of 
financial reporting domestically.\234\ In addition, last year, we 
amended our non-financial statement disclosure requirements for 
offerings by foreign issuers to conform to the international disclosure 
standards adopted by IOSCO in 1998.\235\
---------------------------------------------------------------------------

    \232\ IOSCO is an association of securities regulatory 
organizations and has over 100 members. See IOSCO Annual Report 
(1999), App. III.
    \233\ IOSCO, Press Release, IASC Standards (May 17, 2000), 
available at www.iosco.org/iosco.html.
    \234\ ``International Accounting Standards,'' Securities Act 
Rel. No. 7801 (Feb. 16, 2000) [65 FR 8,896].
    \235\ ``International Disclosure Standards,'' Exchange Act Rel. 
No. 41936 (Sept. 28, 1999) [64 FR 53,900].
---------------------------------------------------------------------------

    The International Federation of Accountants (``IFAC''), in which 
the accounting profession participates actively, has several recent 
initiatives to establish global auditing standards.\236\ Most recently, 
the IFAC Ethics Committee issued for comment an Exposure Draft 
proposing a framework for independence.\237\ In the Exposure Draft, 
IFAC presents a conceptual or principle-based approach to addressing 
auditor independence. Some commenters on our proposal, particularly 
foreign-based firms and organizations such as the Federation Des 
Experts Comptables Europeens (``FEE''), suggested that we too adopt a 
conceptual approach, as opposed to a rules-based approach.\238\ Several 
of these commenters argued that while a rules-based approach has 
certain advantages and is consistent with the historical U.S. approach, 
a conceptual approach, particularly in the area of non-audit services, 
is more efficient and flexible.\239\
---------------------------------------------------------------------------

    \236\ The Institute of Management Accountants, the AICPA, and 
the National Association of State Boards of Accountancy are members 
of IFAC.
    \237\ IFAC Ethics Committee, Independence: Proposed Changes to 
the Code of Ethics for Professional Accountants (Exposure Draft: 
Sept. 15, 2000).
    \238\ See, e.g., Letter of Horst Kaminski, German Institut der 
Wirtschaftsprufer (Institute of Certified Public Accountants) (Sept. 
18, 2000); Letter of Ernst & Young (UK practice) (Sept. 7, 2000); 
Testimony of Jack Maurice, Member of Ethics Working Party, 
Federation des Experts Comptables Europeens (Sept. 21, 2000).
    \239\ See, e.g., Letter of Mike Rake, Chairman, KPMG Europe 
(Sept. 22, 2000); Letter of Ernst & Young (UK practice) (Sept. 7, 
2000).
---------------------------------------------------------------------------

    We understand that many regulators do not agree with the conceptual 
approach,\240\ and several foreign countries prohibit certain non-audit 
services though standards vary from country to country.\241\ Standards 
vary for a number of reasons, including that in some countries, audits 
are conducted by statutory auditors who are directly responsible to 
shareholders, and in some cases audits may be conducted for other than 
financial reporting purposes.
---------------------------------------------------------------------------

    \240\ See Letter from Phillipe Danjou, COB, to Lynn Turner, 
Chief Accountant, SEC (Oct. 10, 2000) (``I can assure you that many 
regulators in Europe (mainly continental Europe) do not agree with 
FEE's [conceptual] approach and have made their views known to the 
European commission when it started its consultation on the proposed 
Recommendations on statutory auditors' independence. I wrote a 
letter to Karel Van Hulle, Head of Unit, European Commission, to 
make clear that COB is not ready to accept a purely conceptual 
system without clear prohibitions.'').
    \241\ Id. (noting that France, Germany, Italy, Spain, Belgium 
and others presently have a system based primarily on specific 
prohibitions of non-audit services, with exceptions for special 
circumstances). See also Letter from Michel Prada, President, COB, 
to Marilyn Pendergast, Chairman, Ethics Committee, IFAC (Sept. 15, 
2000) (commenting on IFAC's Exposure Draft and noting that ``we 
believe that the thrust of the exposure draft should be reversed 
from an `allowed if * * *' system to a `forbidden except when * * *' 
system. The proposed change from a prescriptive approach to a 
framework approach is flawed by the absence of a clear definition of 
an auditor's unique role and position''). In Australia, securities 
regulators recently settled a case with one of the Big Five firms 
where the firm agreed to undertakings that restrict its ability to 
provide certain non-audit services. For example, one of the 
covenants is that the firm agreed not to ``accept an audit 
engagement where [the firm] has valued an asset and the valuation is 
material to the audit engagement. The valuation constitutes a 
service which is a barrier to the firm's ability to provide an 
independent audit opinion on the client's financial statements.'' 
Media Release, Australia Securities and Investments Commission (Nov. 
2, 2000), available at www.asic.gov.au. See also Staff Report, supra 
note 74, at Appendix II; Michael Firth, ``The Provision of Nonaudit 
Services by Accounting Firms to their Audit Clients,'' Contemporary 
Accounting Research Vol. 14, No. 2, pp. 1-21 (Summer 1997). With 
respect to a recognized need by foreign regulators to take some type 
of regulatory action in this area, see Testimony of David A. Brown, 
Q.C., Chair, Ontario Securities Commission (Sept. 13, 2000) (noting 
that for over a year, the Ontario Securities Commission has publicly 
raised concerns about the issue of auditor independence, and that 
``[a]lthough we've not begun to frame a regulatory solution, it has 
become increasingly evident in Canada that some form of regulatory 
involvement in a solution will be essential.'').
---------------------------------------------------------------------------

    We believe that our final rules combine important and useful 
elements of both approaches. As noted, Rule 2-01(c) does not set forth 
all circumstances that may impair an auditor's independence from its 
audit client. For other services, and in particular future services, 
the Preliminary Note makes clear that in applying the general standard 
in Rule 2-01(b), we will look in the first instance to the four 
factors. The four factors provide guiding principles for the 
Commission, similar to what a ``conceptual approach'' would provide.
    We recognize that our system of regulation is not universal. We 
have worked, and will continue to work closely, both directly and 
through IOSCO, with our foreign counterparts on the important issue of 
auditor independence.

D. It Is Appropriate To Ease Restrictions on Financial and Employment 
Relationships

    In our approach to financial and employment relationship 
restrictions, we have attempted to draw lines that promote investor 
confidence but recognize the problems confronting dual career families 
and employees of huge accounting firms. Specifically, in the investment 
and employment area, we have adopted investment and employment rules 
that allow auditors to maximize the opportunities available to them, 
while promoting the public interest and protecting investor confidence.
    As noted in the Proposing Release and above, there have been 
significant demographic changes, changes in the accounting profession, 
and changes in the business environment that have affected accounting 
firms. Among other things, there has been an increase in dual-career 
families and an ever-increasing mobility among professionals. 
Accounting firms have expanded internationally. Most SEC registrants 
now have their financial statements audited by firms that have offices 
and professionals stationed in hundreds of cities around the globe, and 
many of those offices and professionals have no connection to, or 
influence over, a company's audit.
    The current rules on financial and employment relationships of 
auditors were developed largely when the accounting firms were smaller 
and less diversified. The trends discussed above, and others, have 
highlighted the need for us to effect a modernization in these areas. 
In particular, the current rules describing the financial and 
employment relationships that an audit partner's spouse could have with 
a firm's audit client called for modernization. For example, under the 
current rules, the spouse of a partner at an accounting firm could not 
hold certain positions at an audit client or stock in an audit client, 
even through an employee stock compensation or 401(k) plan, even if the 
partner had no connection to the audit. In light of the trends noted 
above, including the growth in dual-career families, we sought to 
address this and similar situations.

[[Page 76030]]

    Accordingly, we are adopting final rules that, among other things, 
reduce the pool of people within audit firms whose independence is 
required for an independent audit of a company and shrink the circle of 
family members whose employment by an audit client impairs an 
accountant's independence. As noted above, we are adopting these 
changes not because doing so will itself enhance independence, but 
because the current rules are broader than necessary to protect 
investors and our securities markets.

IV. Discussion of Final Rules

A. The Preliminary Note

    We have included a Preliminary Note to Rule 2-01 that explains the 
Commission's approach to independence issues. Rule 2-01 does not 
purport to, and the Commission could not, consider all circumstances 
that raise independence concerns. The Preliminary Note makes clear 
that, in applying the standard in Rule 2-01(b), the Commission looks in 
the first instance to whether a relationship or the provision of a 
service:
    (a) creates a mutual or conflicting interest between the accountant 
and the audit client; \242\
---------------------------------------------------------------------------

    \242\ See, e.g., Codification Secs. 601.01 and 601.04.
---------------------------------------------------------------------------

    (b) places the accountant in the position of auditing his or her 
own work; \243\
---------------------------------------------------------------------------

    \243\ See, e.g., Codification Sec. 602.02.c.i.
---------------------------------------------------------------------------

    (c) results in the accountant acting as management or an employee 
of the audit client; or \244\
---------------------------------------------------------------------------

    \244\ See Rule 2-01(b), 17 CFR 210.2-01(b) (accountant cannot 
act as ``director, officer or employee'' of audit client and remain 
independent for purposes of Regulation S-X); Codification 
Sec. 602.02.d.
---------------------------------------------------------------------------

    (d) places the accountant in a position of being an advocate for 
the audit client.\245\
---------------------------------------------------------------------------

    \245\ See, e.g., Arthur Young, 465 U.S. at 819 n.15; 
Codification Secs. 602.02.e.i and ii.
---------------------------------------------------------------------------

    These factors are general guidance and their application may depend 
on particular facts and circumstances. Nonetheless, we believe that 
these four factors provide an appropriate framework for analyzing 
auditor independence issues. We had proposed to include these four 
factors in the general standard of Rule 2-01(b). While some commenters 
agreed with including the four principles in the rule,\246\ others did 
not. Some commenters believed that the principles were too general and 
difficult to apply to particular situations.\247\ Others suggested that 
the principles should more appropriately be used as ``guide posts'' and 
included in a preamble instead of in the rule text.\248\
---------------------------------------------------------------------------

    \246\ See supra note 15.
    \247\ See supra note 16; see also Written Testimony of Dan L. 
Goldwasser, Vedder, Price, Kaufman & Kammholz (July 26, 2000) (while 
acknowledging that ``these concepts are not novel and can be found 
throughout the audit literature,'' stating that they ``should not be 
adopted as guiding principles to be invoked each time a novel 
situation is encountered.'').
    \248\ See, e.g., Testimony of K. Michael Conaway, Presiding 
Officer, Texas State Board of Accountancy (Sept. 20, 2000) (``[W]e 
would ask that [the four principles] be better placed in a preamble 
or a guidance document.''); Testimony of Clarence E. Lockett, Vice 
President and Corporate Controller, Johnson & Johnson (Sept. 20, 
2000) (``[W]e do not believe the four governing principles should be 
stated as firm rules [but rather] be part of the framework and serve 
[as] guiding principles.'').
---------------------------------------------------------------------------

    While the principles were derived from current independence 
requirements, because of these concerns, we are including them in the 
Preliminary Note. In the context of this Preliminary Note, the four 
factors play a role comparable to that of the Ethical Considerations in 
the American Bar Association's Model Code of Professional 
Responsibility. The Model Code contains three separate but interrelated 
parts.\249\ Ethical Considerations ``represent the objectives toward 
which every member of the profession should strive. They constitute a 
body of principles upon which the lawyer can rely for guidance in many 
specific situations.''\250\ Like those Ethical Considerations, the four 
principles constitute a body of principles to which accountants and 
audit committees can look for guidance when an independence issue is 
raised that is not explicitly addressed by the final rule.
---------------------------------------------------------------------------

    \249\ Thomas D. Morgan and Ronald D. Rotunda, eds., The Model 
Code of Professional Responsibility (1995).
    \250\ Id. at Preliminary Statement (citing ``Professional 
Reponsibility: Report of the Joint Conference,'' 44 A.B.A.J., at 
1159 (1958)).
---------------------------------------------------------------------------

    The Preliminary Note states that ``these factors are general 
guidance only and their application may depend on particular facts and 
circumstances.'' The Preliminary Note also reflects the notion that the 
influences on auditors may vary with the circumstances and, as a 
result, Rule 2-01 provides that the Commission will consider all 
relevant facts and circumstances in determining whether an accountant 
is independent.

B. Qualifications of Accountants

    Rule 2-01(a) remains unchanged and requires 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 Securities Act.\251\ It 
acknowledges our deference to the states for the licensing of public 
and certified public accountants.
---------------------------------------------------------------------------

    \251\ Federal Trade Commission, Rules and Regulations Under the 
Securities Act of 1933, art. 14 (July 6, 1933).
---------------------------------------------------------------------------

C. The General Standard for Auditor Independence

    Our rule provides a general standard of auditor independence as 
well as specifying circumstances in which an auditor's independence is 
impaired. As to circumstances specifically set forth in our rule, we 
have set forth a bright-line test: an auditor is not independent if he 
or she maintains the relationships, acquires the interests, or engages 
in the transactions specified in the rule. In identifying particular 
circumstances in which an auditor's independence is impaired, we have 
taken into account the policy goals of promoting both auditor 
objectivity and public confidence that auditors are unbiased when 
addressing all issues encompassed within the audit engagement. We have 
also taken into account the value of specificity, and we have tried to 
give registrants and accountants substantial guidance and 
predictability. The particular circumstances that are set forth in our 
rule as impairing independence are those in which, in our judgment, it 
is sufficiently likely that an auditor's capacity for objective 
judgment will be impaired or that the investing public will believe 
that there has been an impairment of independence.
    Circumstances that are not specifically set forth in our rule are 
measured by the general standard set forth in final Rule 2-01(b). Under 
that standard, we will not recognize an accountant as independent with 
respect to an audit client if the accountant is not, or if a reasonable 
investor knowing all relevant facts and circumstances would conclude 
that the accountant is not, capable of exercising objective and 
impartial judgment on all issues encompassed within the accountant's 
engagement.\252\
---------------------------------------------------------------------------

    \252\ Cf. Staff Report, supra note 74, 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.
---------------------------------------------------------------------------

    The general standard in paragraph (b) recognizes that an auditor 
must be independent in fact and appearance. Some commenters suggested 
that the

[[Page 76031]]

use of an appearance-related standard departs from current rules.\253\ 
As discussed above and in the Proposing Release, the Commission, 
courts, and the profession have long recognized the importance of the 
appearance of independence.\254\
---------------------------------------------------------------------------

    \253\ See, e.g., KPMG Letter.
    \254\ See, supra note 38-40; Proposing Release, Section II.B.
---------------------------------------------------------------------------

    Moreover, the general standard we are adopting merely reflects the 
different means of demonstrating a lack of objectivity. Objectivity is 
a state of mind,\255\ and except in unusual circumstances, a state of 
mind is not subject to direct proof.\256\ Usually, it is demonstrated 
by reference to circumstantial evidence. Accordingly, the final rule is 
formulated to indicate that an auditor's independence is impaired 
either when there is direct evidence of subjective bias, such as 
through a confession or some way of recording the auditor's thoughts, 
or when, as in the ordinary case, the facts and circumstances as 
externally observed demonstrate, under an objective standard, that an 
auditor would not be capable of acting without bias.
---------------------------------------------------------------------------

    \255\ See, supra note 39.
    \256\ See, United States v. Gamache, 156 F.3d 1, 8 (1st Cir. 
1998) (``Now, undoubtedly, establishing intent, short of a situation 
in which it is admitted, is difficult and usually depends on the use 
of circumstantial evidence.'').
---------------------------------------------------------------------------

    The appearance standard incorporated in the general standard is an 
objective one. Appearance is measured by reference to a reasonable 
investor. The ``reasonable person'' standard is embedded in the law 
generally. In particular, the ``reasonable investor'' standard is 
reflected in the concept of materiality under the federal securities 
laws.\257\
---------------------------------------------------------------------------

    \257\ See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 
449 (1976) (information is material if it would be ``viewed by the 
reasonable investor as having significantly altered the `total mix' 
of information made available''); Basic, Inc. v. Levinson, 485 U.S. 
234-236 (1988).
---------------------------------------------------------------------------

    Commenters expressed concern that a general standard based on the 
conclusion of a ``reasonable investor'' may have some imprecision. They 
urged that the general standard require only independence ``in fact.'' 
We believe, however, that we have reduced imprecision substantially by 
describing in some detail particular circumstances that give rise to an 
impairment of independence. Moreover, reliance solely on independence 
``in fact'' would increase the imprecision beyond a ``reasonable 
investor'' test, because independence ``in fact'' is essentially an 
inquiry into the subjective workings of the accountant's mind, whereas 
a ``reasonable investor'' test relies on observable circumstances and 
is thus better suited to uniform and consistent application.
    We recognize that there is an irreducible degree of imprecision in 
the notion of independence. We will be mindful of this imprecision, and 
the range of reasonable views that it engenders, in applying the 
auditor independence rules. We do not, for example, seek to discourage 
the development of non-audit services that do not raise independence 
issues. In considering our response to services not explicitly covered 
by these rules, we will take into account the nature of the service, 
prior contacts with the staff, relevant public statements by the 
Commission or staff, and any related professional literature.
    Paragraphs (c)(1) through (5) require the accountant to be 
independent during the ``audit and professional engagement 
period.''\258\ This term is defined in Rule 2-01(f)(5) 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 date of the audit report.\259\ The use of the word 
``during'' in paragraphs (c)(1) through (5) 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.
---------------------------------------------------------------------------

    \258\ See also AICPA Code of Professional Conduct, ET 
Sec. 101.02 (revised Feb. 28, 1998).
    \259\ Rule 2-01(f)(5) 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 is not 
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 
by other appropriate means.
---------------------------------------------------------------------------

    We have further confined the legal standard by including the 
explicit reference to ``all relevant facts and circumstances.'' To make 
this explicit, we have included the language in the rule text. We have 
also modified the language to refer to whether a reasonable investor 
would ``conclude'' as opposed to ``perceive'' that the accountant was 
not capable of exercising objective and impartial judgment. While this 
is not a substantive change, it makes clear that independence is an 
objective standard measured from the perspective of the reasonable 
investor.
    Current Rule 2-01(c) provides that we will look to all relevant 
circumstances, including all relationships between the accountant and 
the audit client and not just those relating to reports filed with the 
Commission. We proposed to include this language in Rule 2-01(e). Under 
the adopted rule, however, the language appears in Rule 2-01(b) in 
order to highlight that in applying the general standard in Rule 2-
01(b), we will consider ``all relevant circumstances.''
    We remind registrants and accountants that auditor independence is 
not just a legal requirement. It is also a professional and ethical 
duty. That duty requires auditors to remain independent of audit 
clients,\260\ and includes an obligation to ``avoid situations that may 
lead outsiders to doubt [the auditor's] independence.''\261\
---------------------------------------------------------------------------

    \260\ 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.
    \261\ AICPA SAS No. 1, AU Sec. 220.03.
---------------------------------------------------------------------------

    In certain situations, whether or not legally required, the best 
course may be for the accountant to recuse himself or herself from an 
audit engagement. 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 by a 
reasonable investor with knowledge of all relevant facts and 
circumstances as creating, a conflict with the accountant's duty to 
investors.\262\ In this and any similar situation, we encourage 
accountants to seek to recuse themselves from any review, audit, or 
attest engagement, whether or not specifically required by the 
Commission's, the ISB's, or the profession's rules.
---------------------------------------------------------------------------

    \262\ Cf. AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 205 
(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)).
---------------------------------------------------------------------------

D. Specific Applications of the Independence Standard

    Rule 2-01(c) ties the general standard of paragraph (b) to specific 
applications. Paragraphs (c)(1) through (c)(5) address separately 
situations in which an accountant is not independent of an

[[Page 76032]]

audit client because of certain: (1) financial relationships, (2) 
employment relationships, (3) business relationships, (4) transactions 
or situations involving the provision of non-audit services, or (5) 
transactions or situations involving the receipt of contingent 
fees.\263\
---------------------------------------------------------------------------

    \263\ A number of the specified situations are based on examples 
in the Codification and the AICPA and SECPS membership rules.
---------------------------------------------------------------------------

    The proposed rule included a provision under which an accountant's 
independence would have been impaired if the accountant had any of the 
relationships or provided any of the services described by proposed 
Rule 2-01(c), or ``otherwise [did] not comply with the standard'' of 
paragraph (b). We have eliminated from the text of the rule the 
language regarding the accountant's failure ``otherwise'' to comply 
with the standard. Instead, we have modified the structure of paragraph 
(c) to make clear that the paragraph sets forth a ``non-exclusive 
specification of circumstances'' that are inconsistent with the 
standard of paragraph (b).
1. Financial Relationships
    Rule 2-01(c)(1) sets forth the general rule regarding financial 
relationships that impair independence. It addresses, among other 
things, direct or material indirect investments, trustee positions 
involving investment decision-making authority, investments in common 
with audit clients, debtor-creditor relationships, deposit accounts, 
brokerage accounts, commodity accounts, and insurance policies.
    Rule 2-01(c)(1) contains the general standard that ``[a]n 
accountant is not independent if, at any point during the audit and 
professional engagement period, the accountant has a direct financial 
interest or a material indirect financial interest in the accountant's 
audit client.'' The rule then specifies certain financial interests 
that constitute a direct or material indirect financial interest in an 
audit client. As the rule indicates, the list of specified interests is 
not intended to be exclusive. The specified interests represent common 
types of financial interests that impair independence, but the effect 
of other types of financial interests on auditor independence will be 
determined under the general standards of paragraphs (b) and (c)(1).
    In applying the financial relationship provisions of the rule, it 
is important to bear in mind the definition of ``audit client.'' 
``Audit client,'' when used in the rule, includes some ``affiliate[s] 
of the audit client,'' as that term is defined in the rule.\264\ 
Accordingly, financial relationships with certain affiliates of audit 
clients are subject to the provisions of Rule 2-01(c)(1). In this 
discussion, as well as in the rule, references to ``audit client'' 
should be understood to include the appropriate affiliates of the audit 
client.
---------------------------------------------------------------------------

    \264\ See infra Sections IV.H.3 and IV.H.5, for detailed 
discussions of the definitions of ``audit client'' and ``affiliate 
of the audit client.'' As explained below, the affiliates of the 
audit client that are deemed to included in the term ``audit 
client'' for purposes of the financial relationship provisions in 
paragraph (c)(1)(i) are more limited than the group included in 
other parts of the rule.
---------------------------------------------------------------------------

    For the most part, the specified financial interests described in 
this section of the rule impair independence only if they are financial 
interests of the accounting firm, covered persons in the firm, or 
immediate family members of covered persons. (The exception concerns 
situations involving beneficial ownership of more than five percent of 
an entity, or control of an entity.) This represents a liberalization 
from prior restrictions that generally reached all partners in the firm 
regardless of whether they had any relationship to the audit of the 
particular client.
    While the comments we received reflected widespread (although not 
universal) agreement with our goal of modernizing the financial 
relationships restrictions, some commenters urged us not to liberalize 
these restrictions to the extent we proposed. Generally, these 
commenters argued in favor of the prophylactic value of a rule 
precluding a broader scope of persons from having a financial interest 
in an audit client of the firm.\265\ Several of these commenters also 
spoke of the importance of a firm culture that treats all clients as 
clients of the firm, and in which the firm can call on any partner to 
assist with the audit of any client on short notice without having to 
consider whether the partner's personal financial interests preclude 
it.\266\
---------------------------------------------------------------------------

    \265\ See, e.g., Written Testimony of Thomas M. Rowland, Senior 
Vice President, Fund Business Management Group, Capital Research and 
Management Company (Sept. 20, 2000) (restrictions should extend to 
persons in the firm beyond the scope of ``covered persons''); Letter 
of John Spadafora (June 28, 2000) (Narrowing the scope of persons 
whose investments are restricted ``is another step backwards 
creating temptations to pass inside information to those whose 
investments are not restricted.'').
    \266\ See, generally, Written Testimony of J. Michael Cook, 
former Chairman and Chief Executive Officer, Deloitte & Touche (July 
26, 2000); Testimony of Ray J. Groves, former Chairman and Chief 
Executive Officer of Ernst & Young (July 26, 2000).
---------------------------------------------------------------------------

    On the other hand, some commenters, while agreeing generally with 
our proposal to scale back the scope of persons whose financial 
interests are restricted, advocated that we further narrow the group of 
persons who are included in the restrictions. These commenters 
generally expressed a preference for a ``tiered'' approach that would 
restrict even fewer people with respect to some types of financial 
interests.\267\
---------------------------------------------------------------------------

    \267\ See, e.g., Ernst & Young Letter.
---------------------------------------------------------------------------

    The balance we struck between these two sets of concerns was viewed 
favorably by many commenters.\268\ We believe that fair, meaningful, 
and relevant independence rules concerning financial relationships 
should reflect a calibrated approach to determining what specific 
relationships realistically give rise to independence concerns. After 
considering the comments we received, we have drawn the lines 
essentially where we proposed--``covered persons in the firm'' and 
their immediate family members--though we have modified slightly the 
definition of ``covered persons'' in the firm.\269\ The final rule, 
like the proposed 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.
---------------------------------------------------------------------------

    \268\ See, e.g., Written Testimony of William R. Kinney, Jr., 
Professor, University of Texas at Austin (Sept. 20, 2000) (proposed 
changes will ``reduce aggregate regulatory compliance without 
affecting audit quality or increasing independence impairment risk 
for investors''); Testimony of Robert L. Ryan, Chief Financial 
Officer, Medtronic, Inc. (Sept. 20, 2000) (proposed financial 
relationship rules are ``logical, less bureaucratic, and we're 
completely in agreement'').
    \269\ See infra Section IV.H.9 for a detailed discussion of the 
definition of ``covered persons in the firm.''
---------------------------------------------------------------------------

    a. Investments in Audit Clients. Rule 2-01(c)(1)(i) describes 
investments that impair an accountant's independence as to a particular 
audit client. Paragraph (A) provides that an accountant is not 
independent of an audit client if the accounting firm, any covered 
person in the firm, or any immediate family member of any covered 
person has a ``direct investment''--such as stocks, bonds, notes, 
options, or other securities--in the audit client. As the language of 
the rule makes clear, this is not an exclusive list of all ownership 
interests subject to the rule. Other than with respect to the scope of 
persons encompassed by the rule, paragraph (A) does not represent any 
substantive change to our rules on direct investments.
    We noted in the Proposing Release that ``as under current law, the 
rule cannot be avoided through indirect means.''\270\ We stated, as an 
example, that an accountant precluded from having a direct investment 
in an audit client could not evade that restriction by

[[Page 76033]]

investing in the client through a corporation or as a member of an 
investment club.\271\ Some commenters proposed that we address that 
issue with specific rule text, and they proposed language.\272\ While 
not adopting the language proposed by commenters, we have, in the 
interest of increased clarity, included in the final rule language 
addressing that issue.
---------------------------------------------------------------------------

    \270\ Proposing Release, Section III.C.1(a) citing Codification 
Sec. 602.02.b.ii (Example 1).
    \271\ Proposing Release, Section III.C.1(a).
    \272\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

    Specifically, we have added the proviso that an investment through 
an intermediary shall constitute a ``direct investment'' in the audit 
client if either of two conditions is satisfied: ``(1) The accounting 
firm, covered person, or immediate family member, alone or together 
with other persons, supervises or participates in the intermediary's 
investment decisions or has control over the intermediary; or (2) The 
intermediary is not a diversified management investment company . . . 
and has an investment in the audit client that amounts to 20% or more 
of the value of the intermediary's total investments.'' If either of 
these criteria is satisfied, the investment is treated as a direct 
investment in the audit client and, therefore, impairs independence. If 
an investment through an intermediary does not satisfy either of these 
two criteria, however, the investment is considered ``indirect,'' and 
it impairs independence only if it crosses one of the thresholds set 
out in Rule 2-01(c)(1)(i)(D) or (E).
    Rule 2-01(c)(1)(i)(B) provides that an accountant is not 
independent when ``[a]ny 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 \273\ [] with the Commission indicating beneficial ownership of 
more than five percent of an audit client's equity securities, or 
controls an audit client, or a close family member of a partner, 
principal, or shareholder of the accounting firm controls an audit 
client.'' Paragraph (B) is the only one of the financial relationship 
provisions that specifically encompasses a range of persons beyond 
covered persons and their immediate family members. The broader scope 
of coverage under paragraph (B) is based on the view that when a 
financial interest in an audit client of the firm becomes particularly 
large, the fact that the person holding that interest is distanced from 
the audit engagement no longer sufficiently mitigates the potential for 
a conflict.
---------------------------------------------------------------------------

    \273\ 17 CFR 240.13d-101, 13d-102.
---------------------------------------------------------------------------

    We have made one substantive addition to the proposed paragraph 
(B). We have added at the end of the paragraph the clause ``or a close 
family member of a partner, principal, or shareholder of the accounting 
firm controls an audit client.'' This provision identifies additional 
circumstances that impair independence, beyond the circumstances in our 
proposed rule.\274\ For instance, this provision would provide that 
independence is impaired when the sister or parent of a partner in the 
firm who is not a covered person controls an audit client. We agree 
that the circumstances described by this provision would result in an 
impairment of independence. In addition, we note that this provision is 
consistent with existing rules.\275\
---------------------------------------------------------------------------

    \274\ Cf. Ernst & Young Letter; PricewaterhouseCoopers Letter 
(suggesting a similar provision for immediate family members of all 
partners in the firm).
    \275\ See Codification Sec. 602.02.h (Examples 1 and 5).
---------------------------------------------------------------------------

    Rule 2-01(c)(1)(i)(C) provides that an accountant is not 
independent when ``[t]he 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, unless the accounting firm, covered person in the 
firm or immediate family member has no authority to make investment 
decisions for the trust or estate.'' Because a trustee or executor 
typically has a fiduciary duty to preserve or maximize the value of the 
trust's or estate's assets, we believe it is appropriate to treat the 
trustee's or executor's interest as a direct financial interest in the 
audit client and to deem the auditor's independence impaired. We 
understand, however, that a person might serve as a trustee or executor 
without having any authority to make investment decisions for the trust 
or estate. Because we see no reason to consider an auditor's 
independence impaired in those circumstances, we have added the proviso 
at the end of paragraph (C) to include an exception for those 
circumstances.
    Rule 2-01(c)(1)(i)(D) covers material indirect investments in an 
audit client. The basic rule provides that an accountant is not 
independent when ``[t]he 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.'' This provision carries over the existing proscription on 
material indirect investments in audit clients.\276\
---------------------------------------------------------------------------

    \276\ See former Rule 2-01(b).
---------------------------------------------------------------------------

    At the proposing stage, paragraph (D) included two examples of what 
would constitute a material indirect investment: (1) Ownership of more 
than five percent of an entity that has an ownership interest in the 
audit client, and (2) ownership of more than five percent of an entity 
in which the audit client has an ownership interest. A number of 
commenters, however, proposed eliminating those examples as 
unnecessarily restrictive and burdensome. We agree that the examples 
would have consequences beyond what we intended. Accounting firms may, 
through their pension plans or otherwise, acquire more than five 
percent stakes in other entities. In these situations, it may well be 
impracticable for an accounting firm regularly to monitor whether that 
entity has any financial interest in an audit client or whether an 
audit client has any financial interest in the entity.\277\ 
Accordingly, we have omitted those examples in the final rule.
---------------------------------------------------------------------------

    \277\ The analysis is different with respect to situations where 
the entity has a material investment in the audit client, or the 
audit client has a material investment in the entity. We address 
those situations in Rule 2-01(c)(1)(i)(E), discussed below.
---------------------------------------------------------------------------

    Because the material indirect investment rule is a general 
standard, we have also decided to include one additional provision to 
clarify the meaning of ``material indirect investment'' in the context 
of mutual fund investments. Specifically, the rule makes explicit that 
the term ``material indirect investment'' does not include ownership by 
any covered person in the firm, any of his or her immediate family 
members, or any group of the above persons, of five percent or less of 
the outstanding shares of a diversified management investment company 
that invests in an audit client.\278\ Consequently, the material 
indirect investment rules, as adopted, allow auditors to invest in 
management investment companies, provided that the company is 
diversified as defined under the Investment Company Act of 1940.\279\ 
If an investment company is

[[Page 76034]]

non-diversified under the Investment Company Act of 1940,\280\ the 
company must disclose that fact in its prospectus. As a result, an 
accountant can easily determine by reviewing the prospectus whether the 
company is diversified for purposes of the rule. In addition, this 
provision does not constitute any substantive change from the proposed 
rule, because the general categories of examples in the proposed rule 
would have covered this situation. This provision is intended to ensure 
that all firm personnel and their family members can freely invest (up 
to the five percent cap) in diversified mutual funds that are not audit 
clients and are not part of an investment company complex that includes 
an audit client, without bearing the burden of constantly monitoring 
whether, and to what degree, those funds invest in an audit client's 
securities.\281\
---------------------------------------------------------------------------

    \278\ The term ``diversified management investment company'' 
refers to those entities meeting the definitions of ``management 
company'' and ``diversified company'' in Sections 4(3) and 5(b)(1) 
of the Investment Company Act, 15 U.S.C. Secs. 80a-4(3) and 80a-
5(b)(1).
    \279\ Under the Investment Company Act, a ``diversified'' 
management company must meet the following requirements: at least 
75% of the value of its total assets is in cash, cash items, 
Government securities, securities of other investment companies, and 
other securities limited in respect of any one issuer to an amount 
not greater in value than five percent of the value of the total 
assets of such management company and not more than ten percent of 
the outstanding voting securities of such issuer. 15 U.S.C. 
Sec. 80a-5(b)(1).
    \280\ One commenter recommended that diversification be measured 
under Subchapter M of the Internal Revenue Code rather than the 
Investment Company Act of 1940. See Letter of Investment Company 
Institute (Sept. 25, 2000) (``ICI Letter''). Under Subchapter M, at 
the end of each calendar quarter of the taxable year, at least 50% 
of the value of the fund's total assets must be represented by cash, 
cash items, U.S. Government securities, securities of other 
investment companies, and investments in other securities, which, 
with respect to any one issuer, do not represent more than five 
percent of the value of total assets of the fund or more than ten 
percent of the voting securities of the issuer. In addition, no more 
than 25% of the value of the fund's total assets may be invested in 
securities of any one issuer. The Commission determined not to adopt 
the tax code diversification test because an investment company 
could concentrate its investments in a smaller number of issues and 
requires diversification only at the close of each quarter.
    \281\ See Written Testimony of Thomas C. Rowland, Senior Vice 
President, Fund Business Management Group, Capital Research and 
Management Company (Sept. 20, 2000) (suggesting a similar rule).
---------------------------------------------------------------------------

    We have not included accounting firms within this provision for two 
reasons. First, in contrast to most individual investors, accounting 
firms through their pension funds may invest large sums and, therefore, 
better access diversified investment vehicles, such as managed accounts 
that do not invest in their audit clients. At the same time, the large 
amounts that may be invested by an accounting firm, through its pension 
plan or otherwise, increase the chances that the indirect investment 
may be material to the audit client. This should not be understood, 
however, to prevent accounting firms from investing in diversified 
mutual funds. Rather, when they invest in such funds, they must comply 
with the general ``material indirect investment'' standard.
    Second, at the suggestion of commenters,\282\ we have included a 
new paragraph (E) that governs (1) investments in entities that invest 
in audit clients (``intermediary investors'') and (2) investment in 
entities in which audit clients invest (``common investees''). We have 
decided to codify in our rule the substance of the existing AICPA 
restrictions applicable to those situations.\283\ We have codified 
those restrictions in paragraph (c)(1)(i)(E).
---------------------------------------------------------------------------

    \282\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
    \283\ See AICPA Code of Professional Conduct, ET section 101-8.
---------------------------------------------------------------------------

    Paragraph (E), like the AICPA rule, is framed in terms of material 
investments and the ability to exercise significant influence over an 
entity.\284\ In the case of an intermediary investor, paragraph (E) 
provides that an accountant is not independent if the firm, a covered 
person, or an immediate family member of a covered person has either 
(1) a direct or material indirect investment in an entity that has both 
an investment in an audit client that is material to that entity and 
the ability to exercise significant influence over the audit 
client,\285\ or (2) the ability to exercise significant influence over 
an entity that has the ability to exercise significant influence over 
an audit client.\286\
---------------------------------------------------------------------------

    \284\ Here, as elsewhere in the rule, we use the term 
``significant influence'' as it is used in Accounting Principles 
Board Opinion No. 18, ``The Equity Method of Accounting for 
Investments in Common Stock'' (Mar. 1971) (``APB No. 18''). See 
infra Section IV.H.3. Because we have included a specific rule on 
investments in non-clients, as well as the material indirect 
investment rule of paragraph (D), we have decided that a more 
limited definition of ``affiliate of an audit client'' is warranted 
for purposes of the investment rules in paragraph (c)(1)(i). The 
definition of ``audit client'' provides that, for purposes of 
paragraph (c)(1)(i), audit client does not include ``entities that 
are affiliates of the audit client only by virtue of paragraph 
(f)(4)(ii) or (f)(4)(iii) of the section.'' In other words, the only 
``affiliates of the audit client'' that are included in the term 
``audit client'' in section (c)(1)(i) are those that are in a 
control relationship with the audit client or that are part of the 
same investment company complex as the audit client. The rules on 
investments specifically state that an investment in certain 
entities that significantly influence, or are significantly 
influenced by, the audit client, impair the auditor's independence. 
Accordingly, there is no need to include those entities within the 
more general definition of an ``affiliate of the audit client.''
    \285\ See Rule 2-01(c)(1)(i)(E)(1)(ii).
    \286\ Rule 2-01(c)(1)(i)(E)(3). The operation of paragraphs 
(E)(1)(ii) and (E)(3) is illustrated in the chart attached as 
Appendix A.
---------------------------------------------------------------------------

    In the case of a common investee, paragraph (E) provides that an 
accountant is not independent if the firm, a covered person, or an 
immediate family member of a covered person has either (1) a direct or 
material indirect investment in an entity in which an audit client has 
a material (to the audit client) investment and over which the audit 
client has the ability to exercise significant influence,\287\ or (2) 
any material investment in an entity over which an audit client has the 
ability to exercise significant influence.\288\
---------------------------------------------------------------------------

    \287\ Rule 2-01(c)(1)(i)(E)(1)(i).
    \288\ Rule 2-01(c)(1)(i)(E)(2). The operation of paragraphs 
(E)(1)(i) and (E)(2) is illustrated in the chart attached as 
Appendix B.
---------------------------------------------------------------------------

    With respect to paragraph (c)(1)(i)(E)(2), which turns in part on 
whether a covered person's or immediate family member's investment in 
an entity is material to that person, we do not anticipate that 
compliance requires a firm constantly to monitor the net worth of all 
covered persons and their immediate family members in order to know at 
all times whether any particular investment is material to them. We 
anticipate that monitoring for compliance with this paragraph will 
involve routine monitoring of the investments of all covered persons 
and their immediate family members, combined with monitoring of the 
identity of entities over which the firm's audit clients have the 
ability to exercise significant influence. When overlap between those 
categories appears, the firm can take additional steps to determine 
whether the relevant investment is material to the covered persons or 
immediate family members holding the investment.
    If an ``intermediary investor'' or a ``common investee'' becomes an 
affiliate of the audit client under paragraph (f)(4)(i) or (iv), then 
paragraph (E) no longer governs the question of independence. Rather, 
paragraph (A)'s provision concerning direct investments in audit 
clients will apply to that intermediary investor or common investee, 
and any investment in that entity by the firm, a covered person, or an 
immediate family member of a covered person would impair independence.
    b. Other Financial Interests. 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, the 
continued viability of the audit client may be necessary for protection 
of the auditor's own assets (e.g., bank deposits or insurance) 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

[[Page 76035]]

auditor's obligation to serve only investors' interests. We have 
adopted Rule 2-01(c)(1)(ii) largely as proposed, though we have made 
some modifications, described below.
    (i) Loans/Debtor-Creditor Relationships. Rule 2-01(c)(1)(ii)(A) 
provides that an accountant will not be independent when the accounting 
firm, 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, or an audit client's officers, 
directors, or record or beneficial owners of more than ten percent of 
the audit client's equity securities. As proposed, we have also adopted 
exceptions for four types of loans: \289\ (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 borrower's primary residence 
provided the loan was not obtained while the covered person in the firm 
was a covered person.
---------------------------------------------------------------------------

    \289\ Consistent with the Proposing Release, we have treated 
credit card debt as a separate category. See discussion of paragraph 
(c)(1)(ii)(E) below.
---------------------------------------------------------------------------

    As adopted, paragraph (A) varies from the proposed rule in two 
respects, one representing a substantive change and one a clarifying 
change. The substantive change involves increasing to ten percent (up 
from the proposed five percent) the percentage of an audit client's 
securities that a lender may own without posing an independence 
impairment for an accountant who borrows from that lender. We have made 
this change because we believe that doing so will not make the rule 
significantly less effective, and may significantly increase the ease 
with which one can obtain the information necessary to assure 
compliance with this rule. The ten percent threshold corresponds to the 
definitions in the Commission's Regulation S-X of a ``principal holder 
of equity securities,''\290\ as well as a ``promoter.''\291\ In 
addition, other aspects of the securities laws attach significance to 
an equity interest in excess of ten percent.\292\ These definitions and 
substantive legal provisions clearly classify ten percent shareholders 
as having a special and influential role with the issuer. Accordingly, 
a lender owning more than ten percent of an audit client's securities 
would be considered to be in a position to influence the policies and 
management of that client.
---------------------------------------------------------------------------

    \290\ Regulation S-X, Rule 1-02(r), 17 CFR 210.1-02(r).
    \291\ Regulation S-X, Rule 1-02(s)(2), 17 CFR 210.1-02(s)(2).
    \292\ See, e.g., Section 16 of the Securities Exchange Act of 
1934, 15 U.S.C. Sec. 78p.
---------------------------------------------------------------------------

    The clarifying change involves the wording of paragraph (A)(4), 
which describes the mortgage loan exception. The proposed rule referred 
to a mortgage loan ``collateralized by the accountant's primary 
residence.'' In the final rule, we have changed ``accountant'' to 
``borrower,'' because we intend for the exception to apply also to 
mortgage loans obtained by an immediate family member of a covered 
person. The proposed rule also specified that this exception was 
limited to loans ``not obtained while the borrower was a covered person 
in the firm or an immediate family member of a covered person in the 
firm.'' In the final rule, we have changed this language to ``not 
obtained while the covered person in the firm was a covered person.'' 
This change is intended only as a way of clarifying that the test 
focuses on the status of the relevant covered person at the time of the 
mortgage loan.
    (ii) Savings and Checking Accounts. Rule 201(c)(1)(ii)(B) concerns 
savings and checking accounts. It provides that an accountant is not 
independent when the firm, a covered person, or an immediate family 
member of a covered person ``has any savings, checking, or similar 
account at a bank, savings and loan, or similar institution that is an 
audit client, if the account has a balance that exceeds the amount 
insured by the Federal Deposit Insurance Corporation or any similar 
insurer, except that an accounting firm account may have an uninsured 
account balance provided that the likelihood of the bank, savings and 
loan, or similar institution experiencing financial difficulties is 
remote.''
    At the suggestion of commenters, we have modified this provision 
from the proposed rule by adding the exception for accounting firm 
accounts with institutions that have no more than a remote likelihood 
of experiencing financial difficulties.\293\ Large firms often maintain 
account balances well in excess of FDIC limits, and the heavy daily 
volume of large transactions imposes such demands on a financial 
institution that there is, as a practical matter, a very limited 
universe of banks capable of servicing those accounts. Under the 
circumstances, we are persuaded that it is necessary to provide an 
exception that would allow accounting firms (but not individuals who 
are covered persons) to maintain balances above insured limits even if 
the financial institution is an audit client. We emphasize that this is 
a narrow exception mandated by practical necessity, and that, even so, 
the exception only applies as long as there is no more than a remote 
likelihood of the institution experiencing financial difficulties. If 
there is more than a remote likelihood of the institution experiencing 
financial difficulties, then an uninsured balance will impair 
independence because the auditor would be placed in the situation of 
having to decide whether to express an opinion about the institution as 
a going concern when the auditor's own assets may be at risk.
---------------------------------------------------------------------------

    \293\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

    (iii) Broker-Dealer Accounts. Rule 2-01(c)(1)(ii)(C) provides that 
an accountant will not be independent when the accounting firm, any 
covered person in the firm, or any of the covered person's immediate 
family members, has any brokerage or similar accounts maintained with a 
broker-dealer that is 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. Those final 
provisions are as we proposed.
    In addition, we have added to paragraph (C) a provision intended to 
ensure that brokerage accounts maintained outside of the U.S. not 
covered by SIPA will nonetheless not impair independence so long as the 
value of the assets in those accounts is insured or protected pursuant 
to a program similar to SIPA. Some commenters noted that SIPC insurance 
is not available in jurisdictions outside the U.S. and suggested that 
we add this provision.\294\ We believe that this addition represents a 
logical extension of our purpose in originally proposing the SIPA 
exception. Again, however, the insurance must be similar to SIPA for 
the exception to apply.
---------------------------------------------------------------------------

    \294\ See generally, Deloitte & Touche Letter.
---------------------------------------------------------------------------

    (iv) Futures Commission Merchant Accounts. Rule 201(c)(1)(ii)(D) 
provides that the accountant will not be independent when the 
accounting firm, any covered person in the firm, or any covered 
person's immediate family member has any futures, commodity, or similar 
account maintained with a futures commission merchant that is an audit 
client. Few commenters

[[Page 76036]]

commented on this provision, \295\ and we have adopted it exactly as 
proposed.
---------------------------------------------------------------------------

    \295\ See Deloitte & Touche Letter (agreeing that such accounts 
``might, in certain circumstances, create a perception that an 
accounting firm's independence has been impaired'').
---------------------------------------------------------------------------

    (v) Credit Cards. Rule 201(c)(1)(ii)(E) provides that an accountant 
is not independent when the accounting firm, any covered person in the 
firm, or any covered person's immediate family member has ``[a]ny 
aggregate outstanding credit card balance owed to a lender that is an 
audit client that is not reduced to $10,000 or less on a current basis 
taking into consideration the payment due date and any available grace 
period.'' This represents a slight modification from the rule as 
proposed. Under the proposed rule, independence would have been 
impaired the moment that a relevant credit card balance exceeded 
$10,000. Commenters, noting the occasional use of credit cards for 
large consumer purchases, college tuition, and tax payments, asked that 
we modify the rule so that the $10,000 limit applies only as of the due 
date.\296\ We agree that the issue we seek to address in this paragraph 
(E) is equally well addressed with a more flexible approach, taking 
account of the realities of day-to-day life, that allows a credit card 
balance to exceed $10,000 so long as the balance is brought back down 
below $10,000 within the immediate credit card payment cycle.
---------------------------------------------------------------------------

    \296\ See, e.g., AICPA Letter.
---------------------------------------------------------------------------

    (vi) Insurance Products. Rule 201(c)(1)(ii)(F) provides that an 
auditor's independence is impaired whenever any covered person in the 
firm or any immediate family member of a covered person holds any 
individual insurance policy issued by an insurer that is an audit 
client unless: (1) The policy was obtained at a time when the person in 
the firm was not a covered person; or (2) the likelihood of the insurer 
becoming insolvent is remote. The final rule reflects two modifications 
from the proposed rule.
    First, the rule that we proposed would have provided that an 
accounting firm's independence was impaired by having a professional 
liability policy originally issued by an audit client. We have 
reconsidered this issue in light of comments pointing out that 
professional liability insurance for accountants is provided by 
relatively few insurers and, moreover, complex syndication 
relationships among those insurers make it unreasonable to expect that 
any given professional liability insurer will ever be completely absent 
from the coverage scheme that insures its auditor.\297\ The final rule, 
therefore, does not provide that a professional liability policy gives 
rise to an independence impairment. In addition, by leaving the word 
``individual'' in our final rule, we intend to make clear that the rule 
does not apply to professional liability or any other type of insurance 
policy held by an accounting firm.
---------------------------------------------------------------------------

    \297\ Letter of XL Capital Limited (Sept. 25, 2000); AICPA 
Letter; Letter of Swiss Re (Sept. 22, 2000).
---------------------------------------------------------------------------

    Second, the rule that we proposed would have provided that 
independence was impaired by a covered person or immediate family 
member having any individual policy originally issued by an insurer 
that is an audit client. Commenters pointed out how this provision 
could work a hardship where, for example, an accountant obtains a life 
insurance policy from an audit client of the firm, but obtains the 
policy when he or she is not a covered person with respect to the 
client. If that accountant later becomes a covered person with respect 
to that insurer, our proposed rule effectively would have required that 
accountant to obtain that insurance from another carrier. Changing life 
insurers, however, could prove to be very difficult and expensive 
depending on many other factors that could have changed since the 
accountant first obtained the insurance.
    We believe that the goal of this paragraph (F) can be served 
equally well by a provision that largely averts that potential 
hardship. The final rule, therefore, provides that, so long as the 
likelihood of the insurer becoming insolvent is remote, independence is 
not impaired if a covered person or immediate family member obtains a 
policy from an audit client when the covered person is not a covered 
person with respect to that audit client.\298\ If, however, the 
likelihood of the insurer becoming insolvent is not remote, then 
independence is impaired regardless of the lack of ``covered person'' 
status at the time the policy was obtained. In any event, when the 
likelihood of insolvency is remote, and the policy was obtained when 
the covered person was not a covered person, it is our intention that 
the covered person be able to renew the policy and increase the 
coverage if done pursuant to the pre-existing contractual terms of the 
policy.
---------------------------------------------------------------------------

    \298\ See AICPA Letter (suggesting this approach).
---------------------------------------------------------------------------

    Finally, as discussed in more detail below, recusal remains an 
option in some circumstances. If a person or a member of that person's 
immediate family wished to obtain insurance from an audit client, the 
person may be able to recuse himself or herself from being a covered 
person for that audit client. For instance, depending on a firm's 
organization, persons that are covered persons only because they are 
within the definition of the ``chain of command'' may be able to re-
structure their supervisory role with respect to a particular audit 
client so as to fall outside that definition with respect to the audit 
client.
    (vii) Investment Companies. Rule 2-01(c)(1)(ii)(G) addresses 
investments in an entity that is part of an investment company complex. 
The rule provides that, when an audit client is part of an investment 
company complex, an accountant is not independent if the accounting 
firm, a covered person, or an immediate family member of a covered 
person has any financial interest in an entity in the investment 
company complex. Technically, this provision represents an explicit 
statement of a concept that otherwise necessarily follows from other 
aspects of the rule. Specifically, because the definition of 
``affiliate of the audit client'' includes any entity that is part of 
an investment company complex (as defined in Rule 2-01(f)(14)) that 
includes an audit client,\299\ the restrictions included in paragraphs 
(c)(1)(i) and (c)(1)(ii) necessarily apply to any such entity. We have 
singled out these entities in paragraph (G) to minimize the possibility 
that a reader focused on the financial relationship provisions might 
overlook those entities' inclusion as ``an affiliate of the audit 
client.'' We solicited comment on whether we should follow ISB Standard 
No. 2,\300\ and our intent, as stated in the Proposing Release, was to 
codify the substance of ISB Standard No. 2. Commenters generally did 
not object to this concept, although several expressed concerns about 
the definition of ``investment company complex'' as discussed 
below.\301\ We have reworded paragraph (G) from the Proposing Release 
solely for the purpose of clarity. No substantive change is intended.
---------------------------------------------------------------------------

    \299\ See Rule 2-01(f)(4)(iv).
    \300\ ISB Standard No. 2, ``Certain Independence Implications of 
Audits of Mutual Funds and Related Entities,'' at para.3 (Dec. 
1999).
    \301\ See infra Section IV.H.11.
---------------------------------------------------------------------------

    c. Exceptions. We are adopting Rule 2-01(c)(1)(iii) regarding 
limited exceptions to the financial relationship rules substantially as 
proposed, with slight modifications, and we are adding one additional 
exception. These exceptions recognize that there are situations in 
which an accountant, by virtue of being given a gift or receiving an 
inheritance, or because the accounting firm has taken on a new audit 
client, may lack independence

[[Page 76037]]

solely because of events beyond the accountant's control. In these 
circumstances, independence is not deemed to be impaired if the 
financial interest is promptly disposed of or the financial 
relationship is promptly terminated. These exceptions operate to avert 
an independence impairment only with respect to the financial interests 
referenced in the exceptions. These exceptions do not have the effect 
of averting an independence impairment caused by any other factors, 
such as employment relationships or non-audit services.
    (i) Inheritance and Gift. 
Rule 2-01(c)(1)(iii)(A) provides that an accountant's independence will 
not be impaired by virtue of an unsolicited financial interest, such as 
a gift or inheritance, so long as the recipient disposes of the 
interest as soon as practicable, but in no event later than thirty days 
after the recipient has knowledge of, and the right to dispose of, that 
interest. Our proposed version of this provision required that the 
interest be disposed of no later than thirty days after the recipient 
has a right to dispose of it. We have added the phrase ``has knowledge 
of'' to avoid the unfairness that could result in a case where the 
recipient of a financial interest does not learn of that interest 
immediately upon acquiring it. In addition, several commenters from 
foreign jurisdictions noted that there are situations abroad in which 
an accounting firm may be appointed executor of an estate without its 
advance knowledge.\302\ We have modified the rule to address these 
situations. Specifically, we have expanded it to cover ``unsolicited 
financial interests'' even if not acquired through inheritance or gift.
---------------------------------------------------------------------------

    \302\ See Letter of KPMG Europe (Sept. 22, 2000); Written 
Testimony of Institute of the Chartered Accountants in England & 
Wales (``ICAEW'') (Sept. 13, 2000).
---------------------------------------------------------------------------

    (ii) New Audit Engagement. We are adopting Rule 2-01(c)(1)(iii)(B) 
substantially as proposed. It 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 (1) 
signing an initial engagement letter or other agreement to provide 
audit, review, or attest services to the audit client, or (2) 
commencing any audit, review, or attest procedures (including planning 
the audit of the client's financial statements).
    The new audit engagement exception of 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. 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. 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 the earlier of the two events specified in paragraphs 
(B)(2)(i) and (ii).
    We have modified the audit engagement exception slightly from the 
proposed rule. As proposed, the exception would have applied only if 
the firm was independent under the financial relationship rules before 
the earlier of beginning work on the audit or accepting the engagement 
to provide audit, review, or attest services. Commenters have pointed 
out that it would be reasonable to allow for some grace period to 
divest of financial interests after the audit client and the accountant 
first agree to an audit relationship. Otherwise, an accountant would 
have little choice but to come into compliance with the financial 
interest rules before even bidding to become the auditor for a 
particular client.
    Accordingly, we have revised paragraph (B)(2)(i) to focus on the 
``signing of an initial engagement letter or other agreement,'' rather 
than ``accepting the engagement.'' By this change, we mean to afford 
accountants a divestiture window between the time they first understand 
that a new client has selected them to perform audit, review, or attest 
services--or there has been an oral agreement to that effect--and the 
time that an initial engagement letter or other written agreement is 
actually signed, or audit procedures commence. If an accountant is in 
compliance with the financial relationship rules before the earlier of 
that signing or the commencement of audit, review, or attest services, 
the accountant's independence is not impaired by the operation of the 
financial relationship rules of paragraphs (c)(1)(i) and (c)(1)(ii).
    (iii) Employee Compensation and Benefit Plans. We are adopting an 
additional exception to the financial interest rules in response to 
concerns expressed by several commenters. These commenters encouraged 
us as part of this modernization to allow for broader participation by 
immediate family members of auditors in employee compensation and 
benefit plans.\303\ This additional exception is consistent with our 
goal of updating the independence rules in ways that recognize the 
realities of the modern economy (and dual income households) and 
continue to protect the public interest.
---------------------------------------------------------------------------

    \303\ See, e.g., ICI Letter; Deloitte & Touche Letter; see also 
Letter of the Association of Private Pension and Welfare Plans (Aug. 
7, 2000).
---------------------------------------------------------------------------

    The exception is necessary because our employment rules will allow 
an immediate family member of a covered person (most typically a 
spouse) to be employed by an audit client in a position other than an 
``accounting role or financial reporting oversight role'' without 
impairing the auditor's independence. In these situations, the 
immediate family member would remain subject to our financial interest 
rules and therefore could not have a direct financial interest in the 
audit client. Accordingly, an employee in this situation could be 
prevented from participating in a stock-based compensation program.
    We are adopting an additional exception to the financial interest 
rules to provide some relief in these situations. The exception will 
apply to investments in audit clients by immediate family members of 
covered persons who are covered persons only by virtue of being a 
partner in the same office as the lead audit engagement partner of, or 
a partner or manager performing ten or more hours of non-audit services 
for, an audit client. This exception will allow the immediate family 
members of these covered persons to acquire an interest in an audit 
client, if the immediate family member works for the audit client and 
acquires the interest as an ``unavoidable consequence'' of 
participating in an employee compensation program in which employees 
are granted, for example, stock options in the employer as part of 
their total compensation package, without impairing the audit firm's 
independence. The phrase ``unavoidable consequence'' in this paragraph 
means that, to the extent the employee has the ability to participate 
in the program but has the option to select investments in entities 
that would not make him or her an investor in an audit client, the 
employee must choose

[[Page 76038]]

other investments to avoid an impairment of independence.
    Immediate family members of this subset of covered persons must 
dispose of the financial interest as soon as practicable once they have 
the right to do so, however, and they may not otherwise invest in the 
audit client without impairing the firm's independence. Where there are 
legal or other similar restrictions on a person's right to dispose of a 
financial interest at a particular time, the person need not dispose of 
the interest until the restrictions have lapsed. For example, a person 
will not have to dispose of an investment in an audit client if doing 
so would violate an employer's policies on insider trading. On the 
other hand, waiting for more advantageous market conditions to dispose 
of the interest would not fall within the exception.
    This exception is similarly available to immediate family members 
of the same subset of covered persons who must invest in one or more 
audit clients in order to participate in their employer's 401(k) or 
similar retirement plan. Accordingly, under the exception, the spouse 
or another immediate family member of this subset of covered persons 
can participate in a 401(k) plan, even if his or her only investment 
option within the plan is, for example, a mutual fund that is in the 
same investment company complex as a mutual fund that is an audit 
client. If, however, the immediate family member has an alternative in 
the 401(k) plan that does not involve investing in a fund complex for 
which the person's relative is a covered person, then the family member 
may not invest in the audit client without impairing the auditor's 
independence. We highlight that the exception in paragraph 
(c)(1)(iii)(C) is available only to immediate family members of covered 
persons who are covered persons by virtue of being in the same office 
as the lead audit engagement partner of an audit client (paragraph 
(f)(11)(iv)) or because they perform ten or more hours of non-audit 
services for an audit client (paragraph (f)(11)(iii)).
    The Investment Company Institute proposed that the exception apply 
to the immediate family members of all covered persons in the 
firm.\304\ We believe, however, that the exception we are adopting is 
sufficiently broad. As discussed elsewhere in this release, even absent 
this exception, the rules we are adopting significantly shrink the 
circle of firm personnel to whom the financial interest rules apply.
---------------------------------------------------------------------------

    \304\ ICI Letter.
---------------------------------------------------------------------------

    d. Audit Clients' Financial Relationships. Rule 2-01(c)(1)(iv) 
specifies two sets of circumstances in which an audit client's 
financial interests in the accounting firm cause an accountant to be 
not independent of that audit client. We have modified the proposed 
rule as discussed below.
    (i) Investments by the Audit Client in the Auditor. As discussed in 
the Proposing Release, when an audit client invests in its auditor, the 
auditor may be placed in the position of auditing the value of any of 
its securities that are reflected as an asset in the financial 
statements of the audit client. In addition, the accountant may 
reasonably be presumed to have a mutuality of financial interest with 
the owners of the firm, including an audit client-shareholder.\304\
---------------------------------------------------------------------------

    \305\ See Letter from POB to ISB (Jan. 12, 2000) (``Public 
ownership in an auidt 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' '').
---------------------------------------------------------------------------

    Under Rule 2-01(c)(1)(iv)(A), an accountant is not independent with 
respect to an audit client when the audit client has, or has agreed to 
acquire, any direct investment in the accounting firm, such as stocks, 
bonds, notes, options, or other securities, or the audit client's 
officers or directors are record or beneficial owners of more than five 
percent of the equity securities of the accounting firm. In applying 
this provision, it is important to remember that the definition of 
accounting firm includes ``associated entities'' of the accounting 
firm, including any that are public companies. Paragraph (A) seeks to 
prevent a situation in which an accountant, in order to audit asset 
valuations of a client that holds securities of the accounting firm, 
must value the accounting firm's own securities. Paragraph (A) also 
seeks to prevent a situation in which the audit client, or in some 
circumstances its officers and directors, can exercise any degree of 
influence over the accounting firm, whether by virtue of the accounting 
firm's fiduciary obligation to its investors or by nominating and 
voting for directors.
    The AICPA noted in its comment letter that its current rules also 
do not permit an audit client to hold any investment in its 
auditor.\306\ The AICPA was critical of the application of our proposed 
provision, at least without a materiality threshold, to subsidiaries 
and other entities related to the accounting firm. Consistent with our 
general approach, we have decided to apply this rule to not only the 
corporate entity performing the audit, but also its subsidiaries and 
associated entities. We note that we have eliminated the definition of 
``affiliate of the accounting firm,'' which many commenters argued 
captured more entities with some relation to the accounting firm than 
necessary.\307\
---------------------------------------------------------------------------

    \306\ See AICPA Letter.
    \307\ See infra Section IV.H.2.
---------------------------------------------------------------------------

    The proposed rule did not include any provision restricting audit 
client officers and directors from owning the accounting firm's 
securities. In that respect, our proposed approach was more liberal 
than existing law, which deems independence impaired if an audit 
client's officers or directors own any equity securities of the 
accounting firm. We sought comment, however, on whether the rule's 
prohibitions should also apply to other situations in which the audit 
client has a financial interest, such as when the audit client's CEO 
invests in the accounting firm. Although some commenters opposed the 
addition of this notion,\308\ we have determined that the final rule 
should liberalize existing law, simply not to the extent we proposed. 
Accordingly, the final rule provides that independence is impaired if 
an officer or director of the audit client owns more than five percent 
of the equity securities of the accounting firm. We believe that 
investments in the accounting firm by audit client officers and 
directors do not routinely give rise to independence concerns, but that 
concerns arise when an officer or director of the audit client 
accumulates a significant stake in the accounting firm. Because record 
or beneficial ownership interests exceeding five percent will be 
reflected in Schedule 13D filings relating to the accounting firm, the 
firm will be able to monitor for compliance with this provision, 
without having to rely solely on an intrusive investigation or audit 
client monitoring of its officers' and directors' investments.
---------------------------------------------------------------------------

    \308\ See Written Testimony of William Travis, McGladrey & 
Pullen LLP (Sept. 20, 2000).
---------------------------------------------------------------------------

    (ii) Underwriting. 
Rule 2-01(c)(1)(iv)(B) provides that an accountant is not independent 
of an audit client when the accounting firm ``engages an audit client 
to act as an underwriter, broker-dealer, market maker, promoter, or 
analyst with respect to securities issued by the accounting firm.'' 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

[[Page 76039]]

offering, an underwriter either buys and then resells a company's 
securities or receives a commission for selling the securities. In 
either circumstance, were an audit client to act as underwriter of an 
accounting firm's or its associated entity'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.
    In addition, 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 is engaged to perform other financial services for an accounting 
firm, such as making a market in the accounting firm's securities or 
issuing an analyst report concerning the securities of the accounting 
firm.
    We have reworded paragraph (B) from the proposed wording to avert 
an unintended consequence. The proposed rule provided that independence 
would be impaired if an audit client ``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.'' Worded that way, the provision could be read to 
impair independence any time, for example, a broker-dealer issues an 
analyst's report making a favorable recommendation concerning the 
securities of any associated entity of an accounting firm, because, in 
a broad sense, that report could benefit the accounting firm and could 
be seen as a ``service for'' the accounting firm. To avoid any 
possibility of that construction, we have reworded paragraph (B) to 
make clear that independence is impaired only if the accounting firm 
actually ``engages'' the audit client for the purpose of obtaining 
those services.
2. Employment Relationships
    We are adopting, substantially as proposed, Rule 2-01(c)(2), which 
sets forth the employment relationships that impair an auditor's 
independence. As discussed in the Proposing Release, independence 
requirements related to employment relationships between accountants or 
their family members and audit clients are based on the premise that 
when an accountant is employed by an audit client, or has a close 
relative or former colleague employed in certain positions at an audit 
client, there is a significant risk that the accountant would not be 
capable of exercising the objective and impartial judgment that is the 
hallmark of independence.
    We are modernizing the employment relationship rules in a manner 
consistent with the public interest and investor protection. We are 
keenly aware of the changes in traditional family structures, the 
increased mobility of professional employees, the recent globalization 
of accounting firms, and similar changes in society at large. We have 
determined that, in this environment, existing restrictions on 
employment relationships between accountants or their family members 
and audit clients are more restrictive than necessary to protect 
investors. Accordingly, we are narrowing those restrictions.
    We received a number of comments on our proposals to modernize the 
employment relationship rules. The vast majority of commenters who 
spoke to this issue supported modernization in general, even if they 
did not support all aspects of our proposals.\309\ For example, some 
commenters who agreed with the objectives of our proposals questioned 
if the ISB rather than the Commission should prescribe requirements in 
this area.\310\ Some commenters expressed a preference for the language 
used in ISB proposals and ISB Standard No. 3.\311\ ISB Standard No. 3, 
``Employment with Audit Clients,'' states, ``An audit firm's 
independence is impaired with respect to an audit client that employs a 
former firm professional who could, by reason of his or her knowledge 
of and relationships with the audit firm, adversely influence the 
quality or effectiveness of the audit, unless the firm has taken steps 
that effectively eliminate such risk.'' The standard also describes the 
types of safeguards that the ISB believes would effectively eliminate 
the risk of an impairment of independence.
---------------------------------------------------------------------------

    \309\ See PricewaterhouseCoopers Letter (``We endorse and 
applaud the SEC's initiatives to modernize the archaic financial 
interest and employment rules in order to reflect today's social and 
business realities. We support, for the most part, the treatment of 
these topics in the Release.'').
    \310\ See, e.g., Deloitte & Touche Letter; Letter of Steven 
Ryan, Chair, Financial Accounting Standards Committee, American 
Accounting Association (Oct. 12, 2000); Written Testimony of John C. 
Bogle, Public Member, ISB (July 26, 2000).
    \311\ See, e.g., AICPA Letter; Written Testimony of William T. 
Allen, Chair, ISB (July 26, 2000).
---------------------------------------------------------------------------

    We appreciate the concepts underlying ISB Standard No. 3 and 
strongly support firms' use of quality controls and ``safeguards'' to 
encourage their partners and employees to be aware of and adhere to 
auditor independence standards. We are concerned, however, that a 
``safeguards'' approach, which is dependent on a firm's self-analysis 
and self-reviews, will not provide a definitive standard. In our view, 
independence is better assured by consistent and uniform rules, rather 
than by rules that rely on the auditor's assessment of the extent of 
its own self-interest. Furthermore, it has been our experience that the 
existence of safeguards or quality controls alone does not ensure 
compliance with even the most basic independence regulations.\312\ 
Accordingly, we have chosen a more objective standard for employment 
relationships, which is described in paragraph (c)(2).\313\
---------------------------------------------------------------------------

    \312\ See, e.g., Letter from Lynn E. Turner, Chief Accountant, 
SEC, to Charles A. Bowsher, Chairman, Public Oversight Board (Dec. 
9, 1999); Letters from Lynn E. Turner, Chief Accountant, SEC, to 
Michael A. Conway, Chair, SECPS (Nov. 30, 1998; Dec. 9, 1999). These 
letters are available on our website.
    \313\ Nevertheless, we encourage, and we expect, firms to follow 
the steps described in ISB Standard No. 3, including the steps to be 
taken in the period after the firm's professional reports an 
intention to join an audit client and the steps to be taken after 
the professional actually joins the audit client. We also anticipate 
that peer reviews conducted by the POB will cover firms' compliance 
with these steps.
---------------------------------------------------------------------------

    Like the financial interest rules we are adopting, the employment 
relationship rules greatly reduce the pool of people within audit firms 
whose families are affected by the independence requirements. Paragraph 
(c)(2) sets forth the general rule that an auditor is not independent 
of an audit client if the accountant or a family member has an 
employment relationship with an audit client. The provision includes a 
non-exclusive list of employment relationships that are inconsistent 
with the general standard of paragraphs (b) and (c)(2). Employment 
relationships not specifically described in paragraphs (c)(2)(i) 
through (c)(2)(iv) are subject to the general test of paragraphs (b) 
and (c)(2).
    The following are examples of employment relationships that impair 
an auditor's independence under the final rule.\314\
---------------------------------------------------------------------------

    \314\ These examples are illustrative only and should not be 
relied upon as a complete list of employment relationships that 
impair an accountant's independence under paragraphs (b) and (c)(2).
---------------------------------------------------------------------------

     A current partner of an accounting firm serves as a member 
of the board of directors of the audit client;

[[Page 76040]]

     A sibling of a covered person is employed by an audit 
client as the director of internal audit;
     A former professional employee of an accounting firm who 
resigned from the accounting firm two years ago is employed by an audit 
client in an accounting role and the former employee receives a pension 
from the firm tied to the firm's revenues or profits;
     A former partner of an accounting firm accepts the 
position of chief accounting officer at an audit client, and the former 
partner continues to maintain a capital balance with the accounting 
firm; or,
     A former director of an audit client becomes a partner of 
the accounting firm, and that individual participates in the audit of 
the financial statements of the audit client for a period during which 
he or she was a director of the audit client.
    We discuss each of the rules giving rise to these examples in turn.
    a. Employment at Audit Client of Accountant. 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. Paragraph 
(2)(i) 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 serves as a member 
of the board of directors or similar management or governing body 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. 
Rule 2-01(c)(2)(ii) provides that certain employment relationships 
between covered persons' close family members and an audit client will 
impair the auditor's independence. As discussed below, close family 
members include the covered person's spouse, spousal equivalent, 
dependents, parents, nondependent children, and siblings. The 
application of the rule to close family members stands in contrast to 
the financial interest rules, 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. As we explained 
in the Proposing Release, we believe this distinction is appropriate 
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.
    Like the proposed rule, final Rule 2-01(c)(2)(ii) limits the 
employment relationships that impair auditor independence when held by 
a close family member of a covered person to those involving an 
``accounting role or financial reporting oversight role.'' As a result, 
an audit client's employment of even an immediate family member will 
not necessarily impair an auditor's independence, unless that family 
member is in an ``accounting role or financial reporting oversight 
role.''
    Not all commenters agreed with the scope of the rule, some arguing 
that our proposal was too generous and others arguing that the proposal 
was too restrictive.\315\ In this regard, we note that the ISB has 
taken a more restrictive approach in suggesting 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.\316\ 
We continue to believe, however, that we need only apply our 
restriction to family members in an ``accounting role or financial 
reporting oversight role'' at an audit client. Some commenters, on the 
other hand, argued for a rule that did not impose restrictions on close 
family members of all covered persons. While we acknowledge that 
individuals who are covered persons because they provide ten or more 
hours of non-audit services to the audit client or work in the same 
office as the lead audit engagement partner are less likely to be able 
to influence an audit than covered persons who are on the audit 
engagement team or in the ``chain of command,'' we do not agree that 
the likelihood is so remote as to warrant carving their close family 
members out of the rule.
---------------------------------------------------------------------------

    \315\ Compare Letter of Paula Morris, MPA, CPA, Assistant 
Professor, Kennesaw State University (Sept. 25, 2000) (expressing 
her concerns about loosening the rules regarding spouses' and 
dependents' employment relationships) with Deloitte & Touche Letter 
(suggesting that an audit client's employment of a close family 
member of a covered person who is not on the audit engagement team 
or in the chain of command, should not be deemed to impair the 
auditor's independence, even if the person holds an accounting or 
financial reporting oversight role because there is only a ``remote 
likelihood'' that such a person could influence the audit).
    \316\ ISB, ``Invitation to Comment 99-1: Family Relationships 
Between the Auditor and the Audit Client'' (July 1999).
---------------------------------------------------------------------------

    We define ``accounting role or financial reporting oversight role'' 
in Rule 2-01(f)(3). The definition includes two categories of persons. 
One category includes those with more than minimal influence over the 
contents of the accounting records or anyone who prepares them. This 
typically would include certain persons working in the accounting 
department or who perform accounting functions. We have not chosen to 
reach as many persons in the audit client's accounting department as 
are covered by the ``audit sensitive'' category in the AICPA's 
employment rules.\317\ The definition also may include certain 
individuals, such as an accounts receivable supervisor or manager, who 
are relied upon by management to calculate amounts that are placed 
directly into the company's financial statements.
---------------------------------------------------------------------------

    \317\ AICPA Code of Professional Conduct, ET Sec. 101.11.
---------------------------------------------------------------------------

    The second category includes those who influence the preparers or 
the contents of the financial statements of the audit client. The 
definition lists positions in which we believe a person generally 
wields the type of influence over the financial statements that causes 
independence concerns, such as 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.
    Several commenters expressed support for the concept of 
``accounting role or financial reporting oversight role,'' but 
recommended that we modify the definition in various ways, for example, 
by eliminating vice president of marketing from the scope of the rule 
or making the list an exhaustive list of covered positions.\318\ We 
believe that the vice president of marketing makes important 
determinations that affect the company's financial results.\319\ These 
include, for example, supervising sales that result in the revenues 
reported in financial statements, shaping sales policies and 
procedures, and participating at a high level in the formulation of the 
company's budget. For these reasons, we consider a vice president of 
marketing to be involved in a financial reporting oversight role. We 
have declined to make the list of positions exhaustive because titles 
alone do not always accurately describe a person's duties and 
functions.
---------------------------------------------------------------------------

    \318\ AICPA Letter (``For the most part, the specific positions 
listed in the definition . . . are appropriate and provide helpful 
advice to practitioners. . . . however . . . we do not believe the 
vice president of marketing should be included in this list.''); 
Ernst & Young Letter.
    \319\ See, e.g., In the Matter of Jimmy L. Duckworth, CPA, AAER 
No. 1205 (Nov. 10, 1999); In the Matter of Pinnacle Micro, Inc., 
Scott A. Blum, and Lilia Craig, AAER No. 975 (Oct. 3, 1997).
---------------------------------------------------------------------------

    Other modifications to the definition make explicit our concerns 
about positions in which the employee would

[[Page 76041]]

exercise more than minimal influence over the contents of the 
accounting records or anyone who prepares them, or would exercise 
influence over the contents of the financial statements or anyone who 
prepares them. As noted above, the final rule also incorporates the 
proposed list of examples of positions in which we consider a person to 
exercise influence over the contents of the financial statements or 
people who prepare the financial statements. We have singled out these 
two categories of positions because persons in these positions can 
influence the financial reporting of the company.
    As noted in the Proposing Release, the so-called ``five hundred 
mile rule'' has been eliminated under Rule 2-01(c)(2)(ii). Whether a 
covered person lives near a close family member who is employed by the 
audit client no longer seems relevant in today's world of instantaneous 
international communications and global securities markets. 
Accordingly, we have dispensed with this test of auditor independence.
    c. Employment at Audit Client of Former Employee of Accounting 
Firm. We are adopting Rule 2-01(c)(2)(iii) substantially as proposed, 
with the minor modifications discussed below. 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, 
principal, shareholder, or professional employee of the accounting firm 
in an accounting role or financial reporting oversight role. As we 
noted in the Proposing Release, 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 may well be in a position to influence the content of the audit 
client's accounting records and financial statements on the one hand, 
and 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. A close association between a 
member of the board of directors or of senior management with his or 
her former firm creates an impression of a mutuality of interest and 
may well affect the auditor's judgment.\320\
---------------------------------------------------------------------------

    \320\ See AICPA, Auditing Standards Division, ``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.
---------------------------------------------------------------------------

    In addition, even under the usual circumstances, there is some 
possibility that accounting firm partners may compromise their 
independence in order to secure management positions with the audit 
clients.\321\ That risk is heightened where there is a ``revolving 
door'' between the auditor and the client.\322\ Finally, there is 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 affect the audit as it progresses.\323\ Accordingly, 
under the final rule, as under current requirements, an auditor's 
independence with respect to an audit client is deemed to be impaired 
when former partners, shareholders, principals, or professional 
employees of the firm are employed in an accounting or financial 
reporting oversight role at an audit client, unless certain conditions 
are met.
---------------------------------------------------------------------------

    \321\ 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).
    \322\ See, e.g., AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 
202 (2d Cir. 2000); 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 74, 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.
    \323\ 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 
322, at 4. Our staff has indicated, however, that, if implemented, 
this suggestion would take the form of the firm's independence being 
impaired for a period of time from the date the individual left the 
audit engagement, rather than as a prohibition on hiring the former 
partner. Staff Report, supra note 74, 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% of the companies' CFOs had previous experience 
with the companies' audit firms just before joining the company).
---------------------------------------------------------------------------

    Consistent with our proposal, the final rule provides that 
independence will not be impaired if certain steps are taken to ensure 
the individual's separation from the accounting firm. Under the final 
rule, the former partner, principal, shareholder, 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, other than one providing for regular payment of 
a fixed dollar amount, as described in paragraphs 2-01(c)(2)(iii)(C)(1) 
and (2). Any payment of a fixed dollar amount must be made pursuant to 
a fully funded retirement plan, rabbi trust or similar vehicle. Or, in 
the case of a former professional employee who was not a partner, 
principal, or shareholder of the firm and has been disassociated from 
the accounting firm for more than five years, the fixed payments made 
to the former employee must be immaterial to him or her.
    As proposed, the rule contemplated only fixed payments made 
pursuant to a fully funded retirement plan or rabbi trust.\324\ Several 
commenters expressed concern about the rule's application in foreign 
jurisdictions in which rabbi trusts are not recognized.\325\ In 
response to these comments, we have modified the rule to indicate that 
using a similar payment vehicle will satisfy the rule. If

[[Page 76042]]

a rabbi trust is available in the jurisdiction, however, the accounting 
firm and the former professional must use a rabbi trust, rather than 
some other vehicle.
---------------------------------------------------------------------------

    \324\ As noted in the Proposing Release, 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. Under 
Rule 2-01(f)(16), a ``rabbi trust'' is an irrevocable trust whose 
assets are not accessible to the firm until all benefit obligations 
have been met but are subject to claims of the firm's creditors in 
bankruptcy or insolvency. We are adopting the definition of ``rabbi 
trust'' as proposed.
    \325\ See, e.g., Written Testimony of ICAEW (Sept. 13, 2000).
---------------------------------------------------------------------------

    As noted, to satisfy the conditions of paragraph (C)(1), the 
retirement plan or rabbi trust must be fully funded.\326\ We believe 
that full funding is critical to breaking the link between the firm and 
the individual. Any situation that requires the individual to be 
dependent on the firm to fund his or her retirement payments weds the 
financial interests of the former employee and the firm, and creates 
the potential for the firm to exert influence over the individual, or 
vice versa.
---------------------------------------------------------------------------

    \326\ We would not consider an individual's 401(k) account to 
constitute a financial arrangement with the accounting firm to be 
fully funded for these purposes because, although the investment 
remains subject to market risk, the account balance is not dependent 
on the accounting firm's financial performance even if the firm 
continues to administer the account for the former firm personnel.
---------------------------------------------------------------------------

    The proposed rule did not contain a ``cooling off'' period. We 
solicited comment on whether we should require a mandatory cooling off 
period for former partners and professional staff of an audit firm who 
join an audit client.\327\ Several commenters supported the notion of a 
cooling off period,\328\ but others disagreed.\329\ We have determined 
that a cooling off period unnecessarily restricts the employment 
opportunities of former professionals, and we have decided not to adopt 
a cooling off provision.\330\
---------------------------------------------------------------------------

    \327\ With regard to cooling off periods, see AICPA Board 
Report, supra note 322, at 4 (June 1993) (suggesting that the 
Commission 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) and Lincoln S&L v. Wall, 743 F. Supp. at 917 n.23 (``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.'').
    \328\ See, e.g., Letter of Pamela Roush, Ph.D., CMA (undated).
    \329\ See, e.g., Written Testimony of Mauricio Kohn, CFA, CMA, 
CFM, AIMR (Sept. 20, 2000) (``We do not believe it is necessary to 
impose a mandatory `cooling-off period,' prohibit clients from 
hiring audit firm professionals, or stipulate that an audit firm's 
independence is impaired when its professionals accept key positions 
with current clients.'').
    \330\ Nonetheless, we encourage firms to maintain adequate 
controls to ensure that former employees are not unduly influencing 
the audit engagement team.
---------------------------------------------------------------------------

    We also solicited comment on whether application of the rule should 
depend on whether the professional leaving the accounting firm was a 
partner at the firm or non-managerial audit staff. We considered 
whether to provide a sunset provision so that accounting firms need not 
track all former professional employees indefinitely to determine, for 
purposes of this provision, whether they become employed in an 
accounting role or financial reporting oversight role at an audit 
client. While we believe that it is usual for accounting firms to know 
whether their former partners, principals, or shareholders are employed 
in these roles at an audit client, we understand the practical 
difficulties firms might have tracking all former professionals who 
left the firm while at a managerial or staff level. Accordingly, we are 
adopting a rule under which the accountant's independence will not be 
impaired when a former professional, who was not a partner, joins an 
audit client in an accounting role or financial reporting oversight 
role position after five years, provided the retirement benefits of the 
former employee are immaterial to him or her.
    The materiality provision is necessary because, to satisfy the 
conditions in paragraph (C)(2), the retirement plan does not have to be 
fully funded. In the absence of such funding, we believe that the 
receipt by the former employee of more than an immaterial amount would 
create the unification of financial interests discussed above.
    d. Employment at Accounting Firm of Former Employee of Audit 
Client. We are adopting Rule 2-01(c)(2)(iv) substantially as proposed. 
The rule specifies that individuals who were formerly officers, 
directors, or employees of an audit client and who later become 
partners, principals, or shareholders of the accounting firm will 
impair the independence of the firm with respect to that audit client, 
unless they do not participate in, and are not in a position to 
influence, the audit of the financial statements of the audit client 
covering a period during which the individuals were employed by or 
associated with the audit client. When a former employee of an audit 
client joins the accounting firm, the independence rules ensure that 
the employee is not in a position to influence the audit of his or her 
former employer.\331\ Because participating in the audit of the former 
employer could easily require former employees to audit their own work, 
the rule provides that independence is impaired unless the former 
employees do not participate in and are not in a position to influence 
the audit of the financial statements of the audit client for any 
period during which they were employed by or associated with that audit 
client.
---------------------------------------------------------------------------

    \331\ 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 Rule 2-01(c)(1).
---------------------------------------------------------------------------

    The final rule applies to all former employees of the audit client, 
not only those who were in accounting or financial reporting oversight 
roles. It also applies to former audit client employees whether they 
become partners, principals, or shareholders of the accounting firm or 
professional employees of the firm.\332\
---------------------------------------------------------------------------

    \332\ The AICPA recommended that the rule apply to all 
professional employees of the accounting firm, not just to partners, 
shareholders, and principals. See AICPA Letter. We agree and, 
therefore, have modified the final rule to encompass this situation.
---------------------------------------------------------------------------

3. Business Relationships
    We proposed Rule 2-01(c)(3) to describe the business relationships 
that impair an auditor's independence from an audit client. We are 
adopting the rule substantially as proposed with two minor 
modifications. The rule 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, or any person associated with the audit client in a decision-
making capacity, such as an audit client's officers, directors, or 
substantial stockholders.
    Commenters were generally supportive of the approach we took in the 
proposal, with the exception of one provision.\333\ We proposed that 
independence was also impaired if the accounting firm or any covered 
person had a direct or material indirect business relationship with 
``record or beneficial owners of more than five percent of the [audit 
client's] equity securities.'' This formulation was intended to provide 
a more precise definition of the subset of associated persons who 
constitute ``substantial stockholders'' in the existing restrictions on 
business relationships in the Codification.\334\ Commenters, however, 
expressed concerns with this threshold.\335\ Similarly, one large 
accounting firm expressed concern with

[[Page 76043]]

the proposed language, asserting that our proposal would ``greatly 
expand[] the universe of venture capital firms with which we could not 
have any business relationships.''\336\
---------------------------------------------------------------------------

    \333\ See, e.g., Deloitte & Touche Letter; Written Testimony of 
Dennis Paul Spackman, Chairman, National Association of State Boards 
of Accountancy (Sept. 13, 2000) (``I am in full agreement with the 
provisions of the Commission's proposal [regarding] Business 
Relationships.'').
    \334\ See Codification Sec. 602.02.g.
    \335\ See Deloitte & Touche Letter (``Although we agree with the 
direction of [Rule 2-01(c)(3)], it provides no basis for prohibiting 
business relationships with beneficial owners of more than five 
percent of the equity securities of the audit client or any of its 
affiliates.'').
    \336\ Ernst & Young Letter; see also AICPA Letter (``Such 
sweeping new restrictions would dramatically constrict the parties 
with which accounting firms could engage, even though many such 
parties at most have only very attenuated ties to audit clients. . . 
. We view independence risks as extremely remote in such 
circumstances and, therefore, consider the reach of such provisions 
unnecessarily broad.'').
---------------------------------------------------------------------------

    In response to these comments, we are adopting instead the language 
used in the Codification, which refers to an associated person ``in a 
decision-making capacity, such as an audit client's officers, directors 
or substantial stockholders.'' Because our rule, as adopted, conforms 
more closely to the Codification, we anticipate that it will provide 
greater clarity to the profession in interpreting Rule 2-01(c)(3) and 
address the concerns about the proposal that were articulated by 
several commenters.
    We are also clarifying the rule by adding the words ``to the audit 
client'' after ``provides professional services'' in the last sentence 
of the rule. As discussed in the Proposing Release, the exception for 
providing professional services is meant only to make clear that Rule 
2-01(c)(3) does not address the provision of professional services by 
the auditor to the audit client. The addition of these four words is 
intended to make clear that joint business ventures or prime/
subcontractor arrangements in which audit clients and auditors jointly 
provide ``professional services'' would continue to impair the 
auditor's independence.\337\
---------------------------------------------------------------------------

    \337\ See Codification Sec. 602.02.g; Letter from Jonathan G. 
Katz, Secretary, SEC, to Duane R. Kulberg, Arthur Andersen & Co. 
(Feb. 14, 1989).
---------------------------------------------------------------------------

    We also proposed defining the phrase ``consumer in the ordinary 
course of business'' as part of the definitions explicitly set forth in 
Rule 2-01(f). Commenters, however, expressed concern that, as defined, 
this phrase could have unintended consequences.\338\ Accordingly, we 
omit the definition of ``consumer in the ordinary course of business'' 
in the rules we are adopting and will continue to apply the term 
consistent with its use in the Codification.
---------------------------------------------------------------------------

    \338\ See, e.g., Deloitte & Touche Letter.
---------------------------------------------------------------------------

    As we noted in the Proposing Release, we are retaining a number of 
the examples currently found in the Codification to provide guidance on 
permissible and impermissible business relationships.\339\ We expect 
that the interpretations and examples that have evolved under the 
Codification with respect to this rule will continue to provide useful 
guidance to the profession.
---------------------------------------------------------------------------

    \339\ See infra Section IX; Codification 602.02(g).
---------------------------------------------------------------------------

    We also solicited comment as to whether we should retain the 
``direct or material indirect business relationship'' formulation or if 
there was another formulation that could provide additional or more 
precise guidance. The AICPA asserted that ``not all business 
relationships with audit clients should be proscribed if they are 
immaterial. . . . The inclusion of a materiality standard in the 
context both of [sic] all business relationships (direct and indirect) 
sufficiently mitigates whatever independence risk would be 
posed.''\340\ For the same reasons we have explained before, we do not 
believe that auditors should be allowed to have any direct business 
relationships with their audit clients other than as a consumer in the 
ordinary course of business.\341\ We have carefully considered the 
comments we have received and believe that the rule we are adopting 
constitutes a fair and balanced approach that protects independence 
without unduly restricting business opportunities for auditors or their 
clients.
---------------------------------------------------------------------------

    \340\ See AICPA Letter.
    \341\ See Letter from Jonathan G. Katz, Secretary, SEC, to Duane 
R. Kulberg, Arthur Anderson & Co., (Feb. 14, 1989).
---------------------------------------------------------------------------

4. Non-Audit Services
    a. General Rule. We are adopting a rule that provides that an 
accountant is not independent if the accountant provides the non-audit 
services identified in paragraph (c)(4). The rule is derived from 
current Rule 2-01, our releases that have been incorporated into the 
Codification, and existing AICPA rules.
    The proposed rule identified certain services that could not be 
provided by the auditor without impairing the auditor's independence 
with respect to the audit client ``[e]ven if the audit client 
accept[ed] ultimate responsibility for the work that is performed or 
decisions that are made . . . .'' In the final non-audit services rule, 
Rule 2-01(c)(4), we have eliminated that language. As described below, 
we have added certain exceptions to the non-audit services that impair 
an auditor's independence. These exceptions are appropriate only where 
management takes certain actions and accepts certain responsibilities. 
For example, we have set forth certain circumstances where an auditor 
does not lose his or her independence by providing certain actuarial 
services to insurance company audit clients. The exception, however, is 
available only where management accepts responsibility for significant 
actuarial methods and assumptions.
    The final amendments identify nine non-audit services that, when 
provided by the auditor to an audit client, impair the auditor's 
independence. In the proposed rule, we identified ten such services. 
For many of the non-audit services that we proposed to include in the 
rule, we aimed to codify existing restrictions.\342\ Commenters 
expressed concerns, however, that certain of our proposed rules were 
written more broadly than existing independence rules.\343\ In 
addition, commenters indicated that, to the extent our proposals 
differed from current standards, they believed current standards more 
appropriately circumscribed auditors' non-audit activities.\344\ In 
response to these comments, we made several modifications to the rules, 
including eliminating altogether the provision on expert services.\345\
---------------------------------------------------------------------------

    \342\ See, e.g., Proposing Release, Section III.D.1.(b)(i)(iv) 
(regarding bookkeeping and actuarial services, respectively). But 
see Proposing Release, Section III.D.1.(b)(ii) (regarding financial 
information systems).
    \343\ See, e.g., Testimony of Barry Melancon, President and 
Chief Executive Officer, AICPA (Sept. 21, 2000).
    \344\ See Testimony of Joseph F. Bernardino, Managing Partner, 
Assurance and Business Advisory Services, Arthur Anderson LLP (Sept. 
20, 2000) and Testimony of James E. Copeland, Chief Executive 
Officer, Deloitte & Touche LLP (Sept. 20, 2000) (responsing to 
questions from Chairman Artrhur Levitt, SEC, about whether they 
would be comfortable if our final rules on non-audit services 
paralleled the profession's own rules); see also testimony of K. 
Michael Conaway, President Officer, Texas State Board of Accountancy 
(Sept. 20, 2000).
    \345\ See infra Section IV.D.4.b(x).
---------------------------------------------------------------------------

    b. Particular Non-Audit Services that Impair Independence. (i) 
Bookkeeping or Other Services Related to the Audit Client's Accounting 
Records or Financial Statements. We proposed and are adopting paragraph 
(c)(4)(i), which, with limited exceptions, would deem an auditor's 
independence to be impaired when the auditor performs bookkeeping 
services for an audit client. Even prior to our proposals, auditors 
were restricted by AICPA Ethics Rules and the Codification from 
providing certain bookkeeping services.\346\ As explained in the 
Codification and reiterated in the Proposing Release,\347\ providing 
bookkeeping services for an audit client impairs the auditor's 
independence because the auditor will be placed in the position of 
auditing the firm's work

[[Page 76044]]

when auditing the client's financial statements. It is hard to maintain 
the requisite objectivity about one's or one's firm's own work. This is 
especially true where finding an error would raise questions about the 
adequacy of the bookkeeping services provided by the firm. In addition, 
keeping the books is a management function, the performance of which 
leads to an inappropriate mutuality of interests between the auditor 
and the audit client.
---------------------------------------------------------------------------

    \346\ AICPA Code of Professional Conduct, ET Sec. 101.05; 
Codification Sec. 602.02.c.i.
    \347\ Proposing Release, Section III.D.1(b)(i); Codification 
Sec. 602.02.c.
---------------------------------------------------------------------------

    We have modified our final rule in response to several 
comments.\348\ First, commenters believed that the proposed definition 
should not cover all financial statements, including those not filed 
with the Commission. For example, auditors sometimes prepare statutory 
financial statements for foreign companies, and these are not filed 
with us. At least one commenter requested that we therefore exclude 
those financial statements from the rule's coverage.\349\ Focusing 
solely on whether the financial statements are filed with us would not 
be appropriate in all circumstances, since in some instances statutory 
financial statements form the basis of the U.S. GAAP financial 
statements that are filed with us. Under these circumstances, an 
auditor who has prepared the statutory financial statements of an audit 
client is put in the position of auditing its own work when auditing 
the resultant U.S. GAAP-converted financial statements. Accordingly, 
the final rule amendments cover not only financial statements that are 
filed with us, but also financial statements that form the basis of 
financial statements that are filed with us. As proposed, the final 
amendments also cover any service involving maintaining or preparing 
the audit client's accounting records.
---------------------------------------------------------------------------

    \348\ See, e.g., Deloitte & Touche Letter; AICPA Letter.
    \349\ See, Ernst & Young Letter.
---------------------------------------------------------------------------

    Second, although we proposed to cover services that resulted in the 
accountant generating financial information that would be disclosed to 
investors, commenters believed that this language was too broad. As 
part of the audit process, auditors may generate data in connection 
with evaluating financial information that eventually may be disclosed 
to investors.\350\ We believe that they should continue to be able to 
do so. Accordingly, we narrowed the definition to eliminate this 
language and instead are incorporating wording from the AICPA Ethics 
Rules to the effect that an accountant cannot prepare source documents 
or originate data underlying the client's financial statements without 
impairing independence.\351\
---------------------------------------------------------------------------

    \350\ For example, as part of the audit process, the auditor 
might process adjustments that eventually are incorporated into the 
audit client's financial statements. See Deloitte & Touche Letter.
    \351\ AICPA Code of Professional Conduct, ET Sec. 101.05.
---------------------------------------------------------------------------

    Third, several commenters requested that we provide an exception to 
the rule so that auditors could perform bookkeeping services in 
emergency or other unusual situations.\352\ The Codification provides 
such an exception. Example 6 of Section 602.02.c.ii of the Codification 
states that when, due to the unexpected resignation of a company's 
comptroller at the end of the year, the accountant was called upon to 
provide assistance in closing the books and the accountant did not make 
decisions on a managerial level, the accountant's independence was not 
impaired.\353\ We recognize that there may be emergency or other 
unusual situations, such as the one described above, in which the 
auditor will need to provide bookkeeping services that are otherwise 
prohibited. Accordingly, we are adopting an exception from the 
bookkeeping restriction for emergency or other unusual situations, 
provided that the accountant does not act as a manager or make any 
managerial decisions. We expect that such situations will be rare. We 
encourage registrants and auditors to contact the staff with any 
questions about the application of this provision to particular 
circumstances.
---------------------------------------------------------------------------

    \352\ See, e.g., Deloitte & Touche Lettter.
    \353\ Codification Sec. 601.02.c.ii, Example 6.
---------------------------------------------------------------------------

    Finally, the final rule contains a limited exception related to 
bookkeeping for foreign subsidiaries or divisions of audit clients. The 
Codification provides this type of exception.\354\ The Proposing 
Release noted that the Commission recognized the need for relief in 
this area, and that therefore we had proposed to retain this section of 
the Codification.\355\ In response to commenters' concerns,\356\ 
however, we are incorporating the exception into the rule. Accountants 
therefore may provide these services for foreign divisions or 
subsidiaries of a domestic audit client under certain conditions. 
First, the services must be limited, routine, or ministerial. Second, 
it must be impractical for the entity receiving the services to obtain 
them from another provider.\357\ Third, under the adopted rule as under 
the Codification, the foreign entity for which the accountant is 
performing these services cannot be material to the consolidated 
financial statements. Fourth, as under the Codification, the entity 
must not have employees capable or competent to perform the services. 
Fifth, the services performed must be consistent with local 
professional ethics rules.\358\ Last, as explained in the Codification, 
``the Commission believes 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,'' and that therefore a limit on the services can be 
``based on the relationship of the fee charged for the service to the 
total audit fee charged to the registrant.''\359\ Accordingly, the 
final rule provides that the total fees for the bookkeeping services 
provided by the auditor to a company's foreign entities collectively 
(for the entire group of companies) cannot exceed the greater of one 
percent of the consolidated audit fee or $10,000.\360\
---------------------------------------------------------------------------

    \354\ Codification Sec. 601.02.c.iii.
    \355\ Proposing Release, note 160.
    \356\ Deloitte & Touche Lettter; Ernst & Young Letter; 
PricewaterhouseCoopers Letter.
    \357\ There may be entities that are not large enough to 
maintain the capability in-house, yet there may not be reputable 
providers of these services where domestic companies' foreign 
affiliates are located or a reputable firm may not want to provide 
the Services because they will generate only minimal fees. See 
Codification Sec. 601.02.e.iii.
    \358\ Codification Sec. 601.02.c.iii (requiring compliance with 
this condition, ``so that an informed observer in the foreign 
location would have no cause to question the fact or appearance of 
independence'').
    \359\ Codification Sec. 601.02.c.iii.
    \360\ The Commission has determined to raise to $10,000 from 
$1,000 the dollar threshold in the Codification in light of the 
inflation since the provisions in the Codification were adopted.
---------------------------------------------------------------------------

    (ii) Financial Information Systems Design and Implementation. 
Paragraph (c)(4)(ii) identifies certain information technology services 
that, if provided to an audit client, impair the accountant's 
independence. Paragraph (c)(4)(ii) also identifies other information 
technology services that may be provided to an audit client without 
impairing independence so long as certain conditions are satisfied.
    The rule we adopt today on information technology services 
represents a change from the rule we proposed. Some commenters objected 
to our proposed rule. This provision lay at the heart of some of the 
largest accounting firms' arguments that our proposed rules would 
hinder their access to technology, limit their understanding of their 
clients' operations, and hurt their recruiting efforts.\361\ These 
arguments compete

[[Page 76045]]

with the widespread and persistent perceptions that large, lucrative 
information technology consulting relationships with an audit client 
may give rise to conflicts of interest, may result in auditors 
functioning as management, or may result in an auditor auditing his or 
her own work.
---------------------------------------------------------------------------

    \361\ See generally, Arthur Andersen Letter; Deloitte & Touche 
Lettter.
---------------------------------------------------------------------------

    The final rule reflects a pragmatic approach to a difficult issue. 
The rule singles out certain information technology services as 
independence impairments under any circumstances, and identifies other 
categories of information technology services that will not impair 
independence if certain conditions are fulfilled. Those conditions are 
designed to minimize the potential for an auditor to end up making 
management decisions or auditing his or her own work.
    The rule also takes a pragmatic approach to the potential 
independence problem posed by the economic incentives that accompany 
large consulting contracts. Rather than effectively ban those 
relationships, we are amending the proxy disclosure rules to require 
public companies to make specific disclosure of fees paid to their 
auditor for information technology services. In addition, public 
companies must disclose that their audit committee (or, if there is no 
audit committee, the board of directors) considered whether the 
provision of the information technology services, as well as all other 
non-audit services, is compatible with maintaining the auditor's 
independence.
    As discussed in greater detail below, we anticipate that audit 
committees will consider the independence implications of the 
engagements that are subject to the disclosure requirements. Moreover, 
the disclosure will provide information to enable investors themselves 
to evaluate auditor independence, and will enable future study of 
whether large information technology consulting relationships have an 
effect on audit quality and auditors' independence.
    Paragraph (c)(4)(ii)(A) provides that an accountant is not 
independent of an audit client if the accountant is ``[d]irectly or 
indirectly operating, or supervising the operation of, the audit 
client's information system or managing the audit client's local area 
network.'' These services impair an accountant's independence under 
existing AICPA rules, \362\ and, under the rules we adopt today, will 
impair independence under any circumstances.
---------------------------------------------------------------------------

    \362\ See AICPA Code of Professional Conduct, ET Sec. 101.05.
---------------------------------------------------------------------------

    Under paragraph (c)(4)(ii)(B), ``[d]esigning or implementing a 
hardware or software system that aggregates source data underlying the 
financial statements or generates information that is significant to 
the audit client's financial statements, taken as a whole,'' will 
impair an accountant's independence unless certain conditions are 
met.\363\ This section of the final rule differs from the proposed rule 
in that we have modified the description of the hardware and software 
systems that the rule reaches by adding the phrase ``that aggregates 
source data underlying the financial statements.'' This change was 
suggested by commenters. \364\We have adopted this change because, to 
the extent that the design and implementation activities concern 
hardware and software systems that aggregate source data, they are 
likely to be the types of systems that raise independence concerns.
---------------------------------------------------------------------------

    \363\ Although we anticipate that accountants and their audit 
clients will usually seek to meet these conditions, we note certain 
points about paragraph (c)(4)(ii)(B) relevant to situations where 
these conditions are not met. First, by ``significant,'' we refer to 
information that is reasonably likely to be material to the 
financial statements of the audit client. Since materiality 
determinations may not be final before financial statements are 
generated, an accounting firm may need to evaluate the general 
nature of the information rather than wait to evaluate system output 
during the period of the audit engagement. For example, without 
satisfying the conditions of paragraphs (c)(4)(ii)(B)(1)-(5), an 
accountant would not be independent of an audit client for which it 
designed an integrated Enterprise Resource Planning (``ERP'') 
system. (An ERP system is designed to integrate all functions and 
departments in a company into one computer system that can serve the 
needs of each department.) In addition, without satisfying the 
conditions, a firm's independence would be impaired if it designed 
and implemented an accounts receivable/order management system that 
recorded and summarized sales that were material to the financial 
statements of the audit client. A firm's independence would not be 
impaired, however, if the accounting firm designed and implemented a 
system for a foreign subsidiary whose financial condition and 
results of operations were not material to the financial statement 
of the audit client.
    \364\ Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

    The conditions that the rule imposes are intended to reduce the 
likelihood that the auditor will be placed in a position of making, and 
then auditing, managerial decisions. They are also intended to ensure 
that management will make all significant decisions during the process 
and, at its conclusion, will be fully responsible for the results of 
the project including the proper functioning of the company's internal 
accounting controls.
    The first condition, set out in paragraph (c)(4)(ii)(B)(1), is that 
``the audit client's management has acknowledged in writing to the 
accounting firm and the audit client's audit committee, or if there is 
no such committee then the board of directors, the audit client's 
responsibility to establish and maintain a system of internal 
accounting controls in compliance with Section 13(b)(2) of the 
Securities Exchange Act of 1934, 15 U.S.C. Sec. 78m(b)(2).'' This 
condition makes clear that this statutory responsibility cannot be 
shifted to the accounting firm.
    Paragraphs (c)(4)(ii)(B)(2) and (c)(4)(ii)(B)(3), setting out the 
second and third conditions, complement each other. Paragraph (B)(2) 
articulates the condition that ``the audit client's management 
designates a competent employee or employees, preferably within senior 
management, with the responsibility to make all management decisions 
with respect to the design and implementation of the hardware or 
software system.'' Paragraph (B)(3) articulates the condition that 
``the audit client's management makes all management decisions with 
respect to the design and implementation of the hardware or software 
system including, but not limited to, decisions concerning the systems 
to be evaluated and selected, the controls and system procedures to be 
implemented, the scope and timetable of system implementation, and the 
testing, training and conversion plans.'' These conditions are intended 
to ensure that an audit client that receives information technology 
services from its auditor does not delegate to its auditor 
responsibility for ``management decisions'' relating to the design and 
implementation of the system.
    The fourth condition, set out in paragraph (c)(4)(ii)(B)(4), is 
that ``the audit client's management evaluates the adequacy and results 
of the design and implementation of the hardware or software system.'' 
Paragraph (c)(4)(ii)(B)(5) sets out the fifth condition, that ``the 
audit client's management does not rely on the accountant's work as the 
primary basis for determining the adequacy of its internal controls and 
financial reporting systems.'' These conditions reiterate the 
principles that management is to make all substantive decisions, that 
the auditor should not have a mutual interest in the successful 
operation of the systems, and that the auditor should not be placed in 
the position of auditing his or her firm's decisions about the system.
    The rule expressly does not limit services in connection with the 
assessment, design, and implementation of internal accounting and risk 
management controls, provided the auditor does not act as an employee 
or perform management functions. During the audit, accountants 
generally obtain

[[Page 76046]]

an understanding of their audit clients' systems of internal accounting 
controls and may recommend ways in which those controls can be improved 
or strengthened. This service can be valuable to companies and their 
audit committees, and may also enhance audit quality, without raising 
independence concerns. In addition, we do not see any significant 
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.
    (iii) Appraisal or Valuation Services and Fairness Opinions. We are 
adopting a rule that, with some exceptions, provides that an accountant 
is not independent if the accountant provides appraisal or valuation 
services or any service involving a fairness opinion.\365\ Appraisal 
and valuation services include any process of valuing assets, both 
tangible and intangible, or liabilities. Fairness opinions are opinions 
that an accounting firm provides on the adequacy of consideration in a 
transaction. As explained more thoroughly in the Proposing Release, if 
an audit firm provides these services to an audit client, 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 
suggested by his or her firm that underlie an entry in the financial 
statements.\366\ Where the service involves the preparation of 
projections of future results or future cash flows, the accountant may 
develop a mutuality of interest with the audit client in attaining the 
forecasted results.
---------------------------------------------------------------------------

    \365\ 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 ``Appraisal and 
Valuation Services,'' at 7-9.
    \366\ See generally Codification Sec. 602.02.c.
---------------------------------------------------------------------------

    We solicited comment on whether we should provide an exception from 
the rule when the amounts involved are likely to be immaterial to the 
financial statements that later would be reviewed by the auditor. 
Several commenters stated that such an exception is warranted.\367\ In 
response, we are limiting application of the rule to the provision of 
appraisals, valuations, or services involving a fairness opinion where 
it is reasonably likely that the results, individually or in the 
aggregate, would be material to the audit client's financial statements 
\368\ or where the results would be audited by the auditor. As a 
general matter, auditors would be auditing the results when they 
perform a GAAS audit.
---------------------------------------------------------------------------

    \367\ See e.g., Arthur Anderson Letter; Deloitte & Touche 
Letter; PricewaterhouseCoopers Letter.
    \368\ Of course, reference to financial statements includes 
results of operations, financial conditions and cash flows.
---------------------------------------------------------------------------

    The rule also contains an exception for appraisal or valuation 
services where the accounting firm reviews and reports on work done by 
the audit client itself or an independent, third-party specialist 
employed by the audit client, and the audit client or specialist 
provides the primary support for the balance recorded in the client's 
financial statements. In those instances, because a third party or the 
audit client is the source of the financial information subject to the 
review or audit, the accountant will not be reviewing or auditing his 
or her own work.
    Another exception allows accountants to continue to value an audit 
client's pension, other post-employment benefit, or similar 
liabilities, so long as the audit client has determined and taken 
responsibility for all significant assumptions and data underlying the 
valuation.\369\ Accountants historically have provided pension 
assistance to their audit clients, and if appropriate persons at the 
audit client determine the underlying assumptions and data, we believe 
that independence is not impaired.
---------------------------------------------------------------------------

    \369\ AICPA Code of Professional Conduct, ET Sec. 101.05 states 
that an auditor's independence would not be impaired in connection 
with appraisal and valuation services ``when all significant matters 
of judgment are determined or approved by the client and the client 
is in a position to have an informed judgment on the results of the 
valuation.''
---------------------------------------------------------------------------

    Commenters also stated that an accountant's independence should not 
be deemed impaired when the accountant performs appraisal or valuation 
services as a necessary part of permitted tax services. As the rule 
text and this Release make clear, accountants will continue to be able 
to provide tax services to audit clients. A few commenters pointed out, 
however, that unless accountants can perform appraisal and valuation 
services that are part of a tax planning strategy or for tax compliance 
purposes, the client would not hire the accountant to provide tax 
services.\370\ The final rule makes clear that accountants can perform 
appraisal and valuation services for those purposes without impairing 
independence.
---------------------------------------------------------------------------

    \370\ See, e.g., Arthur Andersen Letter.
---------------------------------------------------------------------------

    Commenters requested an exception for appraisal and valuation 
services where the services are for non-financial purposes. Because our 
principal concern about appraisal and valuation services is that they 
lead auditors to audit their own work, so long as the results do not 
affect the financial statements, appraisal or valuation services 
performed for non-financial purposes do not impair an auditor's 
independence.
    At least one commenter suggested that we include an exception for 
purchase price allocations.\371\ An exception is not appropriate here 
because these allocation decisions, particularly those regarding the 
valuation of intangible assets, can have a direct, significant, and 
immediate impact on companies' financial statements. For example, where 
a company acquires another company with large, on-going in-process 
research and development projects, the acquiring company will need to 
decide how much of the purchase price to allocate to those projects. 
This may affect in turn the amount charged against earnings in the 
current year as in-process research and development expense, and the 
amount to be classified as goodwill and amortized against future years' 
earnings. Any such allocations later will be reviewed in the course of 
the audit, leading the firm to audit its own work.\372\
---------------------------------------------------------------------------

    \371\ Deloitte & Touche Letter.
    \372\ We note in this regard, that if an acquisition 
individually, and when aggregated with other acquisitions reflected 
in the financial statements, is immaterial to the audit client's 
financial statements, then assisting in the allocation of the 
purchase price would not fall within the conditions of the rule and 
therefore would not be deemed to impair the auditor's independence.
---------------------------------------------------------------------------

    Finally, commenters raised concerns about the restriction on the 
provision of contribution-in-kind reports.\373\ We have removed the 
language in the rule referring to contribution-in-kind reports because 
we view such reports to be akin to fairness opinions, which are 
restricted under the final rules. We understand from commenters that 
certain foreign jurisdictions require auditors to issue contribution-
in-kind reports for their audit clients \374\ and that, in some 
European jurisdictions, auditors may be appointed or approved by an 
administrative or judicial authority to act as an independent expert 
and issue a contribution-in-kind report for the audit client.\375\ The 
Commission is sensitive to those issues and in the past has worked with 
foreign regulators and companies to reach an acceptable 
resolution.\376\ We will

[[Page 76047]]

continue our practice of determining whether to accept a contribution-
in-kind report on a case-by-case basis. In this regard, we encourage 
registrants and their auditors to contact the staff to discuss 
particular situations where a foreign jurisdiction requires a 
contribution-in-kind report to enable the staff to work with the 
registrant and the foreign jurisdiction in reaching an appropriate 
resolution.
---------------------------------------------------------------------------

    \373\ See, e.g., Deloitte & Touche Letter; Ernst & Young Letter; 
Letter of KPMG Europe (Sept. 22, 2000).
    \374\ Ernst & Young Letter.
    \375\ See e.g., Deloitte & Touche Letter; Letter of KPMG Europe 
(Sept. 22, 2000).
    \376\ See Letter from Lynn Turner, Chief Accountant, SEC, to 
Antonio Rosati, CONSOB (Aug. 24, 2000). In that letter, our Chief 
Accountant did not deem the auditor's independence to be impaired 
where there were certain agreed-upon procedures for the 
contribution-in-kind report and the accountant represented in the 
report that the report did not express an opinion on the fairness of 
the transaction, the value of the security, or the adequacy of 
consideration to shareholders. This letter is available on our 
website.
---------------------------------------------------------------------------

    (iv) Actuarial Services. SECPS rules currently prohibit member 
accounting firms from providing certain actuarially oriented advisory 
services to insurance companies.\377\ Accountants providing these 
services assume a key management task. In addition, because actuarially 
oriented advisory services may affect amounts reflected in an insurance 
company's financial statements, providing these services may cause an 
accountant later to audit his or her own work. Rule 2-01(c)(4)(iv) 
addresses these issues.
---------------------------------------------------------------------------

    \377\ SECPS Reference Manual (``SECPS Manual'') Sec. 1000.35.
---------------------------------------------------------------------------

    Commenters expressed concern that the proposal was broader than a 
similar SECPS rule, in that the restrictions in the proposal applied to 
services provided to all public companies, not just insurance 
companies, and the proposal did not include the four examples of 
appropriate services that are included in the SECPS rule.\378\ We have 
modified our final rule with respect to actuarial services to parallel 
closely the SECPS rule, including the four exceptions. The final rule 
limits only actuarially oriented advisory services involving the 
determination of insurance company policy reserves and related 
accounts. We are narrowing the prohibition to services for insurance 
companies because, as explained in the SECPS rule, it is primarily in 
these companies that the actuarial function is ``basic to the operation 
and management'' of the company.\379\
---------------------------------------------------------------------------

    \378\ PricewaterhouseCooopers Letter; Ernst & Young Letter; see 
also Deloitte & Touche Letter.
    \379\ SECPS Manual Sec. 1000.35, at para. 5.
---------------------------------------------------------------------------

    The final rule states that an auditor's independence is impaired if 
the audit firm provides certain actuarially oriented advisory services 
involving the determination of insurance company policy reserves and 
related accounts, unless three conditions are met. First, the audit 
client must use its own actuaries or third-party actuaries to provide 
management with the primary actuarial capabilities. Second, management 
must accept responsibility for any significant actuarial methods and 
assumptions employed by the accountant in performing or providing the 
actuarial services. Third, the accountant cannot render the actuarial 
services to the audit client on a continuous basis. All of these 
conditions are designed to ensure that the accountant does not assume a 
management function for the audit client.
    Assuming these conditions are met, the accountant can perform four 
types of actuarial services for an insurance company audit client 
without impairing the accountant's independence. The four types of 
actuarial services are: (i) Assisting management to develop appropriate 
methods, assumptions, and amounts for policy and loss reserves and 
other actuarial items presented in financial reports, based on the 
company's historical experience, current practice, and future plans; 
\380\ (ii) assisting management in the conversion of financial 
statements from a statutory basis to one conforming 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, new markets, 
business acquisitions, and reinsurance needs. Allowing accountants to 
provide these four types of actuarially oriented advisory services 
under the three conditions is consistent with the SECPS rule.\381\ We 
believe that if the conditions are met, in the context of state-
regulated insurance companies, the four services would not constitute 
an assumption of the insurance company management's role or 
responsibilities, and would not impair the auditor's independence.
---------------------------------------------------------------------------

    \380\ Although it addresses a different topic, accountants and 
registrants may refer to ISB, ``Interpretation No. 99:1: Impact on 
Auditor Independence of Assisting Clients in the Implementation of 
FAS 133 (Derivatives)'' for general guidance on what constitutes 
``assistance'' as opposed to ``performing'' certain functions or 
services.
    \381\ See SECPS Manual Sec. 1000.35.
---------------------------------------------------------------------------

    (v) Internal Audit Services. Although companies are not required to 
do so, they may, as part of their internal controls, form internal 
audit departments that are used to make sure that control systems are 
adequate and working. According to the Committee of Sponsoring 
Organizations (``COSO''), internal auditors play an important role in 
evaluating and monitoring a company's internal control system.\382\ As 
explained by Robert Denham, a member of the ISB, at our public 
hearings, ``Good internal auditing . . . requires the internal auditor 
to be very closely integrated with management. The internal auditor is 
part of the management team. He or she is identifying problems and 
providing reports that help management correct those problems.''\383\ 
In sum, ``the internal audit function is, basically, an arm of 
management,''\384\ and internal auditors are, in effect, part of a 
company's internal accounting control system.
---------------------------------------------------------------------------

    \382\ See Committee of Sponsoring Organizations of the Treadway 
Commission, Internal Control--Integrated Framework, at 7 (1992) (the 
``COSO Report'').
    \383\ Testimony of Robert E. Denham (July 26, 2000); see also 
Testimony of John Whitehead, retired Chairman, Goldman Sachs & Co. 
(Sept. 13, 2000) (``internal auditing is the function of 
management'').
    \384\ Testimony of Manuel H. Johnson, Public Member, ISB (July 
26, 2000).
---------------------------------------------------------------------------

    Although a company may prefer to outsource its internal audit 
function, management must continue to be responsible for the 
function.\385\ When a company outsources the function to a third-party 
provider, there may be a concern that management has ceded this 
responsibility. While this is a concern in any internal audit 
outsourcing arrangement, there are additional concerns when a company 
outsources the work to its external auditor. As Comptroller of the 
Currency John D. Hawke, Jr., testified, ``When a bank out-sources its 
internal audit function to the same firm that performs the bank's 
external financial audit . . . the possibility for inherent conflicts 
and impairments of auditor independence and auditor integrity is 
greatest.''\386\ Although Mr. Hawke discussed the conflicts in the bank 
context, his comments are equally applicable to any registrant.
---------------------------------------------------------------------------

    \385\ See AICPA Code of Professional Conduct, ET Sec. 101.15 
(Interpretation 101-13).
    \386\ Testimony of John D. Hawke, Jr. (July 26, 2000). He also 
reported a trend among banks in favor of outsourcing internal audit 
work to the external auditor. He testified that ``[o]f [the] 50 
largest banks'' within the jurisdiction of the OCC, ``8 out-source 
their internal audit, and 7 of those 8 out-source to the same firm 
that does their external audit. That's a pretty good chunk of the 
largest banks.'' Id. In addition, Mr. Hawke reported that in a 
survey of the OCC banks in the Northeast region, one-third outsource 
their internal audit work and half of those banks outsource to their 
external auditor. Id.
---------------------------------------------------------------------------

    Research commissioned by the Institute of Internal Auditors 
indicates that the internal auditors surveyed perceive an independence 
problem where internal audit work is outsourced to the external 
auditor.\387\ In particular,

[[Page 76048]]

in auditing the company's financial statements, the accountant will 
consider the extent to which he or she may rely on the internal control 
system in designing its audit procedures.\388\ When the auditor has 
performed the internal audit work, the auditor will need to consider or 
examine its own work.
---------------------------------------------------------------------------

    \387\ In this study, companies with small, ``mean-sized,'' and 
large internal audit departments were asked to indicate their level 
of agreement (on a scale of zero to five, with five being the 
strongest) with the following statement: ``There is an independence 
problem if the external audit firm performs extended audit services 
(internal audit services) for the same firm for which it performs 
the annual financial statement audit.'' The level of agreement among 
respondents was between 3.7 and 4.0, ``indicating a perception of an 
independence problem.'' Larry E. Rittenberg and Mark A. Covaleski, 
The Outsourcing Dilemma: What's Best for Internal Auditing, at 68 
and Exh. 4-4 (Institute of Internal Auditors Research Foundation 
1997).
    \388\ AICPA SAS No. 55, AU Sec. 319 (effective for audits on or 
after Jan. 1, 1990).
---------------------------------------------------------------------------

    Final Rule 2-01(c)(4)(v) seeks to curb these conflicting interests 
without precluding companies, particularly small companies, from 
obtaining internal audit services from their auditors where the 
auditor's independence would not be compromised. Under the final rule, 
an auditor's independence is impaired by performing more than forty 
percent of the audit client's internal audit work related to the 
internal accounting controls, financial systems, or financial 
statements, unless the audit client has $200 million or less in assets.
    The final rule provides an exception for businesses with $200 
million or less in assets. Specifically, the rule provides that audit 
clients who have less than $200 million in total assets may receive 
more than forty percent of their internal audit functions from their 
auditor without giving rise to an impairment of independence. We 
provide this exception after carefully considering the potential impact 
of our rules on small businesses. At the proposing stage, we requested 
comment on whether we should provide an exception for smaller 
businesses. We adopt this exception in response to comments that we 
received,\389\ and in recognition of the fact that smaller businesses, 
many of which may be located away from major business centers, could 
suffer particular hardships if we do not provide some exception.\390\
---------------------------------------------------------------------------

    \389\ See, e.g., Testimony of John D. Hawke, Jr., Comptroller of 
the Currency (July 26, 2000) (noting concerns about the effect of 
the proposed rule on small banks); Testimony of Wayne A. Kolins, 
National Director of Assurance, BDO Seidman, LLP (Sept. 20, 2000).
    \390\ These hardships could include, for example, difficulty in 
obtaining suitable professional services at a cost appropriate to 
the size of the business, or, for a small accounting firm, the loss 
of a substantial portion of its client base for either its audit or 
internal audit services.
---------------------------------------------------------------------------

    We chose a $200 million threshold for various reasons. From the 
available data, the $200 million threshold appears to provide a line 
below which not only are the companies themselves smaller, but the 
accounting firms that audit them also tend to be smaller.\391\
---------------------------------------------------------------------------

    \391\ Using the $200 million threshold reasonably isolates 
companies that are relatively small themselves--approximately 54% of 
the 9,414 public reporting companies in the Standard & Poors 
Research Insight Compustat Database (``Compustat Database'') `` and 
has the effect of almost completely excepting smaller accounting 
firms. Approximately 85% of the public company audit clients (other 
than bank holding companies) of non-Big Five accounting firms have 
less than $200 million in assets. Of public company audit clients 
with more than $200 million in assets--the companies that would not 
trigger the exception--no more than 6.1% (again, excluding bank 
holding companies) are audited by non-Big Five firms. The source for 
these data is the Compustat Database, October 31, 2000. For further 
analysis, see infra Section V.B. (cost-benefit analysis).
---------------------------------------------------------------------------

    Commenters distinguished the situation in which the auditor 
supplements an audit client's internal audit function from the 
situation in which the auditor supplants the client's internal audit 
function. They suggested that an auditor should not be permitted to 
provide all of the internal audit services required by an audit client 
but should be allowed to provide a limited amount of internal audit 
services without impairing the auditor's independence.\392\ For 
example, Ray J. Groves, former Chairman and Chief Executive Officer of 
Ernst & Young, said that ``limited amounts in specific areas of 
internal out-sourcing make a lot of sense, as opposed to complete out-
sourcing, as long as the audit client maintains their own independent 
internal audit function with capable management and people within 
it.''\393\ These comments in large part reflect the current AICPA rule 
on internal audit outsourcing,\394\ which, as explained by a senior 
official of the AICPA, ``prohibit[s] the complete outsourcing.''\395\ 
In response to these comments and in recognition of the AICPA rule, our 
final rule, with respect to registrants with $200 million or more in 
assets, allows auditors to perform up to forty percent of an audit 
client's internal audit work.\396\
---------------------------------------------------------------------------

    \392\ See, e.g., Testimony of Jacqueline Wagner (Sept. 13, 2000) 
(testifying for the Institute of Internal Auditors) (``The IIA 
believes that the total outsourcing of the internal auditing 
function to the organization's external auditing firm impairs that 
firm's independence.''); Testimony of Dominick Esposito, Chief 
Executive Officer, Grant Thornton LLP (Sept. 13, 2000) (``I think if 
there is the entire internal audit department outsourced, it can 
present a conflict.'').
    \393\ Testimony of Ray J. Groves (July 26, 2000).
    \394\ See AICPA Code of Professional Conduct, ET Sec. 101.15 
(Interpretation 101-13).
    \395\ Testimony of Barry Melancon, President and Chief Executive 
Officer (Sept. 13, 2000). Mr. Melancon also noted that ``[t]here 
still has to be management responsibility for the overall internal 
audit function . . . we certainly agree that the ultimate 
responsibility for internal auditing, the management decision 
making, must [lie] with management, not with the auditor.''
    \396\ When providing internal audit services to an audit client 
with $200 million or more in assets, the auditor must measure the 
internal audit services provided to the audit client in full-time 
employee hours. In order to remain independent, the auditor must 
ensure that it provides 40% or less of the total hours expended by 
the audit client, the auditor and anyone else on internal audit 
matters related to internal accounting controls, financial systems, 
and financial statements, and matters that impact the financial 
statements.
---------------------------------------------------------------------------

    Several commenters expressed concern about the effect of the 
proposed rule on small businesses that have no internal audit 
department or staff. They noted that smaller firms may not have 
sufficient need for full-time internal auditors but nonetheless, may 
need some services that internal auditors typically provide, which they 
obtain from their external auditors. According to these commenters, we 
should encourage this practice. Unless these companies can turn to 
their external auditors, they state, the work will not be done at all. 
Because we agree that small businesses should be encouraged to use 
internal audit services, the final rule allows auditors to provide an 
unlimited amount of internal audit services to clients with less than 
$200 million in assets, provided certain conditions are met.
    In addition, the final rule does not restrict internal audit 
services regarding operational internal audits unrelated to the 
internal accounting controls, financial systems, or financial 
statements. This is because our focus is on services that affect the 
integrity of financial statements and reported financial 
information.\397\
---------------------------------------------------------------------------

    \397\ In addition, performing procedures that generally are 
considered to be within the scope of the engagement for the audit of 
the audit client's financial statements, such as confirming accounts 
receivable and analyzing fluctuations in account balances, would not 
impair the accountant's independence, even if the extent of testing 
exceeds that required by GAAS. For example, if an accountant in 
normal circumstances would plan to observe ten percent of an audit 
client's inventory, but at the audit client's request the accountant 
observes 50% of inventory on hand, the accountant's independence 
would not be impaired.
---------------------------------------------------------------------------

    Under all circumstances in which an auditor performs any internal 
audit services for an audit client, including with respect to companies 
with assets under $200 million, the auditor must comply with the six 
conditions listed in paragraph (B) to avoid an impairment of 
independence. Four of the six conditions are drawn from a ruling 
published in 1996 by the Ethics Committee of the AICPA.\398\ It states 
that AICPA members may provide certain internal audit outsourcing 
services to audit clients without

[[Page 76049]]

impairing their independence, so long as, among other things, (i) the 
client designates a competent member of management to be responsible 
for the internal audit function, (ii) management determines the scope, 
risk, and frequency of internal audit activities, including those to be 
performed by the auditor, (iii) management evaluates the findings and 
results arising from the internal audit activities, including those 
performed by the auditor, and (iv) management evaluates the adequacy of 
the audit procedures performed and the findings resulting from 
performance of those procedures. In addition, consistent with a later 
ruling by the AICPA, the final rule requires that (v) the audit client 
acknowledges its responsibility to establish and maintain a system of 
internal accounting controls in compliance with Section 13(b)(2) of the 
Securities Exchange Act, and (vi) that management not rely on the 
auditor's work as the primary basis for determining the adequacy of its 
internal controls.\399\
---------------------------------------------------------------------------

    \398\ AICPA Code of Professional Conduct, ET Sec. 101.15 
(Interpretation 101-13).
    \399\ AICPA Code of Professional Conduct, ET Sec. 191.206-207 
(Interpretation 101-103).
---------------------------------------------------------------------------

    In the Proposing Release we noted that we were inclined not to 
follow the AICPA rule on internal audit outsourcing because we believed 
that, in providing such services, the auditor assumed a management 
function and, in the course of the audit, would have to review his or 
her own work. As discussed above, however, we have been persuaded that 
the auditor can perform a limited amount of an audit client's internal 
audit function without supplanting management's role or auditing its 
own work. In addition, we have been persuaded that encouraging internal 
audit outsourcing at small businesses is wise public policy. We have, 
accordingly, determined to allow the limited relationships described 
above under the conditions recommended and used at this time by the 
AICPA.
    (vi) Management Functions. Current Rule 2-01 of Regulation S-X and 
the AICPA's rules preclude accountants from acting as management.\400\ 
We are adopting Rule 2-01(c)(4)(vi) as proposed, which 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 or performs any decision-making, 
supervisory, or ongoing monitoring functions.
---------------------------------------------------------------------------

    \400\ Former Rule 2-01(b), 17 C.F.R. 210.2-01(b); AICPA Code of 
Professional Conduct, ET Sec. 101.02.
---------------------------------------------------------------------------

    (vii) Human Resources. Under current SECPS rules, accountants 
cannot perform certain executive recruiting and human resource services 
for audit clients.\401\ Specifically, under those rules, an 
accountant's independence would be impaired if the accountant: (a) 
Searches for or seeks out prospective candidates for managerial, 
executive or director positions with audit clients;\402\ (b) engages in 
psychological testing, or other formal testing or evaluation 
programs;\403\ (c) undertakes reference checks of prospective 
candidates for executive or director positions with audit clients;\404\ 
(d) acts as a negotiator on the audit client's behalf, such as in 
determining position, status or title, compensation, fringe benefits, 
or other conditions of employment;\405\ or (e) recommends, or advises 
an audit client to hire, a specific candidate for a specific job.\406\ 
Those rules do not, however, preclude an accountant from, upon request 
of the audit client, interviewing candidates and advising an audit 
client on the candidate's competence for financial, accounting, 
administrative or control positions.\407\
---------------------------------------------------------------------------

    \401\ See SECPS Manual Sec. 1000.35 App. A; see also AICPA Code 
of Professional Conduct, ET Sec. 101.05 (Interpretation 101-3) 
(deeming an auditor's independence impaired when the auditor 
negotiates employee compensation or benefits, or hires or terminates 
client employees).
    \402\ SECPS Manual Sec. 1000.35 App. A.
    \403\ Id.
    \404\ Id.
    \405\ Id.; AICPA Code of Professional Conduct, ET Sec. 101.05.
    \406\ Id.
    \407\ SECPS Manual Sec. 1000.35 App. A
---------------------------------------------------------------------------

    Excessive involvement 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 that those 
employees failed to perform their jobs appropriately because doing so 
would require the auditor to acknowledge shortcomings in its human 
resource service.
    Commenters were concerned that our proposed language expanded upon 
the limitations in the AICPA and SECPS rules.\408\ For example, 
commenters expressed concern that the proposed rule would prohibit an 
accountant from advising an audit committee on the competence of a 
prospective controller or CFO.\409\ Commenters also were concerned that 
the proposed rule limited accountants from providing tax-related 
services related to structuring compensation packages.\410\ We agree 
that an objective evaluation by the accountant of a candidate's 
competency for an accounting or financial position may be useful to 
some, particularly smaller, companies and that the impact of this 
evaluation is reduced by the proscription that the accountant may not 
recommend that the audit client hire a particular candidate. We also 
believe that an accountant should not negotiate regarding the contents 
of a compensation package the accountant has designed. Accordingly, in 
light of the comments received, we have modified the final rule, and 
final Rule 2-01(c)(4)(vii) more closely parallels the SECPS rules.
---------------------------------------------------------------------------

    \408\ See, e.g., Deloitte & Touche Letter; KPMG Letter; 
PricewaterhouseCoopers Letter; Ernst & Young Letter.
    \409\ See, e.g., KPMG Letter; Ernst & Young Letter.
    \410\ See, e.g., Deloitte & Touche Letter; Ernst & Young Letter.
---------------------------------------------------------------------------

    (viii) Broker-Dealer Services. Current Rule 2-01 states that an 
accountant's independence is impaired if the accountant is connected 
with the audit client as an underwriter or promoter.\411\ The 
Codification further states that concurrent engagement as a broker-
dealer is incompatible with the practice of public accounting.\412\ 
Rule 2-01(c)(4)(viii) combines these provisions with certain provisions 
from the AICPA rules.\413\ As adopted, the amendments state that an 
accountant's independence will be impaired if the accountant acts as a 
broker-dealer, promoter, or underwriter on behalf of an audit client, 
makes investment decisions on behalf of the audit client or otherwise 
has discretionary authority over an audit client's investments, 
executes a transaction to buy or sell an audit client's investment, or 
has custody of assets of the audit client, such as taking temporary 
possession of securities purchased by the audit client. As noted in our 
existing standards, activities such as recommending securities, 
soliciting customers, and executing orders create a mutuality of 
interest and the potential for self-review.
---------------------------------------------------------------------------

    \411\ Former Rule 2-01(b), 17 CFR 210.2-01(b).
    \412\ Codification Sec. 602.02.e.iii.
    \413\ See AICPA Code of Professional Conduct ET Sec. 101.05.
---------------------------------------------------------------------------

    Although our intention was to codify current restrictions, 
commenters believed that our proposal went further.\414\ In particular, 
commenters were concerned that by including the term ``investment 
adviser'' we were precluding accountants from providing certain 
investment advisory or personal financial planning services that they 
currently provide.\415\ In response to

[[Page 76050]]

these concerns, we have removed the term ``investment adviser'' from 
the rule text.
---------------------------------------------------------------------------

    \414\ See, e.g., Ernst & Young Letter; PricewaterhouseCoopers 
Letter.
    \415\ See Arthur Andersen & Co., 1994 SEC No Act. LEXIS 617 
(July 8, 1994) (``Andersen No-Action Letter'') in which the staff 
stated it would not recommend enforcement action under the 
Investment Advisers Act where an accounting firm did not register as 
an investment adviser but an affiliated registered investment 
adviser provided investment advisory services. The staff permitted 
the affiliate to publish a newsletter with financial planning 
information, provided the newsletter does not recommend any specific 
industry sectors or securities, to identify categories of mutual 
funds that satisfy an advisory client's investment objectives, and 
to recommend two or more mutual funds in each category. When an 
advisory client wants more specific advice, the investment advisory 
affiliate accountant will provide a client with a list of two or 
more investment advisers or broker-dealers that meet certain 
predetermined criteria, provided that the accountant does not 
receive any fee or other economic benefit from the mutual funds, 
investment advisers or broker-dealers recommended. The advisory 
affiliate will disclose to advisory clients that the recommended 
mutual funds, investment advisers, or broker dealers may include 
audit clients. See also Ernst & Young Letter (citing Andersen No-
Action Letter).
---------------------------------------------------------------------------

    Current AICPA rules specify investment advisory services that 
accountants may provide to audit clients without impairing their 
independence. Under these rules, accountants can recommend the 
allocation of funds that an audit client should invest in various asset 
classes, based on the client's risk tolerance and other factors; 
provide a comparative analysis of the client's investments to third-
party benchmarks; review the manner in which the audit client's 
portfolio is being managed by investment account managers; and transmit 
a client's investment selection to a broker-dealer, provided that the 
client has made the investment decision and has authorized the broker-
dealer to execute the transaction.\416\ Accountants may continue to 
provide those services without impairing their independence.
---------------------------------------------------------------------------

    \416\ AICPA Code of Professional Conduct, ET Sec. 101.05 
(Interpretation 101-3).
---------------------------------------------------------------------------

    Current AICPA rules also specify investment advisory services 
accountants may not provide to audit clients without impairing their 
independence. The final rule incorporates these restrictions. 
Accordingly, as under the AICPA's rules,\417\ auditors cannot make 
investment decisions for audit clients or exercise discretionary 
trading authority over an audit client's account, cannot execute 
transactions for audit clients, and cannot take custody of an audit 
client's assets. Providing such services creates a mutuality of 
interest and may result in the auditor having to audit the value of 
investments that the auditor made for the client.
---------------------------------------------------------------------------

    \417\ Id.
---------------------------------------------------------------------------

    The Codification states that ``[t]he functions customarily 
performed [by a broker-dealer] include the recommendation of 
securities, the solicitation of customers and the execution of orders, 
any one of which could involve securities transactions of clients 
either as issuer or investor and provide third parties with sufficient 
reason to question the accountant's ability to be impartial and 
objective.''\418\ Because these activities continue to be encompassed 
within the meaning of ``broker-dealer'' under the rule we are adopting, 
and therefore, when performed on behalf of an audit client, impair an 
auditor's independence, we have eliminated the language ``in any 
capacity recommending the purchase or sale of an audit client's 
securities' from the rule text.
---------------------------------------------------------------------------

    \418\ Codification Sec. 602.02.e.iii.
---------------------------------------------------------------------------

    By restricting broker-dealer services to those provided ``on behalf 
of the audit client,'' we do not mean to suggest that an auditor can 
recommend an audit client's securities to either another audit client 
or a non-audit client.\419\ The language ``on behalf of'' the audit 
client encompasses all situations in which the auditor is directly or 
indirectly compensated for the recommendation.
---------------------------------------------------------------------------

    \419\ See Arthur Andersen Letter (acknowledging that it is 
appropriate to prohibit accountants from recommending any specific 
securities to audit clients and from recommending audit clients' 
securities to non-audit clients).
---------------------------------------------------------------------------

    The final rule, however, will not alter current guidance as to the 
corporate finance consulting services auditors provide to audit and 
non-audit clients.\420\ For example, accountants, without impairing 
their independence, may advise audit clients in need of capital that 
one alternative is to do a public offering of their securities. Also, 
the staff has indicated that limited activities on the part of the 
auditor by way of general explanatory work and limited fact finding 
(such as identifying and introducing an audit client to potential 
merger partners that meet specified criteria) would not impair an 
auditor's independence. An auditor's independence would be impaired, 
however, by entering into preliminary or other negotiations on behalf 
of an audit client, by promoting the client to potential buyers, or 
``with respect to subsequent audits of a client if the accountant 
renders advice as to whether, or at what price a transaction should be 
entered into.''\421\ These interpretations of former Rule 2-01(b) apply 
equally to the amended rule we adopt today. To the extent an auditor is 
otherwise permitted to provide services to a non-audit client 
concerning corporate financing transactions to which an audit client is 
a party, the permissibility of those services does not turn on whether 
the advice involves transactions in which the consideration provided by 
an audit client to the non-audit client is in the form of an audit 
client's securities, as opposed to cash or other assets.
---------------------------------------------------------------------------

    \420\ See AICPA Code of Professional Conduct, ET Sec. 101.05, 
Interpretation 101-3, which states that an accountant's independence 
would not be impaired if that accountant assists in developing 
corporate strategies, assists in identifying or introducing the 
client to possible sources of capital that meet the client's 
specifications or criteria, assists in analyzing the effects of 
proposed transactions, assists in drafting an offering document or 
memorandum, or participates in transaction negotiations in an 
advisory capacity.
    \421\ Letter from Edmund Coulson, Chief Accountant, SEC, to 
Edward McGowen, Pannell Kerr Forster, at 2 (July 11, 1988) 
(discussing mergers and acquisition services, among others).
---------------------------------------------------------------------------

    Commenters expressed concern that, because the terms ``securities 
professional'' and ``analyst'' are not defined in the securities laws, 
they would cause confusion.\422\ To avoid any such confusion and to 
limit concerns about overbroad application of those terms, we have 
eliminated those terms from the rule text. We note, however, that 
broker-dealers provide an array of services that may include analyst 
activities.
---------------------------------------------------------------------------

    \422\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

    Finally, we have not included in the final rule the prohibition 
relating to designing broker-dealer or investment adviser compliance 
systems. We have eliminated this provision to conform the rule to 
current law.
    (ix) Legal Services. For the reasons set forth in the Proposing 
Release, we believe that there is a fundamental conflict between the 
role of an independent auditor and that of an attorney. The auditor's 
charge is to examine objectively and report, regardless of the impact 
on the client, while the attorney's fundamental duty is to advance the 
client's interests.\423\ As discussed in the Proposing Release at 
greater length, \424\ existing regulations, \425\ the U.S. Supreme 
Court,\426\ and professional legal organizations \427\ have deemed it 
inconsistent with the concept of auditor independence for an accountant 
to provide legal services to an audit client. Accordingly, we are 
adopting the proposed rule as to legal services with a few 
modifications. Final Rule 2-01(c)(4)(ix) provides that an accountant is 
not independent of an audit client if the accountant provides any 
service to

[[Page 76051]]

an audit client under circumstances in which the person providing the 
service must be admitted to practice before the courts of a U. S. 
jurisdiction.
---------------------------------------------------------------------------

    \423\ See also ISB, ``Discussion Memorandum 99-4: Legal 
Services'' (Dec. 1999).
    \424\ See Proposing Release, Section III.D.1(b)(ix).
    \425\ Codification Sec. 602.02.e.ii.
    \426\ Arthur Young, 465 U.S. at 819-20 n.15.
    \427\ American Bar Association Commission on Multidisciplinary 
Practice, Report to the House of Delegates, at 5 (July 2000) (``ABA 
Report'') (available at www.ABAnet.org/cpr/mdpfinalrep2000.html).
---------------------------------------------------------------------------

    We understand that some firms, largely through their foreign 
affiliates, are providing legal services outside of the United States. 
Moreover, we understand \428\ that lawyers affiliated with foreign 
affiliates of U. S. accounting firms on occasion provide legal services 
in the United States where they are not required to be admitted to a 
bar in the United States. The final rule does not address these 
practices, where local law does not preclude such services and the 
services relate to matters that are not material to the consolidated 
financial statements of an SEC registrant or are routine and 
ministerial. We note, however, that it is clear to us that legal 
services provided outside the United States raise serious independence 
concerns under circumstances other than those meeting at least those 
minimum criteria.
---------------------------------------------------------------------------

    \428\ See Ernst & Young Letter; PricewaterhouseCoopers Letter; 
Arthur Andersen Letter.
---------------------------------------------------------------------------

    We solicited comment on whether our proposed rule on legal services 
created uncertainty or complexity since the prohibition focused on the 
jurisdiction in which the legal services were provided. Commenters 
stated that indeed the rule should be revised because U.S. attorneys 
can, under various circumstances, render legal services in 
jurisdictions where they are not licensed to practice law. For example, 
when an attorney is not licensed to practice law in a particular 
jurisdiction, he or she can apply to a court pro hac vice to be able to 
appear before the court for purposes of the case.\429\ Accordingly, we 
modified the rule so that an accountant's ability to render legal 
services no longer depends on his or her being licensed in the 
jurisdiction where the services are rendered, but rather on whether, 
under the circumstances, the provider of the services must be admitted 
to practice before the courts of a U.S. jurisdiction.
---------------------------------------------------------------------------

    \429\ See, e.g., Va. Sup. Ct. R. 1A:4 (2000).
---------------------------------------------------------------------------

    Some commenters suggested that safeguards, such as firewalls, could 
prevent or cure any independence problem that might arise by virtue of 
an accountant providing legal services to an audit client.\430\ 
Recently, the Commission on Multidisciplinary Practice of the ABA 
considered whether firewalls would address sufficiently issues that 
might arise if a law firm were to provide both legal and other 
services.\431\ That Commission rejected the firewall approach, stating 
``[We] explicitly recognize[] the[] incompatibility [of legal and audit 
services]. [We] do not believe that a single entity should be allowed 
to provide legal and audit services to the same client.''\432\ In light 
of current regulations and the ABA Report, we have determined not to 
adopt a firewall approach.
---------------------------------------------------------------------------

    \430\ See, e.g., Arthur Andersen Letter.
    \431\ See ABA Report, supra note 427.
    \432\ Id. at 5 (footnote omitted).
---------------------------------------------------------------------------

    (x) Expert Services. We are not adopting the proposal to restrict 
the provision of expert services. The proposed rule would have provided 
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''). Commenters 
said that our proposals went beyond current rules.\433\ For example, 
AICPA Ethics Standards permit accountants to serve as expert 
witnesses.\434\
---------------------------------------------------------------------------

    \433\ See, e.g., PricewaterhouseCoopers Letter; Deloitte & 
Touche Letter.
    \434\ AICPA Code of Professional Conduct, ET Sec. 101.202-
101.203.
---------------------------------------------------------------------------

    Commenters argued that accountants may need to act as experts in 
defending work they have done for audit clients before such bodies as 
the Internal Revenue Service, and indeed, this Commission.\435\ As 
stated in the Proposing Release, we did not intend for our proposals to 
prohibit an auditor from testifying as a fact witness to its audit work 
for a particular 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. Nevertheless, to avoid confusion and any 
uncertainty that might be created by permitting the accountant to 
testify in one capacity but not another, we have determined not to 
adopt a restriction on expert services. When an accountant performs 
such services, however, he or she should be particularly mindful of his 
or her duty to maintain objectivity and integrity, as discussed in the 
AICPA Ethics Regulations.\436\
---------------------------------------------------------------------------

    \435\ See, e.g., Arthur Andersen Letter.
    \436\ AICPA Code of Professional Conduct, ET Sec. 102.07 (``[I]n 
the performance of any professional service, a member shall comply 
with rule 102 [ET Sec. 102.01], which requires maintaining 
objectivity and integrity and prohibits subordination of judgment to 
others.* * * Moreover, there is a possibility that some requested 
professional services involving client advocacy may appear to 
stretch the bounds of performance standards, may go beyond sound and 
reasonable professional practice, or may compromise credibility, and 
thereby pose an unacceptable risk of impairing the reputation of the 
member and his or her firm with respect to independence, integrity, 
and objectivity. In such circumstances, the member and the member's 
firm should consider whether it is appropriate to perform the 
services.'').
---------------------------------------------------------------------------

    c. Alternative Approaches to Scope of Services Restrictions. As 
discussed in the Proposing Release, we considered a number of 
alternatives concerning scope of services. We solicited public comment 
on each alternative. After considering the comments received, we have 
determined not to adopt any of the alternatives proposed.
    For the reasons discussed above, we have not adopted a disclosure-
only approach or a complete ban on auditors' provision to audit clients 
of non-audit services. In addition, as discussed above, we welcome and 
encourage active oversight by audit committees with respect to auditor 
independence, but do not believe that such oversight obviates the need 
for the rule we adopt today. In this regard, it is our statutory 
responsibility to protect the public interest.
    We are persuaded that relying on a firewalls approach is also 
unworkable. Under a firewalls approach, there would be a strict 
separation between those professionals in the accounting firm who 
perform audit work for an audit client and those who provide non-audit 
services for the client. GAAS, however, under certain circumstances 
requires that auditors seek out a registrant's consultants in the 
course of an audit to discuss work performed by the consultant.\437\ 
Accordingly, a strict firewalls approach would conflict with GAAS 
requirements.
---------------------------------------------------------------------------

    \437\ AICPA SAS No. 22, AU Sec. 311.04b; AU Sec. 9311.03.
---------------------------------------------------------------------------

5. Contingent Fees
    We proposed to restrict the receipt of contingent fees from audit 
clients, and we continue to believe that contingent fee arrangements 
result in the auditor having a mutual interest with the client. For 
example, if an accounting firm arranged to receive an audit fee of 
$200,000, but half of that fee was contingent on 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 planned IPO and in the continuing viability of the 
audit client. Consequently, we are adopting a restriction on contingent 
fees. In response to comments,\438\ however, we

[[Page 76052]]

modified the rules to parallel more closely the existing 
restrictions.\439\
---------------------------------------------------------------------------

    \438\ See, e.g., PricewaterhouseCoopers Letter; Deloitte & 
Touche Letter.
    \439\ AICPA Code of Professional Conduct, ET Sec. 302.01.
---------------------------------------------------------------------------

    Final Rule 2-01(c)(5) defines a contingent fee as any 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. Contingent fees 
include commissions and similar payments. Consistent with the AICPA 
rules, our definition of ``contingent fees'' contains an exception for 
fees fixed by courts or other public authorities, or, in tax matters, 
fees determined based on the results of judicial proceedings or the 
findings of governmental agencies. We have added the AICPA's exception 
for fees, in tax matters, determined based on the results of judicial 
proceedings or the findings of governmental agencies. This exception is 
based, in part, on the position that when the fee is determined not by 
the parties but by courts or government agencies acting in the public 
interest, it is less likely that such fees will be used to create a 
mutual financial interest between the auditor and audit client. This 
exception also acknowledges that, as explained above, tax services 
generally do not create the same independence risks as other non-audit 
services.
    In response to comments, we have eliminated from the rule text the 
language regarding ``value added'' fees. Some commenters represented 
that accounting firms sometimes receive fees where the client 
determines at the end of the engagement whether the services rendered 
warrant an additional fee, but there is no agreement (written or 
otherwise) for the audit client to pay the additional fee. In these 
situations, the client, at its complete discretion, determines at the 
end of the performance period that the accountant provided services 
that had greater value than the amount due under the contract. That 
type of ``value added'' fee is not within the scope of the 
prohibition.\440\
---------------------------------------------------------------------------

    \440\ As Ray J. Groves, former Chairman and CEO, Ernst & Young 
testified, ``It does not impair independence to reward a 
professional who excels in his or her performance, or who exceeds 
reasonable expectations.'' Written Testimony of Ray J. Groves (July 
26, 2000).
---------------------------------------------------------------------------

    On the other hand, the staff will look closely to determine whether 
a fee labeled a ``value added'' fee is in fact a contingent fee, such 
as where there are side letters or other evidence that ties the fee to 
the success of the services rendered. For example, as discussed in the 
Proposing Release, an auditor might 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. In that case, the 
accounting firm's economic benefit will be greater if the tax credits 
are maximized. Because this interest (in the economic benefit) is 
inconsistent with acting independently in assessing the accuracy of the 
impact on the income tax accounts and financial statements of the tax 
credits, those kinds of fee arrangements are prohibited under the final 
rule.

E. Quality Control Provisions

    We recognize that situations may arise where an accountant's 
independence becomes impaired inadvertently, such as where a family 
member makes an investment of which the covered person is not aware. 
Paragraph (d) addresses those situations. We are adopting a limited 
exception pursuant to which inadvertent violations of these rules by 
covered persons will not make the accounting firm not independent if 
the accounting firm maintains certain quality controls and satisfies 
other conditions. The effect of this provision is that an accounting 
firm that has appropriate quality controls will not be deemed to lack 
independence when an accountant did not know of the circumstances 
giving rise to the impairment and, upon discovery, the impairment is 
quickly resolved.
    As we explained in the Proposing Release, strong quality controls 
deter, detect, and provide a means to address impairments of an 
auditor's independence. Our staff has stated repeatedly that it is 
concerned that firms, particularly larger firms, may lack appropriate 
worldwide quality controls.\441\ The staff has urged certain firms to 
review and modernize existing procedures.\442\
---------------------------------------------------------------------------

    \441\ See Letter from Lynn Turner, Chief Accountant, SEC, to 
Charles Bowsher, Chairman, POB (Dec. 9, 1999); see, e.g., In the 
Matter of PricewaterhouseCoopers, LLP, AAER No. 1098 (Jan. 14, 
1999).
    \442\ See Letters from Lynn Turner, Chief Accountant, SEC, to 
Michael Conway, Chairman, SECPS Executive Committee (Nov. 30, 1998; 
Dec. 8, 1999; May 1, 2000).
---------------------------------------------------------------------------

    Many firms have designed and implemented quality controls or are 
doing so now. In that regard, several commenters wrote that because 
firms already have quality control procedures in place, there is no 
need for this provision.\443\ Other commenters supported the provision 
and asked us to adopt it.\444\ We are adopting this limited exception 
to the general principle that attributes to an entire firm independence 
impairments of individual accountants. We proposed such a limited 
exception in the belief that adequate quality controls would limit the 
occasions in which the exception would come into play. Without such a 
requirement, we fear that the incidence of individual violations would 
be much greater.
---------------------------------------------------------------------------

    \443\ AICPA Letter; Deloitte & Touche Letter; KPMG Letter; 
Letter of Jodi L. McFall, CPA (Sept. 1, 2000); Letter of Electronic 
Data Systems (Sept. 11, 2000); Letter of William Tourville, CPA 
(Sept. 14, 2000); Letter of Gary Whitsell (Sept. 19, 2000).
    \444\ Letter of Thomas Graves (July 18, 2000); Letter of the FEE 
(Sept. 25, 2000).
---------------------------------------------------------------------------

    Paragraph (d) provides that an accounting firm's independence will 
not be impaired solely because a covered person in the firm is not 
independent, as long as three conditions are met. First, the covered 
person must not have known of the circumstances giving rise to the lack 
of independence. The proposed rule provided that to take advantage of 
the exception, the firm must show that the covered person did not know, 
and was ``reasonable in not knowing,'' of the circumstances giving rise 
to the impairment. One commenter suggested eliminating this language 
because, once a firm implements a quality control system envisioned in 
the rule (with automated tracking of investments, ongoing training, and 
inspections and monitoring programs), a person may never be deemed to 
be ``reasonable'' in not knowing the circumstances giving rise to an 
impairment, and the exception would never be available.\445\ 
Accordingly, we have revised the first condition to apply when the 
covered person did not know of the circumstances giving rise to the 
impairment.
---------------------------------------------------------------------------

    \445\ See Ernst & Young Letter.
---------------------------------------------------------------------------

    The second condition is that the covered person's lack of 
independence was corrected as promptly as possible under the relevant 
circumstances after the covered person, or the firm, became aware of 
it. Several commenters suggested adding the phrase ``under the relevant 
circumstances.''\446\ We agree that this change is appropriate because 
whether an action is ``prompt'' depends, at least in part, on the 
surrounding circumstances. In light of this change, however, we also 
have revised this provision so that the lack of independence must be 
corrected as

[[Page 76053]]

promptly as possible under the relevant circumstances.
---------------------------------------------------------------------------

    \446\ See, e.g., Ernst & Young Letter.
---------------------------------------------------------------------------

    The third condition is that the accounting firm must have a quality 
control system in place that provides ``reasonable assurance'' that the 
firm and its employees do not lack independence. As we stated in the 
Proposing Release, we believe that a quality control system is the 
first line of defense to guard against independence impairments. We 
understand that accounting firms vary greatly. The rule we are 
adopting, as proposed, explicitly states that the quality control 
provisions may take into account the size and nature of the firm's 
practice.
    In the Proposing Release, we stated that a firm's quality controls 
should apply to the firm and its affiliates worldwide,\447\ and we 
solicited comment about whether a firm's quality controls should be 
this comprehensive. We received useful comments about the applicability 
of this provision to foreign affiliates.\448\ Because we have 
eliminated the definition of affiliate of the accounting firm, however, 
we have modified the third provision to state that the quality controls 
must cover at least all employees and associated entities of the 
accounting firm participating in the engagement, including employees 
and associated entities located abroad. While we do not necessarily 
expect a firm making use of the limited exception to demonstrate that 
it has implemented appropriate quality control systems in each of its 
offices worldwide, the rule requires that, to avail itself of the 
limited exception, the firm must have quality control systems that 
cover each employee and associated entity participating in the 
engagement for which independence was impaired.
---------------------------------------------------------------------------

    \447\ Proposing Release, n. 192.
    \448\ See Ernst & Young Letter (acknowledging that the 
requirement applies worldwide).
---------------------------------------------------------------------------

    Several commenters stated that while it is appropriate for the 
Commission to examine whether a firm or a covered person is 
independent, we should not prescribe quality controls.\449\ The rule 
does not require any firm to adopt quality controls.\450\ Rather, for 
the reasons stated above, it makes adequate quality controls a 
prerequisite for a limited exception where the firm otherwise would be 
deemed not independent.
---------------------------------------------------------------------------

    \449\ See KPMG Letter; Letter of KPMG Europe (Sept. 22, 20000).
    \450\ GAAS already requires firms to have quality controlls for 
their audit practices and refers auditors to the ``Statements on 
Quality Control Standards'' (``SQCS'') for guidance regarding the 
elements of those systems. AICPA SAS No. 25; AU section 161.
---------------------------------------------------------------------------

    Rule 2-01(d)(4) describes the elements of a quality control system 
that large accounting firms--those with more than 500 SEC registrants 
as audit, review, or attest clients--must have in place to qualify for 
the limited exception.\451\ Many of the elements are set forth in a 
1999 letter from the staff to the SECPS.\452\ While the rule as adopted 
requires only the larger firms to implement these elements to qualify 
for the limited exception, we note that some of these elements may be 
suitable for other firms as well. We discuss the elements below.
---------------------------------------------------------------------------

    \451\ We considered whether to use the number of firm 
professionals, instead of the number of SEC registrants, to 
determine which firms are required to implement the quality controls 
in Rule 2-01(d) to qualify for the limited exception. See SECPS 
Manual Sec. 1000.46. We use number of SEC registrants because we are 
particularly concerned with those firms that audit a large number of 
SEC registants, regardless of the number of professionals, and 
because we can more easily verify the number of SEC registrants 
audited by a firm.
    \452\ Letter from Lynn Turner, Chief Account, SEC, to Michael 
Conway, Chairman, SECPS Executive Committee (DEC. 9, 1999).
    \453\ See, e.g., Letter of KPMG Europe (Sept. 22, 2000).
---------------------------------------------------------------------------

1. Written Independence Policies and Procedures
    The largest firms' independence policies and procedures must be 
reduced to writing. As we stated in the Proposing Release, we expect 
the policies and procedures to be comprehensive, to cover all 
professionals in the accounting firm, and to address all aspects of 
independence, including financial, employment, and business 
relationships, as well as fee arrangements.
2. Automated Systems
    Large firms must have automated systems to identify investments 
that may impair independence. In our proposal, this provision applied 
to all employees in the firm. Commenters stated, however, that it may 
not be necessary for the automated quality control system to include 
the financial investments of persons below the managerial level. 
Commenters also stated that it may be difficult to establish a system 
to identify all financial relationships that might impair 
independence.\453\ These commenters suggested revising the provision 
for an automated tracking system to apply only to partners and 
managerial employees, while adding a provision providing for timely 
dissemination of information about its current list of audit clients to 
all professionals.\454\ We agree with these commenters that non-
managerial employees have less control over the audit process and, 
therefore, need not be included in the automated system. However, to 
meet this limited exception, a firm's quality control system must 
provide reasonable assurance that nonpartners and managerial employees 
are complying with the applicable independence rules. We also have 
clarified the scope of the required automated system, by changing the 
words ``financial relationships'' to ``investments in securities.'' 
Accordingly, an automated system would not need to track covered 
persons' ``other financial interests,'' such as brokerage and credit 
card accounts, to qualify for this limited exception. We also note 
that, for purposes of monitoring compliance with our rule on 
``material'' indirect investments, an automated system need not track 
covered persons' net worth to determine if an indirect investment is 
material to that person. Nonetheless, such a system must provide some 
means of identifying indirect investments that might impair 
independence under the material indirect investment rule.
---------------------------------------------------------------------------

    \454\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

3. Timely Information
    In light of the changes made to the requirement for automated 
systems, we added a provision that applies to all professionals. The 
quality controls of a large firm taking advantage of the limited 
exception must include a system that provides timely information about 
the entities from which the accountant must be independent. We expect 
that this system, for example, would contain current and accurate 
information about audit, review, and attest clients of the accounting 
firm and the affiliates of those audit clients. All professionals 
should be able quickly to determine whether an investment they are 
about to make may cause the independence of the firm to be impaired.
4. Training
    Large firm quality controls also must include annual or ongoing 
firm-wide training about auditor independence, and we are adopting this 
provision as proposed. Each professional in a large accounting firm 
should be able to demonstrate competence with respect to professional 
standards, legal requirements, and firm policies and procedures.

[[Page 76054]]

5. Internal Inspection and Testing
    For a large firm to qualify for the limited exception, its quality 
controls must include an internal inspection and testing program to 
monitor adherence to the independence requirements of the profession, 
standard setters, and other regulatory bodies. This would entail 
procedures to audit, on a test basis, information submitted by 
employees and partners and information in a client investment database. 
Firms also should monitor the investments of the firms themselves and 
their pension and retirement plans, and any business arrangements with 
their audit clients.
6. Notice of Names of Senior Management Responsible for Independence
    We also proposed 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. We are adopting this 
provision as proposed.
7. Prompt Reporting of Employment Negotiations
    The quality control system of a large firm must 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 firm also should have appropriate procedures to 
remove immediately such a professional from an audit client's 
engagement and review the professional's work related to that audit 
client. In addition, we believe such engagements should be selected for 
peer review. As proposed, this provision would have applied to all firm 
professionals. Commenters, however, suggested that the provision should 
apply only to partners and covered persons.\455\ Because of the number 
of professionals employed by the larger firms, and because we are most 
concerned with individuals who may affect the audit, we have revised 
this provision to apply only to partners and covered persons.
---------------------------------------------------------------------------

    \455\ See Ernst & Young Letter; PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

8. Disciplinary Mechanism
    As we proposed, the quality control system of a large firm also 
must have a disciplinary mechanism to ensure compliance. One commenter 
stated that a disciplinary mechanism may only promote compliance, but 
cannot ensure it.\456\ Although no system can guarantee 100% compliance 
in all circumstances, a firm's quality controls should be designed and 
implemented to ensure compliance, not merely to promote it. We are, 
therefore, adopting this language as proposed.
---------------------------------------------------------------------------

    \456\ Letter of KPMG Europe (Sept. 22, 2000).
---------------------------------------------------------------------------

    Several commenters noted that firms operating overseas may be 
prohibited from requesting certain information based on local 
restrictions on information gathering, or they may be required to amend 
an employee's employment contract before doing so.\457\ We are 
sensitive to these concerns and we have responded, in part, by 
providing for a long transition period for accountants operating 
abroad, as discussed below. In any event, the SECPS has required member 
firms to implement quality controls, including many of these 
provisions.\458\ If a firm is unable to apply its quality controls to 
offices outside the U.S., it may be unable to take advantage of the 
limited exception we are adopting.
---------------------------------------------------------------------------

    \457\ See Ernst & Young Letter; Letter of Ernst & Young, U.K. 
(Sept. 7, 2000); Letter of KPMG Europe (Sept. 22, 2000); Deloitte & 
Touche Letter.
    \458\ See Letter from Michael A. Conway, Chairman, SECPS 
Executive Committee, to the Managing Partners of the SECPS Member 
Firms (April 2000).
---------------------------------------------------------------------------

F. Transition and Grandfathering

1. Transition
    a. Appraisal or Valuation Services or Fairness Opinions, and 
Internal Audit Services. We proposed that, for the two years following 
the effective date of Rule 2-01, providing to an audit client certain 
non-audit services identified in the rule would not impair the 
accountant's independence if the services were provided under an 
existing contract and performing the services would not impair the 
accountant's independence under existing requirements. As discussed 
above, we modified eight of the non-audit service provisions proposed 
to parallel or draw from current independence requirements regarding 
these services. Because the restrictions embodied in these provisions 
now more closely parallel current restrictions, we assume that 
accountants currently comply with them.
    With respect to appraisal or valuation services or fairness 
opinions and internal audit services, however, we are providing for a 
longer transition because the new rule extends beyond current 
restrictions. Final Rule 2-01(e)(1)(i) provides that an accountant's 
independence will not be impaired if the accountant continues for up to 
eighteen months to provide to an audit client these services, so long 
as the services did not impair the accountant's independence under pre-
existing independence requirements.
    We recognize that adoption of these and other provisions might 
require a registrant to decide between continuing to engage its 
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. Consequently, with respect to the two identified 
non-audit services, the final rule provides for an eighteen-month 
transition.
    Under the transition provision proposed, accounting firms could not 
have entered into any new non-audit service contracts with their audit 
clients without impairing their independence. In response to 
commenters' concerns that the viability of these lines of business 
could be called into question if they were prohibited from entering 
into new contracts, we modified the provision to allow firms the 
flexibility to make business decisions over the next eighteen months 
that, in light of the new rule, are appropriate for their firms.
    Final Rule 2-01(e)(1)(i), however, requires performance on any 
contracts inconsistent with the non-audit service provisions to be 
completed within eighteen months of the effective date of the final 
rule. To the extent that work on current contracts and contracts 
entered into within eighteen months of the effective date cannot be 
completed before the non-audit service provisions of the final rule 
take effect, accountants must take whatever steps are necessary to 
ensure that, at the end of the eighteen-month transition period, they 
are not providing any non-audit services inconsistent with final Rule 
2-01.
    b. Other Financial Interests and Employment Relationships. Rule 2-
01(e)(1)(ii) provides for a three-month transition for certain of the 
financial interest rules (paragraph (c)(1)(ii)) and all of the 
employment provisions (paragraph (c)(2)) in the final rule. We are 
providing a transition period for these provisions because Rule 2-01 
modestly expands current restrictions on certain accounting firm 
personnel in these areas. Because accounting firms may, therefore, need 
time to educate their employees and provide guidance on the new rule, 
we are providing a transition period of three months after the 
effective date of the rule.

[[Page 76055]]

    c. Quality Control Systems. As discussed at length above, 
accounting firms can take advantage of the limited exception to the 
independence requirements provided by paragraph (d) of the rule, if 
they have in place a quality control system that, based on several 
factors, ``provides reasonable assurance'' that the firm and its 
employees do not lack independence. Under Rule 2-01(d)(4), the quality 
control systems of accounting firms that provide audit, review or 
attest services to more than 500 SEC registrants will not be considered 
to provide reasonable assurance of independence, unless the systems 
have certain characteristics. We are providing a transition provision 
that applies to the implementation date for the specific elements of a 
quality control system as described in paragraph (d)(4) of the rule.
    Recently adopted SECPS provisions require quality controls 
substantially similar to those described in paragraph (d)(4).\459\ 
Because these SECPS requirements are effective December 31, 2000, which 
precedes the effective date for the Commission's final rule, no 
transition date for paragraph (d)(4) is necessary for domestic 
accounting firms. By the date that this rule becomes effective, SECPS 
member firms should have appropriate quality control systems in place.
---------------------------------------------------------------------------

    \459\ SECPS Manual Sec. 1000.46 (April 2000).
---------------------------------------------------------------------------

    In the Proposing Release, however, we noted that foreign offices, 
or foreign ``associated'' or ``sister'' firms, of domestic firms may 
require additional time to develop and implement quality control 
systems that satisfy the requirements of paragraph (d)(4). We solicited 
comment on whether foreign offices, accordingly, should be afforded a 
transition period to phase in the quality control systems necessary to 
take advantage of the limited exception provided by the rule. Some 
commenters suggested that because establishing and implementing quality 
controls to apply worldwide would be difficult, we should provide for a 
long transition period.\460\ In response to these comments, we 
determined to give accounting firms' foreign offices until December 31, 
2002 to implement the quality controls described by the final rule.
---------------------------------------------------------------------------

    \460\ Ernst & Young Letter (suggesting a three-year transition 
period); Letter of Ernst & Young U.K. (Sept. 7, 2000).
---------------------------------------------------------------------------

    We believe that investors in our capital markets should have the 
right to expect that the same quality controls over a firm's adherence 
to the independence requirements apply irrespective of where the audit, 
or where parts of the audit, take place. The two-year transition period 
strikes a reasonable balance between the need for improved quality 
control systems by all offices participating in an audit and the 
practical problems inherent in implementing these controls abroad.
    As a result of this transition provision, before January 1, 2003, 
if a domestic firm with more than 500 SEC registrants as audit clients 
seeks to avail itself of the limited exception in paragraph (d), it 
must have a quality control system that complies with paragraph (d)(4) 
and any foreign office of the firm (or foreign associated or sister 
firm) participating in the audit of that company must have a system 
that provides reasonable assurance of independence, as required by 
paragraph (d)(3). After December 31, 2002, the foreign office (or 
foreign associated or sister firm) also must comply with the 
requirements in paragraph (d)(4).
2. Grandfathering
    The rule provisions related to loans, insurance products, and 
employment relationships take effect three months after the effective 
date of the rule. Under the new rule, absent a grandfathering 
provision, a limited number of accountants or their family members 
might have been required, for example, to refinance a mortgage loan 
with an audit client or to leave their current employment with an audit 
client, in order for the auditor to remain independent. Because we 
would expect it to be more problematic in some cases for auditors and 
their family members to refinance a loan or to obtain a replacement 
insurance policy than, for example, for them to obtain a new credit 
card (from a non-audit client), we have grandfathered these 
relationships in Rule 2-01(e)(2), provided that these relationships do 
not impair independence under existing requirements. The AICPA 
similarly grandfathered certain loans that auditors and their family 
members had with audit clients when it revised its independence 
requirements related to loans in November 1991.\461\ Accordingly, under 
the final rule, auditors and their relatives should not have to alter 
their loan agreements, change insurance policy providers, or require 
family members to find different employment for the accountant to 
maintain his or her independence.
---------------------------------------------------------------------------

    \461\ AICPA Ethical Standard ET Sec. 101.07 (grandfathering 
certain loans that existed as of January 1, 1992).
---------------------------------------------------------------------------

    Likewise, we have grandfathered contracts for the provision of 
financial information systems design and implementation in existence on 
the effective date of the rule. The information technology rule we 
adopt today imposes five conditions on these services, but we believe 
it would be unfair to require auditors providing these services to 
their audit clients under existing contracts to satisfy these 
conditions. We do not, however, believe that the conditions are so 
onerous as to warrant a transition period for new contracts. 
Accordingly, we are grandfathering contracts that are in place on the 
effective date of the rule, but requiring all contracts entered after 
the effective date of the rule to meet the conditions imposed by Rule 
2-01(c)(4)(ii)(B).
3. Settling Financial Arrangements with Former Professionals
    As discussed above, under Rule 2-01(c)(2)(iii), an accounting firm 
will not be considered independent of an audit client if a former 
employee of the firm has an ``accounting role or financial reporting 
oversight role'' at the audit client and the firm and the former 
employee have a financial arrangement that does not satisfy the 
requirements set forth by Rule 2-01(c)(2)(iii). Rule 2-01(e)(3) 
provides that, notwithstanding Rule 2-01(c)(2)(iii), an accounting firm 
will not lose its independence with respect to an audit client if the 
former employee with whom it maintains a financial arrangement 
inconsistent with Rule 2-01(c)(2)(iii) assumed an accounting or 
financial reporting oversight role at the audit client prior to the 
effective date of this rule. With respect to former firm employees who 
join an audit client in such a role after the effective date of this 
rule, however, the firm must ensure that the requirements of paragraph 
(c)(2)(iii) are met in order to maintain its independence with respect 
to the audit client. We are including this provision, which essentially 
grandfathers existing employment relationships between former audit 
firm employees and audit clients, because our intention was not to 
require former firm employees who are currently in accounting or 
financial reporting oversight roles at audit clients to leave their 
positions to preserve the accounting firm's independence.

G. Proxy Disclosure Requirement

    We proposed to require disclosure of certain information regarding, 
among other things, non-audit services provided by the registrant's 
auditor to the registrant. We solicited comment on whether the proposed 
disclosures would be useful to investors. As noted above, most 
commenters addressing the issue supported a disclosure

[[Page 76056]]

requirement, though several raised concerns with elements of the 
proposal.\462\ We believe that with the disclosures we are adopting, 
investors will be better able to evaluate the independence of the 
auditors of the companies in which they invest.\463\ Accordingly, we 
are requiring companies to provide certain disclosures, but we have 
modified the proposed disclosure requirement as discussed below.\464\ 
Our disclosure requirement has three components: (1) Disclosure 
regarding fees billed for services rendered by the principal 
accountant; (2) disclosure regarding whether the audit committee 
considered the compatibility of the non-audit services the company 
received from its auditor and the independence of the auditor; and (3) 
disclosure regarding the employment of leased personnel in connection 
with the audit.
---------------------------------------------------------------------------

    \462\ See supra note 25.
    \463\ See Earnscliffe II, supra note 38, at 45, which states, 
``Most people sensed that the relationship between the auditor and 
auditee was appropriate, typically neither too close nor tension-
ridden. The one area of greater concern had to do with the provision 
of non-audit services to audit clients, where participants felt 
unsettled and discomfited. Avoidance of this practice seemed 
preferred, but disclosure was seen as a helpful alternative step as 
well.''
    \464\ The disclosure requirement pertains to the accounting firm 
that is the registrant's principal accountant. The principal 
accountant generally is the accounting firm that takes 
responsibility for the report on the financial statements of the 
registrant for each year presented. See SEC Division of Corporation 
Finance, ``Accounting Disclosure Rules and Practices: An Overview,'' 
Topic Four, I.D. (Mar. 31, 2000).
---------------------------------------------------------------------------

1. Disclosure of Fees
    The final proxy disclosure rule, like the proposal, requires 
registrants to aggregate and disclose the fee paid for the annual audit 
and for the review of the company's financial statements included in 
the company's Forms 10-Q or 10-QSB for the most recent fiscal 
year.\465\ In light of the other modifications described below, we are 
requiring this fee disclosure under a caption entitled ``Audit Fees.''
---------------------------------------------------------------------------

    \465\ See proposed Rule 14a-101 Item 9(e)(4); Rule 10-01(d) of 
Regulation S-X and Item 310 of Regulation S-B, 17 CFR 210.10-01, 
228.310(b).
---------------------------------------------------------------------------

    We proposed to require registrants to describe each professional 
service, other than audit services, provided by their principal 
accountants during the most recent fiscal year, and to disclose the fee 
for each of these professional services; however, under the proposed 
disclosures, a registrant would not have had to describe the service or 
disclose the fee if the fee for the service was less than the lesser of 
$50,000 or ten percent of its audit fee. We solicited comment on the 
scope of this proposed disclosure. Several commenters believed that 
this proposed disclosure was too detailed. At least one commenter 
worried that the detailed disclosure requirement could place 
registrants at a competitive disadvantage when, for example, they 
disclose that the audit firm was retained to conduct due diligence in 
connection with a possible acquisition.\466\ Other commenters suggested 
that a simpler disclosure, focused on the aggregate amount of non-audit 
and audit services provided to a company by its auditor, would be more 
useful to investors.\467\ We were persuaded by these arguments and, 
accordingly, we are adopting a more limited disclosure requirement.
---------------------------------------------------------------------------

    \466\ Ernst & Young Letter.
    \467\ PricewaterhouseCoopers Letter; Ernst & Young Letter; 
Testimony of J. Michael Cook, former Chairman and Chief Executive 
Officer, Deloitte & Touche (July 26, 2000); Testimony of Philip D. 
Ameen, Chair, Committee on Corporate Reporting, FEI-CRR (Sept. 20, 
2000).
---------------------------------------------------------------------------

    Under the final rule, we are not requiring registrants to describe 
each professional service or to disclose the fee for each service. 
Instead, we are requiring that registrants disclose under the caption, 
``Financial Information Systems Design and Implementation Fees,'' the 
aggregate fees billed for services of the type described in final Rule 
2-01(c)(4)(ii)(B)(information technology services) \468\ rendered by 
the registrant's principal accountant during the most recent year, and, 
under the caption ``All Other Fees,'' the fees billed for all other 
non-audit services, including fees for tax-related services, rendered 
by the principal accountant during the most recent year.
---------------------------------------------------------------------------

    \468\ See supra Section IV.D.4.b(ii). The services described in 
Rule 2-01(c)(4)(ii)(B) relate to systems that aggregate source data 
underlying, or generate information significant to, the financial 
statements, which may be a particular concern to investors. See 
Earnscliffe I, supra note 65, at 24, which states, ``Some felt that 
installing computer systems was not a problem * * * others argued 
that if the computer system had anything to do with the financial 
reporting systems * * * then the auditor would be in serious 
conflict.'' The required disclosure will permit investors to decide 
whether such services create independence concerns.
---------------------------------------------------------------------------

    Although some commenters suggested that we require disclosure only 
of the aggregate fees billed by the principal accountant for audit and 
for non-audit services, we are, in essence, requiring registrants to 
break non-audit services into two categories--one category focused on 
information technology services and one category encompassing all other 
non-audit services. As discussed above, our concern with information 
technology services relates both to the relative size of non-audit fees 
to audit fees and the value of the services themselves.\469\ Our two-
pronged approach responds to both of these concerns.
---------------------------------------------------------------------------

    \469\ See Earnscliffe I, supra note 65, at 26, which describes 
responses to a scenario when the annual audit fee was $1 million and 
the auditor performed computer system work for $10 million, which 
was 1% of the auditor's annual revenues, and states, ``First off, 
the sheer size of the contract was seen as a potential perception 
challenge. Even though $10 million might be good value for the 
client, and only a tiny fraction of the audit firm's business, there 
was a sense of doubt that the firm would be willing to walk away 
from such a relationship, if that were necessary to protect the 
independence of the audit.''
---------------------------------------------------------------------------

    We are also requiring disclosure of fees billed for non-audit 
services, other than information technology services, rendered by the 
principal accountant in the last fiscal year. While we proposed to 
require disclosure of fees for each service as discussed above, we have 
determined to require only disclosure of aggregate fees billed for non-
audit services, excluding information technology services. As noted 
above, commenters generally favored more simple disclosure, believing 
it is more useful to investors. In requiring disclosure of aggregate 
fees, we are adopting a disclosure requirement that is similar to the 
disclosure that the United Kingdom has required since 1989. As 
discussed in the Proposing Release, since 1989, the British government 
has required companies to disclose their annual audit fee and fees paid 
to their auditor for non-audit services.\470\ ``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.''\471\
---------------------------------------------------------------------------

    \470\ Companies Act 1985, Part XI, Chapter V, Auditors, 
Sec. 390B, ``Remuneration of Auditors and Their Associates for Non-
audit Work,'' and Regulations 1991, Sec. 5, ``Disclosure of 
Remuneration for Non-Audit Work.'' See generally Written Testimony 
of Graham Ward, Institute of Chartered Accountants of England and 
Wales (``ICAEW'') (Sept. 13, 2000).
    \471\ 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 sample data came from the 500 largest 
British industrial, listed companies. Firth's findings were 
consistent with his hypothesis.
---------------------------------------------------------------------------

    Some have argued that disclosure should be our sole response to 
auditor independence issues and that we should adopt no additional 
rules, noting that this is the regulatory scheme in the

[[Page 76057]]

U.K.\472\ As we discussed above, we have determined to adopt a two-
pronged approach--disclosure plus restrictions on the provision of 
certain non-audit services. The U.K. disclosure rules are just one 
piece of a larger regime in the U.K. to address auditor independence 
issues. The self-regulatory authority in the U.K. has a majority of 
public members and generally exercises broad examination 
authority.\473\ An ``independent practice inspection unit'' sends 
inspectors to the 20 largest accounting firms (who audit ninety percent 
of the companies listed on the London FTSE) every year to examine the 
accounting firms for independence issues.\474\ The differences in the 
U.K. and U.S. regulatory schemes and self-regulatory approaches 
highlight the need for our two-pronged approach--disclosure plus 
restrictions on the provision of certain non-audit services.
---------------------------------------------------------------------------

    \472\ See Arthur Andersen Letter.
    \473\ See Department of Trade and Industry, ``A Framework of 
Independent Regulation for the Accounting Profession,'' Paras.  29, 
35, 39, 44, and 46 (Nov. 1998).
    \474\ Testimony of Graham Ward, ICAEW (Sept. 13, 2000).
---------------------------------------------------------------------------

    We requested comment on whether, in the case of investment 
companies, the rule should extend beyond the registrant to require the 
disclosures as to all entities in the investment company complex. One 
commenter suggested that applying the proxy disclosure requirements to 
the investment company complex would be of limited utility to 
investors, particularly where the adviser's parent company is an 
entity, such as a bank, broker-dealer or insurance company whose 
operations are completely separate from the investment adviser and the 
registrant. The commenter suggested requiring disclosure only of the 
aggregate fees billed for information technology services and other 
non-audit services provided to certain other service providers in the 
investment company complex.\475\
---------------------------------------------------------------------------

    \475\ ICI Letter.
---------------------------------------------------------------------------

    We recognize that it could be confusing to provide investors with 
disclosure concerning audit and non-audit services for all entities 
(including all the funds) within the investment company complex. We 
believe, however, that the ability to compare the registrant's audit 
fee with the aggregate fees billed for non-audit services provided to 
all the entities that operate an investment company would be useful for 
investors in evaluating the independence of the investment company's 
auditor. Because the adviser plays an integral role in managing and 
overseeing the investment company, we believe the fees billed for non-
audit services provided to a fund's adviser are relevant and should be 
disclosed. In addition, various service providers to the investment 
company are in a control relationship with the adviser. We believe that 
investors should be informed of the aggregate amount of the 
registrant's audit fee and the fees billed for information technology 
services and other non-audit services provided by the independent 
principal accountant to these service providers.
    As a result, the proxy rules require investment companies to 
disclose a fund's audit fee and the aggregate fees billed for 
information technology and other non-audit services provided by the 
registrant's auditors to the registrant, its adviser, and entities in a 
control relationship with the adviser that provide services to the 
registrant. This approach will provide investors with pertinent 
information about the relationship between the fund's auditor and other 
entities in the investment company complex.
2. Audit Committee Disclosure
    As discussed above, audit committees play an important role in 
overseeing the financial reporting process and the auditor's 
independence. We proposed to require that companies disclose in their 
proxy statements whether, before each disclosed non-audit service was 
rendered, the company's audit committee approved, and considered the 
effect on independence of, such service provided by the company's 
principal accountant. Several commenters encouraged us to wait until 
the full effects of recently enacted audit committee reforms are known, 
in particular the effects of ISB Standard No. 1, the new exchange 
listing rules, and our recent audit committee disclosure rules. 
However, we think that the disclosure requirements that we are adopting 
will complement those initiatives by encouraging audit committees to 
focus particular attention on scope of services issues.
    We have modified the proposed disclosure to require disclosure only 
of whether the audit committee considered whether the principal 
accountant's provision of the information technology services and other 
non-audit services to the registrant is compatible with maintaining the 
principal accountant's independence.\476\ In light of the 
recommendations adopted by the O'Malley Panel and the other audit 
committee reforms,\477\ we believe that companies will be providing 
useful information to investors under the modified requirement. 
Investors will be aided by knowing whether the company's audit 
committee considered whether the provision of non-audit services by the 
company's principal accountant is compatible with maintaining the 
accountant's independence. We are requiring issuers to disclose only 
whether the audit committee considered whether the principal 
accountant's provision of non-audit services is compatible with 
maintaining the principal accountant's independence. We are not 
requiring issuers to disclose the conclusions of the audit committee 
deliberations. Accordingly, we see little possibility of private 
liability arising from these disclosures.
---------------------------------------------------------------------------

    \476\ We note that audit committees currently receive 
information about the auditor's provision of non-audit services 
under ISB Standard No. 1 and SECPS Manual Sec. 1000.08. See ISB 
Standard No. 1, supra note 167; SECPS Manual Sec. 1000.08 (requiring 
the auditor to report annually to the audit committee or board of 
directors (or its equivalent in a partnership) of SEC registered 
audit clients on the ``total fees received from the client for 
management advisory services during the year under audit and a 
description of the types of such services rendered'').
    \477\ 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 Panel Report, supra note 20, at para. 5.30.
---------------------------------------------------------------------------

3. Leased Employees
    Under the final amendments, a company will have to disclose, if 
greater than fifty percent of the hours expended on the audit 
engagement, the percentage of hours expended by personnel the principal 
auditor leased or otherwise acquired from another entity. This 
disclosure requirement responds to a recent trend by some 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 
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, as well.\478\ 
We believe that investors

[[Page 76058]]

should be informed of arrangements whereby most of the auditors who 
work on an audit are employed elsewhere.\479\
---------------------------------------------------------------------------

    \478\ 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).
    \479\ 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.
---------------------------------------------------------------------------

4. Proxy Statement
    Finally, under the final rules, companies must provide the 
disclosures we are requiring in their proxy and information statements. 
We solicited comment on whether the disclosure should instead be 
required in the Form 10-K. Some commenters said that the disclosure 
should be made in the Form 10-K,\480\ with some commenters expressing 
concern that the proxy statement will become overloaded with 
information. Other commenters expressed a preference for the disclosure 
to be in proxy statements.\481\ We have determined that the proxy 
statement is the appropriate place for the disclosure since 
shareholders often vote on whether to select or ratify the selection of 
the auditors.\482\ Companies must provide the disclosure only in the 
proxy statement relating to an annual meeting of shareholders at which 
directors are to be elected (or special meeting or written consents in 
lieu of such meeting). This disclosure is not required for companies 
reporting solely under Section 15(d) of the Exchange Act \483\ since 
they are not subject to our proxy rules. Similarly, this disclosure 
will not be required to be provided by foreign private issuers \484\ 
since they have different corporate governance regimes and are not 
subject to our proxy rules.
---------------------------------------------------------------------------

    \480\ See, e.g., Testimony of Robert E. Denham, Member, ISB 
(July 26, 2000) (recommending that disclosure be put in footnotes to 
the financial statements or in the Form 10-K).
    \481\ See, e.g., Letter of Peter C. Clapman, Senior Vice 
President and Chief Counsel, Investments, TIAA-CREF (Sept. 21, 
2000).
    \482\ See Item 9 of Schedule 14A. 17 CFR 240.14a-101.
    \483\ 15 U.S.C. 78(d).
    \484\ ``Foreign private issuer'' is defined in Securities Act 
Rule 405 (17 CFR 230.405) and Exchange Act Rule 3b-4 (17 CFR 240.3b-
4).
---------------------------------------------------------------------------

    Companies must comply with the new proxy and information statement 
disclosure requirements for all proxy and information statements filed 
with us after the effective date.

H. Definitions

    As we proposed, we are including definitions of some of the key 
terms used in Rule 2-01 in paragraph (f) of the Rule. In this section 
of the release, we provide a more detailed explanation of those defined 
terms not discussed in the preceding sections. We have made clear in 
the rule we adopt that paragraph (f) provides definitions only for the 
purposes of Rule 2-01 and not for other sections of Regulation S-X.
    1. ``Accountant''
    We are adopting, as proposed, Rule 2-01(f)(1) that defines the term 
``accountant.'' The rules are written in terms of an accountant's 
independence from the audit client. The definition of ``accountant'' 
includes the accounting firm in which the auditor practices. The 
definition makes clear that an individual accountant's lack of 
independence may be attributed to the firm.
    2. ``Accounting Firm''
    We are adopting the definition of ``accounting firm'' in Rule 2-
01(f)(2) with two modifications from the version proposed. As adopted, 
``accounting firm'' means ``an 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 and 
furnishes reports or other documents filed with the Commission or 
otherwise prepared under the securities laws, and all of the 
organization's departments, divisions, parents, subsidiaries, and 
associated entities, including those located outside of the United 
States.'' The definition also expressly includes ``the organization's 
pension, retirement, investment or similar plans.''
    The first modification is solely to clarify the definition. We have 
simplified the description of what public accounting firms are covered 
under our rule by referring only to those that ``furnish reports or 
other documents filed with the Commission or otherwise prepared under 
the securities laws.'' We believe that this description captures the 
accounting firms subject to our independence requirements. No 
substantive change from the rule as proposed is intended.
    The second change is more significant. As proposed, the definition 
of ``accounting firm'' included ``affiliate of the accounting firm.'' 
The term ``affiliate of the accounting firm'' was separately defined to 
include a broad group of entities that are either 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. Specifically, we defined as an ``affiliate of the 
accounting firm'' any person controlling, controlled by, or under 
common control with the firm, shareholders of more than five percent of 
the firm's voting securities, and entities five percent or more of 
whose securities are owned by the firm. The proposed rule also included 
any officer, director, partner, or co-partner of any of the foregoing.
    We also proposed defining as affiliates of the accounting firm 
certain entities that are business partners of the accounting firm. In 
general, these included 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 proposed definition also included 
all other entities with which the accounting firm is publicly 
associated in certain ways.
    The definition we proposed also attributed to the auditor actions 
and interests of certain entities involved in joint ventures or 
partnerships with the accounting firm in which the parties agree to 
share revenues, ownership interests, appreciation, or certain other 
economic benefits. It also expressly included 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, as well as persons ``co-branding'' or using the same 
(or substantially the same) name or logo as the accounting firm, cross-
selling services with the accounting firm, or co-managing with the 
accounting firm.
    Finally, the proposed definition of ``affiliate of the accounting 
firm'' addressed 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 provided 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,'' and certain persons 
at the lessor are attributed to the audit firm.
    Our proposed definition of ``affiliate of the accounting firm'' 
proved to be one of the most controversial aspects of our proposed 
rule. Many commenters believed that the definition was overbroad and 
expressed concern over the application of the proposed definition to 
their business arrangements. The largest accounting firms were 
concerned that the

[[Page 76059]]

definition, as a practical matter, would inappropriately restrict their 
ability to enter into certain types of business relationships, 
including joint ventures and co-branding arrangements.\485\ One of the 
so-called ``middle tier'' accounting firms expressed concern that the 
proposed definition would reach the ``alliance'' it has arranged with 
other accounting firms and service providers across the country.\486\ 
Many commenters repeated the AICPA's comment that the definition was 
``overbroad.''\487\ Some commenters suggested an alternative, much 
narrower definition that defined affiliates of the accounting firm as 
entities that control, are controlled by, or are under common control 
with the accounting firm.\488\ Some firms acknowledged that, at least 
with respect to the provision of non-audit services, a test based on 
significant influence may be appropriate.
---------------------------------------------------------------------------

    \485\ See, e.g., KPMG Letter; Arthur Andersen Letter.
    \486\ See Written Testimony of Wayne Kolins, National Director 
of Assurance, BDO Seidman, LLP (Sept. 20, 2000).
    \487\ See, e.g., Letter of Fred M. Rock, CPA (Sept. 20, 2000); 
Letter of Centerprise Advisors, Inc. (Sept. 25, 2000).
    \488\ See, e.g., Deloitte & Touche Letter; Testimony of Wayne A. 
Kolins, BDO Seidman, LLP (Sept. 20, 2000).
---------------------------------------------------------------------------

    In light of these comments and after careful consideration, we have 
decided not to adopt the definition of ``affiliate of the accounting 
firm'' we proposed. The issue of what entities other than the legal 
entity issuing reports or other documents filed with the Commission 
should be treated as the accounting firm is of relatively recent 
origin. In recent years, accounting firms have explored new 
``alternative practice structures'' and increasingly entered into new 
business arrangements with entities not engaged in public accounting. 
To date, our staff has dealt with these questions by interpreting the 
existing rules. Our staff's approach has been to analyze these 
situations in light of all relevant facts and circumstances.\489\ We 
proposed a comprehensive definition that described all the relevant 
facts and circumstances that might lead us to conclude that a separate 
legal entity was sufficiently associated with the accounting firm to 
warrant applying the Commission's independence requirements to that 
entity. In light of the comments received, we are persuaded that the 
rule as proposed could have unintended consequences, and that varying 
criteria of affiliation could be appropriate depending on the 
regulatory context in which the issue of attribution arises.
---------------------------------------------------------------------------

    \489\ See Letter of Edmund Coulson, Chief Accountant, SEC, to 
Robert Mednick, Arthur Andersen (June 20, 1990).
---------------------------------------------------------------------------

    Accordingly, we have eliminated the proposed definition of 
``affiliate of the accounting firm'' from the rule we adopt and 
replaced the phrase ``and affiliates of the accounting firm'' in the 
proposed definition of ``accounting firm'' with ``and associated 
entities, including those located outside of the United States.''\490\ 
We intend this phrase to reflect our staff's current practice of 
addressing these questions in light of all relevant facts and 
circumstances, looking to the factors identified in our staff's 
previous guidance on this subject.\491\ While the rules we adopt do not 
provide accounting firms with the certainty of our proposed rule, we 
are convinced that a more flexible approach is warranted as the types 
and nature of accounting firms' business arrangements continue to 
develop.
---------------------------------------------------------------------------

    \490\ Questions of attribution in this context have not been 
analyzed on the basis of ``affiliation'' in the past. Indeed, the 
term ``affiliate of the accounting firm'' is not used in our current 
Rule 2-01 or in the Codification. The term was used in our proposed 
rule, along with the proposed definition of the term, to attempt to 
bring certainty to this issue. Since ``affiliate'' is defined in 
Rule 1-02 of Regulation S-X and we are eliminating the definition of 
``affiliate of the accounting firm,'' we have used the term 
``associated'' instead of ``affiliated'' in our final rules to make 
clear that, consistent with the status quo, the entities treated as 
if they were the accounting firm will not be determined by reference 
to the definition of ``affiliate'' in Rule 1-02 of Regulation S-X. 
While the ``control'' relationships of Rule 1-02 may be adequate to 
warrant treating an entity as the accounting firm for independence 
purposes, Rule 1-02 does not set forth the exclusive circumstances 
in which an entity's interests will be imputed to the accounting 
firm in this context. In addition, we do not intend for the 
definition of ``associated'' used in any other context in the 
federal securities laws to apply to this term.
    \491\ See, e.g., Letter of Edmund Coulson, Chief Accountant, 
SEC, to Robert Mednick, Arthur Andersen (June 20, 1990); Letter of 
W. Scott Bayless, Assistant Chief Accountant, SEC, to Larry 
Edgerton, Elms, Faris & Co. (June 7, 1996); Letter of Lynn E. 
Turner, Chief Accountant, SEC, to Jeff Yabuki, American Express 
Financial Advisors (Nov. 2, 1998); Letter of Lynn E. Turner, Chief 
Accountant, SEC to Michael Gleespen, Century Business Services (Nov. 
2, 1998); Letter of Lynn E. Turner, Chief Accountant, SEC, to Terry 
Putney, H&R Block Business Services (Nov. 2, 1998); Letter of Lynn 
E. Turner, Chief Accountant, SEC, to Michael Conway, KPMG Peat 
Marwick LLP (Jan. 7, 1999); Letter of Lynn E. Turner, Chief 
Accountant, SEC, to Nigel Buchanan, PricewaterhouseCoopers (July 26, 
1999); Letter of Lynn E. Turner, Chief Accountant, SEC, to Kathryn 
A. Oberly, Esq., Ernst & Young (May 25, 2000); Letter of Lynn E. 
Turner, Chief Accountant, SEC, to Antonio Rosati, Director of 
Issuers Division, Commissione Nazionale per le Societa e la Borsa 
(August 24, 2000); Letter of Lynn E. Turner, Chief Accountant, SEC, 
to J. Terry Strange, KPMG (October 16, 2000); see also Codification 
Sec. 602.02.b.ii, Ex. 8; 602.02.b.iv; 602.02.c.iii; 602.02.g, Ex. 5. 
Cf. SECPS Manual Sec. 1000.45 (discussing application of SECPS rules 
to ``foreign associated firm[s]''); AICPA Code of Professional 
Conduct, ET Sec. 101.16 (Interpretation 101-14) (application of 
independence rules to alternative practice structures); AICPA Code 
of Professional Conduct, ET Sec. 505.03 (application of independence 
rules to entities controlled by an accounting firm or its members). 
In addition, accounting firms entering into business transactions in 
which they acquire equity stakes in other companies will need to 
continue to consider whether they will have a direct or material 
indirect business relationship with, or a direct financial interest 
or material indirect financial interest in, any of their audit 
clients that are also clients of or enter into business 
relationships with or invest in or are invested in by that other 
company. See Letter of Lynn E. Turner, Chief Accountant, SEC, to 
Kathryn A. Oberly, Esq., Ernst & Young (May 25, 2000); Letter of 
Lynn E. Turner, Chief Accountant, SEC, to J. Terry Strange, KPMG 
(October 16, 2000).
---------------------------------------------------------------------------

3. ``Affiliate of the Audit Client''
    We are adopting a modified definition of ``affiliate of the audit 
client.'' As proposed, Rule 2-01(f)(4) defined ``affiliate of the 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 was intended to cover both ``upstream'' and 
``downstream'' affiliates of the audit client, including the audit 
client's corporate parent and subsidiary.
    We received a number of comments expressing concern about our 
proposed definition of ``affiliate of the audit client.'' Some members 
of the accounting profession felt that our proposed definition was 
overbroad and would require the auditor to maintain independence from 
entities far removed from the audit client.\492\ Some commenters 
suggested that we should use the ``control'' test currently found in 
Rule 1-02 of Regulation S-X to define an affiliate of an audit client. 
At least one commenter suggested that our proposed definition should be 
limited to only those affiliates that are ``material'' to the audit 
client.\493\
---------------------------------------------------------------------------

    \492\ See AICPA Letter; Arthur Andersen Letter.
    \493\ See Deloitte & Touche Letter.
---------------------------------------------------------------------------

    After considering these comments, we have decided to modify 
substantially our proposed rule. Under the rule we adopt today, 
entities, if not part of an investment company complex, will be 
considered affiliates of the audit client if they satisfy the criteria 
of one of three paragraphs of Rule 2-01(f)(4). First, under paragraph 
(4)(i), which is based on the control definition currently in Rule 1-02 
of Regulation S-X, an entity is an affiliate of the audit client when 
the entity controls, is controlled by, or is under common control with 
the audit client. Second, paragraph (4)(ii) defines as an affiliate of 
the audit client any entity over which the audit client has significant 
influence, unless that entity is not material to the audit client. 
Third, paragraph (4)(iii) includes those entities that have significant 
influence over the

[[Page 76060]]

audit client, unless the audit client is not material to that entity.
    Paragraph (4)(i) now makes clear that entities in a control 
relationship with the audit client, regardless of materiality 
considerations, are affiliates of the audit client for independence 
purposes. This includes the audit client's parent and subsidiaries and 
is consistent with current Rule 2-01(b). We are not convinced, however, 
that a control test alone captures all situations in which an entity is 
sufficiently related to the audit client to require it to be treated as 
the audit client's affiliate for independence purposes. Our 
Codification currently considers entities affiliates of the audit 
client in a number of situations in which control is not present.\494\ 
As under our proposal, we continue to believe that a significant 
influence test sets a proper baseline threshold for audit client 
affiliation because, under the equity method of accounting,\495\ 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. As urged by commenters, 
however, the addition of the materiality threshold to the significant 
influence test should avoid undue hardships to accounting firms in 
situations where their audit clients have numerous affiliates that are 
immaterial to them.
---------------------------------------------------------------------------

    \494\ See Codification Sec. 602.02.b.iii (Ex. 1); 602.02.b.iv; 
602.02.c.iii; 602.02.h (Ex. 9).
    \495\ See APB No. 18.
---------------------------------------------------------------------------

    As in our proposed rule, we continue to use the term ``significant 
influence'' in the definition to refer to the principles in APB No. 18. 
Some commenters suggested that, since the term ``significant 
influence'' is not defined in the rules, it would be difficult to 
apply.\496\ Many other commenters, however, did not object to the term 
or express any uncertainty as to the term's meaning. Given the 
concept's familiarity to the accounting profession and its use in the 
profession's independence requirements, we have decided to retain its 
use without providing an explicit definition in the rules we adopt.
---------------------------------------------------------------------------

    \496\ See Letter of Stanley Keller, Esq., and Richard Rowe, 
Esq., ABA Committees on Federal Regulation of Securities Law and 
Accounting (Sept. 27, 2000).
---------------------------------------------------------------------------

    We use the term ``significant influence'' as it is used in APB No. 
18. It 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,

[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.\497\
---------------------------------------------------------------------------

    \497\ See APB No. 18, at para. 17. Paragraph 17 of APB No. 18 
also discusses a number of considerations that may affect the 
ability of an entity to have significant influence over an investee.

    In addition, we have added a new section to the definition of 
``affiliate of an audit client'' to deal specifically with affiliation 
questions in mutual fund complexes. Paragraph (4)(iv) provides that 
when the audit client is part of an investment company complex, each 
entity in the investment company complex is an ``affiliate of the audit 
client.'' In this respect, we are following the ISB's Standard No. 2, 
``Certain Independence Implications of Audits of Mutual Funds and 
Related Entities.''\498\
---------------------------------------------------------------------------

    \498\ We have, however, narrowed the definition of ``investment 
company complex'' from the definition used in ISB Standard No. 2. 
See infra Section IV.H.11.
---------------------------------------------------------------------------

    While this provision was not in our proposed definition of 
``affiliate of the audit client,'' it was clearly embodied in our 
proposed Rule 2-01(c)(1)(ii)(G), which provided, ``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.'' As we explained in the Proposing Release, this provision was 
meant to reflect the standard of ISB Standard No. 2. We pointed out in 
the Proposing Release that this provision applied to auditor-audit 
client relationships other than financial interests, and sought comment 
on whether it should be limited in any context other than financial 
interests. At least one commenter analyzed our proposed Rule 2-
01(c)(1)(ii)(G) as an extension of the definition of ``affiliate of the 
audit client.''\499\
---------------------------------------------------------------------------

    \499\ See Arthur Andersen Letter.
---------------------------------------------------------------------------

    While some commenters suggested that we limit this principle 
through a restriction on the scope of the ``investment company 
complex'' definition, few commenters disagreed with the ISB's basic 
conclusion that the unique structure of mutual fund complexes warrants 
special rules of affiliation. After considering the comments on this 
issue, we have decided to adopt this provision substantively as 
proposed, but to move it to the definition of ``affiliate of the audit 
client'' to make its purpose and effect clearer.
4. ``Audit and Professional Engagement Period''
    We have adopted the definition of ``audit and professional 
engagement period'' in Rule 2-01(f)(5), as proposed, with one 
modification. As defined, the `audit and professional engagement 
period' is ``[t]he period covered by any financial statements being 
audited or reviewed (the ``audit period''); and the period of the 
engagement to audit or review the audit client's financial statements 
or to prepare a report filed with the Commission (the `professional 
engagement period'').'
    The definition specifies that 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, audit, or attest procedures, whichever is 
earlier,\500\ and that the professional engagement period ends when the 
client or accountant notifies the Commission that the client is no 
longer that accountant's audit client.\501\ Some commenters asserted 
that the professional engagement period should begin when the 
accountant begins its procedures.\502\ Commenters expressed concern 
that ``time will be needed for covered persons and their family members 
to unwind financial interests or employment relationships.''\503\ We 
believe that our rule, as adopted, provides an appropriate amount of 
flexibility and certainty to the auditor because both signing the 
initial engagement letter and beginning the audit procedures are 
entirely within the control of the accountant. An accountant may orally 
agree to an engagement and then simply delay signing an engagement 
letter or beginning procedures so as to toll the start of its 
professional engagement period.
---------------------------------------------------------------------------

    \500\ Rule 2-01(f)(5)(ii)(A).
    \501\ Rule 2-01(f)(5)(ii)(B).
    \502\ See, e.g., Deloitte & Touche Letter.
    \503\ See, e.g., Deloitte & Touche Letter.
---------------------------------------------------------------------------

    With regard to the termination of the professional engagement 
period, we note that the current rules of the SECPS require an auditor 
to notify the Commission in writing that an SEC registrant who was a 
former client is no

[[Page 76061]]

longer a client.\504\ Similarly, a domestic registrant has an 
obligation to report changes in its independent auditor on Form 8-K. 
While no corollary requirement applies to foreign private issuers, 
there is certainly no prohibition against either such an issuer or its 
auditor providing us with a private notification that would suffice to 
end the professional engagement period for purposes of our independence 
assessment, should this be an issue for the accountant or the 
registrant.
---------------------------------------------------------------------------

    \504\ SECPS Manual Sec. 1000.08; cf. AICPA Code of Professional 
Conduct, ET Sec. 101.02.
---------------------------------------------------------------------------

    In response to concerns of commenters,\505\ we are providing a 
limited exception in the definition that applies to foreign private 
issuers who are offering or listing securities in the United States for 
the first time. For auditors of those foreign private issuers who 
previously were not required to, and did not, file any registration 
statement or report with the Commission, the ``audit and professional 
engagement period'' does not include periods ended prior to the 
beginning of the last fiscal year ended before the issuer first filed 
or was required to file a registration statement or report with us, 
provided that the company has fully complied with home country 
independence standards in those prior periods.
---------------------------------------------------------------------------

    \505\ See, e.g., Ernst & Young Letter (``We also would revise 
the definition of `audit and professional engagement period' in the 
Release . . . to codify the Commission staff's practice of only 
requiring the latest audited period in initial filings by foreign 
private issuers to be fully compliant with SEC independence 
rules.'').
---------------------------------------------------------------------------

5. ``Audit Client''
    Rule 2-01(f)(6) defines ``audit client.'' We have defined this term 
as the entity whose financial statements or other information is being 
audited, reviewed, or attested. We believe this is how ``audit client'' 
commonly is used, and we are adopting this as part of the definition. 
Use of this definition, of course, 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.''\506\
---------------------------------------------------------------------------

    \506\ Arthur Young, 465 U.S. at 818.
---------------------------------------------------------------------------

    We have made one change to the definition. Commenters suggested 
adding affiliate of the audit client, defined above, to the definition 
of audit client for the sake of simplicity, and we have done so.\507\ 
The definition of audit client, for purposes of paragraph (c)(1)(i) 
(investments in audit clients), however, does not include entities that 
are affiliates of the audit client by virtue of paragraph (f)(4)(ii) or 
paragraph (f)(4)(iii), which define an affiliate in terms of 
significant influence. As discussed more fully above, if an entity is 
an affiliate of the audit client because of a ``significant influence'' 
relationship, it is covered by the rules relating to material indirect 
investments and investments in non-client entities under (c)(1)(i)(D) 
and (c)(1)(i)(E), and it is not necessary, therefore, to include it in 
the definition of audit client.
---------------------------------------------------------------------------

    \507\ See, e.g., PricewaterhouseCoopers Letter.
---------------------------------------------------------------------------

6. ``Audit Engagement Team''
    Rule 2-01(f)(7) defines the term ``audit engagement team.'' The 
``audit engagement team'' includes the people in the accounting firm 
who are most directly 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 provisions of 
paragraph (c) of 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 with others on the audit engagement team during the audit, 
review, or attestation engagement regarding technical or industry-
specific issues, transactions, or events.''
    Commenters who addressed this definition generally agreed that 
persons in a position to influence the audit, such as the audit 
engagement team, should be covered persons for purposes of the rule's 
restrictions on certain relationships with audit clients.\508\ We have 
adopted the definition with only one variation from the proposed 
definition. The proposed definition included the phrase ``all persons 
who consult, formally or informally, with others . . . .'' In the final 
rule, we have deleted the phrase ``formally or informally,'' to avoid 
unintended overbreadth. Rather, we use the term ``consult'' to refer to 
meaningful discussions related to the audit.
---------------------------------------------------------------------------

    \508\ See, e.g., Deloitte & Touche Letter.
---------------------------------------------------------------------------

7. ``Chain of Command''
    Rule 2-01(f)(8) defines the term ``chain of command.'' This term is 
defined 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 provisions in paragraph 
(c) of Rule 2-01.
    Based on the input of commenters, we have modified this definition 
somewhat from the proposed definition. Commenters stated that our 
definition included too broad a range of persons, capturing people, 
such as managers who could ``influence the . . . compensation of any 
member of the audit engagement team,'' whose connection to the audit is 
too tenuous to reasonably conclude that they have the ability to 
influence the audit.\509\
---------------------------------------------------------------------------

    \509\ See Deloitte & Touche Letter.
---------------------------------------------------------------------------

    We are persuaded that the proposed definition was broader than 
necessary, and we have accordingly sharpened its focus and tried to 
eliminate any ambiguity. As defined in the final rule, ``chain of 
command'' includes all persons who (i) supervise or have direct 
management responsibility for the audit, including at all successively 
senior levels through the accounting firm's chief executive; (ii) 
evaluate the performance or recommend the compensation of the audit 
engagement partner; or (iii) provide quality control or other oversight 
of the audit.''
8. ``Close Family Members''
    We are adopting, as proposed, Rule 2-01(f)(9) that defines ``close 
family members.'' Close family members is defined 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

[[Page 76062]]

in question (parent, nondependent child, and sibling). We distinguish 
the two groups, in part, because 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. Commenters, in general, raised 
few issues with the proposed definition of ``close family members'' 
and, therefore, we are adopting this definition as proposed.
9. ``Covered Persons in the Firm''
    Rule 2-01(f)(11) defines the term ``covered persons in the firm.'' 
The term includes four basic groups. The first two groups, the ``audit 
engagement team'' and the ``chain of command,'' are described above. 
Their inclusion in the category of ``covered persons in the firm'' is 
unchanged from the proposed rule.
    We have modified the description of the third category of covered 
persons from our proposal. The proposed rule referred to ``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.'' We included this category 
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.\510\
---------------------------------------------------------------------------

    \510\ AICPA SAS No. 22, AU Sec. 311.046 and AUI 9311.03.
---------------------------------------------------------------------------

    In response to concerns raised by commenters,\511\ we have modified 
the definition of this category of covered persons in two respects. 
First, we have changed the term ``professional employee'' to 
``managerial employee,'' to encompass a somewhat narrower scope of 
persons. Second, we have set a minimum hour threshold that must be 
crossed before an individual becomes a covered person by virtue of 
providing a non-audit service to an audit client. This subpart of the 
definition now includes only those individuals who have ``provided ten 
or more hours of non-audit services to the audit client for the period 
beginning on the date such services are provided and ending on the date 
the accounting firm signs the report on the financial statements for 
the fiscal year during which those services are provided, or who 
expects to provide ten or more hours of non-audit services to the audit 
client on a recurring basis.''
---------------------------------------------------------------------------

    \511\ See, e.g., Deloitte & Touche Letter; Ernst & Young Letter.
---------------------------------------------------------------------------

    In this definition, the phrase ``beginning on the date such 
services are provided'' refers to the date on which the individual 
provides his or her tenth hour of non-audit service to a particular 
audit client within the space of a single fiscal year of that client. 
For example, if the client's fiscal year runs from January 1 to 
December 31, and an individual provides eight hours of non-audit 
services on February 1 and two hours of non-audit services on June 1, 
then the period described above would commence following the provision 
of the services on June 1. From that date through the date that the 
accounting firm signs the report on the financial statements for that 
fiscal year, that individual is a ``covered person in the firm.'' We 
reiterate: the individual's status as a covered person does not end at 
the conclusion of the fiscal year in question, but continues until the 
firm has signed the report for the financial statements for that fiscal 
year.
    The proposed rule described the fourth category of covered persons 
as ``any other partner, principal, or shareholder from an `office' of 
the accounting firm that participates in a significant portion of the 
audit.'' We included these people on the theory that they are the ones 
most likely to interact with the audit engagement team on substantive 
matters and may exert influence over the audit engagement team by 
virtue of their physical proximity to, or relatively frequent contact 
with, the audit engagement team.
    In response to concerns raised by commenters about the breadth of 
the category, particularly the inclusion of every ``office'' that 
participates in a ``significant portion'' of the audit,\512\ we have 
modified this definition. The final rule narrows the scope of the 
definition to ``any other partner, principal, or shareholder from an 
`office' of the accounting firm in which the lead audit engagement 
partner primarily practices in connection with the audit.'' We are 
persuaded that it is reasonable to draw the line at partners, 
principals, and shareholders, rather than at all ``professional 
employees,'' and that it is also more reasonable and more practicable 
to draw a clear line at the ``office''\513\ of the firm in which the 
lead engagement partner primarily practices.
---------------------------------------------------------------------------

    \512\ See, e.g., Deloitte & Touche Letter; Ernst & Young Letter.
    \513\ For a discussion of the definition of ``office,'' see 
infra Section IV.H.12.
---------------------------------------------------------------------------

    A person who is not a covered person at the time an audit 
engagement begins might nonetheless become a covered person at any time 
during the audit engagement. As soon as events or circumstances bring a 
person within any category of covered person defined above, that person 
is a ``covered person in the firm.'' An individual must be independent 
of the audit client, pursuant to the provisions of the rule, before 
becoming a covered person in the firm. That means, for example, that an 
individual must dispose of any financial interest in the audit client 
completely and irrevocably before being consulted by another covered 
person concerning the audit engagement. For example, the rule does not 
allow the person consulted to participate in a discussion about the 
audit engagement and then ``cure'' an independence impairment by later 
disposing of an investment. Likewise, a person who becomes a covered 
person by rotating onto an engagement or being promoted into the chain 
of command must be independent pursuant to the provisions of the rule 
prior to becoming a covered person.
    One commenter suggested that the definition of ``covered persons in 
the firm'' should include leased accounting personnel.\514\ We note 
that to the extent leased personnel otherwise fall within any category 
of ``covered persons in the firm,'' such as by being on the audit 
engagement team, they will be covered persons in the firm.\515\
---------------------------------------------------------------------------

    \514\ See Deloitte & Touche Letter.
    \515\ For example, leased accounting personnel might consult 
with a professional employee participating in an audit and thereby 
become a member of the audit engagement team.
---------------------------------------------------------------------------

    Because the rule narrows the scope of firm personnel to whom 
investment and employment restrictions apply, an accounting firm 
employee in a distant part of the world, or even down the street, might 
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 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 the 
basis of any material nonpublic information about that client.
10. ``Immediate Family Members''
    We are adopting, as proposed, final Rule 2-01(f)(13), which defines 
``immediate family members'' to mean a

[[Page 76063]]

person's spouse, spousal equivalent, and dependents. 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, we believe 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 independence. By identifying ``immediate family members,'' we 
are identifying 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 received a few comments on the definition of ``immediate family 
members.'' Some commenters agreed that the definition should not 
include emancipated adult children, while others expressed concern that 
non-dependent children were not included in this group.\516\ On 
balance, we believe that, for purposes of these rules, emancipated 
children are sufficiently independent of their parents to warrant not 
imputing their financial interests to their parents. We are, therefore, 
adopting the definition as proposed.
---------------------------------------------------------------------------

    \516\ See Written Testimony of Ronald Nielsen and Kathleen 
Chapman, Iowa Accountancy Examining Board (Sept. 20, 2000).
---------------------------------------------------------------------------

11. ``Investment Company Complex''
    As proposed, the definition of ``investment company complex'' 
focused on investment advisers and entities in a control relationship 
with the adviser, including entities under common control with the 
adviser. The proposed definition was loosely based on ISB Standard No. 
2, which 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.''\517\
---------------------------------------------------------------------------

    \517\ ISB Standard No. 2, supra note 226.
---------------------------------------------------------------------------

    We solicited comment on the definition proposed, and, in 
particular, on whether an alternative definition, focusing on the 
fund's principal underwriter and administrator would be more 
appropriate. Some commenters expressed concern about the scope of the 
investment company complex definition, particularly that it included 
entities that have no direct relationship to investment company 
operations.\518\ These commenters' concern was that all subsidiaries of 
an adviser's parent company would also be included in the investment 
company complex. Therefore, an accounting firm could not provide 
certain non-audit services to, or invest in, subsidiaries of the parent 
of the adviser, even if those subsidiaries operated businesses 
unrelated to the investment company business. Under the proposed 
definition, for example, if a parent company owned an adviser and a 
manufacturing company, the accountant that audited the adviser (or a 
fund advised by the adviser) could not invest in the manufacturing 
company, even though its operations would not be affected by the audit 
of the adviser (or the fund).
---------------------------------------------------------------------------

    \518\ See, e.g., Deloitte & Touche Letter; AICPA Letter.
---------------------------------------------------------------------------

    In response to these comments, we have adopted in Rule 2-01(f)(14) 
a definition of investment company complex that is more limited than 
the one proposed. As adopted, the rule only includes an entity under 
common control with the adviser if the entity provides services to an 
investment company in the investment company complex. More 
specifically, if a sister entity of the investment adviser, other than 
another investment adviser, does not provide administrative, custodian, 
underwriting, or transfer agent services to the adviser or a fund, it 
is not part of the investment company complex.
    As proposed, an entity that would be an investment company but for 
the exclusions provided by section 3(c) of the Investment Company Act 
and that is advised by the investment adviser or sponsored by the 
sponsor is part of the investment company complex. Also, as proposed, 
the definition does not include sub-advisers whose role is primarily 
portfolio management and who provide services pursuant to a subcontract 
with, or are overseen by, an adviser in the complex. There was some 
support for excluding sub-advisers from the definition of investment 
company complex.\519\ We have determined to exclude sub-advisers from 
the definition because a fund, or even its adviser, may not be able to 
know whether the sub-adviser obtained any non-audit services from the 
fund's or the adviser's auditor. Moreover, considering a sub-adviser or 
the funds it advises to be part of the investment company complex 
presents practical difficulties where the sub-adviser is itself an 
adviser in a separate investment company complex.
---------------------------------------------------------------------------

    \519\ See, e.g., Arthur Andersen Letter.
---------------------------------------------------------------------------

12. ``Office''
    Rule 2-01(f)(15) defines ``office'' to mean a distinct sub-group 
within an accounting firm, whether distinguished along geographic or 
practice lines. The term ``office'' is an integral part of the 
description of one category of ``covered persons'' and, thereby, helps 
identify firm personnel who cannot have financial or employment 
relationships with a particular audit client without impairing the 
firm's independence. The definition has not changed from the proposed 
definition.
    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 
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.
    Some commenters raised concerns about the definition of 
office.\520\ One commenter asserted that the proposed definition is 
unworkable and does not provide helpful guidance.\521\ This commenter 
expressed a preference for the ISB's approach to the concept of 
``office or practice unit,'' in the ISB's Exposure Draft on Financial 
Interests and Family Relationships.\522\
---------------------------------------------------------------------------

    \520\ See, e.g., Deloitte & Touche Letter; AICPA Letter.
    \521\ See AICPA Letter.
    \522\ The ISB Exposure Draft, cited in the AICPA Letter, states 
the following: the identification of the relevant ``office'' or 
practice unit is based on the facts and circumstances, including the 
firm's operating structure, and requires judgment. In a traditional 
geographic practice office (one city location with one managing 
partner in charge of all operations--audit, tax, and consulting), 
that location should be considered to be the office. In addition, if 
there are smaller, nearby ``satellite'' offices managed under the 
primary city office, broadly sharing staff, etc., those locations 
should also be considered part of the primary office. On the other 
hand, many firms are now structured more on an industry 
specialization or line-of-service basis, and manage offices on that 
basis. For example, if a financial services group were a separate 
practice unit, and were operated that way with limited contact with 
personnel of other local units, that may represent a separate office 
for purposes of this standard. Substance should govern the office 
classification, and the expected regular personnel interactions and 
assigned reporting channels of an individual may well be more 
important than his or her physical location.

---------------------------------------------------------------------------

[[Page 76064]]

    In some respects, the definition that we adopt overlaps with the 
ISB approach. Like the ISB approach, our definition will necessarily 
involve the application of judgment, governed by substance. And under 
our definition, as under the ISB approach, expected regular personnel 
interactions and assigned reporting channels may well be more important 
than an individual's physical location. We have determined to adopt the 
definition that we proposed, because it is unclear to us that the ISB 
approach would necessarily encompass each distinct sub-group that, in 
particular circumstances, should be encompassed.

I. 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 Rule 2-01. The 
final rule articulates a number of situations and circumstances, such 
as financial relationships, employment relationships, and non-audit 
services that impair auditor independence. Accordingly, we are deleting 
some interpretations included in the Codification, either because they 
are reflected in the revised Rule 2-01 or they have been superseded, in 
whole or in part, by the rule. Because examples have been deleted both 
because they are no longer necessary and because they are inconsistent 
with the final rule, inferences should not be drawn from the deletion 
of a particular example. The revised Codification contains the 
discussion of the final rule from this release, as well as the 
background information and interpretations that may continue to be 
useful in situations not specifically or definitively addressed in 
paragraph (c). Examples of these items include business relationships, 
unpaid prior professional fees, indemnification by clients, and 
litigation.

V. Cost-Benefit Analysis

    The amendments to Rule 2-01 modernize the rules for determining 
whether an auditor is independent in light of (i) investments by 
auditors or their family members in audit clients; (ii) employment 
relationships between auditors or their family members and audit 
clients; and (iii) the non-audit services provided by audit firms to 
their audit clients. In the Proposing Release, we identified three 
constituencies affected by the rule: (1) investors; (2) issuers; and 
(3) accounting firms that provide services affected by this 
release.\523\ Below we discuss the costs and benefits to each of these 
groups. In all cases, we discuss the costs and benefits relative to the 
current regulatory environment.\524\
---------------------------------------------------------------------------

    \523\ While we discuss the costs and benefits to issuers 
separately from those accruing to investors, impacts on the issuers 
are also likely to flow to investors as owners of the issuers' 
securities.
    \524\ It has been suggested that the Proposing Release did not 
clearly specify the baseline from which the costs and benefits were 
being estimated. The following presentation clearly establishes the 
baseline: costs and benefits are compared to current regulations.
---------------------------------------------------------------------------

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

    The final rule clarifies, and in some cases eliminates, certain 
existing requirements under which an accountant's independence is 
impaired by investment and employment relationships between an 
accountant, covered persons, or their families, and an audit client. As 
explained above,\525\ changes in business practices and demographics, 
including an increase in dual-career families, warrant a change in our 
auditor independence requirements to prevent an unnecessary restriction 
on the employment and investment opportunities available to auditors 
and members of their families. To this end, the rule amendments take a 
more targeted approach, focusing on those persons who are involved in 
or can influence an audit. In addition, the rule provides a limited 
exception for accounting firms under which an inadvertent violation of 
these rules by certain persons will not cause a firm's independence to 
be impaired, so long as the firm has quality controls that meet certain 
conditions and the impairment is resolved promptly.
---------------------------------------------------------------------------

    \525\ See supra Section III.B.
---------------------------------------------------------------------------

1. Benefits
    The elimination of certain investment and employment restrictions 
should benefit auditors and their families by permitting a wider range 
of investment and employment opportunities. According to the 1999 
annual reports filed by accounting firms with the SECPS, the five 
largest accounting firms employ approximately 115,000 professionals. 
Other public accounting firms that audit SEC registrants employ an 
estimated 5,000 to 25,000 professional staff. The amendments we are 
adopting will benefit these 120,000 to 140,000 accounting firm 
professional employees and their families by enabling them to invest in 
some public companies in which, under the current rules, they cannot 
invest without impairing the independence of the companies' auditors. 
In addition, under these amendments, audit clients and their affiliates 
may, in certain circumstances, employ family members of some audit firm 
employees without impairing the auditor's 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. Opening employment opportunities to auditors and their 
family members increases their freedom of choice with respect to their 
employment opportunities and may lead to an increase in their 
compensation. Consequently, the amendments have the potential to 
improve the pecuniary and non-pecuniary benefits of employment. These 
benefits may make accounting firms more appealing as a career choice, 
and as a result may aid the firms in their recruiting efforts.\526\
---------------------------------------------------------------------------

    \526\ See Written Testimony of Jack Ciesielski, accounting 
analyst (Sept. 13, 2000) (``I think the real problem in attracting 
talent in the auditing profession is the share ownership 
restrictions placed on auditors. * * * The relaxation of share 
ownership constraints that are proposed in this document should 
allay most fears of future auditors.'').
---------------------------------------------------------------------------

    In addition, independence requirements are found in various 
Commission rules, Commission interpretations, staff letters and 
reports, and, in some cases, AICPA literature. The final rule puts this 
guidance in an easily accessible format that will save interested 
parties costs in ascertaining and complying with the rule.
    Finally, the rule provides that an accounting firm's independence 
will not be impaired solely because a covered person inadvertently 
fails to comply with the independence rules if the firm has adequate 
independence quality controls in place. This limited exception should 
provide a benefit to accounting firms and their employees.
2. Costs
    Modification of the 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

[[Page 76065]]

costs to prepare professional staff to understand and conform to the 
revised rules. With respect to the provisions regarding employment 
relationships and investments, the rule provides a transition period 
and does not cover loan contracts, insurance products, and employment 
relationships undertaken prior to the end of this transition period. 
The rule does not impose any additional costs with respect to the 
separations of former partners that have occurred prior to the 
effective date of this rule. Existing rules will apply to these 
partners. During the transition period, the only cost to separating 
partners and their firms relates to the timing of the payments made as 
part of the separation.\527\ The new rule applies only to those that 
leave the firm after the new rule becomes effective. These 
modifications of the rule from our original proposal will reduce the 
costs of implementation.\528\
---------------------------------------------------------------------------

    \527\ See Rule 2-01(e)(1)(ii).
    \528\ The rules we adopt today are slightly more restrictive 
than current rules with respect to certain financial interests--such 
as credit cards and bank accounts--and employment relationships as 
they relate to covered persons on the audit engagement team. We do 
not anticipate that these changes will impose significant costs.
---------------------------------------------------------------------------

    As discussed above, the rule does not require accounting firms to 
establish quality controls that conform to the rule requirements. In 
the case of the largest firms, the rule specifies minimum 
characteristics of these systems.\529\ Because the limited exception is 
elective, any related costs will be assumed voluntarily, if at all, by 
accounting firms that decide that the benefits of this limited 
exception justify the costs of any incremental changes that are 
necessary to make their quality control systems meet the rule's 
standards.
---------------------------------------------------------------------------

    \529\ Other public accounting firms would have the flexibility 
to adopt a system to comply with the requirement in light of the 
nature and size of their practice. See SAS No. 25, AU Sec. 161.03. 
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.'' See SAS No. 25, AU Sec. 161.02.
---------------------------------------------------------------------------

    An accounting firm that chooses to upgrade its existing quality 
control system to comply with the limited exception should incur only 
the incrementally small costs of implementing any improvements beyond 
what is required by GAAS and SECPS membership requirements.\530\ 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.\531\ 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.''\532\ Because foreign 
accounting firms providing assurance on financial statements filed with 
the SEC are required to adhere to GAAS, they are also subject to these 
same quality control standards.\533\
---------------------------------------------------------------------------

    \530\ Because the threshold for the limited exception is based 
on the number of audit clients rather than professionals, certain 
middle-tier firms, if they grow, may meet the threshold earlier than 
they would under current SECPS requirements. See SECPS Manual 
Sec. 1000.46. We note that our rule does not require implementation 
of these systems, but rather leaves it to the discretion of the 
firm.
    \531\ SAS No. 25, AU Sec. 161 n.1.
    \532\ AICPA Professional Standards: SQCS, QC Sec. 20.09.
    \533\ See ``International Accounting Standards,'' Securities Act 
Rel. No. 7801 (Feb. 16, 2000) [65 FR 8,896]; Form 20-F, Item 8, 
``Financial Information,'' 17 CFR 249.220f.
---------------------------------------------------------------------------

    In addition to requirements imposed by GAAS, public accounting 
firms that are SECPS members must comply with independence quality 
control membership requirements. Further, SECPS guidelines indicate 
that its members are required to assist their foreign associated firms 
to conform to ``U.S. independence requirements of the SEC and ISB, and 
SEC rules and regulations in areas where such rules and regulations are 
pertinent.''\534\ Among other things, member firms with at least 7,500 
professionals must implement an electronic tracking system by no later 
than December 31, 2000.\535\ The final rule supplements 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. Because an accounting firm with 500 SEC registrants 
will likely also meet the SECPS' 7,500 professionals requirement, the 
rule is unlikely to impose a requirement for quality controls that does 
not already exist under GAAS and SECPS membership requirements.
---------------------------------------------------------------------------

    \534\ See SECPS Manual Sec. 1000.45.
    \535\ See Letter from Michael A. Conway, Chairman, Executive 
Committee, SECPS, to the Managing Partners of SECPS Member Firms, 
April 2000 (available at www.aicpa.org).
---------------------------------------------------------------------------

    In the Proposing Release, we asked for comments and data on the 
assessment of potential costs associated with the proposed quality 
control provision, but no commenter provided specific or empirical data 
on this issue. We expect the costs associated with the implementation 
of an amended quality control system to be small. Firms may choose to 
maintain the current restrictions if they determine that the costs of 
establishing the new system exceed the benefits. We nevertheless 
recognize that public accounting firms and their employees will require 
some time to familiarize themselves with, and understand, the amended 
rule. A one-hour review by each of the 120,000 to 140,000 public 
accounting professionals would result in a $3.6 million to $4.2 million 
one-time transition cost.\536\ We include the $4.2 million in our 
aggregate cost estimation. Given that accounting firms currently engage 
in on-going training relating to auditor independence, we believe that 
these transition costs likely represent an over-estimation of the true 
cost imposed by this rule. Further, given that the firms must continue 
the educational process regardless of the rule, we treat this as a one-
time cost.
    Commenters were generally supportive of the proposals regarding 
employment relationships between and investments by auditors or their 
family members and audit clients. As discussed above, after considering 
the comments received, we are adopting the investment and employment 
rules, as modified.\537\
---------------------------------------------------------------------------

    \536\ See Romac International, 1999 Salary Survey and Career 
Navigator: Finance & Accounting (1999), which reports the median 
national public accounting salary to be $47,300 annually. Assuming a 
2080-hour work year, we obtain $22.75 per hour. We increase our 
hourly estimate to $30 to allow for benefits and other overhead 
expenses.
    \537\ See supra Sections IV.D.1, IV.D.2.
---------------------------------------------------------------------------

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

    There is increasing concern that the growth of non-audit services 
provided by auditors to audit clients affects auditor 
independence.\538\ There is also concern that auditors' provision of 
certain non-audit services to audit clients creates a conflict of 
interest that also affects auditor independence. These effects on 
auditor independence may be costly to investors if they lead to, among 
other things, a decrease in the quality of financial reporting, lower 
investor confidence, or both. Importantly, as a result of the conflicts 
created by auditors' provision of non-audit services, investors may 
lose confidence in the quality and integrity of financial reports even 
if there are relatively few dramatic audit failures or restatements. 
Given the size of U.S. securities markets, even a small loss in

[[Page 76066]]

investor confidence has large wealth consequences for investors.
---------------------------------------------------------------------------

    \538\ See supra Section III.B.
---------------------------------------------------------------------------

    After careful consideration of the testimony from four days of 
public hearings and a review of the almost 3,000 comment letters 
received by the Commission, we have narrowed the scope of our proposals 
regarding non-audit services. In the Proposing Release, we enumerated 
ten services that if provided by the auditor to an audit client would 
be considered to be, in whole or in part, incompatible with the concept 
of auditor independence. As discussed above, in many cases we intended 
our proposal to track substantially the existing independence 
requirements of the profession. In response to commenters' concerns 
that our proposals were broader than existing requirements, we have 
made certain modifications.\539\ As a result of our modifications, the 
language in the adopted rule substantially mirrors or draws from 
existing Commission requirements or the professional guidance of the 
AICPA and SECPS with respect to eight non-audit services (not including 
internal audit services). There should, therefore, be minimal costs 
associated with our codification of the provisions regarding these 
eight services. With respect to most information systems consulting, 
auditors may continue to provide these services to an audit client 
without impairing independence, as long as certain conditions are met.
---------------------------------------------------------------------------

    \539\ In the Proposing Release, the proscribed services included 
expert witness services. Expert witness services have been removed 
from the list of services that are per se incompatible with an 
auditor's independence.
---------------------------------------------------------------------------

    The final rule does impose new limitations on auditors' ability to 
provide to audit clients internal audit services without impairing 
independence. If the accounting firm provides both the internal and 
external audit, it may, in effect, be auditing its own work. In this 
situation, the firm cannot, in our view, provide a truly independent 
``second opinion.'' Without a truly independent second opinion, 
material defects in the accounting system may not be detected as 
quickly, if at all. Final Rule 2-01(c)(4)(iv) seeks to curb these 
conflicting interests without precluding companies, particularly small 
companies, from obtaining internal audit services from their auditors 
where the auditor's independence would not be compromised.
    Under the final rule, accounting firms may provide all internal 
audit services to audit clients with assets of $200 million or less, 
provided certain conditions are met. In addition, accounting firms may 
provide up to forty percent of the internal audit services of issuers 
with assets in excess of $200 million, provided the same conditions are 
met.\540\ These conditions are intended to create circumstances in 
which the auditor can continue to exercise objective and impartial 
judgment, and the audit retains its value as a ``second opinion.''
---------------------------------------------------------------------------

    \540\ Under the final rule, the term ``internal audit services'' 
does not include operational internal audit services unrelated to 
the internal accounting controls, financial systems, or financial 
statements. Additional discussion of the impact of this threshold 
appears in Section IV.D.4.b(v).
---------------------------------------------------------------------------

    Relative to the Proposing Release, the $200 million threshold in 
the internal audit provision minimizes the aggregate costs associated 
with the rule without substantially reducing the benefits of greater 
investor confidence in audited financial statements. In addition, the 
$200 million threshold in the internal audit provision minimizes the 
impact of the provision on smaller companies and smaller accounting 
firms.
    The available data indicate that most SEC registrants are audited 
by one of the largest accounting firms, sing 1999 SECPS data, we 
identified 16,653 registrants who filed audited company financial 
statements with the Commission.\541\ Of those 16,653 registrants, the 
Big Five accounting firms audit 12,769 (76.7%) of these companies; the 
next three largest firms (referred to as the ``second tier firms'') 
audit 942 (5.7%); the next 20 largest accounting firms audit 730 
(4.4%); and the remaining 2,212 (13.3%) companies are audited by 
smaller accounting firms.
    In order to estimate the impact of the rule on small companies and 
small accounting firms, we used the Compustat Database.\542\ Our 
analysis indicates that of the 9,414 Compustat covered companies, 4,326 
(46%) have assets of $200 million or more and will be covered by the 
limitation, whereas 5,088 (54.1%) have assets of less than $200 million 
\543\ and will not be covered by the rule. By excluding companies with 
less than $200 million in assets from application of the new limitation 
on these non-audit services for audit clients, the final rule permits, 
subject to certain conditions, large and small accounting firms to 
accept consulting engagements with these small companies that would 
otherwise be prohibited.
---------------------------------------------------------------------------

    \541\ Throughout this section we round percentages to one 
decimal place. As a result some percentage combinations, when 
relevant, will not add to exactly 100.
    \542\ Our purpose in using these data is to estimate the 
association between company size and the auditors classified as Big 
Five, second tier and smaller accounting firms. The Compustat 
Database has two limitations for purposes of this estimate. First, 
the Compustat Database does not include all companies filing with 
the SEC. Second, we note that Compustat includes American Depository 
Receipts (ADRs). Some of the companies issuing ADRs and included on 
Compustat may not be required to file audited financial statements 
with the SEC. The data include 499 non-bank filers who issue ADRs; 
405 are for companies with $200 million or more of assets; and 94 
are companies with less than $200 million in assets. Only 57 of 
these ADR issuers are not audited by Big Five accounting firms.
    The data also include 22 bank holding companies with $200 
million or more of assets that have issued ADRs. The database 
contains information on approximately 9,414 registered companies 
including bank holding companies. Compustat applies set criteria for 
adding companies to the database. The criteria vary depending upon 
whether a company is domiciled in the U.S., Canada or abroad. The 
net effect of these criteria is that Compustat is heavily weighted 
toward larger companies, particularly, larger North American 
companies. If these criteria have the effect of excluding smaller 
companies that may have assets of less than $200 million, this 
analysis will overstate the proportion of companies that will be 
affected by the rule and the impact of the rule on smaller 
companies. See Compustat Database, October 31, 2000.
    \543\ The average revenue of companies with assets of $195--$205 
million is $209 million.
---------------------------------------------------------------------------

    The Compustat Database includes 8,732 non-bank companies: 3,735 
(42.8%) have assets of $200 million or more, and 4,997 (57.2%) have 
assets of $200 million or less. The Compustat data indicate that 
approximately 93.9% of non-bank companies with assets in excess of the 
$200 million threshold are audited by one of the Big Five accounting 
firms. Clients of second tier accounting firms account only for 1.3% of 
this group. The database specifically identifies 107 companies or 2.9% 
as audited by other smaller accounting firms. The remaining 71 (1.9%) 
large companies were not identified with an auditor in the database. If 
we include these 71 companies with the 107 identified as audited by 
smaller accounting firms, at most 4.8% of the companies with assets in 
excess of $200 million are audited by the smaller firms and, therefore, 
potentially impacted by the provision on internal audit services. 
Conversely, 85.7% of non-Big Five audit clients have assets below $200 
million.
    Current and past bank regulators expressed concern about the effect 
of our internal audit proposal on smaller banks serving smaller 
communities.\544\

[[Page 76067]]

The $200 million threshold is designed to limit the impact of the rule 
to larger, national banks. The Compustat Database included 682 bank 
holding companies. Of these, 591 (86.7%) have assets of $200 million or 
more and 91 (13.3%) have assets of less than $200 million. Big Five 
accounting firms audit 382 (64.6%) of the large bank holding companies. 
The next three largest (second tier) firms audit 31 (5.2%) of the large 
bank holding companies. Compustat specifically identified 116 (19.6%) 
as audited by other accounting firms. The data source did not identify 
an auditor for the remaining 62 (10.5%) companies.\545\ The $200 
million exemption permits the 91 smaller bank holding companies, likely 
to serve smaller communities,\546\ to obtain from their auditors 
internal audit services. Accordingly, as adopted, the rule should not 
impose a substantial burden on these institutions and the communities 
they serve. Further, the Compustat criteria for inclusion in the 
database may understate the population of smaller bank holding 
companies.
---------------------------------------------------------------------------

    \544\ See Testimony of Paul Volcker, former Chairman, Board of 
Governors of the Federal Reserve System (Sept. 13, 2000) (``I know 
that when . . . I was Chairman, there was still a question of 
whether banks had to be audited, and they are, of course, examined 
and many of the banks complain that it would be very costly and they 
didn't have the resources for decent internal auditing efforts. . . 
.''); see also Testimony of Laurence H. Meyer, Governor, Board of 
Governors of the Federal Reserve System (Sept. 13, 2000); Testimony 
of John D. Hawke, Jr., Comptroller of the Currency (July 26, 2000). 
Both indicated that their respective organizations have been 
concerned about internal audit outsourcing for some time. Neither 
organization has placed an absolute ban on internal audit 
outsourcing. However, both have provided guidance on the manner in 
which internal audit outsourcing is to be handled.
    \545\ Professional staff of the Office of the Chief Accountant 
obtained the names of bank holding company auditors by searching 
Commission 10-K filings contained in EDGAR. 10KWizard was utilized 
to search the EDGAR database.
    \546\ Only ten of the 91 bank companies with less than $200 
million in assets were located in one of the top 35 U.S. cities by 
population. See Compustat Database, October 31, 2000.
---------------------------------------------------------------------------

    Evidence suggests that internal audit outsourcing is provided 
primarily by the largest of the public accounting firms.\547\ Under the 
adopted rule, auditors will still be able to provide internal audit 
services.\548\ We estimate that the auditor could still provide on 
average as much as sixty-one percent of a company's internal audit 
activity, including internal audit activities not covered by the 
rule.\549\
---------------------------------------------------------------------------

    \547\ The Institute of Internal Auditors (``IIA'') Global 
Auditing Information Network (``GAIN'') cited by Larry E. Rittenberg 
and Mark A. Covaleski in their monograph, The Outsourcing Dilemma: 
What's Best for Internal Auditing for IIA (1997) (``Rittenberg'') 
and Manufacturers Alliance, Survey of General Audit (2000) generally 
include large companies. According to Rittenberg, companies included 
in the IIA GAIN study are large, increasing the probability that the 
GAIN companies are Big Five clients. Only two of the companies 
responding to the Manufacturers Alliance survey used accounting 
firms other than a Big Five firm as the primary external auditor. 
The Alliance survey reported a ten percentage point increase in the 
outsourcing of general audit tasks to the primary external auditor 
between 1995 and 2000. Of the companies using Big Five firms as 
their primary auditor, 42.5% indicated that they outsourced general 
audit work to their primary auditor. The survey also indicates that 
the portion of general audit needs that is outsourced remains fairly 
small, at less than 5% for 72.9% of the respondents.
    \548\ As noted above, our definition of internal audit is 
narrower than that used by Rittenberg and Covaleski.
    \549\ Rittenberg and Covaleski provide data that allows us to 
estimate the potential impact of the 40% limitation included in the 
rule. The Table below uses the information above to estimate the 
internal audit outsourcing and extended audit services that the 
external auditor can perform for the SEC registrant audit clients 
after the new rule is in effect. According to the IIA GAIN 
information in 1995 studied by Rittenberg and Covaleski, 35% of 
internal audit activities were classified as ``operational.'' These 
activities can be fully outsourced under the rule. The remaining 
services were classified as follows: 17% compliance audit; 14% 
information systems; 26% financial audits; 8% other (unspecified). 
The rule will allow 40% of these services to be outsourced. 
Accordingly, under the rule, 61% of internal audit services could be 
outsourced.
    In addition, the Manufacturers Alliance conducted its Survey of 
General Audit, 2000 and received responses from 106 companies of 
which 104 were audited by Big Five firms. It asked respondents how 
general audit time was allocated and received the following 
response: 40.2% control/compliance, 32.3% operational audit, 5.9% 
assisting external audit, 11.0% service requests, 3.4% M&A work and 
7.1% other activities. While the categories are generally not the 
same as those used in the IIA GAIN reports, the operational audit 
component in both surveys is similar. On the other hand, control/
compliance work is much higher for the Alliance survey respondents 
than the apparently similar category used in GAIN. This might be 
attributed to classification problems and/or the time period 
considered. However, in 1995 the Alliance survey reported an even 
higher control/compliance allocation at 46.9%. Further, the Alliance 
survey does not break out IT work specifically, making it difficult 
to compare the two survey results on this dimension. Alliance survey 
respondents did indicate that computer systems oriented work was 
growing rapidly (33%) or somewhat rapidly (59.4%). The Alliance 
survey reported a rise from 20.0% in 1995 to 32.3% in 2000 in the 
operational audit category, a category of internal auditing services 
not prohibited by the rule.
---------------------------------------------------------------------------

    The effect of the rule changes pertaining to internal audit 
outsourcing is to reduce the costs associated with the final rule 
without substantially reducing the benefits. To the extent that the 
final rule, taken as a whole, maintains or increases investors' 
confidence in the reliability of publicly available financial 
information, it increases the integrity of the U.S. securities markets. 
In the Proposing Release, we asked for comments and data on the 
assessment of costs associated with internal audit outsourcing and 
information systems consulting. While the staff garnered and analyzed 
data where it could, we received little data from public commenters 
that could be used in our analysis.\550\
---------------------------------------------------------------------------

    \550\ See Letters from Commissioner Isaac C. Hunt, Jr., supra, 
note 212. Some commenters suggested that by requesting data on the 
costs and benefits of the rule, we asked the public to shoulder a 
burden rightfully belonging to the regulator. See, e.g., Arthur 
Andersen Letter. We do not suggest that any party was obligated to 
provide data in response to our requests for comments. On the other 
hand, where data are exclusively under the control of commenters, 
our rules cannot be criticized for any failure to take into account 
data to which we do not have access. Wherever possible, we relied on 
information supplied by interested parties and other public sources 
of information.
---------------------------------------------------------------------------

1. Benefits
    Benefits are expected to accrue to investors, issuers, providers of 
management consulting services, and public accounting firms. Benefits 
include:
     Greater confidence in auditor independence and increased 
reliability of financial statements to investors, issuers and other 
users;
     Centralizing and codifying of the independence rules; and
     Better operational and investment decisions.
    a. Investors. For the reasons explained in this release, the 
Commission believes that the rule will enhance auditor independence. 
This should result in improved reliability, credibility, and quality of 
financial statements of public companies. Quality financial statements 
depend on subtle choices and judgments in reflecting economic events 
using accounting numbers. Quality financial statements also depend upon 
highly competent and independent auditors. Investors rely on quality 
financial statements in order to invest their funds effectively and 
efficiently. Therefore, the more confidence investors have in the 
independence of the auditor, the more reliance they will place on the 
financial statements when making investment decisions.
    Several representatives of the largest institutional investors in 
the country testified that this rule would enhance auditor 
independence, bolster institutional and individual investor confidence, 
and benefit their plan participants.\551\ One institutional investor 
associated poor performance with poor quality financial reporting and 
``a seemingly meek auditor.''\552\ In a similar vein, another commenter 
asserted that the rule will increase auditor independence and this, in 
turn, may reduce the incidence of fraud or lead to its more timely 
discovery.\553\
---------------------------------------------------------------------------

    \551\ See Letter of Kim Johnson, General Counsel, The Public 
Employees Retirement Association of Colorado (September 1, 2000); 
Testimony of Allen Cleveland, New Hampshire Retirement System (Sept. 
13, 2000); Testimony of John Biggs, Chairman, President and CEO of 
TIAA-CREF (July 26, 2000).
    \552\ See Testimony of Kayla Gillan, General Counsel, CalPERS 
(Sept. 13, 2000).
    \553\ See Testimony of Jay Eisenhofer, Partner, Grant & 
Eisenhofer (Sept. 13, 2000) (``Your rule, I believe, will cut down 
on fraud, cut down on auditor self-interest, and increase the 
reliability of financial statements.'').
---------------------------------------------------------------------------

    Some commenters suggested that there is no empirical evidence that

[[Page 76068]]

shows that the provision of non-audit services damages investors' 
confidence in the independence of auditors or the accuracy of financial 
statements.\554\ Commenters suggested that there is, therefore, no 
basis for our assertion that the rule will benefit investors.\555\ One 
such commenter suggested that the rule might, in fact, decrease 
investor confidence. This commenter argued that investors believe that 
the rule may decrease the quality of audits because auditors will know 
less about the companies they audit.\556\ However, other commenters 
suggested that providing consulting services does not improve the 
quality of audits.\557\ There is also academic and survey evidence that 
users of financial statements believe that the provision of non-audit 
services may impair the auditor's independence.\558\ A public opinion 
poll conducted by Public Opinion Strategies found that approximately 
eighty percent of investors favor a rule that imposes such 
restrictions.\559\ Another survey, conducted by AIMR, reported that 
over sixty-two percent of responding analysts believe that providing 
outsourcing services would likely compromise or impair auditor 
judgment.\560\ Brand Finance, in a survey of U.K. analysts, found that 
ninety-four percent of respondents believed that the current level of 
non-audit service fees was likely to compromise auditor 
independence.\561\
---------------------------------------------------------------------------

    \554\ See, e.g., KPMG Letter.
    \555\ See, e.g., Arthur Andersen Letter.
    \556\ See, e.g., Deloitte & Touche Letter.
    \557\ See, e.g., Testimony of Douglas Scrivner, General Counsel, 
Andersen Consulting (Sept. 20, 2000) (``It is important to note that 
audit firms do not provide consulting services to improve the 
quality of the audits, but rather for commercial considerations. A 
then CEO of one of the Big Five audit firms was quoted recently in 
Business Week saying `If I had to trade an auditing account for 
other business, I would do it.' '').
    \558\ Despite the mixed academic results and the difficulties in 
preparing unbiased survey results, it is clear that the perception 
of auditor independence is important to financial statement users 
and can be affected negatively by the extent and type of non-audit 
services provided by the auditor to audit clients.
    Perception is difficult to establish definitively. A number of 
academics have provided evidence that perceptions are affected by 
the mix of audit and non-audit services provided to audit clients. 
The academic evidence is mixed and subject to alternative 
interpretation. Selected papers by academics include: M. Firth, 
``Perceptions of Auditor Independence and Official Ethical 
Guidelines,'' 55 Acct. Rev., at 451-466 (July 1980) (``Firth''); 
R.A. Shockley, ``Perceptions of Auditors' Independence: An Empirical 
Analysis,'' 56 Acct. Rev., at 785-800 (October 1981) (``Shockley''); 
D.J. Lowe and K. Pany, ``CPA Performance of Consulting Engagements 
with Audit Clients: Effects on Financial Statement Users' Perception 
and Decisions,'' 14 Auditing: J. of Prac. & Theory, at 35-53 (Fall 
1995) (``Lowe 1995''); D.J. Lowe and K. Pany, ``An Examination of 
the Effects of Type of Engagement Materiality, and Structure on CPA 
Consulting Engagements with Audit Clients,'' 10 Acct. Horizons, at 
32-52 (December 1996) (``Lowe 1996''); J.G. Jenkins and K. Krawczyk, 
``Perception of the Relationship Between Nonaudit Services and 
Auditor Independence,'' North Carolina State University, manuscript 
(2000) (``Jenkins & Krawczyk'').
    Generally, Firth and Shockley found that financial statement 
users are more concerned than auditors about the independence 
problems associated with matters such as incentives to retain 
clients in a competitive environment and/or when non-audit services 
are sold to audit clients. More recently, Lowe (1995, 1996) found 
that loan officers and financial analysts appear to perceive little 
or no independence problem at low levels (1% of office revenue) of 
non-audit services, but did exhibit concern as the level of office 
revenues from non-audit services rose. Jenkins & Krawczyk studied 
three group's perceptions about auditor independence and the 
provision of non-audit services to audit clients. The Jenkins and 
Krawczyk study groups are Big Five CPA professionals, non-Big Five 
CPA professionals and a group labeled ``general public,'' composed 
of business professionals and graduate business students. The CPA 
professionals, particularly those associated with the Big Five, 
generally felt that independence was not threatened and in some 
cases might be strengthened by the provision of non-audit services 
to audit clients. The ``general public'' was generally supportive of 
the provision of non-audit services, but less so than the other two 
groups.
    Recent surveys of a variety of financial statement users 
demonstrate the existence of varying degrees of concern for auditor 
independence when offering non-audit services to audit clients. The 
story told by the surveys is admittedly complex. Virtually all of 
the surveys that have been submitted to the public record (Public 
Opinion Strategies, Brand Finance PLC, Earnscliffe, AIMR, Penn 
Schoen Survey, and Pace University) indicate some concern for 
auditor independence. The degree of concern may be, in part, a 
function of the timing of the surveys, the manner in which the 
subjects were queried, and the subject sample selection.
    \559\ Duquesne Poll, supra note 110. The surveyors asked several 
related questions of the subjects. First they asked, ``And from what 
you've seen, read or heard, do you generally favor or oppose this 
SEC proposal?'' This was immediately followed by, ``And do you 
strongly favor/oppose or just somewhat favor/oppose the SEC 
proposal.'' In response to this question, 30% stated that they 
``Strongly Favor'' and 34% that they ``Somewhat Favor'' the SEC 
proposal. The surveyors then provided a one paragraph narrative 
describing the auditor's responsibilities with respect to fair 
presentation of financial statements and a one paragraph narrative 
describing the SEC concerns about the potential conflict of interest 
auditors face when selling both audit and consulting services to the 
same client. The subjects were then asked to state whether they 
strongly/somewhat favor/oppose a position based on this information. 
At this point 49% stated that they ``Strongly Favor'' and 32% stated 
that they ``Somewhat Favor'' the SEC proposal.
    \560\ See Testimony of Mauricio Kohn, CFA, CMA, CFM, AIMR (Sept. 
20, 2000).
    \561\ See Letter of Brand Finance PLC (June 13, 2000).
---------------------------------------------------------------------------

    b. Issuers. Issuers will benefit from the proposed scope of 
services regulations in several respects. First, the rule will 
eliminate some of the uncertainties as to when a registrant's auditor 
will not be recognized as independent. Second, since increased investor 
confidence in financial reporting may encourage investment, the rule 
would facilitate capital formation. Issuers should be able to attract 
capital at lower rates of return or in some circumstances attract 
investment where they currently cannot raise capital.\562\ Third, the 
rule will increase the utility of annual audits to the management of 
issuers.
---------------------------------------------------------------------------

    \562\ See Testimony of Rajib Doogar (Sept. 13, 2000) (``Low 
audit credibility, in turn, will drive up costs of capital, 
affecting the well functioning of capital markets and indeed of the 
US economy as a whole.'').
---------------------------------------------------------------------------

    Management of the issuer also receives benefits from the external 
audit. No less than other investors, managers need reliable financial 
information about potential investment opportunities in order to manage 
their firm's assets. Internally, managers need assurance of the 
effective functioning of the control and reporting systems that produce 
the information on which they base their operating decisions. While 
company managers may obtain the needed assurances through internal 
processes, including internal audit groups, the external auditor also 
contributes to the company managers' assurance that the company's 
internal control processes are functioning effectively and that 
financial and other data are reliable.
    One commenter asserted that to the extent an issuer perceived that 
buying non-audit services from its auditor increased its cost of 
capital to such an extent that it outweighed the benefits of purchasing 
non-audit services, it could protect itself by limiting the amount and 
types of non-audit services it purchased from its auditor.\563\ This 
argument may not fully capture the incentives of management or the 
issuer, however. Academic literature describes how managers' incentives 
can deviate from those of investors.\564\ For example, a company 
manager may have a family or financial relationship with the auditor 
and may benefit from a lack of complete independence from the company's 
auditor. It is difficult for the company to credibly pre-commit to 
restricting the purchase of non-audit services from the auditor. 
Further, managers rely on auditors that may be unaware that they are 
subject to subtle biases that may

[[Page 76069]]

affect their judgments.\565\ Finally, management may be frequently 
marketed to by its auditor to purchase non-audit services.\566\
---------------------------------------------------------------------------

    \563\ See Letter of Charles C. Cox, Kenneth R. Cone, and Gustavo 
E. Bamberger, Lexecon Inc. (Sept. 25, 2000) (``Lexecon Letter'').
    \564\ See, e.g., M.C. Jensen and W.H. Meckling, ``Theory of the 
Firm: Managerial Behavior, Agency Costs and Ownership Structure,'' 3 
J. of Fin Econ, at 305-360 (1976); A.A. Alchian and H. Demsetz, 
``Production, Information Costs, and Economic Organization,'' 62 Am. 
Econ. Rev., at 777-795 (1972). This agency conflict grows out of the 
inability of investors to perfectly control by contract managers' 
behavior. The problem is exacerbated if investors cannot monitor 
management's choices.
    \565\ See M.H. Bazerman, K.P. Morgan, and G.F. Loewenstein, 
``The Impossibility of Auditor Independence,'' 38 Sloan Mgt. Rev. 
89-94 (Summer 1997); Testimony of Professor Max H. Bazerman, 
Northwestern University (July 26, 2000); Testimony of Professor 
George F. Loewenstein, Carnegie Mellon Institute (July 26, 2000); 
J.D. Beeler and J.E. Hunton, ``Contingent Economic Rents: Insidious 
Threats to Auditor Independence,'' manuscript (2000); G. Trompeter, 
``The Effect of Partner Compensation Schemes and Generally Accepted 
Accounting Principles on Audit Partner Judgment,'' 13 Auditing: J. 
Prac. & Theory, at 56-68 (Fall 1994). Trompeter provides 
experimental evidence that compensation schemes can influence 
subject judgments. Trompeter finds that auditors whose rewards are 
based on local office revenues have a tendency to support management 
views more often than if their rewards are computed on the broader 
firm revenue base. In the latter case, loss of a local client does 
not necessarily lead to substantial individual reward losses. 
Trompeter addresses the incentives issue, one of the complex issues 
possibly leading to subtle biases in judgment. His results suggest a 
self-serving bias effects judgment. But see Testimony of Professor 
Urton Anderson, University of Texas (Sept. 21, 2000) and Professor 
Don N. Kleinmuntz, University of Illinois at Urbana-Champaign (Sept. 
21, 2000) for arguments that the self-serving bias is overcome in 
practice by a variety of behavioral and institutional factors. See 
R.R. King, ``An Experimental Investigation of Self-Serving Biases in 
an Auditing Trust Game,'' manuscript (2000).
    \566\ See AICPA Practice Aid Series, Make Audits Pay: Leveraging 
the Audit into Consulting Services (1999). Furthermore, as a result 
of the rule, issuers may avoid marketing pressure from their 
auditors to purchase certain non-audit services.
---------------------------------------------------------------------------

    Although the decision of an individual company to purchase services 
from the auditor may be in the best interest of the company's 
investors, it may not be in the interest of investors in all companies 
as a whole. If decisions by individual company management reduce the 
reliability of audited financial statements as a whole, aggregate 
investment may be misallocated even if any individual company is acting 
in the best interest of its shareholders. It is unlikely that such 
concerns would enter into the company manager's choice of service 
provider even if it were a logical consequence of that choice.
    Audit committees will also have more concise and clearer guidance 
to support their enhanced role in overseeing the management/auditor 
relationship. The amendments to the proxy rules require disclosure of 
whether the audit committee, or the board of directors if there is no 
such committee, considered whether the provision of non-audit services 
by the company's principal accountant is compatible with maintaining 
the principal accountant's independence. Several commenters stated that 
the rule enhances the ability of the audit committee to identify 
situations in which auditor independence may be impaired. For example, 
the Co-Chairman of the Blue Ribbon Committee stated that he thought 
that ``[this rule] would help audit committees do their job 
better.''\567\ Another commenter argued that without this guidance 
audit committees must rely primarily on auditors to determine their own 
independence.\568\
---------------------------------------------------------------------------

    \567\ See Testimony of John C. Whitehead, retired Chairman, 
Goldman Sachs & Co. (Sept. 13, 2000).
    \568\ See Testimony of D. Bevis Longstreth, former SEC 
Commissioner and Member of the O'Malley Panel (Sept. 13, 2000).
---------------------------------------------------------------------------

    c. Public Accounting Firms. The rule provides a general test for, 
and a list of, non-audit services that, when provided to an audit 
client, will impair an auditor's independence. Currently, auditor 
independence requirements are found in several sources, including AICPA 
guidance, the Codification on Financial Reporting, SECPS rules, and a 
variety of Commission interpretive releases and staff no-action 
letters. Consolidating many of these requirements into one rule is an 
important purpose and benefit to this rule.
    Some commenters disagreed that this rule would clarify independence 
requirements for public accounting firms.\569\ These commenters argued 
that the rule creates confusion and therefore increases the amount of 
time that accounting firms, and others, will need to spend on 
compliance.\570\ We disagree. As discussed above, in response to 
comments, we have made significant modifications that clarify the 
rule's requirements. We realize that any rule inevitably requires some 
interpretation. We believe that, as modified, this rule will centralize 
and clarify independence requirements and thus result in increased 
certainty, resulting in a benefit to public accounting firms.
---------------------------------------------------------------------------

    \569\ See, e.g., Lexecon Letter.
    \570\ See, e.g., Deloitte & Touche Letter.
---------------------------------------------------------------------------

    Some commenters have argued that no benefits at all will be created 
by the rule. The basic argument is that no tangible evidence exists 
that independence has been impaired by provision of these non-audit 
services to audit clients.\571\ In testimony, however, several 
individuals recounted litigation experiences and discussed cases in 
which they believed that a lack of independence contributed to an audit 
failure and financial reporting fraud.\572\
---------------------------------------------------------------------------

    \571\ See, e.g., KPMG Letter. See supra Section III.C.4, for a 
discussion of this comment. But see Testimony of J. Michael Cook, 
former Chairman and Chief Executive Officer, Deloitte & Touche (July 
26, 2000) (``I agree with the Commission that the absence of `proof' 
does not justify inaction, particularly when such evidence cannot be 
expected to be demonstrable.'').
    \572\ See, e.g., Testimony of Richard Blumenthal, Attorney 
General, State of Connecticut (Sept. 20, 2000); Testimony of Robert 
Morgenthau, District Attorney for the County of New York (Sept. 13, 
2000); Testimony of Charles R. Drott (Sept. 13, 2000).
---------------------------------------------------------------------------

    Others have argued that economic forces provide sufficient 
incentives to audit firms to ensure independence.\573\ According to one 
such commenter, auditors lose market share when their reputations are 
damaged, either as a result of government action or private 
litigation.\574\
---------------------------------------------------------------------------

    \573\ See, e.g., Lexecon Letter.
    \574\ See, e.g., Lexecon Letter. The authors cite two studies 
that find accounting firms face significant costs when government 
regulators criticize auditors: M. Firth, ``Auditor Reputation: The 
Impact of Critical Reports Issued by Government Inspectors,'' 21 
Rand J. of Econ., at 374-387 (Autumn 1990) and L. R. Davis and D. T. 
Simon, ``The Impact of SEC Disciplinary Actions on Audit Fees,'' 11 
Auditing: J. of Prac. & Theory, at 58-68 (Spring 1992). In the 
former study, the loss of reputation in the U.K. manifested itself 
in lower market share for the largest accounting firms, while in the 
latter loss of reputation was related to a reduction in audit fees. 
We note that in both studies governmental oversight was responsible 
for making public the improper auditor behavior. It is not clear 
from this research that other economic forces were (or are) 
sufficiently strong to impose the costs to loss of reputation.
---------------------------------------------------------------------------

    Commenters also suggested that auditors already have strong 
incentives to maintain their reputations.\575\ The auditor's reputation 
is based on the public's belief in the auditor's objectivity and 
competence. The actual or perceived loss of either objectivity or 
competence can be expected to affect negatively the auditor's ability 
to obtain and retain clients.\576\ We also note that the SECPS mandates 
certain quality controls designed to support auditors' self-
monitoring.\577\ However, evidence suggests that these mechanisms may 
not be sufficient.\578\ One commenter concluded, based on a model of 
the auditor's incentives to maintain independence, that under certain 
circumstances when an auditor can command sufficiently high benefits 
from the mix of services, audit credibility may be diminished.\579\
---------------------------------------------------------------------------

    \575\ See, e.g., Lexecon Letter.
    \576\ See Lexecon Letter for a discussion and bibliography on 
this point.
    \577\ See SECPS Manual Sec. 1000.45 (April 2000).
    \578\ See, e.g., Testimony of Dennis Paul Spackman, Chairman, 
National Association of State Boards of Accountancy (Sept. 13, 
2000); Testimony of Paul Volcker, former Chairman, Board of 
Governors of the Federal Reserve System (Sept. 13, 2000).
    \579\ See Testimony of Rajib Doogar (Sept. 13, 2000).
---------------------------------------------------------------------------

    Some commenters have suggested that litigation acts as an incentive 
for the auditor to maintain independence.\580\ Conversely, another 
commenter noted that the expected cost of an auditor's

[[Page 76070]]

loss of independence due to litigation declined in recent years with 
the passage of the Private Securities Litigation Reform Act of 
1995.\581\
---------------------------------------------------------------------------

    \580\ See, e.g., Lexecon Letter.
    \581\ See Testimony of Professor John C. Coffee, Jr., Columbia 
University (July 26, 2000).
---------------------------------------------------------------------------

    d. Estimation of Benefits of Restricting Certain Non-Audit 
Services. The primary benefit of this rule is increased investor 
confidence in reported financial statements. This benefit is spread 
across all market participants and may manifest itself in changes in 
the investment patterns of individuals and the borrowing costs of 
businesses. Given the sheer magnitude of the U.S. financial system, 
even a small change in investor confidence manifests itself as a large 
aggregate benefit.
    If we measure the increase in investor confidence by a decrease in 
the required rate of return on an investment, it would lead to 
increased profitability for investment opportunities. As a result, the 
change in investor confidence may manifest itself in a revaluation of 
current securities prices. Everyone in the market benefits from this 
change in confidence because all participants can potentially take 
advantage of the increased investment opportunities. All individual 
investors benefit from the general increase in market values while 
businesses benefit in reconsidering their investment opportunities 
within their existing budget constraints and when seeking additional 
capital from the market. The market revaluation will be the result of 
many forces, but should be greater than the change in the required rate 
of return on a percentage basis simply because of the mathematical 
relationship between cash flows, interest rates and securities 
values.\582\
---------------------------------------------------------------------------

    \582\ This effect can be observed in a simple present value 
calculation. Assuming future cash flows of $100 per period and a 
discount rate or required rate of return of 10%, the present value 
of the cash flows in perpetuity is $1,000. If the discount rate is 
reduced to 9%, a 10% change in the discount rate, the present value 
of the future cash flows is $1,111, an 11% change in the present 
value. This analysis ignores the possibility that a decrease in the 
discount rate can change the investment opportunity set and increase 
the per-period cash flows.
---------------------------------------------------------------------------

    Not all market participants may benefit equally. The extent of 
individual and business benefit depends upon their current resources 
and assets, investments and investment opportunities. It is not clear 
whether these conditions would reduce the aggregate economic benefit. 
Because we cannot observe the distribution of benefits to individuals 
and businesses, we assume for the purposes of this estimate that 
benefits accrue primarily to those affected directly by all parts of 
the rule. This group includes businesses (and investors in those 
businesses) that will benefit from the increased confidence.
    To obtain an estimate of the number of individuals and businesses 
that may benefit, we note that, in any given year, approximately 74.3% 
of companies purchase only auditing services from their Big Five 
auditor.\583\ SECPS data further indicate that consulting revenues from 
SEC clients amount to 22.8% of the Big Five firms' total consulting 
revenues. It may be reasonable, therefore, to estimate that only 
twenty-five percent of audit clients will be directly affected by the 
rule.
---------------------------------------------------------------------------

    \583\ While we recognize that the set of firms that may purchase 
such services may change from year to year, we have received no 
evidence to suggest that the fraction of companies that may actually 
purchase such services in any given year is different from our 
estimate.
---------------------------------------------------------------------------

    However, the Big Five accounting firms provide audit and consulting 
services to the largest companies listed on the stock exchanges. 
According to a 1996 GAO report, the then largest six accounting firms 
audited seventy-eight percent of the nation's publicly traded 
companies.\584\ Approximately ninety percent of all companies with more 
than $200 million in assets are audited by one of these five 
firms.\585\ Therefore it is likely that the proportional value of the 
benefits will be significantly greater than twenty-five percent.
---------------------------------------------------------------------------

    \584\ See GAO Report. Appendix B of the Proposing Release, Table 
4 provides a 1999 comparable figure of 76.68%.
    \585\ See Compustat Database (October 31, 2000).
---------------------------------------------------------------------------

    If an increase in investor confidence generated by these rules 
leads to a decrease in the required rate of return, we can estimate the 
benefits based on the current market capitalization. For example, a 
decrease in the cost of capital as small as a single basis point (or 
one one-hundredth of one percent) would lead to an aggregate annual 
impact of approximately $2 billion.\586\ Although increased confidence 
should benefit the entire market, we provide an estimate that limits 
the benefit to those directly affected by the rule. Even if we measure 
the impact on the basis of the proportion of companies that annually 
purchase services covered by the rule (25%), a one basis point 
reduction in the required rate of return would result in an annual 
benefit of approximately $500 million.
---------------------------------------------------------------------------

    \586\ This calculation is based on the aggregate value of U.S. 
equities markets of $16.1 trillion as of September 29, 2000 as 
reported by Wilshire Associates and an additional $4.3 trillion in 
corporate debt outstanding issued by U.S. firms as of June 30, 2000 
as reported by the Board of Governors of the Federal Reserve. 
Therefore the aggregate value of outstanding debt and equity 
securities is $20.4 trillion.
---------------------------------------------------------------------------

    Benefits may also accrue to the economy in the form of more 
efficient contracting, improvements in operating and investing 
decisions by management, and greater market stability. Each of these 
benefits is extremely difficult to measure. We know that many parties 
to contracts rely on financial statement data, management relies on 
such data when negotiating contracts, and reliable financial data 
contributes to both the efficiency of contracting and the effectiveness 
of contract enforcement. Management needs reliable financial 
information when making operational and investment decisions, and 
external auditors contribute to management's assurance about financial 
information. Unexpected financial statement restatements result in 
large market capitalization drops. Recent examples of large unexpected 
financial reports restatements and resulting market capitalization 
losses have been reported.\587\ The logical consequence of such market 
surprises, in addition to the redistribution of gains and losses across 
investors, is greater uncertainty in the market place.\588\ The 
resulting uncertainty may dissuade investors from participating \589\ 
or may increase the required rate of return as a means of ensuring 
against the uncertainty. We make no separate estimate of benefits for 
the above noted items.
---------------------------------------------------------------------------

    \587\ See ``Accounting Wars,'' Bus. Wk., at 156-168 (Sept. 25, 
2000).
    \588\ See Testimony of Bill Patterson, Director, Office of 
Investments, AFL-CIO (Sept. 20, 2000) (``Now, the individual 
investor, I think their interest in the process is really catalyzed 
again around these high profile irregularities like Cendant, 
Sunbeam, Lucent, and Waste Management. I think these are warning 
shots to investors that this is a problem that has to be 
addressed.'').
    \589\ See Testimony of Frank Torres, Consumers Union (Sept. 20, 
2000) (``I think American consumers, from my experience, don't like 
the idea that they might get had.'').
---------------------------------------------------------------------------

    We recognize the difficulty in obtaining direct measures of all the 
benefits associated with each aspect of the rule to each individual or 
group. Therefore, in this section, we limited our estimate to the broad 
economic impact on the capital markets that affects all participants.
2. Costs
    Some commenters suggested that the only way to ensure that the 
provision of certain services does not impair auditor independence is 
to completely prohibit the purchasing of those services from the 
auditor.\590\ We do not believe that

[[Page 76071]]

such a prohibition would serve the investor and issuer communities.
---------------------------------------------------------------------------

    \590\ See, e.g., Letter of Jack Ciesielski, accounting analyst 
(July 14, 2000); Letter of William V. Allen, Jr. (Aug. 22, 2000); 
Testimony of John Biggs, Chairman and CEO of TIAA-CREF (July 26, 
2000); Testimony of Kayla J. Gillan, General Counsel, CalPERS (Sept. 
13, 2000) (``A clear, simple and bright line [prohibition] standard 
will avoid this tendency [toward creative ways to avoid the rule], 
and moreover, I have not heard anyone suggest that there is an 
absence of qualified and cost effective alternatives to the auditor 
performing nonaudit consulting services to the same client.'').
---------------------------------------------------------------------------

    a. Issuers. The final rule has the effect of restricting issuers 
from purchasing certain non-audit services from their auditors. Most of 
the rule's limitations, however, are drawn from existing limitations, 
including the proscription on operating or supervising an audit 
client's information technology function. Moreover, issuers would still 
be allowed to obtain most other information technology services and 
internal audit services from their auditor provided they comply with 
certain conditions. The rule would have the effect, however, of 
preventing issuers with more than $200 million in total assets from 
outsourcing more than forty percent of certain of their internal audit 
activities to their auditor.
    As some commenters noted, the rule may impose costs on some 
issuers.\591\ Issuers that do not competitively bid non-audit services 
or that would have purchased these newly proscribed non-audit services 
solely from their auditors and that are limited by the rule will have 
to look to other professional services firms, including other public 
accounting firms, to provide these services in the future. These 
issuers may incur costs from the use of a separate vendor, including 
the possible loss of any synergistic benefits of having a single 
provider of both audit and non-audit services. The issuer may also 
incur one-time transaction costs associated with identifying and 
choosing another vendor to provide those services.\592\ Estimation of 
these costs is discussed below.
---------------------------------------------------------------------------

    \591\ See, e.g., Lexecon Letter.
    \592\ Some commenters suggested that the rule would impose 
additional costs on small businesses and accounting firms. The 
impact of the rule on small entities is discussed below in Section 
VI.
---------------------------------------------------------------------------

    Some commenters have argued that the rule will sometimes force an 
audit firm to choose between providing an audit or non-audit service to 
a public company client, and that audit firms may forego providing 
audit services, thereby reducing competition for both audit and non-
audit services.\593\ As to internal audit services, in particular, 
however, available evidence suggests it is unlikely that auditors will 
cross the threshold that would require them to choose between external 
audit revenues and internal audit revenues.\594\ Further, it is 
unlikely that any individual firm has particular exclusive expertise in 
the internal audit function and therefore a suitable number of 
competitors likely exists to ensure that the issuer can obtain these 
services elsewhere at a reasonable cost.
---------------------------------------------------------------------------

    \593\ See, e.g., Arthur Andersen Letter; Deloitte & Touche 
Letter.
    \594\ See Manufacturers Alliance, Survey of General Audits 
(2000). In a survey of its members, the Alliance found that just 
less than 96% of respondents outsourced less than 35% of the 
internal audit. This amount is within the 40% threshold allowed by 
the rule.
---------------------------------------------------------------------------

    b. Public Accounting Firms. Public accounting firms may 
individually lose a source of revenue because they will no longer be 
able to sell internal audit services to their audit clients. Any loss 
may be mitigated by the opportunity to market this service to the audit 
clients of other public accounting firms. As discussed above, the $200 
million asset exemption reduces the impact of the rule on the Big Five 
and particularly on the second tier and smaller accounting firms.
    Of the top three second-tier firms with fewer than 1,000 clients, 
one firm has stated that it does not perform internal audit outsourcing 
work for its public company audit clients.\595\ Another firm's 
testimony indicates that it provides minimal proscribed non-audit 
services to its public audit clients.\596\ Thus, it does not appear 
that at least two of the next three largest firms will be significantly 
affected by the rule.
---------------------------------------------------------------------------

    \595\ Memorandum to File No. S7-13-00 (September 23, 2000).
    \596\ See Testimony of William D. Travis, Managing Partner, 
McGladrey and Pullen, LLP (Sept. 20, 2000). According to Mr. Travis' 
testimony, 85% of McGladrey and Pullen LLP's total revenues are 
attributable to accounting, auditing and tax. Therefore, only 15% is 
attributable to all consulting engagements. In addition the 
testimony indicates that approximately 50% of the firm's accounting 
and tax clients purchase audit services and that only 15% of its 
client base is made up of public companies. Mr. Travis also notes 
elsewhere in his testimony that ``[t]he IT practice [] was part of 
what was sold to an affiliate of Block, so the consulting practice 
is owned entirely by Block.'' See also Compustat Database, October 
31, 2000. Compustat lists only five companies with assets of $200 
million or more as audited by McGladrey and Pullen, LLP.
---------------------------------------------------------------------------

    c. Shared Costs. The rule might also affect what some contend are 
synergies (or ``knowledge spillovers'') that arise from providing non-
audit services to an audit client. If they exist, spillovers may 
provide issuers with a more efficient audit or provide the auditor with 
additional knowledge that will enhance not only the concurrent audit, 
but other audits as well. Since synergies may benefit either or both 
parties to some extent, we consider them a potentially shared benefit 
or cost. As well, to the extent that the proposed definition of 
affiliate of the accounting firm or affiliate of the audit client would 
have reduced the market for the provision of internal audit 
outsourcing, we consider that here.
    Some commenters have suggested that the proposed rule's definition 
with respect to affiliate of the accounting firm would be restrictive 
and impose significant costs. We have not adopted the proposed 
definition of an ``affiliate of the accounting firm,'' and left in 
place the existing standards for determining those entities associated 
with a firm that should be deemed to be part of the firm for auditor 
independence purposes. As such, it imposes no additional cost.
    Generally, research on enhanced efficiency or effectiveness of 
providing non-audit services to audit clients is suggestive, but 
indirect and inconclusive.\597\ The recent sale or

[[Page 76072]]

proposed sale of the consulting divisions of several large public 
accounting firms argues against significant knowledge spillovers. If 
efficient and effective audits require expertise most efficiently 
maintained through the provision of consulting services to audit 
clients, there is an incentive to retain consulting practices. Thus, 
the sale of these consulting practices would appear inconsistent with 
the existence of significant synergies that would be negatively 
affected by the rule.\598\
---------------------------------------------------------------------------

    \597\ Two studies in the 1980s documented that audit fees were 
generally greater, after controlling for other factors, for clients 
that also purchased non-audit services from the same public 
accounting firm. See Z. V. Palmrose, ``The effect of non-audit 
services on the pricing of audit services,'' 24 J. of Acct. Res., at 
405-11 (Autumn 1986); D. A. Simunic, ``Auditing, consulting, and 
auditor independence,'' 22 J. of Acct. Res., at 679-702 (Autumn 
1984). Palmrose found that the positive relationship held for both 
incumbent and non-incumbent auditors, suggesting that synergies may 
not exist. Nevertheless, the authors of these studies concluded that 
this evidence was not inconsistent with the hypothesis that the 
joint provision of audit and non-audit services may give rise to 
``knowledge spillovers.'' More recent research documents that these 
higher fees are associated with increased audit effort (in labor 
hours). See L. R. Davis, David N. Ricchiute, and G. Trompeter, 
``Audit Effort, Audit Fees, and the Provision of Non-audit Services 
to Audit Clients,'' 68 Acct. Rev., at 135-50 (Jan. 1993). The 
results of the Davis study therefore cast further doubt on the 
knowledge spillover hypothesis.
    Three recent studies also address the issue of synergies at 
least indirectly. See B. Arrunada, ``The Provision of Non-Audit 
Services by Auditors: Let the Market Evolve and Decide,'' 19 Intl. 
Rev. of Law and Econ., at 513-31 (1999) (``Arrunada''); M. Ezzamel, 
D.R. Gwilliam and K.M. Holland, ``Some Empirical Evidence from 
Publicly Quoted UK Companies on the Relationship Between the Pricing 
of Audit and Non-audit Services,'' 27 Acct. and Bus. Res., at 3-16 
(1996) (``Ezzamel''); K. Pany and P. M. J. Reckers, ``Auditor 
Performance of MAS: A Study of its Effects on Decisions and 
Perceptions,'' Acct. Horizons, at 31-38 (June 1988) (``Pany & 
Reckers''). Ezzamel in the U.K. observed a positive relationship 
between audit fees and non-audit fees. But the authors do not 
distinguish between competing explanations of the observed 
phenomenon. Pany & Reckers conducted an experimental study on U.S. 
loan officers. They did not find deterioration in the loan approval 
rate as consulting fees increased. But they did find limited 
evidence that providing MAS at a level of 90% of audit fees for a 
period of three years may present an independence perception problem 
among some financial analysts. They note that in 1988, levels of MAS 
fees as high as 90% of audit fees were uncommon. Arrunada states 
that after examining the effects of the provision of non-audit 
services on service cost, audit competition, service quality, and 
auditor independence, ``[he] concludes that the provision of non-
audit services reduces total costs, increases technical competence, 
and motivates more intense competition. Furthermore, it does not 
necessarily damage either auditor independence or the quality of 
non-audit services.''
    \598\ See Testimony of Philip A. Laskawy, Chairman, Ernst & 
Young LLP (Sept. 20, 2000). Mr. Laskawy commented on this matter as 
it relates to information systems consulting: We recently sold our 
practice in this area. We did so for a variety of reasons, but one 
reason certainly was that although we did not believe independence 
was actually impaired by this service, we could understand that 
particularly with large fees that sometimes are involved an 
appearance problem could be present. I might note that now that we 
have sold this practice we have not discovered that we are somehow 
enfeebled, unable to perform effective audits or to maintain top-
notch audit and tax practices. In fact, we have found more the 
opposite to be true. Without a large consulting practice to manage 
we are now more targeted and more focused on our core audit and tax 
business, and our audit and tax partners feel as though they, and 
not the management consultants, are in the drivers seat at the firm. 
Moreover, from our clients' perspective, there actually may be an 
advantage in not having such a practice. We have had a greater 
string of wins in obtaining new audit clients since we sold our 
management consulting practice than we had at any time in recent 
history, four new Fortune 500 clients, including two Fortune 50 
companies, just within the last six months.
    See also Testimony of James J. Schiro, Chief Executive Officer, 
PricewaterhouseCoopers, before the Panel on Audit Effectiveness 
(July 10, 2000) (``[Our] restructuring will allow us to rededicate 
ourselves to our core principles.''); Testimony of J. Terry Strange, 
Global Managing Partner, Audit, KPMG LLP, (July 26, 2000) (``In our 
view, the restructurings that are underway are driven by market 
forces, not regulatory considerations.''); Testimony of Thomas 
Goodkind, CPA (Sept. 13, 2000) (responding to a question about his 
experiences relating to synergies and knowledge transfers between 
audit and non-audit staff, Goodkind replied, ``In my experience, a 
transference of knowledge, I've rarely seen that in my 
experience.''); Testimony of Douglas R. Carmichael (July 26, 2000) 
(``The counter argument that consulting improves audit quality is 
also unproven and does not provide a basis for eliminating the 
proposed restrictions.''); Testimony of Douglas Scrivner, General 
Counsel, Andersen Consulting (Sept. 20, 2000) (``It is important to 
note that audit firms do not provide consulting services to improve 
the quality of the audits, but rather for commercial 
considerations.'').
---------------------------------------------------------------------------

    In the Proposing Release, we asked for comment and data on our 
estimates of the number of accounting firms affected by the rule and 
the costs imposed by the rule. We also sought comment and data 
specifically as to the existence and value of such synergies. We 
received many comments but no data. Instead, we estimate the potential 
costs associated with the possible loss of synergy as a percent of 
revenues lost from internal audit outsourcing.
    We base our cost estimates on the total audit, accounting and tax 
revenues for fiscal 1999 for the Big Five public accounting firms.\599\ 
This estimate is $14.9 billion. From this $14.9 billion, we estimate 
the total costs of the internal audit for Big Five audit clients based 
on the relationship between internal audit budgets and external audit 
fees for firms responding to the Manufacturers Alliance survey. On 
average, firms in this sample spent 1.7 times as much on the internal 
audit as they did on the external audit.\600\ Therefore, we estimate 
the aggregate cost of internal audits for Big Five audit clients in 
1999 to be $25.6 billion.
---------------------------------------------------------------------------

    \599\ See Public Accounting Report: Annual Survey of National 
Accounting Firms (2000) (``PAR'').
    \600\ See Manufacturers Alliance, Survey of General Audit 
(2000). We use data from table 13 and table 66 to derive this ratio.
---------------------------------------------------------------------------

    This estimate of aggregate internal audit costs is likely to 
overstate the true costs for two reasons. First, the aggregate revenues 
reported by PAR include tax and accounting services in addition to 
external audit fees. Second, data in the Manufacturers Alliance survey 
suggest that the ratio of internal to external audit fees is smaller 
for smaller companies.\601\ In fact, for the smallest firms in their 
sample, external audit fees exceed the internal audit budget.
---------------------------------------------------------------------------

    \601\ Id. at table 16.
---------------------------------------------------------------------------

    Additional information in the Manufacturers Alliance survey 
indicates that approximately two percent of respondents outsource more 
than fifty percent of their internal audit.\602\ Further, analysis 
described earlier indicated that on average, companies with assets 
greater than $200 million could still purchase as much as sixty-one 
percent of their entire internal audit budget from their external 
auditor. Together, these estimates imply that at most, the restrictions 
will reduce internal audit outsourcing fees to the auditor by 0.8%, or 
$207.7 million. Finally, we apply a growth rate of twenty-one percent 
to these revenues to arrive at a year 2000 estimate of $251.3 
million.\603\
---------------------------------------------------------------------------

    \602\ Id. at table 73.
    \603\ Data are derived from PAR. The average growth rate in non-
audit service revenues in 1999 was 21% and 9% for auditing and 
accounting services. Because there is uncertainty about whether 
individual firms classify internal audit outsourcing as consulting 
or assurance services, we choose the larger growth rate. In the 
current economy this may represent an optimistic growth rate.
---------------------------------------------------------------------------

    Professor Rick Antle testified to the effect that there is little 
reliable evidence as to the size of potential synergies from purchasing 
consulting services from the audit firm, but he has provided an 
estimate.\604\ We agree with Professor Antle's assessment of the 
difficulties inherent in measuring these effects. In his testimony, 
Professor Antle estimated that lost synergies could be on the order of 
ten percent of twice the gross profits before partner compensation and 
taxes of the consulting practice. Further, he estimates the gross 
profit margin to be 0.20.\605\ We acknowledge that there is little 
empirical evidence to support this estimate, but it represents the 
larger of the two estimates presented by the two representatives of the 
accounting firms.\606\ Applying those percentages to our estimate of 
revenues restricted by the rule results in an annual estimate of lost 
synergies of $10.1 million for audit clients who will be forced to 
reduce internal audit outsourcing services from their auditors.
---------------------------------------------------------------------------

    \604\ See Testimony of Professor Rick Antle, Yale University 
(July 26, 2000) (``I'll tell you now that as far as I know there's 
no systematic evidence as to the magnitude of these economies, just 
none that I know of.''). See also Letter of Professor Rick Antle, 
Yale University (Sept. 25, 2000). Professor Antle provides analysis 
to estimate the aggregate cost of lost synergies. He estimates the 
value of the non-audit services as ``the additional value of having 
the consulting done by the audit firm.'' He further estimates this 
value at $700 million, the gross margin attributable to all non-
audit services provided to SEC audit clients in 1999. This number 
likely over-estimates the gross profits for these services in the 
future for two reasons: First, it includes revenues for non-audit 
services for the Big Five firms, two or three of which have sold or 
are committed to selling most of these practices. Second, the rule 
does not prohibit the purchase of all non-audit services by audit 
clients. In addition, Professor Antle estimates the aggregate social 
benefit of non-audit services purchased from any provider. Because 
the rule does not prohibit the purchase of any of these services, 
this estimate is not relevant to the cost-benefit analysis.
    \605\ Professor Antle's assumption about the value of synergies 
to the gross profit before partner compensation implies that the 
value of these synergies is on the order of 4% of non-audit revenues 
from SEC clients.
    \606\ See also Testimony of Charles Cox, Kenneth R. Cone and 
Gustavo E. Bamberger, Lexecon, Inc. (Sept. 25, 2000). These 
commenters also estimate the aggregate cost of lost synergies on the 
order of 1%-2% of non-audit revenues from SEC clients.
---------------------------------------------------------------------------

    In addition, the rule may impose certain transition costs to be 
borne by companies that currently have long-term consulting engagements 
with their auditors for proscribed services. A significant number of 
consulting engagements are short-term projects.\607\

[[Page 76073]]

The rule allows for a transition period of eighteen months for certain 
non-audit services. Over this period, audit firms may continue to 
contract with their audit clients for the newly covered non-audit 
services. The firms entering into new contracts, however, will either 
plan to complete those services by the end of the transition period or 
to assign or sell those contracts to someone else before the end of the 
period because at the end of this period, audit firms may no longer 
provide the newly proscribed services to their audit clients.
---------------------------------------------------------------------------

    \607\ See Testimony of Stephen G. Butler, Chairman and Chief 
Executive Officer, KPMG (Sept. 21, 2000). In response to a 
Commissioner's question about the source of non-audit service 
revenues, Mr. Butler commented that any statement attributing a 
percent of non-audit services to SEC audit clients for his firm 
would be difficult to interpret. Butler stated that ``it is 
difficult to look at that sort of statistic because that's not a 
constant 20% that buys that service from us. It might be 20% of the 
number of our clients this year, it might be the same percentage 
next year, but it might be a totally different 20 percent.''; 
Testimony of Robert K. Elliott, Chairman, AICPA (Sept. 21, 2000) 
(``[auditing is] . . . not an annuity, [but] it is more like an 
annuity than a consulting engagement which, when it's over, it's 
over.'').
---------------------------------------------------------------------------

    In this analysis, we recognize that some companies may face 
transition costs associated with changing the provider of non-audit 
services. But, for the reasons discussed above, we believe those costs 
will be small in the aggregate. Thus, any company whose current 
contract expires during the transition period faces the same costs as 
any new purchaser of the services. Those contracting costs are captured 
above in our analysis of synergies.
    By extension, only companies with contracts for the proscribed 
services extending beyond the transition period will be faced with any 
re-contracting costs imposed by the rule. We note that those re-
contracting costs may be borne by the company itself or by the auditor 
in its attempt to sell the contract to another provider. We received no 
information concerning these costs from commenters. Nevertheless, we 
have included $1.3 million in the cost estimate.\608\
---------------------------------------------------------------------------

    \608\ We assume that these costs may represent as much as 5% of 
the revenues from proscribed services purchased by each affected 
company. If as many as 10% of the purchasers of proscribed internal 
audit services from their auditor have contracts in excess of 
eighteen months and the entire $251.3 million represents revenues 
from proscribed services, the aggregate transition costs would be 
$1.3 million. Some may argue that transition costs are substantially 
higher, but we note that if transition costs are sufficiently high, 
economic theory suggests the service providers would be, on average, 
charging higher fees for the same level of service to the detriment 
of their clients. See, e.g., T. Nilssen, ``Two Kinds of Consumer 
Switching Costs,'' 23 Rand J. of Econ., at 579-589 (Winter 1992).
---------------------------------------------------------------------------

    Commenters also suggested that the rule would generate a cost 
associated with lost effectiveness on the audit and a cost associated 
with recruiting and retention of staff professionals.\609\ We have seen 
no evidence that the rule will lead to less effective audits. Our cost 
estimates associated with lost synergies and scope include efficiency 
costs, if any, associated with an increase in cost to accomplish an 
effective audit. The sale by certain of the Big Five firms of their 
consulting practices further undermines the argument that the loss of 
non-audit business will impair audit effectiveness.
---------------------------------------------------------------------------

    \609\ See, e.g., Arthur Andersen Letter; Deloitte & Touche 
Letter.
---------------------------------------------------------------------------

    We also are skeptical about comments that suggest that the 
prohibition of certain services will make the profession less 
attractive to potential employees,\610\ and increase staff recruiting 
and retention costs. Some argue that less qualified individuals will 
have to be hired to meet personnel needs and that this will ultimately 
lead to less effective audits, with a resulting impact on auditing 
firms, issuers and investors.\611\ We do not believe that the issues of 
retention and recruitment are caused by this rule.\612\ These problems 
are not new and are more systemic. Several commenters have noted that 
starting salaries for recent accounting graduates have failed to keep 
pace with other fields such as information systems, financial and 
treasury analysis and consulting.\613\ Other commenters have stated 
that accounting firms have de-emphasized the audit function, treating 
it more like a commodity.\614\ In addition, despite increases in 
university enrollments, interest in technical fields such as 
accounting, engineering, computer sciences and mathematics have been 
declining.\615\
---------------------------------------------------------------------------

    \610\ See, e.g., Letter of W. Steve Albrecht, Professor and 
Associate Dean, Marriott School of Management, Brigham Young 
University (Aug. 25, 2000); Letter of Professor James Jiambalvo, 
University of Washington (Sept. 14, 2000); Written Testimony of 
Professor Peter Cappelli, Wharton School (Sept. 20, 2000).
    \611\ See, e.g., Testimony of Joseph F. Berardino, Managing 
Partner, Assurance and Business Advisory Services, Arthur Andersen 
(July 26, 2000); Written Testimony of Stephen G. Butler, Chairman 
and Chief Executive Officer, KPMG (Sept. 13, 2000).
    \612\ See Testimony of J. Michael Cook, former Chairman and 
Chief Executive Officer, Deloitte & Touche (July 26, 2000) (``A 
final assertion that quality will ultimately decline because the 
`new audit profession' will be unattractive to the best and 
brightest people. I cannot evaluate that possibility but would 
observe that the audit-dominated firms of the future that today's 
leaders express concerns about are in many respects comparable to 
the firms that attracted them (and me) to the profession twenty or 
more years ago. Certainly much has changed in that time period, but 
I would expect the right leaders to be able to make such firms 
attractive once again.'').
    \613\ See Salary Survey Fall 2000, National Association of 
Colleges and Employers, 2000. Recent starting salaries for 
accounting graduates are 23% lower than those for information 
systems, 24% for consulting and 9% for financial and treasury 
analysis; See also Testimony of Robert K. Elliot, Chairman, AICPA 
(Sept. 21, 2000); Testimony of Barry Melancon, President and Chief 
Executive Officer, AICPA (Sept. 21, 2000).
    \614\ See, e.g., Testimony of Douglas Scrivner, General Counsel, 
Andersen Consulting (Sept. 20, 2000) (``It is more likely that 
recruitment has been jeopardized by the actions of the accounting 
firms themselves. Some of the firms have diverted investment and 
resources out of the audit function and into non-audit services, 
thereby reducing the attractiveness of the audit function as a 
career path. They have created the very environment in which 
accounting majors look elsewhere and audit staff move over to the 
consulting side as quickly as they can.''); See also O'Malley Panel 
Report, supra note 20, at para. 4.4 (``Focus group participants 
often indicated that not only clients, but also engagement partners 
and firm leaders, treat the audit negatively as a commodity.''). See 
generally the Taylor Research and Consulting Group, Inc., Final 
Quantitative Report (2000); Albrecht and R. Sack, Accounting 
Education: Charting the Course through a Perilous Future, at 23 
(August 2000). AICPA statistics presented to the O'Malley Panel 
indicate that from 1992 to 1997 the number of students obtaining 
bachelor degrees declined by 14%, those obtaining finance degrees 
declined by 17%, those obtaining general business degrees declined 
by 8%, and those obtaining marketing degrees declined by 27%.
    \615\ See Digest of Educational Statistics, 1999.
---------------------------------------------------------------------------

C. Costs and Benefits of the Disclosure Requirements

    The final rules require public companies to disclose in their proxy 
statements audit fees, fees for permitted information systems 
consulting and other fees paid to the auditor. The rule also requires 
public companies to disclose, when applicable, that personnel who are 
full- or part-time employees of an entity other than the audit firm 
performed more than fifty percent of the audit. In addition, the audit 
committee or the board of directors must state whether it has 
considered whether the provision of non-audit services by the auditor 
is compatible with maintaining auditor independence.
    Many commenters argued that the provision of information systems 
consulting in and of itself does not impair auditors' 
independence.\616\ This may be true where the conditions described in 
the rule are met. Even when these conditions are met, when the 
information systems consulting fees become large relative to audit 
fees, auditor independence may be at risk. At the same time, we 
understand that the level where impairment may occur may be related to 
other factors such as the closeness of the auditor-client relationship 
or the nature of the client's business and industry. Therefore, we 
believe that investors and audit committees are well-suited to 
determine when provision of these services may cause impairment.
---------------------------------------------------------------------------

    \616\ See, e.g., Written Testimony of Mauricio Kohn, CFA, CMA, 
CFM, AIMR (Sept. 20, 2000) (submitting survey); Letter of Mary Ellen 
Olivierio and Bernard Newman, Lubin School of Business, Pace 
University (Sept. 23, 2000).
---------------------------------------------------------------------------

    The disclosure of fees from the provision of information systems 
and

[[Page 76074]]

other non-audit services provided by a company's auditor is intended to 
assist investors in deciding whether these services affect the 
independence of the auditor. Similar disclosures have been provided in 
the United Kingdom for several years.\617\ The disclosure regarding the 
use 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. As discussed above, some commenters believe 
disclosure alone would not be sufficient to alleviate an impairment of 
auditor independence.
---------------------------------------------------------------------------

    \617\ See Lexecon Letter; Letter of Brand Finance PLC (June 13, 
2000).
---------------------------------------------------------------------------

1. Benefits
    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 or easily 
accessible to the investing public. Further, this information provides 
a description of types of services provided by the public accounting 
firm for all of its clients, rather than for each audit client. The 
rule would provide aggregate fee information for each registrant to the 
market.\618\
---------------------------------------------------------------------------

    \618\ The Commission imposed a similar disclosure requirement 
when it issued ASR 250. As noted above, ASR 250 was withdrawn three 
years later. The rule prompted some academic research at the time. 
Three studies from the period and a current study are of particular 
interest: J. H. Scheiner and J.E. Kiger, ``An Empirical 
Investigation of Auditor Involvement in Non-Audit Services,'' 20 J. 
of Acct. Res., at 482-496 (Autumn 1982) (``Scheiner & Kiger); J. H. 
Scheiner,'' ``An Empirical Assessment of the Impact of SEC Nonaudit 
Service Disclosure Requirements on Independent Auditors and Their 
Clients,'' 22 J. of Acct. Res., at 789-797 (Autumn, 1984) 
(``Scheiner''); G.W. Glezen and J.A. Millar, ``An Empirical 
Investigation of Stockholder Reaction to Disclosures Required by ASR 
No. 250,'' 23 J. of Acct. Res., at 859-870 (Autumn 1985); M. 
Ezzamel, D.R. Gwilliam and K. M. Holland, ``Some Empirical Evidence 
from Publicly Quoted UK Companies on the Relationship Between the 
Pricing of Audit and Non-audit Services,'' 27 Acct. and Bus. Res., 
at 3-16 (1996) (``Ezzamel'').
    Scheiner and Glezen studied the impact of ASR 250 disclosure 
requirements on the provision of audit and non-audit services and 
concluded that the major accounting firms did not significantly 
reduce the amounts of services offered. Glezen compared stockholder 
approval of auditors before and after the issuance of ASR 250 and 
found no significant decline in the approval ratios across the three 
periods. These authors generally conclude that either independence 
is not important to stockholders, a conclusion they consider 
unlikely, or the level of non-audit services did not reach the level 
at which independence was perceived to be threatened. Scheiner 
allows that the firms in his study were not providing clients many 
of the services that fell within the disclosure rule. Scheiner and 
Kiger find evidence that the non-audit services provided to audit 
clients at that time generally ``consisted of traditional accounting 
services--primarily tax services. Less traditional services which 
are often questioned by critics of the accounting profession 
comprise only a small part of total non-audit services.'' They 
further state that at that time, ``[t]he prohibition of non-
accounting, non-audit services would not appear to have a 
substantial impact on firms because these services do not represent 
a large percentage of total revenues.''
    As we discussed in Section III.B., the level of non-audit 
services in general and non-audit services for audit clients in 
particular have increased substantially in recent years. Ezzamel 
found in the U.K. that substantial income was produced by non-audit 
services and that ``the extent of voluntary disclosure of the 
breakdown on non-audit services was limited and the existing 
disclosure requirement allowed considerably variety in the manner in 
which non-audit services incurred or paid abroad were disclosed.''
---------------------------------------------------------------------------

    The disclosure related to non-audit services fees received by 
auditors would give investors insight into the relationship between a 
company and its auditor. In so doing, the disclosure will reduce 
uncertainty about the scope of such relationships by providing facts 
about the magnitude of non-audit service fees. 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 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 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 investors benefit jointly from the prohibition of 
certain services and the disclosure discussed above. Investors benefit 
under the rule from the knowledge that the accounting firms are not 
providing certain services that impair their independence. They will 
also be able to assess the relevance of aggregate compensation to the 
auditor for non-audit services. To the extent that confidence arises 
from both the prohibition and the disclosure aspects of the rule, our 
estimate of annual benefits on the order of one half to two billion 
dollars includes both elements of the rule.
2. Costs
    We believe that the disclosure rule will impose relatively minor 
reporting costs on issuers. Generally, information about auditor fees 
is readily available to registrants. ISB Standard No. 1 requires 
auditors to report on certain independence issues to the audit 
committees of their SEC audit.\619\ 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.\620\ Companies also must report the billings from 
their auditors as expenses and import this billing information into 
their systems. As a result, companies should have ready access to the 
information on fees paid to their auditor for non-audit services.
---------------------------------------------------------------------------

    \619\ ISB Standard No. 1, supra note 167. 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.
    \620\ SECPS Manual Sec. 1000.08(i).
---------------------------------------------------------------------------

    Disclosure of audit and non-audit fees will impose a reporting 
burden on all issuers subject to the proxy disclosure rules. For the 
purpose of the Paperwork Reduction Act, we estimated the aggregate 
reporting cost of $272,620 to complete the appropriate paperwork.\621\ 
Commenters suggested that this estimate is unreasonably low.\622\ Some 
commenters suggested that registrants would spend more time making the 
required disclosures. We do not agree; the disclosures can be made 
using information that registrants will have on hand. We also note that 
the scope of the required disclosure has been significantly reduced 
from the proposal, limiting it to only aggregate audit, IT, and other 
non-audit fees. For the purpose of providing an aggregate cost 
estimate, we consider a range of $272,620 and $1.09 million, but use 
only the top of this range for the total. The rule will not impose 
significant burdens related to storing, analyzing and compiling data, 
or to training employees. Moreover, even if registrants spend more time 
in making the required disclosure, the marginal increase in cost

[[Page 76075]]

will not be significant relative to the overall costs discussed in this 
section. Even assuming the burden is four times as great to make the 
disclosure, the annual cost of complying with the disclosure portion of 
the rule would be $1.09 million.
---------------------------------------------------------------------------

    \621\ In our Paperwork Reduction Act analysis in the Proposing 
Release, we estimate that 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.
    \622\ See Deloitte & Touche Letter. Deloitte & Touche provided 
an estimate of 3-6 hours per filing for a small firm and 50-100 
hours for a large firm, but provided no data to support this 
estimate.
---------------------------------------------------------------------------

D. Estimated Aggregate Costs and Benefits

    The elements of the total quantified cost of the rule are lost 
synergies for those currently purchasing proscribed services; 
transition costs for those currently purchasing both audit and 
proscribed consulting services; professional training to learn the new 
rules regarding employment, investment, and independence; and 
disclosure costs. Using assumptions and methods that tend to overstate 
costs, we estimate the aggregate cost to the U.S. economy to be 
approximately $16.6 million for the first year and $12.4 million for 
subsequent years.\623\
    Finally, we have quantified one primary benefit of the rule as 
increased investor confidence that may lead to a reduction in the 
required rate of return. In summary the rule benefits (i) auditors and 
members of their families as a result of changes in restrictions on 
investment and employment relationships; (ii) family members of 
auditors as a result of changes in the restrictions on employment 
relationships; (iii) issuers by eliminating certain uncertainties about 
their auditor's independence, by increasing investor confidence and 
thus facilitating issuers in raising capital, and by increasing the 
utility of annual audits and quarterly reviews; (iv) public accounting 
firms by clarifying the independence rules; (v) investors who will 
benefit from increased confidence in the reported financial statements; 
and (vi) all of the market participants through more efficient 
contracting, improved operating and investing decisions, and greater 
market stability.
---------------------------------------------------------------------------

    \623\ The ongoing figure is not adjusted for inflation or growth 
in consulting revenues beyond 2000. However, we note that there is a 
slowdown in the growth of these services. See, e.g., PAR, End of a 
Run: National Firms' Growth Rate Slowed In FY 99 (Mar. 31, 2000).
    We note that the transition costs of $1.3 million may be 
incurred at any time over the eighteen-month transition period. We 
include this estimate in the first year only for ease of 
presentation.
---------------------------------------------------------------------------

    Even if the rule leads to only a very small change in that rate of 
return, the annual benefit could be in the range of one half to two 
billion dollars. Benefits may also accrue to the economy in the form of 
more efficient contracting, improvements in operating and investing 
decisions by management and greater market stability. Finally, 
relaxation of the investment and employment constraints on auditing 
professionals and their families may also lead to more efficient 
investments by these persons.

VI. Final Regulatory Flexibility Analysis

    We have prepared this Final Regulatory Flexibility Act Analysis in 
accordance with the Regulatory Flexibility Act (``RFA'').\624\ This 
analysis relates to amendments to Rule 2-01 of Regulation S-X and to 
Item 9 of Schedule 14A \625\ under the Exchange Act. The amendments 
modernize our auditor independence requirements.
---------------------------------------------------------------------------

    \624\ 5 U.S.C. 603.
    \625\ 17 CFR 240.14a-101.
---------------------------------------------------------------------------

    The rules as adopted will not have a significant impact on a 
substantial number of small entities. The vast majority of public 
companies required under the federal securities laws to submit reports 
prepared by an independent accountant to the Commission are not 
``small'' for purposes of the RFA. Moreover, as to the impact on small 
accounting firms, the Big Five accounting firms, which are not small 
entities, provide auditing services for the vast majority of public 
companies. The major effects of these rules, therefore, will not be on 
small entities. Nevertheless, we are mindful of the possible effect of 
our rules on small entities, and we have made certain modifications, 
noted below, that should reduce significantly the impact of the new 
rules on small entities.

A. Reasons for and Objectives of the Rule Amendments

    As discussed above, the federal securities laws require registrants 
to file financial statements that have been audited, and reports that 
have been prepared, by ``independent'' accountants.\626\ Our auditor 
independence requirements are found in Rule 2-01 and interpretations, 
which have been supplemented by staff letters, staff reports, and 
ethics rulings by the accounting profession. Many of the 
interpretations are reprinted in Section 600 of the Codification. We 
have not amended the fact-specific examples in the Codification since 
1983. As discussed more fully above, since that time, there has been a 
dramatic transformation of the accounting industry. Increasingly, 
accounting firms are becoming multi-disciplinary service organizations 
and are entering into novel and complex business relationships with 
their audit clients. At the same time, individual accounting 
professionals have become more mobile, while the geographic location of 
personnel has become less important due to advances in 
telecommunications and the Internet. In addition, an increasing number 
of American families have two wage earners.
---------------------------------------------------------------------------

    \626\ See supra note 8.
---------------------------------------------------------------------------

    To protect the reliability and integrity of the financial 
statements of public companies and to promote investor confidence, we 
must ensure that our auditor independence requirements remain relevant, 
effective, and fair in light of the new business environment. 
Consequently, the rule amendments provide a general standard for 
determining auditor independence and identify relationships that render 
an accountant not independent of an audit client under the standard in 
Rule 2-01(b). The relationships addressed include, among others, 
financial and employment relationships, business relationships, and 
relationships where auditors provide certain non-audit services to 
their audit clients. We also are requiring certain public companies to 
disclose in their annual proxy statements information about, among 
other things, non-audit services provided by their auditors.
    Financial and Employment Relationships. Under former requirements, 
an auditor's independence was impaired if any partner in the firm, any 
manager in an office participating in a significant portion of the 
audit, or certain of their relatives, had a financial interest in, or 
certain employment relationships with, an audit client. As explained 
above, these requirements may have unnecessarily restricted employment 
and investment opportunities for auditors and members of their 
families.
    The amended rule targets application of these particular auditor 
independence rules to those who can actually influence the audit of a 
client. The amended rule allows audit firm partners, other 
professionals, and their families, more freedom in their investments 
and employment decisions and will allow them to take greater advantage 
of future opportunities in these areas. The amended rule shrinks 
significantly the circle of family members and former accounting firm 
personnel whose employment impairs an auditor's independence; the 
amended rule similarly reduces significantly the pool of firm personnel 
whose investments are imputed to the auditor. We believe that the 
amended rule will maximize the opportunities available to auditors 
while promoting the public interest and protecting investor confidence.
    Non-Audit Services. We, along with certain users of financial 
statements,

[[Page 76076]]

have become increasingly concerned about the effects on independence 
when auditors provide both audit and non-audit services to their audit 
clients. These concerns have been exacerbated in recent years by 
changes in the types of non-audit services that accounting firms 
provide as well as by dramatic increases in the fees, in both absolute 
and relative terms, for those non-audit services. As we discuss more 
fully above, the rapid growth of non-audit services has increased the 
economic incentives for the auditor to preserve a relationship with the 
audit client, thereby increasing the risk that the auditor will be less 
vigilant in its objectivity. Additionally, aggregate economic 
incentives aside, certain types of non-audit services by their very 
nature can create conflicts incompatible with objectivity. At the same 
time that more and more individual investors are participating in our 
capital markets, either directly or through mutual funds, pension 
plans, and retirement plans, we have seen growing public concern about 
the increasing importance of non-audit services to accounting firms. 
The amended rule identifies certain non-audit services that, if 
performed by an auditor for an SEC audit client, would render the 
accountant not independent.
    Disclosure. As discussed, the types of non-audit services provided 
by auditors to audit clients have changed, and the fees paid for those 
services have increased. We are adopting a proxy statement disclosure 
requirement focused on the fee relationship between registrants and 
their auditors. Independent studies and the comments we received have 
shown that concerns are likely to be raised about auditor independence 
when the consulting fees paid by a registrant are significant when 
compared to the audit fees. Accordingly, the disclosure we are 
mandating addresses this area and will be useful to investors in 
evaluating auditors' independence. The amendments require registrants 
to disclose in their proxy statements their audit fees, fees for 
financial information systems design and implementation, and the fees 
for other non-audit services rendered by the principal accountant to 
the company. In addition, we are requiring companies to disclose 
whether their audit committees have considered whether the provision of 
financial information systems design and implementation services and 
other non-audit services provided by the company's principal accountant 
is compatible with maintaining the principal accountant's independence. 
Investors accordingly will have access to this information when making 
investment and voting decisions.

B. Significant Issues Raised by Public Comment

    The proposals generated significant comment and broad debate. As we 
discussed in detail above, the final rule amendments, particularly 
those related to non-audit services, have been modified from the 
proposals in response to comment letters, written and oral testimony 
from four days of public hearings, academic studies, surveys, and other 
professional literature.
    At the time we published the Proposing Release, we also prepared an 
Initial Regulatory Flexibility Analysis (IRFA), a summary of which was 
published in the Proposing Release. We requested comment on the IRFA, 
and we received several comments in response. Separately, many 
commenters representing small accounting firms expressed strong support 
for the proposal,\627\ and other commenters representing small 
businesses expressed concerns about the proposal.
---------------------------------------------------------------------------

    \627\ See supra notes 215, 216.
---------------------------------------------------------------------------

    With respect to procedural issues related to the IRFA, one 
commenter questioned our procedure, arguing that we should have 
requested information on the number of small entities affected some 
time earlier and that neither the Proposing Release nor the IRFA 
indicates that the Small Business Administration (``SBA'') reviewed or 
commented on the IRFA.\628\ At the time that we prepared the Proposing 
Release, we prepared the IRFA in accordance with the RFA and made it 
available to the public as required by Section 603 of the RFA. We 
submitted the IRFA to the SBA, and the SBA had no comments on the IRFA. 
The same commenter questioned whether the agency assured that small 
entities had an opportunity to participate in the rulemaking. In 
addition to soliciting extensive comments in the Proposing Release and 
holding four days of hearings at which representatives of small 
accounting firms testified, we published a summary of the IRFA in the 
Federal Register, and many small firms commented on the proposed 
amendments.
---------------------------------------------------------------------------

    \628\ Letter of Jim J. Tozzi, Member, Board of Advisors, Center 
for Regulatory Effectiveness (Aug. 30, 2000) (``Tozzi Letter'').
---------------------------------------------------------------------------

C. Small Entities Subject to the Rule

    For purposes of analyzing the impact on small public companies, the 
Commission has defined ``small business'' in Rule 157 under the 
Securities Act.\629\ Rule 157 provides that ``small business'' means 
any entity whose total assets on the last day of its most recent fiscal 
year were five million dollars or less and is engaged, or proposes to 
engage, in small business financing. 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.\630\ We estimated in the IRFA that 
there are approximately 2,500 Exchange Act reporting companies that are 
small businesses.
---------------------------------------------------------------------------

    \629\ 17 CFR 230.157.
    \630\ 15 U.S.C. Sec. 77c(b).
---------------------------------------------------------------------------

    The Commission also has defined small business for purposes of an 
investment company in Rule 0-10 of the Investment Company Act.\631\ 
This definition provides that an investment company is a ``small 
business'' if it has net assets of $50 million or less as of the end of 
its most recent fiscal year. In the IRFA, we estimated that 
approximately 227 investment companies are small businesses.
---------------------------------------------------------------------------

    \631\ 17 CFR 270.0-10.
---------------------------------------------------------------------------

    Our rules do not define ``small business'' or ``small 
organization'' with regard to accounting firms. The SBA, however, has 
defined a small business, for purposes of accounting firms, as those 
with under $6 million in annual revenues.\632\ In the IRFA, we 
explained that we have limited data indicating revenues for accounting 
firms, and that we cannot estimate the number of firms with less than 
$6 million in revenues. We requested comment on the number of 
accounting firms with revenues under $6 million in order to determine 
the number of small accounting firms potentially affected by the rule 
amendments but received no response. We also requested comment 
generally on the number of small entities that may be affected by the 
rule amendments and received no estimates. One commenter believed that 
we had not identified the full range of types of and number of small 
entities affected or the types of impacts, but the commenter provided 
no further information.\633\
---------------------------------------------------------------------------

    \632\ 13 CFR 121.201.
    \633\ Tozzi Letter.
---------------------------------------------------------------------------

    Several small accounting firms and small companies expressed 
concern about a possible derivative effect of our rule on companies 
that are not registered with us and on the auditors of such 
companies.\634\ These commenters were concerned that state governments, 
state boards of accountancy, and others may adopt rules similar to ours 
without regard to whether the companies are public or

[[Page 76077]]

private. As we explained above, the rules apply to public companies and 
other entities registered with the Commission or otherwise required to 
file audited financial statements with the Commission. In addition, the 
rules are not intended to alter the relationship between federal and 
state agencies, and they do not affect the ability of the states to 
adopt their own rules. Moreover, commenters pointed out that state 
boards have a strong independent tradition.\635\ We expect that the 
state boards of accountancy will continue their practice of exercising 
independent judgment in determining the extent to which our rules 
should be imported into their regulatory regimes.
---------------------------------------------------------------------------

    \634\ See supra notes 218, 219.
    \635\ See supra note 221.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The new rules could potentially affect two primary groups--
registrants and auditors. The rules could affect these two groups 
differently, but in neither case do we expect that the rules would 
result in significant reporting, recordkeeping or other compliance 
requirements. The possible effects of the rules on these two groups are 
as follows:
    Investments and Family Relationships. The rule amendments regarding 
investments and employment relationships liberalize restrictions on 
investments by, and employment available to, accountants and their 
families without impairing the accountant's independence. We stated in 
the IRFA that in this sense, therefore, we are relaxing compliance 
requirements. One commenter noted that although we correctly state that 
we are relaxing certain requirements, the proposed threshold regarding 
a material indirect investment and the proposed definition of affiliate 
of the accounting firm would restrict the ability of small businesses 
to invest in, or enter business relationships with, other firms.\636\
---------------------------------------------------------------------------

    \636\ See, e.g., AICPA Letter.
---------------------------------------------------------------------------

    We recognize these concerns, and we have revised the rules, in 
part, to take them into account. As described above, the rule governing 
a material indirect investment in an audit client is intended to carry 
over the existing proscription on material indirect investments in 
audit clients. In addition, in part because of concerns that the 
definition of ``affiliate of the accounting firm'' would have 
unintended consequences on alliances of small accounting firms, we have 
modified our approach to avoid this result.
    Non-Audit Services. The IRFA discussed whether the proposed rule on 
non-audit services would have a significant effect on small entities. 
Some commenters expressed concern about the effects of the rules on 
small registrants that rely on the special expertise of their auditors 
or that lack resources to engage a second accounting firm to provide 
non-audit services.\637\ Other commenters stated that small businesses 
have long-term relationships with auditors that provide non-audit 
services, or are located in an area with few firms able to provide such 
services.\638\ Some small businesses in rural areas may lack the 
ability to perform the internal audit function on their own.\639\
---------------------------------------------------------------------------

    \637\ Id.; see also Letter of David E. Pertl, Senior Vice 
President and CFO, First Choice, Inc. (Sept. 18, 2000); Letter of 
Kelly Schwarzbeck, CPA, Alexander X. Kuhn & Co. (Aug. 22, 2000); 
Letter of Robert L. Bunting (Aug. 22, 2000).
    \638\ See, e.g., Letter of the California Chamber of Commerce 
(Sept. 15, 2000); Letter of Joseph C. King, CPA, Faulkner & King, 
PSC (Sept. 13, 2000).
    \639\ See, e.g., Letter of Landon J. Brazier, Knight Vale & 
Gregory (Aug. 31, 2000); Letter of Stephen Lange Ranzini, Chairman, 
CEO and President, University Bank (Sept. 9, 2000).
---------------------------------------------------------------------------

    We are sensitive to these concerns and we have modified the rule so 
that eight of the non-audit service provisions parallel or draw from 
current independence requirements regarding those services. We also 
determined not to adopt a restriction on ``expert services. 
Accordingly, with respect to the eight non-audit services, therefore, 
we do not believe that the rules would have a significant effect on 
small businesses.
    We have amended our rule regarding financial information systems 
design and implementation. The rule proposal would have prevented audit 
firms from providing some information technology consulting to their 
audit clients without impairing the firm's independence. The final rule 
singles out certain services as impairing independence and identifies 
other categories of such services that will not impair independence if 
certain conditions are met that are designed to ensure that the audit 
client's management retains responsibility for decision-making 
authority over the client's financial information systems. Accordingly, 
if the conditions are met, a small entity could obtain financial 
information systems design and implementation services.
    With regard to internal audit services, we have revised the rule 
from what we proposed so that the internal audit restrictions do not 
apply to registrants with less than $200 million in assets, as long as 
the registrant follows certain conditions. This, of course, largely 
eliminates the effect of the rule amendments on small entities with 
respect to the auditor's provision of internal audit services to small 
entities. This change from the proposed rule would lower the burden on 
smaller businesses that are not defined as small under our rules. It 
also has the effect of almost completely excepting smaller accounting 
firms from the coverage of this provision of the rule, since the firms 
that audit those companies tend to be smaller. Our analysis indicates 
that approximately fifty-four percent of registrants have assets of 
less than $200 million, which, of course, would exclude all companies 
defined as ``small businesses'' for purposes of the RFA.
    The IRFA also stated that we did not believe that the non-audit 
services provision would have a significant impact on a substantial 
number of small accounting firms and requested comment on the impact. 
Some commenters stated that the rules could harm firms that must offer 
both audit and non-audit services to stay in business,\640\ and one 
commenter recommended that firms with $1 million or less in revenue be 
exempt.\641\
---------------------------------------------------------------------------

    \640\ See, e.g., Letter of Dean R. Heintz, CPA, Casey Peterson & 
Assoc., Ltd. (Aug. 8, 2000); Letter of Patrick J. Day, CPA (Aug. 10, 
2000).
    \641\ Letter of Patrick J. Day, CPA (Aug. 10, 2000).
---------------------------------------------------------------------------

    Other commenters supported the rule amendments relating to non-
audit services. Some noted that rather than harming small accountants, 
the rules could provide smaller firms with new business opportunities 
to provide non-audit services to companies that previously used their 
auditors for these services.\642\
---------------------------------------------------------------------------

    \642\ See Testimony of Larry Gelfond, CPA, CVA, CFE, former 
President of the Colorado State Board of Accountancy (Sept. 13, 
2000); Letter of John Mitchell, CPA (Aug. 14, 2000).
---------------------------------------------------------------------------

    Although we lacked definitive data, the IRFA provided information 
on accounting firms that were likely to be small accounting firms, and 
the number of SEC clients of those firms. The majority of SEC 
registrants are audited by one of the Big Five firms, which are not 
small entities. We have data regarding the approximately 776 accounting 
firms with fewer than 20 SEC audit clients.\643\ Accounting firms with 
fewer than 20 SEC audit clients tend to be smaller accounting firms, 
and we estimate that fewer than twenty percent of these firms provide 
any consulting or non-audit services to their SEC audit clients. Only 
ten to twelve percent of the accounting firms with two or fewer SEC 
audit clients provide

[[Page 76078]]

any consulting or non-audit services to their SEC audit clients. We 
also estimated that the fees of the firms with 20 or fewer SEC audit 
clients that come from consulting and non-audit services provided to 
SEC audit clients average less than 7.5% of the firms' total fees for 
non-audit services, and less than one percent of their total fees. We 
estimated that small accounting firms obtain non-audit or consulting 
fees, on average, from less than one SEC audit client.
---------------------------------------------------------------------------

    \643\ See Public Accounting Report, Special Supplement: Annual 
Survey of National Accounting Firms--2000 (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.
---------------------------------------------------------------------------

    In addition, the change from the proposed rule discussed above--
eliminating restrictions on internal audit services for registrants 
with less than $200 million in assets--would lower the burden on 
smaller accounting firms. We estimate that approximately eighty-five 
percent of the clients of non-Big Five firms have assets of less than 
$200 million.\644\ Thus, as long as certain conditions are met, the 
rule amendments regarding internal audit services would not apply to 
eighty-five percent of audit clients of all but the Big Five firms.
---------------------------------------------------------------------------

    \644\ See Compustat Database, Oct. 31, 2000. The 85% figure 
excludes clients that are bank holding companies. For further 
analysis, see the cost-benefit analysis in Section V.B above.
---------------------------------------------------------------------------

    While we understand that some small businesses may incur some costs 
as a result of the rule amendments, we believe that few small 
businesses will be affected, and that any effects will be minimal. The 
changes we have made in the rules as adopted should ameliorate any 
burden on small firms significantly. Moreover, while some small 
businesses may be required to engage a new firm to perform certain 
functions, there is no comparatively greater effect on small firms with 
respect to costs incurred to choose a new accounting firm. Such costs 
apply equally to larger registrants as to smaller registrants.
    Quality Controls. The new rules establish a limited exception 
pursuant to which inadvertent violations of the rules by covered 
persons in the accounting firm will not render the firm not independent 
if the accounting firm maintains certain quality controls and satisfies 
other conditions. SECPS membership requirements and GAAS already 
require firms to have quality controls over their audit practices, so 
there should be little additional burden on accounting firms that want 
to take advantage of the exception.
    Disclosure. The new proxy disclosure rules require all companies 
subject to our proxy rules to disclose information to shareholders 
regarding fees for audit services, fees for services related to 
financial information systems design and implementation, and fees for 
all other non-audit services. Companies also must disclose if the audit 
committee considered whether the provision of non-audit services by the 
company's principal accountant is compatible with maintaining the 
principal accountant's independence. These requirements would apply to 
small businesses that are subject to the proxy rules, which we estimate 
to be no more than most of the 2,500 small registrants that file 
periodic reports, and 227 investment companies.
    The rules as proposed required, among other things, a description 
of each professional service provided by the principal accountant, 
disclosure of the fee for each, and disclosure of whether the audit 
committee approved the service. We have modified the disclosure 
requirement to eliminate the requirements that companies describe each 
non-audit service provided by their auditors and the fee for each such 
service. We believe that by making these changes, we have accommodated 
commenters' concerns while ensuring that investors have the information 
they need to make judgments about whether the registrant has an 
independent auditor. In addition, the information required should be 
readily available to the registrant because of the requirements under 
ISB Standard No. 1 and the rules of SECPS.\645\
---------------------------------------------------------------------------

    \645\ See supra note 476.
---------------------------------------------------------------------------

E. Agency Action to Minimize Effect on Small Entities

    The RFA directs us to consider significant alternatives that would 
accomplish the stated objectives, while minimizing any significant 
adverse impact on small entities. We considered several alternatives, 
including the following referenced in the RFA: (i) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources of small entities; (ii) the clarification, 
consolidation or simplification of compliance and reporting 
requirements for small entities; (iii) the use of performance rather 
than design standards; and (iv) an exemption from coverage of the new 
rules, or parts of the new rules, for small entities.
    We considered each of the four alternatives, and a variety of 
alternatives to our provisions on non-audit services. With respect to 
the first alternative--establishment of differing compliance or 
reporting requirements--we stated in the IRFA that, with respect to 
investments and employment relationships, we believe that the impact of 
the rules in this area on small entities was already minimal. We did 
not believe, therefore, that establishing differing requirements would 
materially decrease the impact of the rules on small businesses, and we 
did not make special provisions. The IRFA discussed establishing 
differing standards in the area of non-audit services, and further 
discussed the three other alternatives contained in the RFA, mentioned 
above.
    Regarding the provision of non-audit and consulting services by 
small accounting firms, we considered several approaches. As discussed 
above, however, we have determined that our two-pronged approach of 
requiring disclosure and identifying particular non-audit services that 
are incompatible with independence best protects the audit 
process.\646\ In addition, 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 approaches would 
not have a significant impact on a substantial number of small 
businesses or small accounting firms.
---------------------------------------------------------------------------

    \646\ See supra Section IV.G.
---------------------------------------------------------------------------

    The second alternative--the clarification, consolidation or 
simplification of compliance and reporting requirements for small 
entities--is addressed below in connection with our discussion of our 
consideration of the fourth alternative. We have exempted small 
entities from certain provisions of the rules, which simplifies 
compliance requirements for those entities.
    The third alternative mentioned above--use of performance rather 
than design standards--would be difficult, in part, to implement in 
this context. As to the quality controls exception we did implement 
such a performance standard. As to the other components of the rule 
changes, performance standards would not carry out the Commission's 
statutory mandate to ensure that registrants file financial statements 
and reports with us that have been certified by independent public 
accountants. Rather, we must identify and address influences that 
impair independence.
    Some commenters suggested that we adopt the last alternative--an 
exemption from coverage of the new rules, or parts of the new rules, 
for small entities.\647\ Other commenters suggested that our rules not 
apply to audits of smaller public companies, regardless of the size of 
the auditor. These commenters stated that small public companies may be 
in greater need of consulting assistance and may not be able to obtain 
the assistance from anyone other than their

[[Page 76079]]

auditors.\648\ We appreciate this concern and we have made certain 
changes to the rule.
---------------------------------------------------------------------------

    \647\ See, e.g., Letter of Donald G. Mantyla, CPA (Sept. 25, 
2000).
    \648\ Letter of Stanley Keller, Chair, Committee on Federal 
Regulation of Securities, American Bar Association (Sept. 27, 2000); 
Letter of Robert Bunting (Sept. 6, 2000); Letter of P. Gerard 
Sokoloski, CPA, President, NY State Society of Certified Public 
Accountants (Sept. 25, 2000).
---------------------------------------------------------------------------

    The changes we have made recognize that, for some small companies, 
the company's auditor may be the only reasonably available service 
provider for certain services. The final rules, therefore, take into 
account that small firms may need internal audit services from their 
auditors and provide an exception for companies under $200 million in 
assets, subject to certain conditions. For the reasons discussed above, 
aside from these limited areas, we do not believe that a further 
exemption for small entities is appropriate.

VII. Paperwork Reduction Act

    Certain of the provisions in the amendment to Item 9 of Schedule 
14A contain ``collection of information'' requirements within the 
meaning of the Paperwork Reduction Act of 1995.\649\ We published 
notice soliciting comments on the collection of information 
requirements in the Proposing Release and submitted these requirements 
to the Office of Management and Budget (``OMB'') for review in 
accordance with 44 U.S.C. Sec. 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).''
---------------------------------------------------------------------------

    \649\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    OMB approved the rule's collection of information 
requirements.\650\ Regulation 14A (OMB Control No. 3235-0059) was 
adopted pursuant to Section 14(a) of the Exchange Act and prescribes 
information that a company must include in its proxy statement to 
ensure that shareholders 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 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 14A requires certain disclosure related to a 
company's independent accountants and Schedule 14C refers to Schedule 
14A for the disclosure requirements related to the company's 
independent accountants. The final rule requires issuers to disclose in 
Schedules 14A and 14C, among other things, the aggregate fees billed 
for audit services, for financial information systems design and 
implementation services, and for other non-audit services provided by 
the issuer's principal accountant, and certain disclosures regarding 
the company's audit committee.
---------------------------------------------------------------------------

    \650\ One commenter raised a number of issues related to OMB's 
processing and review of our submission. Because OMB has reviewed 
and approved our submission, we do not address these comments here.
---------------------------------------------------------------------------

    The Commission received comments concerning the proposed collection 
of information requirements. Some commenters suggested that the 
collections of information lacks practical utility and noted that we 
rescinded an earlier requirement that issuers disclose information 
concerning non-audit services provided by their auditors.\651\ These 
commenters generally argued that the proposed disclosure was 
unnecessary and would be confusing to registrants and investors.\652\ 
Commenters also argued that we had not adequately demonstrated the need 
for the disclosure requirement.\653\ One commenter suggested that the 
proposed collection of information is duplicative of information 
available to the Commission from the SECPS.\654\
---------------------------------------------------------------------------

    \651\ See, e.g., Letter of Center for Regulatory Effectiveness: 
CRE Report Card on the SEC's Proposed Rule on Auditor Independence 
(``CRE Report Card'').
    \652\ See, e.g., Letter of Douglas R. Cox, Gibson, Dunn and 
Crutcher (Aug. 22, 2000) (``Cox Letter''). This commenter suggested, 
among other things, that the rule mandates disclosure of information 
that would appear irrelevant to the selection of auditors because a 
vote to ratify auditors is not required by the federal securities 
laws or many state laws. The commenter noted that the rule requires 
disclosure on Schedule 14C which does not ask investors to vote on 
any matter. Deloitte & Touche, in its comment letter, suggested that 
the Commission could minimize the burden imposed by the rule by 
requiring disclosure only when the stockholders vote on the approval 
or ratification of the company's accounting firm. Deloitte & Touche 
Letter. The disclosure rule serves a broader purpose than assisting 
shareholders in votes to ratify the selection of an auditor. The 
disclosure rule is one component of our auditor independence rules, 
the purpose of which is to promote the integrity of financial 
statements and promote investor confidence. Thus, the disclosure is 
aimed not only at a registrant's existing shareholders but at 
prospective shareholders as well.
    \653\ Tozzi Letter.
    \654\ CRE Report Card.
---------------------------------------------------------------------------

    We believe that the disclosure requirement is necessary, practical, 
and useful. As discussed more fully above, in recent years there has 
been a dramatic growth in the absolute and relative size of fees 
charged for non-audit services provided to audit clients.\655\ At the 
same time, information about audit firms' provision of non-audit 
services is not as readily available as it was when we rescinded an 
earlier disclosure requirement.\656\ The disclosure we seek is not, 
contrary to one commenter's assertion, readily available through 
industry sources.\657\ Under circumstances where investors have less 
information about a matter that has become more important, we believe 
that the disclosure requirement will prove useful to investors. 
Further, we have modified the rule from that proposed to make the 
disclosed information more understandable to investors.\658\ For 
example, under the rule as adopted, registrants will not disclose a 
line-by-line description of each non-audit service, but rather will 
disclose relevant amounts in the aggregate. Investors will be able to 
determine quickly the amounts spent on non-audit services relative to 
the amount spent on audit services. As discussed below, these 
modifications lower the already minor burden on registrants of making 
this disclosure.
---------------------------------------------------------------------------

    \655\ See Section IV.G for further discussion of the disclosure 
requirement, including discussion of comments received concerning 
that requirement.
    \656\ As discussed in the Proposing Release (see Section II.C.4 
and note 156 of this release), from 1978 to 1982, we required 
companies to disclose in their proxy statements all non-audit 
services provided by their auditors but later rescinded the 
requirement. Among other reasons, our review of proxy disclosures 
convinced us that accounting firms then, in contrast to now, were 
not providing extensive non-audit services to their audit clients. 
In addition, we noted that, even without the proxy statement 
requirement, investors had access to useful data provided to and 
made public by the SECPS.
    \657\ As noted above, the SECPS has stopped publishing 
information about audit firms' provision of non-audit services.
    \658\ See supra Section IV.G.
---------------------------------------------------------------------------

    Commenters also questioned our estimate of the burden imposed by 
the new disclosure requirement.\659\ Specifically, commenters suggested 
that issuers will spend more than one hour on completing the new 
disclosure requirements.\660\ Some commenters suggested that in 
calculating the burden, we did not consider all of the relevant 
factors.\661\ Among other things, some commenters suggested that we 
failed to

[[Page 76080]]

consider burdens relating to storing and analyzing the information, 
training personnel, hiring outside assistance, and putting the 
information into a reporting format.\662\ Further, commenters disagreed 
with our assertion in the Proposing Release that the information 
required to make the disclosure should be readily available to 
respondents.\663\
---------------------------------------------------------------------------

    \659\ See, e.g., Deloitte & Touche Letter; Cox Letter.
    \660\ See, e.g., Deloitte & Touche Letter. Deloitte & Touche 
stated in its comment letter that it ``is difficult to estimate the 
average hours without an empirical study,'' but suggested that 
disclosure would require approximately three to six hours for 
companies with basic reporting systems and approximately 50-100 
hours for companies with more complex reporting systems. As 
discussed below, we have modified the disclosure requirement, and we 
do not agree that the required disclosure will create more than a 
minimal additional burden to companies already preparing Schedules 
14A or 14C.
    \661\ Cox Letter.
    \662\ CRE Report Card; AICPA Letter.
    \663\ See, e.g., Cox Letter.
---------------------------------------------------------------------------

    Commenters also disagreed with our estimate of the number of 
registrants that would be affected by the disclosure requirement. In 
the Proposing Release, we stated the burden would fall primarily on 
one-quarter of registrants because only one-quarter of registrants 
receive non-audit services from their accountants in any given year. 
Some commenters disagreed. While it may be true, these commenters 
suggested, that only twenty-five percent of registrants receive non-
audit services in any given year, a larger percentage receives non-
audit services in some years and not others.\664\ Commenters suggested 
that the percentage of registrants that would have to maintain records 
related to the disclosure requirements would therefore be greater than 
twenty-five percent.\665\ At least one commenter stated that all 
registrants would have to check their records to determine whether they 
must disclose more than just audit fees.\666\
---------------------------------------------------------------------------

    \664\ Id.
    \665\ See, e.g., CRE Report Card.
    \666\ See Deloitte & Touche Letter.
---------------------------------------------------------------------------

    We believe that our estimate of the burden imposed by the 
disclosure requirement is reasonable. While all registrants will have 
to disclose audit fees under the new rule, and, where applicable, 
registrants must make disclosures concerning the use of leased 
personnel on the audit, we believe that the time and expense required 
to make such disclosures will be minimal. In calculating our estimate 
of the burden imposed by the new disclosure requirement, we carefully 
considered the relevant factors.\667\ Further, as discussed above, we 
have reduced the amount and narrowed the scope of disclosure that 
registrants will be required to make. These modifications reduce the 
amount of time spent in making disclosure. For example, as proposed, 
the rule would have required a registrant to describe each professional 
service rendered by its accounting firm, and to disclose the fee paid 
for each service.\668\ Instead, the rule as adopted requires a 
registrant to disclose the aggregate fees paid for audit, information 
technology, and other non-audit services.\669\ This information is 
readily accessible to issuers; \670\ it is an incremental addition to 
previously required disclosure about the identity of a company's 
auditor. In addition, we believe that a registrant will know how much 
it spent during the previous fiscal year on its audit. A registrant 
should be able to determine quickly the amounts paid to its auditor for 
information technology and other non-audit services by consulting its 
internal records. The rule should not require registrants to seek 
significant outside assistance, or substantially modify their systems 
to maintain and collect data. We therefore believe that 2,536 hours is 
a reasonable estimate of the paperwork burden imposed by the rule.\671\
---------------------------------------------------------------------------

    \667\ We do not believe that the new disclosure requirement will 
cause registrants significant burdens associated with administrative 
tasks such as collecting, storing, and formatting the information, 
nor do we believe that compliance with the disclosure rule will 
require significant employee training.
    \668\ The proposed rule required disclosure of each professional 
service during the most recent fiscal year. Under the proposed rule, 
a service did not have to be disclosed if the fee for that service 
was less than $50,000 or ten percent of that registrant's audit fee. 
Commenters suggested that these thresholds were too low, and would 
result in disclosures of insignificant services. As adopted, the 
rule does not require disclosure of each professional service.
    \669\ As proposed, the rule would have required registrants to 
disclose whether the audit committee approved each disclosed non-
audit service and considered the possible effect on the principal 
accountant's independence. As adopted, the rule requires disclosure 
of whether the audit committee considered whether the provision of 
the non-audit services by the principal accountant is compatible 
with maintaining the principal accountant's independence. We do not 
believe that this requirement imposes a significant burden.
    \670\ As noted above, audit committees currently receive 
information about the auditor's provision of non-audit services 
under ISB Standard No. 1 and SECPS Manual Sec. 1000.08. See supra 
note 476.
    \671\ In its comment letter, the AICPA suggested that the 
proposed rule's definition of ``affiliate of the accounting firm'' 
created ambiguities that made the disclosure requirement potentially 
overbroad and burdensome. In response to commenters' concerns, we 
have removed the definition of ``affiliate of the accounting firm'' 
from the rule as adopted. Instead, the rule relies on existing 
guidance concerning when an entity is associated with the accounting 
firm. We believe that, with this modification, the disclosure 
requirement in the final rule is targeted to its purpose and is not 
unduly burdensome.
    \672\ 15 U.S.C. 77b(b); 15 U.S.C. 78c(f); 15 U.S.C. 80a-2(c).
    \673\ See, e.g., KPMG Letter.
    \674\ See supra Sections III.C.1, III.C.3.
    \675\ See supra Section IV.B.1.
---------------------------------------------------------------------------

    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. Compliance with the disclosure 
requirements is mandatory. There is no mandatory retention period for 
the information disclosed, and responses to the disclosure requirements 
will not be kept confidential.

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

    Sections 2(b) of the Securities Act, 3(f) of the Exchange Act, and 
2(c) of the Investment Company Act require the Commission, when 
engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
also to consider whether the action will promote efficiency, 
competition, and capital formation.\672\ The rule amendments update our 
independence requirements in light of developments in the accounting 
profession and in society generally. The rule amendments affect the 
scope of services an auditor may provide to an audit client without 
impairing the auditor's independence and also affect the financial, 
employment and business relationships that an auditor (and certain 
other persons) may have with an audit client without impairing 
independence. The purpose of the amendments is to promote investor 
confidence in the integrity of the audit process and in the audited 
financial statements that investors use to make investment decisions. 
As discussed above, investor confidence promotes market efficiency and 
capital formation. Competition is discussed below.
    With respect to the scope of services provisions, some commenters 
suggested that there is no evidence that auditors' provision to audit 
clients of non-audit services affects auditor independence or 
investors' perceptions of auditor independence, and they therefore 
argued that the rule will not increase investor confidence.\673\ 
Academic studies and other surveys, however, suggest that certain users 
of financial statements have long believed that an auditor's provision 
to an audit client of non-audit services could affect both the 
auditor's objectivity and investor confidence in the financial 
statements.\674\ Furthermore, even a relatively modest increase in 
investor confidence could have a significant, positive effect on the 
economy, \675\ while a relatively modest decrease in investor 
confidence could have significant consequences for the capital 
formation process.

[[Page 76081]]

    Commenters suggested that the proposals would impede efficiency 
because the rule may prevent audit clients from selecting the most 
efficient service provider.\676\ As adopted, however, the rule in large 
part codifies existing limitations on auditors' provision to audit 
clients of non-audit services. To the extent these existing limitations 
or new limitations from our rule prevent the choice of the least costly 
service provider in some situations, we believe such limitations are 
warranted to achieve our goal of enhancing auditor independence.\677\
---------------------------------------------------------------------------

    \676\ See, e.g., Arthur Andersen Letter.
    \677\ Cf. Testimony of Alfred M. King, Valuation Research 
Corporation (July 26, 2000).
---------------------------------------------------------------------------

    With respect to the claim that synergies are created by the 
auditor's provision of both audit and non-audit services, research on 
the evidence of such synergies is inconclusive.\678\ Moreover, the 
recent sales or proposed sales by large accounting firms of their 
consulting divisions \679\ suggest that audit firms' provision of at 
least certain non-audit services creates, at most, limited synergies.
---------------------------------------------------------------------------

    \678\ See supra Section V.B.2(c).
    \679\ Id.
---------------------------------------------------------------------------

    Section 23(a) of the Exchange Act requires the Commission, when 
adopting rules under the Exchange Act, to consider the impact on 
competition of any rule it adopts.\680\ Some commenters suggested that 
the rule would inhibit competition. Some of these commenters argued 
that, in response to the proposed rule, accounting firms would choose 
not to provide audit services in favor of providing non-audit services, 
and that firms already providing the audit might not bid on that 
client's non-audit work.\681\ They suggested that this would lead to 
reduced competition for both audit and non-audit services, reducing 
issuers' choices and increasing their costs. One commenter further 
suggested that reduced competition in the bidding process would place 
firms that chose to split off their consulting competencies at a 
competitive advantage over those that chose to stay together, and 
ultimately cause firms to consider splitting off their consulting 
groups.\682\
    The rule as adopted, however, allows issuers to purchase more non-
audit services from their auditors than would have been allowed under 
the rule as proposed. This modification should reduce the effect on 
competition about which commenters were most concerned.
---------------------------------------------------------------------------

    \680\ 15 U.S.C. 78w(a)(2).
    \681\ See, e.g., Arthur Andersen Letter; Deloitte & Touche 
Letter.
    \682\ See Deloitte & Touche Letter. As discussed above, some 
firms had already split off, or announced the split-off of, their 
consulting practices prior to our Proposing Release. The rule does 
not dictate any particular business model for accounting firms. 
Rather, firms remain free to determine their own structure, 
consistent with the law.
---------------------------------------------------------------------------

    Some commenters suggested that the proposed rule would hinder the 
ability of small accounting firms to compete. They argued that the 
definition of ``affiliate of the accounting firm'' in the proposal 
would restrict small firms from participating in alliances and other 
business relationships, thereby providing larger firms with a 
competitive advantage by limiting the scope of services available to 
clients of small firms.\683\ Still other commenters suggested that if 
the rule results in a reshuffling of clients, medium-sized and small 
firms may suffer a net loss of non-audit service clients. According to 
these commenters, displaced clients of these firms may be more likely 
to engage a better-known firm for non-audit services than another small 
or medium-sized firm.\684\ On the other hand, some commenters stated 
that the proposal would not be harmful to small accounting firms, but 
rather would allow small accounting firms to compete for audit or non-
audit services that could no longer be provided by a company's 
auditor.\685\
---------------------------------------------------------------------------

    \683\ See, e.g., Testimony of Wayne A. Kolins, National Director 
of Assurance, BDO Seidman, LLP (Sept. 20, 2000). As discussed in 
more detail in this release, we have removed the definition of 
``affiliate of the accounting firm'' from the rule as adopted. 
Instead, the rule relies on existing guidance concerning when an 
entity is associated with the accounting firm. We believe that this 
modification addresses commenters' concerns in this area.
    \684\ See id.
    \685\ See, e.g., Testimony of Larry Gelfond, CPA, CVA, CFE, 
Colorado Accountancy Board, September 13, 2000 (``I do not believe 
that [the rule] will in any way hinder our [small] firm. In many 
respects, it may even benefit our firm. . . . I look at this, 
frankly, as an opportunity, particularly in the internal audit 
functions to step in, and given our experience, to work with 
management and with their respective independent auditor, let's say 
a Big Five firm, that this is an area that we can frankly look at as 
a new revenue generator.'').
---------------------------------------------------------------------------

    Commenters also suggested that the rule would make it difficult for 
small businesses to compete. Some expressed concern about the effects 
of the rules on small businesses that rely on the special expertise of 
their auditors or that lack the resources to engage a second accounting 
firm to provide non-audit services; they commented that small 
registrants would be required to either choose a new accounting firm to 
perform audits or to provide non-audit services.\686\ Other commenters 
stated that small businesses have long-term relationships with auditors 
that provide non-audit services, or are located in a geographic area 
with few firms able to provide such services.\687\ Commenters also 
suggested that accounting firms other than the Big Five may stop 
serving SEC registrants, or they may stop providing audit services, in 
both cases leading to less choice and competition.\688\
---------------------------------------------------------------------------

    \686\ See, e.g., AICPA Letter; Letter of David E. Pertl, Senior 
Vice President and CFO, First Choice, Inc. (Sept. 18, 2000); Letter 
of Kelly Schwarzbeck, CPA, Alexander X. Kuhn & Co. (Aug. 22, 2000); 
Letter of Robert L. Bunting (Sept. 6, 2000); Letter of Bruce C. 
Holbrook, Vice Chairman, Goodman & Company, LLP (July 25, 2000); 
Letter of William W. Traynham, CPA, President, Community Bankshares 
Inc. (Aug. 14, 2000).
    \687\ See, e.g., Letter of the California Chamber of Commerce 
(Sept. 15, 2000); Letter of Joseph C. King, CPA, Faulkner & King, 
PSC (Sept. 13, 2000).
    \688\ See, e.g., Letter of Jeffry T. Herbst (Sept. 11, 2000); 
Letter of Richard P. Thornton (Sept. 13, 2000); Letter of Marc J. 
Garofalo, Mayor, Derby, Conn. (Sept. 18, 2000).
---------------------------------------------------------------------------

    As discussed elsewhere in this release, we have modified the rule 
so that the provisions regarding most affected non-audit services do no 
more than codify existing restrictions. For example, under the rule as 
adopted, all registrants may purchase most information technology 
consulting services from their auditors, so long as the stated 
conditions are met. With respect to internal audit services, the 
adopted provision does not restrict registrants with $200 or less in 
assets, as long as certain conditions are met. As a result, small 
businesses should be able to obtain the services they need.
    In addition, approximately eighty-five percent of the public 
company audit clients of non-Big Five accounting firms have assets of 
$200 million or less.\689\ Accordingly, as long as certain conditions 
are met, the rule will not preclude smaller firms from providing 
internal audit services to the vast majority of their public company 
clients. This modification should alleviate many of the commenters' 
concerns about the rule's impact on small accounting firms' ability to 
compete. In any event, to the extent the rule has any anti-competitive 
effect, we believe it is necessary and appropriate in furtherance of 
the goals of the Exchange Act.
---------------------------------------------------------------------------

    \689\ See Compustat Database, October 31, 2000. The 85% figure 
excludes clients that are bank holding companies. For further 
analysis, see supra Section V.B (cost-benefit analysis).
---------------------------------------------------------------------------

IX. Codification Update

    The ``Codification of Financial Reporting Policies'' announced in 
Financial Reporting Release No. 1 (April 15, 1982) is amended as 
follows:
    1. By removing section 602.01.
    2. By amending section 602.02 by removing the preamble paragraph 
immediately preceding the introduction.

[[Page 76082]]

    3. By amending section 602.02.b.i to remove paragraphs 2 and 3.
    4. By amending section 602.02.b.ii to remove examples 1, 2, 3, 4, 
6, 7, 8, and 10, and redesignate examples 5 and 9 as examples 1 and 2.
    5. By amending section 602.02.b.iii to remove examples 1, 2, and 4, 
and redesignate example 3 as example 1.
    6. By removing section 602.02.b.iv.
    7. By amending section 602.02.b.v to remove example 4.
    8. By amending section 602.02.c.i to remove the last two 
paragraphs.
    9. By removing section 602.02.c.ii.
    10. By removing section 602.02.c.iii.
    11. By removing section 602.02.d.
    12. By removing section 602.02.e.ii.
    13. By removing section 602.02.e.iii.
    14. By removing section 602.02.f.
    15. By amending examples 2, 3, 4, 5, 6, 7, 8, 10, 13, 15, 16, 20, 
and 23 in section 602.02.g by replacing the references to ``partner,'' 
``partners,'' ``certifying accountant,'' or ``accountant'' to ``covered 
person,'' ``covered persons,'' ``covered person'' and ``covered 
person,'' respectively, except no change should be made where 
references to ``partner'' are preceded by the word ``limited'' or 
``general.''
    16. By amending section 602.02.g to replace the reference to Rule 
2-01(b) in the last sentence of the first introductory paragraph with 
``Rule 2-01'' and to remove examples 17, 18, 19, and 22 and redesignate 
examples 20, 21, 23, and 24 as examples 17, 18, 19, and 20, 
respectively.
    17. By removing section 602.02.h.
    18. By adding a new section 602.01, captioned ``Discussion of Rule 
2-01,'' to include the text in Section IV of this release.
    19. By amending Section 601.03 to include, at the end, the text in 
Section III.C.6 of this release.
    20. By amending section 602.02 to redesignate sections 602.02.b.v, 
602.02.e.i, 602.02.e.iv, 602.02.g, 602.02.i.i, and 602.02.i.ii as 
sections 602.02.b.iv, 602.02.d.i, 602.02.d.ii, 602.02.e, 602.02.f.i, 
and 602.02.f.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 adopting 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 7, 8, 10, 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, 
31, 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 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, INVESTMENT ADVISERS ACT OF 1940, AND ENERGY 
POLICY AND CONSERVATION ACT OF 1975

    1. The heading for Part 210 is revised as set forth above.

    2. The authority citation for Part 210 is revised to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 
77aa(25), 77aa(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5, 
78w(a), 78ll, 78mm, 79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-
29, 80a-30, 80a-37(a), 80b-3, 80b-11 unless otherwise noted.


    3. By amending Sec. 210.2-01 by adding a preliminary note and 
paragraphs (d), (e) and (f) and revising paragraphs (b) and (c) to read 
as follows:


Sec. 210.2-01  Qualifications of accountants.

Preliminary Note to Sec. 210.2-01

    1. Section 210.2-01 is designed to ensure that auditors are 
qualified and independent of their audit clients both in fact and in 
appearance. Accordingly, the rule sets forth restrictions on 
financial, employment, and business relationships between an 
accountant and an audit client and restrictions on an accountant 
providing certain non-audit services to an audit client.
    2. Section 210.2-01(b) sets forth the general standard of 
auditor independence. Paragraphs (c)(1) to (c)(5) reflect the 
application of the general standard to particular circumstances. The 
rule does not purport to, and the Commission could not, consider all 
circumstances that raise independence concerns, and these are 
subject to the general standard in Sec. 210.2-01(b). In considering 
this standard, the Commission looks in the first instance to whether 
a relationship or the provision of a service: creates a mutual or 
conflicting interest between the accountant and the audit client; 
places the accountant in the position of auditing his or her own 
work; results in the accountant acting as management or an employee 
of the audit client; or places the accountant in a position of being 
an advocate for the audit client.
    3. These factors are general guidance only and their application 
may depend on particular facts and circumstances. For that reason, 
Sec. 210.2-01 provides that, in determining whether an accountant is 
independent, the Commission will consider all relevant facts and 
circumstances. For the same reason, registrants and accountants are 
encouraged to consult with the Commission's Office of the Chief 
Accountant before entering into relationships, including 
relationships involving the provision of services, that are not 
explicitly described in the rule.

    (a) * * *
    (b) The Commission will not recognize an accountant as independent, 
with respect to an audit client, if the accountant is not, or a 
reasonable investor with knowledge of all relevant facts and 
circumstances would conclude that the accountant is not, capable of 
exercising objective and impartial judgment on all issues encompassed 
within the accountant's engagement. In determining whether an 
accountant is independent, the Commission will consider all relevant 
circumstances, including all relationships between the accountant and 
the audit client, and not just those relating to reports filed with the 
Commission.
    (c) This paragraph sets forth a non-exclusive specification of 
circumstances inconsistent with paragraph (b) of this section.
    (1) Financial relationships. An accountant is not independent if, 
at any point during the audit and professional engagement period, the 
accountant has a direct financial interest or a material indirect 
financial interest in the accountant's audit client, such as:
    (i) Investments in audit clients. 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, such as stocks, bonds, notes, options, or other 
securities. The term direct investment includes an investment in an 
audit client through an intermediary if:
    (1) The accounting firm, covered person, or immediate family 
member, alone or together with other persons, supervises or 
participates in the intermediary's investment decisions or has control 
over the intermediary; or
    (2) The intermediary is not a diversified management investment 
company, as defined by section 5(b)(1) of the Investment Company Act of 
1940,

[[Page 76083]]

15 U.S.C. 80a-5(b)(1), and has an investment in the audit client that 
amounts to 20% or more of the value of the intermediary's total 
investments.
    (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 (17 CFR 240.13d-101 
or 240.13d-102) with the Commission indicating beneficial ownership of 
more than five percent of an audit client's equity securities or 
controls an audit client, or a close family member of a partner, 
principal, or shareholder of the accounting firm 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, unless the accounting firm, covered person in the firm, or 
immediate family member has no authority to make investment decisions 
for the trust or estate.
    (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. For purposes of 
this paragraph, the term material indirect investment does not include 
ownership by any covered person in the firm, any of his or her 
immediate family members, or any group of the above persons of 5% or 
less of the outstanding shares of a diversified management investment 
company, as defined by section 5(b)(1) of the Investment Company Act of 
1940, 15 U.S.C. 80a-5(b)(1), that invests in an audit client.
    (E) The accounting firm, any covered person in the firm, or any of 
his or her immediate family members:
    (1) Has any direct or material indirect investment in an entity 
where:
    (i) An audit client has an investment in that entity that is 
material to the audit client and has the ability to exercise 
significant influence over that entity; or
    (ii) The entity has an investment in an audit client that is 
material to that entity and has the ability to exercise significant 
influence over that audit client;
    (2) Has any material investment in an entity over which an audit 
client has the ability to exercise significant influence; or
    (3) Has the ability to exercise significant influence over an 
entity that has the ability to exercise significant influence over an 
audit client.
    (ii) Other financial interests in audit client. An accountant is 
not independent when the accounting firm, 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, or an audit client's officers, 
directors, or record or beneficial owners of more than ten percent of 
the audit client'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 borrower's primary 
residence provided the loan was not obtained while the covered person 
in the firm was a covered person.
    (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, if the account has a balance that exceeds the 
amount insured by the Federal Deposit Insurance Corporation or any 
similar insurer, except that an accounting firm account may have an 
uninsured balance provided that the likelihood of the bank, savings and 
loan, or similar institution experiencing financial difficulties is 
remote.
    (C) Broker-dealer accounts. Brokerage or similar accounts 
maintained with a broker-dealer that is an audit client, if:
    (1) Any such account includes any asset other than cash or 
securities (within the meaning of ``security'' provided in the 
Securities Investor Protection Act of 1970 (``SIPA'') (15 U.S.C. 78aaa 
et seq.));
    (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 SIPA (15 U.S.C. 78fff-3); or
    (3) With respect to non-U.S. accounts not subject to SIPA 
protection, the value of assets in the accounts exceeds the amount 
insured or protected by a program similar to SIPA.
    (D) Futures commission merchant accounts. Any futures, commodity, 
or similar account maintained with a futures commission merchant that 
is an audit client.
    (E) Credit cards. Any aggregate outstanding credit card balance 
owed to a lender that is an audit client that is not reduced to $10,000 
or less on a current basis taking into consideration the payment due 
date and any available grace period.
    (F) Insurance products. Any individual policy issued by an insurer 
that is an audit client unless:
    (1) The policy was obtained at a time when the covered person in 
the firm was not a covered person in the firm; and
    (2) The likelihood of the insurer becoming insolvent is remote.
    (G) Investment companies. Any financial interest in an entity that 
is part of an investment company complex that includes an audit client.
    (iii) Exceptions. Notwithstanding paragraphs (c)(1)(i) and 
(c)(1)(ii) of this section, an accountant will not be deemed not 
independent if:
    (A) Inheritance and gift. Any person acquires an unsolicited 
financial interest, such as through an unsolicited gift or inheritance, 
that would cause an accountant to be not independent under paragraph 
(c)(1)(i) or (c)(1)(ii) of this section, and the financial interest is 
disposed of as soon as practicable, but no later than 30 days after the 
person has knowledge of and 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 paragraph 
(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 paragraph (c)(1)(i) and 
(c)(1)(ii) of this section before the earlier of:
    (i) Signing an initial engagement letter or other agreement 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).
    (C) Employee compensation and benefit plans. An immediate family 
member of a person who is a covered person in the firm only by virtue 
of paragraphs (f)(11)(iii) or (f)(11)(iv) of this section has a 
financial interest that would cause an accountant to be not independent 
under paragraph (c)(1)(i) or (c)(1)(ii) of this section, and the 
acquisition of the financial interest was an unavoidable consequence of 
participation in his or her employer's employee compensation or 
benefits program, provided that the financial interest, other than 
unexercised employee stock options, is disposed of as soon as 
practicable, but no later than

[[Page 76084]]

30 days after the person has the right to dispose of the financial 
interest.
    (iv) Audit clients' financial relationships. An accountant is not 
independent when:
    (A) Investments by the audit client in the accounting firm. An 
audit client has, or has agreed to acquire, any direct investment in 
the accounting firm, such as stocks, bonds, notes, options, or other 
securities, or the audit client's officers or directors are record or 
beneficial owners of more than 5% of the equity securities of the 
accounting firm.
    (B) Underwriting. An accounting firm engages an audit client to act 
as an underwriter, broker-dealer, market-maker, promoter, or analyst 
with respect to securities issued by the accounting firm.
    (2) Employment relationships. An accountant is not independent if, 
at any point during the audit and professional engagement period, the 
accountant has an employment relationship with an audit client, such 
as:
    (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 serves as a member of the board of 
directors or similar management or governing body 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 role or financial reporting oversight role at 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, principal, shareholder, or professional 
employee of an accounting firm is in an accounting role or financial 
reporting oversight role at 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 
accounting firm):
    (1) Pursuant to a fully funded retirement plan, rabbi trust, or, in 
jurisdictions in which a rabbi trust does not exist, a similar vehicle; 
or
    (2) In the case of a former professional employee who was not a 
partner, principal, or shareholder of the accounting firm and who has 
been disassociated from the accounting firm for more than five years, 
that is immaterial to the former professional employee.
    (iv) Employment at accounting firm of former employee of audit 
client. A former officer, director, or employee of an audit client 
becomes a partner, principal, shareholder, or professional employee 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 covering any period during which he or 
she was employed by or associated with that audit client.
    (3) Business relationships. An accountant is not independent if, at 
any point during the audit and professional engagement period, the 
accounting firm or any covered person in the firm has any direct or 
material indirect business relationship with an audit client, or with 
persons associated with the audit client in a decision-making capacity, 
such as an audit client's officers, directors, or substantial 
stockholders. 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 to an audit client or is a 
consumer in the ordinary course of business.
    (4) Non-audit services. An accountant is not independent if, at any 
point during the audit and professional engagement period, the 
accountant provides the following non-audit services to an audit 
client:
    (i) Bookkeeping or other services related to the audit client's 
accounting records or financial statements.
    (A) Any service involving:
    (1) Maintaining or preparing the audit client's accounting records;
    (2) Preparing the audit client's financial statements that are 
filed with the Commission or form the basis of financial statements 
filed with the Commission; or
    (3) Preparing or originating source data underlying the audit 
client's financial statements.
    (B) Notwithstanding paragraph (c)(4)(i)(A) of this section, the 
accountant's independence will not be impaired when the accountant 
provides these services:
    (1) In emergency or other unusual situations, provided the 
accountant does not undertake any managerial actions or make any 
managerial decisions; or
    (2) For foreign divisions or subsidiaries of an audit client, 
provided that:
    (i) The services are limited, routine, or ministerial;
    (ii) It is impractical for the foreign division or subsidiary to 
make other arrangements;
    (iii) The foreign division or subsidiary is not material to the 
consolidated financial statements;
    (iv) The foreign division or subsidiary does not have employees 
capable or competent to perform the services;
    (v) The services performed are consistent with local professional 
ethics rules; and
    (vi) The fees for all such services collectively (for the entire 
group of companies) do not exceed the greater of 1% of the consolidated 
audit fee or $10,000.
    (ii) Financial information systems design and implementation.
    (A) Directly or indirectly operating, or supervising the operation 
of, the audit client's information system or managing the audit 
client's local area network.
    (B) Designing or implementing a hardware or software system that 
aggregates source data underlying the financial statements or generates 
information that is significant to the audit client's financial 
statements taken as a whole, unless:
    (1) The audit client's management has acknowledged in writing to 
the accounting firm and the audit client's audit committee, or if there 
is no such committee then the board of directors, the audit client's 
responsibility to establish and maintain a system of internal 
accounting controls in compliance with section 13(b)(2) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78m(b)(2));
    (2) The audit client's management designates a competent employee 
or employees, preferably within senior management, with the 
responsibility to make all management decisions with respect to the 
design and implementation of the hardware or software system;
    (3) The audit client's management makes all management decisions 
with respect to the design and implementation of the hardware or 
software system including, but not limited to, decisions concerning the 
systems to be evaluated and selected, the controls and system 
procedures to be implemented, the scope and timetable of system 
implementation, and the testing, training, and conversion plans;
    (4) The audit client's management evaluates the adequacy and 
results of the design and implementation of the hardware or software 
system; and
    (5) The audit client's management does not rely on the accountant's 
work as the primary basis for determining the

[[Page 76085]]

adequacy of its internal controls and financial reporting systems.
    (C) Nothing in this paragraph (c)(4)(ii) shall limit services an 
accountant performs in connection with the assessment, design, and 
implementation of internal accounting controls and risk management 
controls, provided the auditor does not act as an employee or perform 
management functions.
    (iii) Appraisal or valuation services or fairness opinions.
    (A) Any appraisal service, valuation service, or any service 
involving a fairness opinion for an audit client, where it is 
reasonably likely that the results of these services, individually or 
in the aggregate, would be material to the financial statements, or 
where the results of these services will be audited by the accountant 
during an audit of the audit client's financial statements.
    (B) Notwithstanding paragraph (c)(4)(iii)(A) of this section, the 
accountant's independence will not be impaired when:
    (1) The accounting firm's valuation expert reviews the work of the 
audit client or a specialist employed by the audit client, and the 
audit client or the specialist provides the primary support for the 
balances recorded in the client's financial statements;
    (2) The accounting firm's actuaries value an audit client's 
pension, other post-employment benefit, or similar liabilities, 
provided that the audit client has determined and taken responsibility 
for all significant assumptions and data;
    (3) The valuation is performed in the context of the planning and 
implementation of a tax-planning strategy or for tax compliance 
services; or
    (4) The valuation is for non-financial purposes where the results 
of the valuation do not affect the financial statements.
    (iv) Actuarial services.
    (A) Any actuarially-oriented advisory service involving the 
determination of insurance company policy reserves and related accounts 
for the audit client, unless:
    (1) The audit client uses its own actuaries or third-party 
actuaries to provide management with the primary actuarial 
capabilities;
    (2) Management accepts responsibility for any significant actuarial 
methods and assumptions; and
    (3) The accountant's involvement is not continuous.
    (B) Subject to complying with paragraph (c)(4)(iv)(A)(1)-(3) of 
this section, the accountant's independence will not be impaired if the 
accountant:
    (1) Assists management to develop appropriate methods, assumptions, 
and amounts for policy and loss reserves and other actuarial items 
presented in financial reports based on the audit client's historical 
experience, current practice, and future plans;
    (2) Assists management in the conversion of financial statements 
from a statutory basis to one conforming with generally accepted 
accounting principles;
    (3) Analyzes actuarial considerations and alternatives in federal 
income tax planning; or
    (4) Assists management in the financial analysis of various 
matters, such as proposed new policies, new markets, business 
acquisitions, and reinsurance needs.
    (v) Internal audit services. Either of:
    (A) Internal audit services in an amount greater than 40% of the 
total hours expended on the audit client's internal audit activities in 
any one fiscal year, unless the audit client has less than $200 million 
in total assets. (For purposes of this paragraph, the term internal 
audit services does not include operational internal audit services 
unrelated to the internal accounting controls, financial systems, or 
financial statements.); or
    (B) Any internal audit services, or any operational internal audit 
services unrelated to the internal accounting controls, financial 
systems, or financial statements, for an audit client, unless:
    (1) The audit client's management has acknowledged in writing to 
the accounting firm and the audit client's audit committee, or if there 
is no such committee then the board of directors, the audit client's 
responsibility to establish and maintain a system of internal 
accounting controls in compliance with section 13(b)(2) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78m(b)(2));
    (2) The audit client's management designates a competent employee 
or employees, preferably within senior management, to be responsible 
for the internal audit function;
    (3) The audit client's management determines the scope, risk, and 
frequency of internal audit activities, including those to be performed 
by the accountant;
    (4) The audit client's management evaluates the findings and 
results arising from the internal audit activities, including those 
performed by the accountant;
    (5) The audit client's management evaluates the adequacy of the 
audit procedures performed and the findings resulting from the 
performance of those procedures by, among other things, obtaining 
reports from the accountant; and
    (6) The audit client's management does not rely on the accountant's 
work as the primary basis for determining the adequacy of its internal 
controls.
    (vi) Management functions. Acting, temporarily or permanently, as a 
director, officer, or employee of an audit client, or performing any 
decision-making, supervisory, or ongoing monitoring function for the 
audit client.
    (vii) Human resources.
    (A) Searching for or seeking out prospective candidates for 
managerial, executive, or director positions;
    (B) Engaging in psychological testing, or other formal testing or 
evaluation programs;
    (C) Undertaking reference checks of prospective candidates for an 
executive or director position;
    (D) Acting as a negotiator on the audit client's behalf, such as 
determining position, status or title, compensation, fringe benefits, 
or other conditions of employment; or
    (E) Recommending, or advising the audit client to hire, a specific 
candidate for a specific job (except that an accounting firm may, upon 
request by the audit client, interview candidates and advise the audit 
client on the candidate's competence for financial accounting, 
administrative, or control positions).
    (viii) Broker-dealer services. Acting as a broker-dealer, promoter, 
or underwriter, on behalf of an audit client, making investment 
decisions on behalf of the audit client or otherwise having 
discretionary authority over an audit client's investments, executing a 
transaction to buy or sell an audit client's investment, or having 
custody of assets of the audit client, such as taking temporary 
possession of securities purchased by the audit client.
    (ix) Legal services. Providing any service to an audit client under 
circumstances in which the person providing the service must be 
admitted to practice before the courts of a United States jurisdiction.
    (5) Contingent fees. An accountant is not independent if, at any 
point during the audit and professional engagement period, the 
accountant provides any service or product to an audit client for a 
contingent fee or a commission, or receives a contingent fee or 
commission from 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 of the circumstances giving 
rise to the lack of independence;

[[Page 76086]]

    (2) The covered person's lack of independence was corrected as 
promptly as possible under the relevant circumstances 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, and that covers at least all 
employees and associated entities of the accounting firm participating 
in the engagement, including employees and associated entities located 
outside of the United States.
    (4) 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 (15 U.S.C. 78l), 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) With respect to partners and managerial employees, an 
automated system to identify their investments in securities that might 
impair the accountant's independence;
    (iii) With respect to all professionals, a system that provides 
timely information about entities from which the accountant is required 
to maintain independence;
    (iv) An annual or on-going firm-wide training program about auditor 
independence;
    (v) An annual internal inspection and testing program to monitor 
adherence to independence requirements;
    (vi) Notification to all accounting firm members, officers, 
directors, and employees of the name and title of the member of senior 
management responsible for compliance with auditor independence 
requirements;
    (vii) Written policies and procedures requiring all partners and 
covered persons to report promptly to the accounting 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
    (viii) A disciplinary mechanism to ensure compliance with this 
section.
    (e) Transition and grandfathering.
    (1) Transition.
    (i) Appraisal or valuation services or fairness opinions and 
internal audit services. Until August 5, 2002, providing to an audit 
client the non-audit services set forth in paragraphs (c)(4)(iii) and 
(c)(4)(v) of this section will not impair an accountant's independence 
with respect to the audit client if performing those services did not 
impair the accountant's independence under pre-existing requirements of 
the Commission, the Independence Standards Boards, or the accounting 
profession in the United States.
    (ii) Other financial interests and employment relationships. Until 
May 7, 2001, having the financial interests set forth in paragraph 
(c)(1)(ii) of this section or the employment relationships set forth in 
paragraph (c)(2) of this section will not impair an accountant's 
independence with respect to the audit client if having those financial 
interests or employment relationships did not impair the accountant's 
independence under pre-existing requirements of the Commission, the 
Independence Standards Board, or the accounting profession in the 
United States.
    (iii) Quality controls. Until December 31, 2002, paragraph (d)(4) 
of this section shall not apply to offices of the accounting firm 
located outside of the United States.
    (2) Grandfathering. Financial interests included in paragraphs 
(c)(1)(ii)(A) and (c)(1)(ii)(F) of this section and employment 
relationships included in paragraph (c)(2) of this section in existence 
on May 7, 2001, and contracts for the provision of services described 
in paragraph (c)(4)(ii) of this section in existence on February 5, 
2001 will not be deemed to impair an accountant's independence if they 
did not impair the accountant's independence under pre-existing 
requirements of the Commission, the Independence Standards Board, or 
the accounting profession in the United States.
    (3) Settling financial arrangements with former professionals. To 
the extent not required by pre-existing requirements of the Commission, 
the Independence Standards Board, or the accounting profession in the 
United States, the requirement in paragraph (c)(2)(iii) of this section 
to settle financial arrangements with former professionals applies to 
situations that arise after the effective date of this section.
    (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 an 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 and 
furnishes reports or other documents filed with the Commission or 
otherwise prepared under the securities laws, and all of the 
organization's departments, divisions, parents, subsidiaries, and 
associated entities, including those located outside of the United 
States. Accounting firm also includes the organization's pension, 
retirement, investment, or similar plans.
    (3) Accounting role or financial reporting oversight role means a 
role in which a person is in a position to or does:
    (i) Exercise more than minimal influence over the contents of the 
accounting records or anyone who prepares them; or
    (ii) Exercise influence over the contents of the 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 audit client means:
    (i) An entity that has control over the audit client, or over which 
the audit client has control, or which is under common control with the 
audit client, including the audit client's parents and subsidiaries;
    (ii) An entity over which the audit client has significant 
influence, unless the entity is not material to the audit client;
    (iii) An entity that has significant influence over the audit 
client, unless the audit client is not material to the entity; and
    (iv) Each entity in the investment company complex when the audit 
client is an entity that is part of an investment company complex.
    (5) Audit and professional engagement period includes both:
    (i) The period covered by any financial statements being audited or 
reviewed (the ``audit period''); and

[[Page 76087]]

    (ii) The period of the engagement to audit or review the audit 
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 audit, review, or 
attest procedures, whichever is earlier; and
    (B) The professional engagement period ends when the audit client 
or the accountant notifies the Commission that the client is no longer 
that accountant's audit client.
    (iii) For audits of the financial statements of foreign private 
issuers, the ``audit and professional engagement period'' does not 
include periods ended prior to the first day of the last fiscal year 
before the foreign private issuer first filed, or was required to file, 
a registration statement or report with the Commission, provided there 
has been full compliance with home country independence standards in 
all prior periods covered by any registration statement or report filed 
with the Commission.
    (6) Audit client means the entity whose financial statements or 
other information is being audited, reviewed, or attested and any 
affiliates of the audit client, other than, for purposes of paragraph 
(c)(1)(i) of this section, entities that are affiliates of the audit 
client only by virtue of paragraph (f)(4)(ii) or (f)(4)(iii) of this 
section.
    (7) 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 with others on the audit engagement team during the audit, 
review, or attestation engagement regarding technical or industry-
specific issues, transactions, or events.
    (8) Chain of command means all persons who:
    (i) Supervise or have direct management responsibility for the 
audit, including at all successively senior levels through the 
accounting firm's chief executive;
    (ii) Evaluate the performance or recommend the compensation of the 
audit engagement partner; or
    (iii) Provide quality control or other oversight of the audit.
    (9) Close family members means a person's spouse, spousal 
equivalent, parent, dependent, nondependent child, and sibling.
    (10) Contingent fee means, except as stated in the next sentence, 
any fee established for the sale of a product or 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 product or service. Solely for the purposes of this section, a fee 
is not a ``contingent fee'' if it is 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. Fees may 
vary depending, for example, on the complexity of services rendered.
    (11) 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 managerial 
employee of the accounting firm who has provided ten or more hours of 
non-audit services to the audit client for the period beginning on the 
date such services are provided and ending on the date the accounting 
firm signs the report on the financial statements for the fiscal year 
during which those services are provided, or who expects to provide ten 
or more hours of non-audit services to the audit client on a recurring 
basis; and
    (iv) Any other partner, principal, or shareholder from an 
``office'' of the accounting firm in which the lead audit engagement 
partner primarily practices in connection with the audit.
    (12) Group means two or more persons who act together for the 
purposes of acquiring, holding, voting, or disposing of securities of a 
registrant.
    (13) Immediate family members means a person's spouse, spousal 
equivalent, and dependents.
    (14) Investment company complex.
    (i) ``Investment company complex'' includes:
    (A) An investment company and its investment adviser or sponsor;
    (B) Any entity controlled by or controlling an investment adviser 
or sponsor in paragraph (f)(14)(i)(A) of this section, or any entity 
under common control with an investment adviser or sponsor in paragraph 
(f)(14)(i)(A) of this section if the entity:
    (1) Is an investment adviser or sponsor; or
    (2) Is engaged in the business of providing administrative, 
custodian, underwriting, or transfer agent services to any investment 
company, investment adviser, or sponsor; and
    (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. 80a-3(c)) that has an 
investment adviser or sponsor included in this definition by either 
paragraph (f)(14)(i)(A) or (f)(14)(i)(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.
    (15) Office means a distinct sub-group within an accounting firm, 
whether distinguished along geographic or practice lines.
    (16) 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

    4. The general authority citation for Part 240 is revised to read, 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
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, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 
and 80b-11, unless otherwise noted.
* * * * *

    5. 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) Disclose, under the caption Audit Fees, the aggregate 
fees billed for professional services rendered for the audit of the 
registrant's annual financial statements for the most recent fiscal 
year and 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.
    (2) Disclose, under the caption Financial Information Systems 
Design and Implementation Fees, the aggregate fees billed for the 
professional services described in Paragraph (c)(4)(ii) of Rule 2-01 
of Regulation S-X (17 CFR 210.2-01(c)(4)(ii)) rendered by the 
principal accountant for the most recent fiscal year. For purposes 
of this disclosure item, registrants that are

[[Page 76088]]

investment companies must disclose fees billed for services rendered 
to the registrant, the registrant's investment adviser (not 
including any sub-adviser whose role is primarily portfolio 
management and is subcontracted with or overseen by another 
investment adviser), and any entity controlling, controlled by, or 
under common control with the adviser that provides services to the 
registrant.
    (3) Disclose, under the caption All Other Fees, the aggregate 
fees billed for services rendered by the principal accountant, other 
than the services covered in paragraphs (e)(1) and (e)(2) of this 
section, for the most recent fiscal year. For purposes of this 
disclosure item, registrants that are investment companies must 
disclose fees billed for services rendered to the registrant, the 
registrant's investment adviser (not including any sub-adviser whose 
role is primarily portfolio management and is subcontracted with or 
overseen by another investment adviser), and any entity controlling, 
controlled by, or under common control with the adviser that 
provides services to the registrant.
    (4) Disclose whether the audit committee of the board of 
directors, or if there is no such committee then the board of 
directors, has considered whether the provision of the services 
covered in paragraphs (e)(2) and (e)(3) of this section is 
compatible with maintaining the principal accountant's independence.
    (5) If greater than 50 percent, disclose the percentage of the 
hours expended on the principal accountant'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.

    Dated: November 21, 2000.

    By the Commission.
Jonathan G. Katz,
Secretary.
BILLING CODE 8010-01-P

[[Page 76089]]

[GRAPHIC] [TIFF OMITTED] TR05DE00.000


[[Page 76090]]


[GRAPHIC] [TIFF OMITTED] TR05DE00.001

[FR Doc. 00-30244 Filed 12-4-00; 8:45 am]
BILLING CODE 8010-01-C