Stock Talk TMF Interview With Securities & Exchange Commission
Chairman Arthur Levitt

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With Bill Barker (TMF Max)
November 2, 2000

With the SEC claiming victory in the matter of selective disclosure, the commission has turned its eye to auditor independence. Concerned that the quality of financial information available to investors might be compromised by companies who use the same firms for consulting and audits, the government is considering rules that, at the very least, will mandate disclosure of such relationships. Bill Barker (TMF Max) spoke with SEC Chairman Arthur Levitt about this issue earlier in the week.

The second portion of Barker's interview with Levitt, published as a separate item, deals with the early days of Regulation FD, which covers selective disclosure.

TMF: Mr. Levitt, thanks for joining us for StockTalk. You are known to the readers of this site mostly for your work on Regulation FD, which is now implemented, and I'd like to ask a couple of questions about that later, but currently there is a new rule that you've turned your attention to regarding auditor independence. I wonder if you could explain what the interest of individual investors might be, and should be, in this rule.

Levitt: Well, today the reliability of the numbers that are reported to investors is absolutely critical. When we see a statement that falls short by a penny or two of expectations, stocks dropping by 30, 40, and 50%, the accuracy of the numbers is greater than any time that I can recall.

Accounting firms in the past derived most of their money from auditing, and all public companies by law must be audited by a CPA. Today, there has been a dramatic change and accounting firms derive more than half their money from non-audit services. Therefore, it's critical that investors know whether the audits of companies that they invest in are impacted by fees paid to their auditor that is much greater than the audit fee. This rule would call for disclosure and it would also eliminate conflicts that an auditor would have in performing certain consulting services for an audit client.

I can think of no rule or regulation that has a greater bearing on public confidence in our markets than this.
I can think of no rule or regulation that has a greater bearing on public confidence in our markets than this question of auditor independence.

TMF: And in saying there is no rule that has a greater bearing on public confidence, you would include Regulation FD, which individual investors certainly did identify as being in their interest -- you would say this is of even greater interest?

Levitt: I would say that this is of comparable interest. These are two initiatives which are geared squarely toward evening the playing field between large institutional interest and the individual investor. These are two initiatives geared toward recognizing the primacy of the individual investor in U.S. markets.

TMF: Now up to this point in time, my understanding, having followed this in the media, is that the accounting profession has countered the initiatives undertaken by your office regarding this rule with the argument that there is no "smoking gun" existing that shows that even if there exists the possibility that an audit could be theoretically compromised by the presence of another relationship -- such as offering advice or something like that -- that there exists no smoking gun at the time that any audit has been negatively affected. What's your response to that argument?

Levitt: Well, I would rather take action when there is the smell of smoke rather than when there's a full-blown fire. But bringing it down to reality, most murder cases, most insider trading cases, are based upon circumstantial evidence. We are seeing more evidence of audit failures today than almost any other time in the history of the commission. We are seeing more evidence of managed numbers by companies that have such an economic hold on their auditors that they are unwilling to stand up for the shareholder.

We have brought a large number of cases involving audit failures -- cases such as W.R. Grace (NYSE: GRA) and Waste Management (NYSE: WMI) -- to mention just a few, with more in the pipeline. Now, it's unrealistic to think that someone is in the room when a CEO of a company says to his auditor, "Look, don't take that write off in year one, it will hurt our earnings. Take it over a period of 10 years or 12 years." I've headed enough audit committees to understand the hold that corporations very often have on their auditors, so I don't accept "the smoking gun argument" one single bit.

TMF: And in the specific cases that you mentioned, were those instances of the presence of auditing and advisory relationship mixed together?

Levitt: Those were cases where there was an advisory and consulting relationship mixed together. For instance, let's say that an auditor for an American company provides a consulting service to provide them with information technology for $100 million and that consulting activity, that project, fails. The system simply didn't work. Consider this conflict.

The auditor would appropriately say, "Let's write off $100 million; it just hasn't worked." The company would say, "Hey, wait a second. We paid you $100 million for this project. You can't ding us twice and say that we've got to write it off in one year and kill our earnings. We've got to write it off over 10 or 15 years." So there is an inherent conflict in the performance of IT services as well as the audit -- and that's one of the things this rule gets at.

We're still in the process of digesting nearly 3,000 letters of comment that we've received.

TMF: You referred earlier to disclosure. What sort of disclosure is there now that an individual investor or an institutional investor could check out, research whether an audit is being conducted by somebody that also has a consulting relationship with a company?

Levitt: There is none now.

TMF: So if, for instance, in the case of MicroStrategy (Nasdaq: MSTR) after the problems with the audit had appeared there, was an investor unable to even investigate whether there was a consulting relationship at all?

Levitt: It would have been very difficult for an investor to find out. The kind of disclosure that we ask for in this rule would call for the company to report on consulting fees above a minimal amount when they exceed the audit fee by a certain amount.

The rule has not been written yet. We're still in the process of digesting nearly 3,000 letters of comment that we've received, which is an extraordinarily large number of letters.

TMF: And were the majority of those letters from individual investors or members of the auditing profession?

Levitt: Well, it cuts a pretty broad road. I would say that probably members of the profession -- being better organized -- tended to focus on sending similar letters. But the letters from individual investors and from academics appeared to clearly favor the rule making.

TMF: Is there any evidence that perhaps the auditing profession took a cue or learned something from the "defeat," one might call it, that the brokerage and analyst profession suffered [from the passage of] Regulation FD?

Levitt: I think the campaign being waged against this rule by the group that represents the auditors has been extensive. They've sent mailings by the hundreds of thousands to accountants all over America, most of whom are not affected by this rule because they don't represent publicly owned companies. So that's caused a large number of letters to be written by accountants that are frightened that this rule might impact them when actually it is geared only toward the "Big Five" -- the largest of the accounting firms that represent the largest number of publicly owned corporations.

Your Turn:
Respond to this interview on our Eyes on the Wise discussion board.