Before the United States Securities and Exchange Commission
On September 13, 2000
Good afternoon. My name is Thomas Gardner and I am co-founder of The Motley Fool, Inc. of Alexandria, Virginia. I would like to thank the Commission for affording me the opportunity to testify today about the issue of auditor independence.
In 1994, my brother, David, and I started The Motley Fool with a mission "to educate, amuse, and enrich the individual investor." Today, we employ more than 350 Fools and have offices operating in the U.S., the U.K., and Germany. We have an internationally syndicated newspaper column carried by more than 190 newspapers and The Motley Radio show syndicated in 145 markets. In addition, we have five New York Times best-selling books, a line of self-published books and research, and a community of Fools more than 2.5 million strong who visit us online at Fool.com, Fool.co.UK, and Fool.de [Germany]. On average, each month across the globe, The Motley Fool is reaching more than 25 million investors with its original mission "to educate, amuse, and enrich the individual investor."
Our work is driven by our belief that average people -- you and I -- ought to take a vastly more active interest in our management of money than we have heretofore. And in order for individual investors to effectively manage their own money, they need education, information, and opportunities for open dialogue. That's what we provide. We teach people the fundamentals of long-term financial management; we highlight online and offline information resources for them; and we manage a 24-hour open network of communication on money between people in more than 100 countries around the globe.
In a world that severely lacks financial instruction of any form, at any educational level, we at The Motley Fool have been reminded every day of the extraordinary value for individual investors of nothing more than simple information -- information about Einstein's miracle of compounding growth, information about the real (after-fee and after-tax) rates of return of managed mutual funds, information about any public company's quarterly earnings result. And I know that it is vital for every stock-market participant to have access to the same corporate information at the same time.
This idea, the need for complete public market transparency, is the source of the integrity and stability that make our markets the envy of the world. For example, the Securities and Exchange Commission's passage of and commitment to the enforcement of Regulation FD, requiring corporations to release material information simultaneously to all investors -- regardless of their geographic location, their professional standing, or the size of their brokerage account -- is a powerful affirmation of the critical necessity of market transparency.
"The first best step the SEC should take is to, without delay, require public companies to disclose the nature and extent of their relationship with auditors in its entirety."
With that as a backdrop, I'd like to discuss why I think the issue of auditor independence is important to individual investors. For business investors, at the heart of making good investment decisions is the need to assess company performance by analyzing financial statements. And embedded in that process is a natural reliance on the truth and accuracy of the financial accounting. It's unrealistic to expect even the most seasoned investor to regularly sniff out accounting irregularities in advance of the SEC doing so. Accordingly, there must be a mechanism or process whereby investors can take comfort in the veracity of the financial statements.
Congress recognized this need when they confirmed federal securities laws which required that all public companies regularly file financial statements audited by an independent auditor. Nowhere else do federal securities laws require a third party to confirm the performance report of a public company.
Unfortunately, commercial activity over the past decade has served to weaken the definition of an otherwise simple word -- "independent." We're losing its prefix. The array of relationships that exist between public companies and their auditors today are moisturizers down a slippery slope toward dependent audits. And when the objectivity of financial audits is compromised, we lose ground on achieving the transparency that is fundamental to a robust public market. Again, without transparency, individual investors -- far and away our market's largest constituency -- will, with each abuse of the system, withdraw their funds for years, perhaps decades, perhaps never to return.
The SEC's congressional mandate is to protect investors and defend the openness, clarity, and visibility of the marketplace. The present state of corporate audits -- with auditing firms inking substantial consulting and business-service contracts with companies whose financial performance they are tasked with objectively inspecting -- is at odds with that SEC mandate. It violates the protection of individual investors. It violates the openness, clarity, and visibility of the marketplace. And it violates existing federal securities laws.
Now, do I have the cure-all solution for corporate auditing? Unfortunately, I don't. The best I can offer today is that independent auditing is critical to the security and opportunity offered by our equities markets. No one on any side of this issue can disagree with that. But there is no simple remedy to the problem. I have two possible solutions that I'd like to share, but they're the thoughts of an individual investor, the manager of a private company, a layman without formal accounting training, and a guy who calls himself Fool. Weight what follows accordingly.
These two ideas have the same goal -- to create clarity in the market and to provide investors with the information they need to make informed investment decisions. Both ideas support our belief that the U.S. market will be strengthened by the attraction of hundreds of millions of individual investors from around the world to our well-policed free-market system. To that end, our "do your own homework, make your own investment decision" mantra at The Motley Fool relies upon full informational disclosure. That also happens to be the basis of our federal securities laws.
Therefore, I think that the first best step the SEC should take is to, without delay, require public companies to disclose the nature and extent of their relationship with auditors, in its entirety. This disclosure is not currently required. It should be. A complete, detailed disclosure would give investors the opportunity to decide for themselves whether or not accompanying commercial relations were impacting the purity of the audit.
Requiring disclosure would serve to force public companies and auditors to earn the trust of the investing community. If a public company maintained a consulting relationship with its auditor, disclosed it fully, and the financial statements were never brought into question, either by a government body or a private lawsuit, then I would see no reason to be any more or less distrustful of the validity of the financial statements.
"Subsidization of the auditing function, a policing watchdog of our open public markets, should not be ruled out."
Likewise, if another public company extended commercial relations with an auditor, disclosed it, and then the financial statements proved inaccurate, this could permanently damage, even destroy, the reputation of both company and auditor. The risks are immense: shareholder lawsuits; civil actions by the SEC and other regulators; criminal prosecution; and of course, the loss of investor confidence in the company and the auditor. Total and continuous disclosure might well introduce risks substantial enough to deter unhealthy, conflicted business relationships between public corporation and independent auditor.
Disclosure is also consistent with free market thinking. Confidence in or skepticism of a company's financial statements will be factored into the market's valuation of that business. When companies and their auditors want to pursue ancillary business relationships, requisite disclosure will help ensure the integrity of the audited financial statements but it will also become a factor in company valuation.
The most important point of a disclosure-based approach is that investors be given the opportunity to receive, digest, and analyze all information material to their investment decision.
A second and more severe form of regulation is to restrict certain relationships between auditors and public companies. This approach seeks to protect investors by upholding the United States Supreme Court's position that auditors be watchdogs for investors with a duty of independently certifying the financial statements of a public company. The High Court has made it exceedingly clear to the auditing community that its responsibilities are to a company's shareholders, not to its executive team.
However, the problem with untying the meaningful and existing commercial ties between auditing businesses and public corporations is that doing so would act as a strike against value creation for auditors. Any restriction, which in effect forces an auditor to scale back or sell its consulting business, will result in a loss of value. And that loss in value extends not just to executives at auditing companies, but throughout the entire industry. This sort of decline in the value of the auditing function would, no doubt, then repel the best certified public accountants from working as auditors. The net result of that would be a lower quality of auditing and, thus, an increased risk to market transparency.
Therefore, I believe that if we move to restrict these relationships in order to protect investors, we must then consider compensating auditing firms for their loss, similar to the theory pursued in eminent domain cases. Subsidization of the auditing function -- a policing watchdog of our open public markets -- should not be ruled out.
I close where I began. This issue is extremely complex. Both sides present viable arguments in support of their position. Unfortunately, none of the solutions I have proposed are a cure-all for the problem. Nonetheless, there is no compelling argument against disclosure here. I urge the SEC to immediately require auditing firms to disclose the full, detailed extent of their relationship with public companies that they audit.
And while I do think that the extension of commercial relations beyond auditing opens investors up to additional risk, nevertheless without any empirical evidence that such relationships actually harm investors I am reticent to support immediate restrictions. However, if evidence can show a correlation between these relationships and the undermining of the integrity of the market -- and I am open to the possibility that such evidence exists -- I believe we should consider subsidizing tighter restrictions against auditor partnerships.
Thank you.
Your Turn:
Share your thoughts on Tom Gardner's testimony and proposals on our Eyes on the Wise discussion board.
Related Links:
RSS Headlines
Fool UK
