FOOL ON THE HILL
Public Markets Under Assault

Media reports about Enron's complex partnerships and document shredding at Enron and Andersen raise serious issues, but the real issue here for maintaining confidence in our public markets is auditor independence. The SEC must now issue a meaningful rule on auditor independence. SEC Chairman Harvey Pitt must acknowledge his unavoidable appearance of impropriety and recuse himself from the Enron investigation and proposed solutions.

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By Tom Jacobs (TMF Tom9)
January 23, 2002

Every day, everywhere in the world, money votes that our public stock markets are the absolute best there is. The globe invests in public companies listed on our stock exchanges because our financial system promises unparalleled integrity. The result is the world's best opportunity for long-term wealth creation.

Today that integrity is under full-frontal assault. Yet the government and media are trying to distract you from the real story and prevent any meaningful fix. 

What you hear are horrible stories about lying and cheating corporate managers, document shredding by the company and its auditors, and accounting technicalities so mind-numbingly complex that they put you to sleep better than the Tax Code. You'd think this was an isolated case of law-breaking and accounting rules, of criminals cooking the books, that requires only enforcing the law and a quick fix of some lines in the Code of Federal Regulations. Even comments from President Bush, who yesterday finally expressed some well-intentioned "outrage" -- did he take The Motley Fool's suggestion last week? -- show that he sees this as an isolated problem with one very bad company. 

Worse, number one stock cop Securities & Exchange Commission Chairman Harvey Pitt, sings the same song. Before an investigation has even gotten off the ground, Pitt pronounced that "auditor independence is not the cause of the problem." Rushing to judgment, he decided that the solution is a new auditor self-regulating body funded and staffed by those it will regulate. He is dead wrong. So dead wrong that no less a star than Charles A. Bowsher, former comptroller general and top green-eye shade guy at the General Accounting Office during the savings and loan debacle, resigned in protest along with every colleague from the Public Oversight Board, which oversees peer review of accounting firms and an auditing industry standards-setting board.     

Auditor independence is exactly the problem. While the relationship between Enron and its Arthur Andersen auditors and consultants might not have been the technical cause of the disaster, you can bet that if there had been true auditor independence -- a separation of auditing and consulting businesses -- it would likely not have happened. Our public markets will be threatened until we act.

Our economy benefits because capital can move freely to its best opportunities for profit. Investors depend on transparency -- accurate information about a publicly traded company's finances and operations -- in order to decide where to allocate their capital. We are the only country in the world that requires third-party audit certification of the financial information that the SEC requires annually from each company in its Form 10-K. Our confidence in the public markets is based on financial statements that are audited and certified by independent public accountants -- emphasis on independent and public -- to comply with generally accepted accounting principles. But this certification is absolutely meaningless if auditors are not independent, and this is what's under attack by the relationship between Enron and its Arthur Andersen auditors and consultants, a relationship that clearly led to misinformation and financial loss.

The public knows this, and the investing danger is clear. Hasn't your mother, a spouse, or a colleague exclaimed in the last weeks, "Well, if we can't count on this information being accurate, then it's all a crapshoot?" It's this kind of scuttlebutt that can cause us a major problem.     

No doubt about it, there are excellent, independent auditors, but this is about large accounting firms that audit our publicly traded companies, and everyone of them knows full well that they grow richer through selling consulting services year round, over and over, than from annual audits. Auditors are increasingly the loss leaders for the more lucrative business of consulting, which is helping companies analyze their management structure, a product line, expansion plans, poor performance, whatever. Everyone knows it, especially mega-firm Arthur Andersen LLP. Andersen was once part of the huge, worldwide, venerable firm of auditors and consultants that broke into two partnerships because partners couldn't come to an agreement about allocating income between the auditing arm, which generated less revenue, and the consultants that brought home the mega-bacon. As you would expect, the auditors group soon developed its own consulting operations.  

This business reality led to relationships between the firms and the companies they audit that are so complex and intertwined -- try incestuous -- that there is an inherent incentive against auditors uncovering and requiring a company to address bad news. The SEC recognized at least 10 threats to independence when it proposed in 2000 to amend the rules governing auditors.

Sadly, despite former Chairman Arthur Levitt and the SEC's best efforts, the proposed rule never got anywhere, limping along to a watered-down final rule effective in 2001. Despite the efforts of our community, Motley Fool co-founder Tom Gardner and writer Bill Barker, and individual investors everywhere, the SEC couldn't fight the lobbyists that urged Congress to hold the SEC budget up for ransom. Tom Gardner observes, "History will treat Arthur Levitt very well. Levitt pushed aggressively for auditor independence -- which it seems the SEC largely abandoned after Levitt's departure. That policy initiative is intensely relevant here. The deeply flawed relationship between Enron, Arthur Andersen, and investors may prove out the cockroach theory. You may only see one in the sink today, but there are piles of them in the crevices." 

So now the government should provide true auditor independence. It's clobbering time.

Mandatory disclosure
When Tom Gardner testified before the SEC in favor of the proposed rule in September 2000, he suggested two options. The first was that "the SEC should... require public companies to disclose the nature and extent of their relationship with auditors, in its entirety.... 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."

Tom testified that disclosure provided a further incentive to avoid behavior that could lead to "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."

Implicitly recognizing that the incentives might prove insufficient, he provided a second option.  

Restrict relationships
The second choice was to restrict certain relationships between auditors and public companies. The testimony implies that this means a separation of auditing from consulting functions. Tom recognized the severity of limiting auditors' ability to create value, and said that there may need to be some public compensation for auditors. Today, Tom says he would do more. "We made very compelling points in our congressional testimony, " but "clearly, we could have gone even farther in demanding that the police force of the public markets improve their watch on auditing."  

Regardless of the view you hold, you must act if you care about the integrity of the greatest public stock markets in the world. Let the SEC and your Congressperson know that you support auditor independence.

Pitt must recuse himself
Harvey Pitt has an appearance of impropriety too large to ignore. He represented accountants for 20 years before joining the SEC and played a key role in ensuring passage of the Private Securities Litigation Reform Act of 1995 that insulated the accounting industry from savings and loan scandal lawsuits and made it nearly impossible to sue the auditors who had declared them clean.

I'm sure Pitt is a man of great integrity. But it should be obvious to anyone that the nation's top protector of the integrity of the public markets -- and the confidence of all investors in those markets -- cannot appear to be partial to the company and industry under investigation and threat of further regulation by his agency. Have we sunk so far that we don't see this? He must recuse himself from the Enron investigation and auditor independence issues. And President Bush should appoint and Congress confirm appointees to fill the SEC's empty seats with people who have no appearance of impropriety. Fast.

Government action must always be a last resort, and it must come from reflection, not reflexivity. The SEC's legal mandate is to maintain confidence in the integrity of the public markets. That integrity is under its full-frontal assault. The SEC has had plenty of time to study auditor independence, and to see the failure of its half measures. It must act now, and without Pitt.

Tom Jacobs (TMF Tom9) owns no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.