How the regulators blew it

Recent rules adopted by the U.S. Securities and Exchange Commission to curb the kind of legal and accounting shenanigans that toppled companies such as Enron and Arthur Andersen, are not as strong as the SEC first indicated they might be. But do they still have enough teeth to make them effective tools in stemming corporate corruption?

On the accounting side, one Wharton faculty member suggests that the new rules fail to address certain issues arising from the Enron case and that the accounting profession should have taken a more positive role in pushing for reform. On the legal side, notes another professor, the wording of the new regulation leaves lawyers "wiggle" room to avoid reporting securities law violations to company executives.

Indeed, critics have charged that several of the new rules are watered-down versions of the SEC's own earlier proposals because the SEC bowed to pressure from lobbyists for the accounting and legal professions. But in voting in late January on a slew of new rules, to fulfill requirements outlined by Congress in last year's Sarbanes-Oxley Act, SEC officials noted that the agency can revisit the rules later if they prove ineffective in curbing wrongdoing by public companies.

The SEC's actions came at meetings on Jan. 22 and 23. One meeting dealt with issues related to accounting firms and auditing, while the other focused on the role of lawyers.

Lawyers and securities laws
The SEC voted unanimously to mandate that lawyers disclose their concerns about possible securities-laws violations to upper management at companies they advise. If executives fail to "respond appropriately" to evidence presented by the lawyer, the lawyer would now be required to alert the company's audit committee or even the full board of directors.

Critics were upset at the new rule because the SEC decided not to require lawyers to notify the agency itself if corporate executives did nothing to respond to the evidence of illegal behavior. The notification--an idea originally proposed by the SEC but criticized by lawyers--would have taken the form of a so-called noisy withdrawal, in which a lawyer informed the agency that he or she has withdrawn as counsel for the company for "professional reasons."

The new SEC rules also establish a complex definition of the phrase "evidence of a material violation" that would trigger a lawyer's obligation to report wrongdoing to company executives. The definition says lawyers must report "credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur."

The new SEC rules also establish a complex definition of the phrase "evidence of a material violation" that would trigger a lawyer's obligation to report wrongdoing to company executives.

G. Richard Shell, professor of legal studies and a lawyer, says the use of a double negative in the definition will make it hard to demonstrate that a lawyer failed to adhere to the rule. "It looks like the legal profession has succeeded in watering down any kind of duty that will cause them great discomfort," Shell says. "The rule also uses the word 'reasonably' twice. It essentially gives any lawyer three or four different wiggle ways to escape any liability. Lawyers are pretty good at crafting regulations. So when you try to regulate them, it's difficult to end up with a rule that will have much bite."

Shell says one difficulty in thwarting wrongdoing in companies stems from the attitudes of two very different kinds of lawyers, which he has dubbed "the trusted counselor" and the "legal enabler." The trusted counselor tries to do the right thing both for his or her clients and society, and sees it as his or her duty to restrain illegal behavior of clients. The legal enabler, by contrast, seeks to implement only what a client wishes, regardless of how many corners need to be cut.

Shell believes the new SEC rule will have benefits in companies with trusted counselors. "I think the rule will add some leverage to the trusted counselors who desire to do the right thing. If you're not one of those lawyers, but just a legal facilitator for whatever a client wants to do, it's difficult to see how this rule will cause you to behave any differently."

Legal studies and business ethics professor Thomas W. Dunfee, also an lawyer, says he recognizes that requiring a lawyer to engage in a noisy withdrawal is a sensitive issue because it goes to the heart of the "question of separation of an independent bar from the government." But he says lawyers need to broaden their view of their responsibilities.

"There's an issue whether lawyers can breach confidentiality and reveal if a client will commit a crime or is engaged in a pattern of crime and fraud," says Dunfee. "Confidentiality can be necessary to perform an essential function in our system, but I don't think it has to be the way the American Bar Association [that fought the earlier SEC proposal] wants it to be. I think there needs to be greater liability imposed on lawyers in a malpractice sense. You think of the relative liability of doctors and accountants. Lawyers seem to presently be sheltered from the storm to an inappropriate degree. It should be permissible for lawyers to speak out in appropriate circumstances."

Frederick D. Lipman, a lecturer at Wharton and a partner at the law firm of Blank Rome in Philadelphia, says the SEC, in voting on the rule concerning lawyers, did water down an earlier proposal. But he says the rule that has been adopted is still more stringent than required by Sarbanes-Oxley.

Sarbanes-Oxley does not require that a lawyer "become a whistle-blower; it just requires that lawyers go up the line and bring [evidence of material securities violations] to the attention of the board of directors," says Lipman, who also teaches at the University of Pennsylvania's Law School and has written about the accounting profession. "The SEC went well beyond Sarbanes-Oxley when it proposed to make lawyers whistle-blowers. The SEC is backtracking on the concept of making lawyers whistle-blowers, but that was never in the statute to begin with."

Auditors and tax advice
At its Jan. 22 meeting, which was devoted to accounting issues, the SEC voted to require that the two most senior audit partners be removed from accounts after five years and then be subject to a five-year "time out" period to ensure that they do not get too chummy with the companies they are auditing. Other partners considered central to the auditing team would be barred from auditing a company's books after seven years and would be subject to a two-year time out period. Critics had hoped for tougher "rotation" rules. An SEC proposal distributed for public comment last fall said that the rotation requirement should apply to all members of an audit team.

The regulators also voted to prohibit auditors from providing a host of consulting services to their audit clients that would require auditors to review their own work and thus impair an accounting firm's independence. These include the design and implementation of financial systems; actuarial and legal advice; appraisal or valuation services; and other expert services related to audits.

Significantly, the SEC decided not to prohibit accountants from continuing to provide tax compliance, tax planning and tax advice to audit clients--a move that did not sit well with critics who wanted a ban on such services. Tax-related services, including advice on tax shelters, are among the most lucrative nonaudit services offered by accounting firms. Last year, the SEC had suggested it might prohibit accountants from providing tax advice.

The SEC also voted to require that public companies disclose in their annual reports the amount of money they pay accounting firms for audit and consulting services. What is more, companies are now required, in their quarterly and annual financial reports, to disclose off-balance-sheet transactions and other relationships that may have a significant current or future effect on the company's financial position.

Wharton accounting professor Phillip C. Stocken says that allowing auditors to also provide tax advice is "probably not good." But he says it is understandable why accounting firms would have fought hard to prevent the SEC from barring them from providing tax services.

"An accounting firm would be reluctant to allow a competitor into a client company to provide tax advice because once that tax-advice relationship has been established, the company might be more inclined to switch auditors," says Stocken. "It comes as no surprise that they were lobbying hard so that the SEC would not prevent them from providing tax advice. If I'm an incumbent firm, my position would be much weakened."

The new SEC rules also may raise costs of auditing and tax advice, according to Stocken. If accounting firms are prohibited from providing tax advice, other firms will pick up that business, so it is not as if that work will disappear. A different accounting firm will audit a client's books and yet another accounting firm will provide it with tax advice. That might be desirable because the auditing firm would pass judgment on the tax work of another firm. But it might be costly for public companies to pay one accounting firm for auditing services and another for tax advice.

Overall, "these requirements will improve the integrity of the financial markets," Stocken says. "The fact that senior partners have to be rotated every five years and the others every seven years is a good thing. It ensures that the relationships firms have with clients don't become too close and the auditors don't lose the objectivity that they should have when they pronounce on financial statements."

There was some thought given to the idea of requiring a rotation of firms, not just partners, as a way of ensuring auditor independence, but Dunfee says that would have been a risky approach. "There are risks to rotating firms. We're not sure what the competitive impact of that would be and what the loss would be in terms of competency and familiarity. Rotating partners is less risky."

No amount of rulemaking will matter much if the SEC does not change its approach to enforcement.

Dunfee says the new SEC rules do not deal with some key matters raised by the Enron debacle. "For example, for the Houston office of Arthur Andersen, the Enron account was a big deal. Even though one might say the revenues generated just from auditing weren't that big for Arthur Andersen as a worldwide company, they were very important for the Houston office. There has to be some consideration whether a local office of an auditing firm is heavily dependent on a single audit client. I haven't seen that addressed."

For his part, Lipman notes that no amount of rulemaking will matter much if the SEC does not change its approach to enforcement. "I think they take a limited budget and spend a lot of time chasing down small-fry and don't spend enough time chasing the big fish. As a result, I hope the new SEC chairman [who will replace the controversial Harvey Pitt] spends more time on how the enforcement program will work."

Lipman says it also would be a good idea for the SEC to invite the chairpersons of audit committees of public companies to an annual conference at which regulators would discuss the importance of auditor independence. "The chairmen of audit committees are the people you expect to exercise oversight, but many have not. A daylong conference could stress the message that auditing is not a buddy-buddy system. Most audit committee members are conscientious but they don't have the knowledge base. They need education."

 
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