I am pleased and honored to be part of this first Baker & McKenzie International Law Lecture. The combination of the Georgetown Law Center and Baker & McKenzie to support a lecture series to explore provocative issues in international law is a marriage made in heaven -- or at least in whatever passes for heaven among lawyers and law professors.
It is particularly a treat to share the podium with Don Langevoort. Don and I were colleagues on the staff of the SEC more years ago than I would care to say. His knowledge of the securities laws deserves the label “encyclopedic,” and I expect to learn more here today than I am able to contribute.
Despite the honor of being part of the inaugural lecture, I must confess that, when Nick Coward first contacted me about the project, I had reservations. The idea of saying anything meaningful, in the course of a 15- or 20-minute presentation, about a subject as vast and complex as international securities regulation, is daunting. I have decided that the best course is to stick to what I have experience with -- the issues the Public Company Accounting Oversight Board -- the PCAOB -- has wrestled with during the past year as we have tried to sort out how to meet our responsibilities with respect to non-U.S. auditors. While we certainly don’t have all the answers, I hope that there may be, in the Board’s experience, lessons on which other regulators could also draw.
II. The Work of the PCAOB
The PCAOB is a recent addition to the world of securities regulation, so I want to begin with a brief review of the Board and its responsibilities. First, however, I should note that the views I express here today are solely my own, and not necessarily those of the Board or its other members or staff.
The creation of the Board was one of the key reforms Congress enacted in the wake of Enron, WorldCom, Tyco, and the long series of other financial reporting scandals that rocked the securities markets and shook the public’s trust during the last several years. Under the Sarbanes-Oxley Act, the Board is a private, non-profit corporation whose mission is to oversee the audits of public companies, to protect the interests of investors, and to further the public interest in the preparation of informative, accurate, and independent audit reports. In short, our basic job is to restore and rebuild investor trust and confidence in audited financial reports. To accomplish this job, Congress gave the Board four primary responsibilities:
First, all accounting firms that issue or prepare audit opinions on the financial statements of U.S. companies must register with the Board. So far, 826 U.S.-based firms, and 29 foreign firms, have registered.
Once a firm is registered, the Board must inspect it. Our inspectors will look at both specific audit engagements and at the firm’s “professionalism” -- including the philosophy management seeks to infuse in the organization; how accountants are compensated, promoted, and trained; and how the firm assures the quality of its practice. The Board will issue inspection reports and require firms to correct any flaws in their quality control systems.
Third, the Board establishes auditing standards, quality control and ethics standards, and independence rules for accounting firms.
Finally, the Board will conduct investigations and bring disciplinary proceedings when it believes that an accounting firm or its employees have violated the law or professional standards. The Board can impose fines, require remedial action, or suspend or bar a firm or individuals from participating in public company audits.
III. The Board’s Responsibilities and Non-U.S. Accounting Firms
A. The Globalization of Auditing
Discharging these responsibilities would be difficult enough if we only had to focus on U.S.-based auditors. However, auditing the financial statements on which U.S. investors rely is a process that occurs in many countries. The companies that are registered with the SEC and that trade in the U.S. markets include about 1,400 foreign private issuers, most of which are audited by local accounting firms in their home countries. Conversely, many U.S.-based public companies are citizens of the world, with branches, subsidiaries, and joint ventures around the globe. Off-shore operations are typically audited by local accountants, on whose work the U.S. accounting firm relies in issuing its audit opinion on the parent’s financial statements.
The major accounting firms are themselves multi-jurisdictional networks firms. One prominent U.S. accounting firm has 312 foreign associated entities, located in 139 different countries. Other large firms have comparable globe-spanning structures.
For these reasons, it would be difficult for the Board to fulfill its mission if we could only oversee U.S.-based auditors. Congress recognized this. The Senate Report on the Sarbanes-Oxley legislation declares that “there should be no difference in treatment of a public company’s auditors * * * simply because of a particular auditor’s place of operation,” and the text of the Act incorporates that principle. Therefore, just as the Board must register, inspect, and, where necessary, investigate and discipline U.S. accounting firms, it must be prepared to do the same with respect to foreign accountants that participate in audits of U.S. publicly traded companies.
B. Practical Problems of Off-shore Oversight
Unfortunately, as logical as “play-in-our-markets, play-by-our-rules” sounds, treating foreign accountants the same as those domiciled in the U.S. is easier said than done. As the Board began to design its regulatory processes, it became readily apparent that there were some serious obstacles in the case of foreign firms.
First, Board registration depends on information about the applicant firm and its associated accountants. But, in many jurisdictions, there are privacy, business confidentiality, and other laws that, we were told, make it impossible to provide some information we require of domestic firms. For example, the Board’s registration form, not surprisingly, calls for the details of criminal cases, and civil and administrative proceedings relating to accounting, against the firm and associated accountants. However, in some countries it is apparently illegal for an employer to seek this kind of personal information from existing employees and illegal to provide it to an off-shore regulatory body like the Board, even if it is known to the employer.
Similarly, a program of foreign inspections would be difficult for the Board to implement unilaterally. The logistics of operating thousands of miles from home aside, it is not clear how our staff could inspect a firm that maintains its records and conducts its audits in a language other than English. And, in some countries, business confidentiality and similar laws might make our inspections illegal, absent the consent of local regulators or of the clients of the firm in question.
Finally, some foreign accounting regulators see the notion of a U.S. body requiring registration and conducting inspections of local firms as an implicit criticism of the quality of their oversight and as offensive to national sovereignty. Why, it was asked, should auditors that are in full compliance with the regulatory requirements in their home country be subjected to additional U.S. oversight? Is this just another example of the U.S. penchant for applying its laws extra-territorially?
IV. The “Sliding Scale” Approach to Regulatory Cooperation
The problem of how to fulfill the Board’s statutory mandate in light of these obstacles has occupied considerable Board time and attention during the past year. One thing was clear from the outset: We would be more effective if we worked cooperatively with non-U.S. auditing regulatory bodies. But what cooperation should mean in practice was initially far from clear.
Some suggested invoking the principle of mutual recognition. That is, as long as a firm was subject to oversight in its home country, the Board should permit it to audit U.S. companies without further registration or inspection. However, the nature of auditor regulation varies widely around the world -- particularly the extent to which oversight is independent of, or conducted by, the accounting profession itself. Since Congress had created the Board to replace professional self-regulation in the U.S., it seemed odd for us to decide to rely on it elsewhere.
The solution that we have fashioned neither duplicates foreign regulation nor defers to it. Instead, we have sought to incorporate the principles of home country law and home country oversight into the way that we will exercise our responsibilities for a non-U.S. auditing firm. This idea has three key features.
First, the Board decided not to exempt foreign accounting firms from registration or inspection, regardless of whether and how they are registered and inspected under their home country’s regulatory system. We have, however, allowed foreign firms nine additional months in which to register (until July 19, 2004) so that they can accumulate the necessary information and understand the Board’s system of oversight. And, we have said that we would also be open, in particular cases, to exploring with foreign regulators the possibilities for sharing registration information so that firms need not provide it twice.
Second, the Board adopted a rule that, in effect, incorporates non-U.S. privacy and confidentiality laws. PCAOB Rule 2105 allows a firm to omit information from its registration application if disclosure would be contrary to home country law. In lieu of the information that the applicant asserts that it cannot provide, it must furnish the Board with –
- A copy of the conflicting non-U.S. law (in English!).
- A legal opinion that submitting the information would violate the conflicting non-U.S. law.
- An explanation of the applicant’s efforts to seek consents or waivers to eliminate the conflict, if the withheld information could be provided to the Board with a consent or waiver.
Third, in the areas of inspections and investigations, the Board has proposed rules under which it would rely on the work of foreign regulators based on a “sliding scale” that takes into account the similarities and differences between the foreign regulator and the Board. Under this approach, the Board would rely most heavily on foreign accounting regulators that have a high level of rigor and of independence from the accounting profession. Conversely, the Board would rely less, and more directly exercise its own oversight, where the foreign regulator is less independent.
We think that this sliding scale approach is both faithful to our Congressional mandate and appropriately deferential to other regulatory regimes. For example, rather than attempting to unilaterally inspect a firm in a particular country, the Board will develop an inspection work program in consultation with the other country’s regulator. The program will allocate the inspection work between the Board’s staff and the staff of the non-U.S. system, and the allocation will vary, depending on the sliding scale. In some cases, the Board’s staff might participate in, or even conduct, the part of the inspection that related to audits of U.S. companies. In other cases, it might provide expertise on U.S. accounting and auditing standards, but ask that the other regulator to perform the “fieldwork.” A similar approach could be taken with respect to investigations.
V. Will It Work?
The ultimate question regarding this concept of how to bring foreign auditors into the Board’s regulatory framework is, “Will it work?” Will the Board be able to forge the kinds of day-to-day working relationships with the auditor oversight bodies in other countries on which the approach is predicated? There is, I think, considerable ground for optimism.
The dialogue the Board and its staff have had with our foreign counter-parts made clear to all of us that we have more in common than we have that divides us. We have discussed the cross-border impact of Board regulation with representatives of the European Union and some of its key member states, and also with accounting regulators in Canada, Australia, Switzerland, and Japan. There is no doubt that the authorities in all of these countries -- and in others as well -- share the goal of instilling public confidence in auditing and financial reporting.
Further, while there are differences in approach, those differences are likely to diminish over time. In the past year, several countries have adopted or proposed corporate reforms to strengthen oversight of the auditing profession, including new registration, inspection, and disciplinary programs. For example, the European Commission recently unveiled amendments to its 8th Company Law Directive. Those amendments would direct each EU member state to create external and independent oversight of auditors in a system that is transparent, well-funded, and “free from any possible undue influence by statutory auditors or audit firms.” PCAOB Chairman McDonough recently described these amendments as “a highly constructive step toward our mutual goal of protecting investors” that will “mesh quite well with the accounting oversight we are putting in place here in the United States.”
I want to conclude with a point I suggested earlier: In our globalized capital markets, the consequences of inaccurate financial reporting and of other financial frauds do not stop at national borders. Just as the collapse of Enron affected both U.S. and non-U.S. investors, revelations concerning companies like Lernout & Hauspie, Parmalat, and Ahold have affected U.S. investors and financial institutions, even though those companies are not based in the U.S.
The Board’s basic job is to instill public confidence in auditing and financial reporting under the U.S. securities laws. While those responsible for investor protection and auditor oversight in other countries may have different approaches, and are understandably concerned about conflict and duplication from the cross-border effects of other regulatory regimes, their underlying goals and ours are the same. The Board’s experience during the past year suggests that, with a bit of goodwill and flexibility, ways can be found to make these differing regulatory regimes work together without having to either surrender sovereignty or compromise on basic principles. That is, I am sure, also true in many other areas of apparent conflict, both within and beyond the field of securities regulation.