Good morning. I am Jay Eisenhofer of the law firm of Grant & Eisenhofer, PA, in Wilmington, Delaware. My practice primarily involves the representation of institutional investors such as state pension funds and private investment managers, in class-action and other plaintiff's securities and corporate litigation.
I am here to tell you that your proposed rule will not make my job any easier. Your rule will cut down on fraud, cut down on auditor self-interest and increase the reliability of financial statements. You are going to make it more difficult for lawyers like me who represent institutional investors that frequently are plaintiffs in securities actions.
As you know, the hardest thing to prove in a securities fraud suit is what is called scienter - or state of mind. In a securities fraud case, you must prove that the defendant intentionally or recklessly misrepresented facts about the company. To prove intent, a plaintiff cannot go into the head of the defendant, so the plaintiff must usually prove intent through circumstantial evidence, including motive. One of the best motives is financial interest. One of the best ways to prove financial interest is showing that the audit firm received substantial, non-audit consulting fees from the client. Fees that would be at risk if the audit firm challenged company management. If you take this away, you are going to be taking away one of the best tool's I have as a lawyer who represents institutional investors that frequently are plaintiffs in securities actions. But you will also be increasing the reliability of financial statements.
I am actually here to endorse the proposed rules for auditor independence that the Commission has proposed. I have been involved in many cases where it has been apparent that theoretically independentauditors are anything but. The auditors approve the financial reporting of the companies they audit and then, sometimes within a few months, the company reports new financial results that are at great variance with those the auditors had approved. The question is -- how could that happen?
This is particularly a problem in the current environment where company stock prices increasingly are dependent upon showing strong growth and on meeting or exceeding the expectations of Wall Street investment analysts. Even one missed profit number can have a significant negative effect on stock price. This places great pressure on executives, many of whom have stock options, to ensure that each quarter their profits are in the range expected, regardless of whether the quarter has been as good as the analysts projected. In order to meet these expectations, corporations will make sometimes questionable assumptions and other changes in order to support earnings in the short term. Again, how does this happen with the auditors supposedly looking over management's shoulders?
As we all know, the annual audit does not always uncover questionable financial practices, or ensure that the company's financial condition is fully and accurately reported. Is it because auditing is a low-margin business that accounting firms use as a way to establish a client relationship? Is it because the audit firms want to stay on good terms with management so they can get those lucrative consulting jobs? People being people, I think we know the answers.
A case in point is a pending lawsuit in which I am involved that has been brought on behalf of the shareholders of Oxford Health Plans, a leading HMO here in the New York area. Oxford was a Wall Street high flier that met or exceeded analysts' earnings expectations for more than 10 straight quarters. It obtained an enviable reputation for providing high quality insurance at reasonable prices and making a healthy profitin the process. In early 1997, its former auditors, who have been named as defendants in the pending lawsuit, issued an unqualified opinion on Oxford's financial statements for 1996. Those financial statements portrayed a fast growing, efficiently run, profitable company. Yet barely eight months after the auditor's clean opinion was submitted, in October 1997, Oxford admitted to substantial problems with its existing reserves and future profitability that caused the price of the stock to fall more than 60 percent in a single day. The stock declined by nearly 90 percent from its high mark of 80 dollars per share, and only recently climbed to the upper-twenties. This admission only came about because of an audit by the New York State Insurance Department.
As a result of the debacle, Oxford's New York State regulators required that the auditor be replaced. In our complaint, we have alleged that the auditor fell down on the job and failed to adequately police management, who was determined to meet the analysts' expectations and maintain or increase the stock price. In my opinion, the reason for the auditor's failure was because the relationship with management became too close. Oxford was a big client, generating substantial fees. Moreover, because of its rapid growth, Oxford promised significantly greater fees in the future through auditing and other relationships. While I recognize that there will always be some claim that the potential for future audit fees will cloud an auditor's judgment, the rules that the Commission has promulgated will eliminate a variety of areas in which an audit firm simply can become too close to management.
In particular, I would like to address the proposed rule that would restrict certain aspects of consulting on the computer systems of audit clients. This is an area with which I am familiar as a result of my experience with Oxford and other matters, including non-securities litigation against computer consulting companies. As we all know from press reports, litigation over failed computer systems is proliferating. The cost of implementing these systems runs into the many millions ofdollars and the problems caused when they malfunction costs in the tens of millions. In Oxford, a significant cause of their problems in 1997, was a computer conversion to a new system that went horribly wrong in late 1996. Despite the substantial computer problems Oxford experienced in the last quarter of 1996, there was nothing in the auditor's report for 1996 that demonstrated the near paralyzing effect these problems were having on the company.
Now, let me emphasize, this is not a case where the auditor had provided significant computer consulting to Oxford. But, what it suggests to me is that if the auditor had been the computer consultant on the project that experienced problems, the likelihood that those problems would have been disclosed decreases appreciably. It is extremely unlikely that the audit arm of an accounting firm would want to publicly expose computer problems that could, potentially, result in litigation by the company against the computer consulting affiliate. Given the centrality of computers to virtually all businesses, I believe that it is extremely important to maintain the separation between auditors, whose job in part is to ferret out computer related problems, and the computer consultants themselves.
I thank you for the opportunity to speak with you today.