Prepared Testimony on Auditor Independence Securities and Exchange Commission

Good morning. My name is Bill Patterson. I am the director of the Office of Investment at the AFL-CIO. American workers are the beneficiaries of approximately $7 trillion in retirement assets through their pensions, 401(k)s, and stock ownership plans. In total, these plans own approximately 25 percent of the equity of American corporations. Members of AFL-CIO unions are the beneficiaries of over $2.5 trillion in assets subject to collective bargaining, including more than $400 billion in union-sponsored multiemployer plans. While some public plans are among the largest institutional investors in the country, most union- sponsored plans are much smaller. And of course, many workers -- both union members and non-members -- are investors on their own behalf.

The AFL-CIO supports the proposed rules on auditor independence. In my comments, I am going to focus on the prohibition of the provision of certain non-audit services to audit clients, since that is what has generated the most controversy.

The argument in favor of stricter rules limiting the provision of non-audit services to audit clients is clear and, to me, compelling. Unlike other functions for which a firm may turn to an outside provider, the audit also serves a public constituency. Without the auditor, there would simply be no way for investors to know if the financial information provided by public corporations was trustworthy. This "gatekeeper" function makes the auditor quite different from other providers of financial services. The vast majority of audits, I am confident, are carried out according to the highest and strictest professional standards, but the danger of an auditor placing a higher priority on maintaining a relationship with a client than on assuring the quality of the client's financial reporting is a real one. This danger grows especially serious when the value of consulting and other service provided by the auditor exceeds, perhaps by a wide margin, the income the firm receives from the audit function itself. Additionally, a number of the non-audit services proscribed under this proposal create clear conflicts with the audit function. If an auditor is providing valuation services to an audit client, for instance, this then places it in the situation of having to critically assess , and perhaps challenge, its own work.

Here I'd like to emphasize a point which has been made by a number of commentators, but which I think bears repeating: That is that it is the perception of auditor independence, as well as the reality, which matters. The strength of US markets rests, more than on any other single factor, on investor confidence. It is not enough that auditors offer an objective assessment of firms' financial statements. It must be absolutely beyond doubt that their assessment is objective. We at the AFL-CIO, you won't be surprised, have our criticisms of the US financial markets. But if there is one area in which we are wholehearted defenders of those markets, it is in the area of transparency and accountability. In terms of providing dependable information to investors, US markets are second to none. And that is an issue that is of equal concern to local union pension funds as it is to TIAA-CREF or CalPERS.

Again, what matters is confidence, or perceptions. The US today is the beneficiary of an enormous inflow of foreign capital. This inflow is of immense value to our economy, and is a reflection of the confidence foreign investors have in the integrity of the US markets. To maintain this confidence ? to assure investors, US and foreign, that the financial statements they base their decisions on can be trusted beyond a shadow of a doubt ? should be worth a good deal, from the point of view of the broad public interest.

Much has been made of the synergies between the audit function and the role of the management consultant. It is unclear to us if any of these synergies are free from the unacceptable conflicts we have been discussing. Additionally, I should point out that their extent is not at all clear. The big five accounting firms are divided on how great a difficulty the ban on non-audit service would create for them as auditors. Two of them have in fact already spun off their consulting arms, a clear judgement on the limited value of those synergies. The former CEO of Deloitte and Touche, who testified here recently, took a similarly skeptical view of the value to the audit of consulting and other non-audit services, and was decidedly in favor of the new rule. According to earlier testimony before this committee, at least three quarters of audit clients purchase no other services from their auditors. Now, this is a very competitive business. If it is even possible to run an auditing business without providing non-audit services to the same clients ? and clearly it is ? the benefits of combining audit and non-audit services simply cannot be that great. Otherwise, why would we find any firm or any issues foregoing those benefits?

There are two other issues I'd like to address. First is the audit committee. Some opponents of the new rule suggest that while there may in some cases be a perception that auditors are not fully independent, this rule is not the way to address those perceptions. Clearly, the only case where an auditor would come under pressure to overlook inappropriate or misleading fraudulent reporting would be where the firm's own commitment to full and accurate disclosure was lacking. So if something needs to be done, the argument goes, it is to strengthen the institutions within the firm that ensure accurate reporting, particularly the audit committee, perhaps by requiring that it be composed only of outside board members.

Now I should make it clear, this is a proposal the AFL-CIO would support. We have long been in favor of a larger and stronger role for independent directors, and have specifically suggested that only outsiders should sit on the audit committee. However, we don't think this would be a substitute for the current rule. The arguments' logic would suggest there is no need for outside auditors in the first place. But there will always be companies that for whatever reason at some point in time do not wish to issue accurate financial statements. That's why we have auditors in the first place ? as a second line of defense for investors. Second, it would not address the perception issue. As I suggested before, because of their distinct quasi-public function, the auditing profession is legitimately expected to hold itself to strict standards of independence. Changes in their clients' corporate governance structures, even useful and appropriate ones, are not a substitute. In passing I'd also like to point out that when the SEC first prodded the NYSE to make audit committees mandatory, there was a great deal of resistance from some quarters ? in some ways, a reaction not unlike what we are seeing now.

Second, and the last issue I'll raise before closing, is the issue of disclosure. Most of the reaction to this proposal has been to the limits on the provision of non-audit services to audit clients. However, the proposed rules also contain a strong disclosure element. As they were until 1982, companies would be required to disclose in their proxies a comprehensive list of non-audit services provided by their auditors and the fees paid for those services. So in the case of non-audit services that didn't clearly compromise independence, and so weren't banned outright under the rules, investors would be left to make their own informed decision. I think this is the right balance to strike. In some cases, there is a clear need for explicit prohibitions, which the proposed rules provide. But where the effect on independence is not so clear-cut, the disclosure requirement sets up ground rules to allow the markets to work ? which I think is the solution all of us in this room would ideally prefer.

In conclusion, the AFL-CIO has arrived at its position by considering the interests of ordinary American workers and their pension funds, many of them small investors and highly vulnerable to financial statement abuse or fraud. For them, unfortunately, the question of auditor independence is not an academic one. It has a direct bearing on their security in retirement.

In recent years, the capital markets have seen a series of high-profile cases of accounting fraud, in which public shareholders lost millions of dollars. The day after Cendant announced it had discovered accounting irregularities its stock plummeted nearly 60 percent, destroying more than $15 billion in market capitalization. Well-known publicly traded companies like Cendant, Sunbeam, Lucent and Waste Management have, in the past few years, engaged in large-scale accounting fraud. As long-term investors, worker pension funds are particularly vulnerable to fraudulent or inadequate financial reporting, which most often inflates earnings over the short term while masking problems affecting a company's long-term prospects. In a world where this kind of fraud does take place, any doubts about auditors' trustworthiness can be corrosive.

We believe that the proposed changes to the auditor independence rules, by extending the range of financial, business and employment relationships that are deemed to create conflicts of interest, will ensure that auditors are genuinely independent. By focusing scrutiny on only those partners and employees who work on or are in a position to influence the audit, the proposal will render enforcement of the rules more efficient. And the requirement that companies disclose in their proxy statements any non-audit services provided by their auditors will give worker-owners and other investors an additional tool in assessing the quality of a company's financial reporting. We believe that these rules will contribute to the transparency which is vital to efficiency and equity in the capital markets.

We urge the Commission to vote in favor of the proposed rules.