(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Enforcement Director Discusses Audit Enforcement Environment

Stephen M. Cutler, the SEC's director of enforcement, stated that he believes the SEC should consider a new enforcement paradigm when it comes to accounting firms. He urged a shift from the traditional emphasis away from charging the entire firm to a consideration of whether the improper behavior of individuals is the product of the firm's "culture, personnel, systems, training, supervision, and procedures."

In recent remarks before the American Institute of Certified Public Accountants, he said that he hopes that the new paradigm will not create more enforcement actions, but rather fewer instances of misconduct. However, Mr. Cutler stressed his belief that holding firms responsible for the actions of their partners will help to add more rigor to public company audits. Many factors have contributed to corporate fraud, Mr. Cutler said, but the one thing that is "virtually guaranteed" to help is to have more rigor in the audits of public companies. He also pointed out the importance of auditors by noting that they are the only parties legally required when a company offers securities to the public. While accountants, lawyers, research analysts, and board members have important roles, "foremost among these is the auditor," he stated.

He also believes that auditors have played a role in the unfortunate trend of companies that offer financial statements that "reflected more aspiration than fact." This situation has evolved, in the director's view, from the conflicts between auditors working for firms that also provide and gain a large part of revenue from, non-audit work. He added that companies have more ability to pressure their auditors because of the diversification into non-audit work. To explain this, he discussed how it is difficult to fire an auditor because of the risk of adverse market reaction to such a move. While companies can change auditors occasionally, he said that if it happens more often than that the stockholders may get concerned and sell the stock. On the other hand, he noted, companies regularly change consultants and the marketplace rarely takes notice of this. Thus, audit firms realize that while they are likely to retain a firm's audit business, the firm can easily take its consulting business elsewhere, and this threat has increased the power of companies to influence their auditors.

Mr. Cutler also said that the pressures that consulting brings to audit work is "far more corrosive and damaging" than any pressure inherent in the fact that companies pay for their own audits. With companies able to change consultants easily, the freedom auditors had due to the stigma involved in changing auditors is eroded. In a recent speech, SEC Commissioner Harvey J. Goldschmid said that the latest SEC data indicates that audit firms earn about 73 percent of their revenue from non-audit services. The ability of companies to use non-audit business to pressure auditors grew at the same time that stock options gave executives great incentive to meet and exceed Wall Street earnings targets, at a time when investors often punished companies hard for failing to meet expectations.

Recent legal factors also contributed to the growth of less accuracy in financial statements. The 1994 Supreme Court decision in Central Bank of Denver v. First Interstate Bank (1993-94 CCH Dec. ¶98,178), which eliminated aiding and abetting in private lawsuits, has had a negative impact, observed Mr. Cutler said. The Private Securities Litigation Reform Act of 1995, which codified that only the SEC, and not private parties, can bring aiding and abetting actions, and which placed other restrictions on class action suits, continues to shape most litigation today, he said.

Mr. Cutler believes that because of the magnitude of today's problems, the SEC needs to examine whether to bring more cases against firms as a whole, and not just to view misconduct as a failure by an individual rather than a firm. The SEC recently completed a report that outlines four factors that the agency can use to determine whether an entire company should be charged. He believes that the four factors also apply to the question of whether an audit firm should be charged. The factors are: 1) self-policing, 2) self-reporting, 3) remediation, and 4) law enforcement cooperation.