Investor Groups File Auditor Rotation Proxy Proposals

Two investor groups recently filed proxy proposals to try to compel companies to adopt auditor rotation policies. But so far, they aren't getting anywhere.

The United Brotherhood of Carpenters Pension Fund and the Sheet Metal Workers' National Pension Fund have submitted proxy proposals to dozens of companies asking management to give shareholders an opportunity to vote at the next annual meeting on an audit firm rotation policy. The proposals say companies should limit the engagement of the external audit firm to seven years, with a three-year cooling off period before the same firm could be rehired.

“We think shareholders should be allowed in on the game to express their views and concerns about auditor independence and rotation,” says Ed Durkin, director of corporate affairs for the United Brotherhood of Carpenters. “We are trying to provide a vehicle for shareholders to speak, but we've had our legs cut out from under us.”

If Durkin is feeling neglected, it's because the proposals have fallen on deaf ears at the companies where they were filed and at the Securities and Exchange Commission.

The carpenters' union submitted its proposal to 42 companies, none of which agreed to place it on the ballot, Durkin says. Ten companies—including Walt Disney, Deere, Alcoa, GE, Prudential Financial, and AT&T—told the SEC they would not place the item on the ballot because it constituted a matter of ordinary business that should be left to management and the board, one of 13 accepted reasons for denying a proxy proposal under SEC rules. The SEC responded with “no-action” letters, indicating that it agreed with the company's view and would not penalize it for denying the proxy proposal. The sheet metal union has submitted similar proposals to several companies and received the same response.

In a handful of cases, the carpenters' union took the process a step further, says Durkin, asking the SEC staff to take the question to the full Commission. The SEC staff declined, prompting the union to withdraw its requests from other corporations that had not yet responded to the proxy proposal. Now the union is regrouping to determine its next step, he says.

In its proposals, the carpenters' union says its research suggests that the largest 100 public companies in the United States have engaged the same audit firm for an average of 28 years, and the largest 500 companies have used the same firm for an average of 21 years. “These long-term financial relationships result in the payment to the audit firm of hundreds of millions of dollars over the average period of engagement,” the union wrote in its proposal to General Electric, which has paid its auditor, KPMG, a total of more than $800 million during the last seven years.

The Public Company Accounting Oversight Board has called out long-term audit relationships as a possible cause for a decline in the quality of audits that is has found in recent routine inspections and enforcement processes. The PCAOB says that too often audit firms don't demonstrate the kind of objectivity and skepticism necessary to dig deeper and ask tough questions. The PCAOB published a concept release in August asking for feedback on whether mandatory rotation or other measures would help bring about more objectivity and skepticism. The European Union is even further along, considering measures to require public companies to rotate auditors and to require audit firms to break out non-audit services into separate legal entities.

The carpenters' union proposal notes that measures have already been put in place in the United States under Sarbanes-Oxley intended to make auditors more independent of management, including mandatory rotation of the lead partner on public company engagements, limits on non-audit services that the audit firm is allowed to provide, and new responsibilities for audit committees to oversee the audit engagement. Still, the PCAOB says it finds audit problems that suggest auditors are not exercising enough objectivity and skepticism. “We believe that an important next step in improving the integrity of the public company audit system is to establish a mandatory audit firm rotation requirement of seven years, thereby limiting long-term client-audit firm relationships that may compromise audit firm independence,” the union said in a statement.

“We think shareholders should be allowed in on the game to express their views and concerns about auditor independence and rotation. We are trying to provide a vehicle for shareholders to speak, but we've had our legs cut out from under us.”

—Ed Durkin,

Director of Corporate Affairs,

United Brotherhood of Carpenters

The SEC, however, may see things differently. Indeed, staff members at the SEC have told the PCAOB that it should do more work to figure out why audits fail before considering measures as radical as mandatory rotation. At a year-end national conference of the American Institute of Certified Public Accountants, SEC staffers practically directed the PCAOB to get a better handle on why audits fail and take a look at some rusty auditor performance standards before pulling the rug from under longstanding auditor-client relationships.

The corporate and SEC response to the proxy proposal is not unusual, says Amy Goodman, a partner with Gibson, Dunn & Crutcher who represented Hewlett Packard in its response to the carpenters' union proposal. “Each year, there are anywhere from 800 to 1,000 shareholder proposals submitted to public companies,” she says. “Very often, if they think they have grounds for excluding the proposal [from the shareholder ballot], they will seek a no-action letter.”

While the corporations and the SEC see a policy on auditor rotation to be a matter of ordinary business for the board to address, the carpenters' union makes a compelling argument, says Ted Allen, head of publications and governance counsel for proxy advisory firm ISS. “We don't have an official opinion on what constitutes ordinary business, but the carpenters do make a pretty good case that this is an issue that rises to the level of a significant policy issue,” he says. Only about a third of proxy proposals make it to the ballot, Allen says, and the SEC rarely changes its view once it issues a no-action letter.

CARPENTERS LETTER

Below is an excerpt from the United Brotherhood of Carpenters and Joiners of America letter requesting an SEC review.

On Nov. 18, 2011, the Division of Corporation Finance staff issued a no-action letter to Deere & Company advising that the staff would not recommend enforcement action to the Securities and Exchange Commission if the company omits from its proxy statement for its 2012 annual meeting a shareholder proposal submitted by the United Brotherhood of Carpenters Pension Fund pursuant to Rule 14a-8 under the Securities and Exchange Act of 1934, as amended. We respectfully request that the Division of Corporation Finance submit the staff decision to the full Commission for review. A copy of this Request for Review is simultaneously being sent to Deere & Company.

The Proposal

The Carpenter Fund Proposal states:

Be It Resolved: That the shareholders of Deere & Co. hereby request that the company's board of directors and its audit committee establish an auditor rotation policy that requires that at least every seven years the company's audit firm rotate of the engagement for a minimum of three years.

The proposal's supporting statement highlights the importance of auditor independence to the integrity of the public company financial reporting system that underpins U.S. and global capital markets. The Carpenter Fund has proposed the auditor rotation policy as an important reform designed to protect the necessary independence, skepticism, and objectivity auditors have toward their audit clients in light of the extremely long and lucrative tenures that characterize the relationships between for-profit audit firms and their corporate audit clients. A copy of the proposal and statement of support is attached to this letter as Exhibit A.

Basis of the Request for Commission Review

Pursuant to Section 202.1( d) of the SEC Rules of Practice, “[t]he staff, upon request or on its own motion, will generally present questions to the Commission which involve matters of substantial importance and where the issues are novel or highly complex.” The Fund's proposal to establish an “auditor rotation policy” involves a matter of substantial importance—protecting and enhancing audit firm independence—that meets the standard for Commission review. Rather than address the proposal substantively and recognize that even if establishing an auditor rotation policy to protect auditor independence might once have been a matter of ordinary business it certainly no longer could be considered such, the staff apparently dealt with the matter rotely, labeling the proposal as one relating to the selection of independent auditors. In fact … the Public Company Accounting Oversight Board and the European Union are considering auditor rotation policies in order to restore investor confidence in the audit process by enhancing auditor independence. It would be ironic, indeed paradoxical, for the Securities and Exchange Commission—the agency charged with protecting investors—to preclude them from weighing in on such an important issue.

Source: Carpenter Fund Request for Review.

Donna Dabney, vice president, secretary, and corporate governance counsel for Alcoa, says the company rejected the carpenters' union proposal because the board needs to retain discretion over when and whether to hire a new auditor. “We don't want to be forced into making changes arbitrarily on a particular date when it may not be in the best interest of the company,” she says.

Dabney says she is opposed to mandatory rotation for two reasons. First, the reforms adopted under Sarbanes-Oxley, especially rotation of the lead engagement partner every five years, have worked, she says. “When you change the audit partner, you go through this process of re-evaluating assumptions that had been made in the past,” she says. “We have gone through that process recently, and it's rigorous and healthy. It maintains the independence and skeptical scrutiny that one would expect an audit firm to provide.”

Second, there just aren't enough options in the audit market to shop for a new firm, Dabney says. “We are limited in the number of firms that have the capability to do our audit,” she says. Alcoa engages PwC to perform the audit, but uses all three of the other Big 4 firms for other non-audit work, she says. “If we make a change in audit firm, we would also have to make a change in our relationship with other firms. That would be a very expensive proposition.”

Cindy Fornelli, executive director of the Center for Audit Quality, says its informal analysis of comments to the PCAOB proposal suggests there's no strong appetite for auditor rotation among capital market stakeholders. Even investors didn't respond in significant number supporting rotation, she says. Fornelli believes one approach to bring about more independence in auditing, in addition to exploring what more auditors can do, is to focus on the role of the audit committee and relate more of what it does to investors. “Make the audit committee more transparent and communicate more with investors as to how they oversee the auditors,” she says. “How do they satisfy themselves that the auditor is independent and objective?”

That's exactly what the United Brotherhood of Carpenters plans to call for in its next round of proxy proposals, says Durkin. “Companies rarely say how long the auditor has been doing the audit,” he says. “If investors knew, they would ask: What are you doing to protect the integrity of independence and skepticism? The union is preparing another round of proxy proposals to another group of companies calling for a policy of disclosure about how the audit committee assures the auditor remains independent, he says.