Auditor Proposals FAQ
1. What's the difference between the Auditor Reputation Proposal and the Auditor Independence Proposal?
2. What is the goal of these proposals?
3. How can investors judge auditor quality? Surely audit committees with independent directors could do a much better job than shareowners.
4. Isn’t auditor selection too complex for investors, since it involves negotiating the fee, the services to be performed, and the choice of audit partner in charge?
5. Like directors, aren't shareowners also biased against tough audits because that might hurt the stock price?
6. What is the relationship between these auditor proposals and the Proxy Advisor proposal?
1. What's the difference between the Auditor Reputation Proposal and the Auditor Independence Proposal?
The Auditor Independence Proposal would let shareowners choose the company's auditor by competitive vote each year. Because the SEC considers auditor selection to be an "ordinary business" decision that shareowners should not get involved in, they continue to allow management to omit the Auditor Independence Proposal from company proxies. The Auditor Reputation Proposal avoids this problem by merely requesting the Board to conduct a nonbinding annual shareowner poll of auditor reputation -- the Board would still choose the auditor.
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2. What is the goal of these proposals?
Both our auditor proposals aim to give auditors an incentive to build their reputations among investors rather than among directors.
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3. How can investors judge auditor quality? Surely audit committees with independent directors could do a much better job than shareowners.
Most audit committee members are substantially more knowledgeable about auditors than most stock market investors, individual and institutional. But unfortunately, board members have incentives to not choose the best auditor. Choosing the best auditor may cost directors their jobs. The best auditor may reveal information showing that the current board is performing badly. This kind of "best auditor" does not yet exist, because no board would hire them. Boards naturally prefer to keep their autonomy, auditors prefer to be hired, so auditors have learned not to rock the boat.
Think of Enron two years before it collapsed. No doubt the damage was already being done. If an auditor revealed it, directors would likely have been replaced sooner. Enron is the extreme case, but I think the real scandal about Enron is that it's not just about Enron. Damage is being caused by similar conflicts of interest at most corporations, just not to such an extreme extent.
Auditor selection by the directors whom the auditor is (in effect) supposed to monitor is one of those conflicts. Choosing directors that are not otherwise formally linked to the firm does not remove this conflict. Calling some directors independent doesn't make them independent.
Even if no one individual or institutional investor is an expert on auditors, the investor community as a whole can still do an effective job of making consensus assessments of auditor quality. With just a few auditing firms serving thousands of corporations for many years, a large amount of information on auditor quality is generated. Auditor reputations could be summarized and communicated in the Wall Street Journal and other media.
Look at the market for personal computers. The average consumer lacks the expertise to assess quality independently, but can easily pick up PC Magazine and read a summary of manufacturers' brand reputations. Such reputations are never 100% accurate, but this system provides an effective incentive for high quality. Giving auditors a business incentive to convince investors of their quality would encourage them to serve shareowners as their true clients.
(The above arguments were published in the paper Proxy Voting Brand Competition.)
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4. Isn’t auditor selection too complex for investors, since it involves negotiating the fee, the services to be performed, and the choice of audit partner in charge?
Audit firm fees, choice of services and quality of individual audit partners in charge are important considerations, and would make it more difficult for investors to choose among auditors. Nonetheless, the general principle of choosing based simply on the audit firm's overall reputation can cover those issues. An auditor could get a lower reputation for being too expensive, for providing inadequate services, or for assigning partners of low quality or ill-matched to the client firm.
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5. Like directors, aren't shareowners also biased against tough audits because that might hurt the stock price?
No. Shareowners can rationally expect that hiring a tough auditor will on average increase the stock price.
Stock market participants know that some companies have hidden bad news that a tough audit could uncover. Before finding out which companies have the bad news, the market discounts the value of all companies. Then any company that hires a tough auditor will see its price go back up if no bad news is found, or down further if there actually is bad news there.
The amount of pre-audit discount is the market's average expectation of bad news impact, so that on average hiring a tough auditor is a wash, except for one key point: the sooner you find out about a problem the sooner you can fix it -- like Enron two years before it went bankrupt. Companies that hire tough auditors can achieve higher future profits by solving problems sooner, so their present values are higher.
Note that most shareowners are outsiders with only public knowledge of their own firm, so they don't know in advance whether their firm is one of the "bad apples".
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6. What is the relationship between these auditor proposals and the Proxy Advisor proposal?
Proxy voting advice is more fundamental and broader in scope than auditor selection. But in the end these proposals are substitutes for each other -- either type of proposal would be an important step in the right direction. There is no need for shareowners to vote for more than one type of independent professional organization to help them monitor management. All roads lead to Rome. Whichever function (auditor or proxy advisor) shareowners take control of first, could well end up fulfilling or overseeing the other function also.
Notice that auditing firms have already expanded to become consulting firms. Notice further the considerable overlaps among the functions of consulting firms, activist investors, and proxy advisory firms. All are professional outsiders looking into a company and giving independent opinions on strategic decisions. If auditing-&-consulting firms can become dependably loyal to shareowners via voting, they may be the most qualified to fulfill this functional role.
However, to keep this shareowner-power intermediary role from getting too powerful and creating substantial agency costs of its own, it may be preferable to limit its function. For example, it may evolve so that shareowners vote to choose an intermediary that only oversees the selection of the auditor and other critical outsourced services, rather than performing those services itself. This is somewhat analagous to the board of directors, which oversees selection of the CEO but doesn't actually manage the firm, and is paid much less than the CEO.
These critical outsourced services could include:
- auditing
- proxy advice
- management consulting
- executive search (for board nominations and CEO)
- compensation consulting
- underwriting
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