October 2022 in Brief: Securities Law

Securities Regulation

SEC Adopts Compensation Clawbacks Rules

By Alan J. Wilson, WilmerHale

On October 26, the Securities and Exchange Commission adopted the long-anticipated rules regarding recovery of erroneously awarded incentive-based compensation. The new rules follow a prescriptive approach, expanding significantly beyond the scope of the initial clawback proposal from 2015 in a few important respects.

As adopted, the new rules require national securities exchanges to establish listing standards requiring listed companies to develop, implement, and disclose clawback policies. The required clawback policies will, with extremely limited exceptions, require a listed company to recover from its executive officers incentive-based compensation received as a result of erroneous financial results during a three-year look-back period when the listed company is required to prepare an “accounting restatement,” including a “Big R” or “little r” restatement. Failure to comply with these new requirements will subject listed companies to delisting.

For a more expansive discussion of these new rules, see WilmerHale’s client alert.

SEC Reopens Comment Period Due to Technological Glitch

By Jason Hyatt, Latham & Watkins

On October 7, the SEC reopened the public comment periods for eleven Commission rulemaking releases and one request for comment due to a technological error that resulted in certain public comments submitted via the internet comment form not being received by the SEC. The comment period was reopened until November 1, 2022, allowing interested persons, whether or not they had previously submitted a comment impacted by this error, to comment or resubmit a comment.

The SEC advised all commenters who submitted a public comment through the internet comment form between June 2021 and August 2022 to check the relevant comment file on SEC.gov to determine whether their comment was received and posted, and, to the extent it has not been posted, commenters should resubmit that comment.

SEC Chief Accountant Addresses Auditors’ Responsibility for Fraud Detection

By Thomas W. White, Retired Partner, WilmerHale

The scope of an independent auditor’s responsibility to detect fraud in the course of the audit of a company’s financial statements is a perennial issue in financial reporting and auditing. On October 11, Acting Chief Accountant Paul Munter of the Securities and Exchange Commission issued a statement setting forth the SEC accounting staff’s current views on this subject.

Mr. Munter observes that “[a]uditors are gatekeepers and therefore the importance of their responsibilities with respect to the identification of risks of material misstatement due to fraud (‘fraud risks’) and the detection of material misstatements in the financial statements due to fraud should not be underestimated.” He notes that “[t]he value of the audit and the related benefits to investors, including investor protections, are diminished if the audit is conducted without the appropriate levels of due professional care and professional skepticism.” He suggests that an auditor must apply a “fraud lens”—in other words, “a focus on the consideration of fraud”—throughout the audit.

The statement identifies “shortcomings” that the staff has observed relating to detection of material misstatements due to fraud. These include areas of concern regarding fraud identified in Public Company Accounting Oversight Board (PCAOB) inspections as well as recent SEC enforcement cases involving improper professional conduct by auditors with respect to fraud risks. Mr. Munter also highlights “particularly troubling feedback that auditors many times frame the discussion of their responsibilities related to fraud by describing what is beyond the auditor’s responsibilities and what auditors are not required to do,” which he asserts is inconsistent with the auditing standard’s affirmative requirements to “plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement . . . .”

The statement discusses at length the auditor’s responsibilities relating to fraud detection under the PCAOB’s auditing standards and section 10A of the Securities Exchange Act, offering the staff’s views on how auditors should apply these standards and “good practices.” Noteworthy staff observations include:

• “[T]he auditor’s responsibilities with respect to fraud are not limited to the explicit requirements within PCAOB AS 2401 [the PCAOB standard regarding consideration of fraud].”
• “[A]uditors should be aware of biases that may impede their ability to gather and objectively evaluate audit evidence. For instance, the mindset of ‘trust but verify’ may represent potential bias if it is anchored in the belief that management is honest and has integrity.”
• “It is critical for auditors to be alert to financial reporting areas that may be more frequently related to fraudulent schemes, such as improper revenue recognition and the intentional misstatement of accounting estimates.”
• “Auditors should continually reassess fraud risks throughout the audit, including when evaluating the audit results and determining whether they themselves have obtained sufficient appropriate audit evidence.”
• “Management is in a unique position to perpetrate fraud, and instances of fraud often involve management override of controls, including concealment of evidence or misrepresentation of information. Auditors must remain diligent when considering and responding to this risk and remain aware of techniques used by management to circumvent existing controls.”

Like all SEC staff pronouncements, Mr. Munter’s statement has no legally binding effect. Nonetheless, the statement appears to reflect a viewpoint that auditors need to do more to detect financial reporting fraud.