August 08, 2016 Articles

Federal Securities Regulators' Enforcement Focus Turns to "Gatekeepers"

Tips on how audit professionals can mitigate the risk of enforcement proceedings

by Eliot T. Burriss and Nicole Figueroa

Accountant and auditor liability issues continue to be a focus for the Securities and Exchange Commission (SEC) and Public Company Oversight Board (PCAOB). Among the many challenges faced by audit firms in this complex regulatory environment, section 10A of the Securities and Exchange Act of 1934 remains a particularly strong area of SEC and PCAOB focus. Since 2015, the SEC and the PCAOB have brought dozens of cases alleging section 10A violations and sanctioned numerous public accounting firms for such violations. The penalties imposed by these regulators have included censure, civil penalties, and limitations on the right to practice on behalf of public companies.  

As discussed below, section 10A requires auditors to implement procedures designed to detect illegal acts and, if such acts are detected, to ensure that the company’s management and audit committee are adequately informed on those matters and take appropriate remedial measures when necessary. While the objectives of section 10A obligations may seem straightforward, compliance can pose considerable challenges in practice. This article outlines the requirements of section 10A and presents practical considerations for situations that may arise in a section 10A investigation. It is meant as a guide and is not exhaustive, as every investigation is different. 

The Basics

In 1995, Congress enacted Title III of the Private Securities Litigation Reform Act of 1995 (PSLRA), which added section 10A to the Securities Exchange Act of 1934. 15 U.S.C. § 78j-1. Among other things, section 10A imposes certain affirmative obligations on independent public accountants that are intended to enhance the detection of fraud in financial reporting. 

In particular, section 10A requires that public company audits contain procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statements. 15 U.S.C. § 78j-1(a). If the firm ultimately determines it is likely that an illegal act occurred and that the act had a material effect on the company’s financial statements, the firm must also assess whether the company took timely and appropriate remedial action in response to the illegal act.  

If remedial action has not been taken, section 10A also requires that an audit firm determine whether the failure to take remedial action is reasonably expected to warrant departure from the auditor’s standard report or resignation from the engagement. See 15 U.S.C. § 78j-1(b)(1)–(2). If so, the audit firm must report this information to the board of directors. Within one day of this report, the company must notify the SEC of the report and provide the audit firm with a copy of the notice furnished to the SEC. Id. If the audit firm does not receive the company’s notice within one business day, section 10A requires the firm to resign from the engagement or provide the SEC with a copy of the firm’s report (or documentation of an oral report) not later than one business day following the failure to receive the requisite notice from the company. 15 U.S.C. § 78j-(b)(3). 

Serious Consequences

An informal survey of the SEC’s Accounting and Auditing Enforcement Releases reveals more than 70 enforcement proceedings involving liability under section 10A.  

Furthermore, the SEC’s enforcement proceedings demonstrate that audit firms are not the only targets of enforcement proceedings brought under section 10A. In fact, while section 10A refers to a “registered public accounting firm,” courts have held on at least two occasions that registered public accountants may also be held primarily liable for section 10A violations if they fail to fulfill their statutory obligations. See, e.g., Sec. & Exch. Comm’n v. Cole, 2015 WL 5737275 (S.D.N.Y. Sept. 19, 2015); Sec. & Exch. Comm’n v. KPMG LLP, 412 F. Supp. 2d 349, 386 (S.D.N.Y. 2006). 

Practical Considerations to Mitigate Risk

In light of the myriad of issues that may arise in the course of an investigation, it is critical to remind audit firm clients to take adequate steps to ensure compliance with section 10A. The following are a few practical considerations to keep in mind: 

Be resourceful. A section 10A investigation will likely raise complicated legal issues. Audit teams should be encouraged to engage their internal resources early—in-house counsel, risk and forensic groups, or the audit firm’s national office (or all of these) may help to quickly identify risk areas and potential pitfalls as they move forward. Similarly, audit firms should consider engaging outside counsel promptly, not only to assist with the complexities of the statute but also to reinforce the attorney-client privilege.

Be timely. When regulators investigate accounting fraud, they frequently scrutinize how the auditor responded when issues surfaced—in other words, what the auditor did (and did not do) following the detection of the possible illegal act. However, regulators are also considering when the auditor responded. Indeed, prompt and timely action is one of the underlying themes of section 10A. For instance, under section 10A, the auditor must “as soon as practicable” inform the appropriate level of management and ensure that the audit committee is adequately informed with respect to potential illegal acts that have been detected or otherwise come to the attention of the auditors unless the act is “clearly inconsequential.” Section 10A also requires the auditor to determine whether the company took “timely” remedial action and, if not, to report this conclusion directly to company’s board of directors “as soon as practicable.”

There is little guidance on what may be considered “as soon as practicable.” To be sure, the particular circumstances will, to a large extent, drive what is considered timely action in the eyes of a regulator. However, it is important to remind clients that auditors should remain abreast of the status and progress of the company’s investigation and comply with reporting obligations (if any) without delay.

Be engaged. Because determining whether a particular act is illegal is generally beyond an auditor’s professional competence, the responsibility for investigating the circumstances surrounding the possible illegal conduct typically lies with the company. However, the fact that an investigation is taking place does not discharge the auditor’s duties under section 10A. For example, Howard Scheck, the former chief accountant for the SEC’s Division of Enforcement, previously remarked that in assessing section 10A compliance, the commission “will be asking questions that bear on the credibility of management’s investigation” and raising questions regarding the scope, performance, and credibility of the company’s investigation that it believes “the auditors should be asking.” Remarks Before the 2011 AICPA National Conference on Current SEC and PCAOB Developments (Dec. 6, 2011).

As previously noted, the statute provides little guidance to auditors and their counsel in this area. Nevertheless, they should both be aware that regulators may look to see if and how the auditors considered, among other things, the identity, experience, and independence of the investigators, the scope of, or performance limitations on, the investigation, and the transparency of the investigation.

Be detailed. As discussed above, section 10A may require the audit firm to make one or more of these three critical determinations: (1) Is it likely than an illegal act has occurred; (2) has the illegal act had a material effect on the company’s financial statements; and (3) has the company taken timely and appropriate remedial actions with respect to the illegal act? 15 U.S.C. § 78j-1(b)(1)–(3). These decisions are significant and will require a thorough analysis of the surrounding circumstances. At each juncture, auditors should consider documenting their analysis with specificity—including details regarding the timing, people, and contents of communications with the company’s management, the investigators, or the audit committee. Proper documentation ensures that there are no ambiguities later regarding the adequacy of the audit firm’s communications with the company, the extent of its involvement in the investigation, or the credibility of its final conclusions and determinations.

Conclusion

Following the foregoing suggestions may not avoid enforcement proceedings against an auditor for a violation of section 10A, but following them could go a long way toward mitigating the risk of such enforcement proceedings and the effect of any sanctions that could be imposed. 

Keywords: commercial and business, litigation, accountant, auditor, enforcement, financial reporting, financial statements, investigation, PCAOB, PSLRA, sanctions, SEC, section 10A, securities  

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