The SEC’s Renewed Focus on Gatekeepers
Since the beginning of the Biden administration, observers have expected a return to more active enforcement by the SEC. Those expectations have included a focus on “gatekeepers”—lawyers, accountants, and auditors who provide verification and certification services that financial market participants rely upon—who find themselves the subject of renewed attention by the SEC’s enforcement staff. In the past year, the director of the SEC’s Division of Enforcement and the SEC’s chair have made clear that they view gatekeeper liability as an important enforcement mechanism in the SEC’s mission to restore the public’s trust in the integrity of financial markets, and the SEC has put these words into action.
Enforcement Director Gurbir Grewal highlights gatekeeper accountability. During an October speech at the Practising Law Institute’s SEC Speaks in 2021, Enforcement Director Gurbir Grewal discussed how holding gatekeepers accountable fits into the SEC’s enforcement paradigm. Gurbir Grewal, Enf’t Dir., SEC Div. Enf’t, Speech at the Practising Law Institute’s SEC Speaks Conference (Oct. 13, 2021). In shaping its strategic priorities, Grewal made clear that the Division of Enforcement is attuned to the public’s decline in trust in the nation’s financial markets, which he attributed in part to “repeated lapses by large businesses, gatekeepers, and other market participants, coupled with the perception that . . . regulators” like the SEC are not holding them fairly accountable. Id. This decline in trust undermines investor confidence in the nation’s capital markets by shaking investors’ belief that the system is fair, efficient, and orderly, he said, which is “detrimental to our economy.” Id.
Part of the SEC’s plan to restore the public’s trust is to increase scrutiny of the lawyers, accountants, and auditors who verify and certify information for the financial markets. Gatekeepers who live up to their obligations are the “first line[] of defense against misconduct,” Grewal said. Id. But when they do not, Grewal warned, “investors, market integrity, and public trust all suffer.” Id. Speaking directly to these professionals, Grewal explained that playing too close to the line on the SEC’s rules and regulations creates significant risk for public companies. He asserted:
It’s when companies start testing those lines that problems emerge and rules are broken. And even if that’s not the case, the public loses faith in institutions that appear to be trying to get away with as much as they can. That’s why gatekeepers will remain a significant focus for the Enforcement Division, as evidenced by some of our recent actions.
Id.
SEC Chair Gary Gensler reinforces gatekeeper accountability. Three weeks later, SEC Chair Gary Gensler emphasized the SEC’s focus on holding gatekeepers accountable during his remarks at the Securities Docket’s annual Securities Enforcement Forum. Gary Gensler, Chair, SEC, Speech at the Securities Docket’s Securities Enforcement Forum (Nov. 4, 2021). He began by invoking the words of the SEC’s first chair, Joseph Kennedy, who said that the “Commission will make war without quarter on any who sell securities by fraud of misrepresentation.” Id. He laid out his vision for enforcement, which is driven by the SEC’s mission to “instill the trust necessary for our markets to thrive.” To that end, he shared four principles that the Division of Enforcement will use as a foundation: (1) economic realities, (2) accountability, (3) high-impact cases, and (4) process.
High-impact cases, Gensler explained, are those that pull “many other actors back from the line”—cases that he distinguished from “everyday fraudsters.” Id. They are the types of cases that “prompt legal alerts, client letters, and bulletins to go out” and cause compliance departments, lawyers, and accountants to “change internal procedures” as well. Id. For Gensler, these high-impact cases include “accounting fraud, insider trading, and recordkeeping violations.” Id. He acknowledged that the latter might come as a surprise—given that “recordkeeping violations” do not usually “grab the headlines”—but he explained that the “underlying obligations are essential to market integrity, particularly given technological developments.” Id.
Before the end of his prepared remarks, Gensler addressed the audience of lawyers, auditors, accountants, bankers, and investment advisers directly. He admonished these professionals, as the “first lines of defense,” to remember that they occupy “positions of trust” by virtue of the reliance of market participants on their advice and thus hold “an important role in upholding the law.” Id. Gensler acknowledged gatekeepers’ responsibility to their clients, but he urged them to remember their “responsibility to the public” and the continued integrity of the nation’s financial markets. Id. When clients get “close to crossing the line,” Gensler insisted, gatekeepers must refrain from simply helping them “paper over the cracks.” Id.
The SEC’s enforcement docket reflects gatekeeper scrutiny. A survey of the Division of Enforcement’s accounting and auditing actions confirms that misconduct by lawyers and audit partners at accounting firms have been subject to enforcement actions by the SEC. The SEC instituted one such action against two audit partners involved in the 2017 IPO of Longfin Corporation, a now-defunct financial technology company whose collapse followed an accounting fraud investigation by the SEC for reporting over $66 million in fictitious revenue (over 89 percent of its total revenue in 2017) from round-trip commodity transactions between Longfin and related parties controlled by its CEO. This third and latest SEC action following Longfin’s IPO was taken against the CPAs responsible for the independent audit of Longfin’s 2017 financial statements.
The SEC’s order found that both audit partners failed to adhere to numerous PCAOB standards in three critical audit areas: revenue recognition, related-party transactions, and the valuation of intangible assets. For example, during the planning phase of the audit, the lead partner failed to consider the overall fraud risks even though he had already identified several red flags, including deficiencies in Longfin’s internal controls; its precarious financial position; and the nature of its commodity sales, which lacked reliable documentation and could not be physically verified. Moreover, he failed to obtain an adequate understanding of and appropriately evaluate Longfin’s numerous sham transactions with related parties—altogether a failure to exercise appropriate due professional care and skepticism. The SEC found that the second partner, who was acting as the engagement quality reviewer, did not sufficiently recognize that these related-party audit procedures failed to address the identified risk of fraud and the lack of supporting documentation. Based on the SEC’s findings on their improper professional conduct, both of the auditors agreed to (1) respective cease-and-desist orders; (2) pay civil penalties; and (3) be denied practice before the SEC for a term of three years and one year, respectively.
The PCAOB’s Ongoing Role in Auditor Oversight
The PCAOB enters 2022 with four new board members on its five-member board as part of the SEC’s shake-up of the accounting regulator in an effort to improve its role in protecting investors and public markets. Erica Y. Williams, the new chair, spent 11 years serving as the deputy chief of staff for three SEC chairs. Christina Ho, a new board member, has a 28-year career with experience in, among other things, public finance and accounting and auditing and most recently served as the vice president of Government Analytics and Information at Elder Research. Kara M. Stein, a new board member, previously was a commissioner of the SEC and most recently was a Distinguished Policy Fellow and lecturer in law at the University of Pennsylvania Carey Law School and director of the AI, Data, and Capital Markets Initiative at the Center on Innovation, University of California Hastings Law School. Before joining the PCAOB as a new board member, Anthony C. Thompson served as executive director and chief administrative officer of the Commodity Futures Trading Commission (CFTC), where he oversaw the Division of Administration. Duane M. DesParte is the only remaining member of the previous board. “Finance is about trust, and the PCAOB has a critical role to play in ensuring that public company financial disclosures can be trusted by investors,” SEC Chair Gary Gensler said in a news release. “With these additions to the board, the PCAOB will have the leadership to meet the mission given to it by Congress.”
The PCAOB’s Strategic Plan 2020–2024 prioritizes audit quality. The PCAOB’s Strategic Plan 2020–2024 provides a guide to the PCAOB’s strategic goals and priorities. PCAOB, Strategic Plan 2020–2024 (2020). The strategic plan identifies, among other goals, two particularly relevant to audit professionals: (1) “drive improvement in the quality of audit services through a combination of prevention, detection, deterrence, and remediation”; and (2) “anticipate and respond to the changing environment, including emerging technologies and related risks and opportunities.” Id. at 7–8.
The strategic plan details how increased inspections and enforcement efforts are key to furthering the PCAOB’s goal of improving the quality of audit services. On December 12, 2021, George Botic, Director of the Division of Registration and Inspection, spoke at the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments. According to Ernst & Young’s Compendium of Significant Accounting and Reporting Issues (December 12, 2021, edition), Botic reported that common deficiencies identified in PCAOB’s inspections in 2021 included issues with allowances for loan losses, business combinations, revenue, inventory, and internal controls over financial reporting (ICFR). Botic noted that the Division of Registration and Inspection increased the random selection of financial statement areas such as cash and cash equivalents to increase the unpredictability of PCAOB inspection activities. Botic also indicated that, in 2022, the PCAOB aims to resume the inspections of foreign companies, which have been paused due to the COVID-19 pandemic. Botic added that inspections in 2022 will continue to assess audit risks impacted by the current economic climate in the United States, including the lingering effects of the pandemic.
Ernst & Young also reported that, at the same conference, Patrick Bryan, Director of the Division of Enforcement and Investigations, discussed the enforcement division’s prioritization of audit violations in line with the strategic plan’s focus on enforcement matters “that pose the greatest risk to investors and are most likely to deter improper conduct.” Ernst & Young, Compendium of Significant Accounting and Reporting Issues (Dec. 12, 2021). Bryan pointed to enforcement matters against audit firms operating outside of the United States relating to alleged deficiencies in their quality-control systems. Bryan indicated that, in 2022, the enforcement division expects to focus its enforcement efforts on audit firms’ failure to address risks or implement systems of quality control connected to the continued effects of the pandemic.
The PCAOB is monitoring risks related to emerging technologies. In 2020, the PCAOB’s Office of the Chief Auditor established a data and technology research project to assess whether the increased use of technology-based tools by auditors and registrants warrants issuing new guidance or changes to PCAOB auditing standards. In May 2021, PCAOB staff published a research update describing its observations, noting that the PCAOB will continue to conduct research and outreach activities to determine whether PCAOB quality-control standards should address the evolving and greater use of technology by audit firms.
According to Ernst & Young’s Compendium, PCAOB Acting Chief Auditor Barbara Vanich indicated in comments provided during the Conference on Current SEC and PCAOB Developments that PCAOB staff members continue to monitor emerging risks to audit services such as auditing cryptocurrency assets, going-concern assessments, and ESG matters. The PCAOB had released a publication in 2020 reminding audit professionals to identify and assess risks related to transactions involving “cryptoassets.” PCAOB Staff, Spotlight: Audits Involving Cryptoassets (2020). At the firm level, PCAOB quality-control standards require audit firms to possess appropriate levels of knowledge and competence to accept or continue a client relationship involving cryptoassets. Engagement teams may need, for example, “specialized skill or knowledge in the areas of cryptography, distributed ledger technology, valuation, and laws and regulations (including with respect to know-your-customer (KYC) and anti-money laundering (AML) provisions).” Id. at 3. Furthermore, the PCAOB observed that auditing financial statements involving cryptoassets creates increased challenges for auditors to recognize fraudulent or other illegal acts, given that cryptoassets are generally designed to conceal an account holder’s identity. The PCAOB also continues to monitor how audit regulators provide assurance to investors on topics such as a company’s ability to continue as a going concern and ESG metrics, which appear outside a company’s financial statement.
The PCAOB establishes priorities for 2022. The PCAOB’s budget for fiscal year 2022 sheds light on the PCAOB’s continued prioritization of inspection, enforcement, and standard-setting measures. In a November 23, 2021, press release, the PCAOB announced the approval of its budget for $310.3 million in fiscal year 2022, an 8 percent increase from $287.3 million in 2021. According to the press release, “[t]he increased funding in 2022 principally reflects cost escalation for inflation, additional staff positions primarily to support inspections and standard-setting activities, and increased travel costs in anticipation of travel resuming in 2022 after being halted given the pandemic.”
The PCAOB’s goals for fiscal year 2022 are expected to be reassessed by the new board. The SEC conducted the swearing-in ceremony of Erica Y. Williams as PCAOB Chair on January 10, 2022, and board member Anthony C. Thompson on January 3, 2022. Chair Williams spent 11 years serving as the deputy chief of staff for three SEC chairs. Before joining the PCAOB, Board Member Thompson served as executive director and chief administrative officer of the Commodity Futures Trading Commission (CFTC), where he oversaw the Division of Administration.
PCAOB Establishing Two New Advisory Groups in Spring 2022
On January 31, 2022, the PCAOB announced its plan to create two new advisory groups: the Investor Advisory Group (IAG) and the Standards Emerging Issues Advisory Group (SEIAG). The IAG will advise the PCAOB on matters concerning the PCAOB’s mission from investors’ perspectives. The SEIAG will advise the PCAOB on existing standards, proposed standards, and potential new standards. If requested by the PCAOB, the SEIAG may also advise on matters other than standards that are of significance to the PCAOB.
The PCAOB is seeking public comments on the proposed governance frameworks of the two new advisory groups as well as membership nominations for both groups. The PCAOB has the sole discretion to appoint members of the advisory groups based on nominations from individuals and organizations. The deadline to either provide comments or submit nominations is February 28, 2022. Chair Williams stated that “[o]btaining input from these groups is obviously a priority for this Board, and we intend to move forward quickly to stand them up fully, appoint new members, and hold public meetings as early as this spring.”
