What’s Ahead in Enforcement?

By looking at NASD and stock exchange regulation, firms can see what might unfold regarding their own.

ne of the main features of the Sarbanes-Oxley Act was the creation of the Public Company Accounting Oversight Board (PCAOB). The PCAOB, a Congressionally created private-sector, nonprofit corporation, was granted sweeping powers over the nation’s external auditors with respect to their auditing of publicly held companies. Some powers are new and unprecedented, and some are akin to those exercised by the Securities and Exchange Commission (SEC) and by various state boards. In essence the PCAOB is treated, in many respects, as if it were a self-regulatory organization under the securities laws. As with the NASD and the stock exchanges, the SEC must approve its rules and review its decisions. This article will help auditors and their attorneys get a good idea of what’s in store for them, allowing them to prepare for the wave of regulatory oversight.

It is too early to assess how well the PCAOB is functioning. The PCAOB has so far promulgated regulations only in some of the areas where it was specifically charged to do so by Sarbanes-Oxley, and its experience is limited. Still, it is not too early to have some informed reactions as to how the combination of the SEC and the PCAOB will affect independent auditors of public companies. CPAs can gain certain insights by comparing the SEC’s and the PCAOB’s oversight responsibilities with respect to five major functions—registration, rule making, inspections, investigations and enforcement—with those of self-regulatory organizations such as the NASD and the stock exchanges. Notably, these functions are the same as the ones the SEC entrusted to the NASD and other self-regulatory organizations, and the experience of those entities could have a precedent-setting effect on the activities of the PCAOB.

In all probability the primary responsibility to investigate and discipline accountants will shift from the SEC to the PCAOB, as Sarbanes-Oxley intended. Other less obvious changes likely will include these: The investigation/
enforcement time cycle will be shortened considerably, SEC injunctive proceedings will be all but abandoned as an enforcement mechanism against accountants, and many important enforcement decisions will revolve around the regulatory perception of a targeted firm’s overall adherence to effective quality control standards.

Registration. Sarbanes-Oxley marks the first federal effort to register accounting firms that perform assurance services for the nation’s public companies. Previously, registration or licensing was done on a state level and the focus was predominantly on the individual, not the firm. Now, as part of the registration process, the PCAOB will gather information about the nation’s accounting firms and make it available for use in subsequent enforcement efforts of the PCAOB and the SEC.

Of the myriad pieces of information that must be included in a firm’s registration application, two items (both apparently borrowed from the broker-dealer requirements) particularly stand out with respect to future enforcement activities:

A statement of the firm’s quality control policies with respect to its accounting and auditing practices.

A compendium of all pending criminal, civil or administrative actions against the firm or any associated person in connection with any audit report.

The firm’s overall compliance with its quality control policies may well determine whether an enforcement action is brought against it at all, and, if so, what sanctions might be sought. Similarly, a firm’s litigation history may well have an impact on enforcement decisions, and the applications (if they become publicly available) may serve as an informational source for civil litigants. Consequently, it is imperative that accounting firms pay great attention to the accuracy of these portions of their registration applications since it is likely they will be revisited in the enforcement process.

From the enforcement point of view, another central feature of the registration application is the consent (akin to that signed by stock exchange members), whereby the registrant agrees to cooperate with the PCAOB’s future investigative requests. Refusing to sign such consent is not a realistic option since the firm will not be registered if it refuses. However, once consent is given, refusal to cooperate with the PCAOB’s subsequent investigatory efforts could result in immediate registration revocation. Thus, the consent provision gives the PCAOB considerable leverage that can be used to expedite any investigation that either it or the SEC wishes to conduct.

Rule making. Under Sarbanes-Oxley, the PCAOB has the responsibility for auditing, quality control and ethical standards. Because of its potential impact on future enforcement actions, the most important standard-setting responsibility of the PCAOB will be for quality control standards—the ones most likely to undergo significant change from the prelegislation framework. Sarbanes-Oxley mandates that quality control standards include requirements for

Monitoring professional ethics and independence.
Internal consultation within the accounting firm.
Audit supervision.
Hiring, professional development and advancement of personnel.
The client’s acceptance and reevaluation.
An internal inspection program.

Since the mandatory requirements must be addressed, accounting firms would be well-advised to devote a good deal of attention to these issues now.

Inspection. While federal authorities commonly conduct inspections, or examinations, of securities and commodities professionals as well as banks and other financial professionals, there has not been a similar government-sponsored program for the nation’s accounting firms. The Sarbanes-Oxley legislation changed that: The PCAOB is statutorily directed to conduct an annual inspection of those registrants who perform audits for more than 100 issuers each year. And it must report immediately to the SEC and state regulatory authorities serious violations found in the course of an inspection. This requirement is a far cry from the current peer review system, which is remedial and not punitive in nature. Under peer review rules, an accounting firm performs a review of another firm on a triennial basis without any requirement to immediately report perceived deficiencies to regulatory authorities.

In its inspections, PCAOB representatives will have complete discretion to review any attestation engagement (at least of public companies) they wish to and more than likely will select engagements that already are the subject of litigation (and which have been identified in the registration application). Further, the inspectors must evaluate the quality control system of the firm and the manner in which that system is documented and communicated. The results of that inspection must be reflected in a draft inspection report and furnished to the firm before it is made final.

The mandatory quality control evaluation likely will play a central role in enforcement litigation. It stands to reason that a firm with a good quality control system will be in a better position with respect to enforcement actions than a firm with a deficient system. Consequently, firms should make every effort to promptly implement an effective quality control system, and such efforts should be well-documented for review by the inspection team. Any criticisms made by the inspectors should be addressed at once—if at all possible—even though the law allows a year for criticisms to be addressed.

The inspection reports the PCAOB ultimately issues will undoubtedly have an impact on enforcement actions. For this reason firms must vigorously seize the opportunity to review and comment upon a draft report. The firm’s response must, by law, be attached to and made part of the report. Since the report can be distributed to the SEC and state regulatory authorities (and, in certain circumstances, even to the public), the firm’s right to append a response is important. Appending a response is also a prerequisite to another important right of the accounting firm—the right to have the SEC review the PCAOB’s report.

If a final inspection report contains criticisms of perceived defects in the firm’s internal control system, the firm has 12 months to correct them to the PCAOB’s satisfaction. If the firm fails to do so, the PCAOB may make the negative inspection report available to the investing public—a result that could have dire consequences for both the firm’s reputation and its posture vis--vis future enforcement actions (as well as in any civil litigation). A firm so threatened must necessarily seek SEC review of the PCAOB’s conclusions if it cannot satisfy the PCAOB with respect to its remedial efforts.

Investigation. The PCAOB’s investigatory powers concerning auditors have the same scope as the powers long held by the SEC. However, the SEC’s overall investigatory reach is much broader since it is empowered to investigate any potential violation of securities laws, while the PCAOB is focused solely on outside auditors. The PCAOB does have the right to ask the SEC to subpoena third parties (such as the audited company) to produce information as an investigatory aid. The PCAOB likely will make such requests in most cases.

The recently finalized investigatory rules are very similar to those of the SEC. An accounting firm’s cooperation with any PCAOB investigation is all but guaranteed because of the severe consequences of the failure to comply—that is, deregistration, based on the consent the firm gave in the application.

What remains to be seen is how the PCAOB’s investigations will be conducted. Will the SEC defer to the PCAOB or vice versa? Or will parallel investigations be conducted, with the SEC investigating the issuer while the PCAOB investigates the accounting firm? Whatever the division of responsibility, the circumstances surrounding the creation of the PCAOB all but guarantee it will play a significant role in the investigatory process.

It also stands to reason that PCAOB investigations of audits will proceed at a much faster pace than traditionally has been the case with SEC investigations. The PCAOB itself (and the compensation guidelines for its professional staff) is the product of legislation that was enacted in an atmosphere of crisis, and it was given the specific directive of compensating its professionals at the levels of private practice. The combination of single focus and a virtually unlimited budget likely will lead to investigatory speed, aided by the access investigators will have to previously compiled registration and inspection information.

It is thus imperative that firms treat any PCAOB investigation with the utmost seriousness. Lawyers and accountants should immediately do what is necessary to prepare for the investigation: for example, review workpapers, interview witnesses and strategize, with a particular emphasis on the firm’s overall compliance with its quality control standards and the question of whether the firm and the associated persons who took part in an audit under investigation need separate representation. It cannot be assumed that luxury of time will be available.

Enforcement. In the past, the SEC has had the choice of bringing administrative proceedings (before an administrative law judge) or injunctive proceedings (before a federal court judge) against auditors of public companies, and it retains that choice. Generally, administrative law proceedings are advantageous to the SEC, injunctive proceedings to the defendant.

The injunctive proceeding has never been an ideal mechanism for the SEC to enforce securities laws against accountants—the accountants are entitled to wide-ranging discovery and are subject to limited remedies. Usually, there is not the same need for speed or disgorgement (that is, repayment of monies illicitly earned in a transaction) vis--vis an offending accountant as there is against an offending issuer, and injunctive success only lays the groundwork for a future contempt action since it is not usually the accountant who has benefited substantially from the violation (and who, therefore, is not likely to be subject to substantial disgorgement). Further, federal district court judges, endowed with life tenure, appear to be more independent-minded than the appointed, limited-term administrative law judges assigned to the SEC, and accounting firm defendants have full access to discovery in an injunction action, a privilege not given to them in administrative proceedings.

Administrative law proceedings, on the other hand, are advantageous to the SEC. Evidentiary rules are not as strict, and the surroundings and the proceedings are familiar. There is no discovery available to the target in the investigative phase, and only limited discovery thereafter. The auditor in an appeal of an administrative law judge’s determination has recourse only to the SEC, the original complainant. While the SEC has always claimed the power to bring disciplinary proceedings against the professionals who practice before it, it has been less than clear the SEC could bring such proceedings against an accounting firm. For this reason, the SEC often has followed the injunctive route in actions against accounting firms even though it is less than ideal.

Sarbanes-Oxley changed the enforcement landscape by increasing the SEC’s powers in administrative proceedings. The SEC now has clear authority to bring administrative proceedings against not only individuals but accounting firms themselves, and the sanctions may include the denial, either temporary or permanent, of the firm’s right to appear before the SEC for, among other reasons, “engaging in unethical or improper professional misconduct.” For the SEC, Sarbanes-Oxley defines misconduct to include negligence, whether in the form of a single instance of highly unreasonable conduct or repeated instances of unreasonable conduct. Thus, there is now clear statutory authority for the SEC to pursue death-knell sanctions, even where the accountant’s conduct lacks intent. Consequently, it is likely the SEC will use administrative proceedings far more than it has in the past.

The PCAOB is given the power to pursue only administrative proceedings, in which it can seek the unprecedented remedy of a person’s “disassociation” from a registered firm and/or the temporary or permanent suspension of the firm’s registration. The PCAOB also can seek a $15 million penalty. It can pursue the more draconian penalties only in egregious circumstances, but such circumstances include “repeated instances of negligent misconduct.” These penalties include disbarment for the individual and the suspension or termination of a firm’s registration, but they cannot be sought by the PCAOB where there is only a “single instance of negligent conduct.” In contrast, the SEC is empowered to do so regarding a single instance when the conduct is judged to be “highly unreasonable”—a disparity that suggests a high-profile case will be prosecuted by the SEC.

The recently approved regulations for the governance of enforcement proceedings by the PCAOB bear a marked similarity to the SEC’s rules of practice and the rules of self-regulatory organizations, such as the stock exchanges. The PCAOB has promulgated a rule—akin to the SEC’s rule on Wells submissions—allowing CPAs and firms to submit a position statement once they are apprised of the nature of the investigation and the violations. The CPA/respondent thus can inform the PCAOB of his or her views on why no proceeding is warranted. The CPA’s right, therefore, to make this Wells-type submission can be a valuable tactical resource in cases where litigation avoidance is the primary concern.

At every turn in the process—the course of the investigation, the Wells-type submission, the administrative hearing, any appeal—the accounting firm will need to address both the merits of the particular situation and the firm’s compliance history. Particularly significant will be the results of any prior litigation and the firm’s adherence to quality control standards. If the audit being challenged is viewed as part of a larger picture of misconduct rather than a departure from the firm’s normal procedures, the PCAOB is more likely to seek the harshest remedies. If the firm has well-developed quality control standards and a proven history of commitment to those standards, it will be hard for the PCAOB to argue that a particular situation is part of a more negative pattern. It is obviously important for the accounting firm’s management to maintain a carefully catalogued inspection history.

It is probable the Wells-type submission process will provide the same forum for potential settlement that it does in an SEC setting. Bear in mind, however, that each such settlement will become part of a litigation history that might be used to judge the firm in the future. Thus, any settlement will have to be negotiated with this larger picture in mind—an outlook that may make settlement more difficult.

As to the conduct of the administrative litigation, it can be safely assumed that litigation will proceed at the same fast pace as the investigations for much the same reason: The PCAOB was created for the particular purpose of policing the accounting profession, and it will have a great political need to demonstrate its effectiveness in its role as soon as it can. Consequently, accountants who become the subjects of investigation must brace themselves for the inevitable litigation.

A potential problem with the administrative proceeding may arise from the fact that the PCAOB’s power is limited to outside auditors. So accounting firms must be aware the PCAOB has no power itself to compel the attendance of unregulated witnesses, such as client representatives at enforcement proceedings. Only the SEC arguably has such power. Presumably, the PCAOB will ask the SEC to issue subpoenas to compel witness attendance and the production of documents in order to give accounting firms the opportunity to summon witnesses with exculpatory information. Even if the SEC exercises its power (the SEC said “the issuance of commission subpoenas in connection with PCAOB disciplinary proceedings would be a novel and potentially complex arrangement,” and it has directed the PCAOB to propose rules governing the issuance of such subpoenas before the SEC is willing to do so), disciplinary proceedings may become complicated when there is a parallel criminal investigation and key witnesses take the Fifth Amendment. In extreme situations, firms may have to seek a stay of disciplinary proceedings until a related matter is completed. At best the procedure will be very cumbersome and may result in the PCAOB’s referring accounting firm administrative proceedings to the SEC after the completion of the investigatory phase, rather than risking a fairness challenge to its disciplinary rules.

When aware that a problem involving the PCAOB exists and that investigative proceedings may be in the offing, lawyers and accountants must be in a high state of readiness at the outset of the proceeding. They must be thoroughly familiar with the firm’s litigation and inspection history, the facts surrounding the engagement in question and any other information garnered in the investigatory phase. They then must use this information to seek whatever discovery the hearing officer is willing to permit (the SEC rules of practice do not mandate discovery) and/or seek the issuance of subpoenas for documents and testimony that may be helpful to the defense.

ANTHONY J. COSTANTINI, JD, is a partner specializing in securities and commercial litigation with Duane Morris LLP in New York City and heads the firm’s professional liability practice. He formerly served as associate general counsel to KPMG Peat Marwick and as regional counsel to the U.S. Commodity Futures Trading Commission. His e-mail address is ajcostantini@duanemorris.com . The author wishes to thank Richard I. Miller, general counsel and secretary of the American Institute of CPAs, for his help in preparing this article. He also thanks his partners Rose Halligan and Aegis Frumento for their contributions.


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