Potts v. SEC
September 21, 2006
CASES
Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847 (Feb. 28, 1981)
Checkosky, Exchange Act Release No. 31, 094, 52 S.E.C. Docket 1122, 1992 WL 211479 (Aug. 26, 1992)
Checkosky, Exchange Act Release No. 38,183, 63 S.E.C. Docket 1691, 1997 WL 18303 (Jan. 21, 1997)
Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994)
Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996)
Lester Witte & Co., Exchange Act Release No. 17,423, ASR No. 285, [1937-1982 ASR Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,307 (Jan. 7, 1981)
Potts, Exchange Act Release No. 39,126, AAER No. 964 (Sept. 24, 1997)
SEC v. Thornton, Litigation Release No. 11,263, AAER No. 118, [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep (CCH) 73,518 (Oct. 16, 1986)
Steadman v. SEC, 603 F.2d 1126 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981)
Stephen Inv. Sec., Inc. v. SEC, 27 F.3d 339 (8th Cir. 1994)
Touche Ross & Co. v. SEC, 609 F.2d 570 (2d Cir. 1979)
Upton v. SEC, 75 F.3d 92 (2d Cir. 1996)
Stephen O. Wade, Exchange Act Release No. 21,095, AAER No. 32, 30 S.E.C. Docket 972, 1984 WL 53374 (June 25, 1984)
STATUTES AND RULES
5 U.S.C. 553 (1994)
15 U.S.C. 78j-1 (1994)
Fed. R. App. P. 29
17 C.F.R. 201.102 (e) (1) (1997) ("Rule 2(e)")
62 Fed. Reg. 12,743, 12,744 & n.6, n.7, n.10 (1997)
OTHER AUTHORITIES
AICPA, SECPS 1000.08(e) (1997)
AICPA, SECPS 1000.08 (f) (1997)
AICPA, SECPS Appendix E (October, 1988)
1 AICPA, AICPA Professional Standards, AU 150.02, 150.04, 326.19 (1997)
Larry P. Bailey, Miller GAAS Guide 4.10 (1998)
Task Force on Rule 102(e) Proceedings, Comm. On Federal Regulation of Securities, American Bar Ass'n Section of Business Law, Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965 (May 1997)
1 See Consent of Respondent Securities and Exchange Commission To Filing of Brief Amicus Curiae (attached as Exhibit A); Consent of Petitioner Robert D. Potts To Filing of Brief of AICPA As Amicus Curiae (attached as Exhibit B).
2 A copy of the relevant passage of the SECPS guidance is attached as Exhibit C, for the convenience of the Court.
3 Now 17 C.F.R. 201.102 (e) (1) (1997), but referred to as Rule 2 (e) (1) herein (as the SEC did) for convenience.
4 Only two Commissioners joined in the opinion of the Commission. Commissioner Johnson concurred and Commissioner Wallman dissented in separate opinions.
5 Indeed, under both GAAS and SEC regulations, it is not necessary that a partner conduct the audit at all. GAAS requires that an independent public accountant be responsible for the audit, and that any audit assistants be properly supervised: "In most audit engagements, several auditors with varying degrees of experience will be used. When two or more auditors are involved in an engagement, there must be a system of review and supervision." Larry P. Bailey, Miller GAAS Guide 4.10 (1998). A recent SECPS membership requirement is that a partner have overall responsibility for every audit, see AICPA, SECPS 1000.08 (e) (1997), and we refer herein to the "partner-in-charge" as does the SECPS guidance.
6 It is debated whether the SEC has authority to announce or amend GAAS. Even assuming that the SEC has such authority, it could only do so by compliance with the notice and hearing provisions of the Administrative Procedure Act. See 5 U.S.C. 553 (1994); 15 U.S.C. 78j-1 (1994); see, e.g., 62 Fed. Reg. 12,743, 12,744 & n.6, n.7, n.10 (1997). It has no powers, by a process akin to common law, to evolve rules binding on registrants and their professionals. Still less may it do so retroactively. See Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,173 (Feb. 28, 1981) (because SEC had never adopted standards applicable to respondent, and because no generally accepted norms applied at the time, interpretation only prospective); Upton v. SEC, 75 F.3d 92, 96 (2d Cir. 1996) (court cannot defer to the SEC's interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation).
7 The SEC avoided the question of whether negligence is an adequate basis for Rule 2(e) sanctions by characterizing Potts' conduct as reckless. Even assuming that recklessness is the applicable state-of-mind requirement, the SEC measured Potts' conduct against the wrong standard in arriving at its determination of recklessness.
The AICPA is the national organization of the certified public accounting profession, with more than 340,000 members. It seeks to promote high professional standards of practice, and has come to be accepted by the profession, the public, and the SEC as an authoritative source of standards and procedures in its field. In particular, the AICPA develops the standards that, after exposure, comment and formal adoption, govern the conduct of audits by certified public accountants, ("CPAs") and are collectively known as "generally accepted auditing standards" ("GAAS").
The AICPA also established the Division for Firms and its SEC Practice Section ("SECPS") in 1977, as a response to public and congressional concern about the profession's oversight of public company audits. Firms whose owners are members of the AICPA and that audit public companies are required to be members in good standing of the SECPS. That, in turn, requires firms to comply with certain guidelines promulgated by the SECPS and overseen by an independent Public Oversight Board that supervises the process in the public interest.
SECPS guidelines promote compliance with an array of prophylactic practices designed to provide heightened assurance that audits will be properly carried out. Those guidelines speak in fairly general terms, and leave much discretion in implementation to individual SECPS member firms.
This flexibility was not accidental, but was meant to balance several sets of competing, valid interests. One was to avoid too-rigid a set of standards so that smaller firms would not find it prohibitive to engage in audits of public companies.
Another was to balance the need for heightened prophylactic measures with the need to avoid dilution of the undelegable responsibility of the partner-in-charge for compliance of the audit with GAAS. This case implicates the second of these sets of concerns, as reflected in the requirement that SECPS firms "[e]stablish policies and procedures ... for a concurring review of the audit report and the financial statements by a partner other than the audit partner-in-charge." AICPA, SECPS 1000.08(f) (1997).
The SECPS published guidance as to the attributes of a concurring review, but left it to individual firms to provide concurring partners with specific guidelines. The SECPS guidelines also emphasized that the concurring reviewer did not displace the role of the partner-in-charge:
The purpose of the concurring review requirement is to provide additional assurance that (1) the financial statements of SEC engagements ... are in conformity with generally accepted accounting principles or other comprehensive basis of accounting and (2) the firm's report thereon is in accordance with generally accepted auditing standards. Performance of a concurring review does not relieve the partner in charge of the engagement from final responsibility for the issuance of the firm's audit report...
AICPA, SECPS, Appendix E (October, 1988)2.
The interest of the AICPA as amicus in this case stems from the SEC's confusion of the SECPS guidance with GAAS, its erroneous articulation of the duties of a concurring review partner under the SECPS guidelines, and its unsupported determination that Petitioner's perceived departure from its incorrectly defined standards could constitute him a threat to the investing public or SEC processes.
Each of these conclusions has serious ramifications for the proper implementation of both GAAS and the SECPS guidelines. The SEC's misapplication of the concurring review requirement both overburdens the reviewing partner's role and dilutes accountability for the audit report. It will prohibitively raise costs by requiring, in essence, two partners-in-charge, and sow confusion as to the nature and required depth of a concurring review. The interpretations laid on the concurring review requirement by the SEC are thus not only erroneous but counterproductive.
We adopt Potts' Statement of the Case in his brief, and provide only a short review of the case here.
Potts was the concurring partner for Touche Ross's audits of Kahler Corporation ("Kahler") for the years 1988 and 1989. In 1987, Kahler acquired an interest in the University Park Hotel ("UPH") and decided to sell it in 1988. Kahler sought to capitalize the operating losses of UPH, rather than deducting them against current income. To do this, Kahler had to meet the requirements of Accounting Principles Board Opinion No. 30, and Emerging Task Force Issue Nos. 85-36 and 84-28. Under these standards, to capitalize operating losses for a business segment held for sale, there must be a reasonable assurance that a net gain will be realized on disposition of the segment, and the seller must have a formal plan of disposition. Gregory Melsen ("Melsen"), the partner-in-charge for the Kahler audits, determined after conducting the annual audits, consulting with Potts and investigating further, that capitalization of the UPH's operating losses was in accordance with generally accepted accounting principles. The details of Potts' review of this conclusion and the audit evidence supporting it are fully described in his brief and will not be reiterated here. Suffice it to say that it is uncontested that Potts' review conformed to then-existing Touche Ross procedures which, in turn, had been adopted in compliance with the SECPS guidelines discussed above.
In 1993, the SEC brought a proceeding under Rule 2(e)(1)3 of its Rules of Practice, charging Potts with improper professional conduct in connection with these audits. The administrative law judge found that Potts had engaged in improper professional conduct. On review, a majority of the SEC agreed that the UPH loss treatment was inappropriate and Potts' review failed to meet professional standards. It sanctioned Potts with a nine-month suspension from practice before the Commission4.
STATEMENT OF THE CASE
We adopt Potts' Statement of the Case in his brief, and provide only a short review of the case here.
Potts was the concurring partner for Touche Ross's audits of Kahler Corporation ("Kahler") for the years 1988 and 1989. In 1987, Kahler acquired an interest in the University Park Hotel ("UPH") and decided to sell it in 1988. Kahler sought to capitalize the operating losses of UPH, rather than deducting them against current income. To do this, Kahler had to meet the requirements of Accounting Principles Board Opinion No. 30, and Emerging Task Force Issue Nos. 85-36 and 84-28. Under these standards, to capitalize operating losses for a business segment held for sale, there must be a reasonable assurance that a net gain will be realized on disposition of the segment, and the seller must have a formal plan of disposition. Gregory Melsen ("Melsen"), the partner-in-charge for the Kahler audits, determined after conducting the annual audits, consulting with Potts and investigating further, that capitalization of the UPH's operating losses was in accordance with generally accepted accounting principles. The details of Potts' review of this conclusion and the audit evidence supporting it are fully described in his brief and will not be reiterated here. Suffice it to say that it is uncontested that Potts' review conformed to then-existing Touche Ross procedures which, in turn, had been adopted in compliance with the SECPS guidelines discussed above.
In 1993, the SEC brought a proceeding under Rule 2(e)(1)3 of its Rules of Practice, charging Potts with improper professional conduct in connection with these audits. The administrative law judge found that Potts had engaged in improper professional conduct. On review, a majority of the SEC agreed that the UPH loss treatment was inappropriate and Potts' review failed to meet professional standards. It sanctioned Potts with a nine-month suspension from practice before the Commission4.
- The SEC Erred In Attributing GAAS Status To The SECPS Guidelines.
The SEC's determination that Potts engaged in improper professional conduct was based solely on its findings that Potts, in his review as concurring partner, deviated from "the duties imposed by GAAP and GAAS." Potts, Exchange Act Release No. 39,126, AAER No. 964, slip op. at 19 (Sept. 24, 1997). The SEC thus fundamentally misconstrued the standards applicable to a concurring partner, and, in so doing, effectively announced a new standard and applied it retroactively. Both the SEC description of the existing standard, and the newly-forged one, if such it be, are erroneous and form no basis for discipline against Potts. The SECPS's requirement of a concurring review pursuant to SECPS guidelines is not part of GAAS and is not required by any SEC rule or regulation. It is, rather, a prudential requirement voluntarily embraced by firms that are members of the AICPA's SECPS as a condition of that membership. The specifics of that review are governed by firm policies adopted as part of the SECPS program, and policed by the peer review process established by the SECPS. None of this is part of, or necessary to comply with, GAAS.
The SEC requires that the financial statements of public companies be audited by an independent public accountant. Under SEC Regulation S-X, the resulting audit opinion must state whether the audit was made in accordance with GAAS. Among other duties, GAAS requires that auditors obtain "[s]ufficient competent evidential matter ... through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit," and "exercise 'the proper degree of professional skepticism to achieve reasonable assurance that material errors or irregularities will be detected.'" Potts, slip op. at 10-11 & n.25 (citation omitted). In signing the firm's audit report, the auditor in charge, usually a partner, takes responsibility for the audit's compliance with these standards.
Neither Regulation S-X nor GAAS requires a concurring review or sets standards for carrying one out5. The SECPS membership requirement of a concurring review is not generally applicable, but applicable only to AICPA members, and firms that are not AICPA members may conduct public-company audits in full compliance with GAAS and SEC regulations without any concurring review at all.
Under the SECPS guidelines for concurring reviews, concurring partners are affirmatively instructed not to assume the responsibilities of the partner-in-charge:
For the concurring review to be an objective review of material accounting, auditing or reporting issues, the concurring reviewer ordinarily should not assume any of the responsibilities of the partner-in-charge of the engagement. Similarly, the concurring reviewer should not have responsibility for any segment of the engagement.
AICPA, SECPS, Appendix E (October, 1988). The partner-in-charge has sole responsibility for ensuring that the audit complies with the requirements of GAAS and for so stating in the audit report, and that responsibility cannot be delegated or shared.
The Potts majority erred in attributing GAAS status to SECPS guidelines for concurring partner review, and thus requiring the concurring reviewer to perform tasks and meet expectations imposed by GAAS on the partner-in-charge. Pursuing this line, the majority referred to the literature describing the GAAS duties of an auditor, and misapplied what it found there to Potts. Thus, the majority relied on the GAAS requirement that all auditors "must perform their work with due care" in finding that a concurring partner must perform all audit duties mandated by GAAS. Rejecting the defense that these standards, as applied to concurring reviewers, were hitherto undefined, the majority simply missed the point, asserting that "[t]he relevant professional standards we apply here are all taken directly from accounting literature. These standards were just as applicable when Potts performed his Kahler audit work as they are today." Potts, slip op. at 12 n.27. So they were and are, to auditors, but not to reviewers. The obligation of reviewers is defined, not by GAAS, but by SECPS guidelines and by additional standards adopted by their firms in conformity with those guidelines. The SEC erred in announcing and applying a new and inappropriate GAAS standard here.
The SEC majority relied on three cases to support its approach. None of these was contested, and analysis of them emphasizes the lack of precedent for the majority's application of GAAS to concurring review.
Only one of the cases cited by the SEC majority concerns a concurring partner at all. In Lester Witte & Co., Exchange Act Release No. 17,423, ASR No. 285, [1937-1982 ASR Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,307, at 62,865 (Jan. 7, 1981), the SEC did not sanction the concurring partner, even though it found the concurring review inadequate because the concurring reviewer did not pursue noted or obvious deficiencies in the audit. Rather, the SEC found that the failure of the concurring partner was attributable to the inadequacies of the firm's review program, and to the partner-in-charge: "As the engagement partner on the Lippincott audit, [the partner-in-charge] bears responsibility for the audit deficiencies which occurred." Id. at 62,865-66. Lester Witte's emphasis on the need for adequate firm guidelines acknowledges that standards for concurring review are not in GAAS, but are the separate responsibility of the firm, consistent with the SECPS guidelines. Lester Witte contradicts, rather than supports, the SEC majority's assertion in this case that the SECPS guidelines were a recognized part of GAAS.
Neither SEC v. Thornton , Litigation Release No. 11,263, AAER No. 118, [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,518 (Oct. 16, 1986), nor Stephen O. Wade , Exchange Act Release No. 21,095, AAER No. 32, 30 S.E.C. Docket 972, 1984 WL 53374 (June 25, 1984), deals with a concurring reviewer under the SECPS guidelines. In Thornton , one of the respondents was responsible for an "impartial quality control review." Thornton , [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) at 63,389-3. Even regarding this respondent as equivalent to a concurring reviewer, Thornton offers no standard for his conduct. In Wade , one of the respondents was the "second partner" on an audit, and was a "designated savings and loan expert" at the accounting firm. Wade , 30 S.E.C. Docket at 978, 1984 WL 53374, at *7. The SEC's opinion does not distinguish between the "second partner" and the partner-in-charge in its analysis of their conduct. Id. at 979, 1984 WL 53374, at *9. Like Thornton , Wade offers no standards or guidance applicable to a concurring partner under the SECPS program, and no suggestion at all that the SECPS guidelines are part of GAAS.
The absence of any authority in either the professional literature or SEC cases for applying GAAS to Potts' conduct makes it clear that the SEC actually engaged here in improper retroactive rulemaking, unfairly burdening Potts with the results6.
- The SEC Erred In Applying GAAS Audit Requirements To Potts' Conduct.
Having erroneously concluded that SECPS guidance for concurring review was part of GAAS, the SEC majority then erroneously construed the duties of an SECPS concurring partner, and imposed on Potts the responsibilities of a partner-in-charge under GAAS. It was his failure to do what he was not required to do that the majority held was sanctionable misconduct. For example, the SEC majority asserted that Potts, as concurring partner, was required to:
All these measures — even if the majority were correct that they should have been taken — are not the responsibilities of a concurring partner under the SECPS guidelines. The SECPS's guidance as to the duties of a concurring partner describes a limited range of duties which do not include participation in the audit itself:
The concurring reviewer's responsibilities should include reading the financial statements and the firm's report thereon and making an objective review of significant accounting, auditing or reporting considerations. Such review should ... include discussions with the partner-in-charge of the engagement and review of selected working papers. The extent of working paper review is a professional judgment which has to be made by the reviewer and will vary with the particular circumstances of each engagement.
AICPA, SECPS, Appendix E (October, 1988). The majority does not suggest that Potts failed to comply with these guidelines in themselves. See Potts, slip op. at 23 n.55. The findings all erroneously measure Potts' conduct by GAAS's audit requirements, and every finding of misconduct is accompanied by citation to GAAS, promulgated by the AICPA and applicable, in terms, toauditors.
The majority concedes that
[a]s an initial matter, we agree with Potts that he, as concurring partner on the audits, did not act unreasonably when he was satisfied initially with his partner Melsen's indications that Kahler intended to dispose of its entire interest in [UPH]. We also agree that Potts, upon becoming aware of audit documentation and his partner's concerns that Kahler planned to sell only a partial interest, acted reasonably in meeting first with [Kahler's CEO] and then in directing Melsen to inquire further about Kahler's intentions regarding the hotel.
Potts, slip op. at 13-14. The misconduct found by the majority consisted only in Potts' failure to take additional steps after the partner-in-charge had investigated, with Potts' supervision, their concerns regarding the accounting treatment of UPH, and had explained to Potts that he was satisfied. The additional steps required by the majority would improperly substitute Potts' judgment for that of the partner-in-charge, and would impose upon Potts the undelegable responsibility of the partner-in-charge.
The error of the SEC majority's analysis of Potts' conduct under GAAS is highlighted by its insistence that Potts should have applied "professional skepticism" to the statements made to him, not by Kahler, but by the partner-in-charge, Melsen. Under the SECPS guidelines, the concurring reviewer is not to assume the partner-in-charge's responsibility, but to act in an advisory, concurring capacity. The "objective review" and "discussion" referred to in the guidelines did not mandate that Potts replace the partner-in-charge's judgment with his own as the result of a skepticism as to Melsen's candor or his ability to perform his duties. Such an audit of the audit is neither required nor permitted by the SECPS guidelines.
Further, the majority's repeated insistence that Potts should have obtained audit evidence graphically illustrates the majority's confusion of the responsibility of the audit engagement team with that of the concurring partner. Under the SECPS guidelines, the extent of the concurring partner's review of the evidence obtained is left to his professional judgment in the circumstances. The duty to obtain "sufficient competent evidential matter" (1 AICPA, AICPA Professional Standards, AU 150.02 (1997)), or to obtain further evidence in certain cases (id. 150.04), or to assess its source (id. 326.19), remains that of the audit team and ultimately the partner-in-charge. The SEC majority found noncompliance with each of these inapplicable duties to be improper professional conduct by Potts. See, e.g. , Potts, slip op. at 14 & n.30, n.31, n.32.
In all of this, the SEC effectively announced and applied a changed set of standards for reviewing partners, unintended by the SECPS regime and inconsistent with it. Those new standards offer no useful guidance to reviewing partners except that they can only be safe if they largely re-do the audit. That, in turn, prohibitively overburdens the reviewing partners, their firms, their clients who must pay for the redundant work, and those firms whose resources make such an endeavor impractical and are thus foreclosed from auditing public companies. And it undermines the most important single safeguard of the integrity of the audit process — the undiluted authority and responsibility of the CPA partner-in-charge who signs the audit opinion.
THE SEC ERRED IN FAILING TO CONSIDER WHETHER POTTS' CONDUCT PRESENTED A FUTURE THREAT TO SEC PROCESSES.
The current Commission is divided on the question of what state of mind is required for sanctions of accountants under Rule 2(e).7 See Potts, slip op. at 27; Checkosky, Exchange Act Release No. 31,094, 52 S.E.C. Docket 1122, 1133, 1992 WL 211479, at *12 (Aug. 26, 1992) (Checkosky I ); Checkosky v. SEC, 23 F.3d 452, 454 (D.C. Cir. 1994); Checkosky, Exchange Act Release No. 38,183, 63 S.E.C. Docket 1691, 1700, 1997 WL 18303, at *10 (Jan. 21, 1997) (Checkosky II ); see also Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,172-73 (Feb. 28, 1981).
Regardless of the state of mind required for sanctions under securities laws or Rule 2(e), the misconduct supporting a Rule 2(e) sanction must, at a minimum, evince a present threat to the integrity of the SEC's procedures or to the investing public.
The SEC's authority to sanction professionals under Rule 2(e) is justified only by the SEC's authority to protect its own procedures, not by any authority to punish wrongdoers:
The Commission, through its Rule 2(e) proceeding, is merely attempting to preserve the integrity of its own procedures, by assuring the fitness of those professionals who represent others before the Commission. Indeed, the Commission has made it clear that its intent in promulgating Rule 2(e) was not to utilize the rule as an additional weapon in its enforcement arsenal, but rather to determine whether a person's professional qualifications, including his character and integrity, are such that he is fit to appear and practice before the Commission.
Touche Ross & Co. v. SEC, 609 F.2d 570, 579 (2d Cir. 1979). The SEC itself has recognized the limits of its authority to impose Rule 2(e) sanctions:
[Rule 2(e)] is addressed to a different problem — professional misconduct — and its sanction is limited to that necessary to protect the investing public and the Commission from the future impact on its processes of professional misconduct.
Carter, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 84,149-50; see also Checkosky II, 63 S.E.C. Docket at 1703, 1997 WL 18303, at *12.
The remedial, rather than punitive, nature and purpose of Rule 2(e) require that the SEC sanction an accountant only when he is currently unfit to practice, or poses a risk to the public. In Johnson v. SEC, 87 F.3d 484, 489 (D.C. Cir. 1996), the D.C. Circuit vacated SEC sanctions under 15 U.S.C. 78o(b)(4), because it found them punitive rather than remedial, and the applicable statute of limitations had therefore run out:
This sanction would less resemble punishment if the SEC had focused on Johnson's current competence or the degree of risk she posed to the public. Despite the SEC's claims to the contrary, however, it is evident that the sanctions here were not based on any general finding of Johnson's unfitness as a supervisor, nor any showing of the risk she posed to the public, but rather were based on Johnson's alleged failure reasonably to supervise...
Id.; see Checkosky, 23 F.3d at 456 ("[i]f the purpose of Rule 2(e) is to protect the integrity of administrative processes, then sanctions for improper professional conduct under 2(e)(1)(ii) are permissible only to the extent that they prevent the disruption of proceedings") (J. Silberman, concurring); see also Steadman v. SEC, 603 F.2d 1126, 1140-41 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).
Consistent with the SEC's and the courts' view that only conduct that threatens the SEC's processes is sanctionable under Rule 2(e), the ABA Task Force on Rule 102(e) Proceedings (the "Task Force") concluded in a recent report that Rule 2(e) sanctions should be imposed only when an accountant poses such a threat:
Whether one agrees with the [Checkosky] majority's position that state of mind is not determinative of whether to find improper professional conduct, or Commissioner Johnson's view that scienter is required, the Task Force believes that the criteria discussed in the Checkosky opinions fail to address what should be the central focus of a disciplinary proceeding: whether, taking into account all of the facts concerning a respondent, including his or her past conduct and current circumstances, the respondent poses a current threat of future conduct harmful to the Commission's processes.
Task Force on Rule 102(e) Proceedings, Comm. On Federal Regulation of Securities, American Bar Association Section of Business Law, Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 977 (May 1997).
The Task Force's compelling argument considered: the possibility that lesser standards for Rule 2(e) sanctions may not pass judicial muster as remedial rather than punitive; the severe effects of SEC sanctions on a public accountants' career; and the lack of clarity or consensus in the Checkosky decisions as to state of mind. Drawing upon other contexts in which the SEC seeks to preclude individuals from practicing before it, the Task Force concluded that the SEC should impose a Rule 2(e) sanction only where an accountant is "substantially unfit" to practice. Id. at 985. In each context examined, the SEC's authority to suspend or enjoin individuals from practice relied on a showing that future violations are likely. See id. at 978. The Task Force believes that the application of differing standards to sanction accountants is unjustified, and that the application of similar standards will provide consistency and predictability. See id. at 985.
The Task Force argues that its recommended standard of "substantial unfitness" is therefore best measured by the same factors applied by the SEC and the courts to sanctions barring a defendant from serving as an officer and director and to injunctions against practicing before the SEC:
[T]he Commission ought to consider and expressly discuss the egregiousness of the underlying conduct, whether the conduct involved an isolated failure or was part of a continuing pattern of misconduct, the accountant's "role" or position when he or she engaged in the conduct, the accountant's degree of scienter, and the accountant's economic stake in the violation.
Id. at 985-86. The Task Force's recommendation is both consistent with the authorized purpose of Rule 2(e) and good policy.
The majority's opinion includes only a single sentence regarding Potts' current fitness to practice: "Potts' substantial departures from his professional duties establishes that this Commission cannot rely upon Potts to perform diligently and with reasonable competence his audit responsibilities." Potts, slip op. at 19. Given the pervasive error of the SEC majority as to what Potts' "professional duties" and "audit responsibilities" properly were, this conclusory "finding" is unsupported by any substantial evidence and cannot be sustained. Cf. Stephen Inv. Sec., Inc. v. SEC, 27 F.3d 339, 341 (8th Cir. 1994); see also Johnson, 87 F.3d at 490 n.9.
The SEC's determination that Potts engaged in improper professional conduct was based solely on its findings that Potts, in his review as concurring partner, deviated from "the duties imposed by GAAP and GAAS." Potts, Exchange Act Release No. 39,126, AAER No. 964, slip op. at 19 (Sept. 24, 1997). The SEC thus fundamentally misconstrued the standards applicable to a concurring partner, and, in so doing, effectively announced a new standard and applied it retroactively. Both the SEC description of the existing standard, and the newly-forged one, if such it be, are erroneous and form no basis for discipline against Potts. The SECPS's requirement of a concurring review pursuant to SECPS guidelines is not part of GAAS and is not required by any SEC rule or regulation. It is, rather, a prudential requirement voluntarily embraced by firms that are members of the AICPA's SECPS as a condition of that membership. The specifics of that review are governed by firm policies adopted as part of the SECPS program, and policed by the peer review process established by the SECPS. None of this is part of, or necessary to comply with, GAAS.
The SEC requires that the financial statements of public companies be audited by an independent public accountant. Under SEC Regulation S-X, the resulting audit opinion must state whether the audit was made in accordance with GAAS. Among other duties, GAAS requires that auditors obtain "[s]ufficient competent evidential matter ... through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit," and "exercise 'the proper degree of professional skepticism to achieve reasonable assurance that material errors or irregularities will be detected.'" Potts, slip op. at 10-11 & n.25 (citation omitted). In signing the firm's audit report, the auditor in charge, usually a partner, takes responsibility for the audit's compliance with these standards.
Neither Regulation S-X nor GAAS requires a concurring review or sets standards for carrying one out5. The SECPS membership requirement of a concurring review is not generally applicable, but applicable only to AICPA members, and firms that are not AICPA members may conduct public-company audits in full compliance with GAAS and SEC regulations without any concurring review at all.
Under the SECPS guidelines for concurring reviews, concurring partners are affirmatively instructed not to assume the responsibilities of the partner-in-charge:
For the concurring review to be an objective review of material accounting, auditing or reporting issues, the concurring reviewer ordinarily should not assume any of the responsibilities of the partner-in-charge of the engagement. Similarly, the concurring reviewer should not have responsibility for any segment of the engagement.
AICPA, SECPS, Appendix E (October, 1988). The partner-in-charge has sole responsibility for ensuring that the audit complies with the requirements of GAAS and for so stating in the audit report, and that responsibility cannot be delegated or shared.
The Potts majority erred in attributing GAAS status to SECPS guidelines for concurring partner review, and thus requiring the concurring reviewer to perform tasks and meet expectations imposed by GAAS on the partner-in-charge. Pursuing this line, the majority referred to the literature describing the GAAS duties of an auditor, and misapplied what it found there to Potts. Thus, the majority relied on the GAAS requirement that all auditors "must perform their work with due care" in finding that a concurring partner must perform all audit duties mandated by GAAS. Rejecting the defense that these standards, as applied to concurring reviewers, were hitherto undefined, the majority simply missed the point, asserting that "[t]he relevant professional standards we apply here are all taken directly from accounting literature. These standards were just as applicable when Potts performed his Kahler audit work as they are today." Potts, slip op. at 12 n.27. So they were and are, to auditors, but not to reviewers. The obligation of reviewers is defined, not by GAAS, but by SECPS guidelines and by additional standards adopted by their firms in conformity with those guidelines. The SEC erred in announcing and applying a new and inappropriate GAAS standard here.
The SEC majority relied on three cases to support its approach. None of these was contested, and analysis of them emphasizes the lack of precedent for the majority's application of GAAS to concurring review.
Only one of the cases cited by the SEC majority concerns a concurring partner at all. In Lester Witte & Co., Exchange Act Release No. 17,423, ASR No. 285, [1937-1982 ASR Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,307, at 62,865 (Jan. 7, 1981), the SEC did not sanction the concurring partner, even though it found the concurring review inadequate because the concurring reviewer did not pursue noted or obvious deficiencies in the audit. Rather, the SEC found that the failure of the concurring partner was attributable to the inadequacies of the firm's review program, and to the partner-in-charge: "As the engagement partner on the Lippincott audit, [the partner-in-charge] bears responsibility for the audit deficiencies which occurred." Id. at 62,865-66. Lester Witte's emphasis on the need for adequate firm guidelines acknowledges that standards for concurring review are not in GAAS, but are the separate responsibility of the firm, consistent with the SECPS guidelines. Lester Witte contradicts, rather than supports, the SEC majority's assertion in this case that the SECPS guidelines were a recognized part of GAAS.
Neither SEC v. Thornton , Litigation Release No. 11,263, AAER No. 118, [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,518 (Oct. 16, 1986), nor Stephen O. Wade , Exchange Act Release No. 21,095, AAER No. 32, 30 S.E.C. Docket 972, 1984 WL 53374 (June 25, 1984), deals with a concurring reviewer under the SECPS guidelines. In Thornton , one of the respondents was responsible for an "impartial quality control review." Thornton , [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) at 63,389-3. Even regarding this respondent as equivalent to a concurring reviewer, Thornton offers no standard for his conduct. In Wade , one of the respondents was the "second partner" on an audit, and was a "designated savings and loan expert" at the accounting firm. Wade , 30 S.E.C. Docket at 978, 1984 WL 53374, at *7. The SEC's opinion does not distinguish between the "second partner" and the partner-in-charge in its analysis of their conduct. Id. at 979, 1984 WL 53374, at *9. Like Thornton , Wade offers no standards or guidance applicable to a concurring partner under the SECPS program, and no suggestion at all that the SECPS guidelines are part of GAAS.
The absence of any authority in either the professional literature or SEC cases for applying GAAS to Potts' conduct makes it clear that the SEC actually engaged here in improper retroactive rulemaking, unfairly burdening Potts with the results6.
Having erroneously concluded that SECPS guidance for concurring review was part of GAAS, the SEC majority then erroneously construed the duties of an SECPS concurring partner, and imposed on Potts the responsibilities of a partner-in-charge under GAAS. It was his failure to do what he was not required to do that the majority held was sanctionable misconduct. For example, the SEC majority asserted that Potts, as concurring partner, was required to:
All these measures — even if the majority were correct that they should have been taken — are not the responsibilities of a concurring partner under the SECPS guidelines. The SECPS's guidance as to the duties of a concurring partner describes a limited range of duties which do not include participation in the audit itself:
The concurring reviewer's responsibilities should include reading the financial statements and the firm's report thereon and making an objective review of significant accounting, auditing or reporting considerations. Such review should ... include discussions with the partner-in-charge of the engagement and review of selected working papers. The extent of working paper review is a professional judgment which has to be made by the reviewer and will vary with the particular circumstances of each engagement.
AICPA, SECPS, Appendix E (October, 1988). The majority does not suggest that Potts failed to comply with these guidelines in themselves. See Potts, slip op. at 23 n.55. The findings all erroneously measure Potts' conduct by GAAS's audit requirements, and every finding of misconduct is accompanied by citation to GAAS, promulgated by the AICPA and applicable, in terms, toauditors.
The majority concedes that
[a]s an initial matter, we agree with Potts that he, as concurring partner on the audits, did not act unreasonably when he was satisfied initially with his partner Melsen's indications that Kahler intended to dispose of its entire interest in [UPH]. We also agree that Potts, upon becoming aware of audit documentation and his partner's concerns that Kahler planned to sell only a partial interest, acted reasonably in meeting first with [Kahler's CEO] and then in directing Melsen to inquire further about Kahler's intentions regarding the hotel.
Potts, slip op. at 13-14. The misconduct found by the majority consisted only in Potts' failure to take additional steps after the partner-in-charge had investigated, with Potts' supervision, their concerns regarding the accounting treatment of UPH, and had explained to Potts that he was satisfied. The additional steps required by the majority would improperly substitute Potts' judgment for that of the partner-in-charge, and would impose upon Potts the undelegable responsibility of the partner-in-charge.
The error of the SEC majority's analysis of Potts' conduct under GAAS is highlighted by its insistence that Potts should have applied "professional skepticism" to the statements made to him, not by Kahler, but by the partner-in-charge, Melsen. Under the SECPS guidelines, the concurring reviewer is not to assume the partner-in-charge's responsibility, but to act in an advisory, concurring capacity. The "objective review" and "discussion" referred to in the guidelines did not mandate that Potts replace the partner-in-charge's judgment with his own as the result of a skepticism as to Melsen's candor or his ability to perform his duties. Such an audit of the audit is neither required nor permitted by the SECPS guidelines.
Further, the majority's repeated insistence that Potts should have obtained audit evidence graphically illustrates the majority's confusion of the responsibility of the audit engagement team with that of the concurring partner. Under the SECPS guidelines, the extent of the concurring partner's review of the evidence obtained is left to his professional judgment in the circumstances. The duty to obtain "sufficient competent evidential matter" (1 AICPA, AICPA Professional Standards, AU 150.02 (1997)), or to obtain further evidence in certain cases (id. 150.04), or to assess its source (id. 326.19), remains that of the audit team and ultimately the partner-in-charge. The SEC majority found noncompliance with each of these inapplicable duties to be improper professional conduct by Potts. See, e.g. , Potts, slip op. at 14 & n.30, n.31, n.32.
In all of this, the SEC effectively announced and applied a changed set of standards for reviewing partners, unintended by the SECPS regime and inconsistent with it. Those new standards offer no useful guidance to reviewing partners except that they can only be safe if they largely re-do the audit. That, in turn, prohibitively overburdens the reviewing partners, their firms, their clients who must pay for the redundant work, and those firms whose resources make such an endeavor impractical and are thus foreclosed from auditing public companies. And it undermines the most important single safeguard of the integrity of the audit process — the undiluted authority and responsibility of the CPA partner-in-charge who signs the audit opinion.
The current Commission is divided on the question of what state of mind is required for sanctions of accountants under Rule 2(e).7 See Potts, slip op. at 27; Checkosky, Exchange Act Release No. 31,094, 52 S.E.C. Docket 1122, 1133, 1992 WL 211479, at *12 (Aug. 26, 1992) (Checkosky I ); Checkosky v. SEC, 23 F.3d 452, 454 (D.C. Cir. 1994); Checkosky, Exchange Act Release No. 38,183, 63 S.E.C. Docket 1691, 1700, 1997 WL 18303, at *10 (Jan. 21, 1997) (Checkosky II ); see also Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,172-73 (Feb. 28, 1981).
Regardless of the state of mind required for sanctions under securities laws or Rule 2(e), the misconduct supporting a Rule 2(e) sanction must, at a minimum, evince a present threat to the integrity of the SEC's procedures or to the investing public.
The SEC's authority to sanction professionals under Rule 2(e) is justified only by the SEC's authority to protect its own procedures, not by any authority to punish wrongdoers:
The Commission, through its Rule 2(e) proceeding, is merely attempting to preserve the integrity of its own procedures, by assuring the fitness of those professionals who represent others before the Commission. Indeed, the Commission has made it clear that its intent in promulgating Rule 2(e) was not to utilize the rule as an additional weapon in its enforcement arsenal, but rather to determine whether a person's professional qualifications, including his character and integrity, are such that he is fit to appear and practice before the Commission.
Touche Ross & Co. v. SEC, 609 F.2d 570, 579 (2d Cir. 1979). The SEC itself has recognized the limits of its authority to impose Rule 2(e) sanctions:
[Rule 2(e)] is addressed to a different problem — professional misconduct — and its sanction is limited to that necessary to protect the investing public and the Commission from the future impact on its processes of professional misconduct.
Carter, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 84,149-50; see also Checkosky II, 63 S.E.C. Docket at 1703, 1997 WL 18303, at *12.
The remedial, rather than punitive, nature and purpose of Rule 2(e) require that the SEC sanction an accountant only when he is currently unfit to practice, or poses a risk to the public. In Johnson v. SEC, 87 F.3d 484, 489 (D.C. Cir. 1996), the D.C. Circuit vacated SEC sanctions under 15 U.S.C. 78o(b)(4), because it found them punitive rather than remedial, and the applicable statute of limitations had therefore run out:
This sanction would less resemble punishment if the SEC had focused on Johnson's current competence or the degree of risk she posed to the public. Despite the SEC's claims to the contrary, however, it is evident that the sanctions here were not based on any general finding of Johnson's unfitness as a supervisor, nor any showing of the risk she posed to the public, but rather were based on Johnson's alleged failure reasonably to supervise...
Id.; see Checkosky, 23 F.3d at 456 ("[i]f the purpose of Rule 2(e) is to protect the integrity of administrative processes, then sanctions for improper professional conduct under 2(e)(1)(ii) are permissible only to the extent that they prevent the disruption of proceedings") (J. Silberman, concurring); see also Steadman v. SEC, 603 F.2d 1126, 1140-41 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).
Consistent with the SEC's and the courts' view that only conduct that threatens the SEC's processes is sanctionable under Rule 2(e), the ABA Task Force on Rule 102(e) Proceedings (the "Task Force") concluded in a recent report that Rule 2(e) sanctions should be imposed only when an accountant poses such a threat:
Whether one agrees with the [Checkosky] majority's position that state of mind is not determinative of whether to find improper professional conduct, or Commissioner Johnson's view that scienter is required, the Task Force believes that the criteria discussed in the Checkosky opinions fail to address what should be the central focus of a disciplinary proceeding: whether, taking into account all of the facts concerning a respondent, including his or her past conduct and current circumstances, the respondent poses a current threat of future conduct harmful to the Commission's processes.
Task Force on Rule 102(e) Proceedings, Comm. On Federal Regulation of Securities, American Bar Association Section of Business Law, Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 977 (May 1997).
The Task Force's compelling argument considered: the possibility that lesser standards for Rule 2(e) sanctions may not pass judicial muster as remedial rather than punitive; the severe effects of SEC sanctions on a public accountants' career; and the lack of clarity or consensus in the Checkosky decisions as to state of mind. Drawing upon other contexts in which the SEC seeks to preclude individuals from practicing before it, the Task Force concluded that the SEC should impose a Rule 2(e) sanction only where an accountant is "substantially unfit" to practice. Id. at 985. In each context examined, the SEC's authority to suspend or enjoin individuals from practice relied on a showing that future violations are likely. See id. at 978. The Task Force believes that the application of differing standards to sanction accountants is unjustified, and that the application of similar standards will provide consistency and predictability. See id. at 985.
The Task Force argues that its recommended standard of "substantial unfitness" is therefore best measured by the same factors applied by the SEC and the courts to sanctions barring a defendant from serving as an officer and director and to injunctions against practicing before the SEC:
[T]he Commission ought to consider and expressly discuss the egregiousness of the underlying conduct, whether the conduct involved an isolated failure or was part of a continuing pattern of misconduct, the accountant's "role" or position when he or she engaged in the conduct, the accountant's degree of scienter, and the accountant's economic stake in the violation.
Id. at 985-86. The Task Force's recommendation is both consistent with the authorized purpose of Rule 2(e) and good policy.
The majority's opinion includes only a single sentence regarding Potts' current fitness to practice: "Potts' substantial departures from his professional duties establishes that this Commission cannot rely upon Potts to perform diligently and with reasonable competence his audit responsibilities." Potts, slip op. at 19. Given the pervasive error of the SEC majority as to what Potts' "professional duties" and "audit responsibilities" properly were, this conclusory "finding" is unsupported by any substantial evidence and cannot be sustained. Cf. Stephen Inv. Sec., Inc. v. SEC, 27 F.3d 339, 341 (8th Cir. 1994); see also Johnson, 87 F.3d at 490 n.9.
This Court should reverse the order of the SEC in its entirety as requested by Petitioner.
Respectfully submitted, |
Richard I. Miller |
Louis A. Craco |
Dated: January 15, 1998
