Accountant Liability in SEC Enforcement Actions.

While SEC investigations can target accounting firms, individual accounting professionals can find themselves individually targeted as well. This can range from individual audit partners to individual staff accountants. It should also be noted that if an accounting firm is targeted, that does not necessarily mean that the individual accounting staff member involved will be targeted, as the two entities are viewed as separate and distinguishable for legal purposes, and the SEC will pursue charges based on that premise.

Along with other administrative bodies and regulatory agencies, the SEC, PCAOB, and private plaintiffs are not alone in their oversight of public companies. For example, while the SEC may have a lower threshold for initiating enforcement proceedings than those required in criminal cases, the SEC still is able to refer matters for criminal prosecution to the Department of Justice, which alone can seek criminal sanctions. Even without a criminal referral, the SEC can impose substantial civil penalties and can pursue cease-and-desist orders with respect to other statutory violations. Further, licensing bodies can pursue their own disciplinary proceedings, and private plaintiffs can sue for fraud and misrepresentation based on the same underlying allegations.

When investigating accounting firms, the SEC will test entity-level liability theories and apply the standard principles of agency and vicarious liability, as well as theories of corporate negligence. The SEC, however, will focus on identifying specific perpetrators and a distinct trail of culpability and liability that can be traceable to individual audit partners and individual staff members who worked with the company involved in the investigated transaction.

When it comes to public companies, Regulation S-X Rule 2-01 applies to the following specific accounting professionals who provide audit, review, and attestation services under PCAOB standards: “An accountant is not independent if, at any point during the audit and professional engagement period, the accountant provides the following non-audit services to an audit client:

• . ..
• . ..
• (i) Bookkeeping or other related accounting services, for example, preparing the audit client’s financial statements from its accounting records, preparing or originating source data underlying the audit client’s financial statements . ..
• (ii) Valuation or similar services, such as valuing financial instruments, property, and other assets . ..
• (iii) Internal audit outsourcing services, meaning acting as, or providing, internal audit services related to the audit client’s internal accounting controls, financial systems, or financial statements;
• (iv) Management functions or related services
• (v) Legal services, meaning any service that, under the circumstances in which it is provided, could be provided only by someone licensed, admitted, or otherwise qualified to practice law in the jurisdiction in which the service is provided; or
• (vi) Expert services unrelated to the audit, meaning providing an expert opinion or other expert service for the audit client, or the audit client’s legal representative, for the purpose of advocating the audit client’s interests in litigation or in a regulatory or administrative proceeding or investigation.”

When Does Deficient Auditing Become Federal Securities Fraud?

Under Section 10(b) of the Securities Exchange Act and Rule 10b-5, the SEC must prove that a defendant acted with “scienter,” or a culpable state of mind. In this context, this means that the SEC must prove that the defendant acted either intentionally or with “recklessness.” In contrast, Section 17(a)(2) and Section 17(a)(3) of the Securities Act permit the SEC to pursue enforcement actions against defendants based upon proof of “ordinary” negligence.

Under Section 20(e) of the Exchange Act, the SEC must prove that a defendant “knowingly or recklessly” provided “substantial assistance” in the commission of a primary securities violation. Similarly, under Section 21C of the Exchange Act, the SEC must prove that a defendant “caused” a primary violation “knowing or recklessly disregarding” that their conduct “could lead to” (i.e. result in) a violation.

While a violation of an auditor’s professional standard alone is not sufficient to establish liability under Rule 10b-5, it can be used to provide evidence of a culpable state of mind under certain circumstances.

For example, in Rule 10b-5 cases, the SEC typically targets individuals it alleges directly participated in deceptive schemes. This establishes primary liability under Rule 10b-5 (i.e. liability of the principal perpetrators), which is distinct from aiding and abetting liability under Section 20(e). Examples of direct participation in the commission of securities fraud include:

• Assisting in accounting fraud;
• Drafting fraudulent financial disclosures;
• Participating in a scheme to artificially inflate a public company’s stock price;
• And other deceptive practices.

Closely-held companies’ audit statements may also raise critical concerns, and such statements can sometimes be used as a key piece of evidence to support an accounting professional’s culpability in Rule 10b-5 investigations. Auditors’ “going concern” assessments, however, are often themselves the most disputed aspects of an auditor’s work in SEC litigation, as different auditors can apply the same standards with varying degrees of judgment and scrutiny.

From a practical standpoint, in the middle of a high-stakes SEC investigation, accountants and auditors will have the opportunity to seek relief based upon:

• Affirmative defenses, if applicable, and other defenses to liability;
• Disputing the SEC’s interpretation of the applicable securities laws;
• Disputing the SEC’s interpretation of professional standards;
• Challenging the SEC’s determination of culpable intent, such as scienter or recklessness;
• Seeking to limit the investigation’s scope;
• Seeking to avoid or resolve parallel proceedings; and
• Attempting to negotiate a settlement favorable to the accounting professional or firm involved.

What Can Rule 102(e) Do to an Accountant?

Under Rule 102(e), the SEC can suspend an accountant or other professional’s right to practice before the Commission, meaning that the accountant can neither represent any securities company nor advise any client on matters pertaining to the SEC. Rule 102(e) also permits the SEC to censure an accountant or impose a practice restriction for a temporary or permanent duration as it deems appropriate.

Rule 102(e) allows for the issuance of these “administrative” sanctions based upon either intentional, knowing, or reckless misconduct, i.e. scienter, as defined above, or upon proof that the accountant engaged in specific forms of improper professional conduct, which are defined broadly to include “negligence” as well. The key requirements for establishing improper professional conduct under Rule 102(e) are:

• “The conduct must be:
• (i) Intentional, knowing, or reckless, or
• (ii) Of such a nature that it is highly unreasonable to conclude that the accountant did not intend to (or did not, or did not have a basis to believe he or she could) violate the applicable rule, statute, or other requirement;”
• “Either of the following two types of negligent conduct: (1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted; or (2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission;” and
• “It must be the result of the individual or firm’s failures (1) to follow the applicable professional standards, (2) to maintain adequate professional capabilities to conduct the audit or other applicable services, or (3) to take care not to use one’s experience or expertise, or other professional skill, in an improper or unlawful manner.”

What Happens if the SEC Establishes Liability?

Once the SEC establishes liability for Rule 102(e) under the above-discussed circumstances, the SEC can then establish a factual basis for sanctioning the accountant under one or more of the SEC’s sanctioning schemes (which differ in particular in respect to scienter and/or negligence standards). As a result, establishing Rule 102(e) liability does not automatically mean that an accountant will face a censure, suspension or temporary restriction or a bar.

What are the Next Steps to Defend Against an SEC Rule 102(e) Administrative Order?

If an accountant or accounting firm wants to challenge an SEC Rule 102(e) administrative order, then the order must first be appealed to the Commission and then challenged by petition for review in the U.S. Court of Appeals for the circuit in which the person resides or has a principal place of business, or in the D.C. Circuit, filed within sixty days after entry of the order. Depending on the order in question, this could mean challenging a final administrative order (which could be based upon a Rule 102(e)(5) showing of good cause to request reinstatement).

What must auditors do after detecting possible illegal acts?

What Must Auditors Do After Detecting Potential Issuer Wrongdoing?

Under Section 10A of the Exchange Act, auditors are required to follow specific procedures when they detect evidence of a possible illegal act that would have a “direct and material effect” on the determination of financial statement amounts:

• “The auditor’s responsibility is limited to the reporting and procedures required by Section 10A of the Exchange Act and the corresponding rules and regulations. The auditor’s auditing engagement requires the auditor to perform procedures that are reasonably designed to obtain reasonable assurance about whether the financial statements are free from material misstatement whether due to error or fraud.”

What are the Auditor’s Responsibilities Under Section 10A?

Under Section 10A, the auditor’s responsibilities in detecting a possible illegal act include:

• Reporting the possible illegal act to appropriate management members;
• Assisting management to ensure the illegal act is properly communicated to the board of directors (if management fails to do so);
• Reporting the illegal act to the issuer’s board (if appropriate) and the SEC (if warranted);
• Ensuring the illegal act is properly disclosed in the financial statements (if material);
• Determining if the illegal act undermines the auditor’s reliance on management’s representations;
• Withdrawing from the engagement (if warranted); and
• Disclosing the illegal act to the SEC (if warranted).

What are the Requirements for Reporting Under Section 10A?

Under Section 10A, auditors must report the possible illegal act directly to the appropriate person(s) and/or entity, as follows:

• (i) Directly to a member of the company’s appropriate management level;
• (ii) Directly to the appropriate member(s) of the issuer’s audit committee;
• (iii) Directly to the issuer’s board (and to the SEC, if warranted) in respect to a specified material illegal act;
• (iv) Directly to the SEC (and to the appropriate member(s) of the issuer’s board and/or audit committee, if warranted) if the issuer’s board fails to notify the SEC of a specified material illegal act as required; and
• (v) Directly to the SEC (and to the appropriate person(s) or entity, if warranted) in respect to all other circumstances.

What are the Requirements for Reporting to the SEC Under Section 10A?

Under Section 10A, when an auditor reports to the SEC of a specified material illegal act, the issuer’s board has one business day to notify the SEC of the same illegal act as a result of the auditor’s report. If the board fails to notify the SEC in a timely manner, the auditor has the option to resign or, in the auditor’s judgment, report the illegal act to the SEC.

What are the Obligations of the Audit Committee and Board of Directors Regarding the Receipt of “Whistleblower” Allegations, Evidence of Fraud, and Other Issues with Financial Reporting and Controls?

Under the Exchange Act, issuers’ audit committees must investigate (i) “any written complaints, or internal or external auditor allegations, relating to accounting, internal accounting controls, or auditing matters”; (ii) “any fraud involving management or others who have a significant role in the issuer’s financial reporting process or who have oversight of the issuer’s financial reporting process”; and (iii) “any other matter reported to the audit committee by an independent public accounting firm concerning any failure or deficiency in the issuer’s internal accounting controls, or any material weaknesses in the issuer’s internal control over financial reporting.”

If you are facing this situation, Spodek Law Group handles federal criminal defense matters nationwide, from offices in New York and Los Angeles.

What Happens During an SEC Investigation of an Accountant or Auditing Firm?

SEC enforcement matters may progress through the following stages:

• (i) Preliminary inquiries (Informal investigation);
• (ii) Formal investigations; and
• (iii) Litigation (Administrative proceedings or judicial litigation).

An informal investigation involves voluntary requests for information, and the formal investigation involves compulsory process. However, regardless of whether the SEC is conducting an informal inquiry or formal investigation, the legal implications and stakes remain the same.

If the SEC determines that it is warranted to conduct a formal investigation, the Commission’s staff will seek authorization to issue subpoenas for the attendance of witnesses and for the production of documentary evidence under Section 21(b) of the Exchange Act. The Commission will then issue a formal investigative order designating the specific staff members who are authorized to issue subpoenas in connection with the investigation.

What are the Key Aspects of a Formal SEC Investigation?

Key aspects of a formal SEC investigation include:

• (i) Subpoenas for Attendance and Production of Documents, where the SEC will compel accountants, audit firms, and other targets to appear before the Commission’s staff and/or produce relevant records;
• (ii) Testimony, where testimony is taken under oath; an accountant, auditor, or other witness is entitled to have counsel present during testimony, and counsel is permitted to intervene during questioning on behalf of the witness;
• (iii) Review of Documentary Evidence, where the SEC reviews the responsive records that were produced by accountants, auditors, and other targets in response to subpoenas for the production of documents; and, and
• (iv) Legal Theories and Applications, where the SEC staff assesses the factual record (i.e. testimony and records produced in response to subpoenas) in light of the applicable securities laws and applicable theories of liability in order to determine if and what charges to pursue, if any.
• Note that while there are many privileges recognized in a formal investigation (i.e. attorney-client, work product, and company-specific privileges), federal law does not recognize a general accountant-client privilege (i.e. the relationship between an accountant/auditing firm and its client is not privileged as a general matter).

What are the Key Stages of the SEC’s Enforcement Process Following a Formal Investigation?

Following a formal investigation, if warranted, the SEC staff will issue a Wells notice to the target(s) of the investigation. A Wells notice sets forth the specific charges that the SEC’s staff is contemplating and provides an opportunity for the recipient(s) to make a written response addressing the charges. The SEC staff then reviews the Wells response(s) and makes a recommendation to the Commission as to whether to issue a formal order instituting proceedings or to file a complaint in federal district court.

What can Auditors and Accountants Do to Mitigate SEC Enforcement Liability?

In order to mitigate potential SEC enforcement liability, auditors and accountants will typically look to invoke the SEC’s “Seaboard” framework. Under this framework, the SEC considers the following factors in order to determine whether to impose sanctions:

• (i) Self-policing (i.e. the extent to which an auditing firm investigated the suspected violations within the auditing firm);
• (ii) Self-reporting (i.e. the extent to which the auditing firm promptly disclosed suspected violations to the SEC);
• (iii) Remediation (i.e. the extent to which the auditing firm has remedial action against the offending staff members); and
• (iv) Cooperation (i.e. the extent to which the auditing firm co-operated with the SEC’s investigation).

While the Seaboard framework is an important consideration for auditors and accountants facing SEC scrutiny, it does not address all potential issues. For example, an auditor will still need to assess whether engagement in prohibited nonaudit services compromise(s) auditor independence with respect to an issuer’s financial reporting disclosures.

What Outcomes Can Follow an SEC Enforcement Action?

A settlement of an SEC enforcement action with an auditor or accounting firm that is the target of the enforcement action requires the approval of the Commission before it becomes final. The Commission then issues an order and/or judgment, which will impose sanctions, and which can include:

• (i) Disgorgement, which is governed by Section 21(d) of the Exchange Act (i.e. and requires proof of scienter under certain circumstances, as discussed above);
• (ii) Injunctions, which are governed by Section 21(d) of the Exchange Act; and
• (iii) Civil Penalties, which are governed by Section 21(d) of the Exchange Act (i.e. and are subject to statutory monetary caps).

The U.S. Supreme Court’s Liu v. SEC ruling is a crucial development in this area as it generally limits equitable disgorgement to “net profits” that are awardable for victims. As a result, auditor and accounting firm liability based on disgorgement must be limited to the specific benefits obtained through illegal conduct.

What are Settlement Undertakings?

Settlement undertakings impose continuing obligations that go beyond the monetary payments imposed by a settlement with the SEC. This includes obligations to engage in remedial training and reporting as necessary, adopt internal safeguards to facilitate compliance with the applicable securities laws, and cooperate with the Commission’s staff.

What are the Statutes of Limitations in SEC Enforcement?

While there are different statutes of limitation in respect to criminal proceedings (which have a five-year statute of limitations under 18 U.S.C. § 3282, subject to tolling), civil penalties, and disgorgement, statutory deadlines and requirements are complex. While the statute of limitations for a civil penalty with respect to an SEC violation of the Exchange Act is generally five years (i.e. under 28 U.S.C. § 2462), the statute of limitations for disgorgement with respect to a knowing or reckless violation of the Exchange Act is ten years (i.e. under Section 21(d)(8) of the Exchange Act).

How Does the Supreme Court’s Ruling in SEC v. Jarkesy Affect SEC Proceedings?

The U.S. Supreme Court’s ruling in SEC v. Jarkesy fundamentally changed the way the SEC is able to seek civil penalties when pursuing an enforcement action in the financial services and corporate world. With respect to civil penalties, the SEC can no longer rely on administrative law judges to impose sanctions. When seeking civil penalties, the SEC will instead need to pursue a jury trial in federal district court. This means that federal-court proceedings, which proceed under the Federal Rules of Civil Procedure and Evidence, can now take much longer to resolve.

How Do Parallel Proceedings Affect an Accountant’s Defense Strategy?

Parallel proceedings can (and frequently do) impact an accountant’s defense strategy in complex ways. Often, state accountancy boards can impose professional discipline independently of federal regulators, while the Department of Justice can pursue criminal charges independently of SEC regulatory proceedings.

Depending on the nature of an alleged securities violation, an accountant or accounting firm can face parallel proceedings from the SEC, PCAOB, private plaintiffs, and (potentially) foreign regulators, as well as from the DOJ. The issue of liability can also carry professional consequences, including licensing issues, debarment from providing services to the government or regulated industries, coverage denial by professional liability insurance carriers, and reputational fallout.

As a general matter, SEC enforcement and PCAOB discipline operate through separate regulatory processes. While the two may overlap in both respect to scope and timing, they are both subject to different procedural rules, standards, and oversight.

What is the PCAOB’s Authority and Responsibility?

Under Section 105 of Sarbanes-Oxley, the PCAOB has the authority to investigate and to impose professional discipline on registered accounting firms and associated persons, i.e., “any individual with respect to whom the public company’s auditor (i) has conducted the audit, review, or attestation engagement referred to in Section 102(a) of this Act or (ii) who has the authority to sign audit reports on behalf of the public company’s auditor.” Along with the SEC, the PCAOB monitors registered firms’ and registered firms’ associated persons’ audits of public companies.

The PCAOB’s authority under Section 105 to investigate and to impose discipline allows for separate proceedings against registered firms and registered firms’ associated persons. This means that, in both the investigative and the adjudicative stages, registered firms and their associated persons (i.e., accountants and auditors) can be treated separately, with each being subject to separate penalties, restrictions, and discipline.

What are the Risks of Accounting Fraud Allegations?

Accounting fraud allegations against individuals or firms will raise concerns of regulatory, criminal, and private civil liability and enforcement. While each of these cases can be decided independently (i.e. without relying upon the result of any other proceeding), a result in one proceeding can often provide justification for pursuing action under another, particularly when this proceeding leads to a conclusion of criminal scienter or a civil fraud violation.

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Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.