[Federal Register Volume 62, Number 52 (Tuesday, March 18, 1997)]
[Rules and Regulations]
[Pages 12743-12750]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-6712]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210 and 240
[Release No. 34-38387; IC-22553; FR-49; File No. S7-20-96]
RIN 3235-AG70
Implementation of Section 10A of the Securities Exchange Act of
1934
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is adopting revisions to its rules to implement the reporting
requirements in section 10A of the Securities Exchange Act of 1934 (the
``Exchange Act''). Section 10A requires, among other things, that the
auditor of an issuer's financial statements report to the issuer's
board of directors certain uncorrected illegal acts of the issuer, and
that the issuer notify the Commission that it has received such a
report. If the issuer fails to provide that notice, the auditor is
required by section 10A to furnish directly to the Commission the
report given to the Board. The amendments to the Commission's Exchange
Act Rules implement those reporting requirements. The Commission also
is adopting revisions to Regulation S-X to conform the definition of
``audit'' in that regulation with the wording in section 10A.
EFFECTIVE DATE: The rule revisions are effective April 17, 1997.
FOR FURTHER INFORMATION CONTACT: Robert E. Burns or W. Scott Bayless,
at (202) 942-4400, Office of the Chief Accountant, Mail Stop 11-3, or
Kathleen Clarke, at (202) 942-0724, Division of Investment Management,
Mail Stop 10-6, Securities and Exchange Commission, 450 Fifth Street,
NW., Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to its
Exchange Act Rules, 17 CFR 240, by adding Rule 10A-1, and
Regulation S-X, 17 CFR 210, by revising Rule 1-02.
[[Page 12744]]
I. Background
Title III to the Private Securities Litigation Reform Act of 1995
(the ``Reform Act''), Public Law No. 104-67, enacted on December 22,
1995, added section 10A to the Exchange Act. As discussed below,
section 10A requires that each audit under the Exchange Act 1
include procedures regarding the detection of illegal acts, the
identification of related party transactions, and the evaluation of the
issuer's ability to continue as a going concern. Section 10A also
codifies certain professional auditing standards regarding the
detection of illegal acts 2 by issuers and imposes expanded
obligations on auditors 3 to report in a timely manner certain
uncorrected illegal acts to an issuer's board of directors. It further
requires the issuer, or if the issuer fails to do so then the auditor,
to provide information regarding the illegal act to the Commission.
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\1\ Because section 10A applies to audits under the Exchange
Act, it and Rule 10A-1 apply to audits of the financial statements
of foreign private issuers that are required under that Act.
\2\ Section 10A(f) defines the term ``illegal act'' broadly to
mean ``an act or omission that violates any law, or any rule or
regulation having the force of law.'' This definition is consistent
generally with Statement on Auditing Standards No. 54, ``Illegal
Acts by Clients,'' para. 2 (January 1, 1989), AU Sec. 317.02, which
states, ``the term illegal acts * * * refers to violations of laws
or governmental regulations.''
\3\ For the purpose of this release, the term ``auditor'' refers
to any independent public or certified public accountant who is
performing or has performed an audit of a registrant's financial
statements and whose audit report has or will be filed with the
Commission in accordance with the federal securities laws or the
Commission's regulations. See, e.g., sections 12(b)(1) (J) and (K),
13(a)(2), and 17(e) of the Exchange Act, 15 U.S.C. 78l(b)(1) (J) and
(K), 78m(a)(2), and 78q(e), and the Commission's Regulation S-X, 17
CFR Sec. 210. The term ``independent accountant'' is used in the
regulatory text in order to be consistent with existing provisions
in Regulation S-X.
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On August 22, 1996, the Commission published for comment proposed
revisions to its rules to implement the reporting requirements set
forth in section 10A and to amend the definition of ``audit'' in
Regulation S-X to conform with the provisions of that section.4
The Proposing Release contains a discussion of each paragraph of
section 10A. Interested parties may wish to refer to the Proposing
Release for additional background information.
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\4\ Securities Exchange Act Release No. 37594, Investment
Company Act Release No. 22162, File No. S7-20-96 (August 22, 1996)
[61 FR 45730] (the ``Proposing Release'').
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More specifically, section 10A(a) provides that each audit required
by the Exchange Act of issuers' financial statements include, ``in
accordance with generally accepted auditing standards, as may be
modified or supplemented from time to time by the Commission--''
1. Procedures designed to provide reasonable assurance of detecting
illegal acts that would have a direct and material effect on the
determination of financial statement amounts;
2. Procedures designed to identify related party transactions that
are material to the financial statements or otherwise require
disclosure therein; and
3. An evaluation of whether there is substantial doubt about the
issuer's ability to continue as a going concern during the ensuing
fiscal year.5
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\5\ Section 10A(a) (1), (2), and (3).
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Certain procedures in each of these three areas already are
required by generally accepted auditing standards (``GAAS'') 6 in
the United States and are further codified in the Statements on
Auditing Standards (``SAS'') 7 adopted by the Auditing Standards
Board (``ASB''), the senior technical body for auditing matters of the
American Institute of Certified Public Accountants (``AICPA''). 8
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\6\ In February 1941, the Commission amended Rule 2-02 of
Regulation S-X, 17 CFR Sec. 210.2-02, to require that the
independent accountant state in his or her report ``whether the
audit was made in accordance with generally accepted auditing
standards * * *'' Accounting Series Release No. 21 (February 5,
1941). In this release, the Commission defined ``generally accepted
auditing standards'' to mean the application of ``generally
recognized normal auditing procedures'' with professional competence
by properly trained persons. The Commission defined ``generally
recognized normal auditing procedures'' to be those normally
employed by skilled accountants and those prescribed by
authoritative bodies dealing with the subject of auditing, such as
accounting societies and governmental bodies having jurisdiction in
the area. Id. Following this addition to the Commission's rules, the
relevant professional committee at the time, the Committee on
Auditing Procedure, began a study to determine which auditing
standards should be included within ``GAAS.'' In 1948, the
membership of the predecessor organization to the American Institute
of Certified Public Accountants (``AICPA'') approved ten standards
as constituting GAAS. See, AICPA, Codification of Statements on
Auditing Standards, AU Sec. 150.02. These ten standards are
supplemented by Statements on Auditing Standards, which currently
are issued by the Auditing Standards Board of the AICPA.
\7\ Currently effective Statements on Auditing Standards are
published by the American Institute of Certified Public Accountants
in the Codification of Statements on Auditing Standards. Provisions
in the Codification are designated as ``AU Sec. __.'' For standards
addressing those procedures mandated by section 10A, see SAS 54,
``Illegal Acts by Clients'' (January 1, 1989), AU Sec. 317; SAS 45,
``Related Parties'' (September 30, 1983), AU Sec. 334; and SAS 59,
64, and 77 reprinted in ``The Auditor's Consideration of an Entity's
Ability to Continue as a Going Concern'' (January 1, 1989), AU
Sec. 341. See also SAS 53, ``The Auditor's Responsibility to Detect
and Report Errors and Irregularities'' (January 1, 1989), AU
Sec. 316. The ASB recently adopted a revision to SAS 53, which will
be entitled ``Consideration of Fraud in a Financial Statement
Audit'' and designated as SAS 82. This new standard should be
published in Spring 1997 and will be applicable to the audits of
1997 financial statements.
\8\ The ASB's 15 members serve on a part-time basis and are
appointed for one year terms that may be extended for up to three
years.
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In addition to the requirement in section 10A(a) that auditors
perform procedures designed to enhance the detection of fraudulent
financial reporting, section 10A(b) contains provisions that would
require an auditor to report directly to the Commission certain
detected illegal acts if the issuer fails to do so.
Under section 10A(b), if, while conducting the audit of the
issuer's financial statements, the auditor becomes aware of information
indicating that an illegal act (whether or not material to the
financial statements) has occurred or may have occurred, then the
auditor would be required, in accordance with GAAS, ``as may be
modified or supplemented from time to time by the Commission,'' to
determine whether it is ``likely'' that an illegal act has occurred
and, if so, its possible effect on the financial statements (including
any contingent monetary effects, such as fines, penalties, and
damages).9 The auditor would be required to inform the issuer's
management of the illegal act ``as soon as practicable.'' In addition,
the auditor must assure him/herself that the issuer's board of
directors is adequately informed, by management or otherwise, of any
detected illegal act.10
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\9\ Section 10A(b)(1)(A). See, SAS 54, Paras. 10-15, AU
Sec. 317.10-.15. Paragraph 11 of SAS 54 sets forth additional audit
procedures that might be necessary once the auditor becomes aware of
a possible illegal act.
\10\ Section 10A(b)(1)(B). See, SAS 54, para. 17, AU
Sec. 317.17.
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Although GAAS contains procedures for similar notification of
illegal acts to managements and boards of directors,11 section
10A(b) contains the additional requirement that these notifications
occur ``as soon as practicable.'' 12
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\11\ See, SAS 54, Paras. 10 and 17, AU Sec. 317.10 and .17.
\12\ The addition of this time period reflects the original
legislative efforts in this area to provide an earlier warning to
the SEC of registrants' potential illegal acts than may occur under
the current Form 8-K procedures, see note 20 infra, and in audit
reports. See H.R. Rep. No. 102-890, 102d Cong., 2d Sess. 3 (1992),
which contained the predecessor legislation to Section 10A and
stated:
This legislation amends the Securities Exchange Act of 1934
(Exchange Act) to improve fraud detection and disclosure with
respect to public companies by codifying auditing standards in
certain specified areas and by providing a mechanism for earlier
warning to the Securities and Exchange Commission of certain illegal
acts by registrants.
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After the auditor determines that the audit committee or the board
of directors has been adequately informed of an illegal act and the
auditor reaches
[[Page 12745]]
three specified conclusions, the auditor is required by section
10A(b)(2) to report those conclusions directly to the board of
directors ``as soon as practicable.'' The three conclusions set forth
in section 10A(b)(2) that trigger the auditor's obligation to report to
the board are that:
1. The illegal act has a material effect 13 on the issuer's
financial statements,
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\13\ The auditor should consider both the quantitative and
qualitative materiality of the act, including contingent liabilities
that might be created by the illegal act. See, e.g., SAS 54, para.
13, AU Sec. 317.13, and SAS 47, ``Audit Risk and Materiality in
Conducting an Audit,'' para. 6 (June 30, 1984), AU Sec. 312.06.
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2. Senior management has not taken, and the board of directors has
not caused senior management to take, timely and appropriate remedial
actions with respect to the illegal act, and
3. The failure to take remedial action is reasonably expected to
warrant either a departure from the auditor's standard audit
report,14 when made, or the auditor's resignation from the audit
engagement.15
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\14\ See, SAS 58, ``Reports on Audited Financial Statements,''
para. 10 (January 1, 1989), AU Sec. 508.10, for a general discussion
of the circumstances that may require the auditor to depart from the
standard report and the types of opinions, other than the standard
report, that may be expressed by the auditor in various
circumstances.
\15\ Section 10A(b)(2) (A), (B), and (C). See generally, SAS 54,
Paras. 18-22, AU Sec. 317.18-.22.
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If the board of directors receives a report that the auditor has
reached these conclusions, then the board has one business day to
notify the Commission that it received such a report. If the auditor
does not receive a copy of the board's notice to the Commission within
that one business day period, then by the end of the next business day
the auditor is required to furnish directly to the Commission a copy of
the report given to the board (or the documentation of any oral report
16).17 The auditor's resignation from the audit engagement
does not negate the auditor's obligation to furnish his or her report
to the Commission in these circumstances.18
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\16\ For documentation requirements under GAAS, see, e.g., SAS
54, para. 17, AU Sec. 317.17, and SAS 61, ``Communication with Audit
Committees,'' para. 3 (January 1, 1989), AU Sec. 380.03.
\17\ Section 10A(b)(3).
\18\ Section 10A(b)(4).
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II. Discussion of Rule Amendments
A. Rule 10A-1.
Rule 10A-1 is based on the premise that the notices and reports
under section 10A are to assist the Commission in performing its
enforcement responsibilities and, therefore, will be non-public.
Disclosure to the public of issuers' illegal acts will continue to be
made in modified audit reports 19 or, when the auditor has
resigned, been dismissed, or elected not to stand for re-election, on
Form 8-K 20 under the Exchange Act and on Form N-SAR 21 under
the Investment Company Act of 1940 (the ``Investment Company Act''),
among others.
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\19\ For the effect of illegal acts on the audit report, see,
SAS 53, Paras. 26 and 27, AU Sec. 316.26 and .27, and SAS 54,
Paras. 18-21, AU Sec. 317.18-.21. See generally, SAS 58, 64, and 79
reprinted in Reports on Audited Financial Statements (January 1,
1989), which describes the standard report and the various opinions
that may be reflected in the auditor's report. SAS 58, Paras. 7-10,
AU Sec. 508.07-.10.
\20\ Item 4 of Form 8-K, 17 CFR Sec. 249.308, Item 304 of
Regulation S-K, 17 CFR Sec. 229.304, and Item 304 of Regulation S-B,
17 CFR Sec. 228.304. In summary, these provisions state that a
registrant must file a Form 8-K, providing the information required
by item 4 of that form, within five business days of the date that
the registrant's auditor (or an independent accountant upon whom the
auditor expressed reliance in its audit report regarding a
significant subsidiary) resigns, declines to stand for re-election,
or is dismissed, and within five business days of the date a new
auditor is engaged. The registrant is to ask the former auditor to
provide the registrant with a letter indicating whether the former
auditor agrees with the disclosures in the Form 8-K that reports the
termination of the audit engagement and, if not, the respects in
which the auditor disagrees. This letter is to be filed with the
Commission as an exhibit by amendment to the registrant's Form 8-K
within 10 business days of the date that the Form 8-K was filed.
The registrant's Form 8-K must state, among other things:
whether the former auditor resigned, was dismissed, or declined to
stand for re-election and the date thereof; whether the auditor
modified his or her report on the registrant's financial statements
for either of the last two fiscal years and, if so, the nature of
the modification; whether the decision to change auditors was
recommended or approved by the audit committee or board of
directors; whether, in connection with the audits of the financial
statements for the two most recent fiscal years, and any subsequent
interim period, there were any disagreements between the auditor and
the registrant on any matter of accounting principles or practices,
auditing scope or procedure, or financial statement disclosure. The
Form 8-K also must provide disclosure of any instance within the
applicable time period where the former auditor advised the
registrant that (1) The internal controls necessary for the
registrant to develop reliable financial statements did not exist,
(2) information had come to the auditor's attention that led him or
her no longer to be able to rely on management's representations, or
that made the auditor unwilling to be associated with the
registrant's financial statements, (3) there was a need to expand
significantly the scope of the audit and, due to the auditor's
resignation or for any other reason, the scope was not expanded, or
(4) information had come to the auditor's attention affecting the
reliability of past audit reports or financial statements and the
issue had not been resolved to the auditor's satisfaction prior to
the auditor's resignation, dismissal, or declination to stand for
re-election.
\21\ Sub-item 77K of Form N-SAR, 17 CFR Sec. 274.101, requires
investment companies filing Form N-SAR to provide the information
required by item 4 of Form 8-K. Sub-item 77K of Form N-SAR notes
that notwithstanding the requirements in Form 8-K to file more
frequently, registrants need only file such information semi-
annually in accordance with the requirements of Form N-SAR.
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In testifying on prior bills that contained the same reporting
requirements, the Commission stated, ``[W]e anticipate that reports
filed under section 10A would be confidential and exempt from
disclosure under the Freedom of Information Act.'' 22 The
Commission further noted,
\22\ Testimony of Richard C. Breeden, Chairman, U.S. Securities
and Exchange Commission, Concerning H.R. 574, The Financial Fraud
Detection and Disclosure Act, Before the Subcommittee on
Telecommunications and Finance of the House Committee on Energy and
Commerce, 103d Cong., 1st Sess., 32 (February 18, 1993).
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Premature disclosure of the issuer and auditor reports could,
among other things, interfere with the Commission's investigation,
deprive the issuer or other persons of the right to a fair trial or
impartial adjudication, constitute an unwarranted invasion of
privacy, or disclose a confidential source. In addition, issuer and
auditor reports under Section 10A might contain confidential
commercial or financial information exempt from disclosure under
FOIA Exemption 4, 5 U.S.C. 552(b)(4).23
\23\ Id., at 32 n. 36.
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The Commission's testimony also states that the direct reporting
provisions in the bill might provide an earlier warning of certain
illegal acts that could allow the Commission to begin enforcement
investigations at an earlier date.24
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\24\ Id., at 31.
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Accordingly, Rule 10A-1 provides that section 10A notices provided
by the board and reports submitted by the auditor will be non-public
and exempt from disclosure under the Freedom of Information Act
(``FOIA'') to the same extent as the Commission's investigative
records.25
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\25\ Rule 10A-1(c). See also 5 U.S.C. 552(b)(7), which exempts
from disclosure certain ``records or information compiled for law
enforcement purposes.''
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Commentators responding to the Proposing Release supported the
position that reports and notices under section 10A should be non-
public. Some suggested, however, that proposed Rule 10A-1 was unclear
as to the availability of FOIA exemptions, in addition to the
exemptions for investigative records, for the information contained in
these notices and reports. An instruction has been added to Rule 10A-
1(c), therefore, specifically to notify issuers and auditors that they
may apply for confidential treatment under additional FOIA exemptions
in accordance with the Commission's normal procedures.26
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\26\ See 17 CFR Sec. 200.83.
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Despite the confidential nature of the reports under section 10A,
these reporting requirements should improve the quality of public
disclosures in
[[Page 12746]]
Forms 8-K and N-SAR and in audit reports on issuers' financial
statements, because it is unlikely that issuers and auditors will make
public disclosures that are incompatible with the confidential reports
made to the Commission. Also, the direct reporting requirements in
section 10A should give auditors additional leverage to prompt
management to correct illegal acts and to make appropriate adjustments
in their financial statements.
Rule 10A-1 designates the Commission's Office of the Chief
Accountant (``OCA'') as the appropriate office to receive the notice
provided by any issuer under section 10A(b)(3) 27 and any reports
provided by auditors under section 10A(b)(3) or 10A(b)(4).28 No
commentators objected to OCA as the designated party to receive these
notices and reports. OCA expeditiously will forward copies of the
notice or report to all appropriate offices and divisions within the
Commission. The notice or report may be provided to other authorities,
as appropriate.29
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\27\ Rule 10A-1(a).
\28\ Rule 10A-1(b).
\29\ See 17 CFR Sec. 240.24c-1.
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Delivery of the notice or report to OCA may occur under Rule 10A-1
in any manner, provided the notice or report is received by OCA within
the statutory time period.30 Currently, the most timely manner of
delivery may be through submission of a facsimile,31 telegraph, or
personal delivery. Issuers should be aware that providing such
information on the Edgar filing system, however, may result in the
information becoming available to the public. In the future, procedures
may be developed for issuers and auditors to deliver confidential
information directly to OCA via electronic mail. Rule 10A-1 would
permit use of such means of delivery.32
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\30\ Rule 10A-1 (a) and (b).
\31\ The phone number for OCA's facsimile machine currently is
(202) 942-9656. Such phone numbers, however, are subject to change
without notice and registrants and auditors should verify the
accuracy of the number before use.
\32\ A similar provision applies to auditors of broker-dealers.
See Rule 17a-5(h)(2) under the Exchange Act, 17 CFR Sec. 240.17a-
5(h)(2), which states that if, during the course of audit or interim
work, the auditor determines that any material inadequacies exist in
the accounting system, internal accounting control, procedures for
safeguarding securities, or certain other practices and procedures,
then the auditor shall call those inadequacies to the attention of
the chief financial officer of the broker-dealer, who has the
obligation to notify the Commission and the designated examining
authority within 24 hours thereafter. If the auditor does not
receive a copy of that notice within that 24 hour period, or if the
auditor disagrees with the statements in the notice, then the
auditor must inform the Commission and the designated examining
authority of the material inadequacy within the next 24 hours.
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Rule 10A-1(a) also sets forth the required contents for a issuer's
notice to the Commission. This notice must be in writing and identify
the issuer and the auditor, and state the date the auditor made its
report to the board. Under the rule proposal, the issuer also would
provide a summary of the report. The summary would describe the act and
the potential impact of that act on the issuer's financial statements.
This information is consistent with the requirement under GAAS that the
auditor's communication with the issuer's audit committee ``should
describe the act, the circumstances of its occurrence, and the effect
on the financial statements.'' 33 One commentator suggested that
issuers have the option of providing either the summary of the
independent accountant's report, as proposed, or directly providing
that report to OCA. This commentator noted, however, that if an issuer
submits the independent accountant's report to OCA a question may arise
regarding the availability to the independent auditor of the section
10A(c) protection against civil liability for the findings,
conclusions, or statements in his or her report.34 As adopted,
Rule 10A-1 incorporates the commentator's suggestion and permits
issuers the option of providing either a summary of the independent
accountant's report or a copy of that report. To clarify the
application of the section 10A(c) safe harbor, Rule 10A-1 now provides
that the safe harbor available to auditors shall apply not only when
the report is furnished to OCA by the auditor but also when it is
provided by the issuer.
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\33\ SAS 54, para. 17, AU Sec. 317.17.
\34\ Section 10A(c) limits auditors' liability in private rights
of action for ``any finding, conclusion, or statement expressed in a
report made pursuant to paragraph (3) or (4) of subsection (b),
including any rule promulgated pursuant thereto''; paragraphs (3)
and (4) of subsection (b) set forth the issuer and auditor reporting
obligations.
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As had been proposed, Rule 10A-1(a) also specifically permits an
issuer to include additional information with the required notice to
the Commission regarding the issuer's view of, and response to, the
section 10A report it has received from the auditor.
Regarding reports filed by auditors, Rule 10A-1(b) specifies that
if the report does not identify clearly both the issuer and the
auditor, then the auditor must attach that information to the report
submitted to OCA.
Rule 10A-1 makes clear that providing the notice or report in
accordance with section 10A and Rule 10A-1 does not, in any way, affect
the obligations of the issuer and the auditor to file and make all
applicable public disclosures required by the Commission's rules,
including, without limitation, Forms 8-K and N-SAR, and of the auditor
to comply with GAAS reporting requirements.35 Similarly, Rule 10A-
1 states that the confidential nature of the notice and the report to
the Commission does not diminish an issuer's or auditor's obligations
to make full disclosures required by the Commission's rules, forms,
reports, or disclosure items, or by applicable professional standards.
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\35\ In addition, one of the membership requirements of the SEC
Practice Section of the AICPA is that members notify registrants in
writing of the cessation of an auditor-client relationship. The
member also is required to send a copy of that notification to the
Commission's Office of the Chief Accountant.
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In response to the Proposing Release, the Commission received
additional comments requesting it to interpret or amend certain
additional provisions of section 10A. For example, some commentators
suggested that the Commission amend the statutory definition of
``illegal act'' to follow more closely the definition in the auditing
literature.36 Another commentator recommended that auditors be
required to report all illegal acts to the board of directors (as
opposed to management), not merely those acts that are material to the
financial statements. One commentator suggested that the Commission
extend the protection for auditors against civil liability found in
section 10A(c) for statements in reports submitted to the Commission
under section 10A(b), to statements made by the auditor in additional
documents and in other contexts. Commentators also requested that the
Commission extend the one-business-day reporting periods in the statute
to five business days. Such comments, however, are beyond the scope of
this rulemaking proceeding and, in some cases, request that the
Commission promulgate rules contrary to the statutory mandate of
section 10A.
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\36\ See SAS 54, para. 2, AU Sec. 317.02, discussed supra note
2.
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B. Rule 1-02(d)
The Commission is adopting the proposed amendment to conform the
definition of ``Audit (or examination)'' in Rule 1-02(d) of Regulation
S-X with section 10A. The amendment notes that audits of the financial
statements of Commission issuers should be performed ``in accordance
with generally accepted auditing standards, as may be modified or
supplemented by the Commission.'' The purpose of this amendment is to
alert auditors and issuers to the possibility that additional
[[Page 12747]]
audit procedures, beyond those required by GAAS, may be required by the
Commission in certain circumstances.
Some commentators objected to the proposed revision of Rule 1-02(d)
on the ground that the Commission's statutory authority to modify or
supplement GAAS is limited to the three circumstances expressly set
forth in section 10A; i.e., illegal acts, related party transactions,
and going concern evaluations.
On the contrary, it has long been recognized by Congress and the
Commission, that the Commission has broad authority to establish
auditing requirements for public companies and their independent audit
firms.37 This implied authority is based on, among other things,
(1) the Commission's authority to prescribe the reports to be filed
with it,38 (2) the provisions in the securities laws that require,
or grant the Commission the authority to require, that certain
financial statements be ``certified * * * by independent public
accountants'' 39 and the Commission's authority to define
technical and trade terms such as ``certified,'' 40 and (3) the
Commission's authority to ensure that the representations in audit
reports and the procedures behind those reports fulfill their statutory
function.41 In enacting the Reform Act, Congress clearly intended
to preserve the Commission's existing implied authority regarding
auditing standards, as evidenced by both the preservation clause in
section 10A(e) and the Conference Committee Report.42
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\37\ See Report by the Subcommittee on Oversight and
Investigations of the House Committee on Interstate and Foreign
Commerce, Federal Regulation and Regulatory Reform, 94th Cong., 2d
Sess., 38 (October 1976), which states, in part, that the Commission
had not then ``exercised fully its statutory authority to remedy
deficiencies in generally accepted auditing standards''; Report on
the Activity of the Committee on Energy and Commerce for the 100th
Congress, House Report 100-1114, 100th Cong., 2d Sess., 364 (Dec.
23, 1988), which states, ``As the primary Agency responsible for
administering the Federal securities laws disclosure requirements,
the SEC has broad authority to establish auditing and accounting
requirements for public companies and independent audit firms''; and
Testimony of Richard C. Breeden, Chairman, U.S. Securities and
Exchange Commission, Concerning H.R. 547, The Financial Fraud
Detection and Disclosure Act, Before the Subcommittee on
Telecommunications and Finance of the House Committee on Energy and
Commerce, 103rd Cong., 1st Sess., 26-27 (Feb. 18, 1993), which
states, in part, ``The Commission [is] prepared, should it prove
necessary to fulfill its statutory mandate, to establish separate
auditing standards that supplement or supplant ASB standards for SEC
registrants.* * * In the same way the Commission has final authority
over the establishment of new financial standards by the FASB, so
too the Commission has final authority over the establishment of
auditing standards to protect the public interest.''
\38\ See, e.g., Sec. 13(b)(1) of the Exchange Act, 15 U.S.C.
78m(b)(1), which states, ``The Commission may prescribe, in regard
to reports made pursuant to this title, the form or forms in which
the required information shall be set forth.* * *''
\39\ Items 25, 26, and 27 of Schedule A to the Securities Act of
1933, 15 U.S.C. 77aa (25), (26) and (27), and Sec. 17(e) of the
Exchange Act, 15 U.S.C. 78q, expressly require that audited
financial statements be filed with the Commission. Sections 12(b)(1)
(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 78l and 78m,
among others, authorize the Commission to require the filing of
financial statements that have been audited by independent
accountants. The Commission requires that certain financial
statements be audited. See, e.g., Article 3 of Regulation S-X, 17
CFR Sec. 210-3-01 et seq.
\40\ See, e.g., Sec. 19(a) of the Securities Act of 1933, 15
U.S.C. 77s(a), and Sec. 3(b) of the Exchange Act, 15 U.S.C. 78c(b).
\41\ See generally James F. Strother, The Establishment of
Generally Accepted Accounting Principles and Generally Accepted
Auditing Standards, 28 Vand. L. Rev. 201, 225 (1975), which states,
``The Commission's powers with regard to auditing are considerable,
even though it lacks the express authority to prescribe auditing
standards and procedures that it has in the case of accounting
principles.''
In the past, the Commission has not found it necessary formally
to exercise its implied power to set auditing standards. In the mid-
1970s, however, the Commission proposed certain procedures for
auditors' reviews of interim financial statements. See Securities
Act Release No. 5579 (April 17, 1975), Accounting Series Release No.
177 (September 10, 1975), Securities Act Release No. 5612 (September
10, 1975). This rulemaking did not go forward when the predecessor
to the ASB acted to establish similar review procedures, and
Commission action became unnecessary.
\42\ See H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess., 47
(Nov. 28, 1995), which states, in part, ``The Conference Committee
does not intend to affect the Commission's authority in areas not
specifically addressed by this provision.''
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In any event, the revision to Rule 1-02(d) is not intended to
change the substantive scope of the Commission's authority to set
auditing standards, or to resolve any dispute that may arise over the
scope of that authority in particular circumstances. Instead, this
amendment is intended to provide adequate and fair notice to all
parties concerned that the Commission, as well as appropriate
professional authorities, may issue guidance to be considered and
adhered to in the performance of audits under the Exchange Act.
As a general matter, the Commission plans to continue its practice
of looking to the private sector standard setting bodies designated by
the accounting profession to provide leadership in establishing and
improving GAAS. Currently, the Commission staff works closely with the
ASB. The staff, among other things, attends ASB meetings, reviews and
provides the ASB with comments on draft Statements on Auditing
Standards, and has periodic meetings with ASB representatives to
discuss items on the ASB agenda and other matters of mutual concern.
The Commission has no present intention to write any new auditing
standards unless it determines that the ASB, or any subsequently
established standard setting organization, is unable or unwilling to
address a significant auditing issue in an appropriate and timely
manner. The Commission will exercise its discretion in determining the
appropriateness and timeliness of the private sector response,
considering the nature of the issue and other factors. Should
Commission action be deemed necessary, the Commission will act promptly
when required by the public interest or for the protection of
investors.43
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\43\ The Statement of Managers, The Private Securities
Litigation Reform Act of 1995, states, at 22, ``The Conference
Committee intends for the SEC to have discretion, however, to
determine the appropriateness and timeliness of the private sector
response. The SEC should act promptly if required by the public
interest or for the protection of investors.''
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III. Investment Companies
Section 10A and Rule 10A-1 apply to all audits required pursuant to
the Exchange Act, including those prepared on behalf of investment
companies, which, among others, have reporting obligations under the
Exchange Act.44
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\44\ See sections 13(a) and 15(d) of the Exchange Act, 15 U.S.C.
78m(a) and 78o(d), and section 30(a) of the Investment Company Act,
15 U.S.C. 80a-29(a). Form N-SAR requires investment companies to
file information with the Commission about their operations,
including audited financial information. Rule 30a-1 under the
Investment Company Act, 17 CFR Sec. 270.30a-1, provides that
investment companies filing annual reports on Form N-SAR are deemed
to have satisfied the reporting requirements of sections 13(a) and
15(d) under the Exchange Act and section 30(a) under the Investment
Company Act.
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In the proposing release, the Commission requested comment
regarding whether the reporting requirements under Rule 10A-1 should be
modified to reflect the specific operations of investment companies. No
commentators, however, addressed this topic. Accordingly, the
Commission has determined that Rule 10A-1 will be adopted as proposed.
IV. Required Findings Regarding Impact on Competition
In the Proposing Release, the Commission requested comments on
whether the proposed amendments, if adopted, would have an adverse
impact on competition or would impose a burden on competition that is
neither necessary nor appropriate in furthering the purposes of the
Securities Act of 1933 and the Exchange Act. One commentator addressed
this issue, indicating that the reporting provisions of proposed Rule
10A-1 would not add to any such burden that might be imposed by section
10A, especially in
[[Page 12748]]
light of the non-public nature of the reports to be filed under the
Rule.
The Commission has considered the proposed amendments in light of
its responsibilities under section 23(a) of the Exchange Act 45
and concluded that the burdens on competition, if any, are necessary
and appropriate in furtherance of the purposes of the Exchange Act,
particularly section 10A.
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\45\ 15 U.S.C. 78w(a).
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V. Cost/Benefit Analysis
The costs of complying with Rule 10A-1, which is intended to carry
out the purposes of new section 10A of the Exchange Act, are expected
to be de minimis. Such costs for an issuer may include converting the
information in the auditor's report to the board into a notice that
conforms to the rule and delivering that notice, via facsimile or
otherwise, to OCA. Costs for the auditor may include assuring that the
report to the board identifies the issuer, as required by the proposed
rule, and the cost of delivering that report, via facsimile or
otherwise, to OCA.
Benefits of compliance with Rule 10A-1 include an earlier warning
to the Commission of possible illegal acts by issuers and potential
improvements in public disclosures in Forms 8-K and N-SAR regarding
changes in issuers' auditors and in audit reports that are modified due
to issuers' illegal acts.
Commentators specifically addressing the issue indicated either
that the anticipated benefits of Rule 10A-1 outweigh the associated
costs, or that the minimal reporting requirements under Rule 10A-1
would not add to any burdens imposed by section 10A of the Exchange
Act.
VI. Summary of Final Regulatory Flexibility Analysis
A Final Regulatory Flexibility Analysis (``FRFA'') concerning Rule
10A-1 has been prepared in accordance with 5 U.S.C. 604. The FRFA notes
that the rule is intended to implement the reporting requirements of
section 10A of the Exchange Act as mandated by Congress. The rule will
not impose any reporting requirements additional to those imposed by
section 10A.
As discussed more fully in the FRFA, the rule will affect small
entities, as defined by the Commission's rules, but only in the same
manner as other entities. By statute, most issuers that fit the
Commission's definitions of small entities are subject to a one-year
delay in the effective date of section 10A, which makes section 10A
(and accordingly Rule 10A-1) applicable to annual reports for any
period beginning on or after January 1, 1997 (instead of January 1,
1996).
Regarding issuers, approximately 1,100 Exchange Act reporting
companies satisfy the Commission's definition of ``small business;'' as
of December 1995, approximately 5,200 broker-dealers were classified as
small entities; and as of August 1995, approximately 1,770 active
registered investment companies were considered small entities.
Although some small auditors may be subject to the Rule 10A-1 reporting
requirements, there is no specific definition of the term ``small
auditor'' and information regarding auditors' revenues, earnings, and
similar data is not publicly available.
There is no reliable way of determining how many small issuers or
auditors will be required to file section 10A reports or notices each
year concerning illegal acts so as to become subject to Rule 10A-1. It
is expected, however, that OCA will receive very few issuer notices
each year and even fewer auditor reports (which are filed only if an
issuer fails to fulfill its reporting obligation).
The FRFA notes that alternatives for providing different means of
compliance for small entities or for exempting small entities from the
rule would be inconsistent with the statutory requirements of section
10A. The cost of complying with the rule should be de minimus, even for
small entities, because the reporting requirements under section 10A
and the rule are based on existing GAAS requirements. Moreover, the
statute essentially requires only an earlier warning regarding matters
that would otherwise be disclosed in Forms 8-K and N-SAR and in audit
reports on issuers' financial statements.
The Commission received no comments on the Initial Regulatory
Flexibility Analysis (``IRFA'') prepared in connection with the
proposing release, and no comment letters specifically addressed to the
IRFA. Two commentators indicated that the anticipated benefits of Rule
10A-1 outweigh the associated costs, and that the minimal reporting
requirements of Rule 10A-1 would not materially add to the burdens
Congress chose to impose by enacting section 10A.
A copy of the analysis may be obtained by contacting Robert E.
Burns, Chief Counsel, Office of the Chief Accountant, U.S. Securities
and Exchange Commission, Mail Stop 11-3, 450 Fifth Street, N.W.,
Washington, D.C. 20549.
VII. Paperwork Reduction Act
As set forth in the Proposing Release, proposed Rule 10A-1 contains
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995 [44 U.S.C. 3501 et seq.]. An agency may
not conduct or sponsor, and a person is not required to respond to, a
collection of information unless it displays a valid OMB control
number. Accordingly, the Commission submitted the proposed rules to the
Office of Management and Budget (``OMB'') for review in accordance with
44 U.S.C. 3507(d), and OMB approved that collection and assigned it
control number 3235-0468. This is the final notice regarding the
collection of information under Rule 10A-1.
The Supporting Statement to the Paperwork Reduction Act submission
noted that Rule 10A-1 is intended to implement the reporting
requirements found in recently enacted section 10A of the Exchange Act,
and that the rule is expected to have a negligible effect on the annual
reporting and cost burden of Commission registrants. As discussed
above, the notice to be provided by the issuer would contain the
minimum amount of information necessary to identify the issuer and the
auditor, indicate the date the auditor provided the report to the board
of directors as specified in section 10A, and summarize the report
given to the board. The summary would be based on information required
to be given to the board of directors under GAAS. The auditor's report,
furnished only in the event that the issuer does not fulfill its
reporting responsibilities, would consist only of the report given to
the board of directors and, if necessary, additional information to
identify clearly the issuer and the auditor.
Potential respondents are entities with reporting obligations under
the Exchange Act and their auditors, although it is anticipated that
the reporting requirements under section 10A rarely will be triggered.
On those rare occasions when the reporting requirement is triggered, it
is estimated that the total recordkeeping and reporting burden, beyond
that directly required by the statute, would not exceed one hour per
respondent.
As notices must be filed by an issuer within one day of receiving a
report from its auditor, and the auditor must file its report (if
necessary) the next day, there are essentially no recordkeeping or
retention requirements.
Filing the notices and reports, when necessary, is required by
section 10A of the Exchange Act and therefore is
[[Page 12749]]
mandatory. As explained above, however, the notices and reports will be
kept confidential while the Commission has an enforcement interest in
the information contained in those notices and reports. In addition,
requests for confidential treatment of such information may be made
under 17 CFR 200.83.
The Commission received no comments in response to its request for
comments, pursuant to 44 U.S.C. 3506(c)(2)(B), concerning: whether the
proposed collection of information is necessary for the proper
performance of the function of the Commission, including whether the
information shall have practical utility; the accuracy of the
Commission's estimate of the burden of the proposed collection of
information; the quality, utility, and clarity of the information to be
collected; and whether the burden of collection of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology, may be minimized.
List of Subjects
17 CFR Part 210
Accounting, Reporting and recordkeeping requirements, Securities.
17 CFR Part 240
Reporting and recordkeeping requirements, Securities.
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT
COMPANY ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975
1. The authority citation for Part 210 is revised to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77aa(25),
77aa(26), 78j-1, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d),
79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-
37(a), unless otherwise noted.
2. By revising Sec. 210.1-02(d) to read as follows:
Sec. 210.1-02 Definitions of terms used in Regulation S-X (17 CFR part
210).
* * * * *
(d) Audit (or examination). The term audit (or examination), when
used in regard to financial statements, means an examination of the
financial statements by an independent accountant in accordance with
generally accepted auditing standards, as may be modified or
supplemented by the Commission, for the purpose of expressing an
opinion thereon.
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
3. The authority citation for Part 240 is revised to read in part
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),
79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, and 80b-11,
unless otherwise noted.
* * * * *
4. By adding an undesignated center heading and Sec. 240.10A-1
following Sec. 240.10(b)-21 to read as follows: Reports Under Section
10A
Sec. 240.10A-1 Notice to the Commission Pursuant to Section 10A of the
Act.
(a)(1) If any issuer with a reporting obligation under the Act
receives a report requiring a notice to the Commission in accordance
with section 10A(b)(3) of the Act, 15 U.S.C. 78j-1(b)(3), the issuer
shall submit such notice to the Commission's Office of the Chief
Accountant within the time period prescribed in that section. The
notice may be provided by facsimile, telegraph, personal delivery, or
any other means, provided it is received by the Office of the Chief
Accountant within the required time period.
(2) The notice specified in paragraph (a)(1) of this section shall
be in writing and:
(i) Shall identify the issuer (including the issuer's name,
address, phone number, and file number assigned to the issuer's filings
by the Commission) and the independent accountant (including the
independent accountant's name and phone number, and the address of the
independent accountant's principal office);
(ii) Shall state the date that the issuer received from the
independent accountant the report specified in section 10A(b)(2) of the
Act, 15 U.S.C. 78j-1(b)(2);
(iii) Shall provide, at the election of the issuer, either:
(A) A summary of the independent accountant's report, including a
description of the act that the independent accountant has identified
as a likely illegal act and the possible effect of that act on all
affected financial statements of the issuer or those related to the
most current three-year period, whichever is shorter; or
(B) A copy of the independent accountant's report; and
(iv) May provide additional information regarding the issuer's
views of and response to the independent accountant's report.
(3) Reports of the independent accountant submitted by the issuer
to the Commission's Office of the Chief Accountant in accordance with
paragraph (a)(2)(iii)(B) of this section shall be deemed to have been
made pursuant to section 10A(b)(3) or section 10A(b)(4) of the Act, 15
U.S.C. 78j-1(b)(3) or 78j-1(b)(4), for purposes of the safe harbor
provided by section 10A(c) of the Act, 15 U.S.C. 78j-1(c).
(4) Submission of the notice in paragraphs (a)(1) and (a)(2) of
this section shall not relieve the issuer from its obligations to
comply fully with all other reporting requirements, including, without
limitation:
(i) The filing requirements of Form 8-K, Sec. 249.308 of this
chapter, and Form N-SAR, Sec. 274.101 of this chapter, regarding a
change in the issuer's certifying accountant and
(ii) The disclosure requirements of item 304 of Regulation S-B or
item 304 of Regulation S-K, Secs. 228.304 or 229.304 of this chapter.
(b)(1) Any independent accountant furnishing to the Commission a
copy of a report (or the documentation of any oral report) in
accordance with section 10A(b)(3) or section 10A(b)(4) of the Act, 15
U.S.C. 78j-1(b)(3) or 78j-1(b)(4), shall submit that report (or
documentation) to the Commission's Office of the Chief Accountant
within the time period prescribed by the appropriate section of the
Act. The report (or documentation) may be submitted to the Commission's
Office of the Chief Accountant by facsimile, telegraph, personal
delivery, or any other means, provided it is received by the Office of
the Chief Accountant within the time period set forth in section
10A(b)(3) or 10A(b)(4) of the Act, 15 U.S.C. 78j-1(b)(3) or 78j-(b)(4),
whichever is applicable in the circumstances.
(2) If the report (or documentation) submitted to the Office of the
Chief Accountant in accordance with paragraph (b)(1) of this section
does not clearly identify both the issuer (including the issuer's name,
address, phone number, and file number assigned to the issuer's filings
with the Commission) and the independent accountant (including the
independent accountant's name and phone number, and the address of the
independent accountant's principal office), then the
[[Page 12750]]
independent accountant shall place that information in a prominent
attachment to the report (or documentation) and shall submit that
attachment to the Office of the Chief Accountant at the same time and
in the same manner as the report (or documentation) is submitted to
that Office.
(3) Submission of the report (or documentation) by the independent
accountant as described in paragraphs (b)(1) and (b)(2) of this section
shall not replace, or otherwise satisfy the need for, the newly engaged
and former accountants' letters under items 304(a)(2)(D) and 304(a)(3)
of Regulation S-K, Secs. 229.304(a)(2)(D) and 229.304(a)(3) of this
chapter, respectively, and under items 304(a)(2)(D) and 304(a)(3) of
Regulation S-B, Secs. 228.304(a)(2)(D) and 228.304(a)(3) of this
chapter, respectively, and shall not limit, reduce, or affect in any
way the independent accountant's obligations to comply fully with all
other legal and professional responsibilities, including, without
limitation, those under generally accepted auditing standards and the
rules or interpretations of the Commission that modify or supplement
those auditing standards.
(c) A notice or report submitted to the Office of the Chief
Accountant in accordance with paragraphs (a) and (b) of this section
shall be deemed to be an investigative record and shall be non-public
and exempt from disclosure pursuant to the Freedom of Information Act
to the same extent and for the same periods of time that the
Commission's investigative records are non-public and exempt from
disclosure under, among other applicable provisions, 5 U.S.C. 552(b)(7)
and Sec. 200.80(b)(7) of this chapter. Nothing in this paragraph,
however, shall relieve, limit, delay, or affect in any way, the
obligation of any issuer or any independent accountant to make all
public disclosures required by law, by any Commission disclosure item,
rule, report, or form, or by any applicable accounting, auditing, or
professional standard.
Instruction to Paragraph (c)
Issuers and independent accountants may apply for additional bases
for confidential treatment for a notice, report, or part thereof, in
accordance with Sec. 200.83 of this chapter. That section indicates, in
part, that any person who, pursuant to any requirement of law, submits
any information or causes or permits any information to be submitted to
the Commission, may request that the Commission afford it confidential
treatment by reason of personal privacy or business confidentiality, or
for any other reason permitted by Federal law.
By the Commission.
Dated: March 12, 1997.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-6712 Filed 3-17-97; 8:45 am]
BILLING CODE 8010-01-P
