[Federal Register Volume 63, Number 117 (Thursday, June 18, 1998)]
[Proposed Rules]
[Pages 33305-33311]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16251]
[[Page 33305]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 201
[Release Nos. 33-7546; 34-40089; 35-26884; 39-2364; IA-1726; IC-23250;
File No. S7-16-98]
RIN 3235-AH47
Proposed Amendment to Rule 102(e) of the Commission's Rules of
Practice
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing an amendment to Rule 102(e) of the Commission's Rules of
Practice. Under Rule 102(e), the Commission can censure, suspend or bar
persons who appear or practice before it. The proposed amendment
clarifies the Commission's standard for determining when accountants
engage in ``improper professional conduct'' under Rule 102(e)(1)(ii).
DATES: Comments must be received on or before July 20, 1998.
ADDRESSES: Submit comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 5th Street, NW.,
Washington, DC. 20549-6009. Comments can be submitted electronically at
the following E-mail address: rule-comments@sec.gov. All comment
letters should refer to File No. S7-16-98; include this file number on
the subject line if E-mail is used. All comments received will be
available for public inspection and copying in the Commission's Public
Reference Room, 450 5th Street, NW., Washington, DC. 20549-6009.
Electronically-submitted comment letters will be posted on the
Commission's Internet Web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Michael J. Kigin, Associate Chief
Accountant, Office of the Chief Accountant, at (202) 942-4400; or David
R. Fredrickson, Assistant General Counsel, Office of the General
Counsel, at (202) 942-0890.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today
is proposing for comment an amendment to Rule 102(e). 1
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\1\ 17 CFR 201.102(e).
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I. The Purpose of this Release
The purpose of this release is to solicit comments on a proposed
amendment to Rule 102(e) of the Commission's Rules of Practice. Under
Rule 102(e), the Commission can censure, suspend or bar professionals
who appear or practice before it. 2 Specifically, pursuant
to the Rule, the Commission can impose a sanction upon a professional
whom it finds, after notice and an opportunity for hearing:
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\2\ The Rule addresses the conduct of attorneys, accountants,
engineers and other professionals or experts who appear or practice
before the Commission. 17 CFR 201.102(e)(2) and (f)(2).
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(i) Not to possess the requisite qualifications to represent
others; or
(ii) To be lacking in character or integrity or to have engaged in
unethical or improper professional conduct; or
(iii) To have willfully violated, or willfully aided and abetted
the violation of, any provision of the Federal securities laws or the
rules and regulations thereunder. 3
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\3\ 17 CFR 201.102(e)(1)(i), (ii) and (iii).
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In a recent opinion addressing the conduct of two accountants, the
U.S. Court of Appeals for the District of Columbia Circuit found that
the Commission had not articulated clearly the ``improper professional
conduct'' element of the Rule. 4 To address the court's
concerns, the Commission is proposing an amendment to the text of Rule
102(e) that clarifies the Commission's standard for determining when
accountants engage in ``improper professional conduct.'' 5
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\4\ Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (``Checkosky
II '').
\5\ This clarification addresses the conduct of accountants
only, and is not meant to address the conduct of lawyers or other
professionals who practice before the Commission.
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II. A Brief Overview of Rule 102(e)
A. The Importance of Rule 102(e)
The Commission adopted Rule 102(e) as a ``means to ensure that
those professionals, on whom the Commission relies heavily in the
performance of its statutory duties, perform their tasks diligently and
with a reasonable degree of competence.'' 6 Courts have
recognized that it is appropriate for the Commission to use a
disciplinary mechanism such as Rule 102(e) to encourage professionals
to adhere to ethical standards and minimum standards of competence.
7 In adopting the Rule, the Commission did not intend to add
an ``additional weapon'' to its ``enforcement arsenal'' 8
but to protect its system of securities regulation and, by extension,
the interests of the investing public.
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\6\ Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979).
The AICPA also recognizes that accountants must discharge their
duties with competence. See, e.g., AICPA Professional Standards,
Vol. 2, ET sec. 56 (1997).
\7\ Rule 102(e) was promulgated under the Commission's broad
authority to adopt those rules and regulations necessary for
carrying out the agency's designated functions and its inherent
authority to protect the integrity of the agency's processes. Three
U.S. Courts of Appeals have upheld the validity of Rule 102(e). See
Touche Ross; Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995);
Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986). The Checkosky
opinions held that the Commission had not clearly articulated the
``improper professional conduct'' standard or the rationale for that
standard. Also, the Checkosky opinions did not decide the issue of
the scope of the Commission's authority.
\8\ Touche Ross, 609 F.2d at 579.
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B. The Important Role of Accountants
Accountants play many roles in the Commission's system of
securities regulation. In recognition of the significance of auditors
and audited financial statements in the Commission's disclosure
process, this release focuses particular attention upon the role of
auditors in the securities registration and reporting processes under
the federal securities laws. The proposed amendment, however, covers
all accountants who appear or practice before the Commission.
9
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\9\ See 17 CFR 201.102(f)(1) and (2). The Commission has
interpreted ``practice'' before the Commission to include
accountants functioning in many roles, including those who serve as
officers of public companies. See, e.g., In re Terrano, Securities
Exchange Act of 1934 (``Exchange Act'') Rel. No. 39485 (Dec. 23,
1997), 66 SEC Docket 494 (Jan. 20, 1998); In re Hersh, Exchange Act
Rel. No. 39089 (Sept. 18, 1997), 65 SEC Docket 1170 (Oct. 14, 1997);
In re Bryan, Exchange Act Rel. No. 39077 (Sept. 15, 1997), 65 SEC
Docket 1129 (Oct. 14, 1997).
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``Corporate financial statements are one of the primary sources of
information available to guide the decisions of the investing public.''
10 Various provisions of the federal securities laws require
publicly held companies to file audited financial statements with the
Commission. 11 These financial statements must be audited by
independent accountants in accordance with generally accepted auditing
standards (``GAAS''). 12 The auditor plans and performs the
audit to obtain reasonable assurance that the financial statements are
free from material misstatement. Commission regulations require the
auditor to issue a report containing an opinion on the financial
statements. 13 The auditor's opinion states whether the
financial statements present fairly, in all material respects, the
financial position of the company as of a specific date. 14
The opinion also states whether the results of the company's operations
and cash
[[Page 33306]]
flows for the year (or other period) then ended, are in conformity with
generally accepted accounting principles (``GAAP''), and whether the
audit was conducted in accordance with GAAS. 15
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\10\ U.S. v. Arthur Young & Co., 465 U.S. 805, 810 (1984).
\11\ See, e.g., Securities Act of 1933 (``Securities Act'')
Schedule A (25)--(27), 15 U.S.C. 77aa(25)--(27); Exchange Act
12(b)(1)(J)--(L), 15 U.S.C. 78l(b)(1)(J)--(L).
\12\ Regulation S-X, 17 CFR 210.1-02(d) (1997).
\13\ See Regulation S-X, 17 CFR 210.2-02 (1985).
\14\ Id.
\15\ Id.
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Investors have come to rely on the accuracy of the financial
statements of public companies when making investment decisions.
Because the Commission has limited resources, it cannot closely
scrutinize each of these financial statements. 16
Consequently, the Commission must rely on the integrity of the auditors
who certify, and accountants who prepare, financial statements. In
short, both the Commission and the investing public rely heavily on
accountants to assure corporate compliance with federal securities law
requirements and disclosure of accurate and reliable financial
information.
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\16\ See Touche Ross, 609 F.2d at 580-81.
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The Commission and the courts have long acknowledged ``the duty of
accountants to those who justifiably rely on [their] reports.''
17 Accountants who issue audit and other reports speak to
investors, publicly representing that the accounting and auditing
standards of the accounting profession have been followed.
18 An incompetent or unethical accountant can damage the
Commission's processes and erode investor confidence in our markets.
19
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\17\ In re Carter, Exchange Act Rel. No. 17595 (Feb. 28, 1981),
22 SEC Docket 292, 298 (Mar. 17, 1981). Cf. Arthur Young, 465 U.S.
at 817-18.
\18\ See Carter, 22 SEC Docket at 298.
\19\ ''In our complex society, the accountant's certificate * *
* can be instruments for inflicting pecuniary loss more potent than
the chisel or the crowbar.'' U.S. v. Benjamin, 328 F.2d 854, 863 (2d
Cir.), cert. denied, 377 U.S. 953 (1964).
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III. The Standard Applied to Accountants
A. ``Improper Professional Conduct'' In General
The Court of Appeals in Checkosky II criticized the Commission for
not clearly articulating when an accountant would be deemed to have
engaged in ``improper professional conduct'' under Rule 102(e)(1)(ii).
This proposed amendment clarifies that whether an accountant engages in
``improper professional conduct'' is determined first by evaluating
whether the accountant violated applicable professional standards. It
also specifies the mental state required before an accountant may be
sanctioned under the Rule. The proposed amendment covers conduct that
the Commission historically has treated as ``improper professional
conduct'' under Rule 102(e)(1)(ii).
Rule 102(e)(1)(ii) has been an effective disciplinary and remedial
tool because it has been used to address a range of misconduct that
poses a future threat to the Commission's processes. 20
Accountants who engage in intentional or knowing misconduct, which
includes reckless misconduct, clearly pose this type of future threat.
Accountants who engage in negligent misconduct also can pose as great a
threat to the Commission's system of securities regulation as
accountants who knowingly violate the professional standards.
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\20\ Carter, 22 SEC Docket at 297. Because Rule 102(e)(1)(ii) is
remedial and not punitive in nature, the conduct must be evaluated
to determine whether the accountant poses a future threat to the
Commission's processes.
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Rule 102(e)(1)(ii) is not meant, however, to encompass every
professional misstep. 21 A harmless judgment error or
immaterial mistake does not pose a future threat to the Commission's
processes and does not constitute ``improper professional conduct.''
Similarly, the Commission does not seek to use the Rule to establish
new standards for the accounting profession.
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\21\ As Commissioner Johnson has noted:
A professional often must make difficult decisions, navigating
through complex statutory and regulatory requirements, and in the
case of accountants, complying with (GAAS) and applying (GAAP).
These determinations require the application of independent
professional judgment and sometimes involve matters of first
impression.
Exchange Act Rel. No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948,
1976 (Feb. 18, 1997) (Johnson, Comm'r, dissenting), rev'd Checkosky
II.
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B. The Proposed Standard
The Rule addresses conduct that fails to meet professional
standards. The proposed amendment delineates categories of conduct that
constitute ``improper professional conduct'' under Rule 102(e)(1)(ii).
These categories are:
(A) An intentional or knowing violation, including a reckless
violation, of applicable professional standards; 22 or
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\22\ ''Applicable professional standards'' includes such things
as generally accepted accounting principles, generally accepted
auditing standards, generally accepted attestation standards, the
AICPA Code of Professional Conduct, the AICPA Statements on
Standards for Consulting Services, the AICPA Statements on Standards
for Accounting and Review Services, pronouncements of the
Independence Standards Board, and certain of the Commission's rules
and regulations.
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(B) Negligent conduct in the following circumstances:
(1) An unreasonable violation of applicable professional standards
that presents a substantial risk, which is either known or should have
been known, of making a document prepared pursuant to the federal
securities laws materially misleading; or
(2) Repeated, unreasonable violations of applicable professional
standards that demonstrate that the accountant lacks competence.
1. Intentional or Knowing Violations, Including Reckless Violations
Subparagraph (A) of the amendment defines ``improper professional
conduct'' to include the most blatant violations of the professional
standards. The Commission consistently has used Rule 102(e)(1)(ii)
proceedings to address these types of violations of the professional
standards. 23
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\23\ See, e.g., In re Finkel, Securities Act Rel. No. 7401 (Mar.
12, 1997), 64 SEC Docket 103 (Apr. 8, 1997); In re Basson, Exchange
Act Rel. No. 35840 (June 13, 1995), 59 SEC Docket 1650 (July 11,
1995); In re F.G. Masquelette & Co, Accounting Series Rel. No. 68,
[1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH), para. 72,087
(June 30, 1982); In re Weiner, Exchange Act Rel. No. 14249 (Dec. 12,
1997), 13 SEC Docket 1113 (Dec. 27, 1977).
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Clearly, an accountant who intentionally or knowingly, including
recklessly 24, violates the professional standards has
engaged in ``improper professional conduct.'' Accountants who engage in
this type of misconduct undoubtedly pose the type of future threat to
the Commission's system of regulation that requires Commission action.
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\24\ See generally SEC v. Blavin, 760 F.2d 706, 711 (6th Cir.
1985); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24
(6th Cir. 1979).
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2. Specific, Negligent Conduct
The proposed amendment also covers specific, negligent violations
of the professional standards.25 The Commission has
recognized that ``an incompetent or negligent auditor can do just as
much harm to public investors and others who rely on him as one who
acts with an improper motive.'' 26 For this reason, the
Commission has stated that negligent conduct can trigger a Rule
102(e)(1)(ii) proceeding, and has brought Rule 102(e)(1)(ii)
proceedings based on negligent conduct.27
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\25\ In other instances, the federal securities laws expressly
subject auditors to liability without requiring intentional
misconduct. For example, the Supreme Court has recognized that
Section 11 allows recovery for ``negligent conduct.'' Herman &
MacLean v. Huddleston, 459 U.S. 375, 384 (1983), referring to Ernst
& Ernst v. Hochfelder, 425 U.S. 185, 210 (1976).
\26\ In re Checkosky, Exchange Act Rel. No. 31094 (Aug. 26,
1992), 52 SEC Docket 1389, 1410 (Sept. 15, 1992), rev'd Checkosky v.
SEC, 23 F.3d 452 (D.C. Cir. 1994) (``Checkosky I''), citing In re
Schulzetenberg, Admin. Proc. 3-6881, slip op. at 2 (Order Denying
Motion to Dismiss Nov. 10, 1987)(unpublished opinion).
\27\ In re Gotthilf, Exchange Act Rel. No. 33949 (April 21,
1994), 56 SEC Docket 1543 (May 10, 1944).
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The Court of Appeals in Checkosky II faulted the Commission for not
articulating with some degree of
[[Page 33307]]
specificity when negligent conduct by an accountant constitutes
``improper professional conduct.'' 28 The proposed amendment
provides this specificity. Specifically, subparagraph (B) of the
amendment defines ``improper professional conduct'' to include: (1) An
unreasonable violation of the applicable professional standards that
presents a substantial risk, which is either known or should have been
known, of making a document prepared pursuant to the federal securities
laws materially 29 misleading; or (2) repeated, unreasonable
violations of the applicable professional standards that demonstrate
that the accountant lacks competence.
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\28\ Checkosky II, 139 F.3d at 224.
\29\ Material, as used in this context, means a substantial
likelihood of being considered significant by a reasonable investor.
Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), citing TSC
Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
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Under this standard, a single violation of the professional
standards could constitute ``improper professional conduct'' if the
violation presents a substantial risk, which is either known or should
have been known, of making a document prepared pursuant to the federal
securities laws materially misleading. Under these circumstances, the
single violation most likely would be related to a transaction or event
as to which any reasonable auditor would give heightened
scrutiny.30 The integrity of the Commission's processes is
threatened by an accountant who fails to exercise due professional care
with respect to the critical areas of his or her professional
responsibilities.
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\30\ Cf. AICPA Professional Standards, Vol. 1 AU sec. 312
(1997).
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For example, an auditor who failed to verify properly the amount of
cash purportedly held in a vault at a branch of a bank, where that
amount constituted 61% of the branch's and 45% of the bank's total cash
on hand, engaged in improper professional conduct under Rule
102(e)(1)(ii).31 In this particular matter, at least
$400,000 of the $2.7 million cash purportedly on hand had been
misappropriated by a bank employee. Although the sum of money
misappropriated may not have been quantitatively material to the bank's
balance sheet, a Rule 102(e)(1)(ii) proceeding was appropriate. Because
a shortage of the total amount of cash actually on hand would impact
materially on the bank's pre-tax earnings, the auditor's failure to
verify properly the cash on hand could be considered negligent under
subparagraph (B)(1) of the proposed amendment since it presented a
substantial risk, which should have been known, of making a document
prepared pursuant to the federal securities laws materially
misleading.32
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\31\ See In re Curtin, Exchange Act Rel. No. 32519 (June 28,
1993), 54 SEC Docket 1137 (July 20, 1993).
\32\ See also In re Valade, Exchange Act Rel. No. 4002 (May 19,
1998), 1998 SEC LEXIS 966; In re Smith, Exchange Act Rel. No. 37738
(Sept. 27, 1996), 62 SEC Docket 2840 (Oct. 29, 1996); In re Denton,
Exchange Act Rel. No. 35381 (Feb. 15, 1995), 58 SEC Docket 2294
(Mar. 14, 1995); In re Lamirato, Exchange Act Rel. No. 33660 (Feb.
23, 1994), 56 SEC Docket 345 (Mar. 15, 1994).
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Proposed subparagraph (B)(2) of the amendment would define improper
professional conduct to include repeated, unreasonable violations of
applicable professional standards that demonstrate that the accountant
lacks competence. Repeated, unreasonable violations of the professional
standards by an accountant can damage both the Commission's processes
and investor confidence in the integrity of financial statements. This
level of incompetence calls into question the reliability of any work
performed by the accountant. Further, an accountant who engages in this
type of misconduct may well benefit from remedial measures before
resuming practice before the Commission. Repeated violations would
include two or more violations that could occur within one audit
33 or in several audits.34 Repeated violations
also could include a course or pattern of violations regardless of
whether the types of violations are similar.
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\33\ See, e.g., In re Childers, Exchange Act Rel. No. 32505
(June 24, 1993), 54 SEC Docket 1017 (July 13, 1993).
\34\ See, e.g., In re Withers, Exchange Act Release No. 34537
(Aug. 17, 1994), 57 SEC Docket 1101 (Sept. 13, 1994).
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C. The ``Good Faith'' Defense
With respect to defenses to a Rule 102(e)(1)(ii) proceeding, the
Commission has never considered the subjective good faith of an
accountant to be an absolute defense.35 Good faith actions
of an accountant are more appropriately considered when determining
what sanction would be appropriate. For instance, an accountant who
acts in good faith, but is unable to conform to the minimum standards
of the profession, may benefit from additional training, peer review,
supervision and other appropriate remedial action undertaken while
suspended from practicing before the Commission or as a condition of
future practice before the Commission.
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\35\ See In re Haskins & Sells, Accounting Series Rel. No. 73
(Oct. 30, 1952), [1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH)
para. 72,092 (June 30, 1982). Similarly, an auditor who is deceived
by the client and commits an audit error in reliance upon the
deception does not have an automatic defense. See generally In re
Hope, Accounting and Auditing Enforcement Rel. No. 109A (Aug. 6,
1986), 36 SEC Docket 663, 750-55 (Sept. 10, 1986). See also In re
Ernst & Ernst, Accounting Series Rel. No. 248 (May 31, 1978), 14 SEC
Docket 1276, 1301 and n.71 (June 13, 1978).
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D. The AICPA Rulemaking Petition
The American Institute of Certified Public Accountants (``AICPA'')
submitted a rulemaking petition to the Commission proposing a
definition for ``improper professional conduct'' under Rule
102(e)(1)(ii).36 The AICPA Rulemaking Petition would define
improper professional conduct in a manner that includes a knowing
violation and a conscious and deliberate disregard of the professional
standards, as well as a course or pattern of misconduct.37
The Commission, like the AICPA, also is proposing that accountants who
engage in knowing misconduct or a course or pattern of misconduct
should be subject to Rule 102(e)(1)(ii) proceedings.
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\36\ Rulemaking Petition by the AICPA Concerning Rule 102(e)
(``AICPA Rulemaking Petition''), SEC File No. 4-410 (May 7, 1998).
\37\ Under the AICPA Rulemaking Petition, before an accountant
can be found to have engaged in ``improper professional conduct,''
the accountant also must pose a current threat to the integrity of
the Commission's processes or to the financial reporting system. See
also Task Force on Rule 102(e) Proceedings, American Bar
Association, Report of the Task Force on Rule 102(e) Proceedings:
Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 985
(May 1997).
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The Commission preliminarily believes that the public interest may
be better served with the somewhat broader definition of ``improper
professional conduct'' proposed in this release. While a harmless
judgment error or immaterial mistake should not trigger a Rule
102(e)(1)(ii) proceeding, reckless and specific negligent misconduct
may require Commission action to protect the integrity of the
Commission's processes and the interests of the investing public.
Accordingly, the Commission has determined to seek comment on the
proposed amendment contained in this release.
IV. General Request For Comments
The Commission requests that any interested persons submit comments
on the proposed amendment to Rule 102(e). The Commission also invites
comments on the following specific issues.
The proposed amendment is intended to clarify the definition of
``improper professional conduct.'' Does the proposed amendment achieve
this objective? This definition is consistent with how the Commission
has applied the ``improper professional conduct'' standard. Would
another definition of ``improper professional conduct'' be
[[Page 33308]]
better suited to achieving the Commission's goal of protecting the
integrity of its processes? Does the proposed amendment include conduct
that should not be considered ``improper professional conduct?'' If
yes, what conduct should be excluded? Does the proposed amendment cover
all of the conduct that should be considered ``improper professional
conduct'' under Rule 102(e)(1)(ii)? If not, what else should be
included? The proposed amendment defines ``improper professional
conduct'' to include ``reckless'' conduct. Should the Commission use a
definition of ``recklessness'' commonly used in cases brought under
Rule 10b-5 of the Exchange Act? 38 Would a less rigorous
standard of ``recklessness'' 39 be more appropriate in the
context of a disciplinary rule such as Rule 102(e)(1)(ii) where the
purpose of the rule is to protect the integrity of the Commission's
processes?
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\38\ See, e.g., Mansbach, SEC v. Steadman, 967 F.2d 636, 641-642
(D.C. Cir. 1992) (both citing Sundstrand Corp. v. Sun Chemical
Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875
(1977)).
\39\ See, e.g., Saba v. Compagnie Nationale Air France, 78 F.3d
664, 668 (D.C. Cir. 1996), citing Farmer v. Brennan, 511 U.S. 825,
836-37 (1994); see generally W. Keeton, et al., Prosser and Keeton
on the Law of Torts (``Prosser''), sec. 34 at 213-214; (5th ed.
1984); Restatement (Second) of Torts sec. 500, comment (a) (1965).
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The proposed amendment defines ``improper professional conduct'' to
include negligent conduct under two specified circumstances. In order
to adequately protect the Commission's processes, should other
circumstances be included?
Does the term ``applicable professional standards'' provide
adequate guidance to the accounting profession? What weight should be
given to the good faith of an accountant at the sanctioning stage of a
Rule 102(e)(1)(ii) proceeding?
Any interested person wishing to submit written comments on any of
the issues set forth in this release are invited to do so by submitting
them in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and
Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549.
Comments also may be submitted electronically at the following e-mail
address: rule-comments@sec.gov. All comment letters should refer to
File No. S7-16-98 this file number should be included on the subject
line if e-mail is used. Comments received will be available for public
inspection and copying in the Commission's public reference room at 450
Fifth Street, NW., Washington, DC 20549. Electronically submitted
comment letters will be posted on the Commission's Internet Web site
(http://www.sec.gov).
V. Summary of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') on the proposed amendment to Rule 102(e). The IRFA
indicates that the proposed amendment would clarify the standard by
which the Commission determines whether accountants have engaged in
``improper professional conduct.''
The IRFA sets forth the statutory authority for the proposed
amendment. The IRFA also discusses the effect of the proposed amendment
on small entities. The IRFA states that approximately 1000 accounting
firms can or do appear or practice before the Commission. While most of
this practice is conducted by the ``Big Six'' firms, which are not
small entities, many smaller firms do practice before the Commission.
However, the Commission does not collect information about revenues of
accounting firms, which information generally is not made public by the
firms, and therefore cannot determine how many of these are small
entities for purposes of the analysis. In any event, the proposed
amendment should have little or no impact on small entities because the
proposal simply clarifies the Commission's standard for determining
when accountants engage in ``improper professional conduct.''
The IRFA states that the proposed amendment would not impose any
new reporting, recordkeeping or compliance requirements, and the
Commission believes that there are no rules that duplicate, overlap or
conflict with the proposed amendment.
The IRFA discusses the various alternatives considered to minimize
the effect on small entities, including: (a) The establishment of
differing compliance or reporting requirements or timetables that take
into account the resources of small entities; (b) the clarification,
consolidation or simplification of compliance and reporting
requirements under the Rule for small entities; (c) the use of
performance rather than design standards; and (d) an exemption from
coverage of the Rule, or any part thereof, for small entities. The
Commission believes it would be inconsistent with the purposes of the
Rule to exempt small entities from the proposed amendment. Different
compliance or reporting requirements for small entities are not
necessary because the proposed amendment does not establish any new
reporting, recordkeeping or compliance requirements. The proposed
amendment is already designed to clarify the current standard employed
in Rule 102(e)(1)(ii), and the Commission does not believe it is
feasible to further clarify, consolidate or simplify the Rule for small
entities. Finally, the proposal does use a performance standard, not a
design standard, to specify what conduct is expected of accountants;
the Commission does not believe different performance standards for
small entities would be consistent with the purposes of the Rule.
The IRFA solicits comments generally, and in particular, on the
number of small entities that would be affected by the proposed
amendment and the existence or nature of the effect. For purposes of
the Small Business Regulatory Enforcement Fairness Act of 1996,
40 the Commission is also requesting information regarding
the potential impact of the proposed amendment on the economy on an
annual basis--in particular, whether the proposed amendment is likely
to have an annual effect on the economy of $100 million or more.
Commenters should provide empirical data to support their views.
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\40\ 5 U.S.C. 801 et seq.
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A copy of the IRFA may be obtained by contacting David R.
Fredrickson, Office of the General Counsel, Securities and Exchange
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
VI. Cost-Benefit Analysis
The Commission requests the views of commenters about any costs or
benefits associated with the proposed amendment. The Commission
anticipates several benefits from the amendment. The amendment will
provide clearer guidance to accountants. Members of the accounting
profession will better understand the standard the Commission uses to
determine ``improper professional conduct'' and thus conduct themselves
accordingly. Also, the clarifying amendment will make it easier for the
Commission, its administrative law judges and the courts to administer
the Rule, which will further benefit the integrity of the Commission's
processes. The Commission anticipates no costs associated with the
proposal.
Section 23(a)(2) of the Exchange Act requires the Commission to
consider the impact of its rules on competition. Moreover, section 2(b)
of the Securities Act, section 3(f) of the Exchange Act and section
2(c) of the Investment Company Act of 1940 (``Investment Company Act'')
require the Commission, when engaged in
[[Page 33309]]
rulemaking that requires a public interest finding, to consider, in
addition to the protection of investors, whether the action will
promote efficiency, competition and capital formation. The Commission
requests data on what effect, if any, the proposed amendment would have
on efficiency, competition and capital formation.
VII. Statutory Authority
The Commission is proposing the amendment to the Rule pursuant to
its authority under section 19(a) of the Securities Act, section 23(a)
of the Exchange Act, section 20(a) of the Public Utility Holding
Company Act of 1935, section 319(a) of the Trust Indenture Act of 1939,
section 211(a) of the Investment Advisers Act of 1940 and section 38(a)
of the Investment Company Act.
Text of Amendment
List of Subjects in 17 CFR Part 201
Administrative practice and procedure, Investigations, Securities.
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 201--RULES OF PRACTICE
1. The authority citation for Part 201, Subpart D continues to read
as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77h-1, 77j, 77s, 77u,
78c(b), 78d-1, 78d-2, 78l, 78m, 78n, 78o(d), 78o-3, 78s, 78u-2, 78u-
3, 78v, 78w, 79c, 79s, 79t, 79z-5a, 77sss, 77ttt, 80a-8, 80a-9, 80a-
37, 80a-38, 80a-39, 80a-40, 80a-41, 80a-44, 80b-3, 80b-9, 80b-11,
and 80b-12 unless otherwise noted.
2. Amend Sec. 201.102 by adding paragraphs (e)(1)(iv) to read as
follows:
Sec. 201.102 Appearance and practice before the Commission.
(e) Suspension and disbarment.--(1) Generally. * * *
(iv) With respect to persons licensed to practice as accountants,
``improper professional conduct'' under Sec. 201.102(e)(1)(ii) means:
(A) An intentional or knowing violation, including a reckless
violation, of applicable professional standards; or
(B) Negligent conduct in the following circumstances:
(1) An unreasonable violation of applicable professional standards
that presents a substantial risk, which is either known or should have
been known, of making a document prepared pursuant to the federal
securities laws materially misleading; or
(2) Repeated, unreasonable violations of applicable professional
standards that demonstrate that the accountant lacks competence.
* * * * *
Dated: June 12, 1998.
By the Commission.
Jonathan G. Katz,
Secretary.
Separate Statement of Commissioner Norman S. Johnson
I write separately to address what I consider to be the plain
import of the two decisions of the United States Court of Appeals for
the District of Columbia Circuit in Checkosky v. SEC, 23 F.3d 452 (D.C.
Cir. 1994) (Checkosky I), and Checkosky v. SEC, 139 F.3d 221 (D.C. Cir.
1998) (Checkosky II). 1 In today's release, the Commission
proposes to adopt a negligence standard under Rule 102(e) of our Rules
of Practice, a matter of crucial importance to the accountants who
practice before us. 2 As Judge Randolph observed:
\1\ The weight the Commission must attach to the views of the
D.C. Circuit cannot be overstated. Under the jurisdictional
provisions of the securities laws, every respondent in a Commission
administrative proceeding has the option of appealing an adverse
outcome to the D.C. Circuit. See, e.g., 15 U.S.C. 77i(a) &
78y(a)(1).
\2\ Rule 102(e) was formerly designated Rule 2(e). There are no
substantive differences between the two rules.
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A proceeding under Rule 2(e) threatens ``to deprive a person of
a way of life to which he has devoted years of preparation and on
which he and his family have come to rely.'' Henry J. Friendly,
``Some Kind of Hearing,'' 123 U. Pa. L. Rev. 1267, 1297 (1975). It
is of little comfort to an auditor defending against such charges
that the Commission's authority is limited to suspending him from
agency practice. For many public accountants such work represents
their entire livelihood. Moreover, when one jurisdiction suspends a
professional it can start a chain reaction.
Checkosky I, 23 F.3d at 479 (opinion of Randolph, J.).
With all due respect to my esteemed colleagues, today's release
reflects precisely the same sort of overly aggressive approach that led
to the Commission's two stinging defeats in Checkosky. The consequences
of overreaching in this area might well be severe. If the Commission
selects an insupportable standard many of the worst offenders of Rule
102(e) may escape sanction altogether. Prudence would seem to dictate a
much more cautious approach than that taken in today's release.
Because I believe that the Commission lacks the authority to adopt
a negligence standard, I must dissent. See Checkosky I, 23 F.3d 452;
Checkosky II, 139 F.3d 221. Even apart from the Checkosky decisions,
adoption of a negligence standard would contravene public policy.
Some background is in order.
I.
Respondents in Checkosky were two accountants who audited the
financial statements of Savin Corporation in the early 1980's. The
Commission brought charges against the accountants in 1987, and in 1992
affirmed an Administrative Law Judge's decision finding violations of
Rule 102(e). See David J. Checkosky, Release No. 34-31094, 1992 SEC
LEXIS 2111 (Aug. 26, 1992). In its first opinion, the Commission found
that Savin's financial statements were false in that the company
improperly capitalized certain expenses for research and development
rather than recording them in their entirety as expenses in the years
incurred. Id. These violations were based on finding that the auditors,
in violation of Generally Accepted Auditing Standards (GAAS), had
improperly permitted Savin to capitalize these expenditures and falsely
certified that Savin's financial statements set forth its financial
condition in accordance with Generally Accepted Accounting Principles
(GAAP). 3 Id.
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\3\ Commissioner Roberts concurred in the majority's finding
that respondents violated GAAS and had misapplied GAAP, but
dissented from the finding that these errors amounted to ``improper
professional conduct'' under Rule 102(e)(1)(ii). 1992 SEC LEXIS
2111, at *47. In Commissioner Roberts' view respondents' conduct did
not provide a sufficient basis for a finding that they would
threaten the Commission's processes. Id. at *48.
---------------------------------------------------------------------------
In Checkosky I, the D.C. Circuit remanded the case because it was
unable to discern from the Commission's opinion the basis for the
Commission's action other than the finding that the accountants had
violated GAAS and falsely certified that the financial statements set
forth the financial condition of the company in accordance with GAAP.
23 F.3rd at 454. The Court held that the Commission was authorized to
promulgate Rule 102(e) as a means to protect the integrity of its
processes, but each of the three judges (Judges Silberman, Randolph and
a district court judge sitting by designation, Judge Reynolds) issued a
separate opinion.
Judges Silberman and Randolph both questioned the Commission's
ability to impose sanctions under Rule 102(e) for misconduct not rising
to the level of scienter, i.e., misconduct that is only negligent.
4 Judge Silberman explained that:
\4\ Senior District Judge Reynolds disagreed with the circuit
judges' conclusion that ``improper professional conduct'' under Rule
102(e)(1)(ii) required proof of scienter. 23 F.3d at 493-95.
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[[Page 33310]]
If 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. Punishment for mere
negligence, so the argument goes, extends beyond this realm of
protective discipline into general regulatory authority over a
---------------------------------------------------------------------------
professional's work.
23 F.3d at 456. Judge Silberman further suggested that the Commission
could not legitimately adopt a negligence standard under Rule 102(e)
because that might amount to ``a de facto substantive regulation of the
profession.'' 23 F.3d at 459; see also 23 F.3d 460 (suggestion that
Commission adoption of negligence standard might be arbitrary and
capricious).
Judge Randolph also questioned the Commission's ability to adopt a
negligence standard. In Judge Randolph's view, the ``Commission's
authority under Rule 2(e) must rest on and be derived from the statutes
it administers,'' such as Section 10(b) of the Exchange Act that
requires scienter. See 23 F.3d at 466-69. Judge Randolph also
extensively discussed an earlier Commission decision that rejected a
negligence standard under Rule 102(e) in a case involving lawyers,
William R. Carter, 47 S.E.C. 471 (1981). See 23 F.3d at 480-87. In
Judge Randolph's view, the reasoning of Carter was equally applicable
to accountants, and precluded the Commission from adopting a negligence
standard under Rule 102(e). See 23 F.3d at 483-87.
On remand, the Commission's majority opinion did not directly
address the mental state question posed by the Court. David J.
Checkosky, Release No. 34-38183, 1997 SEC LEXIS 137 (Jan. 21, 1997).
While the majority found that the accountants had behaved recklessly,
it insisted that any deviation from GAAP or GAAS, including purely
negligent deviations, could violate Rule 102(e), and that the
accountants' recklessness was relevant only to the choice of sanctions.
Id. I dissented from the Commission's second Checkosky opinion because
of my belief that ``improper professional conduct'' requires proof of
scienter, which includes recklessness.5 1997 SEC LEXIS 137,
at *48.
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\5\ See Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033,
1045 (7th Cir. 1977) (defining recklessness as ```highly
unreasonable''' conduct involving ```an extreme departure from the
standards of ordinary care'''); see also, e.g., Mansbach v.
Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979)
(following Sundstrand).
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On appeal in Checkosky II, the D.C. Circuit again reversed. The
Court again found that the Commission had again failed to offer an
adequate explanation of its interpretation of Rule 102(e). 139 F.3d at
222 (referring to the ``multiplicity of inconsistent interpretations''
in the Commission's opinion). Because of the Commission's ``persistent
failure to explain itself'' and ``the extraordinary duration of these
proceedings,'' the Court declined to give the Commission a third chance
to explain itself, and instead invoked the extremely rare remedy of
remanding the case with instructions to dismiss. 139 F.3d at 222 & 227.
More importantly for today's release, the D.C. Circuit in Checkosky
II again questioned the Commission's ability to adopt a negligence
standard under Rule 102(e)(1)(ii). 139 F.3d at 225. The Court appeared
to reaffirm its previous statements about the limits of the
Commission's authority in disciplining securities professionals subject
to Rule 102(e), remarking that ``adoption of a negligence standard
might be ultra vires'' because it might amount to ``a back-door
expansion of [the Commission's] regulatory oversight powers.'' Id.
(citing Checkosky I, 23 F.3d at 459).6
---------------------------------------------------------------------------
\6\ This point is made clear by the concurring opinion, in which
Judge Henderson expressly disagreed with the majority's discussion
of this issue. See 139 F.3d at 227.
---------------------------------------------------------------------------
II.
As explained above, the Checkosky opinions preclude us, as a
practical matter, from adopting a negligence standard. Even were the
situation otherwise, public policy considerations also call for
rejection of a negligence standard. See, e.g., David J. Checkosky,
Release No. 34-38183, 1997 SEC LEXIS 137, at *48 (Jan. 21, 1997)
(dissenting opinion of Commission Johnson). In my view, ``improper
professional conduct'' in Rule 102(e)(1)(ii) requires proof of
scienter.
Our system of securities regulation is based on disclosure. To
ensure that Commission filings and other statements made to the
investing public are truthful and accurate, we have to rely in large
part on the work of talented, well-trained professionals. Accordingly,
I fully agree with former Chairman Williams' statement that we would be
unable to administer effectively the securities laws if those
``involved in the capital raising process were not routinely served by
professionals of the highest integrity and competence, well-versed in
the requirements of the statutory scheme Congress has created.''
Keating, Muething & Klekamp, 47 S.E.C 95, 120 (1979) (concurring
opinion of Chairman Williams); see also Touche, Ross & Co. v. SEC, 609
F.2d 570, 580-81 (2d Cir. 1979) (because of limited resources, ``the
Commission necessarily must rely heavily on both the accounting and
legal professions to perform their tasks diligently and responsibly'').
On the other hand, I also believe that the Commission has a limited
mandate under Rule 102(e) for determining who may ``practice'' before
us, and that we must exercise a high degree of self-restraint in this
area.
As to accountants, the very nature of their responsibilities within
our disclosure system mandates restraint. Accountants, like other
securities professionals subject to Rule 102(e), must make difficult
judgment calls, navigating through complex statutory and regulatory
requirements. In addition, accountants are required to follow GAAS and
to apply GAAP. These determinations demand the application of
independent professional judgment and often involve matters of first
impression.
The Commission itself recognized the importance of these principles
in Carter, when it asserted that, in order to assure the exercise of a
professional's ``best independent judgment,'' the professional ``must
have the freedom to make innocent--or even, in certain cases,
careless--mistakes without fear of (losing) the ability to practice
before'' us. 47 S.E.C. at 504. Equating negligence with ``improper
professional conduct'' will impair relationships between professionals
and their clients. If such an adverse impact occurs, our ability to
rely on these professionals to enhance compliance with the securities
laws will be crippled. I share the view endorsed by the Commission in
Carter that professionals ``motivated by fears for their personal
liability will not be consulted on difficult issues.'' Id.
Securities professionals owe a duty to serve the interests of their
clients. To discharge this duty, professionals must enjoy the
cooperation and trust of their clients. Indeed, in construing Carter,
Judge Randolph observed:
(W)ithout a scienter requirement, lawyers would slant their
advice out of fear of incurring liability, and management therefore
would not consult them on difficult questions. I cannot see why this
sort of reasoning would not apply as well to auditors. I recognize
that although companies need not retain outside counsel, they are
legally compelled to ``consult'' independent accountants * * * .
This creates an obligation on the part of management to cooperate
with and provide information to the auditor. * * * There are,
however, degrees of cooperation. Encouraging management to be
completely candid with its
[[Page 33311]]
auditor about difficult accounting issues may be just as desirable
as encouraging management to consult candidly with outside lawyers,
and for similar reasons.
Checkosky I, 23 F.3d at 485.
Accountants and attorneys are members of ``ancient professions,''
regulated according to rigorous ethical rules enforced by professional
societies and, in the case of accountants, state licensing boards. I
simply do not believe that we should recast negligent violations of an
accounting standard as improper professional conduct under the
Commission's Rules of Practice. That is not an appropriate role for
this Commission. Difficult ethical and professional responsibility
concerns are generally matters most appropriately dealt with by
professional organizations or, in certain cases, malpractice
litigation. Nor do I believe that mere misjudgments or negligence
establishes either professional incompetence warranting Commission
disciplinary action or the likelihood of future danger to the
Commission's processes.
* * * * *
For all these reasons, I believe that the Commission lacks the
authority to adopt a negligence standard under Rule 102(e). Likewise,
the Commission may only hold a professional liable for ``improper
professional conduct'' only if scienter is proven. I urge accountants
and trade groups directly subject to Rule 102(e), as well as any others
who have an interest in Rule 102(e), to submit their views on this
important matter. It is my most fervent hope that the Commission
receives an abundance of comment letters responding to this release.
[FR Doc. 98-16251 Filed 6-17-98; 8:45 am]
BILLING CODE 8010-01-P
