In Checkosky v. SEC, 1998 WL 135489 (D.C. Cir. 1998) ("Checkosky II"), decided in late March 1998, the D.C. Circuit Court of Appeals unanimously ordered the dismissal of SEC proceedings suspending two accountants for "improper professional conduct" under SEC Rule 2(e)(1)(ii). In an opinion highly critical of the agency, the court held that dismissal was warranted in light of the SEC's persistent failure to explain its interpretation of Rule 2(e). Checkosky II is significant for several reasons. First, the decision creates substantial uncertainty over, and may well place on hold, the SEC's enforcement of Rule 2(e). Second, it forces the SEC to make a difficult decision with respect to its regulation of the accounting profession. Third, the decision exemplifies the growing criticism of the SEC for its failure to provide fair notice of the standards by which the agency will judge the conduct of those it regulates.
History of the Case
Checkosky II is the latest chapter in a tale that began in the early 1980's. In 1981, Savin Corporation, after consulting with David Checkosky, a partner at Coopers & Lybrand ("C&L"), began deferring research and development costs instead of expensing those costs immediately as required under generally accepted accounting principles ("GAAP"). During Savin's fiscal years 1981 through 1984, Checkosky and Norman Aldrich, also of C&L, issued audit reports representing that the audits were conducted according to generally accepted auditing standards ("GAAS") and opining that Savin's financial statements conformed with GAAP.
When the SEC discovered Savin's improper expensing of its R&D costs, it brought disciplinary proceedings against Checkosky and Aldrich for "improper professional conduct" in violation of SEC Rule 2(e)(1)(ii) The SEC alleged that Checkosky and Aldrich had misrepresented that Savin's financial statements conformed with GAAP, and that both men had violated GAAS by failing to exercise professional due care with respect to the audit and the audit report. An administrative law judge ("ALJ") found that Checkosky and Aldrich had violated Rule 2(e)(1)(ii), holding that improper professional conduct did not require scienter and that a violation of GAAP and GAAS alone sufficed. The ALJ suspended Checkosky and Aldrich from practicing before the SEC for five years.
In 1992, the SEC affirmed the ALJ's findings, noting that "we have stated that a mental awareness greater than negligence is not required to impose sanctions pursuant to Rule 2(e)(1)(ii)." The SEC's opinion also stated that Checkosky and Aldrich's conduct rose to the level of recklessness, and reduced the suspensions to two years. Checkosky and Aldrich appealed, claiming, among other things, that improper professional conduct in violation of Rule 2(e)(1)(ii) required scienter.
In the D.C. Circuit's 1994 decision, Checkosky v. SEC, 23 F. 3d 452 (D.C. Cir. 1994) ("Checkosky I"), two members of a sharply divided three-judge panel were able to agree only that the case would be "remanded to the Commission for a more adequate explanation of its interpretation of Rule 2(e)(1)(ii) and its application to this case." One member of the panel observed that the SEC did not affirmatively "specify the state of mind necessary and sufficient to constitute a violation" under Rule 2(e)(1)(ii), and called for the SEC to "choose its standard [for liability, i.e., negligence or recklessness] and forthrightly apply it to this case" on remand. Another member of the panel concluded that it was "as plain as can be" that the SEC had employed a negligence standard, but that such a standard was inconsistent with past SEC opinions.
In 1997, the SEC issued an opinion on remand affirming the suspensions and responding to the D.C. Circuit's demand for clarification. The SEC first reiterated that it found that Checkosky's and Aldrich's conduct was reckless. The agency declined to state whether recklessness was required for liability, however, adding that "[w]e believe that Rule 2(e)(1)(ii) does not mandate a particular mental state and that negligent actions by a professional may, under certain circumstances, constitute improper professional conduct." Checkosky and Aldrich again appealed, arguing that the SEC had failed to articulate an intelligible standard for improper professional conduct.
Checkosky II: The D.C. Circuit Attacks a "Deliberately Obscurantist" SEC
Presented with the case for the second time, the D.C. Circuit made no effort to hide its frustration with the SEC. The court attacked the SEC's 1997 opinion as a "tour de force" that managed to both embrace and reject standards of recklessness, negligence and strict liability. The court pointed out that the SEC's opinion (1) asserted the recklessness of Checkosky and Aldrich but then stated that Rule 2(e)(1)(ii) required no particular mental state; (2) stated that negligent actions may, under certain circumstances, constitute improper professional conduct, but failed to define those circumstances; and (3) contained a statement that the SEC's processes are "not necessarily" threatened by innocent mistakes, suggesting that even some non-negligent mistakes will violate Rule 2(e)(1)(ii).
The court added that the SEC seemed almost "deliberately obscurantist" on the mental state standard, and that the SEC's opinion came close to a "self-proclaimed license to charge and prove improper professional conduct whenever it pleases . . . ." Because the SEC had failed to "choose its standard and forthrightly apply it to this case," as instructed by the court in Checkosky I, and because the court observed no signs of progress by the SEC in offering a clear interpretation, the court took the highly unusual step of ordering the SEC to dismiss the proceedings.
The Impact of Checkosky II
The long-term impact of Checkosky II is uncertain. Until the issue of the mental state required for a Rule 2(e)(1)(ii) violation is resolved, the agency may be reluctant to commence such cases for fear that they will be dismissed under Checkosky II. The timing of this delay is particularly unfortunate for the SEC given the agency's recent statements that it will be scrutinizing auditor independence in the wake of the consolidation of the accounting industry. In addition, for certain contemplated enforcement actions under Rule 2(e)(1)(ii), this delay may cause fatal statute of limitations problems under the five-year limitations period. Thus, there is some urgency for the agency to respond to the D.C. Circuit's opinion.
Unless the SEC successfully appeals Checkosky II, the court's insistence that the agency "choose a standard" for Rule 2(e)(1)(ii) will force the SEC to make a difficult decision on its regulation of the accounting profession. As pointed out in Checkosky II, the SEC's adoption of a negligence standard to penalize accountants under Rule 2(e)(1)(ii) might be viewed as a back-door expansion of its regulatory oversight powers. The court in Checkosky I observed that if the SEC were to determine that an accountant's negligence is a per se violation of Rule 2(e), the SEC would be required to consider the administrative burdens of adopting such a standard. In addition, the SEC would have to consider whether adopting a negligence standard constituted de facto substantive regulation of the profession, thus raising questions as to the legitimacy of the SEC's action.
Continued Calls for Fair Notice
Checkosky II is the second decision by a federal appeals court in the past three months that has criticized the SEC for failing to provide fair notice of the standards by which the SEC will judge conduct. In Banca Cremi, S.A. v. Alex. Brown & Sons Inc., a case decided by the Fourth Circuit in December 1997 (separately discussed on pages 5-6), the SEC argued, as amicus curiae, that Rule 10b-5 imposed a duty to disclose the markup on a debt security in a riskless transaction. The court rejected this argument, observing that it was puzzling why the SEC, having already abandoned an effort to require such disclosures administratively, would now seek to impose an identical requirement on dealers judicially. Similarly, in Checkosky II, the D.C. Circuit stated that the SEC's failure to choose a standard for Rule 2(e)(1)(ii) was depriving accountants of the right to practice their profession without revealing the standard of conduct that they had violated.
Checkosky II is significant not only to accountants but to all professionals, and indeed all companies, who are subject to the SEC's regulation. The opinion puts the agency on notice that its interest in maintaining maximum flexibility in enforcing the securities laws is outweighed by the rights of those it regulates to fair notice of the standards by which their conduct will be judged. To the extent that Checkosky II compels the SEC to clarify its standards under Rule 2(e) or in other areas, regulated companies and individuals should welcome the decision.
1 Mr. Carton, an associate in the Securities and Business Litigation Practice Group in our Washington office, was formerly Senior Counsel for the Securities and Exchange Commission's Enforcement Division.