The recent spate of high profile financial scandals and their effect on the U.S. economy may compel the SEC to use a rarely invoked, but powerful, enforcement tool against accounting firms. Section 10A of the Securities Exchange Act of 1934 (the Act), as amended, requires accounting firms to utilize audit procedures designed to detect illegality and to bring material illegal acts they detect during the course of an audit to the attention of senior management and the company's audit committee.
If management does not take proper remedial action, and the illegal acts have a material effect on the financial statements of the company, the accounting firm must report these illegal acts directly to the board of directors, and the board must then notify the SEC.
Even before formal charges are filed, an SEC investigation can often trigger a drop in stock prices or encourage the filing of shareholder suits. Companies should, therefore, protect themselves by understanding an accounting firm's reporting requirements under Section 10A and by responding with proper remedial action to information uncovered during the course of an audit or otherwise indicating that illegal acts may have occurred.
AMENDED SECTION 10A REQUIRES ACCOUNTING FIRMS TO REPORT ILLEGAL ACTS
Section 10A was introduced in 1995 as part of the Private Securities Litigation Reform Act. Starting in late 2000, the SEC brought its first Section 10A enforcement cases, SEC v. Solucorp Indus., Ltd., 99 Civ. 11965 (WCC) (S.D.N.Y. Dec. 13, 1999) (amended complaint adding accountant filed October 31, 2000), and In re Rosetti, Accounting and Auditing Enforcement Release No. 1338, [S.E.C. Accounting Rules] Fed. Sec. L. Rep. (CCH) 74,845, at 63,519 (Oct. 31, 2000).
Subsequent litigation concerning one of these enforcement cases indicates that the SEC may begin regularly enforcing Section 10A against accounting firms that fail to follow the steps outlined under this provision. SEC v. Solucorp Indus., Ltd., 197 F. Supp. 2d. 4 (S.D.N.Y. 2002) Additionally, Congress used the Sarbanes-Oxley Act of 2002 to add a number of amendments to Section 10A relating to stricter standards for accounting firms and audit committees. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, §§ 201-206 & 301, 116 Stat. 745. Accordingly, companies should be aware that greater attention may be directed towards an accounting firm's duties under amended Section 10A to report illegal acts.
CIVIL PENALTIES FOR FAILURE TO REPORT ILLEGAL ACTS
The new law impacts the Section 10A reporting requirement in two significant ways. First, the term "registered public accounting firm" replaces the term "independent public accountant," which has the effect of holding the entire accounting firm liable, rather than the individual accountant, for a failure to investigate and report illegal acts as required under Section 10A. Second, an audit committee is now directly responsible for the appointment, compensation, and oversight of the accounting firm for its audit-related work.
If an accounting firm detects or otherwise becomes aware of information indicating that an illegal act has or may have occurred, whether or not it is perceived to have a material effect on financial statements, the accounting firm has an affirmative duty to determine whether it is likely the illegal act has occurred. If the accounting firm determines that the illegal act has occurred, unless the act is clearly inconsequential, the accounting firm must determine its possible effect on financial statements, and as soon as practicable, inform the appropriate level of management. The accounting firm must also ensure that the audit committee, or board of directors if there is no audit committee, is adequately informed with respect to the illegal acts that have been detected.
If the accounting firm determines that the illegal act has a material effect on the financial statements of the company and that the audit committee is adequately informed of the "material" illegal act, but senior management has failed to take remedial action, the accounting firm must directly report its conclusions to the board of directors. The board of directors must then inform the SEC of the report within one day of its receipt and give the accounting firm notice that the SEC has been notified. If the accounting firm does not receive this notice from the board of directors within one business day, then the accounting firm must furnish a copy of its report directly to the SEC within one business day, or the accounting firm may, at its option, resign from its engagement with the company. If the accounting firm resigns, it must still give the SEC its report within one business day following the company's failure to notify the SEC. Section 10A grants an accounting firm a safe harbor from liability in a private action for reporting to the SEC, but the accounting firm's failure to furnish its report to the SEC may subject it to civil penalties.
DISTRICT COURT SETS LOW THRESHOLD FOR TRIGGERING SECTION 10A
A federal district court set a low threshold for triggering Section 10A's reporting requirements in a recent decision. SEC v. Solucorp Indus., Ltd., 197 F. Supp. 2d. 4 (S.D.N.Y. 2002). In Solucorp, the management backdated a licensing agreement and improperly applied the licensing fees from the agreement to the previous quarter. The accountant was aware of the backdating, advised the chief financial officer of Solucorp's chief operating subsidiary of his finding, but failed to act beyond expressing an unqualified audit opinion. The court concluded that under the plain and unambiguous terms of the statute, an accountant becomes subject to Section 10A requirements "upon acquiring knowledge of information indicating that an illegal act has or may have occurred." Solucorp, 197 F. Sup 2d. at 10 (emphasis added). The court emphasized that there is no scienter requirement in Section 10A, that Section 10A "requires only knowledge of facts indicating that an illegal act may have occurred," and that the SEC does not even have to allege reckless or fraudulent behavior by the accountant. Id. at 11. The court reasoned that imputing a higher threshold requiring actual knowledge that an illegal act had occurred would make superfluous the subsequent language in the statute requiring an accountant to determine whether the illegal act has likely occurred. Id. at 10.
COMPANIES SHOULD ASSIST WITH 10A COMPLIANCE
Corporate managers and directors should be aware of these new developments in SEC enforcement and Section 10A's potentially broad scope. A company can take the following measures to work effectively with an accounting firm acting under its Section 10A duties:
- Ensure that there are open lines of communication between the accounting firm, management and members of the audit committee. If there are good communication lines in place, the accounting firm will normally notify management that an illegal act may have occurred before the accounting firm makes a determination that an illegal act has likely occurred. The company may then form a special committee to investigate the matter, which may include the audit committee itself and the accounting firm, because both of their statutory responsibilities under Section 10A are on the line. The special committee can then determine if an illegal act occurred, whether it has a material effect on the financial statements and what, if any, remedial action is necessary.
- Discuss beforehand any new or unique audit procedures that the accounting firm may utilize during the audit. Section 10A(a)(1) requires accounting firms to implement procedures during the course of an audit to provide reasonable assurance of detecting illegal acts "that would have a direct and material effect on the determination of financial statement amounts." The company should understand any novel or unfamiliar procedures before the audit commences.
- Set out the meaning of Section 10A's undefined terms with the accounting firm prior to the audit. Section 10A includes several undefined terms, for example, what constitutes an inconsequential act, an illegal act and a material effect. Agreeing upon predetermined definitions will minimize future conflicts while helping accountants identify which illegal acts must be reported under Section 10A.
- Communicate clearly with accounting firms about related party transactions. Although it has been little used or referred to, Section 10A(a)(2) contains a provision requiring outside accounting firms to implement procedures "designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein." In light of the related party transactions that were central to recent financial scandals, this function may draw increased scrutiny in the current climate.