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Recent Auditor Independence Cases Suggest SEC's 'Operation Broken Gate'

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Recent Auditor Independence Cases Suggest SEC's 'Operation Broken Gate' Securities Regulation & Law Report™ Reproduced with permission from Securities Regulation & Law Report, 46 SRLR 2415, 12/22/2014. Copyright ஽ 2014 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com ENFORCEMENT Recent Auditor Independence Cases Suggest SEC’s ‘‘Operation Broken Gate’’ Is in Full Swing same time, the Director of the Enforcement Division previewed a renewed ‘‘focus on auditors’’ and, in par- ticular, independence violations.3 And in February, the SEC’s then-Chief Accountant also emphasized that au- ditor independence was a particular concern for the SEC staff.4 The last 18 months of enforcement activity demon- strate that the SEC was not bluffing. As set forth below, the SEC has recently filed multiple auditor indepen- dence cases and released a detailed report with warn- ings for firms that loan staff to their audit clients. Ac- counting firms should note the enforcement activity. BY MATTHEW P. BOSHER s the glut of financial crisis cases approaches the A. Overview of the SEC’s Auditor end of the pipeline, the SEC and other regulators Independence Rules A have inevitably shifted their attention to different targets. At least one of those new targets is an old one: 1 First, a quick refresher on the SEC’s independence accounting firms. rules. Rule 2-01 of Regulation S-X requires auditors to In October 2013, SEC Chair Mary Jo White an- be independent of their SEC audit clients, both in ap- nounced the launch of ‘‘Operation Broken Gate’’—‘‘an initiative to identify auditors who neglect their duties 3 and the required auditing standards.’’2 Around the Ceresny speech, see note 1, supra. 4 Paul Beswick, Chief Accountant, SEC, presentation at the SEC Speaks Conference (Feb. 22, 2014), available at http:// 1 See Andrew Ceresny, Director, SEC Division of Enforce- www.sec.gov/News/Speech/Detail/Speech/1370540846980. ment, Remarks at the American Law Institute Continuing Le- The PCAOB is also focused on independence violations. In a gal Education (Sept. 9, 2013) (describing the SEC Enforcement speech to auditors on Oct. 29, 2014, a PCAOB member noted Division’s ‘‘pivot away from the financial crisis cases and refo- her surprise ‘‘regarding the continuing and pervasive indepen- cus on accounting fraud’’), available at http://www.sec.gov/ dence’’ violations the PCAOB had uncovered. Jeanette M. News/Speech/Detail/Speech/1370539845772. Franzel, Board Member, PCAOB, Developments Related to Au- 2 Mary Jo White, Chair, Securities and Exchange Commis- dits of Brokers and Dealers (Oct. 29, 2014), available at http:// sion, Remarks at the Securities Enforcement Forum (Oct. 9, pcaobus/News/Speech/Pages/10292014_BDF.aspx. She 2013), available at http://www.sec.gov/News/Speech/Detail/ warned auditors that ‘‘[i]t is unacceptable to ‘push the enve- Speech/1370539872100. lope’ on this issue that is central to the integrity of audits and has been settled for years.’’ Id. And on Dec. 8, 2014, PCAOB Chairman James Doty reiterated that ‘‘The bedrock of audit Matthew P. Bosher is a litigation partner with quality is independence....Adhering to independence re- Hunton & Williams. He defends companies, quirements is critically important.’’ Press Release, Public Com- executives, and accountants in disputes pany Accounting Oversight Board, PCAOB Announces Settled Disciplinary Orders Against Seven Audit Firms for Indepen- related to financial reporting and corporate dence Violations When Auditing Broker-Dealers (Dec. 8, governance. 2014), available at http://pcaobus.org/news/Releases/Pages/ 12082014_Enforcement.aspx COPYRIGHT ஽ 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 0037-0665 2 pearance and in fact.5 The SEC’s independence rules s Section 4C(a)(2) of the Exchange Act9 and Rule are voluminous and complex, but the Office of the Chief 102(e)10 of the Commission’s Rules of Practice en- Accountant has articulated four general principles re- able the SEC to censure or suspend professionals lating to auditor independence: for ‘‘improper professional conduct,’’ which, in the SEC’s view, includes independence violations. s A relationship or service may not create a mutual or conflicting interest between the auditor and au- s Issuers must file independent audit reports with dit client. their annual financial statements. To the extent s An auditor may not be in a position of auditing its the auditor is not independent, that report may be own work. inaccurate and the SEC may charge the auditor with causing the issuer to file an inaccurate report. s An auditor may not act as management or an em- ployee of its audit client. s An auditor may not be in a position of being an ad- B. Recent Cases vocate for its client.6 Rule 2-01(c) contains a nonexhaustive list of services, Recent auditor independence cases fall mainly into arrangements and circumstances that violate the inde- two broad categories: (1) cases relating to auditors pro- pendence requirements. Prohibited non-audit services viding prohibited non-audit services to clients or engag- include: ing in prohibited employment (or employment-like) ar- rangements, and (2) cases involving prohibited finan- s bookkeeping; cial ties between an auditor (or its associated entities) s financial information systems design and imple- and audit client (or its affiliates). mentation; s appraisal, valuation and actuarial services; 1. Prohibited Non-audit Services and s internal audit outsourcing; Employment Arrangements s management functions or human resources ser- a. Action Based on FINOP Services to Audit Client11 vices; On June 14, 2013, the SEC filed a settled administra- s investment banking services; tive proceeding against an accounting firm, RRBB, and one of its partners, Brian Zucker. Zucker previously s legal services; and owned his own firm, which focused on providing finan- s expert services unrelated to the audit. cial and operations principal (‘‘FINOP’’) services to The rule also identifies prohibited relationships, in- broker-dealer clients. In October 2011, Zucker’s firm cluding: merged with RRBB. Several of Zucker’s FINOP clients were RRBB audit clients. According to the SEC, after s employment relationships; the firms merged, Zucker served as audit engagement partner for a broker-dealer client, while simultaneous s contingent fee arrangements; providing FINOP services to the client. s direct or material indirect business relationships; The SEC concluded that the simultaneous services and violated auditor independence rules in two ways. First, the FINOP services constituted prohibited non-audit s financial relationships such as credit/debtor and services, including bookkeeping. Second, because, ac- banking relationships. cording to the SEC, a FINOP performs management- In prosecuting auditor independence cases, the SEC level responsibilities for a broker-dealer—including typically invokes one or more of the following federal monitoring the broker-dealer’s compliance with capital securities laws and SEC rules. rules, approving financial reports submitted to regula- s Exchange Act Rule 10A-2 makes it unlawful for an tors and supervision of back-office operations— auditor of an issuer not to be independent.7 Zucker’s provision of FINOP services violated the pro- hibition on an auditor’s performing decision making or s Rule 2-02(b) of Regulation S-X requires accoun- supervisory services for audit clients. tants to state whether audits were conducted in compliance with generally accepted auditing stan- RRBB and Zucker were both charged with causing dards (‘‘GAAS’’).8 GAAS require auditors to be in- the broker-dealer client’s failure to file independently dependent; accordingly, a lack of independence audited financial statements and with 102(e) violations. may lead to a violation of GAAS, which may lead RRBB was censured and paid $12,000 in disgorgement to a violation of Rule 2-02(b). and a $25,000 fine. Zucker was suspended from practic- ing before the SEC, with the right to apply for reinstate- ment after one year. 5 17 C.F.R. § 210-2.01. The independence requirements ap- ply to audits of broker-dealers as well. 6 9 SEC OFFICE OF THE CHIEF ACCOUNTANT,AUDIT COMMITTEES AND 15 U.S.C. § 78d-3. 10 AUDITOR INDEPENDENCE (modified May 7, 2007), available at 17 C.F.R. § 201.102(e). http://www.sec.gov/info/accountants/audit042707.htm. 11 In the Matter of Rosenberg Rich Baker Berman & Co., et 7 17 C.F.R. § 240.10A-2. al., SEC Administrative Proceeding Release No. 34-69765, 8 17 C.F.R. § 210.2-02(b). 2013 WL 2898032 (June 14, 2013). 12-22-14 COPYRIGHT ஽ 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. SRLR ISSN 0037-0665 3 b. Action Against Big Four Firm Based on Non-audit dition to the prohibition on auditors serving as client Services and Loaned Employee12 employees, auditor personnel may not act as client em- The SEC’s Jan. 24, 2014, settled action against a Big ployees either. In other words, an auditor may not do Four firm reflects most vividly the SEC’s focus on audi- indirectly (acting as an employee) what it may not do tor independence. The SEC alleged that the firm vio- directly (being an employee). The SEC instructed audit lated independence rules in two principal ways. firms to consider carefully ‘‘whether the relationship or First, the SEC alleged that the firm provided prohib- service in question would cause the accounting firm’s ited non-audit services to affiliates of two of the firm’s professionals to resemble, in appearance and function audit clients. The prohibited services alleged included . the employees of the audit client.’’ The SEC pointed restructuring services, expert services, bookkeeping to the degree of control the audit client exercises over a and payroll assistance. In one instance, an audit client firm’s loaned staff as a key factor in whether the ar- became an affiliate of a non-audit client pursuant to an rangement compromises the firm’s independence.
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