Improper Influence on Conduct of Audits

MEMORANDUM

Introduction

On May 20, 2003, the Securities and Exchange Commission (the "SEC") issued final rules[1] relating to Section 303(a) [2] of the Sarbanes-Oxley Act of 2002 (the "Act").  The new rules supplement already existing prohibitions under Regulation 13(b)(2) of the Securities Exchange Act of 1934 (the "Exchange Act") and are designed to ensure that management effectuates full disclosure to, and has honest discussions with, the auditor of the issuer's financial statements.  Under new Rule 13b2-2, it is unlawful for any officer or director of an issuer, or any other person acting under their direction, to take any action, directly or indirectly, to coerce, manipulate, mislead or fraudulently influence any independent public or certified accountant[3] engaged in the performance of an audit or review of the financial statements of that issuer that are required to be filed with the SEC if that person knew, or should have known, that such action could, if successful, result in rendering those financial statements materially misleading.[4]  These new rules are effective as of June 27, 2003.

Persons Covered

The new rules concern actions by officers, directors and persons acting "under the direction" of officers and directors.  The SEC interpreted the Act's use of the term "direction" to encompass a broader spectrum of behavior than "supervision."  The SEC has stated that a person may be "acting under the direction" of an officer or director even if he or she is not under the supervision or control of that officer or director.  Such persons include the issuer's employees, customers, vendors or creditors who, under the direction of an officer or director, provide false or misleading confirmations or other false or misleading information to auditors.  Persons acting under the direction of officers and directors may also include other partners or employees of the accounting firm (such as consultants or forensic accounting specialists retained by company counsel) as well as attorneys, securities professionals, or other advisers who pressure an auditor to limit the scope of the audit, issue an unqualified report on the financial statements when such a report would be unwarranted, refrain from objecting to an inappropriate accounting treatment or fail to withdraw an issued opinion on the issuer's financial statements.

Prohibited Conduct

The SEC stated that means of coercing, manipulating, misleading or exerting fraudulent influence include, but are not limited to:

• offering or paying bribes or other financial incentives, including offering future employment or contracts for non-audit services;
• providing an accountant with an inaccurate or misleading legal analysis;
• threatening to cancel or canceling existing non-audit or audit engagements if the accountant objects to the issuer's accounting;
• seeking to have a partner removed from the audit engagement because the partner objects to the issuer's accounting;
• blackmailing; and
• making physical threats.

The SEC release recites other conduct that when predicated by an intent to defraud could violate the rules such as verbal abuse, undue time pressure, failing to provide information on a timely basis, and being unavailable to discuss matters with the auditors on a timely basis.

Under the new rules, actions that could result in rendering materially misleading financial statements include, but are not limited to actions to coerce, manipulate, mislead or fraudulently influence an accountant to:

• issue or reissue an unwarranted report on the issuer's financial statements (due to material violations of generally accepted accounting principles (GAAP), generally accepted auditing standards (GAAS) or other professional standards);
• not perform audit, review or other procedures required by GAAS or other professional standards;
• not withdraw a previously issued report; or
• not communicate matters to the audit committee.

The new rules are not limited to the audit of annual financial statements, and would be applicable to, among other things, a review of interim financial statements and the issuance of a consent to the use of a previously issued audit report. 

Time Period Covered

The new rules apply when the accountant is "engaged in the performance of an audit or review of the financial statements."  The SEC has interpreted this to apply throughout the accountant's professional engagement commencing when the accountant is selected to perform audit or review services and continuing until there is a public notification that the professional relationship has ended.  The engagement period also includes any other time the accountant is asked to make decisions or judgments regarding the issuer's financial statements, including negotiations for retention of the accountant and post-audit relationship decisions regarding prior audit reports.[5] 

Scienter

Section 303 of the Act prohibits conduct by an officer, director or person acting under the direction of an officer or director, if undertaken for the purpose of rendering an issuer's financial statements materially misleading.  The new rules do not require a showing of a particular purpose or intent.  The SEC stated that requiring an element of scienter would have been inconsistent with the rules as they existed prior to their modification.  Accordingly, an officer, director or person acting under the direction of the officer or director, who engages in conduct to improperly influence an auditor will be culpable if he or she knows, or is negligent in not knowing, that the improper influence could, if successful, result in rendering financial statements materially misleading.

The SEC noted that violations of the new rules are illegal acts within Section 10A of the Exchange Act.  Consequently, accountants would be obligated to report violations of the new rules to management and the audit committee and, if remedial action were not taken, to the board of directors and in certain circumstances to the SEC.[6]

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These are only brief descriptions of the SEC's new rules.  This memorandum provides general information only and does not constitute legal advice that may be applied to any particular situation.  Please contact the Partners in our Corporate Department for further advice and assistance.

[1] See the SEC's website at http://www.sec.gov/rules/final/34-47890.htm.

[2] Section 303 of the Sarbanes-Oxley Act of 2002 states:

It shall be unlawful, in contravention of such rules or regulations as the Commission shall prescribe as necessary and appropriate in the public interest or for the protection of investors, for any officer or director of an issuer, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading.

[3] The SEC stated that, while it believes that an officer or director, or person acting under the direction of an officer or director, providing misleading information to an internal auditor would be relevant to the status of the issuer's internal accounting controls or disclosure controls, it would not appear to be related to the purpose of Section 303 and the new rules, which is to protect and enhance the independent audit function. The SEC cautioned, however, that, to the extent work of the internal auditor is used by the independent accountant in conducting an audit or review of the issuer's financial statements, misleading or inaccurate information provided to the internal auditor may be deemed to be provided to the independent accountant.

[4] These rules apply to private issuers that prepare financial statements "that are required to be filed" with the SEC, registered investment companies and small business issuers, and do not establish a private right of action for violation of these rules.

[5] This extends the period beyond the end of the professional engagement if the accountant is considering whether to consent to the use, reissue or withdrawal of a prior years' audit reports. The rules can also apply before the professional engagement period begins, such as when an officer, director or person acting under their direction offers to engage an accounting firm subject to a condition that could result in rendering the financial statements materially misleading, such as a condition that the firm issue an unqualified audit report on financial statements that do not conform with GAAP or limit the scope or performance of audit or review procedures in violation of GAAS.

[6] Similarly, although not explicitly stated, violations of these new rules would likely trigger an attorney's "up the ladder" reporting requirements.