Final Rule:
Amendment to Rule 102(e) of the Commission's Rules of Practice

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 201

(Release Nos. 33-7593; 34-40567; 35-26929; 39-2369; IA-1771; IC-23489; File No. S7-16-98)

RIN 3235-AH47

Amendment to Rule 102(e) of the Commission's Rules of Practice

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange Commission ("Commission") is adopting 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 amendment clarifies the Commission's standard for determining when accountants engage in "improper professional conduct" under Rule 102(e)(1)(ii).

EFFECTIVE DATE: The rule amendment will become effective November 25, 1998.

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 Commission today is adopting an amendment to Rule 102(e).¹

I. Executive Summary

The Commission’s proposal to amend Rule 102(e) was prompted by a recent judicial decision by the U.S. Court of Appeals for the District of Columbia Circuit concerning the conduct of two accountants. The court found that the Commission’s opinions in that case had not articulated clearly the "improper professional conduct" element of the rule.⁴ To address the court's concerns, the Commission published for comment a proposed amendment to Rule 102(e) on June 18, 1998.⁵ To give the public additional time to comment on the proposed amendment, the Commission extended the comment period until August 20, 1998.⁶

The proposed amendment articulated three types of violations of applicable professional standards that would constitute "improper professional conduct." The final rule amendment changes the focus of these provisions from types of violations to types of conduct that result in violations of applicable professional standards. Comment letters addressing these provisions generally supported two parts of the Commission’s proposal: one, knowing or intentional conduct, including reckless conduct; and, two, repeated instances of unreasonable conduct. The Commission adopts these provisions in substantially the form they were proposed.

Rule 102(e) proceedings may also be based on a third type of conduct: "highly unreasonable conduct" that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that "heightened scrutiny" is warranted. This part of the final rule amendment differs from the proposed amendment. This provision covers a single instance of serious misconduct that may not rise to the level of intentional or knowing (including reckless) conduct. The changes from the proposed amendment emphasize that this provision applies only to deviations from professional standards – greater than ordinary negligence but less than recklessness – when an accountant knows or should know of a heightened risk. The final rule amendment refers to this situation as "heightened scrutiny." The differences between the proposed amendment and the final amendment are discussed in detail below.

The amendment is intended to reach violations of applicable professional standards that demonstrate that an accountant lacks competence to practice before the Commission. An accountant who acts intentionally or knowingly, including recklessly, or highly unreasonably when heightened scrutiny is warranted, conclusively demonstrates a lack of competence to practice before the Commission. By contrast, when the Commission brings a Rule 102(e) proceeding for repeated instances of unreasonable conduct, it will also have to find that the conduct indicates a lack of competence.

The Commission received 168 comment letters on the proposed amendment to Rule 102(e). A number of commenters, including individual investors, institutional investors, public interest groups, officers and directors of public companies, and academics, supported the proposed amendment. Several certified public accountants ("CPAs") also expressed their support for the proposed amendment. Most other commenters supported at least some aspects of the proposed amendment. A substantial number of CPAs submitted letters that expressed agreement with an August 1998 memorandum of the American Institute of Certified Public Accountants ("AICPA") criticizing certain aspects of the proposed amendment. Most of these CPA commenters also expressed their support for the amendment to Rule 102(e) proposed in the AICPA’s May 7, 1998 rulemaking petition.⁷ In addition, the five largest U.S. accounting firms and members of interested committees of the American Bar Association submitted letters supporting some, but critical of other, aspects of the proposed amendment.

The Commission acted as expeditiously as practicable in adopting this amendment. The Commission wants to address promptly the Checkosky II court’s concern that the Commission had not clearly articulated its standard for determining when accountants engage in "improper professional conduct." Equally important, the Commission wants to make sure that its processes continue to be protected, and that the investing public continues to have confidence in the integrity of the financial reporting process.

Accurate financial reporting is the bedrock of our capital markets. Accountants play a vital role in assuring issuers’ compliance with reporting requirements. The Commission wishes to underscore the importance of that role and the need for accountants to comply with the standards of conduct applicable to members of their profession. These professional standards include the overarching requirement that auditors exercise due care in their audit of a company’s financial statements. The Commission possesses broad authority, both under the federal securities laws and its own rules, to promote and enforce compliance with professional standards.

Rule 102(e) addresses that category of professional conduct that threatens harm to the Commission’s processes. The rule was not intended to cover all forms of professional misconduct. As discussed below,⁸ the Commission has separate statutory authority that is available to address and deter professional misconduct that is not encompassed by Rule 102(e), as amended in this release.

The final rule amendment clarifies the Commission’s standard for determining when "improper professional conduct" occurs under Rule 102(e)(1)(ii). The amendment will allow the Commission to bring the actions it traditionally has brought under Rule 102(e)(1)(ii). Moreover, the purpose served and the relief provided by the rule are forward-looking. For these reasons, the Commission will use this standard in all cases considered after the amendment’s effective date, except where a trial before an Administrative Law Judge has already commenced,⁹ regardless of when the conduct in question occurred.

II. Background

A. The Importance of Rule 102(e)

Under Rule 102(e), the Commission can censure, suspend or bar professionals who appear or practice before it. Specifically, pursuant to the rule, the Commission can impose a sanction upon a professional whom it finds, after notice and an opportunity for hearing:

(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.¹⁰

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."¹¹ Courts have recognized that it is appropriate for the Commission to use a remedial rule such as Rule 102(e) to encourage professionals to adhere to professional standards and minimum standards of competence when they practice before the Commission. In adopting the rule, the Commission did not intend to add an "additional weapon" to its "enforcement arsenal,"¹² but to protect the integrity and quality of its system of securities regulation and, by extension, the interests of the investing public.

B. The Important Role of Accountants

Accountants play many roles in the Commission's system of securities regulation. One of the most significant roles is in auditing financial statements filed with the Commission. This release focuses particular attention upon the role of auditors in the securities registration and reporting processes under the federal securities laws. The amendment, however, covers all accountants who appear or practice before the Commission.¹³

"Corporate financial statements are one of the primary sources of information available to guide the decisions of the investing public."¹⁴ Various provisions of the federal securities laws require publicly-held companies to file audited financial statements with the Commission.¹⁵ These financial statements must be audited by independent accountants in accordance with generally accepted auditing standards ("GAAS").¹⁶ 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.¹⁷ The auditor's opinion states whether the audit was conducted in accordance with GAAS, and whether the financial statements present fairly, in all material respects, the financial position of the company as of a specific date and the results of its operations and its cash flows for the year (or other period) then ended, in conformity with generally accepted accounting principles ("GAAP").¹⁸

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 every financial statement.¹⁹ Consequently, the Commission must rely on the competence and independence of the auditors who certify, and the 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.

The Commission and the courts have long acknowledged "(t)he duty of accountants to those who justifiably rely on (their) reports."²⁰ The AICPA’s Code of Professional Conduct contains the strong statement that "(t)hose who rely on certified public accountants expect them to discharge their responsibilities with integrity, objectivity, due professional care, and a genuine interest in serving the public."²¹ Due care requires auditors to discharge their responsibilities with competence and diligence and consistent with the profession’s responsibility to the public. Moreover, GAAS requires that "due professional care" be exercised in the performance of audits.²² 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.²³ An incompetent accountant can damage the Commission's processes and erode investor confidence in our markets.²⁴

C. The "Improper Professional Conduct" Standard Applied to Accountants

The Court of Appeals in Checkosky II criticized the Commission for not clearly articulating in that case when an accountant would be deemed to have engaged in "improper professional conduct" under Rule 102(e)(1)(ii). The amendment adopted today addresses this concern by specifying three types of conduct that constitute "improper professional conduct." The Commission believes that a finding of "improper professional conduct" under Rule 102(e) is warranted only when an accountant lacks competence²⁵ to practice before the Commission.

Rule 102(e)(1)(ii) has been an effective remedial tool because it covers a range of conduct that demonstrates that a professional is a future threat to the Commission's processes.²⁶ Accountants who engage in intentional or knowing conduct, which includes reckless conduct, clearly pose this type of future threat. Accountants who engage in certain specified types of negligent conduct also can pose such a future threat.

Rule 102(e)(1)(ii) is not meant, however, to encompass every professional misstep.²⁷ A single judgment error, for example, even if unreasonable when made, may not indicate a lack of competence to practice before the Commission and, therefore, may not pose a future threat to the Commission's processes sufficient to require Commission action under Rule 102(e)(1)(ii).²⁸

The Commission believes that a single judgment error that was highly unreasonable and made in circumstances warranting heightened scrutiny, however, conclusively demonstrates a lack of competence to practice before the Commission.²⁹ Repeated judgment errors may also indicate a lack of competence. Therefore, if the Commission finds that an accountant acted unreasonably in more than one instance (each time resulting in a violation of applicable professional standards), and that this conduct indicates a lack of competence, that accountant engaged in improper professional conduct under the standard adopted today.³⁰

The Commission does not seek to use Rule 102(e)(1)(ii) to establish new standards for the accounting profession. The rule itself imposes no new professional standards on accountants. Accountants who appear or practice before the Commission are already subject to professional standards. Indeed, the Commission will only bring Rule 102(e)(1)(ii) proceedings against accountants who violate applicable professional standards in circumstances that demonstrate their lack of competence to practice before the Commission.³¹

III. Discussion of Amendment

A. The Final Rule

The amendment specifies three types of conduct that constitute "improper professional conduct" under Rule 102(e)(1)(ii). The amendment states:

(iv) With respect to persons licensed to practice as accountants, "improper professional conduct" under §201.102(e)(1)(ii) means:

(A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards; or

(B) Either of the following two types of negligent conduct:

(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.

(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission.

Each section of the final rule amendment refers to a violation of "applicable professional standards."³² The term "applicable professional standards" primarily refers to GAAP, GAAS, the AICPA Code of Professional Conduct, and Commission regulations. Also included are generally accepted standards routinely used by accountants in the preparation of statements, opinions, or other papers filed with the Commission.

The term "applicable professional standards" is broad enough to accommodate changes in the body of professional guidance routinely used by accountants. For example, should international accounting standards be adopted, they would become part of accepted professional guidance. Likewise, pronouncements of the Independence Standards Board, or other bodies yet to be established, would come to form part of the professional guidance that accountants routinely use. As the AICPA concluded, the term "applicable professional standards" is one "that professionals are generally familiar with and can understand."³³

B. Intentional or Knowing Conduct, Including Reckless Conduct

Subparagraph (A) of the amendment defines "improper professional conduct" to include the most blatant violations of applicable professional standards. The Commission consistently has used Rule 102(e) proceedings to address these types of violations of applicable professional standards.³⁴

The Commission is adopting subparagraph (A) of the amendment in substantially the same form as it was proposed. Almost all commenters expressed support for subparagraph (A) of the proposed amendment. Clearly, an accountant who intentionally or knowingly, including recklessly, violates the professional standards conclusively demonstrates a lack of competence to appear before the Commission. Accountants who engage in this type of misconduct pose a future threat to the Commission's processes.

The Commission also requested comments on what definition of "recklessness" is most appropriate. Several commenters suggested that the Commission adopt a definition of "recklessness" used in cases brought under Section 10(b) and Rule 10b-5 of the Securities Exchange Act.³⁵ Although the standards of professional practice are not fraud based, the Commission agrees that, for purposes of consistency under the federal securities laws, "recklessness" in subparagraph (A) of the rule amendment should mean the same thing as courts have defined "recklessness" to mean under the antifraud provisions. "Recklessness" under the antifraud provisions "is not merely a heightened form of ordinary negligence; it is an 'extreme departure from the standards of ordinary care, . . . which presents a danger of misleading buyers or sellers that is either known to the (actor) or is so obvious that the actor must have been aware of it.'"³⁶ This recklessness standard is a lesser form of intent.³⁷

C. Two Specific Types of Negligent Conduct

The final rule amendment also covers two specific types of negligent conduct that result in violations of applicable professional standards.³⁸ The Commission believes that a negligent auditor can do just as much harm to the Commission’s processes as one who acts with an improper motive.³⁹ For this reason, the Commission has brought Rule 102(e) proceedings based on negligent conduct.⁴⁰

The Court of Appeals in Checkosky II faulted the Commission for not articulating with specificity when negligent conduct by an accountant constitutes "improper professional conduct."⁴¹ The final rule amendment provides this specificity. Subparagraph (B) of the amendment defines "improper professional conduct" to include two specific types of negligent conduct:

(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.

(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission.

1. Highly Unreasonable Conduct

The "highly unreasonable" standard in subparagraph (B)(1) of the final rule amendment is an intermediate standard, higher than ordinary negligence but lower than the traditional definition of recklessness used in cases brought under Section 10(b) and Rule 10b-5 of the Exchange Act.⁴² The "highly unreasonable" standard is an objective standard. The conduct at issue is measured by the degree of the departure from professional standards and not the intent of the accountant. The Commission believes that subparagraph (B)(1) describes conduct that poses a threat of future harm to the Commission’s processes and conclusively demonstrates that the accountant lacks competence to practice before it.

The proposed rule referred to "unreasonable" conduct.⁴³ The definition the Commission adopts today includes a higher standard. The final standard reflects the Commission’s conclusion that a single judgment error, even if unreasonable when made, may not indicate a lack of competence to practice before the Commission and, therefore may not pose a future threat to the Commission's processes sufficient to impose remedial sanctions. The Commission neither accepts nor condones unreasonable, or negligent, accounting or auditing errors. To the contrary, such errors could undermine accurate financial reporting. Moreover, the Commission possesses authority, wholly independent of Rule 102(e), to address and deter such errors through its enforcement of provisions of the federal securities laws that impose liability on persons, including accountants, for negligent conduct.⁴⁴

Many commenters objected to the "unreasonable" formulation in this subparagraph of the proposed rule or suggested changes to this subparagraph. Some CPAs and other commenters, for example, expressed concern that the "unreasonable" formulation made accountants unfairly vulnerable and liable for acts of "simple negligence" and errors in judgment.⁴⁵ These commenters maintained that such a standard could restrict accountants’ exercise of their best independent judgment, thereby operating to the detriment of the financial reporting system.⁴⁶

Creating an undue fear that an isolated error in judgment would result in a 102(e) proceeding could be counterproductive in some limited instances.⁴⁷ These concerns are eliminated as to Rule 102(e), or at least alleviated, by raising the threshold for improper professional conduct from one instance of "unreasonable" conduct to one instance of "highly unreasonable" conduct. Subparagraph (B)(1) of the final rule amendment does not permit the Commission to evaluate actions or judgments in the stark light of hindsight, but focuses instead on what an accountant knew, or should have known, at the time an action was taken or a decision was made. Indeed, three of the five largest accounting firms – who expressed concern that the "unreasonable" formulation would chill accountants’ use of their best judgment – suggested that the Commission could appropriately adopt a "highly unreasonable" formulation.⁴⁸ And, as one commenter pointed out, most state licensing provisions include a "gross negligence" standard.⁴⁹

Some commenters questioned whether raising the standard above ordinary negligence was consistent with the purpose of Rule 102(e)(1)(ii) to protect the integrity of the Commission’s processes.⁵⁰ These commenters strongly argued that a negligence standard is needed because accurate financial statements are essential to the investment decision-making process and auditors play a critical role in maintaining investor confidence in the reliability of financial statements.⁵¹ The heightened standard of "highly unreasonable" strikes the appropriate balance between the Commission’s need to protect its processes and accountants’ ability to exercise judgment. In the Commission’s view, the balance is appropriate in part because of the availability of remedies other than Rule 102(e) to address ordinary negligence. The final rule amendment, therefore, is fully consistent with the remedial purposes of Rule 102(e).

The final rule amendment provides that the Commission will bring cases under subparagraph (B)(1) only when an accountant knows or should know that heightened scrutiny is appropriate. The "heightened scrutiny" provision is also an objective standard. Again, the touchstone is the reasonable accountant. "Heightened scrutiny" would be warranted when matters are important or material, or when warning signals or other factors should alert an accountant of a heightened risk,⁵² or as set forth in applicable professional standards.⁵³ Because of the importance of an accountant’s independence to the integrity of the financial reporting system, the Commission has concluded that circumstances that raise questions about an accountant’s independence always merit heightened scrutiny. Therefore, if an accountant acts highly unreasonably with respect to an independence issue, that accountant has engaged in "improper professional conduct."

The proposed amendment focused on conduct presenting "a substantial risk, which is either known or should have been known," of making a document filed with the Commission "materially misleading." At least one commenter questioned whether the phrase was overbroad.⁵⁴ Other commenters correctly noted that the Commission’s standard should not depend on the impact of a violation on financial statements filed with the Commission.⁵⁵ The proper focus should be on the conduct itself, rather than on the risk of harm posed by the conduct.⁵⁶

This change from the proposed rule amendment is consistent with the purpose of Rule 102(e)(1)(ii) to protect the Commission’s processes from accountants who lack competence to appear before it. The final rule amendment addresses this issue by focusing on the behavior of an accountant under the facts and circumstances presented at the time. The standard does not permit judgment by hindsight, but rather compares the actions taken by an accountant at the time of the violation with the actions a reasonable accountant should have taken if faced with the same situation.

One commenter stated that filing a materially false or misleading document with the Commission should be a "threshold requirement" for a finding of improper professional conduct.⁵⁷ The Commission disagrees. The Commission does not need to show that the accountant’s behavior actually caused harm; an accountant can demonstrate a lack of competence even if his conduct did not result in the filing of a false or misleading document. An auditor who fails to audit properly under GAAS – whether recklessly or highly unreasonably – should not be shielded because the audited financial statements fortuitously turn out to be accurate or not materially misleading. For example, the financial statements of a large company’s subsidiary that have been audited by an accountant who acted recklessly or highly unreasonably in violation of GAAS may not be material to the consolidated financial statements filed by the company with the Commission. In that situation, the accountant has demonstrated a lack of competence.

Some commenters contended that the Commission should not have special rules for accountants. These commenters claimed further that, when compared to the standard applied to lawyers, the proposed rule "discriminates" against accountants.⁵⁸ As explained earlier, the amendment to Rule 102(e) focuses on accountants in response to the Checkosky II decision and the need to assure the protection of the Commission’s financial reporting process. As noted, this release does not address the conduct of lawyers.

2. Repeated Instances of Unreasonable Conduct

Subparagraph B(2) of the final rule amendment addresses "(r)epeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards." Repeated instances of unreasonable conduct by an accountant, each resulting in a violation of applicable professional standards, can damage both the Commission’s processes and investor confidence in the integrity of financial statements. Most commenters who addressed the issue supported the notion of bringing Rule 102(e) proceedings against accountants who engage in repeated instances of negligent conduct.⁵⁹

The term "unreasonable," as distinguished from the term "highly unreasonable" used in subparagraph B(1), connotes an ordinary or simple negligence standard. The lower standard of culpability is justified in this instance because the repetition of the unreasonable conduct may show the accountant’s lack of competence to practice before the Commission. If an accountant fails to exercise reasonable care on more than one occasion, the Commission’s processes may be threatened. More than one violation of applicable professional standards ordinarily will indicate a lack of competence.

A few commenters raised questions about what would constitute "repeated instances" of unreasonable conduct.⁶⁰ "Repeated instances" means more than once. The term "repeated" may encompass as few as two separate instances of unreasonable conduct occurring within one audit, or separate instances of unreasonable conduct within different audits. For example, if an auditor fails to gather evidential matter for more than two accounts, or certifies accounting inconsistent with GAAP in more than two accounts, that conduct constitutes "repeated instances" of unreasonable conduct. By contrast, a single error that results in an issuer’s financial statements being misstated in more than one place would not, by itself, constitute a violation of this subparagraph. Certification of accounting inconsistent with GAAP in two or more situations, however, may indicate an accountant’s basic unfamiliarity with the standards of the profession, which may constitute improper professional conduct under subparagraph B(2).

The Commission recognizes that "repeated instances" may not always demonstrate a lack of competence to practice before the Commission. Although the Commission believes that more than one instance of unreasonable conduct will ordinarily indicate a lack of competence, unlike subparagraphs (A) and (B)(1), this subparagraph requires the Commission to make a specific finding that the conduct indicates a lack of competence. The finding is based on an evaluation of the conduct itself and does not require a separate evidentiary basis. This finding is required because two isolated violations of applicable professional standards, for example GAAS, may not pose a threat to the Commission’s processes.

D. Authority

Some commenters questioned the Commission’s authority to adopt a negligence standard under Rule 102(e). As stated in the Proposing Release, Rule 102(e) was promulgated under the Commission's broad authority to adopt those rules and regulations necessary for carrying out its designated functions,⁶¹ and its inherent authority to protect the integrity of its processes. As the Supreme Court has held, "the validity of a regulation promulgated (under an agency’s general rulemaking authority) will be sustained so long as it is 'reasonably related to the purposes of the enabling legislation.'"⁶²

Three U.S. Courts of Appeals have upheld the validity of Rule 102(e).⁶³ As the U.S. Court of Appeals for the Second Circuit recognized:

(Rule 102(e)) represents an attempt by the Commission to protect the integrity of its own processes. It provides the Commission with the 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. As such the Rule is 'reasonably related' to the purposes of the securities laws.⁶⁴

One district court has explicitly held that the Commission’s Rule 102(e) authority is not limited to instances of intentional misconduct or bad faith.⁶⁵

Some commenters either referred to, or echoed, concerns expressed in the separate opinions of two judges of the U.S. Court of Appeals for the D.C. Circuit in Checkosky I questioning the Commission’s authority to use a negligence standard for "improper professional conduct" under Rule 102(e).⁶⁶ One judge suggested that, if the Commission were to determine that an accountant’s negligence was a per se violation of Rule 102(e), the Commission may be exceeding the scope of its authority and engaging in the substantive regulation of the accounting profession.⁶⁷ Similarly, a number of commenters suggested that adoption of a simple negligence standard would exceed the Commission’s authority and encroach on the responsibilities of state boards of accountancy and professional organizations.

Although the Commission believes that it has the authority to do so, the Commission is not adopting a "simple" or "mere" negligence standard. Instead, the Commission is adopting a standard under which two specific types of negligent conduct that result in a violation of applicable professional standards are considered a future threat to the Commission’s processes. The Commission is neither broadly regulating the accounting profession nor preventing accountants from functioning in numerous areas of their professions. Instead, the Commission is protecting the integrity and quality of its processes, and this it emphatically believes – in the public interest and for the protection of investors – it has the power to do.

In addition, the standard adopted today imposes no new professional responsibilities on accountants. Instead, the final rule amendment permits the Commission to bring proceedings against accountants when their violations of professional standards threaten the Commission’s processes. The Commission is not attempting to police accountants’ conduct in any area other than as it affects the operation of the federal securities laws.

One other judge in Checkosky I suggested that the Commission’s authority to adopt a negligence standard under Rule 102(e)(1)(ii) might be limited by substantive provisions of the federal securities laws, such as the antifraud provision of Exchange Act Section 10(b).⁶⁸ Some commenters contended that the Commission could not therefore adopt a definition of "improper professional conduct" that did not require that the accountant acted with "scienter," the mental state required under the Exchange Act’s antifraud provisions.⁶⁹

The definition of "improper professional conduct" that the Commission adopts today does not require scienter in every instance. The Commission believes this is necessary because Rule 102(e) protects the integrity of the Commission’s processes; it is not an enforcement remedy or a weapon against fraud.⁷⁰ As noted above, accountants who engage in two specific kinds of negligent conduct can pose as great a threat to the Commission’s processes as accountants who knowingly violate professional standards. As one commenter noted, "the Commission’s power to regulate professional standards should not be limited by the considerations of scienter that are appropriate in a jurisprudence built on common law definitions of fraud."⁷¹ In addition, as another commenter noted, the federal securities laws impose liability for negligent conduct, as well as for conduct undertaken with scienter.⁷² As this commenter noted, there are other policy reasons for the Commission to apply a negligence standard to accountants who practice before the Commission.⁷³

E. A "Good Faith" Defense

The Commission does not consider the subjective good faith of an accountant to be an absolute defense under Rule 102(e)(1)(ii).⁷⁴ Subjective good faith is inconsistent with a finding of knowing or intentional, including reckless, conduct. Moreover, a Rule 102(e) proceeding based on the particular types of negligence covered in the final rule amendment does not require any subjective inquiry into the accountant’s intent; subparagraphs (B)(1) and (B)(2) of the final rule amendment are objective standards. The Commission may, however, consider the accountant’s good faith when determining what sanctions would be appropriate.

IV. Summary of Regulatory Flexibility Analysis

A summary of the Initial Regulatory Flexibility Analysis ("IRFA") on the proposed amendment to Rule 102(e) was published in the proposing release. The IRFA indicated that the proposed amendment would clarify the standard by which the Commission determines whether accountants have engaged in "improper professional conduct." No comments were received on the IRFA. The Commission has prepared a Final Regulatory Flexibility Analysis ("FRFA") in accordance with 5 U.S.C. 604 on the amendment to Rule 102(e). The following summarizes the FRFA.

The FRFA discusses the need for the rule amendment. Rule 102(e) currently authorizes the Commission to censure an accountant or deny, temporarily or permanently, an accountant's privilege of appearing or practicing before the Commission, if the accountant lacks character or integrity, or has engaged in unethical or "improper professional conduct." The existing rule does not define "improper professional conduct."

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’s opinions in the case had not articulated clearly the "improper professional conduct" element of the Rule. To address the court's concerns, the Commission is clarifying the Commission's standard for determining when accountants engage in "improper professional conduct."

The FRFA explains that the rule amendment is designed to protect the integrity of the Commission's processes. By clarifying the standards applied in determining "improper professional conduct," the amendment will help the Commission, its administrative law judges, and the courts apply the rule fairly and consistently. The amendment will also give practitioners additional guidance about the standards for proceedings under Rule 102(e).

The FRFA explains that the notice of proposed rulemaking indicated how a copy of the IRFA could be obtained, and that no one requested a copy of the IRFA. The IRFA, and the summary of the IRFA that appeared in the notice of proposed rulemaking, also solicited 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. No commenters discussed either the IRFA generally or the number of small entities that would be affected by the proposed amendment.

The FRFA also discusses the effect of the amendment on small entities. The FRFA 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 Five" firms, which are not small entities, many smaller firms do practice before the Commission. The Commission does not, however, 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 Commission’s standard provides a remedy for certain violations of the accountants’ own professional standards and does not impose any new standards of conduct.

The FRFA notes that the amendment would not impose any new reporting, recordkeeping or compliance requirements. The FRFA 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 FRFA notes that two commenters suggested that the proposed rule could have an adverse effect on small accounting firms and/or small public companies. The Commission believes that it has addressed the concern that a simple negligence standard might raise fees or discourage auditors from practice by raising the standard in the final amendment. Finally, the FRFA notes that one commenter contended that the proposed amendment would not impose a disproportionate impact on small entities, and that another commenter wrote that the level of competence expected of a professional must be an absolute standard, regardless of the entity’s size.

A copy of the FRFA 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.

V. Cost-Benefit Analysis

One commenter suggested that the "costs associated with the proposed amendment appear to outweigh its potential benefits,"⁷⁵ but offered no data to support the view. The commenter did describe the costs of the proposed amendment as "costs associated with a decisional standard that fails to provide professionals with adequate notice of the conduct which could be subject to sanction," and costs created by the "exposure of auditors to sanction based on a single negligent mistake," which the commenter believed "would introduce an overly conservative bias into the financial reporting process."⁷⁶

This commenter’s concern that the proposed rule’s use of a simple negligence standard would impose costs was shared by other commenters. Three commenters suggested that adoption of a simple negligence standard would, among other things, cause audit fees to increase.⁷⁷ Likewise, one of these commenters and one other commenter suggested that the proposed rule’s use of a negligence standard would discourage competent practitioners from pursuing careers in public company auditing.⁷⁸

The Commission does not believe that the final rule amendment imposes these costs. First, the Commission believes that the standard it adopts today defines with precision when an accountant’s conduct will subject the accountant to Rule 102(e) proceedings. In fact, the clarification of the Commission’s standard for "improper professional conduct" is one of the benefits of this final rule amendment. Second, these commenters’ concern that accountants will be held liable for a single negligent mistake is addressed by the final rule amendment. As described above, the Commission is not adopting a standard that reaches single acts of simple negligence.

One commenter argued that the proposed rule’s costs outweighed its benefits because it applied to "CPAs and CPA firms whose past errors are not necessarily a precursor of future substandard practice."⁷⁹ The Commission believes that the final rule amendment only reaches accountants whose past violations demonstrate a lack of competence to practice before the Commission.

According to this commenter, the "elimination of individuals and firms whose audit services are unreliable will undoubtedly have a beneficial effect in preventing future investor losses."⁸⁰ Weighed against this benefit, this commenter identified the costs of bringing Rule 102(e) proceedings and the costs "associated with depriving the public of the services of qualified auditors."⁸¹ This commenter stated that the number of accounting firms providing auditing services to public companies has declined sharply in the last 20 years and that there is no assurance that a further decline might not lead to increased audit fees.⁸²

These comments seem directed at the costs and benefits of Rule 102(e) as a whole. The Commission only sought comment on the costs and benefits of its proposal to clarify "improper professional conduct," not the costs and benefits of Rule 102(e). Moreover, the Commission has adopted a standard that is designed to reach only those accountants who lack competence to practice before the Commission. The rule amendment should not therefore "deprive" the public of the service of "qualified auditors." The Commission therefore believes that the costs and benefits described by the commenter will not be affected by the particular standard adopted.

The Commission anticipates several benefits from the final rule 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." Also, the clarified 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 notes that its standard requires in the first instance that the accountant violate applicable professional standards. Therefore, the rule imposes no obligation that accountants are not already subject to. Rather, the amendment merely clarifies that when the Commission finds that an accountant has violated the applicable professional standards in circumstances meeting one of three standards of culpability, that accountant has engaged in "improper professional conduct." The Commission also notes the existence of state accountancy boards, which can discipline accountants for violations of professional standards. In addition, the federal securities laws and state law causes of action may provide for sanctions against accountants for related conduct. Therefore, accountants are already subject to liability and disciplinary schemes that encourage accountants to comply with applicable professional standards. After careful consideration of the comments received, the Commission continues to believe that the amendment will impose no costs.

VI. Efficiency, Competition and Capital Formation

The Commission requested data on what effect, if any, the proposed amendment would have on efficiency, competition and capital formation. No specific data was received in response to this request. One commenter asserted that the rule as proposed would cause "the steps and costs to take a company public" to escalate.⁸³ This commenter did not, however, provide any detail or explanation of why the proposed rule would cause this effect.

The Commission anticipates no effect on capital formation or efficiency, as the rule amendment clarifies an existing standard. Further, because the rule change applies equally to all accountants who practice before the Commission, and because it clarifies an existing standard, there should be no anti-competitive effect. In any event, the Commission believes that any burden on competition imposed by this amendment is necessary and appropriate in furtherance of the purpose of the Exchange Act.

VII. Statutory Authority

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 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 § 201.102 by adding paragraph (e)(1)(iv) to read as follows:

§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 §201.102(e)(1)(ii) means:

(A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards; or

(B) Either of the following two types of negligent conduct:

(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.

(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission.

* * * * *

By the Commission.

Jonathan G. Katz

Secretary

Dated: October 19, 1998

Footnotes

-[1]-   17 CFR 201.102(e).

-[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).

-[3]-   This clarification addresses the conduct of accountants only, and is not meant to address the conduct of lawyers, other professionals or experts who practice before the Commission.

-[4]-   Checkosky v. SEC , 139 F.3d 221 (D.C. Cir. 1998) (" Checkosky II ").

-[5]-   Securities Act Release No. 7546 (June 12, 1998), 63 FR 33305 (June 18, 1998) (the "Proposing Release"). In addition to publishing the Proposing Release in the Federal Register, the Commission also posted it on its Website. The address of the Commission’s Website is http://www.sec.gov.

-[6]-   Securities Act Release No. 7555 (July 15, 1998), 63 FR 39054 (July 21, 1998).

-[7]-   On May 7, 1998, the AICPA submitted a rulemaking petition to the Commission proposing a definition for "improper professional conduct" under Rule 102(e)(1)(ii). Rulemaking Petition by the AICPA Concerning Rule 102(e) ("AICPA Rulemaking Petition"), SEC File No. 4-410 (May 7, 1998).

-[8]-   See discussion on p.20.

-[9]-   Where a hearing has already commenced, an Administrative Law Judge may use the Rule 102(e) standard adopted today if such use would not unfairly prejudice any party. The Administrative Law Judge may also supplement or re-open the record, if necessary, to give any party so requesting the opportunity to provide particular evidence or briefing on the Rule 102(e) standard.

-[10]-   17 CFR 201.102(e)(1)(i), (ii) and (iii).

-[11]-   Touche Ross & Co. v. SEC , 609 F.2d 570, 582 (2d Cir. 1979).

-[12]-   Id . at 579.

-[13]-   See 17 CFR 201.102(f)(1) and (2). For example, the Commission has brought Rule 102(e) proceedings against accountants serving as officers of public companies. See , e.g. , In re Terrano , Securities Exchange Act of 1934 ("Exchange Act") Release No. 39485 (Dec. 23, 1997), 66 SEC Docket 494 (Jan. 20, 1998); In re Hersh , Exchange Act Release No. 39089 (Sept. 18, 1997), 65 SEC Docket 1170 (Oct. 14, 1997); In re Bryan , Exchange Act Release No. 39077 (Sept. 15, 1997), 65 SEC Docket 1129 (Oct. 14, 1997).

-[14]-   U.S. v. Arthur Young & Co. , 465 U.S. 805, 810 (1984).

-[15]-   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. 78 l (b)(1)(J)-(L).

-[16]-   Regulation S-X, 17 CFR 210.1-02(d) (1997).

-[17]-   See Regulation S-X, 17 CFR 210.2-02 (1997).

-[18]-   Id .

-[19]-   See Touche Ross , 609 F.2d at 580-81.

-[20]-   In re Carter , Exchange Act Release No. 17595 (Feb. 28, 1981), 22 SEC Docket 292, 298 (Mar. 17, 1981). Cf . Arthur Young , 465 U.S. at 817-18.

-[21]-   AICPA Professional Standards, Vol. 2 ET section 53.03 (1997).

-[22]-   AICPA Professional Standards, Vol. 1 AU section 230.01 (1997).

-[23]-   See Carter , 22 SEC Docket at 298.

-[24]-   "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).

-[25]-   By "competence" the Commission means not just technical skills, but also an accountant’s willingness and ability to adhere to professional standards, including standards of honesty and fair dealing.

-[26]-   Carter , 22 SEC Docket at 297. Because the purpose of Rule 102(e)(1)(ii) is to address conduct that demonstrates a future threat to the Commission's processes, the rule is remedial and not punitive in nature.

-[27]-   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. In re Checkosky , Exchange Act Release No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948, 1976 (Feb. 18, 1997)(Johnson, Comm'r, dissenting), rev'd Checkosky II .

-[28]-   Such an error, however, may violate applicable professional standards. For example, the AICPA’s Code of Professional Conduct and GAAS require accountants to exercise due care. In addition, such an error may result in a violation of the federal securities laws. See discussion at p. 20. In either event, the person committing such an error, though not subject to discipline under Rule 102(e), would be exposed to the sanctions available under those other provisions.

-[29]-   See Section III.C.1 below.

-[30]-   See Section III.C.2 below.

-[31]-   Under Rule 102(e), the Commission has other authority to protect the integrity of its processes from persons who pose a threat of future harm to those processes. For example, the Commission may censure, suspend or bar persons who the Commission finds "not to possess the requisite qualifications to represent others." 17 CFR 201.102(e)(1)(i).

-[32]-   The final rule amendment will not change the Commission’s practice of bringing Rule 102(e) proceedings against accountants who lack independence. See , e.g. , In re Goodbread , Exch. Act Rel. No. 38035 (Dec. 12, 1996), SEC Accounting Rules (Current Binder) (CCH) ¶ 5,061 (Mar. 1997); In re Iommazzo , Exch. Act Rel. No. 30733 (May 22, 1992), Accounting Series Releases,(1991-95 Transfer Binder) Fed. Sec. L. Rep. (CCH) ¶ 73,844 (July 19, 1995).

-[33]-   Comment Letter of Richard I. Miller, General Counsel & Secretary, AICPA, at 9 (Aug. 20, 1998) ("AICPA Comment Letter").

-[34]-   See , e.g. , In re Finkel , Securities Act Release No. 7401 (Mar. 12, 1997), 64 SEC Docket 103 (Apr. 8, 1997); In re Basson , Exchange Act Release No. 35840 (June 13, 1995), 59 SEC Docket 1650 (July 11, 1995); In re F.G. Masquelette & Co. , Accounting Series Release No. 68, (1937-1982 Transfer Binder) Fed. Sec. L. Rep. (CCH),¶ 72,087 (June 30, 1982); In re Weiner , Exchange Act Rel. No. 14249 (Dec. 12, 1977), 13 SEC Docket 1113 (Dec. 27, 1977).

-[35]-   See , e.g. , Comment Letter of Ernst & Young LLP, at 19-20 (Aug. 20, 1998) ("Ernst & Young Comment Letter"); AICPA Comment Letter, at 8.

-[36]-   SEC v. Steadman , 967 F.2d 636, 641 (D.C. Cir. 1992) (ellipsis in original) (quoting Sundstrand Corp. v. Sun Chemical Corp. , 553 F.2d 1033, 1045 (7th Cir.), cert. denied , 434 U.S. 875 (1977)); see also Potts v. SEC , 151 F.3d 810 (8th Cir. 1998) (finding recklessness under the Steadman standard in a Rule 102(e) proceeding).

-[37]-   See Ernst & Ernst v. Hochfelder , 425 U.S. 185, 193-94 n.12 (1976); see also Steadman , 967 F.2d at 641.

-[38]-   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). See also Securities Act section 17(a)(2) & (3), 15 U.S.C. 77q(a)(2) & (3); Aaron v. SEC , 446 U.S. 680 (1980). In addition, section 21C of the Exchange Act imposes liability when a person is a "cause" of a violation "due to an act or omission the person knew or should have known would contribute to such violation." 15 U.S.C. 78u-3.

-[39]-   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. The amendment adopted today by the Commission, similar to the AICPA Rulemaking Petition, subjects accountants who engage in knowing misconduct as well as a course or pattern of misconduct to Rule 102(e)(1)(ii) proceedings. The amendment adopted today includes two specific types of negligent conduct. The Commission believes that the public interest will be better served by its broader definition of "improper professional conduct."

-[40]-   See, e.g., In re Gotthilf , Exchange Act Release No. 33949 (April 21, 1994), 56 SEC Docket 1543 (May 10, 1994). See also Danna v. SEC , No. C-93-4158 (CW), 1994 WL 315877 (N.D. Cal. Feb. 8, 1994).

-[41]-   Checkosky II , 139 F.3d at 224.

-[42]-   The Commission notes that several cases interpreting the antifraud provisions of the federal securities laws use the phrase "highly unreasonable" as part of the definition of recklessness. See , e.g. , Sundstrand , 553 F.2d at 1045. The Commission does not mean to incorporate that case law by using the term "highly unreasonable" in this context. This release defines the "highly unreasonable" standard – an intermediate standard higher than ordinary negligence and lower than recklessness – with care and precision. The "highly unreasonable" standard adopted today is not scienter-based.

-[43]-   In fact, the proposed rule referred to "(a)n unreasonable violation." At least one commenter correctly pointed out that this formulation implies there may be "reasonable" violations of professional standards. Comment Letter of K. Michael Conaway (Aug. 20, 1998). To eliminate this misconception, and to focus on individual competence, the final rule refers to "unreasonable conduct," not "violations."

-[44]-   See , e.g. , Securities Act section 17(a)(2) & (3), 15 U.S.C. 77q(a)(2) & (3); Exchange Act section 21C, 15 U.S.C. 78u-3; see also Securities Act section 11, 15 U.S.C. 77k. Accountants also may be liable for negligent conduct under the laws of various states, and subject to sanction by state accounting boards, see , e.g. , Fla. Admin. Code Ann. r. 61H1-36.004 (1998).

-[45]-   AICPA Comment Letter, at 15-16; Comment Letter of Arthur Andersen LLP, at 5 (Aug. 17, 1998) ("Arthur Andersen Comment Letter"); Comment Letter of Robert K. Elliott, Partner, KPMG Peat Marwick LLP, at 10-12 (Aug. 20, 1998) ("KPMG Peat Marwick Comment Letter).

-[46]-   Most investors and users of financial statements, however, disagreed. See Comment Letter of Peter C. Clapman, Senior Vice President and Chief Counsel, Investments, TIAA-CREF, at 4 (July 16, 1998); Comment Letter of Josh S. Weston, Chairman of the Board, Automatic Data Processing, Inc. (Aug. 24, 1998) ("Weston Comment Letter"); Comment Letter of Dr. John H. Nugent (Aug. 11, 1998) ("Nugent Comment Letter"); Comment Letter of Kurt N. Schacht, Chief Legal Officer, State of Wisconsin Investment Board, at 1 (July 20, 1998); Comment Letter of Laurence A. Tisch, Co-Chairman of the Board and Co-Chief Executive Officer, Loews Corporation (July 8, 1998); Comment Letter of Steven Alan Bennett, Senior Vice President and General Counsel, Banc One Corporation, at 2 (July 21, 1998). Moreover, commenters from one state board of accountancy supported the proposed standard. Comment Letter of Martha P. Willis, Division Director, State of Florida, Department of Business and Professional Regulation (Aug. 21, 1998).

-[47]-   However, such an error could have legal consequences. See discussion on p. 20.

-[48]-   Comment Letter of J. Michael Cook, Chairman and Chief Executive Officer, and Phillip R. Rotner, General Counsel, Deloitte & Touche LLP, at 6 ("Deloitte & Touche Comment Letter"); Ernst & Young Comment Letter, at 24; Comment Letter of PricewaterhouseCoopers, at 7 (Aug. 20, 1998) ("PricewaterhouseCoopers Comment Letter").

-[49]-   Comment Letter of Wayne A. Kolins, National Director of Accounting and Auditing, BDO Seidman LLP, at 9 (Aug. 19, 1998) (citing Uniform Accounting Act section 10(5)). The Commission is not adopting a "gross negligence" standard because courts have not interpreted the term uniformly. The Commission does not want to adopt a standard that has already been subject to varying interpretations. Fairness to accountants and sound public policy is furthered by using new terminology – the "highly unreasonable" standard – which is defined in this release with precision and clarity. However, the term "gross negligence" is often used – like the Commission’s use of the phrase "highly unreasonable" – as an intermediate standard between ordinary negligence and recklessness.

-[50]-   Weston Comment Letter; Comment Letter of William B. Patterson, Director, Office of Investments, AFL-CIO, at 2 (Aug. 10, 1998) ("AFL-CIO Comment Letter"); see also Comment Letter of Patricia D. McQueen, Vice President, Advocacy, Financial Reporting & Disclosure, and Jonathan J. Stokes, Vice President, Professional Conduct Program, Association for Investment Management and Research, at 3 (Aug. 18, 1998).

-[51]-   See Weston Comment Letter; AFL-CIO Comment Letter, at 2; Nugent Comment Letter; BancOne Comment Letter, at 2; TIAA-CREF Comment Letter, at 3.

-[52]-   See , e.g. , In re Hope , Accounting and Auditing Enforcement Release No. 109A (Aug. 6, 1986), 36 SEC Docket 663, 750-55 (Sept. 10, 1986).

-[53]-   Cf . AICPA Professional Standards, Vol. 1 AU sections 312 and 316 (1997).

-[54]-   PricewaterhouseCoopers Comment Letter, at 5. See also AICPA Comment Letter, at 17.

-[55]-   Comment Letter of John M. Liftin, Chair, Committee on Federal Regulation of Securities, and Richard H. Rowe, Chair, Committee on Law and Accounting, ABA Section of Business Law, at 12 (Aug. 19, 1998).

-[56]-   See Comment Letter of William T. Allen, at 3 (July 10, 1998) ("Allen Comment Letter") (suggesting this approach).

-[57]-   PricewaterhouseCoopers Comment Letter, at 5.

-[58]-   See , e.g. , AICPA Comment Letter, at 21-23; Ernst & Young Comment Letter, at 18-19; KPMG Peat Marwick Comment Letter, at 6-8; Arthur Andersen Comment Letter, at 7-8.

-[59]-   See, e.g. , Allen Comment Letter, at 1.

-[60]-   Ernst & Young Comment Letter, at 21-22 (suggesting that the term "repeated" include more than two violations); KPMG Peat Marwick Comment Letter, at 13; see also Comment Letter of Terry Warfield, PricewaterhouseCoopers Research Scholar, Associate Professor, University of Wisconsin (Aug. 1, 1998).

-[61]-   See Securities Act section 19(a), 15 U.S.C. 77s(a), Securities Exchange Act section 23(a), 15 U.S.C. 78w(a), Public Utility Holding Company Act of 1935 section 20(a), 15 U.S.C. 79t(a), Trust Indenture Act of 1939 section 319(a), 15 U.S.C. 77sss(a), Investment Advisers Act of 1940 section 211(a), 15 U.S.C. 80b-11(a), and Investment Company Act section 38(a), 15 U.S.C. 80a-37(a).

-[62]-   Mourning v. Family Publication Services, Inc. , 411 U.S. 356, 369 (1973) (quoting Thorpe v. Housing Authority of the City of Durham , 393 U.S. 268, 280-81 (1969)).

-[63]-   See Touche Ross , 609 F.2d at 582; Sheldon v. SEC , 45 F.3d 1515, 1518 (11th Cir. 1995); Davy v. SEC , 792 F.2d 1418, 1421 (9th Cir. 1986); see also Potts , 151 F.3d 810.

-[64]-   Touche Ross , 609 F.2d at 582 (quoting Mourning , 411 U.S. at 369).

-[65]-   See Danna v. SEC , No. C-93-4158 (CW), 1994 WL 315877 (N.D. Cal. Feb. 8, 1994).

-[66]-   The Checkosky decisions held that the Commission had not clearly articulated the "improper professional conduct" standard or the rationale for that standard. The Checkosky opinions did not decide the issue of the scope of the Commission's authority. One judge in Checkosky II wrote a separate opinion to state her disagreement with the dictum in Checkosky I questioning the Commission’s authority to ensure that the professionals who practice before it adhere to minimal levels of competence .

-[67]-   Checkosky I , 23 F.3d at 459 (opinion of Silberman, J.).

-[68]-   See Checkosky I , 23 F.3d at 469 (opinion of Randolph, J.).

-[69]-   See , e.g. , Arthur Andersen Comment Letter, at 2-3; KPMG Peat Marwick Comment Letter, at 6.

-[70]-   Commissioner Johnson’s dissent misconstrues the distinction between an enforcement remedy and a remedy that protects the integrity of the Commission’s processes. Rule 102(e) does not cease to protect the Commission’s processes simply because those processes are designed, in turn, to protect investors or because the Commission, in deciding what type of proceeding to bring, may sometimes consider whether it is more appropriate to bring a Rule 102(e) proceeding than an enforcement action. Rule 102(e) protects the integrity of the Commission’s processes because it seeks to assure that professionals who prepare filings made with the Commission have the competence to prepare filings that comply with applicable requirements.

-[71]-   See AFL-CIO Comment Letter, at 3.

-[72]-   See Comment Letter of Joel Seligman, Dean and Samuel M. Fegtly Professor of Law, College of Law, University of Arizona, at 2-3 (Aug. 11, 1998).

-[73]-   Id . at 3.

-[74]-   See In re Haskins & Sells , Accounting Series Release No. 73 (Oct. 30, 1952), (1937-1982 Transfer Binder) Fed. Sec. L. Rep. (CCH) ¶ 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 Release 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). To the extent that dictum in In re Logan , 10 S.E.C. 982 (1942), can be read to provide for a good faith defense, the Commission believes the standard adopted today is preferable.

-[75]-   See AICPA Comment Letter, at 30.

-[76]-   Id . at 30-31.

-[77]-   See Comment Letter of R. Fogg (Aug. 12, 1998); Comment Letter of James Backus (Aug. 13, 1998) ("Backus Comment Letter"); Comment Letter of Kyle E. Carrick (Aug. 20, 1998) ("Carrick Comment Letter").

-[78]-   See BDO Seidman Comment Letter, at 9; Backus Comment Letter.

-[79]-   See ABA Comment Letter, at 7; see also BDO Seidman Comment Letter, at 9 (stating that proposed amendment "makes no distinction between professionals who have erred and those who are likely to err again").

-[80]-   Id .; see also BDO Seidman Comment Letter, at 9.

-[81]-   Id .

-[82]-   ABA Comment Letter, at 7.

-[83]-   See Carrick Comment Letter.

Dissenting Statement of Commissioner Norman S. Johnson

The more than 150 comment letters we have received – the overwhelming majority of them highly critical of the most important part of the proposal – demonstrate that Rule 102(e) is a matter of crucial importance to the accountants who practice before the Commission.⁴ As Judge Randolph observed in Checkosky I: 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." * * * 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.⁵

As nature abhors a vacuum, so does the Commission: its intentions regarding the expansion of its Rule 102(e) authority have quickly become apparent. Within days of the adoption of the new standard on September 23, 1998, the Commission announced a major new initiative to address improper accounting practices.⁶ It is clear to me that the Commission intends for the expanded Rule 102(e) authority it has arrogated to itself in today's release to be an important enforcement weapon in this new initiative.

The proponents of the amendment claim that it is significantly more protective of accountants than the standard set forth in the Commission's June 1998 proposing release.⁷ I disagree. I think that the proposed standard will not preclude the Commission from instituting Rule 102(e) proceedings for simple negligence.

For close to thirty years, I have followed the Commission's Rule 102(e) proceedings – indeed, long ago I wrote two articles on the subject.⁸ In my view, today's release represents another wrong turn in the Commission's Rule 102(e) jurisprudence. Previous wrong turns resulted in the two Checkosky opinions by the D.C. Circuit. Rule 102(e) differs fundamentally from the securities laws enforced by the Commission. The purpose of the securities laws is to protect investors, while the professed purpose of Rule 102(e) is to protect the integrity of the Commission's administrative processes. Under today's proposal, Rule 102(e) will be just another weapon in the Commission's enforcement arsenal. The use of Rule 102(e) as just another enforcement tool eliminates the underpinning of those few Court decisions that have upheld, in the most general terms possible, the Commission's ability even to promulgate Rule 102(e). Thus, the Commission's ability to bring any Rule 102(e) proceeding – under any standard, against even the most egregious violators – may now be in jeopardy. Even assuming the Commission has adequate authority to promulgate Rule 102(e), both Checkosky opinions indicate that the Commission lacks authority to adopt the sort of negligence standard contained in the Release. Under Checkosky, the Commission may only discipline professionals under Rule 102(e) when scienter, including recklessness, is shown.⁹

My long-standing interest in the Commission's Rule 102(e) jurisprudence, as well as my deep-rooted objections to the rule's expansive and improper uses, leads me to set forth my dissenting views at some length and in the following order:

• Because it is impossible to evaluate fairly today's release without consideration of the Commission's past missteps, I outline the history of Rule 102(e) in the first section.

• Next, in the second section, I discuss the Checkosky case, including the D.C. Circuit's two reversals of Commission opinions.

• In the third section, I explain the basis for my view that the Commission lacks legal authority even to promulgate Rule 102(e), and that, in any event, the Commission lacks the legal authority to adopt a negligence standard under Rule 102(e).

• In the fourth section, I demonstrate that the Standard is vague, and that it does not comply with the mandate of both Checkosky I and Checkosky II that we adopt a clear standard.

• In the fifth section, I set forth the various reasons why – even assuming adequate legal authority and clarity – it is not in the public interest for the Commission to adopt the Standard.

• Next, in the sixth section, I question whether the Commission gave adequate notice in its Proposing Release that it might adopt certain aspects of today's release.

• Finally, in the seventh section, I set forth the likely ways in which the Commission will seek to expand its Rule 102(e) authority in the future.

I. “Administrative Oaks” and “Legislative Acorns”: A Brief History of Rule 102(E)

In one of its landmark securities decisions restricting the growth of implied private actions under the federal securities laws, the Supreme Court remarked that Rule 10b-5 was "a judicial oak which has grown from little more than a legislative acorn."¹⁰ The Commission's use of Rule 102(e) to regulate professional conduct might similarly be described as an "administrative oak" growing out of a "legislative acorn." There is no express statutory provision authorizing the Commission to discipline professionals; instead, a handful of courts have upheld the Commission's promulgation of Rule 102(e) as impliedly proper because the rule is "'reasonably related' to the purposes of the securities laws."¹¹ I fully subscribe to the views of a distinguished predecessor, Commissioner Roberta Karmel, who observed in a Rule 102(e) case almost twenty years ago that "(t)he administrative implication of prosecutorial remedies under federal legislation is rife with the same evil" possessed by "judicial implication of private rights of action."¹² In my view, the same disfavor the Supreme Court has enunciated towards implied private rights of action is equally applicable – and probably more so – to implied prosecutorial remedies such as those the Commission utilizes under Rule 102(e).¹³

The Commission first promulgated Rule 102(e) in 1935.¹⁴ In its initial form, the rule contained a requirement that attorneys be admitted to practice before the Commission (as was then required of attorneys and accountants who sought to represent persons before the Internal Revenue Service).¹⁵ In 1938, however, the Commission struck the admission requirement, and since then the rule's only use has been to permit the Commission to censure, suspend or disbar professionals.¹⁶

Although Rule 102(e) has caused a great deal of controversy since its inception,¹⁷ it was only used sparingly during the first 35 years or so of its existence.¹⁸ Things changed in the early 1970's when the Commission embarked on its so-called "access" theory of securities law enforcement.¹⁹ As a consequence of its belief that access to capital markets is controlled by a limited number of professionals, the Commission sought to achieve maximum deterrent value from its limited enforcement resources by suing the gatekeepers, rather than simply proceeding against the principal wrongdoers.²⁰ Accordingly, the Commission brought wave-upon-wave of actions – including many Rule 102(e) administrative proceedings – against securities professionals, accountants and lawyers.²¹

The high water mark of the Commission's "access" theory was probably the National Student Marketing case.²² In National Student Marketing, the Commission brought an injunctive action that charged two nationally prominent law firms and several of their respective partners with aiding and abetting a securities fraud based on their alleged failure to take proper action when they "permitted" their clients to complete a merger that had received shareholder approval based on a proxy statement containing materially misleading financial information.²³ The Commission's complaint alleged that the lawyers had a duty to insist that their clients resolicit proxies based on corrected information, and that, if the clients refused to follow this advice, the lawyers were required to resign and to report the alleged securities violations to the Commission.²⁴ In practical terms, the Commission sought to make involuntary "whistle-blowers" or government agents out of private counsel by "plac(ing) upon the lawyer a responsibility to investigate his clients' activities in search for possible violations of law."²⁵ In discussing National Student Marketing, one Commissioner went so far as to state that, at least in the context of a securities transaction, a lawyer's role was "more akin to that of an auditor," i.e., the lawyer would "have to exercise a measure of independence" from his client and would have to be "acutely cognizant of his responsibility to the public who engage in securities transactions that would never have come about if not for his professional presence."²⁶ Although the Commission brought National Student Marketing as an injunctive action in federal court, it soon changed its emphasis in professional discipline cases and increasingly brought them as administrative proceedings under Rule 102(e).²⁷

Although National Student Marketing involved charges against law firms and individual lawyers, the Commission did not limit its overreaching to the legal profession – indeed, one contemporaneous commentary referred to accountants as the "most actively besieged profession" under Rule 102(e).²⁸ In SEC v. Arthur Young & Co., a case arising from the activities of an oil and gas venture promoter over a seven-year period in the 1960's, the Commission charged a nationally prominent accounting firm and the responsible auditors with committing or aiding and abetting securities fraud.²⁹ Because the case predated the Supreme Court's decision requiring the Commission to prove scienter in its Rule 10b-5 enforcement cases,³⁰ the Ninth Circuit assumed that "negligence, rather than scienter, constitutes the standard by which an accountant's or auditor's performance must be measured."³¹ Before the district court, the Commission argued that the firm and its auditors performed their work "'with blinders on'" and that they should have done "'more'" to reveal the risks to those who invested in the ventures.³² On appeal, the Commission apparently argued that the accountants had failed to perform their audit in a manner that would have revealed to "an ordinary prudent investor, who examined the * * * audits or financial statements, a reasonably accurate reflection of the financial risks * * * ."³³ The Ninth Circuit rejected both formulations of the Commission's argument, noting: To accept the SEC's position would go far toward making the accountant both an insurer of his client's honesty and an enforcement arm of the SEC. We can understand why the SEC wishes to so conscript accountants. Its frequently late arrival on the scene of fraud and violations of the securities laws almost always suggest that had it been there earlier with the accountant it would have caught the scent of wrong-doing and, after an unrelenting hunt, bagged the game. What it cannot do, the thought goes, the accountant can and should. The difficulty with this is that Congress has not enacted the conscription bill that the SEC seeks to have us fashion and fix as an interpretive gloss on existing securities laws.³⁴

To be sure, the Commission's attitude towards the conscription of accountants – and their purported wearing of "blinders," or failures to observe and respond to "red flags" – persists to this day.³⁵

Many legal scholars and members of the securities bar and industry, myself among them, decried the Commission's overreaching in National Student Marketing, Arthur Young and similar cases.³⁶ One commentary described the Commission's efforts, colorfully but accurately, as a "'reign of terror' on broker-dealers, accountants and attorneys."³⁷ Indeed, for more than twenty-five years, the Commission's attempts to set standards for professional conduct, under Rule 102(e) and otherwise, have caused much dissension on the Commission itself.³⁸ The roster of distinguished former Commissioners who have expressed serious doubts about the Commission's expansive uses of Rule 102(e) and other attempts to set professional standards includes: Edward H. Fleischman, Roberta S. Karmel, Philip Lochner, Jr., Richard Y. Roberts, and Steven M.H. Wallman.³⁹

Much of the criticism of the Commission's efforts in this area has focussed on two factors. First, neither the Commission nor its administrative law judges ("ALJ's") have a statutory mandate to establish ethical standards nor any special expertise in the area of professional responsibility; second, the threat of disciplinary action might well intimidate and interfere with the exercise of independent professional judgment and, as to lawyers, might deprive clients of their constitutional right to counsel.⁴⁰ These fears were far from academic: the National Student Marketing case clearly affected the ability and willingness of the securities bar to take zealous positions before the Commission.⁴¹ According to an article co-written by the then-General Counsel of the Commission, the controversy caused by National Student Marketing and similar cases became so heated that it affected the "the Commission's ability to carry out its statutory mandates," because it lessened the necessary cooperation and trust between the Commission, its staff and the securities bar and industry.⁴²

In response to the well-deserved firestorm of criticism caused by National Student Marketing and similar cases, the Commission retreated.⁴³ As to lawyers, the Commission announced that it would commence Rule 102(e) actions only where it could demonstrate scienter and that it would cease bringing "original" Rule 102(e) actions (i.e., the Commission would only bring an administrative proceeding against a lawyer if a federal court first determined that the lawyer had violated the federal securities laws).⁴⁴ As to accountants, the situation was less clear, but, at least for a time, the Commission seemed less aggressive in bringing Rule 102(e) actions against them as well.⁴⁵

In the late 1980's, however, Rule 102(e) actions against accountants became more of a focal point for the Commission.⁴⁶ In 1988, the Commission amended Rule 102(e) to create a presumption that disciplinary proceedings would be public rather than private – previously Rule 102(e) proceedings only became public if sanctions were imposed.⁴⁷ In addition, as an enforcement adjunct to combat "financial fraud," the Commission stepped up its use of Rule 102(e) to bring charges of "improper professional conduct" against the auditors of public companies.⁴⁸ It was in this context that the Commission instituted administrative proceedings under Rule 102(e) against two accountants, David J. Checkosky and Norman A. Aldrich.⁴⁹

II. The Checkosky Decisions

Commissioner Roberts concurred in the majority's finding that respondents violated GAAS and misapplied GAAP, but dissented from the finding that these errors amounted to "improper professional conduct" under Rule 102(e).⁵⁴ In Commissioner Roberts' view, respondents' conduct did not provide a sufficient basis for a finding that they would threaten the Commission's processes.⁵⁵

In Checkosky I, the D.C. Circuit remanded the case because it was unable to discern from the Commission's opinion the basis for its 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.⁵⁶ There was no opinion of the Court, and each of the three judges (Judge Silberman, Judge 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.⁵⁷ 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.⁵⁸ Judge Randolph also extensively discussed a 1981 Commission decision, William R. Carter, which he regarded – correctly, in my view – as "the Commission's most comprehensive discussion of the history, purpose and operation of Rule 2(e)," that rejected a negligence standard in case involving lawyers.⁵⁹ Judge Randolph endorsed the reasoning of Carter: "if a securities lawyer is to exercise his 'best independent judgment * * * he must have the freedom to make to make innocent – or even, in certain cases, careless – mistakes without fear of (losing) the ability to practice before the Commission.'"⁶⁰ In Judge Randolph's view, the exercise of independent professional judgment was equally crucial to accountants, and this consideration would preclude the Commission from adopting a negligence standard, even if only applicable to accountants, under Rule 102(e).⁶¹

Judge Silberman likewise questioned the Commission's ability to adopt a negligence standard. For instance, Judge Silberman explained that: 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.⁶² Judge Silberman similarly 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."⁶³ Judge Silberman further indicated that the adoption by the Commission of a negligence standard, given its previous contrary precedent, might be arbitrary and capricious.⁶⁴

On remand, the Commission's majority opinion did not directly address the mental state question posed by the Court.⁶⁵ Instead, the majority found that the accountants had behaved recklessly, but at the same time insisted that any deviation from GAAP or GAAS, including purely negligent ones, could violate Rule 102(e), and that the accountants' recklessness was relevant only to the choice of sanctions.⁶⁶ I dissented from the Commission's second Checkosky opinion because I believed that "improper professional conduct" required proof of scienter.⁶⁷

On appeal in Checkosky II, the D.C. Circuit again reversed, and scolded the Commission, in scathing terms, for its failure to heed the dictates of Checkosky I.⁶⁸ The Court found that, the prior remand notwithstanding, the Commission had again failed to offer an adequate explanation of Rule 2(e)(1)(ii), but had "voic(ed) instead a multiplicity of inconsistent interpretations."⁶⁹ 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, and instead invoked the exceedingly rare remedy of remanding the case with instructions to dismiss.⁷⁰

In an opinion truly remarkable for the criticism heaped on the Commission, the Court agreed with respondents' contention that the Commission had again "failed to articulate an intelligible standard for 'improper professional conduct' under Rule 2(e)(1)(ii)."⁷¹ The Court noted that not only was the Commission's 1997 opinion unclear, but that, "(i)n something of a tour de force," it managed "to both embrace and reject standards of (1) recklessness, (2) negligence and (3) strict liability – or so a careful (and intrepid) reader could find."⁷² The Court also enumerated numerous contradictions between the Commission's opinion and its appellate brief and oral argument.⁷³ In the Court's view, the Commission's failure to adopt an intelligible negligence standard was so lacking that the Commission had violated "(e)lementary administrative law norms of fair notice and reasoned decisionmaking."⁷⁴ Referring to one part of the Commission's 1997 opinion, the Court sarcastically observed "(i)n the space of four short sentences this passage achieves impressive feats of ambiguity."⁷⁵ The Court continued on, remarking: "Not only does the opinion on remand provide no clear mental state standard to govern Rule 2(e)(1)(ii), it seems at times almost deliberately obscurantist on the question."⁷⁶

In a passage of great portent to today's release, the Court stated that the Commission's instrumental good intentions alone will not suffice: However legitimate and, indeed, essential the Commission's concern about unreliable financial statements may be, it is no substitute for a clearly delineated standard. Instead, the Commission's statements come close to a self-proclaimed license to charge and prove improper professional conduct whenever it pleases, constrained only by its own discretion (combined, perhaps, with the standards of GAAS and GAAP).⁷⁷

As in Checkosky I, the Court questioned the Commission's ability to adopt a negligence standard under Rule 102(e).⁷⁸ The Court appeared to reaffirm its previous statements about the limits of the Commission's authority in disciplining 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."⁷⁹ On this last point, Judge Henderson wrote a two-sentence concurrence to express her disagreement with the majority (Judge Williams, who wrote the opinion, and Chief Judge Edwards).⁸⁰

III. The Commission Lacks the Authority To Promulgate Rule 102(E) or, at the Least, Lacks the Authority To Adopt the Proposed Standard

In addition to rendering a single negligent act, under some circumstances, "improper professional conduct," the other two parts of the Standard create liability for: intentional, knowing or reckless conduct; and a pattern of negligent acts. As the Release correctly notes, most commenters agreed with these parts of the proposal.⁸¹ Assuming the Commission has the authority to promulgate Rule 102(e), I support the intentional or reckless part of the amendment without reservation. As to that part addressing a pattern of negligence, I would generally reach the same result as the majority, but through a different analysis. Assuming adequate authority, the Commission may appropriately bring a charge of "improper professional conduct" under Rule 102(e) only if the pattern of negligence supports an inference that the accountant acted recklessly.⁸² In any event, because of the natural tendency towards the path of least resistance – towards proving one's case the by the easiest method possible – I think that most of the Rule 102(e) cases brought under the new standard will surely be brought under the single negligent act provision.

A. Rule 102(e) Has Become Another Weapon in the Commission's Enforcement Arsenal

In the Release, the Commission explains its refusal to adopt a scienter standard because "Rule 102(e) protects the integrity of the Commission's processes; it is not an enforcement remedy or a weapon against fraud."⁸³ The Commission also insists that "the rule is remedial and not punitive in nature."⁸⁴ I disagree with the first assertion, and think the second assertion is contrary to controlling law in the D.C. Circuit. Although I have come to the conclusion that Rule 102(e) is overly broad, as a structural matter, I do wish to emphasize my view that the Commission, like any adjudicative body, may legitimately adopt a disciplinary rule designed to redress contemptuous, disruptive or obstructionist behavior by advocates who appear in actual proceedings before us.⁸⁵ But Rule 102(e) is not such a permissible rule. I am, of course, aware that several courts have accepted the Commission's professed rationale about the need to protect its administrative processes.⁸⁶ In my view, however, today's amendment – combined with the Commission's recently announced crackdown on improper accounting practices, as well as recent judicial developments – provides an ample basis for a critical reexamination of these precedents.

In Touche Ross, which was decided in 1979, the Commission successfully argued to the Second Circuit that Rule 102(e) was necessary to protect the integrity of its administrative processes.⁸⁷ The Commission has consistently relied on the same rationale since then, which is repeated in today's release.⁸⁸ Before the press of litigation arose, however, the Commission could be more candid. In a speech published in 1974 discussing "spectacular recent failures" such as the collapse of National Student Market Corporation, then-Chairman Ray Garrett made the following statement: We are not entirely happy with the means at our disposal to cause higher standards of professional conduct for investor protection. It is true that we can legislate rules governing the contents of financial statements filed with the Commission, but that won't insure a careful audit, and it certainly won't improve standards of professional conduct by lawyers. Our tools in this context, aside from informal comment and criticism, are enforcement weapons – suspension or disbarment from practicing before the Commission, under Rule 2(e) of our Rules of Practice, and an action for an injunction on the ground that the accountant or lawyer has participated in or aided and abetted a violation of the securities laws, including Rule 10b-5.⁸⁹

Former Chairman Garrett's remarks support the assertion of one commenter, a former Commission enforcement attorney who played a leading role in prosecuting Carter and other Rule 102(e) cases during the 1970's, that protection of the Commission's processes is merely a "convenient legal fiction" or "shibboleth (the Commission) used to win the Touche Ross() case twenty years ago."⁹⁰ This commenter also points out that, as a practical matter, the Commission's staff approaches Rule 102(e) proceedings in the same manner as other enforcement cases, such that charges under Rule 102(e) are just another enforcement alternative.⁹¹ This practical approach will often suit the convenience of potential respondents who may well prefer an administrative settlement of Rule 102(e) charges to other enforcement alternatives (e.g., a federal court injunctive action, in which the Commission would likely seek monetary penalties).⁹²

The Commission's use of Rule 102(e) has not changed since 1974 – it remains an "enforcement weapon." Under usual procedures, the Commission's Division of Enforcement investigates cases, and, in the case of a financial fraud involving a public company, will routinely scrutinize the conduct of the responsible accountants.⁹³ If the Division of Enforcement determines that the accountant's conduct is substandard, the Division of Enforcement will consult with the Commission's Office of the Chief Accountant, and then make an enforcement recommendation to the Commission.⁹⁴ If the Commission authorizes the case as an administrative proceeding under Rule 102(e), the Division of Enforcement prosecutes it in the name of the Office of the Chief Accountant.⁹⁵ As should be apparent from these procedures, notwithstanding surface appearances, Rule 102(e) is much more than a mere disciplinary rule.⁹⁶ If Rule 102(e) were just a disciplinary rule, one would expect that the Commission's use of it would parallel other administrative agencies' use of their respective disciplinary rules – surely the Commission's processes need no greater protection than those of, for instance, the Federal Trade Commission or the Nuclear Regulatory Commission. But the opposite is true. Reflecting the enforcement nature of Rule 102(e), one academic has calculated that, over a 50-year period, the Commission has disbarred or suspended more lawyers than "nearly all other federal agencies combined."⁹⁷ Were accountants included in this tabulation, I am sure the numbers would demonstrate an even greater disparity.

These arguments that the Commission lacks the authority even to promulgate Rule 102(e) are not new. In fact, Commissioner Karmel, in a series of dissents starting almost 20 years ago, made many of the same points I make today.⁹⁸ For instance, Commissioner Karmel began her best-known dissent as follows: This is another Rule 2(e) disciplinary proceeding which arises from the Commission's efforts to protect investors by articulating and enforcing professional responsibility standards for attorneys. The Commission's authority to promulgate Rule 2(e) is tenuous at best. Since the Commission's program is in aid of its prosecutorial function, rather than its rule making or adjudicatory functions, I view it as an invalid exercise of power * * * .⁹⁹

The force of Commissioner Karmel's arguments have increased, rather than diminished with time.¹⁰⁰

Starting with the Second Circuit's decision in Touche Ross,¹⁰¹ the few courts to consider these arguments have rejected them, but I think there is ample cause for reconsideration. As the Release repeatedly recognizes, the legitimacy of Rule 102(e) depends on it having a remedial purpose.¹⁰² A recent decision by the D.C. Circuit, Johnson v. SEC,¹⁰³ however, and the Commission's response to it, place the characterization of Rule 102(e) as "remedial" in great doubt. In Johnson, the D.C. Circuit rejected the Commission's argument that sanctions imposed on a branch manager at a registered broker-dealer, a censure and a six-month suspension, were "remedial"; rather the Court determined that these sanctions fell within the definition of "penalty" for purposes of the statute of limitations.¹⁰⁴ Precisely these same sanctions, censure and suspension, are among the sanctions frequently imposed by the Commission in Rule 102(e) cases. Under the reasoning of Johnson, the punitive nature of Rule 102(e)'s sanctions could well give rise to questions about the Commission's ability to promulgate it. The D.C. Circuit decided Johnson after Checkosky I, but before Checkosky II.¹⁰⁵ In Checkosky II, the D.C. Circuit determined that the Commission had failed to comply with the directions in Checkosky I that it clearly enunciate its standard for Rule 102(e), and thus had no need to determine whether, as a result of Johnson, the Commission still had the authority to promulgate Rule 102(e).

Subsequent action by the Commission indicate its own recognition that this argument may be well-founded. In Angelo P. Danna, CPA, two accountants filed a motion to dismiss a Rule 102(e) proceeding as one seeking a penalty and thus time-barred under Johnson.¹⁰⁶ The Division of Enforcement failed to object, and the Commission dismissed the proceeding.¹⁰⁷ Likewise, in George Craig Stayner, CPA, the Commission dismissed a Rule 102(e) case against an accountant who had raised the Johnson issue, this time over the objection of the Office of the Chief Accountant.¹⁰⁸ In several analogous disciplinary cases not involving Rule 102(e), the Commission has ordered dismissals, without objections from the staff, in response to similar arguments relying on Johnson.¹⁰⁹ Given the time and resources the Commission devoted to Danna and Stayner, one would have thought the Commission would have declined to dismiss these cases if it had any confidence in its chances on the "punitive"/"remedial" question in the D.C. Circuit.

In my view, the purpose of Rule 102(e) is not to protect the Commission's administrative processes, but rather to enforce compliance with the federal securities laws. In addition, under controlling law in the D.C. Circuit, Rule 102(e) is punitive, not remedial. As a result, the Commission lacks the authority even to promulgate Rule 102(e).

B. The Commission Lacks the Authority to Adopt a Negligence Standard

Even assuming the Commission could validly promulgate Rule 102(e), it lacks the authority to adopt a negligence standard. In my view, this conclusion is compelled by the D.C. Circuit's decisions in Checkosky I and Checkosky II.¹¹⁰ Others at the Commission question my interpretation of both Checkosky cases, but I note that this same urge to construe an adverse decision as narrowly as possible (sometimes even more narrowly than possible) is precisely what so enraged the D.C. Circuit in Checkosky II.¹¹¹

I must confess that I remain somewhat mystified by the begrudging attitude towards Checkosky that is prevalent at the Commission. After two of the worst defeats in the Commission's 60-plus year history, we should not adopt merely the absolute minimum necessary to pass muster in the D.C. Circuit. Rather, we should strive toward caution and conservatism, and give ourselves an ample margin for error. The Standard is not cautious; it is not conservative. Instead, the Commission has again reverted to a "push the envelope" strategy, and thrown down the gauntlet to the D.C. Circuit.

Editorializing aside, I believe that the Commission lacks the authority to adopt a negligence standard under Rule 102(e). No appellate court has approved the Commission's adoption of a negligence standard, and I fully concur with the ABA's statement that "the prognosis for appellate court affirmance of * * * a (negligence-based) standard is very poor."¹¹² Of course, the Release denies that what the Commission has adopted is a "simple" or "mere" negligence standard.¹¹³ But the Proposing Release contained similar unconvincing attempts to narrow what seemingly was an all-encompassing standard.¹¹⁴ Interested parties submitted over 150 comment letters, more than half (by my estimate) expressing skepticism or worse as to whether the standard in the Proposing Release truly limited the Commission's discretion to bring Rule 102(e) cases for simple negligence. Though insisting that it has the authority to adopt a "simple" or "mere" negligence standard, the Commission now purports to adopt a higher standard.¹¹⁵ I think that the Standard will not limit the Commission's discretion to bring cases for simple negligence. Moreover, as I discuss in the next section, the revisions to the Proposing Release's standard only add to the lack of clarity surrounding this issue.

As an initial matter, it is important to recognize that today's release actually expands the Commission's Rule 102(e) jurisdiction beyond that encompassed by the Proposing Release. The single negligent act provision in the Proposing Release contained a requirement that the act be tied to "making a document prepared pursuant to the federal securities laws materially misleading."¹¹⁶ The single negligent act provision in the Standard omits this requirement, thereby increasing substantially the potential reach of Rule 102(e).¹¹⁷

The Standard does contain two elements which form the basis for the Commission's claim that it adopts "an intermediate standard, higher than ordinary negligence but lower than the traditional definition of (Rule 10b-5) recklessness."¹¹⁸ These elements are that the alleged misconduct: (1) must be "highly unreasonable," not merely "unreasonable," as in the Proposing Release; and (2) must occur under "circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted."¹¹⁹ On close examination, these elements present only illusory limits on the Commission's discretion to bring charges of "improper professional conduct" based on a single act of negligence.

Unlike "highly unreasonable conduct," the Proposing Release discussed the concept of "heightened scrutiny," and, accordingly, interested parties had the opportunity to explain its drawbacks. The AICPA objected to any attempt by the Commission to use Rule 102(e) proceedings to determine in the first instance the circumstances under which particular items of financial statements require "heightened scrutiny." In our view, auditors should determine which items require increased scrutiny according to existing professional guidance, not because they fear the Commission will, in hindsight, so conclude. Determinations announced retrospectively by an Administrative Law Judge or the Commission would make Rule 102(e) a vehicle for improper back-door regulation through the adjudicatory announcement of standards.¹²⁰

I fully endorse these views.

Furthermore, I think the Commission's use of "heightened scrutiny" is merely a form of materiality that will have no practical effect on limiting the Commission's ability to bring cases for simple negligence. One would think that the