August 20, 1998

Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: File No. S7-16-98

Dear Mr. Katz:

The American Institute of Certified Public Accountants (the "AICPA") welcomes the decision of the Securities and Exchange Commission (the "SEC" or the "Commission") to seek public comment prior to revision of its disciplinary rules for accountants who practice before the SEC. The Commission is to be applauded for seeking, in response to recent directives of the United States Court of Appeals for the District of Columbia Circuit (the "D.C. Circuit"), to create greater certainty and consistency regarding the application of Rule 102(e).¹ The profession fully shares the Commission’s objective of safeguarding its processes and the public interest in reliable and informed capital markets from unsuitable professionals, including incompetent accountants.

I. Overview

The D.C. Circuit has twice within the past five years instructed the Commission to "state clearly and without equivocation its decisional standard with respect to ‘improper professional conduct’ under Rule 102(e)(1)(ii)."² In response, the Commission has now proposed the following language to clarify the meaning of "improper professional conduct":

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

(A) An intentional or knowing violation, including a reckless violation, of applicable professional standards; or

(B) Negligent conduct in the following circumstances:

(1) An unreasonable violation of applicable professional standards that presents a substantial risk, which is either known or should have been known, of making a document prepared pursuant to the federal securities laws materially misleading; or

(2) Repeated, unreasonable violations of applicable professional standards that demonstrate that the accountant lacks competence.³

The AICPA believes that any amendment intended to clarify the meaning and application of Rule 102(e)(1)(ii) must satisfy three basic criteria:

• the amendment must be a reasonable and direct adjunct to the Commission’s explicit statutory powers;

• it must be consistent with the remedial and prophylactic goals of Rule 102(e); and

• it must articulate a clear standard that gives professionals fair notice of the conduct which is subject to sanction.

Category (A) of the proposed amendment,⁴ which would subject knowing or reckless violations of applicable professional standards to sanctions, appears to be within the Commission’s authority and to be consistent with the purposes of the Rule because such knowing or reckless conduct demonstrates the existence of a threat to the Commission’s processes or the financial reporting system. Moreover, Category (A) articulates a clear standard, and thus satisfies all three of the criteria.

Category (B) of the proposed amendment,⁵ however, does not satisfy any of these three criteria. It is not a reasonable and direct adjunct to the Commission’s express powers; nor is it remedial or prophylactic in approach. Indeed, Category (B) potentially reaches conduct that the Commission lacks power to sanction, and which accordingly should not be considered "improper professional conduct" for purposes of Rule 102(e)(1)(ii). With respect to the third criterion, given the ambiguities and potential overbreadth embedded in Category (B), the proposed amendment, considered as a whole, fails to articulate clearly the meaning of the term "improper professional conduct" for purposes of Rule 102(e).

The investing public benefits from accountants who are free to exercise their best independent judgment. Although the Proposing Release disclaims any intent to constrain an accountant’s professional judgment by sanctioning a "harmless judgment error or immaterial mistake,"⁶ the text of Category (B)(1) is broad enough to encompass such behavior, as well as single acts of mere negligence that should not be the subject of Rule 102(e) disciplinary actions. The text of the SEC’s proposed rule thus appears to give the SEC license to disagree with and, in hindsight, potentially sanction any one of the myriad judgments accountants make in the course of performing audits and rendering other professional services. Such an environment obviously would restrict accountants in the sound exercise of their judgment to the detriment of the financial reporting system. Moreover, Category (B) would discriminate unjustifiably against accountants by establishing a stricter standard of conduct for accountants than for (i) attorneys and other professionals who practice before the Commission, and (ii) directors and officers of public companies. This insupportable discrimination, along with the textual vagueness noted above, raises equal protection and due process issues, as well as questions regarding the proposed rule’s validity.

The potential scope of the proposed amendment would transform Rule 102(e) into a "first line of defense" against violations of professional standards. Yet the Commission lacks express disciplinary authority over the professionals who practice before it. Rather, state accountancy boards, bar associations, courts and other similar entities and professional associations exercise primary responsibility for the licensure and discipline of professionals. Moreover, accountants and other professionals who practice before the Commission face significant legal risks, under the common law, and state and federal securities law, for conduct that falls short of applicable professional standards. The professional and legal consequences associated with a failure to comply with professional standards, quite apart from Rule 102(e), serve to punish and deter inappropriate behavior. The need for and validity of the Commission's proposed amendment of Rule 102(e) should be viewed in this broader framework.

A clearer definition of "improper professional conduct" – and one that comports more closely with the disciplinary approach taken by other regulatory and licensing authorities – would better achieve the Commission’s stated goal of "protecting the integrity of its processes."⁷ The AICPA respectfully submits that the proposal advanced in its rulemaking petition of May 7, 1998 provides such a definition and should be adopted by the Commission. Alternatively, and at a minimum, the AICPA would urge the Commission to reshape its proposed amendment so that the standard in Category (B) is within the Commission’s authority, is consistent with the stated purposes of the Rule, and more clearly describes the type of conduct that it encompasses.

II. Criteria for Analysis

As indicated above, the AICPA has reviewed the proposed amendment using three fundamental criteria. These are as discussed in more detail below.

A. Consistency with SEC Legal Authority

The Commission’s authority to discipline professionals under Rule 102(e), is implicit in, and exclusively limited to, its general rulemaking powers pursuant to the provisions of the Securities Exchange Act of 1934 (the "Exchange Act") and other federal securities laws. Accordingly, Rule 102(e) has been upheld only to the extent that the exercise of authority thereunder is "reasonably related" to the express powers of the SEC.⁸ The Supreme Court has made clear that the express language of a statute limits what may be implied.⁹ Therefore, Rule 102(e)(1)(ii) must be interpreted and applied as a reasonable and direct adjunct to the Commission’s explicit statutory powers.

Significantly, in this regard, the Supreme Court has indicated that, with respect to the federal securities laws, conduct not involving scienter (e.g., acts of simple negligence) cannot give rise to an implied sanction or liability.¹⁰

B. Consistency with Remedial and Prophylactic Purpose

The Commission has often observed that Rule 102(e) proceedings are designed not to punish errant individuals or firms, but only to protect the integrity of Commission proceedings.¹¹ The Commission’s sole legitimate goal with respect to Rule 102(e), absent any express statutory authority to punish professionals for misconduct, is to regulate the conduct of practice before it, not to serve as the "first line of defense" against violations of professional standards more generally. Indeed, the Proposing Release itself acknowledges that Rule 102(e) serves a prophylactic purpose that should inform the definitional standard for "improper professional conduct."¹² Accordingly, the articulated standard for when a professional will be deemed to have engaged in "improper professional conduct" must focus on the threat, if any, that the professional’s present fitness poses to the future processes of the Commission — rather than on punishment for past mistakes.

C. Clarity

As a matter of due process, the Government may sanction individuals only if it has articulated a standard of conduct in terms that are clearly understandable, so that the norm is not so vague that "men of common intelligence must necessarily guess at its meaning and differ as to its application."¹³ Due process concerns are inevitably raised when the standard expressed in a law or rule could reach unintentional conduct and thus become "little more than a trap for those who act in good faith."¹⁴ Accordingly, to be upheld, any proposed amendment to Rule 102(e) must provide "fair notice of the standard of conduct to which a citizen is held accountable."¹⁵ Moreover, for policy reasons as well as legal ones, any proposed amendment to Rule 102(e) should be clear and unambiguous.¹⁶

III. Analysis of Proposed Amendment

A. Intentional or Knowing Violations of Applicable Professional Standards

The AICPA supports the inclusion of the language set forth as Category (A) of the proposed amendment. As our rulemaking petition of May 7, 1998 indicated, disciplinary action under Rule 102(e) is warranted against professionals who engage, in the words of the proposed amendment, in an "intentional or knowing violation, including a reckless violation, of applicable professional standards."

Category (A) meets the three criteria for amendments to Rule 102(e). First, the authority it confers should be construed as a reasonable and direct adjunct to the Commission’s statutory authority.¹⁷ The power to sanction professionals for knowing or even reckless misconduct arguably can be implied from certain of the Commission’s express statutory authorities.

Second, Category (A) is consistent with the remedial aims of Rule 102(e). The rule is intended to protect the integrity of the Commission’s administrative processes going forward. Because knowing or reckless misconduct on the part of an accountant suggests a mindset in the professional (i.e., a predilection to repeat such misconduct) likely to pose a threat to the Commission’s future processes, such conduct can properly be sanctioned under Rule 102(e).¹⁸

Finally, Category (A) articulates a clear standard that gives professionals fair notice of the conduct that is subject to sanction. Importantly, as proposed by the Commission, a "reckless violation" of professional standards gives rise to potential sanctions only as a subset of "intentional" or "knowing" behavior. This formulation is consistent with the Supreme Court’s observation in Ernst & Ernst v. Hochfelder that in "certain areas of the law recklessness is considered a form of intentional conduct for purposes of imposing liability" for an act.¹⁹

1. Recklessness

"Reckless" conduct is understood in the context of liability under the federal securities laws to require a conscious and deliberate disregard of applicable professional standards.²⁰ We assume this is the meaning intended by the Proposing Release, and the AICPA urges the Commission to so state in the preamble to the Final Rule or, alternatively, in the Adopting Release. The adoption of any different definition of recklessness for purposes of Rule 102(e) alone – that is, the use of the term "recklessness" to mean something other than its common usage under the federal securities laws – or the failure to define recklessness at all, would create confusion and prevent the average professional practicing before the Commission from understanding what type of conduct is proscribed by the Rule. In short, it would be counterproductive for the Commission to put forward a different standard, especially a "less rigorous" one,²¹ regarding what constitutes reckless conduct under the federal securities laws, or even to leave the profession to guess as to the intended meaning of recklessness in the context of Rule 102(e). Understood as a subset of conscious and deliberate failure to comport with applicable professional standards, however, recklessness is appropriately included as improper professional conduct for purposes of Rule 102(e).

2. Applicable Professional Standards

We believe that the term "applicable professional standards," as used in both Category (A) and Category (B) of the proposed amendment, provides the profession with adequate guidance.²² The term is commonly understood to refer to the provisions of Generally Accepted Accounting Principles ("GAAP") and Generally Accepted Auditing Standards ("GAAS") – and the related professional guidance of the SEC, the Independence Standards Board and the AICPA – applicable to a particular set of facts. A rule that includes this term should be one that professionals are generally familiar with and can understand, and which accordingly provides fair notice of sanctionable conduct. In our view, the identification of precisely which professional standards would apply in specific (and, by definition, unforeseen) situations is not a task that can be accomplished by rule.²³

The use of a general term such as "applicable professional standards," which incorporates by reference the substance of recognized and widely accepted rules set by private standards setters and the profession itself, reflects a due regard for the profession’s long-standing and continuing efforts to define and revise professional standards. The purpose of Rule 102(e) is not to enforce rules and regulations prescribed by Congress or the Commission, but rather to protect the Commission’s processes and the investing public from incompetent or unethical practitioners. It is appropriate, therefore, to assess the conduct of individual practitioners against the widely accepted standards of their own profession to which they must adhere.

B. Negligent Violations of Applicable Professional Standards

While the AICPA agrees that professionals should be subject to sanction under Rule 102(e) for intentional or knowing violations of professional standards, it opposes sanctions for isolated instances of merely negligent conduct. Category (B) of the proposed amendment, which addresses negligence, raises concerns with respect to each of the criteria for Rule 102(e) articulated above. In particular, the power to impose sanctions for negligent professional conduct cannot be construed as a reasonable and direct adjunct to the Commission’s statutory authority. Furthermore, such power is inconsistent with the remedial aims of Rule 102(e). The proposed amendment, moreover, fails to articulate a clear standard that gives professionals fair notice of the conduct that would be subject to sanction. Finally, the approach taken in Category (B) would single out accountants by sanctioning them for following a standard of care that would not be dealt with similarly if engaged in by lawyers, or by the directors and officers of public companies. Such discriminatory treatment cannot be justified.

1. The Commission Lacks Authority to Sanction Professionals for Negligence Alone

The SEC’s proposal would empower the Commission to sanction an accountant for a single act of simple negligence. The AICPA does not believe that such an act can constitute "improper professional conduct" for purposes of Rule 102(e).

As a matter of law, the Commission lacks authority to impose a simple negligence standard as the basis for sanctioning professional conduct.²⁴ The federal securities laws do not expressly authorize the Commission to discipline professionals who practice before it.²⁵ Rule 102(e), at most, is implicit in the Commission’s general rulemaking power pursuant to the Exchange Act and the Securities Act. For example, Section 23(a)(1) of the Exchange Act provides that:

(t)he Commission . . . shall . . . have power to make such rules and regulations as may be necessary or appropriate to implement the provisions (of the Exchange Act) for which (it is) responsible or for the execution of the functions vested in (it) by this chapter.²⁶

As a rule promulgated pursuant to a statute authorizing "necessary or appropriate" measures, Rule 102(e) must be a "legitimate(,) reasonable and direct adjunct to the Commission’s explicit statutory authority."²⁷ Accordingly, the scope of Rule 102(e)(1)(ii) should be determined by reference to statutory provisions in which Congress has expressly authorized the Commission to act against future violations of the securities laws.²⁸

As noted above, Congress in several instances has granted the Commission express authority to protect against future violations of the securities laws. The Commission generally may not exercise this power, however, against individuals whose conduct has been merely negligent. For example, Section 15(b) of the Exchange Act provides that the Commission may revoke or suspend the licenses of broker-dealers, but only for willful violations of the law or after conviction of specified offenses.²⁹ Section 20(b) of the Securities Act and Section 21(d) of the Exchange Act grant the Commission express authority to seek injunctions against future, specifically described violations of the securities laws. Injunctions will not issue, however, absent a showing that "there is a reasonable likelihood that the wrong will be repeated."³⁰ Significantly, a single incident of mere negligence generally does not establish the required likelihood of future misconduct. As stated by Chief Justice Warren Burger, to obtain injunctive relief:

it will almost always be necessary for the Commission to demonstrate that the defendant’s past sins have been the result of more than negligence. Because the Commission must show some likelihood of a future violation, defendants whose past actions have been in good faith are not likely to be enjoined.³¹

Thus, the Commission normally exercises even its express powers to protect against future violations of the securities laws only against persons guilty of knowing or reckless misconduct.

The Commission’s express power in this area, limited as it is largely to instances of intentional misconduct, cannot reasonably be interpreted as giving rise to a broader, implied power to sanction professionals under Rule 102(e) for mere negligence. Analogously, judicial sanctions of attorneys, imposed pursuant to a court’s inherent power to regulate its proceedings, require a finding of much more than mere negligence.³² Further, it is well-settled that even judicial sanctions levied against attorneys pursuant to express statutory authority (unlike the implied authority on which the SEC rests Rule 102(e) sanctions) are not justified in response to "unintended, inadvertent, and negligent acts."³³ Indeed, in many areas, an affirmative finding of bad faith is required for sanctions under a court’s inherent powers.³⁴

Moreover, just as Rule 102(e) must be read in relation to express grants of authority in the federal securities laws, the particular language at issue here, "improper professional conduct," must be interpreted in light of its accompanying terms.³⁵ As former Commissioner Wallman recognized, the term "improper professional conduct" as used in Rule 102(e) is "inextricably intertwined" with the word "unethical" and the phrase "lacking in character or integrity."³⁶ "Unethical" and "lacking in character or integrity" imply bad faith, or intent on the part of the actor.³⁷ Reading the word "improper" in Rule 102(e)(1)(ii) to encompass unintentional conduct, therefore, is entirely inconsistent with the remainder of the Rule. "Improper professional conduct" should be read instead as limited and qualified by its associated terms and the other provisions of the Rule,³⁸ requiring knowing or reckless behavior, though permissibly including a pattern of conduct demonstrating repeated failure to conform to applicable professional standards and consequent unsuitability to continue practice before the SEC.³⁹

A broad reading of the term "improper professional conduct," as the Commission has proposed, would subject accountants to sanction for almost any violation of GAAS or GAAP, thus establishing the Commission as an independent arbiter of professional standards. The assumption of such authority by the Commission is not warranted or, more importantly, authorized by law. As stated by Judge Silberman in Checkosky I, a determination that an accountant’s negligence is a per se violation of Rule 102(e) could "constitute a de facto substantive regulation of the profession and thus raise questions as to the legitimacy of Rule 2(e)(1)(ii) – or at least its scope."⁴⁰ The D.C. Circuit reiterated this concern in Checkosky II, noting that because "much of the substantive law enforced by the Commission requires a showing of scienter, use of a negligence standard to penalize professionals might be viewed as a back-door expansion of its regulatory oversight powers."⁴¹

The Proposing Release disclaims any intention to expand the Commission’s authority, stating that "the Commission does not seek to use the Rule to establish new standards for the accounting profession."⁴² Yet the Proposing Release indicates that the amendment would reach a single violation of professional standards, which "most likely would be related to a transaction or event as to which any reasonable auditor would give heightened scrutiny."⁴³ This statement leaves open the possibility that the Commission would sanction accountants for violations not related to material transactions or events. Equally troubling, the statement implies that the Commission could use Rule 102(e) proceedings to determine in the first instance the circumstances under which particular items of financial statements require "heightened scrutiny."⁴⁴ 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 of the profession through the adjudicatory announcement of standards.⁴⁵ Moreover, to the extent unilateral action by the Commission in the context of Rule 102(e) proceedings deprives accountants of fair notice of what conduct is sanctionable, such action raises significant due process concerns as well.

2. The Proposed Amendment Is Inconsistent with Rule 102(e)’s Remedial Aims

The Commission has stated that it promulgated Rule 102(e) to protect the integrity of its processes, not to "add an ‘additional weapon’ to its ‘enforcement arsenal.’"⁴⁶ That is, the Commission did not intend the rule to provide an alternative remedy for violations of the securities laws.⁴⁷ Rather, Rule 102(e) addresses professional misconduct, and "its sanction is limited to that necessary to protect the investing public and the Commission from the future impact on its processes of professional misconduct."⁴⁸

Sanctioning an accountant for a single act of simple negligence is inconsistent with these remedial aims, because such an act provides no basis for a reasonable inference about a threat to the Commission’s future processes.⁴⁹ Past negligent conduct, even if it involves more than one act, does not necessarily establish a likelihood of a future violation.⁵⁰ As a result, there is no basis supporting the use of Rule 102(e) for sanctioning acts performed in good faith, albeit negligently.

The Commission asserts in the Proposing Release that "an incompetent or negligent auditor can do just as much harm to public investors and others who rely on him as one who acts with an improper motive."⁵¹ As Judge Randolph stressed in Checkosky I, however, the Supreme Court has rejected just such an "effect-oriented approach" in the context of actions under Exchange Act Rule 10b-5. The Supreme Court stated that:

The Commission . . . reasons that . . . the "effect" upon investors of given conduct (by accountants) is the same regardless of whether the conduct is negligent or intentional . . . . The logic of this effect-oriented approach would impose liability for wholly faultless conduct where such conduct results in harm to investors, a result the Commission would be unlikely to support.⁵²

While an isolated act of negligence might result in a material misstatement, such a mistake poses no demonstrable risk to the Commission’s future processes, and thus cannot properly be sanctioned under Rule 102(e).

Just as importantly for purposes of Rule 102(e), the consequences which follow from a negligent act have nothing whatever to do with the issue at hand — the effect, not on investors who may have been harmed by that past act,⁵³ but rather on the integrity of the Commission’s future processes. As stated by former Commissioner Wallman, "unless a past wrong informs a conclusion that there exists a threat to the Commission’s future processes, it is not proper to utilize the fact that there is an impact from that wrong to justify taking action under the Rule."⁵⁴ It is the quality of the behavior - not, as in the proposed amendment, the magnitude of the consequence - that establishes a basis for drawing an inference about future conduct (as required in a "remedial "disciplinary rule).

Finally, the proposed amendment, literally read, provides a basis for sanctioning an accountant whose violation of applicable professional standards presents a substantial risk of making a document materially misleading, even if the violation does not in fact render the document materially misleading. Thus, the proposed amendment conflicts with the Commission’s acknowledgment that an "immaterial mistake does not pose a future threat to the Commission’s processes and does not constitute ‘improper professional conduct.’"⁵⁵ The proposal conflicts, as well, with the spirit of the professional standards themselves, which do not require correction of immaterial errors.

3. The Proposed Amendment Fails to Articulate a Clear Standard of Conduct

The Proposing Release states that Rule 102(e) is not intended to encompass every professional misstep. On its face, Category (B) purports to provide that negligent conduct will constitute "improper professional conduct" only in certain identified circumstances. In its potential application, however, Category (B) suffers from considerable ambiguity as to the circumstances under which negligent conduct will be considered improper professional conduct.⁵⁶ Ultimately, the proposed amendment fails to identify adequately the degree of culpability required to impose sanctions for "improper professional conduct."

While the profession welcomes the Commission’s attempt to distinguish mere negligence from the sort of egregious violations that warrant sanctions, the proposed amendment threatens to perpetuate, rather than cure, uncertainty in this area. In particular, the proposed amendment introduces (but does not define) novel terms and concepts not normally employed in disciplinary matters, including "unreasonable violation" and "substantial risk." Thus, the SEC has ignored its own warning to those engaged in drafting not to "create new jargon that’s unique to your document."⁵⁷

With respect to Category (B), the proposed amendment provides no guidance as to what constitutes an "unreasonable" violation of applicable professional standards (or, conversely, which violations might be "reasonable.") An "unreasonable" violation might be interpreted as one resulting from simple negligence – that is, a violation caused by a moderate or even slight departure from the standard of ordinary care. After all, even a slight departure from the care exercised by the hypothetical "reasonable man" by definition constitutes "unreasonable" conduct. Under this interpretation, the proposed amendment would reach even the slightest negligent conduct which presents a substantial risk of material misstatement, an inappropriate result.

Likewise, the proposed amendment does not adequately identify the circumstances under which a violation of applicable professional standards would present a "substantial risk" of making a document prepared pursuant to the federal securities laws materially misleading. Although the phrase "which is either known or should have been known" is not associated with scienter in the context of Rule 10b-5 actions, the Commission’s use of this phrase to qualify "substantial risk" might be interpreted as permitting the SEC to sanction only knowing or reckless misconduct — an appropriate limitation consistent with the purpose of the Rule. The concurrent use of the term "unreasonable violation," however, suggests a quite different standard, simple negligence.⁵⁸ The Commission’s use of these various elements in proposed Category (B)(1) – "unreasonable violation," "substantial risk" and "known or should have been known" – ultimately creates considerable uncertainty as to the intended standard of conduct.

Finally, sanctioning professionals based upon a retrospective judgment as to the magnitude of an error as reflected in the client’s financial statements, without identifying the standards by which accountants’ materiality judgments will be reviewed, raises an additional due process concern. The proposed amendment, for example, does not provide any guidance as to the circumstances that give rise to a "substantial risk" of material misstatement.⁵⁹ If the Commission treats Rule 102(e) proceedings as a vehicle to decide which transactions and events deserve an accountant’s "heightened scrutiny," thereby modifying the existing professional guidance in an ad hoc fashion, professionals will have little basis in the first instance to understand what conduct might be subject to sanction.

4. The Proposed Amendment Discriminates Against Accountants

The application of a simple negligence standard to accountants would contrast dramatically with the standard the SEC applies to attorneys under Rule 102(e). A simple negligence standard also would subject accountants to far more stringent scrutiny than officers and directors of public companies who are subject to a potential suspension or bar from such service.

In In re Carter, the Commission announced the standard of conduct applicable to attorneys under Rule 102(e) as follows:

(A) lawyer engages in "unethical or improper professional conduct" under the following circumstances: When a lawyer with significant responsibilities in the effectuation of a company’s compliance with the disclosure requirements of the federal securities laws becomes aware that his client is engaged in a substantial and continuing failure to satisfy those disclosure requirements, his continued participation violates professional standards unless he takes prompt steps to end the client’s noncompliance.⁶⁰

Carter clearly establishes that attorneys are not subject to sanctions based on their negligence in failing to detect their clients’ disclosure violations. Instead, sanctions will be imposed only for a knowing failure to correct a client’s noncompliance with the federal securities laws. Moreover, as a matter of policy, the SEC has brought disciplinary proceedings against lawyers only after they have been sanctioned by another body (e.g., a federal court).

The Commission’s proposed approach – amending Rule 102(e) to include the Category (B)(1) treatment of negligence solely for licensed professional accountants – has two discriminatory elements. First, accountants would be held to a harsher standard, simple negligence in some instances, than other professionals. In particular, as discussed in greater detail below, the standards applied to attorney discipline by other bodies typically would not allow suspension, disbarment, or similar sanctions based solely on simple negligence.⁶¹ Second, accountants would continue to be subject to Rule 102(e) actions initiated by the SEC in the absence of any prior or existing professional sanction, while attorneys would not confront a similar risk.

The Commission’s pursuit of Rule 102(e) actions against accountants without any prior adverse findings by licensing authorities, but not against attorneys in similar circumstances, cannot be explained by any relative absence of incentives on the part of accountants to adhere to professional standards. Indeed, like attorneys, accountants who violate professional standards risk a variety of sanctions in addition to those that might be levied under Rule 102(e). These sanctions include civil liability under the common law, as well as under federal and state securities laws, suspension or revocation of a state license to practice, and sanctions imposed by professional associations. These negative legal consequences, apart from any Rule 102(e) implications, serve as strong incentives to accountants to adhere to professional standards. Accordingly, Rule 102(e) should not be used to any greater extent against accountants than attorneys as a basis for sanctioning professional misconduct.⁶²

Under the Commission’s proposal, accountants also would be subject to far greater scrutiny than officers and directors of public companies facing suspension or bar from such service under Section 20(e) of the Securities Act or Section 21(d)(2) of the Exchange Act.⁶³ Pursuant to these statutes, a federal court, at the Commission’s request, may grant a suspension or bar where it finds that (i) the defendant has violated either Securities Act Section 17(a)(1) or Exchange Act Section 10(b), and (ii) the defendant’s "conduct demonstrates substantial unfitness to serve as an officer or director."⁶⁴ Significantly, mere negligence will not support a violation of Securities Act Section 17(a)(1) or Exchange Act Section 10(b); proof of scienter is required.⁶⁵ Furthermore, a violation of one of the statutes will not support a finding of "substantial unfitness" unless aggravating circumstances exist, such as a particularly egregious underlying violation or a high degree of scienter.⁶⁶ Under the Commission’s proposed amendment, on the other hand, accountants could be subject to the same sanction, suspension or bar, for much less serious conduct — isolated acts of simple negligence.⁶⁷

C. Uniform Standard for Professionals

For over sixty years, Rule 102(e)(1) has made no distinction between accountants and other persons, including lawyers. Rather, it has applied to "any person" appearing or practicing before the Commission.⁶⁸ Indeed, as the Commission stated in its answering brief in Touche Ross, "Rule 2(e) of the Commission’s Rules of Practice is part of a regulatory scheme by which the Commission seeks to protect the integrity of its own processes from incompetent, unethical, or dishonest accountants, attorneys, and other professionals and experts, and thereby also to protect the public."⁶⁹

There is no factual basis for discriminating between attorneys and accountants for Rule 102(e) purposes. Like attorneys, accountants are subject to high professional standards enforced through formal codes of ethics and state licensing requirements. In particular, accountants are subject to GAAP, GAAS and various related professional standards. Of course, those standards, and the distinctions between them and the standards applicable to attorneys, reflect the obvious differences between the roles of the two professions.

Accountants, moreover, pose no greater threat to the integrity of the Commission’s processes than do attorneys. Indeed, members of the Commission "have pointed out time and time again that the task of enforcing the securities laws rests in overwhelming measure on (attorneys’) shoulders."⁷⁰ Similarly, in upholding the validity of then-Rule 2(e), the Second Circuit noted that attorneys and accountants play equally vital roles under the federal securities laws.⁷¹

In addition, the policy risks associated with disciplining attorneys for negligence – that clients will not consult attorneys on difficult questions because the attorneys will "slant their advice out of fear of incurring liability" – apply as well to accountants. As Judge Randolph recognized in Checkosky I, although companies are compelled to retain independent auditors and cooperate with them for purposes of the audit:

There are . . . degrees of cooperation. Encouraging management to be completely candid with its auditor about difficult accounting issues may be just as desirable as encouraging management to consult candidly with outside lawyers, and for similar reasons. If imposing discipline on lawyers for negligence would be counterproductive, as Carter determined, it is not immediately apparent why the same would not be true with respect to accountants.⁷²

Like a securities lawyer, an accountant required to exercise his "best independent judgment . . . must have the freedom to make innocent – or even, in certain cases, careless – mistakes without fear of (losing) the ability to practice before the Commission."⁷³

If an agency treats similar cases differently, or makes legal distinctions that are inconsistent with the very terms of its regulations, it acts arbitrarily.⁷⁴ The federal securities laws do not establish different levels of culpability for different types of professionals. Thus, while the standards of a given profession may reflect the unique responsibilities of its members, given its prior guidance in Carter, the Commission may not discriminate, as it has in the Proposing Release, in its evaluation as to whether a particular professional has satisfied the applicable standards.⁷⁵

IV. The AICPA’s May 7, 1998 Proposal

The AICPA believes, as expressed in its May 7, 1998 rulemaking petition, that the best course of action would be for the Commission to adopt a standard under Rule 102(e) that sanctions, in addition to scienter-based violations, only a pattern of conduct demonstrating both repeated failure to meet applicable professional standards and a likelihood of future failure which poses a threat to the Commission’s processes or to the financial reporting system. If Rule 102(e) is to be deemed "remedial," as indeed it must be in order to be upheld, then the SEC has to determine, and be prepared to establish, that conduct subject to sanction under the Rule constitutes such a threat.

A. Language Proposed in May 7, 1998 Petition

The AICPA’s proposal would define "improper professional conduct" under Rule 102(e) as follows:

"Improper professional conduct" as used herein shall mean conduct showing that the professional is (1) substantially unfit to practice before the Commission by reason of:

(a) the commission of a knowing violation of applicable professional standards, or

(b) conduct showing a conscious and deliberate disregard of applicable professional standards, or

(c) a course or pattern of conduct showing repeated failure to conform to applicable professional standards; and

(2) constitutes a current threat to the integrity of the Commission’s processes or of the financial reporting system;

in each case found after due notice of the conduct charged and a fair hearing thereon.

B. Rationale for May 7, 1998 Proposal

The AICPA’s May 7, 1998 proposal would allow the Commission to protect itself, and the investing public, from an incompetent or unethical accountant without creating the legal issues and policy concerns that would arise were individual acts of negligence subject to sanction. Addressing "substantial unfitness" by an accountant if that unfitness poses a threat to the Commission’s processes is reasonably related to the Commission’s express powers and would necessarily serve to protect its processes. As such, it is a standard that professionals can clearly understand and meet.

1. The AICPA’s Proposed "Substantial Unfitness" Standard Is Within the Commission’s Authority and Consistent with Rule 102(e)’s Remedial Purpose

As noted earlier, certain courts have held that the SEC, as an agency with a general power of rulemaking, has the inherent power to discipline those practicing before it. The AICPA’s proposed "substantial unfitness" standard,⁷⁶ which seeks to protect the statutorily mandated functions of the SEC, would be "reasonably related" to the Commission’s express statutory authority.⁷⁷ In other words, the AICPA’s proposed standard recognizes and accommodates the limits of the Commission’s inherent disciplinary authority as recognized by the courts by requiring the SEC not only to find that an accountant is substantially unfit, but also to relate that finding to the proper bounds of the Commission’s authority by focusing upon the likelihood of future impact on the agency’s processes.

The express reference in the AICPA’s proposed standard to the threat posed by a professional’s conduct aligns the standard with Rule 102(e)’s remedial purpose. As a matter of logic, it is difficult to make reasonable inferences about future behavior (e.g., the existence of a threat to the Commission’s processes) from unintentional acts. A course of conduct nevertheless may demonstrate a level of indifference to professional standards or incompetence to observe and apply them (even if most or all of the acts involved were negligent ones) sufficient to justify inferences of substantial unfitness and risk of harm to the Commission’s processes. Sanctions in such cases would serve Rule 102(e)’s remedial purpose.

2. A "Substantial Unfitness" Standard Is More Consistent with State Disciplinary Standards

The AICPA’s proposed "substantial unfitness" standard also reflects the policy established by the Uniform Accountancy Act,⁷⁸ which envisions sanctions against accountants for "(d)ishonesty, fraud, or gross negligence in the performance of services as a licensee . . . ."⁷⁹ Moreover, this substantial unfitness standard would better accord with the standards applied to accountants by many state accountancy boards — the bodies with primary responsibility for accountant licensure and discipline. The state laws and regulations administered by state boards of accountancy often provide for suspension or revocation of a CPA license on a finding of "(d)ishonesty, fraud, or gross negligence."⁸⁰ The "substantial unfitness" standard proposed by the AICPA and supported by the American Bar Association’s Task Force on Rule 102(e) Proceedings⁸¹ would be more consistent with many of these other laws and rules governing the discipline of accountants than the broader and untested standard proposed by the SEC.

The standard proposed by the AICPA also reflects the long-standing partnership between the private and public sectors in setting and enforcing professional standards, and respects the policy choices made by governmental bodies with primary responsibility for accountant discipline. Commissioner Hunt recently stated, in fact, that "(t)he Commission believes that cooperation with the State Boards is terribly important."⁸² Indeed, it has been the Commission’s consistent practice to look to the states, in the first instance, with respect to determinations concerning an accountant’s competence and integrity. Rule 2-01 of Regulation S-X, "Qualifications of Accountants," effectively provides that the Commission will presume that an accountant in good standing who is entitled to practice under the law of his or her state is qualified for SEC practice.⁸³

State bar disciplinary actions against attorneys, which are particularly relevant to Rule 102(e), parallel the approach to professional discipline taken by many state boards of accountancy. The American Bar Association’s Standards for Imposing Lawyer Sanctions turn, in significant part, on a lawyer’s mental state or culpability.⁸⁴ The ABA Standards concluded, based on a comprehensive study of relevant precedent, that suspension or disbarment is inappropriate with respect to almost all good faith errors.⁸⁵ Disbarment is generally appropriate only for knowing or reckless conduct, although, with respect to certain violations, such as misappropriation of client funds, grossly negligent behavior (or a pattern of negligence) can suffice.⁸⁶ Moreover, even suspension, a less serious sanction, is imposed only for intentional violations, with certain exceptions where gross negligence (or "neglect," i.e., a pattern of negligence) will suffice.⁸⁷

C. Alternative Version of "Substantial Unfitness" Standard

The Commission has indicated that, with respect to the AICPA’s May 7, 1998 proposal, it "preliminarily believes that the public interest may be better served with the somewhat broader definition of ‘improper professional conduct’ proposed in this release."⁸⁸ However, in conjunction with this statement, the Commission again noted that "a harmless error or immaterial mistake should not trigger a Rule 102(e)(1)(ii) proceeding."⁸⁹ The Commission appears to be concerned that the language proposed in the AICPA’s rulemaking petition would not reach certain instances of egregious misconduct beyond mere negligence – but short of the knowing or reckless behavior that clearly should fall under Rule 102(e).

While the AICPA does not understand the basis for the Commission’s preliminary conclusion, it recognizes that there can be egregious misconduct "short of willful conduct and yet more culpable than mere negligence."⁹⁰ Similarly, former Commissioner Roberts expressed the view, in his dissent from the first SEC action against Checkosky, that the Commission, in past cases, had looked to the "degree of egregiousness" in determining "whether a sanction was appropriate."⁹¹ Indeed, it is this very characteristic, egregious professional misconduct which bespeaks the likelihood of future failure to comply with applicable standards, that the "pattern" concept found in both the AICPA proposal and the proposed amendment strives to capture.

The AICPA, therefore, respectfully submits that, if the Commission is determined to expand the standard so that it reaches conduct which is not based on scienter or a pattern of misconduct, it limit such acts to egregious misconduct of a type that truly threatens the Commission’s processes. This could be accomplished by adoption of the following as Category (B) of the proposed amendment:

(B) Substantial unfitness to appear or practice before the Commission.

Substantial unfitness, for purposes of this Rule, is either

(i) a course or pattern of conduct demonstrating failure to conform to applicable professional standards, or

(ii) other egregious misconduct violating such standards,

that poses a current threat to the integrity of the Commission’s processes or to the financial reporting system.

Such an alternative formulation of the concept of "substantial unfitness" might preserve the benefits of the AICPA’s initial proposal, including its focus on protecting the Commission’s processes, while potentially reaching the rare case of a single act of egregious misconduct sufficient to pose a threat to the Commission’s processes or the financial reporting system.

The disciplinary rules of the Internal Revenue Service (the "IRS") could provide a useful model in this regard. The IRS has adopted a gross incompetence standard in the disciplinary provisions of Circular 230, governing practice before the IRS, that is applied to all "practitioners" subject to discipline — accountants, attorneys and others. The IRS determined that only violations that are willful, reckless or a result of gross incompetence will subject a practitioner to suspension or disbarment from practice before the IRS.⁹² The term "gross incompetence" establishes a standard equivalent to the obligations governing lawyers under DR 6-101(A),⁹³ which is violated when a lawyer’s conduct involves gross incompetence, or indifference, inadequate preparation under the circumstances and consistent failure to perform obligations to the client. Moreover, in this regard, IRS regulations provide that "(a) pattern of conduct is a factor that will be taken into account in determining whether a practitioner acted knowingly, recklessly or with gross incompetence."⁹⁴

V. Other Comments and Request for Hearings

The SEC has invited comment as to a number of particular questions which we have addressed in detail above. These questions include whether the proposed amendment achieves the objective of clarifying the definition of "improper professional conduct," whether the Commission should define the term "recklessness" in a manner consistent with the use of that term in the context of actions under Rule 10b-5 of the Exchange Act, and whether the term "applicable professional standards" provides adequate guidance to the accounting profession.

The SEC also has invited comment regarding several questions which we address below: