America's Community Bankers
November 25, 2002
Jonathan G. Katz
Re: Improper Influence on Conduct of Audits
Dear Mr. Katz:
America's Community Bankers (ACB)1 is pleased to comment on the proposed rule that would prohibit directors and officers of a company with registered securities or filing reports under the Securities Exchange Act of 1934 (Exchange Act) from improperly influencing the conduct of an audit. This rule would implement section 303(a) of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley).2
Sarbanes-Oxley was passed to strengthen public company corporate governance and financial disclosure in an effort to restore investor confidence in the public markets. Some of the main provisions of the law are focused on increasing the integrity of the audit process when public accounting firms audit the financial statements of public companies. Section 303(a) would prohibit any officer or director of an issuer, or any other person acting under his or her direction, from taking action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering the financial statements materially misleading. In general, the proposed rule tracks the language of the statute, with some important distinctions.
ACB supports reinforcing, through both the statute and the proposed rule, the importance of ensuring the integrity of the auditing process. It should always have been understood, and most directors and officers of public companies do understand, that independent auditors should be permitted to conduct their duties and responsibilities in a competent, honest and ethical manner, without fraudulent influence by management. It is important for the proper functioning of the capital markets that investors have faith in the financial statements issued by public companies.
ACB does have some concerns with the list of actions that the Securities and Exchange Commission (SEC) has identified as possibly constituting improper conduct. The concern is heightened by the fact that the SEC has converted what appears in the law to be a liability standard of willful or intentional conduct to a negligence standard. ACB is concerned that the change in the liability standard will have a chilling effect on the normal, legitimate communication necessary between management of a company and its legal counsel and auditors. This is especially the case since there is no requirement that improper action actually result in the issuance of misleading financial statements. While the rule should be drafted so it helps prevent fraudulent conduct, it should not chill honest and constructive dialogue among the parties involved in preparing, reviewing and analyzing a company's financial statements.
Standard of Liability
ACB opposes the lower standard of liability the SEC is proposing even though there is no private right of action under the law or the rule. Liability under the rule can still result in severe consequences for the affected individual and the SEC could take action against an individual even though the conduct did not result in the issuance of materially misleading financial statements. The SEC states in footnote 17 that "it is the act of fraudulently influencing, coercing, manipulating, or misleading the auditor for the purpose of rendering misleading financial statements" that is unlawful (emphasis added). The SEC also states in the text of the preamble that the facts and circumstances of each case, including the purpose of the conduct, would be relevant to determining whether the conduct would violate the proposed rule (emphasis added).3 These statements are consistent with the statutory language, which declares unlawful any conduct that "fraudulently" influences an accountant "for the purpose of rendering such financial statements materially misleading." Nevertheless, contrary to the statutory language and to the SEC's own language in the footnote and preamble, the SEC has provided in the proposed rule that liability can be found if a person "knew or was unreasonable in not knowing" that such action could, if successful, result in rendering the financial statements materially misleading. Such a negligence standard is inconsistent with Congressional intent to impose liability only when the officer or director purposefully interferes with an audit.
Over the course of the last year, it has become apparent that a rules-based accounting system leaves room for interpretation. Many experts and commentators have noted that there can be honest and legitimate disagreements on how to appropriately account for certain business operations. Other provisions of Sarbanes-Oxley were passed to ensure that there is adequate dialogue among all of the participants responsible for a company's financial statements, including the public accountants, legal counsel, management, the audit committee and the board of directors, about the proper accounting treatment for items that appear in, or have an impact on, the financial statements. Furthermore, the chief executive officer and chief financial officer must certify and vouch for the financial statements filed with the SEC. The certification process can result in criminal liability for an officer who knowingly files a false certification. These provisions of Sarbanes-Oxley will encourage more, not less, dialogue and discussion before the chief executive and financial officers are willing to execute and file certifications with periodic reports. This rule should not be used to chill that required dialogue or honest disagreements among parties involved in the process. Accordingly, the SEC should adopt the standard of liability provided for in Sarbanes-Oxley, which would impose liability on those that intentionally work to subvert the financial statement auditing process.
In addition, the SEC has asked whether it should replace the word "fraudulently" with the word "improperly" in the rule, in order to convey a mental state "short of scienter." Given the clear statutory language requiring a fraudulent state of mind, the answer must be no. The SEC should not lower the standard of conduct from "fraudulently influence" to "improperly influence." The term "fraudulently" was the word specifically chosen by Congress and would require intent on the part of the individual to do harm or deceive before liability could be imposed. Any lower standard would go beyond the intent of Congress, which was to prevent the intentional subversion of the auditing process.
Types of Conduct
ACB believes, as a general matter, that it is helpful and clarifies the SEC position to have the types of actions possibly constituting improper conduct identified in the preamble. It is sufficient to have the list in the preamble and we see no reason why the list should appear in the rule itself. The list should not, however, include providing an auditor with "inaccurate or misleading" legal analysis unless the description of that conduct is revised to require fraudulent or improper intent.
Analysis of legal issues is highly fact-dependent. Attorneys, especially outside counsel, must frequently depend on their clients for factual information upon which to base their legal analysis, and may not be in a position to independently verify the accuracy of the information. Therefore, an attorney may inadvertently include inaccurate facts in an opinion without any improper motive whatsoever. Moreover, the described conduct does not contain any materiality standard. Read literally, the inclusion of a single inaccuracy could give rise to liability, even if the inaccuracy was immaterial to the analysis as a whole.
Many questions of a legal nature that arise during the auditing process may not lend themselves to easy answers and different attorneys operating in good faith may have different, legitimate interpretations of the same legal requirements. Legal advice that was reasonable at the time it was given should not be judged later, with the benefit of hindsight, to have been misleading. If liability could be imposed only if an attorney intentionally misled the auditors, then there would be no concern because that individual should be liable for his or her actions. However, if it is not clear that intent is required, this provision could deprive public companies of getting the best and most complete legal advice possible.
Therefore, this item should be removed from the list unless it is made clear that it would apply only to individuals who provide an auditor with inaccurate or misleading legal analysis with the intention of rendering the financial statements materially misleading.
ACB also believes that the list should not include seeking to have a partner removed from the audit engagement because the partner objects to the issuer's accounting. Audit partners are changed fairly frequently for a variety of reasons. Although the prohibited conduct is described as seeking removal "because" the partner objects, including it on the list may discourage dismissals for otherwise legitimate and appropriate reasons to avoid having actions questioned after the fact.
In addition, we have similar concerns about the conduct of threatening to cancel or canceling an existing non-audit or audit engagement if the auditor objects to the issuer's accounting. If this conduct is not removed from the list, it should be clarified to cover those actions only if they are directly related to the auditor's objections. Otherwise, any cancelation of a contract would be suspect if it came after a disagreement over accounting treatment, even if the cancelation was for an entirely unrelated reason, such as high fees or sloppy work. At a minimum, the description of this conduct should be amended to cover threatening to cancel or canceling existing non-audit or audit engagements "because" the auditor objects to the issuer's accounting.
Actions that Could Result in Materially Misleading Financial Statements
ACB does not believe that the actions listed in proposed section 240.13b2-2(b)(2) as being those actions that "could, if successful, result in rendering such financial statements materially misleading" should be in the rule or the preamble. The list is not exhaustive, so it is unclear how this list adds clarity to the scope or application of the rule. Even though the auditors do not prepare the financial statements, it seems clear that the actions taken to render the financial statements materially misleading would have to be actions that cause the auditors to issue a report that covers financial statements that are materially misleading. Most of the items on the list go more to the conduct that would constitute the fraudulent influence over an auditor and would more appropriately be included in the list of actions that constitute improper conduct.
If the list is maintained either in the rule or the preamble, the activity of failure to communicate matters to the audit committee should be limited to those matters required to be reported under section 204 of Sarbanes-Oxley or other specifically named provisions of the securities laws and regulations. Otherwise, the scope of activity would be too broad without any distinction between material and insignificant matters.
Acting Under the Direction of a Director or Officer
ACB believes that any individual who fraudulently influences an audit for the purpose of rendering financial statements materially misleading should be accountable, whether he or she is acting under the direction of a director or officer, or "at the behest of" or "on behalf of" a director or officer. However, the liability of a director or officer in those latter instances should be clarified. A director or officer should not be held liable under this rule unless they give express direction to a third party to act to fraudulently influence, coerce, manipulate or mislead a public accountant and the third party acts upon this direction. A third party may act in accordance with his or her own agenda, but believe he or she is acting on behalf of, or in the interest of, a director or officer. While management should adopt and enforce a corporate culture that requires all employees to act ethically in exercising their responsibilities, directors and officers should not be held responsible for the actions of others unless those actions result from specific directions.
It would be appropriate for the rule to include a definition of "engaged in the performance of an audit" to clarify the scope of the rule and the potential for liability.
ACB requests that the SEC clarify the definition of "issuer" for purposes of this rule. The SEC appears to be adopting the definition in section 3 of the Exchange Act, when the companies covered by the definition of "issuer" in Sarbanes-Oxley, which should be used in this rule, are a subset of the section 3 issuers.
ACB appreciates the opportunity to comment on this important matter. If you have any questions, please contact the undersigned at (202) 857-3121 or via e-mail at firstname.lastname@example.org, or Diane Koonjy at (202) 857-3144 or via e-mail at email@example.com.