Ernst & Young
5 Times Square
New York, New York 10036
Phone: 212 773-3000
November 25, 2002
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Release No. 34-46685; IC-25773; File No. S7-39-02, Proposed Rule on "Improper Influence on Conduct of Audits"
Dear Mr. Katz:
Ernst & Young is pleased to submit this comment letter on the Commission's proposed rule to implement Section 303(a) of the Sarbanes-Oxley Act ("the Act").
Section 303(a) requires that the SEC issue a rule making it unlawful "for any officer or director of an issuer, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading."
The SEC's proposal provides for a new rule 13b2-2(b), which would supplement existing rule 13b2-2 of Regulation 13B-2 under Section 13(b)(2) of the Securities and Exchange Act of 1934. The existing rule 13b2-2 (to be renumbered 13b2-2(a)) prohibits the making of false or misleading statements, or omissions to make certain statements, to accountants. The new rule 13b2-2(b) would add to the SEC's ability to prosecute individuals who mislead auditors. Improper Influence on Conduct of Audits, 67 Fed. Reg. 65325 (proposed Oct. 24, 2002).
Overview and Background:
The significance of requiring that issuers make truthful statements to their outside auditors can scarcely be overstated. As has often been noted, "[f]or practical reasons of time and cost, an audit rarely, if ever, examines every accounting transaction in the records of a business." Bily v. Arthur Young & Co., 3 Cal. 4th 370, 380, 834 P. 2d 745, 749, 11 Cal. Rptr. 2d 51, 55 (1992). Thus, the auditor, as well as regulators and the public, must expect honesty from management in making accurate statements to the auditor. In fact, Generally Accepted Auditing Standards (GAAS) expressly provide that the auditor must not assume dishonesty - the auditor "neither assumes that management is dishonest nor assumes unquestioned honesty." Codification of Accounting Standards and Procedures, Statement on Auditing Standards No. 1, AU § 230.09 (American Inst. of Certified Pub. Accountants 2001).
There are numerous instances in the auditing literature that stress the importance of truthful management statements. In AU § 333, "Management Representations," GAAS requires that the independent auditor obtain written representations from management. AU § 333.02 states: "During an audit, management makes many representations to the auditor, both oral and written, in response to specific inquiries or through the financial statements . . . Written representations from management ordinarily confirm representations explicitly or implicitly given to the auditor, indicate and document the continuing appropriateness of such representations, and reduce the possibility of misunderstanding concerning the matters that are the subject of the representations."
The auditor is particularly dependent on accurate management representations in certain audit areas. AU § 333.03 provides two - representations regarding related party transactions and management's intentions to discontinue a line of business. Other examples also relate to management's intentions, such as whether long-term assets are held for use or sale, and whether investments in debt securities are held to maturity. These are a few of the many matters that are highly dependent on management providing the auditor with truthful information.
Another example is provided in SAS 57, AU § 342, "Auditing Accounting Estimates." Accounting estimates include such matters as net realizable values of inventory and accounts receivable, property and casualty insurance loss reserves, revenues from contracts accounted for by the percentage-of-completion method, and pension and warranty expenses. AU § 342.02. The auditing standards state: "Management is responsible for making the accounting estimates included in the financial statements," particularly because such estimates "are based on subjective as well as objective factors." AU § 342.03. Many estimates are dependent on the actions that management intends to take, such as whether receivables will be pursued to collection or sold to a factor, or whether certain claims might be settled or pursued through litigation. Again, the appropriate accounting determination depends on the good faith representations of management.
Another important element of the audit is the making of representations to auditors by third parties, such as customers and creditors, and these persons, too, can mislead auditors. As part of the audit process, the auditor seeks confirmations from such third parties about particular items affecting financial statement assertions. The Commission has recognized that "[t]he confirmation procedure is an integral and vital part of the auditing process. Subversion of the process corrupts the integrity of the audit and can injure investors by facilitating the injection of false financial information into the marketplace." In the Matter of Troy Lee Wood, Exchange Act Release No. 37905, 1996 SEC LEXIS 3050, at *9 (Oct. 31, 1996). Accordingly, the Commission has brought numerous proceedings against third parties for making misleading statements to auditors. See id.; see also In the Matter of Richard D. Lemmerman, Exchange Release No. 29737, 1991 SEC LEXIS 2192, at *8 (Sept. 26, 1991); In the Matter of Calvin Shenkir, Jr., Exchange Act Release No. 36446, 1995 SEC LEXIS 2978, at *6 (Oct. 31, 1995); In the Matter of Terry Kuntz & Richard J. Scheer, Exchange Act Release No. 36281, 1995 SEC LEXIS 2490, at *15 (Sept. 26, 1995).
An Ernst & Young review of SEC enforcement releases from 1978 to August 2002 indicates that the Commission has brought numerous cases against both the management of issuers and third parties for making false statements to auditors. Our review shows that the Commission brought more than 300 cases against officers and employees for making misleading representations to the auditor, and more than 30 cases against third parties who provided misleading statements (such as audit confirmations) to auditors.
Ernst & Young's Position:
In view of the importance of this issue, Ernst & Young has been on record as supporting a strengthening of laws prohibiting the making of false statements to auditors. For example, on February 4, 2002, The Wall Street Journal published an "op-ed" piece by Jim Turley, the Chairman of Ernst & Young, entitled "How Accounting Can Get Back Its Good Name." The article stated our support for making a person subject to criminal penalties if he or she lies to an auditor. That result has been achieved: although there have been criminal sanctions imposed for such conduct in the past, the new Section 303 makes clear that improperly influencing the conduct of audits in the manner set forth in the statute may result in the imposition of criminal sanctions. See Exchange Act Section 32(a) (criminal penalties apply to "[a]ny person who willfully violates any provision of this chapter (other than Section 31), or any rule or regulation thereunder the violation of which is made unlawful or the observance of which is required under the terms of this chapter").
We also have believed that an explicit statutory provision was important because, although Rule 13b2-2 currently prohibits the making of misleading statements, there are aspects of the prohibition which could be strengthened. Significantly, Rule 13b2-2 applies only to any director or officer of an issuer, and, although third parties can be liable for "causing" or "aiding and abetting" an issuer's violation, a more effective restriction would make third-party misstatements a direct rule violation. In addition, a direct statutory provision such as Section 303 of the Act would reinforce the importance of this issue and might strengthen the Commission's ability and resolve to pursue enforcement cases in this area.
We have the following specific comments on the rule proposal, which we address in the order that they arise in the Proposing Release:
- The statute prohibits "persons acting under the direction" of an officer or director from making false statements. The Proposing Release states that the word "direction" encompasses a broader category of behavior than "supervision," and therefore includes "customers, vendors, or creditors who . . . provide false information . . . to auditors." 67 Fed. Reg. at 65326. We agree that this is an appropriate interpretation of the statute. We also believe that the Commission might consider broadening the rule still further. As currently proposed, persons who might not actually act "under the direction" of an officer or director should be subject to the same prohibition. For instance, lower-level persons might, without the knowledge of an officer or director, embezzle money from the company and then lie about the embezzlement to the auditor. Such persons should be subject to SEC sanction.
- The Proposing Release gives examples of the types of conduct that might constitute actions to "fraudulently influence" an auditor, including actions such as offering bribes and financial incentives; threatening to cancel or canceling audit or non-audit engagements; seeking to have a partner removed from an engagement because the partner objects to the issuer's accounting; blackmailing; and making physical threats. The Proposing Release asks whether the rule itself should include such a list. 67 Fed. Reg. at 65327.
We believe that such a list is helpful, although it does not seem essential that the rule text itself contain the list. It has been our experience that concrete examples can be very useful to companies in implementing compliance programs because they can make issues more understandable to employees.
We are, however, concerned about one of the specific examples, namely the Proposing Release's suggestion that the payment of "financial incentives" such as "contracts for non-audit services" is one method of improperly influencing the auditor. Id. This statement could easily be misconstrued and should not be included in the Adopting Release. The Commission adopted audit independence rules in 2000, and pursuant to Section 208 of the Act is again adopting rules in this area. Those rules and Section 201 of the Act specify which non-audit services may not be provided by an accounting firm to its audit client. There has of course been much attention focused on this issue, and audit committees are now required to pre-approve all permitted non-audit services. See Section 202 of the Act. We believe that the Proposing Release's statement that "contracts for non-audit services" can be a type of "financial incentive" that could constitute "improper influence" under the new rule simply adds confusion to an issue that is properly addressed in the context of the independence rules rather than in this rulemaking.
- The Proposing Release notes that the Proposed Rule gives a "broad reading" to the statutory phrase "engaged in the performance of an audit" by, for example, making the rule applicable to the time period after the engagement has ended when the auditor is considering whether to issue a consent on the use of prior years' audit reports. 67 Fed. Reg. at 65328. We believe that such a broad reading is appropriate.
- The Proposed Rule gives examples of types of "actions" that could be taken by the auditor and that are covered by the rule - such as issuing an audit opinion that is not warranted under the circumstances and not performing certain audit procedures. Id. For the same reasons noted above, we believe that such examples are helpful and encourage the Commission to keep them, either in the rule text or in the Adopting Release.
- The Proposed Rule would make a person liable if he or she fraudulently influences the auditor and either "knew, or was unreasonable in not knowing, that the improper influence could, if successful, result in rendering financial statements materially misleading." Id. We support the use of a reasonableness standard in this context. The standard seems particularly necessary in order to prevent third parties who provide false confirmations to auditors from being able to assert that they did not do so with the specific purpose of rendering the issuer's financial statements misleading.
We are, however, concerned that third parties might grow increasingly reluctant to provide confirmations if the state-of-mind requirement is too low. In footnote 16 of the Proposing Release, the Commission states: "We view `fraudulently' as modifying only `influence.'" 67 Fed. Reg. at 65327. Thus, the footnote suggests that the remaining words in the phrase - "coerce," "manipulate," and "mislead" - have no modifying adverb. Under this approach, there would be no scienter requirement. The words "coerce" and "manipulate" likely have some element of wrongful intent, but the word "mislead" does not - a person can make a "misleading" statement innocently or honestly, without acting negligently. We would be concerned about a rule that could be violated if a third party "misleads" an auditor innocently or by mistake and was merely "unreasonable" in not knowing that the action could "if successful" result in materially misstated financial statements. That would indeed set a very low threshold.
Clearly, we want third parties to respond accurately to confirmation requests, and we support a broad and vigorous enforcement effort to prosecute third parties who collude with management to mislead the auditor. But the threat of SEC prosecution for innocent mistakes would likely discourage third parties from responding to confirmation requests. Although we do not have empirical data on this point, it has been our experience that third parties are less willing today to respond to such requests than they were 10 or 20 years ago.
Confirmations are used in a wide range of situations - confirmation of accounts receivable is required under GAAS, and confirmations may be used for audit evidence of securities and cash in custodian or trust accounts, life and other insurance policies, cut-off bank statements, advance payment or deposits, credit arrangements with financial institutions, inventory held by others, long-term debt, notes payable and notes receivable, registrar and transfer agent capital stock, terms of sales arrangements, shipping information with carriers, software contract terms, counterparty confirmation of derivative instruments, and accounts payable. If the auditor does not receive replies to confirmation requests, he or she is generally required to apply alternative procedures. Those procedures vary according to the account and assertion in question. In the examination of accounts receivable, for example, alternative procedures might include examination of subsequent cash receipts, shipping documents, or other client documentation. See AU § 330.31-32. But such alternative procedures generally cannot provide evidence as complete and accurate as a confirmation from a third party.
Accordingly, we suggest that the rule might properly establish different scienter standards for the officers, directors, and employees of the issuer on the one hand, and for third-parties on the other. Even if the rule does not require that the issuer "fraudulently" misled the auditor, some adverb properly should modify the word "mislead" as to third parties. The word "fraudulently" is a high standard, and we suggest that the Commission might instead use the word "improperly" (see our separate comment below with respect to officers, directors, and employees).
- The Proposing Release asks several questions about possible wording changes. First, the Release asks whether the phrase "under the direction of an officer or director" might instead state "at the behest of" or "on behalf of" an officer or director. 67 Fed. Reg. at 65328. We think that the change would not be necessary. The phrase "direction of" seems reasonably understandable, but "behest" or "behalf" are words whose meanings are less clear. We think that introducing confusion into this issue could aggravate the concern noted above - that is, discouraging third parties from responding to audit confirmation requests.
Second, the Release asks whether the word "fraudulently" should be replaced with the word "improperly" as a modifier of the word "influence." 67 Fed. Reg. at 65329. Although we have some concern that such a rule might be inconsistent with the legislative intent - the statute includes the word "fraudulently," and we assume that that word is not surplusage - the Commission does have broad rulemaking authority in implementing the Act, and the Commission should not be required to prove fraudulent intent in order to prosecute officers, directors and employees of issuers who make false statements to the auditor. Accordingly, we would support the Commission's decision to promulgate a rule that would not require a showing of fraud as to such persons (although the Commission's statement in footnote 16 that "fraudulently" does not modify the word "mislead" makes this proposed change seem unnecessary).
Third, the Release asks whether the phrase "if the person knew or was unreasonable in not knowing that such action could, if successful, result in rendering such financial statements materially misleading" might be replaced with the phrase "for the purpose of, or have the effect of, rendering the financial statements materially misleading," or with "some other phrase to convey that proving a particular purpose or intent is not required." Id. We do not believe that the proposed alternative formulation would strengthen the rule. It would, in fact, appear to add to the Commission's burden in proving a violation, because it would require either a "purpose" or an "effect." The Proposed Rule, by contrast, could be violated without a purpose ("unreasonableness" would be enough) or an effect (an attempt to materially mislead investors would be sufficient). Accordingly, we would prefer that the Commission adopt the language in the Proposed Rule.
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We would be pleased to provide the Commission with additional information on any of the areas addressed by this letter.
Ernst & Young LLP