December 13, 2002
Mr. Jonathan G. Katz
Re: SEC Release No. 34-46685 (File No. S7-39-02)
Dear Mr. Katz:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities (the "Committee")* of the Business Law Section of the American Bar Association (the "ABA") in response to the Commission's request in the above release (the "Release") for comment on proposed revisions to Rule 13b2-2 (the "Revisions") under the Securities Exchange Act of 1934. The Commission states in the Release that it is proposing to adopt the Revisions "[a]s directed by Section 303(a) of the Sarbanes-Oxley Act of 2002."
The comments expressed in this letter represent the views of the Committee only. They have not been approved by the ABA's House of Delegates or Board of Governors and do not represent the official position of the ABA or the ABA's Section of Business Law. Moreover, they do not necessarily reflect the views of all members of the Committee.
We have two principal concerns about the Revisions and the Release. First, the Commission, rather than simply proposing the Revisions to implement Section 303(a), includes in the Release unnecessary (and we believe in some cases incorrect) interpretations of Section 303(a) and Congressional intent with respect to that provision. Second, Section 303(a) clearly contemplates some type of scienter as an element of a violation. The Revisions would effectively replace this essential element with a much lesser standard of culpability.
In combination, the interpretive language in the Release and the Revisions' elimination of the scienter requirement, would regulate conduct in a way that substantially exceeds, and is inconsistent with, the mandate of Section 303(a) of Sarbanes-Oxley. We believe these extensions of Section 303(a) represent unwise public policy. More generally, given the deadlines imposed by Sarbanes-Oxley, we question the wisdom of the Commission's exceeding its statutory mandate. In the absence of a compelling reason to go beyond the statute, rulemaking in this compressed time frame without the benefit of an adequate comment process and Commission deliberation that can lead to more effective regulation runs a substantial risk of unforeseen and unintended consequences. We recommend that the Commission confine its rulemaking at this time to the direct implementation of the statute and leave for a later day additional measures, if any, that may prove necessary.
As noted in the Release, much of the conduct sought to be reached by the Revisions is already actionable by the Commission under its existing authority, including the ability to bring aiding and abetting charges against persons who provide substantial assistance to an officer or director in bringing improper influence to bear on an auditor. The Release justifies the extension of coverage simply by stating that the Revisions provide "an additional means" of pursuing such conduct. We do not believe that this is an adequate reason to go beyond the statutory mandate. Furthermore, we believe that the Revisions, particularly the elimination of the scienter requirement, would likely have an adverse impact on regular communication between issuers and their auditors and unnecessarily expose those involved in the audit process, including attorneys, to unwarranted exposure to liability.
1. Unnecessary Interpretive Guidance.
We believe that the clearest example of unnecessary interpretive language in the Release is the spin put by the Commission on the meaning of "under the direction" of an officer or director.
The statute, by its terms, applies to officers and directors of an issuer and to persons acting "under the direction" of an officer or director." In the Revisions, the Commission has simply mirrored this statutory language. We believe this is the correct approach -- one producing a regulation that issuers can understand and satisfy. In our view, the Commission should not expand or modify the scope of this provision either by amending the existing definition of "officer" as set forth in Rule 3b-2 or by attempting to define the meaning of "any other person acting under the direction" of an officer or director.
Unfortunately, the Commission did not limit itself to merely proposing the implementing regulation. In the Release, the Commission adds interpretive gloss to Section 303 and the Revisions, stating that the Revisions would apply to persons who are "not under the supervision or control of [an] ...officer or director" (including, according to footnote 13 to the Release, any person who acts pursuant to an "explicit instruction"). The Release then offers illustrations of an extremely broad range of persons who might be covered, e.g., customers, vendors or creditors, as well as attorneys, securities professionals or other advisers. Furthermore, the Commission solicits comment on abandoning even the notion of an "explicit instruction," proposing instead to reach persons who act "at the behest of" or "on behalf of" an officer or director. Thus, while the Commission leaves well enough alone with the Revisions themselves, it tries to expand the purview of the Revisions beyond the statutory mandate through the other language in the Release. In light of the considerations discussed above, we urge that the Commission abandon its illustrations of covered persons and that this provision, as well as the other aspects of the Revisions, be left for plain reading by issuers and their advisors and future application by the Commission and the courts.
The Commission also identifies communications with auditors, such as providing an auditor with inaccurate legal analysis, that can form the basis for violation of the rule. We believe the Commission means this to be so only if accompanied by the predicate improper conduct. It would be helpful if this were made clear.
2. Elimination of Scienter Requirement.
No reasonable person can criticize Section 303(a)'s goal of preventing fraudulent attempts to influence the conduct of audits, through its prohibition of actions that involve an intent to deceive or defraud. Congress explicitly set forth this scienter requirement in its description of the type of conduct, and purpose of that conduct, subject to the prohibition. The Commission, however, through the Revisions and interpretive language in the Release is proposing to effectively eliminate this requirement. We hope that the Commission will reconsider this attempt to expand the reach of the prohibition.
The statute refers to conduct taken "to fraudulently influence, coerce, manipulate, or mislead" an accountant. The Commission itself recognizes the importance of the term "fraudulently," when it asks whether that word should "be replaced with the word `improperly' or some other word to convey a mental state short of scienter." Under general principles of statutory construction, the word "fraudulently" should be understood to apply to each of the four verbs in the series that follows that adverb. The Commission has recognized this approach to statutory construction in defining "material violation" in its proposals to implement Section 307 of Sarbanes-Oxley. Think how awkward the sentence would read if "fraudulently" had to be repeated before each verb. If the intent of Congress was to modify only "influence," as is the view of the Commission, the logical position of "fraudulently induce" would be at the end, not the beginning, of the string.
But even if one accepts the Commission's strained reading of that portion of Section 303(a), the statute continues on to state that the prohibited acts must be "for the purpose of rendering [the] ... financial statements materially misleading." Such words could not more clearly require an intent to achieve a forbidden purpose. Congress obviously intended to avoid interfering with benign or negligent communications.
The Revisions would find an officer, director or person acting under an officer's direction culpable if he or she knew, or was unreasonable in not knowing, that the prohibited action could, if successful, result in the financial statements becoming materially misleading. Under this formulation, the Commission could charge a person who communicates with an accountant with a violation of Section 303(a) if the Commission determines, with the benefit of hindsight, that the person was unreasonable in not knowing that the communication might possibly result in materially misleading financial statements. In effect, the Commission is proposing to substitute a negligence standard for the scienter requirement specified in Section 303(a). Not surprisingly, the Release also requests comment on whether this watered-down purpose required to constitute a violation of the revised rule should be even further watered down to action undertaken either for the purpose of or that would have the effect of rendering the financial statements materially misleading (emphasis added). As the Release admits, it would thus be unnecessary to prove any particular purpose or intent whatsoever.
Congress appropriately adopted Section 303(a) to prevent conduct intended to result in the release of misleading financial statements. The Commission, however, proposes to extend the statute's coverage in a way that could result in serious harm to the relationship among issuers, their advisors and their auditors. It is vital that there be an active dialogue between issuers and their independent public accountants with respect to accounting principles, their application, estimates, judgments, etc. In various releases this year, the Commission has recognized that for any issuer there may be a range of acceptable practices and policies, which of course should be the subject of discussions involving the issuer, its officers, accounting staff and audit committee, along with the auditors. Furthermore, during the audit process (particularly as would be so broadly defined by the Commission), there will inevitably be disagreements between the issuer and the auditors. There is nothing inherently wrong with officers of an issuer or other persons' forcefully advocating a position to their auditors, even one that that ultimately proves to be unacceptable, so long as the purpose of such advocacy is not to pressure the auditors to sign off on financials designed to mislead investors. We believe that this ongoing give and take actually helps to bring about the fairest presentation of the issuer's operating results, financial condition and cash flows, in the best interests of investors. The securities laws, of course, already provide for liability, to both the Commission and third parties, if the published financial statements are in fact misleading.
We are concerned that the Revisions could lead officers and other covered persons to refrain from fully engaging in these productive communications with auditors, in fear of liability when the discussions are viewed by the Commission in hindsight. We do not believe that the public interest would be served by the Commissions' adoption of rules that could chill these critical communications. Consistent with the Commission's position in its release proposing rules to implement standards of professional conduct for attorneys that it "does not want ... to discourage issuers from seeking and obtaining effective and creative legal advice," it should refrain from implementing rules that will discourage the effective exchange of ideas among issuers, their advisors and their auditors.
Additionally, any lawyer making an allegedly misleading statement in an auditor's letter could be subject to prosecution under the Commission's version of Section 303(a). So would any banker confirming balances, any customer confirming receivables, any supplier confirming payables. The Commission could not have invented a better way to discourage third-party cooperation with an audit, which is essential to the audit process and the integrity of audited financial statements. We do not believe this is what Congress intended. For these reasons, we urge that the Commission adopt rules that track the language and meaning of Section 303(a).
We appreciate the opportunity to submit comments. Members of the Committee are available to meet with the Commission and its Staff and to respond to any questions.
cc: Hon. Harvey L. Pitt
Hon. Paul Atkins
Hon. Roel Campos
Hon. Cynthia A. Glassman
Hon. Harvey Goldschmid