Subject: File No. S7-16-98 (Rule 102(e)) Author: "Richard E. Brodsky" Date: 8/13/98 5:04 PM August 13, 1998 Jonathan G. Katz, Esq. Secretary Securities and Exchange Commission 450 Fifth Street, NW Washington, D.C. 20549 Re: File No. S7-16-98: Rule 102(e) Release Dear Mr. Katz: I submit these comments in response to the Proposed Amendment to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.[1] By way of introduction, I am a former SEC Staff lawyer (Enforcement Division, 1973-1981) and have been an active securities litigation and enforcement practitioner since leaving the Commission.[2] Although this letter is somewhat critical of the Commission's practices with respect to Rule 102(e), it is intended that those criticisms strengthen, not weaken, the Commission's enforcement and regulatory processes. In short, the views expressed herein represent the sincere beliefs of a some time participant in, and long time observer, of the evolution of Rule 102(e). This rulemaking is occasioned by two of the most severe and damaging defeats in the Commission's long history, Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994) ("Checkosky I"), and Checkosky v. SEC, 139 F.3d 221 (D.C.Cir. 1998) ("Checkosky II"). Checkosky I and Checkosky II should be viewed by the Commission not as mere tactical defeats, or even merely as a mandate to provide some much-needed underpinning to proceedings against accountants under Rule 102(e)(1)(ii). Rather, these cases should be viewed with due concern to the long-term damage to the Commission's ability effectively to enforce the federal securities laws caused by open judicial hostility to the Commission's exercise of its discretion in this area. In short, Checkosky I and II call for a fundamental reassessment of the function and purpose of Rule 102(e). The first and most vital task of the Commission in this rulemaking is to recognize that the starkest danger to the "integrity" of its "processes" lies in the air of judicial skepticism and, indeed, hostility, present in the two Checkosky decisions. Accordingly, it should devote its attention to ensuring that, through positive action, it restores full judicial confidence in its enforcement program. The Commission has a long, enviable record as the preeminent federal regulatory agency, but that position is threatened by an atmosphere in which the Commission's very ability to administer its own rules is called into question by one of the most important courts in the land.[3] Thus, the list of questions that the Commission poses under its "General Request for Comments", although comprehensive in a narrow sense, is lacking one important, over-riding question: what is the true meaning and purpose of Rule 102(e)? Put differently, how does Rule 102(e) relate to the rest of the Commission's "enforcement arsenal" and how should it be used? An even narrower but fundamental question should also be posed: does the Commission have the authority to proceed under Rule 102(e)(1)(ii) against an accountant when it admits to lack that authority as to lawyers? This latest chapter in the history of Rule 102(e) is the culmination of twenty five or more years of Commission struggle over the function and purpose of Rule 102(e), and, in particular, continues the Commission 's disinclination to admit to the inherent limitations of Rule 102(e) as applied to a broad range of conduct on the part of professionals who "practice" before it. The reasons that the Proposed Amendment fails thus must be viewed in the proper historical context. The Proposed Amendment cannot be properly evaluated in an historical vacuum, even solely within the perspective of the two Checkosky decisions. The Commission should ponder why it is that, almost twenty years after Touche Ross & Co. v. SEC, it is still facing vigorous internal debate as to the reach of Rule 102(e), see Separate Statement of Commissioner Norman S. Johnson, June 12, 1998 (proposed amendment to Rule 102(e)); and that the United States Court of Appeals has twice issued stinging attacks on the integrity of the Commission's use of Rule 102(e). Assuredly, it is not because the critics of the Commission's position do not share the Commission's dedication to keeping our capital markets as free from deceit and manipulation, as Congress envisioned in passing the federal securities laws over sixty years ago. Rather, the continued criticism reflects that, even after decisions of two Courts of Appeal[4] upholding the Commission's authority to proceed against auditors under Rule 102(e), the true meaning and purpose of Rule 102(e) are still very much in doubt. This uncertainty stems from the fact that there is, by definition, no legislative history to guide the present-day Commission in interpreting a rule whose language is vague, and whose purpose is obscure and is therefore mired in controversy. Unfortunately, the Proposed Amendment and the Release fail to address or answer the underlying questions posed above. Instead, the Commission continues to cling to the shibboleth it used to win the Touche Ross & Co. v. SEC[5] case twenty years ago -- the assertion that Rule 102(e) is not an enforcement tool and is designed solely to protect or preserve the Commission's processes. In my view, the Commission's continued reliance on this dubious proposition forces the Commission to take crabbed and, ultimately, indefensible positions in interpreting Rule 102(e). In a real sense, the appellate courts that have directly upheld the validity of Rule 102(e) have done the Commission, in the long run, no favor in perpetuating the legal fiction that, in instituting a proceeding under Rule 102(e), the Commission is not utilizing an "additional weapon" to its "enforcement arsenal", Touche Ross & Co. v. SEC, 609 F.2d at 579, but rather is proceeding under Rule 102(e) to "protect the Commission's processes." This was the Commission's inventive formulation of the theoretical basis for its authority to proceed under Rule 102(e), but, because it was a defensive reaction to arguments that the Commission had no authority to proceed under Rule 102(e), it is difficult to regard it as anything but a convenient legal fiction. Even the Second Circuit in Touche Ross, while accepting the rationale that Rule 102(e) is not an enforcement remedy, was nonetheless constrained to note, 609 F.2d at 580, that, in discussing the role of the SEC in the enforcement of the Foreign Corrupt Practices Act, Congress implicitly gave its approval to the SEC's use of Rule 2(e) proceedings as a possible alternative to injunctive action or criminal referral. See S.Rep.No.95-114, 95th Cong., 1st Sess. 12 n.6 (1977); H.R.Rep.No.95-640, 95th Cong., 1st Sess. 10 n.1 (1977), Reprinted in (1977) U.S.Code Cong. & Ad.News 4098. (emphasis added) Thus, the House Report in question stated: Rule 2(e) of the Commission's Rules of Practice, 17 CFR 201.2(e), authorizes the Commission to censure, suspend, or bar professionals, such as accountants and lawyers, from practicing before the Commission. A public or private Rule 2(e) proceeding might, in the Commission's view, be preferable, or used in addition to a civil injunctive action or criminal referral, in particular cases. These quotations from the Touche Ross decision and H.R. 95- 640 cast great doubt on the Commission's oft-repeated argument that Rule 102(e) is not part of the Commission's "enforcement arsenal". In fact, it is apparent that this argument was, at bottom, a creative solution to a serious legal problem: how to justify bringing disciplinary actions against securities professionals in a forum which was created by a Commission rule, not a Congressional enactment, and in which the strictures of a court proceeding -- the need to plead and prove scienter and to show positive proof of a likelihood of repetitive conduct to justify the issuance of an injunction -- were not present. However useful it was in defeating challenges to the Commission's authority to proceed, this elastic formulation is not only unlimited in its potential reach, and therefore incapable of providing any meaningful definitional limitation to its reach, but, equally importantly, has little relevance to the real world. Long after Touche Ross, academic commentators and experienced practitioners alike appear to acknowledge that Rule 2(e) is, in reality, an alternate enforcement remedy. See, e.g., Simon Lorne and W. Hardy Callcott, Administrative Actions Against Lawyers Before the SEC, 50 Bus. Law. 1293, 1326 (1995)(discussing "practical constraints on the SEC's exercise of prosecutorial discretion" in deciding whether to proceed against attorneys under Rule 2(e) or use another enforcement remedy); Developments in the Law -- Lawyers' Responsibilities and Lawyers' Responses, 107 Harv. L. Rev. 1547, 1614(1994) ("The Securities and Exchange Commission (SEC) enforces securities laws through two primary means: injunctive actions in federal district court and administrative proceedings in its own forum," including Rule 2(e) proceedings); Harvey L. Pitt and Karen L. Shapiro, Securities Regulation By Enforcement: A Look Ahead At the Next Decade, 7 Yale J. on Reg. 149, 171-72 (Winter, 1990) ("Cognizant of the agency's limited resources, and desirous of achieving the maximum (or most efficient) enforcement impact from its available resources, the Commission's staff served notice on the public that the "keys" to the securities marketplace are often controlled by a limited number of well-positioned individuals -- securities professionals, accountants, and lawyers"); Indeed, perhaps the only valid measure of the actual function of such proceedings at the Commission is best seen by how Rule 102(e) proceedings actually come to be. Almost invariably, Rule 2(e) proceedings emerge from Commission investigations of possible securities law violations. The Commission's Enforcement Division investigates, and brings to the attention of the Office of Chief Accountant, the Office of General Counsel, and the Commission, cases in which professionals have done something that could be deemed to be a violation of the securities laws or to evidence "improper professional conduct." Only after the facts are gathered is it determine whether to recommend the institution of a Rule 2(e) proceeding, a  21(c) cease and desist proceeding, or an injunctive action. See, e.g., Lorne and Talcott, supra, 50 Bus. Law. at 1328. Surely, every lawyer who has practiced in and against the Enforcement Division knows that, during an investigation of financial statements audited and reported on by a CPA firm, there is no way to guarantee that, if serious violations are uncovered (or are alleged to be uncovered), the Staff will not recommend the institution of an injunctive action or a cease and desist order, which contain the possibility of monetary penalties. Often the Staff will agree to "go 102(e)", "go cease and desist" or "go injunction" if defense counsel perceives that, in any one case, one or the other remedy is more beneficial or less onerous for the client. In this way, the tenet that the Commission does not regard Rule 102(e) as an alternative enforcement vehicle is clearly observed in the breach. Thus, in all candor, the fact that Rule 102(e) may have the effect of "protecting the Commission's processes" -- by, for example, barring those professionals the Commission views as incompetent or dishonest from practicing before it -- does not change the fact that, undeniably, Rule 102(e) has always functioned as an important "weapon" in the Commission's "enforcement arsenal". Indeed, is it any exaggeration that one of the principal functions, if not purposes, of the Commission's resort to Rule 102(e), has been to enable the Commission to bring an enforcement proceeding against those professionals guilty of misconduct which, for whatever reason, cannot be remedied in an injunctive action? Indeed, at roughly the same time as the Supreme Court held in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), that scienter is required to be alleged and proven in a Rule 10b-5 action, the courts began making it more difficult for the Commission to obtain an injunction. See SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90, 98 (2d Cir. 1978) ("fair to say that the current judicial attitude toward the issuance of injunctions on the basis of past violations at the SEC's request has become more circumspect than in earlier days"). Given this background, it is not surprising that the D.C. Circuit, in Checkosky II, held that the Commission had yet to articulate the standard by which it proposed to measure "improper professional conduct" or the rationale for that standard. Nor is it surprising that two of the three Judges in Checkosky I questioned the authority of the Commission to adopt a negligence standard, particularly after the Commission foreswore negligence as a basis for proceeding under Rule 102(e)(1)(iii) against an attorney. William R. Carter, 47 S.E.C. 471 (1981).[6] The confusion surrounding the meaning and purpose of Rule 102(e) and, especially, Rule 102(e)(1)(ii), finds its apotheosis in the debate over whether that rule can be construed to cover negligence on the part of a professional practicing before the Commission. How can the Commission justify using negligence as a standard to adjudge an accountant guilty of "improper professional conduct" after having strongly suggested, in Carter, that an attorney cannot be held to the same standard? One reads the Rule 102(e) Release in vain for any showing that the incompetent auditing of a registrant's financial statements is any less dangerous than the incompetent drafting of the registrant's registration statement or proxy statement. To paraphrase the Commission's Rule 102(e) Release: 1. Lawyers, too, "play many roles in the Commission's system of securities regulation." 2. Registration and proxy statements, too, "are [among] the primary sources of information available to guide the decisions of the investing public..." 3. While registrants are not required to use securities lawyers to draft or review textual filings with the SEC, their usage is universally understood and recommended. 4. The Commission "cannot closely scrutinize" textual filings, and instead relies on the securities bar to provide expert advice to clients to "assure corporate compliance with federal securities law requirements and disclosure of accurate and reliable ... information." 5. The Commission has long recognized that "an incompetent and unethical [attorney] can damage the Commission's processes and erode investor confidence in our markets."[7] At least, as a result of Checkosky II, the issue is fully joined; presumably, therefore, if the Commission were to adopt the proposed amendment, a future respondent fortunate enough to be able to afford to contest a Rule 102(e) proceeding, such as Messrs. Checkosky and Aldrich, and unfortunate enough to lose at the Commission, can test this issue in a court of law -- if some interested party is not successful in challenging the amendment in a direct appeal from this rulemaking.[8] This, however, is hardly a promising or constructive solution. A much more productive approach for the Commission would be to cease its efforts to develop a consensus on the use of Rule 102(e). Rather than continue spending time and effort trying to tinker with Rule 102(e), while, at the same time, in the words of Commissioner Johnson, actuating the risk that "many of the worst offenders of Rule 102(e) may escape sanction altogether," the Commission should instead chart a new course. At the very least, the Commission should declare that negligent conduct is beyond the purview of Rule 2(e)(1)(ii), whether applied to a lawyer, an accountant, or any other "professional." Or, if it truly wants to seize this opportunity to end the long and unfortunate history of Rule 102(e), it should: 1. abandon the legal fiction that Rule 102(e) has not been used as an "enforcement tool", end its use as such, and rely on other enforcement tools at its disposal to police the conduct of professionals responsible for advising or assisting clients in public filings; 2. act directly in accord with its assertion that Rule 102(e) is premised on its ability to protect the integrity of its processes by henceforth limiting its use to cases of active obstruction of its processes; 3. work cooperatively with State Boards of Accountancy and State Bar authorities where it finds instances of "serious" negligence on the part of professionals; and 4. seek explicit Congressional approval of its claimed authority to bring disciplinary actions against incompetent, reckless or dishonest professionals. Such forthright action would require the Commission to abandon years of legal positions and arguments, but would go a long way towards clearing the air and restoring "confidence in the integrity of the Commission's processes" -- a confidence that, clearly and shockingly, is absent from the D.C. Circuit's two Checkosky decisions. The Commission's greatest fear should not be the fate of Rule 102(e)(1)(ii), but rather whether the open skepticism towards the Commission shown in Checkosky I and II will infect other courts adjudging SEC cases throughout the United States. Were that to happen, the integrity of the United States securities markets will suffer the greatest damage, a result no one of good faith inside or outside the Commission desires. Sincerely yours, Richard E. Brodsky, P.A. **FOOTNOTES** [1]: In this letter, the term "Rule 102(e)" is used to refer to old Rule 2(e) and new Rule 102(e) without distinction. [2]:From 1973 to 1981 I was a staff attorney and Branch Chief with the Division of Enforcement of the Commission in Washington, D.C. While I was with the Staff, I was frequently involved in investigations and proceedings relating to the conduct of attorneys and accountants. Among the major cases on which I worked were the Commission's injunctive action against two partners of a major international law firm arising from the issuance of allegedly false and misleading tax law opinions in the offer and sale of interests in the GeoDynamics oil and gas drilling funds (SEC v. Janetatos, D.D.C. 1976); and the Commission's landmark Rule 102(e) proceeding against two partners of a major Wall Street firm arising from the disclosure violations of National Telephone Company (In re William R. Carter, 47 S.E.C. 471 (1981). These two cases occasioned widespread debate within the Commission as to the proper role of the Rule 102(e) proceeding in the operation of the Commission's responsibilities. I also worked on numerous investigations and proceedings arising from alleged misconduct of accounting firms, including In re Benjamin Botwinick & Co., a 1973 Rule 102(e) proceeding, and SEC v. Price Waterhouse (D.D.C. 1978), the first Commission enforcement action against that firm. Since 1981 I have been in private practice in Miami, Florida and have represented numerous accounting firms in SEC investigations, some of which have resulted in formal proceedings. [3]:Commissioner Johnson stated an unquestioned truism when he noted, in his dissent to the adoption of this proposed rulemaking, that "[t]he weight the Commission must attach to the views of the D.C. Circuit cannot be overstated." One might add to his reference to the jurisdictional authority of the D.C. Circuit to review Commission administrative proceedings the basic respect with which the D.C. Circuit is undoubtedly held by lower courts and fellow Courts of Appeal throughout the federal court system. [4]:See Davy v. SEC, 792 F.2d 1418 (9th Cir. 1986) (Commission has authority to proceed against CPA for unprofessional conduct in auditing registrant's financial statements filed with the Commission); and Touche Ross & Co. v. SEC, 609 F.2d 570 (2d Cir. 1979) (same). Sheldon v. SEC, 45 F.3d 1515 (11th Cir. 1995) is cited along with Davy and Touche Ross in the Commission's Release as "upholding the validity of Rule 2(e)," Release at n.7. But the Commission stands on shaky ground if it seeks to rely on the Eleventh Circuit's decision in Sheldon for the proposition that Rule 102(e) can be used to discipline accountants for negligent auditing of financial statements to be filed with the Commission. Sheldon was an appeal from an adverse decision in an SEC broker-dealer proceeding. One of the respondent's arguments was that the attorney-witnesses against him had been "intimidated" by the SEC's inherent ability to discipline them under then Rule 2(e). The Eleventh Circuit "reject[ed] the contention that the SEC's Rule 2(e) is improper or otherwise taints the fairness of proceedings before the SEC. Having attorneys subject to ethical standards constitutes a safeguard for all parties in a proceeding, not intimidation." (emphasis supplied) This narrow holding certainly upholds the Commission's authority to police attorneys for misconduct in Commission proceedings, but is far removed from the issue before the Commission as a result of Checkosky II. [5]:609 F.2d 570 (2d Cir. 1979) (Rule 2(e) not an "additional weapon" in its "enforcement arsenal" but rather exists to protect the integrity of the Commission's "processes"). [6]:As the Commission is aware, Judge Randolph, in his concurring opinion in Checkosky I, stated that the holding of the Commission in Carter, that wilful or reckless behavior was needed to violate Rule 102(e)(1)(iii) (aiding and abetting), was equally applicable to Rule 102(e)(1)(i) and (ii). [7]:As the Commission noted in Carter: "Significant public benefits flow from the effective performance of the securities lawyer's role. The exercise of independent, careful and informed legal judgment on difficult issues is critical to the flow of material information to the securities markets." [8]:Indeed, the Commission cannot lightly dismiss the risk that, if it proceeds under Rule 102(e)(1)(ii) against an accountant, under any standard of conduct, for actions taken before the final enactment of a definitive interpretation of the rule, a court would find such a proceeding to be violative of due process. This is a distinct possibility under even a moderate reading of Checkosky II, and is foreshadowed by the wording of the Commission's own Rule 102(e) Release, where the Commission asserts in its "IFRA" statement that "[m]embers of the accounting profession will better understand the standard the Commission uses to determine `improper professional conduct' and thus conduct themselves accordingly." No such guidance will be available to an accountant charged with "improper professional conduct" preceding the implementation of the proposed Amendment or, at least, its initial proposal. It is undoubtedly for this reason, among others, that Commissioner Johnson expressed the fear that, as a result of the Commission's actions, "many of the worst offenders of Rule 102(e) may escape sanction altogether."