Dorsey & Whitney LLP
November 25, 2002
VIA INTERNET AND FIRST CLASS MAIL
Jonathan G. Katz, Secretary
Re: Proposed Rules 13b2-2(b) and (c) of Regulation 13B-2; File No. S7-39-02
Dear Mr. Katz:
We appreciate this opportunity to comment on proposed new rules 13b2-2(b) and (c) of Regulation 13B-2 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which the Securities and Exchange Commission (the "Commission") published for comment in Release No. 34-46685 on October 18, 2002 (the "Proposing Release").1
The Commission proposes to redesignate existing rule 13b2-2 of Regulation 13B-2 as rule 13b2-2(a),2 and to add new rules 13b2-2(b) and (c) (together, the "proposed rules").3 The proposed rules are intended to implement section 303(a) of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"). Proposed rule 13b2-2(b) would prevent an officer or director of a company, or any person acting on his or her behalf, from improperly influencing the company's accountant in order to render the company's financial statements required to be filed with the Commission materially misleading. Proposed rule 13b2-2(c) would extend the operation of Regulation 13B-2 to cover any investment advisor, sponsor, depositor, trustee or administrator, or any officer, director or intermediary of such person, acting on behalf of a registered investment company or business development company.
We agree with the objectives of the proposed rules to prevent fraud and other misconduct in connection with the audit of an issuer's financial statements. However, we believe that the proposed rules are written too broadly by imposing a negligence standard upon the officers and directors of filing companies, and their intermediaries, in their dealings with auditors, thereby going beyond the scope of section 303(a) of the Sarbanes-Oxley Act.
Our particular focus in this comment letter is on the implications of the proposed rules on investment banking firms providing corporate finance services to issuers.4 We believe that the proposed rules, if adopted in their current form, would result in significant uncertainty surrounding the professional relationships between public companies and broker-dealers providing investment banking services to those companies. Such uncertainty could have a chilling effect on legitimate business dealings between companies and investment banking firms.
Therefore, we respectfully suggest that the proposed rules should be revised to prohibit, at least in the case of professional advisers such as investment banking firms, only that conduct by a person with respect to an auditor that is intended by such person to cause the audited company's financial statements to be materially misleading, and to proscribe specific practices by identified persons that the Commission has determined are likely to have the effect of unduly influencing auditors in the review of financial statements; thereby eliminating any uncertainty in the application of the rules.
I. The Proposed Rules Exceed The Authority Granted By Section 303(a) Of The Sarbanes-Oxley Act.
Proposed rule 13b2-2(b)(1) contains a negligence standard with respect to the activities of officers and directors of public companies, and persons who act on their behalf. Subparagraph (b)(1) provides, in pertinent part, that
However, section 303(a) of the Sarbanes-Oxley Act mandates that the Commission shall prohibit, by rules promulgated under the statute, only conduct that is intended to mislead. Section 303(a) of the Sarbanes-Oxley Act provides, in pertinent part, as follows:
The Commission suggests that the conduct addressed by the statute includes not only fraudulent activity, which requires the subjective intention to mislead, but also negligence, which requires a lesser, objective measure of fault. Under the standard advanced by the Commission, a broker-dealer acting as an underwriter or otherwise providing investment banking services to a company could unwittingly run afoul of the proposed rules in its dealings with the company's accountants if, in the determination of the Commission, the broker-dealer's actions could have the effect of rendering the company's financial statements materially misleading regardless of whether such action was intentional.
The Commission argues that the word "fraudulently" in section 303(a) modifies only the term "influence" in order to dispense with the requirement for a subjective measure of fault for rules promulgated under the statute. The Commission looks for support to the Committee Report accompanying the Sarbanes-Oxley Act, "which cites as a reason for enacting section 303 the testimony of witnesses who are concerned with addressing fraud and other `misconduct in the audit process.'"7 The Commission notes as well that "[b]ecause there is no private right of action [under Regulation 13B-2] . . . a lesser standard of liability is appropriate."8
But the language of section 303(a) clearly provides that the conduct to be redressed by rulemaking is activity that is intended to mislead. The Commission's interpretation of the statute fails to consider that any action by a person "to fraudulently influence, coerce, manipulate or mislead" the company's accountant must be "for the purpose of rendering [the company's] financial statements materially misleading." No matter how one interprets the several activities identified in the statute, each of them must be for the "purpose" of misrepresenting the company's financial condition. And purpose connotes intention.9
It is, therefore, inappropriate for the Commission to rely solely on the juxtaposition of the word "fraudulently" among the acts specified in section 303(a) to justify a negligence standard where the object of those acts is expressly identified as the intention to mislead.10 If Congress had intended the Commission to rely exclusively on the specified acts to determine the measure of the actors state of mind in devising rules under the section 303(a), it might better have substituted the words "with the effect of" or "with the potential effect of" for the words "for the purpose of" in the final, adverbial clause of the section.
The intention of Congress expressed by the language of section 303(a) should be of primary importance in determining the standard that shall apply to rules formulated under the statute.11 Here, as in all instances of rulemaking by a federal agency, the plain meaning of the statute should control the content of the rules formulated under its authority.12
II. The Proposed Rules Would Create Substantial Uncertainty In The Business Relations Between Public Companies And Broker-Dealers Providing Underwriting And Other Investment Banking Services To Such Companies.
The proposed rules would create substantial uncertainty surrounding the business relations between public companies and broker-dealers retained by such companies to provide underwriting and other investment banking services that involve the broker-dealer in analyzing or assessing audited financial statements in relation to corporate finance transactions. The negligence standard contained in the proposed rules would enable the Commission to determine what constitutes appropriate conduct between broker-dealers and accountants of their investment banking clients at the time the rules are enforced and adjudicated. In this regard, the duties incumbent upon broker-dealers and other persons under the proposed rules would not be clearly established in advance.
The uncertainty surrounding the proposed rules would likely have a chilling effect on the business relations between public companies and broker-dealers that provide investment banking services, and may interfere with the ability of investment bankers to aggressively test the facts underpinning an issuer's audited financial statements. Investment banking firms may be hesitant to have candid discussions with a company's auditor for fear that their activities may be construed as seeking to unduly influence accounting treatments or characterizations. Apart from the impossibility of knowing for certain whether their actions "could, if successful," render the company's financial statements materially misleading, investment bankers would be faced with the dilemma of having to predict what constitutes adequate due diligence sufficient to satisfy the Commission that they are not "unreasonable in not knowing" that their actions could inappropriately influence the company's auditor.
Proposed rule 13b2-2(b)(2) does not provide any guidance with respect to the kinds of practices by officers and directors of public companies, and their intermediaries, that are prohibited by proposed rules 13b-2-2(b)(1). Instead, subparagraph (b)(2) describes certain reactions by auditors (i.e., the publication of a report on an issuer's financial statements that is not warranted in the circumstances; the failure to perform audit, review or other procedures required by generally accepted auditing standards or other professional standards; the failure to withdraw an issued report; and the failure to communicate matters to an issuer's audit committee) that could render the audited company's financial statements materially misleading. Absent the intention to achieve these results, however, any description of the results themselves does not give notice of the kinds of activities prohibited by the proposed rules. We believe, therefore, that subparagraph (b)(2) does not effectively identify the specific practices that the Commission seeks to prevent.
III. The Proposed Rules Should Be Revised To Prohibit Only Conduct That Is Intended To Render A Company's Financial Statements Materially Misleading, And To Prohibit Specific Practices That The Commission Determines Could Unduly Influence Auditors.
We agree with the Commission's stated objectives in promulgating the proposed rules, as follows:
We believe that the scheme articulated above is reasonably designed to implement the general prohibitions of section 303(a) of the Sarbanes-Oxley Act, and separately to proscribe specific practices that the Commission determines could have the effect of improperly influencing auditors. Indeed, we believe that the identification of specific practices that could have the effect of improperly influencing auditors in subparagraph (b)(2) is a more appropriate way to address the concern expressed in the Committee Report that the statute should curtail "fraud and other `misconduct in the audit process'"14 than the adoption of a negligence standard with respect to the proposed rules.
Therefore, we respectfully submit that the Commission should revise the proposed rules to prohibit only that conduct by a person acting under the direction of an officer or director of a public company that is intended by such person to fraudulently influence, coerce, manipulate or mislead an accountant engaged in the audit or review of the issuer's financial statements for the purpose of rendering such statements materially misleading, and to proscribe specific practices by such persons that the Commission has determined are likely to have the effect of unduly influencing auditors in the review of financial statements. With respect to the latter, we believe subparagraph (b)(2) should be rewritten to identify specific practices by persons subject to the proposed rules that the Commission has determined could unduly influence auditors - not the effects upon auditors that the Commission would seek to avoid.
Again, we thank you for the opportunity to express our views on this important matter. We hope the Commission will find these comments useful. We would be pleased to discuss any of these issues with the Commission staff at their convenience.