December 30, 2002
Mr. Jonathan G. Katz
Re: SEC Release No. 34-46685 (File No. S7-39-02)
Dear Mr. Katz:
I am submitting this letter 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 "1934 Act"). 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."
This letter represents my personal views and does not necessarily represent the views of my firm, any partner or any client.
In summary, I describe in this letter how the Revisions appear to track the statutory language but would in fact impose obligations that substantially exceed those mandated in Section 303(a) of Sarbanes-Oxley. I describe how these extensions of Section 303(a) represent unwise public policy. I then conclude that to the extent the Revisions exceed the statutory mandate, the Commission lacks statutory authority to adopt them.
1. Unwarranted Extensions of Section 303(a).
Whose acts are covered. The statute applies only to officers and directors of an issuer and to persons acting "under the direction" of an officer or director. The Revisions use the same language, but the Release states that the Commission intends the Revisions to apply to "officers" as defined in existing Commission rules and requests comment on whether the definition should be further extended.
Also, the Release states that the Revisions would extend 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 persons who might be included within the expanded group of persons covered, e.g., customers, vendors or creditors, as well as attorneys, securities professionals or other advisers.
As far as the definition of "officer" is concerned, I believe it is important for the Commission to be as specific as possible on the corporate employees who are subject to the Revisions. The current definition in Rule 3b-2 has unacceptable ambiguities for Section 303(a) purposes, depending as it does on whether a person "routinely performs corresponding functions." These ambiguities do not present difficulties in most circumstances, but only because the ambiguities are universally resolved by issuers who are in the best position to assess an individual employee's responsibilities for SEC reporting or other purposes and who make it clear to individual employees whether or not they are to be treated as officers .
The Revisions contemplate no such role for issuers, leaving it entirely to individual employees of a reporting company or one of its subsidiaries to guess for themselves whether they are covered when they communicate with the company's auditor. Employees should not be left in doubt on this key issue.
My point is even more compelling for third persons, including co-workers and perhaps persons outside the company, who in communicating with an auditor incur the risk that they will be found to have done so at the "direction" of a corporate employee who may with the benefit of hindsight be alleged to be an "officer" under Rule 3b-2. Third persons should also not be left to guess on these vital points.
As far as such third persons are concerned, the Release's illustrations demonstrate the confusion that will exist as to who is or is not acting at the "direction" of an officer or director. It should be obvious that an officer or director cannot "direct" or "instruct" a customer, vendor or creditor to exert influence of any kind on an auditor. At most, the officer or director can seek to persuade such a person to take such action. But it could be easily alleged, after the fact, that persons outside the company who communicate with the company's auditors were subject to one or another varieties of "persuasion."
I believe Congress' choice of the word "direction" clearly implies that the person induced to exert improper influence must in fact be subject to the officer's or director's supervision or control. Attorneys, securities professionals or other advisers to the issuer, to the extent - but only to the extent -- that they are acting as the issuer's agent, may be covered under this formulation. Other persons with whom the issuer has an arm's length relation, e.g., customers, vendors or creditors, should not be covered.
In fact, however, the Commission makes clear in the Release that it is not looking to the statute for support for its proposals. It 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.
The Commission is imagining conspiracies where none exist. Officers and directors do not sit around at meetings asking whether "no one will rid them of this meddlesome accountant." The adoption of the Commission proposals may have the perverse effect that uncertainty about the scope of the Revisions will make the auditor's job more difficult as a company's employees, customers, suppliers and other third parties are reluctant to have any communication with the auditor at any time.
Indeed, that is what the Commission appears to be trying to achieve. The Release notes at page 9 that the Revisions "might result in some issuers adopting more detailed procedures for communications between the company and the accounting firm that audits the company's financial statements" and that the additional costs of such procedures would be "minor." Of course, "companies" and "firms" do not communicate; individuals do. The uncertainty generated by the Revisions, to say nothing of the hinted expansions, would in my view have a substantial and adverse effect on the audit process.
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. This presumably includes the ability to bring aiding and abetting charges against persons who impose improper influence on an auditor or to bring cease-and-desist proceedings against a person who is a cause of a reporting violation. The Release justifies the extension of coverage simply by stating that the Revisions provide "an additional means" of pursuing such conduct. I believe that this is an insufficient reason to go beyond the statutory mandate.
Indeed, as a policy matter in view of the Commission's current burden of rulemaking imposed by Sarbanes-Oxley and the deadlines imposed by the statute, I question the wisdom of the Commission's proposing rules that unnecessarily go beyond the statute. In the absence of a compelling reason to go beyond the statute, the Commission is needlessly consuming its resources, putting an unnecessarily heavy burden on issuers and their advisers and running a substantial risk of unforeseen and unintended consequences. The costs to the U.S. economy of complying with the mandates of Sarbanes-Oxley will undoubtedly be substantial. I recommend that the Commission confine its rulemaking at this time to the direct implementation of the statute and leave for another day the proposal of additional confidence-enhancing measures.
What conduct is covered. The statute refers to conduct taken "to fraudulently influence, coerce, manipulate, or mislead" an accountant. The Revisions use the same language, while adding "directly or indirectly." The Release also points out, however, that the Commission views the word "fraudulently" as modifying only "influence."
Not only is the Commission's conclusion about the limited reach of the word "fraudulently" contrary to accepted principles of statutory construction, it ignores internal evidence that Congress clearly intended the contrary.
- Principles of statutory construction
There have been numerous federal court decisions construing federal statutes that contain language similar to that used by Congress in Section 303(a) of Sarbanes-Oxley. As far as I am aware, all of them have concluded that a modifying adverb imposing a scienter condition must be construed as applying to all subsequent words in a "string" or "series."
For example, 18 U.S.C. §111(a) imposes criminal penalties on any person who "forcibly assaults, resists, opposes, impedes, intimidates, or interferes with" any designated federal officer. The Court of Appeals for the Fourth Circuit relied on "ordinary rules of grammatical construction" to conclude that "[t]he use of the adverb `forcibly' before the first of the string of verbs, with the disjunctive conjunction used only between the last two of them, shows quite plainly that the adverb is to be interpreted as modifying them all." Long v. United States, 199 F.2d 717, 719 (4th Cir. 1952). The Courts of Appeal for the District of Columbia, Second and Eighth Circuits have all come to the same conclusion. United States v. Arrington, 309 F.3d 40 (D.C. Cir. 2002); United States v. Bamberger, 452 F.2d 696 (2d Cir. 1971), cert. den. 405 U.S. 1043 (1972) (see also United States v. Giampino, 680 F.2d 898 (2d Cir. 1982); United States v. Camp, 541 F.2d 737 (8th Cir. 1976) (see also United States v. Schrader, 10 F.3d 1345 (8th Cir. 1993)).
- Internal evidence
There are four verbs in the Section 303(a) prohibition: influence, coerce, manipulate and mislead. Two of these ("coerce" and "manipulate") suggest a fraudulent purpose. Two of them ("influence" and "mislead") suggest a variety of purposes, ranging from entirely benign conduct at one extreme to simple negligence at the other. In prefacing all four verbs with the word "fraudulently," Congress obviously intended to avoid interfering with benign or negligent communications.
In addition, Section 303(b) of Sarbanes-Oxley states that in any civil proceeding the Commission shall have "exclusive authority" to enforce the provision and any related Commission rules. The exclusion of any private right of action for a violation of Section 303(a) or related Commission rules would have been unnecessary if Congress had intended to reach non-fraudulent conduct, since no provision of the federal securities laws (or any other federal statute) supports a implied private right of action for the conduct described in Section 303(a) unless that conduct is fraudulent.
Finally, the statute specifies that the prohibited acts must be "for the purpose of rendering [the] ... financial statements materially misleading" (emphasis added). Such words clearly require an intent to achieve a forbidden purpose.
In other words, Congress did not only once state that the conduct reached by Section 303(a) had to reach the level of fraud. It said it three times.
As in the case of the persons covered by the Revisions, however, it is clear that the Commission does not really care what Congress had in mind. The Release asks for comment on substituting "improperly" or some other word for "fraudulently" so that the Commission's or its staff's judgment about the "propriety" of a communication will determine the outcome of an administrative proceeding. Does the Commission really expect courts to uphold its determinations based on the Commission's "know[ing] it [impropriety] when it sees it"?
Which communications with accountants are covered? The statute covers acts relating to an accountant "engaged in the performance of an audit" of the issuer's financial statements. The Revision adds a reference to a "review" of financial statements but otherwise uses the same language. The Release, on the other hand, states that the term "engaged in the performance of an audit" includes any activity by an accountant prior to, during and subsequent to the auditor's retention to perform an audit.
The Commission has offered not a shred of evidence to support its broad approach. Absent such evidence, it should assume that Congress intended a common sense meaning of the term "engaged in the performance of an audit," i.e., any time the auditor is performing field work or making judgments about the audit of a particular period's financial statements.
What must be the actor's purpose? As noted above, the statute specifies that the prohibited acts must be "for the purpose of rendering [the] financial statements materially misleading." Finding this language inconvenient, the Release simply ignores it. The Revisions substitute the concept that the officer or director or other person have known that his or her action could, if successful, result in the financial statements becoming materially misleading (or that the person was unreasonable in not knowing that such could be the result).
Not surprisingly, the Release also requests comment on whether the watered-down purpose required to constitute a violation of the revised rule should be 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 frankly points out, it would thus be unnecessary to prove a particular purpose or intent.
II. Harmful Effect of Commission's Proposals
What the Revisions end up contemplating is that an officer or director, or someone acting as his or her "instruction" or "behest," who communicates with an accountant (who may or may not be engaged in an audit) in a way that the Commission decides, with the benefit of hindsight, was "misleading," may be charged with a violation of Section 303(a) if the Commission decides, again with the benefit of hindsight, that the person either was unreasonable in not knowing that the communication could result in the financial statements being materially misleading or that the communication (whatever the person's knowledge or state of mind) had the effect of rendering the financial statements materially misleading.
Any lawyer making an allegedly misleading statement in an auditor's letter would 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. I do not believe this is what Congress intended.
III. No Authority to Adopt Rules to Prohibit Non-Fraudulent Communications
As noted above, Sarbanes-Oxley does not authorize the Commission to adopt rules that would prohibit communications with auditors in the absence of fraudulent intent.
Neither does any other provision of the 1934 Act, and the Commission therefore lacks power to adopt such rules.
In particular, Section 13(b)(2) applies only to issuers. Section 13(b)(4) applies to "any person" but reaches only a person who "knowingly circumvent[s] or knowingly fail[s] to implement a system of internal accounting controls or knowingly falsif[ies] any book, record, or account ...." Section 20(c) makes it unlawful "in the absence of just cause" for any director, officer or securityholders to "hinder, delay, or obstruct" the filing of a 1934 Act report," but this provision also implies fraudulent intent.
Section 21C(a) authorizes the Commission to bring a cease-and-desist proceeding against a person who "causes" a violation of the 1934 Act and whose act or omission the person "knew or should have known would contribute to such violation." The Revisions clearly go beyond the scope of Section 21C(a).
As noted above, the Commission has ample authority to reach "improper influence" on the audit process, not only by means of the additional tools afforded to it by Sarbanes-Oxley but also by using its pre-existing authority to pursue aiding and abetting violations. The Commission has not demonstrated any need to pursue non-fraudulent conduct in this area, much less its statutory authority to do so.
If I can provide further assistance to the Commission, please do not hesitate to communicate with me.