Monday, August 09, 2010

SEC Upholds PCAOB Revocation of Audit Firm’s Registration for Failure to Produce Records

The SEC has sustained the PCAOB’s barring of an auditor from practice and permanently revoking his firm’s registration for violating a Board rule requiring the production of records at the request of Board inspection staff. The auditor’s violative conduct involved a failure to meet multiple production deadlines over a period of months. The SEC found that the sanctions imposed by the Board were appropriate given the protracted nature of the violation and the auditor’s continued issuance of public audit reports while the original inspection requests remained outstanding, as well a the auditor’s failure to offer any assurance that the underlying cause of such delays has been remedied or that this pattern will not be repeated in connection with future inspections. The SEC also found that state of mind and impossibility of performance defenses were unavailable with regard to conduct violating Board Rule 4006. (In the Matter of Gately & Associates, LLC and James P. Gately, CPA, Exchange Act Release No. 62656).

The production of documents obligations under Rule 4006 are is unequivocal, said the SEC, and applies to any request made in furtherance of the Board's authority and responsibilities. The auditor and his firm failed to comply with these requirements. They never provided the requested documents in connection with the selected audit engagement and also failed to provide the information requested in the issuer information and data request form in response to Board deadlines.

The SEC rejected the auditor’s contention that the Board improperly found liability without a hearing on his defense that he did not act with the requisite state of mind, since he was mentally and physically unable to perform as a result of a chemical dependency. The SEC found that the Board is not required to establish that an auditor acted with a particular state of mind in order to establish a violation of Rule 4006. Nothing on the face of either Rule 4006 or Section 102 of Sarbanes-Oxley refers to state of mind.

Rather, said the SEC, auditing firms knowingly take on the burden of compliance with these inspections when they acknowledge that their registration is contingent on their continued cooperation and compliance with any request for testimony or the production of documents made by the Board. The SEC also said that its interpretation of Rule 4006 is consistent with the fact that Sarbanes-Oxley provides for an assessment of knowledge, recklessness and negligence in the Board's analysis of appropriate sanctions.

The SEC similarly rejected the auditor’s defense that fire damage to the firm’s records made it impossible to comply with the Board’s requests. While acknowledging that impossibility of performance may be a common law defense to a breach of contract, the SEC said that this common law contract principle could not be used as an affirmative defense to a violation of the Board's rules. In addition, the auditor and the firm failed to adequately explain how their completion of fourteen audits during the period at issue can be reconciled with an impossibility defense. The SEC also noted that allowing such a defense would be particularly inappropriate when the Commission has rejected similar attempts to apply civil contempt principles to violations of SRO rules.

In order to impose a bar on future association and revocation of registration, Sarbanes-Oxley Section 105(c)(5) requires the Board to find that the conduct at issue was intentional or knowing, which includes reckless conduct, that results in a violation of the applicable regulatory standard.
Noting that this is the first Commission case applying the knowledge, recklessness, and negligence standards in Section 105(c)(5), the SEC said that these standards are similar to the standards for discipline of accountants under SEC Rule 102(e), now codified in Exchange Act Section 4C by Sarbanes-Oxley. Given these similar formulations, the SEC said that its previous interpretations of the Rule 102(e) standards would inform its analysis under Sarbanes-Oxley Section 105(c)(5).

Thus, as in Rule 102(e), the SEC defined recklessness in the context of violating Rule 4006 an extreme departure from the standards of ordinary care which presents a danger to investors or the markets that is either known to the actor or so obvious that the actor must have been aware of it. The first element of this recklessness standard considers whether the auditor conduct departed from applicable statutory, regulatory, or professional standards in this case the standard for inspections under Rule 4006, and if so, the degree of such departure. The Rule requires full and prompt cooperation with Board requests, noted the SEC, and the auditor’s conduct was an extreme departure from this full and prompt standard of care. Not only did the auditor and his firm fail to provide the requested information and records in response to reasonable deadlines, said the SEC, but they also failed to make reasonable efforts to explain and remedy their ongoing failure.

The second prong of the recklessness standard focuses on assessing the actor's state of mind based on evidence establishing what he or she knew or must have known when committing the violation. According to the SEC, the recklessness standard is ultimately meant to identify conduct which, under the circumstances of a given case, results in the conclusion that the reckless person should bear the risk of his or her conduct. Recklessness can be established by an egregious refusal to investigate the doubtful and to see the obvious.

The SEC found that the prolonged failure of the auditor and audit firm to submit to Board inspection presented a risk of harm to investors and the markets that was so obvious that they must have been aware of it. They cannot credibly claim that they genuinely forgot about the Board's unfulfilled inspection requests, or that their conduct resulted from mere inexcusable neglect of their inspection obligation

In light of this known failure to cooperate with the inspection or to use the option to deregister, the auditor and firm acted with reckless indifference to those relying on their audit reports when they continued to issue reports through 2007 and 2008. The risks to investors and markets posed by this conduct were so obvious that they must have been aware of them, reasoned the Commission, particularly given the firm's statutorily-required acknowledgment that the inspections are a condition of Board registration. Given the nature and pattern of violative conduct reflected in this case, the SEC concluded that the revocation of registration and bar imposed by the Board are appropriate to protect the public interest in securing regulatory oversight over the activities of registered accounting firm.