Monday, October 29, 2012

Federal Court Rules Audit Firm Internal Documents Developed in Response to PCAOB Comments Are Privileged in Securities Fraud Action

A federal judge has ruled that the Sarbanes-Oxley Act privilege for PCAOB information protects materials that are specifically for the Board as well as internal audit firm communications that discuss confidential questions or comments made by the Board or reflect the firm’s development of responses to Board inquiries. Because the final version of PCAOB comments and audit firm responses to those comments are all privileged, reasoned the court, then it follows that any internal auditor communications that reveal those comments, or the work to develop the responses to the comments, are also privileged. All of these communications are specifically for the Board because, absent the Board’s audit inspection, these documents and communications would not exist. Thus, the court rejected a discovery request for these documents from plaintiffs in a securities fraud action alleging that the audited company filed false financial statements that failed to timely write off impaired goodwill in connection with a merger. (Bennett v. Sprint Nextel Corp., KPMG, Interested Party, WD Mo., No. 11-9014, Oct 10, 2012)

While the plaintiffs demonstrated that the information they sought was reasonably calculated to lead to the discovery of admissible evidence regarding whether goodwill was properly stated by the company, said the court, the documents were privileged pursuant to Section 105(b)(5)(A) of Sarbanes-Oxley. This privilege provision addresses two circumstances. The first, which was not at issue in this case, involves discovery requests directed to the Board itself. The second circumstance involves discovery requests directed to targets of the Board's investigations. The second aspect of the privilege protects those who are under investigation from being required to divulge their responses to that investigation. 

Specifically, the court found the following documents to be privileged under Section 105(b)(5)(A) because they were prepared by the Board, received by the Board, or specifically for the Board: direct communications between the Board inspectors and KPMG; forms labeled as "Public Company Accounting Oversight Board Inspection Comment Form," including the Board's comments, KPMG's responses, and drafts thereof; spreadsheets including data prepared specifically for the Board; any information revealing specific questions or inquiries from Board members and drafts and final versions of KPMG responses to those questions or inquiries; drafts and final versions of the Engagement Profile; and the kick-off meeting presentation file.

The court found, however, that any substantive information, documents, spreadsheets, or forms that were compiled specifically for the company, but nevertheless used to respond to the Board's inquiries, are not privileged.

The court rejected the argument that the privilege only covers documents in the hands of the Board and does not protect documents in the hands of third parties, namely the audit firm, KPMG. This argument is not supported by the plain language of the statute, which extends the privilege to both materials "prepared . . . for" and "received by" the Board. If only materials in the possession of the Board (i.e. "received by") were protected, then the phrase "prepared . . . for" would be rendered superfluous. Further, the privilege not only protects the Board, but also those who are under investigation from being required to reveal their responses to the Board's inquiries. Thus, the privilege outlined in Section 105(b(5)(A) may be asserted by KPMG.

Similarly rejected was the contention that the "Board" as used in the statute only includes the five appointed Governing Members of the Board, thus excluding the Board’s inspection staff. Sarbanes-Oxley defines "Board" as the "Public Company Accounting Oversight Board," noted the court, and the Board's duties include registering and inspecting audit firms, as well as conducting investigations and disciplinary hearings. The five appointed Board members must necessarily rely on other PCAOB officials to conduct investigations and prepare documents that relate to the investigation, reasoned the court, as well as receive documents relating to the investigation. Thus, the Court found that the "Board" as mentioned in Section 105(b)(5)A) includes the PCAOB's inspectors who actually conduct the investigations.

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