Subject to Inquiry: White Collar, Congressional, SEC, Energy Enforcement & Other Government Inquiries

The Securities and Exchange Commission (SEC) today announced long-awaited appointments of new Public Company Accounting Oversight Board (PCAOB) members.  The SEC appointed James R. Doty as Chair and Jay D. Hanson and Lewis H. Ferguson as members of the PCAOB.  As noted in the Wall Street Journal, together with Daniel L. Goelzer and Steven Harris, these three additions will bring the Board up to a full five members for the first time since 2009. 

Two of the new members bring strong regulatory experience to their new positions.  In addition to being a partner at a firm that represented the PCAOB in connection with its Constitutional challenge, Mr. Doty is a well respected securities lawyer who previously served as the SEC’s General Counsel.  Similarly, Mr. Ferguson served as the PCAOB’s first General Counsel and will now return to the Board following time in private practice.

Meanwhile, Mr. Hanson will draw on his thirty-plus years of experience with McGladrey & Pullen LLP, where he currently serves as a Partner and the National Director of Accounting.  His practical experience in the industry will bring an excellent new perspective to the PCAOB, as Mr. Hanson will be the first former audit partner to sit on the Board – something that should serve the PCAOB well.   

With these new appointments, the PCAOB will also be saying farewell to Charley Niemeier and Bill Gradison, two of the Board’s founding members.  Mr. Niemeier, who was the Acting Chairman when the PCAOB first opened its doors, should be credited for much of the successes and accomplishments the PCAOB has experienced since its inception, including the development of the PCAOB’s inspection program.  Mr. Gradison also served as an Acting Chairman during his term as a Board Member, and both agreed to stay on the Board for far longer than their terms while the SEC searched for their replacements.

On October 21^st, New York’s highest court held that New York law does not permit suits against third parties who allegedly assist or fail to detect corporate wrongdoing.  The court’s holding was in response to certified questions from two different cases: Kirschner v. KPMG, 590 F.3d 186 (2009) and Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, 998 A.2d 280 (2010).  Examples of third parties protected by this ruling include accountants, auditors, and attorneys.

Judge Susan Phillips Read wrote the opinion for the 4-3 majority and noted that the court was “not convinced that altering [its] precedent to expand remedies for these or similarly situated plaintiffs would produce a meaningful additional deterrent to professional misconduct or malpractice.”  Judge Read confirmed that that “the principles of in pari delicto and imputation, … which are imbedded in New York law, remain sound.” 

The in pari delicto defense allows a defendant in a lawsuit to claim that the plaintiff is at least equally at fault.  If the defense is successful, the plaintiff’s claim must be dismissed.  For the defense to be successful, the court must hold the corporation responsible for its employees’ actions by imputing the illegal actions of the corporation’s senior officers to the corporation.

This ruling is another victory in the ongoing fight against third party liability.  This issue keeps popping up across the country in courts and in Congress.  The ruling answers Delaware’s question to New York from earlier this summer.  And the decision comes only three months after the Texas Supreme Court made a similar ruling in denying third party claims against Grant Thornton.  On the other hand, the Pennsylvania Supreme Court limited the availability of in pari delicto earlier this year.

It will be important to pay close attention as more and more courts weigh in on this evolving issue and as Congress considers whether to create a private right of action for third party wrongdoing.

On August 5, the SEC ruled on the first litigated appeal of a PCAOB disciplinary decision.  In the decision, the SEC sustained the PCAOB’s findings and subsequent sanctions while at the same time considering the extent of the PCAOB’s authority to discipline its registered auditing firms and their individual auditors.  See Gately & Assoc., LLC, Exchange Act Rel. No. 62656 (Aug. 5, 2010), Admin. Proc. File No. 3-13535(pdf).

The case involved James P. Gately, a certified public accountant, who is the managing member, president, and sole owner and employee of Gately & Associates, LLC. 

In early 2007, the PCAOB’s Division of Registration and Inspections (“PCAOB Inspections”) contacted Gately to initiate the next inspection of the firm.  Over the next five months, Gately repeatedly rescheduled meetings and deadlines, providing a wide array of excuses without supporting evidence and failing to comply with agreed upon dates without notice.  Eventually, PCAOB Inspections referred the case to the PCAOB’s Division of Enforcement and Investigations (“PCAOB Enforcement”).

On summary disposition, which is essentially the PCAOB equivalent of summary judgment, a PCAOB hearing officer found that Gately and his firm (the “Applicants”) failed to cooperate with PCAOB Inspections and thus violated PCAOB Rule 4006.  The hearing officer permanently revoked the firm’s registration and permanently barred Gately from associating with any registered public accounting firm.

Gately and the firm appealed the hearing officer’s initial decision to the Board members of the PCAOB, who affirmed the hearing officer’s summary disposition order including the sanctions imposed.  In response, the Applicants appealed the decision to the SEC. 

The SEC’s Review of a PCAOB Violation

The SEC quickly demonstrated and held that the Applicants engaged in the conduct found by the PCAOB.  The SEC then held that Applicants’ conduct violated Rule 4006 and that the rule was applied in a manner consistent with the Act.  Ultimately, due to the rejection of the Applicants’ various defenses—that records were destroyed in a fire and that Gately’s state of mind, as a result of a chemical dependency, prevented him from complying—the SEC found that there were no genuine issues at to any material fact and held that Applicants violated Rule 4006 and that summary disposition was appropriate.

The SEC’s Review of PCAOB Sanctions

In considering whether it was appropriate for the PCAOB to impose sanctions, the SEC indicated that Section 105(c)(5) of the Act authorizes bars and revocation based on reckless conduct.  The SEC found that the Applicants’ failure to cooperate with the inspection was reckless and held that revocation of registration and bar from association were appropriate remedial sanctions.  The SEC then held that the sanctions imposed by the PCAOB were appropriate given the nature and pattern of the Applicants’ violative conduct, indicating that the sanctions were necessary to protect the public interest in effective oversight of registered accounting firms.

The investigation and subsequent appeals took more than two years…a fact not lost on Robert Fusfeld and Michael MacPhail, who both wrote about the Gately decision on their blogs.

Takeaways

It is interesting to note that the SEC indicated it would “look to mitigating factors presented in the record when reviewing the PCAOB’s choice of sanction,” and the “remedial and protective efficacy” of the sanctions imposed.  Hopefully, this means that the SEC (and PCAOB) will, for example, consider an individual auditor’s entire career and professional record when determining whether to levy one of the harsher sanctions, including a time-defined or permanent bar from association with a registered public accounting firm.  This should be especially true when the PCAOB’s matter involves a single particular audit engagement and not multiple engagements on which the auditor worked. 

 The SEC’s acknowledgement regarding the nexus between the sanction imposed and the remedial and protective efficacy is equally important, as the PCAOB’s model of regulating the accounting profession is one of self-remediation under the so-called “supervisory model.”  As such, it seems as though the SEC and PCAOB should first determine whether self-remediation is possible before imposing any sanction, including the harsher sanctions available to the PCAOB

In Grant Thornton LLP v. Prospect High Income Fund, ML CBO IV (Cayman), Ltd., et al., No. 06-0975, 2010 Tex. LEXIS 478 (Tex. Jul. 2, 2010), the Texas Supreme Court rejected multiple third party claims against auditor Grant Thornton.

The claims in this case revolved around audit reports issued by Grant Thornton regarding Epic Resorts, LLC’s (“Epic”) compliance with a bond indenture agreement.  Despite allegedly discovering direct evidence to the contrary, Grant Thornton issued reports in 1999 and 2000 confirming that Epic was in compliance with an escrow requirement in the indenture agreement.  On June 15, 2001, Epic defaulted on the bonds in question by missing a scheduled interest payment and the plaintiffs, three hedge funds, forced Epic into bankruptcy.

The court divided the claims against Grant Thornton into two categories: (1) claims brought by purchasers of securities, who indicated that they would not have purchased the securities but for Grant Thornton’s alleged misrepresentations; and (2) claims brought by holders of securities, who stated that the audit reports induced them not to sell the bonds.

Third Party Claims Against Auditors Brought by Purchasers of Securities

With regard to purchaser claims, the court followed the American Law Institute’s Restatement (Second) of Torts § 522 in holding that auditors’ liability is limited to “situations in which the [auditor] is aware of the nonclient and intends the nonclient to rely on the information.”  The court determined that a hedge fund that purchased bonds after Grant Thornton issued its 1999 audit report was not part of the limited group under § 522 for whose benefit and guidance Grant Thornton intended to supply the information and was thus not within Grant Thornton’s scope of liability.

Third Party Claims Against Auditors Brought by Holders of Securities

In considering the holder claims, the court decided a matter of first impression for Texas: are third party holder claims against auditors cognizable under Texas law?  The court held that a plaintiff must show a “direct communication” between the plaintiff and the auditor in order to bring a successful third party holder claim against an auditor.  The plaintiffs in this case did not have direct communications with Grant Thornton, so the court held that the claims failed as a matter of Texas law.

With the onslaught of litigation brought by the market crash, plaintiffs are reaching out more and more to third parties who interacted with failed companies.  Auditor liability in particular has been in the headlines with some frequency recently.  It will be very important going forward for auditors to pay close attention as states continue to redefine the scope of auditor liability.  For now though, in the state of Texas, auditors can breathe a little easier, knowing that ordinary investors will find it much more difficult to successfully bring third party suits against them.

Mark W. Kinghorn contributed to this post.

The U.S. Supreme Court today issued its decision in the lawsuit challenging the constitutionality of the Public Company Accounting Oversight Board (“PCAOB”), affirming in part and reversing in part the judgment of the Court of Appeals in favor of the PCAOB.  Despite the partial reversal, the decision is a major victory for not only the PCAOB but for proponents of the Sarbanes Oxley Act of 2002 (“the Act”), which survived the Supreme Court’s decision.

The Free Enterprise Fund, one of the two plaintiffs to the lawsuit, brought this case in order to find some constitutional deficiency with the Act in order to achieve its ultimate goal of revisiting, and perhaps invalidating, the internal control provisions embedded in the Act’s Section 404.  At the time of the original filing of the lawsuit, which was early 2006, there were many who thought that the Act’s internal control provisions were overly burdensome and would have a negative impact on small businesses and U.S. competitiveness overall.  As the Act contained no “severability clause,” many believed that if one provision was found to be unconstitutional that the Act would fail in its entirety.  This turned out to be wrong.

Although the Court found unconstitutional a provision stating that the SEC could only remove a PCAOB Board member “for good cause” (and thus was a provision that interfered with the President’s executive power), the Court found that this deficiency could easily be severed from the rest of the Act.  Accordingly, the Court noted that no Congressional legislation is necessary to bring the PCAOB’s structure within constitutional parameters, and the internal control provisions in the Act will not have to be revisited as hoped for by the plaintiff.  Indeed, as Justice Roberts wrote:

[T]he Act remains ‘fully operative as a law,’ “ New York v. United States, 505 U. S. 144, 186, and nothing in the Act’s text or historical context makes it “evident” that Congress would have preferred no Board at all to a Board whose members are removable at will, Alaska Airlines, Inc. v. Brock, 480 U. S. 678, 684.  The consequence is that the Board may continue to function as before, but its members may be removed at will by the Commission.

The takeaway is that despite the small change to how PCAOB Board members could be removed by the SEC, all other aspects of the PCAOB and its programs will continue to operate as usual.  This includes the PCAOB’s registration, inspection, enforcement, and standard-setting functions.  More importantly, the SEC is now in a position to appoint three new Board members to the PCAOB to replace holdovers Charles D. Niemeier and Bill Gradison, and the spot vacated by former Chairman Mark W. Olson, who left the PCAOB last year. 

On June 23rd, Florida’s Third District Court of Appeal overturned the largest jury verdict in history against a U.S. accounting firm and ordered a new trial.

Banco Espirito Santo sued BDO Seidman in 2004 over $170 million in losses that allegedly resulted from BDO’s negligence in failing to find fraud during its audits of E.S. Bankest, a company that Espirito Santo backed.

The jury issued its unprecedented award in 2007, which consisted of $170 million to compensate for Espirito Santo’s losses and a whopping $351 million in punitive damages. 

During the trial, BDO warned that losing just $170 million would force the company to layoff employees and endanger the company’s standing.  Being forced to pay three times that amount could cripple the company beyond the point of no return.

The appellate court overturned the exceptional jury award primarily because it found that the trial court erred in deciding to trifurcate the trial, which allowed the trial to be presented in three phases.  This unusual three-part trial allowed the jury to find BDO grossly negligent without considering the conduct of other actors. 

In its opinion, the appellate court wrote, “The cart cannot lead the horse” and “The jurors should have been allowed to consider all of the evidence...” as they decided on BDO’s conduct.  The court concluded, “We have carefully considered every substantive and procedural authority that might be applied to preserve at least some of the jury’s findings.  In this case, however, no such balm is found.”

Steven Thomas, lead counsel for Banco Espirito Santo said, “The evidence of BDO Seidman’s failures of even the most basic auditing procedures is so overwhelming that we expect a new jury will reach the same conclusion as the original jury.”

BDO CEO Jack Weisbaum said, “We are very pleased that the Appeals court has reversed the lower court verdict.  We have consistently stated that we were confident that the jury’s erroneous verdict in this case would be reversed on appeal.”

A new trial date has not yet been scheduled.

The Southern District of New York recently issued an opinion favorable to defendants facing liability under Section 11 of the Securities Act of 1933 for alleged misrepresentations in opinion-based financial statement line items.  In Fait v. Regions Financial Corp., the district court dismissed the Section 11 action because the plaintiff failed to allege that the defendants did not truly hold their publicly stated opinions at the time the statements were made.

Citing the Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, the court held that statements regarding goodwill and loan loss reserves in a company’s financial statements are matters of opinion rather than objective fact.  Fait, the plaintiff, alleged only that these statements were negligently false and misleading.  The court dismissed the case because Fait did not allege that the defendants made statements they believed to be false.

Judge Kaplan considered it significant that Fait’s complaint included a disclaimer that Fait was not alleging that defendants intentionally misstated Regions’ goodwill and loan loss reserves.  Plaintiffs often use similar disclaimers to make clear that their Section 11 claims do not allege violations of Federal anti-fraud provisions that would trigger tougher pleading requirements under the PSLRA and Federal Rule of Civil Procedure 9(b).  Plaintiffs also prefer making Section 11 claims because they impose near-absolute liability for certain defendants.

Judge Kaplan’s decision in Fait is a major setback for plaintiffs trying to thread the needle of bringing a claim under Section 11 while also avoiding heightened pleading requirements. Plaintiffs alleging misrepresentations in opinion-based financial statement line items, who fail to allege that defendants did not subjectively believe the statements at the time they were made, may face the same fate as Fait.

Not surprisingly, Judge Kaplan’s decision is being appealed.  Stay tuned as the Second Circuit weighs in on this important question, which could eventually go all the way to the Supreme Court. 

So, can they?  New York’s answer to this question will have a significant impact on shareholder suits against outside auditors.  Recently, the Supreme Court of Delaware certified a question to the New York Court of Appeals, meaning that Delaware is applying New York law in a case and has asked New York’s highest court to rule on a point before it proceeds.

This case was brought in Delaware Chancery court by a multitude of plaintiffs against a multitude of defendants as a result of the AIG meltdown.  The certified question involves a negligence claim by the stockholders of AIG against PricewaterhouseCoopers (“PwC”). 

PwC moved to dismiss the claim, asserting in pari delicto, and the court granted the motion.  The stockholders appealed that decision to the Supreme Court of Delaware, which chose to certify a question to the New York Court of Appeals before ruling on the appeal.

The In Pari Delicto Defense

The in pari delicto defense allows a defendant in a lawsuit to claim that the plaintiff is at least equally at fault.  If successful, the plaintiff’s claim must be dismissed. 

The Adverse Interest Exception

For the defense to be successful, a court must “impute” the illegal actions of a corporation’s senior officers to the corporation, meaning that the court must hold the corporation responsible for its employees’ actions. 

But, New York recognizes a total abandonment version of the adverse interest exception.  If the employee(s) totally abandoned the corporate interest, a court will not impute their actions to the corporation and the in pari delicto defense will fail.

The Stockholder Suit Exception

Additionally, there is generally an exception to the in pari delicto defense for stockholder suits.  This exception provides that the in pari delicto defense will not bar stockholders from suing wrongdoers within their corporation. 

It is not clear in many jurisdictions, including New York, whether this exception applies when stockholders sue wrongdoers outside the corporation, such as outside auditors.

The Certified Question

The long, complicated question breaks down into two basic questions.  First, generally, can outside auditors use the in pari delicto defense to block suits by stockholders?  Second, what if those outside auditors merely failed to perform the audit in accordance with PCAOB standards and are not co-conspirators in the fraud?

Auditors should pay close attention to this case.  If the court answers yes, auditors operating in New York will no longer be able to prevent stockholder suits with the in pari delicto defense.  A yes response would mean stockholders will be able to successfully sue outside auditors for mere negligence in failing to prevent fraud committed by a corporation.

In response to the release of the examiner’s report on the Lehman bankruptcy, and one that could lead to multiple SEC enforcement investigations, the SEC’s Division of Corporation Finance recently sent out a “Dear CFO letter” to various financial institutions. In the letter, the Staff has asked for information regarding the accounting and disclosure for their transfers of financial assets with an obligation to repurchase the transferred assets. It is clear that the Staff is trying to see if some financial institutions may have misinterpreted or abused the accounting literature to window dress or otherwise misrepresent their financial statements. 

The relevant accounting standard, ASC 860 (which now includes the provisions of FAS 140 (pdf), generally allows a transferor to obtain “sale” accounting treatment if the transferor effectively relinquishes control of the asset. If, however, the transferor maintains a right to repurchase or require the asset, the accounting rules require the transferor to account for the transfer as a secured borrowing because it still has control over the asset. The accounting consequences between the two scenarios are significant, for sale accounting allows a company to record revenue on the income statement and positive cash flow from operations, while accounting for a transfer as a secured borrowing means more debt on the balance sheet and no operational cash flow.

The SEC’s Division of Enforcement will certainly pay close attention to the responses received, as the misapplication of FAS 140 was a prevalent theme throughout the Enron investigation. In one particular case, the SEC settled a fraud action against CIBC for helping Enron meet the technical requirements of FAS 140 and thus achieve sale accounting in connection with multiple Enron asset “sales” to a CIBC financed special purpose entity. In reality, though, the SEC found that the transactions were not real sales but instead were “disguised loans,” as Enron always had control over the transferred assets because it always had the right (and the obligation) to reacquire them.

As such, financial institutions that do have similar Lehman-like transactions need to be prepared for the investigative scrutiny that will undoubtedly follow -- and not just from the SEC but also from criminal, banking and other regulators. In addition, third parties to such transactions such as syndicated lending agents and accounting firms should expect to be participants in what could be significant enforcement activity.