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

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

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.