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

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.