On April 24, 2003, the Securities and Exchange Commission ("SEC"), as required under Section 303(a) of the Sarbanes-Oxley
Act of 2002 (the "Act"), issued a final rule that prohibits officers and directors of public companies, and persons acting
under the direction of an officer or director, from taking any action to coerce, manipulate, mislead or fraudulently influence
the auditor of such company's financial statements for the purposes of rendering the financial statements materially misleading.
The new rule supplements existing rules and is designed to ensure that management makes open and full disclosures to, and
has honest discussions with, the auditor of the company's financial statements.
The prohibitions added by the new rule will go into effect on June 27, 2003.
Who is Covered by the Prohibitions?
The class of persons covered by the rule's prohibitions is broad. The rule explicitly covers the activities of a public company's
officers and directors. The prohibitions also apply to investment companies registered under the Investment Company Act of
1940.
Any other person acting under the "direction" of an officer or director is also covered. The SEC interprets the term "direction"
to encompass a broader category of behavior than "supervision," including persons who do not directly report to the officer
or director. Accordingly, persons acting under the "direction" of the directors and officers might include, not only the company's
employees, but also customers, vendors or creditors who, under the direction of an officer or director, provide false or misleading
confirmations, or other false or misleading information to auditors, or who enter into undisclosed "side agreements" that
undermine the accuracy of a company's financial statements. In addition, under certain circumstances, coverage may extend
to other partners or employees of the independent auditor (such as consultants or forensic accounting specialists retained
by counsel for the company), attorneys, securities professionals, or other advisers who act under the direction of an officer
or director.
In the case of a registered investment company, persons acting under the direction of officers and directors of the investment
company include, among others, officers, directors, and employees of the investment company's investment adviser, sponsor,
depositor, administrator, principal underwriter, custodian, transfer agent, or other service providers.
Prior to the enactment of Section 303 of the Act and adoption of the new rule, activities by such "other persons" acting under
the direction of an officer or director could constitute violations of the anti-fraud or other provisions of the securities
laws, or aiding, abetting or causing a public company's violations of the securities laws. Section 303 of the Act and the
new rule provide the SEC with an additional means of policing actions by persons acting under the direction of an officer
or director to improperly influence the audit process and the accuracy of a public company's financial statements.
Prohibited Conduct
The SEC's new rule prohibits:
an officer or director of a public company, or any other person acting under the direction of such officer or director, from
directly or indirectly taking any action to coerce, manipulate, mislead or fraudulently influence a company's independent
auditors engaged in the performance of an audit or review of the financial statements of that company that are required to
be filed with the SEC if that person knew or was unreasonable in not knowing that such action could, if successful, result
in rendering such financial statements materially misleading.
The language of the new rule substantially mirrors the wording in Section 303(a) of the Act and supplements existing rules
under Rule 13b-2 of the Securities Exchange Act of 1934. There is, however, a significant difference between the new rule
and existing prohibitions. Unlike the existing prohibitions, the SEC may bring an action under the new rule against a person
for actions that were not successful in affecting the audit or review. Conduct that "could, if successful, result in rendering
such financial statements materially misleading" include, but are not limited to, actions taken at any time with respect to
the professional engagement period to coerce manipulate, mislead or fraudulently influence an auditor:
- to issue a report on a company's financial statements that is not warranted in the circumstances (due to material violations
of GAAP, GAAS or other professional standards);
- not to perform audit, review or other procedures required by GAAS or other professional standards;
- not to withdraw an issued report; or
- not to communicate matters to a company's audit committee.
The SEC's release provides examples of actionable conduct:
- offering or paying bribes or other financial incentives, including offering future employment or contracts for non-audit services;
- providing an auditor with inaccurate or misleading legal analysis;
- threatening to cancel or canceling existing non-audit or audit engagements if the auditor objects to the company's accounting;
- seeking to have a partner removed from the audit engagement team because the partner objects to the company's accounting;
and
- blackmailing and making physical threats.
Situations where the Prohibitions of the New Rule Apply
The prohibitions of the rule are not limited to the audit of the annual financial statements. The rule also applies to improperly
influencing an auditor during a review of interim financial statements or in connection with the issuance of a consent to
the use of an auditor's report. In limited circumstances, conduct that occurs outside the professional engagement period is
also prohibited, if the auditors have been called upon to make decisions regarding the financial statements.
Scienter is not a Necessary Prerequisite for a SEC Enforcement Action
Section 303 of the Act states that conduct by an officer, director, or person acting under the direction of the officer or
director, designed to improperly influence a public company's auditor is actionable if undertaken for the purpose of rendering a public company's financial statements materially misleading. The SEC's new rule does not require a showing of
a particular purpose or intent because the SEC believes that requiring an element of scienter would have been inconsistent
with existing prohibitions. Therefore, an officer, director, or person acting under the direction of the officer or director,
who engages in conduct to improperly influence an auditor will be culpable if he or she knows, or is negligent in not knowing,
that the improper influence could, if successful, result in rendering financial statements materially misleading.
No Private Right of Action and Potential Liability
Section 303 of the Act provides the SEC with exclusive authority to enforce Section 303 and any rules or regulations issued
under Section 303. Accordingly, there is no private right of action under the new rule. The SEC may bring an injunctive action
against an individual who violates the new rule. In addition, penalties for a willful violation of the new rule are fines
up to $5 million and prison sentences up to 20 years.
