SEC Proposes Rule Prohibiting Improper Influence on Conduct of Audits

10/29/2002
Client Alert
On October 18, 2002, the Securities and Exchange Commission ("SEC"), as required under Section 303(a) of the Sarbanes-Oxley Act of 2002 (the "Act"), issued proposed rules (See SEC Release 34-46685) to prohibit officers and directors of public companies, and persons acting under the direction of an officer or director, from taking any action to fraudulently influence, coerce, manipulate or mislead the auditor of such company's financial statements for the purposes of rendering the financial statements materially misleading.

The proposed rules supplement existing rules under Rule 13b-2 of the Securities Exchange Act of 1934 (the "Exchange Act") and, together with Rule 13b-2, are designed to ensure that management makes open and full disclosures to, and has honest discussions with, the auditor of the company's financial statements.

Proposed Rules

Under the proposed rules:

  • No officer or director of a public company, or any other person acting under the direction of such officer or director, shall directly or indirectly take any action to fraudulently influence, coerce, manipulate, or mislead 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. This substantially mirrors the wording in Section 303(a) of the Act.
  • Examples of actions 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 fraudulently influence, coerce, manipulate, or mislead an auditor:
    1. to issue a report on a company's financial statements that is not warranted in the circumstances (due to material violations of generally accepted accounting principles, generally accepted auditing standards, or other standards);
    2. not to perform audit, review or other procedures required by generally accepted auditing standards or other professional standards;
    3. not to withdraw an issued report; or
    4. not to communicate matters to a company's audit committee.
The proposed rules provide that similar prohibitions will apply to investment companies registered under the Investment Company Act of 1940, and includes, among the parties to whom the proposed rule applies, any officer or director of such investment company's investment adviser, sponsor, depositor, trustee, or administrator.

Types of Prohibited Conduct

The SEC views the word "fraudulently" as modifying the word "influence" only, such that an officer or director, or any person acting under the direction thereof, can seek to influence, but not "fraudulently influence" the company's independent auditors. It would seem that something less than fraud is sufficient to trigger the other types of prohibited conduct, that is, to "coerce,"manipulate" or "mislead" an auditor. Prohibited conduct is not dependent on whether it is successful in affecting the audit or review. Types of improper influence that the SEC described in the proposing release, include, but are not limited to, directly or indirectly:

  • 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 because the partner objects to the company's accounting;
  • Blackmailing and making physical threats; and
  • Improperly influencing the auditor to, among other things,
    1. issue an unwarranted report on the financial statements, including suggesting or acquiescing in the use of inappropriate accounting treatments or not proposing adjustments required for the financial statements to conform with generally accepted accounting principles;
    2. not perform audit or review procedures that, if performed, might divulge material misstatements in the financial statements;
    3. not withdraw a previously issued audit report when required by generally accepted auditing standards; or
    4. not communicate appropriate matters to the audit committee.
In the proposing release, the SEC noted that the proposed rule would not be limited to the audit of the annual financial statements, but would include, among other things, 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.

Persons Covered

As noted above, the proposed rule would cover the activities of not only officers and directors of a public company, but also any other person acting under the direction of an officer or director. Activities by such "other persons" currently may 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. However, Section 303 of the Act and the proposed rule provide the SEC with an additional means of policing efforts 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.

The SEC interprets Congress' use of the term "direction" in the Act 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, the term also may include other partners or employees of the independent auditor, 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 may 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.

Whether the Proposed Rules Should Require Proof of a Particular Purpose or Intent

Section 303(a) 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. Under the proposed rules, an officer, director, or person acting under the direction of the officer or director, who engaged in conduct to improperly influence an auditor would be culpable if he or she knew, or was unreasonable in not knowing, that the improper influence could, if successful, result in rendering financial statements materially misleading. The SEC proposes that proving a particular purpose or intent is not required.

No Private Right of Action

Section 303(b) of the Act provides the SEC with exclusive authority to enforce the Section and any rules or regulations issued under the Section. Accordingly, there will be no private right of action under final rules to be issued pursuant to Section 303 of the Act.

Anticipated Timeframe for Adoption

The deadline for public comment on the proposed rules is November 25, 2002. The Act mandates that final rules be adopted no later than April 26, 2003.

Email Disclaimer

Unsolicited e-mails and information sent to Morrison & Foerster will not be considered confidential, may be disclosed to others pursuant to our Privacy Policy, may not receive a response, and do not create an attorney-client relationship with Morrison & Foerster. If you are not already a client of Morrison & Foerster, do not include any confidential information in this message. Also, please note that our attorneys do not seek to practice law in any jurisdiction in which they are not properly authorized to do so.

©1996-2019 Morrison & Foerster LLP. All rights reserved.