The PCAOB Takes on Enforcement
by Mary M. Sjoquist and Marilyn H. Weimer

A Different Framework

The Sarbanes-Oxley Act of 2002¹ has been the stimulus for significant corporate reform in public companies in the United States. In addition, Sarbanes-Oxley has changed forever the way auditors of public companies will interact with client audit committees, management, and the internal audit function. However, the creation of the Public Company Accounting Oversight Board (the “Board”), which established a new realm of oversight for auditors of public companies, is considered by many to be the focal point of the legislation.

Sarbanes-Oxley provided the Board with jurisdiction in four primary functional areas related to public accounting firms and their associated persons: registration, inspections, investigations, and standard-setting. To date, most of the Board’s focus has been on registration, inspections, and standard-setting, and rightly so. These functions provide the necessary backdrop for implementing an effective program in the area of investigations and enforcement. In the short period of time since its inception, the Board has registered 771 firms that audit public companies, initiated the implementation of its inspections program with a limited inspection of the four largest auditing firms, and taken significant steps in setting auditing and related professional practice standards for auditors.

Although little has been publicly aired about the nature, timing, and extent of the Board’s enforcement program, looking at Sarbanes- Oxley or hearing the stern warnings voiced by the Board’s chairman, William McDonough, would convince anyone that the enforcement program will be a robust and completely new regulatory enforcement regime. If that is not sufficient, a review of the Board’s pending enforcement rules makes clear that all who are within its jurisdictional reach should be prepared; we’re definitely not in Kansas anymore. The legislative history of Sarbanes-Oxley provides insight into the strong enforcement powers given to the Board. Former SEC Chairman Arthur Levitt testified before the Senate Committee on Banking, Housing and Urban Affairs urging the creation of a “truly independent oversight body that has the power not only to set the standards by which audits are performed but also to conduct timely investigations that cannot be deferred for any reason and to discipline accountants.”² Congress appears to have taken this advice to heart when it crafted the provisions giving the Board enforcement capabilities.³ Sarbanes-Oxley requires the Board to investigate alleged violations of the law and grants power to thwart non-cooperation with a Board investigation, and ultimately to sanction violators, in a significant way. These provisions are a distinct message to the auditing profession that the days of peer review are over.

The Board’s enforcement powers are dependent on two factors. First, similar to its other powers, the Board cannot exercise enforcement authority without acquiring jurisdiction over the entities and persons it is mandated to oversee. That jurisdiction came about after October 22, 2003, when Sarbanes-Oxley prohibited any auditing firm from preparing or issuing, or participating in the preparation or issuance of, any audit report with respect to any issuer unless it is a registered public accounting firm. Registration was the gateway to the Board’s jurisdiction: all registered public accounting firms, and their associated persons, are subject to the Board’s enforcement powers.

[T]he [PCAOB’s] enforcement program will be a robust and completely new regulatory enforcement regime.

Second, and also similar to all of the rules promulgated by the Board, the Board’s enforcement rules are subject to approval of the SEC before they may become effective.⁴ On September 29, 2003, the Board adopted a comprehensive set of disciplinary and hearing rules which are currently pending SEC approval.⁵ This article reviews and analyzes several notable aspects of the proposed rules.

The New Enforcement

Section 107 of Sarbanes-Oxley describes the SEC’s oversight responsibilities and enforcement authority over the Board as consistent with and similar to the SEC’s oversight relationship with the “registered securities associations” or selfregulatory organizations in its jurisdiction. This description may lead some to believe that the Board’s rules and procedures regarding enforcement and disciplinary actions will mimic those of other self-regulatory organizations. To a limited extent, this is true. The Board drew significantly from previously established, timeand litigation-tested models in developing its own rules. Models included the rules of the Commission and the NASD, rules governing civil procedures and fair hearings procedures adopted from the Administrative Procedures Act, the federal rules of evidence, and the rules of the federal court in the Southern District of New York. However, the similarity ends there. The Board extracted from these ready sources only those necessary portions that ensure fairness and efficacy. All of the Board’s rules are designed to promote a unique framework capable of swift, relevant, and meaningful enforcement.

The Board’s enforcement capabilities point to a very potent and agile program. The Board is assembling a team of investigators, auditors, and attorneys who will work together to investigate possible violations of laws or standards by registered public accounting firms and their associated persons. Investigations will be based on issues referred from Board inspectors or other regulatory bodies, events disclosed in public filings and media reports, and tips or whistleblowing. And where it finds violations of laws or standards by registered public accounting firms or their associated persons, the Board has the authority to impose significant monetary and other remedial sanctions.

While the Board’s authority is to investigate registered public accounting firms and their associated persons, its investigations also may result in referrals of audit clients to the Commission, to other functional regulators such as the federal banking agencies, or, at the direction of the Commission, to the U.S. Justice Department or state criminal or regulatory authorities, depending on the nature of the alleged violation. The Board will seek voluntary cooperation from audit clients of registered public accounting firms but, should voluntary disclosure be refused, the Board has authority to seek SEC subpoenas for witnesses and documents.

In With The…Old?

Despite the Board’s determination to develop an independent legacy of enforcement rules— primarily in response to the environment under which it was created—its members are sensitive to the fact that there is no virtue in “reinventing the wheel” for those processes that provide battle-worn evidence of fairness and justice. This decision was a victory for familiarity, even though only a small percentage of the proposed rules are a complete adaptation of other law enforcement rules of procedure. The majority of the proposed rules are hybrids, if not completely new. The following covers some of the more essential points that the Board, in adopting its proposed rules, modeled after an existing enforcement framework.

Nonpublic investigations

Similar to the Commission’s long-standing policy on conducting nonpublic investigations, the Board’s investigations also will be nonpublic. Board staff will conduct both informal inquiries and formal investigations⁶ in a manner similar to that established by the Commission. However, the Board chose not to incorporate other features of existing investigative models (notably the Commission’s and the NASD’s), despite calls to do so by commenters in the public comment period. For example, commenters suggested the Board should permit parties to an investigation to petition for the investigation to be closed, and should always provide Wells⁷ submission opportunities from prospective defendants. Although the Board declined to formally adopt such practices, it nonetheless acknowledged that the rules are sufficiently flexible to allow the Board and the staff to consider such developments or to incorporate such practices in the future.⁸

Fifth Amendment

Unlike most other non-governmental entities, the Board has determined that it will honor valid assertions of the privilege against self-incrimination as a basis for declining to provide documents or information in response to an accounting board demand.9 As a non-governmental entity, the Board has a strong argument that the Fifth Amendment does not apply to its processes, and thus could require registered public accounting firms or their associated persons to testify or produce documents. A failure to do so would then constitute a violation of the Board’s rules and the Board could initiate disciplinary actions and impose sanctions. The NASD follows this generally accepted view.

The Board, however, has chosen “not…to invade the province of any legitimately asserted privilege that would, under prevailing law, be treated as a valid basis for declining to provide documents or information in response to a Commission subpoena, including valid assertions of the privilege against self-incrimination under the Fifth Amendment….”¹⁰ But be forewarned: “taking the Fifth” will have consequences. The Board fully intends to draw any negative inferences that such an assertion may present in Board investigations and disciplinary proceedings. In addition, the Board intends to report assertions of the Fifth Amendment to other appropriate authorities as provided under Sarbanes-Oxley.

Attendance at testimony

The Board received a number of comments relating to attendance at testimony in its investigations. Commenters were concerned that the proposed rules would not allow for additional persons, such as technical expert consultants, to attend witness testimony sessions. Commenters believed that such consultants protect a witness’s rights and help to produce better testimony.

As it is currently proposed, the Board’s rule allows for the witness and his or her counsel to attend an investigative testimony session. However, the rule also “provides sufficient flexibility for the staff to permit a technical consultant to be present during investigative testimony…in appropriate circumstances and on appropriate terms.”¹¹

The Board rejected the proposition that persons only tangentially related to an investigation may attend testimony. Additionally, to protect its processes, the Board will not allow a registered public accounting firm’s internal counsel or other personnel to effectively monitor an investigation by sitting in on testimony of all firm personnel. Only counsel who affirmatively states he or she represents the witness may attend testimony.¹²

Statement of position

The Wells process is a well-known and established practice within the Commission’s Division of Enforcement. When the staff of the Division of Enforcement has reached a point where it anticipates making a recommendation to the Commission regarding an enforcement action, it has the discretion to (and, absent exigent circumstances, generally does) grant prospective defendants an opportunity to provide a statement to the Commission supporting their position as to why an enforcement action may be unwarranted or a lesser remedial sanction would be more appropriate. Commissioners have found the Wells process to be a valuable and important part of the Commission’s adjudicatory practices and have encouraged its use.

The Board likewise recognizes the value of this procedure and has adopted something similar in its proposed enforcement rules. Like the Commission’s Wells Notice, the Board’s “Statement of Position” will allow enforcement staff to advise prospective parties to Board investigations of the general nature of an investigation and allow for the prospective party to submit a statement of position and interests to the Board. Although some commenters urged the Board to make the process mandatory, the Board opted to retain flexibility by allowing staff discretion to determine whether to grant such opportunities. It is more likely than not that Board staff will permit prospective defendants to provide a statement of position, but if circumstances warrant,¹³ the staff is not obligated to do so.

Investigative/administrative procedures

Overall, the Board’s operational structure for its investigative, enforcement, and administrative adjudicatory process will be loosely modeled after the Commission’s more than 30 years of experience with a formal Division of Enforcement. ¹⁴ The Board has adopted those processes and best practices from the Commission that will provide a solid platform for fairness and integrity. Specifically, investigations will be initiated by Board action in a formal order of investigation. After an investigation or at an appropriate point during an investigation, the Board’s investigation and enforcement staff will make recommendations for enforcement actions, if warranted, to the Board. The determination to bring such actions rests exclusively with the Board.

The administrative hearing and adjudicatory process will be managed by independent hearing officers, whose decisions, unless appealed to the Board, will be final decisions of the Board. Decisions of the Board may be appealed to the Commission, which maintains broad oversight of the Board’s functions.

There is another aspect of the Commission’s investigative and administrative procedures that the Board is hoping to emulate: the Commission’s reputation for enforcement tenacity and vitality. The Board’s enforcement program will have the advantages of a focused population—registered public accounting firms and associated persons—as well as a highly competent and professional staff in the area of auditing and accounting matters and the ability to react and act quickly on matters brought before it. By seizing upon these advantages, the Board is aiming to build an agile and effective enforcement program. Of course, this facet of the Board’s operations remains to be tested, as the Board’s rules regarding investigations and enforcement have not yet been approved by the SEC.

Now, the Differences

Although the elements of the Board’s enforcement program are still the subject of theoretical discussions, there is no lack of evidence concerning the direction the Board envisions for that program. The Board intends to dispense swift, relevant, and meaningful discipline on firms and their associated persons after an opportunity for hearing and relevant due process. ¹⁵ Chairman McDonough’s first public speech demonstrated that resolve when he admonished registered public accounting firms and their associated persons not to break the rules or ignore the spirit of the law even while meeting the letter of the law. His promise to violators who failed to heed his cautions was, “…woe be unto you. There will be consequences, and they will be grave.”¹⁶ The following is a summary of new things to come should the SEC approve the Board’s rules in form and substance as the Board adopted them.

Non-cooperation proceedings

Proposed Rule 5110, Non-cooperation with an Investigation, should be an effective tool to curb frivolous appeals and time-delaying tactics in Board investigations. The Board has clear authority to impose disciplinary sanctions on registered public accounting firms and associated persons for refusing to testify, produce documents, or otherwise cooperate with the Board in connection with an investigation.¹⁷ The Board has not attempted to define each and every situation under which a firm or an associated person may be in violation of the rule, but there are three clear possibilities:

1. Abusing the Board’s processes for the purpose of obstructing an investigation. Purposely¹⁸ filing appeals that do not have a reasonable basis for prevailing in an effort to delay an investigation, disciplinary sanction, or an administrative hearing opinion.

2. Knowingly providing false testimony and or false documents in a Board investigation. The Board’s initial proposed rule contained language that made the omission of material information a basis for institution of non-cooperation proceedings. This language raised concern among commenters, who asserted that it would create an overly harsh burden on potential witnesses who would be required to determine materiality of information important to a Board investigation. The Board responded to those concerns by substituting the language of the federal perjury statute.¹⁹

3. Failing to facilitate an associated person’s cooperation with the Board. An associated person’s non-cooperation does not automatically create non-cooperation liability for a registered public accounting firm. However, if the firm fails to secure the associated person’s cooperation with the Board or fails to end its association with the non-cooperating associated person, such failure could jeopardize the firm’s registration status and its ability to audit public companies.²⁰ Under the proposed rules, disciplinary proceedings for non-cooperation with an investigation would be subject to special and expedited procedures. ²¹

Nonpublic hearings

The Board’s rules, as proposed, provide for two types of hearing procedures: one to determine whether to disapprove a registration application and another to determine whether to impose disciplinary sanctions on a registered public accounting firm or an associated person. In both cases, the rules provide that the hearings will be nonpublic, with limited exceptions.

A disciplinary hearing may be made public if the Board so orders for good cause shown and if all parties to the matter consent. If any one party objects to the hearing being made public, the hearing will be nonpublic. In contrast, whether a registration hearing is public or not is solely within the Board’s discretion. The factors the Board will consider in determining whether a registration hearing will be public have not yet been articulated.

Accounting board demands

The Board does not possess subpoena powers, but Sarbanes-Oxley does grant the Board the equivalent authority to require testimony and documents from registered public accounting firms and associated persons of such firms in the form of an accounting board demand, or ABD. The Board also may request testimony and the production of documents from any other person, including any client of a registered public accounting firm, that the Board considers relevant or material to an investigation.

ABDs are no less demanding than subpoenas. Failure to respond to an ABD may subject a firm or its associated persons to a non-cooperation hearing and possible disciplinary proceedings. Additionally, if a person or entity other than a registered public accounting firm or an associated person fails to comply with a request for testimony or the production of documents, the Board may be able to compel production of documents or testimony by requesting that the Commission issue a subpoena. The mechanics of that process have not yet been developed or tested by the Board and the SEC.

Sanctions

By all measures, the sanctions available for imposition on registered public accounting firms or their associated persons are substantial. Sarbanes-Oxley provides that the most severe penalties be imposed for those violations that evidence intentional, knowing conduct or repeated instances of negligent conduct. Such sanctions include suspensions, bars, revocation of registration, limitations on activities, and monetary penalties (which could be up to $750,000 for individuals and up to $15 million for registered public accounting firms, per violation).

The most severe sanction for a registered public accounting firm, obviously, is the revocation of its registration with the Board. The imposition of this sanction would ring the death knell for a firm’s public auditing business. The “lesser” sanctions, if they can be called that, include censure, additional professional education or training, lower amounts of monetary penalties, and other appropriate penalties that the Board may provide for in its rules.²² If the Board imposes any of the disciplinary sanctions outlined above, it will report the sanction to the SEC, any appropriate state regulatory authority or foreign accountancy licensing board, and (once all stays have been lifted²³ ) to the public.

A note of interest is that in addition to the fact that the statutory civil money penalties that the Board may impose are significantly higher than those established under the securities laws in civil actions in U.S. district courts,²⁴ the disbursement of those funds also serves a different purpose. Until the enactment of Section 308 of Sarbanes-Oxley, known as the Fair Funds provision, civil money penalties collected in SEC enforcement actions were sent to the U.S. Treasury. Section 109(c)(2) of Sarbanes-Oxley requires that all civil money penalties assessed on registered public accounting firms or associated persons by the Board be used to fund a merit scholarship program for accounting students in accredited degree programs.

Coordination with SEC Enforcement

Both Sarbanes-Oxley and the Board’s own rules require coordination of the Board’s and the SEC’s enforcement activities. However, at this point, any discussion regarding coordination of enforcement actions would be purely theoretical. Since the Board is still in the process of establishing its enforcement program, the implications of such coordination are difficult to assess.

A thoughtful framework is likely to include coordination that reduces or eliminates duplication of efforts. The SEC has a strong enforcement background that can provide experienced investigative skills, and the Board is in the process of building in its own enforcement model. This, together with the Board’s highly seasoned arsenal of accountants and auditors, should provide the Board with the expertise to unearth the intricacies of complex auditing and securities matters. No matter how you slice this coordination effort, it’s a recipe for one tough enforcement regime.

About the Author

Mary M. Sjoquist (SjoquistM@pcaobus.org) is Special Counsel to PCAOB Board Member Bill D. Gradison. Marilyn H. Weimer (WeimerM@pcaobus.org) is Special Counsel to Board Member Daniel L. Goelzer. The views expressed herein are solely those of the authors and are not necessarily those of the PCAOB or any of its Members or other staff.

Notes

1. Pub. L. No. 107-204, 116 Stat. 745 (2002).

2. Prepared “Statement of the Honorable Arthur Levitt, Jr., Chairman, Securities and Exchange Commission, 1993-2000” before the U.S. Senate Committee on Banking, Housing and Urban Affairs hearings on “Accounting and Investor Protection Issues Raised by Enron and Other Public Companies,” February 12, 2002, available at <http://banking.senate.gov/02_02hrg/021202/levitt.htm>.

3. Section 105, “Investigations and Disciplinary Proceedings,” generally authorizes the Board to establish by rule the Board’s investigatory and disciplinary processes. That section also provides the Board’s authority to impose sanctions and fines for violations of Sarbanes-Oxley, professional standards, various other laws, and certain rules of the Commission.

4. Section 107(b)(2) of Sarbanes-Oxley provides in pertinent part, “No rule of the Board shall become effective without prior approval of the Commission.” The Commission also has other oversight responsibilities with respect to the Board’s enforcement and disciplinary program, including review authority of Board disciplinary actions.

5. PCOAB Release 2003-015 (Sept. 29, 2003), available at <www.pcaobus.org/rules/Release2003-015.pdf>. On November 10, 2003, the SEC expedited approval of the Board’s hearing and adjudicatory rules on a temporary basis in order to provide a process and procedure for resolving issues relating to registration applications. A further opportunity for public comment will be provided when the Commission publishes the permanent rules on investigations and adjudications for comment.

6. Rules 5100 and 5101 describe generally the processes by which the staff will conduct informal inquiries and the Board will commence and close formal investigations, respectively.

7. In 1972, the Commission’s Advisory Committee on Enforcement Policies and Practices chaired by John A. Wells made a number of recommendations to its newly formed Division of Enforcement, including the recommendation that potential subjects of an SEC enforcement action should have an opportunity to submit a written statement presenting their position to the Commission. Securities Act Release No. 5310 (Oct. 4, 1972).

8. See PCAOB Release 2003-015, supra note 5, at A2-12 to14.

9. An accounting board demand is a command by the Board to produce documents and/or to appear at a certain time and place to give testimony.

10. See PCAOB Release 2003-015, supra note 5, at A2-33. Certain privileges under law allow a person to decline to provide testimony or documents in response to a Commission subpoena. The list of privileges currently includes assertions of the Fifth Amendment, spousal privilege, and attorney-client privilege. It is unlikely the Board will honor so-called psychiatrist-patient or accountant-client privileges in its investigations.

11. Id. at A2-18 to –19. One example of when it would not be appropriate to permit a consultant to be present is when the consultant is a partner or employee of the firm with which the witness is associated. Id.

12. Id. at A2-19.

13. Extenuating circumstances may include instances of expedited enforcement action, legitimate investigative objectives of the Board, or preventing operating risks to other regulatory or law enforcement agencies conducting parallel investigations.

14. Up until 1972, the Commission did not have a formal Division of Enforcement. The Commission’s operating divisions commenced their own investigative and enforcement programs within their respective responsibilities and the Commission’s regional offices conducted virtually all of the investigations. Thirty Eighth Annual Report of the Securities and Exchange Commission (1972).

15. See Working Paper Regarding Board Investigations and Disciplinary Proceedings. PCAOB (April 21, 2003).

16. William J. McDonough, Speech before the Foundation for Accounting Education, New York State Society of Certified Public Accountants (Sept. 9, 2003).

17. Section 105(b)(3) of Sarbanes-Oxley provides that if a registered public accounting firm or any associated person thereof refuses to testify, produce documents, or otherwise cooperate with the Board in connection with an investigation, the Board may suspend or bar such person from being associated with a registered public accounting firm or require the registered public accounting firm to end such association, suspend or revoke the registration of the public accounting firm, and invoke such other lesser sanctions as the Board considers appropriate, and as specified by rule of the Board.

18. The Board has included a scienter element in this provision so that it “will not treat as noncooperation every arguable abuse of the Board’s processes, but only those that involve an intent to obstruct an investigation.” PCAOB Release No. 2003-015, supra note 5, at A2-52.

19. The new language is found in PCAOB Rule 5110(a)(2), which states that the Board may institute a disciplinary proceeding if it appears to the Board that a registered public accounting firm, or a person associated with such a firm, “may have knowingly made any false material declaration or made or used any other information, including any book, paper, document, record, recording, or other material, knowing the same to contain any false material declaration.”

20. Section 102(b)(3)(A) of Sarbanes-Oxley provides that “each application for registration shall include a consent executed by the public accounting firm to cooperation in and compliance with any request for testimony or the production of documents made by the Board…(and an agreement to secure and enforce similar consents from each of the associated persons of the public accounting firm as a condition of their continued employment by or other association with such firm).” Section 102(b)(3)(B) further requires “a statement that such firm understands and agrees that cooperation and compliance…and the securing and enforcement of such consents from its associated persons . . . shall be a condition to the continuing effectiveness of the registration of the firm with the Board.” The Board incorporated these provisions in its Form 1, Registration Form, which all public accounting firms completed and submitted in their applications for registration with the Board.

21. See proposed rule 5110(b).

22. Section 105(c)(4)(G) of Sarbanes-Oxley gave the Board authority to impose any other appropriate sanction provided for in the rules of the Board. Board Rules 5300(a)(7) through (10) provide that such sanctions would include requiring a party to engage an independent monitor, counsel, or other consultant to design compliance policies, and other undertakings.

23. Section 105(e)(1) of Sarbanes-Oxley provides for an automatic stay of any disciplinary actions by the Board upon application to the Commission, or on the Commission’s own institution of review of a disciplinary action, unless and until the Commission orders that the stay be lifted.

24. Section 20(d) of the Securities Act and Section 21(d) of the Exchange Act provide that the Commission may bring an action in U.S. district court to seek civil money penalties. The penalty amounts are structured on a 3-tier system, with the largest penalty amount reserved for those violations involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement and such violation resulted in substantial losses or created a significant risk of substantial losses to other persons. The total statutory penalty amounts in this category are $100,000 for a natural person and $500,000 for any other person per violation.