A Shield For Accounting Firm Docs Under PCAOB Inspection

Transcription

1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: A Shield For Accounting Firm Docs Under PCAOB Inspection Law360, New York (October 29, 2012, 2:42 PM ET) -- It has been seven years since the Public Company Accounting Oversight Board began to inspect accounting firms. From the start, private plaintiffs those suing accounting firms or public companies saw these inspections as a potential source of ammunition for their own lawsuits. So these plaintiffs have repeatedly tried to compel accounting firms to produce documents that the firms created for PCAOB inspections. Accounting firms have resisted, mostly by citing a statutory privilege that protects certain inspectionrelated documents. In response, private plaintiffs have argued that this privilege is too narrow to protect many of the documents that accounting firms create while working on PCAOB inspections. Only two available opinions have addressed this dispute, and they have split on the answer. A 2010 decision, Silverman v. Motorola Inc.[1], reads the privilege quite narrowly, while a 2012 case, Bennett v. Sprint Nextel[2], reads it much more broadly. The source of the privilege is the Sarbanes Oxley Act the familiar SOX which created the PCAOB and the inspection process. Bennett reflects the better understanding of SOX s privilege provision. Bennett does not, however, set out the statutory analysis that clinches its reading of the provision. That analysis confirms that the privilege is broad: It protects all documents that accounting firms create for PCAOB inspections. This article explains why. The Problem: Can Plaintiffs Force Accounting Firms to Produce Materials That the Firms Prepared Solely for PCAOB Inspections? A PCAOB inspection is a complex, multistage, process. It includes extensive give-and-take between the PCAOB staff and the target firm. An inspection inevitably requires the target accounting firm to create an extensive volume of new documents. For example, a critical part of the inspection is the PCAOB staff s examination of workpapers from various audits. After the staff examines the workpapers, it sends detailed comments to the target firm. Some of these comments identify possible audit deficiencies. The firm drafts responses to the comments, a process that typically requires input from an array of firm personnel: audit staff, technical experts and sometimes senior members of the firm. This team generates written materials that include s, technical analyses and other documents discussing the details of the audits.

2 This activity leads, in turn, to a series of additional exchanges between the firm and PCAOB staff. At some point, the staff provides a draft report. The firm reacts to this draft by conducting another internal review process, then responding with additional information, analysis and comments. Ultimately, the PCAOB issues a report, of which part is public and part is confidential. The result, in short, is a lot of new material created by the accounting firm, much of it providing candid discussion of the firm s compliance with professional standards. To private plaintiffs, of course, this new material looks like a potential gold mine for their own lawsuits. Thus the efforts of private plaintiffs to compel accounting firms to produce these documents. But Congress anticipated these efforts. It saw that making these internal documents available to third parties would damage the inspection process, so it shielded the process from public view by creating a statutory privilege. Congress set out this privilege in section 105(b)(5)(A) of SOX, where the key language states that all documents and information prepared or received by or specifically for the Board... in connection with an inspection... shall be confidential and privileged as an evidentiary matter. [3] The provision goes on to say that these documents shall not be subject to civil discovery or other legal process. [4] It even exempts them from disclosure under Freedom of Information Act.[5] Some core applications of this privilege seem to be fairly well settled: It shields all documents in the hands of the PCAOB, and it shields documents in the hands of an accounting firm if the firm has actually submitted copies of those documents to the PCAOB. What is not settled, however, is whether the privilege applies to materials that an accounting firm created for its work on an inspection but did not send to the PCAOB. This is the question on which the two federal district courts have split. 2010: Silverman v. Motorola Inc. In 2010, the United States District Court for the Northern District of Illinois addressed this question in Silverman v. Motorola Inc. The court and the parties focused on the words prepared... for the Board... in connection with an inspection. The court held, in effect, that these words limit the privilege to documents specifically requested by and submitted to the PCAOB.[6] The court stated that the privilege does not apply to documents merely because an accounting firm here, KPMG created them in response to a PCAOB inspection, or because the documents reflect the substance of the inspection process.[7] It is not enough, the court said, that the firm s documents relate to or concern the inspection process.[8] Therefore, the court concluded, the privilege did not apply to internal KPMG communications that discuss... communications with the PCAOB staff.[9] 2012: Bennett v. Sprint Nextel A more recent opinion, from the District of Missouri, disagreed with Silverman s narrow reading of the SOX privilege. In Bennett v. Sprint Nextel, the court held that the privilege extended to all internal materials that the target firm KPMG again prepared while responding to a PCAOB inspection.[10] The court reasoned that, [b]ecause the final version of PCAOB comments and KPMG responses to those comments are all privileged, then... any internal KPMG communications that reveal those comments, or the work to develop the responses to those comments, are also privileged. [11] The court went on to conclude that the internal documents were prepared specifically for the Board because, absent the inspection, these documents and communications would not exist. [12]

3 Bennett gives a much better reading than Silverman of the words prepared... for the Board... in connection with an inspection, as Congress used those words in the context of the privilege provision. Silverman, never explains why these words apply only to materials actually provided to the PCAOB or its staff. (Nor can Silverman square its narrow reading of the words prepared, for, and in connection with an inspection with the accepted broader reading of the related word Board. It seems established that Board is not limited to its narrowest meaning, which would include only the five members of the PCAOB; rather, it receives its natural meaning in the context of this SOX provision, so that it includes the entire PCAOB staff.) An example from a different context helps explain why the Bennett reading is better. Say that, to prepare for a trial, a lawyer creates working documents to make detailed calculations of damages. The lawyer puts the damages totals into summary exhibits. The lawyer presents the summary exhibits at trial. Surely, common language would say that counsel created the underlying calculation documents for trial. In the same way, common language would say that an accounting firm that created internal working documents, then used those documents to draft submissions for the PCAOB, created the internal documents for the Board... in connection with an inspection. And again, recall that the word Board is read broadly to include the agency s entire staff. The Silverman opinion cannot account for this common usage of the words at issue. Statutory Evidence That Clinches the Broad Reading of the Privilege Nor can Silverman be squared with other language in the SOX privilege provision language that clinches the broader reading. (KPMG pointed out this analysis but the court did not adopt it. Id. at *7.) These other words received by the Board rule out the narrow privilege adopted in Silverman. Here is how. We know that the words prepared... for the Board cannot mean received by the Board, because the statute already contains those words. And as Silverman said, correctly, [i]t is a "cardinal principal of statutory construction" that a court must "give effect, if possible, to every clause and word of a statute."[13] So prepared for the Board must refer to something else: It must refer to some documents that were not actually received by the Board. And the most obvious application is to materials that lead to documents that a firm actually sent to the board, but that the firm did not send. Again, see the above example about the working calculations that the lawyer prepared for trial. The conclusion about the privilege s broad scope is further confirmed by its neat fit with the purpose of the SOX inspection provisions. As explained by the PCAOB, that purpose is to institute an inspection process that is supervisory, rather than adversarial, and that leads to remediation before it leads to sanctions.[14] To date, real-world experience with inspections indicates that the statute is, in fact, serving this intended purpose. This purpose would be frustrated by the narrow view of the privilege adopted in Silverman. That view would hinder the PCAOB s ability to conduct exams, for the obvious reason that accounting firms dislike creating documents that private plaintiffs can use to sue them. Under a rule that made internal firm documents available in civil discovery, any responsible firm would avoid putting candid analysis in writing. It would proceed instead through conversations and meetings.

4 Firms also might begin to run inspection-related activities through counsel, creating another layer of cost and generating a new thicket of issues involving the attorney-client privilege. The narrow privilege would, in short, force target firms to shift from a cooperative posture to a defensive one. This shift could, it is fair to say, change the basic nature of the PCAOB examination process. It also would drive up the cost of inspections (to the PCAOB and to accounting firms) and stretch out the time required to complete inspections. The broad privilege created by SOX does not, by the way, alter the pre-existing discovery rights of civil litigants. The rules of civil discovery already entitle plaintiffs to workpapers and other documents from audits, if the audits are relevant to their lawsuits. Any competent plaintiff s counsel who seeks inspection-related material from an accounting firm already has obtained these materials. Conclusion Bennett v. Sprint Nextel gives accounting firms new support for the argument that the statutory privilege shields all materials that firms generate because of the PCAOB inspection process. Although a split in authority now exists, Bennett gives the better reading of SOX Section 105(b)(5)(A). And the analysis set out above explains even more clearly than Bennett why the statutory language rules out the narrow privilege adopted in Silverman. --By Andrew J. Morris, Morvillo LLP Andrew Morris is a partner in Morvillo's Washington, D.C., office, The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] No , 2010 U.S. Dist. LEXIS (N.D. Ill., June 29, 2010) [2] No , 2012 U.S. Dist. LEXIS (W.D. Mo., October 10, 2012) [3] Sarbanes-Oxley 105(b)(5)(A); 15 U.S.C. 7215(b)(5)(A) (emphasis added). [4] Id. [5] Id. [6] Silverman, No. 07-C-4507, 2010 U.S. Dist. LEXIS 81671, *11. [7] Id at *10 [8] Id at *11-12 [9] Id at *10 [10] 2012 U.S. Dist. LEXIS at *10. [11] Id at *11 [12] Id

5 [13] Silverman, 2010 U.S. Dist. LEXIS 81671, at *10-11 [14] The PCAOB discussed the purpose and goals of the inspection program in Pub. Co. Accounting Oversight Bd. Release No , The Process for Board Determinations Regarding Firms; Efforts to Address Quality Control Criticisms in Inspection Reports (March 21, 2006) All Content , Portfolio Media, Inc.