Section 10A Audit Requirements Under the Securities Exchange Act of 1934: A Play In Five Acts. Act One: Angels and Ministers Of Grace Defend Us!

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1 Section 10A Audit Requirements Under the Securities Exchange Act of 1934: A Play In Five Acts Daniel V. Dooley, CPA* Act One: Angels and Ministers Of Grace Defend Us! Title III of the Private Securities Litigation Reform Act of 1995 ( PSLRA ) amends the Securities Exchange Act of 1934 ( Exchange Act ) by adding Section 10A, Audit Requirements (15 USC 78j-1), specifying that each independent audit of an issuer under the Exchange Act shall include, in accordance with generally accepted auditing standards (or, GAAS ): Procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material affect on the determination of financial statements amounts. Section 10A (b), Required Response to Audit Discoveries, sets forth the independent auditor s duties when he or she detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements) has or may have occurred; these duties require that the auditor: (1) determine whether it is likely that an illegal act has occurred; (2) if, so (i.e., that an illegal act is determined to have occurred), determine and consider the possible effect of the illegal act on the financial statements of the issuer (including any contingent monetary effects, such as fines, penalties and damages); and (3) as soon as practicable, inform the appropriate level of management and assure that the audit committee or the board of directors of the issuer is adequately informed, unless such illegal act is clearly inconsequential. Section 10A (f) defines an illegal act to mean: An act or omission that violates any law, or any rule or regulation having the force of law. American Institute of Certified Public Accountants ( AICPA ) Statement on Auditing Standards ( SAS ) No. 54, Illegal Acts by Clients (AICPA Professional Standards, vol. 1, AU ) defines an illegal act, for purposes of audit guidance to mean: Violations of laws or government regulations attributable to the entity whose financial statements are under audit or acts by management or employees acting on behalf of the entity. In practice, and as interpreted by the Securities and Exchange Commission ( SEC ) and by the accounting and auditing profession, Section 10A encompasses: violations of securities laws and regulations (including The Sarbanes-Oxley Act of 2002); violations of anti-bribery provisions of securities law, such as the Foreign Corrupt Practices Act ( FCPA ); money laundering; banking crimes; violations of the Employee Retirement Income Security Act of 1974 ( ERISA ); and various environmental protection laws among others. * Daniel V. Dooley is a partner in the firm of PricewaterhouseCoopers and leads the firm s Securities Litigation Consulting practice. 1

2 Section 10A (b)(2), Response to Failure to Take Remedial Action, requires that the independent auditor, as soon as practicable, shall directly report to the board of directors its conclusions that: (A) the illegal act has a material effect on the financial statements of the issuer; (B) the senior management has not taken, and the board of directors has not caused senior management to take, timely and appropriate remedial actions with respect to the illegal act; and (C) the failure to take remedial action is reasonably expected to warrant departure from a standard report (e.g., an unqualified audit opinion) of the auditor, when made, or warrant resignation from the audit engagement. Section 10A (b)(3) requires an issuer whose board of directors receives a report from its independent auditors covered under Section 10A (b)(2) to inform the SEC within one business day after receiving such a report, and provide the registered public accounting firm with a copy of the notice to the Commission before the expiration of the one-business-day period. If the issuers fails to provide the SEC and the independent auditors with the required notice, the registered public accounting firm is required to: (A) resign from the engagement; or (B) furnish to the Commission a copy of its report (or documentation of any oral report given) not later than one business day following such failure of the issuer to give proper notice. If the independent auditors resign, they still are required to provide the SEC with a copy of their report to the board of directors of the issuer (or the documentation of any oral report given). As described above, Section 10A involves distinct Acts or actions of a number of different actors in a drama that, if not handled properly, can become a tragedy. The actors include independent auditors, the issuer (and its senior management, audit committee and board of directors), the audit committee and board of directors, and the issuer s legal counsel and other advisors; and they each have parts in: (1) detection and preliminary assessment of possible illegal acts, and communication to senior management and directors, by the independent auditors; (2) responses including investigation and remedial actions taken; (3) evaluation by the independent auditors of senior management s and directors response; and (4) conclusions and reporting regarding failure to take timely and appropriate responses and remedial actions. All The World Is A Stage (For Section 10A) The world of SEC registrants has changed dramatically post-enron and since enactment of The Sarbanes-Oxley Act of 2002 ( Sarbanes-Oxley ). When Arthur Andersen died in the last act of the Enron tragedy, the accounting and auditing world took notice. When Sarbanes-Oxley essentially made auditing (at least for auditors of SEC registrants) a regulated profession, the roles of auditors were redefined. Now that the Public Companies Accounting Oversight Board ( PCAOB ) and SEC have begun regulating the accounting and auditing profession, more than ever auditors are an arm of the SEC in the service of detecting and reporting financial frauds. Registered public accounting firms that fail to heed the requirements of Sarbanes-Oxley and Section 10A of the Exchange Act risk suffering the fate of Arthur Andersen. Section 307 of Sarbanes-Oxley, Rules of Professional Responsibility for Attorneys, (Securities Act Release and Exchange Act Release ) also has set the stage for more reporting (up) of potential illegal acts and more potential Section 10A situations. We live in a world where 2

3 the independent auditors and the corporate attorneys have duties to communicate potential illegal acts to senior management, audit committees, and boards of directors of registrants, and possibly to the SEC in order to comply with the requirements of Section 10A of the Exchange Act and Section 307 of Sarbanes-Oxley. This now is a world in which such communications will happen more often whenever potential illegal acts are detected or suspected. Today, the auditing profession is focused, as never before, on detecting financial fraud; and, SEC, DOJ, states attorneys general, media, whistleblowers, and the public at large all are on the hunt for accounting irregularities and illegal acts. And then it started like a guilty thing Upon a fearful summons. Setting The Scene As early as 1999, in an Audit Risk Letter from the Office of the Chief Accountant ( OCA ) of the SEC, dated December 22, 1999, the Commission staff warned the auditing profession of concerns that auditors were not meeting their reporting obligations under Section 10A. Then Chief Accountant Lynn E. Turner commented to the AICPA: Congress clearly intended that Section 10A should result in the Commission receiving an early warning from auditors about their clients' illegal activities. Despite this intention, the Commission has received very few Section 10A reports. The General Accounting Office, at the request of Congressman John Dingell, currently is investigating why such a relatively small number of reports have been submitted to the Commission. The Commission encourages all auditors to review Section 10A and Rule 10A-1 and, when confronted with the proper circumstances, to provide the appropriate notice and reports. In the next year s 2000 Audit Risk Alert to the AICPA, SEC Chief Accountant Lynn Turner again stated: We encourage all auditors to review Section 10A and Rule 10A-1 and, when confronted with the proper circumstances, to provide the appropriate notice and reports. Since these warnings, the SEC has brought an increasing number of actions against auditors for violations of Section 10A, including the following: SEC v. Solucorp Industries, Ltd., Glen R. Olhauser, CA, et al. (Lit. Rel. No. 1337, October 31, 2000) In this civil litigation the SEC charged violations of anti-fraud provisions of the Exchange Act by foreign registrant Solucorp and certain officers and directors, and violation of Section 10A by Canadian Chartered Accountant Glen R. Olhauser ( Olhauser ). In connection with the first action brought involving an alleged Section 10A violation, the SEC stated: On October 31, 2000, the Commission filed an Amended Complaint in the above-mentioned action. The Amended Complaint adds Glenn R. Ohlhauser ("Ohlhauser"), a Chartered Accountant with the Canadian accounting firm MacKay & Partners, as a defendant for failing to take appropriate action on discovering possible illegal conduct during an audit of Solucorp Industries Ltd.'s financial statements in 1998, in violation of Section 10A of the Securities Exchange Act of The action is 3

4 the first civil injunctive action brought by the Commission against an auditor for violating Section 10A, which imposes on auditors certain obligations upon discovering possible illegal conduct. The Commission alleged that Ohlhauser should have, but did not comply with the provisions of Section 10A requiring him to take the following steps in accordance with Generally Accepted Auditing Standards ( GAAS ): (1) determine whether it was likely that Solucorp committed an illegal act by backdating the agreement; (2) determine the possible effect of the illegal act on Solucorp's financial statements for the six-month transition period ended December 31, 1997, including the contingent monetary effect of penalties, fines and damages; and (3) inform the appropriate level of Solucorp's management and assure that Solucorp's audit committee was adequately informed about the illegal act. In re. Jeffery M. Yonkers, CPA (AAER No. 1428, July 27, 2001) In this administrative proceeding the SEC charged Jeffery M. Yonkers ( Yonkers ) an audit senior and then supervisor employed by the accounting firm Marcum & Kliegman with violations of Section 10A in connection with audits, in which Yonkers participated, of Detour Magazine, Inc ( Detour ). The SEC alleged that Yonkers knew but failed to notify Detour's management or board of the illegal acts of Detour intentionally filing incorrect financial statements in Detour's Form 10-QSB interim financial reports. SEC v. Paul Skulsky, Aaron Chaitovsky, Robert Glass, et al. (AAER No. 1652, October 21, 2002) In this this matter involving financial fraud, fraudulent financial reporting and other violations of securities laws of Appoline.com, Inc. and its officers and directors, the SEC also brought charges against former auditors Aaron Chaitovsky ( Chaitovsky ) and Robert Glass ( Glass ) regarding their failure to properly report financial frauds at Appoline.com, Inc., stating: Chaitovsky and Glass failed to take the steps required by Section 10A of the Exchange Act. In particular, Chaitovsky and Glass failed to determine whether it was likely an illegal act had occurred, and, if so, to consider the possible effect of the illegal act on AppOnline's financial statements. Chaitovsky and Glass also failed to take appropriate remedial action, including, informing the appropriate level of AppOnline management and assuring that AppOnline's audit committee was adequately informed with respect to the illegal act. In re. David Decker CPA and Theodore Fricke CPA (AAER Rel. No. 1762, April 24, 2003) In this administrative proceeding under Rule 102(e) of the Commission s Rules of Practice, David Decker ( Decker ) and Theodore Fricke ( Fricke ), former partners in the accounting firm of BKR Metcalf Davis, were charged with violating Section 10A of the Exchange Act in connection with their audit of the 4

5 financial statements of Chancellor Corporation. In the complaint, the SEC alleged that Decker and Fricke had information concerning a potential fraud and: [T]hey willfully violated Section 10A(a)(1) by failing to design appropriate audit procedures to determine whether or not senior management had committed fraud. Decker and Fricke willfully violated Section 10A(b)(1) when they failed to inform Chancellor's audit committee of the suspected senior management fraud. SEC v. KPMG LLP, Joseph T. Boyle, Michael A. Conway, Anthony P. Dolanski, and Ronald A. Safran (Lit. Rel , January 29, 2003) In the pending civil complaint, he SEC has alleged, among other claims, violations of Section 10A by the registered public accounting firm and four of its partners, stating: Defendants KPMG LLP ("KPMG") and certain KPMG partners permitted Xerox Corporation ( Xerox ) to manipulate its accounting practices and fill a $3 billion "gap" between actual operating results and results reported to the investing public from 1997 through The KPMG defendants were not the watch dogs on behalf of shareholders and the public that the securities laws and the rules of the auditing profession required them to be. Instead of putting a stop to Xerox's fraudulent conduct, the KPMG defendants themselves engaged in fraud by falsely representing to the public that they had applied professional auditing standards to their review of Xerox's accounting, that Xerox's financial reporting was consistent with Generally Accepted Accounting Principles ("GAAP") and that Xerox's reported results fairly represented the financial condition of the company. Section 10A of the Exchange Act requires a public accountant conducting an audit of a public company such as Xerox to: (i) determine whether it is likely that an illegal act occurred and, if so; (ii) determine what the possible effect of the illegal act is on the financial statements of the issuer; and (iii) if the illegal act is not clearly inconsequential, inform the appropriate level of management and assure that the Audit Committee of the client is adequately informed about the illegal act detected. If neither management nor the Audit Committee takes timely and appropriate remedial action in response to the auditor's report, the auditor is obliged to take further steps, including reporting the likely illegal act to the Commission. In re, Grant Thornton LLP, Doeren, Mayhew & Co, P.C., et al. (Lit. Rel. No , January 20, 2004) In this administrative proceeding, the SEC alleged violations of Section 10A of the Exchange Act by Grant Thronton and Doeren Mayhew in connection with the audit of MCA Financial Corporation s financial statements for its fiscal year ended January 31, 1998, stating that: Grant Thornton, Doeren Mayhew, [et al.] violated or caused and aided and abetted violations of Section 10A of the Exchange Act. While conducting the 1998 MCA audit, they detected or otherwise became aware of information indicating that illegal acts had or may have occurred.however, they failed to inform MCA's Board of Directors about the illegal acts that were detected or otherwise came to their attention. 5

6 What started as proceedings against individual auditors has progressed of late to actions brought against individuals and registered public accounting firms. In remarks before the AICPA on December 12, 2002, SEC Director of the Division of Enforcement Stephen M. Cutler stated: I believe the Commission should recalibrate its enforcement approach when it comes to audit firms. It is time to adopt a new enforcement model a new paradigm: one that holds an accounting firm responsible for the actions of its partners. The message has reached the intended audience independent auditors of SEC registrants. The scene is set for more Section 10A issues and reporting. All is not well I doubt some foul play. Act Two: Something Is Rotten In The State of Denmark Section 10A is triggered when the independent auditor detects or otherwise becomes aware of information indicating that an illegal act has or may have occurred. AICPA SAS No. 99, Consideration of Fraud in a Financial Statement Audit requires that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. As stated in SAS No. 99, the auditor s consideration of illegal acts and responsibility for detecting misstatements from illegal acts (as defined in AICPA SAS No. 54, Illegal Acts by Clients) that have a direct and material effect on the determination of financial statement amounts is the same as that for errors or fraud. The language used in SAS Nos. 54 and 99 (i.e., having a direct and material effect on the determination of financial statement amounts ) is the precise language used in Section 10A (a)(1) regarding audit requirements. Information concerning a possible illegal act involving financial statement amounts may be developed by: the independent auditors in the course of performing their audit procedures; internal auditors in connection with their reviews of controls and compliance with company policies and procedures; management or employees as a result of review of transactions, supervision of accounting activities, or application of controls and procedures; whistle-blowers as a result of communications through compliance reporting systems or made directly to senior management or directors; and compliance officers or general counsel in the performance of the duties. However developed, information concerning possible illegal acts involving financial statement amounts must be communicated promptly to the independent auditors. Sarbanes-Oxley Section 303, Improper Influence on Conduct of Audits, states in subpart (a): It shall be unlawful for any officer, director, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading. In Exchange Act Rel. No , the SEC issued their final rule: Improper Influence on Conduct of Audits, which revised 17 CFR Part 240, General Rules and Regulations, Securities Exchange Act of 6

7 1934, Section b2-2, Representations and conduct in connection with the preparation of required reports and documents, as follows: (a) No director or officer of an issuer shall, directly or indirectly: (1) Make or cause to be made a materially false or misleading statement to an accountant in connection with; or (2) Omit to state, or cause another person to omit to state, any material fact necessary in order to make statements made, in light of the circumstances under which such statements were made, not misleading, to an accountant in connection with: (i) Any audit, review or examination of the financial statements of the issuer required to be made pursuant to this subpart; or (ii) The preparation or filing of any document or report required to be filed with the Commission pursuant to this subpart or otherwise. (b)(1) No officer or director of an issuer, or any other person acting under the direction thereof, shall directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence any independent public or certified public accountant engaged in the performance of an audit or review of the financial statements of that issuer. Not to communicate promptly to the independent auditors any potential illegal act that might have a direct and material effect of financial statement amounts risks violating Sarbanes-Oxley Section 303 and the SEC s final rule on Improper Influence on Conduct of Audits. As stated in Section 10A, such illegal acts must be considered by the independent auditor whether or not perceived to have a material effect on the financial statements; and the auditor s response of investigation and reporting to management (and assuring that the audit committee or board of directors also is adequately informed) is required by Section 10A, unless the illegal act is clearly inconsequential [emphasis added]. The terms whether or not perceived to have a material effect, and unless clearly inconsequential work in tandem to make it virtually impossible not to communicate any information regarding a potential illegal act to the independent auditors without violating Section 10A and Sarbanes-Oxley Section 303. Once aware of such a potential illegal act, independent auditors have little choice but to report the matter to senior management and the audit committee or board of directors, thus triggering the need for a prompt and appropriate management response including proper investigation and effective remedial actions. This is because the standard for not reporting unless clearly inconsequential is, in practice difficult (if not impossible) to judge or meet, and the risks of not reporting, to the independent auditor, are too great. Without proper investigation it typically is impossible to know, with any reasonable certainty, that a perception of immateriality is correct. Many a massive financial fraud has been detected starting with a seemingly insignificant discovery of a small accounting irregularity, a minor violation of controls or procedures, or what at first impression appears to be inconsequential. The term clearly inconsequential means 7

8 clearly to the independent auditors who ultimately must judge whether to communicate about the possible illegal act to senior management and the audit committee or directors. Seems! Nay it is; I know not seems. Act Three: The Play s The Thing Wherein I ll Catch The Conscience Of The King Now senior management and directors must act, upon being informed by the independent auditors of a possible illegal act. Such information may come by way of the auditor s own detection of a potential accounting irregularity of illegal act, or it may already be known by management through other means. But, the independent auditor s notification and communication is an official action that sets in motion the wheels of Section 10A. Once the independent auditor s communicate to senior management and assure that the audit committee or board of directors are informed, the clock begins to run: for making a prompt and appropriate response, and for taking prompt and effective remedial action. Section 10A imposes no reporting duty to the SEC unless management and directors fail to take timely and appropriate remedial action. In practice, proper response includes: investigation; measurement of the effect of the illegal act on financial statement amounts; assessment of possible misconduct by officers, management or employees; identification of any weaknesses in, or violations of, controls and procedures in respect of the illegal act; and remedial accounting and reporting, control, and personnel actions if warranted. In a number of recent cases where the independent auditors did not resign such as Ahold, McKesson HBOC, and Xerox the auditors suspended their audit work until satisfied that a proper investigation had been conducted and appropriate remedial actions were being taken. Such a circumstance of the auditors suspending their examination in and of itself may be a material event requiring disclosure in a press release and/or filing with the SEC on Form 8-K (or Form 6-K for foreign registrants). In the matter of Xerox, that registrant filed the following report on Form 8-K, Item 5, dated April 2, 2001: Registrant today said that the filing of its year K report would be delayed. This delay relates to an internal review begun last week by Registrant's Audit Committee, in cooperation with Registrant's auditors, KPMG. This will permit a fuller audit review than previously contemplated and a sign-off on the Registrant's 2000 financial statements. KPMG has advised Registrant that it believes that such fuller review is needed for it to satisfy its auditing responsibilities. In the matter of Ahold, the onset of investigations resulted in the company s independent auditors going one step further, withdrawing their audit opinions on previously issued financial statements, as was reported by the registrant on a Form 6-K filed with the Commission dated March 6, 2003, as follows: Koninklijke Ahold N.V. (the "Company") received a letter in Dutch from 8

9 Deloitte & Touche Accountants ("Deloitte"), the Company's independent auditor, dated February 24, 2003 (the "D&T Letter") announcing that Deloitte no longer maintains its auditors' opinions in connection with the annual accounts of the Company for 2000 and 2001 and it no longer permits publication of those opinions. In a number of instances, the current auditor s resigned (or were terminated) as a result of investigations into accounting irregularities and illegal acts including the matters of Adelphia, Health South, Parmalat and WorldCom resulting in the issuer having to engage new auditors and sustaining additional costs and delays in obtaining audited financial statements. In one particular matter, in re Cronos Group (AAER 1587, dated July 2, 2002), the SEC commented on a situation in which the independent auditors resigned specifically because management refused to take prompt and appropriate remedial action as required by Section 10A, stating: Arthur Andersen requested that the board undertake an investigation of the $1.5 million payment [potential illegal act] and all related party transactions of prior years and that it provide a copy of the Counsel's investigation report. Andersen cautioned that if it did not receive an adequate response by January 28, it would take appropriate steps pursuant to Section 10A of the Exchange Act, including resignation from the engagement. On the 28 th the board responded, stating that since the $1.5 million had been returned to the company, no further investigation was warranted. [Management] reiterated this position to Andersen on the 31 st. On February 3, 1997, Andersen resigned as auditor and provided the company the report required by Section 10A of the Exchange Act. Whatever remedial actions are required, they need to be taken seriously by management and directors, done promptly and effectively, and undertaken in complete cooperation (including the fullest measure of communication) with the independent auditors. Usually there are no good outcomes from Section 10A: at best there are only lesser degrees of bad ones; and, in worst cases, the process can lead to significant delays in completions of audits, the need to disclose the material event(s) of suspension of audit work and commencement of investigations, required remedial financial accounting and reporting, controls and personnel actions, or auditor resignations (along with reporting to the SEC regarding the reasons for such). In the dead, vast and middle of the night. Act Four: To Be, Or Not To Be, That Is The Question In Section 10A matters, the independent auditors have the last word: regarding whether they will complete their audit; as to what additional auditing procedures they may perform; concerning what form of opinion they will issue of the financial statements, given the investigation findings and remedial actions taken by management; and ultimately, whether the remedial actions taken were appropriate. To report, or not report, 9

10 under Section 10A solely is the province of the independent auditors. Under Section 10A, this determination is made on the basis to answers to three critical questions: 1. Does the illegal act have a material effect on the financial statements of the issuer? 2. Has management (and the directors) taken timely and appropriate remedial actions? 3. Will failure to take appropriate remedial action warrant departure from a standard (i.e., unqualified opinion) report of the auditor, or warrant resignation from the audit engagement? Considering Materiality of Effect Materiality (or immateriality) now is viewed through the lens of SEC Staff Accounting Bulletin ( SAB ) No. 99, Materiality, and no longer (if ever) depends solely on quantitative measures. In SAB No. 99, citing extensively to accounting literature and court opinions, the SEC staff propounds the following central concept: Under the governing principles, an assessment of materiality requires that one views the facts in the context of the surrounding circumstances, as the accounting literature puts it, or the total mix of information, in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the total mix includes the size in numerical or percentage terms of the misstatement, it also includes the factual context in which the user of financial statements would view the financial statement item. In SAB No. 99, the SEC staff provides non-exhaustive list of factors that should be considered in assessing materiality, and states: Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are whether the misstatement affects the registrant's compliance with regulatory requirements or whether the misstatement involves concealment of an unlawful transaction [emphasis added]. In practice, the amounts need not be material if the circumstances involve violations of laws or regulations. But, how small is small (or rather, what might be clearly inconsequential in the eyes of the SEC)? In a case sounding in FCPA violations, in re Triton Energy (AAER 889, February 27, 1997), the SEC calculated that Triton Indonesia, a wholly-owned subsidiary of Triton Energy, had made illegal payments to government officials or agents totaling approximately $450,000 over a twoyears time period. The SEC charged Triton s president and director, senior vice-president and CFO, controller of the Indonesian subsidiary and various other individuals with violations of FCPA and the books and records provisions of the Exchange Act. In the relevant years, the alleged amount of illegal payments was less than 1 tenth of one percent of Triton s revenues, less than three percent of Triton s reported net loss, and less than three percent of Triton Indonesia s segment sales. Quantitatively immaterial, perhaps; but, the $450,000 in payments represented: unlawful transactions, non- 10

11 compliance with regulatory requirements, and misconduct by a director and officer and other members of management. What a falling off was there. Assessing Whether Remedial Actions Are Appropriate Timely and appropriate remedial action depends on the circumstances; and Section 10A does not define what is meant by appropriate remedial action. However, the AICPA provides some broad guidance in SAS No. 54, Illegal Acts by Clients, paragraph 17 (AU ), which states: Possible remedial actions include disciplinary action against involved personnel adoption of preventative or corrective company policies, and modification of specific control activities. Paragraph 15 of SAS No. 54 (AU ) also states that: The auditor should evaluate the adequacy of disclosure in the financial statements. Thus, basic responses that the independent auditor looks for are: remedial accounting and reporting, control and personnel actions. But, the most fundamental response that auditor s expect in Section 10A situations is an investigation by senior management (that is are not involved in the matter at hand) and/or the issuer s directors (through the board of directors audit committee or a special committee established for this purpose), typically assisted by legal counsel (and, if necessary, other advisors such as forensic accountants). In a monograph by Harvey L. Pitt (former Chairman of the SEC and, at the time of this writing, a senior partner in the law firm of Fried, Frank, Harris, Shriver & Jacobson), Karl A. Groskaufmanis and Vasiliki Tsaganos, Talking The Talk And Walking The Walk: Directors Duties To Uncover And Respond To Management Misconduct, submitted for the Glasser Legal Works Conference on Corporate Compliance and the FCPA (1997), the authors assay the Investigative Process, and write: All indications of significant wrongdoing should be followed up on behalf of the Board. Particularly when the misconduct relates to senior management, and the issues raised are undoubtedly significant, the board should consider its own internal inquiry into the salient facts. Upon notice of significant wrongdoing, the company should immediately review and assure the proper functioning of its compliance program. The Board should consider whether any disclosure, either to investors or to the outside auditors, is necessary or appropriate under the circumstances. Whether or not the investigation is expected to have a material impact on the company s financial statements, the Board should consider disclosure at least on an informal basis to the company s auditors. Investigations should be: objective, neutral, and independent (in that independent directors, special counsel and other advisors are independent of the matters and individuals under investigation); thorough and professional; and, unlimited as to scope. Investigations usually require a collaboration among special legal counsel, advisors (e.g., forensic accountants) to special counsel, management (and the directors), and the independent auditors. Inadequate communication with the auditors, failure to provide 11

12 competent and sufficient evidence supporting the findings and conclusions of the investigation, and recalcitrance (or excessive defensiveness) lead to auditor mistrust, the need for extensive additional audit work, or even auditor resignation. The time is out of joint; O cursed spite That ever I was born to set it right! Act Five: The Rest Is Silence If a proper Section 10A investigation is conducted and appropriate remedial actions are taken, there is no need for independent auditors to report further that is, the auditors have no duty to communicate to the SEC. If a proper investigation is not conducted and/or appropriate actions are not taken, the auditor has no choice but to report to the directors and/or to the SEC. The issuance of such a Section 10A report is disastrous. In almost every case it will lead to a formal SEC investigation. The report will be made public, and its effect on a company s stock price could be severe. Such an unfortunate outcome could well lead to auditor resignation, resulting in delays in obtaining audited financial statements. In subsequent auditor communications to the SEC, the auditor s concerns regarding any accounting irregularity or illegal act will come out. In today s post-enron, post-sarbanes-oxley environment, any Section 10A reporting by independent auditors also is likely to interest the DOJ. No good can come of any circumstance where auditors are forced to report under Section 10A. It is not nor it cannot come to good Appropriate and timely response, objective and independent investigation, effective remedial action are the keys to complying with Section 10A. Good communications and close coordination and cooperation among directors and management, outside counsel, and the independent auditors are critical to achieving the best possible result when Section 10A circumstances arise. No one wants to have a Section 10A circumstance befall a company, its directors and management and its independent auditors; but, these circumstances can and do arise. And, they must be dealt with. Audit Committees and independent auditors that plan with management for what should happen in these circumstances will be much better prepared for when Section 10A comes into play. O! Woe is me, To have seen what I have seen, see what I see! 12

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