New York State Bar Association
One Elk Street
Albany, NY 12207
518-463-3200
Business Law Section
Committee on Securities Regulation
November 25, 2002
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
E-mail address: rule-comments@sec.gov
Attention: Jonathan G. Katz, Secretary
Re: File No. S7-39-02
Improper Influence on Conduct of Audits,
Release No. 34-46685
Ladies and Gentlemen:
The Committee on Securities Regulation of the Business Law Section of the New York State Bar Association appreciates the Commission's invitation in Release No. 34-46685 (the "Release") to comment on proposed rules to implement Section 303(a) of the Sarbanes-Oxley Act of 2002 (the "Act").
The Committee on Securities Regulation (the "Committee") is composed of members of the New York Bar a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice and in corporation law departments. A draft of this letter was circulated for comment among members of the Committee and the views expressed in this letter are generally consistent with those of the majority of members who reviewed and commented on this letter in draft form. The views set forth in this letter, however, are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association or its Business Law Section.
The Committee supports the goal of Section 303 of the Act and the proposed amendments of Rule 13b2-2, which is to safeguard the independent auditor's ability to conduct an audit diligently and report on it accurately. Nonetheless, we have two principal objections to modifications in the statutory standards of fraudulent intent and "acting under the direction" of an officer or director in Section 303 made by the Commission in the proposed rule. In addition, we urge clarification of the meaning of "inaccurate or misleading legal analysis" as an element of conduct constituting a violation of the rule.
First, we believe the Commission is unduly attempting, in the language and interpretation of Rule 13b2-2(b)(1), to remove a purposeful state of mind from the elements of a violation. The purpose standard of Section 303 should be restored in the final rule. Second, while the Commission's interpretation of "acting under the direction" of an officer or director may be appropriate in an employment relationship, it is too broad as applied to third parties. The final rule should provide that actual direction by an officer or director is required for a violation in the case of a third party. Finally, in light of the role of attorneys in representing public companies, advocacy of interpretation and legal analyses should not be the basis for a violation of the rule without specific fraudulent intent.
Since Rule 13b2-2(b) will be enforced only by the Commission, we believe it is especially important that the wording of the final rule, as well as the Commission's interpretive intent relating to it, clearly adopt and incorporate the language and standards for liability contained in Section 303(a) of the Act. We would support the proposed rule provided that the above changes, as discussed in this letter, are made in the final rule.
A. The State of Mind Required for a Violation Should Reflect Fraudulent Intent.
In proposed Rule 13b2-2(b)(1), the Commission has replaced the statutory prohibition on actions "for the purpose of" rendering the issuer's financial statements materially misleading with new language imposing liability for a mental state falling short of actual purpose. In addition, while the proposed rule retains the statutory reference to actions to "fraudulently influence, coerce, manipulate or mislead" the auditors, the Release notes the Commission's view that "fraudulently" modifies only "influence." We object to both the introduction of the non-statutory language and the interpretation of the retained statutory language, since each would reduce unduly the degree of intent required for a violation of Rule 13b2-2(b)(1).
The purpose of rendering financial statements materially misleading should be a required element for violation of Rule 13b2-2(b).
Section 303(a)'s prohibition applies to improper conduct undertaken "for the purpose of" rendering the issuer's financial statements materially misleading. Proposed subparagraph (b)(1) eschews the statutory formulation, and instead would impose liability for improper conduct by a person who "knew or was unreasonable in not knowing that such action could, if successful, result in rendering such financial statements materially misleading." This substitute wording suggests that it would be possible for a person to violate the rule with a state of mind short of fraudulent intent, i.e., merely through reckless or even negligent conduct. The Committee views this liability standard as inconsistent with the purpose and language of Section 303(a).
Section 303(a) is one component of Congress' legislative effort to combat malfeasance by corporate management and others acting under management's direction. This policy goal implies that the behavior sought to be deterred under Section 303(a) is purposive or intentional misconduct; investors are harmed when management and others choose to corrupt the integrity of corporate financial disclosure, including by undermining the audit process. Accordingly, the statute's description of impermissible behavior connotes a meaningful degree of intent: Section 303(a) anticipates rules proscribing "any action to fraudulently influence, coerce, manipulate or mislead" the independent auditor "for the purpose of rendering [the issuer's] financial statements materially misleading" (emphasis added). Given the intent standard that is strongly implied by Congress' language, the Commission would be unwarranted in issuing a final rule that imposed liability for a less purposive state of mind.
We are aware of the argument that departing from an intent-based liability standard is justifiable because Section 303 does not provide for a private right of action. We do not find this rationale persuasive. Apart from the fact that none of the policy, legislative history and language of Section 303(a) indicates that Congress intended the implementing rules to contain a new liability standard, we do not believe, as a practical matter, that the absence of a private right of action meaningfully lessens the deterrent effect of an intent-based liability standard. Since a Commission enforcement action might well be expected to effectively eliminate the defendant's means of livelihood, even an intent-based rule would strongly encourage honest conduct toward the auditors.
For the above reasons, final Rule 13b2-2(b)(1) should restore the statutory language "for the purpose of".1
The Commission's interpretation of "fraudulently influence, coerce, manipulate or mislead" would modify the statutory standard and should be retracted.
Proposed subparagraph (b)(1) remains faithful to the language of Section 303(a) in prohibiting action by senior management and others to "fraudulently influence, coerce, manipulate or mislead" the auditors. Nonetheless, the Release states an interpretive position of the Commission that would, as above, unduly remove a degree of intent from the rule's liability standard.
In note 16 to the Release, the Commission states that it reads "fraudulently" as modifying only "influence" and not "coerce," "manipulate" or "mislead." Underlining the Commission's desire to eliminate intent as an element of a violation, the Release seeks comment on a change to subparagraph (b)(1) (and subparagraph (c)(2)) whereby "fraudulently" would be replaced with "`improperly' or some other word to convey a mental state short of scienter." For the reasons expressed above, the Commission would erode inappropriately the degree of intent required by the rule if it adopted the interpretive approach of note 16 or replaced the word "fraudulently" as suggested. Moreover, there is simply no support in the text of Section 303(a) for limiting the scope of "fraudulently." Had Congress intended this adverb to modify only the first of the four verbs that follow, it would have used the phrase "influence fraudulently, coerce, manipulate or mislead." Congress' intent for a fraud standard to apply to all four verbs is further evidenced by the use in Section 303(a) of the phrase "for the purpose of" rendering the financial statements misleading; this phrase, which implies a fraudulent, intent-based state of mind, follows and therefore effectively modifies the entire litany of verbs. The final rule should retain the word "fraudulently," and the adopting release should retract the Commission's view that this adverb modifies only "influence."
B. Specific Direction by an Officer or Director Should be Required for Conduct by Third Parties to Constitute a Violation of the Rule.
Proposed Rule 13b2-2(b)(1) retains the language of Section 303(a) that anticipates rules prohibiting certain conduct toward the auditors by any person "acting under the direction" of an officer or director. There are two ways in which the Release advances a broad interpretation of this phrase. First, the Commission notes its belief that "acting under the direction" encompasses behavior beyond that of actual supervision by an officer or director.
The Committee does not generally object to this interpretation. Even in the absence of a formal supervisory relationship, it is possible for a member of senior management to convey and exert pressure to enforce his or her desire for certain actions to be taken by other persons. Subject to the caveat we note below, it is appropriate that rules designed to prevent audit-related malfeasance be read flexibly enough to cover this possibility.
The Commission's second interpretive position is that a person may be found to be "acting under the direction" of an officer or director without having received specific directions. This view is evidenced in the first possible change to the wording of subparagraph (b)(1) described in the Release; the Commission suggests replacing "under the direction" of with "at the behest of" or "on behalf of," since this "might better indicate that no specific direction by an officer or director is required to violate the proposed rules." The interpretive position evidenced by this proposed wording change is troublesome.
It may be sensible to permit a violation to be established in the absence of a specific direction where the person acting under an officer's or director's direction is plausibly viewed as within senior management's effective control. The paradigmatic case is that of a mid-level or junior employee. As recent corporate scandals have made lamentably clear, it is possible for senior management to foster a corrupt internal culture in which employees need no explicit instruction to knowingly participate in the creation and dissemination of misleading financial disclosure. By the nature of these circumstances, it might be appropriate for the Commission to be able to assert a Rule 13b2-2(b)(1) violation without pointing to a specific direction, since in essence the direction would be an ongoing, tacit part of the issuer's internal environment.
The same rationale, however, does not apply in the case of third parties. With respect to them, we are not comfortable with the general proposition that liability may exist in the absence of a specific direction.
In the course of an audit, the auditors may make inquiries of parties, such as customers, vendors or creditors, with which the issuer has commercial or financial relationships. The auditor also may seek confirmatory information from outside advisors, such as law firms that represent the issuer. It is conceivable that the auditor could come away from these inquiries with materially incomplete information about the issuer's transactions or liabilities, and thus issue a clean audit report on financial statements that were materially misleading. If the auditor's failure to elicit complete information from a third party resulted from purposive, fraudulent behavior by the third party, liability under the rule would be appropriate; such a case would almost necessarily imply an agreement by the third party to participate in the fraud, in response to a direction or request from senior management.2
It is also possible, though, that the auditor could come away from its inquiries with incomplete information not due to any fraudulent behavior by a third party, but rather because the auditor simply had failed adequately to frame its inquiries or ask questions of the right people. In this case, imposing liability on the third party without evidence of a specific direction from senior management would be a harsh result. Senior management generally does not exert the same degree of effective control over third parties as it does over the employee in the above example. Therefore, the Commission should have to show the existence of a specific direction to which the third party has acquiesced in order to establish liability against the third party. This is consistent with both general principles of fairness and the purpose of the statute, which is to deter and punish actual malfeasance in the audit context.
We are even more concerned by the possibility that the Commission could impose liability on third party professional advisors, such as the attorneys and securities professionals cited in the Release, without needing to show the existence of a specific direction. Absent such a requirement, there is a risk of liability being visited on an issuer's professional advisors as a result of behavior that is inherent to their roles as advocates for the issuer, but that involves no fraudulent intent on their part.
It is not unusual in the context of a transaction involving the issuance of financial statements, such as a securities offering or an acquisition, for the issuer's lawyers, investment bankers or other advisors to engage in vigorous discussions with the auditors over the appropriate accounting treatment of various items. Advisors engage in these discussions to ensure that the auditors have fully considered the treatment of the accounting issues most likely to have a significant impact on the valuation that investors will ascribe to the issuer. While the advisors may articulate as strongly as possible the case for an accounting treatment that will result in a higher valuation for their client, they normally do so without any thought of actually misleading the auditors, much less any directions from senior management to that effect. If, following such conversations, the auditor decides to approve an accounting treatment that is later found to be misleading, the Commission should be required to establish the existence of a specific direction to mislead the auditors in order to impose liability on the advisor. Ultimately the auditor, as a function of its independence, must make its own judgment as to what accounting treatments it will accept for purposes of issuing an audit report. Permitting the Commission to impose liability on advisors absent a specific direction from management would both confuse the issue of who is responsible for issuing an audit report and have an undesirable chilling effect on the willingness of professional advisors to provide strong but legitimate advocacy on behalf of their issuer clients.3
In view of the above, the adopting release should make clear that for third parties to be liable under Rule 13b2-2(b)(1), they must have knowingly misled the auditors in response to the specific direction of an officer or director of the issuer.
C. The Commission Should Clarify that "Inaccurate or Misleading Legal Analysis" Does Not Constitute a Violation of the Rule without Specific Fraudulent Intent.
The Release requests comment on whether the examples of the types of conduct that might constitute improper influence on an auditor, set forth in the Release, should be specifically included in the rule. We believe that the final rule need not contain such a set of examples, since the Commission's illustrative purpose is adequately served by discussing them in the Release. The adopting release should provide guidance, however, about what is meant by "[p]roviding an auditor with inaccurate or misleading legal analysis."
As we discuss in Section B above, there are circumstances in which an issuer's lawyers will press the auditor to consider various accounting treatments. In addition, a response from an attorney may be misleading to the auditor simply because the auditor failed to frame the question properly, without any intent to mislead or awareness that the response would mislead on the part of the attorney. Furthermore, an attorney is often required to respond to an auditor's request, such as in the case of an audit inquiry letter, unlike most other third parties who can chose to disregard a request for information. Finally, a legal response about a very complex transaction necessarily may itself have to be complex, which could be a source of misunderstanding without any intent or knowledge on the part of the attorney.
For the above reasons, the adopting release should clarify the reference to providing misleading or inaccurate legal analysis to indicate that advocacy or a legal analysis without specific fraudulent intent does not fall within the scope of improper influence or a violation of the rule.
* * * * *
We hope the Commission finds these comments helpful. We would be pleased to discuss them with the Staff.
Respectfully submitted,
COMMITTEE ON SECURITIES REGULATION
By Gerald S. Backman
Gerald S. Backman
Chairman of the Committee
Drafting Committee:
Michael J. Holliday, Chair
Philip Bauch
Paul D. Brusiloff
Robert E. Buckholz
Edward H. Cohen
David A. Garbus
Richard E. Gutman
Neila B. Radin
Copy to:
The Honorable Harvey L. Pitt, Chairman
The Honorable Paul S. Atkins, Commissioner
The Honorable Roel C. Campos, Commissioner
The Honorable Cynthia A. Glassman, Commissioner
The Honorable Harvey J. Goldschmid, Commissioner
Alan L. Beller, Esq., Director of Division of Corporation Finance
Giovanni P. Prezioso, Esq., General Counsel
____________________________
| 1 | As is evident by this point, the Committee would object to the third of the possible wording changes on which the Release requests comment. The Commission is apparently considering replacing the phrase in subparagraph (b)(1) (and subparagraph (c)(2)), "if that person knew or was unreasonable in not knowing that such action could, if successful, result in rendering such financial statements materially misleading," with "for the purpose of, or having the effect of, rendering the financial statements materially misleading" (emphasis added). This wording would introduce a state-of-mind element that would be easier for the Commission to establish than that contained in currently proposed subparagraph (b)(1).
| | 2 | One can imagine, for example, a customer entering into a side letter with the issuer providing for the post-sale right to return a product for a refund, or to be reimbursed for subsequent price decreases. If the issuer and the customer agreed to shield this arrangement from the auditors, the audited income statement might show misleadingly high revenues.
| | 3 | The Release indicates that the Commission is considering replacing the phrase "under the direction" with "on behalf of" or "at the behest of." We oppose the first alternative, as it connotes even less need for a specific direction from senior management than does the currently proposed language. The phrase "at the behest of" does not seem meaningfully different from "under the direction," since it indicates some degree of instruction by senior management. For this reason, "at the behest of" would not make the rule clearer on its face; and in any case our concern with that wording would be identical to our concern with "under the direction," i.e., we would object not so much to the language as to the Commission's proposed interpretation of it with regard to third parties.
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