Regulatory: Auditors see increase in SEC Rule 102(e) enforcement activity

Recent proceedings focus on pre-financial crisis audits

Recently, the Securities and Exchange Commission (SEC) has instituted several administrative proceedings against accounting firms and auditors under Rule 102(e) of the Commission’s Rules of Practice for audits of companies—now bankrupt or in financial peril—that occurred in the lead-up to the financial crisis. Just last week in In re John J. Aesoph and Darren M. Bennett, for example, the SEC charged two auditors at KPMG with “improper professional conduct” under Rule 102(e) for their roles in a failed audit of a Nebraska-based bank that hid millions of dollars in loan losses from investors during the financial crisis and was eventually forced to file for bankruptcy. In an SEC news bulletin from Jan. 9, Robert Khuzami, outgoing director of the SEC’s Division of Enforcement, is quoted as saying that the auditors “ignored the red flags surrounding the bank’s troubled real estate loans,” and that “[a]uditors must adhere to professional auditing standards and exercise due diligence rather than merely relying on management’s representations” with respect to the preparation of financial statements. The auditors are now facing temporary or permanent loss of the privilege of appearing or practicing before the SEC. This fallout from the financial crisis, and associated enforcement rhetoric, is causing practitioners to reexamine their potential scope of liability under Rule 102(e), which was, up until now, a little-used weapon in the SEC’s arsenal.  

“Improper professional conduct” under Rule 102(e) has three distinct definitions. The first is “[i]ntentional or knowing conduct, including reckless conduct.” Recklessness under Rule 102(e) must approximate intentional or willful conduct. In this regard, it is akin to the scienter requirements for a securities fraud claim under Section 10(b) of the Securities Exchange Act, and it has been interpreted and applied under that precedent. Making Rule 102(e) more controversial is that there are also two negligence standards under which liability can be found.  The first involves “[a] single instance of highly unreasonable conduct resulting in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted” (emphases added). The second requires a showing of “[r]epeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission” (emphases added). That a form of “negligence-plus” can result in an inability to practice in front of the SEC has created controversy and questions about whether the standard exceeds the scope of the agency’s authority. 

Contributing to the controversy is that what constitutes reasonable versus unreasonable conduct, what components of an audit require heightened scrutiny and what constitutes the proper application of professional standards can be very subjective and, during the course of an audit, requires the exercise of auditor discretion and professional judgment. In determining compliance, the auditor’s conduct must also be considered from the perspective of the time in which the audit was performed, without the benefit of hindsight, which is difficult to accomplish in the context of an enforcement proceeding. This is particularly true when the audit company has subsequently entered bankruptcy and management is being investigated or is accused of fraudulent conduct.

Several Rule 102(e) cases coming out of the financial crisis involve facts similar to Aesoph. In In re Brian Laib, management made representations, the representations proved to be false and became the subject of later litigation or enforcement actions, and the SEC subsequently charged the auditors under Rule 102(e) for failing to discover the misrepresentations. Whether, and to what extent, an auditor should be held accountable for failing to uncover misrepresentation or fraud is a constant tension in the Rule 102(e) context. On one hand, an auditor’s job is to test that representations of management are accurate; on the other hand, management is ultimately responsible for the content of the financial statements and their compliance with U.S. Generally Accepted Accounting Principles. Management is also required to provide the auditors with accurate and complete information, something they typically represent prior to the issuance of an auditor’s opinion. 

Suspension from practice before the SEC is a very harsh sanction for an individual auditor and causes reputational harm to the accounting firm. We should not excuse accountants who acted willfully or turned a blind eye to fraudulent or wrongful conduct by management. But we should also ensure that accountants and accounting firms are not punished for exercising their professional judgment and being second-guessed at a later point in time, under greatly changed circumstances. This is particularly true where management was untruthful and affirmatively misled the auditors. 

Contributing Author

author image

Veronica Rendón

Veronica E. Rendón is a partner in Arnold & Porter’s New York Office in the Securities Enforcement & Litigation Group.

Bio and more articles

Contributing Author

author image

Meredith Esser

Meredith Esser is an associate in the New York Office of Arnold & Porter.

Bio and more articles

Join the Conversation

Advertisement. Closing in 15 seconds.