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.