Compliance Hotline

PCAOB Proposes Ethics Rules for Auditors

The Public Company Accounting Oversight Board has voted unanimously to propose ethics and auditor independence rules concerning independence, tax services, and contingent fees. The proposed rules fall into three areas. First, the proposed rules would identify three circumstances in which the provision of tax services impairs an auditor's independence:

• Proposed Rule 3521 would treat registered public accounting firms as not independent of their audit clients if they enter into contingent fee arrangements with those clients.
• Proposed Rule 3522(a) and (b) would treat a registered public accounting firm as not independent from an audit client if the firm provides services related to planning or opining on the tax consequences of a transaction that is a listed or confidential transaction under Treasury regulations. In addition, proposed Rule 3522(c) includes a provision that would treat a registered public accounting firm as not independent if the firm provides services related to planning or opining on a transaction that is based on an aggressive interpretation of applicable tax laws and regulations.
• Proposed Rule 3523 would set a new requirement to treat a registered public accounting firm as not independent if the firm provided tax services to officers in a financial reporting oversight role of an audit client.

Second, the proposed rules would further implement SOX's pre-approval requirement by strengthening the auditor's responsibilities in connection with seeking audit committee pre-approval of tax services. Specifically, proposed Rule 3524 would require a registered public accounting firm that seeks such pre-approval to supply the audit committee with certain information; discuss with the audit committee the potential effects of the services on the firm's independence, and to document the substance of that discussion.

Third, the rules lay a foundation for the Board's independence rules. Specifically, proposed Rule 3502 would codify, in an ethics rule, the principle that persons associated with a registered public accounting firm should not cause the firm to violate relevant laws, rules, and professional standards due to an act or omission the person knew or should have known would contribute to such violation. Proposed Rule 3520 would include a general obligation requiring registered public accounting firms to be independent of their audit clients throughout the audit and professional engagement period.  A copy of the proposed rules can be seen at www.pcaobus.org/ Rules_of_the_Board/Documents/Docket_017/Release2004-015.pdf 

Second Circuit Rules That SOX Does Not Revive Expired Fraud Claims

In a case of first impression for an appellate court, the Second Circuit has ruled that ' 804 of Sarbanes Oxley, which extends the statute of limitations for private securities fraud cases, does not serve to revive previously expired securities fraud claims. Aetna Life Insurance Co. v. Enterprise Mortgage Acceptance Co. LLC (In re Enterprise Mortgage Acceptance Co. LLC Securities Lit.), No. 03-9261 (Dec. 6).

Under ' 804 of SOX, the statute of limitations for private securities fraud cases was extended from the longer of 1-year-from-the-date-of-occurrence or 3 years from the date of discovery to the longer of 2-years-from-the-date-of-occurrence or 5 years from the date of discovery. Two separate district courts, however, ruled that ' 804 does not revive expired securities fraud claims that were initiated prior to the passage of SOX. Here, the plaintiffs in one case appended additional claims and, in the other, joined an additional defendant, to try to take advantage of SOX's extended statute of limitations.

In affirming the district courts, the Second Circuit held that the legislative history did not clearly demonstrate Congressional intent for retroactive application of ' 804, and that reviving previously stale securities fraud claims has an impermissible retroactive effect. Under Landgraf v. USI Film Products, 511 U.S. 244 (1994), the Supreme Court established a two-part test for determining whether a statute applies retroactively. First, a court must determine if Congress expressly prescribed the statute's proper reach. If the statute is ambiguous or contains no such express command, the second step is to determine if the statute would have retroactive effect, ie, whether it would impair rights a party possessed when he acted, increase a party's liability for past conduct, or impose new duties with respect to transactions already completed. If the statute, as applied, would have any such effects, it will not be applied retroactively without clear congressional intent to the contrary.

Looking at the plain language of ' 804, the court noted that it “does not unambiguously revive previously stale securities fraud claims,” and its “legislative history does not suggest that Congress intended to provide for retroactive application.” Turning to the next prong of Landgraf, the court examined whether extending the statute of limitations to revive expired claims would have a “retroactive effect” and the court concluded that it would. Because neither the language nor the legislative history of ' 804 requires retroactive application to revive plaintiffs' previously expired securities fraud claims the court deferred to the longstanding presumption against retroactive application.

CEO's Misstatement Regarding His Education Does Not Support Securities Fraud Claim

The Fourth Circuit has ruled that a corporation's chief executive officer misstatements about his educational credentials were not enough to support a federal securities fraud claim. Greenhouse v. MCG Capital Corp., No. 03-2318 (Dec. 21).

The founder and CEO of a venture capital company misled a public corporation into believing that he was awarded a college degree when, in truth, he never obtained one. Consequently, the company misrepresented his educational background in the documents publicly filed for investors. After being pressured by a reporter, the CEO disclosed the truth about his background and the company corrected its statements. This caused a sharp but temporary drop in the company's stock price, prompting investors to file a complaint for securities fraud under SEC Rule 10b-5 and Section 11(a) of the Securities Act of 1933. The district court dismissed the case, finding as a matter of law that the statements regarding the CEO's education were immaterial.

The Fourth Circuit affirmed. Rule 10b-5 and Section 11(a) both require that a securities-fraud suit allege a fact that is both untrue and material. The court noted that while “these laws prohibit any misrepresentation of a fact deemed material … they decidedly do not prohibit any misrepresentation — no matter how willful, objectionable, or flatly false — of immaterial facts, even if it induces reactions from investors that, in hindsight or otherwise, might make the misrepresentation appear material. It follows that no matter the attendant outcry or opprobrium about a lie, if the specific fact misrepresented is immaterial, a suit cannot succeed.” The test for materiality in the securities-fraud context was established by the Supreme Court in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), which states that a fact is material if there is “a substantial likelihood that the disclosure of the … fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” To this end, the court pointed out that “a 'reasonable investor' is neither an ostrich, hiding her head in the sand from relevant information, nor a child, unable to understand the facts and risks of investing.” The court concluded that while it was not holding as “a matter of law that a key manager's education could never be material,” it was here. The court stated that a reasonable investor would likely value information such as the years of management in financial institutions of the CEO and other board members, earnings and other financial data, or the strength of competition. There was, however, no credible theory presented as to why the failure of the CEO to complete his fourth year of college would constitute something so important that it would alter the total mix of information available to a reasonable investor.

Company That Withdraws Its SEC Registration Is Not Subject to SOX Jurisdiction

A Labor Department administrative law judge has ruled that where a company requested withdrawal of its SEC registration before approval was effected, the company was not SEC registered and not subject to jurisdiction under ' 806 of Sarbanes Oxley. Roulett v. American Capital Access, DOL ALJ, No. 2004-SOX-78 (Dec. 22).

The whistleblower provision of SOX covers only companies with a class of securities registered under section 12 of the Securities Exchange Act of 1934 or companies required to file reports under section 15(d) of the Securities Exchange Act of 1934. Moreover, the ALJ also stated that “[t]he statute clearly contemplates that a registration shall not become effective until it is approved by the relevant exchange authorities who then must certify to the SEC that the security has been approved.” Therefore, since the complainant's employer filed and then subsequently withdrew its registration statement it would not qualify as effective registration. The ALJ also found “little merit” in the argument that SOX extends to the respondent's activities because it is a “company representative” for publicly traded companies. The regulations define “company representative” as “any officer, employee, contractor, subcontractor, or agent of a company.” But, “[t]he fact that publicly traded companies rely upon respondent's services and purchase its products does not make respondent their contractor, subcontractor or agent.” The ALJ recognized that the respondent's activities could potentially affect the financial welfare of the publicly traded companies with which it does business, but SOX also provides specific requirements for its coverage, which the ALJ would not expand. “In fact,” the ALJ noted, “coverage under the Act has been found not to lie in circumstances where companies are much closer related than those proposed by Complainant, such as where a subsidiary of a publicly traded company is not itself publicly traded.”

PCAOB Proposes Ethics Rules for Auditors

The Public Company Accounting Oversight Board has voted unanimously to propose ethics and auditor independence rules concerning independence, tax services, and contingent fees. The proposed rules fall into three areas. First, the proposed rules would identify three circumstances in which the provision of tax services impairs an auditor's independence:

• Proposed Rule 3521 would treat registered public accounting firms as not independent of their audit clients if they enter into contingent fee arrangements with those clients.
• Proposed Rule 3522(a) and (b) would treat a registered public accounting firm as not independent from an audit client if the firm provides services related to planning or opining on the tax consequences of a transaction that is a listed or confidential transaction under Treasury regulations. In addition, proposed Rule 3522(c) includes a provision that would treat a registered public accounting firm as not independent if the firm provides services related to planning or opining on a transaction that is based on an aggressive interpretation of applicable tax laws and regulations.
• Proposed Rule 3523 would set a new requirement to treat a registered public accounting firm as not independent if the firm provided tax services to officers in a financial reporting oversight role of an audit client.

Second, the proposed rules would further implement SOX's pre-approval requirement by strengthening the auditor's responsibilities in connection with seeking audit committee pre-approval of tax services. Specifically, proposed Rule 3524 would require a registered public accounting firm that seeks such pre-approval to supply the audit committee with certain information; discuss with the audit committee the potential effects of the services on the firm's independence, and to document the substance of that discussion.

Third, the rules lay a foundation for the Board's independence rules. Specifically, proposed Rule 3502 would codify, in an ethics rule, the principle that persons associated with a registered public accounting firm should not cause the firm to violate relevant laws, rules, and professional standards due to an act or omission the person knew or should have known would contribute to such violation. Proposed Rule 3520 would include a general obligation requiring registered public accounting firms to be independent of their audit clients throughout the audit and professional engagement period.  A copy of the proposed rules can be seen at www.pcaobus.org/ Rules_of_the_Board/Documents/Docket_017/Release2004-015.pdf 

Second Circuit Rules That SOX Does Not Revive Expired Fraud Claims

In a case of first impression for an appellate court, the Second Circuit has ruled that ' 804 of Sarbanes Oxley, which extends the statute of limitations for private securities fraud cases, does not serve to revive previously expired securities fraud claims. Aetna Life Insurance Co. v. Enterprise Mortgage Acceptance Co. LLC (In re Enterprise Mortgage Acceptance Co. LLC Securities Lit.), No. 03-9261 (Dec. 6).

Under ' 804 of SOX, the statute of limitations for private securities fraud cases was extended from the longer of 1-year-from-the-date-of-occurrence or 3 years from the date of discovery to the longer of 2-years-from-the-date-of-occurrence or 5 years from the date of discovery. Two separate district courts, however, ruled that ' 804 does not revive expired securities fraud claims that were initiated prior to the passage of SOX. Here, the plaintiffs in one case appended additional claims and, in the other, joined an additional defendant, to try to take advantage of SOX's extended statute of limitations.

In affirming the district courts, the Second Circuit held that the legislative history did not clearly demonstrate Congressional intent for retroactive application of ' 804, and that reviving previously stale securities fraud claims has an impermissible retroactive effect. Under Landgraf v. USI Film Products , 511 U.S. 244 (1994), the Supreme Court established a two-part test for determining whether a statute applies retroactively. First, a court must determine if Congress expressly prescribed the statute's proper reach. If the statute is ambiguous or contains no such express command, the second step is to determine if the statute would have retroactive effect, ie, whether it would impair rights a party possessed when he acted, increase a party's liability for past conduct, or impose new duties with respect to transactions already completed. If the statute, as applied, would have any such effects, it will not be applied retroactively without clear congressional intent to the contrary.

Looking at the plain language of ' 804, the court noted that it “does not unambiguously revive previously stale securities fraud claims,” and its “legislative history does not suggest that Congress intended to provide for retroactive application.” Turning to the next prong of Landgraf, the court examined whether extending the statute of limitations to revive expired claims would have a “retroactive effect” and the court concluded that it would. Because neither the language nor the legislative history of ' 804 requires retroactive application to revive plaintiffs' previously expired securities fraud claims the court deferred to the longstanding presumption against retroactive application.

CEO's Misstatement Regarding His Education Does Not Support Securities Fraud Claim

The Fourth Circuit has ruled that a corporation's chief executive officer misstatements about his educational credentials were not enough to support a federal securities fraud claim. Greenhouse v. MCG Capital Corp., No. 03-2318 (Dec. 21).

The founder and CEO of a venture capital company misled a public corporation into believing that he was awarded a college degree when, in truth, he never obtained one. Consequently, the company misrepresented his educational background in the documents publicly filed for investors. After being pressured by a reporter, the CEO disclosed the truth about his background and the company corrected its statements. This caused a sharp but temporary drop in the company's stock price, prompting investors to file a complaint for securities fraud under SEC Rule 10b-5 and Section 11(a) of the Securities Act of 1933. The district court dismissed the case, finding as a matter of law that the statements regarding the CEO's education were immaterial.

The Fourth Circuit affirmed. Rule 10b-5 and Section 11(a) both require that a securities-fraud suit allege a fact that is both untrue and material. The court noted that while “these laws prohibit any misrepresentation of a fact deemed material … they decidedly do not prohibit any misrepresentation — no matter how willful, objectionable, or flatly false — of immaterial facts, even if it induces reactions from investors that, in hindsight or otherwise, might make the misrepresentation appear material. It follows that no matter the attendant outcry or opprobrium about a lie, if the specific fact misrepresented is immaterial, a suit cannot succeed.” The test for materiality in the securities-fraud context was established by the Supreme Court in Basic, Inc. v. Levinson , 485 U.S. 224 (1988), which states that a fact is material if there is “a substantial likelihood that the disclosure of the … fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” To this end, the court pointed out that “a 'reasonable investor' is neither an ostrich, hiding her head in the sand from relevant information, nor a child, unable to understand the facts and risks of investing.” The court concluded that while it was not holding as “a matter of law that a key manager's education could never be material,” it was here. The court stated that a reasonable investor would likely value information such as the years of management in financial institutions of the CEO and other board members, earnings and other financial data, or the strength of competition. There was, however, no credible theory presented as to why the failure of the CEO to complete his fourth year of college would constitute something so important that it would alter the total mix of information available to a reasonable investor.

Company That Withdraws Its SEC Registration Is Not Subject to SOX Jurisdiction

A Labor Department administrative law judge has ruled that where a company requested withdrawal of its SEC registration before approval was effected, the company was not SEC registered and not subject to jurisdiction under ' 806 of Sarbanes Oxley. Roulett v. American Capital Access, DOL ALJ, No. 2004-SOX-78 (Dec. 22).

The whistleblower provision of SOX covers only companies with a class of securities registered under section 12 of the Securities Exchange Act of 1934 or companies required to file reports under section 15(d) of the Securities Exchange Act of 1934. Moreover, the ALJ also stated that “[t]he statute clearly contemplates that a registration shall not become effective until it is approved by the relevant exchange authorities who then must certify to the SEC that the security has been approved.” Therefore, since the complainant's employer filed and then subsequently withdrew its registration statement it would not qualify as effective registration. The ALJ also found “little merit” in the argument that SOX extends to the respondent's activities because it is a “company representative” for publicly traded companies. The regulations define “company representative” as “any officer, employee, contractor, subcontractor, or agent of a company.” But, “[t]he fact that publicly traded companies rely upon respondent's services and purchase its products does not make respondent their contractor, subcontractor or agent.” The ALJ recognized that the respondent's activities could potentially affect the financial welfare of the publicly traded companies with which it does business, but SOX also provides specific requirements for its coverage, which the ALJ would not expand. “In fact,” the ALJ noted, “coverage under the Act has been found not to lie in circumstances where companies are much closer related than those proposed by Complainant, such as where a subsidiary of a publicly traded company is not itself publicly traded.”