Implementation of Section 10A of the Securities Exchange Act of 1934

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release No. 34-38387; IC-22553; FR-49; File No. S7-20-96]

RIN 3235-AG70

Implementation of Section 10A of the Securities Exchange Act of

1934

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or

``SEC'') is adopting revisions to its rules to implement the reporting

requirements in section 10A of the Securities Exchange Act of 1934 (the

``Exchange Act''). Section 10A requires, among other things, that the

auditor of an issuer's financial statements report to the issuer's

board of directors certain uncorrected illegal acts of the issuer, and

that the issuer notify the Commission that it has received such a

report. If the issuer fails to provide that notice, the auditor is

required by section 10A to furnish directly to the Commission the

report given to the Board. The amendments to the Commission's Exchange

Act Rules implement those reporting requirements. The Commission also

is adopting revisions to Regulation S-X to conform the definition of

``audit'' in that regulation with the wording in section 10A.

EFFECTIVE DATE: The rule revisions are effective April 17, 1997.

FOR FURTHER INFORMATION CONTACT: Robert E. Burns or W. Scott Bayless,

at (202) 942-4400, Office of the Chief Accountant, Mail Stop 11-3, or

Kathleen Clarke, at (202) 942-0724, Division of Investment Management,

Mail Stop 10-6, Securities and Exchange Commission, 450 Fifth Street,

NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to its

Exchange Act Rules, 17 CFR 240, by adding Rule 10A-1, and

Regulation S-X, 17 CFR 210, by revising Rule 1-02.

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I. Background

Title III to the Private Securities Litigation Reform Act of 1995

(the ``Reform Act''), Public Law No. 104-67, enacted on December 22,

1995, added section 10A to the Exchange Act. As discussed below,

section 10A requires that each audit under the Exchange Act 1

include procedures regarding the detection of illegal acts, the

identification of related party transactions, and the evaluation of the

issuer's ability to continue as a going concern. Section 10A also

codifies certain professional auditing standards regarding the

detection of illegal acts 2 by issuers and imposes expanded

obligations on auditors 3 to report in a timely manner certain

uncorrected illegal acts to an issuer's board of directors. It further

requires the issuer, or if the issuer fails to do so then the auditor,

to provide information regarding the illegal act to the Commission.

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\1\ Because section 10A applies to audits under the Exchange

Act, it and Rule 10A-1 apply to audits of the financial statements

of foreign private issuers that are required under that Act.

\2\ Section 10A(f) defines the term ``illegal act'' broadly to

mean ``an act or omission that violates any law, or any rule or

regulation having the force of law.'' This definition is consistent

generally with Statement on Auditing Standards No. 54, ``Illegal

Acts by Clients,'' para. 2 (January 1, 1989), AU Sec. 317.02, which

states, ``the term illegal acts * * * refers to violations of laws

or governmental regulations.''

\3\ For the purpose of this release, the term ``auditor'' refers

to any independent public or certified public accountant who is

performing or has performed an audit of a registrant's financial

statements and whose audit report has or will be filed with the

Commission in accordance with the federal securities laws or the

Commission's regulations. See, e.g., sections 12(b)(1) (J) and (K),

13(a)(2), and 17(e) of the Exchange Act, 15 U.S.C. 78l(b)(1) (J) and

(K), 78m(a)(2), and 78q(e), and the Commission's Regulation S-X, 17

CFR Sec. 210. The term ``independent accountant'' is used in the

regulatory text in order to be consistent with existing provisions

in Regulation S-X.

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On August 22, 1996, the Commission published for comment proposed

revisions to its rules to implement the reporting requirements set

forth in section 10A and to amend the definition of ``audit'' in

Regulation S-X to conform with the provisions of that section.4

The Proposing Release contains a discussion of each paragraph of

section 10A. Interested parties may wish to refer to the Proposing

Release for additional background information.

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\4\ Securities Exchange Act Release No. 37594, Investment

Company Act Release No. 22162, File No. S7-20-96 (August 22, 1996)

[61 FR 45730] (the ``Proposing Release'').

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More specifically, section 10A(a) provides that each audit required

by the Exchange Act of issuers' financial statements include, ``in

accordance with generally accepted auditing standards, as may be

modified or supplemented from time to time by the Commission--''

1. Procedures designed to provide reasonable assurance of detecting

illegal acts that would have a direct and material effect on the

determination of financial statement amounts;

2. Procedures designed to identify related party transactions that

are material to the financial statements or otherwise require

disclosure therein; and

3. An evaluation of whether there is substantial doubt about the

issuer's ability to continue as a going concern during the ensuing

fiscal year.5

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\5\ Section 10A(a) (1), (2), and (3).

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Certain procedures in each of these three areas already are

required by generally accepted auditing standards (``GAAS'') 6 in

the United States and are further codified in the Statements on

Auditing Standards (``SAS'') 7 adopted by the Auditing Standards

Board (``ASB''), the senior technical body for auditing matters of the

American Institute of Certified Public Accountants (``AICPA''). 8

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\6\ In February 1941, the Commission amended Rule 2-02 of

Regulation S-X, 17 CFR Sec. 210.2-02, to require that the

independent accountant state in his or her report ``whether the

audit was made in accordance with generally accepted auditing

standards * * *'' Accounting Series Release No. 21 (February 5,

1941). In this release, the Commission defined ``generally accepted

auditing standards'' to mean the application of ``generally

recognized normal auditing procedures'' with professional competence

by properly trained persons. The Commission defined ``generally

recognized normal auditing procedures'' to be those normally

employed by skilled accountants and those prescribed by

authoritative bodies dealing with the subject of auditing, such as

accounting societies and governmental bodies having jurisdiction in

the area. Id. Following this addition to the Commission's rules, the

relevant professional committee at the time, the Committee on

Auditing Procedure, began a study to determine which auditing

standards should be included within ``GAAS.'' In 1948, the

membership of the predecessor organization to the American Institute

of Certified Public Accountants (``AICPA'') approved ten standards

as constituting GAAS. See, AICPA, Codification of Statements on

Auditing Standards, AU Sec. 150.02. These ten standards are

supplemented by Statements on Auditing Standards, which currently

are issued by the Auditing Standards Board of the AICPA.

\7\ Currently effective Statements on Auditing Standards are

published by the American Institute of Certified Public Accountants

in the Codification of Statements on Auditing Standards. Provisions

in the Codification are designated as ``AU Sec. __.'' For standards

addressing those procedures mandated by section 10A, see SAS 54,

``Illegal Acts by Clients'' (January 1, 1989), AU Sec. 317; SAS 45,

``Related Parties'' (September 30, 1983), AU Sec. 334; and SAS 59,

64, and 77 reprinted in ``The Auditor's Consideration of an Entity's

Ability to Continue as a Going Concern'' (January 1, 1989), AU

Sec. 341. See also SAS 53, ``The Auditor's Responsibility to Detect

and Report Errors and Irregularities'' (January 1, 1989), AU

Sec. 316. The ASB recently adopted a revision to SAS 53, which will

be entitled ``Consideration of Fraud in a Financial Statement

Audit'' and designated as SAS 82. This new standard should be

published in Spring 1997 and will be applicable to the audits of

1997 financial statements.

\8\ The ASB's 15 members serve on a part-time basis and are

appointed for one year terms that may be extended for up to three

years.

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In addition to the requirement in section 10A(a) that auditors

perform procedures designed to enhance the detection of fraudulent

financial reporting, section 10A(b) contains provisions that would

require an auditor to report directly to the Commission certain

detected illegal acts if the issuer fails to do so.

Under section 10A(b), if, while conducting the audit of the

issuer's financial statements, the auditor becomes aware of information

indicating that an illegal act (whether or not material to the

financial statements) has occurred or may have occurred, then the

auditor would be required, in accordance with GAAS, ``as may be

modified or supplemented from time to time by the Commission,'' to

determine whether it is ``likely'' that an illegal act has occurred

and, if so, its possible effect on the financial statements (including

any contingent monetary effects, such as fines, penalties, and

damages).9 The auditor would be required to inform the issuer's

management of the illegal act ``as soon as practicable.'' In addition,

the auditor must assure him/herself that the issuer's board of

directors is adequately informed, by management or otherwise, of any

detected illegal act.10

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\9\ Section 10A(b)(1)(A). See, SAS 54, Paras. 10-15, AU

Sec. 317.10-.15. Paragraph 11 of SAS 54 sets forth additional audit

procedures that might be necessary once the auditor becomes aware of

a possible illegal act.

\10\ Section 10A(b)(1)(B). See, SAS 54, para. 17, AU

Sec. 317.17.

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Although GAAS contains procedures for similar notification of

illegal acts to managements and boards of directors,11 section

10A(b) contains the additional requirement that these notifications

occur ``as soon as practicable.'' 12

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\11\ See, SAS 54, Paras. 10 and 17, AU Sec. 317.10 and .17.

\12\ The addition of this time period reflects the original

legislative efforts in this area to provide an earlier warning to

the SEC of registrants' potential illegal acts than may occur under

the current Form 8-K procedures, see note 20 infra, and in audit

reports. See H.R. Rep. No. 102-890, 102d Cong., 2d Sess. 3 (1992),

which contained the predecessor legislation to Section 10A and

stated:

This legislation amends the Securities Exchange Act of 1934

(Exchange Act) to improve fraud detection and disclosure with

respect to public companies by codifying auditing standards in

certain specified areas and by providing a mechanism for earlier

warning to the Securities and Exchange Commission of certain illegal

acts by registrants.

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After the auditor determines that the audit committee or the board

of directors has been adequately informed of an illegal act and the

auditor reaches

[[Page 12745]]

three specified conclusions, the auditor is required by section

10A(b)(2) to report those conclusions directly to the board of

directors ``as soon as practicable.'' The three conclusions set forth

in section 10A(b)(2) that trigger the auditor's obligation to report to

the board are that:

1. The illegal act has a material effect 13 on the issuer's

financial statements,

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\13\ The auditor should consider both the quantitative and

qualitative materiality of the act, including contingent liabilities

that might be created by the illegal act. See, e.g., SAS 54, para.

13, AU Sec. 317.13, and SAS 47, ``Audit Risk and Materiality in

Conducting an Audit,'' para. 6 (June 30, 1984), AU Sec. 312.06.

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2. 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

3. The failure to take remedial action is reasonably expected to

warrant either a departure from the auditor's standard audit

report,14 when made, or the auditor's resignation from the audit

engagement.15

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\14\ See, SAS 58, ``Reports on Audited Financial Statements,''

para. 10 (January 1, 1989), AU Sec. 508.10, for a general discussion

of the circumstances that may require the auditor to depart from the

standard report and the types of opinions, other than the standard

report, that may be expressed by the auditor in various

circumstances.

\15\ Section 10A(b)(2) (A), (B), and (C). See generally, SAS 54,

Paras. 18-22, AU Sec. 317.18-.22.

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If the board of directors receives a report that the auditor has

reached these conclusions, then the board has one business day to

notify the Commission that it received such a report. If the auditor

does not receive a copy of the board's notice to the Commission within

that one business day period, then by the end of the next business day

the auditor is required to furnish directly to the Commission a copy of

the report given to the board (or the documentation of any oral report

16).17 The auditor's resignation from the audit engagement

does not negate the auditor's obligation to furnish his or her report

to the Commission in these circumstances.18

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\16\ For documentation requirements under GAAS, see, e.g., SAS

54, para. 17, AU Sec. 317.17, and SAS 61, ``Communication with Audit

Committees,'' para. 3 (January 1, 1989), AU Sec. 380.03.

\17\ Section 10A(b)(3).

\18\ Section 10A(b)(4).

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II. Discussion of Rule Amendments

A. Rule 10A-1.

Rule 10A-1 is based on the premise that the notices and reports

under section 10A are to assist the Commission in performing its

enforcement responsibilities and, therefore, will be non-public.

Disclosure to the public of issuers' illegal acts will continue to be

made in modified audit reports 19 or, when the auditor has

resigned, been dismissed, or elected not to stand for re-election, on

Form 8-K 20 under the Exchange Act and on Form N-SAR 21 under

the Investment Company Act of 1940 (the ``Investment Company Act''),

among others.

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\19\ For the effect of illegal acts on the audit report, see,

SAS 53, Paras. 26 and 27, AU Sec. 316.26 and .27, and SAS 54,

Paras. 18-21, AU Sec. 317.18-.21. See generally, SAS 58, 64, and 79

reprinted in Reports on Audited Financial Statements (January 1,

1989), which describes the standard report and the various opinions

that may be reflected in the auditor's report. SAS 58, Paras. 7-10,

AU Sec. 508.07-.10.

\20\ Item 4 of Form 8-K, 17 CFR Sec. 249.308, Item 304 of

Regulation S-K, 17 CFR Sec. 229.304, and Item 304 of Regulation S-B,

17 CFR Sec. 228.304. In summary, these provisions state that a

registrant must file a Form 8-K, providing the information required

by item 4 of that form, within five business days of the date that

the registrant's auditor (or an independent accountant upon whom the

auditor expressed reliance in its audit report regarding a

significant subsidiary) resigns, declines to stand for re-election,

or is dismissed, and within five business days of the date a new

auditor is engaged. The registrant is to ask the former auditor to

provide the registrant with a letter indicating whether the former

auditor agrees with the disclosures in the Form 8-K that reports the

termination of the audit engagement and, if not, the respects in

which the auditor disagrees. This letter is to be filed with the

Commission as an exhibit by amendment to the registrant's Form 8-K

within 10 business days of the date that the Form 8-K was filed.

The registrant's Form 8-K must state, among other things:

whether the former auditor resigned, was dismissed, or declined to

stand for re-election and the date thereof; whether the auditor

modified his or her report on the registrant's financial statements

for either of the last two fiscal years and, if so, the nature of

the modification; whether the decision to change auditors was

recommended or approved by the audit committee or board of

directors; whether, in connection with the audits of the financial

statements for the two most recent fiscal years, and any subsequent

interim period, there were any disagreements between the auditor and

the registrant on any matter of accounting principles or practices,

auditing scope or procedure, or financial statement disclosure. The

Form 8-K also must provide disclosure of any instance within the

applicable time period where the former auditor advised the

registrant that (1) The internal controls necessary for the

registrant to develop reliable financial statements did not exist,

(2) information had come to the auditor's attention that led him or

her no longer to be able to rely on management's representations, or

that made the auditor unwilling to be associated with the

registrant's financial statements, (3) there was a need to expand

significantly the scope of the audit and, due to the auditor's

resignation or for any other reason, the scope was not expanded, or

(4) information had come to the auditor's attention affecting the

reliability of past audit reports or financial statements and the

issue had not been resolved to the auditor's satisfaction prior to

the auditor's resignation, dismissal, or declination to stand for

re-election.

\21\ Sub-item 77K of Form N-SAR, 17 CFR Sec. 274.101, requires

investment companies filing Form N-SAR to provide the information

required by item 4 of Form 8-K. Sub-item 77K of Form N-SAR notes

that notwithstanding the requirements in Form 8-K to file more

frequently, registrants need only file such information semi-

annually in accordance with the requirements of Form N-SAR.

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In testifying on prior bills that contained the same reporting

requirements, the Commission stated, ``[W]e anticipate that reports

filed under section 10A would be confidential and exempt from

disclosure under the Freedom of Information Act.'' 22 The

Commission further noted,

\22\ Testimony of Richard C. Breeden, Chairman, U.S. Securities

and Exchange Commission, Concerning H.R. 574, The Financial Fraud

Detection and Disclosure Act, Before the Subcommittee on

Telecommunications and Finance of the House Committee on Energy and

Commerce, 103d Cong., 1st Sess., 32 (February 18, 1993).

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Premature disclosure of the issuer and auditor reports could,

among other things, interfere with the Commission's investigation,

deprive the issuer or other persons of the right to a fair trial or

impartial adjudication, constitute an unwarranted invasion of

privacy, or disclose a confidential source. In addition, issuer and

auditor reports under Section 10A might contain confidential

commercial or financial information exempt from disclosure under

FOIA Exemption 4, 5 U.S.C. 552(b)(4).23

\23\ Id., at 32 n. 36.

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The Commission's testimony also states that the direct reporting

provisions in the bill might provide an earlier warning of certain

illegal acts that could allow the Commission to begin enforcement

investigations at an earlier date.24

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\24\ Id., at 31.

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Accordingly, Rule 10A-1 provides that section 10A notices provided

by the board and reports submitted by the auditor will be non-public

and exempt from disclosure under the Freedom of Information Act

(``FOIA'') to the same extent as the Commission's investigative

records.25

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\25\ Rule 10A-1(c). See also 5 U.S.C. 552(b)(7), which exempts

from disclosure certain ``records or information compiled for law

enforcement purposes.''

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Commentators responding to the Proposing Release supported the

position that reports and notices under section 10A should be non-

public. Some suggested, however, that proposed Rule 10A-1 was unclear

as to the availability of FOIA exemptions, in addition to the

exemptions for investigative records, for the information contained in

these notices and reports. An instruction has been added to Rule 10A-

1(c), therefore, specifically to notify issuers and auditors that they

may apply for confidential treatment under additional FOIA exemptions

in accordance with the Commission's normal procedures.26

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\26\ See 17 CFR Sec. 200.83.

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Despite the confidential nature of the reports under section 10A,

these reporting requirements should improve the quality of public

disclosures in

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Forms 8-K and N-SAR and in audit reports on issuers' financial

statements, because it is unlikely that issuers and auditors will make

public disclosures that are incompatible with the confidential reports

made to the Commission. Also, the direct reporting requirements in

section 10A should give auditors additional leverage to prompt

management to correct illegal acts and to make appropriate adjustments

in their financial statements.

Rule 10A-1 designates the Commission's Office of the Chief

Accountant (``OCA'') as the appropriate office to receive the notice

provided by any issuer under section 10A(b)(3) 27 and any reports

provided by auditors under section 10A(b)(3) or 10A(b)(4).28 No

commentators objected to OCA as the designated party to receive these

notices and reports. OCA expeditiously will forward copies of the

notice or report to all appropriate offices and divisions within the

Commission. The notice or report may be provided to other authorities,

as appropriate.29

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\27\ Rule 10A-1(a).

\28\ Rule 10A-1(b).

\29\ See 17 CFR Sec. 240.24c-1.

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Delivery of the notice or report to OCA may occur under Rule 10A-1

in any manner, provided the notice or report is received by OCA within

the statutory time period.30 Currently, the most timely manner of

delivery may be through submission of a facsimile,31 telegraph, or

personal delivery. Issuers should be aware that providing such

information on the Edgar filing system, however, may result in the

information becoming available to the public. In the future, procedures

may be developed for issuers and auditors to deliver confidential

information directly to OCA via electronic mail. Rule 10A-1 would

permit use of such means of delivery.32

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\30\ Rule 10A-1 (a) and (b).

\31\ The phone number for OCA's facsimile machine currently is

(202) 942-9656. Such phone numbers, however, are subject to change

without notice and registrants and auditors should verify the

accuracy of the number before use.

\32\ A similar provision applies to auditors of broker-dealers.

See Rule 17a-5(h)(2) under the Exchange Act, 17 CFR Sec. 240.17a-

5(h)(2), which states that if, during the course of audit or interim

work, the auditor determines that any material inadequacies exist in

the accounting system, internal accounting control, procedures for

safeguarding securities, or certain other practices and procedures,

then the auditor shall call those inadequacies to the attention of

the chief financial officer of the broker-dealer, who has the

obligation to notify the Commission and the designated examining

authority within 24 hours thereafter. If the auditor does not

receive a copy of that notice within that 24 hour period, or if the

auditor disagrees with the statements in the notice, then the

auditor must inform the Commission and the designated examining

authority of the material inadequacy within the next 24 hours.

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Rule 10A-1(a) also sets forth the required contents for a issuer's

notice to the Commission. This notice must be in writing and identify

the issuer and the auditor, and state the date the auditor made its

report to the board. Under the rule proposal, the issuer also would

provide a summary of the report. The summary would describe the act and

the potential impact of that act on the issuer's financial statements.

This information is consistent with the requirement under GAAS that the

auditor's communication with the issuer's audit committee ``should

describe the act, the circumstances of its occurrence, and the effect

on the financial statements.'' 33 One commentator suggested that

issuers have the option of providing either the summary of the

independent accountant's report, as proposed, or directly providing

that report to OCA. This commentator noted, however, that if an issuer

submits the independent accountant's report to OCA a question may arise

regarding the availability to the independent auditor of the section

10A(c) protection against civil liability for the findings,

conclusions, or statements in his or her report.34 As adopted,

Rule 10A-1 incorporates the commentator's suggestion and permits

issuers the option of providing either a summary of the independent

accountant's report or a copy of that report. To clarify the

application of the section 10A(c) safe harbor, Rule 10A-1 now provides

that the safe harbor available to auditors shall apply not only when

the report is furnished to OCA by the auditor but also when it is

provided by the issuer.

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\33\ SAS 54, para. 17, AU Sec. 317.17.

\34\ Section 10A(c) limits auditors' liability in private rights

of action for ``any finding, conclusion, or statement expressed in a

report made pursuant to paragraph (3) or (4) of subsection (b),

including any rule promulgated pursuant thereto''; paragraphs (3)

and (4) of subsection (b) set forth the issuer and auditor reporting

obligations.

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As had been proposed, Rule 10A-1(a) also specifically permits an

issuer to include additional information with the required notice to

the Commission regarding the issuer's view of, and response to, the

section 10A report it has received from the auditor.

Regarding reports filed by auditors, Rule 10A-1(b) specifies that

if the report does not identify clearly both the issuer and the

auditor, then the auditor must attach that information to the report

submitted to OCA.

Rule 10A-1 makes clear that providing the notice or report in

accordance with section 10A and Rule 10A-1 does not, in any way, affect

the obligations of the issuer and the auditor to file and make all

applicable public disclosures required by the Commission's rules,

including, without limitation, Forms 8-K and N-SAR, and of the auditor

to comply with GAAS reporting requirements.35 Similarly, Rule 10A-

1 states that the confidential nature of the notice and the report to

the Commission does not diminish an issuer's or auditor's obligations

to make full disclosures required by the Commission's rules, forms,

reports, or disclosure items, or by applicable professional standards.

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\35\ In addition, one of the membership requirements of the SEC

Practice Section of the AICPA is that members notify registrants in

writing of the cessation of an auditor-client relationship. The

member also is required to send a copy of that notification to the

Commission's Office of the Chief Accountant.

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In response to the Proposing Release, the Commission received

additional comments requesting it to interpret or amend certain

additional provisions of section 10A. For example, some commentators

suggested that the Commission amend the statutory definition of

``illegal act'' to follow more closely the definition in the auditing

literature.36 Another commentator recommended that auditors be

required to report all illegal acts to the board of directors (as

opposed to management), not merely those acts that are material to the

financial statements. One commentator suggested that the Commission

extend the protection for auditors against civil liability found in

section 10A(c) for statements in reports submitted to the Commission

under section 10A(b), to statements made by the auditor in additional

documents and in other contexts. Commentators also requested that the

Commission extend the one-business-day reporting periods in the statute

to five business days. Such comments, however, are beyond the scope of

this rulemaking proceeding and, in some cases, request that the

Commission promulgate rules contrary to the statutory mandate of

section 10A.

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\36\ See SAS 54, para. 2, AU Sec. 317.02, discussed supra note

2.

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B. Rule 1-02(d)

The Commission is adopting the proposed amendment to conform the

definition of ``Audit (or examination)'' in Rule 1-02(d) of Regulation

S-X with section 10A. The amendment notes that audits of the financial

statements of Commission issuers should be performed ``in accordance

with generally accepted auditing standards, as may be modified or

supplemented by the Commission.'' The purpose of this amendment is to

alert auditors and issuers to the possibility that additional

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audit procedures, beyond those required by GAAS, may be required by the

Commission in certain circumstances.

Some commentators objected to the proposed revision of Rule 1-02(d)

on the ground that the Commission's statutory authority to modify or

supplement GAAS is limited to the three circumstances expressly set

forth in section 10A; i.e., illegal acts, related party transactions,

and going concern evaluations.

On the contrary, it has long been recognized by Congress and the

Commission, that the Commission has broad authority to establish

auditing requirements for public companies and their independent audit

firms.37 This implied authority is based on, among other things,

(1) the Commission's authority to prescribe the reports to be filed

with it,38 (2) the provisions in the securities laws that require,

or grant the Commission the authority to require, that certain

financial statements be ``certified * * * by independent public

accountants'' 39 and the Commission's authority to define

technical and trade terms such as ``certified,'' 40 and (3) the

Commission's authority to ensure that the representations in audit

reports and the procedures behind those reports fulfill their statutory

function.41 In enacting the Reform Act, Congress clearly intended

to preserve the Commission's existing implied authority regarding

auditing standards, as evidenced by both the preservation clause in

section 10A(e) and the Conference Committee Report.42

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\37\ See Report by the Subcommittee on Oversight and

Investigations of the House Committee on Interstate and Foreign

Commerce, Federal Regulation and Regulatory Reform, 94th Cong., 2d

Sess., 38 (October 1976), which states, in part, that the Commission

had not then ``exercised fully its statutory authority to remedy

deficiencies in generally accepted auditing standards''; Report on

the Activity of the Committee on Energy and Commerce for the 100th

Congress, House Report 100-1114, 100th Cong., 2d Sess., 364 (Dec.

23, 1988), which states, ``As the primary Agency responsible for

administering the Federal securities laws disclosure requirements,

the SEC has broad authority to establish auditing and accounting

requirements for public companies and independent audit firms''; and

Testimony of Richard C. Breeden, Chairman, U.S. Securities and

Exchange Commission, Concerning H.R. 547, The Financial Fraud

Detection and Disclosure Act, Before the Subcommittee on

Telecommunications and Finance of the House Committee on Energy and

Commerce, 103rd Cong., 1st Sess., 26-27 (Feb. 18, 1993), which

states, in part, ``The Commission [is] prepared, should it prove

necessary to fulfill its statutory mandate, to establish separate

auditing standards that supplement or supplant ASB standards for SEC

registrants.* * * In the same way the Commission has final authority

over the establishment of new financial standards by the FASB, so

too the Commission has final authority over the establishment of

auditing standards to protect the public interest.''

\38\ See, e.g., Sec. 13(b)(1) of the Exchange Act, 15 U.S.C.

78m(b)(1), which states, ``The Commission may prescribe, in regard

to reports made pursuant to this title, the form or forms in which

the required information shall be set forth.* * *''

\39\ Items 25, 26, and 27 of Schedule A to the Securities Act of

1933, 15 U.S.C. 77aa (25), (26) and (27), and Sec. 17(e) of the

Exchange Act, 15 U.S.C. 78q, expressly require that audited

financial statements be filed with the Commission. Sections 12(b)(1)

(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 78l and 78m,

among others, authorize the Commission to require the filing of

financial statements that have been audited by independent

accountants. The Commission requires that certain financial

statements be audited. See, e.g., Article 3 of Regulation S-X, 17

CFR Sec. 210-3-01 et seq.

\40\ See, e.g., Sec. 19(a) of the Securities Act of 1933, 15

U.S.C. 77s(a), and Sec. 3(b) of the Exchange Act, 15 U.S.C. 78c(b).

\41\ See generally James F. Strother, The Establishment of

Generally Accepted Accounting Principles and Generally Accepted

Auditing Standards, 28 Vand. L. Rev. 201, 225 (1975), which states,

``The Commission's powers with regard to auditing are considerable,

even though it lacks the express authority to prescribe auditing

standards and procedures that it has in the case of accounting

principles.''

In the past, the Commission has not found it necessary formally

to exercise its implied power to set auditing standards. In the mid-

1970s, however, the Commission proposed certain procedures for

auditors' reviews of interim financial statements. See Securities

Act Release No. 5579 (April 17, 1975), Accounting Series Release No.

177 (September 10, 1975), Securities Act Release No. 5612 (September

10, 1975). This rulemaking did not go forward when the predecessor

to the ASB acted to establish similar review procedures, and

Commission action became unnecessary.

\42\ See H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess., 47

(Nov. 28, 1995), which states, in part, ``The Conference Committee

does not intend to affect the Commission's authority in areas not

specifically addressed by this provision.''

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In any event, the revision to Rule 1-02(d) is not intended to

change the substantive scope of the Commission's authority to set

auditing standards, or to resolve any dispute that may arise over the

scope of that authority in particular circumstances. Instead, this

amendment is intended to provide adequate and fair notice to all

parties concerned that the Commission, as well as appropriate

professional authorities, may issue guidance to be considered and

adhered to in the performance of audits under the Exchange Act.

As a general matter, the Commission plans to continue its practice

of looking to the private sector standard setting bodies designated by

the accounting profession to provide leadership in establishing and

improving GAAS. Currently, the Commission staff works closely with the

ASB. The staff, among other things, attends ASB meetings, reviews and

provides the ASB with comments on draft Statements on Auditing

Standards, and has periodic meetings with ASB representatives to

discuss items on the ASB agenda and other matters of mutual concern.

The Commission has no present intention to write any new auditing

standards unless it determines that the ASB, or any subsequently

established standard setting organization, is unable or unwilling to

address a significant auditing issue in an appropriate and timely

manner. The Commission will exercise its discretion in determining the

appropriateness and timeliness of the private sector response,

considering the nature of the issue and other factors. Should

Commission action be deemed necessary, the Commission will act promptly

when required by the public interest or for the protection of

investors.43

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\43\ The Statement of Managers, The Private Securities

Litigation Reform Act of 1995, states, at 22, ``The Conference

Committee intends for the SEC to have discretion, however, to

determine the appropriateness and timeliness of the private sector

response. The SEC should act promptly if required by the public

interest or for the protection of investors.''

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III. Investment Companies

Section 10A and Rule 10A-1 apply to all audits required pursuant to

the Exchange Act, including those prepared on behalf of investment

companies, which, among others, have reporting obligations under the

Exchange Act.44

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\44\ See sections 13(a) and 15(d) of the Exchange Act, 15 U.S.C.

78m(a) and 78o(d), and section 30(a) of the Investment Company Act,

15 U.S.C. 80a-29(a). Form N-SAR requires investment companies to

file information with the Commission about their operations,

including audited financial information. Rule 30a-1 under the

Investment Company Act, 17 CFR Sec. 270.30a-1, provides that

investment companies filing annual reports on Form N-SAR are deemed

to have satisfied the reporting requirements of sections 13(a) and

15(d) under the Exchange Act and section 30(a) under the Investment

Company Act.

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In the proposing release, the Commission requested comment

regarding whether the reporting requirements under Rule 10A-1 should be

modified to reflect the specific operations of investment companies. No

commentators, however, addressed this topic. Accordingly, the

Commission has determined that Rule 10A-1 will be adopted as proposed.

IV. Required Findings Regarding Impact on Competition

In the Proposing Release, the Commission requested comments on

whether the proposed amendments, if adopted, would have an adverse

impact on competition or would impose a burden on competition that is

neither necessary nor appropriate in furthering the purposes of the

Securities Act of 1933 and the Exchange Act. One commentator addressed

this issue, indicating that the reporting provisions of proposed Rule

10A-1 would not add to any such burden that might be imposed by section

10A, especially in

[[Page 12748]]

light of the non-public nature of the reports to be filed under the

Rule.

The Commission has considered the proposed amendments in light of

its responsibilities under section 23(a) of the Exchange Act 45

and concluded that the burdens on competition, if any, are necessary

and appropriate in furtherance of the purposes of the Exchange Act,

particularly section 10A.

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\45\ 15 U.S.C. 78w(a).

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V. Cost/Benefit Analysis

The costs of complying with Rule 10A-1, which is intended to carry

out the purposes of new section 10A of the Exchange Act, are expected

to be de minimis. Such costs for an issuer may include converting the

information in the auditor's report to the board into a notice that

conforms to the rule and delivering that notice, via facsimile or

otherwise, to OCA. Costs for the auditor may include assuring that the

report to the board identifies the issuer, as required by the proposed

rule, and the cost of delivering that report, via facsimile or

otherwise, to OCA.

Benefits of compliance with Rule 10A-1 include an earlier warning

to the Commission of possible illegal acts by issuers and potential

improvements in public disclosures in Forms 8-K and N-SAR regarding

changes in issuers' auditors and in audit reports that are modified due

to issuers' illegal acts.

Commentators specifically addressing the issue indicated either

that the anticipated benefits of Rule 10A-1 outweigh the associated

costs, or that the minimal reporting requirements under Rule 10A-1

would not add to any burdens imposed by section 10A of the Exchange

Act.

VI. Summary of Final Regulatory Flexibility Analysis

A Final Regulatory Flexibility Analysis (``FRFA'') concerning Rule

10A-1 has been prepared in accordance with 5 U.S.C. 604. The FRFA notes

that the rule is intended to implement the reporting requirements of

section 10A of the Exchange Act as mandated by Congress. The rule will

not impose any reporting requirements additional to those imposed by

section 10A.

As discussed more fully in the FRFA, the rule will affect small

entities, as defined by the Commission's rules, but only in the same

manner as other entities. By statute, most issuers that fit the

Commission's definitions of small entities are subject to a one-year

delay in the effective date of section 10A, which makes section 10A

(and accordingly Rule 10A-1) applicable to annual reports for any

period beginning on or after January 1, 1997 (instead of January 1,

1996).

Regarding issuers, approximately 1,100 Exchange Act reporting

companies satisfy the Commission's definition of ``small business;'' as

of December 1995, approximately 5,200 broker-dealers were classified as

small entities; and as of August 1995, approximately 1,770 active

registered investment companies were considered small entities.

Although some small auditors may be subject to the Rule 10A-1 reporting

requirements, there is no specific definition of the term ``small

auditor'' and information regarding auditors' revenues, earnings, and

similar data is not publicly available.

There is no reliable way of determining how many small issuers or

auditors will be required to file section 10A reports or notices each

year concerning illegal acts so as to become subject to Rule 10A-1. It

is expected, however, that OCA will receive very few issuer notices

each year and even fewer auditor reports (which are filed only if an

issuer fails to fulfill its reporting obligation).

The FRFA notes that alternatives for providing different means of

compliance for small entities or for exempting small entities from the

rule would be inconsistent with the statutory requirements of section

10A. The cost of complying with the rule should be de minimus, even for

small entities, because the reporting requirements under section 10A

and the rule are based on existing GAAS requirements. Moreover, the

statute essentially requires only an earlier warning regarding matters

that would otherwise be disclosed in Forms 8-K and N-SAR and in audit

reports on issuers' financial statements.

The Commission received no comments on the Initial Regulatory

Flexibility Analysis (``IRFA'') prepared in connection with the

proposing release, and no comment letters specifically addressed to the

IRFA. Two commentators indicated that the anticipated benefits of Rule

10A-1 outweigh the associated costs, and that the minimal reporting

requirements of Rule 10A-1 would not materially add to the burdens

Congress chose to impose by enacting section 10A.

A copy of the analysis may be obtained by contacting Robert E.

Burns, Chief Counsel, Office of the Chief Accountant, U.S. Securities

and Exchange Commission, Mail Stop 11-3, 450 Fifth Street, N.W.,

Washington, D.C. 20549.

VII. Paperwork Reduction Act

As set forth in the Proposing Release, proposed Rule 10A-1 contains

``collection of information'' requirements within the meaning of the

Paperwork Reduction Act of 1995 [44 U.S.C. 3501 et seq.]. An agency may

not conduct or sponsor, and a person is not required to respond to, a

collection of information unless it displays a valid OMB control

number. Accordingly, the Commission submitted the proposed rules to the

Office of Management and Budget (``OMB'') for review in accordance with

44 U.S.C. 3507(d), and OMB approved that collection and assigned it

control number 3235-0468. This is the final notice regarding the

collection of information under Rule 10A-1.

The Supporting Statement to the Paperwork Reduction Act submission

noted that Rule 10A-1 is intended to implement the reporting

requirements found in recently enacted section 10A of the Exchange Act,

and that the rule is expected to have a negligible effect on the annual

reporting and cost burden of Commission registrants. As discussed

above, the notice to be provided by the issuer would contain the

minimum amount of information necessary to identify the issuer and the

auditor, indicate the date the auditor provided the report to the board

of directors as specified in section 10A, and summarize the report

given to the board. The summary would be based on information required

to be given to the board of directors under GAAS. The auditor's report,

furnished only in the event that the issuer does not fulfill its

reporting responsibilities, would consist only of the report given to

the board of directors and, if necessary, additional information to

identify clearly the issuer and the auditor.

Potential respondents are entities with reporting obligations under

the Exchange Act and their auditors, although it is anticipated that

the reporting requirements under section 10A rarely will be triggered.

On those rare occasions when the reporting requirement is triggered, it

is estimated that the total recordkeeping and reporting burden, beyond

that directly required by the statute, would not exceed one hour per

respondent.

As notices must be filed by an issuer within one day of receiving a

report from its auditor, and the auditor must file its report (if

necessary) the next day, there are essentially no recordkeeping or

retention requirements.

Filing the notices and reports, when necessary, is required by

section 10A of the Exchange Act and therefore is

[[Page 12749]]

mandatory. As explained above, however, the notices and reports will be

kept confidential while the Commission has an enforcement interest in

the information contained in those notices and reports. In addition,

requests for confidential treatment of such information may be made

under 17 CFR 200.83.

The Commission received no comments in response to its request for

comments, pursuant to 44 U.S.C. 3506(c)(2)(B), concerning: whether the

proposed collection of information is necessary for the proper

performance of the function of the Commission, including whether the

information shall have practical utility; the accuracy of the

Commission's estimate of the burden of the proposed collection of

information; the quality, utility, and clarity of the information to be

collected; and whether the burden of collection of information on those

who are to respond, including through the use of automated collection

techniques or other forms of information technology, may be minimized.

List of Subjects

17 CFR Part 210

Accounting, Reporting and recordkeeping requirements, Securities.

17 CFR Part 240

Reporting and recordkeeping requirements, Securities.

In accordance with the foregoing, Title 17, Chapter II of the Code

of Federal Regulations is amended as follows:

PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL

STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF

1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT

COMPANY ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975

1. The authority citation for Part 210 is revised to read as

follows:

Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77aa(25),

77aa(26), 78j-1, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d),

79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-

37(a), unless otherwise noted.

2. By revising Sec. 210.1-02(d) to read as follows:

Sec. 210.1-02 Definitions of terms used in Regulation S-X (17 CFR part

210).

* * * * *

(d) Audit (or examination). The term audit (or examination), when

used in regard to financial statements, means an examination of the

financial statements by an independent accountant in accordance with

generally accepted auditing standards, as may be modified or

supplemented by the Commission, for the purpose of expressing an

opinion thereon.

* * * * *

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF

1934

3. The authority citation for Part 240 is revised to read in part

as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,

77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,

78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),

79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, and 80b-11,

unless otherwise noted.

* * * * *

4. By adding an undesignated center heading and Sec. 240.10A-1

following Sec. 240.10(b)-21 to read as follows: Reports Under Section

10A

Sec. 240.10A-1 Notice to the Commission Pursuant to Section 10A of the

Act.

(a)(1) If any issuer with a reporting obligation under the Act

receives a report requiring a notice to the Commission in accordance

with section 10A(b)(3) of the Act, 15 U.S.C. 78j-1(b)(3), the issuer

shall submit such notice to the Commission's Office of the Chief

Accountant within the time period prescribed in that section. The

notice may be provided by facsimile, telegraph, personal delivery, or

any other means, provided it is received by the Office of the Chief

Accountant within the required time period.

(2) The notice specified in paragraph (a)(1) of this section shall

be in writing and:

(i) Shall identify the issuer (including the issuer's name,

address, phone number, and file number assigned to the issuer's filings

by the Commission) and the independent accountant (including the

independent accountant's name and phone number, and the address of the

independent accountant's principal office);

(ii) Shall state the date that the issuer received from the

independent accountant the report specified in section 10A(b)(2) of the

Act, 15 U.S.C. 78j-1(b)(2);

(iii) Shall provide, at the election of the issuer, either:

(A) A summary of the independent accountant's report, including a

description of the act that the independent accountant has identified

as a likely illegal act and the possible effect of that act on all

affected financial statements of the issuer or those related to the

most current three-year period, whichever is shorter; or

(B) A copy of the independent accountant's report; and

(iv) May provide additional information regarding the issuer's

views of and response to the independent accountant's report.

(3) Reports of the independent accountant submitted by the issuer

to the Commission's Office of the Chief Accountant in accordance with

paragraph (a)(2)(iii)(B) of this section shall be deemed to have been

made pursuant to section 10A(b)(3) or section 10A(b)(4) of the Act, 15

U.S.C. 78j-1(b)(3) or 78j-1(b)(4), for purposes of the safe harbor

provided by section 10A(c) of the Act, 15 U.S.C. 78j-1(c).

(4) Submission of the notice in paragraphs (a)(1) and (a)(2) of

this section shall not relieve the issuer from its obligations to

comply fully with all other reporting requirements, including, without

limitation:

(i) The filing requirements of Form 8-K, Sec. 249.308 of this

chapter, and Form N-SAR, Sec. 274.101 of this chapter, regarding a

change in the issuer's certifying accountant and

(ii) The disclosure requirements of item 304 of Regulation S-B or

item 304 of Regulation S-K, Secs. 228.304 or 229.304 of this chapter.

(b)(1) Any independent accountant furnishing to the Commission a

copy of a report (or the documentation of any oral report) in

accordance with section 10A(b)(3) or section 10A(b)(4) of the Act, 15

U.S.C. 78j-1(b)(3) or 78j-1(b)(4), shall submit that report (or

documentation) to the Commission's Office of the Chief Accountant

within the time period prescribed by the appropriate section of the

Act. The report (or documentation) may be submitted to the Commission's

Office of the Chief Accountant by facsimile, telegraph, personal

delivery, or any other means, provided it is received by the Office of

the Chief Accountant within the time period set forth in section

10A(b)(3) or 10A(b)(4) of the Act, 15 U.S.C. 78j-1(b)(3) or 78j-(b)(4),

whichever is applicable in the circumstances.

(2) If the report (or documentation) submitted to the Office of the

Chief Accountant in accordance with paragraph (b)(1) of this section

does not clearly identify both the issuer (including the issuer's name,

address, phone number, and file number assigned to the issuer's filings

with the Commission) and the independent accountant (including the

independent accountant's name and phone number, and the address of the

independent accountant's principal office), then the

[[Page 12750]]

independent accountant shall place that information in a prominent

attachment to the report (or documentation) and shall submit that

attachment to the Office of the Chief Accountant at the same time and

in the same manner as the report (or documentation) is submitted to

that Office.

(3) Submission of the report (or documentation) by the independent

accountant as described in paragraphs (b)(1) and (b)(2) of this section

shall not replace, or otherwise satisfy the need for, the newly engaged

and former accountants' letters under items 304(a)(2)(D) and 304(a)(3)

of Regulation S-K, Secs. 229.304(a)(2)(D) and 229.304(a)(3) of this

chapter, respectively, and under items 304(a)(2)(D) and 304(a)(3) of

Regulation S-B, Secs. 228.304(a)(2)(D) and 228.304(a)(3) of this

chapter, respectively, and shall not limit, reduce, or affect in any

way the independent accountant's obligations to comply fully with all

other legal and professional responsibilities, including, without

limitation, those under generally accepted auditing standards and the

rules or interpretations of the Commission that modify or supplement

those auditing standards.

(c) A notice or report submitted to the Office of the Chief

Accountant in accordance with paragraphs (a) and (b) of this section

shall be deemed to be an investigative record and shall be non-public

and exempt from disclosure pursuant to the Freedom of Information Act

to the same extent and for the same periods of time that the

Commission's investigative records are non-public and exempt from

disclosure under, among other applicable provisions, 5 U.S.C. 552(b)(7)

and Sec. 200.80(b)(7) of this chapter. Nothing in this paragraph,

however, shall relieve, limit, delay, or affect in any way, the

obligation of any issuer or any independent accountant to make all

public disclosures required by law, by any Commission disclosure item,

rule, report, or form, or by any applicable accounting, auditing, or

professional standard.

Instruction to Paragraph (c)

Issuers and independent accountants may apply for additional bases

for confidential treatment for a notice, report, or part thereof, in

accordance with Sec. 200.83 of this chapter. That section indicates, in

part, that any person who, pursuant to any requirement of law, submits

any information or causes or permits any information to be submitted to

the Commission, may request that the Commission afford it confidential

treatment by reason of personal privacy or business confidentiality, or

for any other reason permitted by Federal law.

By the Commission.

Dated: March 12, 1997.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-6712 Filed 3-17-97; 8:45 am]

BILLING CODE 8010-01-P