Proposed Amendment to Rule 102(e) of the Commission's Rules of Practice

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 201

[Release Nos. 33-7546; 34-40089; 35-26884; 39-2364; IA-1726; IC-23250;

File No. S7-16-98]

RIN 3235-AH47

Proposed Amendment to Rule 102(e) of the Commission's Rules of

Practice

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is

proposing an amendment to Rule 102(e) of the Commission's Rules of

Practice. Under Rule 102(e), the Commission can censure, suspend or bar

persons who appear or practice before it. The proposed amendment

clarifies the Commission's standard for determining when accountants

engage in ``improper professional conduct'' under Rule 102(e)(1)(ii).

DATES: Comments must be received on or before July 20, 1998.

ADDRESSES: Submit comments in triplicate to Jonathan G. Katz,

Secretary, Securities and Exchange Commission, 450 5th Street, NW.,

Washington, DC. 20549-6009. Comments can be submitted electronically at

the following E-mail address: [email protected]. All comment

letters should refer to File No. S7-16-98; include this file number on

the subject line if E-mail is used. All comments received will be

available for public inspection and copying in the Commission's Public

Reference Room, 450 5th Street, NW., Washington, DC. 20549-6009.

Electronically-submitted comment letters will be posted on the

Commission's Internet Web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Michael J. Kigin, Associate Chief

Accountant, Office of the Chief Accountant, at (202) 942-4400; or David

R. Fredrickson, Assistant General Counsel, Office of the General

Counsel, at (202) 942-0890.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today

is proposing for comment an amendment to Rule 102(e). 1

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\1\ 17 CFR 201.102(e).

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I. The Purpose of this Release

The purpose of this release is to solicit comments on a proposed

amendment to Rule 102(e) of the Commission's Rules of Practice. Under

Rule 102(e), the Commission can censure, suspend or bar professionals

who appear or practice before it. 2 Specifically, pursuant

to the Rule, the Commission can impose a sanction upon a professional

whom it finds, after notice and an opportunity for hearing:

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\2\ The Rule addresses the conduct of attorneys, accountants,

engineers and other professionals or experts who appear or practice

before the Commission. 17 CFR 201.102(e)(2) and (f)(2).

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(i) Not to possess the requisite qualifications to represent

others; or

(ii) To be lacking in character or integrity or to have engaged in

unethical or improper professional conduct; or

(iii) To have willfully violated, or willfully aided and abetted

the violation of, any provision of the Federal securities laws or the

rules and regulations thereunder. 3

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\3\ 17 CFR 201.102(e)(1)(i), (ii) and (iii).

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In a recent opinion addressing the conduct of two accountants, the

U.S. Court of Appeals for the District of Columbia Circuit found that

the Commission had not articulated clearly the ``improper professional

conduct'' element of the Rule. 4 To address the court's

concerns, the Commission is proposing an amendment to the text of Rule

102(e) that clarifies the Commission's standard for determining when

accountants engage in ``improper professional conduct.'' 5

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\4\ Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (``Checkosky

II '').

\5\ This clarification addresses the conduct of accountants

only, and is not meant to address the conduct of lawyers or other

professionals who practice before the Commission.

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II. A Brief Overview of Rule 102(e)

A. The Importance of Rule 102(e)

The Commission adopted Rule 102(e) as a ``means to ensure that

those professionals, on whom the Commission relies heavily in the

performance of its statutory duties, perform their tasks diligently and

with a reasonable degree of competence.'' 6 Courts have

recognized that it is appropriate for the Commission to use a

disciplinary mechanism such as Rule 102(e) to encourage professionals

to adhere to ethical standards and minimum standards of competence.

7 In adopting the Rule, the Commission did not intend to add

an ``additional weapon'' to its ``enforcement arsenal'' 8

but to protect its system of securities regulation and, by extension,

the interests of the investing public.

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\6\ Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979).

The AICPA also recognizes that accountants must discharge their

duties with competence. See, e.g., AICPA Professional Standards,

Vol. 2, ET sec. 56 (1997).

\7\ Rule 102(e) was promulgated under the Commission's broad

authority to adopt those rules and regulations necessary for

carrying out the agency's designated functions and its inherent

authority to protect the integrity of the agency's processes. Three

U.S. Courts of Appeals have upheld the validity of Rule 102(e). See

Touche Ross; Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995);

Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986). The Checkosky

opinions held that the Commission had not clearly articulated the

``improper professional conduct'' standard or the rationale for that

standard. Also, the Checkosky opinions did not decide the issue of

the scope of the Commission's authority.

\8\ Touche Ross, 609 F.2d at 579.

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B. The Important Role of Accountants

Accountants play many roles in the Commission's system of

securities regulation. In recognition of the significance of auditors

and audited financial statements in the Commission's disclosure

process, this release focuses particular attention upon the role of

auditors in the securities registration and reporting processes under

the federal securities laws. The proposed amendment, however, covers

all accountants who appear or practice before the Commission.

9

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\9\ See 17 CFR 201.102(f)(1) and (2). The Commission has

interpreted ``practice'' before the Commission to include

accountants functioning in many roles, including those who serve as

officers of public companies. See, e.g., In re Terrano, Securities

Exchange Act of 1934 (``Exchange Act'') Rel. No. 39485 (Dec. 23,

1997), 66 SEC Docket 494 (Jan. 20, 1998); In re Hersh, Exchange Act

Rel. No. 39089 (Sept. 18, 1997), 65 SEC Docket 1170 (Oct. 14, 1997);

In re Bryan, Exchange Act Rel. No. 39077 (Sept. 15, 1997), 65 SEC

Docket 1129 (Oct. 14, 1997).

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``Corporate financial statements are one of the primary sources of

information available to guide the decisions of the investing public.''

10 Various provisions of the federal securities laws require

publicly held companies to file audited financial statements with the

Commission. 11 These financial statements must be audited by

independent accountants in accordance with generally accepted auditing

standards (``GAAS''). 12 The auditor plans and performs the

audit to obtain reasonable assurance that the financial statements are

free from material misstatement. Commission regulations require the

auditor to issue a report containing an opinion on the financial

statements. 13 The auditor's opinion states whether the

financial statements present fairly, in all material respects, the

financial position of the company as of a specific date. 14

The opinion also states whether the results of the company's operations

and cash

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flows for the year (or other period) then ended, are in conformity with

generally accepted accounting principles (``GAAP''), and whether the

audit was conducted in accordance with GAAS. 15

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\10\ U.S. v. Arthur Young & Co., 465 U.S. 805, 810 (1984).

\11\ See, e.g., Securities Act of 1933 (``Securities Act'')

Schedule A (25)--(27), 15 U.S.C. 77aa(25)--(27); Exchange Act

12(b)(1)(J)--(L), 15 U.S.C. 78l(b)(1)(J)--(L).

\12\ Regulation S-X, 17 CFR 210.1-02(d) (1997).

\13\ See Regulation S-X, 17 CFR 210.2-02 (1985).

\14\ Id.

\15\ Id.

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Investors have come to rely on the accuracy of the financial

statements of public companies when making investment decisions.

Because the Commission has limited resources, it cannot closely

scrutinize each of these financial statements. 16

Consequently, the Commission must rely on the integrity of the auditors

who certify, and accountants who prepare, financial statements. In

short, both the Commission and the investing public rely heavily on

accountants to assure corporate compliance with federal securities law

requirements and disclosure of accurate and reliable financial

information.

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\16\ See Touche Ross, 609 F.2d at 580-81.

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The Commission and the courts have long acknowledged ``the duty of

accountants to those who justifiably rely on [their] reports.''

17 Accountants who issue audit and other reports speak to

investors, publicly representing that the accounting and auditing

standards of the accounting profession have been followed.

18 An incompetent or unethical accountant can damage the

Commission's processes and erode investor confidence in our markets.

19

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\17\ In re Carter, Exchange Act Rel. No. 17595 (Feb. 28, 1981),

22 SEC Docket 292, 298 (Mar. 17, 1981). Cf. Arthur Young, 465 U.S.

at 817-18.

\18\ See Carter, 22 SEC Docket at 298.

\19\ ''In our complex society, the accountant's certificate * *

* can be instruments for inflicting pecuniary loss more potent than

the chisel or the crowbar.'' U.S. v. Benjamin, 328 F.2d 854, 863 (2d

Cir.), cert. denied, 377 U.S. 953 (1964).

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III. The Standard Applied to Accountants

A. ``Improper Professional Conduct'' In General

The Court of Appeals in Checkosky II criticized the Commission for

not clearly articulating when an accountant would be deemed to have

engaged in ``improper professional conduct'' under Rule 102(e)(1)(ii).

This proposed amendment clarifies that whether an accountant engages in

``improper professional conduct'' is determined first by evaluating

whether the accountant violated applicable professional standards. It

also specifies the mental state required before an accountant may be

sanctioned under the Rule. The proposed amendment covers conduct that

the Commission historically has treated as ``improper professional

conduct'' under Rule 102(e)(1)(ii).

Rule 102(e)(1)(ii) has been an effective disciplinary and remedial

tool because it has been used to address a range of misconduct that

poses a future threat to the Commission's processes. 20

Accountants who engage in intentional or knowing misconduct, which

includes reckless misconduct, clearly pose this type of future threat.

Accountants who engage in negligent misconduct also can pose as great a

threat to the Commission's system of securities regulation as

accountants who knowingly violate the professional standards.

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\20\ Carter, 22 SEC Docket at 297. Because Rule 102(e)(1)(ii) is

remedial and not punitive in nature, the conduct must be evaluated

to determine whether the accountant poses a future threat to the

Commission's processes.

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Rule 102(e)(1)(ii) is not meant, however, to encompass every

professional misstep. 21 A harmless judgment error or

immaterial mistake does not pose a future threat to the Commission's

processes and does not constitute ``improper professional conduct.''

Similarly, the Commission does not seek to use the Rule to establish

new standards for the accounting profession.

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\21\ As Commissioner Johnson has noted:

A professional often must make difficult decisions, navigating

through complex statutory and regulatory requirements, and in the

case of accountants, complying with (GAAS) and applying (GAAP).

These determinations require the application of independent

professional judgment and sometimes involve matters of first

impression.

Exchange Act Rel. No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948,

1976 (Feb. 18, 1997) (Johnson, Comm'r, dissenting), rev'd Checkosky

II.

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B. The Proposed Standard

The Rule addresses conduct that fails to meet professional

standards. The proposed amendment delineates categories of conduct that

constitute ``improper professional conduct'' under Rule 102(e)(1)(ii).

These categories are:

(A) An intentional or knowing violation, including a reckless

violation, of applicable professional standards; 22 or

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\22\ ''Applicable professional standards'' includes such things

as generally accepted accounting principles, generally accepted

auditing standards, generally accepted attestation standards, the

AICPA Code of Professional Conduct, the AICPA Statements on

Standards for Consulting Services, the AICPA Statements on Standards

for Accounting and Review Services, pronouncements of the

Independence Standards Board, and certain of the Commission's rules

and regulations.

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(B) Negligent conduct in the following circumstances:

(1) An unreasonable violation of applicable professional standards

that presents a substantial risk, which is either known or should have

been known, of making a document prepared pursuant to the federal

securities laws materially misleading; or

(2) Repeated, unreasonable violations of applicable professional

standards that demonstrate that the accountant lacks competence.

1. Intentional or Knowing Violations, Including Reckless Violations

Subparagraph (A) of the amendment defines ``improper professional

conduct'' to include the most blatant violations of the professional

standards. The Commission consistently has used Rule 102(e)(1)(ii)

proceedings to address these types of violations of the professional

standards. 23

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\23\ See, e.g., In re Finkel, Securities Act Rel. No. 7401 (Mar.

12, 1997), 64 SEC Docket 103 (Apr. 8, 1997); In re Basson, Exchange

Act Rel. No. 35840 (June 13, 1995), 59 SEC Docket 1650 (July 11,

1995); In re F.G. Masquelette & Co, Accounting Series Rel. No. 68,

[1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH), para. 72,087

(June 30, 1982); In re Weiner, Exchange Act Rel. No. 14249 (Dec. 12,

1997), 13 SEC Docket 1113 (Dec. 27, 1977).

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Clearly, an accountant who intentionally or knowingly, including

recklessly 24, violates the professional standards has

engaged in ``improper professional conduct.'' Accountants who engage in

this type of misconduct undoubtedly pose the type of future threat to

the Commission's system of regulation that requires Commission action.

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\24\ See generally SEC v. Blavin, 760 F.2d 706, 711 (6th Cir.

1985); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24

(6th Cir. 1979).

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2. Specific, Negligent Conduct

The proposed amendment also covers specific, negligent violations

of the professional standards.25 The Commission has

recognized that ``an incompetent or negligent auditor can do just as

much harm to public investors and others who rely on him as one who

acts with an improper motive.'' 26 For this reason, the

Commission has stated that negligent conduct can trigger a Rule

102(e)(1)(ii) proceeding, and has brought Rule 102(e)(1)(ii)

proceedings based on negligent conduct.27

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\25\ In other instances, the federal securities laws expressly

subject auditors to liability without requiring intentional

misconduct. For example, the Supreme Court has recognized that

Section 11 allows recovery for ``negligent conduct.'' Herman &

MacLean v. Huddleston, 459 U.S. 375, 384 (1983), referring to Ernst

& Ernst v. Hochfelder, 425 U.S. 185, 210 (1976).

\26\ In re Checkosky, Exchange Act Rel. No. 31094 (Aug. 26,

1992), 52 SEC Docket 1389, 1410 (Sept. 15, 1992), rev'd Checkosky v.

SEC, 23 F.3d 452 (D.C. Cir. 1994) (``Checkosky I''), citing In re

Schulzetenberg, Admin. Proc. 3-6881, slip op. at 2 (Order Denying

Motion to Dismiss Nov. 10, 1987)(unpublished opinion).

\27\ In re Gotthilf, Exchange Act Rel. No. 33949 (April 21,

1994), 56 SEC Docket 1543 (May 10, 1944).

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The Court of Appeals in Checkosky II faulted the Commission for not

articulating with some degree of

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specificity when negligent conduct by an accountant constitutes

``improper professional conduct.'' 28 The proposed amendment

provides this specificity. Specifically, subparagraph (B) of the

amendment defines ``improper professional conduct'' to include: (1) An

unreasonable violation of the applicable professional standards that

presents a substantial risk, which is either known or should have been

known, of making a document prepared pursuant to the federal securities

laws materially 29 misleading; or (2) repeated, unreasonable

violations of the applicable professional standards that demonstrate

that the accountant lacks competence.

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\28\ Checkosky II, 139 F.3d at 224.

\29\ Material, as used in this context, means a substantial

likelihood of being considered significant by a reasonable investor.

Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), citing TSC

Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

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Under this standard, a single violation of the professional

standards could constitute ``improper professional conduct'' if the

violation presents a substantial risk, which is either known or should

have been known, of making a document prepared pursuant to the federal

securities laws materially misleading. Under these circumstances, the

single violation most likely would be related to a transaction or event

as to which any reasonable auditor would give heightened

scrutiny.30 The integrity of the Commission's processes is

threatened by an accountant who fails to exercise due professional care

with respect to the critical areas of his or her professional

responsibilities.

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\30\ Cf. AICPA Professional Standards, Vol. 1 AU sec. 312

(1997).

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For example, an auditor who failed to verify properly the amount of

cash purportedly held in a vault at a branch of a bank, where that

amount constituted 61% of the branch's and 45% of the bank's total cash

on hand, engaged in improper professional conduct under Rule

102(e)(1)(ii).31 In this particular matter, at least

$400,000 of the $2.7 million cash purportedly on hand had been

misappropriated by a bank employee. Although the sum of money

misappropriated may not have been quantitatively material to the bank's

balance sheet, a Rule 102(e)(1)(ii) proceeding was appropriate. Because

a shortage of the total amount of cash actually on hand would impact

materially on the bank's pre-tax earnings, the auditor's failure to

verify properly the cash on hand could be considered negligent under

subparagraph (B)(1) of the proposed amendment since it presented a

substantial risk, which should have been known, of making a document

prepared pursuant to the federal securities laws materially

misleading.32

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\31\ See In re Curtin, Exchange Act Rel. No. 32519 (June 28,

1993), 54 SEC Docket 1137 (July 20, 1993).

\32\ See also In re Valade, Exchange Act Rel. No. 4002 (May 19,

1998), 1998 SEC LEXIS 966; In re Smith, Exchange Act Rel. No. 37738

(Sept. 27, 1996), 62 SEC Docket 2840 (Oct. 29, 1996); In re Denton,

Exchange Act Rel. No. 35381 (Feb. 15, 1995), 58 SEC Docket 2294

(Mar. 14, 1995); In re Lamirato, Exchange Act Rel. No. 33660 (Feb.

23, 1994), 56 SEC Docket 345 (Mar. 15, 1994).

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Proposed subparagraph (B)(2) of the amendment would define improper

professional conduct to include repeated, unreasonable violations of

applicable professional standards that demonstrate that the accountant

lacks competence. Repeated, unreasonable violations of the professional

standards by an accountant can damage both the Commission's processes

and investor confidence in the integrity of financial statements. This

level of incompetence calls into question the reliability of any work

performed by the accountant. Further, an accountant who engages in this

type of misconduct may well benefit from remedial measures before

resuming practice before the Commission. Repeated violations would

include two or more violations that could occur within one audit

33 or in several audits.34 Repeated violations

also could include a course or pattern of violations regardless of

whether the types of violations are similar.

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\33\ See, e.g., In re Childers, Exchange Act Rel. No. 32505

(June 24, 1993), 54 SEC Docket 1017 (July 13, 1993).

\34\ See, e.g., In re Withers, Exchange Act Release No. 34537

(Aug. 17, 1994), 57 SEC Docket 1101 (Sept. 13, 1994).

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C. The ``Good Faith'' Defense

With respect to defenses to a Rule 102(e)(1)(ii) proceeding, the

Commission has never considered the subjective good faith of an

accountant to be an absolute defense.35 Good faith actions

of an accountant are more appropriately considered when determining

what sanction would be appropriate. For instance, an accountant who

acts in good faith, but is unable to conform to the minimum standards

of the profession, may benefit from additional training, peer review,

supervision and other appropriate remedial action undertaken while

suspended from practicing before the Commission or as a condition of

future practice before the Commission.

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\35\ See In re Haskins & Sells, Accounting Series Rel. No. 73

(Oct. 30, 1952), [1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH)

para. 72,092 (June 30, 1982). Similarly, an auditor who is deceived

by the client and commits an audit error in reliance upon the

deception does not have an automatic defense. See generally In re

Hope, Accounting and Auditing Enforcement Rel. No. 109A (Aug. 6,

1986), 36 SEC Docket 663, 750-55 (Sept. 10, 1986). See also In re

Ernst & Ernst, Accounting Series Rel. No. 248 (May 31, 1978), 14 SEC

Docket 1276, 1301 and n.71 (June 13, 1978).

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D. The AICPA Rulemaking Petition

The American Institute of Certified Public Accountants (``AICPA'')

submitted a rulemaking petition to the Commission proposing a

definition for ``improper professional conduct'' under Rule

102(e)(1)(ii).36 The AICPA Rulemaking Petition would define

improper professional conduct in a manner that includes a knowing

violation and a conscious and deliberate disregard of the professional

standards, as well as a course or pattern of misconduct.37

The Commission, like the AICPA, also is proposing that accountants who

engage in knowing misconduct or a course or pattern of misconduct

should be subject to Rule 102(e)(1)(ii) proceedings.

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\36\ Rulemaking Petition by the AICPA Concerning Rule 102(e)

(``AICPA Rulemaking Petition''), SEC File No. 4-410 (May 7, 1998).

\37\ Under the AICPA Rulemaking Petition, before an accountant

can be found to have engaged in ``improper professional conduct,''

the accountant also must pose a current threat to the integrity of

the Commission's processes or to the financial reporting system. See

also Task Force on Rule 102(e) Proceedings, American Bar

Association, Report of the Task Force on Rule 102(e) Proceedings:

Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 985

(May 1997).

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The Commission preliminarily believes that the public interest may

be better served with the somewhat broader definition of ``improper

professional conduct'' proposed in this release. While a harmless

judgment error or immaterial mistake should not trigger a Rule

102(e)(1)(ii) proceeding, reckless and specific negligent misconduct

may require Commission action to protect the integrity of the

Commission's processes and the interests of the investing public.

Accordingly, the Commission has determined to seek comment on the

proposed amendment contained in this release.

IV. General Request For Comments

The Commission requests that any interested persons submit comments

on the proposed amendment to Rule 102(e). The Commission also invites

comments on the following specific issues.

The proposed amendment is intended to clarify the definition of

``improper professional conduct.'' Does the proposed amendment achieve

this objective? This definition is consistent with how the Commission

has applied the ``improper professional conduct'' standard. Would

another definition of ``improper professional conduct'' be

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better suited to achieving the Commission's goal of protecting the

integrity of its processes? Does the proposed amendment include conduct

that should not be considered ``improper professional conduct?'' If

yes, what conduct should be excluded? Does the proposed amendment cover

all of the conduct that should be considered ``improper professional

conduct'' under Rule 102(e)(1)(ii)? If not, what else should be

included? The proposed amendment defines ``improper professional

conduct'' to include ``reckless'' conduct. Should the Commission use a

definition of ``recklessness'' commonly used in cases brought under

Rule 10b-5 of the Exchange Act? 38 Would a less rigorous

standard of ``recklessness'' 39 be more appropriate in the

context of a disciplinary rule such as Rule 102(e)(1)(ii) where the

purpose of the rule is to protect the integrity of the Commission's

processes?

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\38\ See, e.g., Mansbach, SEC v. Steadman, 967 F.2d 636, 641-642

(D.C. Cir. 1992) (both citing Sundstrand Corp. v. Sun Chemical

Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875

(1977)).

\39\ See, e.g., Saba v. Compagnie Nationale Air France, 78 F.3d

664, 668 (D.C. Cir. 1996), citing Farmer v. Brennan, 511 U.S. 825,

836-37 (1994); see generally W. Keeton, et al., Prosser and Keeton

on the Law of Torts (``Prosser''), sec. 34 at 213-214; (5th ed.

1984); Restatement (Second) of Torts sec. 500, comment (a) (1965).

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The proposed amendment defines ``improper professional conduct'' to

include negligent conduct under two specified circumstances. In order

to adequately protect the Commission's processes, should other

circumstances be included?

Does the term ``applicable professional standards'' provide

adequate guidance to the accounting profession? What weight should be

given to the good faith of an accountant at the sanctioning stage of a

Rule 102(e)(1)(ii) proceeding?

Any interested person wishing to submit written comments on any of

the issues set forth in this release are invited to do so by submitting

them in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and

Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549.

Comments also may be submitted electronically at the following e-mail

address: [email protected]. All comment letters should refer to

File No. S7-16-98 this file number should be included on the subject

line if e-mail is used. Comments received will be available for public

inspection and copying in the Commission's public reference room at 450

Fifth Street, NW., Washington, DC 20549. Electronically submitted

comment letters will be posted on the Commission's Internet Web site

(http://www.sec.gov).

V. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis (``IRFA'') on the proposed amendment to Rule 102(e). The IRFA

indicates that the proposed amendment would clarify the standard by

which the Commission determines whether accountants have engaged in

``improper professional conduct.''

The IRFA sets forth the statutory authority for the proposed

amendment. The IRFA also discusses the effect of the proposed amendment

on small entities. The IRFA states that approximately 1000 accounting

firms can or do appear or practice before the Commission. While most of

this practice is conducted by the ``Big Six'' firms, which are not

small entities, many smaller firms do practice before the Commission.

However, the Commission does not collect information about revenues of

accounting firms, which information generally is not made public by the

firms, and therefore cannot determine how many of these are small

entities for purposes of the analysis. In any event, the proposed

amendment should have little or no impact on small entities because the

proposal simply clarifies the Commission's standard for determining

when accountants engage in ``improper professional conduct.''

The IRFA states that the proposed amendment would not impose any

new reporting, recordkeeping or compliance requirements, and the

Commission believes that there are no rules that duplicate, overlap or

conflict with the proposed amendment.

The IRFA discusses the various alternatives considered to minimize

the effect on small entities, including: (a) The establishment of

differing compliance or reporting requirements or timetables that take

into account the resources of small entities; (b) the clarification,

consolidation or simplification of compliance and reporting

requirements under the Rule for small entities; (c) the use of

performance rather than design standards; and (d) an exemption from

coverage of the Rule, or any part thereof, for small entities. The

Commission believes it would be inconsistent with the purposes of the

Rule to exempt small entities from the proposed amendment. Different

compliance or reporting requirements for small entities are not

necessary because the proposed amendment does not establish any new

reporting, recordkeeping or compliance requirements. The proposed

amendment is already designed to clarify the current standard employed

in Rule 102(e)(1)(ii), and the Commission does not believe it is

feasible to further clarify, consolidate or simplify the Rule for small

entities. Finally, the proposal does use a performance standard, not a

design standard, to specify what conduct is expected of accountants;

the Commission does not believe different performance standards for

small entities would be consistent with the purposes of the Rule.

The IRFA solicits comments generally, and in particular, on the

number of small entities that would be affected by the proposed

amendment and the existence or nature of the effect. For purposes of

the Small Business Regulatory Enforcement Fairness Act of 1996,

40 the Commission is also requesting information regarding

the potential impact of the proposed amendment on the economy on an

annual basis--in particular, whether the proposed amendment is likely

to have an annual effect on the economy of $100 million or more.

Commenters should provide empirical data to support their views.

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\40\ 5 U.S.C. 801 et seq.

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A copy of the IRFA may be obtained by contacting David R.

Fredrickson, Office of the General Counsel, Securities and Exchange

Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

VI. Cost-Benefit Analysis

The Commission requests the views of commenters about any costs or

benefits associated with the proposed amendment. The Commission

anticipates several benefits from the amendment. The amendment will

provide clearer guidance to accountants. Members of the accounting

profession will better understand the standard the Commission uses to

determine ``improper professional conduct'' and thus conduct themselves

accordingly. Also, the clarifying amendment will make it easier for the

Commission, its administrative law judges and the courts to administer

the Rule, which will further benefit the integrity of the Commission's

processes. The Commission anticipates no costs associated with the

proposal.

Section 23(a)(2) of the Exchange Act requires the Commission to

consider the impact of its rules on competition. Moreover, section 2(b)

of the Securities Act, section 3(f) of the Exchange Act and section

2(c) of the Investment Company Act of 1940 (``Investment Company Act'')

require the Commission, when engaged in

[[Page 33309]]

rulemaking that requires a public interest finding, to consider, in

addition to the protection of investors, whether the action will

promote efficiency, competition and capital formation. The Commission

requests data on what effect, if any, the proposed amendment would have

on efficiency, competition and capital formation.

VII. Statutory Authority

The Commission is proposing the amendment to the Rule pursuant to

its authority under section 19(a) of the Securities Act, section 23(a)

of the Exchange Act, section 20(a) of the Public Utility Holding

Company Act of 1935, section 319(a) of the Trust Indenture Act of 1939,

section 211(a) of the Investment Advisers Act of 1940 and section 38(a)

of the Investment Company Act.

Text of Amendment

List of Subjects in 17 CFR Part 201

Administrative practice and procedure, Investigations, Securities.

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

of Federal Regulations is proposed to be amended as follows:

PART 201--RULES OF PRACTICE

1. The authority citation for Part 201, Subpart D continues to read

as follows:

Authority: 15 U.S.C. 77f, 77g, 77h, 77h-1, 77j, 77s, 77u,

78c(b), 78d-1, 78d-2, 78l, 78m, 78n, 78o(d), 78o-3, 78s, 78u-2, 78u-

3, 78v, 78w, 79c, 79s, 79t, 79z-5a, 77sss, 77ttt, 80a-8, 80a-9, 80a-

37, 80a-38, 80a-39, 80a-40, 80a-41, 80a-44, 80b-3, 80b-9, 80b-11,

and 80b-12 unless otherwise noted.

2. Amend Sec. 201.102 by adding paragraphs (e)(1)(iv) to read as

follows:

Sec. 201.102 Appearance and practice before the Commission.

(e) Suspension and disbarment.--(1) Generally. * * *

(iv) With respect to persons licensed to practice as accountants,

``improper professional conduct'' under Sec. 201.102(e)(1)(ii) means:

(A) An intentional or knowing violation, including a reckless

violation, of applicable professional standards; or

(B) Negligent conduct in the following circumstances:

(1) An unreasonable violation of applicable professional standards

that presents a substantial risk, which is either known or should have

been known, of making a document prepared pursuant to the federal

securities laws materially misleading; or

(2) Repeated, unreasonable violations of applicable professional

standards that demonstrate that the accountant lacks competence.

* * * * *

Dated: June 12, 1998.

By the Commission.

Jonathan G. Katz,

Secretary.

Separate Statement of Commissioner Norman S. Johnson

I write separately to address what I consider to be the plain

import of the two decisions of the United States Court of Appeals for

the District of Columbia Circuit in Checkosky v. SEC, 23 F.3d 452 (D.C.

Cir. 1994) (Checkosky I), and Checkosky v. SEC, 139 F.3d 221 (D.C. Cir.

1998) (Checkosky II). 1 In today's release, the Commission

proposes to adopt a negligence standard under Rule 102(e) of our Rules

of Practice, a matter of crucial importance to the accountants who

practice before us. 2 As Judge Randolph observed:

\1\ The weight the Commission must attach to the views of the

D.C. Circuit cannot be overstated. Under the jurisdictional

provisions of the securities laws, every respondent in a Commission

administrative proceeding has the option of appealing an adverse

outcome to the D.C. Circuit. See, e.g., 15 U.S.C. 77i(a) &

78y(a)(1).

\2\ Rule 102(e) was formerly designated Rule 2(e). There are no

substantive differences between the two rules.

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A proceeding under Rule 2(e) threatens ``to deprive a person of

a way of life to which he has devoted years of preparation and on

which he and his family have come to rely.'' Henry J. Friendly,

``Some Kind of Hearing,'' 123 U. Pa. L. Rev. 1267, 1297 (1975). It

is of little comfort to an auditor defending against such charges

that the Commission's authority is limited to suspending him from

agency practice. For many public accountants such work represents

their entire livelihood. Moreover, when one jurisdiction suspends a

professional it can start a chain reaction.

Checkosky I, 23 F.3d at 479 (opinion of Randolph, J.).

With all due respect to my esteemed colleagues, today's release

reflects precisely the same sort of overly aggressive approach that led

to the Commission's two stinging defeats in Checkosky. The consequences

of overreaching in this area might well be severe. If the Commission

selects an insupportable standard many of the worst offenders of Rule

102(e) may escape sanction altogether. Prudence would seem to dictate a

much more cautious approach than that taken in today's release.

Because I believe that the Commission lacks the authority to adopt

a negligence standard, I must dissent. See Checkosky I, 23 F.3d 452;

Checkosky II, 139 F.3d 221. Even apart from the Checkosky decisions,

adoption of a negligence standard would contravene public policy.

Some background is in order.

I.

Respondents in Checkosky were two accountants who audited the

financial statements of Savin Corporation in the early 1980's. The

Commission brought charges against the accountants in 1987, and in 1992

affirmed an Administrative Law Judge's decision finding violations of

Rule 102(e). See David J. Checkosky, Release No. 34-31094, 1992 SEC

LEXIS 2111 (Aug. 26, 1992). In its first opinion, the Commission found

that Savin's financial statements were false in that the company

improperly capitalized certain expenses for research and development

rather than recording them in their entirety as expenses in the years

incurred. Id. These violations were based on finding that the auditors,

in violation of Generally Accepted Auditing Standards (GAAS), had

improperly permitted Savin to capitalize these expenditures and falsely

certified that Savin's financial statements set forth its financial

condition in accordance with Generally Accepted Accounting Principles

(GAAP). 3 Id.

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\3\ Commissioner Roberts concurred in the majority's finding

that respondents violated GAAS and had misapplied GAAP, but

dissented from the finding that these errors amounted to ``improper

professional conduct'' under Rule 102(e)(1)(ii). 1992 SEC LEXIS

2111, at *47. In Commissioner Roberts' view respondents' conduct did

not provide a sufficient basis for a finding that they would

threaten the Commission's processes. Id. at *48.

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In Checkosky I, the D.C. Circuit remanded the case because it was

unable to discern from the Commission's opinion the basis for the

Commission's action other than the finding that the accountants had

violated GAAS and falsely certified that the financial statements set

forth the financial condition of the company in accordance with GAAP.

23 F.3rd at 454. The Court held that the Commission was authorized to

promulgate Rule 102(e) as a means to protect the integrity of its

processes, but each of the three judges (Judges Silberman, Randolph and

a district court judge sitting by designation, Judge Reynolds) issued a

separate opinion.

Judges Silberman and Randolph both questioned the Commission's

ability to impose sanctions under Rule 102(e) for misconduct not rising

to the level of scienter, i.e., misconduct that is only negligent.

4 Judge Silberman explained that:

\4\ Senior District Judge Reynolds disagreed with the circuit

judges' conclusion that ``improper professional conduct'' under Rule

102(e)(1)(ii) required proof of scienter. 23 F.3d at 493-95.

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[[Page 33310]]

If the purpose of Rule 2(e) is to protect the integrity of

administrative processes, then sanctions for improper professional

conduct under 2(e)(1)(ii) are permissible only to the extent that

they prevent the disruption of proceedings. Punishment for mere

negligence, so the argument goes, extends beyond this realm of

protective discipline into general regulatory authority over a

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professional's work.

23 F.3d at 456. Judge Silberman further suggested that the Commission

could not legitimately adopt a negligence standard under Rule 102(e)

because that might amount to ``a de facto substantive regulation of the

profession.'' 23 F.3d at 459; see also 23 F.3d 460 (suggestion that

Commission adoption of negligence standard might be arbitrary and

capricious).

Judge Randolph also questioned the Commission's ability to adopt a

negligence standard. In Judge Randolph's view, the ``Commission's

authority under Rule 2(e) must rest on and be derived from the statutes

it administers,'' such as Section 10(b) of the Exchange Act that

requires scienter. See 23 F.3d at 466-69. Judge Randolph also

extensively discussed an earlier Commission decision that rejected a

negligence standard under Rule 102(e) in a case involving lawyers,

William R. Carter, 47 S.E.C. 471 (1981). See 23 F.3d at 480-87. In

Judge Randolph's view, the reasoning of Carter was equally applicable

to accountants, and precluded the Commission from adopting a negligence

standard under Rule 102(e). See 23 F.3d at 483-87.

On remand, the Commission's majority opinion did not directly

address the mental state question posed by the Court. David J.

Checkosky, Release No. 34-38183, 1997 SEC LEXIS 137 (Jan. 21, 1997).

While the majority found that the accountants had behaved recklessly,

it insisted that any deviation from GAAP or GAAS, including purely

negligent deviations, could violate Rule 102(e), and that the

accountants' recklessness was relevant only to the choice of sanctions.

Id. I dissented from the Commission's second Checkosky opinion because

of my belief that ``improper professional conduct'' requires proof of

scienter, which includes recklessness.5 1997 SEC LEXIS 137,

at *48.

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\5\ See Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033,

1045 (7th Cir. 1977) (defining recklessness as ```highly

unreasonable''' conduct involving ```an extreme departure from the

standards of ordinary care'''); see also, e.g., Mansbach v.

Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979)

(following Sundstrand).

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On appeal in Checkosky II, the D.C. Circuit again reversed. The

Court again found that the Commission had again failed to offer an

adequate explanation of its interpretation of Rule 102(e). 139 F.3d at

222 (referring to the ``multiplicity of inconsistent interpretations''

in the Commission's opinion). Because of the Commission's ``persistent

failure to explain itself'' and ``the extraordinary duration of these

proceedings,'' the Court declined to give the Commission a third chance

to explain itself, and instead invoked the extremely rare remedy of

remanding the case with instructions to dismiss. 139 F.3d at 222 & 227.

More importantly for today's release, the D.C. Circuit in Checkosky

II again questioned the Commission's ability to adopt a negligence

standard under Rule 102(e)(1)(ii). 139 F.3d at 225. The Court appeared

to reaffirm its previous statements about the limits of the

Commission's authority in disciplining securities professionals subject

to Rule 102(e), remarking that ``adoption of a negligence standard

might be ultra vires'' because it might amount to ``a back-door

expansion of [the Commission's] regulatory oversight powers.'' Id.

(citing Checkosky I, 23 F.3d at 459).6

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\6\ This point is made clear by the concurring opinion, in which

Judge Henderson expressly disagreed with the majority's discussion

of this issue. See 139 F.3d at 227.

---------------------------------------------------------------------------

II.

As explained above, the Checkosky opinions preclude us, as a

practical matter, from adopting a negligence standard. Even were the

situation otherwise, public policy considerations also call for

rejection of a negligence standard. See, e.g., David J. Checkosky,

Release No. 34-38183, 1997 SEC LEXIS 137, at *48 (Jan. 21, 1997)

(dissenting opinion of Commission Johnson). In my view, ``improper

professional conduct'' in Rule 102(e)(1)(ii) requires proof of

scienter.

Our system of securities regulation is based on disclosure. To

ensure that Commission filings and other statements made to the

investing public are truthful and accurate, we have to rely in large

part on the work of talented, well-trained professionals. Accordingly,

I fully agree with former Chairman Williams' statement that we would be

unable to administer effectively the securities laws if those

``involved in the capital raising process were not routinely served by

professionals of the highest integrity and competence, well-versed in

the requirements of the statutory scheme Congress has created.''

Keating, Muething & Klekamp, 47 S.E.C 95, 120 (1979) (concurring

opinion of Chairman Williams); see also Touche, Ross & Co. v. SEC, 609

F.2d 570, 580-81 (2d Cir. 1979) (because of limited resources, ``the

Commission necessarily must rely heavily on both the accounting and

legal professions to perform their tasks diligently and responsibly'').

On the other hand, I also believe that the Commission has a limited

mandate under Rule 102(e) for determining who may ``practice'' before

us, and that we must exercise a high degree of self-restraint in this

area.

As to accountants, the very nature of their responsibilities within

our disclosure system mandates restraint. Accountants, like other

securities professionals subject to Rule 102(e), must make difficult

judgment calls, navigating through complex statutory and regulatory

requirements. In addition, accountants are required to follow GAAS and

to apply GAAP. These determinations demand the application of

independent professional judgment and often involve matters of first

impression.

The Commission itself recognized the importance of these principles

in Carter, when it asserted that, in order to assure the exercise of a

professional's ``best independent judgment,'' the professional ``must

have the freedom to make innocent--or even, in certain cases,

careless--mistakes without fear of (losing) the ability to practice

before'' us. 47 S.E.C. at 504. Equating negligence with ``improper

professional conduct'' will impair relationships between professionals

and their clients. If such an adverse impact occurs, our ability to

rely on these professionals to enhance compliance with the securities

laws will be crippled. I share the view endorsed by the Commission in

Carter that professionals ``motivated by fears for their personal

liability will not be consulted on difficult issues.'' Id.

Securities professionals owe a duty to serve the interests of their

clients. To discharge this duty, professionals must enjoy the

cooperation and trust of their clients. Indeed, in construing Carter,

Judge Randolph observed:

(W)ithout a scienter requirement, lawyers would slant their

advice out of fear of incurring liability, and management therefore

would not consult them on difficult questions. I cannot see why this

sort of reasoning would not apply as well to auditors. I recognize

that although companies need not retain outside counsel, they are

legally compelled to ``consult'' independent accountants * * * .

This creates an obligation on the part of management to cooperate

with and provide information to the auditor. * * * There are,

however, degrees of cooperation. Encouraging management to be

completely candid with its

[[Page 33311]]

auditor about difficult accounting issues may be just as desirable

as encouraging management to consult candidly with outside lawyers,

and for similar reasons.

Checkosky I, 23 F.3d at 485.

Accountants and attorneys are members of ``ancient professions,''

regulated according to rigorous ethical rules enforced by professional

societies and, in the case of accountants, state licensing boards. I

simply do not believe that we should recast negligent violations of an

accounting standard as improper professional conduct under the

Commission's Rules of Practice. That is not an appropriate role for

this Commission. Difficult ethical and professional responsibility

concerns are generally matters most appropriately dealt with by

professional organizations or, in certain cases, malpractice

litigation. Nor do I believe that mere misjudgments or negligence

establishes either professional incompetence warranting Commission

disciplinary action or the likelihood of future danger to the

Commission's processes.

* * * * *

For all these reasons, I believe that the Commission lacks the

authority to adopt a negligence standard under Rule 102(e). Likewise,

the Commission may only hold a professional liable for ``improper

professional conduct'' only if scienter is proven. I urge accountants

and trade groups directly subject to Rule 102(e), as well as any others

who have an interest in Rule 102(e), to submit their views on this

important matter. It is my most fervent hope that the Commission

receives an abundance of comment letters responding to this release.

[FR Doc. 98-16251 Filed 6-17-98; 8:45 am]

BILLING CODE 8010-01-P