Amendment to Rule 102(e) of the Commission's Rules of Practice
Federal RegisterOct 26, 1998
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting 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 amendment clarifies the
Commission's standard for determining when accountants engage in
``improper professional conduct'' under Rule 102(e)(1)(ii).
EFFECTIVE DATE: The rule amendment will become effective November 25,
1998.
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 Commission today is adopting an
amendment to Rule 102(e).\1\
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\1\ 17 CFR 201.102(e).
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I. Executive Summary
Under Rule 102(e) of the Commission's Rules of Practice, the
Commission can censure, suspend or bar professionals who appear or
practice before it.\2\ Today, the Commission is amending Rule 102(e) to
clarify the Commission's standard for determining when accountants \3\
engage in ``improper professional conduct'' under subsection (1)(ii) of
the rule.
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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).
\3\ This clarification addresses the conduct of accountants
only, and is not meant to address the conduct of lawyers, other
professionals or experts who practice before the Commission.
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The Commission's proposal to amend Rule 102(e) was prompted by a
recent judicial decision by the U.S. Court of Appeals for the District
of Columbia Circuit concerning the conduct of two accountants. The
court found that the Commission's opinions in that case had not
articulated clearly the ``improper professional conduct'' element of
the rule.\4\ To address the court's concerns, the Commission published
for comment a proposed amendment to Rule 102(e) on June 18, 1998.\5\ To
give the public additional time to comment on the proposed amendment,
the Commission extended the comment period until August 20, 1998.\6\
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\4\ Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (``Checkosky
II'').
\5\ Securities Act Release No. 7546 (June 12, 1998), 63 FR 33305
(June 18, 1998) (the ``Proposing Release''). In addition to
publishing the Proposing Release in the Federal Register, the
Commission also posted it on its Website. The address of the
Commission's Website is http://www.sec.gov.
\6\ Securities Act Release No. 7555 (July 15, 1998), 63 FR 39054
(July 21, 1998).
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The proposed amendment articulated three types of violations of
applicable professional standards that would constitute ``improper
professional conduct.'' The final rule amendment changes the focus of
these provisions from types of violations to types of conduct that
result in violations of applicable professional standards. Comment
letters addressing these provisions generally supported two parts of
the Commission's proposal: one, knowing or intentional conduct,
including reckless conduct; and, two, repeated instances of
unreasonable conduct. The Commission adopts these provisions in
substantially the form they were proposed.
Rule 102(e) proceedings may also be based on a third type of
conduct: ``highly unreasonable conduct'' that results in a violation of
applicable professional standards in circumstances in which an
accountant knows, or should know, that ``heightened scrutiny'' is
warranted. This part of the final rule amendment differs from the
proposed amendment. This provision covers a single instance of serious
misconduct that may not rise to the level of intentional or knowing
(including reckless) conduct. The changes from the proposed amendment
emphasize that this provision applies only to deviations from
professional standards--greater than ordinary negligence but less than
recklessness--when an accountant knows or should know of a heightened
risk. The final rule amendment refers to this situation as ``heightened
scrutiny.'' The differences between the proposed amendment and the
final amendment are discussed in detail below.
The amendment is intended to reach violations of applicable
professional standards that demonstrate that an accountant lacks
competence to practice before the Commission. An accountant who acts
intentionally or knowingly, including recklessly, or highly
unreasonably when heightened scrutiny is warranted, conclusively
demonstrates a lack of competence to practice before the Commission. By
contrast, when the Commission brings a Rule 102(e) proceeding for
repeated instances of unreasonable conduct, it will also have to find
that the conduct indicates a lack of competence.
The Commission received 168 comment letters on the proposed
amendment to Rule 102(e). A number of commenters, including individual
investors, institutional investors, public interest groups, officers
and directors of public companies, and academics, supported the
proposed amendment. Several certified public accountants (``CPAs'')
also expressed their support for the proposed amendment. Most other
commenters supported at least some aspects of the proposed amendment. A
substantial number of CPAs submitted letters that expressed agreement
with an August 1998 memorandum of the American Institute of Certified
Public Accountants (``AICPA'') criticizing certain aspects of the
proposed amendment. Most of these CPA commenters also expressed their
support for the amendment to Rule 102(e) proposed in the AICPA's May 7,
1998 rulemaking petition.\7\ In addition, the five largest U.S.
accounting firms and members of interested committees of the American
Bar Association submitted letters supporting some, but critical of
other, aspects of the proposed amendment.
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\7\ On May 7, 1998, the AICPA submitted a rulemaking petition to
the Commission proposing a definition for ``improper professional
conduct'' under Rule 102(e)(1)(ii). Rulemaking Petition by the AICPA
Concerning Rule 102(e) (``AICPA Rulemaking Petition''), SEC File No.
4-410 (May 7, 1998).
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The Commission acted as expeditiously as practicable in adopting
this amendment. The Commission wants to address promptly the Checkosky
II court's concern that the Commission had not clearly articulated its
standard for determining when accountants engage in ``improper
professional conduct.'' Equally important, the Commission wants to make
sure that its processes continue to be protected, and that the
investing public continues to have confidence in the integrity of the
financial reporting process.
Accurate financial reporting is the bedrock of our capital markets.
Accountants play a vital role in assuring issuers' compliance with
reporting requirements. The Commission wishes
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to underscore the importance of that role and the need for accountants
to comply with the standards of conduct applicable to members of their
profession. These professional standards include the overarching
requirement that auditors exercise due care in their audit of a
company's financial statements. The Commission possesses broad
authority, both under the federal securities laws and its own rules, to
promote and enforce compliance with professional standards.
Rule 102(e) addresses that category of professional conduct that
threatens harm to the Commission's processes. The rule was not intended
to cover all forms of professional misconduct. As discussed below,\8\
the Commission has separate statutory authority that is available to
address and deter professional misconduct that is not encompassed by
Rule 102(e), as amended in this release.
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\8\ See discussion on p.20.
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The final rule amendment clarifies the Commission's standard for
determining when ``improper professional conduct'' occurs under Rule
102(e)(1)(ii). The amendment will allow the Commission to bring the
actions it traditionally has brought under Rule 102(e)(1)(ii).
Moreover, the purpose served and the relief provided by the rule are
forward-looking. For these reasons, the Commission will use this
standard in all cases considered after the amendment's effective date,
except where a trial before an Administrative Law Judge has already
commenced,\9\ regardless of when the conduct in question occurred.
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\9\ Where a hearing has already commenced, an Administrative Law
Judge may use the Rule 102(e) standard adopted today if such use
would not unfairly prejudice any party. The Administrative Law Judge
may also supplement or re-open the record, if necessary, to give any
party so requesting the opportunity to provide particular evidence
or briefing on the Rule 102(e) standard.
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II. Background
A. The Importance of Rule 102(e)
Under Rule 102(e), the Commission can censure, suspend or bar
professionals who appear or practice before it. Specifically, pursuant
to the rule, the Commission can impose a sanction upon a professional
whom it finds, after notice and an opportunity for hearing:
(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.\10\
\10\ 17 CFR 201.102(e)(1)(i), (ii) and (iii).
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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.'' \11\ Courts have recognized
that it is appropriate for the Commission to use a remedial rule such
as Rule 102(e) to encourage professionals to adhere to professional
standards and minimum standards of competence when they practice before
the Commission. In adopting the rule, the Commission did not intend to
add an ``additional weapon'' to its ``enforcement arsenal,'' \12\ but
to protect the integrity and quality of its system of securities
regulation and, by extension, the interests of the investing public.
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\11\ Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979).
\12\ Id. at 579.
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B. The Important Role of Accountants
Accountants play many roles in the Commission's system of
securities regulation. One of the most significant roles is in auditing
financial statements filed with the Commission. This release focuses
particular attention upon the role of auditors in the securities
registration and reporting processes under the federal securities laws.
The amendment, however, covers all accountants who appear or practice
before the Commission.\13\
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\13\ See 17 CFR 201.102(f)(1) and (2). For example, the
Commission has brought Rule 102(e) proceedings against accountants
serving as officers of public companies. See, e.g., In re Terrano,
Securities Exchange Act of 1934 (``Exchange Act'') Release No. 39485
(Dec. 23, 1997), 66 SEC Docket 494 (Jan. 20, 1998); In re Hersh,
Exchange Act Release No. 39089 (Sept. 18, 1997), 65 SEC Docket 1170
(Oct. 14, 1997); In re Bryan, Exchange Act Release 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.''\14\ Various provisions of the federal securities laws require
publicly-held companies to file audited financial statements with the
Commission.\15\ These financial statements must be audited by
independent accountants in accordance with generally accepted auditing
standards (``GAAS'').\16\ 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.\17\
The auditor's opinion states whether the audit was conducted in
accordance with GAAS, and whether the financial statements present
fairly, in all material respects, the financial position of the company
as of a specific date and the results of its operations and its cash
flows for the year (or other period) then ended, in conformity with
generally accepted accounting principles (``GAAP'').\18\
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\14\ U.S. v. Arthur Young & Co., 465 U.S. 805, 810 (1984).
\15\ 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).
\16\ Regulation S-X, 17 CFR 210.1-02(d) (1997).
\17\ See Regulation S-X, 17 CFR 210.2-02 (1997).
\18\ 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 every financial statement.\19\ Consequently, the Commission
must rely on the competence and independence of the auditors who
certify, and the 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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\19\ See Touche Ross, 609 F.2d at 580-81.
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The Commission and the courts have long acknowledged ``[t]he duty
of accountants to those who justifiably rely on [their] reports.'' \20\
The AICPA's Code of Professional Conduct contains the strong statement
that ``[t]hose who rely on certified public accountants expect them to
discharge their responsibilities with integrity, objectivity, due
professional care, and a genuine interest in serving the public.'' \21\
Due care requires auditors to discharge their responsibilities with
competence and diligence and consistent with the profession's
responsibility to the public. Moreover, GAAS requires that ``due
professional care'' be exercised in the performance of audits.\22\
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.\23\ An incompetent accountant
can damage the Commission's processes
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and erode investor confidence in our markets.\24\
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\20\ In re Carter, Exchange Act Release No. 17595 (Feb. 28,
1981), 22 SEC Docket 292, 298 (Mar. 17, 1981). Cf. Arthur Young, 465
U.S. at 817-18.
\21\ AICPA Professional Standards, Vol. 2 ET section 53.03
(1997).
\22\ AICPA Professional Standards, Vol. 1 AU section 230.01
(1997).
\23\ See Carter, 22 SEC Docket at 298.
\24\ ``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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C. The ``Improper Professional Conduct'' Standard Applied to
Accountants
The Court of Appeals in Checkosky II criticized the Commission for
not clearly articulating in that case when an accountant would be
deemed to have engaged in ``improper professional conduct'' under Rule
102(e)(1)(ii). The amendment adopted today addresses this concern by
specifying three types of conduct that constitute ``improper
professional conduct.'' The Commission believes that a finding of
``improper professional conduct'' under Rule 102(e) is warranted only
when an accountant lacks competence \25\ to practice before the
Commission.
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\25\ By ``competence'' the Commission means not just technical
skills, but also an accountant's willingness and ability to adhere
to professional standards, including standards of honesty and fair
dealing.
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Rule 102(e)(1)(ii) has been an effective remedial tool because it
covers a range of conduct that demonstrates that a professional is a
future threat to the Commission's processes.\26\ Accountants who engage
in intentional or knowing conduct, which includes reckless conduct,
clearly pose this type of future threat. Accountants who engage in
certain specified types of negligent conduct also can pose such a
future threat.
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\26\ Carter, 22 SEC Docket at 297. Because the purpose of Rule
102(e)(1)(ii) is to address conduct that demonstrates a future
threat to the Commission's processes, the rule is remedial and not
punitive in nature.
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Rule 102(e)(1)(ii) is not meant, however, to encompass every
professional misstep.\27\ A single judgment error, for example, even if
unreasonable when made, may not indicate a lack of competence to
practice before the Commission and, therefore, may not pose a future
threat to the Commission's processes sufficient to require Commission
action under Rule 102(e)(1)(ii).\28\
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\27\ 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.
In re Checkosky, Exchange Act Release No. 38183 (Jan. 21, 1997),
63 SEC Docket 1948, 1976 (Feb. 18, 1997) (Johnson, Comm'r,
dissenting), rev'd Checkosky II.
\28\ Such an error, however, may violate applicable professional
standards. For example, the AICPA's Code of Professional Conduct and
GAAS require accountants to exercise due care. In addition, such an
error may result in a violation of the federal securities laws. See
discussion at p. 20. In either event, the person committing such an
error, though not subject to discipline under Rule 102(e), would be
exposed to the sanctions available under those other provisions.
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The Commission believes that a single judgment error that was
highly unreasonable and made in circumstances warranting heightened
scrutiny, however, conclusively demonstrates a lack of competence to
practice before the Commission.\29\ Repeated judgment errors may also
indicate a lack of competence. Therefore, if the Commission finds that
an accountant acted unreasonably in more than one instance (each time
resulting in a violation of applicable professional standards), and
that this conduct indicates a lack of competence, that accountant
engaged in improper professional conduct under the standard adopted
today.\30\
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\29\ See Section III.C.1 below.
\30\ See Section III.C.2 below.
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The Commission does not seek to use Rule 102(e)(1)(ii) to establish
new standards for the accounting profession. The rule itself imposes no
new professional standards on accountants. Accountants who appear or
practice before the Commission are already subject to professional
standards. Indeed, the Commission will only bring Rule 102(e)(1)(ii)
proceedings against accountants who violate applicable professional
standards in circumstances that demonstrate their lack of competence to
practice before the Commission.\31\
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\31\ Under Rule 102(e), the Commission has other authority to
protect the integrity of its processes from persons who pose a
threat of future harm to those processes. For example, the
Commission may censure, suspend or bar persons who the Commission
finds ``not to possess the requisite qualifications to represent
others.'' 17 CFR 201.102(e)(1)(i).
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III. Discussion of Amendment
A. The Final Rule
The amendment specifies three types of conduct that constitute
``improper professional conduct'' under Rule 102(e)(1)(ii). The
amendment states:
(iv) With respect to persons licensed to practice as
accountants, ``improper professional conduct'' under
Sec. 201.102(e)(1)(ii) means:
(A) Intentional or knowing conduct, including reckless conduct,
that results in a violation of applicable professional standards; or
(B) Either of the following two types of negligent conduct:
(1) A single instance of highly unreasonable conduct that
results in a violation of applicable professional standards in
circumstances in which an accountant knows, or should know, that
heightened scrutiny is warranted.
(2) Repeated instances of unreasonable conduct, each resulting
in a violation of applicable professional standards, that indicate a
lack of competence to practice before the Commission.
Each section of the final rule amendment refers to a violation of
``applicable professional standards.'' \32\ The term ``applicable
professional standards'' primarily refers to GAAP, GAAS, the AICPA Code
of Professional Conduct, and Commission regulations. Also included are
generally accepted standards routinely used by accountants in the
preparation of statements, opinions, or other papers filed with the
Commission.
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\32\ The final rule amendment will not change the Commission's
practice of bringing Rule 102(e) proceedings against accountants who
lack independence. See, e.g., In re Goodbread, Exch. Act Rel. No.
38035 (Dec. 12, 1996), SEC Accounting Rules [Current Binder] (CCH)
para. 5,061 (Mar. 1997); In re Iommazzo, Exch. Act Rel. No. 30733
(May 22, 1992), Accounting Series Releases, [1991-95 Transfer
Binder] Fed. Sec. L. Rep. (CCH) para. 73,844 (July 19, 1995).
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The term ``applicable professional standards'' is broad enough to
accommodate changes in the body of professional guidance routinely used
by accountants. For example, should international accounting standards
be adopted, they would become part of accepted professional guidance.
Likewise, pronouncements of the Independence Standards Board, or other
bodies yet to be established, would come to form part of the
professional guidance that accountants routinely use. As the AICPA
concluded, the term ``applicable professional standards'' is one ``that
professionals are generally familiar with and can understand.'' \33\
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\33\ Comment Letter of Richard I. Miller, General Counsel &
Secretary, AICPA, at 9 (Aug. 20, 1998) (``AICPA Comment Letter'').
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B. Intentional or Knowing Conduct, Including Reckless Conduct
Subparagraph (A) of the amendment defines ``improper professional
conduct'' to include the most blatant violations of applicable
professional standards. The Commission consistently has used Rule
102(e) proceedings to address these types of violations of applicable
professional standards.\34\
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\34\ See, e.g., In re Finkel, Securities Act Release No. 7401
(Mar. 12, 1997), 64 SEC Docket 103 (Apr. 8, 1997); In re Basson,
Exchange Act Release No. 35840 (June 13, 1995), 59 SEC Docket 1650
(July 11, 1995); In re F.G. Masquelette & Co., Accounting Series
Release 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, 1977), 13 SEC Docket 1113 (Dec. 27, 1977).
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The Commission is adopting subparagraph (A) of the amendment in
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substantially the same form as it was proposed. Almost all commenters
expressed support for subparagraph (A) of the proposed amendment.
Clearly, an accountant who intentionally or knowingly, including
recklessly, violates the professional standards conclusively
demonstrates a lack of competence to appear before the Commission.
Accountants who engage in this type of misconduct pose a future threat
to the Commission's processes.
The Commission also requested comments on what definition of
``recklessness'' is most appropriate. Several commenters suggested that
the Commission adopt a definition of ``recklessness'' used in cases
brought under Section 10(b) and Rule 10b-5 of the Securities Exchange
Act.\35\ Although the standards of professional practice are not fraud
based, the Commission agrees that, for purposes of consistency under
the federal securities laws, ``recklessness'' in subparagraph (A) of
the rule amendment should mean the same thing as courts have defined
``recklessness'' to mean under the antifraud provisions.
``Recklessness'' under the antifraud provisions ``is not merely a
heightened form of ordinary negligence; it is an `extreme departure
from the standards of ordinary care, * * * which presents a danger of
misleading buyers or sellers that is either known to the [actor] or is
so obvious that the actor must have been aware of it.' '' \36\ This
recklessness standard is a lesser form of intent.\37\
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\35\ See, e.g., Comment Letter of Ernst & Young LLP, at 19-20
(Aug. 20, 1998) (``Ernst & Young Comment Letter''); AICPA Comment
Letter, at 8.
\36\ SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992)
(ellipsis in original) (quoting Sundstrand Corp. v. Sun Chemical
Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875
(1977)); see also Potts v. SEC, 151 F.3d 810 (8th Cir. 1998)
(finding recklessness under the Steadman standard in a Rule 102(e)
proceeding).
\37\ See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-94 n.12
(1976); see also Steadman, 967 F.2d at 641.
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C. Two Specific Types of Negligent Conduct
The final rule amendment also covers two specific types of
negligent conduct that result in violations of applicable professional
standards.\38\ The Commission believes that a negligent auditor can do
just as much harm to the Commission's processes as one who acts with an
improper motive.\39\ For this reason, the Commission has brought Rule
102(e) proceedings based on negligent conduct.\40\
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\38\ 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). See also Securities
Act section 17(a) (2) & (3), 15 U.S.C. 77q(a)(2) & (3); Aaron v.
SEC, 446 U.S. 680 (1980). In addition, section 21C of the Exchange
Act imposes liability when a person is a ``cause'' of a violation
``due to an act or omission the person knew or should have known
would contribute to such violation.'' 15 U.S.C. 78u-3.
\39\ 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. The
amendment adopted today by the Commission, similar to the AICPA
Rulemaking Petition, subjects accountants who engage in knowing
misconduct as well as a course or pattern of misconduct to Rule
102(e)(1)(ii) proceedings. The amendment adopted today includes two
specific types of negligent conduct. The Commission believes that
the public interest will be better served by its broader definition
of ``improper professional conduct.''
\40\ See, e.g., In re Gotthilf, Exchange Act Release No. 33949
(April 21, 1994), 56 SEC Docket 1543 (May 10, 1994). See also Danna
v. SEC, No. C-93-4158 (CW), 1994 WL 315877 (N.D. Cal. Feb. 8, 1994).
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The Court of Appeals in Checkosky II faulted the Commission for not
articulating with specificity when negligent conduct by an accountant
constitutes ``improper professional conduct.'' \41\ The final rule
amendment provides this specificity. Subparagraph (B) of the amendment
defines ``improper professional conduct'' to include two specific types
of negligent conduct:
\41\ Checkosky II, 139 F.3d at 224.
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(1) A single instance of highly unreasonable conduct that
results in a violation of applicable professional standards in
circumstances in which an accountant knows, or should know, that
heightened scrutiny is warranted.
(2) Repeated instances of unreasonable conduct, each resulting
in a violation of applicable professional standards, that indicate a
lack of competence to practice before the Commission.
1. Highly Unreasonable Conduct
The ``highly unreasonable'' standard in subparagraph (B)(1) of the
final rule amendment is an intermediate standard, higher than ordinary
negligence but lower than the traditional definition of recklessness
used in cases brought under Section 10(b) and Rule 10b-5 of the
Exchange Act.\42\ The ``highly unreasonable'' standard is an objective
standard. The conduct at issue is measured by the degree of the
departure from professional standards and not the intent of the
accountant. The Commission believes that subparagraph (B)(1) describes
conduct that poses a threat of future harm to the Commission's
processes and conclusively demonstrates that the accountant lacks
competence to practice before it.
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\42\ The Commission notes that several cases interpreting the
antifraud provisions of the federal securities laws use the phrase
``highly unreasonable'' as part of the definition of recklessness.
See, e.g., Sundstrand, 553 F.2d at 1045. The Commission does not
mean to incorporate that case law by using the term ``highly
unreasonable'' in this context. This release defines the ``highly
unreasonable'' standard--an intermediate standard higher than
ordinary negligence and lower than recklessness--with care and
precision. The ``highly unreasonable'' standard adopted today is not
scienter-based.
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The proposed rule referred to ``unreasonable'' conduct.\43\ The
definition the Commission adopts today includes a higher standard. The
final standard reflects the Commission's conclusion that a single
judgment error, even if unreasonable when made, may not indicate a lack
of competence to practice before the Commission and, therefore may not
pose a future threat to the Commission's processes sufficient to impose
remedial sanctions. The Commission neither accepts nor condones
unreasonable, or negligent, accounting or auditing errors. To the
contrary, such errors could undermine accurate financial reporting.
Moreover, the Commission possesses authority, wholly independent of
Rule 102(e), to address and deter such errors through its enforcement
of provisions of the federal securities laws that impose liability on
persons, including accountants, for negligent conduct.\44\
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\43\ In fact, the proposed rule referred to ``[a]n unreasonable
violation.'' At least one commenter correctly pointed out that this
formulation implies there may be ``reasonable'' violations of
professional standards. Comment Letter of K. Michael Conaway (Aug.
20, 1998). To eliminate this misconception, and to focus on
individual competence, the final rule refers to ``unreasonable
conduct,'' not ``violations.''
\44\ See, e.g., Securities Act section 17(a)(2) & (3), 15 U.S.C.
77q(a)(2) & (3); Exchange Act section 21C, 15 U.S.C. 78u-3; see also
Securities Act section 11, 15 U.S.C. 77k. Accountants also may be
liable for negligent conduct under the laws of various states, and
subject to sanction by state accounting boards, see, e.g., Fla.
Admin. Code Ann. r. 61H1-36.004 (1998).
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Many commenters objected to the ``unreasonable'' formulation in
this subparagraph of the proposed rule or suggested changes to this
subparagraph. Some CPAs and other commenters, for example, expressed
concern that the ``unreasonable'' formulation made accountants unfairly
vulnerable and liable for acts of ``simple negligence'' and errors in
judgment.\45\ These commenters maintained that such a standard could
restrict accountants' exercise of their best independent judgment,
thereby operating to the
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detriment of the financial reporting system.\46\
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\45\ AICPA Comment Letter, at 15-16; Comment Letter of Arthur
Andersen LLP, at 5 (Aug. 17, 1998) (``Arthur Andersen Comment
Letter''); Comment Letter of Robert K. Elliott, Partner, KPMG Peat
Marwick LLP, at 10-12 (Aug. 20, 1998) (``KPMG Peat Marwick Comment
Letter).
\46\ Most investors and users of financial statements, however,
disagreed. See Comment Letter of Peter C. Clapman, Senior Vice
President and Chief Counsel, Investments, TIAA-CREF, at 4 (July 16,
1998); Comment Letter of Josh S. Weston, Chairman of the Board,
Automatic Data Processing, Inc. (Aug. 24, 1998) (``Weston Comment
Letter''); Comment Letter of Dr. John H. Nugent (Aug. 11, 1998)
(``Nugent Comment Letter''); Comment Letter of Kurt N. Schacht,
Chief Legal Officer, State of Wisconsin Investment Board, at 1 (July
20, 1998); Comment Letter of Laurence A. Tisch, Co-Chairman of the
Board and Co-Chief Executive Officer, Loews Corporation (July 8,
1998); Comment Letter of Steven Alan Bennett, Senior Vice President
and General Counsel, Banc One Corporation, at 2 (July 21, 1998).
Moreover, commenters from one state board of accountancy supported
the proposed standard. Comment Letter of Martha P. Willis, Division
Director, State of Florida, Department of Business and Professional
Regulation (Aug. 21, 1998).
---------------------------------------------------------------------------
Creating an undue fear that an isolated error in judgment would
result in a 102(e) proceeding could be counterproductive in some
limited instances.\47\ These concerns are eliminated as to Rule 102(e),
or at least alleviated, by raising the threshold for improper
professional conduct from one instance of ``unreasonable'' conduct to
one instance of ``highly unreasonable'' conduct. Subparagraph (B)(1) of
the final rule amendment does not permit the Commission to evaluate
actions or judgments in the stark light of hindsight, but focuses
instead on what an accountant knew, or should have known, at the time
an action was taken or a decision was made. Indeed, three of the five
largest accounting firms--who expressed concern that the
``unreasonable'' formulation would chill accountants'' use of their
best judgment--suggested that the Commission could appropriately adopt
a ``highly unreasonable'' formulation.\48\ And, as one commenter
pointed out, most state licensing provisions include a ``gross
negligence'' standard.\49\
---------------------------------------------------------------------------
\47\ However, such an error could have legal consequences. See
discussion on p. 20.
\48\ Comment Letter of J. Michael Cook, Chairman and Chief
Executive Officer, and Phillip R. Rotner, General Counsel, Deloitte
& Touche LLP, at 6 (``Deloitte & Touche Comment Letter''); Ernst &
Young Comment Letter, at 24; Comment Letter of
PricewaterhouseCoopers, at 7 (Aug. 20, 1998)
(``PricewaterhouseCoopers Comment Letter'').
\49\ Comment Letter of Wayne A. Kolins, National Director of
Accounting and Auditing, BDO Seidman LLP, at 9 (Aug. 19, 1998)
(citing Uniform Accounting Act section 10(5)). The Commission is not
adopting a ``gross negligence'' standard because courts have not
interpreted the term uniformly. The Commission does not want to
adopt a standard that has already been subject to varying
interpretations. Fairness to accountants and sound public policy is
furthered by using new terminology--the ``highly unreasonable''
standard--which is defined in this release with precision and
clarity. However, the term ``gross negligence'' is often used--like
the Commission's use of the phrase ``highly unreasonable''--as an
intermediate standard between ordinary negligence and recklessness.
---------------------------------------------------------------------------
Some commenters questioned whether raising the standard above
ordinary negligence was consistent with the purpose of Rule
102(e)(1)(ii) to protect the integrity of the Commission's
processes.\50\ These commenters strongly argued that a negligence
standard is needed because accurate financial statements are essential
to the investment decision-making process and auditors play a critical
role in maintaining investor confidence in the reliability of financial
statements.\51\ The heightened standard of ``highly unreasonable''
strikes the appropriate balance between the Commission's need to
protect its processes and accountants' ability to exercise judgment. In
the Commission's view, the balance is appropriate in part because of
the availability of remedies other than Rule 102(e) to address ordinary
negligence. The final rule amendment, therefore, is fully consistent
with the remedial purposes of Rule 102(e).
---------------------------------------------------------------------------
\50\ Weston Comment Letter; Comment Letter of William B.
Patterson, Director, Office of Investments, AFL-CIO, at 2 (Aug. 10,
1998) (``AFL-CIO Comment Letter''); see also Comment Letter of
Patricia D. McQueen, Vice President, Advocacy, Financial Reporting &
Disclosure, and Jonathan J. Stokes, Vice President, Professional
Conduct Program, Association for Investment Management and Research,
at 3 (Aug. 18, 1998).
\51\ See Weston Comment Letter; AFL-CIO Comment Letter, at 2;
Nugent Comment Letter; BancOne Comment Letter, at 2; TIAA-CREF
Comment Letter, at 3.
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The final rule amendment provides that the Commission will bring
cases under subparagraph (B)(1) only when an accountant knows or should
know that heightened scrutiny is appropriate. The ``heightened
scrutiny'' provision is also an objective standard. Again, the
touchstone is the reasonable accountant. ``Heightened scrutiny'' would
be warranted when matters are important or material, or when warning
signals or other factors should alert an accountant of a heightened
risk,\52\ or as set forth in applicable professional standards.\53\
Because of the importance of an accountant's independence to the
integrity of the financial reporting system, the Commission has
concluded that circumstances that raise questions about an accountant's
independence always merit heightened scrutiny. Therefore, if an
accountant acts highly unreasonably with respect to an independence
issue, that accountant has engaged in ``improper professional
conduct.''
---------------------------------------------------------------------------
\52\See, e.g., In re Hope, Accounting and Auditing Enforcement
Release No. 109A (Aug. 6, 1986), 36 SEC Docket 663, 750-55 (Sept.
10, 1986).
\53\ Cf. AICPA Professional Standards, Vol. 1 AU sections 312
and 316 (1997).
---------------------------------------------------------------------------
The proposed amendment focused on conduct presenting ``a
substantial risk, which is either known or should have been known,'' of
making a document filed with the Commission ``materially misleading.''
At least one commenter questioned whether the phrase was overbroad.\54\
Other commenters correctly noted that the Commission's standard should
not depend on the impact of a violation on financial statements filed
with the Commission.\55\ The proper focus should be on the conduct
itself, rather than on the risk of harm posed by the conduct.\56\
---------------------------------------------------------------------------
\54\ PricewaterhouseCoopers Comment Letter, at 5. See also AICPA
Comment Letter, at 17.
\55\ Comment Letter of John M. Liftin, Chair, Committee on
Federal Regulation of Securities, and Richard H. Rowe, Chair,
Committee on Law and Accounting, ABA Section of Business Law, at 12
(Aug. 19, 1998).
\56\ See Comment Letter of William T. Allen, at 3 (July 10,
1998) (``Allen Comment Letter'') (suggesting this approach).
---------------------------------------------------------------------------
This change from the proposed rule amendment is consistent with the
purpose of Rule 102(e)(1)(ii) to protect the Commission's processes
from accountants who lack competence to appear before it. The final
rule amendment addresses this issue by focusing on the behavior of an
accountant under the facts and circumstances presented at the time. The
standard does not permit judgment by hindsight, but rather compares the
actions taken by an accountant at the time of the violation with the
actions a reasonable accountant should have taken if faced with the
same situation.
One commenter stated that filing a materially false or misleading
document with the Commission should be a ``threshold requirement'' for
a finding of improper professional conduct.\57\ The Commission
disagrees. The Commission does not need to show that the accountant's
behavior actually caused harm; an accountant can demonstrate a lack of
competence even if his conduct did not result in the filing of a false
or misleading document. An auditor who fails to audit properly under
GAAS--whether recklessly or highly unreasonably--should not be shielded
because the audited financial statements fortuitously turn out to be
accurate or not materially misleading. For example, the financial
statements of a large company's subsidiary that have been audited by an
accountant who acted recklessly or highly unreasonably in violation of
GAAS may not be material to the consolidated financial statements filed
by the company with the Commission. In that situation, the
[[Page 57169]]
accountant has demonstrated a lack of competence.
---------------------------------------------------------------------------
\57\ PricewaterhouseCoopers Comment Letter, at 5.
---------------------------------------------------------------------------
Some commenters contended that the Commission should not have
special rules for accountants. These commenters claimed further that,
when compared to the standard applied to lawyers, the proposed rule
``discriminates'' against accountants.\58\ As explained earlier, the
amendment to Rule 102(e) focuses on accountants in response to the
Checkosky II decision and the need to assure the protection of the
Commission's financial reporting process. As noted, this release does
not address the conduct of lawyers.
---------------------------------------------------------------------------
\58\ See, e.g., AICPA Comment Letter, at 21-23; Ernst & Young
Comment Letter, at 18-19; KPMG Peat Marwick Comment Letter, at 6-8;
Arthur Andersen Comment Letter, at 7-8.
---------------------------------------------------------------------------
2. Repeated Instances of Unreasonable Conduct
Subparagraph B(2) of the final rule amendment addresses
``[r]epeated instances of unreasonable conduct, each resulting in a
violation of applicable professional standards.'' Repeated instances of
unreasonable conduct by an accountant, each resulting in a violation of
applicable professional standards, can damage both the Commission's
processes and investor confidence in the integrity of financial
statements. Most commenters who addressed the issue supported the
notion of bringing Rule 102(e) proceedings against accountants who
engage in repeated instances of negligent conduct.\59\
---------------------------------------------------------------------------
\59\ See, e.g., Allen Comment Letter, at 1.
---------------------------------------------------------------------------
The term ``unreasonable,'' as distinguished from the term ``highly
unreasonable'' used in subparagraph B(1), connotes an ordinary or
simple negligence standard. The lower standard of culpability is
justified in this instance because the repetition of the unreasonable
conduct may show the accountant's lack of competence to practice before
the Commission. If an accountant fails to exercise reasonable care on
more than one occasion, the Commission's processes may be threatened.
More than one violation of applicable professional standards ordinarily
will indicate a lack of competence.
A few commenters raised questions about what would constitute
``repeated instances'' of unreasonable conduct.\60\ ``Repeated
instances'' means more than once. The term ``repeated'' may encompass
as few as two separate instances of unreasonable conduct occurring
within one audit, or separate instances of unreasonable conduct within
different audits. For example, if an auditor fails to gather evidential
matter for more than two accounts, or certifies accounting inconsistent
with GAAP in more than two accounts, that conduct constitutes
``repeated instances'' of unreasonable conduct. By contrast, a single
error that results in an issuer's financial statements being misstated
in more than one place would not, by itself, constitute a violation of
this subparagraph. Certification of accounting inconsistent with GAAP
in two or more situations, however, may indicate an accountant's basic
unfamiliarity with the standards of the profession, which may
constitute improper professional conduct under subparagraph B(2).
---------------------------------------------------------------------------
\60\ Ernst & Young Comment Letter, at 21-22 (suggesting that the
term ``repeated'' include more than two violations); KPMG Peat
Marwick Comment Letter, at 13; see also Comment Letter of Terry
Warfield, PricewaterhouseCoopers Research Scholar, Associate
Professor, University of Wisconsin (Aug. 1, 1998).
---------------------------------------------------------------------------
The Commission recognizes that ``repeated instances'' may not
always demonstrate a lack of competence to practice before the
Commission. Although the Commission believes that more than one
instance of unreasonable conduct will ordinarily indicate a lack of
competence, unlike subparagraphs (A) and (B)(1), this subparagraph
requires the Commission to make a specific finding that the conduct
indicates a lack of competence. The finding is based on an evaluation
of the conduct itself and does not require a separate evidentiary
basis. This finding is required because two isolated violations of
applicable professional standards, for example GAAS, may not pose a
threat to the Commission's processes.
D. Authority
Some commenters questioned the Commission's authority to adopt a
negligence standard under Rule 102(e). As stated in the Proposing
Release, Rule 102(e) was promulgated under the Commission's broad
authority to adopt those rules and regulations necessary for carrying
out its designated functions,\61\ and its inherent authority to protect
the integrity of its processes. As the Supreme Court has held, ``the
validity of a regulation promulgated [under an agency's general
rulemaking authority] will be sustained so long as it is `reasonably
related to the purposes of the enabling legislation.' '' \62\
---------------------------------------------------------------------------
\61\ See Securities Act section 19(a), 15 U.S.C. 77s(a),
Securities Exchange Act section 23(a), 15 U.S.C. 78w(a), Public
Utility Holding Company Act of 1935 section 20(a), 15 U.S.C. 79t(a),
Trust Indenture Act of 1939 section 319(a), 15 U.S.C. 77sss(a),
Investment Advisers Act of 1940 section 211(a), 15 U.S.C. 80b-11(a),
and Investment Company Act section 38(a), 15 U.S.C. 80a-37(a).
\62\ Mourning v. Family Publication Services, Inc., 411 U.S.
356, 369 (1973) (quoting Thorpe v. Housing Authority of the City of
Durham, 393 U.S. 268, 280-81 (1969)).
---------------------------------------------------------------------------
Three U.S. Courts of Appeals have upheld the validity of Rule
102(e).\63\ As the U.S. Court of Appeals for the Second Circuit
recognized:
---------------------------------------------------------------------------
\63\ See Touche Ross, 609 F.2d at 582; Sheldon v. SEC, 45 F.3d
1515, 1518 (11th Cir. 1995); Davy v. SEC, 792 F.2d 1418, 1421 (9th
Cir. 1986); see also Potts, 151 F.3d 810.
[Rule 102(e)] represents an attempt by the Commission to protect
the integrity of its own processes. It provides the Commission with
the 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.
As such the Rule is 'reasonably related' to the purposes of the
securities laws.\64\
---------------------------------------------------------------------------
\64\ Touche Ross, 609 F.2d at 582 (quoting Mourning, 411 U.S. at
369).
One district court has explicitly held that the Commission's Rule
102(e) authority is not limited to instances of intentional misconduct
or bad faith.\65\
---------------------------------------------------------------------------
\65\ See Danna v. SEC, No. C-93-4158 (CW), 1994 WL 315877 (N.D.
Cal. Feb. 8, 1994).
---------------------------------------------------------------------------
Some commenters either referred to, or echoed, concerns expressed
in the separate opinions of two judges of the U.S. Court of Appeals for
the D.C. Circuit in Checkosky I questioning the Commission's authority
to use a negligence standard for ``improper professional conduct''
under Rule 102(e).\66\ One judge suggested that, if the Commission were
to determine that an accountant's negligence was a per se violation of
Rule 102(e), the Commission may be exceeding the scope of its authority
and engaging in the substantive regulation of the accounting
profession.\67\ Similarly, a number of commenters suggested that
adoption of a simple negligence standard would exceed the Commission's
authority and encroach on the responsibilities of state boards of
accountancy and professional organizations.
---------------------------------------------------------------------------
\66\ The Checkosky decisions held that the Commission had not
clearly articulated the ``improper professional conduct'' standard
or the rationale for that standard. The Checkosky opinions did not
decide the issue of the scope of the Commission's authority. One
judge in Checkosky II wrote a separate opinion to state her
disagreement with the dictum in Checkosky I questioning the
Commission's authority to ensure that the professionals who practice
before it adhere to minimal levels of competence.
\67\ Checkosky I, 23 F.3d at 459 (opinion of Silberman, J.).
---------------------------------------------------------------------------
Although the Commission believes that it has the authority to do
so, the Commission is not adopting a ``simple'' or ``mere'' negligence
standard. Instead, the Commission is adopting a standard under which
two specific types of negligent conduct that result in a
[[Page 57170]]
violation of applicable professional standards are considered a future
threat to the Commission's processes. The Commission is neither broadly
regulating the accounting profession nor preventing accountants from
functioning in numerous areas of their professions. Instead, the
Commission is protecting the integrity and quality of its processes,
and this it emphatically believes--in the public interest and for the
protection of investors--it has the power to do.
In addition, the standard adopted today imposes no new professional
responsibilities on accountants. Instead, the final rule amendment
permits the Commission to bring proceedings against accountants when
their violations of professional standards threaten the Commission's
processes. The Commission is not attempting to police accountants'
conduct in any area other than as it affects the operation of the
federal securities laws.
One other judge in Checkosky I suggested that the Commission's
authority to adopt a negligence standard under Rule 102(e)(1)(ii) might
be limited by substantive provisions of the federal securities laws,
such as the antifraud provision of Exchange Act Section 10(b).\68\ Some
commenters contended that the Commission could not therefore adopt a
definition of ``improper professional conduct'' that did not require
that the accountant acted with ``scienter,'' the mental state required
under the Exchange Act's antifraud provisions.\69\
---------------------------------------------------------------------------
\68\ See Checkosky I, 23 F.3d at 469 (opinion of Randolph, J.).
\69\ See, e.g., Arthur Andersen Comment Letter, at 2-3; KPMG
Peat Marwick Comment Letter, at 6.
---------------------------------------------------------------------------
The definition of ``improper professional conduct'' that the
Commission adopts today does not require scienter in every instance.
The Commission believes this is necessary because Rule 102(e) protects
the integrity of the Commission's processes; it is not an enforcement
remedy or a weapon against fraud.\70\ As noted above, accountants who
engage in two specific kinds of negligent conduct can pose as great a
threat to the Commission's processes as accountants who knowingly
violate professional standards. As one commenter noted, ``the
Commission's power to regulate professional standards should not be
limited by the considerations of scienter that are appropriate in a
jurisprudence built on common law definitions of fraud.'' \71\ In
addition, as another commenter noted, the federal securities laws
impose liability for negligent conduct, as well as for conduct
undertaken with scienter.\72\ As this commenter noted, there are other
policy reasons for the Commission to apply a negligence standard to
accountants who practice before the Commission.\73\
---------------------------------------------------------------------------
\70\ Commissioner Johnson's dissent misconstrues the distinction
between an enforcement remedy and a remedy that protects the
integrity of the Commission's processes. Rule 102(a) does not cease
to protect the Commission's processes simply because those processes
are designed, in turn, to protect investors or because the
Commission, in deciding what type of proceeding to bring, may
sometimes consider whether it is more appropriate to bring a Rule
102(e) proceeding than an enforcement action. Rule 102(e) protects
the integrity of the Commission's processes because it seeks to
assure that professionals who prepare filings made with the
Commission have the competence to prepare filings that comply with
applicable requirements.
\71\ See AFL-CIO Comment Letter, at 3.
\72\ See Comment Letter of Joel Seligman, Dean and Samuel M.
Fegtly Professor of Law, College of Law, University of Arizona, at
2-3 (Aug. 11, 1998).
\73\ Id. at 3.
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E. A ``Good Faith'' Defense
The Commission does not consider the subjective good faith of an
accountant to be an absolute defense under Rule 102(e)(1)(ii).\74\
Subjective good faith is inconsistent with a finding of knowing or
intentional, including reckless, conduct. Moreover, a Rule 102(e)
proceeding based on the particular types of negligence covered in the
final rule amendment does not require any subjective inquiry into the
accountant's intent; subparagraphs (B)(1) and (B)(2) of the final rule
amendment are objective standards. The Commission may, however,
consider the accountant's good faith when determining what sanctions
would be appropriate.
---------------------------------------------------------------------------
\74\ See In re Haskins & Sells, Accounting Series Release 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 Release 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). To the extent that
dictum in In re Logan, 10 S.E.C. 982 (1942), can be read to provide
for a good faith defense, the Commission believes the standard
adopted today is preferable.
---------------------------------------------------------------------------
IV. Summary of Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis (``IRFA'')
on the proposed amendment to Rule 102(e) was published in the proposing
release. The IRFA indicated that the proposed amendment would clarify
the standard by which the Commission determines whether accountants
have engaged in ``improper professional conduct.'' No comments were
received on the IRFA. The Commission has prepared a Final Regulatory
Flexibility Analysis (``FRFA'') in accordance with 5 U.S.C. 604 on the
amendment to Rule 102(e). The following summarizes the FRFA.
The FRFA discusses the need for the rule amendment. Rule 102(e)
currently authorizes the Commission to censure an accountant or deny,
temporarily or permanently, an accountant's privilege of appearing or
practicing before the Commission, if the accountant lacks character or
integrity, or has engaged in unethical or ``improper professional
conduct.'' The existing rule does not define ``improper professional
conduct.''
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's opinions in the case had not articulated clearly the
``improper professional conduct'' element of the Rule. To address the
court's concerns, the Commission is clarifying the Commission's
standard for determining when accountants engage in ``improper
professional conduct.''
The FRFA explains that the rule amendment is designed to protect
the integrity of the Commission's processes. By clarifying the
standards applied in determining ``improper professional conduct,'' the
amendment will help the Commission, its administrative law judges, and
the courts apply the rule fairly and consistently. The amendment will
also give practitioners additional guidance about the standards for
proceedings under Rule 102(e).
The FRFA explains that the notice of proposed rulemaking indicated
how a copy of the IRFA could be obtained, and that no one requested a
copy of the IRFA. The IRFA, and the summary of the IRFA that appeared
in the notice of proposed rulemaking, also solicited 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. No commenters discussed either the IRFA generally or the
number of small entities that would be affected by the proposed
amendment.
The FRFA also discusses the effect of the amendment on small
entities. The FRFA 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 Five'' firms, which are not small
entities, many smaller firms do practice before the Commission. The
Commission does not, however, collect information about revenues of
accounting firms, which information generally is not made public by the
[[Page 57171]]
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
Commission's standard provides a remedy for certain violations of the
accountants' own professional standards and does not impose any new
standards of conduct.
The FRFA notes that the amendment would not impose any new
reporting, recordkeeping or compliance requirements. The FRFA 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 FRFA notes that two commenters suggested that the proposed rule
could have an adverse effect on small accounting firms and/or small
public companies. The Commission believes that it has addressed the
concern that a simple negligence standard might raise fees or
discourage auditors from practice by raising the standard in the final
amendment. Finally, the FRFA notes that one commenter contended that
the proposed amendment would not impose a disproportionate impact on
small entities, and that another commenter wrote that the level of
competence expected of a professional must be an absolute standard,
regardless of the entity's size.
A copy of the FRFA 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.
V. Cost-Benefit Analysis
The Commission requested comments on any costs or benefits
associated with the proposed amendment. No commenters offered any
specific cost or benefit estimates. Several commenters, however,
discussed the costs and benefits of the proposed amendment in general
terms.
One commenter suggested that the ``costs associated with the
proposed amendment appear to outweigh its potential benefits,'' \75\
but offered no data to support the view. The commenter did describe the
costs of the proposed amendment as ``costs associated with a decisional
standard that fails to provide professionals with adequate notice of
the conduct which could be subject to sanction,'' and costs created by
the ``exposure of auditors to sanction based on a single negligent
mistake,'' which the commenter believed ``would introduce an overly
conservative bias into the financial reporting process.'' \76\
---------------------------------------------------------------------------
\75\ See AICPA Comment Letter, at 30.
\76\ Id. at 30-31.
---------------------------------------------------------------------------
This commenter's concern that the proposed rule's use of a simple
negligence standard would impose costs was shared by other commenters.
Three commenters suggested that adoption of a simple negligence
standard would, among other things, cause audit fees to increase.\77\
Likewise, one of these commenters and one other commenter suggested
that the proposed rule's use of a negligence standard would discourage
competent practitioners from pursuing careers in public company
auditing.\78\
---------------------------------------------------------------------------
\77\ See Comment Letter of R. Fogg (Aug. 12, 1998); Comment
Letter of James Backus (Aug. 13, 1998) (``Backus Comment Letter'');
Comment Letter of Kyle E. Carrick (Aug. 20, 1998) (``Carrick Comment
Letter'').
\78\ See BDO Seidman Comment Letter, at 9; Backus Comment
Letter.
---------------------------------------------------------------------------
The Commission does not believe that the final rule amendment
imposes these costs. First, the Commission believes that the standard
it adopts today defines with precision when an accountant's conduct
will subject the accountant to Rule 102(e) proceedings. In fact, the
clarification of the Commission's standard for ``improper professional
conduct'' is one of the benefits of this final rule amendment. Second,
these commenters' concern that accountants will be held liable for a
single negligent mistake is addressed by the final rule amendment. As
described above, the Commission is not adopting a standard that reaches
single acts of simple negligence.
One commenter argued that the proposed rule's costs outweighed its
benefits because it applied to ``CPAs and CPA firms whose past errors
are not necessarily a precursor of future substandard practice.'' \79\
The Commission believes that the final rule amendment only reaches
accountants whose past violations demonstrate a lack of competence to
practice before the Commission.
---------------------------------------------------------------------------
\79\ See ABA Comment Letter, at 7; see also BDO Seidman Comment
Letter, at 9 (stating that proposed amendment ``makes no distinction
between professionals who have erred and those who are likely to err
again'').
---------------------------------------------------------------------------
According to this commenter, the ``elimination of individuals and
firms whose audit services are unreliable will undoubtedly have a
beneficial effect in preventing future investor losses.'' \80\ Weighed
against this benefit, this commenter identified the costs of bringing
Rule 102(e) proceedings and the costs ``associated with depriving the
public of the services of qualified auditors.'' \81\ This commenter
stated that the number of accounting firms providing auditing services
to public companies has declined sharply in the last 20 years and that
there is no assurance that a further decline might not lead to
increased audit fees.\82\
---------------------------------------------------------------------------
\80\ Id.; see also BDO Seidman Comment Letter, at 9.
\81\ Id.
\82\ ABA Comment Letter, at 7.
---------------------------------------------------------------------------
These comments seem directed at the costs and benefits of Rule
102(e) as a whole. The Commission only sought comment on the costs and
benefits of its proposal to clarify ``improper professional conduct,''
not the costs and benefits of Rule 102(e). Moreover, the Commission has
adopted a standard that is designed to reach only those accountants who
lack competence to practice before the Commission. The rule amendment
should not therefore ``deprive'' the public of the service of
``qualified auditors.'' The Commission therefore believes that the
costs and benefits described by the commenter will not be affected by
the particular standard adopted.
The Commission anticipates several benefits from the final rule
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.'' Also,
[[Page 57172]]
the clarified 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 notes that its standard requires in the first instance that
the accountant violate applicable professional standards. Therefore,
the rule imposes no obligation that accountants are not already subject
to. Rather, the amendment merely clarifies that when the Commission
finds that an accountant has violated the applicable professional
standards in circumstances meeting one of three standards of
culpability, that accountant has engaged in ``improper professional
conduct.'' The Commission also notes the existence of state accountancy
boards, which can discipline accountants for violations of professional
standards.
In addition, the federal securities laws and state law causes of
action may provide for sanctions against accountants for related
conduct. Therefore, accountants are already subject to liability and
disciplinary schemes that encourage accountants to comply with
applicable professional standards. After careful consideration of the
comments received, the Commission continues to believe that the
amendment will impose no costs.
VI. Efficiency, Competition and Capital Formation
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 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 requested data on what effect, if any, the proposed
amendment would have on efficiency, competition and capital formation.
No specific data was received in response to this request. One
commenter asserted that the rule as proposed would cause ``the steps
and costs to take a company public'' to escalate.\83\ This commenter
did not, however, provide any detail or explanation of why the proposed
rule would cause this effect.
---------------------------------------------------------------------------
\83\ See Carrick Comment Letter.
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The Commission anticipates no effect on capital formation or
efficiency, as the rule amendment clarifies an existing standard.
Further, because the rule change applies equally to all accountants who
practice before the Commission, and because it clarifies an existing
standard, there should be no anti-competitive effect. In any event, the
Commission believes that any burden on competition imposed by this
amendment is necessary and appropriate in furtherance of the purpose of
the Exchange Act.
VII. Statutory Authority
The Commission is adopting 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 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) Intentional or knowing conduct, including reckless conduct,
that results in a violation of applicable professional standards; or
(B) Either of the following two types of negligent conduct:
(1) A single instance of highly unreasonable conduct that results
in a violation of applicable professional standards in circumstances in
which an accountant knows, or should know, that heightened scrutiny is
warranted.
(2) Repeated instances of unreasonable conduct, each resulting in a
violation of applicable professional standards, that indicate a lack of
competence to practice before the Commission.
* * * * *
By the Commission.
Dated: October 19, 1998.
Margaret H. McFarland,
Deputy Secretary.
Dissenting Statement of Commissioner Norman S. Johnson
Although I have the deepest respect for my esteemed colleagues, I
must dissent from the Commission's decision to issue today's
release.\1\ Despite the good faith demonstrated by my colleagues
throughout this difficult rulemaking process, I believe that the
Commission is repeating past mistakes by again attempting to ``push the
envelope'' of its permissible authority under Rule 102(e) of our Rules
of Practice, which governs the ability of professionals to practice
before the Commission. In my view, the Commission's release disregards
the plain import of the two Checkosky decisions of the United States
Court of Appeals for the District of Columbia Circuit.\2\ The release
amends our Rule of Practice 102(e) so that an accountant's single act
of negligence may amount, under some circumstances, to ``improper
professional conduct,'' with the likely result of depriving an
accountant of his or her livelihood.\3\
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\1\ The standard contained in today's release (the ``Standard'')
was adopted at an open meeting of the Commission on September 23,
1998. See SEC Defines ``Improper Professional Conduct'' by
Accountants, 1998 WL 649370 (S.E.C.) (News Release Sept. 23, 1998).
\2\ See Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994)
(``Checkosky I''); Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998)
(``Checkosky II''). 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).
\3\ Amendment to Rule 102(e) of the Commission's Rules of
Practice, Securities Act Release No. 33-7593 (October 19, 1998) (the
``Release''). Before the recodification of the Commission's Rules of
Practice in 1995, Rule 102(e) was formerly designated Rule 2(e).
There are no substantive differences between the two rules. When
directly quoting pre-1995 materials, I have left references to
``Rule 2(e)'' intact; otherwise all references to the former Rule
2(e) appear as ``Rule 102(e).''
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The more than 150 comment letters we have received--the
overwhelming majority of them highly critical of the most important
part of the proposal--demonstrate that Rule 102(e) is a matter of
crucial importance to the accountants
[[Page 57173]]
who practice before the Commission.\4\ As Judge Randolph observed in
---------------------------------------------------------------------------
Checkosky:
\4\ See, e.g., Richard I. Miller, General Counsel & Secretary,
American Institute of Certified Public Accountants (``AICPA''),
Comment Letter (``CL'') 84; Arthur Andersen LLP, CL 98; Ernst &
Young, LLP, CL 100; see also John M. Liftin, Chair, Committee on
Federal Regulation of Securities, and Richard H. Rowe, Chair,
Committee on Law and Accounting, American Bar Association, Section
of Business Law (``ABA''), CL 81.
---------------------------------------------------------------------------
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.'' * * * 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.\5\
\5\ Checkosky I, 23 F.3d at 479 (Randolph, J.) (quoting Henry J.
Friendly, ``Some Kind of Hearing'', 123 U. Pa. L. Rev. 1267, 1297
(1975)). Almost without exception, the comment letters bear out
Judge Randolph's remarks, indicating that even if an accountant
receives ultimate vindication, the mere bringing of charges of
``improper professional conduct'' by the Commission may well have a
``career-crippling'' effect. See Arthur Andersen, CL 98 at 1 & 5-6;
see also, e.g., J.D. Fluno, Vice Chairman, W.W. Grainger, Inc., CL
75; ABA, CL 81 at 11.
---------------------------------------------------------------------------
As nature abhors a vacuum, so does the Commission: its intentions
regarding the expansion of its Rule 102(e) authority have quickly
become apparent. Within days of the adoption of the new standard on
September 23, 1998, the Commission announced a major new initiative to
address improper accounting practices.\6\ It is clear to me that the
Commission intends for the expanded Rule 102(e) authority it has
arrogated to itself in today's release to be an important enforcement
weapon in this new initiative.
---------------------------------------------------------------------------
\6\ Remarks by SEC Chairman Arthur Levitt, The ``Numbers Game'',
New York University Center for Law and Business (Sept. 28, 1998)
http://www.sec.gov/news/speeches/spch220.txt>; SEC Press Release
98-95 (Sept. 28, 1998) http://www.sec.gov/news/press/98-95.txt>
(announcing ``a major address on the state of accounting'' that will
express Commission ``concern that the quality of financial reporting
in corporate America is eroding and * * * [will] present an action
plan that calls on the entire financial community to remedy the
problem''); see Jube Shiver Jr., SEC to Crack Down on Inflated
Earnings, L.A. Times, Sept. 29, 1998, at B1; see also Saul Hansell,
S.E.C. Crackdown on Technology Write-Offs, N.Y. Times, Sept. 29,
1998, at C1.
---------------------------------------------------------------------------
The proponents of the amendment claim that it is significantly more
protective of accountants than the standard set forth in the
Commission's June 1998 proposing release.\7\ I disagree. I think that
the proposed standard will not preclude the Commission from instituting
Rule 102(e) proceedings for simple negligence.
---------------------------------------------------------------------------
\7\ Proposed Amendment to Rule 102(e) of the Commission's Rules
of Practice, Securities Act Release No. 7546, 1998 WL 311988
(S.E.C.) (June 12, 1988), 63 Fed. Reg. 33305 (June 18, 1998) (the
``Proposing Release'').
---------------------------------------------------------------------------
For close to thirty years, I have followed the Commission's Rule
102(e) proceedings indeed, long ago I wrote two articles on the
subject.\8\ In my view, today's release represents another wrong turn
in the Commission's Rule 102(e) jurisprudence. Previous wrong turns
resulted in the two Checkosky opinions by the D.C. Circuit. Rule 102(e)
differs fundamentally from the securities laws enforced by the
Commission. The purpose of the securities laws is to protect investors,
while the professed purpose of Rule 102(e) is to protect the integrity
of the Commission's administrative processes. Under today's proposal,
Rule 102(e) will be just another weapon in the Commission's enforcement
arsenal. The use of Rule 102(e) as just another enforcement tool
eliminates the underpinning of those few Court decisions that have
upheld, in the most general terms possible, the Commission's ability
even to promulgate Rule 102(e). Thus, the Commission's ability to bring
any Rule 102(e) proceeding--under any standard, against even the most
egregious violators--may now be in jeopardy. Even assuming the
Commission has adequate authority to promulgate Rule 102(e), both
Checkosky opinions indicate that the Commission lacks authority to
adopt the sort of negligence standard contained in the Release. Under
Checkosky, the Commission may only discipline professionals under Rule
102(e) when scienter, including recklessness, is shown.\9\
---------------------------------------------------------------------------
\8\ See Norman S. Johnson, The Dynamics of SEC Rule 2(e): A
Crisis for the Bar, 1975 Utah L. Rev. 629; Norman S. Johnson, The
Expanding Responsibilities of Attorneys in Practice Before the SEC:
Disciplinary Proceedings Under Rule 2(e) of the Commission's Rules
of Practice, 25 Mercer L. Rev. 637 (1974).
\9\ See Robert D. Potts, Exchange Act Release No. 39126, 1997 WL
690519 (S.E.C.), at *12 (Sept. 29, 1997) (Commissioner Johnson,
concurring), aff'd on other grounds, 151 F.3d 810 (8th Cir. 1998);
David J. Checkosky, Exchange Act Release No. 38183, 1997 WL 18303
(S.E.C.), at *14 (Jan. 21, 1997) (Commissioner Johnson, dissenting),
rev'd, Checkosky II, 139 F.3d 221.
---------------------------------------------------------------------------
My long-standing interest in the Commission's Rule 102(e)
jurisprudence, as well as my deep-rooted objections to the rule's
expansive and improper uses, leads me to set forth my dissenting views
at some length and in the following order:
Because it is impossible to evaluate fairly today's
release without consideration of the Commission's past missteps, I
outline the history of Rule 102(e) in the first section.
Next, in the second section, I discuss the Checkosky case,
including the D.C. Circuit's two reversals of Commission opinions.
In the third section, I explain the basis for my view that
the Commission lacks legal authority even to promulgate Rule 102(e),
and that, in any event, the Commission lacks the legal authority to
adopt a negligence standard under Rule 102(e).
In the fourth section, I demonstrate that the Standard is
vague, and that it does not comply with the mandate of both Checkosky I
and Checkosky II that we adopt a clear standard.
In the fifth section, I set forth the various reasons
why--even assuming adequate legal authority and clarity--it is not in
the public interest for the Commission to adopt the Standard.
Next, in the sixth section, I question whether the
Commission gave adequate notice in its Proposing Release that it might
adopt certain aspects of today's release.
Finally, in the seventh section, I set forth the likely
ways in which the Commission will seek to expand its Rule 102(e)
authority in the future.
I. ``Administrative Oaks'' and ``Legislative Acorns'': A Brief
History of Rule 102(E)
In one of its landmark securities decisions restricting the growth
of implied private actions under the federal securities laws, the
Supreme Court remarked that Rule 10b-5 was ``a judicial oak which has
grown from little more than a legislative acorn.'' \10\ The
Commission's use of Rule 102(e) to regulate professional conduct might
similarly be described as an ``administrative oak'' growing out of a
``legislative acorn.'' There is no express statutory provision
authorizing the Commission to discipline professionals; instead, a
handful of courts have upheld the Commission's promulgation of Rule
102(e) as impliedly proper because the rule is `` `reasonably related'
to the purposes of the securities laws.'' \11\ I fully subscribe to the
views of a distinguished predecessor, Commissioner Roberta Karmel, who
observed in a Rule 102(e) case almost twenty years ago that ``[t]he
administrative implication of
[[Page 57174]]
prosecutorial remedies under federal legislation is rife with the same
evil'' possessed by ``judicial implication of private rights of
action.'' \12\ In my view, the same disfavor the Supreme Court has
enunciated towards implied private rights of action is equally
applicable--and probably more so--to implied prosecutorial remedies
such as those the Commission utilizes under Rule 102(e).\13\
---------------------------------------------------------------------------
\10\ Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 732, 737
(1975).
\11\ Checkosky I, 23 F.3d at 455 (Silberman, J.) (quoting Touche
Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979)); see also,
e.g., Daniel L. Goelzer & Susan Ferris Wyderko, Rule 2(e):
Securities and Exchange Commission Discipline of Professionals, 85
Nw. U. L. Rev. 652, 652 (1991) (lawyers and accountants ``are not
subject to direct regulation under the federal securities laws,''
and their licensing and discipline is ``largely a matter committed
to state licensing bodies and professional associations'').
\12\ Keating, Muething & Klekamp, 47 S.E.C. 95, 111 (1979)
(Commissioner Karmel, dissenting). Unfortunately, Commissioner
Karmel dissented in the context of a settled enforcement action, so
there was no opportunity for judicial review of the issues she
raised. Several commentators have suggested that attempts to evade
appellate review are a hallmark of the Commission's Rule 102(e)
jurisprudence. See, e.g., Ann Maxey, SEC Enforcement Actions Against
Securities Lawyers: New Remedies v. Old Policies, 22 Del. J. Corp.
L. 537, 552-53 (1997); Richard W. Painter & Jennifer E. Duggan,
Lawyer Disclosure of Corporate Fraud: Establishing a Firm
Foundation, 50 S.M.U. L. Rev. 225, 271 (1996).
\13\ See Touche Ross & Co. v. Redington, 442 U.S. 560 (1979);
see also, e.g., Central Bank v. First Interstate Bank, 511 U.S. 164
(1994); Keating, 47 S.E.C. at 111 & 116 n.35 (Commissioner Karmel,
dissenting). The Supreme Court has approved the use of implied
ancillary remedies, such as when the Commission seeks, e.g.,
disgorgement as a remedy in a typical enforcement action, but that
situation seems readily distinguishable from Rule 102(e), in which
both the cause of action and its remedy are implied. Cf. Franklin v.
Gwinnett County Public Schools, 503 U.S. 50 (1992) (approving
implied remedy to express cause of action).
---------------------------------------------------------------------------
The Commission first promulgated Rule 102(e) in 1935.\14\ In its
initial form, the rule contained a requirement that attorneys be
admitted to practice before the Commission (as was then required of
attorneys and accountants who sought to represent persons before the
Internal Revenue Service).\15\ In 1938, however, the Commission struck
the admission requirement, and since then the rule's only use has been
to permit the Commission to censure, suspend or disbar
professionals.\16\
---------------------------------------------------------------------------
\14\ See Touche Ross & Co. v. SEC, 609 F.2d 570, 578 n.13 (2d
Cir. 1979) (``Touche Ross''); Harold Marsh, Jr., Rule 2(e)
Proceedings, 35 Bus. Law. 987, 987 (1980).
\15\ Marsh, supra note 14, 35 Bus. Law. at 987.
\16\ Id. Although Rule 102(e) reaches all types of professionals
who might practice before the Commission, including engineers or
expert witnesses, there have been only a few cases in the rule's 63-
year history that did not involve either a lawyer or an accountant.
---------------------------------------------------------------------------
Although Rule 102(e) has caused a great deal of controversy since
its inception,\17\ it was only used sparingly
[[Page 57175]]
during the first 35 years or so of its existence.\18\ Things changed in
the early 1970's when the Commission embarked on its so-called
``access'' theory of securities law enforcement.\19\ As a consequence
of its belief that access to capital markets is controlled by a limited
number of professionals, the Commission sought to achieve maximum
deterrent value from its limited enforcement resources by suing the
gatekeepers, rather than simply proceeding against the principal
wrongdoers.\20\ Accordingly, the Commission brought wave-upon-wave of
actions--including many Rule 102(e) administrative proceedings--against
securities professionals, accountants and lawyers.\21\
---------------------------------------------------------------------------
\17\ The following is a sampling of the literature discussing
the Commission's use of Rule 102(e), the vast bulk of it
extraordinarily critical--particularly when one discounts articles
by Commission officials defending policies they themselves have
helped formulate and administer. (I find it ironic that the number
of law review articles discussing Rule 102(e) dwarfs the number of
actual federal court decisions construing it by a factor of
approximately 10 to 1). See, e.g., Roberta S. Karmel, Regulation by
Prosecution: The Securities and Exchange Commission vs. Corporate
America 173-83 (1982); ABA, Statement of Policy Adopted by ABA
Regarding Responsibilities and Liabilities of Lawyers in Advising
with Respect to the Compliance of Clients with Laws Administered by
the Securities and Exchange Commission, 31 Bus. Law. 543, 545
(1975); ABA Task Force on Rule 102(e) Proceedings, Report of the
Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against
Accountants, 52 Bus. Law. 965 (1997); David H. Barber, Lawyer Duties
in Securities Transactions Under Rule 2(e): The Carter Opinions,
1982 B.Y.U. L. Rev. 513; Arthur Best, Shortcomings of Administrative
Agency Lawyer Discipline, 31 Emory L.J. 535 (1982); Judah Best, In
Opposition to Rule 2(e) Proceedings, 36 Bus. Law. 1815 (1981);
Dennis J. Block & Charles J. Ferris, SEC Rule 2(e)--A New Standard
for Ethical Conduct or an Unauthorized Web of Ambiguity, 81 Cap. U.
L. Rev. 501 (1982); John C. Burton, SEC Enforcement and Professional
Accountants: Philosophy, Objectives and Approach, 28 Vand. L. Rev.
19 (1975); Michael P. Cox, Regulation of Attorneys Practicing Before
Federal Agencies, 34 Case W. Res. L. Rev. 173 (1984); Joseph C.
Daley & Roberta S. Karmel, Attorneys' Responsibilities: Adversaries
at the Bar of the SEC, 24 Emory L.J. 747 (1975); Mitchell F. Dolin,
SEC Rule 2(e): After Carter-Johnson: Toward a Reconciliation of
Purpose and Scope, 9 Sec. Reg. L.J. 331 (1982); James R. Doty et
al., The Professional as Defendant, in 23rd Annual Institute on
Securities Regulation 681 (PLI Corp. Law & Practice Course Handbook
Series No. B4-6978, 1991); Robert A. Downing & Richard L. Miller,
Jr., The Distortion and Misuse of Rule 2(e), 54 Notre Dame Law. 774
(1979); Robert W. Emerson, Rule 2(e) Revisited: SEC Disciplining of
Attorneys since In re Carter, 29 Am. Bus. L.J. 155 (1991); Ralph C.
Ferrara, Administrative Disciplinary Proceedings Under Rule 2(e), 36
Bus. Law. 1807 (1981); Ted J. Fiflis, Choice of Federal or State Law
for Attorneys' Professional Responsibility in Securities Matters, 56
N.Y.U. L. Rev. 1236 (1981); Monroe H. Freedman, A Civil Libertarian
Looks at Securities Regulation, 35 Ohio St. L.J. 280 (1974); Ray
Garrett, Jr., Social Responsibility of Lawyers in Their Professional
Capacity, 30 U. Miami L. Rev. (1976); Daniel L. Goelzer, The SEC and
Opinion Shopping: A Case Study in the Changing Regulation of the
Accounting Profession, 52 Brook. L. Rev. 1057 (1987); Stuart C.
Goldberg, Policing Responsibilities of the Securities Bar: The
Attorney-Client Relationship and the Code of Professional
Responsibility--Considerations for Expertizing Securities Attorneys,
19 N.Y.L.F. 221 (1973); Paul Gonson, Disciplinary Proceedings and
Other Remedies Available to the SEC, 30 Bus. Law. 191 (1975); Kent
Gross, Attorneys and Their Corporate Clients: SEC Rule 2(e) and the
Georgetown ``Whistle Blowing'' Proposal, 3 Corp. L. Rev. 197 (1980);
Samuel H. Gruenbaum, The SEC's Use of Rule 2(e) to Discipline
Accountants and Other Professionals, 56 Notre Dame Law. 820 (1981);
Samuel H. Gruenbaum & Marc I. Steinberg, Accountants' Liability and
Responsibility: Securities, Criminal and Common Law, 13 Loy. L.A. L.
Rev. 247 (1980); Stanley A. Kaplan, Some Ruminations on the Role of
Counsel for a Corporation, 56 Notre Dame L. Rev. 873 (1981); Roberta
S. Karmel, A Delicate Assignment: The Regulation of Accountants by
the SEC, 56 N.Y.U. L. Rev. 959 (1981); Roberta S. Karmel, Attorneys'
Securities Law Liabilities, 27 Bus. Law. 1153 (1972); John J.
Kelleher, Scourging the Moneylenders from the Temple: The SEC, Rule
2(e) and the Lawyers, 17 San Diego L. Rev. 501 (1980); Michael R.
Klein, The SEC and the Legal Profession: Material Adverse
Developments, 11 Inst. on Sec. Reg. (PLI) 604 (1979); Reynold Kosek,
Professional Responsibility of Accountants and Lawyers Before the
Securities and Exchange Commission, 72 L. Libr. J. 453 (1979);
Steven C. Krane, The Attorney Unshackled: SEC Rule 2(e) Violates
Clients' Sixth Amendment Right to Counsel, 57 Notre Dame L. Rev. 50
(1981); Werner Kronstein, The Carter-Johnson Case: A Higher
Threshold for SEC Actions Against Attorneys, 9 Sec. Reg. L.J. 293
(1981); Michael R. Lanzarone, Professional Discipline: Unfairness
and Inefficiency in the Administrative Process, 51 Fordham L. Rev.
818 (1983); Philip H. Levy, Regulation of the Accounting Profession
Through Rule 2(e) of the SEC's Rules of Practice: Valid or Invalid
Exercise of Power?, 46 Brook. L. Rev. 1159 (1980); Frederick D.
Lipman, The SEC's Reluctant Police Force: A New Role for Lawyers, 49
N.Y.U. L. Rev. 437 (1974); Simon M. Lorne, The Corporate and
Securities Adviser, the Public Interest, and Professional Ethics, 76
Mich. L. Rev. 423 (1978); Lewis D. Lowenfels, Expanding Public
Responsibilities of Securities Lawyers: An Analysis of the New Trend
in Standard of Care and Priorities of Duties, 74 Colum. L. Rev. 412
(1974); Harold L. Marquis, An Appraisal of Attorneys'
Responsibilities Before Administrative Agencies, 26 Case W. Res. L.
Rev. 285 (1976); Arthur F. Mathews, SEC Injunctive Proceedings
Against Attorneys, 36 Bus. Law. 1819 (1981); Christine Neylon
O'Brien, SEC Regulation of the Accounting Profession: Rule 2(e), 21
Gonz. L. Rev. 675 (1985); L. Ray Patterson, The Limits of the
Lawyer's Discretion and the Law of Legal Ethics: National Student
Marketing Revisited, 1979 Duke L.J. 1251; Marvin G. Pickholtz, SEC
Regulation of Professionals, 4 Rev. Fin. Serv. Reg. 165 (1988);
Irving M. Pollack, The SEC Lawyer: Who is His Client and What are
His Responsibilities?, 49 Geo. Wash. L. Rev. 453 (1981); Martin B.
Robins, Policeman, Conscience or Confidant: Thoughts on the
Appropriate Response of a Securities Attorney Who Suspects Client
Violations of the Federal Securities Laws, 15 J. Marshall L. Rev.
373 (1982); Michel Rosenfeld, The Transformation of the Attorney-
Client Privilege: In Search of an Ideological Reconciliation of
Individualism, the Adversary System, and the Corporate Client's SEC
Disclosure Obligations, 33 Hastings L.J. 495 (1982); Quinton F.
Seamons, Inside the Labyrinth of the Elusive Standard Under the
SEC's Rule 2(e), 23 Sec. Reg. L.J. 57 (1995); Morgan Shipman, The
Need for SEC Rules to Govern the Duties and Civil Liabilities of
Attorneys Under the Federal Securities Statutes, 34 Ohio St. L.J.
231 (1973); George J. Siedel, Rule 2(e) and Corporate Officers, 39
Bus. Law. 455 (1984); Marshall L. Small, An Attorney's
Responsibilities Under Federal and State Securities Laws: Private
Counselor or Public Servant?, 61 Cal. L. Rev. 1189 (1973); Mindy
Jaffe Smolevitz, The Opinion Shopping Phenomenon: Corporate
America's Search for the Perfect Auditor, 52 Brook. L. Rev. 1077
(1987); Theodore Sonde, Professional Disciplinary Proceedings, 30
Bus. Law. 157 (1975); Marc I. Steinberg, Attorney Liability Under
the Securities Laws, 45 Sw. L.J. 711 (1991); Wallace L. Timmeny,
Responsibilities of Lawyers in Connection with the Sale of Municipal
Securities, 36 Bus. Law. 1799 (1981); Francis M. Wheat, The Impact
of SEC Professional Responsibility Standards, 34 Bus. Law. 969
(1979); David B. Wilkins, Who Should Regulate Lawyers?, 105 Harv. L.
Rev. 799 (1992); Harold M. Williams, Corporate Accountability and
the Lawyer's Role, 34 Bus. Law. 7 (1978); Marie L. Coppolino, Note,
Rule 2(e) and the Auditor: How Should the Securities and Exchange
Commission Define its Standard of Professional Conduct?, 63 Fordham
L. Rev. 2227 (1995); Michael J. Crane, Note, Disciplinary
Proceedings Against Accountants: The Need for a More Ascertainable
Improper Professional Conduct Standard in the SEC's Rule 2(e), 53
Fordham L. Rev. 351 (1984); Robert G. Day, Note, Administrative
Watchdogs or Zealous Advocates? Implications for Legal Ethics in the
Face of Expanded Attorney Liability, 45 Stan. L. Rev. 645, 673
(1993); William Kenneth C. Dippel, Comment, Attorney Responsibility
and Carter Under SEC Rule 2(e): The Powers That Be and the Fear of
the Flock, 36 Sw. L.J. 897 (1982); Todd J. Flagel, Note, Securities
Law: SEC Must Clarify Its Position as to the Level of Culpability
that Must Be Shown to Constitute a Rule 2(e)(1)(ii) Violation By
Accountants, 20 Dayton L. Rev. 1083 (1995); Note, Attorney
Discipline by the SEC: 2(e) or not 2(e)?, 17 New Eng. L. Rev. 1267
(1982); Note, The Duties and Obligations of the Securities Lawyer:
The Beginning of a New Standard for the Legal Profession?, 1975 Duke
L.J. 121; Note, SEC Disciplinary Proceedings Against Attorneys Under
Rule 2(e), 79 Mich. L. Rev. 1270 (1981); Comment, SEC Disciplinary
Rules and the Federal Securities Laws: The Regulation, Role and
Responsibilities of the Attorney, 1972 Duke L.J. 969.
\18\ As to the lawyers, the first Rule 102(e) proceeding was not
brought until 1950, and only five cases were brought before 1960.
See Keating, 47 S.E.C. at 112 (Commissioner Karmel, dissenting). The
number of Rule 102(e) cases against accountants during from 1935 to
1970 was also de minimis by comparison to recent years when the
Commission has brought (according to statistics supplied by our
Office of the Chief Accountant) an average of over 25 cases
annually. See Marsh, supra note 14, 35 Bus. Law. at 987-89.
Commentators seem to agree that, for various reasons, it is
impossible to obtain accurate historical statistics regarding Rule
102(e) proceedings, particularly for the period before 1975. See
Emerson, supra note 17, 29 Am. Bus. L.J. at 173-83 (comprehensive
effort to tabulate number and type of Rule 102(e) proceedings
against lawyers through 1989); Marsh, supra note 14, 35 Bus. Law. at
988.
\19\ See, e.g., Burton, supra note 17, 28 Vand. L. Rev. at 19-
20; Simon M. Lorne & W. Hardy Callcott, Administrative Actions
Against Lawyers Before the SEC, 50 Bus. Law. 1293, 1297 (1995);
Maxey, supra note 12, 22 Del. J. Corp. L. at 549.
\20\ Harvey L. Pitt & Karen L. Shapiro, Securities Regulation by
Enforcement: A Look Ahead at the Next Decade, 7 Yale J. on Reg. 149,
171-74 (1990).
\21\ Id.; see also Emerson, supra note 17, 29 Am. Bus. L.J. at
176 (for attorneys, peak years of Rule 102(e) enforcement activity
were 1975 through 1977, when the Commission brought actions against
53 attorneys and three law firms).
---------------------------------------------------------------------------
The high water mark of the Commission's ``access'' theory was
probably the National Student Marketing case.\22\ In National Student
Marketing, the Commission brought an injunctive action that charged two
nationally prominent law firms and several of their respective partners
with aiding and abetting a securities fraud based on their alleged
failure to take proper action when they ``permitted'' their clients to
complete a merger that had received shareholder approval based on a
proxy statement containing materially misleading financial
information.\23\ The Commission's complaint alleged that the lawyers
had a duty to insist that their clients resolicit proxies based on
corrected information, and that, if the clients refused to follow this
advice, the lawyers were required to resign and to report the alleged
securities violations to the Commission.\24\ In practical terms, the
Commission sought to make involuntary ``whistle-blowers'' or government
agents out of private counsel by ``plac[ing] upon the lawyer a
responsibility to investigate his clients'' activities in search for
possible violations of law.'' \25\
---------------------------------------------------------------------------
\22\ SEC v. National Student Marketing Corp., [1971-1972
Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 93,360, at 91,913
(D.D.C. 1972) (complaint). Less than two weeks after the filing of
the National Student Marketing complaint, the Wall Street Journal
reported that it had become the ``best-read document since Gone With
the Wind.'' Green, Irate Attorneys--A Bid to Hold Lawyers
Accountable to Public Stuns, Angers Firms, Wall St. J., Feb. 15,
1972, at 1, col. 1; see also Samuel H. Gruenbaum, Corporate/
Securities Lawyers: Disclosure, Responsibility, Liability to
Investors, and National Student Marketing Corp., 54 Notre Dame Law.
795 (1979).
\23\ National Student Marketing, [1971-1972 Transfer Binder]
Fed. Sec. L. Rep. (CCH) para. 93,360, at 91,913; see also Lorne,
supra note 17, 76 Mich. L. Rev. at 455.
\24\ SEC v. National Student Marketing Corp., [1971-1972
Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 93,360 at para.
48(i).
\25\ Milton V. Freeman, Recent Governmental Attacks on the
Private Lawyer as an Infringement of the Constitutional Right to
Counsel, 36 Bus. Law. 1791, 1792 (1981); see Cox, supra note 17, 34
Case W. Res. L. at 204 (referring to attempts by Commission towards
the ``enlistment of attorneys as agents of the government'');
Wilkins, supra note 17, 105 Harv. L. Rev. at 836 (Commission has
appeared to engage in ``overzealous enforcement'' actions against
lawyers in order to encourage them to serve as watchdogs over their
clients). Accord Mathews, supra note 17, 36 Bus. Law. at 1829; Marc
I. Steinberg, Attorney Liability for Client Fraud, 1991 Colum. Bus.
L. Rev. 1, 9.
---------------------------------------------------------------------------
In discussing National Student Marketing, one Commissioner went so
far as to state that, at least in the context of a securities
transaction, a lawyer's role was ``more akin to that of an auditor,''
i.e., the lawyer would ``have to exercise a measure of independence''
from his client and would have to be ``acutely cognizant of his
responsibility to the public who engage in securities transactions that
would never have come about if not for his professional presence.''
\26\ Although the Commission brought National Student Marketing as an
injunctive action in federal court, it soon changed its emphasis in
professional discipline cases and increasingly brought them as
administrative proceedings under Rule 102(e).\27\
---------------------------------------------------------------------------
\26\ A.A. Sommer, The Emerging Responsibilities of the
Securities Lawyer, [1973-1974 Transfer Binder] Fed. Sec. L. Rep.
(CCH) para. 79,631, 83,686, at 83,689 to 83,690 (Jan. 24, 1974). I
have the highest regard for former Commissioner Sommer, but I have
long believed that this notion of lawyer as auditor is contrary to
traditional canons of professional responsibility. See Johnson,
supra note 8, 1975 Utah L. Rev. at 645-50.
\27\ During the 1970's, federal courts increasingly placed
limitations on the Commission's ability to bring suit and obtain
injunctive relief. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S.
185, 197-198 (1976) (proof of scienter required in a Rule 10b-5
action); SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90,
98 (2d Cir. 1978) (``current judicial attitude toward the issuance
of injunctions on the basis of past violations at the SEC's request
has become more circumspect than in earlier days''). Convincing
evidence exists demonstrating that the Commission increased its use
of Rule 102(e) administrative proceedings after National Student
Marketing as a means to circumvent these judicially-imposed
limitations. See Downing & Miller, supra note 17, 54 Notre Dame Law.
at 783-85 (quoting June 1976 memorandum from Commission's General
Counsel to Commission's Chairman suggesting that the Commission
might appropriately bring Rule 102(e) actions in situations in which
a professional's conduct would not satisfy the Hochfelder
requirement of scienter for Rule 10b-5 actions); see also, e.g.,
Arthur Best, supra note 17, 31 Emory L.J. at 550 (lesser negligence
standard ``may explain why SEC chose'' to bring Rule 102(e) action,
rather than injunctive action against major accounting firm, and
this option ``can be viewed either as an advantage of the
administrative process or as a dangerous discretionary weapon that
ought not to be available to the agency''); James P. Hemmer,
Resignation of Corporate Counsel: Fulfillment or Abdication of Duty,
39 Hastings L.J. 641, 650 (1988) (``The unwillingness of the courts
to issue injunctions when there is no likelihood of recurring
violation * * * is at least one of the principal factors in the
SEC's increasing use of rule 2(e) proceedings to govern the
discipline of professionals.'').
---------------------------------------------------------------------------
Although National Student Marketing involved charges against law
firms and individual lawyers, the Commission did not limit its
overreaching to the legal profession--indeed, one contemporaneous
commentary referred to accountants as the ``most actively besieged
profession'' under Rule 102(e).\28\ In SEC v. Arthur Young & Co., a
case arising from the activities of an oil and gas venture promoter
over a seven-year period in the 1960's, the Commission charged a
nationally prominent accounting firm and the responsible auditors with
committing or aiding and abetting securities fraud.\29\ Because the
case predated the Supreme Court's decision requiring the Commission to
prove scienter in its Rule 10b-5 enforcement cases,\30\ the Ninth
Circuit assumed that ``negligence, rather than scienter, constitutes
the standard by which an accountant's or auditor's
[[Page 57176]]
performance must be measured.''\31\ Before the district court, the
Commission argued that the firm and its auditors performed their work
``with blinders on'' and that they should have done ``more'' to reveal
the risks to those who invested in the ventures.\32\ On appeal, the
Commission apparently argued that the accountants had failed to perform
their audit in a manner that would have revealed to ``an ordinary
prudent investor, who examined the * * * audits or financial
statements, a reasonably accurate reflection of the financial risks * *
*.'' \33\ The Ninth Circuit rejected both formulations of the
Commission's argument, noting:
\28\ See Downing & Miller, supra note 17, 54 Notre Dame Law. at
775 n.6; see also id. at 774 (``Recent 2(e) proceedings against
accountants demonstrate that the SEC has converted the rule from one
designed to serve the limited salutary purpose of exercising
disciplinary authority over the incompetent, unethical or dishonest
accounting practitioner to a rule which has effectively been
utilized to pervasively regulate accounting firms and the profession
as a whole.'').
\29\ 590 F.2d 785, 786 (9th Cir. 1979).
\30\ Aaron v. SEC, 446 U.S. 680 (1980).
\31\ 590 F.2d at 787.
\32\ 590 F.2d at 787.
\33\ 590 F.2d at 787-88.
---------------------------------------------------------------------------
To accept the SEC's position would go far toward making the
accountant both an insurer of his client's honesty and an
enforcement arm of the SEC. We can understand why the SEC wishes to
so conscript accountants. Its frequently late arrival on the scene
of fraud and violations of the securities laws almost always suggest
that had it been there earlier with the accountant it would have
caught the scent of wrong-doing and, after an unrelenting hunt,
bagged the game. What it cannot do, the thought goes, the accountant
can and should. The difficulty with this is that Congress has not
enacted the conscription bill that the SEC seeks to have us fashion
and fix as an interpretive gloss on existing securities laws.\34\
\34\ 590 F.2d at 788.
---------------------------------------------------------------------------
To be sure, the Commission's attitude towards the conscription of
accountants--and their purported wearing of ``blinders,'' or failures
to observe and respond to ``red flags''--persists to this day.\35\
---------------------------------------------------------------------------
\35\ In a later case upholding disciplinary sanctions imposed by
the Commission on an accountant under Rule 102(e), the Ninth Circuit
purported to distinguish Arthur Young. See Davy v. SEC, 792 F.2d
1418, 1422 (9th Cir. 1986). I confess to being confused by Davy--one
would think that if the Commission were barred from directly
``conscript[ing] accountants'' under the substantive securities
laws, it would also be barred from indirectly ``conscript[ing]
accountants'' under Rule 102(e). The real distinction seems to be
that Davy, unlike Arthur Young, involved truly egregious scienter-
based misconduct by an accountant. See 792 F.2d at 1422 (referring
to Commission finding, supported by ``substantial evidence,'' that
the accountant ``knowingly participated in the fraud practice by
[the issuer] on the investing public''). In any event, Davy does not
support the Commission's adoption of the Standard, because the Court
went to great lengths to limit its holding:
We do not consider whether cases can arise in which the SEC in
Rule 2(e) matters exceeds its proper jurisdictional boundaries. The
precise reach of the SEC in these situations has not been defined
and we leave that task for a future case which implicates that
question directly.
Id.; see also id. (``there may be cases where the SEC should not
be empowered to determine the standards by which accountants, or
attorneys for that matter, are to be judged''; ``[w]e pretermit any
discussion of the SEC's power to determine standards for discipline
under Rule 2(e) until we have the issue squarely before us'').
---------------------------------------------------------------------------
Many legal scholars and members of the securities bar and industry,
myself among them, decried the Commission's overreaching in National
Student Marketing, Arthur Young and similar cases.\36\ One commentary
described the Commission's efforts, colorfully but accurately, as a ``
`reign of terror' on broker-dealers, accountants and attorneys.'' \37\
Indeed, for more than twenty-five years, the Commission's attempts to
set standards for professional conduct, under Rule 102(e) and
otherwise, have caused much dissension on the Commission itself.\38\
The roster of distinguished former Commissioners who have expressed
serious doubts about the Commission's expansive uses of Rule 102(e) and
other attempts to set professional standards includes: Edward H.
Fleischman, Roberta S. Karmel, Philip Lochner, Jr., Richard Y. Roberts,
and Steven M.H. Wallman.\39\
---------------------------------------------------------------------------
\36\ See, e.g., Daley & Karmel, supra note 17, 24 Emory L.J.
747; Downing & Miller, supra note 17, 54 Notre Dame Law. 774;
Freeman, supra note 25, 36 Bus. Law. 1791; Johnson, supra note 8,
1975 Utah L. Rev. 629; Johnson, supra note 8, 25 Mercer L. Rev. 637.
\37\ Dennis J. Block & Jonathan M. Hoff, SEC Moves Against
Attorneys Under the Remedies Act, N.Y.L.J., Sept. 23, 1993, at 5
(quoting Harvey L. Pitt & Dixie L. Johnson, Justice Delayed, Justice
Denied: Observations on the SEC's `Kern' Decision, N.Y.L.J., July
11, 1991, at 5).
\38\ See, e.g., Keating, 47 S.E.C. at 109 (Commissioner Karmel,
dissenting); Richard E. Brodsky, P.A., CL 54.
\39\ Keating, 47 S.E.C. at 112 (1979) (Commissioner Karmel,
dissenting); see also Potts, 1997 WL 690519 (S.E.C.), at *17
(Commissioner Wallman, dissenting); David J. Checkosky, 50 S.E.C.
1180, 1198 (1992) (Commissioner Roberts, concurring in part and
dissenting in pertinent part); Allied Stores Corp., 1987 SEC LEXIS
4306, at *19 (June 29, 1987) (Commissioner Fleischman, dissenting);
Richard Y. Roberts, CL 18.
It appears that the Rule 102(e) skeptics on the Commission have
not always been in the minority. See Potts, 1997 WL 690519 (S.E.C.),
at *12 (Commissioner Johnson, concurring) (noting that the
Commission was ``evenly split two-two'' on the issue of whether a
single act of mere negligence was sufficient for liability under
Rule 102(e)); see also Checkosky I, 23 F.3d at 487 (discussing media
reports that, at a preliminary stage, three Commissioners had voted
to overturn the `` `harsh sanction' '' imposed by the Administrative
Law Judge); David J. Checkosky, 50 S.E.C. at 1182 (denying
respondents' ``factual assertion that * * * the Commission had
[earlier] rendered a final opinion in this case and improperly
refused to publish it'').
---------------------------------------------------------------------------
Much of the criticism of the Commission's efforts in this area has
focussed on two factors. First, neither the Commission nor its
administrative law judges (``ALJ's'') have a statutory mandate to
establish ethical standards nor any special expertise in the area of
professional responsibility; second, the threat of disciplinary action
might well intimidate and interfere with the exercise of independent
professional judgment and, as to lawyers, might deprive clients of
their constitutional right to counsel.\40\ These fears were far from
academic: the National Student Marketing case clearly affected the
ability and willingness of the securities bar to take zealous positions
before the Commission.\41\ According to an article co-written by the
then-General Counsel of the Commission, the controversy caused by
National Student Marketing and similar cases became so heated that it
affected ``the Commission's ability to carry out its statutory
mandates,'' because it lessened the necessary cooperation and trust
between the Commission, its staff and the securities bar and
industry.\42\
---------------------------------------------------------------------------
\40\ See Keating, 47 S.E.C. at 112-17 & n.31 (1979)
(Commissioner Karmel, dissenting); see also, e.g., Kivitz v. SEC,
475 F.2d 956, 962 (D.C. Cir. 1973) (reversing Commission finding of
liability in Rule 102(e) disbarment case; declining to give
Commission any deference in matters of alleged professional
misconduct); Judah Best, supra note 17, 36 Bus. Law. at 1817;
Freeman, supra note 25, 36 Bus. Law. at 1792-94; Lorne & Callcott,
supra note 19, 50 Bus. Law. at 1301-03.
\41\ Cf. Lorne, supra note 17, 76 Mich. L. Rev. at 455-56
(recounting post-National Student Marketing incident in which a
lawyer, unable to compel disclosure, resigned from his law firm and
reported the matter to the SEC; after the disclosure was made, a
class action lawsuit followed that was settled upon payment of
$785,000, $625,000 of which came from the lawyer's former firm, and
only $160,000 from the client).
\42\ Lorne & Callcott, supra note 19, at 1300-01 (referring to
actions against lawyers).
---------------------------------------------------------------------------
In response to the well-deserved firestorm of criticism caused by
National Student Marketing and similar cases, the Commission
retreated.\43\ As to lawyers, the Commission announced that it would
commence Rule 102(e) actions only where it could demonstrate scienter
and that it would cease bringing ``original'' Rule 102(e) actions
(i.e., the Commission would only bring an administrative proceeding
against a lawyer if a federal court first determined that the lawyer
had violated the federal securities laws).\44\ As to accountants, the
[[Page 57177]]
situation was less clear, but, at least for a time, the Commission
seemed less aggressive in bringing Rule 102(e) actions against them as
well.\45\
---------------------------------------------------------------------------
\43\ Lorne & Callcott, supra note 19, at 1303-04; Pitt &
Shapiro, supra note 20, 7 Yale J. on Reg. at 174; see also Freeman,
supra note 25, 36 Bus. Law. at 1792.
\44\ William R. Carter, 47 S.E.C. 471, 511-12 (1981); Lorne &
Callcott, supra note 19, at 1303-04 (referring to a speech given by
the Commission's then-General Counsel: Edward Greene, Lawyer
Disciplinary Proceedings Before the Securities and Exchange
Commission, [1981-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH)
para. 83,089, at 84,800 (Jan. 13, 1982)). In 1988, the Commission
ratified Mr. Greene's speech in a release that stated: ``the
Commission, as a matter of policy, generally refrains from using its
administrative forum to conduct de novo determinations of
professional obligations of attorneys.'' Disciplinary Proceedings
Involving Professionals Appearing or Practicing Before the
Commission, Securities Act Release No. 6783, 53 Fed. Reg. 26,427,
26,431 n.30, 1988 WL 278442 (F.R.) (July 13, 1988); see also id.
(referring to Commission practice of generally instituting Rule
102(e) proceedings ``only where the attorney's conduct has already
provided the basis for a judicial or administrative order finding a
securities law violation in a non-Rule 2(e) proceeding'').
\45\ Pitt & Shapiro, supra note 20, 7 Yale J. on Reg. at 174.
---------------------------------------------------------------------------
In the late 1980's, however, Rule 102(e) actions against
accountants became more of a focal point for the Commission.\46\ In
1988, the Commission amended Rule 102(e) to create a presumption that
disciplinary proceedings would be public rather than private--
previously Rule 102(e) proceedings only became public if sanctions were
imposed.\47\ In addition, as an enforcement adjunct to combat
``financial fraud,'' the Commission stepped up its use of Rule 102(e)
to bring charges of ``improper professional conduct'' against the
auditors of public companies.\48\ It was in this context that the
Commission instituted administrative proceedings under Rule 102(e)
against two accountants, David J. Checkosky and Norman A. Aldrich.\49\
---------------------------------------------------------------------------
\46\ Goelzer & Wyderko, supra note 11, 85 Nw. U.L. Rev. at 653.
\47\ Rule 102(e)(7); see Disciplinary Proceedings Involving
Professionals Appearing or Practicing Before the Commission,
Securities Act Release No. 6783, 53 Fed. Reg. 26,427, 1988 WL 278442
(F.R.) (July 13, 1988).
\48\ Goelzer, supra note 17, 52 Brook. L. Rev. at 1061; see also
infra note 135.
\49\ David J. Checkosky, Order Instituting Private Proceedings,
File No. 3-6776 (Nov. 12, 1987).
---------------------------------------------------------------------------
II. The Checkosky Decisions
Checkosky and Aldrich, partners at one of the nation's preeminent
accounting firms, were the engagement partner and audit manager in
connection with audits of the Savin Corporation from 1981 to 1984.\50\
The Commission brought a Rule 102(e) proceeding against them in 1987,
and in 1992 affirmed an ALJ's finding of ``improper professional
conduct.'' \51\ In its initial 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.\52\
These violations were based on a 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'').\53\
---------------------------------------------------------------------------
\50\ David J. Checkosky, 50 S.E.C. 1180, 1180-81 (1992).
\51\ 50 S.E.C. at 1180-81.
\52\ 50 S.E.C. at 1181.
\53\ 50 S.E.C. at 1181.
---------------------------------------------------------------------------
Commissioner Roberts concurred in the majority's finding that
respondents violated GAAS and misapplied GAAP, but dissented from the
finding that these errors amounted to ``improper professional conduct''
under Rule 102(e).\54\ In Commissioner Roberts' view, respondents'
conduct did not provide a sufficient basis for a finding that they
would threaten the Commission's processes.\55\
---------------------------------------------------------------------------
\54\ 50 S.E.C. at 1198 (Commissioner Roberts, concurring in part
and dissenting in part).
\55\ 50 S.E.C. at 1198 & 1212-14.
---------------------------------------------------------------------------
In Checkosky I, the D.C. Circuit remanded the case because it was
unable to discern from the Commission's opinion the basis for its
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.\56\ There
was no opinion of the Court, and each of the three judges (Judge
Silberman, Judge Randolph and a district court judge sitting by
designation, Judge Reynolds) issued a separate opinion.
---------------------------------------------------------------------------
\56\ 23 F.3rd at 454.
---------------------------------------------------------------------------
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.\57\
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.\58\ Judge
Randolph also extensively discussed a 1981 Commission decision, William
R. Carter, which he regarded--correctly, in my view--as ``the
Commission's most comprehensive discussion of the history, purpose and
operation of Rule 2(e),'' that rejected a negligence standard in case
involving lawyers.\59\ Judge Randolph endorsed the reasoning of Carter:
``if a securities lawyer is to exercise his `best independent judgment
* * * he must have the freedom to make innocent--or even, in certain
cases, careless--mistakes without fear of [losing] the ability to
practice before the Commission.' '' \60\ In Judge Randolph's view, the
exercise of independent professional judgment was equally crucial to
accountants, and this consideration would preclude the Commission from
adopting a negligence standard, even if only applicable to accountants,
under Rule 102(e).\61\
---------------------------------------------------------------------------
\57\ Senior District Judge Reynolds dissented from the circuit
judges' conclusion that ``improper professional conduct'' under Rule
102(e) required proof of scienter. 23 F.3d at 493-95.
\58\ See 23 F.3d at 466 & 468-69.
\59\ See 23 F.3d at 484; see also 23 F.3d at 480-87 (citing
William R. Carter, 47 S.E.C. 471 (1981)).
\60\ 23 F.3d at 484 (ellipsis and brackets in original; quoting
Carter, 47 S.E.C. at 504).
\61\ See 23 F.3d at 483-87.
---------------------------------------------------------------------------
Judge Silberman likewise questioned the Commission's ability to
adopt a negligence standard. For instance, Judge Silberman explained
that:
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
professional's work.\62\
---------------------------------------------------------------------------
\62\ 23 F.3d at 456.
Judge Silberman similarly 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.'' \63\ Judge Silberman further indicated that the adoption
by the Commission of a negligence standard, given its previous contrary
precedent, might be arbitrary and capricious.\64\
---------------------------------------------------------------------------
\63\ 23 F.3d at 459.
\64\ 23 F.3d at 460; see also 23 F.3d at 458-59 (referring to
Carter, 47 S.E.C. 471, and Kenneth N. Logan, 10 S.E.C. 982 (1942)).
---------------------------------------------------------------------------
On remand, the Commission's majority opinion did not directly
address the mental state question posed by the Court.\65\ Instead, the
majority found that the accountants had behaved recklessly, but at the
same time insisted that any deviation from GAAP or GAAS, including
purely negligent ones, could violate Rule 102(e), and that the
accountants' recklessness was relevant only to the choice of
sanctions.\66\ I dissented from the Commission's second Checkosky
opinion because I believed that ``improper professional conduct''
required proof of scienter.\67\
---------------------------------------------------------------------------
\65\ David J. Checkosky, 1997 WL 18303 (S.E.C.) (Jan. 21, 1997).
\66\ 1997 WL 18303 (S.E.C.), at *10.
\67\ 1997 WL 18303 (S.E.C.), at *14.
---------------------------------------------------------------------------
On appeal in Checkosky II, the D.C. Circuit again reversed, and
scolded the Commission, in scathing terms, for its failure to heed the
dictates of Checkosky I.\68\ The Court found that, the prior remand
notwithstanding, the Commission had again failed to offer an adequate
explanation of Rule 2(e)(1)(ii), but had ``voic[ed] instead a
multiplicity
[[Page 57178]]
of inconsistent interpretations.'' \69\ 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, and instead invoked the exceedingly rare
remedy of remanding the case with instructions to dismiss.\70\
---------------------------------------------------------------------------
\68\ E.g., 139 F.3d at 222.
\69\ 139 F.3d at 222.
\70\ 139 F.3d at 222; see also id. at 227.
---------------------------------------------------------------------------
In an opinion truly remarkable for the criticism heaped on the
Commission, the Court agreed with respondents' contention that the
Commission had again ``failed to articulate an intelligible standard
for `improper professional conduct' under Rule 2(e)(1)(ii).'' \71\ The
Court noted that not only was the Commission's 1997 opinion unclear,
but that, ``[i]n something of a tour de force,'' it managed ``to both
embrace and reject standards of (1) recklessness, (2) negligence and
(3) strict liability--or so a careful (and intrepid) reader could
find.'' \72\ The Court also enumerated numerous contradictions between
the Commission's opinion and its appellate brief and oral argument.\73\
In the Court's view, the Commission's failure to adopt an intelligible
negligence standard was so lacking that the Commission had violated
``[e]lementary administrative law norms of fair notice and reasoned
decisionmaking.'' \74\ Referring to one part of the Commission's 1997
opinion, the Court sarcastically observed ``[i]n the space of four
short sentences this passage achieves impressive feats of ambiguity.''
\75\ The Court continued on, remarking: ``Not only does the opinion on
remand provide no clear mental state standard to govern Rule
2(e)(1)(ii), it seems at times almost deliberately obscurantist on the
question.''\76\
---------------------------------------------------------------------------
\71\ 139 F.3d at 223.
\72\ 139 F.3d at 223.
\73\ 139 F.3d at 223-24.
\74\ 139 F.3d at 224.
\75\ 139 F.3d at 225.
\76\ 139 F.3d at 225.
---------------------------------------------------------------------------
In a passage of great portent to today's release, the Court stated
that the Commission's instrumental good intentions alone will not
suffice:
However legitimate and, indeed, essential the Commission's
concern about unreliable financial statements may be, it is no
substitute for a clearly delineated standard. Instead, the
Commission's statements come close to a self-proclaimed license to
charge and prove improper professional conduct whenever it pleases,
constrained only by its own discretion (combined, perhaps, with the
standards of GAAS and GAAP).\77\
---------------------------------------------------------------------------
\77\ 139 F.3d at 225.
As in Checkosky I, the Court questioned the Commission's ability to
adopt a negligence standard under Rule 102(e).\78\ The Court appeared
to reaffirm its previous statements about the limits of the
Commission's authority in disciplining 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.'' \79\ On this last
point, Judge Henderson wrote a two-sentence concurrence to express her
disagreement with the majority (Judge Williams, who wrote the opinion,
and Chief Judge Edwards).\80\
---------------------------------------------------------------------------
\78\ 139 F.3d at 225.
\79\ Id. (citing Checkosky I, 23 F.3d at 459 (Silberman, J.)).
\80\ 139 F.3d at 227. Unlike the majority, Judge Henderson
apparently believed that the Commission did have the authority to
adopt a negligence standard under Rule 102(e). Id. (the Commission,
like every regulatory body, ``possesses--and must possess--authority
to maintain the professional standards of its practitioners'').
---------------------------------------------------------------------------
III. The Commission Lacks the Authority to Promulgate Rule 102(E)
or, at the Least, Lacks the Authority To Adopt the Proposed
Standard
As a result of this rulemaking process, I have reexamined the
Commission's rationale for promulgating Rule 102(e), that is, the rule
has a remedial purpose to protect the integrity of the Commission's
administrative processes. This reexamination leads me to the conclusion
that Rule 102(e) does not have that remedial purpose, rather it is or
has become just another weapon in the Commission's enforcement arsenal.
Rule 102(e)'s status as an enforcement tool removes the basis relied
upon by those few courts that have upheld the Commission's ability even
to promulgate Rule 102(e). Furthermore, even assuming the authority to
promulgate Rule 102(e) in some form, the Commission may not adopt the
negligence standard set forth in today's release.
In addition to rendering a single negligent act, under some
circumstances, ``improper professional conduct,'' the other two parts
of the Standard create liability for: intentional, knowing or reckless
conduct; and a pattern of negligent acts. As the Release correctly
notes, most commenters agreed with these parts of the proposal.\81\
Assuming the Commission has the authority to promulgate Rule 102(e), I
support the intentional or reckless part of the amendment without
reservation. As to that part addressing a pattern of negligence, I
would generally reach the same result as the majority, but through a
different analysis. Assuming adequate authority, the Commission may
appropriately bring a charge of ``improper professional conduct'' under
Rule 102(e) only if the pattern of negligence supports an inference
that the accountant acted recklessly.\82\ In any event, because of the
natural tendency towards the path of least resistance--towards proving
one's case the by the easiest method possible--I think that most of the
Rule 102(e) cases brought under the new standard will surely be brought
under the single negligent act provision.
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\81\ See Release at 3, 15 & 26.
\82\ Compare Potts, 1997 WL 690519 (S.E.C.), at *12 & n.1
(Commissioner Johnson, concurring) with Potts, 1997 WL 690519
(S.E.C.), at *17 (Commissioner Wallman, dissenting).
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A. Rule 102(e) Has Become Another Weapon in the Commission's
Enforcement Arsenal
In the Release, the Commission explains its refusal to adopt a
scienter standard because ``Rule 102(e) protects the integrity of the
Commission's processes; it is not an enforcement remedy or a weapon
against fraud.'' \83\ The Commission also insists that ``the rule is
remedial and not punitive in nature.'' \84\ I disagree with the first
assertion, and think the second assertion is contrary to controlling
law in the D.C. Circuit. Although I have come to the conclusion that
Rule 102(e) is overly broad, as a structural matter, I do wish to
emphasize my view that the Commission, like any adjudicative body, may
legitimately adopt a disciplinary rule designed to redress
contemptuous, disruptive or obstructionist behavior by advocates who
appear in actual proceedings before us.\85\ But Rule 102(e) is not such
a permissible rule. I am, of course, aware that several courts have
accepted the Commission's professed rationale about the need to protect
its administrative
[[Page 57179]]
processes.\86\ In my view, however, today's amendment--combined with
the Commission's recently announced crackdown on improper accounting
practices, as well as recent judicial developments--provides an ample
basis for a critical reexamination of these precedents.
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\83\ Release at 31; see also id. at 7-8.
\84\ Release at 11 & n.26; see also id. at 6 & 23.
\85\ Many of the abuses of Rule 102(e) stem from the all-
encompassing way in which the Commission has defined ``practice
before'' us to include, at least at an earlier time, not only
appearances before us and the staff, and filings made with us, but
also office work by professionals directly related to the federal
securities laws. See Robert J. Haft, Liability of Attorneys and
Accountants for Securities Transactions para. 8.01[2], at 8-3
(1997); see also Richard D. Hodgin, 49 S.E.C. 8, 10 (1979); SEC v.
Ezrine, Litigation Release No. 6481, 1974 WL 13435 (S.E.C.) (Aug.
15, 1974). In addition, partners of a disqualified professional may
not permit the sanctioned person to participate in Commission
matters, to participate in profits from their Commission business,
or to hold him or her out as entitled to practice before the
Commission. Haft, supra, at 8-3 to 8-4. Finally, partners and
associates of a disqualified firm may not practice before the
Commission as long as they remain associated with the firm, even if
they joined the firm after the disqualification. Id. at 8-4.
\86\ See Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995);
Davy, 792 F.2d at 1421; Touche Ross, 609 F.2d at 582.
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In Touche Ross, which was decided in 1979, the Commission
successfully argued to the Second Circuit that Rule 102(e) was
necessary to protect the integrity of its administrative processes.\87\
The Commission has consistently relied on the same rationale since
then, which is repeated in today's release.\88\ Before the press of
litigation arose, however, the Commission could be more candid. In a
speech published in 1974 discussing ``spectacular recent failures''
such as the collapse of National Student Market Corporation, then-
Chairman Ray Garrett made the following statement:
\87\ 609 F.2d at 579.
\88\ Release at 7-8.
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We are not entirely happy with the means at our disposal to
cause higher standards of professional conduct for investor
protection. It is true that we can legislate rules governing the
contents of financial statements filed with the Commission, but that
won't insure a careful audit, and it certainly won't improve
standards of professional conduct by lawyers. Our tools in this
context, aside from informal comment and criticism, are enforcement
weapons--suspension or disbarment from practicing before the
Commission, under Rule 2(e) of our Rules of Practice, and an action
for an injunction on the ground that the accountant or lawyer has
participated in or aided and abetted a violation of the securities
laws, including Rule 10b-5.\89\
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\89\ Ray Garrett, Jr., New Directions in Professional
Responsibility, 29 Bus. Law. 7, 11 (1974) (emphasis added); see also
id. at 9 (referring to stockholders of National Student Marketing
losing ``in excess of $400 million in 3 months''). In Touche Ross,
the Second Circuit purported to find support for the proposition
that the Commission did not use Rule 102(e) as ``an additional
weapon in the its enforcement arsenal'' in a Commission release that
predated Chairman Garrett's remarks. See 609 F.2d at 579 (citing
Securities Act Release No. 5088 at 1, 1970 SEC LEXIS 645 (Sept. 24,
1970)). This release, however, supports the Touche Ross citation, if
at all, only in the most general sense.
Former Chairman Garrett's remarks support the assertion of one
commenter, a former Commission enforcement attorney who played a
leading role in prosecuting Carter and other Rule 102(e) cases during
the 1970's, that protection of the Commission's processes is merely a
``convenient legal fiction'' or ``shibboleth [the Commission] used to
win the Touche Ross[] case twenty years ago.'' \90\ This commenter also
points out that, as a practical matter, the Commission's staff
approaches Rule 102(e) proceedings in the same manner as other
enforcement cases, such that charges under Rule 102(e) are just another
enforcement alternative.\91\ This practical approach will often suit
the convenience of potential respondents who may well prefer an
administrative settlement of Rule 102(e) charges to other enforcement
alternatives (e.g., a federal court injunctive action, in which the
Commission would likely seek monetary penalties).\92\
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\90\ Richard E. Brodsky, P.A., CL 54, at 1 n.2 & 4. Mr. Brodsky
candidly admits that he has ``represented numerous accounting firms
in SEC investigations'' since leaving the Commission in 1981. Id. at
1 n.2.
\91\ Richard E. Brodsky, P.A., CL at 6.
\92\ Id.; see also Judah Best, supra note 17, 36 Bus. Law. at
1815 (from perspective of defense counsel, Rule 102(e) ``is a great
settlement device''--``a means of avoiding the necessity of an
injunction if you can bargain successfully for it'').
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The Commission's use of Rule 102(e) has not changed since 1974--it
remains an ``enforcement weapon.'' Under usual procedures, the
Commission's Division of Enforcement investigates cases, and, in the
case of a financial fraud involving a public company, will routinely
scrutinize the conduct of the responsible accountants.\93\ If the
Division of Enforcement determines that the accountant's conduct is
substandard, the Division of Enforcement will consult with the
Commission's Office of the Chief Accountant, and then make an
enforcement recommendation to the Commission.\94\ If the Commission
authorizes the case as an administrative proceeding under Rule 102(e),
the Division of Enforcement prosecutes it in the name of the Office of
the Chief Accountant.\95\ As should be apparent from these procedures,
notwithstanding surface appearances, Rule 102(e) is much more than a
mere disciplinary rule.\96\ If Rule 102(e) were just a disciplinary
rule, one would expect that the Commission's use of it would parallel
other administrative agencies' use of their respective disciplinary
rules--surely the Commission's processes need no greater protection
than those of, for instance, the Federal Trade Commission or the
Nuclear Regulatory Commission. But the opposite is true. Reflecting the
enforcement nature of Rule 102(e), one academic has calculated that,
over a 50-year period, the Commission has disbarred or suspended more
lawyers than ``nearly all other federal agencies combined.'' \97\ Were
accountants included in this tabulation, I am sure the numbers would
demonstrate an even greater disparity.
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\93\ See Ferrara, supra note 17, 36 Bus. Law. at 1807-09.
\94\ Id.; Coppolino, Note, supra note 17, 63 Fordham L. Rev. at
2232.
\95\ Id.: see SEC Announces Organizational Changes as to
Accountants, Consumer Affairs, 1193 Daily Exec. Rep. (BNA) No. 236,
at d-3 (Dec. 10, 1993). For lawyers, our Office of the General
Counsel takes the place of the Division of Enforcement in
recommending and prosecuting Rule 102(e) cases. Id.
\96\ Many commenters have observed that the Commission's
aggressive use of Rule 102(e) goes well beyond other agencies' use
of comparable disciplinary rules (with the possible exception of the
Office of Thrift Supervision, which intentionally modelled its
disciplinary rule on Rule 102(e)). See, e.g., ABA, CL 81 at 3-4; see
also Ted Schneyer, A Tale of Four Systems: Reflections on How Law
Influences the ``Ethical Infrastructure'' of Law Firms, 39 S. Tex.
L. Rev. 245, 263 (1998) (``Over the years, the Securities and
Exchange Commission (SEC) and, more recently, the Office of Thrift
Supervision (OTS) have asserted far-reaching authority to directly
regulate lawyers who practice in their fields, much as judges
regulate trial lawyers.''); Ted Schneyer, Professional Discipline
for Law Firms?, 77 Cornell L. Rev. 1, 43-44 (1991) (under Rule
102(e), SEC has been the ``most aggressive agency'' in disciplining
lawyers). In addition, the Commission's use of Rule 102(e) goes well
beyond standards used to enforce the disciplinary rules of most
courts. See ABA CL 81, at 3-4; AICPA, CL 84 at 12.
\97\ Emerson, supra note 17, 29 Am. Bus. L.J. at 178.
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These arguments that the Commission lacks the authority even to
promulgate Rule 102(e) are not new. In fact, Commissioner Karmel, in a
series of dissents starting almost 20 years ago, made many of the same
points I make today.\98\ For instance, Commissioner Karmel began her
best-known dissent as follows:
\98\ Keating, 47 S.E.C. at 111 (Commissioner Karmel,
dissenting); see also, e.g., Darrel L. Nielsen, 49 S.E.C. 50, 51
(1980) (Commissioner Karmel, dissenting); Bernard J. Coven, 49
S.E.C. 46, 47 (1979) (Commissioner Karmel, dissenting); Hodgin, 49
S.E.C. at 11 (Commissioner Karmel, dissenting).
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This is another Rule 2(e) disciplinary proceeding which arises
from the Commission's efforts to protect investors by articulating
and enforcing professional responsibility standards for attorneys.
The Commission's authority to promulgate Rule 2(e) is tenuous at
best. Since the Commission's program is in aid of its prosecutorial
function, rather than its rule making or adjudicatory functions, I
view it as an invalid exercise of power * * *.\99\
\99\ Keating, 47 S.E.C. at 109; see also id. at 111 (expressing
disapproval of use of Rule 2(e) as ``a general enforcement tool to
discipline attorneys''). Though Commission Karmel questioned most
strongly the Commission's authority to regulate the conduct of
attorneys, she questioned the Commission's authority to regulate the
conduct of accountants as well. See id. at 111 & 115 n.31; see also
Nielsen, 49 S.E.C. at 52-54 (Commissioner Karmel, dissenting).
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[[Page 57180]]
The force of Commissioner Karmel's arguments have increased, rather
than diminished with time.\100\
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\100\ The academic commentary largely supports the view that
Rule 102(e) is ``just part of the SEC's disciplinary enforcement
arsenal.'' Emerson, supra note 17, 29 Am. Bus. L.J. at 167; see
generally supra note 17.
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Starting with the Second Circuit's decision in Touche Ross,\101\
the few courts to consider these arguments have rejected them, but I
think there is ample cause for reconsideration. As the Release
repeatedly recognizes, the legitimacy of Rule 102(e) depends on it
having a remedial purpose.\102\ A recent decision by the D.C. Circuit,
Johnson v. SEC,\103\ however, and the Commission's response to it,
place the characterization of Rule 102(e) as ``remedial'' in great
doubt. In Johnson, the D.C. Circuit rejected the Commission's argument
that sanctions imposed on a branch manager at a registered broker-
dealer, a censure and a six-month suspension, were ``remedial''; rather
the Court determined that these sanctions fell within the definition of
``penalty'' for purposes of the statute of limitations.\104\ Precisely
these same sanctions, censure and suspension, are among the sanctions
frequently imposed by the Commission in Rule 102(e) cases. Under the
reasoning of Johnson, the punitive nature of Rule 102(e)'s sanctions
could well give rise to questions about the Commission's ability to
promulgate it. The D.C. Circuit decided Johnson after Checkosky I, but
before Checkosky II.\105\ In Checkosky II, the D.C. Circuit determined
that the Commission had failed to comply with the directions in
Checkosky I that it clearly enunciate its standard for Rule 102(e), and
thus had no need to determine whether, as a result of Johnson, the
Commission still had the authority to promulgate Rule 102(e).
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\101\ 609 F.2d 570. In one of the many ironies surrounding Rule
102(e), the opinion in Touche Ross was written by Judge Timbers.
Before Judge Timbers' distinguished service as a federal judge, he
served with distinction as the Commission's General Counsel in the
mid-1950's. At that time, the General Counsel had supervisory
responsibility for overseeing all the Commission's Rule 102(e)
cases.
\102\ Release at 7, 11 & n.26, 19 & 31.
\103\ 87 F.3d 484 (D.C. Cir. 1996). At the time Johnson was
decided, I disagreed with its reasoning, and supported the
Commission's unsuccessful efforts to seek Supreme Court review.
Regardless of my earlier disagreement with Johnson and my support of
continuing efforts to raise this issue in other circuits, Johnson
represents controlling law in the D.C. Circuit and will almost
certainly be a factor the next time the D.C. Circuit reviews Rule
102(e).
\104\ 87 F.3d at 485-87 (construing 28 U.S.C. 2462).
\105\ Because Johnson came after Checkosky I, I regard the
statements of Judges Silberman and Randolph supporting the
Commission's ability to promulgate Rule 102(e) as less than
authoritative. See 23 F.3d at 455 (Silberman, J.) & 472 (Randolph,
J.). Because there was no opinion of the Court in Checkosky I, the
D.C. Circuit probably need not invoke en banc procedures in its next
review of Rule 102(e) to determine whether to follow the Second
Circuit's decision in Touche Ross. Any panel of the D.C. Circuit
would have the power to decide to follow or not to follow Touche
Ross.
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Subsequent action by the Commission indicate its own recognition
that this argument may be well-founded. In Angelo P. Danna, CPA, two
accountants filed a motion to dismiss a Rule 102(e) proceeding as one
seeking a penalty and thus time-barred under Johnson.\106\ The Division
of Enforcement failed to object, and the Commission dismissed the
proceeding.\107\ Likewise, in George Craig Stayner, CPA, the Commission
dismissed a Rule 102(e) case against an accountant who had raised the
Johnson issue, this time over the objection of the Office of the Chief
Accountant.\108\ In several analogous disciplinary cases not involving
Rule 102(e), the Commission has ordered dismissals, without objections
from the staff, in response to similar arguments relying on
Johnson.\109\ Given the time and resources the Commission devoted to
Danna and Stayner, one would have thought the Commission would have
declined to dismiss these cases if it had any confidence in its chances
on the ``punitive''/``remedial'' question in the D.C. Circuit.
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\106\ Exchange Act Release No. 38499, 1997 WL 197555 (S.E.C.)
(April 14, 1997). These respondents had earlier sought to enjoin the
Commission in federal court from commencing the Rule 102(e)
proceedings; in an unpublished decision (relied on in the Release at
18 & 29), the district court held that the Commission's Rule 102(e)
authority is not limited to instances of intentional misconduct or
bad faith. See Danna v. SEC, 1994 WL 315877 (N.D. Cal. Feb. 8,
1994).
\107\ 1997 WL 197555 (S.E.C.).
\108\ Exchange Act Release No. 39994, 1998 SEC LEXIS 956 (May
14, 1998).
\109\ See, e.g., Paul C. Kettler, Exchange Act Release No.
40011, 1998 SEC LEXIS 986 (May 20, 1998); Richard M. Kulak, Exchange
Act Release No. 38657, 1997 SEC LEXIS 1113 (May 20, 1997).
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In my view, the purpose of Rule 102(e) is not to protect the
Commission's administrative processes, but rather to enforce compliance
with the federal securities laws. In addition, under controlling law in
the D.C. Circuit, Rule 102(e) is punitive, not remedial. As a result,
the Commission lacks the authority even to promulgate Rule 102(e).
B. The Commission Lacks the Authority To Adopt a Negligence Standard
Even assuming the Commission could validly promulgate Rule 102(e),
it lacks the authority to adopt a negligence standard. In my view, this
conclusion is compelled by the D.C. Circuit's decisions in Checkosky I
and Checkosky II.\110\ Others at the Commission question my
interpretation of both Checkosky cases, but I note that this same urge
to construe an adverse decision as narrowly as possible (sometimes even
more narrowly than possible) is precisely what so enraged the D.C.
Circuit in Checkosky II.\111\
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\110\ See supra Section II.
\111\ A respected securities scholar, Dean Joel Seligman of the
University of Arizona College of Law, submitted a comment letter
opining that, although ``there is some uncertainty'' because of the
Checkosky decisions, the Commission has the authority under the
federal securities laws to adopt a negligence standard for Rule
102(e). See CL 53 at 2. Dean Seligman qualified his endorsement in
other important ways--even he expressed concerns about the clarity
of the June proposal. See CL 53 at 3. Dean Seligman's opinion is
contrary to the clear weight of academic commentary. See, e.g.,
Downing & Miller, supra note 17, 54 Notre Dame Law. at 775-81;
Maxey, supra note 12, 22 Del. J. Corp. L. at 563-64; Flagel, Note,
supra note 17, 20 Dayton L. Rev. at 1095-98; see also supra note 17.
In addition, most other commenters share my view that the Checkosky
opinions appear to preclude the Commission from adopting a
negligence standard. See ABA, CL 81 at 3; Robert K. Elliott,
Partner, KPMG Peat Marwick LLP (``KPMG Peat Marwick''), CL 82 at 2-
3; AICPA, CL 84 at 4-5 & 10-15; see also, e.g., Don Hummel,
Administrative Director, Department of Commerce and Insurance,
Tennessee State Board of Accountancy, CL 12; Richard Y. Roberts, CL
18.
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I must confess that I remain somewhat mystified by the begrudging
attitude towards Checkosky that is prevalent at the Commission. After
two of the worst defeats in the Commission's 60-plus year history, we
should not adopt merely the absolute minimum necessary to pass muster
in the D.C. Circuit. Rather, we should strive toward caution and
conservatism, and give ourselves an ample margin for error. The
Standard is not cautious; it is not conservative. Instead, the
Commission has again reverted to a ``push the envelope'' strategy, and
thrown down the gauntlet to the D.C. Circuit.
Editorializing aside, I believe that the Commission lacks the
authority to adopt a negligence standard under Rule 102(e). No
appellate court has approved the Commission's adoption of a negligence
standard, and I fully concur with the ABA's statement that ``the
prognosis for appellate court affirmance of * * * a [negligence-based]
standard is very poor.'' \112\ Of course, the Release denies that what
the Commission has adopted is a ``simple'' or ``mere'' negligence
standard.\113\ But the Proposing Release contained similar
[[Page 57181]]
unconvincing attempts to narrow what seemingly was an all-encompassing
standard.\114\ Interested parties submitted over 150 comment letters,
more than half (by my estimate) expressing skepticism or worse as to
whether the standard in the Proposing Release truly limited the
Commission's discretion to bring Rule 102(e) cases for simple
negligence. Though insisting that it has the authority to adopt a
``simple'' or ``mere'' negligence standard, the Commission now purports
to adopt a higher standard.\115\ I think that the Standard will not
limit the Commission's discretion to bring cases for simple negligence.
Moreover, as I discuss in the next section, the revisions to the
Proposing Release's standard only add to the lack of clarity
surrounding this issue.
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\112\ ABA, CL 81 at 3. Cf. Checkosky I, 23 F.3d at 456
(Silberman, J.) (courts of appeals have not ``squarely addressed''
question of Commission's authority to adopt a negligence standard
under Rule 102(e)). Although the Eleventh Circuit's subsequent
opinion in Sheldon, 45 F.3d at 1518, discussed generally the
Commission's authority to promulgate Rule 102(e), it did not address
the negligence question.
\113\ Release at 30.
\114\ Proposing Release, 1998 WL 311988 (S.E.C.), at *4.
\115\ Release at 30.
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As an initial matter, it is important to recognize that today's
release actually expands the Commission's Rule 102(e) jurisdiction
beyond that encompassed by the Proposing Release. The single negligent
act provision in the Proposing Release contained a requirement that the
act be tied to ``making a document prepared pursuant to the federal
securities laws materially misleading.'' \116\ The single negligent act
provision in the Standard omits this requirement, thereby increasing
substantially the potential reach of Rule 102(e).\117\
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\116\ Proposing Release, 1998 WL 311988 (S.E.C.), at *3.
\117\ See supra note 85 and accompanying text.
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The Standard does contain two elements which form the basis for the
Commission's claim that it adopts ``an intermediate standard, higher
than ordinary negligence but lower than the traditional definition of
[Rule 10b-5] recklessness.'' \118\ These elements are that the alleged
misconduct: (1) Must be ``highly unreasonable,'' not merely
``unreasonable,'' as in the Proposing Release; and (2) must occur under
``circumstances in which an accountant knows, or should know, that
heightened scrutiny is warranted.'' \119\ On close examination, these
elements present only illusory limits on the Commission's discretion to
bring charges of ``improper professional conduct'' based on a single
act of negligence.
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\118\ Release at 18.
\119\ Release at 14.
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Unlike ``highly unreasonable conduct,'' the Proposing Release
discussed the concept of ``heightened scrutiny,'' and, accordingly,
interested parties had the opportunity to explain its drawbacks. The
AICPA objected to any attempt by the Commission to
use Rule 102(e) proceedings to determine in the first instance the
circumstances under which particular items of financial statements
require ``heightened scrutiny.'' In our view
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