United States: The SEC Brings Charges Against 'Gatekeeper' Accountants

Last Updated: October 7 2013
Article by James A. Rolfes

In a "crackdown" on the "gatekeepers" who put investors at risk when they fail to uncover financial statement fraud and misstatements, the Securities and Exchange Commission this week highlighted the work of "Operation Broken Gate" when it announced the filing of several proceedings against certified public accountants and their firms. Just three months ago, the SEC made headlines with the formation of its Financial Reporting and Audit Task Force, a move many categorized as nothing more than a reformatted articulation of Enforcement Division's various historical initiatives to address financial statement-based securities violations. The filing of these proceedings, however, serves as the initial manifestation of the SEC's refocused efforts to target accounting matters, and is perhaps a harbinger of the aggressive enforcement proceedings to come.

While no doubt the proceedings announced September 30, 2013, have been the subject of SEC investigations for some time, the SEC's revelation of "Operation Broken Gate" follows shortly upon the July 2, 2013 SEC announcement of the Financial Reporting and Audit Task Force and the Commission's intent to dedicate resources to detecting fraudulent or improper financial reporting. According to the SEC, this task force will "concentrate on expanding and strengthening the Division of Enforcement's efforts to identify securities law violations relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures." Further, the SEC plans to use technology-based tools, such as the Accounting Quality Model, to identify potential investigatory targets, conduct street sweeps in particular industries and accounting areas, and rely on the increased number of accounting-related whistleblower reports the SEC has received in the past couple of years. All of this suggests increased regulatory scrutiny of accountants and auditors, and inevitably, increased enforcement activity directed at accountants, an objective reiterated by Andrew Ceresney, the co-director of the SEC's Enforcement Division, in mid-September.

The proceedings filed Monday are in this vein. Three of the matters arose from the work of an SEC task force internally dubbed "Operation Broken Gate" – i.e., matters the SEC stated arose from "the agency's ongoing efforts to hold gatekeepers accountable for the important roles they play in the securities industry." This "gatekeeper" reference recognizes that the federal securities laws explicitly require public companies to obtain independent audits conducted in accordance with professional standards, and the public's reliance on such auditors to assure that public companies disclose accurate financial information.

As alleged by the SEC, the work of Malcolm Pollard, John Kinross-Kennedy and Wilfred Hanson, and the accounting firms through which they conducted their audits, deviated markedly from the professional standards. The SEC claimed that each of these individuals on numerous engagements failed to conduct their audits in accordance with the audit standards set by the Public Company Accounting Oversight Board (PCAOB). The "repeated instances of unreasonable conduct" underlying the charged violations included failures to obtain management representations; maintain adequate work papers; consider and document fraud evidence; or obtain engagement quality reviews, or have the experience necessary to conduct such reviews. The SEC also cited these auditors for not investigating evidence of illegal activity, not reporting that evidence to the appropriate level of management, failing to employ appropriate and timely audit checklists and guides, and lacking recent and relevant audit or accounting experience. Two of these accountants, without either admitting or denying the charges, settled with the SEC and agreed to five-year bans from practicing before the Commission and, in one instance, a $30,000 fine. For the third, the SEC is seeking similar relief in a proceeding before an SEC administrative law judge.

On September 30, 2013, the SEC also announced that it had charged a New Jersey-based accounting firm, and one of its founding members, in connection with the "botched audits of a China-based company that failed to disclose related party transactions." According to the SEC allegations, the firm of Patrizio & Zhao LLC and John Zhao failed to consider the client's limited operating history and the lack of employees knowledgeable about U.S. accounting when planning and conducting their audits. The auditor also ignored "red flags" that suggested the client had failed to report related party transactions – i.e., the auditors' discovery of numerous related parties and related party transactions the client neither identified nor disclosed. The SEC further cited the audit team for placing improper reliance on management representations, failing to obtain competent evidential matter, and failing to prepare adequate audit documentation. Such "repeated instances of unreasonable conduct indicating a lack of competence" justified censure under Commission Rule of Practice 102(e)(1)(ii), as well as a finding that the accounting firm and its founding member caused the client's primary violation of the securities laws. Both the accounting firm and Zhao agreed to settle with the SEC (without admitting or denying the charges), and received three-year bans from practicing before the Commission. The SEC further assessed the accounting firm with a $30,000 fine.

Granted, the SEC brought these actions based on apparent egregious auditing deficiencies against small accounting firms that lacked personnel with appropriate experience, and thus perhaps have less predictive value as to whether the SEC will bring similar claims against larger accounting firms or the accountants at more established public companies. But the language used to describe the cases, the reference to the dedicate task force and SEC-reiterated intent to target those "gatekeepers" who permit the issuance of misstated financial statements, all suggest that accountants and auditors associated with public companies will face even greater scrutiny in the near future.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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