Sarbanes-Oxley Act Update - SEC Issues New Rules Under Section 303 Prohibiting Improper Influence Of Auditors

On May 20, 2003, the SEC issued new rules under Section 303 of the Sarbanes-Oxley Act, which prohibit officers and directors of an issuer, and persons acting under their direction, from taking "any action to coerce, manipulate, mislead, or fraudulently influence" the auditor of the issuer's financial statements if that person "knew or should have known that such action, if successful, could result in rendering [such statements] materially misleading." Sound like common sense? Well, it is, sort of . . . . The new rules, which become effective on June 27, 2003, cover broad categories of people and conduct.

• Directors and Officers. In addition to corporate directors, the SEC has defined the term "officer" to include the issuer's president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and any person routinely performing corresponding functions with respect to any organization. The term "officer" also encompasses other "executive officers," including the Chief Executive Officer and other officers who perform policy-making functions.
• Persons "Acting Under the Direction of" Directors and Officers. Persons need not be under the supervision or control of an officer or director to be acting under their direction. As a result, persons subject to the new rules include not only an issuer's employees, but may also include customers, vendors and creditors who, under the direction of an officer or director, provide false and misleading confirmations or information to auditors, or who enter into "side agreements" that enable the issuer to mislead the auditor. In addition, employees of the accounting firm, attorneys, securities professionals and other third parties who pressure or otherwise improperly influence the conduct of the audit may be covered by the new rules.

• Improper Influence. The new rules prohibit any action to "coerce, manipulate, mislead, or fraudulently influence" the conduct of an audit. A nonexclusive list of improper conduct noted in the release includes: offering or paying bribes or other financial incentives (such as offers for future employment or engagements), providing an inaccurate or misleading legal analyses, threatening to cancel or canceling existing engagements if the auditor objects to the issuer's accounting, seeking to have an audit partner removed from the engagement because he or she objects to the issuer's accounting, blackmailing and making physical threats.
• Engaged in the Performance of an Audit. The new rules regulate conduct that occurs at any time during the professional engagement period and at any other time the auditor is called upon to make decisions or judgments regarding the issuer's financial statements. This period can extend to actions taken before the formal engagement (e.g., conditioning the engagement upon an auditor agreeing to apply an improper accounting treatment) or after the formal engagement has ended (e.g., improperly influencing a disengaged auditor who is considering whether to issue a consent on the use of prior years' audit reports).
• Rendering Financial Statements Materially Misleading - Knowledge Standard. Only actions that a person "knew or should have known" could render the issuer's financial statements materially misleading are prohibited. It is not necessary that the person "intended" to cause such an effect, nor is it necessary that the actions be successful in producing misleading financial statements. Such actions include those that might improperly influence an auditor to: (1) issue an unwarranted report on an issuer's financial statements (due to material violations of GAAP or other standards), (2) not perform an audit, review or other procedures required by other professional standards, (3) not withdraw an issued report, or (4) not communicate matters to an issuer's audit committee.

These new rules, in combination with the existing rules, are designed to ensure that management makes open and full disclosures to, and has honest discussions with, the auditor of the issuer's financial statements. The SEC has exclusive authority to enforce Section 303 of the Sarbanes-Oxley Act. There is no private right of action under the rules.

The text of the new rules is available on the SEC's website at http://www.sec.gov/rules/final/33-8220.htm. If you have questions regarding these rules or their implications for your company, please contact a Davis Wright Tremaine corporate finance attorney or email us at corporatefinanceadvisory@dwt.com.

This Corporate Finance News Brief is a publication of the Business Transactions/Corporate Finance Group of Davis Wright Tremaine LLP. Our purpose in publishing this News Brief is to inform of developments in business, corporate finance and securities laws. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.