United States: Proposed Expansion Of Auditor Liability Would Be Ill-Advised

The Public Company Accounting Oversight Board's proposed revisions in September to its Rule 3502 significantly expand its authority to impose liability on accountants for contributing to a violation of PCAOB rules, securities laws, or professional standards. The board shouldn't make these changes. The deadline for comments on the proposal is Nov. 3.

Rule 3502 prohibits people associated with registered public accounting firms from taking or omitting an action while "knowing, or recklessly not knowing, that the act or omission would directly and substantially contribute to a violation." This means the PCAOB must establish scienter—at a minimum, an "extreme departure from the standard of ordinary care for auditors" in the face of a known or obvious risk.

The board wants to replace this with a negligence standard, under which an associated person could be fined and prohibited from associating with a registered public accounting firm for an "act or omission that the person knew orshould have known would contribute" to a primary violation. The accountant's intent wouldn't matter.

The PCAOB acknowledges its proposal nearly mirrors the original version of Rule 3502 it proposed in 2004. Back then, the PCAOB changed its mind, instead deciding a scienter requirement "strikes the right balance." Now it suggests that developments in the law and the auditing profession in the past two decades warrant expanding its authority to discipline auditors.

That logic is flawed. First, its proposed changes to Rule 3502 stand on shaky legal ground. The Sarbanes-Oxley Act of 2002, which created the PCAOB, doesn't mention what the PCAOB calls "contributory liability." Section 105(c)(6) of the act creates secondary liability for certain supervisors of associated persons who commit violations, but it includes requirements and a safe harbor that are absent from Rule 3502.

The PCAOB primarily relies on Sarbanes-Oxley Act Section 103(a)(1) for its authority to expand Rule 3502 liability. But Section 103(a)(1) permits it to promulgate "ethics standards." The proposed expansion of Rule 3502 doesn't resemble an ethics standard. It would permit the PCAOB to discipline auditors who make mistakes they "should have known" would contribute to a violation even when they behave honestly and in good faith—not unethically.

Chair Erica Williams observed in September that the Securities and Exchange Commission is able to "seek civil money penalties in enforcement actions against associated persons when they negligently cause firm violations." But Congress extended that authority to the SEC, not the PCAOB. And while the SEC can discipline accountants for "improper professional conduct" that contributes to a violation of professional standards, the bar is much higher than what the PCAOB has proposed: The SEC must prove that the accountant engaged in "intentional or knowing conduct," "highly unreasonable conduct," or "repeated instances of unreasonable conduct."

Second,the board's justification for revising Rule 3502 isn't persuasive. The board says that there's an incongruity in Rule 3502, but its proposed revision would createrather than resolve any incongruity.

The PCAOB suggests Rule 3502's scienter requirement contributed to its decisions not to pursue disciplinary proceedings against some individuals when firms committed violations, but it hasn't provided any evidence. Not every firm violation involves misconduct worthy of professional discipline and the destruction of auditors' careers. In fact, the PCAOB has been able to punish certain supervisors for negligent conduct under Sarbanes-Oxley Act Section 105(c)(6) for almost two decades, but it announced its first disciplinary proceeding under that provision only last year.

The PCAOB's proposed revision could create illogical outcomes. For example, is negligence enough to impose liability when the primary violation involves intentional misconduct by the accounting firm or a third party? It would be unreasonable if the board could charge individuals for negligent conduct that's merely one contributing cause of a primary violation that involves intentional misconduct.

The proposal raises another question: Is the proposed change intended to address negligent conduct by supervisors that purportedly contributes to a violation, notwithstanding Section 105(c)(6)'s safe harbor and other requirements?

Third, a negligence standard would be particularly inappropriate for auditors. While the PCAOB's five members agreed to seek comments on the proposed revision, the two accountants expressed concern about the impact on the auditing profession. PCAOB member Duane DesParte said in September that "if anything, audits have become more complex, involve greater judgment, and include more participants than in 2004 when Rule 3502 was first contemplated."

Another member, Christina Ho, said, "If we make the public company auditing profession unattractive in the name of investor protection, we may be doing a disservice for investors in the long run." A disciplinary investigation or proceeding alone, even if unsuccessful, can significantly harm an auditor's career.

The PCAOB correctly rejected its proposed negligence standard for contributory liability under Rule 3502 after proposing it two decades ago. The increasing complexity of the auditing profession makes a negligence standard even less suitable now.

Originally published by Bloomberg Law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.