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Thoughts on Improving the PCAOB Investigative and Enforcement Process

Friday, December 7, 2012

By Richard Marmaro and Charles Walker,Skadden, Arps, Slate, Meagher & Flom LLP


The Public Company Accounting Oversight Board (the “PCAOB” or the “Board”), established by Congress in 2002 as a nonprofit corporation charged with overseeing public company auditors, investigates and disciplines registered public accounting firms and persons associated with them for violations of the federal securities laws and PCAOB regulations.1Since its creation, the PCAOB Division of Enforcement and Investigations has undertaken scores of investigations of accounting firms big and small and has filed dozens of cases against auditors and individuals. For a firm or individual, the consequences of an investigation are enormous. PCAOB investigations present not only a tremendous strain on resources, taking up huge amounts of time at significant expense, but for individual professionals, these investigations can prove a “death sentence” in themselves, with firms often taking employment action early in the process before facts are established.

Once an investigation is completed, the PCAOB has a broad range of sanctions available, ranging from revocation of registration (for firms) and a permanent bar from association with a registered public accounting firm (for individuals) to censure or other more modest penalties.


Despite the tremendous impact of an investigation, the PCAOB has only a skeletal framework of rules to guide its enforcement staff and has provided no clear guidance on its investigative policies and procedures. Unfortunately, the PCAOB enforcement staff has filled this void by creating a lengthy and painful track record of aggressive and burdensome investigations.

To be sure, the PCAOB, its staff and those subject to PCAOB investigations all share a mutual interest in moving enforcement matters forward fairly and expeditiously. That shared interest also includes a desire that the staff's investigative and enforcement practices and procedures not only be rational, fair and effective, but that they be perceived by all involved as rational, fair and effective.

We believe, however, that current practice does not further these goals as well as it might. For example, in our experience, and the experience of others, investigative testimony and accounting board demands for documents are often unfocused, with overbroad document requests requiring burdensome and expensive collection and production efforts, and multiple days of testimony that consume large amounts of time from individuals and counsel. At the other end of the process, the penalties sought by the staff in settlement are often so draconian that individuals may feel compelled to litigate. We briefly describe below key aspects of the PCAOB investigative process, and contrast the PCAOB's approach with that of other regulators. We also offer some suggestions on how aspects of the PCAOB investigative process may be improved.

Planning the Investigation.

A significant perceived problem with the staff's investigative conduct is their “fishing expedition” approach to matters under inquiry. As discussed further below, broad document demands are common, and the staff is often reluctant to narrow the production demand, even after receiving assurance that documents will be preserved. Testimony requests seek multiple days of testimony, usually with only the broadest outlines of topics provided in advance. It is apparent that the staff's investigations are in many cases not being calibrated to the facts at hand.

Other government agencies require that investigative staff carefully plan and focus before commencing an investigation. For example, the Department of Justice Antitrust Division Manual requires that “[a]t the beginning of any investigation, staff should immediately determine the scope and focus of its investigative effort” and “establish a plan describing what is to be done, how and when it will be done, and who will do each task.”2 The investigative plan “should address, at least … theories of [liability]; evidence that would support each theory, and from where the evidence could be obtained; the specific tasks that are necessary to obtain the necessary evidence; when staff plans to accomplish those tasks; and which staff members will be primarily responsible for those tasks.”3 The Manual notes that “[t]he most effective investigations are very often the result of carefully planned strategies that are well developed at the outset of the investigation.”4

Relevant Internal Revenue Service (“IRS”) procedures are also instructive. IRS examinations, although entitled “examinations,” are akin to regulatory enforcement investigations, and often result in an adversary proceeding. The IRS Large Business and International Division's Quality Examination Process (“QEP”) calls for an Initial Planning Meeting with the taxpayer. At that meeting, the “exam team” discusses, among other things, the IRS document request and dispute resolution options with the taxpayer. IRS guidance on the QEP notes that an effective investigative process can be maintained under this framework, with ongoing communications following the Initial Planning Meeting: “IRS agents and exam teams retain the authority to determine which issues will be examined, and what documentation is needed to conduct the exam. Timely, clear and consistent communication between the team and taxpayer during the process can directly influence the scope of the examination and the depth of the analysis for issues under audit.”5


The Federal Rules of Civil Procedure also require parties to coordinate and carefully plan the discovery process before beginning that process. Rule 26 states that parties must meet and confer “as soon as practicable” to, among other things, “develop a proposed discovery plan” and “attempt[] in good faith to agree on the proposed discovery plan.”6 The plan must state the parties' views and proposals on a variety of issues, including “the subjects on which discovery may be needed, when discovery should be completed, and whether discovery should be conducted in phases or limited to or focused on particular issues.”7


The PCAOB should consider whether additional attention should be devoted to the front end of the investigative process. An initial effort at focusing on the topics to be investigated may bring heightened efficiency to the process. In addition, consideration should be given to periodic (e.g., quarterly) review meetings with counsel after an investigation begins, in order to facilitate communication regarding the scope and status of an investigation, outstanding information requests, and other topics and questions relevant to the investigation.


The Investigative Process.
Document Demands

PCAOB Rule 5103, promulgated pursuant to SOX Section 105, governs demands for production of audit workpapers and other documents from registered public accounting firms and associated persons. That rule provides:

The Board, and the staff of the Board designated in an order of formal investigation, may issue an accounting board demand for the production of audit work papers or any other document or information in the possession of a registered public accounting firm or any associated person thereof, wherever domiciled, that the Board or its staff considers relevant or material to the investigation.


The Rule also provides that an accounting board demand for documents “set forth a reasonable time and place for production”; that copies and not original documents may be produced (unless originals are expressly required by the demand); and that any originals not produced “be maintained in a reasonably accessible manner,” “be readily available for inspection by the staff,” and “not be destroyed without the staff's consent.” In addition, the Rule provides that unless the demand indicates otherwise, documents that exist in electronic form must be produced in that form.

Neither SOX nor the PCAOB Rules place any constraints on the PCAOB staff with respect to the scope or extent of its document demands, other than those noted above. At the time Rule 5103 was promulgated, one commenter proposed that the rule include a “reasonableness” requirement.8 The PCAOB declined to include that requirement in the rule.9 Another commenter suggested that the rules permit Board review of the scope of a staff-issued accounting board demand for documents. That suggestion was also rejected by the Board.10

Because there is no review mechanism in place, registered public accounting firms and associated persons are able to seek review of a document demand only through non-compliance, exposing themselves to substantial sanctions in non-cooperation proceedings under Rule 5110.11

With each demand for documents, and with each demand for testimony, the staff should be aware of the tremendous burdens the demand is placing on the firms and individuals involved.


In practice, accounting board demands for documents are often extremely broad in scope, asking for all documents that could conceivably bear on multiple years of audit work. In many cases, despite assurances by a firm or individual that all documents relevant to the investigation will be preserved, the staff often requires the physical production of all documents subject to the demand, and is frequently reluctant to negotiate the scope of a request.

Testimony

Accounting board demands for testimony raise similar concerns. The PCAOB staff's ability to take testimony from associated persons of registered public accounting firms is governed by PCAOB Rule 5102, which was promulgated pursuant to SOX Section 105. This authority allows the staff to “require the testimony of any registered public accounting firm or any person associated with a registered public accounting firm, with respect to any matter that the Board considers relevant or material to an investigation.”

PCAOB Rule 5102(b) states that an accounting board demand for testimony shall:


  • “give[] reasonable notice of the time and place for the taking of testimony;”

  • “state[] the method or methods by which the testimony shall be recorded, which may be by sound or sound-and-visual, but shall include by stenographic means;” and

  • “if the person to be examined is a registered public accounting firm, [provide] a description with reasonable particularity of the matters on which examination is requested.”


Neither SOX nor the PCAOB Rules place any constraints on the PCAOB staff with regard to investigative testimony other than those noted above.12 In practice, the staff will often issue sequential demands for multiple days of testimony, resulting in three or four days of testimony, followed by a subsequent request or requests weeks or months later for additional days of testimony. It is not uncommon for the staff to cover the same topics on different occasions, and for the staff to shift their focus in the course of the investigation in order to cover new or different topics. Little guidance is offered to counsel prior to testimony. The practice often appears haphazard, and is extremely burdensome to witnesses.


Considerations for Improving the Document and Testimony Process.


We recognize that in some cases, perhaps many cases, the staff may be undertaking a broad-ranging investigation that may not permit, in the staff's view, an initial limit on the scope of the inquiry. Nevertheless, in every case, with each demand for documents, and with each demand for testimony, the staff should be aware of the tremendous burdens the demand is placing on the firms and individuals involved.

Other government agencies recognize the burdens of the investigative process and require limits on the staff in that process. For example, the Federal Energy Regulatory Commission Revised Policy Statement on Enforcement13 provides that “the Commission and staff recognize the financial and time burdens that compliance with discovery requests impose on companies, which must continue to conduct their ordinary business while at the same time meeting staff's needs.” As a result, the “staff targets its discovery requests to the specific demands of the investigation, refrains from seeking information unnecessary to the resolution of the issues and conduct examined, and works with the subject of an investigation to accommodate reasonable requests regarding the production of data.”14

The IRS's QEP noted above calls for discussion of document requests with the taxpayer; that the taxpayer be informed of the intent of the document request; that the purpose of the document request be plainly stated in its text; that there be discussion of the issues involved; and that a required response time be established.15

The Federal Rules of Civil Procedure also recognize the burdens of discovery and place limits on it. The Advisory Committee Notes on Rule 26 state that the spirit of discovery rules are violated by, among other things, the “overuse of discovery,” which “results in excessively costly and time-consuming activities that are disproportionate to the nature of the case, the amount involved, or the issues or values at stake.”16


Rule 26(b)(2)(B) states that “[a] party need not provide discovery of electronically stored information from sources that the party identifies as not reasonably accessible because of undue burden or cost.”17 Rule 26(b)(2)(C) requires the court to “limit the frequency or extent of discovery” to the extent that: “(i) the discovery sought is unreasonably cumulative or duplicative, or can be obtained from some other source that is more convenient, less burdensome, or less expensive; (ii) the party seeking discovery has had ample opportunity to obtain the information by discovery in the action; or (iii) the burden or expense of the proposed discovery outweighs its likely benefit, considering the needs of the case, the amount in controversy, the parties' resources, the importance of the issues at stake in the action, and the importance of the discovery in resolving the issues.”18


Similarly, Rule 30 of the Federal Rules of Civil Procedure requires a party to obtain leave of court or agreement of the opposing party to conduct more than 10 depositions, depose a person more than once, or depose a person for longer than one day of seven hours.19 An objective of this Rule, according to the Advisory Committee Notes, “is to emphasize that counsel have a professional obligation to develop a mutual cost-effective plan for discovery in the case.”20

The PCAOB should consider the policies and practices of these other agencies (as well as the principles animating the Federal Rules of Civil Procedure) and assess whether additional attention should be paid to limiting the scope and breadth of demands for documents and testimony, in order to more effectively target discovery requests to the issues under inquiry, and to make the process less burdensome to the firms and individuals involved. Frequent and transparent communication with counsel about the staff's discovery needs may aid the staff in developing more targeted discovery requests. This may include periodic review meetings with counsel, as discussed above. Consideration should also be given to the proposals of commenters on the original rule that a “reasonableness” provision be included in the rule, and allowing Board review in appropriate circumstances of accounting board demands for documents and testimony.


Sanctions

The PCAOB's available sanctions against registered public accounting firms and associated persons are found in SOXSection 105(c)(4): (i) temporary suspension or permanent revocation of registration; (ii) temporary or permanent suspension or bar of a person from further association with any registered public accounting firm; (iii) temporary or permanent limitation on the activities, functions or operations of a firm or person (other than in connection with required additional professional education or training); (iv) civil money penalties; (v) censure; (vi) required additional professional education or training; or (vii) any other appropriate sanction provided for in the rules of the Board.

PCAOB Rule 5300 lists additional sanctions that may be imposed on registered public accounting firms, including requiring a firm to engage an independent monitor or consultant; to adopt or implement additional policies; or to obtain an independent review and report on one or more engagements.

At or near the conclusion of an investigation, the staff may engage in settlement discussions. In practice, the PCAOB staff is frequently unwilling to discuss sanctions for individuals lesser than revocation, bar or censure. As these penalties are of severe consequence for an individual, the settlement process often stalls, and litigation ensues, even in cases that might be resolved with lesser sanctions.

Alternatives such as deferred prosecution agreements and non-prosecution agreements should be looked at as viable alternatives to Board disciplinary proceedings.


It is not clear that the staff have clear standards with regard to available sanctions. There are no published PCAOB guidelines with regard to sanctions. Other agencies, however, have comprehensive guidelines regarding sanctions.

For example, the Financial Industry Regulatory Authority (“FINRA”), the financial regulator for the securities industry, has developed detailed guidelines for use in determining appropriate remedial sanctions for member firms and associated persons.21It publishes the guidelines so others may understand what sanctions may be applicable to various violations and use the guidelines in crafting settlements. It revises the guidelines periodically to reflect recent developments in disciplinary actions and settlements.

The FINRA guidelines detail typical securities-industry violations; recommendations as to fine amounts, suspensions, bars, or other sanctions for each violation; and potential principal considerations specific to each violation. The guidelines list “General Principles Applicable to All Sanction Determinations,” which are intended to promote consistency and uniformity in sanctions. They include designing sanctions “to deter future misconduct and to improve overall business standards,” imposing more severe sanctions for recidivists, and tailoring “sanctions to respond to the misconduct at issue.”22

The FINRA guidelines also list “Principal Considerations in Determining Sanctions,” which are applicable to disciplinary actions. The factors include whether an individual or member firm accepted responsibility for misconduct, attempted to conceal the misconduct, provided substantial assistance to FINRA during its examination or investigation, or demonstrated that the misconduct was aberrant.23


The PCAOB should consider developing guidelines regarding sanctions that may be imposed against firms and individuals. Providing clear standards would provide both the staff and those under investigation a framework within which to assess a given matter, and would likely facilitate resolution in many cases.

The PCAOB should also consider whether its staff should be armed with a broader range of remedies. With individuals in particular, any PCAOB enforcement action is of most serious moment. Because even a censure of an associated person will have a profound effect on that individual – essentially ending that individual's career in public accounting – the staff should have the ability to resolve cases short of revocation, bar or censure, and should have viable alternatives for settlement. Other agencies recognize that sanctions can be deferred or declined in a settlement. For example, the SEC's Enforcement Manual24 describes tools available to the SEC Staff to facilitate and reward cooperation in investigations and enforcement actions, including deferred prosecution agreements and non-prosecution agreements.

The PCAOB should consider whether additional guidance should be provided to the staff to allow leeway in the sanctions sought in the context of settlement of an enforcement action. In particular, alternatives such as deferred prosecution agreements and non-prosecution agreements should be looked at as viable alternatives to Board disciplinary proceedings.

Ongoing Guidance on Process and Sanctions.

In addition to the above considerations, the PCAOB and the staff should consider providing ongoing guidance on process and sanctions in the form of an Investigations and Enforcement Manual, such as the manual promulgated by the SEC Enforcement Division and FINRA's Sanctions Guidelines.

This would provide guidance to the staff of the Division in carrying out its duties. While such a manual would not create any substantive or procedural rights for any party, it would provide a framework of understanding for counsel and witnesses and a reference for all involved in the enforcement and investigation process. Such a framework may, in turn, lead to additional meaningful cooperation and speedier resolutions of investigations and enforcement matters.

Messrs. Marmaro and Walker are partners at Skadden, Arps, Slate, Meagher & Flom LLP, resident in the firm's Los Angeles and Washington, D.C. offices, respectively. The views expressed in this article are solely those of the authors, and are not necessarily shared or endorsed by the firm or its partners. The authors gratefully acknowledge the assistance of Skadden counsel Joshua Ellis and associate Kate Lesker in the preparation of this article.

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