The New Auditor Report
In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. Among other additions, an audit report will need to include critical audit matters (CAMs) and disclosure the tenure of the auditor. The new rule and requirements related to audit reports are significant as the audit report is the document in which the auditor itself communicates to the public and investors.
The new standard will require auditors to describe CAMs that are communicated to a company’s audit committee. Critical audit matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.
The new audit report standard also adds information related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks.
The process in finalizing the rule has been lengthy, having begun in 2010 in response to investor- and public-initiated comments. Once proposed, the rule went through three rounds of public solicitation for comment. Of particular concern is whether the new requirements will result in increased nuisance shareholder litigation, costing the company and its investors, and whether it will result in a chill on auditor-company communications. In a statement related to the new auditor report, SEC Chairman Jay Clayton expressly addressed this concern, stating:
“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.
I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”
As an aside, as with any rule making, SEC rules and regulations can and do result in unintended consequences. This is an issue I’ve raised many times over the years in my blogs, including, for example, the multitude of differences between requirements for smaller reporting companies and emerging growth companies, a topic the SEC is now working on addressing and rectifying. It is great to see Chair Clayton discuss this phenomenon directly and for the rule itself to take measures to monitor and initiate changes based on implementation analysis.
There are certain carve-outs from some of the rule requirements, including the CAM requirements. In particular, the CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans; however, they do specifically apply to smaller reporting companies. Moreover, the rule requires extensive post-implementation review, in light of the potential for negative unintended consequences, and such review could result in changes to the rule itself and its implementation schedule.
The New Audit Report Rules
The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.
The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. A CAM is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”
For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.
The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.
Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed. The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.
The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.
In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.
All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.
The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.
The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.
Effective Dates
All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2018
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SEC Chief Accountant Speaks On Financial Reporting
On June 8, 2017, the SEC Chief Accountant, Wesley R. Bricker, gave a speech before the 36th Annual SEC and Financial Reporting Institute Conference. The speech, which this blog summarizes, was titled “Advancing the Role of Credible Financial Reporting in the Capital Markets.” As usual, I’ve included commentary throughout.
Introduction and Role of the PCAOB
The speech begins with some general background comments and a discussion of the role of the PCAOB. Approximately half of Americans invest in the U.S. equity markets, either directly or through mutual funds and employer-sponsored retirement plans. The ability to judge the opportunities and risks and make investment choices depends on the quality of information available to the public and importantly, the quality of the accounting and auditing information. Mr. Bricker notes that “[T]he credibility of financial statements have a direct effect on a company’s cost of capital, which is reflected in the price that investors are willing to pay for the company’s securities.”
The quality of financial statements begins with the company’s internal accounting and audit committees; however, an audit by an independent accountant provides investor confidence in the financial statements themselves. Mr. Bricker notes the importance of having an independent auditor that is thorough in their review and testing of the financial statements to ensure that they are accurate and do not contain any misstatements. In order to ensure that this process works, both the profession itself and regulators must be actively involved.
The Public Company Accounting Oversight Board (“PCAOB”) has broad oversight and responsibility related to the audit and auditors of public companies and broker-dealers. The PCAOB sets accounting standards, completes registration and inspection of audit firms and has enforcement authority. The PCAOB inspection process includes a review of audit files and of internal controls and processes of audit firms. The reports are made public via Staff Inspection Briefs and individual inspection reports. Also, a list of registered qualified PCAOB auditors is readily available on the PCAOB website.
The PCAOB completes an annual review of current and emerging audit issues and publishes and sets audit standards and changes. The PCAOB also publishes guidance for auditors and the audit process. As an example, the PCAOB recently proposed a new standard for audit reports. The proposed new standard would require auditors to describe “critical audit matters” that are communicated to a company’s audit committee. Critical matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.
The proposal would also add information to the audit report related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks. The SEC has yet to approve the rule. If/when approved, the new rule would be implemented for large accelerated filers beginning mid-2019 and for all other companies starting in 2021. Mr. Bricker notes that this proposed change is significant as the audit report is the document in which the auditor itself communicates to the public and investors.
International Collaboration
Mr. Bricker then discusses international collaboration with foreign regulators and standard setters. He notes that “in today’s interconnected world economy, investors depend on high quality auditing and auditing standards around the world,” also noting that “U.S. investors routinely invest in companies based outside the United States and listed in non-U.S. jurisdictions to diversify their portfolio.”
Turning to some facts and figures, U.S. investors invested $9 trillion in foreign equity and long-term debt, including through mutual funds. Investment in domestic equity and long-term debt comes in at $61.4 trillion. This number continues to increase. During the week ending May 17, 2017, U.S. investors added $9.9 billion to U.S.-based mutual and exchange traded funds which invest abroad. This was the largest weekly increase since July 2015.
It is important for investors to be aware of the processes, regulations, regulators and governance in place related to audits and auditing standards outside of the U.S. Although Mr. Bricker continues on the importance of international audit standards, and trust in the audit process, he does not refer to any specific initiatives or guidelines in that regard.
New GAAP Accounting Standards; Revenue Recognition
Recently there have been several changes to accounting processes and several other proposed changes. One that will have a material impact is related to revenue recognition. As requested by investors, businesses and the marketplace, FASB and IASB recently adopted new revenue-recognition standards which will be implemented over the next three years. Mr. Bricker does not get into the details of the new revenue-recognition standard but emphasizes that the audit committee and auditors need to participate in and have an understanding of how the company is implementing the changes, including a flow through to internal controls and procedures.
The following is my very high-level summary of the impact on contracts from the complex new revenue recognition standards. The revenue recognition changes are designed to assist an investor in understanding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts and customers. As revenue recognition is initially determined by the terms of a contract, it is important when drafting contracts to consider the financial statement impact. The new standard sets forth five steps to consider.
The first step is to identify the particular contract, which is an agreement between two or more parties that creates enforceable rights and obligations. The new standard requires that multiple contracts, between the same parties, entered into at or near the same time, must be combined and analyzed as one contract if (i) the contracts are negotiated as a package with a single commercial objective; (ii) the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or (iii) the goods or services promised in the contracts are a single performance obligation.
The second step is to identify the performance obligations, which is a promise in a contract with a customer to transfer to the customer either: (i) a good or service (or bundle of goods or services) that is distinct; or (ii) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service is distinct if both of the following conditions are met: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and (ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
This step is vitally important as revenue is recognized when or as performance obligations are satisfied, and thus a contract must clearly identify those performance obligations. One blog I read gave a great example of where contract drafting can result in different revenue recognition—in particular, where a developer enters into a contract to build a completed building for a particular purpose for a customer. The contract may be written whereby parts of the delivered project have distinct and independent value, such as engineering, site clearance, construction, installation of equipment and finishing such that revenue is recognized upon delivery of these distinct elements. Contrarily the contract could be written such that the individual parts are not separately identifiable, but rather only the end product, such that revenue would not be recognized until such end product is provided.
The third step is determining the transaction price which is the amount of consideration to be paid in exchange for delivering the promised goods or services to a customer, excluding amounts collected on behalf of third parties. The two main considerations are: (i) variable consideration – if the consideration is variable, the company should estimate either the expected value or the most likely amount, depending on which will be the more likely; and (ii) constraining estimates of variable consideration – a company should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Transaction price can also vary based on non-cash consideration, discounts, rebates, refunds, performance bonuses, penalties, contingent payments and the like. An example would be where a custom asset is being built and the price is contingent upon a delivery deadline, with a performance bonus for early delivery and penalties for later delivery. An additional complexity may be where the price is based on an independent appraisal at the time of delivery. Complex variables may prohibit revenue recognition until a contract is fully performed.
The fourth step is to allocate the transaction price to the performance obligations in the contract. This amount should reflect the amount a company would be entitled to in exchange for satisfying each performance obligation. To be able to recognize revenue based on allocation, the contract should clearly identify a particular distinct delivered good or service on a stand-alone selling-price basis. The allocation can be very complex and the amount of revenue recognized could end up differing from a stated value in a contract, which may be arbitrary.
The fifth step is to recognize revenue when or as the company satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when or as the customer obtains control of that good or service. Where a good or service is transferred over time, revenue may be recognized if one of the following conditions is met: (i) the customer simultaneously receives and consumes the benefits provided by the company’s performance over time; (ii) the company’s performance creates or enhances an asset that the customer controls as it is being created or enhanced; or (iii) the company’s performance does not create an asset with an alternative use to that company, and the company has an enforceable right to payment for performance completed to date (customized products or services).
Where performance and delivery are not over time, a company should consider the following as to when to recognize revenue: (i) the company has a present right to payment for the asset; (ii) the customer has legal title to the asset; (iii) the company has transferred physical possession of the asset; (iv) the customer has the significant risks and rewards of ownership of the asset; or (v) the customer has accepted the asset.
Also not included in Mr. Bricker’s speech is that some companies have chosen to adopt the new standards already, including Ford Motor Company, General Dynamics, Raytheon, Alphabet, First Solar and United Health Group. The MD&A for each of these companies contains a summary of the changes and how they impact their particular company and its financial statements.
Internal Control over Financial Reporting
Internal controls over financial reporting are controls designed to provide reasonable assurance that the company’s financial statements are prepared in accordance with GAAP. Internal controls provide the guidance and road map for management to effectively ensure timely and accurate financial reporting. All companies are required to maintain internal controls over financial reporting, whether or not such company is subject to the Sarbanes-Oxley Act.
Mr. Bricker advocates the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework for assessing the effectiveness of internal controls. The Treadway Commission is the National Commission on Fraudulent Reporting and has long been accepted as providing acceptable guidance on internal controls over financial reporting, and processes for management to assess same.
Mr. Bricker does not get into the specifics of the COSO framework for evaluating internal controls. However, I am providing a brief summary. In 1992 COSO developed a model for evaluating internal controls which has become the widely recognized standard for which companies measure the effectiveness of their systems of internal controls. COSO defines internal control as “a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance” of the achievement of objectives if the following categories: (i) effectiveness and efficiency of operations; (ii) reliability of financial reporting; and (iii) compliance with applicable laws and regulations.
From a very high level, COSO states that in an effective enterprise risk management (ERM) and effective internal control system, all of the following five components must be present:
- A Control Environment – which includes: (i) integrity and ethical values; (ii) a commitment to competence; (iii) a strong board of directors and audit committee; (iv) management’s philosophy and operating style; (v) organizational structure; assignment of authority and responsibility; and (vi) human resource policies and procedures;
- Risk Assessment – which includes: (i) company-wide objectives; (ii) process level objectives; (iii) risk identification and analysis; and (iv) managing change.
- Control Activities – which includes: (i) policies and procedures; (ii) security (application and network); (iii) application change management; (iv) business continuity/backups; and (v) outsourcing.
- Information and Communication – which includes (i) qualify of information; and (ii) effectiveness of communication; and
- Monitoring – which includes: (i) ongoing monitoring; (ii) separate evaluations; and (iii) reporting deficiencies.
Strong internal controls not only detect and prevent material errors or fraud in financial reporting but also contribute to better accountability and information flows. In other words, internal controls over financial reporting assist a company in better management and potential profitability in addition to the important reporting and securities-law matters. Where a company must disclose a material weakness in its internal controls, investors will discount the price accordingly, especially at the institutional level. Moreover, where a company has reported a material weakness and plan of remediation, and then executes on such plan, the investor response is very positive, including a reduced cost of capital and improved operating performance.
Although not discussed by Bricker, both the NYSE and NASDAQ consider reported material weaknesses in internal controls when reviewing an application for listing on the exchange.
Auditor Independence
Public trust in financial reporting is maintained by protecting the independence of the outside auditor. A company’s audit committee plays an important role in overseeing and communicating with the outside auditor. Bricker states that in order for the system to be effective, the audit committee must “own the selection of the audit firm, make the final decision when it comes time to negotiate the audit fee, and oversee the auditor’s independence.”
As part of the independent auditor selection, the audit committee should be open to the possibility of circumstances that might require adjustments to prior-period financial statements. Mr. Bricker includes as examples the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error.
Reminders to the Audit Profession
Mr. Bricker points out that audit firms themselves are organizations with the inherent pressures that personnel of any organization can face. Audit firms themselves must monitor and have internal controls in place to ensure quality audits and audit relationships. One pressure that definitely can impact the quality of an audit is a deadline. Bricker points out that audit firms need to plan and allocate resources to ensure that there is time to address potential issues under the deadline of SEC filing requirements. I note that the biggest complaint my clients make about their auditors relates to issue spotting at the last minute and requested material changes to financial statements, such as revenue recognition, right before a filing is due, without the time to properly research and address the matter.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2017
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SEC Completes Inflation Adjustment To Civil Penalties
The SEC has completed the first annual adjustment for inflation of the maximum civil monetary penalties administered under the SEC. The inflation adjustment was mandated by the Federal Civil Penalties Inflation Adjustment Improvements Act of 2015, which requires all federal agencies to make an annual adjustment to civil penalties.
The SEC adjusted civil penalties that can be imposed under the Securities Act of 1933, Securities Exchange Act of 1934, Investment Company Act of 1040, Investment Advisors Act of 1940 and Sarbanes-Oxley Act of 2002. Under the Sarbanes-Oxley Act of 2002 civil penalties are those imposed by the PCAOB in disciplinary proceedings against its accountant members.
The penalty increase applies to civil monetary penalties (“CMP”). A CMP is defined as “any penalty, fine, or other sanction that: (1) is for a specific amount, or has the maximum amount, as provided by federal law; and (2) is assessed or enforced by an agency in an administrative proceeding or by a federal court pursuant to federal law.”
The following is a table of the new CMP’s.
| U.S. Code citation | Civil monetary penalty description | New Adjusted penalty amounts |
| 15 U.S.C. 77h-1(g)(Securities Act Sec. 8A(g)) | For natural person | $8,289 |
| For any other person | 82,893 | |
| For natural person / fraud | 82,893 | |
| For any other person / fraud | 414,466 | |
| For natural person / fraud / substantial losses or risk of losses to others or gains to self | 165,787 | |
| For any other person / fraud / substantial losses or risk of losses to others or gain to self | 801,299 | |
| 15 U.S.C. 77t(d)(Securities Act Sec. 20(d)) | For natural person | 9,054 |
| For any other person | 90,535 | |
| For natural person / fraud | 90,535 | |
| For any other person / fraud | 452,677 | |
| For natural person / fraud / substantial losses or risk of losses to others | 181,071 | |
| For any other person / fraud / substantial losses or risk of losses to others | 905,353 | |
| 15 U.S.C. 78u(d)(3)(Exchange Act Sec. 21(d)(3)) | For natural person | 9,054 |
| For any other person | 90,535 | |
| For natural person / fraud | 90,535 | |
| For any other person / fraud | 452,677 | |
| For natural person / fraud / substantial losses or risk of losses to others or gains to self | 181,071 | |
| For any other person / fraud / substantial losses or risk of losses to others or gain to self | 905,353 | |
| 15 U.S.C. 78u-1(a)(3) (Exchange Act Sec. 21A(a)(3)) | Insider trading – controlling person | 2,011,061 |
| 15 U.S.C. 78u-2(Exchange Act Sec. 21B) | For natural person | 9,054 |
| For any other person | 90,535 | |
| For natural person / fraud | 90,535 | |
| For any other person / fraud | 452,677 | |
| For natural person / fraud / substantial losses or risk of losses to others | 181,071 | |
| For any other person / fraud / substantial losses or risk of losses to others | 905,353 | |
| 15 U.S.C. 78ff(b)(Exchange Act Sec. 32(b)) | Exchange Act / failure to file information documents, reports | 534 |
| 15 U.S.C.78ff(c)(1)(B)
(Exchange Act Sec. 32(c)(1)(B)) |
Foreign Corrupt Practices – any issuer | 20,111 |
| 15 U.S.C.78ff(c)(2)(B)
(Exchange Act Sec. 32(c)(2)(B)) |
Foreign Corrupt Practices – any agent or stockholder acting on behalf of issuer | 20,111 |
| 15 U.S.C. 80a-9(d)(Investment Company Act Sec. 9(d)) | For natural person | 9,054 |
| For any other person | 90,535 | |
| For natural person / fraud | 90,535 | |
| For any other person / fraud | 452,677 | |
| For natural person / fraud / substantial losses or risk of losses to others or gains to self | 181,071 | |
| For any other person / fraud / substantial losses or risk of losses to others or gain to self | 905,353 | |
| 15 U.S.C. 80a-41(e)(Investment Company Act Sec. 42(e)) | For natural person | 9,054 |
| For any other person | 90,535 | |
| For natural person / fraud | 90,535 | |
| For any other person / fraud | 452,677 | |
| For natural person / fraud / substantial losses or risk of losses to others | 181,071 | |
| For any other person / fraud / substantial losses or risk of losses to others | 905,353 | |
| 15 U.S.C. 80b-3(i) | For natural person | 9,054 |
Further Reading
Background: A Trend Towards Increased Enforcement
The SEC has demonstrated a trend to deter securities law violations through regulations and stronger enforcement including the SEC Broken Windows policy, increased Dodd-Frank whistleblower activity and reward payments, and increased bad-actor prohibitions.
The SEC Broken Windows policy is one in which the SEC is committed to pursue infractions big and small; where they are committed to investigate, review and monitor all activities and not just wait for someone to call and complain or just wait for the big cases. The idea is that small infractions lead to bigger infractions, and the securities markets have had the reputation that minor violations are overlooked, creating a culture where laws are treated as meaningless guidelines. So the SEC thinks it is important to pursue all types of wrongdoings—not just big frauds, but negligence-based cases and the enforcement of prophylactic measures as well.
In a speech by Mary Jo White back in October 2013, she announced the policy and the SEC’s enforcement initiative. The policy is modeled after one pursued by the NYPD back in the nineties under Mayor Rudy Giuliani, which resulted in helping to clean up the streets of New York. The analogy is that if a window is broken and someone fixes it, it is a sign that disorder will not be tolerated, but if no one fixes it, the thought is that no one cares and no one is watching so why not break more windows.
Although I believe that the new chairman, commissioners and division chiefs at the SEC will be more business-friendly than their predecessors, I also think enforcement of legal infractions will always remain a priority.
SEC Civil Penalties
Under the law, penalties differ depending on whether the SEC pursues and resolves an action in an SEC administrative proceeding or through a federal court action. In SEC administrative proceedings, there are three tiers of maximum penalties. For most civil violations, the SEC can impose a first-tier money penalty for “each act or omission” violating the securities laws. Second-tier violations involve at least reckless misconduct. Third-tier violations involve fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement that resulted in substantial losses to victims or substantial pecuniary gain to the wrongdoer.
The tiers are the same when a proceeding is heard in federal court, except that the SEC also has the option of seeking, instead, a penalty equal to the wrongdoers’ “ill-gotten gain” from the violation.
According to a Yale Law Journal article published in October 2014, since 2000 penalties have grown 30% year-over-year, compared to only a 3% growth in cases filed. The article points out that Xerox’s 2002 $10 million civil penalty was then “the largest ever levied in a Commission action against a public company for financial fraud,” and that since that time, corporate penalties have skyrocketed. As I’ve noted in several prior blogs, the SEC is very vocal about its use of penalties as a deterrent and its commitment to increase that trend.
Proposed SEC Penalties Act
In July 2015 Congress passed the SEC Penalties Act to increase the per-violation caps. The Act did not move past its initial congressional passage. The Act proposed to increase penalties for first-tier violations to the greater of $10,000 for individuals or $100,000 for entities, or the gross pecuniary gain by the wrongdoer. Second-tier penalties are increased to the greater of $100,000 for individuals or $500,000 for entities, or the gross pecuniary gain by the wrongdoer. Third-tier penalties are increased to the greater of (i) $1 million per violation for individuals or $10 million per violation for entities, (ii) three times the gross pecuniary gain, or (iii) the losses incurred by victims as a result of the violation. The SEC Penalties Act also triples the penalty cap for recidivists who have been held criminally or civilly liable for securities fraud in the last five years.
The Act also provides authority to seek civil penalties for violations of previously imposed injunctions or bars with each violation and each day of continuing violation being considered a separate offense. The penalties under the proposed Act would apply in both administrative and federal court proceedings.
Particular Considerations Related to Administrative Proceedings
The SEC Penalties Act, as written in its beginning form, treats administrative court and federal court proceedings equally. However, the administrative court process is not an equal forum, and based on a barrage of negative attacks, including lawsuits, appeals and media coverage, requires review and attention. An analysis by the Wall Street Journal in 2015 indicated that in the last five years, the SEC has won 90% of cases brought in its own administrative courts but only 69% of cases brought in federal court. Part of the disparity could be that the SEC chooses to settle or drop “losing” claims, but that still leaves a large discrepancy.
Moreover, the Dodd-Frank Act, enacted in 2010, for the first time granted the SEC the authority to impose civil penalties in administrative proceedings against any person the SEC claims violated the securities laws, regardless of whether that person or firm is in the securities business. In other words, Dodd-Frank opened the doors for the SEC’s own administrative proceedings to be just another forum for the pursuit of any securities law violations. Common sense tells us that this change, seven years ago, directly relates to the uproar in the defensive bar.
Over the past years a slew of cases have been filed challenging the SEC’s power in administrative actions and the administrative process. In June 2015 in the case Hill vs. SEC, a federal district court in Atlanta granted injunctive relief preventing the SEC from proceeding with an administrative proceeding on the grounds that the proceeding was unconstitutional. Without getting overly complex, Hill argued that the SEC administrative process (i) violated Article I of the constitution by letting the SEC pick the forum in which to pursue claims (administrative court or federal court) and that power is limited to Congress; (ii) violated the Seventh Amendment right to a jury trial (administrative court proceedings are heard by an administrative court judge); and (iii) violated the Article II Appointments Clause.
The federal court rejected the first two arguments but found that the there was enough evidence and support of a violation of the Appointments Clause to support the granting of a temporary injunction. In particular, the SEC administrative law judge was an inferior officer that, under Article II, must be appointed by either the president, a court of law, or a department head. In fact, the judge had not been appointed by the SEC commissioner (department head), the president or a court.
In August 2016 the U.S. Court of Appeals for the D.C. Circuit ruled that the administrative law judge’s appointment was proper. However, in December 2016 the 10th U.S. Circuit Court of Appeals ruled that SEC administrative law judges are not constitutionally appointed. The matter may next be heard by the Supreme Court.
Liability for Signing SEC Report, Including CEO and CFO Certifications
I am often asked about potential liability for signing SEC reports and, in particular, the CEO and CFO certifications. An officer providing a false certification potentially could be subject to SEC action for violating Section 13(a) or 15(d) of the Exchange Act and to both the SEC and private actions for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5. Each of these violations could be a first-, second- or third-tier violation depending upon the level of scienter by the signing officer or director and the damage resulting from the false report. In practice, courts consider the actual facts, including the signer’s involvement or scope of knowledge of the information in the reports, and do not consider the signing of the report itself dispositive. The SEC advocates the view that officers and directors have a proactive responsibility to ensure the accuracy of the reports they sign and have concurrent liability.
As a reminder, a public company with a class of securities registered under Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC. The underlying basis of the reporting requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Reports filed with the SEC can be viewed by the public on the SEC EDGAR website. The required reports include an annual Form 10-K, quarterly Form 10Q’s, and current periodic Form 8-K, as well as proxy reports and certain shareholder and affiliate reporting requirements.
These reports are signed by company officers and directors. A company officer signs a Form 10-Q and all company directors sign a Form 10-K. Moreover, the Sarbanes-Oxley Act of 2002 (“SOX”) implemented a requirement that the company’s principal executive officer or officers and principal financial officer or officers execute certain personal certifications included with each Form 10-Q and 10-K. Certifications are not required on a periodic Form 8-K.
Although it is the function of the officer that determines the requirement to execute the certifications, for purposes of this blog, I will refer to the principal executive officer as the “CEO” and the principal financial officer as the “CFO.” All companies that file reports under the Exchange Act, whether domestic or foreign, small business issuers or well-known seasoned issuers, are required to include the sw. Under the CEO/CFO certification requirement, the CEO and CFO must personally certify the accuracy of the information contained in reports filed with the SEC and the procedures established by the company to report disclosures and prepare financial statements.
A company’s CEO and CFO must each provide two certifications as part of the company’s quarterly Form 10-Q and annual Form 10-K. The certifications are required under Sections 302 and 906 of the SOX. The certifications are executed individually and filed as exhibits to the applicable quarterly and annual filings. Although certifications are not included in reports other than Forms 10-Q and 10-K, the disclosure controls and procedures to which the CEO and CFO certify must ensure full and timely disclosure in all current reports, as well as definitive proxy materials and definitive information statements.
Section 302 Certification
Under Section 302, the CEO and CFO make statements related to the accuracy of the reports filed with the SEC and the controls and procedures established by the company to ensure the accuracy of such reports. The certification must be in the exact form set forth in the rule, and the wording may not be changed in any respect whatsoever. The CEO and CFO must each certify that:
- He or she has reviewed the report;
- Based on his or her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading;
- Based on his or her knowledge, the financial statements and financial information fairly present, in all material respects, the company’s financial condition, results of operations and cash flows of the company;
- The certifying officer(s) is/are responsible for:
- establishing and maintaining disclosure controls and procedures;
- having designed such disclosure controls and procedures to ensure that they are informed of all material information;
- having each evaluated the effectiveness of the disclosure and financial controls and procedures as of the end of each period in which they are making the certification; and
- having disclosed their conclusions regarding the effectiveness of the controls and procedures in the subject Form 10-Q or 10-K;
- He or she has disclosed to the company auditors and to the audit committee any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which could adversely affect the company’s ability to record, process, summarize and report financial data;
- He or she has disclosed to the company auditors and to the audit committee any fraud, material or not, that involves employees who have a significant role in internal controls over financial reporting; and
- Any changes in the internal controls or financial reporting have been disclosed in the subject Form 10-Q or 10-K, including changes designed to correct deficiencies or material weaknesses.
If a material weakness is uncovered, it must be disclosed in a Form 10-K and, as a result, management cannot conclude that its controls and procedures are effective. The SEC defines a material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The disclosure of a material weakness should include the nature of the weakness, its impact on financial reports and plans or steps and changes made to correct the disclosed material weakness.
Section 906 Certification
Under Section 906, the CEO and CFO must attest that the subject periodic report with financial statements fully complies with the Exchange Act and that information in the report fairly presents, in all material respects, the company’s financial condition and results of operations. Like the Section 302 certification, the Section 906 certification must be in the exact form set forth in the rule and the wording may not be changed in any respect whatsoever.
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The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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