Call it the other whistleblowing provision of the corporate-governance world: Section 10A of the Securities Exchange Act.
While Sarbanes-Oxley might hog the spotlight when it comes to anti-fraud legislation, Section 10A has evolved into a quiet but powerful force to root out corporate misdeeds. Created as part of the Securities Litigation Reform Act of 1995, Section 10A essentially requires an auditor to take certain actions when it discovers that an illegal act has occurred—regardless of whether the act is material to the company’s financial statement.
Exactly how many Section 10A investigations exist (or have existed) is unknown because many issues raised by auditors are resolved adequately by management and never come to the attention of regulators. Also, some issues that do catch the Securities and Exchange Commission’s eye may not be clearly linked to the initial 10A report. But experience shows that 10A reports are “fairly common,” says Robert Giuffra, a partner with the law firm Sullivan & Cromwell. “Whenever there’s a whiff of any [illegality], accountants will ask the company to conduct an investigation.”
Lamont
Grace Lamont, who heads the securities-litigation group at PricewaterhouseCoopers, says the increased sensitivity to fraud has made auditors “a lot more aware of their responsibilities,” although “every investigator, every lawyer [and] every adviser will come at it from a different angle.”
Scheck
The nature of an investigation prompted by Section 10A depends on whether senior management itself has been implicated in any illegal act, says Howard Scheck, a partner with Deloitte Financial Advisory Services. Once a problem has been identified, he says, the auditor’s role is to follow up and ensure that it has been addressed properly. Once the Section 10A probe is triggered, it “quickly becomes the same as any investigation,” he says.
Bloch
And the pressure to resolve the issue quickly to the auditor’s satisfaction can be enormous because SEC filings may have to be delayed while an investigation is underway, notes David Bloch, a principal with Deloitte. “A late filing could be the death knell for some companies—it could essentially shut off their flow of funds,” he says.
Investigating Illegal Acts
Under Section 10A, the auditor must determine whether it is “likely” that an illegal act has indeed occurred, consider the possible consequence to the company’s financial statements, and inform the appropriate level of management about the issue. The auditor also is obligated to inform the company’s audit committee about the potential illegal act, unless the act in question is “clearly inconsequential.” Whether or not the auditor ceases any auditing activities depends on the individual circumstances and potential seriousness.
The definition of illegal act in Section 10A is very broad; the SEC has interpreted it to cover items beyond financial misconduct. Because auditors are not experts on what is and is not illegal, the burden of conducting the actual investigation is generally shifted to management, who may pass the probe on to in-house lawyers or outside legal counsel. Supervision of the investigation may be the responsibility of the auditing committee, under certain situations.
THE STATUTE
Below is an excerpt of Section 10A, outlining an auditor's duties to report possibly illegal acts.
If, in the course of conducting an audit pursuant to this title to which subsection (a) applies, the registered public accountanting firm detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the firm shall, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission:
determine whether it is likely that an illegal act has occurred; and
if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including any contingent monetary effects, such as fines, penalties, and damages; and
as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors of the issuer in the absence of such a committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of such firm in the course of the audit, unless the illegal act is clearly inconsequential.
If, after determining that the audit committee of the board of directors of the issuer, or the board of directors of the issuer in the absence of an audit committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of the firm in the course of the audit of such firm, the registered public accountanting concludes that:
the illegal act has a material effect on the financial statements of the issuer;
the senior management has not taken, and the board of directors has not caused senior management to take, timely and appropriate remedial actions with respect to the illegal act; and
the failure to take remedial action is reasonably expected to warrant departure from a standard report of the auditor, when made, or warrant resignation from the audit engagement;
[then] the registered public accountanting firm shall, as soon as practicable, directly report its conclusions to the board of directors.
An issuer whose board of directors receives a report under paragraph (2) shall inform the Commission by notice not later than 1 business day after the receipt of such report and shall furnish the registered public accountanting firm making such report with a copy of the notice furnished to the Commission. If the registered public accountanting firm fails to receive a copy of the notice before the expiration of the required 1-business day period, the registered public accountanting firm shall:
resign from the engagement; or
furnish to the Commission a copy of its report (or the documentation of any oral report given) not later than 1 business day following such failure to receive notice.
Source
Securities And Exchange Commission
The investigation typically results in a report about the conduct in question and any remedial action deemed necessary. The auditor has the responsibility of assessing the appropriateness of the company’s response and is only required to make a report to the company’s board of directors if there has been no “timely and appropriate remedial action” taken in response to an illegal act. Such a report also must be made if the illegal act will materially affect the financial statements or the failure to take remedial action warrants the auditor’s resignation.
Once a Section 10A report is made by the auditor to the board, the board is required to inform the SEC of this fact.
First Responders
Timothy Harkness, a partner with the law firm Kramer Levin Naftalis & Frankel, says sometimes potential illegal acts are uncovered first by the company, which self-reports to the auditor. That is often a wise move; “most companies would rather get out in front the situation,” he says.
In many situations, Harkness says, a discussion happens about what the auditor expects management to do to ensure that the auditor’s 10A obligations are fulfilled. “The auditor may say to the company, ‘I expect a flow of information to make sure you’re taking the appropriate remedial measures,’” Harkness explains. “The auditors become active observers of the company’s [remedial] steps.”
Harkness also cautions that, “There are illegal acts, and then there are illegal acts. The appropriate remedial measure [in every case] may not be a full board investigation.”
Landy
Charles Landy, a former SEC prosecutor and now partner at the law firm Pillsbury Winthrop Shaw Pittman, notes that “when a 10A investigation is done properly—and the auditor concludes that everything has been done consistent with the responsibilities of management and their own responsibilities under Section 10A—it never gets reported as a 10A investigation.”
Still, like all investigations, Section 10A probes are no company’s idea of a good time. “They cost a lot of money and distract the attention of a lot of people, some of whom have to deal with it on a regular basis,” Landy says. The biggest problem, he says, is making sure that the response to the auditors’ notice of an illegal act is “appropriate, thorough and solves the problem.”
Giuffra
Section 10A is not always fun for auditors either, Landy adds; if the SEC determines that the auditor failed to fulfill its duties under the provision, the Commission can bring proceedings against the auditing firm.
The provision “does not get as much attention as it deserves,” Giuffra says. “In the post-Enron, post-WorldCom, post-SOX environment, accountants are highly sensitized to being asleep at the switch. Section 10A has [made them] the first responders in a situation of potential corporate wrongdoing.”
A Delicate Balance
Scott Weiss, a former auditor and now partner with the law firm Greenberg Traurig, says one trap for the unwary conducting Section 10A investigations is to be sure that the probes are truly independent. In some cases, he says, in-house counsel will be too conflicted to conduct such an investigation.
Weiss
Weiss, not surprisingly, recommends hiring an outside law firm to help. “Most companies instinctively know this, but many will try to avoid it because of the nature of the expense,” he says. “These investigations can get very expensive very quickly. For a small public company, it could literally crush the company.”
Companies generally “will go to great lengths to resolve [the issue] and resolve it to the satisfaction of the internal auditor,” Weiss says, citing the problems that would arise if a company had to change auditors or if the matter was reported formally to the SEC.
The major legal tension between the company and the auditors may involve the issue of what precisely is reported to the auditors about the investigation. That can raise concerns about waiving attorney-client privilege and making documents potentially discoverable by plaintiffs in future private lawsuits.
“You want to open up your books to the auditors to show that nothing is wrong—that’s what the auditors would like,” Weiss says. “But then you have your lawyers saying, ‘No, if you do that you’ve waived the privilege.’”
Harkness
Companies have to make sure that fear of waiving privileges “doesn’t impede a thorough investigation that satisfies the auditors,” Harkness warns.
“One of the challenges in this area is explaining to people who’ve never gone through the process what the rules of the road are,” Harkness says. “If you get off on the wrong foot because you’re trying to be protective of privileges or the company, if you send along signals that you’re not taking things seriously—that can really hurt the company.”
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