In a review of a PCAOB disciplinary proceeding the SEC took the rare step of cancelling the PCAOB’s finding that an audit partner of a Big Four firm engaged in repeated instances of negligent conduct during the audit of a mortgage REIT’s financial statements.
The facts were extreme. The audit firm issued an unqualified audit opinion on February 27, 2008, and the company filed its 2007 Form 10-K, including the audit opinion, on February 28, 2008. The same day it filed its Form 10-K, the company received more than $150 million in margin calls. Although the company had represented that it had $150 million in available liquidity two days earlier, the company was able to meet only $31.6 million in calls on February 28. The SEC stated that it was not clear from the record why this was the case but, regardless, this led to a notice of default and additional cross-defaults. The company received an additional $125 million in margin calls on February 29—the next day— and was able to meet only $15.7 million of them.
The audit partner learned of these post-audit margin calls and defaults on Sunday, March 2, 2008. After consulting with others at the audit firm, interviewing management, and reviewing emails and other documents, the audit partner and her team concluded that the company’s financial statements contained material misstatements related to whether losses to the company’s ARM Assets were other than temporary (OTTI) and therefore needed to be recognized in the company’s income statement.
The audit partner sent the company’s audit committee a letter on March 4, 2008, notifying the committee that the audit firm’s audit opinion of February 27 should no longer be relied upon, that the company’s financial statements contained material misstatements, and that the audit report “should have contained an explanatory paragraph indicating that substantial doubt exists relative to the [c]ompany’s ability to continue as a going concern for a reasonable period of time.”
On March 5, the company’s board of directors concluded that the company needed to restate its financial statements and, on March 11, the company filed an amended Form 10-K in which it restated portions of its 2007 financial statements. Unlike in its original Form 10-K, the company concluded that a more than $400 million decline in its Purchased ARM Assets was an OTTI because the company may not be able to hold those securities for the foreseeable future and may need to sell them to satisfy margin calls from lenders or to otherwise manage its liquidity position. This caused the company to include in its net loss for 2007 roughly $427.8 million in previously unrealized losses in its Purchased ARM Assets, which, along with certain other charges not at issue, increased the company’s losses by more than 75%—from $875 million to $1.546 billion.
The company’s amended Form 10-K also included the audit firm’s revised audit report. The report explained that the company did not have the financial resources as of March 6, 2008 to satisfy approximately $610 million in margin calls associated with its reverse repurchase agreements and other financial instruments and that failure to satisfy those margin calls was an event of default under the reverse repurchase agreements. These events, the report explained, provided lenders the discretion to declare the entire unpaid amounts due and payable on demand and to force liquidation of the company’s assets to satisfy those obligations. The report concluded that these matters raised substantial doubt about the company’s ability to continue as a going concern.
On appeal from the PCAOB’s final decision the issue presented to the SEC was the PCAOB’s finding that the audit partner engaged in “repeated instances of negligent conduct, each resulting in a violation of the applicable statutory, regulatory, or professional standard.” The PCAOB expressly declined to find that the audit partner engaged in “reckless conduct.”
The SEC noted it had not previously specified what constitutes “repeated instances” of negligent conduct under Sarbanes-Oxley, but that it had analyzed a similar provision in the SEC’s analogous Rule of Practice 102(e). Rule of Practice 102(e) uses largely the same language as in Sarbanes-Oxley Section 105(c)(5) in allowing the Commission to suspend an accountant from appearing before it if that accountant is found to have engaged in “[r]epeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards . . . .” When the SEC adopted Rule 102(e) it explained that “repeated” can “encompass as few as two separate instances of unreasonable conduct occurring within one audit, or separate instances of unreasonable conduct within different audits.” When adopting the rule the SEC added that “a single error that results in an issuer’s financial statements being misstated in more than one place would not, by itself, constitute [repeated instances of unreasonable conduct].”
The SEC also noted negligence is the failure to exercise reasonable care or competence, which the SEC has described as an objective standard “measured by the degree of the departure from professional standards rather than the intent of the accountant.” In this case, the PCAOB erroneously found that the audit partner engaged in repeated instances of negligent conduct under Sarbanes-Oxley Section 105(c)(5) on two, alternate bases: first, because of the audit partner’s alleged auditing failures encompassed two audit areas—going concern and OTTI/ability to hold—and not just one financial statement account; and, alternatively, because “even if these two audit areas were treated as one,” the audit partner allegedly failed to take four auditing steps within her going-concern and OTTI inquiries and that each of these failures constituted an independent instance of negligence.
The SEC found that the PCAOB has not established either basis for determining that the audit partner engaged in more than one instance of negligent conduct. The PCAOB did not establish how the audit partner’s alleged audit deficiencies constituted repeated instances of negligent conduct for purposes of Sarbanes-Oxley solely because they affected the two audit areas of going-concern and OTTI. Moreover, the preponderance of the evidence did not support the conclusion that the audit partner’s decisions to take, or not take, four audit steps each constituted an instance of negligence. The record did not support the conclusion that the audit partner engaged in the conduct that the PCAOB found her to have engaged in regarding two of those audit steps. Regarding the two other steps, the record does not support the conclusion that the audit partner’s conduct constituted repeated instances of negligent conduct in the context of her audit. Accordingly, there was not a sufficient basis to support the PCAOB’s findings that the audit partner engaged in repeated instances of negligent conduct and the SEC concluded it could not sustain the PCAOB’s imposition of sanctions.
The SEC did not remand for further proceedings.
Given the extreme facts, the SEC sent a clear message to the PCAOB that its enforcement proceedings and related Board actions need to make sense and, assuming they make sense, be documented much better. Restatements alone do not violate Sarbanes-Oxley.