Potts v. SEC 

1. TABLE OF AUTHORITIES
2. INTEREST IN THE AICPA AS AMICUS CURIAE
3. STATEMENT OF THE CASE
4. ARGUMENT
   
   
   
   1. THE SEC ERRED IN FINDING IMPROPER PROFESSIONAL CONDUCT.
      
      1. The SEC Erred In Attributing GAAS Status To The SECPS Guidelines.
      2. The SEC Erred In Applying GAAS Audit Requirements To Potts' Conduct.
   2. THE SEC ERRED IN FAILING TO CONSIDER WHETHER POTTS' CONDUCT PRESENTED A FUTURE THREAT TO SEC PROCESSES.
5. CONCLUSION

The American Institute of Certified Public Accountants ("AICPA"), with the consent of the parties¹ respectfully submits this brief as amicus curiae, pursuant to Fed. R. App. P. 29, in support of the petition of Robert D. Potts ("Potts"), seeking reversal of the Opinion and Order Imposing Remedial Sanctions of the Securities Exchange Commission ("SEC") issued on September 24, 1997. The SEC sanctioned Potts for "improper professional conduct" in performing duties as a concurring reviewer during an audit of certain financial statements in 1988 and 1989.

AICPA, SECPS, Appendix E (October, 1988)².

The interest of the AICPA as amicus in this case stems from the SEC's confusion of the SECPS guidance with GAAS, its erroneous articulation of the duties of a concurring review partner under the SECPS guidelines, and its unsupported determination that Petitioner's perceived departure from its incorrectly defined standards could constitute him a threat to the investing public or SEC processes. 

Each of these conclusions has serious ramifications for the proper implementation of both GAAS and the SECPS guidelines. The SEC's misapplication of the concurring review requirement both overburdens the reviewing partner's role and dilutes accountability for the audit report. It will prohibitively raise costs by requiring, in essence, two partners-in-charge, and sow confusion as to the nature and required depth of a concurring review. The interpretations laid on the concurring review requirement by the SEC are thus not only erroneous but counterproductive.

In 1993, the SEC brought a proceeding under Rule 2(e)(1)³ of its Rules of Practice, charging Potts with improper professional conduct in connection with these audits. The administrative law judge found that Potts had engaged in improper professional conduct. On review, a majority of the SEC agreed that the UPH loss treatment was inappropriate and Potts' review failed to meet professional standards. It sanctioned Potts with a nine-month suspension from practice before the Commission⁴.

1. The SEC Erred In Attributing GAAS Status To The SECPS Guidelines.

Neither Regulation S-X nor GAAS requires a concurring review or sets standards for carrying one out⁵. The SECPS membership requirement of a concurring review is not generally applicable, but applicable only to AICPA members, and firms that are not AICPA members may conduct public-company audits in full compliance with GAAS and SEC regulations without any concurring review at all. 

Under the SECPS guidelines for concurring reviews, concurring partners are affirmatively instructed not to assume the responsibilities of the partner-in-charge:

For the concurring review to be an objective review of material accounting, auditing or reporting issues, the concurring reviewer ordinarily should not assume any of the responsibilities of the partner-in-charge of the engagement. Similarly, the concurring reviewer should not have responsibility for any segment of the engagement.

AICPA, SECPS, Appendix E (October, 1988). The partner-in-charge has sole responsibility for ensuring that the audit complies with the requirements of GAAS and for so stating in the audit report, and that responsibility cannot be delegated or shared.

The Potts majority erred in attributing GAAS status to SECPS guidelines for concurring partner review, and thus requiring the concurring reviewer to perform tasks and meet expectations imposed by GAAS on the partner-in-charge. Pursuing this line, the majority referred to the literature describing the GAAS duties of an auditor, and misapplied what it found there to Potts. Thus, the majority relied on the GAAS requirement that all auditors "must perform their work with due care" in finding that a concurring partner must perform all audit duties mandated by GAAS. Rejecting the defense that these standards, as applied to concurring reviewers, were hitherto undefined, the majority simply missed the point, asserting that "[t]he relevant professional standards we apply here are all taken directly from accounting literature. These standards were just as applicable when Potts performed his Kahler audit work as they are today." Potts, slip op. at 12 n.27. So they were and are, to auditors, but not to reviewers. The obligation of reviewers is defined, not by GAAS, but by SECPS guidelines and by additional standards adopted by their firms in conformity with those guidelines. The SEC erred in announcing and applying a new and inappropriate GAAS standard here.

The SEC majority relied on three cases to support its approach. None of these was contested, and analysis of them emphasizes the lack of precedent for the majority's application of GAAS to concurring review.

Only one of the cases cited by the SEC majority concerns a concurring partner at all. In Lester Witte & Co., Exchange Act Release No. 17,423, ASR No. 285, [1937-1982 ASR Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,307, at 62,865 (Jan. 7, 1981), the SEC did not sanction the concurring partner, even though it found the concurring review inadequate because the concurring reviewer did not pursue noted or obvious deficiencies in the audit. Rather, the SEC found that the failure of the concurring partner was attributable to the inadequacies of the firm's review program, and to the partner-in-charge: "As the engagement partner on the Lippincott audit, [the partner-in-charge] bears responsibility for the audit deficiencies which occurred." Id. at 62,865-66. Lester Witte's emphasis on the need for adequate firm guidelines acknowledges that standards for concurring review are not in GAAS, but are the separate responsibility of the firm, consistent with the SECPS guidelines. Lester Witte contradicts, rather than supports, the SEC majority's assertion in this case that the SECPS guidelines were a recognized part of GAAS.

Neither SEC v. Thornton , Litigation Release No. 11,263, AAER No. 118, [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,518 (Oct. 16, 1986), nor Stephen O. Wade , Exchange Act Release No. 21,095, AAER No. 32, 30 S.E.C. Docket 972, 1984 WL 53374 (June 25, 1984), deals with a concurring reviewer under the SECPS guidelines. In Thornton , one of the respondents was responsible for an "impartial quality control review." Thornton , [1982-1987 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) at 63,389-3. Even regarding this respondent as equivalent to a concurring reviewer, Thornton offers no standard for his conduct. In Wade , one of the respondents was the "second partner" on an audit, and was a "designated savings and loan expert" at the accounting firm. Wade , 30 S.E.C. Docket at 978, 1984 WL 53374, at *7. The SEC's opinion does not distinguish between the "second partner" and the partner-in-charge in its analysis of their conduct. Id. at 979, 1984 WL 53374, at *9. Like Thornton , Wade offers no standards or guidance applicable to a concurring partner under the SECPS program, and no suggestion at all that the SECPS guidelines are part of GAAS.

The absence of any authority in either the professional literature or SEC cases for applying GAAS to Potts' conduct makes it clear that the SEC actually engaged here in improper retroactive rulemaking, unfairly burdening Potts with the results⁶.

2. The SEC Erred In Applying GAAS Audit Requirements To Potts' Conduct.

In all of this, the SEC effectively announced and applied a changed set of standards for reviewing partners, unintended by the SECPS regime and inconsistent with it. Those new standards offer no useful guidance to reviewing partners except that they can only be safe if they largely re-do the audit. That, in turn, prohibitively overburdens the reviewing partners, their firms, their clients who must pay for the redundant work, and those firms whose resources make such an endeavor impractical and are thus foreclosed from auditing public companies. And it undermines the most important single safeguard of the integrity of the audit process — the undiluted authority and responsibility of the CPA partner-in-charge who signs the audit opinion.

2. THE SEC ERRED IN FAILING TO CONSIDER WHETHER POTTS' CONDUCT PRESENTED A FUTURE THREAT TO SEC PROCESSES.

The current Commission is divided on the question of what state of mind is required for sanctions of accountants under Rule 2(e).⁷ See Potts, slip op. at 27; Checkosky, Exchange Act Release No. 31,094, 52 S.E.C. Docket 1122, 1133, 1992 WL 211479, at *12 (Aug. 26, 1992) (Checkosky I ); Checkosky v. SEC, 23 F.3d 452, 454 (D.C. Cir. 1994); Checkosky, Exchange Act Release No. 38,183, 63 S.E.C. Docket 1691, 1700, 1997 WL 18303, at *10 (Jan. 21, 1997) (Checkosky II ); see also Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,172-73 (Feb. 28, 1981). 

Regardless of the state of mind required for sanctions under securities laws or Rule 2(e), the misconduct supporting a Rule 2(e) sanction must, at a minimum, evince a present threat to the integrity of the SEC's procedures or to the investing public.

The SEC's authority to sanction professionals under Rule 2(e) is justified only by the SEC's authority to protect its own procedures, not by any authority to punish wrongdoers:

The Commission, through its Rule 2(e) proceeding, is merely attempting to preserve the integrity of its own procedures, by assuring the fitness of those professionals who represent others before the Commission. Indeed, the Commission has made it clear that its intent in promulgating Rule 2(e) was not to utilize the rule as an additional weapon in its enforcement arsenal, but rather to determine whether a person's professional qualifications, including his character and integrity, are such that he is fit to appear and practice before the Commission.

Touche Ross & Co. v. SEC, 609 F.2d 570, 579 (2d Cir. 1979). The SEC itself has recognized the limits of its authority to impose Rule 2(e) sanctions:

[Rule 2(e)] is addressed to a different problem — professional misconduct — and its sanction is limited to that necessary to protect the investing public and the Commission from the future impact on its processes of professional misconduct.

Carter, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 84,149-50; see also Checkosky II, 63 S.E.C. Docket at 1703, 1997 WL 18303, at *12.

The remedial, rather than punitive, nature and purpose of Rule 2(e) require that the SEC sanction an accountant only when he is currently unfit to practice, or poses a risk to the public. In Johnson v. SEC, 87 F.3d 484, 489 (D.C. Cir. 1996), the D.C. Circuit vacated SEC sanctions under 15 U.S.C. 78o(b)(4), because it found them punitive rather than remedial, and the applicable statute of limitations had therefore run out:

This sanction would less resemble punishment if the SEC had focused on Johnson's current competence or the degree of risk she posed to the public. Despite the SEC's claims to the contrary, however, it is evident that the sanctions here were not based on any general finding of Johnson's unfitness as a supervisor, nor any showing of the risk she posed to the public, but rather were based on Johnson's alleged failure reasonably to supervise...

Id.; see Checkosky, 23 F.3d at 456 ("[i]f the purpose of Rule 2(e) is to protect the integrity of administrative processes, then sanctions for improper professional conduct under 2(e)(1)(ii) are permissible only to the extent that they prevent the disruption of proceedings") (J. Silberman, concurring); see also Steadman v. SEC, 603 F.2d 1126, 1140-41 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).

Consistent with the SEC's and the courts' view that only conduct that threatens the SEC's processes is sanctionable under Rule 2(e), the ABA Task Force on Rule 102(e) Proceedings (the "Task Force") concluded in a recent report that Rule 2(e) sanctions should be imposed only when an accountant poses such a threat:

Whether one agrees with the [Checkosky] majority's position that state of mind is not determinative of whether to find improper professional conduct, or Commissioner Johnson's view that scienter is required, the Task Force believes that the criteria discussed in the Checkosky opinions fail to address what should be the central focus of a disciplinary proceeding: whether, taking into account all of the facts concerning a respondent, including his or her past conduct and current circumstances, the respondent poses a current threat of future conduct harmful to the Commission's processes.

Task Force on Rule 102(e) Proceedings, Comm. On Federal Regulation of Securities, American Bar Association Section of Business Law, Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 977 (May 1997).

The Task Force's compelling argument considered: the possibility that lesser standards for Rule 2(e) sanctions may not pass judicial muster as remedial rather than punitive; the severe effects of SEC sanctions on a public accountants' career; and the lack of clarity or consensus in the Checkosky decisions as to state of mind. Drawing upon other contexts in which the SEC seeks to preclude individuals from practicing before it, the Task Force concluded that the SEC should impose a Rule 2(e) sanction only where an accountant is "substantially unfit" to practice. Id. at 985. In each context examined, the SEC's authority to suspend or enjoin individuals from practice relied on a showing that future violations are likely. See id. at 978. The Task Force believes that the application of differing standards to sanction accountants is unjustified, and that the application of similar standards will provide consistency and predictability. See id. at 985.

The Task Force argues that its recommended standard of "substantial unfitness" is therefore best measured by the same factors applied by the SEC and the courts to sanctions barring a defendant from serving as an officer and director and to injunctions against practicing before the SEC:

[T]he Commission ought to consider and expressly discuss the egregiousness of the underlying conduct, whether the conduct involved an isolated failure or was part of a continuing pattern of misconduct, the accountant's "role" or position when he or she engaged in the conduct, the accountant's degree of scienter, and the accountant's economic stake in the violation.

Id. at 985-86. The Task Force's recommendation is both consistent with the authorized purpose of Rule 2(e) and good policy.

The majority's opinion includes only a single sentence regarding Potts' current fitness to practice: "Potts' substantial departures from his professional duties establishes that this Commission cannot rely upon Potts to perform diligently and with reasonable competence his audit responsibilities." Potts, slip op. at 19. Given the pervasive error of the SEC majority as to what Potts' "professional duties" and "audit responsibilities" properly were, this conclusory "finding" is unsupported by any substantial evidence and cannot be sustained. Cf. Stephen Inv. Sec., Inc. v. SEC, 27 F.3d 339, 341 (8th Cir. 1994); see also Johnson, 87 F.3d at 490 n.9.

¹ See Consent of Respondent Securities and Exchange Commission To Filing of Brief Amicus Curiae (attached as Exhibit A); Consent of Petitioner Robert D. Potts To Filing of Brief of AICPA As Amicus Curiae (attached as Exhibit B).

² A copy of the relevant passage of the SECPS guidance is attached as Exhibit C, for the convenience of the Court.

³ Now 17 C.F.R. 201.102 (e) (1)   (1997), but referred to as Rule 2 (e) (1) herein (as the SEC did) for convenience.

⁴ Only two Commissioners joined in the opinion of the Commission. Commissioner Johnson concurred and Commissioner Wallman dissented in separate opinions.

⁵ Indeed, under both GAAS and SEC regulations, it is not necessary that a partner conduct the audit at all. GAAS requires that an independent public accountant be responsible for the audit, and that any audit assistants be properly supervised: "In most audit engagements, several auditors with varying degrees of experience will be used. When two or more auditors are involved in an engagement, there must be a system of review and supervision." Larry P. Bailey, Miller GAAS Guide 4.10 (1998). A recent SECPS membership requirement is that a partner have overall responsibility for every audit, see AICPA, SECPS 1000.08 (e)   (1997), and we refer herein to the "partner-in-charge" as does the SECPS guidance.

⁶ It is debated whether the SEC has authority to announce or amend GAAS. Even assuming that the SEC has such authority, it could only do so by compliance with the notice and hearing provisions of the Administrative Procedure Act. See 5 U.S.C. 553 (1994); 15 U.S.C. 78j-1 (1994); see, e.g., 62 Fed. Reg. 12,743, 12,744 & n.6, n.7, n.10 (1997). It has no powers, by a process akin to common law, to evolve rules binding on registrants and their professionals. Still less may it do so retroactively. See Carter, Securities Act Release No. 17,597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,173 (Feb. 28, 1981) (because SEC had never adopted standards applicable to respondent, and because no generally accepted norms applied at the time, interpretation only prospective); Upton v. SEC, 75 F.3d 92, 96 (2d Cir. 1996) (court cannot defer to the SEC's interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation).

⁷ The SEC avoided the question of whether negligence is an adequate basis for Rule 2(e) sanctions by characterizing Potts' conduct as reckless. Even assuming that recklessness is the applicable state-of-mind requirement, the SEC measured Potts' conduct against the wrong standard in arriving at its determination of recklessness.