Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-03-01265/USCOURTS-caDC-03-01265-0/pdf.json

Parties Involved:
Brian L. Berry
Petitioner
Michael J. Marrie
Petitioner
Securities and Exchange Commission
Respondent

Document Text:

Notice: This opinion is subject to formal revision before publication in the

Federal Reporter or U.S.App.D.C. Reports. Users are requested to notify

the Clerk of any formal errors in order that corrections may be made

before the bound volumes go to press.

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 20, 2004 Decided July 16, 2004

No. 03-1265

MICHAEL J. MARRIE AND BRIAN L. BERRY,

PETITIONERS

v.

SECURITIES AND EXCHANGE COMMISSION,

RESPONDENT

On Petition for Review of an Order of the

Securities and Exchange Commission

Michael F. Perlis argued the cause for petitioners. With

him on the briefs was Wrenn E. Chais.

Michael A. Conley, Attorney, Securities & Exchange Commission, argued the cause for respondent. With him on the

brief were Giovanni P. Prezioso, General Counsel, and Eric

Summergrad, Deputy Solicitor.

 Bills of costs must be filed within 14 days after entry of judgment.

The court looks with disfavor upon motions to file bills of costs out

of time.

USCA Case #03-1265 Document #836437 Filed: 07/16/2004 Page 1 of 20
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Before: HENDERSON, ROGERS and GARLAND, Circuit Judges.

Opinion for the Court filed by Circuit Judge ROGERS.

ROGERS, Circuit Judge: This appeal challenges an opinion

and order of the Securities and Exchange Commission denying two certified public accountants the privilege of practicing

before the Commission. It revisits the question of whether

the Commission has articulated a clear standard for a finding

of ‘‘improper professional conduct’’ under Rule 102(e) of its

Rules of Practice, 17 C.F.R. § 201.102(e). We conclude that

the lack of clarity identified in the two Checkosky v. SEC

opinions of the court, 23 F.3d 452 (D.C. Cir. 1994) (‘‘Checkosky I’’), and 139 F.3d 221 (D.C. Cir. 1998) (‘‘Checkosky II’’),

was not rectified until Rule 102(e) was amended in 1998. As

amended, Rule 102(e) establishes that one of the mental

states required for a finding of ‘‘improper professional conduct,’’ is recklessness, defined as an extreme departure from

the standard of ordinary care for auditors. Although the rule

is clear now, because it was unclear at the time of the

sanctioned conduct in 1994 and the Commission’s application

of the amended Rule is impermissibly retroactive, we grant

the petition for review.

I.

Michael Marrie and Brian Berry, as employees of the

accounting firm, Coopers & Lybrand LLP (‘‘Coopers’’), acted

as engagement partner and manager, respectively, for Coopers’ 1994 audit of California Micro Devices, Inc. (‘‘Cal Micro’’), which designs, manufactures, and distributes electric

circuits and semiconductors. As engagement partner and

engagement manager, Marrie and Berry were responsible for

ensuring that the 1994 fiscal year audit of Cal Micro was

conducted in accordance with generally accepted auditing

standards (‘‘GAAS’’), and that the financial statements filed

with the Securities and Exchange Commission were in conformity with generally accepted accounting principles

(‘‘GAAP’’). They prepared an audit plan and began field

work in July 1994, and on September 29, 1994, filed with the

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Commission the company’s Form 10–K annual financial report for the fiscal year ending June 30, 1994.

Marrie and Berry conducted the audit against a backdrop

of massive financial reporting fraud by Cal Micro, unknown to

the accountants. The Commission found that in fiscal year

1994, the company fraudulently recognized revenue and receivables for the sale of unshipped or non-existent products,

even though its stated policy was to recognize revenue for

products only upon shipment to customers; falsified sales

records, invoices, and shipping documents, such as shipping

merchandise to fictitious customers; and improperly overstated net assets and income, while understating net loss.

Cal Micro had attempted to make reported revenues as high

as possible in order to maintain the impression of growth

after it had lost one of its major customers, Apple Computer

Inc., which had accounted for 32% of the company’s total

product sales the prior year. To avoid detection for improper

revenue recognition, Cal Micro’s management attempted to

‘‘clean’’ the company’s books before the end of the fiscal year,

informing Marrie and Berry that it had decided to issue

approximately $12 million in credit to ‘‘write off’’ certain

accounts receivable. On August 4, 1994, however, Cal Micro

issued a press release announcing its net income and earnings

for the fourth quarter of 1994, and stated that it was writing

off $8.3 million, not $12 million of accounts receivable, $1.3

million of which was written off as bad debt expense. Because amounts written off for returned products would be

deducted directly from reported revenues, while amounts

written off as bad debt would be treated as expenses and

would not decrease reported revenues, Cal Micro attempted

to maximize the portion of the write-off allocated to bad debt

expense. Following the August 4, 1994 press release, however, Cal Micro’s stock price dropped and shareholders brought

a lawsuit alleging accounting improprieties.

Regardless, on August 25, 1994, Marrie and Berry, on

behalf of Coopers, presented their independent accountants’

report addressed to Cal Micro’s shareholders and directors,

stating that Cal Micro’s financial statements complied with

GAAP and that the audit had been conducted in accordance

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with GAAS. Following an independent investigation, Cal

Micro filed a revised financial report with the Commission on

February 6, 1995, showing a net loss of $15.2 million instead

of earnings of $5 million, total revenue of $30.1 million rather

than the previously reported $45.3 million, accounts receivable of $6.3 million instead of $16.9 million, $5.1 million in

inventories instead of $13.9 million, and net property and

equipment of $7.4 million instead of the previously reported

$10.4 million.

On August 10, 1999, just shy of five years after Marrie and

Berry presented the audit report to Cal Micro’s shareholders,

the Commission, through the Division of Enforcement and

Office of the Chief Accountant, instituted disciplinary proceedings against Marrie and Berry pursuant to Rules

102(e)(1)(ii) and 102(e)(1)(iv)(A). The Commission alleged

that Marrie and Berry had engaged in improper professional

conduct in that they each ‘‘violated GAAS by failing to

exercise appropriate professional skepticism, obtain sufficient

competent evidential matter, or adequately supervise field

work’’ in connection with three aspects of the 1994 audit: (1)

the write-off of $12 million of accounts receivable; (2) the

confirmation of the accounts receivable; and (3) the accounting of the sales returns and allowances for sales returns. The

Commission also claimed that Marrie’s and Berry’s failures to

examine the write-off, to investigate discrepancies in the

confirmation responses, and to analyze Cal Micro’s sales

returns and the adequacy of its allowance for returns, were

‘‘an extreme departure from professional standards.’’ Further, according to the Commission, Marrie and Berry were

reckless in ignoring ‘‘unmistakable red flags’’ that indicated

potential accounting irregularities in the areas of revenue

recognition, accounts receivable confirmations, sales returns,

sales cutoff, and cash collections. As a result, the Commission alleged that Cal Micro’s financial statements for the

fiscal year 1994 were materially false and misleading and

were not prepared in conformity with GAAP.

On September 21, 2001, an administrative law judge

(‘‘ALJ’’) dismissed the charges, finding that Marrie and Berry

had not engaged in improper professional conduct within the

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meaning of Rule 102(e). The ALJ ruled that reckless conduct

under Rule 102(e)(1)(iv)(A) ‘‘must approximate an actual intent to aid in the fraud being perpetrated by the audited

company,’’ and that the Commission had failed to prove that

Marrie’s and Berry’s conduct had been reckless. In re

Marrie, Initial Decision of the ALJ, Release No. 101, File.

No. 3–9966, at 35, 81 (Sept. 21, 2001)(‘‘In re Marrie I’’). On

July 29, 2003, the Commission reversed the dismissal of the

charges and imposed remedial sanctions barring Marrie and

Berry from practicing before the Commission, subject to Rule

102(e)(5)’s provision for reinstatement. See 17 C.F.R.

§ 201.102(e)(5). In sanctioning Marrie and Berry, the Commission stated that ‘‘[t]he question is not whether an accountant recklessly intended to aid in the fraud committed by the

audit client, but rather whether the accountant recklessly

violated applicable professional standards. Recklessness,

then, can be established by a showing of an extreme departure from the standard of ordinary care for auditors.’’ In re

Marrie, Exchange Act Release No. 48246, 2003 WL 21741785

at *11–*12 (July 29, 2003) (‘‘In re Marrie II’’). According to

the Commission, proof of an actual intent to defraud or assist

in a fraud was not required. Id. at *12. Nor was it necessary to show that the auditor had filed a ‘‘materially’’ misleading document: ‘‘An auditor who fails to audit properly under

GAAS should not be shielded because the audited financial

statements fortuitously are not materially misleading.’’ Id. at

*13. Finally, the Commission did not consider a good faith

defense. The Commission found that Marrie and Berry

recklessly violated fundamental principles of audit work,

failed to exercise due care and appropriate professional skepticism, and failed to collect sufficient competent evidential

matter to provide a basis for the audit opinion with respect to

Cal Micro’s write-off, accounts receivable, and sales returns.

Id. at *30.

II.

Rule 102(e), 17 C.F.R. § 201.102(e), provides the Commission with a means to ensure that the professionals on whom it

relies ‘‘perform their tasks diligently and with a reasonable

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degree of competence.’’ Touche Ross & Co. v. SEC, 609 F.2d

570, 582 (2d Cir. 1979). It is directed at protecting the

integrity of the Commission’s own processes, as well as the

confidence of the investing public in the integrity of the

financial reporting process. Recognizing the particularly important role played by accountants in preparing and certifying the accuracy of financial statements of public companies

that are so heavily relied upon by the public in making

investment decisions, the Commission, following the court’s

Checkosky opinions, adopted amendments to Rule 102(e) to

specify under what circumstances accountants could be held

liable under the Rule. Prior to the 1998 amendments, Rule

102(e) provided that:

(1) Generally. The Commission may censure a person

or deny, temporarily or permanently, the privilege of

appearing or practicing before it in any way to any

person who is found by the Commission after notice and

opportunity for hearing in the matter: (i) Not to possess

the requisite qualifications to represent others; or (ii) To

be lacking in character or integrity or to have engaged

in unethical or improper professional conduct; or (iii)

To have wilfully violated, or willfully aided and abetted

the violation of any provision of the Federal securities

laws or the rules and regulations thereunder.

17 C.F.R. § 201.102(e)(emphasis added). On June 12, 1998,

in response to the court’s holding in Checkosky II, 139 F.3d at

223, that the Commission had failed to articulate a clear

standard for ‘‘improper professional conduct,’’ the Commission proposed amendments to Rule 102(e) to set forth categories of conduct that would constitute ‘‘improper professional

conduct.’’ The amendments provided, among other things,

that a finding of ‘‘improper professional conduct’’ could be

made based on reckless conduct, as defined in the securities

fraud context, see SEC v. Steadman, 967 F.2d 636, 641–42

(D.C. Cir. 1992); Sundstrand Corp. v. Sun Chem. Corp., 553

F.2d 1033, 1045 (7th Cir. 1977), cert. denied, 434 U.S. 875

(1977), but with no accompanying requirement of an actual

intent to defraud. The 1998 amendments, effective NovemUSCA Case #03-1265 Document #836437 Filed: 07/16/2004 Page 6 of 20
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ber 25, 1998, added the language in Rule 102(e)(1)(iv), which

provides:

With respect to persons licensed to practice as accountants, ‘improper professional conduct’ under

§ 201.102(e)(1)(ii) means: (A) Intentional or knowing

conduct, including reckless conduct, that results in a

violation of applicable professional standards; or (B)

Either of the following two types of negligent conduct:

(1) A single instance of highly unreasonable conduct

that results in a violation of applicable professional

standards in circumstances in which an accountant

knows, or should know, that heightened scrutiny is

warranted.

(2) Repeated instances of unreasonable conduct, each

resulting in a violation of applicable professional standards, that indicate a lack of competence to practice

before the Commission.

17 C.F.R. § 201.102(e)(1)(iv)(emphasis added).

Marrie and Berry contend that the Commission impermissibly retroactively applied its ‘‘non-fraud based’’ recklessness

standard to the Rule 102(e) proceedings for conduct occurring

in 1994, and erred in finding recklessness where there was no

knowing violation or intent to defraud. The Commission

responds that retroactivity is not an issue because Rule

102(e)(1)(iv)(A) is consistent with its practice well before the

misconduct at issue, and that in 1998 the Commission simply

codified a standard that had been applied previously. It

maintains that in borrowing the definition of recklessness

from Steadman, 967 F.2d at 641–42, and Sundstrand, 553

F.2d at 1045, it was not required to import into its Rule the

requirement in those cases of actual knowledge of fraud. In

its brief, the Commission states that the applicable professional standards at issue in the Rule are ‘‘indisputably not

fraud-based.’’ Respondent’s Br. at 25.

A.

The court has engaged in an extended dialogue with the

Commission about its standard for sanctioning professionals

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for ‘‘improper professional conduct.’’ The court has twice

concluded that the Commission had failed to articulate an

intelligible standard for ‘‘improper professional conduct’’ under Rule 2(e)(1)(ii), the predecessor to Rule 102(e), and had

failed to specify what mental state was required for a violation of the Rule. In Checkosky I, 23 F.3d at 460–62, where

there was no majority opinion, Judge Silberman, writing

separately, referred to two unreconciled lines of Commission

authority—one based on negligence, the other on recklessness—regarding whether a professional acting in good faith

could be subject to discipline for improper professional conduct. The Commission had stated that ‘‘a mental awareness

greater than negligence [wa]s not required,’’ Checkosky I, 23

F.3d at 459, but also ‘‘note[d]’’ that the accountants’ conduct

rose to the level of recklessness. Id. at 460. The judge

concluded it was unclear both whether simple negligence

could constitute a violation of the Rule, and also whether

recklessness meant a ‘‘higher form of ordinary negligence,’’ or

‘‘a lesser form of intent,’’ as defined in Steadman, 967 F.2d at

641–42, and Sundstrand, 553 F.2d at 1045. See Checkosky I,

23 F.3d at 460. Those cases defined recklessness as ‘‘not

merely a heightened form of ordinary negligence,’’ but ‘‘an

extreme departure from the standards of ordinary care, TTT

which presents a danger of misleading buyers or sellers that

is either known to the defendant or is so obvious that the

actor must have been aware of it.’’ Steadman, 967 F.2d at

641–42 (citations omitted); Sundstrand, 553 F.2d at 1045. In

Steadman, the court stated that this type of recklessness was

‘‘a lesser form of intent.’’ Steadman, 967 F.2d at 642 (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th

Cir. 1977)).

Judge Randolph, by contrast, concluded that there was no

ambiguity with regard to the Commission’s finding that negligence sufficed for a violation of Rule 2(e)(1)(ii), id. at 480, but

that the Commission had failed adequately to justify its ruling

that accountants could be suspended from practice under

Rule 2(e)(1)(ii) without any proof of an intent to defraud or

bad faith. Id. at 479. Referring to the Commission’s decision in In re Carter, [1981 Transfer Binder] Fed. Sec. L. Rep.

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(CCH) ¶ 82,847 (Feb. 28, 1981), involving a Rule 2(e) proceeding against lawyers, he concluded that the Commission had

failed adequately to justify why auditors, but not lawyers,

could be found to have engaged in ‘‘improper professional

conduct’’ without proof of an intent to defraud. Id. at 483–85.

As the language of Rule 2(e)(1)(ii) drew no distinction between professionals, applying to ‘‘any person’’ who practices

before the Commission, id. at 485, and the definitions from

the federal securities laws did not make culpability turn on

the nature of the professional, id. at 486, he reasoned that the

Commission was obligated in changing course to supply a

reasoned analysis, which it had failed to do. See id. at 487.

Because he concluded that the Commission had acted arbitrarily and capriciously, vacation of the Commission’s order

was required in his view rather than the simple remand to the

Commission that was favored by Judge Silberman and

adopted by the court. Id. at 454, 467.

On remand the Commission provided a further explanation,

then affirmed the suspension of the accountants. But, in

Checkosky II, 139 F.3d at 226, the court concluded that the

Commission had still failed to provide ‘‘a uniform theory as to

the necessary mental state for a violation of Rule 2(e)(1)(ii).’’

In the court’s view, the Commission on remand had simultaneously embraced and rejected standards of recklessness,

negligence, and strict liability, with no guidance as to which

standard it had relied upon in finding a violation of the Rule.

Id. at 223. Although the Commission first appeared to rely

on a theory of recklessness, it proceeded to state that it was

treating recklessness as relevant only to the sanction, that

Rule 2(e)(1)(ii) did not mandate a particular mental state, and

that negligence could, ‘‘under certain circumstances, constitute improper professional conduct.’’ Id. at 224 (citations

omitted). The Commission did not define those circumstances with any degree of specificity, and offered no further

definition of negligence than those deviations from GAAP or

GAAS that ‘‘threaten the integrity of the Commission’s processes.’’ Id. This left open the possibility, the court observed, that the standard might not even require a showing of

negligence, for there was no way of knowing in advance what

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kind of errors — non-negligent, innocent mistakes or isolated,

serious deviations from GAAS or GAAP — would meet this

standard. Id. at 224–25. In addition, the court concluded the

Commission had again failed to articulate a clear standard for

the mental state required to violate Rule 2(e)(1)(ii). Id. at

225. For these reasons, the court observed that ‘‘the Commission’s statements come close to a self-proclaimed license

to charge and prove improper professional conduct whenever

it pleases, constrained only by its own discretion (combined,

perhaps, with the standards of GAAS and GAAP).’’ Id.

Because of ‘‘strong signs’’ that the Commission was unlikely

to provide a uniform theory ‘‘anytime soon,’’ the court remanded with instructions to dismiss the charge. Id. at 226–

27.

B.

Congress has codified Rule 102(e)(1) as amended in 1998 in

the Sarbanes–Oxley Act of 2002, 15 U.S.C. § 78d–3, and we

begin with the observation that in the amended Rule 102(e),

the Commission has cured the defects identified in Checkosky

I and II. Absent such a conclusion, there would be no need

to address Marrie’s and Berry’s retroactivity contentions for,

once again, the Rule would be unclear.

The amended Rule clearly sets out the standard for when

an accountant is deemed to have engaged in ‘‘improper professional conduct.’’ It provides that ‘‘improper professional

conduct’’ means ‘‘[i]ntentional or knowing conduct, including

reckless conduct that results in a violation of applicable

standards.’’ 17 C.F.R. § 201.102(e)(1)(iv)(A). It also identifies two types of negligent conduct that would warrant sanctions. Id. § 201.102(e)(1)(B). In its accompanying explanation of the amended Rule, the Commission stated that ‘‘for

purposes of consistency under the federal securities laws,’’ it

was adopting the Sundstrand/Steadman definition of recklessness used for substantive violations of the securities laws.

Amendments to Rule 102(e) of the Commission’s Rules of

Practice, Fed. Sec. L. Rep. (CCH) ¶ 86,052, at 80,844 (Oct. 19,

1998) (‘‘Adopting Release’’). Thus, recklessness means ‘‘not

merely a heightened form of ordinary negligence,’’ but ‘‘an

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extreme departure from the standards of ordinary care, TTT

which presents a danger of misleading buyers or sellers that

is either known to the (actor) or is so obvious that the actor

must have been aware of it.’’ Id. The Commission added,

‘‘This recklessness standard is a lesser form of intent.’’ Id.

However, it emphasized that the standards for finding a

violation of professional conduct were ‘‘not fraud based,’’ id.,

indicating that the elements for violations of professional

practice would not be identical to that of the federal securities

laws. In explaining the amended Rule, the Commission also

rejected suggestions that filing a materially false or misleading document should be a threshold requirement for a finding

of improper professional conduct, concluding that, ‘‘[a]n auditor who fails to audit properly under GAAS TTT should not be

shielded because the audited financial statements fortuitously

turn out to be accurate or not materially misleading.’’ Id. at

80,847. Finally, the Commission stated that good faith, although it may remain relevant in determining the appropriate

sanction, would not be a defense to reckless conduct, because

good faith would be ‘‘inconsistent with a finding of knowing or

intentional, including reckless, conduct.’’ Id. at 80,849.

Thus, as of November 25, 1998, when the amendments took

effect, the Commission provided a uniform theory of the

necessary mental state required for a finding of improper

professional conduct, see Checkosky II, 139 F.3d at 225,

defined recklessness, and specified the types of negligent

conduct that would result in a violation of the Rule. See

Checkosky I, 23 F.3d at 459–60 (Silberman, J.). Further, in

amending the Rule, the Commission’s accompanying statement eliminated any lack of clarity as to good faith created by

its precedents. See, e.g., Checkosky I, 23 F.3d at 458 (Silberman, J.).

The language and history of the amended Rule support the

Commission’s interpretation that ‘‘recklessness’’ under that

Rule can be demonstrated simply by evidence of ‘‘an extreme

departure from the standard of ordinary care for auditors.’’

In re Marrie II, at *14. In this case, the Commission

explained that ‘‘[a]dherence to applicable professional auditing standards protects the Commission’s processes regardless

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of whether a fraud has been committed.’’ Id. The Commission further explained in In re Marrie II that ‘‘[r]equiring

proof of a mental state approximating an actual intent to aid

in the fraud committed by the audited company would conflict

with this purpose and fail to protect the Commission’s processes from accountants who lack competence to appear

before it.’’ Id. The Commission reasoned that a non-fraud

based standard was warranted given the heavy reliance that

it and the public placed on accountants ‘‘to assure disclosure

of accurate and reliable financial information as required by

the federal securities laws.’’ Id. Although it stated in a

cryptic footnote that the ‘‘concept of materiality’’ continued to

be relevant, see id. at *13 n.18, it explained that the Rule did

not require a showing that the financial statements filed by

the accountants be false or materially misleading, for the

Commission’s concern was to protect the integrity of its

processes and investor confidence in its markets. Id. at *12–

*13. Thus, ‘‘[a]n auditor who fails to audit properly under

GAAS should not be shielded because the audited financial

statements fortuitously are not materially misleading. An

auditor who skips procedures designed to test a company’s

reports or looks the other way despite suspicions is a threat

to the Commission’s processes.’’ Id. at *13.

The 1998 amendments reflect choices that the Commission

was authorized to make in promulgating its Rule, and Marrie

and Berry do not contend to the contrary. Instead, they

contend that the Commission took ‘‘diametrically opposite

positions’’ in explaining the 1998 amendments and in its

holding in their case. They proceed on the basis that the

Commission’s adoption of the Sundstrand/Steadman definition of recklessness also required inclusion of a fraud element.

But, in contending that they could not be found culpable

absent a finding of conscious or deliberate conduct, which the

Commission conceded was lacking, their premise is faulty.

The Commission’s authority to discipline professionals has

long been distinguished from the execution of its substantive

enforcement functions. See Touche Ross, 609 F.2d at 579.

Marrie and Berry proceed under the erroneous assumption

that because the Commission borrowed the definition of reckUSCA Case #03-1265 Document #836437 Filed: 07/16/2004 Page 12 of 20
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lessness used in substantive anti-fraud provisions, it also was

required to adopt other elements of a securities fraud violation into Rule 102(e)(1)(iv)(A), such as the requirements of an

intent to defraud and materiality. As explained in Checkosky

I, however, Rule 2(e), the predecessor to Rule 102(e), was

‘‘analytically distinct from substantive provisions of the securities laws,’’ and cases such as Steadman, 967 F.2d at 641–42,

which involved those provisions, were not determinative in

the analysis of whether improper professional conduct had

occurred. See Checkosky I, 23 F.3d at 456 (Silberman, J.).

Their contention, therefore, that recklessness must involve

deliberate or conscious conduct by an auditor, fails to appreciate that the Sundstrand/Steadman line of cases addressed

violations of Section 10(b) of the Securities and Exchange Act

and Rule 10b–5 that were targeted specifically at securities

fraud. Here, the Commission did not, and did not need to,

charge fraud or aiding and abetting the fraud of Cal Micro,

but instead charged Marrie and Berry on the basis of formulated standards of professional practice designed to protect

the Commission’s processes.

No more problematic is Marrie’s and Berry’s contention

that the amended Rule is arbitrary and capricious, see 5

U.S.C. § 706, or unconstitutionally vague, see Gates & Fox

Co. v. Occupational Safety & Health Review Comm’n, 790

F.2d 154, 156–57 (D.C. Cir. 1986), by failing to provide fair

warning of the conduct it prohibits or requires, and by

incorporating an elastic concept of recklessness that opens

the door to second-guessing of accountants’ judgment calls.

Because of ‘‘[t]he complexity of [GAAP] and [GAAS],’’ see

Checkosky I, 23 F.3d at 479 (Randolph, J.) (quoting James F.

Strother, The Establishment of Generally Accepted Accounting Principles and Generally Accepted Auditing Standards,

28 Vand. L. Rev. 201, 203 (1975)), calling for ‘‘[j]udgments [to]

be made about specific transactions’’ about which auditors

could disagree, defining ‘‘recklessness’’ in the context of audits entails obvious difficulties. See id. (citing Jerry Sullivan

et al., Montgomery’s Auditing 19 (10th ed. 1985)). In the

1998 amendments, however, the Commission has specified the

applicable intent standard and has limited the occasions

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where it will find sanctionable conduct to ‘‘extreme departure[s]’’ from professional standards that demonstrate that an

accountant lacks competence to practice before the Commission. Adopting Release, at 80,844. It cannot be gainsaid that

the Commission could reasonably conclude that any licensed

accountant is on notice of professional standards generally

and of what constitutes extreme departures in particular.

For this reason, professional disciplinary Rules have withstood vagueness challenges. See, e.g., United States v.

Hearst, 638 F.2d 1190, 1197 (9th Cir. 1980). The duties to

exercise due care, see American Institute of Certified Public

Accountants (‘‘AICPA’’), Codification of Statements on Auditing Standards, AU § 230.02, to obtain sufficient evidential

matter, see id. AU § 150.02, and to exercise professional

skepticism, see id. AU § 316.16, are ‘‘standards to which all

accountants must adhere.’’ Potts v. SEC, 151 F.3d 810, 813

(8th Cir. 1998). See In re Potts, 53 S.E.C. 187, 196–97 (Sept.

24, 1997); see also Ponce v. SEC, 345 F.3d 722, 739 (9th Cir.

2003); Checkosky I, 23 F.3d at 472 (Randolph, J.). Rule 202

of AICPA’s Code of Professional Conduct recognizes the

Codification of Statements on Auditing Standards as an

interpretation of GAAS. As the Commission explained in the

instant case, professional misconduct constituting an extreme

departure occurs, for instance, when an auditor ‘‘skips procedures designed to test a company’s reports or looks the other

way despite suspicions.’’ In re Marrie II, at *13. The

Commission’s standard for recklessness, then, as guided and

limited by generally accepted standards of the profession,

does not entail arbitrary subjective second-guessing of auditing judgment calls.

To the extent that Marrie and Berry point out that GAAS

did not ‘‘technically’’ require them to audit the write-off, they

miss the point. The Commission did not fault them for failing

to audit the write-off, but with failing to exercise the requisite

professional skepticism. The Commission concluded that the

necessary professional skepticism was lacking because they

failed to follow up on their own request that Cal Micro

provide a documented analysis of the $12 million write-off,

even though they were well aware that the write-off was

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unusually large and had occurred near the end of the fiscal

year. Under GAAS, accountants must test ‘‘transactions that

are both large and unusual, particularly at year-end.’’ AICPA, AU § 316.20. As certified public accountants, Marrie

and Berry were deemed to understand the need to obtain

adequate documentation to support a write-off of such a

staggering amount, and, indeed, their call for documentation

evinced an appreciation of what was required of them in

conducting the audit. Under the circumstances, the Commission could reasonably conclude that their failure to obtain the

necessary documentation was an extreme departure from

professional standards.

For these reasons, we conclude Marrie and Berry have

failed to show that the Commission’s amended Rule is arbitrary or capricious or unconstitutionally vague.

C.

Turning to the Commission’s application of amended Rule

102(e) in this case, we hold, in light of Checkosky I and II,

that the Commission erred in applying its non-fraud Rule

retroactively, for there was no ‘‘ascertainably certain’’ standard for finding ‘‘improper professional conduct’’ under Rule

102(e) in the summer of 1994 when Marrie and Berry audited

Cal Micro. See General Elec. Co. v. EPA, 53 F.3d 1324, 1330

(D.C. Cir. 1995). Fair notice of the standards against which

one is to be judged is a fundamental norm of administrative

law: ‘‘[t]here is no justification for the government depriving

citizens of the opportunity to practice their profession without

revealing the standard they have been found to violate.’’

Checkosky II, 139 F.3d at 225–26. ‘‘Given the enormous

impact on accountants TTT that the Rule has, and in fairness

to petitioners, the Commission must be precise in declaring

the standard against which petitioners’ conduct is measured.’’

Checkosky I, 23 F.3d at 462 (Silberman, J.). See id. at 479

(Randolph, J.); see also Checkosky II, 139 F.3d at 227. As

late as March 27, 1998, when Checkosky II was decided, the

court concluded that the Commission had failed to articulate

an intelligible standard for what constituted ‘‘improper proUSCA Case #03-1265 Document #836437 Filed: 07/16/2004 Page 15 of 20
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fessional conduct,’’ and had failed to specify the state of mind

necessary for a violation of the Rule. Marrie and Berry,

therefore, were not on notice in the summer 1994 either of

the contours of the Commission’s recklessness standard or

that they could be barred from practice before the Commission without proof of intent to defraud or lack of good faith.

While the Commission maintains that as certified public

accountants, Marrie and Berry knew that they would be held

to certain professional standards, such as GAAS and GAAP,

this was no less true for the petitioners in Checkosky I and II,

whom the court determined were nevertheless entitled to

more specific guidance as to the Commission’s interpretation

of the Rule.

Further, we cannot agree with the Commission that it did

not retroactively apply a new recklessness standard. In

Landgraf v. USI Film Products, 511 U.S. 244, 269 (1994), the

Supreme Court set out the standard for retroactivity. A

statute is not retroactive merely because it is applied in ‘‘a

case arising from conduct antedating the statute’s enactment;’’ rather, the operative inquiry is ‘‘whether the new

provision attaches new legal consequences to events completed before its enactment.’’ Id. at 269–70. The Court observed

that ‘‘familiar considerations of fair notice, reasonable reliance, and settled expectations’’ should offer guidance in those

hard cases where a finding of retroactivity requires balancing

‘‘the nature and extent of the change in the law and the

degree of connection between the operation of the new rule

and a relevant past event.’’ Id. at 270. In the administrative

context, this court in National Mining Association v. Department of Labor, 292 F.3d 849, 859 (D.C. Cir. 2002), held that ‘‘a

rule is retroactive if it ‘takes away or impairs vested rights

acquired under existing law, or creates a new obligation,

imposes a new duty, or attaches a new disability in respect to

transactions or considerations already past.’ ’’ (quoting Ass’n

of Accredited Cosmetology Sch. v. Alexander, 979 F.2d 859,

864 (D.C. Cir. 1992)).

In applying the amended Rule 102(e) to Marrie’s and

Berry’s conduct in 1994, the Commission has imposed new

legal consequences and new legal duties: the elimination of

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the good faith defense and of the requirement that materiality be proved by showing that a false or misleading financial

statement had been filed. Prior to the 1998 amendments, the

court concluded it was unclear whether good faith could be a

defense to recklessness or a finding of improper professional

conduct, as evidenced by conflicting lines of Commission

precedents. See Checkosky I, 23 F.3d at 458 (Silberman, J.).

Several Commission opinions suggested that absent knowing

conduct, good faith was a defense to recklessness. For

instance, in In re Logan, 10 S.E.C. 982 (1942), the Commission indicated in dictum that good faith was a defense, and in

In re Carter, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH)

¶ 82,847, at 84, 145 (Feb. 28, 1981), the Commission stated

that lawyers ‘‘acting in good faith and exerting reasonable

efforts to prevent violations of the law’’ could not be held

liable for violation of Rule 2(e)(1)(ii). However, in In re

Haskins & Sells, Accounting Series Releases No. 73, [1937–

1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 72,092, at

62,197 (Oct. 30, 1952), the Commission stated that good faith

was not a defense, at least for auditors, to a Rule 2(e)

proceeding. See also In re Schulzetenberg, Admin. Proc. 3–

6881, slip op. at 2 (Nov. 10, 1987) (unpublished) (same). But

see Checkosky I, 23 F.3d at 459 (Silberman, J.), 482 (Randolph, J.).

Given Commission precedent and our own, the Commission’s statement in adopting the 1998 amendment to Rule

102(e) that good faith was not a defense, see Rule 102(e)(1)(ii),

and that ‘‘[s]ubjective good faith is inconsistent with a finding

of knowing or intentional, including reckless, conduct,’’ Adopting Release, at 80,849, imposed new legal consequences. At

the time of the 1994 audit, Marrie and Berry did not have fair

notice that they could be sanctioned for improper professional

conduct even if they had been acting in good faith. In view of

the Commission’s prior opinions and, even assuming they

predicted the Commission would adopt the Sundstrand/Steadman recklessness standard, they had reason to

believe that recklessness required proof of either an intent to

defraud or a reckless disregard of their legal obligations. See

Steadman, 967 F.2d at 641–42. Indeed, the ALJ interpreted

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the Sundstrand/Steadman recklessness standard, as adopted

by the Commission for Rule 102(e) violations, to include a

requirement of an actual intent to defraud.

The Commission also changed the legal landscape in applying the amended definition of recklessness to Marrie’s and

Berry’s conduct in 1994 when it altered the element of

materiality. The Rule, as it is now interpreted, does not

require a showing of false or misleading financial statements.

In maintaining that it had always abided by the Sundstrand/Steadman definition of recklessness, see Respondent’s

Br. at 34, the Commission was bound to apply the materiality

requirements of those cases or make clear that it was adopting a different requirement. The court in Sundstrand, 553

F.2d at 1045, held that reckless omissions of material facts

upon which others had placed ‘‘justifiable reliance’’ would

result in liability under the securities laws. Id. at 1044. See

also Steadman, 967 F.2d at 640–41. In the securities fraud

context, an omission was defined as material ‘‘if there was a

substantial likelihood that a reasonable shareholder would

consider it important in deciding how to vote.’’ Basic Inc. v.

Levinson, 485 U.S. 224, 231 (1988) (quoting TSC Industries,

Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). In the

instant case, however, the Commission stated that recklessness could be found without a finding of this type of materiality, namely, the filing of ‘‘false financial statements’’ and

financial statements that contain a ‘‘material misstatement.’’

In re Marrie II, at *13. Until the 1998 amendments to Rule

102(e), the Commission had not clarified that this type of

materiality would no longer be required to find recklessness

under Rule 102(e), and Marrie and Berry could not be held to

have known of the change at the time of the audit.

Notwithstanding these altered requirements for proving

unprofessional conduct as a result of recklessness, the Commission contends that the amended Rule is not impermissibly

retroactive because it ‘‘is substantively consistent with prior

regulations or prior agency practices, and has been accepted

by all Courts of Appeals to consider the issue.’’ Nat’l Mining, 292 F.3d at 860. There are several problems with the

Commission’s position. First, its statement is untrue because

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it ignores this court’s Checkosky opinions, which declared the

Commission’s earlier approach too unclear to enforce. The

Commission’s related contention that, even absent the altered

requirements of the amended Rule, Marrie and Berry could

have been sanctioned because the Commission found both

that they had acted with a lesser form of intent and that they

cannot have acted in good faith, see In re Marrie II at *11;

Adopting Release, at 80,849, simply repeats the Commission’s

claim that the type of reckless misconduct engaged in by

Marrie and Berry had always been a basis for discipline

under Rule 102(e) and its predecessors. Yet, prior to the

amended Rule, the court in Checkosky I and II determined

that the Commission had not been ‘‘precise in declaring the

standard against which [accountants’] conduct is measured.’’

Checkosky I, 23 F.3d at 462 (Silberman, J.); see also Checkosky II, 139 F.3d at 227.

Second, the cases cited in the Commission’s opinion for the

proposition that the amended Rule 102(e) simply codified its

longstanding use of the recklessness standard were decided

after Marrie’s and Berry’s sanctioned conduct. See, e.g., In

re Ponce, Exchange Act Release No. 43235 (Aug. 31, 2000), 73

S.E.C. Dkt. 442, 465 n.52, aff’d, 345 F.3d at 741–42. The one

exception, In re Jackson, 48 S.E.C. 435 (Jan. 21, 1986),

neither defined recklessness nor specified the standard for

finding a violation of applicable professional standards, and, in

any event, was applying a rule that the court in Checkosky I

and II concluded failed to give fair notice. While in 1997 the

Commission in In re Potts, 53 S.E.C. at 204 n.40, applied the

same Sundstrand/Steadman definition of recklessness as

adopted by the Commission in the amended Rule 102(e) and,

by its opinion, gave notice that a finding of recklessness could

be made without a finding of fraudulent intent, its opinion

postdated by three years Marrie’s and Berry’s sanctioned

conduct and the filing of their Form 10–K report to the

Commission. Moreover, the court in Checkosky II, 139 F.3d

at 226, observed that even in Potts, the Commission failed ‘‘to

settle on a uniform theory as to the necessary mental state

for a violation of [the] Rule’’ (referring to Rule 102(e)’s

predecessor). In addition, in Potts, although the Commission

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discussed an auditor’s duties under GAAS to determine

whether financial statements contained material misstatements, see 53 S.E.C. at 196–97, it failed to clarify whether, by

adopting the Sundstrand/Steadman definition of recklessness, it was also adopting the element of materiality required

in the securities fraud context.

The court is constrained to hold, in light of Checkosky I and

II, that regardless of whether the evidence showed that

Marrie’s and Berry’s conduct in auditing Cal Micro was

reckless under Rule 102(e) because it involved extreme departures in professional standards, the Commission’s recklessness standard was unclear in the summer 1994 when Marrie

and Berry conducted the audit. Although the 1998 amendments to Rule 102(e) rectified the lack of clarity identified in

Checkosky I and II, application of the amended Rule, which

changed the legal landscape with respect to the standard for

finding ‘‘improper professional conduct,’’ to conduct in 1994

was impermissibly retroactive. Accordingly, we grant the

petition and reverse the Commission’s opinion and order of

July 29, 2003, without reaching the other challenges in the

petition for review.

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