[Federal Register Volume 62, Number 52 (Tuesday, March 18, 1997)]
[Rules and Regulations]
[Pages 12743-12750]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-6712]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release No. 34-38387; IC-22553; FR-49; File No. S7-20-96]
RIN 3235-AG70


Implementation of Section 10A of the Securities Exchange Act of 
1934

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is adopting revisions to its rules to implement the reporting 
requirements in section 10A of the Securities Exchange Act of 1934 (the 
``Exchange Act''). Section 10A requires, among other things, that the 
auditor of an issuer's financial statements report to the issuer's 
board of directors certain uncorrected illegal acts of the issuer, and 
that the issuer notify the Commission that it has received such a 
report. If the issuer fails to provide that notice, the auditor is 
required by section 10A to furnish directly to the Commission the 
report given to the Board. The amendments to the Commission's Exchange 
Act Rules implement those reporting requirements. The Commission also 
is adopting revisions to Regulation S-X to conform the definition of 
``audit'' in that regulation with the wording in section 10A.

EFFECTIVE DATE: The rule revisions are effective April 17, 1997.

FOR FURTHER INFORMATION CONTACT: Robert E. Burns or W. Scott Bayless, 
at (202) 942-4400, Office of the Chief Accountant, Mail Stop 11-3, or 
Kathleen Clarke, at (202) 942-0724, Division of Investment Management, 
Mail Stop 10-6, Securities and Exchange Commission, 450 Fifth Street, 
NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to its 
Exchange Act Rules, 17 CFR 240, by adding  Rule  10A-1,  and  
Regulation  S-X, 17 CFR 210, by revising Rule 1-02.

[[Page 12744]]

I. Background

    Title III to the Private Securities Litigation Reform Act of 1995 
(the ``Reform Act''), Public Law No. 104-67, enacted on December 22, 
1995, added section 10A to the Exchange Act. As discussed below, 
section 10A requires that each audit under the Exchange Act <SUP>1 
include procedures regarding the detection of illegal acts, the 
identification of related party transactions, and the evaluation of the 
issuer's ability to continue as a going concern. Section 10A also 
codifies certain professional auditing standards regarding the 
detection of illegal acts <SUP>2 by issuers and imposes expanded 
obligations on auditors <SUP>3 to report in a timely manner certain 
uncorrected illegal acts to an issuer's board of directors. It further 
requires the issuer, or if the issuer fails to do so then the auditor, 
to provide information regarding the illegal act to the Commission.
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    \1\ Because section 10A applies to audits under the Exchange 
Act, it and Rule 10A-1 apply to audits of the financial statements 
of foreign private issuers that are required under that Act.
    \2\ Section 10A(f) defines the term ``illegal act'' broadly to 
mean ``an act or omission that violates any law, or any rule or 
regulation having the force of law.'' This definition is consistent 
generally with Statement on Auditing Standards No. 54, ``Illegal 
Acts by Clients,'' para. 2 (January 1, 1989), AU Sec. 317.02, which 
states, ``the term illegal acts * * * refers to violations of laws 
or governmental regulations.''
    \3\ For the purpose of this release, the term ``auditor'' refers 
to any independent public or certified public accountant who is 
performing or has performed an audit of a registrant's financial 
statements and whose audit report has or will be filed with the 
Commission in accordance with the federal securities laws or the 
Commission's regulations. See, e.g., sections 12(b)(1) (J) and (K), 
13(a)(2), and 17(e) of the Exchange Act, 15 U.S.C. 78l(b)(1) (J) and 
(K), 78m(a)(2), and 78q(e), and the Commission's Regulation S-X, 17 
CFR Sec. 210. The term ``independent accountant'' is used in the 
regulatory text in order to be consistent with existing provisions 
in Regulation S-X.
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    On August 22, 1996, the Commission published for comment proposed 
revisions to its rules to implement the reporting requirements set 
forth in section 10A and to amend the definition of ``audit'' in 
Regulation S-X to conform with the provisions of that section.<SUP>4 
The Proposing Release contains a discussion of each paragraph of 
section 10A. Interested parties may wish to refer to the Proposing 
Release for additional background information.
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    \4\ Securities Exchange Act Release No. 37594, Investment 
Company Act Release No. 22162, File No. S7-20-96 (August 22, 1996) 
[61 FR 45730] (the ``Proposing Release'').
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    More specifically, section 10A(a) provides that each audit required 
by the Exchange Act of issuers' financial statements include, ``in 
accordance with generally accepted auditing standards, as may be 
modified or supplemented from  time to time by the Commission--''
    1. Procedures designed to provide reasonable assurance of detecting 
illegal acts that would have a direct and material effect on the 
determination of financial statement amounts;
    2. Procedures designed to identify related party transactions that 
are material to the financial statements or otherwise require 
disclosure therein; and
    3. An evaluation of whether there is substantial doubt about the 
issuer's ability to continue as a going concern during the ensuing 
fiscal year.<SUP>5
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    \5\ Section 10A(a) (1), (2), and (3).
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    Certain procedures in each of these three areas already are 
required by generally accepted auditing standards (``GAAS'') <SUP>6 in 
the United States and are further codified in the Statements on 
Auditing Standards (``SAS'') <SUP>7 adopted by the Auditing Standards 
Board (``ASB''), the senior technical body for auditing matters of the 
American Institute of Certified Public Accountants (``AICPA''). <SUP>8
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    \6\ In February 1941, the Commission amended Rule 2-02 of 
Regulation S-X, 17 CFR Sec. 210.2-02, to require that the 
independent accountant state in his or her report ``whether the 
audit was made in accordance with generally accepted auditing 
standards * * *'' Accounting Series Release No. 21 (February 5, 
1941). In this release, the Commission defined ``generally accepted 
auditing standards'' to mean the application of ``generally 
recognized normal auditing procedures'' with professional competence 
by properly trained persons. The Commission defined ``generally 
recognized normal auditing procedures'' to be those normally 
employed by skilled accountants and those prescribed by 
authoritative bodies dealing with the subject of auditing, such as 
accounting societies and governmental bodies having jurisdiction in 
the area. Id. Following this addition to the Commission's rules, the 
relevant professional committee at the time, the Committee on 
Auditing Procedure, began a study to determine which auditing 
standards should be included within ``GAAS.'' In 1948, the 
membership of the predecessor organization to the American Institute 
of Certified Public Accountants (``AICPA'') approved ten standards 
as constituting GAAS. See, AICPA, Codification of Statements on 
Auditing Standards, AU Sec. 150.02. These ten standards are 
supplemented by Statements on Auditing Standards, which currently 
are issued by the Auditing Standards Board of the AICPA.
    \7\ Currently effective Statements on Auditing Standards are 
published by the American Institute of Certified Public Accountants 
in the Codification of Statements on Auditing Standards. Provisions 
in the Codification are designated as ``AU Sec. __.'' For standards 
addressing those procedures mandated by section 10A, see SAS 54, 
``Illegal Acts by Clients'' (January 1, 1989), AU Sec. 317; SAS 45, 
``Related Parties'' (September 30, 1983), AU Sec. 334; and SAS 59, 
64, and 77 reprinted in ``The Auditor's Consideration of an Entity's 
Ability to Continue as a Going Concern'' (January 1, 1989), AU 
Sec. 341. See also SAS 53, ``The Auditor's Responsibility to Detect 
and Report Errors and Irregularities'' (January 1, 1989), AU 
Sec. 316. The ASB recently adopted a revision to SAS 53, which will 
be entitled ``Consideration of Fraud in a Financial Statement 
Audit'' and designated as SAS 82. This new standard should be 
published in Spring 1997 and will be applicable to the audits of 
1997 financial statements.
    \8\ The ASB's 15 members serve on a part-time basis and are 
appointed for one year terms that may be extended for up to three 
years.
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    In addition to the requirement in section 10A(a) that auditors 
perform procedures designed to enhance the detection of fraudulent 
financial reporting, section 10A(b) contains provisions that would 
require an auditor to report directly to the Commission certain 
detected illegal acts if the issuer fails to do so.
    Under section 10A(b), if, while conducting the audit of the 
issuer's financial statements, the auditor becomes aware of information 
indicating that an illegal act (whether or not material to the 
financial statements) has occurred or may have occurred, then the 
auditor would be required, in accordance with GAAS, ``as may be 
modified or supplemented from time to time by the Commission,'' to 
determine whether it is ``likely'' that an illegal act has occurred 
and, if so, its possible effect on the financial statements (including 
any contingent monetary effects, such as fines, penalties, and 
damages).<SUP>9 The auditor would be required to inform the issuer's 
management of the illegal act ``as soon as practicable.'' In addition, 
the auditor must assure him/herself that the issuer's board of 
directors is adequately informed, by management or otherwise, of any 
detected illegal act.<SUP>10
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    \9\ Section 10A(b)(1)(A). See, SAS 54, Paras. 10-15, AU 
Sec. 317.10-.15. Paragraph 11 of SAS 54 sets forth additional audit 
procedures that might be necessary once the auditor becomes aware of 
a possible illegal act.
    \10\ Section 10A(b)(1)(B). See, SAS 54, para. 17, AU 
Sec. 317.17.
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    Although GAAS contains procedures for similar notification of 
illegal acts to managements and boards of directors,<SUP>11 section 
10A(b) contains the additional requirement that these notifications 
occur ``as soon as practicable.'' <SUP>12
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    \11\ See, SAS 54, Paras. 10 and 17, AU Sec. 317.10 and .17.
    \12\ The addition of this time period reflects the original 
legislative efforts in this area to provide an earlier warning to 
the SEC of registrants' potential illegal acts than may occur under 
the current Form 8-K procedures, see note 20 infra, and in audit 
reports. See H.R. Rep. No. 102-890, 102d Cong., 2d Sess. 3 (1992), 
which contained the predecessor legislation to Section 10A and 
stated:
    This legislation amends the Securities Exchange Act of 1934 
(Exchange Act) to improve fraud detection and disclosure with 
respect to public companies by codifying auditing standards in 
certain specified areas and by providing a mechanism for earlier 
warning to the Securities and Exchange Commission of certain illegal 
acts by registrants.
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    After the auditor determines that the audit committee or the board 
of directors has been adequately informed of an illegal act and the 
auditor reaches

[[Page 12745]]

three specified conclusions, the auditor is required by section 
10A(b)(2) to report those conclusions directly to the board of 
directors ``as soon as practicable.'' The three conclusions set forth 
in section 10A(b)(2) that trigger the auditor's obligation to report to 
the board are that:
    1. The illegal act has a material effect <SUP>13 on the issuer's 
financial statements,
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    \13\ The auditor should consider both the quantitative and 
qualitative materiality of the act, including contingent liabilities 
that might be created by the illegal act. See, e.g., SAS 54, para. 
13, AU Sec. 317.13, and SAS 47, ``Audit Risk and Materiality in 
Conducting an Audit,'' para. 6 (June 30, 1984), AU Sec. 312.06.
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    2. 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
    3. The failure to take remedial action is reasonably expected to 
warrant either a departure from the auditor's standard audit 
report,<SUP>14 when made, or the auditor's resignation from the audit 
engagement.<SUP>15
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    \14\ See, SAS 58, ``Reports on Audited Financial Statements,'' 
para. 10 (January 1, 1989), AU Sec. 508.10, for a general discussion 
of the circumstances that may require the auditor to depart from the 
standard report and the types of opinions, other than the standard 
report, that may be expressed by the auditor in various 
circumstances.
    \15\ Section 10A(b)(2) (A), (B), and (C). See generally, SAS 54, 
Paras. 18-22, AU Sec. 317.18-.22.
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    If the board of directors receives a report that the auditor has 
reached these conclusions, then the board has one business day to 
notify the Commission that it received such a report. If the auditor 
does not receive a copy of the board's notice to the Commission within 
that one business day period, then by the end of the next business day 
the auditor is required to furnish directly to the Commission a copy of 
the report given to the board (or the documentation of any oral report 
<SUP>16).<SUP>17 The auditor's resignation from the audit engagement 
does not negate the auditor's obligation to furnish his or her report 
to the Commission in these circumstances.<SUP>18
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    \16\ For documentation requirements under GAAS, see, e.g., SAS 
54, para. 17, AU Sec. 317.17, and SAS 61, ``Communication with Audit 
Committees,'' para. 3 (January 1, 1989), AU Sec. 380.03.
    \17\ Section 10A(b)(3).
    \18\ Section 10A(b)(4).
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II. Discussion of Rule Amendments

A. Rule 10A-1.

    Rule 10A-1 is based on the premise that the notices and reports 
under section 10A are to assist the Commission in performing its 
enforcement responsibilities and, therefore, will be non-public. 
Disclosure to the public of issuers' illegal acts will continue to be 
made in modified audit reports <SUP>19 or, when the auditor has 
resigned, been dismissed, or elected not to stand for re-election, on 
Form 8-K <SUP>20 under the Exchange Act and on Form N-SAR <SUP>21 under 
the Investment Company Act of 1940 (the ``Investment Company Act''), 
among others.
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    \19\ For the effect of illegal acts on the audit report, see, 
SAS 53, Paras. 26 and 27, AU Sec. 316.26 and .27, and SAS 54, 
Paras. 18-21, AU Sec. 317.18-.21. See generally, SAS 58, 64, and 79 
reprinted in Reports on Audited Financial Statements (January 1, 
1989), which describes the standard report and the various opinions 
that may be reflected in the auditor's report. SAS 58, Paras. 7-10, 
AU Sec. 508.07-.10.
    \20\ Item 4 of Form 8-K, 17 CFR Sec. 249.308, Item 304 of 
Regulation S-K, 17 CFR Sec. 229.304, and Item 304 of Regulation S-B, 
17 CFR Sec. 228.304. In summary, these provisions state that a 
registrant must file a Form 8-K, providing the information required 
by item 4 of that form, within five business days of the date that 
the registrant's auditor (or an independent accountant upon whom the 
auditor expressed reliance in its audit report regarding a 
significant subsidiary) resigns, declines to stand for re-election, 
or is dismissed, and within five business days of the date a new 
auditor is engaged. The registrant is to ask the former auditor to 
provide the registrant with a letter indicating whether the former 
auditor agrees with the disclosures in the Form 8-K that reports the 
termination of the audit engagement and, if not, the respects in 
which the auditor disagrees. This letter is to be filed with the 
Commission as an exhibit by amendment to the registrant's Form 8-K 
within 10 business days of the date that the Form 8-K was filed.
    The registrant's Form 8-K must state, among other things: 
whether the former auditor resigned, was dismissed, or declined to 
stand for re-election and the date thereof; whether the auditor 
modified his or her report on the registrant's financial statements 
for either of the last two fiscal years and, if so, the nature of 
the modification; whether the decision to change auditors was 
recommended or approved by the audit committee or board of 
directors; whether, in connection with the audits of the financial 
statements for the two most recent fiscal years, and any subsequent 
interim period, there were any disagreements between the auditor and 
the registrant on any matter of accounting principles or practices, 
auditing scope or procedure, or financial statement disclosure. The 
Form 8-K also must provide disclosure of any instance within the 
applicable time period where the former auditor advised the 
registrant that (1) The internal controls necessary for the 
registrant to develop reliable financial statements did not exist, 
(2) information had come to the auditor's attention that led him or 
her no longer to be able to rely on management's representations, or 
that made the auditor unwilling to be associated with the 
registrant's financial statements, (3) there was a need to expand 
significantly the scope of the audit and, due to the auditor's 
resignation or for any other reason, the scope was not expanded, or 
(4) information had come to the auditor's attention affecting the 
reliability of past audit reports or financial statements and the 
issue had not been resolved to the auditor's satisfaction prior to 
the auditor's resignation, dismissal, or declination to stand for 
re-election.
    \21\ Sub-item 77K of Form N-SAR, 17 CFR Sec. 274.101, requires 
investment companies filing Form N-SAR to provide the information 
required by item 4 of Form 8-K. Sub-item 77K of Form N-SAR notes 
that notwithstanding the requirements in Form 8-K to file more 
frequently, registrants need only file such information semi-
annually in accordance with the requirements of Form N-SAR.
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    In testifying on prior bills that contained the same reporting 
requirements, the Commission stated, ``[W]e anticipate that reports 
filed under section 10A would be confidential and exempt from 
disclosure under the Freedom of Information Act.'' <SUP>22 The 
Commission further noted,

    \22\ Testimony of Richard C. Breeden, Chairman, U.S. Securities 
and Exchange Commission, Concerning H.R. 574, The Financial Fraud 
Detection and Disclosure Act, Before the Subcommittee on 
Telecommunications and Finance of the House Committee on Energy and 
Commerce, 103d Cong., 1st Sess., 32 (February 18, 1993).
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    Premature disclosure of the issuer and auditor reports could, 
among other things, interfere with the Commission's investigation, 
deprive the issuer or other persons of the right to a fair trial or 
impartial adjudication, constitute an unwarranted invasion of 
privacy, or disclose a confidential source. In addition, issuer and 
auditor reports under Section 10A might contain confidential 
commercial or financial information exempt from disclosure under 
FOIA Exemption 4, 5 U.S.C. 552(b)(4).<SUP>23

    \23\ Id., at 32 n. 36.
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    The Commission's testimony also states that the direct reporting 
provisions in the bill might provide an earlier warning of certain 
illegal acts that could allow the Commission to begin enforcement 
investigations at an earlier date.<SUP>24
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    \24\ Id., at 31.
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    Accordingly, Rule 10A-1 provides that section 10A notices provided 
by the board and reports submitted by the auditor will be non-public 
and exempt from disclosure under the Freedom of Information Act 
(``FOIA'') to the same extent as the Commission's investigative 
records.<SUP>25
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    \25\ Rule 10A-1(c). See also 5 U.S.C. 552(b)(7), which exempts 
from disclosure certain ``records or information compiled for law 
enforcement purposes.''
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    Commentators responding to the Proposing Release supported the 
position that reports and notices under section 10A should be non-
public. Some suggested, however, that proposed Rule 10A-1 was unclear 
as to the availability of FOIA exemptions, in addition to the 
exemptions for investigative records, for the information contained in 
these notices and reports. An instruction has been added to Rule 10A-
1(c), therefore, specifically to notify issuers and auditors that they 
may apply for confidential treatment under additional FOIA exemptions 
in accordance with the Commission's normal procedures.<SUP>26
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    \26\ See 17 CFR Sec. 200.83.
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    Despite the confidential nature of the reports under section 10A, 
these reporting requirements should improve the quality of public 
disclosures in

[[Page 12746]]

Forms 8-K and N-SAR and in audit reports on issuers' financial 
statements, because it is unlikely that issuers and auditors will make 
public disclosures that are incompatible with the confidential reports 
made to the Commission. Also, the direct reporting requirements in 
section 10A should give auditors additional leverage to prompt 
management to correct illegal acts and to make appropriate adjustments 
in their financial statements.
    Rule 10A-1 designates the Commission's Office of the Chief 
Accountant (``OCA'') as the appropriate office to receive the notice 
provided by any issuer under section 10A(b)(3) <SUP>27 and any reports 
provided by auditors under section 10A(b)(3) or 10A(b)(4).<SUP>28 No 
commentators objected to OCA as the designated party to receive these 
notices and reports. OCA expeditiously will forward copies of the 
notice or report to all appropriate offices and divisions within the 
Commission. The notice or report may be provided to other authorities, 
as appropriate.<SUP>29
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    \27\ Rule 10A-1(a).
    \28\ Rule 10A-1(b).
    \29\ See 17 CFR Sec. 240.24c-1.
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    Delivery of the notice or report to OCA may occur under Rule 10A-1 
in any manner, provided the notice or report is received by OCA within 
the statutory time period.<SUP>30 Currently, the most timely manner of 
delivery may be through submission of a facsimile,<SUP>31 telegraph, or 
personal delivery. Issuers should be aware that providing such 
information on the Edgar filing system, however, may result in the 
information becoming available to the public. In the future, procedures 
may be developed for issuers and auditors to deliver confidential 
information directly to OCA via electronic mail. Rule 10A-1 would 
permit use of such means of delivery.<SUP>32
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    \30\ Rule 10A-1 (a) and (b).
    \31\ The phone number for OCA's facsimile machine currently is 
(202) 942-9656. Such phone numbers, however, are subject to change 
without notice and registrants and auditors should verify the 
accuracy of the number before use.
    \32\ A similar provision applies to auditors of broker-dealers. 
See Rule 17a-5(h)(2) under the Exchange Act, 17 CFR Sec. 240.17a-
5(h)(2), which states that if, during the course of audit or interim 
work, the auditor determines that any material inadequacies exist in 
the accounting system, internal accounting control, procedures for 
safeguarding securities, or certain other practices and procedures, 
then the auditor shall call those inadequacies to the attention of 
the chief financial officer of the broker-dealer, who has the 
obligation to notify the Commission and the designated examining 
authority within 24 hours thereafter. If the auditor does not 
receive a copy of that notice within that 24 hour period, or if the 
auditor disagrees with the statements in the notice, then the 
auditor must inform the Commission and the designated examining 
authority of the material inadequacy within the next 24 hours.
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    Rule 10A-1(a) also sets forth the required contents for a issuer's 
notice to the Commission. This notice must be in writing and identify 
the issuer and the auditor, and state the date the auditor made its 
report to the board. Under the rule proposal, the issuer also would 
provide a summary of the report. The summary would describe the act and 
the potential impact of that act on the issuer's financial statements. 
This information is consistent with the requirement under GAAS that the 
auditor's communication with the issuer's audit committee ``should 
describe the act, the circumstances of its occurrence, and the effect 
on the financial statements.'' <SUP>33 One commentator suggested that 
issuers have the option of providing either the summary of the 
independent accountant's report, as proposed, or directly providing 
that report to OCA. This commentator noted, however, that if an issuer 
submits the independent accountant's report to OCA a question may arise 
regarding the availability to the independent auditor of the section 
10A(c) protection against civil liability for the findings, 
conclusions, or statements in his or her report.<SUP>34 As adopted, 
Rule 10A-1 incorporates the commentator's suggestion and permits 
issuers the option of providing either a summary of the independent 
accountant's report or a copy of that report. To clarify the 
application of the section 10A(c) safe harbor, Rule 10A-1 now provides 
that the safe harbor available to auditors shall apply not only when 
the report is furnished to OCA by the auditor but also when it is 
provided by the issuer.
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    \33\ SAS 54, para. 17, AU Sec. 317.17.
    \34\ Section 10A(c) limits auditors' liability in private rights 
of action for ``any finding, conclusion, or statement expressed in a 
report made pursuant to paragraph (3) or (4) of subsection (b), 
including any rule promulgated pursuant thereto''; paragraphs (3) 
and (4) of subsection (b) set forth the issuer and auditor reporting 
obligations.
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    As had been proposed, Rule 10A-1(a) also specifically permits an 
issuer to include additional information with the required notice to 
the Commission regarding the issuer's view of, and response to, the 
section 10A report it has received from the auditor.
    Regarding reports filed by auditors, Rule 10A-1(b) specifies that 
if the report does not identify clearly both the issuer and the 
auditor, then the auditor must attach that information to the report 
submitted to OCA.
    Rule 10A-1 makes clear that providing the notice or report in 
accordance with section 10A and Rule 10A-1 does not, in any way, affect 
the obligations of the issuer and the auditor to file and make all 
applicable public disclosures required by the Commission's rules, 
including, without limitation, Forms 8-K and N-SAR, and of the auditor 
to comply with GAAS reporting requirements.<SUP>35 Similarly, Rule 10A-
1 states that the confidential nature of the notice and the report to 
the Commission does not diminish an issuer's or auditor's obligations 
to make full disclosures required by the Commission's rules, forms, 
reports, or disclosure items, or by applicable professional standards.
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    \35\ In addition, one of the membership requirements of the SEC 
Practice Section of the AICPA is that members notify registrants in 
writing of the cessation of an auditor-client relationship. The 
member also is required to send a copy of that notification to the 
Commission's Office of the Chief Accountant.
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    In response to the Proposing Release, the Commission received 
additional comments requesting it to interpret or amend certain 
additional provisions of section 10A. For example, some commentators 
suggested that the Commission amend the statutory definition of 
``illegal act'' to follow more closely the definition in the auditing 
literature.<SUP>36 Another commentator recommended that auditors be 
required to report all illegal acts to the board of directors (as 
opposed to management), not merely those acts that are material to the 
financial statements. One commentator suggested that the Commission 
extend the protection for auditors against civil liability found in 
section 10A(c) for statements in reports submitted to the Commission 
under section 10A(b), to statements made by the auditor in additional 
documents and in other contexts. Commentators also requested that the 
Commission extend the one-business-day reporting periods in the statute 
to five business days. Such comments, however, are beyond the scope of 
this rulemaking proceeding and, in some cases, request that the 
Commission promulgate rules contrary to the statutory mandate of 
section 10A.
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    \36\ See SAS 54, para. 2, AU Sec. 317.02, discussed supra note 
2.
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B. Rule 1-02(d)

    The Commission is adopting the proposed amendment to conform the 
definition of ``Audit (or examination)'' in Rule 1-02(d) of Regulation 
S-X with section 10A. The amendment notes that audits of the financial 
statements of Commission issuers should be performed ``in accordance 
with generally accepted auditing standards, as may be modified or 
supplemented by the Commission.'' The purpose of this amendment is to 
alert auditors and issuers to the possibility that additional

[[Page 12747]]

audit procedures, beyond those required by GAAS, may be required by the 
Commission in certain circumstances.
    Some commentators objected to the proposed revision of Rule 1-02(d) 
on the ground that the Commission's statutory authority to modify or 
supplement GAAS is limited to the three circumstances expressly set 
forth in section 10A; i.e., illegal acts, related party transactions, 
and going concern evaluations.
    On the contrary, it has long been recognized by Congress and the 
Commission, that the Commission has broad authority to establish 
auditing requirements for public companies and their independent audit 
firms.<SUP>37 This implied authority is based on, among other things, 
(1) the Commission's authority to prescribe the reports to be filed 
with it,<SUP>38 (2) the provisions in the securities laws that require, 
or grant the Commission the authority to require, that certain 
financial statements be ``certified * * * by independent public 
accountants'' <SUP>39 and the Commission's authority to define 
technical and trade terms such as ``certified,'' <SUP>40 and (3) the 
Commission's authority to ensure that the representations in audit 
reports and the procedures behind those reports fulfill their statutory 
function.<SUP>41 In enacting the Reform Act, Congress clearly intended 
to preserve the Commission's existing implied authority regarding 
auditing standards, as evidenced by both the preservation clause in 
section 10A(e) and the Conference Committee Report.<SUP>42
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    \37\ See Report by the Subcommittee on Oversight and 
Investigations of the House Committee on Interstate and Foreign 
Commerce, Federal Regulation and Regulatory Reform, 94th Cong., 2d 
Sess., 38 (October 1976), which states, in part, that the Commission 
had not then ``exercised fully its statutory authority to remedy 
deficiencies in generally accepted auditing standards''; Report on 
the Activity of the Committee on Energy and Commerce for the 100th 
Congress, House Report 100-1114, 100th Cong., 2d Sess., 364 (Dec. 
23, 1988), which states, ``As the primary Agency responsible for 
administering the Federal securities laws disclosure requirements, 
the SEC has broad authority to establish auditing and accounting 
requirements for public companies and independent audit firms''; and 
Testimony of Richard C. Breeden, Chairman, U.S. Securities and 
Exchange Commission, Concerning H.R. 547, The Financial Fraud 
Detection and Disclosure Act, Before the Subcommittee on 
Telecommunications and Finance of the House Committee on Energy and 
Commerce, 103rd Cong., 1st Sess., 26-27 (Feb. 18, 1993), which 
states, in part, ``The Commission [is] prepared, should it prove 
necessary to fulfill its statutory mandate, to establish separate 
auditing standards that supplement or supplant ASB standards for SEC 
registrants.* * * In the same way the Commission has final authority 
over the establishment of new financial standards by the FASB, so 
too the Commission has final authority over the establishment of 
auditing standards to protect the public interest.''
    \38\ See, e.g., Sec. 13(b)(1) of the Exchange Act, 15 U.S.C. 
78m(b)(1), which states, ``The Commission may prescribe, in regard 
to reports made pursuant to this title, the form or forms in which 
the required information shall be set forth.* * *''
    \39\ Items 25, 26, and 27 of Schedule A to the Securities Act of 
1933, 15 U.S.C. 77aa (25), (26) and (27), and Sec. 17(e) of the 
Exchange Act, 15 U.S.C. 78q, expressly require that audited 
financial statements be filed with the Commission. Sections 12(b)(1) 
(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 78l and 78m, 
among others, authorize the Commission to require the filing of 
financial statements that have been audited by independent 
accountants. The Commission requires that certain financial 
statements be audited. See, e.g., Article 3 of Regulation S-X, 17 
CFR Sec. 210-3-01 et seq.
    \40\ See, e.g., Sec. 19(a) of the Securities Act of 1933, 15 
U.S.C. 77s(a), and Sec. 3(b) of the Exchange Act, 15 U.S.C. 78c(b).
    \41\ See generally James F. Strother, The Establishment of 
Generally Accepted Accounting Principles and Generally Accepted 
Auditing Standards, 28 Vand. L. Rev. 201, 225 (1975), which states, 
``The Commission's powers with regard to auditing are considerable, 
even though it lacks the express authority to prescribe auditing 
standards and procedures that it has in the case of accounting 
principles.''
    In the past, the Commission has not found it necessary formally 
to exercise its implied power to set auditing standards. In the mid-
1970s, however, the Commission proposed certain procedures for 
auditors' reviews of interim financial statements. See Securities 
Act Release No. 5579 (April 17, 1975), Accounting Series Release No. 
177 (September 10, 1975), Securities Act Release No. 5612 (September 
10, 1975). This rulemaking did not go forward when the predecessor 
to the ASB acted to establish similar review procedures, and 
Commission action became unnecessary.
    \42\ See H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess., 47 
(Nov. 28, 1995), which states, in part, ``The Conference Committee 
does not intend to affect the Commission's authority in areas not 
specifically addressed by this provision.''
---------------------------------------------------------------------------

    In any event, the revision to Rule 1-02(d) is not intended to 
change the substantive scope of the Commission's authority to set 
auditing standards, or to resolve any dispute that may arise over the 
scope of that authority in particular circumstances. Instead, this 
amendment is intended to provide adequate and fair notice to all 
parties concerned that the Commission, as well as appropriate 
professional authorities, may issue guidance to be considered and 
adhered to in the performance of audits under the Exchange Act.
    As a general matter, the Commission plans to continue its practice 
of looking to the private sector standard setting bodies designated by 
the accounting profession to provide leadership in establishing and 
improving GAAS. Currently, the Commission staff works closely with the 
ASB. The staff, among other things, attends ASB meetings, reviews and 
provides the ASB with comments on draft Statements on Auditing 
Standards, and has periodic meetings with ASB representatives to 
discuss items on the ASB agenda and other matters of mutual concern.
    The Commission has no present intention to write any new auditing 
standards unless it determines that the ASB, or any subsequently 
established standard setting organization, is unable or unwilling to 
address a significant auditing issue in an appropriate and timely 
manner. The Commission will exercise its discretion in determining the 
appropriateness and timeliness of the private sector response, 
considering the nature of the issue and other factors. Should 
Commission action be deemed necessary, the Commission will act promptly 
when required by the public interest or for the protection of 
investors.<SUP>43
---------------------------------------------------------------------------

    \43\ The Statement of Managers, The Private Securities 
Litigation Reform Act of 1995, states, at 22, ``The Conference 
Committee intends for the SEC to have discretion, however, to 
determine the appropriateness and timeliness of the private sector 
response. The SEC should act promptly if required by the public 
interest or for the protection of investors.''
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III. Investment Companies

    Section 10A and Rule 10A-1 apply to all audits required pursuant to 
the Exchange Act, including those prepared on behalf of investment 
companies, which, among others, have reporting obligations under the 
Exchange Act.<SUP>44
---------------------------------------------------------------------------

    \44\ See sections 13(a) and 15(d) of the Exchange Act, 15 U.S.C. 
78m(a) and 78o(d), and section 30(a) of the Investment Company Act, 
15 U.S.C. 80a-29(a). Form N-SAR requires investment companies to 
file information with the Commission about their operations, 
including audited financial information. Rule 30a-1 under the 
Investment Company Act, 17 CFR Sec. 270.30a-1, provides that 
investment companies filing annual reports on Form N-SAR are deemed 
to have satisfied the reporting requirements of sections 13(a) and 
15(d) under the Exchange Act and section 30(a) under the Investment 
Company Act.
---------------------------------------------------------------------------

    In the proposing release, the Commission requested comment 
regarding whether the reporting requirements under Rule 10A-1 should be 
modified to reflect the specific operations of investment companies. No 
commentators, however, addressed this topic. Accordingly, the 
Commission has determined that Rule 10A-1 will be adopted as proposed.

IV. Required Findings Regarding Impact on Competition

    In the Proposing Release, the Commission requested comments on 
whether the proposed amendments, if adopted, would have an adverse 
impact on competition or would impose a burden on competition that is 
neither necessary nor appropriate in furthering the purposes of the 
Securities Act of 1933 and the Exchange Act. One commentator addressed 
this issue, indicating that the reporting provisions of proposed Rule 
10A-1 would not add to any such burden that might be imposed by section 
10A, especially in

[[Page 12748]]

light of the non-public nature of the reports to be filed under the 
Rule.
    The Commission has considered the proposed amendments in light of 
its responsibilities under section 23(a) of the Exchange Act <SUP>45 
and concluded that the burdens on competition, if any, are necessary 
and appropriate in furtherance of the purposes of the Exchange Act, 
particularly section 10A.
---------------------------------------------------------------------------

    \45\ 15 U.S.C. 78w(a).
---------------------------------------------------------------------------

V. Cost/Benefit Analysis

    The costs of complying with Rule 10A-1, which is intended to carry 
out the purposes of new section 10A of the Exchange Act, are expected 
to be de minimis. Such costs for an issuer may include converting the 
information in the auditor's report to the board into a notice that 
conforms to the rule and delivering that notice, via facsimile or 
otherwise, to OCA. Costs for the auditor may include assuring that the 
report to the board identifies the issuer, as required by the proposed 
rule, and the cost of delivering that report, via facsimile or 
otherwise, to OCA.
    Benefits of compliance with Rule 10A-1 include an earlier warning 
to the Commission of possible illegal acts by issuers and potential 
improvements in public disclosures in Forms 8-K and N-SAR regarding 
changes in issuers' auditors and in audit reports that are modified due 
to issuers' illegal acts.
    Commentators specifically addressing the issue indicated either 
that the anticipated benefits of Rule 10A-1 outweigh the associated 
costs, or that the minimal reporting requirements under Rule 10A-1 
would not add to any burdens imposed by section 10A of the Exchange 
Act.

VI. Summary of Final Regulatory Flexibility Analysis

    A Final Regulatory Flexibility Analysis (``FRFA'') concerning Rule 
10A-1 has been prepared in accordance with 5 U.S.C. 604. The FRFA notes 
that the rule is intended to implement the reporting requirements of 
section 10A of the Exchange Act as mandated by Congress. The rule will 
not impose any reporting requirements additional to those imposed by 
section 10A.
    As discussed more fully in the FRFA, the rule will affect small 
entities, as defined by the Commission's rules, but only in the same 
manner as other entities. By statute, most issuers that fit the 
Commission's definitions of small entities are subject to a one-year 
delay in the effective date of section 10A, which makes section 10A 
(and accordingly Rule 10A-1) applicable to annual reports for any 
period beginning on or after January 1, 1997 (instead of January 1, 
1996).
    Regarding issuers, approximately 1,100 Exchange Act reporting 
companies satisfy the Commission's definition of ``small business;'' as 
of December 1995, approximately 5,200 broker-dealers were classified as 
small entities; and as of August 1995, approximately 1,770 active 
registered investment companies were considered small entities. 
Although some small auditors may be subject to the Rule 10A-1 reporting 
requirements, there is no specific definition of the term ``small 
auditor'' and information regarding auditors' revenues, earnings, and 
similar data is not publicly available.
    There is no reliable way of determining how many small issuers or 
auditors will be required to file section 10A reports or notices each 
year concerning illegal acts so as to become subject to Rule 10A-1. It 
is expected, however, that OCA will receive very few issuer notices 
each year and even fewer auditor reports (which are filed only if an 
issuer fails to fulfill its reporting obligation).
    The FRFA notes that alternatives for providing different means of 
compliance for small entities or for exempting small entities from the 
rule would be inconsistent with the statutory requirements of section 
10A. The cost of complying with the rule should be de minimus, even for 
small entities, because the reporting requirements under section 10A 
and the rule are based on existing GAAS requirements. Moreover, the 
statute essentially requires only an earlier warning regarding matters 
that would otherwise be disclosed in Forms 8-K and N-SAR and in audit 
reports on issuers' financial statements.
    The Commission received no comments on the Initial Regulatory 
Flexibility Analysis (``IRFA'') prepared in connection with the 
proposing release, and no comment letters specifically addressed to the 
IRFA. Two commentators indicated that the anticipated benefits of Rule 
10A-1 outweigh the associated costs, and that the minimal reporting 
requirements of Rule 10A-1 would not materially add to the burdens 
Congress chose to impose by enacting section 10A.
    A copy of the analysis may be obtained by contacting Robert E. 
Burns, Chief Counsel, Office of the Chief Accountant, U.S. Securities 
and Exchange Commission, Mail Stop 11-3, 450 Fifth Street, N.W., 
Washington, D.C. 20549.

VII. Paperwork Reduction Act

    As set forth in the Proposing Release, proposed Rule 10A-1 contains 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995 [44 U.S.C. 3501 et seq.]. An agency may 
not conduct or sponsor, and a person is not required to respond to, a 
collection of information unless it displays a valid OMB control 
number. Accordingly, the Commission submitted the proposed rules to the 
Office of Management and Budget (``OMB'') for review in accordance with 
44 U.S.C. 3507(d), and OMB approved that collection and assigned it 
control number 3235-0468. This is the final notice regarding the 
collection of information under Rule 10A-1.
    The Supporting Statement to the Paperwork Reduction Act submission 
noted that Rule 10A-1 is intended to implement the reporting 
requirements found in recently enacted section 10A of the Exchange Act, 
and that the rule is expected to have a negligible effect on the annual 
reporting and cost burden of Commission registrants. As discussed 
above, the notice to be provided by the issuer would contain the 
minimum amount of information necessary to identify the issuer and the 
auditor, indicate the date the auditor provided the report to the board 
of directors as specified in section 10A, and summarize the report 
given to the board. The summary would be based on information required 
to be given to the board of directors under GAAS. The auditor's report, 
furnished only in the event that the issuer does not fulfill its 
reporting responsibilities, would consist only of the report given to 
the board of directors and, if necessary, additional information to 
identify clearly the issuer and the auditor.
    Potential respondents are entities with reporting obligations under 
the Exchange Act and their auditors, although it is anticipated that 
the reporting requirements under section 10A rarely will be triggered. 
On those rare occasions when the reporting requirement is triggered, it 
is estimated that the total recordkeeping and reporting burden, beyond 
that directly required by the statute, would not exceed one hour per 
respondent.
    As notices must be filed by an issuer within one day of receiving a 
report from its auditor, and the auditor must file its report (if 
necessary) the next day, there are essentially no recordkeeping or 
retention requirements.
    Filing the notices and reports, when necessary, is required by 
section 10A of the Exchange Act and therefore is

[[Page 12749]]

mandatory. As explained above, however, the notices and reports will be 
kept confidential while the Commission has an enforcement interest in 
the information contained in those notices and reports. In addition, 
requests for confidential treatment of such information may be made 
under 17 CFR 200.83.
    The Commission received no comments in response to its request for 
comments, pursuant to 44 U.S.C. 3506(c)(2)(B), concerning: whether the 
proposed collection of information is necessary for the proper 
performance of the function of the Commission, including whether the 
information shall have practical utility; the accuracy of the 
Commission's estimate of the burden of the proposed collection of 
information; the quality, utility, and clarity of the information to be 
collected; and whether the burden of collection of information on those 
who are to respond, including through the use of automated collection 
techniques or other forms of information technology, may be minimized.

List of Subjects

17 CFR Part 210

    Accounting, Reporting and recordkeeping requirements, Securities.

17 CFR Part 240

    Reporting and recordkeeping requirements, Securities.

    In accordance with the foregoing, Title 17, Chapter II of the Code 
of Federal Regulations is amended as follows:

PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL 
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT 
COMPANY ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975

    1. The authority citation for Part 210 is revised to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77aa(25), 
77aa(26), 78j-1, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d), 
79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-
37(a), unless otherwise noted.

    2. By revising Sec. 210.1-02(d) to read as follows:


Sec. 210.1-02  Definitions of terms used in Regulation S-X (17 CFR part 
210).

* * * * *
    (d) Audit (or examination). The term audit (or examination), when 
used in regard to financial statements, means an examination of the 
financial statements by an independent accountant in accordance with 
generally accepted auditing standards, as may be modified or 
supplemented by the Commission, for the purpose of expressing an 
opinion thereon.
* * * * *

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    3. The authority citation for Part 240 is revised to read in part 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, and 80b-11, 
unless otherwise noted.
* * * * *
    4. By adding an undesignated center heading and Sec. 240.10A-1 
following Sec. 240.10(b)-21 to read as follows: Reports Under Section 
10A


Sec. 240.10A-1  Notice to the Commission Pursuant to Section 10A of the 
Act.

    (a)(1) If any issuer with a reporting obligation under the Act 
receives a report requiring a notice to the Commission in accordance 
with section 10A(b)(3) of the Act, 15 U.S.C. 78j-1(b)(3), the issuer 
shall submit such notice to the Commission's Office of the Chief 
Accountant within the time period prescribed in that section. The 
notice may be provided by facsimile, telegraph, personal delivery, or 
any other means, provided it is received by the Office of the Chief 
Accountant within the required time period.
    (2) The notice specified in paragraph (a)(1) of this section shall 
be in writing and:
    (i) Shall identify the issuer (including the issuer's name, 
address, phone number, and file number assigned to the issuer's filings 
by the Commission) and the independent accountant (including the 
independent accountant's name and phone number, and the address of the 
independent accountant's principal office);
    (ii) Shall state the date that the issuer received from the 
independent accountant the report specified in section 10A(b)(2) of the 
Act, 15 U.S.C. 78j-1(b)(2);
    (iii) Shall provide, at the election of the issuer, either:
    (A) A summary of the independent accountant's report, including a 
description of the act that the independent accountant has identified 
as a likely illegal act and the possible effect of that act on all 
affected financial statements of the issuer or those related to the 
most current three-year period, whichever is shorter; or
    (B) A copy of the independent accountant's report; and
    (iv) May provide additional information regarding the issuer's 
views of and response to the independent accountant's report.
    (3) Reports of the independent accountant submitted by the issuer 
to the Commission's Office of the Chief Accountant in accordance with 
paragraph (a)(2)(iii)(B) of this section shall be deemed to have been 
made pursuant to section 10A(b)(3) or section 10A(b)(4) of the Act, 15 
U.S.C. 78j-1(b)(3) or 78j-1(b)(4), for purposes of the safe harbor 
provided by section 10A(c) of the Act, 15 U.S.C. 78j-1(c).
    (4) Submission of the notice in paragraphs (a)(1) and (a)(2) of 
this section shall not relieve the issuer from its obligations to 
comply fully with all other reporting requirements, including, without 
limitation:
    (i) The filing requirements of Form 8-K, Sec. 249.308 of this 
chapter, and Form N-SAR, Sec. 274.101 of this chapter, regarding a 
change in the issuer's certifying accountant and
    (ii) The disclosure requirements of item 304 of Regulation S-B or 
item 304 of Regulation S-K, Secs. 228.304 or 229.304 of this chapter.
    (b)(1) Any independent accountant furnishing to the Commission a 
copy of a report (or the documentation of any oral report) in 
accordance with section 10A(b)(3) or section 10A(b)(4) of the Act, 15 
U.S.C. 78j-1(b)(3) or 78j-1(b)(4), shall submit that report (or 
documentation) to the Commission's Office of the Chief Accountant 
within the time period prescribed by the appropriate section of the 
Act. The report (or documentation) may be submitted to the Commission's 
Office of the Chief Accountant by facsimile, telegraph, personal 
delivery, or any other means, provided it is received by the Office of 
the Chief Accountant within the time period set forth in section 
10A(b)(3) or 10A(b)(4) of the Act, 15 U.S.C. 78j-1(b)(3) or 78j-(b)(4), 
whichever is applicable in the circumstances.
    (2) If the report (or documentation) submitted to the Office of the 
Chief Accountant in accordance with paragraph (b)(1) of this section 
does not clearly identify both the issuer (including the issuer's name, 
address, phone number, and file number assigned to the issuer's filings 
with the Commission) and the independent accountant (including the 
independent accountant's name and phone number, and the address of the 
independent accountant's principal office), then the

[[Page 12750]]

independent accountant shall place that information in a prominent 
attachment to the report (or documentation) and shall submit that 
attachment to the Office of the Chief Accountant at the same time and 
in the same manner as the report (or documentation) is submitted to 
that Office.
    (3) Submission of the report (or documentation) by the independent 
accountant as described in paragraphs (b)(1) and (b)(2) of this section 
shall not replace, or otherwise satisfy the need for, the newly engaged 
and former accountants' letters under items 304(a)(2)(D) and 304(a)(3) 
of Regulation S-K, Secs. 229.304(a)(2)(D) and 229.304(a)(3) of this 
chapter, respectively, and under items 304(a)(2)(D) and 304(a)(3) of 
Regulation S-B, Secs. 228.304(a)(2)(D) and 228.304(a)(3) of this 
chapter, respectively, and shall not limit, reduce, or affect in any 
way the independent accountant's obligations to comply fully with all 
other legal and professional responsibilities, including, without 
limitation, those under generally accepted auditing standards and the 
rules or interpretations of the Commission that modify or supplement 
those auditing standards.
    (c) A notice or report submitted to the Office of the Chief 
Accountant in accordance with paragraphs (a) and (b) of this section 
shall be deemed to be an investigative record and shall be non-public 
and exempt from disclosure pursuant to the Freedom of Information Act 
to the same extent and for the same periods of time that the 
Commission's investigative records are non-public and exempt from 
disclosure under, among other applicable provisions, 5 U.S.C. 552(b)(7) 
and Sec. 200.80(b)(7) of this chapter. Nothing in this paragraph, 
however, shall relieve, limit, delay, or affect in any way, the 
obligation of any issuer or any independent accountant to make all 
public disclosures required by law, by any Commission disclosure item, 
rule, report, or form, or by any applicable accounting, auditing, or 
professional standard.

Instruction to Paragraph (c)

    Issuers and independent accountants may apply for additional bases 
for confidential treatment for a notice, report, or part thereof, in 
accordance with Sec. 200.83 of this chapter. That section indicates, in 
part, that any person who, pursuant to any requirement of law, submits 
any information or causes or permits any information to be submitted to 
the Commission, may request that the Commission afford it confidential 
treatment by reason of personal privacy or business confidentiality, or 
for any other reason permitted by Federal law.

    By the Commission.

    Dated: March 12, 1997.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-6712 Filed 3-17-97; 8:45 am]
BILLING CODE 8010-01-P