[Federal Register Volume 63, Number 117 (Thursday, June 18, 1998)]
[Proposed Rules]
[Pages 33305-33311]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16251]



[[Page 33305]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 201

[Release Nos. 33-7546; 34-40089; 35-26884; 39-2364; IA-1726; IC-23250; 
File No. S7-16-98]
RIN 3235-AH47


Proposed Amendment to Rule 102(e) of the Commission's Rules of 
Practice

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing an amendment to Rule 102(e) of the Commission's Rules of 
Practice. Under Rule 102(e), the Commission can censure, suspend or bar 
persons who appear or practice before it. The proposed amendment 
clarifies the Commission's standard for determining when accountants 
engage in ``improper professional conduct'' under Rule 102(e)(1)(ii).

DATES: Comments must be received on or before July 20, 1998.

ADDRESSES: Submit comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 5th Street, NW., 
Washington, DC. 20549-6009. Comments can be submitted electronically at 
the following E-mail address: <a href="/cdn-cgi/l/email-protection#aedcdbc2cb83cdc1c3c3cbc0daddeeddcbcd80c9c1d8"><span class="__cf_email__" data-cfemail="b0c2c5dcd59dd3dfddddd5dec4c3f0c3d5d39ed7dfc6">[email protected]</span></a>. All comment 
letters should refer to File No. S7-16-98; include this file number on 
the subject line if E-mail is used. All comments received will be 
available for public inspection and copying in the Commission's Public 
Reference Room, 450 5th Street, NW., Washington, DC. 20549-6009. 
Electronically-submitted comment letters will be posted on the 
Commission's Internet Web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Michael J. Kigin, Associate Chief 
Accountant, Office of the Chief Accountant, at (202) 942-4400; or David 
R. Fredrickson, Assistant General Counsel, Office of the General 
Counsel, at (202) 942-0890.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today 
is proposing for comment an amendment to Rule 102(e). <SUP>1</SUP>
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    \1\ 17 CFR 201.102(e).
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I. The Purpose of this Release

    The purpose of this release is to solicit comments on a proposed 
amendment to Rule 102(e) of the Commission's Rules of Practice. Under 
Rule 102(e), the Commission can censure, suspend or bar professionals 
who appear or practice before it. <SUP>2</SUP> Specifically, pursuant 
to the Rule, the Commission can impose a sanction upon a professional 
whom it finds, after notice and an opportunity for hearing:
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    \2\ The Rule addresses the conduct of attorneys, accountants, 
engineers and other professionals or experts who appear or practice 
before the Commission. 17 CFR 201.102(e)(2) and (f)(2).
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    (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 willfully violated, or willfully aided and abetted 
the violation of, any provision of the Federal securities laws or the 
rules and regulations thereunder. <SUP>3</SUP>
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    \3\ 17 CFR 201.102(e)(1)(i), (ii) and (iii).
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    In a recent opinion addressing the conduct of two accountants, the 
U.S. Court of Appeals for the District of Columbia Circuit found that 
the Commission had not articulated clearly the ``improper professional 
conduct'' element of the Rule. <SUP>4</SUP> To address the court's 
concerns, the Commission is proposing an amendment to the text of Rule 
102(e) that clarifies the Commission's standard for determining when 
accountants engage in ``improper professional conduct.'' <SUP>5</SUP>
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    \4\ Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (``Checkosky 
II '').
    \5\ This clarification addresses the conduct of accountants 
only, and is not meant to address the conduct of lawyers or other 
professionals who practice before the Commission.
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II. A Brief Overview of Rule 102(e)

A. The Importance of Rule 102(e)

    The Commission adopted Rule 102(e) as a ``means to ensure that 
those professionals, on whom the Commission relies heavily in the 
performance of its statutory duties, perform their tasks diligently and 
with a reasonable degree of competence.'' <SUP>6</SUP> Courts have 
recognized that it is appropriate for the Commission to use a 
disciplinary mechanism such as Rule 102(e) to encourage professionals 
to adhere to ethical standards and minimum standards of competence. 
<SUP>7</SUP> In adopting the Rule, the Commission did not intend to add 
an ``additional weapon'' to its ``enforcement arsenal'' <SUP>8</SUP> 
but to protect its system of securities regulation and, by extension, 
the interests of the investing public.
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    \6\ Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979). 
The AICPA also recognizes that accountants must discharge their 
duties with competence. See, e.g., AICPA Professional Standards, 
Vol. 2, ET sec. 56 (1997).
    \7\ Rule 102(e) was promulgated under the Commission's broad 
authority to adopt those rules and regulations necessary for 
carrying out the agency's designated functions and its inherent 
authority to protect the integrity of the agency's processes. Three 
U.S. Courts of Appeals have upheld the validity of Rule 102(e). See 
Touche Ross; Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995); 
Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986). The Checkosky 
opinions held that the Commission had not clearly articulated the 
``improper professional conduct'' standard or the rationale for that 
standard. Also, the Checkosky opinions did not decide the issue of 
the scope of the Commission's authority.
    \8\ Touche Ross, 609 F.2d at 579.
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B. The Important Role of Accountants

    Accountants play many roles in the Commission's system of 
securities regulation. In recognition of the significance of auditors 
and audited financial statements in the Commission's disclosure 
process, this release focuses particular attention upon the role of 
auditors in the securities registration and reporting processes under 
the federal securities laws. The proposed amendment, however, covers 
all accountants who appear or practice before the Commission. 
<SUP>9</SUP>
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    \9\ See 17 CFR 201.102(f)(1) and (2). The Commission has 
interpreted ``practice'' before the Commission to include 
accountants functioning in many roles, including those who serve as 
officers of public companies. See, e.g., In re Terrano, Securities 
Exchange Act of 1934 (``Exchange Act'') Rel. No. 39485 (Dec. 23, 
1997), 66 SEC Docket 494 (Jan. 20, 1998); In re Hersh, Exchange Act 
Rel. No. 39089 (Sept. 18, 1997), 65 SEC Docket 1170 (Oct. 14, 1997); 
In re Bryan, Exchange Act Rel. No. 39077 (Sept. 15, 1997), 65 SEC 
Docket 1129 (Oct. 14, 1997).
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    ``Corporate financial statements are one of the primary sources of 
information available to guide the decisions of the investing public.'' 
<SUP>10</SUP> Various provisions of the federal securities laws require 
publicly held companies to file audited financial statements with the 
Commission. <SUP>11</SUP> These financial statements must be audited by 
independent accountants in accordance with generally accepted auditing 
standards (``GAAS''). <SUP>12</SUP> The auditor plans and performs the 
audit to obtain reasonable assurance that the financial statements are 
free from material misstatement. Commission regulations require the 
auditor to issue a report containing an opinion on the financial 
statements. <SUP>13</SUP> The auditor's opinion states whether the 
financial statements present fairly, in all material respects, the 
financial position of the company as of a specific date. <SUP>14</SUP> 
The opinion also states whether the results of the company's operations 
and cash

[[Page 33306]]

flows for the year (or other period) then ended, are in conformity with 
generally accepted accounting principles (``GAAP''), and whether the 
audit was conducted in accordance with GAAS. <SUP>15</SUP>
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    \10\ U.S. v. Arthur Young & Co., 465 U.S. 805, 810 (1984).
    \11\ See, e.g., Securities Act of 1933 (``Securities Act'') 
Schedule A (25)--(27), 15 U.S.C. 77aa(25)--(27); Exchange Act 
12(b)(1)(J)--(L), 15 U.S.C. 78l(b)(1)(J)--(L).
    \12\ Regulation S-X, 17 CFR 210.1-02(d) (1997).
    \13\ See Regulation S-X, 17 CFR 210.2-02 (1985).
    \14\ Id.
    \15\ Id.
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    Investors have come to rely on the accuracy of the financial 
statements of public companies when making investment decisions. 
Because the Commission has limited resources, it cannot closely 
scrutinize each of these financial statements. <SUP>16</SUP> 
Consequently, the Commission must rely on the integrity of the auditors 
who certify, and accountants who prepare, financial statements. In 
short, both the Commission and the investing public rely heavily on 
accountants to assure corporate compliance with federal securities law 
requirements and disclosure of accurate and reliable financial 
information.
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    \16\ See Touche Ross, 609 F.2d at 580-81.
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    The Commission and the courts have long acknowledged ``the duty of 
accountants to those who justifiably rely on [their] reports.'' 
<SUP>17</SUP> Accountants who issue audit and other reports speak to 
investors, publicly representing that the accounting and auditing 
standards of the accounting profession have been followed. 
<SUP>18</SUP> An incompetent or unethical accountant can damage the 
Commission's processes and erode investor confidence in our markets. 
<SUP>19</SUP>
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    \17\ In re Carter, Exchange Act Rel. No. 17595 (Feb. 28, 1981), 
22 SEC Docket 292, 298 (Mar. 17, 1981). Cf. Arthur Young, 465 U.S. 
at 817-18.
    \18\ See Carter, 22 SEC Docket at 298.
    \19\ ''In our complex society, the accountant's certificate * * 
* can be instruments for inflicting pecuniary loss more potent than 
the chisel or the crowbar.'' U.S. v. Benjamin, 328 F.2d 854, 863 (2d 
Cir.), cert. denied, 377 U.S. 953 (1964).
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III. The Standard Applied to Accountants

A. ``Improper Professional Conduct'' In General

    The Court of Appeals in Checkosky II criticized the Commission for 
not clearly articulating when an accountant would be deemed to have 
engaged in ``improper professional conduct'' under Rule 102(e)(1)(ii). 
This proposed amendment clarifies that whether an accountant engages in 
``improper professional conduct'' is determined first by evaluating 
whether the accountant violated applicable professional standards. It 
also specifies the mental state required before an accountant may be 
sanctioned under the Rule. The proposed amendment covers conduct that 
the Commission historically has treated as ``improper professional 
conduct'' under Rule 102(e)(1)(ii).
    Rule 102(e)(1)(ii) has been an effective disciplinary and remedial 
tool because it has been used to address a range of misconduct that 
poses a future threat to the Commission's processes. <SUP>20</SUP> 
Accountants who engage in intentional or knowing misconduct, which 
includes reckless misconduct, clearly pose this type of future threat. 
Accountants who engage in negligent misconduct also can pose as great a 
threat to the Commission's system of securities regulation as 
accountants who knowingly violate the professional standards.
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    \20\ Carter, 22 SEC Docket at 297. Because Rule 102(e)(1)(ii) is 
remedial and not punitive in nature, the conduct must be evaluated 
to determine whether the accountant poses a future threat to the 
Commission's processes.
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    Rule 102(e)(1)(ii) is not meant, however, to encompass every 
professional misstep. <SUP>21</SUP> A harmless judgment error or 
immaterial mistake does not pose a future threat to the Commission's 
processes and does not constitute ``improper professional conduct.'' 
Similarly, the Commission does not seek to use the Rule to establish 
new standards for the accounting profession.
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    \21\ As Commissioner Johnson has noted:
    A professional often must make difficult decisions, navigating 
through complex statutory and regulatory requirements, and in the 
case of accountants, complying with (GAAS) and applying (GAAP). 
These determinations require the application of independent 
professional judgment and sometimes involve matters of first 
impression.
    Exchange Act Rel. No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948, 
1976 (Feb. 18, 1997) (Johnson, Comm'r, dissenting), rev'd Checkosky 
II.
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B. The Proposed Standard

    The Rule addresses conduct that fails to meet professional 
standards. The proposed amendment delineates categories of conduct that 
constitute ``improper professional conduct'' under Rule 102(e)(1)(ii). 
These categories are:
    (A) An intentional or knowing violation, including a reckless 
violation, of applicable professional standards; <SUP>22</SUP> or
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    \22\ ''Applicable professional standards'' includes such things 
as generally accepted accounting principles, generally accepted 
auditing standards, generally accepted attestation standards, the 
AICPA Code of Professional Conduct, the AICPA Statements on 
Standards for Consulting Services, the AICPA Statements on Standards 
for Accounting and Review Services, pronouncements of the 
Independence Standards Board, and certain of the Commission's rules 
and regulations.
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    (B) Negligent conduct in the following circumstances:
    (1) An unreasonable violation of applicable professional standards 
that presents a substantial risk, which is either known or should have 
been known, of making a document prepared pursuant to the federal 
securities laws materially misleading; or
    (2) Repeated, unreasonable violations of applicable professional 
standards that demonstrate that the accountant lacks competence.
1. Intentional or Knowing Violations, Including Reckless Violations
    Subparagraph (A) of the amendment defines ``improper professional 
conduct'' to include the most blatant violations of the professional 
standards. The Commission consistently has used Rule 102(e)(1)(ii) 
proceedings to address these types of violations of the professional 
standards. <SUP>23</SUP>
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    \23\ See, e.g., In re Finkel, Securities Act Rel. No. 7401 (Mar. 
12, 1997), 64 SEC Docket 103 (Apr. 8, 1997); In re Basson, Exchange 
Act Rel. No. 35840 (June 13, 1995), 59 SEC Docket 1650 (July 11, 
1995); In re F.G. Masquelette & Co, Accounting Series Rel. No. 68, 
[1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH), para. 72,087 
(June 30, 1982); In re Weiner, Exchange Act Rel. No. 14249 (Dec. 12, 
1997), 13 SEC Docket 1113 (Dec. 27, 1977).
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    Clearly, an accountant who intentionally or knowingly, including 
recklessly <SUP>24</SUP>, violates the professional standards has 
engaged in ``improper professional conduct.'' Accountants who engage in 
this type of misconduct undoubtedly pose the type of future threat to 
the Commission's system of regulation that requires Commission action.
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    \24\ See generally SEC v. Blavin, 760 F.2d 706, 711 (6th Cir. 
1985); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 
(6th Cir. 1979).
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2. Specific, Negligent Conduct
    The proposed amendment also covers specific, negligent violations 
of the professional standards.<SUP>25</SUP> The Commission has 
recognized that ``an incompetent or negligent auditor can do just as 
much harm to public investors and others who rely on him as one who 
acts with an improper motive.'' <SUP>26</SUP> For this reason, the 
Commission has stated that negligent conduct can trigger a Rule 
102(e)(1)(ii) proceeding, and has brought Rule 102(e)(1)(ii) 
proceedings based on negligent conduct.<SUP>27</SUP>
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    \25\ In other instances, the federal securities laws expressly 
subject auditors to liability without requiring intentional 
misconduct. For example, the Supreme Court has recognized that 
Section 11 allows recovery for ``negligent conduct.'' Herman & 
MacLean v. Huddleston, 459 U.S. 375, 384 (1983), referring to Ernst 
& Ernst v. Hochfelder, 425 U.S. 185, 210 (1976).
    \26\ In re Checkosky, Exchange Act Rel. No. 31094 (Aug. 26, 
1992), 52 SEC Docket 1389, 1410 (Sept. 15, 1992), rev'd Checkosky v. 
SEC, 23 F.3d 452 (D.C. Cir. 1994) (``Checkosky I''), citing In re 
Schulzetenberg, Admin. Proc. 3-6881, slip op. at 2 (Order Denying 
Motion to Dismiss Nov. 10, 1987)(unpublished opinion).
    \27\ In re Gotthilf, Exchange Act Rel. No. 33949 (April 21, 
1994), 56 SEC Docket 1543 (May 10, 1944).
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    The Court of Appeals in Checkosky II faulted the Commission for not 
articulating with some degree of

[[Page 33307]]

specificity when negligent conduct by an accountant constitutes 
``improper professional conduct.'' <SUP>28</SUP> The proposed amendment 
provides this specificity. Specifically, subparagraph (B) of the 
amendment defines ``improper professional conduct'' to include: (1) An 
unreasonable violation of the applicable professional standards that 
presents a substantial risk, which is either known or should have been 
known, of making a document prepared pursuant to the federal securities 
laws materially <SUP>29</SUP> misleading; or (2) repeated, unreasonable 
violations of the applicable professional standards that demonstrate 
that the accountant lacks competence.
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    \28\ Checkosky II, 139 F.3d at 224.
    \29\ Material, as used in this context, means a substantial 
likelihood of being considered significant by a reasonable investor. 
Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), citing TSC 
Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
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    Under this standard, a single violation of the professional 
standards could constitute ``improper professional conduct'' if the 
violation presents a substantial risk, which is either known or should 
have been known, of making a document prepared pursuant to the federal 
securities laws materially misleading. Under these circumstances, the 
single violation most likely would be related to a transaction or event 
as to which any reasonable auditor would give heightened 
scrutiny.<SUP>30</SUP> The integrity of the Commission's processes is 
threatened by an accountant who fails to exercise due professional care 
with respect to the critical areas of his or her professional 
responsibilities.
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    \30\ Cf. AICPA Professional Standards, Vol. 1 AU sec. 312 
(1997).
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    For example, an auditor who failed to verify properly the amount of 
cash purportedly held in a vault at a branch of a bank, where that 
amount constituted 61% of the branch's and 45% of the bank's total cash 
on hand, engaged in improper professional conduct under Rule 
102(e)(1)(ii).<SUP>31</SUP> In this particular matter, at least 
$400,000 of the $2.7 million cash purportedly on hand had been 
misappropriated by a bank employee. Although the sum of money 
misappropriated may not have been quantitatively material to the bank's 
balance sheet, a Rule 102(e)(1)(ii) proceeding was appropriate. Because 
a shortage of the total amount of cash actually on hand would impact 
materially on the bank's pre-tax earnings, the auditor's failure to 
verify properly the cash on hand could be considered negligent under 
subparagraph (B)(1) of the proposed amendment since it presented a 
substantial risk, which should have been known, of making a document 
prepared pursuant to the federal securities laws materially 
misleading.<SUP>32</SUP>
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    \31\ See In re Curtin, Exchange Act Rel. No. 32519 (June 28, 
1993), 54 SEC Docket 1137 (July 20, 1993).
    \32\ See also In re Valade, Exchange Act Rel. No. 4002 (May 19, 
1998), 1998 SEC LEXIS 966; In re Smith, Exchange Act Rel. No. 37738 
(Sept. 27, 1996), 62 SEC Docket 2840 (Oct. 29, 1996); In re Denton, 
Exchange Act Rel. No. 35381 (Feb. 15, 1995), 58 SEC Docket 2294 
(Mar. 14, 1995); In re Lamirato, Exchange Act Rel. No. 33660 (Feb. 
23, 1994), 56 SEC Docket 345 (Mar. 15, 1994).
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    Proposed subparagraph (B)(2) of the amendment would define improper 
professional conduct to include repeated, unreasonable violations of 
applicable professional standards that demonstrate that the accountant 
lacks competence. Repeated, unreasonable violations of the professional 
standards by an accountant can damage both the Commission's processes 
and investor confidence in the integrity of financial statements. This 
level of incompetence calls into question the reliability of any work 
performed by the accountant. Further, an accountant who engages in this 
type of misconduct may well benefit from remedial measures before 
resuming practice before the Commission. Repeated violations would 
include two or more violations that could occur within one audit 
<SUP>33</SUP> or in several audits.<SUP>34</SUP> Repeated violations 
also could include a course or pattern of violations regardless of 
whether the types of violations are similar.
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    \33\ See, e.g., In re Childers, Exchange Act Rel. No. 32505 
(June 24, 1993), 54 SEC Docket 1017 (July 13, 1993).
    \34\ See, e.g., In re Withers, Exchange Act Release No. 34537 
(Aug. 17, 1994), 57 SEC Docket 1101 (Sept. 13, 1994).
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C. The ``Good Faith'' Defense

    With respect to defenses to a Rule 102(e)(1)(ii) proceeding, the 
Commission has never considered the subjective good faith of an 
accountant to be an absolute defense.<SUP>35</SUP> Good faith actions 
of an accountant are more appropriately considered when determining 
what sanction would be appropriate. For instance, an accountant who 
acts in good faith, but is unable to conform to the minimum standards 
of the profession, may benefit from additional training, peer review, 
supervision and other appropriate remedial action undertaken while 
suspended from practicing before the Commission or as a condition of 
future practice before the Commission.
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    \35\ See In re Haskins & Sells, Accounting Series Rel. No. 73 
(Oct. 30, 1952), [1937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) 
para. 72,092 (June 30, 1982). Similarly, an auditor who is deceived 
by the client and commits an audit error in reliance upon the 
deception does not have an automatic defense. See generally In re 
Hope, Accounting and Auditing Enforcement Rel. No. 109A (Aug. 6, 
1986), 36 SEC Docket 663, 750-55 (Sept. 10, 1986). See also In re 
Ernst & Ernst, Accounting Series Rel. No. 248 (May 31, 1978), 14 SEC 
Docket 1276, 1301 and n.71 (June 13, 1978).
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D. The AICPA Rulemaking Petition

    The American Institute of Certified Public Accountants (``AICPA'') 
submitted a rulemaking petition to the Commission proposing a 
definition for ``improper professional conduct'' under Rule 
102(e)(1)(ii).<SUP>36</SUP> The AICPA Rulemaking Petition would define 
improper professional conduct in a manner that includes a knowing 
violation and a conscious and deliberate disregard of the professional 
standards, as well as a course or pattern of misconduct.<SUP>37</SUP> 
The Commission, like the AICPA, also is proposing that accountants who 
engage in knowing misconduct or a course or pattern of misconduct 
should be subject to Rule 102(e)(1)(ii) proceedings.
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    \36\ Rulemaking Petition by the AICPA Concerning Rule 102(e) 
(``AICPA Rulemaking Petition''), SEC File No. 4-410 (May 7, 1998).
    \37\ Under the AICPA Rulemaking Petition, before an accountant 
can be found to have engaged in ``improper professional conduct,'' 
the accountant also must pose a current threat to the integrity of 
the Commission's processes or to the financial reporting system. See 
also Task Force on Rule 102(e) Proceedings, American Bar 
Association, Report of the Task Force on Rule 102(e) Proceedings: 
Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 985 
(May 1997).
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    The Commission preliminarily believes that the public interest may 
be better served with the somewhat broader definition of ``improper 
professional conduct'' proposed in this release. While a harmless 
judgment error or immaterial mistake should not trigger a Rule 
102(e)(1)(ii) proceeding, reckless and specific negligent misconduct 
may require Commission action to protect the integrity of the 
Commission's processes and the interests of the investing public. 
Accordingly, the Commission has determined to seek comment on the 
proposed amendment contained in this release.

IV. General Request For Comments

    The Commission requests that any interested persons submit comments 
on the proposed amendment to Rule 102(e). The Commission also invites 
comments on the following specific issues.
    The proposed amendment is intended to clarify the definition of 
``improper professional conduct.'' Does the proposed amendment achieve 
this objective? This definition is consistent with how the Commission 
has applied the ``improper professional conduct'' standard. Would 
another definition of ``improper professional conduct'' be

[[Page 33308]]

better suited to achieving the Commission's goal of protecting the 
integrity of its processes? Does the proposed amendment include conduct 
that should not be considered ``improper professional conduct?'' If 
yes, what conduct should be excluded? Does the proposed amendment cover 
all of the conduct that should be considered ``improper professional 
conduct'' under Rule 102(e)(1)(ii)? If not, what else should be 
included? The proposed amendment defines ``improper professional 
conduct'' to include ``reckless'' conduct. Should the Commission use a 
definition of ``recklessness'' commonly used in cases brought under 
Rule 10b-5 of the Exchange Act? <SUP>38</SUP> Would a less rigorous 
standard of ``recklessness'' <SUP>39</SUP> be more appropriate in the 
context of a disciplinary rule such as Rule 102(e)(1)(ii) where the 
purpose of the rule is to protect the integrity of the Commission's 
processes?
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    \38\ See, e.g., Mansbach, SEC v. Steadman, 967 F.2d 636, 641-642 
(D.C. Cir. 1992) (both citing Sundstrand Corp. v. Sun Chemical 
Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875 
(1977)).
    \39\ See, e.g., Saba v. Compagnie Nationale Air France, 78 F.3d 
664, 668 (D.C. Cir. 1996), citing Farmer v. Brennan, 511 U.S. 825, 
836-37 (1994); see generally W. Keeton, et al., Prosser and Keeton 
on the Law of Torts (``Prosser''), sec. 34 at 213-214; (5th ed. 
1984); Restatement (Second) of Torts sec. 500, comment (a) (1965).
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    The proposed amendment defines ``improper professional conduct'' to 
include negligent conduct under two specified circumstances. In order 
to adequately protect the Commission's processes, should other 
circumstances be included?
    Does the term ``applicable professional standards'' provide 
adequate guidance to the accounting profession? What weight should be 
given to the good faith of an accountant at the sanctioning stage of a 
Rule 102(e)(1)(ii) proceeding?
    Any interested person wishing to submit written comments on any of 
the issues set forth in this release are invited to do so by submitting 
them in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and 
Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549. 
Comments also may be submitted electronically at the following e-mail 
address: <a href="/cdn-cgi/l/email-protection#e99b9c858cc48a8684848c879d9aa99a8c8ac78e869f"><span class="__cf_email__" data-cfemail="245651484109474b4949414a5057645741470a434b52">[email protected]</span></a>. All comment letters should refer to 
File No. S7-16-98 this file number should be included on the subject 
line if e-mail is used. Comments received will be available for public 
inspection and copying in the Commission's public reference room at 450 
Fifth Street, NW., Washington, DC 20549. Electronically submitted 
comment letters will be posted on the Commission's Internet Web site 
(http://www.sec.gov).

V. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') on the proposed amendment to Rule 102(e). The IRFA 
indicates that the proposed amendment would clarify the standard by 
which the Commission determines whether accountants have engaged in 
``improper professional conduct.''
    The IRFA sets forth the statutory authority for the proposed 
amendment. The IRFA also discusses the effect of the proposed amendment 
on small entities. The IRFA states that approximately 1000 accounting 
firms can or do appear or practice before the Commission. While most of 
this practice is conducted by the ``Big Six'' firms, which are not 
small entities, many smaller firms do practice before the Commission. 
However, the Commission does not collect information about revenues of 
accounting firms, which information generally is not made public by the 
firms, and therefore cannot determine how many of these are small 
entities for purposes of the analysis. In any event, the proposed 
amendment should have little or no impact on small entities because the 
proposal simply clarifies the Commission's standard for determining 
when accountants engage in ``improper professional conduct.''
    The IRFA states that the proposed amendment would not impose any 
new reporting, recordkeeping or compliance requirements, and the 
Commission believes that there are no rules that duplicate, overlap or 
conflict with the proposed amendment.
    The IRFA discusses the various alternatives considered to minimize 
the effect on small entities, including: (a) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources of small entities; (b) the clarification, 
consolidation or simplification of compliance and reporting 
requirements under the Rule for small entities; (c) the use of 
performance rather than design standards; and (d) an exemption from 
coverage of the Rule, or any part thereof, for small entities. The 
Commission believes it would be inconsistent with the purposes of the 
Rule to exempt small entities from the proposed amendment. Different 
compliance or reporting requirements for small entities are not 
necessary because the proposed amendment does not establish any new 
reporting, recordkeeping or compliance requirements. The proposed 
amendment is already designed to clarify the current standard employed 
in Rule 102(e)(1)(ii), and the Commission does not believe it is 
feasible to further clarify, consolidate or simplify the Rule for small 
entities. Finally, the proposal does use a performance standard, not a 
design standard, to specify what conduct is expected of accountants; 
the Commission does not believe different performance standards for 
small entities would be consistent with the purposes of the Rule.
    The IRFA solicits comments generally, and in particular, on the 
number of small entities that would be affected by the proposed 
amendment and the existence or nature of the effect. For purposes of 
the Small Business Regulatory Enforcement Fairness Act of 1996, 
<SUP>40</SUP> the Commission is also requesting information regarding 
the potential impact of the proposed amendment on the economy on an 
annual basis--in particular, whether the proposed amendment is likely 
to have an annual effect on the economy of $100 million or more. 
Commenters should provide empirical data to support their views.
---------------------------------------------------------------------------

    \40\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------

    A copy of the IRFA may be obtained by contacting David R. 
Fredrickson, Office of the General Counsel, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

VI. Cost-Benefit Analysis

    The Commission requests the views of commenters about any costs or 
benefits associated with the proposed amendment. The Commission 
anticipates several benefits from the amendment. The amendment will 
provide clearer guidance to accountants. Members of the accounting 
profession will better understand the standard the Commission uses to 
determine ``improper professional conduct'' and thus conduct themselves 
accordingly. Also, the clarifying amendment will make it easier for the 
Commission, its administrative law judges and the courts to administer 
the Rule, which will further benefit the integrity of the Commission's 
processes. The Commission anticipates no costs associated with the 
proposal.
    Section 23(a)(2) of the Exchange Act requires the Commission to 
consider the impact of its rules on competition. Moreover, section 2(b) 
of the Securities Act, section 3(f) of the Exchange Act and section 
2(c) of the Investment Company Act of 1940 (``Investment Company Act'') 
require the Commission, when engaged in

[[Page 33309]]

rulemaking that requires a public interest finding, to consider, in 
addition to the protection of investors, whether the action will 
promote efficiency, competition and capital formation. The Commission 
requests data on what effect, if any, the proposed amendment would have 
on efficiency, competition and capital formation.

VII. Statutory Authority

    The Commission is proposing the amendment to the Rule pursuant to 
its authority under section 19(a) of the Securities Act, section 23(a) 
of the Exchange Act, section 20(a) of the Public Utility Holding 
Company Act of 1935, section 319(a) of the Trust Indenture Act of 1939, 
section 211(a) of the Investment Advisers Act of 1940 and section 38(a) 
of the Investment Company Act.

Text of Amendment

List of Subjects in 17 CFR Part 201

    Administrative practice and procedure, Investigations, Securities.

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

PART 201--RULES OF PRACTICE

    1. The authority citation for Part 201, Subpart D continues to read 
as follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77h-1, 77j, 77s, 77u, 
78c(b), 78d-1, 78d-2, 78l, 78m, 78n, 78o(d), 78o-3, 78s, 78u-2, 78u-
3, 78v, 78w, 79c, 79s, 79t, 79z-5a, 77sss, 77ttt, 80a-8, 80a-9, 80a-
37, 80a-38, 80a-39, 80a-40, 80a-41, 80a-44, 80b-3, 80b-9, 80b-11, 
and 80b-12 unless otherwise noted.

    2. Amend Sec. 201.102 by adding paragraphs (e)(1)(iv) to read as 
follows:


Sec. 201.102  Appearance and practice before the Commission.

    (e) Suspension and disbarment.--(1) Generally. * * *
    (iv) With respect to persons licensed to practice as accountants, 
``improper professional conduct'' under Sec. 201.102(e)(1)(ii) means:
    (A) An intentional or knowing violation, including a reckless 
violation, of applicable professional standards; or
    (B) Negligent conduct in the following circumstances:
    (1) An unreasonable violation of applicable professional standards 
that presents a substantial risk, which is either known or should have 
been known, of making a document prepared pursuant to the federal 
securities laws materially misleading; or
    (2) Repeated, unreasonable violations of applicable professional 
standards that demonstrate that the accountant lacks competence.
* * * * *
    Dated: June 12, 1998.
    By the Commission.

Jonathan G. Katz,

Secretary.

Separate Statement of Commissioner Norman S. Johnson

    I write separately to address what I consider to be the plain 
import of the two decisions of the United States Court of Appeals for 
the District of Columbia Circuit in Checkosky v. SEC, 23 F.3d 452 (D.C. 
Cir. 1994) (Checkosky I), and Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 
1998) (Checkosky II). <SUP>1</SUP> In today's release, the Commission 
proposes to adopt a negligence standard under Rule 102(e) of our Rules 
of Practice, a matter of crucial importance to the accountants who 
practice before us. <SUP>2</SUP> As Judge Randolph observed:

    \1\ The weight the Commission must attach to the views of the 
D.C. Circuit cannot be overstated. Under the jurisdictional 
provisions of the securities laws, every respondent in a Commission 
administrative proceeding has the option of appealing an adverse 
outcome to the D.C. Circuit. See, e.g., 15 U.S.C. 77i(a) & 
78y(a)(1).
    \2\ Rule 102(e) was formerly designated Rule 2(e). There are no 
substantive differences between the two rules.
---------------------------------------------------------------------------

    A proceeding under Rule 2(e) threatens ``to deprive a person of 
a way of life to which he has devoted years of preparation and on 
which he and his family have come to rely.'' Henry J. Friendly, 
``Some Kind of Hearing,'' 123 U. Pa. L. Rev. 1267, 1297 (1975). It 
is of little comfort to an auditor defending against such charges 
that the Commission's authority is limited to suspending him from 
agency practice. For many public accountants such work represents 
their entire livelihood. Moreover, when one jurisdiction suspends a 
professional it can start a chain reaction.

Checkosky I, 23 F.3d at 479 (opinion of Randolph, J.).
    With all due respect to my esteemed colleagues, today's release 
reflects precisely the same sort of overly aggressive approach that led 
to the Commission's two stinging defeats in Checkosky. The consequences 
of overreaching in this area might well be severe. If the Commission 
selects an insupportable standard many of the worst offenders of Rule 
102(e) may escape sanction altogether. Prudence would seem to dictate a 
much more cautious approach than that taken in today's release.
    Because I believe that the Commission lacks the authority to adopt 
a negligence standard, I must dissent. See Checkosky I, 23 F.3d 452; 
Checkosky II, 139 F.3d 221. Even apart from the Checkosky decisions, 
adoption of a negligence standard would contravene public policy.
    Some background is in order.

I.

    Respondents in Checkosky were two accountants who audited the 
financial statements of Savin Corporation in the early 1980's. The 
Commission brought charges against the accountants in 1987, and in 1992 
affirmed an Administrative Law Judge's decision finding violations of 
Rule 102(e). See David J. Checkosky, Release No. 34-31094, 1992 SEC 
LEXIS 2111 (Aug. 26, 1992). In its first opinion, the Commission found 
that Savin's financial statements were false in that the company 
improperly capitalized certain expenses for research and development 
rather than recording them in their entirety as expenses in the years 
incurred. Id. These violations were based on finding that the auditors, 
in violation of Generally Accepted Auditing Standards (GAAS), had 
improperly permitted Savin to capitalize these expenditures and falsely 
certified that Savin's financial statements set forth its financial 
condition in accordance with Generally Accepted Accounting Principles 
(GAAP). <SUP>3</SUP> Id.
---------------------------------------------------------------------------

    \3\ Commissioner Roberts concurred in the majority's finding 
that respondents violated GAAS and had misapplied GAAP, but 
dissented from the finding that these errors amounted to ``improper 
professional conduct'' under Rule 102(e)(1)(ii). 1992 SEC LEXIS 
2111, at *47. In Commissioner Roberts' view respondents' conduct did 
not provide a sufficient basis for a finding that they would 
threaten the Commission's processes. Id. at *48.
---------------------------------------------------------------------------

    In Checkosky I, the D.C. Circuit remanded the case because it was 
unable to discern from the Commission's opinion the basis for the 
Commission's action other than the finding that the accountants had 
violated GAAS and falsely certified that the financial statements set 
forth the financial condition of the company in accordance with GAAP. 
23 F.3rd at 454. The Court held that the Commission was authorized to 
promulgate Rule 102(e) as a means to protect the integrity of its 
processes, but each of the three judges (Judges Silberman, Randolph and 
a district court judge sitting by designation, Judge Reynolds) issued a 
separate opinion.
    Judges Silberman and Randolph both questioned the Commission's 
ability to impose sanctions under Rule 102(e) for misconduct not rising 
to the level of scienter, i.e., misconduct that is only negligent. 
<SUP>4</SUP> Judge Silberman explained that:

    \4\ Senior District Judge Reynolds disagreed with the circuit 
judges' conclusion that ``improper professional conduct'' under Rule 
102(e)(1)(ii) required proof of scienter. 23 F.3d at 493-95.

---------------------------------------------------------------------------

[[Page 33310]]

    If the purpose of Rule 2(e) is to protect the integrity of 
administrative processes, then sanctions for improper professional 
conduct under 2(e)(1)(ii) are permissible only to the extent that 
they prevent the disruption of proceedings. Punishment for mere 
negligence, so the argument goes, extends beyond this realm of 
protective discipline into general regulatory authority over a 
---------------------------------------------------------------------------
professional's work.

23 F.3d at 456. Judge Silberman further suggested that the Commission 
could not legitimately adopt a negligence standard under Rule 102(e) 
because that might amount to ``a de facto substantive regulation of the 
profession.'' 23 F.3d at 459; see also 23 F.3d 460 (suggestion that 
Commission adoption of negligence standard might be arbitrary and 
capricious).
    Judge Randolph also questioned the Commission's ability to adopt a 
negligence standard. In Judge Randolph's view, the ``Commission's 
authority under Rule 2(e) must rest on and be derived from the statutes 
it administers,'' such as Section 10(b) of the Exchange Act that 
requires scienter. See 23 F.3d at 466-69. Judge Randolph also 
extensively discussed an earlier Commission decision that rejected a 
negligence standard under Rule 102(e) in a case involving lawyers, 
William R. Carter, 47 S.E.C. 471 (1981). See 23 F.3d at 480-87. In 
Judge Randolph's view, the reasoning of Carter was equally applicable 
to accountants, and precluded the Commission from adopting a negligence 
standard under Rule 102(e). See 23 F.3d at 483-87.
    On remand, the Commission's majority opinion did not directly 
address the mental state question posed by the Court. David J. 
Checkosky, Release No. 34-38183, 1997 SEC LEXIS 137 (Jan. 21, 1997). 
While the majority found that the accountants had behaved recklessly, 
it insisted that any deviation from GAAP or GAAS, including purely 
negligent deviations, could violate Rule 102(e), and that the 
accountants' recklessness was relevant only to the choice of sanctions. 
Id. I dissented from the Commission's second Checkosky opinion because 
of my belief that ``improper professional conduct'' requires proof of 
scienter, which includes recklessness.<SUP>5</SUP> 1997 SEC LEXIS 137, 
at *48.
---------------------------------------------------------------------------

    \5\ See Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 
1045 (7th Cir. 1977) (defining recklessness as ```highly 
unreasonable''' conduct involving ```an extreme departure from the 
standards of ordinary care'''); see also, e.g., Mansbach v. 
Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979) 
(following Sundstrand).
---------------------------------------------------------------------------

    On appeal in Checkosky II, the D.C. Circuit again reversed. The 
Court again found that the Commission had again failed to offer an 
adequate explanation of its interpretation of Rule 102(e). 139 F.3d at 
222 (referring to the ``multiplicity of inconsistent interpretations'' 
in the Commission's opinion). Because of the Commission's ``persistent 
failure to explain itself'' and ``the extraordinary duration of these 
proceedings,'' the Court declined to give the Commission a third chance 
to explain itself, and instead invoked the extremely rare remedy of 
remanding the case with instructions to dismiss. 139 F.3d at 222 & 227.
    More importantly for today's release, the D.C. Circuit in Checkosky 
II again questioned the Commission's ability to adopt a negligence 
standard under Rule 102(e)(1)(ii). 139 F.3d at 225. The Court appeared 
to reaffirm its previous statements about the limits of the 
Commission's authority in disciplining securities professionals subject 
to Rule 102(e), remarking that ``adoption of a negligence standard 
might be ultra vires'' because it might amount to ``a back-door 
expansion of [the Commission's] regulatory oversight powers.'' Id. 
(citing Checkosky I, 23 F.3d at 459).<SUP>6</SUP>
---------------------------------------------------------------------------

    \6\ This point is made clear by the concurring opinion, in which 
Judge Henderson expressly disagreed with the majority's discussion 
of this issue. See 139 F.3d at 227.
---------------------------------------------------------------------------

II.

    As explained above, the Checkosky opinions preclude us, as a 
practical matter, from adopting a negligence standard. Even were the 
situation otherwise, public policy considerations also call for 
rejection of a negligence standard. See, e.g., David J. Checkosky, 
Release No. 34-38183, 1997 SEC LEXIS 137, at *48 (Jan. 21, 1997) 
(dissenting opinion of Commission Johnson). In my view, ``improper 
professional conduct'' in Rule 102(e)(1)(ii) requires proof of 
scienter.
    Our system of securities regulation is based on disclosure. To 
ensure that Commission filings and other statements made to the 
investing public are truthful and accurate, we have to rely in large 
part on the work of talented, well-trained professionals. Accordingly, 
I fully agree with former Chairman Williams' statement that we would be 
unable to administer effectively the securities laws if those 
``involved in the capital raising process were not routinely served by 
professionals of the highest integrity and competence, well-versed in 
the requirements of the statutory scheme Congress has created.'' 
Keating, Muething & Klekamp, 47 S.E.C 95, 120 (1979) (concurring 
opinion of Chairman Williams); see also Touche, Ross & Co. v. SEC, 609 
F.2d 570, 580-81 (2d Cir. 1979) (because of limited resources, ``the 
Commission necessarily must rely heavily on both the accounting and 
legal professions to perform their tasks diligently and responsibly''). 
On the other hand, I also believe that the Commission has a limited 
mandate under Rule 102(e) for determining who may ``practice'' before 
us, and that we must exercise a high degree of self-restraint in this 
area.
    As to accountants, the very nature of their responsibilities within 
our disclosure system mandates restraint. Accountants, like other 
securities professionals subject to Rule 102(e), must make difficult 
judgment calls, navigating through complex statutory and regulatory 
requirements. In addition, accountants are required to follow GAAS and 
to apply GAAP. These determinations demand the application of 
independent professional judgment and often involve matters of first 
impression.
    The Commission itself recognized the importance of these principles 
in Carter, when it asserted that, in order to assure the exercise of a 
professional's ``best independent judgment,'' the professional ``must 
have the freedom to make innocent--or even, in certain cases, 
careless--mistakes without fear of (losing) the ability to practice 
before'' us. 47 S.E.C. at 504. Equating negligence with ``improper 
professional conduct'' will impair relationships between professionals 
and their clients. If such an adverse impact occurs, our ability to 
rely on these professionals to enhance compliance with the securities 
laws will be crippled. I share the view endorsed by the Commission in 
Carter that professionals ``motivated by fears for their personal 
liability will not be consulted on difficult issues.'' Id.
    Securities professionals owe a duty to serve the interests of their 
clients. To discharge this duty, professionals must enjoy the 
cooperation and trust of their clients. Indeed, in construing Carter, 
Judge Randolph observed:

    (W)ithout a scienter requirement, lawyers would slant their 
advice out of fear of incurring liability, and management therefore 
would not consult them on difficult questions. I cannot see why this 
sort of reasoning would not apply as well to auditors. I recognize 
that although companies need not retain outside counsel, they are 
legally compelled to ``consult'' independent accountants * * * . 
This creates an obligation on the part of management to cooperate 
with and provide information to the auditor. * * * There are, 
however, degrees of cooperation. Encouraging management to be 
completely candid with its

[[Page 33311]]

auditor about difficult accounting issues may be just as desirable 
as encouraging management to consult candidly with outside lawyers, 
and for similar reasons.

Checkosky I, 23 F.3d at 485.
    Accountants and attorneys are members of ``ancient professions,'' 
regulated according to rigorous ethical rules enforced by professional 
societies and, in the case of accountants, state licensing boards. I 
simply do not believe that we should recast negligent violations of an 
accounting standard as improper professional conduct under the 
Commission's Rules of Practice. That is not an appropriate role for 
this Commission. Difficult ethical and professional responsibility 
concerns are generally matters most appropriately dealt with by 
professional organizations or, in certain cases, malpractice 
litigation. Nor do I believe that mere misjudgments or negligence 
establishes either professional incompetence warranting Commission 
disciplinary action or the likelihood of future danger to the 
Commission's processes.
* * * * *
    For all these reasons, I believe that the Commission lacks the 
authority to adopt a negligence standard under Rule 102(e). Likewise, 
the Commission may only hold a professional liable for ``improper 
professional conduct'' only if scienter is proven. I urge accountants 
and trade groups directly subject to Rule 102(e), as well as any others 
who have an interest in Rule 102(e), to submit their views on this 
important matter. It is my most fervent hope that the Commission 
receives an abundance of comment letters responding to this release.
[FR Doc. 98-16251 Filed 6-17-98; 8:45 am]
BILLING CODE 8010-01-P


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