[Federal Register Volume 89, Number 127 (Tuesday, July 2, 2024)]
[Notices]
[Pages 54895-54922]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2024-14487]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-100429; File No. PCAOB-2024-04]
Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Amendment to PCAOB Rule 3502 Governing Contributory
Liability
June 26, 2024.
Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002
(``Sarbanes-Oxley'' or the ``Act''), notice is hereby given that on
June 20, 2024, the Public Company Accounting Oversight Board (the
``Board'' or the ``PCAOB'') filed with the Securities and Exchange
Commission (the ``Commission'') the proposed rules described in items I
and II below, which items have been prepared by the Board. The
Commission is publishing this notice to solicit comments on the
proposed rules from interested persons.
I. Board's Statement of the Terms of Substance of the Proposed Rules
On June 12, 2024, the Board adopted an amendment to PCAOB Rule
3502, Responsibility Not to Knowingly or Recklessly Contribute to
Violations (collectively, the ``proposed rules''). The text of the
proposed rules appears in Exhibit A to the SEC Filing Form 19b-4 and is
available on the Board's website at https://pcaobus.org/about/rules-rulemaking/rulemaking-dockets/docket-053 and at the Commission's Public
Reference Room.
II. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
In its filing with the Commission, the Board included statements
concerning the purpose of, and basis for, the proposed rules and
discussed any comments it received on the proposed rules. The text of
these statements may be examined at the places specified in Item IV
below. The Board has prepared summaries, set forth in sections A, B,
and C below, of the most significant aspects of such statements. In
addition, to the extent that Section 103(a)(3)(C) of the Act applies to
the proposed rules, the Board is requesting that the Commission approve
the proposed rules, pursuant to that provision, for application to
audits of emerging growth companies (``EGCs''), as that term is defined
in Section 3(a)(80) of the Securities Exchange Act of 1934 (``Exchange
Act''). The Board's request is set forth in section D.
A. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
(a) Purpose
Congress authorized the Board to promulgate rules and standards to
govern auditor conduct.\1\ To that end, in 2005, the Board codified
auditors' longstanding ethical obligation not to contribute to firms'
violations in PCAOB Rule 3502, Responsibility Not to Knowingly or
Recklessly Contribute to Violations.\2\ For well over a decade now, the
Board has brought enforcement proceedings against associated persons
pursuant to Rule 3502.
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\1\ See Section 103(a)(1) of Sarbanes-Oxley; see also, e.g., id.
101(c)(2), (c)(4), (c)(6) & (g)(1).
\2\ Ethics and Independence Rules Concerning Independence, Tax
Services, and Contingent Fees, PCAOB Release No. 2005-014, at 9
(July 26, 2005), available at https://pcaobus.org/Rulemaking/Docket017/2005-07-26_Release_2005-014.pdf (``The Board proposed
[Rule 3502] to codify the ethical obligation of associated persons
of registered firms not to cause registered firms to commit [ ]
violations.'').
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Yet Rule 3502's current formulation contains an incongruity that
places negligent contributors to firms' violations beyond the rule's
reach. That incongruity stems from the notion that registered firms,
like any legal entity, can act only through natural persons. It
logically follows that when a registered firm is found to have acted
negligently, it is likely that such negligence is attributable to at
least one natural person's negligence.
Rule 3502, however, at present requires a level of culpability
higher than negligence--at least recklessness--before the Board can
impose sanctions against associated persons who directly and
substantially contribute to firms' negligence-based violations. Put
another way, Rule 3502 requires a showing of more than negligence by
individuals for the Board to sanction them for conduct resulting in
negligence by firms. Thus, under current Rule 3502, associated persons
who do not exercise reasonable care and contribute to firms' violations
may escape liability and accountability--even while the firms
committing the violations do not. The Board believes that amending Rule
3502 addresses this incongruity, and therefore better protects
investors and promotes quality audits.
(b) Statutory Basis
The statutory basis for the proposed rules is Title I of the Act.
B. Board's Statement on Burden on Competition
Not applicable. The Board's consideration of the economic impacts
of the proposed rules is discussed in section D below.
C. Board's Statement on Comments on the Proposed Rules Received From
Members, Participants or Others
The Board released the proposed rule amendment for public comment
in PCAOB Release No. 2023-007 (September 19, 2023). The Board received
28 written comment letters; one comment letter was subsequently
withdrawn. The Board has carefully considered all comments received.
The Board's response to the comments it received and the changes made
to the rules in response to the comments received are discussed below.
Introduction
In the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley'' or the
``Act''), Congress established the Board in the wake of a series of
high-profile corporate collapses that laid bare auditor misconduct and
the need for a new type of oversight of the public accounting
industry.\3\ As part of its
[[Page 54896]]
comprehensive, multipronged approach to such oversight, Congress
authorized the Board to investigate, bring charges against, and
sanction (when appropriate) registered public accounting firms and
associated persons \4\ thereof for violations of the laws, rules, and
standards that Congress charged the Board with enforcing.\5\ That
enforcement authority covers a wide array of auditor conduct, including
negligent conduct.
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\3\ Public Law 107-204, 15 U.S.C. 7201 et seq.; see S. Rep. No.
107-205, at 3 (2002) (``The purpose of [Sarbanes-Oxley] is to
address the systemic and structural weaknesses affecting our capital
markets which were revealed by repeated failures of audit
effectiveness and corporate financial and broker-dealer
responsibility in recent months and years.''). As the Senate Report
notes, ``the frequency of financial restatements by public companies
ha[d] dramatically increased'' in the run up to the passage of
Sarbanes-Oxley. S. Rep. No. 107-205, at 15; see id. (``From 1990-97,
the number of public company financial restatements averaged 49 per
year, but jumped to an average of 150 per year in 1999 and 2000.'').
\4\ An associated person is ``any individual proprietor,
partner, shareholder, principal, accountant, or professional
employee of a public accounting firm, or any independent contractor
or entity that, in connection with the preparation or issuance of
any audit report . . . (1) shares in the profits of, or receives
compensation in any other form from, that firm; or (2) participates
as agent or otherwise on behalf of such accounting firm in any
activity of that firm.'' PCAOB Rule 1001(p)(i). The definition of an
``associated person'' does not include persons engaged only in
clerical or ministerial tasks. See id.
\5\ See Sections 105(b) & (c) of Sarbanes-Oxley.
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Congress also authorized the Board to promulgate rules and
standards to govern auditor conduct.\6\ To that end, in 2005, the Board
codified auditors' longstanding ethical obligation not to contribute to
firms' violations in PCAOB Rule 3502, Responsibility Not to Knowingly
or Recklessly Contribute to Violations.\7\ For well over a decade now,
the Board has brought enforcement proceedings against associated
persons pursuant to Rule 3502.
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\6\ See id. 103(a)(1); see also, e.g., id. 101(c)(2), (c)(4),
(c)(6) & (g)(1).
\7\ Ethics and Independence Rules Concerning Independence, Tax
Services, and Contingent Fees, PCAOB Release No. 2005-014, at 9
(July 26, 2005) (``2005 Adopting Release''), available at https://pcaobus.org/Rulemaking/Docket017/2005-07-26_Release_2005-014.pdf
(``The Board proposed [Rule 3502] to codify the ethical obligation
of associated persons of registered firms not to cause registered
firms to commit [ ] violations.'').
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Yet Rule 3502's current formulation contains an incongruity that
places negligent contributors to firms' violations beyond the rule's
reach. That incongruity stems from the notion that registered firms,
like any legal entity, can act only through natural persons. It
logically follows that when a registered firm is found to have acted
negligently, it is likely that such negligence is attributable to at
least one natural person's negligence.
Rule 3502, however, at present requires a level of culpability
higher than negligence--at least recklessness--before the Board can
impose sanctions against associated persons who directly and
substantially contribute to firms' negligence-based violations. Put
another way, Rule 3502 requires a showing of more than negligence by
individuals \8\ for the Board to sanction them for conduct resulting in
negligence by firms. Thus, under current Rule 3502, associated persons
who do not exercise reasonable care and contribute to firms' violations
may escape liability and accountability--even while the firms
committing the violations do not. The Board believes that amending Rule
3502 addresses this incongruity, and therefore better protects
investors and promotes quality audits.
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\8\ For ease of reference, this release sometimes refers to
associated persons who are the contributory actors for purposes of
Rule 3502 as ``persons'' or ``individuals.'' The Board notes,
however, that both natural persons and entities can be associated
persons, and therefore Rule 3502 charges can be brought against both
natural persons and entities, consistent with the meaning of the
term ``person associated with a registered public accounting firm.''
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Accordingly, following notice and comment, the Board has amended
Rule 3502 by changing from recklessness to negligence the liability
standard for associated persons' contributory conduct. As explained in
greater detail below, the Board believes, based on its experience and
having considered the comments received, that the amendment better
aligns Rule 3502 with the scope of the Board's enforcement authority
under Sarbanes-Oxley, thus further advancing the Board's mission of
investor protection.
Rulemaking History
On September 19, 2023, the Board proposed to amend Rule 3502 in two
ways: (1) by changing from recklessness to negligence the standard of
conduct for associated persons' contributory liability and (2) by
providing that, to be charged with violating Rule 3502, an associated
person contributing to a registered firm's violation need not be an
associated person of the firm that commits the primary violation (i.e.,
that an associated person of one registered firm can contribute to a
primary violation of another registered firm).\9\ The Board received 28
comment letters on the Proposal from commenters across a range of
affiliations.\10\ In general, commenters recognized the importance of
an effective PCAOB enforcement program and in holding individuals
accountable when there are violations of applicable laws, rules, and
professional standards. The final rule amendment--which, as detailed
below, does not include the second aspect of the Proposal--is informed
by the comments received on the Proposal, which are discussed
throughout this release.
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\9\ Proposed Amendments to PCAOB Rule 3502 Governing
Contributory Liability, PCAOB Release No. 2023-007 (Sept. 19, 2023)
(``2023 Proposing Release'' or the ``Proposal''), available at
https://assets.pcaobus.org/pcaob-dev/docs/default-source/rulemaking/053/pcaob-release-no.-2023-007-rule-3502-proposal.?=7d49cc51_9.
\10\ Comment letters on the Proposal, as well as a staff white
paper regarding characteristics of emerging growth companies, are
available on the Board's website in Rulemaking Docket No. 053,
available at https://pcaobus.org/about/rules-rulemaking/rulemaking-dockets/docket-053/letters. One of the comment letters was
withdrawn.
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Background
PCAOB Rule 3502 codifies associated persons' ethical obligation not
to contribute to a registered firm's violations of the laws, rules, and
standards that the Board is charged with enforcing. The rule provides
grounds for secondary liability when an associated person of a
registered firm acts at least recklessly to directly and substantially
contribute to such a violation. Although the rule as adopted in 2005
incorporated a recklessness standard, the rule as proposed in 2004
required that individuals only negligently contribute to a firm's
violation to be subject to liability.\11\ Whereas negligence ``is the
failure to exercise reasonable care or competence,'' \12\ recklessness
requires ``an extreme departure from the standard of ordinary care''
that ``presents a danger to investors or to the markets that is either
known to the (actor) or is so obvious that the actor must have been
aware of it.'' \13\ Indeed, Sarbanes-Oxley characterizes ``reckless
conduct'' as a subset of ``intentional or knowing conduct,'' \14\
whereas negligence is an ``objective'' standard that is not measured by
``the intent of the accountant.'' \15\
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\11\ See Proposed Ethics and Independence Rules Concerning
Independence, Tax Services, and Contingent Fees, PCAOB Release No.
2004-015, at 18 & n.40 (Dec. 14, 2004) (``2004 Proposing Release''),
available at https://pcaobus.org/Rulemaking/Docket017/2004-12-14_Release_2004-015.pdf.
\12\ In re SW Hatfield, C.P.A., SEC Release No. 34-69930, at 35
n.169 (July 3, 2013) (citation and quotation marks omitted).
\13\ Id. at 29 (citation and quotation marks omitted); see also
Marrie v. SEC, 374 F.3d 1196, 1204 (D.C. Cir. 2004); 2005 Adopting
Release at 13 (``[T]he phrase `knew, or was reckless in not knowing'
is a well-understood legal concept, and the Board intends for the
phrase to be given its normal meaning.'').
\14\ See Section 105(c)(5)(A) of Sarbanes-Oxley.
\15\ In re Melissa K. Koeppel, CPA, PCAOB File No. 105-2011-007,
at 166 (Dec. 29, 2017) (quoting In re Kevin Hall, CPA, SEC Release
No. 34-61162, at 12 (Dec. 14, 2009) (quotation marks omitted)).
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The Board has adopted negligence as the liability standard for
actionable contributory conduct under Rule 3502.
[[Page 54897]]
And for good reason: A negligence standard is appropriate based on the
Board's extensive experience with Rule 3502 since the rule's adoption
nearly two decades ago, it closes a gap in the PCAOB's regulatory
framework that can lead to anomalous results, and it advances certain
objectives in the Board's 2022-2026 Strategic Plan in furtherance of
the Board's overall mission.
In the first subsection below, the Board reviews the Board's 2004
proposal and 2005 adoption of Rule 3502. Then, the Board details the
reasons for the amendment the Board has adopted to modernize and
strengthen the rule.
A. History of Rule 3502
As part of a package of proposed ethics and independence rules, the
Board proposed PCAOB Rule 3502 in 2004.\16\ In issuing the proposal,
the Board observed that ``[w]hile certain types of violations, by their
nature, may give rise to direct liability only for a registered public
accounting firm, the firm's associated persons bear an ethical
obligation not to be a cause of any violations by the firm.'' \17\
Accordingly, through Rule 3502, the Board sought to ``codify that
obligation'' and ``make it clear that the obligation is enforceable by
the Board.'' \18\ Using language ``intended to articulate a negligence
standard,'' the proposed version of Rule 3502 subjected associated
persons to potential contributory liability if they ``knew or should
have known'' that an act or omission by them would contribute to a
firm's primary violation.\19\
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\16\ See generally 2004 Proposing Release at 18-19. As
originally proposed (and adopted), Rule 3502 was entitled
Responsibility Not to Cause Violations. See id. at A-4; 2005
Adopting Release at A-5. Shortly after adoption, however, the Board
changed the title of the rule to its current title, Responsibility
Not to Knowingly or Recklessly Contribute to Violations. The Board
made the change ``[a]fter discussions with the SEC'' and ``to avoid
any misperception that the rule affects the interpretation of any
provision of the federal securities laws.'' Ethics and Independence
Rules Concerning Independence, Tax Services, and Contingent Fees,
PCAOB Release No. 2005-020, at 2 (Nov. 22, 2005), available at
https://pcaob-assets.azureedge.net/pcaob-dev/docs/default-source/rulemaking/docket017/2005-11-22_release_-020.pdf?sfvrsn=69338fcd_0.
In so doing, however, the Board clarified that ``[t]he rule, as
amended, should be interpreted and understood to be the same as the
rule adopted by the Board.'' Id.
\17\ 2004 Proposing Release at 18.
\18\ Id.
\19\ Id. at 18 n.40; see id. at A-4 (proposed rule text).
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Following a public comment period,\20\ the Board adopted Rule 3502
with two modifications from the proposal. First, while affirming its
authority to promulgate a negligence-based ethics rule prohibiting
contributory conduct,\21\ the Board revised the liability standard from
negligence to recklessness, which the Board at that time believed would
``strike[ ] the right balance in the context of th[e] rule.'' \22\
Second, the Board modified ``contribute''--the verb that describes the
connection between the associated person's conduct and the firm's
primary violation--by adding the words ``directly and substantially.''
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\20\ ``Several commenters supported the rule as proposed and
noted that they saw the rule as essential to the Board's ability to
carry out its disciplinary responsibilities under the Act,'' 2005
Adopting Release at 9, while others did not fully endorse it. Their
objections were based principally on the view that negligence might
be an ill-suited liability standard ``in light of the complex
regulatory requirements with which auditors must comply'' and out of
concern that such standard ``would allow the Board, or the SEC, to
proceed against associated persons who in good faith, albeit
negligently, have caused a registered firm to violate applicable
laws or standards.'' Id. at 9, 13. Certain commenters ``also
questioned the Board's authority to adopt the proposed rule, or at
least the proposed rule with a negligence standard.'' Id. at 9.
\21\ See id. at 12 n.23.
\22\ 2005 Adopting Release at 13; see id. at 12 & n.23.
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The latter modification was made due to commenters expressing
concern that, because of the collaborative nature of accounting work,
each individual involved in formulating a decision or other action that
ultimately leads to a firm violation could be held liable for causing
the violation.\23\ The Board explained that the addition of
``directly'' means, among other things, that an associated person's
conduct must ``either essentially constitute[ ] the [firm's]
violation'' or be ``a reasonably proximate facilitating event of, or a
reasonably proximate stimulus for, the violation.'' But, the Board
clarified, ``directly'' does not place outside the scope of Rule 3502
contributory conduct ``just because others also contributed to the
violation, or because others could have stopped the violation and did
not.'' ``Substantially,'' the Board explained, means that an associated
person's conduct must ``contribute[ ] to [a] violation in a material or
significant way,'' though it need not be ``the sole cause of the
violation.'' \24\
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\23\ See id. at 9, 13.
\24\ Id. at 13.
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B. Reasons for the Amendment
As the Board previously recognized, when an associated person
causes a firm to commit a violation, such conduct ``operates to the
detriment of the protection of investors.'' \25\ The following
subsections explain why the modification to Rule 3502 is appropriate in
furtherance of the Board's mission to protect the interests of
investors and further the public interest in the preparation of
informative, accurate, and independent audit reports.
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\25\ 2005 Adopting Release at 10.
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1. Aligning Rule 3502 With the Board's Enforcement Authority
As the Board previously has explained, a registered firm ``can only
act through the natural persons who serve as its agents, including its
associated persons.'' \26\ Accordingly, ``a natural person's actions
may render both the [firm] primarily liable and the natural person
secondarily liable.'' \27\ Yet under the current formulation of Rule
3502, an incongruity exists between the respective requisite mental
states for liability of a registered firm resulting from an associated
person's conduct and for liability of the associated person: A firm can
commit a primary violation of certain laws, rules, or standards by
acting negligently, but an associated person who directly and
substantially contributed to that violation must have acted at least
recklessly to be secondarily liable.
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\26\ 2004 Proposing Release at 18; see 2005 Adopting Release at
12 (``[Registered] firms . . . can only act through the natural
persons that comprise them, many of whom are `associated persons'
subject to the Board's ethics standards and disciplinary
authority.''). Indeed, as one commenter on the Proposal put it, a
firm is the sum of its parts.
\27\ In re Timothy S. Dembski, SEC Release No. 34-80306, at 13-
14 n.35 (Mar. 24, 2017) (quoting SEC v. Koenig, 2007 WL 1074901, at
*7 (N.D. Ill. Apr. 5, 2007)).
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This incongruity means that associated persons may have weaker
incentives to exercise the appropriate level of care in their audit
work. They may not exercise reasonable care (the standard for
negligence) if they know that they cannot be held individually liable
by the PCAOB for a firm's primary violation unless an act or omission
by them amounts to an ``an extreme departure from the standard of
ordinary care for auditors'' (the standard for recklessness).\28\ The
modification to Rule 3502's liability standard from recklessness to
negligence closes this regulatory gap, which should incentivize
associated persons to be more deliberate and careful in their
[[Page 54898]]
actions. Indeed, ``accountability frequently improves outcomes.'' \29\
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\28\ Marrie, 374 F.3d at 1204; see Russell G. Pierce & Eli Wald,
The Relational Infrastructure of Law Firm Culture and Regulation, 42
Hofstra L. Rev. 109, 129 (2013) (explaining how rules from the legal
industry's governing body that would restrict lawyers' limited
liability ``will encourage lawyers to devote more energy to
maintaining the quality of the firm because they could potentially
face personal liability for poor quality services''); see also
Colleen Honigsberg, The Case for Individual Audit Partner
Accountability, 72 Vand. L. Rev. 1871, 1885 (2019) (arguing that
``existing deterrence mechanisms have failed to produce optimal
audit quality'' and ``are ineffective'').
\29\ Honigsberg, supra, at 1902.
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Numerous commenters agreed with the Board's regulatory concerns
noted above. These commenters generally noted that the Board's concerns
were valid and clear, and that a negligence standard would better align
Rule 3502 with the scope of the Board's enforcement authority under
Sarbanes-Oxley and provide a tool to eliminate incongruous results in
liability between individuals and firms. Indeed, one commenter
characterized the difference between negligence and recklessness as
``substantial'' and ``consequential'' and noted that the current gap in
liability standards directly impacts the Board's ability to fulfill its
statutory mission.\30\
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\30\ Comment Letter from Better Markets at 3 (Nov. 3, 2023).
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Another commenter remarked that a negligence standard will enable
the PCAOB and the U.S. Securities and Exchange Commission (SEC or
``Commission'') to more efficiently and effectively pursue enforcement
cases regardless of which entity has the resources to bring the case.
Commenters also stated that a negligence standard would appropriately
align Rule 3502's liability threshold with the standard of care that
auditors currently should be exercising when performing their
professional responsibilities and that both the Commission and civil
plaintiffs in private litigation currently can pursue cases against
auditors for negligence. In encouraging the PCAOB to adopt the
Proposal, one commenter further noted that the change to negligence
would bolster investors' expectations that accountants will be
independent and diligent in their audit work.
Other commenters, however, believed that the Proposal did not
present a sufficient rationale for moving to a negligence standard
after the Board previously declined to do so in 2005. These commenters
opined that the same concerns about a negligence standard that existed
in 2005 exist today and questioned whether there were significant
enough developments to merit the change.\31\ Indeed, certain commenters
acknowledged the incongruity discussed in the Proposal but contended
either that it is not significant or problematic, that it is not an
impediment to enforcement, or that closing the gap in liability
standards would not change auditor conduct.\32\ One commenter stated
explicitly that no incongruity or gap exists.
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\31\ In support of such assertion, one commenter cited F.C.C. v.
Fox Television Stations, Inc., 556 U.S. 502 (2009). The rationale
articulated in the Proposal and this adopting release, however, more
than satisfies Fox's criteria for a conscious change in policy. See
id. at 515 (``[I]t suffices that the new policy is permissible under
the statute, that there are good reasons for it, and that the agency
believes it to be better, which the conscious change of course
adequately indicates.''). As to auditors' reliance on the standard
in the current rule, as in Fox, the Board is not ``punishing
[auditors] without notice of the potential consequences of their
action.'' Id. at 518. That is so because the adoption of a
negligence standard, by itself, does not impose any civil money
penalty or other sanction; rather, sanctions are available only if
Rule 3502 is violated after the amended rule becomes effective.
\32\ One commenter stated that the Proposal failed to articulate
how the change to negligence would align Rule 3502 with Sarbanes-
Oxley and questioned whether there were cases where the current
recklessness standard did not suffice to hold persons accountable.
The Proposal, however, made both of these points clear. See 2023
Proposing Release at 7 (describing the current misalignment with
Sarbanes-Oxley); id. at 24-25 (discussing estimated cases in 2022).
That commenter and one other also noted that the PCAOB has been able
to assess significant penalties under the current Rule 3502
formulation and that the Board's disciplinary proceedings have
resulted in collateral consequences for firms and individuals. While
that may be the case, the Board did not adopt a negligence standard
for the purpose of facilitating an increase in penalties; rather, as
the Proposal explained, the Board proposed--and has adopted--a
negligence standard to facilitate an increase in accountability and
deterrence. See 2023 Proposing Release at 7.
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Several commenters also stated that auditors are subject to
sufficient oversight under the current framework, including via the
PCAOB's inspection program, enforcement in Commission proceedings, and
enforcement by state regulatory agencies. Certain of these commenters
further stated that a negligence standard would risk, among other
things, disturbing the PCAOB's inspection process by upsetting
inspection dynamics and threatening the cooperative and constructive
nature of the process that has developed over time.
The Board is mindful of the efficiencies gained through open
dialogue with firms and individuals alike during the inspection
process. Given that firms and individuals already are subject to a
negligence standard for primary violations, however, the Board does not
believe that the incremental change of moving from recklessness to
negligence for contributory conduct will have a chilling effect on
inspections, especially given that the Board will continue to exercise
discretion about when to bring Rule 3502 charges.\33\
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\33\ One commenter expressed concern over whether the inspection
process is sufficiently robust to conclude that an associated person
has contributed to a firm's negligence-based violation, and
relatedly, another asserted that auditors believe that the Board is
holding them to an inspections bar that constantly evolves.
Inspection staff's findings, however, are not conclusive for
purposes of imposing legal liability under Rule 3502 (or any PCAOB
rule). See PCAOB Inspection Procedures: What Does the PCAOB Inspect
and How Are Inspections Conducted?, available at https://pcaobus.org/oversight/inspections/inspection-procedures (``[A]ny
references in [an inspection] report to violations or potential
violations of law, rules, or professional standards are not a result
of an adjudicative process and do not constitute conclusive findings
for purposes of imposing legal liability.''). Rather, whether there
is legal liability for a violation and whether conduct merits
sanctions (and if so, what the sanctions are) are determined through
the adversarial process involving the Board's Division of
Enforcement and Investigations and only after respondents have been
afforded the opportunity to present a defense.
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Commenters also opined that amending Rule 3502 is unnecessary
because the Board's then-proposed (now-adopted \34\) QC 1000 standard
provides clearer expectations with regard to individuals in quality
control (QC) roles.\35\ Although the Board agrees that QC 1000
crystallizes the responsibilities of certain individuals serving in QC
roles, Rule 3502 applies more broadly than to just those particular
individuals. Thus, although QC 1000 and Rule 3502 could overlap to
cover the same conduct in some circumstances, there are other
circumstances in which there would not be overlap.\36\
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\34\ This release references several professional standards that
the Board has adopted but which are pending Commission approval, and
which therefore are subject to change. See Section 107(b) of
Sarbanes-Oxley.
\35\ See generally A Firm's System of Quality Control and Other
Amendments to PCAOB Standards, Rules, and Forms, PCAOB Release No.
2024-005 (May 13, 2024) (``QC 1000 Release'').
\36\ See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375,
383 (1983) (``While some conduct actionable under Section 11 may
also be actionable under Section 10(b), it is hardly a novel
proposition that the 1934 [Securities Exchange] Act and the 1933
[Securities] Act `prohibit some of the same conduct.' `The fact that
there may well be some overlap is neither unusual nor unfortunate.'
'' (citations omitted)).
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Commenters similarly expressed mixed views about whether the change
to negligence would incentivize auditors to more fully comply with
applicable laws, rules, and standards that the Board is charged with
enforcing. Multiple commenters remarked in the affirmative, noting that
such incentivization is foreseeable and that a negligence standard will
encourage individuals and firms to maintain a high level of quality in
their audit work, which in turn benefits investors and financial
markets alike. Indeed, one commenter remarked that the current
recklessness standard inadequately incentivizes associated persons to
exercise the appropriate level of care in their audit work. This
commenter also noted that, beyond incentivizing individuals'
compliance, a negligence standard also would incentivize firms to
ensure, through training and other measures, that their
[[Page 54899]]
employees are complying with applicable professional standards.
By contrast, other commenters argued that a negligence standard
will not incentivize compliance, for a variety of reasons. Multiple
commenters premised such view on the downstream effects that oversight
with respect to firms has on individuals. According to certain of these
commenters, such effects (e.g., reduced responsibility on audits,
compensation- and promotion-related consequences), as well as other
firm policies and preventative measures (such as training), are
sufficient to guard against negligence and incentivize individual
compliance. Another commenter opined that the auditor reporting model
and the identification of auditors in Form AP suffice to address
individual accountability.
While the Board agrees that each of the above factors may play a
role in driving individual accountability in certain respects, none is
a form of regulatory accountability that is akin to the Board's
authority to bring enforcement proceedings and impose publicly a range
of disciplinary sanctions as remedial measures. Moreover, the market-
driven consequences relating to the auditor reporting model and
identification of auditors on Form AP are felt primarily (if not
exclusively) by the engagement partner on an audit, while Rule 3502
applies more broadly.
Another commenter questioned whether a negligence standard would
have a deterrent effect (or close any gap) given that auditors already
are subject to a negligence standard for contributory liability in
Commission actions. One commenter noted that, given that auditors
already are subject to negligence actions by other entities (including
the Commission and state regulators), empirical evidence should be
provided to support how auditor behavior would change under a
negligence standard for Rule 3502.\37\ As the Board previously noted,
however, an increase in the number of regulators on alert for the same
or similar violative conduct increases the likelihood of that conduct
being detected and, consequently, the likelihood that the conduct would
be sanctioned.\38\
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\37\ This commenter did not provide the source of any data or
propose any methods by which to generate empirical evidence on this
subject.
\38\ 2023 Proposing Release at 14 n.51.
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In other commenters' views, a negligence standard would not
incentivize compliance because sanctions are ineffective to deter mere
errors in judgment. As explained below, however, the amendment does not
target mere errors in judgment, but rather unreasonable conduct.
Multiple commenters also posited that a lower threshold for auditor
liability may have a negative impact on audit quality, including at
smaller firms. Indeed, one commenter asserted that the impact of the
proposed rule change (and proceedings brought pursuant to it) would be
felt more acutely by firms that are not affiliated with the largest
global networks, despite those firms having a significantly smaller
share in auditing the market capitalization of U.S. issuers. These
commenters generally attributed what they view as a potential loss in
audit quality to several factors, including recruiting, retention, and
staffing challenges; reduced collaboration among auditors; and auditors
engaging in unproductive, excessive self-protective behavior. The Board
addresses below commenters' concerns about the amendment's potential
impacts on audit quality and smaller firms, respectively.
2. The Board's Implementation Experience
Although the Board viewed Rule 3502's recklessness liability
threshold as ``strik[ing] the right balance in the context of th[e]
rule'' at the time of the rule's adoption in 2005, the threshold had
not yet been tested in practice by the PCAOB, and experience has shown
that it prevents the Board from executing its investor-protection
mandate to the fullest extent that Congress authorized in Sarbanes-
Oxley.
In the instances in which the Board has instituted proceedings
against firms for negligence-based violations, the Board has not been
able to charge Rule 3502 violations against the individuals that
negligently contributed to those firms' violations. Although the
decision not to bring charges against individuals varies case by case
and is at the Board's discretion, it remains that the Board has been
legally barred by the current formulation of Rule 3502 from holding
accountable under Rule 3502 individuals who negligently, directly, and
substantially contributed to the firms' violations.\39\
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\39\ As the 2005 Adopting Release notes, however, Rule 3502 ``is
not the exclusive means for the Board to enforce applicable Board
rules and standards against associated persons.'' 2005 Adopting
Release at 14 n.25.
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The Board's application of Rule 3502 in various contexts supplies
experience-based reasons for the proposed amendment to the liability
standard. For example, when dealing with the design and implementation
of firm QC policies and procedures under applicable QC standards, the
Board has observed that registered firms that commit a QC violation
often have multiple individuals with overlapping QC responsibility but
that no single individual was reckless in failing to act, and thus no
individual can be held personally accountable for the firm's QC
failure.\40\ And yet, individuals with QC responsibility at a firm are
often in some of the most important decision-making roles within the
firm because a compliant QC system serves as the backstop to ensure
that all other professional standards are followed.\41\
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\40\ The Board's recently adopted QC 1000 standard mitigates
this concern to an extent by requiring firms to assign one or more
individuals to certain roles with designated responsibilities within
a firm's QC system. See QC 1000 Release at 82-86. The concern
remains, though, because ``[a] firm may have multiple individuals or
multiple layers of personnel supporting these roles.'' Id. at 83.
\41\ See QC Sec. 20.03, System of Quality Control (``A firm has
a responsibility to ensure that its personnel comply with the
professional standards applicable to its accounting and auditing
practice. A system of quality control is broadly defined as a
process to provide the firm with reasonable assurance that its
personnel comply with applicable professional standards and the
firm's standards of quality.''); QC 1000 Release at 70-71 (setting
forth, in QC 1000.05, the objective of a firm's QC system).
---------------------------------------------------------------------------
Multiple commenters suggested that a negligence standard should not
apply to enforcement of QC matters because the Board's inspection
function already provides it with transparency into a firm's QC system.
Inspections (and, relatedly, remediation) of QC matters, however, are
distinct from enforcement, including with respect to the available
potential consequences for firms and individuals, respectively. Yet
Congress also expressly envisioned that the Board's inspections program
would inform its enforcement activities.\42\ Such entwinement is
therefore a feature of Sarbanes-Oxley--not a flaw or a reason not to
adopt a negligence standard.
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\42\ See, e.g., Section 104(c)(3) of Sarbanes-Oxley (requiring
the Board, ``in each inspection,'' to ``begin a formal investigation
or take disciplinary action, if appropriate, with respect to any
[potential] violation [identified during an inspection], in
accordance with this Act and the rules of the Board'').
---------------------------------------------------------------------------
One commenter also appeared to interpret the Proposal as the Board
suggesting that having multiple people with overlapping responsibility
for a firm's QC system is an obstacle to investor protection or
enhanced audit quality and that a single individual needs to be held
accountable for a QC violation in the absence of reckless behavior.
That was not the Board's intent; rather, the Board meant simply what it
said: When there are multiple individuals involved in the QC function,
it could be that no individual's conduct rose to the level of
recklessness
[[Page 54900]]
despite a firm's QC failure, thus allowing persons who negligently,
directly, and substantially contribute to a QC failure to avoid
individual accountability under Rule 3502.\43\
---------------------------------------------------------------------------
\43\ See 2023 Proposing Release at 9.
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Moreover, the Board did not mean to imply that a single person
``needs'' to be held individually accountable in all circumstances for
negligence contributing to a firm's QC failure.\44\ The Board exercises
discretion about whom to charge and what charges to bring, and even in
the absence of a charge, the potential to be held individually liable
for contributory negligence may increase the amount of care and
attention dedicated to QC by responsible individuals. Indeed, while
reflecting only a modest change, the Board anticipates that the
amendment will have a positive impact on audit quality as a result of
its deterrent effect.
---------------------------------------------------------------------------
\44\ Comment Letter from PricewaterhouseCoopers LLP at A4 (Nov.
2, 2023).
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Another comment letter posited that a negligence standard would
place an unfair burden on national office partners responsible for a
firm's QC functions and engagement quality review partners, who the
comment letter asserted typically do not have the authority to
establish firm strategies or allocate resources. This commenter
expressed concern that the Board would pursue enforcement actions
against a single individual when a firm's partners collectively are
responsible for the strategy and resource allocation decisions that led
to a firm's violation. Regardless of whether collective responsibility
is uniformly the practice, the Board should not be precluded from
exercising its discretion to pursue a Rule 3502 charge against an
individual who failed to exercise reasonable care and competence, even
in cases involving a firm's strategy or resource-allocation decisions
that led to a QC failure.
In addition to the QC context, Rule 3502 also arises in sole-
proprietorship cases, in which the sole owner and sole partner of a
firm causes the firm to commit a violation. Yet for some types of
violations, there is not always sufficient evidence of reckless
behavior. A negligence standard thus would promote greater
accountability by the sole proprietor and prevent that person from
being shielded from individual liability under Rule 3502.
One commenter sought clarity regarding how Rule 3502 might be
applied to sole proprietors. The Board notes that examples include
instances in which firms fail to obtain an engagement quality review
\45\ or fail to file (or file timely) required PCAOB forms.\46\ In each
scenario, the respective primary violations can be committed only by a
firm because the obligations are imposed solely on the firm,\47\ yet a
sole proprietor of a firm could negligently, directly, and
substantially contribute to the firm's violation of the relevant PCAOB
rules and standard.
---------------------------------------------------------------------------
\45\ E.g., In re Jack Shama, PCAOB Release No. 105-2024-004
(Jan. 23, 2024); In re Robert C. Duncan Accountancy Corp., PCAOB
Release No. 105-2022-010 (June 22, 2022); In re Tamba S. Mayah, CPA,
PCAOB Release No. 105-2021-007 (Sept. 13, 2021).
\46\ See, e.g., In re Jeffrey T. Gross, Ltd., PCAOB Release No.
105-2019-016 (July 23, 2019) (primary violation of PCAOB Rule 3211
relating to Form AP).
\47\ See AS 1220, Engagement Quality Review; PCAOB Rule 2200,
Annual Report (Form 2 filing rule); PCAOB Rule 2203, Special Reports
(Form 3 filing rule); PCAOB Rule 3211, Auditor Reporting of Certain
Audit Participants (Form AP filing rule).
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Another commenter identified independence violations as a common
type of case not mentioned above and for which the commenter believes
that a negligence standard of contributory liability would promote
greater individual accountability. The Board agrees.\48\ Another
commenter identified a data compilation regarding cases and fact
patterns that the commenter said could be a resource in confirming and
validating the change to Rule 3502.\49\
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\48\ Indeed, as the Board has previously stated, Rule 3502 is
``essential to the proper functioning of the Board's independence
rules.'' 2004 Proposing Release at 19; see 2005 Adopting Release at
14.
\49\ The resource is available at https://wp.nyu.edu/compliance_enforcement/category/artificial-intelligence. PCAOB
staff's review indicates that what the commenter referred to as
qualitative data mainly consists of blog posts written on a wide
array of legal issues and news articles that are much broader in
scope, cannot be analyzed readily in their entirety, and are not
directly relevant to the Board's analysis.
---------------------------------------------------------------------------
3. Advancing the Board's Investor-Protection Mandate
In the Board's 2022-2026 Strategic Plan, the Board expressed a
rejuvenated focus on the PCAOB's investor-protection mandate and stated
its intent ``to modernize and streamline our existing standards . . .
where necessary to meet today's needs.'' \50\ The Board also expressed
an intent to ``engag[e] in vigorous and fair enforcement that promotes
accountability and deterrence,'' including by ``tak[ing] a more
assertive approach to bringing enforcement actions'' and ``hold[ing]
accountable'' those who commit ``violations that result from negligent
conduct.'' \51\ The amendment to Rule 3502 is consistent with those
goals.
---------------------------------------------------------------------------
\50\ PCAOB, Strategic Plan 2022-2026, at 10, available at
https://assets.pcaobus.org/pcaob-dev/docs/default-source/about/administration/documents/strategic_plans/strategic-plan-2022-2026.pdf?sfvrsn=b2ec4b6a_4/.
\51\ Id. at 3, 13; see also id. at 8 (``[W]e are focused on
aggressively pursuing all statutory legal theories for charging
respondents and remedies available in executing our enforcement
program, which is central to protecting investors and promoting the
public interest.'').
---------------------------------------------------------------------------
When Congress enacted Sarbanes-Oxley, it empowered the Board to
promulgate and adopt certain standards and rules, to inspect registered
firms for compliance with those standards and rules, and to enforce
compliance by firms and their associated persons. Among the tools that
Congress provided to the Board for enforcement is the ability to impose
certain sanctions for negligent conduct, including single instances of
negligence.\52\ That liability threshold serves a dual function: It
incentivizes auditors to conduct their work knowing that reasonable
care is the standard for assessing it (i.e., deterrence), and it allows
the Board to publicly discipline auditors who were found to have not
exercised an appropriate degree of care (i.e., accountability).\53\
Each of those functions--one ex ante to auditors' conduct and the other
ex post--goes to the core of the Board's mission of protecting
investors and promoting high-quality audits.
---------------------------------------------------------------------------
\52\ See Sections 105(c)(4) & (c)(5) of Sarbanes-Oxley; Rules on
Investigations and Adjudications, PCAOB Release No. 2003-015, at A2-
58 (Sept. 29, 2003), available at https://assets.pcaobus.org/pcaob-dev/docs/default-source/rulemaking/docket_005/release2003-015.pdf?sfvrsn=35827b4_0 (``The Act plainly contemplates that
disciplinary proceedings can be instituted for a violation based on
a single negligent act.''). The Board received multiple comments
regarding its authority to pursue enforcement proceedings based on
single instances of negligence, and the Board addresses those
comments below.
\53\ See Honigsberg, supra, at 1899 (``Individual accountability
could provide a counterweight to the current incentive structure. .
. . [A]udit partners do not internalize the full consequences of an
audit failure. Promoting individual brands will better address this
inefficiency and reduce externalities by causing audit partners to
internalize these failures.''); see also Gina-Gail S. Fletcher,
Deterring Algorithmic Manipulation, 74 Vand. L. Rev. 259, 268-69
(2021) (``[I]f the applicable laws are narrow, only capturing the
most blatant misconduct, wrongdoers may not be deterred from
breaking the law. . . . [D]eterrence is effective if regulators have
strong, suitable tools to enforce the regime and market actors know
whether they are violating the law.'').
---------------------------------------------------------------------------
The current formulation of Rule 3502, however, stops short of
deploying the Board's authority to sanction negligent conduct to the
fullest extent by requiring at least reckless conduct before an
associated person can be held secondarily liable. The amendment that
the Board has adopted to Rule 3502's liability standard removes this
constraint and makes the rule both a more effective deterrent and a
more
[[Page 54901]]
effective enforcement tool, and in so doing, better aligns the rule
with Sarbanes-Oxley.\54\
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\54\ See PCAOB, Strategic Plan 2022-2026, at 10 (``Effective
auditing, attestation, quality control, ethics, and independence
standards advance audit quality and are foundational to the PCAOB's
execution of its mission to protect investors.'').
---------------------------------------------------------------------------
Several commenters stated that it is clear and understandable how
the amendment to Rule 3502 advance the Board's statutory mandate to
protect investors, including by promoting the twin goals of
accountability and deterrence. One such commenter remarked that a
negligence standard ``may be needed'' to enhance accountability to
investors,\55\ while another noted that such standard ``fall[s]
squarely'' within the scope of the Board's mission and ``clearly and
unambiguously advances'' the Board's cause.\56\ Still another opined
that the amendment would ensure consistency between the liability
standard and investor expectations and that ``it makes no sense'' to
have differing standards for firms and individuals.\57\
---------------------------------------------------------------------------
\55\ Comment Letter from Council of Institutional Investors at 5
(Oct. 26, 2023).
\56\ Comment Letter from Better Markets at 8.
\57\ Comment Letter from Center for American Progress at 2 (Nov.
3, 2023).
---------------------------------------------------------------------------
As to deterrence, multiple commenters stated that the amendments
should result in auditors being more likely to comply with their
respective legal requirements. One commenter further opined that a
negligence standard ``sends a strong message'' to auditors regarding
the requisite level of care that they should be applying in their
work.\58\
---------------------------------------------------------------------------
\58\ Comment Letter from Better Markets at 5.
---------------------------------------------------------------------------
Other commenters expressed a different view of the amendments
relative to investor protection. One commenter stated that, should the
amendment discourage certain individuals from accepting important QC
roles for fear of being held liable, the public's interest would not be
served by having less cautious or less qualified individuals fill those
roles. Another opined that the amendments would incentivize high-
quality talent to avoid the audit profession, which could lead to lower
audit quality, increased audit fees, and a large number of delistings.
As certain other commenters pointed out and as the Board observed in
the Proposal, however, auditors already are subject to liability and
disciplinary schemes that encourage them to comply--and not just avoid
reckless noncompliance--with applicable statutory, regulatory, and
professional standards.
Still another commenter expressed uncertainty about how a change to
negligence will achieve further investor-protection benefits. This
commenter remarked that the Board currently has means to hold
accountable individuals who are negligent in various contexts and that
investors are best protected when noncompliance is avoided in the first
place. While the Board agrees that avoiding noncompliance in the first
instance promotes audit quality and benefits investors, the Board views
the addition of another enforcement tool to deter negligent conduct
(including conduct that currently is beyond the Board's reach), and to
hold accountable those who engage in such conduct, as a complement to--
not mutually exclusive from--avoiding noncompliance.
Beyond deterrence and accountability, multiple commenters remarked
that the amendments should enhance investors' confidence, both in
audits and in the information provided in companies' financial
statements. Some commenters noted that a change to a negligence
standard would protect investors by encouraging auditors to be more
careful about their work and positively affecting capital-market
efficiency. Another commenter offered several additional downstream
investor-protection benefits, including that as audit quality improves,
the likelihood of auditors being subjected to meritorious litigation,
and the risks and costs to investors resulting from that litigation (as
well as misstatements and omissions in audited financial statements),
should be reduced.
Discussion of the Amendment
As discussed above, the Board has amended PCAOB Rule 3502 by
changing the liability standard from recklessness to negligence. The
details of the amendment are discussed in the following subsections.
A. Text of the Amended Rule and the Negligence Standard Generally
The Board has amended Rule 3502's liability standard as proposed by
deleting the phrase ``knowing, or recklessly not knowing'' (and certain
ancillary surrounding text) and inserting elsewhere into the rule the
phrase ``knew or should have known'' (and certain ancillary surrounding
text). The outgoing phrase describes conduct that amounts to at least
recklessness,\59\ whereas the incoming phrase sets a negligence
standard using ``classic negligence language.'' \60\ Consequently, the
Board is changing the standard for contributory liability from an
``extreme departure from the standard of ordinary care'' \61\
(recklessness) to ``the failure to exercise reasonable care or
competence'' (negligence).\62\
---------------------------------------------------------------------------
\59\ See 2005 Adopting Release at 12 n.23.
\60\ In re KPMG Peat Marwick LLP, SEC Release No. 34-43862 (Jan.
19, 2001) (``Ordinarily, the phrase `should have known' . . . is
classic negligence language.''), pet. for review denied, KPMG, LLP
v. SEC, 289 F.3d 109 (D.C. Cir. 2002); see also Erickson Prods.,
Inc. v. Kast, 921 F.3d 822, 833 (9th Cir. 2019) (`` `[S]hould have
known' . . . is a negligence standard. To say that a defendant
`should have known' of a risk, but did not know of it, is to say
that he or she was `negligent' as to that risk.''); KPMG, 289 F.3d
at 120 (``knew or should have known'' is language that ``virtually
compel[s]'' a negligence standard).
\61\ Marrie, 374 F.3d at 1204 (citation and quotation marks
omitted).
\62\ SW Hatfield, SEC Release No. 34-69930, at 35 n.169
(citation and quotation marks omitted).
---------------------------------------------------------------------------
Such a change addresses the incongruity and related issues noted
above. Specifically, it aligns the requisite mental states for
liability of a registered firm and for liability of an associated
person whose conduct directly and substantially contributed to the
firm's violation.\63\ In so doing, the modification should better
incentivize associated persons to exercise the appropriate level of
care, thus promoting investor protection.
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\63\ However, the sanctions to which a contributory actor may be
subject upon being found to have violated Rule 3502--including
whether the Board may impose any of the heightened sanctions in
Section 105(c)(5) of Sarbanes-Oxley--depend on the associated
person's conduct and not that of the firm that commits the primary
violation.
---------------------------------------------------------------------------
Numerous commenters remarked that a change to negligence is
appropriate, and with limited exception, commenters remarked that the
proposed language to effectuate that change--which the Board has
adopted--is clear and understandable.
One commenter called the proposed rule text (``knew or should have
known'') ``overly vague and broad'' and asserted that, in contrast to
an accountability framework that sets forth clear expectations, the
proposed rule does not provide notice of specific conduct that may lead
to a violation.\64\ As the Proposal explained (and as repeated above),
however, the ``knew or should have known'' phrasing is ``classic
negligence language,'' and negligence is ``the failure to exercise
reasonable care or competence.'' \65\ Indeed, one commenter remarked
that such language is ``familiar in the American legal system.'' \66\
Moreover, as discussed in the 2005 Adopting Release and the Proposal
(and as discussed below), the Board has delineated through its
explanation of ``directly and substantially'' the nexus and magnitude
that an auditor's conduct must have to
[[Page 54902]]
a firm's primary violation to be actionable. The Board is thus
satisfied that such a well-known standard in the law, supplemented by
additional parameters that have been in place for nearly two decades,
is neither vague nor overly broad.
---------------------------------------------------------------------------
\64\ Comment Letter from RSM US LLP at 1 (Nov. 3, 2023).
\65\ 2023 Proposing Release at 13 & n.45.
\66\ Comment Letter from Center for Audit Quality at 11 (Nov. 2,
2023).
---------------------------------------------------------------------------
Several commenters sought clarity over how the adopted text of Rule
3502 (``knew or should have known''), as well as the definition of
negligence (``failure to exercise reasonable care or competence''),
would interact with other standards of conduct applicable to auditors,
and in particular the obligation of exercising due professional care
under then-proposed (now-adopted) AS 1000, General Responsibilities of
the Auditor in Conducting an Audit.\67\ To be sure, due professional
care and reasonable care and competence are largely overlapping
concepts.\68\ However, the Board wishes to emphasize three points.
---------------------------------------------------------------------------
\67\ See General Responsibilities of the Auditor in Conducting
an Audit and Amendments to PCAOB Standards, PCAOB Release No. 2024-
004, at 30-39 (May 13, 2024) (``AS 1000 Release'') (subject to
Commission approval); see also AS 1015, Due Professional Care in the
Performance of Work.
\68\ See AS 1000 Release at A1-3 (``due professional care''
includes ``acting with reasonable care and diligence''); see also QC
1000 Release at 81 (``We are adopting this provision [QC 1000.10]
with modifications to align with the descriptions of due
professional care and professional skepticism being adopted in AS
1000.'').
---------------------------------------------------------------------------
First, while there may be overlap, AS 1000 does not apply to all
conduct for which the Board has enforcement authority; \69\ thus, there
is a need for a separate rule with a negligence standard. Second,
because Rule 3502 includes the ``directly and substantially'' modifier,
it will not always be the case that conduct that violates the
obligation of due professional care also violates Rule 3502; thus, Rule
3502 is not duplicative of AS 1000, even if conduct violating the
latter may also violate the former in certain circumstances. Third,
Rule 3502--located within the ``Ethics and Independence'' section of
the Board's rules regarding professional practice standards--reflects
an overarching ethical obligation, and the Board believes it
appropriate to codify that general obligation, even if it overlaps with
more specific provisions in particular professional standards.
---------------------------------------------------------------------------
\69\ See AS 1000 Release at 30-31 (delineating the parameters of
``all matters related to the audit'' to which AS 1000's requirement
to exercise due professional care applies).
---------------------------------------------------------------------------
A substantial number of commenters did not appear to support the
change. In general, these commenters stated that they do not believe
that negligence is an appropriate standard for assessing conduct and
compliance on complex audit engagements, which commenters said require
a wide range of judgments. For instance, one commenter opined that what
could be labeled as a ``violation'' of professional standards instead
may be only a difference of opinions between accountants about a
particular pronouncement(s). That commenter further opined that, by
proposing a negligence standard, the Board misunderstands the nature of
audits. Several other commenters opined that it is bad policy to
penalize errors in judgment and for the PCAOB to second-guess auditors'
good-faith decisions in situations involving the application of
professional judgment.
As noted above, however, firms and associated persons already are
subject to a negligence standard for their primary violations,
including for single instances of negligence that violate professional
standards.\70\ The amendment to Rule 3502 therefore affects only an
incremental (albeit important) change, and only for contributory
conduct. Given the Board's nearly two decades of experience
distinguishing isolated, good-faith errors in professional judgment
from conduct that warrants disciplinary action, as well as the modest
estimated increase in Rule 3502 cases that would result from the
amendment, the Board does not anticipate that a change in the liability
standard for contributory conduct will be used to sanction isolated,
good-faith errors in professional judgment--let alone be wielded as a
``blunt'' or ``draconian'' instrument, as one commenter suggested
\71\--including with respect to less senior engagement team
members.\72\ The amendment focuses on unreasonable conduct; it does not
impose strict liability.\73\
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\70\ See, e.g., In re Sassetti, LLC, PCAOB Release No. 105-2024-
018 (Mar. 28, 2024); In re Berkower, LLC, PCAOB Release No. 105-
2024-016 (Mar. 28, 2024).
\71\ Comment Letter from U.S. Chamber of Commerce at 2 (Nov. 7,
2023).
\72\ To iterate what the Board said in 2005, Rule 3502 is not
``a vehicle to pursue compliance personnel who act in an
appropriate, reasonable manner that, in hindsight, turns out to have
not been successful.'' 2005 Adopting Release at 14.
\73\ ``Strict liability is imposed upon a defendant without
proof that he was at fault. In other words, when liability is
strict, neither negligence nor intent must be shown.'' Dobbs' Law of
Torts Sec. 437.
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One commenter opined that a Rule 3502 charge could cause associated
persons to ``lose their livelihood'' due to ``career-ending penalties''
under the Proposal.\74\ Several other commenters expressed a similar
concern about the negligence threshold and the potential collateral
effects and impacts on auditors' careers. While the Board appreciates
that disciplinary orders have consequences--as they should--research
suggests that auditors remain gainfully employed following a
culpability finding.\75\ And in all events, the Board emphasizes that
it is not the Board's intent to pursue, through Rule 3502 charges, what
one commenter described as ``foot-faults'' or ``unintentional slips,
pure errors of judgment, and innocuous errors on `technicalities.' ''
\76\ Nor do the Board's standards require that auditors exercise
``perfect judgment at all times,'' as one commenter put it,\77\ to
avoid an enforcement proceeding (under Rule 3502 or otherwise).\78\
---------------------------------------------------------------------------
\74\ Comment Letter from RSM US LLP at 1, 2.
\75\ See J. Krishnan, M. Li, M. Mehta & H. Park, Consequences
for Culpable Auditors, available at https://ssrn.com/abstract=4627460. In their working paper studying audit
professionals subject to Commission or PCAOB enforcement proceedings
between 2003 and 2019, the authors make three key findings: First, a
substantial number of culpable auditors remain gainfully employed by
their firms one year after the enforcement event (26% of Big 4 and
43% of non-Big 4 culpable auditors). Second, culpable individuals
leaving Big 4 firms primarily move to the corporate sector and
secure senior or mid-level executive positions at private firms. By
contrast, culpable auditors departing from non-Big 4 firms tend to
join other non-Big 4 public accounting firms, often as partners.
Third, . . . the large majority of culpable auditors do not engage
in liquidity-increasing real estate transactions around enforcement.
\76\ Comment Letter from U.S. Chamber of Commerce at 9, 10.
\77\ Comment Letter from RSM US LLP at 3.
\78\ See AS 1015.03, Due Professional Care in the Performance of
Work (quoting a treatise describing the obligation of due care as:
``[N]o man, whether skilled or unskilled, undertakes that the task
he assumes shall be performed successfully, and without fault or
error; he undertakes for good faith and integrity, but not for
infallibility, and he is liable to his employer for negligence, bad
faith, or dishonesty, but not for losses consequent upon pure errors
of judgment.'' (citation omitted)); AS 1000 Release at 31 (``We
continue to believe that the description of due professional care in
the final standard is consistent with the description in AS 1015.03
(and the reference in the current standard to the legal treatise,
Cooley on Torts), which uses the terms `reasonable care and
diligence' and `good faith and integrity but not infallibility' to
describe due care.'').
---------------------------------------------------------------------------
Some commenters expressed concern over the notion that, as a result
of the amendment, the Board would be able to pursue conduct that is not
itself a violation but that merely contributes to a violation. One
commenter characterized this as a ``significant change from current
PCAOB enforcement policy,'' \79\ but in fact it is no change at all;
under the current version of Rule 3502, the Board can bring charges for
conduct that is not itself a primary violation. The amendment merely
changes the standard for when an individual's contributory conduct
becomes actionable; it does not alter whether the
[[Page 54903]]
contributory conduct must be an independent violation apart from the
firm's underlying primary violation.
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\79\ Comment Letter from U.S. Chamber of Commerce at 2.
---------------------------------------------------------------------------
Several commenters expressed concern regarding a negligence
standard in Rule 3502 in light of the current regulatory environment--
specifically amidst the Board's other standard-setting projects,
including the then-proposed (now-adopted) quality control standard, QC
1000. These commenters opined that new requirements in proposed and
adopted other standards may put auditors at greater risk of violating
Rule 3502, including based on the introduction or modification of key
concepts and their interrelation to negligence.
The Board appreciates that audits, especially of large enterprises,
have the potential to be quite complex and can require input from
various individuals, including individuals not on the engagement team.
QC systems likewise can be quite complex and require input from
numerous people. And as in 2005, ``[t]he Board also recognizes that
persons subject to its jurisdiction must comply with complex
professional and regulatory requirements in performing their jobs.''
\80\ But complexity is not a reason to allow negligent auditors--
individuals who by definition have acted unreasonably--to contribute
directly and substantially to firms' violations without consequence.
Indeed, as one commenter noted, the complexity of audits and the
current environment in which companies operate--which is rapidly
changing and subject to emerging risks--supports amending Rule 3502
because audited financial statements are becoming increasingly
important.
---------------------------------------------------------------------------
\80\ 2005 Adopting Release at 14.
---------------------------------------------------------------------------
The Board also recognizes that it recently has adopted amendments
to several standards \81\ and has proposed amendments to other
standards \82\ and to certain PCAOB rules.\83\ This is consistent with
the Board's Strategic Plan, which states: ``We expect to propose and
adopt numerous amendments and new standards over the coming years, in
accordance with our standard-setting and research agendas. We also plan
to evaluate certain existing standards to determine whether they are
outmoded.'' \84\ Many of the newly adopted standards, moreover, have
staggered effective dates, and thus auditors will not be required to
come into compliance with each of them at the same time.\85\ And in all
events, as firms make efforts to comply with new standards, it
necessarily follows that individuals who could be subject to Rule 3502
also would be making such efforts because firms can act only through
their natural persons.
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\81\ See generally Amendments Related to Aspects of Designing
and Performing Audit Procedures that Involve Technology-Assisted
Analysis of Information in Electronic Form, PCAOB Release No. 2024-
007 (June 12, 2024) (subject to Commission approval); QC 1000
Release; AS 1000 Release; The Auditor's Use of Confirmation, and
Other Amendments to PCAOB Standards, PCAOB Release No. 2023-008
(Sept. 28, 2023); Planning and Supervision of Audits Involving Other
Auditors and Dividing Responsibility for the Audit with Another
Accounting Firm, PCAOB Release No. 2022-002 (June 21, 2022).
\82\ See, e.g., Proposed Auditing Standard--Designing and
Performing Substantive Analytical Procedures and Amendments to Other
PCAOB Standards, PCAOB Release No. 2024-006 (June 12, 2024);
Proposing Release: Amendments to PCAOB Auditing Standards related to
a Company's Noncompliance with Laws and Regulations And Other
Related Amendments, PCAOB Release No. 2023-003 (June 6, 2023).
\83\ See, e.g., Proposing Release: Firm Reporting, PCAOB Release
No. 2024-003 (Apr. 9, 2024); Firm and Engagement Metrics, PCAOB
Release No. 2024-002 (Apr. 9, 2024); Proposals Regarding False or
Misleading Statements Concerning PCAOB Registration and Oversight
and Constructive Requests to Withdraw from Registration, PCAOB
Release No. 2024-001 (Feb. 27, 2024).
\84\ PCAOB, Strategic Plan 2022-2026, at 10.
\85\ See PCAOB Release No. 2022-002, at 58 (effective for audits
of financial statements for fiscal years ending on or after December
15, 2024); PCAOB Release No. 2023-008, at 96 (effective for audits
of financial statements for fiscal years ending on or after June 15,
2025); AS 1000 Release at 96 (with limited exception, effective for
audits of financial statements for fiscal years beginning on or
after December 15, 2024); QC 1000 Release at 378 (effective December
15, 2025); PCAOB Release No. 2024-007, at 61 (effective for audits
of financial statements for fiscal years beginning on or after
December 15, 2025).
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The Board does not intend for any of its new or revised standards,
either alone or in conjunction with the amendment the Board has
adopted, to ``create[ ] a trap for the unwary,'' as one commenter
opined.\86\ Far from it, the Board's standard-setting agenda seeks to
modernize standards in a way that promotes high-quality audits through
compliance in the first instance. Enforcement proceedings promote this
same ex ante focus on compliance insofar as they serve as a deterrent
to other auditors from engaging in the same or similar misconduct.
---------------------------------------------------------------------------
\86\ Comment Letter from U.S. Chamber of Commerce at 10.
---------------------------------------------------------------------------
Finally, some commenters expressed concern about whether an
associated person could be liable for negligence under Rule 3502 in
situations where a primary violation by a firm requires a standard
higher than negligence. One commenter remarked that holding an
associated person liable in such circumstances would be ``unprecedented
(and unlawful)'' and stated that the Board should consider specifically
exempting violation-causing conduct when a primary violation involves
intentional conduct.\87\ Another commenter sought clarity from the
Board on the issue and asked whether the Board believes that individual
liability in such a scenario would be appropriate. Although the Board
will continue to evaluate whether to bring Rule 3502 charges on a case-
by-case basis, when the firm's primary violation requires more than
negligence, the Board does not anticipate charging individuals for
negligently contributing to such violations.\88\
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\87\ Comment Letter from RSM US LLP at 3.
\88\ See Howard v. SEC, 376 F.3d 1136, 1141 (D.C. Cir. 2004)
(``Although we held in KPMG, LLP v. SEC, that the `knew or should
have known' language in Sec. 21C embodied a negligence standard for
purposes of that case, it does not necessarily follow that
negligence is the standard'' where ``scienter [is] an element of the
primary violations.''); KPMG Peat Marwick, SEC Release No. 34-43862
(``We hold today that negligence is sufficient to establish
`causing' liability under Exchange Act Section 21C(a), at least in
cases in which a person is alleged to `cause' a primary violation
that does not require scienter.'').
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B. Retention of ``Directly and Substantially''
As proposed, the Board has decided to retain the ``directly and
substantially'' modifier to describe the connection between a
contributory actor's conduct and a registered firm's primary
violation.\89\ Thus, for conduct to ``directly'' contribute to a
primary violation, it must ``either essentially constitute[ ] the
violation''--in which case the conduct necessarily is a direct cause of
it \90\--or be ``a reasonably proximate facilitating event of, or a
reasonably proximate stimulus for, the violation''; but it need not
``be the final step in a chain of actions leading to the violation.''
\91\ Moreover, ``directly'' does not excuse an associated person who
negligently ``engages in conduct that substantially contributes to a
violation, just because others also contributed to the violation, or
because others could have stopped the violation and did
[[Page 54904]]
not.'' \92\ Nor would it necessarily excuse an associated person's
conduct when another actor engages in intentional misconduct that might
otherwise break the chain of causation--in particular where the
associated person's conduct is at least negligent and created the
situation for the other actor to engage in intentional misconduct, and
where the associated person realized or should have realized the
potential for, and likelihood of, such third-party intentional
misconduct.\93\
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\89\ See 2005 Adopting Release at 13. As discussed above, the
``directly and substantially'' modifier was added in response to
commenters' concerns that a negligence standard might sweep too
broadly. See also 2005 Adopting Release at 13. Because the Board is
retaining ``directly and substantially,'' as explained herein, the
guardrails that the Board put in place in 2005 in response to such
concerns remain in Rule 3502.
\90\ Cf. Paul F. Newton & Co. v. Tex. Commerce Bank, 630 F.2d
1111, 1118 (5th Cir. 1980) (``[C]ommon law agency principles,
including the doctrine of respondeat superior, remain viable in
actions brought under the Securities Exchange Act and provide a
means of imposing secondary liability for violations of the Act
independent of Sec. 20(a). The federal securities statutes are
remedial legislation and must be construed broadly, not technically
and restrictively.'').
\91\ See 2005 Adopting Release at 13.
\92\ Id.
\93\ See Restatement (Second) of Torts Sec. 448 (``The act of a
third person in committing an intentional [violation] is a
superseding cause of harm to another resulting therefrom, although
the actor's negligent conduct created a situation which afforded an
opportunity to the third person to commit such a [violation], unless
the actor at the time of his negligent conduct realized or should
have realized the likelihood that such a situation might be created,
and that a third person might avail himself of the opportunity to
commit such a [violation].'').
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For its part, ``substantially'' continues to require that the
associated person's conduct ``contribute[ ] to the violation in a
material or significant way,'' though it ``does not need to have been
the sole cause of the violation.'' \94\ The Board stresses that Rule
3502 is not intended to ``reach an associated person's conduct that,
while contributing to the violation in some way, is remote from, or
tangential to, the firm's violation.'' \95\
---------------------------------------------------------------------------
\94\ 2005 Adopting Release at 13.
\95\ Id.; see also id. at 14 (the Board does not ``seek to reach
those whose conduct, unbeknownst to them, remotely contributes to a
firm's violation''). One commenter opined that the distinction
between obligations placed on individuals and firms, respectively,
should not be disturbed insofar as there may be instances where it
is appropriate for a firm to be sanctioned for a violation but where
no particular individual played a sufficient role in that violation.
This commenter urged the Board to not use Rule 3502 to ``collapse
this distinction.'' Comment Letter from Center for Audit Quality at
9. The Board agrees--there are indeed instances where it is
appropriate to sanction a firm but not any individual(s) (under Rule
3502 or otherwise). The amendment the Board has adopted does nothing
to collapse that distinction: It changes only the actionable
standard of conduct, but does nothing to alter the nexus and
magnitude requirements of ``directly and substantially,'' i.e., it
does not alter the requisite sufficiency of an individual's role
relative to a firm's violation.
---------------------------------------------------------------------------
Commenters generally encouraged the Board to retain the ``directly
and substantially'' modifier, including one commenter remarking that
the Board's reasons for retaining it ``remain valid.'' \96\ Multiple
commenters, moreover, stated that these terms are clear and
understandable. One commenter posited that the Board should not retain
``directly and substantially'' as part of Rule 3502.
---------------------------------------------------------------------------
\96\ Comment Letter from Ernst & Young LLP at 4 (Nov. 3, 2023).
---------------------------------------------------------------------------
Several commenters sought additional clarity around the terms
``directly and substantially.'' For instance, one commenter noted that
the terms are not defined in Rule 3502 and claimed that the purported
lack of clarity will make the rule inoperable. This commenter suggested
that the Board instead import a more established legal doctrine of
causation. Another commenter called the terms ``subjective'' and asked
for a clearer articulation of them,\97\ and another asked whether the
terms ``will be applied differently moving forward.'' \98\
---------------------------------------------------------------------------
\97\ Comment Letter from Accounting & Auditing Steering
Committee of the Pennsylvania Institute of Certified Public
Accountants at 5 (Nov. 2, 2023).
\98\ Comment Letter from Audit and Assurance Services Committee
of the Illinois CPA Society at 3 (Nov. 2, 2023).
---------------------------------------------------------------------------
Having considered all commenters' views, the Board is satisfied
that the modifier ``directly and substantially'' is sufficiently clear
and operable and believes that no further delineation of the terms is
needed at this time. The Board notes that, going back to the 2005
Adopting Release, the explanation of ``directly and substantially''
includes concepts from established legal principles (e.g., ``directly''
includes circumstances where an individual's conduct is a ``reasonably
proximate facilitating event of, or a reasonably proximate stimulus
for, the [firm's] violation'').
The Board further notes that, based on the amended rule text,
``directly and substantially'' would apply only to the sufficiency of
the connection between an associated person's conduct and a firm's
violation. Thus, to be liable under Rule 3502, a person must have
known, or should have known, that an act or omission by them would
contribute--but not that it would directly and substantially
contribute--to a firm's violation.
One commenter remarked that the Board failed to explain its
intention behind this aspect of the amendment and that the wording
creates potential ambiguities and unfairness. The Board, however, sees
it differently--by eliminating the need for any inquiry into
individuals' mental states regarding the manner in which their conduct
contributes to the firm's violation, the Board believes that the rule
has the potential to be applied more uniformly (and thus more fairly).
Moreover, if an associated person knew or should have known that his or
her conduct would contribute to a violation in any way, then that
individual should not be able to evade liability simply because the
individual did not know the extent of the nexus and magnitude of such
contribution. But in all events, the Board iterates that, absent
conduct ``directly and substantially'' contributing to a firm's
violation, an individual's actions or omissions are not subject to
discipline under Rule 3502.
Two commenters opined that the Proposal suggested that the Board
was open to a tertiary liability theory, in which a first associated
person's conduct contributes to the conduct of a second associated
person, which in turn contributes to a registered firm's violation. But
as those commenters also recognized, the rule still would require the
first person's conduct to directly and substantially contribute to the
firm's violation.\99\ Thus, contrary to those commenters' concerns, the
definition of ``directly'' is not stretched beyond what it would be if
there were no second person involved, let alone beyond common usage of
the word.
---------------------------------------------------------------------------
\99\ See 2023 Proposing Release at 17 n.65; e.g., In re Shandong
Haoxin Certified Public Accountants Co., Ltd., PCAOB Release No.
105-2023-045, at ] 65 (Nov. 30, 2023) (multiple individuals violated
Rule 3502 in connection with the same primary violation by the firm
through different (though related) contributory conduct).
---------------------------------------------------------------------------
Finally, some commenters suggested other phrases or concepts to
incorporate into the rule to modify ``contribute.'' One commenter
called for limiting liability to ``egregious actions.'' \100\ Such a
standard, however, more aptly describes conduct that is reckless (as
opposed to negligent),\101\ which would be contrary to what the Board
intends for the amendment to accomplish.
---------------------------------------------------------------------------
\100\ Comment Letter from Accounting & Auditing Steering
Committee of the Pennsylvania Institute of Certified Public
Accountants at 5.
\101\ See, e.g., In re Gately & Assocs., LLC, SEC Release No.
34-62656, at 18 (Aug. 5, 2010) (``Recklessness can be established by
an `egregious refusal to investigate the doubtful and to see the
obvious.' '' (citation omitted)).
---------------------------------------------------------------------------
That same commenter expressed the view that the negligence standard
should not apply to a professional who spends only a de minimis amount
of time on an engagement, and further suggested that the Board add
language to clarify that liability would only extend to a professional
having a substantive level of participation on the engagement. Another
commenter similarly suggested that the Board require that an associated
person's conduct be a ``substantial factor'' in bringing about the
firm's violation.\102\ The Board, however, believes that the contours
of ``substantially'' (in ``directly and substantially'') suffice to
help ensure that Rule 3502 is applied only to those individuals with a
substantive level of participation or responsibility on an engagement
with respect to a firm's violation in connection with an audit. And as
the Board previously has
[[Page 54905]]
expressed--in the 2005 Adopting Release, in the Proposal, and above--
Rule 3502 is not intended to reach an associated person's conduct that,
while contributing to the violation in some way, is remote from, or
tangential to, the firm's violation.
---------------------------------------------------------------------------
\102\ Comment Letter from RSM US LLP at 7.
---------------------------------------------------------------------------
C. No New Liability Standard in Light of the Commission's Authority
As explained in the Proposal, associated persons already are
subject to potential liability--including money penalties--for
negligently contributing to registered firms' violations of numerous
laws and rules governing the preparation and issuance of audit reports
via the Securities Exchange Act of 1934 (``Exchange Act'').
Specifically, Section 21C of the Exchange Act authorizes the Commission
to institute cease-and-desist proceedings against any ``person that is,
was, or would be a cause of [a] violation [of the Exchange Act or any
rule or regulation thereunder], due to an act or omission the person
knew or should have known would contribute to such violation,'' \103\
and Section 21B further authorizes the Commission to ``impose a civil
penalty'' upon finding that such person ``is or was a cause of [such]
violation.'' \104\ Section 3(b)(1) of Sarbanes-Oxley, in turn, provides
that ``[a] violation by any person of . . . any rule of the Board shall
be treated for all purposes in the same manner as a violation of the
[Exchange Act] or the rules and regulations issued thereunder.'' Thus,
the amendment to Rule 3502's liability threshold does not subject
auditors to any new or different standard to govern their conduct in
light of the Commission's authority.\105\
---------------------------------------------------------------------------
\103\ 15 U.S.C. 78u-3(a); see also 15 U.S.C. 77h-1(a), 80a-
9(f)(1), 80b-3(k)(1).
\104\ 15 U.S.C. 78u-2(a)(2). The Commission's Section 21B
authority to impose civil penalties for violations in Section 21C
cease-and-desist proceedings was added in 2010 as part of the Dodd-
Frank Wall Street Reform and Consumer Protection Act. See Public Law
111-203.
\105\ Nor does the Commission's authority to sanction associated
persons' negligent contributory conduct detract from the proposed
amendment's deterrent effect. As previously noted, as an increase in
the number of regulators on the lookout for the same or similar
violative conduct increases the likelihood of that conduct being
detected and, consequently, the likelihood that the conduct would be
sanctioned. See Anton R. Valukas, White-Collar Crime and Economic
Recession, 2010 U. Chi. Legal F. 1, 12 (2010) (``One of the most
powerful deterrents to misconduct is an increased threat of
prosecution. . . . A `can do' accountant is less likely to provide
questionable opinions if there is a substantial certainty that he
will be caught and punished.''); see also Fletcher, supra, at 268
(``Certainty of punishment''--including ``the possibility of
detection, apprehension, conviction, and sanctions''--is one of two
``primary factors'' that drive deterrence.).
---------------------------------------------------------------------------
Numerous commenters seemed to disagree with that proposition for
several reasons. Some commenters pointed out that the Commission cases
cited in footnote 52 of the Proposal, while each a proceeding under
Section 21C of the Exchange Act, were also proceedings under Commission
Rule of Practice 102(e), which requires either ``[a] single instance of
highly unreasonable conduct that results in a violation'' or ``repeated
instances of unreasonable conduct, each resulting in a violation of
applicable professional standards.'' \106\ Sanctions are not available
under Rule 102(e) when an auditor engages in a single instance of
unreasonable (but not highly unreasonable) conduct.\107\ Thus, certain
commenters said that the cases were not ``on par'' with what the Board
intends through the amendment to Rule 3502.\108\
---------------------------------------------------------------------------
\106\ 17 CFR 201.102(e); see In re David S. Hall, P.C., SEC
Initial Decision Release No. 1114 (Mar. 7, 2017) (ALJ Op.), decision
made final, SEC Release No. 34-80949 (June 15, 2017); In re Gregory
M. Dearlove, CPA, SEC Release No. 34-57244 (Jan. 31, 2008); In re
Philip L. Pascale, CPA, SEC Release No. 34-51393 (Mar. 18, 2005).
\107\ See Amendment to Rule 102(e) of the Commission's Rules of
Practice, SEC Release No. 34-40567 (Oct. 26, 1998) (``[T]he
Commission is not adopting a standard that reaches single acts of
simple negligence.'').
\108\ Comment Letter from Center for Audit Quality at 7; Comment
Letter from Moss Adams LLP at 3 (Nov. 3, 2023). One commenter
observed that the Commission proposed but ultimately declined to
adopt an ordinary negligence standard for contributory conduct by
accountants under Rule 102(e). But as that commenter also
recognized, the Commission did so while expressly acknowledging that
an ordinary negligence standard in Rule 102(e) would have been
duplicative of authority that it already possessed. See SEC Release
No. 34-40567 (``Moreover, the Commission possesses authority, wholly
independent of Rule 102(e), to address and deter such errors through
its enforcement of provisions of the federal securities laws that
impose liability on persons, including accountants, for negligent
conduct.''). The Board, by contrast, lacks ability to pursue
contributory negligent conduct based on the current formulation of
Rule 3502.
---------------------------------------------------------------------------
To be sure, those commenters are correct that the cases cited in
footnote 52 of the Proposal involve proceedings under Commission Rule
102(e), as well as under Section 21C. Commenters, however, did not
appear to contest that the Commission has the authority to bring
proceedings for single acts of ordinary negligence under Section 21C,
including for civil money penalties (authorized by Section 21B),
without also proceeding under Commission Rule 102(e).\109\ Rather,
commenters instead suggested only that the Commission rarely exercises
such authority in practice. While that may be the case, the Board's
point nonetheless remains: The amendment to Rule 3502's liability
threshold does not subject auditors to any new or different standard to
govern their conduct.
---------------------------------------------------------------------------
\109\ Indeed, civil money penalties are not available under
Commission Rule 102(e)--only censure or denial (temporary or
permanent) of the privilege of appearing or practicing before the
Commission. 17 CFR 201.102(e). Thus, the Commission would not need
to meet Rule 102(e)'s ``highly unreasonable conduct'' standard to
impose a civil money penalty for a single act of negligence under
Section 21B of the Exchange Act.
---------------------------------------------------------------------------
The Commission release cited by certain commenters when advancing
the contrary argument makes this point abundantly clear. In it, the
Commission stated that a single act of negligence ``may result in a
violation of the federal securities laws'' and that ``the person
committing such an error, though not subject to discipline under Rule
102(e), would be exposed to the sanctions available under [such] other
provisions.'' \110\ The Commission noted elsewhere in its release that
a single act of ordinary negligence ``could have legal consequences.''
\111\
---------------------------------------------------------------------------
\110\ SEC Release No. 34-40567 at n.28; see also id. at n.38
(``In other instances, the federal securities laws expressly subject
auditors to liability without requiring intentional misconduct. . .
. [S]ection 21C of the Exchange Act imposes liability when a person
is a `cause' of a violation `due to an act or omission the person
knew or should have known would contribute to such violation.' '').
\111\ Id. at n.47.
---------------------------------------------------------------------------
One commenter suggested that Section 21C proceedings are an inapt
analog for charges under Rule 3502 because Section 21C was intended to
quickly enjoin conduct that may lead to violations, but was not
designed to be a sanctions-imposing provision. Whether that was the
original intent of Section 21C,\112\ Section 21B now indisputably
allows for sanctions (in the form of monetary penalties) in a
proceeding under Section 21C when an auditor or any other person was
negligent in causing violations by others. Indeed, much like Section
21B's direct-violation provision, the text of the secondary-violation
provision in Section 21B expressly contemplates the imposition of a
penalty based on conduct that already occurred.\113\
---------------------------------------------------------------------------
\112\ The commenter's cited authority does not appear to support
that view. See Andrew M. Smith, SEC Cease-and-Desist Orders, 51
Admin. L. Rev. 1197, 1226 (1999) (``The legislative history of the
[statute that includes Section 21C] is not clear as to whether
Congress intended to require the SEC to find a reasonable likelihood
of future violation before imposing a cease-and-desist order,
although a strong argument can be made that Congress did not intend
to require the SEC to make such a finding. In addition, most, if not
all, of the proponents and architects of cease-and-desist authority,
and many who have commented on the [relevant statute] and its
predecessor legislative proposals, believe that such a finding is
not necessary.'').
\113\ 15 U.S.C. 78u-2(a)(2)(B) (``In any proceeding instituted
under [Section 21C] against any person, the Commission may impose a
civil penalty, if the Commission finds, on the record after notice
and opportunity for hearing, that such person . . . is or was a
cause of the violation of any provision of this chapter, or any rule
or regulation issued under this chapter.'' (emphasis added)); see
also Smith, supra, at 1199 (``[Section 21C's] plain language--`has
violated'--appears to authorize the SEC to base a cease-and-desist
order upon a single past violation, without any showing that the
violator is likely to break the law in the future.'' (emphasis
added)).
---------------------------------------------------------------------------
[[Page 54906]]
This commenter also posited that, in addition to a primary
violation, Section 21C also requires a finding of harm to the public
that was in part caused by a contributory negligent act. While that may
be the case for issuance of a temporary order pursuant to Section
21C(c), no such finding is required for imposition of a monetary
penalty under Section 21B.\114\ And regardless, although harm is not an
element of proof for a Rule 3502 violation, inherent in any proceeding
under Rule 3502 is the foundational principle that the Board is
bringing the proceeding and imposing sanctions ``to protect the
interests of investors and further the public interest in the
preparation of informative, accurate, and independent audit reports.''
\115\
---------------------------------------------------------------------------
\114\ Compare 15 U.S.C. 78u-3(c)(1), with id. 78u-2(a)(2). In
any event, it would appear that harm to the public interest is
sufficient, but not required, for a temporary restraining order
under Section 21C, as that provision allows the Commission to enter
a temporary restraining order ``[w]henever the Commission determines
that the alleged violation or threatened violation . . . is likely
to result in significant dissipation or conversion of assets,
significant harm to investors, or substantial harm to the public
interest.'' Id. 78u-3(c)(1) (emphasis added).
\115\ Section 101(a) of Sarbanes-Oxley. As the Commission has
recognized, moreover, even ``unreasonable, or negligent, accounting
or auditing errors . . . could undermine accurate financial
reporting.'' SEC Release No. 34-40567.
---------------------------------------------------------------------------
Another commenter remarked that in a Commission proceeding for
ordinary negligence under Section 21C (and not also for highly
unreasonable conduct under Rule 102(e)), the Exchange Act limits what
sanctions the Commission can impose, and in the commenter's view, the
Commission lacks the authority to impose certain sanctions that the
Board can impose. But while the available sanctions for a single act of
negligence might be different in a proceeding under Rule 3502 compared
with one under Section 21C--indeed, the Commission can seek certain
sanctions that the Board cannot \116\--Sarbanes-Oxley does place
express limits on what sanctions the Board can impose.\117\ In the
Board's view, that the limitations on sanctions in the Exchange Act and
in Sarbanes-Oxley, respectively, might not be the same in all respects
does not render the Board's enforcement authority ``unprecedented.''
\118\
---------------------------------------------------------------------------
\116\ The Commission's authority is more expansive in other
ways, as well. For example, as noted in the Proposal, the Commission
is not limited to holding accountable auditors for contributory
conduct with respect to primary violations committed only by
registered firms; rather, the Commission also may hold accountable
auditors who cause violations by any other person, including
issuers. See 2023 Proposing Release at 9 n.33. Additionally, while
Rule 3502 applies only to associated persons of registered firms,
the Commission's authority under Section 21C is not so limited; it
applies to ``any person,'' including nonaccounting professionals. 15
U.S.C. 78u-3(a); see also id. 78c(a)(9) (defining ``person'').
\117\ See Section 105(c)(5) of Sarbanes-Oxley. One commenter
sought clarity with respect to footnote 48 of the Proposal, and
specifically the circumstances under which the Board would be
permitted to impose heightened sanctions. The Board takes this
opportunity to clarify that, although the amendment to Rule 3502
allows the Board to sanction single instances of negligent
contributory conduct, the heightened sanctions referenced in Section
105(c)(5) of Sarbanes-Oxley--specifically, those sanctions listed in
subparagraphs (A) through (C) and (D)(ii) of Section 105(c)(4)--
would not be available for a Rule 3502 violation absent a finding
that the individual who violated Rule 3502 acted at least recklessly
or committed repeated acts of negligence each resulting in a
violation of an applicable statutory, regulatory, or professional
standard.
\118\ Comment Letter from Center for Audit Quality at 8. This
commenter also sought to cast as inappropriate a negligence standard
for Rule 3502 in light of the mental state required for aiding and
abetting liability. The Board agrees with the commenter that aiding
and abetting generally requires knowing conduct, which is why the
Board has not relied on that theory of liability--in 2004, in 2005,
in the Proposal, or now--as an analog or basis for Rule 3502. See,
e.g., 2005 Adopting Release at 11 n.20 (``Rule 3502, of course,
differs from an aiding-and-abetting cause of action in important
respects. Among other things, the rule does not apply whenever an
associated person causes another to violate relevant laws, rules and
standards. Rather, Rule 3502 applies only when an associated person
causes a violation by the registered firm with which the person is
associated.'').
---------------------------------------------------------------------------
D. Authority for the Amendment
Several commenters expressed doubt regarding the Board's statutory
authority for the amendment in two respects: They questioned whether
the Board has the authority to sanction single acts of ordinary
negligence as a general matter (i.e., in cases of direct violations or
otherwise), and they questioned the Board's authority to promulgate a
contributory liability rule at the negligence standard. In general,
these commenters asserted that the Board's authority in these respects
is either unclear or rests on questionable interpretations of Sarbanes-
Oxley. One commenter further opined that the Proposal ignores
congressional intent and that the Board's authority is ``not as settled
as the Proposal assumes,'' \119\ and still another comment letter
posited that Sarbanes-Oxley is clear that in the absence of repeated
negligence, sanctions should not be imposed.
---------------------------------------------------------------------------
\119\ Comment Letter from U.S. Chamber of Commerce at 2.
---------------------------------------------------------------------------
Although the Board believes that its authority in both respects is
well-settled for reasons the Board has previously explained,\120\ the
Board nonetheless addresses these commenters' views.
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\120\ See 2004 Proposing Release at 18; 2005 Adopting Release at
10-12; see also 2023 Proposing Release at 12 n.43.
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1. Authority To Sanction Single Acts of Negligence Generally
The text of Section 105 of Sarbanes-Oxley plainly permits the Board
to impose liability for single acts of negligence. Specifically,
Section 105(c)(4) authorizes the Board to impose an array of
sanctions--listed in subparagraphs (A) through (G)--upon finding that a
registered firm or associated person engaged in violative conduct,
without reference to the level of culpability required but ``subject to
applicable limitations'' in Section 105(c)(5). Section 105(c)(5), in
turn, provides that ``[t]he sanctions and penalties described in
subparagraphs (A) through (C) and (D)(ii) of [Section 105(c)(4)] shall
only apply to [ ] intentional or knowing conduct, including reckless
conduct,'' or ``repeated instances of negligent conduct each resulting
in a violation of the applicable statutory, regulatory, or professional
standard.'' Section 105(c)(5) thus does not restrict the Board's
authority to impose for single acts of negligence certain sanctions--
those in subparagraphs (D)(i) and (E) through (G) of Section 105(c)(4).
The Board has long recognized this grant of authority,\121\ as did
multiple commenters. One commenter agreed that the Board has had
authority to bring enforcement proceedings for negligence ``[s]ince the
PCAOB's creation,'' \122\ and another posited that Congress ``clearly''
intended for the Board to sanction associated persons for negligent
conduct.\123\ Still another asserted that Sarbanes-Oxley ``empowers''
the Board
[[Page 54907]]
to sanction associated persons in instances ``when their conduct was
not intentional or reckless.'' \124\ Indeed, this latter commenter
opined that the Proposal created a ``misimpression'' that associated
persons currently can only be sanctioned for intentional or reckless
misconduct.\125\ This of course was not the Board's intent.
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\121\ Two decades ago, the Board stated:
The Act plainly contemplates that disciplinary proceedings can
be instituted for a violation based on a single negligent act.
Section 105(c)(5) of the Act provides that the Board may impose the
more severe sanctions authorized by section 105(c)(4) only in cases
that involve intentional or knowing conduct (including reckless
conduct) or repeated instances of negligent conduct. Implicit in
that provision is that a violation based on a single instance of
negligent conduct is sufficient to warrant a disciplinary proceeding
to impose lesser sanctions.
PCAOB Release No. 2003-015, at A2-58-59 (emphases added); see
also id. at A2-76 (``[S]ection 105(c)(5) of the Act requires
scienter or repeated negligence for imposition of the most severe
sanctions. The Act does not limit the standard that must be met for
imposition of other sanctions.''); 2005 Adopting Release at 12 n.23.
\122\ Comment Letter from North American Securities
Administrators Association, Inc. at 1 (Nov. 13, 2023).
\123\ Comment Letter from Center for American Progress at 3.
\124\ Comment Letter from Ernst & Young LLP at 2.
\125\ Id.
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Other commenters, however, took the opposite view. One comment
letter opined that, when read together, the provisions of Sections
105(c)(4) and (c)(5) discussed above make clear that unless negligent
conduct is repeated, sanctions and penalties ``should not be applied.''
\126\ If Congress had intended for all sanctions listed in Section
105(c)(4) to be unavailable absent reckless conduct or repeated acts of
negligence, however, then it would have had no reason to make the
specific carve-outs that it did in Section 105(c)(5); there would be no
point to them. Such an interpretation thus runs contrary to both
Section 105(c)(5)'s text and the bedrock principle of statutory
construction to not read a statute in a way that renders language
superfluous.\127\
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\126\ Comment Letter from Eight Accounting Professors (Cannon,
et al.) at 4 (Nov. 2, 2023).
\127\ See, e.g., FCC v. NextWave Personal Cmmc'ns Inc., 537 U.S.
293, 302 (2003) (``[E]ven Sec. 525(a) itself contains explicit
exemptions for certain Agriculture Department programs. These latter
exceptions would be entirely superfluous if we were to read Sec.
525 as the Commission proposes--which means, of course, that such a
reading must be rejected.''); see also TRW Inc. v. Andrews, 534 U.S.
19, 31 (2001) (``[W]ere we to adopt [respondent's] construction of
the statute, the express exception would be rendered insignificant,
if not wholly superfluous.'' (citation and quotation marks
omitted)).
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2. Authority for a Negligence-Based Contributory-Liability Rule
Congress intended to grant to the Board ``plenary authority'' to
establish or adopt ethics standards.\128\ To that end, Section
103(a)(1) of Sarbanes-Oxley mandates that the Board
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\128\ S. Rep. 107-205, at 8.
shall, by rule, establish . . . and amend or otherwise modify or
alter, such auditing and related attestation standards, such quality
control standards, such ethics standards, and such independence
standards to be used by registered public accounting firms in the
preparation and issuance of audit reports . . . as may be necessary
or appropriate in the public interest or for the protection of
investors.\129\
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\129\ See also Section 101(c)(2) of Sarbanes-Oxley.
As the Board twice recognized nearly two decades ago--once when it
proposed Rule 3502 and again when the Board adopted it--a contributory
liability rule merely codifies auditors' longstanding ethics
obligations.\130\
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\130\ 2004 Proposing Release at 18; see 2005 Adopting Release at
9. Beyond codifying auditors' ethics obligations, Rule 3502 is also
``essential to the proper functioning of the Board's independence
rules.'' 2004 Proposing Release at 19; see also 2005 Adopting
Release at 14. As the Board previously explained:
For example, Rule 3521 provides, in part, that a registered firm
is not independent of its audit client if the firm provides that
audit client with a service for a contingent fee. When an associated
person causes . . . the registered firm to provide that service for
a contingent fee, Rule 3502 would allow the Board to discipline the
associated person for that conduct.
2005 Adopting Release at 14.
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Some commenters nonetheless expressed doubt about whether the
statutory authority to regulate ethical conduct equates to a statutory
authority to sanction negligent conduct. In doing so, one such
commenter appeared to interpret the Proposal's discussion of the
Commission's authority under Section 21C of the Exchange Act to mean
that the Board was relying on that provision as authority for the
amendment. The Board, however, did not rely (and is not relying) on
Section 21C of the Exchange Act as a source of authority for its
negligent contributory-liability standard; rather, the Board agrees
with the commenter that such provision applies only to the Commission.
The Proposal's discussion of Section 21C instead was meant to show
that, by adopting a negligence threshold in Rule 3502, the Board would
not be subjecting auditors to any new standard to govern their
contributory conduct.\131\
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\131\ 2023 Proposing Release at 14 (discussing Section 21C and
concluding: ``Thus, the proposed amendment to Rule 3502's liability
threshold would not subject auditors to any new or different
standard to govern their conduct.'').
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As the Board previously explained, ``an associated person's ethical
obligation is not merely to refrain from knowingly causing a violation
but also to act with sufficient care to avoid negligently causing a
violation.'' \132\ Such obligation has deep historical roots. For
instance, the AICPA's Code of Professional Conduct at the time that
Sarbanes-Oxley was enacted (and still today) made it an ``act
discreditable to the profession''--and therefore a violation of its
ethics rules \133\--for a member accountant to ``permit[ ] or direct[ ]
another to make[ ] materially false and misleading entries in the
financial statements or records of an entity'' ``by virtue of his or
her negligence.'' \134\ Just the same if a member were to ``permit[ ]
or direct[ ] another to sign[ ] a document containing materially false
and misleading information'' ``by virtue of his or her negligence.''
\135\
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\132\ 2005 Adopting Release at 9.
\133\ The AICPA's Ethics Rulings are a body of decisions made by
the AICPA's professional ethics division's executive committee that
``summarize the application of Rules of Conduct and Interpretations
to a particular set of factual circumstances.'' Introduction, Code
of Professional Conduct (as Adopted January 12, 1988), available at
https://us.aicpa.org/content/dam/aicpa/research/standards/codeofconduct/downloadabledocuments/2014december14codeofprofessionalconduct.pdf; see also AICPA Code of
Professional Conduct Sec. 0.500.01 (updated June 2020) (``The code
is the only authoritative source of AICPA ethics rules and
interpretations.'' (italics omitted)).
\134\ AICPA Code of Professional Conduct, ET Sec. 501.05(a),
Negligence in the Preparation of Financial Statements or Records
(emphases added), recodified at Section 1.400.040.01.
\135\ Id. Sec. 501.05(c) (emphases added).
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Congress clearly had in mind the AICPA Code of Professional Conduct
when it authorized the Board to promulgate ethics standards. The AICPA
had a prominent presence during the drafting of Sarbanes-Oxley and in
the run up to its passage,\136\ and beyond Congress empowering the
Board to write its own ethics standards, it also empowered the Board to
``adopt as its rules[ ] . . . any portion of any statement of auditing
standards or other professional standards'' and to ``modify,
supplement, revise, or subsequently amend, modify, or repeal, in whole
or in part, any portion of any [such] statement.'' \137\ In other
words, Congress authorized the Board to adopt (and later amend or
modify) parts of the AICPA's Code of Professional Conduct as the
Board's ethics standards, and at the time of Sarbanes-Oxley's
enactment, that Code included prohibitions on negligent contributory
conduct.
---------------------------------------------------------------------------
\136\ During committee hearings for Sarbanes-Oxley, the Senate
heard testimony from five individuals who were serving, or
previously had served, in leadership roles within the AICPA
(including the AICPA's then-current Chair and its former Chair), and
also relied on data provided by the AICPA. See S. Rep. 107-205, at
3-4, 61, 63; see also H.R. Rep. No. 107-414, at 19 (2002) (noting
that the AICPA's then-President and CEO provided testimony to a
House of Representatives committee on a related bill).
\137\ Section 103(a)(3) of Sarbanes-Oxley (emphasis added). In
2003, the Board adopted parts of the AICPA Code of Professional
Conduct as its interim ethics standards, Establishment of Interim
Professional Auditing Standards, PCAOB Release No. 2003-006, at 10
(Apr. 18, 2003), and the Commission approved such adoption ``as
consistent with the requirements of [Sarbanes-Oxley],'' Order
Regarding Section 103(a)(3)(B) of the Sarbanes-Oxley Act of 2002,
SEC Release No. 34-47745 (Apr. 25, 2003).
---------------------------------------------------------------------------
One commenter cited a provision of the AICPA Code of Professional
Conduct that has a ``knowingly'' standard for contributory conduct
(Section 0.200.020.04). This commenter also cited the Board's then-
proposed (now-adopted) EI 1000, Integrity and Objectivity, to note that
the definition of ``integrity'' in that standard includes
[[Page 54908]]
``[n]ot knowingly or recklessly misrepresenting facts,'' without
reference to negligence.\138\ However, this commenter did not
acknowledge that the AICPA Code also has contributory-conduct
provisions at the negligence standard, as discussed above.
---------------------------------------------------------------------------
\138\ QC 1000 Release at A4-1.
---------------------------------------------------------------------------
Certain commenters compared the Board's authority for a
contributory negligence standard in Rule 3502 to private plaintiffs'
inability to bring suit under Section 10(b) of the Exchange Act \139\
for aiding and abetting securities fraud. To be sure, in Central Bank
of Denver, the U.S. Supreme Court held that ``there is no private
aiding and abetting liability under Sec. 10(b)'' ``[b]ecause the text
of Sec. 10(b) does not prohibit aiding and abetting.'' \140\ But that
holding regarding an implied private right of action has little bearing
on the Board's authority for the amendment.
---------------------------------------------------------------------------
\139\ 15 U.S.C. 78j.
\140\ Cent. Bank of Denver, N.A. v. First Interstate Bank of
Denver, N.A., 511 U.S. 164, 191 (1994).
---------------------------------------------------------------------------
The Board draws its authority for the amendment from different text
in a different statute. As explained above, Congress empowered the
Board to promulgate ethics standards pursuant to Section 103(a) of
Sarbanes-Oxley, which is distinct from any congressional grant of
authority to the Commission, including those in Sections 10(b) or 21C
of the Exchange Act.\141\ There is no analogous statutory mandate for
the Commission to ``establish . . . ethics standards'' in the area of
auditors' professional responsibility.
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\141\ Section 105 of Sarbanes-Oxley also supplies authority to
adopt the proposed amendment. See 2005 Adopting Release at 12; 2023
Proposing Release at 12 n.43. As the Board previously explained,
``Section 105 authorizes the Board to investigate and, when
appropriate, discipline registered firms and their associated
persons,'' and because (1) ``[c]ertain types of violations, by their
nature, may give rise to direct liability only for a registered
public accounting firm,'' and (2) ``[s]uch firms . . . can only act
through the natural persons that comprise them,'' it follows that
(3) ``[w]hen one or more of those associated persons has caused that
firm to'' commit a violation, ``it is appropriate, and consistent
with the Board's duty to discipline registered firms and their
associated persons under Section 101(c)(4) of the Act, that the
Board be able to discipline the associated person for that
misconduct.'' 2005 Adopting Release at 12.
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The Board, however, indisputably does have such a mandate in
Section 103(a)(1) of Sarbanes-Oxley,\142\ and with that distinct
mandate comes distinct authority.\143\ Indeed, as the Commission
recognized when approving the Board's adoption of Rule 3502 in 2006,
``the rule is within the scope of the PCAOB's authority, particularly
its authority to establish ethical standards.'' \144\ Section
103(a)(1), moreover, is an enabling (or authorizing) statute that
permits the Board to establish standards to govern the preparation and
issuance of audit reports ``as may be necessary or appropriate in the
public interest,'' which text provides broad rulemaking authority.\145\
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\142\ One commenter remarked that Section 103 ``is not
untethered'' from the rest of Sarbanes-Oxley. Comment Letter from
U.S. Chamber of Commerce at 4. The Board agrees: Section 103 tethers
directly to Section 101(c)(2), which mandates that the Board
``establish or adopt, or both, by rule, auditing, quality control,
ethics, independence, and other standards . . . in accordance with
section 7213 [103] of this title.'' Indeed, doing so is an express
``Dut[y] of the Board'' under Section 101(c). Section 101(c)(2) is
thus another source of authority for the Board's amendment.
\143\ Nor does Section 103(a) of Sarbanes-Oxley include the
telltale terms of a statute that requires a mental state higher than
negligence, as does Section 10(b) of the Exchange Act. See Ernst &
Ernst v. Hochfelder, 425 U.S. 185, 197 (1976) (``Section 10(b) makes
unlawful the use or employment of `any manipulative or deceptive
device or contrivance' in contravention of Commission rules. The
words `manipulative or deceptive' used in conjunction with `device
or contrivance' strongly suggest that Sec. 10(b) was intended to
proscribe knowing or intentional misconduct.''); id. at 199 (``The
argument simply ignores the use of the words `manipulative,'
`device,' and `contrivance' [are] terms that make unmistakable a
congressional intent to proscribe a type of conduct quite different
from negligence.'').
\144\ Order Approving Proposed Ethics and Independence Rules
Concerning Independence, Tax Services, and Contingent Fees and
Notice of Filing and Order Granting Accelerated Approval of the
Amendment Delaying Implementation of Certain of these Rules, SEC
Release No. 34-53677, at 9 (Apr. 19, 2006).
\145\ See, e.g., AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366,
377-78 & n.5 (1999) (construing a provision allowing the FCC to
``prescribe such rules and regulations as may be necessary in the
public interest to carry out'' the relevant statute as a ``general
grant of rulemaking authority'' sufficient for the FCC to promulgate
the regulations at issue); Metrophones Telecommc'ns, Inc. v. Global
Crossing Telecommc'ns, Inc., 423 F.3d 1056, 1068 (9th Cir. 2005)
(``Given the reach of the [FCC's] rulemaking authority under Sec.
201(b)''--which granted to the FCC the ``broad power to enact such
`rules and regulations as may be necessary in the public interest to
carry out the provisions of this Act' ''--``it would be strange to
hold that Congress narrowly limited the Commission's power to deem a
practice `unjust or unreasonable.' ''); Brown v. Azar, 497 F. Supp.
3d 1270, 1281 (N.D. Ga. 2020) (``[W]hen an agency is authorized to
`prescribe such rules and regulations as may be necessary in the
public interest to carry out the provisions of the Act,' Congress'
intent to give an agency broad power is clear.''), appeal dismissed
as moot, 20 F.4th 1385 (11th Cir. 2021) (mem.).
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So, too, is Section 101(g)(1) of Sarbanes-Oxley--yet another source
of authority for the amendment. That provision authorizes the Board to
promulgate rules to ``provide for . . . the exercise of its authority,
and the performance of its responsibilities under this Act,'' which
include ``enforc[ing] compliance'' with applicable laws, rules, and
standards; ``conduct[ing] investigations and disciplinary
proceedings''; and ``impos[ing] appropriate sanctions where
justified.'' \146\ Section 101(g)(1) thus empowers the Board to
implement the Board's ``ultimate purposes'' under Sarbanes-Oxley of
``protect[ing] the interests of investors and further[ing] the public
interest in the preparation of informative, accurate, and independent
audit reports.'' \147\ The amendment, and Rule 3502 generally, do
precisely that.
---------------------------------------------------------------------------
\146\ Sections 101(c)(4) and (6) of Sarbanes-Oxley.
\147\ Section 101(a) of Sarbanes-Oxley; In re Permian Basin Area
Rate Cases, 390 U.S. 747, 780 (1968) (``We are, in the absence of
compelling evidence that such was Congress' intention, unwilling to
prohibit administrative action imperative for the achievement of an
agency's ultimate purposes.''); see Doe v. FEC, 920 F.3d 866, 870-71
(D.C. Cir. 2019) (``When an agency's `empowering provision' ''
permits the agency ```to make, amend, and repeal such rules . . . as
are necessary to carry out the provisions of' '' the statute, ``the
courts will sustain a regulation that is `reasonably related' to the
purposes of the legislation.'' (citations omitted)).
---------------------------------------------------------------------------
Statement Regarding the Proposed Amendment To Clarify the Relationship
Between Contributory Actor and Primary Violator
As noted above, in addition to proposing a change in Rule 3502's
liability standard, the Proposal also contemplated amending Rule 3502
to provide that an associated person contributing to a violation need
not be an associated person of the registered firm that commits the
primary violation (i.e., that an associated person of one registered
firm can contribute to a primary violation of another registered
firm).\148\ Specifically, the Board proposed changing the word ``that''
to ``any'' immediately before the reference to the registered public
accounting firm that commits the primary violation. After due
consideration, the Board has decided not to adopt any changes to Rule
3502 to implement this aspect of the Proposal, for two primary reasons.
---------------------------------------------------------------------------
\148\ See 2023 Proposing Release at 16-17.
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First, as the Proposal explained, the Board's rules already
contemplate that associated persons can be associated with more than
one registered firm at the same time.\149\ Specifically, PCAOB Rule
1001(p)(i)'s definition of an ``associated person'' provides that if a
firm reasonably believes that one of its associated persons is
primarily associated with another registered firm, then that person is
excluded from the definition of an ``associated person,'' but only
``for purposes of completing a registration application on Form 1, Part
IV of an annual report on Form 2, or Part IV of a Form 4 to succeed to
the registration status of a predecessor.'' For all other purposes,
that carveout does not apply, thus underscoring that, in the context of
Rule 3502's reference to an
[[Page 54909]]
``associated person,'' a person can be associated with two or more
registered firms at once.
---------------------------------------------------------------------------
\149\ See id. at 10 n.36.
---------------------------------------------------------------------------
Second, an individual who ``directly and substantially''
contributes to a firm's violation (consistent with the meaning of that
phrase in Rule 3502, as described above) in all instances likely also
will have ``participate[d] as agent or otherwise on behalf of such [ ]
firm in any activity of that firm'' ``in connection with the
preparation or issuance of any audit report,'' and thus be an
``associated person'' of that firm.\150\ In the Board's view, this
definition of ``associated person,'' in combination with the notion
that a person can be associated with multiple firms at the same time,
renders unnecessary the proposed change from ``that'' to ``any'' in
Rule 3502.
---------------------------------------------------------------------------
\150\ See Section 2(a)(9) of Sarbanes-Oxley (emphases added);
PCAOB Rule 1001(p)(i).
---------------------------------------------------------------------------
The Board appreciates commenters' feedback on this aspect of the
Proposal. As one commenter surmised, this aspect of the Proposal was
aimed at providing for equal accountability by associated persons as
firm structures evolve. Based on the two points noted above, however,
the Board believes that such accountability currently exists.\151\ It
was not the Board's intent through this aspect of the Proposal to deter
collaboration or the sharing of perspectives between firms. And, to the
extent that commenters believe that this aspect of the Proposal would
exacerbate their concerns with respect to a negligence standard, the
Board's decision not to adopt any amendment in this regard should help
to alleviate those concerns.
---------------------------------------------------------------------------
\151\ Beyond these two points, one commenter opined that ``in
most, if not all, cases,'' an auditor's direct and substantial
contribution to a primary violation by a firm with which the auditor
is not associated also would have at least negligently, directly,
and substantially contributed to a primary violation by a firm with
which the auditor is associated. Comment Letter from Ernst & Young
LLP at 4. This proposition further underscores the point that no
clarifying amendment is needed given the current regulatory
framework.
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Effective Date
If the amendment to PCAOB Rule 3502 is approved by the Commission,
then (as proposed) the Board intends that it would become effective 60
days from the date of Commission approval.\152\ In that regard, the
Board anticipates that conduct occurring more than 60 days after
Commission approval would be subject to Rule 3502, as amended, but that
conduct occurring prior to, or within 60 days after, Commission
approval would not be subject to the amendment to Rule 3502.
---------------------------------------------------------------------------
\152\ See 2023 Proposing Release at 31.
---------------------------------------------------------------------------
Commenters expressed mixed views regarding the effective date. One
commenter agreed that 60 days after Commission approval is appropriate,
and another stated that it did not disagree with the Board's basis for
an effective date 60 days after Commission approval. Another commenter
stated that it could not comment on an appropriate effective date
because the Board should redeliberate and repropose amendments to Rule
3502. Other commenters encouraged the Board to delay the effectiveness
until the Board more fulsomely assesses the costs of the amendment and
considers the amendment's impact on the profession and audit quality.
Several commenters suggested that the Board delay the effectiveness
of any amendment to Rule 3502 to provide for time to gauge the impact
of other then-pending proposals, including QC 1000 and AS 1000 (both of
which have since been adopted). In general, these commenters opined
that the impact of the amendment to Rule 3502 could depend on how the
amendment interacts with, and the potential unintended consequences of,
changes to other professional standards. Another commenter encouraged
the Board to delay the effectiveness of the amendment for medium-sized
and smaller firms, including those in non-U.S. jurisdictions, to
appropriately understand the amendment's ramifications and to respond
accordingly.
The Board recognizes that it is in various stages of the process of
modernizing several of its standards and rules to protect the interests
of investors and further the public interest. Those updates (both
adopted and proposed) reflect that, over the years, audits and the
audit industry have evolved, and the Board's standards and rules should
as well.\153\ The Board also appreciates that its revised standards and
rules may require adjustment by individuals and firms, which is why
each of those standards also includes (or proposes to include, in the
case of proposals) a delay in its respective effective date following
the date of Commission approval.\154\ The notion that multiple
standards are being modernized in parallel, however, is not a basis for
permitting individuals--regardless of the size of the firm(s) with
which they are associated--to negligently, directly, and substantially
contribute to firms' primary violations. And as noted above, as firms
make efforts to comply with new standards, it necessarily follows that
individuals who could be subject to Rule 3502 also would be making such
efforts (because firms can act only through their natural persons).
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\153\ See PCAOB, Strategic Plan 2022-2026, at 10 (``[A]s
important as [auditing, attestation, quality control, ethics, and
Independence] standards are, some of them were written by the audit
profession prior to the PCAOB's establishment and have not been
updated since we adopted them in 2003 on what was intended to be an
interim basis. The world has changed since 2003, and our standards
must adapt to keep up with developments in auditing and the capital
markets. We intend to modernize and streamline our existing
standards and to issue new standards where necessary to meet today's
needs.'').
\154\ See PCAOB Release No. 2022-002, at 58 (effective for
audits of financial statements for fiscal years ending on or after
December 15, 2024); PCAOB Release No. 2023-008, at 96 (effective for
audits of financial statements for fiscal years ending on or after
June 15, 2025); AS 1000 Release at 96 (with limited exception,
effective for audits of financial statements for fiscal years
beginning on or after December 15, 2024); QC 1000 Release at 378
(effective December 15, 2025); PCAOB Release No. 2024-007, at 61
(effective for audits of financial statements for fiscal years
beginning on or after December 15, 2025); see also PCAOB Release No.
2024-006, at 61 (contemplating effectiveness for audits of fiscal
years beginning on or after December 15 in the year of approval by
the Commission); PCAOB Release No. 2024-003, at 89 (proposing
effective dates of 90 days after Commission approval for certain
aspects and no earlier than March 31, 2026, or one year after
Commission approval, whichever is later, for other aspects); PCAOB
Release No. 2024-002, at 186 (proposing phased effective dates
beginning no earlier than October 1 in the year after Commission
approval); PCAOB Release No. 2024-001, at 63 (proposing an effective
date of six months after Commission approval to comply with certain
aspects); PCAOB Release No. 2023-003, at 94 (contemplating
effectiveness for audits of fiscal years beginning in the year after
approval by the Commission, or if Commission approval occurs in the
fourth quarter of a calendar year, effectiveness for audits of
fiscal years beginning two years after the year of Commission
approval).
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Accordingly, having considered the comments and for the reasons
above, the Board continues to believe that 60 days after Commission
approval is an appropriate effective date for the amendment to Rule
3502. That period provides sufficient time for associated persons to
familiarize themselves with the applicable legal standards and to
increase their diligence as necessary and appropriate, which enhances
audit quality and therefore serves the interests of the public and
better protects investors.
D. Economic Considerations and Application to Audits of Emerging Growth
Companies
The Board is mindful of the economic impacts of its rulemaking.
This section describes the baseline for evaluating the economic impacts
of the amendment to Rule 3502, the need for rulemaking, its expected
economic impacts (including benefits, costs, and potential
[[Page 54910]]
unintended consequences), and reasonable alternatives considered. Due
to data limitations, much of the economic analysis is qualitative;
however, it incorporates quantitative information, including PCAOB
enforcement data and academic and industry research, where feasible.
The Board sought information relevant to the economic analysis
throughout this rulemaking and has carefully considered the comments
submitted, including the data and studies suggested by the commenters.
A. Baseline
Section C above describes the important components of the baseline
against which the amendment's economic impacts are considered,
including the current formulation of Rule 3502 and the Board's
implementation experience. The Board discusses below the Board's
enforcement activities. Table 1 presents PCAOB enforcement data on Rule
3502 charges from 2009-2024.\155\ This table provides historical
information on how frequently individuals have been charged under the
current formulation of Rule 3502.
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\155\ Table 1 contains data through April 30, 2024. The Board
brought the first Rule 3502 charge in 2009 for conduct committed
after the effective date of Rule 3502 in April 2006.
Table 1--Number and Incidence of Rule 3502 Charges, 2009-2024
----------------------------------------------------------------------------------------------------------------
Cases with Rule 3502 Incidence of Rule
Year charges Firms sanctioned 3502 charges (%)
(A) (B) C = A/B
----------------------------------------------------------------------------------------------------------------
2009.......................................... 2 5 40
2010.......................................... 0 2 0
2011.......................................... 2 6 33
2012.......................................... 3 4 75
2013.......................................... 5 10 50
2014.......................................... 2 20 10
2015.......................................... 17 37 46
2016.......................................... 14 30 47
2017.......................................... 15 42 36
2018.......................................... 8 13 62
2019.......................................... 8 19 42
2020.......................................... 2 13 15
2021.......................................... 3 14 21
2022.......................................... 6 30 20
2023.......................................... 5 43 12
2024.......................................... 4 20 20
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Total..................................... 96 308 31
----------------------------------------------------------------------------------------------------------------
Source: Settled and Adjudicated Disciplinary Orders Reported by the Board to the Public Pursuant to Section
105(d) of Sarbanes-Oxley, available at https://pcaobus.org/oversight/enforcement/enforcement-actions.
Column A shows the number of cases in which associated persons were
found to have violated Rule 3502 (includes settled and adjudicated
cases); column B shows the number of cases in which registered firms
were sanctioned (for any violation); and column C is the ratio of the
two, expressed as a percentage to reflect the proportion of firm cases
when an associated person was charged with Rule 3502 by the Board.
From 2009 through April 30, 2024, there have been a total of 96
cases with Rule 3502 violations. At an average of six per year, the
number of Rule 3502 cases was highest in 2015 at 17 and lowest in 2010,
when no Rule 3502 violations were found.\156\ The 96 cases represent 31
percent of the total number of cases in which the Board sanctioned
firms for violations from 2009-2024. The data presented in the table
does not predict how many Rule 3502 violations the Board might find
because of the amendment; it indicates that in over two-thirds of the
cases in which a firm was sanctioned, no contributory actor was held
accountable under Rule 3502.\157\
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\156\ Column Year refers to the year the firms were sanctioned.
Column A reflects Rule 3502 cases involving sanctions of one or more
respondents as one instance. Some firms were sanctioned in different
years than associated persons were sanctioned for the corresponding
Rule 3502 violations. In such cases, Rule 3502 violations by
associated persons are counted in the same year the firms were
sanctioned. Therefore, column A can be interpreted as a subset of
cases in Column B.
\157\ One commenter asserted that Table 1 in the Proposal did
not illuminate whether the cases without Rule 3502 charges would
have merited or supported a Rule 3502 charge for individual
negligence had that option been available, and suggested that the
PCAOB perform that analysis, even if for a shortened period of 5
years. Another commenter also suggested that this analysis does not
indicate cases where a Rule 3502 charge would have been
inappropriate or where the absence of charges was supported by the
Board's exercise of prosecutorial discretion. However, the Board
notes that staff has already performed an analysis of that nature
for the immediately preceding two years, which forms the basis of
the estimated increase in the number of cases discussed below. See
also 2023 Proposing Release at 24-25 (providing estimate for 2022).
Performing an analysis for additional older years may be potentially
less robust, given the extremely fact-based nature of the
evaluation; staff recollections of whether all of the available
investigatory evidence could have supported a negligence claim are
naturally less reliable for older matters; and relevant staff may
have since departed the PCAOB.
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Commenters suggested alternative means of assessing the baseline
for this amendment. Some commenters suggested that the Board consider
the Commission's enforcement data. However, PCAOB enforcement data is a
more relevant comparison because this data is limited to cases brought
by the PCAOB, offering a more precise perspective for understanding the
baseline of the amendment. Although the Commission's enforcement data
is valuable, it is impacted by various factors, including the
Commission's case mix, prosecutorial discretion, resource allocation
decisions, and enforcement priorities. While the Commission and the
PCAOB coordinate enforcement efforts as required by Sarbanes-Oxley,
their respective mandates are separate from each other. Given these
separate mandates,
[[Page 54911]]
inclusion of the Commission's data herein would not contribute to a
fuller understanding of the PCAOB's historical practices.
Other commenters suggested that, rather than the comparison
provided in Table 1 of individual Rule 3502 cases to firm cases, a more
relevant comparison would be PCAOB enforcement proceedings against
firms to PCAOB enforcement proceedings against individuals (under Rule
3502 and otherwise). One of these commenters acknowledged, however,
that such a comparison would not shed meaningful light on the need for
the proposed change, and the Board agrees. Because contributory
liability under Rule 3502 is distinct from primary liability,
aggregating individual liability for all types of violations would not
contribute to an understanding of the PCAOB's historical application of
Rule 3502. Column A in Table 1 focuses on contributory liability only
and therefore more clearly illuminates the baseline of the PCAOB's use
of Rule 3502 as currently formulated.
Another commenter suggested conducting a survey regarding the
resulting internal impact of PCAOB enforcement proceedings at the firm
level on associated individuals. While a well-designed survey may
provide additional insights, the Board believes that staff analysis
based on PCAOB enforcement activities provides a sufficiently reliable
basis for assessing the need for and scope of the amendment to Rule
3502.\158\
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\158\ Further, the suggested survey would have shed light on
firms' internal disciplinary measures taken against associated
individuals, which, as discussed below, are important but not
equivalent in effect to public proceedings.
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B. Need
This section discusses the problem the amendment intends to address
and how the amendment addresses the problem.
1. Problems To Be Addressed
The need for the amendment arises from a current gap in the PCAOB's
regulatory framework. Specifically, as described in detail in section C
above, the gap in the PCAOB's regulatory framework relates to a
misalignment between the liability standard for firms that commit
violations resulting from an associated person's conduct and the
liability standard for the associated person who contributes directly
and substantially to the firm's violation. Under the current
formulation of Rule 3502, while firms can be held accountable by the
PCAOB for violations due to negligence, individuals can be held liable
for their contributory conduct only if their conduct was at least
reckless, a more stringent standard than negligence. That is, Rule
3502's current formulation places negligent individual contributors to
firms' violations beyond Rule 3502's reach.
The gap discussed above creates regulatory inefficiency and
undermines the PCAOB's regulatory objectives, including furthering the
public interest in the preparation of informative, accurate, and
independent audit reports. Inefficiency arises under the current
regulatory framework because the PCAOB cannot hold individuals
accountable for negligent contributory conduct while the Commission
can, and therefore the PCAOB would have to refer one part of a broader
case to the Commission to take action (as it deems appropriate) against
the negligent individual. If the Commission decided to move forward
with a separate case against the individual, Commission staff may need
to familiarize themselves with the case, potentially reinterview
witnesses, and undertake (as needed) additional investigative steps.
This could result in delays and, given that these activities would
relate to substantially the same set of facts that the PCAOB is seeking
to establish with respect to the firm, would render duplicative the
PCAOB's prior work in these areas, thereby creating inefficiencies.
Moreover, if the Commission chooses not to pursue the case (for
example, due to resource constraints or competing priorities), the
individual's negligent conduct may go unsanctioned.\159\ This lack of
individual accountability could hinder the effectiveness of the PCAOB's
enforcement proceedings and may lead to under-deterrence among
individuals within the industry, as they observe only the firm being
penalized without consequences for the individuals responsible for the
negligent conduct.
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\159\ See, e.g., Samuel B. Bonsall IV, Eric R. Holzman & Brian
P. Miller, Wearing out the Watchdog: The Impact of SEC Case Backlog
on the Formal Investigation Process, 99 Acct. Rev. 81, 81 (2024)
(``We find that higher office case backlog decreases the likelihood
of an investigation into a restating firm. . . . Backlog also
impacts pursued investigations, leading to more prolonged
investigations, a lower Accounting and Auditing Enforcement Releases
likelihood, and smaller SEC penalties. Our evidence suggests that
busyness undermines the SEC's investigation process.'').
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2. How the Amendment Addresses the Need
The amendment to Rule 3502 addresses the need by aligning the
liability standards for firms and associated persons. It changes the
liability standard for individual contributory conduct from
recklessness to negligence. Doing so closes the regulatory gap
described above and allows the Board to hold individuals accountable
when they directly and substantially contribute to a firm's violation
if their contributory act or failure to act was negligent but not
reckless. By closing the gap, the amendment eliminates the obstacles in
the public enforcement framework and helps improve regulatory
efficiency.
The amendment does not result in a novel expansion of liability to
reach conduct that is currently not subject to enforcement, as the
Commission already has authority to discipline associated persons who
negligently cause a firm's violation. Instead, it merely provides the
PCAOB with the ability to hold individuals accountable similar to the
Commission.
Some commenters agreed that the amendment would address the
regulatory gap within the existing framework. However, other commenters
challenged the need for the amendment. Some commenters asserted that
the PCAOB already has tools for disciplining individuals and that the
absence of Rule 3502 charges does not imply a lack of individual
accountability. To be sure, the PCAOB currently has the authority to
hold individuals accountable for violations of rules that contemplate
individual responsibility, and the Board actively brings cases to hold
individuals accountable for wrongdoing. But Rule 3502 is a distinct
authority that creates and enforces a distinct obligation, and
currently, the PCAOB is unable to hold individuals accountable under
that rule when they act unreasonably but not recklessly. The amendment
thus is not ``duplicative,'' as some commenters suggested,\160\ and the
Board's analysis therefore centers on the need to close this particular
regulatory gap to give the PCAOB the appropriate tool for these sets of
circumstances.
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\160\ Comment Letter from U.S. Chamber of Commerce at 7; Comment
Letter from Center for Audit Quality at 6.
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Other commenters asserted that the PCAOB's need was not sufficient
to justify the amendment to Rule 3502 that these commenters considered
profound, with its attendant costs and consequences. Certain of these
commenters suggested that any change in auditor behavior that the PCAOB
hopes to accomplish has already been accomplished by the Commission's
ability to bring cases for negligent conduct, and that therefore the
PCAOB has not shown a convincing need. As
[[Page 54912]]
discussed in section C above, the amendment to Rule 3502 is not a
significant shift in the liability landscape. Rather, it allows the
PCAOB to discipline associated persons for negligently contributing to
firms' violations, which is misconduct that the Commission currently
can pursue. The Board recognizes, however, that this incremental
increase in the PCAOB's enforcement capability may in turn generate
certain incremental effects on auditor behavior, as discussed further
below.
Some commenters also asserted the absence of adequate evidence to
support the need for the amendment. However, the comments received did
not offer data that can be used to supplement the analysis
meaningfully, and the Board is not aware of additional data or
quantitative analysis that could be performed. Thus, as noted at the
outset, the Board has performed limited quantitative analysis where
possible but relies largely on qualitative analysis to inform this
rulemaking.
One comment letter noted that the PCAOB's current inspection
program is effective in enhancing audit quality, citing academic
research to support that view.\161\ While the Board acknowledges that
the PCAOB's inspection program plays a vital role in enhancing audit
quality, the PCAOB's enforcement program plays a distinct but
complementary role in holding firms and associated persons accountable
for violations, and thereby sanctioning and deterring unlawful conduct.
The amendment aims to fill a gap in that latter program by helping to
ensure that individuals negligently contributing to a firm's violations
are held accountable and that the integrity of the audit process is
strengthened. The continued persistence of a high rate of audit
deficiencies also suggests that, while the inspections and enforcement
processes may be effective at enhancing audit quality, as the commenter
describes, additional efforts are needed, including through this
rulemaking.\162\
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\161\ For example, the commenter cited Lindsay M. Johnson,
Marsha B. Keune & Jennifer Winchel, U.S. Auditors' Perceptions of
the PCAOB Inspection Process: A Behavioral Examination, 36 Contemp.
Acct. Res. 1540, 1557 (2019) (``Overall, participants described
substantial modifications in their audit approach in response to
inspection findings and the anticipation of inspections. These
modifications are consistent with auditors and their firms actively
working to comply with PCAOB expectations . . . .''). This
behavioral study examined auditors' observations and behaviors in
response to the PCAOB inspection process, focusing on factors such
as perceived power and trust in the regulatory body.
\162\ See, e.g., PCAOB Report: Audits with Deficiencies Rose for
Second Year in a Row to 40% in 2022 (July 25, 2023), available at
https://pcaobus.org/news-events/news-releases/news-release-detail/pcaob-report-audits-with-deficiencies-rose-for-second-year-in-a-row-to-40-in-2022.
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In general, commenters did not introduce arguments or data that
caused the Board to rethink its assessment of the need: there is a
regulatory gap, the gap is small because the Commission already has the
ability to bring negligence-based secondary-liability cases, but the
gap can nonetheless result in regulatory inefficiencies or an
incremental absence of deterrence and accountability, respectively. The
amendment would close this gap, yielding the economic impacts discussed
further below.
C. Economic Impacts
This section discusses the expected benefits and costs of the
amendment and potential unintended consequences.
A critical component of the Board's assessment of the economic
impacts of this amendment is the Board's assessment of the likely
number of PCAOB enforcement cases that would be brought under the
amended rule. For the Proposal, staff examined enforcement matters from
2022 to assess the potential increase in recommended cases had Rule
3502 included the proposed amendment. Staff estimated two to three
instances in 2022 where the amendment could have prompted staff to
recommend a Rule 3502 charge.\163\ Staff also indicated that, based on
its expertise, that number would be broadly consistent with other
years.
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\163\ See 2023 Proposing Release at 25. This is an estimate of
cases in which staff would likely have recommended Rule 3502 charges
against natural persons. Because Rule 3502 charges can be brought
against associated persons, which include both natural persons and
legal entities, it is possible that the estimate could be higher if
it were to include potential additional cases against legal
entities. However, due to the complexity of the fact patterns
presented in such cases, staff could not estimate the number of
additional cases that would have been brought against such entities.
Additionally, although the Proposal's estimate included the second
aspect of the Proposal, staff has confirmed that the estimate
remains appropriate without that aspect.
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For this release, staff updated its analysis to include an
additional year (2023); for 2023, staff also believes that, had
negligence been the standard in Rule 3502, two or three instances could
have prompted staff to recommend a Rule 3502 charge.\164\ The Board
continues to note that this estimate may vary to the extent that there
are modifications to other Board standards or changes in enforcement
priorities.
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\164\ Staff were limited in the ability to perform further
analysis given the intensively fact-specific nature of investigatory
and charging decisions. Further, the availability (or
unavailability) of potential charges can itself shape the
investigatory process. Finally, determining whether all the
available facts and circumstances would have supported a staff
recommendation against an individual for negligent contributory
conduct also depends on an intimate familiarity with the entire
investigatory file as it pertains to that individual's conduct and
the relevant standard of care. As recollections fade over time, a
case-specific analysis of what charges could have been supported
becomes less reliable. Other staff have moved to different roles
within the PCAOB or departed the organization entirely. The Board
therefore focused its analysis on the most recent time period where
relevant staff members are available and their knowledge is the
freshest, and then confirmed staff's view of whether it has any
reason to believe that this time period would not be representative
of the broader trend.
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This analysis influenced, and continues to influence, the Board's
assessment of the likely benefits, costs, and potential unintended
consequences of the amendment--namely, that auditors are already held
to a contributory negligence standard, that the change here is only
adding the PCAOB as an enforcer, and that this change therefore would
have meaningful but incremental benefits. As discussed further below,
it would result in more efficient enforcement in specific cases, and it
may prompt individuals to exercise the appropriate level of care and to
make firms more efficiently allocate resources, which would raise audit
quality. It would also have some incremental anticipated costs, and
unintended consequences that parallel the anticipated costs, including
litigation, liability, and opportunity costs, and potential
inefficiencies in terms of self-protective behavior.
One commenter agreed with the Board's expectation that the economic
impact will be modest while others challenged this analysis. They took
issue with the estimate of only a few additional cases for 2022
resulting from the amendment, questioning the basis and relevance of
this prediction. Based on extensive experience, staff believes that
this number is a fair average representation across other years and
provides an estimate of the additional cases resulting from the Board
pursuing charges under the amendment. In fact, as discussed above,
staff updated its analysis to include data from 2023 and that analysis
generated an estimate of two to three additional cases in 2023,
consistent with that for 2022. Overall, the estimation approach
espoused here (with respect to both 2022 and 2023) applies expert
judgment to the PCAOB's recent case data to offer a pragmatic
perspective.\165\
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\165\ An alternative approach would involve providing an upper
bound of the number of cases, i.e., the total number of firm cases
that were brought each year. This can be easily derived from Table
1. However, not every firm case would be associated with individual
contributory liability, and some cases would involve individual
primary liability too. Therefore, the Board declined to engage in
this alternative approach and rather relied on staff's expertise in
terms of providing a more pragmatic perspective on the additional
number of cases under the amendment.
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[[Page 54913]]
Moreover, the PCAOB has existing authorities to bring charges
against individuals--both for primary violations and for at least
reckless contributory conduct; \166\ the amendment therefore would
close a gap regarding one particular type of conduct (negligent
contributory conduct) rather than supplanting these other forms of
accountability. Staff's estimate of two to three additional cases thus
appears objectively reasonable.
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\166\ Here, the Board agrees with commenters who pointed out
that the PCAOB has alternative means of bringing charges against
individuals.
---------------------------------------------------------------------------
In terms of the potential variability in the future of other
standards, including QC 1000 and AS 1000, commenters took issue with
the uncertainty that poses. But standards and regulatory priorities are
always evolving in a bid to keep pace with developments in the relevant
environments (e.g., developments within the regulated industry, legal
developments, etc.). Indeed, there could be benefits to amending Rule
3502 in tandem with other standards if it means that individuals, in
determining how their registered firm should implement the new
standards, are more sharply aware of the standard of care that is
expected of them and can design their firm's implementation strategies
accordingly. Moreover, if the Board assumes that the number of Rule
3502 cases increases more significantly in the future because the facts
and circumstances of those matters show that individuals are failing to
act reasonably under newer PCAOB requirements, and thereby contributing
to firms' violations of other standards, then the Board expects that
both the benefits and costs of Rule 3502 would be higher.\167\
---------------------------------------------------------------------------
\167\ Conversely, if the number of additional cases declines
over time due to changes in auditor behavior in response to the Rule
3502 enforcement risk, this may translate into an increase in
benefits discussed below.
---------------------------------------------------------------------------
Some commenters posited that the amendment would represent a
profound change in liability and have significant impacts on the
profession and far-reaching unintended consequences. As previously
discussed, the amendment does not effectuate a fundamental shift in the
liability landscape, but rather aligns the PCAOB's secondary liability
standard with that of the Commission. And thus, as discussed below, the
Board has assessed that there would be recognizable but not significant
benefits, or costs, attributable to enhanced compliance with other
PCAOB rules and standards.
The Board has considered this discrepancy between commenters'
assertions of the significance of the amendment and the Board's
analysis of the amendment's incremental effect. This discrepancy could
be the result of unstated assumptions on commenters' parts:
One possibility is that commenters are aware of (but do
not acknowledge expressly) a more significant deficit in associated
persons failing to act reasonably, which the Board has not detected
through its oversight, such that there will be considerably more
opportunities for enforcement under the amended rule than the Board has
assumed in its analysis. In that case, the Board would expect to see
more cases potentially being brought, with more benefits from enhanced
compliance with PCAOB standards, and more costs from the actions that
individuals would take to come into compliance and demonstrate the
reasonableness of their actions if challenged.
Another possibility is that commenters believe that the
PCAOB would exercise its discretion under the amended rule
irresponsibly--choosing to pursue cases against individuals over
differences in reasonable judgments, or cases where an individual had
only a remote connection to, or was responsible for only a small
fraction of, the decision-making process that led to a firm's
violation--and thus they believe that the unintended consequences
(e.g., self-protective behaviors) would be more significant than staff
estimates. The Board does not believe that commenters' concerns are
warranted. As described, the Board intends to deploy its prosecutorial
discretion responsibly, informed by the recommendations of its staff,
and any sanctions imposed by the Board are subject to de novo review by
the Commission,\168\ all of which guides the Board's exercise of
discretion in determining what matters to pursue.
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\168\ See Section 107(c) of Sarbanes-Oxley; see also, e.g., SW
Hatfield, C.P.A., SEC Release No. 34-69930, at 2-3.
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The Board discusses these points in more detail below.
1. Benefits
This subsection presents the expected benefits of the amendment,
particularly enhancements in regulatory efficiency and individual
accountability, as well as positive impacts on capital markets. Several
commenters agreed with the Board's analysis, while others disagreed
with certain aspects of the Board's assessment of the benefits. The
Board discusses these in more detail below.
One commenter asserted that the benefits discussion in the Economic
Analysis section of the Proposal is high-level and lacks application of
the specifics of the amendment. The benefits discussions--in the
Proposal and in this release--however, touch upon a crucial aspect of
the amendment, which involves expanding the PCAOB's enforcement
authority to discipline associated persons for negligently contributing
to violations of a firm. While the discussion may appear broad, it is
intended to highlight the overarching benefits of this expansion,
including enhancing individual accountability, strengthening investor
protection, and promoting greater adherence to applicable laws, rules,
and professional standards.
The following sections discuss regulatory efficiency and individual
accountability and expected impacts on capital markets.
i. Regulatory Efficiency and Individual Accountability
The amendment can improve regulatory efficiency by enabling the
PCAOB to bring a case involving negligence against a firm and the
responsible relevant associated person(s), rather than referring part
or all of the case to the Commission or charging only the firm. Under
the status quo, the Commission (as well as other authorities such as a
state board of accountancy), but not the PCAOB, can bring such cases.
By contrast, the PCAOB can only sanction the firm and defer to the
Commission to take action against the negligent individual (as the
Commission deems appropriate).
By enabling the PCAOB to address violations by a firm and
contributory violations by its associated persons concurrently, the
amendment ensures that individuals who fail to meet their
responsibilities with reasonable care are held accountable. This method
of reinforcing individual accountability and facilitating improvement
among practitioners elevates overall audit quality, benefiting both
firms and investors by reducing the likelihood of negligent conduct.
a. Effects on Associated Persons
Enabling the PCAOB to hold individuals accountable can lead to more
deterrence among all individual associated persons. Currently,
individuals may act inappropriately if they discount the likelihood of
public sanction because the PCAOB lacks the ability to bring charges
for negligent contributory conduct, although they
[[Page 54914]]
may not be able to avoid sanction by the Commission or private sanction
by their firms. However, the imposition of a firm's disciplinary action
against individuals depends on the detection and investigation of the
individuals' misconduct. Detection, in turn, may depend on the
frequency and efficacy of external review processes, e.g., PCAOB
inspections. Additionally, without a noncompete agreement, a firm
cannot prevent a partner from associating with a different registered
public accounting firm and performing issuer or broker-dealer audit
work, or from becoming employed by an issuer or broker-dealer in an
accountancy or financial management capacity; in contrast, a PCAOB
sanction may do so.\169\ Finally, a firm cannot suspend an individual's
CPA license, but a PCAOB sanction can lead to collateral consequences
with relevant state accountancy authorities.\170\
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\169\ See Section 105(c)(7) of Sarbanes-Oxley.
\170\ See, e.g., N.Y. State Rules of the Board of Regents Sec.
29.10(f); see also Section 105(d)(1) of Sarbanes-Oxley (requiring
the Board to report disciplinary sanctions it imposes to, among
others, ``any appropriate State regulatory authority or any foreign
accountancy licensing board with which [a sanctioned] firm or person
is licensed or certified'').
Also, a firm may expel a partner, but such an action is unlikely
to be public (e.g., a private settlement may contain nondisclosure
and antidisparagement clauses) and thereby is less likely to be an
effective deterrent to associated persons of other firms as compared
to a public sanction. Similarly, a firm may be able to inflict a
private financial penalty (e.g., through a claw-back or forfeiture
of paid-in capital or deferred compensation). However, a firm may
not have effective provisions in its partnership agreements or may
view enforcing those clauses as uneconomical if forced to litigate
them as a contractual dispute.
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Because of the reasons discussed above, adding the PCAOB as an
additional enforcer may increase auditors' perception that negligent
conduct may be detected, investigated, and effectively sanctioned;
doing so therefore can provide additional deterrence against
misconduct, even though the risk of liability resulting from the
additional deterrence is not a large one insofar as the Commission
currently has the authority to discipline associated persons for
negligently causing a firm's violations. Academic literature also
suggests that public authorities' sanctioning tools (e.g., public
censure, fines, associational prohibitions) deter future misconduct
more effectively than private reprimands by a firm.\171\
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\171\ See, e.g., John T. Scholz, Enforcement Policy and
Corporate Misconduct: The Changing Perspective of Deterrence Theory,
60 Law & Contemp. Probs. 253, 265 (1997). Scholz states:
When corporations have the means of punishing subordinates for
illegal behavior, punishing the corporation rather than individuals
responsible for wrongdoing may serve to strengthen the corporation's
private enforcement system. Criminal prosecution of individuals will
be necessary, however, whenever the potential gains to the
individual from illegal behavior far exceed the worst punishment the
firm could impose.
See also Michelle Hanlon & Nemit Shroff, Insights Into Auditor
Public Oversight Boards: Whether, How, and Why They ``Work,'' 74 J.
Acct. & Econ. 1, 4 (2022) (``We find that the majority of
respondents think that POB [Public Oversight Board] inspectors have
greater authority (enforcement options) than peer-reviewers and that
the culture at POBs is more conducive to detecting auditing
deficiencies.'').
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By increasing individual accountability and the potential for
liability, the amendment can provide incremental deterrence against
future violations and, hence, enhance incentives for individuals to
perform important roles with reasonable care. Individuals that exercise
reasonable care, in turn, may contribute to better compliance practices
in their firms. This change is expected to lead to more diligent
adherence to professional standards. In fact, in support of the
amendment, one commenter contended that the heightened level of
deterrence would reduce the risk of substandard audits by encouraging
auditors to adhere to professional standards and regulations to avoid
liability.
The amendment's effect as a deterrent to auditor misconduct
generated different viewpoints from commenters. Some commenters
indicated that reducing the liability threshold from recklessness to
negligence would deter misconduct, lead to more careful work by
auditors, and enhance audit quality. These commenters also indicated
the proposed change in liability would boost public confidence,
increase investors' confidence in financial statements, and strengthen
the financial markets. One commenter suggested that improvements in
audit quality will reduce financial misstatements and omissions as well
as auditor litigation risk and costs to investors resulting from such
litigation. This is consistent with the Board's analysis presented
here.
By providing incremental deterrence and, hence, enhancing
individual auditors' incentives in the performance of their audits, the
amendment can improve audit quality. Academic literature suggests that
auditors' incentives to perform high-quality audits can increase with
greater enforcement.\172\ Furthermore, in general, academic research
provides evidence that enforcement proceedings have a deterrent effect
\173\ and can potentially improve audit quality of non-sanctioned
entities that are aware of sanctions imposed on others.\174\ Other
related literature also discusses the role of regulation in providing
auditors with incentives for improving audit quality.\175\
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\172\ See, e.g., Ralf Ewert & Alfred Wagenhofer, Effects of
Increasing Enforcement on Financial Reporting Quality and Audit
Quality, 57 J. Acct. Res. 121, 123 (2019) (``Our main finding is
that auditing and enforcement are complements in a low-intensity
enforcement regime but can become substitutes in a strong regime.
The auditor's incentives to perform a high-quality audit increase
with greater enforcement because the expected penalty rises, and
they decrease with lower anticipated earnings management.'').
\173\ See Robert H. Davidson & Christo Pirinsky, The Deterrent
Effect of Insider Trading Enforcement Actions, 97 Acct. Rev. 227,
227 (2022) (``Insiders who have witnessed [a Commission] enforcement
action have a lower probability for future conviction than their
unexposed peers.'').
\174\ See, e.g., Phillip Lamoreaux, Michael Mowchan & Wei Zhang,
Does Public Company Accounting Oversight Board Regulatory
Enforcement Deter Low-Quality Audits? 98 Acct. Rev. 335, 339 (2023)
(``We find that audit firm responses to PCAOB enforcement only occur
following sanctions of like-sized firms. That is, small firm
responses only follow sanctions of small firms and large firm
responses only follow sanctions of large firms. Specifically,
following the PCAOB sanction of a small audit firm, the likelihood
of misstatement is 2.2 percentage points lower for clients of
competing non-sanctioned small audit firm offices in the same
[Metropolitan Statistical Area]. In contrast, following PCAOB
sanctions of a large audit firm, the likelihood of misstatements
decreases by 2.6 percentage points for clients of non-sanctioned
audit offices within the sanctioned audit firm.'').
\175\ See, e.g., A.C. Pritchard, The Irrational Auditor and
Irrational Liability, 10 Lewis & Clark L. Rev. 19, 19 (2006)
(``Audit quality is promoted by three incentives: reputation,
regulation, and litigation.'').
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By contrast, one commenter asserted the amendment does not deter
conduct because penalties are not an effective method to deter one-time
mistakes, inadvertence, and errors in judgement. Another commenter
expressed a concern that the PCAOB did not explain how the amendment
would result in Rule 3502 becoming a more effective deterrent than the
current formulation of Rule 3502. Other commenters expressed skepticism
that the amendment will incentivize individuals or change behavior. One
commenter expressed concern that the amendment may not incentivize the
negligent or reckless auditors as intended because those individuals
may be the least risk averse. The Board considered these commenters'
perspectives as well as academic research noted above that suggests
enforcement proceedings have a deterrent effect.\176\ The Board
believes that there is sufficient support for the Board's belief that
the amendment would enhance deterrence (albeit
[[Page 54915]]
incrementally) and that the deterrence would lead to benefits.
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\176\ See, e.g., Ralf Ewert & Alfred Wagenhofer, Effects of
Increasing Enforcement; Robert H. Davidson & Christo Pirinsky, The
Deterrent Effect of Insider Trading Enforcement Actions; Lamoreaux,
et al., Does Public Company Accounting Oversight Board Regulatory
Enforcement Deter Low-Quality Audits?
---------------------------------------------------------------------------
One commenter stated that the Proposal implied that ``the
discipline imposed by a firm (whether financial penalty or even
expulsion) is less likely to be an effective deterrent to others' ''
misconduct compared to public sanction, but that there was a lack of
evidence in the Proposal to support such a claim.\177\ Unlike internal
disciplinary measures, public sanctions are visible to everyone,
including potential clients and employers.\178\ This public visibility
may result in all associated individuals exercising greater care while
carrying out their responsibilities. Therefore, as discussed in more
detail above, the Board believes that public discipline can enhance the
deterrence effect beyond what internal discipline can achieve, making
it a key tool for enforcing accountability and upholding high standards
in the audit profession.\179\
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\177\ Comment Letter from National Association of State Boards
of Accountancy at 2 (Oct. 24, 2023). Another commenter expressed
that the firm's approach to prevent and respond to instances of
negligence in response to inspection findings may impact the
individual more, as the firm's actions may more directly dictate an
individual's future. But as discussed above, while the Board
acknowledges that the PCAOB's inspection program plays a vital role
in enhancing audit quality, the PCAOB's enforcement program plays a
distinct but complementary role in holding firms and associated
persons accountable for violations, and thereby punishing and
deterring unlawful conduct. In other words, there is a distinction
to be made between firm's quality control and private sanctions
deterring misconduct.
\178\ On one hand, if a person receiving a private sanction
remains an associated person of the same firm, such a firm may have
incentives (e.g., to win new business or keep existing business) not
to disclose the private sanction to clients, prospective clients, or
the public, or may have agreed not to do so. On the other hand, if a
person receiving a private sanction leaves the firm, whether as part
of the sanction or voluntarily, and then seeks, for example, to join
a new firm (or an issuer or broker-dealer in an accountancy or
financial management capacity), the prior firm might not disclose
details about the sanction to the new prospective firm or employer,
whether per nondisclosure or anti-disparagement provisions or as a
matter of general policy.
Furthermore, the sufficiency of private sanctions is hard to
square with the PCAOB's authority to discipline formerly associated
persons of firms, as provided by Section 929F of the Dodd-Frank Wall
Street Reform and Consumer Protection Act. See Section 2(a)(9)(C) of
Sarbanes-Oxley. If a private sanction (i.e., expelling the
associated person from the firm) were sufficient, Congress
presumably would not have given to the PCAOB the power to impose a
public sanction against an individual who is no longer associated
with a registered firm.
\179\ See, e.g., Scholz, Enforcement Policy and Corporate
Misconduct 265.
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b. Effects on Firms
Some firms choose to invest in staffing and resources voluntarily
to comply better with regulatory requirements. Yet, competitive
pressures from other firms that prefer not to make similar investments
may lead these firms to reconsider their investment decisions. With the
amendment, however, all firms lacking adequate staffing and resources
would now face enhanced possibility of sanctions of their associated
persons, prompting them to make additional investments. This change is
expected to improve audit quality by counteracting underinvestment of
staffing and resources, thereby reducing noncompliance by audit firms.
This collective uplift mitigates any single firm's competitive concerns
and promotes broader societal benefits by fostering a more robust and
reliable compliance environment resulting in improved overall audit
quality.
Individual auditors, perceiving greater litigation and liability
risks, are likely to change their behavior and take their professional
responsibilities more seriously, ensuring that their actions are
objectively reasonable under the circumstances. This shift in
individual behavior can lead to greater compliance by firms with their
respective legal requirements, including auditing standards, quality
control standards, and ethics and independence standards, which were
enacted to promote audit quality and investor interests. In other
words, by preventing individual negligence, the amendment can also
mitigate firm negligence, as individuals' actions directly impact firm
actions, such as implementing better quality control systems.\180\ One
commenter agreed that the amendment will result in firms being more
likely to comply with their respective legal requirements.
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\180\ Quality control systems play a fundamental and widespread
role in overall audit quality. These systems are essential in
ensuring the audit process adheres to professional standards. A
robust quality control system can help firms to detect and address
factors that compromise audit quality.
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ii. Capital Market Impact
As explained above, the amendment can introduce an incremental
deterrent effect, which could lead to improvements in audit quality.
Increased audit quality can improve financial reporting quality and
enhance investors' confidence in the information provided in companies'
financial statements. Because auditors have a responsibility to provide
reasonable assurance about whether the financial statements are free of
material misstatement, higher audit quality could increase the
likelihood that the auditor would discover a material misstatement or
would qualify its audit opinion when a material misstatement exists and
is not corrected by management. If a Commission registrant were to
include such a qualified audit opinion in a filing with the Commission,
then Commission staff may deem the registrant's filing to be
deficient.\181\ Furthermore, a qualified audit opinion may evoke
negative market reactions. For these reasons, higher audit quality
could incentivize issuers to take steps to ensure their financial
statements are free of material misstatement. Issuers could take these
steps proactively, prior to the audit, or in response to adjustments
requested by the auditor.
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\181\ See 17 CFR 210; see also Financial Reporting Manual Sec.
4220, Division of Corporation Finance, SEC, available at https://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.pdf.
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Financial statements that are free of material misstatement are of
higher quality and more useful to investors. In particular, more
reliable financial information allows investors to improve the
efficiency of their capital allocation decisions. Investors may also
perceive less risk in capital markets generally, leading to an increase
in the supply of capital.\182\ An increase in the supply of capital
could increase capital formation while also reducing the cost of
capital to companies.\183\ A reduction in the cost of capital reflects
a welfare gain because it implies investors perceive less risk in the
capital markets.
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\182\ See, e.g., Hanwen Chen, Jeff Zeyun Chen, Gerald J. Lobo &
Yanyan Wang, Effects of Audit Quality on Earnings Management and
Cost of Equity Capital: Evidence from China, 28 Contemp. Acct. Res.
892 (2011); Richard Lambert, Christian Leuz & Robert E. Verrecchia,
Accounting Information, Disclosure, and the Cost of Capital, 45 J.
Acct. Res. 385 (2007).
\183\ Cost of capital is the rate of return investors require to
compensate them for the lost opportunity to deploy their capital
elsewhere. Equivalently, cost of capital is the discount rate
investors apply to future cash flows. Cost of capital depends on,
among other factors, the riskiness of the underlying investment.
Accordingly, the rate of return required by equity holders--cost of
equity capital--and the rate of return required by debt holders--
cost of debt capital--may differ to the extent equity and debt
securities expose investors to different levels of risks. For
theoretical discussion on the link between the greater availability
of information to investors and cost of capital, see, for example,
Richard A. Lambert, Christian Leuz & Robert E. Verrecchia,
Information Asymmetry, Information Precision, and the Cost of
Capital, 16 Rev. Fin. 1, 16-18 (2012); David Easley & Maureen
O'Hara, Information and the Cost of Capital, 59 J. Fin. 1553, 1571
(2005); and William Robert Scott & Patricia C. O'Brien, Financial
Accounting Theory 412 (Prentice Hall 3d ed. 2003).
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Commenters agreed that the amendment will enhance investors'
confidence both in audits and in the information provided in companies'
financial statements, as well as have an incremental positive effect on
capital-market efficiency.
2. Costs
This section discusses the expected costs of the amendment. Because
the
[[Page 54916]]
amendment is expected to lead to an increase in the number of
enforcement cases by the PCAOB, the Board discusses costs to firms and
individuals, and costs to issuers.
The Board's assessment of the degree of the anticipated costs is
affected by the Board's estimate of the number of additional cases to
be brought, as discussed at the outset of this section. As discussed
there, the amendment is expected to result in a slight increase in the
number of PCAOB enforcement cases (two to three per year) due to the
changed liability threshold. Any additional cases due to the amendment
will involve legal costs, which could result in substantial costs for
the firms and individuals involved. Staff could not provide an estimate
for the per-case cost; however, the small number of incremental cases
could limit the aggregate cost of the amendment, in particular, when
the total number of issuers and broker-dealers is taken into account.
i. Costs to Firms and Individuals
With the anticipated increase of enforcement proceedings of two to
three per year, certain firms will incur direct and indirect costs with
respect to those proceedings as a result of the amendment. These costs
include legal costs and broader financial and operational impacts.
Direct costs include increased hours and resources (including
attorneys, experts, and other personnel) to prepare for, respond to,
and defend against investigations and charges--actual or anticipated.
The Board expects that, in most cases, the costs of defending
associated persons who have negligently contributed to a firm's
violation will be borne by the firm.\184\ The direct defense costs can
be grouped into two categories based on the stage of the matter:
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\184\ That is, the Board believes that the firm would have
advancement and indemnification agreements in place with relevant
firm personnel. In certain circumstances, it is possible that an
individual respondent that is found liable would have to reimburse
the firm (or the firm's insurer) for defense costs, but the extent
and nature of that obligation depends on the facts and circumstances
as applicable to the terms and conditions of the indemnification and
insurance agreements.
---------------------------------------------------------------------------
First, during the investigative stage, staff works to
determine whether it is likely that a primary violation occurred and if
so, whether an individual directly and substantially contributed to the
violation. Because this inquiry already takes place (albeit to
determine whether someone acted recklessly rather than negligently),
the incremental resource cost to firms at the investigative stage will
not be significant.
Second, staff works to determine whether the individual
acted negligently and notifies the potential respondent of that
determination. After this point, the direct costs of the amendment to
firms may increase more significantly.\185\ Staff lacks sufficient data
to reliably estimate the costs of each matter because the costs depend
on numerous factors, including the duration of the matter,\186\ the
complexity of the matter (e.g., a complex audit case versus a simpler
case of noncompliance with PCAOB filing requirements), the number and
nature of counsel and expert witnesses retained, and so forth.\187\
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\185\ One commenter expressed concern that the PCAOB's
investigations and enforcement could become at least marginally more
costly given enforcement requirements of the negligence criteria.
The Board agrees; there could be incremental costs to the PCAOB of
pursuing negligence-based cases. The Board expects these would be
generally proportional to the costs discussed above for potential
individual respondents (e.g., both sides may need to hire expert
witnesses to litigate whether conduct met the standard of care).
Another comment letter expressed doubt that the firm would cover an
individual's defense costs if the individual chose to mount a
defense that involved attributing responsibility to the firm. The
Board believes that in these circumstances, it is more likely that
the firm would nonetheless have to continue abiding by its
advancement and indemnification obligations, but that the firm might
then have to retain separate counsel for the individual, which would
increase the overall costs as discussed (given an increase in
complexity and number of counsel).
\186\ As set out in the PCAOB rules, a PCAOB enforcement case
has numerous stages where the proceedings might halt. For example, a
persuasive Rule 5109(d) submission may convince the staff not to
recommend proceedings; the Board may determine not to institute
proceedings under Rule 5200; the Hearing Officer might dismiss the
matter; the matter might end with a Hearing Officer's initial
decision; or the initial decision might be appealed to the Board,
the Commission, or the courts. The longer the litigation, the
greater the costs (e.g., attorney fees, expert witness fees, and
opportunity costs).
\187\ These factors make it impracticable to construct a
quantitative estimate of the anticipated cost--there is no
``typical'' case that the Board could use to construct an estimate
that would be extensible across the two to three cases per year
anticipated here. While the Board requested information about costs,
including relevant data, commenters did not provide specific data
about defense costs that would permit the Board to construct a
quantified estimate. The Board's analysis therefore continues to be
qualitative in nature.
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Apart from these direct defense costs, if the individual is
adjudicated as having acted negligently and a sanction is imposed, the
individual would incur potential financial costs of having been found
liable for failing to act with reasonable care and thereby contributing
to the firm's violation. To the extent that there are civil money
penalties, they would be assessed against the individual.\188\
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\188\ If not foreclosed from doing so, individuals might seek to
have their firm bear these financial costs pursuant to
indemnification agreements, insurance agreements, or otherwise.
However, such agreements or arrangements might not cover civil money
penalties.
---------------------------------------------------------------------------
A firm that has indemnification agreements in place that would
compel it to bear the financial burden of defending or indemnifying
associated persons may choose to purchase insurance to help alleviate
the contingent financial burden. If so, it would have to buy insurance
in the market, and the pricing of such insurance may depend on the
risks of loss identified by the underwriting process. Or a firm may
self-insure against such liabilities, in which case the amount held in
reserve or reinsurance may vary based on anticipated losses.
There may also be opportunity costs as enforcement proceedings
distract individuals from their everyday responsibilities. The
opportunity costs relate to diversion from engagement tasks and other
work.
Further, an individual may incur reputational costs, such as
adverse employment or career events. Commenters asserted that the
effects of the Proposal would include causing harm to individuals'
careers (e.g., by being removed from issuer client service roles or
being demoted) and collateral consequences (e.g., follow-on proceedings
by state boards of accountancy or disciplinary measures by other
regulators) consistent with having been found to have violated the
Board's standards, and hence the federal securities laws. The Board
agrees and recognizes that these costs could exist in any proceeding
brought under the amendment. \189\ While the Board may consider the
relevant facts and circumstances in determining the sanction it
believes appropriate in the public interest, the Board recognizes that
additional consequences beyond the sanctions imposed in the case
frequently occur. The Board acknowledges that these consequences could
be significant to the individual against whom they are imposed.
However, the Board also believes that these consequences would not be
significant in the aggregate, taking into account the number of
associated persons across all registered firms and in light of the
anticipated number of additional proceedings likely to be brought as a
result of the amendment.
---------------------------------------------------------------------------
\189\ See J. Krishnan, M. Li, M. Mehta & H. Park, Consequences
for Culpable Auditors, available at https://ssrn.com/abstract=4627460.
---------------------------------------------------------------------------
Certain commenters raised concerns about the potential increase in
legal costs for firms. In particular, they noted the increased legal
liability that
[[Page 54917]]
associated persons might face under the amendment, which may result in
higher costs of firms defending their associated persons and liability
insurance for firms. Other commenters voiced concerns about the
potential for increased state-level investigations and disciplinary
proceedings against individuals, which could lead to the suspension or
revocation of professional licenses. However, another commenter
asserted the amendment's contributory negligence standard would better
align the PCAOB's liability approach with the majority of the states'
liability approach, which does not limit individual liability for
negligent conduct.
The Board agrees that the amendment could increase legal and
liability insurance costs, as well as the number of state
investigations. Those incremental costs, however, would not be
significant based on the two to three additional cases expected per
year.
Several commenters highlighted that the amendment could
significantly increase audit firms' litigation risk and legal liability
for small firms. They indicated that increased costs, encompassing
defense expenditures and opportunity costs, are expected to
disproportionately affect small firms, which may lack the resources and
market influence to offset these expenses. The commenters cautioned
that small firms with a limited capacity to absorb these costs or
demand higher fees could face significant challenges.
The Board acknowledges that litigation risk and legal liability
involve costs, and those costs may have a greater impact on small
firms, where direct costs and distractions are less absorbable by
firms' other activities or personnel. For example, small firms are
especially vulnerable to increases in legal costs, as small firms may
disproportionately bear the burden of insuring against the risk.
However, the Board believes certain features of the market and this
amendment would limit these effects.
First, smaller firms typically have simpler supervisory structures
that may make it easier for these firms to supervise their partners to
help to ensure that partners are acting with reasonable care.\190\ They
also may be less impacted by the concern raised by other commenters
that responsibility for firm compliance could be divided up among many
individuals, with accountability for any one act of negligence being
more difficult to establish. Second, in assessing insurance costs, the
Board distinguishes between market-wide effects (i.e., a market-wide
increase in directors & officers or professional liability coverage)
and specific-firm effects (i.e., a specific firm experiencing an
increase in the cost of insurance if it has a specific claim brought
against its associated persons). The Board believes the market-wide
effects are likely to be smaller: Again, the Commission already has the
authority to bring negligence-based cases, and the staff has estimated
that the amendment would result in an average of two to three more
cases per year. The Board believes it less likely that the amendment or
resulting incremental claims experience would cause a significant shift
in underwriters' perception of risk and thus the availability or
pricing of insurance for smaller firms in general. However, the Board
acknowledges that the impact on a specific firm that is involved in a
specific matter could be more significant; an increase in its
individual claims experience could cause an increase in the cost of
coverage and/or retention amounts in the future or make it more
difficult to secure acceptable coverage.
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\190\ The Board acknowledges that smaller firms may have fewer
resources to invest in dedicated supervisory structures. However,
given that their respective QC systems oversee a smaller number of
engagements, the same level of resources may not be necessary for
the firm to nonetheless obtain reasonable assurance that their
personnel comply with applicable professional standards and
regulatory requirements.
---------------------------------------------------------------------------
In addition to the direct costs described above, the amendment
could result in indirect costs as individuals adjust their behavior and
put forth additional effort to ensure they do not contribute to a
firm's violation through their negligence. However, to the extent that
these indirect costs are incurred to bring previously negligent conduct
up to a level of reasonable care, these costs are properly allocable to
the underlying law, rule, or standard that the firm is alleged to have
violated, as those provisions each assume a level of costs necessary
for the firm to comply.
One commenter expressed concerns about a requirement in the
Proposal that involves the application of ``directly and
substantially'' only to the sufficiency of the connection between an
associated person's conduct and a firm's violation. The commenter
asserted that this is an important change from the present rule, under
which an alleged violator must know (or recklessly not know) not only
that they are contributing to a violation, but also that the
contribution is direct and substantial. The Board notes that its
analysis, which includes staff estimate of two to three additional
cases per year based on the Proposal, takes into account the
application of ``directly and substantially'' only on the sufficiency
of the connection between the associated person's conduct and a firm's
violation. The Board does not believe that this change would be a
significant driver of costs to individuals or firms in the
aggregate.\191\
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\191\ Nor would it be a significant contributor to costs in
particular cases; indeed, it might save costs by avoiding effort
seeking to establish the reasonableness of the individual's belief
as to the directness and substantialness of the participation or
lack thereof where a direct and substantial connection in fact has
already been established.
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ii. Costs to Issuers (Audit Fees)
To the extent that firms pass on some of the costs to their audit
clients, the amendment could result in audit fee increases to cover
firms' compliance costs related to the amendment. Consistent with this
notion, academic studies find that increased enforcement intensity can
lead to temporary increases in audit fees for some issuers.\192\
Further academic research provides evidence that audit fees increase
with the auditor's assessment of business risk, which includes risk of
regulatory sanctions, among others.\193\ The findings indicate that the
increases in audit fees are due to the increase in the number of audit
hours, but not hourly rates.
---------------------------------------------------------------------------
\192\ Annita Florou, Serena Morricone & Peter F. Pope, Proactive
Financial Reporting Enforcement: Audit Fees and Financial Reporting
Quality Effects, 95 Acct. Rev. 167, 167 (2020) (``We examine the
costs and benefits of proactive financial reporting enforcement by
the U.K. Financial Reporting Review Panel. Enforcement scrutiny is
selective and varies by sector and over time, yet can be anticipated
by auditors and companies. We find evidence that increased
enforcement intensity leads to temporary increases in audit fees and
more conservative accruals. However, cross-sectional analysis across
market segments reveals that audit fees increase primarily in the
less-regulated AIM segment, and especially those AIM companies with
a higher likelihood of financial distress and less stringent
governance. On the contrary, less reliable operating asset-related
accruals are more conservative in the Main segment and, in
particular, those Main companies with stronger incentives for higher
financial reporting quality. Overall, our study indicates that
financial reporting enforcement generates costs and benefits, but
not always for the same companies.'').
\193\ See, e.g., Timothy B. Bell, Wayne R. Landsman & Douglas A.
Shackelford, Auditors' Perceived Business Risk and Audit Fees:
Analysis and Evidence, 39 J. Acct. Res. 35 (2001).
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3. Potential Unintended Consequences
The following discussion describes potential unintended
consequences that the Board considered and, where applicable, factors
that mitigate the adverse effects, such as the steps the Board has
taken or the existence of countervailing forces.
i. Self-Protective Behavior
The Board recognized in the Proposal that auditors might engage in
self-
[[Page 54918]]
protective behavior.\194\ Specifically, while the threat of enforcement
action can motivate individuals to act in a manner consistent with
their legal obligations, it can also result in excessive monitoring and
self-protective behavior, leading to an inefficient allocation of time
and resources. The effect on audit quality may change as the degree of
intervention increases. Individuals may spend more time on a task than
is necessary to accomplish it at the appropriate level of care.
Similarly, individuals may excessively document the nature of their
task performance to demonstrate compliance in a future proceeding. Time
spent on unproductive, self-protective activities may detract from
other important obligations and directly impact audit quality.
---------------------------------------------------------------------------
\194\ See 2023 Proposing Release at 26.
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Many commenters echoed this concern and emphasized the potential
significance of this issue, including that its effects may discourage
effective collaboration between and among accountants, especially in
complex audits. Some of these commenters expressed concern that moving
to a negligence standard for contributory liability would lead to
sanctions of professionals who make judgments in good faith. A few
commenters asserted that emphasizing every error an auditor makes will
encourage auditors to focus on defensive auditing--which could result
in a decrease in audit quality. These commenters' concerns center on
the prospect that increased liability risk could lead auditors to
prioritize self-protective measures (e.g., overemphasizing compliance
documentation) and excessive monitoring over more important audit
tasks, particularly in small- and mid-sized firms with limited
resources. Another comment letter raised concerns about the impact of
coercive enforcement strategies on audit practices, suggesting that
such strategies could lead to defensive behaviors rather than genuine
quality improvements.
The Board notes that the compliance and documentation requirements
in applicable professional standards are designed to sufficiently
demonstrate compliance, thus mitigating the need for excessive,
unproductive documentation.\195\ Furthermore, the possibility of such
self-protective behavior is not new. As discussed above, the Commission
currently can initiate enforcement proceedings against individuals for
negligent contributory conduct.\196\ And, as commenters have pointed
out, the PCAOB currently possesses a robust enforcement regime covering
negligent primary conduct. Therefore, the risk of litigation and
sanctions is already a factor in the current regulatory environment,
driving the existing need for individuals to act with reasonable care
and to be able to demonstrate their compliance. Thus, while the Board
acknowledges some inefficient behavior could result from the amendment,
consistent with the incremental increase in deterrence that the Board
posits above, the Board continues to believe that the likelihood that
the amendment would drive significant increases in self-protective
behavior is low.
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\195\ See, e.g., AS 1215, Audit Documentation.
\196\ Also, as discussed in section C above, the AICPA's Code of
Professional Conduct makes certain negligent contributory acts by
individuals an ``act discreditable to the profession.'' See AICPA
Code of Professional Conduct, ET Sec. 501.05(a), Negligence in the
Preparation of Financial Statements or Records, recodified at
Section 1.400.040.01.
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ii. Lack of Available Personnel or Compensation Enhancements
As recognized in the Proposal, excessive risk of enforcement action
could unintentionally discourage auditors from accepting important
audit roles if they fear being held liable, leaving these roles to be
accepted by less cautious or less qualified individuals.\197\
Alternatively, auditors may seek to offset the increased risk by
demanding higher compensation for taking certain roles or
responsibilities, which could have downstream effects on audit fees.
---------------------------------------------------------------------------
\197\ See 2023 Proposing Release at 26.
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Many commenters remarked about the amendment's potential negative
impact on the accounting and audit workforce. These commenters
highlighted an existing ``talent crisis,'' especially affecting small-
and mid-sized firms. They noted that the amendment's threshold for
sanctionable conduct and resulting increased liability risks could
intensify the crisis. The commenters contended that the amendment might
discourage talented individuals at various career stages from engaging
in PCAOB-regulated work, potentially leading to lower audit quality,
higher fees, and public company delisting. The commenters identified
fear of punitive action and a culture of defensive auditing as factors
that could deter newcomers from entering the profession and prompt
experienced auditors to leave, further jeopardizing the talent
pipeline. In addition, the commenters argued that the amendment would
affect the on-the-job nature of auditors' learning. Many of the same
commenters also raised concerns that a shift to a negligence standard
might discourage experienced auditors from accepting essential roles
due to the fear of increased liability for good faith judgments.
According to these commenters, a negligence standard could dissuade
risk-averse and diligent professionals integral to a firm's quality
control system, thus affecting auditors' development, training, and
monitoring. One commenter added that this amendment in combination with
other recent proposed standards may exacerbate the talent crisis
problem.
Some commenters cited literature to support their concerns that
there has been a steady decline in the number of accounting graduates
and that this is partly due to the regulatory environment making the
profession unappealing.\198\ While the cited studies indicate a decline
in the number of accounting graduates and professionals or a waning
interest in the accounting profession, they do not expressly point out
regulatory oversight as a reason for the decline. Rather, according to
one of these studies, the 150 CPA credit hour requirement as well as
relatively low starting salaries are the two main reasons for not
choosing accounting as a major among college students who considered
accounting.\199\
---------------------------------------------------------------------------
\198\ See Association of International Certified Professional
Accountants, 2023 Trends Report (2023), available at https://www.aicpa-cima.com/professional-insights/download/2023-trends-report; see also Center for Audit Quality and Edge Research,
Increasing Diversity in the Accounting Profession Pipeline:
Challenges and Opportunities (2023) (``CAQ-Edge Report''), available
at https://thecaqprod.wpenginepowered.com/wp-content/uploads/2023/07/caq_increasing-diversity-in-the-accounting-profession-pipeline_2023-07.pdf.
\199\ See CAQ-Edge Report at 7; see also Daniel Aobdia, Qin Li,
Ke Na & Hong Wu, The Influence of Labor Market Power in the Audit
Profession, Social Science Research Network (SSRN) (2024), available
at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4732093
(``[W]e confirm that audit offices in more concentrated labor
markets have greater labor market power and exercise it in the form
of higher skill requirements and greater required effort from their
auditors, at similar or slightly lower wages.'').
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The Board acknowledges the commenters' concerns about the
amendment's potential impact on auditing personnel. However, the lack
of available auditing personnel is likely the result of the interplay
between numerous factors in the labor market. On the supply side, a
notable decline in the number of entry-level auditors, as evidenced by
a significant decrease in the number of new CPA candidates, suggests a
waning interest among entry-level professionals in auditing
[[Page 54919]]
careers.\200\ A study found that for graduates who have already
completed the 150 CPA credit hour requirement, finding the time to
study for the CPA exam and the overall rigor of the exam are the most
significant challenges to licensure.\201\ Other contributing factors
may include the retirement of baby boomers and a lack of diversity in
the profession.\202\
---------------------------------------------------------------------------
\200\ According to the 2023 Trends Report, the number of new CPA
candidates decreased from 48,004 in 2016 to 30,251 in 2022.
\201\ See CAQ-Edge Report at 15.
\202\ See Drew Niehaus, Fixing the Crisis in Accounting: Five
Steps to Attracting Tomorrow's CPAs, CPA Journal (Nov. 2022), and
Mark Maurer, Job Security Isn't Enough to Keep Many Accountants from
Quitting, Wall St. J. (Sept. 22, 2023), available at https://www.wsj.com/articles/accounting-quit-job-security-675fc28f.
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On the demand side, as the economy grows, businesses evolve, and
more companies go public, the demand for auditors will increase.\203\
Furthermore, technological advancements and the integration of digital
tools into business processes have created a need for auditors with
expertise in cybersecurity, blockchain, and data analytics.\204\ Taking
into account the current state of supply of and demand for auditors,
attracting talent likely would depend primarily on factors under firms'
control, such as auditor compensation, especially given that college
students have cited low starting salary as one of the main hurdles to
choosing accounting as a major.
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\203\ See Bureau of Labor Statistics, Occupational Outlook
Handbook: Accountants and Auditors, available at https://www.bls.gov/ooh/business-and-financial/accountants-and-auditors.htm#tab-6 (``In general, employment growth of accountants
and auditors is expected to be closely tied to the health of the
overall economy. As the economy grows, these workers will continue
being needed to prepare and examine financial records. In addition,
as more companies go public, there will be greater need for public
accountants to handle the legally required financial documentation.
The continued globalization of business may lead to increased demand
for accounting expertise and services related to international trade
and international mergers and acquisitions.'').
\204\ See, e.g., Najoura Elommal & Riadh Manita, How Blockchain
Innovation Could Affect the Audit Profession: A Qualitative Study,
37 J. Innovation Econ. & Mgmt. 37, 38 (2022) (``According to Alles
(2015), the use of advanced technologies and blockchain by audit
clients would be the catalyst for the adoption of these technologies
by auditors. Blockchain, associated with other digital technologies,
could change the audit process by modifying the way in which the
auditor accesses data, collects evidence, and analyzes data
(Rozario, Thomas, 2019). Auditors have the choice only to integrate
these technologies and to change their organization and their
process at the risk of losing their legitimacy in the audit
market.'').
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Thus, while the Board acknowledges the potential for this amendment
to affect the market for audit services, the Board disagrees with
commenters' assessment of the magnitude of these risks. First, the
Board continues to believe that the Board is not establishing a novel
burden on individuals to refrain from acting negligently and thereby
contributing to a firm's violation; instead, the Board is merely
providing a mechanism for the PCAOB to discipline individuals who fail
to meet that standard. The effect is, therefore, the incremental
probability of PCAOB enforcement. However, this increased probability
is not so novel and significant that it would be expected to impact
noticeably the market for associated persons' services. Second, firms
have a tool at their disposal--adjusting compensation--that could tend
to increase the supply of these services as needed, although there may
be short-term displacements. The increased cost of labor may be
absorbed by firms or passed to issuers and investors through increased
audit fees.
iii. Reduced Competition in the Audit Market
The amendment to Rule 3502 could disproportionately impact small-
and medium-sized firms if they are less able to bear the cost of
defending their personnel. As discussed above, these costs include
attorney fees to defend associated persons against charges and
distracting personnel from generating income from the performance of
client services. In an extreme case, a firm might not be able to
sustain its practice considering the negative impact; more broadly,
less profitable firms may perceive that the risk of such costs is too
significant compared to their existing net profit from issuer and
broker-dealer audit work and, therefore, decide to exit those markets.
This result could further consolidate the market for issuer and broker-
dealer audit services.
Several commenters asserted that the amendment could reduce
competition in the audit market. They noted that the increase in
liability could discourage firms, especially non-U.S. firms, from
participating in U.S. issuer and broker-dealer audits. One commenter
argued that the amendment ``may inadvertently create barriers'' for
smaller firms and those servicing emerging industries by elevating the
risk profile of conducting audits.\205\ Another commenter asserted that
there has been a decline in PCAOB-registered firms auditing issuers and
broker-dealers due to regulatory burdens.
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\205\ Comment Letter from Chamber of Digital Commerce at 1 (Nov.
2, 2023).
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The likelihood that defense costs cause substantial changes in the
relevant markets is lowered by three factors. First, a firm may already
defend against an allegation of negligent primary conduct (brought
using the PCAOB's current authority) such that, in any additional cases
brought under the amended rule, defending individuals facing a charge
of negligent contributory conduct would likely involve common sets of
facts and legal theories and could be done more efficiently (i.e., at
lower additional cost) as compared to a wholly novel proceeding.
Second, a firm may already defend an individual against an allegation
of primary violations, involving common sets of facts and legal
theories related to an allegation against a firm. Third, the
Commission's existing authority to sanction associated persons for
negligent contributory conduct means that firms' profitability
calculations should already factor in the risk of defending personnel
against charges of this nature, albeit with a modestly greater
frequency in light of the amended rule. Thus, in addition to the firm's
defense, the incremental cost of defending an individual may not be as
significant as it appears at first glance.\206\
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\206\ One commenter stated that the assertions in the Proposal
that defense costs would be lowered by an increase in the volume of
cases to defend is not based in fact. It appears that the nature of
the Board's assertion was misinterpreted; as discussed above, the
Board believes that individuals and firms will incur additional
litigation costs to defend against charges brought under the amended
rule. However, the Board has considered the nature of those costs
and how they would relate to the way that staff might investigate
and make recommendations regarding these cases, and the frequency of
those charges, and the Board believes that those factors diminish
the size of the expected increase--i.e., while costs will go up,
they will go up less than if firms needed to defend a wholly new
class of charges.
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While the Board agrees that there has been a decline in the number
of firms performing audits of public companies, the Board notes that
firms may decide to cease providing audits for any number of reasons,
mostly strategic in nature.\207\ While the amendment could lead some
firms to exit the issuer audit market because of increased risk of
higher expected litigation expenses (thus reducing competition), this
exit might involve low-quality auditors and lead to better matching
between auditors and clients.\208\ While the
[[Page 54920]]
amendment may induce market shifts, the resulting landscape could be
characterized by a higher concentration of more capable and compliant
audit firms, mitigating the negative impacts on the competitive
landscape.
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\207\ Michael Ettredge, Juan Mao & Mary S. Stone, Small Audit
Firm De-registrations from the PCAOB-Regulated Audit Market:
Strategic Considerations and Consequences, Social Science Research
Network (SSRN) (2022), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3572291.
\208\ One study suggests that PCAOB inspections incentivize low-
quality auditors to exit the market, resulting in an overall
improvement in audit quality. See Mark L. DeFond & Clive S. Lennox,
The Effect of SOX on Small Auditor Exits and Audit Quality, 52 J.
Acct. & Econ. 21, 39 (2011) (``We conclude that while the PCAOB
inspections are intended to improve audit quality primarily through
the remediation of poor audit practices, they also improve audit
quality by incentivizing the lower quality auditors to exit the
market.'').
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iv. Other Distortions/Inefficiencies
One commenter expressed concern that the amendment could change the
dynamics of the settlement negotiation process during enforcement cases
and ``tip the scale'' in the PCAOB's favor.\209\ The commenter further
contended that the PCAOB may pursue weaker cases, which would divert
its resources to less meritorious cases, while another commenter
asserted its belief that the PCAOB will appropriately exercise its
prosecutorial discretion. Some commenters asserted that the amendment
could have negative effects on the PCAOB's inspections program. One
commenter noted that the amendment could cause firms to be particularly
reluctant to provide services to novel industries.
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\209\ Comment Letter from U.S. Chamber of Commerce at 12.
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The Board emphasizes that the amendment is designed to enhance
regulatory oversight and accountability, not to unfairly ``tip the
scale'' against firms and their associated persons. The PCAOB is
committed to using its enforcement resources efficiently, and the Board
emphasizes that enforcement proceedings are based on substantive
evidence and legal principles, thereby helping to maintain the
integrity and effectiveness of the PCAOB's overall enforcement process
to protect investors' interests. Moreover, the Board believes that
enhancements to the PCAOB's enforcement program will serve as a natural
complement to the inspections program; even today, with a primary
liability regime based on negligence, the vast majority of inspection
deficiencies do not result in enforcement proceedings. The Board does
not anticipate that the incremental effects of the amendment to Rule
3502 will prompt significant changes in the nature of the inspections
process that has developed over time.
The amendment is intended to strengthen the PCAOB's ability to
address instances of negligence that may harm investors or undermine
the integrity of the audit process, ensuring a more effective and
transparent regulatory framework. On balance the Board believes that
the amendment will enhance audit quality, not diminish it. Enhancements
in audit quality will also benefit emerging industries: while the
amendment does not specifically target these industries, it is
precisely because these industries operate in evolving regulatory and
legal frameworks that they may benefit from more thorough and diligent
auditing practices. Therefore, the Board believes that, rather than
deterring firms from engaging with innovative sectors, the amendment
can serve to enhance the quality and effectiveness of audits in these
industries, ultimately benefiting both participants in the emerging
industries and investors.
D. Alternatives Considered
The Board considered two alternatives to the amendment, as
discussed below.\210\
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\210\ As discussed in section C above, the Proposal considered
amending Rule 3502 to provide that an associated person that
negligently contributes to a firm's violation need not be an
associated person of the firm that commits the primary violation.
The Board decided not to adopt this aspect of the Proposal.
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1. Alternative Articulations of the Standard of Liability
Rather than amending Rule 3502 as done, the Board considered
rewriting Rule 3502 to mirror the language in the cease-and-desist
provisions of the Exchange Act, 15 U.S.C. 78u-3(a).
The primary benefit of such an approach would be to facilitate
interpretive alignment with the scope of the Commission's causing-
liability regime, which may provide associated persons with more
clarity on the nature of the legal risk. However, for more than a dozen
years, the Board has developed a distinguishable body of practice under
Rule 3502 through its enforcement program--including via the rule-based
requirement that any contribution to a primary violation be ``direct[ ]
and substantial[ ]''--and the amended rule will maintain that familiar
practice while narrowly adjusting only the standard of liability.
In response to comments, the Board also considered other potential
liability standards, including whether to adopt a framework that would
require a showing of multiple acts of negligence to hold an individual
liable for contributory conduct at the negligence level. Commenters
noted that because Section 21C proceedings are usually brought in
conjunction with Rule 102(e) proceedings, the Commission often pursues
a multiple acts of negligence or a heightened form of negligence
theory. Commenters also discussed their belief that it would be
inequitable or inappropriate for the Board to hold individuals liable
for one-time errors.
However, as discussed in section C above, while the Commission
often chooses to bring Section 21C and Rule 102(e) matters together,
nothing requires it to do so. Similarly, under the amendment, the Board
may choose to bring a case that has repeated acts of negligence, so
that an appropriate remedial sanction can be imposed. Or, in
appropriate facts and circumstances, it may choose to bring a case that
involves a single act of negligence. This optionality thus mirrors that
available to the Commission under Section 21C. Requiring multiple
instances of negligence, moreover, would not fully close the regulatory
gap noted above, would not give the Board authority that is co-
extensive with the Commission, and would not fully achieve the
efficiency benefits that the amendment seeks to achieve.
2. Removing Additional Barriers to Contributory Liability
The Board also considered an alternative that would expand the
Board's ability to hold persons liable for contributing to firm
violations by changing the ``directly and substantially'' modifier that
describes the relationship of an associated person's contribution to a
firm's primary violation, including removing it altogether. This is
currently an element of proof required for the Board to find a
violation of Rule 3502.
Removing ``directly and substantially'' would enable the Board to
use Rule 3502 to hold accountable any individual who took part in any
way in the chain of events leading to a firm's violation, even if only
remotely. The relationship between contributory conduct and the primary
violation could be a discretionary factor to consider in bringing a
proceeding in the first instance and when determining the appropriate
sanction.
This alternative could improve audit quality by ensuring that all
individuals with relevant professional responsibilities are
appropriately motivated to perform their responsibilities with
reasonable care. However, this could exacerbate the costs and
unintended consequences discussed above in conjunction with the
amendment. Therefore, this alternative might lead to excessive
motivation for auditors to increase defensive efforts that do not
contribute to audit quality (e.g., excessive self-protective measures
in anticipation of future litigation).
The amended rule maintains the criteria of nexus and magnitude
(``directly and substantially'') for an associated person's
contribution to a firm's violation, although it does not
[[Page 54921]]
require proof that the individual knew or was negligent in not knowing
that their conduct would be a direct and substantial contributor. These
requirements appropriately specify the conduct the Board considers
actionable for ``contributing'' to a primary violation, as outlined
above. This approach tailors the incentives to individuals with the
most direct responsibility for firm compliance. In other words, the
amendment continues to focus on individuals most likely influenced by
increased litigation risk leading to improved firm compliance and audit
quality. Conversely, individuals who are less involved would experience
lower benefits in relation to costs and unintended consequences.
3. Nonenforcement Alternatives Suggested by Commenters
Several commenters asserted that an alternative to the amendment is
for the Board to provide auditors with additional guidance, training,
and tools illustrating successful and problematic practices. Commenters
indicated that this could be achieved through enhanced communication,
such as issuing interpretive guidance and publishing observations from
enforcement activities, to educate auditors and to help them better
understand accountability expectations for associated persons, or
through implementing a real-time consultation process similar to the
Commission's. One commenter also expressed appreciation of the PCAOB's
Spotlight series that is published to help users of financial
statements better understand the PCAOB's activities and observations.
Although the Board agrees that these alternative approaches are
beneficial, devoting additional resources to activities buttressing
these approaches, without addressing the existing regulatory gap, would
not yield the benefits discussed above that are associated with
providing the PCAOB with the appropriate tool to hold individuals
accountable for failing to act reasonably and contributing directly and
substantially to a firm's violation. An increase in the number of
regulators that can pursue negligent contributory conduct increases the
likelihood of the conduct being detected and deterred through a range
of sanctions that can be imposed by the PCAOB, including training.
One commenter suggested an alternative to the amendment could be to
adopt standards addressing the roles of individuals involved in
designing and monitoring firms' systems of quality control. The
commenter believes this approach would provide predictability in
enforcement of PCAOB standards and would more effectively accomplish
the PCAOB's goals. While addressing the conduct of individuals involved
in designing and monitoring a firm's system of quality control is
important, the scope of the amendment, and Rule 3502 generally, are
broader than quality control.\211\ As discussed previously, the
amendment aims to address a specific gap in the PCAOB's regulatory
framework related to liability standards for firms and associated
persons, ensuring a more consistent and effective regulatory framework.
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\211\ QC 1000, if approved by the Commission, would provide
clear expectations for certain individuals serving in quality
control roles. QC 1000 and Rule 3502 may overlap in some but not all
circumstances because Rule 3502 applies to individuals more broadly
than just quality control roles.
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Special Considerations for Audits of Emerging Growth Companies
The amendment does not impose additional requirements on emerging
growth company (EGC) audits. Accordingly, the Board believes that
Section 103(a)(3)(C) of Sarbanes-Oxley does not apply. Nevertheless,
the discussion of benefits, costs, and potential unintended
consequences above generally applies to the audits of EGCs, and the
Board includes this analysis for completeness.
Under Section 104 of the Jumpstart Our Business Startups Act (JOBS
Act), rules adopted by the Board after April 5, 2012, generally do not
apply to the audits of EGCs, as defined in Section 3(a)(80) of the
Exchange Act, unless the Commission ``determines that the application
of such additional requirements is necessary or appropriate in the
public interest, after considering the protection of investors, and
whether the action will promote efficiency, competition, and capital
formation.'' \212\ As a result of the JOBS Act, the rules and related
amendments to PCAOB standards adopted by the Board are generally
subject to a separate determination by the Commission regarding their
applicability to audits of EGCs.
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\212\ See Public Law 112-106 (Apr. 5, 2012). Section
103(a)(3)(C) of Sarbanes-Oxley, as added by Section 104 of the JOBS
Act, also provides that any rules of the Board requiring (1)
mandatory audit firm rotation or (2) a supplement to the auditor's
report in which the auditor would be required to provide additional
information about the audit and the issuer's financial statements
(auditor discussion and analysis) do not apply to an audit of an
EGC. The amended Rule 3502 falls outside these two categories.
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To inform consideration of the application of auditing standards to
audits of EGCs, Board staff prepares a white paper annually that
provides general information about the characteristics of EGCs.\213\ As
of November 15, 2022, PCAOB staff identified 3,031 companies that self-
identified with the Commission as EGCs and filed audited financial
statements in the 18 months preceding that date.\214\
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\213\ For the most recent EGC report, see White Paper on
Characteristics of Emerging Growth Companies and Their Audit Firms
at November 15, 2022 (February 20, 2024), available at https://pcaobus.org/resources/other-research-projects (``EGC White Paper'').
\214\ The EGC White Paper uses a lagging 18-month window to
identify companies as EGCs. Please refer to the ``Current
Methodology'' section of the EGC White Paper for details. Using an
18-month window enables staff to analyze the characteristics of a
fuller population in the EGC White Paper, but may tend to result in
a larger number of EGCs being included for purposes of the present
EGC analysis than would alternative methodologies. For example, an
estimate using a lagging 12-month window would exclude some EGCs
that are delinquent in making periodic filings. An estimate as of
the measurement date would exclude EGCs that have terminated their
registration or exceeded the eligibility or time limits. See id.
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EGCs are likely to be newer public companies, which may increase
the importance to investors of the external audit to enhance the
credibility of management disclosures. All else equal, the benefits of
the higher audit quality resulting from the amendment may be more
significant for EGCs than for non-EGCs, including improved efficiency
of capital allocation, lower cost of capital, and enhanced capital
formation. By increasing the likelihood that associated persons are
held accountable for their negligent contributory roles in firm
violations, the amendment to Rule 3502 aims to bolster investor
confidence in the audit process. Because investors who lack confidence
in a company's financial statements may require a larger risk premium
that increases the cost of capital to companies, the improved audit
quality resulting from applying the amendment to EGC audits could
reduce the cost of capital to those EGCs.\215\
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\215\ For a discussion of how increasing reliable public
information about a company can reduce risk premiums, see David
Easley & Maureen O'Hara, Information and the Cost of Capital, 59 J.
Fin. 1553, 1573 (2004) (``These findings suggest an important role
for the accuracy of accounting information in asset pricing. Here,
greater precision directly lowers a company's cost of capital
because it reduces the riskiness of the asset to the uninformed.'').
---------------------------------------------------------------------------
The amendment could impact competition in an EGC product market if
the costs disproportionately affect the EGCs relative to their
competitors. However, as discussed above, the costs associated with the
amendment are expected to be small, particularly given the Commission's
existing authority to sanction associated persons for single
[[Page 54922]]
acts of contributory negligence. Therefore, the amendment's impact on
competition, if any, is expected to be limited. Overall, the amendment
is expected to enhance audit quality and increase the credibility of
financial reporting by EGCs, thereby fostering efficiency.
Some commenters agreed that the amendment should apply to audits of
EGCs and that doing so would benefit such audits. One commenter
remarked that there was no reason not to apply the amendment to audits
of EGCs and that the principles, standards, and scope of enforcement
against violations involving contributory negligence should be the same
regardless of the scale and size of the entity and of the firm. Another
commenter posited that excluding EGCs from the application of the
amendment would be inconsistent with protecting the public interest.
As previously discussed, one commenter suggested that the amendment
would have a greater impact on smaller firms with fewer resources to
defend personnel and navigate an uncertain liability environment, and
consequently, these firms are more likely to cease auditing entities
that require PCAOB-registered auditors. The Board agrees that the
amendment may have a greater impact on smaller firms to the extent that
their individual auditors are investigated under the amended rule, and
the firms are unable to absorb the direct costs and distractions. This
would, in turn, impact EGCs because they are more likely than non-EGCs
to engage small firms.\216\ The Board believes that the amendment
should apply uniformly to audits of EGCs to maintain high standards of
audit quality and uphold investor protection across all entities.
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\216\ Staff analysis indicates that, compared to exchange-listed
non-EGCs, exchange-listed EGCs are approximately 2.6 times as likely
to be audited by a firm that is not affiliated with the largest
global networks, and approximately 1.3 times as likely to be audited
by a triennially inspected firm. Source: EGC White Paper and S&P.
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Considering these comments and the reasons explained above, the
Board will request that the Commission determine, to the extent that
Section 103(a)(3)(C) of the Sarbanes-Oxley applies, that it is
necessary or appropriate in the public interest, after considering the
protection of investors and whether the amendment will promote
efficiency, competition, and capital formation, to apply the amendment
to audits of EGCs.
III. Date of Effectiveness of the Proposed Rules and Timing for
Commission Action
Within 45 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the Board consents, the Commission will:
(A) By order approve or disapprove such proposed rules; or
(B) Institute proceedings to determine whether the proposed rules
should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed
rules are consistent with the requirements of Title I of the Act.
Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/rules/pcaob); or
Send an email to [email protected]. Please include
PCAOB-2024-04 on the subject line.
Paper Comments
Send paper comments in triplicate to Vanessa A.
Countryman, Secretary, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549-1090.
All submissions should refer to PCAOB-2024-04. This file number should
be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's internet website (https://www.sec.gov/rules/pcaob). Copies
of the submission, all subsequent amendments, all written statements
with respect to the proposed rules that are filed with the Commission,
and all written communications relating to the proposed rules between
the Commission and any person, other than those that may be withheld
from the public in accordance with the provisions of 5 U.S.C. 552, will
be available for website viewing and printing in the Commission's
Public Reference Room, 100 F Street NE, Washington, DC 20549, on
official business days between the hours of 10 a.m. and 3 p.m. Copies
of such filing will also be available for inspection and copying at the
principal office of the PCAOB. Do not include personal identifiable
information in submissions; you should submit only information that you
wish to make available publicly. We may redact in part or withhold
entirely from publication submitted material that is obscene or subject
to copyright protection. All submissions should refer to PCAOB-2024-04
and should be submitted on or before July 23, 2024.
For the Commission by the Office of the Chief Accountant.
Sherry R. Haywood,
Assistant Secretary.
[FR Doc. 2024-14487 Filed 7-1-24; 8:45 am]
BILLING CODE 8011-01-P