The Need for Transparency in PCAOB Disciplinary Proceedings 

DATE Sept. 28, 2010 
SPEAKER(S): Claudius B. Modesti, Director of Enforcement 
EVENT: New York State Society of CPAs' SEC Conference 

I wish to address the most pressing issue facing the Board's enforcement program and its ability effectively to protect investors — the nonpublic nature of our disciplinary proceedings.

Currently under the Sarbanes-Oxley Act of 2002, these proceedings are required to be nonpublic unless the Board finds good cause to make them public and all parties consent to open them to the public.

On August 24, our Acting Chairman Dan Goelzer asked Congress to amend the Sarbanes-Oxley Act, so that PCAOB disciplinary proceedings will be public. Right now, the PCAOB is virtually unique among similar regulators in that our disciplinary proceedings are required by law to be kept confidential through charging, hearings, initial decision, and even appeal. I'd like to talk with you today about some of the reasons why our Board has asked for the law to be changed, and how important the proposed change is for the Board to properly fulfill its mission to protect investors.

Since so much of our enforcement work now occurs out of the public's sight, it may be helpful to describe in general terms how the Board's investigative and disciplinary processes work. The Division conducts investigations into potential violations of professional auditing standards and other matters within the Board's jurisdiction. During our investigations, we obtain and review documents and take testimony from witnesses. Witnesses are entitled to many procedural safeguards, such as right to counsel. Our investigations are nonpublic by law, and there is no proposal to change that. Some of our investigations ultimately do not result in any recommendation to bring charges, for various reasons. In those cases, the investigative record and the identity of those whose conduct was reviewed will remain nonpublic, and that is as it should be.

In other cases, as the result of an investigation, the Division may recommend disciplinary proceedings to be brought against an accounting firm, individual auditors, or both. Such a decision is not made lightly, and those who may face charges as a matter of practice have an opportunity to be heard in the charging process. Before the Board decides whether to bring a disciplinary case, my Division generally provides those who may be charged with substantial notice of the potential charges against them and an opportunity to make a written submission explaining any disagreements or concerns they may have with the potential charges. First, those written submissions are diligently evaluated by the Division before it decides whether to make any disciplinary recommendation to the Board. Then, those written submissions are provided to the Board to consider, along with the Division's recommendation, in deciding whether to bring a case. Thus, those who face charges have their concerns carefully considered before the Board approves a litigated disciplinary proceeding.

Upon the Division's recommendation, if the Board then votes to institute a disciplinary proceeding, the auditor or audit firm that has been charged has a choice between settling the case or litigating with the Board's enforcement staff. If the choice is litigation, the matter is assigned to the Board's hearing officer. After pre-trial proceedings, there is a hearing at which the staff must prove its case and the respondent may present its defense. Evidence is introduced, and witnesses testify. Once the hearing officer issues his decision, either party — the auditor or the enforcement staff — may appeal to the Board. As in any appeal, the parties file briefs and may request oral argument. If the Board's decision is unfavorable to the auditor or firm, they may appeal again — this time to the SEC. In that event, the Board continues to be prohibited from reporting its decision to the public, unless and until the Commission allows the Board-imposed sanction to take effect. From the initiation of the disciplinary proceeding, through the hearing and initial decision, and then on appeal to the Commission, as required by the Sarbanes-Oxley Act, the entire proceeding takes place behind closed doors.

This nonpublic nature of Board disciplinary proceedings has serious adverse consequences for the investing public, audit committees, the auditing profession, the Board, and other interested parties, such as Congress.

First, the nonpublic feature of our disciplinary proceedings denies the public access to important information regarding PCAOB cases. During the course of the proceeding, investors, audit committees, and other interested parties are kept in the dark about a respondent's alleged misconduct — no matter how serious. Even after the Board has found sufficient cause to initiate formal proceedings and a disinterested hearing officer has found that the alleged violations occurred, the matter may still remain unknown to the public at least until the case is appealed to the Commission. As a result, investors are unaware that companies in which they may have invested are being audited by accountants who have been charged, even sanctioned, by the Board. For example, during the recent nonpublic proceedings regarding an audit firm called Gately & Associates, the firm issued 29 additional audit reports on public company financial statements between the commencement of the Board's proceeding and the public disclosure of the Board's charges, which did not occur until the Commission sustained the Board's findings and sanctions to expel the Gately firm from public company auditing and bar Mr. Gately from being an associated person.

Second, respondents have an incentive to litigate Board cases, regardless of whether they believe they will ultimately prevail. Contesting the allegations rather than seeking a settlement allows respondents to continue with their public company audit practice without any disclosure to clients or investors of the Board's charges for as long as the litigation is ongoing. In the Gately & Associates matter, over two years elapsed between the filing of the Board's case and the public disclosure of the sanctions. During Gately's trial before a hearing officer, appeal to the Board and appeal to the Commission, the public was not aware of what the Board alleged, what the hearing officer decided as to liability and sanctions, and how the Board affirmed the hearing officer's findings and sanctions. Meanwhile, the firm continued to pursue its public company audit practice. Other firms and their auditors may litigate to delay disclosure of their audit deficiencies, so that whenever the deficiencies do become public, they can be portrayed as "old news" that does not reflect on the firm's current practices.

Third, the incentive to litigate rather than settle has the effect of consuming considerable PCAOB resources — resources which as you know come directly from accounting support fees paid by publicly-traded companies. The resources that now must be committed to litigation could be deployed to investigate other potential audit failures. For example, the litigation of three recent cases involving partners at major international accounting firms has required over 17,000 hours of the PCAOB enforcement staff's time in conducting the litigation. This expenditure of time does not include the time PCAOB staff put into investigating these relatively complex audit matters and does not include the time put into other litigated proceedings. Indeed, two of these cases are still pending, and more staff time will be required to complete the proceedings — while the public remains unaware even that proceedings have been instituted. As resources are drained by this litigation, Board investigations addressing potential risks to investors due to issues surrounding other audits of public companies do not receive the full attention they deserve.

Fourth, the public is deprived of critical information necessary to evaluate the Board's enforcement program. The current nonpublic nature of our proceedings provides no transparency into our performance or priorities. During the course of a PCAOB disciplinary proceeding, there is no public disclosure of the conduct the Board considers to merit discipline, which firms and individuals the Board has charged, what issues are being litigated, and whether the Board's enforcement staff has won or lost. As a result, the public is left uninformed about the level of activity in the Board's enforcement program and how the Board uses its enforcement resources. Allowing for our contested disciplinary proceedings to be made public would certainly strengthen the Board's efforts to promote public trust in the financial reporting process.

Finally, the nonpublic nature of the contested disciplinary proceedings limits the Board's ability to use enforcement authority as a tool to improve audit quality and deter violations of the Board's rules. When the Board concludes that an alleged audit failure warrants disciplinary proceedings, the audit profession does not learn of that decision for an extended time period. Thus, other auditors who face similar situations will not be aware of what conduct prompted the Board to take disciplinary action or the potential severity of sanctions that might result from a violation.

This is all in sharp contrast to an SEC administrative proceeding against an auditor. If the SEC were to bring the same case, alleging the same violations, against the same auditor, the SEC's charges would be disclosed at the time the Commission instituted its proceeding. Any administrative trial would be open to the public. If there were an appeal to the Commission and an oral argument, the public could attend. The ability — or inability — of the Commission's staff to prove its charges would be a matter of public record. In the case of the PCAOB proceeding, no other auditor, no investor, no audit committee, no member of the media is entitled to know who has been charged, or for what, or the outcome of the case until appeals are exhausted.

For many years, the SEC faced a similar problem. Old SEC Rule 2(e) contained a presumption in favor of private disciplinary proceedings involving accountants, auditors, and lawyers. Because proceedings against accountants and auditors were private, there were incentives for delay and protracted litigation. It was not unusual for cases against the major accounting firms to take many years to work through the nonpublic process. In the late 1980s, the Commission changed the presumption in its rule from private to public disciplinary proceedings. Unfortunately, we find ourselves with the same problem the Commission confronted, but lack the option of solving it by amending the Board's rules. Public proceedings would require a change in the Sarbanes-Oxley Act.

The reasons why the Commission opened its 2(e) proceedings against auditors to the public support making Board proceedings public:

I should stress again that under the Board's proposed amendment to the Sarbanes-Oxley Act, PCAOB investigations will of course remain nonpublic, so auditors and others will have the full protection of the confidentiality provided by the Act unless and until the Board determines that charges should be brought. In addition, this legislative proposal would not change what is disclosed in the Board's inspection reports regarding Board inspections.

In my view, once the Board's processes result in charges being brought, a process to which the Board and its staff devote very careful thought and attention, the public has a right to know about it. We have been very encouraged by Congress' response so far to the Board's proposal. We hope that the auditing profession will work to support this important initiative to protect the interests of American investors.

Thank you.