Thursday, December 10, 2009

SEC's Khuzami 'Skeptical' of Auditors' Claims on Privilege

In remarks at an AICPA conference earlier this week, SEC Enforcement Director Robert Khuzami said:

We have seen a number of audit firms withhold subpoenaed documents and assert work product privilege on behalf of an audit client. We are skeptical of such claims, especially after the recent en banc decision in Textron which held that tax accrual work papers prepared by in-house counsel were not entitled to work product privilege.

As background, Khuzami explained that in the Textron case: "the IRS sought those work papers and the company refused, claiming work product privilege. The court rejected that argument, noting that the 'work product privilege is aimed at protecting work done for litigation, not in preparing financial statements.'

He added: "the First Circuit’s common sense analysis is how we evaluate these types of assertions of privilege." Specifically, Khuzami warned:
We do not see how the audit documentation prepared by or relied on by an auditor in connection with an audit report can be privileged, or how any claimed privilege hasn’t been waived. Audit documentation is collected or prepared for the purpose of issuing an audit opinion, not for the purpose of litigation. And sharing the work product with auditors, who are supposed to be “public watchdogs,” strongly undermines any such claim.

My two cents (I remind you of the disclaimer on the right side of this blog): From a layperson's perspective (i.e. as an accountant, not a lawyer), I was surprised by Khuzami's statement (and, in turn, the related statement of the First Circuit) that implies documentation prepared in contemplation of potential litigation - and documentation prepared to support tax accruals, litigation accruals, or other financial statement items - are necessarily mutually exclusive; I can see how certain documentation could be understood to potentially fulfill both purposes (although I am aware that there are specified practices and Federal Rules of Evidence, etc. with respect to maintaining and protecting privilege.)

Notably, there appears to be some precedent in certain circuits (although not the First Circuit) in which preparation of certain documents in anticipation of potential litigation as a 'primary motivating purpose' - even if not the sole purpose - of creating the documentation, satisfies some Circuit Courts that the documents should be considered privileged. See: The pursuit of transparency does not trump the work product privilege, by Michelle M. Henkle, Tax Executive Magazine, May-June 2008.

However, in the event that detailed workpapers prepared solely for litigation are to retain privilege, companies are at risk of waiving the privilege by disclosing that information to their auditors to back up tax accruals, litigation accruals, or other items. Thus, companies are is in a catch-22 situation: if their audit firm insists on viewing certain documentation (which the client viewed as privileged) in support of, e.g., a tax accrual - as opposed to agreeing to alternate means of becoming satisfied with the accruals - companies may have to choose between potentially waiving privilege, or enduring the wrath of their auditor (which theoretically could result in, e.g., a qualified audit opinion, or in the auditor resigning from the engagement.)

I asked Stan Keller of law firm Edwards Angell Palmer & Dodge LLP about Khuzami's remarks on privilege. Keller serves as Chair of the American Bar Association's Committee on Audit Responses, and has served as a member of ABA's Task Force on Attorney-Client Privilege. Here's what Keller said:

The Textron decision represents one Circuit's view and is contrary to the position of several other Circuits providing broader work product protection. Indeed, Textron has petitioned the U.S. Supreme Court to grant certiorari review. I would think the SEC should also be concerned about the ability of issuers to share information with their auditors to insure the integrity of financial reporting and the effectiveness of audits.
Later, I was able to track down Susan Hackett, Senior Vice President and General Counsel of the Association of Corporate Counsel, who is leading ACC's advocacy efforts on Privilege Protection, for her views. I shared with her Stan Keller's comments which I received earlier in the day; here's what Hackett had to say:
Stan’s right about this decision being such a deviation from other authority defining attorney work product protections. ACC will join many others in the legal and business community to protest this latest ruling and request that the Supreme Court set the record straight. This decision hamstrings public companies’ in-house lawyers from advising auditors and corporate financial managers in a manner that promotes accuracy and transparency in financial reporting and certification. It eviscerates the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege; so is the message that in-house lawyers and auditors shouldn’t talk? Or that they should only talk when they can provide happy news that they wouldn’t mind seeing on the front page tomorrow? According to the court that issued this most recent ruling, ‘any lawyer’ would call Textron’s counsel’s assessment of potential liability mere tax or business documents, not litigation documents that would afford them work product protections. But by ‘any lawyer,’ the court is certainly not referring to the 24,000 in-house counsel members of ACC.
Other Topics Covered by Khuzami:
'Cooperation Initiative, Fraud, Audit Committees, Clawbacks
Khuzami - who as noted in this press release formerly served as a federal prosecutor for 11 years with the United States Attorney's Office for the Southern District of New York, and as General Counsel for the Americas at Deutsche Bank - also covered these topics in his remarks at the AICPA conference:
  • Changes in the Enforcement Division
  • The Division's new 'Cooperation Initiative' (which, he noted, could pose conflicts of interest for certain attorney-client relationships)
  • Financial Statement and Accounting Fraud (detailing some recent high profile cases)
  • The Role of Audit Committees
  • "Clawback” Under Section 304 of the Sarbanes-Oxley Act, and
  • Hedge Funds and Derivatives
Enforcement Associate Chief Accountant's Advice For Preparers, Auditors
Jason Flemmons, Associate Chief Accountant in the SEC's Division of Enforcement, followed Khuzami's remarks at the AICPA conference, by detailing more of the Division's efforts on financial statement and accounting fraud. Here's a few highlights from Flemmons' remarks:
Recent conditions have put significant strain on core necessities such as financial solvency and access to credit. I firmly believe that these additional pressures have only increased the risk and motivation for companies to commit financial fraud. Challenging economic times are not immune to financial skullduggery. To the contrary, financial fraud is 100% recession proof.

Accordingly, I can assure you that our staff remains more committed than ever to protecting the investing public and sanctioning those who break the rules. I also believe that the initiatives that Rob and the Chairman have undertaken in their brief time at the Commission will greatly strengthen the Division and maximize our effectiveness. For example, by delegating formal order authority to the Division’s senior officers, the number of formal investigations opened this year has more than doubled....

...with respect to financial statement preparers, I believe that the root causes of our enforcement actions are not driven by the individual accounting issues involved, but rather by two much more basic principles: integrity and transparency. Accordingly, the themes that I will briefly address today are not esoteric accounting concepts, but are rather much more fundamental. Make no mistake, the types of accounting issues that we encounter run the gamut, ranging from novel FAS 133, multiple element arrangement and tax accounting abuses to simply making the numbers up. However, the accounting improprieties cited in our enforcement actions against preparers are the product of integrity and/or transparency defects, not the other way around. I am hopeful that these comments will serve as effective reminders and helpful advice on how to stay out of trouble as we approach the end of the calendar year and, for many registrants, 2009 fiscal year end.

Under the heading of 'integrity' Flemmons focused on two topics: accounting estimates, and how companies handle the discovery of problems in financial reporting. Under the heading of 'transparency,' he focused on the importance of avoiding intentionally distorting MD&A trends, and to avoid 'fiddling" or manipulating non-GAAP metrics in a way that is misleading (noting as an example the recent case against SafeNet, the first action brought against a company under Reg G.)

Flemmons also warned preparers: "Misleading an outside auditor is in itself a violation of Commission rules. We have charged more than 500 individuals with lying to auditors since Sarbanes Oxley was enacted, including dozens this past year."

On the flip-side, he warned auditors:
An important topic that I want to emphasize today is that the existence of management fraud does not provide an automatic exemption to auditors from SEC enforcement action. In fact, many, if not most, of our cases against outside auditors have arisen from financial frauds by client management who went to great lengths to mislead auditors....A common thread in many of our enforcement actions against outside auditors is the failure to demonstrate professional skepticism by obtaining persuasive audit evidence. It is not enough to obtain
suggestive, but opaque, evidence....The Commission has also brought many actions that involved very well designed audits that would have exposed financial frauds had the fundamental principles of due care, professional skepticism and audit evidence been properly applied. In these instances the auditors had the equivalent of first down and goal on the one yard line and elected to punt.

Flemmons, who according to this bio, was formerly a litigation consultant in the Financial Advisory Services practice at PwC before joining the SEC in 2000, has a speaking style (i.e. in writing) that reminds me of former SEC Chief Accountant Lynn Turner, in terms of some of the illustrative langauge and persuasiveness. Flemmons wrapped up his remarks:
I would like to close with a reminder that everyone in this room is a gatekeeper. From the accounting clerk of a public company to the CFO, or from a first year audit staff to a national office partner at a public accounting firm, each and every one of you plays a crucial role in maintaining a capital market system of the highest caliber and integrity. I urge all of you to take your gatekeeping responsibilities seriously and with utmost alacrity. By working together, we will continue to promote and protect the most prestigious and influential securities markets in the world.

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Francine McKenna said...

Edith, on the privilege issue... Don't confuse auditor workpapers prepared as part of the audit and workpapers prepared by a company's accountants and tax professionals and then disclosed (or often not due to worries about waiving privilege) to auditors when they come in to do the audit. I think two different things and different cases apply. I wrote about auditors access to "privileged" information here:

With regard to Flemmons, I like what I hear. "In these instances the auditors had the equivalent of first down and goal on the one yard line and elected to punt."

And, "I would like to close with a reminder that everyone in this room is a gatekeeper...every one of you plays a crucial role in maintaining a capital market system of the highest caliber and integrity. I urge all of you to take your gatekeeping responsibilities seriously and with utmost alacrity."

linda said...

I would like to close with a reminder that everyone in this room is a gatekeeper...every one of you plays a crucial role in maintaining a capital market system of the highest caliber and integrity. I urge all of you to take your gatekeeping responsibilities seriously and with utmost alacrity."
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