Modesti, PCAOB Director of Enforcement and Investigations, Calls For More Transparency

This is a text of the speech today by Claudius Modesti, PCAOB Director of Enforcement and Investigations, for the AICPA’s Conference on SEC and PCAOB Developments.

I’ve written about the PCAOB’s request to have the Sarbanes-Oxley law changed to allow transparency in disciplinary proceedings. I’ve also written about the SEC’s recent action that effectively squelches timely disclosure of current cases via an appeals process catering to the audit firms’ desire to keep problems private for as long as possible.

In light of recent insider trading allegations against two senior partners at Deloitte, another partner at Ernst & Young, the audit failures at banks, and other serious cases Mr. Modesti alludes to, it’s critically important legislators give the PCAOB tools to hold auditors and audit firms accountable.

The text of his speech today is in full and unedited.  Any emphasis is mine.


Good Afternoon.

The views I express are my own and do not necessarily reflect the views of the Board or Board staff.

I want to thank the AICPA for the opportunity to speak here today.

2010 marked my sixth full year as Director of the Division of Enforcement and Investigations for the Board.  I have the honor of leading a group of more than 48 attorneys, accountants and other professionals dedicated to protecting the interests of investors through the Board’s enforcement mechanism.  Enforcement’s deputy directors, Kyra Armstrong, Ray Hamm, Marion Koenigs and Jerry Decker are the persons responsible for helping me manage and direct the Division’s work.  Marion Koenigs, our newest Deputy Director Accountant has joined me today and, after my remarks, she will address certain aspects of our enforcement program.

Our Division has a full investigative docket.  In 2010 we opened 27 formal and informal investigations, involving a range of audits by large and small audit firms.

We have been adding staff to our Division’s ranks throughout 2010.  Because of ongoing litigation, including new litigation that the Board commenced this year, and the potential for even more litigation, we also have prioritized our hiring of litigators and have had the good fortune of continuing to attract experienced and highly-skilled litigators.  Most recently we hired Mark Adler, the former Deputy Chief Litigation Counsel of SEC Enforcement, to play a critical role in our litigation efforts.

Non-Public Proceedings

As some of you may already know, the most critical issue facing the Board’s enforcement program and its ability effectively to protect investors is the non-public nature of our disciplinary proceedings.

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

The Board has asked Congress to amend the Sarbanes-Oxley Act to allow its disciplinary proceedings to 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.

The Board’s enforcement rules and the Division’s practices, including its version of the Wells process, provide persons facing possible disciplinary proceedings with significant opportunities to defend their conduct before any charges are brought.  When charges are brought, those decisions are not made lightly.

Upon the Division’s recommendation, if the Board 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 non-public 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 non-public 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, including who the respondent is, which audit firm they work for, and for which audit failure he or she is responsible, 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, and even sanctioned, by the Board.

For example, during recent proceedings against 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 non-public proceeding and the eventual 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 the allegations contained in the order issued by the Board, the hearing officer’s findings as to liability and sanctions, and the Board’s affirmance of those findings. 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. 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 well 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.  Because litigation requires such significant investments of staff time and other resources, over time this resource drain may divert us from the important task of timely pursuing new investigations of potential auditor misconduct that may threaten investor interests.   I should note that, with the Dodd-Frank Act’s expansion of the Board’s disciplinary authority to include broker-dealer audits, the obstacles I am discussing with you will be further exacerbated to the extent the Board brings contested disciplinary proceedings against  auditors of brokers and dealers.

Fourth, the public is deprived of critical, concrete information necessary to evaluate the Board’s enforcement program. The current non-public 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 non-public 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 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.  In the end, non-public disciplinary proceedings undermine the Board’s ability to send strong signals to the profession and the investing public about, for example, the need for professional skepticism and due care in the conduct of audits.

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 a 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 non-public 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 ability to solve it by rulemaking. Public proceedings would require a change in the Sarbanes-Oxley Act.

I stress that under the Board’s proposed amendment to the Sarbanes-Oxley Act, PCAOB investigations would of course remain non-public, 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.

I believe the legislative proposal put forth by the Board to make our disciplinary proceedings public is the only effective way to address these issues.  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.

Thank you.

9 replies
  1. Feed the Baby
    Feed the Baby says:

    As much as I would love to diaper up Mr. Assange and pin him firmly in his crib, this is a case in point where the need for a way to distribute information outweighs the illegality of leaking it. Did Sarbanes and Oxley write the totally non-public investigation through litigation process into the original legislation or was it forced in to get it passed? Was it heavily lobbied by Accounting firms? For that matter, did the AICPA have an important role? I think it’s time to invest in Accounting Firm futures. They seem to have an invincible teflon surface.

  2. Aubrey M. Farb
    Aubrey M. Farb says:

    I agree with Mr. Modeski. The current rule is almost like locking the barn door after the horse has been stolen.

    I am sure that Sarbanesp-Oxley has been of some help; however, it is naive to believe that persons who have committed fraud or other crimes, which are felonies would have any qualms against signing the certificatuions required under the act. A little perjury on top of feelonies just doesn’t inhibit anyone.

    The answer is to change the system. So long as the auditors are paid huge fees by their clients, there will always be a bias on the part of the auditors in favor of protecting the client and thereby protecting the auditor’s fees.

    I recommend that surety companies be qualified to issue performance bonds to public companies. The surety companies would hire the auditors and pay their fees. Now the auditors will have responsibility to the surety comoany that employed them and they will protect everyone by revealing the truth. Not only that. In the event of a misstep by an auditor, the surety company can sue for dammages and refuse to appoint the firm as auditors for other companies.

    Until we change the system, which is badly flawed and broken, we will always be at the mercy of the cozy relationships betweeen auditors and their clients.
    One only has to study the history of WorldCom to see how the close relationship between the partners in charge of the audit and the company led to covering up the mammoth fraud that could easily been revealed by Arthuir Andersen. Or, one might look at the Enron case. The minutes of Andersen’s executive committee reveal that the firm had misgivings about continuing to represent Enron, but decided to keep the client because the estimated fees for the following year were estimated to be more than $100,000,000. So much for independence.

    The auditing profession has been given a monopoly to audit public companies. Yet, the profession has not lived ujp to its obligations to the public and to our governkent to honor their pledge of INDEPENDENCE which they so proudly proclaim.

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