Section 10A of the Securities and Exchange Act of 1934 requires reporting by auditors to the Securities and Exchange Commission (SEC) when, during the course of a financial audit, an auditor detects likely illegal acts that have a material impact on the financial statements and appropriate remedial action is not being taken by management or the board of directors.
The Private Securities Litigation Reform Act of 1995 (Public Law 104- 67) added Section 10A to the Securities Exchange Act of 1934 (15 U. S. C. 78j- 1). Section 10A reporting requirements first became effective for fiscal years beginning on or after January 1, 1996.
The GAO prepared a report in February 2000 and again in September 2003 at the request of Congress, regarding the audit industry’s compliance with Section 10A. The GAO also reported the statistics for SEC enforcement actions under Section 10A.
The February 2000 report stated that six Section 10A reports had been submitted by audit firms through December 14, 1999. Records from the SEC’s Office of the Chief Accountant show that during the period December 15, 1999 through May 15, 2003 – four years of turmoil in the markets and in the accounting industry – an additional 23 Section 10A reports were submitted.
From the inception of the 10A reporting requirement in 1996 through May 15, 2003, a total of 29 Section 10A reports were submitted to the SEC. The reports cover a variety of potential illegal acts, including improper revenue recognition, unusual capital transactions relating to stock warrants, inadequate financial statement disclosures, and failure to disclose expenses relating to stock options.
In the 2003 report, the AICPA attributed the low level of 10A reporting to the reasons they cited as stated in the 2000 GAO report: In most cases, management or the board of directors, often with the participation of internal or external counsel, took timely and appropriate action to address a situation involving an illegal act when it was brought to their attention by auditors.
According to SEC officials in 2003, all Section 10A reports from 1996 to 2003 were investigated. Of the 29 SEC registrants named in the reports as of 2003, 10 were the subject of active SEC enforcement investigations, 8 had actions brought against them by the SEC, and 11 reports were closed without formal action being taken by the SEC.
Injunctive actions and administrative proceedings were filed in 8 cases alleging violations such as (1) failure to disclose transactions in public statements to shareholders and the SEC, (2) inclusion of fraudulently- valued assets on financial statements filed with the SEC, (3) underreporting the value of inventory resulting in an understatement of expenses and liabilities and an overstatement of income, and (4) improper revenue recognition and understatement of expenses.
A violation reported under Section 10A may be closed without formal action being taken by the SEC because the registrant is no longer publicly traded, has a very small dollar amount of assets, or is no longer doing business. In certain instances, after discussions with the SEC, the registrants took remedial action, which the SEC found satisfactory, such as obtaining a review of the registrant’s quarterly financial statements filed with the SEC.
In 2002, the American Institute of Certified Public Accountants (AICPA) issued a new audit standard for detecting fraud, Statement on Auditing Standards (SAS) 99: Consideration of Fraud in a Financial Statement Audit. The AICPA believed SAS 99 would substantially change auditor performance, thereby improving the likelihood that auditors will detect material misstatements in financial statements due to fraud by placing an increased focus on exercising professional skepticism throughout the audit. The new standard required auditors to identify and consider risks of material misstatement due to fraud when planning and performing the audit through brainstorming among audit team members, inquiring of management, performing analytical procedures, considering inappropriate reporting of revenue and management override of internal controls, evaluating internal controls that address the identified risks of fraud, and assessing throughout the audit and at the completion of the audit the risk of fraud based on the results of auditing procedures.
The new standard also required auditors to communicate about fraud to management, the audit committee, and others, and to document the auditors’ consideration of fraud. SAS 99 was adopted and effective for audits of financial statements for periods beginning on or after December 15, 2002. The PCAOB, the regulator for the auditing industry established by the Sarbanes-Oxley Act in 2002, updated the standard the first time with Auditing Standard No. 5, adopted in 2007. The PCAOB revised the standard further in December 2010 as AU Section 316: Consideration of Fraud in a Financial Statement Audit.
The Sarbanes-Oxley Act of 2002 also contains a number of provisions aimed at improving the quality of audits of public companies including more audit committee involvement with the auditor, a requirement for auditors to attest to management’s assessment of internal controls over financial reporting, a requirement for audit partner rotation, prohibition of certain non-audit services to audit clients, prohibition of providing audit services to a company that employs as a top official a previous member of the audit engagement team, and greater penalties for failure to report fraud.
Rule 240 10A-1 states that auditor reports under Section 10A must be submitted to the SEC’s Office of the Chief Accountant. The report must be in writing and identify the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. In addition, the report must include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements. The rule is based on the premise that the reports under Section 10A are supposed to assist the SEC in performing its enforcement responsibilities and therefore, the auditors’ reports are nonpublic.
After receiving and logging the Section 10A reports, the Office of the Chief Accountant forwards the reports to the Division of Enforcement, which conducts investigations into possible violations of federal securities laws and prosecutes the SEC’s cases. The reports are also forwarded to other divisions within the SEC, including the Division of Corporation Finance, which reviews the financial statements and other financial reports filed by SEC registrant companies. The Office of the Chief Accountant and the Division of Enforcement monitor the progress on any investigation initiated or facilitated by a Section 10A report.
Auditors are still getting used to an external regulatory regime under the PCAOB since 2002 versus the self-regulatory regime they operated under with the AICPA, their trade organization, as the rulemaker and enforcer. Frauds did not end after the Sarbanes-Oxley Law was enacted. It’s now apparent that fraud drove many of the financial crisis failures. The subprime crisis turned into a credit crisis then a full blown financial crisis. Major industrial and financial services companies in the United States and abroad were bailed out, forcibly acquired, and effectively nationalized in order to survive.
During that time, no warning bells for shareholders and society as a whole, in the form of “going concern” opinions, were sounded. As financial crisis litigation has increased, we are now seeing, almost four years later, the extent to which accounting fraud, disclosure fraud, and accounting manipulation played a role in these failures. We have also seen a record number of enforcement actions for illegal acts by corporations and individuals under the Foreign Corrupt Practices Act.
Section 10A is not mentioned very often in enforcement actions against auditors. Frankly, there are few enforcement actions against auditors at all compared to the number of enforcement actions against client company executives. But 10A has been mentioned recently on two specific occasions.
“The reliability of global capital markets depends on auditors fulfilling their obligation to investors to perform robust audits, resulting in well-founded audit reports. Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors’ failure to uncover the Satyam fraud.”
On April 5, 2011, the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) announced settled disciplinary orders against five firms, members of the PricewaterhouseCoopers LLP (PwC) global network, for violations of PCAOB rules and standards and for violations of federal securities laws as well as improper professional conduct by PW India while PW Bangalore served as auditor of record for Satyam.
In addition, the SEC also sanctioned the PW India firms for, “violation of Section 10A(a) of the Exchange Act by failing to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.”
Technically, this was not an enforcement action for, “failing to report likely illegal acts that have a material impact on a company’s financial statements,” but instead for failing to perform the audit in such a way that those illegal acts have a high likelihood to be detected. The SEC, and the PCAOB which filed a simultaneous enforcement action, chose to believe that PW India was ignorant of the illegal acts. The jury is still out, literally, in India, on whether the Price Waterhouse India auditors were aware of the illegal act, complicit in the fraud with executives, and did not report them or were simply incompetent as the SEC would lead us to believe.
On October 3, 2011, the PCAOB issued Staff Audit Practice Alert No. 8, Audit Risks In Certain Emerging Markets.
In the Alert, the PCAOB warned that although authorities in many emerging market countries were taking steps to improve investor protection, the PCAOB, “has observed from its oversight activities some conditions in audits of certain companies in emerging markets that indicate heightened fraud risk. Other situations have come to light in recent corporate filings with the Securities and Exchange Commission (“SEC”) and in SEC orders suspending trading in securities of certain companies in emerging markets.”
In just two months in 2011, more than 24 companies with their principal place of business in the People’s Republic of China (“PRC”) filed Forms 8-K with the SEC reporting auditor resignations, accounting irregularities, or both. “In some instances, the auditor’s letter of resignation stated that the auditor resigned because of circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934 (“Exchange Act”).” 
- How many of the auditors associated with the 24 companies with their principal place of business in the People’s Republic of China that filed 8-Ks also filed 10A reports? Did the auditors who mentioned, “circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934,” file 10A reports with the SEC?
- Did the auditors of the two PRC-based companies where the SEC issued stop order proceedings perform their duties under Section 10A or did they fail to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts?
- Will we see any SEC enforcement actions against these auditors for failing to detect these illegal or fraudulent acts via proper audits and failure to report the illegal acts to the SEC?
- Did the auditors do their job in China?
Investors count on the auditors as the last defender of shareholder interests before regulators and the lawyers get involved. I wanted to see if the auditors had at least warned the SEC of potential frauds and illegal acts, in particular during the period leading up to the 2008 financial crisis bailouts.
I checked with the GAO in June of 2011 to see if anyone in Congress had asked for an update since 2003 on Section 10A reporting by auditors. Chuck Young, Managing Director of Public Affairs said, “No, we have not done any review since the one in 2003.”
So I prepared a Freedom of Information Act (FOIA) request in June and then again in October for the same information Congress and the GAO had previously requested from the SEC. The first request I made covered the entire period since the last report to Congress, 2003, until the present. It also referred to a tracking system that the 2003 report said would be implemented to help track these submissions by auditors and the SEC’s actions on them.
5) It was reported to the GAO in May 2003 that the Division of Enforcement was developing a computer tracking system for referrals of Section 10A reports, as well as complaints concerning possible financial reporting violations. Please attach any status reports that document the development progress and eventual implementation of this “computer tracking system”.
Unfortunately, the helpful response from the SEC to my initial request was that a request for data for the period May 16, 2003 through May 31, 2011 was too extensive, especially because the above referenced “computer tracking system” had not yet been implemented.
So I revised my request to cover just the years since January 1, 2007 as a start. The idea was to replicate the statistics the GAO had prepared, at least. If I could also see the underlying reports and data, all the better.
In December the SEC responded to my request, but refused to provide information about three of the four inquiries. They cited confidential treatment of investigatory materials or they told me to do my own investigating. I will appeal. I can also appeal to the House Financial Services Committee’s Subcommittee on Oversight and Investigations. Maybe the Congressmen will make a new request to the GAO to update this important oversight report since it’s not been done during the post-Sarbanes-Oxley era and now post-financial crisis period.
It’s quite surprising that the one substantive response from the SEC I did get was to my FOIA inquiry regarding the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.
The SEC replied that, “ a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.”
There are still many unanswered questions about how and why the financial crisis frauds occurred. New frauds, such as the Chinese reverse merger frauds, took advantage of a public listing loophole that the SEC and auditors missed. All these investor losses occurred under the supposedly watchful eyes of auditors, who are paid dearly to protect shareholders but in many cases are either complicit, incompetent, or both.
Dear SEC, Please send me the following records:
As was mentioned in our letter of October 25, 2011, the FOIA was not intended to compel agencies to become ad hoc investigators for requestors whose requests are not compatible with their own information retrieval systems. Nor does the FOIA require agencies to conduct legal research and answer questions disguised as FOIA requests. Consequently, we have processed the portions of your request where responsive records exist; however, we did not process the portions wherein questions are posed.
(1) Please provide the number of Section 10A submissions, by year, from January 1, 2007 through September 30, 2011 and a copy of each report filed that identifies the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. The filing should include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements.
(2) Please provide the status of the SEC actions on those 10A reports that were filed, by year, between January 1, 2007 and September 30, 2011.
SEC Response: After consulting with Commission staff, we have determined the following: With respect to items 1 and 2 of your request, responsive records are withheld in their entirety under FOIA Exemptions: 5 U.S.C. § 552 (b) (3) and 7(A), 17 CFR § 200.80 (b) (3) and (7) (i).
The internal records which consist of material pertaining to Rule 240 10A-1 are protected form disclosure under FOIA Exemption 3. Exemption 3 permits the withholding of documents specifically exempted from disclosure by another Federal statute. Section 240.10A-1 states in part, that records submitted under this section, “shall be deemed to be an investigative record and shall be non-public and exempt for disclosure pursuant to the Freedom of Information Act to the same extent an for the same periods of time that the Commission’s investigative records are non-public and exempt for disclosure under among other applicable provisions, 5 U.S.C. 552 (b) (7) and 17 CFR 200.80 (b) (7).” See, 17 CFR § 240.10A-1.
In addition, with respect to on-going enforcement activities pertaining to any f the 10A submissions, the records are protected form release under Exemption 7(A), which protects form disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.
(3) Please provide the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.
SEC Response: With respect to Item 3 of your request, based on the information you provided in your letter, a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.
(4) Please provide the number of 8-Ks filed for auditor changes each year 2007-2010 and the number of requests for additional information from the registrants as needed to clarify matters reported on 8-Ks for auditor changes.
During this period, did the Division of Corporation Finance identify any significant potential violations of SEC laws and regulations as a result of auditor changes, or forward any matters to the Division of Enforcement for further investigation? How many were identified or forwarded, by year January 1, 2007 to September 30, 2011? Please include status reports of these investigations, if any.
SEC Response: Finally, with respect to Item 4 of your request, a significant portion of the information sought is publicly available on our website at www.sec.gov under the section “Filings and Forms.” Specifically, anyone can search the EDGAR database for Form 8-Ks filed during any year, and for staff comment letters and response letters for any filings filed during 2007-2010. The Commission does not maintain a retrieval system designed for culling data based on the information cited in your request.
 The General Accounting Office, the audit, evaluation and investigative arm of Congress, exists to support Congress in meeting its constitutional responsibilities and to help improve the performance and accountability of the federal government for the American people. GAO examines the use of public funds; evaluates federal programs and policies; and provides analyses, recommendations, and other assistance to help Congress make informed oversight, policy, and funding decisions. GAO’s commitment to good government is reflected in its core values of accountability, integrity, and reliability
 U.S. General Accounting Office, Securities Exchange Act: Review of Reporting Under Section 10A, GAO/AIMD-00-54R (Washington, D.C.: Feb. 4, 2000).
 The PCAOB was established pursuant to the Sarbanes-Oxley Act of 2002 (Act) to oversee the audits of public companies that are subject to the U.S. Federal securities laws. As provided for by the Act, the PCAOB will set professional standards (including auditing, attestation, quality control, ethics, and independence standards) to be used by public accounting firms registered with the PCAOB in the preparation and issuance of audit reports of public companies.
 See letter from SEC Chairman Mary Schapiro, dated April 27, 2011, to the Chairman of the House Subcommittee on TARP, Financial Services, and Bailouts of Public and Private Programs, Congressman Patrick McHenry, at http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.
 See the discussion in the section in the PCAOB Alert on illegal acts.
 See SEC Press Release, Stop Order Proceedings Instituted Against China Intelligent Lightning and Electronics, Inc., and China Century Dragon Media, Inc. (June 13, 2011) at: http://www.sec.gov/news/press/2011/2011-127.htm
 See, e.g., Longtop Financial Technologies Limited, Form 6-K (May 23, 2011), Exhibit 2 at: http://www.sec.gov/Archives/edgar/data/1412494/000095012311052882/d82501 exv99w2.htm.
 Blakey v. DOJ, 549 F. Supp. 362, 366-367 (D.D.C. 1982).
 Satterlee v. IRS, No. 05-3181, 2006 WL 3160963, at *3 (W.D. Mo. Oct. 30, 2006).
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