The Scourge of Sarbanes-Oxley Part I
Under the S-O Act, the U.S. Securities and Exchange Commission (SEC) essentially can determine the terms and conditions under which financial gatekeepers can assist public companies in accessing U.S. market investors in any jurisdiction. Accordingly, and in light of the global environment in which public companies operate, the S-O Act has serious implications for international public accounting firms worldwide.
In legal terms, any person associated with a public accounting firm,3 that is, a legal entity that is engaged in the practice of public accounting or preparing or issuing audit reports, or registered with the Public Company Accounting Oversight Board established pursuant to §101 of the S-O Act, is subject to the S-O Act.4 If you are an auditor working for an international audit firm, it is irrelevant whether you are a U.S. citizen or a citizen of the Republic of Xanadu. Any foreign public accounting firm, or person associated with such firm, that prepares or provides an audit report with respect to any "issuer"5 is subject to the S-O Act in the same manner and to the same extent as a public accounting firm that is organized under the laws of the United States or any state.6 The S-O Act specifies that U.S. law will govern the relationship between the public company and its foreign auditor, regardless of whether their consulting agreement designates the law applicable to the agreement.
By requiring that the parties' relationship be exclusively governed by U.S. law and resolved in the U.S. courts, the S-O Act undermines the parties' autonomy and home countries' legal guarantees with respect to choice of law, choice of forum and jurisdictional principles.
Further, if a foreign audit firm issues an opinion or performs material services upon which a U.S. audit firm relies in issuing all or part of any audit report or any opinion contained in an audit report, the foreign audit firm will be deemed to have consented to producing its workpapers for the Board or the SEC in connection with any informal or formal investigation by either body with respect to that audit report, and to be subject to the jurisdiction of the U.S. courts for purposes of enforcement of any request for production of such workpapers.7 Conversely, a U.S. audit firm that relies on the opinion of a foreign audit firm will be deemed to have consented to producing the audit workpapers of the foreign audit firm and, as a condition of its reliance on the opinion of the foreign audit firm, to have secured the agreement of such firm.8
The S-O Act states clearly that the court will apply U.S. law regardless of the (foreign) jurisdiction where a judicial or administrative proceeding brought under the S-O Act is pending. This scope poses a potential legal conflict to the extent that foreign auditors are of different nationalities and cultures and, hence, are accustomed to a different business environment and are subject to the legal requirements and judicial systems of their home countries. For example, some countries use the International Accounting Standards (IAS) rather than the U.S. Generally Accepted Accounting Principles (GAAP), while other countries, particularly in the Latin American region, have their own accounting standards.
Surprisingly, given the globalization of financial markets, the S-O Act ignores that foreign jurisdictions have procedures substantially different than those that exist under U.S. laws. For instance, in Latin America, the concepts of due diligence and discovery either do not exist or their scope is very narrow. Similarly, in some European countries, an auditor could not agree to produce its workpapers without the prior consent of the client and will often be subject to criminal sanctions under domestic regulations. In countries such as Denmark and France, public companies must have joint audits. Under the S-O Act, if one of the auditors fails to register with the Board, it could not, or should not, sign the joint audit report. This could create a major problem for a public company if the unregistered auditor could not be immediately replaced, as is the case in France, where auditors are elected or appointed by the general assembly of shareholders for a period of six years.9 By requiring that the parties' relationship be exclusively governed by U.S. law and resolved in the U.S. courts, the S-O Act undermines the parties' autonomy and home countries' legal guarantees with respect to choice of law, choice of forum and jurisdictional principles.
The Board and the SEC have the discretion to provide accommodations for foreign auditors where possible without foregoing investor protection. The Board has made certain accommodations for foreign auditors, such as (1) not requiring them to furnish registration information to the Board if to do so would violate home country laws, (2) extending the registration period by six months so they may have sufficient time to evaluate any conflicts of law and (3) limiting registration only to proprietors, partners and principals of foreign accounting firms that furnish in excess of 10 hours of services on a particular audit.10 These accommodations should permit foreign auditors to follow the spirit of the S-O Act without disrupting home country practices.11
The S-O Act should contribute to a global environment of honest, practical and effective financial reporting. However, based on the legal conflicts sparked by the S-O Act, it may be unrealistic to imply the consent of a foreign audit firm or person associated with such firm to producing its audit workpapers to the Board or the SEC in connection with an investigation by either body or an administrative or a judicial proceeding pending in the United States. Because the S-O Act ignores governing law, choice of forum and jurisdictional principles in its regulation of domestic and foreign financial service providers, it remains to be seen whether the S-O Act will become a globally accepted standard of corporate and professional accountability. Further, it remains to be seen whether relevant regulation in other countries will change to create a global business environment that promotes early risk assessment and prevention and supports establishing and implementing sound corporate governance programs.
It behooves audit firms to retain counsel to evaluate the legal conflicts created by the S-O Act prior to advising their client on a course of action. This precautionary measure should be taken at least with respect to matters involving Latin American countries, where compliance with the S-O Act may pose a high risk to public companies because of major deficiencies in the local financial reporting systems such as weak books, records and internal controls and the absence of a code of conduct to guide audit firms. In the meantime, if a U.S. audit firm is planning to rely on the opinion of its foreign counterpart to issue an audit report, the former should require the foreign audit firm to turn over its audit workpapers at the time it delivers its opinion to avoid a potential violation of the S-O Act and criminal liability under the law. The S-O Act imposes severe criminal penalties for the failure of auditors to comply with the new disclosure requirements.
The second part of this article will consider the criminal fraud provisions of the S-O Act as applied by federal regulators to what may be the test case12 for establishing auditor's criminal liability.
2 In addition to U.S. public companies and foreign public companies registered with the SEC or whose securities are listed in a U.S. national stock market, the S-O Act also applies to a "foreign private issuer," a term defined in SEC Rule 3b-4 to include a corporation or other organization incorporated or organized under the laws of any foreign country unless (1) more than 50 percent of its voting securities are directly or indirectly held of record by residents of the United States, and (2)(i) the majority of its officers or directors are U.S. citizens or residents, (ii) more than 50 percent of the assets of the issuer are located in the United States or (iii) the business of the issuer is administered principally in the United States. Return to article
3 The S-O Act defines "person associated with a public accounting firm" (or with a "registered pubic accounting firm") and "associated person of a public accounting firm" (or of a "registered public accounting firm") as any individual proprietor, partner, shareholder, principal, accountant or other professional employee of a public accounting firm or any other 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 an agent or otherwise on behalf of such accounting firm in any activity of that firm. 116 Stat. 745 §2(a)(9). Return to article
4 Although registration with the Board is mandatory under §102 of the S-O Act, it will not by itself subject a foreign public accounting firm to the jurisdiction of the U.S. courts, other than with respect to controversies between such firms and the Board. Return to article
5 Section 2(a)(7) of the S-O Act defines the term "issuer" as an issuer, within the meaning of §3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), the securities of which are registered under §12 of that Act (15 U.S.C. 781), or that is required to file reports under §15d (15 US.C. 78o(d)), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn. Return to article
10 Based on the speech "Embracing International Business in the Post Enron Era" by Commissioner Roel C. Campos, SEC Centre for European Policy Studies, made in Brussels, Belgium, on June 11, 2003. Return to article
11 However, the Board may also issue a ruling declaring that a foreign public accounting firm (or a class of such firms) that is not covered under §106(a)(1) plays such a substantial role in the preparation and furnishing of such reports for particular issuers that it is necessary or appropriate to subject such firm(s) to the S-O Act as a matter of public policy. See §106(a)(2). Return to article