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PCAOB Schedules Vote to Issue Proposed Rule on Contributory Liability for Audit Firm Violations

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 6 minute read

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 6 minute read

The Public Company Accounting Oversight Board (PCAOB) scheduled a public meeting for Sept. 19, 2023, to consider issuing a proposal that would change its rules on contributory liability for audit firm violations.

The item in question is PCAOB Rule 3502, Responsibility Not to Knowingly or Recklessly Contribute to Violations, which “governs the liability of associated persons who contribute to a registered public accounting firm’s primary violation of the laws, rules, and standards that Congress has charged the Board with enforcing,” according to the audit regulatory board’s meeting announcement.

The PCAOB did not give more detail, but this rulemaking item was put on its short-term agenda in May.

Under the leadership of chair Erica Williams, the PCAOB has set for itself a very ambitious standard-setting agenda with a goal to move each project in a timely manner than in the past.

In the spring of this year, the board not only updated its standard-setting and research projects but also added four rulemaking projects that are separate from standards related to the performance of audit. These rulemaking projects are focused on “enhancing investor transparency and enforcement of PCAOB rules,” according to the board.

Rule 3502, which became effective in 2006, states that a “person associated with a registered public accounting firm shall not take or omit to take an action knowing, or recklessly not knowing, that the act or omission would directly and substantially contribute to a violation by that registered public accounting firm of the [Sarbanes-Oxley] Act, the Rules of the Board, the provisions of the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto, including the rules of the [U.S. Securities and Exchange] Commission issued under the Act, or professional standards.”

Rulemaking Needed: Standard of Behavior on Negligence

Former SEC Chief Accountant Lynn Turner, who is well-versed in accounting and auditing rules and regulations, said that when the PCAOB originally proposed the rule, the board also wanted to establish a standard of behavior related to negligence.

The SEC, as the securities markets regulator, oversees the board, and all significant changes to the PCAOB’s rules and standards must first be approved by the commission before they can become effective.

When the SEC put the PCAOB’s rule out for comment in March 2006, it stated that the board had received several comment letters that supported the original proposal as the rule would be essential for the board to carry out its disciplinary proceedings.

The PCAOB was established by the Sarbanes-Oxley Act of 2002 following accounting scandals at companies like Enron and WorldCom.

But others, including the largest accounting firms and an accounting trade association, did not support the rule as proposed. And the PCAOB adopteded a revised final rule.

“In general, these commenters objected to the proposed rule’s use of a negligence standard in light of the complex regulatory requirements with which auditors must comply,” the SEC said in Release No. 34-53427, Notice of Filing of Proposed Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees, when it exposed the PCAOB’s then-final rules for public comment. “Some of these commenters also questioned the Board’s authority to adopt the proposed rule, or at least the proposed rule with a negligence standard. The Board has carefully considered these comments and determined to adopt Rule 3502, with some modifications.”

The SEC, however, stated that the PCAOB “continues to believe that it is authorized to adopt the rule,” pointing to Section 103(a), which directs the board to, “by rule, establish . . . such ethics standards … as required by this Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors.”

Nevertheless, after considering the comments, the PCAOB decided to modify the scope of Rule 3502 “to apply only when an associated person causes the registered firm’s violation due to an act or omission the person ‘knew, or was reckless in not knowing, would directly and substantially contribute to such violation.’”

The board first decided to change the state-of-mind requirements in the rule.

“While the Board believes it has the authority to adopt a negligence standard, the Board believes the revised standard strikes the right balance in the context of this rule,” the SEC stated in the release. “The Board believes that the phrase “knew, or was reckless in not knowing” is a well-understood legal concept, and the Board intends for the phrase to be given its normal meaning.”

Second, the PCAOB decided to change the phrase used to describe the connection between the associated person’s conduct and the violation.

Rule 3502 provides that the associated person’s act or omission must “directly and substantially contribute to [the firm’s] violation.”

“A number of commenters expressed concern that adoption of a negligence standard would allow the Board, or the SEC, to proceed against associated persons who in good faith, albeit negligently, have caused a registered firm to violate applicable laws or standards,” the SEC stated about the comment letters.

Thus, unfortunately, “in bending to the request from the profession, the PCAOB at the time dropped the negligence standard from the final Rule,” said Turner, who was the SEC’s top accountant from July 1998 to August 2001 and knows the entire history of Sarbanes-Oxley and the PCAOB’s work. “But this was nonsensical as SOX specifically provides for fines and penalties for repeated instances of negligent acts.”

He is currently a member of the PCAOB’s two advisory groups.

“When in 1998, the SEC adopted a revised SEC Rule 102(e) regarding unprofessional conduct by auditors, it also incorporated a standard for repeated acts of negligence,” Turner explained.

Rule 102 describes the rules related to the appearance and practice before the commission. And Rule 102(e) is related to suspension and disbarment.

“And at that time, some of the largest international audit firms wrote letters of support for the standard established by the SEC, and subsequently accepted by the federal courts,” Turner said.

At the time, SEC Commissioner Harvey Goldschmid and Turner were both involved in writing the commission rule and the first draft of what became Sarbanes-Oxley on this matter.

“It appears the PCAOB is now proposing to make some sort of revision to this rule, whatever it may be,” Turner said. “Hopefully they will propose and adopt a rule that is consistent with both the SEC rule and SOX, as they proposed back with their original rule proposal.”


This article originally appeared in the September 15, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.

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