January 5, 2006

SEC Issues Statement on Financial Penalties

Yesterday, the SEC issued a statement on how the SEC intends to penalize companies with monetary fines going forward. This is a topic that generated much internal debate among the SEC’s Commissioners during Chairman Donaldson’s tenure.

During that time, Republican Commissioners Paul Atkins and Cynthia Glassman disagreed with their Democratic counterparts over whether such penalties deter wrongdoing and whether they unfairly punish shareholders who were
already harmed by the misconduct that led to the penalty. They argued that the SEC should focus on punishing the individuals who broke laws, since shareholders bear the burden of corporate penalties. According to news reports, the Commissioners met for over 40 hours to agree on these new guidelines.

As Chairman Cox noted in his remarks, the SEC’s new statement is intended to create objective standards to make enforcement penalties more predictable and consistent. Enforcement Director Linda Chatman Thomsen also gave some remarks.

The SEC used two cases to illustrate its approach – one resulting in a $50 million penalty and the other requiring the company only to hire an independent consultant to review the company’s financial accounting policy. The SEC slapped McAfee with a $50 million penalty for a nearly two-year fraud that pumped up revenue by $622 million. On the other hand, the SEC did not not lodge financial penalties against Applix because its conduct was confined to two discrete transactions that under-reported losses in 2001. The SEC moved against individual executives at both companies. More on this topic coming soon!

New 10-K and 10-Q Cover Pages Posted!

We have posted Word files of an updated 10-K cover page and a 10-Q cover page in the “Hot Topics Box” on home page. Lots of new checkboxes to add this time around…

Aiding and Abetting by Doing Nothing

Keith Bishop alerts us to an interesting California decision from November that addresses the issues of whether mere inaction can constitute aiding and abetting and the obligations of auditors to report up, Frame v. PricewaterhouseCoopers. The Frame opinion is another twist in the Grafton Partners saga – earlier this year, the California Supreme Court held that predispute jury trial waivers contained in the auditor’s engagement letter were unenforceable in Grafton Partners v. Superior Court, 36 Cal. 4th 944 (2005).

Below is some analysis from Keith: This case involves an appeal of the dismissal of claims against PwC for aiding and abetting fraud and conspiracy to commit fraud. The facts are rather complicated – but the argument on appeal was that PwC committed fraud by (1) returning documents reflecting the fraud; (2) destroying workpapers; (3) writing an internal e-mail that did not discuss the details of the fraud; (4) a PwC partner allegedly committing perjury in an SEC hearing; and (5) agreeing not to write and not writing an audit report that would have disclosed the fraud.

The Court of Appeal found that the first four items when viewed independently were insufficient to demonstrate a triable issue of material fact. However, the Court of Appeal found that when combined with the fifth item (absence of audit reports), a reasonable trier of fact could conclude that PwC provided substantial assistance to the fraud.

Note that this case deals with mere inaction (as opposed to omission in a communication) – the trial court had ruled that there was no evidence of an affirmative misrepresentation or misleading disclosure by PwC. On appeal, PwC argued that it had no duty to disclose. However, the Court of Appeal found that an independent duty is not required for aiding and abetting liability. PwC also contended that it had the option of not preparing an audit report under Generally Accepted Auditing Standards (GAAS) and its engagement letter (which expressly stated that PWC could decline to issue a report). The appellate court, however, found that neither GAAS nor the engagement letter prohibited disclosing the fraud to others.

The Court of Appeal found that the GAAS provisions were not necessarily controlling since they did not refer to limited partnerships. It also cited the inspection rights of limited partners under California law. In upholding the dismissal of the plaintiffs’ conspiracy claims against PwC, the Court of Appeal found that PwC had no independent legal to inform the limited partners.

This appears to be inconsistent with the Court’s statements with respect to aiding and abetting. However, the Court stated that in the context of aiding and abetting, the failure to disclose was relevant to the issue of whether PwC fulfilled its duty to its clients. This is not the same as whether PwC had and independent duty to the limited partners. Thus, the aiding and abetting claim survived dismissal while the conspiracy claim did not.

We have posted a copy of the opinion – as well as a correction of the original opinion – in our “Securities Litigation” Practice Area. And “Court of Appeal” is not a typo – for some reason, the California court likes it singular…