Norman B. Arnoff
Norman B. Arnoff (NYLJ/Rick Kopstein)

Andrew Ceresney, the Securities and Exchange Commission’s co-enforcement director, in an address Sept. 19, 2013, declared “[t]he importance of pursuing financial fraud cannot be overstated” and “comprehensive, accurate and reliable financial reporting is the bedrock upon which our markets are based because false financial information saps investor confidence and erodes the integrity of the markets.” Material misstatements and omissions in financial reporting, however, are not exclusively caused by fraud. The accounting profession, like any other profession serving in the capital markets, must be held to the highest professional standards and therefore focus has to be given to serious professional malpractice in the regulatory context. This should be the case, even where the professional lacks bad intent.

A review of the SEC’s recent rule 102(e) proceedings should demonstrate whether the commission is proceeding against accountants not merely for fraud but serious professional malpractice and thereby strengthening investor protection. “Comprehensive, accurate, and reliable financial reporting” as one of the bedrocks of our markets will only be established and maintained when professional standards of competency are emphasized and enforced to the same extent as ethics.

SEC Rule 102(e)

Before an analysis is made of the recent cases to see what categories they predominantly fall in, it is essential to review the text of SEC Rule 102(e)1 to see if the scope of the rule is intended to protect the public investor from the accountant’s serious professional malpractice. In essence the commission can suspend or permanently bar an accountant from practicing before the commission (which includes assisting in or causing filings and reports made); (1) if the accountant “[d]oes not possess the requisite qualifications to represent others;” (2) “[i]s lacking in character or integrity or has engaged in unethical or improper professional conduct;” and/or (3) [w]illfully violated or willfully aided and abetted the violation of any of the federal securities laws, rules, or regulations.” Clearly the first factor above implicates professional malpractice in the regulatory context..

In the 1998 amendment to Rule 102(e) the commission clarified the Rule’s scope as follows:

Rule 102(e) proceedings may also be based on… ‘highly unreasonable conduct’ that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that ‘heightened scrutiny’ is warranted. This … covers a single instance of serious misconduct that may not rise to the level of intentional or knowing (including reckless) conduct. [T]his provision applies only to deviations from professional standards greater than ordinary negligence but less than recklessness—when one knows or should know of a heightened risk. The final rule refers to this situation as “heightened scrutiny….

The [Rule]…is intended to reach violations of applicable professional standards that demonstrate that an accountant lacks competence to practice before the Commission. An accountant who acts intentionally or knowingly, including recklessly, or highly unreasonably when heightened scrutiny is warranted, conclusively demonstrates a lack of competence to practice before the Commission. By contrast, when the Commission brings a Rule 102(e) proceeding for repeated instances of unreasonable conduct, it will also have to find that the conduct indicates a lack of competence.” (Emphasis added).

The policy behind this segment of the Rule was explained by the Commission as follows:

Accurate financial reporting is the bedrock of our capital markets. Accountants play a vital role in assuring issuer compliance with the reporting requirements. The Commission wishes to underscore the importance of that role and the need for accountants to comply with the standards of conduct applicable to members of their profession. The professional standards include the overarching requirement that auditors exercise due care in their audit of a company’s financial statements. The Commission possesses broad authority, both under the federal securities laws and its own rules to promote and enforce compliance with professional standards.

There is no doubt that the rule extends coverage to professional malpractice, albeit of the most serious nature. The rule’s plain language states in the pertinent part: “Either of the following two types of negligent conduct” are within the rule’s scope:

(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which the accountant knows, or should know that heightened scrutiny is warranted.

(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards that indicate a lack of competence to practice before the commission.” (Emphasis added).

In reference to “applicable professional standards” the release states that the term “primarily refers to GAAP, GAAS, the AICPA Code of Professional Conduct, and the Commission regulations.” The term also includes “generally accepted standards routinely used by accountants in the preparation of statements, opinions, or other papers filed with the Commission.”

The Cases

The key questions are: whether the commission in the administrative disciplinary proceedings brought against accountants sufficiently articulate and apply professional standards; and is there a commitment to focus on professional competency standards to establish and maintain those standards adequate to protect investors? There are a number of categories of cases with varying themes including audit failure, misleading financial reporting produced by varying causes; obstruction and interference with SEC processes; and violation of regulatory requirements that the commission has recently brought.

The cases brought by the SEC under Rule 102(e) in the last few years have increased significantly and do significantly focus on serious professional malpractice. It is the intent of this article and the articles to follow, to make sense out of the recent cases and determine whether and how the SEC is utilizing SEC Rule 102(e) to protect the integrity of its processes and most significantly to strengthen investor protection.

In re Marrie and Berry2 was a proceeding in which the Administrative Law Judge (ALJ) initially found two accountants had not engaged in improper professional conduct within the meaning of Rule 102(e) because their conduct did not meet the recklessness standard codified in Rule 102(e). One of them was the audit manager “primarily responsible for the supervision of the audit work” including “the planning of the audit and interactions between the audit team and…[the issuer's] management” and the other was the engagement partner. The commission reversed the ALJ.

The audit failure consisted in write-offs of accounts receivable not correctly reported, improper confirmation of accounts receivable, and improper recognition of revenue based upon the amount of sales and returns. The commission found the conduct to be reckless, defining recklessness as follows:

…We … [have] adopted the definition used in Rule 102(e) ‘for the purposes of consistency under the federal securities laws’ … to highlight that reckless conduct is not merely a heightened form of ordinary negligence, but rather a lesser form of intent. In adopting this definition, however, we specifically noted that the standards of professional conduct are not fraud based.

The definition of reckless conduct establishes the mental state that must be shown with respect to conduct that results in a violation of applicable professional standards. The question is not whether an accountant recklessly intended to and…[did aid] in the fraud committed by the audit client, but rather whether the accountant recklessly violated applicable professional standards. Recklessness, then can be established by showing of an extreme departure from the standard of ordinary care for auditors.

The Commission and the investing public rely heavily on accountants to assure disclosure of accurate and reliable financial information as required by the federal securities laws. Adherence to applicable professional auditing standards protects the Commission’s processes, regardless of whether a fraud has been committed because it ensures that certified financial statements of public companies have been audited appropriately. Requiring proof of a mental state approaching an actual intent to aid in the fraud, committed by the audited company would conflict with this purpose and fail to protect the Commission’s processes from accountants who lack competence to appear before it.

While the above defines a species of professional malpractice it does not equate with the typical contract-tort definition of malpractice that merely requires ordinary negligence that proximately causes cognizable harm to the client and those intended to be benefited by the accountant-auditor’s services. In the regulatory context greater emphasis is and should be placed upon a serious lack of adherence to professional standards. The commission in its opinion declared:

Auditors are required by professional standards to comply with GAAS when conducting an audit. An auditor who fails to audit properly under GAAS should not be shielded because the audited financial statements fortuitously are not materially misleading. An auditor who skips procedures designed to test a company’s report or looks the other way despite suspicions is a threat to the Commission’s processes. Even if an auditor’s professional conduct does not result in false financial statements, it damages the integrity of the Commission’s processes because filings with the Commission are unreliable if auditors certify that their audits were conducted in accordance with GAAS when in fact they were not. Accordingly a determination that…[respondents] engaged in improper professional conduct does not depend on finding that…[the issuer's audited financial statements…contained a material misstatement."

Loans, Controls, Competence

Thus, regulatory malpractice, if nothing else, is a serious breach of professional standards compromising a regulatory agency's processes and is squarely within the SEC's jurisdiction. Another case squarely within the category of regulatory malpractice in the audit failure context is In re James Vincent Poti, CPA.3 This was a public administrative proceeding where respondent made an Offer of Settlement that the commission accepted. Respondent was the engagement partner. The audit was of a bank and bank holding company. Respondent failed to subject the loan loss estimates to audit. As the engagement partner, respondent had responsibility to make the ultimate audit decisions, audit the programs, review audit work papers and follow the Public Company Accounting Oversight Board's (PCAOB) audit standards.

The bank experienced a dramatic increase in real estate loan losses that the accountant had to know. Notwithstanding that current valuations of collateral were to show the security of the loans, they, as well as the relevant information on the guarantors of the loans, were absent. Respondent was well aware of the foregoing, and that was evidenced by the audit team's conspicuous criticism of management and their communications with the board to update critical information. Thus there was a significant and known risk of the financials being materially misleading which was disregarded by the accountant.

The exposure was significantly material in dollar amount plus there was a current trend in "troubled real estate losses." The information gaps were critical. The SEC Order making findings and imposing remedial sanctions noted "[i]n commercial real estate a current appraisal provides persuasive evidence of current market conditions on the appraised value of the collateral.” Further, “a written appraisal was the only way to determine the fair value of collateral securing collateral dependent loans.” The bank, notwithstanding, lacked collateral for “a significant percentage of…{the} collateral-dependent…{and} impaired loans and that was not identified or reported by the auditors.”

Further “[c]urrent financial information for borrowers and guarantors…[were] also…critical for the condition of the loan.” This information was also missing, notwithstanding that the bank’s credit manual “highlighted the importance of guarantor financial information…[in] evaluating collectability.” The foregoing was ignored, and an unqualified opinion was given in regard to the financials. Audit risk too was clearly ignored. The findings and conclusions drawn on the operative facts by the commission highlighted the basic flaws of the audit and observed that professional standards if not complied with will inevitably lead to a finding of regulatory malpractice sufficient to warrant sanctions.

A series of other cases evidences the commission’s focus upon regulatory malpractice, i.e., a serious breach of professional standards that compromises the public interest because it threatens (if nothing else) the regulatory framework and its processes. Another case that implicated these issues was In re: John J. Aesoph CPA and Darren Bennett, CPA4 which addressed violation of PCAOB audit standards in respect to inadequate auditing of the internal controls applicable to financial reporting. The respondents “did not effectively address one of the most important and riskiest components of the bank’s loan loss calculations; management’s use of stale and inadequate appraisals to value the bank’s loan loss calculations…{and} management’s use of stale and inadequate appraisals to value the collateral underlying the bank’s FAS 114 loans.”

The order instituting the proceedings alleged the respondents “failed to adequately identify and evaluate defects in the design and operating effectiveness of controls over collateral valuation that would have been important to the auditors’ conclusion about whether … controls sufficiently addressed the assessed risk of misstatement.” Skepticism with heightened sensitivity to apparent risk is deemed an essential professional standard for the auditor to follow. In the context of the audit, “the auditors were required to be particularly attuned to management bias, intentional or not…[as] auditors normally should consider ‘the historical experience of the entity in making past estimates.’” Most critically “the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors, management used in making the estimates.” (Emphasis added).

Breach of professional standards in the audit and/or review context are the cases that best illustrate regulatory malpractice and will inevitably fit within Rule 102(e) if the malpractice occurs in relation to securities transactions and filings. In re:John Kinsoss-Kennedy5 involved a fact pattern where the auditor represented that he performed the work and services requisite for an audit but did not in fact perform them. Respondent did not: plan the audit properly; obtain sufficient competent audit evidence or confirm material transactions; obtain the necessary management representations; communicate with the prior auditors or the audit committee; cause disclosure in relation to third-party transactions; or comply with auditor rotation procedures to reasonably assure independence. All of the foregoing were basic audit procedures, and the conduct of the respondent constituted “negligent conduct, consisting of repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards” that indicated a lack of competence to practice before the Commission.”


A focus upon accounting fraud to strengthen investor protection is critical. However, it is limited and the scope of concern has to be broader if we are to give greater assurance to achieve maximum investor protection. SEC Rule 102(e) proceedings that are instituted based upon a reckless failure to comply with professional standards achieve the right balance. Regulatory malpractice that threatens the commission’s processes are clearly and should be the predominant concern to the SEC when it exercises its Rule 102(e) jurisdiction.

The standard of “a reckless failure to comply” is also fully consistent with the Dodd–Frank Wall Street Reform and Consumer Protection Act. The defining differences between good faith error, ordinary negligence, and a reckless failure to comply with professional standards as a matter of sound public policy also warrants that the standard be based not on ordinary negligence and not upon fraud but reckless failure to comply with professional standards in order to give more reasonable assurance for investor protection.

A professional malpractice basis rather than one based upon fraud for administrative disciplinary proceedings against accountants works better. It allows as well as mandates the setting of textually clear and fair standards for those who we expect to adhere to the highest professional standards of competency, ethics and honor which they must do if they are to practice before the commission, and at the same time recognizes the reality that there is on occasion good faith human error that in retrospect may cross the zone of discretion but should not be subject to sanction consistent with the remedial purposes of the federal securities laws.

Norman B. Arnoff practices with the Law Offices of Norman B. Arnoff and serves as a legal malpractice expert consultant and witness.


1. 17 CFR Part 101 SEC Release Nos. 33-7593; 34-40567 35-26929; 1A-1771, 1C-23489; File No. S7-16-98.

2. SEC Rel. No. 48246, Rel. No. 1823 Admin. Proc. File No. 3-9966 (July 29, 2003).

3. SEC Release No. 71117, Rel. 3519; Admin. Proc. (Dec. 18, 2013).

4. SEC Rel. 68605, Rel. No. 3436, Admin. Proc. File 3-15168 (January 9, 2013).

5. SEC Rel. 71154, Rel. 3520, Admin. Proc. 3-15536 (Dec. 20, 2013).