REG. D UPDATE—The “Bad Actor” Rule

By Marc A. Leaf

Each year, thousands of businesses and investment funds raise billions of dollars in capital through unregistered offerings under Rule 506—the most widely used exemption under Regulation D under the Securities Act of 1933, as amended. With a median offering size of $1.5 million, most Regulation D offerings are relatively small, but the aggregate amount of capital raised in these offerings rivals the registered public offering market.

Last year, as mandated by the Dodd-Frank Act, the SEC amended Rule 506 to prohibit issuers from relying on that exemption if the issuer or another covered person has been convicted of, or is subject to judicial or regulatory sanctions for, certain violations of law. This amendment, known as the “Bad Actor” rule, became effective September 23, 2013.  A year following the effective date, a few key practice points can be gleaned from our experience.

Overview of the Bad Actor Rule

The “Bad Actor” rule is codified as new paragraphs (d) and (e) to Rule 506.  Rule 506(d)(1) provides that the exemptions in Rule 506(b) and Rule 506(c) are not available if a covered person has had a disqualifying event. For this purpose, “covered persons” include, in addition to the issuer, any of the following:

  • Directors, general partners, and managing members of the issuer;
  • Executive officers of the issuer, and other officers participating in the offering;
  • 20 percent beneficial owners of the issuer;
  • Promoters;
  • Investment managers and principals of pooled investment funds; and
  • Any person compensated for soliciting investors (as well as the general partners, directors, officers, and managing members of any compensated solicitor).

Events that trigger disqualification under the rule include:

  • Criminal convictions relating to securities transactions, false filings with the SEC, or certain securities-related businesses;
  • Court injunctions and restraining orders relating to securities transactions, false SEC filings, securities-related business activities, or obtaining money or property through the mail by means of false representations;
  • Final orders of certain financial regulators that bar the covered person from associating with a regulated entity or engaging in certain financial business activities, or that are based on a violation of antifraud rules, or any postal service false representation order;
  • SEC orders revoking the registration of a regulated person, limiting the activities of such a person, or imposing industry, collateral or penny stock bars;
  • SEC cease-and-desist orders with respect to the scienter-based antifraud rules or violations of Section 5;
  • Suspension or expulsion from a self-regulatory organization; and
  • In the case of any registrant, issuer or underwriter named in any registration statement or Regulation A offering statement filed with the SEC, the issuance of a suspension or stop order with respect to such registration statement or offering statement, or any ongoing investigation relating to the same.

The look-back period is five years, except in the case of criminal convictions (for persons other than the issuer, its predecessors, and affiliated issuers) and certain regulatory orders based on antifraud violations, for which the look-back is ten years, and for certain SEC or SRO suspensions, revocations, bars, expulsions, and related orders, which result in disqualification so long as they remain in effect. If a covered person ceases to be subject to an order, judgment or decree that would other result in disqualification—for instance, if the order is vacated or dissolved—no disqualification will result.

These disqualification provisions only apply to events that occur on or after the rule’s September 23, 2013, effective date. However, under new Rule 506(e), any disqualifying event occurring prior to September 23, 2013, must be disclosed by the issuer to each purchaser in a Rule 506 transaction if that event would otherwise have resulted in disqualification pursuant to Rule 506(d)(1).

An issuer may seek a waiver of Rule 506(d)(1) from the SEC upon a showing of good cause that the disqualification is not necessary under the circumstances. Authority to grant such waivers has been delegated to the SEC’s Division of Corporation Finance. The SEC also retains authority to grant waivers under Rule 506(d), and has recently exercised that authority in connection with several settled SEC enforcement proceedings, as well as a criminal proceeding settled by the U.S. Department of Justice. Waiver requests should be submitted to, and will be evaluated by, Staff in the Division’s Office of Small Business Policy. 

In addition, any court or regulatory authority that enters an order, judgment or decree that would otherwise trigger disqualification may itself exempt such action from Rule 506(d)(1) at any time prior to the relevant sale under Rule 506. 

Neither the disqualification provisions of Rule 506(d)(1) nor the disclosure requirements of Rule 506(e) apply if the issuer can establish that it did not know, and in the exercise of reasonable care, could not have known, of the facts giving rise to such disqualification or disclosure obligation.

Key Practice Points

The provisions of Rule 506(d) are in many respects comparable to existing disqualification provisions in Rule 262 (Regulation A) and Rule 505 (an exemption under Section 3(b) of the Securities Act for certain offers and sales not exceeding $5,000,000)—although the universe of covered persons in Rule 506(d) is different from the earlier disqualification rules, and new state and federal regulatory orders have been added to the list of disqualifying events. However, Regulation A and Rule 505 are used relatively rarely compared to Rule 506, so the experiences of practitioners under those prior disqualification provisions may not be wholly relevant to understanding the impact of Rules 506(d) and 506(e). Given both the greater frequency and larger size of Rule 506 offerings, it is not surprising that Rule 506(d) has already had a substantial impact on securities practice with respect to unregistered offerings.

Here are three key takeaways from the first year of implementing the Bad Actor rule:

1.  Factual Inquiry. Given the breadth of potential disqualification triggers under Rule 506(d)(1), a key provision of the rule for both issuers and investors is Rule 506(d)(2)(iv), which erases the disqualifying effect of an event if the issuer can establish that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed. Similar language excuses a failure to furnish, on a timely basis, information about an otherwise disqualifying event that occurred prior to the effective date of the rule. Both provisions are subject to the condition that the issuer has made a “factual inquiry” into whether any disqualifications exist. 

The SEC has provided only limited guidance on the scope of inquiry required for an issuer to benefit from this “reasonable care” exception, rejecting a one-size-fits-all approach in light of the wide variety of Regulation D offerings and participants. Rather, the issuer’s objective should be to gather information that is complete and accurate as of the time of the relevant transactions, without imposing an unreasonable burden—either on itself or other participants.  The steps required to meet this standard will vary based on the facts and circumstances concerning the issuer, other offering participants, and other factors. Practitioners should note that the requirement of a “factual inquiry” can also be found in the NASAA-approved Model Accredited Investor Exemption (MAIE), which has been adopted in some form by a majority of the states. The MAIE also requires the issuer to conduct a “factual inquiry” before asserting a reasonable care exception, but does not specifically identify the steps required. 

To meet the requirements of the Bad Actor rule, the Rule 506 offering process has developed to require factual inquiry regarding the existence of any potential disqualification under the rule. This inquiry now customarily includes questionnaires or certifications, in many cases accompanied by contractual representations, covenants, and undertakings. In some cases, issuers have also enhanced or introduced background checks or other procedures in connection with their hiring processes to confirm that executive officers and other officers who participate in offerings are free of disqualifying events. Investors may also require specific representations and warranties from the issuer in purchase agreements to confirm that the issuer has appropriate procedures in place to satisfy its reasonable care obligations.


  • Issuers in continuous or long-lived offerings, including pooled-investment vehicles, need to update their inquiry process on a periodic basis—but covered persons no longer relevant to the offering, such as former officers, directors and beneficial owners, and paid solicitors who have ceased their involvement in the transaction, do not need to be included in subsequent inquiries.
  • Rule 508 of Regulation D provides that a failure to comply with a term, condition or requirement of Rule 506 or another Regulation D exemption will not result in the loss of the exemption if an issuer can demonstrate, among other things, that the failure was insignificant with respect to the offering as a whole and that a good faith and reasonable attempt was made to comply with all of the applicable terms of the exemption sought. However, the SEC has indicated that Rule 508 would not cover circumstances in which an offering was disqualified based on Rule 506(d), or excuse a failure to provide the disclosure required by Rule 506(e). 

2.  Waivers. The SEC’s Division of Corporation Finance has granted a waiver of disqualification five times since the effective date of the Bad Actor rule. Four additional waivers were granted directly by the Commission.[1] In eight out of nine cases, the entity requesting relief was an affiliate of a regulated entity in the securities industry. Waivers granted under the Bad Actor rule are posted on the Division’s website, together with the formal waiver request. Reviewing these letters can highlight what the Staff is looking for when it evaluates such requests:

  • None of the violations for which a waiver was granted relate directly to the offer or sale of securities by the applicant. Several applicants noted that the violations were not scienter-based.
  • Seven of the applicants represented that the conduct giving rise to the disqualifying event was not pervasive in the applicant’s organization. A number of applicants also pointed to the passage of time since the relevant conduct.
  • Seven of the applicants represented that since the conduct giving rise to the disqualifying event, the applicant had removed wrong-doers, instituted procedures and/or taken other steps to improve compliance and prevent the recurrence of such conduct.
  • Eight of the applicants claimed that third parties would be adversely affected by the applicant’s disqualification.
  • Two applicants pointed to the cooperation demonstrated by the applicant in connection with the Staff’s investigation relating to the disqualifying event.
  • Two applicants claimed that, in light of the other sanctions or remedies imposed upon the applicant in connection with the disqualifying event, permitting such disqualification to stand would be unduly or disproportionately harsh.

Importantly, each of the applicants represented that, for a period of five years from the date of the disqualifying judgment, order or decree, it would furnish or cause to be furnished to each purchaser in any offering under Rule 506 otherwise subject to disqualification, a description of the judgment, order or decree, a reasonable time prior to sale. We understand that it is currently staff policy to require such an undertaking as a condition to any waiver of disqualification under the Bad Actor rule.


  • The Bad Actor rule does not include any provision for waiver of the disclosure obligation under Rule 506(e), and the SEC Staff advises that such disclosure obligations are not waivable. This is consistent with the Staff’s position to require disclosure as a condition to any waiver of disqualification under Rule 506(d).
  • Practitioners should contact the SEC's Office of Small Business Policy in the Division of Corporation Finance prior to submitting any waiver requests. The Staff is happy to provide guidance on the waiver process and will usually review a draft form of request and provide feedback. However, the Staff cannot grant waiver requests with respect to any disqualification until the disqualifying event has occurred. Nevertheless, it is often possible to have the waiver become effective at the same time as the injunction or administrative order settling a matter is issued. To be best positioned for a timely waiver, issuers negotiating a settlement that could constitute a disqualifying event should contact the SEC’s Office of Small Business Policy as soon as practicable to discuss the process.

3.  Understanding the Form of Injunction. Disqualification under Rule 506(e) can be triggered by, among other things, any court order that restrains or enjoins a covered person from engaging in any conduct or practice in connection with the purchase or sale of any security. This category of disqualifying event includes the standard “obey-the-law” injunction sought by the SEC in both settled and non-settled actions in U.S. district court. 

Traditionally, the “obey-the-law” injunction is broadly written to cover both direct and indirect conduct. A standard form of injunction sought by the Commission and entered in many districts for violations of the Securities Exchange Act is as follows:

IT IS HEREBY ORDERED, ADJUDGED, AND DECREED that Defendants and Defendants’ agents, servants, employees, attorneys, and all persons in active concert or participation with them who receive actual notice of this Final Judgment by personal service or otherwise are permanently restrained and enjoined from violating, directly or indirectly, Section ___ of the Securities Exchange Act of 1934, and Rule ___ promulgated thereunder, by using any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, in connection with the purchase or sale of any security, to ….

By its terms, notice of the injunction may be given to, or served upon, various persons other than the named Defendants, who would then be “subject to” a court order that restrains them from engaging in a practice in connection with the purchase or sale of a security. Accordingly, participants in Regulation D offerings may wonder if this type of order may give rise to disqualification of an offering pursuant to Rule 506(d) if a covered person could be deemed to be an agent, servant, employee, attorney or other person in active concert or participation with the Defendant. If so, how could an issuer make the necessary factual inquiry with respect to such persons, to satisfy the reasonable care exception in Rule 506(d)(2)(iv), or Rule 506(e)?

However, these concerns are not necessary: the Commission interprets the disqualifying effects of injunctions and other court orders to apply only to the persons specifically named in the order. Consistent with prior SEC Staff practice in connection with Rules 262 and 505, other persons who are not specifically named but who come within the scope of an order (such as, for example, agents, attorneys and persons acting in concert with the named person) will not be treated as “subject to” the order for purposes of disqualification under Rule 506(d).


[1] The waivers granted by delegated authority were all issued between November 2013 and March 2014; the waivers granted by direct action of the Commission were all issued after April 2014.


Can Regulation A+ Deliver on JOBS Act Capital Efficiency Promises?

By Brian J. Lynch and Matthew F. Havey

The SEC has proposed rules to institute Title IV of the Jumpstart Our Business Startups Act (JOBS Act) and add an exemption from registration under Section 3(b) of the Securities Act of 1933, as amended.  These rules, commonly referred to as “Regulation A+,” were proposed on December 18, 2013 and can be found here.  The SEC may finalize the rules on Regulation A+ in the near term, but this likely will occur after a number of Dodd-Frank rulemaking initiatives are docketed.

Regulation A+ is designed to improve upon Regulation A.  Currently, Regulation A allows companies to sell up to $5 million of securities to investors over a rolling 12-month period.  The compliance costs of Regulation A are high, as companies must comply with state laws in each state where funds are sought.  Accordingly, offerings under Regulation A have been infrequent over a sustained period, as many companies have opted towards more user-friendly alternatives like Regulation D, which preempts state securities law and allows for multiple exemptions from registration, including Rule 506, which can be effected without regard to a maximum offering limit.  The high cost of compliance under Regulation A and the $5 million offering limit are often cited as deterrents to more frequent usage.  See, for instance, a report by the U.S. Government Accountability Office.

The proposed Regulation A+ would create two different tiers.  Much like the current Regulation A, Tier 1 would allow companies to sell up to $5 million of securities to accredited and unaccredited investors over a rolling 12-month period, including up to $1.5 million on behalf of selling security-holders.  Tier 2 would allow companies to sell up to $50 million of securities to accredited and unaccredited investors over a rolling 12-month period, including up to $15 million on behalf of selling security-holders.  Companies could choose whether to proceed under either Tier, but Tier 2’s higher proceeds limit comes with a cost to individual investors, as the Tier 2 rules would prohibit purchases of securities worth more than 10% of the greater of an investor’s annual income and net worth.  This individual investment limit is based upon existing standards of income and net worth for “accredited investors.”   Regulation A+ would also allow companies to “test the waters” of the general public before making an offering – that is, before or after filing an offering statement, companies could communicate with potential investors to assess their interest in an offering.  

While Regulation A+ may represent a practical response to the market’s qualms with existing Regulation A, one key issue is under hot debate: the proposed preemption of state qualification and registration requirements for Tier 2 offerings.  Federal preemption, as currently proposed, would allow offerings of any amount up to $50 million to forego state securities laws.  The North American Securities Administrators Association and several Congressional leaders have opposed the preemption on legal grounds, claiming that the preemption conflicts with the JOBS Act.  Several U.S. Senators submitted a comment letter to this effect in August 2014.  The JOBS Act gives the SEC authority to provide exemptions from state Blue Sky laws when securities are sold on a national exchange or to qualified purchasers.  Opponents of the preemption claim that Regulation A+ ignores the requirement that potential purchasers be qualified, but proponents claim that preemption is valid under the JOBS Act as it defines “qualified purchasers” to be “all purchasers in a Tier 2 offering.” 

Proponents of the currently proposed Regulation A+ will largely look to the popularity of Regulation D and the infrequent utilization of Regulation A as proof that federal preemption is necessary for Regulation A+ to provide capital raising benefits. Proponents, including many in the investment community, advocate the benefits to individual businesses and the overall economy of easier access to capital and greater liquidity through Regulation A+.  Opponents of the currently proposed Regulation A+, including certain regulators, will point to the need for investor protection and the risks arising from this emerging market.  If included in the final rule, the preemption would certainly lighten the compliance burden believed to have discouraged many from offering under Regulation A.  The challenge facing the SEC will be assuring more risk-averse parties (including certain members of Congress) that the other investor protections of Regulation A+ are robust enough to justify federal preemption.

The premise of Regulation A+ is operably strong – midsize companies thirsting for capital could complete a “mini-IPO” and access up to $50 million without the more extensive costs and regulatory requirements associated with a full S-1 IPO under the current system.  Post-offering reporting obligations and costs would be reduced under Regulation A+, as compared to current reporting rules.  Ongoing reporting will enable (1) Regulation A+ investors to achieve immediate resale liquidity after an offering and (2) ongoing secondary trading by market participants.  If the final rules preempt state law, Regulation A+ should garner popular usage and alter the landscape of small and mid-market securities offerings.  If the final rules do not provide for preemption, Regulation A+ will “jumpstart” little and in time will join Regulation A on the shelf as a dusty, red-tape bookend.


SEC’s “Gatekeeper” Enforcement Initiative Impacts Directors

By Stephen G. Stroup

Senior SEC officials have become increasingly vocal in recent months about the roles and responsibilities of corporate “gatekeepers” and the need to impose stronger penalties on those who fail to satisfy their professional obligations.  One notable example came from SEC Commissioner Luis A. Aguilar, who issued a rare dissenting opinion in In the Matter of Lynn R. Blodgett and Kevin R. Kyser, CPA, File No. 3-16045 (Aug. 28, 2014).  Blodgett involved a former chief financial officer charged in a public company’s failure to comply with its financial reporting, record-keeping, and internal control obligations.  Commissioner Aguilar took particular exception to the SEC’s willingness to resolve what he termed to be “egregious conduct” by the CFO without the institution of fraud charges.  He also characterized the more than $200,000 in penalties and disgorgement levied upon the CFO to be “a wrist slap at best.”  As Commissioner Aguilar commented in his dissent:

Accountants – especially CPAs – serve as gatekeepers in our securities markets.  They play an important role in maintaining investor confidence and fostering fair and efficient markets.  When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust.  To this end, when these accountants engage in fraudulent misconduct, the Commission must be willing to charge fraud and must not hesitate to suspend the accountant from appearing or practicing before the Commission.

While Commissioner Aguilar’s remarks in Blodgett concentrated on accountants, his general reference to corporate gatekeepers was especially noteworthy, since it dovetailed neatly with the SEC’s latest enforcement priorities.  Last year, the SEC’s Enforcement Division instituted what it internally labeled “Operation Broken Gate.”   This enforcement initiative targets corporate gatekeepers who fail to comply with their professional responsibilities and place investors at risk of undetected fraud or material misstatements in financial statements and corporate disclosures.

“Operation Broken Gate” roughly coincided with the arrival of SEC Chair Mary Jo White, whose brief tenure has featured a notable increase in sanctions imposed against both companies and individuals.  During a speech at Stanford University in June, Chairwoman White discussed the importance that the SEC places on “gatekeepers” in a presentation titled “A Few Things Directors Should Know about the SEC.”   She advised that while “the term ‘gatekeeper’ [refers] to auditors, lawyers and others who have professional obligations to spot and prevent potential misconduct,” corporate directors are “the essential gatekeepers upon whom [the] investors and, frankly, the SEC rely.”  Chairwoman White proceeded to spotlight two enforcement proceedings this year SEC v. AgFeed Industries, Inc. and In the Matter of L&L Energy, Inc. – in which the SEC brought charges against directors (and, in particular, audit committee chairpersons) for their “disturbing” failure to prevent corporate fraud and the issuance of false public filings at their respective companies.

Chairwoman White’s presentation served as far more than just a series of cautionary tales from the regulatory frontlines.  Far more significantly, it also provided a pragmatic blueprint for “conscientious, diligent director[s]” to avoid the prospect of personal liability through the adoption of essential corporate governance measures designed to detect and prevent potential violations. These measures collectively provide an invaluable perspective on the SEC’s likely approach when assessing director performance in connection with future charging enforcement decisions. They included:

  • Setting a proper “tone at the top”: Directors need to establish expectations for senior management and their companies, and exercise appropriate oversight to ensure that those expectations are being satisfied.  Selecting CEOs who understand and embrace corporate governance should be one of their highest priorities.
  • Understanding the company’s business: Directors should be asking senior management the hard questions and listening to what is being said – and not said.  Gaining an astute appreciation for their company’s business model and the associated risks allows directors to identify and promptly address potential “red flags.”
  • Instituting strong compliance programs: Directors should ensure that ethics and honesty are viewed as fundamental corporate values through the adoption of robust corporate compliance programs, which include regular employee training and accessible codes of conduct that place no employees “above the law.”
  • Implementing a responsive internal whistleblower program: Directors need to foster a corporate culture that encourages, empowers and potentially rewards employees who report instances of possible wrongdoing – and support an environment in which whistleblower complaints are taken seriously and addressed appropriately.  
  • Evaluating the need to self-report potential violations: When wrongdoing has been uncovered, directors need to reach an informed decision whether a violation warrants disclosure to the company’s regulators, mindful that self-reporting, cooperation and remediation may lessen the scope of investigations and the severity of sanctions.

Many of these measures that Chairwoman White identified may seem familiar to those who have grappled with Sarbanes-Oxley compliance in the past.  Nevertheless, there is every reason to believe that they will take on added significance in the SEC’s evolving enforcement landscape.  SEC Director of Enforcement Andrew Ceresney announced recently that “financial reporting cases for 2014 so far have surpassed last year’s total number of cases by 21 percent,” which reverses a substantial downward trend in such enforcement proceedings that originated during the early stages of the economic crisis.  With the economy now slowly improving and financial reporting cases poised to regain their regulatory prominence, it is prudent for directors to revisit and, if necessary, begin the process of strengthening the oversight measures at their public companies.

SEC’s Broken Window Enforcement Program Gets a Boost from “Quantitative Analytics” and “Algorithms”

By Mary P. Hansen, William L. Carr and Matthew A. Luber

The SEC recently announced that it had charged, in settled administrative proceedings, 28 individuals and investment firms that failed to “promptly report information about their holdings and transactions in company stock” and six public companies that contributed to “filing failures by insiders or fail[ed] to report their insiders’ filing delinquencies.”  The SEC obtained a total of $2.6 million in civil monetary penalties as a result of the filed charges. The individual amounts ranged from $25,000 to $150,000. These cases are the latest example of the SEC’s focus on strict liability violations of the federal securities laws.

All of the charges arise under Sections 13(d), 13(g), and 16(a) of the Securities Exchange Act of 1934, as amended. These sections require certain forms to be filed, irrespective of profits or the reasons for engaging in the stock transaction “to give investors an idea of the purchases and sales by insiders[,] which may in turn indicate their private opinion as to prospects of the company.”  Specifically:

  • Form 3.  Pursuant to Section 16(a) and Rule 16a-3, company officers, directors, and certain beneficial owners of more than 10% of a registered class of a company’s stock (“insiders”) are required to file initial statements of holdings on Form 3. Specifically, within 10 days after becoming an insider, the insider must file a Form 3 report disclosing his or her beneficial ownership of all securities of the issuer.
  • Form 4.  To keep information disclosed on Form 3 current, insiders must file Form 4 reports disclosing purchases and sales of securities, exercises and conversions of derivative securities, and grants or awards of securities from the issuer within two business days following the execution date of the transaction.
  • Form 5.  Insiders are required to file annual statements on Form 5 within 45 days after the issuer’s fiscal year-end to report any transactions or holdings that should have been, but were not, reported on Form 3 or 4 during the issuer’s most recent fiscal year and any transactions eligible for deferred reporting (unless the corporate insider has previously reported all such transactions).
  • Schedule 13D.  Beneficial owners of more than 5% of a registered class of a company’s stock must use Schedule 13D and Schedule 13G to report holdings or intentions with respect to the respective company. The duty to file is not dependent on any intention by the stockholder to gain control of the company, but on a mechanical 5% ownership test. A Schedule 13D must be filed within ten days of the transaction, and a Schedule 13G must be filed within 10 to 45 days of the transaction, depending on the category of filer and the percentage of acquired ownership. Importantly, Section 16(a) also requires an investment adviser to file required reports of behalf of funds that it manages when the fund’s ownership or transactions in securities exceed the statutory thresholds.
  • S-K Item 405 Disclosure. Public companies are required to disclose in their annual meeting proxy statements or in their annual reports, “known” Section 16 reporting delinquencies by its insiders. This disclosure is commonly referred to as the "Item 405 disclosure." The Item 405 disclosure of any late filings or known failures to file must (i) identify by name each insider who failed to file Forms 3, 4, or 5 on a timely basis during the most recent fiscal year or prior fiscal years and (ii) set forth the number of late reports, the number of late-reported transactions, and any known failure to file. An issuer does not have an obligation under Item 405 to research or make inquiry regarding delinquent Section 16(a) filings beyond the review specified in the item.

Moreover, although insiders remain responsible for the timeliness and accuracy of their required Section 16(a) reports, the SEC has encouraged companies to assist their officers and directors in submitting their filings, or even submitting the required form on the insider's behalf to ensure accurate and timely filing. The SEC’s recent action makes clear, however, that reliance on the company does not excuse violations as the insider retains ultimate responsibility for the filings. The majority of the charged individuals told the SEC that their delinquent filings resulted from the failure of the company to make timely filings on their behalf. In one case, disclosures in the company’s annual proxy statements relating to Section 16(a) compliance revealed that the filing of the insider reports was late because of “lack of staffing,” “late receipt of necessary information,” and “a change in the processing of these forms and delays caused by an email server malfunction.” The SEC still charged the insider because the insider took “ineffective steps to monitor whether timely and accurate filings were made” on his or her behalf by the company.

Finally, without providing any details, the SEC claimed that it used “quantitative analytics” and algorithms to identify individuals and companies with especially high rates of filing deficiencies. The SEC’s filing of these actions underscores its willingness to devote resources to pursuing strict liability violations, while demonstrating the SEC’s efforts to use quantitative analysis and algorithms to identify violations and to streamline the investigative process.  It also serves as a stark reminder of the importance of a strong compliance program and continued diligence, by both companies and insiders, with respect to these Section 13 and 16 insider filings.


Selected Auditing Developments

By Elizabeth A. Diffley

PCAOB Addresses Related Party Transactions and Unusual Transactions

The Public Company Accounting Oversight Board (PCAOB) has adopted Auditing Standard No. 18, Related Parties (AS 18), addressing related party transactions, as well as related amendments addressing significant unusual transactions and transactions with executive officers.  The new standard and amendments will be effective, subject to SEC approval, for audits of financial statements for fiscal years beginning on or after December 15, 2014.

The changes are designed to strengthen auditor performance requirements in areas posing an increased risk of material misstatements in financial statements and contributing to prominent financial frauds.  In his statements in connection with the adoption, PCAOB member Lewis H. Ferguson noted that “our inspections have revealed that, where related party or significant unusual transactions are involved, auditors need to adopt a particularly inquisitive and professionally skeptical mindset.  [These] standards and amendments ... help ensure that these expectations are understood, not just by the auditor, but also by management and audit committees.”

Where existing standards provide only guidance and suggested procedures for evaluating related parties and related party transactions, AS 18 prescribes specific procedures that auditors will be required to perform.  AS 18 will require auditors to:

  • Obtain an understanding of the company’s relationships and transactions with related parties, including understanding the nature of the relationships and the terms and business purposes (or lack thereof) of transactions;
  • Evaluate whether the company has properly identified its related parties and relationships and transactions with related parties; 
  • Perform specific procedures if the auditor determines that a relationship or transaction with a related party previously undisclosed to the auditor exists;
  • Perform specific procedures regarding each related party transaction that is either required to be disclosed or determined to be a significant risk; and
  • Communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties and other significant matters arising from the audit regarding the company’s relationships and transactions with related parties.

Additionally, during its risk assessment process, the auditor must inquire of the audit committee or its chair about the audit committee’s understanding of the company’s significant relationships and transactions with related parties, as well as whether any member of the audit committee has any concerns about relationships or transactions with related parties.  

Significant unusual transactions are generally those outside the normal course of business or otherwise unusual given the auditor’s understanding of the company and its environment.  Amendments adopted concurrently with AS 18 prescribe specific audit procedures intended to improve the auditor’s identification and evaluation of significant unusual transactions, and add factors for the auditor to consider in evaluating whether they may have been transacted to engage in fraudulent financial reporting or misappropriation of assets.  The PCAOB also adopted amendments prescribing procedures the auditor must perform to obtain an understanding of the company’s financial relationships and transactions with executive officers.  Though auditors will not be called upon to assess the appropriateness or reasonableness of executive compensation, it is notable that the auditor will be required to conduct inquiries of the compensation committee chair and any compensation consultants regarding the structuring of executive officer compensation arrangements.

Though the new standard and amendments are applicable to auditors, not the companies they audit, and the PCAOB has indicated that the largest auditing firms already perform many of the newly required procedures, companies are still likely to find the enhanced and expanded requirements to have a noticeable impact on the conduct of their audits.  In particular, as a result of the increased focus on the auditor’s understanding of the business purpose underlying transactions, auditors may request more, and spend more time reviewing, underlying transaction documents.  They may also spend more time discussing these topics with management and board members.  Company management teams and audit engagement leaders should discuss the impact of these changes during the audit planning phase, as they will have to make arrangements to address the auditor’s expanded inquiry and communication requirements with respect to the compensation committee, compensation consultants and audit committee.  The increased attention to related party and significant transactions also identifies the importance of involving auditors early when entering these transactions.

This development also underscores the importance of maintaining appropriate related party transaction policies and complying with them.  Companies should consider revisiting their policies to determine if revisions are merited and to confirm they are following appropriate recordkeeping and other procedures. 

Auditor’s Reporting Model

As discussed in our September 2013 update, the PCAOB has proposed two new auditing standards that would expand the content of audit reports.  Key among the changes would be a requirement to include a discussion of critical audit matters, as well as expand the auditor’s responsibility regarding information outside the financial statements.  In connection with the auditor reporting model proposal, the Center for Audit Quality (CAQ) has released a report of its key findings from a collaborative effort by members of the public company auditing profession to field test certain aspects of the auditor’s reporting model proposals.  The CAQ’s report identified certain implementation challenges and recommended that the PCAOB consider suggestions to mitigate them, such as including materiality as a factor to be considered in determining what constitutes a critical audit matter, and clarifying how an auditor would effectively communicate those factors that were most important to the determination that a matter was a critical audit matter.

The PCAOB’s Standard-Setting Agenda indicates that it is analyzing the comments received on the proposal and, during the second half of 2014, drafting a reproposal for the board’s consideration.  Given that the PCAOB intends to issue a reproposal, which will be subject to another round of public comment, it appears that the changes from the original proposal may be substantial.

Source: September Update