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SEC Central
The SEC's New Weapon: Section 10A

July 2002In 1995, with little fanfare, the SEC added a powerful new weapon to its enforcement arsenal, specifically directed at independent auditors ... Section 10A of the Securities Exchange Act of 1934, as amended. Although, to date, the SEC has only made limited use of Section 10A, the recent spate of false financial disclosures ensures more extensive use of this powerful new weapon.

Section 10A has three components:

(a) audit procedures;
(b) let the audit committee know; and
(c) let the SEC know.

The audit procedures component requires the independent auditor to utilize procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts, identify related party transactions that are material to the financial statements or otherwise require disclosure therein and an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year. The statute states that these audit procedures must be effectuated in accordance with generally accepted auditing standards, "as may be modified or supplemented from time to time by the Commission." This phrase, for the first time by statute, gives the SEC the authority to modify or supplement GAAS.

The "let the audit committee know" component of the statute requires the outside accounting firm to initially determine whether or not an illegal act has occurred and, if so, to determine the possible effect of that illegal act on the financial statements of the issuer, and, as soon as practicable, inform the appropriate level of the company's management to assure that the audit committee is adequately informed with respect to the illegal acts that have been detected, or have otherwise come to the attention of the outside auditor. The only exception is if the illegal act is clearly inconsequential.

The "let the SEC know" element requires the outside auditors to promptly notify the SEC that the company has not properly responded or to resign and include these facts in its resignation disclosures filed with the SEC.

There are a number of interesting legal issues that need to be resolved. Section 10A(f) defines "illegal act" as "an act or omission that violates any law, or any rule or regulation having the force of law." Although the legislative history indicates that this should be narrowly construed, the SEC has made it clear in the two enforcement actions filed to date and in a Staff Advisory Bulletin that the term "illegal act" should be read expansively. SAB 99, 64 Fed. Reg. 45,150, 45,154 (August 19, 1999).

The SEC has also taken the position that neither materiality nor scienter is relevant with respect to an alleged violation of Section 10A. Recently, Judge Conner in SEC v. Solucorp Ind., Limited, 197 F. Supp. 2d 4 (S.D.N.Y. 2002) agreed with the SEC, holding that Section 10A requires only knowledge of facts indicating an illegal act may have occurred and that there is no scienter requirement under the plain and unambiguous language of that statute.

The SEC also instituted an administrative proceeding, In re Rossetti, Accounting and Auditing Enforcement Release No. 1338, Fed. Sec. L. Rep. (CCH)  74,845 (Oct. 31, 2000) alleging that the company's books and records were organized in such a fashion that it was difficult for the issuer to break down income and expenses by the quarter in which they were accrued.

Therefore, the company simply "fractionalized" its financial statements covering a longer period and reported those fractionalized amounts in its several quarterly reports. Also, the SEC alleged that the issuer failed to properly account for certain stock option expenses. The SEC alleged that the two accountants knew or were "reckless" in not knowing about these departures from GAAP. Section 10A(d) specifically authorizes civil penalties in cease and desist proceedings brought against an accounting firm under Section 10A. The accountants recently settled.

Because of the limited litigation to date, and the phraseology of Section 10A, there appear to be a number of open legal issues:

1. Will the courts limit the definition of illegal acts to those that have an impact or effect on the financial statements filed with the SEC based on the underlying legislative history?

2. What is the true meaning of the word "likely" in the "let the audit committee know" element of the statute? Section 10A requires the auditor to determine "whether it is likely that an illegal act has occurred."

3. How does the outside auditor determine whether an illegal act is likely to have occurred?

4. What is the meaning of "timely and appropriate remedial measures?"

5. Does Section 10A apply to illegal acts discovered outside of the audit?

6. What new obligations, if any, does Section 10A impose on management and audit committees? For example, should it review company policies and procedures directed to preventing and detecting illegal acts?

7. What effect does Section 10A have on the SEC's authority to promulgate auditing standards that vary from GAAS?

Section 10A is a potentially powerful new weapon in the SEC enforcement arsenal to be launched whenever the SEC believes the outside auditor fails to bring an illegal act or related party transaction impacting on the company's financial statements to the attention of the company's audit committee. Because of its newness and uniqueness, this statute should prove to be a fertile ground for litigation in the future. At the very least, the financial professionals must be aware of this statute, what it requires, the time limits imposed and ramifications if the company does not promptly take appropriate remedial action. [FN]

[FN] Copies of Section 10A and Judge Conner's opinion in SEC v. Solucorp can be obtained by contacting the author at Hecht & Associates, P.C., 60 East 42nd Street, Suite 5101, New York, NY 10165 or at

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.

2002 SmartPros Ltd. All Rights Reserved.

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