During the course of an SEC investigation, the SEC presented KPMG with some Xerox documents that KPMG had never seen before. KPMG then confronted Xerox with these documents and demanded an explanation. Xerox's audit committee then retained outside counsel to conduct an independent investigation.
On May 24, 2001, KPMG met with high-ranking members of the SEC enforcement staff to answer questions regarding the report of outside counsel to the audit committee and the Xerox audit. At that meeting, according to KPMG, it specifically asked the SEC staff if there were other matters that they should be aware of in connection with their investigation which might impact on Xerox's financial statements. On the following day, the SEC enforcement staff set up a conference call indicating that Xerox had not made certain disclosures in the Notes to its financial statements and specifically referred to issues concerning sales-type leases, including margin normalization and residual value accounting, which required additional disclosures. At that meeting KPMG inquired as to whether there were any other matters that it should be aware of in connection with the SEC's investigation which might impact on Xerox's financial statements. According to KPMG, the SEC staff advised it that it had covered all of the issues.
KPMG then issued its audit report on Xerox's 2000 financial statements. The SEC then filed its complaint that included claims relating to KPMG's audit of these financial statements. KPMG asserted equitable defenses that this was unfair because if it had known that the SEC staff had additional concerns, those concerns would have been addressed before it signed off on Xerox's 2000 financial statements.
In granting the SEC's motion to strike the equitable defenses of estoppel, waiver and unclean hands, the District Court took the position that unlike private litigants, federal agencies are generally not subject to such equitable defenses because federal agencies are required to uphold the law. The Court noted that such defenses are only available in the most egregious of circumstances, which result in prejudice that reaches a constitutional level. Also, the accounting firm's duty to properly audit financial statements in accordance with law is independent from an investigation by a federal agency.
The District Court also admonished KPMG for relying on oral statements when the SEC had issued a written procedure to assist financial professionals on how to obtain pre-clearance from the SEC of accounting actions. First, you must make the submission in writing, preferably at least five days before you want a response. Secondly, after the SEC has responded you can submit a letter to the staff setting forth the Company's understanding of the staff position. If the SEC staff approves the draft, then it may, but is not required to, put a copy of the final letter in its files.
However, a review of the Guidance for Consulting with the Office of Chief Accountant, as modified on March 9, 2003, (the "Guidance") does not deal with the type of situation set forth in the KPMG scenario. First, the KPMG dealings were with the enforcement staff, and the role, if any, of the Chief Accountant's Office in these two meetings is not disclosed in the opinion. By definition, this Guidance is only applicable to a totally separate department, the Chief Accountant's Office. Second, KPMG was brought into the investigation by the SEC, and the context of an enforcement investigation is quite different from an audit. Also, one does not know the extent of the participation of the Chief Accountant's Office in a particular enforcement proceeding. Third, there are no specific time limits in the Guidance, especially as to when the Chief Accountant's Office must respond. Fourth, in view of the suggested time limits imposed by the SEC on when to submit the request, such a written procedure can often be impractical, as the answer, if given, will be after the required filing date.
Under the circumstances of this case it would appear that if the SEC staff had additional concerns, it should voice those concerns to the financial professional before the audit is signed off on, rather than waiting until after the accounting firm has signed off and then accusing them of fraud in a civil suit.
The lesson of this story is two-fold: (i) if you have the luxury of time, make your request to the Chief Accountant's Office way in advance, hope that the accounting staff can respond in time, hope that the response is favorable and hope that the SEC staff will file a copy of your letter memorializing their response in the its file and (ii) do not rely on the oral representations of the SEC's enforcement staff, because if you do and are then sandbagged, according to one federal judge, you cannot raise this inequitable conduct as a defense.
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.
