Deficient completion of D&O questionnaire leads to SEC action and disgorgement

By Cydney Posner

You might be interested in this recent (sort of) settlement of an SEC administrative proceeding, noted in a recent Corporate Counsel, in which the stomach-turning result could have easily been avoided had the respondent properly completed--believe it or not--his D&O questionnaires. The case also highlights how critical it is to ensure that nothing impairs the independence of a company's auditors.

Mark Thompson was a director of three public companies audited by EY. Thompson and EY collaborated in creating a series of audio CDs designed for business development purposes over a 19-month period during which Thompson sat on the boards of all three companies and the audit committee of one. For his efforts, EY paid Thompson compensation of $377,500 and, during the same period, Thompson’s director compensation from the three companies totaled $100,662. Even though all three companies had engaged EY as auditor prior to the commencement of Thompson’s business relationship with EY, the SEC found that the relationship impaired EY’s independence as the auditor of each of these issuers, causing each issuer to lack independently audited financial statements. (Not a pretty problem.) In addition to his independence-impairing relationship, Thompson failed to disclose the conflict of interest, voted on the retention of each company’s auditor and on the inclusion of auditor-retention recommendations in proxy solicitations to each company’s shareholders; and signed three annual reports and one audit committee report incorrectly claiming that the companies’ auditor was independent, resulting in reporting violations for each issuer. Moreover, as an audit committee member for one of the companies, Thompson shared direct responsibility for the appointment, compensation and oversight of the company’s independent auditor. Each company provided Thompson D&O questionnaires soliciting information concerning the nature of any relationships between Thompson and EY; however, Thompson failed to fully furnish the details of his relationship with EY in response to these items.

The auditor independence rules generally prohibit all direct, and all material indirect, business relationships between auditors and their audit clients, including audit-client directors. (Rule 2-01(c)(3) of Reg S-X provides that an "accountant is not independent if, at any point during the audit and professional engagement period, the accounting firm or any covered person in the firm has any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors, or substantial stockholders. The relationships described in this paragraph do not include a relationship in which the accounting firm or covered person in the firm provides professional services to an audit client or is a consumer in the ordinary course of business." The SEC found that the relationship between EY and Thompson violated that prohibition. The sole exception to the prohibition is for relationships that involve a "consumer in the ordinary course of business." . That exception is available only where a relationship is both "in the ordinary course of business" for both parties, and at least one of the parties is acting as a "consumer." The SEC did not view the Thompson/EY relationship to qualify for that exception because the relationship’s collaborative nature (the CDs were joint products developed for end users) gave rise to an unacceptable "mutuality of interest" between the auditor and the audit client: the advancement of the auditor’s interest depended, to some extent, upon the client. Accordingly, the SEC concluded that Thompson’s relationship with EY satisfied neither prong of the exception for a consumer in the ordinary course of business.

The SEC determined that (1) the filing of non-independent audit reports violated federal securities statutes and rules requiring that those filings include independently audited financials and (2) non-disclosure of the relationship in proxy solicitations recommending EY’s retention as auditor violated the proxy rules. As Thompson was found to be the cause of these violations he was ordered to cease and desist and to disgorge approximately $124,000.

EY also had a few problems of its own, having expressly confirmed to each of the companies that it was "independent" and therefore able to serve as each client’s external auditor.

This content is provided for general informational purposes only, and your access or use of the content does not create an attorney-client relationship between you or your organization and Cooley LLP, Cooley (UK) LLP, or any other affiliated practice or entity (collectively referred to as “Cooley”). By accessing this content, you agree that the information provided does not constitute legal or other professional advice. This content is not a substitute for obtaining legal advice from a qualified attorney licensed in your jurisdiction and you should not act or refrain from acting based on this content. This content may be changed without notice. It is not guaranteed to be complete, correct or up to date, and it may not reflect the most current legal developments. Prior results do not guarantee a similar outcome. Do not send any confidential information to Cooley, as we do not have any duty to keep any information you provide to us confidential. This content may be considered Attorney Advertising and is subject to our legal notices.