Navigating the Complex Waters of SEC Rule 102(e): A Legal Perspective

Dmitriy Smirnov
March 1, 2024
Securities Law

Recently, the Securities and Exchange Commission (SEC) initiated a 102(e) administrative proceeding against Clark Schaefer Hackett & Co. (“CSH”), a public accounting firm, pursuant to Sections 4C and 21C of the Securities Exchange Act of 1934 (“Exchange Act”), and Rule 102(e)(1)(ii) of the Commission’s Rules of Practice. 

Rule 102(e)(1)(ii) provides, in pertinent part, that:

The Commission may . . . deny, temporarily or permanently, the privilege of appearing or practicing before it . . . to any person who is found . . . to have engaged in unethical or improper professional conduct.

In essence, the SEC found that CSH violated the Commission’s auditor independence rules. In early 2020, CSH audited Lordstown Motors Corp.’s 2019 financial statements under Generally Accepted Audit Standards (“GAAS”). During the same engagement, Lordstown provided the company with non-audit services by assisting management in preparing the financial statements and performing bookkeeping services. Later in 2020, in connection with Lordstown’s anticipated merger with another company, CSH conducted an audit of the same 2019 financial statements under PCAOB standards. CSH represented that it was “independent” in the auditor’s report it issued to Lordstown under PCAOB standards, and the report was included in public filings with the Commission by both companies. 

Rule 2-01 of Regulation S-X requires that auditors like CSH be independent of their audit clients both in fact and appearance. Rule 2-01(c) of Regulation S-X provides that an auditor is not independent if, at any point during the audit and professional engagement period, the audit firm provides certain non-audit services to the client. The SEC found that CSH violated those independence standards standards “because it audited and prepared the financial statements and provided bookkeeping services to Lordstown during the audit and professional engagement period. The SEC found that CSH violated Rule 2-02(b) of Regulation S-X and caused Lordstown’s violations of Sections 13(a) and 14(a) of the Exchange Act, and Rules 13a-1 and 14a-3 thereunder. CSH’s conduct also constituted improper professional conduct pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(ii) of the Commission’s Rules of Practice.

As a consequence of CSH’s violations, the SEC disgorged CSH’s net profits, meaning CSH was forced to return the money it was paid to prepare the audited report. In addition, CSH paid a $50,000 monetary penalty and had to retain, at its own expense, an independent consultant who would be charged with reviewing and evaluating CSH’s audit, review, and quality control policies and procedures for a report to be submitted to the SEC.  And this penalty was mitigated because CSH cooperated and agreed to remediate. 

This case highlights the importance for the auditor of maintaining independence within the auditing process. CSH’s error not only invalidated the audited financial statements but also caused its client to violate Section 13 of the Securities Exchange Act, underscoring the delicate balance auditors must maintain to ensure the integrity of financial reporting.

Rule 102(e) is a significant component of the SEC’s enforcement strategy and has been instrumental in upholding the standards of professionalism and ethical conduct within the securities market. Adopted in 1935, Rule 102(e) empowers the SEC to discipline attorneys, accountants, and other professionals who either directly violate securities laws or engage in unethical practices that undermine the regulatory framework. The rule is a testament to the importance of these “gatekeepers” on the financial markets—and the SEC’s role in ensuring their professional candor and fitness—as their roles are pivotal in aiding compliance and deterring fraudulent activities.

The Intricacies of Rule 102(e) Explained

Rule 102(e) is fairly broad in scope, targeting any professional misconduct that violates federal securities laws or demonstrates a lack of integrity or competence. For accountants, this encompasses anything from intentional misconduct to a single instance of grossly unreasonable behavior that breaches professional standards. The rule underscores the SEC’s commitment to maintaining market integrity by ensuring that those who practice before it adhere to the highest standards of professional conduct.

The SEC’s authority under Rule 102(e) is robust and includes the ability to censure or suspend professionals from practicing before it. Such disciplinary actions, while subject to appeal in federal courts, often see the SEC’s determinations upheld, given the deference courts typically extend to the agency’s expertise. This underscores the significant implications for professionals in the securities field, where a Rule 102(e) inquiry can be career-threatening.

The Sarbanes-Oxley Act and Its Role

The Sarbanes-Oxley Act of 2002 (“SOX”) reshaped the compliance landscape for public companies and public accounting firms to further combat fraudulent financial reporting. To be SOX compliant, public companies doing business in the U.S. must: (1) implement internal controls to protect financial data from tampering; (2) file regular reports with the SEC confirming the effectiveness of security controls and the accuracy of financial disclosures; and (3) file an annual independent audit of their financial statements and controls. In this way, the SOX Act echoes the sentiments of Rule 102(e), further empowering the SEC’s to ensure that professionals appearing before it abide by the principles of accountability and ethical conduct necessary to ensure the fair and efficient operation of the market. Consequently, the SOX Act and Rule 102(e) provide an important framework for legal and accounting professionals, guiding their conduct and ensuring their roles as gatekeepers are executed with the utmost integrity.

Preparing for and Responding to a 102(e) Hearing

Facing a Rule 102(e) proceeding necessitates a strategic approach, beginning with a thorough review of the SEC’s allegations and an understanding of the procedural aspects of these hearings. Unlike traditional court proceedings, hearings under Rule 102(e) operate under a distinct set of rules where hearsay can be admissible and the SEC’s broad discretion can dictate the pace and scope of the process.

The Implications of Rule 102(e) Disciplinary Actions

The consequences of disciplinary action under Rule 102(e) extend beyond immediate professional ramifications. Such proceedings can trigger further civil or criminal investigations, with potential charges ranging from securities fraud to conspiracy under various federal statutes. The stakes are high, and the need for experienced federal defense counsel cannot be overstated. Proactive engagement and a robust defense strategy are paramount in navigating the intricacies of Rule 102(e) and mitigating the potential fallout.

Final Thoughts

The recent case against the auditing firm serves as a stark reminder of the importance of an auditor to maintain its independence when serving in that role and the severe consequences of a breach of that rule. Rule 102(e) is a powerful tool in the SEC’s arsenal, designed to maintain the integrity of the securities markets through the regulation of professional conduct. For attorneys, accountants, and other professionals practicing before the SEC, understanding and adhering to the tenets of Rule 102(e) is not just a matter of compliance, but a foundational element of their professional responsibility and ethical obligation to the markets they serve.

Alejandro Soto is a former senior official with the SEC and leads Fridman Fels & Soto, PLLC’s Securities Litigation and SEC Enforcement Practice Group.