The Sarbanes-Oxley Act: Advancing the SEC’s Ability to Obtain Foreign Audit Documentation in Accounting Fraud Investigations

Tuesday, January 1st, 2002 at 12:00 am by David M. Stuart and Charles F. Wright
David M. Stuart and Charles F. Wright, The Sarbanes-Oxley Act: Advancing the SEC’s Ability to Obtain Foreign Audit Documentation in Accounting Fraud Investigations, 2002 Colum. Bus. L. Rev. 749

The Sarbanes-Oxley Act (‘the Act‘ or ‘Sarbanes-Oxley‘)–signed into law by President George W. Bush on July 30, 2002, after near unanimous votes in the House and Senate–has been called the ‘most radical redesign of the federal securities laws since the 1930s‘ and ‘the most sweeping legislation affecting accounting, disclosure and corporate governance in a generation.‘ President Bush called the Act ‘the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.‘ The Act addresses numerous issues arising out of the environment created by the accounting debacles at Enron, Global Crossing, Tyco, Xerox, and WorldCom, to name a few. Certain provisions of the Act will be particularly important to the Securities and Exchange Commission’s (‘SEC‘ or ‘Commission‘) enforcement program. Those provisions are intended to require both foreign public accounting firms and their U.S. counterparts to produce overseas workpapers when the SEC seeks such documents in its investigations. If enforced by the U.S. courts, these provisions will constitute a significant advancement in the SEC’s ability to efficiently investigate large accounting fraud cases.

With the recent increase in investigations by the Division of Enforcement of the SEC into accounting fraud, it is now more important than ever that the SEC have full and ready access to documents created by auditors. The detailed documentation prepared by an issuer’s independent auditor of the procedures and testing performed, and the conclusions, observations and opinions reached during the course of an independent audit (commonly known as the ‘audit workpapers‘), often acts as the clearest and most organized roadmap to complex transactions and accounting issues. Moreover, the audit workpapers contain information that does not exist in the company’s own books and records because the company generally does not perform as a matter of course the analyses required of an auditor under Generally Accepted Auditing Standards (‘GAAS‘). This should be particularly true under the new standard, Statement on Auditing Standards (‘SAS‘) (effective 12/15/02), governing an auditor’s responsibilities with respect to consideration of fraud in financial statements. SAS No. 99 requires, among other things, designing tests that would be unpredictable and unexpected by the issuer. Furthermore, if the company is engaged in fraud, it may understandably go to great lengths to avoid documenting its accounting. Indeed, from an accounting fraud or forensic perspective, audit workpapers contain many things that typically would not be found in the company’s own records, such as analyses of fraud risk factors, evaluations of internal controls, identification of red flags and documentation of communications, discussions and meetings between a company’s management and the audit team concerning accounting issues.

Thus, there is a critical need for transparency in the work performed by independent auditors on behalf of their clients. After all, the independent auditor carries out such work for the benefit of the public, not the company that hires it. In the words of Chief Justice Burger:

By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This ‘public watchdog‘ function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant’s interpretations of the client’s financial statements would be to ignore the significance of the accountant’s role as a disinterested analyst charged with public obligations. The SEC’s need to obtain workpapers is addressed in part through the Securities & Exchange Act of 1934 (the ‘Exchange Act‘) and the Securities Act of 1933 (the ‘Securities Act‘). These statutes empower the SEC to compel production of audit documentation from U.S. auditing firms through investigative subpoenas. Thus, as a matter of law, the SEC has the undisputed ability to obtain audit workpapers of U.S.-based audit firms. However, audits of foreign issuers and multinational corporations include a significant amount of audit work performed outside of the United States by foreign affiliates of U.S. audit firms or by foreign auditors engaged specifically for an audit of certain foreign operations. With increases in the globalization of American businesses and the increasing number of foreign issuers seeking access to the U.S. capital markets, audits of such concerns may involve the work of dozens of overseas audit firms. For example, the case of Xerox Corporation, a company that recently issued a restatement in excess of $6 billion as a result of settling an accounting fraud action with the SEC, involved the accounting of operations around the world. In another instance, in October 2001, the Commission brought an accounting fraud action against Aremissoft, a multinational software company that was listed on Nasdaq. Aremissoft had offices in England, Cyprus and India and its auditors–Pannell Kurr Foster– were located in those countries. Most recently, the Commission filed an accounting fraud action against three former officers of auto-shipping firm A.C.L.N., Ltd., a Cyprus corporation, and its auditor–BDO Cyprus. Notwithstanding the critical role of overseas audit work, historically, the SEC’s ability to obtain foreign audit workpapers has been laden with difficulties.

In the case of a multinational U.S. corporation, the U.S. audit firm generally signs the requisite audit report containing an audit opinion that relied upon its foreign affiliates to perform the audit procedures for the overseas operations. The U.S. firm usually oversees and coordinates the international audit of such multinational issuers, dictating the audit steps and procedures the foreign firm must perform. The foreign firm, in turn, typically submits to the U.S. firm summary memoranda (sometimes called ‘completion memos‘) that address its audit work performed for a particular region or country’s segment of the international company’s financial statements. The U.S. accounting firm then uses such memoranda when it issues its audit report on the U.S. company’s consolidated financial statements. In the case of the foreign issuer registered with the Commission, not even the summary memoranda make it to the United States since the consolidation is generally performed overseas by a foreign accounting firm where the foreign issuer is based.

Comprehensive SEC investigations require access to the foreign audit workpapers. Although prior to Sarbanes-Oxley Congress had passed legislation attempting to deal with the multinational aspects of securities laws violations, that legislation has been, for all intents and purposes, ineffective for purposes of SEC investigations into accounting fraud. Thus far, jurisdictional limitations and creative partnership structures of the auditing firms, overlaid by problems associated with American regulatory agencies asserting their authority over foreign sovereigns, have proven to be significant hurdles to gaining such access.

The following article discusses the background of the SEC’s efforts to obtain foreign documentation in its investigations, the provisions of Sarbanes-Oxley addressing that issue, and the implications and limitations of those provision

Author Information

David Stuart and Charles Stuart are both Senior Counsel on the Securities and Exchange Commission's Financial Fraud Task Force in the Division of Enforcement