Smackdown in SPAC Town: SEC Penalizes Pair of Auditors and PCAOB Tags In
The SEC did not take time off for the summer when it comes to enforcement activity involving auditors of special purpose acquisition companies (known as SPACs and addressed by us previously). While others may have been strolling through Europe or relaxing on a sandy beach, the SEC's Division of Enforcement was busy announcing settlements with two major audit firms and some of their executives relating to their audits of SPAC clients, one of which was settled in coordination with the Public Company Accounting Oversight Board (PCAOB).
SEC to Auditors: Quality Over Quantity
In a June 21, 2023, order, the SEC settled with an auditor over charges that its audits for hundreds of new clients, mostly SPACs, caused systemic quality control and supervision failures during a 21-month period (from January 2020 through October 2021). During this time, the auditor had a 285 percent increase in the number of audits it issued, but its hiring practices failed to keep up to meet the increased demand, and it was unable to staff the audits sufficiently with experienced personnel to conduct or review the audits.1
The SEC noted that of the 860 SPAC-related initial public offerings (IPOs) that took place from 2020 through 2021, this firm audited more than 400 of them, and its audits grew from 185 public companies in 2019 to a total of 575 issuers by 2022, the majority of which were SPACs. According to the SEC, this rapid growth, without the concomitant expansion in staff or resources, caused the auditor's failures.
SEC Director of Enforcement Gurbir Grewal remarked that the auditor had "prioritized increased revenue over audit quality."
The SEC found that the auditor violated Rule 2-02(b)(1) of Regulation S-X for stating falsely in numerous audit reports that it had conducted the audits in accordance with PCAOB standards and Exchange Act Section 4C(a)(2) and Rule 102(e)(1)(ii) for engaging in improper professional conduct. Rule 2-02(b)(1) requires an auditor to certify in the audit report "whether the audit was made in accordance with generally accepted auditing standards," including PCAOB standards.2 Exchange Act Section 4C(a)(2) and SEC Rule of Practice 102(e)(1)(ii) authorize the commission to censure an accountant or deny, temporarily or permanently, an accountant's privilege of appearing or practicing before the commission if the accountant lacks character or integrity or has engaged in unethical or "improper professional conduct."3
Without admitting or denying the charges, the auditor agreed to pay a $10 million civil monetary penalty. The auditor also agreed to several undertakings, including: 1) retaining an independent consultant to review and evaluate its audit, review and quality control policies and procedures and issue a written report and recommendations within eight months of engagement, which the auditor would accept and implement; 2) not accepting more than three new audit clients per quarter without first receiving clearance from the independent consultant; 3) ensuring that its affiliate in Asia adopt the same undertakings; 4) providing training to its personnel on any changes to the firm's policies and procedures following the independent consultant's findings; and 5) informing all of its audit professionals of the terms of the order within 10 days of its issuance.
More recently, in a Sept. 13, 2023, order, the SEC settled with the former lead partner who oversaw quality control for the audit firm's public company practice.
The SEC found that the partner violated Exchange Act Section 4C(a)(2) and Rule 102(e)(1)(ii) of the SEC's Rules of Practice for engaging in improper professional conduct and caused the auditor to violate Rule 2-02(b)(1) of Regulation S-X in connection with the issuance of numerous SPAC audit reports, which all falsely stated that the auditor had conducted its audits in accordance with PCAOB standards.
The partner agreed to pay a civil monetary penalty of $75,000 and that, for three years after the date of the order, he would have no leadership, management, oversight or supervisory position or any decision-making role in connection with client acceptance or quality control at any registered public accounting firm.
In a separate settlement order with the PCAOB, issued the same day and based on the same conduct, the agency found that the auditor violated PCAOB Quality Control Standards Section 20 (QC § 20), which focuses on systems of quality control for accounting and auditing practice. The PCAOB's order found that the auditor's system of quality control failed to, among other things, provide reasonable assurance that the firm would take only engagements that could be reasonably expected to be completed with professional competence and failed to perform procedures to appropriately identify and assess the risks of material misstatement at the assertion level for SPAC audits.
The auditor agreed to pay a $3 million civil penalty and to make certain additional undertakings beyond what it agreed to in the SEC settlement, including: 1) training all audit staff, 2) creating the role of and hiring a "Chief Quality Officer" to oversee its quality control systems and 3) forming an audit committee to provide oversight on the auditing business. Notably, this is the first settlement in which the PCAOB has required a registered firm to make functional changes to its supervisory structure related to its system of quality control.
As PCAOB Chair Erica Y. Williams stated: "If firms put profits ahead of PCAOB standards that protect investors, there will be consequences. Today's order makes clear, the PCAOB will use every tool at our disposal, including requiring a firm to change its supervisory structure, in order to ensure compliance with PCAOB standards."
SEC to Auditors: But Does It Pass the Smell Test?
In an Aug. 14, 2023, settlement with the United Kingdom arm of a different international auditing firm, the SEC made abundantly clear that it will go aggressively after auditors involved in SPACs (and, in this instance, the firm's CEO, who was the engagement partner on the audit, along with a senior auditor who was the audit's engagement quality reviewer) even when the auditor is overseas and the audit report is not for a U.S.-based issuer. Importantly, the auditor prepared an audit report for the foreign private entity that merged into a domestic SPAC. In 2021, the SEC settled an enforcement action against the de-SPAC issuer involving charges that the company defrauded investors by overinflating the number of paying subscribers and amount of revenue it had when, in reality, the company had negligible revenue and hardly any subscribers. As part of that settlement, the company, which neither admitted nor denied the charges, agreed to pay $38.8 million in disgorgement.
Focusing on the audit firm, the SEC issued a sweeping 31-page order,4 in which it found that the auditor overlooked red flags and failed to exercise an appropriate level of due care or professional skepticism when the company presented fabricated agreements, inauthentic confirmation letters and emails from fake third parties to the audit team. The SEC further found that the auditor failed to use experienced audit and supervisory personnel, confirm statements that the company had entered into certain agreements with third parties, maintain adequate audit documentation and conduct a sufficient quality control process. According to the SEC, the auditor misrepresented that the financial statements fairly presented in all material respects and did not conduct the audit in accordance with PCAOB quality control standards.
Eric Werner, the Regional Director of the SEC's Fort Worth Regional office, stated that the auditor's failure "contributed to the air of legitimacy that allowed [the company] to become a publicly traded company."
The SEC found that the auditor violated Rule 2-02(b)(1) of Regulation S-X for falsely attesting that it had conducted the audit in conformance with PCAOB standards and Exchange Act Section 4C(a)(2) and Rule 102(e)(1)(ii) of the SEC's Rules of Practice for engaging in improper professional conduct. The SEC also found that the auditor caused the issuer to violate Exchange Act Section 13(a) and Rule 13a-19 for allowing it to incorporate the false audit report into the company's Form 20-F and violated Exchange Act Section 14(a) and Rule 14a-9 for allowing its false audit report to be included in the company's joint proxy and registration statement. Exchange Act Section 13(a) requires issuers to file annual reports with the SEC, and Rule 13a-19 requires a foreign private issuer that was a shell company immediately before entering into a transaction that causes it to cease being a shell company to report that transaction on Form 20-F.5 Exchange Act Section 14(a) and Rule 14a-9 prohibit material misrepresentations and omissions in proxy statements.6
Without admitting or denying the charges, the auditor agreed to a $750,000 civil monetary penalty and to disgorgements of $187,740 and $28,104 in prejudgment interest, which the SEC deemed satisfied by the audit firm's payment of $11.5 million in an earlier settlement with the issuer's investors. The auditor also agreed to several undertakings, including to 1) withdraw its PCAOB registration, 2) not accept any new SEC-registered clients without first retaining an independent consultant to review the auditor's policies and procedures and issue a written report and recommendations within five months of engagement, which the auditor would accept and implement, 3) provide comprehensive training to each audit professional who would be working with SEC-registered clients and 4) certify it completed the undertakings.
The engagement partner and engagement quality reviewer each settled to charges that they violated Exchange Act Section 4C(a)(2) and Rule 102(e)(1)(ii) for engaging in improper professional conduct, and each caused the auditor's violations of Regulation S-X and Exchange Act Section 14(a) and Rule 14a-9 and caused the issuer to violate Exchange Act Section 13(a) and Rule 13a-9.
Without admitting or denying the charges against them, the engagement partner and engagement quality reviewer agreed to pay $25,000 and $10,000 in civil monetary penalties and to suspensions from appearing before the SEC as accountants for five and two years, respectively.
First, it is worth emphasizing that the PCAOB settlement is the first time the PCAOB has required a registered audit firm to make functional changes to its supervisory structure. Does this signal that the PCAOB is feeling emboldened? Are there similar settlements on the horizon? Only time will tell.
Second, a word on the SEC's jurisdictional reach. The agency has made clear that it will not shy away from enforcing the U.S. securities laws against a foreign branch of an audit firm when it provides accounting services that make their way into U.S. public company filings. In this instance, the auditor's U.K. arm did not audit the financial statements of a U.S. issuer but prepared an audit report for a foreign private entity that merged into a U.S. company in a de-SPAC transaction. The audit report was then incorporated by reference into the company's shell company report on Form 20-F and its joint proxy and registration statement. The SEC's exercise of jurisdiction over the auditor's U.K. branch cautions that audit firms should not assume their international offices are beyond the SEC's reach and should take care to assess the potential downstream journey a seemingly extraterritorial audit report may undergo.
Lastly, the undertakings in these settlements merit serious consideration. Perhaps more than the monetary penalties imposed, the undertakings potentially have systemic and long-lasting impacts on these audit firms' operating structure. Such fundamental and lasting changes are likely to impact the auditors far more significantly than the one-time financial penalties imposed.
It goes without saying that auditors would be well advised to keep their antennae up when it comes to increased enforcement activity, particularly when it comes to audits involving SPACs.
The SECond Opinions Blog will continue to monitor enforcement developments involving SPACs and provide further updates. If you need any additional information on this topic – or anything related to SEC enforcement – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.
2 17 CFR § 210.2-02(b)(1).
3 15 U.S.C. § 78d–3; 17 CFR § 201.102(e)(1)(ii) and (iv).
4 This order and the 38-page order in the earlier matter are recommended reading for auditors working with SPACs or startup company clients with limited operating history.
5 15 U.S.C. § 78m; 17 C.F.R. § 240.13a-19.
6 15 U.S.C. § 78n; 17 C.F.R. § 240.14a-9.