Counsel’s Role When Situations Go Bad During Financial Audits- A Few Reflections on Maintaining Positive Auditor Relations


Understand the Auditor’s Reporting Provision

Section 10A of the Securities Exchange Act of 1934 is commonly known as the “reporting up and reporting out” provision applicable to public company auditors. Under Section 10A, if auditors “detect or otherwise become aware” of information indicating that an illegal act (whether or not perceived to have a material effect on the issuer’s financial statements) has or may have occurred, they must do two things:

1. Determine whether it is likely that an illegal act has occurred and, if so, determine and consider the possible effects of the illegal act on the issuer’s financial statements; and

2. Inform the issuer and ensure that the audit committee is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of the auditors in the course of the audit, unless the illegal act is clearly inconsequential.

Know the Definition of an Illegal Act

Contrary to common intuition, an illegal act does not necessarily require knowledge or intentional misconduct. The statute itself defines an illegal act to mean “an act or omission that violates any law, or any rule or regulation having the force of law.” The U.S. Securities and Exchange Commission (SEC) takes the position, for example, that a nonintentional violation of the books and records provisions of Section 13(b (2) of the Securities Exchange Act of 1934 is sufficient to state a violation that qualifies as an illegal act under Section 10A. Although it is difficult to equate a books and records violation with, say, a major embezzlement, both situations are covered by Section 10A’s use of illegal acts and require a measured but serious response.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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