SEC Inspector General Urges Expanded PCAOB Reach, Whistleblower Program

James Hamilton, J.D., LL.M., Principal Analyst, CCH Federal Securities Law Reporter; and CCH Derivatives Regulation Law Reporter.

As the House Financial Services Committee prepares financial regulatory reform legislation, the SEC’s Inspector General has suggested the implementation of a number of specific reforms. In a letter to Rep. Paul Kanjorski, chair of the Capital Markets Subcommittee, H. David Kotz urged Congress to extend the jurisdiction of the PCAOB to audit reports prepared by a domestic registered or foreign public accounting firm regarding issuers, broker-dealers, investment advisers and any companies subject to U.S. securities laws.

The PCAOB is able to address many auditing problems through a combination of inspections and standard-setting. In addition, the PCAOB's supervisory model uses several tools to improve audit quality, correct audit deficiencies, and promote compliance with applicable standards and laws. In the Inspector General’s view, extending the jurisdiction of the PCAOB would allow for increased oversight of these accounting firms and reduce the risks associated with unknown accounting firms that have been able to avoid scrutiny. The IG said that H.R. 1212, as currently introduced, accomplishes many of these same goals, except that he recommends that the legislation clarify that PCAOB oversight be extended to audit reports prepared by a registered accounting firm which provides reports for investment advisers, investment companies and other registered entities, as well as registered broker-dealers.

Introduced by Rep. Kanjorski, HR 1212 would extend the PCAOB’s jurisdiction to audit reports prepared by a domestic registered or foreign public accounting firm regarding issuers, brokers and dealers, and any companies subject to securities laws. It would also direct the Board to establish standards for independence to be used by a registered public accounting firm and conduct annual inspections to assess compliance of each registered public accounting firm that regularly provides audit reports for more than 100 brokers and dealers

The Inspector General also recommended changes to the Investment Advisers Act to require the use of independent custodians in a manner similar to Section 17(f) of the Investment Company Act, which requires the use of an independent custodian by mutual funds. Section 17(f) requires a registered management company to place and maintain its securities and similar investments in the custody of a bank or a dealer admitted to a national securities exchange, subject to SEC rules. Rule 17f-2(b) requires that all such securities and similar investments be deposited in the safekeeping of, or in a vault or other depository maintained by, a bank or other company whose functions and physical facilities are supervised by federal or state authority. The rule further provides that investments so deposited shall be physically segregated at all times from those of any other person and can be withdrawn only in connection with transactions of the character described in the rule. In the IG’s view, this custodian requirement essentially removes the ability of an investment adviser to fraudulently use the proceeds invested by new investors to make payments to old investors.

The IG also noted that hedge funds are currently exempt from the Investment Company Act and are not subject to the independent custodian requirement. In addition, investment advisers who are also registered broker-dealers are currently permitted to clear their trades through their own broker-dealer firm. Thus, the IG urged that both investment advisers and hedge funds be required to use an independent custodian.

The IG is aware that the SEC is currently proposing amendments to its custody rule under the Investment Advisers Act to require a written report from an independent public accountant that includes an opinion regarding the custodian's controls relating to custody of client assets if the client accounts are not maintained by an independent qualified custodian. However, the IG believes that a more direct way to remedy this statutory loophole would be to amend the Investment Advisers Act in conformity with the Investment Company Act.

The Sarbanes-Oxley Act requires ongoing certifications of certain reports by chief executive officers and chief financial officers of public reporting companies. Executives who knowingly file noncompliant reports face possible criminal prosecution including substantial fines and imprisonment. The IG observed that certifications have been effective controls to ensure compliance with particular requirements or guidelines.

Thus, the Inspector General recommends imposing a requirement of certification by senior officers of registered investment advisers showing that they conducted adequate due diligence in connection with investments. This certification requirement should also apply to all funds of hedge funds. The adequate level of due diligence required in accordance with the certification may be defined pursuant to a particular model of best practices, such as the Managed Fund Association model or the Alternative Investment Management Association model, or could be developed by the SEC. In the IG’s view, enforcing an adequate level of due diligence would ensure that investors have adequate information when investing through intermediaries.

The IG further noted that bounty programs are an effective tool to encourage whistleblowers to come forward and provide necessary incentives for outside entities to bring complaints about possible illegal activity. Although the bounty system has been in place at the SEC for more than 20 years, he observed, there have been relatively few awards made. The SEC program is limited to insider trading cases and, said the IG, the criteria for judging bounty applications are broad, somewhat vague and not subject to judicial review.

The Inspector General recommends that Congress authorize the SEC to award a bounty for information leading to the recovery of a civil penalty from any violator of the federal securities laws, not simply insider trading violations. Congress should also provide specific criteria for awarding bounties, including a provision that, where a whistleblower relies upon public information, such reliance does not constitute an absolute bar to recovering a bounty. The statute should also require that the whistleblower be provided with status reports at certain milestones during the investigation or examination that was based on the tip.

Currently, Section 21A(e) of the Exchange Act authorizes the SEC to award a bounty to a person who provides information leading to the recovery of a civil penalty from an insider trader, from a person who tipped information to an insider trader, or from a person who directly or indirectly controlled an insider trader. All bounty determinations, including whether, to whom, or in what amount to make payments, are within the sole discretion of the SEC, however, the total bounty may not currently exceed 10 per cent of the amount actually recovered from a civil penalty pursuant to a court order.