Is the SEC Creeping Between Law Firms, Auditors and Public Companies? (Perspective)

Photo by Chris Kleponis/ Bloomberg News.

Editor’s Note: The author of this post is the former West Coast Chair of the Securities Enforcement Practice at DLA Piper and founded his own boutique firm.

By Nicolas Morgan, Zaccaro Morgan

In April 2014, Elliot Berman and his auditing firm Berman & Company received a Securities and Exchange Commission subpoena regarding an investigation into one of his clients, MusclePharm Corporation.

Like many auditors, Berman had inserted a clause into his contract that required MusclePharm to pay his legal expenses in the event of such an investigation.

But the SEC didn’t like that arrangement. This March, the SEC filed an action against him, in effect telling Berman to pay his own legal expenses if he wanted to be considered an independent auditor.

In the SEC’s view, the fact that MusclePharm had agreed to reimburse Berman & Co. for legal costs associated with the SEC investigation destroyed Berman & Co.’s independence as an auditor. I take the opposing view that the SEC’s aggressive theory threatens to upend the relationship between auditors, their lawyers, and their clients.

The alleged lack of independence arose from the SEC’s conflating provisions in the audit engagement letter: one requiring indemnification and another requiring reimbursement of expenses.

The SEC focused on various pronouncements for the proposition that an indemnification provision undermines auditor independence.  For example, both the Public Company Accounting Oversight Board (“PCAOB”) and SEC have issued guidance that an indemnity agreement providing an accountant with immunity from liability for its own negligent acts or from misrepresentations by management will impair an audit firm’s independence.

However, the SEC’s action against Berman & Co. directly quotes the reimbursement provision of its engagement letter, pointing to the auditor’s request to MusclePharm for payment of $272,000 in legal costs incurred in connection with preparing for and providing testimony in an SEC investigation into MusclePharm.

The SEC’s action against Berman & Co. creates confusion and uncertainty for auditors and their clients by implying that reimbursement of an auditor’s costs related to an SEC investigation into the company, rather than indemnification of the auditor’s liability, is improper.

The SEC’s attack on auditors seeking reimbursement of legal fees and costs from audit clients is reminiscent of a prior government effort to influence the relationship between auditors and their law firms.

About ten years ago, in connection with criminal investigations of tax shelters, a New York federal court judge lambasted the government for threatening to indict KPMG to coerce the auditing firm into cutting off payment of its employees’ legal fees in connection with the government’s investigation.  As the Judge noted, “[t]he underlying theme is that the government may not both prosecute a defendant and then seek to influence the manner in which he or she defends the case.”

Fallout from the KPMG debacle led to harsh criticism and, ultimately, prosecutorial reform and new guidelines, known as the McNulty memorandum, under which a company’s decision to pay legal fees is not to be held against the company.

The SEC’s action against Berman & Co. threatens to cast a new pall over the relationship between those caught up in a government investigation and their lawyers.  By conflating legal fee reimbursement, which does not undermine independence, with indemnity, which may, the SEC is unnecessarily interfering in the relationship between companies and their auditors and between auditors and their counsel.  Without reimbursement provisions, many auditors will be unwilling to take on certain engagements because of fear that they would have to shoulder the unpredictable and sometimes exorbitant costs associated with producing documents and providing testimony in response to a government or third-party subpoena.

If the SEC persists in this view, it will dramatically alter the relationship between public companies and their auditors and threaten the ability of some public companies to engage auditors and satisfy their financial reporting obligations.

Zaccaro Morgan LLP partner Sam Puathasnanon contributed.