SOX Limitations On The Services Provided By External Auditors

During the current market crisis, it has become fashionable to argue for a revamping of the current regulatory structure. Those suggestions are frequently coupled with comments about the need for additional regulation and more authority for regulatory agencies such as the Securities and Exchange Commission. Even former SEC Chairman Christopher Cox, hardly a champion of increased regulation, called on Congress to give the SEC additional regulatory authority as discussed here.

The Sarbanes Oxley Act, passed in the wake of huge corporate scandals such as Enron, Worldcom, Global Crossing and others, as well as the demise of accounting giant Arthur Anderson, contains a number of restrictions on outside auditors to ensure independence. In this regard, the Act requires that the audit committee be responsible for the hiring, supervision and retention of the outside auditors and, in addition, imposes a number of other restrictions regarding the outside auditors. These include a requirement that the audit committee pre-approve all services purchased from the outside auditors, limits on the services which can be provided by those auditors and audit partner rotation requirements.

One of the services which SOX precludes issuer from purchasing is internal auditing services. Specifically, the outside audit firm cannot also serve as the internal auditors. The purpose of this and the other limitations in the Act is to ensure in substance, as well as appearance, the independence of the outside auditors. Underlying these restrictions, in part, is the notion that the outside auditor should not have to review or audit their own work, a situation which could arise if the outside auditors also serve as the internal auditors.

The results of a recent study calls into question the ban on the outside auditors serving as the internal auditors. According to CFO.com, a study by three professors has concluded that the “knowledge of a company that an external auditor gained from internal auditing lowered the chances of publishing misleading or fraudulent financial results … .” These findings seem to call into question at least part of the predicate for the restrictions on services outside auditors can provide to an issuer under SOX. At the same time, the results of the study are preliminary, produced from limited data and subject to peer review. Even if these results are confirmed, it seems unlikely in the current environment that the SOX restrictions will be repealed.

Other conclusions of these professors may however, have a more practical impact. In an earlier paper this same team of researchers concluded that issuers may achieve efficiencies and reduce fees paid to outside auditors if they have a high quality internal auditing function on which the outside auditors can rely. Douglas F. Prawitt, Nathan Y. Sharp, and David A. Wood, “Does Internal Audit Quality Affect the External Audit Fee?” The results of this study may suggest to issuers that an investment in the internal audit function is worthwhile, not only to achieve better controls but also economies in audit fees. It may also suggest that audit committees should carefully consider this question when discussing fees with the outside audit firm.

SLUSA And The Delaware Carve Out

The Securities Litigation Uniform Standards Act of 1998 (SLUSA) generally precludes shareholders from bringing a class action securities fraud suit in state court. The Act was passed to prevent an end run around the stringent substantive and pleading requirements of the Private Securities Litigation Reform Act of 1995. SLUSA does have exceptions, however. In Madden v. Cowen & Co., Case No. CV-06-04886 (9th Cir. Feb. 11, 2009), the Ninth Circuit defined the scope of one of those exceptions known as the Delaware carve-out.

The suit arose out of the acquisition of St. Joseph Medical Corp. and its controlled entity, Orange Coast Managed Care Services by FPA Medical Management. Both St. Joseph and Orange were privately held corporations. FPA was publicly traded.

In 1997, the management of St. Joseph and Orange formed a special committee to seek a buyer for the two companies. Cowen was engaged to assist. Eventually Cowen arranged for FPA to acquire the shares of St. Joseph and Orange in an exchange offer. Cowen issued a fairness opinion in connection with the deal. Shortly after the transaction closed, FPA reported poor earnings and its stock price dropped by 75%. Two months, later the company filed for bankruptcy. At the time, its share price was about 0.5% of what it was at the time of the deal with St. Joseph and Orange.

The sixty three shareholders of St. Joseph, a California corporation, and Orange, a Delaware company, filed suit against FPA’s management in California state court. That case was removed under SLUSA after which the district court granted summary judgment in favor of the defendants. The Ninth Circuit affirmed. Subsequently, this suit was brought against Cowen for negligent representations and professional negligence under California law. Defendants removed the action under SLUSA and the district court granted a motion to dismiss.

The Ninth Circuit reversed. SLUSA generally precludes covered class actions from being brought in state court the Circuit Court noted. There are exceptions, however. The Delaware carve-out, Section 16(d) of the Securities Act and Section 28(f) of the Exchange Act were added to SLUSA to “preserve state-law actions brought by shareholders against their own corporations in connection with extraordinary corporate transactions requiring shareholder approval, such as mergers and tender offers, regardless whether the corporations issued nationally traded securities.”

There are five key elements to the Delaware carve-out: 1) the suit must be based on the law of the state in which the issuer is incorporated; 2) it must involve a communication with respect to the sale of the issuers securities; 3) the communication must be made for or on behalf of the issuer or an affiliate; 4) it must be to shareholders of the issuer; and 5) it must concern specified shareholder decisions including a response to a tender offer or an exchange offer. If these elements are met the suit cannot be removed.

Here, the suit clearly falls within the Delaware carve-out. The case is based on California state law where the issuer, St. Joseph, is incorporated and it involves a communication concerning an exchange offer for securities. Accordingly, the carve-out applies, according to the Court.

Defendants claim however, that that St. Joseph is not an issuer within the meaning of the exception. This claim is based on the argument that the word “issuer” in the carve-out means “covered issuer.” The latter is a defined term which generally refers to publicly traded shares. The former is not a defined term. After examining the plain language of the statute, the court concluded that there is nothing which limits the undefined term “issuer” to the scope of the defined term “covered issuer” in the carve-out. Accordingly, the Court rejected the argument and, since the carve-out applies, reversed the lower court.