In an era of widespread “hacking” and theft of confidential information, nearly all organizations have an interest in ensuring that email communications are secure.  Law firms protect the confidentiality of email communications by using elaborate security measures including robust firewalls and difficult-to-crack passwords.   Within the legal industry, such measures have been deemed sufficient to justify continued use of ordinary email programs such as Microsoft Outlook to communicate confidential information relating to, among other things, non-public SEC investigations.  However, about two years ago, the SEC evidently concluded that such measures were insufficient, and started using a web-based encrypted email program (“smail”) operated by Nasdaq-listed ZixCorp.   Many staff members (particularly in Western SEC regional offices) have resisted using smail, but the agency apparently has made it mandatory, and the trend is towards more widespread deployment.

When a member of the SEC Enforcement staff sends a “Smail” email to opposing counsel, the recipient receives a message stating: “You have a U.S. Securities and Exchange Commission Secure Email message from [email address of staff member].”  To view the secure message, click here.”  The recipient must then fill out a web page “form” that requires them to enter their email address and password, which must meet the SEC’s security requirements.   Only then can the recipient read and/or reply to the email.

Assuming that the SEC’s use of encrypted emails is necessary and justified (which I doubt), smail poses several operational disadvantages compared to regular email.  The most obvious disadvantage is the inconvenience of not being able to read, or respond to, the message using one’s regular Outlook email program.  This is not a major problem for desktop users who are able to easily launch Internet Explorer or some other web browser, but it can present significant difficulties for users who are traveling or otherwise out of the office.  Older PDAs and smartphones (such as my old Blackberry) offer less than satisfactory Internet access, both in terms of slowness and poor navigational capabilities.  In practice, I could not access “smail” message using my old Blackberry.  Given the time-sensitivity of many e-mail communications with the Enforcement staff, the Web-based nature of smail operates as a disadvantage for the defense bar.

The program’s undisclosed miserly email retention policy presents other problems.  Sent and received emails apparently are kept for only 90 days, and there is no obvious way to archive or store older emails.  For instance, users may not store older emails in folders created for that purpose.  Given the importance of email communications, which the Enforcement staff is using smail to send subpoenas and correspondence, the SEC’s unwillingness to provide users with a means of storing emails is inexcusable.  Members of the defense bar should make a practice of cutting and pasting smail email communications so they can be saved as Word documents or otherwise archived on their own network. 

Over the last several years, many Chinese companies, with the assistance of underwriters including WestPark Capital, engaged with reverse mergers with public shells, enabling the companies to trade on U.S. exchanges without going through the regulatory scrutiny entailed by an IPO.   These transactions gave the companies access to U.S. capital markets, but also subjected them to U.S. law, including the requirement to file financial statements audited by a PCAOB-registered firm with the SEC. 

Eager to profit from the booming Chinese economy, many smaller North American firms held themselves out as having Chinese capabilities.  With the assistance of local Chinese accounting firms that did the actual fieldwork, the U.S. firms issued a series of unqualified, “clean,” audit opinions.

Starting in 2010, the PCAOB started to crack down on registered audit firms doing business in China.  In a March 14, 2011 report  about accounting and auditing standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S. publicly traded companies through reverse mergers, the PCAOB a number of factors that may undermine the ability of audit firms to complete their audit functions completely or effectively.

MaloneBailey, identified in the PCAOB report as the U.S.-based firm with the most Chinese reverse merger company clients, was also the subject of a negative PCAOB inspection report dated February 24, 2011.  This inspection report stated that “[i]n some cases, the deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had  not obtained sufficient competent evidential matter to support its opinion on the issuer's financial statements.”  In my experience, reports containing such findings are routinely referred to the PCAOB enforcement staff for prosecution. 

In apparent reaction to the risks presented by its Chinese clients,  during the spring of 2011, Malone Bailey  resigned as auditor for NIVS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media and accused these companies of fraud.  As a result, the audits of the companies’ financial statements were not completed in time to enable the companies to file Forms 10-K for their 2010 fiscal years.   All of the companies were required to launch costly internal investigations, are in the process of being delisted from various exchanges and are besieged by SEC investigations and shareholder lawsuits.  The SEC recently instituted stop order proceedings against China Intelligent Lighting and China Century Dragon Media Inc. on suspicion of accounting fraud.

None of these companies have yet restated their financials or disclosed the results of their internal investigations, so it is unclear whether MaloneBailey’s allegations have merit.  Only time will tell whether the firm, having failed to detect fraud in prior periods it audited, reacted appropriately to indications of impropriety observed as the result of more stringent audit procedures, or simply threw its Chinese clients under the bus to improve its standing with the PCAOB, to the great detriment of these companies and their shareholders. 

 

 

 

 

 

 

including WestPark Capital, engaged with reverse mergers with public shells, enabling the companies to trade on U.S. exchanges without going through the regulatory scrutiny entailed by an IPO.   These transactions gave the companies access to U.S. capital markets, but also subjected them to U.S. law, including the requirement to file financial statements audited by a PCAOB-registered firm with the SEC. 

Over the last several years, many  U.S. audit firms eager to profit from the booming Chinese economy, held themselves out as having Chinese capabilities.  With the assistance of local Chinese accounting firms that did the actual fieldwork, the U.S. firms issued a series of unqualified, “clean,” audit opinions.

Starting in 2010, the PCAOB started to crack down on registered audit firms doing business in China.  In a March 14, 2011 report  about accounting and auditing standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S. publicly traded companies through reverse mergers, the PCAOB a number of factors that may undermine the ability of audit firms to complete their audit functions completely or effectively.

 

MaloneBailey, identified in the PCAOB report as the U.S.-based firm with the most Chinese reverse merger company clients, was also the subject of a negative PCAOB inspection report dated February 24, 2011.  This inspection report stated that “[i]n some cases, the deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had  not obtained sufficient competent evidential matter to support its opinion on the issuer's financial statements.”  In my experience, reports containing such findings are routinely referred to the PCAOB enforcement staff for prosecution. 

 

In apparent reaction to the risks presented by its Chinese clients,  during the spring of 2011, Malone Bailey  resigned as auditor for NIVS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media and accused these companies of fraud.  As a result, the audits of the companies’ financial statements were not completed in time to enable the companies to file Forms 10-K for their 2010 fiscal years.   All of the companies were required to launch costly internal investigations, are in the process of being delisted from various exchanges and are besieged by SEC investigations and shareholder lawsuits.  The SEC recently initiated stop order proceedings against China Intelligent Lighting and China Century Dragon Media Inc. on suspicion of accounting fraud.

 

None of these companies have yet restated their financials, so it is unclear whether MaloneBailey’s allegations have merit.  Only time will tell whether the firm, having failed to detect fraud in prior periods it audited, reacted appropriately to indications of impropriety observed as the result of more stringent audit procedures, or simply threw its Chinese clients under the bus to improve its standing with the PCAOB, to the great detriment of these companies and their shareholders.

 

 

 

 

 

 

 

 

 

 

In July 2010, the state of Colorado amended the law governing the types of events that can lead to disciplinary proceedings by the Colorado Board of Accountancy against CPAs and CPA firms, to specify that such events include “Discipline taken against the person's right to practice before” the PCAOB.  See §§ 12-2-123 and 12-2-124, C.R.S.  Previously, the law did not specify that PCAOB proceedings could justify the imposition of state disciplinary proceedings. These changes highlight the difficulties faced by CPAs and accounting firms that have received notice of an intended PCAOB disciplinary proceeding by the PCAOB’s Division of Enforcement, and are considering whether to settle.  These proceedings typically arise from purported audit deficiencies identified by PCAOB inspectors.    

In deciding whether to settle, individuals and firms under threat by the PCAOB must carefully consider the law of the state(s) in which they are licensed.  For instance, New York law is more limited than Colorado law, defining “unprofessional conduct” as including “having been found guilty of improper professional practice or professional misconduct in a disciplinary proceeding brought by the United States Securities and Exchange Commission or the Public Company Accounting Oversight Board, where the conduct upon which the finding or admission of guilt was based would, if committed in New York State, constitute professional misconduct under the laws of New York State.” See Rules of the Board of Regents § 29.10(f) (emphasis supplied).   This leaves open the possibility that a settlement order based on a particular PCAOB standard  or rule does not support the New York State Board of Public Accountancy’s disciplinary proceedings.  In contrast, certain other states, including Florida, do not specifically mention PCAOB orders as a basis for disciplinary proceedings.  See, e.g., Fla. Stat. § 473.323. 

 The likelihood of sanctions by a particular state disincentivizes individuals and firms from settlement with the PCAOB, and is likely to increase the number of cases litigated by the PCAOB.   Although individuals and firms may be able to survive a temporary or permanent PCAOB sanction depriving of their ability to perform public company audits, states have the power to take away someone’s CPA license.  Such a license is needed to practice public accountancy, which entails issuing or preparing any audit report, including reports relating to privately held entities.  Defense lawyers and clients therefore must weigh the benefits of settlement with the PCAOB, which include avoiding the costs and risks of litigation with that organization, against the costs and risks associated with Board of Accountancy investigations and/or litigation.   Individuals and firms in this difficult situation should engage experienced counsel qualified to advise them about the collateral consequences of settlement.  They also should ensure that they have the maximum amount of insurance coverage pursuant to a policy that clearly covers state and PCAOB disciplinary proceedings.