Accountable Independence: SEC Sues Indemnified Audit Firm
Tuesday, November 28, 2023

One of the critical attributes required of an accounting firm that desires to perform audits of a business’s financial statements is INDEPENDENCE. This is not just a descriptive term referring to the separation of the accounting firm from the business being audited; it is in fact a very technical regulatory requirement enshrined in regulations of the U.S. Securities and Exchange Commission (“SEC”) since the earliest days of the Commission. The primary SEC pronouncement concerning the financial statements of public companies is found in Regulation S-X, first promulgated in 1940. Over 40 years ago in 1982, in connection specifically with the responsibilities of accounting firms performing audits of those statements, the SEC issued its “Codification of Financial Reporting Policies” (the “Codification”) to “provide current, meaningful guidance to registrants’ [i.e., public companies’], INDEPENDENT [emphasis added] accountants and others in complying with the Commission’s requirements.” Pursuant to the applicable SEC regulations, audits performed by an accounting firm that is not independent are not acceptable audits; and any statement by the non-independent firm to the contrary is probably a fraud on the audit client and, perhaps more importantly, on any recipient of the audit report including the investing public.

The requirement for independence in an accounting firm that audits financial statements has been a recurring topic discussed by Paul Munter, Acting Chief Accountant of the SEC. His Aug. 29, 2022 Statement reminded all accounting firms practicing before the Commission of their need to maintain independence, i.e., to avoid even the appearance of a potentially conflicting relationship with an audit client. See the discussion of that Statement in my Oct. 3, 2022 Blog “Independence Days: SEC Acting Chief Accountant Guides on PE Investment and Consultant Divestiture.” The Statement made clear that the SEC was very concerned that certain investment relationships could compromise the independence of the accounting firm. The topic came up again in connection with the proposed division of Ernst & Young into two firms, one to do audits and the other to consult, all as discussed in my Aug. 1, 2022 blog “Who Are You?: Auditor or Consultant, and Still Cheating on Exams.” As laid out in my Dec. 21, 2021 Blog “Uniform Independence: SEC Sanctions Accountants and Lawyers,” so-called “value added” billing was held to be a form of contingent compensation that made the accounting firm recipient lose its independence vis-à-vis the audits the firm performed. Another facet of the independence requirement is that the accounting firm bear the risks related to the performance of its audit services. As the Preliminary Note to SEC Rule 2-01 of Regulation S-X states concerning accounting firm relationships, the Commission evaluates whether a particular relationship:

“Creates a mutual or conflicting interest between the accountant and the audit client; places the accountant in the position of auditing his or her own work; results in the accountant acting as management or an employee of the audit client; or places the accountant in a position of being an advocate for the audit client.”

Since at least 1982, the SEC has instructed that indemnification of the accounting firm by the audit client to provide financial protection for the accounting firm in connection with its performance of audit services “impair[s] auditor independence.” Indeed, the Codification expressly provides:

“When an accountant and his client…have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, one of the major stimuli to objective and unbiased consideration of the problems encountered in a particular engagement is removed or greatly weakened… Consequently, the accountant cannot be recognized as independent for the purpose of certifying the financial statements of [a client].”

That position has been restated periodically, including in SEC releases in 2004. Moreover, it is consistent with similar guidance in 2006 from other federal regulators found in the “Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit Engagement Letters”. Further, SEC independence requirements were expressly adopted by the Public Company Accounting Oversight Board (“PCAOB”) after its creation as an affiliate of the SEC pursuant to the Sarbanes-Oxley legislation of 2002. An accounting firm wishing to perform audit work for a public company must be registered with the PCAOB.

PRAGER METIS CPAs, LLC

The accounting firm of Prager Metis CPAs, LLC (“PM”), headquartered in New York City, has been registered with PCAOB since 2003. According to PM’s website:

“Prager Metis is a top international advisory and accounting firm with over 100 partners and principals, more than 600 team members, and twenty-three offices worldwide including New York, New Jersey, California, D.C. Metro, Connecticut, Florida, Massachusetts, Nevada, North Carolina, London, UK, Chennai, India, and the Metaverse.”

In 2013 Prager and Fenton LLP combined with Metis Group LLC, but (according to the firm’s website) its antecedents date back 100 years. The website avers “[c]lients come to Prager Metis for the expert advice that protects and grows the value of their world.” As of the time period December 2017 through October 2020, PM had 54 public company clients as well as four Broker/Dealers, and one Register Investment Adviser. According to the Complaint (the “Complaint”) filed by the SEC in the U.S. District Court for the Southern District of Florida on Sept. 29, 2023, during that same period, PM performed 62 audits, 11 examinations, and 144 reviews of the financial statements of those clients. Of the 62 audits, 54 were for public company clients. PM earned more than $3,000,000 for these audits, exams, and reviews, each one of which was undertaken pursuant to one of 87 engagement letters. Each of those letters contained a paragraph in which the client undertook one of two indemnification variants:

A. In 77 letters:

“In the event that we become obligated to pay any judgment, fine, penalty, or similar award or sanction; agree to pay any amount in settlement: and/or incur any costs including legal fees…and if such obligation is a direct or indirect result of any inaccurate or incomplete information that you provide to us during the course of this engagement…you agree to indemnify us, and hold us harmless as against such obligations, agreements and/or costs.”

B. In 14 letters:

“…the Company agrees to release and indemnify [Prager] and its personnel from any liability and cost relating to our services under this agreement attributable to any knowing misrepresentations by management.”

PM was not independent as to any of the audits performed pursuant to any of those engagement letters. Hence, any of the audit reports provided by PM in those cases (each of which stated that it was a “Report of Independent Registered Public Accounting Firm”) was effectively a fraud upon the client and upon any recipient of the report. The Complaint notes that a new PM partner on Jan. 9, 2019, called to the attention of the PM management the independence issue raised by the indemnification provisions in the PM engagement letters. But according to the Complaint, PM continued to use the same letter form for an additional 51 engagement letters, not correcting the template until Dec. 9, 2019.

Only after October 2020 did PM adopt a policy prohibiting indemnification provisions in engagement letters. Further, PM was required as a PCAOB registered accounting firm to inform the audit committees of clients “at least annually… in writing with the audit committee of the client all relationships between [PM] and the client that ‘may reasonably be thought to bear on independence…’ [and to] affirm in writing that [PM] was independent.” This was not done, i.e., PM did not bother to inform its audit clients that PM had violated the law and made audit reports that were noncompliant with federal securities law, so that the clients were themselves in violation of the law.

On Sept. 11, 2020, the PCAOB sent two inspection teams to PM as part of its regular accounting firm reviews. Each of the inspection teams identified the indemnification paragraph in the engagement letter with a public company and notified PM of the deficiency and that the audits provided to those issuers were in violation of the respective issuer’s periodic disclosure obligations under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Indeed, the Complaint asserts the following:

[I]n annual and quarterly reports filed with the Commission, [PM]’s issuer clients included certifications by their principal executive and financial officers that the reports fully complied with Exchange Act Section 13(a) or 15(d) requirements, which include… [having] independent accountants auditing, reviewing, or certifying the financial statements included in those reports. A reasonable investor…would consider as material: that [PM] was not independent when it was purporting to be [such]; that [PM] was not ‘capable of exercising objective and impartial judgment…’; and that…[PM]’s issuer and broker dealer clients’ financial statements and client assets in the custody of an investment adviser had not been audited, reviewed, certified, or examined by an independent accountant, as required under the federal securities laws.

On Sept. 25, 2020, PM responded to PCAOB conceding that the indemnification paragraphs were non-compliant. PM, after consulting with its insurance carrier, adopted a new template for its engagement letters. According to the Complaint PM did not, however, inform PCAOB that:

  1. it had been including the indemnification paragraphs in all engagement letters since 2017;
  2. PM had been on notice of the problem since at least January 2019, when a new lateral PM partner raised the issue; or
  3. even after adopting a new engagement template PM signed five new engagements using the old form.

Nor did PM inform PCAOB that even after all that, PM entered into an engagement with a public company on Oct. 28, using the old template.

Based on the demonstrated failures by PM to comply with applicable SEC regulations, the Commission in the Complaint alleges that:

a) PM violated Rule 2-02(b) of Regulation S-X with respect to 42 issuer clients;

b) PM aided and abetted violations by identified members of its clients of Sections 13(a) and 15(d) of the Exchange Act and Rules 13a-1, 13a-11, 13a-13, 15d-1 and 15d-13 thereunder;

c) PM violated Section 17(a) of the Exchange Act and Rules 17a-5(i) thereunder with respect to four broker/dealer clients;

d) PM also aided and abetted those four broker/dealer clients in violating Section 17(a) of the Exchange Act and Rule 17a-5 thereunder; and

e) PM aided and abetted four investment adviser clients in violating Section 206(4) of the Investment Advisers Act of 1940, as amended (the “IA Act”) and Rule 206(4)-2 thereunder.

The Commission asks the Court to:

  1. permanently enjoin PM and its officers, agents, servants, employees, attorneys, and anyone else acting in concert with them from future violations of the cited SEC laws and regulations;
  2. order the disgorgement of ill-gotten gains together with prejudgment interest; and
  3. order the payment of civil money penalties pursuant to provisions of the Exchange Act and the IA Act.

Attached to the Complaint as Exhibit I is a 15-page listing of the 62 PM clients (each identified only by number) and the SEC filings and corporate documents that included the deficient PM audit reports.

It is difficult to accept PM’s assertions that it is a professional firm that can claim “[c]lients come to Prager Metis for the expert advice that protects and grows the value of [the client’s] world;” no matter what the PM website says.

 

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