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Federal Court Limits Sarbanes-Oxley Protection to PCAOB-Auditor Documents Prepared Specifically for the Board

By Jim Hamilton

Sarbanes-Oxley provisions protecting PCAOB-auditor documents from disclosure are expressly limited to materials that an audit firm prepared specifically for the Board, ruled a federal judge, and do not protect from discovery documents related to or concerning the Board?s inspection process. Indeed, the plain language of Section 105(b)(5)(A) makes clear that Congress did not create a blanket privilege regarding the PCAOB inspection process. Thus, in a securities fraud action alleging that a company failed to disclose the effect of significant financial transactions in violation of GAAP and SEC rules, the outside auditor was ordered to produce all documents on the accounting and disclosure of the transactions that were not prepared specifically for the PCAOB. In addition, the audit firm must give the investors a privilege log describing the nature of any documents that it has withheld pursuant to Section 105(b)(5)(A). (Silverman v. Motorola, Inc. et al., ND Ill, June 29, 2010, No. 07 C 4507).

Section 105(b)(5(A) is a clear and unambiguous provision that protects from disclosure only materials that an accounting firm prepared specifically for the Board. Since there is no ambiguity in this statutory provision, noted the court, there was no need to look any further than the text of the statue in order to resolve the discovery issue. Inclusion of the phrase "specifically for the Board" makes clear that the statute is applicable to only a portion of any information or documents that may derive from, refer to, or relate to a PCAOB inspection. The court rejected KPMG?s assertion that the statutory protection includes any documents related to or concerning the PCAOB inspection process since to accept the firm?s premise would extend interpretation of the provision beyond its plain language and render meaningless the phrase "specifically for the Board."

The court similarly rejected an assertion set forth by the Center for Audit Quality in its amicus brief that internal KPMG documents relating to the inspection process are prepared specifically for the Board because absent the inspection they would never have been created in the first place. If Congress intended the privilege to protect all materials related to a Board inspection, reasoned the court, the text of Section 105(b)(5)(A) would reflect that intention. Instead, the statute limits the protection to materials prepared specifically for the Board. Despite arguments by KPMG and CAQ regarding the legislative history of Sarbanes-Oxley, the court said that it did not need to consider legislative history because the plain language of the statute is clear and there was no need to judicially look beyond its text.

The court also rejected KPMG?s contention that documents relating to the PCAOB's inspection of the firm?s audit practice are irrelevant to this litigation because violations of accounting and auditing standards are generally insufficient to support a securities fraud claim. Because the defendants have placed their accounting at issue by contending that the company acted in conformance with GAAP, noted the court, they have necessarily placed KPMG's communications regarding the corporate transactions directly at issue. Given that the PCAOB conducted an investigation of KPMG to determine whether its audits complied with professional standards, and that the PCAOB made specific findings regarding deficiencies associated with the firm?s auditing procedures of the transactions, continued the court, these documents are directly relevant to this litigation.

Also rejected was the firm?s assertion that the requests for the documents were unduly burdensome. The audit firm has already produced documents in this litigation, noted the court, and the requests at issue are limited in time and scope. In addition, the investors agreed to reimburse the firm for reasonable production and copying costs and only requested to take the depositions of two KPMG professionals.

Full post as published by Jim Hamilton's World of Securities Regulation on November 10, 2010 (boomark / email).