Application of the "Failure to Supervise" Provision of the Sarbanes-Oxley Act of 2002 and Solicitation of Comment on Rulemaking Concepts

Public company auditing, especially in the large firm context, is heavily dependent on proper supervision. Engagement teams are not sent out on their own to conduct audits as they see fit. On the contrary, firms have detailed audit manuals and elaborate systems of quality control, designed to insure that engagements are conducted in accordance with firm practice and with the applicable auditing standards. The effectiveness of these tools is, in turn, largely a function of the skill and diligence of the supervisory personnel throughout the firm's hierarchy who are charged with implementing them. Firms obviously cannot act, or fail to act, independent of their personnel; the actions of the firm are those of its partners and staff. When something goes wrong in an audit, the problem can frequently be traced to some type of supervisory breakdown.

The Sarbanes-Oxley Act recognized the key role that proper supervision plays in auditing and the key role that supervisory failure often plays in audit failure. Section 105(c)(6) of the Act authorizes the Board to impose sanctions for a failure to reasonably supervise an associated person who has violated the Board's standards or the law. The Act also creates a defense that supervisors may invoke when they are charged with failure to supervise. That defense depends on the firm having established reasonable supervisory procedures, the individual having discharged his or her responsibilities under those procedures, and the absence of any reasonable cause to believe that the procedures were not being followed.

This structure of sanctions for failure to supervise, coupled with an affirmative defense based on adequate procedures and good faith compliance, has been a familiar feature of the securities broker-dealer landscape for many years. Sarbanes-Oxley borrowed those concepts and directed the Board to apply them to auditors. So far, however, the Board has never brought a failure to supervise case. Since sanctions for failure to supervise are new to the world of auditing, it may therefore not be entirely clear how and when the Board intends to exercise this authority.

The release the Board is issuing today seeks to address those questions. The release outlines the basics of the statutory failure to supervise provisions and explains how the Board interprets them. The discussion is necessarily somewhat abstract. Although the release lays out the general parameters of supervisory failure, not every possible application can be spelled out in detail in advance.

It is important to stress that this release is not intended to inaugurate a new framework for auditor supervision or to usher in a new era in which members of firm management can be charged whenever something goes wrong in an audit. The audit and quality control standards that the Board inherited from the profession contained supervisory and quality control requirements. Those have always been enforceable and remain the principal source of supervisory responsibilities. Neither Section 105(c)(6) nor the release impose new supervision requirements.

For that reason, engagement partners, individuals in charge of firm quality controls, or managing partners and practice heads should not interpret the Board's action today as opening the door to liability for failing to meet any new or different standards of conduct than those they should have been meeting all along. They should, however, recognize that the release does mean that the Board is prepared to address supervisory failures when they occur, on a case-by-case basis, through its Enforcement program.

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Many individuals worked on the release, and I would like to thank all of them for their efforts. They include Michael Stevenson, who headed the project, and Carole Yanofsky, both of whom are in the General Counsel's Office. Bella Rivshin and Chris David in the Office of the Chief Auditor, and Claudius Modesti and Mark Kaprelian in the Division of Enforcement and Investigations, also played important roles. Our colleagues at the SEC have also devoted much time and attention to the release, and I appreciate their helpful and supportive input.

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