Regulatory risks faced by Auditors: the calm before the wave?

Much has been written about the scope of auditor liability. Even more ink has been spilled about the increasing prevalence of civil litigation against auditors and accountants, such as the recent court decisions against the auditors of Livent Inc. and Castor Holdings Ltd., the landmark settlement by the auditor of Sino-Forest Corporation, primary and secondary market class actions against auditors of reporting issuers, and lawsuits by third parties as in the ongoing saga of Philip Services Corp. In our view, the plethora of commentary on auditor liability fails to account for the increasing risks that auditors face from securities regulators.

The Old World Order: auditor oversight was typically left to self-regulatory organizations

Prior to 2010, we found no reports of enforcement proceedings between an auditor and a Canadian securities regulator. Auditor oversight was generally left to self-regulatory organizations, such as the Institute of Chartered Accounts of Ontario.

In the wake of the Enron scandal, the Canadian Public Accountability Board (CPAB) was created as Canada’s audit regulator with the aim of contributing to public confidence in the integrity of financial reporting of reporting issuers. Securities regulation was enacted to require that all auditors of Canadian reporting issuers be registered and in good standing with the CPAB, which could impose restrictions or sanctions on its members.

In the old world order, an auditor’s interaction with a securities regulator typically occurred in the context of being compelled to provide information about the auditor’s client, with the scope of production or disclosure being the subject of negotiation and potentially, litigation. This scenario played out fully in Deloitte & Touche LLP v. Ontario (Securities Commission),1 which went all the way to the Supreme Court of Canada.2

As a general proposition, auditors – especially the large established firms – were trusted to function as gatekeepers to ensure appropriate financial disclosure and also trusted to police themselves, as a profession, to ensure that auditors fulfilled that function.

Is the Old World Gate Broken?

In the United States, the Securities and Exchange Commission (SEC) has formally designated its ongoing efforts to identify auditors who fail to carry out their duties consistent with their professional standards as "Operation Broken Gate".3 In a speech on September 19, 2013, the SEC’s Co-Director of the Division of Enforcement stated:

"… we will continue to focus on auditors. … auditors play a crucial role in the financial reporting process by serving as the ‘public watchdog.’ So, it is important that we carefully monitor their work and ensure that they fully comply with their professional obligations. If there is a significant restatement or if we learn about improper accounting from a whistleblower, our proactive efforts, or the media, then you can expect that we will scrutinize not only the CEO, CFO and Controller, but also the engagement partner, engagement quality reviewer, and the auditing firm as a whole. We are going to probe the quality of the audit and determine whether the auditors missed or ignored red flags, whether they have proper documentation, and whether they followed professional standards."4

Operation Broken Gate is in full swing. In the last six-months, the SEC has entered into several administrative settlements with auditors, including with KPMG LLP in relation to the violation of rules requiring auditors to remain independent from their clients.5 The SEC was also successful in a controversial ruling against the Chinese affiliates of the Big Four accounting firms for not producing documents related to China-based companies under investigation by the SEC.6

The New World Order: securities regulators get serious about auditor oversight

As in many other areas, it appears that Canadian securities regulators are increasingly showing signs of following the American lead. Currently, the Ontario Securities Commission (OSC) has two enforcement proceedings against auditors. It is critical for auditors to appreciate that these proceedings by the OSC, which appear to have bypassed the CPAB, are likely not anomalies. In fact, the OSC’s recent crackdown on auditors was largely predictable.

On November 1, 2011, Howard Wetston, the Chair and CEO of the OSC informed market participants that the OSC’s preliminary findings had uncovered important information about the role of gatekeepers and boards, specifically governance challenges where the management and bulk of operations are located in a foreign jurisdiction.7 On March 20, 2012, the OSC published a staff notice8 summarizing its review of emerging market issuers and outlining principal sources of concern relating to, among other things, disclosure and the role of auditors. At the time, Mr. Weston publicly stated:

"The OSC expects issuers and gatekeepers to act in a manner that promotes investor protection and supports confidence in our capital markets … This review uncovered a number of areas where issuers and gatekeepers need to improve in order to meet their obligations and we will be monitoring their progress to ensure the interests of investors are placed first."9

Any skepticism about auditor oversight being a priority for securities regulators was laid to rest on October 17, 2013 when the Canadian Securities Administrators (CSA), an umbrella organization of Canada’s provincial and territorial securities regulators, published revisions to auditor oversight rules10 that would give securities regulators greater oversight in situations where the CPAB has imposed significant remedial actions on an auditor. The Chair of the CSA stated the following about the proposed rules:

"Auditors are key gatekeepers … Receiving information about audit firms enables securities regulators to better assess systemic issues and consider, in a timely manner, whether regulatory action is needed."11

Is the Wave Coming?

Securities enforcement against auditors has arrived in Canada. In 2012 and 2013, the OSC initiated separate proceedings against Ernst & Young LLP for alleged breaches of the Securities Act12 in relation to its audits of Sino-Forest Corporation13 and Zungui Haixi Corporation14 respectively. In both proceedings, the OSC is seeking a reprimand, an administrative penalty which could be as high as $1 million, the disgorgement of any amounts obtained by the auditor as a results of its non-compliance with securities law, and the costs of the OSC’s investigation and prosecution.

There should be no doubt that Canadian securities regulators will take a direct interest in the auditor of a reporting issuer facing financial reporting allegations. In our view, the lack of enforcement proceedings by Canadian securities regulators against the auditors of Nortel Networks Corporation, Livent Inc. and Philip Services Corp. should be seen as last vestiges of the old world order; these exceptions may not be followed in the new world order.

Taking Shelter: seeking timely legal advice is critical

When approached by a securities regulator, an auditor should seek timely legal advice. Although the advice will be tailored to the auditor’s specific circumstances, the following issues may need to be considered:

  • An auditor may need to respond to regulatory information requests without knowing whether a formal investigation or enforcement proceeding will be started. These responses should be verified for accuracy and carefully drafted with a litigation strategy in mind.
  • Investigative steps taken prior to or in lieu of contested proceedings are becoming routine and are critical to addressing regulatory concerns and preserving the auditor’s ability to seek credit for cooperation or to litigate, if necessary.
  • When sharing information with a securities regulator, careful consideration should be given to the auditor’s confidentiality obligations to the client and the client’s claims of privilege over information in the auditor’s possession.
  • The SEC and other Canadian securities regulators have historically cooperated with each other. Therefore, any response to one regulator should consider its effect, if any, on ongoing or potential proceedings by other regulators.
  • Self-reporting breaches of securities legislation may be considered in the appropriate circumstances. The OSC has recently issued credit-for-cooperation guidelines,15 which – in theory – would allow a party to resolve regulatory issuers in an efficient and cost effective manner, perhaps by way of a no-enforcement agreement (where an enforcement proceeding is either not commenced or discontinued) or a no-contest settlement (where an auditor settles without admitting any wrongdoing). Legal advice is critical to explore whether these outcomes are achievable and appropriate in the circumstances.
  • Plaintiffs in lawsuits, including class actions, in which an audit firm is a defendant, may launch parallel (and pre-emptive) complaints to securities regulators with a view to obtaining additional ammunition to use in the civil claim (at little or no cost to the plaintiffs).
  • A settlement agreement with a securities regulator is public and, generally speaking, can be used in civil cases against the auditor.
  • Settling a regulatory proceeding does not necessarily protect an auditor from exposure to class actions, even where the regulatory proceeding results in restitution to putative class members.
  • Even relatively minor violations of securities legislation may prompt regulatory action. The SEC’s Chair confirmed that a "broken windows" approach to securities enforcement is being applied to ensure that minor violations do not fester into larger regulatory issues.16
  • Auditors can face criminal and quasi-criminal liability for breaches of securities legislation. For instance, it is an offence under the Securities Act of Ontario17 to make a materially misleading or untrue statement or omission in any document required to be filed or submitted to the regulator. A violation of this provision could lead to a fine of as much as $5 million and/or imprisonment for a term of up to five years less a day.

As securities regulators strive to find ways to prevent broken windows from becoming broken gates, it is not surprising that they have ventured into areas once left to self-regulatory control. In a new world where information is generally widely available and instantaneously accessible, regulators must be seen to be proactive rather than deferring to self-regulatory bodies to investigate their members. Moreover, with American securities regulators flexing their muscles in these new domains, there should be no surprise when Canadian authorities follow suit.

The wave is coming, and auditors who fail to prepare risk being swept under by the growing power of the tide.

1 Deloitte & Touche LLP v. Ontario (Securities Commission), 2003 SCC 61.

2 The Supreme Court upheld the production of material compelled from the auditor since it was required by the respondent issuer -- also the auditor’s client -- to defend itself in the proceeding commenced by the Ontario Securities Commission.

3 Release No. 2013-207, September 30, 2013, See

4 Speech by Andrew Ceresney, Co-Director of the Division of Enforcement, to American Law Institute Continuing Legal Education, Washington, D.C, September 19, 2013. See

5 File No. 3-15687, See Settlement,

6 The auditors have indicated that they will appeal the decision rendered by SEC administrative judge Cameron Elliot on January 22, 2014. Among other things, the auditors argued that production of the information sought by the SEC would violate Chinese law, thereby subjecting their employees to jail time.

7 OSC Chair Howard Wetston Outlines OSC’s Approach to Regulating in the New Financial Reality, November 1, 2011, See

8 Staff Notice 51-720, "Issuer Guide for Companies Operating in Emerging Markets".

9 OSC Report Outlines Concerns Related to Emerging Markets Issuers, March 20, 2012, See

10 National Instrument 52-108, "Auditor Oversight".

11 CSA Seeks More Information About the Quality of Audit Firms Through Proposed Changes to Auditor Oversight Rule, October 17, 2013, See

12 Securities Act, RSO 1990, c S.5.

13 No determination has been made in this case, which is currently scheduled for a hearing on the merits commencing on November 11, 2014.

14 No determination has been made in this case, which is currently scheduled for a hearing on the merits commencing on May 1, 2015.

15 OSC Staff Notice 15-702, "Revised Credit for Cooperation Program".

16 Speech by Chair Mary White at the Securities Enforcement Forum in Washington, D.C., October 9, 2013, See

17 Section 122, Securities Act, RSO 1990, c S.5.