SEC Chief Accountant: the Potential Pitfalls of Purported Crypto "Assurance" Work
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In the wake of recent scandals and insolvencies within the crypto industry, there has been a growing concern about the firms, including accounting firms, that provide professional services to web3 companies. Some web3 companies advertise their retention of third-party firms, including accounting firms, to conduct reviews of specific aspects of their business, often presented as a "audits," which, in the accounting world, has a very specific meaning and use. This blog post aims to shed light on the potential hazards and risks to professional service providers emphasizing the responsibilities and risks professional service providers must be aware of when engaging in alternative-audit services for web3 clients. The key takeaway from the Staff - it is crucial to understand (and disclose ) that alternative-audit arrangements, despite their increasing prevalence, are not the same as traditional financial audits, and do not necessarily hold the same level of rigor and comprehensiveness, and, therefore, may not provide the level of disclosure expected by investors (or required by regulators).
Professional Services - Open to Heightened Risk?
Looking to the statements made by the SEC’s Chief Accountant, it is clear that the view of the Staff is that, before accepting any engagement, firms should meticulously consider the statements made by itself or its clients regarding the scope of work performed and the procedures followed. Statements in these areas, if deemed to be misleading, could lead to legal liability for the accounting firm itself under the antifraud provisions of the federal securities laws. In situations where clients misrepresent the nature of an accounting firm's work, the onus is on the accounting firm to take appropriate actions, such as a "noisy withdrawal," to disassociate itself from the client. While this would be terrible customer service, it may be required in order to avoid potential liabilities on the part of the firm.
Looking further in Mr. Munter’s statement, accounting firms are urged to evaluate the risks and responsibilities during their client acceptance procedures. To prevent misinterpretation, contractual prohibitions can be implemented, restricting non-audit clients from making misleading references to terms such as "audit," "GAAS," "PCAOB standards," and "PCAOB inspections."
When dealing with new market entrants in the crypto industry that may pursue a public offering in the future, accounting firms sometimes provide limited non-audit consultation services with the intention of later accepting an audit engagement. However, Mr. Munter notes that firms taking this approach must assess whether these non-audit engagements could affect their independence and ability to meet applicable ethical requirements when accepting an audit engagement from the same client in the future, and make clear the result of such clarification efforts to the client.
Rule 2-01 of Regulation S-X is designed to ensure that auditors are both factually and perceptually independent when performing audits subject to the Staff’s independence requirements. The determination of independence considers all relevant facts and circumstances, including relationships between the accountant and the audit client. Any relationship or service that creates a mutual or conflicting interest between the accountant and the audit client can raise questions about independence.
What Should Accountants, in Particular, be Concerned With?
Accounting firms should carefully examine their public statements or assertions to avoid giving the impression of mutual interest with their audit clients or acting as advocates on their behalf. Failure to maintain independence may lead to sanctions, including suspension, under Rule 102(e) of the Commission's Rules of Practice.
Potential Liability Pursuant to Rule 102(e) of the Commission's Rules of Practice Violation of antifraud provisions or independence requirements may result in the censure or suspension of an accounting firm or its accountants from practicing before the Commission under Rule 102(e). The rule aims to ensure that professionals performing tasks relied upon heavily by the Commission do so with diligence and competence. Improper professional conduct by an accountant, including negligence or knowing violations of professional standards, can lead to sanctions under this rule. Given the significance of an accountant's independence in maintaining the integrity of the financial reporting system, any circumstances raising questions about independence will be subject to heightened scrutiny.
In the wake of the ongoing scrutiny surrounding Tether, the Hong Kong-based company behind the eponymous cryptocurrency, the world of crypto has been abuzz with discussions and concerns. Tether, a digital token intended to mirror the value of the U.S. dollar, is considered a "stablecoin" that offers investors a safer store of value than volatile cryptocurrencies like Bitcoin. However, its credibility and claims have come under intense scrutiny, leading to regulatory investigations and public doubt.
What About Law Firms and Other Professional Services Providers?
Recentluy, in an effort to address the growing skepticism, Tether hired Freeh, Sporkin & Sullivan (FSS), a Washington, D.C. law firm founded by former FBI director Louis Freeh, to conduct a comprehensive investigation into its compliance and transparency. FSS's engagement, although not an official audit, involved examining Tether's bank balances and verifying whether the company indeed held sufficient reserves to back its circulating tokens.
According to Louis Freeh, in an exclusive interview with Yahoo Finance, the first challenge in the investigation was "to size and understand the scope of what we were going to do." The firm wanted to ensure that the client understood that this investigation was not an official audit, and it would focus on due diligence and examination instead.
"We gave them the report, and they waived the privilege if they wanted to make it public," Freeh explained, highlighting the transparency of the investigation and the client's decision to publish the report. However, the fact that the investigation was conducted by a firm hired by the client led to some skepticism among critics.
Criticism and Skepticism (But is There Liability?)
Despite the positive findings of the FSS investigation, critics and skeptics have raised doubts about the report's credibility and objectivity. Some have questioned whether FSS's findings were influenced by Tether's engagement, calling the the firm's reputation into question. As discussed above, the issue impartiality often arises in internal investigations conducted by private firms, where potential conflicts of interest can cloud the objectivity of the findings.
In response to this criticism, Louis Freeh addressed the inherent challenges of conducting investigations as a private entity hired by a client. He stated, "That's one of the occupational hazards of this type of practice." He emphasized that maintaining their reputation and integrity is of utmost importance, and they ensure that their work remains consistent with the facts, regardless of the client's position.
Another point of contention was the relationship between FSS and one of Tether's banks, which raised concerns about possible conflicts of interest. Judge Eugene Sullivan, a partner at FSS, has a connection with one of Tether's banks. However, Freeh clarified that the judge was not involved in conducting interviews with the banking partners, and they took significant measures to minimize his engagement in the matter. They sought to maintain objectivity throughout the investigation.
Critically, FSS's investigation was not an official "audit" carried out by the "big four" accounting firms. FSS clarified that their engagement was focused on due diligence, examining accounts, and compliance procedures, rather than being a formal audit. This distinction led some to dismiss the investigation as a "phony audit."
Future of Non-Audit Audits
The Tether investigation marked FSS's first foray into the world of cryptocurrencies, and despite criticism, Louis Freeh and his team remain optimistic about the potential in this evolving sector. The firm's experience in money-laundering protocols and compliance requirements positions them to offer valuable services to companies operating in the crypto space.
"We're very comfortable with the procedure, and the scope of what we did, and the people who did it," said Louis Freeh. He expressed excitement about the work in the cryptocurrency space and the potential to offer innovative solutions to address the essential questions investors have.
To expand their capabilities in this area, FSS is actively recruiting experts in the cryptocurrency field. The firm is considering the possibility of creating a specific crypto group within the company. "We have a lot of experience in money-laundering protocols, looking at SEC guidance, FinCEN compliance requirements," Freeh explained, indicating their preparedness to delve further into this specialized area.
As the web3 industry continues to change and mature , the significance of transparency and reliability in the professional services providers in the industry becomes increasingly important and increasingly subject to scrutiny. Regulatory rules and concepts will likely be imported into the crypto space to ensure the protection of investors and address concerns of fraud. FSS's engagement with Tether may mark the beginning of a new era of cryptocurrency-related investigations, as more companies seek reputable firms to provide objective assessments and bolster credibility in the digital asset landscape. While critics may question the findings of private investigations, the emphasis on transparency and thoroughness sets the stage for potential growth in this specialized sector.
What Does it All Mean?
In conclusion, professional services firms have a crucial gatekeeper role in reporting syste, and the public places great trust in their actions and activities. To maintain this trust, accountants, lawyers, and other professionals must conduct their activities with integrity, ensuring that their names and services are not used to mislead investors.
The risks associated with providing non-audit services in the crypto industry demand careful consideration and adherence to ethical standards. By acting with transparency and upholding their responsibilities, service providers can continue to inspire public confidence and trust, but perhaps critcially the tension between statutory and profession-specifical ethical rules provides an opportunity to non-firm service providers.
Without the same requirements imposed on traditional professional service providers, ALSPs and other emerging compliance and regulatory service prociders (such as BSL Group) are uniquely positioned to serve as an intermediate for web3 companies looking to navigate an evolving legal and regulatory landscape in a way that is less likely to implicate significant risk for traditional professional service firms (and thereby implicating adjusted and increasedd fees to account for such risk).
(Note: This blog post is based on the statement provided by the staff of the Office of the Chief Accountant (OCA) and does not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff.)
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email at david@bsl.group, on telegram @davidlopezkurtz on twitter @lopezkurtz and on LinkedIn here.
