Recent disclosures of faulty practices at Enron and WorldCom have put CPA conduct under a microscope. They have led, too, to the 2002 passage of the Sarbanes-Oxley Act, with its sweeping changes to the U.S. financial reporting system and restrictions on services a CPA may provide to audit clients. Nevertheless, changes in auditor independence rules in 2001 gave CPAs more freedom in managing their personal stock portfolios to buy and sell securities issued by their firm's clients. The changes increased the risk that CPAs and their firms might inadvertently violate laws prohibiting insider trading unless they have careful procedures in place to avoid that possibility.
Partners and staff face tough decisions when managing the insider trading risk inherent in the freedom to buy and sell securities. It's a responsibility that requires a meticulous response in this post-Enron, Sarbanes-Oxley Act era. Many large accounting firms now have internal legal task forces to consider insider trading issues, and all accounting firms need to be aware of new insider trading risks. Smaller CPA firms may not yet have safeguards against them in place, however. This article summarizes insider trading laws, presents four common scenarios to illustrate how insider trading risks may arise in accounting firms and recommends steps CPAs and their firms can take to manage those risks. (For more information on SEC Rule 2-01 revisions, see "The Engagement Team Approach to Independence," J0fA, Feb.01, page 57.)
WHAT THE RULES SAY
Rules under the Securities Exchange Act of 1934 make it unlawful for any person, in connection with the purchase or sale of a security (publicly traded or not), to engage in any action that deceives or would operate as a fraud upon any person.
In general, insider trading occurs when a person has "material, nonpublic information" about a security or its issuer and buys or sells that security. The SEC says an individual with such inside information either must abstain from trading in the securities of the company or properly disclose what he or she knows before buying or selling them. Violators of these rules are subject to civil penalties of up to three times the illegal profits gained or losses avoided by the insider trading plus criminal penalties. Criminal penalties for individuals may be a fine of as much as $5 million, prison for as long as 20 years--or both. Courts also permit injured private parties to sue for damages.
To decide whether insider trading has taken place, the courts and the SEC apply three sets of rules: traditional, misappropriation and tender-offer rules (see "Insider Trading Risk in Practice" page 50).
FOUR INSIDER TRADING SCENARIOS
The scenarios below illustrate situations in which CPA firms are likely to face insider trading risks. In each situation traditional insider trading rules apply to information anyone in the firm gets from a firm client. If that information is about a tender offer, the tender offer rules could apply as well. If a firm partner or employee discloses the inside information to a confidant who is not a firm partner or employee, then the misappropriation rules may apply.
A partner of a CPA firm owns stock in a firm client. She does not participate in any attest engagements for this client, is not in a position to influence the client's attest engagements or the professional staff performing those engagements and works in an office of the firm that performs none of the attest work for the client. At a recent meeting, this partner learns about certain nonpublic activities of the client that are not material in and of themselves. But the partner combines that information with other publicly available information about the client or the industry and concludes that the client's stock price will decline. Can she sell the stock without violating insider trading rules?
Recommended action: The partner in this case may believe the information about the client was not material and that a sale of the stock would be lawful. But since the nonpublic information led the partner to sell, others might conclude the information is by definition material and that the sale is unlawful insider trading. To avoid liability risk, the partner should make no sale until after the information becomes public.
A partner in a CPA firm is responsible for attestation engagements for a client of the firm. He maintains his independence from the client. The partner learns the client has...