News & Insights

Auditor Liability Bulletin

May 31, 2024

Court Denies Motion to Dismiss SEC Claims for Independence Violations Based on Engagement Letter Indemnity Provisions

On May 29, 2024, the U.S. District Court for the Southern District of Florida issued an Order denying a motion to dismiss by Prager Metis CPAs LLP and Prager Metis CPAs, LLC (together, “Prager”) challenging claims that they violated the SEC’s auditor independence rule by including indemnification provisions in their client engagement letters. The SEC’s complaint alleges, among other things, violations of Regulation S-X and Rule 17a-5(i) of the Exchange Act for repeated violations of the auditor independence rule.

According to the complaint, between December 2017 and October 2020, Prager included provisions in its 87 engagement letters for related audits, reviews, and exams that indemnified Prager from liabilities resulting from Prager’s clients’ misrepresentations or the provision of incomplete or inaccurate information. The SEC alleged that because of these provisions, the firm could not have been independent from its clients as required by SEC Rule 2-01(b).

In its motion to dismiss, Prager first argued that the SEC’s complaint fails because there is no categorical rule that the inclusion of any indemnity provision necessarily impairs an accountant’s independence, and such a result would be contrary to Rule 2-01(b)’s text that “all relevant facts and circumstances” be considered in evaluating independence. The court rejected this argument, finding, among other things, that the SEC alleged facts raising concerns specific to Prager’s indemnity provisions, including that (a) two Prager partners themselves voiced concerns that the indemnity provisions impaired their independence and (b) the PCAOB had previously notified Prager that the provisions may impair independence, but Prager continued the practice despite those warnings. Prager also argued that the SEC’s claim should be dismissed because most of the engagement letters did not provide for indemnification if Prager acted negligently, citing SEC guidance (§ 602.02.f.i of the Codification of Financial Reporting Policies and the SEC’s Office of the Chief Accountant: Application of the Commission’s Rules on Auditor Independence FAQs) and arguing that independence concerns are triggered only when an indemnification provision immunizes accountants for their own negligence. The court rejected this argument as well, noting that the cited guidance included disclaimers that it was not definitive, and concluding that “even though an auditor is not shielded where it has been negligent, its independence may nonetheless be diminished where its incentive to conduct an exhaustive investigation as to its client’s representation is weakened.”