The Supreme Court decision on Free Enterprise Fund v. PCAOB will be handed down on June 28th. Whether the PCAOB is or isn’t declared unconstitutional, there are some key gaps in the original Sarbanes-Oxley legislation that should be addressed. Now is the time to give the PCAOB the tools it needs to be as effective as possible.
For those of you less familiar with the issues involved, the Journal of Accountancy does a great job of laying it out:
The case hinges on two intertwined legal issues that are unrelated to the effectiveness of the PCAOB, according to Metzger. The first issue is whether the PCAOB violates the appointments clause of the Constitution.
Even though the PCAOB is organized as a private-sector organization, because it was created by Congress with regulatory authority, the plaintiffs argue, it is legally an agency of the federal government for constitutional purposes. As such, PCAOB board members are appointed officers of the government.
The plaintiffs contend that the SEC’s oversight of the PCAOB, which includes approval of its budget, rules and disciplinary actions, falls short of comprehensive supervision because the SEC has no power over the PCAOB’s investigations or standard-setting agenda. This means, the plaintiffs say, that the five members of the PCAOB are principal officers of the government who must be appointed by the president.
The second issue raised by the plaintiffs is the separation of powers doctrine, which requires the president to execute laws made by Congress—to be in charge of the government. The power to appoint officers of the government is one indicator of presidential authority. The power to remove officers of the government is another. Under SOX, only the SEC can remove members of the PCAOB and then only under limited circumstances.
How will the case be decided? Legal blogger Josh Blackman has an opinion:
…this case will probably be settled along the lines of judicial non-involvement, whereas the liberal justices would join in a broader decision uphold the constitutionality of the Board. Charting a middle course between those two issues probably goes a long way toward explaining the delay in opinion.
How did this case ever get this far? Goes to show you the power of the overall anti-Sarbanes-Oxley sentiment and the sympathy for the small businessman, even if in this case he’s a CPA that won’t accept the fact his firm wasn’t ready for the post-SOx prime time.
Jonathan Weil in Bloomberg: Two years ago, a tiny Las Vegas accounting firm called Beckstead & Watts LLP filed a lawsuit challenging the constitutionality of the Public Company Accounting Oversight Board, after receiving an unflattering report card from the auditing profession’s fledgling regulator. The suit once seemed like a quixotic attempt at revenge, especially after a federal judge ruled against Beckstead last year. Not anymore, though…
At Beckstead, the board’s inspectors in 2004 found a firm with just one partner and two professional staff people, auditing the books of 61 companies. Many of its audits were lousy, the inspectors concluded. Beckstead responded by teaming with a nonprofit outfit called the Free Enterprise Fund and suing the board. Big-name lawyers agreed to take their case, including former Whitewater prosecutor Kenneth Starr, who signed their appellate brief.
Matt Kelly, Managing Editor of Compliance Week, calls the case a “time bomb”.
Sometime this month, the U.S. Supreme Court will rule on the question of whether the Public Company Accounting Oversight Board’s oversight structure is unconstitutional. It is entirely possible that the conservative majority on the court will side with the conservative activists who brought suit against the PCAOB, and invalidate its existence.
Nobody in Washington is talking about what to do after that.
I asked SEC Commissioner Luis Aguilar how the SEC might want to resolve the issue. He said the commissioners know the problem is out there and they have “Plans A, B and C” to respond, but declined to say what any of those plans might be. I asked Frank as well, and he essentially said his committee would work with the Senate Banking Committee to craft some legislative response, depending on exactly what the Supreme Court’s ruling says.
Matt’s prediction: The Supreme Court will rule the PCAOB an unconstitutional body, and ultimately the solution will be to peel away the appointed board and re-organize the rest of it as a Division of Public Accounting operating within the SEC.
The PCAOB has been challenged since its inception in 2002. In the past they tended to see the audit firms through rose-colored glasses. A post of mine all the way back in early 2008 was pretty critical:
It seems many feel we can rest easy, now that the profession in the US is not self regulating but regulated by the PCAOB, under the direction of the SEC. There’s an impression they’re looking at both the audits and the firms themselves.
Although they may be starting to lose their baby teeth, in reality, they’re just a warm puppy.
Not only are investors and the public prohibited from seeing the results of the private portion of the PCAOB’s reports, but the PCAOB under Mark Olson is, in truth, reluctant to judge the management of the firms themselves. And they’re not willing to entertain any contrary views.
I asked Mr. Olson the question directly at the Compliance Week Conference last June. He clearly stated that they were sticking primarily to re viewing the quality of audits themselves.
“…the PCAOB sees itself as regulators of the audit firms with regard to audit quality, and so any additional disclosure will come only as it relates to audit quality.”
The PCAOB is full of former Big 4 partners. They are loathe to criticize their colleagues, notwithstanding any symbolic fines. And when they do try to put a little meat into their critique, they are swatted back like so many houseflies.
Does the PCAOB, in its current form, really have the cojones to dig into the firms’ relationships to the major commercial and investment banks, private equity firms and related money men? I think not. Can we be sure these relationships are not fraught with both independence and integrity problems?
When I met with Senator Ted Kaufman in Washington DC two weeks ago, I made some recommendations for new legislation in the event the PCAOB is declared unconstitutional.
Speedy Congressional action will be necessary to reestablish the PCAOB or a comparable regulatory authority within the SEC, if we want to continue independent regulation of the audit firms. But let’s take the time to plug not only any gaps that may be cited by a potential Supreme Court decision regarding Presidential authority but also to fix some other critical holes in the original legislation.
Although I am a strong supporter of Sarbanes-Oxley, the law and the PCAOB have been vulnerable to criticism because of the hasty way the legislation, patterned after regulation of broker/dealers, was enacted. Given the chance, let’s give the PCAOB the teeth it needs to do its job for investors.
Some recommendations for a new PCAOB law:
- Eliminate the revolving door
- Eliminate obstacles to inspections of international firms
- Make Part 2 of the inspection reports public in all instances
- Enforce stronger sanctions on a more timely basis and more clearly delineate responsibility for sanctions between the PCAOB and SEC
- Give the PCAOB the power, under law, to review or stop mergers and acquisitions by the firms that may not be in the public’s interest or may cause independence violations
- Put bigger teeth into the inspections process
Eliminate the revolving door
Thomas Ray, the Chief Auditor and Director of Professional Standards for the PCAOB since its inception, returned to his old firm, KPMG, in March of 2009.
Why wasn’t there a “no revolving-door” rule included when the PCAOB was established? Is there anything to prevent the Big 4 partners who staffed the accounting firm regulator from immediately returning to a firm they regulated, before their seat at PCAOB is even cold?
Even the SEC has stricter rules.
• Mr. Ray was at the PCAOB when KPMG escaped the guillotine in the tax shelter case.
• Mr. Ray presided over investigations of partner misconduct at Deloitte.
• Mr. Ray has an ongoing super-embarrassing issue with Mr. Flanagan, the accused former Deloitte Vice Chairman who allegedly traded on inside information about twelve of his audit clients.
• Mr. Ray is in the middle of the controversy regarding auditors and their judgment and application with regard to fair value accounting. (Although no one from PCAOB or the audit firms has been called before Congress to answer for their lack of judgment or lack of competence regarding complex financial instruments.)
Imagine the “wisdom and knowledge” about KPMG and all the other firms that Thomas Ray brings back to KPMG’s Professional Standards Office ? Am I the only one who thinks this is another slap in the face to the taxpayers, the shareholders, the professionals?
Next up, Mark Olson’s “retirement.” Am I to expect no one will notice, be surprised, be outraged, or prohibit him from returning to EY or, even worse, to a bank?
Update: March 20, 2009
Per a conversation with the PCAOB’s Inspector General, I was pointed to the PCAOB Ethics Code, approved by the PCAOB in June 2003 and effective pursuant to SEC Release No. 34-48755, File No. PCAOB-2003-04. (November 7, 2003)
This is all there is related to post-employment restrictions. How does this compare to general SEC post-employment restrictions, given that the SEC is the PCAOB’s governing agency?
Even if Mr. Ray had very good personal reasons for wanting to return to the private sector, it appeared his move back to KPMG gave him an opportunity, with few restrictions, to take advantage of his experience at the PCAOB for the benefit of his old firm.
Where did Mark Olson, former PCAOB Chairman, go after he left?
“We understand the issues of our clients from every perspective. The federal, regulatory, and financial services industry backgrounds of our professionals allow us to provide our clients with both the solution and the advantage. We help our clients think through problems, resolve issues, and identify opportunities.”
Mark W. Olson, Co-Chairman, Corporate Risk Advisors LLC.
Let’s put an end to the revolving door at the PCAOB.
Eliminate obstacles to inspections of international firms
“The Public Company Accounting Oversight Board (PCAOB) published a list of more than 400 non-U.S. companies whose securities trade in U.S. markets, but whose PCAOB-registered auditors the Board currently cannot inspect because of asserted non-U.S. legal obstacles…The auditors of the issuers appearing on the list are located in China, Hong Kong, Switzerland and 18 European Union countries.
The PCAOB continues to work to eliminate obstacles to inspections in these jurisdictions.”
Current law prohibits sharing of PCAOB inspection reports with foreign regulators. Because of this, many foreign regulators will not share their own reports or their countries have restricted PCAOB access, even though these issuers are listed on US exchanges. Obstacles must be eliminated that prohibit sharing of information across boundaries and reciprocity and cooperation between the US regulators and the regulators in home countries of more than 400 non-U.S. companies whose securities trade in U.S. markets.
And where the PCAOB does have the right to inspect, they need to speed up the issuance of their reports. We are still waiting for an inspection report of Indian firms from the spring of 2008, pre-Satyam fraud. The report is very late. If the PCAOB caught the issues, its tardiness makes the PCAOB findings ineffectual and of no use to the public. If the PCAOB inspectors didn’t catch the issues either the inspectors were incompetent and/or PwC was also extremely inept at auditing or extremely adept at aiding and abetting the fraud. Until the report is issued, we have no idea if the process was effective at all or if PwC covered-up the issues that precipitated the exposure of the Satyam fraud less than a year later.
Inspections and other documents produced via investigations and enforcement are not discoverable in civil actions per the Sarbanes-Oxley Act of 2002.
(A) CONFIDENTIALITY.—Except as provided in subparagraph (B), all documents and information prepared or received by or specifically for the Board, and deliberations of the Board and its employees and agents, in connection with an inspection under section 104 or with an investigation under this section, shall be confidential and privileged as an evidentiary matter (and shall not be subject to civil
discovery or other legal process) in any proceeding in any Federal or State court or administrative agency, and shall be exempt from disclosure, in the hands of an agency or establishment of the Federal Government, under the Freedom of Information Act (5 U.S.C. 552a), or otherwise, unless and until presented in connection with a public proceeding or released in accordance with subsection (c).
This insulates the firms from accountability for repeated lapses in audit quality and compliance with standards. This prohibition on discovery for civil proceedings should be eliminated. In addition, the names of issuers who were the subject of audit discrepancies noted in inspection reports should be public and those issuers forced to disclose the resolution of the discrepancy noted.
Make Part 2 of the inspections reports public in all instances
The PCAOB prepares written report on each inspection and provides it, in appropriate detail, to the SEC and to certain state regulatory authorities. The Board also makes portions of the reports available to the public; however, certain information is restricted from public disclosure, or its disclosure is delayed, as required by the Act.
“Many reports contain nonpublic content, which may include, among other things, discussion of potential defects in a firm’s system of quality control. Any such quality control criticisms remain nonpublic if the firm addresses them to the Board’s satisfaction within 12 months after the report date. If a firm fails to satisfactorily address any of the quality control criticisms within 12 months, the portion of the report discussing the particular criticism(s) is made publicly available.”
Firms are openly flouting the prohibitions regarding audit partner compensation tied to business development and are still struggle mightily with enforcement of legal and regulatory compliance activities such as independence and rules against insider trading. The rule in the firms seems to be, “Ask for forgiveness not permission.”
Enforce stronger sanctions on a more timely basis and more clearly delineate responsibility for sanctions between the PCAOB and SEC
The PCAOB can issue an, “order of formal investigation when it appears that an act or practice, or omission to act, by a registered public accounting firm or any person associated with a registered public accounting firm may violate any provision of the Act, the Rules of the Board, the provisions of the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto, including the rules of the Commission issued under the Act, or professional standards.”
The SEC can also charge both the audit firms and individual professionals in the firms with violations of the securities laws and violations of rules specific to auditors such as independence.
From the Bally’s case: By issuing these false and misleading audit opinions, E&Y was a cause of and aided and abetted Bally’s violations of Sections 17(a)(2) and (3) of the Securities Act and
Sections 13(a) and (b)(2)(A) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1, 13a- 11, and 13a-13. E&Y also violated Section 10A of the Exchange Act by not bringing to the attention of Bally’s Audit Committee Bally’s false and misleading disclosures of the $55 million special charge.
The SEC did not finalize the sanctions the Bally’s case against EY and the partners involved until six years later. The PCAOB has not sanctioned any Big 4 firm except Deloitte (twice). There may be ongoing investigations in cases such as the Flanagan-Deloitte inside trader case, but we will never know if they’re even considering sanctions against Flanagan or Deloitte unless or until sanctions are final.
There should be stronger sanctions against the firms – bigger fines and more timely charges. There must be better cooperation between the SEC and PCAOB in the case of auditor malpractice and aiding and abetting of securities fraud and more transparency regarding pending investigations or those where the audit firm or individuals are disputing it. Timely charges are critical because when sanctions aren’t finalized until after an audit partner retires they lose their impact and deterrent power.
Finally, there should be a centralized list of auditors who are currently or were in the past sanctioned so investors and the media can monitor their ongoing employment by the firms and/or continued responsibility for client work, placement in internal firm administrative roles or ongoing involvement in professional associations.
Give the PCAOB the power, under law, to review or stop mergers and acquisitions by the firms that may not be in the public’s interest or may cause independence violations
The PCAOB has no power to insure firms handle such acquisitions well from an independence perspective except for citing them after the fact when violations occur.
When BearingPoint Inc declared bankruptcy, there were a number of firms interested in parts of the whole. The company, the legacy consulting firm of public accounting firm KPMG spun off in 2000, was eventually bought in early 2009 by Deloitte who took most of the government services practice and PwC who took major parts of the commercial services practice to boost their reemergence as a systems integrator.
There were many, many instances of conflicts between Deloitte’s and PwC’s audit clients and existing BearingPoint consulting engagements. PwC, shortly after the acquisition, cut more than three hundred of its own consulting staff to make room for the BearingPoint professionals. Were these acquisitions in the best interest of the public given the firms’ primary responsibility as public accounting firms?
PwC has failed to make a dent in the systems integration market and Deloitte’s ongoing failures to perform are marked by repeated lawsuits. I question the wisdom of the regulator in allowing this expansion in the consulting businesses at that time.
The accounting regulator, the PCAOB, needs the power to review and stop such acquisitions if they jeopardize the firms’ primary public duty – auditing public companies.
Put bigger teeth into the inspections process
When I look back at earlier PCAOB inspections, I can see some cases where the inspectors identified and warned of issues that resulted in failures. It isn’t easy to figure this out, since the issuers are not identified. But with the benefit of hindsight, it’s apparent to me that the PCAOB inspectors certainly identified the issues over and over that would eventually cause many future failures if not the specific instances where those failures did eventually occur.
There are at least two cases I’ve identified where adequate identification and warning of poor audit processes was made: American Home and Huron Consulting. Slow issuance of the inspection reports, the lack of transparency caused by the secrecy provisions of the act and the overall obstinacy of the firms meant that, in these two cases, there was no warning of American Home’s failure or prevention of Huron’s restatement.
It’s been apparent to me that the audit firms don’t take the inspection results seriously, and don’t significantly change their processes as a result. In some cases they publicly embarrassed the PCAOB by openly disagreeing with them.
This is not the way to treat a regulator. Although the inspection process is intense, time consuming and very expensive for the audit firms to comply with, they are clearly paying it only lip service. They view it as a necessary evil rather than a constructive or a deterrent force. This must change if the PCAOB is ever going to be an effective tool for protecting the investor public.
Some readers have encouraged me to included the names of the legislators who will be most likely responsible for any new PCAOB legislation. An emergency bill will probably come out of the Senate Banking Committee Subcommittee on Securities, Insurance, and Investment. Interestingly there are no women on this committee. Hmmmm…
They are responsible for:
– Securities, annuities, and other financial investments
– SEC: SIPC: CFTC (single stock futures and other financial instruments within CFTC jurisdiction)
– Government securities
– Financial exchanges and markets
– Financial derivatives
– Accounting standards
Democratic Subcommittee Members
Republican Subcommittee Members