Court Ruling Probes PCAOB’s Accountability

July 8th, 2010

The Public Company Accounting Oversight Board (PCAOB) emerged largely intact after a legal battle that challenged its very existence (Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al., Supreme Court, June 28, 2010). On the surface, this ruling appears to be good news for investors. But the ruling doesn’t fully address the matter of the PCAOB’s accountability and it opens the door for future changes by Congress.

The key points:

  • By a narrow 5-4 decision, the Supreme Court stopped short of declaring the entire Sarbanes-Oxley Act unconstitutional and ordering the PCAOB to stop work.
  • Instead, the Court carved out a seemingly minor organizational provision or “structural flaw” that it said could be addressed separately.
  • At issue is SOX’s “double-for-cause” rule. SOX established the PCAOB under the SEC’s oversight. As enacted, the law said PCAOB members could be removed only for good cause by the SEC, whose members in turn can be removed by the President of the United States only for cause, (such as neglect of duty or malfeasance).
  • The Court’s ruling removes the “double-for-cause” rule and gives the SEC the authority to remove PCAOB members at will.
  • The reasoning for the ruling is that SOX’s “double-for-cause” rule represents an unacceptable “diffusion of power.” The resulting “diffusion of accountability” runs counter to the guiding principle that the President should oversee the conduct of all who execute laws in this country.

Our observations and recommendations:

  • Investors should be relieved to see that both the PCAOB and SOX are still standing. The PCAOB is an important cornerstone of the SOX Act, a pivotal law passed by Congress following the Enron and WorldCom accounting scandals. The intent of the law is to provide greater investor protection through higher audit quality.
  • However, the Court’s carve-out oversimplifies the complex issues involved. It also opens the door for Congress to explore alternative or supplemental ways to remedy the structural flaw.
  • Although the system of checks and balances is good in government, there are also important practical considerations for a board like the PCAOB. The PCAOB board members are not government employees and the so-called flaw in SOX was put in place intentionally to insulate the highly paid technical experts who serve on the PCAOB from political pressures.
  • The nature of the PCAOB’s work demands some sort of practical expedient because: (a) it involves contentious matters and occasionally unpopular decisions, and (b) the preservation of audit quality demands high standards of technical expertise, objectivity, and neutrality – all of which can be difficult to govern through normal political processes.
  • The discussions also leave important issues unresolved. One key open issue regards the right of appeal for those who feel adversely and unfairly affected by the PCAOB’s work. The recent court case started when a Nevada accounting firm received a report critical of its auditing procedures and was informed the PCAOB planned to begin a formal investigation. Firms in this position should have suitable recourse.
  • There should also be suitable recourse for public companies that wish to protest increases in the mandatory fees imposed on them in an effort to provide an independent source of revenue for both the PCAOB and its accounting standard-setting counterpart, the Financial Accounting Standards Board. There are reports of fee increases of 30 and 40 percent over the past two years despite difficult economic conditions. For true accountability, companies and investors should be provided with clearer cost justifications.

The full text of the Supreme Court’s ruling is available at
http://www.supremecourt.gov/opinions/09pdf/08-861.pdf. The full docket is available
here.

Entry Filed under: Governance

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