[youtube:http://www.youtube.com/watch?v=tck32PTDzig 285 234]
PCAOB
CEI won a significant victory yesterday in Free Enterprise Fund v. Public Company Accounting Oversight Board, the first Supreme Court case to which we served as co-counsel. The Court held the lack of removal power for PCAOB members to be unconstitutional and opened up an avenue of litigation for entrepreneurs to challenge its current rules and disciplinary actions under the Sarbanes-Oxley Act that created it.
Many people made this victory possible. So here is our “Oscar speech” that tries to thank each of them. (Note to Academy Awards buffs: There is one major difference. There is nothing to be read in those whom we left out. It’s just that there are so many countless people to thank, even for encouraging words that kept us going).
We were very fortunate to have a principled membership organization like the Free Enterprise Fund as a client. Founded by Steve Moore (now of course a prominent editorial writer for the Wall Street Journal), FEF helped bring the focus of fiscal conservatism to new areas such as SOX and securities law. Moore’s successor as FEF chairman, Mallory Fact0r, provided valuable guidance from his vast business acumen as well as the initial funding to bring the case forward. Factor was ably assisted by the fund’s then executive director E. O’Brien Murray. Current FEF chairman Steve Goodrich is continuing the FEF’s good work.
We were also very fortunate to be working with a top legal team, beginning with lead counsel Michael Carvin and his associates at the Jones Day law firm Noel Francisco and Christian Vergonis. And we also had the expertise of the brilliant legal minds of former Solicitor General Ken Starr and former Assistant Attorney General Viet Dinh.
Before the court case, nine separtate amici briefs were also filed on our behalf. Indiana University Law Profess Donna Nagy, who wrote one of the first law review articles exposing the constitutional defects of the PCAOB, organized a brief signed by 15 law professor, including UCLA’s Stephen Bainbridge and Brooklyn College’s Roberta Karmel, the SEC’s first female commissioner who was appointed by President Carter.
Former Attorneys General Edwin Meese, Richard Thornburgh, and William Barr weighed in on a brief from the Washington Legal Foundation. The Cato Institute and its senior fellow Ilya Shapiro filed a brief that highlighted both the costs of Sarbanes-Oxley rules enforced by the PCAOB and incorporated public choice economic theory to show how agency’s incentives are skewed. And Factor again weighed in on our behalf, joining in an amicus brief filed American Civil Rights Union Counsel Peter Ferrara.
Finally, we can never thank enough for his courage and perseverance our client Brad Beckstead, partner in the two-person Henderson, Nev., accounting firm Beckstead & Watts. Nearly five years ago, Beckstead shared with us his concerns that the PCAOB was showering on him and the firms he audited mounds of red tape that increased costs and was of little value to shareholders. We began to discuss filing a lawsuit. Beckstead joined FEF, and they both became the plaintiffs, represented by CEI and the Jones Day legal team. This case is a victory for Brad Beckstead and all the entrepreneurial “Davids” he represents who just beat the “Goliath” of the PCAOB.
[youtube:http://www.youtube.com/watch?v=vYBTdSDPPm4 285 234]
The members of the Public Company Accounting Oversight Board (PCAOB), an agency being challenged in the Supreme Court on December 7, aren’t appointed by the president, nor can he remove them. The General Accounting Office describes the PCAOB as “an independent board with sweeping powers and authority;” its rules and red tape cost the economy billions of dollars every year (with an long-term cost of perhaps $1 trillion).
Yet the government suggests in its brief that the president has “fully effective control” over the PCAOB (see pg. 46 of that brief). That’s not the only peculiar claim made in the PCAOB’s defense.
The case raises the issue of whether members of an agency — the PCAOB — picked by the members of yet another independent agency — the five Commissioners of the Securities and Exchange Commission (SEC) acting as a group — are, in light of their broad policy making role, actually “principal officers” who thus should have been picked instead by the president under the Constitution’s Appointments Clause. Alternatively, assuming that PCAOB members are mere “inferior” officers, the case raises the issue of whether they should have been picked, as the Appointments Clause requires for inferior officers, by the “Head” of a “Department,” rather than the SEC Commissioners acting collectively (the SEC has a Chairman who manages it and supervises its staff).
Government lawyers argue that the PCAOB is so controlled by the SEC that its members are mere inferior officers, and claim that the SEC is headed by all its Commissioners, not its Chairman. But as Jonathan Moore has noted, a long-time SEC commissioner debunked these claims on December 3. Former SEC Commissioner Paul Atkins took the exact opposite view, in a panel discussion at the American Enterprise Institute, which one can view and listen to here (Atkins was the fifth speaker; I also spoke at the event, and Jonathan Moore, who was in the audience, questioned the panel).
Atkins spoke at length about the PCAOB and how difficult it was for the SEC to influence the PCAOB. He noted that the PCAOB had enough autonomy to frustrate the SEC’s attempts at oversight. When the SEC sought a business plan from the PCAOB, the PCAOB Chairman said that “the statute was his business plan” and more or less failed to comply. It took five years to get something akin to a business plan from the PCAOB. Atkins said that PCAOB’s “Audit Standard 2” “has a very checkered history” and illustrated the “limits” of SEC oversight. The 400 pages of requirements from Auditing Standard No. 2 made compliance with Sarbanes-Oxley “very difficult” and “very costly.”
Atkins noted that “All five commissioners” were in favor of “radical” changes to it, yet it took years for them to obtain merely “some” changes to that audit standard, owing to the need for consensus and PCAOB foot dragging. He recounted how the PCAOB adopts “staff-driven” rules through “informal rulemaking” that apply without being approved by the SEC, regardless of Sarbanes-Oxley’s formal approval process for rules. Atkins says, for example, that its guidance regarding “stock options” was “not subject to any rule at all,” despite functioning in practice as a rule. While the SEC has to approve formal rules, the PCAOB functions heavily through informal rules never approved by the SEC. He said that “Peekaboo does have real power,” “investigative power,” and “prosecutorial power.” Although the SEC theoretically reviews the PCAOB’s budget, Atkins noted that “staff at Peekaboo were not telling the truth” about the PCAOB’s budget system to the SEC, making evaluation of its budget and spending difficult. He noted that on the SEC’s website, there is video footage of his concerns over this at the last budget meeting. He noted that because of the PCAOB’s separate status and the SEC’s lack of control over PCAOB staff, the “SEC found it didn’t really have the authority” to control the PCAOB’s budget that it supposedly did.
Atkins noted that the SEC’s “power is not plenary” over the PCAOB, that it was difficult to get a group consensus focused on oversight over the PCAOB, and that oversight of the PCAOB was “like pushing on a string.” He said that the current set-up under Sarbanes-Oxley is a “very difficult way for the SEC to oversee a separate board.” He cited “flawed implementation of [SOX Section] 404” from 2002 to 2006 as an example, and noted the “incredible amount of attention diverted” to accounting issues that were not important as a result of the PCAOB’s internal-controls rules.
He addressed the question of whether the SEC’s chairman is its head for appointments clause purposes. He said that the Founders realized the “committee structure” or the “committee system was not a very effective decision making type of body” for things like appointments, and cited the 1950 Reorganization Plan 10 that vested “authority over the budget” and “HR decisions” in the SEC’s chairman. Although he noted that “consensus” is desired for key posts like the General Counsel, when push comes to shove, “in reality, he [the Chairman] can still appoint who he wants.” He said that the idea that PCAOB members – or even SEC members – were really accountable to the president was silly, and that the SEC’s own history “illustrates how difficult it is for the President to assert authority” over the SEC, much less the PCAOB.
Atkins’ observations debunk the government’s suggestion that the president has “fully effective control” over the SEC – and the lower court ruling upholding the PCAOB, which claimed that the SEC was not headed by its Chairman, but by SEC Commissioners as a group – a claim based on that court’s inconsistent reasoning. Law professor Donna Nagy similarly debunks claims that the PCAOB is “heavily controlled” by the SEC in a forthcoming article in the Pittsburgh Law Review, noting that PCAOB members are “principal officers” “acting with significant discretion and autonomy outside the SEC’s control” who constitutionally must be appointed by the president — not, as is currently the case, by the SEC Commissioners as a group.
Also available online is the text of SEC Commissioner Paul Atkins’s earlier 2006 speech noting the SEC’s limited ability to control the PCAOB (such as the PCAOB’s unapproved guidance on subjects like “options grants” and the PCAOB chair’s view that the PCAOB is more like the SEC’s “cousin” than its subordinate).
Courts sometimes take judicial notice of such statements. See Nebraska v. EPA, 331 F.3d 995, 998 n.3 (D.C. Cir. 2003) (taking judicial notice of statements on web site); Cf. Parents Involved in Community Schools v. Seattle School District No. 1, 551 U.S. 701, 780 n. 30 (2006) (Thomas, J., concurring) (quoting from web site); id. at 730, n.14 (plurality) (citing news articles about website’s earlier content).
On December 7, the U.S. Supreme Court will hear Free Enterprise Fund v. Public Company Accounting Oversight Board. The case, brought by CEI and Jones Day attorneys on behalf of the Free Enterprise Fund, challenges the constitutionality of the way Public Company Accounting Oversight Board (also known as PCAOB, or not so affectionately as Peekaboo) members are appointed. The PCAOB, which was established by the Sarbanes-Oxley Act of 2002, is an independent governmental agency (according to Sarbanes-Oxley it is a private institution, but even supporters of the Board’s structure admit that it is a governmental body) whose members are selected by the SEC commissioners collectively. The lawyers arguing the case argue that this selection process violates the appointments clause of the Constitution.
The Constitution, in Article 2 sec. 2, establishes that the President “Shall have Power, by and with the Advice and Consent of the Senate to… nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”
According to the Constitution, the President is responsible for appointing what has later been defined as “principal officers.” Further, if the officers are deemed to be “inferior officers,” Congress may give appointment power to the President, a judge, or the head of a department. Lawyers for the Free Enterprise Fund charge that regardless of whether the PCAOB members are principal or inferior, the Constitution has been violated. The President does not appoint the board members, and as such, if they are principal officers, the Constitution has been violated. If the board members, however, are inferior officers, they have not been appointed by a head of a department, rather, they have been appointed by the SEC commissioners.
Lawyers defending the constitutionality of the PCAOB have charged that the board members are inferior officers, and that the SEC commissioners collectively are the head of the SEC. Further, they claim that the SEC has complete control over the PCAOB through several powers, including the power to review all PCAOB rules, and approving the PCAOB’s budget. As such, they argue, this direct supervisory authority makes the PCAOB clear inferior officers, and since the President has control over the SEC commissioners, who have control over the PCAOB, the President has “fully effective control” over the PCAOB.
Yesterday, however, at an American Enterprise Institute event titled “Public Company Accounting Oversight Board: A Preview”, former SEC Commissioner (2002-2008) Paul Atkins provided an alternative story of the SEC’s control over the PCAOB, as well as refuting the claim that the SEC commissioners are collectively the head of the SEC.
Atkins noted several areas in which the PCAOB managed to evade SEC controls and operate very independently of the SEC. First, he stated that the PCAOB’s budget was not nearly as under control by the SEC as has been claimed. Atkins stated that the “staff at Peekaboo were not telling the truth” to the SEC about the PCAOB’s budget. His experience at the SEC led him to the conclusion that the SEC “didn’t really have the authority it supposedly did” over the PCAOB’s budget.
At one point, the SEC asked the PCAOB for a business plan regarding their operations. The PCAOB chairman informed the SEC that Sarbanes-Oxley “was his business plan” and for five years the PCAOB evaded the SEC’s demand for a business plan.
After the PCAOB produced their “Audit Standard 2”, “all five” SEC commissioners were in favor of “radical” changes to it, and yet it took the SEC years to even make “some” changes to the auditing standards due in part to PCAOB recalcitrance.
He stated that the PCAOB used “informal rulemaking” to adopt “staff-driven” rules which evaded the need to obtain SEC approval for all rules. As an example, he says that the PCAOB’s rule making regarding stock options was “not subject to any rule at all” despite functioning as a rule.
Atkins directly refuted the claim that the SEC has plenary power over the PCAOB, stating bluntly that the SEC’s “power is not plenary” regarding the PCAOB. He even said that a good analogy for SEC oversight of the PCAOB was that of “pushing on a string”.
Atkins also implied that considering the SEC commissioners as a collective head for the SEC was ignoring the realities of the day-to-day operation of the SEC. He stated that the chairman has considerably more power than the other commissioners. He noted that the 1950 Reorganization Plan 10 gave “authority over the budget” and “HR decisions” to the SEC’s chairman. He did say that consensus among the commissioners is generally important, but said that “in reality, he can still appoint whoever he wants” to critical appointment posts. And yet, this does not apply to the PCAOB, who are appointed collectively by the SEC. Further, Atkins even questioned whether or not the President had direct power over the SEC, a lynchpin of the defenders of the SEC’s argument. He stated that the SEC’s history “illustrates how difficult it is for the President to assert authority” over the SEC, much less the PCAOB.
Atkins’ telling of the SEC and PCAOB’s relationship calls much of the PCAOB’s legal defense into question. If the SEC lacks reliable control over the PCAOB, how can the President have “fully effective control” over the PCAOB? If, one wonders, the SEC chairman is treated as the appointer for other positions within the SEC, which implies that he is the head of the department, why is it that he does not have the power to appoint the PCAOB members? And why is the SEC chairman sufficiently powerful to act as the head in all other appointment cases, but when it comes to the PCAOB he must act as an equal to his fellow commissioners? And further, if the President lacks even control over the SEC, how can he truly have control over the PCAOB members, who are an additional step further down the chain of command?
These are some questions the justices should be asking on December 7.
After months of talk about solutions that would rev up job growth and the economy, today the House Financial Service Committee may finally adopt a true bipartisan stimulus. Led by Democratic Reps. Carolyn Maloney of New York and John Adler of New Jersey, two amendments will likely be introduced to the Investor Protection Act that would truly stimulate the economy by partially liberating investors, entrepreneurs and innovators from the shackles of a seven-year-old “investor protection” law that has added billions in costs while providing little if any benefits to investors and doing nothing to prevent the recent financial crisis: the Sarbanes-Oxley Act of 2002.
Maloney, whose most recent legislative accomplishment was the Credit Card Holders Bill of Rights that was signed by President Obama in May and hailed by liberal groups, has teamed with conservative Rep. Scott Garrett, R-N.J., to introduce an amendment to extend the exemption for smaller public companies – those with less than a $75 million market cap – from the costly audit of internal controls from the law’s Section 404 to at least June 2011 and until the Securities and Exchange Commission and Government Accountability Office each perform a study. This is important because the current exemption expires next June, and SEC Chairman Mary Schapiro recently said that there will absolutely, positively be no further extension, despite the limited research on the effects of Sarbox on the very smallest companies and the extensive research showing often devastating burdens on midsize and even large ones.
Rep. Adler goes one further. His amendment would exempt small and midsize companies – those with market caps of less than $700 million, the mark above which the SEC classifies companies as “large accelerated filers” – from Sarbox Section 404 until the SEC promulgates “regulations that take into consideration the different characteristics and limitations of various sized companies,” according to a “Dear Colleague” from Adler. In the letter, obtained by OpenMarket but not yet posted on the web, Adler states: “My amendment will increase America’s competitiveness within the global economy and create jobs here at home. When a company goes public, investors invest capital, the company expands and jobs are created.”
Indeed, new research from the University of Pittsburgh’s Kenneth Lehn and others demonstrates in detail the damage Sarbox is doing to job growth by showing how its costs reduce business spending on research and development and other precursors to job growth. Rammed through Congress in 2002 in the rush to “do something” after the Enron and WorldCom accounting scandals, Sarbox has had many perverse effects recognized by Republicans and Democrats. In 2006, now-Speaker Nancy Pelosi decried the law’s “unintended consequences” for entrepreneurs.
University of Rochester researcher Ivy Zhang has found that Sarbox has racked up $1.4 trillion in direct and indirect costs to the U.S. economy, with no quantifiable economic benefits. By far, the biggest cost is from Section 404’s internal control mandates, which the American Electronics Association calculated as costing U.S. public companies $35 billion a year, and as much as quadrupled an individual company’s auditing and compliance costs, according to the Foley & Lardner law and consulting firm. This section’s price tag is largely because the Public Company Accounting Oversight Board, the powerful yet unaccountable regulator created by Sarbox (and whose constitutionality is being challenged in a case before Supreme Court this term in which CEI attorneys are serving as co-counsel), required full-blown audits for internal controls as well as a company’s number. That is what turned Sarbox into what has been called “The Accountants Full Employment Act,” in which accountants are reviewing “internal controls” such as possession of office key, the number of letters in an employee password and other items of little relevance to the average shareholder.
Tech journalist John Battelle reported that Sarbox was even frustrating for a company as big as Google, because of the extensive red tape that went along with documenting innovative technology. According to Battelle, becoming Sarbox compliant when Google went public in 2004 was “no small feat,” because “the law requires an audit trail of every third party transaction, and Google has millions of them a week in its [search] engine.” And keep in mind that Google already had a market cap of more than $1 billion when it went public in 2004. So the smaller innovative companies with the potential to be the Googles and Microsofts of tomorrow might not be able to get over this Sarbox hurdle and raise the capital they need by going public.
And new, groundbreaking research shows that Sarbanes-Oxley hits cutting edge software and biotechnology firms especially hard, reducing the amounts they spend on research and development that could lead to new fields that create new job. A 2008 paper from University of Pittsburgh economist Kenneth Lehn that was selected for a conference of the Federal Reserve Bank of Atlanta finds that “greater evaluation and testing of
internal controls [is] required for firms with activities involving specialized knowledge.” And Lehn’s study includes data from 2007, after the SEC and PCAOB supposed “tailored” Sarbox to make compliance easier for smaller companies.
A letter from The Biotechnology Industry Organization that Lehn cites states that biotech firms “are directing precious resources from core research and development of new therapies for patients” to costly Sarbox compliance.
And ironically, the bells and whistles of Sarbanes-Oxley’s “internal controls” may ironically be taking the core focus off of rooting out fraud. In 2007 Countrywide Financial Corp. was praised for its Sarbox controls by the Institute of Internal Auditors. Two years and many scandals later, its former executives have been charged with securities fraud. And certainly, overall transparency doesn’t increase when companies go private or delay going public, as many have chosen to do because of Sarbox’s costs.
In addition to the valuable Adler and Maloney-Garrett measures, Rep. Michelle Bachmann, R-Minn., will likely introduce a worthy amendment to keep the underlying Investor Protection Act from expanding Sarbox and the PCAOB’s reach to include non-public broker dealers (an incredible power grab that jettisons the whole justification for Sarbox protection of average investors – they might have to change the name to the NCAOB – Nonpublic Company Accounting Oversight Board) until the Supreme Court rules on the entity’s constitutionality.
Her amendment will also likely propose transferring the responsibility of appointing powerful members of the PCAOB from the SEC to the President, with Senate confirmation. This is what CEI and other attorneys argue in the court case is constitutionally required, since PCAOB members are important “principal officers” with authority to make rules that have such a large impact on the U.S. economy. The Bachmann amendment is also bipartisan in spirit, as it gives more power to President Obama, but also institutes the constitutional accountability needed for this powerful agency.
The events leading to the Dow’s climbing over 8000 today can be properly called the Mark-to-Market Relief Rally. More than any expected action of the bureaucrats and politicians at the G20, the decision today of the Financial Accounting Standards Board (FASB) to relax strict application of mark-to-market accounting mandates, urged on by members of Congress of both parties, it what’s giving investors something to cheer for.
In this era that supposedly signifies the return of big government, it is heartening that on this issue, Republicans and Democrats worked together to push for this common-sense free-market reform that will do much to get our economy going and could save taxpayers billions in avoiding the need for bailouts.
In CEI’s recently released “Bipartisan Agenda for Economic Liberalization,” we advise Congress to “make accounting regulators accountable” and to “require regulators to suspend mark-to-market accounting mandates such as Financial Accounting Standard 157 until better guidance is developed for illiquid markets.” Thanks to members of Congress such as Paul Kanjorski, Ed Perlmutter, and Peter DeFazio on the Democratic side and Spencer Bachus, Scott Garrett, and Michelle Bachmann (here’s her statement on today’s action) on the GOP side pushing FASB to reform the rules, a significant step has been taken toward this objective being achieved.
By itself, this change will not make the price of mortgage assets higher or lower. Rather, it will allow price discovery to occur. Mark-to-market distorted the market by forcing banks to take losses on mortgage assets even if the underlying loans were still performing, based on the last fire sale price of similar assets. Respected banking analyst Richard Bove pointed out that because of mark-to-market, Bank of New York Mellon had to value its portfolio of commercial mortgage-backed securities with a 1 percent default rate as if it had a 25 percent default rate. This resulted in a $70 billion loss of liquidity to the financial system from this bank alone. (Bove’s analysis doesn’t seem to be available online, but is described in this brilliant article on the investor site MotleyFool.com by Liz Peek.)
With the expected change to mark-to-market today, whether banks hold or sell toxic assets should not be a concern. Either way, this rule change will help keep toxic assets from weighing down banks’ “regulatory capital” and unnecessarily tightening the lending they do. And it will save taxpayers billions by letting the market simply value the assets at prices similar to what government programs such as Treasury Secretary Tim Geithner’s Public Private Investment Partnership seek to buy them for.
The concerns about FASB’s independence is also misplaced. Rather, the concern should be that this quasi-private board, whose edicts are embedded in federal regulations and have a profound affect on the economy, is unaccountable to the American people. Many accountants, economists, and other experts have long criticized mark-to-market for being pro-cyclical, resulting in assets being valued too high during a boom, as when Enron utilized mark-to-market to manipulate its earnings, and causing a downward spiral during a bust. Yet FASB refused to take those concerns under consideration until Congress pushed it to.
Saying that only accountants can determine accounting policy in federal regulation is like saying that only members of the military can make policy regarding war. Today’s change in mark-to-market rules is a good first step toward restoring the accountability of big accounting bodies like FASB and the Public Company Accounting Oversight Board.
If there is anything regrettable about today’s action, it is that Hank Paulson and Tim Geithner didn’t push through this reform sooner and save the economy all this consternation and taxpayers all those billions. CEI has been advocating mark-to-market reform almost from the time that the current FASB rule (Financial Accounting Standard 157) was implemented in late 2007, and here is a link to an op-ed I wrote for the Wall Street Journal in September 2008 on how the mark-to-market mandate was a significant factor in spreading the credit contagion.
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