Photobucket - Video and Image Hosting On Thursday December 21, 2006, the parties to a case pending in the United States District Court for the District of Columbia will argue whether the Sarbanes-Oxley Act’s provisions establishing the Public Company Accounting Oversight Board (PCAOB) are unconstitutional. Although the case focuses on only a narrow part of the Act, it has the potential to bring down the entire statute.

The lawsuit was filed on February 7, 2006 by the Free Enterprise Fund against the PCAOB in the United States District Court for the District of Columbia, and is pending before Judge James Robertson. The FEF essentially contends that the Sarbanes-Oxley Act’s provisions establishing the PCAOB violate the separation of powers established in the U.S. Constitution. According to a December 16, 2006 Wall Street Journal op-ed piece by the FEF’s counsel, Kenneth Starr, entitled "A Verdict on Sarbanes-Oxley: Unconstitutional" (here, subscription required), the FEF contends that the PCAOB’s statutory enabling language is constitutionally defective because "unelected commissions should not have the power to regulate, tax and even punish companies and individuals." (Kenneth Starr is now a professor at Pepperdine Law School, but the former federal appellate judge and U. S. Solicitor General is perhaps best known for his service as the Independent Counsel whose investigation of the Whitewater scandal ultimately led to the impeachment of President Bill Clinton.)

Even though the FEF’s suit is addressed only to Sarbanes-Oxley’s PCAOB enabling provisions, the case has the potential to preclude enforcement of the entire Act, at least according to University of Illinois Law School professor Larry Ribstein. In a December 16, 2006 post (here) on his Ideoblog, Ribstein states, "it is a tribute to the haste and sloppiness of the Act’s creation that it contains no clause saving the rest of the Act if a particular provision is declared unconstitutional." So, according to Ribstein, if the FEF’s arguments against the PCAOB’s enabling provisions are found unconstitutional, the ruling would "bring down SOX."

At Thursday’s hearing, the parties will present their oral arguments on FEF’s motion for summary judgement. Oddly, the Court is hearing argument on the summary judgment motion without having first ruled on the PCAOB’s motion to dismiss the case for lack of jurisdiction. A ruling on the summary judgment motion is not likely until early next year.

According to Wikipedia, the Free Enterprise Fund is a free market advocacy group that promotes economic growth, lower taxes, and limited government. The group was founded by economist and policy analyst Stephen Moore. (The Wall Street Journal, in printing Starr’s op-ed advocacy piece on behalf of the FEF, neglected to mention that Moore, the FEF’s founder, is a member of the Wall Street Journal Editorial Board.) The current chairman of the FEF is Mallory Factor, founder of the merchant bank, Mallory Factor, Inc. The website has a lengthy decription of Factor’s business and political activities, here. (Readers should judge the reliability of the site’s information for themselves.)

Update: A December 22, 2006 Washington Post article describing oral argument on the summary judgment motion may be found here.

The Peekaboo Cloak of Secrecy: The PCAOB comes in for criticism from a completely different direction in a December 15, 2006 Washington Post article entitled "Auditing Reform: Mission Accomplished!" (here, registration required). The article is critical of the PCAOB (which, according to the article, is known as "’Peekaboo’ to its friends in the industry") because of the Board’s reliance on a scheme of "prudential regulation" to supervise the Big Four accounting firms. According to the article, prudential regulation "rests on behind-the-scenes collaboration between regulator and regulated." The biggest problem with this "industry friendly" approach, according to the article, is that

by its nature, it overlooks the worst kind of abuses – those that become so commonplace that everyone thinks they’re acceptable. Recent examples range from "managing" quarterly earnings to doling out hot stock offerings to favored customer. At some level, the lawyers, auditors and regulators understood that they violated basic principles of fair dealing. And yet few thought to question these practices.

In the end, it took whistleblowers and outsiders like journalists and states attorneys general to expose these abuses and force new rules. But in the closed loop of a prudential regulator system, none of that would have happened. The whole idea is to keep the heathens out and work things out behind the scenes, without lawsuits, public sanctions or disclosure of embarrassing details….

I have trouble believing that, as the PCAOB asks us to believe, the Big Four have miraculously transformed their corporate cultures, pushed out the bad apples and fixed all their quality-control problems…as long as the PCAOB shrouds its every action involving the Big Four under a cloak of prudential secrecy, we’ll never know, will we?

The source of these kinds of criticisms may perhaps be seen in the PCAOB’s December 14, 2006 release of its "2005 Inspection Report of Pricewaterhouse Coopers LLP" (here). According to a December 16, 2006 Wall Street Journal article entitled "PCAOB Finds Problems at Pricewaterhouse Coopers" (here, subscription required), the PCAOB found deficiencies in the accounting firm’s audit of nine companies, noting that the firm "failed in some cases to catch or address errors in the way the companies applied accounting rules or lacked sufficient evidence to back up some of its decisions."

However, according to the Journal article, "in keeping with the Board’s policies, the report doesn’t identify the companies that had their audits cited." In addition, only a portion of the Board’s report is made public; the report section detailing criticisms of the accounting firm’s quality-control systems is "kept secret and never made public if the firm is able to show that it has corrected the problems cited within 12 months of the report’s issuance."

The PCAOB must issue annual inspection reports for any accounting firm that audits 100 or more public companies. According to the Journal article, the PCAOB "has been criticized for the length of time it is taking to issue annual reports" and the Board has "yet to issue 2005 inspection reports for Ernst & Young LLP and KPMG LLP."

The Ultimate Solution to Accounting Misconduct: While the U.S. accounting profession may chafe under the current regulatory scheme and bemoan its liability exposure, they should at least be relieved to know that the Chinese method of regulatory enforcement has not caught on here. According to a December 15, 2006 article (here), a Chinese court has affirmed the death penalty for an accountant who was involved in defrauding bank customers out of millions of dollars. Liu Yibang is accused of conspiring with Zhou Limin, the head of the China Construction Bank branch in Xi’an, by collecting up to $61 million from organizations and individuals by offering fake accounts with high interest rates. The two defendants have now exhausted their death sentence appeals, and the criminal sentence will be enforced.