Lawsuit Threatens Sarbanes-Oxley Act
By Jane Bryant Quinn
Sunday, July 20, 2008
Just when you thought that the drive toward better financial
accounting couldn't be stopped, a stick may be shoved into the
spokes. A decision expected soon from a federal court might
throw the Sarbanes-Oxley Act into limbo. The law, also known as
SOX, is essential to the movement for accurate and honest
corporate reports. Congress could rescue SOX but perhaps with
its beating heart cut out.
A sideways challenge to the law is before the
U.S. Court of Appeals
for the District of Columbia Circuit. The question: whether the
Public Company Accounting Oversight Board,
created by Sarbanes-Oxley to clean up the
auditing profession, is constitutional. In a June 5 memo, Linda
Lord, head of legislative and regulatory affairs for the banking
giant UBS, called it "highly likely" that PCAOB would lose the
case. "Not only will it be put out of business," she wrote, "but
SOX in its entirety will fall."
That's because the law lacks a "severability" clause. If one of
its provisions is found to be unconstitutional, the whole law
Lord may be wrong, of course. The court may decide the other
way. But if it does strike down PCAOB, it couldn't come at a
worse time for investors. The financial crisis linked to
subprime loans left the valuation of trillions of dollars of
securities in doubt. Nothing is more important to the
functioning of markets than pulling reliable numbers out of this
Congress passed Sarbanes-Oxley in 2002 after the Enron and
frauds, with an assist from
and a host of lesser perps. During those years, the accounting
industry was supposedly regulating itself for audit quality and
integrity. In practice, accountants were gliding along with the
corporate cheaters in return for luscious consulting fees.
Sarbanes-Oxley set up PCAOB (pronounced peek-a-boo), funded by
public companies, to create better auditing standards and police
their quality. It made other sensible changes, too, including
enhanced requirements for auditing a company's internal
financial controls and insisting that chief executives and chief
financial officers certify the financials as accurate.
You might think those would be normal public-company practices,
and you would be wrong. Many powerful executives as well as
smaller firms have been lobbying to dump Sarbanes-Oxley ever
since. Among other things, they sob that the law costs too much.
(I should note that good accounting costs pennies compared with
chief executive bonuses -- but then, chief executives never
think they cost too much.)
The challenge to PCAOB is technical, having to do with whether
the president rather than the
Securities and Exchange Commission
should appoint board members. The plaintiff, Beckstead & Watts,
a small accounting firm in Henderson, Nev.,
audits companies trading on the
Over the Counter Bulletin Board
In 2004, PCAOB reviewed Beckstead's audits and found that, in
eight cases, the firm "did not obtain sufficient competent
evidential matter to support its opinion on the issuer's
financial statements." Beckstead disagreed, the board instituted
formal proceedings against the firm, and a lawsuit was born.
Competitive Enterprise Institute,
a Washington-based nonprofit group that backs the lawsuit, says
Sarbanes-Oxley creates "rules that hurt businesses and don't
help investors." Don't help investors? Really? Are investors
better off buying stocks based on sloppy or fraudulent
The research firm Glass, Lewis in San
reports that, in 2003, 4.1 percent of all listed U.S. firms restated their reported
earnings to correct mistakes. Under Sarbanes-Oxley, which forced
stricter scrutiny, that number jumped to 11.5 percent in 2006.
Since then, it has edged down, as companies have improved their
internal financial controls. That's good for investors and good
for management, too. Chief executives make better decisions when
they've got sharper financial information.
It takes independent audit oversight to get this done. "It was
new to the U.S. with SOX,"
says PCAOB Chairman
"Now the developed countries and many developing ones are
mandating it, too." At the top of the board's priority list:
subprime issues and audit standards for measuring the fair value
of those slippery derivatives.
If the appeals court does throw out PCAOB, what happens next?
Beckstead asked the court to stop the board dead in its tracks.
More likely, the court would allow a stay of its decision while
the case is appealed to the Supreme Court.
In theory, Congress could respond just by changing the structure
of PCAOB's board. In practice, Sarbanes-Oxley will be opened to
all the business interests that hope to hollow it out. "It turns
into a food fest," says Lynn Turner, former chief accountant for
For example, small businesses want to be exempted from the audit
rules requiring better financial controls. That would amount to
a thumb in investors' eyes. "The smaller the company, the more
likely fraud is to occur," says James Cox, a law professor at
Auditing rules could be simplified, but no public company should
get a free pass.
Foreign companies would seek more exemptions, too. Chief
executives and chief financial officers would try to escape from
having to attest to the integrity of their company's internal
controls -- never a good sign. The new rules defending auditor
expertise and independence could be lost.
If the court supports PCAOB, Beckstead may appeal to the Supreme
Court. Sarbanes-Oxley still won't be out of the woods.
Jane Bryant Quinn, author of "Smart and Simple Financial
Strategies for Busy People," is a Bloomberg News columnist.
Alexis Leondis in New York contributed to