Lawsuit Threatens Sarbanes-Oxley Act

The accounting rules were created after the scandal at Enron cost its employees and shareholders dearly.
The accounting rules were created after the scandal at Enron cost its employees and shareholders dearly. (By David J. Phillip -- Associated Press)
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 Enron-tainted 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 goes down.

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 morass.

Congress passed Sarbanes-Oxley in 2002 after the Enron and WorldCom frauds, with an assist from Adelphia Communications, Global Crossing, HealthSouth, Tyco International 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 Exchange.

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.

The 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 accounting?

The research firm Glass, Lewis in San Francisco 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 Mark Olson. "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.

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