Institutional Investors Defend an Independent PCAOB as Integral to Reform of Securities Markets

In a Supreme Court brief, a consortium of major institutional investors view the PCAOB’s authority to establish auditing, attestation, quality control, and independence standards, subject to SEC approval, as central to the oversight structure around which a reformed investment market is being built. This is in contrast to the patchwork, voluntary system the Board replaced. Essentially, the brief argues that it would be deleterious to investor confidence to return to an industry-centric peer review system of audit oversight whose strongest sanction was expulsion from the AICPA. The PCAOB, by contrast, has the discretion, subject to SEC review, to choose from a broad array of sanctions for a rule violation, ranging from censure through permanent disbarment. Thus, the consortium urged the Supreme Court to rule in the Board’s favor in an action challenging its constitutionality. The amicus brief was signed by, among others, the Council of Institutional Investors, CalPERS, and TIAA-CREF.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The main argument is that, under the Appointments Clause, Board Members are Officers of the Unites States subject to appointment by the President and not by the SEC, as is currently required by Sarbanes-Oxley. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

According to the brief, fundamental to the PCAOB’s mission is its power to set auditing standards. For generations, establishing auditing standards had been the province of the AICPA, which used various arms to exercise this authority. According to the brief, the total mix produced a situation that threatened the independence and objectivity of the entire process of promulgating standards and supervising the public auditing industry. Shifting the authority to promulgate auditing standards from the accountants’ own trade association to the independent PCAOB, reasoned the institutional investors, restored the fact and perception of objectivity.

Because the PCAOB starts its rulemaking from a position of independence from the regulated industry and also because that process invites participation by affected shareowners and other stakeholders, reasoned the brief, the outcome is likely to be standards that better protect investors’ interest in the accuracy of financial statements. Moreover, the confluence of rulemaking, inspection, and enforcement authority in the Board means that standards are more likely to evolve quickly and effectively to meet real-world needs.

Rejecting the contention by other amici that the PCAOB’s auditing standards are too burdensome, the institutional investors found comfort in the fact that the Board’s rules are subject to notice-and-comment review before the SEC, which receives the comments of public companies regarding burdens of compliance.

Further, drawing on the lessons from the history of voluntary self-regulation, Congress endowed the PCAOB with the necessary enforcement tools to fulfill its mission, including inspection authority, investigatory powers, and recourse to significant sanctions. All of these tools are subject to SEC oversight. And PCAOB inspections go beyond reviewing auditors for technical compliance, noted amici, delving into the broader business context of audit practices and influencing those practices.

In the view of the institutional investors, the increased regularity and rigor of inspections greatly improve the odds of detecting violations of auditing standards or auditor independence rules. Further adding to the PCAOB’s ability to detect and correct violations in a timely manner is the lifting of any restraint on inspection of audit engagements that are the subject of litigation or other ongoing controversy.

Under the previous peer review regime, reviews of such engagements were delayed until after litigation or other disputes were resolved. Under that system, said the brief, years could pass from the time a violation was committed to when it was caught and punished, if at all. The PCAOB’s new flexibility to review engagements even while a lawsuit or controversy is pending provides for more swift and certain correction of violations, contended the brief, furthering the interest of investors in removing the financial reporting process from the hands of incompetent or unethical auditors.

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