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 would rescue SOX but perhaps with its beating heart cut out.
A sideways challenge to the law is currently before the U.S. Court of Appeals for the District of Columbia Circuit. The question: whether the Public Company Accounting Oversight Board, created by SOX 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 AG, called it "highly likely" that the PCAOB would lose its 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 SOX in 2002 after the Enron Corp. and WorldCom Inc. frauds, with an assist from Adelphia Communications Corp., Global Crossing Ltd., HealthSouth Corp., Tyco International Ltd. 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.
SOX set up the 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 CEOs and CFOs 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 SOX ever since. Among other things, they sob that the law costs too much. (I should note that good accounting costs pennies compared with CEO bonuses -- but then, CEOs never think they cost too much.)
The challenge to the PCAOB is technical, having to do with whether the president should appoint board members rather than the Securities and Exchange Commission. The plaintiff, Beckstead & Watts LLP, 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 Washington-based Competitive Enterprise Institute, which backs the lawsuit, says that SOX 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 & Co. in San Francisco reports that, in 2003, 4.1 percent of all listed U.S. firms restated their reported earnings to correct mistakes. Under SOX, which forced stricter scrutiny, that number jumped to 11.5 percent in 2006. Since then, it has edged down, as companies improved their internal financial controls. That's good for investors and good for management, too. CEOs 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.
If the appeals court does throw out the 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 the PCAOB board. In practice, SOX 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 the SEC.
No free passes
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 Duke University. Auditing rules could be simplified but no public company should get a free pass.
Foreign companies would seek more exemptions, too. CEOs and CFOs 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. SOX still won't be out of the woods.
Quinn, a leading personal finance writer, and author of ``Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.