June 3, 2011

Thundershock! PCAOB’s New Chair Floats Mandatory Auditor Rotation

Yesterday, new PCAOB Chair Jim Doty delivered this speech that should be considered the most profound public policy speech ever made by a PCAOB Chair. Jim talks about cultural challenges that still impede auditor independence and skepticism – and then calls for a broad public policy debate to repair the credibility and transparency of the audit. Jim lays out four areas that this debate should touch – auditor’s reporting model, auditor independence, more context for audit committees and audit transparency – all of which have several items within them. But the one item that surely will get people talking is this excerpt from his speech:

The PCAOB’s efforts to address these problems through inspections and enforcement are ongoing. But considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of independence to the performance of quality audit work, the Board is prepared to consider all possible methods of addressing the problem of audit quality — including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.

The idea of a regulatory limit on auditor tenure is not new. Over the years, it has been considered by a variety of commentators and organizations. Through this public debate, the basic arguments both for and against mandatory term limits have been fairly well described.

I won’t revisit all the history now. But most recently, in 2002, Congress considered requiring firm term limits during the debates that led to the Sarbanes-Oxley Act. It ultimately decided that the idea required more study and directed the GAO to prepare a report. That report, issued in 2003, noted that the SEC and the Board would need several years to evaluate whether the Sarbanes-Oxley reforms — including audit partner rotation — were sufficient, or whether further independence measures are necessary to protect investors.

The PCAOB has now conducted annual inspections of the largest audit firms for eight years. Our inspectors have reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures. We have conducted more than 1,500 inspections of smaller domestic firms and of non-U.S. firms. These include multiple inspections of hundreds of those firms. And our inspectors have identified hundreds more cases involving what they determined to be audit failures.

Based on this work, I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against. I don’t have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public.

As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset. We expect to issue this concept release around the same time that we issue the concept release on the auditor’s reporting model, in order that they can be considered together in a holistic manner.

Proxy Access: What If the SEC Loses the Lawsuit?

As we breathlessly wait for a decision in the proxy access lawsuit brought by the Chamber of Commerce and Business Roundtable in the US Court of Appeals for the DC Circuit, it is fair to consider what might happen in the wake of the decision – which is expected sometime over the next few months. As I blogged last month, the SEC was questioned pretty hard during oral argument by the three judges – giving some indication that the SEC may lose the case.

If the SEC loses, Brian Breheny of Skadden Arps notes that the agency’s three options are:

1. Reapprove the Rule 14a-11 provisions and then have the 14a-11 rules and 14a-8 amendments become effective at the same time;

2. Lift the stay on Rule 14a-8 and allow those amendments to go into effect for the ’12 proxy season and then approve the Rule 14a-11 amendments later; and

3. Do nothing.

It’s possible that the SEC could hold off on lifting the stay on Rule 14a-8 at any time because the SEC imposed the stay on those amendments even though they were not the subject of the lawsuit. They could lift this part of the stay regardless if they win or lose. Meaning, if they lose, they could say “we are letting the 14a-8 amendments become effective while we consider what, if anything, we will do with the 14a-11 rules after the decision.”

But they could also lift the 14a-8 stay if they win because of the timing of the decision. For instance, if the decision is issued after the deadlines for filing the Schedule 14N or other 14a-11 deadlines, the SEC may think it would be better to wait until next year. This scenario is highly unlikely – but anything is possible…

Poll: When Will the Proxy Access Lawsuit Be Decided?

It’s expected that the US Court of Appeals for the DC Circuit will deliver its decision sometime this summer, but we don’t know if that indeed will happen – or when within the summer it will take place. Take a moment for this anonymous poll to provide your own input on this hot topic:

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– Broc Romanek