Tag: PCAOB

Custody Rule Gotcha on PCAOB “Registered and Subject to Regular Inspection”

A friend in the private fund compliance community just came up with another “gotcha” under the Custody Rule. His client used an auditor that was registered with PCAOB, but had not yet been inspected. He thought it was enough to be registered, while waiting for an inspection. An SEC examiner argued that the auditor needed to be inspected.

It turns out, neither one was right.

Custody hands holding cahs in handcuffs

He and the examiner took a deep dive into the meaning of “subject to inspection” regarding the custody rule. Even thought the SEC used “subject to inspection” in the Custody Rule, it is not defined anywhere by the SEC. It turns out it was up to PCAOB to define “subject to inspection” in the PCAOB rules.

PCAOB says that you are an “inspected firm” if you have audited at least one issuer of public securities. Otherwise, PCAOB does not inspect that auditor. It is outside it’s statutory authority.

“The Sarbanes-Oxley Act authorizes the PCAOB to inspect registered firms for the purpose of assessing compliance with certain laws, rules, and professional standards in connection with a firm’s audit work for clients that are “issuers,” as that term is defined in the Act,* and (following amendments to the Act in 2010) a firm’s audit work for clients that are securities brokers or dealers. Many PCAOB-registered firms perform no such work, and the work they do perform is not within the scope of the PCAOB’s statutory responsibility and authority to assess. The PCAOB does not inspect those firms.”

The SEC takes that to mean that they are not therefore “subject to regular inspection”.

This is terrible result for private fund managers.

You can search for registered auditors on the PCAOB website. It shows the firm’s registration and which of the five categories the firm falls under. You need an “A” to see that the firm has audited at least one public company.  A “C” audit of a broker-dealer will also work. It looks like a “B”, “D”, or “E” will be a problem.

This dovetails into the other technical issue I noted in the Custody Rule regarding “independence.” That definition also refers to the public company reporting side under Regulation S-X. That standard of independence is higher than the independence standard contractually required by investors under fund documents.

Unfortunately, this is a cautionary tale for a fund manager using a smaller auditor. The firm may be registered with PCAOB, but if its practice does not include public companies or broker/dealers, the firm may not meet the standards of the Custody Rule for audited financial statements. Check the PCAOB website.

PCAOB is Fixed – May Take Other Agencies Down (or get Fixed)

In the Free Enterprise vs. PCAOB decision, the Supreme Court found that a double layer of limitation of firing for cause is unconstitutional. You can’t have an agency where the officers are only removable for cause under another federal agency whose members are only removable for cause. One level of protected tenure is acceptable, but two is not.

In his dissent, Justice Breyer argued that PCAOB is not the only agency that had two level of protected tenure. He goes on to name names. He identifies four other appointments that have more than one level of protection.

Federal Labor Relations Authority: Foreign Service Labor Relations Board
“The Chairperson [of the FLRA, who also chairs the Board] may remove any other Board member . . . for corruption, neglect of duty, malfeasance, or demonstrated incapacity to perform his or her functions . . . .” 22 U. S. C. §4106(e)

General Services Administration: Civilian Board of Contract Appeals
“Members of the Civilian Board shall be subject to removal in the same manner as administrative law judges, [i.e., ‘only for good cause established and determined by the Merit Systems Protection Board.’] ” 41 U. S. C. §438(b)(2)

Postal Service: Inspector General
“The Inspector General may at any time be removed upon the written concurrence of at least 7 Governors, but only for cause.” 39 U. S. C. §202(e)(3)

Social Security Administration: Office of the Chief Actuary
“The Chief Actuary may be removed only for cause.” 42 U. S. C. §902(c)(1)

I think Justice Breyer just removed tenure from these positions.  In reading the PCAOB decision, I don’t think these positions are unconstitutional. Merely, they have lost their tenure and can now be removed at-will by the independent boards that appoint them.

PCAOB is Ruled Unconstitutional

This morning, the United States Supreme Court issued its opinion in the case of Free Enterprise Fund v. PCAOB. For me in the compliance world, the case was about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gave the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

The Supreme Court ruled that the limitations on the power to remove the members of the board is unconstitutional under the separation of powers doctrine. The board members are inferior officers, and the method of appointment under the Sarbanes-Oxley Act violates the Appointments Clause.

The ruling does not seem to shut down PCAOB immediately since the Court declined to allow a broad injunction against PCAOB’s continued operation. The challengers to the method of PCAOB board-member appointment are entitled to a declaratory order “sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive.”

The Court also found the PCAOB provisions severable from the rest of Sarbanes-Oxley, so they did not invalidate the entire law.

There will have to be some quick tinkering by the SEC and Congress on how to deal with the ruling.

Administrative law professors will need to tinker with their classroom teaching and casebooks to address this case and its implications.

Update – Some key quotes from the Opinion:

We hold that the dual for-cause limitations on the removal of Board members contravene the Constitution’s separation of powers.

The Act before us does something quite different. It not only protects Board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists. That decision is vested instead in other tenured officers—the Commissioners— none of whom is subject to the President’s direct control.The result is a Board that is not accountable to the President, and a President who is not responsible for the Board.

Second Update

[T]he existence of the Board does not violate the separation of powers, but the substantive removal restrictions imposed by §§7211(e)(6) and 7217(d)(3) do. Under the traditional default rule, removal is incident to the power of appointment. … Concluding that the removal restrictions are invalid leaves the Board removable by the Commission at will, and leaves the President separated from Board members by only a single level of good-cause tenure. The Commission is then fully responsible for the Board’s actions, which are no less subject than the Commission’s own functions to Presidential oversight.

That leaves the 15 U.S.C. §7211(e)(6) and 15 U.S.C. §7217(d)(3) out in the cold, but saves PCAOB and Sarbanes-Oxley from destruction in a very narrow ruling. It seems that Congress will not need to take any action since the decision merely grants the SEC the right to remove any Board member for any reason. No longer is removal limited to a firing “for cause.”

There may be some argument that the past rulings and standards set by PCAOB were made by an unconstitutional. That’s heading down a path way beyond my expertise (or interest).

So life will continue on, but the PCAOB board members have  less job security.

Sources:

Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

Image of Old West Bank – It’s a beautiful bank is by oddsock

Tuesday Morning Quarterback of Free Enterprise v. PCAOB

pcaob logo

On Monday, the Supreme Court listened to the oral arguments in Free Enterprise Fund v. Public Company Accounting Oversight Board (08-861). For me in the compliance world, the case is about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gives the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

If the Supreme Court agrees that PCAOB isn’t constitutional, it could force a revisit of Sarbanes-Oxley, or at least the portion of it that creates PCAOB. In a broader view for constitutional scholarship, the case could also call into question other independent agencies and how they appoint members of those agencies.

David Zaring in The Conglomerate thinks that the Supreme Court is unlikely to get in the way of an important government agencey. After all eliminating an agency is a sever sanction.

Orin Kerr in The Volokh Conspiracy> got the impression that the arguments did not go well for the challengers to the constitutionality of the Public Company Accounting Oversight Board.

Fawn John Johnson and Jess Bravin in The Wall Street Journal look to Justice Kennedy as the key to which way the Supreme Court will decide. The liberal justices are less likely to find fault with the independent agencies. For conservative legal scholars, the case is less about the accounting board itself than about the “unitary executive” theory, which holds that because the president is accountable to the electorate, he must be able to remove federal officials at will.

The transcript and reports seem to focus on how much control the SEC has over PCAOB. Hans Bader points out that the SEC had previously expressed its frustration about how little control it had over PCAOB, seemingly contrary to the arguments made in front of the Supreme Court.

David Zaring in The Conglomerate points out that the number of law review articles referring to “PCAOB”: 1021.  Number referring to “PCOAB”: 29. So much for the higher scholarship and editing of law review articles over blogs.

UPDATE:

Broc Romanek, of The Corporate Counsel.net provides a great first-hand account of the hearing and his experience at the Supreme Court the day of the hearing: My SCOTUS Experience: The Full Monty.

References:

Is PCAOB Constitutional?

vanderbilt law review

Now that Jones v. Harris has been argued, we have to sit and wait for the decision. But there is another compliance case coming up for argument in front of the Supreme Court: Free Enterprise Fund v. PCAOB.

The PCAOB case is much sexier than the Jones case since it involves the president’s constitutional powers of appointment and the separation of powers under the Constitution. (At least as far as compliance is sexy.)

The November 2009 edition of the Vanderbilt Law Review has a quartet of articles that focus on the PCAOB case and the underlying constitutional issues:

Congress created the Public Company Accounting Oversight Board PCAOB under the umbrella of the Securities and Exchange Commission. If PCAOB is a government agency and its members are officers, then the appointment of the PCAOB is very odd. The President can appoint the SEC Commissioners, but only remove them “for cause.” Then in turn the SEC Commissioners appoint the PCAOB members.

The issues arises from the Appointments Clause of the U.S. Constitution U.S. CONST. Art. I, § 2, cl. 2;:

[The President] shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Are the PCAOB‟s Members “principal officers” of the United States, whose appointment must, be made by presidential nomination and Senate approval? Even if they are “inferior officers” of the United States, does PCAOB violate the Constitution‟s arrangement for the appointment and removal of such officers because they are put entirely in the hands of the SEC, an independent regulatory commission, beyond the effective reach of presidential oversight?

There are lots of interesting issues discussed in these articles and lots of interesting things the Supreme Court could do in its opinion for the PCAOB case. It could have broader implications to other government commissions, accountants and compliance professionals.

Is the Public Company Accounting Oversight Board Unconstitutional?

pcaob_logo

That question is on the docket for the Supreme Court in October. The Court agreed to rule on the constitutionality of the Public Company Accounting Oversight Board in Free Enterprise Fund v. PCAOB (08-861). The Sarbanes-Oxley Act passed in 2002 created PCAOB as a new government agency to regulate firms that audit the books of publicly traded companies. The key question in the case is whether the Act violated the separation-of-powers doctrine.

This amici brief from a group of law professors says: No, its unconstitutional.

As law professors who have studied and written about the massive accounting and corporate governance scandals that prompted the passage of the Act, we applauded Congress’s decision to establish a new independent regulator to oversee the conduct of the auditors of public companies. We have been concerned, however, that the particular design chosen by Congress accorded the PCAOB substantial discretion and autonomy without imposing constitutionally sufficient accountability. The current economic crisis in the financial markets has raised for us another concern: that Congress may use the design of the PCAOB in creating additional independent financial regulators. Ultimately, we hope that a decision by this Court will prompt Congress to restructure the PCAOB as a regulator that is more accountable and transparent.

The professors in the brief are: Stephen Bainbridge, Robert Bartlett, William Birdthistle, Timothy Canova, Lawrence Cunningham, James Fanto, Theresa Gabaldon, Lyman Johnson, Roberta Karmel, Donna Nagy, Lydie Pierre-Louis, Adam Pritchard, Margaret Sachs, Gordon Smith, and Kellye Testy.

The Cato Institute and law professors Larry Ribstein and Henry Butler came to the same conclusion.

Historically, the power to remove an official “for cause” was seen as “an impediment to, not an effective grant of, Presidential control.” Morrison v. Olson, 487 U.S. 654, 706 (1988) (Scalia, J., dissenting). But at least traditional independent agencies are subject to this control. That much is settled. Here, the Board is protected from Presidential control by two layers of “for cause” removal statutes—rendering removal effectively impossible.

Also lining up against PCAOB are The Washington Legal Foundation, Mountain States Legal Foundation and American Civil Rights Union.

Reference:

Supreme Court to Rule on Sarbanes-Oxley

pcaob_logo

On Monday, the Supreme Court agreed to rule on the constitutionality of the Public Company Accounting Oversight Board. The Sarbanes-Oxley Act passed in 2002 created PCAOB as a new government agency to regulate firms that audit the books of publicly traded companies. The key question in the case is whether the Act violated the separation-of-powers doctrine. The case is Free Enterprise Fund v. PCAOB (08-861).

In this challenge, Free Enterprise Fund and Beckstead and Watts, LLP, LLP contend that Title I of the Sarbanes-Oxley Act of 2002 , 15 U.S.C. §§ 7211-19, violates the Appointments Clause of the Constitution and separation of powers because it does not permit adequate Presidential control of the Public Company Accounting Oversight Board. Congress made the Board’s exercise of its duties subject to the control of the Securities and Exchange Commission. The SEC sets the rules and may remove members. In turn, the President appoints members of the SEC, with the advice and consent of the Senate, and may remove them for cause. In appellants’ view this  scheme vests Board members “with far reaching executive power while completely stripping the President of the authority to appoint or remove those members or otherwise supervise or control their exercise of that power.”

Effectively, they object that the members of PCAOB, an independent agency, are appointed by the SEC, another independent agency, instead of the President. Neither the President of the United States nor a Presidential alter ego possesses any power to remove PCAOB members for cause or otherwise.

The D.C. Circuit did not accept this challenge and ruled in favor of PCAOB and the United States.

References:

New Custody Rules for Investment Advisers

sec-seal

The Securities and Exchange Commission proposed rule amendments as part of their Open Meeting on May 14, 2009. They talked about the proposed rules, but have not actually made them available. It is hard to judge the potential impact of the rules with being able to see them.

According to the press release and the speech by Mary Schapiro here is a summary of the proposed rules:

  • All registered investment advisers with custody of client assets will undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.
  • If you are an investment advisers whose client assets are not held or controlled by a firm independent of the adviser, you will be required to obtain a SAS-70 report that describes the controls in place, tests the effectiveness of those controls, and provides the results of those tests.
  • You would be required to disclose in public filings with the SEC the identity of the independent public accountant that performs your “surprise exam.”
  • The proposed rules would require that all custodians holding advisory client assets directly deliver custodial statements to the clients instead of through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser.

According to Commissioner Schapiro: “We are taking this action in response to major investment scams — such as Madoff — and many other potential Ponzi schemes.”

Public comments on the proposed rule amendments must be received by the Commission within 60 days after their publication in the Federal Register.

References:

Auditing Standard No. 5 for Smaller Companies

pcaob_logoPCAOB released Staff Views for applying the provisions of PCAOB Standard No. 5 for audits of smaller, less complex public companies (.pdf) on January 23, 2009. Standard No. 5 is focused on assessing the effectiveness of internal controls over financial reporting. This Staff View of PCAOB Standard No. 5 discusses how to scale an audit to fit with smaller companies.