The Public Company Accounting Oversight Board Disaster You Cant Make This Stuff Up
As new revelations of corporate accounting irregularities surfaced during the first half of 2002, the public accounting profession came under intense scrutiny and criticism as a result of its perceived failure to expose any of these large-scale, long-running accounting frauds before meltdown occurred. In certain cases, gross negligence or outright complicity by accountants was alleged. Investor and political outrage finally peaked around mid-year with the back-to-back bankruptcy filings of Adelphia Communications and WorldCom, along with the discovery of misuse/misappropriation of corporate assets and massive accounting irregularities, respectively. (Subsequent revelations at WorldCom have tripled the size of initial earnings misstatements, which now reach back to 1998.) Furthermore, as details emerged on the full extent of Arthur Andersen's relationship with Enron and other failed audit clients, it soon became common knowledge that many large accounting firms were typically providing a lucrative suite of non-audit services to audit clients, with such non-audit service fees often dwarfing audit-related fees. Irate investor watchdogs and politicians quickly seized upon this widespread practice as a potential impediment to the independence requirement of the accountant in the performance of the attest function. To too many, it had become apparent that major accounting firms had frequently been too lax, cozy, or compromising with certain audit clients, and the accounting profession could no longer be trusted to regulate itself.
The quick passage of the Sarbanes-Oxley Act on July 30, 2002, was generally hailed as an effective means of dealing with the burgeoning crisis of confidence in American equity markets. The framework of the Act sought to regulate the accounting profession, improve corporate governance and financial disclosure requirements, and ultimately restore investor confidence in the integrity and transparency of public companies' financial statements and accompanying disclosures.
A key feature of the Act was the replacement of the system of self-regulation for the accounting profession and the creation a Public Company Accounting Oversight Board (PCAOB), consisting of five full-time, independent members whose function was to oversee public company audits. The PCAOB was given broad powers and authority, including those to register public accounting firms, to set by rule auditing, ethics, quality control and independence standards, to inspect the auditing operations of registered accounting firms, to investigate violations of ethics or conduct set by the profession itself and the PCAOB's own rules, and to enforce compliance with the new legislation and the PCAOB's own rules. The Act required the Securities and Exchange Commission (SEC) to appoint members to the PCAOB within 90 days of the Act's passage—that is, by Oct. 28, 2002.
The eventual appointment of Hon. William Webster, the former director of the FBI and CIA, as chairman of the PCAOB on Oct. 25 and subsequent revelations about his recent involvement as a director of a small, troubled company proved to be a major embarrassment for the SEC, prompting the resignations of Chairman Harvey Pitt, Chief Accountant Robert Herdman, and lastly, Judge Webster himself.
The General Accounting Office (GAO), the investigative arm of Congress, at the request of House Reps. John Dingell (D-Mich.) and Barney Frank (D-Mass.), conducted an inquiry into the events leading up to the resignation of Judge Webster on Nov. 12, 2002, and drafted recommendations to improve the PCAOB selection process. The GAO report was released in late December and is available on the agency's web site (www.gao.gov). The report provides a startling account of a dysfunctional process that was deeply flawed and rudderless almost from its inception. Many details of the GAO report have already been widely covered in the print medium, particularly those that elaborated on procedural flaws in the identification, selection and vetting of PCAOB candidates, and the utter lack of effective communications among the SEC's chairman, commissioners, chief accountant and general counsel throughout the process.
But the most intriguing aspect of the GAO report is that the abundance of poor judgment exercised by certain key players in this drama—particularly Chief Accountant Robert Herdman—has generally been underreported in the press. Chairman Pitt hired Mr. Herdman as the SEC's Chief Accountant in September 2001 after having spent his entire 30-year career in the public accounting profession. He and Mr. Pitt had known each other for several years, dating back to Mr. Pitt's days as a lawyer representing the accounting profession and its interests on Capitol Hill.
While Chairman Pitt had overall responsibility for the selection process, he asked Chief Accountant Herdman to take the lead in identifying potential nominees for the PCAOB, according to the GAO report. As for a PCAOB chairman, "The SEC chairman initially planned that he, along with a Democratic commissioner and the chief accountant, would approach candidates about the chairmanship." Chairman Pitt wanted each member of the PCAOB to be beyond reproach, and asked the general counsel to vet candidates and "...at a minimum, identify any significant potential problems or conflicts, real or perceived, involving accounting and other related issues." His stated goal was to avoid politicizing the process and obtain unanimous votes from all five commissioners for each PCAOB member nominated.
Following the commissioners' loss of initial support for John Biggs as PCAOB chairman in early-October, Chairman Pitt, his chief of staff and Chief Accountant Herdman met with Judge Webster on Oct. 15 and urged him to consider serving as chairman. During this meeting, Chairman Pitt reminded Judge Webster of the media scrutiny and possible criticism his nomination would receive, to which Judge Webster expressed some concern that he had been a director and head of the audit committee of U.S. Technologies (USXX), a small company he stated was on the brink of failure, and asked the SEC officials to check and see if its records indicated any problems relating to USXX. The company was primarily a contract manufacturer of furniture and electronic components facilitated through the use of prison labor, but had also made numerous small acquisitions of information technology companies. USXX had annual sales of less than $3.0 million in 2000 and 2001. Judge Webster became a director of USXX in April 2000 and resigned this position in July 2002.
Subsequent to that meeting, Chairman Pitt asked Chief Accountant Herdman to look into USXX. Mr. Herdman then asked his secretary to determine whether there were any open or closed SEC investigations of the company. Neither Mr. Herdman nor anyone else who attended the Oct. 15 meeting with Judge Webster contacted the SEC's general counsel, who was responsible for vetting PCAOB candidates. The SEC's Division of Enforcement informed the office of the chief accountant that there was an allegation of misconduct by an officer of USXX involving a Schedule 13D filed in 1999. This infraction did not involve Judge Webster, and the matter was expected to be closed shortly. On the basis of this information, Chief Accountant Herdman concluded that this matter should not affect Judge Webster's nomination as PCAOB chairman, and this information was indirectly passed on to Chairman Pitt, who then informed Judge Webster on Oct. 22 that his involvement with USXX would not affect his nomination. Judge Webster then spoke with the other commissioners and general counsel, and later agreed to be considered for PCAOB chairman on Oct. 23.
Chief Accountant Herdman then conducted a second inquiry into Judge Webster's involvement with USXX on Oct. 24 after receiving a draft of a newspaper article on the very topic. This time he asked a staff member to review certain of the company's periodic filings with the SEC. On the morning of Oct. 25, the day Judge Webster and the other four PCAOB nominees were to be voted on by the Commission, the chief accountant's staff learned from its review of the company's filings that USXX's audit committee had dismissed its external auditor in August 2001, one month after the auditor informed the company of material internal control weaknesses. Specifically, BDO Seidman LLP informed USXX's audit committee and senior management verbally and in a letter of a material weakness in internal control "related to financial and accounting infrastructure including lack of an experienced CFO, deficiencies in recording material transactions timely, and in the organization and retention of financial documents and accounting records."
Upon learning about the results of this second inquiry, Chief Accountant Herdman determined that, "...in his view and his staff's view, nothing had come to light that affected the suitability of Judge Webster to serve as PCAOB chairman." Neither Judge Webster nor USXX's current or former auditor was contacted to obtain additional information on this issue. Furthermore, Chief Accountant Herdman did not inform the SEC chairman, commissioners or general counsel of his new findings since he did not believe these events posed a problem for Judge Webster's nomination. The vote proceeded as scheduled on Oct. 25, with Judge Webster winning approval by a 3-2 margin. One commissioner vetoed the entire slate, "...stating that the selection process was inept and seriously flawed," while another commissioner dissented on Judge Webster based on the belief that Mr. Biggs, the previous candidate under consideration, was more qualified for the position of PCAOB chairman.
On Oct. 28, Judge Webster contacted Chairman Pitt and informed him that law enforcement authorities were investigating USXX's CEO for allegations of fraud. The GAO report found no evidence that Chairman Pitt or the other commissioners knew of the findings of Chief Accountant Herdman's second inquiry prior to the Oct. 25 vote. They, as well as the general counsel, claim to have learned of the information withheld from them by Chief Accountant Herdman in newspaper articles appearing within a few days after the vote. And the rest, as they say, is history. If the entire Judge Webster episode had been a deliberate set-up, it could not have been more successful in discrediting—at least momentarily—the Commission and its leader, Chairman Pitt.
Assuming that Chief Accountant Herdman wasn't the designated fall guy for the Commission (not exactly the craziest of thoughts), it stretches the limits of credulity that Herdman's best judgment told him that none of the facts that emerged about USXX from his second inquiry should have any negative bearing on Judge Webster's nomination. Given the public's heightened sensitivity to corporate scandals, its perception that the Bush administration was soft on white-collar wrongdoing and the intense public outcry to get tough on corporate misdeeds, it was an absolute imperative that nominees to the PCAOB—the very body created by congressional mandate to discourage and punish future misdeeds—had to be eminently qualified and squeaky-clean in order to be deemed worthy of consideration. Chairman Pitt said as much early in the process. Granted, the Commission was under tremendous pressure to appoint a board within the approaching 90-day deadline, but there should be no sympathy for this predicament since the Commission's own terribly ineffective selection and vetting process (as described in the GAO report) was largely responsible for cutting it so close in the first place. As embarrassing as it would have been to attempt to delay or postpone the vote on Oct. 25 and conduct further inquiry on Judge Webster and USXX, Chief Accountant Herdman ultimately did far more damage to the Commission's credibility by concealing new information from all of the commissioners, allowing the vote to proceed and labeling it a judgment call.
Furthermore, the following additional information on USXX may or may not have been known by Chief Accountant Herdman prior to the Oct. 25 vote, but was knowable via a quick 60-minute search I made through the company's Form 10-K and 8-K filings with the SEC:
- During the year-ended Dec. 31, 2000, Mr. Gregory Earls, USXX's co-chairman and co-CEO, also fulfilled the roles of CFO and principal accountant officer of the company. Between March 15, 2001, and year-end 2001, Mr. Earls was chairman, CEO, president and CFO of the company. This is a stark example of incompatible job functions and poor (probably non-existent) corporate governance policy.
- USXX did not hire a Chief Financial Officer until January 2002.
- During 2001, there were several transactions and/or transfers between the company and CEO Earls or entities controlled by CEO Earls. Though the company disclosed these items, they are the types of incestuous dealings that investors have increasingly frowned upon in the current environment.
- All but one of 10 directors of USXX resigned within six months of each other in the first-half of 2002, with six directors resigning between February and April 2002 and three others, including Judge Webster, resigning in July 2002. CEO Earls was left as the only director of the company following these resignations.
- As of April 27, 2001, each member of USXX's board of directors, including Judge Webster, was awarded 350,000 at-the-money stock options with a three-year vesting period as compensation for serving as directors during the previous year. Even under the most conservative option pricing assumptions, the theoretical value of these options was extremely generous compensation for directors of such a small company as USXX.
Former Chairman Pitt has since stated that he believes the GAO report vindicates him—a rather amazing assertion. True enough, the report does confirm that he had no knowledge of certain facts known by Mr. Herdman on the day of the vote, and therefore did not withhold such critical information from the other commissioners. But the Commission's ineptitude in handling the selection and vetting process, which the GAO report goes to great lengths to criticize, apparently left Mr. Pitt feeling unblemished even though he bore ultimate responsibility for the overall undertaking.
What does any of this have to do with Turnaround Topics? Not much, I suppose, except to serve as an object lesson to practitioners that under certain circumstances even the brightest minds, sharpest talents, most experienced and reputable businesspeople are capable of poor judgment and bad decisions, especially when the wrong incentives are in place. In retrospect, Judge Webster, a man with a long and distinguished career of public service and accomplishment, must have surely pondered over why he ever agreed to serve as director of a small, quasi-shady outfit like USXX. Former Senator George Mitchell of Maine, a director of several Fortune 500 companies as well as USXX during this time, must have had these same second thoughts as well. Moreover, Judge Webster's own seasoned instincts should have told him to beg off the PCAOB chair position given that the demise of USXX was still an unfolding story with murky details from which he had disassociated himself only three months earlier. Nine directors don't usually resign their positions within six months due solely to a company's financial deterioration. Clearly Judge Webster had personally done nothing wrong or illegal, but he was just too close to any potential stink for a reasonable person's comfort. Chairman Pitt unwisely opted not to involve himself enough in a mission that was critical to the integrity of the Commission. Lastly, Chief Accountant Herdman failed to perform adequate due diligence and then crossed his fingers and hoped it wouldn't matter anyway. As the hippies used to say in the '60s, "Question authority." That may not be such simplistic advice after all.