Dennis T. Whalen

1. Stay focused on the audit committee’s top priority: financial reporting and related internal control risk. The challenges of ongoing economic uncertainty and volatility, coupled with the impact of cost-reductions, major public policy initiatives, and an uncertain yet clearly more complex regulatory environment, will require the attention of every audit committee. Meeting this workload challenge will require focused (yet flexible) agendas, with an eye on the company’s key financial reporting and related internal control risks.

2. Continue to monitor accounting judgments and estimates, and prepare for accounting changes. Monitor fair value estimates, impairments and management’s assumptions underlying critical accounting estimates. Recognize that the company’s greatest financial reporting risks are often in areas where there is a range of possible outcomes, and where management is called upon to make difficult judgments and estimates.

3. Consider whether the financial statements and disclosures tell the company’s story. Given the importance of transparency to the investor community, as well as the Securities and Exchange Commission’s ongoing focus on financial disclosures, consider how disclosures can be improved to better address expectations.

4. Focus on the company’s plans to grow and innovate. Growth, strategy and innovation will be front and center as companies search for top-line growth and look beyond the recessionary environment. A key challenge will be monitoring and calibrating growth plans to appropriately balance risk and reward. Given historically low valuations and high levels of corporate cash on hand, understand the company’s position in the M&A “ecosystem.”

5. Reassess the company’s vulnerability to business interruption and its crisis readiness. The global inter-connectivity of business, markets and risk poses challenges for virtually every company. Ensure that management is weighing a broad spectrum of “what-if” scenarios. Is the company’s crisis response plan robust and ready to go?

6. Understand how technology change and innovation are transforming the landscape—and impacting the company. IT risk discussions should be moving (rapidly) beyond “defensive” issues to address the critical challenge today: understanding the transformational implications of IT and emerging technologies—the cloud, social media, mobile technologies and data— and the strategic issues they present.

7. Focus on asymmetric information risk and seek out dissenting views. Is the audit committee hearing views from those below and beyond senior management – e.g., from middle management and business unit leaders, sell-side analysts and critics, and other third parties—about the risks and challenges facing the company? Recognize when asymmetric information risk—the over-reliance on senior management’s information and perspective—is too high.

8. Consider the impact of the regulatory environment on compliance programs and business plans. The increasing complexity of the global regulatory environment—including compliance challenges posed by the Foreign Corrupt Practices Act and the U.K. Bribery Act, the SEC’s whistleblower program, and Dodd-Frank provisions on conflict minerals and compensation clawbacks— will require continued attention. The right tone at the top and throughout the organization is critical.

9. Understand the company’s significant tax risks and how they are being managed and modeled. To stay abreast of critical tax risks—including internal control, compliance and disclosure issues—establish a clear communications protocol for management to update the audit committee on tax risk-management activities.

10. Monitor the PCAOB’s initiatives on auditor independence and transparency, and consider the implications for the audit committee. PCAOB initiatives designed to promote auditor independence, objectivity and professional skepticism have potentially significant implications for the audit process and the role of the audit committee. Consider how the audit committee currently reinforces auditor independence and skepticism, and whether a more robust audit committee report would be beneficial to investors.

The full text of “Ten To-Do’s for Audit Committees in 2012” is available at www.auditcommitteeinstitute.com.

Dennis T. Whalen is partner in charge and executive director of KPMG’s Audit Committee Institute.

Larry Smith (left), Terry Iannoconi and Rosalie Wolf (photos by Jacuqulyn Maisonneuve)

One key area of interest was the need for detailed disclosures of corporate political contributions in light of the Citizens United case, and “robust oversight” of donations. A clear policy on the reporting is necessary for any company, participants said, with some investors calling for a “no-donations” policy at some firms.

Company policies were widely approved by shareholders in 2011, with ISS’s final U.S. Postseason Report noting that proxy contests were less prevalent in the past year. Only nine contested meetings went to a shareholder vote during the first half of 2011, compared to 14 and 25 for the same periods in 2010 and 2009, respectively.

This article is adapted from the “Summary of Proceedings of the 2011 Audit Committee Chair Advisory Council,” available free to all NACD members at NACDonline.org.

“Say-on-pay” proposals were voted down at 1.6 percent of the Russell 3000 firms reporting results, involving only 38 companies through September 2011, and pay programs received an average of 92.1 percent support from investors. As say-on-pay votes gave shareholders an alternative to voting against compensation committee members, the number of Russell 3000 directors failing to garner majority support fell by nearly half.

An SEC update to the Advisory Council highlighted a number of issues upper most on the Commission’s agenda with key implications for audit committee oversight—including Dodd-Frank rulemaking on conflict mineral disclosures, clawbacks of executive compensation and median-pay calculations, as well as offshore cash and the use of non–GAAP metrics in SEC filings.

Advisory Council delegates expressed particular concern over future clawback provisions. They agreed on the importance of ensuring a clear, unambiguous tone at the top and expectations that all relevant facts are considered when making a restatement decision. Yet some noted that the clawback provisions raise some problematic questions, including: Do companies have the systems to implement this? What are the metrics being used? And, if earnings per share (EPS) is used, will it create measurement challenges related to shares outstanding, timing and other inputs to the EPS metric?

In addition, the SEC update noted that the Commission may consider allowing statistical sampling to alleviate possibly cumbersome calculations of median pay, and is examining material disclosures regarding cash held offshore.

Auditors emphasized the need to consider the potential impact of accounting changes on IT systems. In order to avoid “Y2K-like scrambles,” Advisory Council delegates agreed that both audit committees and management should begin identifying what the company needs for implementation, including processes and resources.

Concern about the volume of disclosures required in SEC filings was a particular sticking point. Participants noted the ongoing problem of “disclosure overload,” compounded by the widespread use of boilerplate disclosures driven largely by the fear of litigation. “Telling investors that if the company doesn’t sell products its performance could suffer, doesn’t tell them anything, really,” said one participant.

The Public Company Accounting Oversight Board has a number of initiatives underway, including possible changes to the auditor’s traditional “pass/ fail” reporting model and mandatory audit firm rotation. There was general agreement that a more robust audit committee report—describing in more detail what the audit committee does—would be beneficial. However, the scope of an expanded audit committee report may be limited to what corporate counsel is comfortable saying in the proxy. Attendees also expressed desire for more communication and transparency about the PCAOB inspection process and the significance of inspection findings.

Regarding auditor independence and skepticism, participants noted the difficulty of challenging the auditors. Using executive sessions effectively and meeting with the auditor informally, outside of regular meetings, may be invaluable solutions. While informal meetings may provide additional nuance, in formal meetings the auditor should provide views and perspective, not simply “We did the audit, and it complies with accounting standards.”

Citing the 2011 KPMG Audit Committee Institute survey that revealed that IT risk and emerging technologies are the top issues that audit committee members want to devote more time to over the next 12 months, participants discussed the significant— and accelerating—challenge of effectively overseeing IT risk and governance.

Boards (often with the audit committee taking the lead) are delving deeper into the risks posed by IT and emerging technologies that are transforming the business landscape, from cloud and social media to mobile devices and data analytics. “Defensive” IT risks—data security and privacy, compliance, business continuity and the integrity of financial reporting system—are in the forefront, but boards are also increasingly concerned about strategic IT risks— those posed by the failure to leverage technology to innovate and build competitive advantage. As a leading practice, companies are putting “governance frameworks” into place for IT, data and social media to help manage and oversee these assets as a risk and an opportunity. “Any board that’s not focused on this is missing the boat,” noted one audit chair.

Recognizing that information prepared and presented by management can dominate the boardroom agenda and dialogue, attendees discussed the ongoing challenge of “asymmetric information risk,” as well as clues or indicators of when this risk is too high. While clearly a full board issue, audit committees—given their inclination to view information through a “risk lens”—may be in the best position to monitor this issue.

The group discussed what actions would be meaningful countermeasures to asymmetric information risk, with much of the dialogue focusing on the importance of bringing third-party information and “dissenting views” to the board.

Takeaways
NACD identified three action items stemming from the dialogue to advance audit committee practices and address the common objectives of Advisory Council representatives:

• Identify and facilitate opportunities for audit committee chairs to meet with the PCAOB and exchange views on a more regular and proactive basis.
• Draft a model or template for an expanded audit committee report.
• Develop a board-level educational resource to help directors better understand—and stay apprised of—IT risks and emerging technologies.

Participants
Charles E. (Eddie) Adair: Audit Committee Chair, Tech Data Corp.

James B. Bachmann: Audit Committee Chair, Nationwide Insurance

Joseph R. Bronson: Audit Committee Chair, Jacobs Engineering Group

Meredith B. Cross: Director, SEC Division of Corporation Finance

Gerald M. Czarnecki: Audit Committee Chair, State Farm

Kenneth Daly: President and CEO, National Association of Corporate Directors

Cynthia A. Fornelli: Executive Director, Center for Audit Quality

Peter Gleason: CFO, Managing Director, National Association of Corporate Directors

Daniel L. Goelzer: Member, PCAOB

Judith Richards Hope: Audit Committee Chair, General Mills

Sherrill Hudson: Audit Committee Chair, Publix Supermarkets

Terry Iannaconi: Senior Technical Partner, KPMG LLP

James P. Liddy: U.S. Vice Chair, Audit, KPMG LLP

Mary Pat McCarthy: U.S. Vice Chair, KPMG LLP, Executive Director, KPMG’s Audit Committee Institute

Patrick S. McGurn: Special Counsel, Institutional Shareholder Services

George Muñoz: Audit Committee Chair, Marriott International

Charles H. Noski: Audit Committee Chair, Microsoft

Michael J. Passarella: Audit Committee Chair, Unum Group

David Y. Schwartz: Audit Committee Chair, Walgreen

Lawrence W. Smith: Member, FASB

J.W. Mike Starr: Deputy Chief Accountant, SEC

Richard G. Tilghman: Audit Committee Chair, Sysco Corp.

Rosalie J. Wolf: Audit Committee Chair, TIAA-CREF

Ann Yerger: Executive Director, Council of Institutional Investors

There is a good likelihood that the PCAOB will replicate its prior behavior and adopt (or approve something similar to) the new audit standards, making them applicable to public company audits. Further, major thrusts of the new audit standards are (i) to highlight the role and responsibility of management in the preparation of an entity’s financial statement and (ii) to encourage communication between the auditors of an entity and those charged with corporate governance. It is inevitable that there will be extended, and more meaningful, discussions on myriad  topics that are closely related to the entity’s financial statements. Given this inevitability, it behooves directors to familiarize themselves with the more-interactive environment they are likely to encounter in the near-term future, since it will be interwoven with the question of whether the directors have successfully discharged their fiduciary responsibilities.

The Genesis of Current Accounting Standards
The primary responsibility for generating auditing standards has fallen upon the American Institute of Certified Public Accountants (AICPA), since its predecessor American Institute of Accountants was appointed to that task by the Federal Reserve Board in 1917. Since 1978, that task has been the province of the Auditing Standards Board (ASB), which is the senior technical committee of the AICPA. Over the years, the ASB and its predecessors have generated 120 Statements on Auditing Standards, which are included in the Codification of Statements on Auditing Standards and have come to be known as Generally Accepted Auditing Standards (GAAS).

By virtue of the Sarbanes-Oxley Act of 2002, the PCAOB assumed the responsibility for promulgating auditing standards relating to the financial statements of public companies. With some exceptions, the PCAOB has adopted the pre-existing GAAS as its own.

The Need to Change Auditing Standards
An event that caused the ASB to decide to overhaul its auditing standards was globalization. As entities become more multi-national, their various components became subject to the accounting and auditing rules of different jurisdictions. In an attempt to address this hodge-podge, the International Auditing and Attestations Standards Board (IAASB) began to develop standards that it hoped would be applicable worldwide. The AICPA, however, did not think it appropriate to blindly adopt auditing standards promulgated by an entity that lacked the background to fully understand the development of American audit standards. Thus, the ASB was asked to converge U.S. GAAS with the international standards being developed to the extent possible so the two standards would be more consistent while allowing for divergence where appropriate.

Since a rewrite was necessary, the ASB decided that it should also include the concept of clarity. As 120 standards had been developed over the years by different sets of people, it was felt that an overhaul, including the use of simpler language, would provide a more unified structure that was easier for an auditor to understand.

Also bearing directly on the clarity aspect of the project was the fact that the language used in the standards sometimes obscured the difference between mandatory requirements and applicable guidance.  Thus, the new standards were written in such a way as to clearly distinguish between the two.

By way of example, a comparison of the related parties standard is instructive. The current standard, promulgated in 1983, is 12 paragraphs in length and accompanied by several auditing interpretations generated since. The PCAOB standards are a virtually verbatim adoption. By contrast, the proposed new standard is twenty-seven paragraphs in length, accompanied by 52 more paragraphs of applicable guidance.  As one might imagine, it is both more comprehensive and more specific.

The Roles of Those Charged With Governance
It has always been the auditor’s mantra that an entity’s financial statements are the primary responsibility of corporate management. This makes perfect sense since the management chooses the accounting, develops applicable policies, hires the personnel to implement those policies, establishes and maintains internal controls and then supervises compliance. While management responsibility is the basic premise on which an audit is conducted, mention was only sporadically made in GAAS since the focus was primarily on the auditor.  This has now changed.

The 10 bedrock auditing standards, which have been in existence for more than half-a-century, and which made no mention of management responsibility, will soon be extinct. They are replaced by a Preface to the new Codification which in its second-numbered paragraph has a detailed explanation of why management responsibility is a basic audit premise. Previously, the auditor was encouraged to discuss management responsibility before taking on an audit; now, the management’s acknowledgment of its responsibilities is a mandatory part of an engagement without which an audit cannot be undertaken. The standard auditor’s report, which formerly made a generalized reference to management responsibility, will soon have a detailed explanation for the benefit of recipients.

In addition to this intensification of focus on management responsibilities, the new standards are rife with provisions encouraging a dialogue (and sometimes providing a script) between the auditors and those charged with corporate governance, whenever certain issues arise. Again illustrative is the proposed related party standard.  The basic premise is weaved into one of the application paragraphs, with an explanation as to why the premise is particularly important in the related party context.

How Changes Will Affect Outside Directors
The outside director will approve an audit engagement that acknowledges the role of management in the preparation of financial statements, and will receive an audit report that describes that role at length. It will be impossible for that director to say, with any degree of plausibility, that he/she has no understanding of what that role might be.

Instead, that director would be best served by asking both management and auditor their respective understandings of that role, what policies, procedures, and internal controls are designed to assist in that role, and how well management is meeting those responsibilities. Any unsatisfactory or inconsistent answer should be followed up on, and a concise record should be made of the inquiries and responses to minimize future questions as to whether the directors had fulfilled their fiduciary responsibilities.

Similarly, the increased emphasis on communication between the auditors and those charged with corporate governance will undoubtedly result in more such communications. As the ultimate stewards of the business entity, the directors can only discharge their fiduciary responsibilities by paying close attention to these discussions, resolving any issues that arise, and keeping a careful record of what has transpired.

Of course, one might say that a careful director would do all these things under the present standards, and one would be right. The difference under the new standards is that these circumstances will arise more often. The director should anticipate this development and decide what types of issues should be addressed, after consulting with counsel and consultants as appropriate. The minefield of compliance with fiduciary responsibilities will be tricky and it is best to negotiate it with experienced assistance.

And properly addressing the issues that will be raised is important. Obviously, it is important from a litigation possibility perspective and from the perspective of discharging fiduciary obligations; but it is also important from the perspective of fostering better management performance and more reliable financial statements.
Anthony Costantini is a New York-based partner in the law firm of Duane Morris LLP,.recently completed a three-year term as a public member of the Auditing Standards Board.

It behooves directors to familiarize themselves with the more-interactive environment they are likely to encounter in the near-term future, since it will be interwoven with the question of whether they have successfully discharged their fiduciary responsibilities.

SEC Commissioner Elisse B. Walter emphasized the agency’s continuing focus on disclosures in a recent speech at the annual Corporate Counsel Institute. “[The SEC’s] efforts have been extensive, but, in my view, corporate MD&As are still not where they should be…I call on you to do everything you can to assure that the companies that you serve provide disclosure that enables their owners…to view the company and its prospects through the eyes of insiders.”

In a speech before the AICPA National Conference on current SEC and PCAOB developments, Robert Khuzami, director of the SEC’s Division of Enforcement, said that during investigations of financial fraud, the SEC will “want to ensure that board members have properly discharged their duties when significant financial frauds occur…For audit committees, this means an active role in the accounting and
auditing issues confronting issuers…[and] insuring that the ‘tone at the top’ reflects…a desire to produce accurate financial statements that reflect the true picture of a company’s performance.”

At our Annual Audit Committee Issues Conference, there was a good discussion as to how audit committees are overseeing their companies’ disclosures—e.g., the nature of the committee’s involvement with management’s disclosure committee; the process and timeline for review of the company’s 10-K, 10-Q, and other SEC filings; and most importantly, how to get “behind” the numbers and ensure that financial reports contain proper disclosures.

An oversight practice that several audit committee members recommended was “benchmarking”—to compare the company’s important disclosures with others in the industry. Ask management’s disclosure committee, or perhaps the CFO organization, to take the lead and compare the company’s key disclosures to those of industry leaders.

Among the potential disclosure areas to benchmark:

Critical accounting policies, judgments and estimates. The SEC has repeatedly stressed the importance of explanations regarding the company’s most critical accounting policies, the judgments and uncertainties affecting the application of those policies, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Compare the company’s critical accounting policies, judgments and estimates with others in the industry. Are they more or less aggressive? Are they different? If
so, why? Do the company’s disclosures provide incrementally useful information, such as sensitivity data about the estimates, or are they “boilerplate” or redundant?

Risk factors. As a result of the economic crisis and uncertainty, companies have reassessed and, as necessary, updated their risk-factor disclosures to reflect the new risks to the company’s business. Consider what risk factors others in the industry have disclosed, and how these risk factors and related disclosures differ from the company’s and why. Does the company’s risk-factor disclosure clarify rather than obscure which risk factors are most significant?

Non-GAAP performance metrics. Twenty percent of the SEC’s comment letters in 2009 questioned the use of non-GAAP measures, suggesting that many companies—and the SEC—continue to wrestle with this area of disclosure. Clearly, non-GAAP information (both non-GAAP financial measures and non-financial measures) is playing an increasingly important role in “telling the company’s story” to the marketplace. Consider the types of non-GAAP performance metrics others in the industry disclose, and whether these metrics provide important insights into the company’s financial performance and operations.

SEC comment letters. As part of the benchmarking effort, monitor SEC comment letters sent to others—particularly those in your industry—as these letters contain the views of SEC staff regarding
important accounting and disclosure issues, and can help identify emerging issues that will be the focus of SEC attention for your industry.

Depending on the company and industry,there may be other disclosures to compare. Clearly, benchmarking can help management and the audit committee have a more robust discussion about what the company is disclosing, why and how.

Mary Pat McCarthy is U.S. vice chair, KPMG LLP, and executive director of KPMG’s Audit Committee Institute. Teresa E. Iannaconi is
a partner in the national office of KPMG LLP.

Among federal agencies, the two most active in governance have been the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB).

The Commission’s Agenda
SEC Chair Mary Schapiro recently announced her rulemaking agenda in testimony before the Senate Appropriations Subcommittee on Financial Services and General Government. Noting the accomplishments of her agency in 2009, including proxy-disclosure enhancements and the end of discretionary broker voting for directors, she highlighted several 2010 agenda items ,including proxy-access rules, to“facilitate the effective exercise of the rights of shareholders to nominate directors to the boards of the companies they own.” The SEC is still receiving comments on this proposed rule, Facilitating Shareholder Director Nominations, well past the January deadline. In its early comment on the rule, the NACD emphasized that any new rule should include a mechanism for nominating/governance committees of the board to comment in the proxy on any candidates proposed directly by shareholders, as well as on the committee’s own nominees.

In a related development, SEC staff members are working on a “concept release” on proxy voting, reportedly slated for July 2010. (Concept releases, which are issued only a few times a year at most, are the SEC’s way of testing the waters for a potential revised or new rule.) This concept release would be an important companion to the one on equity market structure issued in January 2010—which presciently addressed the underlying causes of the market crash five months later. Aimed at reforming flaws in proxy voting, this upcoming concept release responds to proxy plumbing concerns expressed by a variety of constituents in the corporate governance community, including chief executives, directors and investors. Problems likely to be tackled include empty voting, double voting and anonymous voting due to default applications of the “objecting beneficial owner” (OBO) category rather than non-objecting beneficial owner (NOBO).

Auditing Priorities
Prioritization is the theme as the PCAOB studies comments received from the Proposed Auditing Standard on Communications with Audit Committees. Comments show that laundry lists are out, key issues are in. In the words of NACD Director Dennis Beresford, who chairs the Fannie Mae audit committee, “A significant danger is that auditors would perhaps focus too much on meeting these extensive requirements to the detriment of truly effective communications with audit committees. For example, audit committee members probably are more interested in knowing auditors’ assessment of the quality of financial management and the ‘tone at the top’ of a corporation than most of the matters covered by the required communications.”

“I do think that the PCAOB really needs to learn more about what audit committee members want to hear from auditors before finalizing a new standard.” —NACD Director Dennis Beresford

Beresford, former longtime chair of the Financial Accounting Standards Board (FASB) and now an accounting professor at the University of Georgia, commended that board for its initiative, but suggested dialogue: “I do think that the PCAOB really needs to learn more about what audit committee members want to hear from auditors before finalizing a new standard.”

Beresford is co-chairing the NACD 2010 Blue Ribbon Commission on the Audit Committee along with NACD Director Michele Hooper, another champion of focus. When the corporate community was pushing back against (now-defunct) Audit Standard 2 implementing Sarbanes-Oxley Section 404 on assessment of internal controls, Hooper gave Roundtable testimony urging the PCAOB and SEC to focus more on risk oversight and less on noncritical issues, and the dialogue succeeded, yielding a more effective and efficient Audit Standard 5. The dialogue is déjà vu all over again, as one of the Commission members is Brian Wolohan, associate director at the PCAOB’s Office of Research and Analysis.

Dodd Bill Advances
Financial stability may not return any time soon to our fair land, but S.3217, the Restoring American Financial Stability Act of 2010, is well on its way to passage. On May 5, the Senate voted 93-5 to pass an amendment from Senate Banking Chairman Christopher Dodd (DCT) Dodd and ranking member Sen. Richard Shelby (R-AL) to address concerns about the bill’s potential for more major bailouts. The new amendment includes an orderly liquidation mechanism for the Federal Deposit Insurance Corporation to unwind failing financial firms that are “systemically significant.” Shareholders and unsecured creditors will still bear losses and management will be removed. Regulators will still have the authority to break up a company if it poses a “grave threat to the financial stability of the United States.” Following the May 6 glitch-driven crash in markets (the day after passage of the amendment!), Dodd told the host of Face the Nation that his financial reform legislation could have helped protect U.S. markets.

The governance provisions in the Dodd financial bill, outlined in the April/May “Washington Update” remain untouched. Starting at Sec. 951, these include new rules on say-on-pay, compensation committee independence, executive compensation disclosures, clawbacks, prohibitions on employee and director hedging, as well as voting by brokers (now moot due to the SEC’s 2009 broker voting rule). Moving on to Sec.971, the governance provisions in the bill cover majority voting, SEC authority to issue rules on proxy access, and disclosure regarding chair and CEO separation (moot due to the SEC’s 2010 proxy rule mandating such disclosure “enhancements” among others).

To cope with these new requirements, likely to be signed into law soon, boards should adopt NACD’s Key Agreed Principles as a minimum standard for governance. Directors then need to work closely with internal and external counsel on complying with the new requirements, which mostly involve issues of communications and disclosure rather than policy.

Will this bring a flood of new lawsuits? Is this a case of “après moi le déluge” (to quote the weather predictions of King Louis XV of France). It’s just one more reason to engage proactive legal counsel to keep the waters at bay.

The Supreme Court heard oral arguments this week in Free Enterprise Fund v. Public Company Accounting Oversight Board, No. 08-861, where the Court is expected to address the constitutionality of Congress’s creation of the Public Company Accounting Oversight Board through the Sarbanes-Oxley Act of 2002.

The Act requires, for the first time, that auditors of U.S. public companies be subject to external and independent oversight, charging the PCAOB with this responsibility. Although it has commenced few major enforcement actions, the PCAOB has significant authority over the rules and standards applicable to auditors of public companies; it recently adopted a new auditing standard and has proposed a suite of seven new standards.

The PCAOB also performs annual inspections of registered firms that regularly audit more than 100 public companies, and at least triennial inspections of all other registered firms. Specifically at issue here, the Court will consider whether Congress ran afoul of the Appointments Clause of the Constitution when it granted authority to appoint and remove Board members of the PCAOB to the Securities and Exchange Commission rather than the President.

BACKGROUND

In the wake of the collapses of Enron and Worldcom, Congress passed the Sarbanes-Oxley Act of 2002, which, among other reforms, created the PCAOB. The PCAOB, which consists of five members appointed by the SEC and removable by the SEC “for good cause,” is charged with overseeing auditors of public companies by registering public accounting firms, establishing audit and ethics standards, conducting inspections and investigations of registered accounting firms, and disciplining violators.

The PCAOB is subject to significant oversight and control by the SEC: among other restrictions: (i) the PCAOB could commence operations only upon SEC approval of its organization and procedures, (ii) its rules are effective only upon prior approval by the SEC, (iii) its existing rules may be modified by the SEC, and (iv) its adjudications are subject to de novo review by the SEC.

Free Enterprise Fund, a non-profit public interest organization, and Beckstead and Watts LLP, an accounting firm subject to a formal investigation by the PCAOB, brought a facial challenge against the constitutionality of the PCAOB’s creation in the United States District Court for the District of Columbia. Plaintiffs alleged that the Act’s creation of the PCAOB violated the Appointments Clause, the separation of powers doctrine, and non-delegation principles. Plaintiffs argued that the Act did not permit adequate Presidential control of the PCAOB, and that the absence of day-to-day supervision of the PCAOB by the SEC and the for-cause limitation on the SEC’s removal power meant the PCAOB’s Board members were not inferior officers and therefore must be appointed by the President.

Defendants—the PCAOB and the United States—moved for summary judgment. Defendants argued that the PCAOB was composed of inferior officers within the meaning of the Appointments Clause, and that the SEC is a Department that may be assigned appointment power. Accordingly, Congress had constitutional authority to vest appointment and termination authority in the SEC. The district court agreed and granted Defendants’ motion for summary judgment.

On appeal, the Court of Appeals for the District of Columbia Circuit affirmed the district court’s finding that the PCAOB Board members were inferior officers. The court reasoned that exercise of the PCAOB’s powers under the Act is subject to comprehensive control by the SEC and PCAOB Board members are accountable to and removable by the SEC. The court further determined that the Act ensures that all PCAOB functions are subject to pervasive SEC control, including approval of its annual budget and supporting fees.

The President’s ability to appoint and remove SEC Commissioners, and the Commissioners’ ability to appoint PCAOB Board members and remove them for cause, “preserves sufficient Executive influence over the Board through the Commission so as not to render the President unable to perform his constitutional duties.”  The court similarly rejected Plaintiffs’ argument that for-cause removal unconstitutionally limits the SEC’s removal power because the SEC’s power to change or limit PCAOB functions at will blunts the constitutional impact of for-cause removal.

The D.C. Circuit, like the district court, also rejected Plaintiffs’ contentions that, even if PCAOB Board members are inferior officers, they cannot be appointed by the SEC because the SEC is not a “Department” and the Commissioners of the SEC are not its “Head” within the meaning of Article II. The SEC is “Cabinet-like,” the court explained, because “it exercises executive authority over a major aspect of government policy, and its principal officers are appointed by the President with the advice and consent of the Senate.”

In his dissenting opinion, Judge Brett M. Kavanaugh of the D.C. Circuit observed that for-cause removal has long been criticized as inconsistent with the text of the Constitution. Noting that both SEC Commissioners and PCAOB Board members are only removable for cause, Judge Kavanaugh stated that the Act created a “double for-cause removal structure [that]. . . completely strips the President’s removal power and. . .poses a greater restriction on the President’s constitutional authority than a single for-cause provision.”

SUMMARY OF THE ARGUMENT

Before the Supreme Court, Plaintiffs-Petitioners argued that the Act violated the separation of powers by insulating the PCAOB from Presidential supervision and control and that the Act violated the Appointments Clause because the PCAOB members are not inferior officers and the SEC is not a Department Head. Petitioners asserted that the PCAOB is “unique among Federal regulatory agencies in that the President can neither appoint nor remove its members, nor does he have the ability to designate the chairman or review the work product, so he is stripped of the traditional means of control that he has over the traditional independent agencies.”

Justice Anthony M. Kennedy began by asking what harms or dangers other than the cost of compliance are “inherent in the power of the board unmonitored or unchecked by the SEC, to investigate?” Petitioners identified the cost of compliance and burdensome investigation beyond SEC review as among the chief hardships imposed by the Act. In clarifying the difference between a cabinet head and the SEC in response to Justice Sonia Sotomayor’s questioning, Petitioners stated that an independent agency is not subject to the President’s plenary control while a cabinet head is.

Justice Stephen G. Breyer inquired whether there is a law preventing the President from removing an SEC Commissioner without cause. Although there is no explicit prohibition on at-will removal of Commissioners, Petitioners noted that the SEC is modeled after the FTC and, under a prior case where the President was precluded from terminating membership in the War Claims Commission, one must look at the function of the agency in determining if removal is for cause or at will. Justice Breyer further pressed the Petitioners, noting that “if an executive officer appoints an inferior officer, which the executive officer can remove for cause, I can’t see a Constitutional problem.” Petitioners responded that the President cannot control the appointment of Board members.

Defendant-Respondent United States, represented by the Solicitor General’s office, maintained that the President has constitutionally sufficient control over the SEC, and the SEC has comprehensive control over the PCAOB. As such, the President has constitutionally sufficient control over the PCAOB. Justice Antonin Scalia, however, observed that “the Chairman [of the SEC,] which is. . .the knife that the President has into the SEC, has no role in the control of the Board.”

According to the Government, there is no difference between the SEC’s supervision of the PCAOB and the supervision of any other SEC function because the SEC could reach out and abrogate any PCAOB rules or promulgate its own rules, which includes delegating control of the PCAOB to the Chairman of the SEC. Chief Justice John G. Roberts responded, “Well the Board can act, and the SEC can, I suppose, retroactively veto their actions, but the SEC doesn’t propose what actions the Board takes, actions which can have significant, devastating consequences for the regulated bodies.”

Chief Justice Roberts then posed the question, “Why did Congress set up a separate Board if it was going to be entirely controlled by the SEC?” The Government replied that Congress did not want the PCAOB to compete with the “resource-strapped” SEC for resources. Additionally, by placing the PCAOB outside of the normal civil services laws, the PCAOB may attract employees it could not attract on normal civil service salaries. In response to the Government’s assertion that for-cause removal was previously approved by the Court, Chief Justice Roberts noted that the two for-cause removal provisions create “for-cause squared,” leading to a “significant limitation” that prior case law did not recognize.

Defendant-Respondent PCAOB similarly argued that the SEC has pervasive authority over the Board because: (i) the SEC can rescind the Board’s authority, (ii) Board inspections and investigations are subject to plenary SEC control, and (iii) the SEC controls the Board’s budget and salaries.

Justice Scalia asked the PCAOB’s counsel: “Do you know any parallel situation where there is a, supposedly, agency composed of inferior officers who have the power to tax the public unless it’s overturned by somebody else?” PCAOB replied that it is not an uncommon feature, but the most critical aspect of the Act is that the judgment and decisions of the SEC control the Board: “[T]he Board can propose, but it’s the SEC that decides.” Justice Scalia opined, “I think if the President called up the FCC and said, ‘I want you to rule this way,’ I think there would be an impeachment motion in Congress.”

IMPLICATIONS

In Free Enterprise Fund, the Court has the opportunity to clarify the extent to which Congress may assign appointment and removal authority to entities other than the President that are not directly controlled by the President. If the Court sides with the Petitioners-Plaintiffs, one of the centerpieces of the Sarbanes-Oxley reforms—the creation of the PCAOB— will be sidelined. But Congress and the Obama Administration could probably remedy that result by making members of the PCAOB directly appointed by the President (and still subject to removal only for cause) or by making members of the PCAOB removable at will by the SEC, as suggested by Chief Justice Roberts.

In the long term, however, a finding of unconstitutionality would place significant limits on the ability of Congress to create additional independent agencies or executive positions that are not directly subject to significant Presidential appointment and removal power.

Peter Bresnan and Jonathan Youngwood, litigation partners with Simpson Thacher & Barlett, contributed to this blog. Bresnan, based in Washington, is a former deputy director in the Division of Enforcement at the SEC. He can reached at pbresnan@stblaw.com. Youngwood, based in New York, regularly represents financial institutions and public companies in securities, corporate control and other complex litigation. He can reached at jyoungwood@stblaw.com. Bashiri Wilson is an associate with Simpson Thacher & Barlett who contributed to this article.

What we also discovered in putting the list together was that in some instances, it became impossible to separate the captain from the team. This year’s D100 is a case in point: Our editors and board of advisors were nearly unanimous in our selection of President Barack Obama as this year’s most powerful corporate governance influence. And yet, to do justice to the seismic shift his policies have brought about in the boardroom, we also had to recognize the many other  “New Voices” in the Administration who are now leading the greatest financial reform of American business since the 1930s.

So, we ask that in the pages ahead you pay more attention to who counts, and less to how we count, in arriving at our final selection of individuals and institutions that have met the requirement to be “most influential.” We think you’ll agree it’s an intricate and impressive mosaic where the whole equals much more than the sum of its parts, which may or may not be greater than 100.

Regulators & Rulemakers

Team Obama
It is often written that reasonable people may disagree, and with Americans and their Presidents, it is practically a way of life. But even an unreasonable person could only conclude that this President and his Administration are having a profound and lasting influence over the boardroom. President Barack Obama has demonstrated an enormous capacity for calm in uncertain times. His relative youth leads to frequent comparisons to John F. Kennedy and his communications skills to those of Ronald Reagan. But it is his aggressive response to the unparalleled economic challenges that greeted him at the dawn of his young presidency that harkens back to an earlier figure of towering influence,  Franklin D. Roosevelt.

FDR’s massive social and financial reform programs—the creation of Social Security as part of the New Deal, the establishment of the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Company (FDIC)—helped restore confidence in the nation’s banking system coming out of the Great Depression. One could plausibly take major portions of FDR’s New Deal and substitute his name with President Obama’s.  The implementation of the $787-billion American Economic Recovery Act one month after Obama took office, coupled with his handling of the Troubled Asset Relief Program (TARP), which sought to strengthen the financial sector by buying up the assets and equity from troubled banks, has clearly helped the nation avoid further financial disaster and put the economy on the path to recovery.

And finally, turning again to the FDR playbook, Obama assembled a team of wise men and women, formidable economic and business minds, whose decisions are having a lasting effect on the role of the corporate director. Preeminent among them was the choice of Rahm Emanuel as chief of staff. Described as a veritable “influence machine,” within the Administration and Congress, the former Congressman from Obama’s home state of Illinois is known as a hard-charging, brutally candid, sometimes combative, acutely intelligent man who can get things done and knows the ways of the Capitol and the boardroom.

The Enforcers
Perhaps second only to Obama in terms of her influence on boards and corporate governance, career regulator Mary Schapiro heads up the 75-year-old SEC. Before the crisis, the agency’s very existence was in question: “Obsolete,” “out of touch,” and “behind the times” were just some of the many terms uttered by detractors. The Commission, under former chairman Christopher Cox, was pilloried for missing the Madoff scandal.

As former SEC chairman and Directorship 100 Hall of Famer, Arthur Levitt described her: “She has the skills, the intellect, and the character to be a superb SEC chair.” But Schapiro will face a new kind of challenge in the role, not just that of proving her own qualifications, but also instituting a significant remodeling of the SEC itself, as she works to bring it into the new regulatory era.

Moving swiftly to address regulatory concerns in the wake of the financial crisis, the SEC has rolled out a series of proposals that could embody the biggest change to the rules of the game for directors in some time. Schapiro, who is no stranger to the boardroom, having served on the boards of Duke Energy and Kraft Foods, has overseen proposed rule changes on proxy access, broker voting, say on pay, and new requirements for disclosure on executive compensation and director qualifications. It’s now up to her and fellow commissioners Kathleen Casey, Elisse Walter, Luis Aguilar, and Troy Paredes to determine the final regulations that emerge from the proposals.

Other key players Schapiro has brought into the SEC include Senior Advisor Kayla Gillan, Chief Accountant James Kroeker, and Director of Enforcement Robert Khuzami. Gillan was a founding board member of the Public Company Accounting Oversight Board (PCAOB) and former general counsel to CalPERS. Kroeker joined the SEC as deputy chief accountant in 2007 from Deloitte and Touche where he had been a partner in the firm’s national accounting services group. Kroeker recently said that the proposed road map for the convergence of International Financial Reporting Standards,pushed to the back burner amid the larger issues of market reform, would be restored as another top priority. Khuzami is a former federal prosecutor, has pledged to improve the SEC’s enforcement performance by creating specialized units to provide “structure and resources for staff to ‘get smart’ about certain products, markets, regulatory regimes, practices and transactions.”

TARP Overseers
Another example of Obama’s preference for brains over politics was his reappointment of Sheila Bair to chair the FDIC. Another fiscally conservative Republican, on Bair’s watch alone this year, 94 banks have failed, creating a new challenge:  how to replenish the fund. Bair has also been an integral part of the team overseeing TARP. Neil Barofsky is a former New York assistant attorney general confirmed by the Senate in December as special inspector general. Dubbed the “TARP Cop,” his job is to figure out how and where the $700-billion TARP funds are spent, reporting directly to the President and providing updates to the Congressional Oversight Panel chaired by bankruptcy expert and Harvard Law School professor, Elizabeth Warren. COP’s first report, released in February, casti-  gated then-Treasury Secretary Henry Paulson for his performance and lack of transparency, reporting that the Treasury Department  had overpaid by $78 billion for the assets it bought from banks.

Interestingly, while Obama sponsored and was a strong proponent of  “say on pay” legislation while a senator, since appointing Kenneth Feinberg special master of compensation, he has appeared unwilling to make the issue a top priority. Feinberg, who has immersed himself in some of the country’s most troublesome and high-profile cases, is considered a superb choice, both in terms of skill and temperament, by Capitol Hill insiders. His most noteworthy case was the 33 months of pro-bono work he did following the 2001 terrorist attacks to determine how much each victim would receive from the federal government’s September 11th Victim Compensation Fund.

Feinberg may in fact be perfectly suited for a job that most compensation specialists see as thankless, and possibly as a “no win” situation. As the Obama Administration’s comp expert, Feinberg was called on to monitor the compensation of executives in what were once some of America’s most prestigious corporations, now TARP recipients, including American International Group (AIG), Bank of America, Citibank, Chrysler, GMAC, and General Motors.

Fed to the Rescue
To prevent American capitalism from spiraling deeper into the abyss, nine months after President Obama made his first Cabinet announcement, he re-nominated Ben Bernanke as Federal Reserve chairman. The former Princeton economics professor was selected by Bush in 2005 to succeed Alan Greenspan. In 2008 after the market crashed, Bernanke invoked emergency powers, slashed interest rates, and spent trillions of dollars to right the financial system. Just last month, he declared the recession “likely over.” Though he seldom gives interviews, Bernanke is never far from the public eye and has been a stalwart in the transition between presidential administrations and in the effort to stem the economic slide.

When then President-elect Obama named his economics team, it included players who, like Bernanke, were already steeped in the crisis details, demonstrated a studied understanding of Depression-era economics, or some combination of both. Enter Treasury Secretary Timothy Geithner and Chief White House Economic Advisor Lawrence H. Summers. Geithner, who is currently pushing legislation to provide more systematic regulation of financial institutions, including new limits on executive compensation, recently told one interviewer that he is optimistic major reforms will be passed.

Prior to his appointment replacing Henry Paulson, Geithner was president of the Federal Reserve Bank of New York and part of the team central to the critical negotiations that resulted in Bear Stearns being tucked into JPMorgan Chase, Merrill Lynch going to Bank of America, Lehman Bros. disappearing, and Citigroup and other struggling banks getting a lifeline.

Summers, the former Harvard University economist who became its president following his tenure as Treasury Secretary to President Clinton, is director of the Cabinet’s National Economic Council. The group was established in 1993 to coordinate and ensure that the President’s economic policy agenda is carried out.

Rounding out the team, Paul Volcker, the former Fed chief under Clinton, was selected to chair the president’s economic recovery advisory board. And Christina Romer, a former UC Berkeley economist, who administration sources suggest is well- regarded by both parties, chairs the Council of Economic Advisers. Her appointment was seen as a further triumph of brain over politics in Obama’s approach to talent recruitment.