Re-Posting -- Internal Control Reports Under Sarbanes-Oxley: Hazards Out of Washington

In my first job in journalism, back on a small-town newspaper, the last critical deadline risk was a break-down of our creaky old press. Now it's that the elves of the internet somehow got Monday's post out via Twitter and my news groups, but failed to feed it to e-mail subscribers.

This re-posting is with my appreciation to all, and my apologies for either the delay or the duplication.

What’s in store for reporting on internal controls under the Sarbanes-Oxley law? The most important Washington development was not last week’s legislative merry-go-round over possible small-company exemption.

As discussed here, the SEC had earlier pushed back its deadline under Section 404(b) for auditor reports. Impelled by White House Chief of Staff Raum Emanuel, the House Financial Services Committee responded with approval of a permanent exemption, as proposed by Representatives Scott Garrett (R-NJ) and John Adler (D-NJ) (teed up in Edith Orenstein’s post of November 4 on her FEI Blog).

What may yet emerge from Congress is anybody’s guess – considering the opposition of Committee Chairman Barney Frank (D-Mass) and SEC Chairman Mary Schapiro and Commission Luis Aguilar. Their view is championed by Floyd Norris of the New York Times, quoting ex-SEC chief Arthur Levitt – here – in whose hyperbolic antagonism the climb-down on Section 404 would rank with repeal of the Bill of Rights or perhaps the Ten Commandments.  

Much more ominous, across the country in Seattle, was the October 27 opinion and order of federal district judge Marsha Pechman. As discussed by Kevin LaCroix (D&O Diary), Judge Pechman has sustained most of the shareholders’ class lawsuit against fallen home lending giant Washington Mutual, along with its senior executives and Deloitte, its auditors.

The case is based not only on the usual array of claimed false financial and other statements, but on WaMu’s allegedly defective internal controls and the opinions of management and the auditors – claims that WaMu “misrepresented the state of its internal controls, which were weakened in order to facilitate WaMu’s reckless lending practice,” and that Deloitte “made the false and misleading statement that its internal control reports were audited ‘in accordance with the PCAOB’s standards’.”

From the very passage of Sarbanes-Oxley in 2002, its requirement for opinions on internal controls has been an under-appreciated time bomb. Under Judge Pechman’s Order, the fuse is now lit, live and sparkling.

WaMu presents a major survivability hazard for Deloitte -- and by extension, for the viability of the entire big-firm assurance franchise. The investor claims involve securities totaling more than $ 4 billion -- well above the destruction threshold of Deloitte or any of the large accounting firms (see here).

And the plaintiffs are represented by the veteran law firm of Bernstein Litowitz Berger & Grossman – reported to have achieved five of the ten largest securities fraud recoveries in history, and to have collected over $ 20 billion on behalf of investors – here – thus no strangers to the extraction of serious amounts from their adversaries.

In the early years of Sarbanes-Oxley, while the accounting firms were reaping major revenues from their work on big-client compliance, two topics largely dominated the discourse: whether the cost was actually achieving any real value to the capital markets, and whether there could be a screwing down of the escalated fee increases felt to be windfalls to the large firms.

Two other themes were either lost or absent in the discussion. The first was that Section 404 reports and opinions comprised a new class of publicly-accessible statements on which investors might claim reliance to their detriment – no less than traditional financial statements and audit reports – a chicken now come home to roost in Seattle.

The second was the ultimate but eventual day of reckoning, with the certain arrival of large internal control failures. There a crucial mis-alignment lay concealed: the accounting profession’s cash-based business model involves immediate profit distribution to reward current partners, while the related litigation burden lies inchoate and deferred until inflicted years later on succeeding generations.

This kind of disconnect is broadly familiar:

• ·      The immediate benefits of large public works are consistently over-stated, for failure to recognize, for example, the future radioactive waste disposal costs of a de-commissioned nuclear plant, or the environmental disaster of a strip mine or a silted-up hydroelectric project.
• ·      Only now are the re-cycling impacts of consumer goods becoming visible – whether in the recoverability of scrap auto components or the packaging of home appliances or the extraction of metals and chemicals from old computers and refrigerators.
  
• ·      Closer to home, it’s a fair bet that the strategists in the law and accounting firms responsible for the tax shelter strategies so aggressively sold to their clients a decade ago did not include in their business plans the costs of their legal defenses, criminal trials, fines and civil settlements.
• ·      And nowhere is the timing mis-match more acute than in the legislative arena, where the sleight-of-hand calculations for health reform proposals or military hardware procurement or tax code revisions are fanciful exercises in advocacy.

In the same way, it is no small understatement that the profitability of the Big Four’s Sarbanes-Oxley compliance work would have been unpleasantly re-calculated, when the law was enacted in 2002, if future litigation exposures running into WaMu’s billions had been taken into account.

So concerning the yes-or-no desirability of Sarbanes-Oxley 404 for smaller companies, there is this interesting question:

With the potentially catastrophic impact of a WaMu trial now pending, and claims among the roster of failed financial institutions lurking in the background – why would a young partner in a Big Four firm think that more such expanded Sarbanes-Oxley work is a good idea?

Those who may think so are invited to explain why – especially to their dependents and their creditors.  

 

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Comments

[baigh]

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