Washington is a strange town! The more you succeed, the more you attract enemies. If you outperform all prior occupants of your office, behave like a model gentleman, and achieve what no one thought possible, that will make you a political target, and, worse yet, attract the neurotic envy of all those you have outshone. If one individual among all U.S. financial regulators has earned world-wide respect in recent years—both for his brains and diplomacy—, it has been James R. Doty, Chair of the Public Company Accounting Oversight Board (“PCAOB”).[1] Guess what that means?

Yes, no good deed goes unpunished in contemporary Washington, and last week the Wall Street Journal quoted SEC Chair Mary Jo White saying that the SEC was “identifying” candidates to replace him.[2] For weeks, there has been gossip that his enemies were organizing. Given that his term is up in October, such an announcement would usually be the signal for a Commissioner to quietly step aside. But Jim Doty does not want to go gently into the good night, and believes that the PCAOB and he have a number of important goals that they are on the verge of achieving. Also, he has the committed support of powerful allies in the institutional investor community and elsewhere. Finally, SEC Chair White has been publicly criticized by Senator Elizabeth Warren for White’s alleged tendency to favor the status quo and side with the interests of the industry over those of investors. This case may prove the acid test for that critique. A decision by SEC Chair White to replace Doty could push Senator Warren to seek the replacement of White (and force Hillary Clinton to “identify” a new SEC Chair if she is elected). At the least, Chair White would have burnt her bridges to the investor community. The stakes then are high for all, as they are for the auditing industry and investors, as next explained.

The PCAOB is a critical actor in financial regulation whose role is not well understood by the general public. Created by the Sarbanes-Oxley Act (“SOX”) in the wake of the Enron, WorldCom and other accounting scandals, it was Congress’s answer to the undeniable fact that self-regulation in the auditing profession had proven a dismal failure. Thus, SOX mandated that all auditing firms that audited publicly held companies (and certain others) had to register and be subject to the rules and oversight of the PCAOB. Functionally, the PCAOB is analogous to the Financial Industry Regulatory Authority (“FINRA”), which has similar jurisdiction over virtually all broker-dealers. Both FINRA and PCAOB are “self-regulatory organizations” (or “SROs”) whose authority (unlike that of the SEC) goes well beyond anti-fraud rules and permits them to enforce the “rules of the club”—i.e., professional standards. Both are subject to the oversight of the SEC, which can remove their members with or without cause.[3]

Against this backdrop, we now need to survey what PCAOB has recently done—and who it has offended. At the outset, it is important to recognize the state of play within the auditing industry. Audit revenues are shrinking as a proportion of the major audit firms’ total revenues. This is partly a consequence of the fact that the number of public companies in the U.S. is declining rapidly. The PCAOB has, itself, predicted that “if present trends continue, within ten years, audits may yield less than 20 percent of the revenues of the global networked accounting firms.”[4] The implication here is that the global audit firms have a reduced incentive to compete over a shrinking market. Instead, they may wish to use auditing as largely a loss leader to attract other and more lucrative consulting business. Thus, they want to hold clients and view active competition as something of a zero sum game (you win one client on Monday and lose another on Tuesday to the rival you defeated on Monday). Better then not to compete!

Things are very different, however, in Europe and the U.K., where the regulatory rules are changing and more active competition is evident. Particularly in the U.K., there have been two major changes:

First, the engagement partner signs the audit report in his or her own name in addition to the name of the firm. Presumably, the key goal here is to increase accountability. Nonetheless, recent studies in those jurisdictions in which the partner signs the audit report find that there are additional impacts: the market recognizes and prices the difference, responding to differences in the reputation of different audit partners.[5] Also, one study of U.K. audits finds improvements in the measures of audit quality—in short, the auditors did a better job when operating under the signature requirement.[6]

The PCAOB has hardly been racing to adopt this reform, but it could not ignore what Europe and parts of Asia have been doing. In 2009 (well before Chairman Doty’s tenure began), it issued its first concept release to consider an engagement partner signature requirement. Predictably, it heard the response that such a requirement would trigger a flood of litigation against the engagement partner. Today, this is debatable in light of the Supreme Court’s intervening decision in Janus Capital.[7] But the key point is that the PCAOB, under Doty, did not simply reject this claim, but restructured its proposal to respond to it. Essentially, it dropped the signature requirement and replaced it with a disclosure requirement. Specifically, it has developed a new PCAOB form, “Auditor Reporting of Certain Audit Participants” (or “Form AP”), which would identify the engagement partner. In their comment letters on this proposal, the Big Four audit firms saw this as a significant improvement, and PriceWaterhouseCoopers even stated that:

“We believe that requiring disclosure of the information on proposed Form AP, rather than in the auditor’s report, eliminates the concerns about potential liability under Section 11 of the Securities Act.”[8]

In short, PCAOB was flexible and accommodating, and the major audit firms found the new compromise acceptable.

A second area in which the PCAOB has shown great initiative involves the form and context of the audit report. The PCAOB’s simple goal here is to provide investors with more and better information. Here again, the PCAOB has been responding to developments in Europe and the U.K. In the U.K., the Financial Reporting Council (“FRC”) has required “extended audit reports” for financial statements for periods beginning after October 1, 2012.[9] Some 900 U.K. companies are now subject to this requirement. In a 2015 report, the FRC found that not only have auditors in the U.K. complied with the expanded requirements, but they have voluntarily made further changes in the form of their report to enhance its informativeness to investors. Audit firms in the U.K. are competing to innovate and improve the quality and usefulness of their report. And investors are responding. Revealingly, a prominent investor group in the U.K. has this year started a new tradition of giving awards to recognize “outstandingly useful audit reports.”[10] This idea of Oscars for auditing shows both investor interest and the willingness of audit firms to compete to attract that interest. This has not yet begun to happen in the U.S., but the PCAOB is moving to make the audit report less of an unvarying verbal formula and more of a source of information.

Although the auditing industry has not publicly confronted the PCAOB on these reforms, it is certainly likely that some want to delay these reforms (or simply kill them) and believe that blocking the reappointment of Duty will further that goal. Still, the only people who have openly criticized Doty have been SEC staffers, and here we come to the most interesting part of this story.

Recall Cinderella’s two step-sisters. Drap and mediocre, they were still consumed by envy for Cinderella, while somehow convinced of their own superiority and hopeful that they could land Prince Charming for themselves. Once, the Office of the Chief Accountant at the SEC was a prestigious position, staffed by eminent persons (such as Sandy Burton, who later became Dean of Columbia Business School). Burton was one of several SEC Chief Accountants who fought notable battles against “pooling of interests” and other accounting shenanigans. But that was long ago. More recently, the Office of the Chief Accountant has been upstaged by the PCAOB, which negotiates agreements with foreign regulators, issues auditing standards, hires world-class economists (such as Luigi Zingales) as their advisors, and generally gets all the publicity. This has not gone unnoticed at the Chief Accountant’s office, which would like to view the PCAOB as merely a subordinate vassal agency. But the media knows better and can distinguish stars from step-sisters. The current Chief Accountant, James Schurr, is a retired Deloitte partner who seems to have taken the protection of the industry as his priority. He has publicly criticized Doty and the PCAOB as “too focused on its disclosure effort and not enough on… the nuts and bolts of conducting audits.”[11] That is silly but revealing in its attitude. The PCAOB actually conducted a record number of examinations in 2014 and brought an increased number of enforcement proceedings (including against partners at major Big Four firms). But unlike the SEC, the PCAOB by statute cannot disclose who it is suing or for what—until all appeals are exhausted or a settlement reached. Thus, it cannot brag or celebrate its achievements.

Viewed from a distance, it seems clear that most of Washington now understands that a still angry public wants individual accountability. Last week, the Department of Justice announced new guidelines under which corporations will only receive substantial credit for pleading guilty if they provide evidence against the responsible employees and agents who caused them to violate the law.[12] Hillary Clinton has similarly announced that prosecuting individuals, and not the corporate entity, should be the priority. But among the SEC and its network of subordinate SROs, only the PCAOB has come up with a coherent strategy for stressing individual accountability (namely, disclosing the identity of the engagement partner). Meanwhile, the SEC persists with its standard “neither admit nor deny” settlements. If Chairman Doty is replaced for pursuing his initiatives, the SEC and its Chair will have revealed their deafness to the public’s mood (and Senator Warren will be able to say “I told you so,”).

The departure of Doty would have a number of adverse consequence for the PCAOB, including:

1. It probably would end or slow both the PCAOB’s attempt to disclose the identity of the engagement partner, which attempt the SEC has long slowed, and its efforts to expand and enhance the form and content of the audit report. Some of us older guys can still remember when the SEC was in favor of transparency, but it takes a good memory;
2. It may also brake or end the PCAOB’s developing “dialogue” with audit committees. Here, in another important initiative, the PCAOB is developing tools to assist and inform audit committees, both about the PCAOB’s findings about their own audits and also related statistical information;
3. It will probably collapse the developing bridge between the PCAOB and academic economists. Under Doty, the PCAOB created the Center for Economic Analysis. Staffed by world-class economists, it is dedicated to investigating the costs and benefits of audits and auditing, and the impact of auditing on capital formation. A regulator denied such information is flying blind; and
4. Under Doty, the PCAOB has similarly built bridges to foreign regulators, an effort capped (after several years of delicate negotiation) by the 2013 enforcement cooperation agreement with China. The common denominator in all these efforts has been Doty’s diplomacy and persistence.

Even if a worthy successor were found, the implicit signal from Doty’s replacement would be that the PCAOB should give up on its innovations and stick to its knitting—i.e., the “nuts and bolts” of ordinary auditing. Yet, around the world, auditing and audit reports are changing. Only in the U.S. have practices remained static. If auditing in the U.S. is to evolve and grow, it must find new areas where it can give credible assurances that investors find useful. That requires research and reaching out to all constituencies. Much as some audit firms might wish to return to the quiet life before the PCAOB appeared on the scene, that quiet world is shrinking into insignificance. The profession, at least as much as investors, needs a regulator who is trying to make it relevant. As his reforms make the role of engagement partner more prominent, they may also make the position more attractive to a younger generation that aspires to being more than a simple “bean-counter.”

Today, it is premature to predict whether Doty will be replaced or reappointed at the PCAOB. The battle will play out over the next several weeks. But, at the worst, he will be remembered. Sadly, in Washington, mediocrity is increasingly winning it its ancient and unending battle with excellence.

ENDNOTES

[1] As a matter of full disclosure, the author should note that he is a member of the Strategic Advisory Committee to the PCAOB. This involves no remuneration, and he bears his own travel expenses.

[2] See Michael Rapoport and Andrew Ackerman, “SEC Weighs New Names to Lead Audit Regulator,” The Wall Street Journal, September 10, 2015, at C-3.

[3] This was the holding of Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), which permitted the appointment of PCAOB members by the SEC, but struck down the “for cause” removal provision in the Sarbanes-Oxley Act as an unconstitutional limitation on the President’s removal power.

[4] This statistic and prediction was presented by James Doty in a recent speech. See James Doty, Keynote Address, Baruch College 14^th Annual Financial Reporting Conference, May 7, 2015, at p. 4.

[5] See Robert Knechel et al., Does the Indentity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions¸ (forthcoming in Contemp. Acct. Res. in 2015); Daniel Aobidia et. al., Capital Market Consequences of Audit Partner Quality (forthcoming in The Acct. Rev. in 2015).

[6] See Joseph Carcello & Chan Li, Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the U.K., 88 The. Acct. Rev. 1511 (2013) (finding improvements in several financial indicators of audit quality).

[7] See Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011). Janus holds that the “maker” of a statement is the person with “control” over it. Whether the engagement partner has such control or whether only the audit firm, itself, is the “maker” is an open question that I will not address here.

[8] This is from PriceWaterhouseCoopers 2015 Comment Letter with regard to PCAOB’s “Improving Transparency in Audits” proposal. Similar statements (with small variations) were made by the rest of the Big Four.

[9] See Financial Reporting Council, Extended Auditor’s Reports—A Review of Experience in the First Year (March 2015).

[10] The award was given by the Investment Association and was first awarded in 2014. A panel of six judges chose the winners. See Doty, supra note 4, at 9. Awards were given for the most “insightful” and the most “innovative” reports in different size classes.

[11] See Francine McKenna, “DOJ’s New Focus on Individual Prosecutions May Be a Response to Judicial Challenges,” MarketWatch, September 10, 2015 (quoting Mr. Schnurr).

[12] Id. (quoting Deputy Attorney General Sally Yates).

The preceding post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.