Governments sometimes use private ordering – the delegation of regulatory authority to the private sector – in regulating commerce, finance, and business more generally. In a new article, available here, I focus on one of the federal government’s most prominent uses of private ordering: the delegation to the Financial Accounting Standards Board (“FASB”), a private-sector body, by the Securities and Exchange Commission of its authority over financial disclosure – including authority to promulgate the standards underlying that disclosure. This delegation raises issues that directly challenge private ordering’s legitimacy.

The standards set by FASB form the basis of U.S. generally accepted accounting principles (“GAAP”), which are used for reporting corporate and other financial information. GAAP-compliant disclosure is recognized as authoritative by the accounting profession and by federal and state agencies and is generally deemed to satisfy the disclosure requirements of the federal securities laws.

The goals of private ordering are to engage private-sector experts with greater expertise than typically available within a government agency in order to promulgate efficient and independent rules. Private ordering usually is successful but sometimes fails in achieving these goals. In the context of the delegation of financial disclosure authority to FASB, my article examines why.

There are two fundamentally different methods of private ordering. One method delegates virtually full governmental regulatory authority – both to formulate and implement rules – to the private sector (“full-delegation private ordering”), subject only to the delegating agency’s ultimate authority. Another method involves a more limited delegation of authority, typically enabling the private sector to formulate rules that still require government implementation (“limited-delegation private ordering”). As currently practiced, the SEC’s delegation of financial disclosure authority to FASB represents full-delegation private ordering.

Full-delegation private ordering can promulgate efficient rules to the extent the private sector provides expertise beyond that available to the government. Furthermore, at least in principle, private-sector experts should be less subject than government officials to political pressures. In the context of FASB, however, full-delegation may be less successful than limited-delegation private ordering in achieving legitimacy, or at least the public perception of legitimacy.

There are two reasons for this. First, because FASB’s members are mostly accountants and financial-statement preparers, they must comply with the GAAP standards they promulgate; to that extent, they are conflicted. Second, members of FASB have been subject to pressures from various special interest groups, including preparers and auditors of accounting statements. FASB members, however, lack the limited-delegation-private-ordering requirement of government enactment, which could help to protect them from these conflicts and pressures.

In theory, the constitutional requirement that the SEC retain ultimate power to veto FASB’s standards (the non-delegation doctrine) might serve to protect FASB members. In practice, however, that veto power is infrequently exercised. Although the SEC technically oversees FASB, it exercises little control over FASB or its promulgation of GAAP standards.

Perhaps due at least in part to these conflicts and pressures, FASB has been subject to much criticism. Some allege that GAAP has become a rigid rules-based system that often elevates form over substance and is more useful to auditors and accountants than to investors – even though securities disclosure should be designed to protect investors. Although a rules-based system has merit insofar as it can help to ensure consistency, rules can be exploited through loopholes. GAAP’s 3% minimum outside-equity requirement for non-consolidation, which allowed Enron to avoid having to consolidate the debt of its special purpose entities used for hedging, and GAAP’s Financial Accounting Standard 140, which allowed Lehman Brothers to temporarily remove liabilities from its balance sheet, exemplify loopholes that allowed those firms’ financial reports to distort economic reality, leading to catastrophic results. Enron strictly complied with GAAP’s non-consolidation rule in all but one instance, and it fully disclosed its special-purpose-entity hedging transactions. That compliance and disclosure did not, however, provide investors with the entire picture of the risks involved with those transactions. The 3% GAAP rule also was so low as to be easily manipulated. Similarly, Lehman’s GAAP-compliant transactions allowed it to hide debt and obscure its real financial condition.

Other criticisms focus on FASB’s slow pace of standard-setting. For example, FASB has placed a significant emphasis on “simplification” efforts that benefit preparers of financial statements, rather than improvements to such statements that investors have requested for decades. Indeed, FASB’s tendency to protect the accounting profession to the detriment of investors has longstanding precedent. In 2022, the SEC’s acting chief accountant, Paul Munter, even spoke out about the “slow pace of FASB standard setting.”

Furthermore, FASB has been accused of focusing on marginally refining existing accounting standards to the exclusion of addressing important emerging issues. Over the past decade, for example, FASB has prioritized simplifying the reporting burden on financial statements rather than tackling major new investor concerns such as the reporting of internally developed intangible assets and changes to the reporting of cash flows. These “simplification” projects appear to benefit and provide relief to preparers and their auditors, suggesting that FASB’s focus favors the internal priorities of its board members as well as those who lobby FASB externally. In contrast, the legitimacy of FASB as an institution, and consequently the legitimacy of the private ordering of financial disclosure, depends on protecting investors.

Although attempts have been made to improve FASB’s private ordering, they do not directly address the potential problems arising out of its full-delegation character. For example, Congress passed the Sarbanes-Oxley (“SOX”) Act in 2002 after Enron’s collapse, in hopes of restoring investor confidence by improving the accuracy and reliability of accounting standards. However, to achieve this, the SOX Act established the Public Company Accounting Oversight Board for oversight of auditing bodies, not for the setting of accounting standards. Some also critique the SOX Act for prioritizing form over substance, utilizing procedural methods to work through complex structural problems that require more than a quick fix. Moreover, Section 404 of the SOX Act subjects companies to a control review process by reviewers who “may have lacked top-level experience in evaluating broad-based systemic risk.” Michael W. Peregrine & Charles W. Elson, The Important Legacy of the Sarbanes Oxley Act, Harv. L.S. Forum Corp. Gov. (Aug. 30, 2022). Effectively, many companies have relied on those with “less than complete expertise” to appraise their risk, making at least some reliance on external reviewers unwarranted.

The fact that Lehman Brothers’ collapse, which took place years after enactment of SOX, can be attributed to similar issues as Enron’s collapse further exhibits the SOX Act’s shortcomings in getting at the root of the problem. Both scandals involved the use of potentially manipulative practices that were technically available through form-over-substance loopholes in FASB’s rules-based accounting standards.

Ultimately, any proposals to improve accounting standards must address not only those standards but also the structure behind their promulgation. The article examines potential solutions, including replacing FASB’s full-delegation private ordering with a more limited-delegation approach. Limited delegation could shift the burden of evaluation and endorsement to the SEC, while allowing FASB to retain discretion to propose the standards.

There is significant precedent for limited-delegation private ordering. In an accounting context, for example, the private ordering of UK accounting standards works that way. Limited-delegation private ordering should increase the public’s perception, if not also the reality, of legitimacy. FASB’s standard setting would start with the accounting profession’s expertise but ultimately would be subject to the needs of the public, particularly investors whose needs have been largely ignored by FASB.

Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. This post is based on his new article, “Rethinking Private Ordering: The Financial Disclosure Quandary,” forthcoming in the University of Illinois Law Review and available here.