Special Report: Accounting firms, SEC hobble U.S. audit watchdog

By Charles Levinson

WASHINGTON (Reuters) - James Schnurr, just two months into his job as chief accountant at the U.S. Securities and Exchange Commission, stood before a packed ballroom in Washington last December and upbraided a little-known regulator.

The Public Company Accounting Oversight Board, or PCAOB, oversees the big firms that sign off on the books of America’s listed companies. And the board was “moving too slowly,” Schnurr said, to address auditing failures that in recent years had shaken public confidence in those firms.

These were fighting words in the decorous auditing profession, and they hit their target. PCAOB Chairman James Doty was among those attending the annual accounting-industry gala where Schnurr spoke. And Schnurr was Doty’s new supervisor.

“This is going to get ugly,” Doty said to a colleague afterward.

In his new SEC job, Schnurr now had direct authority over the PCAOB – a regulator that just a few years earlier had derailed his C-suite ambitions at Deloitte & Touche. As deputy managing partner at the world’s largest accounting firm, Schnurr had commanded an army of auditors – until a string of damning PCAOB critiques of Deloitte’s audits led to his demotion.

Then, in August 2014, SEC Chair Mary Jo White named Schnurr to his SEC post. It was a remarkable instance of Washington’s “revolving door” for professionals moving between government and industry jobs.

Schnurr wasn’t the only one with a Deloitte tie. White had counted Deloitte among her clients while a partner at law firm Debevoise & Plimpton. White’s husband, John White, is a partner at law firm Cravath Swaine & Moore, which also counts Deloitte among its clients.

Schnurr’s speech was part of a yearlong campaign to oust Doty and thwart his efforts to implement rules that would increase auditors’ accountability to investors and their independence from the companies they audit. Doty’s proposals grew out of a broad consensus inside and outside government that the Big Four accounting firms had fallen down in the years leading up to the recent financial crisis.

Deloitte, Ernst & Young, PricewaterhouseCoopers and KPMG audit companies that account for 98 percent of the value of U.S. stock markets. During the crisis, nine major financial institutions collapsed or were rescued by the government within months of receiving clean bills of health from one of the Big Four. While Schnurr was deputy managing partner at Deloitte, the firm signed off on the books of Bear Stearns, Washington Mutual and Fannie Mae. Each went bust soon after, costing investors over $115 billion in losses.

“CONSTRUCTIVE FEEDBACK”

Doty’s efforts have floundered, in large part because Schnurr’s office has used its oversight powers to block, weaken and delay them, according to a dozen current and former SEC and PCAOB officials. Schnurr’s staff has also campaigned to have Doty removed from office, these people said.

Doty’s term ended on Oct. 24. He continues to serve as PCAOB chairman day-to-day, waiting for the SEC to decide whether or not to reappoint him.

The standoff is a test of who holds sway with regulators in Washington – investors large and small who seek better disclosure of what really goes on inside companies, or the financial-services establishment that’s supposed to serve those investors.

In September, 29 people wrote to White urging her to reappoint Doty – including two past SEC chairpeople, former Federal Reserve Chair Paul Volcker, and John Bogle, the founder of mutual fund giant Vanguard Group.

“The accounting firms have been letting corporations get away with reporting all kinds of funny pro forma earnings,” Bogle said in an interview. “The addition of Jim Doty to the PCAOB was a big upgrade. And if the firms are angry with him, he’s clearly doing something right.”

Deloitte spokesman Jonathan Gandal said his firm appreciated the “constructive feedback” it gets from the PCAOB. “We are proud of the excellent trajectory our inspection results have demonstrated over the past four years,” he said.

A spokeswoman for PricewaterhouseCoopers, Caroline Nolan, said PwC “is supportive of the PCAOB and efforts to increase transparency in the accounting profession.” KPMG and Ernst & Young declined to comment.

“U.S. rule-making is a complex process that involves people with many different perspectives who care deeply about the issues,” PCAOB chief Doty said in a written statement. “I think this is the case with the PCAOB and SEC in the work we do together, including proposals to give more information to investors about who is leading the audits of the companies in which they invest.”

The SEC’s Schnurr and White declined to comment.

Though Schnurr’s career comeback as the SEC’s top accountant is striking, his ties to the industry are part of a pattern. Each of his predecessors, going back at least to 1992, came from senior partnerships at one of the Big Four accounting firms. Some returned to their firms when their stint as chief accountant ended.

Deloitte enjoys special influence. A former Deloitte partner has controlled the SEC Chief Accountant’s Office for 10 of the past 20 years. The five-person PCAOB board has two former partners from law firms representing Deloitte and the father of a Deloitte auditor. Deloitte declined to comment on its clout.

“The very people the PCAOB is regulating are the ones that are overseeing them,” said Lynn E. Turner, a former Big Four accounting executive who served as chief accountant of the SEC from 1998 to 2001.

SEC spokesman John Nester said Big Four experience isn’t a requirement to be chief accountant. “What’s required is deep expertise in financial reporting and public company audits, as well as knowledge and experience with the standard setting process to assist the Commission and the PCAOB in their investor protection mission,” Nester said.

The SEC’s defenders say its critics overstate the power of both the Office of the Chief Accountant over the PCAOB and of the Big Four firms at the commission. The Big Four, they say, are natural talent pools from which to recruit the SEC’s accounting czars, some of whom have been strict regulators.

Some Big Four accounting firm officials, meanwhile, say the tensions with the PCAOB stem from turf battles and personality clashes and aren’t part of any industry effort to undermine a tough watchdog. The Big Four say they don’t oppose regulations that improve standards, but believe the PCAOB would be more effective if it pushed rules focused on the nuts and bolts of auditing.

The U.S. Congress created the PCAOB in 2002 by passing, with near-unanimous bipartisan support, the Sarbanes-Oxley Act. The goal was to tighten controls on the auditing industry following a string of colossal accounting scandals, most notably the 2001 collapse of energy company Enron Corp.

Lawmakers gave the new regulatory board powers to fight corruption and monitor accounting firms, and laid out tough criminal penalties for accounting fraud. The law’s drafters gave PCAOB board members and staff some of the richest salaries in government to insulate them from the allure of private sector payouts. Doty makes $672,676 a year – 68 percent more than the U.S. president and nearly three times as much as SEC Chief Accountant Schnurr.

“BEHAVING A LITTLE AGGRESSIVE”

The PCAOB would report to the SEC, which was given oversight of the board’s budget and its rule-making. The commission could appoint board members but had limited power to remove them. The bill’s co-author, Senator Paul Sarbanes, wanted the new regulator to have some independence from the SEC, which, he told Congress, has “not adequately protected the public’s interests.”

The PCAOB began aggressive yearly inspections of audits by U.S. accounting firms and published its findings in lengthy reports for each firm. It was a dramatic change from the pre-Enron days, when big firms chummily policed each other through an industry-run self-regulator.

“Many thought this new regulator was behaving a little aggressive,” said a former Deloitte partner.

In 2005, Deloitte promoted Schnurr to deputy managing partner, responsible for overseeing the firm’s massive network of auditors, determining how audits were conducted, and serving as the face of the firm in dealing with the new regulator.

After Schnurr’s promotion, Deloitte’s attitude toward the PCAOB hardened, according to former Deloitte executives and PCAOB officials. That view is supported by the public correspondence between Deloitte and the regulator. In the two years after Schnurr took over, Deloitte’s performance on annual inspections deteriorated. In both years, it led all big four accounting firms in audit failures, inspection reports show.

PCAOB inspectors found that Deloitte had reached partnership agreements with companies Deloitte was auditing, a practice that had been banned. They also found cases where Deloitte auditors appeared to have intentionally ignored significant accounting mistakes by a client.

Deloitte responded combatively. “We believe that the efficacy of the inspection process itself is compromised,” Deloitte wrote in a 2006 letter to the PCAOB. The letter named Schnurr as the lead point of contact at Deloitte.

A person close to Schnurr said that he was only one person among a group of senior Deloitte executives, including the chief executive and general counsel, who drafted the company’s responses to the PCAOB.

On Schnurr’s watch as deputy managing partner at Deloitte, the firm signed off on the books of Bear Stearns and other financial clients that went bust soon after. In 2007, the year Deloitte gave Bear Stearns the clean audit, PCAOB inspectors found that Deloitte’s “failure to appropriately challenge management’s representations occurred in numerous areas.” Deloitte, inspectors concluded, did not “exercise due care and professional skepticism when performing audits.”

FIGHTING BACK

As Deloitte’s relationship with the PCAOB frayed, Schnurr urged defiance, said a former Deloitte partner who worked on regulatory matters.

“He believed we should not accept things we disagreed with just to be agreeable,” said the former partner.

After both the 2007 and 2008 inspections, Deloitte didn’t address a range of systemic failures identified by the PCAOB within the 12-month period mandated by law. That meant that the PCAOB was free to release its most damning findings to the public. Disclosure would be an embarrassing and potentially costly blow for Deloitte.

On March 26, 2009, Deloitte wrote to the PCAOB that the board had no right to question the decisions of the firm’s auditors. “In our view, such reasonable judgments should be respected and not second-guessed,” Deloitte wrote.

The following day, Deloitte announced without explanation that Schnurr was moving to a more junior role in the firm.

“He was not happy,” said a former SEC official who was close to Schnurr.

Schnurr viewed his reassignment as a normal career progression, a person close to him said.

Deloitte spokesman Gandal said Schnurr “had a distinguished 38-year career with Deloitte.” As for Deloitte’s relationship with the board, he said: “The constructive feedback we receive through the PCAOB inspection process has assisted us significantly in achieving our objective of continuously enhancing the quality of our audits, and fulfilling our important commitment to the public interest.”

The SEC gained a tighter grip over the PCAOB in 2010 as a result of a Supreme Court case. In Free Enterprise Fund v PCAOB, small accounting firms unhappy with the board’s oversight challenged the Sarbanes-Oxley Act. The court ruled that a provision of the law violated the U.S. Constitution because it limited the ability of the executive branch – in this case, the SEC – to remove board members.

The next year, three spots on the board opened up. PCAOB board members are chosen by the SEC’s five-person commission, who customarily turn to the Office of the Chief Accountant for recommendations on candidates.

LINKS TO DELOITTE

Another former Deloitte partner, Jim Kroeker, was chief accountant at the time. His deputy was a former PricewaterhouseCoopers partner named Brian Croteau. They backed a trio of candidates to fill the vacant board slots, according to former SEC officials. All three had links to Deloitte.

SEC spokesman John Nester said that the Chief Accountant’s Office does not have any formal role in selecting PCAOB appointments.

Kroeker is now vice-chairman of the Financial Accounting Standards Board. He said in a written statement to Reuters: “Because the elements of the story presented to me appear to be based on non-public information, I can say only that they are inaccurate.” He declined to be specific. Croteau declined to comment.

The new board members included two lawyers from firms that counted Deloitte as major clients, as well as a former partner of accounting firm McGladrey & Pullen LLP, whose daughter is an auditor in Deloitte’s Phoenix office. The three new members declined to comment on the industry connections.

One of the three newcomers was Doty. He was picked to chair the board. His résumé suggested he would get along with the accounting industry. He was a protégé of James Baker, secretary of state in the George H.W. Bush administration, and had spent 40 years with Baker’s influential law firm, Baker & Botts. Among his clients were oil-services giant Halliburton, George W. Bush and Deloitte.

“Seriously, can it get any worse for investors than Bush family lawyer James Doty?” Frances McKenna, an accounting industry analyst, wrote in Forbes after the appointments.

That first year, all three new appointees had to recuse themselves from votes related to Deloitte, hobbling a majority of the board.

But Doty surprised observers. Three months into office, in April 2011, he warned lawmakers in public testimony of “very fundamental problems of the audit profession.”

Early in Doty’s tenure, on Oct. 17, 2011, the PCAOB dropped a bomb on Deloitte. It published the most critical parts of the damning 2007 inspection report – the first time the PCAOB had used its name-and-shame power against the Big Four.

SIGNATURE BATTLE

The report accused Deloitte auditors of kowtowing to client executives. It noted “cause for concern” about the “objectivity” of Deloitte’s auditors, criticizing “a firm culture that allows, or tolerates, audit approaches … that rely largely on management representations.”

Doty also unveiled concepts for rules aimed at increasing auditors’ accountability to investors and independence from the companies they serve. He took two of the concepts straight from the recommendations a bipartisan Treasury Department committee made in 2008. Despite the bipartisan panel’s backing, the industry strongly opposed the new rules.

The first would require auditors to include in their final audit reports a thorough discussion of any high-stakes judgment calls – such as when to recognize revenue and which items to expense – that can have a major impact on a company’s appearance of health.

A second would require a company to rotate its auditor every 10 years or so. Supporters believed the rule would bolster auditors’ independence and rigor.

Both proposed rules have languished amid stiff opposition from the accounting industry and the SEC’s Office of the Chief Accountant.

Finally, Doty relaunched a push for a requirement that the individual accountant in charge of an audit personally sign the final audit report. The Treasury panel had argued that such a rule would encourage an auditor to pay extra care to their work, and allow investors to see individual auditors’ track records.

Accounting firms argued that the name rule would expose an auditor to legal liability, raising litigation costs for the accounting firms and auditing costs for corporate America.

Doty tweaked the proposal. Instead of making auditors sign their name to each audit report, a firm could simply identify the lead auditor. Doty and PCAOB lawyers believed this would address the liability concerns.

But when he sent the proposal to the SEC for review, the Chief Accountant’s Office nixed it. Office chief Kroeker, the former Deloitte partner, and deputy Croteau, the former PricewaterhouseCoopers partner, said the new rule didn’t sufficiently reduce liability risks for the firms. Plus, they told Doty, the potential benefits to investors didn’t seem to outweigh the costs - such as increased litigation - that the rule would impose on accounting firms.

In July 2012, Kroeker stepped down as SEC chief accountant. In his place, the SEC chairwoman at the time, Elisse Walter, appointed another Big Four partner, Paul Beswick of Ernst & Young. “I have never known people at the SEC to be there to serve the industry,” Walter said in an interview, “and that includes Paul Beswick, and his predecessors, and his successor.”

CARRYING WATER FOR THE BIG FOUR

For months, Doty negotiations with Beswick and Croteau went nowhere. Tensions came to a head at Doty’s 8th floor corner office in the PCAOB headquarters on Farragut Square in Washington, D.C. “You’ll be perceived as carrying water for the Big Four,” Doty told the SEC’s Croteau, according to a person close to Doty and Croteau. Croteau and his staff stormed out.

In a subsequent meeting, Beswick urged Doty to focus on less-controversial rules. Doty told Beswick that he was so biased in favor of the accounting industry that he had no business serving as chief accountant and that he should resign, according to a person briefed on the meeting.

Beswick has since resumed his partnership at Ernst & Young. He declined to comment, according to firm spokeswoman Amy Call Well.

The industry began mobilizing against Doty. At a meeting of a PCAOB advisory group at the Center for Audit Quality, an accounting industry lobby group, representatives of several big firms tore into him.

“He’s beating up on our profession, this has to stop,” one firm representative complained, according to a person present at the meeting.

In May 2014, Schnurr retired from Deloitte. Three months later, SEC Chair White tapped him as the new Chief Accountant.

“Mary Jo was very high on him,” said a former SEC official close to both Schnurr and White.

The SEC declined to make White available to comment, directing Reuters to comments she made at the time of the appointment. White said in a statement then that she chose Schnurr for his “deep knowledge of accounting and auditing standards” and “his extensive experience interacting with regulators.”

A DRESSING-DOWN IN PASADENA

Three months later, Schnurr criticized the PCAOB in his speech at an annual gala of the accounting profession. Doty was especially stung by Schnurr’s public accusation that the PCAOB was dragging its feet on new auditing rules, a person close to Doty said.

Doty believed his proposals would have gone through years ago if they hadn’t been blocked by Schnurr’s office. The problem was that Doty was pushing rules the industry didn’t like, the PCAOB chief believed, according to a person close to him.

Earlier this year, Schnurr and Doty tussled over who would have the power to hire and assign economists within the PCAOB. Doty had added to and shuffled his economics staff. It was a savvy battle for Schnurr to pick, said one PCAOB official, because economists shape the cost-benefit analyses necessary for passing new auditing rules. A critical cost analysis can doom a rule.

Doty got to stick with the personnel changes he had made, but was warned that he would need SEC approval in the future. Nester, the SEC spokesman, said that the changes violated a 2010 SEC rule banning the PCAOB from shifting more than $1 million of its budget from one program area to another without prior SEC clearance.

Schnurr escalated his public attacks. At a conference in Pasadena this summer, he again denounced the PCAOB’s failure to pass new auditing rules, saying there were “very significant and fundamental issues that will need to be addressed” at the board.

On Tuesday, the PCAOB finally voted through a watered-down version of the rule with Schnurr’s backing. The new rule – the first and only audit reform enacted by the PCAOB in direct response to the financial crisis - includes a major concession: Instead of naming the auditor in the audit report, each firm will file the auditor’s name in a separate form at a later date with the PCAOB.

For many investors, including the well-known short seller Carson Block, it was a partial victory at best: a step in the right direction, but thoroughly watered down, according to a letter Block wrote to the PCAOB.

"It took the PCAOB years to require the name of the audit partner be disclosed in a manner investors will find difficult to track,” said Turner, the former SEC chief accountant.

PCAOB board member Steven Harris, who helped draft the Sarbanes-Oxley act as a staffer working for Sen. Sarbanes in 2002, said at Tuesday’s board meeting that the final rule absolved auditors from being “liable for deficient audits that harm investors, even if those audits are carried out so recklessly as to meet the legal standards for fraud.”

“It is not clear, to me at least, why this should be the board’s goal,” Harris said.

A SECOND TERM?

This September, on the sidelines of a PCAOB advisory group meeting at the Army and Navy Club in Washington, D.C., SEC Chairwoman White chatted with a scrum of beat reporters. She told them that the SEC was “identifying interested and qualified candidates” to replace Doty upon the expiration of his term in October.

Doty had said publicly he wanted to serve a second term. Many inside the PCAOB interpreted White’s comments as the first public indication from the SEC chief that she was inclined to back the industry against Doty.

A spokeswoman for the SEC, Gina Talamona, said White was making a general comment about the protocol for picking PCAOB board members, whether for a new appointment or a re-appointment, not commenting on any candidate.

White’s comments called attention to her own ties to the accounting industry. Deloitte had been a client of White’s when she was a lawyer in private practice. Her husband, lawyer John White, sits on a PCAOB advisory group. His law firm, Cravath Swain & Moore, has a long history of working for Big Four firms. Cravath defended Deloitte in investor lawsuits over the Bear Stearns collapse and the accounting fraud at Adelphia Communications Corp.

The Center for Effective Government, a Washington, D.C., watchdog group, called on White to recuse herself in Doty’s reappointment in light of her husband’s position as a PCAOB advisor. Cravath was touting his advisory role on its Web site. Soon after, Cravath removed those lines from its site.

SEC ethics officials determined it is appropriate for White to participate in the selection of PCAOB board members, according to Talamona, the SEC spokeswoman. A Cravath spokesperson said John White and the firm had no comment.

Doty’s term ended on Oct. 24 without any SEC action. That leaves him in limbo, until the commissioners choose to vote on whether to reappoint him.

(This story has been refiled to correct title and links of previous stories in the series. This is part 3 of Wall Street’s Way, on Reuters.com: http://www.reuters.com/investigates/special-report/usa-accounting-PCAOB/)

(Edited by Michael J. Williams)