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ABA members argue legality of audit firm rotation proposal

July 6, 2012

The watchdog for U.S. auditors has been debating some of the toughest reforms in many auditors’ memories this year. Now some legal experts are questioning whether it has the authority to impose its most controversial idea – making companies switch, or rotate, audit firms after a set number of years.

In a letter to the Public Company Accounting Oversight Board, members of the American Bar Association joined a long line of critics of rotation. The lawyers cited the 2002 Sarbanes-Oxley act, which created the PCAOB, and questioned where it gave the board any authority to mandate rotation.

The letter was signed by the chairs of ABA’s federal regulation of securities committee and its law and accounting committee.

If they are correct, it would be a blow to investor advocates, who fought for years to have an independent standard-setter with broad powers over audit firms.

Before Sarbanes-Oxley, the audit profession set its own standards, which were often criticized for being laced with qualifications that helped auditors avoid legal liability.

“I don’t doubt for a moment that the auditing standards the PCAOB has control over would include standards for auditor independence, and would obviously include rotation,” James Cox, a law professor at Duke University, said in an interview.

Any challenge to the PCAOB’s standard-setting authority might be difficult, thanks to a little-noticed provision in the 2010 Dodd-Frank financial reform act. It amended Sarbanes-Oxley and gave the PCAOB broader powers to set independence standards that are in the public interest or necessary to protect investors.

But the PCAOB could still be challenged if it mandated rotation without having cost-benefit data to support that move, said John Coffee, a law professor at Columbia University.

“The big question is not whether they have the authority, but what they have to do to exercise that authority so as to withstand judicial review,” he said.

The U.S. Court of Appeals in the District of Columbia last year struck down a Securities and Exchange Commission rule on “proxy access” for lack of an adequate cost-benefit study, Coffee noted. Since the SEC has to approve any PCAOB rule, the same thing could happen to a rotation rule, he said.

The ABA’s letter said much the same thing.

“The D.C. court is extremely hostile to SEC regulation,” striking down four SEC rules in the last few years, Coffee said.

The backlash against rotation has been formidable. The U.S. Chamber of Commerce, the nation’s largest lobbying group for corporations, has pressed Congress to block it, and hundreds of letters have poured in to the PCAOB from companies and audit firms opposing it.

The issue has become such a political football that Cox said he doubts a broad mandate requiring rotation will be passed. One alternative would be for for the PCAOB to use rotation on a limited basis, as a sanction when serious audit problems are found at a company that had a long-tenured auditor, Cox said.

Officials at the PCAOB have said it is too soon to say whether rotation will even get to the proposal stage. They have said they plan to continue getting feedback through this year and any rule proposal would not come before 2013.

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