Is the SEC a Threat to FASB’s Independence?

A new agreement between the SEC and FASB gives the regulator greater say over future board candidates. Could that open a door for political interfe...
Marie Leone and Sarah JohnsonMarch 30, 2007

With the holidays fast approaching at the end of 2001, Harvey Pitt, then chairman of the Securities and Exchange Commission, was presiding over a collapse in investor confidence. That fall Enron had imploded in one of the most spectacular finance scandals in memory, and it looked increasingly as though its auditor, Arthur Andersen, had been careless — or perhaps even complicit — in some of the energy company’s most questionable dealings.

In the midst of this, Pitt recalls, the Financial Accounting Foundation (FAF) informed the SEC — by phone — that it had settled on a new nominee to replace Edmund Jenkins, the outgoing chairman of the Financial Accounting Standards Board. Pitt claims he cannot recall the candidate’s name. However, it was probably G. Michael Crooch, then and now a FASB member, who confirms he was a candidate at the time. Like Jenkins, Crooch was a veteran of Arthur Andersen, and had succeeded Jenkins as head of the firm’s professional-standards group.

That was the group involved in ordering the shredding of Enron-related documents, although those instructions were issued on October 12, 2001 — more than 14 months after Crooch left Andersen for FASB in July 2000. As Pitt recalls it, however, the nominee had been involved in some way in the Enron audit. “It was a nonstarter,” he says.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Pitt balked at the FAF’s selection, and its 11th-hour phone call. “I told them this was not sufficient notice, and no way were we going to approve it,” says Pitt, who adds he sent the FAF back to the drawing board. Four months later, the FAF formally announced a new nominee, current FASB chairman Robert Herz, then a senior partner with PricewaterhouseCoopers.

Fast forward to December 11, 2006, when the FAF notified the SEC that it would reappoint Herz, and appoint or reappoint six FAF trustees, at the start of the new year. There is no evidence that the SEC objected to any of the candidates, who are all now in position. But the 19-day notice, coming just before official Washington all but shut down for the holidays, apparently prompted the SEC to demand a more formal process for vetting future FAF and FASB candidates. Earlier this week, that move raised questions in the media about whether the SEC was grabbing for more power over FASB.

Not so, says SEC spokesman John Nester. The Sarbanes-Oxley Act, he says, “requires us to certify the standard setter every year, in terms of its capacity and capability to perform in that role.”

In a two-page memo to the SEC written March 9, the FAF confirms the SEC’s new mandates, including the regulator’s time line for reviewing candidates for FASB and its parent, the FAF. In addition, the memo states that the SEC has the power to nominate candidates to FASB and the FAF, and has the right to interview candidates during the selection process. “In order for us to fulfill [our] congressional mandate,” says Nester, “we look at a number of things, including corporate governance.”

Pitt notes that even before Sarbox, both he and his predecessor, Arthur Levitt, had direct input into the appointment of FASB members. “I would describe this as much ado about nothing,” he says of the recent debate. But other observers, including one current FASB member, fret that the memo may chip away at FASB’s independence.

In its new agreement, the SEC “goes a great deal further [than before] in its involvement in the selection process,” says Edward Trott, who is set to retire from FASB this year. In the past, the SEC “suggested” candidates, he says, but it never sought to formalize its power to nominate or interview. He says that while the SEC has always had statutory authority to set accounting standards, the regulator looked to the private sector to provide an “independent” perspective on accounting issues. Trott worries that the new formal process will open the door to more political tinkering with standard-setting, either directly from the SEC or indirectly from Congress.

Former FASB chairman Jenkins told that he, too, was alarmed by media reports earlier this week. “I am very concerned that this new protocol provides the basis for Congress — which has the responsibility to oversee the SEC — to get more directly involved with FASB, and I think it’s a step in the wrong direction.” (Jenkins also told that he could not confirm Pitt’s account of Herz’s selection as his successor, but agreed that the SEC was involved in FASB nominations.)

The Securities Act of 1934 gives the SEC oversight over accounting standard setters and the accounting rules used in public company financial filings. But it was Sarbox that sought to ensure FASB’s independence by switching its funding source from audit firms, which had a vested interest in the accounting industry, to the SEC. In a post-Sarbox policy statement issued in 2003, the SEC emphasized “the importance of the FASB’s independence” to ensure that accounting rules are free from bias, and explained that Sarbox requires the SEC to evaluate the organizational structure, operations, and procedures of FASB and the FAF.

Without defining the term, the statement mentioned that the SEC should receive “timely notice” of potential appointments, but confirmed that the “final determination” for overseeing, funding, and appointing members to FASB still rests in the hands of the FAF.

In contrast, the FAF’s March memo, whittled down from a nine-page briefing document, specifically requires that the FAF give the regulator at least 30 days, and preferably 45, to review FASB and FAF candidates and their qualifications. That is a more specific layer of detail than is contained in the 2003 policy statement, although the memo repeats the earlier declaration that the FAF makes the final decision regarding board member and trustee appointments.

“On the face of it, having SEC input into the nomination process in a fairly transparent way would not be the end of the world,” opines Damon Silvers, associate general counsel for the AFL-CIO, an institutional investor. But Silvers says the union is concerned because the move to formalize the selection process means that the SEC could exert pressure on FASB, and, in turn, on the standard setter’s rulemaking. “It’s not appropriate for [the SEC] to be holding the hand that holds the pen,” contends Silvers.

What Silvers and others fear is a replay of political strong-arming of FASB that came to a head in 1994. That was the year that under intense pressure from Congress, FASB backed off of a proposal to expense stock options, compromising not only the board’s position on expensing but also its very independence as a standard setter. FASB members and others involved in that decision now regret the move. Former SEC chairman Levitt admitted to CFO magazine in 2003 that urging FASB to back off was “the biggest mistake I made” during his eight-year tenure.

Politics interfered with stock-option rulemaking again, in 2003, when the House of Representatives threatened to push through a bill requiring a three-year study on the economic impact of employee stock-option plans before an accounting rule could gain SEC approval. The bill, which never took root, was viewed by critics as a stall tactic orchestrated by lawmakers who were pressured by constituents at Silicon Valley companies, and other high-growth corporations, who regularly doled out large stock-option awards to employees. Among the 111 co-sponsors of the bill was then-California congressman Christopher Cox, now chairman of the SEC.

FASB ultimately won the protracted battle, and in 2005 issued FAS 123R, the standard that requires companies to expense stock options and carry the charge on their balance sheets.

To be sure, the SEC’s original nine-page brief appears to have been prompted by SEC concerns about timing. But the effort clearly resurrected memories of earlier political battles. “I think the first draft made it look like the SEC was stepping over its bounds with respect to independence,” says John Radford, an FAF trustee and Oregon’s state controller. “I don’t think [the SEC was] trying to overstep its bounds; it wanted more influence and chances to make some comments. [But] it was the detailed nature of the [brief] that put the board off,” he told Still, says Radford, the SEC makes clear in the two-page memo that the final decision regarding new appointments rests with the FAF. “I don’t see that the SEC has impinged on the independence of the board.”

“At the end of the day, we still decide who gets appointed and who doesn’t get appointed,” insists W. Steve Albrecht, an FAF trustee and associate dean at Brigham Young University’s Marriott School of Management. Albrecht vouches for the independence of the FAF and insists that the memo represents nothing more than a clarification of a system already in place. “Nobody, including the SEC or anyone else, would run roughshod over [the FAF, which] would do anything that it could to protect that independence,” he says. “People are making a mountain out of a molehill” over the memo.

Others feel the same way. Sarbox co-author Rep. Michael Oxley (R-Ohio) told he has “great confidence” that the SEC knows what it is doing and “won’t overstep bounds.” Regarding the memo, he noted: “I think everything will be transparent . . . it doesn’t keep me up at night.” Similarly, University of Georgia accounting professor Dennis Beresford, the former FASB chairman who faced congressional pressure in 1994, says the agreement “is not a big deal,” and not a blow to FASB independence.

Beresford claims that since 1973, when FASB took over standard-setting duties from the American Institution of Certified Public Accountants, the SEC has interfered only twice with accounting rules. The first time was in 1979 when it overruled FASB and allowed both the “successful efforts” and “full cost” methods of accounting to be used by oil-and-gas-producing companies when booking reserve quantities and costs. The second time was in 1994 when Congress pushed the SEC to shelve the stock-option expensing rule.

Still, Beresford thinks the SEC should probably come up with a standard practice so its involvement in the selection process does not depend on “who’s in charge” at the SEC.

This story includes additional reporting by Alan Rappeport, Stephen Taub, David M. Katz, and Tim Reason.