For whistleblowers and their (past or present) employers, one of the more important features of the SEC’s new whistleblower program regulations is Rule 21F-17 (copied in part below).  Over the years, targets of whistleblower claims have employed increasingly aggressive and sophisticated tactics — including “gag orders,” TROs, and breach of confidentiality agreement or even trade-secret-theft claims — to intimidate whistleblowers and prevent them from alerting regulators and law enforcement about wrongdoing.  Rule 21F-17 is a significant step toward ending such shenanigans and should encourage more SEC whistleblowers to come forward.

Among other things, Rule 21F-17 clearly prohibits any “person” from taking “any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce” most confidentiality agreements. (Emphasis added.)  Confidentiality agreements covering attorney-client privileged information are generally excepted from this ban under Rule 21F-4(b)(4). But even the 21F-4(b)(4) exceptions have exceptions outlined in 21F-4(b)(4)(v).

The bottom line: Attempting to silence a would-be SEC whistleblower is more dangerous now than ever before.  Employers would do well to carefully analyze the extent to which their “investigative” activities — which far too often include firing and suing the very whistleblowers who prompt such investigations — are themselves an additional violation of SEC Rule 21F-17.

§ 240.21F-17 Staff communications with individuals reporting possible securities law violations.

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement (other than agreements dealing with information covered by § 240.21F-4(b)(4)(i) and § 240.21F-4(b)(4)(ii) of this chapter related to the legal representation of a client) with respect to such communications.

(b) If you are a director, officer, member, agent, or employee of an entity that has counsel, and you have initiated communication with the Commission relating to a possible securities law violation, the staff is authorized to communicate directly with you regarding the possible securities law violation without seeking the consent of the entity’s counsel.

…

240.21F-4(b)(4) The Commission will not consider information to be derived from your independent knowledge or independent analysis in any of the following circumstances:

(i) If you obtained the information through a communication that was subject to the attorney-client privilege, unless disclosure of that information would otherwise be permitted by an attorney pursuant to § 205.3(d)(2) of this chapter, the applicable state attorney conduct rules, or otherwise;

(ii) If you obtained the information in connection with the legal representation of a client on whose behalf you or your employer or firm are providing services, and you seek to use the information to make a whistleblower submission for your own benefit, unless disclosure would otherwise be permitted by an attorney pursuant to § 205.3(d)(2) of this chapter, the applicable state attorney conduct rules, or otherwise; or …

(iii) In circumstances not covered by paragraphs (b)(4)(i) or (b)(4)(ii) of this section, if you obtained the information because you were:

(A) An officer, director, trustee, or partner of an entity and another person informed you of allegations of misconduct, or you learned the information in connection with the entity’s processes for identifying, reporting, and addressing possible violations of law;

(B) An employee whose principal duties involve compliance or internal audit responsibilities, or you were employed by or otherwise associated with a firm retained to perform compliance or internal audit functions for an entity;

(C) Employed by or otherwise associated with a firm retained to conduct an inquiry or investigation into possible violations of law; or

(D) An employee of, or other person associated with, a public accounting firm, if you obtained the information through the performance of an engagement required of an independent public accountant under the federal securities laws (other than an audit subject to §240.21F-8(c)(4) of this chapter), and that information related to a violation by the engagement client or the client’s directors, officers or other employees.

(iv) If you obtained the information by a means or in a manner that is determined by a United States court to violate applicable federal or state criminal law;

(v) Exceptions. Paragraph (b)(4)(iii) of this section shall not apply if:

(A) You have a reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or property of the entity or investors;

(B) You have a reasonable basis to believe that the relevant entity is engaging in conduct that will impede an investigation of the misconduct; or

(C) At least 120 days have elapsed since you provided the information to the relevant entity’s audit committee, chief legal officer, chief compliance officer (or their equivalents), or your supervisor, or since you received the information, if you received it under circumstances indicating that the entity’s audit committee, chief legal officer, chief compliance officer (or their equivalents), or your supervisor was already aware of the information.

The single largest group of health care whistleblowers are health care workers themselves — nurses, doctors, dentists, therapists and billing professionals — who encounter fraud on the job.  Do such health care workers violate HIPAA by disclosing patient protected health information (“PHI”) when blowing the whistle?  There is no need for them to do so.  Naturally, it helps to work with knowledgeable legal counsel from an early stage in the process. 

First, HIPAA privacy rules penalize only “covered entities” — including specified natural persons like doctors and nurses — who pass along PHI without patient authorization. Natural persons — the living, breathing kind — can be covered entities, but are not always. A whistleblower who is not a covered entity (or a business associate or attorney of a covered entity) is not subject to HIPAA rules.*

Second, for individuals who are covered entities, HIPAA rules provide disclosure “safe harbors” including the following:

(1) A covered entity is not considered to have violated [HIPAA] if a member of its workforce or a business associate discloses protected health information, provided that:

(i) The workforce member or business associate believes in good faith that the covered entity has engaged in conduct that is unlawful or otherwise violates professional or clinical standards, or that the care, services, or conditions provided by the covered entity potentially endangers one or more patients, workers, or the public; and

(ii) The disclosure is to:

(A) A health oversight agency or public health authority authorized by law to investigate or otherwise oversee the relevant conduct or conditions of the covered entity or to an appropriate health care accreditation organization for the purpose of reporting the allegation of failure to meet professional standards or misconduct by the covered entity; or

(B) An attorney retained by or on behalf of the workforce member or business associate for the purpose of determining the legal options of the workforce member or business associate with regard to the conduct described in paragraph (j)(1)(i)….

While it is possible that an individual relator could be a covered entity under HIPAA, HHS Reg. 164.502(j), specifically authorizes covered entities to share PHI (“protected healthcare information”) with their attorneys in whistleblower cases.

HHS’ Covered Entity Charts and associated regulations state that natural persons can be covered entities if they “furnish, bill or receive payment for, health care in the normal course of business and (send) any covered transactions electronically.”   The question that doesn’t seem to be addressed anywhere is whether an individual employee of a healthcare provider provides healthcare “in the normal course of business” for purposes of the regulation.

For what it’s worth, we’ve never heard of a False Claims Act whistleblower being held in violation of HIPAA regulations for disclosing PHI to his or her attorneys or to law enforcement authorities.   One way around the PHI-disclosure concerns is to redact PHI from medical billing records for use in court filings and disclosure statements provided to the Department of Justice.

It is important to keep in mind, however, that beyond HIPAA lurk other document-removal and -sharing traps.  For example, it is becoming more common for employers to sue whistleblowers for breach of confidentiality agreements in employment contracts or company policy manuals.  They may also sue for misappropriation of trade secrets.  Likewise, some state computer privacy laws make it a crime for employees to access company computers or databases without authorization. Each of these potential traps must be addressed on its own terms.

It is fair to say that would-be whistleblowers are normally safest not attempting to access any company documents — in hardcopy or electronic format — which they are not authorized to access as part of their normal job responsibilities.  It is also important to obtain legal advice early the process to work through evidence-related issues on the front end.

* HIPAA is not the only legal hazard for would-be whistleblowers. State-level privacy laws also lurk.

# # #

Not legal advice.  For advice specific to your situation, you should contact an attorney with experience in dealing with whistleblower matters.

Whenever “risk-management” professionals characterize their prognostications as near-certain, I get nervous.  Memories of the Berlin Wall, Black-Scholes, Long-Term Capital Management, Salomon Brothers and AIG dance before my eyes.  Today’s exhibit A: Bruce Pounder’s September 2, 2010 CFO.com article, “Why the SEC Won’t Flip the IFRS Switch.”

Pounder’s “most significant” point — that “for the SEC to order a switch from future U.S. GAAP to future IFRS despite substantial differences … the SEC would have to conclude that the FASB and its standard-setting predecessors completely failed to get U.S. GAAP ‘right’” — embodies a whopping non sequitur.*  Why? Among other things, there is no “right” GAAP any more than there is “a” right spelling of “grey”.

Where Pounder wants to find “right” GAAP answers, reality offers fact-, culture- and jurisdiction-dependent opinions mixed with probability distributions.  The historical record is devoid of a single “right” reported net income number, no matter the GAAP.   When a company reports net income of $X what readers should see is more along the lines of, “With a probability of 95%, our net income was somewhere within the continuum $X plus or minus $100 million.”  And even this net income assertion is of dubious value because it utilizes a variable unit of measure — whether we’re talking U.S., Hong Kong, or Australian $ doesn’t really matter.  None of these currencies offers a constant value.

Hence, the SEC could justifiably say, “We will move to IFRS because while U.S. GAAP narrows P&L uncertainty somewhat in relation to IFRS, the costs of maintaining and regulating an accounting system that duplicates IFRS are higher than the benefits of the associated reduction in uncertainty.”

Will the SEC quickly move to IFRS?  Probably not.  Would it be a good idea?  That depends on the objectives of accounting standards, a matter of considerable controversy.  Arguably, the world of finance is a better place with competing accounting standards-setters.  On some level, they keep each other honest.  Over the long haul, Nassim Taleb offers good counsel: Find out which way the risk management professionals are headed and then run (don’t walk) in the opposite direction.

Is the SEC on a roll or just looking over its shoulder at salivating securities whistleblowers? On the heels of settling with Goldman Sachs last week for $550 million, the SEC yesterday announced its $111+ million take from settling accounting fraud charges against Dell Computer and several current and former Dell executives including Michael Dell, Kevin Rollins and James Schneider.  The three will pay the SEC $4M, $4M and $3M, respectively, to settle.  Assuming the facts are as stated by the SEC, they’re fortunate. And wasn’t the Sarbanes-Oxley Act supposed to prevent this kind of thing?

The allegations center on misleading disclosures about Dell’s revenue sources and “cookie-jar reserves” by means of which, the SEC alleged in its complaint in the U.S. District for the District of Columbia, Dell and its executives led the market to believe Dell’s financial performance was much better than it actually was:

… Dell Inc., Michael Dell, Rollins, and Schneider misrepresented the basis for the company’s ability to consistently meet or exceed consensus analyst EPS estimates from fiscal year 2002 through fiscal year 2006. Without the Intel payments, Dell would have missed the EPS consensus in every quarter during this period.

… in one internal 2004 email to Michael Dell … Rollins noted that Dell’s reliance on Intel payments was a strategic “problem,” stating that “for 3 qtrs now, Intel money has made the qtr. A bad way to run the railroad.” …

… Dell’s most senior former accounting personnel, including Schneider … engaged in improper accounting by maintaining a series of “cookie jar” reserves that it used to cover shortfalls in operating results from FY 2002 to FY 2005… [making] it appear that it was consistently meeting Wall Street earnings targets and reducing its operating expenses through the company’s management and operations…

[Allegedly], Intel made exclusivity payments to Dell in order for Dell not to use CPUs manufactured by its rival – Advance Micro Devices, Inc. (AMD). These exclusivity payments grew from 10 percent of Dell’s operating income in FY 2003 to 38 percent in FY 2006, and peaked at 76 percent in the first quarter of FY 2007. The SEC alleges that Dell Inc., Michael Dell, Rollins, and Schneider failed to disclose the basis for the company’s sharp drop in its operating results in its second quarter of fiscal 2007 as Intel cut its payments after Dell announced its intention to begin using AMD CPUs. In dollar terms, the reduction in Intel exclusivity payments was equivalent to 75 percent of the decline in Dell’s operating income. Michael Dell, Rollins, and Schneider had been warned in the past that Intel would cut its funding if Dell added AMD as a vendor. Nevertheless, in Dell’s second quarter FY 2007 earnings call, they told investors that the sharp drop in the company’s operating results was attributable to Dell pricing too aggressively in the face of slowing demand and to component costs declining less than expected.

… the reserve manipulations allowed Dell to materially misstate its earnings and its operating expenses as a percentage of revenue … for over three years. The manipulations also enabled Dell to misstate materially the trend and amount of operating income of its EMEA segment, an important business unit that Dell also highlighted, from the third quarter of FY 2003 through the first quarter of FY 2005.

Floyd Norris and I don’t often see eye-to-eye on accounting issues.  However, taking the SEC’s allegations as true, it’s hard to argue with Norris that the fines imposed fit the crimes alleged.  Dell Computer will pay $100 million to settle its part of the case.  Hypothetically speaking, if the Dell case were subject to the new SEC whistleblower program, the whistleblowers would be legally entitled to between 10 and 30 percent of the more than $110 million the SEC will collect from the defendants.

Was it mere coincidence that the SEC suddenly settled with Goldman Sachs for $550 million — a figure widely seen as a fraction of what Goldman should have paid — on the same day, July 15, 2010, that the new SEC whistleblower bounty program finally passed both houses of Congress?

While the legislation did not actually become effective until the President signed it on July 21, the timing is interesting.  Consider that the new law, if applicable to the Goldman case, would require the SEC to pay a whistleblower 10%-30%  of the $550 million settlement.  That’s between $55 million and $165 million.  It’s not hard to imagine the SEC wanting to hustle a settlement to avoid a potential obligation to share the $550 million with whistleblowers who might have contributed something to the case after the effective date of the law.*

For aspiring SEC whistleblowers, as outlined in the SEC’s civil complaint, the $550 million Goldman Sachs settlement was a product of alleged misrepresentations that violated three primary federal securities laws: Section 17(a) of the Securities Act of 1933 (15 U.S.C. §77q(a)), Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §78j(b) and Exchange Act Rule 10b-5, 17 C.F.R. §240.10b-5.  While these code sections may read like Greek to the uninitiated, what they all boil down to is that companies like Goldman who sell “securities” like stocks and bonds to investors are required to provide potential investors ALL material information — positive, negative and neutral — about the proposed investment.

The SEC alleges, in general, that Goldman made

materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) Goldman structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities (“RMBS”) and was structured and marketed by Goldman in early 2007 when the United States housing market and related securities were beginning to show signs of distress.

More specifically, the complaint alleges that Goldman and its co-defendant Fabrice Tourre “recklessly or negligently misrepresented in the term sheet, flip book and offering memorandum for ABACUS 2007-AC1 … the significant role in the portfolio selection process played by Paulson & Co., a hedge fund with financial interests in the transaction directly adverse” to investors in the fund:

Undisclosed in the marketing materials and unbeknownst to investors [Paulson] played a significant role in the portfolio selection process.

The complaint also alleges that the defendants misled one investor, ACA, into believing that Paulson invested in the equity of ABACUS 2007AC1 and, accordingly, that Paulson’s interests in the collateral section process were closely aligned with ACA’s when in reality their interests were sharply conflicting:

After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS** portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future.

In short, the SEC says, Goldman and Tourre misled ABACUS 2007-AC1′s investors about Paulson’s role in structuring the deal and concealed the fact that Paulson was betting against the fund’s portfolio.

Bottom line: Was the synchronicity of the Goldman settlement and the passage of H.R. 4173 just a coincidence?  I doubt it.

# # #

* Under transitional provisions of Act Section 924(b), information brought to the SEC by whistleblowers is “original” and therefore qualifies for the SEC bounty program as long as it is submitted after enactment of the WSRCPA, no matter how long it takes the SEC to write associated regulations.  The date of enactment was July 21, 2010.

** RMBS stands for Residential Mortgage Backed Securities.

The leviathan Dodd-Frank bill, newly renamed the “Restoring American Financial Stability Act of 2010,” has been taken up by the Senate.  On CSPAN-2, Hawaii Senator Daniel Akaka is now droning on about how “too many investors don’t know the difference between a broker and investment advisor.”  Note well:  Both “Wall Street Reform” and “Consumer Protection” have disappeared from the bill’s title.  My brief analysis of the securities whistleblower provisions, in Act Section 922, tells me that once the bill is signed by the President the SEC should brace for a deluge of securities fraud claims.  These claims will take years to process but the process holds out some hope that securities whistleblowers may receive some compensation for their efforts to bring fraud to light.

Thinking of blowing the whistle on securities fraud?  Thanks to the  Dodd-Frank Restoring American Financial Stability Act of 2010 (H.R. 4173), it now makes financial sense to consider it.

Securities whistleblowers may not have much company in cheering H.R. 4173 but Section 922 is a major improvement over the largely non-functional anti-retaliation provisions of the old Sarbanes-Oxley § 806.

For readers familiar with the somewhat comparable False Claims Act (a.k.a. “FCA”), in some respects Section 922 is nearly identical.  In others, it differs significantly.  In theory at least, both statutes offer whistleblowers potentially handsome financial rewards for bringing forward “original information” about fraud.  The awards generally range between 15 and 30 percent under the FCA (10-30 percent under § 922)  of what the government collects as a result of the whistleblower’s disclosures.  The FCA seeks to protect government funds from unscrupulous contractors and tax cheats.  In contrast, Section 922 purports to shield investors from securities fraud.  Other major points of comparison and divergence follow.

Size Matters

Section 922 makes awards only in cases where the “monetary sanctions” collected from the defendant exceed $1,000,000.  In contrast, there is no statutory floor on FCA claims although practically speaking each U.S. attorney’s office has its own threshold.  There are just too many FCA cases and too few assistant U.S. attorneys to follow them all.  Some won’t consider a case alleging less than $1,000,000 in “single damages”.  Others will jump at $500K.  Local context can loom large.

Section 922 excludes more whistleblowers

Section 922 offers no private cause of action

Unlike the FCA which authorizes plaintiffs called “relators” to sue even if the government decides not to, under § 922 only the government can pursue a securities fraud claim.  If the SEC chooses not to pursue a whistleblower case, the whistleblower is pretty much out of options.  To place this in practical context, not even Harry Markopolos — with all of his data and analysis — could force his Bernie Madoff case into court if the SEC didn’t want to go.

“Original information” is broader under Section 922

While the term “original information” is not used in the FCA, the FCA also makes awards only for the provision of new information.  That said, Section 922′s formulation of “original information” appears to be more expansive than that of the FCA.

Unlike the FCA, Section 922 includes within its domain of “original information” not only bare “knowledge” but also “analysis” provided by a whistleblower.  This should be seen as significantly expanding the “original information” perimeter to include private analysis of publicly available data like that which enabled Harry Markopolos to detect the Madoff fraud long before the SEC did.  While it is possible that an FCA whistleblower may have won a settlement on the basis of such analysis alone, I am not currently aware of any such case.

On the flip side, Section 922 excludes from permissible “original information” information “exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report (as opposed to federal government, in the FCA), hearing, audit, or investigation, or from the news media, unless the whistleblower is a source of the information.  The phrases “exclusively derived” and “a source” are exclusive to Section 922 — they do not appear in the FCA.

Arguably, the net impact of “government,” “exclusively derived,” and “a source” — together with the addition of the word “analysis” — is to expand the pool of “original information” for SEC whistleblowers beyond than that available to FCA relators.

Section 922 will be administered by a dedicated SEC office

FCA relators should be so lucky.  FCA claims are typically administered and enforced by Main Justice DOJ Civil Division attorneys or by local Assistant US Attorneys who have lots of responsibilities in addition to FCA cases.  The focus offered by a special SEC whistleblower office should give SEC whistleblowers a leg up assuming that it is properly staffed and managed.

SEC determines Section 922 awards

Unlike the FCA where the district courts have authority to approve FCA settlements and associated whistleblower awards, Section 922 grants the SEC complete discretion to identify award recipients and set largely unappealable award amounts.

Act § 21F(c)(1)(B) directs the SEC to “take into consideration” a specific list of four factors in making awards.**  However, the House-Senate Conference Committee’s softening of the Senate version language of § 21F(c)(1)(B) from “shall account for” to “shall take in consideration” signals that the SEC can weight and apply these factors almost at will.  Act § 21F(f) deprives district courts of any supervisory role, sending award appeals directly to the circuit courts which must review SEC decisions in accordance with Section 706 of the federal Administrative Procedure Act.  As a practical matter, SEC decisions on awards will be very difficult to overturn on appeal.

Readers may judge for themselves what awards whistleblowers should expect in light of the fact that awards will be paid out of the same SEC Investor Protection Fund from which the SEC’s OIG will fund its activities.

Bottom line: Dodd-Frank offers pros and cons for SEC whistleblowers.  While it isn’t nearly as robust as the FCA, Dodd-Frank is a major improvement over Sarbanes-Oxley.  If you’re thinking of blowing the SEC whistle and can’t wait to get started, give us a call.  We can help you blow with greater velocity and focus.

# # #

* The emphasis on “and” is mine.  The contextual meaning of the phrase “contrary to the requirements of section 10A” is anybody’s guess at this point.  This kind of legislative loose end keeps litigators employed and drives auditors — who crave definition and bright lines — to distraction.

** The § 21F(c)(1)(B) award-amount factors are as follows:

1. the significance of the information provided by the whistleblower to the success of the action;

2. the degree of assistance provided by the whistleblower and any legal representative of the whistleblower in a covered judicial or adrninistrative action;

3. the SEC’s programmatic interest in deterring violations of the securities law by making awards to WBs; and

4. such additional relevant factors as the Commission may establish by rule or regulation.

*Cross-posted at Whistleblower Central.

Does “academic freedom” include the right to falsify data in government grant applications? One might think so, to hear Rachel Levinson Waldman, senior counsel for the American Association of University Professors. She (and 810 Virginia professors) have objected to Virginia Attorney General Ken Cucinelli’s civil investigative demand or “CID” (shown below) that the University of Virginia produce documents and communications relating to $485,000 in government funds it received on behalf of then UVA prof Michael Mann (of Climategate Hockey Stick fame) for the study of global warming theories.

CIDs are a powerful tool available to government investigators under the Federal False Claims Act and some state corollaries such as Virginia’s Fraud Against Taxpayers Act. The intent of these acts is to combat fraud in government contracting. Quoted in Times Higher Education UK, Levinson says Cucinelli’s CID is a politically-motivated assault on academic freedom:

“The breadth of the request suggests that it is meant to intimidate faculty members and discourage them from pursuing politically controversial work; it’s a shot across the bow,” she said.

“(This) injection of politics into the academic arena is … counter not only to the interests of scholars in climate science, but also to the interests of the state’s flagship institution in academic excellence.”

Kent Willis, executive director of the American Civil Liberties Union for Virginia, warned that if the institution were to “roll over”, it “could chill university-based scientific inquiry”.

Is the breadth of the AG’s request that unrealistic? Seems to me that it should be easier for UVA to locate and produce all correspondence related to the grants than to have to sift through thousands of documents in search of a medium-sized subset. The language of the CID is quite specific. If UVA and Professor Mann have conducted themselves in a properly scientific fashion, the requested documents, despite their likely volume, should be easily accessed in electronic or hard copy format.

Isn’t it true that politics are first “injected” into science when scientists ask taxpayers to fund their “politically controversial work”? In fact, seems to me that the central question before the Attorney General is really the extent to which the grant funds were used for scientific inquiry versus political advocacy on behalf of the climate change lobby.

Surely, in exchange for the funds, Mann and UVA agreed that the taxpayers or their representatives could later demand documentation to ensure that the funds were properly spent. Is it really so outrageous, now that the motivations of Mann and his colleagues have been notoriously called into question, that the State of Virginia wants a closer look?

Can’t scientists who invite taxpayers into their labs by taking tax money minimize their political (and legal) troubles by telling the truth in their grant applications and keeping the kind of well-organized, verifiable scientific data that is the hallmark of real science? Or should taxpayers just learn to gracefully write off their hard-won dollars the moment they are “granted” to “scientists”? Doesn’t the question answer itself?

None of this is to say that Michael Mann has been found liable for fraud. That is the question Cucinelli is investigating. Having accepted taxpayer funds to support Mann’s research into global warming, should Mann and the University of Virginia be insulated from the mere inquiry by the taxpayers’ representatives into whether Mann and UVA told the truth to taxpayers about what they were going to do with that money? When an academic receives research funds on the basis of specific factual assertions made to the patrons of his research (in this case, the taxpayers) even AAUP must — for its own good — insist that those factual assertions be taken seriously. The alternative is the complete termination of taxpayer funding of research.

It seems fair to say that while academic freedom fills a crucial role in ordered democracy, it is a privilege rather than a right. It carries with it the obligation to pursue academic and scientific objectives, not political ones. It is precisely because of the perception that Professor Mann and his colleagues have disregarded this obligation in a coordinated attempt to affect policy that taxpayers have become suspicious. It is to resolve these suspicions one way or another that Virginia’s Attorney General has issued such a broad CID to UVA.

With today’s SCOTUS decision in Free Enterprise Fund v. PCAOB, the Public Accounting Oversight Board (“PCAOB”) survives but with less swagger and self-importance than before.  This decision holding unconstitutional the “dual for-cause limitation” on the President’s ability to fire PCAOB members leaves the PCAOB’s form intact but downgrades its political independence.

Henceforth, according to the Supreme Court, the SEC can fire PCAOB members at will.  To what effect? The SEC can now be held directly accountable for PCAOB actions and the President indirectly accountable.  If you believe in government accountability, this is all to the good.  Before, under SOX language that made PCAOB appointments seemingly more iron-clad than tenured university posts, the PCAOB was beholden to no one.

Some may hold to the view that this kind of tenure was necessary to protect “investor interests”.  They quixotically imagine accounting and auditing to be apolitical, ivory-tower technocracies somehow above the fray.  Listen in on a FASB or IASB meeting and you see a completely different picture.  The reality is that accounting and politics are joined at the hip because all accounting is property and all property is politics.  Isolate the PCAOB from accountability and you throw the property baby out with the political bathwater. 

The majority opinion authored by Chief Justice Roberts is an instant classic.  It might well be required reading for every high school student and accounting professor in America.  It should be tested on the CPA exam.  Some of the most significant language appears at pdf pages 20-33 (hard copy pages 14-27).  A particularly compelling passage (most internal citations omitted) appears here:

The Board’s mission is said to demand both “technical competence” and “apolitical expertise,” and its powers may only be exercised by “technical professional experts.” In this respect the statute creating the [PCAOB] is, we are told, simply one example of the “vast numbers of statutes governing vast numbers of subjects, concerned with vast numbers of different problems, [that] provide for, or foresee, their execution or administration through the work of administrators organized within many different kinds of administrative structures, exercising different kinds of administrative authority, to achieve their legislatively mandated objectives”…

One can have a government that functions without being ruled by functionaries, and a government that benefits from expertise without being ruled by experts. Our Constitution was adopted to enable the people to govern themselves, through their elected leaders. The growth of the Executive Branch, which now wields vast power and touches almost every aspect of daily life, heightens the concern that it may slip from the Executive’s control, and thus from that of the people. This concern is largely absent from the dissent’s paean to the administrative state…

The Framers [of the U.S. Constitution] created a structure in which “[a] dependence on the people” would be the “primary controul on the government.” The Federalist No. 51, at 349 (J. Madison). That dependence is maintained, not just by “parchment barriers,” but by letting “[a]mbition . . . counteract ambition,” giving each branch “the necessary constitutional means, and personal motives, to resist encroachments of the others.” A key “constitutional means” vested in the President — perhaps the key means — was “the power of appointing, overseeing, and controlling those who execute the laws.” And while a government of “opposite and rival interests” may sometimes inhibit the smooth functioning of administration, “[t]he Framers recognized that, in the long term, structural protections against abuse of power were critical to preserving liberty.”

Calls to abandon those protections in light of “the era’s perceived necessity” are not unusual. Nor is the argument from bureaucratic expertise limited only to the field of accounting. The failures of accounting regulation may be a “pressing national problem,” but “a judiciary that licensed extra constitutional government with each issue of comparable gravity would, in the long run, be far worse.” Neither respondents nor the dissent explains why the [PCAOB’s] task, unlike so many others, requires more than one layer of insulation from the President — or, for that matter, why only two. The point is not to take issue with for-cause limitations in general; we do not do that. The question here is far more modest. We deal with the unusual situation, never before addressed by the Court, of two layers of for-cause tenure. And though it may be criticized as “elementary arithmetical logic,” two layers are not the same as one.

The President has been given the power to oversee executive officers; he is not limited, as in Harry Truman’s lament, to “persuad[ing]” his unelected subordinates “to do what they ought to do without persuasion.” In its pursuit of a “workable government,” Congress cannot reduce the Chief Magistrate to a cajoler-in-chief.

Most market participants who learn the facts of the case will likely end up agreeing with the Supreme Court that the PCAOB’s two layers of for-cause “insulation” were too much.  They were incompatible with America’s constitutional form of government and, therefore, bad for personal liberty and property rights.   The Court rightly asks, for example, what justifies the Sarbanes-Oxley Act’s impossibly high bar for removal of a PCAOB board member:

A Board member cannot be removed except for willful violations of the [Sarbanes-Oxley] Act, [PCAOB] rules, or the securities laws; willful abuse of authority; or unreasonable failure to enforce compliance—as determined in a formal Commission order, rendered on the record and after notice and an opportunity for a hearing. §7217(d)(3); see §78y(a). The Act does not even give the Commission power to fire Board members for violations of other laws that do not relate to the Act, the securities laws, or the Board’s authority. The President might have less than full confidence in, say, a Board member who cheats on his taxes; but that discovery is not listed among the grounds for removal under§7217(d)(3).7

This is the sort of knee-jerk, “torch and pitchforks” legislation too often inspired by hysteria.  With Sarbanes-Oxley, it was Enron.   (Today, it’s AIG and Lehman Brothers.)  But viewed rationally, what God of accounting and auditing could possibly deserve such job security?  The decision to overturn it is a return to sanity and the rule of law.  It reaffirms the vitality of the Constitution and reminds government officials that they are (at least somewhat) accountable for their conduct to the people who put them in office.

This SCOTUS opinion will likely reverberate through the halls of government for decades to come so long as the words “law” and “Constitution” retain any meaning.  And they had better retain meaning for the survival of the accounting profession which, after all, exists to account for the value and disposition of property rights guaranteed by . . . the Constitution.

More background on the case can be found at the Free Enterprise Fund and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board Wiki.  Another insightful resource is Steven Calebrisi’s pre-decision SCOTUSCast (22 minutes).

Business executives everywhere can breath a sigh of relief this morning after the U.S. Supreme Court (“SCOTUS”) yesterday struck down former Enron CEO Jeff Skilling’s convictions for so-called “honest services fraud”.  While the SCOTUS decision temporarily leaves intact Skilling’s other convictions, they are now on life-support. More on this theme in my March 2008 blog entry, Jeff Skilling is Innocent, and Tom Kirkendall’s excellent Skilling Wins at the Supreme Court.  The fundamental injustice and market foolishness of Skilling’s conviction were also the subject of my October 2007 presentation to the North Atlanta GSCPA, Skilling Appeals.

The full text of the SCOTUS Skilling opinion (written by J. Ginsburg) can currently be accessed through the SCOTUS Slip Opinion site.  Interesting that J. Sotomayor, with more trial experience than any other Justice, was (shockingly, in my view) the only one of the nine justices to agree with Skilling that his Houston jury was tainted by pre-trial publicity.  But no matter: Skilling is on the verge of getting out of jail entirely or receiving a significantly shorter sentence.

This decision at least partially restores my faith in the judicial system and makes me wonder if I’ve misjudged Ginsberg and Sotomayor.  Good for them.  Good for Skilling.  Good for America.

Question for another day:  How will Congress — now in the final stages of negotiating yet another ill-advised financial markets “reform” — respond to this SCOTUS decision?