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Congress Questions PCAOB Broker-Dealer Audit Rule

June 6, 2011

Lawmakers in Congress, along with the American Institute of CPAs, have written to the Public Company Accounting Oversight Board questioning how far a proposed interim rule for auditing broker-dealers should extend.

The rule stems from a provision of the Dodd-Frank Act that was enacted in response to the lack of oversight of the audits of Bernard Madoff’s investment operations by his longtime accounting firm, Friehling & Horowitz. The surviving partner in that firm, David Friehling, pleaded guilty last year to fraud charges and has been stripped of his CPA license (see Madoff Accountant Stripped of CPA License).

Section 982 of last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act contained a provision extending the PCAOB’s authority to inspect auditors of broker-dealers, but allowed the PCAOB to differentiate public accounting firms that issue audit reports only for one or more brokers or dealers that do not receive, handle or hold customer securities or cash, or are not a member of the Securities Investor Protection Corporation. The PCAOB has issued a proposed interim rule to carry out that provision of the Dodd-Frank Act. The AICPA and several congressmen have objected, however, saying that the rule would go too far, by extending the oversight to firms that audit so-called “introducing broker dealers.” They do agree that inspections of firms that audit for “clearing, carrying and custodial broker-dealers” are needed, though, as they receive and handle the actual customer securities and cash.

On May 27, House Financial Services Committee Chairman Spencer Bachus, R-Ala., and House Subcommittee on Capital Markets and Government Sponsored Enterprises Chairman Scott Garrett, R-N.J., wrote to PCAOB Chairman James Doty expressing their concerns. They wanted to know about the “costs and benefits” of the proposed interim rule as it applies to auditors of introducing broker-dealers.

“We believe the case has yet to be made for the PCAOB to extend its oversight to include the auditors of introducing broker-dealers,” they wrote. “Introducing broker-dealers are typically small businesses, with reduced capital requirements and limited infrastructure and staff. Because many auditors of these firms are also small businesses, compliance with a new federal regulatory regime may present particular challenges. Furthermore, introducing broker-dealers may not accept client funds, and if they receive client funds inadvertently, safeguards exist to ensure that these entities do not keep the money. Thus, it is difficult to envision how an inspection of an introducing broker-dealer’s auditor would protect the broker-dealer’s customers.”

Bachus and Garrett suggested the PCAOB should conduct more research and demonstrate whether the benefits to investors of regulating the auditors of introducing broker-dealers would exceed the costs of compliance.

The letter echoed some of the comments in earlier letters by another group of Congressmen who have CPA licenses and make up the recently formed Congressional CPA Caucus and by the AICPA itself. The Congressional CPA Caucus letter, sent to PCAOB officials in mid-February, noted, “In this initial interim rule, we believe that the most appropriate route for the PCAOB to take is to focus your oversight on those audit firms whose broker-dealer clients have access to investor funds,” they wrote. “These so-called ‘clearing, carrying, and custodial’ broker-dealers are the class of auditors for whom there is broad consensus for additional regulation. We urge the PCAOB to act quickly to begin an effective and targeted inspection program over these auditors.”

They urged the PCAOB to undertake a study on the benefits of registering and inspecting auditors of introducing broker-dealers, but said it would be a mistake to extend regulation to them at this juncture.

AICPA president and CEO Barry Melancon also sent a comment letter in mid-February to the PCAOB, expressing the institute’s overall support for the board’s proposed interim inspection rule, but cautioning against extending it to auditors of introducing broker-dealers. “The AICPA firmly believes that PCAOB registration and inspection should apply to auditors of those broker-dealers holding and investing customer cash or securities (clearing, carrying and/or custodial),” he wrote. “These broker-dealers present the only realistic risk to investors because of the activities they perform on behalf of investors. Introducing broker-dealers, on the other hand, do not or only have a limited right to handle cash, and accordingly pose no systemic risk to the markets and investors. We believe the auditors of this class of broker-dealers can and should be handled differently.”

Melancon disagreed with the SEC’s position that broker-dealers that are not carrying, clearing or custodial firms are of enough risk to investors that their audits should be subject to PCAOB regulation because the broker-dealers are permitted to receive customer cash or securities on a limited basis.

Mat Young, director of congressional and political affairs at the AICPA, told me Monday that the AICPA position essentially meshes with the letter written last month by Bachus and Garrett.

“We think that there is a strong compelling public policy argument for new oversight of auditors of clearing and custodial broker-dealers,” he said. “Clearing and custodial broker-dealers have access to investor funds, and therefore there would be the greatest benefit of additional oversight. However, we do not believe that the case has yet been made that there should be additional regulations over the auditors of the introducing broker dealers, which is essentially what Chairmen Bachus and Garrett said in their letter.”

He noted that the introducing broker-dealers essentially introduce their clients to those people who take custody of the funds and clear the trades, and under FINRA and SEC rules they may not take investor funds. Young dismissed the notion that the additional regulation might have made a difference in the case of Madoff and his former accounting firm.

“There are certain things that regulators can do a very good job of and we support a regulatory scheme over the profession,” he said. “But when people flat out lie, it’s really hard to detect those lies. So in a case like that, the best cop on the beat to detect what was going wrong are the principal regulators, such as the SEC and FINRA. They are the ones who directly have oversight of broker-dealers. And the broker-dealer, in this case, Madoff, was the one who was committing the fraud. If you want to figure out the best way to address someone like a Madoff, then you need to beef up the oversight ability of the SEC and FINRA.”

Unfortunately, though, the oversight ability of the SEC and FINRA has not always proven to be up to the task of catching a Madoff or even a mini-Madoff, even when whistleblowers like Harry Markopolos brought the problems to the regulators’ attention.

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