The Public Company Accounting Oversight Board Disaster You Cant Make This Stuff Up

For most business professionals, restructuring advisors and investors, 2002 has already been indelibly
memorialized as the year of mega-bankruptcies and corporate malfeasance, unfortunately with significant
overlap between the two. BankruptcyData.com recently reported that 191 public companies with $379
billion in assets filed for bankruptcy in 2002, compared to 257 public companies with $259 billion in
assets in 2001. Some have pointed out that the mammoth-sized failures distort these figures, but even if we
exclude the three largest bankruptcies in each of these two years, it is clear that the average size of a public
company bankruptcy grew significantly in 2002, with average assets of $950 million compared to $634
million in 2001. Corporate failure was big business in every sense in 2002. Remarkably, issues of
accounting irregularities figured in four of the top five bankruptcies of 2002.

</p><p>As new revelations of corporate accounting irregularities surfaced during the first half of 2002, the
public accounting profession came under intense scrutiny and criticism as a result of its perceived failure to
expose any of these large-scale, long-running accounting frauds before meltdown occurred. In certain cases,
gross negligence or outright complicity by accountants was alleged. Investor and political outrage finally
peaked around mid-year with the back-to-back bankruptcy filings of Adelphia Communications and
WorldCom, along with the discovery of misuse/misappropriation of corporate assets and massive
accounting irregularities, respectively. (Subsequent revelations at WorldCom have tripled the size of initial
earnings misstatements, which now reach back to 1998.) Furthermore, as details emerged on the full extent
of Arthur Andersen's relationship with Enron and other failed audit clients, it soon became common
knowledge that many large accounting firms were typically providing a lucrative suite of non-audit services
to audit clients, with such non-audit service fees often dwarfing audit-related fees. Irate investor watchdogs
and politicians quickly seized upon this widespread practice as a potential impediment to the independence
requirement of the accountant in the performance of the attest function. To too many, it had become
apparent that major accounting firms had frequently been too lax, cozy, or compromising with certain audit
clients, and the accounting profession could no longer be trusted to regulate itself.

</p><p>The quick passage of the Sarbanes-Oxley Act on July 30, 2002, was generally hailed as an effective
means of dealing with the burgeoning crisis of confidence in American equity markets. The framework of
the Act sought to regulate the accounting profession, improve corporate governance and financial disclosure
requirements, and ultimately restore investor confidence in the integrity and transparency of public
companies' financial statements and accompanying disclosures.

</p><p>A key feature of the Act was the replacement of the system of self-regulation for the accounting
profession and the creation a Public Company Accounting Oversight Board (PCAOB), consisting of five
full-time, independent members whose function was to oversee public company audits. The PCAOB was
given broad powers and authority, including those to register public accounting firms, to set by rule
auditing, ethics, quality control and independence standards, to inspect the auditing operations of registered
accounting firms, to investigate violations of ethics or conduct set by the profession itself and the
PCAOB's own rules, and to enforce compliance with the new legislation and the PCAOB's own rules. The
Act required the Securities and Exchange Commission (SEC) to appoint members to the PCAOB within 90
days of the Act's passage—that is, by Oct. 28, 2002.

</p><p>The eventual appointment of Hon. William Webster, the former director of the FBI and CIA, as
chairman of the PCAOB on Oct. 25 and subsequent revelations about his recent involvement as a director of
a small, troubled company proved to be a major embarrassment for the SEC, prompting the resignations of
Chairman Harvey Pitt, Chief Accountant Robert Herdman, and lastly, Judge Webster himself.

</p><p>The General Accounting Office (GAO), the investigative arm of Congress, at the request of House
Reps. John Dingell (D-Mich.) and Barney Frank (D-Mass.), conducted an inquiry into the events leading up
to the resignation of Judge Webster on Nov. 12, 2002, and drafted recommendations to improve the
PCAOB selection process. The GAO report was released in late December and is available on the agency's
web site (www.gao.gov). The report provides a startling account of a dysfunctional process that was deeply
flawed and rudderless almost from its inception. Many details of the GAO report have already been widely
covered in the print medium, particularly those that elaborated on procedural flaws in the identification,
selection and vetting of PCAOB candidates, and the utter lack of effective communications among the
SEC's chairman, commissioners, chief accountant and general counsel throughout the process.

</p><p>But the most intriguing aspect of the GAO report is that the abundance of poor judgment exercised by
certain key players in this drama—particularly Chief Accountant Robert Herdman—has generally been
underreported in the press. Chairman Pitt hired Mr. Herdman as the SEC's Chief Accountant in September
2001 after having spent his entire 30-year career in the public accounting profession. He and Mr. Pitt had
known each other for several years, dating back to Mr. Pitt's days as a lawyer representing the accounting
profession and its interests on Capitol Hill.

</p><p>While Chairman Pitt had overall responsibility for the selection process, he asked Chief Accountant
Herdman to take the lead in identifying potential nominees for the PCAOB, according to the GAO report.
As for a PCAOB chairman, "The SEC chairman initially planned that he, along with a Democratic
commissioner and the chief accountant, would approach candidates about the chairmanship." Chairman Pitt
wanted each member of the PCAOB to be beyond reproach, and asked the general counsel to vet candidates
and "...at a minimum, identify any significant potential problems or conflicts, real or perceived, involving
accounting and other related issues." His stated goal was to avoid politicizing the process and obtain
unanimous votes from all five commissioners for each PCAOB member nominated.

</p><p>Following the commissioners' loss of initial support for John Biggs as PCAOB chairman in
early-October, Chairman Pitt, his chief of staff and Chief Accountant Herdman met with Judge Webster on
Oct. 15 and urged him to consider serving as chairman. During this meeting, Chairman Pitt reminded Judge
Webster of the media scrutiny and possible criticism his nomination would receive, to which Judge Webster
expressed some concern that he had been a director and head of the audit committee of U.S. Technologies
(USXX), a small company he stated was on the brink of failure, and asked the SEC officials to check and
see if its records indicated any problems relating to USXX. The company was primarily a contract
manufacturer of furniture and electronic components facilitated through the use of prison labor, but had also
made numerous small acquisitions of information technology companies. USXX had annual sales of less
than $3.0 million in 2000 and 2001. Judge Webster became a director of USXX in April 2000 and resigned
this position in July 2002.

</p><p>Subsequent to that meeting, Chairman Pitt asked Chief Accountant Herdman to look into USXX. Mr.
Herdman then asked his secretary to determine whether there were any open or closed SEC investigations of
the company. Neither Mr. Herdman nor anyone else who attended the Oct. 15 meeting with Judge Webster
contacted the SEC's general counsel, who was responsible for vetting PCAOB candidates. The SEC's
Division of Enforcement informed the office of the chief accountant that there was an allegation of
misconduct by an officer of USXX involving a Schedule 13D filed in 1999. This infraction did not involve
Judge Webster, and the matter was expected to be closed shortly. On the basis of this information, Chief
Accountant Herdman concluded that this matter should not affect Judge Webster's nomination as PCAOB
chairman, and this information was indirectly passed on to Chairman Pitt, who then informed Judge
Webster on Oct. 22 that his involvement with USXX would not affect his nomination. Judge Webster then
spoke with the other commissioners and general counsel, and later agreed to be considered for PCAOB
chairman on Oct. 23.

</p><p>Chief Accountant Herdman then conducted a second inquiry into Judge Webster's involvement with
USXX on Oct. 24 after receiving a draft of a newspaper article on the very topic. This time he asked a staff
member to review certain of the company's periodic filings with the SEC. On the morning of Oct. 25, the
day Judge Webster and the other four PCAOB nominees were to be voted on by the Commission, the chief
accountant's staff learned from its review of the company's filings that USXX's audit committee had
dismissed its external auditor in August 2001, one month after the auditor informed the company of
material internal control weaknesses. Specifically, BDO Seidman LLP informed USXX's audit committee
and senior management verbally and in a letter of a material weakness in internal control "related to
financial and accounting infrastructure including lack of an experienced CFO, deficiencies in recording
material transactions timely, and in the organization and retention of financial documents and accounting
records."

</p><p>Upon learning about the results of this second inquiry, Chief Accountant Herdman determined that,
"...in his view and his staff's view, nothing had come to light that affected the suitability of Judge Webster
to serve as PCAOB chairman." Neither Judge Webster nor USXX's current or former auditor was contacted
to obtain additional information on this issue. Furthermore, Chief Accountant Herdman did not inform the
SEC chairman, commissioners or general counsel of his new findings since he did not believe these events
posed a problem for Judge Webster's nomination. The vote proceeded as scheduled on Oct. 25, with Judge
Webster winning approval by a 3-2 margin. One commissioner vetoed the entire slate, "...stating that the
selection process was inept and seriously flawed," while another commissioner dissented on Judge Webster
based on the belief that Mr. Biggs, the previous candidate under consideration, was more qualified for the
position of PCAOB chairman.

</p><p>On Oct. 28, Judge Webster contacted Chairman Pitt and informed him that law enforcement authorities
were investigating USXX's CEO for allegations of fraud. The GAO report found no evidence that Chairman
Pitt or the other commissioners knew of the findings of Chief Accountant Herdman's second inquiry prior
to the Oct. 25 vote. They, as well as the general counsel, claim to have learned of the information withheld
from them by Chief Accountant Herdman in newspaper articles appearing within a few days after the vote.
And the rest, as they say, is history. If the entire Judge Webster episode had been a deliberate set-up, it
could not have been more successful in discrediting—at least momentarily—the Commission and its leader,
Chairman Pitt.

</p><p>Assuming that Chief Accountant Herdman wasn't the designated fall guy for the Commission (not
exactly the craziest of thoughts), it stretches the limits of credulity that Herdman's best judgment told him
that none of the facts that emerged about USXX from his second inquiry should have any negative bearing
on Judge Webster's nomination. Given the public's heightened sensitivity to corporate scandals, its
perception that the Bush administration was soft on white-collar wrongdoing and the intense public outcry
to get tough on corporate misdeeds, it was an absolute imperative that nominees to the PCAOB—the very
body created by congressional mandate to discourage and punish future misdeeds—had to be eminently
qualified and squeaky-clean in order to be deemed worthy of consideration. Chairman Pitt said as much early
in the process. Granted, the Commission was under tremendous pressure to appoint a board within the
approaching 90-day deadline, but there should be no sympathy for this predicament since the Commission's
own terribly ineffective selection and vetting process (as described in the GAO report) was largely
responsible for cutting it so close in the first place. As embarrassing as it would have been to attempt to
delay or postpone the vote on Oct. 25 and conduct further inquiry on Judge Webster and USXX, Chief
Accountant Herdman ultimately did far more damage to the Commission's credibility by concealing new
information from all of the commissioners, allowing the vote to proceed and labeling it a judgment call.

</p><p>Furthermore, the following additional information on USXX may or may not have been known by
Chief Accountant Herdman prior to the Oct. 25 vote, but was knowable via a quick 60-minute search I
made through the company's Form 10-K and 8-K filings with the SEC:
</p><ul>
<li>During the year-ended Dec. 31, 2000, Mr. Gregory Earls, USXX's co-chairman and co-CEO, also
fulfilled the roles of CFO and principal accountant officer of the company. Between March 15, 2001,
and year-end 2001, Mr. Earls was chairman, CEO, president and CFO of the company. This is a stark
example of incompatible job functions and poor (probably non-existent) corporate governance policy.

</li><li>USXX did not hire a Chief Financial Officer until January 2002.

</li><li>During 2001, there were several transactions and/or transfers between the company and CEO Earls or
entities controlled by CEO Earls. Though the company disclosed these items, they are the types of
incestuous dealings that investors have increasingly frowned upon in the current environment.

</li><li>All but one of 10 directors of USXX resigned within six months of each other in the first-half of
2002, with six directors resigning between February and April 2002 and three others, including Judge
Webster, resigning in July 2002. CEO Earls was left as the only director of the company following
these resignations.

</li><li>As of April 27, 2001, each member of USXX's board of directors, including Judge Webster, was
awarded 350,000 at-the-money stock options with a three-year vesting period as compensation for
serving as directors during the previous year. Even under the most conservative option pricing
assumptions, the theoretical value of these options was extremely generous compensation for directors
of such a small company as USXX.

</li></ul>

<p>Former Chairman Pitt has since stated that he believes the GAO report vindicates him—a rather
amazing assertion. True enough, the report does confirm that he had no knowledge of certain facts known
by Mr. Herdman on the day of the vote, and therefore did not withhold such critical information from the
other commissioners. But the Commission's ineptitude in handling the selection and vetting process, which
the GAO report goes to great lengths to criticize, apparently left Mr. Pitt feeling unblemished even though
he bore ultimate responsibility for the overall undertaking.

</p><p>What does any of this have to do with Turnaround Topics? Not much, I suppose, except to serve as an
object lesson to practitioners that under certain circumstances even the brightest minds, sharpest talents,
most experienced and reputable businesspeople are capable of poor judgment and bad decisions, especially
when the wrong incentives are in place. In retrospect, Judge Webster, a man with a long and distinguished
career of public service and accomplishment, must have surely pondered over why he ever agreed to serve as
director of a small, quasi-shady outfit like USXX. Former Senator George Mitchell of Maine, a director of
several Fortune 500 companies as well as USXX during this time, must have had these same second
thoughts as well. Moreover, Judge Webster's own seasoned instincts should have told him to beg off the
PCAOB chair position given that the demise of USXX was still an unfolding story with murky details
from which he had disassociated himself only three months earlier. Nine directors don't usually resign their
positions within six months due solely to a company's financial deterioration. Clearly Judge Webster had
personally done nothing wrong or illegal, but he was just too close to any potential stink for a reasonable
person's comfort. Chairman Pitt unwisely opted not to involve himself enough in a mission that was
critical to the integrity of the Commission. Lastly, Chief Accountant Herdman failed to perform adequate
due diligence and then crossed his fingers and hoped it wouldn't matter anyway. As the hippies used to say
in the '60s, "Question authority." That may not be such simplistic advice after all.