The Supreme Court Agrees To Hear Constitutional Challenge To PCAOB

The Supreme Court agreed, in an order issued Monday, to hear a challenge to the constitutionality of the Public Company Accounting Oversight Board created as part of the Sarbanes Oxley Act. Free Enterprise Fund and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board and U.S.A., Case No. 08-861 (S.Ct. Filed Jan. 8, 2009). This is the second securities-related case which will be heard next term. The first is Jones v. Harris Associates, L.P., No. 08-586 (S.Ct. Filed Nov 3, 2008). That case, as discussed here, concerns Section 36(b) of the Investment Company Act.

Free Enterprise Fund raises two constitutional questions regarding the PCAOB. First, whether the SOX sections creating the Board violate the Constitution’s separation of powers. Second, whether the Act violates the Appointments Clause. The District Court granted summary judgment in favor of defendants. The court of appeals affirmed in a 2-1 decision and later declined to rehear the case or consider it en banc in a 5-4 ruling.

The PCAOB grew out of the accounting scandals at Enron, Worldcom and other companies which propelled the passage of the Sarbanes Oxley Act. In essence, SOX gives the Board, a private corporation whose members are appointed to staggered terms by a majority vote of the SEC, authority to oversee the audits of public companies that are subject to the securities laws. The PCAOB has the authority under SOX to require audit firms to register with it and comply with its auditing and ethical standards. The Board also has the authority to investigate the conduct of registered firms and their associated persons and to initiate disciplinary proceedings in which sanctions can be imposed. The provisions of SOX which created the Board were modeled on sections of the Exchange Act regarding self-regulatory organizations. The Board is subject to oversight by the SEC, but not the President.

Petitioners contend that the action presents “‘the most important separation of powers case regarding the President’s appointment and removal powers to reach the courts in the last 20 years,'” quoting the dissenting opinion in the Court of Appeals. Key issues are based on Article II of the Constitution which grants to the President the executive power of the government – the general administrative control of those executing the laws including the power of appointment and removal of executive officers. Petitioners claim that this provision was violated by the creation of the PCAOB.

In undertaking what Petitioners term a “novel experiment,” Congress stripped the President of his ability to appoint or remove board members. This was done because Congress wanted to insulate the Board from political pressures. In view of the extensive powers of the Board, including its law enforcement functions, Petitioners claim that PCAOB Board members are officers within the meaning of the Appointments clause of the Constitution, who must be appointed by the President and subject to his authority. Indeed, the creation of the Board in a manner which deprives the President of any real authority over its members is directly contrary to the Supreme Court’s appointment clause decisions, although there is no conflict among the circuits on this question, according to Petitioners. Petitioners were supported by an amicus brief submitted by The Washington Legal Foundation.

Respondents, supported by the United States (in a brief signed by the SEC), argued essentially that Petitioners have mischaracterized the powers and authority of the Board. The Appointment Clause requires that principal officers be appointed by the President and confirmed by the Senate. Inferior officers, defined as those “whose work is directed and supervised at some level by others who were appointed by Presidential nomination with the advise and consent of the Senate,” need not be directly appointed by the President. While Petitioners’ claim that the Board has extraordinary authority with little supervision, in fact SOX gives the SEC pervasive authority over all aspects of the Board and its activities. Accordingly Board members are inferior officers not subject to Presidential appointment power.

The stakes in this case are significant. If Petitioners prevail, it could be the end of the PCAOB and the comprehensive regulation of public company auditors Congress crafted in the wake of the corporate scandals which dominated the headlines early in this decade. Whether Congress would pass new legislation in that event is problematic at best. If the PCAOB provisions are stuck down and Congress failed to act, presumably standard-setting and regulation of the profession would return to its pre-SOX status, which many found inadequate. The case will be heard next fall.