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Securities Law Commentary
Free Enterprise Fund v. PCOAB: Sarbanes-Oxley’s PCAOB Is Not Unconstitutional
Enterprise Fund v. PCAOB
Posted: 10/23/2008
By: Joel B. Ginsberg, Esq.
Companies Mentioned: Beckstead and Watts, LLP, Free Enterprise Fund, Public Company Accounting Oversight Board
Introduction
In its long-awaited opinion in Free Enterprise Fund v. PCAOB, 537 F.3d 667 (D.C. Cir. 2008), the Circuit Court for the D.C. Circuit upheld the Sarbanes-Oxley Act of 2002 – specifically that Act’s establishment of the Public Company Accounting Oversight Board (“PCAOB”) – against constitutional challenges. The plaintiffs argued that Act violates both the Appointments Clause of the Constitution as well as separation-of-powers principles by creating the PCAOB as a virtually independent, autonomous agency over which the President has minimal practical control and authority. The Court disagreed, finding that the Securities and Exchange Commission, over which the President has an appropriate amount of control, has sufficient legal authority over the PCAOB to support a finding that the Act is constitutional. But this case is far from over – appeals are expected, including to the U.S. Supreme Court, meaning that the future of Sarbanes-Oxley is still in question.
Detailed Commentary
Background
The Sarbanes-Oxley Act of 2002, 15 U.S.C. sections 7201 et seq. (the “Act”), was enacted in response to several major corporate accounting scandals that cost investors millions and shook public confidence in American capital markets. The Act (often referred to as “Sarbox” or “SOX”) establishes new and/or enhanced standards for all U.S. public company boards, managements, and public accounting firms.
Title 1 of Sarbox establishes a new quasi-public agency, the Public Company Accounting Oversight Board (“PCAOB”), which is empowered to register public accounting firms, establish auditing and ethics standards, conduct inspections and investigations of registered firms, impose sanctions, and set its own budget funded by annual fees. 15 U.S.C. section 7211(c), 7219(c) and 7219 (d). Pursuant to the Act, the PCAOB and its board members are appointed and controlled by the commissioners of the Securities and Exchange Commission (“SEC”), who can fire PCAOB board members “for cause” only.
Since its enactment, Sarbox has been the subject of heated debate. Supporters argue that Sarbox was necessary to restoring public confidence in capital markets and strengthening corporate accounting controls. Opponents of the bill take issue with the “red tape” resulting from Sarbox that decreases American competitiveness and in particular acts as a barrier to entry for micro-cap and development stage companies, which cannot afford to pay the high cost of compliance. Public companies will pay $35 billion (and 30,700 man hours) per year to comply with the Sarbox “internal controls.” 1 A University of Rochester study estimated the overall costs of the Act to shareholders at $14 million.2
The Challengers: PCOAB violates the Appointments Clause and the separation of powers
The Constitutional challenge to Sarbox in Free Enterprise Fund v. PCAOB, 537 F.3d 667 (D.C. Cir. 2008), was brought by the Free Enterprise Fund, a non-profit public interest organization, and one of its members, Nevada accounting firm Beckstead and Watts, LLP. Beckstead and Watts was registered with PCAOB and was subject to an ongoing formal investigation that commenced in 2005.
The Plaintiffs levied two primary constitutional challenges against the creation and existence of PCAOB: that it violates the Appointments Clause, and that it violates separation-of-powers safeguards. The Appointments Clause (U.S. Const. Art II, section 2, cl. 2), states that the President shall appoint, with the advice and consent of the Senate, “Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, who Appointments are not herein otherwise provided for…” However, the clause enables Congress to vest the appointment of “inferior officers” in the President, the Courts of Law or the “Heads of Departments.”
The Plaintiffs alleged that the PCAOB was an essentially autonomous department, evidenced by the fact that the SEC did not have day-to-day supervision over the PCAOB, and its board members could only be removed “for cause.” As a result, PCAOB board members could not be considered “inferior officers” and therefore, only the President, and not the SEC commissioners, should be able to appoint them. The plaintiffs claimed that because the Act enables only the SEC (not the President) to appoint PCAOB board members, it violates the Appointments Clause.
Even if PCAOB board members were construed as “inferior” officers, the Appointments Clause allows their appointment to be delegated only to the Head of the Department – the SEC Chairman. Because all SEC commissioners collectively appoint the PCAOB board members under to the Act, plaintiffs argue that this violates the Appointments Clause because the collective group of commissioners is not the same things as a “Head” of the Department.
The plaintiffs further alleged that the Act violates separation-of-powers principles by enabling only the SEC commissioners, not the President, to remove PCAOB board members, and then only “for cause.” In order to influence and control the PCAOB, claim the plaintiffs, the President has to go through two levels of “for cause” removal – one for the SEC commissioners and a second level for the PCAOB. Putting those limitations on the President’s abilities and functions violates separation of powers principles, said plaintiffs.
The district and circuit courts find no constitutional violation
The U.S. District Court for the District of Columbia granted summary judgment in favor of the defendants, upholding the constitutionality of the Sarbox provisions. In August 2008, the Circuit Court for the D.C. Circuit affirmed the grant of summary judgment in a 2-1 split decision.
The D.C. Circuit court determined that the PCAOB board members were in fact “inferior officers” of the government. The court disagreed with the Plaintiffs’ characterization of the PCAOB as an autonomous agency, articulating numerous ways in which the Act empowers the SEC with comprehensive control over the PCAOB. “[T]he Act ensures that all Board functions are subject to pervasive Commission control, including approval of its annual budget and supporting fees, 15 U.S.C. § 7219(b), (d).” 537 F.3d at 681.
Because the PCAOB members are inferior officers, subject to the direction and supervision of the SEC, it is constitutionally appropriate to delegate the appointment of those board members to the Department Head. The Circuit Court further found that the SEC “is a “Department[]” whose “Head[]” consists of the several Commissioners” so it does not violate the Appointments Clause for the PCAOB board to be appointed by this collective department “Head.” Id. at 678.
As to the separation of powers argument, the Court held that a President’s powers of control over administrative officers are not absolute, and have often been subjected to some limitations. In this instance, the Court determined that the Act did not so limit the President’s authority over the PCAOB as to be unconstitutional. “Although the President does not directly select or supervise the Board’s members, the President possesses significant influence over the Commission, which in turn possesses comprehensive control over the Board.” Id. at 681.
Judge Kavanaugh’s strong dissent may induce Supreme Court review
The one dissenting Circuit Court Judge, Hon. Brett M. Kavanaugh, wrote such a strong dissent that it alone may beg for Supreme Court review. Judge Kavanaugh characterized the case as “the most important separation-of-powers case regarding the President’s appointment and removal powers to reach the courts in the last 20 years.” 537 F.3d at 685.
Judge Kavanaugh wrote that Sarbox renders the accounting oversight board “unaccountable and divorced from Presidential control to a degree not previously countenanced in our constitutional structure… such unaccountable power is inconsistent with individual liberty.” Id. at 687, 688.
The dissenting judge further explained: “The President’s power to remove is critical to the President’s power to control the Executive Branch and perform his Article II responsibilities. Yet under this statute, the President is two levels of for-cause removal away from Board members, a previously unheard-of restriction on and attenuation of the President’s authority over executive officers.” Id. at 686.
As of the date of this commentary, the plaintiffs filed a petition for rehearing en banc, and the Circuit Court is awaiting PCAOB’s response. Almost regardless of the outcome of that motion, most commentators expect the Supreme Court to grant certiorari review (assuming it is requested) – some are even betting that the Supreme Court will ultimately declare the provision unconstitutional.3 If the PCAOB provision of the Act is found unconstitutional, all of Sarbox may be declared unconstitutional, as the Act lacks a severability clause. Stay tuned.
The author, Joel B. Ginsberg, Esq., is an associate in the transactional department of Zuber & Taillieu LLP, focusing on corporate law, and securities and finance law.
1 See article published by the Competitive Enterprise Institute: http://cei.org/gencon/019,04988.cfm.
2 http://w4.stern.nyu.edu/accounting/docs/speaker_papers/spring2005/Zhang_Ivy_Economic_Consequences_of_S_O.pdf.
3 See, for example, an Editorial of The New York Sun, August 26, 2008, found at http://www.nysun.com/editorials/sell-sarbanes-oxley/84635/.
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