The Supreme Court ruled against the Public Company Accounting Oversight Board in a 5-4 decision, finding that the way board members are removed by the SEC is unconstitutional.
In the closely watched case, the court ruled that limitations on the power to remove the members of the PCAOB only for cause are unconstitutional under the separation of powers doctrine. However, the court found that the appointment of the board members does not violate the Constitution, and it kept in place the other provisions of the Sarbanes-Oxley Act under which the PCAOB was established. The result reverses in part, affirms in part, and remands to the lower courts.
Chief Justice John Roberts wrote the majority opinion, supported by Clarence Thomas, Antonin Scalia, Samuel Alito, and Anthony Kennedy. Justices Stephen Breyer, John Paul Stevens, Ruth Bader Ginsburg and Sonia Sotomayor dissented.
In the case, Free Enterprise Fund v. PCAOB, the conservative advocacy group sued the PCAOB along with an accounting firm, Beckstead & Watts, that had received some criticisms of deficiencies in one of its periodic audit evaluations by the PCAOB. The plaintiffs lost the case in two lower court decisions.
"I’m very happy that the Supreme Court was able to find in favor for us," said Beckstead & Watts managing partner Brad Beckstead in an interview. "I’m happy that they went straight to the source of the problem and found a way to fix the unconstitutional portion of the Sarbanes-Oxley Act."
However, the PCAOB also pronounced itself to be happy with the decision. “We are pleased that the decision allows the PCAOB to continue without interruption to carry out its important mission of overseeing public company audits in order to protect investors and promote the public interest,” said PCAOB Acting Chairman Daniel L. Goelzer in a statement.
The Free Enterprise Fund charged that the method of appointing members of the PCAOB under the Sarbanes-Oxley Act of 2002 was unconstitutional as the members were appointed by the Securities and Exchange Commission, and not directly by the president. The SEC could only remove the members for cause.
The Supreme Court declined to allow a broad injunction against the court’s continued operation, but agreed with the plaintiffs that the removal required a "double layer" of for-cause removal, with SEC members who could only be removed for cause and PCAOB members who could only be removed for cause. The ruling will allow PCAOB members to be removed "at will" by the SEC.
"The government errs in arguing that, even if some constraints on the removal of inferior executive officers might violate the Constitution, the restrictions here do not," wrote Roberts for the court. "There is no construction of the Commission’s good-cause removal power that is broad enough to avoid invalidation. Nor is the Commission’s broad power over board functions the equivalent of a power to remove board members."
Roberts noted that the PCAOB can continue to function. The court severed from the rest of the Sarbanes-Oxley Act the for-cause provision outlining the removal of the PCAOB members.
Instead, the challengers to the method of appointing board members of the PCAOB are entitled to a declaratory order "sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive."
"They pretty clearly say that the removal provision is severable," said Brad Joondeph, professor of law at the Santa Clara University School of Law. "Everything about Sarbanes-Oxley remains in place except for the fact that members of the board no longer have the good cause removal protection. In effect, everything continues as it has."
In his dissent, Breyer took issue with some of the hypothetical arguments in the majority's decision, including what would happen if both the president and the SEC wanted to remove a PCAOB board member, but had varying judgments as to whether they have good cause to do so.
"Once we leave the realm of hypothetical logic and view the removal provision at issue in the context of the entire Act, its lack of practical effect becomes readily apparent," wrote Breyer in the dissenting opinion. "That is because the statute provides the Commission with full authority and virtually comprehensive control over all of the Board’s functions. Those who created the Accounting Board modeled it, in terms of structure and authority, upon the semiprivate regulatory bodies prevalent in the area of financial regulation, such as the New York Stock Exchange and other similar self-regulating organizations."
Solicitor General Elena Kagan had argued the case on behalf of the government. Her confirmation hearings as a Supreme Court justice began Monday, the same day the court handed down its ruling in the PCAOB case.
“We’re very happy with the result,” said John Berlau, financial policy director and director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute, which has been involved in litigating the case on behalf of Beckstead & Watts and the Free Enterprise Fund. “This is a big ruling, and a big victory for America’s entrepreneurs and investors as well as for the Constitution. Congress tried to sidestep by saying that the PCAOB wasn’t even a government agency. We’ve got a ruling that all agencies will have to be held to the Constitution’s mechanisms of accountability.”
Berlau believes that some of the PCAOB’s rulemaking over the years may be invalidated as a result of the ruling. "When there is an unconstitutional body that makes rules, those rules can be made invalid," he said.
However, Professor Joondeph disagrees. "I’m almost certain that this is purely prospective," he said. "They refused to give it injunctive relief. They ensured that these petitioners and everyone going forward has the right to have decision-making from a properly constituted board, but wouldn’t invalidate anything that has gone before. That would be consistent with similar decisions in the past where there was a separation of powers problem."
Beckstead of Beckstead & Watts said that he was encouraged that Congress has addressed the burden of Sarbanes-Oxley on small business issuers by including a relief provision in the financial reform bill exempting small business from audits of internal control.
"I’m hopeful that Congress will continue to look for ways to ease the barriers of entry for small business into the capital markets by reducing costs relative to audits and compliance with the Sarbanes Oxley Act," he said. He added that he looks forward to going back to the lower courts that ruled against his firm in the previous decisions in the case, "and fixing whatever problems that they had that are contrary to the findings of the Supreme Court."
However, accounting groups seemed contented with the decision. "My take is that this is a very narrow ruling," said Cindy Fornelli, executive director of the Center for Audit Quality. "All in all, the Supreme Court upheld the constitutionality of the PCAOB. Other than the removal process, where they found the removal of the PCAOB members only for cause was unconstitutional. I think they took pains to make very clear that the appointment of the PCAOB board members is constitutional, that the functionality of the PCAOB is constitutional, and that the removal provision can be severed from the rest of Sarbanes-Oxley. This flaw in the Sarbanes-Oxley Act does not render the rest of the Act unconstitutional."
Fornelli believes that the PCAOB will now have an easier time filling some of the open slots for board members. "I would certainly think to the extent that anybody who was considering a board appointment had any doubts, those doubts should now be removed, and it should free those people up, whoever they may be, to consider the role on its merits as opposed to having that uncertainty as to whether or not the PCAOB as constituted was constitutional. So it would be my hope that can free potential board members and the SEC to make those appointments as expeditiously as possible."
“The court’s ruling is a victory for investors and for the accounting profession," said American Institute of CPAs president and CEO Barry Melancon in a statement. "The decision effectively fixes the constitutionality of the PCAOB by making board members subject to `at will’ removal by the SEC and therefore the president. It sustains the continued function of both the PCAOB and Sarbanes-Oxley. As such, the court rejected a transparent attempt to undermine the post-Enron reforms that have served our financial markets well.”
The PCAOB noted in a statement that the Supreme Court held that the Sarbanes-Oxley Act’s provisions making PCAOB Board members removable by the Securities and Exchange Commission only for good cause were inconsistent with the Constitution’s separation of powers.
"Because the Court severed these provisions from the Act, however, no legislation is necessary to bring the Board’s structure within constitutional requirements," said the PCAOB. "The consequence of the Court’s decision is that PCAOB Board members will be removable by the SEC at will, rather than only for good cause. All other aspects of the SEC’s oversight, the structure of the PCAOB and its programs are otherwise unaffected by the Court’s decision. Accordingly, all PCAOB programs will continue to operate as usual, including registration, inspection, enforcement, and standard-setting activities."
The SEC also provided its reaction, noting that the Supreme Court held that the restriction on removal of Board members under the Sarbanes-Oxley Act of 2002 violates separation of powers principles, but found that the provision was severable from the remainder of the Sarbanes-Oxley Act. "The Court stated that the Act 'remains fully operative as a law' with the for-cause restrictions excised, leaving the members of the PCAOB subject to removal by the Commission without restriction. The opinion does not call into question any action taken by the PCAOB since its inception."
“I am pleased that the Court has determined that the Board’s operations may continue and the Sarbanes-Oxley Act, with the Board’s tenure restrictions excised, remains fully in effect," said SEC Chairman Mary L. Schapiro in a statement. "The PCAOB is a cornerstone of the Sarbanes-Oxley Act and serves a critical role in promoting investor protection and audit quality. We look forward to continuing to work with the Board in connection with its mission to oversee auditors in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.”
The Sarbanes-Oxley Act of 2002 established the PCAOB, and the Act provides the SEC with oversight authority over the PCAOB, the SEC noted. “It is important to understand that the PCAOB’s auditing standards, as approved by the Commission, continue to apply,” said SEC Chief Accountant James L. Kroeker in a statement. “Audit firms are required to be registered with the PCAOB and they remain subject to inspections.”
Ernst & Young global chairman and CEO James Turley also expressed his support for the ruling. "Independent regulation of the profession post-Sarbanes Oxley has strengthened audit quality and confidence in financial reporting," he said. "We are pleased that the Court's decision provides that the PCAOB's independent oversight can continue without interruption. Although today's ruling found a flaw in a provision within SOX regarding the removal of Board members, the Court held that Sarbanes Oxley remains the law.”
A joint statement from former Sen. Paul Sarbanes, D-Md., and former Rep. Michael Oxley, D-Ohio, who wrote the Sarbanes-Oxley Act, also supported the decision. "The PCAOB provides essential protections to the more than half of American households that invest savings in securities," they said. "It ensures the integrity of public company audits and, thereby, the accuracy of financial reporting. The PCAOB enjoys widespread support from investors as well as from the accounting profession. The decision from the Supreme Court adjusts the law in a way that allows the PCAOB to continue to ensure the integrity of public company audits. The Board's essential protections of American investors will continue."
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