A decision is expected soon in Free Enterprise Fund v. Public Company Accounting Oversight Board, a Supreme Court case that calls into question the future of Sarbanes-Oxley (SOX) and the PCAOB.
So what happens if the court rules against the PCAOB?
“A key question is how far an adverse ruling would go,” says Michael Young, a partner in the law firm Willkie, Farr and Gallagher LLP who specializes in financial reporting and auditing. “So much financial reporting infrastructure has been built around Sarbanes-Oxley that it’s hard to think through the domino-type impact that an adverse ruling might have.”
Because the Sarbanes-Oxley Act (SOX) does not contain a severability clause, a provision that allows one part of a law to be struck down while keeping the other provisions in force, some observers have pointed out that the entire law could be invalidated by the Supreme Court, which would eliminate the funding of FASB under SOX section 109 and regulations regarding internal control over financial reporting under section 404.
Two legal experts interviewed by the JofA think it’s unlikely the court would strike down the entire law. “It’s theoretically possible but highly unlikely the court would come out with such a broad ruling,” says Donna Nagy, a professor at Indiana University Law School who wrote an amicus brief on behalf of securities law professors who support the plaintiffs’ argument. Constitutional law professor Gillian Metzger at Columbia Law School, who wrote an amicus brief in support of the PCAOB, offers a similar view. “The Roberts court has shown a preference toward narrow, incremental rulings,” she said.
According to Metzger, who was a clerk under Supreme Court Justice Ruth Bader Ginsburg, the court does not need a severability clause to sever only the parts of SOX that it might find unconstitutional. Though Metzger says she’s not a SOX expert, she believes the court would look at the structure of the law to see what parts could stand without others.
SOX is organized into 11 titles and 1,107 sections. The PCAOB is created under Title 1, and appointment and removal of its members is covered in section 101. If the court finds a constitutional problem with the PCAOB under the appointments clause of the Constitution, Metzger says the court is likely to look at whether the rest of the law can remain in effect without the PCAOB.
A court ruling based on the separation of powers doctrine or on both separation of powers and appointments could be more complicated, she says.
One likely possibility, according to both legal scholars, is that the court could give Congress a period of time to fix SOX if it finds a constitutional problem with the law.
The plaintiffs who filed the lawsuit, Free Enterprise Fund and Beckstead and Watts LLP, a Henderson, Nev., CPA firm, have made it clear that they take issue with SOX more broadly and not just with the provisions of the law that created the PCAOB.
“Sarbanes-Oxley has been a disaster for American businesses, with yearly auditing costs averaging a staggering $1.34 million, more than quadrupling the costs before the law’s implementation in 2001,” says the Free Enterprise Fund on its website.
“The costs to comply with the Sarbanes-Oxley Act of 2002 are a ‘barrier to entry’ for small entrepreneurial and developing companies,” says Beckstead and Watts Managing Partner Brad Beckstead, in a letter on the firm’s website. “Inclusive in those costs are the regulatory burdens for auditors of small companies to comply with the standards established by the PCAOB.”
The Center for Audit Quality (CAQ), a public policy organization affiliated with the AICPA, while pointing out that it and its members “have had and will continue to have views that diverge from the PCAOB on various matters,” said in its amicus brief that “establishment of the PCAOB has generally been seen by auditors as a net positive for the profession, capital markets and investors.”
The CAQ also expressed concern over the negative consequences of ruling against the PCAOB at a time of market and financial upheaval. “Overturning the established system of regulation will exacerbate investors’ fears about the integrity of capital markets, and interfere with the ongoing work of regulation,” says the CAQ brief. “Were the Court to find the PCAOB as established to be constitutionally impermissible, the uncertainty surrounding the effect of past regulations, and the question of what form future regulation would take, would have negative consequences for investors, the profession and the markets generally.”
The CAQ brief did not address the constitutional questions raised by the plaintiffs or the effectiveness of other provisions of SOX outside the scope of the PCAOB.
The case hinges on two intertwined legal issues that are unrelated to the effectiveness of the PCAOB, according to Metzger. The first issue is whether the PCAOB violates the appointments clause of the Constitution. Article II, Section 2 of the Constitution reads:
“[The President] shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”
Even though the PCAOB is organized as a private-sector organization, because it was created by Congress with regulatory authority, the plaintiffs argue, it is legally an agency of the federal government for constitutional purposes. As such, PCAOB board members are appointed officers of the government.
Earlier in its history PCAOB officials suggested that it was not a government agency at all, says Nagy. But now, at least in regards to the case pending before the Supreme Court, the PCAOB has conceded that it is a government agency for constitutional purposes, she says. The PCAOB says in its brief that its board is composed of “inferior officers” of the government. As inferior officers, the PCAOB can be appointed by the SEC as prescribed in SOX, which for constitutional purposes is the head of a government department.
But the plaintiffs disagree. To be inferior officers, they say, there must be comprehensive supervision by superior officers. The plaintiffs contend that the SEC’s oversight of the PCAOB, which includes approval of its budget, rules and disciplinary actions, falls short of comprehensive supervision because the SEC has no power over the PCAOB’s investigations or standard-setting agenda. This means, the plaintiffs say, that the five members of the PCAOB are principal officers of the government who must be appointed by the president.
The second issue raised by the plaintiffs is the separation of powers doctrine, which requires the president to execute laws made by Congress—to be in charge of the government. The power to appoint officers of the government is one indicator of presidential authority. The power to remove officers of the government is another. Under SOX, only the SEC can remove members of the PCAOB and then only under limited circumstances. So, the plaintiffs say, even if the PCAOB is composed of inferior officers, it is still unconstitutional because the president can’t remove them.
But the PCAOB and Solicitor General and Supreme Court nominee Elena Kagan, who argued in support of the PCAOB before the Supreme Court, emphasize that the president appoints and can remove, at least for cause, SEC commissioners.
“They contend that by virtue of the SEC’s comprehensive supervision of the PCAOB, separation of powers requirements are therefore met,” says Metzger. The debate over the strength of the president’s power in relation to the separation of powers doctrine has been heating up for some time and not just in relation to this case, says Metzger, who believes prior court precedent favors the PCAOB on the separation of powers issue. But she says the majority of the current court could be interested in strengthening presidential power.
The current Supreme Court session’s schedule runs through June 28.
Meanwhile, the SEC staff has been contingency planning in the event that the court rules against the PCAOB. “We’ve done the contingency planning first and foremost to provide ourselves with the ability to immediately address potential filing concerns and day 1 issues so that we can respond quickly,” SEC Chief Accountant James Kroeker told the JofA in an April interview. Such filing concerns could include which auditing standards to follow and whether an auditor formerly registered with the PCAOB could still be used, he said.
Responding to a follow-up request for more details, SEC staff pointed to Kroeker’s May 21 testimony before a congressional panel. “The commission stands ready to issue any interpretive guidance that may be necessary to provide continuity and minimize any disruption in the U.S. capital markets,” said Kroeker.
For its part, a PCAOB spokesperson did not respond to the question of whether it has a contingency plan. “The PCAOB has explained why it believes the Sarbanes-Oxley Act is constitutional in its briefs and argument to the Supreme Court,” said PCAOB spokesperson Shauna Riley. “We look forward to the Court’s ruling.”
—Matthew G. Lamoreaux (email@example.com) is a JofA senior editor.
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