Is the PCAOB Unconstitutional?

A lawsuit argued recently before the United States Supreme Court will determine whether the existence of the private-sector, non-profit corporation supervising public accounting firms’ legal compliance violates the U.S. Constitution’s separation of powers doctrine, specifically the appointments clause and removal authority.

On Dec. 7, 2009, the Supreme Court heard oral arguments on the legality of the Public Company Accounting Oversight Board (PCAOB), created by the Sarbanes-Oxley Act of 2002 (SOX) to protect investors and the public interest by overseeing public company auditors and promoting informative, fair, and independent audit reports.

Analysts believe this landmark case ultimately could lead to SOX’s demise at a time when public companies continue to shoulder the heavy burden of annual compliance costs.  The death of SOX would significantly change how SEC-registered companies are regulated and likely improve the nation’s economy as funds are freed up to invest elsewhere.  Based on a study by American Enterprise Institute and the Brookings Institution, SOX has cost the economy nearly $1 trillion since its inception.

An SEC Office of Economic Analysis survey reveals that SOX Section 404 alone is still imposing more than $2.3 million annually in direct compliance costs upon average-size companies, with even larger long-term expenses on smaller companies.  About 70 percent of smaller public companies stated that Section 404 has motivated them to consider going private while 77 percent of smaller foreign firms say it motivated them to consider abandoning their American stock exchange listings altogether. 

Background - The case, Free Enterprise Fund vs. Public Company Accounting Oversight Board, was filed in 2006 by a certified public accountant whose small Nevada firm endured a costly examination under Sarbanes Oxley rules.  The plaintiff is a not-for-profit organization promoting limited government, lower taxes and freer markets.

The fund’s attorney argued that PCAOB board members are “officers of the United States,” and therefore must be appointed by the President with the advice and consent of the Senate.  Currently, PCAOB board members are not presidentially appointed but rather are chosen by the Securities and Exchange Commission, which the fund believes is unconstitutional.  This leads to a round-robin double standard that is not defined and thus limits the ability of the president to regulate the PCAOB’s daily activities.

The president does not have sufficient control of the PCAOB, argued the fund’s attorney, because even though the President can dismiss the chairman of the SEC, he cannot dismiss PCAOB board members, who are appointed by the SEC’s commissioners, who in turn are appointed by the SEC chairman. 

Arguments on behalf of the United States and PCAOB counter that the president has control over the PCAOB through the SEC.  They stated that the SEC has complete control over the actions of the PCAOB, since the president has the right to dismiss the chairman of the SEC, with whom comprehensive control over the PCAOB is held, and he in turn has constitutionally sufficient control over the PCAOB. 

How Damaging Has SOX Been? A survey by University of Minnesota economist Ivy Zhang has tracked stock trading from 2002 to periods when the SEC considered exempting small companies from SOX’s onerous audit requirements.  The survey shows that U.S. stocks had an increased likelihood of “negative abnormal returns” during times of possible increased SOX regulations.  Studies also show that SOX has led to decreased capital expenditures and research and development as compared to the United Kingdom and Canada.  

In their 2007 study Sarbanes-Oxley and Corporate Risk-Taking, authors Leonce Bargeron, Kenneth Lehn and Chad Zutter of the University of Pittsburgh note that the SOX law greatly discourages innovation. They write that by “increasing the role of independent directors in corporate governance and expanding/criminalizing their liability for corporate misdeeds, SOX discourages directors from approving risky investments that are costly to monitor.”  These regulations have had a significant impact on all public companies, especially non-accelerated filers, and are a drain on the U.S. economy. 

All this could possibly change with a Supreme Court ruling against the PACOB.  Because the SEC failed to include a “severability clause” when drafting SOX, meaning should any part of the PCAOB be declared invalid, so would the rest of SOX as its creating engine.  Therefore, if the PCAOB is deemed unconstitutional, all of SOX could fall with it.

Likelihood of PCAOB’s Demise?  Although the fall of SOX generally would be applauded by Corporate America, the possibility of a favorable judgment is not likely.  If the Supreme Court were to rule in favor of Free Enterprise Fund, it opens the door for many independent agencies to be similarly challenged.  While fund attorneys have made headway in indentifying the PCAOB as a unique federal agency, but U.S. Solicitor General Kagan and PCAOB attorneys have significant political influence, and their argument of constitutionally sufficient control by the president appears to be swaying more votes. 

As stated in The National Law Journal (Dec. 14, 2009): “The U.S. Supreme Court appeared inclined to leave well enough alone Monday and not tinker with the structure of an accounting oversight board [PCAOB] created by the Sarbanes-Oxley Act of 2002.”  Justice Breyer was quoted during oral arguments stating “My goodness, there are so many shapes and sizes for government agencies.”  It seems as though he believes it will be difficult to single out the PCAOB without reevaluating many other agencies that have already been deemed constitutional.