Professional Liability Update

U.S. Supreme Court Invalidates Portion of Sarbanes-Oxley Act Regarding Removal of PCAOB Members

The Supreme Court held today in a 5-4 decision that the statutory structure of the Public Company Accounting Oversight Board (“PCAOB”) is unconstitutional. The PCAOB is the entity created by the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) to regulate firms that audit public companies. In spite of the PCAOB’s constitutional infirmity, however, the Court did not order the PCAOB to cease operations. Rather, it severed and invalidated the unconstitutional provisions, allowing the PCAOB’s work to continue as before—subject to constitutionally appropriate oversight. The practical effect on the accounting industry should be minimal.

The Court reviewed the PCAOB’s structure in Free Enterprise Fund v. Public Company Accounting Oversight Board, No. 08-861. Reversing the judgment of the U.S. Court of Appeals for the D.C. Circuit, which had rejected a challenge to the PCAOB’s constitutionality, the Court held that the way that members of the PCAOB could be removed violates the Appointments Clause of the Constitution. Under Sarbanes-Oxley, members of the PCAOB are appointed by, and can be removed only by, the Securities and Exchange Commission (“SEC”). Such removal must be for “good cause.” Similarly, the members of the SEC can only be removed by the President for good cause. Taken together, the Court held that the two levels of good-cause removal unduly insulates the PCAOB from the President’s control, and prevents him from adequately supervising and holding it accountable. (The Court did not find that the method of appointing PCAOB members presented a constitutional problem.)

As drafted, therefore, Sarbanes-Oxley violates the constitutional principle of separation of powers. But rather than tell Congress to start fresh, by invalidating all the past and continuing work of the PCAOB (as some had expected), the Court severed the statutory provisions limiting the removal of PCAOB members. Under today’s decision, the PCAOB will continue to function as it has, but the SEC may remove PCAOB members at will, rather than only for good cause shown. This change eliminates the dual good-cause requirement and places the PCAOB alongside other government entities that are subordinate to independent agencies.

The importance of the PCAOB’s work appears to have heightened the Court’s concern that its structure have a proper constitutional basis. After the financial crisis in 2001, Congress established the PCAOB in 2002 and charged it with “oversee[ing] the audit of public companies” to protect investors and the public. Its work was intended to ensure “informative, accurate, and independent audit reports.” 15 U.S.C. § 7211(a). To achieve this mission, Sarbanes-Oxley authorized the PCAOB to register firms that audit public companies, promulgate standards for those audits, conduct inspections of registered firms and investigate those firms for violations (along with taking disciplinary action when warranted). It even had the authority to set its own budget by assessing fees on registered firms. But all of these actions were subject to SEC oversight. Most of the PCAOB’s rules could not take effect until approved by the SEC, and the SEC could set aside any PCAOB action. It could even decide to simply do all the work of the PCAOB itself, thereby displacing the PCAOB.

Although the SEC had broad authority to override the PCAOB, the Court concluded that the vast stretch of government power invested in the PCAOB was too much for an entity that was so far removed from presidential oversight. Under today’s ruling, the PCAOB will be able to continue its work, but its members will now be subject to removal under a far lesser standard.