In its final decision of the past term, Free Enterprise Fund v. Public Company Accounting Oversight Board, a 5-4 majority of the Supreme Court held that limits in the Sarbanes-Oxley Act of 2002 (the ―Act‖) on the ability to remove members of the Public Company Accounting Oversight Board (the ―PCAOB‖ or ―Board‖) violated separation of powers under the Constitution. Having found the removal provisions unconstitutional, however, the Court declined to strike down the PCAOB’s existence or otherwise disturb the Act. Instead, in its narrowly crafted decision, the Court opined that, with the removal provisions excised from the Act, the PCAOB’s structure is consistent with the Constitution and the Act remains fully operative.
Both the petitioners and the PCAOB declared victory after the ruling, an indication that neither party’s arguments met with total success before the Court. By ruling in favor of the petitioners on their separation-of-powers claim, the Court sent Congress a clear message that multiple layers of restrictions on the ability to remove high-level Government officers impermissibly constrain the President’s authority to oversee those who execute federal law. At the same time, the Court’s refusal to enjoin the Board’s continued operations means that the decision will have limited impact on the PCAOB, Board-registered accounting firms, and the public companies that fund the PCAOB’s operations.
The PCAOB’s Background
In response to Enron and other highly publicized business scandals and earnings restatements, Congress enacted the Act in 2002. In addition to revising corporate governance standards, enhancing disclosure requirements, and increasing criminal penalties for violations of the federal securities laws, the Act created the PCAOB to oversee auditors of public companies. In doing so, Congress provided the new body with expansive authority, previously lacked by the Securities and Exchange Commission (the ―SEC‖), to regulate public accounting firms.
The Board’s structure was modeled on private self-regulatory organizations in the securities industry like the New York Stock Exchange and FINRA. The Board’s five members are appointed to five-year terms by the SEC. All accounting firms – whether U.S. or foreign-based – that play a substantial role in the audit of SEC-registered issuers or broker-dealers must register with the Board.1 Under the Act, the PCAOB is authorized to (1) establish auditing standards, (2) inspect registered public accounting firms, and (3) conduct investigations and disciplinary proceedings and, where appropriate, impose sanctions on registered firms and their associated persons. It has no jurisdiction over public companies, but public companies (defined as ―issuers‖ in the Act) pay an annual fee to finance the Board’s operations, since Congress did not want the Board to depend financially on the profession it regulates.
Under the Act, the PCAOB is subject to extensive SEC oversight. By way of example, the SEC must approve all new PCAOB auditing standards, and PCAOB disciplinary sanctions also are subject to SEC review and potential modification. However, the Act included other provisions designed to promote the Board’s independence. Of particular relevance to the Free Enterprise case, the Act did not permit the SEC to remove Board members at will, but instead only ―for good cause shown,‖ in accordance with specific procedures.
Since the PCAOB’s creation, the major U.S. accounting firms and professional groups generally have supported the Board’s efforts to enhance audit quality. Some firms, however, have chafed under the new regimen. One such firm was a Nevada-based accounting firm, Beckstead and Watts, LLP. Following a review of the firm in 2004, the PCAOB issued an inspection report that included criticisms of the firm’s quality controls. The PCAOB’s Enforcement Staff also began a formal investigation of the firm.2 Aggrieved by the Board’s actions, the firm joined forces with the Free Enterprise Fund, a nonprofit advocacy group, to file suit challenging the PCAOB’s constitutionality and seeking an injunction to prevent the Board from exercising its powers under the Act.
Ironically, while the PCAOB was created to strengthen the oversight of public company auditors, the plaintiffs alleged that the Board itself was subject to insufficient oversight by the Executive Branch. Specifically, the plaintiffs argued that the SEC Commissioners responsible for appointing Board members could be removed by the President only for ―inefficiency, neglect of duty, or malfeasance in office,‖3 and that the SEC, in turn, could remove Board members only ―for good cause‖ under the Act. They asserted that the two layers of ―for-cause‖ removal provisions violated the Constitution’s separation-of-powers principle (and raised other challenges under the Appointments Clause). While the District Court for the District of Columbia and a divided panel of the Court of Appeals for the D.C. Circuit ruled in favor of the PCAOB, the Supreme Court agreed in May 2009 to hear the case.
The Supreme Court’s Analysis
Writing for the majority, Chief Justice Roberts opined that the ―dual for-cause‖ removal provision for Board members unconstitutionally interfered with the President’s authority to oversee the execution of federal law. The Court emphasized that a critical aspect of the Constitution’s vesting of executive power in the President is the authority to appoint, oversee, and control those who execute the laws. While the Court had previously upheld limited restrictions on the President’s power to remove executive officers, the majority opinion noted that the Court’s prior cases had involved only one level of ―protected tenure‖ separating the President from an officer exercising executive responsibilities. In comparison, the Court found that the ―dual for-cause‖ removal provisions in the Act left the President insufficiently accountable for the Board’s actions.4 As a result, the Court concluded that the Act’s removal provisions were contrary to Article II’s vesting of executive power in the President, and that the petitioners were entitled to declaratory relief ―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.‖5
The petitioners also sought to convince the Court that, because the Board was improperly insulated from Presidential oversight, all of its operations — including its inspection and enforcement activities — were invalid. The Court declined the invitation to rule so broadly. Instead, it held that the unconstitutional provisions limiting the SEC’s authority to remove Board members were severable from the remainder of the Act. In the Court’s view, ―the existence of the Board does not violate the separation of powers, but the substantive removal restrictions imposed by [the Act] do.‖6 The Court treated those provisions as void, leaving Board members removable at will by the SEC. With the offending provisions excised from the Act, the Court permitted the PCAOB to continue to function, and the other provisions of the Act remain fully operative.7
Implications of the Court’s Decision
Despite its narrow holding, the Free Enterprise decision has several implications for both accounting firms and public companies. The opinion also may lead to future challenges to agency actions in contexts far removed from the PCAOB’s oversight of the public accounting profession.
Removal Provisions in Other Federal Laws Are Now Also Constitutionally Suspect. While the Court may not have previously addressed the precise issue raised in Free Enterprise, the Act is not the only federal law that incorporates ―dual for-cause‖ removal provisions. Indeed, in his dissenting opinion, Justice Breyer identified 573 federal officials who currently are removable only for cause by higher-level officials who, in turn, are removable only for cause by the President. Cautioning that the Court’s holding ―threatens to disrupt severely the fair and efficient administration of the laws,‖8 Justice Breyer predicted that the majority opinion would lead to constitutional challenges to past actions taken by other departments, offices, and bureaus of the Federal Government. Although the relief granted in any such lawsuits might be limited, as in Free Enterprise, the Court’s analysis provides future litigants with a virtual roadmap to challenge a panoply of other federal statutes and regulations.
The Court’s Decision Resolves Questions as to the PCAOB’s Viability. For most of its brief history, the PCAOB has operated under the cloud of a lawsuit that threatened its very existence. Free Enterprise eliminates that doubt; as the Board stated in a press release following the Court’s decision, ―all PCAOB programs will continue to operate as usual, including registration, inspection, enforcement, and standard-setting activities.‖9 Insofar as the lengthy litigation was a distraction to the Board, however, PCAOB-regulated firms reasonably can expect to see a reinvigorated Board.
The Sarbanes-Oxley Act Emerged Largely Intact. In addition to creating the PCAOB, the Act imposed a plethora of new and, in some cases, expensive compliance obligations on public companies. In attacking the provisions of the Act governing the appointment and removal of PCAOB members, the petitioners reportedly hoped that a successful challenge would call into question the Act’s other mandates. On this score, however, their efforts fell short: other than the excised tenure restriction provision, the Court’s decision does not affect any of the Act’s requirements or any regulation adopted under the Act.
Prior Board Actions May Yet Be Challenged. Following the Court’s decision, the SEC issued a statement noting that the ruling ―does not call into question any action taken by the PCAOB since its inception.‖10 It remains to be seen, however, whether the Court’s conclusion that the petitioners were entitled to declaratory relief will prompt firms or individuals who — unlike the petitioners — have been formally sanctioned by the PCAOB to challenge the validity of Board actions taken prior to the Court’s decision.
