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What will the PCAOB case in the Supreme Court mean for SOX compliance?

A case before the U.S. Supreme Court is challenging the authority of the entity that oversees public company auditors -- but don't expect SOX compliance to go away.

Earlier this month, the Supreme Court heard oral arguments in a case that could have far-reaching consequences for the future of the Public Company Accounting Oversight Board (PCAOB).

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Depending on the court's ruling in Free Enterprise Fund and Beckstead and Watts LLP v. PCAOB, the authority of the entity that oversees the auditors of public companies, and by extension Sarbanes-Oxley Act (SOX) compliance, could be significantly altered. However, it's doubtful that public companies will get relief from SOX compliance by the Supreme Court, regardless of the ruling. A final decision is expected in June.

The PCAOB is a nonprofit corporation created the Sarbanes-Oxley Act. The question before the Supreme Court is whether the PCAOB's membership, appointed by the Securities and Exchange Commission (SEC), is constitutional.

"The lawyers found a quirky way to threaten PCAOB and SOX itself," said Francine McKenna, managing editor at re: The and a former director at PricewaterhouseCoopers. "Whatever the decision, I don't think it should be construed as a referendum on either. The plaintiff found an obscure, high-impact issue to take to court that came out of the PCAOB stating the firm wasn't up to doing the audit in question." The small Nevada accounting firm in question, Beckstead and Watts LLP, filed suit after undergoing a costly audit in 2006.

Appointments clause at issue

Professor Jason Mazzone, a constitutional scholar at Brooklyn Law School, explained that appointment authority and the separation of powers are at the heart of the case.

"The first issue lies in the 'appointments clause' of the Constitution," he said, referring to Article 2, Section 2, Clause 2. In the clause, the Constitution distinguishes between inferior and principal officers, the latter of which must be named by the president and confirmed by the Senate. Inferior officers go through that mechanism or Congress can give the power to appoint to the president, Congress or Supreme Court.

"Therein lies the problem," said Mazzone. "If the PCAOB members are inferior, Congress would have the power to appoint them. The challenge to law is that the SEC isn't a department in a traditional sense. The SEC is supposed to be independent regulatory agency. That presents Congress with a bit of a problem, given that powers go to the head of a department. Here, SEC commissioners are making appointments to the PCAOB, not the SEC chair."

The second problem, "which is probably what they will win on," said Mazzone, has to do with separation of powers, or the degree of control that the president has over members of the Public Company Accounting Oversight Board. Part of the executive powers granted to the president under the Constitution is control under officers beneath him.

"The PCAOB is quite isolated from presidential control," said Mazzone. "One of the things the Supreme Court has looked at in the past is where the president has the ability to remove somebody. The court has upheld laws that state the president can only remove someone for cause. The SEC can remove members of board and the president can remove members of the SEC. But the PCAOB, in effect, has a double layer of insulation from the president himself."

That was precisely the argument that Michael Carvin, the attorney representing the petitioners, made in his opening statement to the Supreme Court. "The board is unique among federal regulatory agencies in that the president can neither appoint nor remove its members, nor does he have any ability to designate the chairman or review the work product, so he is stripped of the traditional means of control that he has over the traditional independent agencies," he said. "On the other side of the balancing test, Congress provided no reason for stripping him of these traditional means of control." (A full transcript of oral arguments is available at

Analysis and resources
for the PCAOB
Transcript of oral arguments for PCAOB vs. Free Enterprise Fund and Beckstead and Watts (PDF).

Cornell University Law School's Legal Information Institute summarized the PCAOB case.

The SCOTUS Blog wrote about the PCAOB case, Sarbanes-Oxley and its devilish details.

The SCOTUS Blog also created a SCOTUS Wiki entry for the PCAOB case.

Yale Law School's Comparative Administrative Law Blog features commentary on the constitutional questions surrounding the PCAOB.

The Enterprise Resilience Blog posted an opinion on the context surrounding the PCAOB case.

Solicitor General Elena Kagan argued to the contrary. "The way this board has set up the statutory scheme and structure makes it clear that the SEC has comprehensive authority not just over the rulemaking, but over the investigative and inspection activities of the board," she said.

And speaking for the Public Company Accounting Oversight Board itself, Washington lawyer Jeffrey A. Lamken reiterated Kagan's arguments concerning how strong SEC oversight of the board is. "It is the judgment and the decision of the SEC that controls. The board can propose, but it's the SEC that decides."

Mazzone said the justices of the Supreme Court are likely to "be more concerned about the extent to which the president can supervise what the board is doing." The issue is not the control of the PCAOB by the SEC, which Mazzone said is "tight, if not total," but that the ability of the president to assert authority is more attenuated. "The separation of powers, with regard to execution of laws, is the most serious problem the board will have when it decides this case," said Mazzone.

"The way this board has set up the statutory scheme and structure makes it clear that the SEC has comprehensive authority not just over the rulemaking, but over the investigative and inspection activities of the board. This comes down to issues of accountability. Voters are supposed to be able to hold members of the executive branch accountable. If part of the executive branch is insulated, it's hard to hold the president accountable for actions taken in his name," he said.

Narrow Supreme Court ruling anticipated

What happens if the Supreme Court decides rule against the PCAOB, based on Constitutional grounds? "Congress can easily fix the statute, if the Supreme Court invalidates it," said Mazzone. "They'll need to state that the president can terminate members of the board for cause. My hunch is that this will be a narrow ruling. I can't think of any other area where this double insulation exists."

A common concern has been whether actions the PCAOB has taken in the past will be similarly rolled back with such a ruling. "My sense is that the court will apply the ruling prospectively," said Mazzone. "In other cases, the court has reached back. Here, the court is likely to give relief to the plaintiff in this case, but I doubt that they would hold the past actions of the board as invalid. The court is too practical to want to do that, given the disruption. There would be a period where the board couldn't do anything in its current form until Congress amended the statute."

Professor Thomas Folsom of Regent University put the consequences of such a ruling into the context of a nested-tree diagram. "If you get to a ruling where the PCAOB is an unauthorized body, and it's not clear that that's so, I get the sense that in the case involving the SEC, either they're cutting the salami mighty thin or that it's the commissioner or the commission itself making the appointment. If they get to the fact that it's about the appointment, many cards will fall. If that happens, they may need to re-appoint the board or re-ratify regulations. That's significant but still housekeeping. The apocalyptic version, where the PCAOB and SOX is dissolved, is extremely unlikely."

For SOX compliance reform, look to Congress

Given the unlikelihood of relief from SOX compliance by the Supreme Court, compliance officers should watch another branch of government for regulatory changes: Congress. Currently, only large public companies are subject to requirement of SOX 404(b) compliance requirements, which have frequently been described as both expensive and onerous.

The SEC has repeatedly delayed the effective date for SOX 404(b) requirements for small public companies. Earlier this year, however, SEC Commissioner Luis A. Aguilar said that a relevant study was "close to final," and that there was anecdotal evidence that both sections have enabled efficiencies and improved the ability for companies to operate. "If I was a betting person -- and I do go to Las Vegas once in a while -- I would say companies need to be more familiar with 404(b) than they are now," Aguilar said.

In October, the SEC said that companies with a public float of under $75 million would need to begin complying in June. However, the passage of the massive financial regulatory bill in the U.S. House of Representatives may change that requirement permanently. The Wall Street Reform and Consumer Protection Act -- H.R. 4173 -- included a provision authored by New Jersey representatives Scott Garrett (R) and John Adler (D) that would continue to exempt companies with market capitalizations of $75 million or less from Section 404(b) compliance. An amendment on the House floor to remove this language of this exemption was rejected by a broad, bipartisan vote.

Additionally, Rep. Michael Capuano (D-Mass.) authored a provision that would direct the SEC to perform a study that evaluates the costs and benefits of compliance with SOX 404(b) compliance for companies that have public floats of less than $700 million and revenues of less than $250 million. The Senate has yet to take up the bill, however, and it is unclear whether the SOX provision will be included in its version of the sweeping financial regulatory reform legislation in 2010.

SOX compliance and IT

McKenna said an extreme outcome would be unlikely and unproductive: "There's very little understanding of positive aspects of the law, including components other than 404 compliance." McKenna has argued forcefully, in fact, for "Sarbanes-Oxley for everyone," including smaller firms.

"404 was flawed in its execution, but that doesn't mean it's not something that shouldn't have been done and done well," she said. "SOX is being threatened because of the pressures on cost. IT professionals are being disproportionately threatened."

Let us know what you think about the story; email: Alexander B. Howard, Associate Editor

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