Risk & Compliance

Sarbox Stays: PCAOB Judged Constitutional

An appeals court upholds the legality of the PCAOB, which was challenged on separation-of-powers issues.
Alan RappeportAugust 22, 2008

A federal appeals court decided Friday that the Public Company Accounting Oversight Board, and the Sarbanes-Oxley Act that created it, are constitutional. The ruling denies a claim that the existence of the PCAOB violates the Constitution’s separation-of-powers principle.

The decision by the U.S. Court of Appeals for the District of Columbia Circuit preserves Sarbanes-Oxley and the board, which watches over auditors of public companies. The premise of the challenge was that because Congress created the board it should be accountable to the President, but instead it is an independent entity whose members are appointed by an independent agency (the Securities and Exchange Commission) and that functions with broad executive powers.

The challenge began in 2006 when Beckstead and Watts LLP, a Nevada-based accounting firm, complained that the PCAOB was not a legal body after the board criticized the firm for some of its audits in 2004. The Free Enterprise Fund, a policy group that fights for small government issues, took the PCAOB to court on behalf of Beckstead.

Michael Carvin, an attorney at Jones Day in Washington, D.C., argued the case for the Free Enterprise Fund but was not available for comment on Friday.

In an article last April in the New York University Journal of Law and Business, Carvin wrote about how the separation of powers between branches of government protects citizens and political institutions by creating checks and balances. “Congress violated these fundamental precepts when, in reaction to headline-grabbing accounting scandals involving Enron, WorldCom, and other companies, it hastily created the Public Company Accounting Oversight Board as part of the Sarbanes-Oxley Act of 2002,” he wrote.

The board’s reporting structure violates the separation-of-powers principle under Article II of the Constitution, the lawsuit contended, because “the board’s wide-ranging exercise of executive or administrative power is immune from presidential supervision or control.” The lawsuit, which notes that the PCAOB is not appointed by or removable by the President, also cites the Article II provisions stating that “executive power shall be vested in the President” and “he shall take care that the laws be faithfully executed.”

Friday’s 2-1 decision by a three-judge panel could still be appealed to a circuit appeals court or to the Supreme Court, if either opts to take the case. Ultimately the judges in favor of the decision concluded that since the chairman of the SEC serves at the President’s pleasure and the SEC appoints PCAOB members, the President has sufficient influence over the board despite not appointing its members.

Taking a less-nuanced approach, Judge Brett Kavanaugh, the lone dissenter, argued that the restrictions on the President’s authority over the board render the PCAOB “divorced from Presidential control to a degree not previously countenanced in our constitutional structure.”

“The two constitutional flaws in the PCAOB statute are not matters of mere etiquette or protocol,” wrote Kavanaugh.

For their part, the PCAOB and the SEC were pleased with the decision.

“The PCAOB is gratified by the Court of Appeals’ decision today, upholding the District Court’s decision in the PCAOB’s favor,” it said in a statement, noting that several investor groups backed such an outcome.

SEC chairman Christopher Cox called the result “welcome news” and maintained that the PCAOB’s continued existence is “vital to protecting investors and furthering the public interest.”

If the Free Trade Fund had been successful, defenders of Sarbanes-Oxley argued, the legitimacy of such other independent agencies as the SEC, the Federal Communications Commission, and the Federal Trade Commission could have been called into question.

“To roll the clock back because of a technical issue with the law would be throwing the baby out with the bathwater,” Patrick Finnegan, director of the financial reporting policy group at the CFA Institute, told CFO.com. “This is ultimately in the best interests of lots of people at the table.”