The Sarbanes-Oxley Act has long wrapped up executives in a cloak of frustration. Now a high-powered legal challenge to the Public Company Accounting Oversight Board wants to unravel the whole thing.
At issue is the very constitutionality of the PCAOB, and whether it wields so much influence over public commerce that its members should be appointed by the president and approved by the Senate. But the free-enterprise think tank behind the challenge minces no words about its ultimate goal: bringing down Sarbanes-Oxley as a whole.
Factor
“It is now clear that the costly regulatory burdens imposed by [SOX] absolutely outweigh its benefits,” says Mallory Factor, chairman of the Free Enterprise Fund, which filed suit against the PCAOB in federal court Feb. 7. “The PCAOB and the Sarbanes-Oxley Act raise unconstitutional barriers to needed liquidity, discourage entrepreneurship and innovation, and hinder U.S. competitiveness by denying access to needed capital. [And] the high cost of compliance that disproportionately affects smaller public companies is having long-term, exponential negative implications for [the] economy.”
Ordinarily, a challenge to one aspect of a statute wouldn’t put the entire law at risk. Sarbanes-Oxley, however, has no “severability provision,” so invalidating any one portion of it theoretically tosses out the whole thing.
“I know of no way the courts can cure a constitutional problem [regarding the PCAOB] by slicing out the unconstitutional provision and leaving the rest [of SOX] standing,” says Peter Wallison, a scholar at the American Enterprise Institute and a critic of the PCAOB. The courts could give Congress six months or a year to re-enact Sarbanes without the defective provision, he says, but doing so opens the door to wholesale changes in the statute.
Kaufman
But David Kaufman, a partner with the law firm Duane Morris in Chicago, says companies unhappy with the burdens of Sarbanes compliance should not start hoping for relief any time soon.
“I want to give these guys kudos for being creative but, at the end of the day, any judge worth their salt is going to find this statute to be constitutional,” Kaufman says. “A good judge would find a reason to make it work, so that SOX would continue.”
‘Agency Run Amok’
EXCERPT
The excerpt below is from the Introduction of the case filed in the U.S. District Court for the District of Columbia, Free Enterprise Fund and Beckstead & Watts v. The PCAOB:
Introduction
1. This is an action challenging the formation and operation of the Public Company
Accounting Oversight Board (the “Board”), an entity created by the Sarbanes-Oxley Act of 2002
(the “Act”) to “oversee the audit of public companies that are subject to the securities laws.” In
carrying out this mandate, the Board is authorized to and does exercise broad governmental
power, including the power to “enforce compliance” with the Act and the securities laws, to
regulate the conduct of auditors through rulemaking and adjudication, and to set its own budget
and to fund its own operations by fixing and levying a tax on the nation’s public companies. As
a result, and notwithstanding the Act’s effort to characterize the Board as a private corporation,
the Board is a government entity subject to the limits of the United States Constitution, including
the Constitution’s separation of powers principles and the requirements of the Appointments
Clause. The Board’s structure and operation, including its freedom from Presidential oversight
and control and the method by which its members are appointed, contravene these principles and
requirements. For this reason, the Board and all power and authority exercised by it violate the
Constitution.
2. Referred to by one Senator as an entity with “massive unchecked powers,” the Board
exercises broad discretion to set policy and impose regulations governing the conduct of public
accounting firms. In connection with its open-ended mandate, the Board’s five members —
appointed for five-year terms by the Securities Exchange Commission (SEC) — have the power
to set the Board’s budget at any level they desire, and to fund the Board’s operations through a
“fee” levied on all public companies. The Board also has the power to promulgate auditing
standards and rules, including rules that expand upon the Act’s list of nonaudit services that
accounting firms are prohibited from offering to a client contemporaneously with an audit.
Under the Act, moreover, any violation of the Board’s rules constitutes a violation of the federal securities laws, subjecting accountants and accounting firms to potential civil and criminal
liability.
3. The Board also exercises core executive powers to “enforce compliance” with the Act
by conducting periodic inspections of accounting firms and subjecting those firms to
investigations and disciplinary proceedings. In connection therewith, the Board has the power to
punish accounting firms and individual accountants for the violation of the Board’s rules,
professional accounting standards or federal law, with sanctions of up to $2,000,000 for
inadvertent violations and up to $15,000,000 for knowing or reckless ones.
4. The Board has exercised its broad powers to impose burdensome standards that
accounting firms are required to follow when auditing public companies, which ultimately bear
the costs of these added procedures. In the Board’s first year of operation alone, the Act’s
regulations resulted in more than $35 billion in compliance costs imposed on the nation’s
businesses.
5. In addition to wielding broad rulemaking and enforcement powers, the members of
the Board have the authority to set their own salaries. The Board in 2003 paid its chairman an
exorbitant salary of $556,000, and paid each of its other four members a similarly excessive
salary of $452,000.
6. Because the Board exercises governmental powers, it is, for constitutional purposes, a
part of the federal government, and its members — who exercise significant authority pursuant
to the laws of the United States — are officers of the United States.
7. Despite its vast authority and the far-reaching consequences of its actions, the Board
is immune from the supervision and control of the President. The Board’s members are not
appointed or removable by the President or by the head of any executive department answerable to him. They are, rather, appointed by the SEC, itself an independent agency. Even the SEC,
moreover, exercises only limited review of Board actions. The SEC may only remove Board
members if they have “willfully violated” applicable laws or regulations, “willfully abused” their
authority, or “failed to enforce” applicable laws and regulations “without reasonable justification
or excuse.” The SEC’s other review functions are similarly circumscribed. Thus, the Board
exercises wide-ranging, core governmental powers immune from presidential oversight in
contravention of the most fundamental elements of the Constitution’s separation of powers
principles.
8. In addition, although the Board members exercise significant, core governmental
powers, they are appointed by the SEC rather than in the manner required by Article II of the
Constitution. Their appointments, and the Board’s exercise of its delegated powers, are therefore
contrary to the Appointments Clause of the Constitution.
9. The Board is also the recipient of improperly and unconstitutionally delegated
legislative power, including, but not limited to, its broad power to enact law, its authority to set
its own budget without any constraint or legislative cap, and its authority to fund that budget
through the imposition of a tax on all public companies...
Source
Free Enterprise Fund and Beckstead & Watts v. The PCAOB (Feb. 7, 2006)
The challenge to the PCAOB was filed by the Free Enterprise Fund along with Beckstead and Watts, a small accounting firm in Nevada. Brad Beckstead, the managing partner, says that his firm has become “a casualty of a government agency run amok.”
As a result of Sarbanes-created obligations, the firm “can no longer serve the needs of small publicly traded companies while continually having to focus our time and monetary resources answering to the incessant demands of an unaccountable PCAOB,” Beckstead says. “The ultimate consequence of the PCAOB actions will be to put small public companies out of business, force them to de-list or take their public offerings… to Europe or Asia.”
The PCAOB did conduct an inspection of Beckstead and Watts last September, and said it found eight different deficiencies in Beckstead audits it had reviewed, mostly for shoddy fieldwork or evidence collection. The inspection report did not disclose its findings about the firm’s quality controls.
Wallison
Wallison says he and other opponents of the PCAOB have been “talking to people for years,” but that small accounting firms have been reluctant to take a stand against the entity that regulates them. “It’s fortunate that this one accounting firm is willing to take them on,” he says.
Lawyers involved in the suit include Kenneth Starr, the former U.S. solicitor general and Whitewater special counsel, and Viet Dinh, a professor at Georgetown Law School who was the chief architect of the USA Patriot Act when he worked in the Department of Justice. The Free Enterprise Fund is financing the litigation.
The lawsuit claims that the PCAOB violates separation-of-powers principles because the board performs an executive function, but the president does not have the power to appoint or remove board members. Under Sarbanes law, the Securities and Exchange Commission appoints PCAOB members.
Carvin
“The PCAOB is not accountable to any elected official or the citizens subject to PCAOB regulation,” says Michael Carvin, a lawyer in Washington office of Jones Day, which is involved in the suit. Carvin was a high-ranking official in the Reagan Justice Department and was one of the lead attorneys for George W. Bush in the 2000 election recount controversy.
In addition, the suit claims that the PCAOB violates the appointments clause of the Constitution (Article II section 2) because board members are not appointed by the president with the advice and consent of the Senate.
Cox
James Cox, a securities law professor at Duke University, however, bluntly says the lawsuit “is going to fail.” He likens the structure of the PCAOB to Independent Counsel’s Office, where an independent counsel is appointed by the attorney general.
Although there are some situations “where you have appointive powers and they have to be by the president and with the consent of the Senate, that doesn’t apply to so-called subordinates,” Cox notes. “If you look at the PCAOB, it’s being staffed by five subordinates. It’s highly appropriate for them to be appointed by the chairman of the SEC.”
Cox also says the presence of high-profile counsel like Starr reflects little about the merits of the suit. “Ken Starr is a lawyer who likes to identify himself with free-market suits and this is the quintessential free-market case,” Cox notes. “The mere fact that they [the plaintiffs] have good lawyers willing to give their time to this is consistent with the image that people on the political right sort of wanting to care of their political base.”
Spokesmen for the PCAOB itself declined to comment on the case.
Wallison dismisses any suggestion that the big four accounting firms have any involvement in the challenge to the PCAOB.
“This is not a stalking horse for the bigger firms,” Wallison says. “They’re delighted with the PCAOB. Regulation has been great for the big firms. It prevents smaller firms from ever becoming big firms because they have to pay enormous amounts to comply with the regulations, unlike the large firms, which can spread out the cost of regulation. Big firms have never had so much profitability.”
Kaufman says he doubts that the Supreme Court would second-guess Congress on such an important piece of legislation that was passed with overwhelming bipartisan support. “Particularly at the Supreme Court level, you have to try to get into the head of the congressman,” he says. “The justices would have to think, ‘If I was a rational congressman or woman, I would do exactly what they did’.”
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