Client Alert

Public Company Accounting Oversight Board Upheld as Constitutional

Client Alert

September 4, 2008

On August 22, 2008, the United States Court of Appeals for the District of Columbia Circuit upheld the constitutionality of Title I of the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board (“PCAOB”). Free Enterprise Fund v. Public Company Accounting Oversight Board, No. 07 5127, __ F.3d __, 2008 WL 3876143 (D.C. Cir. Aug. 22, 2008). A divided panel of the Court rejected challenges to the PCAOB on the grounds that its establishment violated the Appointments Clause of the U.S. Constitution and the principle of separation of powers, over a lengthy dissent which called the case “the most important separation-of-powers case regarding the President’s appointment and removal powers to reach the courts in the last 20 years.”

Background

The PCAOB is an independent executive agency created by the Sarbanes-Oxley Act to oversee the process by which public companies are audited. The PCAOB is empowered to, among other things, register public accounting firms, establish auditing and ethics standards, conduct inspections and investigations of registered firms, impose sanctions, and set its own budget.

Although the PCAOB is an independent agency with substantial powers, it is subject to oversight by the SEC. The SEC’s oversight includes, among other things, the power to approve rules of the PCAOB, the power to review de novo any adjudication by the PCAOB, and the power to modify or cancel any sanction imposed by the PCAOB. In addition, the PCAOB’s five members are appointed by the SEC. Members may be censured or removed from office “for good cause shown” upon a finding by the SEC. The President, however, has no direct unilateral power to appoint or remove a member of the PCAOB.

The plaintiffs in the Free Enterprise case — a public interest organization and a Nevada accounting firm — brought a lawsuit challenging the creation of the PCAOB on constitutional grounds. They argued that the statutory scheme which established the PCAOB vests its members “with far reaching executive power while completely stripping the President of the authority to appoint or remove those members or otherwise supervise or control their exercise of that power.” The district court granted summary judgment dismissing the case in favor of the PCAOB, and on appeal the D.C. Circuit affirmed.

Majority Opinion

The majority opinion of the Court of Appeals noted that the challenge against the PCAOB’s constitutionality was a “facial challenge,” which placed upon the plaintiffs-appellants “a heavy burden to show that the provisions of which [they] complain[ ] are unduly severe in all circumstances and cannot be constitutionally applied.” The majority held that the plaintiffs-appellants failed to meet this burden.

First, the majority held that Sarbanes-Oxley’s creation of the PCAOB did not encroach upon the President’s appointment power. Under the Appointments Clause as construed by the courts, “principal” officers in the executive branch must be appointed by the President but Congress by statute may authorize “inferior” officers to be appointed by persons or bodies other than the President. The majority held that, contrary to the contentions of the plaintiffs-appellants, PCAOB members were “inferior officers” because they were subject to “explicit and comprehensive” direction and supervision by the SEC. “What is key under the . . . analysis,” the majority explained, “is the fact that [PCAOB] members have no power to render a final decision on behalf of the United States unless permitted to do so by other Executive officers” who are appointed by the President, namely the members of the SEC.

Next, the majority held that creation of the PCAOB did not violate the principle of separation of powers, which forbids one branch of the federal government from encroaching on the constitutionally defined powers of another. As applied in Free Enterprise, the issue was whether Congress improperly encroached on the powers of the President by restricting the President’s control over the PCAOB, an agency with regulatory functions generally reserved for the executive branch.

The majority relied on the Supreme Court’s decision in Humphrey’s Executor v. United States, 295 U.S. 602 (1935), and subsequent cases holding that the creation by Congress of independent executive agencies (such as the Federal Trade Commission) did not violate the principle of separation of powers. “The bulk of [plaintiffs-appellants’] challenge to the Act was fought — and lost — over seventy years ago when the Supreme Court decided Humphrey’s Executor.” The majority held that the President had sufficient power to influence the PCAOB to satisfy separation-of-powers concerns because, among other things, he had power to appoint and remove (for cause) the Commissioners of the SEC which, in turn, had the power to appoint and remove (for cause) the members of the PCAOB. “Given the constitutionality of independent agencies and the [SEC’s] comprehensive control over the [PCAOB], [plaintiffs-appellants] cannot show that the statutory scheme so restricts the President’s control over the [PCAOB] as to violate separation of powers.”

Dissenting Opinion

The lengthy and strongly worded dissenting opinion took issue with the majority’s decision that creation of the PCAOB did not violate the principle of separation of powers. In particular, the dissent disagreed with the majority’s reliance on Humphrey’s Executor and case law concerning independent agencies like the Federal Trade Commission under the particular facts in Free Enterprise. “There is a world of difference,” the dissent wrote, “between the legion of Humphrey’s Executor-style agencies and the PCAOB: The heads of Humphrey’s Executor independent agencies are removable for cause by the President, whereas members of the PCAOB are removable for cause only by another independent agency, the Securities and Exchange Commission.” (Emphasis in original.) The dissent concluded that this structure, where the President is “two levels of for-cause removal away” from PCAOB members, “effectively eliminates any Presidential power to control the PCAOB, notwithstanding that the Board performs numerous regulatory and law enforcement functions at the core of the executive power.”

The dissent also disagreed with the majority’s holding, in connection with the Appointments Clause issue, that PCAOB members were “inferior” officers because they were subject to SEC supervision. In the dissent’s view, PCAOB members are not “inferior” because the SEC lacks at-will removal power over the PCAOB’s members and could not “prevent and affirmatively command, and manage the ongoing conduct of, all PCAOB functions.”

Conclusion

The constitutionality of the PCAOB remains established, at least for now. However, in view of the split 2 to 1 decision, it remains to be seen whether, as some early observers have predicted, the plaintiffs-appellants will seek further review by the full D.C. Court of Appeals or will petition the United States Supreme Court for certiorari. Even if the decision is not further reviewed, the potential still remains for a future litigant to bring an “as applied” constitutional challenge to the statute, attempting to present an evidentiary record that would call into question the majority’s conclusion that the President has adequate control over the PCAOB. The last chapter on the constitutional propriety of the PCAOB thus may yet to have been written.