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Updated – Is the PCAOB Unconstitutional?

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Update

Seven former SEC Chairs, namely Arthur Levitt, Rod Hills, William Donaldson, Harvey Pitt, and David Ruder, filed an amicus brief in this case asking the Court to uphold the constitutionality of the PCAOB.

Oral arguments are set to be heard on December 7, 2009.

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On May 18, 2009, the United States Supreme Court agreed to hear Free Enterprise Fund v. PCAOB, a case that challenges the structure of the Public Company Accounting Oversight Board as unconstitutional. The PCAOB has been called many things, but is it unconstitutional, and if it is, what then?

PCAOB Structure

Formation of the PCAOB

In 2002, in response to a series of accounting scandals including Enron and WorldCom, Congress hastily passed the Sarbanes-Oxley Act of 2002 (“SarBox”), which created the PCAOB (the “Board”) as a new entity to oversee the audits of public companies. Specifically, the Board’s purpose is “to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.”

Appointment and Removal of Board Members is Vested with the SEC

The Board consists of five members who are appointed by the Securities and Exchange Commission (the “SEC”), after consultation with the Chairman of the Board of Governors of the Federal Reserve (currently Ben Bernanke) and the Secretary of the Treasury (currently Tim Geithner). Appointment is by a majority vote of the five SEC Commissioners.

A member of the Board may be removed only upon a finding of good cause by the SEC.

Powers of the Board

Senator Phil Gramm (R-TX) said in July 2002 of the Board,

“This board is going to have massive power, unchecked power, by design. . . . We are setting up a board with massive power that is going to make decisions that affect all accountants and everybody they work for, which directly or indirectly is every breathing person in the country. They are going to have massive unchecked powers.”

The Board can, subject to approval or termination by the SEC:

  • impose regulations controlling the auditing of all public companies;
  • dictate services that can and cannot be performed by accountants;
  • impose a tax in the form of the accounting support fee that it levies;
  • inspect, investigate, and punish accounting firms, and individual accountants, for violating its regulations, professional standards, or federal laws;
  • fine an accountant up to $100,000, or an accounting firm up to $2 million, for a violation of its rules;
  • set the salaries of its own board members.

The Appointments Clause of the Constitution

The Appointments Clause is found in Article II, Section 2, clause 2 of the U.S. Constitution. The Appointments Clause gives the President the power to “nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the Supreme Court, and all other Officers of the United States, whose Appointments are not herein provided for. . . but Congress may, by Law, vest the Appointment of such inferior officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.” Thus, an officer of the United States must either be appointed by the President, or, if the officer is an “inferior officer,” by either (1) the President, (2) a Court, or (3) a Head of Department. This is a crucial component of the separation of powers concept in our government.

The Issues Before the United States Supreme Court

Are Members of the Board Officers of the United States?

If the members of the Board are considered officers of the United States, then under the Appointments Clause they come under the power of the President. Principal officers are to be nominated by the President and confirmed by the Senate, while inferior officers are appointed by either the President, a Court, or a Head of Department. Whether or not members of the Board are considered officers of the United States is one of the issues before the Supreme Court.

Are the Five Commissions of the SEC the Head of a Department?

Assuming that members of the Board are officers of the United States, and the extensive powers given to the Board as outlined above indicates that they are, then the next issue (because the Board is not appointed by the President or a Court) is whether the five Commissioners of the SEC are considered the Heads of a Department. The SEC has a Chair, whom most would consider to be its head. But appointment to the Board is by a majority of the Commissioners of the SEC, not by its Chair. What’s more, the Commissioners of the SEC must consult with the Chairman of the Board of Governors of the Federal Reserve and the Secretary of the Treasury.

Is the SEC a Department?

Lawyers arguing against the Board have cited precedent that the term “Departments” in the Appointments Clause refers only to those entities that resemble cabinet departments and are directly accountable to the President, and whose heads are called “cabinet ministers.” Thus, they argue, the SEC is not a Department and its leaders, even if they are considered “heads”, cannot appoint an officer of the United States.

The Court of Appeals Decision

The United States Court of Appeals for the District of Columbia held in favor of the Board. In its decision, which was decided by a 2-1 vote, the Court held that members of the Board are inferior officers of the United States. The Court further held that the SEC was a Department, and that the five Commissioners of the SEC were the Heads of Department and thus under the control of the President. Therefore, the structure of the PCAOB was not in violation of the Appointments Clause and was constitutional.

The lone dissenting judge decided that the members of the Board were principal officers because they are not directed and supervised by the SEC, are not removable at will by the SEC, and the SEC cannot manage Board inspections, investigations or enforcement actions. Thus, as principal officers, the members of the Board must be appointed by the President and confirmed by the Senate. Further, the dissenting judge felt that Congress intended for the members of the Board to be principal officers because of the massive power given to them.

The Effect of a Ruling Against the PCAOB

Corrective Structural Matters

The dissenting judge from the Court of Appeals outlined two relatively simple corrections to the constitutional flaws he found. First, Congress could simply amend the statute to require, for example, that the members of the Board, like the heads of other agencies, be appointed by the President and confirmed by the Senate, and thereafter be removable by the President. Alternatively, Congress could make the Board part of the SEC – directed, supervised, and removable at will by the five Commissioners of the SEC - just like other inferior officers of the SEC.

Historical PCAOB Disciplinary Actions

Some commentators have suggested a much more important effect of a decision against the PCAOB. In two Supreme Court cases, Freytag v. C.I.R (1991) and Ryder v. United States (1995), the Supreme Court affirmed that an individual or firm discliplined by a government agency can challenge that discipline if agency officials were improperly appointed. Thus, an accountant subject to enforcement proceedings by the PCAOB may have standing to challenge the structure of the PCAOB as a defense to any disciplinary action against him. They might also have standing to challenge the underlying policies such as the PCAOB’s broad interpretation of Section 404 of SarBox, the tax levied on public companies by the PCAOB, and other rules used to impose sanctions.

Important Precedent

More important than both of the effects outlined above may be the impact this case has on the separation of powers doctrine under which the Appointments Clause was adopted. On its face, a decision against the PCAOB appears to give power to the President. However, the Obama administration is expected to file a brief in support of the PCAOB, seemingly against its own interests. Why? Because a decision in favor of the PCAOB will support the concept of government agencies created by one branch of government but essentially unchecked by another branch of government. It will undermine the separation of powers and checks-and-balances doctrines put in place by our country’s founders. Given the Obama administration’s tendency to increase the role of government, evidenced by the appointment of over 20 czars as of the date of this article, this case presents a very slippery slope indeed. As a result, this may be one of the most important decisions in the first set of cases heard by Obama appointee Sonia Sotomayor.