Constitutionality of the Public Company Accounting Oversight Board

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1 Constitutionality of the Public Company Accounting Oversight Board U.S. Supreme Court Concludes That Only the Tenure Provisions of the Sarbanes-Oxley Act Governing the Removal of PCAOB Members Are Unconstitutional SUMMARY One of the primary changes instituted by the Sarbanes-Oxley Act of 2002 ( SOX ) was the creation of the Public Company Accounting Oversight Board (the Board ) to regulate participants in the accounting industry and to promulgate accounting and auditing rules. The Board s members are appointed by the Securities and Exchange Commission (the Commission ) and, in accordance with SOX, could be removed by the Commission only for cause. In Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al., No (June 28, 2010) ( Free Enterprise Fund ), plaintiffs challenged the constitutionality of the Board and sought an injunction preventing the Board from exercising its powers. In a 5-4 decision, the U.S. Supreme Court declared unconstitutional the provision of SOX allowing removal of Board members only for cause. The majority concluded that SOX violated principles of the separation of powers because it improperly shielded the Board from direct Presidential oversight, given that the President could remove an SEC commissioner only for cause and the Commission, in turn, could remove a Board member only for cause. The Court remedied this constitutional deficiency by invalidating these tenure restrictions and thus making members of the Board removable by the Commission at will. The Court did not otherwise limit the validity of SOX, holding that [t]he Sarbanes-Oxley Act remains fully operative as a law with these tenure restrictions excised. This decision, the Court explained, does not affect the validity of rules promulgated or actions taken by the Board either before or after the decision. The Court s opinion, however, leaves unanswered questions regarding the validity of for cause New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 restrictions on the removal of other inferior officers within agencies and departments of the Executive Branch. BACKGROUND Free Enterprise Fund arose out of the Public Company Accounting Oversight Board s investigation of the accounting practices of Beckstead and Watts, LLP, a registered accounting firm. Following the Board s requests for documents, Beckstead, along with the Free Enterprise Fund (a nonprofit organization of which Beckstead is a member), filed the underlying lawsuit asserting that the Board is unconstitutional and seeking an injunction preventing the Board from exercising its powers. The Board generally has expansive power to regulate participants in the accounting industry: Every accounting firm both foreign and domestic that participates in auditing public companies under the securities laws must register with the Board, pay it an annual fee, and comply with its rules and oversight. The Board is charged with enforcing SOX, promulgating auditing and ethics standards, and exercising supervisory and enforcement authority. The Board is overseen by the Securities and Exchange Commission, which appoints the five-member Board through staggered five-year terms. The Commission also has the authority, for example, to modify rules promulgated by the Board and sanctions imposed by the Board. SOX, however, restricts the Commission from removing members of the Board except for good cause shown. In the district court, plaintiffs argued that SOX contravened the principles of the separation of powers by conferring wide-ranging Executive power on Board members without subjecting them to sufficient Presidential control. Plaintiffs specifically argued that, because the President could remove a Commissioner only for cause and the Commission could remove a member of the Board only for cause, SOX improperly limited the President s control over the Board. The district court disagreed, granting summary judgment in favor of the Board. The United States Court of Appeals for the District of Columbia Circuit affirmed the district court s ruling in a 2-1 decision, also holding that the President s influence over the Commission and the Commission s control of the Board were sufficient to satisfy constitutional requirements. The U.S. Supreme Court granted certiorari, and the United States intervened to defend the constitutionality of SOX. SUPREME COURT S OPINION The Supreme Court, in a 5-4 opinion written by Chief Justice Roberts, reversed the D.C. Circuit s ruling and declared unconstitutional SOX s for cause removal provisions, yet fashioned a narrow remedy. In particular, the Court held that SOX remains fully operative as a law, but that the Commission may now remove Board members at will. -2-

3 The Supreme Court concluded that the limitations on removal of members of the Board by the Commission violate the principles of the separation of powers. It ruled that the dual restraints on Board members removal the President can remove members of the Commission only for cause, and the Commission, in turn, can remove Board members only for cause render the President unable to perform his constitutional duties. Chief Justice Roberts explained that by insulating the Board with two layers of for cause restrictions on removal, SOX withdraws from the President any decision on whether that good cause exists. That decision is vested instead in other tenured officers the Commissioners none of whom is subject to the President s direct control. The Supreme Court then turned to the appropriate remedy. The majority rejected the argument that the lack of Presidential oversight rendered the Board s previous acts unconstitutional. Instead, the Supreme Court held that the unconstitutional tenure provisions are severable from the remainder of the statute. The appropriate remedy, the majority held, is to invalidate the for cause removal limitation and leave[] the Board removable by the Commission at will. SOX thus remains fully operative as a law with these tenure restrictions excised. The Supreme Court acknowledged that it left several questions unanswered. The Court did not decide the status of other Government employees... [or] whether lesser functionaries subordinate to officers of the United States must be subject to the same sort of control as those who exercise significant authority pursuant to the laws. Chief Justice Roberts observed that our holding also does not address that subset of independent agency employees who serve as administrative law judges. The Court, however, was quick to clarify that [n]othing in [its] opinion... should be read to cast doubt on the use of what is colloquially known as the civil service system within independent agencies. The dissent, written by Justice Breyer, expressed concern that the majority s opinion effectively removes a provision designed to protect the personal independence of the Board when it engages in adjudicatory functions and acts as technical experts. The dissent warned that the majority opinion could have unusually broad sweep because the term inferior officer has been interpreted broadly, putting the job security and administrative actions and decisions at risk for hundreds, perhaps thousands of high level government officials. To illustrate the potential impact of the majority s decision, the dissent included appendices listing hundreds of positions that could be affected, including positions at the Social Security Administration, National Labor Relations Board and Federal Trade Commission. IMPLICATIONS The Free Enterprise Fund decision removes the recent uncertainty regarding the continued existence of the Board. As stated by the Court, the decision will not have an immediate effect on the Board s authority or on the auditing and accounting industry, although the Commission s new ability to remove Board members at will may result in some perceived loss of the Board s independence. The ruling should -3-

4 nonetheless clear the way for the Commission promptly to fill three seats on the Board that were left vacant while this decision was pending. The broader implications of this decision for other agencies and departments of the Executive Branch are yet to be determined. If the dissent s predictions come to pass, Free Enterprise Fund may signal a move towards greater Executive Branch control over other independent administrative agencies by removing tenure protections for higher-level officers, which may alter the composition of these agencies by making such appointments more political in nature or changing the pool of candidates interested in such positions. * * * Copyright Sullivan & Cromwell LLP

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