Sarbanes-Oxley and PCAOB Survive Challenge; SEC Oversight Strengthened

July 01, 2010

The Public Company Accounting Oversight Board (“PCAOB” or “Board”), a private, nonprofit corporation that regulates auditors of public companies, will continue operations following the Supreme Court’s determination that board members were too far removed from Presidential oversight. The case, Free Enterprise Fund v. Public Company Accounting Oversight Bd., No. 08-861, slip op. at 10 (U.S. June 28, 2010), began as a challenge to the constitutionality of the Sarbanes-Oxley Act and the PCAOB under the Appointments Clause (Art. II, §2, cl. 2) and separation of powers. Id. at 6.

The Court ruled, 5-4, that the PCAOB’s tenure structure did violate the separation of powers requirement, did not violate the Appointments Clause, and could be cured without invalidating either Sarbanes-Oxley or the PCAOB. Instead, it merely found unconstitutional the tenure protections insulating PCAOB members from removal by the SEC at will.

The PCAOB’s Dual-Layer Protection

The Sarbanes-Oxley Act, among other things, created the PCAOB as a non-governmental board modeled on self-regulatory organizations such as the New York Stock Exchange. The PCAOB was given broad responsibilities, including enforcing the Sarbanes-Oxley Act, the securities laws, the SEC’s rules, its own rules, and professional accounting standards. The Board itself can issue severe sanctions in its disciplinary proceedings, up to and including the permanent revocation of a firm’s registration, a permanent ban on a person’s associating with any registered firm, and penalties of up to $15 million.

To avoid political influence, Board members were to be appointed to five-year terms by the SEC and were removable only for good cause, subject to a formal process (including a right to judicial review). See 5 U. S. C. §§554(a), 556(a), 557(a), (c)(B); 15 U. S. C. §78y(a)(1). SEC commissioners similarly cannot be removed except for “inefficiency, neglect of duty, or malfeasance in office.” See Humphrey’s Executor v. United States, 295 U. S. 602, 620 (1935) (internal quotation marks omitted). PCAOB members were accordingly protected from Presidential review by two layers: (1) the good cause and process requirements of Sarbanes-Oxley; and (2) the strong protections provided to the commissioners appointing them.

The Dual For-Cause Limitation on Removal of Board Members Is Unconstitutional

Although neither the protection afforded PCAOB members nor the protection afforded SEC commissioners is alone an unconstitutional limitation upon the President’s authority, the Court had never before considered them in combination. As a matter of first impression, then, the Court was obliged to consider whether two layers of protection violated the principle that Article II confers on the President “the general administrative control of those executing the laws.” See Myers v. United States, 272 U.S. 52, 164 (1926).

Sarbanes-Oxley not only protected Board members from removal except for good cause, but withdrew from the President any decision on whether that good cause exists. The Court therefore ruled that it violated the fundamental principle that the President “cannot delegate ultimate responsibility or the active obligation to supervise that goes with it,” because Article II “makes a single President responsible for the actions of the Executive Branch.” Clinton v. Jones, 520 U. S. 681, 712-13 (1997) (Breyer, J., concurring). The Court even quoted Truman’s famous observation: “The buck stops with the president.” Free Enterprise Fund, slip op. at 17.

In essence, the Court has found a constitutional requirement that either the President or an officer over whom he has direct control must be able to remove primary regulators at will. The Court determined that the PCAOB’s tenure protections violated this principle and that the SEC must have broad discretion to remove PCAOB members at will.

The Unconstitutional Protection Is Severable

The Court specifically declined petitioners’ invitation to hold that the Board’s “freedom from Presidential oversight and control” rendered it “and all power and authority exercised by it” unconstitutional and held instead that the unconstitutional tenure provisions are severable. Free Enterprise Fund, slip op. at 27-28. It is unclear whether the Court’s opinion leaves room for a direct challenge to any specific past action by the PCAOB during the time the offending tenure provisions were in effect. Although not part of the Court’s opinion, the syllabus prepared by the Reporter of Decisions suggests otherwise:

The consequence is that the Board may continue to function as before, but its members may be removed at will by the Commission.

Where a law is fully operative after its unconstitutional elements are excised, and it is not evident that the legislature would not have enacted the law without the invalid portion, the valid portion of the law will remain in effect. The Court avoided a lengthy examination of this question, merely saying that the severability of the removal limitations “seems clear.” Id. at 29. Going forward, it will be interesting to see if the Court applies this approach more generally to constitutional challenges to other major legislation.

The Dissent

Justice Breyer, joined by Justices Stevens, Ginsburg, and Sotomayor, contended in dissent that the dual-layer review violates no separation-of-powers principle. The dissent urged judicial restraint in this regard, based upon the complexities of governmental administration, the legislative and executive branches’ expertise, and the multiple facets of oversight authority, and argued that the PCAOB’s adjudicatory role necessitates the tenure protections provided by Sarbanes-Oxley. Justice Breyer also noted that the majority’s decision “threatens to disrupt severely the fair and efficient administration of the laws,” and that there are other agencies that might run afoul of the Court’s ruling, such as the Foreign Service Labor Relations Board of the Federal Labor Relations Authority, the Civilian Board of Contract Appeals in the General Services Administration, the Inspector General of the Postal Service, and the Office of the Chief Actuary of the Social Security Administration.

For more information about the subject matter of this alert, please contact any of the lawyers listed below:

Dale E. Barnes, Co-chair, Securities Litigation, 415.393.2522

Jordan D. Hershman, Co-chair, Securities Litigation, 617.951.8455

This article was originally published by Bingham McCutchen LLP.