Thursday, March 22, 2007

PCAOB is Constitutional Declares Federal Judge

By James Hamilton, J.D., LL.M.

In a very important decision for the Sarbanes-Oxley Act, a federal judge has ruled that the PCAOB is constitutional and rejected the ``facial’’ claims of an audit firm inspected by the Board as nothing more than a hypothetical scenario of an over zealous or rogue PCAOB investigator. If such a scenario ever becomes real, said the court, the SEC could change the rules to prevent improper investigations or remove Board members for good cause. (Free Enterprise Fund and Beckstead & Watts et al. v. PCAOB, DC of DC, Civil Action No. 06-0217, Mar 21, 2007).

Judge James Robertson rejected the claim that the appointment of PCAOB members violates the Appointments Clause of the Constitution, which empowers the President to appoint officers of the United States, while allowing Congress to vest the appointment of inferior officers in Heads of Departments. The audit firm argued that PCAOB members are not inferior officers since they are neither appointed nor supervised on a daily basis by principal officers directly accountable to the President. But the court said that PCAOB members are inferior officers since they have no power to render a final decision on behalf of the US and are subject to oversight and removal by the SEC.

The court also rejected the argument that PCAOB members should have been appointed by the SEC chair rather than by the entire Commission. The audit firm lacked standing to bring this assertion, reasoned the court, since the SEC chair has voted for every member of the Board and the firm did not allege that its injuries were in any way attributable to the current PCAOB membership.

Finally, the court said that Congress constitutionally delegated legislative power to the PCAOB since the legislative delegation effected by Sarbanes-Oxley is squarely within the bounds of modern non-delegation doctrine. The court noted that the Board applies intelligible standards of auditing, quality control, and ethics that are either required by Sarbanes-Oxley or SEC rules or are in the public interest for investor protection.

The SEC had vigorously defended the PCAOB against this constitutional attack on the appointment process of Board members and the manner in which the Board conducts its operations. In a joint brief with the Justice Department, the SEC contended that the method detailed in Sarbanes-Oxley for appointing Board members satisfies the Appointments Clause. In addition, the brief said that the pervasive authority of the SEC to supervise and control the PCAOB’s activities refutes the depiction of the Board as a rogue agency running unchecked over the separation of powers. Also, the Commission said that the Board’s performance of diverse functions pursuant to a variety of intelligible principles defeats the argument that Sarbanes-Oxley unconstitutionally delegated legislative power to the Board.

In an unusual and possibly historic move, seven former SEC chairs, including William Donaldson, Arthur Levitt, Harvey Pitt, David Ruder, and Roderick Hills, had filed an amicus brief defending the PCAOB as constitutional. The former chairs described the PCAOB as being squarely within the historical structure of federal regulation of the capital markets, which has relied for decades on a unique combination of public-private institutional relationships under SEC oversight.
The Board exists, maintained the former SEC heads, because of a Congressional conclusion that the system of profession-dependent self-regulation of auditing contributed to the financial scandals of the recent past. And nothing in the federal Constitution denies Congress the power to make the policy judgments reflected in the legislative design of the PCAOB-SEC relationship, according to the brief.