by Michael Connor

The U.S. Supreme Court ruled that an accounting board created by the Sarbanes-Oxley Act was unconstitutional because of the way its members were appointed, but the justices said the board could continue to function as the result of changes stemming from the court’s decision.

US Supreme CourtIn a 5-4 opinion written by Chief Justice John Roberts, the justices also did not question the constitutionality of the broader Sarbanes-Oxley Act, ruling that the Act “remains fully operative as a law.”

Congress enacted the Sarbanes-Oxley Act of 2002 (PDF) after a series of celebrated accounting debacles at companies such as Enron, WorldCom and Tyco International.  Among other measures, the Act introduced tighter regulation of the accounting industry under a new Public Company Accounting Oversight Board (PCAOB). The Board is composed of five members, appointed to staggered 5-year terms by the Securities and Exchange Commission.

The Free Enterprise Fund, a conservative non-profit group, and a small Nevada accounting firm launched a legal challenge to the PCAOB, asserting that the Sarbanes-Oxley Act violates the Constitution’s requirement of separation of powers among the three branches of government. They argued before the court that the PCAOB is unconstitutional because the Securities and Exchange Commission, not the president, appoints members of the PCAOB board.  As a result, they suggested, the President could not remove or fire board members even if he wanted to.

In an opinion that seemed to make the case for strong executive power, Justice Roberts said that the power given to the SEC to appoint the PCAOB board was unconstitutional, writing: “The Constitution that makes the President accountable to the people for executing the laws also gives him the power to do so. That power includes, as a general matter, the authority to remove those who assist him in carrying out his duties. Without such power, the President could not be held fully accountable for discharging his own responsibilities; the buck would stop somewhere else. Such diffusion of authority ‘would greatly diminish the intended and necessary responsibility of the chief magistrate himself.’”

Justice Roberts said the mere existence of the PCAOB did not violate the constitution, and the unconstitutional aspects of the PCAOB could be separated from the Sarbanes-Oxley legislation. The plaintiffs in the case, he wrote, were entitled to “relief sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive.”

Because of the Court’s ruling that the restrictions on removing board members were invalid, Justice Roberts said, “the consequence is that the Board may continue to function as before, but its members may be removed at will by the Commission.”

Supporters of the Sarbanes-Oxley legislation and the PCAOB had feared that the court ruling might have a significant impact on a broad set of financial controls and regulatory mechanisms introduced since Sarbanes-Oxley was adopted in 2002.

“At the end of the day, the decision probably changes very, very little,” said Joseph A. Grundfest, Professor of Law and Business at Stanford Law School.   The SEC previously could only remove PCAOB board members “for good cause,” Mr. Grundfest said, but with the court’s ruling the SEC now has the authority to remove board members at will. “All the other provisions of Sarbanes-Oxley remain intact, and the constitutionality of the PCAOB is not at issue,” he added.

In a statement, SEC Chairman Mary L. Schapiro said: “I am pleased that the Court has determined that the Board’s operations may continue and the Sarbanes-Oxley Act, with the Board’s tenure restrictions excised, remains fully in effect.  The PCAOB is a cornerstone of the Sarbanes-Oxley Act and serves a critical role in promoting investor protection and audit quality. We look forward to continuing to work with the Board in connection with its mission to oversee auditors in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.”

James L. Kroeker, the SEC’s Chief Accountant, said “it is important to understand that the PCAOB’s auditing standards, as approved by the Commission, continue to apply. Audit firms are required to be registered with the PCAOB and they remain subject to inspections.”

PCAOB Acting Chairman Daniel L. Goelzer said: “We are pleased that the decision allows the PCAOB to continue without interruption to carry out its important mission of overseeing public company audits in order to protect investors and promote the public interest.”