Regulation: Free Enterprise suit a hollow victory

Detractors of the Sarbanes-Oxley Act (SOX), and in particular the PCAOB, which was born out of the 2002 legislation, have pitched a long battle, and they had their long-awaited day in court in July. While they won a victory of sorts, it was a hollow one. In fact, with the affirmation of the principles under which the 
oversight board was created, it could easily be argued that Free Enterprise Fund vs PCAOB turned out to be 
a win for the pro-SOX crowd.

While its language is relatively benign, the ruling could have had a serious impact on the existing regulatory scheme and the validity of the entire Sarbanes-Oxley Act. In the days leading up to the case, Susan Hackett, senior vice president and general counsel at the Association of Corporate Counsel (ACC), said that ‘it is anticipated that during Thursday’s (June 24) case 
pronouncements, [the Supreme Court] will rule on an appeal that could rock the corporate legislative and 
litigation agenda for the foreseeable future. In the Free Enterprise case, the constitutionality of Sarbanes-Oxley is challenged, based on what many believe is simply poorly drafted language in the Act’s provisions 
creating the PCAOB.

‘While a ‘fix’ for the offending text and the 
resulting appointments process could be relatively 
simple, if the Court agrees that a fix is needed to cure 
a Constitutional problem with the Act, the entire 
Act could be invalidated.’

In the end, this was not the case. In a 5-4 majority decision, the judges did find some constitutional issues with the appointment of PCAOB members – and, more specifically, with the technique for their removal – but did not rule the entire body invalid.

Any outcome other than a maintaining of the status quo would have been a shock. In fact, as Jim Hamilton, principal federal securities law analyst at Wolters Kluwer, explains, ‘such a result would have gone against what Congress is trying to do in its newly signed 
financial reform legislation. The lawmakers in Washington are trying to strengthen the role of the PCAOB by giving it the authority to examine and 
oversee the broker-dealer community.’

Overstepping the mark?
Hackett laid out the importance of the ruling in a 
written statement issued the day after the decision. ‘The Supreme Court’s ruling is important both in its content and in the manner in which the case was decided,’ she wrote. ‘The Court invalidated a controversial provision in the Sarbanes-Oxley Act, which creates and provides for the appointment of the PCAOB, and, in doing so, engaged in a significant and extensive discussion of Article II/Separation of Powers. One might therefore argue that the Court was concerned that agencies (such as the PCAOB) created by legislation (such as Sarbanes-Oxley) are likely to exercise substantial and growing independent powers in governing corporate behavior (without direct oversight), and thus must be firmly tied to the authority of the branch of government which 
creates them: they must not be allowed to travel too 
far from their charter.

‘The Court, however, voted its clear confidence in the regulation of corporate governance as prescribed by Sarbanes-Oxley, which it could have struck 
down wholesale given that the Act does not contain a severability clause. The Court inferred from Congressional intent and case precedent that they did not need to invalidate the entire Act for the flaw 
in this relatively small provision.’

The decision was applauded by the accounting profession and most of the major investor groups. Corporate and business associations have been generally silent on the matter, although few expected the case to have any significant impact on the operation of the oversight board or the application of SOX.

Cindy Fornelli, executive director at the Council for Audit Quality (CAQ), wrote: ‘The CAQ is pleased that the US Supreme Court’s decision will allow the continued operation of the Public Company Accounting Oversight Board without any changes or legislative action. This narrow decision clearly severs the PCAOB board member removal process from the rest of the Sarbanes-Oxley Act and reaffirms all 
provisions of the law except for the power to 
remove the board members.’

According to Fornelli, any other decision than to allow the continued operation of the PCAOB would have been detrimental to the market as a whole. ‘The PCAOB was put in place to achieve the goals Congress embodied in SOX,’ she wrote. ‘Evidence demonstrates that audit quality and investor confidence have improved since the Board’s creation. The decision will prevent any disruption to the key activities of the PCAOB, including setting auditing standards and the public company audit oversight process – critical 
factors in the continued strength and stability of 
our capital markets.’

Ann Yeger, executive director of the Council of Institutional Investors, supports Fornelli’s opinion regarding the role the PCAOB plays in ensuring 
market stability. ‘The PCAOB has played a vital role in improving the quality of public company financial reports,’ she says. ‘Its careful, independent oversight of the auditing profession has enhanced investor 
protection and helped to restore confidence in the integrity of the markets.’

Here to stay
So what does all this mean for companies and 
their auditors? Firstly, these developments should put 
to bed – at least for now – any thoughts of a repeal 
of all or part of SOX. Companies must continue 
to operate under the regime, and should ensure 
that their systems are up to code.

‘At the same time,’ wrote Hackett, ‘with this 
decision, the Court has weighed in on the difficult and contentious issue of whether and how the President, Congress or regulators must have the ultimate ability to control (and be responsible for) the direction of increasingly powerful institutions, such as the PCAOB, which are in charge of significant oversight of companies.’

While some detractors, including the protagonists in the Free Enterprise suit, may not be happy with the outcome, it could be that it is actually a better result than if the Court had ruled differently and ordered a re-evaluation of SOX. Such a decision would have resulted in the Act being sent back to Congress 
for re-affirmation, and given the current mood in DC, the resulting law might actually have ended 
up being harsher than the original.

Hackett has stated that ‘in order to fix the problem, Congress will have to re-authorize the entire SOX legislation with new language in the relevant section.’ The ACC thinks that if the Act is deemed unconstitutional and no workaround is found to solve the problem of this clause, undesirable changes could ensue. The risk is that Congress – in this heated climate of anti-corporate sentiment – would proceed to re-authorize SOX with more than a cursory fix to the singular appointments process problem. ‘Indeed,’ Hackett concludes, ‘it is 
conceivable that the re-proposed legislation would become a Christmas tree on which every ornament of corporate reform and governance would be hung.’