Sarbanes-Oxley Can Now Sleep Easily at Night: The PCAOB Case

In its typical rush to finish its term by July 4, the U.S. Supreme Court just released an opinion in the case challenging the constitutionality of the PCAOB, Free Enterprise Fund v. Public Company Accounting Oversight Board. This commentary discusses the decision, considers its implications for challenges to Sarbanes-Oxley and makes a few remarks about what the decision portends for future challenges to similar kinds of legislation.

Professor Fanto writes: As Congress appears to be about to pass mammoth financial and business legislation in response to the financial crisis, the last major set of laws addressing a business-related crisis, the Sarbanes-Oxley Act of 2002, has receded into the background. Sarbanes-Oxley was passed after the revelation of accounting-related scandals in several enormous publicly traded companies, primarily Enron and WorldCom. It was revealed that executives in these firms, as well as in others, had engaged in widespread fraud in order to disguise the poor financial state of their companies so that their company's stock price remained high. This fraud was accomplished primarily through the manipulation of financial statements, often done with the aid of internal accountants and outside accounting firms.

Sarbanes-Oxley was essentially designed to improve the reliability of financial statements in publicly traded firms. It accomplished this goal in ways that are too numerous to summarize here, but a few examples show the Act's purpose. The role of the board in supervising internal and external auditing was significantly enhanced. This was done primarily through the board audit committee, which was to be composed of financially literate independent directors with at least one member who was a financial expert. This committee would supervise internal auditing and, significantly, the hiring, firing and relationship with the external accounting firm, which certified the company's financial statements. Even more significantly, Sarbanes-Oxley greatly enhanced the oversight of the outside auditing firms by creating the Public Company Accounting Oversight Board ("PCAOB"), which, among other things, set standards of conduct for these firms, examined and disciplined them and otherwise exercised oversight over them. Although a private nonprofit corporation, the PCAOB administers federal laws relating to the accounting firms.

Before the onset of the recent financial crisis, Sarbanes-Oxley was the subject of a concerted attack by the business community and some academic critics for imposing too many costs on public firms in return for uncertain benefits. This is not the place to discuss this attack and related criticisms, other than to say that it was recognized that smaller public companies did suffer inordinately from the legislation. One message of the criticism was that Sarbanes-Oxley had made the U.S. securities markets uncompetitive so that foreign firms were no longer listing their securities in the United States and securities markets in other countries were supplanting the traditional U.S. dominance in this area. This criticism included a litigation strategy of challenging Sarbanes-Oxley in court. The most serious challenge was to the constitutionality of the PCAOB, which conducted its mission nearly as an independent agency under the supervision of the SEC, which was clearly an independent agency. One thought behind the challenge was that, if the status of the PCAOB could be undermined, much of Sarbanes-Oxley's requirements relating to accounting firms, and perhaps even the entire statute, might fall. [footnote omitted]

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