Supreme Court: A Sarbox Split

The Supreme Court rules that the setup of the PCAOB violates separation-of-powers principles, but keeps the board alive – and dashes any prospects of a Sarbanes-Oxley rewrite.

In a ruling against the makeup of the Public Company Accounting Oversight Board, the U.S. Supreme Court has tweaked part of the Sarbanes-Oxley Act but decided that such a change does not open up the entire 2002 law to scrutiny. The ruling also preserves the legitimacy of the PCAOB, which oversees the accounting industry.

In a 5-4 decision, the judges restricted their views to whether the President has “adequate control” over board-member appointments for overseeing “a vital sector of our economy.” To fix what the majority thought was a discrepancy, the judges ruled that the board members should be subject to at-will removal by their overseers, the Securities and Exchange Commission. Previously, the SEC could fire board members only for cause.

The five-member board has been operating in limbo for more than a year while its structure was in question. At the same time, Sarbox critics, including the petitioners in the Supreme Court case, had hoped a decision against the PCAOB would have led to a rewrite of some of the law’s provisions, particularly as Congress works on another piece of major regulatory-reform legislation. They had presumed that denouncing one piece of the law could open up the entire document to renewed debate. Instead, though, the decision against the PCAOB “was about as gentle a finding as you could expect,” says Mark Olson, former chairman of the board, who now co-chairs consultancy Corporate Risk Advisors.

Still, separate from the court case, lawmakers do appear likely to allow just over half of publicly traded companies to be exempt from what is considered one of the most burdensome sections of Sarbox, which requires businesses to get their auditor’s opinion on their internal controls over financial reporting.

Monday’s ruling clarifies that the SEC’s commissioners can remove PCAOB board members at will, giving them more oversight than they technically had before today. In other words, the PCAOB could lose some of its independence from its overseer and be subject to more political whims, according to Olson. Currently, the SEC appoints the board members and has approval of its standards and budget.

The four-year-old lawsuit alleged that the President has no power to intervene in anything the PCAOB does. Sarbox “not only protects board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists,” wrote Chief Justice John Roberts in the majority opinion.

In effect, the Supreme Court’s ruling allows the PCAOB to continue to operate as is and for the board to continue inspecting and regulating accounting firms as it has been since Congress ended self-regulation of the audit industry eight years ago. “The decision will prevent any disruption to the public company audit oversight process, a critical factor in the continued strength and stability of our capital markets,” explains Cindy Fornelli, executive director of the Center for Audit Quality, which represents 800 audit firms.

The SEC, which oversees the PCAOB, released a statement after the Supreme Court ruling emphasizing that the board’s auditing standards are still in effect and that audit firms are still subject to its inspections, which occur on an annual or triennial basis, depending on each firm’s size.

What remains uncertain is who will run the board going forward. Currently holding one slot open, the board has operated with an acting chairman since Olson stepped down last July. It also has two board members with expired terms, including Charles Niemeier, whose term ended in October 2008.

The outcome for the PCAOB could have been far more negative. Olson says others like him who have left the board feel “relief” from the decision, as “there was a general feeling that [the ruling] could have been more onerous.”

The petitioners are also claiming satisfaction with the decision. “From a court perspective, this is what we hoped for,” says Jones Day partner Michael Carvin, who represented the Free Enterprise Fund, a policy group interested in promoting small government that had taken on a case of a small accounting firm criticized by the board after one of its inspections.

Part of Carvin’s positive attitude comes from the fact that his client’s broader hopes for questioning the PCAOB — that a ruling against the board could unravel all of Sarbox, or at least its more-burdensome provisions — are in one sense coming to fruition. As written, the regulatory reform bill currently in Congress would exempt the smallest of publicly traded companies, or those with market capitalization below $75 million, from Section 404(b), which requires an audit opinion on internal controls. All public companies have to get their management’s signoff on internal controls under Section 404(a).

Since its inception, the PCAOB, a nongovernmental entity, has come under fire for having little oversight, and its board members have been criticized for having little practical experience. In response to the tight-knit group of auditors and corporations during Enron’s heyday, Sarbox’s writers purposely promoted independence when it stopped the self-regulation of audit firms and created the PCAOB. Only two of the board’s five members can be a certified public accountant, and if one of the CPAs serves as chairman, he or she cannot have been practicing during the previous five years.

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