US watchdog's fate in the balance as supreme court rules on Sarbox legality

America’s accounting watchdog, the Public Company Accounting Oversight Board (PCAOB), could be altered or even scrapped after the US Supreme Court agreed to consider a lawsuit challenging the constitutionality of the 2002 law that created it.

As the highest judicial authority in the country, the Supreme Court’s announcement on 18 May that it would hear a case this autumn brought against the Sarbanes-Oxley Act of 2002 has caused a major stir.

Congress, of course, passed the law in response to the accounting scandals surrounding firms such as Enron, WorldCom and Arthur Andersen. The law created the PCAOB to act as a regulator of auditors of public companies to protect against manipulative accounting practices.

The legal case centres on a provision giving the US Securities and Exchange Commission (SEC) the authority to appoint the PCAOB’s five-member board.

The SEC was given that responsibility in part to establish a degree of political independence in the selection of board members, but plaintiffs in the case argue that it runs foul of the president’s power under the US constitution to appoint all ‘officers of the United States’ federal government’.

The plaintiffs include an accounting firm, Beckstead & Watts, the Competitive Enterprise Institute and the Free Enterprise Fund, groups that promote limited government regulation and intervention into the markets.

Critics of Sarbanes-Oxley have long chafed at its strict auditing requirements and high compliance costs, complaining that it was an overreaction by Congress to the accounting scandals.

The Supreme Court could decide to invalidate the law ­ and with it the PCAOB, in which case Congress would be forced to make revisions. A lower federal appeals court in Washington upheld the law in August 2008.

In a possible sign of the uncertainty surrounding the PCAOB, the board’s chairman, Mark W Olson, announced shortly after the Supreme Court’s decision to hear the case, that he would resign his post at the end of July ­ more than a year before his term expired. Olson said his decision was ‘entirely personal and reflects my desire at this time of life to establish new priorities.’

The Washington-based Competitive Enterprise Institute applauded the Supreme Court’s decision to hear the case. ‘The Founding Fathers wanted powerful government officials to be vetted by the president and the Senate, to help ensure agencies remain accountable to elected officials and ultimately the American people,’ CEI’s general counsel, Sam Kazman, said in a statement.

‘The PCAOB imposes massive regulatory burdens on public companies, under threat of criminal and civil penalties, yet the regulators are completely unaccountable to the people, the president or the Senate.’

Brad Beckstead, managing partner of Beckstead and Watts, welcomed the announcement.

Acknowledging that the broader 2002 legislation is the real target of the challenge, Beckstead wrote in a statement that compliance costs for Sarbanes-Oxley are a ‘barrier to entry’ for small entrepreneurial and developing companies.

‘Auditors ultimately pass those compliance costs to their clients by driving up audit fees,’ Beckstead said.

‘Consequently, the burdens have pushed the majority of micro-cap and development-stage companies either out of business or offshore. We must continue to fight against the burdens of over-regulation on small business and hold the PCAOB accountable to the public.’

The US government has fought the case thus far and defended both the broad Sarbanes-Oxley law and the PCAOB.

SEC spokesman, John Nester, said: ‘We agree with the Court of Appeals ruling and believe that Congress acted properly and within its constitutional authority when it established the accounting oversight board to protect investors.’ He said the commission looked forward to making its arguments before the Supreme Court.

A PCAOB spokesperson echoed the statement and said the board was ‘confident’ that its structure was constitutional. However, the board’s strategic plan does acknowledge that defending the constitutional challenge will require ‘significant resources’.

Also chiming in on the PCAOB’s behalf is the Washington-based Council of Institutional Investors (CII), which has filed legal briefs with two previous courts and plans to weigh in again with the Supreme Court. CII spokeswoman, Amy Borrus, said the PCAOB is ‘carefully designed by Congress to provide the necessary independence, accountability and authority needed to both serve and protect investors and improve the competitiveness of the US capital markets.’

The role of the public accounting oversight board

The Public Company Accounting Oversight Board currently has a five-member board plus an additional 30 staff in its Washington headquarters. It is then supported by eight regional offices in Atlanta, Dallas, New York, Orange County, Chicago, Denver, San Francisco and Northern Virginia.

From PCAOB’s Strategic Plan 2008-2013

The [Sarbanes-Oxley] Act gives the PCAOB four primary responsibilities: registration of accounting firms that audit public companies trading in US securities markets; inspections of registered public accounting firms; establishment of auditing and related attestation, quality control, ethics, and independence standards for registered public accounting firms; and investigation and discipline of registered public accounting firms and their associated persons for violations of specified laws or professional standards.

Since its inception, the board has moved aggressively to develop these four program areas to fulfill its statutory responsibilities and, in doing so, takes a supervisory approach to auditor oversight. Under this approach, the Board endeavors to address many auditing problems through a combination of inspections and standards-setting.