Cindy Fornelli, executive director, Center for Audit Quality

The building blocks that shape the Sarbanes-Oxley Act have been given a significant legal push. Whether they tumble is up to the Supreme Court of the United States, which is deliberating the fate of the act’s overseer, the Public Company Accounting Oversight Board (PCAOB).

The constitutionality of the PCAOB has been challenged by Nevada-based accounting firm Beckstead and Watts and the Free Enterprise Fund, a non-profit group based in Springfield, Virginia, that promotes limited government and tax relief. 

Specifically, the court challenge is based on the appointments clause of the U.S. Constitution as well as separation-of-powers safeguards. The former is intended to promote political accountability by requiring that important government officials be picked by the president with the advice and consent of the Senate.

That did not happen with Public Company Accounting Oversight Board, which is empowered by the U.S. Securities and Exchange Commission (SEC) to review accountants and firms that audit reporting issuers. As a result, those leading the charge against the PCAOB believe the law is on their side.

If the court rules in their favour, the impact would reverberate throughout the accounting profession, the business sector, the federal government in the United States — and beyond.

“It would be too facile to say this is just a U.S. problem,” said Norm Emblem, a partner with the law firm Fraser Milner Casgrain LLP in Toronto. “A lot of people will be looking at this decision,” he added.

Indeed, Donna Nagy, a professor at the Indiana University Maurer School of Law, noted in a recent research paper exploring the issue, “No matter how the Supreme Court rules on the constitutional issues, its decision in Free Enterprise Fund is bound to have far-reaching implications for the future of securities enforcement and financial regulation in general.”

The first ripple would be felt by the PCAOB itself and the U.S. Securities and Exchange Commission, which appoints and supervises the five-member board.

“It’s hard to see how the court could craft an appointment process. That is constitutional. That is really up to Congress,” said Gillian Metzger, a professor of law at Columbia University in New York. 

“One alternative possibility for the interim,” she added, “is that the SEC does some emergency rule-making. It may try to take over some of the duties on an interim basis.”

It may not be enough, however. “If the court finds against the PCAOB, it could certainly invalidate the PCAOB’s rules, such as its burdensome internal controls rules extending the reach of Section 404 of Sarbanes-Oxley,” said Hans Bader, senior attorney with the Competitive Enterprise Institute, a public interest group based in Washington, D.C., and one of the petitioners in the case challenging the PCAOB.

That would save companies millions of dollars, according to Bader. He noted that the American Electronics Association estimated annual compliance costs at $35 billion a year while a University of Rochester researcher estimated total SOX costs at $1.4 trillion.

“(Invalidation) would result in more IPOs happening in the U.S. — after Sarbanes-Oxley’s passage, IPOs virtually dried up in the U.S., with some moving to London — and thus would result in more jobs in the U.S. and more capital for small businesses through equity markets.”

“That might indirectly help Canada as well, given Canada’s close economic links to the U.S. and reliance on the U.S. as its major export market,” Bader added.

However, “Firms have had to pay dearly through the nose to comply with Sarbanes-Oxley,” noted Emblem. “If you spend millions and millions of dollars getting up to speed and things are undone, people will be asking ‘Where is my rebate?’”

However, he added, “I don’t think it will come to that.”

One major concern is that if the door is opened to recast Peek-a-boo, as the Public Company Accounting Oversight Board is often referred to, the door is also open for Congress to tinker with the Sarbanes-Oxley Act itself.

“We’ve … witnessed attempts to chip away at the Sarbanes-Oxley Act in recent months. Amendments offered during Congressional consideration of the Investor Protection Act in October sought to exempt non-accelerated filers from compliance with Section 404(b),” Cindy Fornelli, executive director of the Center for Audit Quality, a public policy organization based in Washington, D.C., said in a speech recently to the American Institute of Certified Public Accountants.

That could become much more pronounced if the Supreme Court rules the PCAOB is unconstitutional. “If this is determined to be unconstitutional, there is no telling what the U.S. Congress will do with the rest of the act,” said Emblem. “Companies are just up to speed and may have to meet a whole bunch of new rules.”

“If (the legislature) is going back anyway, they could start cleaning up elsewhere,” he added. “It’s a be-careful-what-you-wish-for situation.”

Indeed, noted Metzger, “once Congress has to act, that opens up the statute.

“There is less focus on the short term and more on the longer term,” she added. “There will be a legislative effort to try to change some of the provisions.”

And there will be resistance. “No law is perfect. But by any measure, SOX has been a public policy success story. And it should be preserved for all investors’ sake, not just those in large public companies,” Fornelli told the CPA conference delegates in her speech. 

“Frankly,” she added, “I am troubled by the fact that key elements of a law deemed essential in the wake of Enron and Worldcom are now seen as disposable.”

“Companies will be less burdened if the PCAOB’s rules are struck down,” Bader said. 

“The PCAOB’s rules did nothing to prevent the mortgage crisis in the U.S. or detect the mis-valuation of subprime mortgage backed securities,” Bader noted. “Indeed, Countrywide Financial, which helped spawn the crisis by making risky loans, was celebrated as a paragon of Sarbox compliance — which did it no good.  The PCAOB rules distract attention away from core business strategy to ‘internal controls’ trivia like how many strings are in employee passwords.”

Metzger pointed out that the court does have another option — depending on what it rules to be unconstitutional about the PCAOB.

“In the past … the court has ruled the mandatory nature of guidelines unconstitutional and severed the mandatory language in the statute and made it advisory.

“It’s a slick way to do it,” she added, “It’s conceivable this could appeal to the court.”

Congress could also move quickly to avoid the fallout that a PCAOB in limbo could create. Congress likely would act quickly to restructure the PCAOB either as a traditional independent regulatory agency or as a unit within the SEC with members who are SEC employees, Nagy noted in her research paper entitled Is the PCAOB a “Heavily Controlled Component” of the SEC?: An Essential Question in the  Constitutional Controversy.

Still, she stressed, “the legislative process could open the door to additional changes.”

And not just for the PCAOB. “A broad holding by the court could raise questions about the level of independence asserted by even longstanding federal agencies such as the Federal Reserve, an entity often described as ‘the most independent of all federal agencies and the least subject to congressional oversight.’” noted Nagy.

In addition, she said, no matter what constitutional verdict is ultimately rendered for the PCAOB, the court’s decision may affect the self-regulatory organizations in the securities industry, such as New York Stock Exchange and the Financial Industry Regulatory Authority. “Indeed, because Congress modeled the SEC’s oversight of the PCAOB on the statutory provisions applicable to the NYSE and NASD, the court is likely to examine closely the relationship between those SROs and the SEC in the course of its analysis of the PCAOB.”

The only certainty may well be change. Even if the Free Enterprise Fund and Beckstead and Watts, LLP lose their legal challenge, expect the landscape to shift, cautioned Nagy. “If the PCAOB’s structure is upheld by the court, we can expect Congress to create many more independent regulators answerable in only limited respects to the SEC or other independent regulators.

“Congress has already been urged to create PCAOB-like entities to oversee credit rating agencies and the mutual fund industry,” she added.

The Supreme Court decision is expected within the next few months.