Free Enterprise Fund v. Public Co. Oversight Bd. (08-861)
Oral argument: Dec. 7, 2009
Appealed from: United States Court of Appeals for the District of Columbia Circuit (Aug. 22, 2008)
AGENCIES, ADMINISTRATIVE LAW, SEPARATION OF POWER, APPOINTMENTS CLAUSE, SARBANES-OXLEY ACT OF 2002
In 2002, Congress passed the Sarbanes-Oxley Act in reaction to the perceived failures of the self-regulatory system for accounting procedures that led to the infamous Enron and WorldCom scandals. The Act established the Public Company Accounting Oversight Board to supervise the audit of public companies. Although the Board is under the authority of the Securities and Exchange Commission, its members are not subject to direct removal or appointment by the President and it retains the power to set and raise its own budget. In this case, the Supreme Court will determine whether the Act’s establishment of the Board is an unconstitutional violation of separation of power principles and whether the Board’s structure violates the Appointments Clause. Petitioners argue that the Act violates separation of powers by diminishing the President’s ability to control or supervise Board members. Respondents argue that the Act does not violate separation of powers because Congress can grant exclusive appointment and removal authority to the Heads of Departments. Petitioners additionally argue that the Board’s structure violates the Appointment Clause because Board members are Principal Officers and, even if they were to be construed as Inferior Officers, their appointment is still unconstitutional, because the SEC is not a “Department” and its Commissioners are not the SEC’s “Head,” as required by the Clause. In response, Respondents argue that Board members are inferior officers because they are controlled directly by the SEC, and that the SEC is in fact a “Department” over which the President can exercise broad control and the Commission is its “Head” because it exercises the SEC’s collective powers. The case will ultimately determine the permissibility of the scheme currently in place that regulates US financial markets.
1. Whether the Sarbanes-Oxley Act of 2002 violates the Constitution's separation of powers by vesting members of the Public Company Accounting Oversight Board ("PCAOB") with far-reaching executive power while completely stripping the President of all authority to appoint or remove those members or otherwise supervise or control their exercise of that power, or whether, as the court of appeals held, the Act is constitutional because Congress can restrict the President's removal authority in any way it "deems best for the public interest."
2. Whether the court of appeals erred in holding that, under the Appointments Clause, PCAOB members are "inferior officers" directed and supervised by the Securities and Exchange Commission ("SEC"), where the SEC lacks any authority to supervise those members personally, to remove the members for any policy-related reason or to influence the members' key investigative functions, merely because the SEC may review some of the members' work product.
3. If PCAOB members are inferior officers, whether the Act's provision for their appointment by the SEC violates the Appointments Clause either because the SEC is not a "Department" under Freytag v. Commissioner, 501 U.S. 868 (1991), or because the five commissioners, acting collectively, are not the "Head" of the SEC.
Whether the Sarbanes-Oxley Act violates the Constitution’s separation of powers doctrine by stripping the President of authority to select or remove members of the Public Company Accounting Oversight Board (“Board”), and whether the Board members are properly categorized as “inferior officers”, the Securities and Exchange Commission (“SEC”) is properly categorized as a “Department”, and the five commissioners are properly the “Head” of the SEC, so as to be consistent with the Constitution’s Appointments Clause.
The notorious financial accounting scandals involving Enron and Worldcom demonstrated the inadequacies of the self-regulatory reporting requirements governing many public companies. See Free Enterprise Fund v. Public Company Accounting, 537 F.3d 667, 669 (D.C. Cir. 2008). In response, Congress enacted the Sarbanes-Oxley Act of 2002, which established the Public Company Accounting Oversight Board (“Board”) to supervise the audit of public companies. See id. The Act provided that the Securities and Exchange Commission (“SEC”), after meeting with the Chairman of the Board of Governors of the Federal Reserve and the Secretary of the Treasury, appoint the Board’s five members. See id. Although the Act subjects the Board to the SEC’s oversight, it allows the Board to register public accounting firms, establish standards for auditing and ethics, inspect and investigate registered firms, impose sanctions, and set it owns budget by charging annual fees. See id.
The SEC does have comprehensive authority over the Board: it dictates when the Board can commence operations, when its rules can take effect, and also amends the Board’s rules. See Free Enterprise Fund, 537 F.3d at 669. Additionally, the SEC has the authority to review the board’s adjudications de novo. See id. at 670. This standard gives the SEC expansive power over the sanctions that the Board imposes. See id. The SEC may—upon a finding of a Board member’s willful violation of the Act, abuse of authority, or failure to enforce compliance with a rule or standard—remove or censure any member of the Board. See id. It can also impose limitations on the Board’s activities if it finds that the Board has not carried out its statutory duties. See id.
Petitioners are Free Enterprise Fund, a non-profit public interest organization, and Beckstead and Watts LLP (“B & W”), an accounting firm based in Nevada and subject to the Board’s authority. See Free Enterprise Fund, 537 F.3d at 670. B & W has been subject to an ongoing investigation by the Board that commenced in 2005. See id. In 2006, the two Petitioners (collectively “the Fund”) jointly filed a complaint alleging that the Board’s creation violated the Appointments Clause, the political doctrine of separation of powers, and non-delegation principles. See id. The Fund sought declaratory relief and also sought to enjoin the Board from carrying out its duties, including the ongoing investigation of B & W. See id.
The United States intervened to defend the Act’s constitutionality, and the District Court granted the Board and United States’ motion for summary judgment. See Free Enterprise Fund, 537 F.3d at 670. The Fund appealed to the United States Court of Appeals for the District of Columbia Circuit, which held that the Sarbanes-Oxley Act did not violate the appointments clause or the separation of powers principles and, therefore, affirmed the District Court’s grant of summary judgment. See id. at 685.
On May 18, 2009, the U.S. Supreme Court granted the Fund’s petition for certiorari to assess whether the Sarbanes-Oxley Act of 2002 violates the separation of powers principles and the Appointments Clause. See Questions Presented.
In this case, the Supreme Court will determine whether the Sarbanes-Oxley Act of 2002 violates the Constitution’s separation of powers framework by assigning too much power to the Public Company Accounting Oversight Board (“the Board”) without providing any residual control power to the President to supervise the Board, and whether the Act’s grant of power to the Securities and Exchange Commission (“SEC”) violates the Appointments Clause. Petitioners, Free Enterprise Fund and Beckstead and Watts LLP, argue that the Act does indeed violate the Constitution’s mandated separation of powers because it diminishes the President’s ability to control or supervise the Board members, and additionally, the Board’s structure violates the Appointment Clause. See Brief for Petitioner, Free Enterprise Fund and Beckstead & Watts LLP at 25, 45. Respondents, the Board, counter that there is no Appointment Clause violation, as the SEC directly controls Board members, and the President can in turn exercise broad control over the SEC. See Brief for Respondent, Public Company Accounting Oversight Board at 15, 31–32. Respondents also argue that the Sarbanes-Oxley Act does not violate separation of powers because Congress may grant exclusive appointment and removal authority to the Heads of Departments without unconstitutionally restricting the President’s or SEC’s authority. See id. at 36, 45. The Court’s decision will have a profound impact on the current framework under which federal regulation governs financial transactions both in the United States and abroad.
Over two dozen law professors and the American Civil Rights Union urge the Court to rule in Petitioners’ favor, arguing that because the separation of powers ultimately increases public accountability, such a ruling would lead to a system of financial regulation more responsive to public’s needs. See Brief of Amici Curiae Law Professors in Support of Petitioner at 20; Brief of Amicus Curiae American Civil Rights Union in Support of Petitioner at 13. A judge that would have ruled for Petitioners argued that the importance of separation of powers lies in the clarity it provides to the public: when the public can clearly tell which branch of government is responsible for unfavorable regulation, they can use the tools afforded by a democratic society to make their grievances known. See Free Enterprise Fund v. Public Accounting Oversight Board, 537 F.3d 667, 688 (D.C. Cir. 2008) (Kavanaugh, J., dissenting). Amici curiae, the Cato Institute and Professors Larry Ribstein and Henry Butler, further argue that the influence of interest groups over the legislature is very likely to result in interest group influence over these agencies. See Brief of Amici Curiae the Cato Institute and Professors Larry Ribstein and Henry Butler in Support of Petitioner at 13.
In response, Amici curiae Constitutional Law and Administrative Law scholars argue that such private-public regulatory schemes have always been pervasive in the finance industry, specifically pointing to the New York Stock Exchange and the NASD (now called the FINRA). See Brief of Amicus Curiae Constitutional and Administrative Law Scholars in Support of Respondents at 24. Additionally, amicus curiae National Association of State Boards of Accountancy argues that, even if the Court finds the provisions unconstitutional, it is critical that the Board continue to function because abolishing it would lead to a regulatory void. See Brief of Amicus Curiae the National Association of State Boards of Accountancy in Support of Respondents at 28. They argue that, without the Board, the regulatory responsibility would fall to the SEC, which does not have the resources or mandate to take over the Board’s responsibilities. See id. They point out that this responsibility would then fall to the state boards, which in turn rely on the Board to play a crucial role in their investigation and discipline of CPAs. See id. at 28. In fact, they argue that many states have incorporated the Board’s decisions and standards into state statutes and rules on accountancy. See id.
In response, The Claremont Institute, on behalf of Petitioner, cites to the need for accountability, given that the Board’s opaque actions have already substantially increased the costs imposed on small businesses who seek to go public. See Brief of Amicus Curiae the Claremont Institute for Constitutional Jurisprudence in Support of Petitioner at 31. Amicus Curiae the Cato Institute claims that it is now four times more expensive for a company to go public than it was before the Sarbanes-Oxley Act. See Brief of the Cato Institute at 27–28. The Cato Institute points out that much of this cost results from unnecessary regulation because the Board duplicates duties that other agencies already impose. See id. at 28.
In response to this, the Center for Audit Quality on behalf of the Board argues that the Board is actually serving its purpose, as it is responsible for the increase in public confidence in US Capital Markets, because the public is now able to trust financial information released by publicly traded US Companies. See Brief of Amicus Curiae Center for Audit Quality in Support of Respondent at 8–9. Additionally, the Center for Audit Quality argues that the Board has increased audit quality by identifying problems early on and remedying them. See id. at 11–12.
The Cato Institute views the international problems posed by private regulation as another negative implication of a ruling in the Board’s favor: the Board’s imposition of American standards on international accounting firms auditing US companies has been problematic and has even fostered a threat of retaliation. See Brief of the Cato Institute at 18–19. The Cato Institute points out that the Board’s regulation is categorically incompatible with much of foreign auditing regulation, which ultimately leaves foreign auditors in a bind. See id. at 19–20. For example, the Institute points out that, whereas French law deems an auditor’s disclosure of clients’ secrets a criminal offense, the Board’s regulations require French auditors to produce on demand potentially confidential information, such as their clients’ working papers and testimony of personnel. See id. at 20. Further, the Cato Institute argues that the Board’s international regulation also compromises the President’s capacity to speak authoritatively for the nation, which in turn deprives him or her of leverage in negotiations. See id. at 22.
Violation of Separation of Powers Doctrine? Extent of Presidential Powers
The United States Constitution takes care to separate the three branches of powers—the executive, legislative, and judiciary—and to vest the executive power in a single President. See U.S. Const. art. I § 8, art. II § 2, art. III § 2. This doctrine is an important tool for ensuring checks and balances among the branches, and for promoting accountability. See Free Enterprise Fund v. Public Accounting Oversight Board, 537 F.3d 667, 688 (D.C. Cir. 2008) (Kavanaugh, J., dissenting).
Petitioner Free Enterprise Fund (“the Fund”) argues that the Constitution’s separation of powers doctrine is violated because the President cannot fully exercise his constitutionally appointed functions since he lacks adequate control over the Public Company Accounting Oversight Board (“the Board”). See Brief for Petitioner, Free Enterprise Fund, et al. at 24. The Fund’s main contention is that the Sarbanes-Oxley Act (“Act”) deprives the President of his power to remove Board members, thus stripping the President of a powerful tool for control. See id. at 25. The Fund highlights that unlike every other independent agency, here the President is precluded from appointing or removing board members. See id. According to the dissenting judge in Free Enterprise Fund v. Public Accounting Oversight Board, the President is two levels of for-cause removal away from Board members, which he argues is an unprecedented restriction of the President’s authority. See 537 F.3d at 686. For the President to remove a Board member, he must direct a majority of the Commissioners of the Securities and Exchange Commission (“SEC”) to do so—and only if the Commissioner has a for-cause reason to dismiss the Board member, representing an unconstitutional restriction, according to the Fund. See Brief for Petitioner at 31.
The Fund additionally argues that the President’s control over the Board is further restricted because the President cannot influence the Board through the SEC. See Brief for Petitioner at 29. The Fund points out that only the Chairman of the SEC is beholden to the President, since the Chairman serves “at the pleasure of the President,” while the power to appoint Board members is vested in the entire Commission—a bipartisan body with fixed terms only removable for cause. See id. at 29-30. Furthermore, the Fund argues that the President lacks the power to review the Board’s work product, and the President cannot influence the Board through financial means since the Board raises its own money through direct taxation of registered corporations. See id.
Respondent, the Board, argues that because the President has constitutionally adequate control over the SEC, and the Act in turn provides the SEC with unconditional control over the Board, there is no separation of powers violation. See Brief for Respondent, Public Company Accounting Oversight Board (“PCAOB”), et al. at 45. Respondent, United States, counters the Fund’s removal contention by arguing that the relevant question here is whether two for-cause removal provisions is permissible in the context of the Act. See Brief for Respondent, United States of America (“USA”) at 47. The United States argues that the President's direct removal power over Board members is not the only tool for control, and since the Act provides the SEC with sufficient control, then the “constitutional validity of the President’s relationship with the SEC carries over to the Board as well.” See id. The United States demonstrates this by stressing the numerous mechanisms in place that enable the SEC to supervise the Board, noting that the SEC has the power to reject Board actions that affect private parties and relieve the Board of any of its responsibilities if it is inconsistent with the public interest, among other things. See id. at 47-48.
In addition, the United States argues that the SEC effectively has at-will removal power of Board members because the Commission can prescribe standards for the Board and has broad authority to remove members who willfully violate any provision of the Act, the rules of the Board, or securities law. See Brief for Respondent, USA at 50. The United States characterizes the Board as an “inferior officer,” over which the President never has direct right to remove, but is required to supervise in traditional chain of command fashion. See id. at 40, 42.
Violation of the Appointments Clause? Board Members as “Inferior Officers”
The Constitution gives the President power to appoint executive officers who exercise executive authority delegated by the President, upon advice and consent of the Senate. See U.S. Const. art. II § 2. The Appointments Clause also permits Congress to vest the appointment of inferior officers in the heads of departments. See id.
The Fund argues that the Act violates the Appointments Clause because the Board members are principal officers exercising executive authority and should not have been appointed without the President and Senate taking responsibility. See Brief for Petitioner at 43. The Fund disputes the United States’ contention that Board members are “inferior officers,” arguing that an inferior officer is one who is subject to effective control through the power of removal and day-to-day oversight and direction; furthermore having a superior officer is necessary but not sufficient to establish the status of an inferior officer. See id. at 46-47. With this standard in mind, the Fund argues that the Board is in fact an independent entity that wields sweeping power as demonstrated by its ability to establish standards for all accountants, enforced through criminal sanctions, and is not subject to the normal constraints of the congressional budget process, because it funds itself through taxation. See id. at 49.
The Board counters that the Fund’s proposed test in determining who is an inferior officer flouts the Supreme Court’s clear “direction and supervision” test set out in Edmond v. United States. See Brief for Respondent, PCAOB at 20. The Board argues that the Fund points to factors that have nothing to do with direction and supervision and that the exercise of significant authority is rather who controls that exercise of power. See id. at 19. Instead, the Board urges that the proper standard for measuring whether one is an inferior officer is whether he has a superior. See id. at 15. The Board again points to the SEC’s wide-sweeping authority over the Board’s activity and composition to demonstrate that the SEC effectively acts as a principal to the Board’s inferior office. See id. at 16; Brief for Respondent, USA at 47.
The Fund refutes this by arguing that the SEC's direction and supervision over the Board is not significant, emphasizing that the Board can only be removed for cause, that there is little day-to-day supervision, and the SEC review of Board action does not constitute supervision, because it “does not extend to the members personally, but is limited to their judgments.” See Brief for Petitioner at 54. To be a superior to an inferior officer, the Fund contends that a superior must directly supervise its officer, not just the work. See id.
The Board responds that the Supreme Court has consistently found that for-cause removal is consistent with an inferior officer’s status. See Brief for Respondent, PCAOB at 21. In reaction to the Fund’s argument that the SEC lacks supervisory control over the Board, the Board points to 15 U.S.C. § 7217(d)(1), which authorizes the SEC to relieve the Board of any responsibility, in order to enforce compliance with the Act, thus giving SEC the power to rescind all or any part of the Board’s investigative and disciplinary power at any time. See id. at 23-24. According to the Board, knowledge of the SEC’s power ensures the Board’s day-to-day compliance. See id. at 25.
Violation of the Appointments Clause? “Department” and “Head” Classifications
The Fund relies on the Supreme Court case Freytag v. Commissioner, which held that characterizing an independent agency, the Tax Court, as a “Department” would defy the purposes of the Appointments Clause. See Freytag v. Commissioner, 501 U.S. 868 (1991). The Fund argues that the Act similarly violates the Constitution because the SEC is as an independent agency. See Brief for Petitioner at 59. The Fund claims that a “Department” is an entity directly accountable to the President, and subject to political oversight. See id. at 58. In addition, the Fund argues that the Chairman of the SEC, not the five Commissioners, act as the “Head” of the SEC. See id. at 60. The Fund cites Freytag, stating that the Court recognized the danger of a diffuse appointment power and rejected efforts to expand that power beyond a single person. See id.
The Board also cites to Freytag and Justice Scalia’s concurrence that independent regulatory agencies such as the SEC are “Departments.” See Brief for Respondent, PCAOB at 30. The Board contends, however, that even if the Fund's standard is applied, the SEC is a “Department” because agencies are considered part of the executive branch and therefore answer directly to the President. See id. The Board contends that the five Commissioners, acting collectively, can head the Fund because Congress has declared that the “head of an agency may be a commission or board with more than one member.” See id. at 33. Additionally, the Board emphasizes that it is the Commission as a whole that promulgates rules and reviews sanctions, not the Chairman. See id.
In Free Enterprise Fund v. Public Co. Oversight Bd., the Supreme Court will decide whether the Sarbanes-Oxley Act violates the Constitution’s separation of powers doctrine, or the Appointments Clause. In doing so, the Supreme Court will determine the scope of the President’s constitutional powers to appoint and remove officers in the Executive Branch. This case will ultimately decide the permissibility of the current scheme that regulates U.S. financial markets.
Edited by: Lara Haddad
• Wex: Law about Securities
• Wex: Law about Separation of Powers
• Securities Prof Blog, Law Professor Blogs Network: Securities