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Breaking: Sarbanes-Oxley to the Supremes:

This morning the Supreme Court granted certiorari in Free Enterprise Fund v. Public Company Accounting Oversight Board, a constitutional challenge to portions of the Sarbanes-Oxley Act. Appointments Clause cases don't come along all that often, and this one's a doozy — "Humphrey's Executor squared" according to Judge Kavanaugh's dissent on the D.C. Circuit. Our prior posts on this case are collected here.

Links to the filings, and today's other cert grants, are on SCOTUSBlog here.

Hans:
This is good news for American investors and prospects for economic recovery, since a victory in this case will give the President an added incentive and ability to adopt policies that foster economic growth.

The PCAOB has been very bad for the economy. The red tape created by the PCAOB has costs business over $35 billion a year, according to the American Electronics Association, and has cost the economy as a whole over a trillion dollars, according to a Brookings-AEI study. And yet, the PCAOB failed to detect fundamental problems with the rating and valuation of sub-prime mortgage-backed securities. And the biggest beneficiaries of the law have been the big accounting firms that failed to warn the public about Enron and similar scandals, which are charging record fees to help businesses comply with the mountain of red tape created by the PCAOB.

If the President can pick and remove the PCAOB members, as the Appointments Clause requires for principal officers, he will be on the hook for their policy failures, and thus have an interest in making them develop sound policies that protect investors and don't stifle economic growth. He won't be able to blame the red tape on an unaccountable agency whose officials he doesn't select or control.

Moreover, giving the President that role promotes even-handed application of the law. A bureaucrat is less likely to abuse individual citizens if he knows he is accountable to their elected representative, the president. And he is more likely to stand up to vested interests that have lobbyists on Capitol Hill if he knows the president selected him and will back him up.
5.18.2009 10:58am
Houston Lawyer:
While I believe the law to be unconstitutional, I do not expect that this administration or Congress intends to undo any of the substantive overkill caused by Sarbanes Oxley. I fear the next round of regulation will be Sarbox squared.
5.18.2009 11:16am
rosetta's stones:
I agree. Cap and Trade, and health care intrusions, would bring on another whole dimension of regulatory review, I suspect. Watch for it.
5.18.2009 11:22am
Hans:
The Supreme Court's decision to review this case is good news, since a successful constitutional challenge will give the President an added incentive and ability to implement policies that promote economic growth.

The PCAOB has been bad for the economy and investors alike. Its red tape costs business over $35 billion a year, according to the American Electronics Association, and its red tape has cost the economy as a whole over a trillion dollars, according to a Brookings-AEI joint study. And yet, the PCAOB failed to detect fundamental problems with the rating and valuation of sub-prime mortgage-backed securities. And the biggest beneficiaries of the PCAOB's regulations ave been the big accounting firms that failed to warn the public about Enron and similar scandals, which are charging record fees to help businesses comply with the mountain of red tape created by the PCAOB.

If the President can pick and remove the PCAOB members, as the Appointments Clause requires for principal officers, he will be on the hook for their policy failures, and thus have an interest in making them develop sound policies that protect investors and don't stifle economic growth. He won't be able to blame the red tape on an unaccountable agency whose officials he doesn't select or control.

Moreover, giving the President that role promotes even-handed application of the law. A bureaucrat is less likely to abuse individual citizens if he knows he is accountable to their elected representative, the president. And he is more likely to stand up to vested interests that have lobbyists on Capitol Hill if he knows the president selected him and will back him up.

Even if PCAOB members were not principal officers, but rather inferior officers who the Constitution's appontments clause permits to be appointed by a department head rather than the President, their manner of appointment is still invalid and a source of unaccountability and mischief. PCAOB members are picked by SEC Commissioners as a group (which led to a disorganized selection process for the first PCAOB members), not by the head of any cabinet department, or even the SEC's chairman, who picks the SEC's own officers.

In the decision below, the divided D.C. Circuit Court of Appeals voted 2-to-1 to uphold a provision of the Sarbanes-Oxley Act, over a strong dissent by Judge Kavanaugh, in the case of Free Enterprise Fund v. Public Company Accounting Oversight Board. But the court's decision rests on reasoning that is disturbingly inconsistent.

This case is a constitutional challenge to the PCAOB, the regulatory board set up by Sarbanes-Oxley, as a violation of the Appointments Clause and separation of powers. The PCAOB is enormously important: The PCAOB enjoys "massive power," "unchecked power by design," according to a Senator who voted to create it. And the PCAOB members are paid more than the President himself.

But rather than being picked by the President with Senate approval, the way important government officials are supposed to be, PCAOB members are picked by SEC Commissioners as a group (which led to a disorganized selection process for the first PCAOB members).

The lawsuit says that violates the Appointments Clause of the Constitution, which requires that government officials be picked by the President or (for inferior officers) by the "Head of a Department." The lawsuit also argued that the PCAOB members are so unaccountable to the president, who can't remove them (the SEC Commissioners collectively can, but only for "willful" misconduct), that it violates separation of powers.

In order to reject the constitutional challenges, the court's majority had to rely on inconsistent reasoning. First, it claimed that the SEC's Chairman is NOT the SEC's head, but rather "simply one" of "several commissioners," making the SEC Commissioners collectively the head of the SEC. See Slip Opinion, at pg. 20 ("The [SEC's] Chairman . . . is simply one Commissioner"); Opinion, pg. 21 ("The commission" is a body "whose 'Head' consists of the several commissioners"). Only by doing that could it rule that the SEC Commissioners collectively are the "Head" of a department and thus are permitted by the Appointments Clause to make appointments. (Never mind that the Chairman has been described by the SEC itself as its "chief executive" and "head").

Then, just a few pages later, the opinion suddenly suggested just the opposite: that the SEC's chairman was, after all, the SEC's head. Confronted with the argument that the PCAOB is not accountable to the President through his appointees, such as the SEC's chairman (who, unlike other SEC commissioners, serves at the president's pleasure), the court stated that the President does have indirect influence over the PCAOB through the SEC, because the president picks the SEC Chairman, who "dominates commission policymaking." See Opinion, Pg. 24. (It said that "by appointment of the Commission chairman, who serves at the pleasure of the President and often 'dominate[s] commission policymaking,' the President can influence Commission policy and control who directs 'the administrative side of commission business, select[s] most staff, set[s] budgetary policy, and as a consequence command[s] staff loyalties.'" See Opinion, pg. 24). But if the Chairman so "dominates commission policymaking," that is because he is the SEC's actual "head" (its "top executive," as the SEC concedes), not a mere figurehead.

That inconsistency illustrates that the lower court's decision was erroneous, even if its contested premises (that PCAOB officers are inferior officers, and that the SEC is a department for appointments-clause purposes) were true.
5.18.2009 11:31am
Oren:



The PCAOB has been very bad for the economy. The red tape created by the PCAOB has costs business over $35 billion a year, according to the American Electronics Association, and has cost the economy as a whole over a trillion dollars, according to a Brookings-AEI study.

It's unclear to what extent PCAOB (whatever it's many flaws) has increased investor confidence in the numbers that firms post and therefore led to the more efficient allocation of capital. Information asymmetry, even if only perceived and not actual (as is probably the case for the vast majority of firms), is a huge barrier to an efficient capital market.
5.18.2009 11:41am
Oren:
Amending my last: I'm not saying the cost is worth it, but Brookings/AEI are only looking at the downside, not the upside, which is transparently self-serving. Of course the policy has costs -- but many argue that, post-Enron (again, even if this is a perception among investors that does not reflect the truth), such controls have benefits far outweighing the costs.
5.18.2009 11:43am
JonC:
Assuming that this is the study in question, is does not appear to be the case that "Brookings/AEI are only looking at the downside, not the upside." The study weighed costs and benefits.
5.18.2009 11:52am
Soronel Haetir (mail):
Too bad we won't get a ruling that all executive agencies that aren't fully answerable to the President are unconstitutional.
5.18.2009 11:54am
Jim at FSU (mail):
With all due respect, the supposed value of Sarbanes-Oxley is horseshit. If transparency was supposed to have prevented more Enrons, why didn't it prevent the current mess?

The politicians got the benefit of the doubt and they screwed up. Sarbanes-Oxley is enormously expensive to comply with, had harmful side effects (mark to market rule and the banking liquidity rule interactions) and all of its benefits were apparently illusory. Can we move on already?
5.18.2009 11:55am
not Jim at FSU:
Wow, that's "all due respect"? Why don't you tell us what you really think....
5.18.2009 12:09pm
RobbLDC (mail) (www):
Jim,

I don't want to get due respect or anything, but perhaps you could explain your alternative to "mark to market". If we are going to have any accounting standards at all, what is the alternative to the market value of currently held assets?

I would like to take out a loan based on the value of my house in some possible future, but I think that few investors will be willing to play ball...

Robb in DC
5.18.2009 12:31pm
Malvolio:
It's unclear to what extent PCAOB (whatever it's [sic] many flaws) has increased investor confidence in the numbers that firms post and therefore led to the more efficient allocation of capital.
This is a common defense of SarbOx regulation generally -- that it's good for a company to endure vigorous oversight, because its reputation will be enhanced by the resulting clean bill of health (the other possibility, that the oversight actually improve corporate governance, I have never heard made).

OK, say I, make it voluntary. If SarbOx improves a corporation's ability to raise capital, let corporations "opt-in". All the SarbOx experts to whom I have made this proposal have burst out laughing at the idea that anyone would subject himself to SarbOx without the compulsion of law.
5.18.2009 12:37pm
rosetta's stones:

I would like to take out a loan based on the value of my house in some possible future, but I think that few investors will be willing to play ball...


They were up 'til a short while ago.

No job? No income?

No problem! We'll just fold that mortgage into these here derivatives, and we're set. Real estate market has to go up, right?

And if it doesn't, there's always the taxpayers.

It's an interesting juxtaposition, this post with the pirate posts. The law goes with whichever buccaneer is swinging the cutlass, I guess, as long as he's tight with the pirate clan.
5.18.2009 12:42pm
Oren:
JonC -- the paper maintains the dubious hypothesis that they could figure out what stock prices were if SOX wasn't in place. It's a fundamentally counter-factual proposal.
5.18.2009 12:46pm
Edmund Unneland (mail):
Eugene Volokh asked earlier about whether multi-headed departments would have been a creature known in the founding generation. Since they took much from British practice, wouldn't the Board of Admiralty, the Board of Trade and the Lords Commissioners of the Treasury be examples?
5.18.2009 12:57pm
Malvolio:
What happens if the Supremes rule the method of appointing the PCAOB unconstitutional? Are the current board members immediately removed? Are their actions and ruling void? What about companies that have been penalized for violating the rules promulgated by the unconstitutional board?

Even if I didn't hate SarbOx as much as I do, I would still want this ruling, just so I could watch.
5.18.2009 12:58pm
ArthurKirkland:
If this is the study I think it is, I believe the most prominent criticism was that the author(s) ascribed broad market losses to the regulatory provisions but did not ascribe broad market gains in the same manner. I believe at least one author tempered some of the quantifications consequent to that point.

I do not know enough to make a guess concerning the Appointments issue, and I am open to debate (ideally involving sources not funded by big business and/or reflexively opposed to regulation) regarding Sarbanes-Oxley, but the clustermuck caused by financial firms causes me to support revival of the Glass-Steagall Act. On second thought, I never supported repeal, so the more accurate assertion is that the market failures have reinforced my conclusion that Glass-Steagall repeal was foolish and that the regulations should be revived.
5.18.2009 1:02pm
einhverfr (mail) (www):
Hmmm.... First, I think that SOX was somewhat the wrong approach to the problem. There is no reason the SEC couldn't have made better use of the FASB instead of having this other board established. Also, I think there are a number of other issues with the law not related to this challenge. I do agree that we need more corporate accounting controls, but I don't think SOX was the answer.

SOX is a classic example of why we need more diversity of background in Congress. How many congressmen know more accounting than they need to know in order to file their taxes? Off the top of my head I can't think of any who have an accounting background. I describe the approach as "take a problem, have a bunch of folks look at solutions who know very little about the inner nature of the problem, and then draft an approach that looks impressive to anyone who is outside the field."

Also no amount of controls will prevent occasional problems. When folks want to lie and stay within the rules, they will do so. At best you can minimize the problems. You cannot eliminate them. This being said, SOX is, in my estimation, a fairly bad solution.
5.18.2009 1:07pm
JB:
If transparency was supposed to have prevented more Enrons, why didn't it prevent the current mess?

1) The current mess arose from a different type of chicanery than Enron. Your question is like asking "If increased airport security was supposed to have prevented more 9/11s, why didn't it prevent the London and Madrid attacks?

2) Your main point, however, is sound: Regulation based on closing specific loopholes and preventing specific sharp practices will continue to fail to protect us. We need to look at the root causes of the threats that face us (terrorism, irresponsible business practices), and develop strategies to deal with those. We can debate, sometimes vigorously and acrimoniously, what the best strategies are, but as long as we are focusing on the symptoms and not the disease we will remain sick.
5.18.2009 1:10pm
The River Temoc (mail):
The IPO market under $25 million has dried up, at great cost to the innovation ecosystem in Silicon Valley. I attribute a lot of this to SOX compliance costs. We need to do a bottom-up review of Sarbanes-Oxley to see what needs to be ditched.
5.18.2009 1:17pm
einhverfr (mail) (www):
My rule when it comes to investing:

"If I can't audit it, I don't trust it."

Simple, and it works for me.
5.18.2009 1:25pm
arthur:
Note to the SarbOx haters: A rulign that this statute is unconstitutional will considerably increase President Obama's power. The substantive regulations will remain and a statutory amendment, presumably passed 60-40 on straight party lines, with any democratic waverers promised some of the newly available patronage jobs, will replace SEC appointment with presidential appointment.
5.18.2009 1:48pm
Dave N (mail):
einhverfr,

Seems like a good strategy to me, too.
5.18.2009 2:19pm
Paul B:
I'm skeptical that SOX has provided benefits equal to the time and money spent as the results of its requirements, but anyone who says it costs $35 billion, much less $1 trillion (7% of GNP)has absolutely no credibility.

Silicon Valley's self serving views on tax and accounting policy - stock options shouldn't be reported as an expense, carried interest should be treated as capital gains etc.- will undercut anything said by high tech companies and venture capitalists in the future (such as the importance of free trade or the value of immigrant visas for highly skilled professionals).
5.18.2009 2:45pm
byomtov (mail):
All the SarbOx experts to whom I have made this proposal have burst out laughing at the idea that anyone would subject himself to SarbOx without the compulsion of law.

Which proves exactly nothing. Managers don't like to be subject to regulations, in my experience, whether the regulations make sense or don't.
5.18.2009 2:54pm
BGates:
the paper maintains the dubious hypothesis that they could figure out what stock prices were if SOX wasn't in place. It's a fundamentally counter-factual proposal.

See also "jobs created or saved", "short-term unemployment with and without gargantuan Democratic patronage spending".
5.18.2009 3:42pm
William D. Tanksley, Jr:
Information asymmetry, even if only perceived and not actual (as is probably the case for the vast majority of firms), is a huge barrier to an efficient capital market.


I disagree. Information asymmetry is inherent to life. The seller always knows more about the product than the buyer, the borrower knows more than the lender, and the manager/employee knows more than the owner/stockholder. This can't possibly be remedied; any attempt to remedy it will be gamed.
5.18.2009 5:03pm
John Moore (www):
From my exposure in the hospitality industry, SOX is an enormous burden for almost no purpose. Every IT change ends up going through all sorts of review, even if it is in a system that doesn't do the financials.

My current employer went private, partly due to SOX.
5.18.2009 6:33pm
einhverfr (mail) (www):
Also, interestingly, nearly all of my investments of late are small, private investments where I have access to financial records. I expect this to continue for me or even accelerate.
5.18.2009 7:16pm
Don MacKay (mail) (www):
What happens if the Supreme Court issues an opinion that the appointment process is unconstitutional?

In my opinion, all lower courts would be unlikely to enforce any claim or right based upon compliance or non-compliance with standards or regulations promulgated by the PCAOB. I imagine any parts of SarbOx that can stand independently of any action by the PCOAB would still be given effect.

Maybe the simple solution is this: Get rid of SarbOx and the PCAOB. Make all officers and directors of corporations criminally liable for the criminal acts of their corporations. Prosecutors could grant immunity on an individual basis to certain officers or directors who cooperate with investigators. You could even build-in whistle-blower protection. Such potential liability would certainly cause officers and directors to actually PAY ATTENTION to what their companies are doing, and to voluntarily institute processes to assure themselves that activities are above-board.

This would not hang an officer for the bad business judgment of a corporation that results in unpaid corporate debt. The officer would not be liable merely for unpaid bills, but the officer would be liable if the corporation, for example, committed criminal fraud to induce the creditor to extend credit to the corporation, whether or not the officer knew of the fraud. I can't think of a better incentive for the officer to make sure their employees comply with the law, and to voluntarily keep accurate records which are audited regularly to catch any problems. If a problem is discovered through the audit, and it is voluntarily brought to the public prosecutor's attention, the officer should be immune from liability for that problem.

Here's a fun question: If the appointments are deemed unconstitutional, would the current members of the PCAOB continue to earn their fat salaries until Congress passes (and the President fails to veto) legislation terminating their positions? I think the answer is "yes", unless some "cause" can be found for the SEC to terminate them sooner.
5.19.2009 4:02pm

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