Corporate Governance

Free Enterprise Fund v. PCAOB: Regulation, the Free Market, and the Constitution: Introduction (Part 1)

By J. Robert Brown

We will spend a couple of days on an important but little reported case, FEF v. PCAOB.  Back in the early days of Sarbanes Oxley (SOX), the knives were out.  Everything about the Act was flawed, from the process used in adoption to each of the specific provisions.  SOX was labeled "quack corporate governance."  As discussed in Criticizing the Critics:  Sarbanes Oxley and Quack Corporate Governance, the views often rested on empirically unsound foundations, something that became increased over time.     

One of the more curious developments during the period of easy criticism was the lawsuit brought by the Free Enterprise Fund and an accounting firm, Beckstead & Watts, challenging the constitutionality of the PCAOB.  The case rarely made the news.  The issues were esoteric (the constitutional authority to appoint and remove officers), the implications seemingly narrow.  When the case did surface, however, it typically generated a salacious title suggesting that the constitutionality of the entire Act was at risk. 

As the case wound its way through the courts, the courts seemed unlikely to cooperate with the efforts.  In a succinct opinion, the district court found no merit to the complaint, concluding that the PCAOB rested on a firm constitutional footing.  Many expected the same outcome on appeal.

The panel hearing the case, however, raised a number of concerns, particularly over the SEC's authority to remove members of the PCAOB for cause.  One judge characterized the authority as an independent agency within an independent agency.  At least from the oral argument, therefore, there appears to be some risk that the court will strike down provisions affecting the PCAOB, particularly those relating to the SEC's removal authority.  

A negative decision will do more than imperil the PCAOB.  It will represent a death knell for the concept of self regulation.  Although self regulation has long been a part of the system of securities regulation, it has been a flawed model.  The main problem concerns the willingness of SROs to take steps that are disadvantageous to its members.  This can be seen most clearly with respect to concerns over the willingness of SROs to enforce their own rules.  Congress attempted to retain the concept of self regulation while fixing the governance structure.  By allowing the SEC to appoint and remove members of the board of the PCAOB, Congress ensured that the self regulatory organization would be less beholden to industry and more likely to enforce its rules.  It is this model that is under challenge in FEF v. PCAOB.

With the case having been argued on April 15, a decision is expected soon.  It is appropriate then to spend a few days (most of the week actually) discussing the case.  We have posted on the DU Corporate Governance web site most if not all of the important documents on the case, including the assorted amici filed in the appellate case.

Full post as published by The Race to the Bottom on June 30, 2008 (boomark / email).