The U.S. Supreme Court hears arguments on Monday testing the constitutionality of the federal anti-fraud law that grew out of the Enron scandal. At issue is the constitutionality of the board Congress created to oversee independent audits of publicly traded companies.
But even more could be at stake.
As Congress debates what measures are needed to avoid a repeat of the financial institution failures of the last year, it is hard to remember that eight years ago, a different kind of scandal shook the foundations of the business world. It involved the collapse of some of the nation's largest corporations — Enron, WorldCom and Tyco — and how those companies deceived their investors through sham outside audits. Enron's bankruptcy in 2001 was, at the time, the largest in U.S. history.
"It was the canary in the mine shaft," says Paul Sarbanes, who in 2001 was chairman of the Senate Banking Committee.
"You had a number of major companies engaged in convoluted, often fraudulent, accounting schemes to inflate their earnings, to hide their losses and to drive up their stock prices," he observes.
And the outside audits of these companies, even though conducted by industry standards, were worthless.
The debacles provoked a crisis of confidence in capital markets. After extensive hearings, Democrat Sarbanes and his Republican counterpart in the House, Michael Oxley, co-authored a bill to ensure that investors would get accurate financial information about publicly traded companies. President George W. Bush signed it into law in 2002.
Instead of allowing the accounting industry to regulate itself, as it had before, the law created the Public Company Accounting Oversight Board, the PCAOB, or, as it is uncharitably known, "peekaboo." The board is technically private and is funded by a fee charged to the firms being audited. Its five board members are top accounting specialists appointed by the Securities and Exchange Commission.
But pro-business conservatives have attacked the board as unconstitutional. They contend it is a hybrid institution accountable to no one, that both makes rules to govern public accounting and enforces them.
Lawyer Michael Carvin, arguing Monday in the Supreme Court, says that the law is unconstitutional. He says that "combining the the ability to make laws and enforce them [is] what King George did." That, he says, is "the ultimate definition of tyranny."
Carvin represents the Free Enterprise Fund, the conservative, anti-regulation, anti-tax group that is bringing the challenge. One of the group's members, Brad Beckstead, runs a small public company auditing firm and became the focus of PCAOB inspectors in 2004. He says the board made him "the poster boy for what they labeled as rogue audit firms."
As Beckstead tells it, seven board inspectors spent 14 days in his office and found his audits deficient. Although his clients were publicly traded, he says that they were tiny start-ups with limited resources, and that using industry standards, he scaled the audits to the size of each firm.
"The PCAOB for two years was making my life miserable," Beckstead says. "It became so burdensome to comply with their constant requests that it was consuming my time and my staff's time, and I was no longer profitable as a business."
Beckstead and the Free Enterprise Fund challenged the Sarbanes-Oxley law in court, and lost, appealing ultimately to the U.S. Supreme Court.
Arguing on their behalf, Carvin contends that the law violates the Constitution's requirement that the powers of the three branches of government be separate and that the president be able to enforce the laws with officers he appoints and can fire. He argues that the PCAOB is unconstitutional because the SEC, not the president, appoints the board.
The PCAOB "is exercising extraordinarily powerful government, potentially tyrannical power," he contends. "And what kind of control does the president have over it? None. Zero." If President Obama wanted to "fire these morons," Carvin says, he couldn't.
That's nonsense, says former Sen. Sarbanes. Any actions the board takes "have to have the OK of the SEC."
And this isn't token supervision, according to seven former chairmen of the SEC, both Democrat and Republican. Roderick Hills, one of the Republican former chairmen, has served for five years on the PCAOB's advisory board and says that in that time he hasn't seen any PCAOB rule adopted without "pre-clearance from the SEC."
He says the board meets "laboriously" with the SEC over the PCAOB budget, rules and disciplinary actions. Nothing, not even a subpoena, can be issued without the permission of the SEC. Indeed, Hills says the control is so great that it is of considerable frustration to the board's members.
The government defends the constitutionality of the board — noting that the president must appoint and the Senate must confirm the board's boss: the SEC commissioners. The commissioners, so the argument goes, are principal officers — like Cabinet secretaries. And the people they supervise, in this case the PCAOB members, are inferior officers not directly controlled by the president under the Constitution. In other words, the board is no different from the general counsel of the SEC or the agency's chief enforcement officer.
Those challenging the PCAOB note that the board's members can only be fired for cause — meaning for some egregious action. But the government contends that it is a red herring since the SEC can eliminate the salaries of the PCAOB, its budget, and can even take functions away from the board.
There are big stakes in this case, more than meet the casual eye.
On both the left and the right, the case is seen as a legal attack on the legitimacy of all independent agencies. "It's almost the last gasp of the unitary executive branch theory which we heard a lot about over the last generation," says NYU law professor Richard Pildes, who wrote the brief on behalf of the former SEC chairmen.
The unitary executive theory was espoused by conservatives — among them now Chief Justice John Roberts and now Justice Samuel Alito — when they served in the Reagan and Bush administrations in the 1980s.
The theory, which had a kind of conservative rebirth then, contends that independent agencies of the modern administrative state — the SEC, the Federal Trade Commission, the Federal Communications Commission, for instance — are unconstitutional because, while agency commissioners are appointed by the president, they can only be fired for cause, so the president doesn't have complete control over them.
The problem, says Pildes, is that conservatives have consistently lost that legal battle, beginning 75 years ago, during the New Deal, and again in the 1980s. He sees this case as an effort to relitigate that big battle in the context of the SEC and this new board.
Carvin, the lawyer challenging Sarbanes-Oxley, almost admits as much. The Constitution, he observes, doesn't mention the SEC. "If the president can't tell the SEC what to do because they are independent," he argues, "then the fact that the SEC nominally controls the PCAOB is completely irrelevant.
And if the independent agencies created in the New Deal are a so-called fourth branch of government, he contends the PCAOB is the "fifth branch."
That would be "a fun philosophical argument," says former SEC Chairman Hills, but it is "too dangerous," in terms of the repercussions for capital markets. "What they are trying to do would do far too much damage to our system."
Now the Supreme Court will decide.