Free Enterprise Fund v. PCAOB: Regulation, the Free Market, and the Constitution (The Structure of the PCAOB) (Part 2)

There is much debate in the record about whether the PCAOB is nothing new (just another SRO) or something never seen before.  The answer, perhaps unsurprisingly, falls in the middle.  

In some respects, the PCAOB looks like a private sector organization. It is a non-profit corporation, a status required by SOX. See Section 101(a) (“The Board shall be a body corporate, operate as a nonprofit corporation, and have succession until dissolved by an Act of Congress.”).  We don't, therefore, see the PCAOB converting to a for profit organization as was done by the NYSE and Nasdaq. 

The Act disclaims the entities' status as an agency or establishment of the United States. Section 101(b). As a result, members of the PCAOB and the employees are not subject to civil service requirements, most noticeably the limitations on salary.  The ability to pay higher salaries and, presumably, to dismiss employees with less fanfare, provide an opportunity for a more market oriented organization. The organization can play competitive salaries and has greater flexibility to react to shifts in the market.   Published reports put the chairman at over $600,000 and the other board members over $500,000 (amounts that have drawn umbrage from Commissioner Atkins).

As with the traditional self regulatory organizations, the PCAOB is subject to considerable regulatory oversight. The SEC must approve any rule before it becomes effective. Section 107(b). As with the traditional self regulatory organizations, the SEC can also impose rule changes on the PCAOB. See Section 107(b)(5). Likewise, disciplinary actions are subject to Commission review. Section 107(c). The Commission may also “relieve the Board of any responsibility to enforce compliance with any provision” of the securities laws and may discipline the Board for, among other things, a failure “to enforce compliance with any” provision or rule. Section 107(d).

With a private sector business form and tight SEC review, the PCAOB resembles the other self regulatory organization.  The primary difference arises in the governance structure.  Under SOX, it is the Commission that determines the membership of  PCAOB.  This can be compared with directors at the NYSE, which were historically elected by members and are now elected by shareholders.  The directors elected under the current configuration, therefore, must engage in profit maximizing behavior.  And while the NYSE has taken steps to insulate its regulatory function from interference, it is safe to say that tension exists between profit maximization and the regulatory mission.   

SOX sought to address governance issues, particularly the problem of industry capture, by giving the SEC the right to appoint and remove the directors.  Under SOX, the PCAOB is headed by a board with five members.  The members must be: 

• appointed from among prominent individuals of integrity and reputation who have a demonstrated commitment to the interests of investors and the public, and an understanding of the responsibilities for and nature of the financial disclosures required of issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance of audit reports with respect to such disclosures.

Two members shall be certified public accountants. The chairman cannot have been a practicing certified accountant for the five years prior to appointment and all members must be “independent” of any public accounting firm. See Section 101(e) (members may not “share in any of the profits of, or receive payments from, a public accounting firm”).

It is the SEC (collectively) that appoints the members, “after consultation with the Chairman of the Board of Governors of the Federal Reserve System and the Secretary of the Treasury.” Section 101(e)(4). The members have five year terms but serve “until a successor is appointed.”  Board members are limited to two terms but may be removed from office “in accordance with section 107(d)(3), for good cause shown.” The provision provides that removal may occur for willful violations of the law, willful abuse of authority, or the failure, “without reasonable justification or excuse” to enforce compliance with the Act. Section 107(d)(3).

In other words, the members of the PCAOB are beholden to the SEC, not to industry, not to profit maximization.  Moreover, the Act specifically references a failure to enforce as a basis for "for cause" removal.  It is quite clear in creating the structure that Congress intended to meld self regulation and private sector sensibilities to a system of governance independent of the industry subject to regulation.  It is this model that is under challenge in this 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.