Constitutionality of SarbanesOxley before court

June 26, 2010
| By Pete Daly |
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The U.S. Supreme Court is expected to rule soon on a legal challenge to the 2002 Sarbanes-Oxley act, which created the Public Company Accounting Oversight Board and put a heavy accounting burden on small, publicly held companies in the process — and is said to have reduced the numbers of IPOs since.

However, a Grand Rapids attorney with long experience in securities offerings doubts there will be a flood of IPOs if the legal challenge to Sarbanes is successful.

“I think part of this is an attempt to get rid of Sarbanes — you find the weakest point and you exploit it. And the fact is, if they were to invalidate the PCAOB because of the appointments clause or because of the separation of powers, I think Congress could very quickly go in and say, ‘OK, we’re going to change this and say that the members of PCAOB have to be appointed by the president,” said Jeff Ott, a partner at Warner Norcross & Judd.

“We’ve lived with Sarbanes long enough that I don’t see chaos coming out of it, if this thing were to be invalidated,” he added. “I just think there are too many folks in Congress that are going to say, ‘OK, if you want to invalidate it on a technicality, we’ll fix it.’”

The Sarbanes-Oxley Act was passed by Congress in response to corporate accounting scandals revealed by the Enron and Worldcom failures, and others, in which stock holders collectively lost hundreds of millions of dollars.

The Free Enterprise Fund, a Washington, D.C.-area organization that filed the lawsuit the Supreme Court is deciding now, describes itself as a nonprofit, 501(c)(4) organization “focusing on limited government and tax relief. The Free Enterprise Fund is also the leading nonprofit advocacy group dedicated to fighting the so-called Sarbanes-Oxley law.”

The FEF website states that “the cure” for the corporate accounting scandals “proved to be worse than the disease. Sarbanes-Oxley has been a disaster for American businesses, with yearly auditing costs averaging a staggering $1.34 million, more than quadrupling the costs before the law’s implementation. …”

The website continues: “Sarb-Ox is a job and productivity killer, costing our economy nearly $35 BILLION each year: out of the wallets of working men and women; out of the returns on investors’ IRAs; out of the bank accounts of American taxpayers — and right into the coffers of lawyers and accountants. Experience shows the law doesn’t even work. You can’t make people more honest by making them fill out more paperwork or by treating every manager like a criminal.”

The Free Enterprise Institute suit maintains that the Public Company Accounting Oversight Board, which was created by the Securities and Exchange Commission to enforce Sarbanes-Oxley, violates the constitutional doctrine of separation of powers by insulating the PCAOB’s wide-ranging exercise of government powers from presidential oversight and control, and by granting the power to the SEC to appoint the PCAOB members instead of the president.

Ott said one of the key pieces of Sarbanes-Oxley gave the PCAOB the power to set standards for auditors and the auditing process of publicly held companies or companies that were moving toward an IPO.

Ott said Sarbanes-Oxley “basically says it is illegal for someone to issue an audit report on the financial statements of a publicly traded company, or somebody who’s in the process of going public, unless that accounting firm is registered with and satisfies the standards of the PCAOB.”

That regulation “basically took a chunk of typically smaller accounting firms out of the business of doing the auditing for smaller public companies or smaller companies that were looking to go public,” added Ott.

Ott said Sarbanes-Oxley “probably” has kept down the number of IPOs since it was passed, and it definitely led many small publicly held companies to go back to being privately held. That was due to section 404, which requires companies to implement internal controls over financial reporting.

“Their outside auditing firm had to come in and attest to the adequacy of the internal controls,” said Ott. “It was a huge and incredibly expensive process for a lot of these companies.”

“Right after Sarbanes passed, a number of companies saw what was coming with the 404 compliance,” said Ott. “They went private — or they ‘went dark’ is the other phrase that people use – but basically they said, look, we don’t need to be public. It’s too expensive. It’s too much of a burden and it’s just not worth it.”

Sarbanes-Oxley was “Congress’s answer to the last financial crisis, where you had lots of accounting scandals. … Given the environment we’re in right now,” if part or all of the act were found invalid by the Supreme Court, “I would think (Congress) could fix it fairly quickly.”

As far as a sudden increase in IPOs, Ott noted that “people are being careful.”

“It’s not a great market to be going out and trying to sell stock right now, either,” he added.

IPOs also take time, said Ott.

“To get a company prepped and ready to go for an IPO takes a while.”

Ott’s legal work has focused on securities offerings, securities compliance, and mergers and acquisitions.

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