President Bush Signs Corporate Reform LegislationAugust 2002
On July 30th, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act"). As Washington’s response to the recent scandals at Enron, WorldCom, Tyco International, Adelphia Communications and Global Crossing, the Act sweeps broadly in transforming the public accounting industry and reforming corporate disclosure and governance
While the Act applies primarily to publicly-traded companies and the accounting firms that audit them, it may lead over time to the establishment of "best-practice" principles for private companies, regulated financial institutions and smaller accounting firms. This bulletin is intended to provide an executive-level overview of the Act’s provisions.
We would be pleased to answer any questions that result from your review of this summary.
I. ACCOUNTING REFORM
A. Public Accounting Oversight
Congress has assigned much of the blame for the recent corporate failures on a lack of meaningful oversight of the accounting industry and lax independence rules for firms engaged to audit the financial statements of public companies. The Act establishes a new independent governing body, known as the Public Company Accounting Oversight Board (the "Oversight Board"), to set rules and provide oversight to public accounting firms that perform audits on companies registered or required to file reports under the Securities Exchange Act of 1934 (the "1934 Act").
The Oversight Board will consist of five full-time members appointed by the SEC in consultation with the Federal Reserve Board and the Treasury Department, and will remain under the control and oversight of the SEC. Only two members of the Oversight Board may be current or former certified public accountants; if one of those members is the chairperson, that member must not have served in the public accounting industry during any of the previous five years.
The Oversight Board will act as the primary federal regulator of accounting firms that audit public companies. No accounting firm will be permitted to audit a public company until it is registered with the Oversight Board. In addition, the Oversight Board has been charged with compiling a new set of auditing, quality control and ethical standards, conducting investigations to ensure compliance with those standards, and investigating and sanctioning violations of those standards. The Oversight Board is not authorized to establish generally accepted accounting principles ("GAAP"); these principles will remain the domain of the FASB.
The Act also requires public companies to pay fees to fund the Oversight Board and the FASB. Fees will be based on each company’s market capitalization.
B. Auditor Independence
The Act limits the ability of registered public accounting firms to provide non-audit services to audit clients. Nine categories of non-audit services, some of which are already addressed in current SEC regulations, are explicitly prohibited: bookkeeping; financial information system design and implementation; appraisal and valuation; actuarial; internal audit; human resources; broker or dealer, investment advisor, or investment banking; legal and expert; and any other services the Oversight Board determines by regulation.
New constraints are placed on other types of non-audit services that can be provided to audit clients. Specifically, prior approval by the public company’s audit committee must be obtained and disclosed in the company’s SEC filings.
The Act requires registered public accounting firms to rotate the lead and reviewing audit partners for public companies every five years, and commissions a study to evaluate the potential effects regarding mandatory rotation of accounting firms as a whole. In addition, accounting firms are prohibited from issuing an opinion on the financial statements of a public company whose CEO or one of the chief financial or accounting officers was employed by that firm and participated in the prior year’s audit.
C. Auditor Communications with Audit Committee
The Act requires registered public accounting firms to report the following information to a company’s audit committee:
- all critical accounting policies and practices;
- alternative treatments of financial information available under GAAP that were discussed with management;
- the ramifications of applying each methodology; and
- the auditor’s preference as to which treatment is most appropriate.
In addition, the auditor must provide the audit committee with all other material written communications between the auditor and management, including management letters and schedules of unadjusted differences.
II. CORPORATE GOVERNANCE
A. Loans to Public Company Directors and Executive Officers
Effective immediately, a public company is prohibited from making a loan to any of its directors or executive officers. Loans already existing at the date of enactment are "grandfathered" and can continue to be maintained as long as the terms of the loan are not substantially changed and the loan is not renewed.
Certain exceptions are allowed, primarily relating to loans arising in the normal course of business, including the following: home improvement loans; consumer credit; loans under an open-end credit plan; charge cards; and certain credit extended by brokers or dealers already permitted under Federal Reserve rules.
An additional carve-out was included in the Act for loans by insured depository institutions to their executive officers or directors. The financial institutions industry successfully lobbied for this exception by arguing that there is already substantial regulation of these loans under the Federal Reserve Board’s Regulation O.
B. Public Company Audit Committee Standards
The Act sets forth specific independence requirements for a company’s audit committee. Each member of the audit committee must be a member of the company’s board of directors and otherwise be independent. To be considered independent, no audit committee member may accept any consulting or advisory fees from the company and may not be an "affiliated person" of the
company or its subsidiaries. This provision will require companies to examine all relationships between the company and each member of its audit committee.
The Act requires the audit committee to be directly responsible for the appointment, compensation and oversight work of any registered public accounting firm performing audit functions. These registered public accounting firms are required to report directly to the audit committee. The Act clarifies that the audit committee is authorized to engage independent counsel
and other advisors as needed to perform advisory functions, resolve financial reporting disagreements between management and the auditor, and establish procedures to address complaints regarding accounting and auditing matters and ensure the confidentiality and anonymity of employee complaints.
The Act directs the SEC to issue final rules within 180 days requiring public companies to disclose whether or not the audit committee is comprised of at least one member who is considered a "financial expert," as will be defined by the SEC.
C. Corporate Executive Responsibility
By August 29, 2002, the SEC must issue rules requiring corporate CEOs and CFOs to sign and certify in the company’s annual and quarterly SEC reports the following: (1) the officer has reviewed the report; (2) to the officer’s knowledge the report does not make any untrue statement or omit any statement of material fact; (3) to the officer’s knowledge the report fairly presents the financial condition of the company; (4) the officers have established and are maintaining effective internal controls to ensure material information relating to the company and its subsidiaries is made known to the officers; (5) the officers have disclosed to the auditors and audit committee any significant deficiencies that could adversely effect the internal controls or any fraud (whether or not material) that involves management or employees who have a significant role in the internal controls; and (6) the report details any significant changes in the internal controls or in other factors that could affect the internal controls.
A knowing failure to certify these reports is a criminal felony punishable by a maximum fine of $1 million and a maximum prison sentence of ten years. A willful failure increases the maximum fine to $5 million and the maximum prison sentence to twenty years.
If the company is required to prepare an accounting restatement due to material noncompliance with securities law reporting requirements, corporate CEOs and CFOs are subject to the forfeiture of any compensation bonus and profits realized from the sale of securities during the twelve months following the first public issuance or filing with the SEC.
In addition, effective 180 days from enactment, it will be unlawful for any director or executive officer to purchase, sell, or otherwise acquire or transfer any equity security of the company during specified "blackout periods" when the company’s employees are restricted from trading their company stock held in stock benefit plans. If there is a violation, any profit realized by the director or executive officer must be forfeited to the company. The application of this provision will be subject to forthcoming SEC regulations. Companies will be required to provide notification of a "blackout period" to their directors, executives and the SEC.
The Act also requires a company’s individual account plan administrator to provide written notification to plan participants and beneficiaries that shall include: the reasons for the blackout period; an identification of the investments and other rights affected; the dates of the blackout period; and a statement that the participant or beneficiary should evaluate the appropriateness of their current investment prior to the effective dates of the blackout period.
D. Corporate Counsel Responsibility
The SEC will be issuing new rules, no later than January 2003, governing the professional conduct of attorneys who appear and practice before the SEC in any way in the representation of a public company. One rule will require attorneys to report evidence of a material violation of securities law or a breach of fiduciary duty by the company to the company’s chief legal counsel or the CEO. If the appropriate response is not taken by either of these individuals, the attorney has a duty to report to the audit committee or directly to the board of directors.
III. NEW SEC DISCLOSURES
The Act mandates certain additional disclosures. Specifically, the SEC is directed to issue final rules within 180 days of enactment regarding:
- Off-balance sheet transactions and other relationships with unconsolidated entities that could have a material effect on the company’s financial statements.
- "Pro forma" financial information. This information, which could include EBITDA or other non-GAAP financial measures, must not be misleading in any material respect and must be reconciled to the company’s GAAP presentation.
- Adoption of a code of ethics for the company’s senior financial officers. Any change to or waiver of such code of ethics would be subject to "immediate disclosure."
Effective August 29, 2002, the Act shortens the allowable time for filing Form 4 reports, the reports filed by directors, executive officers and 10% shareholders relating to their change in stock ownership of the company. Currently, these reports are due by the tenth day of the month following the change. The Act requires that these reports now be filed by the second business
day following the change. In addition, beginning in not more than one year, these reports will have to be filed with the SEC electronically and posted on the company’s web site.
Annual reports on Form 10-K will be required to contain a statement by management indicating their responsibility for maintaining an adequate system of internal controls, an assessment as to their effectiveness, and a report by the registered public accounting firm attesting to such assessment.
The Act directs the SEC to issue rules requiring public companies to disclose "on a rapid and current basis" and "in plain English" additional information concerning material changes in a company’s financial condition or operations.
The Act further directs the SEC to review the periodic reports of all public companies no less frequently than every three years.
IV. SECURITIES ANALYST CONFLICTS OF INTEREST
By July 30, 2003, the SEC will promulgate new rules to address securities analyst conflicts of interest and disclosure procedures. The conflict of interest rules will be designed to address conflicts that can arise when securities analysts employed by registered brokers or dealers recommend equity securities in research reports and public appearances. The disclosure rules will require securities analysts and registered brokers or dealers to publicly disclose any conflicts of interest that are known or should have been known to exist at the time of the public appearance or date of distribution of a research report.
The Act also prohibits investment banking firms from retaliating against analysts who write unfavorable research reports about the firm’s clients or prospective clients.
V. PENALTIES AND REMEDIES
A. New Felonies Created
The Act creates a new federal obstruction of justice felony, punishable by a fine and up to twenty years imprisonment, for knowingly altering, destroying, concealing, or falsifying records with the intent to obstruct a federal investigation or bankruptcy case. The same penalties are also in place for tampering with records or otherwise impeding an official proceeding.
A new federal record retention policy is also created for accountants conducting an audit. These auditors must maintain all audit workpapers (including, but not limited to, documents, communications, and electronic records) for five years. A willful violation is punishable by a fine and up to ten years imprisonment.
The Act creates a new federal securities fraud felony, punishable by a fine and up to twenty-five years in prison, for knowingly defrauding a person in connection with any security or making a sale or purchase of a security under fraudulent pretenses. Any person conspiring to commit this securities fraud is subject to a felony conviction punishable by the same fine and prison sentence.
Finally, the Act creates a new federal obstruction of justice felony to protect "whistleblowers" by punishing public companies who discharge, demote, suspend, threaten, harass, or discriminate against an employee because that person has furnished information and/or participated in a proceeding relating to a violation of federal criminal mail fraud statutes (including wire fraud, bank fraud and securities fraud statutes), SEC securities rules, or federal rules prohibiting fraud against shareholders.
B. Criminal Penalty Enhancements
Maximum-length prison sentences for mail and wire fraud were increased under the Act from five years to twenty years. The punishment for individuals violating ERISA and related regulations increased from a maximum fine of $100,000 to $500,000 and maximum imprisonment from one year to five years. The fine associated with a company’s violation of ERISA increased
from a maximum fine of $100,000 to $500,000.
C. 1934 Act Violations
The punishment for individuals violating the 1934 Act and related regulations increased from a maximum fine of $1 million to $5 million and maximum imprisonment from ten years to twenty years. The penalty for a company’s violation increased from a maximum fine of $2.5 million to $25 million.
D. Private Actions
The federal statute of limitations for a private right of action that involves a claim of fraud has been extended to five years after the date of a violation, or two years after the discovery of the violation.
E. Investor Restitution Fund
Currently, most of the money the SEC recovers for securities violations goes, not to aggrieved investors, but rather to the United States Treasury. Under the Act, an investor restitution fund is created whereby any money recovered by the SEC in a disgorgement action, including money obtained as a civil penalty, is held in a fund for the benefit of the victims of securities violations.
F. No Bankruptcy Discharge of Securities Law Liability
The Act amends the Bankruptcy Code to make nondischargeable in bankruptcy any liabilities that are incurred as a result of violating federal or state securities laws.
This bulletin is published to provide our friends and clients with current information that may affect their businesses. This information is not intended to serve as specific legal advice or as a solicitation for business.