The Sarbanes-Oxley Act of 2002 represents an important reform of the federal securities laws. It addresses many diverse issues and will significantly change the regulation of public companies. It may also indirectly affect all businesses and their professional advisors.
Key Provisions of the Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (the “Act”) was signed into law by President Bush on July 30, 2002. It was enacted in response to a series of highly-publicized events involving corporate governance, accounting issues and related matters. Among other things, the Act assigns new powers and regulatory responsibilities to the Securities and Exchange Commission (the “SEC”). The Act tightens the regulation of public companies and their directors, officers and professional advisors. The Act may also have the effect of establishing new standards of business and professional conduct that will affect all businesses and their professional advisors.
A full discussion of the complex provisions of the Act and their consequences is beyond the scope of this article. This article does not address provisions unique to foreign issuers, provisions concerning analyst and investment banking relationships and provisions mandating various studies to be undertaken by the SEC and the U.S. Comptroller General. More detailed information can be provided that will address specific situations. A brief overview of some of the key provisions of the Act is set forth below:
Audit Committees - The SEC must require the exchanges to adopt rules governing audit committees of listed companies. Members of audit committees must meet new independence requirements and the audit committee will have greater authority in dealing with outside auditors.
Audits and Auditors - The SEC must adopt rules making it unlawful for any officer or director of an issuer “to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit” of the financial statements of an issuer in an effort to make such financial statements materially misleading. The SEC must adopt rules that expand existing auditor independence requirements, require audit partner rotation at 5 year intervals, require auditor reports to the audit committee, and require that the performance of non-audit services be preapproved by the issuer’s audit committee.
Certifications of Periodic Reports - There are two separate sections, Section 906 and Section 302, governing certifications of periodic reports. Section 906 is effective immediately and carries criminal penalties for knowing or willful false certification. It requires the issuer’s chief executive officer (the “CEO”) and chief financial officer (“CFO”) to certify that the report fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) and that the information fairly presents, in all material respects, the financial condition and results of operation of the issuer. Section 302 requires the SEC to adopt rules requiring that the CEO and CFO make certifications of each annual and quarterly report filed with the SEC which will include statements about internal controls.
Code of Ethics for Senior Financial Officers - The SEC is required to adopt rules requiring disclosure of whether issuers have adopted a code of ethics for senior financial officers and if not, why not. Any change in or waiver of the provisions of such a code of ethics will require disclosure on Form 8-K.
Crimes, Penalties and Civil Actions - The Act establishes new federal crimes with severe criminal penalties concerning (1) destruction of records in federal investigations, (2) destruction of corporate audit records, (3) securities fraud involving a public company, and (4) tampering with documents used in official proceedings. The Act increases criminal penalties for mail fraud, wire fraud and ERISA violations and for “willful” violations of the Exchange Act. The Act makes it more difficult for a securities law violator to obtain a discharge in bankruptcy for disgorgement orders or penalties. The Act provides for review of sentencing guidelines by the United States Sentencing Commission with a view to increasing sentences of certain offenses. The Act also lengthens the statute of limitations for commencement of private civil actions alleging securities law violations in some circumstances and creates a new civil action intended to protect employees of public companies who engage in “whistleblowing” activities.
Disclosure Requirements - The Act requires that (1) financial statements that are required to be prepared in accordance with or reconciled to generally accepted accounting principles GAAP”) must reflect all material correcting adjustments required by GAAP or SEC rules that have been identified by a registered public accounting firm, (2) the SEC adopt rules requiring disclosure of “all material off-balance sheet transactions, arrangements, obligations (including contingent relationships) and other relationships” that have a material current or future financial effect, (3) the SEC adopt rules requiring that pro forma figures be reconciled to GAAP figures in all filings with the SEC, (4) transactions resulting in changes in stock ownership by directors, officers and 10% shareholders generally be disclosed within 2 business days following the execution of the transaction, (5) future annual reports filed with the SEC on Form 10-K must contain an “internal control report”attested to by each registered public accounting firm that prepared the audit report for the issuer, (6) the SEC adopt rules defining a “financial expert” and requiring that each issuer disclose whether at least one member of its audit committee is a financial expert and if not why not, (7) the SEC perform more systematic review of disclosures made by issuers in periodic reports, and (8) the SEC adopt rules requiring disclosure to the public of material events on a rapid and current basis.
Forfeiture of Bonuses and Profits - In the event that accounting restatements are required because of misconduct, the Act provides that the CEO and CFO of the issuer may be required to reimburse the issuer for certain forms of incentive compensation.
Pension Fund Blackout Periods - Trading by directors and executive officers of an issuer in stock acquired in connection with service with or employment by the issuer is prohibited during any pension fund blackout period as defined in the Act. Any profit realized when such trading was prohibited may be recovered by the issuer.
Personal Loans to Executives - With certain limited exceptions, the Act makes it unlawful for any issuer “to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.” This prohibition may preclude future use of some common compensation arrangements.
Professional Responsibilities of Attorneys- The SEC is required to adopt rules of professional conduct for attorneys appearing before the SEC that would require such attorneys to report evidence of material violations of securities laws or breach of fiduciary duty to the issuer’s chief legal counsel or CEO and, in the absence of an appropriate response, to the issuer’s audit committee.
Company Accounting Oversight Board - the Act establishes a new Public Company Accounting Oversight Board (the “Accounting Oversight Board”) which will regulate registered public accounting firms and their associated persons. The Board will perform various regulatory functions, including establishing and enforcing auditing, quality control, ethics, independence and other standards. The Board will function under the oversight of the SEC.
SEC Enforcement Powers - The Act increases the enforcement powers of the SEC by giving it authority to (1) seek a court order freezing funds if it appears likely that an issuer may expend such funds to make extraordinary payments to directors, officers, agents or employees of the issuer, (2) bar an individual from serving as a director or officer of a public company on a temporary or permanent basis through a cease-and-desist administrative hearing, (3) seek from any federal court “any equitable relief” that may be appropriate for the benefit of investors, (4) discipline professionals who practice before the SEC, (5) cause civil penalties to be deposited in a disgorgement fund to be used for the benefit of victims of the violation involved, (6) bar individuals from the securities industry if they have been found to have engaged in fraudulent conduct and barred by a state securities, banking or insurance regulator.
Effective Dates - The Act contains provisions that became effective immediately on July 30, 2002, and provisions that become effective at later dates as described below. Provisions of the Act that became effective immediately include (1) the Section 906 certification requirements, (2) forfeiture provisions triggered by certain accounting restatements, (3) the prohibition of personal loans to executives, (4) the whistleblower protection provisions, (5) the limitations on bankruptcy discharges, (6) the extension of the statute of limitations for private securities fraud actions and (7) the creation of new criminal offenses. Within 30 days the SEC is to issue rules concerning Section 302 certifications and acceleration of reporting of insider transactions. Within 90 days the SEC is to propose various rules to implement the Act. Within 180 days the SEC is to issue final rules concerning responsibilities of attorneys for public companies, reconciliation of pro forma financial statements to GAAP, and disclosure of material off-balance sheet transactions and the bar on trading by directors and officers during pension fund blackout periods becomes effective. Within 270 days the SEC is to issue final rules concerning audit committees. Within one year transaction reports under Section 16 of the Exchange Act be filed electronically and published on the internet within one day following the filing. The deadline for accounting firms that audit public companies to register with the Accounting Oversight Board may extend past the first anniversary of the Act.