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Alarmed by what it perceived to be an epidemic of corporate and accounting
fraud, Congress passed the Sarbanes-Oxley Act of 2002. It revolutionized
the nature of the public corporation in the United States—making what
is perhaps the most significant body of new securities law in 70 years.
More than just new regulations addressing the relations between corporations
and their shareholders, it changes decades—generations—of
corporate practices and corporate governance, of accounting practices,
of traditions and responsibilities in the legal profession, and in financial
firm practices.
The new Sarbanes-Oxley Act . . .
• Mandates new rules regarding the composition and duties of boards of
directors, putting greater responsibilities on the boards’ audit committees.
No longer can boards be comprised of barely qualified relatives
and friends, but must include a majority of independent outsiders. The
audit committee, now at the heart of corporate financial certification,
can no longer be comprised of insiders with little or no financial expertise,
but must now include outsiders with proven financial statement
expertise. Retaining and monitoring the corporation’s auditors, auditor
consulting contracts, and 401(k) plans are no longer the province of
management, but are now the purview of the audit committee. This is
a radical reversal of corporate practice, and takes from the hands of
management a great deal of traditional responsibility for financial controls
and puts more responsibility on the Board of Directors. Under
these rules, the failure of directors and officers to comply with the new
requirements would constitute a breach of duty of care, and the SEC
might declare an individual unfit to be a public officer or director, with
substantial personal penalties.
• Creates a new structure to oversee the accounting profession for publicly
traded companies. The new Public Company Accounting Oversight
Board (PCAOB) is required to review annually all CPA firms that serve
publicly traded companies. All public accounting firms must be registered
by the PCAOB in order to be eligible to audit public companies.
For decades, the accounting profession has relied on self-regulation,
and has fought off congressional and other governmental attempts at
regulation from outside the profession. However, following a rash of
cases in which accounting firms were found to have severely violated
accounting rules, and certainly following the demise of Arthur Andersen,
one of the world’s largest accounting firms, for its role in the Enron
scandal, the government felt it could no longer rely upon the accounting
profession to regulate itself. Thus, PCAOB.
• Makes it a crime to destroy or conceal documents in order to impede a
federal investigation. Arthur Andersen’s shredding material documents
was integral to the fraud case against Enron and the accounting firm.
• Limits consulting practice as part of the accounting and audit practice.
What had begun some decades ago as an auditor’s service to
clients, assisting in non-accounting related business consulting and in
establishing and managing a client’s financial systems and controls,
ultimately began to grow beyond the boundaries of true independence.
What actually happened in most cases was that the consulting
practice of a client-CPA relationship became so lucrative that some
accounting firms couldn’t resist client entreaties to fudge an audit to
keep the consulting business. This is one of the significant practices
that led to a rash of corporate scandals, and that precipitated the
Sarbanes-Oxley Act.
• Requires CEOs and CFOs to certify the accuracy of financial reports.
Following the scandals, it became clear that either the CEOs and CFOs
were completely ignorant of the financial aspects of their companies, or
that they were using ignorance to excuse themselves from responsibility
for their companies’ fraud. They can no longer say, in effect, “I didn’t
know the gun was loaded.”
• Requires that managers annually report on the effectiveness of internal
control over financial reporting, and that auditors regularly scrutinize
and evaluate these controls. This regulation implementing
Section 404 of the Sarbanes-Oxley Act puts a spotlight on internal
controls, and demands strict establishment and management of these
controls. A discussion of the internal controls must be included
in annual reports. While companies have used internal financial
controls to protect the company against fraud and other unethical
behavior, management must now acknowledge that responsibility, and
have the efficacy of these controls assessed and attested to by the
company’s auditors.
• Forces CEOs to give up gains from stock options and bonuses granted
on the basis of false reporting. It also makes it easier to criminally prosecute
corporate executives who destroy evidence (as was done in the
Enron and other cases) or to defraud investors. Lying to the SEC and
otherwise committing fraudulent acts now means extensive fines
and lengthened prison terms imposed by the Justice Department and
States Attorneys general. The SEC has civil authority to levy fines
and restrain the perpetrator from further participation in the securities
markets, and serving as an officer or director of a public company.
• Requires executives to disclose their stock sales within two days, which
is a weapon against insider trading.
• Requires shareholder approval of option plans, as part of the effort to
increase shareholder democracy.
• Creates a raft of new filing regulations, including limitations on the use
of non-GAAP (Generally Accepted Accounting Principles) financial
measures. Regulation G adds to the general disclosure principles of the
anti-fraud provisions of the 1934 Securities Exchange Act. It provides
that if a registrant furnishes to the SEC or publicly discloses a non-
GAAP financial measure it must first make a presentation of the most
directly comparable financial measure calculated in accordance with
GAAP, and then provide a reconciliation that’s quantitative for both
historical and prospective measures of the differences between the non-
GAAP financial measure and the most directly comparable GAAP
measure. NIRI’s Louis Thompson notes that “Congress and the SEC
wanted to take the mystery out of earnings, and help investors understand
a company’s true results. I also believe,” he added, “that there’s
a recognition at both the SEC and FASB (Financial Accounting Standards
Board) that GAAP itself is not an end all.” Professor Baruch Lev,
of the Stern School of Business at New York University, is quoted in the
NIRI publication Standards of Practice For Investor Relations, as
pointing out that more than half of the average S&P 500 company’s
market value is due to intangible assets. Regulation G also says that
releases must be posted on the company’s web site, which, Thompson
points out, alters the way news is to be disseminated.
• Allows workers to diversify 401(k) plans away from company stock
holdings after being at the firm for 3 years.
• Requires the SEC to formulate rules preventing analysts’ conflict of
interest.
• Mandates corporate codes of ethics.
The radical nature and stringency of Sarbanes-Oxley controls were,
naturally, not universally greeted with joy by every segment of management.
A question arose about the effect of the Act on the role of the chief
financial officer, whose duties under the Act were most affected. The Act,
for example, requires that authority to hire external auditors now goes to
the board’s audit committee—and takes it away from the CFO. Yet, a poll
by CFO magazine of more than 300 senior finance executives finds them
split on whether the governance reforms enacted by the Act are worth the
considerable effort of implementing them. They are also divided about
whether CFOs should work merely to satisfy the letter of the law or go further
and embrace its spirit.
The poll showed, however, that despite the shift of responsibility mandated
by the Sarbanes-Oxley, fully 70 percent of finance executives believe
the CFO’s standing ultimately will be enhanced. Talks by the magazine’s
editors with finance executives, academics, activists, and experts in the
governance field strongly suggest that the emergence of these more influential
finance chiefs will depend in large measure on their response to a new
corporate world in which power is more diffuse and penalties are substantially
increased.
In the months following the enactment of Sarbanes-Oxley, the cost of
compliance increased substantially for the 14,000 companies that trade
publicly. One estimate is that the annual cost of being public nearly doubled,
from $1.3 million to almost $2.5 million. Several companies are said
to have withdrawn initial public offerings because of the compliance costs.
And yet, the beginning of 2004 showed an increase in new offerings, which
simply means that the need for capital trumps the cost of capital and the
efforts to get it. FedEx reported that implementation of Section 404 alone
cost approximately $20 million.
At the same time, as Sarbanes-Oxley is integrated into the corporate
practice, it’s proving its ability to define best corporate practice. And by
demonstrating compliance, it informs the investor of corporate integrity.
An interesting sidebar to Sarbanes-Oxley is that an increasing number
of non-public companies, not required to abide by Sarbanes-Oxley regulations,
are nevertheless doing so. They say that the regulations serve as models
of good management. Furthermore, should they ultimately go public,
their experience in complying with the law should help them in the marketplace.
This is also true with foreign-based companies listed on the NYSE
and NASDAQ as ADRs.
Most significantly, the SEC and the U.S. Department of Justice have
already begun to indict corporate officers who have violated statutes of Sarbanes-
Oxley. Sarbanes-Oxley is not an empty drum.
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