Sarbanes Oxley Act - Business Ethics

Sarbanes Oxley Act

Jenny Mead and Robert J. Sack

On July 30, 2002, in response to a series of financial scandals that had rocked the corporate world in the United States, the Sarbanes Oxley Act (SOX), HR 2673, or ‘‘Corporate and Criminal Fraud Accountability Act,’’ was signed into law. After the Enron collapse in the fall of 2001, Senator Paul S. Sarbanes (D, Maryland) pro posed a set of dramatic new laws. However, Representative Michael G. Oxley (R, Ohio) pro posed a set of milder laws. While those two proposals were working their way through the legislative process, the huge fraud at telecommunications giant WorldCom became apparent, and any political support for a milder set of reforms disappeared. In fact, some have suggested that the new Act be called the ‘‘World Com Act.’’ The law was intended to bolster public confidence in the United States’ capital markets and impose new duties and significant penalties for non compliance on public companies and their executives, directors, auditors, attorneys, and securities analysts. The provisions of the new law primarily apply only to public companies filing form 10 K with the Securities and Exchange Commission, their auditors, and securities analysts. 

The Act deals with a wide variety of corporate governance issues, as outlined in the following text, and it is sure to have an impact on many people who work in the finance side of publicly held companies. But there appear to be two areas where the Act will have its most dramatic effect: 

1. The Act requires the chief executive officer and the chief accounting officer of every company of publicly held companies to sign a report that is to be included with every filing the company makes with the Securities and Exchange Commission, stating that they have reviewed the filing and that, to the best of their knowledge and belief, the filing – including the financial statements for the period – contains no material misstatement. They are also required to attest to their belief that the company has an adequate system of internal control, and that the system was effective, as of the date of the report. In the Congressional hearings into the collapse of Enron and WorldCom, a number of the key executives from those firms testified that they did not know about the underlying frauds, that these frauds were the work of their accounting staff people. 
2. These attestation provisions have had a number of interesting effects. Most importantly, many companies have adopted a build up approach to these new responsibilities. The companies have asked the heads of the operating units and the key functional units to sign a similar attestation, forcing those people to think carefully about their own role in their companies’ reports to their stockholders. Following on that new perspective, we have seen at least one chief financial officer resign his post, and send a letter to the company’s audit committee, outlining his concerns about the company’s financial accounting. It is also important to note that the Act contains new protections for whistleblowers. 
3. The Act virtually eviscerates the accounting profession. Under the Act a new quasi governmental body (independent, but under the jurisdiction of the SEC) took over the setting of audit standards, the determination of rules of independence for auditors, the investigation of apparent failed audits, and the enforcement of professional standards and rules. The new board (the Public Company Accounting Oversight Board, or PCAOB) has been staffed with some dedicated people, and it will be interesting to see how the accounting profession evolves under their leadership. 

The major provisions of the Sarbanes Oxley Act are as follows. 

Title I: Public Company Accounting Oversight Board . 

• The five member PCAOB oversees the audit of public companies, establishes audit report standards and rules, and inspects, investigates, and enforces compliance on the part of registered public accounting firms and those associated with these firms. The board, a corporate entity funded by fees imposed on public companies, operates as a non profit corporation that will exist indefinitely until dissolved by Congress, and its decisions are subject to oversight and review by the SEC. To restrict ties to the accounting industry, only two members may be certified public accountants; member terms are five years. 
• Requires auditing standards to include a seven year retention period for audit work papers; a second partner review and approval; evaluation of whether internal control structures and procedures include records that accurately reflect transactions and disposition of assets; only senior man agers and directors may authorize receipts and expenditures; and description of both material weaknesses in internal controls and of material non compliance. 
• Mandates continuing inspections of public accounting firms for compliance, annually for firms providing audit reports for more than 100 issuers and three years for those providing audit reports for less than 100 issuers. 
• The PCAOB is empowered to impose disciplinary or remedial sanctions on registered firms and their associates for intentional con duct or repeated instances of negligent con duct. 
• Directs the SEC to report to Congress on adoption of a principles based accounting system by the US financial reporting system. 

Title II: Auditor Independence 

• Prohibits auditors from simultaneously per forming specified non audit services for a client such as bookkeeping, investment banking, or actuarial services. 
• Requires five year auditor rotation of lead partner. 
• Auditors must report to the audit commit tees on critical accounting policies and practices used in the audit, alternative treatments and their ramifications within GAAP, and material written communications between the auditor and senior management of the issuer. 
• Places a one year prohibition on an auditor performing audit services if the issuer’s senior executives had been employed by that auditor and had participated in the audit of the issuer during the one year period preceding the audit initiation date. 

Title III: Corporate Responsibility 

• Company CEOs and CFOs must certify that financial reports and conditions are accurate and fairly presented. These officers are re sponsible for effective internal controls ensuring that reported information is correct. 
• In the event of accounting restatement of financial material because of non compliance, the CEO and CFO forfeit certain bonuses and compensation from the company. 
• Although required to be on the board, audit committee members must otherwise be independent, with no affiliation with or compensation from the issuer. 
• Company directors and executive officers are banned from trading their company’s stock during pension fund blackouts. 

Title IV: Enhanced Financial Disclosures 

• Financial reports filed with SEC must reflect all material correcting adjustments and disclose all material off balance sheet transactions and relationships that might have affected the financial status of an issue. 
• With some exceptions, a corporation is prohibited from giving personal loans to its executives and directors. 
• Senior management, directors, and principal stockholders must disclose changes in securities ownership of swap agreements within two business days (formerly ten business days) after the close of the calendar month. 
• Annual reports must contain internal control reports stating management responsibility for these controls and assessing their effectiveness. 
• Requires disclosure of whether a company had adopted an ethics code for its senior financial management. 
• Regular and systematic SEC reviews of peri odic disclosures by issuers required. 

Title V: Analyst Conflicts of Interest 

• Restricts investment bankers’ ability to pre approve research reports. 
• Protects analysts from employer retaliation after writing negative analyses of publicly traded companies. 
• Strengthens structural division in registered brokers or dealers between analysts and in vestment bankers. 
• Prohibits supervision of research analysts by people involved in investment banking activity. 
• Establishes blackout periods for broker or dealer participants in a public offering from distributing reports related to the offering. 
• Strengthens full disclosure requirements for research analysts making public appearances and for brokers and dealers in their research reports. 

Title VI: Commission Resources and Authority 

• . Authorizes additional funds for the commission to carry out its functions, powers, and duties. 
• . Expands SEC’s disciplinary authority by allowing it to consider orders of state securities commissions when deciding whether to limit brokers and dealers’ activities, functions, or operations. 
• . Authorizes federal courts to prohibit people alleged to have violated securities laws from participating in an offering of penny stock. 
• . Authorizes the SEC to censure any individual appearing before the commission who has engaged in unethical or improper professional conduct. 

Title VII: Studies and Reports 

. Authorizes the commission to conduct studies on securities professionals who have participated in, but not been penalized for, securities violations; factors leading to consolidation of public accounting firms and the impact of this reduction on the securities market; SEC enforcement actions taken against companies which violate reporting requirements and restatement of financial statements; the role and function of credit rating agencies in the operations of the securities market; and a GAO study of whether investment banks and financial advisors assisted public companies in manipulating their earnings and obfuscating their true financial conditions. 

Title VIII: Corporate and Criminal Fraud Accountability 

. Imposes criminal penalties for obstructing or influencing either a federal investigation or a matter in bankruptcy by concealing, falsifying, destroying, or altering information. Auditor failure to retain review work papers for five year period results in ten year prison sentence. 

. Provides whistleblower protection for employees of a publicly traded company who participate or assist in an investigation of fraud or other misconduct by federal regulators, Congress, or supervisors. 

. Any person who knowingly defrauds share holders of a publicly traded company is subject to a fine or imprisonment of up to 25 years. 

. Certain debts incurred in violation of securities fraud laws are non dischargeable in bankruptcy. 

. Extends the statute of limitations to permit a private right of action for a securities fraud violation to not later than two years after its discovery or five years after the date of the violation. 

Title IX: White Collar Crime Penalty Enhancements 

New penalties imposed for violations: 

• Mail fraud: 20 years, $250,000. 
• Wire fraud: 20 years, $250,000. 
• Violations of the Employee Retirement Income Security Act of 1974 (or pension fund fraud): 10 years, $500,000. 
• Certification of false financial report: 20 years, $5 million. 
• Securities fraud (new provision): 25 years and $250,000. 

Title X: Corporate Tax Returns 

. A corporation’s federal income tax return should be signed by its CEO. 

Title XI: Corporate Fraud Accountability 

• . Amends federal criminal law to establish a maximum 20 year prison term for tampering with a record or otherwise impeding an official proceeding. 
• . Violating the 1934 Security Exchange Act: 20 years, $5 million. 
• . Authorizes SEC to prohibit a violator of rules governing manipulative, deceptive devices, and fraudulent interstate transactions from serving as officer or director of a publicly traded company. 
• . SEC may seek injunction to freeze extraordinary payments earmarked for designated persons or corporate staff under investigation for possible violations of federal securities law.

Bibliography

Bloomenthal, H. S. (2002). Sarbanes Oxley Act in Perspective. St. Paul, MN: West Group.

Hamilton, J. and Trautmann, T. (2002). Sarbanes Oxley Act of 2002: Law and Explanation. Chicago: CCH.