On July 30, President Bush signed into law the Accounting Industry Reform Act of 2002 (formally, the Sarbanes-Oxley Act of 2002). The Act imposes myriad and significant new changes in both auditing practices and corporate responsibility. Although widely covered in the press, the Act is far wider in scope than commonly reported on television and in print. In this month’s Report , we’ll dig deeply into the Act’s prohibitions and dictates, and see what it means for auditors, public companies, and the men and women who manage them.
New Corporate Responsibility Rules
Perhaps of greatest personal interest to company managers will be the Act’s corporate responsibility rules, found in Title 3 of the Act. First, CEOs and CFOs are required to certify that an issuer’s financials, as disclosed in periodic SEC filings, fairly present the operations and financial condition of the issuer. CEOs and CFOs are required to forfeit certain bonuses and compensation received following an issuer’s accounting restatement due to noncompliance with securities laws. Serious and knowing violations of financial certification can result in jail time–up to 10 years for the most egregious misconduct.
Second, courts are authorized to permanently bar SEC rule violators from serving as an officer or director of an issuer if the person’s conduct demonstrates unfitness to serve. The current standard is “substantial unfitness”.
Insider trades will be prohibited during pension fund “blackout periods” of 3 days or more, and profits from such trades will be recoverable from insiders. This provision grows directly from a widely reported Enron device that operated as follows: Enron managers would switch pension plan administrators–effectively freezing all trading in pension accounts during the changeover. Thus, rank-and-file employees were prevented from making sales of Enron stock in their pension accounts; meanwhile upper-level managers dumped stock. Blackout periods, if triggered, must be reported to directors, and executive officers, and the SEC.
The Act vests an issuer’s audit committee with responsibility for the appointment, compensation, and oversight of its auditor. Committee members must serve on an issuer’s board of directors, but must otherwise be independent.
Auditor Independence Rules
The Act amends the Securities and Exchange of ’34 to prohibit auditors from performing a wide range of non-audit services on behalf of issuers, with small exceptions. The issuer’s “audit partner” must change at least every 5 years. The Act prohibits an auditor from performing audit services for an issuer if the issuer’s senior management officials had been employed by such firm and participated in the audit of that issuer during the one-year period preceding the audit initiation date.
Public Company Accounting Oversight Board
The Act establishes the Public Company Accounting Oversight Board to (1) oversee the audit of public companies, (2) establish audit report standards and rules, and (3) investigate, inspect, and enforce compliance relating to registered public accounting firms. The SEC will enjoy general oversight of the Board, and the power to review Board actions. All public auditors must register with the Board, submit an application with annual fees, and submit annual reports.
Enhanced Financial Disclosures & Enhanced Conflict of Interest Prohibitions
The Act directs the SEC to do the following:
* Enact rules to require disclosure of all material off-balance sheet transactions and relationships.
* Enact rules to require the presentation of pro forma financial information in a manner that is not misleading.
* Issue rules requiring a code of ethics for issuers’ senior financial officers.
* Prescribe rules mandating inclusion of an internal control report and assessment within annual reports.
Issuers may no longer make personal loans to corporate executives (with very limited exceptions). Changes in ownership of securities by principal stockholders and executives must now be reported in 2 days, rather than 10 days.
Analyst Conflict of Interest Rules
The Act directs the SEC to adopt rules governing securities analysts’ potential conflicts of interest (and requiring the disclosure of conflicts), including the following:
* Restricting the prepublication clearance or approval of research reports by persons either engaged in investment banking activities, or not directly responsible for investment research.
* Limiting the supervision and compensatory evaluation of securities analysts to officials who are not engaged in investment banking activities.
* Prohibiting a broker or dealer involved with investment banking activities from retaliating against a securities analyst as a result of an unfavorable research report that may adversely affect the investment banking relationship of the broker or dealer with the subject of the research report.
* Establishing safeguards to assure that securities analysts are separated within the investment firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision.
Corporate and Criminal Fraud Accountability
The Act amends Federal criminal law to prohibit knowingly destroying, concealing, or falsifying records with the intent to obstruct or influence an investigation, and auditor failure to maintain for five years all audit or review work papers. It directs the SEC to promulgate regulations regarding the retention of audit records containing conclusions, opinions, analyses, or financial data.
Certain debts resulting from violations of federal or state securities law or due to fraud will no longer be dischargeable in bankruptcy. Furthermore, the U.S. Sentencing Commission (it drafts federal sentencing guidelines) is instructed to review and amend sentencing guidelines for obstruction of justice, record destruction, fraud, and organizational criminal misconduct. Finally, any person who defrauds shareholders of a public company is subject to fines and/or imprisonment.
The Mixed Bag
Peppered throughout the Act are various provisions mandating studies and reports, and increasing appropriations to the SEC, and authorizing additional SEC enforcement personnel.
When Does the Act Take Effect?
The Act is wide-ranging, and its implementation schedule depends on the provision. Some provisions require the SEC to make changes to existing rules, which will not be effective until enacted. The Act will be completely implemented 270 days from July 30, the day of its passage.
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Michael Spadaccini is the author of 8 books on self-help legal matters such as, Ultimate LLC Compliance Guide: Covers All 50 States (Ultimate Series), Ultimate Book of Forming Corps, LLCs, Partnerships & Sole Proprietorships, and Ultimate Guide to Forming an LLC in Any State, Second Edition (Ultimate Series).
You can view his Amazon Author Profile Here.