Corporate
Aug. 7, 2002
New Law Targets Corporate Officers and Accounting Firms
Focus Column - By Andrew B. Serwin
By Andrew B. Serwin
"Corporations have neither bodies to be punished, nor souls to be condemned, they therefore do as they like." Lord Edward Thurlow, English jurist, "The Oxford Dictionary of Quotations" (5th ed. 1999).
Concerns about corporate malfeasance are not unique to this time. Indeed, it seems that major economic events, particularly when they occur in less than thriving economic times, drive concerns about corporate responsibility to the forefront of the American political agenda.
In the 1930s, these concerns led to the enactment of the federal securities laws, which are now an indispensable portion of the legal fabric of this country.
The almost daily reports of an accounting scandals and large corporate bankruptcies recently led Congress and President Bush to enact a law that embodies some of the most sweeping corporate reforms ever aimed at publicly held companies. And while the condemnation of souls is not an element of the act, there will be many bodies for the judiciary to punish.
HR3763, the Sarbanes-Oxley Act of 2002, signed into law on July 30, represents a marked departure from prior attempts at corporate reform. While previous statutory schemes focused almost exclusively on the corporation's conduct, this law focuses attention on the conduct of corporate officers and public accounting firms.
The act does not simply set standards; it greatly increases the Security and Exchange Commission's ability to enforce these more stringent requirements because the SEC is to receive an additional $776,000,000 to carry out its duties.
There are several key changes with which all publicly held companies, and the accounting firms that serve them, must become acquainted in the near future. Some changes will affect the content of SEC filings that, for many companies, must be completed in the next several weeks.
• Officers and directors. One issue of obvious concern to lawmakers was addressing the perception that corporate officers could exert influence over the company's auditors. The act prohibits any officer or director, or any person acting under their direction, from taking any action to fraudulently influence, coerce, manipulate or mislead auditors. This is but the beginning of the new requirements on corporate officers, which include certification requirements related to financial accuracy and internal controls.
The act's new certification requirements relate to a company's periodic reports - its Form 10-K and 10-Q reports. The chief executive officer and chief financial officer must sign a certification that the company's periodic reports do not contain any untrue statement of a material fact or omit a material fact necessary to make the statements not misleading and that the financial statements, and other financial information in the report, fairly present, in all material respects, the financial condition and results of operations of the company for the periods presented in the report.
These corporate officers also have additional certification requirements and responsibilities relating to the internal controls of the companies that they manage. The certifying officers must establish, maintain and design internal controls to ensure that other corporate officers or employees provide them with material information related to the company and its consolidated subsidiaries.
In addition to certifying the existence of these internal controls, the signatories also must acknowledge that they have evaluated the efficacy of the company's internal controls within the 90 days preceding the filing of the report and that the periodic report discloses the conclusions of their evaluation regarding the effectiveness of the internal controls.
The certification also must state that the chief executive and chief financial officers have reported to the company's auditors and audit committee of the board of directors information regarding all significant deficiencies in the design or operation of internal controls that could adversely affect the company's ability to record, process, summarize and report financial data.
The report also must identify any material weaknesses in internal controls, as well as any fraud, whether or not material, that involve management or other employees who have a significant role in the company's internal controls. It also must report whether there were significant changes in internal controls or in other factors that could have a significant impact subsequent to the evaluation date. Any recommendations regarding corrective actions for significant deficiencies and material weaknesses also must be contained in the report.
A certification that the report complies fully with the requirements of the Securities Exchange Act of 1934 and that the report fairly represents, in all material respects, the financial condition of the company also is required. The act imposes significant fines and criminal penalties on officers who knowingly or willfully file a report that does not comply with these requirements.
While certain portions of the certification requirements become effective within the next 30 days, the portion of the certification requirements that can result in criminal sanctions became effective immediately and is a required element the Form 10-Q filings that many companies must file on or before Aug. 14.
• Public accounting companies. Perhaps the most striking new requirement contained in the act is the creation of a Public Company Accounting Oversight Board. The SEC is to organize the board within 270 days of the effective date of the act, and the SEC will have ultimate supervisory responsibility. The SEC and the board are required to coordinate their investigations.
The act grants the board broad supervisory, investigative, disciplinary and enforcement powers over public accounting firms, including the power to:
• Enforce mandatory registration of public accounting firms that prepare audit reports for publicly held companies.
• Establish auditing, quality control, ethics and independence standards, as well as other standards relating to the preparation of audit reports.
• Enforce compliance with the act, as well as any rules or regulations promulgated under the act.
• Conduct inspections of registered public accounting firms.
• Conduct investigations and disciplinary proceedings, including imposing appropriate sanctions, where justified, regarding registered public accounting firms and people associated with such firms.
While discretion exists regarding the adoption of professional standards, the act has set forth certain minimum requirements, including the requirement that public auditors prepare and maintain audit work papers for a minimum of seven years, provide for a concurring or second partner review of each audit report and describe in each audit report the scope of the auditor's testing of the internal control structure and procedures of the company.
The board also has been given the amorphous mandate of enforcing other duties or standards that it, or the SEC, determines are "necessary or appropriate" to promote high professional standards with respect to auditors and audit reports or to otherwise carry out the act.
Another major change regarding public accounting firms is the new prohibition on accounting firms offering "nonaudit" services to companies for whom they perform audits. These nonaudit services include:
• Bookkeeping or other services related to the accounting records or financial statements of the audit client.
• Financial information systems design and implementation.
• Appraisal or valuation services, fairness opinions or contribution-in-kind reports.
• Actuarial services.
• Internal audit outsourcing services.
• Management functions or human resources.
• Broker, dealer, investment adviser or investment banking services.
• Legal services and expert services unrelated to the audit.
• Any other services that the board determines, by regulation, are impermissible.
If a company wants to utilize the public accounting firm to perform nonaudit functions, the audit committee of the company must give the company advance approval. This approval also must be disclosed to investors in the company's Form 10-Ks and Form 10-Qs.
The act also places new internal restrictions on public accounting firms. First, the partners in charge of conducting a company's audit and review must be "rotated" to another assignment every five years, apparently in order to promote auditor independence.
Moreover, there is a prohibition on accounting firms performing an audit for a company if the company's chief executive officer, controller, chief financial officer, chief accounting officer or any person in an equivalent position was employed by the public accounting firm within one year of the performance of an audit.
• Disgorgement of executive compensation and restrictions on trading. Concerns over lack of executive accountability for corporate misconduct led lawmakers to place severe financial penalties on chief executives and chief financial officers. If, as a result of misconduct, a company is required to prepare an accounting restatement due to the company's material noncompliance with any financial reporting requirements of the security laws, the chief executive officer and the chief financial officer must reimburse the company for:
• Any bonus or other incentive-based or equity-based compensation received by that person from the company during the 12-month period following the first public issuance or filing with the SEC (whichever occurs first) of the financial document embodying such financial reporting requirement.
• Any profits realized from the sale of securities of the company during that 12-month period.
There are also new restrictions on executives' sale of securities that result from recent allegations that companies permitted executives to sell securities while simultaneously precluding lower-level employees from trading in their pension funds.
With certain exceptions, it is now unlawful for any director or executive officer to purchase, sell or otherwise acquire or transfer any equity security of the company during a company-imposed "pension fund blackout period," thus placing the executives in the same position as all other employees.
While these changes themselves are significant, there are likely to be other significant reforms because the SEC and the Public Accounting Oversight Board have been granted broad authority to make rules. As such, standards and requirements are likely to evolve over time. Companies that are not mindful of the changes could run afoul of the new requirements quite easily.
Andrew B. Serwin is a senior associate in Baker & McKenzie's San Diego office. His practice emphasizes complex civil litigation, including securities and unfair competition litigation, and transactional matters related to corporate governance.
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