The Sarbanes-Oxley Act of 2002 (Act), the corporate reform legislation signed into law by President Bush on July 30, will effect sweeping changes in securities, criminal and other federal laws affecting public companies, public accounting firms, investment bankers, lawyers, and public company directors and executive officers.
The Act has broad implications for the corporate governance and audit and financial reporting process and other disclosure and compensation practices of public companies ("issuers"). Certain provisions of the new law could significantly increase the risks and magnitude of personal liability for the directors and executive officers of public companies. Because of the unexpected speed with which the legislation was passed before Congress’ annual August recess, it is anticipated that several provisions of the Act will result in unanticipated consequences and practical difficulties.
Many provisions of the Act mandate, supplement, preempt or require modifications to, various proposed rule changes that have been pending before the U.S. Securities and Exchange Commission (SEC) and the stock exchanges in response to recent events. In many cases, the Act directs the SEC to adopt rules and regulations (in some cases, as indicated below, within 30 days) necessary or appropriate to clarify and implement the new law.
Highlights of key provisions of the Act summarized below include the following:
- increased regulation and oversight of the accounting profession;
- more stringent auditor and audit committee independence requirements;
- enhanced CEO and CFO certification requirements;
- increased issuer disclosure;
- increased criminal penalties; and
- new professional responsibility standards for attorneys.
Clients and others are encouraged to contact members of the McDermott Will & Emery Corporate Responsibility Practice Group identified at the end of this advisory or their regular McDermott Will & Emery lawyer for further information regarding the Act or other congressional, SEC or other regulatory initiatives concerning securities law, corporate governance and related matters.
Oversight of Accounting Profession
The Act creates a Public Company Accounting Oversight Board to register, oversee, regulate, inspect and discipline public accounting firms, including foreign audit firms whose audit reports are included in SEC filings, and persons associated with such firms. The Board will establish and enforce auditing, quality control, ethics and independence standards and rules.
The five-member Board will be appointed by the SEC (after consultation with the Chairman of the Federal Reserve and Secretary of the Treasury) to staggered five-year terms within 90 days of enactment of the Act. Two, but no more than two, members of the Board shall be or have been certified public accountants.
Public accounting firms registering with the Board will be required to submit detailed information in their registration applications and mandated annual reports, including information regarding their clients, services provided and fees received for audit, non-audit and other accounting services. Public accounting firms will be required to pay registration and annual fees to cover the costs of processing and reviewing applications and annual reports.
The SEC will have oversight and enforcement authority over the Board funded by new fees imposed on publicly traded companies based on their market capitalization. The Act requires the Board to be ready to discharge its duties pursuant to the Act within 270 days of the Act’s enactment.
Subject to exemptive authority granted to the SEC, the Act amends the Securities Exchange Act of 1934 (Exchange Act) to prohibit registered public accounting firms from performing for an issuer audit client any of the following services (some of which are already prohibited) by regulation:
- bookkeeping and similar services;
- 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 or dealer, investment advisor or investment banking services;
- legal services and expert services unrelated to audit, and
- any other services proscribed by the Board.
In addition, subject to de minimis exceptions and exemptive authority granted to the SEC, the provision of other non-audit services by outside auditors (such as tax services) will require pre-approval by the issuer's audit committee and disclosure of such approval in periodic reports filed by the issuer with the SEC.
The lead or coordinating audit partner with responsibility for an issuer’s audit must be rotated at least once every five years and the legislation directs that a study be done by the U.S. Comptroller General as to the advisability of a law requiring issuers to rotate audit firms periodically. The Act also precludes an audit firm from serving as outside auditor to an issuer where a former employee of the audit firm is working as a CEO, CFO, controller or chief accounting officer within a year of the individual’s participation in the audit firm's audit of the client.
Audit Committee Independence
Not later than 270 days after the Act’s enactment, the SEC shall require that the listing standards of the stock exchanges and Nasdaq will mandate that audit committees be composed solely of "independent" members, with the board members qualifying as independent being only those who receive no compensation from the issuer other than directors’ fees and who are not "affiliated persons" (a term not defined in the Act) of the issuer or its subsidiaries. This requirement appears to go beyond a recommended change to the New York Stock Exchange listing standards that would have reserved some discretion to boards of directors to determine whether or not direct or indirect relationships between a director and the issuer are material to the ability of the director to act independently.
The Act also mandates that audit committees have direct responsibility for hiring and overseeing the work of the auditors, establish procedures for the receipt and handling of anonymous submissions from employees regarding questionable accounting practices, and receive reports from the auditors regarding the issuer’s critical accounting policies and material communications between the auditors and company management.
CEO and CFO Certifications
Subject to possible civil and criminal penalties for false certifications, commencing upon a final SEC rule to be implemented within 30 days of the enactment of the Act, CEOs and CFOs of all issuers will be required to certify, to the best of their knowledge, as to the accuracy and completeness of each quarterly and annual report, that the financial statements in the report present fairly the company’s financial condition and results of operations, and that they have evaluated the adequacy of the issuer’s internal controls. This provision of the Act is in addition to the SEC order of June 27, 2002, requiring one-time sworn statements by the CEOs and CFOs of the largest 947 U.S. based public companies, but is substantially similar to a pending SEC rule proposal (SEC Release No. 34-46079, issued June 17, 2002) to require certifications on an on-going basis.
The Act also adds another certification provision to federal criminal law under which the CEO and CFO are required to certify that Exchange Act reports comply with securities laws and the information in such reports present fairly the issuer’s financial condition and results of operations. A CEO or CFO that knowingly files a false certification may be fined up to $1 million and/or imprisoned for up to 10 years. A willful violation is punishable by a fine up to $5 million and/or imprisonment of up to 20 years.
Disgorgement of Compensation and Stock Sale Profits by CEOs and CFOs upon Restatements Due to Misconduct
The Act requires forfeiture of certain bonuses and profits realized by the CEO and CFO of a company that is required to prepare an accounting restatement due to the issuer’s "material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws." Specifically, the CEO and CFO must reimburse to the issuer any bonus or other incentive- or equity-based compensation received, and any profit realized from the sale of the issuer’s stock sold, during a specified recapture period. Reimbursement is required whether or not the CEO or CFO engaged in or knew of the misconduct. The "recapture period" is the 12-month period following "the first public issuance or filing with the SEC (whichever first occurs) of the financial document embodying such financial reporting requirement."
Prohibition of Personal Loans to Senior Executives
Effective on enactment, the Act prohibits "personal loans" to executive officers and directors subject to certain narrow exceptions. It is unclear how this prohibition will apply to standard executive compensation practices, such as employee relocation loans, cashless stock option exercises and other arrangements.
Retirement Fund Blackout Periods
Effective 180 days after enactment of the Act, directors and executive officers will be prohibited from purchasing or selling the issuer’s equity securities during certain "black-out periods" imposed on tax-qualified defined contribution plans, such as Section 401(k) plans. In general, a "blackout period" is defined under the Act as a temporary suspension of trading in company stock of more than three days applicable to fifty or more plan participants. The prohibition on purchases or sales is "with respect to such equity security if such director or officer acquires such equity security in connection with his or her service or employment as a director or executive officer." This provision is subject to certain exceptions and further SEC rulemaking and clarification.
Investor Restitution Fund
The Act provides that civil penalties levied by the SEC as a result of any judicial or administrative action brought by the SEC under the securities laws will be directed to a fund for the benefit of harmed investors. This provision also requires the SEC to study and develop better methods to more fairly provide restitution to injured investors and improve collection rates.
Off-Balance Sheet Transactions and Pro Forma Financial Information
The Act mandates final rules from the SEC within 180 days of enactment of the law regarding enhanced financial information disclosures in periodic reports filed with the SEC, including information on off-balance sheet transactions and reconciliation of any "pro forma" financial information to that resulting from application of generally accepted accounting principles.
Each report that contains financial statements filed with the SEC must reflect all material correcting adjustments identified by the auditor.
The Act will require issuers to disclose "on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer" as the SEC determines is necessary or useful. This provision appears consistent with a pending SEC proposal (SEC Release No. 34-46084, issued June 17, 2002) to add 11 new items that a reporting company would be required to file under Form 8-K, including the following:
- entry into a material agreement not made in the ordinary course of business;
- termination of a material agreement not made in the ordinary course of business;
- termination or reduction of a business relationship with a customer that constitutes a specified amount of the issuer’s revenues;
- creation of a direct or contingent financial obligation that is material to the issuer;
- events triggering a direct or contingent financial obligation that is material to the issuer, including any default or acceleration of an obligation;
- exit activities including material write-offs and restructuring charges;
- any material impairment;
- a change in a rating agency decision, issuance of a credit watch or change in an issuer’s outlook;
- movement of the issuer’s securities from one exchange or quotation system to another, delisting of the issuer’s securities from an exchange or quotation system, or a notice that an issuer does not comply with a listing standard;
- conclusion or notice that security holders no longer should rely on the issuer’s previously issued financial statements or a related audit report; and
- any material limitation, restriction or prohibition, including the beginning and end of lock-out periods, regarding the issuer’s employee benefit, retirement and stock ownership plans.
The proposal would also move the following two items from other Exchange Act reports to Form 8-K:
- unregistered sales of equity securities by the issuer and
- material modifications to rights of holders of the issuer’s securities.
Also, the proposal would shorten the filing deadline for Form 8-K to two business days after an event triggering the form's disclosure requirements.
Accelerated Insider Transaction Reporting
Officers and directors subject to the short-swing reporting and profit recapture provisions of Section 16 of the Securities Exchange Act of 1934, will be required under new rules the SEC is directed to adopt within 30 days of the law’s enactment to report their transactions in their company’s stock and related derivative securities electronically within two business days (unless the SEC determines that two days is not feasible). This provision of the Act and subsequent SEC rulemaking, and the prohibition in the Act on loans to insiders, appears to render unnecessary much, but not all, of a pending SEC proposal to require companies to report insider stock and loan transactions and information on so-called Rule 10b5-1 plans, on a real time basis (SEC Release No. 34-45742, issued April 12, 2002).
Financial Expert on Audit Committee
Issuers will be required to disclose whether - and if not, why not - at least one and which member of the audit committee is a "financial expert" as defined by the SEC in further rulemaking under specified guidelines set forth in the Act.
Code of Ethics for Senior Financial Officers
Issuers will be required to disclose whether - and if not, why not - it has a code of ethics for senior financial officers. Subsequent waivers or changes to this code must be promptly disclosed on a Form 8-K.
SEC Reviews of Periodic Filings
The Act will require the SEC to review the periodic reports of each issuer at least once every three years and provides criteria for the SEC to consider in prioritizing reviews, including, among others, the occurrence of a restatement, volatility in an issuer’s stock price, size of market capitalization and emerging companies with disparities in price to earnings ratios. The Act also provides for a significant increase in SEC funding (to $776 million in fiscal 2003).
Analyst Conflicts of Interest
The SEC will be required under the Act to adopt rules to enhance protections against conflicts arising between the provision of securities research and investment banking.
Expanded Criminal Penalties, Non-Discharge of Securities Claim Liabilities in Bankruptcy and Whistleblower Provisions
The Act provides for enhanced criminal penalties for a broad array of white-collar crimes and an increase in the statute of limitations for securities fraud lawsuits. The statute of limitations for private rights of action with respect to securities fraud is extended to the earlier of two years after the discovery of facts constituting the violation or five years after the violation.
The Act will make it a crime for an officer or director of an issuer to fraudulently influence, coerce, manipulate or mislead an independent auditor in the performance of an audit. The Act also imposes criminal penalties for the destruction, alteration and falsification of documents in federal investigations and bankruptcy proceedings, extends the maximum prison term to 25 years for securities fraud, enhances white-collar crime penalties and imposes corporate fraud accountability.
Debts arising from claims that result from violations of securities law cannot be discharged in bankruptcy.
In addition, the Act provides for a temporary freeze on extraordinary payments to employees of companies under investigation by the SEC and makes it a crime to retaliate against corporate whistleblowers.
Professional Responsibility Standards for Attorneys
The Act requires the SEC to establish minimum standards of professional conduct for attorneys appearing and practicing before the SEC in any way in the representation of issuers, including a rule:
- requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the chief executive officer of the company (or the equivalent thereof); and
- if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee of the board of directors of the issuer or to another committee of the board of directors comprised solely of directors not employed directly or indirectly by the issuer, or to the board of directors.
Application to Foreign Issuers and Companies in Registration
The Act defines issuer as "an issuer (as defined in section 3 of the Securities Exchange Act of 1934…), the securities of which are registered under section 12 of that Act ...or that is required to file reports under section 15(d)." It makes no distinction between a U.S. company and a foreign issuer. This means that unless and until the SEC exempts foreign issuers, the provisions of the Act, including for example, the immediate prohibition on loans to officers and directors, will apply to foreign companies. In addition, for the first time, a foreign issuer will be subject to various provisions of federal securities laws that did not previously apply or that the stock exchanges routinely waived, such as audit committee composition and independence rules, signature and certification requirements, among others.
The definition of issuer for purposes of the legislation also includes a company that has filed a registration statement with the SEC that has not yet become effective or been withdrawn.