Dramatic Changes to Corporate Governance for Public Companies and New Framework for Oversight of Auditors
Note to Reader: The following update summarizes the Sarbanes-Oxley Act of 2002 and reflects developments through August 1, 2002.
Many provisions of the Act must be implemented through SEC rulemaking which will occur during the remainder of 2002 and throughout
the first half of 2003. Please consult MoFo's website for additional updates summarizing SEC rulemaking initiatives and other
developments occurring after August 1, 2002.
On July 30, 2002, the President signed into law the "Sarbanes-Oxley Act of 2002" (the "New Law"). The New Law will result
in broad corporate and accounting reform for public companies and the accounting firms that audit them. Many provisions of
the New Law are effective immediately, or by August 29, 2002, and others will require immediate planning to address rule changes
that will occur over a longer timeframe. Public companies may need to make immediate changes to comply with certain aspects
of the New Law including the following:
- prohibition of most loans to the company's directors and executive officers (and equivalents thereof);
- the chief executive officer ("CEO") and chief financial officer ("CFO") of a public company must certify each Securities and
Exchange Commission ("SEC") periodic report containing financial statements;
- audit committee approval of any services provided to the company by the audit firm with certain exceptions for de minimis
services;
- review of audit committee membership to confirm compliance with requisite independence and experience standards;
- all SEC periodic reports that contain financial statements in accordance with or reconciled to generally accepted accounting
principles ("GAAP") must reflect all "material correcting adjustments" that have been identified by the company's audit firm;
- required "real time" reporting by the company of certain material changes in the financial condition or operations of the
company;
- new whistleblower protections for employees who come forward with information relating to violations of the federal securities
laws; and
- potential compensation disgorgement provisions applicable to the company's CEO and CFO upon a restatement of financial results
attributable to misconduct.
Public companies may need to make rapid changes to comply with the following aspects of the New Law that will become effective
by August 29, 2002:
The New Law also provides a number of extremely important changes to the liability and penalty provisions of the federal securities
laws including new and expanded criminal penalties governing various securities law violations and significant changes in
the statute of limitations applicable to private securities law enforcement actions. This latter group of changes as well
as other provisions of the New Law may usher in a new wave of private securities class action litigation in connection with
actual and alleged securities law violations.
What Companies are Affected by the New Law?
The New Law is structured to cover a broad range of companies. Any company with a class of securities registered under section
12 of the Securities Exchange Act of 1934 (the "Exchange Act") or required to file reports under section 15(d) of the Exchange
Act must comply. In addition, any company that files or has filed a registration statement that has not yet become effective
under the Securities Act of 1933 (the "Securities Act"), and that it has not withdrawn, also will be covered. Therefore, foreign
private issuers, small business issuers, and private companies that have filed an IPO registration statement must be aware
that changes implemented by the New Law would apply to them unless specifically excluded by the New Law, the Exchange Act,
the Securities Act or rule. For example, the New Law generally prohibits a private company that has filed an IPO registration
statement from making personal loans to the company's directors and executive officers; however, the New Law's certification
requirement does not apply to such private companies because private companies are not required to file annual reports or
quarterly reports with the SEC until after their Exchange Act or Securities Act registration statements become effective.
Foreign private issuers will need to carefully monitor the SEC rule-making process and consult with counsel regarding application
of the New Law, since a number of the provisions of the statute immediately apply to such issuers, even though prior SEC proposals
would have exempted foreign private issuers. For example, both certification requirements contained in the New Law apply to
foreign private issuers because the certification requirements apply to all companies that file annual reports pursuant to
the Exchange Act. The SEC's outstanding certification rule proposal exempts foreign private issuers. However, on August 2,
2002, the SEC issued a statement indicating its intention to amend its rule proposal so that it is consistent with the New
Law. Hence, the SEC's final certification rule will apply to foreign private issuers. As the SEC implements and interprets
the New Law over the upcoming months, foreign private issuers would be well advised to consult with counsel about the most
recent SEC developments.
Changes to the Duties and Conduct of Corporate Officers and Directors
CEO and CFO Certifications
The New Law will require the principal executive officer and principal financial officer of a public company (usually a company's
CEO and CFO) to certify the truthfulness and completeness of the disclosure and financial statements in every annual and quarterly
report filed by the company. Currently, the CEO and CFO are required to sign the annual report, and a CFO is also required
to sign the quarterly report; neither report contains a certification requirement. The SEC has already proposed a similar
rule (see our update SEC Proposes Management's Certification of Quarterly and Annual Reports, June 2002), and the SEC has ordered the CEOs and CFOs of 947 of the largest public companies to submit certifications covering
disclosure in those companies' most recent SEC filings (see our update SEC Alert: SEC Orders Senior Officers of Large Public Companies to Attest to the Accuracy of Their Company's Financial Statements, July 2002). The New Law requires that the SEC adopt a rule implementing the New Law's certification requirement by August
29, 2002, and the SEC has indicated its intention to adopt and make effective a certification rule on or before that date.
The SEC's rule will require that CEOs and CFOs begin providing their certifications in their company's next quarterly or annual
report filed after the rule's adoption. For public companies with a calendar year-end, this would mean that their third quarter
quarterly reports must include CEO and CFO certifications. The SEC's rule will require foreign private issuers to provide
CEO and CFO certifications in their annual reports, and, possibly, in their Form 6-Ks.
The New Law requires the SEC to modify the language of the CEO and CFO certifications contained in its current rule proposal.
The wording of the certification in the New Law is broader in scope than the certification in the SEC's current rule proposal
and certification order. The New Law requires that a CEO and CFO certify in every annual and quarterly report that:
- he or she has read the report;
- based on the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material
fact necessary in order to make the statements made, in light of the circumstances under which such statements were made,
not misleading; and
- based on such officer's knowledge, the financial statements and other financial information included in the report fairly
present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods
presented in the report.
The New Law also includes additional certifications which are not in the SEC's current rule proposal. These additional certifications
require the CEO and CFO to certify in each annual or quarterly report that they:
- are responsible for establishing and maintaining internal controls;
- have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries
is made known to such officers by others within such entities, particularly during the period in which the periodic reports
are being prepared;
- have evaluated the effectiveness of the company's internal controls as of a date within 90 days prior to the report;
- have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation
as of that date;
- have indicated in the report whether or not there were significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard
to significant deficiencies and material weaknesses; and
- that they have disclosed to the company's auditors and audit committee:
- --all significant deficiencies in the design or operation of internal controls which could adversely affect the company's
ability to record, process, summarize, and report financial data and have identified for the company's auditors any material
weaknesses in internal controls; and
- --any fraud, whether or not material, that involves management or other employees who have a significant role in the company's
internal controls.
The New Law also includes criminal penalties for a false certification. However, Section 906 of the New Law that imposes such
penalties refers to a differently worded certification (not limited to the certifying person's knowledge) than what is described
in Section 302 of the New Law and referred to above. Under Section 906, each periodic report containing financial statements
filed with the SEC must be accompanied by a written statement by the CEO and CFO that:
- the report fully complies with Section 13(a) and 15(d) of the Exchange Act, as applicable, and that the information contained
in the report fairly presents, in all material respects, the financial condition and results of operations of the company
at the dates and for the periods indicated.
Neither Section 906 nor Section 302 refers to the other; therefore, each must be considered separately. Section 302 certifications
are not required until the SEC adopts a final certification rule, which will be no later than August 29, 2002. Section 906
is effective immediately. It remains to be seen whether Congress will address the confusion raised by these dual certifications.
The SEC has already indicated that it will not interpret the substantive requirements of Section 906. Until Congress acts
to clarify Section 906's application, all public companies should be consulting with counsel about the specific certifications
that may be required
before filing any annual report, quarterly report or Form 8-K that contains financial statements.
In connection with the Section 302 certifications relating to internal controls, the SEC must also adopt a related rule (no
timeframe is provided in the New Law) that will require that each annual report contain an internal control report, which
must:
- state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures
for financial reporting; and
- contain an assessment, as of the end of the most recent fiscal year of the company, of the effectiveness of the internal control
structure and the procedures of the company for financial reporting.
As part of the annual report, the company's independent auditor for the year will have to attest to and report on the assessment
made by management.
Prohibitions of Loans to Executive Officers and Directors
The New Law immediately makes it unlawful for any public company (including a private company that has filed a registration
statement pursuant to the Securities Act or Exchange Act that has not gone effective) directly or indirectly, including through
any subsidiary, from extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit,
in the form of a personal loan to or for any director or executive officer. Any loan in existence prior to the adoption of
the New Law on July 30, 2002 is exempt from this prohibition as long as there is no "material modification" to the loan or
any renewal of the loan after the adoption of the New Law on July 30, 2002. The New Law does not define what would constitute
a "material modification," so any company that has a preexisting loan to a director or executive officer (or equivalent thereof)
will need to evaluate whether such arrangement will be affected by the New Law by a modification of the loan in the future.
In addition, the prohibition covers any executive officer "or equivalent thereof." The New Law leaves the interpretation of
who are equivalents of executive officers to the SEC.
The New Law contains very limited exceptions to the general prohibition of personal loans. The following categories of loans
made or provided in the ordinary course of a company's business by financial institutions and other lenders are not prohibited:
- home improvement and manufactured home loans (as that term is defined in section 5 of the Home Owners' Loan Act);
- consumer credit (as defined in section 103 of the Truth in Lending Act);
- any extension of credit under an open end credit plan (as defined in section 103 of the Truth in Lending Act);
- charge card (as defined in section 127(c)(4)(e) of the Truth in Lending Act);
- loans made or maintained by an insured depository institution (as defined in section 3 of the Federal Deposit Insurance Act),
if the loan is subject to the insider lending restrictions of section 22(h) of the Federal Reserve Act; or
- any extension of credit by a broker or dealer registered under section 15 of the Exchange Act to an employee of that broker
or dealer to buy, trade, or carry securities that is permitted under rules or regulations of the Board of Governors of the
Federal Reserve System pursuant to section 7 of the Exchange Act.
Although the New Law does not mandate any further rulemaking by the SEC, we anticipate that the SEC will adopt rules to interpret
various aspects of the loan prohibition to address issues that are unclear on the face of the statute including what constitutes
a prohibited material modification of a preexisting loan as well as how the New Law affects certain common employee benefit
arrangements such as split dollar life insurance contracts that may be viewed to have a component which constitutes a loan.
Since the loan prohibition is effective upon adoption of the New Law, some companies may have immediate compliance questions
pending adoption by the SEC of any clarifying regulations. Companies would be well advised to seek the assistance of counsel
in interpreting these provisions of the New Law. In addition, we anticipate that some companies will elect to conduct immediate
compliance audits to address the effect of the New Law on existing loan arrangements and other employee benefit plans.
Accelerated Public Disclosure of Equity Securities Transactions by Directors, Executive Officers and Insiders
Currently, under Section 16 of the Exchange Act, directors, executive officers and insiders (beneficial holders of more than
10% of a company's equity securities) generally must file a Form 4 to disclose certain purchases or sales of their company's
securities in paper form or electronically with the SEC within 10 days of the end of the month in which the transaction occurred.
The New Law requires these individuals to file their Form 4s, in paper form or electronically, before the end of the second
business day following the day on which the transaction was executed. The accelerated deadline for Form 4s will go into effect
beginning August 29, 2002. In addition, by July 30, 2003, all Section 16 filings must be filed solely in electronic form with
the SEC, and a subject company will have to disclose such filings on its website, if the company maintains a website.
The SEC has proposed a rule that would require a public company to disclose on a Form 8-K its directors' and executive officers'
purchases and sales of equity securities within two business days from the execution of the transaction see our update SEC Proposes Expanding the Events Required to be Reported in Form 8-K, April 2002). In its proposing release, the SEC indicated that if Congress amended Section 16 to accelerate the filing deadline
for Form 4s, it might drop its proposal to require a subject company to file such a report within two business days of the
transaction. The proposing release also indicated that the SEC could revise its proposal to require a joint filing by the
company and the individual. The public comment period for the SEC's proposed rule ended on June 24, 2002. Now that Congress
has acted to amend Section 16 consistent with the goal of the SEC's proposed rule, to accelerate the reporting of securities
transactions of management and insiders, the SEC may adopt a final rule in the next few weeks that reflects these changes
to Section 16. The New Law also provides the SEC with explicit authority to establish exceptions to the two-business day deadline
for Form 4s, if the SEC determines that such deadline is not feasible in certain cases. Therefore, the SEC's final rule may
also provide details of the circumstances under which extensions of the deadline are warranted. Regardless of the SEC's final
rulemaking, persons covered by Section 16 must be prepared to begin filing their Form 4s within two business days from the
date of any transaction executed on or after August 29, 2002.
Prohibition of Director and Executive Officer Trading during Pension Fund Blackout Periods
The New Law generally prohibits directors and executive officers from purchasing, selling or otherwise acquiring or transferring,
during any pension fund "blackout period," any equity security of their company, if the director or executive officer has
received such security in connection with his or her service or employment as a director or executive officer of the company.
"Blackout period" is defined in the New Law. Any profit realized by the director or executive officer as a result of such
an unlawful transaction is recoverable by the company. The New Law requires that specific notice be provided to plan participants,
directors and officers, and to the SEC in advance of an upcoming blackout period. The New Law confers broad rulemaking authority
on the SEC to clarify these provisions. Rulemaking authority also is provided to the Secretary of Labor with respect to the
notice provisions. The general prohibition and notice requirements outlined above will take effect on January 26, 2003. However,
since rulemaking will contribute significantly to the specific compliance provisions and the New Law does not impose any deadlines
on the SEC's rulemaking in this area, the New Law requires "good faith" (not defined) compliance from and after January 26,
2003.
Forfeiture of Certain Bonuses and Profits
The New Law requires that if a company restates its financial statements as a result of misconduct relating to any financial
reporting requirement under the federal securities laws, the company's CEO and CFO will have to reimburse the company for:
- any bonus or other incentive-based or equity-based compensation received from the company; and
- any profits realized from the sale of the company's securities
received by the CEO or CFO during the 12-month period following the first public issuance or filing with the SEC (whichever
first occurs) of the financial document embodying the financial reporting requirement required to be restated. This requirement
is effective immediately; however, there are many open issues. What constitutes "misconduct" is critical to the application
of this provision; however, the New Law does not define this term. In addition, the New Law does not clarify who will have
the authority to enforce this provision, nor is it clear whether this provision will include private rights of actions for
enforcement by shareholders of the company as in the case of Section 16. The New Law provides that the SEC may exempt any
person from the application of this rule as it deems necessary and appropriate. In exercising its exemptive authority and
its general rulemaking authority under the Exchange Act, the SEC may provide guidance and clarification regarding these forfeiture
issues.
Changes to the Powers of Audit Committees of Public Companies
The New Law grants the audit committee of a public company oversight over the entire auditing process for the company. It
requires that the audit committee of each public company be directly responsible for the appointment, compensation, and oversight
of the work of the company's independent auditor. All audit committee members must be "independent" members of the company's
board of directors. In order to be considered "independent," an audit committee member must not accept any consulting, advisory,
or other compensatory fee from the company (except fees paid for his or her service as a director and committee member) or
be an affiliated person of the company or any of its subsidiaries. The audit committee is required to establish procedures
for (i) the receipt, retention and treatment of complaints received by the company regarding accounting, internal accounting
controls, or auditing matters and (ii) confidential, anonymous submissions from employees identifying possible accounting
misdeeds. The audit committee is given the authority to engage independent counsel and other advisers. A company must provide
the funding that the audit committee determines is necessary to compensate the independent auditor and any advisers hired
by the audit committee. No later than April 26, 2003, the SEC must adopt rules directing the national securities exchanges
and national securities associations to prohibit the listing of any security of any public company that does not comply with
these new audit committee provisions.
An audit committee of a public company (not just a public company with a class of securities listed on a stock exchange or
Nasdaq) should immediately pre-approve all audit and non-audit services provided by the company's outside auditor, except
for de minimis non-audit services (defined in the New Law), given the ambiguity in when the preapproval is required. The audit
committee may delegate its pre-approval power to one or more of its members. Any audit committee pre-approval of non-audit
services must be disclosed in the public company's periodic reports upon SEC rulemaking. In addition, the company's auditor
is required to timely report to the audit committee:
- all critical accounting policies and practices to be used;
- all alternative treatments of financial information within GAAP that have been discussed with management, ramifications of
the use of such alternative disclosures and treatments, and the treatment preferred by the auditor; and
- other material written communications between the auditor and management, such as any management letter or schedule of unadjusted
differences.
By January 26, 2003, the SEC must issue a final rule requiring all public companies to indicate whether their audit committee
membership includes at least one "financial expert," and if not, the reasons why not. For a more detailed discussion of this
future SEC rule, see
"Congressional Mandate for Specific SEC Rulemaking" below.
Changes to the Periodic Reporting by Public Companies
Beginning July 30, 2002, the New Law adds a general requirement that every SEC filing made pursuant to the Exchange Act that
contains financial statements which are required to be prepared in accordance with (or reconciled to) GAAP reflect all material
correcting adjustments that have been identified by the company's independent auditor in accordance with GAAP and SEC rules
and regulations.
The New Law also requires that a public company disclose "on a rapid and current basis" any information concerning material
changes in the financial condition or operations of the company in plain English, which may include trend and qualitative
information and graphic presentations. This provision is consistent with the SEC's current rule proposal relating to "real
time" reporting of significant corporate events by public companies on Form 8-K (see our update SEC Proposes Additional Current Disclosures and Shortens Filing Deadline for Form 8-Ks, July 2002). The New Law does not mandate a deadline for the SEC to adopt this rule.
Expanded SEC Authority and Enforcement Powers
The New Law provides the SEC with the financial resources to increase significantly the size of its workforce in order to
enhance its oversight and enforcement efforts.
The SEC is given the power to censure any person or deny a person the privilege of appearing and practicing before the SEC
if the SEC determines that the person does not meet certain professional standards and acts unethically.
The New Law also gives the SEC expanded authority to prohibit persons from serving as officers or directors of a company.
In the past, SEC Enforcement had to demonstrate in court that a director's or officer's conduct demonstrates "substantial
unfitness" under Section 21(d) of the Exchange Act to prohibit the person from continuing to serve as a director or officer.
The New Law lessens the SEC's burden under the statute by requiring only a showing of "unfitness."
In connection with SEC investigations, the New Law also gives the SEC the authority to request that a court impose a temporary
freeze of a public company's "extraordinary payments" (including compensation) to any director, officer, partner, controlling
person, employee or agent of the company under investigation.
New and Expanded Criminal Penalties
The New Law adds several new criminal penalties for conduct relating to securities law violations:
- anyone who knowingly alters, destroys, mutilates, conceals, covers up or makes a false entry in any record or document with
the intent to impede, obstruct or influence a federal investigation or bankruptcy matter can be fined and/or imprisoned for
up to 20 years;
- anyone who knowingly and willfully violates a new five-year audit and review workpaper retention requirement for auditing
firms, or SEC rules or regulations relating to the retention of such workpapers, can be fined and/or imprisoned for up to
10 years;
- anyone who knowingly executes, or attempts to execute, a scheme or artifice to defraud any person in connection with any security
of a public company, or obtains, by means of false or fraudulent pretenses, representations, or promises, any money or property
in connection with the purchase or sale of any security of a public company can be fined and/or imprisoned for up to 25 years;
and
- a CEO or CFO who provides a false certification in connection with the filing of the company's annual or quarterly reports
with the SEC can be subject to penalties ranging from up to $1 million and 10 years in prison for a "knowing" violation or
up to $5 million and 20 years in prison for "willful" violations. As discussed earlier under "CEO and CFO Certifications,"
the content of the certification referred to in the criminal penalties provision differs from the certification described
elsewhere in the New Law. It remains to be seen whether and how the SEC will address this apparent discrepancy in its final
rule implementing the certification requirement.
Prior to the New Law, criminal liability did exist for securities fraud; however, this new criminal penalty for securities
fraud seemingly is much broader than existing liability under Section 10(b) of the Exchange Act. Under Section 10(b), the
securities fraud must be committed in connection with the "purchase" or "sale" of a security, but under the New Law's criminal
securities fraud provisions, the securities fraud must be committed only "in connection with any security."
The New Law increases the criminal penalties for several existing white collar crimes:
- the penalty for conspiracies and attempts to violate offenses such as mail fraud, wire fraud, bank fraud and the new securities
fraud statute are increased to match the penalties set for each of those substantive offenses, rather than being limited to
the five year maximum penalty available under the general federal conspiracy statute;
- the penalty for a willful violation of any provision of the Exchange Act is increased to up to $5 million (previously $1 million)
and/or imprisonment up to 20 years (previously 10 years). For a person other than a natural person, the penalty is increased
to up to $25 million (previously $2.5 million);
- the penalty for committing mail fraud and wire fraud is increased from five to 10 years imprisonment; and
- the penalty for defrauding a pension fund has been increased from up to $5,000 and one year in prison to up to $100,000 and
10 years in prison. For a person other than a natural person, the penalty is increased to up to $500,000.
The New Law requires that United States Sentencing Commission review and, where appropriate, amend the sentencing guidelines
for crimes under the federal securities laws.
Whistleblower Protections
The New Law adds a new provision designed to encourage employees of public companies to come forward with information relating
to violations of the federal securities laws without fear of retribution from their employers. Anyone who knowingly retaliates
or takes any action against any person for providing any information to law enforcement relating to a possible violation of
any federal statute could be fined and/or imprisoned up to 10 years.
Civil Liability in Private Rights of Action
The New Law creates private rights of actions for suits by "whistleblowers" and recovery of profits from insider trades during
pension fund blackout periods. Other than these two circumstances, the New Law does not expressly create new private rights
of actions. However, beginning on July 30, 2002, the statute of limitations for securities fraud in a private right of action
in extended to the earlier of (i) two years after discovery of the facts constituting the violation and (ii) five years after
the violation. In addition, the new certification requirements and the expanded disclosure and reporting requirements prescribed
by the New Law will probably increase the number of private claims brought under the federal securities laws.
Congressional Mandate for Specific SEC Rulemaking
In addition to the SEC rulemaking discussed above, the New Law mandates that the SEC engage in future rulemaking to address
the following:
Enhanced Financial Disclosures
The SEC must issue final rules by January 26, 2003 to require that:
- each annual and quarterly report required to be filed with the SEC disclose all material off-balance sheet transactions, arrangements,
obligations (including contingent obligations), and other relationships of the company with unconsolidated entities or other
persons, that may have a material current or future effect on financial condition, changes in financial condition, results
of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses; and
- every public disclosure (including SEC filings and press releases) that contains pro forma financial information be presented
in a manner that (i) does not contain an untrue statement of material fact or omit to state a material fact necessary in order
to make the pro forma financial information, in light of the circumstances under which it is presented, not misleading, and
(ii) reconciles the pro forma presentation with the company's GAAP results.
Rule of Professional Conduct for Lawyers
The SEC must also issue final rules by January 26, 2003 to:
- set forth minimum standards of professional conduct for all attorneys appearing and practicing before the SEC in the representation
of public companies; and
- require an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation
by the company or its agents to the chief legal counsel or CEO of the company, and if the counsel or CEO does not appropriately
respond to the evidence (such as taking necessary remedial measures or imposing sanctions), the attorney must report the misconduct
to the audit committee or other board committee comprised solely of independent directors, or to the board of directors.
Additional Requirements relating to Senior Financial Officers, Audit Committees, Officers and Directors
The SEC must propose rules by October 28, 2002 and adopt such rules by January 26, 2003 to:
- require a public company to disclose in its periodic reports whether or not the company has adopted a "code of ethics" for
senior financial officers. If not, it must explain the reasons why. Any changes to, or waivers of, such code of ethics must
be promptly disclosed on a Form 8-K; and
- require a public company to disclose in its periodic reports whether or not the company has at least one "financial expert"
as a member of its audit committee, and if not, it must explain why. The New Law does not define who will qualify as a "financial
expert," instead, the SEC is directed to define the term with consideration given to the skills usually required of a person,
"through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal
accounting officer of a [public company], or from a position involving the performance of similar functions."
The SEC must propose a rule by October 28, 2002 and adopt a final rule by April 26, 2003 to:
- make it unlawful for any officer or director of a public company, or those acting under their direction, to take any action
to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in auditing
the financial statements of the company for the purpose of rendering such financial statements materially misleading.
Research Analysts' Conflicts of Interest
The SEC must adopt rules no later than July 30, 2003 to:
- address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and
public appearances. On July 24, 2002, the SEC proposed rules that will require certain certifications and disclosures by research
analysts in their research reports and public appearances, and the SEC indicated that additional rulemaking would be forthcoming.
The New Law provides guidelines for the SEC in proceeding with this future rulemaking.
Changes to the SEC Periodic Review Process of Public Companies
The New Law directs the SEC to regularly and systematically review the periodic reports of public companies. At a minimum,
every public company must be reviewed at least once every three years. In determining whether to review a particular public
company, the SEC must consider:
- material restatements by the company;
- significant volatility in the company's stock price as compared to other companies;
- companies with the largest market capitalization;
- emerging companies with disparities in price to earnings ratio;
- companies whose operations significantly affect any material sector of the economy; and
- any other factors that the SEC considers relevant.
Creation of the Public Company Accounting Oversight Board
The New Law creates the Public Company Accounting Oversight Board (the "Board") to oversee the audit process of public companies
and periodically inspect public accounting firms. The SEC has until April 26, 2003 to appoint the initial Board members. In
the interim, the SEC will be responsible for the establishment and administrative transition to the Board's operation. The
Board will not be an agency of the federal government. It will be a nonprofit corporation under the general oversight of the
SEC. The Board will be comprised of five full-time members. The New Law permits only two members of the Board to be, or have
been, certified public accountants; however, if one of the two members is the chairperson, he or she must not have been a
practicing certified public accountant in the prior five years before his or her Board appointment. Each Board member will
serve a five year term except for the initial members (other than the chairperson) whose terms will be staggered and be appointed
by the SEC. The Board will be given broad powers, subject to the approval of the SEC, to establish and adopt auditing standards,
register public accounting firms that audit public companies and conduct investigations and inspections of public accounting
firms. All accounting firms that conduct audits for public companies, including foreign accounting firms, will be required
to register with the Board. The Board will have the power to suspend, bar and fine registered accounting firms and their associated
persons. All registered accounting firms will be inspected by the Board on a regular basis. The SEC will oversee the Board
similar to how the SEC oversees a national securities association. Public accounting firms and public companies will both
contribute to the funding of the Board.
Auditor Independence
A registered public accounting firm will be prohibited from providing the following services contemporaneously while it is
the outside auditor for the company:
- bookkeeping or other services related to accounting records or financial statements of the company;
- 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 adviser, or investment banking services;
- legal services and expert services unrelated to the audit; and
- any other service that the Board determines, by regulation, is impermissible.
The Board will have to the power to exempt, on a case by case basis, any person, company, public accounting firm or transaction
from the above prohibitions. In order for a registered public accounting firm to provide a non-audit service to an audit client
other than the nine listed above, the non-audit service will have to be pre-approved by the audit committee of the public
company (see description under "Changes to Powers of Audit Committees of Public Companies" above). Every five years, a registered
public accounting firm must rotate the audit partner responsible for reviewing the audit of a public company client. A registered
public accounting firm will not be permitted to audit a public company where the company's CEO, CFO, controller, chief accounting
officer, or any person serving in an equivalent capacity, has been employed by the accounting firm and participated in any
capacity in the audit of that company during the one year period preceding the date of the initiation of the audit. The New
Law orders the Comptroller General of the United States to study and review the potential effects of requiring the mandatory
rotation of registered public accounting firms as auditors of public companies and submit a report to Congress no later than
July 30, 2003.
Conclusion
The New Law is clearly the most comprehensive statutory revision to the federal securities laws in over 60 years. Key changes
to the rules that affect public companies, their management, employees, counsel and others will go into effect literally overnight.
The remaining provisions will require compliance in the next several months. Over that time, the SEC also will be issuing
numerous rules implementing and interpreting the provisions of the New Law. In addition, House Financial Services Committee
Chairman Michael G. Oxley (R-Ohio), who co-sponsored the New Law, has indicated that there may be a "technical corrections"
bill considered by Congress to address certain technical problems in the New Law.
