By Barton S. Sacher
Scott A. Burr and
Joseph A. Sacher
On July 30, the most comprehensive and sweeping changes in the federal securities laws in 70 years, since the creation of the Securities and Exchange Commission in 1934, were signed into law. That law,1 officially titled the “Sarbanes-Oxley Act of 2002,” but commonly referred to as the “Public Company Accounting Reform and Investor Protection Act of 2002,” was drafted in response to public outcries following the collapse last year of Enron Corp. and the role played by its auditor, Arthur Andersen, in helping to conceal the company’s precarious financial condition. After languishing for months, the bill gained additional public support and added momentum from disclosures of accounting abuses and other blatant securities frauds at several other big companies — and finally took off (as the stock market plunged) after reports emerged in late June of WorldCom’s nearly $4-billion “accounting misstatement.” During July, the bill sailed through the U.S. House of Representatives by a vote of 423 to 3, and received an even more lopsided vote in the Senate of 99 to 0. The new law is designed to crack down on corporate criminals and to help restore confidence in the honesty, integrity, and fundamental strength of the American economy and the American marketplace.
Now, we begin the time-intensive task of sifting through the Act, to see how it changes existing law, and what it means for companies, their officers and directors, the securities industry, the accounting and securities law professions and, of course, the investors. Time and space here only permit us to identify the new highlights that are most significant. Hereafter, however, only the foolish practitioner will operate in this arena without mastering the old and new details.
Establishment of An Accounting Oversight Board
The centerpiece of the Act is the creation of an independent Accounting Oversight Board, a nonprofit corporation subject to SEC oversight.2 Public accounting firms that conduct audits of public issuers will be required to register with the board.3 The board is directed to review annually each accounting firm that conducts more than 100 audits a year, while accounting firms conducting fewer than 100 audits yearly are to be reviewed every three years.4 No public accounting firm (beginning 180 days after the Act’s enactment, or approximately February 1, 2003) can prepare audits related to a securities issuer without being registered with the board.5
The board can investigate potential violations of accounting rules, professional standards, and securities laws and impose sanctions on any accounting firm or associated person rule-breakers for (a) intentional or knowing conduct, including reckless conduct, that results in any violation of applicable statutory, regulatory, or professional standards, or (b) repeated instances of negligent conduct.6 The sanctions it may impose include the temporary suspension or permanent revocation of a firm’s registration; the temporary or permanent suspension or bar of a person from further association with any registered public accounting firm; the temporary or permanent limitation on the activities, functions, or operations of any such firm or person; a civil monetary penalty; censure; the requirement of additional professional education; or any other appropriate sanction.7 The sanctioned party may appeal the sanction to the commission for review.8 The board’s power extends not only to domestic accounting firms, but also to foreign public accounting firms that audit financial statements of any issuer subject to U.S. securities laws.9
The board will include five members (two who are, or have been CPAs) appointed by the SEC within 90 days after the Act takes effect.10 The board must be fully operational and deemed capable by the commission of executing its duties within 270 days, approximately nine months after the law’s enactment, on or about June 1, 2003.11
The newly established Accounting Oversight Board will set auditing standards.12 However, the Act directs the Financial Accounting Standards Board (FASB) to continue its role in setting accounting standards (e.g., Generally Accepted Accounting Principles, GAAP) and provides public funding for the FASB to fulfill this role.13
The board replaces the recently disbanded Public Oversight Board, which was financed and overseen by the American Institute of Certified Public Accountants, the auditing profession’s trade group.
For the first time, the government is curtailing ancillary services provided by accounting firms. Under the Act, an accounting firm cannot provide both audit and consulting services to a single client.14 Specifically, if an accounting firm is auditing a client pursuant to the securities laws, the accounting firm cannot also help that client with bookkeeping or other services related to accounting records or financial statements, financial information systems design, appraisal or valuation services, actuarial services, management functions or human resources, broker-dealer or investment advisory services, or legal services.15
The Act does allow the Accounting Oversight Board authority to grant case-by-case exceptions,16 and does not limit accounting firms from providing non-audit services to public companies that they do not audit, or to any private companies.17
Registered public accounting firms will also have to rotate their lead partner (the partner in charge of the audit engagement) and their review partner (the partner brought in to review the work of the lead partner and audit team) on all audits, so that neither role is performed by the same accountant for the same company for more than five consecutive years.18
Increasing Senior Management Accountability
The Act places a great deal of accountability squarely on the shoulders of senior executives at publicly held companies, through a number of specific provisions designed to make senior management more accountable, and to improve financial disclosures.
Certification. CEOs and CFOs are now required to formally certify that they have reviewed their company’s financial reports and (a) 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, in light of the circumstances under which such statements were made, not misleading, (b) the financial statements, and other financial information included in the report, fairly represent in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report, (c) the company has established and maintained adequate internal controls, and (d) the company and its management have disclosed to the auditors and the audit committee all significant deficiencies in the internal controls and any fraud, whether material or not, that involves management or other employees who have a significant role in the company’s internal controls.19
The CEO and CFO are prevented from benefiting from bonuses or profits they receive from the sale of securities of the company during the 12-month period following the first public issuance or filing with the commission of the financial document if it is proven that they misstated their company’s financials.20 The certification provisions apply to senior managers at U.S.-based companies, as well as CEOs and CFOs of companies that reincorporate outside the U.S. The Act calls for companies to comply with these provisions within 30 days of enactment, or by September 1, 2002.21
Freezing Assets. During an investigation, the SEC can now seek an order in federal court imposing a 45-day freeze on extraordinary payments (whether compensation or otherwise) to corporate executives, in some instances ex parte. The freeze may be extended up to an additional 45 days and, if enforcement action is initiated, the freeze may be extended until the action is concluded. The targeted payments would be placed in escrow by the issuer, ensuring that disputed payments are either taken, or returned, after appropriate hearing.22
Restrictions on Services. As a result of the Act, the SEC, in administrative cease and desist proceedings, can now bar persons from serving as public company officers or directors, if they are found to have committed a securities law violation and their conduct demonstrated “unfitness” to serve as an officer or a director.23 Previously, only a federal court could issue an order prohibiting a person from acting as an officer or director of a public company after a court finding of “substantial unfitness.” Additionally, the commission may now seek “any equitable relief that may be appropriate or necessary for the benefit of investors,” an undefined remedy clearly open to interpretation, and clearly one which will generate much litigation.24
Audit Committee Independence. Under the Act, each member of the audit committee of the company must be a member of the board of directors and has to be independent from company management. This means that an audit committee member may not accept consulting, advisory, and/or other fees from the public issuers, except compensation for service on the board, the audit committee, or some other committee. The audit committees are directly responsible for the appointment, compensation and oversight of the work of the auditors. The committee must develop procedures for addressing complaints concerning audit issues.25
Code of Ethics. Public companies now will also be required to disclose whether they have adopted a code of ethics for senior management and, if not, why. The SEC is ordered to issue final rules on this provision within 180 days of enactment, or approximately February 1, 2003.26 Prior to the enactment of the Act, these standards of ethical conduct for attorneys were only suggested, laudatory professional standards set forth in the American Bar Association Model Rules of Professional Conduct.27
Setting Rules for Attorneys
Although the Act contains only two sections directly related to lawyers, the thrust of those sections is powerful. The Act requires the SEC to adopt rules within six months setting forth minimum standards of professional conduct for attorneys appearing and practicing before it. Such rules are to include requiring counsel to report material evidence of a securities law violation, or a breach of fiduciary duty, by the company or any agent thereof to the chief legal counsel or chief executive officer of the company. If those officials neglect to respond appropriately — and it remains unclear just what that means — the attorney must go to the audit committee or the full board. What is also unclear is what the attorney is supposed to do if it turns out the audit committee or board is complicit in the wrongdoing or refuses to take remedial action.28 In sum, however, these new provisions underscore and make clear that the outside securities counsel’s client is the public corporation, and that future actions are intended to benefit the client’s public shareholders, not entrenched management.
Ratcheting Up Punishment
The Act creates much harsher punishment for those corporate executives who engage in corporate fraud, and serious protections for those employees who report it and those investors who are victimized by it.
Financial Statement Certification. The Act calls for top corporate executives to certify that financial statements of the company fairly and accurately represent the financial condition of the company. Company executives who knowingly fail to comply with this provision could face fines of up to $1 million and 10 years in jail, or both; executives who willfully fail to comply could see fines as high as $5 million and jail terms of 20 years, or both.29
Securities Fraud. The Act creates a new, 25-year felony sentence under Title 18 for defrauding shareholders of publicly traded companies.30 Currently, unlike bank fraud or health care fraud, there is no generally accessible statute that deals with the specific problem of securities fraud. In these cases, federal investigators and prosecutors are forced to either resort to a patchwork of technical Title 15 offenses and regulations, which may criminalize particular violations of securities law, or to treat the cases as generic mail or wire fraud cases, requiring the criminal prosecutors to meet the technical elements of those statutes in order to reach their five-year maximum penalties.
The Act creates a new 25-year felony for securities fraud, through a more general and less technical provision comparable to the bank fraud and health care fraud statutes in Title 18. It adds a provision to Chapter 63 of Title 18 at section 1348, which would criminalize the execution or attempted execution of any scheme or artifice to defraud persons in connection with securities of publicly traded companies or obtain their money or property. The provision is not intended to be read to require proof of technical elements from the federal securities laws, and is intended to provide needed enforcement flexibility in the context of publicly traded companies in order to protect shareholders, and prospective shareholders, against all of the creative types of schemes and frauds which inventive criminals may devise in the future. The intent requirements are to be applied consistently with those found in 18 U.S.C. §§1341, 1343, 1344, and 1347.
Mail and Wire Fraud. The maximum criminal penalties for executives found guilty of committing mail and wire fraud is raised to 20 years jail time per count (up from 5 years).31
Whistleblower Protections. The Act creates a civil cause of action32 and criminal sanctions against those public companies and their agents who retaliate against whistleblowers, which includes both fines and up to 10 years in jail as sanctions.33 Employees who take lawful steps to disclose information or otherwise assist criminal investigators, federal regulators, Congress, supervisors (or other proper people within a corporation), or parties in a judicial proceeding in detecting and stopping fraud are covered. If the employer then takes illegal action in retaliation for lawful and protected conduct, the employee is permitted to file a complaint with the Department of Labor, to be governed by the same procedures and burdens of proof now applicable in the whistleblower law in the aviation industry. The employee can bring the matter to federal court only if the Department of Labor does not resolve the matter in 180 days (and there is no showing that such delay is due to the bad faith of the claimant) as a normal case in law or equity, with no amount in controversy requirement. The whistleblower employee may obtain reinstatement, backpay, and compensatory damages, including reasonable attorney fees and costs, if the claim prevails. The employee has a 90-day statute of limitations for the bringing of the initial administrative action before the Department of Labor.
Bankruptcy Loopholes. The Act changes the Bankruptcy Code to make judgments and settlements arising from state and federal securities law violations brought by state or federal regulators and private individuals per se nondischargeable, thereby helping to protect victims of fraud by preventing corporate wrongdoers from sheltering their assets under the umbrella of bankruptcy.34 Current bankruptcy law may permit wrongdoers to discharge their obligations under court judgments or settlements based on securities fraud and securities law violations.
Statute of Limitations. The Act permits investors to bring securities fraud cases up to two years after the discovery of facts constituting violations, or up to five years after such violations occurred.35 This overrides and extends current law enacted through Private Securities Litigation Reform Act (“PSLRA”) in 1995, after the Supreme Court’s 1991 decision in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson,36 under which all such cases could only be brought within one year of discovery and within three years of when the violation occurred. This provision, alone, will have far-reaching impact on the timing and number of private civil cases.
Document Destruction. The Act strengthens laws that criminalize obstruction of justice, such as document shredding or falsifying records, calling for fines, and up to 20 years imprisonment, if found guilty.37 The Act also punishes as a felony, with up to 10 years imprisonment, the willful failure to preserve financial audit papers of companies that issue securities as defined in the Securities Exchange Act of 1934. Accountants are independently required to preserve audit work papers for five years from the conclusion of the audit. Moreover, the SEC by rule can expand the definition of additional “records” that must be retained.
Quicker Disclosure and Banning Loan Issuance
Under the Act, insider stock trades will have to be reported by the second day following any transaction.38 Under current law, insiders do not have to report trades until the tenth day of the month following the month in which the trade occurred, meaning that an insider trade could go unreported for as many as 40 days. Companies have 30 days to comply with the new deadline after the Act becomes effective.39
Senior management also is prohibited from any insider trading during all pension fund blackout periods, with this provision going into effect 180 days after the law’s enactment.40
The Act further orders companies, within one year, to file disclosures related to insider stock transactions electronically with the SEC and then to post these statements on the Internet within a day after they were filed with the commission. The companies are also directed to post these statements on their own Web sites by the end of the day after they were filed.41
The Act makes it unlawful for any public company to make loans to its executive officers and directors. There are a few narrow exemptions. One exemption applies to consumer credit loans made to executives on market terms in the ordinary course of the company’s consumer credit business. Another exemption applies to banks that are already covered by Federal Reserve regulations on insider loans.42
Victims’ Safety Net
Should any administrative or judicial proceeding mandate the disgorgement of funds by a securities issuer (including any civil penalties collected), the SEC would be authorized to set up a disgorgement fund (for the distribution of such funds to victims), to which people could give gifts, bequests, and property for such allocation.43
The SEC’s Task
SEC funding for fiscal year 2003 is authorized at $776 million.44 The commission’s current budget is $438 million. Of the total $776 million proposed: $102.7 million would be used to increase pay levels and benefits for SEC employees so that they are on a par with banking regulators; $108.4 million would be used for technology improvements and funding needs stemming from the September 11 terrorist attacks that destroyed the commission’s Northeast Region Office; and $98 million would be used to add 200 new professionals, mostly auditors and enforcement staff.45
The Act also directs the SEC to complete a study of the role and function of the credit-rating agencies in the securities market.46 The study is to be sent to House and Senate committees within 180 days of the law’s enactment. In conducting the study, the SEC is to consider the roles that credit-rating agencies play in evaluating issuers, any impediments to their being able to accurately appraise the financial resources and risks of issuers, and whether there are any barriers preventing other entities from becoming credit-rating agencies that need to be removed. The commission is also directed to examine whether the credit rating agencies have any conflicts of interest.
The SEC is also required to study the violators and violations of the securities laws, as well as the sanctions imposed, and to complete the study within six months of the bill’s enactment.47
The Public Company Accounting Reform and Investor Protection Act of 2002 establishes a carefully constructed statutory framework to deal with the numerous perceived conflicts of interest that in recent years have appeared to undermine the integrity of our capital markets, and betray the trust of millions of investors. The changes in our nation’s financial accounting structure contained in this law will undoubtedly strengthen the confidence and trust of investors, and will increase the transparency and acceptability of financial statements. At the same time, public companies, their officers and directors, the accounting industry, and outside securities counsel are all presented with greater responsibilities and intricate rules with which they must now comply. Understanding these detailed provisions, and the additional rules and regulations that will follow shortly, is now imperative. Newer, stronger compliance is now mandated, as a result of the current hostile environment demanding more enforcement and harsher penalties. The failure to heed these requirements in the current environment may prove to be catastrophic. Those who continue to adhere to a “let them eat cake” mentality may face the economic and professional guillotine quite swiftly. Thus, all future SEC investigations may prove to be much more serious than in the past, requiring heightened alertness and the best possible defense from the get-go.
Barton S. Sacher is the senior, founding partner of the Miami firm of Sacher, Zelman, Van Sant, Paul, Beiley, Hartman, Terzo & Waldman, P.A.; the former chief of investigations and enforcement of the Securities Exchange Commission’s Southeastern Region; and a securities law practitioner for 30 years. Scott A. Burr, of counsel to the firm, has developed a 15-year expertise in the prosecution and defense of class action lawsuits. Joseph A. Sacher is a senior associate in the firm’s securities law group. Sacher, Zelman, Van Sant, et al. regularly represent foreign and domestic individuals, public companies, broker-dealers and others in securities transactions, periodic filings, litigation and regulatory proceedings before the SEC, NASD, and state and federal courts, and provides advice and representation to accounting firms and law firms as well.
1 H.R. 3763; S-2673.
2 Title I, Secs. 101, 107.
3 Title I, Sec. 102.
4 Title I, Sec. 104.
5 Title I, Sec. 102(a).
6 Title I, Sec. 105(c)(5).
7 Title I, Sec. 105(c)(4).
8 Title I, Secs. 105(e),107(c).
9 Title I, Sec. 106.
10 Title I, Sec. 101(e).
11 Title I, Sec. 101(d).
12 Title I, Sec. 103(a).
13 Title I, Secs. 103, 108, 109(a).
14 Title II, Sec. 201(a).
16 Title II, Sec. 201(b).
17 Title II, Sec. 202.
18 Title II, Sec. 203.
19 Title III, Sec. 302(a).
20 Title III, Sec. 304(a).
21 Title III, Sec. 302(b), (c).
22 Title XI, Sec. 1103.
23 Title III, Sec. 305(a).
24 Title III, Sec. 305(5).
25 Title III, Sec. 301.
26 Title IV, Sec. 406.
27 ABA Model Rules of Professional Conduct, 2002 Edition, Client-Lawyer Relationship Rule 1.13, Organization as Client.
28 Title III, Sec. 307.
29 Title IX, Sec. 906.
30 Title VIII, Sec. 807.
31 Title IX, Sec. 903(a), (b).
32 Title VIII, Sec. 806.
33 Title XI, Sec. 1107.
34 Title VIII, Sec. 803.
35 Title VIII, Sec. 804.
36 501 U.S. 350, 111 S.Ct. 2773, 115 L.Ed.2d 321 (1991).
37 Title VIII, Sec. 802.
38 Title IV, Sec. 403.
40 Title III, Sec. 306(a); Title XI, Sec. 1102..
41 Sec. 403.
42 Title IV, Sec. 402.
43 Title III, Sec. 308.
44 Title VI, Sec. 601.
46 Title VII, Sec. 702.
47 Title VIII, Sec. 703.