July 30, 2002

Corporate Reform Bill Becomes Law

Holland & Knight Alert
Steven Sonberg

On July 25, 2002, the House and Senate overwhelmingly approved a compromise corporate reform act, the Sarbanes-Oxley Act of 2002 (the "Act"), effecting tighter accounting, corporate fraud and securities laws.  On July 30, 2002, President Bush signed the Act into law.

Some of the key provisions of the Act are summarized below.

Public Company Accounting Oversight Board

The Act creates a five-member, private-sector board to oversee the accounting industry.  The board will consist of two members with accounting backgrounds and three members without accounting backgrounds.  The duties of the board include:

  • registering accounting firms that prepare audit reports for public companies
  • establishing auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports
  • conducting inspections of registered public accounting firms (annually for larger accounting firms)
  • conducting investigations and disciplinary proceedings concerning registered public accounting firms and persons associated with such firms

Auditor Independence

The Act prohibits accounting firms from providing a wide range of consulting and other non-auditing services to their audit clients.  Such prohibited 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
  • 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

The Act also includes amendments to the Securities Exchange Act of 1934 intended to further ensure auditor independence.  Such amendments include:   

  • all audit and non-audit services provided by the issuer’s auditor to be pre-approved by the issuer’s audit committee with the approval of non-audit services to be disclosed to investors in periodic reports required by the Exchange Act
  • audit partner rotation at least every five years
  • specific reports to be made by the issuer’s auditors to the issuer’s audit committee
  • a prohibition against service by a former auditor as a chief executive officer, controller, chief accounting officer, or in any other equivalent position for a one-year period

Corporate Responsibility

The Act includes provisions intended to further ensure corporate responsibility.  Such provisions include:

  • specific standards for public company audit committees
  • the certification by principal officers of annual or quarterly reports filed with the SEC
  • the forfeiture of certain bonuses and profits by the chief executive officer and chief financial officer paid to them by public companies found to have engaged in certain financial reporting wrongdoing
  • the prohibition of insider trades during pension fund blackout periods
  • the prohibition of personal loans from companies to their top officials and directors

The Act also provides that the SEC shall issue rules setting forth minimum standards of professional conduct for attorneys appearing and practicing before it, including a rule requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty by the company to the company’s chief legal counsel or chief executive and, if such officers do not appropriately respond to the evidence, to the company’s audit committee or board of directors.

Enhanced Financial Disclosures

The Act includes provisions intended to further enhance corporate financial disclosures.  The Act provides, among other requirements, that company insiders promptly notify the SEC when they buy or sell company stock.

The Act also provides that the SEC shall issue rules requiring:

  • enhanced disclosure of off-balance-sheet transactions
  • an internal control report to be included in each annual report
  • disclosures regarding whether a public company has adopted a code of ethics for its senior financial officers
  • disclosures regarding whether a public company’s audit committee has at least one member who is a financial expert
  • a review by the SEC of the periodic disclosures of certain issuers on a regular and systematic basis
  • real-time disclosure of certain events that impact a company’s financial health

Analyst Conflicts of Interest

The Act requires that the SEC impose new rules with respect to financial analysts to prevent conflicts of interest.

Criminal Penalties for Corporate Fraud

The Act imposes broad new criminal penalties for corporate wrongdoers.  Such penalties include: 

  • a prison term of up to 20 years for destroying or altering documents sought in federal investigations
  • a prison term of up to 25 years for those who “knowingly” engage in securities fraud
  • a fine of up to $5,000,000 and a prison term of up to 20 years for certain officers who “willfully” and “knowingly” certify false financial statements
  • an increase in the maximum prison term for any person convicted of certain types of conspiracy charges
  • an increase in the maximum prison term for mail and wire fraud (from 5 years to 20 years)
  • an increase in the maximum prison term for violations of federal employee-benefits laws (from one year to 10 years)

Additionally, the SEC has been given broader enforcement authority, including the authority to:

  • bar corporate wrongdoers for life from serving as officers or directors of any public company
  • freeze payments made from companies to certain people suspected of violating securities laws

The Act also:

  • prohibits individuals who violated the securities laws from using bankruptcy protection to avoid paying judgments to defrauded investors and other victims
  • increases the time permitted to bring securities fraud lawsuits against corporations
  • provides for federal protection for company whistle blowers

Since the passage of these broad new laws, House and Senate lawmakers have already turned their attention to additional legislation focusing on other issues that have arisen as a result of the recent highly publicized corporate failures.  Accordingly, additional legislation, as well as actions by the stock exchanges and other self-regulatory organizations, in this area is expected.

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