On December 2, 2001, the Enron Corporation, a highlyrespected and rapidly growing energy-trading company filed for bankruptcy. It had inflated its earnings by nearly $600 million in the 1994-2001 period. This had become known less than a month before. Enron, with assets of $62.8 billion, became the largest bankruptcy in U.S.
history. Its stock closed at 72 cents on December 2. It had been over $75 a share one year earlier. Investors lost billions and employees lost their life savings. Exactly 241 days later, on July 30, 2002, the President signed into law the Public Company Accounting Reform and Investor Protection Act of 2002. The act’s two chief sponsors were Senator Paul Sarbanes (D-MD) and Representative Michael G. Oxley (R-OH). The legislation thus carried the short title of Sarbanes-Oxley Act of 2002, subsequently abbreviated as SOX or SarbOx. In the opinion of most observers of securities legislation, SOX is viewed as the most important new law enacted since the passage of the Securities and Exchange Act of 1934.
The Enron debacle would have been prevented if audits of the company had detected accounting irregularities or if the company would have been required to disclose transactions not directly reflected on its balance sheet. Incentives and rewards used within the company and dealings with entities imprecisely associated with Enron contributed to the massive failure. Furthermore, insider trading took place toward the end while employees holding company stock as part of their pensions were prevented from trading them during a so-called “blackout” period.
Sarbanes-Oxley was principally a reaction to this failure. However, during this same period, the equally dramatic actual or pending bankruptcies of WorldCom, a long-distance telecommunications company, and Tyco, a diversified equipment manufacturer, influenced the content of the legislation. SOX thus deals with 1) reform of auditing and accounting procedures, including internal controls, 2) the oversight responsibilities of corporate directors and officers and regulation of conflicts of interest, insider dealings, and the disclosure of special compensation and bonuses, 3) conflicts of interest by stock analysts, 4) earlier and more complete disclosure of information on anything that directly and indirectly influences or might influence financial results, 5) criminalization of fraudulent handling of documents, interference with investigations, and violation of disclosure rules, and 6) requiring chief executives to certify financial results personally and to sign federal income tax documents.
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Summary Of Provisions
Sarbanes-Oxley governs the activities of publicly traded companies. It aims at protecting investors who, unlike investors in privately held corporations, are presumed to be at a greater distance from management and therefore more vulnerable. Any and all companies, of any size, the stock of which is publicly traded (whether on a stock exchange or over the counter) are subject to SOX; thus it touches a certain range of small business as well.
The act has 11 titles, i.e., major subdivisions. These in turn are divided into sections. The sections of Title IV, for instance, begin with Section 401 and end with Section 409. It is common practice in referencing pieces of legislation to refer to section numbers. Some sections are more controversial or difficult than others and will be more frequently mentioned in articles. An example is Section 404 in SOX which deals with internal accounting controls—which has imposed significant data processing costs. In the following explanations sectional references are omitted. A title-by-title summary follows.
Title I – Public Accounting Oversight Board Title I creates an independent Public Accounting Oversight Board under the general oversight of the Securities and Exchange Commission. PAOB is charged with newly registering, regulating, inspecting, and generally overseeing companies that audit publicly traded companies. PAOB owes its origin to auditing failures that surfaced during the Enron bankruptcy. The Board is self-funded by the fees that it is authorized to charge.
Title II – Auditor Independence Next is Title II which legislates the behavior of auditing firms in particular. Its most important provisions severely restrict auditing firms from carrying out compensated activities for their auditing clients that fall outside the boundaries of auditing narrowly viewed. Such “outside” activities include the provision of services like bookkeeping, accounting, financial information systems design, appraisals, and many other jobs. This prohibition is based on the notion that audit firms may be influenced in their audit practices in favor of a client from whom they are getting other profitable business. Other provisions of Title II require that audit partners are rotated after five years of service auditing a client (lest relations become too cozy) and also prohibit financial officers of the audited firm from having been employed by the audit company.
Title III – Corporate Responsibility Title III specifies the responsibilities of public companies in relation to financial and accounting behavior. It requires that companies establish audit committees made up of independent board members who have no financial ties to the company; they may, of course, be paid for their board duties. The chief executive and the chief financial officer both must certify the material correctness of financial statements underlying audit reports. It forbids officers and board members from attempt improperly to influence audits. If financial statements must be revised because of misconduct, the CEO and CFO forfeit bonuses or incentives or profits from securities sales.
Directors and officers may be barred from service for violating certain SEC requirements. While the trading of a pension fund is suspended (a “blackout” period), insider trading is prohibited as well—a provision that also harks back to Enron where insiders traded while pension funds were frozen.
Title IV – Enhanced Financial Disclosures The intention of Title IV is to cause corporations to make public transactions not heretofore normally required to be discussed, such as off-balance sheet transactions (of the sort that, in part, caused Enron’s failure) and relationships with “unconsolidated entities” that could influence the company’s finances. The SEC is charged with studying the matter in greater detail as well. Directors, officers, and stockholders with 10 percent or more holdings are required to make certain transactions public—such as special bonuses and stock grants or large dispositions of stock. Companies are prohibited from making loans to any director or executive (echoing a problem discovered at WorldCom). The Title also mandates that companies with codes of ethics make these codes public. Changes in financial conditions must be disclosed in real time.
Another important requirement of the Title is that every annual report must contain a special report on internal controls. Such controls must be established and maintained and then assessed every year. (This is the “costly” Section 404.) Such controls consist of special methods of testing financial reports and data to determine their truth and coherence.
Title V – Analyst Conflicts of Interest Securities analysts who recommend the purchase of securities to the public are addressed by Title V. It requires that National Securities Exchanges and associations of registered securities formulate and adopt rules governing conflicts of interest for analysts. The aim of the Title is to prevent situations in which favorable recommendations are in effect “bought” by indirect favors of one sort or another.
Titles VI and VII – SEC Role and Studies These titles address the SEC’s role and specify studies to be undertaken.
Title VIII – Corporate and Criminal Fraud Accountability Title VIII makes it a felony to destroy documents and to create fraudulent documents in order to thwart federal investigations. It mandates auditors to keep all paper work related to an audit for five years. It changes the statute of limitations on securities fraud claims and extends whistleblower protections to those who disclose closely held company information to parties in a lawsuit. Title VIII also establishes a new crime for securities frauds punishable by up to10 years in prison and fines.
Title IX – White Collar Crime Penalty Enhancements The best-known provision of Title IX is that financial reports made to the SEC must be certified by the CEO and CFO who must state that such reports are in compliance with the securities act and include all material aspects of the company’s finances. Violations of this provision carry a fine of $500,000 and up to five years in prison. Other provisions in this Title address mail and wire fraud, making it a crime to interfere with official proceedings and tampering with records; give the SEC the right to seek a court-ordered freeze of payments to company directors, agents, and employees; and enable the SEC to prevent any person convicted of securities fraud from holding office as a director or officer of a publicly traded company.
Title X – Corporate Tax Returns This Title requires that the CEO sign corporate income tax returns.
Title XI – Corporate Fraud and Accountability This Title, which Congress entitles as the “Corporate Fraud Accountability Act of 2002,” specifically amends the U.S. Code to make tampering with records and interfering with official proceedings a crime and sets the penalty for this crime (a fine or imprisonment for no more than 20 years). It gives the SEC authority to temporarily freeze extraordinary payments to directors, officers, agents and employees of a company during investigations of security law violations, and codifies the SEC’s right to prohibit persons convicted of securities fraud from serving as a director or officer of a public company.
Major Dos And Don’ts
Sarbanes-Oxley can also be reduced to 13 dos and don’ts—provided here strictly for reference and as reminders. The publicly traded company, needless to say, is well advised to implement SOX requirement only after close study of the law itself with the help of experts.
The list follows: 1. Audit firms shall be registered. They must do audits only. If they do other work for a company, they must not do audits for that company.
2. The company’s audit committee members shall be independent board members.
3. Stock analysts shall be subject to conflict of interest rules.
4. Companies must disclose all pertinent information that may in any way affect company finances, whether on or off the balance sheet.
5. Companies shall not lend money to executive officers or directors.
6. CEO and CFO compensation, bonuses, and profit sharing shall be reported to the public.
7. Insider trades must be made public immediately.
8. Insiders shall not trade company stock during periods of pension fund blackouts.
9. Financial reports must be certified by the CEO and CFO.
10. Financial reports must be accompanied by a special report on internal controls and an assessment on how well they work.
11. Federal income tax filings must be signed by the CEO.
12. Whistleblowers shall be protected.
13. Violators shall pay higher fines and spend longer times in prison than heretofore.
Evolution And Cost
In early 2006, implementation of Sarbanes-Oxley was well underway. The Public Company Accounting Oversight Board was in operation and had issued interim standards as of April 16, 2003. Costs of implementation have shown up most dramatically as information technology expenditures in support of Section 404 compliance (accounting controls). Wikipedia, in its article on SOX, citing Financial Executives International (FEI) data, based on 217 companies with revenues over $5 billion, indicated average compliance to have been $4.36 million per company. Compliance costs for companies with lower revenues have averaged $1.9 million.
Opinion on the overall benefits of Sarbanes-Oxley is divided. Some claim that the financial activities of publicly traded companies are still severely under-regulated while others hold that SOX was necessary but that some of its requirements are not cost-effective.