Securities and Securities Enforcement
August 2002
The Sarbanes-Oxley Act and the
New Order of Corporate Disclosure
by Jeffrey B. Maletta and Nicholas G. Terris*
President Bush has signed into law landmark
legislation, the Sarbanes-Oxley Act of 2002 (the
“Act”), to address what Congress believes are the
causes of recent scandals that have shaken Wall
Street and Main Street.
The Act sweeps broadly. It imposes a new regulatory
regime on the accounting profession and new
obligations on brokerage firms, analysts, and
lawyers. We focus in this Alert on provisions that
will directly, and in some cases immediately, affect
the way public companies (those that are registered
under Section 12 of the Exchange Act or file reports
under Section 15(d) of that Act, including non-U.S.
issuers) operate their internal financial systems and
disclose information to the public.
Some of these measures will require public
companies to react now. For example, the Act
provides that, as of the signing of the legislation,
chief executive officers and chief financial officers
must certify the accuracy of the company’s periodic
reports. False statements could subject the signing
officer to SEC enforcement actions, third-party civil
liability under the antifraud provisions of the
securities laws, and criminal sanctions.
Other provisions are not self-executing but direct the
SEC to issue rules in the future. In one potentially
dramatic departure from the securities laws’
historical philosophy of “periodic disclosure,” the
SEC is directed to issue rules requiring that certain
material information be continuously disclosed to
investors on a “real time” basis. While the full effect
of these provisions will not be felt immediately, it is
plain that the Act will impose substantial new
responsibilities on management and audit committees
and considerable new costs on issuers.
CERTIFICATION OF FINANCIAL REPORTS
The Act contains two distinct provisions calling for
certain certifications in connection with financial
statements, one effective immediately and one
effective only upon the issuance of rules that the SEC
is directed to adopt within 30 days after the
legislation’s enactment. These provisions go
significantly beyond the certifications required by the
June 27, 2002 SEC Order directed to 947 identified
public companies.
Immediately Effective Requirement for
Certification of Reports
Section 906, entitled “Corporate Responsibility for
Financial Reports,” provides that, effective
immediately, each periodic report (possibly including
a Form 8-K) containing financial statements that a
public company files with the SEC must be
accompanied by a certification by the CEO and CFO
stating that the periodic report containing the
Jeffrey Maletta and Nicholas Terris are a Partner and an Associate, respectively, in K&L’s Securities Enforcement and
Litigation Practice. Both are resident in the firm’s Washington, D.C. office.
*
Kirkpatrick & Lockhart LLP
financial statement “fully complies” with the
Exchange Act disclosure requirements, and that the
information contained in the report fairly presents, in
all material respects, the financial condition and
results of operations of the company.
Although it is not clear from the Act or its sparse
legislative history, this provision seems to require
CEOs and CFOs to determine whether the reports
comply with the myriad technical SEC regulations
governing content and accounting rules.
Violation carries criminal penalties, including a fine
of up to $1 million and a maximum 10 years
imprisonment for “knowingly” making a false
certification and a fine of up to $5 million and a
maximum of 20 years imprisonment for “willfully”
doing so. Because this provision appears in the
federal criminal code, it is not clear that the SEC
possesses authority to clarify or otherwise
administer it.
any fraud committed by employees with
significant responsibility for internal controls.
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Provision Requiring SEC Rules Within 30 Days
A separate provision of the Act, Section 302, directs
the SEC to develop, within 30 days, new rules for
more elaborate certifications of periodic reports by
CEOs and CFOs. The Act provides the SEC with
some instructions as to the content of these rules:
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A company’s CEO and CFO must certify that
he or she has reviewed each annual or quarterly
report and that, based on the officer’s
knowledge, the report contains no material
misstatements or omissions, and the financial
statements fairly present the company’s
condition. This aspect of the certification
provision is generally similar to certification
required by the recent SEC Order.
CEOs and CFOs also must certify that they are
responsible for establishing and maintaining
internal controls, that they have designed such
internal controls to ensure that they are made
aware of material information relating to the
company and its consolidated subsidiaries, and
have evaluated the effectiveness of the internal
controls within the past 90 days.
CEOs and CFOs must certify that they have
disclosed to the auditors and audit committee
significant deficiencies in internal controls and
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While this certification provision is not placed
in the criminal code, it may be enforced in a
criminal prosecution under a provision of the
Exchange Act making it a crime to willfully
and knowingly make false statements in
documents filed with the SEC.
The SEC may enforce this provision civilly and
administratively. If the conduct amounts to a
violation of Rule 10b-5 -- a known or reckless
misstatement -- under new statutory authority,
the SEC may bar individuals from serving as
officers or directors of public companies.
The certification requirement creates additional
exposure for officers and for public companies
in private securities litigation. Class action
plaintiffs will likely point to the certifications
regarding internal controls as “evidence” that
an executive “must have” been aware of
material information regarding the company or,
alternatively, that the executive made a
material misstatement by certifying the
adequacy of internal controls.
Public companies should consider reviewing
their Directors and Officers Indemnification
Insurance in light of the personal certifications
by the CEO and CFO. See K&L’s Alert issued
in July 2002 entitled “The SEC’s Certification
Requirement For CEO’s And CFO’s: How It
May Affect Recoveries Under D&O Insurance
Policies And Corporate Indemnification
Provisions.”
Each public company should develop internal
procedures, tailored to each company’s individual
organization, governance arrangements, and
business, to assure that the certifications are accurate
and that the covered reports meet regulatory
standards.
NEW CORPORATE DISCLOSURE
REQUIREMENTS
In addition to the certification provisions, the Act
imposes a number of significant changes to
substantive corporate disclosure requirements. Most
will not take effect until after the SEC issues
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implementing rules, but two require immediate
attention:
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Material Adjustments. Effective
immediately, financial statements filed with the
SEC must reflect the material adjustments
under GAAP that have been identified by a
company’s auditor. (Sec. 401).
Faster Disclosure of Insider Trades.
Beginning 30 days following the Act’s
enactment, directors, executive officers, and
10% shareholders must report company stock
trades (i.e., file Form 4) by the end of the
second business day following the transaction.
(Sec. 403).
The Act also adds other disclosure requirements,
including the following requirements that will take
effect within six months after the SEC issues rules:
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Off-Balance-Sheet Transactions. In response
to Enron’s extensive use of so-called special
purpose entities and other transactions that
were not reflected on its financial statements,
the Act directs the SEC to issue rules requiring
that periodic reports disclose all material offbalance-sheet transactions. (Sec. 401).
capitalization, (4) that are emerging companies with
disparities in price-to-earning ratios, or (5) whose
operations significantly affect any material sector of
the economy.
Finally, the Act sets the stage for future SEC rules
mandating a “continuous disclosure” regime. Until
now, the securities laws generally allowed companies
to remain silent (about good news as well as bad
news) except when they are issuing securities or
when they are required to make disclosures in annual
and other periodic reports. In a significant change,
the Act authorizes the SEC to issue rules requiring
public companies to disclose “on a rapid and current
basis,” in plain English, information concerning
material changes in a company’s financial condition
or operations. (Sec. 409). This will make disclosure
decisions an everyday part of public company
management.
NEW REGULATION OF AUDITS
The Act significantly alters the way in which public
companies hire and work with auditors, and it may
require some companies to rapidly reconfigure their
boards of directors.
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Pro Forma Earnings. The SEC is also
directed to develop rules defining and
prohibiting misleading pro forma financial
information and requiring that it be reconciled
with GAAP earnings. (Sec. 401).
Codes of Ethics. The SEC will develop rules
requiring companies to disclose whether they
have adopted a code of ethics for senior
financial officers and, if not, why not. The
rules also will require disclosure of waivers of
the code of ethics for senior financial officers.
(Sec. 406).
The Act also directs the SEC to review “on a regular
and systematic basis,” and no less than every three
years, the periodic filings of companies whose stock
trades on national markets. (Sec. 408). In
scheduling the reviews, the SEC is required to
consider issuers: (1) that have issued material
restatements of financial results, (2) that experience
significant volatility in their stock price as compared
to other issuers, (3) with the largest market
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Independent Audit Committee Members.
Audit committee members of publicly traded
companies must be independent -- they may
not receive any compensation from the
company, other than directors’ fees, or be an
“affiliated person” of the company or its
subsidiaries. (Sec. 301). This will take effect
within nine months and will be established by
rules of the national securities exchanges.
Audit Committee Expertise. Companies will
be required by SEC rule to be adopted within
six months to disclose in their periodic filings
whether their audit committees include among
their members at least one “financial expert” (a
term to be defined in future SEC rulemaking)
and, if not, to provide an explanation for the
absence of such a member. (Sec. 407).
Audit Committee Responsibilities. Audit
committees must hire and oversee the
company’s auditor and establish procedures for
the receipt of complaints regarding accounting
(including for the anonymous submission by
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corporate employees of concerns regarding
questionable accounting). To assist audit
committee members in fulfilling these
extensive new duties, the Act provides that
audit committees shall have the authority to
engage independent counsel and other advisers.
(Sec. 301). This takes effect within nine
months and will be established by rules of the
national securities exchanges.
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Auditor Reporting Requirements. Auditors
are required to furnish reports to audit
committees setting forth information regarding
critical accounting policies and practices and
alternative treatments of financial information
that have been discussed with management
including disagreements between the auditor
and management. (Sec. 204).
Auditor Independence Standards. The Act
also sets standards designed to enhance auditor
independence that will affect the way
companies work with their auditors. Non-audit
services are generally prohibited (most notably
bookkeeping and design of financial
information systems) to audit clients. Other
non-audit services may be furnished to audit
clients only with the pre-approval of the audit
client’s audit committee and the disclosure of
the arrangement in the company’s periodic
reports. (Secs. 201, 202).
Auditor Rotation. Lead and reviewing audit
partners must “rotate” and may not provide
audit services to a company if either the lead or
reviewing partner has performed audit services
for the company in each of the company’s five
previous fiscal years. (Sec. 203).
PROVISIONS AFFECTING EXECUTIVE TRADING
AND COMPENSATION
The Act contains provisions affecting executive
compensation, loans, and insider transactions in
company shares:
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Disgorgement of Profits in the Event of
Restatements. Effective immediately, in the
event of an accounting restatement that results
from material non-compliance with SEC
financial reporting requirements, CEOs and
CFOs must disgorge bonuses and other
incentive-based compensation and profits on
stock sales received during the 12-month
period following the initial release of the
financials that were later restated, if the noncompliance results from “misconduct.” (Sec.
304). Companies are to seek such
disgorgement and, if they do not, they may
invite a shareholder suit or SEC enforcement
action to enforce the corporate right.
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No Loans to Executives. Effective
immediately, public companies may not
directly or indirectly extend credit to any
director or executive officer. Limited
exceptions are provided, principally for certain
loans made in the ordinary course of business
and on the same terms offered to the public.
For example, a mortgage lender that provides a
mortgage loan to a director at the same rates as
provided to the public would be permitted.
Extensions of credit maintained on the date of
the Act’s enactment are not affected, but such
prior credit extensions may not be materially
modified or renewed. (Sec. 402).
Trading Restrictions. Effective six months
after the effective date of the Act, insiders will
be prohibited from trading company stock
during so-called “blackout periods” during
which company employees are prevented from
trading company stock in their retirement
plans. Insider trading policies should be
modified accordingly. (Sec. 306).
PROVISIONS EXTENDING CIVIL LIABILITY
The Act contains numerous provisions that directly
increase or extend civil liability for violations of the
federal securities laws.
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Longer Statute of Limitations. Under
current law, securities fraud class actions must
be filed within one year of the discovery of
facts relevant to the fraud claim or three years
after the date of the alleged fraud. The Act
lengthens these periods to three years and five
years, respectively, for “all proceedings” that
are “commenced on or after the date of
enactment of th[e] Act.” (Sec. 804). Plaintiffs
can be expected to argue that this effectively
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revives claims that otherwise would have been
barred under the one-year/three-year period.
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Protection for Whistle-blowers. The Act
creates a limited private cause of action for
compensatory damages and litigation costs for
employees who are retaliated against because
of any “lawful act” done to provide
information to the government or to assist in a
proceeding that was filed, or about to be filed,
relating to (among other things) any provision
of federal law relating to fraud against
shareholders. (Sec. 806). This latter category
appears to include current employees who
provide assistance in private shareholder
lawsuits.
Officer and Director Bars and Penalties.
The Act authorizes the SEC in an
administrative proceeding to issue (or in a
federal court proceeding to seek) orders
barring individuals from serving as officers and
directors who violate antifraud rules and who
exhibit “unfitness” to serve. (Secs. 305, 1105).
Previously, only federal courts could issue
these orders on a showing of “substantial
unfitness.”
Non-Dischargeability in Bankruptcy. The
Act provides that debts incurred in violation of
federal or state securities laws in federal and
state judicial and administrative proceedings
are non-dischargeable in bankruptcy even if
fraud is not present. It appears that damages
for negligent misstatements in violation of
Section 11 of the Securities Act may be nondischargeable. (Sec. 803).
PROVISIONS EXTENDING CRIMINAL LIABILITY
The Act defines several new crimes for violation of
the securities laws or interfering with an
investigation, and imposes severe penalties,
including:
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Executing or attempting to execute a scheme or
artifice to defraud someone in connection with
securities (punishable by a maximum 25-year
sentence). (Sec. 807).
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Corruptly destroying, mutilating, concealing,
or falsifying documents with the intent to
impair their integrity or availability for use in
an official proceeding (maximum 20-year
sentence). (Sec. 1102).
Retaliating against certain whistle-blowers
(those who provide truthful information to a
law enforcement officer relating to the possible
commission of any offense) (maximum 10-year
sentence). (Sec. 1107).
The Act also increases penalties for violations of
existing criminal statutes that cover the securities
industry. For example, a maximum 20-year prison term
may now be imposed for mail fraud (previously the
maximum sentence was 5 years).
OTHER PROVISIONS
Accounting Oversight Board and Future
Standard Setting Body
The Act effects other dramatic changes on the
portion of the accounting industry that audits public
companies. (The Act does not affect small- and
medium-sized accounting firms that do not audit
public companies. The regulation of such firms is
left to the States.)
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Accounting Oversight Board. The Act ends
what one witness at congressional hearings
termed the profession’s “Byzantine and
insufficient … combination of public oversight
and voluntary self-regulation.” It creates a
five-member “Public Company Accounting
Oversight Board” with which accounting firms
must register. In addition to its authority to
establish rules governing audit quality control,
ethics, and independence, the Board is
endowed with investigative and disciplinary
powers, including levying significant monetary
penalties and permanently barring an
accounting firm or associated person from
auditing public companies. Only two Board
members may be certified public accountants.
The Board is not a government agency, but will
be funded by fees on all publicly traded
companies. It will be subject to SEC
oversight.
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Future Standard Setting Body. Apart from
the Board, the Act also authorizes the SEC in
the future to recognize a new standard setting
body that will be charged with developing
GAAP for purposes of the securities laws.
Analyst Conflicts of Interest
In the wake of the highly publicized investigation by
New York Attorney General Eliot Spitzer, the Act
also includes provisions directing the SEC to
promulgate rules addressing conflicts of interest to
which securities analysts are subject. (Sec. 501). As
with some of the provisions affecting the accounting
industry, these rules will have relatively little direct,
immediate impact on most public companies
notwithstanding their potential systemic significance.
Rules of Professional Conduct for Attorneys
The Act includes a provision requiring the SEC to set
forth professional standards for attorneys that
practice before it. (Sec. 307). These will include
rules requiring attorneys to report evidence of
material securities law violations or breaches of
fiduciary duties to a company’s general counsel or
CEO and, if they do not appropriately respond, to the
board of directors or an independent committee
thereof. The provision is not effective until the SEC
issues rules, the deadline for which is six months
after the Act’s enactment. K&L will provide a
separate Alert once these rules are adopted.
CONCLUSION
While it leaves the basic system of federal securities
regulation largely intact, the Act reflects a new
emphasis on corporate governance and compliance,
areas traditionally governed by state law, or the rules
of self-regulatory organizations. We can speculate
whether it will fulfill the congressional goal of
renewing investor confidence. We can be certain it
will require public companies to make significant
changes in the way they generate and disclose
financial information.
__________________________________________
If you have any questions about the Sarbanes-Oxley
Act of 2002, please contact:
Tom Cooney (202.778.9076/tcooney@kl.com),
Jeff Maletta (202.778.9062/jmaletta@kl.com) or
Nicholas Terris (202.778.9408/nterris@kl.com).
Alternatively, the K&L attorney with whom you most
often work can direct you to the appropriate people
within the firm for your specific needs.
Kirkpatrick & Lockhart LLP
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should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2002 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.