Chapter
16
Securities
Regulations
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
U.S. Financial Markets
8000
7000
6000
5000
Total Market Value Of
U.S. Stocks
Bank Deposits
4000
3000
2000
1000
0
1980
1985
1990
1995
Source: Securities And Exchange Commission: GPRA Report, Industry Statistics
1996
16-2
Introduction
 Securities Regulation Began
Due To Great Depression Of
1930’s
 Designed To Give Potential
Investors Factual
Information To Make
Informed Decision
 Federal & State Laws
16-3
Security Investment
 Exists When
• Person Invests
• Others Manage It For Profit
 Questions:
• Common Business Activity?
• Reasonable Expectation Of
Profit?
• Profits Earned Through
Efforts Of Someone Else?
16-4
What is a Security?
 Per the acts includes:
• Note, Stock, Bond, Debenture
• Evidence of Indebtedness
• Certificate of Interest, Certificate of
Subscription
• Investment Contract, Voting Trust
Certificate
• Interest in Oil, Gas or Mineral Rights
• Other interests “commonly known as
securities”
16-5
What is a Security?
 Bankers Trust Company served as an agent for corporate
customers by placing their commercial paper for sale. This
function of a commercial bank acting as a dealer of commercial
paper was challenged by the Securities Industry Association.
Issue: Were these sales subject to federal securities laws?
Held: Yes. The sale of commercial paper is a security and the
Glass-Steagall Act prohibits commercial banks from acting as a
dealer of such securities. Securities Industry Association v.
Board of Governors of the Federal Reserve System, 104
S.Ct. 2979 (1984).
16-6
What is a Security?
 W.J. Howey Company and Howey-in-the-Hills Service, Inc., are Florida corporations under
common control and management. Howey Company offered to sell to the public its orange
grove, tree by tree. Howey-in-the-Hills Service, Inc., offered these buyers a contract
wherein the appropriate care, harvesting, and marketing of the oranges would be provided.
Most of the buyers who signed the service contracts were nonresidents of Florida who had
very little knowledge or skill needed to care for and harvest the oranges. These buyers were
attracted by the expectation of profits. When the profits were not forthcoming, the buyers
sued based on the 1933 Securities Act registration requirements not being satisfied. Issue:
Did the Howey Company sell securities? Held: Yes. Sales of orange trees and services
contracts were sales of securities. Under the Federal Securities Act of 1933 a security exists
whenever one person invests money in a common enterprise with the exception of profits
resulting from the efforts of another person. Upon examination of these orange grove
transactions, these essential requirements of a security were found to be present. Since the
registration requirements were not satisfied, the controllers of these "Howey" companies
have violated the Federal Securities Act of 1933. SEC v. W.J. Howey Co., 328 U.S. 293
(1946).
16-7
Securities &
Exchange Commission (SEC)
 Created In 1934-35
Commissioners
 Quasi-Legislative &
Quasi-Judicial
 Regulates
• Stock Exchanges
• Utility Holding Companies
• Investment Trusts
• Investment Advisors
16-8
SEC Filings
1,600
1,400
1,200
1,000
IPO Filings
Repeat Issuers
800
600
400
200
0
1995
1996
1997
http://www.sec.gov/pdf/annrep01/ar01fulldisc.pdf
1998
1999
2000
2001
16-9
Documents For
Securities Sale
 Registration Statement
• Disclosure Of Financial
Info.
• Periods
 Pre-filing Period
 Waiting Period- 20 Days,
Tombstone Ad
 Post-effective Period
 Prospectus- Final
Financials
16-10
Exchange Act:
Initial Registrations
1,200
1,000
800
600
400
200
0
1995
1996
http://www.sec.gov/pdf/annrep01/ar01fulldisc.pdf
1997
1998
1999
2000
2001
16-11
Registration
Statement Liability
 Untrue Statements Of
Material Fact
 Omits Material Facts
 Omits Information
Resulting In Misleading
Potential Investor
16-12
Fraudulent Transactions
 Attempt To Defraud
 Attempt To Obtain
Money/Property By
Untrue/Misleading Statements
 Attempt To Engage In
Transaction/Practice To
Defraud/Deceive Purchaser
16-13
Security
Transaction Defenses
 Materiality- Prudent
Investor Would Use
 Statute Of Limitations- 1
Year After Discovery, No
More Than 3 Years
 Due Diligence- Reasonable
Review Of Financials
16-14
SEC Enforcement
& Litigation
 Section 10(b) & Rule
10b.5- Materiality
 Persons Liable
• Insiders
• Broker-Dealers
• Corporations Who’s
Stock Purchased/Sold
• Those Who
Aid/Abet/Conspire To
Defraud
16-15
Insider Transactions
 Insider
• Owns More Than 10%
• Director/Officer
 Insiders Must File Within 10
Days
 Short-Swing Profits
 Non-Public Information
 Civil & Criminal Liability
16-16
State Blue Sky Laws
 Registration By
• Notification
• Qualification
• Coordination
 Exemptions
• Isolated Transaction
• Limited Offer Within Stated Time
• Private Offering
• Number Of Holder Not Greater Than
Specified
16-17
Overview of Legislation
 Regulation of Publicly Traded Securities
 Securities Act of 1933- Disclosure on
IPO’s (one-time)
 Securities Exchange Act of 1934Periodic Disclosures
• Monthly, Quarterly, Annual
 Securities & Exchange Commission
(SEC)
16-18
Securities Act (1933)
 Disclosure Law- Going Public
 Sanctions Of Violations- Intentional
• Criminal Punishment
• Civil Liability For Injured Parties
• Injunction- Equitable Remedy
 Parties That Must Comply
• Issuers
• Underwriters
• Controlling Persons
• Sellers
16-19
Securities Act of 1933
 Registration Requirements
• the purpose of requiring registered securities offerings is to
•
•
•
•
ensure that investors have the information they need to
make intelligent investment decisions.
Registration Statement - Document describing company and
its securities
Reviewed by SEC to make sure not per se fraudulent
Prospectus - Document used to promote a security
the purpose of Section 5’s restrictions on when and how a
seller of securities may communicate with prospective
buyers: to ensure that an investor has the time to make an
intelligent investment decision based on either the
prospectus or face-to-face communications in which the
investor has an opportunity to ask questions.
16-20
Securities Act of 1933
 Electronic FilingEDGAR
 Exemptions
• Securities
Government issued or
guaranteed
Short-term notes and
drafts
16-21
Securities Act of 1933
 That Section 3 of the 1933 Act exempts the following securities from the
registration and prospectus requirements:
 a. Commercial paper arising out of current transactions with a maturity not









exceeding nine months.
b. Securities issued by not-for-profit corporations.
c. Government securities.
d. Securities of national banks, state banks, or the Federal Reserve Board.
e. Securities of savings and loan institutions and farmers' cooperatives.
f. Securities issued by carriers subject to the Interstate Commerce Commission.
g. Insurance contracts.
h. Exchanges with existing security holders.
i. Intrastate offerings.
j. Securities declared exempt by the SEC's rules and regulations.
16-22
Antifraud Provisions
of 1933- Liability
Improper Offers/Sales
• Improper:
Timing
Manner
Content
16-23
Antifraud Provisions
of 1933- Liability
Defective Registration Statements
 Section 11 liability:
• a. Privity is not required.
• b. Reliance is not ordinarily required.
• c. The purchaser need not prove that the
defendants were negligent. Instead, the
defendants must disprove their
negligence by establishing DUE
DILIGENCE.
16-24
Antifraud Provisions
• Defective Registration Statements
 see Gustafson v. Alloy Company below
• Under Section 12(1) of the 1933 Act the remedy is
rescission or damages.
 Nonprofit securities
 Financial institution securities
 ICC-regulated
 Insurance and annuity contracts
16-25
Antifraud Provisions
 The shareholders of Alloyd, Inc. sold their stock in a private sale agreement. The
contract specified a price for the estimated increased value in the company's
worth between the time of sale and the end-of-the-year audited financial
statements. The contract further provided that any party disappointed with
estimated value could seek an adjustment after the financial records were audited.
The buyers were disappointed with the estimated increased value. Rather than
seeking an adjustment in the purchase price, they sought to rescind their purchase
under § 12(2) claiming that the information provided (as a prospectus) at the time
of the sale was false or misleading. Issue: Does § 12(2) apply to private sale
contracts? Held: No. When the 1933 Act was enacted, the term prospectus was
well understood to refer to documents soliciting the public to acquire securities
from the issuer. Section 12(2) does not extend to a private sale contract since that
contract is not held out to the public as a "prospectus" in the meaning of the 1933
Act. Gustafson v. Alloyd Co., Inc., 115 S.Ct. 1061 (1995).
16-26
Securities Exchange Act
(1934)
 Being Public- File Forms With:
• Stock Exchange
• SEC- Periodic Reports
 Affects
• Businessperson
• Accountant
• Lawyer
• Investor
16-27
Securities Exchange Act of
1934
 Registration of SecuritiesDisclosure Required when
• 500 or more shareholders
and issuer’s assets > $3
million
• Interstate trading
• On a national stock
exchange
16-28
Securities Exchange Act of
1934
 Periodic Reports
• Gallagher v. Abbott Laboratories
 The court ruled that Abbott did not
violate the disclosure provisions of the
1934 Act because it did not have duty
to disclose all information material to
its stock prices as soon as it was
discovered by the company. The court
stressed that, rather than continuous
disclosure, the 1934 Act insists only
upon periodic disclosure.
16-29
Securities Exchange Act of
1934
 Short-Swing Trading by Insiders
• Individual filing by Insiders
• Insider =
 Officer with registered equity securities
 Director
 Owner of 10% or more of a class of
equity securities
• Issuer can recover insider trade gains
within 6 month period
• Purpose: To prevent speculation based on
inside information
16-30
Securities Exchange Act of
1934
 Regulation of Proxy Solicitations
• to allow shareholders to exercise their
voting rights intelligently and to permit
insurgent shareholders to have a fair
opportunity to oust incumbent
management.
• the information required by the SEC to be
included in proxy statements where
directors are to be elected. (This is in
addition to the requirements for annual
financial reports that must be sent with or
prior to a proxy statement for an annual
meeting.)
16-31
Securities Exchange Act of
1934
 Regulation of Proxy Solicitations
 a. The person making the solicitation of proxies
and the methods to be employed.
 b. Interests of directors, officers, and certain
others in matters to be acted upon.
 c. Certain information about nominees and
those continuing in office, including occupation
for the last five years, relationships to executive
officers, and interests in firms that deal with the
corporation.
 d. Whether the corporation has audit,
nominating, and compensation committees, and
if so, their membership and how often they met
in the past year.
16-32
Securities Exchange Act of
1934
 Regulation of Proxy Solicitations
 e. Names of directors who have attended less
than 75 percent of directors and board
committee meetings.
 f. Certain information if a director has resigned
or declined to stand for reelection because of a
disagreement with the corporation.
 g. Compensation of directors, including fringe
benefits—specific directions are given as to
how this information must be shown.
 h.
Name of and information about the
independent public accountants and their
relationship with the corporation.
16-33
Provisions of
1934 Act- Liability
 Prohibit Manipulation of
Security Price
• e.g. “Wash Sale” simultaneous sale/buy
 Impose Liability for False
Statements in Filed Documents
16-34
Section 10(b) & Rule 10(b-5)
 Section 10(b) and Rule 10b-5 is the most

important liability section in the securities
laws!
Misstatements/Omissions
• Elements of a Rule 10b-5 violation
(Designed to stop fraud)
 (1). In an omission case, the fraud
requirement dictates that there be a
duty to disclose, usually because of
a fiduciary duty owed the plaintiff.
16-35
Section 10(b) & Rule 10(b-5)
 Misstatements/Omissions
• Elements of a Rule 10b-5 violation
 (2). If there is no fraud—that is, no
misstatement or omission— there is no
Section 10(b) liability. Thus, mere corporate
mismanagement or other breach of a
fiduciary duty that corporate managers owe
to shareholders does not create liability
under this provision. There must be a
misstatement or omission.
 Rule 10b-5 requires a showing of scienter—
intent to deceive. Note, however, that
recklessness may establish scienter
16-36
Section 10(b) & Rule 10(b-5)
• Plaintiff must be Purchase
or Seller
• Must show Reliance,
unless omission
• Statute of Limitations May
Apply
16-37
Section 10(b) & Rule 10(b-5)
 San Leandro Emergency Medical Group v. Philip Morris
• Philip Morris was held to have not omitted a material
fact and, therefore, not did not violate Rule 10b-5. The
court held that Philip Morris did not have a duty to give
advance notice of its deviation from the company’s
historical pricing strategy. First, when it made its initial
optimistic assessments, the company had no idea they
were unreasonable. Second, the court was reluctant to
require companies to give advance notice of sensitive
pricing information out of fear it would become
available to competitors.
16-38
Section 10(b) & Rule 10(b-5)
 Conduct- Rule 10(b-5)
• Continuous Immediate
Disclosure of Material
Information
16-39
Section 10(b) & Rule 10(b-5)
 Conduct- Rule 10(b-5)
• Inside Information
 Anyone, not just an officer or director, who
has information that is material (likely to
affect investors’ desire to buy, sell, or hold
the corporation’s securities) about the
corporation and that is not generally
available to the investing public violates Rule
10b-5 of the SEC if he or she trades in the
security. There have been a number of recent
actions by the SEC against people such as
printers and secretaries who had gained
inside information and acted upon it.
16-40
Section 10(b) & Rule 10(b-5)
 Conduct- Rule 10(b-5)
• United States v. O’Hagan
 An attorney in a law firm that represented a
corporation began purchasing call options
for the corporation’s stock after learning of
the company’s confidential tender offer
plans. The court found the attorney
criminally liable for securities fraud in
violation of Section 10(b) and Rule 10b-5
under the misappropriation theory.
16-41
Section 10(b) & Rule 10(b-5)

SEC v. ZANDFORD, 122 S.Ct. 1899 (2002)
 FACTS: William Wood opened an investment account for the stated
purpose of preserving the principal and producing income. This
investment account authorized Charles Zandford to exercise his
discretion in determining which investments to make on behalf of Mr.
Wood and his daughter. Through the purchase of securities, Mr.
Zandford fraudulently transferred funds from the Wood investment
account. The SEC sought to have Mr. Zandford repay funds taken
from the Wood account. Mr. Zandford argued the SEC lacks
jurisdiction over these wrongful acts since the transactions were not
in connection with the sale of a security. The District Court ruled in
favor of the SEC, but the Fourth Circuit reversed.
 ISSUE: Were the transactions conducted by Mr. Zandford “in
connection with the purchase or sale of any security?”
16-42
Section 10(b) & Rule 10(b-5)

SEC v. ZANDFORD, 122 S.Ct. 1899 (2002)
 DECISION:
 REASONS:
Yes.
1. The SEC has consistently held that a broker violates
Section 10b and Rule 10b-5 when he accepts payment for securities that
not delivered or sells securities while misappropriating the funds.
•
2. Courts should defer to this reasonable interpretation of
securities laws by the SEC.
•
3. Mr. Zandford’s fraud coincided with the sales of
securities; thereby subjecting himself to the jurisdiction of the SEC.
16-43
tender Offer Regulation
 History
• Tender Offer - Public Offer to purchase
shares at a specified price. May be in
connection with hostile takeover attempt.
 Williams Act (1968)
• To give both sides opportunity to present
their case
16-44
Tender Offer Regulation
 State’s Typically Regulate Tender Offers
 Shareholders are protected by federal tender offer rules:
• a. Minimum offering period. Shareholders have at least 20
business days to consider their decision to sell.
• b. Withdrawal period. Shareholders may withdraw their
tendered shares if a higher bid is made. This allows an
investor to reconsider an imprudent decision and promotes
an auction market for the shares.
• c. Proration of purchases. Shareholders need not fear
tendering too late if the offer is oversubscribed, since the
purchaser must prorate its purchases among all tenderers.
16-45
State Securities Legislation
 State Securities
Regulations/ Blue-Sky
Laws
 Broker-Dealer
Registration Typically
Required
 Uniform Securities Act
(1985)
16-46
Sarbanes-Oxley Act
(2002)
 Increase In SEC Budget
 Created Public Company
Accounting Oversight Board
 Members Of Corporate Audit
Committee Must Be
Independent
 CEOs Certify Financial
Statements
 Increases Criminal Penalties
16-47
Overview of Presentation
I. Disclosure
 Earnings Releases
 Non-GAAP Financial Measures
 MD&A
 Certification/Disclosure Controls & Procedures/Item 307
Disclosure
II. Relationship with Outside Auditor
 Retaining, Supervising and Managing Relationship with Outside
Auditor
 Non-audit Services — Procedures For Pre-approval and Disclosure
III. Boards and Committees
IV. Other Governance Issues
 Codes of Ethics
 Lawyer Professional Responsibility
16-48
Earnings Release
 New Earnings Release Filing Requirement.
 Earnings releases regarding a completed fiscal quarter or a
completed fiscal year must be furnished on Form 8-K.
 Timing: must be furnished to the SEC within five business
days after release is disseminated.
 Requirement is set forth in new Item 12 on Form 8-K.
 Requirement effective beginning March 23, 2003.
16-49
Filing Information vs. Furnishing Information:
Liability and Incorporation by Reference
 Information provided under Item 12 of Form 8-K will be
treated as “furnished” rather than “filed” for Exchange Act
and Securities Act purposes.
 This means that the company will not have liability for the
information under Section 18 of the Exchange Act.
 But the company will still have liability under Rule 10b-5.
 The fact that the information is “furnished” rather than
“filed” also means that the earnings release will not be
automatically incorporated by reference in a registration
statement, proxy statement or other report, unless the
company expressly so states. This means you don't have
automatic Securities Act liability.
16-50
What Is and Isn’t
Covered by Item 12?
 You must furnish if you make a public announcement or
release of material non-public information regarding results
of operations or financial condition for a completed
quarterly or annual fiscal period.
 You don’t have to furnish again if you repeat the same
information in subsequent announcements. For example, if
you mail quarterly reports to stockholders that contain the
same information, you don’t need to file the report.
 You do need to furnish again if you amend or supplement
the previous announcement in material ways.
 You don’t have to furnish announcements of earnings
estimates for future or ongoing fiscal periods, unless these
16-51
estimates are included as part of the earnings release.
What Does the Rule Say About Earnings Calls and
Similar Announcements
of Earnings Information?
 the disclosure occurs within 48 hours after related
written release that has already been furnished on
Form 8-K;
 the presentation is broadly accessible to the public;
 the financial and statistical information is made
available on the registrant's website; and
 the presentation was announced by a widely
disseminated press release that included information
on how to access the information.
16-52
What Does This Mean?
If you are doing an earnings call, you should
file an 8-K in advance, and make sure that the
other requirements regarding announcement
and availability of the information are
satisfied.
Good news: many companies are already
doing this as part of their regular procedures.
16-53
Relationship of New Filing
Requirement to Regulation FD
 Regulation FD provides that if you disclose
material nonpublic information to specified
persons, you must simultaneously disclose to
the public generally.
 Companies can satisfy the Regulation FD
disclosure requirement by filing a Form 8-K.
The rules provide that you can furnish the
information under Item 9. This is not the only
way, however. Other forms of public
dissemination also work.
16-54
Regulation FD, (Cont.)
 Principal differences between Regulation FD and new
earnings release filing requirements relate to timing
and form of disclosure. Earnings release rules require
filing in 5 business days; Regulation FD requires
immediate disclosure. Earnings release rules require
filing on 8-K; Regulation FD permits other forms of
disclosure.
 Suggestion for earnings call procedures: file furnish
earnings release on Form 8-K in advance of call.
Satisfy other earnings release rules regarding
telephonic announcements. Then you are OK under
both rules.
16-55
Non-GAAP
Financial Measures
 New Regulation G
Pro-forma is defined as including or excluding amounts from
comparable GAAP Measures (e.g. EBITA, “core earnings”)
 Press Releases

Must include GAAP number

Prominence

Reconcile
 In a Filing

Must include reason why Non-GAAP measure is useful
 Prohibited

No Non-GAAP in financials or notes

Omitting items identified as “non-recurring” when there was a
similar item within the two previous years or is likely to be
within the succeeding two years

Liquidity measures that exclude cash settled charges

Giving non-GAAP items titles that make them sound like GAAP

16-56
Recent Guidance on MD&A
 Both before and after SOX, the SEC has focused extensively
on MD&A
 January 2002 interpretive release focuses on MD&A
discussion of liquidity and capital resources, including offbalance sheet financing, trading activities involving nonexchange traded contracts accounted for at fair value, and
transactions with related parties
 December 2001 release on “critical accounting policies,”
followed by May 2002 release proposing rules requiring a new
section in MD&A discussing “critical accounting estimates”
 January 2003 final rules on off-balance sheet financing
16-57
Recent Guidance
On MD&A, Continued
 Preparing MD&A that will satisfy the rules and
SEC staff is more difficult than ever
 The rulemaking is not yet over—the staff is
still working on the final critical accounting
estimates rules
 Some commissioners have recently expressed
concern about making MD&A disclosure too
voluminous and burdensome
16-58
New Rules on Off-Balance
Sheet Arrangements
 Companies must expand discussion of off-balance sheet
arrangements. The final rule defines these arrangements more
narrowly than the proposed rule.
 The company must discuss the transaction if it is “reasonably
likely” to have a material effect on the company. The staff did not
adopt the “more than highly remote” standard it originally
proposed, which would have been more demanding.
 MD&A must include tabular disclosure of contractual obligations.
The table must disclose the nature and the amount of the
obligation.
 The rules apply to filings that include financial statements for
fiscal years ending on or after June 15, 2003.
16-59
What Is Covered
Covered Off-balance Sheet Arrangements
 Guarantee contracts
 Retained interest in assets transferred to an unconsolidated
entity
 Obligations under certain derivative instruments
 Obligations arising out of variable interests
Contractual Obligations Table Must Identify:
 Long term debt obligations
 Capital lease obligations
 Operating lease obligations
 Purchase obligations
 Other long term liabilities on balance sheet
16-60
Other Liquidity and
Capital Resources Issues
 Discuss short-term liquidity needs.
 How will short-term liquidity needs be satisfied?
Identify the sources of short term liquidity.
 What are the circumstances that are reasonably likely
to affect sources of short term funding?
 Remember that the SEC staff takes the view that
“reasonably likely” is a lower threshold than “more
likely than not.”
16-61
Related Party Transactions
 The January 2002 interpretive release discussed these
transactions. The focus has only intensified since
then.
 The release makes the point that discussion of related
party transactions may be appropriate even if
transaction is not covered by Item 404 of Regulation
S-K.
 Does a party have a relationship with the company
that enables the company to negotiate transactions
that would not be available in true arms' length
negotiations?
16-62
Critical Accounting Estimates
 Proposal: companies must identify “critical
accounting estimates.”
 A critical accounting estimate is an accounting
estimate that is highly uncertain at the time made, and
different estimates that the company reasonably could
have used would have had a material impact on the
financial statements.
 The proposed rules would require a discussion of the
critical estimates, and a quantitative sensitivity
analysis showing how financial statements and
financial performance would have changed if the
estimates had changed. They would also require a
discussion of any changes in the estimates.
16-63
CEO/CFO Certification Under
Section 302 Of The Act
 He/She has reviewed the report.
 Based on his or her knowledge, the report does not contain any untrue statement
of material fact or omit to state a material fact necessary in order to the statement
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by the report.
 Based on his or her knowledge, the financial statements, and other financial
information included in the report, fairly present in all material respects the
financial condition, results of operations and cash flows of the company as of, and
for, the periods presented in the report. (emphasis added.)
 He or she and the other certifying officers: (a) are responsible for establishing and
maintaining disclosure controls and procedures; (b) have designed such
disclosure controls and procedures to ensure that material information is made
know to them, particularly during the period in which the periodic report is being
prepared; (c) have evaluated the effectiveness of the disclosure controls and
procedures as of a date within 90 days prior to the filing date of the report; and (d)
have presented i the report their conclusions about the effectiveness of the
disclosure controls and procedures based on the required evaluation as of the
date.
16-64
CEO/CFO Certification Under
Section 302 Of The Act, Cont.
 He or she and the other certifying officers have disclosed to the
auditors and the audit committee: (a) 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
auditors any material weaknesses in internal controls; and (b)
any fraud, whether or not material, that involves management or
other employees who have a significant role in the internal
controls.
 He or she and the other certifying officers 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
16-65
deficiencies and material weaknesses.
CEO/CFO Certifications Under
Section 906 of the Act
 Requires the CEO/CFO of public companies to submit a
statement with certain filings certifying that the filing “fully
complies” with the Exchange Act reporting requirements and
“fairly presents” in all materials respects the company’s
financial condition and results of operations.
 Applies to each Form 10-K and Form 10-Q filed by a company
subject to Section 13(a) or 15(d) of the Exchange Act, as well
as to Forms 20-F filed by foreign issuers or any 11-K filed by
an employee benefit plan.
 Section 906 certifications are not required to be included with
8-K and 6-K or with proxy statements.
16-66
Certification/Disclosure Controls
& Procedures
 You already have procedures
 Create disclosure committee
 Review and document Your
disclosure controls and procedures
 Flow down certification
16-67
Procedural Steps
 Complete a documentation file
 Involve GC to protect privilege
 Discuss the disclosure committee’s findings




with the principal officers
Meet with the outside auditors
Meet with the audit committee and the board
Complete final evaluation of disclosure
controls and procedures
Sign-off on disclosure in the periodic report
and execute principal officer certifications
16-68
Relationship with
Outside Auditors
Intent of SOX and rules is clear:
 Make sure auditors act independently and
don't align themselves too closely with
management
 Audit committee plays a critical role in serving
as the check and balance on a company's
financial reporting system
16-69
Retention of Outside
Auditors, Etc.
Section 301 of SOX requires audit committees to:
 Have independent members
 Be “directly responsible,” in its capacity as a committee of the
board, for the appointment, compensation and oversight of
the work of the outside auditor
 Put in place procedures for the submission of complaints and
concerns about auditing and accounting matters
 Have the authority to engage outside advisors and to
compensate both the advisors and the outside auditor
 Be appropriately funded by the issuer
Rules direct the national securities exchanges/associations to
refuse listing of issuers whose audit committees don't comply
with the requirements
Proposed rules – not yet adopted; comment period still open (Feb.
18)
16-70
Retention and Oversight
of Outside Auditors
The audit committee must be directly responsible for the
appointment, compensation, retention and oversight of the work of
any outside auditor engaged (including resolution of disagreements
between management and the auditor regarding financial reporting)
for the purpose of preparing or issuing an audit report or related
work or performing other audit, review or attest services for the
issuer, and each such outside auditor must report directly to the audit
committee
 Includes power not to retain, or to terminate, the outside auditor

Includes authority to approve all engagement fees and terms

Not in conflict with any charter document or statutory (e.g., state or
foreign) provisions, such as shareholder selection of the auditor
16-71
Engagement of
Advisors and Funding
Each audit committee must have the authority to
engage independent counsel and other advisors, as it
determines necessary to carry out its duties
 Needed to perform its role effectively
Each issuer must provide appropriate funding for the
audit committee
 Don't want management to have discretion
regarding funding
16-72
Non-Audit Services
Prohibited Activities
 Section 201 of SOX prohibited accountants who audit
an issuer from contemporaneously providing 9
specific types of non-audit services, plus any other
service that the Accounting Oversight Board
determines is impermissible
 Any other non-audit service can be provided only if
pre-approved by the audit committee
16-73
Non-Audit Services
Audit Committee Pre-Approval
The audit committee must pre-approve all allowable services by the
company's auditors
May establish policies and procedures for pre-approval provided they
are:
 Detailed as to the particular service
 The audit committee is informed of each service
 Not a delegation of responsibilities to management
 Designed to safeguard the continued independence of the auditors
Appointment of Designated Representatives
Disclosure of Pre-Approval Procedures in proxy statement/annual report
Limited Exceptions—de minimus; unanticipated connection
Companies should put these in place now if they haven’t already
16-74
Non-Audit Services
 Bookkeeping or other services related to the accounting
records or financial statements
 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
 Expert services unrelated to the audit
 Any other service that the Accounting Oversight Board
determines is impermissible
16-75
Non-Audit Services
Tax Services
 Section 201 specifically states that an “accounting firm may
engage in any non-audit service, including tax services, that is
not described [above]...” after audit committee approval
 The SEC’s proposed rule appeared to prohibit tax services
 Significant discussion and comment about whether tax
services should be allowed
 Under the final rules, accountants will be able to continue to
provide tax compliance, tax planning and tax advice to audit
clients, subject to
pre-approval requirements
 However, the rules prohibit auditors from representing an audit
client in tax court or other situations involving public advocacy
 Close scrutiny by audit committees
16-76
Disclosure of Audit
and Non-Audit Services
Have to disclose in periodic reports all non-audit services approved
by the audit committee
Also have to disclose in the proxy statement/annual report fees paid
to the independent accountant during the past 2 fiscal years for:
 Audit services
 Audit-related services
 Tax services
 Other services
Disclosure of the audit committee's pre-approval policies and
procedures and the percent of fees paid pursuant to the de
minimus exception by category
16-77
Audit Partner Rotation
Lead partner and concurring/reviewing partner must rotate after 5 years
and be subject to a 5-year "time out" period after rotation
Certain other significant “audit partners” will have a 7-year rotation
period with a 2-year time out period
“Audit partner”:
 A partner who is a member of the engagement team who has
responsibility for decision-making on significant auditing,
accounting and reporting matters that affect the financial
statements or who maintains regular contact with management
and the audit committee.
 Includes the lead partner on audits of 20% subsidiaries
 Does not include technical or industry-specific partners
16-78
Limits on Compensation
Accountant is not independent if, at
any time during the audit and
professional engagement period,
any audit partner earns or receives
compensation based on that partner
procuring engagements with the
client to provide any services other
than audit, review or attest services.
16-79
Cooling Off Period
Section 206 of SOX set a 1-year cooling off period before a
member of the audit engagement team can accept
employment in certain, designated positions with a
company.
Under the rules, if a member of management involved in
overseeing financial reporting matters for an issuer was the
lead partner, concurring partner or any other member of the
audit engagement team who provided more than 10 hours
of audit review or attest services (with certain exceptions)
within 1 year preceding the commencement of the audit of
the current year’s financial statements, then the accounting
firm is not independent.
 Calculation of time period – could effectively be 23month period
16-80
Communication
with Audit Committee
Accounting firm has to report, prior to the filing of its audit report
with the SEC, to the audit committee:
 All critical accounting policies and practices used by the
issuer
 All material alternative accounting treatments of financial
information within GAAP that have been discussed with
management, including the ramifications of the use of such
alternative treatments and disclosures and the treatment
preferred by the accounting firm
 Other material written communications between the
accounting firm and management
16-81
Improper Influence of Auditors
Section 303 of SOX prohibits “any officer or director of an
issuer, or any other person acting under the direction thereof,
to take any action to fraudulently influence, coerce,
manipulate, or mislead any...accountant engaged in the
performance of an audit of the financial statements of that
issuer for the purpose of rendering such financial statements
materially misleading.”
 Proposed rules – not final
 Rule mirrors Section 303 but instead of "for the purpose
of...” uses the words “knew or was unreasonable in not
knowing that such action could, if successful, result in
rendering financial statements materially misleading”
 No Scienter/Intent Test?
 Persons acting "at the behest or on behalf of” officers or
directors v. “under the direction”
 Specific examples of improper action or influence
16-82
Additional Practical Considerations —
What You Should Be Doing
 Effective dates
 Review and amend (as necessary)
audit committee charters
 Resolving disputes with auditors
 What if there is an accounting
mistake?
16-83
The Regulatory Landscape
SOX
 Corporate governance provisions primarily impact
audit committees
New York Stock Exchange and NASDAQ Proposed
Listing Standards




Boards of directors
Audit committees and auditor independence
Nominating/corporate governance committees
Compensation committees
16-84
The Board of Directors
NYSE
 Majority of “independent” directors


“No material relationship” with company
Five year “cooling-off” period for employees of
company and outside auditor (includes immediate
family members)
 Board must determine independence of each director

Board may adopt categorical independence standards
NASDAQ
 Objective independence standards
 Look back three years
 Greater of 5% or $200,000 for business relationships
16-85
Board Committees — NYSE
Structure and responsibilities
 Audit, compensation, nominating/corporate governance
committees required
 Composed entirely of independent directors
Charters — Key committees must have charters that:
 Address purpose and responsibilities enumerated by NYSE
 Provide for annual performance evaluation
Outside advisors
 Audit committee must have authority to retain advisors
without Board approval
 Compensation, nominating/corporate governance committees
should have sole authority to retain advisors
16-86
Board Committees — NASDAQ
Structure and responsibilities
 Audit committee required
 Compensation and nominating/corporate governance
committees not required, but
 Director nominations and compensation of Section 16
officers must be approved by:
• An independent committee or
 “Independent” committee may have 1
non-independent director
• A majority of the independent directors
Charters
 Audit committee must have charter that addresses
responsibilities mandated by SOX
16-87
The Audit Committee
Qualifications mandated by SOX:
 Members may not:

Receive fees other than for serving as a director
• Direct and indirect payments
• Also prohibited under NYSE proposals

Be an “affiliated person” of company or its subsidiaries
 Audit committee financial expert

Disclosure

Definition

Safe harbor
16-88
The Audit Committee
Responsibilities mandated by SOX:
 Relationship with outside auditor


SOX — “Directly responsible” for appointment,
compensation and oversight
NYSE — Sole authority to hire and fire, including
to approve all audit engagement fees and terms
 Pre-approve all audit and permissible non-audit
services
 Authority to engage and compensate outside
advisors
 Establish procedures for receiving complaints
about auditing and accounting matters
16-89
The Audit Committee
NYSE proposals require that charter address specific responsibilities,
including:
 Discussing financial statements with management and outside
auditor, including MD&A
 Discussing company policies on earnings releases, financial
information and earnings guidance provided to analysts and
rating agencies
 Holding periodic private sessions with management, internal
auditors and outside auditor
 Discussing policies on risk assessment and risk management
 Setting hiring policies for former employees of outside auditor
NASDAQ: Charter must cover items mandated by SOX
16-90
The Nominating/Corporate
Governance Committee
NYSE proposals require that charter address:
 Committee’s purpose, which must be to:


Identify individuals qualified to become Board members,
and select (or recommend that Board select) director
nominees
Develop and recommend corporate governance principles
to Board
 Committee’s responsibilities, which must reflect:

Board criteria for selecting new directors

Oversight of Board and management evaluations
16-91
The Nominating/Corporate
Governance Committee
Optional responsibilities that many companies are including in their
charters:
 Make recommendations to the Board regarding the structure,
composition and functioning of the Board and its committees
 Review and recommend retirement and other tenure policies for
directors
 Review other public company directorships held by or offered to
directors and senior officers
 Review and assess the channels through which the Board receives
information and the quality and timeliness of information received
 Review and recommend changes to director compensation

May be done in whole or in part by compensation committee at
some companies
16-92
The Compensation Committee
NYSE proposals require that charter address:
 Committee’s purpose, which must be to:


Discharge Board responsibilities relating to compensation
of executives
Produce annual report on executive compensation for
inclusion in proxy statement
 Committee’s responsibilities, which must be to:


Review and approve corporate goals and objectives
relevant to CEO compensation, evaluate CEO performance
in light of objectives, and set CEO compensation based on
evaluation
Make recommendations to Board about incentivecompensation and equity-based plans
16-93
The Compensation Committee
Optional responsibilities that many companies are including in their
charters:
 Oversee the company’s overall compensation structure, policies
and programs and assess whether that structure establishes
appropriate incentives for management and employees
 Monitor compliance by officers and directors with the company’s
stock ownership guidelines
 Review and recommend employment agreements and severance
arrangements for executives
 Review succession plans relating to the CEO and other senior
officers

May be done in whole or in part by nominating/corporate
governance committee at some companies
16-94
Codes of Ethics
Codes of ethics for senior financial officers (SOX)
 Also covers principal executive officers under SEC rules
 Definition
 Disclosure
 Whether company has code
 Alternatives
• File a copy of code with 10-K
• Post on website
• Provide copies on request
 Changes or waivers on 8-K or website
 Effective Dates
 July 15, 2003
 December 15, 2003 (smaller issues)
NYSE-listed companies must adopt and post on their websites code(s) of business
conduct and ethics for:
 Employees
 Officers
 Directors
16-95
Codes of Ethics, Continued
Under the NYSE proposals, a company’s code of conduct must:
 require that any waivers of the code for directors or executive
officers be made only by the board or a board committee and
that these waivers be promptly disclosed to stockholders; and
 contain compliance standards and procedures that provide
for prompt and consistent action against violations
At a minimum, the code of conduct should address:
 conflicts of interest
 corporate opportunities
 confidentiality
 fair dealing
 protection and proper use of company assets
 compliance with laws, rules and regulations, including laws
on insider trading
 encouraging the reporting illegal or unethical behavior 16-96
New Standards of Professional
Conduct For Attorneys
 Adopted January 23, 2003
 Rules implement Section 307 of the SOX
 Effective 180 days after publication in the
Federal Register (late July or early August)
 Additional 60-day comment period for
proposed “noisy withdrawal” requirements
16-97
What Will The Rules
Require Attorneys To Do?
 An attorney must report evidence of a material
violation by an issuer or its agent “up the ladder” to
the issuer's chief legal counsel or the chief legal
officer and the CEO (or to the Qualified Legal
Compliance Committee, if the issuer has created one).
 If the chief counsel or CEO does not “respond
appropriately” to the evidence, the attorney must
report the evidence to the audit committee, another
independent committee or the full board of directors.
16-98
What Is A Qualified
Legal Compliance Committee?
 Consists of at least one member of the
issuer's audit committee and two or more
additional, independent directors
 May be created by the issuer as an alternative
procedure for reporting evidence of material
violations
 Responsible for receiving and reviewing
evidence of material violations, and
recommending appropriate issuer responses
16-99
What Will The Rules
Permit Attorneys To Do?
An attorney may, without the consent of the issuer-client,
reveal confidential information related to the representation to
the extent that the attorney reasonably believes necessary:
 To prevent the issuer from committing a material
violation likely to cause substantial injury to the
financial interests or property of the issuer or investors;
 To prevent the issuer from committing an illegal act; or
 To rectify the consequences of a material violation or
illegal act in which the attorney's services have been
used.
 Note possible conflict with state law obligations.
16-100
To Whom
Will The Rules Apply?
 The rules will apply to attorneys “appearing and practicing”
before the SEC in the representation of issuers, but the
proposed definition of “appearing and practicing” has been
narrowed significantly.
 Under the final rules, a covered attorney is one who
provides legal services to an issuer and has an attorneyclient relationship with that issuer. This includes the
issuer's in-house attorneys and its outside counsel.
 If the representation involves preparing or reviewing
documents to be filed with or submitted to the SEC, the
attorney must have notice that such documents will be filed
with or submitted to the SEC.
16-101
What Evidence Will Trigger An
Attorney’s Reporting Obligations?
 The rules contain an objective standard.
 An attorney’s reporting obligation will be
triggered only if he or she has “credible
evidence” based upon which it would be
unreasonable for a prudent and
competent attorney not to conclude that
it is “reasonably likely” that a material
violation has occurred, is occurring or is
16-102
about to occur.
What Happened To The Proposed
“Noisy Withdrawal” Requirements?
The proposed rules would have required an attorney to
withdraw and report his or her withdrawal to the SEC if the
board failed to respond appropriately to evidence of a material
violation.
 The SEC received numerous comments from attorneys,
issuers and others concerned about the impact these
provisions could have on the attorney-client
relationship.
 In response to comments, the SEC has revised the noisy
withdrawal provisions and will extend the comment
period for an additional 60 days.
 The revised proposal still would require attorney
withdrawal, but would require the issuer (rather than the
attorney) to disclose publicly the attorney's withdrawal.16-103