Lessons Learned from the Sarbanes-Oxley Act

Winter 2004Cole Schotz Docket

In response to the Enron collapse and the bankruptcies of WorldCom, Global Crossing and other corporate giants, Congress enacted Public Law 107-204, commonly known as the Sarbanes-Oxley Act (“SOA”) on July 30, 2002. It has been said that SOA is the most far-reaching legislation pertaining to public companies and the persons and professionals associated with them since the 1930s. While SOA generally imposes requirements and restrictions only on public companies, closely-held companies may be able to learn a lesson or two from it by re-focusing on certain key corporate and fiduciary responsibilities.

Highlights of the SOA

The official text of SOA is 66 pages in length, and contains 11 sections. It is intended to apply not only to U.S. publicly-traded companies, but also to certain other “issuers” with registration or reporting requirements pursuant to the Securities Exchange Act of 1934 (the “Exchange Act”). SOA mandated the creation of the Public Company Accounting Oversight Board (“PCAOB”), which is a non-profit corporation whose mission is to oversee the auditors of public companies. The PCAOB consists of two CPAs and three non-CPAs, and is funded through mandatory fees placed on public companies. The PCAOB has the ability to enact and enforce auditing standards and rules for public company auditors, and the ability to investigate and discipline auditors who do not comply with its standards. Its aim is to protect the interests of investors and restore public faith in the accounting procedures and disclosures of public companies.

SOA established a number of reporting requirements for auditors of public companies. Reports generated by the public company’s auditor are to be submitted to that company’s audit committee (discussed below), if one exists, rather than to management. Auditors must report any new “critical” accounting policies, alternative treatment of financial information and any accounting disagreements to the audit committee. Auditors cannot perform non-audit services (such as bookkeeping, appraisals, actuarial services, and information systems design and implementation) to avoid the possibility of “self-serving” audits. An auditor is also prohibited from conducting an audit if one of the public company’s top officials (such as CEO, CFO or controller) had been employed by the auditor and worked on the company’s audit during the preceding one-year period. The head of the audit team must be rotated, in most instances, every five years.

Standards for corporate governance and guidelines for director and executive officer activities are also addressed by SOA. The CFO or CEO must certify the appropriateness of financial statements and disclosures contained within them, and must confirm that the disclosures fairly present, in all material respects, the operations and financial condition of the public company. It is illegal for any officer or director of a public company to fraudulently influence, coerce, manipulate or mislead any auditor so that financial statements are materially misleading. In short, the CFO or CEO of the public company must certify each quarterly and annual report filed with the Securities and Exchange Commission to confirm that the officer has reviewed the report and the truthfulness of the information in it, and that the report does not contain an untrue statement of material fact. The certification must also indicate, among other things, that the CFO or CEO has disclosed to the auditor any significant deficiencies in the design and implementation of “internal controls” that are intended to monitor fraud within the company, and that that officer has disclosed any fraud involving management or employees involved in the company’s internal controls. Any “off-balance sheet” transactions that could materially impact the current or future financial condition of the company must be disclosed in the company’s public filings. Loans to executive officers and directors are prohibited, except in certain limited circumstances. Federal income tax returns of the company must be signed by the CFO or CEO.

 Each public company is encouraged to have an audit committee consisting of members of its board of directors. When no audit committee exists, the board of directors in its entirety must fill that function. The audit committee is responsible for the appointment and oversight of the auditor, and must implement procedures for the receipt and treatment of complaints received by the company regarding accounting, internal controls and auditing. The audit committee must also have authority to hire independent legal counsel or other advisors to assist it to carry out its duties. Activities of the audit committee must be appropriately funded by the company. Each company’s annual report must contain an “internal control report” which assesses, on an annual basis, the internal control structure and procedures for financial reporting.

Lessons for a Closely-Held Company

What can shareholders and directors of closely-held companies learn from SOA? The possibilities are endless, but perhaps the following ideas deserve some thought:

In other words, in jurisdictions where compelled defamation is a viable cause of action, courts recognize an exception to the usual rule requiring communication of the defamatory statement by the defendant where it is reasonable to anticipate that the defamed party will be compelled to disclose the content of the defamatory statement to a third party.  Hence, the full moniker of the claim is compelled self-publication defamation.  (See, e.g., McKinney v. County of Santa Clara, 110 Cal. App.3d 787 (1980); Van-Go Transport Co., Inc.; J.Crew Group, Inc. v. Griffin, No. 90 Civ. 2663, 1990 WL 193918 at 2 (S.D.N.Y Nov.27, 1990)).

  • Recognize the legal duties of directors and officers. Corporate officers are responsible for day-to-day management, while the board of directors is charged with overall management of the company. Officers and directors have legal and fiduciary responsibilities (the most basic being the “duty of care” and the “duty of loyalty”) to shareholders, whether majority or minority, and to the company. When voting on extraordinary matters or while carrying out day-to-day responsibilities in the ordinary course of business, officers and directors must be sensitive to their responsibility to enhance the company’s value for the benefit of its shareholders. Complete and full disclosure by directors to shareholders on a periodic basis will help ensure shareholder satisfaction.
  • Address conflicts of interest appropriately before taking action. If the company has an opportunity to transact business with a shareholder or director of the company, the “duty of loyalty” may create a conflict of interest. While the interested shareholder may want the directors to approve the deal, all of the shareholders of the company may not feel that the transaction is in their best interests. The use of executive committees and shareholder or director voting by non-interested persons are steps that can be taken to help ensure that potential conflicts are appropriately addressed.
  • Set up internal controls. While it may be convenient for one person to control all financial aspects of a company, the opportunity for fraud is enhanced. Delegate responsibilities and implement internal control procedures, and monitor accounting activities closely.
  • Let auditors and attorneys do their jobs. Although it may be inconvenient when auditors and attorneys ask about transactions and need to review paperwork, such work ultimately is in the best interests of the shareholders and the company, and can act as additional safeguards against fraudulent activities.
  • Seek expertise when necessary. It is rare that a closely-held company has the expertise to do everything using in-house resources. The retention of an outside expert may be cost-efficient and can reveal internal cover-ups and inefficiencies.
  • Treat board of director appointments seriously. Shareholders have the right to appoint directors in a closely-held company. Rather than having a sibling or friend fill a position that carries with it important legal responsibilities, seek the best and brightest person to fill the role.
  • When consulting with legal counsel, don’t leave out the details. Often when officers and directors confer with corporate counsel, they paint the “big picture” and then ask for advice. Yet it is the omission of “small” details that can create big problems (and huge headaches) for directors and officers. Perhaps the most important lesson from the Sarbanes-Oxley Act is that details and disclosures are critical to both extraordinary and day-to-day corporate activities. Officers and directors should be encouraged to speak candidly with corporate counsel to avoid pitfalls and problems.

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