(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

A bill to address systemic and structural weaknesses in the auditing of financial statements and rectify a breakdown in corporate financial and broker-dealer responsibility has passed the Senate. The Public Company Accounting Reform and Investor Protection Act (S. 2673) would also require steps to enhance the direct responsibility of senior corporate management for financial reporting and for the quality of financial disclosures made by public companies.

The bill creates a strong independent board to oversee the auditors of public companies. It strengthens auditor independence from corporate management by limiting the scope of consulting services that auditors can offer their public company audit clients. In addition, the bill enhances the responsibility of public company directors and senior managers for the quality of the financial reporting and disclosure made by their companies. The measure also seeks to limit and expose to public view possible conflicts of interest affecting securities analysts. Finally, the measure increases the SEC's annual authorization from $481 million to $776 million and extends the SEC's enforcement authority, as well as mandating studies of accounting firm concentration and the role of credit rating agencies.

The measure would create a public company accounting oversight board subject to SEC review. It is envisioned that the board will establish auditing, quality control, ethics, and independence standards for public company auditors and will inspect accounting firms that conduct those audits. It will investigate potential violations of applicable rules and impose sanctions if those violations are established.

The board would have five full-time members. Two of the members will have an accounting background. All members will have to have a demonstrated commitment to the interests of investors, as well as an understanding of the financial disclosures required by the securities law. The board members would be appointed by the SEC after consultation with the Federal Reserve and the Department of the Treasury and would serve staggered 5-year terms. They could not engage in other business while they were doing this work. Congress expects that the salaries of the board’s staff would be fully competitive with comparable private-sector positions in order to ensure a high-quality staff.

Under the Act, accounting firms that audit public companies would have to register with the board. A failure to register or loss of registration would render a firm unable to continue its public company audit practice. Upon registering, a company would consent to comply with requests by the board for documents or testimony made in the course of the board's operations.

The board would possess plenary authority to establish or adopt auditing, quality control, ethics, and independence standards for the auditing of public companies. But this grant of authority is not intended to exclude accountants or other interested parties from participating in the standard-setting process. So the board may adopt rules that are proposed by professional groups of accountants or by one or more advisory groups created by the board.

The Act provides for the inspection of registered accounting firms by the board. Firms that audit more than 100 public companies are to be inspected annually. Firms that audit less than that are inspected every 3 years, although the board has the power to adjust these inspection schedules. The board would also have investigative and disciplinary authority. The bill also applies to foreign public accounting firms that audit financial statements of companies that come under U.S. securities laws.

S. 2673 seeks to formalize the role of the Financial Accounting Standards Board in setting accounting standards. Accounting standards are different from auditing standards, which the new oversight board will set. The bill provides for guaranteed funding of the new oversight board and the FASB by public companies.

The issue of auditor independence is at the center of the legislation. The bill contains a list of nine non-audit services that an accounting firm doing the audit of a public company cannot provide to that company. These include, for example, bookkeeping or other services related to the accounting records or financial statements of the audit client, financial information systems design, appraisal or valuation services, actuarial services, management functions or human resources, broker or dealer or investment adviser services, and legal services. The central theme running through these nine prohibitions is that the provision of these services to a public company audit client creates a fundamental conflict of interest for the accounting firm in carrying out its audit responsibility. The bill, however, provides the board authority to grant case-by-case exceptions, so if a case could be made why an auditor's performing a consulting service ought to be permitted, there is some flexibility to permit it. In addition, no limitations are placed on accounting firms in providing non-audit services to public companies that they do not audit or to any private companies.

Separately, the bill requires the company’s audit committee of the board of directors to pre-approve all of the services, both audit and non-audit, that an auditor will provide to the company. The audit committee does not have to make a particular finding in order to pre-approve an activity. Audit committee members are expected to vote consistent with their fiduciary standards. While the bill requires the audit committee to pre-approve a non-audit service before it commences, the committee is allowed to pre-approve at any time in advance of the activity. For example, an audit committee could grant pre-approval at its March meeting for a non-audit service that would begin in July.

While the bill does not require companies to rotate their accounting firms, it does require a registered public accounting firm to rotate its lead partner and its review partner on audits so that neither role is performed by the same accountant for the same company for more than five consecutive years. The lead partner is the partner in charge of the audit engagement, and the review partner refers to the outside partner brought in to review the work done by the lead partner and the audit team.

In another effort to protect the independence of the audit, the bill imposes a one-year cooling off period with respect to the top positions in the company, so that a company cannot hold out to the audit team the immediate prospect of an important position in the company.

The bill contains a number of provisions designed to improve the public company financial disclosures. In this spirit, the bill would require CEOs and CFOs to certify their companies’ financial reports and prevents them from benefiting from profits they receive as a result of misstatements of their company’s financials. Thus, CEOs and CFOs who make large profits by selling company stock or receiving company bonuses while management is misleading the public about the financial health of the company would have to forfeit their profits and bonuses realized after the publication of a misleading report.

The bill requires the CEOs and CFOs of companies to certify that the corporate financial statements and disclosures fairly present the company’s operations and financial conditions. An amendment offered by Sen. Byron Dorgan, adopted by the full Senate, states that foreign reincorporations will have no effect on the certification required from CEOs and CFOs. It will still be required after the transfer of a company’s domicile from inside the U.S. to outside the U.S.

In addition, the bill requires enhanced financial disclosures. Thus, public companies must disclose all off-balance-sheet transactions and conflicts. Similarly, pro forma disclosures would have to be done in a way that is not misleading and also be reconciled with a presentation based on generally accepted accounting principles.

The Senate measure provides for a strong public company audit committee that would be directly responsible for the appointment, compensation, and oversight of the work of the auditors, which makes it clear that the primary duty of the auditors is to the company's board of directors and the investing public, and not to senior management. The audit committee members must be independent from company management. In addition, the audit committee would have to develop procedures for addressing complaints concerning auditing issues and also put in place procedures for employee whistleblowers to submit their concerns regarding accounting or auditing matters.

Insider Transactions

The bill also requires the prompt disclosure of insider stock trades. They must be reported by the second day following any transaction. The SEC is given the authority to set another reporting time if the agency finds that the two-day time period is not feasible. Currently, insiders do not have to report trades until the tenth day of the month following the month in which the trade occurred. The current deadline allows too long a delay in reporting insider transactions.

Originally, the Sarbanes bill would have mandated the disclosure of loans made by the company to its executive officers and directors. The Senate, however, adopted an amendment offered by Sen. Charles Schumer that makes it unlawful for any public company to make loans to its executive officers and directors. The provision, which amends Section 13 of the Exchange Act, contains a narrow exemption for consumer credit loans made to the officer or director on market terms in the ordinary course of the company’s consumer credit business.

Another amendment offered by Sen. Schumer, and accepted by the full Senate, directs the SEC to conduct a comprehensive study of all aspects of special purpose entities, including the extent of their use, the potential exposure faced by investors due to SPEs, whether SPEs should be disclosed on company balance sheets, if the material participation requirements are adequate, and if FASB's guidelines on SPEs are sufficient to protect investors. The amendment requires the SEC to make recommendations to Congress on SPEs to provide transparency and protection to investors if it determines that FASB's rules are insufficient.

An amendment to the bill by Sen. Patrick Leahy was adopted by the full Senate. The Leahy amendment was generally designed to restore accountability by punishing and preventing fraud, preserving the evidence of fraud, and protecting victims of fraud. Specifically, the amendment creates a new federal felony for securities fraud with a ten-year maximum penalty. This new ten-year felony is comparable to existing bank and health care fraud statutes. The amendment also provides for a review of the existing sentencing guidelines for fraud cases and for organizational misconduct to make them tougher as well.

The Leahy Amendment also creates two new anti-shredding penalties, which set clear requirements for preserving financial audit guides and close loopholes in current anti-shredding laws. These provisions set a clear requirement that corporate audit documents must be saved for 5 years, a time period selected because it happens to be the statute of limitation for most federal crimes. In this spirit, the amendment lengthens the statute of limitation for securities fraud by extending it from the current earlier of one year from discovery or three years from the fraud to two years from discovery or five years from the fraud. Finally, the amendment protects victims of securities fraud by amending the bankruptcy code to make judgments and settlements based upon securities law violations nondischargeable.

An amendment to the bill offered by Sen. Trent Lott was approved by the full Senate. The amendment would allow the SEC, during an investigation, to seek an order in federal court imposing a 45-day freeze on extraordinary payments to corporate executives. The targeted payments would be placed in escrow, ensuring that corporate assets are not improperly taken from an executive's personal benefit. If an executive is charged with violations of federal securities laws prior to the expiration of the court order, the escrow would continue until the conclusion of legal proceedings, again, with court approval.

The Lott Amendment would also empower the SEC to bar persons from serving as officers or directors if they committed a securities law violation and their conduct demonstrated unfitness to serve as an officer or a director. Under current law, only a federal court can issue an order prohibiting a person from acting as an officer or director of a public company.