Sarbanes-Oxley Act Provides Sweeping Corporate and Accounting Reform

CCH Analysis by Peter Rasmussen, J.D.

A conference committee of the House and Senate reached agreement on a bill that would make sweeping changes to the regulatory scheme for financial reporting and independent auditing. While the bill incorporates some aspects of legislation previously passed by the House, such as longer prison terms for fraud, the conference committee approved much of the substance of S.2673, a bill introduced in the Senate by Sen. Sarbanes and passed by a vote of 97-0. In addition to the new criminal penalties, the bill requires accelerated reporting of insider trading activity and creates a board to oversee the accounting profession. President Bush is expected to sign the final version of the bill.

Audit Oversight

The measure will create a five-member board to oversee the accounting industry. The board would raise money by assessing fees and could subpoena documents from public companies. The SEC had previously proposed to create a similar board administratively, but questions had existed concerning the agency's authority to create a body that can discipline the accounting profession. Sen. Sarbanes said legislation was needed to codify these powers for the SEC, to insure that the accounting oversight board's powers are not challenged in court. According to the conference bill, the new board's actions are subject to review by the SEC. The agency would have the authority to assign additional responsibilities to the oversight board and could request that the board conduct special investigations of accounting firms. The conference committee also agreed that the board should be required to notify the SEC of any pending board investigation involving potential violations of the securities laws. Additionally, the bill provides that the board should coordinate its efforts with the SEC's enforcement division as necessary to protect ongoing SEC investigations. Provisions of the bill limiting dissemination by the board of information concerning investigations was also modified in conference. The committee clarified the bill's language to eliminate any implication that the measure could be deemed to limit SEC access to such information.

Non-Audit Services

The bill restricts what services accounting firms may offer to clients. In conference, House and Senate negotiators agreed to the substance of the restrictions contained in the Senate bill. Among the activities that audit firms could not provide for their audit clients are 1) bookkeeping, appraisal and actuarial services, 2) management functions or human resources work, 3) broker-dealer, investment adviser or investment banking services, 4) legal services and 5) expert services unrelated to auditing. The bill does specify, however, that audit firms could perform other than these specified non-audit services if pre-approved by the board's audit committee.

Criminal and Civil Sanctions

The conference committee adopted the criminal penalty provisions from the House bill, which provided for longer maximum sentences than the Senate measure. The House bill mandated maximum sentences of 20 years for such crimes as mail and wire fraud, and allows maximum sentences of up to 25 years for securities fraud. Civil penalties would also be increased, and the bill restricts the discharge of such obligations in bankruptcy. The conference committee also agreed to accept a House proposal to permit the SEC to use civil penalty funds to compensate fraud victims. Such penalty amounts would be added to amounts disgorged to compensate securities fraud victims. The bill requires CEOs and CFOs to sign and certify company financial statements, with possible criminal penalties for false statements. In conference, the certification standards for liability were changed from "reckless and knowing" misstatements to "willing and knowing" misstatements. Additionally, board chairpersons who were not executive officers would not be required to certify the reports. This requirement will also extend to U.S. companies incorporated abroad for tax purposes.

Insider Loans

The Senate bill prohibition on companies making loans to executives survived the conference review. Under an exception, credit card companies could continue to issue cards to employees and securities firm employees may maintain margin loan accounts with their firms. This provision will not be retroactive, however, as was specified in the Senate bill.

Disclosure Issues

A new section of the bill, Section 409, concerns real-time corporate disclosure. Issuers will be required to publicly disclose additional information concerning material changes in the financial condition or operations of the issuer on a current basis. SEC rulemaking will define the specific requirements of the mandated reporting. The bill also requires the SEC to regularly and systematically review corporate filings. Each issuer must be reviewed at least every three years. Material restatements, the level of market capitalization and price volatility are factors specified for the SEC to consider in scheduling reviews.

Trading Blackouts

Company executives and directors are also restricted from trading stock during blackout periods, which are periods when employees cannot trade retirement fund-held company stock. These insiders would be prohibited from engaging in transactions in any equity security of the issuer during any blackout period when at least half of the issuer's individual account plan participants are not permitted to purchase, sell or otherwise transfer their interests in that security. The conference bill also calls for adding a 30-day advance notice period of any blackouts to be added to ERISA. SEC Chairman Pitt congratulated the conference committee and Sen. Sarbanes and Rep. Oxley, the committee chairmen from the House and Senate. Chairman Pitt applauded the efforts of Congress in "working together to reach consensus to enact reforms designed to restore integrity to the nation's financial markets and to serve the interests of U.S. investors."