CCH Analysis of Securities Reform Law
President Bush asked for fast action on a corporate reform bill and Congress obliged. Now, the time-intensive task of sifting through the Sarbanes-Oxley Act of 2002 to see how it changes existing law and what it means for companies, investors and the securities and accounting industries begins, according to CCH Inc., a leading provider of securities law information and software. With the President about to sign the bill into law, and many of the changes taking effect immediately or within the near future, there’s no time to waste.
"The legislation will be of significant aid to investors," said James Hamilton, JD, LLM, senior securities law analyst for CCH. "It will bring about enhanced market transparency and give investors more confidence that financial statements are accurate. This fundamentally changes the way public companies do business and how the accounting profession performs its statutorily required audit function. There’s no doubt that it is the most significant change to securities law since the 1934 Securities Exchange Act."
The Act’s major provisions closely follow the Democrat-sponsored bill passed by the Senate earlier this month. A few concessions were made to Republican-backed ideas, however, including the complete adoption of tougher criminal penalties for corporate fraud. And, while the Act covers significant ground, the Securities and Exchange Commission (SEC) has issued several proposed rules that seek additional requirements from publicly traded companies.
Below, CCH provides an overview and analysis of major provisions of the new law and what additional rules may be next from the SEC. (For more information and related resources, visit http://www.cch.com/securitiesreform  )
Accounting Oversight Board
One of the most fundamental changes for the industry is the creation of an independent Accounting Oversight Board, a nonprofit corporation subject to SEC oversight. The new board’s power has been ratcheted back from the initial Democrat bill, directing the SEC to have more control over the Oversight Board, similar to the powers it now has over the National Association of Securities Dealers (NASD).
Accounting firms that conduct audits of public firms will be required to register with the board. The board is directed to review annually each accounting firm that conducts more than 100 audits a year; accounting firms conducting fewer than 100 audits yearly are to be reviewed every three years.
The board can investigate potential violations of rules and impose sanctions on the rule-breakers. The board’s power extends not just to domestic accounting firms but also to foreign public accounting firms that audit financial statements of companies under U.S. securities laws.
The board will include five members (two who are or have been CPAs) appointed by the SEC within 90 days after the Act takes effect. The board must be fully operational and deemed capable by the Commission of executing its duties within 270 days, approximately nine months, after the law’s enactment.
The newly established Accounting Oversight Board will set auditing standards. However, the Act directs the Financial Accounting Standards Board (FASB) to continue its role in setting accounting standards (e.g., Generally Accepted Accounting Principles, GAAP) and provides public funding for FASB to fulfill this role.
For the first time, the government is curtailing ancillary services provided by accounting firms. Under the Act, accounting firms will be barred from providing several non-audit services to their audit clients. These include bookkeeping or other services related to accounting records or financial statements; financial information systems design, appraisal or valuation services; actuarial services; management functions or human resources; broker or dealer or investment advisor services; and legal services.
The Act does allow the Accounting Oversight Board authority to grant case-by-case exceptions and does not limit accounting firms from providing non-audit services to public companies that they do not audit or to any private companies.
Registered public accounting firms also will have to rotate their lead partner (the partner in charge of the audit engagement) and their review partner (the partner brought in to review the work of the lead partner and audit team) on audits so that neither role is performed by the same accountant for the same company for more than five consecutive years.
Senior Management Accountability
The Act places a great deal of accountability squarely on the shoulders of senior executives at publicly held companies, containing a number of provisions designed to make senior management more accountable and to improve financial disclosures. Among the provisions:
- Certification. CEOs and CFOs are required to certify their company’s financial reports and are prevented from benefiting from profits they receive if it’s proven that they misstated their company’s financials. The certification provisions apply both to senior managers at U.S.-based companies as well as CEOs and CFOs of companies that reincorporate outside the U.S. The Act calls for companies to comply with this within 30 days of enactment.
- Freezing Assets. During an investigation, the SEC can now seek an order in federal court imposing a 45-day freeze on extraordinary payments to corporate executives. The target payments would be placed in escrow, ensuring that corporate assets are not improperly taken from an executive’s personal benefit.
- Restrictions on Services. The SEC now can 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. Previously, only a federal court could issue an order prohibiting a person from acting as an officer or director of a public company.
- Audit Committee Independence. Under the Act, the audit committee has to be independent from company management and audit committees are directly responsible for the appointment, compensation and oversight of the work of the auditors. The committee must develop procedures for addressing complaints concerning auditing issues and procedures for employee whistleblowers to submit their concerns regarding accounting or auditing issues.
- Code of Ethics. Public companies also will be required to disclose whether they have adopted a code of ethics for senior management and, if not, why. The SEC is ordered to issue final rules on this within 180 days of enactment.
- Corporate Fraud. While much of the Act mirrors the Senate’s earlier bill, most of the corporate fraud provisions are from legislation the House passed earlier this month. These provisions include:
- Financial Statement Certification. The Act calls for top corporate executives to certify that financial statements of the company fairly and accurately represent the financial condition of the company. Company executives who knowingly fail to comply with this provision could face fines of up to $1 million and 10 years in jail, or both; executives who willfully fail to comply could see fines as high as $5 million and jail terms of 20 years, or both.
- Securities Fraud. The Act creates a new felony for securities fraud, punishable by up to 25 years in prison.
- Mail and Wire Fraud. Executives found guilty of committing these types of fraud could be sentenced up to 20 years of jail time.
- Whistleblower Protections. The Act creates criminal sanctions against those who retaliate against whistleblowers and includes both fines and up to 10 years in jail.
- Bankruptcy Loopholes. The Act changes the bankruptcy code to make judgments and settlements based upon securities law violations non-dischargeable, thereby helping to protect victims of fraud by preventing corporate wrongdoers from sheltering their assets under the umbrella of bankruptcy.
- Document Destruction. The Act strengthens laws that criminalize obstruction of justice, such as document shredding or falsifying records, calling for fines and up to 20 years imprisonment if found guilty.
Disclosure of Insider Transactions and Banning Loan Issuance
Under the Act, insider stock trades will have to be reported by the second day following any transaction. Under current law, insiders do not have to report trades until the tenth day of the month following the month in which the trade occurred, meaning that an insider trade could go unreported for as many as 40 days. Companies have 30 days to comply with the new deadline after the Act becomes effective.
Senior management also is prohibited from any insider trading during pension fund blackout periods, with this provision going into effect 180 days after the law’s enactment.
The Act further orders companies, within one year, to electronically file disclosures related to inside stock transactions, with the SEC then posting these statements on the Internet within a day after they were filed. The companies also are directed to post these statements on their own web site by the end of the day after they were filed.
The Act makes it unlawful for any public company to make loans to its executive officers and directors. There are a few narrow exemptions. One exemption applies to consumer credit loans made to executives on market terms in the ordinary course of the company’s consumer credit business. Another exemption applies to banks that are already covered by Federal Reserve regulations on insider loans.
Added Regulation Likely from SEC Proposed Rules
Over the past several months, the SEC also has been busy, taking initiative and issuing several proposed rules. While the Act covers some of these areas and, therefore, preempts any SEC rules, there are many areas not addressed. Among the proposed SEC rules not covered in the Act are:
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