Public Companies Are Facing a Radically Altered Environment
Landmark legislation and far reaching rule changes will forever alter the landscape of corporate governance
In the last year, corporate America has been rocked by a succession of scandals related to financial reporting abuses, insider profiting and loss of employment and retirement benefits by large numbers of employees. One result has been an unprecedented drop in the public equity markets, which has sharply reduced the net worth of tens of millions of investors and diminished retirement account values.
Now reaction has come in the form of the Sarbanes-Oxley Act of 2002, new SEC disclosure requirements, and revisions in the listing requirements of the NYSE and the NASDAQ stock markets. These changes are profound and will affect every public company, large and small. Sarbanes-Oxley is the most significant securities legislation since the 1930s, when the principle of honest and accurate financial reporting became the cornerstone of the federal securities laws.
These changes will also profoundly affect members of the board of directors and senior management. Directors and officers must take immediate steps to comply with the new laws and regulations or risk SEC sanctions, civil litigation, the loss of D&O liability insurance and an investor backlash.
Senior executives are responsible for financial statements. Sarbanes-Oxley makes the CEO and CFO personally responsible for the company’s financial statements and internal controls, with related civil and criminal liabilities. These executives must certify to the absence of misleading statements or omissions (the Rule 10-5 fraud standard) and that the financial statements fairly present the company’s financial position and results of operations (the auditor’s opinion) with respect to all financial reports filed with the SEC (10-K and 10-Q). They must also comment on the nature and sufficiency of internal controls. In addition, neither the CEO, the CFO nor the chief accounting officer can have been involved, as an employee or affiliate of the auditor, with any audit of the company for up to one previous year.
SEC reports will be broadened. The SEC is proposing that Form 8-K be filed in as little as two business days after directors and officers buy or sell securities of their company, including derivatives of such securities, or adopt, modify or terminate periodic plans to buy or sell such securities or receive loans (now barred by Sarbanes-Oxley). The SEC has also proposed 17 additional Form 8-K items relating to material contracts and customers, financial obligations, business exit activities, debt impairment and rating changes, listing changes, withdrawn financial statements and opinions, employee plans, sales of unregistered securities, modification of stockholder rights, and changes in directors and executive officers. In addition, the Management’s Discussion and Analysis in 10-K and 10-Q reports will be expanded by an SEC proposal that would add an in-depth analysis of critical accounting principles. The SEC is also working on additional certification requirements for the CEO and CFO.
Audit committees will control financial reporting. Sarbanes-Oxley requires every public company to have an Audit Committee of the Board of Directors. This committee will oversee company accounting and reporting. The Audit Committee must be made up of independent directors — with a recommendation that one is an expert in accounting and finance — and the committee may have its own staff and counsel. All accounting matters will be supervised by the Audit Committee, including the hiring and firing of auditors, their compensation and assignments. Auditors will be required to advise the Audit Committee on all significant accounting issues and disputes with management. The Audit Committee will evaluate the internal controls of the company. Further, it will receive reports from outside counsel and employees concerning possible improprieties that are not appropriately disposed of by management.
Auditors are regulated. Every public company auditor must register with a newly created Public Company Accounting Oversight Board. This board will give accounting guidance, review the auditor’s work, inspect the auditor’s work product and oversee disciplinary proceedings including suspension or loss of registration. The Oversight Board is supervised by the SEC, and could function somewhat like the NASD with broker-dealers. Audit partners will have to rotate assignments every five years, and firm rotation is being considered. Auditors are barred from non-audit services (including tax services) without Audit Committee approval. Certain non-audit activities are prohibited.
Attorneys will be regulated. Sarbanes-Oxley directs the SEC to formulate rules of conduct for counsel who practice “in any way” before the SEC. Sarbanes-Oxley requires that if counsel becomes aware of an irregularity, it must be discussed with the principal legal officer or the CEO. If appropriate action is not taken, then it must be discussed with the Audit Committee or the board of directors. CEOs will either have to deal with troublesome issues identified by counsel or have the issues put before the Audit Committee or the board of directors. Disputes brought to the Audit Committee or the board of directors will have to be disclosed in SEC reports.
Certain executive benefits are prohibited. Sarbanes-Oxley prohibits loans or loan guarantees to senior executives. Further, if a company has to restate its financial statements, senior executives will have to return bonuses, equity and incentive based compensation and equity sale profits arising for one year after first publication of the financial statements being restated. Executives are prohibited from trading in the company’s equity at such time as retirement plans are blacked out, that is, participants can’t reallocate their portfolios.
NYSE and NASDAQ will have new governance rules. NYSE proposals focus on the creation of a corporate Compensation Committee composed of independent directors. The Compensation Committee would act independently of the company’s board of directors with its own advisors. This committee would oversee key issues such as CEO compensation, and work to better harmonize the CEO’s interests with the shareholders. NASDAQ requires a similar committee for its listed companies. Both NYSE and NASDAQ proposals require that a majority of the full board of directors be independent. NYSE and NASDAQ proposals also cover Audit Committees, but Sarbanes-Oxley will likely control in that area.
Civil and criminal penalties are increased. Sarbanes-Oxley has a number of provisions making serious violations of its provisions criminal offenses, toughening sentencing guidelines and extending the statute of limitations on civil fraud actions.
D&O insurance costs will increase. Responding to a surge in stockholder lawsuits and the expectation of more to come, insurance companies are raising premiums and deductibles while demanding corporate accountability, the adoption of effective internal controls and corporate governance policies and procedures.
What should you do now?
- Sophisticated counsel should immediately conduct a compliance audit, and then working with the board of directors and management, take the following steps:
- Analyze the structure of the board of directors and determine “independent” status
- Review existing committee membership and charters and make required revisions
- Meet with the board of directors, senior management, accounting and finance staffs and auditors to determine whether there are any accounting or reporting problems
- Conduct an in-depth investigation and fully document any indicated problems and resolutions
- Review internal financial controls
- Review existing insurance and pursue needed enhancements
- Create procedures in support of the CEO/CFO certification process
- Create a corporate policy related to employees reporting improprieties, to be added to the company’s employee handbook
- Create a code of ethics for senior management
- Create a timely and comprehensive reporting regime to enable compliance with the numerous items of revised Form 8-K
- Review recent SEC periodic reports of the company to identify enhancements that will be required, and start planning to meet those requirements, including information gathering and drafting
- Consider revisions in the employment agreements of senior management both with respect to compensation and to comply with the stringent financial reporting and certification requirement of Sarbanes-Oxley.
The Corporate Governance Practice Group of Ruskin Moscou Faltischek, P.C. includes highly experienced general corporate, securities, white-collar crime, employment, litigation and alternative dispute resolution attorneys who are fully conversant with this complex landscape and will assist in your timely compliance with these new and difficult legal requirements.
You may contact any of us at 516-663-6600 or via e-mail: