Sarbanes-Oxley Act of 2002

Sarbanes-Oxley Act of 2002 Basic provisions for managers

Sarbanes-Oxley Act of 2002 • Why enacted? Enron, WorldCom, Adelphia, Waste Management, Tyco, and attendant accounting scandals • Specifically, what was the improper conduct? • -corrupt, overly compliant auditors who actually were not independent of their clients (conflictS of interest: client pays auditor? Who decides if re-engagement?

Sarbanes-Oxley Act (more) • More problems leading to S/O ’s passage: • -corp officers claim they ‘didn ’t know ’ about financial corruption of subordinates (defense of ‘no knowledge ’) • -corp officers receiving generous bonuses for ‘bad performance ’

Sarbanes-Oxley (more) • Examples of CEO, corp officer misconduct: • -Tyco CEO, Dennis Kozlowski authorized loans of millions of $ to dozens of Tyco execs to buy their loyalty (without board OK, 51 Tyco execs received $56 million in bonuses--and $39 million more to pay taxes on bonuses to wipe out loans from Tyco to them;

Sarbanes-Oxley (more) • Kozlowski bought with Tyco money without bd. Authorization: land & house in Boca Raton, FL worth $29,756,000; apt rental in NYC from 1997 to 2001, $1,320,000 • -bought $7.2 mill. Co-op in NYC for ex-wife with Tyco $ without Bd authorization • -bought second NYC apt for self for $16.8 mill. Without Bd authorization

Sarbanes-Oxley (more) • More Kozlowski corp extravagance: • -renovations on second NYC apt: $3mill more (without Bd authorization) • -furnished second apt. For $11 mill using Tyco money w/o bd authorization (furnishings included traveling toilet box $17,000; poodle umbrella stand $15,000; $6,000 shower curtain; $2,900 coat hangars

Sarbanes-Oxley (more) • Other corp wrongs leading to S/O Act: • -insider trades during pension blackout periods • -issuance of ‘fictional ’ corp financial rpts (e.g., Enron ’s ‘ off-balance sheet ’ SPEs, special purpose entities removing debt) • -manager ’s ‘plausible denial ’ of improprieties: ‘You mean that was going on right here in our company? ’

Overview of Sarbanes-Oxley (P.L. 107-204) • Title 1: PCAOB (Public Company Acctg Oversight Board) • Title 2: Auditor Independence • -1934 SEC Act amended: add to s 10 (g) unlawful for registered public acctg firm doing an audit for an issuer to provide the issuer at the same time any non-audit service such as 1)“bookkeeping or services related to acctg records or financial statements; • 2) financial info systems design and implementation

PCAOB (Public Co Acctg Oversight Board) • PCAOB established by Sarbanes-Oxley • Purpose: protect investor interests and further independent audit reports • NOT a federal agency • PCAOB’s employees NOT fed. Employees • Duties of PCAOB: 1) register public acctg firms; 2) establish stds for audit rpts; 3) inspect registered public acctg firms; 4) investigate & discipline reg. Pub. Acctg firms; 5) other duties to promote high prof’l stds in audit services; 6) enforce compliance w/ S/O; 7) set staff budget

PCAOB (more) • PCAOB bd members: 5 appointed from “prominent individuals of integrity & reputation who demonstrated commitment to investors and public…” • Who appts bd members? SEC after consulting w/ Sec Treas & Chrmn of Fed • Term for bd members: 5 yrs after initial bd (whose term is staggered so people rotate on each yr.); 2 term limit for each member

S/O: Audit committee ‘financial expert’ • S/O s 407 requires each “issuer” to disclose “whether or not” and “if not, the reasons therefore” the audit committee is comprised of at least 1 member who is a “financial expert” • “Financial expert”= consider whether a person has through education and experience as a public accountant or auditor or principal financial officer, controller, or principal acctg officer of an issuer, or from a position involving performance of similar functions 1) an understdg of GAAP & financial statements and…

S/O: “Financial expert” (more) • …experience in a) preparat. Of auditing financial statements of generally comparable issuers AND • b) application of such principles in connection with acctg for estimates, accruals, and reserves; • -experience with internal acctg controls • -AND an understanding of audit committee functions

S/O: Criminal penalties for altering documents • S 802: “Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with intent to impede, obstruct, or influence the investigation or proper administration of any matter w/in the jdx of any dept or agency in U.S. or bkcy case, shall be fined or imprisoned not more than 20 yrs or both

S/O: Destruction of corporate audit records • S 802 (18 U.S.C. s 1520): “Any acct who conducts an audit of an issuer … shall maintain all audit or review workpapers for a period of 5 yrs from end of fiscal yr in which audit or review was concluded.” • SEC must promulgate rules re records retention such as workpapers, documents that form the basis of an audit or review, memoranda, correspondence, communications, other documents, and records (incl. Electonic records) created, sent, rec’d in connection w/ audit or review

S/O (overview, cont’d.) More prohibited services concurrent w/ audit -appraisal or valuation services, fairness opinions, or contribution in kind reports -actuarial services -internal audit outsourcing services -management functions or human resources -legal services and expert services unrelated to the audit -any other service that Board determines is impermissible

S/O Overview (more) • S 202 Preapproval requirements: audit committee must preapprove ALL audit services and NON-audit services (de minimus exception: not >5% of total revenues paid by issuer to auditor during FY where non-audit services provided)… • S 203 Audit partner rotation: unlawful for RPAF to provide audit services to issuer if lead ptnr responsible for review ing audit has performed audit services for issuer in each of prior 5 FY

S/O Overview (more) • S 204: Auditor rpts to audit comm’ee. • -RPAF must timely rpt to audit committee • -all critical acctg policies & practices used • -all alternative treatments of financial info w/in GAAP discussed w/ man’t, ramifications of use of alternatives, and treatment preferred by RPAF • -any material written communications betw RPAF and man’t (such as man’t letter or schedule of unadjusted differences)

S/O Overview (more) • S 205 (conforming amendments) • S 206: Conflicts of interest: Unlawful for RPAF to perform for issuer any audit service req’d by fed sec acts if CEO, controller, CFO, CAO, or equivalent, was employed by RPAF and participated in any capacity in audit during prior 1 year to start of the audit

S/O Overview (more) • S 207: Study of mandatory rotation of RPAFs • … • Title IV: Enhanced Financial Disclosures • Req’d financial rpts must reflect material CORRECTING adjustments • Off-balance sheet txacts: w/in 180 days of date of enactment of S/O, SEC must issue final rules providing each req’d financ. Rpt filed must disclose ALL MATERIAL OFF-BALANCE SHEET txacts, arrangements, obligations et al relation that may have material effect on financial condit

S/O Overview (more) • S 401 (b): SEC rules on “pro forma” figures (what are ‘pro forma’ figures? Remove non-recurring to arrive at core earnings flow of biz/or “Julia Child” cooking the books legally to remove embarrassing items under pretext of non-recurring) must appear by 180 days after S/O passage: rules must make “pro formas” appear so financials not materially misleading

S/O Overview (more) • S 402 Enhanced conflict of interest • -prohibition on personal loans to execs: • Unlawful for issuer to arrange for credit extension, renew extension in form of personal loan to any dir or exec officer • “Grandfather” in credit extensions existing on day S/O enacted if NO material MODIFICATION or RENEWAL • Exceptions: NOT precluded: 1) home improvement & mfgd home loans, consumer credit, credit extension under open end credit

S/O Overview (more) • Exceptions to personal loan prohibition (cont’d):…charge card, or any extension of credit by a broker under s 15 of fed sec laws to an EE of that broker or dlr IF • -IN ORDINARY COURSE BIZ • -OF A TYPE GENERALLY AVAIL. TO PUBLIC BY THAT ISSUER • -MADE ON MKT TERMS OR TERMS NO MORE FAVORABLE THAN TO GEN PUBLIC

S/O Overview (more) • S 403: Disclosures certain txacts under 16(b) for officers, dirs, and holders of 10% of equity class (very large SHs) must file statements w/ SEC re equity sec … • -When to file: time of registr of sec on nat’l sec exchg • -w/in 10 days after becoming beneficial owner, dir or officer • -if change ownership equity sec before end of second biz day following day txact executed

S/O Overview (still more) • S 404: Management assessment of internal controls: • -Each annual rpt MUST contain INTERNAL CONTROL REPORT stating • -responsib of man’t to establ & maintain adeq internal syst controls for financial rptg • -assessment as of end FY of effectiveness of internal control structure & procedures • Each audit rpt by RPAF of issuer must ATTEST to, REPORT on, assessment made by issuer’s man’t.

Public company audit committees • Section 301: • -s (m)(1):SEC must direct national securities exchanges and national securities associations to prohibit listing of any security of an issuer not in compliance with paragraphs 2-6: • s (m)(2): Responsibilities relating to registered public acctg. Firms: audit committee of issuer directly responsible...

Audit committees (more) • Audit committee as a committee of board of directors, is directly responsible for appointment, compensation, and oversight of the work of any registered public acctg firm employed by the issuer (including resolution of disagreements between management & the auditor regarding financial reporting) for the purpose of preparing or issuing audit rpt...

Audit committee (more) • …or related work, and each such registered public acctg firm shall report DIRECTLY to the audit committee • Independence of audit committee: • -each issuer ’s audit comm. Member shall be a member of issuer ’s board and shall otherwise be ‘ independent ’

Audit committee (more) • ‘ independence ’: for purposes of this paragr. a member of the audit comm. May NOT other than as an audit comm member or board or other board committee: • -accept any consulting, advisory, or other compensatory fee from the issuer OR issuer ’s subsidiary or affiliate

Audit committees (still more) • SEC has authority to EXEMPT particular relationships from audit committee requirement (de minimus?) ‘ as SEC determines appropriate ’ • Complaints to audit committee: Each audit committee must set up procedures for: receipt, retention, and treatment of complaints received by ISSUER re acctg, internal controls, or audit matters

Audit committee (still more) • Complaints (more) • -there shall exist audit committee procedures for confidential, ‘ anonymous ’ submission by employees of the issuer of concerns regarding questionable acctg or audit matters • Audit committee has authority to hire advisors it decides are needed to carry out its duties (budget?)

Audit committees (more yet) • Funding: issuer SHALL provide appropriate funding, as determined by AUDIT COMMITTEE to pay for: • -registered public acctg firm to render/issue audit report AND • -to any advisers employed by audit committee (what is ‘ appropriate ’ funding? How much veto does this give bd?

Corporate responsibility for financial reports • Why cooked financials: the ‘ SCAM ’: Hire our ‘ Consultants ’, they ’ll increase your earnings, and our auditors with ‘ sign off ’ on whatever strategy they come up with! • S/O s 302(a): SEC shall for every company filing periodic reports under 13(a), 15(d) require that the principal CEO/-s and principal CFO, CERTIFY in each annual or quarterly rpts THAT:

Corp. Responsibility for financial rpts (more) • Certification that: • -signing officer has ‘reviewed ’ the rpt. • -based on officer ’s knowledge, rpt does not contain any untrue statement of material fact or omit to state a material fact needed to make the statements in light of circumstances under which statements were made, not misleading;

Corp. Responsibility for financial rpts (still more) • ‘ Certification ’ also means: • -based on officer ’s knowledge, financial statements et al financial info included in rpt, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the rpt (cf. ‘ off-books ’ special purpose entities to remove debt from issuer ’s balance sheet)

Corp. Responsibility for financials (and more) • ‘ Signing officers ’: • -responsible for establishing and maintaining internal controls; • -have designed such internal controls to ensure that material information relating to issuer and its consolidated subsidiaries is made known to such officers by others w/in those entities, particularly when periodic rpts being prepared

Corporate responsibility for financial rpts (more) • Signing officers: • -have evaluated effectiveness of issuer ’s internal controls as of a date w/in 90 days before the rpt; and • -have presented in the rpt their conclusions re the effectiveness of their internal controls based on their effectiveness as of that date

Corporate financial rpts (more) • Signing officers: • -have disclosed to issuer ’s auditors and audit committee: • -ALL significant deficiencies in design or operation of internal controls (IC)which could adversely affect issuer ’s ability to record, process, summarize, and rpt financial data and have identified for issuer ’s auditors ANY mat. Wknss in IC

Corp. Responsibility for financial rpts (more) • Signing officers have disclosed to auditors and audit committee: • -ANY fraud, whether material or IMMATERIAL, that involves management or other employees who have a significant role in the issuer ’s internal controls

Improper influence on conduct of audits • S 303(a) It shall be unlawful… for any officer or director of an issuer or other person acting under the direction thereof, … to fraudulently influence, coerce, manipulate, or mislead any independent public or certified acct engaged in …audit of financial statements … for purpose of rendering …materially misleading. ’

Some questions re s 303 • May dir, o tell subordinate to burn, shred, conceal document? • May dir, o meet w/ co auditor to discuss ‘ co situation ’? • Does CEO, CFO have to go through audit comm ’ee to communicate w/ auditor? • May CEO, CFO meet w/ auditor? Ex parte? • Preemption? Significance

S 304: Forfeiture of certain bonuses &profits • 304(a): If issuer req ’d. to prepare acctg restatement due to issuer ’s material noncompliance, as result of misconduct, w/ financial rptg requ ’t of sec. Laws, CEO, CFO of issuer must reimburse issuer: • -for any bonus, incentive-based or equity-based pay rec ’d during 12 mos. Following 1st public issuance of document restating financial rptg requ ’t;

S 304 (more) • -CEO, CFO of issuer must reimburse issuer • -for any profits realized from sale of securities of issuer during 12 mos after restatement of acctg rptg requ ’t under sec laws

Officer, dir bars & penalties under s 305 • ‘ subst ’l unfitness ’ no more; now just ‘ unfit ’ (lessens std to find O, dir wrongdoing) under s 21(d)SEC Act & 20(e) of SA ‘ 33 • 305(b): In any action brought by SEC under any sec law, SEC may seek and any fed ct may grant any equitable relief appropriate or necessary for investor benefit

Insider trades during pension fund blackouts • S 306: Except to extent SEC provides otherwise, it is unlawful for any director or exec. Officer of an issuer of any equity security (other than exempt sec) dir/indir to purchase, sell, or otherwise acquire or transfer any equity sec of an issuer (other than exempt sec) during any blackout period w/ respect to any equity sec if such dir or officer acquires sec in connection w/ • service or employment as dir or officer

S/O: Sanctions for Prohib tds during blackout period • Any profits realized by dir or exec officer during blackout period trades from any sale, purchase or other acquisition or tnsfr in violation of this subsec shall be recovered by issuer, irrespective of intent of dir or exec officer in entering the txaction • Actions brot by issuer or owner of any sec of issuer in issuer ’s name if issuer not act

S/O: What is a ‘ blackout period? • Blackout period means any period of >3 consecutive biz days during which ability of not fewer than 50% of participants/benefic under IAcctPlan maintained by issuer to buy, etc in any equity of issuer held in such acct is temporarily suspended by issuer or fiduciary of the plan

S/O ’s enhanced conflict of interest provisions • S 402 Enhanced conflict of interest: prohibition on personal loans to execs. (directly or indirectly thru’ subsid to extend, maintain credit, arrange for extension of credit, or renew extension, in form of personal loan to ANY dir or exec officer of that issuer; grandfathers in loans existing on date S/O enacted if no material alteration or renewal post S/O • S 402: Limits: not preclude any home improvement and mfgd home loans, consumer credit, or any extension of credit under open end credit plan, or a charge card, …

S/O: Enhanced conflict of interest provisions(more) • S 402 (2)… or any extension of credit by a broker or dealer registered under s 15 of this title to an employee of that broker or dealer to buy, trade, or carry securities, that is permitted under Fed Res regs… a) made IN THE ORDINARY COURSE OF THE CONSUMER CREDIT business of such issuer; b) of a type the issuer generally makes available to the public c) made by such issuer ON MARKET TERMS or terms no more flexible than offered to gen public for such credit extensions

Sarbanes-Oxley Act of 2002