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16. Securities Regulations. U.S. Financial Markets. Source: Securities And Exchange Commission: GPRA Report , Industry Statistics. Introduction. Securities Regulation Began Due To Great Depression Of 1930’s Designed To Give Potential Investors Factual Information To Make Informed Decision

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Securities Regulations

u s financial markets
U.S. Financial Markets

Source: Securities And Exchange Commission: GPRA Report, Industry Statistics

  • Securities Regulation Began Due To Great Depression Of 1930’s
  • Designed To Give Potential Investors Factual Information To Make Informed Decision
  • Federal & State Laws
security investment
Security Investment
  • Exists When
    • Person Invests
    • Others Manage It For Profit
  • Questions:
    • Common Business Activity?
    • Reasonable Expectation Of Profit?
    • Profits Earned Through Efforts Of Someone Else?
what is a security
What is a Security?
  • Per the acts includes:
    • Note, Stock, Bond, Debenture
    • Evidence of Indebtedness
    • Certificate of Interest, Certificate of Subscription
    • Investment Contract, Voting Trust Certificate
    • Interest in Oil, Gas or Mineral Rights
    • Other interests “commonly known as securities”
what is a security1
What is a Security?
  • Bankers Trust Company served as an agent for corporate customers by placing their commercial paper for sale. This function of a commercial bank acting as a dealer of commercial paper was challenged by the Securities Industry Association. Issue: Were these sales subject to federal securities laws? Held: Yes. The sale of commercial paper is a security and the Glass-Steagall Act prohibits commercial banks from acting as a dealer of such securities. Securities Industry Association v. Board of Governors of the Federal Reserve System, 104 S.Ct. 2979 (1984).
what is a security2
What is a Security?
  • W.J. Howey Company and Howey-in-the-Hills Service, Inc., are Florida corporations under common control and management. Howey Company offered to sell to the public its orange grove, tree by tree. Howey-in-the-Hills Service, Inc., offered these buyers a contract wherein the appropriate care, harvesting, and marketing of the oranges would be provided. Most of the buyers who signed the service contracts were nonresidents of Florida who had very little knowledge or skill needed to care for and harvest the oranges. These buyers were attracted by the expectation of profits. When the profits were not forthcoming, the buyers sued based on the 1933 Securities Act registration requirements not being satisfied. Issue: Did the Howey Company sell securities? Held: Yes. Sales of orange trees and services contracts were sales of securities. Under the Federal Securities Act of 1933 a security exists whenever one person invests money in a common enterprise with the exception of profits resulting from the efforts of another person. Upon examination of these orange grove transactions, these essential requirements of a security were found to be present. Since the registration requirements were not satisfied, the controllers of these "Howey" companies have violated the Federal Securities Act of 1933. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
securities exchange commission sec
Securities & Exchange Commission (SEC)
  • Created In 1934-35 Commissioners
  • Quasi-Legislative & Quasi-Judicial
  • Regulates
    • Stock Exchanges
    • Utility Holding Companies
    • Investment Trusts
    • Investment Advisors
sec filings
SEC Filings

documents for securities sale
Documents For Securities Sale
  • Registration Statement
    • Disclosure Of Financial Info.
    • Periods
      • Pre-filing Period
      • Waiting Period- 20 Days, Tombstone Ad
      • Post-effective Period
  • Prospectus- Final Financials
exchange act initial registrations
Exchange Act:Initial Registrations

registration statement liability
Registration Statement Liability
  • Untrue Statements Of Material Fact
  • Omits Material Facts
  • Omits Information Resulting In Misleading Potential Investor
fraudulent transactions
Fraudulent Transactions
  • Attempt To Defraud
  • Attempt To Obtain Money/Property By Untrue/Misleading Statements
  • Attempt To Engage In Transaction/Practice To Defraud/Deceive Purchaser
security transaction defenses
Security Transaction Defenses
  • Materiality- Prudent Investor Would Use
  • Statute Of Limitations- 1 Year After Discovery, No More Than 3 Years
  • Due Diligence- Reasonable Review Of Financials
sec enforcement litigation
SEC Enforcement & Litigation
  • Section 10(b) & Rule 10b.5- Materiality
  • Persons Liable
    • Insiders
    • Broker-Dealers
    • Corporations Who’s Stock Purchased/Sold
    • Those Who Aid/Abet/Conspire To Defraud
insider transactions
Insider Transactions
  • Insider
    • Owns More Than 10%
    • Director/Officer
  • Insiders Must File Within 10 Days
  • Short-Swing Profits
  • Non-Public Information
  • Civil & Criminal Liability
state blue sky laws
State Blue Sky Laws
  • Registration By
    • Notification
    • Qualification
    • Coordination
  • Exemptions
    • Isolated Transaction
    • Limited Offer Within Stated Time
    • Private Offering
    • Number Of Holder Not Greater Than Specified
overview of legislation
Overview of Legislation
  • Regulation of Publicly Traded Securities
  • Securities Act of 1933- Disclosure on IPO’s (one-time)
  • Securities Exchange Act of 1934- Periodic Disclosures
    • Monthly, Quarterly, Annual
  • Securities & Exchange Commission (SEC)
securities act 1933
Securities Act (1933)
  • Disclosure Law- Going Public
  • Sanctions Of Violations- Intentional
    • Criminal Punishment
    • Civil Liability For Injured Parties
    • Injunction- Equitable Remedy
  • Parties That Must Comply
    • Issuers
    • Underwriters
    • Controlling Persons
    • Sellers
securities act of 1933
Securities Act of 1933
  • Registration Requirements
    • the purpose of requiring registered securities offerings is to ensure that investors have the information they need to make intelligent investment decisions.
    • Registration Statement - Document describing company and its securities
    • Reviewed by SEC to make sure not per se fraudulent
    • Prospectus - Document used to promote a security
    • the purpose of Section 5’s restrictions on when and how a seller of securities may communicate with prospective buyers: to ensure that an investor has the time to make an intelligent investment decision based on either the prospectus or face-to-face communications in which the investor has an opportunity to ask questions.
securities act of 19331
Securities Act of 1933
  • Electronic Filing- EDGAR
  • Exemptions
    • Securities
      • Government issued or guaranteed
      • Short-term notes and drafts
securities act of 19332
Securities Act of 1933
      • That Section 3 of the 1933 Act exempts the following securities from the registration and prospectus requirements:
      • a. Commercial paper arising out of current transactions with a maturity not exceeding nine months.
      • b. Securities issued by not-for-profit corporations.
      • c. Government securities.
      • d. Securities of national banks, state banks, or the Federal Reserve Board.
      • e. Securities of savings and loan institutions and farmers' cooperatives.
      • f. Securities issued by carriers subject to the Interstate Commerce Commission.
      • g. Insurance contracts.
      • h. Exchanges with existing security holders.
      • i. Intrastate offerings.
  • j. Securities declared exempt by the SEC's rules and regulations.
antifraud provisions of 1933 liability
Antifraud Provisions of 1933- Liability
  • Improper Offers/Sales
    • Improper:
      • Timing
      • Manner
      • Content
antifraud provisions of 1933 liability1
Antifraud Provisions of 1933- Liability

Defective Registration Statements

  • Section 11 liability:
    • a. Privity is not required.
    • b. Reliance is not ordinarily required.
    • c. The purchaser need not prove that the defendants were negligent. Instead, the defendants must disprove their negligence by establishing DUE DILIGENCE.
antifraud provisions
Antifraud Provisions
  • Defective Registration Statements
    • see Gustafson v. Alloy Company below
  • Under Section 12(1) of the 1933 Act the remedy is rescission or damages.
    • Nonprofit securities
    • Financial institution securities
    • ICC-regulated
    • Insurance and annuity contracts
antifraud provisions1
Antifraud Provisions
  • The shareholders of Alloyd, Inc. sold their stock in a private sale agreement. The contract specified a price for the estimated increased value in the company's worth between the time of sale and the end-of-the-year audited financial statements. The contract further provided that any party disappointed with estimated value could seek an adjustment after the financial records were audited. The buyers were disappointed with the estimated increased value. Rather than seeking an adjustment in the purchase price, they sought to rescind their purchase under § 12(2) claiming that the information provided (as a prospectus) at the time of the sale was false or misleading. Issue: Does § 12(2) apply to private sale contracts? Held: No. When the 1933 Act was enacted, the term prospectus was well understood to refer to documents soliciting the public to acquire securities from the issuer. Section 12(2) does not extend to a private sale contract since that contract is not held out to the public as a "prospectus" in the meaning of the 1933 Act. Gustafson v. Alloyd Co., Inc., 115 S.Ct. 1061 (1995).
securities exchange act 1934
Securities Exchange Act (1934)
  • Being Public- File Forms With:
    • Stock Exchange
    • SEC- Periodic Reports
  • Affects
    • Businessperson
    • Accountant
    • Lawyer
    • Investor
securities exchange act of 1934
Securities Exchange Act of 1934
  • Registration of Securities-Disclosure Required when
    • 500 or more shareholders and issuer’s assets > $3 million
    • Interstate trading
    • On a national stock exchange
securities exchange act of 19341
Securities Exchange Act of 1934
  • Periodic Reports
    • Gallagher v. Abbott Laboratories
      • The court ruled that Abbott did not violate the disclosure provisions of the 1934 Act because it did not have duty to disclose all information material to its stock prices as soon as it was discovered by the company. The court stressed that, rather than continuous disclosure, the 1934 Act insists only upon periodic disclosure.
securities exchange act of 19342
Securities Exchange Act of 1934
  • Short-Swing Trading by Insiders
    • Individual filing by Insiders
    • Insider =
      • Officer with registered equity securities
      • Director
      • Owner of 10% or more of a class of equity securities
    • Issuer can recover insider trade gains within 6 month period
    • Purpose: To prevent speculation based on inside information
securities exchange act of 19343
Securities Exchange Act of 1934
  • Regulation of Proxy Solicitations
    • to allow shareholders to exercise their voting rights intelligently and to permit insurgent shareholders to have a fair opportunity to oust incumbent management.
    • the information required by the SEC to be included in proxy statements where directors are to be elected. (This is in addition to the requirements for annual financial reports that must be sent with or prior to a proxy statement for an annual meeting.)
securities exchange act of 19344
Securities Exchange Act of 1934
  • Regulation of Proxy Solicitations
      • a. The person making the solicitation of proxies and the methods to be employed.
      • b. Interests of directors, officers, and certain others in matters to be acted upon.
      • c. Certain information about nominees and those continuing in office, including occupation for the last five years, relationships to executive officers, and interests in firms that deal with the corporation.
      • d. Whether the corporation has audit, nominating, and compensation committees, and if so, their membership and how often they met in the past year.
securities exchange act of 19345
Securities Exchange Act of 1934
  • Regulation of Proxy Solicitations
      • e. Names of directors who have attended less than 75 percent of directors and board committee meetings.
      • f. Certain information if a director has resigned or declined to stand for reelection because of a disagreement with the corporation.
      • g. Compensation of directors, including fringe benefits—specific directions are given as to how this information must be shown.
      • h. Name of and information about the independent public accountants and their relationship with the corporation.
provisions of 1934 act liability
Provisions of 1934 Act- Liability
  • Prohibit Manipulation of Security Price
    • e.g. “Wash Sale” - simultaneous sale/buy
  • Impose Liability for False Statements in Filed Documents
section 10 b rule 10 b 5
Section 10(b) & Rule 10(b-5)
  • Section 10(b) and Rule 10b-5 is the most important liability section in the securities laws!
  • Misstatements/Omissions
    • Elements of a Rule 10b-5 violation (Designed to stop fraud)
      • (1). In an omission case, the fraud requirement dictates that there be a duty to disclose, usually because of a fiduciary duty owed the plaintiff.
section 10 b rule 10 b 51
Section 10(b) & Rule 10(b-5)
  • Misstatements/Omissions
    • Elements of a Rule 10b-5 violation
      • (2). If there is no fraud—that is, no misstatement or omission— there is no Section 10(b) liability. Thus, mere corporate mismanagement or other breach of a fiduciary duty that corporate managers owe to shareholders does not create liability under this provision. There must be a misstatement or omission.
      • Rule 10b-5 requires a showing of scienter—intent to deceive. Note, however, that recklessness may establish scienter
section 10 b rule 10 b 52
Section 10(b) & Rule 10(b-5)
  • Plaintiff must be Purchase or Seller
  • Must show Reliance, unless omission
  • Statute of Limitations May Apply
section 10 b rule 10 b 53
Section 10(b) & Rule 10(b-5)
  • San Leandro Emergency Medical Group v. Philip Morris
    • Philip Morris was held to have not omitted a material fact and, therefore, not did not violate Rule 10b-5. The court held that Philip Morris did not have a duty to give advance notice of its deviation from the company’s historical pricing strategy. First, when it made its initial optimistic assessments, the company had no idea they were unreasonable. Second, the court was reluctant to require companies to give advance notice of sensitive pricing information out of fear it would become available to competitors.
section 10 b rule 10 b 54
Section 10(b) & Rule 10(b-5)
  • Conduct- Rule 10(b-5)
    • Continuous Immediate Disclosure of Material Information
section 10 b rule 10 b 55
Section 10(b) & Rule 10(b-5)
  • Conduct- Rule 10(b-5)
    • Inside Information
      • Anyone, not just an officer or director, who has information that is material (likely to affect investors’ desire to buy, sell, or hold the corporation’s securities) about the corporation and that is not generally available to the investing public violates Rule 10b-5 of the SEC if he or she trades in the security. There have been a number of recent actions by the SEC against people such as printers and secretaries who had gained inside information and acted upon it.
section 10 b rule 10 b 56
Section 10(b) & Rule 10(b-5)
  • Conduct- Rule 10(b-5)
    • United States v. O’Hagan
      • An attorney in a law firm that represented a corporation began purchasing call options for the corporation’s stock after learning of the company’s confidential tender offer plans. The court found the attorney criminally liable for securities fraud in violation of Section 10(b) and Rule 10b-5 under the misappropriation theory.
section 10 b rule 10 b 57
Section 10(b) & Rule 10(b-5)
  • SEC v. ZANDFORD, 122 S.Ct. 1899 (2002)
  • FACTS: William Wood opened an investment account for the stated purpose of preserving the principal and producing income. This investment account authorized Charles Zandford to exercise his discretion in determining which investments to make on behalf of Mr. Wood and his daughter. Through the purchase of securities, Mr. Zandford fraudulently transferred funds from the Wood investment account. The SEC sought to have Mr. Zandford repay funds taken from the Wood account. Mr. Zandford argued the SEC lacks jurisdiction over these wrongful acts since the transactions were not in connection with the sale of a security. The District Court ruled in favor of the SEC, but the Fourth Circuit reversed.
  • ISSUE: Were the transactions conducted by Mr. Zandford “in connection with the purchase or sale of any security?”
section 10 b rule 10 b 58
Section 10(b) & Rule 10(b-5)
  • SEC v. ZANDFORD, 122 S.Ct. 1899 (2002)
  • DECISION: Yes.
  • REASONS: 1. The SEC has consistently held that a broker violates Section 10b and Rule 10b-5 when he accepts payment for securities that not delivered or sells securities while misappropriating the funds.
    • 2. Courts should defer to this reasonable interpretation of securities laws by the SEC.
    • 3. Mr. Zandford’s fraud coincided with the sales of securities; thereby subjecting himself to the jurisdiction of the SEC.
tender offer regulation
tender Offer Regulation
  • History
    • Tender Offer - Public Offer to purchase shares at a specified price. May be in connection with hostile takeover attempt.
  • Williams Act (1968)
    • To give both sides opportunity to present their case
tender offer regulation1
Tender Offer Regulation
  • State’s Typically Regulate Tender Offers
  • Shareholders are protected by federal tender offer rules:
    • a. Minimum offering period. Shareholders have at least 20 business days to consider their decision to sell.
    • b. Withdrawal period. Shareholders may withdraw their tendered shares if a higher bid is made. This allows an investor to reconsider an imprudent decision and promotes an auction market for the shares.
    • c. Proration of purchases. Shareholders need not fear tendering too late if the offer is oversubscribed, since the purchaser must prorate its purchases among all tenderers.
state securities legislation
State Securities Legislation
  • State Securities Regulations/ Blue-Sky Laws
  • Broker-Dealer Registration Typically Required
  • Uniform Securities Act (1985)
sarbanes oxley act 2002
Sarbanes-Oxley Act (2002)
  • Increase In SEC Budget
  • Created Public Company Accounting Oversight Board
  • Members Of Corporate Audit Committee Must Be Independent
  • CEOs Certify Financial Statements
  • Increases Criminal Penalties
overview of presentation
Overview of Presentation

I. Disclosure

  • Earnings Releases
  • Non-GAAP Financial Measures
  • MD&A
  • Certification/Disclosure Controls & Procedures/Item 307 Disclosure

II. Relationship with Outside Auditor

  • Retaining, Supervising and Managing Relationship with Outside Auditor
  • Non-audit Services — Procedures For Pre-approval and Disclosure

III. Boards and Committees

IV. Other Governance Issues

  • Codes of Ethics
  • Lawyer Professional Responsibility
earnings release
Earnings Release
  • New Earnings Release Filing Requirement.
  • Earnings releases regarding a completed fiscal quarter or a completed fiscal year must be furnished on Form 8-K.
  • Timing: must be furnished to the SEC within five business days after release is disseminated.
  • Requirement is set forth in new Item 12 on Form 8-K.
  • Requirement effective beginning March 23, 2003.
filing information vs furnishing information liability and incorporation by reference
Filing Information vs. Furnishing Information: Liability and Incorporation by Reference
  • Information provided under Item 12 of Form 8-K will be treated as “furnished” rather than “filed” for Exchange Act and Securities Act purposes.
  • This means that the company will not have liability for the information under Section 18 of the Exchange Act.
  • But the company will still have liability under Rule 10b-5.
  • The fact that the information is “furnished” rather than “filed” also means that the earnings release will not be automatically incorporated by reference in a registration statement, proxy statement or other report, unless the company expressly so states. This means you don't have automatic Securities Act liability.
what is and isn t covered by item 12
What Is and Isn’t Covered by Item 12?
  • You must furnish if you make a public announcement or release of material non-public information regarding results of operations or financial condition for a completed quarterly or annual fiscal period.
  • You don’t have to furnish again if you repeat the same information in subsequent announcements. For example, if you mail quarterly reports to stockholders that contain the same information, you don’t need to file the report.
  • You do need to furnish again if you amend or supplement the previous announcement in material ways.
  • You don’t have to furnish announcements of earnings estimates for future or ongoing fiscal periods, unless these estimates are included as part of the earnings release.
what does the rule say about earnings calls and similar announcements of earnings information
What Does the Rule Say About Earnings Calls and Similar Announcements of Earnings Information?
  • the disclosure occurs within 48 hours after related written release that has already been furnished on Form 8-K;
  • the presentation is broadly accessible to the public;
  • the financial and statistical information is made available on the registrant's website; and
  • the presentation was announced by a widely disseminated press release that included information on how to access the information.
what does this mean
What Does This Mean?

If you are doing an earnings call, you should file an 8-K in advance, and make sure that the other requirements regarding announcement and availability of the information are satisfied.

Good news: many companies are already doing this as part of their regular procedures.

relationship of new filing requirement to regulation fd
Relationship of New Filing Requirement to Regulation FD
  • Regulation FD provides that if you disclose material nonpublic information to specified persons, you must simultaneously disclose to the public generally.
  • Companies can satisfy the Regulation FD disclosure requirement by filing a Form 8-K. The rules provide that you can furnish the information under Item 9. This is not the only way, however. Other forms of public dissemination also work.
regulation fd cont
Regulation FD, (Cont.)
  • Principal differences between Regulation FD and new earnings release filing requirements relate to timing and form of disclosure. Earnings release rules require filing in 5 business days; Regulation FD requires immediate disclosure. Earnings release rules require filing on 8-K; Regulation FD permits other forms of disclosure.
  • Suggestion for earnings call procedures: file furnish earnings release on Form 8-K in advance of call. Satisfy other earnings release rules regarding telephonic announcements. Then you are OK under both rules.
non gaap financial measures
Non-GAAP Financial Measures
  • New Regulation G
    • Pro-forma is defined as including or excluding amounts from comparable GAAP Measures (e.g. EBITA, “core earnings”)
  • Press Releases
    • Must include GAAP number
    • Prominence
    • Reconcile
  • In a Filing
    • Must include reason why Non-GAAP measure is useful
  • Prohibited
    • No Non-GAAP in financials or notes
    • Omitting items identified as “non-recurring” when there was a similar item within the two previous years or is likely to be within the succeeding two years
    • Liquidity measures that exclude cash settled charges
    • Giving non-GAAP items titles that make them sound like GAAP
recent guidance on md a
Recent Guidance on MD&A
  • Both before and after SOX, the SEC has focused extensively on MD&A
  • January 2002 interpretive release focuses on MD&A discussion of liquidity and capital resources, including off-balance sheet financing, trading activities involving non-exchange traded contracts accounted for at fair value, and transactions with related parties
  • December 2001 release on “critical accounting policies,” followed by May 2002 release proposing rules requiring a new section in MD&A discussing “critical accounting estimates”
  • January 2003 final rules on off-balance sheet financing
recent guidance on md a continued
Recent Guidance On MD&A, Continued
  • Preparing MD&A that will satisfy the rules and SEC staff is more difficult than ever
  • The rulemaking is not yet over—the staff is still working on the final critical accounting estimates rules
  • Some commissioners have recently expressed concern about making MD&A disclosure too voluminous and burdensome
new rules on off balance sheet arrangements
New Rules on Off-Balance Sheet Arrangements
  • Companies must expand discussion of off-balance sheet arrangements. The final rule defines these arrangements more narrowly than the proposed rule.
  • The company must discuss the transaction if it is “reasonably likely” to have a material effect on the company. The staff did not adopt the “more than highly remote” standard it originally proposed, which would have been more demanding.
  • MD&A must include tabular disclosure of contractual obligations. The table must disclose the nature and the amount of the obligation.
  • The rules apply to filings that include financial statements for fiscal years ending on or after June 15, 2003.
what is covered
What Is Covered

Covered Off-balance Sheet Arrangements

  • Guarantee contracts
  • Retained interest in assets transferred to an unconsolidated entity
  • Obligations under certain derivative instruments
  • Obligations arising out of variable interests

Contractual Obligations Table Must Identify:

  • Long term debt obligations
  • Capital lease obligations
  • Operating lease obligations
  • Purchase obligations
  • Other long term liabilities on balance sheet
other liquidity and capital resources issues
Other Liquidity and Capital Resources Issues
  • Discuss short-term liquidity needs.
  • How will short-term liquidity needs be satisfied? Identify the sources of short term liquidity.
  • What are the circumstances that are reasonably likely to affect sources of short term funding?
  • Remember that the SEC staff takes the view that “reasonably likely” is a lower threshold than “more likely than not.”
related party transactions
Related Party Transactions
  • The January 2002 interpretive release discussed these transactions. The focus has only intensified since then.
  • The release makes the point that discussion of related party transactions may be appropriate even if transaction is not covered by Item 404 of Regulation S-K.
  • Does a party have a relationship with the company that enables the company to negotiate transactions that would not be available in true arms' length negotiations?
critical accounting estimates
Critical Accounting Estimates
  • Proposal: companies must identify “critical accounting estimates.”
  • A critical accounting estimate is an accounting estimate that is highly uncertain at the time made, and different estimates that the company reasonably could have used would have had a material impact on the financial statements.
  • The proposed rules would require a discussion of the critical estimates, and a quantitative sensitivity analysis showing how financial statements and financial performance would have changed if the estimates had changed. They would also require a discussion of any changes in the estimates.
ceo cfo certification under section 302 of the act
CEO/CFO Certification Under Section 302 Of The Act
  • He/She has reviewed the report.
  • Based on his or her knowledge, the report does not contain any untrue statement of material fact or omit to state a material fact necessary in order to the statement made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report.
  • Based on his or her knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition, results of operations and cash flows of the company as of, and for, the periods presented in the report. (emphasis added.)
  • He or she and the other certifying officers: (a) are responsible for establishing and maintaining disclosure controls and procedures; (b) have designed such disclosure controls and procedures to ensure that material information is made know to them, particularly during the period in which the periodic report is being prepared; (c) have evaluated the effectiveness of the disclosure controls and procedures as of a date within 90 days prior to the filing date of the report; and (d) have presented i the report their conclusions about the effectiveness of the disclosure controls and procedures based on the required evaluation as of the date.
ceo cfo certification under section 302 of the act cont
CEO/CFO Certification Under Section 302 Of The Act, Cont.
  • He or she and the other certifying officers have disclosed to the auditors and the audit committee: (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the company’s ability to record, process, summarize and report financial data and have identified for the auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the internal controls.
  • He or she and the other certifying officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
ceo cfo certifications under section 906 of the act
CEO/CFO Certifications Under Section 906 of the Act
  • Requires the CEO/CFO of public companies to submit a statement with certain filings certifying that the filing “fully complies” with the Exchange Act reporting requirements and “fairly presents” in all materials respects the company’s financial condition and results of operations.
  • Applies to each Form 10-K and Form 10-Q filed by a company subject to Section 13(a) or 15(d) of the Exchange Act, as well as to Forms 20-F filed by foreign issuers or any 11-K filed by an employee benefit plan.
  • Section 906 certifications are not required to be included with8-K and 6-K or with proxy statements.
certification disclosure controls procedures
Certification/Disclosure Controls & Procedures
  • You already have procedures
  • Create disclosure committee
  • Review and document Your disclosure controls and procedures
  • Flow down certification
procedural steps
Procedural Steps
  • Complete a documentation file
  • Involve GC to protect privilege
  • Discuss the disclosure committee’s findings with the principal officers
  • Meet with the outside auditors
  • Meet with the audit committee and the board
  • Complete final evaluation of disclosure controls and procedures
  • Sign-off on disclosure in the periodic report and execute principal officer certifications
relationship with outside auditors
Relationship with Outside Auditors

Intent of SOX and rules is clear:

  • Make sure auditors act independently and don't align themselves too closely with management
  • Audit committee plays a critical role in serving as the check and balance on a company's financial reporting system
retention of outside auditors etc
Retention of Outside Auditors, Etc.

Section 301 of SOX requires audit committees to:

  • Have independent members
  • Be “directly responsible,” in its capacity as a committee of the board, for the appointment, compensation and oversight of the work of the outside auditor
  • Put in place procedures for the submission of complaints and concerns about auditing and accounting matters
  • Have the authority to engage outside advisors and to compensate both the advisors and the outside auditor
  • Be appropriately funded by the issuer

Rules direct the national securities exchanges/associations to refuse listing of issuers whose audit committees don't comply with the requirements

Proposed rules – not yet adopted; comment period still open (Feb. 18)

retention and oversight of outside auditors
Retention and Oversight of Outside Auditors

The audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of any outside auditor engaged (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work or performing other audit, review or attest services for the issuer, and each such outside auditor must report directly to the audit committee

  • Includes power not to retain, or to terminate, the outside auditor
  • Includes authority to approve all engagement fees and terms
  • Not in conflict with any charter document or statutory (e.g., state or foreign) provisions, such as shareholder selection of the auditor
engagement of advisors and funding
Engagement of Advisors and Funding

Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties

  • Needed to perform its role effectively

Each issuer must provide appropriate funding for the audit committee

  • Don't want management to have discretion regarding funding
non audit services
Non-Audit Services

Prohibited Activities

  • Section 201 of SOX prohibited accountants who audit an issuer from contemporaneously providing 9 specific types of non-audit services, plus any other service that the Accounting Oversight Board determines is impermissible
  • Any other non-audit service can be provided only if pre-approved by the audit committee
non audit services1
Non-Audit Services

Audit Committee Pre-Approval

The audit committee must pre-approve all allowable services by the company's auditors

May establish policies and procedures for pre-approval provided they are:

  • Detailed as to the particular service
  • The audit committee is informed of each service
  • Not a delegation of responsibilities to management
  • Designed to safeguard the continued independence of the auditors

Appointment of Designated Representatives

Disclosure of Pre-Approval Procedures in proxy statement/annual report

Limited Exceptions—de minimus; unanticipated connection

Companies should put these in place now if they haven’t already

non audit services2
Non-Audit Services
  • Bookkeeping or other services related to the accounting records or financial statements
  • Financial information systems design and implementation
  • Appraisal or valuation services, fairness opinions or contribution-in-kind reports
  • Actuarial services
  • Internal audit outsourcing services
  • Management functions or human resources
  • Broker or dealer, investment adviser, or investment banking services
  • Legal services
  • Expert services unrelated to the audit
  • Any other service that the Accounting Oversight Board determines is impermissible
non audit services3
Non-Audit Services

Tax Services

  • Section 201 specifically states that an “accounting firm may engage in any non-audit service, including tax services, that is not described [above]...” after audit committee approval
  • The SEC’s proposed rule appeared to prohibit tax services
  • Significant discussion and comment about whether tax services should be allowed
  • Under the final rules, accountants will be able to continue to provide tax compliance, tax planning and tax advice to audit clients, subject to pre-approval requirements
  • However, the rules prohibit auditors from representing an audit client in tax court or other situations involving public advocacy
  • Close scrutiny by audit committees
disclosure of audit and non audit services
Disclosure of Audit and Non-Audit Services

Have to disclose in periodic reports all non-audit services approved by the audit committee

Also have to disclose in the proxy statement/annual report fees paid to the independent accountant during the past 2 fiscal years for:

  • Audit services
  • Audit-related services
  • Tax services
  • Other services

Disclosure of the audit committee's pre-approval policies and procedures and the percent of fees paid pursuant to the de minimus exception by category

audit partner rotation
Audit Partner Rotation

Lead partner and concurring/reviewing partner must rotate after 5 years and be subject to a 5-year "time out" period after rotation

Certain other significant “audit partners” will have a 7-year rotation period with a 2-year time out period

“Audit partner”:

  • A partner who is a member of the engagement team who has responsibility for decision-making on significant auditing, accounting and reporting matters that affect the financial statements or who maintains regular contact with management and the audit committee.
  • Includes the lead partner on audits of 20% subsidiaries
  • Does not include technical or industry-specific partners
limits on compensation
Limits on Compensation

Accountant is not independent if, at any time during the audit and professional engagement period, any audit partner earns or receives compensation based on that partner procuring engagements with the client to provide any services other than audit, review or attest services.

cooling off period
Cooling Off Period

Section 206 of SOX set a 1-year cooling off period before a member of the audit engagement team can accept employment in certain, designated positions with a company.

Under the rules, if a member of management involved in overseeing financial reporting matters for an issuer was the lead partner, concurring partner or any other member of the audit engagement team who provided more than 10 hours of audit review or attest services (with certain exceptions) within 1 year preceding the commencement of the audit of the current year’s financial statements, then the accounting firm is not independent.

  • Calculation of time period – could effectively be 23-month period
communication with audit committee
Communication with Audit Committee

Accounting firm has to report, prior to the filing of its audit report with the SEC, to the audit committee:

  • All critical accounting policies and practices used by the issuer
  • All material alternative accounting treatments of financial information within GAAP that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm
  • Other material written communications between the accounting firm and management
improper influence of auditors
Improper Influence of Auditors

Section 303 of SOX prohibits “any officer or director of an issuer, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading.”

  • Proposed rules – not final
  • Rule mirrors Section 303 but instead of "for the purpose of...” uses the words “knew or was unreasonable in not knowing that such action could, if successful, result in rendering financial statements materially misleading”
  • No Scienter/Intent Test?
  • Persons acting "at the behest or on behalf of” officers or directors v. “under the direction”
  • Specific examples of improper action or influence
additional practical considerations what you should be doing
Additional Practical Considerations — What You Should Be Doing
  • Effective dates
  • Review and amend (as necessary) audit committee charters
  • Resolving disputes with auditors
  • What if there is an accounting mistake?
the regulatory landscape
The Regulatory Landscape


  • Corporate governance provisions primarily impact audit committees

New York Stock Exchange and NASDAQ Proposed Listing Standards

  • Boards of directors
  • Audit committees and auditor independence
  • Nominating/corporate governance committees
  • Compensation committees
the board of directors
The Board of Directors


  • Majority of “independent” directors
    • “No material relationship” with company
    • Five year “cooling-off” period for employees of company and outside auditor (includes immediate family members)
  • Board must determine independence of each director
    • Board may adopt categorical independence standards


  • Objective independence standards
    • Look back three years
    • Greater of 5% or $200,000 for business relationships
board committees nyse
Board Committees — NYSE

Structure and responsibilities

  • Audit, compensation, nominating/corporate governance committees required
  • Composed entirely of independent directors

Charters — Key committees must have charters that:

  • Address purpose and responsibilities enumerated by NYSE
  • Provide for annual performance evaluation

Outside advisors

  • Audit committee must have authority to retain advisors without Board approval
  • Compensation, nominating/corporate governance committees should have sole authority to retain advisors
board committees nasdaq
Board Committees — NASDAQ

Structure and responsibilities

  • Audit committee required
  • Compensation and nominating/corporate governance committees not required, but
    • Director nominations and compensation of Section 16 officers must be approved by:
      • An independent committee or
        • “Independent” committee may have 1 non-independent director
      • A majority of the independent directors


  • Audit committee must have charter that addresses responsibilities mandated by SOX
the audit committee
The Audit Committee

Qualifications mandated by SOX:

  • Members may not:
    • Receive fees other than for serving as a director
      • Direct and indirect payments
      • Also prohibited under NYSE proposals
    • Be an “affiliated person” of company or its subsidiaries
  • Audit committee financial expert
    • Disclosure
    • Definition
    • Safe harbor
the audit committee1
The Audit Committee

Responsibilities mandated by SOX:

  • Relationship with outside auditor
    • SOX — “Directly responsible” for appointment, compensation and oversight
    • NYSE — Sole authority to hire and fire, including to approve all audit engagement fees and terms
  • Pre-approve all audit and permissible non-audit services
  • Authority to engage and compensate outside advisors
  • Establish procedures for receiving complaints about auditing and accounting matters
the audit committee2
The Audit Committee

NYSE proposals require that charter address specific responsibilities, including:

  • Discussing financial statements with management and outside auditor, including MD&A
  • Discussing company policies on earnings releases, financial information and earnings guidance provided to analysts and rating agencies
  • Holding periodic private sessions with management, internal auditors and outside auditor
  • Discussing policies on risk assessment and risk management
  • Setting hiring policies for former employees of outside auditor

NASDAQ: Charter must cover items mandated by SOX

the nominating corporate governance committee
The Nominating/Corporate Governance Committee

NYSE proposals require that charter address:

  • Committee’s purpose, which must be to:
    • Identify individuals qualified to become Board members, and select (or recommend that Board select) director nominees
    • Develop and recommend corporate governance principles to Board
  • Committee’s responsibilities, which must reflect:
    • Board criteria for selecting new directors
    • Oversight of Board and management evaluations
the nominating corporate governance committee1
The Nominating/Corporate Governance Committee

Optional responsibilities that many companies are including in their charters:

  • Make recommendations to the Board regarding the structure, composition and functioning of the Board and its committees
  • Review and recommend retirement and other tenure policies for directors
  • Review other public company directorships held by or offered to directors and senior officers
  • Review and assess the channels through which the Board receives information and the quality and timeliness of information received
  • Review and recommend changes to director compensation
    • May be done in whole or in part by compensation committee at some companies
the compensation committee
The Compensation Committee

NYSE proposals require that charter address:

  • Committee’s purpose, which must be to:
    • Discharge Board responsibilities relating to compensation of executives
    • Produce annual report on executive compensation for inclusion in proxy statement
  • Committee’s responsibilities, which must be to:
    • Review and approve corporate goals and objectives relevant to CEO compensation, evaluate CEO performance in light of objectives, and set CEO compensation based on evaluation
    • Make recommendations to Board about incentive-compensation and equity-based plans
the compensation committee1
The Compensation Committee

Optional responsibilities that many companies are including in their charters:

  • Oversee the company’s overall compensation structure, policies and programs and assess whether that structure establishes appropriate incentives for management and employees
  • Monitor compliance by officers and directors with the company’s stock ownership guidelines
  • Review and recommend employment agreements and severance arrangements for executives
  • Review succession plans relating to the CEO and other senior officers
    • May be done in whole or in part by nominating/corporate governance committee at some companies
codes of ethics
Codes of Ethics

Codes of ethics for senior financial officers (SOX)

  • Also covers principal executive officers under SEC rules
  • Definition
  • Disclosure
    • Whether company has code
    • Alternatives
      • File a copy of code with 10-K
      • Post on website
      • Provide copies on request
    • Changes or waivers on 8-K or website
  • Effective Dates
    • July 15, 2003
    • December 15, 2003 (smaller issues)

NYSE-listed companies must adopt and post on their websites code(s) of business conduct and ethics for:

  • Employees
  • Officers
  • Directors
codes of ethics continued
Codes of Ethics, Continued

Under the NYSE proposals, a company’s code of conduct must:

  • require that any waivers of the code for directors or executive officers be made only by the board or a board committee and that these waivers be promptly disclosed to stockholders; and
  • contain compliance standards and procedures that provide for prompt and consistent action against violations

At a minimum, the code of conduct should address:

  • conflicts of interest
  • corporate opportunities
  • confidentiality
  • fair dealing
  • protection and proper use of company assets
  • compliance with laws, rules and regulations, including laws on insider trading
  • encouraging the reporting illegal or unethical behavior
new standards of professional conduct for attorneys
New Standards of Professional Conduct For Attorneys
  • Adopted January 23, 2003
  • Rules implement Section 307 of the SOX
  • Effective 180 days after publication in the Federal Register (late July or early August)
  • Additional 60-day comment period for proposed “noisy withdrawal” requirements
what will the rules require attorneys to do
What Will The Rules Require Attorneys To Do?
  • An attorney must report evidence of a material violation by an issuer or its agent “up the ladder” to the issuer's chief legal counsel or the chief legal officer and the CEO (or to the Qualified Legal Compliance Committee, if the issuer has created one).
  • If the chief counsel or CEO does not “respond appropriately” to the evidence, the attorney must report the evidence to the audit committee, another independent committee or the full board of directors.
what is a qualified legal compliance committee
What Is A Qualified Legal Compliance Committee?
  • Consists of at least one member of the issuer's audit committee and two or more additional, independent directors
  • May be created by the issuer as an alternative procedure for reporting evidence of material violations
  • Responsible for receiving and reviewing evidence of material violations, and recommending appropriate issuer responses
what will the rules permit attorneys to do
What Will The Rules Permit Attorneys To Do?

An attorney may, without the consent of the issuer-client, reveal confidential information related to the representation to the extent that the attorney reasonably believes necessary:

  • To prevent the issuer from committing a material violation likely to cause substantial injury to the financial interests or property of the issuer or investors;
  • To prevent the issuer from committing an illegal act; or
  • To rectify the consequences of a material violation or illegal act in which the attorney's services have been used.
  • Note possible conflict with state law obligations.
to whom will the rules apply
To Whom Will The Rules Apply?
  • The rules will apply to attorneys “appearing and practicing” before the SEC in the representation of issuers, but the proposed definition of “appearing and practicing” has been narrowed significantly.
  •  Under the final rules, a covered attorney is one who provides legal services to an issuer and has an attorney-client relationship with that issuer. This includes the issuer's in-house attorneys and its outside counsel.
  •  If the representation involves preparing or reviewing documents to be filed with or submitted to the SEC, the attorney must have notice that such documents will be filed with or submitted to the SEC.
what evidence will trigger an attorney s reporting obligations
What Evidence Will Trigger An Attorney’s Reporting Obligations?
  • The rules contain an objective standard.
  • An attorney’s reporting obligation will be triggered only if he or she has “credible evidence” based upon which it would be unreasonable for a prudent and competent attorney not to conclude that it is “reasonably likely” that a material violation has occurred, is occurring or is about to occur.
what happened to the proposed noisy withdrawal requirements
What Happened To The Proposed “Noisy Withdrawal” Requirements?

The proposed rules would have required an attorney to withdraw and report his or her withdrawal to the SEC if the board failed to respond appropriately to evidence of a material violation.

  • The SEC received numerous comments from attorneys, issuers and others concerned about the impact these provisions could have on the attorney-client relationship.
  • In response to comments, the SEC has revised the noisy withdrawal provisions and will extend the comment period for an additional 60 days.
  • The revised proposal still would require attorney withdrawal, but would require the issuer (rather than the attorney) to disclose publicly the attorney's withdrawal.