A Summary of SOX Washington DC

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The SOX statute is more or less an outline, with full details coming in the form of SEC rules for implementation as well as pronouncements from the newly created PCAOB. Most of SOX’s provisions currently apply to public companies that file Form 10-K with the SEC; however, more and more companies are opting for voluntary compliance to insulate themselves from future litigation risks and unforeseen management liabilities. This section gives you a broad view of what the new law contains and what it requires of today’s companies in the United States.

Title I: Aiming at the audit profession
SOX establishes a five-member Public Company Accounting Oversight Board (PCAOB) that tells auditors what they’re supposed to be evaluating and sets rules about the relationships and ties auditors can have with the companies they audit. The SEC oversees the PCAOB, which is funded through fees collected from issuers. The PCAOB (affectionately nicknamed “Peek-a-boo” by many auditors, attorneys, and other professionals) has the following responsibilities:

To oversee the audit of public companies: The accounting profession used to regulate itself through a voluntary organization known as the Association of Independent Certified Public Accountants (AICPA), but Enron proved that the old system didn’t work very well.

To establish audit report standards and rules: Auditors wait avidly for the issue of these standards and rules to clear up confusion and aid them in performing their day-to-day duties after SOX.

To register audit firms: The PCAOB is in charge of registering, inspecting, investigating, and enforcing compliance of public accounting firms as well as CPAs and other people in the profession. Any public accounting firm that participates in any audit for a company covered by SOX is required to register with the PCAOB. Title I of SOX also empowers the PCAOB to impose disciplinary or remedial sanctions on audit firms. Title I of SOX provides for change in several major areas:

Work paper retention: Title I contains some new administrative requirements for auditors, including a rule that audit firms retain all their work papers for seven years.

Two-partner requirement: Two partners now have to sign off on every audit.

Evaluation of internal control: Auditors must evaluate whether the companies they audit have internal control structures and procedures that ensure that their financial records accurately reflect transactions and disposition of assets. Auditors must also assess whether the companies appropriately authorize receipts and expenditures and verify that transactions are made only with authorization of senior management. If companies don’t have adequate internal controls in place, the auditors must describe any material weaknesses in the internal control structures and document instances of material noncompliance.

Inspections of audit firms: Auditors must submit to continuing inspections by the PCAOB. Firms that provide audit reports for more than 100 public companies get inspected once a year. Firms that audit fewer than 100 companies get reviewed every three years.

Title II: Ensuring auditor independence
Title II of SOX focuses on conflicts of interests arising from close relationships between audit firms and the companies they audit; namely, it prohibits auditors from performing certain nonaudit services to clients they audit. However, SOX allows audit committees (internal committees charged with overseeing the audit process within publicly traded companies) to approve some nonaudit services that aren’t expressly forbidden by Title II of SOX (see Chapter 8 for more on audit committees and nonaudit services). Title II also requires auditors to report to the audit committee on accounting policies used in the audit and document communications with management. To further protect against conflicts of interest, audit partners must be rotated to prevent individuals from getting too close to the companies they audit. Specifically, a partner is prevented from being the lead or reviewing auditor for more than five consecutive years. An auditor faces a one-year prohibition if the company’s senior executives were employed by that audit firm during the one-year period preceding the audit initiation date.

Title III: Requiring corporate accountability
Title III of SOX focuses on the company’s responsibility to ensure that the financial statements it distributes to the public are correct. Its two main provisions include:

Establishment of audit committees: SOX requires each company subject to SOX to form a special audit committee. Each member of the audit committee must be a member of the board of directors but otherwise independent in the sense that he or she receives no other salary or fees from the company.

Management certification: Title III requires CEOs and CFOs to certify:

That periodic financial reports filed with the SEC don’t contain untrue statements or material omissions

That financial statements fairly present, in all material respects, the financial conditions and results of operations

That the company’s CEOs and CFOs are responsible for internal controls, and that the internal controls are designed to ensure that management receives material information regarding the company and any consolidated subsidiaries

That internal controls have been reviewed within 90 days prior to the report

Whether any significant changes have been made to the internal controls Title III also makes it unlawful for corporate personnel to exert improper influence on an audit for the purpose of rendering financial statements materially misleading. For example, Title III does the following:

It requires a company’s CEO and CFO to forfeit certain bonuses and compensation received if the company has to issue corrected financial statements (called restatements) due to noncompliance with SEC rules.

It bans directors and executive officers from trading their public company’s stock during pension fund blackout periods.

It obligates attorneys appearing before the SEC to report violations of securities laws and breaches of fiduciary duty by a public company.

For the benefit of victims of securities violations, it creates a special disgorgement fund that’s funded by the fines companies have to pay to the SEC.

Title IV: Establishing financial disclosures, loans, and ethics codes
Title IV contains several key SOX provisions, including the following:

Disclosure of adjustments and off–balance sheet transactions: Financial reports filed with the SEC must reflect all material corrections to the financial statements made in the course of an audit. This title also requires disclosure of all material off–balance sheet transactions and relationships that may have a material effect on the financial status of an issue.

Prohibition of personal loans extended by a corporation to its executives: Such loans are prohibited if they’re subject to the insider lending restrictions of the Federal Reserve Act.

Disclosure of changes to inside stock ownership: Senior management, directors, and principal stockholders have to disclose changes in their ownership of corporate stock within two business days of making the transaction.

Internal control certification: The now-famous Section 404 provides
that annual reports filed with the SEC must include an internal control report stating that management is responsible for the internal control structure and procedures for financial reporting. The report should also state that management assesses the effectiveness of the internal controls for the previous fiscal year.

Code of ethics: Companies subject to SOX must disclose whether they have adopted a code of ethics for their senior financial officers and whether their audit committees have at least one member who’s a financial expert.

Regular SEC review: Article IV requires regular SEC reviews of the disclosure documents that companies file each year with the SEC.

Title V: Protecting analyst integrity
SOX Title V is aimed at preventing several types of conflicts of interest. Among other things, it does the following:

Restricts the ability of investment bankers to preapprove research reports

Ensures that research analysts aren’t supervised by persons involved in investment banking activities

Prohibits employer retaliation against analysts who write negative reports

Requires specific conflict of interest disclosures by research analysts who make information available to the public

Title VI: Doling out more money and authority
Title VI authorizes the SEC to spend at least $98 million to hire at least 200 qualified professionals to oversee auditors and audit firms. It also gives the SEC the authority to

Censure persons appearing or practicing before it for unethical or improper professional conduct.

Consider orders of state securities commissions when deciding whether to limit the activities, functions, or operations of brokers or dealers. Title VI also directs federal courts to prohibit persons from participating in small (penny) stock offerings if the SEC initiates proceedings against them.

Title VII: Supporting studies and reports
Title VII of SOX funds and authorizes a number of reports and studies that do the following:

Look at factors leading to the consolidation of public accounting firms and its impact on capital formation and securities markets

Address the role of credit-rating agencies in the securities markets

Examine whether investment banks and financial advisors assisted public companies in earnings manipulation and obfuscation of financial conditions

Title VIII: Addressing criminal fraud and whistle-blower provisions
Here are the main points of SOX’s Title VIII:

It imposes criminal penalties (maximum 10 years in prison) for knowingly destroying, altering, concealing, or falsifying records with intent to obstruct or influence a federal investigation or bankruptcy matter.

It imposes sanctions on auditors who fail to maintain for a five-year period all audit or review work papers pertaining to securities issuers.

It makes certain debts incurred in violation of securities fraud laws nondischargeable in bankruptcy.

It extends the statute of limitations for private individuals to sue for securities fraud violations. Individuals can sue no later than two years after the violation is discovered or five years after the date of the violation.

It provides whistle-blower protection by prohibiting a publicly traded company from retaliating against an employee who assists in a fraud investigation; executives who target whistle-blowers are subject to fines or imprisonment of up to 25 years.

Title IX: Setting penalties for white-collar crime
Title IX increases penalties for mail and wire fraud from 5 to 20 years in prison and penalties for violations of the Employee Retirement Income Security Act of 1974 to up to $500,000 and 10 years in prison. In particular, Title IX establishes criminal liability for corporate officers who fail to certify financial reports, including maximum imprisonment of 10 years for knowing that the periodic report doesn’t comply with SOX and 20 years imprisonment for willfully certifying a statement known to be noncompliant.

Title X: Signing corporate tax returns
Title X of SOX expresses that a corporation’s federal income tax return “should” be signed by its chief executive officer.

Title XI: Enforcing payment freezes, blacklists, and prison terms
Title XI adds to the criminal penalties aimed at fraud that are established by SOX’s other sections. Here are some of the main parts of this title:

This section amends federal criminal law to establish a maximum 20- year prison term for tampering with a record or otherwise impeding an official proceeding.

It authorizes the SEC to seek a temporary injunction to freeze “extraordinary payments” to corporate management or employees under investigation for possible violations of securities law. Currently, there’s no specific definition as to what constitutes an “extraordinary payment.”

It prohibits persons who violate state or federal laws governing manipulative, deceptive devices and fraudulent interstate transactions from serving as officers or directors of publicly traded corporations.

Title XI increases penalties for violations of the Securities Exchange Act of 1934 to up to $25 million dollars and up to 20 years in prison.

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