In 2002 there were many legislative and rule-making proposals in response to Enron, Global Crossing, Tyco, WorldCom, and other large business failures. In July Congress enacted the Sarbanes-Oxley Act of 2002, and since then the Securities and Exchange Commission (“SEC”) has proposed or adopted a number of implementing regulations. In addition, the New York Stock Exchange and NASDAQ have proposed, in coordination with the SEC, several major corporate governance initiatives. This memorandum briefly outlines those new and proposed rules which impact the general counsel, corporate secretary, and managers of all U.S. public companies, as well as many private companies which have pension, 401(k), and stock option plans for their employees. It is not intended to be in-depth; it just highlights the areas of activity.


Glossary:
“SEC” means Securities and Exchange Commission.
“MD&A” means the management’s discussion and analysis section of a listed company’s annual report.
“NASD” means National Association of Securities Dealers.
“NYSE” means New York Stock Exchange.
“CEO” means chief executive officer.
“CAO” means chief accounting officer.
“CFO” means chief financial officer.
“CLO” means chief legal officer.
“Public company” means a company having a class of equity securities registered under the Securities Exchange Act of 1934, as amended.


Sarbanes-Oxley Act of 2002


P.L. 107-204 (H.R. 3763); enacted July 30, 2002

Sarbanes-Oxley represents the most significant revision of the federal securities laws in decades. The law has 26 primary operative provisions covering a wide range of subjects. The purpose of the following list is simply to identify the primary operative provisions of Sarbanes-Oxley; virtually every one of the following items would warrant an entire article to do it justice.

1. Establishes an oversight Board (the Public Company Accounting Oversight Board) for auditors and auditing of public companies [Title I of the Act]
   a. Broad powers over audit firms, similar to the NASD’s powers over brokers
   b. SEC has oversight over the Board
   
   
2. Establishes auditor independence standards [Title II]
   a. limits non-audit services provided to audit clients
   b. requires public auditors to have partner rotation
   c. requires auditor to report to client’s audit committee
   d. disqualifies an auditor if an auditor employee goes in-house to certain high-level positions (CAO, CFO, etc.) unless that person did not participate in the audit of that client for at least the past year
   
   
3. Requires public companies to have audit committees [Sec. 301]
   a. all committee members must be “independent”
   i. no consulting or other fees
   ii. no former employees
   b. committees must have their own budgets, be able to hire their own expert advisors, and establish procedures to receive and assess complaints
   
   
4. Requires the CEO and CFO to certify with respect to:
   a. accuracy and completeness of the public company’s financial reports
   b. the company’s maintenance of internal controls
   c. their personal involvement in connection with establishing and overseeing internal controls and related matters
   Also requires public companies to provide internal control assessment reports. Provides criminal penalties for knowing or willful false or incomplete certifications. [Secs. 302, 404, and 906]
   
   
5. Prohibits the improper influence of an auditor or the conduct of an audit of a public company’s financial statements [Sec. 303]
   
   
6. Causes a forfeiture of CEO and CFO 12 months of bonuses and stock profits if a public company restates its financial statements due to material noncompliance as a result of misconduct [Sec. 304]
   
   
7. Causes a forfeiture of stock trading profits if a director or executive officer of a public company transfers company stock during a pension (401(k)) fund blackout period [Sec. 306]
   a. Blackout period is any period of more than 3 consecutive days during which participants in a pension (401(k)) plan cannot transfer interest in their accounts
   b. Does not apply to traditional pension plans (defined benefit plans); applies only to account-type defined contribution plans which have a company stock fund, which most commonly are 401(k) plans
   
   
8. Regulates professional responsibility for attorneys representing public companies in connection with the SEC [Sec. 307]
   a. In-house and outside attorneys must now report evidence of a material violation of securities laws or breach of fiduciary duties up the ladder:
   i. first to the CLO or CEO
   ii. then (if no appropriate response) to the audit committee or the full board
   iii. if ultimately no appropriate response, the Act contemplates that outside attorneys must undertake a noisy withdrawal, which effectively would publicly disclose the problem; however, after much criticism, SEC has postponed adopting a noisy withdrawal rule (comment period ends in April, 2003)
   iv. in-house counsel is not required to withdraw (i.e., resign)
   b. if the public company has a qualified legal compliance committee consisting of independent non-employee directors, then the matter could be reported to that committee, which would be responsible to deal with the matter from that point forward
   c. these rules generally apply to subsidiaries of public companies as well as their parent companies, and may apply to non-subsidiary affiliated companies (i.e., joint ventures and the like)
   d. many details are not clear, especially regarding who the rule applies to and under what circumstances; see also #17 below
   e. the federal reserve and other banking industry regulators are expected eventually to adopt similar rules which would apply to attorneys representing banks and thrifts, whether or not they are public companies; the banking rules may be stricter than those adopted by the SEC, especially with respect to noisy withdrawals
   
   
9. Requires enhanced financial statement disclosures [Sec. 401], especially:
   a. off-balance sheet transactions
   b. special-purpose entities
   c. pro-forma data
   
   
10. Prohibits public companies from extending credit for “personal” loans to directors and executive officers, and from arranging such credit [Sec. 402]
    a. Many open issues; what is a personal loan?
    b. This is a criminal provision
    c. Pre-existing debt is grandfathered; there are some exceptions for banks and brokerages
    d. This provision has effectively ended split-dollar life insurance programs, where companies appeared to “loan” premiums to participating officers; efforts to create an exception for such programs have not yet succeeded
    
    
11. Requires stock holding and transaction reports by directors and executive officers and 10% stockholders to be filed 2 business days after the trade [Sec. 403]
    a. The new rule requires reports to be filed much faster than old rule
    b. Many old exemptions and deferrals have been rescinded
    c. Electronic filings of reports have become much more common, and will be required in the near future; filings in that form can be accessed by anyone over the internet (www.sec.gov)
    d. The new rule essentially forces companies to take over the reporting process
    
    
12. Requires public companies to disclose whether or not they have a Code of Ethics for senior financial officers [Sec. 406]
    a. Any waivers from the Code must be disclosed
    b. Any amendments to the Code must be disclosed.
    
    
13. Requires disclosure whether or not at least one audit committee member is a “financial expert” in addition to being “independent” [Sec. 407]
    
    
14. Requires SEC to review all public companies regularly (at least every 3 years) [Sec. 408]
    a. there is no regular review cycle at present
    b. SEC probably can not staff this function at present; however, the SEC’s budget is being increased [Sec. 601] specifically to hire more people
    
    
15. Requires public companies to file many material event disclosures immediately (SEC rules to follow) [Sec. 409]
    
    
16. Deals extensively with analyst conflicts of interest [Title V]
    a. Requires certain prohibitions and disclosures affecting how analysts (and their firms) interact with those public companies upon which they report
    b. Could become extremely detailed and intrusive into the relationships of individual analysts with their firms, and the relationships of the firms with public companies
    c. For example, if a firm fires an analyst, he/she could claim it was retaliatory for writing a non-glowing report about the firm’s public company client
    
    
17. Authorizes SEC to discipline persons who practice before the Commission [Sec. 602] and to bar persons from serving as officers or directors of public companies [Sec. 1105]
    a. “Practice before the Commission” means advising public companies regarding their public disclosures or securities compliance.
    b. Concept also is relevant to #8 above
    
    
18. Authorizes federal courts to bar penny stock offerings, based on actual or alleged misconduct [Sec. 603]
    
    
19. Attempts to integrate the SEC with the state (blue sky) discipline system for brokers and investment advisers [Sec. 604]
    
    
20. Requires the SEC to conduct various studies [Title VII]
    
    
21. Imposes new/harsher penalties for altering or destroying documents with the intent to impede an investigation [Sec. 802]
    
    
22. Renders securities fraud debts nondischargeable in bankruptcy [Sec. 803]
    a. Includes federal fraud and common law debts in connection with securities
    b. Includes securities fraud judgments from state court proceedings
    c. Includes securities fraud settlements
    
    
23. Increases the limitation period for federal securities fraud actions [Sec. 804]
    a. 2 years after discovery, but not more that 5 years after violation
    b. old rule was 1 and 3
24. Creates whistle blower protections for all employees of public companies [Secs. 806 and 1107]
    a. Gives employees another weapon to retaliate against employer if fired
    b. Retaliation could give rise to criminal penalties
    
    
25. Enhances criminal penalties for defrauding public company shareholders [Titles IX and XI]
    
    
26. Enhances various other white-collar criminal penalties [Titles IX and XI] (including substantial enhancements under ERISA [Sec. 904])

The Federal Reserve Board has stated that the federal banking regulators are examining whether provisions similar to Sarbanes-Oxley should be adopted as part of the corporate governance rules applicable to banks, thrifts, and other regulated financial institutions, whether or not they are public companies under the SEC’s jurisdiction. The banking rules may be more intrusive than the SEC’s rules. That is particularly a concern as regards the rules (under Sarbanes Sec. 307) requiring attorneys to report evidence of material violations up the ladder, and (perhaps) to make a noisy withdrawal if the client does not respond appropriately.


Director Independence and Other Corporate Governance Matters

The NYSE has proposed rules that would require at least a majority of most listed company boards to be “independent.” The NYSE’s proposed rules would require an affected Board to make determinations as to whether a majority of board members are independent, and to disclose the bases for those determinations in the listed company’s proxy statement. The standard for determining whether a director is independent is whether the director “has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the Company).” The board may fulfill the proxy disclosure requirements by adopting categorical independence standards, disclosing those standards in the proxy, and making a general statement regarding the independent directors meeting that standard. If any independent director does not meet that standards, the board must make specific disclosures regarding why that director is nevertheless determined to be independent.

The NYSE’s proposed rules prohibit findings of independence for any director who: (1) is affiliated with or employed by one of the company’s auditors, (2) is an employee of another listed company on whose compensation committee one of the executive officers of the listed company in question serves, and (3) is an employee or executive officer of another company that accounts for at least 2% or $1 million of the listed company’s consolidated gross revenues or vice versa. These prohibitions continue for 5 years after the relationship ends, and also apply if the relationship is between the listed company and one of the director’s immediate family members (i.e. spouse, parents, children, siblings, in-laws and anyone who shares the director’s home). The proposed rules also presume non-independence for any director who has received (or whose immediate family member has received) more than $100,000 per year in direct compensation from the listed company (other than director and committee fees and pension or other forms of deferred compensation). Like the prohibitions, the presumption lasts for 5 years.

As currently drafted, the proposed rules would give affected listed companies eighteen months to comply, or up to 30 months for certain companies with classified boards.

The NYSE has also proposed that all members of each of a listed company’s board’s audit committee, compensation committee, and nominating committee must be independent. For the audit committee, the requirement is already codified by Sarbanes-Oxley (see #13 above). The other requirements are new.

The NYSE has also eliminated the treasury stock exception to its shareholder approval rule. Previously, a listed company was not required to submit certain equity compensation plans involving only treasury stock to its shareholders for approval.

While the NYSE has been the most active of the exchanges in adopting these reforms, it is expected that NASDAQ will adopt similar reforms.


Stock Options

Last year Senator Carl Levin and others proposed to prevent a company from deducting stock option compensation unless the company also recognized an expense for the options on its financial statements. Sarbanes-Oxley did not incorporate that proposal.

Over the last several years there has been much written in accounting circles about whether expensing of stock options ought to be mandatory. At present, expensing remains voluntary for most companies. However, opposition seems to be slowly fading. Several major companies (such as General Electric) now expense their options, and several major accounting firms have relaxed or withdrawn their opposition (at this writing, the most recent to do so was Ernst & Young LLP). Many practitioners privately believe that mandatory expensing in some form is inevitable, although when that might occur, and what form it would take, is anyone’s guess. A major problem remains valuation and the related issue of timing. If the expense is recognized at grant, every conceivable valuation method either is arbitrary or subject to manipulation, or possibly both. If the expense is recognized continually while the option is outstanding, the size of the expense would be unpredictable and could become extremely large; in other words, under that scheme a company with substantial outstanding options would have an incentive to hold its own stock price in check.

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