Corporate America in Crisis:Sarbanes-Oxley Act of 2002

www.morganlewis.comPresented by:

Linda L. GriggsPaul Huey-BurnsWashington Office

Frank G. Zarb, Jr.Northern Virginia Office

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Sarbanes-Oxley Act of 2002

Provisions effective upon signing by President Bush on July 30, 2002– Section 906 certification by CEO and CFO in periodic reports containing

financial statements

– New liability provisions, among others:• Extension of statute of limitations (§ 804)• Prohibition on extending, arranging or renewing personal loans, directly or indirectly, to directors

and executive officers (§ 402)• Employee whistleblower protections (§ 806)• Disgorgement of profits and bonus following restatement (§ 304)

Provisions effective on August 29, 2002– Two-business day deadline for filing reports on Form 4 (§ 403)

• SEC rules adopted effective August 29, 2002 (34-46421)

– Section 302 certification by CEO and CFO in annual and quarterly reports

• SEC rules adopted effective August 29, 2002 (33-8124)

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SOA (continued)

Provisions effective by January 26, 2003– Disclosure regarding audit committee financial expert (§ 407)

• SEC proposal dated October 22, 2002 (33-8138)

– Disclosure regarding the existence of a code of ethics for senior financial officers and any waiver of such a code (§ 406)

• SEC proposal dated October 22, 2002 (33-8138)

– Disclosure relating to off-balance sheet obligations (§ 401)• SEC proposal dated October 30, 2002

– Clarification of pension plan trading black-out (§ 306) • SEC proposal dated October 30, 2002

– Disclosure of non-GAAP financial measures (§ 306) • SEC proposal dated November 4, 2002

– Retention of records relating to audits and reviews (§ 802)• SEC proposal dated November 21, 2002

– Standards of professional conduct by attorneys (§ 307)• SEC proposal dated November 21, 2002

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SOA (continued)

Provisions effective by January 26, 2003 (continued)– Prohibited non-audit services (§ 201)

• SEC proposal dated December 2, 2002 (33-8154)

– Audit committee pre-approval of audit and nonaudit services and disclosure of approval on nonaudit services (§ 202)

• SEC proposal dated December 2, 2002 (33-8154)

– Rotation of engagement team partners (§ 203)• SEC proposal dated December 2, 2002 (33-8154)

– Provision by registered outside auditors of report on critical accounting policies and practices, alternative treatment of financial information within GAAP and other matters (§ 204)

• SEC proposal dated December 2, 2002 (33-8154)

– One-year cooling off period when former engagement team members become management (§ 206)

• SEC proposal dated December 2, 2002 (33-8154)

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SOA (continued)

Provisions effective by April 26, 2003 – SEC rule to implement Section 301 must require the delisting of companies

whose audit committee:• Is not independent as defined, that is, receives no compensation other than fees for serving as a

director and member of the audit committee and other committees and is not an affiliated person;• Does not have the sole authority to hire and dismiss the outside auditors;• Does not have the sole authority to determine and pay the outside auditors;• Does not have the authority to oversee the work of the outside auditors, who must report directly to

the audit committee;• Does not have the authority to resolve any disagreements between management and the outside

auditors; and • Does not have procedures for the receipt, retention and treatment of complaints regarding

accounting, internal accounting controls or auditing matters and for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters.

– Prohibition on improper influence on the audit process (§ 303)• SEC proposal dated October 18, 2002 (34-46685)

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SOA (continued)

Provisions effective by July 30, 2003– SEC rules to require electronic disclosure about stock beneficial ownership

of insiders (§ 403) Provisions with no required effective date

– Requirement for annual management report on internal controls (§ 404(a))• SEC proposal dated October 22, 2002 (33-8138)

– Requirement for attestation by outside auditors of management’s report on internal controls (§ 404(b))

• SEC proposal dated October 22, 2002 (33-8138)

– Attestation standards for reports of outside auditors on management report on internal controls

• Format of report in Section 103(a)(2)(A)(iii)

– Real-time disclosure (§ 409)

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Financial Expert

SEC has proposed rules requiring issuers to disclose whether or not a “financial expert” serves on the Audit Committee

Proposed rules require (among other things) experience in preparing or auditing financial statements of public company with similar accounting issues

SROs have said they may require listed companies to have a “financial expert” on the Audit Committee

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Codes of Conduct/Ethics

Sarbanes-Oxley directs SEC to require disclosure by public companies of:

– Whether they have adopted a “code of ethics” for senior financial officers

– Waiver or amendment of any provision of the code of ethics for senior financial officers

Proposed SEC rule would require companies to disclose:– whether they have a code of ethics that applies to CEO as well as senior

financial officers

– disclosure of waivers on 8-K or Internet

– requires that code of ethics be filed with annual report

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What is a “Code of Ethics”?

Sarbanes-Oxley defines “code of ethics” as standards to promote:– Honest and ethical conduct, including the handling of conflicts of interest

– Full, fair, accurate, timely and understandable disclosure in SEC reports

– Compliance with rules and regulations

Proposed SEC rule would:– define “code of ethics” to include also mechanisms for reporting and

dealing with violations and resolving conflicts of interest with an appropriate person and compliance with laws

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Stock Exchange Proposals

Applies to all employees, officers, directors

Adoption required

Waivers only by Board or Board Committee

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Off-Balance Sheet Arrangements

January 2002 interpretive release – Guidance on disclosure about liquidity and capital resources

• Financial guarantees or commitments, provisions in agreements that could accelerate maturity or create financial obligation, off-balance sheet arrangements

• Tabular presentation of contractual and commercial obligations

– Disclosure about information about the valuation of non-exchange traded contracts

– Related party transactions November 4, 2002 SEC release would implement SOA Section 401(a)

– Disclosure threshold – likelihood of occurrence is not remote

– Broader than January 2002 release

– Disclosure of business purpose, significant terms, and other details

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Non-GAAP or “Pro Forma” Financial Information

December 2001 Cautionary Advice on Pro Forma Data in Earnings Releases

SEC proposal implements SOA Section 401(b) relating to non-GAAP or “pro forma” financial information– Proposed new Regulation G and amendments to Item 10

– Would apply to public written or oral disclosures of material information containing a “non-GAAP” measure

Proposal would require disclosure of– Most directly comparable GAAP measure

– Reconciliation to GAAP

– In SEC filings, also disclose purpose of disclosure and whymanagement believes the non-GAAP measure is useful

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“Non-GAAP Financial Measures”

Defined as numerical measures that:

– Exclude amounts that are included in comparable GAAP measure

– Include amounts that are excluded in comparable GAAP measure

– Does not include statistical data like unit sales, number of employees, number of subscribers

– Does not include financial information that is consistent with GAAP measures

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Prohibitions

Cannot give non-GAAP measure greater prominence than comparable GAAP measure

Cannot exclude from a liquidity measure charges or liabilities that must be settled in cash

Cannot exclude “non-recurring” or “unusual” items that are likely to recur

Cannot present non-GAAP measure in financial statements

Cannot use titles or descriptions that cause confusion with GAAP measure

Cannot present non-GAAP per-share measure

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8-K Filing of Certain Press Releases

File with SEC all releases that disclose material non-public information about results or financial condition

Release not eligible for non-filed status

Oral announcement need not be filed on an 8-K under certain circumstances, including that the financial information is posted on the company’s website

Non-GAAP financial measures in the filed release may have to comply with Item 10

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Conduct by Attorneys

SEC proposal relating to conduct by attorneys would implement Section 307 of SOA

Would require an attorney appearing or practicing before the Commission to report to– the company’s chief legal officer or the chief legal officer and CEO or,

– if such person(s) do not provide a timely or appropriate response or, if reporting to such person(s) is futile, the company’s audit committee or some other committee or

– a qualified legal compliance committee of the board

– any reasonable belief that a material violation of the securities laws, a material breach of fiduciary duty or a similar material violation.

Definition of attorney is broad: licensed or holding out

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Attorneys’ Conduct (continued)

Except if the attorney has reported the material violation to the qualified legal compliance committee,– If an outside attorney does not receive an appropriate or timely response, the

attorney must make a “noisy withdrawal” and notify the SEC about the withdrawal for professional considerations and his/her disaffirming of particular disclosure.

– If an attorney employed by the company does not receive an appropriate or timely response, the attorney must notify the SEC that he/she is disaffirming particular disclosure but need not resign his/her employment.

A qualified legal compliance committee must, among other conditions, have the authority to direct the company to adopt appropriate remedial measures.– Reporting to the qualified legal compliance committee, if the company

has formed one, would avoid the need for a noisy withdrawal or notification to the SEC

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Accountants’ Independence

SEC proposal to implement 201 of SOA – Will eliminate certain exceptions from existing prohibited nonaudit services,

including limited exceptions for bookkeeping, valuations and internal audit outsourcing

– SEC proposal release confirms that M&A diligence is okay but raises questions relating to tax services

SEC proposal to implement Section 202 of SOA will require the audit committee to pre-approve all audit and nonaudit services and disclose in proxy or Form 10-K any pre-approval policies and procedures for nonaudit services

SEC proposal to implement Section 203 of SOA will require mandatory rotation every 5 years of partners involved in the audit

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Critical Accounting Policies

SEC proposal to implement Section 204 of SOA will require the outside auditors to provide to the audit committee oral or written information relating to critical accounting estimates, alternative accounting treatments and written communications with management

December 2001 Cautionary Advice on Critical Accounting Estimates– Estimates requiring the most difficult, subjective or complex judgments

– Explain likelihood that materially different amounts would be reported under different conditions or using different assumptions

– Loan loss reserves, valuations, warranties

May 2002 Proposal

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Improper Influence on Outside Auditors

Would implement Section 303 of SOA SEC proposal to prohibit action to “fraudulently influence, coerce,

manipulate, or mislead” any outside auditor in connection with an audit or review of financial statements

Rule could apply to employees and agents of the company, outside counsel, partners and employees of the outside auditors and customers, vendors and creditors of the company

Level of culpability may be less than “intent,” and possibly mere negligence

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Internal Controls

October 22, 2002 SEC proposal to implement Section 404 of SOA and require annual report of management on internal controls and procedures for financial reporting and attestation of such report

October 22, 2002 SEC proposal would also require quarterly evaluation of internal controls and procedures for financial reporting and disclosure about:

– Effectiveness of internal controls and procedures and

– Changes in internal controls during the covered period

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New Relationship Between Audit Committees & Outside Auditors

Section 301 of SOA requires the SEC to adopt rules to require the delisting of a company whose audit committee – is not independent as defined (no compensation and not affiliated) and– does not have the sole authority to hire, dismiss and pay the outside

auditors;– does not have the authority to oversee the work of the outside auditors,

who must report directly to the audit committee, including to resolve any disagreements between management and the outside auditors;

– does not have the authority to retain and pay advisors; and– does not have procedures for the receipt, retention and treatment of

complaints regarding accounting, internal accounting controls or auditing matters and for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters.