Corporate Governance - USA Sarbanes-Oxley Act “SOX”

Corporate Governance - USACorporate Governance - USA

Sarbanes-Oxley ActSarbanes-Oxley Act “SOX” “SOX”

Lecture 15&16Lecture 15&16ByByAbdur Rashid MirzaAbdur Rashid MirzaUniversity of LahoreUniversity of Lahore

Enduring UnderstandingEnduring Understanding

The Sarbanes-Oxley Act was enacted to The Sarbanes-Oxley Act was enacted to establish new or enhanced standards for establish new or enhanced standards for U.S. public company boards, Management, U.S. public company boards, Management, and public accounting firms.and public accounting firms.

Essential QuestionsEssential Questions

Why was the Sarbanes-Oxley Act Why was the Sarbanes-Oxley Act needed?needed?

How does the Sarbanes-Oxley Act How does the Sarbanes-Oxley Act protect stockholders and institutions?protect stockholders and institutions?

ObjectivesObjectives

Describe the events that caused the Describe the events that caused the passing of the Sarbanes-Oxley Act.passing of the Sarbanes-Oxley Act.

Relate the Sarbanes-Oxley Act to Relate the Sarbanes-Oxley Act to accounting.accounting.

Explain the goals of the Sarbanes-Oxley Explain the goals of the Sarbanes-Oxley Act.Act.

Describe each of the 11 titles of the Describe each of the 11 titles of the Sarbanes-Oxley Act.Sarbanes-Oxley Act.

What is SOX?What is SOX?

Also known as the Public Company Also known as the Public Company Accounting Reform and Investor Accounting Reform and Investor Protection Act of 2002Protection Act of 2002

Created by US Senator Paul Sarbanes (D-Created by US Senator Paul Sarbanes (D-Maryland) and US Congressman Michael Maryland) and US Congressman Michael Oxley (R-Ohio) Oxley (R-Ohio)

Signed into law July 30, 2002Signed into law July 30, 2002 Most dynamic securities legislation since Most dynamic securities legislation since

the Securities and Exchange Acts of the Securities and Exchange Acts of

1933 and 19341933 and 1934

Purpose of SOXPurpose of SOX

Establish new or enhanced Establish new or enhanced standards for U.S. public company standards for U.S. public company boards, management, and public boards, management, and public accounting firmsaccounting firms

Relation to AccountingRelation to Accounting

Bad accounting procedures, both Bad accounting procedures, both intentional and non-intentional, led to the intentional and non-intentional, led to the collapse and subsequent investigation of collapse and subsequent investigation of several large companiesseveral large companies

Public outrage led Congress to pass Public outrage led Congress to pass SOX to regulate audits of public company SOX to regulate audits of public company accounting procedures and hopefully accounting procedures and hopefully prevent false financial reportsprevent false financial reports

Relation to Accounting, Relation to Accounting, continued…continued…

Companies that do not follow standard Companies that do not follow standard accounting procedures may use methods accounting procedures may use methods that mislead investors about the financial that mislead investors about the financial health of the company. health of the company.

These practices range from just unethical These practices range from just unethical to illegal. to illegal.

Why was SOX passed?Why was SOX passed?

Failure of Boards of Directors and executives Failure of Boards of Directors and executives to double-check financial recordsto double-check financial records

Intentional misrepresentation of financial statusIntentional misrepresentation of financial status Loans from major banks to risky companies Loans from major banks to risky companies

hurt bank investors and encouraged others to hurt bank investors and encouraged others to make risky investments in those companiesmake risky investments in those companies

Misrepresentation of company earnings Misrepresentation of company earnings caused stockholders to make seemingly good caused stockholders to make seemingly good investments that cost them large sums of investments that cost them large sums of moneymoney

Why was SOX passed?, Why was SOX passed?, continued…continued…

Auditor conflicts of interestAuditor conflicts of interest Some auditing firms provided consulting Some auditing firms provided consulting

services to the companies they audited. services to the companies they audited. Proper auditing procedures, such as challenging Proper auditing procedures, such as challenging

a company’s accounting procedures, could a company’s accounting procedures, could damage the client relationship under the damage the client relationship under the consulting agreement. consulting agreement.

This caused bad accounting practices and This caused bad accounting practices and misrepresentation of financial information to go misrepresentation of financial information to go unchecked, leading to the collapse of several unchecked, leading to the collapse of several companies, like Enron, Worldcom, Healthsouth companies, like Enron, Worldcom, Healthsouth and Tyco.and Tyco.

Causes of Sarbanes-OxleyCauses of Sarbanes-Oxley

HeadlinesHeadlines

Audience QuizAudience Quiz

The Problem for Corporate America

Deficit

Audience QuizAudience Quiz

The TRUST deficitThe extraordinary loss of

trust in corporations and their leaders

Goals of SOXGoals of SOX

Regain public confidence in marketsRegain public confidence in markets Improve corporate governanceImprove corporate governance Increase executive accountability Increase executive accountability Increase efforts to Increase efforts to prevent, detect,

investigate and remediate fraud and misconduct

Title I – Public Company Title I – Public Company Accounting Oversight BoardAccounting Oversight Board

Created as a non-profit organization to oversee audits Created as a non-profit organization to oversee audits of public companiesof public companies

Under the authority of the Securities Exchange Under the authority of the Securities Exchange Commission (SEC)Commission (SEC)

Comprised of 5 appointed members w/ a max of 2 CPA’sComprised of 5 appointed members w/ a max of 2 CPA’s Duties:Duties:

Register existing public accounting firms Register existing public accounting firms which prepare audits for publicly traded which prepare audits for publicly traded companies companies

Audit the auditors Audit the auditors Establish and amend rules and standards (in Establish and amend rules and standards (in

cooperation with other standard setters)cooperation with other standard setters) Try and penalize registered public Try and penalize registered public

accounting firms who fail to comply with the accounting firms who fail to comply with the rulesrules

Title II – Auditor Title II – Auditor IndependenceIndependence

Prohibits registered public accounting Prohibits registered public accounting firms from performing non-audit services firms from performing non-audit services for companies they auditfor companies they audit

Prevents conflicts of interestPrevents conflicts of interest

Title III – Corporate Title III – Corporate ResponsibilityResponsibility

CEOs and CFOs must certify accuracyCEOs and CFOs must certify accuracy Surrender bonuses and profits if information Surrender bonuses and profits if information

is misrepresentedis misrepresented

Title IV – Enhanced Title IV – Enhanced Financial DisclosuresFinancial Disclosures

Forbids most personal loans to chief Forbids most personal loans to chief executivesexecutives

Disclosure of code of ethics for senior Disclosure of code of ethics for senior financial officersfinancial officers

Disclosure of members of company audit Disclosure of members of company audit committeecommittee Should include at least one financial expertShould include at least one financial expert

Title V – Analyst Conflicts Title V – Analyst Conflicts of Interestof Interest

Requires registered securities Requires registered securities associations to adopt rules that prevent associations to adopt rules that prevent conflicts of interestconflicts of interest Ex: Recommendations of analysts in Ex: Recommendations of analysts in

research reportsresearch reports

Title VI – Commission Title VI – Commission Resources and AuthorityResources and Authority

Increased SEC budget to $780 millionIncreased SEC budget to $780 million $98 million used to hire 200 employees to $98 million used to hire 200 employees to

oversee auditorsoversee auditors

SEC has the authority to investigate and SEC has the authority to investigate and punish violators of security lawpunish violators of security law

Title VII – Studies and Title VII – Studies and ReportsReports

US Comptroller General US Comptroller General (The (The Comptroller Comptroller General of the United StatesGeneral of the United States is the director of is the director of the the Government Accountability Office ( (GAOGAO, , formerly known as the General Accounting Office formerly known as the General Accounting Office to conduct a study about the consolidation of to conduct a study about the consolidation of public accounting firms)public accounting firms)

Also conduct investigation of security law Also conduct investigation of security law violations in the cases of Enron, violations in the cases of Enron, WorldCom, etc. WorldCom, etc.

Title VIII – Corporate and Title VIII – Corporate and Criminal Fraud AccountabilityCriminal Fraud Accountability

To knowingly create, destroy, or manipulate To knowingly create, destroy, or manipulate documents or impede federal investigations documents or impede federal investigations is considered a crimeis considered a crime

Punishment = Fines, maximum 20 years in Punishment = Fines, maximum 20 years in prison, or bothprison, or both

Audit reports should be kept for 5 yearsAudit reports should be kept for 5 years Whistleblower protectionWhistleblower protection Dishonest or illegal activities (Dishonest or illegal activities (misconduct) occurring in a ) occurring in a

government departmentgovernment department

Title IX – White-collar Crime Title IX – White-collar Crime Penalty EnhancementsPenalty Enhancements

CEOs and CFOs must certify that CEOs and CFOs must certify that financial statements are accurate financial statements are accurate representations of the company’s representations of the company’s conditioncondition

Punishment = Max $5 million fine and/or Punishment = Max $5 million fine and/or max 20 year punishmentmax 20 year punishment

SEC may ban anyone convicted of a SEC may ban anyone convicted of a security crime from holding an executive security crime from holding an executive position at a public companyposition at a public company

Title X – Corporate Tax Title X – Corporate Tax ReturnsReturns

Federal income tax returns must be Federal income tax returns must be signed by the Chief Executive Officer signed by the Chief Executive Officer (CEO) of the company(CEO) of the company

Title XI – Corporate Fraud Title XI – Corporate Fraud AccountabilityAccountability

Destroying/altering evidence or otherwise Destroying/altering evidence or otherwise obstructing securities fraud proceedings obstructing securities fraud proceedings may be punished with a fine and/or up to may be punished with a fine and/or up to 20 years in prison20 years in prison

SEC may freeze payments to accused SEC may freeze payments to accused individualsindividuals

Any revenge to whistleblowers is subject Any revenge to whistleblowers is subject to fines and/or 10 years imprisonmentto fines and/or 10 years imprisonment

SummarySummary

The Sarbanes-Oxley Act of 2002 was passed The Sarbanes-Oxley Act of 2002 was passed to regain public confidence in the stock market to regain public confidence in the stock market following a string of major accounting fraud following a string of major accounting fraud cases involving public companies. cases involving public companies.

A plan to accomplish this objective is outlined A plan to accomplish this objective is outlined in 11 titles, which:in 11 titles, which: Prohibit conflicts of interestProhibit conflicts of interest Increase corporate accountabilityIncrease corporate accountability Increase accounting transparencyIncrease accounting transparency Form an oversight board to enforce the new rulesForm an oversight board to enforce the new rules

Exam QuestionsExam Questions

1.1. The Sarbanes-Oxley Act was passed in:The Sarbanes-Oxley Act was passed in:a. 1935b. 1974c. 1999d. 2002

2.2. What events led to the passing of SOX?What events led to the passing of SOX?a. Collapse of the auto industrya. Collapse of the auto industryb. A string of accounting scandals at public b. A string of accounting scandals at public companiescompaniesc. Great Depressionc. Great Depressiond. Discrimination in the accounting professiond. Discrimination in the accounting profession

Exam Questions, Exam Questions, continued…continued…

3.3. What government institution was established by SOX to oversee What government institution was established by SOX to oversee auditors?auditors?AnswerAnswer

4.4. The Public Company Accounting and Oversight Board is under The Public Company Accounting and Oversight Board is under the authority of:the authority of:a. North Atlantic Treaty Organization (NATO)a. North Atlantic Treaty Organization (NATO)b. Food and Drug Administration (FDA)b. Food and Drug Administration (FDA)c. Securities Exchange Commission (SEC)c. Securities Exchange Commission (SEC)d. US Treasuryd. US Treasury

5.5. Name 4 titles of the Sarbanes-Oxley Act.Name 4 titles of the Sarbanes-Oxley Act.AnswerAnswer


6.6. According to Title X, who should sign the company tax return?According to Title X, who should sign the company tax return?a. Chief Executive Officer (CEO)a. Chief Executive Officer (CEO)b. President of External Accounting Firmb. President of External Accounting Firmc. Chief Financial Officer (CFO)c. Chief Financial Officer (CFO)d. Company’s Head of Accountingd. Company’s Head of Accounting

7.7. What events involving major public companies led to the What events involving major public companies led to the passing of SOX?passing of SOX?a. Intentional misrepresentation of company financial recordsa. Intentional misrepresentation of company financial recordsb. Auditor conflicts of interestb. Auditor conflicts of interestc. Risky loans from banks based on false earningsc. Risky loans from banks based on false earningsd. all of the aboved. all of the above


8.8. What is the criminal penalty for violation of SOX?What is the criminal penalty for violation of SOX?a. life in prisona. life in prisonb. fines and/or maximum 20 years in prisonb. fines and/or maximum 20 years in prisonc. maximum 5 years in prisonc. maximum 5 years in prisond. tax increased. tax increase

9.9. True/False: Under SOX, auditors are not allowed to True/False: Under SOX, auditors are not allowed to provide non-audit services (consulting) to the provide non-audit services (consulting) to the companies they audit.companies they audit.

10.10. True/False: SOX does not apply to privately held True/False: SOX does not apply to privately held companies.companies.

Effects of Sarbanes-OxleyEffects of Sarbanes-Oxley

If you’re a criminal –If you’re a criminal –

the risks of doing businessthe risks of doing businessabsolutely have increasedabsolutely have increased

Crimes/PenaltiesCrimes/Penalties

•• Created new federal crimesCreated new federal crimes

•• Enacted whistleblower protection and cause of Enacted whistleblower protection and cause of actionaction

Increased criminal penalties for mail/wire fraudIncreased criminal penalties for mail/wire fraud Restricted bankruptcy discharge of securities Restricted bankruptcy discharge of securities

liabilitiesliabilities Lowered threshold officer/director barsLowered threshold officer/director bars Lengthened statute of limitations for securities Lengthened statute of limitations for securities

fraudfraud Gave SEC power to freeze assetsGave SEC power to freeze assets

Senate InvestigationSenate InvestigationEffects of Sarbanes-OxleyEffects of Sarbanes-Oxley

●● Auditors Auditors

●● Securities analystsSecurities analysts

●● Government agenciesGovernment agencies

●● Board of DirectorsBoard of Directors

●● Credit rating agenciesCredit rating agencies

●● Financial institutionsFinancial institutions


AuditorsAuditors•• Enacted auditor independence Enacted auditor independence

requirementsrequirements

•• Gave guidance to state regulatory Gave guidance to state regulatory authoritiesauthorities

Made it unlawful to mislead public Made it unlawful to mislead public company auditorscompany auditors


Securities Analysts/Government Securities Analysts/Government AgenciesAgencies

•• Regulation mandated by SOXRegulation mandated by SOX

•• SEC budget increasedSEC budget increased

•• SEC required to review public company’s SEC required to review public company’s filings more oftenfilings more often

““Real time” disclosureReal time” disclosure


Boards of DirectorsBoards of Directors

•• CEO/CFO certificationsCEO/CFO certifications•• Bonus restrictionsBonus restrictions•• professional conduct rulesprofessional conduct rules•• Enhanced reporting requirementsEnhanced reporting requirements•• Loan prohibitionsLoan prohibitions•• Internal controls attestationsInternal controls attestations•• Codes of ethicsCodes of ethics•• Audit committee requirements (including “audit Audit committee requirements (including “audit

committee financial experts”) and disclosurescommittee financial experts”) and disclosures


Credit Rating AgenciesCredit Rating Agencies SEC required by SOX to study Credit Rating SEC required by SOX to study Credit Rating

AgenciesAgencies ““Congressional Response” from October 7, 2002 Congressional Response” from October 7, 2002

responseresponse

Investment BanksInvestment Banks GAO required by SOX to study investment banksGAO required by SOX to study investment banks ““Congressional Response” from January 2, 2003 Congressional Response” from January 2, 2003

reportreport

Corporate Scandal - Corporate Scandal - EducationEducation

Some commentators have noted the Some commentators have noted the education level of some of those education level of some of those

involved in some corporate scandals:involved in some corporate scandals:

““How could a Harvard MBA behave so How could a Harvard MBA behave so unethically?”unethically?”

Corporate Scandal - Corporate Scandal - EducationEducation

There’s no relation between education There’s no relation between education and human decencyand human decency

““You can be a Ph.D and an S.O.B.”You can be a Ph.D and an S.O.B.”

Justice Oliver Wendell HolmesJustice Oliver Wendell Holmes

So - What So - What ReallyReally Got Us Got Us Here?Here?

It’s not their M.B.A.It’s not their M.B.A.

It’s their DNAIt’s their DNA

Moral DNAMoral DNAIn my mind, the most important thing that a Board of

Directors should do is determine the elements that must be embedded in the company's moral DNA…It should be the

foundation on which the Board builds a corporate culture based on a philosophy of high ethical standards and accountability. This culture should penetrate every level

of the organization and influence all of the board's decisions including the selection of a CEO and the senior management team who will ultimately ensure that the

company's operations reflect its philosophy.

William DonaldsonFormer SEC ChairmanRemarks made to the Economic Club of New YorkMay 8, 2003

What’s SOX Got To Do What’s SOX Got To Do With It?With It?

Three separate sections of SOX (805, Three separate sections of SOX (805, 905 and 1104) address the US Federal 905 and 1104) address the US Federal Sentencing Guidelines (the “Guidelines”)Sentencing Guidelines (the “Guidelines”)

Guidelines amended in 2004 to change Guidelines amended in 2004 to change references from “Compliance” programs references from “Compliance” programs to “to “EthicsEthics and Compliance Programs” and Compliance Programs”

Boards given direct oversight Boards given direct oversight responsibilityresponsibility

US Sentencing Guideline US Sentencing Guideline RevisionsRevisions““Good corporate citizens have been Good corporate citizens have been incorporating ethical standards into their incorporating ethical standards into their compliance programs for a number of years, compliance programs for a number of years, and recent legislation, such as [SOX], has and recent legislation, such as [SOX], has adopted ethics as a guiding principle.”adopted ethics as a guiding principle.”

Commission Vice Chair Ruben Castillo Commission Vice Chair Ruben Castillo stated “A good corporate citizen must first stated “A good corporate citizen must first and foremost operate ethically.”and foremost operate ethically.”

Corporate Culture and Corporate Culture and PerformancePerformance

““Corporate Ethics: Right Makes Corporate Ethics: Right Makes Might”Might”

Avoiding scandal isn’t the only reason to observe Avoiding scandal isn’t the only reason to observe a stringent code of conduct. Doing the right thing a stringent code of conduct. Doing the right thing also generates more tangible dividendsalso generates more tangible dividends

Business WeekBusiness Week

April 11, 2002April 11, 2002

The Present and Future The Present and Future SolutionSolution

Not in the lawsNot in the laws

The limit of the law is not the test of right and The limit of the law is not the test of right and wrongwrong

People who do their job and do the right thingPeople who do their job and do the right thing

Corporate Governance - USA Sarbanes-Oxley Act “SOX”

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