SARBANES-OXLEY: A BRIEF OVERVIEW On July 30, 2002, the United States Congress passed, by a nearly unanimous vote, the Public Accounting Reform and Investor Protection Act of 2002", commonly known as the Sarbanes-Oxley Act. 15 U.S.C.A. 7201, et. seq. Congress passed the Act in reaction to the corporate accounting scandals of Enron, WorldCom, and Global Crossing. Its effect is to significantly modify federal regulation of the accounting profession and of corporate governance, areas previously left to regulation by the States. It also impacts attorney-client relations as a result of its attorney disclosure requirements. This article will discuss the impact of Sarbanes-Oxley on (1) publicly traded companies ( issuers ) 1 ; (2) CPA firms that audit publicly traded companies; and (3) attorneys who work for or have clients that are publicly traded companies. 2 Accountants are now subject to oversight by a Public Company Accounting Oversight Board. This is a self-regulating body for the accounting profession whose purpose is to establish auditing standards and impose discipline on that profession. The Board is a private body, a non-profit corporation, which is subject to SEC oversight. It has five members, all of whom are appointed by the SEC and each of whom serves a five year term. All accounting firms who prepare audit reports for publicly traded companies must register with the Board and maintain this registration. The duties of the Board include establishing auditing, quality control, ethics, and independence standards for the preparation of audit reports. It is also the Board s duty 1 Under the Act, this includes their employees, officers, and 10% owners. 2 The provisions dealing with brokers, dealers, investment bankers and financial analysts who work for these companies are not addressed herein.
to inspect, investigate, and discipline public accounting firms and to enforce compliance with the Act. One of the principal goals of Sarbanes-Oxley was to strengthen auditor independence. To accomplish that goal, the Act prohibits accounting firms from providing certain non-audit services contemporaneous with auditing any public company. Examples of the non-audit services which are prohibited are bookkeeping services, actuarial services, investment services, appraisal or valuation services, human resource services, and legal services unrelated to the audit. The Act also prohibits an accounting firm from auditing any public company whose CEO, CFO, or controller was at any time in the past year, an employee of the accounting firm. Further, the Act requires that auditors rotate the position of lead audit partner every five years. The Act has wide ranging effects on the publicly traded companies themselves. Sarbanes-Oxley strengthens the powers and responsibilities of the company s audit committee and mandates that the audit committee be composed exclusively of independent directors. It requires that CEO s and CFO s certify in every annual and quarterly report that they have reviewed the report and that the reports do not contain untrue statements or omissions of material facts. The Act imposes enhanced criminal sanctions for certifications that are knowingly false. Sarbanes-Oxley requires that the reporting company make real time disclosures of material changes in their financial condition and to report off-balance sheet transactions that might have a material effect on the financial health of the company. Sarbanes-Oxley makes it unlawful for an officer or director to take any action to fraudulently influence, coerce, manipulate, or mislead the auditing CPA firm. The Act empowers the SEC to prohibit non-compliant companies
from being listed on national security exchanges. Attorneys are affected by Sarbanes-Oxley in one particular manner. Section 307 of the Act provided that the SEC should issue rules setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers.... 15 U.S.C.A. 7245 (emphasis added). The Act requires that the SEC include a rule (1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof to the chief legal counsel or chief executive officer of the company and (2) if the counsel or officer does not appropriately respond to the evidence, to the audit committee of the board of directors... or to another committee of the board of directors comprised solely of directors not employed directly or indirectly by the issuer, or to the board of directors. 15 U.S.C.A. 7245 (emphasis added). In accordance with Section 307, the SEC enacted rules governing attorney action. These rules can be found at 17 C.F.R. 205. The rules define several of the key terms of Section 307. Appearing and practicing before the Commission is not as narrowly defined as one might initially suspect. Briefly, under 17 C.F.R. 205.2(a), this phrase means (i) appearing and practicing before the Commission; (ii) representing an issuer in a Commission proceeding or in connection with any Commission investigation; (iii) providing advice regarding any document that the attorney has notice will be filed with or submitted to or incorporated into any document to be filed with or submitted to the Commission; or, (iv) advising an issuer as to whether information is required.
Evidence of a material violation is defined with double negatives that make it difficult to follow: credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur. In other words, it means credible evidence based upon which a prudent and competent attorney would reasonably conclude that it is reasonably likely that a violation has occurred, is occurring, or is about to occur. The phrase appropriate response is given a multi-part definition. Under 17 C.F.R. 205.2 an appropriate response means a response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes (1) that no material violation has occurred, is occurring, or is about to occur; (2) that the company has adopted appropriate remedial measures; or (3) that the company has retained an attorney to review the reported evidence. An issue arising out of Section 307 and its regulations is the extent to which they impose obligations on attorneys which are in addition to or in conflict with State Rules of Professional Conduct. Rule 1.13(b) of the Alabama Rules of Professional Conduct provides that if a lawyer for an organization knows that an officer, employee, or any person associated with the organization is engaged in action, intends to act, or refuses to act related to the representation that is a violation of a legal obligation to the organization or a violation of law which reasonably might be imputed to the organization and is likely to result in substantial injury to the organization, the lawyer shall proceed as is reasonably necessary in the best interest of the organization. The rule provides a list of measures the lawyer can consider, but no specific action is required.
The Comments to Rule 1.13 are similar to the regulations under Section 307. Under Rule 1.13, one finds these comments: when the lawyer knows that the organization may be substantially injured by action of a constituent that is violation of law... it may be reasonably necessary for the lawyer to ask the constituent to reconsider the matter. If that fails, the Comments suggest that the lawyer may need to have the matter reviewed by higher authority in the organization. Unlike Section 307, whether to have the matter reviewed is left more to the discretion of the lawyer. Rule 1.13 does not provide a precise statement of a corporate ladder that must be climbed. Rather, the Comments state that clear justification should exist for seeking review over the head of the constituent normally responsible for it. The stated policy of the organization may define circumstances and prescribe channels for such review.... Even in the absence of organizational policy, however, the lawyer may have an obligation to refer a matter to higher authority, depending on the seriousness of the matter and whether the constituent in question has apparent motives to act at variance with the organization s interest. The Comments to Rule 1.13 further state that review by the chief executive officer or by the board of directors may be required when the matter is of importance commensurate with their authority. At some point it may be useful or essential to obtain an independent legal opinion. In an extreme case, it may be reasonably necessary for the lawyer to refer the matter to the organization s highest authority. Ordinarily, that is the board of directors or similar governing body. The potential for a conflict between the obligations under Sarbanes-Oxley and those under State Rules of Professional Conduct is in part addressed by Rule 205.6(c) of the SEC regulations. It states that an attorney who complies in good faith with the
provisions of this part shall not be subject to discipline or otherwise liable under inconsistent standards imposed by any state or other United States jurisdiction where the attorney is admitted or practices. At one time there was some suggestion that the regulations under Section 307 would include a noisy withdrawal provision. The original rules proposed by the SEC included such a provision when the corporate ladder did not respond appropriately. Enactment of these rules were postponed for further public comment due to extensive criticism from attorneys.