Sarbanes-Oxley

On December 2, 2001, the Enron Corporation, a highly-respected and rapidly growing energy-trading company filed for bankruptcy. It had inflated its earnings by nearly $600 million in the 1994—2001 period. This had become known less than a month before. Enron, with assets of $62.8 billion, became the largest bankruptcy in U.S. history. Its stock closed at 72 cents on December 2. It had been over $75 a share one year earlier. Investors lost billions and employees lost their life savings. Exactly 241 days later, on July 30, 2002, the President signed into law the Public Company Accounting Reform and Investor Protection Act of 2002. The act's two chief sponsors were Senator Paul Sarbanes (D-MD) and Representative Michael G. Oxley (R-OH). The legislation thus carried the short title of Sarbanes-Oxley Act of 2002, subsequently abbreviated as SOX or SarbOx. In the opinion of most observers of securities legislation, SOX is viewed as the most important new law enacted since the passage of the Securities and Exchange Act of 1934.

The Enron debacle would have been prevented if audits of the company had detected accounting irregularities or if the company would have been required to disclose transactions not directly reflected on its balance sheet. Incentives and rewards used within the company and dealings with entities imprecisely associated with Enron contributed to the massive failure. Furthermore, insider trading took place toward the end while employees holding company stock as part of their pensions were prevented from trading them during a so-called "blackout" period.

Sarbanes-Oxley was principally a reaction to this failure. However, during this same period, the equally dramatic actual or pending bankruptcies of WorldCom, a long-distance telecommunications company, and Tyco, a diversified equipment manufacturer, influenced the content of the legislation. SOX thus deals with 1) reform of auditing and accounting procedures, including internal controls, 2) the oversight responsibilities of corporate directors and officers and regulation of conflicts of interest, insider dealings, and the disclosure of special compensation and bonuses, 3) conflicts of interest by stock analysts, 4) earlier and more complete disclosure of information on anything that directly and indirectly influences or might influence financial results, 5) criminalization of fraudulent handling of documents, interference with investigations, and violation of disclosure rules, and 6) requiring chief executives to certify financial results personally and to sign federal income tax documents.

SUMMARY OF PROVISIONS

Sarbanes-Oxley governs the activities of publicly traded companies. It aims at protecting investors who, unlike investors in privately held corporations, are presumed to be at a greater distance from management and therefore more vulnerable. Any and all companies, of any size, the stock of which is publicly traded (whether on a stock exchange or over the counter) are subject to SOX; thus it touches a certain range of small business as well.

The act has 11 titles, i.e., major subdivisions. These in turn are divided into sections. The sections of Title IV, for instance, begin with Section 401 and end with Section 409. It is common practice in referencing pieces of legislation to refer to section numbers. Some sections are more controversial or difficult than others and will be more frequently mentioned in articles. An example is Section 404 in SOX which deals with internal accounting controls—which has imposed significant data processing costs. In the following explanations sectional references are omitted. A title-by-title summary follows.

Title I—Public Accounting Oversight Board

Title I creates an independent Public Accounting Oversight Board under the general oversight of the Securities and Exchange Commission. PAOB is charged with newly registering, regulating, inspecting, and generally overseeing companies that audit publicly traded companies. PAOB owes its origin to auditing failures that surfaced during the Enron bankruptcy. The Board is self-funded by the fees that it is authorized to charge.

Title II—Auditor Independence

Next is Title II which legislates the behavior of auditing firms in particular. Its most important provisions severely restrict auditing firms from carrying out compensated activities for their auditing clients that fall outside the boundaries of auditing narrowly viewed. Such "outside" activities include the provision of services like bookkeeping, accounting, financial information systems design, appraisals, and many other jobs. This prohibition is based on the notion that audit firms may be influenced in their audit practices in favor of a client from whom they are getting other profitable business. Other provisions of Title II require that audit partners are rotated after five years of service auditing a client (lest relations become too cozy) and also prohibit financial officers of the audited firm from having been employed by the audit company.

Title III—Corporate Responsibility

Title III specifies the responsibilities of public companies in relation to financial and accounting behavior. It requires that companies establish audit committees made up of independent board members who have no financial ties to the company; they may, of course, be paid for their board duties. The chief executive and the chief financial officer both must certify the material correctness of financial statements underlying audit reports. It forbids officers and board members from attempt improperly to influence audits. If financial statements must be revised because of misconduct, the CEO and CFO forfeit bonuses or incentives or profits from securities sales. Directors and officers may be barred from service for violating certain SEC requirements. While the trading of a pension fund is suspended (a "blackout" period), insider trading is prohibited as well—a provision that also harks back to Enron where insiders traded while pension funds were frozen.

Title IV—Enhanced Financial Disclosures

The intention of Title IV is to cause corporations to make public transactions not heretofore normally required to be discussed, such as off-balance sheet transactions (of the sort that, in part, caused Enron's failure) and relationships with "unconsolidated entities" that could influence the company's finances. The SEC is charged with studying the matter in greater detail as well. Directors, officers, and stockholders with 10 percent or more holdings are required to make certain transactions public—such as special bonuses and stock grants or large dispositions of stock. Companies are prohibited from making loans to any director or executive (echoing a problem discovered at WorldCom). The Title also mandates that companies with codes of ethics make these codes public. Changes in financial conditions must be disclosed in real time. Another important requirement of the Title is that every annual report must contain a special report on internal controls. Such controls must be established and maintained and then assessed every year. (This is the "costly" Section 404.) Such controls consist of special methods of testing financial reports and data to determine their truth and coherence.

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