27. What is the “Sarbanes-Oxley Act”?
The Sarbanes-Oxely Act (SOX) is the primary federal law governing corporate governance and accountability across multiple aspects of corporate business practice. SOX specifically regulates markets, brokers, dealers, accounting and auditing, on-going government and shareholder disclosure by reporting companies, insider trading, anti-fraud, proxy regulation and so forth. SOX established a new regulatory body, increased the authority of existing regulators, as well as imposed regulations beyond those of the self-regulating, industry organizations. The primary objectives of SOX are to promote:
• Fairness to Shareholders – SOX requires or promotes governance provisions that protect shareholder rights and allow shareholders to exercise those rights through governance procedures, such as shareholder meetings.
• Fairness to Stakeholders – SOX requires or promotes governance provisions that take into consideration the interests of employees, suppliers, buyers, and the local community.
• Heightened Director and Board Responsibilities – SOX places specific requirements on the composition of boards of directors, including skill and independence requirements. Notably, in an effort to promote director independence in decision making, SOX requires corporations to employee committees for special purposes.
⁃ Example: SOX requires boards appoint an audit committee where all members are independent of corporate operations (not officers of the corporation) with at least one financial expert as a member of the committee.
• Director and Officer Ethics – SOX imposes additional obligations on corporations to establish and maintain ethical standards for officer and director conduct and decision-making.
⁃ Example: SOX prohibits the corporation from making personal loans to corporate executives or their families.
• Disclosure and Accountability – SOX places requirements on boards to increase transparency in corporate governance practices. This includes implementing procedures for ensuring accurate accounting practices and public disclosure mechanisms.
⁃ Note: SOX requires internal review procedures and independence of external auditors that report directly to the corporation’s independent audit committee. Further, SOX requires that key officers of the corporation (the CEO and CFO) certify the accuracy of the financial statements and that internal financial controls are in place and subject to the independent audit committee’s review.
Accounting and Disclosure Procedures – SOX imposed a number of reforms on the accounting and financial reporting requirements of public companies. The primary requirements are as follows:
• The Public Company Accounting Oversight Board (PCAOB) – SOX established the PCAOB to regulate auditors charged with reviewing the accounting procedures and disclosure statements of public companies.
⁃ Note: Prior to the establishment of the PCAOB, public company auditors were self-regulated or subject to the standards imposed by private institutions, such as the Financial Accounting Standards Board (FASB) or American Institute of Certified Public Accountants (AICP).
• External Auditing Firms – SOX now requires that a firm in charge of auditing the corporation refrain from serving as independent consultants to that same firm. This includes refraining from bookkeeping, system designs and implementation, appraisals and valuations, actuarial services, human resources functions, and investment banking services for the audited company. Further, the corporation must change auditing firms at least every 5 years. There are also restrictions on the ability of company executives to have worked for the auditing firm within the prior year.
⁃ Note: Prior to SOX, external auditing firms could simultaneously serve as consultants to the corporation that it is auditing. The created an inherent conflict of interest. Further, allowing corporations to employ the same auditors for extended periods increased the likelihood that on-going, improper accounting practices would not be discovered. Without periodically rotating in new auditors, there was no real check on the accounting firm.
Securities Regulations – Much of the regulatory process prescribed by SOX is carried out by the Securities and Exchange Commission. SOX includes provisions that strengthen the ability of the SEC to oversee corporate governance matters and enforce violations.
• Example: SOX established a criminal charge for conspiring to commit securities fraud. It also increased the criminal and civil penalties for committing securities fraud. SOX provides additional protections against discrimination for those reporting conduct that violates the securities laws (“whistleblower protection”).
• Discussion: What do you think was the driving force behind the passage of SOX? Why do you think focused on accounting standards and securities regulations to promote its objectives of fairness and ethics?
• Practice Question: What are the primary corporate governance requirements and objectives of these requirements under the Sarbanes-Oxley Act?