Sarbanes-Oxley Act: Expanded Enforcement

By Philip K. Kleckner and Craig Jackson

Editor’s Note: Part 3 of a series

Incentive compensation plans were factors in the demise of Enron, Global Crossing, and WorldCom. During the late 1990s, several CEOs saw the opportunity to exercise their stock options at enormous personal gains, then abandoned the company and other shareholders when the business began to collapse.

Tougher Enforcement

The Sarbanes-Oxley Act addressed many of the issues behind recent accounting failures. The penalties set by Sarbanes-Oxley sections 302, 304, 802, 906, and 1102 are intended to deter corporate fraud in the future.

Sections 302 and 906. These sections require corporate CEOs and CFOs to certify quarterly and annual reports filed with the SEC. The certification states the CEO and CFO claim the following:

• They have reviewed the report.
• Based on their knowledge, the report is truthful and does not omit material information.
• Based on their knowledge, the financial statements fairly present, in all material respects, the financial position, results of operations, and cash flows.
• They are responsible for disclosure controls and procedures and have reviewed those procedures within the 90 days preceding the report filing date.
• All material weaknesses in internal controls have been disclosed to the audit committee and the independent auditors. In addition, all known instances of fraud, material or not, that involve personnel involved with internal control have also been disclosed.
• Significant changes to internal controls subsequent to the most recent evaluation have been disclosed, including corrective action with regard to deficiencies.

Intentional violation of this certification is subject to criminal penalties with fines of up to $5 million and up to 20 years in prison.

Section 304. This section states that if a company must restate its financial statements due to material noncompliance, misconduct, or with any financial reporting requirement, the CEO and CFO must reimburse the company for any of the following items:

• Bonus or other incentive-based or equity-based compensation received during the 12-month period following issuance of the financial statements, including restatements.
• Profits realized from the sale of its securities during that 12-month period.

Sections 802 and 1102. The act creates severe penalties and fines to punish those who disrupt an official investigation. Section 802 has two provisions that address the destruction of corporate documents. The first addresses documents within a company:

Whoever knowingly alters, destroys, mutilates, conceals, or falsifies records, documents or tangible objects with the intent to obstruct, impede or influence a legal investigation, shall be subject to fines and or up to 20 years of imprisonment.

The second provision addresses a company’s auditors:

Auditors must retain records relevant to the audits and reviews of financial statements filed with the SEC, including workpapers and other documents that form the basis of the audit or review, as well as correspondence for a period of no less than seven years.

The Cost of Doing Business

On July 8, 2004, former Enron President Kenneth Lay pleaded not guilty to the criminal indictment against him. If convicted on all 53 counts, Lay could receive up to 175 years in prison plus fines totaling more than $5.7 million. Separately, the SEC has filed civil charges against Lay, seeking more than $90 million. Considering the punishment Lay faces under prior law, the Sarbanes-Oxley penalties add little. The most substantial effect that the act will have is the level of scrutiny given a company’s financial statements. Hopefully, this scrutiny will reestablish investors’ confidence in the markets.

The objective of the act is to ensure that companies take every step necessary to ensure the accuracy of their financial statements. How will CEOs improve their internal controls enough to ensure that they will not end up in jail?

A normal audit of a company’s financial statements does not provide the assurances necessary to satisfy Sarbanes-Oxley. Auditors are prohibited from providing the services that would help executives have full assurance over their accounting systems and controls. Independent forensic accountants would not be disqualified under Sarbanes-Oxley because they do not perform audit functions; they offer the services necessary to provide additional scrutiny, to provide review of internal controls, and to investigate fraud so that executives can ensure their financial statements are free and clear of material misstatement.

Prior to Sarbanes-Oxley, white-collar criminals rarely considered that they might receive jail sentences for their questionable actions. Now that the SEC has the authority to make this happen, unscrupulous executives may reconsider committing fraud. However much money they make, they are unlikely to be able to enjoy it behind bars.

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