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Sarbanes and Oxleys Act 2002 of USA

Written by: Paras Kumar Jain (Company Secretary)
Personal Law
Legal Service
  • The collapse of Enron and WorldCom, as well as other well-publicized financial debacles, have led to an unprecedented level of attention paid to corporate governance, financial disclosure, and auditing issues. These conditions warranted US legislators to take a strong action to tighten the belts of erring corporates. In wake of the above conditions American Congress presented Sarbanes Oxley Act, 2002 to the President on July, 2002 after passing it in the senate by a 99-0 vote and in the house by a 423-3 margin. President Bush signed the Sarbanes Oxley Act, 2002 into law the morning of July 30 2002.
    This Act is named after its primary architects, Senator Paul Sarbanes and Representative Michael Oxley. The Act deal with issues of auditor independence, corporate responsibility, enhanced financial disclosures, conflicts of interest, and corporate accountability, among other things. The Act also establishes a Public Company Accounting Oversight Board.

    Sarbanes Oxley Act, 2002 directly affects the following

    1. Certified Public Accountants of Publicly traded companies
    2. Publicly traded companies their employees, officers and owners including holders of more than 10% of the outstanding common shares.
    3. Attorneys who work for or have publicly traded companies as their clients
    4. Brokers, dealers, investment bankers and financial analyst who work for publicly traded companies.

    Sarbanes Oxley Act, 2002 (SOA) provides for the following

    Establishment of Public Company Accounting Oversight Board (Pcaob) Sec 101

    The SOA provides for establishment of PCAOB consisting of five members. This Board is subject to oversight by Securities Exchange Commission, USA. The Board will oversea the audit of Publicly Traded Companies.

    Every CPA or a CPA firm, auditing publicly traded companies have to register himself/themselves with PCAOB.

    Beginning 180 days after the SEC determination, it will be unlawful for any firm that is not registered with the Board to prepare or issue, or to participate in the preparation or issuance of, any audit report with respect to any issuer.

    Public Company Audit Committee Sec 301/407

    The SOA provides for constitution of Audit Committee responsible for appointment, compensation and oversight of the work of independent auditors. Members of the Audit Committee should be members of the Board of Directors of the Company and must be independent, meaning he/she must not accept any consulting, advisory or other compensatory fees from the issuer company; however he/she may draw sitting fees. Member of Audit Committee must also not be affiliated to subsidiary of the issuer Company. This Audit Committee is charged with the responsibility of establishing, reviewing the procedure for the receipt, treatment of accounts, internal control or auditing complaints received by the issuer from the interested/effected parties. On January 9, 2003, the Securities and Exchange Commission had released proposed rules under the Sarbanes-Oxley Act of 2002 (the Act) to strengthen the independence and authority of the audit committees of listed companies.

    Auditor Reports- Sec 204

    The SOA requires that registered public accounting firms should report directly to issuers Audit Committee:
    all critical accounting policies and practices to be used;
    all alternative treatments of financial information within GAAP that have been discussed with management, ramifications of the use of such alternative treatments, and the treatment preferred by the registered public accounting firm; and other material written communication between the registered public accounting firm and management, such as any management letter or
    schedule of unadjusted differences.

    Conflicts Of Interest- Sec 206

    The SOA provides that registered public accounting firm may not perform any audit service for an issuer if the CEO, CFO, controller, chief accounting officer or any person serving in an equivalent position was employed by such firm and participated in any capacity in the audit of that issuer during the one-year period preceding the date of the initiation of the audit.

    Audit Partner Rotation- Sec 203

    The SOA provides for rotation of lead audit partner and partner reviewing the audit every five years. However note should be taken of the fact that rotation of Audit firm is not. ****

    Independent Audit Sec 201

    CPA or CPA firms auditing publicly traded companies are also prohibited from providing services outside the scope of practice of auditors.
    Prohibited services include:
    1. Bookkeeping or other services related to the accounting records or financial statements of the audit client;
    2. Financial information systems design and implementation;
    3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
    4. Actuarial services;
    5. Internal audit outsourcing services;
    6. Management functions or human resources;
    7. Broker or dealer, investment adviser, or investment banking services;
    8. Legal services and expert services unrelated to the audit;
    9. Any other service that the Board determines, by regulation, is impermissible.

    However note should be taken of the fact that CPA/ CPA firms may continue to provide tax services such as tax planning, tax management or other permitted non audit services provided such services are pre-approved by the issuers Audit Committee . The issuer Company must disclose approval of permitted non audit services in its periodic reports.

    Audit Records Sec

    The SOA requires any accountant who conducts an audit of a public company's securities under section 10A of the Securities Exchange Act of 1934 to maintain all audit or review work papers for 5 years from the end of the fiscal period relating to such audit. Penalties for a willful violation of such laws, rules or regulations pertaining to the destruction of corporate audit records include fines, imprisonment up to 10 years or both

    CEOS and CFOS Required To Affirm Financials- Sec 302

    The SOA requires CEO and Principal Finance Officer to certify that: the signing officer has reviewed the report; based on the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact in order to make the statements made not misleading, in light of the circumstances under which the statements were made;

    based on the officer's knowledge, the financial statements (and all other information contained in the report) fairly present in all material respects the financial condition and results of operations of the issuer for the periods presented; the signing officers are responsible for establishing and maintaining internal controls and other matters relating to such internal controls; the signing officers have disclosed to the auditors and the audit committee any fraud involving management (or other employees who have a significant role in internal controls) and significant deficiencies regarding internal controls if any ; and the signing officers have indicated in the report whether or not there were significant changes in internal controls or other factors that could significantly affect internal controls after the date of their evaluation.

    Penalty For Wrong Certification Sec 304

    The SEC's rules are effective now. If an issuer is required to restate its financials due to the material noncompliance , "as a result of misconduct", of CEO or CFO with any financial reporting requirement under the securities laws, then such CEO and CFO will have to reimburse the issuer for:
    1. any bonuses (or other incentive-based or equity-based compensation) received by that person from the issuer during the 12-month period following the first public issuance or filing (whichever occurs first) with the SEC of the financial document embodying such financial reporting requirement and
    2. any profits realized from the sale of securities of the issuer during that 12-month period. This would include performance-driven salary increases, cash or stock bonuses and profits from stock option exercises.However SEC is empowered to exempt any person from this forfeiture rule in appropriate cases. Point noteworthy is that the SOA does not define Misconduct and it limits its approach to misconduct by CEO and CFO only .

    Pension Fund Blackout Period /Insider Trading Sec 306/403
    Directors and Executives Officers are prohibited from dealing in equity securities of the issuer company during pension fund blackout period. The issuer is obliged to forfeit any profits realised by such directors or executive officers during such period.

    Its the responsibility of the Issuer to notify directors and executive officers, as well as the SEC, of such blackout periods. In the event of a pension plan blackout, a public company must provide notification to the SEC on a Form 8-K filed no later than the date on which the company notifies its directors and executive officers The Act further provides that SEC is required to frame rules not later than April 26, 2003 directing national securities exchanges and associations to prohibit the listing of any security of an issuer does not comply with this new requirement. For these purposes, a blackout period is defined generally to include
    any period of more than three consecutive business days during which the ability of at least 50% of the participants or beneficiaries under all individual account plans maintained by the issuer to trade in issuers equity securities held in such an individual account plan is temporarily suspended by the issuer or a plan fiduciary. Changes in equity ownership (i.e., stock purchases, sales, option grants and option exercises) by directors, officers, and 10% beneficial owners must be reported by the end of the second business day following the transaction date.

    Financial Disclosures- Sec 401 /409

    All 10 K ( Annual Filing) , 10 Q ( Quarterly Filing ) with the SEC must disclose all material off balance sheet transactions, arrangements, obligations ( including contingent liability) , relationship of the issuer with unconsolidated entities and other relationship that may have a material effect on the issuers present or future financial condition, proforma financial information in any report filed with the SEC or in any public release must not contain any misleading or misstatement or omit material fact necessary to make the financial information not misleading. Such information must be reconcilable with the financial conditions and operating results prepared under US GAAP. This provision plugs the advantage enjoyed by the corporate of excluding various types of negative financial data from press releases to create more positive pro forma results.

    Ban On Loan To Directors And Executive- Sec 402

    Section 402 of SAO prohibits US and foreign Companies with Securities traded in the US from making or arranging from third parties any type of personal loan to directors or executive directors. It appears that existing loans are not affected but material modification or renewal of loan and arrangement of existing loans are banned. However, credit and charge cards issued by businesses to their employees, margin loans for personal securities brokerage accounts held by brokerage employees, and loans by financial institutions to their employees that are regulated by the Federal Reserve are exempted One point to be noted is that exemption applies only to broker dealers registered with the SEC, thereby excluding most Non US broker dealer.

    Thus exceptions provided in Section 402 are very narrow covering only loans made in the ordinary course of business and at market rates by the issuer who are financial institution or otherwise in the business of consumer lending.

    Power To Bar Officers And Directors- Sec 305

    The SOA empower the SEC to permanently bar persons from serving as a director or officer of a public company in an administrative proceeding before the SEC. This power of barring a person from serving as a director or officer of a public Company was previously only entrusted toa federal district court.

    Responsibility Of Attorneys - Sec 307

    The Attorneys dealing with the publicly traded Companies are required to report evidence of material violation of securities law or breach of fiduciary duty ( or similar violation) by the issuer or any agent of the issuer to the Chief Counsel or CEO and if the Counsel or CEO does not appropriately respond to the evidence, the attorney must report the evidence to the audit committee, another committee composed entirely of independent directors, or the board of directors. These requirements will drastically change the relationship between Directors / officers of public companies and legal counsel.

    Securities Analyst Requirements Sec 501

    The SOA provides that Brokers and dealers of securities should not retaliate or threaten to retaliate against an analyst employed by the broker or dealer as a result of an adverse, negative or unfavorable research report on a public company. The SOA further provides that Securities analysts and brokers or dealers should disclose conflicts of interest, such as:
    (a) Whether the analyst has investments or debt in the company it is reporting on;
    (b) Whether any compensation received by the broker, dealer or analyst is appropriate in the public interest and consistent with the protection of investors;
    (c) Whether an issuer has been a client of the broker or dealer; and
    (d) Whether the analyst received compensation with respect to a research report based on investment banking revenues.

    No Discharge In Bankruptcy- Sec 803

    Section 803 of the SOA provides that debts arising from judgments or settlements in civil and criminal securities fraud proceedings, including common law fraud in connection with the purchase or sale of a security, cannot be discharged in bankruptcy.

    Management Assessment Of Internal Controls- Sec 403

    The SOA requires each annual report of an issuer must contain an "internal control report", which shall:
    (1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and
    (2) contain an assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting


    1. For alteration, destruction, concealment of any records with the intent of obstructing a federal investigation then penalty could a fine and/or up to 10 years imprisonment
    2. Anyone who knowingly executes, or attempts to execute, a scheme to defraud a purchaser of securities then penalty could be fine and/or up to 5 years imprisonment
    3. Any CEO or CFO who recklessly violates his or her certification of the companys financial statements then penalty could be fine of up to $1,000,000 and/or up to 10 years imprisonment
    4. Any CEO or CFO who willfully violates his or her certification of the companys financial statements then penalty would be fine of up to $5 million and/or up to 20 years imprisonment penalty would be
    5. Two or more persons who conspire to commit any offense against or to defraud the U.S. or its agencies then penalty could be fine and/or up to 10 years imprisonment
    6. Any person who corruptly alters, destroys, conceals, etc., any records or documents with the intent of impairing the integrity of the record or document for use in an official proceeding then penalty would be fine and/or up to 20 years imprisonment.
    7. In case of Mail and wire fraud penalty could be upto 10 years imprisonment

    The SOA increases accountability standards for directors, officers, auditors, securities analysts and legal counsel involved in the financial markets. Senator Paul Sarbanes has brought forward legislation that could have far-reaching implications for worldwide audits. The SOA Act leaves the issues of board independence, expensing of stock options, untouched. For private companies, the impact is less noticeable since the SOA is targeted specifically at public companies. The SOA does not distinguish between US and non-US issuers; it applies to all companies with a listing in the US. Companies cannot retaliate against an employee for providing information or assisting in US fraud investigations.

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