The recent, twentieth anniversary of the Sarbanes-Oxley Act (“Sarbanes”) offers an important corporate responsibility teaching moment for corporate executives, board members and their accounting and legal advisors. This is especially the case given that so many of them were not in similar positions when the law was enacted on July 30, 2002, and may be unfamiliar with the extraordinary circumstances that led to its enactment.
Sarbanes reflected a bipartisan Congressional effort to respond firmly to widespread accounting scandals and notorious incidents of corporate fraud in 2000-2001. These prompted several economy-shaking bankruptcies that undermined public confidence in corporate financial statements. The ripple effects of these incidents impacted principles of corporate governance, and the manner in which legal and accounting firms interact with their clients.
The scope of the Congressional response became one of the most consequential corporate governance and finance developments in history, the implications of which are felt in C-Suites and boardrooms to this day.
The legislative effort that led to Sarbanes’ enactment was precipitated by a shocking series of bankruptcies and similar financial collapses of major U.S. corporations within an uncomfortably short period of time. The most prominent of these collapses involved the energy trading firm Enron, which for a number of years had been lauded by the financial media for its innovative orientation and its workforce culture. When it filed for Chapter 11 protection in December, 2001 it became the largest bankruptcy in U.S. history at that time. It was soon surpassed in such ignominy by the July 2002 bankruptcy of the telecommunications firm WorldCom.
During that time period several other communications, cable television, enterprise software and security systems companies similarly sought bankruptcy protection. The totality of these collapses led to billions of dollars in financial losses to investors, the loss of thousands of jobs, economic damage to the suppliers and communities that served these companies, and severely damaged public faith in the capital markets.
The Root Cause Analysis
The Sarbanes drafters sought to address the root causes of the financial scandals that had arisen in Enron and the other companies, which were disquietly similar in nature. These included intricate business models that made external monitoring difficult; complex financial statements that confused stockholders and analysts alike; highly aggressive revenue recognition and “mark-to-market accounting” practices; and speculative special-purpose entities and the management conflicts they presented.
The root causes also extended to alleged conflicts of interest involving auditors and securities analysts, respectively; inadequate corporate disclosures; misaligned executive compensation incentives; governance structures that lacked the expertise necessary to properly monitor the business and its financial practices; overly aggressive corporate cultures that placed little value on ethics and compliance; and the marginalization of the corporate legal function.
Core Sarbanes Themes
The resulting legislation reflected at least six major themes, all of which were focused on the identified root causes of the financial scandals:
Theme One: Oversight of the Accounting Profession. Sarbanes created the Public Company Accounting Oversight Board (PCAOB), and charged it with the responsibility to exercise independent oversight of the public accounting sector including, but not limited to, the registration of accounting firms and the development of auditing and related attestation standards, quality control and ethics.
Theme Two: Reconfiguration of the Audit/Client Relationship. Sarbanes established new standards intended to preserve auditor independence and prevent related conflicts of interest, including the prohibition of an auditor performing certain identified non-audit/consulting services contemporaneously with the performance of an audit. It also included provisions dealing with audit partner rotation, auditor approval requirements and auditor reporting requirements.
Theme Three: Audit Committee Matters. A major aspect of Sarbanes was the requirement that public company audit committees be composed of members of the corporation’s board of directors, and to be otherwise “independent” according to a specific definition. It also mandated that audit committees include at least one “financial expert” amongst its membership; establish procedures for considering complaints regarding accounting and internal control matters, and have the authority to engage independent advisors.
Theme Four: Executive Responsibility. Sarbanes added new rules associated with the certification of financial statements by senior executive officers; the prohibition of executive interference in the audit process; and the forfeiture of executive compensation elements in certain circumstances following an accounting restatement.
Theme Five: Enhanced Disclosure Obligations. Also key were new requirements for enhanced financial disclosures associated with transactions that are required to be filed with the SEC, and the establishment of specific internal control mechanisms for financial reporting.
Theme Six: White Collar Criminal Focus. Sarbanes made dramatic additions to criminal law as it related to financial records, reporting and disclosure. It added federal criminal penalties for knowingly and willfully destroying, altering, concealing or falsifying financial records for the purpose of obstructing or influencing a federal investigation and retaliating against a corporate whistleblower in certain circumstances. It also enhanced existing criminal penalties associated with certain types of white-collar crimes and classified as a felony the failure of an executive to certify financial reports as required by law.
Related Extensions of the Statute
Sarbanes’ influence has extended beyond the public company sector, and also beyond the four corners of the law itself.
For example, not only did some limited provisions of the statute apply to private companies as well as public companies (e.g., document destruction and whistleblower retaliation protection), many of its provisions have formed the basis for “best practices” or other similar guidelines in the private/not-for-profit corporate sectors. These include matters relating to auditor independence, audit committee composition, internal controls, and executive responsibility.
In addition, Sarbanes has had a remarkable impact on corporate governance, including the focus on corporate responsibility and ethics generally; the obligation to exercise oversight of the reliability of financial statements; the importance attributed to oversight of audit and compliance functions; board composition (especially relating to director competencies); the finance committee’s role in preserving accurate financial reporting to the board; and the importance attributed to director independence. Perhaps more thematically important was the gentle shift in corporate control from the CEO to the board.
These and other Sarbanes provisions have led to significant changes in the professional responsibility of attorneys, particularly as they relate to the identification and nature of the lawyer’s client, “reporting up the ladder” requirements, and matters as to client confidentiality.
Sarbanes’ Perceived Limitations
Like any major revision of the status quo, Sarbanes was subject to substantial criticism in its development and following its enactment. Many of these criticisms related to its scope (e.g., it was overbroad); to its jurisdiction (e.g., it represented an unnecessary intrusion of the federal government into the financial markets); that it somehow constituted the federalization of corporate governance; and its potential negative impact on the IPO market. Over time, many these criticisms have failed to take root or otherwise undermine the legitimacy of the law.
Yet two Sarbanes elements have been subjected to more sustained criticism. The first in this regard is the concern that Sarbanes uses procedural prescriptions to solve perceived problems. The danger with such rules of thumb is that they lead to a “tick the box” approach to complex issues and become a triumph of form over substance. The important theory gets lost in form.
The second is a by-product of the first and has been perhaps Sarbanes’ most controversial provision. Section 404 requires an annual internal controls certification that was well-intentioned but to some is seriously problematic. By subjecting broadly defined internal controls to significant bureaucratic review by the outside reviewer who may have lacked top-level experience in evaluating broad-based systemic risk, Congress may have created two distinct problems that, in the views of some, remain to be fully addressed.
As viewed through this lens, many large scale control reviews by those with less than complete expertise in non-accounting issues has led to increased costs to the company without creating a truly meaningful corresponding risk analysis. According to this argument, many boards relied on such an analysis to assume that all financial risk had been appropriately addressed. However, the 2008 financial crisis demonstrated that such reliance may have been unjustified in some situations.
In that crisis, most of the collapsed banks had risk departments and external review of the banks’ practices. Yet rarely did these and other control mechanisms serve to identify the serious risk of the financial instruments that destroyed so many institutions and almost cratered the entire financial system. The criticism was that such evaluation was beyond the competency of many of the participating evaluators. Yet, the 404 reviews were said to have given the directors and the public confidence in the institutions’ financial health with—in some circumstances—disastrous consequences. As critical to an organization’s health as internal controls present, the 404 approach remains controversial and to some observers has cast an unfortunate shadow over Sarbanes.
The Ultimate Legacy
Its limitations notwithstanding, there is a strong argument that Sarbanes has accomplished its core goal of preserving public confidence in the financial markets and in financial reporting. The law has fundamentally changed the relationship between the company and the audit/auditor, enhanced the reliability of financial reporting, established the PCAOB and sparked the corporate responsibility movement—thus creating a more robust respect for corporate compliance, fiduciary duty to shareholders, attentive board oversight and ethical behavior. It is also undeniable that there has been a drastic reduction in the number of public company financial accounting scandals since its enactment.
A new generation of corporate leaders has entered the boardroom since 2002, and for many of them the magnitude of the financial crisis, its root causes and the impact of the law’s provisions may have faded. As Sarbanes-Oxley’s anniversary is upon us, there is definite value in leadership education, and perhaps introspection, on how the commerce and governance we know today was shaped by this momentous legislation.