On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002. The bill makes substantial changes in the law pertaining to public companies, particularly with respect to the provisions relating to accounting and public companies’ relationship with their accountants.

The bill is quite extensive, running 66 pages, and covers many topics, ranging from the creation of a public accounting oversight board to the increasing of penalties and the extending of the statutes of limitations for certain violations. This article does not attempt to summarize every aspect of the bill, but instead focuses on the provisions of immediate interest to companies required to file periodic reports pursuant to Section 12 or Section 15(d) of the Securities Exchange Act of 1934 and companies filing a registration statement for the offer of securities under the Securities Act of 1933 (defined in the bill as "issuers"),1 especially the provisions requiring issuers to take specified actions or stop taking actions that they previously may have engaged in.

This article summarizes the text of the bill, and the parenthetical references after paragraphs are to the corresponding sections of the bill. Many of the provisions require the adoption of rules by the Securities and Exchange Commission, and these provisions cannot be fully understood until the rulemaking is complete. Further, several provisions of the bill, although not requiring implementing rules, are very unclear and may be subject to interpretation or explanation by the Commission.

Provisions Requiring Action or Attention Immediately Following Enactment

Section 16 Trading Reporting

The obligation under Section 16 of the Securities Exchange Act of directors, officers and 10% shareholders to report their transactions in the issuer’s equity securities is significantly altered. Basically, reports on Form 4 will now be required to be filed within two business days after the transaction being reported. (The prior law required the transactions to be reported within 10 days after the end of the month in which the transaction occurred.) This change in the law is effective 30 days after the enactment of the bill. (Section 403)

This change in long established law should be promptly reported to all directors and officers reporting under Section 16. This change will require a significant change in behavior by issuers, directors and officers. Among other things, reports will be required to be prepared and filed much more quickly and the ability to report multiple transactions after the end of a month has been eliminated.

Beginning not later than one year after enactment of the bill, reports on Form 4 will be required to be filed electronically, and the issuer, if it maintains a corporate web site, will be required to post the filing on its web page not later than one business day following the filing.

Prohibition on Loans to Directors and Executive Officers

Effective upon enactment of the bill, issuers and their subsidiaries are prohibited from extending or maintaining credit, arranging for the extension of credit or renewing an extension of credit, in the form of a personal loan to or for any director or executive officer of the issuer. This prohibition applies not only to loans for the purchase of securities but also to loans for other purposes. (Section 402)

The bill "grandfathers" existing loans provided that they are not materially modified or extended. It also has exceptions for certain loans made in the ordinary course of the issuer’s business and available on the same terms as offered to the public (such as bank loans, broker margins loans, credit card debt, etc.). Presumably travel advances are not intended to be "an extension of credit in the form of a personal loan," but it’s not clear. Although this and other ambiguities may be clarified by interpretations by the Commission staff, because the provision is effective immediately, issuers must proceed with caution.

Provisions Requiring Attention with the Next Periodic Report

The bill immediately requires the chief executive officer and chief financial officer of an issuer to certify in each periodic report containing financial statements that the report fully complies with the reporting requirements of Section 13(a) or 15(d) of the Securities Exchange Act and that information contained in the report fairly presents, in all material respects, the financial condition and results of operations of the issuer. This section provides that it shall be a criminal offense to make such certification knowing that the report does not comply with these requirements. (Section 906)

In a separate provision, the bill requires that, not more than 30 days after enactment of the bill, the Commission adopt rules requiring that the principal executive officer and the principal financial officer of an issuer certify in each annual or quarterly report that:

1. the signing officer has reviewed the report;
2. 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 necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading;
3. based on the officer’s knowledge, the financial statements and other financial information included in the report fairly present in all material respects the financial condition and results of operations of the issuer as of and for the periods presented in the report;
4. the signing officers (a) are responsible for establishing and maintaining internal controls, (b) have designed such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers, (c) have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report and (d) have presented in the report their conclusions about the effectiveness of their internal controls based upon their evaluation;
5. the signing officers have disclosed to the issuer’s auditors and the audit committee of the board (a) all significant deficiencies in the design or operation of internal controls which could adversely effect the issuer’s ability to record, process, summarize and report financial data and have identified for the issuer’s auditors any material weakness in the internal controls and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and
6. the signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

(Section 302)

Provisions Requiring Attention within the Next 180 Days

Off-Balance Sheet Transactions. Not more than 180 days after enactment of the bill, the Commission is required to adopt rules providing that each annual and quarterly report required to be filed with the Commission shall disclose all material off-balance sheet transactions (including contingent obligations) and other relationships of the issuer with unconsolidated entities that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses. (Section 401(a))

Pro Forma Financial Information. Not more than 180 days after enactment of the bill, the Commission is required to adopt rules providing that pro forma financial information included in any periodic or other report filed with the Commission, or in any public disclosure or press release, shall be presented in a manner that (a) does not contain an untrue statement of material fact or omit to state a material fact necessary in order to make the pro forma financial information, in light of the circumstances under which it is presented, not misleading and (b) reconciles it with the financial condition and results of operations of the issuer under generally accepted accounting principles. (Section 401(b))

Real Time Issuer Disclosure. The reporting requirements are amended to require issuers to report "on a rapid and current basis such additional information concerning material changes in financial condition or operations" as the Commission determines by rule are necessary. No time period is specified for the adoption of such rules. This requirement may be addressed as part of the Commission’s currently pending proposal to substantially enlarge the items required to be reported on Form 8-K and to accelerate the filing of Form 8-K. (Section 409)

Corporate Responsibility

Code of Ethics for Senior Financial Officers. Not more than 180 days after the enactment of the bill, the Commission is required to adopt rules requiring issuers to disclose whether or not (and if not, the reasons why not) the issuer has adopted a code of ethics for senior financial officers, including the chief financial officer and controller or principal accounting officer. The issuer will be required to report immediately any change in or waiver of the code of ethics. (Section 406)

Audit Committee Financial Expert. Not more than 180 days after the enactment of the bill, the Commission is required to adopt rules requiring issuers to disclose whether or not (and if not, the reasons why not) the issuer’s audit committee includes at least one member who is a "financial expert." The Commission is directed to define the term "financial expert" and in defining the term is directed to consider whether the person has, through education and experience, an understanding of generally accepted accounting principles and financial statements, experience in the preparation or auditing of financial statements of generally comparable issuers, experience in applying such principles in connection with accounting for estimates, accruals and reserves, experience with internal accounting controls and an understanding for audit committee functions. (Section 407)

Trading During Blackout Periods

Trading Prohibited. Beginning 180 days after the enactment of the bill, except to the extent otherwise provided in rules adopted by the Commission, it shall be unlawful for any director or executive officer of an issuer to purchase, sell, or otherwise acquire or transfer any equity security of the issuer during a blackout period with respect to that security if the director or officer acquires such equity security in connection with his or her service or employment as a director or officer. (Section 306)

Blackout Period Defined. Blackout period means a period of more than three consecutive business days during which the ability of not fewer than 50 percent of the participants or beneficiaries under all individual account plans maintained by the issuer to purchase, sell or otherwise acquire or transfer an interest in any equity of such issuer held in such account is suspended by the issuer or by a fiduciary of the plan. It does not include, under rules to be adopted by the Commission, regularly scheduled periods in which the participants may not trade if such period is included in the plan and timely disclosed to employees. (Section 306)

Notice Required. If any director or executive officer is subject to the requirements of this provision in connection with a blackout period, the issuer is required to timely notify such directors and officers and the Commission of such blackout period. (Section 306)

ERISA Provisions. Extensive corresponding changes to ERISA pertaining to required notices to plan participants are also adopted in the bill. (Section 306)

Responsibility of Attorneys

Within 180 days after the enactment of the bill, the Commission is required to adopt rules requiring attorneys representing issuers concerning securities matters to

1. report evidence of a material violation of securities law or breach of fiduciary duty by the company or an agent thereof to the chief legal counsel or the chief executive officer of the issuer and
2. if the counsel or officer does not appropriately respond to the evidence, report the evidence to the audit committee, another committee composed solely of directors not employed by the issuer or to the board of directors.

(Section 307)

Provisions Requiring Attention within the Next 270 Days

Additional Audit Committee Requirements. Not more than 270 days after enactment of the bill, the Commission shall require the national securities exchanges and Nasdaq to prohibit the listing of any security of an issuer that does not comply with the following requirements:

1. The audit committee shall be directly responsible for the appointment, compensation and oversight of any registered public accounting firm employed by the issuer, including the resolution of any disagreements between management and the auditor regarding financial reporting.
2. Each member of the audit committee shall be independent. In order to be independent, the member may not, except as a member of the audit committee, the board or another board committee, accept any consulting, advisory or other compensatory fee from the issuer or be an affiliated person of the issuer or any subsidiary of the issuer.
3. The audit committee shall establish procedures for (a) the receipt and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters and (b) the confidential anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.
4. The audit committee shall have the authority to engage independent counsel and other advisers as it determines necessary.
5. The issuer shall provide for appropriate funding, as determined by the audit committee, for the payment of compensation to the registered public accounting firm employed by the issuer for the purpose of issuing an audit report and to any advisers employed by the committee.

(Section 301)

Provision Requiring Attention Before Next Audit

Rotation of Audit Partners. The bill prohibits a registered public accounting firm from providing audit services to an issuer if the lead or coordinating audit partner (having primary responsibility for the audit) or the audit partner responsible for reviewing the audit has performed audit services for that issuer in each of the five previous fiscal years of that issuer. Note that the provision focuses on the person and not the firm, so the partner’s change in firms does not affect the five year period. This requirement will be applicable with respect to the next audit of the issuer’s financial statements. (Section 203)

Cooling Off Period. The bill also prohibits a registered public accounting firm from providing audit services to an issuer if the chief executive officer, controller, chief financial officer, chief accounting officer or any person serving in an equivalent position for the issuer was employed by that registered public accounting 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. This requirement will be applicable with respect to the next audit of the issuer’s financial statements. (Section 206)

Assessment of Internal Controls. The Commission is required to adopt rules requiring each annual report on Form 10-K to contain a report (a) stating the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting and (b) containing an assessment, as of the end of the most recent fiscal year, of the effectiveness of the internal controls and procedures. The issuer’s auditors will be required to attest to and report on this assessment made by management. (Section 404)

Provision Requiring Attention Next Year

Registration of Accountants

Public Company Accounting Oversight Board. The bill establishes a new public company accounting oversight board. The Board will have extensive authority to oversee public company accountants. The board is required to be set up within 270 days after the enactment of the bill. (Section 101)

Registered Public Accounting Firms. The bill provides for the registration of public accounting firms. 180 days after the Commission determines that the Board is ready to commence operation, only accounting firms registered with the Board will be permitted to prepare or issue, or participate in the preparation or issuance of, audit reports for any issuer. (Section 102)

Non-Audit Services

Prohibition of Non-Audit Services. Except as provided below, beginning 180 days after the Board commences operation, the bill prohibits any registered public accounting firm that performs any audit of an issuer required by the Securities Exchange Act (principally the audit of annual financial statements) from providing contemporaneously with the audit to that issuer any non-audit service, including: (i) bookkeeping or other services related to the accounting records or financial statements of the audit client, (ii) financial information systems design and implementation, (iii) appraisal or valuation services, fairness opinions or contribution-in-kind reports, (iv) actuarial services, (v) internal audit outsourcing services, (vi) management functions or human resources, (vii) broker-dealer, investment adviser or investment banking services, (viii) legal services and other "expert services unrelated to audit" and (ix) any other service that the Board determines, by regulation, is impermissible. (Section 201)

Non-Audit Services Permitted with Pre-Approval. A registered public accounting firm may provide any non-audit service, expressly including tax services, not listed in (i) through (ix) above for an audit client if the activity is approved in advance by the audit committee of the issuer.

Pre-Approval of Audit and Non-Audit Services. All auditing services (which may include comfort letters in connection with securities underwriting) and non-audit services provided to an issuer by the auditor of the issuer must be pre-approved by the audit committee. The audit committee is permitted to delegate such approval to one or more of its members. Any pre-approval given pursuant to this delegated authority must be reported to the full audit committee at its next meeting. (Section 202)

Disclosure of Pre-Approval. Any pre-approval of non-audit services must be disclosed in the issuer’s periodic reports. (Section 202)

Other Provisions

Enhanced SEC Review. The Commission is directed to establish a system of periodic review of issuers’ periodic reports, including financial statements. All issuers will be required to be reviewed at least once every three years. (Section 408)

Improper Influence on Conduct of Audit. Within 270 days after the enactment of the bill, the Commission is required to adopt rules prohibiting officers and directors of issuers and persons acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent auditor engaged in the performance of an audit of the issuer’s financial statements for the purpose of rendering such financial statements materially misleading. (Section 303)

Forfeiture by CEO and CFO. If an issuer is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement, the chief executive officer and the chief financial officer are required to return to the issuer (a) any bonus or other incentive-based or equity-based compensation received during the 12-month period following the first public issuance or filing with the Commission of the financial document embodying such financial reporting requirement and (b) any profits realized from the sale of securities of the issuer during that 12-month period. (Section 304)

Document Destruction or Alteration. Substantial new criminal penalties are enacted for destroying or altering records or documents with the intent to impede an investigation by any U.S. government agency. Also, the Commission is required to adopt within 180 days new rules concerning the retention of documents created, sent or received in connection with an audit, and criminal penalties are adopted for knowing and willful violation of these rules. (Section 802 and Section 1102)

Statute of Limitations Extended. For proceedings commenced after enactment of the bill, the statue of limitations for bringing actions alleging securities fraud is extended to the earlier of two years after discovery of the facts constituting the violation or five years after such violation. (Section 804)