The Sarbanes-Oxley Act, or SOA, requires audit committees to be directly responsible for the appointment (subject to shareholder approval), compensation and oversight of the registered public accounting firm, including the resolution of disagreements between management and the auditor regarding financial reporting. The auditors are now required to report directly to the audit committee. Members of the audit committee must be truly independent, subject to an exemption, if granted, by the SEC. If the audit committee does not include a financial expert, this fact must be disclosed. Audit committees are now required to adopt written procedures to receive and address complaints regarding accounting, internal controls and auditing issues, including procedures to maintain the confidentiality of the whistle blower.

A key SOA requirement is to provide the audit committee with the authority and funding to engage independent counsel and other advisors as determined by the audit committee. It is now common practice for the independent directors of a mutual fund to retain independent counsel who is paid by the fund. In the analogous mutual fund context, the SEC staff has stated that the independent directors are well served by the assistance of legal counsel who is truly independent of management and the outside law firm to the corporation. Independent counsel should disclose all actual or potential conflicts of interest and furnish an undertaking to the audit committee to provide it with any potential conflicts of interest as they arise. The use of truly independent counsel is also a factor looked upon favorably by the courts and may help to shield independent directors who are members of the audit committee as well as management. Speech by SEC staff. “Awarding Complacency, Advocating Reform: The Commission’s Independent Fund Directors Initiative.” Paul Roye, 1999 WL 985310 (SEC). Independent counsel is a tool that can benefit the audit committee by assisting them in marshaling arguments to balance those presented by management in matters involving actual or apparent conflicts of interest. Independent counsel will also assist the audit committee to evaluate issues with an independent and critical eye; e.g., on the key assumptions underlying the financial statements to be included in the MD&A section of filings with the SEC. Independent counsel can also be invaluable in assisting the members of the audit committee in obtaining the information they need to fulfill their legal duties.

Independent directors who are members of the audit committee of a public company now have much more power, with the commensurate responsibilities, than the independent directors of a mutual fund. Thus, members of the audit committee, with their own independent counsel, are in an even better position to ask the hard questions and obtain disinterested legal advice.

Indirectly, the SOA has further strengthened the audit committee by making it unlawful for any corporate officer or director or person acting under their direction to fraudulently influence, coerce, manipulate or mislead any accountant engaged in preparing an audit, for the purpose of rendering the audit report materially misleading. There should be significant litigation on what is “fraudulently” induced, coerced, manipulated or misled. First, the resolution of certain accounting issues require judgment calls, such as estimates of items that could or actually do impact significantly on the presentation of the financial statements. Second, under the 1995 Reform Act, violations of GAAP standing alone, are insufficient to establish a violation of the anti-fraud provisions of Section 10b-5 of the Exchange Act. Third, do you need the type of additional facts such as proving opportunity and motive to establish “fraudulently” induced or misled under Section 10b-5.

New issuer and management disclosure requirements

In an effort to improve disclosure of financial information, the SOA requires that the financial statements disclose any material adjustment under GAAP identified by the outside auditor. Quarterly and annual reports will be required to disclose all material off-balance sheet transactions, arrangements, obligations and other relationships of the company with unconsolidated entities or other persons that may have an effect on the company’s financial condition, changes in financial condition, results of operations, liquidity, capital expenditures and/or resources, or a significant component of revenues or earnings. The SOA has directed the SEC to adopt rules providing for reconciliation of pro forma data and financial data prepared in accordance with GAAP.

The company’s annual report filed with the SEC must be accompanied by a statement of management that management is responsible for creating and maintaining adequate internal controls. The statement must set forth management’s assessment of the effectiveness of these controls. The company’s auditor must report on and attest to management’s assessment of the effectiveness of the internal controls, which is now considered to be a core responsibility of the auditor and an integral part of the audit report.

The SOA requires a company to disclose, whether or not it has adopted a code of ethics for its senior financial officers, and if not, why. The SOA sets forth three general principles: (i) honest and ethical conduct, including the ethical resolution of actual or apparent conflicts of interest between personal and professional relationships; (ii) full, fair, accurate, timely and understandable disclosure in SEC filings; and (iii) compliance with applicable governmental rules and regulations.

Commentators have indicated that the SOA is the most significant securities legislation since 1940. When the SOA is coupled with new Section 10A of the Exchange Act of 1934 and the SEC release on disclosure of and extensive discussion of the material estimates and assumptions underlying the company’s financial statements, the rules and working environment of the financial professionals and the persons advising these persons have become much more complicated and intense. There will be numerous legal issues and internal policy considerations relating to the implementations of these provisions of the SOA.

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.