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S. System of corporate governance, many public and private bodies, including the U. S. Congress, launched reform efforts. (See Exhibit 1 . ) This note summarizes a few of these initiatives. It focuses on efforts of national significance undertaken during 2002 and 2003. (See Exhibit 2. ) Legislation and Regulations Serbians-Solely Act On July 30, 2002, President George W. Bush signed the Serbians-Solely Act into law. 2 The act was widely viewed as the federal government’s most significant response to the loss of confidence in corporate reporting.
Initially spurred by the collapse of Enron in December 2001 , the bill gained momentum from the World accounting scandal in June 2002, and within a month, it was passed almost unanimously by the U. S. Senate and House of Representatives. The legislation, which applies to U. S. Audit firms and public issuers of securities as well as overseas companies listed on U. S. Exchanges, was intended to protect investors, improve corporate disclosures, discourage fraud, and restore confidence in securities markets. The act established a new accounting oversight board, the Public Company
Accounting Oversight Board (PEPCO), described below, and imposed new requirements on companies, audit committees, and corporate executives, as well as audit firms and corporate lawyers. Under Serbians-Solely, chief executives and chief financial officers are required to certify the accuracy and completeness of their companies’ financial reports. Companies must implement effective internal controls and disclose whether they have adopted a code of ethics for their senior financial officers and, if not, why not.
Executives and directors are banned from trading their company’s stock during pension fund blackout periods (I. . , whenever plan participants’ ability to acquire or transfer interests in the stock is suspended) and, as a rule, may not receive personal loans from their companies. Professor Lynn Sharp Paine and Research Associate Kim Eric Batcher prepared this note from public sources as the basis for class discussion. Research Associate Christopher M. Burner, J. D. , assisted in preparing Exhibit 3 of the note.
Copyright 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 2163, or go to http://www. Hobs. Harvard. Deed. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means??electronic, mechanical, photocopying, recording, or otherwise??without the permission of Harvard Business School.
This document is authorized for use only by Gang Penn in Burns 4211 Corporate Finance taught by Burns OHIO STATE UNIVERSITY from August 2014 to December 2014. 304-091 The act increases criminal penalties for securities fraud to as much as 25 years in prison. It also extends the statute of limitations in securities fraud cases to five years, or two years from the time of discovery, and introduces a new felony for shredding documents or otherwise impeding a federal investigation into fraud. Whistle-blower” employees??those who report their concerns about financial misconduct to company or federal authorities??are granted protections against their employers. Several of Serbians-Solely requirements apply to auditors and board-level audit committees. The act prohibits accounting firms from offering certain types of intonation services such as consulting, requires the rotation of lead and reviewing audit partners every five years, erects auditors to report to audit committees instead of management, and restricts membership on audit committees to independent directors. See Exhibit 3 for summary of key provisions. ) Securities and Exchange Commission (SEC) Congress directed the SEC to develop detailed rules to implement various provisions of the Serbians-Solely Act. As of 2003, the SEC had adopted rules in the following areas, as well as others:3 Certification of periodic reports Disclosure of off-balance-sheet transactions Reconciliation of pro formal earnings releases to generally accepted accounting principles (GAP)
Accelerated disclosure of insider trades Disclosure of whether a code of ethics for executive officers is in place Disclosure of whether a financial expert sits on the audit committee Auditor independence Reporting by securities lawyers of evidence of fraud Public Company Accounting Oversight Board (PEPCO) On April 25, 2003, the SEC endorsed the PEPCO, a new private-sector, nonprofit corporation mandated by the Serbians-Solely Act and funded by public companies. 4 The five-member PEPCO is entrusted with overseeing the audits and auditors of public companies.
Audit rims must register with the board, which is empowered to inspect the larger firms annually and to impose discipline on firms that violate securities laws, auditing standards, and professional conduct standards. In October 2003, the board proposed a new standard for auditing public companies’ internal controls over financial reporting. Auditors must report any significant deficiencies or material weaknesses they find to the company’s audit committee and inform management of all internal control deficiencies.
They must also assess whether a company’s audit committee is effective and independent. The PEPCO has approved the registration of more than 600 accounting firms and proposed rules for inspecting and investigating non-U. S. Accounting firms. 2 New York Stock Exchange (NYSE) and Nasdaq In June 2002, the New York Stock Exchange and the Nasdaq Stock Market proposed new corporate governance standards for listed companies. Approved by the SEC on November 4, 2003,5 these standards apply to all U. S. Impasses listed on these exchanges and require non-U. S. Companies to disclose any differences between their governance practices and the standards required of U. S. Companies. The NYSE and Nasdaq rules, which agree substantially in their main points, were slated to go into effect during 2004. The new standards established strict criteria for director independence beyond the requirements of Serbians-Solely. The NYSE rules require that boards comprise a majority of independent directors and convene regular sessions without management present.
Companies must also have an audit committee with at least three members who are independent and financially literate, as well as independent nominating and compensation committees. In addition, the new standards require companies to have a code of conduct for directors, officers, and employees and call for continuing education for directors. Separately, a committee of the NYSE reviewed governance practices of the stock exchange itself, issuing a report in June 2003. Subsequent outrage over then-chairman Richard A. Grass’s compensation package??totaling $187. Million in deferred pay and retirement benefits?? led to a further governance proposal, approved by the SEC in December. This proposal created a smaller board of directors, wholly independent except for the CEO and chairman; created an advisory board of executives representing the Nose’s constituents; separated he Nose’s regulatory and marketplace functions; and increased disclosures. Law Enforcement The SEC stepped up its enforcement activities in 2002 and 2003, initiating 678 civil enforcement actions in PAYOFF, up from 484 in PAYOFF and 598 in PAYOFF. The agency was investigating about 2,200 cases as of October 2003. Between 2001 and 2003, the agency also increased the number of large companies under investigation for misconduct such as fraud and improper accounting, failing to make adequate disclosures, inflating earnings, and making low-interest loans to executives. The largest targets in 2001 were Waste Management, Sunbeam, and their auditor Arthur Andersen. Major enforcement actions in 2002 involved Enron, World, Tycoon, Delphic, Dyne, Rite Aid, Xerox, and/or their executives.
In 2003, the SEC also brought actions against Healthiness, Sweet, KEMP, Putnam Investment Management, and Martha Stewart on various charges, including fraud, self-dealing, and insider trading. In April 2003, 10 of the largest investment banks agreed to pay $1. 4 billion to settle SEC enforcement actions concerning analysts’ conflicts of interest. Department of Justice The Justice Department, including the FBI and the Criminal Division, stepped up its enforcement of federal antiradar laws in conjunction with the SEC and the interagency Corporate Fraud Task Force, created by President Bush in July 2002.
During the task force’s first year, federal prosecutors investigated over 500 individuals and companies, charged 354 defendants with corporate fraud, and 3 obtained convictions or guilty pleas from 25 Coos. 7 The department and the task force put new emphasis on coordination among enforcement agencies. They also started promoting a “real-time” approach to enforcement, which reduced from years to months the time between commencement of an investigation and the bringing of charges.
Companies (or their executives) facing criminal charges as of early 2004 included Enron, World, Tycoon, Delphic, Rite Aid, Healthiness, and Sweet. Federal Sentencing Guidelines In October 2003 an advisory group of the U. S. Sentencing Commission recommended modifications to the organizational sentencing guidelines, a set of parameters used by Judges to sentence corporations or other organizations convicted of fraud, environmental crimes, ax offenses, or other criminal acts. Under the guidelines, originally promulgated in 1991 , organizations with preexisting compliance programs could receive fines mitigated by as much as 95%. To qualify for a reduced fine, companies had to show that they had an effective compliance program meeting seven criteria: defined standards and procedures capable of reducing criminal activity, high-level oversight, due care in delegating authority, effective communication, steps to achieve compliance, consistent enforcement, and steps to respond to violations and prevent further offenses.
The 2003 modifications spelled out some of these provisions more clearly and added a few new ones. Under the 2003 proposals, which were subsequently adopted, companies are required to promote a culture oriented toward ethics and compliance, assign responsibility for compliance to specific high-level personnel, train all employees in company standards and procedures, perform ongoing risk assessments, monitor and audit their compliance programs, and provide an anonymous reporting system.
New York Attorney General In New York, State Attorney General Eliot Sprites initiated a series of investigations into the financial industry. Among his principal targets were pervasive conflicts of interest involving research analysts at investment banks. 9 Based on e-mail evidence that analysts privately lacked confidence in stocks they were recommending to the public, Sprites filed a complaint against Merrill Lynch and applied public pressure until the company settled the matter, paying a $100 million fine.
This settlement prompted a Joint investigation into investment banks by the SEC, the NYSE, and the National Association of Securities Dealers (NASA) (with Splitter’s cooperation), which resulted in the $1. 4 billion settlement mentioned earlier. The banks were required by the settlement to separate their investment and research activities and to provide independent research to investors. At Splitter’s insistence, they were also banned from the practice of “spinning,” by which banks handling initial public offerings gave attractive stock allocations to executives of corporate clients.
In autumn of 2003, the attorney general exposed abuses at mutual fund companies that had allowed traders to engage in “late trading” and “market timing” to take advantage of share prices that were unavailable to other investors. Putnam Investments, Bank of America, Strong Capital Management, and there were implicated. While this controversy continued, Sprites went on in early 2004, accompanied by the SEC, to investigate former NYSE chairman Dick Grass’s lavish compensation. Professional and Business Associations American Bar Association (ABA) In August 2003, the American Bar Association adopted a set of corporate governance practices to strengthen the roles of lawyers, directors, and executives in promoting responsible corporate behavior. 10 The ABA stressed the need for regular meetings and lines of communication between general counsel and committees of independent directors, as well as between outside and inside counsel, to issues potential violations of law by companies or their officers.
Such communication was intended to enable lawyers and general counsel to report their concerns to higher authorities without disrupting their relationships with executive officers. American Institute of Certified Public Accountants (CPA) The CPA, the largest body representing the U. S. Accounting profession, presented a draft of new auditing standards in March 2003. 11 The standards instruct auditors on how to evaluate companies’ internal control systems, including their antiradar programs and procedures for selfsameness by management.
Because the Serbians-Solely Act assigned authority for standards setting to the PEPCO, the CPA proffered its own standards in the form of guidance for the institute’s members, as well as a reference for the SEC to consider in developing its final rule on assessment of internal controls. Earlier, in March 2002, before the enactment of Serbians-Solely, the CPA had backed the creation of a new regulatory body to oversee auditors. Business Roundtable The Business Roundtable, an association of Coos, issued its revised “Principles of Corporate Governance” in May 2002. 12 In this document it advocated the following best practices:
Shareholder approval of stock options Publication by companies of corporate governance principles Mechanisms for employees to report wrongdoing without retribution Board committees for audit, corporate governance, and compensation, with only independent directors Substantial majority of independent directors on boards Prompt disclosure Management incentives linked to shareholders’ long-term interests Audit committee responsible for selection and tenure of outside auditors Conference Board The Conference Board, a nonprofit organization that conducts business research, sponsored the formation of a blue-ribbon Commission on
Public Trust and Private Enterprise, which issued 5 recommendations on executive compensation, corporate governance, and audit and accounting issues in late 2002 and early 2003. 13 The multistory commission included Arthur Levity, Jar. , former chairman of the SEC; John Boggle, founder of the Vanguard Group; Paul Blocker, former chairman of the Federal Reserve System; Andy Grove, chairman of Intel Corporation; Ralph Larsen, former CEO of Johnson & Johnson; and other experts from the public and private sectors and academia. Executive compensation, the commission proposed, should