The Sarbanes-Oxley Act of 2002

Wednesday, July 31, 2002

H.R.3763 - The Sarbanes-Oxley Act of 2002

A lot has been made, perhaps without justification, of the July 30, 2002 passage of H.R. 3763, The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley" or The Act). Having read the Act, I suspect that the great praise is unfounded. I intend to address three issues presented within the act. First, I will address stock options as considered (or neglected, as the case may be) by Sarbanes-Oxley. Second, I will address the creation of a Commission designed to oversee audits and corporate accounting practices, and the potential efficacy of this Commission. Finally, I will address the modifications to the Federal Sentencing Guidelines as it relates to corporate fraud.

The failure to directly address accounting practices as they relate to stock options and other corporate incentives in Sarbanes-Oxley indicates the flaw in Federal regulation of corporate practices.

Sarbanes-Oxley was designed to address the fraudulent accounting practices undertaken by the accountants for Enron and WorldCom. One of the biggest problems with regard to the accounting used in preparation of financial statements by corporations has been the issue of non-salary executive compensation. Corporations, as part of a combined incentive and retention program, often offer executives stock options and enhanced performance pay. The key debate, with regard to accounting practices, has been how these incentives should be depicted on annual and quarterly corporate financial reports.

The position of the Internal Revenue Service has been that corporations, in order to fairly obtain the tax benefits often garnered on corporations based on their compensation plans, should list these compensation plans (options, in particular) as expenses on their financial reports. See Simon Kennedy and Brendan Murray, IRS Proposes Stock Options be Expensed for Some U.S. Affiliates, Bloomberg News Wire Service(Jul. 26, 2002). If corporations were to expense executive compensation plans, this would reduce their overall profits. However, there are those, including the celebrated and successful CEO of Berkshire Hathaway, Warren Buffett, who argue that this reduced profit figure is a more accurate reflection of a corporation's performance. See Warren E. Buffett, Who Really Cooks the Books, NY Times (Jul. 24, 2002). "When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don't belong in the earnings statement, where in the world do they belong?" Id.

Sarbanes-Oxley only indirectly addresses the problem of the inclusion of executive compensation in financial statements. Title I, Section 108 of the Act requires audits to follow generally accepted accounting practices for the preparation of corporate financial statements. It makes no judgment as to the treatment of options by corporate auditors. This leaves it to the newly created Oversight Board to determine what standards are acceptable in the treatment of options. As noted by Mr. Buffett, supra, this leaves open the loopholes created by the 1994 Securities Act. There is no requirement that corporations accurately reflect executive compensation as an expense on their financial reports. Thus, it is still possible that earnings statements by corporations remain 3-5% higher than actual corporate earnings, even with the enactment of Sarbanes-Oxley. This can become problematic, as shareholders will not have accurate information upon which they can act to ensure accountability in their Boards of Directors. C.f., In re Walt Disney Co. Derivative Litigation (where shareholders challenged compensation programs awarding astounding amounts of money to Michael Ovitz as part of a "golden parachute").

The creation of the new Oversight Board fails to directly address the true problems of recent corporate fraud: direct accountability of corporate boards to their shareholders.

Section 101 of the Act establishes the Public Company Accounting Oversight Board (PCAOB... why can't they pick acronyms that are pronounceable?). PCAOB will then adopt policies and create an annual report that will be submitted to the SEC, which will, in turn, submit that report to the Senate Committee on Banking, Housing, and Urban Affairs (which should be a committee addressing torrid relationships in Chicago). Basically, the PCAOB will act as an ethics advisory committee (in New Jersey, the closest equivalent is the Supreme Court Committee on Attorney Ethics) for those accountants that engage in audits of public companies. The Board will be able to punish accountants that engage in misconduct during public audits. The Board will (and I think this is most important and troubling) set the standard used in accounting practices. In other words, the Board decides what is an appropriate accounting formula.

The first problem with the Board is simple. Yes, the Board will be able to punish "bad" accountants. Here's a simple rhetorical question: were we not able to punish "bad" accountants in the past? Of course not. Fraud has been punishable going all the way back to early British common law. Why do we need a new administrative body to punish people for fraud? Is this not the purpose of the SEC and the Department of Justice? If the old agencies - SEC and DOJ - were either unwilling or unable to punish accountants and corporate officers adequately for fraudulent conduct, the sole result should have been a modification of the sentencing guidelines (which was made in

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