Corporate Governance — Three Things CFO’s and CEO’s Need to Know Now
August 30, 2002
In reaction to growing public outrage over financial scandals and weakening investor confidence, President Bush signed into law on July 30th the Sarbanes-Oxley Act of 2002 (the “Act”), containing perhaps the most sweeping changes to the Federal securities laws since 1934. While the details of several of the Act’s changes will be the subject of regulations which the Securities and Exchange Commission (the “SEC”) has been directed to promulgate, three issues in particular require immediate attention by management of public companies.
1. Certifications and Internal Controls. Effective immediately, all “periodic reports” containing financial statements must include certifications signed by the CEO and CFO that the report fully complies with the requirements of the Securities Exchange Act of 1934 and fairly presents, in all material respects, the financial condition and results of operations of the company. The penalties for willfully or knowingly filing a false certification are severe: fines of up to $5 million and imprisonment of up to 20 years. In addition, the Act directs the SEC to adopt rules not later than August 29, 2002 requiring CEOs and CFOs to file much more extensive certifications in each 10-Q and 10-K that the report is accurate, that the presentation contained in the financial statements is fair, that the signing officers have designed internal controls to ensure that material information is made known to them and that they have reported to the company’s audit committee and its auditors any deficiencies in such controls and any acts of fraud involving management.
Securities lawyers are now grappling with certain ambiguities surrounding these certifications, such as whether they may be qualified as to knowledge, whether they must be filed with Current Reports on Form 8-K and whether they should be filed as an exhibit to the report. What is clear is that CEOs and CFOs will need to develop internal due diligence systems and safeguards to ensure the integrity of the information gathering and reporting process. These procedures should include the establishment of an internal disclosure committee reporting to the CEO and CFO whose efforts should be carefully documented in back-up memoranda and in minutes of any formal meetings.
2. Loans to Officers and Directors. Effective immediately, public companies are prohibited from directly or indirectly making any new extensions of credit, or arranging for the extension of credit, in the form of a personal loan to any executive officer or director. The Act contains exceptions for certain designated loans, such as home improvement loans, consumer credit and margin accounts of broker-dealer employees, if the loan is made in the ordinary course of the company’s business, of a type that is generally made available by the company to the public and made on terms no more favorable than those offered to the general public. Current loans to directors and officers that were outstanding as of July 30 are not affected by the prohibition so long as there is no modification to any material term following such date.
Without further clarification, the loan prohibition would appear to impact many common fringe benefits, such as personal use of corporate credit cards, corporation relocation programs that offer mortgage loans and advancement of litigation expenses under indemnification provisions pending eligibility determination. Accordingly, companies should review all fringe benefit practices and indemnification provisions for officers and directors and discontinue prospectively those that would be considered loans under the Act.
3. Beneficial Ownership Reports. Effective August 29, 2002, officers, directors and 10% stockholders will be required to report changes in beneficial ownership of company stock or derivative securities prior to the end of the second business day following the date the transaction was executed. Previously, insiders generally had until the tenth day of the calendar month following the transaction date in which to file. The SEC is authorized to extend the two-day filing requirement for transactions in which the two-day period is not feasible.
Given the new extraordinarily tight two-day filing deadline, the current standard compliance mechanism of sending out monthly questionnaires will no longer be adequate. At a minimum, companies should send written notices now to its insiders regarding the new requirements and follow these up with periodic reminders. Companies should also consider establishing arrangements with designated brokers to provide electronic reporting to the SEC or real-time notification of transaction orders to the company.
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