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Sarbanes-Oxley Bill
Executive Board of Director & Compliance Impacts

From the NACD
Director Summary…
House and Senate: Sarbanes-Oxley Bill

After months of parallel activity in response to major corporate failures-from the Enron bankruptcy to more recent catastrophes-the stars are aligning for change. The House, the Senate, and the White House have recently completed major initiatives in corporate reform, while the NASDAQ Stock Exchange and the New York Stock Exchange have submitted new listing requirements to a newly strengthened Securities and Exchange Commission. The following summarizes key facts of the House and Senate July 25: Sarbanes-Oxley Bill.

On July 30, 2002, President Bush signed into law The Public Accounting Reform and Investor Protection Act-technically, H.R. 3763ENR, known as the Sarbanes-Oxley bill after its sponsors Sen. Paul Sarbanes (D-MD) and Rep. Michael Oxley (R-OH). The new law has been hailed as a landmark comparable to the securities and securities exchange acts that created the SEC. The time frame for these new requirements is less than 10 months - 270 days from the effective date of the bill, which was July 30th.

With nearly a dozen sections and more than 80 subsections, the legislation covers many topics-from analyst conflicts of interests to document shredding. Among other goals, the law creates a publicly funded oversight board to monitor auditors, strengthens auditor independence in other ways, increases CEO accountability for financial statements, increases criminal penalties for fraud, makes CEOs and CFOs sign off on financials, eases private securities litigation, and gives the SEC more resources and authority to enforce securities laws. The new law exacts new penalties for fraud: disbarring of directors and officers found guilty of fraud, longer prison sentences for certain types of white-collar crime, and return of ill-gotten gains to benefit defrauded shareholders.

The biggest impacts for board of directors, however, will come from provisions which require greater board member independence, including the need to establish both a Nominating/Corporate Governance Committee and a Compensation Committee where committee board members must be independent. In addition, this new legislation will significantly set new powers for the audit committees. The legislation requires:

1.New standards for auditor independence, banning nine types of consulting services that auditors have been able to provide in the past, namely:

• Bookkeeping or other services related to the accounting records or financial statements of the audit client
• Financial information systems design and implementation
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
• Actuarial services
• Management functions or human resources
• Broker or dealer, investment adviser, or investment banking services
• Legal services and expert services unrelated to the audit, and
• Any other service that the [new oversight] board determines, by regulation, is impermissible.

Impact = New oversight challenge: Companies will now need to seek new vendors for non-audit services, and directors will need to monitor this transfer carefully.

2. That the SEC mandate stock exchange listing requiring committee disclosure of the presence or absence of at least one member who is a "financial expert," defined as a person with understanding of generally accepted accounting principles and financial statements, experience in the preparation or auditing of financial statements of generally comparable issuers and the application of such principles in connection with the accounting for estimates, accruals, and reserves, experience with internal accounting controls, and an understanding of audit committee functions.

Impact = More recruitment work: Audit committees that do not have such an expert will be striving to recruit one in an environment where many other companies are attempting to do so at the same time. Due to the high demand and the need to comply with board of director independence, it is likely that arms length search and recruiting conducted by an outside search firm will be the search norm for all new board membership.

3. A new section of the annual report on internal control, describing the responsibility of management for the internal audit function and assessing its effectiveness.

Impact = Better understanding of internal audit: This will make clear the vital role that internal control plays in governance.

4. That auditors give reports to the audit committee on all critical accounting policies and practices to be used, as well as reports on the auditors' discussions with management about accounting policies and any material matters.

Impact = Better information, less "hounding": In the past, the burden was on audit committees to obtain the information; now the information is more likely to come to them automatically (though audit committees should still insist on timely delivery).

5. That the SEC prohibit the listing of any company, after giving it a chance to "cure defects" that does not comply with new congressionally imposed listing standards that give the audit committee new powers, such as the exclusive power to appoint the auditor, and new access to funding, such as funds to pay for legal advice.

Impact = More Audit Committee power: Audit committees will have new clout-and the funds to wield it. Audit committees will be under scrutiny as they select advisors. Advice: Boards should use them only when needed, pay them only what is appropriate (not excessively), select only those who are qualified and independent.

Given these new changes and requirements, it is imperative that companies search out new board of director members with the continued goal of excellence in the talent that they seek to provide in corporate leadership and governance. But in addition, there is now an emphasis towards independence in an effort to enhance the integrity of the shareholder position. Finding this talent should not be taken lightly and will likely require outside search firm support to avoid any perceptions of internal influence.

The preceding was an excerpt from the August 2, 2002 Alert Edition of Director's Monthly Extra, reprinted with permission by the NACD.

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