This is “Appendix A: Sarbanes-Oxley and Other Recent Reforms”, appendix 1 from the book Governing Corporations (v. 1.0).
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The Sarbanes-Oxley Act of 2002 imposes significant new disclosure and corporate governance requirements for public companies and also provides for substantially increased liability under the federal securities laws for public companies and their executives and directors. After it was adopted, the NYSE, NASDAQ, and AMEX adopted more comprehensive reporting requirements for listed companies, and the Securities and Exchange Commission (SEC) issued a host of new regulations aimed a strengthening transparency and accountability through more timely and accurate disclosure of information about corporate performance.
The most important changes concern director independence, the composition and responsibilities of the audit, nominating and compensation committees, shareholder approval of equity compensation plans, codes of ethics or conduct, the certification of financial statements by executives, payments to directors and officers of the corporation, the creation of an independent accounting oversight board, and the disclosure of internal controls.
New stock exchange listing requirements stipulate that the majority of directors of public companies be “independent.”An exception is made for “controlled companies”—those for which more than 50% of the voting power is held by an individual, a group, or other company. The rules further state, “No director will qualify as independent unless the board affirmatively determines that the director has no material relationship with the listed company” and require companies to disclose determinations of independence in its annual proxy statement or, if the company does not file an annual proxy statement, in the company’s annual report on Form 10-K filed with the SEC.
The rationale for increasing independence was that shareholders, by virtue of their inability to directly monitor management behavior, rely on the board of directors to perform critical monitoring activities and that the board’s monitoring potential is reduced, or perhaps eliminated, when management itself effectively controls the actions of the board. Additionally, outside directors may lack independence through various affiliations with the company and may be inclined to support management’s decisions in hopes of retaining their relationship with the firm. Requiring a board to have a majority of independent directors therefore increases the quality of board oversight and lessens the possibility of damaging conflicts of interest.
Rule 10A-3 under the Exchange Act directs the stock exchanges and NASDAQ to require listed companies to have an audit committee composed entirely of independent directors. Subsequent stock exchange and SEC amendments further strengthened this provision by requiring the following, among other things:
At least one member of the audit committee is a “financial expert,” defined as someone who has
The reasons behind these reforms are self-evident. Audit committees are in the best position within the company to identify and act in instances where top management may seek to misrepresent reported financial results. An audit committee composed entirely of outside independent directors can provide independent recommendations to the company’s board of directors. The responsibilities of the audit committee include review of the internal audit department, review of the annual audit plan, review of the annual reports and the results of the audit, selection and appointment of external auditors, and review of the internal accounting controls and safeguard of corporate assets.
New NYSE and SEC rules require that
These reforms respond to the unprecedented growth in compensation for top executives and a dramatic increase in the ratio between the compensation of executives and their employees over the last 2 decades. A reasonable and fair compensation system for executives and employees is fundamental to the creation of long-term corporate value. The responsibility of the compensation committee is to evaluate and recommend the compensation of the firm’s top executive officers, including the CEO. To fulfill this responsibility objectively, it is necessary that the compensation committee be composed entirely of outside independent directors.
New NYSE and SEC rules stipulate that
Nominating new board members is one of the board’s most important functions. It is the responsibility of the nominating committee to nominate individuals to serve on the company’s board of directors. Placing this responsibility in the hands of an independent nominating committee increases the likelihood that chosen individuals will be more willing to act as advocates for the shareholders and other stakeholders and be less beholden to management.
An equity-compensation planA plan or other arrangement that provides for the delivery of equity securities, including options, of the listed company to any service provider as compensation for services. is a plan or other arrangement that provides for the delivery of equity securities (including options) of the listed company to any service provider as compensation for services. Equity-compensation plans can help align shareholder and management interests, and equity-based awards are often very important components of employee compensation. New NYSE and SEC rules require shareholder approval for stock option plans or other equity compensation plans and any material modification of such plans. These rules are subject to a significant number of exemptions, however. Separately, new accounting rules have changed the accounting of stock options.For more on this subject, see Chapter 8 "CEO Performance Evaluation and Executive Compensation" in this volume.
New rules also require that public companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees; include its code of business conduct and ethics on its Web site; and each annual report filed with the SEC must state that the code of business conduct and ethics is available on the Web site. The code of conduct must comply with the definition of a “code of ethics” set forth in section 406 of Sarbanes-Oxley and provide for an enforcement mechanism that ensures prompt and consistent enforcement of the code, protection for persons reporting questionable behavior, clear and objective standards for compliance, and a fair process by which to determine violations.
Sarbanes-Oxley requires the following:
The principal executive officer and principal financial officer of the company must certify in each annual and quarterly report that
Any CEO or CFO who provides the certification knowing that the report does not meet the above-listed standards can be fined up to $1 million, imprisoned for up to 10 years, or both.
Sarbanes-Oxley and subsequent SEC directives stipulate that
The Public Company Accounting Oversight Board (PCAOB)A private-sector, nonprofit corporation created by Sarbanes-Oxley to oversee accounting professionals who provide independent audit reports for publicly traded companies. is a private-sector, nonprofit corporation created by Sarbanes-Oxley to oversee accounting professionals who provide independent audit reports for publicly traded companies. Its responsibilities include
When Congress created the PCAOB, it gave the SEC the authority to oversee the PCAOB’s operations, to appoint or remove members, to approve the PCAOB’s budget and rules, and to entertain appeals of PCAOB inspection reports and disciplinary actions.
As directed by section 404 of Sarbanes-Oxley, the SEC adopted a rule requiring registered companies to include in their annual reports a report of management on the company’s internal control over financial reporting. The internal control reportA rule within Sarbanes-Oxley that requires registered companies to include in their annual reports a report on the company’s internal control over financial reporting. must include