Sarbanes-Oxley May Apply To Your Company After All

Photo of Bill Glahn
Wilbur A. Glahn, III
Director, Litigation Department
January 1, 2002

The corporate fraud legislation signed into law July 30, 2002, and known as the “Sarbanes-Oxley Act of 2002,” addresses systemic and structural weaknesses affecting the U.S. capital markets revealed by scandals such as Enron and WorldCom. The law “federalizes” the accounting industry, establishing an independent accounting board to oversee the audit of public companies, providing standards for audit, quality control, and ethics.

The provisions in the Act apply primarily only to public companies registering their stock with the SEC. As a result, Sarbanes-Oxley appears to have little, if any, applicability to private corporations. The Act may, however, have unintended consequences that will reverberate in corporate law for years to come and may establish more stringent standards of care for all corporate officers and directors, whether in public or private companies.

In New Hampshire, directors and officers are held to the standard of care that “an ordinarily prudent person in a like position would exercise under similar circumstances.” If acting in “good faith,” and in “the best interests of the corporation” under that standard, officers and directors are not liable to shareholders or third parties for their actions and are entitled to rely on “information, opinions, reports or . . . financial statements” prepared by employees, lawyers, accountants or committees.

Sarbanes-Oxley does not directly “federalize” corporate governance rules applicable to directors or officers of non-public companies. The Act recognizes, however, that the standards established by the Act may be applied to private companies by state law or regulation. While the Act disclaims any such attempt to federalize state standards for the accounting industry, it contains no similar disclaimer for its standards of corporate governance. Standards of conduct established by federal legislation often find their way into state statutes and often provide a readily available guideline for courts interpreting common law standards of care or for judging the “care of an ordinarily prudent person.” The officers and directors of private corporations in New Hampshire and elsewhere should therefore study the Act carefully, for although not now directly governing their conduct, it may indirectly do so in the future.

Among the areas of corporate governance for public companies “federalized” by Sarbanes-Oxley are the following:

  1. Control of the Company’s Auditors. The Act includes provisions establishing that the Audit Committee of the Board of Directors or, if no such committee exists, the entire Board, is responsible for the appointment and oversight of the company’s auditors and requires that the auditors report not to the management but directly to the Committee or the Board.
  2. Complaint and Whistleblower Procedures. The Act imposes a requirement that the Audit Committee or Board establish procedures for receiving and addressing complaints regarding accounting or auditing matters and for “confidential anonymous submissions by employees” of the company regarding those matters. It also prohibits public companies from retaliating in any way against whistleblowers who provide information in federal or internal investigations or who assist others filing securities lawsuits against the company, and provides a civil cause of action for those employees.
  3. Certificate of Financial Statements. The Act requires that the SEC develop rules imposing a duty on CEOs and CFOs to review and sign all annual and quarterly reports (including financials) and to certify that: (a) those reports fairly present, in all material respects, the company’s condition and are not misleading; and (b) the signing officers have developed internal controls to ensure that information is made known to them, and have disclosed to the company’s auditors and Board of Directors all deficiencies in controls which could affect the accuracy of the financial data and “any fraud, whether or not material, that involves management or other employees with a significant role in internal controls.” The Act further declares the “sense of the Senate” that the Federal income tax returns of all corporations should be signed by the CEO.
  4. New Professional Responsibilities and Obligations for Lawyers. The Act mandates the development of new rules under which lawyers will be required to (a) report evidence of a “material breach” of securities laws, breach of fiduciary duty or “similar violation by the company or any agent thereof” to the company’s CEO or chief legal counsel, and (b) if no “appropriate response” is taken by management, to report the violation to the board of directors. These rules have the potential to create significant tension between outside counsel and management and to fundamentally change the nature of that relationship.

Once these standards are interpreted and enforced by the courts, prudent professionals will conform their conduct to these rules. Likewise, members of corporate boards will be far more reluctant to rely – as allowed by New Hampshire law – on information received from officers, committees, counsel or accountants without further investigation or direct reports to the board. Finally, corporate officers, mindful of the comments of Senator McCain that “when criminal charges are pursued, it is not necessarily the firm that should be charged but the individuals at the helm of the corporate ship who should be prosecuted,” will demand far more information on corporate finances. While it is too soon to tell how this “federalization” of corporate governance will play out for private companies, corporate officers, directors and counsel should pay close attention to Sarbanes-Oxley and its future development.