The Sarbanes-Oxley Act
The Laws That Govern the Securities Industry
1. Securities Act of 1933
Often referred to as the "truth in securities" law, the
Securities Act of 1933 has two basic
objectives:
Require that investors receive
financial and other significant information concerning securities
being offered for public sale; and
Prohibit deceit,
misrepresentations, and other fraud in the sale of securities.
Purpose of Registration
A
primary means of accomplishing these goals is the disclosure of
important financial information through the registration of
securities.
This information enables investors, not the
government, to make informed judgments about whether to purchase a
company's securities.
While the SEC requires that the information
provided be accurate, it does not guarantee it. Investors who
purchase securities and suffer losses have important recovery
rights if they can prove that there was incomplete or inaccurate
disclosure of important information.
The Registration Process
In general, securities sold in
the U.S. must be registered. The registration forms companies file
provide essential facts while minimizing the burden and expense of
complying with the law. In general, registration forms call for:
A description of the company's properties and business;
A description of the security to be offered for sale;
Information about the management of the company; and
Financial statements certified by independent accountants.
Registration statements and prospectuses become public shortly
after filing with the SEC. If filed by U.S. domestic companies,
the statements are available on the EDGAR database accessible at
www.sec.gov. Registration statements are subject to examination
for compliance with disclosure requirements.
Not all
offerings of securities must be registered with the Commission.
Some exemptions from the registration requirement include:
Private offerings to a limited number of persons or institutions;
Offerings of limited size;
Intrastate offerings;
and
Securities of municipal, state, and federal
governments.
By exempting many small offerings from the
registration process, the SEC seeks to foster capital formation by
lowering the cost of offering securities to the public.
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2. Securities Exchange Act of 1934
With this Act, Congress created the Securities and Exchange
Commission.
The Act empowers the SEC with broad authority over all
aspects of the securities industry.
This includes the power to
register, regulate, and oversee brokerage firms, transfer agents,
and clearing agencies as well as the nation's securities self
regulatory organizations (SROs).
The various stock exchanges, such
as the New York Stock Exchange, and American Stock Exchange are
SROs.
The National Association of Securities Dealers, which
operates the NASDAQ system, is also an SRO.
The Act also
identifies and prohibits certain types of conduct in the markets
and provides the Commission with disciplinary powers over
regulated entities and persons associated with them.
The
Act also empowers the SEC to require periodic reporting of
information by companies with publicly traded securities.
Corporate Reporting
Companies with
more than $10 million in assets whose securities are held by more
than 500 owners must file annual and other periodic reports. These
reports are available to the public through the SEC's EDGAR
database.
Proxy Solicitations
The Securities Exchange Act also
governs the disclosure in materials used to solicit shareholders'
votes in annual or special meetings held for the election of
directors and the approval of other corporate action.
This
information, contained in proxy materials, must be filed with the
Commission in advance of any solicitation to ensure compliance
with the disclosure rules.
Solicitations, whether by management or
shareholder groups, must disclose all important facts concerning
the issues on which holders are asked to vote.
Tender Offers
The Securities Exchange Act requires
disclosure of important information by anyone seeking to acquire
more than 5 percent of a company's securities by direct purchase
or tender offer.
Such an offer often is extended in an effort to
gain control of the company. As with the proxy rules, this allows
shareholders to make informed decisions on these critical
corporate events.
Insider Trading
The securities laws broadly prohibit
fraudulent activities of any kind in connection with the offer,
purchase, or sale of securities.
These provisions are the basis
for many types of disciplinary actions, including actions against
fraudulent insider trading.
Insider trading is illegal when a
person trades a security while in possession of material nonpublic
information in violation of a duty to withhold the information or
refrain from trading.
Registration of Exchanges, Associations, and Others
The
Act requires a variety of market participants to register with the
Commission, including exchanges, brokers and dealers, transfer
agents, and clearing agencies.
Registration for these
organizations involves filing disclosure documents that are
updated on a regular basis.
The exchanges and the National
Association of Securities Dealers (NASD) are identified as
self-regulatory organizations (SRO).
SROs must create rules that
allow for disciplining members for improper conduct and for
establishing measures to ensure market integrity and investor
protection. SRO proposed rules are published for comment before
final SEC review and approval.
3. Trust Indenture Act of 1939
This Act applies to debt securities such as bonds, debentures,
and notes that are offered for public sale.
Even though such
securities may be registered under the Securities Act, they may
not be offered for sale to the public unless a formal agreement
between the issuer of bonds and the bondholder, known as the trust
indenture, conforms to the standards of this Act.
4. Investment Company Act
of 1940
This Act regulates the
organization of companies, including mutual funds, that engage
primarily in investing, reinvesting, and trading in securities,
and whose own securities are offered to the investing public.
The
regulation is designed to minimize conflicts of inte
rest that
arise in these complex operations.
The Act requires these
companies to disclose their financial condition and investment
policies to investors when stock is initially sold and,
subsequently, on a regular basis.
The focus of this Act is on
disclosure to the investing public of information about the fund
and its investment objectives, as well as on investment company
structure and operations.
It is important to remember that the Act
does not permit the SEC to directly supervise the investment
decisions or activities of these companies or judge the merits of
their investments.
5. Investment Advisers Act
of 1940
This law regulates
investment advisers.
With certain exceptions, this Act requires
that firms or sole practitioners compensated for advising others
about securities investments must register with the SEC and
conform to regulations designed to protect investors.
Since the
Act was amended in 1996, generally only advisers who have at least
$25 million of assets under management or advise a registered
investment company must register with the Commission.
6. Sarbanes-Oxley Act of 2002
On July 30, 2002, President Bush signed into law the
Sarbanes-Oxley Act of 2002, which he characterized as "the most
far reaching reforms of American business practices since the time
of Franklin Delano Roosevelt."
The Act mandated a number of
reforms to enhance corporate responsibility, enhance financial
disclosures and combat corporate and accounting fraud, and created
the "Public Company Accounting Oversight Board," also known as the
PCAOB, to oversee the activities of the auditing profession.
Summary of SEC Actions and SEC Related Provisions Pursuant to the
Sarbanes-Oxley Act of 2002
The
Act established the Public Company Accounting Oversight Board
Section 108(b) - On April 25, 2003, the SEC recognized the
Financial Accounting Standards Board as the accounting standard
setter.
Section 108(d) - On July 25, 2003, the SEC issued a
study on principles-based accounting.
Section 109 - The Act
established an independent funding source for the FASB.
Section 303 - On April 24, 2003, the SEC adopted rules forbidding
the improper influence on outside auditors.
Section 802 -
On January 22, 2003, the SEC adopted rules governing the retention
of audit records by outside auditors
Improving the "Tone at the
Top"
Section 302 - On
August 27, 2002, the SEC adopted rules requiring CEOs and CFOs to
certify financial and other information in their companies'
quarterly and annual reports.
Section 304 - This section
requires management to return bonuses or profits from stock sales
received within 12 months of a restatement resulting from material
non-compliance with financial reporting requirements as a result
of misconduct.
Section 306 - On January 15, 2003, the SEC
adopted rules prohibiting company officers from trading during
pension fund blackout periods.
Section 402 - This section
prohibits companies from making loans to insiders.
Section
403 - On August 27, 2002, the SEC adopted rules that accelerated
deadlines and mandated electronic filing of disclosures of insider
transactions in company stock.
Section 406 - On January 15,
2003, the SEC adopted rules requiring companies to disclose
whether they have a code of ethics for their CEO, CFO and senior
accounting personnel.
Section 401(a) - On
January 22, 2003, the SEC adopted rules requiring disclosure of
all material off-balance sheet transactions.
Section 401(b)
- On January 15, 2003, the SEC adopted Regulation G, governing the
use of non-GAAP financial measures, including disclosure and
reconciliation requirements.
Section 404 - On May 27, 2003,
the SEC adopted rules requiring an annual management report on and
auditor attestation of a company's internal controls over
financial reporting.
Section 408 - This
section requires that the Commission review the Exchange Act
reports of each company no less frequently than once every three
years.
Section 301 - On
April 1, 2003, the SEC adopted rules directing the SROs to adopt
listing standards for audit committees.
Section 407 - On
January 15, 2003, the SEC adopted rules requiring the disclosure
about financial experts on audit committees.
Section 307 -
On January 23, 2003, the SEC adopted rules governing standards of
conduct for attorneys appearing and practicing before the
Commission.
Section 501 - On July 29, 2003, the SEC
approved new SRO rules governing research analyst conflicts of
interest.
Enhancing Enforcement Tools
Section 106 - This
section addresses SEC access to foreign audit workpapers.
Section 305 - This section sets standards for imposing officer and
director bars and penalties.
Section 308 - This section
establishes FAIR Funds for Investors and requires a study of the
same, which the SEC issued on January 24, 2003.
Section 602
- This section addresses the SEC's authority over professionals
who appear and practice before the Commission.
Section 603
- This section grants federal courts the ability to impose penny
stock bars.
Section 703 - On January 24, 2003, the SEC
issued a study on aiding and abetting liability under the federal
securities laws.
Section 704 - On January 24, 2003, the SEC
issued a study of enforcement actions involving violations of
reporting requirements and restatements.
Section 803 - This
section provides that debts are not dischargeable in bankruptcy if
they were incurred as a result of securities fraud.
Section
1103 - This section allows the SEC to temporarily freeze certain
extraordinary payments made to securities law violators.
Section 1105 - This section gives the SEC the authority in
administrative proceedings to prohibit persons from serving as
officers or directors.Management's Report on Internal Control over
Financial Reporting
Management's report on internal control over
financial reporting and certification of disclosure in Exchange
Act periodic reports
Section 404 of the Act
directs the Commission to adopt rules requiring each annual report
of a company, other than a registered investment company, to
contain
(1) a statement of
management's responsibility for establishing and maintaining an
adequate internal control structure and procedures for financial
reporting; and
(2) management's
assessment, as of the end of the company's most recent fiscal
year, of the effectiveness of the company's internal control
structure and procedures for financial reporting.
Section 404 also
requires the company's auditor to attest to, and report on
management's assessment of the effectiveness of the company's
internal controls and procedures for financial reporting in
accordance with standards established by the Public Company
Accounting Oversight Board.
The Commission received
over 60 comments on the Section 404 proposals that expressed
general overall support for the Commission's approach to
implementing Section 404 of the Act.
The adopting release
will incorporate a number of changes recommended by commenters.
Under the final rules, management's annual internal control
report will have to contain:
A statement of
management's responsibility for establishing and maintaining
adequate internal control over financial reporting for the
company;
A statement identifying the framework used by
management to evaluate the effectiveness of this internal control;
Management's assessment of the effectiveness of this internal
control as of the end of the company's most recent fiscal year;
and
A statement that its auditor has issued an attestation
report on management's assessment.
Under the new rules,
management must disclose any material weakness and will be unable
to conclude that the company's internal control over financial
reporting is effective if there are one or more material
weaknesses in such control.
Furthermore, the
framework on which management's evaluation is based will have to
be a suitable, recognized control framework that is established by
a body or group that has followed due-process procedures,
including the broad distribution of the framework for public
comment.
The new rules implementing Section 404 of the Act
will define the term "internal control over
financial reporting" to
- Mean a process
designed by, or under the supervision of, the registrant's
principal executive and principal financial officers, or persons
performing similar functions, and effected by the registrant's
board of directors, management and other personnel, to provide
reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting
principles and includes those policies and procedures that pertain
to the maintenance of records that in reasonable detail accurately
and fairly reflect the transactions and dispositions of the assets
of the registrant;
- Provide reasonable assurance
that transactions are recorded as necessary to permit preparation
of financial statements in accordance with generally accepted
accounting principles, and receipts and expenditures of the
registrant are being made only in accordance with authorizations
of management and directors of the registrant; and
-
Provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of the
registrant's assets that could have a material effect on the
financial statements.
The Commission also voted to adopt
amendments requiring companies to perform quarterly evaluations of
changes that have materially affected or are reasonably likely to
materially affect the company's internal control over financial
reporting.
Compliance with the rules regarding management's
report on internal controls will be required as follows:
companies, other than foreign private issuers, meeting the
definition of an "accelerated filer" in Exchange Act Rule 12b-2
(generally, U.S. companies that have equity market capitalization
over $75 million and have filed an annual report with the
Commission) will be required to comply with the management report
on internal control over financial reporting requirements for
fiscal years ending on or after June 15, 2004, and all other
issuers, including small business issuers and foreign private
issuers, will be required to comply for their fiscal years ending
on or after April 15, 2005.
Certifications
The final
rules will amend the exhibit requirements for periodic reports to
add the certifications required by Sections 302 and 906 of the
Sarbanes-Oxley Act to the list of required exhibits to be included
in reports filed with the Commission.
Under the final rules,
the specific form and content of the Section 302 certification
will be set forth in the applicable exhibit filing requirements
for a company's periodic reports.
The amendments will
permit companies to "furnish" rather than "file" the Section 906
certifications with the Commission. Thus, the certifications will
not be subject to liability under Section 18 of the Exchange Act.
Moreover, the
certifications will not be subject to automatic incorporation by
reference into a company's Securities Act registration statements,
which are subject to liability under Section 11 of the Securities
Act, unless the issuer takes steps to include the certifications
in a registration statement.
The rules and form amendments
concerning Section 302 and Section 906 certifications generally
will become effective sixty days after their publication in the
Federal Register.
Rule 3a-8
As adopted by the
Commission, new Rule 3a-8 under the Investment Company Act will
modernize the test that R&D companies use in determining their
status under the Act.
R&D companies tend to have few
tangible assets and often hold large amounts of capital in liquid
instruments so that funds are readily available for research and
development activities. Some R&D companies also enter into
strategic alliances that may include a strategic investment, where
one R&D company purchases a non-controlling securities position in
another company. As a result, an R&D company may fall within the
definition of investment company.
The new rule will serve
as a nonexclusive safe harbor from the definition of investment
company in Section 3(a)(1) of the Act.
The analysis set
forth in the new rule generally will focus on an R&D company's use
of its capital and other indicia of the company's primary
engagement in a non-investment business. Generally, a company will
be eligible to rely on the rule's nonexclusive safe harbor if it:
Has research and
development expenses that are a substantial percentage of its
total expenses for its last four fiscal quarters combined and that
equal at least half of its net income derived from investments in
securities for that period;
Has investment-related expenses
that do not exceed five percent of its total expenses for its last
four fiscal quarters combined;
Makes its investments to
conserve capital and liquidity until it uses the funds in its
primary business subject to certain exceptions; and
Is
primarily engaged, directly or through a company or companies that
it controls primarily, in a noninvestment business, as evidenced
by the activities of its officers, directors and employees, its
public representations of policies, and its historical
development.
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