Sarbanes Oxley Act

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The Sarbanes-Oxley Act is a federal law that was enacted on July 30, 2002 in reaction to the major corporate scandals that were going on at that time, such as that which involved the infamous Enron. Included in the bill are responsibilities entrusted to the boards of directors for public corporations, along with the criminal penalties that can be enforced in response to certain kinds of misconduct. The Act also demands that the Securities and Exchange Commission create regulations to guide corporations in their compliance with the law. To explore this concept, consider the following Sarbanes Oxley Act definition.

Definition of Sarbanes Oxley Act

Noun

  1. A federal law governing corporate responsibilities and liabilities

Origin

2002                Federal legislation

History of the Sarbanes Oxley Act

The purpose of the Sarbanes-Oxley Act was to crack down on corporate fraud. For example, the Sarbanes-Oxley Act, in addition to creating the Public Company Accounting Oversight Board (PCAOB) (which does exactly what its name would suggest), also banned the act of company loans being given to executives. The Act also provides whistleblowers with job security so that those who witness something unlawful can report it without fearing they will be terminated as a result.

Named for sponsors Senator Paul Sarbanes and Congressman Michael Oxley, the Act became law on July 30, 2002, and is enforced by the Securities and Exchange Commission. A number of events that occurred between 2000 and 2002 set up the history of the Sarbanes-Oxley Act. The highly-publicized frauds that took place at companies like Enron, Tyco, and WorldCom highlighted the fact that significant problems existed with regard to conflicts of interest, and the incentives that companies were handing out to their high-level employees.

In a 2004 interview, Senator Sarbanes made the following statement:

“The Senate Banking Committee undertook a series of hearings on the problems in the markets that had led to a loss of hundreds and hundreds of billions, indeed trillions of dollars in market value. The hearings set out to lay the foundation for legislation. We scheduled 10 hearings over a six-week period, during which we brought in some of the best people in the country to testify …

“The hearings produced remarkable consensus on the nature of the problems: inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analysts’ conflict of interests [sic], inadequate disclosure provisions, and grossly inadequate funding of the Securities and Exchange Commission.”

The Act is effective at holding CEOs personally accountable for the errors that can occur within the accounting audits within their companies. As one might expect, the early history of the Sarbanes-Oxley Act shows that many were pessimistic about the Act at first. For one thing, they worried that it would make the U.S. less enjoyable to do business with. They also thought it was nearly impossible to implement. For example, the Sarbanes-Oxley Act was considered to be too corrective and expensive to actually enforce.

However, looking back on the history of the Sarbanes-Oxley Act, it is now even clearer that regulation of the banking industry was incredibly important, due to the financial crisis that occurred in 2008, often referred to now as “the Great Recession.” The most notable elements of the Great Recession, which lasted from December 2007 to June 2009, were the bursting of the housing bubble and the drop of the stock market. Many people found themselves living in homes that were suddenly worth less than what they owed on them, and poverty rose as income levels dropped, most people could no longer afford their expenses.

Banking practices of the time also contributed in a major way to the enactment of the Sarbanes-Oxley Act. The fact that firms needed to borrow money should have told the investors that the firms were not safe to invest in. Such was the case with Enron. However, several major banks gave Enron loans while either ignoring or simply misunderstanding the risks the company was facing. As a result, investors and their clients were hurt by bad loans when Enron couldn’t pay them back, which led to large settlement payments being made by the banks. The Sarbanes-Oxley Act was created, in part, to prevent something like this from happening again.

Elements of the Sarbanes Oxley Act

Title III contains several important elements of the Sarbanes-Oxley Act. Specifically, it pertains to a company’s “Corporate Responsibility for Financial Reports.” This section includes all of the certifications that a financial report is supposed to contain before being submitted. Organizations who attempt to avoid fulfilling these requirements can be penalized in accordance with the provisions of the Act.

Examples of required certifications include acknowledgments that:

  • The signing officers have reviewed the report
  • The report does not contain any false statements or omissions, nor is it misleading in any way
  • The financial statements and related information presented are a fair and accurate representation of the company’s financial condition

Additional elements of the Sarbanes Oxley Act can be found within its eleven Titles, which are outlined below.

  • Title I: Public Company Accounting Oversight Board (PCAOB) – Mentioned earlier, the PCAOB oversees the accounting firms that provide auditing services to businesses. It defines and enforces the procedures necessary for audits to be in compliance with the Act.
  • Title II: Auditor Independence – This section restricts auditing companies from providing non-audit services, such as consultations, to the same clients. It also addresses things like requirements for new auditor approvals and auditor reporting.
  • Title III: Corporate Responsibility – The section specifies the individual responsibilities that senior executives are expected to take to ensure the accuracy and completeness of a company’s financial reports.
  • Title IV: Enhanced Financial Disclosures – This section details the reporting requirements for financial transactions, including the controls that are put in place to ensure the accuracy of financial audits and reports.
  • Title V: Analysts Conflicts of Interest – This section defines the code of conduct for security analysts and requires that any known conflicts of interest be disclosed as soon as one becomes aware of them.
  • Title VI: Commission Resources and Authority – This section defines the conditions under which a person can be banned from practicing as a financial authority.
  • Title VII: Studies and Reports – This section talks about the effects that can occur from public accounting firms being consolidated, as well as the role of credit rating agents in security market operations.
  • Title VIII: Corporate and Criminal Fraud Accountability – This section goes into the details surrounding the criminal penalties that one can incur from manipulating, destroying, or altering financial records or interfering with investigations. This is also the provision that contains whistleblower protections.
  • Title IX: White Collar Crime Penalty Enhancement – This section recommends stronger sentencing guidelines for white-collar crimes and conspiracies. It also makes the failure to certify financial reports a criminal offense.
  • Title X: Corporate Tax Returns – This is perhaps the simplest element of the Sarbanes Oxley Act. This section requires that the Chief Executive Officer (CEO) of a company be the one to sign the company’s tax return.
  • Title XI: Corporate Fraud Accountability – This section talks about corporate fraud and records tampering insofar as being criminal offenses, and then ties those offenses to their respective penalties.

Sarbanes Oxley Act Example Involving the Fishing Industry

The Sarbanes Oxley Act does not only apply to Wall Street corporations and banks. Title VIII, Section 802 (a) makes it unlawful to hide, destroy, or alter any records or objects for the purpose of obstructing a federal investigation. In 2014, the applicability of this provision was put to the test by a commercial fisherman.

In this example of the Sarbanes-Oxley Act being challenged, John Yates, a commercial fisherman, was working in the Gulf of Mexico when a federal agent conducted an inspection of his ship. The agent noticed that Yates had undersized red grouper in his ship, which was a violation of U.S. regulations regarding federal conservation.

The federal agent instructed Yates to keep the grouper separate from the other fish. Yates instead instructed his crew to throw the grouper back overboard. This resulted in Yates being prosecuted under the Sarbanes-Oxley Act, specifically the provision that reads that a person can be fined or imprisoned for a maximum of 20 years if he:

“…knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence a federal investigation.”

At his criminal trial, Yates argued that fish were not the kind of “tangible objects” referred to in the Act’s provision. Rather, he argued, the tangible objects referred to in the Act covered objects used to store information, such as computer hard drives. The District Court disagreed, and Yates was ultimately convicted and sentenced to 30 days in prison.

Yates appealed the conviction, and the U.S. Court of Appeals for the Eleventh Circuit affirmed his conviction. The Court of Appeals held that fish are physical objects, and are therefore defined as being tangible objects.

The case was escalated to the U.S. Supreme Court, which ultimately reversed the lower court, holding that a tangible object as referred to in the Act is one that is “used to record or preserve information.” This definition, therefore, did not extend to fish.

Associate Justice Elena Kagan argued, in her dissenting opinion, that “[a tangible object] is a discrete thing that possesses physical form,” and that yes, this argument should extend to fish. To further illustrate her point, Kagan cited the Dr. Seuss book One Fish Two Fish Red Fish Blue Fish as general evidence. Kagan believed that fish could, and should, be covered as tangible objects under the provisions of the Sarbanes-Oxley Act.

Related Legal Terms and Issues

  • Acquittal – A judgment declaring a person not guilty of the crime with which he has been charged.
  • Audit – An official inspection of an organization’s financial accounts.