Sarbanes-Oxley Act (SOX)
What it is:
The Sarbanes-Oxley Act, officially named theReform and Investor Protection Act of 2002, became law on July 30, 2002. The law was informally named after its sponsors, Senator Paul Sarbanes (D-MD) and Representative Michael G. Oxley (R-OH).
How it works/Example:
All companies (both foreign and domestic) that have registered equity or debt securities under the Securities Exchange Act of 1934 are subject to the Sarbanes-Oxley Act. Foreign public accounting firms must also comply with the Act if they perform work for companies subject to the Act.
One of the most important goals of the Act is to ensure that company directors and officers are aware of and accountable for the financial condition of the companies they manage.
This is most evident in the Act's requirement that the board of directors of most public companies have an audit committee. This committee must appoint, inspect, regulate, and control the actions of the company's auditing firm. The auditors in turn report directly to the audit committee.
Additionally, the CEO and CFO of any company subject to the Sarbanes-Oxley Act must certify in writing that the company's financial disclosures comply with the law and accurately represent the company's condition. To prevent directors and officers from issuing misleading financial statements in order to obtain personal benefits, the Sarbanes-Oxley Act makes it a federal crime for a company officer to pressure or manipulate an auditor into signing off on misleading financial statements. Further, if a company is forced to restate its financials, then in most cases the firm's CEO and CFO must give back any bonuses, compensation, or profits made on personal trades of the company's securities during the year after the faulty documents were initially disclosed.
One of the fundamental philosophies underlying Sarbanes-Oxley is that those who are aware of corporate wrongdoing have the ability and means to correct it. As a result, the Sarbanes-Oxley Act extends whistleblower protections to employees. The Act also states that if a company's internal lawyer discovers material securities law violations, then the attorney must report these violations to the company's chief counsel or CEO, and on up the chain of command to the board of directors if no appropriate response is given.
Sarbanes-Oxley also directs the SEC to subject securities analysts to stricter rules regarding conflicts of interest. In particular, the Sarbanes-Oxley Act seeks to improve the objectivity and independence of securities analysts by further separating the investment banking and securities analysis functions of most financial-services companies.
Why it matters:
The Sarbanes-Oxley Act of 2002 came in the wake of some of the nation's largest financial scandals, including the bankruptcies of Enron, WorldCom, and Tyco. As such, the Act is widely considered to contain some of the most dramatic changes to federal securities laws since the 1930s.
The Sarbanes-Oxley Act goes beyond requiring corporate boards to adopt codes of ethics. It substantially raises the standards and requirements for directors, officers, auditors, securities analysts, and corporate lawyers. As part of its eye toward reform, the Act also toughened the consequences for financial misconduct. Violations of the Act can range from censure to prison sentences and multimillion-dollar penalties. The statute of limitations on several kinds of securities fraud charges were also extended, and more provisions were made to ensure that the victims of the fraud -- frequently individual investors -- received at least some of the monetary damages paid by the violators. Importantly, the SEC now has the authority freeze any payment to an officer, director, partner, or agent during an investigation.
The Act is not without disadvantage, however. The legal, managerial, and technological costs of compliance can total millions of dollars, even for small companies. These high coasts have motivated (and may continue to motivate) some companies to delist their shares from the major exchanges, to go private or in some cases to stay private. Arguably, for some small firms, the cost savings associated with avoiding compliance may actually increase shareholder value.