UK: Sarbanes-Oxley:The US Experience and the UK Reaction

What lessons can we learn from the US experience of this legislation to date, and to what extent should directors and their insurers fear or welcome recent UK and European attempts to address these issues?

We consider the US experience in this article, and the UK and European response in a companion article in the next edition of this review.

The Sarbanes-Oxley Act 2002 (‘Sarbox’) was intended to usher in a new regime of corporate accountability and disclosure in the wake of a series of very public scandals that severely dented investor confidence in corporate America. A year and a half on, with a large proportion (but not all) of Sarbox now in force,¹ the first cases involving Sarbox provisions have now been decided. As enforcement momentum begins to grow, the practical effect of this new legislation is therefore now beginning to be felt.

It will not be until some time after Sarbox has come fully into force that we can fairly judge the full extent of its impact. We do not, for example, yet know whether a more open and accountable system will indeed emerge, and investor confidence return as a result, or whether companies will, as some fear, be drowned by ever increasing compliance costs, and handicapped by the desertion of the top directors put off by the increased personal obligations to which they are subject.

The recent developments summarised below do, however, give us an insight into how Sarbox is working out so far, and provide a backdrop against which to express some tentative thoughts (in a forthcoming article) about the attempt to do something similar here and in the EU at large:²

Rica Foods: In August 2003, this US poultry group became the first subject of Sarbox enforcement action by the US Securities and Exchange Commission (SEC). According to the SEC’s complaint, Rica Foods filed an annual report in which several material errors affected its financial statements, and which also contained an unqualified auditor’s report even though its auditors had not yet provided it with a signed report. The company’s CEO and CFO had nevertheless filed the required certification of the accuracy of the company’s financial statements.3 A settlement was reached (involving no admission of guilt), under which Rica Foods and its CEO and CFO agreed to an injunction permanently barring future Sarbox violations, and a $25,000 penalty against the CEO. Although the SEC did not insist on a swingeing fine, this demonstrates the seriousness with which the SEC intends to approach the requirement to certify the accuracy of company’s financial statements.

Vivendi Universal: This media group was the next subject of enforcement action. The SEC’s complaint involved multiple claims of misconduct and securities violations by Vivendi and its then CEO. The allegations against Vivendi included, for example, issuing misleading press notices, authorised by the CEO, that gave a false picture of its cash flow and liquidity and making improper adjustments to increase its disclosed earnings substantially in order to meet adventurous earnings targets that had already been communicated to the market. Whilst the SEC’s investigation was ongoing, it used new Sarbox powers (under s.1103) to freeze the CEO’s ‘golden parachute’ severance package of $21 million. A settlement was subsequently reached, under which Vivendi agreed to pay a civil penalty of $50 million, and the CEO, and another director, agreed to pay disgorgement and civil penalties totalling over $1 million. The CEO also agreed to relinquish his claim to the severance package, and to accept a 10 year prohibition on serving as an officer or director of a public company.

The Bank of Floyd (Virginia): The first case involving the Sarbox provisions protecting corporate whistle-blowers came in early February 2004. The Bank’s CEO was fired in October 2002 after raising concerns about the Bank’s financial reporting and internal controls, as well as alleged insider trading. The US Judge who heard the case ordered the Bank and its holding company to rehire the CEO with back-pay. This is believed to be one of the first judicial decisions on a Sarbox complaint and demonstrates a clear willingness to apply these new provisions to protect employees who expose misconduct within their company.

The early cases involving the US Sarbanes- Oxley Act demonstrate the significant new powers that now exist in the US to investigate and punish those responsible for corporate misconduct. A clear willingness to use these powers has also been demonstrated, both in the way these cases have been pursued and in the very clear stance taken by the regulators in public.

However, whilst greater corporate accountability and disclosure are undoubtedly in the public interest, investors and ultimately the economy as a whole will suffer if companies and their directors become excessively concerned about their new obligations, and the potentially draconian consequences of complying, or about slipping up and failing to meet the new standards. It is therefore important that in trying to achieve what are clearly vital goals, the authorities do not lose sight of the bigger picture and score an own goal.

Company directors, and their insurers, will therefore wish to keep a close watch on recent developments in the UK and Europe intended to cover some of the same ground as Sarbox, a topic to which we return in the next edition of this review.