Valuation analysts who practice in the bankruptcy arena frequently rely on published financial statements and other financial/operational disclosures of guidelines for publicly traded companies. This is particularly true with regard to (1) the valuation of spin-off opportunities, (2) the component business valuation aspects of a plan of reorganization, and (3) collateral valuations for debtor-in-possession (DIP) financing, etc. Accordingly, analysts who perform bankruptcy valuations depend on the reliability of data and the adequacy of disclosure of the annual and periodic reports that public companies file with the SEC. And, in good measure, that reliability and adequacy depend on (1) the integrity of the public company CEO and CFO and (2) the independence of the public company auditors.

The Sarbanes-Oxley Act of 2002 reforms the financial/management disclosures and corporate governance/ responsibility of public companies. The act also affects how the public accounting profession will perform its function of auditing public companies. The act includes provisions (1) to reform the oversight of the public accounting profession, (2) to improve the quality and reliability of corporate financial reporting and (3) to strengthen the independence of auditors and public company audit committees.

This discussion will summarize the major provisions of the act, which valuation analysts who practice in the bankruptcy arena should be aware of.

Summary of the Act

The act amends certain provisions of the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act). The act also amends certain sections of the Investment Company Act of 1940 (Investment Act) and the Investment Advisors Act of 1940 (Advisors Act).

The provisions of the act regarding corporate governance, disclosure, auditors and related matters generally apply to "issuers." The term "issuer" means an issuer of any securities registered under the Exchange Act that (1) is required to file reports under §15(d) of the Exchange Act or (2) has filed a registration statement under the Securities Act that has not yet become effective. Some of the provisions of the act, such as the requirement for notice of blackout periods and certain of the criminal penalties, have broader application.

1. Accounting Oversight Board—The act creates a new Public Company Accounting Oversight Board, with broad powers over the public accounting profession and independent audit firms.
2. Auditor Independence—Auditors may no longer provide certain specified non-audit services to their audit clients. Permitted non-audit services must be pre-approved by the issuer's audit committee. Lead audit partners must be rotated every five years. Auditors must report to the company audit committee regarding (1) critical accounting policies, (2) possible alternative treatments of financial information and (3) other material written communications between the auditor and company management. An accounting firm may not audit an issuer if the company's CEO, CFO, controller or chief accounting officer was employed by the accounting firm and participated in the audit in any capacity during the last year.
3. Board of Directors Audit Committees—The requirements for an issuer to be listed on a stock exchange or on Nasdaq listing standards must include a provision that the corporation's audit committee be directly responsible for the appointment, compensation and oversight of the company auditors. Also, the audit committee must be comprised only of independent directors.
4. Certification of Periodic Financial Reports—Each time the issuer files a periodic report that contains financial statements, that report must include a written statement by the CEO and CFO. That statement must certify that the report complies with the Exchange Act and fairly presents, in all material respects, the issuer's financial condition and results of operations. In addition, the act empowers the SEC to issue rules requiring specified additional certifications.
5. Corporate Governance and Responsibility/Reimbursement of CEO/CFO Compensation—This provision relates to situations when an issuer restates its financial statements due to material noncompliance with financial reporting requirements as a result of misconduct. In such instances, the CEO and CFO must repay any (1) bonus, (2) other incentive-based or equity-based compensation received or (3) profits on stock trades realized during the 12-month period after the issuance or filing of the misstated financial statements.
6. Insider Trades During Blackout Periods—Notice must be given to benefit plan participants of any "blackout periods" during which the plan participants cannot trade. The issuer directors and executive officers may not trade during the benefit plan "blackout periods." If the issuer directors or officers do trade during the blackout periods, any profits earned from the prohibited trading must be repaid to the issuer.
7. Loans to Officers and Directors—Issuers may not make any new loans, or modify any existing loans, to their officers or directors.
8. Enhanced Financial Statement Disclosures—All financial statements reported by an issuer must reflect all material correcting adjustments identified by the company's auditors. The SEC is directed to issue rules regarding (1) the disclosure of off-balance sheet transactions and other similar matters and (2) the disclosure of pro forma financial information.
9. Issuer and Management Disclosure/ Insider Transactions—SEC Form 4 is the statement of change of beneficial ownership of a company insider (as defined by the Exchange Act). The filing of Form 4 is now due within two business days after the securities trade occurred.
10. Other Issuer and Management Disclosures—The act orders the SEC to issue rules requiring that each issuer include in its periodic reports disclosures concerning (1) the company's internal controls and financial reporting procedures, (2) whether (i) it has adopted a code of ethics and (ii) it had any changes in or waivers to its code of ethics, (3) whether its audit committee includes a "financial expert" and (4) additional information concerning material changes in its financial condition or operations (in plain English and on a real-time basis).
11. Fraud and Criminal Penalties—The act adds or increases criminal penalties for a number of securities and corporate governance matters. The act increases the statute of limitations for actions related to private securities laws. The act provides that debts arising from securities fraud are not dischargeable in bankruptcy. In addition, the act authorizes the SEC to seek a freeze on any payments to directors, officers and others during an investigation of securities violations.
12. SEC Resources and Authority—The act requires the SEC to review periodic reports on a regular basis. And the act requires the SEC to issue rules regarding the minimum standards of professional conduct for attorneys practicing before the SEC.
13. Securities Analysts and Securities Research Reports—The act requires the SEC to issue rules that address conflicts of interest of securities analysts.
14. Regulatory Studies and Reports—The act requires the SEC, the Comptroller General of the U.S. and the General Accounting Office (GAO) to conduct a number of studies with the consideration of possible additional legislation or regulation.
15. Fraud and Criminal Penalties/ Whistleblower Protections—The act creates federal protection for whistle-blowers and protects issuer employees when they act lawfully to disclose information about fraudulent activities within their company.
16. Corporate Fraud Accountability—The act expands the authority of the SEC to prohibit "unfit" individuals from serving as officers or directors of an issuer.

Accounting Oversight Board

The act establishes a new Public Company Accounting Oversight Board. The Oversight Board will be a nonprofit corporation subject to SEC oversight (similar to the way the SEC has oversight of self-regulatory organizations such as the stock exchanges). The Oversight Board will be funded by fees assessed against issuers in amounts to be determined by the Oversight Board. Individual assessments will be proportionate to each issuer's relative equity market capitalization.

The Oversight Board will:

1. register public accounting firms that prepare audit reports for issuers,
2. issue rules relating to auditing, quality control, ethics, independence and other standards relating to the preparation of audit reports for issuers,
3. conduct inspections of registered public accounting firms (1) annually for a firm that audits more than 100 public companies and (2) every three years for other firms,
4. conduct investigations and disciplinary proceedings concerning registered public accounting firms and their partners, shareholders, principals, accountants and other professional employees,
5. perform such other duties as the Oversight Board or the SEC determines appropriate (1) to promote high professional standards and improve the quality of audit services, (2) to protect investors, or (3) to further the public interest, and
6. enforce compliance by registered public accounting firms with the act, the Oversight Board rules, accounting professional standards and the securities laws relating to (1) the preparation and issuance of audit reports and (2) accountants' obligations and liabilities.

Auditor Independence

The act contains a series of provisions intended to enhance public accounting firm auditor independence. As part of these provisions, a public accounting firm may not provide the following services to its audit clients:

1. bookkeeping or other services related to the accounting records or financial statements of the audit client,
2. financial information systems design and implementation,
3. appraisal or valuation services, fairness opinions, or contribution-in-kind reports,
4. actuarial services,
5. internal audit outsourcing services,
6. management functions or human resources,
7. broker, dealer, investment advisor or investment banking services,
8. legal services and other expert services unrelated to the audit, or
9. any other services that the Oversight Board, by regulation, deems to be impermissible.

A public accounting firm may provide other non-audit services not specified in the above list—but only if approved in advance by an issuer's audit committee. Pre-approval is not required if:

1. The aggregate amount of such services does not exceed five percent of the total revenues paid to the auditor in the year in which the non-audit services were provided;
2. The issuer did not recognize at the time of the auditor's engagement that the services were non-audit services; and
3. The non-audit services are promptly brought to the attention of, and approved by, the audit committee before completion of the audit.

Any such pre-approval must be disclosed in the issuer's periodic reports filed with the SEC. The audit committee may delegate the authority to grant pre-approvals to one or more of its members.

Certification of Periodic Financial Reports

The act contains two separate provisions regarding the certification of periodic financial reports filed under the Exchange Act. In the first provision, the act requires that each periodic report filed with the SEC that contains financial statements be "accompanied" by a written statement signed by both the CEO and the CFO. That written statement must certify that:

1. The report complies with the requirements of §13(a) or 15(d) of the Exchange Act; and
2. The information contained in the report fairly presents, in all material respects, the issuer's financial condition and results of operations.

In the second provision, the act directs the SEC to issue rules requiring the issuer CEO and CFO to certify, in each quarterly or annual report, that:

1. The corporate officer has reviewed the report;
2. Based on the officer's knowledge, the report does not (i) contain any untrue statement of a material fact or (ii) omit to state a material fact necessary to ensure that the statements are not misleading;
3. The signing officers (i) are responsible for establishing and maintaining internal controls, (ii) have designed those internal controls to ensure that material information relating to the issuer is made known to such officers, (iii) have evaluated the effectiveness of such controls as of a date within 90 days prior to the report and (iv) have presented in the report their conclusions about the effectiveness of their internal controls based on such evaluation;
4. The officers have disclosed both to the issuer's auditors and to the issuer's audit committee (1) all significant deficiencies in the design or operation of internal controls that could adversely affect the issuer's ability to (i) record, (ii) process, (iii) summarize and (iv) report financial data and (2) any fraud involving management or other employees who have a significant role in the issuer's internal controls;
5. The officers have identified to the issuer's auditors any material weaknesses in internal controls; and
6. The officers have indicated in the report whether there were any significant changes (i) in internal controls or (ii) in other factors that could significantly affect internal controls subsequent to the date of their evaluation—including any corrective actions with regard to (1) significant deficiencies and (2) material weaknesses.

Enhanced Financial Statement Disclosures

Any report filed with the SEC that contains financial statements required to be presented in accordance with generally accepted accounting principles (GAAP) must reflect all material correcting adjustments that have been identified by the issuer's public accounting firm.

The act directs the SEC to issue rules to ensure that each quarterly or annual report filed with the SEC disclose (1) all material off-balance sheet transactions, (2) arrangements, obligations or other relationships with unconsolidated entities or other persons that may have a material current or future effect on financial condition, (3) changes in financial condition, (4) results of operations, (5) liquidity, (6) capital expenditures and (7) significant revenue and expense components.

The act directs the SEC to issue rules regarding pro forma financial information included in any SEC filing, any public disclosure, and any press or other release. The new rules are intended to ensure that the pro forma financial information:

1. not contain an untrue statement of a material fact or omit to state a material fact necessary to make the pro forma financial information (in light of the circumstances under which it is presented) not misleading, and
2. be reconciled with the issuer's financial condition or results of operations prepared in accordance with GAAP.

Other Issuer and Management Disclosures

The act directs the SEC to issue rules requiring that each issuer's annual report include a statement of (1) management's responsibilities for establishing and maintaining (i) an adequate internal control structure and (ii) financial reporting procedures, and (2) management's assessment of the effectiveness of such structure and procedures. The issuer's auditor must attest to and report on management's assessment.

The act directs the SEC to issue rules requiring an issuer to disclose in its periodic reports whether it has adopted a code of ethics for senior financial officers, and if not, the reasons why not. The new SEC rules must require an issuer to report immediately any change in or waiver from its code of ethics.

The act directs the SEC to issue rules requiring an issuer to disclose in its periodic reports (1) whether or not its board of directors audit committee includes at least one member who is a "financial expert" (to be defined by the SEC) and (2) if not, why not. In its definition of a "financial expert," the SEC is directed to consider whether a person, through education and experience (1) as a public accountant or auditor or (2) as a senior financial officer, has:

1. an understanding of GAAP and financial statements,
2. experience in preparing or auditing financial statements of generally comparable issuers and the application of GAAP in accounting for estimates, accruals and reserves,
3. experience with internal accounting controls, and
4. an understanding of board of director audit committee functions.

The act directs the SEC to issue rules requiring issuers to disclose, in plain English and on a real-time basis, additional information concerning material changes in (1) its financial condition or (2) its results of operations as necessary for the protection of investors and in the public interest.

Effective Dates of the Act

The following provisions of the act are effective as of July 30, 2002:

1. auditor independence
2. prohibition against improper audit influence
3. periodic financial report certifications by CEOs and CFOs
4. CEO/CFO reimbursement to the issuer following accounting restatements
5. lower standard for barring directors and officers, and equitable relief
6. ban on personal loans to issuer officers and directors
7. whistleblower protections
8. expanded financial disclosure
9. new and enhanced enforcement provisions
10. provisions affecting the SEC resources and authority

The SEC appointed the Accounting Oversight Board and must determine by April 26, 2003, that the Oversight Board is duly organized and capable of performing its duties. Public accounting firms are required to be registered within 180 days after the SEC makes the public determination that the oversight is fully functional.

The following provisions of the act are effective as of Oct. 28, 2002: code of ethics for senior financial officers and the disclosure of audit committee financial expert. The following provisions of the act are effective as of Jan. 26, 2003: notices of and prohibition against insider trading during a benefit fund blackout period.

Conclusion

In the wake of massive public company audit failures, periodic report disclosure errors and omissions, and financial statement accounting restatements, Congress intended the Sarbanes-Oxley Act of 2002 to address systemic weaknesses in public company financial disclosures/corporate governance and public company/auditor relationships. This discussion affects all of the major provisions of the act and summarized the provisions that are most relevant to valuation analysts. Valuation practitioners who perform bankruptcy analyses should be aware of how the act increases the reliability and thoroughness of public company financial disclosures.

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Footnotes

¹ Certified in business valuation by ASA and as an appraiser by the state of Illinois. Return to article