New England Biz Law Update
Companies and their lawyers are scrambling mightily to comply with the sweeping provisions of the Sarbanes-Oxley Act since its passage in July 2002, and as a result have been largely successful in setting up appropriate corporate governance procedures, experts tell New England In-House.
But while compliance programs have been set up, in-house lawyers are now faced with an even harder task: Making it all work effectively.
One looming deadline is Nov. 14, the effective date for establishing certification controls and procedures to ensure internal audits and financial statements are accurate (Section 404 of the statute).
“In-house lawyers have been flooded with memos and CLE seminars on this and they have a good understanding of what’s required. But the real question is, can we make it work,” observed John Marvin of Sonnenschien Nath & Rosenthal in Kansas City, Mo.
Meanwhile, two large questions remain largely unanswered: Will Sarbanes-Oxley actually prevent financial scandals and will it bolster investor confidence?
While the law is definitely forcing companies to pay far greater attention to corporate governance, some experts question whether it will make any real difference in the long run since honest companies typically were already doing what is required under the law, and dishonest executives will likely not be deterred either way.
“The success of the law substantially depends on the verve and attentiveness of independent boards of directors,” said Stephen M. Honig, a corporate law expert at Duane Morris in Boston. “Directors have been thrust to the forefront. In some companies, directors are actively seeking control of corporate governance. But I question whether most directors will remain vigilant.”
Stanley Keller, corporate law partner at Palmer & Dodge in Boston, said the “real issue now is whether does it all end up being justified from a cost/benefit standpoint. Will Sarbanes-Oxley stop fraud and wrongdoing? No. Will it slow it down and increase the reliability of financial reporting? Yes. But it comes at price. Does it all end up being justified?”
For many smaller companies, the answer is a decided “No!”
Robert LaRose of Thompson Coburn in St. Louis said, “What it has done has added more burdens for already law abiding companies. It’s increased stress and liability and costs, but for what purpose? Perhaps for some incremental benefit. But is it enough to boost investor confidence? Probably not.”
Dean Hanley of Boston’s Foley Hoag added: “Some of my clients are downright miserable. They’re just shaking their heads. The cost of compliance could wipe out the profits of some companies. However, larger companies just seem to be sort of shrugging it off.”
Indeed, many feel that Sarbanes-Oxley is a “Fortune 500” solution imposed on companies of all sizes. As Keller phrased it: “Congress acted with a meat cleaver instead of a rapier.”
But Jeffrey Leerink, president of Boston brokerage firm Leerink Swann and Coe, said he believes investor confidence is on the upswing as a result of Sarbanes-Oxley.
“When you combine SarBox with the stock exchange reforms, a lot has been put into place to restore investor confidence. Institutional investors by and large trust the financial reports more today than in the recent past because of the certification rules under SarBox,” Leerink said.
Even so, many experts said corporate fraud would continue to take place regardless of the law, essentially based on the notion that Congress can’t legislate morality.
“What remains to be seen is how sustainable is the change in attitudes at the board level and in upper management,” said Keller.
“The largest change,” said Susan Hackett, general counsel of the Washington, D.C.-based Association of Corporate Counsel, “is the idea that the corporate culture has to be worked on. That’s the most crucial element of the process. A company can make all the changes required by the law, but what policies do you adopt to make upper management and employees generally more ethical? What you are really talking about is corporate ‘morality.’ That’s the conundrum. There’s no silver bullet.”
Tom Murphy of McDermott Will & Emery in Chicago remarked that the “big remaining question is whether the additional focus on checklists and procedures will actually reduce the likelihood of the problems we’re all aware of and improve corporate governance and corporate decision making.”
While those larger questions remain to be played out, in-house counsel have plenty to think about in making sure their companies are prepared to handle the new regulatory regime.
Experts contacted by New England In-House agreed that the day-to-day burdens imposed by law will not abate and, if anything, will increase in the foreseeable future.
They pointed to the following major concerns and gave tips on how in-house counsel can manage them.
The New Paradigm
Experts stressed that Sarbanes-Oxley – while ostensibly covering public companies – has taken over as the new way of thinking on corporate governance for all companies, including private and non-profits.
According to Hackett, lawyers at privately held companies have to pay attention to Sarbanes-Oxley when their companies go looking for investments or for insurance.
“Investors are looking to see if you are doing things consistent with Sarbanes-Oxley,” she said. “Same with insurance companies. They’re looking to see if you’re acting consistent with law when setting premiums and deciding whether to issue policies.”
She also noted that many public companies are shying away from doing business with private companies that aren’t living up to the standards set by Sarbanes-Oxley.
Daily Routine
In-house counsel must on a regular basis assess whether their company’s actions trigger Sarbanes-Oxley.
“What used to be done on a periodic basis has to become a daily checklist of what’s happening at the company today that may have to be disclosed, or may be an issue of accounting controls and financial controls,” said Andrew Merken of Burns & Levinson in Boston. “In-house counsel have to be very proactive and tell folks in their organizations what to be aware of and how to deal with it.”
Sarbanes-Oxley has seeped into the minds of many business leaders, according to Stephen L. Palmer of Kirkpatrick & Lockhart in Boston.
“It has put the issue of corporate governance compliance on the minds of business people, not just the legal team. Business people are now routinely asking whether the company has a SEC compliance or SarBox issue. That’s a good development,” Palmer said.
Bridging The Gap
In-house counsel must also make every effort to be a trusted go-between among directors and upper management.
“From the perspective of our membership,” said Hackett of the ACC, “general counsel really wants to develop a closer relationship with boards of directors and be far more active in educating them and keeping them up to date. They want to be seen as the bridge and help with the timely flow and presentation of information.
“Prior to board meetings,” Hackett continued, “they want to help upper management understand what they need to provide to the board on the new rules and regulations. They want to show the board that the company has a handle on things. They also want to show upper management that the board wants to help the company grow and be successful. They can be excluded from that role and feel underutilized.”
In addition, as boards of directors get more active in corporate governance, in-house lawyers want to remain a trusted advisor, rather than have the board immediately turn to outside counsel, Hackett said.
“The board should start with in-house counsel first if they have a concern, rather than go to outside counsel for advice right off the bat,” she said. “And in-house counsel wants to participate in the selection of outside counsel, and setting the terms of engagement.”
Keller added: “In-house counsel need to recognize their role as advisors to the board in helping it fulfill its function, to structure it and assist it in creating committees. There should be direct communication between counsel and the board, not just through management. Separate sessions with the board are very important.”
Aside from working closely with both the board and upper management, in-house counsel should be always on the look out for new board members, suggested Paul Klug of the St. Louis office of Polsinelli Shalton Welte.
“In choosing a board, management and existing board members have to be cognizant of the need to increase the number of independent members, which will help in the auditing aspect,” Klug said. “You should avoid relying on the ‘buddy’ system.”
According to LaRose of Thompson Coburn, “in-house counsel should be constantly searching for the next potential candidate for the board of directors, and selling the company to them. If you see an ‘up-and-comer’ be the first one to offer a directorship. It’s harder now to attract and retain directors in light of greater potential liabilities under the Act.”
Avoid The Paper Trail
In the process of complying with Sarbanes-Oxley and the new stock exchange rules, companies are creating records that could be misinterpreted in litigation, according to Marvin.
As a result, in-house counsel have to be extremely careful when creating documents related to the evaluation processes required under the act. “Don’t create a paper trail that a strike suit lawyer can beat you over the head with later in litigation,” Marvin cautioned.
As a way to protect the company, in-house lawyers should make every effort to help preserve attorney-client and work product privileges, and communicate orally, if possible, rather than committing information to paper, Marvin noted.
Whistleblowers
While companies so far have successfully defeated most whistleblower claims under Sarbanes-Oxley, it remains a concern if for no other reason than the potentially bad publicity resulting from the mere filing of a claim.
“There’s great pressure on companies to settle before a complaint is filed to avoid the publicity in the current climate,” said Michael Delikat of the Orrick law firm in New York City. “Even if a complaint has no merit, there’s a concern over the impact on a company’s share price. Even if you beat the complaint before the Department of Labor or in court, the damage may have already been done.”
Delikat said companies should aggressively counter a whistleblower claim by:
Also, an aggressive investigation immediately following a complaint can set up a forceful defense that the practice complies with general accounting principles, which may effectively persuade a plaintiff’s attorney that the claim lacks merit, Delikat observed.
Companies should also encourage employees to come forward with legitimate complaints over financial wrongdoing, Delikat advised.
“Provide incentives to those who file complaints, such as with concrete monetary rewards or favorable mention on a performance evaluation,” he advised. “You shouldn’t take retaliatory actions against whistleblowers. You want to get the word out to employees about how you view this and that they’ll be rewarded if they follow up.”
Delikat said relatively few companies have set up effective whistleblower procedures.
“Some companies are still shell shocked and still believe it’s not important to encourage self reporting,” he said. “You’re really talking about changing corporate culture. Most big companies have complied with Sarbanes-Oxley, but as to whether they really have put meat behind the bones and are encouraging people to come forward, I’m not so sure. But change is coming slowly.”
D&O Policies
Jonathan Bell of Greenberg Traurig in Boston noted that some carriers are refusing to pay on claims made under directors’ and officers’ policies on the basis of inaccurate public filings.
“The problem,” Bell explained, “is that some directors may not be aware of the inaccuracy. CEOs and CFOs have close to strict liability since they are signing certifications. But carriers are trying to attribute to directors the knowledge of officers who did know [of any financial inaccuracies].”
Bell urged in-house counsel to “carefully review their company’s director and officers’ liability policy to make clear to directors what level of attribution of knowledge of financial wrongdoing they will have. That needs to be understood and explained. Once the lawsuit starts, it’s much more difficult to explain when people are not covered.”
Get On Top Of The Financials
In-house lawyers shouldn’t leave the financial details to the auditors and accountants, experts cautioned.
“At first blush, a lot of these issues appear to be the responsibility of accountants,” Keller said. “But the Act is much too important to leave it entirely to the accountants. Counsel needs to be more involved in auditing and accounting issues, and creating internal controls. Upper management should be looking to inside counsel for guidance on whether they should certify the financial reports, and whether they need to make additional disclosures. Historically, in-house counsel hasn’t done that, but the best ones now are facing up to that responsibility.”
That’s particularly important when it comes to ensuring compliance with the Section 404 internal audit requirements, according to Murphy of McDermott Will & Emery.
“This is clearly the biggest issue people are struggling with today,” he said. “Questions are being raised over how much you have to do and how far you have to go and what’s enough in the way of internal procedures to audit your internal controls.”
Murphy said what’s required “is substantially more than just a good faith effort. While this largely falls to finance and accounting, in-house lawyers certainly have to be involved in this.”
Tony Malone, CEO of employee hotline specialist, The Network, noted, “people are struggling with what it takes to have an effective internal control structure for Section 404 purposes. They are having trouble determining the scope of what’s required. Companies can help themselves by communicating with employees on an ongoing basis in determining what the best practices are.”
One particular accounting problem that has arisen is revenue recognition, according to Bell of Greenberg Traurig.
“What I’ve come across repeatedly is that auditors are having difficulty recognizing revenue. They’ve received the cash, but they can’t recognize the revenue,” Bell said. “The consequence is reduced revenue for companies. I understand the caution auditors are employing, but that caution results in misinformation reaching the public. There needs to be a clarification by the SEC or the various accounting bodies of the revenue recognition rule so people can truly understand what revenue companies are carrying.”
Marvin added that in-house counsel shouldn’t just copy corporate governance compliance programs created by other companies.
“You have to deeply involved and not just pay lip service to the requirements under the Act,” Marvin said. “Don’t adopt form committee charters. There has to be a real effort to observe the spirit and letter of Sarbanes-Oxley. Your company won’t get protections under the Act unless truly committed to complying with it. You can point to the existence of these procedures to give you some protection when challenged. You don’t have to be right, you just have to be careful.”
Keeping An Eye On State Law
While Sarbanes-Oxley has dominated the headlines, various states are considering similar laws.
“A significant amount of regulation is taking place at the state level,” Hackett said, “and not just geared toward public companies, but all companies.”
Also, in-house lawyers need to keep tabs on codes of ethics in their state, suggested Rebekah Poston of Steel Hector & Davis in Miami, particularly regarding the attorney-client privilege.
“States are reacting to Sarbanes and are looking to modify their ethics rules for lawyers and they may not be consistent with what the ABA is recommending in the Model Rules [of Professional Conduct],” Poston said.
Sentencing Guidelines
Poston noted also that amendments to the federal sentencing guidelines on corporate compliance go into effect in November, including increased penalties for fraud.
Of particular importance is that the various mitigating factors in sentencing organizations, such as an effective internal compliance program, will be part of the actual guidelines rather than part of the comments to the guidelines.
“You have to have and enforce a compliance program that’s commensurate with your company. Meeting those factors is mandatory, not discretionary any more,” Poston said.
In-house counsel must take an active role in educating the board of directors of the importance of establishing and enforcing a “corporate compliance mentality,” she said. “You need to get directors to ask, ‘is this organization committed from top down to compliance and how are we enforcing it?’”
Investigatory ‘Due Process’
Honig, of Duane Morris, noted that a recurring difficulty is assessing how thoroughly to investigate an internal complaint.
“It’s very difficult to evaluate the reliability and bias or lack of bias in a given complaint directed to an audit committee or board of directors, yet a company is typically constrained by governance procedures to substantially investigate everything that is raised,” Honig said.
“In-house counsel needs to develop a ‘due process’ protocol in handling complaints,” Honig added. “The ‘accused’ should know the full contents of the allegations and should have the right to review and comment on the information that is gathered bearing upon the accusation before it is finalized.”
Honig also suggested that individuals accused of wrongdoing but eventually exonerated should be reimbursed for any attorneys’ or accounting fees incurred as part of responding to the investigation.
“There may be such corporate indemnification programs, but they are not common,” he said.
(Questions or comments can be directed to the writer at: [email protected].)
