RETIREMENT AND PENSION SYSTEMS; BUSINESS (GENERAL);

RETIREMENT AND PENSIONS SYSTEMS;

Court Cases; Federal laws/regulations;

You asked for general information about (1) President Bush’s employee retirement savings protection proposals and the act that incorporated them and (2) the arguments raised for and against the act.

SUMMARY

Prompted by a spate of corporate governance and accounting scandals, some involving several billion dollars in pension funds held by publicly traded companies, President Bush proposed measures to protect employees’ 401(k) savings. He proposed giving employees (1) more flexibility to manage their retirement funds; (2) greater freedom to diversify their stock portfolios by allowing them to sell their company stock after three years; (3) better access to professional investment advice to help them make informed decisions about their savings, and information about how their 401(k)s are performing; and (5) 30 days notice of any blackout period during which they are barred from trading or borrowing from their 401(k)s, and holding executives to the same blackout period restrictions as other employees.

On July 30, 2002, Congress enacted the pension blackout provisions as part of the more comprehensive Sarbanes-Oxley Act (PL 107-204). Among other things, the act seeks to restore investor confidence in the stock market and protect employees’ 401(k) retirement savings by addressing shortcomings in the federal securities laws made evident by the corporate financial scandals involving such major corporations as Enron (energy), WorldCom (telecommunications), and Arthur Andersen (accounting).

The act’s main provisions address auditing, corporate governance, and financial reporting and disclosure—issues at the heart of the scandals. Among other things, it:

1. creates a board with broad powers to oversee accountants, directs the Security Exchange Commission (SEC) to require public companies to establish audit committees to oversee their outside auditors, and prohibits auditors from performing most nonaudit services for their clients;

2. requires chief financial officers (CFOs) or chief executive officers (CEOs) to certify that periodic financial statements that companies submit to SEC fairly present the company’s financial state, and bars directors from trading company stock during periods when employees are barred from selling stock they have in pension-type plans;

3. enhances financial disclosure requirements for companies;

4. provides job protection for corporate whistleblowers (employees who report violations of securities or antifraud laws to their supervisors, investigators, or Congress);

5. increases criminal and civil penalties for securities fraud; and

6. broadens enforcement mechanisms.

The act affects approximately 42 million workers who have retirement savings in 401(k) pension plans. It applies to U. S. public companies (and foreign public companies listed on the U. S. stock exchanges. )

The act’s critics say it hurts smaller companies unable to find the resources required to comply with it, will increase corporate costs because of the onerous rules, does not go far enough and will have little effect on big corporations because, in many cases, it merely codifies existing practice. The act’s supporters say it strengthens workers’ ability to manage their retirement savings, adds safeguards to protect against corporate fraud, and makes companies more accountable.

The report summarizes some of the act’s major provisions.

BACKGROUND

Congress enacted the Sarbanes-Oxley Act in response to major financial fraud at big U. S. corporations such as Enron, Arthur Andersen, and WorldCom. The catalyst for the act was WorldCom’s revelation that top executives had engaged in questionable bookkeeping and financial misrepresentation involving several billion dollars. One major consequence of the spate of corporate fraud and financial wrongdoing was that many people lost their retirement income invested in pension plans, such as 401(k)s.

Among other things, the scandals (1) revealed major accounting and corporate governance laxity, (2) highlighted ongoing concerns about auditing firms playing dual and sometimes conflicting roles, and (3) exposed numerous questionable corporate financial practices that included overstating shareholders’ earnings and understating earnings of top executives.

To help protect the retirement savings of workers, President Bush proposed that:

1. workers get 30 days notice before any blackout period—the time when they cannot sell, buy, or borrow from their 401(k)s;

2. corporate executives be required to follow the same rules that other employees follow during blackout periods;

3. workers be able to sell their company stock after holding it for three years so their retirement savings are not tied up in the stock of a single company;

4. investors receive better information, including quarterly reports, about how their 401(k)s are performing; and

5. workers have access to professional investment advice so they can make informed decisions about their savings.

Congress passed the first two measures as part of the Sarbanes-Oxley Act.

SARBANES-OXLEY ACT

Auditing

Standards and Oversight. The act creates a Public Company Accounting Oversight Board, under SEC, to oversee audit functions of public companies. The board must establish audit, quality control, ethics, and other standards for audit reports subject to SEC approval. Auditors must register with it and conduct audits according to its standards. It may inspect, investigate, discipline, fine, and sanction firms and certified public accountants who violate its rules and standards, and may suspend them from conducting audits for public companies (§ 101).

Audit Practice and Procedures. The act directs SEC to require each public company to have an independent audit committee that meets specified criteria. The committee must appoint, pay, and oversee the company’s outside auditors. It must establish procedures for handling complaints about accounting, internal controls, or audit matters, and protecting employees who report questionable accounting or auditing practices (§ 301).

Non-Audit Services. In an attempt to eliminate perceived conflicts of interest in the wake of Andersen’s dual role at Enron as auditor and financial advisor, the act bars auditors from performing most nonaudit services for their clients, including consulting, internal accounting, financial information system design, and investment banking services.

Corporate Governance

The act contains several provisions designed to ensure the accuracy of financial statements public companies file with SEC. Among other things, it requires CEOs to establish internal controls, and CEOs and CFOs to certify that their companies’ annual and quarterly reports containing financial statements fairly and accurately reflect the companies’ financial state and results of the companies’ operations (§ 906). False certifications carry fines of up to $ 5 million and imprisonment for up to 20 years. The act also makes it illegal for company executives or directors to improperly influence or mislead auditors if their actions would make financial statements materially misleading (§ 303).

The act requires CEOs or CFOs of public companies to forfeit bonuses, incentive awards, and profits gained from selling company stock if the companies must restate their financial statements because of misconduct resulting in material noncompliance with the financial reporting requirements of the securities laws (§ 304).

Generally, the act bars public companies from extending personal loans to, or arranging personal loans for, their directors or executive officers (§ 402).

The act imposes stricter disclosure requirements on officers, directors, and shareholders who own 10 percent or more of public companies, generally requiring them to report stock transactions to SEC within two business days. Within a year, SEC and public companies that have web pages must make such reports available on the Internet (§ 403).

The act prohibits directors or executive officers during blackout periods from trading any company equity security they received as compensation if the company’s 401(k) retirement plans are not allowed to trade. Companies must timely notify directors, officers, and SEC of blackout periods. Also, pension plan administrators must give participants 30 days notice of any blackout, including the reasons for it, its starting date and length, investments and rights affected, and a statement advising participants to evaluate the appropriateness of their portfolio before the blackout period begins. Companies may recover profits that directors and executive officers realize from trading in violation of the ban (§ 306).

Enhanced Financial Disclosures

The act requires SEC to adopt rules requiring that companies:

1. disclose material off-balance sheet transactions “and relationships that have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses” (§ 401) and

2. reconcile any published financial projections to the company’s financial conditions prepared in accordance with Generally Accepted Accounting Principles (§ 401).

The act requires companies to disclose publicly in plain English and on a “rapid and current basis” all material changes in their financial state or operations, including trends, qualitative information, and graphic presentations, that SEC determines are necessary to protect investors and in the public interest (§ 409).

Crimes and Penalties

The act creates new offenses, increases penalties for several existing ones, and directs the U. S. Sentencing Commission to review sentencing guidelines for “white collar” crimes to determine that penalties are commensurate with the gravity of the offenses (§ 905).

Among other things, the act:

1. imposes fines and prison terms of up to 20 years on people who knowingly destroy, alter, or falsify records to frustrate federal investigations, or in federal bankruptcy cases (§§ 802 & 1102);

2. imposes criminal penalties on auditors of public companies who fail to retain records for the periods required by law (§ 802);

3. increases the fines and five-year prison term for CEOs and CFOs to $ 1 million or 10 years for knowingly certifying false financial reports and $ 5 million or 20 years for willful false certifications (§§ 902 & 906);

4. expands federal criminal prohibitions against mail and wire fraud to include conspiracy and attempts to commit these offenses; and

5. substantially increases maximum penalties for violating mail fraud statutes or criminal provisions of the Employee Retirement Income Security Act (§§ 903, 904, & 1106).

Enforcement

Whistleblower Protection. The act prohibits public companies from penalizing whistleblowers for reporting conduct they reasonably believe violates U. S. securities or antifraud laws. It also protects employees who testify or participate in or file certain securities or antifraud proceedings. An employee or other covered party whose rights are violated is entitled to relief, including reinstatement, back pay, attorney fees, and litigation costs (§ 806).

SEC Authority. The act:

1. allows SEC temporarily to freeze “extraordinary payments” proposed by public companies to officers, directors, controlling persons, or employees during any investigation for possible securities law violations (§ 1103);

2. allows SEC to issue cease and desist orders to bar people from serving as directors or officers of public companies if they violate certain securities law antifraud provisions, rather than requiring SEC to go to court for an order (§ 1105);

3. broadens considerably SEC’s authority to seek forfeiture of profits in court and allows it to seek appropriate or necessary equitable relief that may benefit investors;

4. directs SEC to require that public companies disclose in their periodic reports submit to the commission whether they have established corporate ethics codes for senior financial officers, to immediately inform the public of changes or waivers (§ 406);

5. requires SEC to review disclosures, including financial statements, by public companies on a “regular and systematic basis,” but at least every three years (§ 408); and

6. directs SEC to establish minimum standards of professional conduct for attorneys appearing before the commission to represent public companies. The standards must require attorneys to report to CEOs or CFOs evidence of violations of the securities laws, breaches of fiduciary duty, or similar violations (§ 307).

ARGUMENTS FOR AND AGAINST THE ACT

Critics say the cost of complying with the act is too high. They argue that (1) it will be particularly burdensome for smaller companies, many of which will be unable to find the resources needed to comply and (2) the numerous rules and regulations could stifle innovation, particularly by small companies whose financial flexibility might be severely constrained by the added expense of compliance resulting from higher audit fees, legal advice, insurance, and revised financial controls, among other costs. According to some of these critics, the cost of compliance may influence some public companies to go private and foreign companies to shun the U. S. market.

Some critics say the act does not go far enough. They argue that it does little to combat corporate tax evasion and excessive executive compensation, for example. According to Lawrence Cunningham, Boston College Law School professor, “the act’s main provisions are stunts to promote investor confidence,” the most prominent example being “the essentially redundant but much publicized requirement for top executives to certify their financial statements. ” He argues that the act merely restates numerous existing regulations with the force of federal law and its incremental provisions are nothing more than patchwork (The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And it Might Just Work), Boston college Law, Research Paper No. 01, November 7, 2002)).

Critics also contend that the whistleblower provision may encourage spurious claims of fraud or other regulatory violations, inundating SEC with meaningless allegations. This would make it harder for SEC to identify and investigate legitimate allegations and divert SEC resources from real wrongdoing.

The act’s supporters say the act benefits shareholders by making executives and directors more accountable. Further, by addressing problems in financial disclosure, corporate governance, and auditing issues that were at the heart of the various corporate scandals, the act will help bolster investor confidence in the stock market. In this regard, they cite the broad powers of the new accounting oversight board, the role of audit committees, and SEC’s enhanced enforcement authority.

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