In Enron insiders were selling their shares and minting millions just
before the filing of the bankruptcy in full knowledge of what was about to
come but they were depraved and ethic-less to put a ban on employees.
Now if this were to happen all the profit earned would be forfeited.
SOX imposes stringent disclosure requirements. The result is that all material
off balance sheet transactions and special purpose entities are required to be
disclosed in annual and quarterly financial reports. In addition:
All financial trading by executives or directors has to be disclosed within two
The current financial condition needs to be disclosed;
In the event of the use of pro forma numbers by the corporation, then what
would be the financial results by using generally accepted financial prin-
ciples must be shown; and
A code of ethics for finance officers, or its waiver, should be disclosed
(Bumgardner, Larry â€˜Reforming Corporate Americaâ€™, available on website
link at end of the chapter and on the CD-Rom).
The SOX reforms were in direct response to the malfeasance of executives
and utter disregard of their duties by directors of Enron. Now any executives
certifying the financial statements personally should be aware that misrep-
resentation and misleading can land them in prison for even 20 years. The
CEO and CFO could go to jail for 10 years and/or face a fine of up to $1 mil-
lion if they are aware of any false statement and a fine of up to $5 million
and/or 20 years of confinement in jail if the false statement is signed by them
willingly (Section 309 of SOX dealing with criminal certification).
Part E â€“ Case Studies of Business Risks
SOX requires executives to make honest disclosures as to the financial state of
the company and not allow personal financial interest or conflict to creep in
while making any decision on behalf of the company. They are accountable for
the financial dealings of the company. Executives now face enhanced criminal
penalties for up to 20 years in respect of mail or wire fraud (Section 903 of
SOX). The destruction of documents in order to obstruct justice is now a crim-
inal offence and accounting records are not to be destroyed until five years have
elapsed following the completion of the audit (Duffey 2002).
Impact of SOX
In total it can be said that executives and accountants have to be very care-
ful in carrying out their duties towards the shareholders. Otherwise they
will suffer the same fate as the superstars of Enron and Arthur Andersen
have had to suffer, that is criminal trials, convictions, civil liabilities, loss
of reputation and livelihood, etc. SOX makes executives, directors and
auditors face dire consequences if they carry out fraud upon investors.
The disclosure requirements mean that the executives cannot keep
investors in the dark: as noted, in the case of Enron for almost four years
unscrupulous executives were able to hide the true financial state of Enron
through off balance sheet transactions and SPEs.
The disclosure requirements are also made mandatory for corporate attorneys
under the provisions of Section 307. It has been commented that SOX has in fact
treated lawyers lightly in comparison with the accounting profession. They are
only the subject of this section which has placed lawyers practising before the
SEC under an obligation to report corporate wrongdoings. The light handling of
attorneys by SOX is attributed to the scope of the self-monitoring and regulatory
discipline systems already existing within the profession (Anello 2004).
Reforms of the New York Stock Exchange and NASDAQ
These new rules particularly affect the constitution and conduct of the board.
As a result:
The boards of listed companies must have boards with a majority of inde-
The audit, compensation and nominating committees must consist only of
independent directors; and
There must be a semi-annual executive session in the absence of management.
The rules provide for objectivity in oversight by the board by requiring inde-
pendent directors to be in the majority on the board and to be the only ones to
constitute the committees mentioned above. Now audit committee members
Chapter 22 â€“ Legal risk management in the US â€“ the United Statesâ€™ response to the Enron collapse 563
cannot draw any fee other than directorâ€™s fees. In Enron the board lost its inde-
pendence by drawing compensation in addition to their directorsâ€™ fees, such as
The Compensation Committee
The rules lay down guidelines for the Compensation Committee to deter-
mine the compensation for the CEO and require it to have a charter setting
out its purpose, duties and responsibilities. Enronâ€™s directors could not
oversee effectively the excessive compensation of its executives on
account of their lack of independence.
The sole responsibility of selecting and nominating directors and members of
the committees lies with the governance/nominating committee. Therefore the
CEO does not have the power to remove any director at his will. This provision
gives absolute independence to independent directors without the fear of being
removed through management opposition.
The regular executive sessions without the presence of management
enable more frank and unrestricted interaction among themselves. These
interactions provide for more effective monitoring of management unlike
the case in Enron where executives were present at the meetings of the
board (Elson and Gyves 2003).
The rules also require corporations to disclose how the shareholders can inter-
act with the independent directors to express their concerns in confidentiality.
The code of conduct and ethics for management, directors and employees is
required to be made public and all relevant information has to be provided on
the companyâ€™s website.
The NYSE and NASDAQ Listing Rules did not provide for the disclosure
of the functioning of the nominating committees. Therefore in November
2003 the SEC approved new proxy statement disclosure rules requiring for
the disclosure of the functioning of nominating committees and for inter-
action between security holders and the board. The enhanced disclosure
requirements put security holders in a better position to analyse and
understand the nomination process (DeGaetano 2005).
Part E â€“ Case Studies of Business Risks
As regards executive compensation, the NYSE has made it obligatory to have
compensation plans approved by shareholders (Garrett 2004).
The positive effects of post-Enron reforms
The effects of the changes that have been introduced to improve corporate gov-
ernance by the legislative and regulatory reforms in post-Enron corporate
America are discussed below. These changes relate to:
The independence of the audit committee;
The increase in criminal penalties for white collar crime and the effects on
The creation of PCAOB for enhanced regulation of auditors;
The prohibition of non-audit services;
The prohibition of loans to directors and executives;
Various kind of disclosures to provide transparency as regards the function-
ing of the company;
Making attorneys liable for not reporting wrongdoing;
The attempt to eliminate any conflict of interest affecting analysts;
A prohibition on insider trading;
A prohibition on improperly influencing an audit report;
Making executives liable for false certification of corporation statement; and
The protection of whistleblowers.
Further comment on the impact of key changes follows:
Independence of the audit committee:
This has been examined above and has been considered to be very positive.
Enhancement of criminal penalties for the commission of white collar crime:
It has been recognised in the US that white collar crimes can harm a soci-
ety socially and economically and are comparable to the crimes committed
by organised gangsters and drug traffickers. Therefore the sentence for wire
and mail fraud has been increased from five to 20 years (Section 903 of
SOX) and for security fraud the sentence has been increased to 25 years
(Section 807 of SOX). The view is that executives who indulge in insider
trading and betray the trust of investors are much more depraved than ordin-
ary gangsters, because they are misusing their position of trust. The increase
in criminal penalty is a step in the right direction to deter those executives
who are tempted to commit fraud to earn a personal fortune.
Effect on directors:
The provisions of SOX have affected directors considerably. In all boards
of listed companies, the majority must be independent directors so that
there is independence and objectivity in oversight. Some of the committees
are to be constituted only of independent executive directors. The audit
committee will be constituted only of independent directors of whom at
least one should be a financial expert and will be responsible for the over-
sight of the external auditor. Under SOX specifically, the issue of directorsâ€™
Chapter 22 â€“ Legal risk management in the US â€“ the United Statesâ€™ response to the Enron collapse 565
independence from the influence of management has been effectively
addressed by different provisions so that directors are not marred by con-
flict of interest and do not have a problem in asking difficult questions
The creation of the PCAOB:
The collusion of Arthur Andersen with executives of Enron brought to
light the need for regulation of the accounting profession. The PCAOB is
now responsible for registering accounting firms, inspecting their work
and disciplining if they go off track under the influence of executives of the
company they audit. The PCAOB is to supervise and monitor the working
of external auditors to safeguard the interest of investors (Sections 101â€“105
The prohibition on non-audit services:
Most of the non-audit services which accounting firms used to provide to
a company that they were auditing have been prohibited. This prohibition
is advantageous in two ways, first, the auditors can concentrate on audit-
ing and second, the chances of their being persuaded by executives of the
company and acquiescing to their fraudulent demands are eliminated
since the fear of losing their engagement as providers of consultancy ser-
vices is removed (Section 201 of SOX).
New rules for special purpose entities (SPEs)
Enron was able to transfer its losses to SPEs to appear to be a profitable
company. Now it is not possible because companies have to disclose the
SPEsâ€™ results in their financial statement if the company is a de facto bene-
ficiary and imbibes the gains and losses of the SPE.
Companies are also required to state off balance sheet transactions
(Section 401(a) of SOX).
In the light of these two new rules related to SPEs, companies will not
be able to shift their debt to SPEs which are in fact owned and controlled
by them to deceive the investors and the public that the company is in a
sound financial position when in reality it is not.
In the post-Enron era the resources available to SEC have been increased by
Congress and, in turn, SEC has decided to apply some of its resources to
review the filings of fortune 500 companies (Section 408(c) of SOX).
Steps to eliminate analystâ€™s conflict of interest:
The Wall Street firms settled charges of $1.4 billion with the New York
Attorney General and SEC when they were accused that stock research
activities were manipulated by them in order to gain fees for their banking
They also agreed to provide their client with independent research in add-
ition to the research provided by them;
Part E â€“ Case Studies of Business Risks
Title V of SOX prevents banking firms from striking back against their ana-
lyst if the client companies are criticised by them in their reports and bank-
ing executives are not allowed to set the compensation for their firmâ€™s
equity analysts; and
The New York Attorneyâ€™s litigation and SOX enable more independent and
unbiased research from banks (Section 501 of SOX).
Prohibition on loans:
SOX prohibits the extending of loans to the directors and executives of the
company (Section 402(a) of SOX).
Prohibition on improperly influencing audits and reimbursement:
The directors and officers are prohibited from influencing the audits of the
company: if they do so then it is illegal under SOX (Section 303 of SOX).
In the case of filing of any restatement of the companyâ€™s finances then all
bonuses and compensation based on equity and profits earned by way of
sale of securities in the previous 12 months prior to the restatement of
finances will have to be reimbursed to the company; and
This provision will protect investors from unscrupulous insiders who â€“ as
in the case of the Enron executives â€“ know that the company is about to
collapse and mint money as a result of having internal information
(Section 305 of SOX).
Prohibition on insider trading in pension fund blackouts:
This provision of SOX is also in direct response to the misdeeds of the
directors and executives of Enron. They sold the companyâ€™s equity secur-
ities during the period when employees of Enron were barred from doing
so. Now SOX bans directors and executives from selling companiesâ€™ equity
securities during pension blackouts (Section 306 of SOX).
Certifications by CFO and CEO:
The CFO and CEO are required to sign and certify the company reports to
SEC and, in the event of false statement; they will be liable for civil and
criminal liabilities (Section 302 of SOX).
Enhanced corporate attorneyâ€™s responsibility:
The corporate attorneys are required to report to the chief legal officer or
chief executive officer of any material violation of the fiduciary duty or of