Tag: Sarbanes-Oxley

PCAOB is Ruled Unconstitutional

This morning, the United States Supreme Court issued its opinion in the case of Free Enterprise Fund v. PCAOB. For me in the compliance world, the case was about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gave the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

The Supreme Court ruled that the limitations on the power to remove the members of the board is unconstitutional under the separation of powers doctrine. The board members are inferior officers, and the method of appointment under the Sarbanes-Oxley Act violates the Appointments Clause.

The ruling does not seem to shut down PCAOB immediately since the Court declined to allow a broad injunction against PCAOB’s continued operation. The challengers to the method of PCAOB board-member appointment are entitled to a declaratory order “sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive.”

The Court also found the PCAOB provisions severable from the rest of Sarbanes-Oxley, so they did not invalidate the entire law.

There will have to be some quick tinkering by the SEC and Congress on how to deal with the ruling.

Administrative law professors will need to tinker with their classroom teaching and casebooks to address this case and its implications.

Update – Some key quotes from the Opinion:

We hold that the dual for-cause limitations on the removal of Board members contravene the Constitution’s separation of powers.

The Act before us does something quite different. It not only protects Board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists. That decision is vested instead in other tenured officers—the Commissioners— none of whom is subject to the President’s direct control.The result is a Board that is not accountable to the President, and a President who is not responsible for the Board.

Second Update

[T]he existence of the Board does not violate the separation of powers, but the substantive removal restrictions imposed by §§7211(e)(6) and 7217(d)(3) do. Under the traditional default rule, removal is incident to the power of appointment. … Concluding that the removal restrictions are invalid leaves the Board removable by the Commission at will, and leaves the President separated from Board members by only a single level of good-cause tenure. The Commission is then fully responsible for the Board’s actions, which are no less subject than the Commission’s own functions to Presidential oversight.

That leaves the 15 U.S.C. §7211(e)(6) and 15 U.S.C. §7217(d)(3) out in the cold, but saves PCAOB and Sarbanes-Oxley from destruction in a very narrow ruling. It seems that Congress will not need to take any action since the decision merely grants the SEC the right to remove any Board member for any reason. No longer is removal limited to a firing “for cause.”

There may be some argument that the past rulings and standards set by PCAOB were made by an unconstitutional. That’s heading down a path way beyond my expertise (or interest).

So life will continue on, but the PCAOB board members have  less job security.

Sources:

Portugal and Ethics Hotlines

Under guidelines published by the Portuguese Data Protection Authority on the 1st October 2009, a whistleblower cannot make a report anonymously. I have to admit that I can’t read Portuguese, so reading Deliberação Nº 765 /2009 does not help me much in interpreting the limitations. (Google translate helps.)

Most EU member states allow anonymous reporting as a last resort. Portugal went a step further and outlawed anonymous reporting completely.

The Portugal guidelines also limit hotline use to reports of corruption, banking and financial crime and internal accounting controls. It’s not allowed for breaches of general codes of conduct. To go a step further, whistleblowers may only report against individuals in managerial positions.

If you are a public company with operations in Portugal and required to have whistleblower hotline under Sarbanes-Oxley, you need to look at these limitations. They seem to be in direct conflict.

Thanks to Bill Piwonka of EthicsPoint for letting me know about this. EthicsPoint supplies my company’s hotline.

Sources:

SOX Whistleblower Protections at Mutual Fund Companies

We know that Sarbanes-Oxley offers protections to employees at public companies, but does it also protect employees at mutual fund companies?

Yes. At least according to Judge Woodcock of the Massachusetts U.S. District Court.

The Employees

The decision is for two cases that were combined because of the common defendant. According to the decision, Jackie Hosang Lawson worked at Fidelity for more than a decade, before she questioned (1) an expense for “Guidance Interactions”, (2) the improper retention of 12b-1 fees, (3) the methodology that affected fund profitability models, (4) issues with a new source system, (5) allocations of internet expenses, and (6) errors in a back office group. She claims to have received poor job performance ratings, missed a promotion and other bad acts as a result of her raising the issues. She filed four separate whistleblower complaints with OSHA that ended up as this federal district court case.

Jonathan M. Zang started at Fidelity in 1997 as an equity research analyst and eventually became a portfolio manager. Zang objected to what he saw as inaccurate disclosure of portfolio manager compensation in an SEC filing for one of his funds. Zang contended that Fidelity retaliated by giving him poor performance ratings and ultimately fired him.

The Mutual Funds

The Fidelity mutual funds are publicly traded, but do not have any employees. The mutual funds hired FMR LLC and other Fidelity affiliates to act as advisers to the funds and those advisers have the employees. (This is the typical arrangement for mutual funds.)

The fund company took the position that Lawson and Zang were employees of a private company (FMR is private) and are not covered by the SOX whistleblower protection. Lawson and Zang argue that SOX protections are not only for employees of public companies but also for employees of private companies, particularly those that act as investment advisers to public investment companies.

The Statute

The statutory provision in question [18 U.S.C. §1514A(a)]provides:

No company with a class of securities registered under section 12 of the Securities Exchange Act of 1934 … or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of employment because of any lawful act done by the employee ….

The Reasoning

If Zang or Lawson were direct employees of the mutual fund there is little question that they would be protected.

Judge Woodlock looked at the broader provision of Sarbanes-Oxley and found that the intent was to address the problems of shareholder fraud in the public markets.  The judge feels that the protections applies to employees of  “any related entity of a public company.”

The Lawson and Zang are either contractors, subcontractors, or agents of publicly held investment companies. “If the Funds did not
have investment advisers as their agents, the only activity that could take place on the Funds’ behalf would be actions taken by the Board of Trustees.”

Judge Woodlock did not rule on the substance of the plaintiffs’ claims. He did side with Fidelity and dismissed wrongful discharge claims under state law.

The Future

I expect we will hear more about this case on appeal.

Sources:

Media Leak is not Protected as a SOX Whistleblower

Leaking information to the media about bad financial controls is not protected by SOX whistleblower retaliation clause.

Nicholas P. Tides and Matthew C. Neumann were working as “Audit IT SOX auditors” at The Boeing Company. They made several complaints about auditing deficiencies to their supervisors. They claimed “that Boeing’s auditing culture was unethical and that the work environment was hostile to those who sought change.”

So they took their story to Andrea James, a reporter from the Seattle Post-Intelligencer, providing her with information and documents.

Boeing ended up firing Tides and Neumann. They sued claiming they were wrongly fired as whistleblowers and were protected under Section 806 of Sarbanes-Oxley.

The court pointed out that 18 USC § 1514A(a)(1) states that the protection exists when

the information or assistance is provided to or the investigation is conducted by—

(A) a Federal regulatory or law enforcement agency;

(B) any Member of Congress or any committee of Congress; or

(C) a person with supervisory authority over the employee (or such other person working for the employer who has the authority to investigate, discover, or terminate misconduct)

None of these three cover a reporter or media outlet, so no protection to the whistleblower.

Sources:

Disclosure: I own some Boeing stock.

Public Companies Fail to Disclose Ethics Waivers

usha rodrigues

According to Usha Rodrigues from University of Georgia Law School and Mike Stegemoller from Texas Tech University – Rawls College of Business, in their paper Placebo Ethics, public companies are failing to disclose ethics waivers.

They focused on Section 406 of Sarbanes-Oxley which requires public companies to disclose when they have granted an ethics waiver to top executives. Section 406(b) states:

“The Commission shall revise its regulations concerning matters requiring prompt disclosure on Form 8-K (or any successor thereto) to require the immediate disclosure, by means of the filing of such form, dissemination by the Internet or by other electronic means, by any issuer of any change in or waiver of the code of ethics for senior financial officers.”

The regulations for Section 406 provide:

§229.406 (Item 406) Code of ethics:
(a) Disclose whether the registrant has adopted a code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. If the registrant has not adopted such a code of ethics, explain why it has not done so.

(b) For purposes of this Item 406, the term code of ethics means written standards that are reasonably designed to deter wrongdoing and to promote:

(1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; …

Rodrigues and Stegemoller were able to take advantage of the overlap between the 406 disclosure requirements and the disclosures required by Item 404 of Regulation S-K for related party transactions with an amount in excess of $120,000. One of the challenges of determining compliance with disclosure requirements is you can’t tell if there was a need for a disclosure unless the information is disclosed. This overlap allowed them to find items in the 10-k proxy statement that should have been reported immediately under Section 406.

Their sample set was 200 public companies. From January 1, 2003 through December 31, 2007 they found only one waiver filed under Section 406 for these 200 companies. They also looked beyond their sample set and found that of the 5,000± public companies there have only been 36 waivers filed using Form 8-K.

They took the next step and looked at the 10-K filings for their sample set of companies for related party transactions. Fifteen companies failed to disclose related party transactions that should have been reported immediately under Section 406. They found lots of other disclosures that were in a gray area. (This should be no surprise to Michelle Leder at Foototed.org who loves finding these things.)

One theory is that the public companies prefer to dump these related party transactions into the 10-K proxy statement where there is already a flood of information rather than specifically calling out the transaction in a separate Form 8-K. (Again, Michelle Leder loves digging up this stuff.) There is a difference between immediate disclosure and eventual disclosure.

Another surprise in the paper was that most of the companies in the sample set did not prohibit related party transactions in their code of ethics. Only 30 prohibited these transactions. These omissions also would appear to be a violation of Section 406 since the regulation requires a code to deal with conflicts of interest. Personally, I don’t see how you can call something a code of ethics if it does not prohibit related party transactions.

References:

Tuesday Morning Quarterback of Free Enterprise v. PCAOB

pcaob logo

On Monday, the Supreme Court listened to the oral arguments in Free Enterprise Fund v. Public Company Accounting Oversight Board (08-861). For me in the compliance world, the case is about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gives the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

If the Supreme Court agrees that PCAOB isn’t constitutional, it could force a revisit of Sarbanes-Oxley, or at least the portion of it that creates PCAOB. In a broader view for constitutional scholarship, the case could also call into question other independent agencies and how they appoint members of those agencies.

David Zaring in The Conglomerate thinks that the Supreme Court is unlikely to get in the way of an important government agencey. After all eliminating an agency is a sever sanction.

Orin Kerr in The Volokh Conspiracy> got the impression that the arguments did not go well for the challengers to the constitutionality of the Public Company Accounting Oversight Board.

Fawn John Johnson and Jess Bravin in The Wall Street Journal look to Justice Kennedy as the key to which way the Supreme Court will decide. The liberal justices are less likely to find fault with the independent agencies. For conservative legal scholars, the case is less about the accounting board itself than about the “unitary executive” theory, which holds that because the president is accountable to the electorate, he must be able to remove federal officials at will.

The transcript and reports seem to focus on how much control the SEC has over PCAOB. Hans Bader points out that the SEC had previously expressed its frustration about how little control it had over PCAOB, seemingly contrary to the arguments made in front of the Supreme Court.

David Zaring in The Conglomerate points out that the number of law review articles referring to “PCAOB”: 1021.  Number referring to “PCOAB”: 29. So much for the higher scholarship and editing of law review articles over blogs.

UPDATE:

Broc Romanek, of The Corporate Counsel.net provides a great first-hand account of the hearing and his experience at the Supreme Court the day of the hearing: My SCOTUS Experience: The Full Monty.

References:

In-House Counsel as Whistleblowers under SOX

whistleblower

Section 806 of the Sarbanes-Oxley Act (18 USC §1514A) expressly authorizes any “person” alleging discrimination based on protected conduct to file a complaint with the Secretary of Labor and, thereafter, to bring suit in an appropriate district court. There is no exception for lawyers or in-house counsel.

Recently, the Ninth Circuit tackled this issue in the case of Van Asdale v. International Game Technology.

Shawn and Lena Van Asdale were in-house counsel for IGT. As part of the merger of IGT with another company, the Van Asdales raised some issues regarding the validity of a valuable patent owned by IGT. They thought the patent issue should be disclosed in connection with the merger. Their bosses thought otherwise and fired them instead.The Van Asdales sued, asserting a whistleblower claim under the SOX because they were terminated for reporting possible shareholder fraud in connection with that merger.

What About Legal Ethics Restrictions?

IGT argued that the Van Asdales were prohibited from filing suit because of  their ethical obligations as Illinois-licensed attorneys. There is some Illinois law that “in-house counsel do not have a claim under the tort of retaliatory discharge.” Balla v. Gambro, Inc., 584 N.E. 2d 104 (Ill. 1991). However, this case is based on federal law, not Illinois law. So the court rejected that argument.

What About Attorney-Client Privilege?

The Van Asdale’s case is based on a conversation the two had with their boss regarding a pending litigation matter involving the company. To bring the case, they have to disclose information subject to the attorney-client privilege.

The Court looked at Section 806 of the Sarbanes-Oxley Act (18 USC §1514A) which expressly authorizes any “person” alleging discrimination based on protected conduct to file a complaint. Since there is no exception, in-house counsel should not be prevented from bringing a claim. There are ways to protect information. The trial court should “use the many ‘equitable measures at its disposal’ to minimize the possibility of harmful disclosures, not to dismiss the suit altogether.”

What About the Substance of the SOX Claim?

Beyond the attorney-client privilege in the case, there was also a disagreement of the standards for the claim under the whistleblower protections of SOX.

The plaintiffs only needed to show that they reasonably believed that there might have been fraud and were fired for suggesting further inquiry. Section 1514A prohibits discriminating  against an employee for “provid[ing] information . . . regarding any conduct which the employee reasonably believes constitutes a violation of” a listed law. So an employee “must have (1) a subjective belief that the conduct being reported violated a listed law, and (2) this belief must be objectively reasonable.”

References:

Image is by HughElectronic: Whistleblower. http://www.flickr.com/photos/hughelectronic/ / CC BY 2.0

Whistleblower Programs: Challenges for Multinational Companies

skadden

Katherine D. Ashley, Gary DiBianco, Dana H. Freyer, Matthias Horbach, Pierre Servan-Schreiber of Skadden, Arps, Slate, Meagher & Flom LLP put together a nice article addressing the challenges of exporting the whistleblower requirements under Section 301 of Sarbanes-Oxley to operations in the European Union: Whistleblower Programs: Challenges for Multinational Companies. 

Section 301 of the Sarbanes-Oxley Act of 2002 created a requirement that public company audit committees establish procedures for the “confidential, anonymous submission by employees of the company of concerns regarding questionable accounting or auditing matters.” Most companies have expanded the use of this hotline to include any violation of law or violation of company policy.

On the other side of the Atlantic, European labor and data protection laws offer more protection and rights to the whistleblower’s target. It is struggle to get a whistleblower hotline that works around the world. The folks at Skadden offer some suggestions in their article.

See also:

SEC’s Notice and Access Rules: What Do They Mean For Your Company?

noticeandaccessComputershare has put together a White Paper that they distributed through Compliance Week: An Explanation of the SEC Notice and Access Rules: What Do They Mean for Your Company? (.pdf)[For Compliance Week Subscribers]

Pamela Eng, Product Manager for Computershare Investor Services takes us through The SEC’s Shareholder Choice Regarding Proxy Materials rules in Release No. 34-56135 (.pdf) issued July 26, 2007.

[I mentioned some of my confusion about the Notice and Access Rules in SEC Requirements for Online Annual Reports and Proxy Statements. (Thankfully, the rule is not in my domain.)]

Pamela points out that there are now three ways to provide annual meeting materials to shareholders:

  • Notice Only. You can send just a notice with a link to materials on the website.
  • Full-Set. When you send the full set of printed materials.
  • Mixed Set.  When you send some and leave the rest online.

The idea behind the “notice only” delivery was to save printing and delivery costs. Theoretically, the information is more useful online because it searchable and linkable.

It seems even Pamela is not completely happy with the rule. She offers six recommendations to the SEC on how the rule could be improved.

  • Allow more flexible timing for posting online documents
    We requested that the SEC allow the online documents to be made available one or two days
    after the initial mailing has been sent, rather than on the mailing date. This would give extra
    time for companies to get their documents approved and programmed for the website.
  • Allow more time to fulfill holder requests
    The rule gives only three days to fulfill requests for registered holders, yet gives nine days
    to fulfill the requests of beneficial holders. Our recommendation was to allow six days for
    fulfillment on both sides.
  • Change the 40-calendar-day timeline
    A number of companies had problems meeting the 40-day deadline for notice-only mailings,
    which led us to request that the deadline be moved to 30 calendar days before the meeting.
    Shareholders will still have plenty of time to request materials before the meeting date.
  • Allow educational information to be included with the notice-only mailing
    Because of shareholder complaints about confusion and issuer concerns about holder
    education, we advocated the inclusion of educational information with the notice. This
    information could explain the regulations and why holders are receiving a notice.
  • Allow the voting telephone number to appear on the notice
    The SEC was concerned about possible uninformed or capricious voting by registered holders,
    who would vote without first viewing the proxy materials, so it did not allow the voting
    telephone number to appear on the notice. We believe that holders understand the issues, and
    that allowing the number to be placed on the notice will help holders better understand the
    overall process.
  • Issue an FAQ, Q&A or other written clarification of the rules
    The new notice and access rules are potentially confusing to both issuers and shareholders, and
    confusion may increase as many more companies begin the process in 2009. We asked that the
    SEC issue some written clarifications, possibly including a frequently asked questions document
    (FA Q); a question and answer bank; or, in some cases, a rewrite of the rules themselves.

Lawyer’s Noisy Withdrawal from Stanford Case

sjoblomLawyers must protect their clients’ confidence, but they can’t aid in the commission of a potential crime. The Wall Street Journal covered some of the facts leading up to the “noisy withdrawal” of Thomas Sjoblom of Proskauer Rose LLP from their representation of the Stanford Financial Group: Top Lawyer’s Withdrawal From Stanford Case Waves a Flag.

There was much consternation over the idea of an attorney whistle-blowing on her client back when Sarbanes-Oxley was adopted. Legal ethics, business ethics and ethics were at odds. An attorney is divided between doing what is right for society at large, for her client and her own income.

Lawyers represent guilty people. They are there to help them through the legal system and ensure the government did not overstep its constitutional limitations. Stanford was in trouble and needed the help of lawyers. In this time of crisis Stanford’s lawyer ended his representation.

Charlie Green finds much fault with the approach and found the use of “disaffirm” to be a bit trivial for the magnitude of the underlying scandal.  Stephen Gillers in his comment points out that “the word ‘disaffirm’ is actually a term of art in New York legal ethics.”

I am giving Mr. Sjoblom the benefit of the doubt that he did not find out about the fraud at Stanford until sometime in late January or early February when they had to respond to the SEC subpoena. It certainly sounds like the February 10 testimony of Laura Pendergest-Holt, a Stanford executive, in front SEC investigators did not go well. She got arrested and Mr. Sjoblom made his noisy withdrawal.

There is a lot of work ahead for Stanford’s lawyers in sorting out the facts, defending the company and defending the executives. Sjoblom stepped away from this representation and turned down hundreds of thousands if not millions of dollars or revenue to be made from the representation.

There is a big difference between defending a criminal and being a witness to a crime. It sounds like Mr. Sjoblom realized that he had become a witness to a crime and incapable of defense.

Someday we may hear the true story of what happened. As with the Madoff scandal, I am very interested in finding out the underlying facts. Did they start out bad? If they originally had good intentions, what made these people go bad?

See also:

The Law:

17 CFR 205.3(b) provides:

Duty to report evidence of a material violation. (1) If an attorney, appearing and practicing before the [Securites and Exchange] Commission in the representation of an issuer, becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney shall report such evidence to the issuer’s chief legal officer (or the equivalent thereof) or to both the issuer’s chief legal officer and its chief executive officer (or the equivalents thereof) forthwith. By communicating such information to the issuer’s officers or directors, an attorney does not reveal client confidences or secrets or privileged or otherwise protected information related to the attorney’s representation of an issuer.

This regulation was promulgated under Section 307 of Sarbanes Oxley Act of 2002.