Under the Gramm-Leach Bliley Act of 1999, the Depression-era Glass-Steagall Act, which erected a wall between commercial banking and investment banking, was repealed. Financial holding companies are now permitted to own banks, insurance companies and securities firms. Thanks in part to this and other deregulation efforts, the lack of regulation, and cross-industry mergers and acquisitions, potential conflicts of interest now abound.
 

Congress has attempted to deal with the current crisis in confidence in all of these industries through the enactment of the Sarbanes-Oxley Act, signed into law on July 30, 2002. This law establishes new standards for corporate governance and disclosure.

In response to Sarbanes-Oxley and the general dissatisfaction with corporate accounting, the SEC has implemented a requirement, found at @906 of Sarbanes-Oxley, that the chief executive officers and chief financial officers of the 1,000 largest corporations personally certify financial statements. This requirement has real teeth, as these individuals could be subjected to fines up to $5 million and 20 years in jail for certifying false financial reports -- material misstatements or omissions of fact, and not fairly presenting the company's financial condition.
 

If financial statements have to be restated, that could lead to disgorgement by the CEO and CFO of bonuses and profits from the sale of stock received during the 12-month period beginning with the filing of the statements later restated.  And financial statements must now disclose off-balance sheet transactions.
 

Pursuant to Sarbanes-Oxley, the New York Stock Exchange has also implemented new standards in corporate governance and practices, the principal among these being the requirement that audit committees of boards of directors consist entirely of truly independent directors -- directors with no conflicts of interest and no vendor status to the corporation.
 

Audit committees are required to put in place procedures to handle the complaints of employee whistleblowers concerning company accounting issues, and whistleblowers are granted federal protection. Internal auditors and the compensation committee must report directly to the board's audit committee. Companies must disclose whether audit committees include at least one member who is a financial expert.
 

Both the NYSE and National Association of Securities Dealers now require that the majority of directors of listed companies be independent. Of course "independent" does not necessarily mean quality. Both Enron and WorldCom had independent boards. What you want are independent directors who only serve on a small number of boards and who have the intellect and experience to think strategically and who also have a sense of ownership in a company. After all, directors represent shareholders -- owners of the company -- and should therefore be serious owners of the company's stock themselves.
 

Sarbanes-Oxley requires the SEC to promulgate a rule requiring companies to disclose whether or not they have adopted a code of ethics for senior financial officers and, if not, why not. Changes or waivers to the code of ethics must be disclosed.
 

Under @402 of Sarbanes-Oxley, corporate loans to officers of publicly traded companies for personal purposes, including to exercise stock options, are now forbidden, except in the cases of securities firms and banks. Under regulation O, banks can lend to officers and directors on the same terms and conditions as to other customers, subject to detailed regulation.
 

It appears that the advance of litigation expenses to officers and directors under indemnification requirements is still permitted, as are travel and similar advances for business related reimbursable expenses.
 

Sarbanes-Oxley creates a new federal entity, the Public Company Accounting Oversight Board, which is subject to SEC oversight and review. This oversight board will have broad authority to: regulate auditors of public companies; set auditing, quality control, ethical and independence standards; and investigate violations.
 

The oversight board will be funded by mandatory fees paid by all public companies. The existing Financial Accounting Standards Board continues, but is given statutory recognition and full financial independence from the accounting industry through guaranteed funding from public companies.
 

Public accounting firms, including foreign accounting firms, that prepare audit reports on SEC-registered companies, must register with the oversight board. Audit firms must prepare and maintain supporting documentation relating to audit reports and must maintain audit work papers for seven years.
 

On Oct. 21, 2002, the SEC published for comment rules implementing @303[a] of Sarbanes-Oxley, which prohibits improper influencing of accountants. Under proposed Rule 13b2-2[b], it would be unlawful for management to fraudulently influence, coerce, manipulate or mislead an accountant who is preparing auditing statements to be filed with the SEC.
 

Sarbanes-Oxley directs the SEC to adopt rules requiring attorneys to report securities law violations. Under Sarbanes-Oxley, lawyers are required to notify the audit committee or their client's board of directors of management misconduct or any other material violation of law that top officers refuse to rectify. Sarbanes-Oxley also directs the SEC to issue rules pertaining to professional responsibility for research analysts.
 

On Oct. 3, 2002, the NYSE and NASD announced proposed rules targeting analyst conflicts of interest. Among other things, these rules would require each member organization to review and approve compensation of each research analyst.
 

In determining compensation, the member organization would be prohibited from considering a research analyst's contribution to the firm's investment banking business and research analysts would be prohibited from participating in solicitation meetings with perspective investment banking clients.
 

Assemblyman Neil Cohen, D-Union, has introduced A-2669, which upgrades criminal fines and penalties for corporate fraud and provides for civil action for treble damages under certain circumstances.
 

The accounting profession is already regulated at the state level by the State Board of Accounting. Although the activities of the board of accounting seem somewhat pre-empted by the new federal oversight board, that is true only with respect to public companies that report to the SEC. The board of accounting continues to have exclusive regulatory jurisdiction over the small and medium-sized accounting firms that audit private companies.
 

Of course, it is likely that the board of accounting will be influenced by the precedents set by the federal oversight board in setting accounting standards.
 

The status of the private American Institute of CPAs is not affected by Sarbanes-Oxley. It too is deeply involved in setting standards for auditors.
 

I have previously suggested that New Jersey repeal N.J.S.A. 2A:53A-25, the statute that grants immunity to the accounting profession when sued by third parties not in "privity." Banks, of course, rely on financial statements when making a loan.
 

Nonetheless, a bank relying on phony financial statements cannot sue the accountants [because of this statute] unless the bank has a letter from the accounting firm indicating that it realizes that the bank is relying on the financial statements -- that is, a letter creating privity. This is rarely done.
 

Pending repeal of this statute, some imaginative counsel representing bankrupt corporations are seeking one or more "honest" directors to authorize them to go after the accountants on behalf of the bankrupt corporation. The theory is that the corporation itself has privity and that directors who themselves did not engage in fraud are in a position to authorize a suit against the accountants. Honest directors are not themselves fraudulent and, therefore, have standing to make an equitable claim.
 

Several corporations and banks have announced that they will voluntarily expense stock options. Although management typically does not attend audit committee meetings, more boards are holding executive sessions of the full board from which management, including management board members, are excused.
 

Indeed, both the NYSE and the NASD now require that boards regularly meet without the CEO present. The definition of independent is being tightened, with full disclosure to the board of all vendor-debtor relationships of individual board members to the corporation or bank.
 

Where a board member has a personal interest in a vote, he or she is now typically excused from the board meeting room during discussion and voting. Audit committees, which now consist entirely of independent board members, are approving the selection of outside auditors, and increasingly are approving in advance any nonauditing services and fees from the outside auditors.
 

We should expect to see more disclosure concerning executive compensation, including voluntary reporting of perquisites, such as lavish benefits for directors, management and retired executives. And, even if not reported to shareholders, management is increasingly making sure that all perquisites are reported to, and approved by, their boards, if for no other reason than that they may later be sued for disgorgement if they do not obtain this approval.
 

The crisis in confidence is at root a moral one. Best practices need to be agreed to. Management sets the moral tone at any company. The board should be alert to that tone and should relieve management of its duties where that tone is other than full compliance with all laws. Reputation is key and boards are stepping forth to restore integrity where it has been compromised at the top.
 

With market declines, many executives find themselves being villainized. Legislators and regulators have gotten the message and the imbalance in favor of laissez-faire is swinging the other way. With all the initiatives under way at the federal and state level, as well as voluntarily, one can realistically hope that the era of corporate financial abuse scandals will soon fade and that a period where financial statements are once again deemed reliable has already commenced.
 

In the alternative, permanent, healthy skepticism will be the order of the day.

 

Geoffrey M Connor

 

The author is a partner at Reed Smith of Princeton and is chair of the banking law section of the New Jersey State Bar Association. From 1990 to 1994, he was commissioner of banking of the state of New Jersey.

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