Prior to the Great Stock Market Crash of 1929, government and investors did not perceive any need for federal regulation of the securities market. Recommendations that the federal government require financial disclosure and prevent the fraudulent sale of stock were never seriously considered.
The SEC was created because of an economic catastrophe that has maintained its notoriety in infamy. When the stock market crashed in October 1929, many investors lost fortunes. Banks also were great losers in the Crash because they had invested heavily in the stock markets. During this Crash, people feared that banks might not be able to pay back the money in their accounts. A "run" on the banking system caused many bank failures. Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence, regulate the securities market, and regulate shareholder-reporting requirements.
The Securities and Exchange Commission (SEC) is a governmental agency concerned with the securities industry; its effectiveness is its enforcement authority. The primary mission of the U.S. Securities and Exchange Commission is to protect investors and maintain the integrity of the securities markets. It is a necessary governmental agency because unlike the banking world, where deposits are guaranteed by the federal government, stocks, bonds and other securities can lose value.
The laws and rules that govern the securities industry in the United States are derived from this concept: "All investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it." To achieve this goal, the SEC requires public companies to disclose meaningful financial and other information to the public.
In addition to monitoring publicly held companies, the SEC also oversees stock exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies.
Prelude to Sarbanes-Oxley Act
In spite of the SEC’s power and influence - corporate scandals, deception, and bankruptcies produced consequential and innumerable financial disasters, especially conspicuous was the period from 2000 to 2002. The following annual data shows the magnitude of public companies that filed for bankruptcy during that period.
2002: 189 public companies with assets of $382 billion
2001: 257 public companies with assets of $259 billion
2000: 176 public companies with assets of $95 billion
The two most infamous corporate bankruptcies and scandals were Enron Corporation and WorldCom, Inc. A scandal involved Tyco International, Ltd., but bankruptcy was not imminent. There were several other notable bankruptcies and scandals during this period. Coverage of these three companies will provide an overview leading to the passage of the Sarbanes-Oxley Act of 2002.
Enron Corporation was an energy company with 21,000 employees and was one of the world’s leading electricity, natural gas and communications companies. In 2001, Enron filed for bankruptcy. The collapse of Enron, the second largest bankruptcy in U.S. history, caused thousands of employees to lose their life savings in 401(k) plans tied to the energy company's stock.
In 2002, WorldCom (at that time, the nation's No. 2 long-distance phone company; 60,000 employees) filed for Chapter 11 bankruptcy after it revealed that it had improperly booked $3.8 billion in expenses. WorldCom's bankruptcy is the largest in United States history, dwarfing that of Enron Corp. These two bankruptcies caused significant personal loss to shareholders and creditors.
In 2002, Tyco International Ltd’s former management was charged with improper and illegal activities including nearly $100 million in unauthorized payments to them or associates.
The fall of Enron and WorldCom, the Tyco scandal and several other corporate catastrophes sunk public confidence as to corporate reporting and the reliability of the public accounting profession to critically low levels. The stock market crashed during the period 2000-2002 was far-reaching. The technology bubble burst in March 2000 was another factor contributing to the volatility of the stock market.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act (named after its architects Senator Paul Sarbanes and Representative Michael Oxley) was signed into law on July 30, 2002. This act introduced significant legislative changes to financial practice and corporate governance regulation. The act contains restrictive new rules with the stated objective: "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws".
The Sarbanes-Oxley Act of 2002 (the "Act") is legislation passed by the U.S. Congress to protect investors from the potential fraudulent accounting activities by publicly held corporations. The Act improves the accuracy and reliability of corporate disclosures under securities laws. The Act contains criminal provisions applicable to a company’s management and its public auditing firm. These provisions strengthen criminal sanctions for violators by:
Creating new federal criminal offenses
Increasing penalties for existing federal criminal offenses
The Sarbanes-Oxley Act is arranged by eleven "titles". The more important sections relative to compliance within these eleven titles generally are 302, 401, 404, 409, and 802. The topics covered in these sections are:
Section 302: Corporate Responsibility for Financial Reports
Section 401: Disclosures in Periodic Reports
Section 404: Assessment of Internal Controls
Section 409: Disclosures
Section 802: Criminal Penalties
Executives must certify the financial statements. This certification enumerates:
The signing officers have reviewed the report
The report does not contain any misleading or material untrue statements or material omissions
The financial statements and related information fairly present the financial condition and the results of operations
The signing officers are responsible for internal controls and have evaluated these internal controls within the previous ninety days
The officers have provided a list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities
Disclosing significant changes in internal controls or related factors that could have a negative impact on the internal controls
Financial statements are required to be accurate and do not contain incorrect statement.
The company is required to publish information in their annual reports concerning:
The scope and adequacy of the internal control structure
The procedures for financial reporting
A statement assessing the effectiveness of the internal controls and procedures.
In addition to the auditor’s opinion on the financial statements, Section 404 requires that the public accounting firm, in its auditor’s report, assess and report on the effectiveness of the internal control system and procedures for financial reporting.
Issuers of financial statements are required to disclose information on material changes in their financial condition or operations. These disclosures should be supported by graphic presentations as appropriate.
Fines and/or up to 20 years imprisonment are imposed for altering, destroying, mutilating, concealing, falsifying records with the intent to obstruct, impede or influence a legal investigation.
Fines and/or imprisonment up to 10 years on any accountant who knowingly and willfully violates the requirements of maintenance of all audit or review papers for a period of 5 years.