Responding to a number of scandals involving fraud at publicly owned companies, the U.S. Congress in 2002 enacted a new law intended to make undetected fraud less likely to occur. The law applies only to public companies, mainly those whose securities are registered in accordance with the Securities Exchange Act. Even so, experts predict that it will have an enormous impact on private companies as well.
Among the changes many businesses, public and private, will undergo are creating mechanisms for fraud whistle blowing by employees, adapting to a different relationship with their external auditors, upgrading internal financial controls, becoming much more aggressive at preventing fraud, and improving audit committee accountability. This magnitude of change is why the Sarbanes-Oxley Act has been variously described as “a paradigm shift” in how companies do business and “a whole new way of thinking about corporate governance.”
Some of the most notable of the act’s requirements include:
- Management must certify the accuracy of their companies’ financial statements.
- Management must attest to the effectiveness of their internal financial controls.
- Outside auditors must attest to the accuracy of management reports.
- The internal audit committee must have independence and must include financial experts.
- Steps must be taken to improve fraud detection and prevention (e.g., an employee hot line for reporting fraud, training about fraud, a written corporate anti-fraud policy).
- Auditors must proactively look for material misstatements in financial reports, evaluate opportunities to commit fraud, and maintain a skeptical attitude to the company’s reports.
Some experts predict that more private companies will fall under new rules similar to or the same as Sarbanes-Oxley as states enact new laws and apply them to private companies doing business in the state.
Many banks and insurance companies are demanding a higher standard of action to prevent fraud and are closely examining a borrower or insured’s fraud prevention efforts. Private companies that deal regularly with banks and insurance companies, and those that are potential acquisition targets, might find that they must comply with new rules even though they are not required to do so by law. While previously a banker’s only concern was whether they would get paid, now they are more likely to be concerned with whether management has done enough to avoid the risk of financial mismanagement.
Insurers, too, are engaging in increased oversight. Prices are going up on coverage in every area of financial fraud and mismanagement risk. Underwriters are reviewing private companies’ financial statements much more carefully and sometimes require interviews to obtain additional explanations.
Customers, clients, professional services providers, and business partners of privately held companies want to avoid the spotlight of scandal and may insist on adherence to the principles of Sarbanes-Oxley.
Private company directors are also likely to push for stricter fraud-prevention efforts in light of a recent federal court decision that will hold them responsible for fiscal misconduct by company management under a standard of due care and loyalty just as directors of public companies are. In Pereira v. Cogan, et al. (294 B.R. 449, S.D.N.Y. 2003) the judge ruled that directors at bankrupt Trace International Holdings Inc. failed in their responsibilities by allowing Marshall Cogan, Trace’s chairman and controlling shareholder, to drain company funds by drawing excessive compensation, loans, and dividends. Significantly, the Trace directors were found to have violated their fiduciary duties irrespective of whether Mr. Cogan’s self-dealing actions were the result of, or enabled by, board action.
The court noted that, during the period in question, the Trace board held no meetings and that, when it acted, it did so by written consent. The directors argued that they should not be liable, since they had not taken any action nor played any part in the improper transactions. But the court rejected this idea, noting that directors have a duty to be informed of significant corporate expenditures and to disapprove of those that are not in the best interest of the corporation or its shareholders.
It will be years before the full effects of this new climate of corporate financial accountability will be realized. For many private companies, as for public ones, the likelihood is that there will be little choice but to change some of their practices and to spend more to prevent fraud and other financial mismanagement.