Tread Lightly When Tweaking Sarbanes-Oxley

Michael W. Peregrine is a partner at McDermott Will & Emery LLP. This post is based on an article by Mr. Peregrine; his views do not necessarily reflect the views of McDermott Will & Emery or its clients. Thomas J. Murphy assisted in the preparation of this post.

Nascent discussions about repealing discrete sections of the Sarbanes Oxley Act should be monitored closely by proponents of effective corporate governance. As the federal regulatory pendulum swings hard to an extreme, even the most limited proposals to amend the Act could conceivably invite unintended consequences. This is particularly the case if caught in the tailwind of efforts to amend or repeal Dodd-Frank and other financial regulations. If unchecked, such actions could severely undermine the culture of corporate responsibility that has been a crucial legacy of Sarbanes.

These discussions have arisen in the context of the Trump Administration’s overarching interest in making the public markets more accessible to private companies, in part through reducing related regulatory barriers. Indeed, by Executive Order dated February 3, 2017, President Trump set forth the “Core Principles for Regulating the United States Financial System”, which Principles include the goal of making financial regulation efficient, effective, and appropriately tailored. Numerous articles over the last three months have spoken to legislative and other interest in scaling back provisions of Dodd Frank, and those portions of Sarbanes Oxley deemed particularly burdensome.

The “big picture” criticism of Sarbanes has historically been the extent to which its provisions prompt growing companies to shift away from public offerings. More specific criticism has long been focused on the controversial Section 404, addressing internal controls. In essence, Section 404(a) requires all public companies to include in their annual reports on Form 10-K a report from management that speaks to the effectiveness of the company’s internal control over financial reporting. Section 404(b) requires a public company’s independent auditor to attest to, and report on, management’s assessment of the effectiveness of those internal controls.

To its supporters, Section 404 has resulted in improved financial reporting and greater transparency for public companies. To its detractors, the financial expense (e.g., increased audit fees) and administrative costs associated with Section 404 are so excessive as to outweigh any benefit to investors. Rather, the detractors argue, the costs of Section 404 compliance could be put to better use by companies in creating jobs or satisfying demand for their products and services.

Dodd-Frank amended Sarbanes by adding a new Section 404(c) providing relief from the auditor attestation requirement of Section 404(b) to issuers who are neither accelerated filers nor large accelerated filers. Although non-accelerated filers will continue to provide the report from management in their annual reports, the permanent exemption from 404(b) for smaller issuers was expected to significantly reduce the ongoing costs of being a public company. In a subsequent study directed by Dodd Frank, the SEC declined to recommend any further amendment to Section 404. The 2012 JOBS Act included a provision exempting “emerging growth companies” from 404(b) attestation. Nevertheless, the criticism of Section 404 has continued among many in the business community.

This Executive Order has been generally interpreted as initiating the process for a rollback of Dodd-Frank, which the President has repeatedly denigrated as burdensome and needlessly complex. This has prompted many companies and commercial interest groups to advocate for expanding the exemption under Section 404(c), if not the actual repeal of the entire provision. Indeed, media reports speculate that the Republicans’ proposed replacement for Dodd Frank would contain such an additional exemption.

On its own, further amendment of Section 404—or even its complete repeal—by a Dodd Frank replacement legislation would appear to have little implications for corporate governance. Section 404 was perceived as an important means for assuring investor protection and reducing the risk of corporate fraud. It is independent of the primary corporate governance provisions of the Sarbanes statute and has no direct governance implications except for the related oversight responsibilities of the audit committee. (Other provisions of Dodd Frank do, of course, address governance matters but those pale in comparison to the extent included within Sarbanes).

But when viewed in a larger context, placing any provision of Sarbanes “in the mix” carries some risk for collateral damage to the corporate responsibility principles grounded in that Act. This has nothing to do with the merits of revising or replacing Section 404, and everything to do with the current anti-regulatory climate in Washington, D.C.—especially as it relates to financial regulation. The legislative momentum sparked by the Executive Order, and inflamed by the proposed repeal/replacement of Dodd Frank, could conceivably undermine Sarbanes. After all, Section 404 is not the only controversial provision of the Act.

Fair arguments can be made for the amendment or repeal of a number of other, long-controversial provisions of Sarbanes; e.g., audit partner rotation (Section 301); financial report certification (Section 302); restrictions on the provision of non-audit services (Section 201) and obstruction of justice (Section 802). Also “in play” could be several provisions tied to related sections of Dodd Frank; e.g., the executive compensation claw-back provisions of Section 304 and the “whistleblower” provisions of Sections 301 and 1107.

The status of these and other controversial provisions is made potentially tenuous by the broad scope of the February 3 Executive Order and by the political and business orientation of many new Trump Administration appointees with oversight over financial laws and regulations. This is particularly the case with respect to a law that some observers believe (perhaps unfairly) has served to “federalize” certain principles of corporate law and fiduciary duty, or otherwise forces boards to concentrate too much on matters of compliance and law, instead of guidance to management.

The concern is that once Sarbanes is opened to piecemeal revision (e.g., Section 404), the entire statutory framework could be open to repeal in pursuit of the Core Principles (e.g., job creation, and reducing administrative burdens for business). It’s like the popular analogy about the olive jar; it’s very hard to get the first olive out of the jar, but once you do, the rest of them come out very easily. And the more that “come out of the jar” (i.e., sections of Sarbanes rolled back), the more potential for Sarbanes to be undermined.

From a governance perspective, the impact could be catastrophic. That’s because Sarbanes is so much more than an anti-corporate fraud statute; it has become the keystone of modern corporate governance; the spark to the corporate responsibility environment that remains in force to this day. In a very large sense, it is “where it all began”; i.e., the seismic recalibration of corporate direction from the executive suite back to the board. It achieved this in two major ways. First, by means of its express provisions addressing corporate governance. And second, the extent to which it prompted or otherwise influenced related regulatory requirements (e.g., SEC rules); industry guidance (e.g., stock exchange listing requirements); best practices compilations (e.g., the ABA’s “Cheek Report”); professional standards (e.g., AICPA, state rules of professional responsibility) and state corporate law of multiple stripes.

The need for caution is underscored as the fifteenth anniversary of Sarbanes approaches. A new generation of corporate leaders has entered the boardroom since July 30, 2002. Their related memories are likely to be dim; many may lack familiarity with the Act and the circumstances that led to its enactment. To the under-informed fiduciary, measures to amend or repeal portions of Sarbanes could send the unfortunate message that the governance laws, principles and practices it prompted are redundant, excessive or a burden to broader principles of jobs growth and economic development.

And that would be a terrible blow to responsible fiduciary conduct—and to those who advise fiduciaries on such conduct. For, as the daily headlines suggest, the failures of corporate governance that led to the enactment of Sarbanes could certainly happen again in today’s boardrooms. It would be so ironic if the Core Principles of the Executive Order, and the resulting efforts to “rationalize the Federal financial regulatory framework”, had the unintended consequence of undermining longstanding principles of governance accountability.

But let’s be clear: the sky is not falling. As of this writing there is no notable movement to amend any provision of Sarbanes-Oxley, much less Dodd Frank. Administration officials are not directly targeting Sarbanes as a focal point in their efforts to reform financial regulation. Neither has the Administration expressed any specific concern with corporate responsibility tenets. Yet there is a clear interest within some groups in Congress, and their constituents, for reform of certain financial regulations. Should Dodd Frank reform efforts move forward, the possibility of Sarbanes revisions would logically follow in the legislative queue.

Proponents of corporate responsibility should thus remain watchful as efforts for financial regulatory reform take shape. There is much to be said for the Core Principles, and for the economic and other benefits that might arise from selective legislative amendment. Yet there is value, even at this early stage, in offering a “tread carefully” message to those who, for no doubt good and proper reasons, would consider implementing the Executive Order through “tweaking” controversial provisions of Sarbanes.

The more that interested observers are alert to the potential for financial regulation reform, the less likely it is that any such reform will work to undermine the vitality of Sarbanes’ governance provisions, and its broader legacy of corporate responsibility.

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