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Sarbanes-Oxley and the "Reliance on Others Defense" December 2002 Scienter [intent to defraud] is an element of proof in all criminal prosecutions and in non-governmental civil actions for violations of Section 10b and Rule 10b-5, the general anti-fraud provisions and regulations under the Securities Exchange Act of 1934. In these types of actions involving alleged false and misleading financial statements and disclosures, a common defense is that since I reasonably relied on others, I did not have the requisite intent to defraud. The impact of the Sarbanes-Oxley Act (SOA) on this defense will vary, depending upon the particular position of the individual defendant with the company and the type and complexity of the financial issues underlying the alleged fraudulent misconduct. The defendant claiming the reliance on others defense has the burden of proving that he or she justifiably relied on someone else. Merely burying your head in the sand, especially when you have a duty to investigate, will not satisfy this burden. In fact, the judge can give a "willful blindness" instruction to the effect that a particular defendant had the requisite knowledge if he had deliberately avoided knowledge of the facts that would have made his conduct illegal.
The effect of the SOA on this affirmative defense as to improper financial disclosures should be analyzed for three particular categories:
As to the CEO and CFO, I believe that the SOA effectively eliminates this defense as to financial statements and disclosures, with one possible exception. Section 302 of the SOA, as amplified by the applicable SEC rules, requires: (i) that these persons have reviewed the report being filed with the SEC; (ii) that based on that person's knowledge, the report does not contain any untrue statement of a material fact, or omit to state a material fact necessary to make the statements made, in the light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report; and (iii) based on that person's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition, results of operations and cash flow of the issuer as of and for the periods presented in the report.
The SOA added a new provision which requires that the certifying officers are responsible for establishing and maintaining "disclosure controls and procedures" for the issuer and have: designed such disclosures controls and procedures to ensure that material information relating to the issuer, including its consolidated subsidiaries, is made to them by others within those entities particularly during the period in which the periodic reports are being prepared; evaluated the effectiveness of the company's disclosure controls and procedures as of a date within 90 days prior to the filing date of the report; and presented in the report their conclusions about the effectiveness of the disclosure controls and procedures based on such evaluation.
The CEO and CFO must also disclose, based on their most recent evaluation to the company's auditors and audit committee of the board of directors, all significant deficiencies in the design or operation of "internal controls" which could adversely affect the company's ability to record, process, summarize and report financial data, and have identified for the company's auditors any material weaknesses in audit controls and any fraud, whether or not material that involves management or other employees who have a significant role in the company's internal controls. Finally, the CEO and CFO and other certifying officers have to indicate in the report whether or not there were any significant changes in the internal controls or in other factors that could significantly affect internal controls subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
With respect to other officers and employees engaged in the preparation of the financial statements and other financial information, I believe that the SOA does not affect this defense. What will be determinative is that person's role as a participant or reviewer, or knowledge of, any improper recording of financial information. Also whether that person had a duty to report that information to the appropriate person or entities and what that person did, if anything, to correct the impropriety is relevant. In that connection, Section 806 of the SOA provides "whistle blower" protection for employees of publicly-traded companies who properly disclose any alleged financial reporting or disclosure impropriety. Of course, in the real world, some employees will be reluctant to by-pass their immediate superiors to report a financial impropriety because of the fear that they may lose not only their job, their perceived ability to obtain another job because of their whistle blowing and reluctance to rely on litigation to be compensated for their lost wages and court costs. Other relevant factors include: the complexity of the alleged improper financial disclosure and whether this was an isolated transaction or part of a pattern. The impact of the SOA on directors, who also serve as members of the audit committee, to use this defense is yet to be determined. However, I believe some preliminary thoughts would be useful. First, the SOA specifically authorizes the audit committee to obtain its own independent counsel and, where appropriate, independent financial expert, whose services are to be paid for by the issuer. The failure to take advantage of this right could be viewed by either the government or plaintiff's attorneys as reckless conduct which rises to such a level that it could make these directors deemed participants in the fraud. I believe that the SOA, along with other recent pronouncements by the SEC, imposes a duty on the members of the audit committee to become more involved in the audit and MD&A financial disclosures, including planning the audit, understanding the key accounting issues and estimates used by the company in formulating its financial statements and to work with the officers and financial professionals employed by the company to ensure that there are proper internal controls at all levels to prevent the improper recording and reporting of transactions. Furthermore, the type of alleged financial impropriety will be critical. Where it is the case of not recording the sales returns, or other WorldCom type frauds, these should have been unearthed by proper internal controls. However, where the alleged financial impropriety relates to properly documented difficult judgment calls, this defense may be appropriate. When this type of judgment is combined with disclosures consistent with the SEC's recent proposals to make the financial statements more transparent by disclosing the basis for key estimates and assumptions and what will be the impact if the estimates are not reached or exceed the estimates used in the financial statement, you will give this defense even more validity. In short, where the financial reporting issues have been thoroughly discussed by the outside auditors, members of the audit committee and management, those discussions are properly documented, and there is rational basis for that particular accounting decision, this should insulate the members of the audit committee from liability based on hindsight. Under these circumstances the CEO and CFO should still be able to urge this as a defense. In this connection, one should look at the applicable state law because, in certain instances, that can contain a statutory good faith defense for directors to claims of improper financial reporting and disclosures, e.g., Section 13.1-690 of the Virginia Code; 18 § 1027.E of the Oklahoma Statutes Annotated.
For purposes of the reliance on others defenses for alleged improper financial disclosures, the SOA emphasizes the need to implement, enforce and continually re-evaluate internal controls and properly document participation of the auditors, audit committee and the audit committee counsel and expert in how critical accounting issues are rationally resolved. Return to SEC Central.
CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article. |
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