Sarbanes-Oxley Act

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The Sarbanes-Oxley Act (SOX) is a federal act passed in 2002 with bipartisan congressional support to improve auditing and public disclosure in response to several accounting scandals in the early-2000s. The act was named after the bill sponsors, Senator Paul Sarbanes and Representative Michael Oxley, and is also commonly referred to as SOX. Find the statutory text here: Pub.L. 107–204.

Background 

In the early-2000s, accounting scandals at major firms shook financial markets, calling on Congress to increase investor protection. Enron was one the major firms embroiled in such accounting scandals, as the firm’s stock price dropped from $90.75 at its peak in the fall of 2000 to $0.26 by the time it filed for bankruptcy in 2002. The drastic drop in stock prices occurred when a whistleblower exposed Enron’s practice of hiding debts and losses using accounting techniques, such as hiding toxic debt and assets from investors and creditors in off-balance-sheet special purpose vehicles. This blow to investors, along with similar scandals at major public corporations such as WorldCom and Tyco International, led Congress to strengthen disclosure and auditing requirements for public corporations to try to restore investor confidence in U.S. capital markets by passing the Act in 2002. 

Provisions:

In enacting SOX, one of Congress’s primary aims was to prevent a firm’s management from interfering with an independent financial audit. Section 302 and 303 seek to enhance the independence of audits through regulating internal procedures and management actions. Section 302, codified 15 U.S.C. § 7241, requires public companies to adopt internal procedures for ensuring accuracy of financial statements and makes the CEO and CFO directly responsible for the accuracy, documentation, and submission of the financial reports and internal control structure. 

Section 101–109, codified 15 U.S.C. §§ 7211–7220 with amendments to various sections of the Securities Act, created the Public Company Accounting and Oversight Board (PCAOB) to oversee public audit companies and promulgate auditing standards to ensure quality reporting and independent auditing. In 2009, the U.S. Supreme Court in PCAOB v. Free Enterprise Fund found the PCAOB removal provision—that the President may not remove a PCAOB commissioner but may only influence their tenure through the SEC commissioners, whom the President can only remove for cause, who may remove PCAOB commissioners only for cause—to be unconstitutional. However, the Court only severed the provision requiring the SEC to have cause to remove PCAOB commissioners, leaving PCAOB intact. 

Congress also sought to ensure the Act’s effectiveness by providing for robust enforcement and oversight provisions. Section 301, codified  18 U.S.C. § 1350 which imposes criminal liability on any officer, i.e. a CEO and CFO, who knowingly or willfully submits non-complying financial statements. Section 303, codified 15 U.S.C. § 7242, which makes it unlawful for any officer or director to exercise improper influence on audits, such as through coercion, manipulation, or fraud. Section 404, codified 15 U.S.C. § 7262, which requires management to establish adequate internal control structure and procedures for financial reporting. It also requires management to submit an end-of-the-year assessment on the effectiveness of the internal control structure. 

Particularly in response to the Enron accounting scandal, Congress sought to regulate certain types of public disclosures used to cover losses. Section 401 amended 15 U.S.C. § 78m(j) to require disclosure of off-balance sheet transactions. Also, in recognition of the role of whistleblowers in exposing the accounting scandals of the early-2000s, Congress passed Section 806, codified 18 U.S.C. § 1514A, which prohibits public companies from retaliating against whistleblowing employees. The U.S. Supreme Court in Lawson v. FMR extended the whistleblower protections in § 1514A to employees of a public company’s private contractors and subcontractors. 

Impact: 

One major criticism of SOX is the cost that greater disclosure and internal control requirements poses on smaller firms seeking to raise public funds. A Columbia Law Review Article, Sarbane-Oxley’s Effects on Small Firms: What is the Evidence?, found a degree of support in the argument that SOX disproportionately affected smaller firms and decreased the number of Initial Public Offerings (IPOs). A Financial Executives International study found net benefits to SOX, however, in net decreases in compliance costs and increased accuracy in financial statements. Overall, the cost of SOX’s greater internal control and disclosure requirements balanced with the benefit of greater financial statement accuracy is a matter of policy still subject to debate. 

[Last updated in April of 2021 by the Wex Definitions Team]