Executive Certification Requirements in the Sarbanes-oxley Act of 2002: a Case for Criminalizing Executive Recklessness

• Publication year: 2003

SEATTLE UNIVERSITY LAW REVIEWVolume 27, No. 2FALL 2003

Executive Certification Requirements in the Sarbanes-Oxley Act of 2002: A Case for Criminalizing Executive Recklessness

Christopher Wyant(fn*)

I. Introduction

The collapse of once-great corporations such as Enron and WorldCom drew intense scrutiny to the ivory-tower executives heading those institutions, as well as to the severe economic consequences of fraudulent financial disclosures.(fn1) While the Enron debacle involved the use of off-balance-sheet transactions to shift losses to a complex network of subsidiaries and partnerships, the misstated losses at WorldCom appear to have been simple fraud.(fn2) In August 2002, Michael Kooper, a senior executive in Enron's finance department, pled guilty to charges of money laundering and conspiracy to commit wire fraud.(fn3) While nineteen Enron employees have been indicted by the Federal government, the two top executives, Jeffery Skilling and Kenneth Lay, have not been tied to the accounting fraud.(fn4) Scott Sullivan, a former chief financial officer at WorldCom, was indicted along with WorldCom's director of general accounting for securities fraud and for making false filings with the Securities and Exchange Commission ("SEC").(fn5) The economics of securities investment leads one to conclude that the negative impact of these corporate failures on investor confidence has disrupted capital markets.(fn6)

Had institutional investors, individual shareholders, and employees with pensions at stake known the truth about the collapsed companies, billions of dollars worth of time and money would have been allocated to other uses.(fn7) Both initial investment choices (securities with no history) and the valuation of existing stock prices (securities that have been on the market for some time) should reflect an assessment of the earnings prospects and risks associated with the issuing company and its operations.(fn8) When investors and analysts believe their financial assessments are misled by questionable or fraudulent financial disclosures, the market fails to correctly allocate resources.(fn9) The general economic malaise that followed the collapse of Enron, WorldCom, and others lends empirical support to this model.(fn10)

This loss in investor confidence prompted Congress and President Bush to adopt a spate of new measures designed to address "systemic and structural weaknesses affecting the capital markets."(fn11) Collectively, this legislation is embodied in the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act), which impacts nearly every aspect of the system that brings financial information from a public corporation to existing and potential investors, including the areas of accounting oversight, auditor independence, corporate governance, analyst conflicts of interests, and fraud.(fn12) In response to the Enron and WorldCom disasters, Congress stated that the purpose of the Sarbanes-Oxley Act is to protect investors by improving the reliability and accuracy of corporate disclosures made pursuant to securities laws.(fn13)

This Comment focuses on sections 302 and 906 of the Sarbanes-Oxley Act. Section 302 requires Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs), or their equivalents, to personally certify the accuracy of financial disclosure filings required by the SEC and to vouch for the reliability of the internal corporate controls that produce that information.(fn14) Section 906 contains an additional certification requirement and provides specific criminal penalties for willful or knowing violations of that requirement.(fn15) An efficiency-based analysis of these two sections of the Sarbanes-Oxley Act suggests that including a recklessness standard of intent would be more likely to increase the accuracy of the information, reduce the aggregate costs of obtaining the information, and restore much-needed investor confidence. As a result, Congress should amend the Sarbanes-Oxley Act to create a single, coherent certification requirement with criminal penalty provisions that incorporate recklessness as a standard of intent giving rise to criminal culpability.

In order to understand why Congress should amend the Sarbanes-Oxley Act, one must understand how security disclosure laws evolved. This Comment begins by briefly looking at how financial disclosure regulations and criminal sanctions have operated in the years leading up to the Sarbanes-Oxley Act. Relevant portions of the landmark Securities Act of 1933, as amended,(fn16) and the Securities Exchange Act of 1934, as amended,(fn17) make up the subject matter of Part II. Part III looks at the specific changes, or lack thereof, that the Sarbanes-Oxley Act has attempted to impose on financial disclosure laws. This Comment gives particular attention to the currently bifurcated and incoherent certification requirements of sections 302 and 906, which are redundant and largely ineffectual. One must understand these sections in order to grasp the failures of the prior system and the impact, if any, that the Sarbanes-Oxley Act is likely to have on the regulatory failures that it purports to combat.

Finally, Part IV will show that Congress should amend the certification requirements and the criminal penalties in the Sarbanes-Oxley Act in two important ways. First, Congress should rid the Sarbanes-Oxley Act of the redundant and confusing dual certification requirements in order to reduce compliance costs and dispose of what could be a costly trap for the unwary. Second, the amended version of the Sarbanes-Oxley Act should include a recklessness standard of intent that will encourage executives to ensure that financial information is accurate enough to protect all stakeholders and to restore investor confidence.(fn18)

II. Financial Disclosure Laws Before the Sarbanes-Oxley Act

Financial disclosure requirements are primarily found in two landmark securities laws from the Depression era-the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act").(fn19) The Securities Act requires that companies register all the securities it offers to the general public with the SEC and that it provide a prospectus for prospective investors.(fn20) This Act focuses on the initial investment scenario, where a security or venture has no history upon which investors can rely.(fn21) The Exchange Act requires all companies listing securities on a national exchange to register with the SEC and to file annual and periodic (most often quarterly) financial reports with the SEC.(fn22) In contrast to the Securities Act, the Exchange Act was intended to provide investors with ongoing information useful in deciding whether to purchase existing securities on an open market.(fn23) These two securities laws often required duplicate filings and superfluous paperwork from a common core of information.(fn24)

The dual disclosure schemes remained largely separate until 1982, when the SEC adopted a partially integrated disclosure system, known as Regulation S-K, that attempted to combine elements of the Securities Act and the Exchange Act.(fn25) Regulation S-K requires management to disseminate annual and quarterly reports of audited financial statements; to make disclosures regarding the corporation's liquidity, capital resources, and results of operations; and to discuss favorable and adverse trends.(fn26) Regulation S-K places a greater emphasis on periodic disclosures, as established in the Exchange Act, rather than on the initial prospectus reporting of the Securities Act.(fn27)

Given that both the Exchange Act (through Regulation S-K) and the Sarbanes-Oxley Act (discussed in Part III infra) address the same periodic disclosure requirements, it is important to compare the standards of criminal liability and penalties imposed by these Acts.(fn28) This comparison should make clear that the Sarbanes-Oxley Act has done little to change the criminalization of inaccurate and fraudulent disclosures post-Enron/WorldCom. The Exchange Act establishes criminal liability for willful violations of all its provisions, and for willfully and knowingly making false or misleading statements in all documents required to be filed under the Exchange Act.(fn29) Historically, a natural person convicted under section 32(a) of the Exchange Act could be fined up to $1 million, or imprisoned up to ten years, or both.(fn30) However, a person could not be criminally liable if he or she could prove lack of knowledge of the rule or regulation that was violated.(fn31) The Sarbanes-Oxley Act purported to make meaningful changes to this system of criminal enforcement.(fn32)

III. Sarbanes-Oxley Act Failed to Meaningfully Impact Financial Disclosure Laws

Similar to the Exchange Act, the Sarbanes-Oxley Act addresses periodic reporting standards. It requires that companies file under sections 13(a) or 15(d) of the Exchange Act, which also ensures that financial reports are certified.(fn33) Pursuant to section 13(a), every issuer of a security registered on an exchange must file the following information with the SEC: (1) information and documents needed to keep reasonably current the information filed in registering; and (2) annual and quarterly reports as the SEC may prescribe.(fn34) Section 15(d) simply covers any supplemental filings of annual or quarterly reports.(fn35) Thus, the Sarbanes-Oxley Act does not make...