The new Sarbanes law

by francine Hardaway on August 1, 2002

The new Sarbanes law, hurriedly passed by Congress this week to stop the stock market slide, will make it much less comfortable to be a CFO or a CEO, especially in a public company. No longer can companies make loans to directors or executive officers, even to purchase stock in the company. And if a company restates as a result of any misconduct, the CEO and CFO must give back any bonuses they earned during the year following the restatement period and any profits earned from the sale of stock � even if it�s founder�s stock, even if you had no fault in the restatement. A good example is that of a salesman who issues a side letter, which later forces the company to restate. The CEO never knew about the letter, but he�s still responsible.

It will be even less comfortable to sit on the board of such a company. And early stage companies who think they might ever want to go public should begin to act like public companies as soon as possible, forming boards that behave like public company boards– according to a distinguished panel of Silicon Valley attorneys and accountants with whom I breakfasted the day after the law passed.

Board members often used to be �friends of the company,� internal and external executives who almost always rubber-stamped management�s decisions and got to play a few rounds of golf in return.

It�s all different now, especially on boards or committees of boards that deal with audits or compensation. The Sarbanes-Oxley bill says you either have to have an audit committee, or a board that is entirely independent. Companies must have senior financial code of conduct, and there also must be whistleblower procedures in place.

There is an even finer line than ever between how much an audit committee member should know and how much they can rely on management. Average amount of time for audit committee meetings will double to about 20 hours a year, about 7x a year (3 telephonic).

Being on a corporate board, especially on an audit committee, will thus cease to be a sinecure for retirees and become a time-consuming job in which financial literacy is required. Audit committee members must understand and evaluate internal controls and determine whether they are appropriate to achieve the company�s operating, reporting, and compliance objectives. Moreover, audit committees will approve all fees paid to external auditors, which will put them in the position of policing the external auditor.

Better memorize Warren Buffet�s three questions to auditors: If you had prepared these statements, what would you have done differently? If you were an investor, would you consider these statements adequate information to judge an investment? How would you have prepared these statements if you were the CEO?

As a board member, you will now be required to be diligent, be proactive, and ask
tough questions about financial reporting practices � how aggressive or conservative are they? Do the reporting practices put the company at risk? Advice to management is to
demonstrate through words or deeds a commitment to the highest levels of ethics and sound financial reporting practices; integrate risk management into decision-making across the entire company; respond diligently to potential risk indicators; and
understand the effect of the company�s extended enterprise on risk management.

Okay, says the panel, so you have avoided the audit committee, but you are on the compensation committee. Well, here�s what you are faced with: America now hates stock- based compensation, perceiving it as dissociated from long term shareholder interests. Class action lawsuits by institutional investors are settled by putting into effect new compensation and corporate governance rules. That�s why Silicon Valley companies, against their better judgment, will move toward expensing options. They can�t stand the criticism, which comes from old line companies who compensate executives with cash because they have it.

For early stage companies compensation will be a huge problem: how do you attract CEOs and CFOs to this high risk under-compensated position? If you decide to compensate your executives with stock, you must now articulate the justification for it, and every year you must hire compensation consultants and review the CEO�s compensation. But the point will soon be moot: in this market, everyone will want compensation in cash. And although the current scandals are largely not a Silicon Valley phenomenon, the SV model is being penalized in favor of cash-rich old economy companies.

What�s the takeaway from all of this? There will be a lot more paper work, a lot more due diligence on all sides, and a lot less motivation to innovate. And will we stop the few people who want to defraud investors? No way. It�s like airport security. It inconveniences you and me, who get wand-searched six times while the next suicide bomber checks his unscreened bag.



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