Question

The director of your accounting department has requested that you conduct research on the Sarbanes- Oxley Act of 2002 (SOX). Discuss what effects SOX has had on improving corporate governance. Then research, identify, and summarize a specific corporate crime case or issue.   

The summary should include a good description of the facts of the case, the issue before the court, and the legal reasoning and decision or outcome (the court’s ruling) of the case, if there is one. Lastly, state whether SOX has created more confidence in the capital markets or not.

Answer 1

Discuss what effects SOX has had on improving corporate governance. :

#1: It reformed and re-empowered the corporate board of directors.

The most prominent change SOX engendered was a shift from a perspective that the board serves management to a perspective that management is working for the board. “That’s what our corporate structure in the U.S. intended, but you were seeing it exercised less in the day-to-day and more in the formalities of documentation,” says Ralph DeMartino, chair of the global securities group at Cozen O’Connor. “That’s been a radical shift.”

SOX also recognized that director independence is necessary for the board to serve effectively as a check on management. It allows for director liability if the board fails to exercise the appropriate oversight.

Steve Blonder, a principal at Much Shelist, says that in the wake of SOX, companies are stronger and subject to additional oversight from more proactive board members with greater technical expertise. In general, he says, the increased demands and need for independence has led to greater diversity among the people who serve on boards.

Today, the audit committee of the board has greater powers and many more responsibilities, such as working with external auditors of internal controls. “They’re kind of king of the hill of any board committee,” says William Currier, a partner at White & Case and a former (SEC) assistant director who was at the agency during the SOX rulemaking and implementation. “Now under certain circumstances, if management or [the audit committee of the board] doesn’t respond to reports [of misconduct] from independent auditors, the independent auditors have the obligation to inform the SEC that there has been a dispute and to resign. That’s a huge amount of leverage and responsibility directly derived from SOX.”

In general, boards are more focused on their responsibilities, says Linda Chatman Thomsen, who was director of the SEC’s Division of Enforcement from 2005 to 2009 and led the Enron investigation. Thomsen now is a partner at Davis Polk & Wardwell.

“It may be luck or effective enforcement and laws, but since, I haven’t seen an Enron or a WorldCom blowup to the magnitude that we saw those kinds of public company issues [before SOX],” she says.

#2: It encouraged the adoption of corporate codes of ethics.

SOX required companies to disclose whether their senior executives and financial officers followed a code of ethics. If they didn’t have one, they had to explain why. Around the same time, both the New York Stock Exchange and Nasdaq adopted rules requiring that listed companies adopt and disclose a code of conduct. While the SOX rule didn’t require adoption of a code, it made clear that the SEC expected one.

“Over the past 20 years, the government has been encouraging employers to adopt ethics and compliance programs in a number of ways,” says Chip Jones, a Littler Mendelson shareholder who counsels clients on such programs.

Since the mid-1980s, for example, federal sentencing guidelines have said companies with an effective ethics and compliance program would face reduced criminal sanctions. “Sarbanes-Oxley is just one regulatory framework pushing companies in that direction,” Jones says.

But even Enron had implemented a code of ethics that specifically prohibited some of the board and executives’ later misconduct. It’s clear the mere existence of a corporate code of conduct is useless without compliance.

#3: It created the PCAOB.

SOX created the independent Public Company Accounting Oversight Board (PCAOB) in 2002 to oversee the independent auditors of public companies, replacing a self-regulatory scheme and mandating true independence. The Board’s inspection powers mean the audits of companies’ internal controls are subject to scrutiny.

“To me, the creation of the PCAOB may be one of the most important features of the whole Sarbanes-Oxley structure,” Currier says. “On demand, the PCAOB can call up any given partner at any given [accounting firm] and ask to see all of his work papers for his last five engagements.”

Accounting firms that audit public companies must register with the PCAOB, and are subject to annual or triennial agency inspections, depending on their size. Currently the Board is in various stages of exploration of new initiatives in the wake of the financial crisis. They include new ways of promoting the transparency of audits, updating audit report formats, expanding foreign inspections and ensuring the independence of auditors. This includes a measure to require mandatory firm rotation, or term limits, between a public company and its audit firm

Then research, identify, and summarize a specific corporate crime case or issue.

Krispy Kreme Doughnuts (KKD), a once high flying growth stock has been hampered as of late with shareholder lawsuits. When sales growth and earnings began to drop significantly in 2003, the company blamed its problems on the popularity of low-carbohydrate diets like Atkins and South Beach at the time. But the SEC began probing Krispy Kreme's accounting for franchise buybacks and is now facing shareholder lawsuits for inflating profits. Senior management officials allegedly knew of the problems, but continued to pad sales figures by doubling doughnut shipments to wholesale customers at the end of fiscal quarters, according to lawsuits.


Inflated Sales:

The suit alleges that between January 2003 and last May, when Krispy Kreme issued a profit warning, "the company issued false and misleading statements, including false financial results" and "repeatedly ratcheted upward its public quarterly and fiscal year revenue and earning projections ... all in the face of slowing sales and market saturation."

In addition, the lawsuit claims,CEO Scott Livengood, former COO officer John W. Tate and former CFO Randy S. Casstevens - "unloaded more than 475,000 shares of Krispy Kreme stock for proceeds of $19.8 million", while fully aware sales were declining since January 2003. The charges, leveled by two unidentified "confidential witnesses" who are former employees of the company, is included in a recent filing in the lawsuit.

According to one witness cited, Krispy Kreme double-shipped wholesale customer orders at the end of quarters on four separate occasions while the witness worked for the company.

Testimony by a former sales manager at a Krispy Kreme outlet in Ohio, said a regional manager ordered that retail store customers be sent double orders on the last Friday and Saturday of the 2004 fiscal year, explaining "that Krispy Kreme wanted to boost the sales for the fiscal year in order to meet Wall Street projections." The witness said the manager explained that the doughnuts would be returned for credit the following week - once fiscal 2005 was under way.

The witness "understood that it was commonplace at Krispy Kreme to channel stuff in order to meet Wall Street expectations," according to the complaint.

Some could also argue that Krispy Kreme auditors Price WaterHouse-Coopers (PWC) should have noticed a pattern of large shipments at the end of the year with corresponding credits the following fiscal year during the course of their audit. Typical audit procedures would be to confirm with KKD's customers their purchases. In addition monthly variations analysis should have led someone to question the spike in doughnut shipments at fiscal year end.


Accounting Irregularities:

The SEC is investigating if Krispy Kreme used questionable methods to inflate profit when it bought back its Michigan franchise for $32.1 million last year. PWC refused to sign off on quarterly results. It was only after the firm retained the services of outside legal counsel to verify the methodology that Krispy Kreme was allowed to put the matter behind them. The outcome of the SEC investigation is still pending.

If PWC were not already under scrutiny for failing to detect inflated sales, PWC may have considered signing off on the accounting methodology based on immateriality. However, under SOX accountability and reporting requirements, Price WaterHouse had a profession and legal obligation to bring forth publicly, any irregularities immediately. When the smoke clears, expect Krispy Kreme to look for a new auditor in an attempt to appease shareholders.


Management Accountability:

Chief executive officer Scott Livengood "announced his retirement" at the age of 52 from Krispy Kreme Doughnuts Inc. (KKD) amid allegations of padded sales figures. Livengood was replaced as CEO by Stephen Cooper, a renowned industry turnaround specialist who most recently headed the Enron Corp. bankruptcy reorganization.

According to the company, Livengood will be paid $45,833 a month, the equivalent of his current base salary, for a six-month consulting term. Livengood's departure also triggers an option to purchase 330,125 shares of Krispy Kreme stock; he now has vested options to purchase more than 1.3 million shares.

In its latest SEC filing, the company said net income for the year could be reduced by as much as 7.6 percent.

Under SOX, senior management would still be liable for fraud for knowingly signing off on the financial results. In addition, I expect other senior management officials, particularly in Krispy Kreme's internal accounting division to depart in the coming months as management review should have been in place to question all the credits issued for the return of overshipments.