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White Collar Criminal Defense Alert

July 31, 2002

Sarbanes-Oxley Act of 2002 Creates New Federal Crimes

By R. Scott Thompson, Esq. and Matthew M. Oliver, Esq.

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n the wake of the largest corporate accounting scandals in this country’s history, the United States Congress has passed legislation that radically alters the legal landscape in which public companies and the accounting firms who audit those companies operate. The Sarbanes-Oxley Act

• f 2002 (the “Act”), which President Bush signed

into law yesterday, contains a number of diverse provisions the broad reach of which extends not

• nly to the perceived targets of Congressional ire --

the public accounting industry and the officers and directors of large public companies - but to small and medium-sized public and private companies, and their directors, officers, and employees.

Separation of Auditing and Consulting Businesses

The heart of the Sarbanes-Oxley Act is the mandatory separation of the audit function provided by accounting firms from the consulting services such firms offer to their publicly-traded

• clients. Until very recently, the major accounting

firms routinely provided a variety of consulting services to their public audit clients, often generating more revenue from the consulting practice than from the traditional audit work. Such practices led to the inference in the well-publicized case of Enron and Arthur Andersen that accounting firms were willing to scrutinize audits less closely in order to maintain the more lucrative consulting relationships. The Act seeks to remedy the purported conflict

• f interest inherent in the dual audit/

consulting relationship by directly prohibiting accounting firms from providing most non-audit services, including bookkeeping, information technology, valuation, and actuarial services, to companies for whom public audit services are performed. The Act also creates the Public Company Accounting Oversight Board, which operates under the supervision of the Securities and Exchange Commission. The Board is charged with the broad task of regulating the public accounting

• industry. Its role has been described as “auditing

the auditors”, and its specific duties include promulgating and enforcing registration requirements, industry rules, regulations and professional standards. The Board is empowered to monitor compliance with its directives through investigations and disciplinary proceedings.

New Federal Crimes: Document Destruction and Tampering

The Act also confronts one of the more well- publicized issues emanating from the Enron scandal by criminalizing the destruction of documents relating to a federal investigation or bankruptcy, as well as the destruction of audit

• records. Specifically, the Act makes it a crime

punishable by fines and imprisonment up to twenty years to knowingly alter or destroy documents or records “with the intent to impede, obstruct, or

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influence the investigation

• r

proper administration

• f

any matter within the jurisdiction of any [government] department or agency” or in any bankruptcy case. This new federal crime applies not only to public companies, but to privately-held companies and their officers, directors, and employees, as well. The Act also requires accountants to “maintain all audit or review workpapers [in connection with the audit of a public company] for a period of 5 years from the end of the fiscal period in which the audit or review was conducted.” The Securities and Exchange Commission is charged with promulgating more detailed rules for the enforcement of this prohibition, and knowing violations of the Act or the rules promulgated thereunder are punishable by fines and imprisonment up to ten years. Finally, the Act seeks to close a perceived loophole in the existing federal witness tampering statute by specifically prohibiting the alteration or destruction of documents or records relating to an

• fficial government proceeding. Such conduct

also is punishable by fines and imprisonment of up to twenty years, and is applicable equally to public and privately-held companies.

New Federal Crime: Securities Fraud

The Sarbanes-Oxley Act purports to deal not

• nly with the perceived abuses of corporate power

which the recent spate of accounting scandals has highlighted for the public, but also broadly extends the reach of federal criminal law by creating several new federal crimes and also by increasing penalties applicable to existing crimes. The Act creates a new crime of securities

• fraud. Criminal liability attaches to those who (i)

knowingly engage in a scheme or artifice to defraud, or attempt to engage in a scheme or artifice to defraud, in connection with a registered security; or (ii) obtain money or property by false pretenses in connection with the purchase or sale

• f a registered security. The crime is punishable by

fine and imprisonment of up to twenty-five years. As a practical matter, the new federal crime of securities fraud adds little to the arsenal of federal

• prosecutors. Criminal securities fraud is routinely

prosecuted under existing mail and wire fraud statutes and, given the reach of those statutes and the nature of securities transactions, it is difficult to conceive of a factual scenario in which the new criminal securities fraud provisions would be violated but the existing mail and/

• r wire fraud

statutes would not. Accordingly, the creation of the new federal crime of securities fraud appears to be more cosmetic than substantive, with one caveat - the penalties for the new crime exceed those applicable to mail and wire fraud.

New Federal Crime: Certification of False Financial Statements

The Act also requires chief executive officers and chief financial officers of public companies to certify, in SEC filings containing the company’s financial statements, that such statements are true and accurate in all material respects. Those who knowingly certify false or misleading financial statements are criminally liable for fines of up to $1,000,000 and imprisonment for up to ten years. Knowing and willful violations are punishable by fines of up to $5,000,000 and imprisonment for up to twenty years.

Enhanced Penalties for Various Existing Federal Crimes

The Act also strengthens federal criminal law through the enhancement of penalties applicable to various existing crimes. For example, the Act

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increases the penalty for mail and wire fraud from a maximum five-year term of imprisonment to a maximum term of twenty-five years. The Act also increases criminal penalties for public companies and their directors and officers who knowingly submit false statements in required SEC filings. Individual liability is increased to a maximum fine

• f $5,000,000, up from $1,000,000, and a

maximum prison term of twenty years, up from ten

• years. Fines for corporate violators are increased

from $2,500,000 to $25,000,000. In addition, the Act increases penalties for criminal violations of the Employee Retirement Income Security Act (“ERISA”). Individual violators are now subject to a maximum fine of $100,000, up from $5,000, and a maximum term of imprisonment of ten years, up from one year. Likewise, corporations -- both public and private -

• are now subject to a maximum fine of $500,000,

up from $100,000.

Impact on Federal Sentencing Guidelines

The Act requires the United States Sentencing Commission, the body responsible for revisions to the Federal Sentencing Guidelines, to review and amend the Guidelines to implement the provisions

• f the Act. Specifically, the Commission must

create guidelines for the various new white collar crimes created by the Act, including applicable downward departure factors and penalty

• enhancements. The Commission must promulgate

such amendments within 180 days of passage of the

• Act. The Commission is also instructed to review

the guidelines applicable to the crimes of fraud and

• bstruction of justice to ensure that the guidelines

sufficiently deter and punish such conduct.

New Federal Crime: Attempt and Conspiracy

The creation of the new crime of securities fraud and the enhancement of penalties for various

• ffenses are not the most significant changes in

federal criminal law wrought by the Sarbanes- Oxley Act. That distinction belongs to the provision of the Act that criminalizes the attempt to commit any federal crime. Prior to the passage of the Act, certain specific statutes penalized attempt, such as those relating to money laundering. Generally, however, an attempt to commit a federal crime has never been illegal under federal law. The Act brings federal criminal law in line with state criminal laws, which typically make an attempt to commit a crime (even if unsuccessful) a crime in itself. Federal prosecutors seeking to prosecute an inchoate crime will no longer need to rely solely on conspiracy or aiding and abetting theories of liability. Violations of the new attempt statute are punishable by the same penalties applicable to the underlying offense, and apply uniformly to attempts committed by public or private companies, and their directors, officers, and employees.

Impact on Securities Litigation

Although the provisions of the Sarbanes- Oxley Act regulating the public accounting industry are the most publicized aspects of the new legislative scheme, there are other portions of the Act which will have greater immediate impact on public companies and their directors and officers, particularly in the area of securities litigation. For example, the Act prohibits company insiders from trading company stock acquired pursuant to their

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affiliation with the company during pension and retirement fund “blackout” periods. The goal of this provision is to prevent directors, officers, and

• ther insiders from selling stock acquired through

the exercise of options at times when employees or retirement plan participants cannot dispose of company stock. Insiders who reap profits on the sale of company stock during such “blackout” periods are liable to the company -- or to shareholders suing on the company’s behalf -- for such profits. This provision has the potential to expand to new arenas the kind of shareholder derivative litigation commonly brought to recover short-swing profits under Section 16(b). In addition, the Act extends the statute of limitations for securities fraud actions. Shareholders alleging securities fraud must now file a lawsuit within two years of discovering the alleged violation, but in no event more than five years from the date the alleged violation occurred, as opposed to the previous “one year from discovery, three years from occurrence” structure. The impact of the lengthened statute of limitations is probably lessened by the Private Securities Litigation Reform Act’s “lead plaintiff” and “lead counsel” appointment provisions, which incentivize class action lawyers to file shareholder suits as quickly as possible. Indeed, it is common for multiple shareholder class actions to be filed within days, if not hours, of a significant adverse

• event. Instead, the impact of the new limitations

period will most likely appear in the form of expanded class periods encompassing greater numbers of purchasers and challenging multiple financial statements. The compromise legislation is also notable for provisions that were included in original bills introduced in the House and Senate, but which were not included in the final package. For example, a previous bill sought to create aiding and abetting liability for securities fraud under Section 10(b) and Rule 10b-5, passage of which would have effectively overruled the United States Supreme Court decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Another proposal would have restored, in certain circumstances, joint and several liability for securities fraud violations. Although these measures ultimately were rejected, the fact that such proposals were contemplated demonstrates that Congress has come a long way from the mid-90’s when, in passing both the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act, the

• bject of legislation in the securities context was to

rein in shareholder class action lawsuits.

Impact on the Employment Relationship

The Sarbanes-Oxley Act also impacts the legal relationship between employers and their employees by increasing the protections afforded to employees of public companies who face retaliation for reporting securities fraud. Specifically, the Act declares it unlawful to “discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee” because of such employee’s provision of information or assistance to a federal regulatory or law enforcement agency, any member of Congress or Congressional committee, or a supervisor, relating to violations or suspected violations of the federal securities laws. An employee subjected to such treatment in violation of the statute may file a complaint with the Secretary of Labor within ninety days of the act

• f retaliation. If the Secretary of Labor does not

act on the complaint within 180 days, the employee may seek court review. If successful, the employee may recover compensatory damages,

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reinstatement, and back pay, as well as fees for attorneys and expert witnesses. Moreover, the Act imposes criminal penalties upon public and private companies, and their directors, officers, and employees, including fines and a maximum term of imprisonment of ten years, for any knowing act of retaliation against an employee based on the employee’s provision of truthful information to a law enforcement officer in connection with the commission or possible commission of a federal crime.

Conclusion

The primary objective of Congress in passing the Sarbanes-Oxley Act was to restore confidence in the capital markets after a remarkable series of corporate accounting scandals involving some of the country’s largest public companies and their

• auditors. While the Act achieves its stated goal of

fundamentally altering the structure of the relationship between public companies and the auditors who certify their financial statements, it does much more. The Act creates a number of new federal crimes, many of which apply to both public and private companies, and their directors,

• fficers, and employees, and also significantly

enhances penalties applicable to a host of existing white collar crimes. Moreover, the Act extends the statute of limitations applicable to shareholder securities fraud class actions, and prohibits company insiders from selling shares at times when pensioners and retirees are precluded from doing

• so. Whether the Act will achieve its goal of

restoring public confidence in the integrity of the markets, and whether the wide-ranging changes in federal criminal and securities laws were necessary to achieve that goal, are issues that will continue to be assessed in the coming months and years. For more information on this issue or any other criminal defense matter, please contact R. Scott Thompson, Chair of Lowenstein Sandler’s White Collar Criminal Defense Practice Group, at 973.597.2532 or at rthompson@ lowenstein.com, or Matthew M. Oliver, a member of the Group, at 973.597.2318 or at moliver@ lowenstein.com.

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