The Company
5.4 The financial and accounting framework
MM Companies Inc. then amended an earlier suit to allege that the
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August expansion of the board from five to seven members and the appointment of two new members by the incumbent board violated the shareholders’ voting rights and stood in violation of the Chancery Court principles as developed and articulated under both Blasius and Unocal . The Court rejected MM’s amended claim, finding that the board expan- sion ‘did not impact the shareholder vote or the shareholders choices in any significant way’.
The Supreme Court of Delaware reversed the Court of Chancery’s deci- sion. The Supreme Court ruled that the Unocal standard of review must be applied whenever a board adopts any defensive measure ‘in response to some threat to corporate policy and effectiveness which touches upon issues of control’.
The Court found that:
This case presents a paragon of when the compelling justification standard of Blasius must be applied within Unocal ’s requirement that any defensive measure be proportionate and reasonable in relation to the threat posed. The Unocal standard of review applies because the Liquid Audio board’s action was a ‘defensive measure taken in response to some threat to corporate policy and effectiveness which touches upon issues of control’.
Further, the Supreme Court ruled that the compelling justification stand- ard of Blasius had to be applied within an application of the Unocal stand- ard to that specific defensive measure because the primary purpose of the board’s action was to interfere with or impede the effective exercise of the shareholder franchise in a contested election for directors.
Company Accounting Oversight Board (PBAOB) to oversee the audit of public companies that are subject to the securities laws.
5.4.1 Section 302 : Corporate responsibility for financial reports Pursuant to section 302 of the SOX Act, the CEO and the chief financial officer (CFO) of a publicly-traded corporation should certify that (i) they have reviewed the financial statements being filed, (ii) to the best of their knowledge, the financial statements do not contain any untrue statement of material fact or omit to state a material fact relevant to the truthful- ness of the financial records, (iii) the financial statements and notes or addenda thereon, fairly represent in all material respects the statement of condition, the statement of income, and the cash flows, as of the period being reported, (iv) they are responsible for setting up and maintaining proper disclosure controls and procedures.
5.4.2 Section 404: Assessment of internal control
Section 404(a) requires both the CEO and the CFO to annually assess and certify the effectiveness of the corporation internal auditing process.
In addition, the SOX Act requires the CEO and the CFO to disclose any material weaknesses uncovered in the company’s internal auditing proc- ess. Furthermore, section 404(b) requires that the company’s external or independent auditor examine the management assessment of the inter- nal audit process, and report as to the effectiveness of such assessment.
5.4.3 Section 906: Certification of compliance with the SEC
Section 906 requires both the CEO and the CFO to sign and certify that the company’s financial statements comply with the SEC requirements, and fairly represent the statement of condition, income, and cash flow for the reported period. While this provision is well-received by financial analysts it falls short of requiring a comprehensive disclosure and does not include the disclosure of foreseeable risk factors. The contrast with the UK’s Combined Code is striking. The UK code requires listed compa- nies to review annually ‘all material controls, including financial opera- tion and compliance controls, and risk management systems’.
5.4.4 Section 101 : The Public Company Accounting Oversight Board Under section 101(c), the PCAOB duties include, inter alia: (i) the registra- tion of public accounting firms that prepare audit reports for issuers; (ii) the adoption of rules for auditing, quality control, ethics, independence,
and other standards relating to the preparation of audit reports for issu- ers; (iii) the conduct of investigations and disciplinary proceedings con- cerning the public auditing companies. In practice, the effects of the PCOAB are very limited. To be more effective, the five PCAOB board members must be academic experts in the field of accounting, finance and business, with special skill and expertise in the preparation and issuance of audit reports with respect to the required disclosures. That is the approach taken by prominent European countries such as France, Germany and the UK. Unless such a reform is conducted the PCAOB will remain ineffective and auditing scandals will flourish, and the victims of fraud belittled through inconsiderate settlements in inconsistent federal court systems. The cross-selling of consulting services by auditing firms, the credit rating agencies, the analysts, coupled with the roll-over prac- tice between the federal agency employees in SEC, the Federal Reserve, and other agencies justify and support a call for an enhanced standard of liability controlled by gatekeepers. Moreover, the auditing and rating agency industries have been characterized as super-concentrated by the Government Accountability Office (GAO). Facing new series of regula- tions, the gatekeeper numbers remain static despite the request for more thorough fact-checking.
This tendency will persist as the PCAOB recognized in 2008 that its quality controls are inadequate. To protect shareholders and the financial markets’ trust, the US government can do three things: (i) to enhance the standard of liability, (ii) to use its constitutional power as a market partici- pant to shift public contracts to mid-size firms, and/or (iii) back up the EU Commission effort to dismantle the Big Four, which is too big to control.
The EU Commission is considering a ‘Regulation’ that could eradicate the conflicts of interest under which the Big Four operates. The draft of the regulation, in part, says: ‘audit firms of significant dimension should not be allowed to undertake other services unconnected to their statutory audit function such as consultancy and advisory services’. Whether it is the EU today, or tomorrow China, and the G20, the restructuring proposal would allow other small and mid-sized audit firms to penetrate the audit- ing market and provide quality-orientated audit, rather than the compla- cent unqualified opinions we become so accustomed to, PCOAB are very limited. The SOX Act requires that the five members of the PCAOB:
be appointed from among prominent individuals of integrity and repu- tation who have a demonstrated commitment to the interests of inves- tors and the public, and an understanding of the responsibilities for and nature of the financial disclosures required of issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance of audit reports with respect to such disclosures.
To be more effective, and due to the mission assigned to the board, it would be better if the SOX Act used a precise qualification such as:
the five PCAOB board’s members should be prominent PhD professors in Accounting or a related science, for at least 10 years, with certified public accountant (CPA) qualification in effect, and a deep commit- ment to the auditing industry.
Such an enhanced qualification for the PCAOB members would pro- vide them with heightened status close to the Federal Reserve executives in charge of monetary and tax policies. That is the approach taken by prominent European countries such as France, Germany and the United Kingdom. Unless such a reform is conducted, the PCAOB will remain inef- fective, auditing scandals will flourish, and the victims of fraud will be belittled through inconsiderate settlements in inconsistent federal courts.
5.4.5 Section 301: Independent financial expert in the board Section 301 of the SOX Act requires that at least one member of the board of directors with financial expertise sit on the corporation audit commit- tee. Failure to meet this requirement will trigger criminal liabilities.
5.4.6 Section 1101: Corporate tax returns
Section 1101 of the SOX Act requires that the federal income tax return of a corporation be signed by the CEO of such corporation.