Corporation scenario paper

Sarbanes-Oxley Act Page 1

Sarbanes-Oxley Act

Paula E. Noble

University of Phoenix


PART A:

“The Securities and Exchange Commission was created in 1934 to police the U.S.

financial markets. Today, the Securities and Exchange Commission continues to create

legislation tightening reporting standards and providing more transparency.

Unfortunately, increasing standards often comes after a failure of the system. The

Sarbanes-Oxley Act of 2002 is a primary example of legislation following financial

market failure. Sarbanes-Oxley influenced public businesses through transformation of

the financial system.

Public companies required to comply with Sarbanes-Oxley incur additional costs directly

attributed to the legislation. Initial costs related to the act include increased expense for

annual audits, which public accounting companies pass on to clients. Accounting

companies also incurred additional liability with increased due diligence and time

necessary to complete audits. In addition, the scope of audits broadened with the

inclusion of Section 404. Not only do public companies pay high prices for audits, but

they also must purchase or create internal control software, create an internal control

plan and track and review their internal performance. Penalties for non-compliance are

steep.” (The Impact of the Sarbanes-Oxley Act on American Businesses, 2015)

These changes affect ethical decisions both for the better and for the worse. The

primary factor affecting those decisions adversely are the costs incurred to maintain

compliance to the act. Some companies look for the least costly method that would

somewhat show that they are complying even though the methods and, personnel, and


software applications may not be of very high standards especially if ethical codes of

conduct do not exist or are not adhered to in the company. “A working definition of

business ethics is a consciousness or awareness of what is right or wrong in the

workplace and taking responsibility for an ethical course of action given its impact on

the business and its constituents” (The Legal Environment of Business, 2011).

Unfortunately, too often the consciousness or awareness is focused on what is income

and what are expenses thereby focusing solely on profits. For that reason, if such a

company finds that compliance with the Sarbanes Oxley-Act of 2002 is affecting profits

that company may be inclined to look for cheaper ways to display an appearance of

compliance especially when the use of corporate jets and other perks as well as earning

bonuses are affected. They may also be wary of the increase in paperwork.

The article goes on to mention however, “The swath of change brought about by

Sarbanes-Oxley is wide and deep. The primary changes resulted in the creation of the

Public Company Accounting Oversight Board, the assessment of personal liability to

auditors, executives and board members and creation of the Section 404. That section

refers to required internal control procedures, which did not exist before Sarbanes-

Oxley. Public companies are now required to include an internal control report with their

annual audit. The oversight board is responsible for monitoring public accounting

companies, and works with the SEC. Based on size, accounting forms undergo reviews

every one to three years. In addition to the board reviews, public accounting firms now


carry personal liability for their audits”. (The Impact of the Sarbanes-Oxley Act on

American Businesses, 2015)

What that does is force ethical behavior on companies, their owners and board

members. “Companies that fail to be committed to managing business ethics as part of

their business model have no clear moral compass to guide leaders through complex

dilemmas about what is right or wrong”. (The Legal Environment of Business, 2011)

The Sarbanes Oxley-Act ensures that companies comply with moral standards outlined

in the act. It is their moral compass which also adds the benefit of preventing legal

liability for the company.

Furthermore, there are penalties for non-compliance such as fines and / or

imprisonment. Non-compliance is considered a criminal act. Enforcement has become

increasingly aggressive. “The SOX Act also provided for additional enforcement

apparatus and increased penalties for violation of existing securities laws. Violators of

the SOX Act are subject to both civil penalties and criminal prosecution. For example,

officers who certify required financial report filing knowing that the report is either

inaccurate or knowing that the report was not subject to required controls before the

certification are subject to criminal penalties of up to $1 million in fines and 10 years of

incarceration. For cases in which the certification was used as part of a larger fraudulent

scheme, the penalties increase to $5 million in fines and 20 years of incarceration. The


SOX Act also specifically directs the U.S. Sentencing Commission to amend sentencing

guidelines to provide for harsher penalties for those convicted of securities fraud

statutes.” (The Legal Environment of Business, 2011).

The article written by Jeremy Slaughter cites the history, the changes, the company

costs, the investors, and the financial markets. It highlights the burdens to companies,

but shows the rewards for compliance as well as the penalties or adverse effects

caused by non-compliance.


REFERENCES: Slaughter, Jeremy; The Impact of the Sarbanes-Oxley Act on American

Businesses, http://smallbusiness.chron.com/impact-sarbanes-oxley-act-

american-businesses-1547.html, 2015; McGraw-Hill; The Legal Environment of

Business, 2011

http://smallbusiness.chron.com/impact-sarbanes-oxley-act-american-businesses-1547.html

http://smallbusiness.chron.com/impact-sarbanes-oxley-act-american-businesses-1547.html


PART B:

1. What category of corporation is Pharma and what are the options in terms of

structure and raising Capital?

“Corporations may be classified into one or more categories that reflect their overall

purpose, capitalization (how they are funded), location, and structure. The two major

categories are corporations that are owned exclusively by a group of private individuals

(known as privately held), and corporations that sell their ownership interest via public

stock exchanges (publicly held)”. (The Legal Environment of Business, 2011)

Pharma would be categorized as a “privately held corporation”. This corporation is

owned exclusively by three private people, Adams, Barker, and Cornelius. This type of

corporation serves well for a group of individuals who will own the corporation with

some actively involved with the management while others are involved in a limited or

indirect capacity. In the case of Pharma, Adams and Barker were involved with or

engaged with research related to inventing a patentable pharmaceutical product.

“Cornelius would use his contacts to find a manufacturer to produce and market the

patented drug. Privately held corporations are those that do not sell ownership interests

through sales via a broker to the general public or to financial institutions or public

investors. Privately held corporations have substantial flexibility in terms of their internal


operating procedures and do not generally have to comply with rigorous corporate

structures or formalities. For example, in lieu of an actual meeting, privately held

corporations often use a single document signed by each principal to dispose of

necessary tasks such as elections of directors or issuing stock. This document is known

as a unanimous consent resolution. Many states also give privately held corporations

the option of electing to become a closely held or family held entity. This option further

restricts the number or type of owners that a corporation may have, but gives even

more flexibility on how the business venture may be organized and managed. Note that

even though many privately held corporations have a relatively small number of

shareholders, there is no limit in terms of revenue. It is not uncommon for corporations

with revenues in the eight-figure range to be privately held. Often, the flexibility of a

privately held corporation outweighs any desire of the principals to be able to capitalize

the business through a sale to the general public”. (The Legal Environment of

Business, 2011)

2. Would Pharma be eligible to be an S corporation? If one of the shareholders

objected, could the other two vote to become an S corporation without the third?

Pharma could choose to become an S corporation because Pharma is a normal

corporation with few shareholders and one in which net income or losses are passed on


to shareholders in accordance with Internal Revenue Code whereby corporations must

meet specific eligibility criteria and they must notify the IRS about their choice to be

taxed as an S corporation within a specified period of time. If one of the shareholders

objected, then becoming an S corporation would not be an option. All three of the

shareholders must consent to becoming an S corporation. All other qualifications are

met by Pharma. Pharma is a domestic corporation without nonresident or alien

shareholders. They have a single class of stock and none of its partners are a

corporation, partnership, or discretionary trust. The number of shareholders is only

three which is far below the maximum of one hundred. None of the shareholders own

more than eighty percent of stocks in any subsidiary corporations.

3. Did Adams have the right to hire Elliot without the others’ consent? Suppose that

Cornelius believes that Elliot is not a good hire for Pharma. Can he fire Elliot?

Although Adams may have had the legal right to hire Elliot without the consent of the

others, it was a morally wrong decision not to seek the consent of the other

shareholding partners. As a privately held corporation which is small in size, the

promotion of business efficiency is an objective best served by enabling the owners to

arrange the organization of the enterprise as they choose unless such decisions are

outside the scope of the partnership business which would make it impossible to carry


on the ordinary business of the partnership which would then require unanimous

consent. Under partnership law the partners can arrange internal decision making as

they choose but, regardless of their internal arrangements, any partner has apparent

authority to bind the partnership on a matter in the ordinary course of business unless

the third party has knowledge that the particular partner has no authority in fact.

4. Suppose Cornelius is unhappy with the transaction. Does he have any say in the

matter? Does he have the power to stop the sale?

Accepting an acquisition offer from the pharmaceutical company, Multi-Drug (MD) by

Adams and Barker would be considered a structural decision and is not within the

general framework or structure of the business as it exists. That decision would have to

be made by a unanimous consent of the shareholders. Unfortunately for Cornelius his

share in the company of thirty percent is far outnumbered by a combined seventy

percent owned by Adams and Barker. As a shareholder Cornelius does have a say in

the matter, but he has no power to stop the sale.

5. Have Adams and Barker breached their fiduciary duties to Cornelius? If so, what

duties, specifically, and how were they breached?


“General partners have a set of duties that ensure they are acting in the best interest of

the partnership. These are known as fiduciary duties. These duties are very similar to

duties owed by an agent to a principal. Fundamentally, the RUPA sets out these duties

as threefold: (1) loyalty, (2) care, and (3) good faith”. “The good faith standard requires

that partners exercise appropriate discretion in dealing with other partners and third

parties concerning the partnership’s business enterprise operations. (The Legal

Environment of Business, 2011) Adams and Barker were not acting in good faith when

they accepted the proposal from MD. They were clearly looking out for their own

interest. Not only were they motivated by a five year employment agreement, but they

also had total disregard for Cornelius’ investment which was twice the amount being

accepted from Multi-Drug pharmaceutical company.

6. Are Adams and Barker protected by the business judgment rule? Why or why not?

There are three hurdles to clear when seeking protection by the business judgment rule.

Those are having no private interest, having the best decision relating to the decisions,

and rational belief. “In order to claim protection under the business judgment rule, the

director must have had no financial self-interest in the disputed transactions or

decision”. (The Legal Environment of Business, 2011) One could argue that Adams


and Barker are protected by this rule due to the fact that they were not receiving any

direct financial benefits. One could argue though, that receiving a five year employment

borderlines financial benefits especially given the worsening financial position of

Pharma. Adams and Barker also lacked diligence in investigating the proposal,

decision, and transaction and never consulted outside experts. “Directors’ and officers’

decision-making procedures must be set up in a way that allows careful decisions to be

made regarding the best interests of the corporation”. (The Legal Environment of

Business, 2011) The argument could be made both ways about protection by the

business judgment rule concerning rational belief. For Pharma to survive and become

viable it was obvious that some decisions had to be made, but was the sale of the

assets in the best interest of the corporation, or was it in the best interest of Adams and

Barker? One can only conclude that the directors violated all their duties of financial

interests, care and rational belief and were not acting with best information and, thus,

cannot be shielded by the business judgment rule.

7. What type of lawsuit, derivative or direct, would be filed by Cornelius to:

a. Force Adams and Barker to have a shareholders’ meeting and formal vote.

b. Recover against Adams and Barker for damages Cornelius suffered as a result of an

alleged breach of duty.


“Shareholders enforce their rights and fiduciary duties through the use of a lawsuit in the

form of a shareholder’s derivative action or a shareholder’s direct action. In a derivative

suit, an individual shareholder (or a group of shareholders) brings a lawsuit against an

insider in the name of the corporation itself. Most derivative lawsuits are brought

because the shareholder alleges a breach of fiduciary duty of care or loyalty by an

insider”. (The Legal Environment of Business, 2011)

Forcing Adams and Barker to have a shareholders meeting and formal vote would have

to be ensued through a derivative lawsuit by Cornelius. The decision to sell to MD

would be considered an injury to the company and indirectly causing harm to Cornelius.

Damages Cornelius suffered as a result of the alleged breach of duty could be

considered as an injury to a shareholder and would be pursued as a direct lawsuit. One

could certainly argue that having invested one hundred thousand dollars in a company

that ends up selling its assets for fifty thousand dollars without consultation, much less,

consent could be considered as having caused direct personal injury. In addition,

Cornelius may have spent countless hours pursuing the acquisition of a manufacturer to

produce and market the drug when patented. Having no further say or interest in the

company may have also caused direct harm to his reputation.


REFERENCE: McGraw-Hill; The Legal Environment of Business, 2011; Clancy v King,

936 A.2d 852 (Md. 2008); Case 15.2 H. Carl McCall, Trustee of the New York

Common Retirement Fund, et Al., Derivatively on behalf of Columbia / HCA

Healthcare Corporation v Scott, et al., 239 F.3d 808 (6th Cir. 2001)