S A R B A N E S - O X L E Y I M P L E M E N TAT I O N

The Tenth Anniversary of SOX: Its Impact and ImplicationsFor Future Securities Litigation and Regulatory Enforcement Activity

BY ELAINE HARWOOD AND LAURA SIMMONS

Introduction

T he Sarbanes-Oxley Act (SOX) was enacted in 2002in the wake of a series of high-profile corporateand accounting scandals. SOX introduced major

changes to corporate governance and the regulation offinancial reporting that affected both publicly tradedcompanies and their auditors. Ten years after the pas-

sage of SOX, we reflect on the impact of certain of itskey provisions and identify implications that may influ-ence the direction of private securities litigation andregulatory enforcement activity in the future.

The Impact of SOXThe dramatic increase in financial statement restate-

ments as issuers first complied with the provisions ofSOX is well-known, as is the decline that followed insubsequent years. This latter trend has been attributedto improved corporate governance as a result of SOX.Although we have not seen restatements as large asthose of Enron and WorldCom in recent years, it is notclear that SOX has caused a reduction in the number ofrestatements across all publicly traded companies. Asshown in Figure 1, the number of restatements during2007 through 2009 declined, but they remained abovepre-SOX levels. Moreover, in 2010, the declining trendin the number of restatements reversed, and the num-ber of restatements has continued to grow.

Although SOX does not appear to have caused abroad decrease in the number of restatements, it hasbeen attributed as a cause for the dramatic decrease inthe number of securities class actions filed in recentyears.1 As shown in Figure 2, since 2005, securitiesclass actions filings alleging misstatements or omis-

1 See, for example, NPR, ‘‘Sarbanes-Oxley Lowers Corpo-rate Fraud Lawsuits,’’ http://www.npr.org/templates/story/story.php?storyId=12555895

Elaine Harwood is a vice president in the LosAngeles office of Cornerstone Research. Sheheads the firm’s Accounting Practice andserves as a consultant and expert witness pri-marily in cases involving accounting anddamages analyses.

Laura Simmons is a senior advisor in theWashington, DC, office of CornerstoneResearch. She serves as a consultant andexpert witness primarily in cases involvingaccounting analyses, securities case damages,and research on securities lawsuits.

VOL. 10, NO. 28 JULY 13, 2012

COPYRIGHT � 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 1542-9563

CorporateAccountabilityReport®

sions have averaged just under 150 per year, comparedwith just over 200 for 1997 through 2005.2

Since the number of restatements post-SOX has notdeclined, but the number of securities case filings has

dropped, it is not surprising that accounting issues havebecome more prevalent in securities class actions in re-cent years. Specifically, the proportion of settled securi-ties class actions involving accounting issues has aver-aged roughly 65 percent since 2005, compared withonly about 55 percent of settled cases in earlier years.3

Moreover, as shown in Figure 3, accounting cases con-tinue to represent the majority of total settlementvalues.

When SOX was passed, there were concerns that liti-gation could increase as a result of the Section 404 re-quirements that management and auditors report on in-ternal controls over financial reporting (referred to asSOX 404(a) and SOX 404(b), respectively). Althoughthis was not the case in the early years of SOX 404 re-porting more than 70 percent of filings over the pasttwo years that involved accounting allegations also in-cluded allegations of internal control weaknesses.

As shown in Figure 4, allegations of internal controlweaknesses have increased despite a general decreasein corresponding company announcements reportinginternal control weaknesses. This trend may suggestthat plaintiffs believe that including allegations of inter-nal control weaknesses will bolster their position in liti-gation, regardless of whether material weaknesseswere actually present.

Settlements in recent years, however, do not supportthat position. While Figure 5 suggests a slight increase

2 Although SOX was passed in 2002, this comparison forclass action filings focuses on the time period through 2005 toallow for the implementation of one of the most significantprovisions of SOX (specifically, Section 404 related to internalcontrol reporting, which became effective in late 2004 for ac-celerated filers and is discussed in further detail below). SeeCornerstone Research, Securities Class Action Filings—2011Year in Review, for further discussion of trends related to casefilings.

3 This information is computed using the Cornerstone Re-search securities class action settlements database.

2

To request permission to reuse or share this document, please contact permissions@bna.com. In your request, be sure to include the following in-formation: (1) your name, company, mailing address, email and telephone number; (2) name of the document and/or a link to the document PDF; (3)reason for request (what you want to do with the document); and (4) the approximate number of copies to be made or URL address (if posting to awebsite).

7-13-12 COPYRIGHT � 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. CARE ISSN 1542-9563

in settlement amounts for cases that involved allega-tions of internal control weaknesses without companyannouncements, it shows a larger increase for cases inwhich those allegations were in fact accompanied by

announcements that weaknesses were present. More-over, when we apply regression analysis to control forthe effects of multiple factors on settlement amounts,we find that internal control weakness allegations are

Figure 2

Figure 3

3

CORPORATE ACCOUNTABILITY REPORT ISSN 1542-9563 BNA 7-13-12

associated with higher settlement amounts only forthose cases in which there was a corresponding com-pany announcement.4

In addition to requiring management and auditor re-porting on internal controls, SOX increased funding forthe SEC and created the Public Company AccountingOversight Board (PCAOB) to regulate and, when con-sidered necessary, discipline auditors of publicly tradedcompanies. As shown in Figure 6, SEC investigationshave increased significantly after the enactment ofSOX. PCAOB enforcement, however, is still in its earlystages, as shown in Figure 7.

In addition to increased levels of enforcement activ-ity, SEC penalties have increased in recent years. Priorto SOX, the largest penalty was the $10 million settle-ment with Xerox in April 2002.5 Settlements have in-creased since SOX was enacted, as shown in Figure 8.There have been several settlements in the hundreds ofmillions of dollars in recent years, including the 2006settlement of $800 million with AIG.6

SOX may have contributed to the decrease in high-profile restatements that led to its enactment. However,based on recent trends in restatements, securities litiga-tion, and regulatory enforcement activity, it is not clearwhether the effects of SOX have been as strong across

all publicly traded companies or will continue in thefuture.

What Are the Implications for Future SecuritiesLitigation and Regulatory Enforcement Activity?

As discussed below, several key provisions of SOX,as well as changes to those provisions, may influencesecurities litigation and regulatory enforcement activityin the future.

Coordination of Enforcement Activity. SOX includedprovisions for the coordination and referral of enforce-ment activity. Specifically, the PCAOB can refer inves-tigations to the SEC, criminal prosecutors, and, since itsability to impose sanctions is limited (i.e., the PCAOBdoes not have the authority to revoke a CPA’s license),to the appropriate State Board of Accountancy.7 Paral-lel or related proceedings may increase in the future asa result of PCAOB investigations or enforcement. Be-cause the PCAOB may refer an investigation to the SECif it discovers potential violations of securities laws, en-forcement actions against publicly traded companiesmay also increase in the future. Following a step fur-ther, if additional enforcement actions result from thisincreased coordination, it could lead to an increase inprivate securities litigation.

The importance of cross-border enforcement has in-creased since the passage of SOX, due to a number offactors, such as the global financial crisis and recentconcerns about Chinese reverse merger transactions.PCAOB Chairman James R. Doty recently referred tothe ‘‘heightened fraud risk found in some emerging

4 As discussed in Securities Class Action Settlements—2011Review and Analysis, Cornerstone Research has developed asettlement prediction model that explains approximately 70percent of the total variation in settlement amounts. The singlemost important determinant of settlement is a measure of in-vestor losses. Other important predictors, however, relate tothe nature of the allegations and the parties involved in thecase.

5 http://www.sec.gov/news/headlines/xeroxsettles.htm.6 http://www.sec.gov/news/press/2006-19.htm.

7 See Section 105(b)(4) of the Sarbanes-Oxley Act, ‘‘Coor-dination and Referral of Investigations,’’ http://www.sec.gov/about/laws/soa2002.pdf.

Figure 4

4

7-13-12 COPYRIGHT � 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. CARE ISSN 1542-9563

Figure 6

0

200

400

600

800

1,000

1,200

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: SEC Annual Reports

Note: All numbers refer to the fiscal years employed by the SEC, beginning October 1 and ending September 30

SEC Investigations1997–2011

0.

Figure 7

PCAOB Enforcement Activity

2005–2011

Year

Investigations

Initiated

Adjudicated

Disciplinary

Orders

Settled

Disciplinary

Orders

2005 17 0 4

2006 8 0 3

2007 4 0 9

2008 6 0 4

2009 13 1 6

2010 15 2 7

2011 n.a. 2 8[1]

Source: PCAOB Annual Reports, Adjudicated and Settled DisciplinaryOrders.Note: 1. The 2011 PCAOB Annual Report does not include information regarding thenumber of formal investigations initiated.

5

CORPORATE ACCOUNTABILITY REPORT ISSN 1542-9563 BNA 7-13-12

market companies that trade on U.S. exchanges,’’ 8 andRobert Khuzami, the Director of the SEC’s Division ofEnforcement recently stated, ‘‘The SEC will hold ac-countable publicly-traded companies, including foreigncompanies that violate the U.S. securities laws and dis-rupt the U.S. capital markets.’’ 9 Coordination amongthe SEC, PCAOB, and their non-U.S. counterparts incross-border enforcement is expected to increase in thefuture and has the potential to result in additional en-forcement actions.

Exemptions from SOX 404(b) Requirements. SOX 404requirements initially were designed to be phased in.‘‘Accelerated filers,’’ generally companies with marketcapitalization of $75 million or more, filed managementand auditor reports on internal controls beginning withtheir annual reports for fiscal years ending on or afterNov. 15, 2004. Smaller companies (non-accelerated fil-ers) were not required to file those reports until severalyears later. As a result of the unexpectedly high costs ofcompliance with SOX 404 experienced by acceleratedfilers, however, the SOX 404(b) requirement for an au-ditor’s report on internal controls for non-acceleratedfilers was repeatedly delayed. In June 2010, when theDodd-Frank Wall Street Reform and Consumer Protec-tion Act was enacted, non-accelerated filers were per-manently exempted from an audit report on internalcontrols.10

The exemption from the requirement for an auditopinion on internal controls was also extended toemerging growth companies when the Jumpstart OurBusiness Startups (JOBS) Act was enacted on April 5,2012.11 It extended the exemption from the require-ment for an audit opinion on internal controls to fiveyears after an IPO for emerging growth companies, de-fined as companies with less than $1 billion in annualrevenues.12 Chairman Mary Schapiro recently ex-pressed concerns about extending that exemption:

I continue to believe that the internal control auditrequirement put in place after the Enron andother accounting scandals of the early 2000’s hassignificantly improved the quality and reliabilityof financial reporting and provides important in-vestor protections, and therefore believe thischange is unwarranted.13

Exemptions from the requirement for an audit of in-ternal controls decrease the potential impact of SOX on

8 See http://pcaobus.org/News/Releases/Pages/10032011_SAPA8.aspx.

9 SEC Release No. 2012-59, ‘‘SEC Charges China-BasedCompany and Others with Stock Manipulation,’’ April 11,2012, http://www.sec.gov/news/press/2012/2012-59.htm.

10 See Study and Recommendations on Section 404(b) ofthe Sarbanes-Oxley Act of 2002 For Issuers With Public FloatBetween $75 and $250 Million, April 2011, page 25 for a sum-mary of the final compliance dates for SOX 404 reporting afterthe enactment of Dodd-Frank.

11 See http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf.

12 Prior to the JOBS Act, compliance with SOX 404 was notrequired in an IPO and in the first annual report after an IPO.

13 http://www.aicpa.org/advocacy/issues/downloadabledocuments/404b/3-13-12_sec_chm_schapiro_letter_to_johnson.pdf. Dodd-Frank required the SEC to con-duct a study that would address the burden of SOX 404(b) andspecifically consider whether an exemption from that require-ment should be extended for companies that conduct initialpublic offerings (IPOs). That study recommended that the ex-emption not be extended beyond the approximately 60 percentof companies that were exempt under Dodd-Frank, highlight-ing ‘‘strong evidence that the auditor’s role in auditing the ef-fectiveness of ICFR improves the reliability of internal controldisclosures and financial reporting overall and is useful to in-vestors.’’ Study and Recommendations on Section 404(b) ofthe Sarbanes-Oxley Act of 2002 For Issuers With Public FloatBetween $75 and $250 Million, April 2011, page 8, http://www.sec.gov/news/studies/2011/404bfloat-study.pdf.

6

7-13-12 COPYRIGHT � 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. CARE ISSN 1542-9563

smaller companies and may influence the amount andtype of litigation and regulatory enforcement in the fu-ture. Specifically, to the extent that the perspective thatSOX 404 requirements have led to improved corporategovernance and less litigation is correct, smaller com-panies could face increased litigation in the future.

Public PCAOB Hearings. Under SOX, a PCAOB en-forcement proceeding remains confidential unless eachparty consents to a public hearing. Because the require-ment for confidentiality does not apply to the SEC, theallegations in a case against an auditor that is broughtby the SEC would be public immediately; however, thesame allegations against that auditor would be confi-dential if the case were brought by the PCAOB.

The PCAOB has expressed concerns about the effectsof the confidential nature of hearings, including that‘‘investors are unaware that companies in which theymay have invested are being audited by accountantswho have been charged, even sanctioned, by theBoard.’’ 14 Accordingly, the ‘‘PCAOB EnforcementTransparency Act of 2011’’ has been introduced in boththe House and the Senate to amend SOX to makePCAOB hearings public (unless the PCAOB, on its ownmotion or that of another party, decided the hearingsshould not be public).

The American Institute of Certified Public Accoun-tants (AICPA) explained that the confidential nature ofPCAOB enforcement proceedings was established byCongress in recognition of the fact that a good reputa-

tion is essential in the audit profession and publicationof unproven allegations could end the career of an au-ditor or the existence of an audit firm.15 Public hearingsmay also increase litigation against auditors and/or maymake it easier for plaintiffs in private litigation to col-lect enough facts to survive motions to dismiss. In addi-tion, auditors may be encouraged to settle related litiga-tion earlier, so that such litigation is resolved prior tothe time that PCAOB investigations lead to formalcharges.

ConclusionAs we reflect on the past ten years since the enact-

ment of SOX, the environment surrounding private se-curities litigation and regulatory enforcement activityremains volatile. Its future direction may be influencedby certain provisions related to SOX, such as coordina-tion of enforcement activity and the increased exemp-tion from SOX 404 (b) reporting, as well as pending leg-islation to make PCAOB hearings public in the future.

The views expressed in this article are solely those ofthe authors, who are responsible for the content, and donot necessarily represent the views of CornerstoneResearch.

� 2012 Cornerstone Research.

14 See, for example, http://pcaobus.org/News/Speech/Pages/09282010_ModestiTransparency.aspx .

15 ‘‘Written Testimony of Barry C. Melancon, CPA on Be-half of the American Institute of Certified Public AccountantsBefore the Subcommittee on Capital Markets and GovernmentSponsored Enterprises House Financial Services CommitteeU.S. House of Representatives,’’ March 28, 2012, page 11,http://financialservices.house.gov/UploadedFiles/HHRG-112-BA-WState-BMelancon-20120328.pdf.

7

CORPORATE ACCOUNTABILITY REPORT ISSN 1542-9563 BNA 7-13-12