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Sarbanes Oxley : Law : Thought Leader
The Sarbanes-Oxley Act
Implications for Environmental Management
By
Ben Pfefferle III
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Ben Pfefferle III
Partner Environmental Practice Group
BakerHostetler
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Congress enacted Sarbanes-Oxley in 2002 as a response to the unprecedented financial fraud uncovered in companies such as Enron, WorldCom, and others. The stated purpose of the Act is to "protect investors by improving the accuracy and reliability of corporate disclosures. . . " Although the primary focus in the media and in many corporate boardrooms has been on financial disclosure, many companies will also need to take a close look at their environmental controls and reporting procedures. Recent SEC studies indicate that many public companies have not consistently complied with the environmental reporting requirements. Changes brought about by the Sarbanes-Oxley Act, including increased enforcement, more accountability, and tougher penalties, will likely turn this trend around.
After Sarbanes-Oxley, top executives must certify the accuracy of each annual and quarterly report. Executives must also certify that the company has procedures and controls in place that will uncover and report to the top any material liabilities. These certification requirements make the CEO and CFO ultimately responsible for ensuring that potential environmental liabilities are disclosed to the public.
The Act also requires the SEC to conduct regular and systematic review of the financial statements of reporting companies. Now that EPA enforcement actions are public information and the EPA regularly shares information with the SEC, the focus of these reviews will most certainly include environmental liabilities. With the potential for criminal and civil liability for non-compliance greatly increased, it is essential that executives understand the requirements for environmental disclosure and determine whether their current system is in compliance.
The CFO and CEO are now ultimately responsible for assuring adequate disclosure.
Arguably the most influential changes made by the Sarbanes-Oxley Act are those intended to increase the accountability at the top level of corporations. The act requires the CEO and CFO to certify the following in each quarterly and annual report:
? he or she has reviewed the report being filed;
? based on his or her knowledge, the report does not contain any untrue statements of a material fact or omit to state a material fact;
? based on his or her knowledge, the financial statements, and other financial information included in the report, fairly present in all material aspects, the financial condition, results of operations and cash flows of the company;
? he or she is responsible for establishing and maintaining disclosure controls and procedures and internal control over financial reporting for the company and that these have been evaluated within the last 90 days;
? the disclosure controls and procedures ensure that material information relating to the company is made known to them by others with sufficient speed to allow ?timely? decisions regarding disclosure; and
? the internal control over financial reporting provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Generally Accepted Accounting Principles (GAAP).
These requirements are designed to undercut the ?I didn?t know? defense for executives. In light of these new SEC rules, it is imperative that companies evaluate their current environmental reporting system. Senior management must, in effect, certify that procedures are in place to transmit environmental information to the top, that environmental disclosures comply with the periodic and annual reporting requirements, and that environmental liabilities are accurately reflected in the financials in accordance with GAAP.
Disclosure controls and procedures.
The required controls and procedures must be designed to ensure that information required to be disclosed is recorded, processed, summarized and reported, within the time periods specified. The term ?disclosure controls and procedures? has a broader meaning than ?internal controls? and is intended to refer both financial and non-financial disclosures. Because environmental costs and liabilities are required to be disclosed, the veracity of this certification depends to some extent on the integrity of the company?s environmental management systems. Steps must be taken to make sure that information about potential liabilities and costs are gathered and communicated to management to allow timely decisions regarding disclosure. Because management must certify that these steps are taken, failure to do so can result in SEC sanctions even when the failure does not lead to a lack of disclosure.
Fundamentally, the new SEC rules do not require companies to do anything that they were not already required to do. The certification requirement, however, provides increased incentive for companies to make sure they are doing them properly. The requirements for adequate controls and procedures are complex, and because of the liability and sanctions associated with the failure to meet them, counsel should be involved with both the implementation and review of these procedures. At the most basic level, the controls and procedures should meet the following guidelines:
? Top management be should be involved in supervising the design and operation of the procedures.
? The procedures need to be documented and must be communicated to all personnel.
? The procedures should be sufficiently detailed to lay out the overall approach and provide guidance, but sufficiently brief that they will provide flexibility for variation, will be understandable by those who need to follow them and will be followed.
? The procedures should be customized for the company?s managements structure, industry, and business processes.
? The procedures should be overseen by a central person or group.
? The procedures should be reviewed and evaluated for effectiveness in a formal session conducted by top management on a quarterly basis for U.S. companies and an annual basis for non-U.S. companies.
Violations are now much more likely to be discovered.
Congress reacted strongly to the fact that the SEC had not meaningfully reviewed Enron?s filings for the 5 years preceding the companies collapse. The Sarbanes-Oxley Act now requires ?regular and systematic review? of the financial statements of reporting companies. Under no circumstances, may any company?s filings be reviewed less than once every three years. In addition the SEC is required to pay special attention to disclosures made by companies such as the following:
? issuers that have issued material restatements of financial results;
? issuers that experience significant volatility in their stock price;
? issuers with the largest market capitalization;
? emerging companies with disparities in price to earning rations; and
? issuers whose operations significantly affect any material sector of the economy.
With respect to environmental disclosure in particular, there has been a recent push from various fronts to increase enforcement. The EPA has conducted numerous studies and has reported that the vast majority of reporting companies are not meeting environmental disclosure obligations and that this trend is putting investors at risk. The EPA has also begun a policy of distributing to reporting companies notices of their duty to disclose potential liabilities in the face of enforcement actions. In addition, the EPA has launched the Enforcement and Compliance History Online (ECHO) which allows the public to compare the environmental history of a company to disclosures made in SEC filings, also available online.
It has also been reported that the SEC and the EPA now share information regarding the disclosure of potential liabilities stemming from enforcement actions. The United States Government Accountability Office released a report in July, 2004 examining whether the SEC is adequately regulating environmental disclosures. The GAO recommended that the SEC ?take steps to improve the tracking and transparency of information related to its reviews of companies? filings, and to work with the [EPA] to explore ways to take better advantage of EPA data relevant to environmental disclosure.? The report also notes that the EPA has already taken action with respect to these recommendations by adding to its website the comment letters it issues in response to companies? annual filings as well as any responses to those letters given by the company.
The cost of non-compliance is now much higher.
The Sarbanes-Oxley act now authorizes imprisonment for up to 10 years and $1 million in fines if a CEO or CFO knowingly certifies a report that does not satisfy the requirements of the act. The act also defines a higher offense for those who ?willfully? certifies a report they know does not satisfy the requirements of the act. Penalties for this offense are up to 20 years and $5 million in fines. The difference between the required state of mind for these offenses is not well articulated in the Act, and it remains to be seen the level of culpability the courts will require for these different penalties to be assessed.
The Act increases the penalty for securities fraud to 25 years. The statute of limitations for civil suits alleging securities fraud has been increased to two years after discovery or five years after the violation occurred. The Act also gives the SEC power to bar individuals from serving as directors or officers for committing securities fraud, whereas previously a court order was required for such a step. The standard has also been lowered from ?substantially unfit? to ?unfit? in response to criticism that the courts have been unwilling to impose such a penalty in the past. In addition, the Act amended the federal bankruptcy code preventing the discharge of debts of individuals resulting from judgments and settlements relating to securities fraud.
CEO?s and CFO?s who must restate their company?s financials due to ?misconduct? relating to the financial reporting requirements run the risk of having to reimburse the corporation for up to 12 months of their incentive-based or equity-based compensation. It is not clear whether these provisions must be enforced by the SEC, whether the corporation can bring a cause of action, and whether a shareholder can bring such a cause derivatively. It is also not clear what level of culpability is required for to constitute misconduct under the provision. The uncertainties surrounding this provision necessitate the initial accuracy of financial statements.
The determination of what needs to be disclosed often depends on the materiality standard.
SEC Rule 12b-2 states that, ?The term ?material,? when used to qualify a requirement for furnishing information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered.? With respect to applying this standard to speculative events, the Supreme Court has adopted an approach which compares the probability that the event will occur and the anticipated magnitude of the event.
The SEC has specifically rejected the use of a numerical threshold to determine materiality, favoring instead an approach that considers ?all relevant considerations.? With respect to misstatements or failures to disclose, relevant factors for the determination of materiality include the following:
?Whether the misstatement masks a change in earnings or other trends;
? Whether the misstatement turns a loss into income or vice versa;
? Whether the misstatements masks a failure to meet analysts? projections,
? Whether the misstatement hides an illegal activity, etc.
The mixing of qualitative and quantitative factors can result in a numerically insignificant matter being considered by the SEC and the courts to be material. In light of higher standards of accountability and the greater consequences of noncompliance, companies should always error on the side of accurate and full disclosure.
SEC provisions relating to environmental disclosure.
The SEC rules that establish the requirement for environmental costs and liabilities to be disclosed are as follows
? Regulation S-K, Item 101?Description of Business. Registrant must disclose the material effects that complying or failing to comply with environmental regulations is likely to have on earnings, competitive position, and capital expenditures.
? Regulation S-K, Item 103?Legal Proceedings. Under this provision, reporting companies must provide a brief description of any material pending legal proceeding and any material proceeding known to be contemplated in which the government is a party. With respect to proceedings that involve primarily a claim for damages, a description is unnecessary here unless the amount involved is greater than 10% of the company?s assets. However, aggregation of amounts involved is required for proceedings which involve substantially similar legal and factual issues.
If a government agency is a party, i.e. the EPA, a proceeding must be disclosed if it likely to result in $100,000 of liability, regardless of materiality. This requirement can easily trip up larger companies. Because the EPA will usually plead in a manner so as to maximize possible fines, it often does not take much to face up to $100,000 in potential liability to the EPA. In addition, for many companies, the $100,000 threshold is nowhere near what would normally be considered material.
If a company has a reasonable basis to believe that it will win a proceeding, disclosure is not required. Companies who feel they have such a reasonable basis should take great care to document this in case future disputes arise.
? Regulation S-K, Item 303?Management?s Discussion and Analysis. The purpose of this section is to provide a narrative explanation of a company?s financial statements that enables investors to see the company through the eyes of management. Companies must disclose ?known trends, events or uncertainties? that may have a material effect on the company?s financial condition. A 1989 SEC Interpretive Release emphasized that these guidelines include environmental trends such as the cost of complying with anticipated new regulations and Superfund liabilities.
Materiality with respect to this provision is not governed by the probability/magnitude test. Instead, the issuer must make two determinations when deciding whether to disclose a known uncertainty:
1. If the known uncertainty is not reasonably likely to occur, then no disclosure is required.
2. If the first determination cannot be made, the issuer must evaluate the effects of the contingency on the assumption that it will come to pass. Disclosure is then required unless management determines that a material effect on the company?s financial status is not reasonably likely even if the event were to occur.
Generally, a company is under a duty to disclose material information in the registration documents used in the sale of securities and in the periodic SEC filings required by the provisions described above. The registration must be accurate at the time it is used to sell stock and not just when it is filed, but there is no general duty for continuous disclosure of material developments. There is, however, currently a split in the circuits on whether there is a duty to update when new information indicates that previous disclosure is no longer accurate. Sarbanes-Oxley appears to give the SEC the power to require continuous disclosure of material developments, although no such provisions have, as of yet, been implemented.
The SEC is moving toward more rigid disclosure requirements regarding accounting estimates.
In 2003, the SEC released MD&A guidance that advises companies to disclose and quantify ?critical accounting estimates.? An estimate is considered to be critical if different numbers the company could have chosen, or that are reasonably likely to be chosen later, would materially change the outlook of the company. Estimations of potential environmental liability are likely to fall within this definition.
The guidance suggests, first of all, the disclosure of the fact that such numbers are mere estimates. Secondly, the company should demonstrate the sensitivity of financial results to changes in each accounting estimate by disclosing what the financial results would be had other possible estimates been used.
SEC interpretive releases are staff interpretations of what is required by the current rules. So while companies would be well advised to adhere to the guidance found in these interpretations, it is conceivable that a court could find the requirements of the rules met without the additional information. It should be noted, however, that the SEC guidance concerning critical accounting estimates closely tracks a 2002 proposed rule change, and it appears that these new rules may soon be adopted.
The preamble to the proposed rule indicates that an additional requirement would likely be probabilistic decision analysis. This analytical tool generates a probability distribution which would tell investors the likelihood that any particular possible outcome would be realized. Investors could then use this information along with the sensitivity data to better understand a company?s position with respect to any potential liability. This analysis is also suggested by recently adopted ASTM guidelines for estimating environmental costs and liabilities.
Great care should be taken to preserve documents with potential significance in any federal investigation or proceeding.
The act expands the reach of the obstruction of justice laws and significantly raises the maximum penalty for violations. The Act criminalizes the destruction, falsification, concealment, etc. of any document or object with the intent to obstruct or influence any investigation carried out by the federal government. Persons violating this provision can be fined and sentenced up to 20 years.
While this provision was not designed to reach routine document destruction, the current regulatory environment likely necessitates greater care in such procedures. Documents relating to potential environmental liabilities should never be destroyed. Once a company learns a government investigation is likely to commence, all relevant documentation must be retained, including drafts and emails.
Companies should evaluate employment procedures in light of the new ?whistleblower? provisions.
Two separate Sarbanes-Oxley provisions provide protection to an employee who reports violations of certain federal offenses. The first provision, applies only to reporting companies and defines a civil action against an employer under certain retaliatory circumstances. The provision protects an employee who reasonably believes a violation of the securities fraud provisions has occurred and either aids in any action related to that fraud or supplies information to his or her supervisor, a government agency, or member of Congress. The provision sets forth rather complex procedures that must be followed by both the employee and employer in contemplation of such a cause of action. Remedies available include, reinstatement, payment of back pay with interest, and attorney fees.
The second provision defines, under limited circumstances, a criminal offense for retaliatory acts against an employee. This provision is narrower than the first, in that it only protects the act of reporting to a federal law enforcement agency. The provision is broader than the first in that it appears to apply with respect to any federal offense not just securities fraud. The person who intentionally authorizes any such retaliation can be fined and sentenced up to 10 years in prison.
Both provisions can have implications for environmental matters. The first can play a role when it is alleged that a company is covering up potential environmental liabilities in order to defraud investors. An employee who exposes such liabilities would be protected under the act. Because the second provision is not limited to securities fraud, it would likely protect an employee who reports environmental violations to the EPA.
The scope and application of the these laws is unclear and the personal and corporate cost of non-compliance can be significant. Counsel should be involved at the first hint of a problem. In addition, the following general steps should be considered:
? Write a corporate code of conduct that encourages employees to report potential financial, environmental, legal or other misconduct.
? Include a "no-retaliation" policy and identify employees who are to receive complaints of whistle-blower retaliation.
? Establish a corporate compliance hotline and/or name a corporate compliance or ethics officer.
? Keep personnel files, disciplinary records and termination records and document them well.
The impact of the Sarbanes-Oxley Act will be felt by privately held companies.
Initially, some of the provisions with respect to whistleblowing and document destruction are universal in application. In addition, legislation that closely parallels many of the requirements of the act has been introduced in some states. Even the smallest companies must review document retention and human resource procedures for compliance with these new guidelines.
Private companies that desire to one day go public or that may be acquired by publicly- held companies should monitor their ability to comply with the requirements of the act. A company whose control procedures do not meet the Sarbanes-Oxley standards may be less desirable a target for acquisition. If a target does not have proper procedures in place, an acquiring company will not be able to make the certifications required by the Act once the acquisition is complete, which may negatively affect the value of the acquired company.
Other business arrangements may also require private companies to comply with certain provisions of the act. Lenders often require borrower certifications in closing packages; the act may influence the content of these certifications even with respect to private companies. It has even been suggested that the availability of capital may be limited in the advent of state legislation prohibiting venture, pension, and incubator funds from investing in companies that do not comply with the Act. Privately held companies that do business with publicly-held companies or government entities may find themselves subject to Sarbanes-related provisions as a matter of contract.
Insurance requirements may also be influenced by the provisions found in Act. Bonding and surety companies may require similar disclosure and financial controls. Premiums for director and officer insurance have already spiked in the aftermath of corporate scandals, and the requirements of the act is already generating more rigorous requirements and broader exclusions from coverage. Privately-held companies that carry such insurance will be effected by these developments.
Conclusion
The Sarbanes-Oxley Act has introduced many changes to corporate governance and reporting requirements. The effects of these changes are widespread. Management should not overlook the implications Sarbanes-related requirements have had on environmental reporting requirements. Failure to take such implications into consideration can result in severe corporate and personal consequences. Proper planning and monitoring is needed to protect the corporation, directors, and officers from significant liability.
Ben Pfefferle III
Partner Environmental Practice Group
BakerHostetler
Ben L. Pfefferle, III, is a partner in the Environmental Practice Group, with an emphasis on environmental compliance; hazardous and toxic waste issues; Superfund litigation and private cost recovery; environmental permitting; and redevelopment, acquisition and divestiture of environmentally impaired commercial and industrial property. Mr. Pfefferle serves as common counsel for multiparty PRP groups at several National Priority List Superfund sites. He defends companies in civil, criminal and administrative enforcement proceedings involving state and federal Clean Air Act, Clean Water Act, Solid Waste Disposal, RCRA (hazardous waste) and CERCLA (Superfund) actions. In addition, he is involved in the prosecution of private environmental indemnity claims as well as the prosecution and defense of private cost recovery actions.
Mr. Pfefferle has supervised and evaluated environmental audits, performed due diligence evaluations for the acquisition and divestiture of various manufacturing facilities, and developed and provided training for environmental management systems. He has resolved and litigated disputes involving environmental permits including Title V and state air permits, NPDES (waste water) permits, and RCRA corrective action and closure proceedings. Mr. Pfefferle has assisted clients in obtaining ?No Further Action Letters? and ?Covenants Not to Sue? from governmental authority pursuant to state Brownfield programs, allowing environmentally impaired property to be redeveloped and returned to productive use.
Mr. Pfefferle is a member of the American Bar Association Section of Litigation, Environmental Committee, and current Chairman of its Brownfields Litigation Subcommittee; and is a member of the Section of Natural Resources, Energy and Environmental law. He is a member of the Ohio State and Columbus Bar Association Environmental Law Committees and is a former chairman of the latter Committee, where he served four terms. He is a Fellow of the Columbus Bar Foundation. Mr. Pfefferle is listed in Who?s Who in America and Who?s Who in American Law and is ranked by a peer review group to be among the top five percent of Ohio lawyers (Law and Politics Media, 2004).
Mr. Pfefferle is immediate past chairman of the Board of Directors for the Make-A-Wish Foundation of Greater Ohio and Kentucky, where he oversaw the growth of the charity to the fifth largest chapter in the United States and a reorganization of its multi-state Board of Directors to improve governance efficiency.
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