Barbara Borden, who represents public companies for Cooley Godward, says companies late with their reports can face penalties as severe as delisting. (photo/alandeckerphoto.com)

The Telecom Cowboy is getting a cell; not a cell phone, but a jail cell. Last month, Bernard Ebbers, once the powerful CEO of WorldCom, wept as he learned he had been sentenced to 25 years in prison for corporate fraud after his $11 billion company collapsed. Even with time off for good behavior, the 63-year-old Ebbers could be behind bars until 2027, when he will be 85.

Ebbers’ sentence is the latest in a string of high-profile CEO convictions that include Adelphia Communications Corp. (founder John Rigas was sentenced to 15 years), Tyco Corp. (former CEO L. Dennis Kozlowski faces up to 30 years), and Martha Stewart, who was put under house arrest after serving five months in prison.

In response, San Diego CEOs are reviewing internal reports on how well their companies are complying with the Sarbanes-Oxley corporate disclosure law passed by Congress in 2002.

In general, the law demands greater accountability from executives in the reporting of their company’s financial position by having them certify personally for the accuracy of results. Corporate committees were given new authority to hire outside experts (lawyers and accountants) to conduct independent investigations of financial irregularities.

If executives are anxious about being cast as the next Bernie Ebbers, accountants are looking to distance themselves from the specter of Arthur Andersen, the Big Five accounting firm that dissolved in the wave of post-2001 financial scandals. The remaining Big Four firms have become more exacting, say attorneys, in their demands of their clients.

Otto Sorensen, attorney at Luce Forward Hamilton & Scripps, says parts of the new federal corporate disclosure law are helpful and others don’t address the cause of the financial scandals. (photo/alandeckerphoto.com)

“Parts of Sarbanes are appropriate and helpful,” says Otto Sorensen, an attorney at Luce Forward Hamilton & Scripps. “There are others that don’t really address the causes of the scandals that gave rise to Sarbanes and have imposed significant costs on public companies, especially smaller ones.”

Section 404 of Sarbanes requires corporations to impose cash management controls, controls to ensure that a sale has actually occurred, inventory controls, and others to ensure the information that is released to the public is accurate. Management has to sign off on the sufficiency of the controls, and the auditors have to sign off on management’s assessment.

“It’s very expensive to develop internal controls and procedures for $100 million to $200 million market cap companies, like we have in San Diego,” says Scott Wolfe, an attorney at Latham & Watkins. “A pharmaceutical company might be in their drug development phase, but they’re still spending $1 million on outside consultants to comply with 404 requirements.”

Auditors aren’t taking any chances. “Auditors are being very careful and when there are significant issues they go to a national audit group faster than they used to,” Wolfe says. “The accounting firms have put together groups out of their main office, very sophisticated and very aware of the emerging issues.”

The demand for greater accountability is leading to “increasing tension between companies and their auditors,” says John Niedernhofer, Barney & Barney senior account executive in executive risk practice (see sidebar). “It used to be if you made a discretionary management decision and the auditors didn’t agree you’d come down to the office and work it out. Now the auditors demand layer after exhaustive layer of self-serving documentation — it’s not fun for the auditors — but it is creating a highly adversarial relationship.”

An auditor who resists the decisions of its client runs the risk of being fired.

“So you find another auditor and they find something they disagree with,” Niedernhofer explains. “And you have to put out a press release saying we had to change auditors and that’s not good for investors. Then you have the expense of the new auditors, and by the way they found things they disagreed with so we have to go back over last year’s revenue and so on.”

A restatement has the potential to cause its own chain reaction of events, including executive shakeups.

Scott Wolfe, an attorney at Latham & Watkins, says it is expensive to develop internal controls and procedures for $100 million to $200 million market cap companies. (photo/alandeckerphoto.com)

“It does create a lot of havoc from the mundane to the significant, such as companies facing delisting if they’re late with their reports,” says Barbara Borden, who represents public companies for Cooley Godward. “The crucial thing is getting their arms around what happened and why, and doing it in a sensible fashion.”

Borden says a restatement also brings up whether there are “personnel issues that have to be addressed; it’s now typical for an audit committee to retain its own counsel and conduct an internal investigation of what happened for multiple purposes.”

One focus of the internal probe is to determine whether the error is due to fraud, malfeasance or honest error. “It could be about a person you had a lot of confidence in and they make one really bad judgment,” says Borden, “but we’re almost in a zero tolerance world, so one bad judgment could lead to terminating one or more senior officers.”

Searching For Accountability

Wolfe says the search for accountability leads CFOs and CEOs to ask for backup certifications, or “upstream certifications,” so that the top executives feel comfortable with the information they’re getting from controllers and inside legal counsel.

Another restatement consequence: if executives receive bonuses based on inaccurate financial statements, the bonuses can be recouped by the company.

Ultimately, however, internal controls can only offer so much protection in preventing scandals.

“What’s ironic is that big scandals like Enron, WorldCom, and Tyco did not occur as a consequence of an absence of internal controls,” says Sorensen. “They occurred because bad people were doing bad things, and if they had all the internal controls in the world you still would have had fudging in WorldCom, and with Tyco you would still have Kozlowski looting the company.”

John Tishler represents public companies as an attorney at Sheppard Mullin. “After Sarbanes-Oxley, the exchanges and Nasdaq adopted rules requiring that certain actions must be taken by committees of independent directors, even though the board itself must generally be composed of a majority of independent directors,” Tishler says. “For companies with smaller boards or boards that meet frequently, the required committee actions are often also discussed and considered by the full board, and require the participation of management in order for the committee to be fully informed. Inside directors can usually participate in committee meetings even though they do not vote. The result is often a complex web of committee and board agendas and meetings. It is difficult to see how the added complexity benefits shareholders in most cases.”

U.S. firms also compete in the global marketplace against firms not subject to Sarbanes-Oxley. “Competitors in India and China who don’t have these rules have been able to focus on raising capital, developing and selling products,” Sorensen says, “whereas U.S. companies have been focused on counting beans.”