The August 14th deadline for CEO’s and CFO’s of America’s largest 947 companies to certify their financial statements has come and gone without incident. There have been no significant or unexpected earnings restatements, and virtually every company has fully complied with the SEC’s certification order issued June 27. Even AOL Time Warner — practically the last of the big companies to certify, and widely feared to be a neutron restatement bomb just waiting to explode — squeaked in under the wire with only a $49 million boo-boo to confess.
Now that it’s over, investors have heaved a great sigh of relief. But it’s not over. It’s just beginning. And it’s certifiably nuts.
When President Bush signed the Sarbanes Oxley Act on July 30 he put in place onerous and ambiguous certification requirements for all public companies, not just the top 947, under the Act’s Section 906. And these new requirements took effect immediately, making yesterday the first certification deadline for as many as 16,000 other public companies. The penalty for certifying bad financials: fines up to $5 million, and up to 20 years in prison.
This sweeping certification requirement was a last-minute add-on to the Sarbanes Oxley bill, appearing on page 126 of this 130-page legislative behemoth, and occupying less than half a page of text. It’s a masterpiece of bad law. A Securities and Exchange Commission official, speaking to me on condition of anonymity, called the people who wrote this law “idiots,” and said that “some very sleepy senators decided to add Section 906.”
First, Section 906 took effect the moment that Bush signed the Act. Since it requires that “Each periodic report containing financial statements” be certified when filed, that effectively gave most of the 16,000 public companies not already under the SEC’s certification order just two week’s warning. That’s because filings for fiscal quarters ended June 30 are always due 45 days after the close of the quarter — and the overwhelming majority of public companies keep their books in synch with calendar quarters.
Second, there are no objective standards for exactly what CEO’s or CFO’s are actually certifying. Under Section 906, they must certify “that information contained in the periodic report fairly represents, in all material respects, the financial condition and results of operations of the issuer.” But what does “fairly” mean? What is “material”? Who knows — but the CEO or CFO who guesses wrong is a felon.
Third, there is no statutory form for the certification. CEO’s and CFO’s are simply commanded to “certify,” without any instructions on how to do it, or statement of what the acceptable standards for it will be. At least when the SEC ordered big-company CEO’s and CFO’s to certify, the agency gave them a form to fill out.
Fourth, there is no specific list of which filings have to be certified, and which do not. What exactly is a “periodic report containing financial statements”? Even my source at the SEC didn’t know. My source wondered, for example, whether the “idiots” intended to include proxy statements — they are crucial filings that contain financial statements, but they aren’t strictly “periodic.”
Fifth, the certification is absolute and unconditional. The SEC order for big companies required CEO’s and CFO’s only to certify “to the best of my knowledge.” But Section 906 offers no such safe harbor. The penalties called for in Section 906 — fines up to $5 million and prison terms up to 20 years — are only for CEO’s and CFO’s whose violations are “knowing.” But penalties are determined in a separate trial phase from guilt or innocence. That means that, while a CEO won’t go to jail for as long as John Walker Lindh unless his violation is “knowing,” he could still be found guilty of a felony even though he acted in utter innocence and good faith. After explaining this part to me, my SEC source asked, “Did I mention the ‘i’-word already?”
Sixth, the Sarbanes Oxley Act contains an entirely separate section — Section 302 — that instructs the SEC to go through its normal rules-making process to come up with procedures for CEO and CFO certification. But what’s the point? As my SEC source told me, “Any SEC rules will always be trumped by the statutory power of Section 906.” So when the SEC obeys the Act and comes up with its own rules, there will then be two entirely separate certification requirements, each with different and potentially conflicting requirements.
So while the financial media made great theatre Wednesday by counting down the big-company certifications as they poured into the SEC, they (as usual) missed the real story. The real story is that thousands upon thousands of smaller companies — most of whom don’t have the legal resources of corporate giants, and all of whom had just two weeks to prepare — had to certify, too. Out of up to 16,000 companies, how many of them were as unaware as the media that this sweeping certification requirement even exists?
So let’s not be complacent that all the certifications are duly filed. Potentially thousands of them aren’t — but outside the 947 big companies, the SEC isn’t saying. And of the many thousands that were filed, who knows how many will be in the wrong format (since no format was specified)? Who knows how many will have certified financials that will be found later not to be “fair” (since no standards of fairness were established)? Who knows how many will contain mis-statements that are “material” (since no threshold of materiality was specified)?
For every unknown in Section 906, a Sword of Damocles now hangs over the heads of CEO’s and CFO’s all over America. Exercising an honest judgment in good faith that is later contradicted by the SEC — or an infraction by the lowest level employee in the smallest foreign subsidiary of which the CEO and CFO had no knowledge — are now potentially felonies. How would you like to be the CEO of Citigroup, signing off that the accounting for your banks in Zaire — to pick a country at random — is “fair” and that you’ve included everything that is “material”?
And this gives federal authorities a blank check on re-regulation — and don’t think the feds won’t try to cash it. Today companies that seek to merge have to agree to all manner of ad hoc regulatory covenants in order to obtain antitrust clearance under the Hart Scott Rodino Act — take a look at the hoops Hughes Electronics and Echostar are being made to jump through. Well, from now on every CEO and CFO in America will be subject to this same kind regulatory blackmail, whether they’re trying to do a merger or not: “do what we say, or we put you on the hook for your accounting.”
Just how long do we expect CEO’s and CFO’s to continue doing their jobs, living under the threat that at any moment even their honest and innocent judgments could cause them to be branded as felons, facing the same prison sentence imposed on an American who fought with the Taliban, and exposed to endless class action lawsuits from civil plaintiffs?
I spoke about this with the CEO and founder of a top NASDAQ-listed technology company last week. When I asked him if he and his CFO intended to certify their quarterly financials in time for the deadline, he rolled his eyes and said that they already had. Then, reflecting on all that it took for him to build his multibillion dollar business from the ground up over the last decade, he said sadly, “You know, sometimes I ask myself just how much more of this I can take.”
When bad laws make criminals of innocent CEO’s, innocent men won’t want to be CEO’s anymore — only corrupt men will. And when bad laws confer arbitrary power upon federal bureaucrats, the bureaucrats will become as corrupt as those CEO’s. Is this any way to ensure accountability and restore trust in markets? No– this legislative cure is worse than the disease.
