CHED Center of Development in Business and Management Education

College of Business and Economics

A Study of the U.S. Sarbanes-Oxley Act in Relation to Philippine Law on Corporate Governance
SERIES 2004-05

Juris Bernadette M. Tomboc, CPA, J.D., MSIRM

De La Salle University Manila, Philippines

The CBERD Working Paper Series constitutes studies that are preliminary and subject to further revisions. They are being circulated in a limited number of copies only for purposes of soliciting comments and suggestions for further refinements. The studies under the Series are unedited and unreviewed. The views and opinions expressed are those of the author(s) and do not necessarily reflect those of the Center. Not for quotation without permission from the author(s) and the Center. For comments, suggestions or further inquiries please contact: Center for Business and Economics Research and Development (CBERD) 2nd Floor, Medrano Hall, La Salle Bldg., 2401 Taft Avenue, Manila, Philippines Tel Nos: (632) 3030869 and (632) 5244611 loc. 149; Fax No: (632) 3030869 Email: cberesearch@dlsu.edu.ph Or visit our website at http://www.dlsu.edu.ph

About the Author

Atty. Juris Bernadette M. Tomboc is a full-time faculty member of the Commercial Law Department of DLSU-Manila. She earned her B.S. in Business Administration and Accountancy (1989) from the University of the Philippines, her Juris Doctor (1994) from the Ateneo de Manila University, and her M.S. in Industrial Relations Management (2004) from DLSU-Manila.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

Table of contents 1. Introduction 2. Discussion a. Public Company Accounting Oversight Board b. Auditor independence i. Services outside the scope of practice of auditors ii. Audit partner rotation iii. Conflicts of interest (in the recruitment for employment of audit team members by client companies c. Corporate responsibility i. Public company audit committees ii. Corporate responsibility for financial reports d. Enhanced financial disclosures i. Disclosures in periodic reports ii. Prohibition of personal loans to executives iii. Code of ethics for senior financial officers iv. Disclosure of audit committee financial expert v. Real-time disclosures e. Corporate and criminal fraud accountability i. Criminal penalties for altering documents ii. Criminal penalties for defrauding shareholders of publicly traded companies f. White-collar penalty enhancements i. Criminal penalties for violation of the Employee Retirement Security Act of 1974 (U.S.) ii. Corporate responsibility for financial reports g. Corporate fraud accountability 3. Conclusion and recommendations Bibliography 4 5 5 5 5 5 6 6 6 7 8 8 8 8 9 9 10 10 11 11 11 11 12 12 13

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

Abstract
The United States government passed the Sarbanes-Oxley Act of 2002 seeking to promote greater responsibility, accountability and transparency of external auditors and corporate governing bodies with respect to financial statements and reports of publicly traded companies. The Philippines has responded through the Securities and Exchange Commission through the issuance of a Code of Corporate Governance and Rules 68 and 68.1 implementing the Securities Regulation Code summarized in a Financial Disclosures checklist. On the other hand, professional accountants in the Philippines have adopted a Code of Ethics and moved towards the adoption of international accounting standards. There are still, however, remaining areas for improvement in Philippine law on corporate governance, such as: the required composition of the board audit committee; need for real-time disclosures and imposition of stiffer penalties for corporate and criminal fraud.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

1.

Introduction

United States President George W. Bush signed into law the Sarbanes-Oxley Act (referred to in this study as the Act) on July 30, 2002. A barrage of scandals in recent years involving the corporate and financial services sector prompted the move by U.S. government. It has been alleged that unscrupulous accounting, mismanagement and fraud may have caused huge losses of hard-earned savings of American workers and retirees (Shurtz and Pett 2004). There is a strong link between the sustained financial viability of employees retirement and mutual funds and the performance by listed companies considering that a substantial portion of said funds are invested in traded securities. In the Philippines, a similar scandal involved deposed President Joseph Ejercito Estrada who was accused of owning BW Resources Corporation jointly with Mr. Dante Tan who was facing charges of insider trading. The rapid rise and fall in the market value of BW Resources Corporation shares of stock caused large losses to the Social Security System (SSS) as it had likewise invested heavily in the said shares. As a result of the said scandal, in addition to other cases against him involving alleged plunder, President Estrada was forced by the public to resign from his position (Estrada vs. Desierto et al. 2001) . The Sarbanes-Oxley Act amended relevant provisions of the U. S. Securities Exchange Act of 1934 and increased criminal penalties for violation of basic reporting and disclosure requirements of the U.S. Employee Retirement Security Insurance Act. While the Sarbanes-Oxley Act specifically applies only to companies whose shares of stock are listed in U.S. stock exchanges and U.S. audit firms, a study of the provisions of the Act could be relevant for purposes of benchmarking with developments on corporate governance worldwide. It could also be significant in strengthening the Philippine financial market in order to pave the way for new investments to spur economic growth. Moreover, it could be important for purposes of providing safeguards with respect to the investments of social security funds and other public funds. This study aims to: (1) identify and explain key features of the Sarbanes-Oxley Act; (2) compare the provisions of the Sarbanes-Oxley Act and Philippine law on corporate governance; and (3) recommend appropriate measures for corporate law reform in the Philippines.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

2.

Discussion

a. Public company accounting oversight board Section 101 of the Sarbanes-Oxley Act provides for the creation of the U.S. Public Company Accounting Oversight Board (referred to in this study as the Board). The Board is organized as a non-profit institution similar to the Philippine Institute of Certified Public Accountants (PICPA). However, the Board has a specialized function, that is, to oversee audits of all public companies, that is, those companies whose shares of stock are listed and traded in the public stock exchanges. The Board was created to protect the interests of the investing public by ensuring that financial reports of listed companies are informative and accurate with respect to their true financial conditions, results of operations, and sources and uses of funds, and disclosures of other information that may influence the market prices of their shares of stock. The Board is also tasked with ensuring that audit companies and their partners have no other financial interest in their client companies, which may affect the quality of their audit reports. In the Philippines, the Philippine Regulatory Board of Accountancy is tasked under the Revised Accountancy Law of 2004 with the supervision, control and regulation of the practice of accountancy and has the power to oversee the quality of audits of all financial statements. b. Auditor independence Services outside the scope of practice of auditors Section 201 of the Sarbanes-Oxley Act prohibits firms performing audits of listed companies from engaging in other financial services for the latter. Prohibited activities include bookkeeping, financial system design and implementation, appraisal or valuation services, actuarial services, internal audit outsourcing services, management or human resources consultancy, investment advising, and legal and other expert services not connected to the audit. The purpose of the prohibition is to prevent audit firms from acquiring other financial interests in their client companies, aside from the external audit, which may influence the quality of audit reports. The Code of Ethics for Professional Accountants in the Philippines prohibits firms performing audits of listed companies from acquiring other engagements with that are directly related to the preparation of financial statements such as bookkeeping, information technology and actuarial services. However, it does not prohibit external auditors from performing other services not directly connected to the preparation of financial statements such as taxation and management consultancy. ii. Audit partner rotation A corollary provision with respect to auditor independence is Sec. 203 of the Sarbanes-Oxley Act which provides for the rotation of audit lead (or coordinating) partners every five (5) years. In practice, this provision could simply translate to 5 i.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

hiring by listed companies of a new external auditor or audit firm every five (5) years. The evident intention of this provision is to discourage external auditors from acquiring an interest in preserving their relationship with their clients that may, in turn, likewise influence the quality of audit reports. However, it may be argued that this provision does not preclude external auditors from seeking other engagements with or acquiring any other pecuniary interest in their audit clients during or after the conduct of their audit. The Code of Ethics for Professional Accountants in the Philippines requires the rotation of audit lead partners in audits of listed companies and likewise recommends such practice with respect to the conduct of external audits, in general. iii. Conflicts of interest (in the recruitment for employment of audit team members by client companies) Section 208 of the Sarbanes-Oxley Act expressly prohibits the retaining of an audit firm if the listed companys chief executive officer, controller, chief financial officer, or any person serving an equivalent position was employed by the audit firm and participated in any capacity in the audit of the listed company within a one-year period preceding the audit. This provision, in effect, seeks to prevent listed companies from taking advantage of personal connections for purposes of securing a favorable audit opinion by recruiting as an employee a former influential audit team member/s. The Code of Ethics for Professional Accountants in the Philippines requires auditors to consider whether the employment of former audit team members in client companies will constitute a threat to their independence. c. Corporate responsibility Public company audit committees Section 301 of the Sarbanes-Oxley Act requires listed companies to create board audit committees and specifies the rules governing its composition and functions. The Sarbanes-Oxley Act requires all of the members of the board audit committees to be independent from the listed company. Independence means that the board audit committee members have not accepted any other consulting, advisory, or compensatory fee from the listed company. It also means that they are not otherwise affiliated to the company or any of its subsidiaries. Independence by the board audit committee is crucial considering that they supervise the work of external auditors, including appointing them and fixing their compensation, and function as an intermediary between the external auditors and the client company. The requirement of independence by internal board audit committees is intended as an additional protection of the independence by external audit firms from their client companies. In the Philippines, the Code of Corporate Governance (SEC 2002) provides for the inclusion of independent directors in the board of public companies. However, 6 i.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

it does not require that all the members of the audit committee be independent. The board in public companies in the Philippines may be composed of at least five (5) but not more than fifteen (15) members elected by the stockholders of which at least two (2) independent directors, or at least twenty percent (20%) of the members of the Board, whichever is lesser. The Code of Corporate Governance further requires the creation of audit committees in publicly traded companies composed of at least three (3) Board members, preferably with accounting or finance background, with one (1) independent director and another with related audit experience. The requirement of only (1) independent director in the board audit committee may lead to the impairment of the independence of its members who directly hire and compensate external auditors pursuant to the Code of Corporate Governance that, in turn, may also influence the quality of audit reports. ii. Corporate responsibility for financial reports Section 302 of the Sarbanes-Oxley Act requires a certification of listed companies annual and/or quarterly reports by the principal executive officer or officers, and principal financial officer or officers, or persons performing similar functions. Thus, the chief executive officers and the chief financial officers expressly assume responsibility for the correctness and accuracy of annual and/or quarterly reports. Their certification likewise assures the integrity of their companys system of internal controls, as well as the sufficiency of disclosures of all material information and corrections made to deficiencies in internal controls. The purpose of the requiring a certification is to be able to clearly identify accountability and to hold as responsible for information contained in periodic company reports those who are control of the disclosure of information and preparation of reports, namely CEOs and CFOs of listed companies. In the Philippines, the SEC released a Financial Disclosures Checklist summarizing the disclosures required by SRC Rules 68 and 68.1 and current SFAS/IAS in effect as of January 1, 2004. The checklist includes a Statement of Managements Responsibility certifying, among others, that: (1) financial statements have been prepared in conformity with generally accepted accounting standards; (2) management maintains a system of accounting and reporting which provides for the necessary internal controls; (3) management has disclosed to the audit committee and to its external auditor significant weaknesses in internal controls; and (4) its board of directors has reviewed the financial statements.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

d. Enhanced financial disclosures i. Disclosures in periodic reports Section 401 of the Sarbanes-Oxley Act requires that financial reports must include a statement of all material correcting adjustments and off-balance sheet transactions, arrangements, obligations, and other relationships of the issuer that may have a material current or future effect on the company. The requirement is intended to provide additional information and, thus, protection to investors. In the Philippines, the Accounting Standards Council requires disclosure of all significant accounting policies (SFAS No. 15 1986) and all related party transactions (SFAS No. 16 1986) although there is a move towards adopting international accounting standards by 2005. Currently, the SECs Financial Disclosures checklist recommends disclosure of correction of all fundamental errors and related party transactions. ii. Prohibition on personal loans to executives Section 402 of the U.S. Sarbanes-Oxley Act prohibits the granting by listed companies of personal loans to executives. The objective of the prohibition is to prevent executives from acquiring a personal interest in the company that may conflict with their fiduciary obligation to its stockholders. It prevents executives from taking advantage of their position in the company and from competing for company funds with business uses and stockholders (i.e., dividends). Directors in Philippine boards were previously prohibited under the Corporation Code of the Philippines from receiving compensation as such; they may only receive reasonable per diems. The foregoing provision has been amended by section 8, chapter II of the Code of Corporate Governance now allowing the payment of remuneration to directors. As a safeguard, however, directors are prohibited from participating in decisions involving their own remuneration. In addition, all compensation paid to directors must be disclosed. Further, directors receiving compensation for services rendered to a corporation in a capacity other than as directors are still subject to the requirements for approval of contracts with self-dealing directors provided under sections 32 and 33 of the Corporation Code of the Philippines. There is no similar prohibition on personal loans to executives under Philippine law. iii. Code of ethics for senior financial officers Section 406 of the U.S. Sarbanes-Oxley Act prescribes the adoption of a Code of Ethics for senior financial officers of listed companies. Although the provision is directive in nature and there is no sanction attached for its non8

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

fulfillment, it is an attempt to shape the attitudes by senior financial officers of listed companies. Legislation may not always foresee and provide for all the possible ethical issues that may arise in business. However, an honest and ethical environment may make up for what is lacking in the law. There could be no other more encompassing guide with respect to fair dealings between directors and officers of corporations and their stockholders and the public than the ethical and honest conduct by the former. Although the SEC has adopted a Code of Corporate Governance, it has not yet come up with a similar code of ethics for senior financial officers. iv. Disclosure of audit committee financial expert Section 407 of the U.S. Sarbanes-Oxley Act requires listed companies to disclose in their periodic reports whether or not the board committee has at least one (1) member who is a financial expert. A financial expert is one who possesses an understanding of audit committee functions and generally accepted accounting principles and financial statements. Further, he must possess experience with respect to the preparation or audit of financial statement of similar companies, including the application of accounting principles with respect to estimates, accruals and reserves (usually required to be disclosed in notes to financial statements) and internal controls. The apparent objective of Sec. 407 is to ensure that the board audit committee will be capable of performing its task of supervising the external auditors and functioning as both an internal and external control to assure audit quality. Under Philippine law, the Code of Corporate Governance requires at least one (1) board audit committee member to have related audit experience and gives preference to those with accounting or finance background although the latter does not specify the nature of the required audit experience. v. Real-time disclosures Section 409 of the U.S. Sarbanes-Oxley Act of 2002 requires corporations to disclose to the public of changes in the financial condition and operations of listed companies on a rapid and current basis. The requirement is intended for the protection of investors who base their decisions concerning daily transactions of listed and traded shares on information that is available to them. Delayed disclosure of material relevant information may result in undue advantage being taken by any group who may obtain material information in advance from any source to the prejudice of other stockholders as well as the public. Under Philippine law, the decision on whether or not to use inside information is still left to the discretion of individual insiders. Section 27 of the Securities Regulation Code declares as unlawful the selling or buying of any security by an insider while in possession of material information that is not generally 9

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

available to the public, although the insider may avoid liability by proving that said information was not gained from such relationship, or that he disclosed the information to the other party, or had reason to believe that the other party is also in possession of the same information. Although the Code of Corporate Governance recognizes the right of stockholders to all information for which management is accountable and that which it is duty-bound to disclose, it does not require disclosures by corporations to be done on a real-time basis. e. Corporate and criminal fraud accountability Criminal penalties for altering documents Section 802 of the Sarbanes-Oxley Act imposes a fine and a maximum imprisonment of 20 years for the destruction, alteration or falsification of records in Federal investigations. The same section imposes a fine and a maximum imprisonment of 10 years for the destruction of corporate audit records and work papers (to be kept for a period of 5 years from the end of the fiscal period in which the audit or review was conducted). The imposition of higher penalties under the Sarbanes-Oxley Act for destruction, alteration falsification of records of listed companies under investigation took into consideration their potential adverse effect on the public. Under Philippine law, section 172 of the Revised Penal Code of the Philippines imposes a fine of P5,000 and the penalty of prison correctional in its medium and maximum periods (ranging from 2 years, 4 months and 1 day to 6 years) for the crime of falsification by private individuals and the use of falsified documents. Falsification of documents is considered as a less grave felony under Art. 9 and is, thus, imposed a correctional (not an afflictive) penalty, as defined under Article 25 of the Philippines Revised Penal Code. Further, section 235, in relation to 203 and 222, of the National Internal Revenue Code of the Philippines requires corporations to keep their books of accounts and other accounting records for 3 years. In case of fraud or fraudulent return with intent to evade tax or of failure to file a return, however, assessment may be made at any time within ten (10) years after the discovery of the fraud, falsity or omission. The penalties in case of violation of a general provision in the National Internal Revenue Code, under sections 256 and 275 thereof, is a fine of not more than one thousand pesos (P1,000) or imprisonment of not more than six (6) months, or both, in the case of individuals, and a fine of not less than fifty thousand pesos (P50,000) but not more than one hundred thousand pesos (P100,000), in the case of corporations. i.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

10

June 2004

ii. Criminal penalties for defrauding shareholders of publicly traded companies Section 807 of the Sarbanes-Oxley Act imposes a fine and imprisonment of not more than 25 years on whoever executes, or attempts to execute, as scheme or artifice to defraud any person in connection with listed securities. The same penalty is imposed on any person who obtains, by means of fraud or fraudulent pretenses, money or property from a person in connection with the purchase or sale of any listed security. On the other hand, the Securities Regulation Code, under section 73 thereof, imposes a fine of not less than P50,000 nor more than P5,000,000, or imprisonment of not less than 7 years nor more than 21 years, or both, in the discretion of the court, for any violation of the said Code, in general. In addition, in case of fraud, section 58 thereof requires payment of damages sustained by the injured party. f. White-collar penalty enhancements i. Criminal penalties for violation of the Employee Retirement Security Act of 1974 (U.S.) Sec. 904 of the Sarbanes-Oxley Act increased the fine from $5,000 to $100,000, and imprisonment from 1 year to 10 years, in case of violation by a natural person, and from $100,000 to $500,000 in case of violation by a corporation of Sec. 501 of the Employees Retirement Security Act (ERISA). Sec. 501 of the ERISA applies to all willful violations, including violations involving the duty of disclosure and reporting, plan descriptions, annual reports, filing and furnishing of information, reporting of participants benefit rights, and retention of records. (Shurtz and Pett 2003) The imposition of heavier penalties took into consideration the potential injury to public welfare of any violation of disclosure and reporting requirements under the ERISA. The Philippines has no law similar to the ERISA requiring disclosure and reporting, setting of standards of conduct of plan administrators, protection of beneficiaries by vesting of accrued interests, setting minimum standards of funding, and requiring termination insurance of employee benefit plans. ii. Corporate responsibility for financial reports Sec. 906 of the U.S. Sarbanes-Oxley Act provides for the imposition of a fine of not more than $1,000,000 and penalty of imprisonment for not more than 10 years for certification by a chief executive officer of a listed companys periodic financial statements or reports while knowing that they do not comply with all the requirements of the U.S. Securities Exchange Act of 1934, as amended. The penalty is higher (fine of not more $5,000,000 and imprisonment of not more than 20 years) in case of willful certification. Thus, the U.S. Sarbanes-Oxley Act imposes a fine for any false certification although it did not necessarily result in a material misstatement or omission. Further, the penalties imposed by the Sarbanes-Oxley Act are more 11

U.S Sarbanes-Oxley Act and Philippine Law on Governance

June 2004

onerous for willful certification as compared to those imposed under the Philippine Tax Code for willful falsification or essential misstatement in financial reports. Under the National Internal Revenue Code of the Philippines, in case of willful falsification of any report or statement bearing on any examination or audit for tax purposes by any financial officer, he will be subject, upon conviction, to a fine of not less than P50,000 but not more than P100,000 and imprisonment of not less than 2 years but not more than 6 years. The same penalties are imposed in case of certification of financial statements containing essential misstatement of facts or omission in respect of the transactions, taxable income, deduction and exemption. g. Corporate fraud accountability Section 1106 of the Sarbanes-Oxley Act increased the fine from $1,000,000 to $5,000,000 and the penalty of imprisonment from 10 to 20 years for any willful violation by a natural person of the U.S. Securities Exchange Act of 1934, as amended. The same penalties are imposed on the making of any false or misleading statement in any document or report that is required to be filed under the said Securities Exchange Act. Further, the Sarbanes-Oxley Act increased the fine from P2,500,000 to $25,000,000 in case of violations committed by corporations. As previously mentioned, under section 73 of the Securities Regulation Code imposes a lower fine of not less than P50,000 but more than P5,000,000, or imprisonment of not less than 7 years nor more than 21 years, or both, in the discretion of the court, for any violation of the said Code. 3. Conclusion and recommendations Although the Philippines has followed the worldwide trend of improving standards of corporate governance, there are still weaknesses in the system that may become critical in implementation. These are with respect to following areas that were culled from the foregoing comparison between the Sarbanes-Oxley Act and Philippine law on corporate governance, namely: the composition of the board audit committees in publicly traded companies, the need for real-time disclosures of material information, and the need for stiffer penalties for the commission of corporate and criminal fraud. These improvements are seen to be necessary in order to strengthen the Philippine financial market in order to generate more investments. In addition, there is a need for the codification of the different rules and regulations concerning corporate governance to assist in providing a more rational and consistent application. Likewise, there is a need to look into the provision for a system of periodic reporting and disclosure by retirement and social security funds in order to safeguard the publics interest in them.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

12

June 2004

Bibliography Act No. 3815, as amended (1930). Revised Penal Code of the Philippines. Batas Pambansa Blg. 68 (1980). Corporation Code of the Philippines. Board of Accountancy (2004). Code of Ethics for Professional Accountants in the Philippines. Professional Regulation Commission. Estrada vs. Desierto, et al. (2001) G.R. Nos. 146710-15. Supreme Court of the Philippines. Financial Disclosures Checklist (2004). Securities and Exchange Commission. House Resolution No.3763 (2002). Sarbanes-Oxley Act. United States House of Representatives. Philippine Institute of Certified Public Accountants. www.picpa.com.ph Republic Act No. 8424 (1997). National Internal Revenue Code of 1997. Republic Act no. 8799. Securities Regulation Code. Republic Act No. 9298 (2004). Philippine Accountancy Act of 2004. SEC Memorandum Circular No. 2 (2002). Code of Corporate Governance. Securities and Exchange Commission. Securities and Exchange Commission (2003). www.sec.gov.ph Securities and Regulation Code Rule 68 (2003). Rules and Regulations Covering Form and Content of Financial Statements. Securities and Exchange Commission. Shurtz, R.D. and Pett, C.R. (2004). Staying Out of Jail Under ERISAs Bulked-Up Criminal Penalties. Benefits Law Journal. New York.

U.S Sarbanes-Oxley Act and Philippine Law on Governance

13

June 2004