Compliance Hotline

FormerHealthSouth CEO Challenges Constitutionality of SOX

Former HealthSouth Chairman and CEO, Richard Scrushy, who is the first person to have been charged criminally under ' 906 of the Sarbanes-Oxley Act, has filed a motion to have three of the 85 charges filed against him dismissed. He claims that the requirement that a CEO certify the accuracy of a company's financial statements is unconstitutional because it imposes criminal liability on an act that is derivative of another act that may not be criminal. He argues that technical non-compliance with the 1934 Securities Exchange Act does not necessarily result in criminal liability unless it involves willingly or knowingly making false statements of material fact. Under SOX, however, technical non-compliance now invokes criminal liability for a CEO. U.S. v. Scrushy, N.D. Ala., Case No. CR-03-BE-0530-S (April 5).

SEC Publishes PCAOB's Proposed Auditing Standard for Comment

The Securities and Exchange Commission has issued Release No. 34-49544 to solicit comments on the Public Company Accounting Oversight Board's Proposed Rule on Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. All comments to the proposed rule should be submitted on or before May 17, 2004.

The auditing standard addresses both the work that is required to audit internal control over financial reporting and the relationship of that audit to the audit of the financial statements. Section 404(a) of the Sarbanes-Oxley Act of 2002, and the Securities and Exchange Commission's related implementing rules, requires the management of a public company to assess the effectiveness of the company's internal control over financial reporting. Section 404(b) of the Act, as well as Section 103, directed the PCAOB to establish professional standards governing the independent auditor's attestation, and reporting, on management's assessment of the effectiveness of internal control.

The auditing standard on internal control was submitted by the PCAOB to the Securities and Exchange Commission for approval, as required by the Sarbanes-Oxley Act.

Omnimedia Board Found To Be Independent

A shareholder derivative action challenging the independence of the board of directors of Martha Stewart Living Omnimedia (MSO) has been dismissed by the Delaware Supreme Court, affirming a lower court ruling. Beam v. Stewart, No. 501, 2003 (March 31, 2004).

The Supreme Court, sitting en banc, found that four of the six directors were independent despite holding a friendly relationship with Martha Stewart and conducting a modicum of business interactions with her or her company. In finding a majority of the directors independent, the court concluded that the plaintiff “failed to demonstrate demand futility” as required under Delaware law to pursue a derivative action. To commence a derivative action under Delaware law, a shareholder must either ask the board to initiate a suit and receive an unreasonable refusal, or the shareholder must successfully argue that such demands are futile because directors cannot make an unbiased decision. Here, the plaintiff claimed that Stewart breached her duties of loyalty and care by wrongfully selling her shares in ImClone Systems and “by mishandling the media attention that followed, thereby jeopardizing the financial future of MSO.” Further that demand to sue was futile because a majority, or at least three, of the six board members were not independent because of their close ties with Stewart.

The court found that “[a]llegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director's independence.” The panel rejected the claim that professional and social relationships among board members would sway their decision. The court found that “structural bias” arguments required more evidence of improper influence than was presented here. In addition, the court similarly dismissed the argument that Stewart, as a 94 % shareholder of Omnimedia, improperly influenced the directors. Absent evidence “demonstrating that the directors are beholden to [Ms. Stewart],” the court stated, it could not excuse the demand requirement needed to launch a derivative suit.

FASB Publishes Proposal on Equity-Based Compensation

On March 31, 2004, the Financial Accounting Standards Board (FASB) published an Exposure Draft, Share-Based Payment, an Amendment of FASB Statements No. 123 and 95. This proposal was made in response to requests from investors and many other parties to improve the current accounting standards relating to employee stock compensation in financial statements. It seeks to improve existing accounting rules and provide more complete, higher quality information for investors. The proposed change in accounting would replace existing requirements under FAS 123, Accounting for Stock-Based Compensation, and APB Opinion No 25, Accounting for Stock Issued to Employees. The comment period for the exposure draft ends June 30, 2004.

The exposure draft covers a wide range of equity-based compensation arrangements. Under the Board's proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements.

Since the Board added the project to its agenda 1 year ago, the FASB has held over 35 public meetings, conducted field visits with companies and employee benefit consultants from across the country and consulted with recognized valuation experts and numerous other parties.

The proposal seeks to achieve substantial convergence in this important area between U.S. and international accounting standards. Reports show that approximately 500 public companies in the U.S. are treating stock options as an expense or plan to do so in the near future. The International Accounting Standards Board and Canada recently issued requirements to expense share-based payments, including employee stock options.

The Board plans to hold public roundtable meetings to gather additional input on the proposal.

SEC Charges Corporate Chairman and Officers With Fraud Under Sarbanes-Oxley

On March 24, 2004 The SEC filed a complaint in the U.S. District Court for the Southern District of New York against Cedric Kushner Promotions, Inc., its Chairman of the Board, Chief Executive Officer, President and Founder Cedric Kushner (Kushner), its Principal Financial and Accounting Officer, James DiLorenzo (DiLorenzo), and its former Executive Vice President and Secretary and a current director, Steven Angel (Angel) for violating the antifraud, record-keeping, and reporting provisions of the federal securities laws. As part of this action, the Commission alleges that Kushner and DiLorenzo violated the certification requirements of the Sarbanes-Oxley Act of 2002, and Rule 13a-14 of the Securities Exchange Act of 1934 (Exchange Act). SEC v. Cedric Kushner Promotions, Inc., Cedric Kushner, James DiLorenzo and Steven Angel, Civil Action No. 04 CV 2324 (TPG) (AJP) SDNY

According to the complaint, CKP filed a Form 10-KSB for the year ended Dec. 31, 2002, that contained what purported to be unqualified independent auditor reports authorized and issued by its former and current auditors. However, neither auditor had actually provided those reports to CKP and the company instead filed forged auditor reports. Moreover, CKP filed its Form 10-KSB without obtaining either independent auditor's consent. The complaint alleges that the financial statements included in the filing contained material misstatements and substantial errors, including a misstatement of total assets in 2002 by over 100%.

According to the complaint, despite their failure to obtain a signed audit report and material errors in the Company's financial statements, Kushner and DiLorenzo each personally certified that the filing fairly and accurately presented CKP's financial condition, in violation of Commission rules adopted pursuant to Section 302 of the Sarbanes-Oxley Act, which require an issuer's principal executive and financial officer to certify financial and other information contained in the quarterly and annual reports. Prior to certifying, the complaint alleges, Kushner failed to read either the Sarbanes-Oxley certification or the filing to which it was attached, or to take any steps to ascertain whether the filing was true and accurate. After both auditors wrote letters protesting the forged auditor reports to CKP pursuant to Exchange Act Section 10A, the company filed a Form 8-K containing the auditors' letters and simultaneously filed a Form 10-KSB/A removing the auditor reports, but including new materially inaccurate financial statements. The complaint charges that DiLorenzo and Angel substantially participated in the creation of both these filings.

The complaint seeks an injunction against CKP based on its violation of Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Exchange Act Rules 10b-5, 12b-20 and 13a-1. The complaint also seeks an injunction, officer and director bars, and civil monetary penalties against Kushner and DiLorenzo based on their primary violations of Exchange Act Section 10(b) and Exchange Act Rules 10b-5 and 13a-14, and their aiding and abetting CKP's violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B), and Exchange Act Rules 2b-20 and 13a-1. The complaint further charges that Kushner is liable for CKP's violations as a “control person” under Exchange Act Section 20(a). Lastly, the complaint seeks an injunction, an officer and director bar, and a civil penalty against Angel based on his primary violations of Exchange Act Section 10(b) and Exchange Act Rule 10b-5 or, in the alternative, based on his aiding and abetting violations of Exchange Act Section 10(b) and Exchange Act Rule 10b-5 by CKP, Kushner and DiLorenzo, and his aiding and abetting violations of Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B), and Exchange Act Rules 12b-20 and 13a-1 by CKP.

FormerHealthSouth CEO Challenges Constitutionality of SOX

Former HealthSouth Chairman and CEO, Richard Scrushy, who is the first person to have been charged criminally under ' 906 of the Sarbanes-Oxley Act, has filed a motion to have three of the 85 charges filed against him dismissed. He claims that the requirement that a CEO certify the accuracy of a company's financial statements is unconstitutional because it imposes criminal liability on an act that is derivative of another act that may not be criminal. He argues that technical non-compliance with the 1934 Securities Exchange Act does not necessarily result in criminal liability unless it involves willingly or knowingly making false statements of material fact. Under SOX, however, technical non-compliance now invokes criminal liability for a CEO. U.S. v. Scrushy, N.D. Ala., Case No. CR-03-BE-0530-S (April 5).

SEC Publishes PCAOB's Proposed Auditing Standard for Comment

The Securities and Exchange Commission has issued Release No. 34-49544 to solicit comments on the Public Company Accounting Oversight Board's Proposed Rule on Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. All comments to the proposed rule should be submitted on or before May 17, 2004.

The auditing standard addresses both the work that is required to audit internal control over financial reporting and the relationship of that audit to the audit of the financial statements. Section 404(a) of the Sarbanes-Oxley Act of 2002, and the Securities and Exchange Commission's related implementing rules, requires the management of a public company to assess the effectiveness of the company's internal control over financial reporting. Section 404(b) of the Act, as well as Section 103, directed the PCAOB to establish professional standards governing the independent auditor's attestation, and reporting, on management's assessment of the effectiveness of internal control.

The auditing standard on internal control was submitted by the PCAOB to the Securities and Exchange Commission for approval, as required by the Sarbanes-Oxley Act.

Omnimedia Board Found To Be Independent

A shareholder derivative action challenging the independence of the board of directors of Martha Stewart Living Omnimedia (MSO) has been dismissed by the Delaware Supreme Court, affirming a lower court ruling. Beam v. Stewart, No. 501, 2003 (March 31, 2004).

The Supreme Court, sitting en banc, found that four of the six directors were independent despite holding a friendly relationship with Martha Stewart and conducting a modicum of business interactions with her or her company. In finding a majority of the directors independent, the court concluded that the plaintiff “failed to demonstrate demand futility” as required under Delaware law to pursue a derivative action. To commence a derivative action under Delaware law, a shareholder must either ask the board to initiate a suit and receive an unreasonable refusal, or the shareholder must successfully argue that such demands are futile because directors cannot make an unbiased decision. Here, the plaintiff claimed that Stewart breached her duties of loyalty and care by wrongfully selling her shares in ImClone Systems and “by mishandling the media attention that followed, thereby jeopardizing the financial future of MSO.” Further that demand to sue was futile because a majority, or at least three, of the six board members were not independent because of their close ties with Stewart.

The court found that “[a]llegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director's independence.” The panel rejected the claim that professional and social relationships among board members would sway their decision. The court found that “structural bias” arguments required more evidence of improper influence than was presented here. In addition, the court similarly dismissed the argument that Stewart, as a 94 % shareholder of Omnimedia, improperly influenced the directors. Absent evidence “demonstrating that the directors are beholden to [Ms. Stewart],” the court stated, it could not excuse the demand requirement needed to launch a derivative suit.

FASB Publishes Proposal on Equity-Based Compensation

On March 31, 2004, the Financial Accounting Standards Board (FASB) published an Exposure Draft, Share-Based Payment, an Amendment of FASB Statements No. 123 and 95. This proposal was made in response to requests from investors and many other parties to improve the current accounting standards relating to employee stock compensation in financial statements. It seeks to improve existing accounting rules and provide more complete, higher quality information for investors. The proposed change in accounting would replace existing requirements under FAS 123, Accounting for Stock-Based Compensation, and APB Opinion No 25, Accounting for Stock Issued to Employees. The comment period for the exposure draft ends June 30, 2004.

The exposure draft covers a wide range of equity-based compensation arrangements. Under the Board's proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements.

Since the Board added the project to its agenda 1 year ago, the FASB has held over 35 public meetings, conducted field visits with companies and employee benefit consultants from across the country and consulted with recognized valuation experts and numerous other parties.

The proposal seeks to achieve substantial convergence in this important area between U.S. and international accounting standards. Reports show that approximately 500 public companies in the U.S. are treating stock options as an expense or plan to do so in the near future. The International Accounting Standards Board and Canada recently issued requirements to expense share-based payments, including employee stock options.

The Board plans to hold public roundtable meetings to gather additional input on the proposal.

SEC Charges Corporate Chairman and Officers With Fraud Under Sarbanes-Oxley

On March 24, 2004 The SEC filed a complaint in the U.S. District Court for the Southern District of New York against Cedric Kushner Promotions, Inc., its Chairman of the Board, Chief Executive Officer, President and Founder Cedric Kushner (Kushner), its Principal Financial and Accounting Officer, James DiLorenzo (DiLorenzo), and its former Executive Vice President and Secretary and a current director, Steven Angel (Angel) for violating the antifraud, record-keeping, and reporting provisions of the federal securities laws. As part of this action, the Commission alleges that Kushner and DiLorenzo violated the certification requirements of the Sarbanes-Oxley Act of 2002, and Rule 13a-14 of the Securities Exchange Act of 1934 (Exchange Act). SEC v. Cedric Kushner Promotions, Inc., Cedric Kushner, James DiLorenzo and Steven Angel, Civil Action No. 04 CV 2324 (TPG) (AJP) SDNY

According to the complaint, CKP filed a Form 10-KSB for the year ended Dec. 31, 2002, that contained what purported to be unqualified independent auditor reports authorized and issued by its former and current auditors. However, neither auditor had actually provided those reports to CKP and the company instead filed forged auditor reports. Moreover, CKP filed its Form 10-KSB without obtaining either independent auditor's consent. The complaint alleges that the financial statements included in the filing contained material misstatements and substantial errors, including a misstatement of total assets in 2002 by over 100%.

According to the complaint, despite their failure to obtain a signed audit report and material errors in the Company's financial statements, Kushner and DiLorenzo each personally certified that the filing fairly and accurately presented CKP's financial condition, in violation of Commission rules adopted pursuant to Section 302 of the Sarbanes-Oxley Act, which require an issuer's principal executive and financial officer to certify financial and other information contained in the quarterly and annual reports. Prior to certifying, the complaint alleges, Kushner failed to read either the Sarbanes-Oxley certification or the filing to which it was attached, or to take any steps to ascertain whether the filing was true and accurate. After both auditors wrote letters protesting the forged auditor reports to CKP pursuant to Exchange Act Section 10A, the company filed a Form 8-K containing the auditors' letters and simultaneously filed a Form 10-KSB/A removing the auditor reports, but including new materially inaccurate financial statements. The complaint charges that DiLorenzo and Angel substantially participated in the creation of both these filings.

The complaint seeks an injunction against CKP based on its violation of Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Exchange Act Rules 10b-5, 12b-20 and 13a-1. The complaint also seeks an injunction, officer and director bars, and civil monetary penalties against Kushner and DiLorenzo based on their primary violations of Exchange Act Section 10(b) and Exchange Act Rules 10b-5 and 13a-14, and their aiding and abetting CKP's violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B), and Exchange Act Rules 2b-20 and 13a-1. The complaint further charges that Kushner is liable for CKP's violations as a “control person” under Exchange Act Section 20(a). Lastly, the complaint seeks an injunction, an officer and director bar, and a civil penalty against Angel based on his primary violations of Exchange Act Section 10(b) and Exchange Act Rule 10b-5 or, in the alternative, based on his aiding and abetting violations of Exchange Act Section 10(b) and Exchange Act Rule 10b-5 by CKP, Kushner and DiLorenzo, and his aiding and abetting violations of Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B), and Exchange Act Rules 12b-20 and 13a-1 by CKP.