What is really important for tax executives in Sarbanes-Oxley?

By now, readers of The Tax Executive and other professional tax journals undoubtedly have read a great deal about one portion of the recently passed Sarbanes-Oxley legislation: (1) the provisions that limit the kinds of services that auditing firms can provide to their clients. (2) This article is about other portions of Sarbanes-Oxley having far reaching and potentially more serious implications for corporate tax executives. These provisions can impose severe penalties for (i) "altering" documents (3) and (ii) "misleading" or otherwise "improperly influencing" auditors. (4)

These new provisions are broader in scope than their counterparts under prior law, and even perceived violations of these provisions could prove personally disastrous to tax executives who might be involved. Moreover, the provisions may apply to situations that tax executives routinely face, including (i) the provision of advice to other personnel within the company concerning the drafting and revision of corporate documents, and (ii) communications with auditors concerning income tax reserves and other items to be incorporated into financial statements.

That these important parts of Sarbanes-Oxley have attracted relatively little attention in the tax community may reflect a tendency to view tax practice as a "thing apart" from broader areas of the law, such as securities regulation. Hence, over the years, tax practice has come to be perceived as a highly specialized area with its own language, its own set of penalty provisions, and its own body of ethical rules.

This sense of separation, however, can be misleading, and in the aftermath of Sarbanes-Oxley, it can pose particular dangers. Indeed, for publicly traded companies, tax practice is a form of federal securities practice, and elements of a company's tax reporting that are perceived as distorting financial statements can create liabilities both for the company and for individuals within the company.

This concern is far from theoretical. Even before Sarbanes-Oxley, tax executives found themselves at or near the centers of high-profile government investigations, and passage of the Act has increased the likelihood that the actions of tax executives will become subject to scrutiny in the future. Tax executives, therefore, stand in the thick of today's focus on corporate governance and responsibility.

Dealing with the new law, and the increased scrutiny it has spawned, will not be easy. Inevitably, tax executives will need to increase the level of formality with which they approach the tasks of drafting and revising potentially sensitive documents and of communicating with financial auditors, while eschewing excessive procedural constraints that could unduly impair the efficiency of the office (and unduly impose on the privacy of the company's tax personnel).

The difficulties faced in reaching the appropriate balance mean that tax executives must devote attention and energy to addressing the new provisions. This article describes the important new provisions and suggests practical steps that tax executives might take in the short term to protect their companies and themselves.

Rules Relating to the "Alteration" and "Falsification" of Documents

Section 802(a) of Sarbanes-Oxley introduces to the federal criminal law the following provision:

   Whoever knowingly alters, destroys, mutilates,
   conceals, covers up, falsifies, or makes a false entry
   in any record, document, or tangible object
   with the intent to impede, obstruct, or influence
   the investigation or proper administration of any
   matter within the jurisdiction of any department
   or agency of the United States or any case filed
   under title 11, or in relation to or contemplation of
   any such matter or case, shall be fined ..., imprisoned
   not more than 20 years, or both.

The new law supplements prior, and still-existing, provisions of the criminal law that are more limited in scope. (5)

There is little if any doubt that "matter[s] within the jurisdiction of any department or agency of the United States" includes federal tax matters. Therefore, almost all of the documents that tax executives create, review, and comment upon in the course of their work appear to be covered by the new provision.

The language in the new law prohibiting the destruction, mutilation, or concealment of documents seemingly requires little interpretation. The references to "altering," "concealing," "covering up," "falsifying," or "making false entries," however, are not as easy to construe. Given the immediate historical context of Sarbanes-Oxley, including the government's successful prosecution of Arthur Andersen following the collapse of Enron, these terms may be of surprisingly broad application.

Following the trial in which Andersen was convicted on one count of obstruction of justice, several jurors, in post-trial interviews, indicated that their votes in favor of conviction were influenced in particular by instructions that Andersen's inside counsel, Nancy Temple, had provided by e-mail to David Duncan, an Andersen partner. (6) In her e-mail, Ms. Temple advised Mr. Duncan to revise certain language that he had proposed including in a draft memorandum. Ms. Temple did not advise Mr. Duncan to destroy the initial draft, and in fact both the initial draft and Ms. Temple's e-mail were preserved and entered into evidence at the Andersen trial. Ms. Temple's e-mail reads, as follows: (7)

   Dave--Here are a few suggested
   comments for consideration.

   --I recommend deleting references
   to consultation with the legal group
   and deleting my name on the memo.
   Reference to the legal group consultation
   arguably is a waiver of attorney-client
   privileged advice and if
   my name is mentioned it increases
   the chances that I might be a witness,
   which I prefer to avoid.

   --I suggested deleting some language that might
   suggest we have concluded the [Enron press] release
   is misleading.

   --In light of the "non-recurring" characterization,
   the lack of any suggestion that this characterization
   is not in accordance with GAAP,
   and the lack of income statements in accordance
   with GAAP, I will consult further within the
   legal group as to whether we should do anything
   more to protect ourselves from potential
   ... issues.

   Nancy

Following the trial, in opposing Andersen's post-verdict motion to overturn the conviction, the government argued that Ms. Temple's suggestions for revising the draft did, indeed, constitute a proper basis for criminal conviction under then-existing law. The government said:

   Temple's actions clearly were an attempt to withhold
   an object (the draft memorandum) and to
   alter, destroy, and conceal that object.... Temple
   altered the draft version of a document so that
   the final version of that document--which would
   serve as the internal Andersen memorandum documenting
   its position regarding the Enron third-quarter
   press release--would present a more
   favorable view of what had transpired and hide
   the fact that Andersen had concluded that Enron's
   press release was misleading.... Congress
   certainly did not mean [then-existing law's] prohibition
   on "altering" a document to apply only to
   those few companies that may still use whiteout
   to make changes to typewritten drafts of documents. (8)

Andersen argued in reply that criminal conviction based on a lawyer's advice to amend a draft document would call into question a wide range of actions that most attorneys and others would consider routine:

   [I]t is not an exaggeration to say
   that identical acts take place every
   day at every substantial law
   firm and general counsel's office
   in the country. We are confident
   that similar conduct occurs routinely
   at the Department of Justice,
   too; supervisors there regularly
   propose edits to the factual
   sections of briefs (or of letters to
   Congress) so as to change the impression
   the documents will make
   on the reader. (9)

The district court, in its brief denial of Andersen's motion, did not address this argument.

This episode is not made less sobering by Andersen's conviction under prior law, before the Sarbanes-Oxley Act broadened the law's coverage. Sarbanes-Oxley was seemingly intended to tighten the provisions of prior law to remove any question that the type of conduct attributed to Ms. Temple, in providing advice regarding language to be included in newly drafted documents, would be subject to sanction. Following enactment of the Sarbanes-Oxley Act, one prominent legislator expressed the view that the Act did, in fact, intend to expand prior law's prohibitions to encompass the "creation" of false documents, as well as the alteration or destruction of existing documents. (10)

Tax executives often review draft transactional documents, typically prepared initially by personnel outside the tax department, to determine whether the drafts describe the facts of proposed (or completed) transactions in a way that is conducive to the desired tax treatment. Often such reviews focus on whether the draft adequately describes the business purpose for a transaction, a topic that has received substantial attention recently in light of pending controversies involving "tax shelters." Tax executives also review and suggest amendments to documents with regard to the impressions they convey concerning a large number of other issues raised under the tax law in a virtually limitless variety of settings. These issues include, for example, whether an intercompany obligation is intended to constitute debt or equity, whether a particular transaction should be viewed as occurring as part of a larger series of transactional steps or should be characterized independently of other steps, and whether particular services being provided by a corporation are intended to benefit the parent company or a subsidiary.

In light of Sarbanes-Oxley and the outcome of the Andersen trial, under what circumstances might a tax executive's instructions for amending a draft document be viewed as "altering" or "falsifying" the document, perhaps to such an extent as to expose the tax executive to possible criminal liability? The not-terribly-helpful answer at this early date is, of course, that no one knows, and that the outcome in any situation is likely to depend on the facts, perhaps as interpreted by a prosecutor, judge, or jury with hindsight, and based in part, perhaps, on then-prevailing public perceptions. This lack of clarity is likely to prevail for some time.

What is clear, however, is that the new rules in Sarbanes-Oxley, combined with the public attention accorded to the situations giving rise to its adoption, have significantly changed the environment. Put simply, the actions of tax executives in drafting and recommending changes to documents are more likely to be scrutinized than in the past. Also, to the extent questions arise, the attitudes of enforcement authorities and the public will likely be less sympathetic than in the past, and the likelihood of sanctions, including serious ones, has increased.

Historically, the drafting and amending of sensitive documents has typically occurred on a very informal basis, with little scrutiny of potential liabilities and little or no memorialization of the rationale behind decisions. This informality is probably attributable to a number of factors, including (i) the desire to avoid unnecessarily memorializing arguments that tax authorities might use to challenge a company's reporting positions, (ii) the additional costs and inefficiencies inevitably imposed by increased levels of formality, and (iii) a natural desire to maintain a reasonable level of privacy concerning a group's internal deliberations. All of these factors retain force today; they are legitimate and should not be ignored.

Following Sarbanes-Oxley, however, a complete absence of formal guidelines on who should draft and review tax-sensitive documents, and how their work should be memorialized, will likely not provide an adequate level of protection to the tax department and to the company overall. Indeed, an absence of procedural safeguards could easily create an impression of lack of due care, and perhaps even a perception of concealment, in the event that the documents come under intensive scrutiny in the future. Despite the costs, the establishment of internal guidance governing the process by which tax departments draft and edit corporate documents appears prudent if undue exposure to risk is to be avoided.

Rules Regarding "Misleading" or "Improperly Influencing" Auditors

Section 303 of the Sarbanes-Oxley Act provides that the Securities and Exchange Commission is to adopt final rules that prohibit officers and directors, and any other persons acting at their direction, from taking any action to "fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit...." Willful violations can subject a person to imprisonment for up to 20 years. (11)

On October 18, 2002, the Securities and Exchange Commission issued proposed regulations to implement section 303. The preamble to the proposed regulations suggests that "misleading" an auditor should be interpreted as including "[p]roviding an auditor with inaccurate or misleading legal analysis...." (12)

Among the most routine functions tax executives perform is to provide the company's auditors with analyses that the auditors are to consider in reviewing the company's income tax reserves. This function of the tax executive always has been sensitive--probably more so than commonly recognized. Indeed, all of the high-profile financial news stories that apparently motivated the Sarbanes-Oxley legislation have, in one way or another, prominently involved tax positions taken by companies or the determination of tax reserves. (13) Even before Sarbanes-Oxley, tax issues figured prominently in SEC investigations, and tax executives already have become deeply involved in those investigations. The Sarbanes-Oxley Act, with its explicit criminal prohibition against "misleading" auditors, has heightened the level of sensitivity by increasing the potential stakes to tax executives from SEC probes of their communications with auditors.

The provisions of Sarbanes-Oxley, especially when viewed against the manner in which tax matters already have become embroiled in high-profile corporate investigations, suggest strongly that tax departments should promptly review the manner in which they communicate with the company's auditors. It is probably not an exaggeration to say that to date, many companies' communications with auditors concerning tax reserves and related matters have been marked by a high degree of informality, without the benefit of written protocols describing how such communications should be conducted and memorialized. The reasons for the historically high degree of informality are, again, understandable. Audit workpapers are not privileged, and written memoranda generated in the course of determining tax provisions could assist tax authorities in challenging the company's positions. This concern today is even more acute than in the past, since the IRS has announced a policy of requesting access to audit workpapers in respect of its efforts to address certain "tax shelter" activities. (14)

Despite the legitimate concerns related to confidentiality, tax departments should almost certainly inject a greater degree of formality, including written memorialization of advice provided, into their communications with the company's financial auditors. Indeed, auditing firms themselves are likely to increase their documentation of such communications in the wake of Sarbanes-Oxley, and tax departments should work with the financial auditors to develop workable procedures. (15)

A higher level of documentation and formality undoubtedly will come at a cost. Increases in the extent to which discussions concerning tax reserves are memorialized may lead to far-reaching changes in the way tax practice is conducted, and not all of these changes might be desirable. Despite the likely costs, the new rules confirm that the near-complete informality that has characterized communications between tax departments and auditors places tax departments, their personnel, and their companies at risk. Virtually every tax department of U.S. publicly traded companies will need to implement changes in this area. (16)

What Should Be Done Now?

The provisions of Sarbanes-Oxley relating both to the alteration, destruction, or falsification of documents, and to the misleading of auditors are likely to remain subject to substantial uncertainty for some time. It is clear, however, that tax executives should take steps to ensure that they are conducting their activities in a manner that is sensitive to the new provisions.

1. Document Retention Guidelines. At a minimum, the head of every tax department of a publicly traded company should initiate a review of the department's document retention and destruction policies. Inside or outside counsel who are well versed in the new legislation should be consulted in this review.

Not only Sarbanes-Oxley, but also the events that led to the Act, have almost certainly altered the balance between retention and disposal of documents. In addition, as a practical matter, it is possible that existing policies have not always been observed with adequate care. For both reasons, the Act should prompt a review and, as necessary, revision of the tax department's existing document retention policies.

2. Procedures for Document Review. Similarly, the tax department should ensure that the drafting of transactional documents, as well as the review and editing of such documents prepared by others, takes place in an orderly manner. Records should be sufficient to enable the tax department, if necessary, to demonstrate who had ultimate responsibility for the drafting or editing, and what steps (including the concurrence of at least one senior reviewing official within the department) were taken to ensure that the factual characterizations contained in the documents were accurate. In addition, the process of drafting and editing transactional documents should be coordinated with the company's document retention policy (which should address, for example, the extent to which intermediate drafts of documents should be retained).

Again, the introduction of formality and structure into the drafting and editing process is likely to prove difficult, especially since the conventional wisdom in the past probably has been to treat the process very informally, with little if any recordkeeping. There should be little doubt, however, in the wake of the Andersen trial and Sarbanes-Oxley, that the conventional wisdom is no longer appropriate.

3. Procedures for Communications with Auditors. Tax directors should now exercise greater control over communications between the tax department and financial auditors. Particularly in the current uncertain and emotion-laden environment, the tax director needs to be alert for situations in which communications with financial auditors might, in retrospect, be viewed as being subject to excessively loose standards and therefore subject to question.

In the relatively near term, tax departments will inevitably become subject to revised procedures governing communications with financial auditors, involving substantially more written documentation than typically has been used in the past. Tax departments will need to work closely with auditors to develop procedures that provide the necessary protections to the auditors, the companies and, ultimately, the public, while minimizing burdens. The process of developing and adapting to the new procedures will take time; in many respects, it is likely to be difficult. The ultimate result may well be a substantial and broad-ranging transformation in the nature of tax practice within a publicly traded company.

In summary, although discussions of the portions of Sarbanes-Oxley dealing with the provision of tax advice by audit firms have had, perhaps understandably, a certain "box office appeal" among tax professionals, the most important implications of the legislation for tax executives may arise from other portions of the Act. Inevitably, these other provisions will impart to the activities of tax departments a higher level of formality and require greater attention to written recordkeeping than has been accepted as necessary in the past. (17) Arguably, these implications of the new legislation are unfortunate; many might feel that elements of the legislation represent an overreaction even to the severe problems that had arisen in the months preceding the legislation. Regardless of one's feelings on these questions, however, the legislation poses immediate implications for tax executives, and these implications cannot safely be ignored. Every tax department should ensure that it addresses the implications of the new legislation thoughtfully, systematically, and promptly.

(1) Sarbanes-Oxley Act of 2002 (cited below as the "Act"), Pub. L. 107-204, 116 Stat. 745 (2002).

(2) See, e.g., The Tax Executive, September-October 2002, pages 402-418.

(3) Act [section] 802.

(4) Act [section] 303.

(5) For example, 18 U.S.C. [section] 1512(b) provides, as follows:

   Whoever knowingly uses intimidation or physical force,
   threatens, or corruptly persuades another person, or attempts
   to do so, or engages in misleading conduct toward
   another person, or attempts to do so, or engages in misleading
   conduct toward another person, with intent to--

   ....

   (2) cause or induce any person to--

      (A) withhold testimony, or withhold a record, document,
      or other object, from an official proceeding;
      [or]

      (B) alter, destroy, mutilate, or conceal an object with
      intent to impair the object's integrity or availability
      for use in an official proceeding.

   ....

   shall be fined under this title or imprisoned not more
   than 10 years, or both.

To run afoul of the new rule, a person need not act corruptly, and there is no need for the government to point to a particular official proceeding.

(6) See, e.g., Jonathan D. Glarer & John Schwarz, Enron's Many Strands: The Deliberations, N.Y. Times, June 17, 2002, at A14; Jonathan Weil, et. al., Auditor's Ruling: Andersen Win Lifts U.S. Enron Case, Wall St. J., June 17, 2002, at A1.

(7) See Destruction of Enron-Related Documents by Andersen Personnel: Hearing Before the House Subcomm. on Oversight & Investigations of the Comm. on Energy & Commerce, 107th Cong. 58 (Jan. 24, 2002) (reprinting Ms. Temple's e-mail).

(8) Govt's Mem. of Law in Opp. to Andersen's Motion for a Judgment of Acquittal or a New Trial at 19 (filed Aug. 1, 2002).

(9) Andersen's Reply in Support of its Motion at 3-4 (filed Aug. 13, 2002).

(10) Letter from Sen. Patrick Leahy to Atty. Gen. John Ashcroft, Aug. 2, 2002.

(11) Section 3 of the Sarbanes-Oxley Act treats violations of the Act as violations of the Securities Exchange Act of 1934, 15 U.S.C. [subsection] 781 et seq. Section 32 of the 1934 Act establishes the criminal sanctions.

(12) Securities and Exchange Commission, Proposed Rule: Improper Influence on Conduct of Audits, Oct. 18, 2002.

(13) See, e.g., Peter Behr & April Witt, Visionary's Dream Led to Risky Business; Opaque Deals, Accounting Sleight of Hand Built an Energy Giant and Ensured its Demise, Washington Post, Jul. 28, 2002 at A1 (discussing tax positions of Enron Corp.); Mark Maremount & Laurie P. Cohen, New York Prosecutors Seek Auditor Link in Tyco Probe, Wall Street Journal Europe, Sept. 30, 2002 at A1; Carrie Johnson & Ben White, Worldcom Arrests Made; Two Former Executives Charged with Hiding Expenses, Washington Post, Aug. 2, 2002, at A1.

(14) See Internal Revenue Service, Announcement 2002-63, I.R.B. 2002-27, 72 (Jul. 8, 2002).

(15) Under section 802 of the Sarbanes-Oxley Act, auditors are required to retain specified audit workpapers, generally for a period of five years. Under proposed rules, the documents to be retained include draft documents that reflect disagreements that arose in the course of the audit. See Securities and Exchange Commission, Proposed Rule: Retention of Records Relevant to Audits and Reviews, Nov. 21, 2002.

(16) Section 307 of the Sarbanes-Oxley Act may create additional requirements for tax executives who also are lawyers. Section 307 requires lawyers who have evidence of material securities law violations to take persistent actions to appraise higher-ranking officials of the company, including members of boards of directors, of the evidence. See generally Securities and Exchange Commission, Proposed Rule: Implementation of Standards of Professional Conduct for Attorneys, Nov. 21, 2002.

(17) Cf. Jonathan Eig, Keeping the Books: One CFO Finds His Orderly World Upset After Enron, Wall St. J., Nov. 14, 2002, Al.