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Sarbanes-Oxley and Corporate Real Estate

2006 SIOR Spring ConventionLa Quinta Resort & Club · La Quinta, California

April 22, 2006

Presented by

Richard C. Mallory, Esq., Allen Matkins Leck Gamble & Mallory LLP

(415) 273-7488 • rmallory@allenmatkins.com

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Materials prepared in part by Terry Connelly, Dean, School Materials prepared in part by Terry Connelly, Dean, School of Business, Golden Gate University, with commentary by of Business, Golden Gate University, with commentary by Marc Greenberg, Associate Professor and Director of the Marc Greenberg, Associate Professor and Director of the

Intellectual Property Law Program, Golden Gate UniversityIntellectual Property Law Program, Golden Gate University

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Corporate Ethics and Trust in Today’s Financial World

• “If you do right by the numbers, the numbers will do right by you.”Unnamed freshman chemistry instructor

Circa 1961

• “We can make the numbers come out any way we want.”Unnamed Wall Street Executive

Circa 1991

• “We’re Enron; we don’t need to have good accounting.”Unnamed Enron employee

Circa 2001

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US Newspaper Headlines June 26, 2002:

• Just a random, ordinary day at the office…– “Adelphia Communications Files for

Bankruptcy-Court Protection“– “U.S. Investigates British Bankers in Enron

Case”– “Qwest Tries to Justify Accounting Methods to

a Staunch SEC”– “WorldCom Admits $3.8 Billion Accounting

Error”

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Headlines…

• Just a random, ordinary day at the office…– “Lenders’ Deals Aided Energy-Firm Results”– “Teen Settles Matter With SEC of Scheme to

Raise Stock Price”– “Many CEOs bend the rules (of golf) – 82%

admit being less than honest on their scorecards, survey says”

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The Sarbanes-Oxley Act of 2002

• One month later…..– Dow Jones Industrial Average had fallen from 9126 to

7532 – a 17.5% decline.

– The Sarbanes-Oxley Act of 2002 was approved by the US Congress and signed by the President: “to protect investors by improving the accuracy and reliability of corporate disclosures.”

– Sarbanes-Oxley: The most significant legislation regulating corporate and financial market behavior since the Securities Acts of 1933 and 1934.

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• Sarbanes-Oxley was a comprehensive, systemic response to systemic, large-scale corruption.– In 2002, corporate write-downs amounted to 140% of

reported earnings of public companies, reflecting adjustments to previous reported earnings between 1998 and 2001.

– And this was before any announcements in 2003 or 2004 or this year, like the $9 billion restatement by Fannie Mae.

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Impact on Issuers of Listed Securities

• Specifically Related To Officers– Two separate CEO/CFO certification requirements:

• Criminal provision requiring certification in each filed periodic report containing financial statements stating that the report (i) “fully complies” with the Exchange Act requirements (no materiality qualifier); and (ii) “fairly presents, in all material respects, the financial condition and results of operations of the issuer.”

• A civil provision requiring certification that (i) the financial statements and other financial information “fairly present in all material respects” the company’s financial condition; and (ii) the officer accepts responsibility for and makes several other representations regarding internal controls.

– Can’t be blind to ‘red flags’, deaf to whistleblowers, dumb about accounting.

– Increases risk of personal liability for shareholder losses on future restatements.

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Impact on Attorneys and Others

• SEC to establish rules for corporate attorneys requiring them to report evidence of a material violation of securities law, a breach of fiduciary duty or similar violation by the company to its Chief Legal Counsel or CEO.

• If management does not respond appropriately, the attorney must report the evidence to the audit committee.

• Any person who knowingly alters, destroys, mutilates, conceals, covers up or falsifies, or makes a false entry in, any document with intent to impede, obstruct or influence any government department or agency investigation (or conspires to do so) may be fined and jailed for up to 20 years.

• Any person who knowingly executes or attempts a scheme or artifice to defraud in connection with a public security may also be fined or jailed; this provision expands possible criminal liability exposure both inside and outside the company to include legal, accounting and financial advisors.

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In Summary:

• Sarbanes-Oxley Creates New Federal Civil and Criminal Standards for Corporate and Professional Behavior on Matters Previously Left to the States Or Self-Regulatory Bodies.– Sarbanes-Oxley has a comprehensive, systemic impact.

– Suddenly, everyone involved in corporate governance is an accountant – or, at least, accountable.

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• Sarbanes-Oxley and the Clean-up of Toxic Financial Reporting– Characteristics of the Legislation

• Comprehensive

• Systemic

• Highly Prescription

• Expensive!

– Example of Sarbane-Oxley’s Replacement of Self-Regulation with Detailed Official Standard-Setting: The PCAOB and Sections 103 and 404

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• Public Company Accounting Oversight Board– Established to oversee accounting profession– Covering auditing, quality control, ethics

• Establishes or adopts auditing standards • Issues quality control standards

– Monitoring ethics and independence– Consulting on audit issues– Supervision, hiring, training– Client acceptance and continuance– Internal inspections– 2nd partner reviews

• Sanctions for poor supervision• Seven year working paper retention

– Rules for reporting on management’s assessment of Internal Controls (Section 404)

– Registration requirements

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New “Early Warning” Standards

• The PCAOB Auditing Standard No. 2 frames the auditing engagement concerning internal controls as an audit, not merely a review or other limited exercise.

• Standard No. 2 requires auditors to deliver two control-related opinions – one opinion on management’s assertions concerning control effectiveness, and a separate opinion on the auditor’s own assessment of whether a company is maintaining effective internal control over financial reporting.

• The result is that auditors will now provide a total of three opinions: one opinion on the financial statements and two opinions concerning internal controls.

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• “Material Weaknesses” versus “Significant Deficiencies”– Material weakness in controls is a particularly severe form of significant deficiency.

Significant deficiencies pose consequential risks for financial statement reliability, while material weaknesses pose material risks.

• Auditors are required to disclose and explain “material weaknesses” publicly, but need only bring “significant deficiencies” to the attention of management and audit committees.

• Whether a significant deficiency amounts to a material weakness depends on the possibility that a financial misstatement could result. This depends on both the likelihood and magnitude, measured using various factors.

• Standard No. 2 specifically provides that ineffective audit committees can be treated as a significant deficiency at minimum, and possibly as a material weakness.

• Is this not a conflict or an “independence” issue itself: how can an audit firm audit the audit committee that it reports to and that evaluates its performance and continued engagement?

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The Future of Sarbanes-Oxley

– Coming Soon: To a Self-Regulatory Body Near You• NY Stock Exchange reforms

– Coming Soon to a Not-for-Profit Entity Near You• Non-profit Integrity Act of 2004• Independent audit required for charities with annual gross

revenues of $2 million.• Must also have audit committees.

– Coming Soon to a Government-Supported Enterprise Near You

• $9 billion restatement by Fannie Mae• Senior officers out

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– Coming Soon to a Government Unit Near You?– Employee pension fund accounting will probably be a

major focus, both for corporate and governmental entities.• Remaining corporate defined-benefit plans are underfunded by

$450 billion.• State employee retirement plan liabilities exceed assets by $366

billion.

– The ultimate cure: continued education and training in Sarbanes-Oxley compliance for corporate staff, executives, directors and audit committees.

• But don’t expect all A’s!

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Issues for the Real Estate Professional

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Internal Issues

• Is your employer or parent company a publicly-traded company? If so:– Review its SEC SOX compliance filings – you should

assume your competitors and clients will be doing that review.

– Confirm that if you want to book your commission on the date of full execution of the lease, your commission agreements state that the commission is earned upon execution of the lease, and payable on the traditional basis, e.g. the first half is payable upon removal of any contingencies and the second half is payable upon the lease commencement date.

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– The auditors will be reading every lease to confirm that the accounting for the public brokerage company takes into account precisely what the leases require, such as the execution of a lease commencement date letter as a condition to occupancy.

– If there is an inconsistency between what the lease say and what the commission agreement says, you will need to have a “variance letter” prepared and executed by the landlord, the tenant and the broker bringing the listing agreement into precise alignment with the lease language.

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• Your hard work in achieving state and local incentives for your publicly traded clients needs to be rigorously documented and tracked in order to rationalize the leasing acquisition and disposition decisions of your clients, because all of its real estate costs drive the decision of the corporate real estate executive as to location, and those costs need to be accurately analyzed and assessed.

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• The immediate impact of Section 404 of SOX is that it requires company officers to accept responsibility for the accuracy of the information presented in financial reports as reviewed by the SEC. The CFO and CEO will look to you to support their reports regarding real estate decisions with the most accurate data and process justification you can generate. Failure to accurately provide SEC-related data will expose the company and its CEO and CFO to substantial liability from those who rely on that data, including shareholders.

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• Real estate officers of your publicly traded clients need to be prepared by you to certify the accuracy of the reports and methodologies used to derive these numbers, since accounting and finance rely on them to correctly portray, at any given point in time, the company’s financial position. Incorrect or inaccurate information provided by the real estate department could have serious implications for the company.

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• The relationships of your publicly traded clients to their vendors will be audited and thus must be carefully documented with evidence of the basis for selection of such vendors, including real estate brokerage. Expect that listing and commission agreements will become more formal and will need to comply with SOX.

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• You should prepare to compete for your share of what is sure to become a major increase in the outsourcing of the real estate accounting function and other business processes in order to increase efficiency and allocate risk with respect to such activities. Expect the centralization of the real estate process at your publicly traded clients. Strive to qualify to be a part of these processes.

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External Issues

• Your property owner clients should be reviewing SOX compliance filings of prospective tenants who are publicly traded companies.

• Look for areas of concern as to the company’s viability and suitability as a tenant.

• These clients tend to be large occupiers of space, and if their condition is shaky, a bankruptcy or other problem can cause significant losses for the Property Owner.

• SOX gives you more and more reliable information on which to base leasing terms and acceptance.

• As the agent for these owners, you may have a professional duty to review these materials, or at least advise your clients of their availability for review. You need to know what these filings are, what they contain, and how to get access to them.

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External Issues

• Your prospective tenants should be reviewing the SOX compliance filings of the prospective landlords for signs of corporate weakness that could signal a future sale of their office buildings.

• More importantly, real estate professionals should do this review of their own clients to look for signs of company weakness (thin capitalization, poor debt/equity ratios, significant losses) which may hurt your client’s prospects at securing A-list space – you should figure that the landlord is reviewing, and/or demanding this information from your clients, so you should make review of it a part of your initial client review process.

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Public v. Private Ownership

• At present, SOX applies only to publicly traded companies. This is not likely to remain so limited. Prudence suggests that conducting a SOX like review of records of privately held companies will be the norm in the future, and that legislative calls to expand SOX to private companies are likely.