What is Sarbanes-Oxley Act?

The Sarbanes–Oxley Act of 2002 (or SOX) is well known as the “Public Company Accounting Reform and Investor Protection Act” and also as “Corporate and Auditing Accountability, Responsibility, and Transparency Act”. It is the United States’ Federal law that sets expanded requirements for all U.S. public companies, boards, management, large non-profit companies and public accounting firms to protect investor interests. This law was a direct response to the financial scandals and reforms of 2002 (including the stunning bankruptcies of Enron, WorldCom, Tyco, etc.) and connected to corporate governance failures.

What is the Purpose of the Sarbanes-Oxley Act?

Those companies’ failures would have been prevented if audits of the companies had detected accounting irregularities or if the company would have been required to disclose transactions not directly reflected on its balance sheet.

The Sarbanes-Oxley was created to protect shareholdersand all type of investors and general public interests from accounting errors that might not be revealed in the process of an annual audit. SOX aims to prevent fraudulent practices through transparency and integrity of financial reporting, improved disclosures and statements that help to show “cause-and-effect” connections between corporate activities and financial results. It increases the accountability of CEOs and CFOs of public companies. It improves the overall professional, legal and ethical standards of boards, officers, auditors and lawyers, and helps to protect whistleblowers who play an important role in corporate ethics. It is also applicable for non-profit and small private businesses (if they want to follow “The Platinum Standard” of the best management practices). This US law is a great tool to protect investor interests and widely used by the majority of countries around the world.

Public Companies’ Risks vs. Condo Industry Risks

While Sarbanes-Oxley widely applies to all publicly owned companies, large companies of the non-profit sector and SMEs (that follow the best practice), SOX principles have not yet reached the condominium industry. However, the nature of corporate management and risks within public companies and condominiums are very similar, except in terms of marketing, sales and public relations processes. The wellbeing of both kinds of corporations (and stakeholders) depends on corporate Managers’ relevant professionalism and decency, the history of the company’s management and reputation, and the level of corporate governance. However, taking into account these facts: public company Managers usually go through a very through selection process, designed to bring the very best people to manage the corporation and they usually hire based on their level of professionalism and past performance. Condo Director positions have no requirements regarding any professional knowledge, skills, past performance in a relevant field, nor do they consider the applicant’s reputation. Condo Board Directors may not have the same level of business experience and sophistication as needed for successful condo-management. Bill 106 puts disclosure and training requirements for Directors and for Licensing for Property Managers that might help to improve the quality of management, but it is not possible to get the relevant high quality of knowledge and skills during a very short period of time. Therefore, there is a high risk of unqualified Directors existing in these positions despite an absence of any relevant professional background.

Public company Managers and Board Directors have material incentives based on the company’s performance results, but Condo Property Managers and Board Directors do not have any incentives or penalties for good or bad performance. Financial Statements and Condo reporting does not always include any Condominium KPIs that could show the progress clearly. All of that might decrease the level of responsibility and motivation for Directors and Condo Managers (who’s conflict of interests is not required to be reported by Bill 106) and create a favourable atmosphere for kickbacks. It means Condo Corporations have a very high risk of corporate governance failure and Condominium financial damage.

Public company Managers’ and Directors’ reputations are usually verified thoroughly but the information about candidates who run for the Board is never verified. They could make a good impression on the condo owners, but might lack the knowledge needed, and could have been previously convicted of a crime, or be financially unstable. And the “wrong Directors” might be elected repeatedly. Bill 106 requires a disclosure of a conflict of interests from Directors but does not give any tool to verify that information or to defend whistleblowers. SOX could do that.

The public company election process is usually strictly formalized and transparent, but the Condo election process design does not provide a reasonable warranty of election fairness and it might be subject to manipulation. SOX compliance and written Internal Control procedures could help to solve that problem.

Public company procurement processes and procedures are usually highly formalized and designed in compliance with all applicable laws and regulations, and tested in the course of Internal Controls procedures according to SOX requirements. Such procedures provide a reasonable warranty that the company’s results will be achieved with planned efficiency and effectiveness. Moreover, the price information of material and service suppliers of public companies is usually open to the public, so it can be compared and verified. Such open price information improves competition and public companies usually get the best prices. But the Condo Industry procurement process supposes a lot of weaknesses connected with the absence of the price and reputation information of the Condo Industry service suppliers. For some reason, it is next to impossible to find and compare Condo Industry service suppliers’ prices. Condo Directors can only get the price and reputation information using direct contact with the supplier. Taking into account that the Condo Director position is not a paid job and the collection of information is a very time-consuming process, Directors cannot invest enough of their time to collect all the information to make a reasonable decision. Procurement decisions are usually made based on the restricted information supplied by a Condo property Manager. So, the price and quality of condo services and total Maintenance Fee are fully dependent on the Property Manager’s professionalism, reputation and motivation. But taking into account the usual Condo situation where good or bad performance does not influence the Property Manager rewarding it, there might be a decrease in the Condo Management team’s motivation and the probability of them making the right choice of a condo service supplier based on price/quality/reputation indicators. And the absence of formal Internal Controls procedures (including lack of physical control of Contractors’ actual job performance) increases risks that a selection of condo suppliers might be based on a good personal relationship between a service supplier and a property Manager or Director. So, the highest risk of a conflict of interests exists.

Public companies usually have a formal Capital Budget, Investment Programmes and Business Plans based on reliable statistical data and adjusted to the current needs and plans. Such Programmes and Budgets are usually subject to a high level of control and assessment. But Condo Reserve Fund might be subject to manipulation. The annual Contribution amount is usually advised by a third party in the course of Reserve Fund Study, and the Board usually does not revise it accepting as the final decision. However, taking into account the fact that the Reserve Fund annual Contribution is about 25-40% of the annual condo budget and the Board usually does not pay enough of attention to review a Reserve Fund Study, a list of the current and planned repairs and replacements needs, the selection of Contractors for major assets replacements, or repairs. Also, there is no any clear unified methodology on amount of Reserve Fund contributions and no any useful statistics of condos’ capital expenditures during a condo building’s lifetime. So, there are no industry best practice standards and statistics available on the market now.

It is clear! Condo owners face much higher risks connected with their condo investments than public company investors, and condo investors need an even better protection tool. Financial improprieties and fraud are not limited to public companies. Condominiums and co-ops may experience misleading financial statements, conflicts of interest and questionable transactions. Sarbanes-Oxley has created a heightened awareness of the need for sound governance practices and accounting transparency for condominium boards, so Sarbanes-Oxley principles must be very useful in condominium governance.

What Kind of Improvements Should Condo Owners Expect from Bill 106 Implementation and What Kind of Problems are Still Not Addressed?

It prohibits condo Managers (or anyone acting for them) from soliciting proxies for election purposes for meetings of owners. The reliability of election procedures will be improved. But there is no reasonable assurance that election procedures will be designed correctly in order to minimize risks.

Licensing.It must improve condo management processes. But it might not improve contractor selection processes, or the quality of contractor services and prices.

Code of Ethics and Disclosure of a Conflict of Interests.Certainly, it should increase the quality of Condo-management services and decrease risks. But the procedure of a Conflict Resolution still needs to be written by professionals in the field of Internal Controls.

Information Certificates.This new requirement will provide condo owners and potential buyers with very valuable information and most important: Condominium Registrars will be responsible for receiving all information from condominium Directors, such as annual returns, notices in change in boards, and will oversee the mandatory Director training. This Registrar also will be responsible for creating and maintaining public access to these documents. But the Bill 106 does not clarify purposes, terms and procedures of getting such information by the General Public. And there are a few doubtful wordings under “Confidentiality” heading, like clause 9.8: “…A person who obtains information in the course of exercising a power or carrying out a duty related to the administration of this Part or the regulations relating to this Part shall preserve secrecy with respect to the information and shall not communicate the information to any person except as may be required in connection with a proceeding under this Act or in connection with the administration of this Act or the regulations…”

This means: Condo information might not be really available to all of the public. And Condo Boards, owners and potential condo buyers might not have any comparable information for their understanding of their Condo performance, reviewing of market tendencies, or their analysis, comparison and decision-making.

Condo Industry KPIs Will Provide Condo Information Comparability for Decision-Making

There are a lot of Condos on the market and all are different. But it is possible to create some indicators that might help Condo Directors, Condo owners and potential investors in decision-making. The list of suggested information is here. Let’s try to make the Condo Industry transparent! It would be highly appreciated if anyone can offer any improvements to the list.

What Kind of Benefits Should be Expected from SOX, KPIs Application and in Making Condo Industry Information Open to the General Public?

Publicity of Information and KPIs will give the Public an opportunity to:

Monitor and compare market-sensitive information and performance of different condos using some comparable KPIs.

Selective usage of SOX principles would enhance Boards’ accountability, increase the transparency of Condo operations and improve condo efficiency and effectiveness. By using a written conflict-of-interest policy and whistle blower protections, requiring Internal Audit committee and lawyers to report evidence of irregularities, condominium Boards will be adopting best practices that are likely to become the new standard for corporate governance and for condo owners’ protection.

The SOX requires an annual assessment of Internal Controls. An Internal Audit Committee can play a key role in the financial governance of the Condominium Industry. Such committee responsibility will oversee current condo management and reporting processes and develop proper Internal Control Procedures to improve the quality of services, reliability of condo financial reporting and Condo cost efficiency, to see earlier and more complete disclosure of information on anything that directly and indirectly influences or might influence Condominium financial results, and to ask questions and look for problems.

One of the major SOX requirements is to protect whistle-blowers. Now some condo lawyers offer to the Board such policies that encourage the Board of Directors to keep some information in strict confidence, such as to not finagle Reserve Fund study and to not “shop around” (providing micromanaging). All of that, together with not-disclosed managerial information is a great soil for wrongdoing. The whistle-blower can play an important role in condominium governance, for example, in revealing kickbacks for building renovation or capital projects. It would be reasonable to adopt SOX application regarding whistle-blower protections for Board members, and condo Managers and employees of condominiums.

Compliance with Sarbanes-Oxley might be connected with some financial cost if there are no volunteers with an appropriate qualification among the Condo owner. Most condominiums operate on tight budgets and lean staffing sufficient just to cover the usual operational expenses of residential buildings. But most of Canadian Condos have 200-300 units, so it is a high probability to find experienced Internal Auditors among Condo owners. The Internal Audit Committee might be organized on a volunteer-owners basis taking into account Internal Audit background and Certification. It will make Condo operations as transparent as possible. Such measures will provide a reasonable warranty that:

Condo financial reporting will be reliable and transparent and information disclosure will include all details that might influence a Condo’s well-being
Condominiums will reach all objectives with expected operational effectiveness and efficiency (the property value will be increased, quality/cost of condo service will be optimal)
and all Condo operations will be in compliance with laws, regulations and policies

Extra Benefits from SOX Application, Public Access to Condo Reporting and KPIs:

The open Condo Services Price Information and Condo Performance Information based on KPIs will encourage competition between Condo Management Companies and different Condo Service Companies on the market, decrease this market’s barriers for a lot of potential Condo contractors that currently have all resources to provide the best service for Condominiums at the best prices but do not have a good relationship with Management Companies or Directors and have no opportunities to provide their services to the Condo. As a result of such competition, Property Management Companies and Condo Contractors will strive to improve the quality of services, adjust their prices accordingly to be flexible in such competition and as a result – condo fees should be decreased. And as a natural consequence, it should boost the Canadian economy’s efficiency because of condo owners’ disposable income increase. It will stimulate a consumption of goods and services offered by the market.

This move must be very helpful to Condo Boards, the owners and potential investors to monitor the Condominium performance. The Board will spend significantly less time for analyzing condo performance. The Board will just monitor Condo performance analyzing KPIs of different Condos and requiring correction actions from the Property Manager.