SULLIVAN & CROMWELL
|125 Broad Street
New York, NY 10004-2498
LOS ANGELES PALO ALTO WASHINGTON, D.C.
FRANKFURT LONDON PARIS
BEIJING HONG KONG TOKYO
August 19, 2002
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan G. Katz, Secretary
File No. S7-21-02
Release Nos. 34-46079; 34-46300
Certification of Disclosure in Companies
Quarterly and Annual Reports
Ladies and Gentlemen:
This letter responds to the request of the Securities and Exchange Commission for comments on its June 14, 2002 release entitled Certification of Disclosure in Companies Quarterly and Annual Reports (the Original Release), as supplemented by the Commissions August 2, 2002 release seeking comment on the certification rules required by Section 302 of the Sarbanes-Oxley Act of 2002 (the Supplemental Release and, together, the Releases).
We have focused our comments on three subjects: (i) which reports are covered by Section 302 certification, (ii) the disclosure procedures supporting the certification and (iii) the content of the certification itself.
First, we support the Commissions approach reflected in the Supplemental Release that Forms 10-K, 10-Q, 20-F and 40-F are the only reports that Section 302 covers, and that Section 302 certification does not apply to reports on Forms 8-K or 6-K. We also believe that foreign governmental issuers, registered investment companies and special purpose issuers should not be subject to Section 302 certification. We suggest that the Commission provide in the implementing rules that Section 302 certification is required only in reports for fiscal periods ending on or after August 29.
Second, we believe that Section 302 has superseded the Commissions proposed rules 13a-15 and 15d-15 and that the Commission should withdraw those rules. We recommend that, in implementing Section 302s requirements related to internal controls, the Commission not impose overly specific disclosure procedures. For example, we believe that the Commission should not incorporate into the rule itself its suggestion that companies create a committee responsible for disclosure. In order to minimize conflicts with home country requirements, required disclosure procedures should, in particular, be kept as general as possible for foreign private issuers.
Third, we ask that the Commission clarify that the certifying officers will be treated as having designed the internal controls, for the purposes of Section 302, if they reviewed the structure and effectiveness of the internal controls. We also believe that the Commission should make clear that fairly present[s] should be understood by reference to the particular report in which the certification appears. Finally, we believe that Section 302 has superseded proposed rules 13a-14 and 15d-14 and that the Commission should withdraw those rules.
Reports Covered by Section 302 Certification
We support the Commissions approach reflected in the Supplemental Release that Forms 10-K, 10-Q, 20-F and 40-F are the only reports that Section 302 covers, and that Section 302 certification does not apply to reports on Forms 8-K or 6-K. We also believe that foreign governmental issuers, registered investment companies and special purpose issuers should not be subject to Section 302 certification.
1. Forms 8-K and 6-K
Section 302 requires that a reporting companys chief executive officer and chief financial officer make the specified certification in each annual or quarterly report filed or submitted under section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the Exchange Act).
We concur that Section 302 does not apply to reports on Form 8-K. Form 8-K reports are not annual or quarterly report[s]. Instead, Form 8-K is entitled Current Report and is filed episodically and in response to particular events. In contrast, Form 10-Q is entitled Quarterly Report and Forms 10-K, 20-F and 40-F are entitled Annual Report and are filed quarterly and annually, respectively.
We also concur that Section 302 does not apply to reports on Form 6-K. Form 6-K reports are not filed annually or quarterly, but rather on an ad hoc basis to place on the U.S. record what has been made public outside the United States. Therefore, they fall outside of Section 302s purview.
2. Foreign Governmental Issuers, Registered Investment Companies and Special Purpose Entities
Foreign Governmental Issuers. We believe that Section 302 should not be read as applying to foreign governmental issuers that have had effective Securities Act registration statements on Schedule B and file reports on Form 18-K. The Section 302 rules should so provide. Section 302 by its terms applies only to companies, not all issuers. Thus, it was plainly written with corporate issuers in mind. Applying Section 302 to foreign governmental issuers raises a number of thorny conceptual and practical issues. First, requiring the certification would raise serious comity issues. Second, the meaning of the terms principal executive or principal financial officer, internal controls or audit committee is unclear in the context of a foreign governmental issuer. As these issues illustrate, Section 302 clearly was not written to cover foreign governmental issuers, and we therefore do not believe that it should be read in such a fashion.
Registered Investment Companies. We recommend that the Commission exempt registered investment companies from Section 302.1 If construed literally, Section 302 could apply to registered investment companies, but we think that to do so would not be appropriate. As noted above, we believe that, for Section 302, Congress had in mind operating companies that are followed by securities analysts and whose periodic reports affect prices in secondary market trading. Its requirements do not work well for registered investment companies, which under the existing federal securities laws are structured very differently and, for the substantial majority both per capita and by assets, do not trade in secondary markets. Investment companies generally have no employees and contract all functions to third parties. Although investment companies have principal executive and principal financial officers, these are notional positions, ordinarily filled by officers or employees of an investment companys adviser or administrator. In addition, responsibility over internal controls may be divided among various unaffiliated third parties, making it difficult for the signing officers to certify as to the establishment and maintenance of internal controls. Accordingly, the in terrorem effect of personal liability is unnecessary and inappropriate. Therefore, we believe that investment companies should be exempt, and that the new rules should so provide.
Furthermore, Section 302 certification is not necessary to protect investors; the Investment Company Act of 1940 (the ICA) and, in the case of open-end management investment companies, the Securities Act of 1933 (the Securities Act) already provide substantial safeguards. The ICA regulates substantially all activities of investment companies, and the CEO and CFO (and directors) of open-end investment companies are always subject to heightened liability on their financial statements and other disclosures under section 11 of the Securities Act due to their continuous share offerings. Section 302 certification would not add any significant further protection.
Even if the Commission decides that investment companies should be subject to Section 302, we recommend deferring implementation until the Commission can devote careful attention to the host of issues raised by investment companies. For example, reports on Form N-SAR, which are filed under Section 13(a) or 15(d) of the Exchange Act and, as a result, are the reports as to which certification would be required by Section 302, do not include financial statements or other information useful to investors for which certification would be meaningful. The annual and semiannual reports to shareholders, which are required to be filed under Section 30(b) of the ICA and include financial statements, are not filed or submitted under Section 13(a) or 15(d) of the Exchange Act and, as a result, are not covered by Section 302. The Commission would have to amend long-standing ICA rules to provide that these reports are filed under Exchange Act Section 13(a) or 15(d) in order that Section 302 cover them. We believe that such an amendment, or one requiring financial statements to be included with Form N-SAR, would require notice and a comment period under the Administrative Procedures Act. Moreover, these annual and semi-annual reports do not contain information comparable to reports on Forms 10-K and 10-Q and are not appropriate for the certification required by Section 302. For these reasons alone, we urge that investment companies be exempt at least temporarily, pending careful review of how Section 302 ought to apply.
Asset-Backed and Other Special Purpose Issuers. We also recommend that the Commission exempt special purpose entities from Section 302. Like foreign governmental issuers and registered investment companies, special purpose vehicles issuing asset-backed securities, employee benefit plans (filing annual reports on Form 11-K) and similar types of U.S. registrants are not companies in a conventional sense or as intended by the Act. One result of this is that they commonly do not have principal executive or principal financial officers, or even persons performing similar functions, who could sign a Section 302 certification.
3. Implementation Date
We recommend that the Commission make clear that Section 302 certification and its implementing rules do not apply to any annual or quarterly report for a fiscal period ending prior to August 29.2 Doing so will ensure that registrants have adequate notice of the specific requirements contained in the implementing rules and sufficient time to implement appropriate responsive procedures.
Disclosure Procedures Supporting Certification
We believe that Section 302 has superseded proposed rules 13a-15 and 15d-15 and that the Commission should not require specific disclosure procedures.
1. Section 302 Has Superseded Proposed Rules 13a-15 and 15d-15
We believe that the substance of proposed rules 13a-15 and 15d-15 has been incorporated into Section 302(a)(4). Paragraph (a) of proposed rules 13a-15 and 15d-15, which required issuers to maintain sufficient procedures to assure that necessary information is collected, processed and disclosed, could be incorporated into the Section 302 rules by clarifying that the term internal controls in Section 302(a)(4) includes the procedures contemplated by the proposed rules. The signing officers would then be required to certify that they are responsible for establishing and maintaining such controls. Paragraph (b), which required an annual evaluation of these procedures, has been superseded by the requirement of Section 302(a)(4)(C) that the certifying officers evaluate the effectiveness of internal controls every quarter.
For these reasons, we believe that Section 302 has superseded proposed rules 13a-15 and 15d-15 and that the Commission should withdraw them.
2. General Disclosure Procedures
In its Original Release, the Commissions proposed rules 13a-15 and 15d-15 did not impose specific disclosure procedures on companies. Instead, the proposed rules included a general requirement that issuers maintain sufficient procedures to assure that necessary information is collected, processed and disclosed. We recommend that the Commission continue to adhere to this approach in its rules implementing Section 302.
We believe that a general approach is best for two reasons. First, Section 302 contains enough detail to provide a useful framework for designing disclosure procedures. For example, it requires that the internal controls ensure that material information is made available as necessary for disclosure, that evaluations are conducted and that significant deficiencies are reported. Second, general implementing rules will give companies flexibility to design appropriate disclosure procedures. Because every companys business is different, their disclosure focuses vary accordingly. Specifically mandated procedures may not fit a particular company, causing it to struggle with implementation or maintain irrelevant procedures.
In particular, we advise against incorporating into the rule a requirement that companies create a committee responsible for disclosure matters. The Commission may wish in its adopting release to recommend the creation of a disclosure committee as a best practice. We support this approach, and agree that many companies may find such a practice appropriate. Because some companies will find such a requirement burdensome and unnecessary, however, we recommend against incorporating the practice into the new rules.
Avoiding specific prescriptions is particularly important for foreign private issuers, since the Commissions requirements might conflict with home country requirements or practices. If the Commission decides to incorporate specific requirements as to disclosure procedures, we recommend exempting foreign private issuers from that portion of the rules.
Content of Certification
The rules should clarify that certifying officers will be treated as having designed internal controls, for the purposes of the required certification, if they have reviewed the structure and effectiveness of those controls and that fairly present[s] should be understood by reference to the particular report in which the certification appears. We also believe that Section 302 has superseded proposed rules 13a-14 and 15d-14.
1. Section 302(a)(4)(B): Internal Controls Design
Section 302 requires that the certification state that the certifying officers have designed internal controls. Taken literally, this language is problematic. The vast majority of companies already have internal controls that the signing officers are unlikely to have personally designed. Therefore, to require the signing officers to certify that they have designed the internal controls makes no sense unless design encompasses review of the procedures established by others. Moreover, the requirement is meant to ensure that the certifying officers are sufficiently involved in overseeing the internal controls, and literally designing the controls is not necessary for that objective; it is met if the certifying officers review the structure and effectiveness of the controls.
For these reasons, we recommend that, as an interpretive element of the rule, the Commission state that certifying officers will be deemed to have designed the internal controls if they have reviewed their structure and effectiveness.
2. Section 302(a)(3): Fairly Presents
The Section 302 certification requirements have not changed the substance of what must be disclosed under the federal securities laws. Section 302 was not intended to establish a new disclosure requirement, but rather to improve the quality and clarity of a companys disclosure and to provide more safeguards that the existing substantive standards were fully met. For instance, although Section 302 repeats the disclosure standard for material information found in Exchange Act Rules 10b-5(b) and 12b-20, it adds a certification requirement to encourage senior officers to put a high priority on disclosure issues.
As a result, we believe that Section 302s requirement that the signing officers certify that the information in the report fairly present[s] the financial condition and results of operations of the issuer should be understood to mean fairly presents in each particular context in which it is applied. For example, information in a Form 10-Q should be understood as fairly present[ed] if it supplements and updates the annual report as it should. Similarly, financial statements and other financial information (such as the Managements Discussion and Analysis) in annual Form 20-F reports of foreign private issuers should be understood as fairly present[ed] even though prepared according to home jurisdiction accounting requirements. We would urge the Commission to clarify that understanding in the rule itself, or at least in an instruction to the rule.
3. Proposed Rules 13a-14 and 15d-14
In its Original Release, the Commission proposed rules 13a-14 and 15d-14, which required the principal executive officer and principal financial officer to certify the companys quarterly and annual reports. We believe that Section 302 has superseded these rules and recommend they not be adopted.
We appreciate the opportunity to submit comments. We are available to meet with the Commission or the Staff and to respond to any questions.
|Very truly yours,
SULLIVAN & CROMWELL
|1||The Commission has the authority to exempt registered investment companies from Section 302 pursuant to Section 3(a) of the Sarbanes-Oxley Act of 2002 (the Act).|
|2||Section 302(c) requires that the Commissions implementing rules be effective by August 29. It does not address whether the substantive certification requirements should be effective for reports for fiscal periods ending prior to that date.|