November 27, 2002
Mr. Jonathan G. Katz, Secretary
Re: File No. S7-40-02
Dear Mr. Katz:
This letter comments solely on those provisions of the above-referenced proposed rule that seek to implement 15 USC 7265, Section 407 of Public Law 107-204 (the Sarbanes-Oxley Act), regarding financial expertise on audit committees of publicly traded companies. It does not include any comments regarding provisions of the proposed rule that concern codes of ethics (pursuant to Section 406) or internal control reports (pursuant to Section 404).
I. SUMMARY COMMENTS ON FOUR MAJOR POINTS:
To achieve the goals of P.L.107-204, the Commission in its rulemaking must be mindful of the overall purposes of the Act. These purposes include:
These two goals prompt each of the four major comments below.
(A) The Commission’s proposal to have “financial expert” decisions made by each corporate Board is constructive and fair if and only if the Commission clearly delineates the responsibilities of Board members, audit committee members, and the “financial expert(s)” serving on that committee so as to prevent inadvertent expansion (or contraction, in the case of those individuals not designated financial experts) of their liability. Without such explicit provisions in the final rule, the Commission can not fairly charge the Board with this responsibility. (Board disclosure requirements follow the same logic – inasmuch as Sarbanes-Oxley did not require the Board to specifically identify or to publicly disclose the identity of the “financial expert(s)” serving on its audit committee, the Commission can fairly impose these additional responsibilities only if it also explicitly deals with the potential state-law consequences otherwise being created for Board members of companies doing their best to fulfill their newly assigned responsibilities in this area.)
(B) To achieve the purposes of the Act, the definition of “financial expert” should include a strong element of “independence”. It would be laughable if companies could fulfill the requirement of including a “financial expert” simply by retaining their CFO or some other non-independent expert on their audit committees.
(C) The proposed definition of “independence” with respect to financial experts is severely inadequate in that it would apparently deem as “independent” an audit committee member who receives payments from a professional services firm which provides audit or non-audit consulting services to the company on whose Board he or she serves. The final definition of “independence” should exclude any financial expert who shares in any of the profits of, or receive payments from, an accounting or professional services firm which provides services to the company, as well as those (like the CFO) who receive payments directly from the company. Use of the definition of “independence” used in 10A(m)(3)(B)(ii) of the Exchange Act is incongruous in the context of rules proposed to ensure audit committee independence from auditors and consultants as well as from a company’s financial managers.
(If the Commission feels that such a restriction would unduly limit the pool of eligible financial experts, an exception could be considered to permit financial experts who do not chair the audit committee to receive payments from such audit or non-audit consulting firms for prior activities unrelated to the issuer. This potential lower standard of independence for financial experts who do not also chair the audit committee is consistent with the separation of functions principle central to effective internal controls, whether at the audit committee and Board levels or in management and operations. Prior employment of a financial expert by an audit or consulting firm which currently or prospectively provides services to the issuer, without continuing receipt of profit-sharing, pension, or other payments from such firms by that individual, may not raise this same level of concern, though here too a mandatory split of the functions of financial expert and audit committee chair could be considered in such cases if the Commission wishes to address even this level of perceived potential conflict through this rulemaking process without totally disqualifying this class of individuals from audit committee service as “financial experts”.)
(D) Based on dozens of discussions with directors, academics, auditors, and other experts since the draft rules were proposed, there is a serious need to clear up confusion about the definition and parameters that a Board may consider in identifying “financial expert(s)”. Much misinformation is being disseminated in this regard. Promulgating a clear final rule will go far to accomplish this goal of correcting widespread misinformation regarding these requirements.
II. DISCUSSION OF THE FOUR MAJOR COMMENTS:
(A) Protecting good-faith determinations by Boards, or in the alternative not requiring Boards to specify their financial experts.
Despite the length of the proposed rule and its commentary, Section 407 (15 USC 7265) is brief, in pertinent part simply instructing the Commission to “issue rules, as necessary or appropriate in the public interest and consistent with the protection of investors, to require each issuer, … to disclose whether or not, and if not, the reasons therefor, the audit committee of that issuer is comprised of at least 1 member who is a financial expert, as such term is defined by the Commission [and … ] In defining the term ``financial expert'' …, the Commission shall consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions -- (1) an understanding of generally accepted accounting principles and financial statements; (2) experience in -- (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions.”
The statute thus requires public companies to respond to a yes/no question (“Is there at least one financial expert on your audit committee?”) and, only if the answer is no, to provide reasons.
It is fair and reasonable for the Commission to expand this statutory command and to impose it specifically on the Board if and only if the Commission simultaneously protects a well-intentioned Board from unreasonable liability if it should happen to guess wrong (in some future judge’s or jury’s minds) on what the Commission definition means. If the final rule does not provide such protection,
(1) Boards will potentially be exposed to unintended liability for guessing wrong about some future interpretation of the Commission’s final rule, and
(2) Most Boards, no matter how well intentioned and how well “stocked” their audit committees may be with experts in all aspects of financial, accounting, and commercial transactions, may be well advised by counsel to claim that they are not certain whether any of their audit committee members, or if so which ones, fall within the yet-to-be-adjudicated scope of the Commission’s rule. The only certain way to avoid liability, if the final rule does not provide adequate protection for good-faith determinations, would be to neither affirm nor deny that any particular member of the audit committee is a “financial expert”.
To avoid these unfair or counterproductive results, the following language or its equivalent should be included in the final rule:
“The mere designation of a financial expert does not impose a higher or lower degree of individual responsibility or obligation on any member of the board. The financial expert designation shall neither increase nor decrease the duties and obligations of individuals so designated or of other members of the audit committee or of the board of directors individually or collectively. A board which in good faith determines one or more individuals to be financial experts based on an assessment of the factors in this rule directly by the board or based upon advice from a qualified nonprofit or proprietary enterprise which has considered the understanding and experience of such individuals in light of the factors set forth in this rule and advised the board thereon, shall not by virtue of that determination or its publication be subject to liability individually or collectively. All board members share an equal responsibility to exercise due loyalty and due care. Designation of an individual as a financial expert does not alter the responsibility of that individual or of any other board member to exercise due loyalty and due care.”
(B) Including independence as an element of being a financial expert for a company, AND (C) Specifying that “independent” directors may not be paid by audit or non-audit consulting firms.
The following language or its equivalent should be included in the final rule:
“the term "financial expert" means a member of an audit committee of an issuer who does not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee, accept any consulting, advisory, or other compensatory fee from the issuer; is not an affiliated person of the issuer or any subsidiary thereof; does not share in any of the profits of, or receive payments from, any accounting or professional services firm which provides services to the issuer, and who has, through education and experience … “
(D) Clarifying the parameters that may be considered in identifying financial experts.
The Commission correctly rejected a “bright line” rule which nonetheless is being incorrectly perceived by many “experts”, including most business journalists who have written of the “financial expert” proposal. To clarify the Commissioner’s intended meaning, the final rule should include positive language clarifying the scope of the Board’s discretion in identifying financial experts, such as:
“In determining that an audit committee member is a “financial expert” based on an assessment of the factors in this rule directly by the board or based upon advice from a qualified nonprofit or proprietary enterprise which has considered the understanding and experience of such individuals in light of the factors set forth in this rule and advised the board thereon, no individual shall be considered a “financial expert” unless he or she has, in the judgment of the board of directors, (I) An understanding of generally accepted accounting principles and financial statements; (ii) Experience applying such generally accepted accounting principles in connection with generally comparable entities; (iii) Experience preparing, auditing, reviewing, or analyzing financial statements that present accounting issues faced by generally comparable entities; (iv) Experience with internal controls and procedures for financial reporting; and (v) An understanding of audit committee functions. Such understanding and experience may have been acquired through education and experience as a public accountant or auditor, or a principal financial officer, controller, or principal accounting officer, of a company that, at the time the person held such position, was required to file reports pursuant to section 13(a) or 15(d) of the 1934 Act, or experience in one or more positions that involve the performance of similar functions or that results, in the judgment of the board of directors, independently or after having received advice from a qualified nonprofit or proprietary enterprise which has considered the understanding and experience of such individual, in the person's having similar expertise and experience.”
III. Selected Minor Questions Posed in Rulemaking Notice:
The notice of proposed rulemaking asked numerous specific questions of which several deserve response even in a letter such as this focused solely on the “financial expert” definition.
Q.: Would investors benefit from disclosure of the number of the financial experts serving on the company's audit committee? Or would it suffice to require disclosure only of whether at least one financial expert serves on the audit committee?
If the Board is not provided with explicit protection from liability for “guessing wrong” about how this definition will be interpreted by judges and juries, issuers with multiple financial experts on their audit committee might nonetheless be well advised not to express an opinion on this question. Accordingly, the statutory yes/no question (Is there a financial expert on your audit committee and if not, why not?) would be most appropriate, if the Commission declines to add these explicit Board protections in the final rule.
If the final rule does incorporate protection for good-faith determinations by Boards based on their own independent assessment of the factors set forth in the rule or on advice from a qualified nonprofit or proprietary enterprise which has considered the understanding and experience of such individuals in light of the factors set forth in this rule and advised the Board thereon, then some marginal utility may result for investors knowing the number of financial experts determined by the Board to be serving on the audit committee.
Q. Do investors need to know the names of the financial experts on the audit committee? Would disclosure of the names discourage people from serving as financial experts on an audit committee? Should the Commission specifically address the issue of the degree of individual responsibility, obligation or liability under state or federal law of a person designated as a financial expert as a result of the designation? If the Commission should address this issue, how should it do so?
See the language proposed under II.A. of this letter, above. Yes, the Commission should specifically state that individual liability does not increase or decrease by virtue of appointment to the audit committee or designation as a “financial expert”. With this protective language, few financial experts should be dissuaded from participating and some marginal benefit may result from investors knowing the names of the designated experts.
Should we modify the proposed definition of "financial expert" in any way? If so, how?
See II.B. and II.C. above.
Q. Should we require a financial expert to have direct experience preparing or auditing financial statements of reporting companies? Should experience reviewing or analyzing such financial statements suffice? If so, why?
Many of the most expert analysts of financial statements have not technically “prepared” or “audited” them. Professors of accounting or finance, some forensic accountants, career SEC officials, etc., are examples. Experience reviewing or analyzing financial statements should suffice, as should preparing or auditing financial reports that were not required to be filed with the SEC but which nonetheless met all applicable reporting and audit standards for the enterprise.
Q.: Should we use a term other than "financial expert"? For example, would the term "audit committee financial expert" be a more appropriate title?
It is possible that the term “audit committee financial expert” would reduce confusion.
Q. Should we require disclosure of whether the financial experts are independent, as proposed? If so, should we define "independent" in the same manner as the term is used in Section 10A(m)(3) of the Exchange Act? Should we incorporate an independence requirement into the definition of financial expert" so that any designated financial expert must be independent to qualify under the definition?
A requirement of independence from both the issuer and any provider to the issuer of audit or non-audit consulting services should be included within the concept and definition of “financial expert”, consistent with the goals of Sarbanes-Oxley to protect Board-level decision making from undue domination by either audit firms or corporate financial managers. The definition of independence proposed under II.B. and II.C. above is accordingly and necessarily broader than that under Section 10A(m)(3) and incorporates both these concepts of independence – from the issuer and from the auditor (or provider of non-audit services).
If the comments posted online are indicative, there is a clear consensus that the proposed rule is too restrictive in its definition of the qualifications of financial experts, fails to sufficiently emphasize the leeway that Boards should have in assessing understanding and experience acquired in other than the specified job titles, and does not provide sufficient guidance or protection to Boards attempting in good faith to meet and surpass the minimum requirements for audit committee composition and expertise.
I also emphasize the need for financial experts – and indeed all members of audit committees – to be independent of the auditors and providers of non-audit services to the issuer, as well as of the issuer itself.
Boards of directors face substantial difficulties in fulfilling their responsibilities. SEC rules should assist by providing (i) clear direction for new decisions assigned to them, (ii) protection for Boards that take and reveal these decisions in good faith, and (iii) adequate flexibility for Boards to identify, attract, and fully utilize those experts who developed their understanding and experience in nontraditional roles. The proposed modifications and comments contained in this letter would further assist Boards, the exchanges, and the Commission in promoting the major goals of P.L. 107-204, the Sarbanes-Oxley Act, which include strengthening corporate Board governance and ensuring adequate independence of a company’s financial decision makers from its audit and/or consulting firms.
CEO Council of Florida