Shook, Hardy & Bacon, L.L.P.
November 29, 2002
Mr. Jonathan G. Katz
Re: File No. S7-40-02
Dear Mr. Katz:
We are submitting this letter to comment on the proposed rules being promulgated by the Commission pursuant to Section 407 of the Sarbanes-Oxley Act of 2002. In general, we are concerned that the proposed definition of "financial expert" is too narrow and may result in a less qualified class of financial experts than could be obtained, and would be available, if a broader definition were applied.
Accountant Focused Definition
We believe the proposed definition focuses too much on accounting expertise and very little on financial expertise. Many of our clients have looked to experienced active and retired chief executives, investment banking professionals and academicians in the areas of finance and economics ("Academicians"). These individuals have business experience and knowledge that could provide greater value to the audit committee than mere technical knowledge of generally accepted accounting principals ("GAAP"). To the extent technical issues are presented, section 10A(m) of the Securities Exchange Act of 1934 (the "Exchange Act") provides the audit committee with an open checkbook to retain independent technical advisers who they can generally rely upon in good faith under state corporate law (see, Delaware General Corporation Law §141(e)).
Performance of Similar Functions
The proposed definition of "financial expert" provides that a person who does not meet one of the enumerated categories (i.e., a public accountant, auditor, principal financial officer, controller or principal accounting officer of a reporting company) can be a financial expert if the board of directors determines that he or she has experience in one or more positions that involve the performance of similar functions or that results in the person having similar expertise and experience. If the board makes such a determination, it is required under Instruction 2 to disclose the basis for such determination.
We are concerned that inadequate guidance has been given to boards as to how to make this determination. For instance, must the person have held a position with a reporting company, or can the board rely upon an analogous experience not involving a reporting company. We also see little value in the board being required to disclose the basis of the determination and fear that such disclosure will further drive companies away from consideration of individuals who are not strictly accountants and who do not satisfy the rigid requirements of Item 309.
Economics and Independence of the Financial Expert
Many commenters have expressed their concerns about the availability of an adequate number of individuals to satisfy the financial expert requirement for all public companies and mutual funds. We echo those concerns and would hope that the final rules give companies more latitude and more comfort in satisfying those requirements with executives or professionals with adequate financial expertise.
We also point to the expected increased cost of finding and maintaining an audit committee. Many attorneys are counseling their individual clients to not except positions on audit committees. Uncertain risk in the area of litigation and the increased public scrutiny of audit committee actions may result in the perceived costs of working on an audit committees to exceed the perceived benefit. While this can be characterized as merely a cost of doing business in the public securities markets, there are adverse consequences. These consequences are exacerbated by the shrinking population of available financial experts that may arise as a result of the proposed rules.
Companies may be required to hire professional financial experts who will be placed on the boards and paid substantial fees. This alone creates concerns about independence as the amount of the fee becomes a more material part of the expert's total compensation or net worth. If the pool of qualified financial experts is decreased due the proposed definition, we can expect to see fees increasing, perhaps significantly. With this scenario, one can imagine financial experts working for two or three public companies as their sole source of income. These experts may become virtual employees, elected to the board through the proxy machinery controlled by management. We would suggest that independence in such cases could be compromised.
Instruction 3 to Reg. S-K Item 229.309 lists a number of factors that a board can consider in evaluating the education and experience of a potential financial expert. Instruction 4 states that those factors are not replacements for the attributes listed in Instruction 1 and requires each financial expert to satisfy all of the attributes listed in Instruction 1. Those attributes focus entirely on accounting knowledge and experience that many financially astute directors may not completely satisfy. Further, it seems inconsistent that chief executive officers, who are now required to certify the financial statements of their own reporting companies, may not qualify as financial experts to another. Ironically, many chief executive officers, investment banking professionals and Academicians would have difficulty satisfying the attributes of Instruction 1, but a junior level CPA having recently passed the CPA exam might satisfy each attribute.
We would recommend that the Commission modify the attributes in Instruction 1 to clearly allow non-accountants to qualify as a financial expert. In clause (a), it is unclear what satisfies an "understanding" of GAAP and financial statements. Please consider replacing "[a]n understanding" with "[a] general understanding," "[a] working knowledge" or similar language. More importantly, clauses (b) and (c) of Instruction 1 seem to require specific accounting experience. Clause (b) states that the potential financial expert must have experience applying GAAP in connection with estimates, accruals and reserves generally comparable to those of the company. Clause (c) states that the potential financial expert must have experience preparing or auditing financial statements that present accounting issues that are generally comparable to those of the company. As proposed, these clauses make it almost impossible to designate a financial expert that has not had very specific experience in preparing or auditing financial statements (i.e., specific accounting experience). We suggest that clause (c) be moved to Instruction 3 as a factor for consideration of education and experience, and that clause (b) be revised to qualify an individual who does not have hands-on experience applying GAAP in connection with accounting for estimates, accruals and reserves if the individual has experience, as an executive officer, investment banking professional or Academician that allows such individual to understand the company's application thereof.
We also ask the Commission to consider adding to the factors in Instruction 3, the following:
l. Whether the person is required to provide, or has experience providing, certifications required under §240.13a-14 or §240.15d-14 in connection with the filing of reports by an issuer pursuant to section 13(a) or 15(d) of the Exchange Act;
We are also concerned with the requirement that the financial expert's qualifying position be with a company filing reports pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"). This also significantly reduces the pool of available experts and would exclude individuals that have financial expertise and experience with private companies. We would recommend consideration of making this a factor for evaluating education and experience under Instruction 3, rather than a required attribute under Instruction 1.
Please consider expanding the definition of "financial expert" to allow companies to designate individuals, such as chief executives, investment banking professionals and Academicians, as their financial expert. Also, please consider removing the requirement in Instruction 2 of Item 309 that the board disclose the basis for its determination.
Thank you for the opportunity to comment on the proposed rules.