American Bankers Association
November 29, 2002
Jonathan G. Katz
Re: File No. S7-40-02; Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002
Dear Mr. Katz:
The American Bankers Association (ABA) appreciates the opportunity to comment on the proposed rule, "Disclosure Required by Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002." The focus of this letter is the portions of the proposal relating to Section 407, "Disclosure of audit committee financial expert" and Section 404, "Management assessment of internal controls." ABA brings together all categories of banking institutions to best represent the interests of the rapidly changing industry. Its membership - which includes community, regional, and money center banks and holding companies, as well as savings associations, trust companies and savings banks - makes ABA the largest banking trade association in the country.
The ABA is extremely concerned about the impact of the proposal on audit committees. We recognize that the Securities and Exchange Commission (SEC) is simply attempting to develop rules to implement the Sarbanes-Oxley Act and to comply with both the legal requirements and the intent of Congress; however, in this instance, we believe that the SEC has gone beyond what is required by the Act or intended by Congress. While the intent is to improve corporate governance for the benefit of shareholders and other interested parties, we believe that the proposal could have just the opposite impact. We encourage the SEC to amend the proposal, specifically with respect to the definition of a financial expert and the public disclosure of the name of the financial expert, prior to issuance as a final rule.
SECTION 407 - FINANCIAL EXPERT
Section 407 of the Sarbanes-Oxley Act (Disclosure of Audit Committee Financial Expert) reads as follows:
(a) RULES DEFINING "FINANCIAL EXPERT".-The Commission shall issue rules, as necessary or appropriate in the public interest and consistent with the protection of investors, to require each issuer, together with periodic reports required pursuant to sections 13(a) and 15(d) of the Securities Exchange Act of 1934, to disclose whether or not, and if not, the reasons therefore, 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.
(b) CONSIDERATIONS.-In defining the term "financial expert" for purposes of subsection (a), 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.
(c) DEADLINE FOR RULEMAKING.-The Commission shall-
(1) propose rules to implement this section, not later than 90 days after the date of enactment of this Act; and
(2) issue final rules to implement this section, not later than 180 days after that date of enactment.
To summarize, the law requires the SEC, by January 26, 2002, to issue final rules: (1) defining financial expert, taking into account certain qualifications and focusing on rules that are in the public interest and consistent with the protection of investors, and (2) requiring disclosure as to whether or not the issuer has a financial expert on the audit committee.
The SEC's proposed definition of a financial expert follows, very closely, the language in the statute. The SEC is proposing that a "financial expert" be defined as a person who has, 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 Exchange Act, or experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the company's board of directors, in the person's having similar expertise and experience), the following attributes:
Definition of financial expert
It appears that in determining whether a person qualifies as a financial expert, registrants may choose someone who has: (1) education and experience (including experience related to a registrant), or (2) experience with similar functions (including supervision of others in performing specific functions and analysis of financial statements, but not requiring experience related to a registrant). We believe that the proposed definition is not clear enough on these points and request that the SEC clarify the rules and state that experience includes the supervision of others.
Without clarifying the definition, we respectfully submit that no matter how well intended, the proposed definition of a financial expert is unreasonable and will unnecessarily limit the pool of potential candidates eligible to fulfill that designation. The people in question are supposed to be first directors, and secondly audit committee members, and thirdly financial experts. However, the proposal appears to place the level of importance in the reverse order, which may force companies to search for and settle on candidates who meet the technical requirements, but might not have been otherwise considered because they have too limited a vision and background to be a preferable choice as a director. The financial expert should be someone who has experience in the finance area - a good business person in terms of being able to review and assess the financial information and affairs of an organization regardless of whether it is a public or private organization.
The role of the audit committee and its members is to oversee rather than re-audit the financial statements. The proposed rules appear to be aligned more with the latter than with the former. The Sarbanes-Oxley Act empowers the audit committee with the ability to hire experts. Therefore, if technical expertise is required for a specific issue, the audit committee could hire such an expert.
The proposed definition of a financial expert is so limiting that only a certain group of people would be eligible, and that group is not necessarily the best qualified for audit committee membership. A person could be well qualified as a "financial expert" for audit committee purposes, but will not meet each of the qualifications being proposed by the SEC. Direct experience in preparing or auditing financial statements of an SEC registrant should not be required of the financial expert. That would limit eligible persons to too small a set with, possibly, too small a set of other expertise, which may not make them best suited for the responsibilities required of them. For example, a fairly junior CPA might qualify due to active involvement in preparing 10-Ks or 10-Qs, even though that person might have no experience managing an organization. A controller of a small SEC registrant might qualify, even though a treasurer of a major organization might not. Whether one agrees or disagrees with these specific examples, it is fair to say that the limitations in the proposal for qualifying as a financial expert are severe and not necessarily in the best interests of shareholders.
In the proposal, the SEC states that it has not proposed a "bright line" test and requests comments as to whether such a test is needed. We would argue that the line is actually pretty bright in the proposal, at least with respect to excluding certain types of individuals for eligibility. We believe that the group should be broadened. We also believe that if the SEC is in agreement with our views, then the final rules should so state rather than simply leaving it to the board to make the determination. In other words, a bright line test is not necessary, but the existing test is too restrictive.
In an informal survey of approximately 100 of ABA's community banks, only about 9 banks believe that one of their audit committee members would meet the definition of a financial expert. Clearly, many of those banks are not SEC registrants, but we believe that there could be a significant level of turnover in both large and small bank audit committees as a result of this proposal. We recognize that a company is not required to have a financial expert and can disclose that it does not have one; however, we also believe that companies will try very hard to include a financial expert on their audit committees rather than disclose that they do not have one.
The question is whether the definition as proposed is in the public interest and consistent with the protection of investors. If a qualified person is replaced with a less qualified person, simply based upon the proposed definition, it would not be in the public interest. It would be a disservice to investors and other users of public company financial information if, as a result of this proposal, companies choose to place on their audit committees individuals who have technical financial report preparation experience as opposed to individuals who have significant expertise in financial matters and interpreting financial information. It would be better to include individuals who have the knowledge and experience to inquire as to sensibility and application of accounting principles and whether or not that application makes sense and is being properly presented based on the substance of transactions rather than form. The more global, inquiring, financially savvy individuals do not necessarily fit the proposal definition. The SEC has the ability, within the law, to determine what is in the public interest, and the law provides additional leeway for the SEC by stating that it "shall consider" the various qualifications rather than that it "shall require" them. The SEC has both the ability and the responsibility to ensure that the definition to be used is in the public interest.
Insured depository institutions are already required to include members with banking or related financial management expertise on their audit committees (in accordance with the Federal Deposit Insurance Act). We strongly suggest that the SEC work with the Federal Deposit Insurance Corporation (FDIC) to determine how they define and evaluate financial management expertise. In our view, financial management expertise is different from the proposed definition, in that a manager of such processes would qualify. And, we believe that is appropriate and in the best interest of shareholders.
We do not believe that the SEC is required to use the list of considerations described in the law to define a financial expert; rather, those are to be considered in determining what is in the public interest. However, if the SEC believes that it must use those same qualifications, the SEC might consider changing (b) above from "or from a position involving the performance of similar functions" to "or from a position involving the performance or management of similar functions".
We believe that the SEC should not incorporate the independence requirement into the definition of a financial expert. The new laws are already creating change, and the SEC should permit these new rules to work before requiring an even stricter standard.
We question the portions of the proposal requiring that the financial expert's experience be related to a public company and that the experience be in connection with generally comparable types of accounting. It seems to assume that a good quality audit committee financial expert can only be from a public company and that someone from a different type of company would not be a good financial expert in the context of the registrant. This, clearly, is not the case. It could well be that it would be more valuable to have someone who is a financial expert, but who is also able to come to audit committee meetings with fresh eyes and fresh questions.
Without a change in the definition of a financial expert, we believe that many audit committees will need to search for a person who meets that definition. Banks are typically among the most sophisticated businesses in their communities. Identifying someone who will fit the description as proposed will be difficult, particularly because those criteria will need to be met in addition to the sophistication level that is desired by financial institutions in selecting board members. This is best exemplified by considering community banks, but it can be just as problematic with larger institutions.
The proposal states that "The primary benefit of having a financial expert serving on a company's audit committee is that the person, with his or her enhanced level of financial sophistication or expertise, can serve as a resource for the audit committee as a whole in carrying out its functions." We believe that the specific criteria required by the proposal could result in a person with financial understanding, but not necessarily the financial expertise or financial sophistication necessary to serve on an audit committee. In effect, it could result in a less qualified person and exclude a more qualified person, which would not be in the best interests of shareholders.
The SEC raised several other questions in its proposal, to which we are briefly responding:
Disclosure of financial expert
The banking industry is taking very seriously the requirements of Sarbanes-Oxley and the SEC proposals. Although institutions are permitted to not have a financial expert on the audit committee as long as they disclose why not, this is not something that financial institutions are eager to do. There could be market pressure, regulatory pressure, or internal corporate desire to have a financial expert. The industry would much prefer that the definition of financial expert be amended in the final rules.
Additionally, we strongly advise against disclosing the name of the financial expert and whether such person is independent. We share the apparent concern that the SEC has, as indicated in the proposal, about the level of responsibility that the financial expert may be deemed to have versus other members of the audit committee. Without a doubt, the financial expert will feel an additional burden. We believe that the impression of having additional responsibility, whether it is in fact the case or not, will make it more difficult to find a person willing to serve as the financial expert. The identification by name in a public document of the person who has the desired skill sets and experience should not be seen as the objective; instead, the objective in this case should be to ensure that the board of directors has discharged its fiduciary responsibility to ensure that there is such a director on the audit committee. To require public disclosure of the name of the person simply makes the burden worse, and gives the appearance of heaping additional responsibility on the financial expert. Not only will it be difficult to find someone with the qualifications described in the proposal, but the responsibilities implied by being named the financial expert will also make it difficult to find someone who is also willing to serve.
The law does not require disclosure of the name of the financial expert or whether such individual is independent, and we ask that the SEC not require it in the final rules. Enough focus is already being place on that individual, and further disclosure will only make it more difficult to identify a qualified person who is also willing to serve. Disclosure of whether at least one financial expert serves on the audit committee is sufficient.
Our additional comments relating to disclosure are:
The law requires that the SEC issue final rules to implement these provisions by January 26, 2003. Such date is certainly close, and, depending upon what the final rules require, the result could be fairly extensive searches for qualified financial experts. The law requires the SEC to issue rules by that date; however, it also permits the SEC to determine the effective date of the provisions.
Because companies will need to understand the final rules prior to making any changes in audit committee composition, it would be virtually impossible to have a financial expert in place upon issuance of the rule. The SEC will need to provide sufficient time for registrants to identify the appropriate changes that are needed and to have those changes approved at their regular meeting of shareholders, which is typically when directors are approved. It may be difficult for many companies to identify and obtain agreement from a new financial expert director prior to the 2003 meeting of shareholders. At a minimum, we recommend that existing audit committees be permitted to finish their work relating to companies' 2003 financial statements, and that implementation of the new SEC rules relating to Sarbanes-Oxley section 407 be applicable at the earliest beginning with 2004 financial statements. A rapid compliance with the final rules could inadvertently cause the selection of a director to be a more hurried process than is appropriate for a position of great fiduciary responsibility.
SECTION 404 - MANAGEMENT ASSESSMENT OF INTERNAL CONTROLS
Under FDICIA, banking institutions of a certain size are required to evaluate internal controls, report on them, and obtain an external auditor's assessment of management's reporting. The proposal states that the SEC is coordinating with the federal banking regulators to eliminate, to the extent possible, any unnecessary duplication between the SEC proposal and the FDIC's requirements.
The banking industry spent a significant amount of time and hard dollar costs in order to comply with FDICIA. Those processes have been working for a number of years and can provide the SEC with possibly the only existing methodology that is being used on a broad basis. We believe that the processes have worked and that compliance with the FDICIA requirements should satisfy the requirements under the proposal. The SEC proposal focuses on registrants (holding companies), whereas, FDICIA tends to focus on individual institutions. We encourage the SEC to work with the federal banking agencies to streamline these requirements to avoid duplication and unnecessary costs. From a cost/benefit perspective, it is difficult for us to see any reason to require registrants whose banks are currently complying with FDICIA to follow any additional procedures. They should be able to use their existing systems and evaluation procedures.
We generally agree with the SEC's definition of "internal controls and procedures for financial reporting"; however, we recommend that it be amended as follows: "controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with generally accepted accounting principles as addressed by the Codification of Statements on Auditing Standards Section 319 or any superseding definition or other literature specific to the definition of internal controls that is issued or adopted by the Public Company Accounting Oversight Board."
Our additional comments relating to internal control reporting are:
In conclusion, we appreciate the opportunity to provide our views, and we encourage the SEC to work with industry to help ensure a smooth and appropriate transition. Please feel free to contact me at 202-663-5318 for additional information.