United States of America
Comments of the Edison Electric Institute
I. Introduction and Overview
The Edison Electric Institute ("EEI") appreciates the opportunity to comment on the Securities and Exchange Commission's ("SEC" or "the Commission") Proposed Rule on Disclosure Required by Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002.1 While EEI is generally supportive of much of the Commission's proposal, we have several concerns primarily related to internal controls issues, including our request that a standard reporting conclusion be specified. We are also concerned that: 1) the proposed quarterly evaluations of internal controls would be very costly and of little value; 2) disclosures about codes of ethics, waivers, and compliance need to be kept simple and clear, avoiding duplication; and 3) substantial flexibility should be retained in determining whether a company's audit committee has sufficient financial expertise. We request that companies be allowed the option to consider the expertise of their audit committee as a whole, or to rely on the audit committee of a parent or affiliate, or to use an independent consultant to fulfill the requirement of a "financial expert" to the audit committee.
EEI is the association of the United States investor-owned electric companies, international affiliates, and industry associates worldwide. Our U.S. members serve more than 90 percent of the ultimate customers in the shareholder-owned segment of the industry and nearly 70 percent of all electric utility ultimate customers in the nation, generating almost 70 percent of the electricity produced in the United States.
The Commission states that its proposed new rules and amendments to current rules are intended to implement the requirements in sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002.2 Specifically, the Commission says that Section 404 requires a report of internal controls in a company's annual report with certain requirements, Section 406 requires disclosure of a company's code of ethics for senior financial officers, and Section 407 requires that a company disclose whether its audit committee includes at least one member that is a financial expert and a proposal to define a "financial expert." 67 Fed. Reg. at 66208, column 3. The Commission proposes to expand on these requirements in a number of ways. For example, the Commission also would require companies to disclose whether their codes of ethics apply to their principal executive officers, to disclose all financial experts on the audit committee, and to make certain disclosures in their quarterly reports in addition to their annual reports. The Commission also poses a series of questions about its proposals.
In the remainder of these comments, EEI will respond to a number of these questions and will explain our areas of concern in more detail.
II. EEI Comments on the Commission's Proposals
A.Section 404 Related Requirements -
1. Definition of "Internal Controls and Procedures"
a) The Commission asks whether it should prepare a definition of internal controls and procedures for financial reporting and, if so, whether the proposed definition is appropriate. 67 Fed. Reg. at 66220, column 2.
As the SEC observes in the preamble to its proposed rule, there are a number of existing definitions of internal controls dating back to as early as 1958. Consistency in interpretation of the term "internal controls" as encompassed by the Commission's rule is important. EEI believes that the Commission's proposed definition, which relies on the definition in the AICPA Codification of Statements on Auditing Standards (AU) Section 319, is appropriate. This definition has gained wide acceptance and appears to be reasonably well understood.
b) The Commission asks whether it should define the term "internal controls and procedures for financial reporting" using the AICPA's Codification of Statements on Auditing Standards Section 319 definition and, if not, whether there are any other definitions the Commission should use. Id.
As stated above, the AICPA definition is the most widely used and is appropriate for use in this rule.
c) The Commission asks whether it should prepare specific disclosure criteria and standards for the management report and, if so, what disclosure criteria and standards the Commission should consider. Id.
One of the objectives of developing a company's management report is to assist investors in understanding the risk and control consciousness of the company. Without some standards around the reporting conclusion, the presentation, and thus interpretation of the report could vary widely. EEI believes that there should be standards in place for the benefit of the readers.
The standards should fall along the lines of those used by external auditors when rendering an opinion on financial statements. There should be a standard unqualified conclusion, which could also allow room for further explanation if deemed necessary, but the conclusion itself should be standard. A second option should be similar to a qualified report, where a conclusion is provided with explanation(s) as to variances and the impact variances have on the conclusion. Without this type of standard, there could be a significant diversion of reports subject to a wide latitude in interpretation, making comparisons difficult.
2. Disclosures Relating to Internal Controls and Procedures
a) The Commission asks whether it should change the rules to require periodic evaluations of both the company's disclosure controls and procedures and its internal controls and procedures for financial reporting. 67 Fed. Reg. at 66222, column 1.
EEI has significant concerns about the substantial additional costs and low incremental value that would stem from quarterly internal control evaluations. Internal control evaluations include not only assessing the design of the controls but also the effectiveness of their operation. Performing these assessments will be an extensive and time-consuming process. The external audit firms that will be required to provide an assessment of the annual evaluations are contemplating significant additional costs related to performing this work. If those firms anticipate significant costs to perform an annual assessment of a company's review, it is clear that company management will also be required to spend large amounts of time and resources in performing the annual evaluation. To compound this by requiring such evaluations to be performed quarterly would be excessive.
If internal controls have not significantly changed since a prior evaluation, re-performing the evaluation of controls provides little additional value. But even if the controls have changed, a better approach to disclosure would be the one currently used in company quarterly certifications: Certifying officers should indicate what, if any, significant changes in internal controls or other factors that could significantly affect internal controls have occurred subsequent to the date of the evaluation. This would focus the reader's attention on significant changes, relaying important information to the reader without companies having to expend large amounts of time and resources re-evaluating their overall internal control programs each quarter.
b) The Commission asks whether the company should have to file the attestation report as part of the annual report, if so whether should the report have to appear in a particular part of the annual report, and if so where. 767 Fed. Reg. at 66215, column 2.
EEI believes the attestation report should be filed as a part of the annual report. This will give readers full disclosure and will provide them with knowledge of any reservations the external auditor may have with the internal controls. This report should be located adjacent to the management evaluation report.
B. Section 406 Related Requirements -
1. Definition of "Code of Ethics"
a) The Commission asks whether it should expand the definition of "code of ethics" as proposed, or the definition should adhere to the language in Section 406(c) of the Sarbanes-Oxley Act, and whether other ethical principles should be included in the definition. 67 Fed. Reg. at 66215, column 2.
EEI supports the Commission's proposal to expand the definition of "code of ethics" as proposed. The addition of the second, fifth, and sixth prongs covering avoidance of conflicts of interest, prompt internal reporting of violations, and accountability for adherence to the code are cornerstones of any effective code of ethics.
2. Applicability Disclosures
a) The Commission asks if the new rules should address whether a company has a code of ethics that applies to its principal executive officer as proposed, or should track the language of Section 406 of the Sarbanes-Oxley Act and require a company only to disclose whether it has a code of ethics that applies to its senior financial officers. Id.
EEI would support the Commission's proposal to direct companies to disclose whether their codes of ethics apply to their principal executive officers as well as their senior financial officers because all levels of senior management should be subject to the same code. At the same time, the new rules should reflect that this additional disclosure goes beyond the requirements of the Sarbanes-Oxley Act and is informational.
b) The Commission asks whether the rules should cover a broader group of officers and, if so, which officers the rules should cover, including whether the general counsel or all executive officers should be covered. Id.
Again, EEI would support the Commission directing companies to disclose whether their codes of ethics apply to all executive officers. The executive officers set the ethical culture of the company and should have a common code of ethics that sets forth the standards of ethical behavior. At the same time, if the Commission requires such additional disclosure, the new rules should reflect that additional disclosure goes beyond the requirements of the Sarbanes-Oxley Act and is informational.
c) The Commission asks whether the proposed rules should require a company to disclose whether it has a code of ethics that applies to its directors, whether most companies have a code of ethics that applies to the board of directors, and whether the same code of ethics generally apply to the company's executive officers and its directors. Id.
Again, EEI would support the Commission directing companies to disclose whether they have a code of ethics that applies to their directors, if that information would be of interest to investors. However, EEI is not aware whether most companies have a code of ethics that apply to the board of directors or whether the same code of ethics generally applies to the company's executive officers and its directors. Therefore, if the Commission requires such additional disclosure, the new rules should reflect that the additional disclosure goes beyond the requirements of the Sarbanes-Oxley Act and is informational.
3. Compliance and Waiver Disclosures
a) The Commission asks whether it should require the company to describe its procedures to ensure compliance with the code of ethics. Id.
EEI does not believe that a company should be required to describe its procedures for ensuring compliance with its code of ethics. Publishing the code of ethics will provide investors with substantial information regarding a company's ethics culture. Requiring companies to go further and to publish details about their compliance procedures would add excess detail to company reports that we believe would not be of significant value to most investors, especially because evaluating those procedures would typically require detailed knowledge about company internal structure and operations that most investors will not have.
b) The Commission asks whether it should require the company to describe its procedures for granting a waiver from a provision of its code of ethics. Id.
Waivers to the code of ethics are considered significant events and will be disclosed on Form 8K as proposed. Adding a requirement to disclose the process for granting a waiver adds little value because investors should be evaluating the significance of the waiver granted, not the process used in granting the waiver.
c) The Commission asks whether there are any privacy concerns it should consider that would warrant narrowing the disclosure requirements regarding a grant of a waiver from the code. 67 Fed. Reg. at 66216, column 3.
The description of any waiver granted should be generic enough to protect privacy concerns of individuals.
d) The Commission asks whether a "waiver" is a sufficiently distinct and formal event that the obligation to disclose will not present any difficulties of interpretation, and whether the Commission should modify the requirement to ensure that "de facto, post hoc" waivers of codes granted or acceded to after the occurrence of a "violation" are reported. Id.
Waivers should be sufficiently defined to include distinct and formal events prior to occurrence as well as significant "de facto, post hoc" waivers granted or acceded to after the occurrence. Adding clarity to the definition of a waiver will ensure consistent reporting of waivers by all companies.
4. Disclosure Mechanisms
a) The Commission asks whether a company should have to file the code of ethics as an exhibit to its annual report as proposed and, if not, whether the Commission should require the company to describe the principal topics that the code addresses. 67 Fed. Reg. at 66215, column 2.
The Commission should allow companies either to post copies of their codes of ethics on their websites with a brief reference to the website address in their annual reports or to file copies of the codes as an exhibit to their annual reports. Most companies now have websites, and many post or can post their codes of ethics on those websites. In fact, NYSE companies are required to do so. The Commission should allow companies to rely on website posting rather than imposing a duplicative reporting requirement.
b) The Commission asks whether it should require disclosure regarding the existence of a code of ethics in other reports and registration statements, including Securities Act and Exchange Act registration statements. Id.
If a company has included the necessary disclosures about its code of ethics in its annual report or on its website, that should suffice. Only if a company has done neither (for example because it is a new company and has not yet issued an annual report), or there is a significant change in the required disclosure between annual reports, should the Commission require interim disclosure in some other report or in a registration statement. Multiple disclosures in SEC documents add little marginal value.
c) The Commission asks whether it should require a company to provide the proposed code of ethics disclosure in its quarterly reports, proxy and information statements, and Securities Act registration statements. 67 Fed. Reg. at 66216, column 1.
Again, the Commission should require disclosure in one of these other reports only if a company has not already disclosed information about its code of ethics or there is a significant change in disclosure between annual reports.
d) The Commission asks whether companies that use the Internet to disclose changes to or waivers from their code of ethics also should be required to have technology that allows investors to be notified by e-mail when such new information is posted to the website. 67 Fed. Reg. 66216, column 3.
Such an e-mail requirement should not be put in place, as it would be overly burdensome and impractical to implement. Further, some investors may not have access to e-mail.
e) The Commission asks whether it should require the filing of a Form 8-K regardless of whether a company provides the proposed disclosure about changes to or waivers from the code of ethics on its website. The Commission also asks whether investors need access to this information for longer than 12 months, and how to permit Internet disclosure but also maintain a lasting public record of the information. Id.
If investors need a lasting public record of changes to or waivers from the codes of ethics, and those changes and waivers are not sufficiently reflected in company annual reports, filing these disclosures using the Form 8-K may be the simplest method of maintaining a lasting public record as to such changes. However, EEI encourages the Commission to avoid duplicative records.
f) The Commission asks whether it should specify where and how the disclosure about changes to or waivers from a code should appear on a company's website if the company opts for the website method of dissemination. 67 Fed. Reg. at 66216, column 3.
The Form 10-K should specify the Internet address where the disclosure can be located on the company's website. Companies should have the flexibility of determining where and how the disclosures should appear on their websites.
g) The Commission asks whether there are other means of electronic dissemination it should permit. Id.
EEI does not have other means of electronic dissemination to recommend.
g) The Commission asks whether it should require a company choosing to disclose information about ethics code changes or waivers through its Internet website to provide advance notice in the company's annual report of its intent to satisfy the disclosure requirements in this manner as proposed. Id.
Providing such advance notice in the annual report is advisable. But the Commission needs to allow a transition period for companies to post information about changes and waivers on their websites without such advance notice until their next annual report after the new rules take effect. During this period, companies should be able to post such changes on their website without such advance notice.
5. Miscellaneous Other Code Disclosure-Related Issues
(Proposed Rule Preamble Section II.B. 2, 4, and 5)
a) The Commission asks whether it should require the company to disclose the date of adoption of its code of ethics and the date of the most recent update or the company's frequency of review of the code. 67 Fed. Reg. 66215, column 2.
Some companies have had a code of ethics for many years and may not know the original date of adoption. The Commission should require that the code of ethics include its most recent date of revision. This would establish sufficient version control.
b) The Commission asks whether the code of ethics disclosure requirements should apply to foreign private issuers as proposed and, if not, why not. 67 Fed Reg. at 66216, column 1.
The disclosure requirement should apply to foreign private issuers.
c) The Commission asks whether it should require all Exchange Act reporting companies to disclose their website addresses and, if so, whether it should specify the location of this disclosure (for example on the front cover of all periodic and current reports along with the company's street address) and whether a company should have to disclose its website address in or on the front cover of, all of its Exchange reports, proxy and information statements, Exchange Act registration statements, and/or Securities Act registration statements. Id.
The Commission should encourage companies to reflect their website addresses on their filings but not make it a requirement. This information provides an easy way for investors to access the company's website.
C. Section 407 Related Requirements -
Financial Experts on the Audit Committee
The Commission requests comment on numerous issues relating to disclosure of information about audit committee financial experts. EEI fully supports Congress's goal and that of the Commission of having financial expertise available to the audit committee. At the same time, we encourage the Commission to provide companies with substantial leeway to obtain the necessary financial expertise, by recognizing that a wide variety of training and experience may qualify individuals to provide such expertise.
In this regard, we support the Commission's proposal to allow boards of directors to consider a wide array of factors in determining whether a company has one or more financial experts on its audit committee. The Commission is correct to recognize that no one set of criteria fits all companies or all circumstances. Further, if the Commission were to define "financial expert" too narrowly, it would exclude highly qualified individuals from serving in that capacity. In addition, we encourage the Commission to revise proposed Item 309 to Regulations S-K and S-B to provide flexibility in securing the requisite independent financial expertise through the services of a consultant, by aggregating the financial expertise and skills of audit committee members, or by relying on the expertise available through a parent or affiliate company.
In the preamble to its proposed rule, the Commission says "[t]he 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. 67 Fed. Reg. at 66210, column 2. As the Commission appears to recognize, there are various ways of providing this expertise to the audit committee, as just discussed.
In the preamble, the Commission summarizes the criteria set forth in section 407 of the Sarbanes-Oxley Act for determining whether a person is a "financial expert." According to the Commission, section 407 requires the Commission to consider whether the person has - through education and experience as a public accountant, auditor, principal financial officer, comptroller (the SEC uses the term controller), or principal accounting officer of an issuer, or from a position involving the performance of similar functions - various qualifications, including experience in the preparation or auditing of financial statements of generally comparable issuers and the application of generally accepted accounting principles in conjunction with the accounting for estimates, accruals and reserves. 67 Fed. Reg. at 66211, column 1.
The Commission's proposed instructions to Item 309 of Regulations S-K and S-B build on this definition by reflecting that the company board of directors can determine whether a person's prior training and experience qualify that person to serve as a financial expert, including experience "preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements." In addition, the Commission lists 10 factors that a company's board of directors should consider in determining whether a potential financial expert has the requisite attributes, including the person's direct experience reviewing, preparing, auditing, or analyzing financial statements filed under Exchange Act sections 13(a) and 15(d), level of familiarity and experience with the use and analysis of financial statements of public companies, and other relevant qualifications. Finally, the Commission notes that this is not intended to be an exhaustive list, and that the proposed rules do not specify the number of factors that an individual must satisfy. Instead, the Commission would allow the board of directors to determine the right mix of necessary education and experience. 67 Fed. Reg. at 66211, column 2 through 66212, column 2.
EEI agrees with the Commission's proposal to allow flexibility and judgment in applying the financial expert disclosure requirement. This approach should allow companies to obtain the necessary financial expertise for their audit committees while also ensuring that the companies can obtain directors with the substantial, broad-scale business and other backgrounds necessary to provide broad policy advice to the company and its management. A board member who is not an accountant, auditor, CPA, or CFO can still have the experience and intellect to read and understand financial statements, to understand and apply internal controls and fulfill audit committee functions, and be able to assess whether a company's financial statements fairly present the financial condition of a company. We encourage the Commission to allow such individuals to serve as audit committee members and financial experts by preserving in its final rule the language in the proposed rule that would allow the board of directors to make this determination. We also encourage the Commission to recognize that an individual does not have to come from a publicly-traded company background, nor from the same industry or the same size company, to have necessary or beneficial financial expertise.
In addition, as already mentioned, the Commission should allow companies the option to obtain financial expertise from their audit committee as a whole, from a parent or affiliate's audit committee, or from outside consultants. Neither Sarbanes-Oxley nor the Commission requires that there be an individual financial expert who meets all the stated criteria on the company's audit committee, perhaps in recognition that a variety of broader considerations apply to the selection of board members. Given that Congress has recognized the importance of having financial expertise available to the audit committee without specifying that one individual must provide such expertise, the Commission reasonably can allow companies to obtain such expertise in manners other than by having a single financial expert as a member of the committee.
One obvious mechanism would be for the committee to secure the services of a financial expert as an independent advisor to the committee in the same way that compensation committees may retain the services of independent executive compensation consultants. In addition, the Commission's desire that the audit committee have a high level of financial expertise could be fulfilled by aggregating the financial experiences and expertise of all members of the audit committee to fulfill the specific criteria established by the Commission, or by allowing the company to rely on a parent or affiliate audit committee's financial expertise.
Congress seems to have left up to the board the determination whether this additional level of expertise needs to be provided by a single member of the audit committee or through such other means. Therefore, we recommend that the Commission revise proposed Item 309 to Regulations S-K and S-B explicitly to provide such flexibility in securing the requisite independent financial expertise through options such as the financial expertise of the audit committee as a whole, a parent or affiliate's audit committee, or the services of a consultant. Any of these options should qualify as an acceptable method of fulfilling Congress's and the Commission's desire to have adequate financial expertise available to the audit committee.
Finally, the Commission should defer application of the new disclosure requirements until the next proxy season, to give companies time to satisfy the requirements.
III. Summary of EEI Concerns
To summarize the concerns of EEI and our members, we request that the Commission take all our comments into consideration with particular emphasis on internal controls issues, including our request that a standard reporting conclusion be required. We are also concerned that the costs of the proposed quarterly internal control evaluations will be prohibitive and of little value; disclosures relating to codes of ethics and compliance with and waivers from the codes need to be kept simple and streamlined, avoiding duplication; and the Commission should retain a broad, flexible approach to determining whether a company has requisite financial expertise on its audit committee. We also request that the use of the audit committee as a whole, a parent or affiliate audit committee, or an independent consultant be allowed to fulfill the requirement of a "financial expert" to the audit committee. Finally, the Commission needs to provide for orderly transition to any new rule, allowing companies to comply with the new rule as of the next annual report or proxy statements, as discussed above.
If the Commission or its staff have any questions about these comments, please contact either me at the following phone number, Julia Valliere at (202) 508-5449, David Stringfellow at (202) 508-5494, or Henri Bartholomot at (202) 508-5622.