November 29, 2002
Jonathan G. Katz, Secretary
Re: Proposed Rule: Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002
Dear Mr. Katz:
We are pleased to have this opportunity to submit this letter in response to the Securities and Exchange Commission's request for comments on its proposed rules contained in Release No. 34-46701 (the "Release") regarding disclosures required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Act").
A. Proposed Disclosure About Financial Experts Serving on a Company's Audit Committee.
1. Disclosure of the Name of the Financial Expert. Section 407 of the Act requires the SEC to adopt rules regarding disclosure of members of the audit committee who are "financial experts." The Release proposes to add new Item 309 to Regulations S-K and S-B which would require companies to disclose the number and names of persons the board of directors has determined to be "financial experts" serving on the company's audit committee and whether the financial expert(s) is "independent." The Release solicits comments on the question of whether the names of the person or persons designated as financial experts should be disclosed and whether the SEC specifically should address the degree of individual responsibility and liability that a person designated as a financial expert has as a result of the designation.
Our view is that the SEC (a) should not require companies to disclose the name of the person determined to be a financial expert, and (b) should specifically provide, in the most explicit and comprehensive language possible, that there is no additional individual responsibility or liability associated with being designated as a financial expert. It is already very difficult, in the current environment, for companies to attract high quality directors, particularly those who would qualify as financial experts under the new, higher standard. This is particularly true for those companies that are not Fortune 500 companies. We are concerned that qualified individuals will be even more unwilling to accept the designation of financial expert if they are designated publicly as such and if there is not a clear statement by the SEC that no increased responsibility or liability exists from being so designated.
We believe that the purpose of Section 407 of the Act is to encourage companies to include individuals with strong accounting backgrounds on their audit committees by requiring negative disclosures for failing to do so, not to increase the visibility and potential personal legal exposure of those willing to serve as a financial expert. We also believe that naming the designated financial experts will not provide investors with additional comfort or material information. If investors are told whether or not at least one member of the audit committee is a financial expert, the purpose of Section 407 will have been achieved. Shareholders will be able to make their own assessment of the financial acumen of the directors by reviewing the biographical information included for each director and nominee in the annual meeting proxy statement.
2. Definition of Financial Expert. Section 407(b) of the Act provides guidance on what the SEC should consider when defining the term "financial expert." The Release proposes to provide instructions to new Item 309 to Regulations S-K and S-B to guide boards of directors in determining what factors to consider in making that determination. The Release solicits comments on the question of whether the SEC should create a "bright-line" test for the definition of "financial expert" and, if so, what the test should be.
Our view is that because of the wide range of educational backgrounds and experience which should qualify an individual to be designated as a "financial expert," a bright-line test is not practical and could limit a company's ability to find financial experts to serve on its audit committee. Given the difficulty in attracting financially sophisticated directors discussed above, we believe that investors as a whole will be better protected if companies have some discretion in determining what education and experience is required for a person to be a financial expert so that companies will be able to successfully attract and retain members with the desired expertise.
While we generally favor bright-line tests because of their ease of application, in this case, we would recommend instead the use of a safe harbor test, so that if the director met certain requirements, the company would know that the director can be considered a financial expert for purposes of complying with Section 407 of the Act. This would allow companies that prefer the certainty of a bright-line test to have that certainty, but also would allow candidates with more unique accounting experience to satisfy the requirement where deemed appropriate by the Board.
3. Frequency of Disclosure of Existence of Financial Expert. Section 407(a) of the Act requires companies to provide disclosures regarding financial experts in their periodic reporting. The Release proposes to require companies to provide such disclosure in their annual reports, but not in quarterly reports. The Release solicits comments on the question of whether the SEC should require more frequent disclosure or disclosure in other SEC filing documents.
Our view is that annual disclosure of whether a company has a financial expert on its audit committee is adequate. We would not be opposed to a requirement that a company file a Form 8-K disclosing that it no longer has a financial expert on its audit committee if it has previously disclosed that it had such a financial expert, but only if the company has not replaced the departing financial expert within a specified time period. This time period should be in the range of 120 to 180 days to give a company adequate time to find a suitable replacement before being required to make what is likely to be perceived by investors as a negative disclosure. As indicated earlier, we believe that many publicly traded companies, especially smaller companies, may have difficulty finding one, much less two or more, financial experts to serve on their audit committees. Accordingly, if they lose their financial expert for any reason, a requirement that they immediately disclose that fact would be onerous. Instead, they should be given an opportunity to locate a suitable replacement for the financial expert before being required to provide such a negative disclosure. In our experience, the process of finding, interviewing and appointing director candidates, if done correctly, requires a significant effort by a board and generally takes four to six months to complete.
B. Proposed Code of Ethics Disclosure.
1. Officers Covered by the Code of Ethics. Section 406(a) of the Act requires the SEC to adopt disclosure rules regarding companies' codes of ethics for its senior financial officers. The Release proposes to add new Item 406 to Regulations S-K and S-B which would require the code of ethics to apply to the company's principal executive officer as well as the senior financial officers expressly contemplated by the Act. The Release solicits comments on the question of whether the SEC should go beyond the explicit requirements of the Act to cover the principal executive officer and a broader group of officers (including the general counsel).
Our view is that investors have an interest in knowing not only whether a company's senior financial officers, but also whether its principal executive officer, are subject to a code of ethics. Given that the senior financial officers report ultimately to the principal executive officer, we believe that investors are entitled to the assurance that the same code of ethics that covers the financial officers also covers the person with authority over such officers. In addition, we believe that, as a practical matter, companies are likely to have their code of ethics cover the principal executive officer whether or not required by the SEC. Therefore, we believe that the SEC's proposal to go beyond the requirements of the Act is worthwhile in this case because investors can obtain valuable additional comfort without companies being subject to an overly burdensome additional requirement.
With respect to the code of ethics covering a group of officers broader than the senior financial officers and the principal executive officer, however, we agree with the position taken in the Release not to expand the list at this time. We believe that it would not be appropriate to so expand coverage in advance of the final approval of the proposals advanced by the NYSE and Nasdaq on this subject, which are likely to require a code of ethics covering all directors, officers and employees. We believe the SEC requirements and all listing standards on this subject should be uniform.
2. Disclosure on the Internet. Section 406(b) contemplates the alternative of companies making the required disclosure of changes or waivers to the code of ethics by "dissemination by the Internet ...." Proposed new Item 5.05 of Form 8-K would permit a company to provide the required disclosures on its Internet website without having to file a Form 8-K so long as the company disclosed in its most recently filed annual report its Internet address and intention to provide disclosure in that manner. The Release solicits comments on the question of whether the SEC should require the filing of a Form 8-K regardless of whether the company provides the proposed waiver disclosure on its website.
Our view is that companies should be permitted to make such disclosures on their websites without having to file a Form 8-K. Section 406(b) of the Act clearly contemplates this alternative and we believe investors look to companies' websites as a primary source of information. However, we do believe that the SEC should adopt uniform guidelines for how such disclosures are made on the websites (including the duration of the disclosure) so that investors do not have to explore every company's website in order to find such information and so that companies can be certain that they are complying with the applicable disclosure requirements. In addition, we believe that if a company chooses the route of website disclosure, the company should be required to prominently disclose in its Form 10-K its Internet address and intention to provide disclosure in that manner so that investors know that they need to look to the website for more information. We believe this is a practical solution that satisfies the legitimate needs of investors for easy access to company information.
C. Management's Internal Controls and Procedures for Financial Reporting
1. Definition of "Internal Controls and Procedures for Financial Reporting." The Release proposes amendments to Item 307 of Regulations S-K and S-B to require a company's annual report to include disclosures regarding "internal controls and procedures for financial reporting," with such term having the meaning given in Exchange Act Rules 13a-14(d) and 15d-14(d). The Release proposes amendments to those regulations which would define such term by means of a specific reference to the AICPA Codification of Statements on Auditing Standards Section 319. The Release solicits comments on the question of whether such term should be defined, whether the use of the Section 319 definition is appropriate, and, if that definition is not appropriate, what other definition should be used.
Our view is that the SEC should define "internal controls and procedures for financial reporting" for purposes of the requirement that companies provide an internal control report. As articulated in the Release, there have been many attempts to define internal controls in the past by various organizations. As a result, there is significant uncertainty among companies looking for guidance in addressing this disclosure requirement. We believe that all companies should be directed to a single definition of that term so that (a) companies may have increased confidence that they are satisfying the disclosure requirements, and (b) investors may have increased confidence that each company's disclosure is based on the same underlying principles.
We believe that the definition set forth in AICPA Section 319 is satisfactory and should be incorporated by reference in the SEC's rules. Companies should be subject to a single definition rather than one for auditing purposes and potentially another for SEC reporting purposes.
2. Quarterly Evaluation of Internal Controls and Procedures for Financial Reporting. Recently, the SEC adopted new Item 307 of Regulations S-K and S-B to require disclosure in companies' annual and quarterly reports about evaluations of disclosure controls and procedures and whether there have been any changes to internal controls. Even though Section 404 of the Act requires only an annual evaluation of the company's internal controls for financial reporting, the Release proposes amendments to Exchange Act Rules 13a-15 and 15d-15 which would require management to disclose such internal controls evaluation, as well as its evaluation of disclosure controls and procedures, in each of the company's annual and quarterly reports. The Release solicits comments on whether those proposed rule changes should be adopted.
Our view is that the requirement that management evaluate the effectiveness of the design and operation of their company's internal controls and procedures for financial reporting should be limited to annual reports and that companies should not be required to perform such an evaluation on a quarterly basis. Annual evaluations would coincide with the annual filing of the company's internal control report and the auditor's attestation of that report. Unlike the evaluation of a company's disclosure controls and procedures, a requirement to evaluate a company's internal controls and procedures for financial reporting is better suited to an annual evaluation that would be conducted in conjunction with a company's audit of its annual financial statements, the preparation and filing of the company's internal control report, and the attestation of that report by the company's auditors.
Furthermore, we believe that, during each year, investors will be sufficiently protected by the requirement that companies disclose any significant changes to internal controls as well as by the parallel certification requirement under Section 302 of the Act. If the company does not disclose any such changes, then investors can rely on the most recent annual report in which companies have made the required evaluation.
Finally, for the reasons discussed above, because we believe the SEC should not require evaluation of internal controls and procedures for financial reporting on a quarterly basis, the Section 302 certification should not be amended to require quarterly certification on this subject.
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We appreciate the opportunity to provide our suggestions to these important new regulations. Please feel free to contact Mark A. Metz (313-568-5434) or Brendan J. Cahill (248-203-0721) if you have any questions regarding this letter.