November 29, 2002
Jonathan G. Katz
Re: Release Nos. 33-8138, 34-46701, IC-25775 (the "Releases"); File No. S7-09-02
Dear Mr. Katz:
We appreciate the opportunity to comment on the proposed rules (the "Proposed Rules") implementing Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"). Our comments are based on our experience representing issuers, although the comments are solely our own and are not intended to represent the views of our clients.
We share the Commission and Congress's desire to improve the standards applicable to reporting issuers' audit committees, codes of ethics and internal controls and the availability of information concerning an issuer's ability to meet those standards. The goals of informing the investing public of what types of expertise is on an issuer's audit committee, setting out the ethical standards principal executive and senior financial officers are held to, and providing investors with necessary confidence in the quality of an issuer's internal controls are laudable. We are supportive of these provisions in the Sarbanes-Oxley Act and their purpose. We are also supportive of the intent behind the regulations proposed by the Commission. Our comments to the Proposed Rules aim to highlight provisions that could have the effect of working against the purported purpose. In each situation we have attempted to provide constructive comments that we believe would reinforce the goals of the Proposed Rules and the Sarbanes-Oxley Act.
Comments to Provisions Implementing Sarbanes-Oxley Act Section 407 - "Financial Experts"
We believe that the Commission should use the definition of "financial expert" found in the Sarbanes-Oxley Act. The Sarbanes-Oxley Act set forth a fairly detailed description of the criteria to be used to establish whether a person that was serving as a member of an issuer's audit committee could be designated a "financial expert". The Sarbanes-Oxley Act implied that the pool of persons would, with some exceptions, be limited to, among other things, persons who have experience:
We are supportive of a definition of "financial expert" that ensures that the investing public is aware of whether there are persons acting on an issuer's audit committee that are well versed in financial statements and financial reporting. However, we are also concerned that if the definition is so narrowly defined the pool of available "experts" will be so shallow so as to make it difficult and in some cases impossible for an issuer to recruit qualified members to its audit committee. We believe that a number of changes the Proposed Rules make to the definition of financial expert found in the Sarbanes-Oxley Act will have this effect, while at the same time providing little or no added protection to investors.
First, under the Proposed Rules, a financial expert would be required to have experience applying GAAP in connection with the accounting for estimates, accruals and reserves that are "generally comparable" to those used in an issuer's financial statements. As well, the Proposed Rules would require financial experts to have experience preparing or auditing financial statements that present accounting issues "generally comparable" to those raised by the issuer. While these changes to the wording in the Proposed Rules from the Sarbanes-Oxley Act are subtle, we believe that they could be interpreted to have a meaningful difference in application. By focusing on "generally comparable" to a reporting issuer as opposed to having familiarity with "financial statements of generally comparable issuers", we are concerned that the Commission has unnecessarily narrowed the pool of financial experts. Based on the Proposed Rules, it would seem that an issuer may be limited to choosing persons to serve in the financial expert capacity that:
Due to the need to recruit independent directors, most of the persons in the first two categories would be unavailable. Practically, persons in the last category would also likely not be available. Therefore, we are concerned that if the definition in the Proposed Rules is retained, issuers will have a difficult task in recruiting "financial experts" to serve on their audit committees.
As a result, we would recommend that the Proposed Rule be modified to utilize the Sarbanes-Oxley Act definition of financial expert and reference to "generally comparable" to the issuer to be removed.
Second, we do not believe that a "financial expert" serving on the audit committee of a foreign private issuers should be required to have experience in the reconciliation of financial statements to U.S. GAAP. We suggest that financial experts on the audit committees of foreign private issuers should only be required to have experience in dealing with the generally accepted accounting principles used by the issuer.
The Proposed Rules would create the expectation that, in order to be considered a financial expert, a person dealing with the financial affairs of a foreign private issuer would need experience not only with the GAAP of the issuer's home country but with U.S. GAAP as well. We believe that in many jurisdictions few, if any, individuals would have this requisite level of financial experience, making it difficult for the audit committees of foreign private issuers to contain a "financial expert" as defined in the Proposed Rules. We therefore recommend that, in the case of foreign private issuers, the definition of "financial expert" be drafted to accommodate persons with recognized expertise in financial accounting in accordance with the standards of the issuer's home country. If the Commission is concerned that this standard differs from that expected from financial experts of U.S. issuers, provision could be made to disclose in its Form 20-F that the foreign private issuer in applying the definition did not take into account whether the financial expert had experience in the reconciliation of financial statements with U.S. GAAP.
Third, we believe that financial experts should not be limited to persons that have gained their experience at U.S. reporting companies. Persons who have gained their financial experience at companies that are not reporting companies should not automatically be excluded from qualification as a "financial expert". The requirement that financial reporting experience be gained at U.S. reporting companies imposes a significant hurdle, in particular for foreign issuers. We believe that persons who have obtained considerable financial reporting experience at companies which had not at the time listed securities in the United States may nevertheless have the ability to critically analyze an issuer's financial reports, and the exclusion of these persons from qualification as "financial experts" solely on the basis that such experience was not gained at U.S. reporting issuers would impose an undue burden on such issuers without measurable benefit to investors.
Under the Proposed Rules, issuers would be required to disclose the names of any financial experts. The rationale for this Proposed Rule is that such disclosure would assist investors in evaluating "the disclosure that describes the background and business experience of the company's directors." It is not clear to us how the disclosure of the name of any financial expert would materially assist investor evaluation of an issuer's directors. The names of all the audit committee members are disclosed in the annual report and proxy statement of an issuer and an investor can easily determine the amount of experience any director has. We do not believe that informing the investing public that a particular person in fact has met the criteria of financial expert provides any more information.
The Sarbanes-Oxley Act's purpose was to make sure investors were notified whether there existed a person or persons that have some standard of financial/accounting competency on an issuer's audit committee. We are supportive of this goal. We however do not believe this goal is furthered by providing the name of any particular individual.
Moreover, we believe that requiring the disclosure of names would discourage people from being considered as a "financial expert". Candidate financial experts may be discouraged from serving if they were so named due to a fear of increased litigation or liability. While the commentary to the Proposed Rule states that there is no additional liability from being an audit committee's financial expert, candidates might understandably feel that the expectation on the part of investors is elevated in relation to audit committee members not named as financial experts. Any judgments made in relation to, for instance, critical accounting policies might be seen by investors as the judgment of the individual financial expert, and not the committee. Should any accrual be reversed or estimate prove to be faulty, investors may disproportionately assign blame and liability to the designated financial expert.
We believe that the potential cost to an issuer as a result of member of the audit committee refusing to be named as a financial expert far outweighs any marginal gain from such disclosure. We recommend not requiring disclosure of the name, but only the existence and number, of any financial expert on the audit committee.
In addition, we strongly urge the Commission to specifically provide in the regulations a clear statement that designation as a "financial expert" does not impose any individual responsibility, obligation or liability under state or federal law.
We agree with the Commission that the Board of Directors should determine what members of the audit committee are financial experts under the definition provided by the Proposed Rules. We also believe that if there are particular criteria an issuer utilizes in making that determination they should state that on their website or in a public filing. We however do not believe it is appropriate for the deliberations of the Board as to whether any particular individual meets the criteria of financial expert should be made public.
The Proposed Rules also request comment relating to whether issuers should disclose information relating to financial experts in their quarterly reports, or disclose the arrival or departure of these experts on Form 8-K. We believe that the best place to disclose whether or not a financial expert is on an issuer's audit committee would be on the issuer's quarterly reports on Form 10-Q. The Commission's pending Form 8-K proposals would already require an issuer to disclose of the arrival or departure of a director on Form 8-K. If the arrival or departure of a financial expert on an issuer's audit committee is similarly made on Form 8-K, this may be tantamount to naming the financial expert, which as we have already discussed may discourage many qualified individuals from serving on audit committees. We also believe that Form 8-K filings are an inappropriate vehicle to disclose the presence of financial experts on an issuer's audit committee, as the sheer number of 8-K filings made by an issuer do not make them an effective tool for the clear disclosure of this information. We believe a specifically designated item in the Form 10-Q will better enable investors to find the relevant information.
Comments to Provisions Implementing Sarbanes-Oxley Act Section 406 - Codes of Ethics
Under the Proposed Rules, reporting issuers would be required to disclose whether or not they have adopted a code of ethics that applies to principal executive or senior financial officers and is in compliance with certain standards. We agree with the substance of these Proposed Rules. However, we request that the Commission make one clarification in the Proposed Rules. Many issuers have and will be required by the NYSE or Nasdaq to have a code of ethics that covers a wide range of topics, including but not limited to those set out by the Proposed Rules. Moreover, these codes of ethics will often incorporate more employees than just the principal executive and senior financial officers of an issuer.
We request that the Commission clarify that an issuer can have one code of ethics that covers more topics and persons than required by the Proposed Rules, so long as the code of ethics at least covers the topics and persons required by the Proposed Rules. We also request that the Commission clarify that any requirement to disclose this code of ethics, or to report waivers or other changes to this code of ethics, specifically apply only to the extent that the provisions mandated by the Proposed Rules affect these persons and topics. This would facilitate issuers having one code of ethics internally rather than two separate ones - one for the Commission rules and another one for other purposes.
Comments to Provisions Implementing Sarbanes-Oxley Act Section 404 - Internal Controls
As currently drafted in response to Section 404 of the Sarbanes-Oxley Act, the Proposed Rules would require issuers to conduct quarterly and annual evaluations of their internal controls. Each annual report would have to include an "internal control report" which would contain, among other things, management's assessment of the effectiveness of internal controls and financial reporting procedures, and an issuer's independent accountants would be required to attest to this evaluation. Also, in each annual and quarterly report, an issuer's CEO and CFO would have to certify that they have evaluated the effectiveness of these internal controls. The quarterly evaluations were not provided for in the Sarbanes-Oxley Act.
While we fully agree with the aim behind these Proposed Rules, our concern is that these rules impose on their face significant new requirements which would create uncertainty among issuers and their accountants. The Commission itself has recognized in its proposing release that the new internal control report and auditor attestation requirements are significant and could be onerous, and has proposed delaying the effectiveness of these rules to enable the Public Company Accounting Oversight Board to adopt standards for auditor attestation engagements, as contemplated by Section 404 of the Sarbanes-Oxley Act, and to allow other relevant parties to prepare for compliance. As currently set out, the Proposed Rules do not indicate what steps independent auditors and management are supposed to take to meet the Proposed Rules' requirements for quarterly and annual evaluations of internal controls.
Currently, the Commission requires interim financial statements included in reports on Form 10-Q to be reviewed by an independent public accountant using generally accepted auditing standards. These standards, as set out in Statement on Auditing Standards No. 71, do not mandate an evaluation of internal controls, but only certain inquiries into an issuer's internal control structure and any significant changes thereto. A full evaluation of the effectiveness of an issuer's internal controls is generally conducted only in conjunction with the annual audit.
We believe that issuers and their officers should stand behind their financial statements and we are supportive of the efforts to enhance the review of internal controls. However, we believe that it would be advisable to put in place a review process to be done annually and then to determine whether or not that process or part of that process can or should be done on a quarterly basis. In particular, we are also concerned that these quarterly certifications be implemented at a time when issuers are already having the time period shortened for the filing of their quarterly results.
We would recommend that the Commission focus on the annual evaluation process and concentrate its effort, in conjunction with the Public Company Accounting Oversight Board, on identifying what role each of the participants - the independent accountants, management, and audit committee/board of directors, is required to play in reviewing an issuer's internal controls.
Once this new improved annual process has been implemented, the Commission could then revisit the concept of adding all or part of this process to the quarterly reviews. Therefore, at that time, certifications made by officers will provide confidence in a meaningful and a well defined process.
We appreciate your consideration of our comments. Please call Timothy E. Peterson of our Firm at 011 44 20 7972 9676 if you have any questions about or require clarification of our comments.