Computer & Communications Industry Association
November 25, 2002
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
RE: File No. S7-40-02
On behalf of the Computer & Communications Industry Association (CCIA), I submit the following comments regarding the Security and Exchange Commission (SEC) proposed rules regarding requirements for "financial experts" on corporate audit committees pursuant to the Sarbanes-Oxley Act. CCIA supports the goals of the Sarbanes-Oxley Act to improve corporate governance and to restore investor confidence in publicly traded companies. However, we are concerned that the new requirements for financial experts on audit committees could impose difficult burdens on many companies without providing significant improvement in corporate oversight or benefits to investors.
CCIA is an association of computer, communications, Internet and technology companies that range from small entrepreneurial firms to some of the largest members of the industry. CCIA was founded over 30 years ago and our members include equipment manufacturers, software developers, providers of electronic commerce, networking, telecommunications and online services, resellers, systems integrators, and third-party vendors. Our member companies employ nearly one million people and generate annual revenues exceeding $300 billion.
In its proposal, the SEC seeks input on its proposed rule establishing the criteria for financial experts. Among other questions, the SEC asks:
- Should we require a financial expert to have direct experience preparing or auditing financial statements of reporting companies? Should experience reviewing or analyzing such financial statements suffice? If so, why?
- Should a financial expert have to possess all of the "attributes" listed in the proposed definition? Should we broaden the scope of individuals who may qualify as such an expert?
CCIA respectfully submits that these two issues are in fact subsets of the same question, and that is, which elements listed in the proposal are critical to ensure the proper functioning of an audit committee? As explained in greater detail below, we believe that a financial expert should be required to possess all of the attributes set forth in Sarbanes Oxley except direct experience preparing or auditing financial statements, and should have more broad-based financial experience as set forth in the additional criteria the board should consider.
The Proper Role of the Audit Committee is Oversight, Not Preparation
Notwithstanding the failings of the audit committees in recent well-documented corporate collapses, the proper role of the audit committee, while vital, is in many way limited. To quote Lynn Turner, former Chief Accountant for the SEC, "the role of the audit committee is one of proactive oversight of the financial reporting and disclosure process and the results of that process. It cannot supplant the day-to-day responsibilities of management to ensure the accuracy of the financial statements." If proactive oversight, further defined by some to mean the willingness and ability to challenge management and the board constructively, is the objective, it makes sense to consider whether at least one member of the audit committee possesses the tools to conduct this type of due diligence.
The skills that a financial expert should possess to challenge the external auditor and management constructively include:
- Ability to review and comprehensively understand and challenge the conclusions set forth in the financial statements;
- Ability to understand the risk environment in which the issuer operates;
- Thorough understanding of the nature of the issuer's business and an understanding of its business operations;
- An understanding of the securities law requirements for public issuers and particularly for issuers in a similar business or industry sector; and
- A thorough understanding of public issuer financial statements through experience analyzing and reviewing financial statements.
As the proposal now stands, we support the expansion of the types of backgrounds one might possess to qualify as a financial expert beyond the strict accounting and financial requirements of Section 407 of the Sarbanes-Oxley Act. The proposed rule, in this regard, is a significant improvement, reflecting the value of diverse membership and experience on the audit committee.
The addition of other criteria that the board should consider in determining who is or is not a financial expert also appropriately reflects that a variety of skill sets are required to conduct proactive oversight. Moreover, explicitly requiring the board to review its audit committee members to ensure that at least one person possesses the requisite experience to challenge the management and the auditors meaningfully is a substantive and much needed improvement on Section 407 that we embrace.
Despite these strong improvements, the proposed rule contains a major flaw that inevitably would not improve investor confidence in the functioning of an audit committee. By requiring the financial expert to possess direct experience preparing audit or financial statements, the SEC assumes that only individuals with an audit background can provide the level of oversight that is necessary post-Enron. Similarly, by limiting the definition of financial expert only to those with a finance and accounting background, the proposal comes dangerously close to depriving the Board and management of the disparate perspectives that are critical to constructive and willing due diligence. Those who understand the environment in which the issuer conducts business, and the competitive risks that it faces are in a much better position to raise questions about whether the financial statements fairly and accurately reflect that business and environment than one who simply understands GAAP.
In contrast, putting the emphasis on an audit committee member's actual experience preparing or auditing financial statements neither guarantees that the individual has the capacity and experience to challenge the audit results intellectually, nor assures that the underlying financial statements are fairly or accurately prepared and presented. It does begin to move the audit committee down a slippery slope, away from oversight and due diligence, to encroach upon the role of the external auditor and day-to-day management, threatening to engulf the audit committee in technical questions as to how GAAP should be applied. By emphasizing practical experience preparing or auditing financial statements, the proposal sends a message to every audit committee member that his or her first priority should be on technical accounting issues, and not the larger accuracy and fair presentation issues that should be the domain of the audit committee. Once the audit committee journeys down this path, the question then becomes, who oversees the overseers? It also bears repeating that the problem with Enron and its progeny was not that these companies failed to have qualified members on the audit committee. It was that these members failed to discharge their responsibilities, and did not fulfill their fiduciary duty to the companies or their stockholders.
Attached are suggested modifications to the SEC's proposed rule, which we believe would ensure appropriate and effective representation on corporate audit committees. We believe that with these suggested changes, the SEC would make certain that qualified and capable men and women will serve on these important entities.
Jason M. Mahler
Vice President and General Counsel
Disclosure Required by Section 407 of the Sarbanes-Oxley Act of 2002
(CCIA comments in italics)
- Transition Period: If no transition period is provided, upon effective date of the new rules, many public issuers will immediately be out of compliance. Furthermore, competition to find qualified members to serve as the financial expert on audit boards will likely be quite intense, particularly if the SEC adopts the rule as proposed. Consequently, a transition period is necessary, preferably one that is at least 18 months from the rule's effective date.
- Name and Process: The SEC asks whether it should require the name of the financial expert to be disclosed, as well as the process used by the board to determine who is the financial expert on the board. The impetus for the rule is to allow investors to assess the credentials of the individual(s) serving as the financial expert.
(a) There is value to investors in articulating the reasoning behind the selection of the financial expert, specifically the factors that merited selection. By articulating the selection criteria, investors can determine for themselves how qualified the financial expert is to carry out audit committee responsibilities.
(b) All members of the board and the audit committee owe fiduciary duties to investors. All members of the audit committee have a responsibility to conduct due diligence and oversight to ensure that the financial statements accurately and fairly present the finances and operations of the business. By requiring biographical information on each board member, investors can conclude whether the board, individually and collectively, is qualified to discharge its responsibilities. This information is already required in proxy materials. Identifying the financial expert by name, on the other hand, lends no additional probative value and may, in fact, create an unrealistic public perception. At a minimum, identifying the financial expert may create a perception among the public that this individual has special responsibilities not shared by the rest of the audit committee and the board itself, or that the responsibilities of the other members is somehow diminished. The designation of a financial expert by itself creates this conflict, but identifying this expert by name exacerbates the problem.
(c) If the SEC chooses not to adopt a rule that requires the identification by name of a financial expert, it is imperative that the Commission explicitly, as part of the rule, adopt language that negates the perception that the financial expert has special responsibilities or liabilities, and, conversely, that other audit committee members do not have lesser responsibilities.
- Impact on Listing Exchanges: Under Section 301(m) of the Sarbanes-Oxley Act, the SEC is directed, by March 2003, to direct the national listing exchanges to change their rules to prohibit the listing of any issuer not in compliance with audit committee requirements of the Act. As a consequence, the listing exchanges are moving to revise their listing requirements to comply with the Sarbanes-Oxley Act. NASDAQ has already proposed to strengthen its financial expert rules to mirror the Section 407 requirements. If the SEC implements the rule as proposed, NASDAQ will be forced to update its rules to reflect these additional requirements. Thus, although the law is written simply as a disclosure requirement (disclose who is the financial expert or the reasons why there is no financial expert), the practical consequences are that an issuer on NASDAQ potentially faces delisting if there is no financial expert on its audit board. This is particularly a problem if no transition period is permitted. The practical effect is beyond the law's requirement and arguably beyond the law's intent.
Code of Ethics:
(a) The SEC asks whether the code of ethics should be disclosed as part of either the annual report, or other filings required under the federal securities laws, and whether the process for ensuring compliance with the code should be published. It also suggests that perhaps simply stating that the code exists, or publishing the topics covered in the code might suffice. There is unquestionable value, if one is forced to codify ethics, in ensuring that the document is a living blueprint through an effective enforcement and compliance effort, including how frequently the plan is reviewed. On the other hand, required public disclosure of an increasing amount of the day-to-day management and oversight responsibilities may subject honest and effective management to the constant threat of harassment and second guessing by well meaning members of the public, draining resources away from more productive pursuits. Simply disclosing that a public issuer has adopted a code of ethics should suffice since a misleading or materially false disclosure will subject the individual and issuer to potential liability.
(b) Changes and Waivers:
- Form 8-K: The SEC is proposing to add a requirement to file a Form 8-K whenever a waiver is granted to an officer covered by the code, or the code is changed. Minimally, to avoid triggering the requirement that a filing is required for even technical corrections, the SEC should adopt a materiality standard relating to changes in written codes of ethics. Additionally, the SEC needs to give guidance as to what constitutes a waiver for these purposes. For example, does an exception granted pursuant to a process within a code of ethics whereby certain actions are excepted if the process is followed and certain approvals obtained constitute a waiver for purposes of this Act?
- Internet Disclosure: Certain issuers may choose to use their websites as an alternative to filing a Form 8-K to notify individuals of a change/waiver in code of ethics. Again, this should probably be modified by some materiality standard. If this option is selected, the change must be posted for 12 months, and retained indefinitely for five years (on the theory that Form 8-Ks of available to investors indefinitely.) There is a further suggestion that the SEC may require the use of technology to notify investors as to changes in the code of ethics as they are posted on the website. This requirement may not only be fairly burdensome, but practically impossible as it is highly unlikely that a public issuer has e-mail information on every single shareholder. Moreover, why place a greater obligation on issuers, that choose to post on a website rather than on those filing a Form 8-K Finally, the SEC wants input as to whether it should tell companies opting to use the website method where to place it. Other than a requirement that the posting be clear and conspicuous, the SEC should not be in the business of designing websites. It simply does not have the resources, nor is a single answer appropriate for every website or every company.