Martin E. Winter
October 9, 2002
Robert E. Burns, Esq.
Rulemaking Required by Section 407
Dear Mr. Burns:
I understand that you are among those leading the effort on the part of the staff in advising the Commission with respect to the rulemaking on the definition of "financial expert" required by Section 407 of the Sarbanes-Oxley Act - an important matter that appears to have drawn relatively little commentary in the wake of the law's enactment. I write to offer a suggestion on this subject and share a few related views on corporate audit committees insofar as they may prove helpful to you and others at the agency in shaping the forthcoming rule proposal.
By way of background, I was once a principal with Arthur Young & Co. and continue to be a certified public accountant. I later served as the secretary and treasurer of a public company and as chief financial officer of a private investment firm. I currently serve as chief executive officer of Independent Board Advisory Services LLC, a consulting firm that advises boards of directors on corporate governance, financial reporting and accounting matters.
Section 407 and Defining Financial Expertise
The Section 407 Mandate. Over the last few years, many have called for and taken notable steps to strengthen the oversight and involvement of corporate audit committees in the financial reporting processes of their respective issuers. The national securities exchanges, for example, now require committee members to have some degree of financial "literacy" - a standard that, between the leading exchanges, leaves open the question of whether one must be able to read the music or simply be able to play by ear, as it were.
Section 407 of the Sarbanes-Oxley Act, however, now requires something substantially more: that issuers disclose whether or not the audit committee of that issuer is comprised of at least one member who is a "financial expert," as that term will be defined by the Commission in its forthcoming rulemaking. If no committee member is so qualified, the issuer will have to face the difficult task of stating the reasons why not. Although styled as a disclosure rule, Section 407 and its ensuing rules should lead to new and welcome normative standards for the financial savvy of corporate audit committees.
Financial Expertise. The extent to which Section 407 and related provisions of the Sarbanes-Oxley Act may bring about meaningful reforms in corporate governance and financial reporting will, to an important degree, turn on the manner in which the Commission delineates the financial expertise requirement. On this score, Congress has taken steps to ensure that certain critical qualifications be met. Specifically, Section 407 requires the Commission to consider whether the designated 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."
Some following this provision have expressed uncertainty about whether these considerations need only be reviewed by the Commission in formulating its definition or whether they must be part of any definition the agency adopts. In either case, these considerations represent a remarkable list. Among them, emphasis may need to be placed on the need for experience with "generally comparable issuers," particularly given that the Conference Committee saw fit to add this qualification to the already impressive set of criteria proposed by the Senate. In my view, seeking experience specific to the issuer's industry, size and financial complexity, for example, makes good sense.
Near-Term Compliance Challenges
For all the good embodied in the financial expert standard, meeting its terms by the end of this fiscal year and even perhaps the next may be difficult for a majority of our nation's public companies. My own review of the audit committee composition of the Fortune 250, a fairly seasoned and sophisticated sample group, suggested that less than ten percent would currently satisfy the considerations posed by Section 407. I expect that a review of the more than 10,000 public companies who file periodic reports with the Commission would reveal a similar gap and a much better sense of the absolute number of issuers who may struggle at the outset to meet the new audit committee standard, perhaps vying with each other in an early scramble to obtain the people and experience they need (particularly in view of recently imposed rules by the national securities exchanges, including a restriction on the total number of board memberships one person may hold). While I support the implementation of the new standard, I fear that many issuers will feel pressured to fill the post with the first person they can find who meets the definition rather than searching for those best suited to advising them and comparable companies. Given the near-term compliance challenges the new standard will pose, some flexibility, consistent with Commission practice and other provisions of the Act, would likely improve the implementation and ultimate effectiveness of Section 407 and its related rules. Accordingly, I offer the following suggestion.
A Possible Solution to this Near-Term Issue
The Commission might, as it has in the past, allow for a phase-in period for compliance with the forthcoming financial expert standard during which audit committees could engage outside, independent financial experts to satisfy the new rule. Among its provisions, the Sarbanes-Oxley Act cites the authority of public company audit committees to engage their own financial and other advisers, recognizing that many committees have engaged such advisers for some time as a matter of best practice. I believe that a phase-in period of this sort would be consistent with that provision and practice, and result in benefits to issuers and ultimately public investors as companies and boards could conduct more meaningful searches for those directors best suited to providing them with sound advice and judgment on financial matters borne of, among other things, experience with comparable issuers.
Given that possibility, I feel strongly that this option should be subjected to the rigors of the public notice and comment process through the forthcoming rule proposal. I believe that the ensuing commentary from those following Section 407 will bear out its merits. Finally, while others may disagree, I do not believe that an auditor could provide this service to a reporting company audit client given the primacy of its independence obligations and its public watchdog function.
I would be happy to discuss this suggestion and my other thoughts, or supplement them, should you think that would be helpful to you or others at the Commission. You may reach me at the address above or by telephone at (212) 759-4433. Many thanks for your consideration.
cc: Mr. Robert K. Herdman
Giovanni P. Prezioso, Esq.