P.O. Box 2240
Easton, MD 21601
November 28, 2002
Re: Financial Expert Proposed Rule, File No. S7-40-02
To the Securities and Exchange Commission:
The Commission's proposed definition of the term "financial expert" has positive aspects. For example, it is proper not to have a bright-line test, it is proper for the entire board of directors to make the determination as to which of its members are "financial experts", and it is proper to require that boards disclose the backgrounds of their financial experts or the other reasons that they found those members to be qualified. However, on the key issue of discussing and defining the term, the proposed definition is not in the best interests of good corporate governance.
The requirement should be relatively neutral as to what factors caused a board to make its determination that one of its members is a financial expert. The rule should require that boards disclose whether they have a "financial expert" on their audit committees; and in that disclosure they should be required to state the background of each person they name as a financial expert, including whether that person has experience in auditing and financial statement preparation in companies of comparable complexity.
The way the proposed rule is written almost guarantees that boards of directors will select accountants as their financial experts, even though in many cases people with other backgrounds might equally well or better fulfill that function. The rule should not prejudice the ability of boards of directors to choose qualified non-accountants as their audit committee financial experts. Disclosure of qualifications is sufficient to alert investors if a board has made a careless choice.
A restatement of the Proposed Rule to make it more neutral and more conducive to boards choosing independent members who have the skills that are needed is attached to this letter as Appendix A.
This comment will review five factors that indicate that the Commission's proposed standard should be amended:
- The statutory purpose of the requirement and its reference to factors that the Commission must consider.
- The meaning of the term "financial".
- The character of the people that Congress and the Commission would hope to attract as financial experts.
- Some of the types of people that boards would have a hard time determining to be financial experts under the Commission's proposed definition.
- A look at the real boardroom discussion that the Commission's proposed definition would provoke.
At the outset, let me advise the Commission of my own background: I have represented audit committees of boards of directors, including registered investment companies, banks and public companies, for over 30 years. In that capacity and as a bank officer with oversight responsibility for financial reporting, I have observed the conduct of people with many different kinds of backgrounds as audit committee members. I also have represented, both in an advisory capacity and as litigation counsel, one of the major public accounting firms, and in that capacity have been among the final decision-makers on many sensitive accounting issues. I also have represented and advised the New York State Banking Department on bank insolvency matters. I have been the outside legal counsel for public companies. I also have authored several books in what I used to think was the financial field: one on the S&L debacle; a handbook for bank directors; a pamphlet for bank audit committees; and, most recently, "Corporate Governance for Public Company Directors", Aspen Publishers, 2002 forthcoming.
It is my belief that the Commission's proposed definition of "financial expert" would set back the cause of good corporate governance and would promote "pro-forma-ism" in American boardrooms.
The Proposed Rule's formulation appears to be the Commission's attempt to comply with the inartfully drafted congressional mandate. The Senate Report's description of the financial expert disclosure requirement (which was almost identical in S. 2673, the bill it was describing, to the law as enacted) appears to be a more coherent statement than the statutory language. It reads as follows:
I. Disclosure of audit committee financial expert
As discussed above, the Committee received testimony about the important role played by the audit committee in corporate governance. The Committee believes the effectiveness of the audit committee depends in part on its members' knowledge of and experience in auditing and financial matters. Investors may find it relevant in making their investment decisions whether an issuer's audit committee has at least one member who has relevant, sophisticated financial expertise with which to discharge his or her duties. The bill requires the SEC to adopt rules requiring issuers to disclose whether their audit committees include among their members at least one ``financial expert.'' In defining ``financial expert,'' the SEC shall consider whether a person understands GAAP and financial statements, has experience preparing or auditing financial statements, has experience with internal accounting controls, and understands audit committee functions.
This description makes it clear that the congressional intent was what it should have been: Investors may find it relevant whether the audit committee has members with the requisite financial expertise to perform their functions at a high level. "In defining `financial expert,' the SEC shall consider whether a person understands GAAP and financial statements, has experience preparing or auditing financial statements, has experience with internal accounting controls, and understands audit committee functions." These are appropriate factors for the SEC and boards of directors to consider.
How or why the language of the statute should be subject to interpretations so at variance with its intent does not appear from the written record. But it also is possible to read the statutory language as being consistent its stated intent. That is, the Commission shall "consider" the stated factors in its rule-making.
The dictionary definition of "financial" has nothing to do with accounting. It has to do with managing money; it has to do with analyzing businesses. Accounting, as I have written elsewhere, is merely the language that people use to describe a business. And while it is true that one cannot understand or analyze a business without understanding accounting as a language, the operative process is analysis; accounting, the language, is just a tool. From a definitional point of view, chartered financial analysts, to take an example, may have better training than accountants to perform financial analysis.
To answer this question, we have to define what an audit committee does (and does not do) that is important to the protection of the corporation, its assets and its stockholders. The audit committee does not audit. The audit committee does not prepare financial statements. The audit committee does not design internal controls or risk management systems. The audit committee reviews all those things.
To review well, audit committee members must of course understand the language of accounting, which we call GAAP. But that is only a beginning. They must ferret out the most significant estimates and variables in the particular company's accounting, understand them, and then not be afraid repeatedly to ask apparently dumb questions about them. Accountants tend to be reluctant to ask apparently dumb questions of other accountants. Especially if they are retired accountants, it is natural that they don't want their peers to think they are out of touch or not up to date. Other financial experts are not as likely to be protective of their own image when questioning accountants.
A financial expert serving on an audit committee doesn't just ask "Is this in accordance with GAAP?" A financial expert asks, "Why does this have to be so complex?" And "What is the substance of this transaction?"
Reviewing auditing is difficult for any audit committee member, regardless of how expert. Auditors (inside and outside) can (and often will) tell you all the tests they did. Even for an expert, it's hard to see what important tests might have been missed. Sometimes the auditors will explain some of the tests they didn't do, and that will give an audit committee member an opportunity to ask why. More often, reviewing auditing has to be done like reviewing accounting. Audit committee members have to analyze what the real accounting risks of the business are, and then they have to bore in on those risks and the level of auditing that has been done with respect to them. This takes knowledge of auditing but not experience actually doing it. What this takes most of all is knowledge about how frauds have been perpetrated in the past. My study of corporate frauds, which has been on-going for most of the last 30 years, suggests that there are no genuinely new frauds. Whether we look back at Robert Vesco and Equity Funding 30 years ago or at the Enron and WorldCom frauds of 1997-2001, we find they were nothing new. They were old frauds in modern, complicated packages.
Most frauds aren't even that complex. The accounting profession group "COSO" studied financial frauds from 1987 to 1997 and found that
"Over half the frauds involved overstating revenues by recording revenues prematurely or fictitiously. Many of those revenue frauds only affected transactions recorded right at period end (i.e., quarter end or year end). About half the frauds also involved overstating assets by understating allowances for receivables, overstating the value of inventory, property, plant and equipment and other tangible assets, and recording assets that did not exist."
Financial experts know what to look out for. Analysis, not mechanical auditing, detects fraud.
A financial expert speaks accounting and can analyze a company's financial position and risks. To be a good audit committee member, a financial expert needs one more quality: Persistence. A good audit committee member has to persistently (but politely) ask sometimes slightly nasty and often apparently dumb questions, then follow up persistently if the answers don't 100% hold water. That's the kind of person the definition of financial expert should seek to define.
4. Examples of Directors Whom the Proposed Rule Would Make the Board's Determination of "Financial Expert" Difficult to Explain
The Proposed Rule requires a special explanation whenever a board determines that someone who has no accounting degree and has never been a CFO of a public company or an auditor is in fact a "financial expert". This difficulty would apply, for example, to:
- Every current SEC Commissioner.
- Paul Volcker, Warren Buffet and Robert Rubin.
- Every person who is a Chartered Financial Analyst but doesn't happen to be an accountant.
- Every graduate of Wharton with a degree in Finance who doesn't also happen to be an accountant.
- Every securities lawyer who doesn't also happen to be an accountant.
It seems to me that many of these people are financial experts of exactly the type that we should encourage boards to select as the financial experts on their audit committees. The rule should not prejudice the ability of boards to choose these people.
The key point at which the definition of financial expert matters is when the nominating committee is deciding the profile of the new directors it wants to attract. With the proposed rule's bias in favor of accountants, audit committees will automatically decide they should have an accountant. Why would directors decide otherwise, when to do so will force them to explain what they did, whereas the accountant will get them off the hook?
The issue also may arise after interviewing director candidates. The nominating committee or the board will discuss the candidates and their virtues and drawbacks. If the board does not already have a "financial expert", they will have to try to envision their justification of why somebody who is not an accountant is a financial expert. Somewhere along the way, a director will say, "Why go to the trouble. Let's just take the accounting guy." Everyone will agree.
Unless the Commission believes that only accountants can supervise accountants, it should correct the bias that is inherent in the Proposed Rule. See Appendix A.
Very truly yours,
§229.309 (Item 309) Audit committee financial experts.
Disclose the number and names of the persons that the registrant's board of directors has determined to be the financial experts serving on the registrant's audit committee, as defined in section 3(a)(58) of the Exchange Act (15 U.S.C. 78c(a)(58)). Also disclose whether the financial expert or experts are independent as that term is used in section 10A(m)(3) of the Exchange Act (15 U.S.C. 78j-1(m)(3)), and if not, an explanation of why they are not. Also disclose the education and experience of the financial expert and the basis on which the registrant's board of directors has determined that such person is a financial expert. If the registrant's board of directors has not determined that a financial expert is serving on its audit committee, the registrant must disclose that fact and explain why it does not have such an expert.
Instructions to Item 309.
[Section 1 should describe attributes that the board must find a person to have in order to be considered a financial expert. It should not state how the financial expert has attained those attributes. This list should include a requirement of analytical skill, since that is, in addition to independence, the most important attribute for an audit committee member and the most important aspect of financial expertise.]
1. For purposes of the determination by the board of directors under this Item 309, the term "financial expert" means a person who has, through education and experience, the following attributes:
a. An understanding of generally accepted accounting principles and financial statements;
b. An understanding of how such generally accepted accounting principles apply to the accounting for estimates, accruals, and reserves, if any, used in the registrant's financial statements and has experience with accounting estimates and accruals that are of comparable complexity to the estimates, accruals and reserves used in the registrant's financial statements;
c. The analytical skill to probe whether the registrant's financial statements fairly present its financial condition and results of operations;
d. Experience with internal controls and procedures for financial reporting; and
e. An understanding of audit committee functions.
[The former Section 2 becomes unnecessary.]
3. In evaluating the education and experience of a person, the board of directors should consider the following factors in the aggregate:
a. The level of the person's accounting or financial education, including whether the person has earned an advanced degree in finance or accounting;
b. Whether the person is a certified public accountant, or the equivalent, in good standing, and the length of time that the person actively has practiced as a certified public accountant, or the equivalent;
[Item c is mostly redundant and overemphasizes the importance of being an accountant.]
d. Whether the person has served as a principal financial officer, controller or principal accounting officer of a company that, at the time the person held such position, was required to file reports pursuant to section 13(a) or 15(d) of the Exchange Act, and if so, for how long;
[Item e also overemphasizes the accounting function.]
f. The person's level of familiarity and experience with applicable laws and regulations regarding the preparation of financial statements that must be included in reports filed under section 13(a) or 15(d) of the Exchange Act;
g. The level and amount of the person's direct experience reviewing, preparing, auditing or analyzing financial statements that must be included in reports filed under section 13(a) or 15(d) of the Exchange Act;
h. The person's past or current membership on one or more audit committees of companies that, at the time the person held such membership, were required to file reports pursuant to section 13(a) or 15(d) of the Exchange Act;
i. The person's level of familiarity and experience with the use and analysis of financial statements of public companies;
j. Whether the person has any other relevant qualifications or experience that would assist him or her in understanding and evaluating the registrant's financial statements and other financial information and to make knowledgeable and thorough inquiries whether:
i. The financial statements fairly present the financial condition, results of operations and cash flows of the registrant in accordance with generally accepted accounting principles; and
ii. The financial statements and other financial information, taken together, fairly present the financial condition, results of operations and cash flows of the registrant; and
k. In the case of a foreign private issuer, the person's level of experience in respect of public companies in the foreign private issuer's home country, generally accepted accounting principles used by the issuer, and the reconciliation of financial statements with U.S. generally accepted accounting principles.
4. Although the board of directors should consider the factors listed in Instruction 3, those factors are not replacements for, and a financial expert must satisfy, all of the attributes listed in Instruction 1 to this Item.
5. In the case of foreign private issuers with two-tier boards of directors, for purposes of this Item 309, the term "board of directors" means the supervisory or non-management board.
6. A registrant that is an Asset-Backed Issuer (as defined in §240.13a-14(g) and §240.15d-14(g) of this chapter) is not required to disclose the information required by this Item.