Calvert Group, Ltd.November 27, 2002 Via electronic delivery: rule-comments@sec.gov
Re: Disclosure Required by Section 407 of the Sarbanes-Oxley Act of 2002 (File No. S7-40-02) Dear Mr. Katz: On behalf of Calvert Group, Ltd. 1 ("Calvert"), we are writing to comment on the proposal by the Securities and Exchange Commission (the "Commission") to implement the requirements in Section 407 of the Sarbanes-Oxley Act of 2002 (the "Act"). The Commission proposal (the "Proposal") would require an issuer to disclose the number and names of persons serving on its audit committee that the board of directors has determined to be "financial experts," as defined by the Commission, and whether they are independent of management.2 If the audit committee has no financial experts, the issuer would be required to disclose the reasons why it does not. In summary, Calvert recommends that the Commission not apply Section 407 to investment companies. Application of Section 407 to investment companies would not aid or protect investment company investors because Section 407 disclosure would not provide such investors with any meaningful information, insofar as there is no need for "financial experts," as contemplated by the Commission, for investment companies. In this regard, the Commission should note that the financial statements and accounting policies for investment companies are relatively straightforward as compared to those of operating companies and should further note the absence of reported abuses regarding investment company financial statements. If the Commission resolves to apply Section 407 to investment companies, Calvert recommends that the Commission adopt a definition of "financial expert" for investment companies that recognizes the differences between operating companies and investment companies. In this regard, the Commission should not limit the occupational background of a financial expert to specified job categories and should eliminate, among other things, the requirement that a financial expert have direct experience preparing or auditing financial statements. We also recommend that the Commission take additional measures to effectuate its position stated in the Proposing Release that the designation of "financial expert" does not impose a higher degree of individual responsibility, obligation or liability on a member of an audit committee, and that the Commission implement a transitional period of eighteen months from the effective date of any new requirements for investment companies to comply with such requirements. I. Statutory Background Section 407 of the Act states that the Commission shall issue rules, as necessary or appropriate in the public interest and consistent with the protection of investors, to require each issuer to disclose whether or not (and if not, the reasons why) the audit committee of that issuer is comprised of at least one member who is a financial expert, as such term is defined by the Commission.3 The Commission has proposed to implement Section 407 with respect to registered management investment companies by adding disclosure requirements to proposed Form N-CSR. As described in the Proposing Release, proposed Item 4 of Form N-CSR would require a registered management investment company to disclose annually the following: (1) the number and names of persons that the board of directors has determined to be the financial experts serving on the investment company's audit committee; (ii) whether the financial expert or experts are independent, and if not, an explanation of why they are not; and (iii) if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert.4 The Commission proposes the same definition of "financial expert" for investment companies as for operating companies, except that it will not include a factor relevant to foreign private issuers.5 The instructions to proposed Item 4 of Form N-CSR therefore would define the term "financial expert" to mean a person who has, through education and experience as a public accountant or auditor or 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 Securities Exchange Act of 1934 (the "Exchange Act"), or experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the company's board of directors, in the person having similar expertise and experience), the following attributes:
II. Application of Section 407 of the Act to Investment Companies Congress provides the Commission flexibility in issuing rules under Section 407 of the Act. Under Section 407, the Commission must issue rules "as necessary or appropriate in the public interest and consistent with the protection of investors" to require each issuer to disclose whether or not (and if not, the reasons why) the audit committee of that issuer is comprised of at least one member who is a financial expert, as such term is defined by the Commission.7 We believe that the Commission should exercise its discretion and not apply Section 407 to investment companies. Application of Section 407 to investment companies would neither further the public interest nor protect investment company shareholders because it would not meaningfully enhance financial oversight or the expertise of investment company audit committees. As an initial matter, we note that in introducing the Proposal, the Commission observed that many of the recent corporate scandals in the U.S. have centered on the quality of a company's financial disclosure and have, among other things, highlighted problems that can occur as a result of inadequate oversight of a company's management and auditors by the company's board of directors or audit committee.8 Investment companies on the whole, however, unlike many operating companies, have not encountered problems regarding financial disclosure. Against this backdrop, the Commission should recognize that the fundamental differences between investment companies and operating companies regarding corporate disclosure and financial reporting militate against application of Section 407 to investment companies. Unlike operating companies, the assets of an investment company are comprised largely of investment securities, and there are limited activities that take place in an investment company. Thus, financial disclosures are more straightforward as compared to operating companies, and the underlying business activities of an investment company are more easily reflected in the financial statements. In addition, few judgments or interpretations of accounting standards are necessary to prepare financial statements of investment companies, and there is less opportunity for differing treatment of transactions or for manipulating interpretations of accounting principles. In light of the foregoing, the enhanced financial expertise required for a designated member of an audit committee of an operating company is not required for an investment company, and thus the Commission's concept of "financial expert" is not relevant to investment companies. The absence of reported abuses regarding investment company financial statements attests to the effective oversight of investment company accounting, auditing processes and financial statements, and to the sufficient financial expertise that already exists on investment company audit committees. We also note that a critical part of Section 407 appears to be intended to address specific abusive practices carried out by operating companies. Section 307 requires the Commission to consider as a factor in defining "financial expert" whether a person has experience in "accounting for estimates, accruals, and reserves."9 This provision appears to focus on certain abuses observed in many operating companies. In contrast to operating companies, investment companies do not employ traditional accounting estimates (most portfolio securities are priced at market value). Furthermore, investment companies accrue income and expenses daily (with little opportunity for differing treatment of transactions) and typically do not have reserves. In addition, the Commission should note the significant fund governance disclosure requirements that already exist for directors of registered investment companies, a number of which were adopted in January 2001.10 Investment companies are required to disclose significant information about their directors in the company's annual report and/or statement of additional information, including occupational experience in the past five years and a description of any relationship or transaction that causes a person to be deemed an interested person of the company. Furthermore, investment companies must disclose all information separately for independent directors and disclose any conflicts of interest of independent directors.11 Each investment company also must disclose information on each standing committee of the board (including an audit committee), including functions of the committee, committee members, and the number of committee meetings held during the last fiscal year. In sum, application of Section 407 to investment companies would not aid or protect investment company investors because Section 407 disclosure would not provide such investors with any meaningful information, insofar as there is no need for "financial experts," as contemplated by the Commission, in the investment company context. Furthermore, such disclosure would not enhance the accuracy of financial statements for investment companies, which, as stated above, have not encountered the financial disclosure problems of operating companies. Application of Section 407 would likely create unnecessary expenses through the recruitment of "financial experts," as defined by the Commission, with no material benefit to investment company shareholders. It also might harm the interest of investment company shareholders in instances where a fund must disclose it has no financial expert on an audit committee, which might unfairly raise negative connotations about an investment company's financial reporting. III. Definition of Financial Expert for Investment Companies If the Commission resolves to apply Section 407 to investment companies, the Commission should modify the definition of "financial expert" described in the Proposal. We believe that the Sarbanes-Oxley Act provides the Commission flexibility in defining the term "financial expert." In this regard, Section 407 of the Sarbanes-Oxley Act of 2002 specifies attributes that the Commission must consider in crafting the definition of financial expert. The Commission should exercise this discretion and modify the definition of financial expert for investment companies in recognition of the differences between investment companies and operating companies, namely the straightforward nature of investment company accounting policies and financial statements, as described above. The Proposal essentially requires a specific occupational record for a financial expert. As stated above, the Proposal requires the financial expert to have experience as a public accountant or auditor or 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 or experience that involves the performance of similar functions.12 Calvert believes that the Commission should not require a financial expert to be selected from a specific occupational category. This narrow requirement excludes a potentially large number of financially sophisticated individuals, such as a chief operating officer, chief executive officer, or other senior corporate officer of a company with financial oversight responsibilities; an accounting professor; and a highly experienced financial analyst or other position with experience in reviewing and analyzing financial statements. Such excluded individuals might have significant investment company experience, including past service on boards and audit committees of investment companies; an understanding of generally accepted accounting principles, financial statements and the operation of internal controls and procedures for financial reporting; an understanding of audit committee functions; and familiarity and experience with the use and analysis of financial statements of investment companies. In short, Calvert believes that there are numerous occupations and experiences other than those identified in the Proposing Release that could provide a financial expert who could provide effective oversight of investment company accounting, auditing processes and financial statements. As stated above, the Proposal also requires that a financial expert show, through the specified educational and occupational background, five attributes. Calvert agrees that a financial expert for an investment company should have two of the specified attributes: (1) a general understanding of generally accepted accounting principles and financial statements and (2) an understanding of audit committee functions. The Commission, however, should not require from a financial expert for an audit committee of an investment company (1) experience applying generally accepted accounting principles in connection with the accounting for estimates, accruals, and reserves generally comparable to those, if any, used in the registrant's financial statements; (2) experience preparing or auditing financial statements that present accounting issues generally comparable to those raised by the registrant's financial statements; and (3) experience with internal controls and procedures for financial reporting. We recommend that the Commission change these three required attributes to factors13 that a Board should consider in designating a financial expert.14 While perhaps necessary for a financial expert for an operating company, these attributes are not necessary for a financial expert of an investment company to effectively monitor the accounting and audit processes of, and ensure accurate financial statements for, investment companies.15 As stated earlier, the straightforward structure and accounting of investment companies, as compared to operating companies, justifies fewer restrictions on the potential pool of qualified financial experts for investment companies. As the Commission makes clear, "[t]he role of the financial expert is to assist the audit committee in overseeing the audit process, not to audit the company."16 In addition, the financial expert is to "serve as a resource for the audit committee as a whole in carrying out its functions."17 As demonstrated above, there are a large number of individuals who do not meet the overly rigid criteria proposed by the Commission, but who would be able to effectively monitor the work of outside auditors of an investment company, assess the adequacy of an investment company's internal controls and procedures and gauge the thoroughness of an investment company's financial statements. The Proposal would impose unnecessary requirements on a financial expert for an investment company and also unreasonably limit the number of experienced individuals who could fulfill the responsibilities of such a financial expert. The Commission should allow an investment company Board to evaluate the totality of a potential financial expert's education and experience, without undue restrictions. IV. Potential Liability of Financial Expert The Commission states in the Proposing Release that it does not intend to impose a higher degree of individual responsibility, obligation or liability on audit committee members designated as "financial experts," nor does it intend for such persons to be considered experts for purposes of Section 11 liability under the Securities Act of 1933.18 In this regard, the Commission should take additional measures to protect financial experts of investment companies, including, but not limited to, a statement in each of Form N-SAR and proposed Form N-CSR that no such responsibility, obligation, or liability should attach to such financial experts. V. Transitional Period Calvert believes that there will be significant competition to obtain individuals who are willing and qualified to serve as financial experts for investment companies, as defined by the Commission in the Proposing Release. In light of the foregoing, we recommend that the Commission implement a transitional period of eighteen (18) months from the effective date of any new requirements for investment companies to comply with such requirements. * * * * * * * * * If you have any questions regarding our comments, please feel free to contact either of us at (301) 951-4881. Sincerely,
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