Emerson Electric Co.
November 29, 2002
Mr. Jonathan G. Katz
Washington, DC 20549-0609
RE: Comments on Proposed Rules Pursuant to Sections 404, 406 and 407 of the Sarbanes-Oxley
Dear Mr. Katz:
I am Senior Vice President, Secretary and General Counsel of Emerson Electric Co. ("Emerson"). Emerson's common stock is registered under Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act") and is traded on the New York Stock Exchange. The purpose of this letter is to provide the Commission with Emerson's comments in response to the Proposed Rules Pursuant to Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Act"); Release Nos. 33-8138, 34-46701 and IC-25775, File No. S7-40-02 (the "Proposed Rules").
Emerson supports the goals stated by Congress underlying the Sarbanes-Oxley Act of 2002 (the "Act") to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. However, we are submitting this letter to highlight some of the practical implications that Emerson and other reporting companies are likely to encounter in attempting to comply with the Proposed Rules.
Because the Act gives the Commission a significant role in implementing rules relating to many of the Act's new requirements, Emerson urges the Commission to ensure that, to the extent the Commission has been left with rule-making discretion under the Act and otherwise under the securities laws, including, in particular with respect to the Commission's general exemptive authority pursuant to Section 36 of the Exchange Act and its rule-making authority pursuant to Section 23 of the Exchange Act, it carefully weighs the benefits to the investing public against the burdens to be placed on issuers by any new rules. Emerson submits the following comments before the Commission adopts final rules regarding disclosures of 1) internal control structure and procedures for financial reporting, 2) code of ethics and 3) audit committee financial experts.
Section 404 - Internal Controls and Procedures for Financial Reporting
The proposed definition of "internal controls and procedures for financial reporting" appears too broad. We believe the definition should be a subset of the AU Section 319 definition. For clarity, we suggest that the final rule should limit the definition to "controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with generally accepted accounting principles."
Section 404 of the Act only requires an annual assessment of a company's internal control structure and procedures for financial reporting. Testing of internal controls and procedures for financial reporting on a quarterly basis is not practical and would be cost prohibitive. Testing of internal controls is a continuous process that takes place throughout the year at numerous operational locations of a company, which culminates with the review of all findings from across the company and a determination of whether the internal controls are effective. While we oppose the proposed quarterly review of controls, if the final rule should require some form of quarterly certification, this certification should be limited to negative assurance that nothing has come to the individual's attention since the prior year's evaluation to suggest that the controls are no longer effective. Such a certification is consistent with the Section 302 certification that no significant changes to the controls have occurred during the quarter, and could be incorporated into a single certification.
We believe that the attestation procedures of internal controls by the accounting firm should be limited in scope. Section 404(b) states that the attestation on internal controls shall not be a separate engagement, clearly noting that the procedures should be performed within the context of the audit. Extensive procedures could be cost prohibitive. We have been informed that fees for these reports could range from 20 percent to greater than 100 percent of the annual audit fee. We urge the Commission and Public Company Accounting Oversight Board (the "PCAOB") together with the AICPA, Big Four public accounting firms and industry representatives develop reasonable procedures that weigh the cost-benefit of such testing and attestation. Such attestation should be narrowly defined consistent with the narrowing of the definition of internal controls and procedures for financial reporting previously suggested. Further, the attestation report of the accounting firm on management's assessment of internal controls should not be filed as part of the Form 10-K. Section 404(b) does not require such an exhibit and including it may create an unreasonable expectation by investors of the procedures performed by the accounting firm.
In order to give the PCAOB, the AICPA and registered public accounting firms sufficient time to adopt standards, train personnel, and prepare for the increasing workload, the final rules should apply no earlier than fiscal years beginning after December 15, 2002. A hastened enactment of the rules does not benefit investors, and may cause more harm than good.
Section 406 - Code of Ethics
We agree that waivers or violations of the company's Code of Ethics related to senior financial officers should be disclosed and that allowing disclosure of such via a company's website is reasonable. A copy of the Code of Ethics should not be required as an exhibit to the Form 10-K as Section 406 of the Act does not require such a disclosure. Since a proposed New York Stock Exchange rule, which requires posting of a listed company's Code of Ethics on its website, is expected to be adopted, no further rules from the Commission on this matter are necessary.
Section 407 - Financial Expert
The Proposed Rules would require companies to disclose the number and names of the audit committee members they have determined to be financial experts and whether or not each such expert is independent. The Proposed Rules define a financial expert as a person who has, through education and experience as a public accountant, auditor, principal financial officer, controller, or principal accounting officer, (1) an understanding of generally accepted accounting principles and financial statements, (2) experience applying such generally accepted accounting principles in connection with accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant's financial statements, (3) experience preparing or auditing financial statements that present accounting issues that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant's financial statements, (4) experience with internal controls and procedures for financial reporting, and (5) an understanding of audit committee functions.
The Proposed Rules will present a compliance problem for many reporting companies. First, we recommend that the Commission allow the Board of Directors of each company to determine, based on the Act's guidance, whether members of the audit committee possess the requisite education, experience and expertise to effectively serve on the audit committee. Second, we urge the Commission to more clearly define "experience applying such generally accepted accounting principles in connection with accounting" and "experience preparing or auditing financial statements." A strict reading of these requirements would imply that, to qualify as a financial expert, a person would need actual hands on experience in the preparation or auditing of financial statements. While we agree that having such hands on experience would be valuable, requiring such experience disqualifies many people who through other experience, such as years of service as a chief financial officer or audit committee member or other position in which financial statements are routinely scrutinized and reviewed, have the background necessary to serve as a financial expert for an audit committee, even though they have never been involved in the actual preparation or audit of the financial statements. Finally, we urge the Commission to more clearly define "experience applying such generally accepted accounting principles in connection with accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant's financial statements." Under a strict reading of this requirement, the number of people qualifying as experts for any given company is greatly limited by the interaction of this requirement, the requirement in the Act that all audit committee members be independent and antitrust laws restricting the ability of employees of competitors from serving on the board of a company. Under the strict definition, the only people who will have experience in estimates, accruals and reserves generally comparable to the issuer are (1) those who prepare or audit the issuer's financial statements internally, (2) the independent accountants who prepare or audit the issuer's financial statements, (3) those who prepare or audit financial statements of companies in the same line of business as the issuer internally, (4) the independent accountants who prepare or audit financial statements of companies in the same line of business as the issuer, and (5) anyone who has held any of these positions in the past. The first two classes of people are excluded due to the fact that they are not independent and therefore not permitted to serve on audit committees. Many members of the third class of potential financial experts could be excluded from service because of restrictions in Section 8 of the Clayton Act that prohibit a person from serving as a director or board-elected or board-appointed officer of two or more companies that are in competition with each other. The fourth class of people would be legally eligible to serve but could be resistant to serve due to the likely negative client response resulting from an auditor serving on the board of a competitor. This leaves those who have had the required financial experience in the past but who no longer hold the positions in which they gained that experience. However, even these people would be subject to "cooling-off periods" before they could be deemed independent, a requirement for audit committee service, and many would likely be subject to non-competition agreements restricting them from working for competitors for some period of time.
In addition, we would urge that requiring the disclosure of audit committee financial experts be delayed for at least one year after the issuance of final rules. Based on even a loose reading of the definition of financial expert given in the Proposed Rules, it is likely that many reporting companies will not currently have audit committee members, or even board members, that meet the requirements of a financial expert. Therefore, upon issuance of final rules, hundreds of companies will immediately be in the market for new directors meeting the definition of financial expert. This, combined with the proposed New York Stock Exchange rule restricting any one person from serving on more than three audit committees, will create a shortage of board applicants who qualify as financial experts. Therefore, significant time will be required for all reporting companies to locate, evaluate and elect even one audit committee financial expert. Requiring companies to disclose that they have not yet been able to locate a financial expert to serve on their audit committees, without providing a reasonable period of time in which to do so, will create an unwarranted negative implication for some companies.
This difficulty in locating qualified financial experts is exacerbated by the provision in the Proposed Rules requiring reporting companies not only to disclose that the audit committee contains at least one financial expert, as required by Section 407 of the Act, but also to disclose the number of financial experts on their audit committees. This added requirement will result in reporting companies competing for the limited number of qualified experts not only for one expert per company but to have as many as possible so that their financials appear more reliable than those of other companies with fewer experts on their audit committees. We urge the Commission to provide a significant phase-in period. This would provide reporting companies with the time required to recruit, elect and appoint to the audit committee properly qualified individuals without being hurt by the negative implication of disclosing that they have not yet obtained a financial expert to serve on their audit committee. In addition, the Commission should consider eliminating, or at least provide better definitional guidance regarding, some of the other requirements in the Proposed Rules, such as disclosing the number of financial experts and requiring them to have experience with comparable issuers, that will make it more difficult for reporting companies to locate and recruit qualifying financial experts.
Emerson urges the Commission to consider carefully the practical issues raised in this letter. In many instances, the Proposed Rules go far beyond the statutory mandate set forth in the Act and in so doing create a substantial burden of compliance on reporting companies. At the least, the Proposed Rules, when finalized, should provide a significant phase-in period for several of the disclosure requirements. We thank you for the opportunity to comment on this important matter. Should the Commission have any questions regarding our comments, please do not hesitate to contact the undersigned.