New York State Bar Association
One Elk Street
Albany, NY 12207
518-463-3200
Business Law Section
Committee on Securities Regulation
August 19, 2002
Securities and Exchange Commission
Re: File No. S7-21-02
Ladies and Gentlemen:
The Securities Regulation Committee of the Business Law Section of the New York State Bar Association appreciates the invitation of the Securities and Exchange Commission (the "Commission") in Releases No. 34-46079 and 34-46300 (the "Releases") to comment on the subject of certifications of disclosures contained in annual and quarterly reports.
The Committee on Securities Regulation (the "Committee") is composed of members of the New York Bar, a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice and in corporation law departments. A draft of this letter was circulated for comment among members of the Committee, but, as a result of the limited amount of time for comment, the distribution was limited to a relatively small working group in addition to the Drafting Committee. The views expressed in this letter are generally consistent with those of the majority of members who reviewed and commented on the letter in draft form, but these views are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association, or its Business Law Section.
The Commission's original certification proposal in Release No. 34-46079, issued on June 14, 2002, became largely academic after enactment of the Sarbanes-Oxley Act of 2002 on July 30, 2002. We are therefore commenting only on those questions where important decisions still remain to be made.
1. The Commission should prescribe a form of certification containing minimum requirements that signing officers can vary to meet their particular circumstances.
We believe that the obvious intention of Congress in giving the Commission thirty days to adopt rules under Section 302 while at the same time setting forth fairly narrow requirements for the content of the certifications was to enable the Commission to consider the different ways in which the requirements of the statute might be implemented in light of the statutory purpose. We think it is important for the Commission to be flexible in responding to this initiative. When the Commission adopted Order No. 4-460 requiring companies with $1.2 billion or more of revenues to file written certifications, it also adopted a fairly rigid format which was not to be altered by certifying companies; but that certification was a one-time requirement. The form of certification now envisaged is, by contrast, a permanent one that all companies will have to provide periodically with all of the covered reports. We think it is important to recognize that companies will face circumstances from time to time that make certification in any particular form difficult or problematic for reasons other than simple noncompliance and that the certification should allow these companies the flexibility to deal with circumstances as they arise. We also suggest in greater detail below that certain companies may wish to add references to generally accepted accounting principles of one kind or another in drafting their certifications, and foreign private issuers will also need to be able to qualify their certifications by reference to requirements imposed on them by law or by custom in their countries.
2. A form of certification should be authorized by the Commission that satisfies the requirements of both Section 302 and Section 906 of the Sarbanes-Oxley Act.
The Commission should harmonize the rules it adopts to implement Section 302 with the provisions of Section 906, in order to produce a single form of certification by CEOs and CFOs based on standards that are discernible and commonly understood by both the certifying officers and investors, as well as legally enforceable. We believe that the express and implicit references to the Securities Exchange Act of 1934 (the "1934 Act") in Sections 302 and 906 provide ample authority for the Commission to develop and adopt a coherent set of requirements.
When the Sarbanes-Oxley Act was being revised in the Conference Committee, an effort was made to reconcile the language of Section 302 with the language of Section 906, and apparently several people thought that this had been done when the bill was voted on. Nevertheless, when the language of the statute became publicly available, it was apparent that the Commission was given the authority in Section 302 to prescribe a form of certification within thirty days of enactment, whereas Section 906 was effective immediately upon enactment and required that statements containing a specified content accompany each "periodic report containing financial statements" filed with the Commission.
We believe that the Commission should reconcile these two provisions by providing expressly in the rule it adopts in accordance with Section 302 that a certification in the form authorized to be filed thereunder will meet the requirements of Section 906 as well. This is appropriate because there could really be no difference in the intent or purpose of the two sections. Section 302 authorizes the Commission to prescribe the form of the certification, whereas Section 906 provides for criminal penalties for failing to file an appropriate certification, but the purpose of the certificate filed under each section is clearly the same. Certification would not be necessary in order to set forth the requirements for the material to be included in reports filed by issuers or in order to provide penalties for noncompliance with the requirements, and indeed before the enactment of the Sarbanes-Oxley Act there were requirements and there were penalties; they were just changed by Sarbanes-Oxley. The obvious purpose of requiring the CEO and CFO to certify is to make them appreciate their personal responsibility for compliance with the requirements, but no rational person could reasonably consider that making them sign twice is necessary to accomplish this purpose.
Section 906 requires the written statement that accompanies the periodic report to certify that "the periodic report containing the financial statements fully complies with the requirements of Section 13(a) and 15(d) of the [1934 Act] and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer." By contrast, Section 302 refers to quarterly or annual reports filed under Section 13(a) and 15(d) of the 1934 Act, which we believe are the "periodic reports containing financial statements" that Section 906 was referring to.
Instead of requiring the certificate to state that the report "fully complies with the requirements of section 13(a) or 15(d)" of the 1934 Act, Section 302 requires it to state that "based on the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading." Since Sections 13(a) and 15(d) only require issuers to file reports prescribed by the Commission, it is necessary to refer to other provisions of the 1934 Act to give meaning to "fully complies" with Sections 13(a) and 15(d). It is a violation of the 1934 Act for an issuer to file a report containing misstatements or omissions, and Rule 12b-20 of the 1934 Act, which governs reports filed under Sections 13(a) and 15(d), expressly requires that there be added "such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading." In addition, the specific information required by the applicable regulations and forms of the reports is typically couched in terms of material information.
The final portion of the statement required by Section 906, i.e., that "information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer," is changed in Subsection 3 of Section 302(a) to refer to "financial statements and other financial information" rather than just "information" and to add that the time period "as of, and for, the periods presented in the report," which is omitted from Section 906. Again, however, there could be no difference between these two concepts.
In addition, both sections use the term "fairly present(s)," which is the general standard used in the United States for auditors' reports and management representations and warranties on financial statements. "Fairly presents" has a generally understood meaning only with reference to financial statements; other information included in reports is governed by the terminology of misstatements and omissions that is used throughout the Federal securities laws. Time periods should be included in certifications because financial statements necessarily set forth financial condition as of a particular point in time and results of operations for particular periods.
It is standard to qualify the "fairly presents" statement by reference to "in conformity with generally accepted accounting principles" or similar language which may refer to principles followed in the United States or some other country. If for some reason the financial statements do not comply with GAAP, the certification should disclose any material differences. This qualification does two things: it requires that the financial statements adhere to some standards or set of rules, such as US GAAP; and it distinguishes among different sets of standards such as UK GAAP or International Accounting Standards (IAS), which in some cases can produce financial statement treatment quite different from US GAAP. This qualification should be included or at least permitted in certifications filed with the Commission to insure a commonly understood meaning that is legally enforceable. Appropriate adjustments will have to be made by foreign private issuers.
We recognize that some people have expressed the view that technical compliance with GAAP is not sufficient to meet a "fairly presents" standard in the abstract and that additional disclosure is required, but in light of the additional statements in certifications expressly covering material misstatements and omissions, we believe that including a GAAP qualification will not affect the Commission's ability to question the fairness or propriety of any particular presentation it may wish to examine.
The "fairly presents" certification in Section 302 is not limited to the financial statements, but also applies to "other financial information" included in the Form 10-K or 10-Q. In addition to summary information from the financial statements, this other information could include non-GAAP financial measures such as EBITDA (earnings before income taxes, depreciation and amortization) and pro forma financial information. Although the Commission has expressed concern about the use of non-GAAP pro forma earnings information, it has not prohibited the use of pro forma information, but has provided guidance to address those concerns. Similarly, some types of non-GAAP information are thought to be useful in helping to understand a company's financial condition and performance, again provided that certain guidelines are followed. However, the "fairly presents" form of certification is geared to GAAP financial statements, and not such other financial information. Therefore, we urge the Commission to provide in the rules for the certification to apply to "other financial information taken together with the financial statements," and not just "other financial information."
Finally, the rules should expressly provide for a "knowledge" qualification in the certification under Section 906 that is comparable to the qualification provided in Section 302. The two statements that are required to be certified under Section 302 expressly provide a "based on the officer's knowledge" qualification. Similarly, Section 906 expressly specifies a "knowing" standard for criminal penalties for making the prescribed certifications knowing that the covered report does not meet the requirements of the certifications. Therefore, the rules should provide for any certification to be "based on the officer's knowledge" or a similar "knowledge" qualification.
3. The Commission should clarify that certifications are required only for annual and quarterly reports on Forms 10-K, 10-Q, 20-F, 40-F, 10-KSB and 10-QSB.
Since Section 906 refers to "periodic reports containing financial statements," whereas Section 302 refers to "quarterly and annual reports," there is a question whether Section 906 intended to require certification of Form 8-K reports that contain pro forma financial information or the results of an acquisition subsequent to the last report filed, or Form 6-K reports furnished by foreign private issuers.
We believe that the concept of "periodic reports" in Section 906 was intended to refer to reports that are filed or submitted on regular cycles or intervals and not just those that are filed on an ad hoc basis. A Form 8-K is designated as a "current" report rather than a "quarterly" or "annual" report. We also note that Paragraph (a)(4)(B) of Section 302 refers to "periodic reports" as being the type of reports covered by that section, making it clear that the same kinds of reports were envisaged by both sections. Moreover, Release No. 34-46084 on the proposed new Form 8-K items states in
Section I: "The Exchange Act rules require public companies to make periodic disclosures at annual and quarterly intervals, with other important information reported on a more current basis."1 It would also be inappropriate to require earnings releases filed under cover of Form 8-K to contain certifications, because the summary format of the financial information presented in such releases is not sufficient to meet the "fairly presents" standard as commonly understood, and this would discourage issuers from filing these releases on Form 8-K. In light of the detail that is required in certifications under Section 302, particularly the description of internal controls and the reference to the period during which the periodic reports are being prepared, we think that this detail contemplates that the procedure should be followed only in connection with annual or quarterly reports.
Similarly, Form 6-K reports, which in any event are "made" or "furnished" rather than "filed" and are not deemed to be filed for the purpose of Section 18 of the 1934 Act, are not necessarily provided on a regular schedule. Although many foreign issuers do regularly provide interim financial statements on Form 6-K, the context of the interim financial statements is dictated by the home country requirements and not by U.S. securities laws. Consequently, it would be difficult for most foreign issuers to make Section 302 or Section 906 certifications as currently drafted. Indeed, requiring them to certify could be viewed as a way of requiring them to meet the Form 10-Q reporting standards, which would not be appropriate for most foreign private issuers.
It is important for the Commission, as the agency responsible for interpretation and implementation of the 1934 Act and the Sarbanes-Oxley Act, to make an authoritative pronouncement on this question so that the thousands of companies that are required by Sarbanes-Oxley to certify will know with some degree of assurance what is required.
4. The concept of internal controls that is required to be certified by Section 302 of the Sarbanes-Oxley Act should be interpreted in a flexible manner.
The Commission's Release No. 34-46079 issued on June 14, 2002 contained a proposed requirement that the certifying officers state that they had "reviewed the results of the evaluation of the procedures maintained by the company to collect, process and disclose, in a timely manner, the information" contained in the report. It did not require that any particular procedures be followed, nor did it require that the signing officer attest to the efficacy of such procedures. The final version of Sarbanes-Oxley, however, is much more precise in requiring the signing officers to take personal responsibility for the procedures.
Paragraph (4) of Section 302(a) contains several specific requirements. First, they must state that they are "responsible for establishing and maintaining internal controls." Secondly, they have to state that they "have designed" the internal controls so as to "ensure" that material information is made known to them. Third, the signing officers must evaluate the "effectiveness" of the controls as of a specified date within ninety days prior to the report (which we assume means prior to the date on which the report is to be filed with the Commission, rather than ninety days prior to the period covered by the report). Finally, Sarbanes-Oxley requires the report to present the signing officers' "conclusions about the effectiveness" of the controls "based on their evaluation" as of the specified date. This latter statement appears to contemplate that, if the officers are not fully satisfied with their evaluation of the internal controls, they will publicly disclose that fact in the report.
There is a further inconsistency between Paragraphs (4) and (5) of Section 302(a) in that Paragraph (5) requires the signing officers to "have disclosed" to the auditors and the audit committee significant deficiencies in the design of operation of the internal controls as well as any fraud involving employees who have a significant role in internal controls, but the implication is that these types of significant deficiencies may be disclosed to the auditors and the audit committee without being mentioned expressly in the report. We recommend that the form of certification authorized by the Commission recognize that information disclosed to auditors about possible deficiencies in design or operation of internal controls may be kept confidential in appropriate cases.
Paragraph (6) of Section 302(a) also requires the signing officers to indicate in the report whether or not there were significant changes in the internal controls or other factors that could significantly affect internal controls subsequent to the date of their evaluation. Thus, if they evaluate the controls as of a specified date, discover deficiencies and direct that the deficiencies be corrected, they would be required to disclose these facts in the report unless they make a subsequent evaluation within 90 days in which they find the deficiencies to have been corrected.
The detailed reporting concerning internal controls that is contemplated by Section 302 of Sarbanes-Oxley will be a new and thoroughly unfamiliar requirement to most issuers. Although all issuers have, and have long had, procedures for collecting and evaluating information, few issuers currently have other specific procedures that they have applied on a quarterly basis for the purpose of evaluating the efficacy of the information gathering procedures, yet Sarbanes-Oxley appears to require all issuers to have such additional procedures and to follow them on a quarterly basis. We believe that many issuers will require some time to institute and perfect evaluative procedures of this type. Accordingly, we believe the Commission should adopt a form of certification that will enable issuers to take time to institute and evaluate new procedures without requiring them to make overly detailed statements about such procedures at this point.
5. Foreign private issuers should be permitted to use a different form of certification from domestic issuers.
For most purposes of the Federal securities laws, a treatment has been allowed for foreign issuers that is different from that for domestic issuers. Generally speaking, foreign private issuers are required to file only Form 20-F (or Form 40-F in the case of certain Canadian issuers) which contains annual financial statements, and most do not file quarterly reports on Form 10-Q. Many foreign issuers provide reports under cover of Form 6-K, but these vary from country to country. In any event, we believe that the rules should make clear that, absent special circumstances, foreign private issuers need to certify only annual reports.
Secondly, many foreign issuers will not have the same kind of structure as domestic issuers for collecting information internally and reporting it in their annual and other reports. Many are required by local law to have statutory auditors or other specified employees that have the duty of collecting and reporting information. It may not be possible for the signing officers to certify, as contemplated by Sarbanes-Oxley, that they are responsible for establishing and maintaining internal controls. Moreover, foreign issuers may not have audit committees comparable to those of United States domestic issuers that would be the appropriate body to receive reports of deficiencies. As a result, we believe that foreign private issuers should be permitted to include additional statements in their certifications under Section 302 or omit information that would otherwise be required in the case of domestic issuers. Exactly what kind of statements would be needed is unclear at this point but we think that the Commission's rules under these sections ought to state expressly that foreign private issuers may vary the form of certification in whatever manner they deem to be appropriate.
Section 302(b) of Sarbanes-Oxley on foreign reincorporations does not appear to be addressed to foreign private issuers. It refers to domestic issuers that reincorporate or engage in other transactions that result in the transfer of the domicile of the corporation or its offices from inside the United States to outside the United States. Presumably, this was intended to refer to companies that are only changing their jurisdiction of incorporation but not all of their operations outside the United States and that foreign companies whose operations have always been and are still principally conducted outside the United States are not intended to be disadvantaged by the provisions of Section 302. We believe that this point should be made clear in the rules.
6. Registered investment companies should not be required to file certifications.
Generally speaking, registered investment companies are subject to financial reporting and other requirements that are quite different from other companies. Among other things, they are not required to file periodic reports under Sections 13(a) or 15(d) of the 1934 Act. The reports that they do file contain information that is unique to investment companies. The companies themselves do not generally have employees but are managed by management companies that collect information and furnish it to the Board of Directors of the investment company, and in many cases the officers of the registered investment company are personnel of the management company. We suggest that the Commission should exempt them from certification at this time and consider issuing a concept release on how the purpose or intent of certification could reasonably be extended to registered investment companies.
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We hope the Commission finds these comments helpful. We would be happy to meet with the Staff to discuss these comments further.
Respectfully submitted,
COMMITTEE ON SECURITIES REGULATION
By Gerald S. Backman
Drafting Committee:
Richard R. Howe, Chair
Copy to:
The Honorable Harvey L. Pitt, Chairman
__________________________
E-mail address: rule-comments@sec.gov
Attention: Jonathan G. Katz, Secretary
Certification of Disclosure in Companies' Quarterly and
Annual Reports, Release Nos. 34-46079 and 34-46300
Gerald S. Backman
Chairman Of The Committee
Richard E. Gutman
Michael J. Holliday
Adrian Ketri
Cathleen E. McLaughlin
The Honorable Paul Atkins, Commissioner
The Honorable Roel Campos, Commissioner-designate
The Honorable Cynthia A. Glassman, Commissioner
The Honorable Harvey Goldschmid, Commissioner
Alan L. Beller, Esq., Director of Division of Corporation Finance
Giovanni P. Prezioso, Esq., General Counsel
Paul F. Roye, Director of Division of Investment Management
1 The SEC web site uses the heading "1934 Act Registration Statements & Periodic Reports" for the section where the text of forms and reports is given for numerous forms including Form 8-K as well as Forms 10-K and 10-Q, and Rule 13a-16 under the 1934 Act refers to issuers filing periodic reports on Forms 10-K, 10-Q and 8-K in a list excluding certain types of issuers from those foreign private issuers required to provide reports on Form 6-K. This small number of shorthand references to a group of reports and forms does not outweigh the common understanding of the term "periodic reports" and the overwhelming usage of that term to refer solely to Forms 10-K and 10-Q.