Mellon Financial Corporation
December 2, 2002
Mr. Jonathan G. Katz
Re: Release Nos. 33-8138; 34-46701; IC-25775
Dear Mr. Katz:
We are writing to comment upon the portion of the above release relating to disclosure required by Section 407 of the Sarbanes-Oxley Act of 2002 (the "Act"). We believe the proposed definition of "financial expert" is so narrow and technical as to limit to a great degree the pool of eligible candidates and thus threatens the very improvement of audit committee performance the Act intended to promote.
We believe that the proposal should be modified in the following respects:
We suggest that these modifications can be made consistently with the statutory mandate in the Act that the Commission in defining the term financial expert, "consider" the factors enumerated in Section 407(b) of the Act.
Our reasons for these modifications are as follows.
1. It will be very difficult for 14,000+ reporting companies to recruit financial experts as proposed to be defined.
The proposed definition essentially lifts the factors that the Commission was statutorily directed to consider and makes them prerequisites. Under the proposal, an issuer would be required to recruit an individual having an occupational history as an auditor or chief financial officer or the like of a reporting company. Mandating that the individual have been an accounting practitioner will severely limit the number of available candidates for the financial expert position. And the risk of increased liability exposure for the financial expert, notwithstanding Commission assurances to the contrary, will limit the number of those willing to serve. The stringency of the definition is not sufficiently relieved by the provision that an individual's occupational background could be "in one or more positions that involve the performance of similar functions", or that has resulted, in the judgment of the board of directors, "in the person's having similar expertise and experience" to that of a public accountant, auditor, or chief financial or accounting officer or controller. For example, it might be difficult for a board to determine even that a chief executive officer of a reporting company, or an experienced financial analyst, with outstanding financial and accounting sophistication, had "similar expertise and experience" to that of one of the enumerated job categories.
The additional requirement of experience with financial statements presenting accounting issues "generally comparable" to those faced by the issuer further narrows the field of qualifying candidates. The vagueness of this standard will cause a board of directors to be cautious. A board of a lending institution may legitimately conclude, for example, that a financial expert must have experience with the application of generally accepted accounting principles regarding credit loss reserves. Or a particular issuer may have as one of its important accounting practices or policies the question of valuation of intangible assets including goodwill; if so, its board may conclude that the financial expert requires experience in that area.
Of course, most issuers have several critical accounting issues. As a general matter, the particular significant accounting issues for a particular issuer are driven by its own specific mix of businesses and may change from time to time as businesses change or as a result of the influence of external factors. Finding an individual, who must have the designated accounting practitioner background, with experience in applying accounting principles to one or two of the important issues faced by the company may be difficult enough. Finding an individual who has experience with the full matrix of significant accounting issues facing a particular issuer may prove impossible.
Further, the significant accounting questions faced by an issuer will likely change over time. Under the proposed rule, an individual who met the definition of financial expert at one point could find himself or herself outside the definition, as the corporation encounters new accounting issues with which the individual has no prior experience.
2. The rule as proposed could pressure issuers to compromise other normal director qualifications.
Members of the audit committee, including the designated financial expert, are members of the full board and must meet the same high qualification standards as other board members. These include independence of mind, a recognition of the importance of the board's tasks, integrity, a sense of commitment and accountability, a record of achievement, experience with organizations, leadership and strategic thinking and the ability and self-confidence to ask tough questions. The combination of such qualities is rare, so nominating committees must be diligently selective in their consideration of potential candidates. This is in the interest of the investing public.
At the same time, issuers may wish to avoid having to disclose the absence of a financial expert on the audit committee. Consequently, they may be tempted to compromise other qualification standards of board membership, less explicit but no less important than the financial expert tests specified in the rule, in order to obtain a director who does meet the narrow financial expert definition.
As the 1999 Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees stated (Report, p.7),
We believe that an expansion of the definition of financial expert as we have suggested would bring the requirements more in line with the audit committee's oversight and monitoring role and would facilitate the selection of an individual bringing a broader range of qualifications to bear.
3. The proposal could have the effect of frustrating the purpose of Section 407.
The purpose of Section 407 of the Act was to enhance and improve audit committee performance. If the definition of financial expert remains in the proposed form, many issuers will be unable to recruit an individual who qualifies and thus will have no choice but to make the disclosure that they have no financial expert on the audit committee, together with an explanation of the reasons. In this way, the stringency of the rule will likely result in a great deal of increased disclosure about the absence of financial experts and little actual change in audit committee membership or performance.
A less stringent definition of financial expert would make it more practical to recruit new members to upgrade the audit committee. This, in turn, would likely result in issuers recruiting more qualified audit committee members and a resulting higher level of audit committee performance.
4. The proposed modifications are consistent with Section 407 of the Act.
Under a caption titled "Considerations", Section 407(b) of the Act requires the Commission to "consider" certain matters in defining the term financial expert. We suggest that the statute does not require that the Commission's definition specify that a financial expert must exhibit the occupational background and attributes enumerated but only that such matters be taken into account by the Commission in developing its definition.
Section 407(a) of the Act also directs that the rules issued by the Commission be "necessary or appropriate in the public interest and consistent with the protection of investors." This mandate, coupled with the fact that Section 407(b) is not directive except as to consideration, permits the Commission to exercise its regulatory discretion in developing a definition of financial expert which is workable and will promote investor protection.
For the reasons outlined above, we suggest that an approach best suited for investor protection would enumerate factors for board consideration (with the modifications suggested below), but would also allow the board to take into account other factors in its business judgment. We suggest that the ultimate criterion be that the individual have "accounting or financial management expertise." This is the terminology used by the 1999 Blue Ribbon Committee in making its recommendations as to audit committee competence.
The Commission also has the flexibility in "considering" the Sarbanes factors to reach a judgment that modifications may be in the best interest of investors. Our suggested modifications to the factors relating to occupational experience and experience with other issuers fall into this category. We also note that the statutory factors refer to experience with the preparation or auditing of financial statements of generally comparable issuers, not presenting generally comparable accounting questions. We believe the Commission has the discretion to specify in what respect the issuers are generally comparable, and we suggest for the reasons described above that this should focus on the size and complexity of the issuer, rather than specific accounting issues.
With the modifications we have suggested, we believe the proposal is more balanced, more practical, more likely to result in improved audit committee performance, and better geared to the protection of the investing public.
5. The effective date of the new rule should permit adequate time for issuers to recruit a financial expert.
Time will be required for issuers to recruit a financial expert. We suggest that in order to provide adequate time any new disclosure rule not be effective for at least one year after its adoption. This will permit issuers in good faith to seek out and recruit financial experts without having to explain the absence of a financial expert in the interim.
Thank you for your consideration.
cc: Martin G. McGuinn