November 27, 2002
Securities and Exchange Commission
Re: File No. S7-40-02-Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002
Ladies and Gentlemen:
We are submitting this letter in response to the request of the Securities and Exchange Commission (the "Commission") for comments on the Commission's proposed rules to implement Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act").1 We commend the Commission and its staff for the high quality and speed of their efforts in carrying out the regulatory mandates of the Sarbanes-Oxley Act, and we appreciate the opportunity to comment on these proposed rules.
I. Audit Committee Financial Expert Disclosure
A. The proposed definition of "financial expert" is too narrow and would exclude important categories of qualified persons.
We believe the Commission's proposed definition of "financial expert" is too narrow. Although the Commission purports to be avoiding a "bright-line" test, the proposed definition contains restrictive standards that would exclude many highly qualified persons from the pool of potential financial experts. The proposed definition would require, among other things, that a person have direct experience preparing or auditing financial statements and experience applying generally accepted accounting principles ("GAAP") in connection with certain specific types of accounting.2 Read together with the proposed list of factors for consideration, the definition will be difficult to satisfy if a person does not have extensive experience as a public accountant or auditor, or as a CFO, controller or chief accounting officer, in each case at a public company in the same industry as the issuer.3 Although the proposed rules do permit a financial expert to have gained the requisite attributes through "similar expertise and experience," the attributes themselves suggest a very narrow reading of this provision. Whether or not a person has served as an auditor, CFO or principal accounting officer, he or she would still have to have actual experience preparing or auditing financial statements. The proposed definition would disqualify even highly financially literate persons, including, for example, many CEOs, financial analysts, fund managers, lawyers and academics, who do not have such experience.
We recognize that both Section 407 and the Commission's proposal are intended to be "more detailed and rigorous" (as noted in the Proposing Release) than the current rules of the New York Stock Exchange and Nasdaq regarding financial expertise. We believe the Commission could, however, improve on its proposed definition without compromising the congressional mandate.
We strongly urge the Commission to change the definition of "financial expert" to provide that a person who has experience reviewing or analyzing financial statements could be considered a financial expert, even if he or she has not been involved in preparing or auditing them. The audit committee is an oversight body, not an executive body, and we believe it would be particularly inappropriate to exclude from the pool of potential financial experts persons who are highly skilled in understanding financial statements and GAAP but who do not have direct experience preparing or auditing financial statements or actually applying GAAP. Indeed, such persons may in many cases be more skeptical, more independent (in the non-technical sense of the word) and more sensitive to issues of transparency of financial disclosure than financial or accounting officers whose only financial experience has been working on behalf of issuers. Moreover, to exclude such persons would be to impose a substantial burden on reporting companies at a time when identifying qualified audit committee members who are willing to undertake the new roles and responsibilities being imposed on them is likely to become increasingly difficult.
The Commission's proposed definition would also require that a person have "experience with internal controls and procedures for financial reporting." We believe the Commission should clarify that this requirement could be satisfied if a person had extensive knowledge of internal controls and procedures for financial reporting, but not necessarily direct experience designing, implementing or evaluating such controls and procedures on behalf of an issuer or an auditor.4
We further believe the Commission's proposed changes to the attributes in the statutory definition are both overly restrictive and potentially confusing.5 These changes would narrow significantly the scope of the required attributes. Without further guidance, it would be difficult for companies and boards of directors to interpret what it means for a person to have experience with "accounting issues" or "accounting for estimates, accruals and reserves" that are "generally comparable" to those of a particular issuer.6 Moreover, we do not think it would be fruitful for the Commission to attempt to define a specific basis for comparison of accounting issues or accounting estimates across different companies. Rather, we believe the Commission should return to the more general requirements of Section 407 that a person have experience with (i) the financial statements of generally comparable issuers and (ii) the application of GAAP in connection with accounting for estimates, accruals and reserves, and should leave it to boards of directors to make the necessary determination of expertise in light of the other required attributes and, as indicated in the Proposing Release, the "totality of an individual's education and experience."
B. The proposed requirement to disclose the basis for determinations regarding financial expertise should be eliminated.
While we agree with the Commission's proposal to permit boards of directors to determine that a person's "similar expertise and experience" satisfies the experience requirements of the definition, we believe that disclosure of the basis for any such determination is unnecessary and potentially burdensome. Under the proposed rules, a company would already be required to disclose the number and names of the financial experts serving on its audit committee, each of whom would have to possess all of the attributes set forth in the definition. We do not believe it is appropriate to require a company to provide further disclosure to "justify" a determination of the board of directors regarding a person's "similar expertise and experience." Such a requirement would likely result in boilerplate disclosure repeating biographical information already required to be included in annual reports,7 and at the same time it would oblige companies to single out and highlight the personal experience of particular audit committee members, many of whom may be reluctant to have such information disclosed in this manner.8 We do not believe the potential benefit of such disclosure outweighs the potential burden on the decision-making process and on reporting companies seeking to identify qualified persons willing to serve on audit committees. We therefore recommend that the Commission eliminate Instruction 2 to the proposed rule.
C. The proposed definition of "independent" should be changed.
We agree with the Commission that disclosure of whether a financial expert is "independent" could be important to investors; however, we believe that the proposed definition is potentially confusing and overbroad and should be changed.
The proposed definition of "independent" is problematic in part because it relies on the term "affiliated person," which is defined in Section 3(a)(19) of the Securities Exchange Act of 1934 (the "Exchange Act") by reference to Section 2(a)(3) of the Investment Company Act of 1940 (the "Investment Company Act").9 Section 2(a)(3) provides that an "affiliated person" of another person means:
"(A) any person directly or indirectly owning, controlling, or holding with power to vote, five per centum or more of the outstanding voting securities of such other person;
(B) any person five per centum or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person;
(C) any person directly or indirectly controlling, controlled by, or under common control with, such other person;
(D) any officer, director, partner, copartner, or employee of such other person;
(E) if such other person is an investment company, any investment adviser thereof or any member of an advisory board thereof; and
(F) if such other person is an unincorporated investment company not having a board of directors, the depositor thereof."
Subparagraphs (A), (B) and (C) of the definition are not tailored specifically to individual rather than corporate affiliations, with the result that the definition appears to contain significant gaps. Thus, for example, under a plain reading of the definition, an audit committee member would be an "affiliated person" of an issuer if he or she personally owned five percent or more of the issuer's outstanding voting securities, but would not be an "affiliated person" by reason of being an employee of a parent company that owned 100 percent of the issuer's outstanding voting securities.
In order to clarify the proposed independence requirement, we would recommend building into the definition of "independent" a revised concept of "affiliated person" that is specifically tailored to address the kinds of relationships that a director may have with a company. The revised definition would separately describe both (i) those entities for which being an officer or employee would be a disqualifying factor and (ii) the rules under which personally owning, controlling or holding securities of the issuer would be a disqualifying factor. In crafting a revised definition, we urge the Commission to avoid establishing a bright-line test.10
We believe the Commission should provide in a revised definition that an officer or employee of a significant minority shareholder of an issuer (or its affiliates), or an individual who is personally such a minority shareholder of the issuer (or its affiliates), could be considered independent. In practice, representatives of minority shareholders may often be the most knowledgeable and well-qualified persons to perform the independent oversight functions of the audit committee.
We note that the proposed prohibitions contained in the definition of "independent" are subject to a carve-out (for obvious reasons) for activities undertaken in a person's capacity as a member of the audit committee, the board of directors or any other board committee of the issuer. We believe this carve-out should be extended so that a person would not be disqualified solely by reason of being a director of the issuer or any affiliate of the issuer. This would allow a person to serve as an independent financial expert on the board of both an issuer and its subsidiary. Under the definition as proposed, such a person would be disqualified for purposes of the independence requirement at the issuer level by reason of being a director at the subsidiary level. We believe this aspect of the proposed definition would be problematic for many public companies that have the same board members serving at both the issuer and subsidiary levels. Moreover, we are not aware of any meaningful policy basis to prevent board members from serving on the audit committees of both parent and subsidiary, and we believe in many cases there could be benefits to such an arrangement in terms of expertise and efficiency.
We assume the Commission intends to adopt the same definition of "independent" for purposes of rules under both Section 407 and Section 301, and we urge the Commission to address the issues discussed above in proposing rules under Section 301. This would provide the opportunity for public comment on a revised definition, which we believe will be beneficial given the importance and complexity of the issues. We also urge the Commission to harmonize its independence rules with those currently being proposed by the New York Stock Exchange and Nasdaq.
To provide for an orderly implementation of the new rules regarding director independence, we suggest that the rules under Section 407 and Section 301 become effective together for the first annual report for a fiscal year ending more than 180 days after adoption of both sets of rules.
D. The rules should provide explicitly that a financial expert will not be considered an expert for purposes of Section 11 liability.
The Commission noted in the Proposing Release that it does not intend for a person to be considered an expert for purposes of liability under Section 11 of the Securities Act of 1933 solely as a result of being designated as an audit committee financial expert. To avoid any potential for confusion, the Commission should explicitly include a statement to that effect in the rules.
E. The rules should state explicitly that a person's designation as a financial expert will not affect state law duties and obligations.
The Commission noted in the Proposing Release that it does not intend for the designation of an audit committee member as a financial expert under Section 407 to either increase the obligations of such person or decrease the obligations of other board members not so designated. We believe there is a risk, however, that under the laws of some states such a designation could affect the degree of responsibility of different board members.11 In order to clarify this issue and to avoid deterring potential financial experts from serving on audit committees, we recommend that the Commission state explicitly in the rules that a financial expert designation under Section 407 is not intended to increase or decrease the duties, obligations or liabilities of any board members otherwise arising under state or federal law.
II. Code of Ethics Disclosure
A. The proposed code of ethics disclosure requirement should not be expanded to cover other officers and directors.
Section 406 of the Sarbanes-Oxley Act requires disclosure of whether an issuer has adopted a code of ethics for "senior financial officers." While we understand the Commission's reasons for extending this requirement to CEOs, we do not believe the rules should cover a broader group of corporate officers or directors. Both the New York Stock Exchange and Nasdaq have recently proposed new listing standards that would require all listed companies to adopt codes of business conduct applicable to directors, officers and employees. In light of these initiatives, we do not believe it is necessary or appropriate for the Commission to expand further on Congress's mandate in this area, particularly in the case of directors, who are not, as such, employees of issuers and who are separately subject to state law duties and obligations.
B. The Commission should not change Form 6-K to require current disclosure of amendments and waivers of foreign private issuers' codes of ethics.
Foreign private issuers are not presently subject to specific disclosure requirements under the Exchange Act on a quarterly or current basis, and we do not believe the Commission should introduce such a requirement in the context of code of ethics disclosure. Form 6-K requires a foreign private issuer to disclose only information that it files or makes public under home country regulations or that it otherwise distributes to security holders. To introduce a specific current disclosure requirement regarding amendments and waivers to codes of ethics would represent a significant departure from the Commission's traditional accommodation of foreign private issuers with respect to current reporting, and we do not believe the potential value of the proposed disclosure merits such a change.
III. Internal Controls and Procedures for Financial Reporting
A. Final rules regarding internal controls should not take effect until the Public Company Accounting Oversight Board has issued or adopted the necessary attestation standards.
We agree with the Commission's observation in the Proposing Release that Congress did not intend for the rules under Section 404 to take effect until the Public Company Accounting Oversight Board (the "PCAOB") had established the relevant standards for attestation engagements. The attestation standards will affect not only the auditor's attestation and report but also management's evaluation and internal control report.12 While we agree with the Commission that delaying the effectiveness of such rules so that they would apply beginning in respect of fiscal years ended on or after September 15, 2003 should give the PCAOB sufficient time to act, there is a possibility that the PCAOB will not have acted by such time. Rather than risk requiring issuers, even on an interim basis, to provide internal control reports and attestations based on uncertain standards, the Commission should provide explicitly that the rules under Section 404 will become effective only in respect of fiscal years ended on or after the later of (i) September 15, 2003 and (ii) the date 90 days following the issuance or adoption by the PCAOB of the relevant attestation standards.
B. The Commission should not adopt specific disclosure criteria and standards for management's internal control report.
We agree with the Commission's decision not to propose specific criteria and standards for internal control reports. We believe companies should have the flexibility to tailor the content of such reports to their particular businesses and circumstances. Moreover, we believe it would be inappropriate for the Commission to impose specific criteria and standards at a time when the PCAOB has not yet adopted the relevant attestation standards or considered whether to amend the Commission's proposed definition of "internal controls and procedures for financial reporting."
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We thank you for the opportunity to comment on the Proposing Release. We would be happy to discuss with you our comments or any other matters you feel would be helpful in your review of the proposals. Please do not hesitate to contact Nicolas Grabar or Leslie N. Silverman in New York (212-225-2000) or Edward F. Greene in London (44-20-7614-2200) if you would like to discuss these matters further.
Very truly yours,