The Association of the Bar
of the City of New York
42 West 44th Street
New York, NY 10036-6689
Committee on Securities Regulation
November 29, 2002
Via email: firstname.lastname@example.org
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan G. Katz, Secretary
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Securities Regulation of the Association of the Bar of the City of New York (the "Committee") in response to Release Nos. 33-8138, 34-46701 and IC-25775, dated October 22, 2002 (the "Release"), in which the Securities and Exchange Commission (the "Commission") announced proposed rules (the "proposed rules" or "proposals") implementing Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (the "Act").
Our Committee is composed of lawyers with diverse perspectives on securities issues, including academics, members of law firms, and in-house counsel at investment banks.
The Committee commends the Commission and its staff for the very high standards of quality they have maintained in addressing the extraordinary regulatory agenda imposed by the Act. The Release and the proposed rules, like the other actions the Commission has taken under the Act, are well-crafted and carefully thought out. Our Committee believes, however, that the fundamental investor protection objectives of the Act would be better served if the Commission gave additional consideration to specific elements of the proposed rules, as set forth in this letter.
I. Rules Implementing Section 407
A. The proposed rules should not further restrict the definition of "financial expert" imposed by the Act.
The disclosure requirement mandated by Section 407 of the Act has two purposes: to ensure that investors are fully informed about the level of financial expertise represented on the audit committee, and to foster an improvement in that level. To achieve these purposes, the definition of "financial expert" must strike a balance. If it is too easy to meet, of course, neither objective will be adequately served. But there are also dangers if the definition is too difficult to meet. The pool of candidates may be too small, other appropriate criteria for selection will be overshadowed, and in the end some audit committees will be less qualified.
We believe that the proposed rules impose an extremely limited conception of "financial expert." It will be very difficult to recruit audit committee members who fit this narrow conception and are otherwise appropriate candidates. The biggest obstacles are the requirements of (a) personal involvement in auditing and internal controls and (b) familiarity with the specific issues in the issuer's financial statements. Individuals with these qualifications will often be inappropriate candidates for other, valid business reasons-for example, they may be associated with other companies in the same sector, and an issuer may have a variety of reasons (including confidentiality, competitive considerations or antitrust or other legal concerns) not to invite such a person to serve on its board. In addition, SRO rules will limit the number of boards on which a director may serve. Because of their scarcity, we expect that the cost of the services of qualified audit committee members will increase, placing an undue burden particularly on small businesses.
Companies may comply with the proposed rules by disclosing that they have no financial expert, as defined in the Commission's rules, but if many do so the purposes of Section 407 will not be well served.1
Much in the proposal tracks the attributes that Section 407 directs the Commission to consider. The statute would permit the Commission to deal more flexibly with these attributes, but apparently the Commission has decided that it will not. However, in three significant ways, the proposed rules change the balance Congress struck in Section 407 to make the definition more difficult to meet. We urge the Commission to reconsider these three points. Additional rigidity in the definition will not further investor protection.
The list of attributes in Section 407 of the Act includes the following item:
(2) experience in-
(A) the preparation or auditing of financial statements of generally comparable issuers; and
(B) the application of [generally accepted accounting] principles in connection with the accounting for estimates, accruals and reserves ... .
The proposal renders this in two items of Instruction 1, as follows (emphasis added):
- Experience applying ... generally accepted accounting principles in connection with the 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; [and]
- Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements ... .
The italicized language, read together with the requirement that the experience must have been gained at publicly reporting companies, will make it very difficult for an issuer to find anyone who qualifies as a financial expert, other than people who have been involved with another public company in the same industry.2
This is excessively restrictive. It will sharply limit the pool of eligible candidates, particularly for a company in a new, complex or unusual business. And it is unnecessary, because the experience required to evaluate a proposed financial statement presentation, or to consider estimates, accruals and reserves, is not limited to the issuer's industry. Indeed, an industry insider might be less inclined to exercise the requisite objectivity and skepticism than an equally sophisticated audit committee member with experience in a different industry. We note that there has been no suggestion that such a standard be applied to the lead audit partner at the issuer's independent auditor. We believe that the Commission should revert to the statutory language.
Section 407 requires that the attributes of a financial expert must have been gained in specified positions "or from a position involving the performance of similar functions." Instruction 1 to the proposed rules3 elaborates on this alternative in the following terms:
or experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the board of directors, in the person's having similar expertise and experience) ... .
Instruction 2 provides that if the board relies on "similar expertise and experience" as contemplated by the parenthetical, the registrant must disclose the basis for the board's determination. The qualifications of each board member will be publicly disclosed anyway, and this additional disclosure requirement imposes an unnecessary burden. Issuers and boards will have to explore, in evaluating a candidate's expertise and experience, whether they were acquired by "performing similar functions" or are merely "similar." The distinction is too fine to warrant this degree of attention, and no investor protection purpose is served by requiring it. The Commission should eliminate Instruction 2.
The proposal includes in Instruction 3 a list of factors to be considered in evaluating the education and experience of a person to determine whether she qualifies as a financial expert. The list is unnecessary, because the attributes included in Instruction 1 are not difficult to apply and will, as Instruction 4 properly states, control the determination.
Even though the list largely states the obvious, it will foster a mechanical approach to the determination, with formulaic questionnaires for internal purposes and boilerplate recitations for external purposes. The list of factors also will tend to exclude consideration of matters that do not appear there, even if they bear on the attributes of financial expertise. This extensive list of factors will result in a "check-the-box" approach to the determination rather than a more principles-based analysis. None of this will further the purposes of Section 407.
B. Effectiveness of the rules should be delayed.
After the Commission adopts final rules, a company will need time to evaluate its current audit committee, to decide whether to add members and, if so, to recruit new members. This comes at a time when other requirements applicable to the composition of the audit committee are still in flux: the self-regulatory organization rules and the implementation of Section 301 of the Act.4 Ideally, companies could at the same time evaluate and respond to the new listing standards and to rules under Section 301. To have these various changes all take effect at different times would be a wholly avoidable source of confusion. It would be very unfortunate if issuers were forced into three rounds of adjustments or evaluations of their boards-first for the Section 407 rules, then again for the Section 301 rules, and then again for the listing standards. As it is, companies are currently preparing for the 2003 proxy without the benefit of certainty on any of the rules governing board and audit committee composition.
The most orderly implementation would result if there were an interval between publication of the final rules and the next proxy season, and then a further interval before the first annual report season in which compliance with the disclosure requirement is required. That would permit issuers to elect new financial experts to the board at the annual meeting, and their first disclosure would say they had done so. Otherwise, large numbers of companies will be forced to say in their 2003 annual reports that they have not had enough time to place a financial expert on the audit committee. Such an outcome will not promote investor confidence.
To address these concerns, 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.5 As an interim measure, the Commission could require proxy statements to disclose in broad terms the financial, accounting and auditing qualifications of audit committee members. The Commission should also acknowledge, in adopting Section 407 rules, that many issuers may publish their annual reports at a time when the directors who will meet the financial expert requirements have been proposed but not yet elected, and it should encourage an issuer in this circumstance to disclose which candidates will meet the requirements if they are elected.
This would also eliminate two specific problems that will arise in applying the rules under Section 407 before the rules under Section 301. First, issuers that are not now subject to any U.S. rules requiring that they have an audit committee include (a) foreign private issuers, (b) issuers with listed debt but no listed or quoted equity and (c) issuers that have offered securities in registered offerings but have no listed or quoted securities.6 An issuer that does not yet have an audit committee should not be required to make Section 407 disclosures until the Commission has adopted rules under Section 301 and those rules have taken effect as to that issuer. Otherwise, in view of the statutory definition of "audit committee," it will be required to make the Section 407 disclosures with respect to its entire board of directors, which is an inappropriate burden.
The second problem that will arise if the Section 407 rules apply before the Section 301 rules concerns the definition of "independence." The proposed rules require that the Section 407 disclosure extend to whether a financial expert is independent, and while we agree with the Commission's reasons for extending the Act in this way, it should not do so until it has provided a definition of independence. The language of Section 301 on independence gives rise to interpretive difficulties that we hope the Commission will address in adopting rules, and there is no reason to require issuers to address them before the Commission does so.7
C. The rules should state that a "financial expert" under Section 407 is not an "expert" under Section 11 of the Securities Act of 1933.
The Release states that the Commission does not intend for a person to be considered an expert for purposes of Section 11 of the Securities Act solely by reason of his or her designation as a financial expert on the audit committee for purposes of Section 407 and the implementing rules. We believe that the risk of confusion on this point is real, and that the Commission's goal would be better served if the rules stated that no person shall be deemed an expert for purpose of Section 11 solely by reason of designation as a financial expert. The statement should be included with the requirement to provide the disclosure in Regulation S-B, Regulation S-K and Form 20-F.
D. The rules should state that designation under Section 407 does not affect the obligations of board and audit committee members.
In the Release, the Commission expresses the view that the designation of a financial expert should not increase the obligations of the person designated or reduce the obligations of the other board and audit committee members.8 Corporate law in some states could, however, be read to provide other board and audit committee members with statutory protection for relying on the designated financial expert and exercising a reduced level of vigilance on financial and accounting matters.9 It is also possible that the designation itself could heighten the exposure of the person so designated to a variety of legal risks.10 Even the perception (whether or not it is correct as a matter of law) that the designated financial expert has special responsibilities not shared by other board and audit committee members could adversely affect how governance actually functions in this area.
Accordingly, we suggest that the rules include a statement to the effect that the identification of an audit committee member as a financial expert for purposes of Section 407, and the related disclosure, do not impose a higher degree of responsibility on the person so designated or reduce the responsibilities of the other audit committee members or the board of directors. We believe this is a critical addition, and failure to add this provision will make attracting people to this position extremely difficult. More importantly, such a statement will put investors and other board members on notice that these financial experts will not have heightened liability and that other board members' obligations in financial matters are not obviated.
II. Rules Implementing Section 406
Section 406 of the Act requires disclosure concerning a code of ethics for senior financial officers, and the proposed rules require that the code also apply to the chief executive officer. Corporate ethics questions pertaining to senior financial officers are quite specific, and broadening the scope of this requirement dilutes its specific focus. We do not think it should be expanded further. This area will presumably be addressed by forthcoming rules of the exchanges and the NASD. In particular, the New York Stock Exchange has proposed that all listed companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waiver of the code for directors or executive officers.11 There is no need for the Commission to expand on Congress' mandate.
The Commission should clarify that if the specified individuals are subject to more than one code of conduct, the company should apply the proposed rules only to the most narrowly focused code that meets the criteria of the rule. Many companies will have a separate code of ethics applicable to the specified individuals, with substantive requirements and specific procedures based on the specific ethics questions pertaining to their positions. They will also have a broader code that applies to others, often many others, in addition to the specified individuals. For such a company, the proposal could be read to require disclosures as to both the narrow code and the broader code. The rules should be clarified so that such a company can meet the requirements of the Section 406 rules with respect to the narrower code only. This is all Congress intended.
III. Rules Implementing Section 404
The Release correctly states that the effectiveness of the rules implementing Section 404 of the Act should be delayed "to enable the PCAOB to act and other relevant parties to prepare for compliance." The proposed rules would accordingly apply to reports for years ending after September 15, 2003.
The proposed delay might prove inadequate. From our discussions with issuers and auditors, we believe that the implementation of Section 404 will require many companies and their auditors to make significant changes in their practices, and at least part of the changes must await action by the PCAOB.
We believe that few companies currently conduct an extensive evaluation of internal controls and procedures for financial reporting in connection with their annual audit. Rather most companies approach internal control testing on a continuous rolling cycle, devoting more attention to those areas that are more critical. For many companies, even that testing and evaluation is at a high level. We believe that few independent accounting firms currently conduct the level of review of internal controls that will be required for verification. The degree of internal control testing by an accounting firm depends on the degree of substantive testing it performs in connection with the audit-the less the independent auditors rely on substantive testing, the more they rely on internal controls and must therefore test them, and visa versa. We are informed that, in general, the larger the enterprise the less substantive testing the auditors perform. However, even in these instances, the testing is generally based upon the control environment rather than testing and sampling of specific controls and procedures.
Based on these observations, we expect that compliance with the proposed rules will impose substantial costs on most issuers, and perhaps particularly on small businesses. The involvement of outside auditors in the preparation of quarterly reports is likely to increase, and with it their fees. We believe that the cost of the Section 404 auditor verification will be significant for all issuers, and there have been suggestions that the increase could be as much as 50% or more of the annual auditing fee.
For these reasons, we suggest that the Commission reflect on the additional burden being placed on companies, especially small businesses, and give consideration to steps that could alleviate this burden. For example, giving companies and their auditors (many of whom are auditing a company's financial statements for the first time this year, having replaced Arthur Andersen) additional time to plan their evaluation and verification will be helpful. While we recognize that Section 404 requires the evaluation to be at the end of the fiscal year, companies should be permitted to rely on a continuous evaluation process. We do not believe that this would reduce the quality of the evaluation and verification, as any verification would require a conclusion that the controls and procedures have been designed to be effective, as well as that they have operated effectively throughout the period covered.
We suggest that the rules be effective for any fiscal year that ends more than 90 days after the Commission confirms that the PCAOB has taken all the action needed. When the PCAOB does act, the Commission may want to reconsider the specific language of its rules and certification requirements in light of the procedures the PCAOB establishes.
IV. Improvements in Section 302 certification requirements
As part of its implementation of Section 404 of the Act, the Commission proposed several improvements in the certification requirements adopted in August 2002 to implement Section 302 of the Act.12 These improvements would take effect only when the rules implementing Section 404 become effective. We believe, however that four of them should be effective sooner, because they provide useful clarifications to the certification requirements. These are:
- The use of the term "internal controls and procedures for financial reporting." The Release acknowledges that there is extensive confusion over the scope of the expression "internal controls," and it argues persuasively for the more specific term.13 There is no reason why this clarification of the rules should be delayed.
- The use of the balance sheet date as the Evaluation Date. This is the correct practical solution, but as the certification requirements are now formulated, a foreign private issuer that files its 20-F after March 31 must evaluate its disclosure controls and procedures as of a date subsequent to the balance sheet date. This is unnecessary and can be easily fixed by implementing this feature of the proposal now.
- The clarification that the certifying officers need not personally design the controls and procedures. This more precisely describes the nature of their responsibility.
- The clarification that significant deficiencies, including material weaknesses, must be disclosed to both the auditors and to the audit committee.
* * * * *
Please note that Committee member Wayne Carlin of the United States Securities and Exchange Commission did not participate in the preparation of this letter or the decision by the Committee to submit this letter to the Commission. In addition, this letter does not necessarily reflect the individual views of members of the Committee.
Members of the Committee would be pleased to answer any questions you might have regarding our comments, and to meet with the Staff if that would assist the Commission's efforts.
/s/ Charles M. Nathan, Jr.
Charles M. Nathan, Jr., Chair
Committee on Securities Regulation
/s/ Nicolas Grabar
on behalf of the ad hoc subcommittee members named below
cc: Alan Beller, Director
Division of Corporation Finance
Securities and Exchange Commission
Ad Hoc Subcommittee:
Norman D. Slonaker
1 Note 38 of the Release, which refers to the forthcoming new corporate governance rules of the New York Stock Exchange and the NASD, is unclear about the Commission's intentions concerning the interaction of those rules with the proposed rules under Section 407. We urge that the SRO rules, which will govern audit committee composition, define financial expertise less restrictively than the disclosure requirements under Section 407.
2 Note 47 of the Release describes this as a clarification, but it significantly tightens the requirements of the Act. The words "generally comparable" in Section 407 have much less specific application than in the proposed rules.
3 We cite the instructions as they are numbered in the proposed new Item 309 of Regulation S-K. The numbering differs in the proposed new Item 15(b) of Form 20-F.
4 Section 301 of the Act requires the Commission to adopt rules directing the securities exchanges and the NASD to prohibit the listing of any security of an issuer that does not have a fully independent audit committee. These rules must be adopted by April 26, 2003, although presumably they will provide for a transition period for issuers to come into compliance.
5 The Act requires the Commission to adopt rules under Section 407 by January 26, 2003, but neither the Act nor the Release addresses when the proposed rules will become effective.
6 The first two categories are within the scope of Section 301, although the Commission could determine to exempt them. The third category is outside the scope of Section 301, but within the scope of Section 407 and the proposed rules. Some foreign private issuers already have an audit committee under non-U.S. law or practice, but have not adapted it to be responsive to Section 301. Such an issuer should also have an opportunity to adapt its board composition to the forthcoming requirements under Section 301 before making Section 407 disclosures.
7 In particular, we expect the Commission to clarify the expression "affiliated person" in Section 301, as it applies to representatives of major shareholders. See Section 3(a)(19) of the Exchange Act and Section 2(a)(3) of the Investment Company Act of 1940.
8 Release Part II.A.1, text at notes 43-44.
9 See Delaware General Corporation Law §141(e), New York Business Corporations Law § 717(a).
10 For example, his or her duty of care under corporate law may be understood in light of his or her higher qualifications, and this could affect the interpretation of indemnification and insurance provisions. See Model Business Corp. Act, Section 8.30, Official Comment at 8-170; Committee on Corporate Laws, Section of Business Law, American Bar Association, Corporate Director's Guidebook - 1994 Edition, 49 Bus. Law. 1243, 1252-53 (1994).
11 Subsection 9 of the Corporate Governance Rule Proposals approved by the NYSE Board of Directors on August 1, 2002.
12 Release, note 122.
13 See Release, text at notes 108 & 109. The Division of Corporation Finance has already adopted an interpretation under which the two terms are in effect equivalent. See Question No. 20 in Division of Corporation Finance-Sarbanes-Oxley Act of 2002-Frequently Asked Questions (November 8, 2002, revised November 14, 2002).