Software & Information Industry Association
November 27, 2002
Mr. Jonathan G. Katz
RE: File No. S7-40-02
Dear Mr. Katz:
Thank you for the opportunity to comment on the Securities and Exchange Commission's ("SEC" or "Commission") proposed rule implementing new disclosures required by the Sarbanes-Oxley Act of 2002 ("Act").
The Software & Information Industry Association (SIIA) is the principal trade association for the software and digital content industry. SIIA provides global services in government relations, business development, corporate education and intellectual property protection to more than 500 leading software and information companies. SIIA's membership consists of some of the largest and oldest technology enterprises in the world, as well as many smaller and newer companies.
On behalf of SIIA, I submit the following comments regarding the Commission's proposed rules implementing disclosures required by Sections 404, 406 and 407 of the Act.
1. Definition and Implementation of "Financial Expert" Pursuant to Sec. 407 of the Sarbanes-Oxley Act of 2002
The term "financial expert," as defined in the proposed rule, is crafted so narrowly that it would exclude qualified individuals like investment bankers, commercial bankers, government officials, and venture capitalists who have strong financial analysis credentials, in favor of a small group of individuals who happen to have received their Certified Public Accountant certification or have experience as a Chief Financial Officer at a public company.
In response to questions posed by the Commission regarding which criteria are essential regarding the role of the financial expert, SIIA believes that the Commission should broaden the scope of individuals who may qualify as an expert by eliminating the requirement that the financial expert possess direct experience preparing or auditing financial statements in the final rule promulgated under Section 407. Rather, the Commission should focus more keenly on the critical elements to ensure the proper functioning of an audit committee. We note that the chairman of Enron's Audit Committee, Robert Jaedicke, was a professor of accounting and former dean of the Graduate School of Business at Stanford, and a renowned accountant.
Key Criteria for an Audit Committee and Financial Experts
The role of an audit committee, and that of a financial expert, is to effectively oversee a company's board and management. Therefore, SIIA supports efforts by the Commission to ensure that members of the audit committee and the financial expert are adequately qualified for this function, rather than requiring that they are qualified to actually perform the work of the audit committee. Therefore, we have identified the following objectives and responsibilities for a financial expert and an audit committee:
In combining these responsibilities, it is essential that a financial expert and an audit committee possess the skills and ability to scrutinize and challenge the conclusions set forth in a financial statement, rather than to prepare the statement itself. We are concerned, however, that the proposed rule places too much emphasis on the ability to prepare and audit financial statements-functions that they are not intended to carry out. By requiring strict finance and accounting experience, the rule improperly shifts the role of the audit committee from overseeing accurate and fair presentation of financial statements, to technical accounting responsibilities, or at least creates the perception of such.
This change could potentially lead audit committees in the wrong, undesired direction, away from oversight and due diligence. If audit committees are to begin embarking upon the responsibility of the external auditor and day-to-day management, this threatens to engulf the audit committee in technical questions as to how generally accepted accounting principles (GAAP) should be applied. If the proposed rule takes affect as is, we are concerned that the audit committees run the risk of getting mired in application of GAAP, rather than remaining focused on appropriate business models and competitive risks within the relevant market sector.
On the other hand, SIIA strongly supports both the Commission's proposed expansion of criteria-beyond the strict accounting and financial requirements of Section 407 of the Act-enabling an individual to qualify as a financial expert, and requiring board review of its audit committee members. In this regard, the proposed rule significantly improves the focus on qualified, diverse representatives on an audit committee. Moreover, explicitly requiring the board to review its audit committee members to ensure that at least one person possesses the requisite experience to meaningfully scrutinize and challenge the management and the auditors is a useful addition to the requirements of Section 407 in the Act.
Naming, Determination Process and Liability of the Financial Expert
Regarding the Commission's proposal to name the financial expert and the proposed process for determination of the financial expert, SIIA does not believe that the name of the financial expert should be disclosed. Not only does the mere designation of a financial expert create a false perception among the public that this "expert" has special responsibilities not shared by the rest of the audit committee and the board itself, but the specific identification of that individual further exacerbates this false perception.
SIIA believes that disclosure of the selection criteria enables investors to determine for themselves how qualified the financial expert is to carry out audit committee responsibilities. While there is value to investors in articulating the reasoning behind the selection of the financial expert, specifically the factors that merited selection, there is limited additional value in requiring disclosure of the name of the financial expert.
All members of the audit committee have a responsibility to conduct due diligence and oversight to ensure that the financial statements accurately and fairly present the finances and operations of the business, and all thereby owe fiduciary duties to investors. By requiring biographical information on each board member, investors can adequately conclude whether the board, individually and collectively, is qualified to discharge its responsibilities. Identifying the financial expert by name simply adds no additional probative value. Regardless of the decision whether or not to require identification of a financial expert by name, it is critical that the Commission explicitly clarify that the financial expert is subject to neither special responsibilities, nor special liability, in comparison to the other members of the audit committee. If such a clarification is not made by the Commission as part of the final rule (as opposed to informal commentary), there will be a significant disincentive for individuals to assume the role of financial experts.
The proposal does not contain a transition period for compliance with these new disclosures. If no transition period is provided, upon effective date, many public issuers will immediately be out of compliance. Moreover, should this provision be implemented as proposed, we are concerned that the result could be an intense competition among companies for a professional that meets the qualification-drawing from a limited group of qualified candidates. Therefore, we strongly recommend that there be a transition period for this implementation process, realistically a period of time no shorter than 18 months.
Impact on Listing Exchanges
If the SEC implements the rule as proposed, NASDAQ will be forced to update its rules in accordance. Thus, although the law is written simply as a disclosure regarding the financial expert or the reasons why there is no financial expert, the rule will practically result in the potential delisting of an issuer on NASDAQ if no financial expert is named. Not only does this present what we consider to be a serious, unintended consequence, taken in conjunction with the lack of a transition period, it would likely be an immediate result for many companies.
2. Implementation of Code of Ethics Disclosure, Pursuant to Sec. 406 of the Sarbanes-Oxley Act of 2002.
SIIA strongly supports the Act's requirement for companies to disclose whether or not a company has adopted a code of ethics, and whether or not that code of ethics is applied to its principal financial officers. Additionally, in requiring the codification of ethics, it is critical to ensure that the statement of ethics undergoes continuous, effective enforcement processes. However, SIIA is concerned that the proposed requirement of public disclosure for an increasing amount of day-to-day management and oversight responsibilities may subject honest and effective management to the constant threat of harassment and second guessing by members of the public-regardless of good intentions. This, in turn, could have the undesirable affect of draining valuable resources away from more productive endeavors.
Rather, simple disclosure that a public issuer has adopted a code of ethics, and that the code applies to principal financial officers, achieves the two critical objectives we feel were intended by the Act, and strongly needed for investors. First, such a disclosure provides necessary insight into the ethical leadership of a company, and an ability to determine that a company meets an ethical threshold. Second, the code of ethics would subject the issuer to potential liability in the event of a misleading or materially false disclosure.
If the Commission does choose to require companies to provide notice of change in a written code of ethics, either in Form 8-Ks or via Internet disclosure, it is critical that their be a materiality standard adopted relating to changes. Additionally, it is critical that the Commission provide guidance as to what constitutes a waiver for these purposes. For example, it is not clear whether an exception granted pursuant to a process within a code of ethics, whereby certain actions are excepted if the process is followed and certain approvals obtained, constitutes a waiver for purposes of this Act.
SIIA appreciates the emphasis on utilizing the Internet for electronic notification by issuers, but we caution the Commission not to craft requirements so specifically as to make them impractical or unfeasible. While the high-tech industry is likely to be leading in the ability to notify individuals electronically, even members of SIIA would fall short of some of the proposed requirements. Specifically, it is unlikely that a company would have the Internet information on every single shareholder. Therefore, such a recommendation for the necessary technology to be made available to enable the electronic notification of investors does not seem practical. Finally, while we encourage the Commission to embrace the use of technology, we are concerned that the added burden created by the proposal would provide a disincentive for those companies that would otherwise wish to provide notice via the Internet, rather than via an 8-K.
3. Proposed Rules Requiring Inclusion of an Internal Control Report, Pursuant to Sec. 404 of the Sarbanes-Oxley Act of 2002
With respect to the proposed rules regarding management's internal controls and procedures for financial reporting, SIIA has two recommendations pertaining to the Attestation to, and Report on, Management's Internal Control Report by the Company's Auditor, implementing Sec. 404(b) of the Act. First, in response to the Commission's suggestion that auditor attestation be included as part of the annual report, we believe that deferring the effective date until there are known standards in place to determine who is a qualified auditor and established standards for attesting internal control reports, is the appropriate approach for those attestations to be useful. That is, unless the SEC establishes those standards at the outset. Second, with respect to the Commission's proposal for quarterly reviews of the internal controls, in addition to that of the disclosure controls, SIIA believes that annual reporting, attestation and certification should suffice, given that the internal controls generally do not change significantly during the course of an annual reporting period.
Again, thank you for the opportunity to comment on these proposed rules. We look forward to working with you in the future to further help guide effective implementation of the Sarbanes-Oxley Act of 2002.