December 4, 2002
Via E-mail- firstname.lastname@example.org
Jonathan G. Katz
Re: Proposed Rule: Disclosure required by Section 407 of the Sarbanes-Oxley Act of 2002 (the "Act"); Release Nos., 33-8138; 34-46701 (the "Financial Expert Proposals")
Dear Mr. Katz:
This letter is submitted on behalf of the Committee on the Federal Regulation of Securities of the American Bar Association's Business Law Section (the "Committee") in response to the Commission's request for written comments on the Financial Expert Proposals. This letter recommends changes to make these proposals more workable for reporting companies.
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the Committee, nor does it necessarily reflect the views of all the members of the Committee.
The Financial Expert Proposals do not mandate that a financial expert serve on an issuer's audit committee. Instead, the proposals require only that disclosure be made as to whether or not an issuer's audit committee includes a financial expert (in addition to other related information). Even though the designation of a financial expert is voluntary, we believe that a salutary public purpose would be served by having a person of special knowledge and experience with respect to financial matters serving on the audit committees of public companies. We also believe that many, if not most, public companies would want to be able to state that their audit committees have a financial expert as a member.
Notwithstanding the benefits that would accrue to an issuer and its shareholders by having a financial expert serve on its audit committee, for the reasons discussed below, we are concerned that the Financial Expert Proposals set too high a standard for defining a financial expert. By using such strict criteria, the number of persons who would qualify for the designation will be severely limited, and as a result, many public companies may conclude that no members of their audit committees have the requisite qualifications. In lieu of designating a financial expert, many companies may provide information about the financial expertise of persons serving on their audit committees (either in an annual report, proxy statement or on a website). We are concerned that the adoption of a standard that many companies will be unable meet would result in a failure of the purpose of Section 407 of the Act, and would not be in the best interests of investors.
II. The definition of "financial expert."
A. The language of Section 407 of the Act gives the Commission latitude to create a more flexible and workable definition. Section 407 of the Act requires the Commission, in defining the term "financial expert," to "consider" whether a person has, through education and experience in various types of positions or functions, acquired the attributes of financial expertise identified in the section. We believe this language permits the Commission to define a financial expert as a person with some (but not all) of these financial attributes or with different attributes. We believe the Commission has broad latitude to define the term as it deems necessary or appropriate in the public interest and consistent with the protection of investors. The Commission's approach in the Financial Expert Proposals demonstrates that it understands its statutory mandate the same way. For example, the Commission departs from the statutory language to permit a board to determine that a person possesses the identified financial attributes even though the person has not served in one of the positions or functions identified in the Act. Despite this helpful expansion of the statutory language, the Commission proposes to define a financial expert by providing a nearly verbatim list of the financial attributes that Congress only intended to be considered by the Commission.1 By doing so, the Commission would decrease significantly the number of individuals who will be able to meet the financial expert standard.
B. The proposed definition overemphasizes accounting and auditing experience. The Commission's list of proposed attributes of a financial expert includes:
The Commission's proposed definition unnecessarily focuses on people who have education and experience in accounting, auditing and the production of financial statements for public companies. This excludes people who are educated and experienced in financial due diligence and the use and analysis of financial statements. For example, many credit and investment analysts, investment bankers, financiers and business leaders (e.g., chief executives) do not have an education or hands-on experience in auditing or accounting; but they do have expertise in assessing the quality of financial reports and using financial statements to make financing, investing and other strategic decisions. They understand how businesses operate and how financial statements are used to represent business operations. They also understand the importance of critical accounting policies and estimates and the various incentives and opportunities managers may have to influence internal and outside auditors to improperly characterize the financial performance of a business. Were the Commission's proposed definition to be adopted in the final rule, many boards may be led to conclude that only former accountants and CFOs qualify as financial experts. 2
C. Education and experience with a reporting company should not be a prerequisite. The requirement that the financial expert acquire the identified attributes in a position or function at a reporting company seems unnecessarily restrictive.3 Many people with financial savvy and accounting and auditing experience acquire that expertise serving with or for non-reporting companies, including privately-held financial services firms. In addition, in industries with few public companies, this requirement, when combined with the "generally comparable" requirement discussed in section II. D below, would severely limit the availability of financially proficient directors who will qualify.
D. The "generally comparable" requirement is unnecessarily restrictive. Requiring that the experience be with accounting issues or with estimates, accruals, and reserves that are "generally comparable to those raised by the registrant's financial statements" could limit companies to designating persons with experience in a similar business segment or who have worked for a competitor. This criteria further narrows the number of persons who could meet the definition of financial expert. A person with experience at a manufacturing company may therefore not qualify as a financial expert for a media or health care company. When adopting its final definition, the Commission should acknowledge the value of persons serving on an audit committee who have good judgment and extensive business experience, as well as the ability to understand and appreciate the key accounting issues of another industry. If the rule were adopted as proposed, it could lead companies to choose persons to serve on their boards who are less qualified or experienced than they would prefer to designate, merely because they would satisfy the standards of having experience in a comparable business.
E. The proposed definition may cause many companies to disclose that they do not have a financial expert. The Commission's definition of financial expert would place many companies in the position of having to disclose that they do not have a "financial expert" and the reasons why they do not have such an expert. Section 407 of the Act is a "designate or explain" statute, but designation of a financial expert is clearly to be preferred over explanation because the designation is presumed to improve audit committee function and better protect investors' interests. Defining the term too narrowly will undermine this objective. To the extent that a company is unable to recruit a qualifying financial expert, the company will simply disclose that its audit committee does not include a financial expert. It is hard to imagine that Congress meant the Commission to define the term in so stringent a manner as to cause many companies to disclose that their audit committees do not include financial experts.
We recommend that the Commission revise the proposed definition either to modify the list of required attributes to permit persons who have education or experience in the use and analysis of financial statements to qualify as a financial expert or to change the list of financial attributes into a list of required considerations for the board to weigh in determining financial expertise. The latter approach asks the board, consistent with its fiduciary duties, to determine the best combination of financial skills for audit committee members of a particular company, without mandating that the audit committee member have a skill set mandated by regulation. This approach has the additional benefit of squaring with the existing approach of the SROs with respect to financial sophistication.
F. The definition of financial expert and the term itself are not consistent with a director's role. The proposed definition of "financial expert" assumes a set of skills that is not consistent with the traditional role of an audit committee member. The role of the audit committee is not to re-audit the company's financial reports, but to provide diligent oversight of the company's financial reporting process. While experience and education in accounting and auditing may assist a board member in his or her oversight task, it should not be a requirement.
Although Section 407 of the Act uses the term "financial expert," we believe the Commission should use a different term to identify the audit committee members with financial proficiency. The term "financial expert" suggests that the identified director serves the company primarily as an expert, rather than as a director who oversees management and the auditors and other experts that the directors and the company engage to provide professional services. Suggesting that a director is an expert misunderstands the recognized role of a director whose responsibility it is to oversee management and in so doing to rely on experts to assure compliance with accounting and legal requirements.
Furthermore, the term "expert" has significance under Section 11 of the Securities Act of 1933 and case law, which the Commission notes in the proposing release "suggests a higher level of due diligence than is consistent with the audit committee's oversight responsibilities." Directors engage auditors to "expertise" financial information in the registration statement. Audit firms bring the requisite staff and resources to perform this responsibility, and are well compensated for performing it. In addition, under the common law governing negligence, experts are held to a higher standard of care. Suggesting that audit committee members serve as "experts" confuses the traditional roles of experts and directors. If an audit committee member is expected to bring expertise to his job, wouldn't he be held responsible if he fails to discover matters that an accounting "expert" should have discovered? To address this concern, we recommend using the label "financially proficient director." (The emphasis is on the term "director," with the term "financially proficient" used as an adjective for the director's primary role, which is to serve as director.) Our term suggests that the person brings the requisite skills and experience to his role as an audit committee member, but is not himself serving as the expert.
III. Increased liability concerns.
We believe many directors who would qualify as financial experts will refuse to be named and serve as a financial expert due to legitimate concerns about their being held to a higher standard of care than a director not so identified. To address this concern, we suggest that the Commission should confirm in the text of the final rules that "mere designation of the financial expert [does] not impose a higher degree of individual responsibility or obligation on a member of an audit committee."4 State law, not federal securities law, should govern the issue of how a director's level of sophistication affects the duties the director owes to shareholders. Without this express statement or something like it, we believe that courts might apply to the designated board member the tougher standards that they apply to experts in other liability contexts, and effectively expect a higher level of care and expertise from the "expert" directors. Courts might feel obligated to do so, given that these disclosure rules invite investors to place greater reliance upon the financial expert's experience, judgment and ability to oversee the company's financial reporting.
IV. Content and location of the disclosure.
While the Act does not specifically require disclosure of the number and names of the financial expert or experts sitting on the audit committee, the Commission has stated that it would be appropriate to mandate these requirements, citing investor interest. On balance, we do not object to naming the financial expert inasmuch as we think many companies will want to do so voluntarily and most investors could determine the financial expert from the required biographical information of the audit committee members. We do not see any reason whatsoever to require disclosure of more than one financial expert. In truth, most companies are going to find it hard to determine that they have one expert let alone two and if an issuer can name more than one, they should be able to do so on a voluntary, not mandated, basis.
With respect to the location of the disclosure concerning the financial expert, the Act expressly states that public companies must provide this disclosure in their periodic Exchange Act reports. The Commission proposes to require companies to include the new disclosure in their annual reports on Forms 10-K and 10-KSB, but not to require companies to include this disclosure in their quarterly reports. We agree with this position. In addition, we believe this disclosure should most appropriately be included in the issuer's proxy statement together with the other required disclosures concerning the audit committee. If this is done, investors and stockholders could look to one document -- the proxy statement -- for a complete description of the audit committee, its composition and its functions. To satisfy the statutory requirement that the disclosure be included in the 10-K and 10-KSB, we recommend the addition of a new Item 16 in Part III of Forms 10-K and 10-KSB titled "Audit Committee's Financial Proficiency."
V. Application to small business.
The need for a more flexible definition of "financial expert" is particularly acute for smaller companies. While investors in smaller companies should have the same protection from fraud and abuse as those in larger companies, the burdens on smaller companies would be greater in terms of their ability to recruit directors with the proposed expertise. The risks of serving as a director of a smaller company are often perceived as being greater, due often to the highly volatile nature of their business operations and competitive environments, to the resources that can be brought to bear on issues such as the hiring and retention of qualified management personnel and the development and implementation of internal control systems. Further, in view of the limited compensation that smaller businesses can afford to pay to directors for their services (often less than $15,000 - $20,000 annually), and the costs associated with obtaining director's and officer's liability insurance, the narrow definition of financial expert in the proposals will make it extremely difficult for smaller companies to find directors who would be qualified and willing to serve as "financial experts" on the audit committees of such companies. Therefore, despite the Commission's statements regarding the lack of distinction among responsibilities and liabilities of the directors serving on the audit committee, the more knowledge and experience required of the director designated as the financial expert, the more difficult it will be for a smaller company to identify, recruit and hire qualified persons.
VI. Application to subsidiaries and guarantors.
In a number of situations, a company would be deemed an "issuer" as defined in the Act but would not be an independent entity. These include:
In these situations, the audit committee of the public parent would have the responsibility to oversee the financial reporting of the subsidiary issuers. In most cases, the boards of these subsidiaries are composed of senior management of the parent company and do not have (and are not required to have) independent directors or audit committees. Accordingly, we believe it would be unnecessary to require these subsidiaries either to designate an audit committee having a financial expert or to disclose that they do not have a financial expert. We believe investors' interests would be adequately protected by disclosure at the parent level.5
VII. Application to foreign private issuers.
Based upon our discussions with various foreign private issuers, we believe that it will be extremely difficult, and in many cases it may be impossible, for a foreign private issuer to recruit a person to serve on the issuer's audit committee who has both the requisite skills and experience to meet the financial expert test set forth in the proposed rule. The requirement that a financial expert have both experience as a public accountant or auditor, or as a principal financial officer, controller, or principal accounting officer, of an Exchange Act reporting company (see Section II.C above), as well as an understanding of home country generally accepted accounting principles ("GAAP") will significantly limit the number of persons who will be eligible to serve as the financial expert on the audit committee of a foreign private issuer's board of directors. Even in foreign jurisdictions with relatively many Exchange Act reporting companies, the pool of eligible persons will be small. For example, it appears from our review that there are currently only approximately 37 United Kingdom companies with equity listed on the Nasdaq Stock Market, and approximately 55 United Kingdom companies listed on the New York Stock Exchange. In jurisdictions having fewer Exchange Act reporting companies, the difficulty of identifying candidates will be commensurately greater. The number would be further reduced because many persons having experience with Exchange Act reporting companies may not meet a particular foreign private issuer's criteria for board membership. Further, having identified a person who may be eligible, that person may not be willing to join the issuer's board and accept the designation as financial expert.
In addition to the foregoing matters, the proposing release states that a board should consider a person's level of experience with reconciliation of financial statements with U.S. GAAP. In order for a person to be familiar with U.S. GAAP reconciliation requirements, that person should presumably have not only an understanding of the general rules applicable to the reconciliation of the home country GAAP to U.S. GAAP, but also a continuing awareness of all material developments to U.S. GAAP that may affect the issuer's reconciliation, including changes to applicable interpretations. Although experience with reconciliation is listed only as a "consideration," we believe that the statement proposed to be included in the definition of financial expert that the directors should consider this factor, as well as the other considerations set forth in the proposed rule (including those that explicitly relate to Exchange Act reporting), will yet further reduce the number of persons who the board will be able to conclude have the requisite financial expertise to qualify as a financial expert.
If the board of directors of a foreign private issuer is not able to designate a financial expert because the applicable standards are too high, it might not seek to recruit a member of the audit committee who would be able to meet many of the other criteria associated with the financial expert test. Because we believe it would be in the best interests of a foreign private issuer and its shareholders to have at least one member of its audit committee meeting a very high standard of experience and education, we believe that the final rule adopted by the Commission should revise the proposed definition of financial expert in the context of a foreign private issuer to eliminate any requirement that the financial expert have experience with an Exchange Act reporting company, and also to clarify that knowledge of, or experience with, Exchange Act reporting obligations (including experience with reconciliation of home country GAAP to U.S. GAAP), is not a required criterion for the financial expert of a foreign private issuer. In the event the Commission determines not to amend the definition of financial expert in the context of foreign private issuers as suggested above, we would propose as an alternative that, in lieu of requiring a foreign private issuer to state that it does not have a financial expert and explaining the reasons why it does not have such an expert, a foreign private issuer be permitted to disclose whether or not the audit committee has retained as a consultant or other adviser a person or firm which is familiar with that issuer's home country GAAP and also has expertise regarding the preparation of financial statements that are required to be included in periodic reports filed under Section 13(a) or 15(d) of the Exchange Act.
VIII. Coordination with the SRO financial sophistication requirements.
The Financial Expert Proposals are only disclosure rules, but to the extent the SROs adopt the Commission's proposed definition as part of their listing requirements (as the Nasdaq has suggested that it may), listed companies who cannot hire an audit committee member meeting the definition will be forced to delist their securities from trading. The Commission should coordinate with the SROs to assure that either the SROs do not adopt the Commission's definition as a listing requirement or that the definition is sufficiently supple so that if it is made part of the SRO's listing standards it does not inadvertently result in the delisting of many companies securities.
We appreciate the opportunity to submit comments. We are available to meet with the Commission or the Staff and to respond to any questions.
1 Where Congress desires specific requirements to be incorporated into rules or standards, it knows how to instruct the Commission or the SROs to do so. The independence requirements for audit committee members in Section 301 of the Act is a good example.
2 The Financial Expert Proposals require the board to determine that a person qualifies as a financial expert only if that person possess each of the identified attributes. Thus, for example, we believe that many internal auditors, although experts in GAAP, do not have expertise in the "preparation of financial statements" as required in the proposals and, consequently, would not qualify. Furthermore, we understand that a number of companies are prohibiting their CFOs from serving on audit committees of other issuers for fear that they could be tainted with any financial disclosure problems at those issuers. This further reduces the universe of persons who would qualify as financial experts.
3 We note some ambiguity in the language of the proposed definition as it relates to the requirement that a person have acquired the attributes in service to a reporting company. The proposed definition permits the board to determine that a person has acquired the identified financial attributes even though he or she has not served in one of the identified jobs or functions. But it is not clear that the board may determine that a person has the attributes even if he or she did not acquire those attributes working with or for a reporting company. Clarification of this point would be helpful.
4 The language in the proposing release only states that the designation "should not impose a higher degree of responsibility or obligation . . ." on the person so identified. We do not believe that a sentence in the release text would assure potential financial experts that a higher standard of care does not apply to them in being identified as the financial expert. Without sufficient assurance, many qualified directors would be discouraged from serving as a financial expert.
5 We believe that these types of subsidiary issuers are not within the spirit and should be excluded from all aspects of the Sarbanes-Oxley Act. Requiring these issuers to comply with the Act when their public parent also complies serves no useful regulatory purpose, is unnecessarily burdensome on management and imposes costs that do not result in a commensurate benefit to investors.