November 29, 2002
Mr. Jonathan G. Katz,
Re: Proposed Rules Relating to Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (File No. S7?40?02)
Dear Mr. Katz:
We are pleased to respond to Release No. 34-46701, in which the Securities and Exchange Commission solicited comments on its proposed rules implementing the provisions of the Sarbanes-Oxley Act of 2002 relating to financial expert and code of ethics disclosure and internal control reports.
We have set forth below specific aspects of the proposed rules relating to financial expert and code of ethics disclosure that we believe, based on our review and on discussion with our clients, should be modified in order to promote the underlying statutory purposes of Sections 406 and 407 of the Act.
I. Financial Expert Disclosure
A. Broaden the Definition of Financial Expert.
The feedback we are receiving from many companies is that they do not believe they currently have a board member who satisfies the proposed definition of "financial expert". We expect that many companies seeking to add a board member who is a financial expert will have great difficulty identifying candidates who:
We believe that there is a substantial risk that the narrow definition will cause many companies either not to have a financial expert on the audit committee or to accept a financial expert who would not otherwise meet the standards for board membership. Such a result would tend to undermine the statutory purpose of enhancing the quality and effectiveness of audit committees in overseeing the auditing process.
We urge the Commission to take a different approach to the determination of whether a director is a "financial expert". The proposed rule defines "financial expert" more rigidly than Section 407 requires. Section 407 provides a list of criteria for the Commission to consider in defining "financial expert", but does not require that financial experts satisfy all of these criteria or suggest that the Commission should so require. We suggest that the Commission adopt a more inclusive approach that recognizes that financial expertise can be developed in a variety of ways. In particular, we believe that the Commission should permit a finding of financial expertise notwithstanding a failure to possess the attributes specified in clauses b., c. or d. of Instruction 1 to Item 309 (and each of the other comparable proposed provisions), if the board of directors determines, in its business judgment, that the director in question is otherwise qualified to serve as a financial expert, and the basis for this determination is disclosed.
In addition, and especially if the more inclusive approach described above is not adopted, we believe that the listed attributes themselves should be modified in three critical respects, as follows:
Change "preparing or auditing" financial statements to "preparing, auditing, reviewing or analyzing." Our primary concern is the severe limitation imposed by the requirement that a financial expert have experience "preparing or auditing" suitable financial statements. The Commission specifically requested comment on whether experience reviewing or analyzing financial statements should be sufficient to qualify as a financial expert if the person does not have direct experience preparing or auditing financial statements. We believe that it should, and we strongly urge the Commission to replace the words "preparing or auditing" in clause b. with "preparing, auditing, reviewing or analyzing."
A requirement that a financial expert actually have experience preparing or auditing financial statements would dramatically limit the pool of qualified individuals to a small subset of those with the financial expertise suitable to the audit committee's oversight function. For example, sophisticated financial analysts, bankers, chief executive officers, money managers and other professional investors can clearly provide useful financial expertise to many companies' audit committees, and a broader definition would encourage their use. Even a highly qualified professor of finance or accounting who has devoted his or her career to the study of financial statements would not qualify as a financial expert if he or she does not have professional experience as an accountant or financial officer. While these individuals may not have experience in preparing or auditing financial statements, they may have extensive experience in reviewing, analyzing and using financial statements and in questioning management and auditors in respect of financial statements. The Commission itself recognizes that "the role of the financial expert is to assist the audit committee in overseeing the audit process, not to audit the company." See Section II.A.1 of the proposing release. Permitting the financial expert's experience to be in the review or analysis of financial statements is consistent with this role.
Eliminate the comparability requirements. The second critical aspect that we believe must be addressed is the requirement in clauses b. and c. that the individual's experience be with estimates, accruals and reserves and other accounting issues that are "generally comparable" to the issuer's. We urge the Commission to eliminate these comparability requirements. Requiring a financial expert who has experience with the accounting issues that the issuer deals with is unnecessary and unduly limiting. We believe that it should be sufficient for the director in question to have general experience with the judgmental processes and disciplines applied in accounting. For example, an otherwise qualified individual may have extensive experience with financial institutions and accounting matters but may lack experience with a particular accounting issue, such as reserving for disability insurance products. A director with such general accounting experience will be able to acquire the requisite company-specific knowledge through his or her work as a director, and will also be able to understand and develop an expertise in new issues as they arise. In addition, general financial experience, even from a different industry context, will add valuable perspective to audit committee deliberations.
Moreover, companies are typically reluctant to add - and indeed may be prohibited from adding - directors affiliated with companies in the same industry. In such cases, the only director candidates meeting the clause b. and c. requirements may be retired or for other reasons inactive, which could in turn raise concerns about their desirability as directors.
At a minimum, the Commission should eliminate the comparability requirement from clause b., since the statute refers only to general experience applying GAAP in connection with accounting for estimates, accruals and reserves, and does not contemplate any comparability requirement at all in this area.
Ease the requirements for foreign private issuers. The third critical aspect to address relates to foreign private issuers. We urge the elimination of the references in clause k. of Instruction 3 to Item 309 (and each of the other comparable proposed provisions) to experience in public companies in the issuer's home country and reconciliation of financial statements with U.S. GAAP. The number of candidates who both know home country GAAP and U.S. GAAP and have experience with SEC-reporting companies will be extremely limited. We believe that requiring experience in the accounting principles used by the foreign private issuer, when considered in the aggregate with the other factors and in light of the five listed attributes, would be sufficient to achieve the goals of Section 407 without unreasonably limiting the pool of eligible candidates.
Furthermore, we suggest that the Commission specify in the rule, or at least in the adopting release, that experience relating to a company that is listed on a home country stock exchange, but that is not an SEC-reporting company, may be deemed by the company's board of directors, depending on the particular circumstances, to result in the individual having "similar expertise and experience" as that derived from experience with SEC-reporting companies. In many countries, the number of SEC-reporting companies is very small, and requiring experience with SEC-reporting companies will exclude many otherwise qualified individuals who may have extensive experience with the financial statements of major home country companies.
B. Adopt a Rule Protecting Against Heightened Financial Expert Liability
We suggest that the Commission promulgate a rule expressly providing that designation and disclosure as a financial expert should have no effect on director liability. We believe that if being identified as a financial expert entails a greater liability risk, then companies will have much greater difficulty finding qualified individuals who are willing to be so identified. The proposing release provides that the "mere designation of the financial expert should not impose a higher degree of individual responsibility or obligation on a member of the audit committee" and that the Commission does not intend for the identified financial expert to be an "expert" for the purposes of Section 11 under the Securities Act. We agree with and support the Commission's views in this regard. These statements in the proposing release, however, are not likely to provide a sufficient basis for federal or state courts to reach the same conclusions as to liability.
We believe that the Commission should promulgate a rule stating that no director shall be subject to any additional liability, responsibility or obligation under the federal securities laws or other applicable law as a result of the financial expert designation or disclosure. This rule should be constructed with sufficient breadth to cover liabilities based on, among other things, due diligence obligations, scienter determinations, control person status and Section 11 expert status. We believe that this statement should be included in a formal Commission ruling, not merely the text of a release, particularly in light of Section 19(a) of the Securities Act, Section 23(a)(1) of the Exchange Act and Section 38(c) of the Investment Company Act, each of which provides that liability under the respective act will not be imposed for any act done in good faith in conformity with any rule, regulation or order of the Commission.
Moreover, we urge the elimination of the requirement to disclose the names of the financial experts on the audit committee. Requiring identification of the financial experts by name will not provide investors with a significantly greater understanding of the quality of the audit committee and, by heightening potential liability, will make it much more difficult for companies to find qualified individuals willing to serve as financial experts.
C. Provide a Transition Period
The Commission requests comment on whether a transition period would be appropriate. We note that the New York Stock Exchange, in proposing new director independence standards, intends to give companies 24 months to find suitable qualified directors that meet the new standards. We suggest that the Commission provide a similar transition period to give companies time to conduct what we expect to be, in many cases, a most challenging search for suitable board members who also qualify as financial experts.
III. Codes of Ethics
We believe that the Commission should not add to the statutory definition of the code of ethics the requirement that the code be "reasonably designed to deter wrongdoing." This language, together with the statement in footnote 66 of the proposing release that codes of ethics "generally seek to instruct those to whom they apply as to improper or illegal conduct or activity and to prohibit such conduct or activity," could be read to require that the code of ethics include detailed instructions on precisely how the covered employees must act to avoid acting improperly or illegally, in the manner of a compliance manual or codification of internal controls.
The statute's requirement that the code's provisions be "reasonably necessary to promote" certain conduct contemplates a more general statement of ethical standards. For many companies a detailed compliance manual would be useful to have, but this is not generally thought of as the company's "code of ethics." Moreover, if the company's code of ethics were required to serve the function of a compliance manual, many companies might feel compelled to water down and weaken their existing compliance procedures and policies in order to avoid the disclosure of immaterial changes in and waivers of the code. In addition, many companies may have different compliance policies relating to different subject matters, geographic regions, company departments or employee categories; it would be impractical in those cases to embody the policies in a single code of ethics for disclosure purposes. We believe that the Commission's proposed focus on deterring wrongdoing in addition to promoting ethical conduct reflects a fundamentally different conception of what a code of ethics should be from that of Congress. If the Commission does not eliminate this requirement from the rule, then we believe that the Commission should state in the adopting release that in order to be "reasonably designed to deter wrongdoing" the code does not need to be a detailed compliance manual or codification of internal controls, but instead can be a general statement of ethical standards.
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We appreciate the opportunity to comment to the Commission on the proposed rules, and would be happy to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to Donald C. Walkovik (212-558-3911), David B. Harms (212-558-3882) or John T. Bostelman (212-558-3840).
cc: Giovanni P. Prezioso
Jackson M. Day
Alan L. Beller
Paul F. Roye
Annette L. Nazareth