Sarbanes-Oxley Act Disclosures Proposed
- The Securities and Exchange Commission recently proposed rules to implement disclosure requirements under sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002. Release Nos. 33-8138, 34-46701, IC-25775, 67 Fed. Reg. 66208 (Oct. 22, 2002). The proposals would require a public company to (1) disclose whether it has an independent financial expert serving on its audit committee, (2) disclose whether it has adopted a code of ethics coverings its principal executive officers and senior financial officers, and (3) file an annual internal control report of management. The proposal also includes several conforming revisions to the SEC's recently adopted certification rules and related requirements. Comments on the proposals are due by November 29, 2002. The release is available on the Federal Register web site (search for "page 66208"), at
Financial Expert on Audit Committee
Section 407 of the Sarbanes-Oxley Act requires the SEC to adopt rules requiring a public company to disclose whether its audit committee includes at least one member who is a financial expert and defining the term "financial expert." The SEC has proposed a rigorous definition, requiring the "financial expert" (really an accounting expert) to have each of five attributes:
--An understanding of generally accepted accounting principles (GAAP) and financial statements;
--Experience applying GAAP 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;
--Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements;
--Experience with internal controls and procedures for financial reporting; and
--An understanding of audit committee functions.
Many boards of directors will find that they do not have any independent directors meeting the SEC's proposed test. The New York and American Stock Exchanges and Nasdaq already have rules requiring at least one member of an audit committee to have accounting expertise, but their definitions of accounting expertise are not as demanding as the SEC's proposed rule; the SEC also said it intends to propose rules requiring listed companies to have a completely independent audit committee as a condition to listing. The disclosure is to be made annually in the Form 10-K. All registered management investment companies would be required to make the disclosure and would do so in proposed Form N-CSR; disclosure would not be required for unit investment trusts. The Sarbanes-Oxley Act requires the SEC to issue final implementing rules by January 26, 2003.
Code of Ethics
Section 406 of the Sarbanes-Oxley Act requires the SEC to adopt rules requiring a public company to disclose whether it has adopted a code of ethics for senior financial officers; the SEC proposal would also apply to chief executive officers. The Sarbanes-Oxley Act, and the SEC's proposed rules, does not specify the precise content of such a code of ethics, but the SEC says that a comprehensive code should set forth guidelines requiring avoidance of conflicts of interests and material transactions or relationships involving potential conflicts of interests without proper approval, should describe the company's system for the internal reporting of code violations, and should state clearly the consequences for non-adherence to code provisions. The code of ethics would be disclosed in Form 10-K, and any changes to or waivers from the code would require immediate disclosure in a Form 8-K or on the company's website.
For all registered investment companies, disclosure would be required whether each of the investment company, its investment adviser, and its principal underwriter has adopted a code of ethics. Disclosure of the code and any waivers would be made on proposed Form N-CSR or Form N-SAR, as applicable. This code of ethics is different from the code of ethics currently required by Rule 17j-1, but the two codes could be combined into a single comprehensive code of ethics.
The Sarbanes-Oxley Act requires the SEC to issue final rules to implement Section 406 by January 26, 2003. As with the Section 407 rules, the SEC would merely impose a disclosure requirement and would not actually require companies to adopt a code of ethics. However, the New York Stock Exchange included a requirement that listed companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees, and promptly disclose any waivers of the code for directors or executive officers, in its corporate governance rule proposals filed with the SEC on August 16, 2002. Nasdaq proposed a similar requirement for Nasdaq National Market and Small Cap Market issuers in a rule filing on October 9, 2002. The NYSE filing is available at
while the Nasdaq rule filing is at
Internal Control Reports
Section 404(a) of the Sarbanes-Oxley Act provides that the SEC shall prescribe rules requiring each annual report to contain an internal control report, which shall state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Section 404(b) provides that each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer. The SEC proposes to define "internal controls and procedures for financial reporting" to mean controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with GAAP as addressed by Section 319 of the Codification of Statements on Auditing Standards.
The SEC proposes to require a public company to file the internal control report and the auditor's attestation report in its Form 10-K. In addition, the SEC proposes to require the company's management to evaluate the effectiveness of the design and operation of the company's internal controls and procedures for financial reporting with respect to each annual and quarterly report that it is required to file under the Securities Exchange Act of 1934. The new rules are intended to create symmetry between the Section 404 evaluation requirement and the existing officer certification rules under Section 302, which contemplate periodic evaluations of the company's disclosure controls and procedures. Several modifications of the Section 302 rules are also proposed, making this release the most up-to-the-moment version of the SEC's thinking on officer certification.
The Sarbanes-Oxley Act specifically exempts registered investment companies from Section 404 and the SEC rules thereunder. Nevertheless, this release does include several proposed amendments to the investment company officer certification rules, both to conform to the operating company rules and to reflect current SEC thinking.
The Sarbanes-Oxley Act does not impose a deadline for compliance with Section 404. The SEC proposes to apply the new rules under Section 404 to companies whose fiscal years end on or after September 15, 2003. The delay is intended to provide the Public Company Accounting Oversight Board sufficient time to adopt standards for attestation engagements, as well as for companies and auditors to prepare for the expected increase in workload.
Correction: My October 31 post misspelled the name of the SEC's Inspector General, Walter J. Stachnik. The misspelling was based on an erroneous spelling in the New York Times.
John M. Baker <JMB@...>
Stradley, Ronon, Stevens & Young, LLP Http://www.stradley.com
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