(January 30 as updated February 11, 2003.) The Securities and Exchange Commission adopted final rules under the Sarbanes-Oxley Act of 2002 requiring SEC reporting companies (including foreign private issuers) to disclose the identity of their "audit committee financial expert" and whether they have a code of ethics for their senior financial management and CEO. (See SEC Release No. 33-8177, which you can access at http://www.sec.gov/rules/final/33-8177.htm.)

Disclosure of Audit Committee Financial Experts

The final rules require an SEC reporting company to disclose in its annual reports whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. If a company does not have any financial expert on its audit committee, it must explain this absence. The final rules permit, but do not require, a company to disclose that it has more than one such expert.

Required Compliance Dates

The new disclosure is first required for all SEC reporting companies (other than small business issuers) in annual reports for fiscal years ending on or after July 15, 2003. Small business issuers are first required to provide the disclosure in annual reports for fiscal years ending on or after December 15, 2003.

Definition of "Audit Committee Financial Expert"

As adopted, the definition of "audit committee financial expert" is less onerous than previously proposed by the SEC. However, it remains an accounting-oriented and exacting standard. The final rules define an "audit committee financial expert" as a person who has all of the following attributes:

  • An understanding of GAAP and financial statements,

  • An ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves,

  • Experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and level of complexity of issues that can reasonably be expected to be raised by the company's financial statements, or experience actively supervising a person in such activities,

  • An understanding of internal controls and procedures for financial reporting, and

  • An understanding of audit committee functions.

The rules provide that a person must have acquired these five necessary attributes through any one or more of the following means:

  • Education and experience as a principal financial or accounting officer, public accountant or auditor or a position involving the performance of similar functions,

  • Experience "actively supervising" a person in such a position,

  • Experience overseeing or assessing the preparation, auditing or evaluation of financial statements, or

  • "Other relevant experience."

Under the final rules, if a person qualifies as an expert by virtue of possessing "other relevant experience," the company's disclosure must briefly list that person's experience.

Significant Relaxation of Standard

The SEC's proposed rules, published in October 2002, drew significant criticism from commentators who expressed concern that few audit committee members-or, for that matter, few of the country's most experienced investors and business leaders-would qualify under the standard. In particular, the prior proposed definition of "financial expert" was viewed as overly restrictive because it required direct auditing experience of comparable financial statements. Many commentators suggested that the emphasis on technical accounting expertise was misplaced given that the audit committee's role is one of oversight, rather than direct involvement in accounting matters.

The revised definition of "audit committee financial expert" in the final rules relaxes several of the requirements, thereby expanding the pool of individuals who may qualify. For example, the changes suggest that some (though certainly not all) CEOs may qualify under the standard. Significant revisions from the proposed rules include:

  • Eliminating the proposed requirement that a person must have experience applying GAAP in connection with accounting for estimates, accruals and reserves that are "generally comparable" to the estimates, accruals and reserves used in the company's financial statements,

  • Expanding the requirement that a person have experience "preparing or auditing" financial statements to include experience "analyzing or evaluating" such financial statements,

  • Clarifying that a person need not have previous experience with financial statements of another company in the same industry as the company or with another company subject to SEC reporting requirements, by requiring only that their experience have been with financial statements that "present a breadth and level of complexity of accounting issues that are generally comparable" to the company's,

  • Permitting individuals with experience "actively supervising" the preparation, auditing, analysis or evaluation of financial statements to qualify, and

  • Changing "experience with" internal controls to "understanding" such controls.

The SEC cautions, however, that the mere existence of a traditional hierarchical reporting relationship will be insufficient to satisfy the supervisory standard. Instead, the supervisor's experience must involve active participation in and contribution to the process of addressing financial and accounting issues. The supervisor must have general expertise in this area that is at least comparable to the general expertise of those being supervised.

Under this standard, a CEO with considerable operations involvement, but little financial or accounting involvement, may not be exercising the necessary active supervision. The SEC also warned that a person's previous service on an audit committee does not, by itself, mean that he or she has the requisite experience.

Determination of Who Qualifies

Ultimately, the board of directors must independently evaluate each potential audit committee financial expert and determine whether he or she possesses all of the attributes required to satisfy the SEC definition as finally adopted. While the proposing release set forth a preliminary, nonexclusive list of 10 factors that a board of directors might consider in making its determination, the final rules specifically declined to take this "checklist" approach. Instead, the SEC states that "the board should consider all the available facts and circumstances" when making its determination, including consideration of any disciplinary actions to which the director is or has been subject.

Disclosure Obligation Only

As adopted, the rules do not require that a financial expert be placed on each company's audit committee-the rules impose a disclosure obligation only. Until a company is able to identify a financial expert within the SEC's definition, it may have no choice but to disclose the absence of a financial expert on its audit committee, the reasons for this absence and its plans, if any, for finding a director with such qualifications in the future. The SEC noted that, if a company does not have a director who satisfies all of the requirements of an audit committee financial expert, it would be appropriate for a company to explain the aspects of the definition that various committee members do satisfy.

Companies listed on NASDAQ, the NYSE or other securities exchanges must continue to comply with the applicable listing requirements concerning audit committees, such as the current NASDAQ and NYSE requirements that all committee members be financially literate and that at least one committee member be financially sophisticated. Recently proposed NASDAQ rules would also require each listed company to have at least one financial expert (as defined by SEC rules) on its audit committee. The NYSE has not yet proposed a similar rule.

Codification of Safe Harbor from Liability

The rules include a safe harbor, clarifying that an audit committee financial expert will not be deemed an "expert" for any purpose, including under Section 11 of the Securities Act of 1933. In addition, the safe harbor provides that designation of an individual as an audit committee financial expert will not impose any duties, obligations or liability on that individual beyond those imposed on audit committee members generally, nor will it affect the duties, obligations or liability of any other member of the audit committee or board. This safe harbor is only effective at the federal level, and therefore, it is unclear how the identification of, and potential reliance by the board of directors on, such expertise may augment the duties and liabilities of such an expert imposed by state corporation law.

Applicability to Foreign Private Issuers

Like a domestic issuer, a foreign private issuer will have to disclose whether it has an audit committee financial expert in its annual reports on Form 20-F or 40-F. However, the rules do not require foreign private issuers to disclose whether their audit committee financial experts are independent until such time as the SEC's independence rules under Section 301 of the Sarbanes-Oxley Act are finally adopted. The SEC asked for comments by February 18, 2003 as to the appropriate treatment of foreign private issuers in light of its proposed audit committee independence rules.

In addition, the final rules clarify that, with respect to foreign private issuers, the requisite understanding of GAAP need not be of U.S. GAAP. Instead, an audit committee financial expert of such an issuer must have an understanding of the principles used to prepare the issuer's primary financial statements filed with the SEC. In relaxing this standard from the proposal, the SEC recognized that requiring such an expert to possess U.S. GAAP expertise could unduly burden foreign private issuers who use home country accounting principles or international accounting standards to prepare their primary financial statements.

Code of Ethics Disclosure

The SEC also adopted rules that require SEC reporting companies to disclose in their annual reports whether they have adopted a code of ethics for their CEO, CFO, principal accounting officer or controller, or persons performing similar functions. A copy of this code of ethics must be filed as an exhibit to the annual report or made available on the company's website or the company must undertake in its annual report to provide a copy without charge. If a company has not adopted a code of ethics, it must explain the reasons it has not done so.

Compliance Date

The new disclosure is first required for all SEC reporting companies in annual reports for fiscal years ending on or after July 15, 2003.

Content Requirements

The code of ethics contemplated by the rules is a codification of standards reasonably designed to deter wrongdoing and to promote:

  • Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships,

  • Full, fair, accurate, timely and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and in other public communications made by the company,

  • Compliance with applicable governmental laws, rules and regulations,

  • The prompt internal reporting of code violations to an appropriate person or persons identified in the code, and

  • Accountability for adherence to the code.

As finally adopted, the rules omitted a proposed requirement that the code of ethics contain a standard designed to promote "avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the code of any material transaction or relationship that reasonably could be expected to give rise to such a conflict." The SEC indicated that this "avoidance" requirement was unnecessary because the first prong of the proposed definition (concerning the ethical handling of conflicts of interest) adequately addresses the component.

Other than these general topics, the rules do not address the content of a code of ethics. The SEC believes that the details, such as particular standards of conduct, compliance procedures and disciplinary measures, are best left to each company to determine. The SEC also noted that a company may have separate codes of ethics for different types of officers and that the required code of ethics may be part of a broader code that addresses additional issues or applies to additional persons. In those instances, a company can comply by disclosing those portions of the code of ethics that apply to the officers and address the elements covered by the rule.

Disclosure of Waivers on Form 8-K

The rules also require disclosure of any modification or waiver of a company's code of ethics with respect to any of the covered officers on either a Form 8-K or on the company's website within five business days after the modification or waiver. The SEC has indicated that it will consider reducing such period to two business days when it finalizes its proposal to expand and accelerate Form 8-K filing requirements generally. Website disclosure is permitted only if a company has disclosed in its most recent annual report that it intends to disclose such events on its website and provides the website address.

Disclosure Obligation Only

As with the financial expert rules, the proposed code of ethics rules are disclosure-oriented only. They do not require an SEC reporting company to adopt a code of ethics. However, both NASDAQ and the NYSE have proposed rules that would require each listed company (other than foreign private issuers) to adopt a code of ethics and disclose any waivers of the code.

Applicability to Foreign Private Issuers

Like a domestic issuer, a foreign private issuer will have to provide the new code of ethics disclosure in its Exchange Act annual report on Form 20-F or 40-F. A foreign private issuer is required to disclose any change to or waiver from the code of ethics obligations of its senior officers on an exhibit to its Form 20-F or 40-F, however, the SEC encourages such issuers to do so earlier on a Form 6-K or on its website.

Conclusion

The SEC has made an effort to meet the mandate of Sarbanes-Oxley while responding to the expressed concerns of SEC reporting companies that some of the new requirements, as proposed, were overly burdensome and unnecessary. Despite the more relaxed definition of "audit committee financial expert" in the final rules, however, many SEC reporting companies may still find that none of their current audit committee members reasonably can be said to qualify as a financial expert. As the demand for qualifying directors grows, it may become more difficult for a number of companies to attract a satisfactory financial expert to their audit committee. Growing liability concerns and forthcoming rules that would limit the number of audit committees on which a person can serve will only exacerbate the problem.

January 30, 2003, as Updated February 11, 2003