THE RESPONSE TO ENRON: THE SARBANES-OXLEY ACT OF 2002 [PDF]

THE RESPONSE TO ENRON: THE SARBANES-OXLEY ACT OF 2002 AND COMMISSION RULEMAKING

John J. Huber Thomas J. Kim of Latham & Watkins

October 20, 2002

 2002 Latham & Watkins. All rights reserved. All or a part of this outline has been or may be used in other materials published by the authors or their colleagues at Latham & Watkins.

TABLE OF CONTENTS Page I.

INTRODUCTION ...............................................................................................................1

II.

RECENT DEVELOPMENTS .............................................................................................8

III.

CERTIFICATION OF PERIODIC REPORTS ...................................................................9

IV.

DISCLOSURE CONTROLS AND PROCEDURES ........................................................24

V.

REGULATING OFFICERS AND DIRECTORS .............................................................52

VI.

NEW DISCLOSURE REQUIREMENTS UNDER THE ACT ........................................60

VII.

CORPORATE GOVERNANCE UNDER THE ACT.......................................................66

VIII.

REFORMING THE ACCOUNTING PROFESSION.......................................................75

IX.

SECURITIES ANALYSTS ...............................................................................................82

X.

CRIMINAL SANCTIONS, ENFORCEMENT & LITIGATION.....................................83

XI.

ACCELERATED REPORTING DUE DATES ................................................................89

XII.

DISCLOSING WEBSITE ACCESS TO PERIODIC REPORTS .....................................95

XIII.

COMMISSION GUIDANCE ON MD&A........................................................................97

XIV. CRITICAL ACCOUNTING ESTIMATES.....................................................................111 XV.

CURRENT REPORTS ON FORM 8-K ..........................................................................130

XVI. PRO FORMA FINANCIAL INFORMATION ...............................................................134 XVII. THE ANDERSEN RELEASE.........................................................................................139 XVIII. CONCLUSION................................................................................................................148

I.

INTRODUCTION

Sparked by Enron1 and a series of corporate and accounting scandals,2 President Bush signed the Sarbanes-Oxley Act of 20023 (the “Act”) into law on July 30, 2002. The Act may represent the most dramatic change to the securities laws and their administration since the Great Depression. Wide-ranging in scope, the Act provides a permanent legislative solution to the problems of Enron – and attempts to re-establish investor confidence – by improving the quality of disclosure and financial reporting, strengthening the independence of accounting firms and increasing the role of audit committees and the responsibility of management for corporate disclosures and financial statements. Some of the Act’s provisions are new; others mandate as federal law what heretofore had been proposed as changes to stock market listing standards, or best practices, or rulemaking by the Securities and Exchange Commission (the “Commission”). The Act may also regulate matters that traditionally are the subject of state corporation law4 and adds substantive requirements to the federal securities laws in areas formerly subject only to disclosure requirements. This overlap and intersection between the Act and other laws, regulations and reform initiatives may cause conflicts as well as interpretative issues to arise. The Act is significant for all public companies, both domestic and foreign,5 their officers, 1

For a preliminary analysis of the bankruptcy, see Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. (W.C. Powers, Jr., R.S. Troubh and H.S. Winokur, Jr.), Feb. 1, 2002 (the “Special Report”) (available at www.nysb.uscourts.gov ). Related shareholder lawsuits have been brought in U.S. District Court for the Southern District of Texas, Houston Division. See Tittle v. Enron Corp., No. H-01-3913 (S.D. Tex., complaint filed Apr. 8, 2002); Regents of the Univ. of California v. Lay (In re Enron Corporation Securities Litigation), No. H-01-3624, (S.D. Tex., complaint filed Apr. 8, 2002). 2

For a recent overview of accounting failures and corporate misconduct, see David Wessel, Why the Bad Guys of the Boardroom Emerged en Masse, Wall St. J., June 20, 2002, at A1. See also Alex Berenson and Jennifer Bayot, Stocks Plunge Then Rebound in Reaction to Scandal, N.Y. Times, June 27, 2002, at C1; Simon Romero, WorldCom Facing Charges of Fraud; Inquiries Expand, N.Y. Times, June 27, 2002, at A1 (noting that for many, Worldcom’s overstatement, which is perhaps the largest case of financial fraud, “was as if months of accounting scandals, which have already engulfed Enron, Global Crossing and Adelphia Communications, among others, as well as the auditing firm Arthur Andersen, had finally hit critical mass . . . .”). 3

Sarbanes-Oxley Act of 2002, as included in the Conference Report, H.R. Rep. No. 107-610, approved without change by the Senate and the House of Representatives on July 25, 2002 (available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=107_cong_bills&docid=f:h3763enr.txt.pdf). Note that some of the titles of the Act have their own separate names. For example, Title XI of the Act may also be cited as the “Corporate Fraud Accountability Act of 2002.” 4

The federal interest in doing so appears to be based on the nationwide significance of public companies, i.e., companies with securities registered under Section 12 of the Exchange Act or required to file reports under Section 15(d) of the Exchange Act, and the audit of such companies by public accounting firms, which now will be known as registered public accounting firms and regulated by a new body, the Public Company Accounting Oversight Board, supervised by the Commission. 5

The Act applies to all issuers, both U.S. and non-U.S. issuers, with debt or equity securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) or required to file reports under Section 15(d) of the Exchange Act. Moreover, the Act even applies to companies which file, or have filed, a registration statement that has not yet become effective under the Securities Act of 1933, as amended (the “Securities Act”). See Section 2(a)(7) of the Act. Thus, a private company becomes an “issuer” under the Act

directors and shareholders, as well as market, accounting and legal professionals. Among other things, the Act is intended: •

To strengthen the independence of auditing firms by: ƒ ƒ ƒ

•

To improve corporate disclosure by: ƒ ƒ

•

Establishing a new regulatory body to oversee public company auditors; Redefining the relationship between auditors and their clients; and Placing direct responsibility for the audit relationship on audit committees; Establishing new disclosure requirements for issuers; and Accelerating Section 16 reporting deadlines;

To increase the responsibility of management by: ƒ ƒ ƒ ƒ ƒ

Requiring certification of periodic reports by CEOs and CFOs; Holding the CEO and CFO responsible for restatements due to misconduct; Imposing new obligations and responsibilities on audit committees; Banning most loans to officers and directors; and Increasing a variety of criminal penalties and enforcement measures for securities-related offenses;

immediately upon filing a registration statement on Form S-1 in connection with its initial public offering and will continue to remain an “issuer” until the registration statement is withdrawn. The Act’s application to foreign private issuers could conflict with reporting and corporate governance requirements for these issuers in their home countries. A large number of companies, including foreign private issuers, that have registered securities under the Securities Act (particularly debt securities), have less than 300 holders in the U.S. Nevertheless, these companies continue to file reports with the Commission voluntarily, because of requirements in the indentures for their debt securities. It is unclear whether and to what extent the Act will apply to such “voluntary” filers because, by operation of Section 15(d) of the Exchange Act, these filers’ filing obligations are “automatically suspended” and therefore they do not meet the Act’s definition of “issuer” that the company is “required” to file periodic reports under Section 15(d) of the Exchange Act. While voluntary filers have traditionally been subject to all of the requirements of the Exchange Act as if they were required to file periodic reports, the use of the word “required” in the definition of “issuer” in Section 2(a)(7) of the Act appears to indicate a Congressional intent that volunteers are not within the purview of the Act. Thus, debt issuers, which file periodic reports solely because their indentures require them to do so, should not be subject to the requirements of the Act because they are not required to do so by Section 15(d) of the Exchange Act. The release adopting rules to implement the certification requirements of Section 302(a) of the Act does not definitively resolve this issue. See Final Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release Nos. 33-8124, 34-46427, IC-25722 (Aug. 29, 2002)(available at http://www.sec.gov/rules/final/338124.htm)(the “Final Section 302 Release”). First, Section 302(a) refers to “each company filing periodic reports under … Section 15(d)” of the Exchange Act, rather than “issuer.” Second, the text of the Final Section 302 Release differs from the words of the rules adopted therein. While the text of the Final Section 302 Release states that Rules 13a-14 and 15d-14 under the Exchange Act require certifications in each quarterly and annual report “filed or submitted by the issuer under Section 13(a) or Section 15(d) of the Exchange Act,” the text of the rules themselves only says “filed.” The word “submitted” could be read to include volunteers within the scope of the certification rules, but the text of the rule itself, rather than the Final Section 302 Release, should control. Moreover, it would be anomalous if use of the word “company” changed the meaning of the defined term “issuer” when both refer to Section 15(d) of the Exchange Act. Thus, we believe that volunteers, which are not required to file periodic reports pursuant to Section 15(d), are not subject to the certification requirements of Section 302(a).

2

•

To improve the objectivity of research by: ƒ

•

Addressing conflicts of interest securities analysts may have with the investing banking function of broker/dealers; and

To regulate the conduct of lawyers by: ƒ

Requiring minimum standards of professional conduct for lawyers appearing or practicing before the Commission.

The Act’s provisions become effective at different times, ranging from the date of enactment, July 30, 2002, to later dates specified in the Act or the date on which the required implementing regulations become effective. The crisis in investor confidence began with the bankruptcy of Enron in December 2001 and continued with other corporate and accounting failures in the telecommunications, cable and energy industries and the criminal conviction of Arthur Andersen LLP. Prior to enactment, reform initiatives primarily consisted of Commission and self-regulatory organization or “SRO” rulemaking.6 With the announcement of the accounting scandal at Worldcom in June 2002 and its subsequent bankruptcy filing, the mood in Washington changed. Senator Sarbanes’s bill,7 which had been moribund in the spring, came to life as politicians on both sides realized that corporate governance could be a political issue in the November elections. By mid-July, the Sarbanes-Oxley bill was moving so quickly in Congress that the conference report consisted only of the legislation and did not have the typical commentary that accompanies a bill. Unexpected by most in the spring, the Act became law in the summer. Although the Act supersedes some of the Commission’s recently proposed rules – such as the Commission’s proposed rule to create a public accountability board8 – the Act endorses the 6

President Bush announced his “Ten-Point Plan to Improve Corporate Responsibility and Protect America’s Shareholders,” the Commission issued six proposed rulemaking releases, the New York Stock Exchange (“NYSE”) and The Nasdaq Stock Market (“Nasdaq”) proposed changes to their listing standards with respect to corporate governance, the NYSE and the National Association of Securities Dealers approved rule changes with respect to securities analysts, and numerous bills addressing Enron were proposed in both the House and Senate. See The President’s Ten-Point Plan to Improve Corporate Responsibility and Protect America’s Shareholders, Feb. 7, 2002 (available at http://www.whitehouse.gov/infocus/corporateresponsibility/)(the “Ten-Point Plan”). President Bush stated that “we must improve corporate disclosure, make corporate officers more accountable, and develop a stronger, more independent audit system – all without inviting endless litigation,” and offered ten proposals to effect these three principal goals. The President noted that “[m]ost of these goals can be accomplished by the Securities and Exchange Commission within its existing authority.” See Ten-Point Plan. In mid-June, Chairman Pitt stated that the Commission is engaging in a “fundamental revision” of the disclosure system; is at work on the “most dramatic and far-reaching changes in corporate governance since the agency’s formation”; is having “unparalleled success” in its real-time enforcement efforts; and is generally embarking on an “unparalleled reform crusade.” Harvey L. Pitt, Remarks before the New York Financial Writers Association, June 13, 2002 (available at http://sec.gov/news/speech/spch567.htm)(“Pitt Financial Writers Speech”). Indeed, Chairman Pitt noted that “If you compare the pace and level of activity at our agency over the past nine months, you’ll see they dwarf any comparable period in our agency’s history.” Id. 7

Public Company Accounting Reform and Investor Protection Act of 2002, S. 2673, 107th Cong. 2d Session (2002).

8

Proposed Rule: Framework for Enhancing the Quality of Financial Information through Improvement of Oversight of the Auditing Process, Release Nos. 33-8109, 34-46120, 35-27543 (June 26, 2002)(available at http://www.sec.gov/rules/proposed/33-8109.htm)(the “PAB Release”).

3

Commission’s “fundamental revision” to the disclosure system9 and gives the Commission broad rulemaking authority, akin to that in Section 14(a) of the Exchange Act, which was used to adopt the entire system of proxy regulation. For example, the Act’s new “real time” disclosure provision is consistent with the Commission’s proposed rule to revise current reporting on Form 8-K.10 The new disclosure system being designed by the Commission consists of three tiers.11 The three tiers are: enhanced periodic disclosure, in which the quality and the quantity of information required to be disclosed in annual and quarterly reports on Forms 10-K and 10-Q are enhanced and increased, and the filing deadlines shortened; current disclosure, which the Commission has proposed to amend by including a much longer list of required items to be filed on Form 8-K and changing the due dates for mandatory events to two business days from the five business or 15 calendar days, depending on the nature of the event, now required of items on Form 8-K today; and Regulation FD, which addresses disclosure obligations with respect to material, nonpublic information when issuers communicate with Wall Street professionals. The disclosure system will be augmented by real-time, aggressive enforcement, heightening the importance of compliance.12 As part of its new disclosure system, the Commission adopted accelerated filing periods of 60 and 35 days for annual and quarterly reports, respectively,13 on August 27, 2002, the same 9

See Pitt Financial Writers Speech.

10

See Proposed Rule: Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, Release Nos. 33-8106, 34-46084, 67 Fed. Reg. 42,914 (June 25, 2002)(available at http://www.sec.gov/rules/proposed/338106.htm)(the “8-K Release”). The comment period expired on August 26, 2002, and the Commission has not yet acted on this proposed rule.

11

Even before Enron, in the fall of 2001, Chairman Pitt announced his intention to improve current disclosure. “When we turn to the disclosure regimen we hope to implement, a core principle is that our current disclosure system should not be discarded, but should be supplemented and improved to make our markets even more efficient and more responsive to investor needs. In the system we envision, companies would assume an affirmative obligation to disclose unquestionably significant information whenever it arises and becomes available, instead of being able to wait to disclose the information when the next-scheduled quarterly or annual report is due.” Chairman Pitt, Speech to the Consumer Federation of America Financial Services Conference (Nov. 29, 2001) (available at http://www.sec.gov/news/speech/spch525.htm). See also Chairman Pitt, Remarks before the AICPA Governing Council (Oct. 22, 2001) (available at http://www.sec.gov/news/speech/spch516.htm); Chairman Pitt, Remarks before the Fall Meeting of the ABA Committee on Federal Regulation of Securities (Nov. 16, 2001) (available at http://www.sec.gov/news/speech/spch524.htm). 12

The Commission’s broad view of the scope of its enforcement actions was recently affirmed by the Supreme Court. In SEC v. Zandford, 535 U.S. __ (2002), decided on June 3, 2002, the Supreme Court affirmed the Commission’s broad interpretation of the “in connection with” requirement in Section 10(b) of the Exchange Act to bring within its ambit a broker who sells securities with the intent to misappropriate the proceeds. The Supreme Court stated that the Securities Act should be construed flexibly to effect its purpose to ensure honest securities markets and achieve a high standard of business ethics in the securities industry, thereby promoting investor confidence. 13

See Final Rule: Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports, Release Nos. 33-8128, 34-46464, FR-63 (Sept. 5, 2002)(available at http://www.sec.gov/rules/final/338128.htm)(the “Accelerated Reporting Adopting Release”); Press Release, Commission, “Commission Approves Rule Implementing Provisions of Sarbanes-Oxley act, Accelerating Periodic Filings, and Other Measures,” Aug. 27, 2002 (available at http://www.sec.gov/news/press/2002-128.htm)(“August 27 Press Release”); Proposed Rule:

4

day it adopted final rules implementing Sections 302 and 403 of the Act. The Commission also adopted a rule requiring annual reports to disclose whether investors can obtain access to the company’s periodic reports on the company’s Internet website, and if not, to disclose the reasons why.14 The Commission confronts a monumental threefold task in terms of rulemaking: •

To pursue its reform agenda15 to improve and modernize corporate disclosure and financial reporting to make the disclosures and financial reports more meaningful, transparent and intelligible to the average investor;16

Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports, Release Nos. 33-8089, 34-45741, 67 Fed. Reg. 19,896 (Apr. 23, 2002)(available at http://www.sec.gov/rules/proposed/338089.htm) (“Accelerated Reporting Proposing Release”). 14

See Accelerated Reporting Adopting Release.

15

One of the goals of reform, according to Treasury Secretary Paul O’Neill, who is heading the Bush Administration’s working group on corporate disclosure, is to make corporate information more detailed and understandable without overwhelming investors with data. For example, Secretary O’Neill says that “In order to make sure you don’t get the New York telephone book every quarter and try to figure out for yourself what is and what isn’t important, I would give CEOs the duty to say, ‘These are the five or 10 things that you really ought to pay attention to.’” Glenn Kessler, O’Neill Has No Sympathy for ‘Excuses’ About Scandal, Wash. Post, Feb. 22, 2002, at E1. Compare Secretary O’Neill’s statement to that of Jeffrey Immelt, Chairman of the General Electric Company: “If the annual report or quarterly report has to be the size of the New York City phone book, that’s life… . But the extent to which in order to help my investors feel better, they need to know more things and different things and see it in a different way – I’m always open to that.” See Rachel Emma Silverman, GE to Change Disclosure Practices to Include Details on GE Capital, Wall St. J., Feb. 20, 2002. 16

Relevant rulemaking proposals and guidance include: •

Critical Accounting Estimates: The Commission has proposed a rule that would require discussion of a company’s critical accounting estimates and policies in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” or “MD&A” section of registration statements and quarterly and annual filings. See Proposed Rule: Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies, Release Nos. 33-8098, 34-45907, 67 Fed. Reg. 35,620 (May 20, 2002)(available at http://www.sec.gov/rules/proposed/33-8098.htm)(the “Critical Accounting Release”). The comment period expired on July 19, 2002, and the Commission has not yet acted on this proposed rule. This proposed rule follows the Commission’s guidance on disclosing critical accounting policies published in December 2001. See Cautionary Advice Regarding Disclosure About Critical Accounting Policies, Financial Reporting Release No. 60, Release Nos. 33-8040, 34-45149, 66 Fed. Reg. 65103 (Dec. 12, 2001) (the “December 2001 Cautionary Statement”).

•

MD&A: The Commission has published guidance on how to improve the disclosure of liquidity risks, market price risks, the effects of using off-balance sheet structures and transactions with unconsolidated entities and non-related parties where that information appears necessary to understand significant aspects of a business in the MD&A section. See Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release Nos. 33-8056, 34-45321, 67 Fed. Reg. 3,746 (Jan. 22, 2002) (available at http://www.sec.gov/rules/other/33-8056.htm) (the “MD&A Statement”).

•

New Form 8-K Disclosures and Filing Deadlines: The Commission has proposed a rule that would require several new items or events to be reported on Form 8-K to improve the timeliness of public disclosure of corporate events. The Commission has also proposed that Form 8-K reports be filed within two business days instead of the current five- or 15-day time periods. See 8-K Release.

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•

To implement the Act on a timely basis; and

•

To coordinate all of the various reform proposals and initiatives so that together with the Act, they are consistent and workable.

Given the haste in which the Act was passed, many of its provisions are open to differing interpretations, and some of its provisions may conflict with others.17 This leads to the question of whether the Act will be literally construed or liberally interpreted to implement its purposes. Because the Act instructs the Commission to adopt implementing or clarifying regulations in many provisions, and also provides the Commission with the general authority to adopt “such rules and regulations as may be necessary or appropriate in the public interest or for the protection of investors, and in furtherance of” the Act,18 the Commission has the power to refine the Act through rulemaking.19 Moreover, certain provisions of the Act are administered by other federal agencies, such as the Departments of Justice and Labor, and their interpretations may differ from the Commission’s rulemaking.20 In addition to Commission rulemaking, self-regulatory organizations are in the process of adopting reforms to respond to Enron. The NYSE and Nasdaq have proposed changes to their listing standards with respect to corporate governance, which, in some instances, may impose requirements different than those in the Act.21 These changes are in addition to the analyst independence rules adopted by the National Association of Securities Dealers and the NYSE and •

Pro Forma Financial Information: The Commission has published guidance on how to fairly disclose pro forma financial information. See Release Nos. 33-8039, 34-45124, FR-59, 66 Fed. Reg. 63731 (Dec. 4, 2001)(the “Pro Forma Release”).

•

Arthur Andersen: The Commission has provided guidance to issuers on how to proceed in light of the indictment of Arthur Andersen LLP, Enron’s auditor, which guidance it affirmed upon Andersen’s conviction for obstruction of justice. See Requirements for Arthur Andersen LLP Auditing Clients (Temporary Final Rule and Final Rule), Release Nos. 33-8070, 34-45590, 67 Fed. Reg. 13518 (Mar. 18, 2002)(available at http://www.sec.gov/rules/final/33-8070.htm) (“Andersen Release”); Press Release, Commission, “SEC Statement Regarding Andersen Case Conviction,” June 15, 2002 (available at http://www.sec.gov/news/press/2002-89.htm)(“Andersen Conviction Press Release”).

17

Compare Jonathan Weisman, Some See Cracks in Reform Law, Wash. Post., Aug. 7, 2002, at E1(quoting Senator Grassley (R-Iowa): “Any dummy that reads the bill knows what we meant. We couldn’t have written it any clearer.”). 18

See Section 3(a) of the Act.

19

We understand that there are currently no plans for Congress to pass a technical corrections act.

20

See Weisman, supra note 17, at E1 (“Members of Congress from both parties accused the administration of undermining or narrowing the scope of provisions covering securities fraud, whistle-blower protection and punishment for shredding documents.”).

21

This Outline does not cover the proposed changes in listing standards recently approved by the board of the NYSE and the Board of Directors of Nasdaq, except for certain proposed changes relevant to the Act. Once adopted, this SRO rulemaking will add another level of complexity, especially in corporate governance. For a summary of the Nasdaq’s corporate governance proposals, dated as of September 13, 2002, see Nasdaq, “Summary of NASDAQ Corporate Governance Proposals,” Sept. 13, 2002 (available at http://www.nasdaqnews.com/about/corpgov/CorpGovProp0913.pdf)(the “Nasdaq Proposed Rules”).

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approved by the Commission in May 2002, which may yet be revisited in light of the Act’s provisions on research analyst conflicts of interest.22 It is still too early to tell what the effects of the Act will be. First, viewed as a whole, the Act may represent a paradigmatic shift in the securities regulatory framework.23 Although its focus on periodic reports is consistent with the integrated disclosure system, the Act, together with real-time disclosure, focuses on the Exchange Act almost to the exclusion of Securities Act prospectuses – from the certifications that apply only to periodic reports24 to enhanced review by the Division of Corporation Finance of periodic disclosures.25 Although both the Act and the integrated disclosure system are based on the efficient market theory,26 the Act goes further by directing the Commission to adopt “real time issuer disclosures,” which may include “trend and qualitative information and graphic presentations”27 and could result in a reappraisal of the Commission’s traditional emphasis on historical information as the basis on which investment decisions are made. Of course, whether or not the Act will, in fact, create new and better safeguards against corporate malfeasance and management defalcation as intended by Congress and thereby restore investor confidence in the capital markets remains to be seen. Moreover, it remains to be seen whether the Act will achieve the goals its drafters intended or whether it will have unintended consequences. Among the issues are:

22

The National Association of Securities Dealers’ new rule, Rule 2711, can be found at http://www.nasdr.com/filings/rf02_21.asp. Note, too, that the investor community may also affect the rules governing analysts’ conflicts of interest. CalPERS, the California Public Employees’ Retirement System, has announced that investment banks and money managers wishing to do business with CalPERS will be required to adopt stringent conflict of interest principles. CalPERS’s board of administration voted to adopt a set of investor protection principles that are aimed at requiring firms to be more transparent and more responsive to corporate governance and financial reporting variables. See Press Release, CalPERS, “CalPERS Requires Money Managers and Broker Dealers To Adopt Investor Protection Principles,” Aug. 19, 2002 (available at http://www.calpers.org/whatsnew/press/2002/0819a.htm). 23

The integrated disclosure system places primary emphasis on Exchange Act reports that provide periodic information to the trading markets. Short-form Securities Act registration statements rely on Exchange Act reports through incorporation by reference for company disclosure and add only information about the specific public offering. Adoption of Integrated Disclosure System, Release No. 33-6383, 47 Fed. Reg. 11380 (Mar. 16, 1982). Under the integrated disclosure system, the Commission instituted comprehensive revisions to registration statement forms and procedures. Integrated disclosure is premised on the efficient market theory (i.e., market prices of securities reflect all publicly available information about the issuer). See footnote 26 of this Outline, infra. 24

See Sections 302 and 906 of the Act.

25

See Section 408 of the Act.

26

For an early article addressing this issue, see Homer Kripke, A Search for a Meaningful Securities Disclosure Policy, 31 Bus. Law. 293, 309 (1975). Professor Kripke noted that the efficient market hypothesis, which suggests that information circulates rapidly and market prices adjust rapidly to the information, raises “basic questions as to the whole system of registration of individual securities under the Securities Act of 1933 and the concept that an investor may make a wise decision from a single prospectus.” Indeed, to Professor Kripke, “it would seem that the continuous disclosure process of the Securities Exchange Act of 1934 makes a great deal more sense than the convulsive effort involved in the spasmodic disclosure of the 1933 Act.” 27

See Section 409 of the Act.

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•

whether the Act results in a new compliance system that provides better disclosure and promotes investor confidence or creates a new certification “bureaucracy” intended to protect CEOs and CFOs from missteps;

•

whether the Act results in management being more responsible without decreasing entrepreneurial spirit or makes management risk-adverse because of the individual liability under the Act;

•

whether the Act restores investor confidence and thus promotes capital formation and facilitates economic recovery or slows economic recovery because of its compliance and transaction costs;

•

whether small issuers are able to contend with the increased costs or are forced to consider going private;

•

whether the Act maintains the demarcation between federal securities law and state corporation law or represents an incursion into state corporation law;

•

whether the Act encourages people to be directors of public companies or deters qualified individuals from joining boards of directors or being on audit committees;28

•

whether U.S. markets continue to act as the world’s gold standard by attracting listings by foreign private issuers or cause foreign private issuers to stay in their home country marketplace and use U.S. markets only for Rule 144A transactions; and

•

whether the Act was the right response at the right time or represents an over-reaction to the bear market of the past two years.

Two things are for sure, however: the Act sends a positive message to the plaintiffs’ bar, from longer statutes of limitations to more provisions that provide a fertile field for new case law; and the costs of compliance for public companies, at least initially, will be significant. This Outline addresses and analyzes the provisions of the Act most relevant to corporations and their officers and directors, and also the relevant proposed rules or statements of guidance by the Commission, including its release on Andersen.29 II.

RECENT DEVELOPMENTS

On October 16, 2002, the Commission voted to propose rules implementing Sections 303, 404, 406 and 407 of the Act.30 Section 303 prohibits an issuer’s officers, directors and persons acting under the direction of an officer or director from taking any action to fraudulently 28

See Andrew Ross Sorkin, Back to School, but This One Is for Top Corporate Officials, N.Y. Times, Sept. 3, 2002, at A1 (reporting that officers and directors who attended a program called the Directors’ Consortium “came away daunted and frustrated by the overwhelming message in almost every lecture: the legal landscape is constantly shifting and the liabilities for directors are greater than ever”). 29

Exhibit 1 to this Outline provides a comparison with, and supplies the effective dates of, the Act’s provisions with pending Commission rulemaking proposals. 30

See Press Release, Commission, “SEC Proposes Additional Disclosures, Prohibitions to Implement SarbanesOxley Act,” Oct. 16, 2002 (available at http://www.sec.gov/news/press/2002-150.htm).

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influence, coerce, manipulate or mislead the outside auditor for the purpose of rendering the issuer’s financial statements materially misleading.31 Section 404 requires each annual report to contain an internal control report which acknowledges management’s responsibilities for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and contains management’s assessment of the effectiveness of those structures and procedures. The company’s outside auditor is required to attest and report on management’s assessment.32 Section 406 requires each issuer to disclose in its annual report whether or not it has adopted a code of ethics for senior financial officers and if not, why not. The Commission has expanded the list of persons covered by the code of ethics to include the CEO.33 Section 407 requires each issuer to disclose whether or not its audit committee has at least one member who is a “financial expert,” and if not, the reasons why.34 Each of these proposed rules will have a 30-day comment period following publication in the Federal Register. As of the date of this Outline, none of these proposed rules has been posted on the Commission’s website or published in the Federal Register. III.

CERTIFICATION OF PERIODIC REPORTS A.

Introduction 1. In response to Enron, The Business Roundtable reminded its constituencies of the basic premise of how the modern corporation is managed: “[s]enior management is expected to know how the company earns its income and what risks the company is undertaking in the course of carrying out its business”; further, “it is the responsibility of management, under the oversight of the board and its audit committee, to produce financial statements that fairly present the financial condition of the company and make sufficient disclosures to investors to permit them to assess the financial and business soundness of the company.”35 2. Addressing the same constituencies: the Act contains two different certification provisions, Section 302 and Section 906, each of which requires the CEOs and CFOs of public companies to certify certain matters in periodic reports

31

For a discussion of Section 303, see Section X.B.3 of this Outline.

32

For a discussion of Section 404, see Section VI.D of this Outline.

33

For a discussion of Section 406, see Section VI.E of this Outline.

34

For a discussion of Section 407, see Section VI.F of this Outline.

35

Press Release, The Business Roundtable, “Statement of The Business Roundtable on Corporate Governance Principles Relating to the Enron Bankruptcy,” Feb. 11, 2002 (available at http://www.brtable.org/document.cfm/650).

9

filed with the Commission.36 Section 302 amends the Exchange Act, whereas Section 906 is a criminal provision and amends the federal criminal code, Title 18 of the U.S. Code. 3. Since Section 906 was effective immediately, it applies to periodic reports filed by every domestic or foreign issuer on or after July 30, 2002. With respect to Section 302, the Commission adopted final rules implementing Section 302 that took effect on August 29, 2002, as required by the Act.37 4. Section 906 and Section 302 are in addition to, and do not affect, the certification requirements which the Commission imposed on the CEOs and CFOs of the 947 largest public companies pursuant to a June 27, 2002 investigative order.38 These certifications apply to the company’s last annual report and subsequent filings and use the language of Rule 10b-5(b) and Rule 12b-20 under the Exchange Act. Certifications required by the June 27 Order are due no later than the close of business on the first day that the company is required to file a Form 10-K or Form 10-Q with the Commission on or after August 14, 2002. The Act does not change the requirement for or the form of such certifications. B.

Section 906 1. The Section 906 certification requires each “periodic report containing financial statements” filed under Section 13(a) or 15(d) of the Exchange Act by a domestic or foreign issuer to “be accompanied by” a “written statement” or certification by the CEO and CFO (or their equivalent). a.

A question that has arisen is how the certifications are to

36

Commissioner Roel C. Campos described the new certification requirements in truly plain English: “What is being required is that senior executive officials must say, ‘You have my word that what I am saying is accurate, and I realize that if I fib, I will be in a heap of trouble.’” Stephen Labaton, S.E.C. Pushes Companies To Disclose Data Faster, N.Y. Times, Aug. 28, 2002, at C2. 37

Final Section 302 Release.

38

File No. 4-460: Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 (June 27, 2002)(available at http://www.sec.gov/rules/other/4-460.htm)(the “June 27 Order”). By requiring a written report under oath under Section 21(a) of the Exchange Act, the Commission has revived the “other prong” of Section 21(a). Section 21(a) is widely known as the authority for the Commission’s Reports of Investigation, but Section 21(a) also permits the Commission to “require or permit any person to file with it a statement in writing, under oath or otherwise, as the Commission shall determine, as to all the facts and circumstances concerning the matter to be investigated.” Requiring written statements filed under oath is an aggressive investigative tool and raises the stakes in a company’s decision of whether and how to cooperate with the Staff in an investigation. As Chairman Pitt noted when he announced this action, “this is the third time in history that we have invoked this authority, all within the last few months.” Harvey L. Pitt, Remarks before the Economic Club of New York, June 26, 2002 (available at http://www.sec.gov/news/speech/spch573.htm). The Commission’s use of Section 21(a) resulted in a negative response from the bar. Stanley Keller and Dixie Johnson, Chair and Vice-Chair of the ABA’s Committee on Federal Regulation of Securities, wrote a letter dated July 15, 2002 to Chairman Pitt criticizing the Commission’s use of Section 21(a) in this context.

10

“accompany”39 a filing. There are a number of possibilities: (1) Filing Alternative 1. File the certification as an exhibit to the periodic report40 or in the text of the report, after the signature page. (a) Both of these methods comply with Section 906. However, the certification so filed would also be deemed to be “filed” for purposes of Section 18 of the Exchange Act and incorporated by reference into Form S-3 and Form S-8 registration statements under the Securities Act for purposes of Section 11 liability. Some commentators contend that there is the same practical exposure to liability under other provisions of the securities laws for Section 906 certifications, whether or not they are deemed to be “filed” for Section 18 purposes. It is our view that, by being incorporated by reference into a prospectus, the Section 906 certification can be transformed from a certificate that can be enforced only in a criminal proceeding by the U.S. Attorney’s Office into a disclosure issue that could be the subject of civil litigation. If this occurs, the standard of proof would change from beyond a reasonable doubt in the criminal case to a lesser standard in the civil proceeding. Accordingly, we have not recommended this approach to filing. (b) In the Staff’s view, these certifications may be deemed to be “material” information, and therefore, subject to Regulation FD. In addition, given public and media attention to officer certification, making these certifications publicly available may be necessary for public or investor relations. Both of these filing methods would result in the certifications being publicly available and would also comply with Regulation FD’s broad dissemination 39

While not defined in the Act, the term “accompany” is used in Rule 14a-3(b) under the Exchange Act: at an annual meeting of stockholders in which directors are to be elected, the proxy statement shall be “accompanied” or preceded by the annual report. Although the longstanding practice is to have the annual report precede the proxy statement, it can accompany it by being mailed in the same envelope as the proxy statement. The envelope theory has been used by the Commission in a number of its Internet releases. See, e.g., Final Rules: Use of Electronic Media for Delivery Purposes, Release Nos. 33-7289, 34-37183, IC-21946 (May 9, 1996)(available at http://www.sec.gov/rules/final/33-7289.txt). Also, forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act must be “accompanied” by meaningful cautionary statements in order to take advantage of the safe harbor. The cautionary statement is typically in the same document as the forward-looking statements.

40

This is what the certifying officers at the General Electric Company did. See Exhibit 99.1 and Exhibit 99.2 to the Form 10-Q for the General Electric Company, filed with the Commission on July 31, 2002 (available at http://www.sec.gov/Archives/edgar/data/40545/000004054502000039/exh99-1.htm).

11

requirement. (2) Filing Alternative 2. File the certification separately but contemporaneously with the Form 10-Q as “correspondence” – either on EDGAR or submitted by fax or physical delivery. (a) Filing as “correspondence” would satisfy Section 906’s requirement that the certification “accompany” the report since correspondence would be included in the transmission of the report. However, correspondence is not deemed “filed” for purposes of Section 18 under the Exchange Act, and therefore, would not be incorporated by reference in Securities Act filings by Form S-3 filers. (b) This method would not satisfy Regulation FD’s broad dissemination requirement, and additional steps would be required to achieve this goal, such as a press release or a filing under Item 9 of Form 8-K. (c) Because new Rules 13a-14 and 15d-14 under the Exchange Act require the Section 302 certification to be placed immediately after the signature block on Forms 10K and 10-Q, we believe that filing the Section 906 certification as correspondence is preferable to including it in the periodic report or as an exhibit to the periodic report. (3) Filing Alternative 3. File the certification on Form 8-K under Item 9 contemporaneously with the filing of the periodic report. (a) We believe contemporaneous filing should satisfy the requirement of the Act that the certification “accompany” the Form 10-Q filing because the Form 10-Q is accompanied by a Form 8-K filing. An Item 9, Form 8K filing is publicly available but not deemed to be “filed” for purposes of Section 18 of the Exchange Act and is not incorporated by reference in subsequent Securities Act filings for Form S-3 filers. (b) Filing a Form 8-K report satisfies the dissemination requirement of Regulation FD. (c) It appears that a number of companies are filing their certifications both as “correspondence” and as an Item 9, Form 8-K report, which we also believe satisfies the Act’s requirements. (4)

Filing Alternative 4. File the certification on Form 8-K 12

under Item 5 contemporaneously with the filing of the periodic report. (a) This differs from the Item 9, Form 8-K in one significant respect: it would be deemed to be “filed” for purposes of Section 18 of the Exchange Act and therefore incorporated by reference in subsequent Securities Act filings. (5) The following chart presents in tabular format the possible submission methods and their advantages and disadvantages: Section 906 Submission Method

File as an exhibit Add to the signature page File as correspondence File as Item 5, Form 8-K File as Item 9, Form 8-K ____________________

“Accompany” Deemed “Filed” for Periodic Report Purposes of Section 18 of Exchange Act and Incorporated by Reference into S-3s Yes Yes Yes Yes Yes No Yes* Yes Yes* No

Publicly Regulation FD Available Compliance

Yes Yes No Yes Yes

Yes Yes No Yes Yes

*If the Form 8-K is filed contemporaneously with the periodic report.

b. Note that the CEO and CFO certifications required by the June 27 Order are to be delivered to the Secretary of the Commission and not filed on EDGAR.41 The Staff of the Commission issued a statement in which they advised issuers that in light of the public’s interest in such oaths, they are “nearly certain to be material information.” Hence, the Staff advised issuers to file an Item 9 or Item 5 current report on Form 8-K disclosing the filing of the statements in connection with the June 27 Order and attaching the statements as exhibits to the report and also to post the statements on the issuers’ web sites.42 c. Because the term “periodic report” is not defined in the Act, the question has arisen as to whether the certification requirement applies to Form 6-K or Form 8-K filings that contain financial statements. In the Final Section 302 Release, the Commission states that “Reports that are current reports, such as reports on Forms 6-K and 8-K, rather than periodic (quarterly and annual) reports are not covered by the [Section 302] 41

These certifications are available on the Commission’s web site at http://www.sec.gov/rules/extra/ceocfo.htm.

42

See Statement by the Staff of the Securities and Exchange Commission Regarding the Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 No. 4-460 (July 29, 2002) (available at http://www.sec.gov/rules/extra/staff21a1.htm).

13

certification requirement.”43 Although this statement occurs in the context of Section 302, its reasoning is equally applicable to Section 906. 2. that:

In the “written statement” or certification, the CEO and CFO must certify a. The periodic report “fully complies” with the requirements of Section 13(a) or 15(d) of the Exchange Act; and b. The information contained in the periodic report “fairly presents, in all material respects, the financial condition and results of operations of the company.” (1) Significantly, the first element of the certification does not contain a materiality qualifier. A number of the non-financial reporting requirements applicable to Section 13(a) and 15(d) reports contain a materiality standard. For example, most of the disclosure requirements for the Management’s Discussion and Analysis section of Forms 10-K and 10-Q include a materiality standard. However, there are also many line item disclosure requirements that do not have a materiality standard, such as Item 402 of Regulation S-K, requiring disclosure of executive compensation. (a) The failure to fully comply with rules without a materiality qualifier, such as technical requirements under EDGAR or an exhibit filing requirement, means that a minor mistake could give rise to criminal penalty. (b) Staff comment letters typically contain items that reflect Staff questions as to full compliance. Thus, every Staff comment letter could raise issues about miscertification and the possibility of criminal penalty. Market prices of company securities are already reacting to receipt of Staff comment letters.44 (2) By referring to the requirements of Sections 13(a) and 15(d) of the Exchange Act, the certification covers, among other things, Regulation S-K, which states the requirements for the nonfinancial portions of annual and quarterly reports, and Regulation

43

See Final Section 302 Release. With respect to foreign private issuers submitting interim financial information under cover of Form 6-K, the Commission added that “they do so pursuant to their home country requirements and not because of a Commission requirement… . Therefore, we do not believe that a Form 6-K constitutes a ‘periodic’ report analogous to a quarterly report on Form 10-Q or 10-QSB for which certification is required.” Final Section 302 Release, fn. 50.

44

See Aon Breaks Even; A Charge is Cited, Wall St. J., Aug. 8, 2002, at A7.

14

S-X, which states the requirements for the financial statements required of annual and quarterly reports. (3) Importantly: the penalties for miscertification contained in Section 906 require a “knowing” or “willful” failure to comply, but the express language in Section 906 itself does not refer to the knowledge (or the best of knowledge) of the officer, in contrast to that of the Section 302 certification, which is qualified to the officer’s knowledge, and to the form of certification required of the CEOs and CFOs of 947 companies pursuant to the June 27 Order, which is qualified to the best of the officer’s knowledge. Section 906 does not prohibit such a qualifier, however. Certifying officers may wish to consider qualifying the Section 906 certification to their knowledge in light of the similar qualification included in Section 302. Since the standards for liability under Section 906(c) are “knowing” and “willful” miscertification, the inclusion of a “knowledge” qualifier should be both consistent with the purposes of the Act and, perhaps, helpful with respect to civil liability under other provisions of the securities laws. (a) To date, relatively few registrants’ officers are filing certifications with the knowledge qualifier, even though a number of law firms are endorsing this practice. The reason appears to be a concern that departing from the literal words of the statute will lead to criminal violation or result in negative publicity or have investor relations consequences. (4) Chairman Pitt and the Commission have recently emphasized that compliance with generally accepted accounting principles or “GAAP” is not a defense if the resulting financial statements do not “fairly present” the financial condition and results of operation of the company. The Commission’s recent enforcement action against Edison Schools Inc. exemplifies this point. The Commission found that Edison violated the securities laws by failing to provide accurate disclosure that a substantial portion of its revenues consists of payments that never reach Edison, even though it did not find that Edison’s revenue recognition policies violated GAAP or that earnings were misstated.45 Hence, under Edison Schools, even financial statements that comply with GAAP can be misleading. (5) Consistent with Edison Schools, Chairman Pitt has separately stated that if “literal compliance with GAAP creates a 45

See Press Release, Edison Schools Settles SEC Enforcement Action, May 14, 2002 (available at http://www.sec.gov/news/press/2002-67.htm).

15

fraudulent or materially misleading impression in the minds of shareholders, the accountants could, and would, be held criminally liable.”46 (6) Section 906 does not address what a certifying officer should do in the event that he or she is unable to certify a periodic report for reasons that cannot be resolved before the filing due date. Section 906 does not, on its face, preclude a certifying officer from taking exception to the content of the certification as set forth in Section 906(b). If a certifying officer knows that he or she cannot give a “clean” certification, then the appropriate exceptions should be made and the certification, so amended, should be submitted. Note, however, that a Section 906 certification of a late filing beyond the periods permitted by Rule 12b-25 under the Exchange Act will typically result in a qualified certification, because it would not comply fully with all of the requirements of Section 13(a) and Section 15(d) of the Exchange Act. 3. Section 906 provides for two levels of criminal penalties, depending on the intent of the signing officer: a. If the signing officer “certifies” his written statement “knowing that the periodic report accompanying the statement does not comport with all the requirements” of Section 906 – i.e., does not fully comply with the requirements of Section 13(a) or 15(d) of the Exchange Act and does not fairly present, in all material respects, the financial condition and results of operation of the issuer – then such officer would be fined not more than $1 million or imprisoned not more than 10 years, or both. b. If the signing officer “willfully certifies” his written statement “knowing that the periodic report accompanying the statement does not comport with all the requirements” of Section 906, then such officer would be fined not more than $5 million or imprisoned not more than 20 years, or both. (1) The distinction between certifying “knowingly” and certifying “willfully” is not stated in the Act. In other contexts, “willfully” normally requires a showing that the person had specific knowledge of the law that he or she was violating unless 46

Harvey L. Pitt, Remarks at the Winter Bench and Bar Conference of the Federal Bar Council, Feb. 19, 2002 (available at http://www.sec.gov/news/ speech/spch539.htm). This position was Judge Friendly’s, in the Second Circuit case, United States v. Simon, 425 F.2d 796 (2d Cir. 1969). There, Judge Friendly upheld the conviction of three auditors of Continental Vending Machine Corporation for fraud, even though there was expert testimony at trial that they had complied with GAAP. The trial judge had instructed the jury that compliance with GAAP “may be very persuasive but not necessarily conclusive that the [auditor] acted in good faith and that the facts as certified were not materially false or misleading.” Id. at 805-806.

16

Congress specifies otherwise, whereas “knowingly” does not.47 For example, if a material contract is not filed, “knowing” means that the CEO knows of the existence of the material contract, but does not know that it is required to be filed under Item 601(b)(10) of Regulation S-K; “willfully” means that the CEO knows of the material contract and also knows of the Item 601(b)(10) requirement. 4. The Section 906 certification requirement applies to any periodic report, such as a Form 10-Q or Form 10-K, which a company files after July 30, 2002.48 5. Every public company should review existing procedures to confirm that it is producing accurate and reliable financial statements and collecting, processing and disclosing all material information required to be disclosed in periodic and current reports filed with the Commission. Most of the 947 companies whose CEOs and CFOs are subject to the June 27 Order likely have already taken or are undertaking procedures which will provide adequate basis for the Section 906 certification.49 Companies may wish to undertake appropriate steps to support the certifications before filing their next Form 10-Q or other periodic report. a. To support the Section 906 certification, issuers and their CEOs and CFOs may wish to consider the following steps or procedures: review the draft filing; discuss with the principal drafters at the company the significant issues they have considered in preparing the disclosures; discuss with other senior officers any operational or financial issues that are or are not proposed to be disclosed in the filing, especially trend formation;50 discuss informally with the outside auditors their review of the financial statements included in the filing; and listen to the auditors’ SAS 71 discussions with the audit committee. b. In addition, issuers may also want to review current policies, procedures and personnel; establish or revise compliance procedures using existing resources augmented by new personnel; consider how the statute 47

See, e.g., Ratzlaf v. U.S., 510 U.S. 135 (1994)(holding that to establish that defendant “willfully” violated an antistructuring banking law, the government must prove that the defendant acted with knowledge that his conduct was unlawful). 48

See Proposed Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release No. 3446300 (Aug. 2, 2002)(available at http://www.sec.gov/rules/proposed/34-46300.htm)(the “Section 302 Certification Release”), at fn. 11 (stating that “Section 906 of the Act . . . is effective on enactment of the Act, July 30, 2002”). 49

The Commission’s website has the results of whether each of the respondent companies whose reports were due on August 14, 2002, was able to certify as to the accuracy and completeness of prior disclosure reports. The Staff of the Commission concluded that the CEOs and CFOs of 16 companies whose reports were due August 14, 2002 did not certify to the accuracy and completeness of their companies’ reports and instead filed explanations or other forms of certification. Press Release, Commission, “SEC Staff Completes Processing of CEO, CFO Statements,” Aug. 20, 2002 (available at http://www.sec.gov/news/press/2002-125.htm). 50

For a more detailed discussion of this point, see the Outline’s analysis of the MD&A Statement at Section XIII.

17

will affect the issuer on both a time and responsibility basis; consider a permanent compliance team that can monitor the information-gathering process; coordinate management’s efforts with the audit committee; and consider vertical compliance, in which the compliance team goes down to the operating levels, rather than having data come up to management, perhaps with written internal certifications. Multi-layer materiality judgments at lower levels could be problematic. Persons responsible for smaller portions of the company’s business may not be able to conclude that there is nothing material at their level, even though the items may be immaterial at the consolidated financial statement level or when the company’s business is taken as a whole. c. Given the requirements under Rules 13a-14 and 15d-14 that implement Section 302, issuers may also wish to establish a disclosure committee, which would include outside advisors.51 d. Inasmuch as the Section 906 certification can expose CEOs and CFOs to liability, every public company should also review its D&O policy52 and other indemnity arrangements in light of the new requirement. 6. Other issues include the penalty for not filing the Section 906 certification 53 at all and the impact on the public company if its officer violates this statute. While guidance has not been forthcoming on Section 906, practice is developing rapidly. Thus, the practice may quickly become the rule. C.

Section 302 Certification 1. Section 302 contains a CEO and CFO certification requirement that is more extensive and markedly different than that required under Section 906 and the Commission’s rulemaking proposal on officer certification of periodic reports issued in June 2002.54 As required by the Act, the Commission has adopted final

51

See the discussion at Section III.C.7, infra, of this Outline.

52

Among other things, the D&O policy should have a provision providing for defense costs, and the insured should make sure that the company is covered for private civil liabilities, even if the claim relates to a criminal provision such as Section 906. 53

For example, if a company does not file a tax return, that does not mean that the company has committed tax fraud, although it may have violated other provisions of the tax code. 54

Proposed Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release No. 34-46079, 67 Fed. Reg. 41,877 (June 20, 2002)(available at http://www.sec.gov/rules/proposed/34-46079.htm)(the “Proposed Certification Release”). There are several substantive differences between the form of certification mandated by Section 302 of the Act and the Proposed Certification Release. Although both forms address the material accuracy and completeness of the periodic reports that they cover, the Commission’s proposed form of certification used a “plain English” description for material information – “important to a reasonable investor” – while Section 302 uses the formulation found in Rules 10b-5(b) and 12b-20 under the Exchange Act. In addition, the Act requires an additional attestation regarding the financial disclosure included in these reports and additional information regarding certain aspects and results of the review of internal procedures and controls.

18

regulations – new Exchange Act Rules 13a-14 and 15d-14 – to implement Section 302, which took effect on August 29, 2002. Hence, this certification requirement will apply to third quarter Form 10-Qs for companies whose fiscal year is the calendar year.55 The Commission has also adopted new Exchange Act Rules 13a15 and 15d-15 requiring an issuer to establish and maintain an overall system of disclosure controls and procedures that are adequate to meet Exchange Act reporting obligations. 2. The new rules apply to the principal executive and financial officers of any issuer that files quarterly and annual reports with the Commission under either Section 13(a) or 15(d) of the Exchange Act, including foreign private issuers, banks and savings associations, issuers of asset-backed securities, small business issuers and registered investment companies.56 The new rules will require that the Section 302 certification be included in annual reports on Forms 10-K, 10-KSB, 20-F and 40-F, quarterly reports on Forms 10-Q and 10-QSB and amendments to any of the foregoing.57 Certification is not required for current reports, such as reports on Forms 6-K and 8-K.58 3. The Section 302 certification expressly applies both a materiality standard and a knowledge standard to the CEO’s and CFO’s required statements regarding the financial statements, financial information and other information contained in the covered report. Unlike the Section 906 certification, the Section 302 certification requires extensive representations as to the CEO’s and CFO’s responsibility for the issuer’s reporting controls (both financial and non-financial), including a representation that they have evaluated the effectiveness of those controls on a quarterly basis. 4. The actual text of the Section 302 certification is set forth in the revised forms for the periodic and annual reports. The Commission states that the certification “must be in the exact form set forth in the amendments to the affected reports. The wording of the required certification may not be changed in any respect (even if the change would appear to be inconsequential in nature).”59 55

Related to the Section 302 certification, Section 404 of the Act directs the Commission to establish rules requiring public companies to include “internal control reports” in their annual reports filed with the Commission. Despite the relationship with Section 302, there is no statutory deadline by which the Commission is required to issue rules under Section 404. See the comment letter submitted by Ernst & Young LLP in connection with the certification proposals, File No. S-7-21-02.

56

The Commission is considering whether to extend the certification requirement to other documents filed under the Exchange Act, such as registration statements on Forms 10 and 10-SB and definitive proxy and information statements. See Final Section 302 Release. In addition, it is unclear whether the Section 302 certification requirement applies to volunteer filers. See the discussion in footnote 5 of this Outline, supra. 57

See Final Section 302 Release.

58

Id. The Commission states that “we do not believe that a Form 6-K constitutes a ‘periodic’ report analogous to a quarterly report on Form 10-Q or 10-QSB for which certification is required.” Id. at fn. 50.

59

Id.

19

The certifications will follow immediately after the signature sections of the reports and do not alter the existing signature requirements for quarterly and annual reports file under the Exchange Act. Each signing officer must sign personally and may not have the certification signed on his or her behalf pursuant to a power of authority or any other form of confirming authority.60 5. The certification required by Rules 13a-14 and 15d-14 to be included in each annual and quarterly report is as follows: a.

The signing officer has reviewed the report;

b. Based on the officer’s knowledge, the report does not contain any untrue statement of material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading; c. Based on such officer’s knowledge, the financial statements, and other information included in the report, fairly present in all material respects61 the financial condition, results of operations and cash flows62 of the issuer as of, and for, the periods presented in the report; d.

The signing officers: (1) are responsible for establishing and maintaining “disclosure controls and procedures”;63 (2) have designed such disclosure controls and procedures to ensure that material information relating to the issuer and its

60

See Exchange Act Rule 13a-14(d).

61

With respect to fair presentation, the certification is not limited to a representation that the financial statements have been presented in accordance with GAAP. Citing U.S. v. Simon, as well as Edison Schools, the Final Section 302 Release states the Commission’s belief that Congress “intended this statement to provide assurances that the financial information disclosed in a report, viewed in its entirety, meets a standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principles.” See Final Section 302 Release. To the Commission, “fair presentation” encompasses “the selection of appropriate accounting policies, proper application of appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and events and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer’s financial condition, results of operations and cash flows.” Final Section 302 Release. 62

“Cash flows” has been added to the certification statement by the Commission, as it does not appear in Section 302, because “it is consistent with Congressional intent to include both income or loss and cash flows within the concept of ‘fair presentation’ of an issuer’s results of operations.” See Final Section 302 Release. 63

This term is new; Section 302 uses the term “internal controls.” This new term is meant to incorporate a broader concept of controls and procedures designed to ensure compliance with disclosure requirements generally. This term makes it explicit that the controls contemplated by Section 302(a)(4) are different from the pre-existing concept of “internal controls” that pertains to an issuer’s financial reporting and control of its assets, as addressed in Sections 302(a)(5) and 302(a)(6) and Section 404 of the Act.

20

consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared; (3) have evaluated the effectiveness of the issuer’s disclosure controls and procedures as of a date within 90 days prior to the report; and (4) have presented in the report their conclusions about the effectiveness of the disclosure controls and procedures based on their evaluation as of that date; e. The signing officers have disclosed to the issuer’s auditors and the audit committee of the board of directors: (1) all significant deficiencies in the design or operation of “internal controls”64 which could adversely affect the issuer’s ability to record, process, summarize, and report financial data and have identified for the issuer’s auditors any material weaknesses in internal controls;65 and (2) any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and f. The signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.66 64

“Internal controls” is a pre-existing term relating to internal controls regarding financial reporting. In the accounting literature, such as AU Section 319, “Consideration of Internal Control in a Financial Statement Audit,” internal control is a process – effected by an entity’s board of directors, management, and other personnel – designed to provide reasonable assurance regarding the achievement of objectives in three categories: (a) reliability of financial reporting; (b) effectiveness and efficiency of operations; and (c) compliance with applicable laws and regulations. See AU Section 319. Internal control consists of five interrelated components: (1) control environment sets the tone of an organization, influencing the control consciousness of its people; it is the foundation for all other components of internal control, providing discipline and structure; (2) risk assessment is the entity’s identification and analysis of relevant risks to achievement of its objectives, forming a basis for determining how the risks should be managed; (3) control activities are the policies and procedures that help ensure that management directives are carried out; (4) information and communication systems support the identification, capture and exchange of information in a form and time frame that enable people to carry out their responsibilities; and (5) monitoring is a process that assesses the quality of internal control. 65

This represents a reversal of the usual arrangement in which auditors identify the weaknesses and deficiencies and bring them to management’s and the audit committee’s attention in the management letter. 66

The terms “significant deficiencies” and “material weaknesses” should be interpreted consistent with existing generally accepted auditing standards procedures.

21

6. The focus of the Section 302 certification is on the new term, “disclosure controls and procedures,” which was added to the certification by the Commission in adopting the new Exchange Act rules. Rule 13a-14(c) defines “disclosure controls and procedures” as “controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.” The Commission explains that the term effectuates what “we believe to be Congress’ intent – to have senior officers certify that required material nonfinancial information, as well as financial information, is included in an issuer’s quarterly and annual reports.”67 7. The Commission advises that it is not requiring any particular procedures for conducting the required review and evaluation of “disclosure controls and procedures.” However, the Commission recommends that: a. An issuer create a committee with responsibility for considering the materiality of information and determining disclosure obligations on a timely basis; and b. The committee report to senior management, including the principal executive and financial officers, “who bear express responsibility for designing, establishing, maintaining, reviewing and evaluating the issuer’s disclosure controls and procedures.”68 8. Because the Section 302 certification statements involving disclosure controls and procedures and internal controls require the certifying officers to take certain specified actions, such as evaluating the effectiveness of the controls prior to the date of the report, the Commission states that “these statements will be required as part of the certification only with respect to reports that cover periods ending on or after August 29, 2002, the effective date of the rules required by Section 302 of the Act.”69 9. A CEO or CFO providing a false certification could be subject to Commission action for violating Section 13(a) or 15(d) of the Exchange Act and possibly to both Commission and private actions for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5.70 67

See Final Section 302 Release.

68

See id.

69

Id.

70

See Final Section 302 Release. An issuer’s principal executive and financial officers are already responsible as signatories for the issuer’s disclosures under Sections 13(a) and 18 of the Exchange Act and can be liable for material misstatements or omissions under general antifraud standards. These public affirmations could also expose CEOs and CFOs to an increased likelihood of being personally named as defendants in shareholder suits under Section 10(b) of the Exchange Act, as well as derivative suits, if matters turn out to be different than as represented

22

10. The process to enable Section 302 certifications will be affected by the Commission’s actions to accelerate filing dates for annual and quarterly reports. Accelerated filers will have 60 and 35 days from the end of the period for annual and quarterly reports, respectively.71 Section 302 requires the certifying officer to evaluate the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report and to present his or her conclusion of the effectiveness of such controls as of such date. Subsequently, the officer will be required to update his or her evaluation to the date of the periodic report, indicating whether there were significant changes in internal controls subsequent to the date of the evaluation, including any corrective actions. Consider, then, the following schedule for a calendar year issuer (in a non-leap year), using the accelerated filing deadlines of 60 days for annual reports on Form 10-K and 35 days for quarterly reports on Form 10-Q: a. Form 10-K: evaluate internal controls no earlier than December 2 of the prior fiscal year, and update as of March 1, the filing date. b. First quarter Form 10-Q: evaluate internal controls no earlier than February 4, and update as of May 5. c. Second quarter Form 10-Q: evaluate internal controls no earlier than May 6, and update as of August 4. d. Third quarter Form 10-Q: evaluate internal controls no earlier than August 7, and update as of November 4. (1) Thus, the accelerated reporting dates will result in an ongoing or continuous process of evaluating and updating internal controls by each certifying officer. 11. The Commission adopted Rules 13a-15(a) and 15d-15(a) in slightly different form that as proposed in April. These new rules are intended to complement existing requirements for reporting companies to establish and maintain systems of internal controls with respect to their financial reporting obligations.72 a. Rule 13a-15(a) provides that every issuer with a “class of securities registered pursuant to section 12” of the Exchange Act, and Rule 15d-15 in the certification. Among other things, the obligation to disclose “significant deficiencies” in internal controls creates potential liability to the corporation for failure to report conditions later deemed to be “significant deficiencies.” Similarly, any conditions that are reported presumptively will be deemed “significant” by plaintiffs’ lawyers and create potential liability for failure to correct them. Given the possible liability scenarios, the issue of private rights of action and how broadly or narrowly a court will view the scope of plaintiffs’ claims on certifications remains to be seen. 71

See Accelerated Reporting Adopting Release.

72

Final Section 302 Release.

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provides that every issuer “that files reports under section 15(d)” of the Exchange Act, other than an asset-backed issuer, “must maintain disclosure controls and procedures,” as that term is defined in Rule 13a14(c) and Rule 15d-14(c), respectively. (1) The procedures in each rule cover a broader range of information than only financial information, such as information potentially subject to disclosure under Regulation S-K or relevant to assess the need to disclose developments and risks that pertain to the company’s businesses, including trend formation. (2) Also, the procedures cover information that must be evaluated in the context of Rule 12b-20 under the Exchange Act, which requires disclosure of further material information as may be necessary to make the required statements in light of the circumstances in which they are made in a report not misleading. b. Rules 13a-15(b) and 15d-15(b) provide that within the 90-day period prior to the filing date of each periodic report, management must supervise and participate in an evaluation of the disclosure controls and procedures. This evaluation should address the effectiveness of the design and operation of the issuer’s disclosure controls and procedures. IV.

DISCLOSURE CONTROLS AND PROCEDURES A.

Introduction 1. Among the items that the new officer certifications for periodic reports must cover is the CEO’s and CFO’s responsibility for establishing and maintaining “disclosure controls and procedures.” This is a new term, one which envisions a process in which all information responsive to financial and nonfinancial disclosure requirements is accumulated, tested for quality and communicated to management, including the CEO and CFO, which reviews the information before disclosing it in the periodic report filed in the required time period. The Commission defines the term as controls and other procedures “designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits” under the Exchange Act is: a. “Recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms; and b. “Accumulated and communicated to the issuer’s management, including its principal executive officer or officers and principal financial officer or officers . . . as appropriate to allow timely decisions regarding required disclosure.” In addition to establishing and maintaining disclosure controls and procedures, the CEO and CFO must evaluate the effectiveness of the disclosure controls and 24

procedures within 90 days prior to filing a periodic report and disclose in the report their conclusions about the effectiveness of those controls and procedures. 2. Disclosure controls and procedures are actually implemented by two new rules under the Exchange Act. Rules 13a-15 and 15d-15 require each issuer to have disclosure controls and procedures and to have management evaluate them within 90 days prior to filing a periodic report. Building on these two rules, new Rules 13a-14 and 15d-14 under the Exchange Act specify the reports that must include the officer certifications on disclosure controls and procedures and the text of the certification. The outside auditor does not attest to these CEO and CFO certifications. 3. With respect to internal controls,73 the new certification rules change the dynamic between management and the outside auditor by affirmatively requiring the CEO and CFO to disclose to the outside auditor and the audit committee all significant deficiencies and material weaknesses in internal controls and any fraud, whether or not material, involving management or other employees who have a significant role in internal controls. Significantly, the outside auditor, which is not relieved from its existing responsibilities under GAAS, will continue to “test” internal controls. Moreover, the CEO and CFO must disclose in the periodic report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Thus, while the subject matter of the discussions between the CEO, CFO and the outside auditor is not required to be disclosed, the results of those discussions are disclosable if they result in significant changes or corrections.74 4. The new rules do not require issuers to adopt any particular procedure and specify only what the end result of these controls and procedures must be – the

73

There is an issue concerning the relationship between internal controls and disclosure controls and procedures. Some believe that internal controls are a subset of disclosure controls and procedures because financial and nonfinancial disclosures cannot be presented in periodic reports without effective internal controls. Others believe that internal controls serve different purposes. Under this view, internal controls may overlap with or intersect with disclosure controls and procedures with respect to financial reporting, but generally are not part of disclosure controls and procedures. Section 13(b)(2)(B) of the Exchange Act defines internal controls as pertaining to both financial reporting and control of assets. Clearly, the financial reporting prong of internal controls lies within disclosure controls and procedures. Thus, the question is whether the control or accountability of assets prong of internal controls is also within disclosure controls and procedures. The answer to this issue is important because it affects the scope and content of the officer certifications (are they certifying that they are responsible for maintaining and establishing internal controls relating to the control or accountability of assets?) as well as the responsibilities of the disclosure committee (should the oversight of the disclosure committee include control or accountability of assets?). 74

Because this is a new requirement, practice will need to develop a sufficient basis for management’s assessment of the effectiveness of internal controls as well as the disclosure in periodic reports of significant changes or corrections.

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exact wording of the certification, which cannot be modified or moved.75 However, as the Commission plainly points out, a company that fails to maintain adequate procedures, review them and otherwise comply with the new rules could be subject to Commission enforcement action for violating Section 13(a) of the Exchange Act, even if the failure does not lead to flawed disclosure. In turn, any such failure could lead to liability in private litigation for the certifying officer as a primary violator of Section 10(b) and Rule 10b-5 under the Exchange Act,76 and liability for the issuer under Sections 11 and 12(a)(2) of the Securities Act, where a quarterly or annual report is incorporated by reference into a registration statement on Form S-3.77 5. Before addressing what disclosure controls and procedures should look like, it is important to describe what they must be able to do. Essentially, they must be able to produce quality information that meets disclosure requirements in a timely fashion: a. Disclosure controls and procedures must capture the information potentially subject to disclosure pursuant to Regulation S-X, Regulation SK and Rule 12b-20 under the Exchange Act; b. They must accumulate the information in a manner that is capable of being tested so that the information is reliable; c. They have to be responsive on a real-time basis to inquiries from the CEO and the CFO; and 75

Although the Final Section 302 Release is firm on this point, we expect certain exceptions to be made. For example, certifications are required for any amendments to any periodic report. By necessity, the text of the certification provided in the form of the periodic report would need to be modified to reflect that the officer has reviewed the amendment to the periodic report, and not the periodic report itself. 76

The Commission can bring an action against the CEO or CFO as a primary violator or for aiding and abetting a violation. The potential violations include: aiding and abetting a violation by the issuer of Sections 13(a) or 15(d) of the Exchange Act; and being a primary violator or aider and abettor under Section 10(b) and Rule 10b-5 under the Exchange Act. A corporate officer who signs a Commission filing containing representations can be deemed to “make” the statement in the filing and can be liable as a primary violator of Section 10(b) and Rule 10b-5 under the Exchange Act. See Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Cir. 2000). Of course, Rule 10b-5 requires scienter for a violation. The Commission can bring these actions in court or before an administrative law judge, and the remedies can include barring the CEO or CFO from serving as an officer or director of a public company. In addition to civil liability, the Commission may refer the matter to the Department of Justice. Intentional misstatements or omissions of fact constitute federal criminal violations under 18 U.S.C. § 1001. This is the same provision that caused the stir with respect to the certification provided by many public companies in August 2002 pursuant to the Section 21(a) order. See File No. 4-460: Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 (June 27, 2002)(available at http://www.sec.gov/rules/other/4-460.htm). 77

Because a false certification can also cause liability exposure to the issuer under Sections 11 and 12(a)(2) of the Securities Act where a certification is included in a Form 10-K or Form 10-Q that is incorporated by reference into a registration statement on Form S-3, incorporation by reference can change a Rule 10b-5 action against the CEO or CFO, in which scienter is required, into private litigation against the issuer where negligence is all that is required.

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d. They should be scalable – capable of growing and evolving with the issuer’s business – and flexible enough to adapt to new disclosure requirements. 6. The capability of the disclosure controls and procedures is particularly important for two reasons: a. First, although the CEO and CFO certifications are required only for Form 10-Ks and Form 10-Qs, the disclosure controls and procedures themselves apply to all information required to be disclosed by the issuer in the reports it files or submits under the Exchange Act.78 These reports include required current reports on Form 8-K for domestic issuers, reports on Form 6-K for foreign private issuers and definitive proxy and information statements, even though these filings do not require a certification. b. Second, although the term “disclosure controls and procedures” applies only to required reports under the Exchange Act, issuers should consider how to handle the overlap between the information disclosed in required reports under the Exchange Act and the information disclosed in other contexts, including non-Exchange Act filings with the Commission and informal communications, both oral and written. For example, annual and quarterly reports are incorporated by reference in a registration statement on Form S-3, and earnings press releases are often filed with the Commission on Item 5 or Item 9 of Form 8-K or not filed at all. It may be advantageous from a counseling point of view to include non-Exchange Act filings and informal communications within the responsibilities of disclosure committee to help ensure accuracy and to avoid inconsistency. As a practical matter, the individuals who participate in the Exchange Act reporting process are also likely to participate in the disclosure of information outside of the Exchange Act, which underscores the redundancy of separate controls and procedures for Exchange Act reports and non-Exchange Act disclosures. While not required to do so, it may be beneficial for disclosure controls and procedures to accommodate other disclosures such as: (1) Public offering prospectuses and private placement memoranda; (2)

Earnings press releases;

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The CEO and CFO certification of the annual report includes the information required by Part III of Form 10-K, even if the issuer incorporates the information by reference from the definitive proxy statement or definitive information statement, which it can do if such statement is filed no later than 120 days after the end of the fiscal year. If the proxy statement or information statement is filed after the Form 10-K, then this forward incorporation by reference means that the CEO and CFO will be certifying to disclosure that has not yet been made. Hence, a draft of the information that will be incorporated by reference should be presented to the CEO and CFO at the time of filing the Form 10-K in order to support their certification of the information.

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(3) Earnings guidance at analyst conferences and meetings with market professionals subject to Regulation FD; and (4) Disclosures required by self regulatory organizations, such as the rules of the NYSE and Nasdaq. 7. The design and effectiveness of disclosure controls and procedures should be considered in the context of the other provisions of the Act and the Commission’s rulemaking proposals intended to implement the Act and real-time reporting, as well as the Commission’s own initiatives to improve disclosure. For example: the Commission recently adopted accelerated deadlines for filing periodic reports and is expected to adopt rules requiring more events to be reported on Form 8-K in a shorter time period. Section 409 of the Act also requires the Commission to adopt rules to effect real-time issuer disclosures. Hence, disclosure controls and procedures must enable issuers to report more information, more quickly than before but with at least the same level of reliability, as well as adapt to the new current reporting requirements that may be adopted. Another example: Section 401 of the Act requires the Commission to adopt rules requiring that each annual and quarterly financial report disclose all material off-balance sheet transactions that may have a material current or future effect on financial condition or results of operations as well as rules requiring the fair presentation of pro forma financial information. Separately, the Commission has proposed a significant revision of Item 303 of Regulation S-K, the Management’s Discussion and Analysis section in periodic reports, in its release on critical accounting estimates.79 Hence, if an issuer’s control policies and procedures did not account for these new types of information, upon effectiveness of the final rules, they will need to be revised so that this information is recorded, processed, summarized and reported for each Exchange Act report. 8. Before adopting new procedures or creating new committees, each issuer should consider that complying with the new rules does not necessarily mean materially changing existing disclosure practices. Issuers should assess their existing capabilities and practices across a broad spectrum of formal and informal reporting within the issuer’s organization. This spectrum can range from, at one end, issuers that have the capability of evaluating the information about their business on an ongoing or dynamic basis. These issuers may have in place a business reporting process in which the CEO and other members of senior management are informed on a daily or weekly basis on how the business is doing, and this process may be coordinated with a press release review process and a Commission report review process, among others. Also, their internal controls may be capable of producing and evaluating different types of financial information at very frequent intervals. At the other end of the spectrum are issuers with a static capability of evaluating information, with information accumulated and evaluated less frequently at defined times during a quarter. 79

See Critical Accounting Release. For a discussion of this release, see Section XIV of this Outline.

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Issuers at any point in this spectrum may recognize that formalizing practices that are currently performed on an informal basis, so that the information can be tested for reliability, or augmenting already formal processes, or supplementing existing reporting patterns or flows of information, or improving responsiveness in personnel to be able to disclose more information on a more timely basis, may go a long way in developing disclosure controls and procedures. 9. Each issuer should also consider precedents from other areas that may prove useful in complying with the new rules. Rules 13a-14 and 15d-14 require the CEO and CFO to certify that they have reported significant deficiencies and material weaknesses in internal controls to the audit committee and the outside auditor. These are new responsibilities and duties for the management of most companies, except for the management of bank holding companies, which have been required, under the FDIC Improvement Act of 1991 (“FDICIA”), to evaluate and report on their internal controls since 1993.80 While not identical, both the rules under FDICIA and Rules 13a-14 and 15d-14 place affirmative duties upon management to evaluate the effectiveness of internal controls, to make representations to the outside auditor and to provide a public management report to shareholders. Thus, FDICIA offers a comparable framework from a different body of regulation. Under FDICIA: a.

Financial institution’s management must: (1) Acknowledge responsibility for establishing and maintaining internal controls for financial report; (2) Report on the effectiveness of those controls as of yearend; and (3) Report on the validity and appropriateness of their representations to the outside auditor; and

b. Outside auditor must attest to management’s report on the effectiveness of internal controls. 10. In practice, the rules under FDICIA rely upon a widely recognized integrated framework for internal controls developed by the Committee on Sponsoring Organizations of the Treadway Commission (“COSO”).81 Both FDICIA and COSO can guide issuers and their CEOs and CFOs as they implement disclosure controls and procedures to comply with the certification 80

See Annual Independent Audits and Reporting Requirements, 58 Fed. Reg. 31,332 (July 2, 1993)(codified at 12 C.F.R. pt. 363).

81

The executive summary for the COSO framework can be found at http://www.coso.org/Publications/executive_summary_integrated_framework.htm. See AT 501, “Attestations on Internal Controls for Financial Reporting,” which permits an outside auditor to attest to a governmental standard that has been adopted after opportunity for public comment.

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rules on disclosing all significant deficiencies and material weaknesses in internal controls to the outside auditor and the audit committee. 11. When adopted, the Commission’s new rules under Section 404 of the Act will require each annual report to contain management’s assessment of the effectiveness of the internal control structure and the financial reporting procedures. These rules should provide guidance to CEOs and CFOs with respect to reporting significant deficiencies and material weaknesses in internal controls. 12. The Act has significantly changed the regulatory environment.82 Given the seismic changes to corporate reporting that will result from the Act and the Commission’s rulemaking to implement the Act over the next 12 months, the development of disclosure controls and procedures will be an iterative process.83 We believe that perfection is not required. A good-faith effort to develop and implement disclosure controls and procedures should be adequate.84 B.

First Steps 1.

Evaluate Current Systems and Procedures a. The Commission has not specified or mandated any particular set of disclosure controls and procedures. Indeed, there may be no definitive or “best practices” disclosure controls and procedures that all issuers should aim to adopt because, given issuer diversity, one size does not fit all and procedures will vary from issuer to issuer, depending on size, history, corporate culture, industry and geography. Since issuers already make efforts to ensure that their disclosure is accurate, we suggest issuers focus initially on how to augment or improve current disclosure practices, rather than start from scratch. The first step should be to evaluate their

82

Executives still differ as to whether certification and the other corporate governance initiatives are necessary or are a waste of time. The views of CEOs attending the Business Council meeting in White Sulphur Springs in West Virginia in early October ranged from one executive who believed, “There’s going to be a lot of sand kicked through the wheels of capitalism,” and who focused on the compliance costs (“My insurance doubling – that’s a cost to my shareholders. Signing documents saying that nothing’s changed – that’s a cost to my shareholders”), to others who expressed the position that even though they had been through “a lot of cycles … it’s never been this way before.” See Timely, or a Waste of Time?: Issue of Governance Gets Executives’ Attention, But Only Mixed Approval, at Annual Retreat, Wash. Post, Oct. 5, 2002, at E1. 83

For example, Rule 12b-21 under the Exchange Act, which permits the omission of required information that is unknown and not reasonably available to the issuer because of unreasonable effort or expense, may be helpful in the short term with respect to new disclosure rules, but it is not a long-term solution. Moreover, the disclosure controls developed for the 2002 third quarter Form 10-Q should be refined for the 2002 annual report on Form 10-K. 84

The definition of disclosure controls and procedures in Rules 13a-14 and 15d-14 refers to procedures “designed to ensure,” while the definition of internal controls set forth in AU Section 319 refers to a process designed to provide “reasonable assurance” regarding the achievement of objectives. Query whether the definition of disclosure controls and procedures means absolute assurance or reasonable assurance, and, if the former, whether issuers may undertake a cost/benefit analysis in designing their disclosure controls and procedures. We believe that the objective of disclosure controls and procedures is reasonable assurance, not absolute assurance.

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current disclosure practices and procedures for all required Exchange Act reports. b. The evaluation should focus on how information flows from a “top-down” as well as from a “bottom-up” perspective to determine what information is currently “recorded, processed, summarized and reported” and the reliability and timeliness of that information. From a top-down perspective, the analysis can focus on involving or enhancing the involvement of senior executives in the discussion of trends, strategies and risks to the business of the issuer and its industry, as well as their vision of where the issuer and the economy are headed. In addition, this analysis can focus on how senior executives’ views and the tone at the top are communicated to, and perceived by, the lower echelons of the organization and persons outside the issuer. From the bottom-up perspective, an issuer should ascertain what and when information is currently communicated to the CEO and CFO – an example would be segment information supplied to the Chief Operating Decision Maker (“CODM”), as required under SFAS 131, Disclosures about Segments of an Enterprise and Related Information, which has been in effect since 1997. This evaluation can form the foundation for the action items to meet the new requirements. 2.

Focus on Internal Controls a. Internal controls should be a primary focus for complying with the new rules for several reasons. First, the new certification rules require the CEO and CFO to evaluate internal controls every quarter and disclose to the outside auditor and the audit committee any significant deficiencies and material weaknesses and any fraud involving management or employees with a significant role in internal controls. This is a new responsibility for the management of most issuers, which cannot look to the outside auditor to report deficiencies in the “management’s letter” as it has in the past. b. Second, as the Commission observed, disclosure controls and procedures – the procedures for gathering, analyzing and disclosing all information required to be disclosed in Exchange Act reports – are intended to be “commensurate” with internal controls. We understand “commensurate” to mean equal in measure or scope with internal controls. Therefore, internal controls, which have been required since the late 1970s, can and should provide guidance and serve as a model in conceptualizing and implementing disclosure controls and procedures. As a model, internal controls are particularly apt because the salient question is how to revise existing disclosure practices so that they provide reasonable assurance for non-financial information similar to the reasonable assurance which internal controls should already be providing for financial information. Finally, since disclosure controls and 31

procedures can be viewed as an extension or broadening of internal controls to non-financial information – or financial reporting under internal controls as a subset of disclosure controls and procedures – their similarity is appropriate. c. Internal controls are a formal system of checks and balances, overseen by management and the board of directors and reviewed by the outside auditor. Because of the formality of their structure, internal controls are capable of being evaluated or tested for their reliability. As noted in the accounting literature, in particular, AU Section 319 and the COSO framework, this system of checks and balances is intended to provide reasonable assurance that the following objectives can be achieved: (1)

Reliability of financial reporting;

(2)

Effectiveness and efficiency of operations; and

(3)

Compliance with applicable laws and regulations.

d. In accordance with AU Section 319 and the COSO framework, internal controls generally consist of five interrelated components: (1) Control Environment: Establishes the foundation of the internal control system by providing fundamental discipline and structure, setting the tone of an organization and influencing the “control” consciousness of its people; (2) Risk Assessment: Identifies and analyzes the risks to the corporation and forms a basis for determining how the risks should be managed; (3) Control Activities: Comprise the policies, practices and procedures that help ensure that management objectives are achieved and risk mitigation strategies are carried out; (4) Information and Communication Systems: Support the identification, capture and exchange of information in a form and timeframe that enable people to carry out their responsibilities; and (5) Monitoring: Assesses the quality of internal controls by external oversight by management or third parties or by the application of independent methodologies within internal controls. e. These five internal control components work as a matrix. As such, they can be used to conceptualize and map out disclosure controls and procedures so that they can provide reasonable assurance as to the reliability of Exchange Act reporting and compliance with applicable laws 32

and regulations. In evaluating disclosure controls and procedures, the CEO and CFO will consider both their design and their operation with respect to meeting these objectives. However the CEO and CFO choose to design the disclosure controls and procedures, there are some key attributes of internal controls that should apply to all systems of disclosure controls and procedures: (1)

Formality and Documentation: (a) Like internal controls, disclosure controls and procedures need to be documented and formalized so that they can be proven to exist and, once in existence, can be evaluated by the CEO and CFO. An informal or casual disclosure process, even if it results and has always resulted in accurate and timely Exchange Act filings, may not satisfy the new requirements because it cannot be effectively tested – i.e., subject to inquiry, inspection and observation – for reliability. Moreover, a formal process is likely to achieve greater efficiency and quality than an informal process. (b) Formality and documentation do not mean, however, that the specificity of detail that now accrues to the COSO framework for internal controls, which is spelled out in two volumes, is required for disclosure controls and procedures. Indeed, that level and specificity of detail may be unnecessary or even inappropriate for disclosure controls and procedures.

(2) Checks and Balances: To achieve reliability, disclosure controls and procedures must be designed to foster a system of checks and balances. Examples of checks and balances include coordinating with the outside auditor and the audit committee as well as allowing sufficient time for individuals to review and comment on each periodic report and to implement corrective measures if needed or investigate any disclosure issues as they may arise. C.

Possible Components of Disclosure Controls and Procedures 1. Control Environment: Establishes the foundation of the control system by providing fundamental discipline and structure, setting the tone of an organization and influencing the “control” consciousness of its people; includes the integrity, ethical values and competence of officers and employees, management’s philosophy and operating style, the manner in which management assigns authority and responsibility and organizes and develops employees, and the attention and direction provided by the audit committee and the board of 33

directors a.

Tone at the Top (1) In its 1987 report on fraudulent financial reporting, the Treadway Commission focused on the most important factor to the integrity of the financial reporting process and in preventing fraudulent financial reporting: the tone set by top management that influences the corporate environment within which financial reporting occurs. While this is not a new concept, the tone at the top is an essential element of the control environment for disclosure controls and procedures85 and should emphasize the importance of full, accurate and timely disclosure to the issuer, with accumulation and communication as the means to achieve those objectives.86 The attitude and behavior of the top officers and directors establish the tone at the top; in particular, the CEO has a special role, as his or her attitude, behavior and expectations influence the actions of other members of senior management and set an example for all employees.87 If reliable Exchange Act reporting is a priority to the CEO, then it will be to others. A code of corporate conduct can help to communicate the tone at the top throughout the organization because it signals to all employees the standards for the company’s reporting process. (2) For the CEO and CFO, the tone at the top is particularly important. By virtue of their positions within the organization, their actions and attitudes establish the tone at the top. Because of the new certification requirements, they must, in turn, evaluate the effectiveness of their actions and attitudes with respect to setting the tone at the top and report their conclusions in the periodic report. Certification thus becomes self-criticism.

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Commissioner Glassman reinforced this point in a speech delivered to the American Society of Corporate Secretaries: “First and foremost, Sarbanes-Oxley makes clear that a company’s senior officers are responsible for the culture they create, and must be faithful to the same rules they set out for other employees.” Commissioner Cynthia A. Glassman, Sarbanes-Oxley and the Idea of “Good” Governance, Speech Before the American Society of Corporate Secretaries (Sept. 27, 2002)(available at http://www.sec.gov/news/speech/spch586.htm)(the “Glassman Speech”). 86

Although one size does not fit all, this guidance can be illustrated by an example: A public company, Newco, is a retailer headquartered in Miami with three different business segments: large discount outlets, designer shoe boutiques and a chain of grocery stores. Newco’s CEO and CFO have posted to the internal website a statement of corporate principles about disclosure, emphasizing the importance of full, accurate and timely disclosure. Before being posted, this statement was drafted by Newco’s general counsel and outside counsel, reviewed with the audit committee and the outside auditors and approved by the entire board of directors. 87

The “tone at the top” may be the most effective step for mid-level executives who “are products of the corporate environment in which they work.” Kurt Eichenwald, Even if Heads Roll, Mistrust Will Live On, N.Y. Times, Oct. 6, 2002, at Section 3, page 1.

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b.

Disclosure Policy (1) An organization-wide, formal disclosure policy can provide the framework for disclosure controls and procedures.88 This could be similar to the documentation of other corporate policies for such topics as insider trading, conflicts of interest and corporate governance, in both tone and scope. In addition, the policy could indicate that disclosure controls and procedures include the financial reporting aspect of internal controls and are intended to complement other compliance policies and procedures, such as Regulation FD. (2) The disclosure policy could include a statement of purpose to the effect that all disclosures made by the issuer to its shareholders and to the investment community should fairly present the issuer’s financial condition and results of operations in all material respects, and should be made on a timely basis as required by applicable laws and stock exchange requirements. The policy could also address, among other things, the corporation’s values or principles in preparing disclosure; the new disclosure controls and procedures and the reasons for them; the responsibilities of the disclosure committee, if any; the officers responsible for different sections of the issuer’s reports; and summaries of applicable laws. Implementing the policy could be the primary responsibility of the disclosure committee, with review by outside counsel and oversight by the audit committee. Like other corporate policies, the disclosure policy would be widely distributed throughout the company and discussed in internal employee training programs. (3) The disclosure policy should be drafted as a policy of standards or principles, and not rules. Disclosure controls and procedures are new, and the expectations of what they should look like or how they should perform may change as the Commission implements the Act and adopts other changes to the disclosure system. Principles can provide issuers with greater flexibility to adjust to changing circumstances and expectations, and are also more difficult to evade than rules, which can be both over- and under-inclusive. Hence, unlike the two volumes that implement the COSO standards, the disclosure policy should be specific enough to be capable of evaluation, but not constitute a “tic and tie” sheet.

88

Newco has also adopted a corporate policy on disclosure, which provides more details and procedures about the disclosure process and what and who it entails. This policy will be reviewed in the annual employee training sessions. Like the statement of corporate principles, this policy was drafted by the general counsel and outside counsel, reviewed with the audit committee and the outside auditors and approved by the entire board of directors.

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(4) Here are some rules-of-the-road to consider in formalizing a disclosure policy: (a)

Fit the policy to the needs of the company;

(b)

Do not adopt a policy that will not be followed;

(c) If practice differs from the written policy, amend the policy (or the practice) so that, or until, they are in agreement; and (d) Until the process of designing disclosure controls and procedures is finished, continually evaluate how it is working and adjust it to meet the changing circumstances, particularly the changing business environment and new Commission rules. c.

Review and Approval (1) Oversight of the disclosure controls and procedures by the board of directors and/or audit committee is part of the “control environment,” particularly as the Act now requires the audit committee to be responsible for the auditing and financial reporting process. The oversight function should complement and support disclosure controls and procedures. In addition, disclosure controls and procedures should be developed and maintained in consultation with the internal auditor, outside auditor and outside counsel.

2. Risk Assessment: Identifies and analyzes the risks to achieving accurate and timely disclosure, and forms a basis for determining how the risks should be managed a. In designing disclosure controls and procedures, each issuer needs to implement a process for identifying, analyzing and managing risks to meeting Exchange Act disclosure obligations on a timely basis and in so doing, should consider what the worst-case scenario would be.89 Risks are those external and internal events and circumstances that may lie outside the scope of, or put stress on, various components of disclosure controls and procedures, thereby potentially harming the issuer’s ability to meet its disclosure objectives. Therefore, risk assessment is an ongoing process and will need to be conducted in a fluid and dynamic manner. Risks could 89

Before the new rules, Newco relied on a small group, consisting of the general counsel, the CFO, the CEO, internal audit and investor relations, to address any potential disclosure risks, such as investor conferences or integrating the IT systems of new acquisitions. This is also the same team that handles Regulation FD issues. To formalize a risk management process, Newco intends for now to rely upon the same people but to increase staffing in internal controls, which should help in improving the overall control environment.

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include: (1) Changes in operating environment, such as new business models or products or indigenous growth and acquisitions or entry into foreign markets; (2)

Staffing levels and turnover;

(3) Acquisitions or dispositions or other corporate restructurings; (4)

New legal and accounting requirements; and

(5)

Human error in decision-making.

b. Senior management should consider a three-step framework for assessing an issuer’s risk of satisfying its disclosure objectives: (1) Identify and understand the risks that can lead to failure to fulfill the issuer’s objective to disclosing reliable information on a timely basis – for example, entry into foreign markets in which the issuer lacks appropriate staffing or infrastructure, or the development of a new product which entails a new manufacturing or inventory process; (2) Assess the factors that these risks create within the company – for example, the lack of qualified personnel in the foreign markets to accumulate or evaluate information or the need for auditing procedures for the new product; and (3) Design and implement controls and procedures that will provide reasonable assurance that the issuer’s disclosure objectives will be met – for example, hiring and training bilingual staff in the foreign markets to communicate more effectively with headquarters or consulting with outside experts to adopt auditing standards that comply with GAAS for the new product. 3. Control Activities: Comprise the policies, practices and procedures that help ensure that management objectives are achieved and risk mitigation strategies are carried out a.

Disclosure Committee (1)

Purpose (a) While not specifying particular disclosure controls and procedures, the Commission is recommending that issuers have disclosure committees. Given the scope of 37

disclosure controls and procedures, the need for producing quality information on a timely basis, and the adverse consequences to the certifying individuals and the issuer for faulty certifications or inadequate disclosure controls and procedures, we also recommend the adoption of disclosure committees. The disclosure committee would receive information that is accumulated, assign responsibility for first drafts of reports or sections thereof, revise the drafts and make inquiries when it believes appropriate to assure itself of its completeness and reliability, and make determinations concerning materiality and required disclosure obligations on a timely basis, all in tandem with the CEO and CFO. (b) Creating a disclosure committee with the responsibility for establishing and supervising the issuer’s financial and non-financial disclosure process has the advantage of enhancing efficiency in producing timely information. The committee can also serve as the main vehicle through which the CEO and CFO are able: (i) To evaluate disclosure controls and procedures; (ii) To ensure that the disclosure controls and procedures are designed to ensure that material information is communicated to them; (iii) To make decisions about what information to disclose; and (iv) To conduct the investigation necessary to be able to support their certification that the periodic report does not contain any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made not misleading. (2)

Staffing (a) While the specific composition of the disclosure committee will vary from issuer to issuer, the members should have the skills, experience and position to exercise judgment as to materiality and disclosure and to monitor the disclosure process. The Commission has recommended that the committee include, among others: the principal accounting officer, the controller, the general counsel or 38

other senior legal official, the principal risk management officer, the chief investor relations officer and business unit heads. We would recommend that the internal auditor also be a member of the committee.90 If the disclosure committee is going to have responsibility for preparing initial drafts of Exchange Act reports rather than reviewing drafts prepared by junior personnel, it may be advantageous to designate draftspeople and change their other duties so that they have adequate time to fulfill their new duties. In addition, because immediate action may be required for some filings, or market-sensitive information may be at issue, a subgroup of the disclosure committee could be designated to act in lieu of the full disclosure committee under these circumstances. (b) Each issuer should consider designating a “disclosure coordinator,” who would serve the function of a traffic cop.91 The disclosure coordinator would be responsible for coordinating the activities of the disclosure committee, working with the various business units or departments within the corporation from which information is gathered and interfacing with the audit committee and the board of directors. To maximize effectiveness, the disclosure coordinator could be an executive-level individual charged with responsibility over all aspects of corporate disclosure, including ensuring that procedures are properly documented, communicated, implemented and enforced. The coordinator would also be responsible for preparing and implementing a time and responsibilities schedule and documenting compliance with disclosure policies. While the circumstances among issuers may vary, the disclosure coordinator could be the general counsel or a senior member of the finance department, such as the chief accounting officer. (3)

Responsibilities

90

Newco’s disclosure committee consists of the general counsel, the associate general counsel, the head of investor relations, the heads of the three business segments, the chief operating officer, the head of internal controls and the head of accounting. The general counsel also serves as the disclosure coordinator, and the committee is supported by a staff of five employees, three of whom are from the legal department and two are from internal controls. The disclosure committee consults often with outside counsel and the outside auditors.

91

Commissioner Glassman has proposed that each issuer have an officer with “ownership of corporate compliance and ethics issues,” who would be called the “corporate responsibility officer.” This officer would be responsible for all aspects of the disclosure process, including addressing worst-case scenarios, and would even have the ability to report directly to the board on matters of “significant import to the company or matters involving misconduct by senior management.” See Glassman Speech.

39

(a) The disclosure committee’s responsibilities should be clear,92 and the committee should meet regularly to carry out its responsibilities, which could include, among other things: (i) Assisting the CEO and CFO in establishing and maintaining disclosure controls and procedures and also, in consultation with the internal auditor, internal controls; (ii) Assuring that information that is potentially required to be disclosed is accumulated and communicated to the disclosure committee; (iii) Testing the accumulated information for reliability; (iv) Monitoring the integrity and effectiveness of disclosure controls and procedures; (v) Evaluating the accumulated information and applying the disclosure requirements to it so that timely required reports can be made in compliance with the federal securities laws; (vi) Overseeing the preparation of annual, quarterly and current reports and proxy statements, and presenting them for review to the CEO and CFO as well as the audit committee or its representative; (vii) Overseeing the preparation of non-Exchange Act disclosures, such as registration statements, press releases, earnings guidance, presentations to analysts and the investment community, presentations to ratings agencies, and presenting them for review to the CEO and CFO as well as the audit committee or its representative; (viii) Consulting with the CEO and CFO to assist them in complying with their certification obligations; 92

While these responsibilities can be embodied in a written charter, it may not be necessary; rather, it may be advisable to have only a clear understanding of what the disclosure committee should do. Creating specific duties raises the possibility that those duties will not be fulfilled. If a written charter is adopted, it should state principles, rather than specify all duties for which the disclosure committee is responsible, and it should be regularly reviewed and be capable of being amended to reflect changing circumstances and new rules.

40

(ix) Interfacing with the audit committee and the board of directors; (x) Preparing and updating a detailed time and responsibilities schedule for each required Exchange Act report; (xi) Providing a back-up certification to the CEO and CFO prior to the filing of each periodic report as to the committee’s compliance with its policies and procedures, the proper performance of its responsibilities, the accuracy and completeness of the information contained in the periodic report and the compliance of the periodic report with all legal requirements; (xii) Evaluating, under the direction of the CEO and CFO, the company’s disclosure controls and procedures, including internal controls within 90 days prior to the filing of each Form 10-K and Form 10-Q; and (xiii) Being able to answer due diligence questions from underwriters or placement agents and their counsel in connection with public and private offerings. (4)

Interaction with Internal Controls (a) The disclosure committee should work closely with the finance department and the internal auditor so that both internal controls and disclosure controls and procedures are calibrated to result in consistent determinations of materiality and disclosure. Some areas of overlapping information between the two sets of control include: (i) Non-financial data used in deriving operational or production statistics; (ii) Assessment of compliance with regulatory, contractual or legal requirements; (iii)

FASB No. 5 contingencies; and

(iv) Compliance with income tax laws and regulations. (b)

In addition, the financial information disclosed in a 41

periodic report, viewed in its entirety, must meet a standard of overall material accuracy and completeness that is broader than financial reporting requirements under GAAP. Thus compliance with GAAP and Regulation S-X or compliance with Regulation S-K may not be sufficient when additional statements are necessary to make the required statements that are made not misleading under Rule 12b-20 or Rule 10b-5 under the Exchange Act. Hence, the disclosure committee will need to interact with internal controls to determine whether additional disclosure is necessary to ensure that the financial statements, as well as the non-financial disclosure, meet the standard of overall material accuracy and completeness.93 (5)

Reporting to the Audit Committee (a) Although not required, given the focus of the Act on the audit committee’s responsibility for the auditing and financial reporting process and its oversight over internal controls, it seems logical for the disclosure committee to report to the audit committee in addition to reporting to the CEO and CFO.94

b.

Documentation (1) The preparation and review of periodic reports should be documented to provide the factual basis for the effectiveness of the disclosure controls and procedures as well as to show compliance with corporate policy. Because the CEO and CFO will rely, in large part, on the work of others, documenting each step of the disclosure process will help ensure that their directives are carried out. Documentation will also facilitate the audit committee’s and board of directors’ oversight of the disclosure committee. (2) In addition to a certification from the disclosure committee, issuers may also want to consider back-up, underlying or subcertifications from heads of principal business units or other divisions with respect to factual matters within each individual’s area of knowledge as a component of the review process. Some have also advocated back-up certifications from the members of the disclosure committee. Although it is unclear how effective these back-up certifications will be as a basis for the CEO’s and

93

For a discussion on liability for material misstatements or omissions for false certifications, see footnote 77 of this Outline, supra. 94

See Section 301 of the Act; Section VII of this Outline.

42

CFO’s certifications and requiring them could cause a morale problem if used indiscriminately, they may be effective as part of or a supplement to a system of disclosure controls and procedures. If back-up certifications are required, they should be coordinated with the issuer’s code of conduct. Issuers should consult in-house and outside counsel with respect to documenting this process, particularly in light of litigation-related issues that could arise in the future. 4. Information and Communications Systems: Support the identification, capture and exchange of information in a form and timeframe that enable people to carry out their responsibilities; ensure that information is delivered and communication provided down, across and up the organization a.

The Flow of Information (1) One definition of “disclosure controls and procedures” refers to information being “recorded, processed, summarized and reported.” The other definition of the term refers to information being “accumulated and communicated.” Under AU Section 319, information must be “identified, captured and exchanged.” These three descriptions are synonymous, and their similarity underlines the inter-relationship between internal controls and disclosure controls and procedures and the importance to both of developing procedures of gathering and processing information. (2) Each issuer should consider the flow of information that it needs: where that information comes from; how it can be captured or accumulated; how that information should be processed or summarized or communicated; who should see that information; and the various other steps and processes leading, ultimately, to the decision of whether and how to disclose the information in a periodic report.95 This apparently simple construct can be complex

95

Like many companies, Newco has not reviewed its information-gathering process since its IPO three years ago, when the due diligence document request list and the drafting process required everyone in the organization to focus on where to get the information necessary to meet the demands and requirements of a public offering. Now with the new certification rules in effect, the general counsel is concerned about developing disclosure controls and procedures. Upon advice of counsel, as the first step, she will convene meetings with outside counsel, the outside auditor, the heads of each business unit, marketing, internal audit, accounting, finance, investor relations and the CEO and CFO. The agenda for these meetings is to address, for the first time since the IPO and the due diligence request list, what information is available, where to find it and whether it is reliable. To organize the discussion, the general counsel has in hand: the most recent periodic report; a comprehensive list of items required to be disclosed in an annual report; the due diligence request list from the IPO; and a detailed description of Newco’s information technology systems and the information that they are programmed to collect and analyze. At the conclusion of these meetings, the general counsel should have a good picture of how and where information currently flows throughout the organization, which could provide the information necessary to begin formalizing a structure of disclosure controls and procedures.

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in application.96 (3) The flow of information from the top-down is as important as the flow of information from the bottom-up. Key decisions are made at the senior management and board level. Information about trends, strategy, competition and other material matters are oftentimes known only by senior management and the board. Although the disclosure committee reports to the CEO and CFO, the committee should also obtain information from the CEO and CFO and involve them in the disclosure process at an earlier stage than at the end, which has often been the case in the past. (4) In addition, each CEO and CFO should consider how far down the chain of responsibility to go in order to assure himself or herself of the completeness of the information-gathering process. One approach is to stop at the level of the heads of the principal business units and to require back-up certifications from each of these individuals as to the reliability of the information being reported from such principal business unit to the disclosure committee. However, input from business people who may not be members of the disclosure committee or who may not be the heads of a unit or division may be critical to the information-gathering process. This is ultimately a question for each CEO and CFO to decide, based on the issuer’s own facts and circumstances. (5) Rather than develop new information flows, the issuer should first consider whether existing information flows are adequate or can be enhanced. (a) The segment information being provided to the CODM, who is typically the CEO, and which is typically already available to the CFO, can be augmented to provide additional data and be furnished to the disclosure committee without creating a new process. (b) The role of the internal auditor can be augmented by having the internal auditor test non-financial information as well as track or accumulate non-financial information for the disclosure committee. 96

For example, how does Newco determine a business trend for its chain of grocery stores in the Midwest? This could involve recording or accumulating or capturing information from all retail stores in the Midwest and summarizing the information in such a way as to form a basis for both quantitative and qualitative analysis, and exchanging or communicating that information with various other divisions within the organization, such as inventory, or contract management, or credit financing, in order to provide all of the data points necessary for management to determine that a business trend is occurring. Or, it could be accomplished by a customer survey already being conducted by telephone from New York. A business person may resolve this issue, and his or her input may be critical to the information-gathering process.

44

b.

Time and Responsibilities Schedule (1) To control and organize the flow of information and to coordinate that flow with the disclosure process, issuers should consider creating or augmenting an information and communications system such as a time and responsibilities schedule, which would identify the deadlines for preparing periodic reports and other disclosures as well as the division and delegation of responsibility for various aspects of the required disclosure. This schedule should be managed by the disclosure committee and, in fact, should be a primary focus of the work and activity of the disclosure committee.97 (2) The procedures for periodic reports and other disclosures may vary. For example, the timetable for a press release will differ from that for an annual report, and a formal time and responsibilities schedule may not be needed in every instance. Rather, an informal flow chart can serve to focus attention on the proper scope of actions for other communications, such as presentations to analysts or earnings guidance.98 (3) The detailed time and responsibilities schedule would be a “bottom up” approach to the preparation of the reports. In this respect it would be similar to the internal control procedures conducted by the internal auditor. To assemble a time and responsibilities schedule, issuers will need to determine what information is required to be disclosed – such as, in the case of periodic reports, each applicable item of Regulations S-K and S-X as well as Rule 12b-20 and any new or recent developments or changes in the issuer’s disclosure obligations – to plan where and how to obtain the necessary information. Issuers should consider

97

Some of the steps that the general counsel of Newco will undertake to create a time and responsibilities schedule for updating the business description and the MD&A disclosure for the designer shoe boutique segment are: working with the head of this business segment and internal audit to review the process for gathering information and testing the reliability of that information; charging the head of that unit with the responsibility for presenting information for that segment to the disclosure committee and to the CEO and CFO as well as overseeing the description of the segment and the discussion and analysis of the financial results for the segment; underscoring that responsibility by requiring the head to execute a back-up certification on the information process and disclosure; delegating responsibility to test the reliability of that information to the internal audit team or its equivalent; and including the head of this business segment in the disclosure committee discussions about disclosure. 98

To date, Newco has relied on its Form S-1 registration statement as the template for all of its subsequent periodic reports. Because of the new certifications required of the CEO and CFO and new Commission requirements, the general counsel has decided that for the next periodic filing, the disclosure committee should take a fresh look at the disclosure and approach the periodic filing as it did the registration statement. She has scheduled several drafting sessions for the disclosure committee in order to improve the quality of the disclosure. The outside counsel and outside auditors will also participate in these drafting sessions. She does not think this would be necessary for every filing, however.

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making individual officers or employees responsible for clearly defined tasks in the disclosure process under the supervision and direction of the disclosure coordinator. (4) for:

The time and responsibilities schedule can specify timing (a) Preparing and commenting on periodic reports, including: (i)

Accumulation of data;

(ii)

Testing and review of data;

(iii) Review of specific sections of filings by individuals whose areas of expertise coincide with such sections; (iv) Review and updating of “risk factor” language in light of the company’s changing operations; (v) Initial review by the disclosure committee including a “rules check” on each report so that it complies with Commission rules and regulations; (vi) Review of competitors’ filings and industry analyst reports to determine any needed supplementation of the company’s filings; (vii)

Review by outside auditor and legal counsel;

(viii) Review by CEO and CFO and other senior management; and (ix) Review by the audit committee/board of directors. (b) CEO and CFO meetings with internal and outside auditors and the company’s audit committee regarding internal controls; (c) CEO and CFO evaluation of disclosure controls and procedures within 90 days prior to the filing of the report; (d) CEO and CFO meetings with the disclosure committee to review periodic reports; and

46

(e) Meetings with investor relations to coordinate and oversee earnings announcements. (5) One size does not fit all. A time and responsibilities schedule should be customized to the facts and circumstances unique to an issuer. Several factors to consider in crafting the appropriate level of procedures and specific tasks in a time and responsibilities schedule include: (a) The benefit gained by a procedure or task should be compared against the cost to the company of such procedure or task; (b) Fewer detailed steps may require additional review steps and reliance on the judgments of senior management, which may be more difficult for the CEO and CFO to evaluate; and (c) Fewer detailed steps may be appropriate in light of other controls that an issuer may have in place. For example, staffing levels of participants in the disclosure process and their experience with public company disclosure can affect the level of detail necessary in describing the steps in a time and responsibilities schedule for a periodic report. c.

Reporting Information to the CEO and CFO (1) Disclosure controls and procedures should be designed to ensure that information is known or made available to the CEO and CFO. In addition to direct transmittal of information, such as segment information, the disclosure committee could report information directly to the CEO and CFO and provide them with complete access to the disclosure committee’s database (and to any back-up information relied upon or used by the committee) to support their review prior to executing a certification.

5. Monitoring: Assesses the quality of the system over time through ongoing monitoring and separate evaluations, including through regular management supervision or third-party testing, with report of deficiencies upstream a. Disclosure controls and procedures should be monitored by the disclosure committee or the disclosure coordinator on a regular basis to assess their quality. This can be accomplished by ongoing monitoring activities or external evaluations or a combination of both. The basic types of tests available include inquiry, inspection, observation and flowcharts. For example, a time and responsibilities schedule for a periodic report can be monitored – e.g., by inquiry or observation – 47

throughout the drafting process to help ensure that accurate and timely disclosure will be made and that the CEO and CFO will have sufficient time to review the disclosures to make the required certifications. b. Because disclosure controls and procedures are a new concept, companies should consult with their outside auditor and outside counsel in developing controls and procedures that can be tested. Moreover, issuers may wish to consider outsourcing the monitoring function similar to outsourcing that sometimes occurs with respect to the internal audit function. Indeed, application of an independent evaluation methodology by an outside person under the oversight of the disclosure committee can be helpful in developing and maintaining effective disclosure control. c. Questions to consider when monitoring disclosure controls and procedures include the following: (1) Are the controls and procedures designed to satisfy the issuer’s disclosure objectives? (2) Are the established controls and procedures being acted upon? (3) Have any new factors been identified that create a significant risk that the issuer’s disclosure objectives will not be satisfied? (4) Are disclosure controls and procedures being documented appropriately? D.

Evaluating Disclosure Controls and Procedures and Internal Controls 1.

Introduction a. Rules 13a-14 and 15d-14 under the Exchange Act require the CEO and CFO to certify that they have evaluated disclosure controls and procedures within 90 days prior to filing a periodic report. Correspondingly, Rules 13a-15 and 15d-15 under the Exchange Act require the issuer’s management, including the CEO and CFO, to supervise and participate in an evaluation of the effectiveness of the design and operations of the issuer’s disclosure controls and procedures. For practical purposes, these are one and the same evaluation. The purpose of the evaluation is to determine whether the disclosure controls and procedures are effective at providing reasonable assurance as to the reliability of Exchange Act reports. b. This evaluation can be viewed as an extension of the monitoring and risk assessment components of disclosure controls and procedures. Indeed, the purpose of monitoring is to assess the quality and effectiveness 48

of disclosure controls and procedures, and risk assessment identifies and analyzes the risks to the corporation to achieving reliable Exchange Act reports. The difference, however, is that monitoring and risk assessment are parts of the system, whereas the evaluation must occur from a point of view outside of the system – i.e., by the CEO and CFO. Senior management should consider the role that external sources such as the issuer’s legal counsel and outside auditor can play in the process of evaluating the effectiveness of an issuer’s disclosure controls and procedures. 2.

Timing a. The new rules require management and the CEO and CFO to evaluate disclosure controls and procedures within 90 days of filing the report. There is a debate as to when disclosure controls and procedures should be evaluated since, for both quarterly and annual reports, the evaluation can occur even before the end of the period. A common answer is after the information is accumulated and a draft of the periodic report has been completed, which makes sense given that the purpose of the evaluation is to determine the effectiveness of the controls and procedures in providing reasonable assurance that the periodic report is reliable and timely. However, there may not be sufficient time at this point to perform the procedures necessary to conduct the evaluation – and there will be less time once the rules accelerating the deadlines for filing periodic reports take effect. Hence, evaluating disclosure controls and procedures may need to be conducted at the same time as, rather than after, preparing the periodic report. Moreover, in a dynamic reporting structure where business reports are furnished to the CEO on a daily or weekly basis, the evaluation process can be viewed as ongoing. b. With respect to internal controls, Item 307(b) of Regulation S-K requires the CEO and CFO to disclose in the periodic report any significant changes in internal controls and corrective actions with regard to significant deficiencies and material weaknesses since the date of evaluation. Because this disclosure obligation begins on the date of the evaluation and ends on the date of the filing of the report, issuers can change the starting date of their disclosure obligation by changing the date of the evaluation. This can lead to issuers trying to cure any deficiencies or weaknesses in the design or operation of their internal controls prior to the date of the evaluation in order to avoid disclosing any significant changes or corrections to such deficiencies or weaknesses subsequent to the evaluation date in the periodic report. Issuers may be able to use the flexibility in scheduling their evaluations to shape the content of their disclosure.

3.

Scope and Scale of Evaluations

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a.

Disclosure Controls and Procedures (1) Since the new certification rules do not specify the type of evaluation necessary for a From 10-K or a Form 10-Q, there is an issue as to whether an evaluation for a quarterly report should be of the same scope and scale as that for an annual report. Because neither the rules nor the adopting release refers to different types of evaluations depending on the type of periodic report, it could be inferred that the evaluation should be the same for all periodic reports. We do not believe this should be the result.

b.

Internal Controls (1) Although the CEO and CFO must report in each periodic report any significant changes to internal controls or any corrective actions to significant deficiencies or material weaknesses in internal controls since the date of evaluation, it is unclear to what extent internal controls need to be evaluated for every period.99 Section 404 of the Act requires the annual report to contain an internal control report in which management evaluates the effectiveness of the internal control structure and financial reporting procedures. (2) Internal controls can be very complex and extensive, involving information technology systems with hundreds of functions. A quarterly evaluation of all aspects of internal controls would be extremely burdensome and expensive. Given the different quantum of information required for quarterly reports as compared to annual reports, and the different time periods in which to prepare quarterly reports as compared to annual reports, the practical reality is that internal controls will not be evaluated to the same extent for a quarterly report as compared to an annual report. (3) This issue may not be resolved definitively until the Commission implements Section 404 of the Act. (4) The issues and questions raised in evaluating internal controls include: (a) Whether the financial reporting systems are adequate to produce consistently accurate results; (b)

Whether adequate controls exist to reduce the risk

99

This is compounded by the confusion as to whether internal controls, or only the financial reporting portion of internal controls, is part of disclosure controls and procedures. For a discussion of this debate, see footnote 73 of this Outline, supra.

50

of fraud; (c) Whether the company has systematically monitored and evaluated its internal controls during the reporting period; (d) Any irregularities that involve management or employees who play a significant role in the internal controls or could have an effect on the financial statements; (e) Whether any degradations in internal controls have been: (i) Identified through internal control reviews (questionnaires), internal audit reports and other means; (ii) Corrected or are the subject of current remedial action; (iii) The subject of an auditor’s management letter; or (iv) Prevented the preparation of financial statements in accordance with GAAP; (f) What is being done to address any identified deficiencies; (g) Whether anything came to the attention of the personnel responsible for the preparation of financial reports which would indicate the possibility of significant undisclosed financial exposures or the need for a restatement of prior period financial statements; (h) Any whistle-blower activities from in-house personnel, particularly those related to the finance function or any disagreement or matter that has received “heated” discussion with the outside auditor; (i) Whether the reportable conditions set forth in the outside auditor’s letter have been corrected; (j) Any communications from customers, suppliers, regulatory agencies or lenders concerning noncompliance with laws or agreements; and (k)

Any waivers or requests for waivers of the 51

corporate ethics, insider trading and conduct rules for executive officers, directors and other key employees. 4.

Disclosure of Evaluation a. The end result of the evaluation of disclosure controls and procedures is to provide the procedural predicate to support the substantive provisions of the certification concerning the disclosure in the periodic report. Neither the rules nor the adopting release provide any guidance as to what the actual disclosure of this conclusion should entail. Based on recently filed quarterly reports, a sample of which is attached to this outline as Exhibit 2, it appears that issuers are disclosing only that the CEO and CFO evaluated the disclosure controls and procedures and concluded that they were “effective in timely alerting them to material information relating to the Company required to be disclosed in the Company’s periodic SEC filings.”100 There is no description of the procedures performed or tests applied or the measure or metric by which the CEO and CFO concluded that the disclosure controls and procedures were effective.

V.

REGULATING OFFICERS AND DIRECTORS A.

Bans on Loans to Executive Officers and Directors 1. Section 402 of the Act amends Section 13 of the Exchange Act to prohibit most loans by an issuer (including both U.S. and foreign public companies, and subsidiaries) to its executive officers101 and directors that are made, modified or renewed after July 30, 2002. The provision is effective immediately. 2. Under Section 402, companies may not, directly or indirectly (including through a subsidiary), extend or maintain credit, arrange for the extension of credit, or renew any extension of credit, in the form of a “personal loan” to or for any executive officer or director of the issuer. 3.

The primary exceptions to this prohibition are: a. Any loan that existed on July 30, 2002, so long as it is not thereafter materially modified or renewed; b. Home improvement and manufactured home loans, consumer credit, and credit extended under credit cards, provided in each case that

100

See Exhibit 2 to this Outline.

101

Although “executive officer” is not defined in the Act, it presumably has the same meaning as in Rule 3b-7 under the Exchange Act: The president, vice president in charge of a principal business unit, division or function and other officers or persons who perform policy-making functions, including executive officers of subsidiaries if they perform policy-making functions for the parent.

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such loans are (i) made in the ordinary course of the issuer’s consumer credit business, (ii) of a type that is generally made available by the issuer to the public and (iii) made on market terms or terms no more favorable than those offered to the general public; and c. Loans made by FDIC-insured banks and thrifts that are subject to existing insider lending restrictions of the Federal Reserve Act. However, this exception does not apply to non-U.S. banks whose securities are listed in the U.S. 4. This provision represents a significant change in practice and will require issuers to monitor transactions with executive officers and directors. For example, split-dollar life insurance policies102 and third-party cashless option exercise arrangements103 should be reviewed. 5. Among the growing number of interpretive questions is whether a loan that was extended, or a commitment to make a loan, to an employee before he or she became an executive officer or director must be repaid when the person is elevated to one of those positions. 6. Another issue is whether advances of class action and derivative action defense costs are prohibited, since they are repayable if the recipient is ultimately determined not to be entitled to indemnification. This is significant: if advances are prohibited under this section, then directors will be required to fund their own defense in the event they are sued, pending eventual reimbursement. The initial question is whether the definition of “personal loan” is a federal or state law issue.104 Second, if it is a state law issue, then a review of all decisions on advancement should be undertaken to see if there is any language indicating that an advancement is a form of personal loan. Answers could differ depending on

102

The New York Times has reported that “according to the interpretation of tax lawyers and compensation experts, the premiums on split-dollar policies could be considered interest-free loans because the corporation is eventually reimbursed. The uncertainty over the policies has virtually halted their sale, pending clarification by the government.” Tracie Rozhon and Joseph B. Treaster, Insurance Plans of Top Executives May Violate Law, N.Y. Times, Aug. 29, 2002, at A1. 103

Many corporations have halted the practice of cashless exercise of stock options, in which executives can exercise stock options without putting up their own money, because the application of Section 402 to cashless exercise is unclear. Section 402 was added to the Act by Senator Schumer, who stated that “I believe they [cashless exercise] probably are banned.” He said that when the law was written, “we were not aware of every type of loan that’s made.” However, “[T]he bottom line is that the corporation is not an arms-length lender to its top executives. And in this case, particularly since the loan is so short term and well collateralized, there’s no reason they can’t find financing apart from the corporation.” Joseph B. Treaster and Tracie Rozhon, Another Blow To Executives On Options, N.Y. Times, Aug. 30, 2002, at C1. A spokesman for the Commission stated that “We have no immediate plans to issue guidance on this.” 104

More likely, it is a mixed question of federal and state law: state law determines how advancement works; and federal law (i.e., Section 402), determines whether the advancement is within the meaning of “personal loan.”

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the state of incorporation.105 B.

Section 16 Filing Deadlines 1. Section 403 of the Act amends Section 16(a) of the Exchange Act to shorten the due date for Section 16 insiders (directors, executive officers and greater than 10% beneficial owners) to file Section 16(a) transaction reports to two business days after the transaction has been executed. This means that if a transaction occurs on Monday, the Section 16 report must be filed “before the end of the second day following the day” of the transaction, which would be Wednesday.106 This provision took effect on August 29, 2002. 2. On August 27, 2002, the Commission adopted rule and form amendments that implemented Section 403’s accelerated filing deadline to report transactions by Section 16 insiders.107 These amendments are as follows:108 a. Amend the Section 16(a) forms to conform all references to the Form 4 filing deadline to the statutory two-business day deadline and to reflect that Form 4 is no longer a monthly form. b. Amend Rule 16a-6(b), the small acquisitions rule, to conform the description of the Form 4 deadline to the amended statutory filing deadline. c. Amend Rules 16a-3(f) and Rule 16a-6(a) under the Exchange Act so that transactions between officers or directors and the issuer exempted from Section 16(b) short-swing recovery by Rule 16b-3, previously reportable on an annual basis on Form 5, will be required to be reported within two business days on Form 4;

105

For example, in Advanced Mining Systems v. Fricke, 623 A.2d 82, 84 (1992), the Delaware Court of Chancery considered a former officer’s motion to compel the corporation to advance him expenses reasonably incurred by him in connection with the defense of a suit against him (subject to the usual unsecured undertaking to repay if he was found ultimately not entitled to indemnification). The court stated flatly: “[T]he advancement decision is essentially simply a decision to advance credit.” 106

Section 16(a) formerly required insiders to report transactions in the company’s equity securities within 10 days after the end of each calendar month in which a transaction occurs. Initial reports were required to be filed within 10 days after the insider became subject to the reporting requirement. Thus, if a trade occurred on the first day of a month and the month had 31 days, a Form 4 did not have to be filed for 40 days after the trade date. 107

See Final Rule: Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Release Nos. 34-46421; 35-27563; IC-25720 (Aug. 27, 2002)(available at http://www.sec.gov/rules/final/3446421.htm)(“Final Section 16 Rules”).

108

The Commission plans to publish new forms implementing these amendments as soon as possible. Until the amended forms are available, reporting persons should use the current versions, but should modify box 4 of Form 4 to state the month, day and year of the transaction; and if the reporting person is filing pursuant to an exception to the two business-day filing requirement, the reporting person should include an asterisk next to the trade date in the transaction date column, and add a footnote to disclose the deemed execution date. See Final Section 16 Rules.

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d. Amend Rule 16a-3(g) to calculate the two-business day Form 4 due date differently for the following transactions, for which the Commission has determined that the amended Section 16(a) statutory due date is otherwise not feasible: (1) Transactions pursuant to arrangements that satisfy the affirmative defense conditions of Exchange Act Rule 10b5-1(c), in which the reporting person does not select the date of execution; and (2) “Discretionary transactions,” within the meaning of Rule 16b-3(b)(1) under the Exchange Act, pursuant to employee benefit plans where the reporting person does not select the date of execution. (a) In both of these exceptions, the reporting person has not selected the date of execution. Therefore, the transaction date for these two types of transactions will be deemed to be, in the case of the Rule 10b5-1 trading plan, the date on which the broker, dealer or plan administrator notifies the insider of the execution, or, in the case of the employee benefit plan, the date on which the plan administrator notifies the insider of the execution. The notification date will be deemed to be the third business day following the trade date if actual notification does not occur by then. In each case, the insider must report the transaction on Form 4 before the end of the second business day following the deemed date of execution, as calculated under the applicable rule. (b) The Commission advises that the reporting person make specific arrangements for the broker, dealer or plan administrator to provide the reporting person notice of the transaction execution as soon as possible. By providing for a maximum five-business day filing period for insiders meeting the requirements for the exceptions, the rule limits the potential delay permitted for reporting these transactions. (c) The exception will not be available if the reporting person has selected the date of transaction execution. (d) The format of Form 4 will be modified to include a column entitled “Notice Date” where insiders taking advantage of delayed reporting will provide the date when they received notice of the transaction.

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3. Although the Act authorizes the Commission to change the two-day reporting due date in any case in which it determines that such two-day reporting is “not feasible,”109 the Commission has stated that it will not adopt any exemptions based on non-feasibility other than the two set forth above.110 Note that this new requirement operates the same regardless of where the trade occurs, be it San Francisco, Hawaii or Singapore. Hence, executives will have to plan ahead to time any discretionary trades and their reporting of such trades. 4. Issuers should inform their Section 16 insiders of the changes made by the Act and establish procedures, such as a transaction-by-transaction preclearance requirement, to assist insiders in meeting the shortened filing deadlines. 5. Initially, insiders may continue to file Section 16 reports with the Commission in paper format. However, the Act requires Section 16 reports to be filed electronically as of July 30, 2003, and at that time, will also require issuers to post the Section 16 reports on their web sites. Although the Commission has announced that it will begin rulemaking and related system programming to assure filing on EDGAR by July 30, 2003, the Commission is encouraging insiders to make Section 16(a) filings electronically now.111 The Commission will accept electronically-filed Section 16(a) reports that are not presented in the standard box format and omit the graphic presentation so long as all the required information is presented in the proper order.112 6. Note that Section 403 differs in one material respect from the accelerated insider transaction reporting rules proposed by the Commission in April 2002.113 Section 403 keeps the burden of Section 16 filing squarely on insiders, whereas the Commission’s proposed rules would have required issuers – and not insiders – to report Section 16 transactions on Form 8-K.114 C.

Disgorgement of Bonuses, Incentive-based or Equity-based Compensation

109

In addition, the Commission continues to have exemptive authority under Sections 12(h) and 36(a)(1) of the Exchange Act to prescribe due dates for Section 16 reports. 110

See Final Section 16 Rules.

111

Electronic filing is particularly encouraged because the Commission receives approximately 140,000 Form 4 paper filings per year. This number is expected to increase because of the Act. 112

See Final Section 16 Rules.

113

See Proposed Rule: Form 8-K Disclosure of Certain Management Transactions, Release Nos. 33-8090, 3445742, 67 Fed. Reg. 19,914 (Apr. 23, 2002)(available at http://www.sec.gov/rules/proposed/33-8090.htm)(the “Insider Reporting Release”) The Commission’s proposed rules would have implemented a three-tier disclosure schedule: reports to be filed within two business days if the transaction has an aggregate value of $100,000 or more; reports to be filed by the second business day of the week following the week in which the transaction occurred if its aggregate value is less than $100,000; and no reporting requirement for transactions less than $10,000 until the aggregate cumulative value of unreported transactions exceeds $10,000.

114

In addition, the Insider Reporting Release would have imposed the new deadlines on directors and executive officers, and not to principal security holders. Section 403 of the Act applies to all Section 16 insiders.

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1. If a restatement is required due to the material non-compliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, Section 304 of the Act requires the issuer’s CEO and CFO to disgorge any bonus and other incentive- or equity-based compensation received during the 12-month period following the first public issuance or filing with the Commission (whichever occurs first) of the document embodying the noncompliant report, which could even include an earnings release. Any profits realized by the CEO or CFO from the sale of the issuer’s securities during this 12month period are also required to be disgorged to the issuer.115 Although the Commission is given exemptive authority in Section 304(b), this section appears to be self-executing. While there is no specific statement concerning Commission enforcement or its ability to define terms, we assume that both would be within the Commission’s power. Whether a court would imply a private right of action is an open issue, but one that should be answered in the negative. a. Section 304 does not define what constitutes “misconduct.” The lack of definition raises many issues: for example, does an innocent mistake by a registered public accounting firm or the failure to recheck or get a second opinion constitute “misconduct”? Does negligence constitute “misconduct”? Given the common understanding of “misconduct,”116 we would expect the term to imply an element of scienter, rather than encompass mere mistakes. b. By its terms, Section 304 does not require any nexus between the restatement and the misconduct to trigger forfeiture of the officer’s bonus.117 This lack of causation means that the CEO and the CFO could be held responsible for the “misconduct” of any employee, even a lowlevel employee, or officer of the issuer that is not the CEO or CFO or in 115

Note that this provision was already part of the President’s Ten-Point Plan and the Commission’s enforcement investigations. The Ten-Point Plan proposed that officers should not be allowed to profit from erroneous financial statements and should lose their right to serve in any corporate leadership position. See Ten-Point Plan, Proposals 4 and 5. In response to the Ten-Point Plan and prior to the Act, the Commission announced that it will seek disgorgement of compensation and/or stock options from senior management of public companies in cases of erroneous financial statements resulting from misconduct. Since March 7, 2002, the Commission has sought disgorgement in four cases. See, e.g., Press Release, “SEC Files Fraud Case Against Former President of IGI, INC. Complaint Seeks Permanent Bar as Officer and Director, Return of Gains from Stock Options, Bonuses based on False Financial Results,” Mar. 13, 2002 (available at http://www.sec.gov/news/press/2002-35.txt). In addition, one new proposal that garnered much interest was the proposal offered by Henry Paulson, the Chief Executive Officer of the Goldman Sachs Group, that corporate insiders give back any gains from stock sales made within a year of their company’s filing for bankruptcy protection. This was also suggested by the Financial Services Forum, a group of chief executive officers of 21 of the world’s biggest financial companies. See Patrick McGeehan, An Unlikely Clarion Calls for Change, N.Y. Times, June 16, 2002, Section 3, at 1, 12. 116

Black’s Law Dictionary defines “misconduct” as: “A transgression of some established and definite rule of action, a forbidden act, a dereliction from duty, unlawful behavior, willful in character, improper or wrong behavior; its synonyms are misdemeanor, misdeed, misbehavior, delinquency, impropriety, mismanagement, offense, but not negligence or carelessness.” 117

Note, too, that Section 304 applies to restatements that are favorable, however unlikely.

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cahoots with him or her. For example, a low-level employee’s false reporting of sales to earn higher commissions could result in restating financial statements after the “misconduct” is uncovered. Such an occurrence is possible even with the most diligent of managements and state-of-the-art internal controls. Query whether this should result in any disgorgement under Section 304 by a CEO or CFO who did not know, did not participate, did not benefit from and took all steps possible to prevent the acts and condemned the actions after they were uncovered. c. There can be many reasons for a restatement that do not involve misconduct or non-compliance with the financial statement requirements of the federal securities laws.118 For example, investment bankers may require issuers whose auditor was Arthur Andersen LLP to re-audit last year’s financial statements in order to market a securities offering by the issuer or the engagement of new outside auditors may result in a re-audit, which in either case could result in restatement. d. This provision could also have the effect of incentivizing executives to shift their pay allocation in favor of salaries over bonuses in order to reduce their exposure to potential disgorgement. This would be ironic given the trend to tie executive compensation to performance. e. The scope of the disgorgement is unclear, particularly with respect to stock options and bonuses which are accrued but unpaid. For example, is the issuer required to recover stock options that were granted during the 12-month period even if no stock was purchased or sold during the period? May an executive retain credits to a deferred compensation account if the amount of the credit is determined pursuant to information in the noncompliant report? f. Will this provision result in issuers being even less willing to accommodate Staff comments that effectively request restatements based 118

Audited financial statements may have to be reclassified, restated and supplemented as a result of a number of matters that can occur after the auditor has rendered its audit report, including: (1) reclassifications to make the presentation of amounts in prior financial statements comparable to the presentation in current financial statements; (2) stock splits, which would require all per share data relating to periods preceding the date of the split to be revised for comparability; (3) compliance with Regulation S-X for private companies making an initial public offering and therefore becoming subject to the additional Regulation S-X requirements not mandated under generally accepted accounting principles; (4) transitional disclosures required by Statement of Financial Accounting Standards No. 142; (5) new accounting standards and interpretations requiring retroactive reclassification or pro forma disclosure; (6) changes to segment data under Statement of Financial Accounting Standards No. 131; (7) discontinued operations, particularly under the broadened definition of a discontinued operation under Statement of Financial Accounting Standards No. 144; (8) retroactive accounting changes under paragraph 27 of Accounting Principles Board (APB) Opinion No. 20; (9) changes from the cost method of accounting to the equity method, requiring revision of prior periods to the equity method under paragraph 19m of APB Opinion No. 18; (10) reorganization of entities under common control, which requires retroactive restatement of prior periods pursuant to paragraph D17 of Statement of Financial Accounting Standards No. 141; (11) changes in reporting entity, which must be reflected retroactively pursuant to paragraph 34 of APB Opinion No. 20; and (12) correction of an error, which generally must be retroactively reflected pursuant to paragraph 36 of APB Opinion No. 20.

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on judgment calls? 2. The broad reach of Section 304 may well pose a problem for foreign private issuers. It is not clear, for example, what would happen if the required repayment violated (or arguably violated) the employee’s rights under the employment laws of a non-U.S. jurisdiction. D.

Prohibition on Insider Trades During Pension Fund Blackout Periods 1. Section 306 of the Act prohibits directors and executive officers from acquiring or transferring company equity securities during pension fund “blackout periods.” This provision applies only to securities acquired by a director or executive officer in connection with his or her service or employment as a director or executive officer. To enforce this provision: any profits realized by a director or executive officer in violation of this provision will be recoverable by the issuer. Moreover, if the issuer fails to institute an action to recover such profits within 60 days after being requested to do so by a shareholder, the shareholder can initiate such action on behalf of the issuer. There is a two-year statute of limitations period running from the date on which the profit was realized. 2. “Blackout period” is defined to include any period of more than three consecutive business days during which at least 50% of the employees of the company and its affiliates are precluded from trading their interests in any equity security of the company held in all “individual account plans,” as defined in the Employee Retirement Security Act of 1974 (“ERISA”) – for example, 401(k), profit-sharing and other defined contribution plans. The Act also amends ERISA to add provisions relating to blackout period notice requirements for plan administrators and related matters. The company is required to timely notify directors and executive officers and the Commission of a blackout period, although the Act does not specify how such notification is to occur or what constitutes “timely” notice, as that term is not defined in the Act. 3. Note that this provision would purport to stop a director or executive officer of a foreign issuer from engaging in a prohibited securities transaction during a blackout period even if the securities were sold outside the U.S. to nonU.S. persons, such as on a foreign stock exchange. 4. This provision takes effect on January 26, 2003. Both the Commission and the Secretary of Labor are required to issue rules under this provision. The Secretary of Labor must issue final rules by October 13, 2002, but no deadline is provided for Commission action. a. The Commission’s regulations could provide for application of the requirements on a controlled group basis (i.e., to certain parent, subsidiary or affiliated corporations) to the extent necessary to prevent the evasion of liability. 59

b. The regulations could also grant exceptions to liabilities under Section 306 in cases such as purchases pursuant to an automatic dividend reinvestment program (which could, however, be viewed as a loan under Section 402) or for purchases and sales made pursuant to an advance election. VI.

NEW DISCLOSURE REQUIREMENTS UNDER THE ACT A.

Off-Balance Sheet Transactions 1. Section 401(a) of the Act requires the Commission to adopt rules providing that each annual and quarterly financial report filed with the Commission disclose “all material off-balance sheet transactions, arrangements, obligations (including contingent obligations) and other relationships of the issuer with unconsolidated entities or other persons,” that may have a “material current or future effect” on the issuer’s financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses. 2. Although broadly stated, and requiring Commission rulemaking, this provision echoes the Commission’s Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operation issued in January 2002. The MD&A Statement responded to a petition for guidance from the major accounting firms with respect to three items: liquidity and capital resources, including off-balance sheet arrangements; trading activities involving nonexchange traded contracts accounted for at fair value; and relationships and transactions with persons or entities that derive benefits from their nonindependent relationship with the registrant or the registrant’s related parties.119 a. With respect to off-balance sheet financing arrangements, the MD&A Statement advised that a registrant’s reliance on off-balance sheet arrangements should be described where those arrangements are a source of financing, liquidity or market or credit risk support for the registrant or expose the registrant to liability that is not reflected on the face of the financial statements – under both short-term and long-term planning horizons. Where contingencies inherent in the arrangements are reasonably likely to affect the continued availability of a material historical source of liquidity or financing, the registrant may have to disclose those uncertainties and their effects. b. With respect to relationships with unconsolidated entities or other parties, the MD&A Statement advised that registrants should consider describing transactions or other arrangements with third parties that could result in exposures to the company that are not reflected in the financial statements. Disclosure may be necessary regarding relationships with

119

See MD&A Statement. For a discussion of the MD&A Statement, see Outline at Section XIII.

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unconsolidated entities even where the relationships are narrow in scope. The disclosure may cover a wide range of arrangements, including arrangements with special purpose entities created in connection with receivables securitization facilities or similar asset-backed financing vehicles. 3. Section 401(c) directs the Commission to complete a study of filings by issuers to determine the extent of off-balance sheet transactions and the use of special purpose entities, and whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such transactions in a transparent fashion. In addition to the study, the Commission is required to submit a report to the President the Congress setting forth the contents of its study and any recommendations the Commission has to improve the transparency and quality of off-balance sheet transactions. Hence, future accounting rules on offbalance sheet transactions and special purpose entities will be considered. 4. The Commission is required to adopt final rules with respect to offbalance sheet transactions by January 26, 2003. B.

Pro Forma Financial Information 1. Section 401(b) of the Act requires the Commission to adopt rules pertaining to pro forma financial information.120 Specifically, any reports filed with the Commission or press releases or other public disclosures must present pro forma financial information in a manner that does not contain an untrue statement of material fact or omit to state a material fact necessary in order to make the pro forma financial information, in light of the circumstances under which it is presented, not misleading. The pro forma information must also be reconciled with the issuer’s financial statements reported under GAAP. a. For foreign issuers: it is not clear whether the rules will require reconciliation to U.S. GAAP or simply to the relevant non-U.S. GAAP or to international accounting standards. 2. Section 401(b) overlaps the Commission’s cautionary statement to issuers on pro forma financial information and the Commission’s investor alert to instruct investors about the potential dangers of pro forma information, both of which were issued on December 4, 2001.121 Because the Commission was concerned that pro forma financial information can, under certain circumstances, mislead investors if it obscures GAAP results, the Commission reminded issuers that the antifraud provisions of the federal securities laws apply to pro forma financial

120

In this context, pro forma information is not financials in accordance with Article XI of Regulation S-X or a summary of GAAP financial statements, but rather, information that is prepared on a non-GAAP basis. By its very nature, pro forma information departs from traditional accounting conventions, which can make it difficult for investors to compare the information with other reporting periods and with other companies. 121

For a discussion of these statements, see Outline at Section XVI.

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information, and that the controlling principles underlying pro forma presentation of financial results must be consistently applied and clearly disclosed. 3. Use of non-GAAP measures, such as EBITDA and Adjusted EBITDA, should not be affected by the rulemaking. These terms are already being presented in a manner that complies with the Commission statements. Moreover, they can provide meaningful information to institutional investors, particularly with respect to debt securities, such as the high yield market. 4. The Commission is required to adopt final rules with respect to pro forma information by January 26, 2003. C.

Material Correcting Adjustments 1. Section 401(a) of the Act amends Section 13 of the Exchange Act to require that each financial report containing financial statements required to be prepared in accordance with (or reconciled to) GAAP reflect all material correcting adjustments that have been identified by an issuer’s “registered public accounting firm” as defined in the Act, in accordance with GAAP and Commission rules. It does not appear that Section 401(a) is intended to do anything more than current generally accepted auditing standards now require. Nor does it appear that it will result in new disclosure in periodic reports. “Reflect” does not mean “disclose.” If there are material correcting adjustments, they simply need to be incorporated in the financial statements and do not need to be disclosed in the financial statements or otherwise as adjustments made by the outside accountants. 2. This provision took effect on July 30, 2002. Among the interpretative questions that the statute poses is one of timing: on its face, Section 401(a) uses the term “registered public accounting firm.” There will not be any “registered public accounting firm” until the Commission has organized the Public Company Accounting Oversight Board (the “Board”), which in turn will register accounting firms as “registered public accounting firms.” The Commission has until April 26, 2003 to organize the Board. Hence, if the statute is interpreted literally, Section 401(a) is currently applicable to no one because it is effective immediately but will not implemented until the Commission’s rulemaking with respect to the Board is adopted.

D.

Management Assessment of Internal Accounting Controls 1. Section 404 of the Act requires the Commission to adopt rules to require that each annual report contain an internal control report which would: a. State the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and b.

Contain an assessment, as of the end of the most recent fiscal year, 62

of the effectiveness of such structure and procedures. 2. The issuer’s outside auditor is required to attest to, and report on, the internal control assessment made by the management of the issuer in accordance with the standards for attestation engagements adopted by the new Public Company Accounting Oversight Board established under the Act. 3. There is no deadline imposed by the Act for the Commission to adopt final rules with respect to this provision, but since this provision, like Section 401(a), explicitly refers to registered public accounting firms, it will likely not be applicable until after the Board is organized and accounting firms registered with the Board. E.

Code of Ethics for Senior Financial Officers 1. Section 406 of the Act requires the Commission to adopt rules requiring disclosure of whether the issuer has a code of ethics for senior financial officers: a. Each issuer will be required to disclose in its periodic reports whether or not it has adopted a code of ethics for its senior financial officers – i.e., the principal financial officer and comptroller or principal accounting officer, or persons performing equivalent functions – and, if not, why not; and b. Each issuer will be required to immediately disclose any change in, or waiver of, the code of ethics for senior financial officers, either by filing a Form 8-K or dissemination by the Internet or other electronic means. While the statute does not do so, the Commission’s rulemaking should have a practical standard, such as material change to the code of conduct. Otherwise, the codes may be drafted so broadly that no change will ever be required. 2. This provision does not require a company to adopt a code of ethics for its senior financial officers, only that it disclose whether or not it does – and if not, why not. A “code of ethics” under the Act means any such standards reasonably necessary to promote: a. Honest and ethical conduct, including the handling of actual or apparent conflicts of interest between personal and professional relationships; b. Full, fair, accurate, timely and understandable disclosure in periodic reports; and c.

Compliance with applicable governmental rules.

3. While the Act does not explicitly require board oversight of the code of ethics, this responsibility may fall within the audit committee or compensation 63

committee’s responsibilities. 4. The NYSE and Nasdaq proposals each require their listed companies to adopt and disclose their code of business conduct and ethics and to disclose any waivers of the code for their directors or executive officers. The substance of these codes are not specified in detail, although the Nasdaq proposal would require the code to address, at minimum, conflicts of interest and compliance with applicable laws. 5. The Commission is required to propose rules by October 28, 2002 and to adopt final rules by January 26, 2003. F.

Audit Committee Financial Expert 1. Section 407 of the Act requires the Commission to adopt rules to require each issuer to disclose in its periodic reports whether its audit committee includes among its members at least one “financial expert,” and if not, why not. 2. In defining the term “financial expert,” Section 407 requires the Commission to consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or position involving similar functions: a. Understanding of generally accepted accounting principles and financial statements; b. Experience in preparing or auditing financial statements and applying accounting principles in connection with the accounting for estimates, accruals, and reserves; c.

Experience with internal accounting controls; and

d.

Understanding of audit committee functions.

3. If the Commission takes these “considerations” seriously, it is difficult to conceive of a “financial expert” who would not be a certified public accountant. 4. The NYSE already requires its listed companies’ audit committee members to be financially literate and at least one to have accounting or financial management expertise. The NYSE’s proposed change to its listing standards will require the chair of the audit committee to have accounting or financial management expertise. 5. Nasdaq’s proposed change to its listing standards will require all audit committee members to be able to read and understand financial statements at the time of their appointment. 6.

The Commission is required to propose implementing rules by October 64

28, 2002 and to issue final rules by January 26, 2003. G.

Real-Time Disclosure 1. Section 409 of the Act amends Section 13 of the Exchange Act to require public companies to disclose, in plain English and on a “rapid and current” basis, information to be prescribed by the Commission concerning material changes to their financial condition or operations. The additional disclosures would be implemented by Commission rule, although no deadline is specified. 2. In June 2002, the Commission proposed a rule that would require several new items or events to be reported on Form 8-K to improve the timeliness of public disclosure of corporate events.122 The Commission also proposed that Form 8-K reports be filed within two business days instead of the current five- or 15-day time periods. Section 409 does not appear to affect the 8-K Release, and, indeed, the 8-K Release may form the basis for the Commission’s new rules with respect to “rapid and current” disclosure. The practical effect of this provision is Congressional endorsement of the concept behind the 8-K Release, and reinforcement of the Commission’s authority to require the new 8-K events proposed. Section 409 may, however, require the Commission to propose some form of current reporting – on Form 8-K or otherwise – for foreign companies listed in the U.S. These companies have heretofore been limited to Form 6-K filings (which are considered more of a convenient way to get something into the Commission’s system than required filings) of information released in their home markets.

H.

Commission Review of Periodic Reports 1. Section 408 of the Act requires the Commission to review the disclosures, including financial statements, by public companies with securities listed on an exchange or traded on Nasdaq on a “regular and systematic” basis – which means at least once every three years. In scheduling the reviews, the Commission will consider the following factors: a. Whether the issuer has issued material restatements of its financial results or experienced significant volatility in the stock price as compared to other issuers; b.

Issuers with the largest market capitalization;

c. and

Emerging companies with disparities in price-to-earning ratios;

d. Issuers whose operations significantly affect any material sector of the economy. 122

8-K Release. For a discussion of this proposed rule, see Outline at Section XV.

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2. This provision took effect on July 30, 2002. Because of the recent corporate and accounting scandals, early in 2002, the Division of Corporation Finance undertook to screen the annual reports of most of the Fortune 500 companies, and this screening has already been completed. Of these reports, the Division has selected a “very significant number” to be reviewed on a closer level.123 Under Section 408, however, the Commission must review all public companies, and not just the Fortune 500. As there are over 15,000 public companies and each has to be reviewed in a three-year cycle, the Commission will have to conduct more than 5,000 reviews per year. In its Annual Report for 2001, the Commission reported that in fiscal 2001, it conducted 2,400 reporting issuer reviews, which includes companies subject to Exchange Act reporting whose financial statements were reviewed during the year. In fiscal 1998, 1999 and 2000, the number of reporting issuer reviews for each year was 2,828, 2,550 and 1,535, respectively.124 Hence, Section 408 will require the Commission to more than double the number of reporting issuer reviews conducted in fiscal 2001. VII.

CORPORATE GOVERNANCE UNDER THE ACT A.

Introduction 1. The audit committees of public companies are a special focus of the Act. Four sections apply directly to audit committees and others involve the audit committee indirectly. In the past, the conduct of audit committees has primarily been within the purview of state corporation law and self-regulatory organizations. Only recently has disclosure other than the membership of the audit committee been required. In the later years of Chairman Levitt’s tenure, however, this disclosure became more merit-oriented and the audit committee increasingly became the focus of Commission attention. 2. The Act puts the audit committee squarely in the cross-hairs of federal securities regulation. While sections, like Section 301, recognize that the audit committee acts in its capacity as a committee of the board of directors and thus impliedly recognizes state corporation law, the same section makes the audit committee directly responsible for a number of matters. Thus, sections of the Act, like Section 302, appear to create federal duties for audit committee members and blur the line between federal regulation and state corporation law. 3. In particular, Senator Sarbanes has made it clear that the Act seeks to break the traditional ties between the company’s outside accountants and company management by making the audit committee responsible for the company’s relationship with the outside accountants. This is analogous to the Act’s efforts to break the traditional ties between research analysts and investment

123

See Rachel McTague, SEC to Give Second Level Review to Very Significant Number of Fortune 500, Securities Law Daily, June 14, 2002 (quoting Alan Beller, Director of the Division of Corporation Finance)(available at http://ippubs.bna.com/ip/BNA/sld/nsf/is/A0A5R3M7F3). 124

See Commission, Annual Report for 2001, at 76 (available at http://www.sec.gov/pdf/annrep01/ar01full.pdf).

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bankers. 4. Both the NYSE and Nasdaq, working with the Commission, have voted to propose modifications to several corporate governance standards for their listed companies, including requiring shareholder approval for stock option plans that include executive officers or directors, tightening the definition of an “independent” director and requiring related-party transactions to be approved by the board’s audit committee or comparable body.125 B.

Audit Committee Requirements 1. Section 301 of the Act directs the Commission to require the national securities exchanges and the National Association of Securities Dealers to prohibit listing any company that does not satisfy Section 301’s audit committee requirements. Because this provision applies to issuers only by application of listing standards, private companies with registered public debt who are otherwise subject to the Act will not be subject to these audit committee requirements. In the absence of an audit committee, the entire board will be deemed to constitute an audit committee. In this event, each director would have to satisfy the criteria for audit committee members. These requirements are as follows:126 a. Responsibility. Each audit committee is directly responsible for the appointment, compensation and oversight of the work of its outside auditors, and the auditors will report directly to the audit committee. (1) It appears that the Act vests sole authority with respect to the choice, compensation and oversight of the auditor in the audit committee to the exclusion of the management. b. Independence. Each audit committee member must be “independent,” which under the Act means that he or she cannot, other than in his or her capacity as a member of the audit committee, the board or any other board committee, (1) accept any consulting, advisory or other compensatory fees from the company or (2) be an “affiliated person of the issuer” or any of its subsidiaries.127 (1)

It is unclear what “affiliated person” of the issuer means

125

See Nasdaq Proposed Rules; Press Release, Nasdaq, “Nasdaq Submits First Round of Corporate Governance Changes to the SEC; Announces Plan for Additional Issues for Review this Month,” June 5, 2002 (available at http://www.nasdaqnews.com/news/pr2002/ne_section02_121.html); NYSE Report. The Commission is currently soliciting public comment on these proposed rule changes.

126

As discussed earlier in Section VI.F of this Outline, Section 407 of the Act requires issuers to disclose in their periodic reports whether the audit committee includes at least one member who is a “financial expert,” and if not, why not. Note that this is a disclosure rule only. 127

The Commission is authorized to provide exemptive relief from the independence requirements with respect to particular relationships.

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under Section 301. Section 301 amends Section 10A of the Exchange Act. Section 3(a)(19) of the Exchange Act incorporates the definition of “affiliated person” from the Investment Company Act of 1940, as amended (the “’40 Act”), into the Exchange Act “unless the context otherwise requires.” Section 2(a)(3) of the ’40 Act defines an “affiliated person” as, among other things, a director of a corporation.128 Hence, if an “affiliated person” is by definition a director, then no director can serve on the audit committee. This is nonsensical, and the Commission should clarify the definition of “affiliated person” in the context of Section 301.129 (2) The NYSE and Nasdaq have proposed different and separate definitions of independence. For the NYSE, the board must affirmatively determine that a director is “independent” – meaning that he or she has no material relationship with the listed company, either directly or as a partner, shareholder or an officer of an organization that has a relationship with the company. The NYSE’s definition of “independence” also requires a five-year cooling-off period for former employees of the listed company or of its independent auditor; for former employees of any company whose compensation committee includes an officer of the listed company, and for any of their immediate family members.130 (3) For Nasdaq, the definition of “independent” director prohibits any payments, other than director’s fees but including political contributions, to a director or a family member of the director in excess of $60,000 and any payments to a charity where the director is an executive officer and such payments exceed the 128

Section 2(a)(3) of the Investment Company Act defines “affiliated person” as follows: “‘Affiliated person’ of another person means (A) any person directly or indirectly owning, controlling, or holding with power to vote, five per centum or more of the outstanding voting securities of such other person; (B) any person five per centum or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person; (C) any person directly or indirectly controlling, controlled by, or under common control with, such other person; (D) any officer, director, partner, copartner, or employee of such other person; (E) if such other person is an investment company, any investment adviser thereof or any member of an advisory board thereof; and (F) if such other person is an unincorporated investment company not having a board of directors, the depositor thereof.” 129

While the term “affiliate” is not defined in the Exchange Act, it is defined in Rule 12b-2 under the Exchange Act. If the Congress had used the term “affiliate,” an argument could be made that the term should be defined in accordance with the definition used in Rule 12b-2 and Rule 405 under the Securities Act, which define “affiliate” as a “person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.” 130

In addition, audit committee members are not permitted to receive any compensation from the company other than director’s fees. Disallowed fees would include any fees paid directly or indirectly for services as a consultant or legal or financial advisor. See Press Release, NYSE Approves Measures to Strengthen Corporate Accountability, Aug. 1, 2002 (available at http://www.nyse.com/press/NT00545421.html).

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greater of $200,000 or 5% of either the company’s or the charity’s gross revenues. In addition, a three-year cooling-off period will apply to directors who are not independent due to interlocking compensation committees, receipt of payments in excess of $60,000, a family member being employed as an executive officer of the issuer or any of its affiliates, and having been the partners or employees of the outside auditors who worked on the audit engagement.131 A shareholder owning or controlling 20% or more of the company’s voting securities would not be considered “independent” for purposes of the audit committee, which would also presumably include any persons affiliated with such shareholder. c. Whistleblower Procedures. Each audit committee will establish procedures to receive and respond to any complaints and concerns regarding the company’s accounting, accounting controls or auditing matters, and these procedures will include enabling the issuer’s employees to transmit concerns regarding questionable accounting or auditing matters by “confidential, anonymous submission.” d. Engagement of Advisors. Each audit committee is authorized to engage independent counsel and other advisors. e. Payment of Expenses. The company must provide the appropriate funding, as determined by the audit committee, for payment of compensation to the auditors and advisors of the audit committee. 2. Section 301’s new responsibilities and duties on audit committees also include pre-approval of all audit and non-audit services required by Section 201 and Section 202.132 Although not intended to change state corporation law, Section 301 and other sections of the Act regulate matters traditionally addressed by state or foreign countries’ corporation law.133 a. For example: Section 141 of the Delaware General Corporation Law (the “DGCL”) provides that the business and affairs of a Delaware corporation shall be managed by or under the direction of the board of directors. Section 141(d) provides that the board may designate one or more committees and that such committees, “to the extent provided in the 131

See Nasdaq Proposed Rules.

132

For a discussion of Section 201 and Section 202, see this Outline at Section VIII.B.

133

Note, too, that the NYSE has already voted to approve changes to their listing standards to specify that the chair of the audit committee have accounting or financial management experience; that the audit committee have authority for hiring and firing the independent auditors, and for approving any significant non-audit work by the auditors, subject to ratification by the majority-independent board of directors; and that an audit committee member associated with a major shareholder, defined as owning 20% or more of the equity, may not vote in audit committee meetings. The overlap between the NYSE proposed changes and the Act will need to be clarified.

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resolution of the board of directors, or in the bylaws of the corporation, shall have and may exercise all the powers and authority of the board of directors in the management of the business and affairs of the corporation,” except adopting or amending the bylaws and approving or adopting or recommending to the stockholders any action or matter required by the DGCL to be submitted to the stockholders for approval. b. With respect to public companies, the Act may be viewed as blurring the line between federal law and state corporation law, such as Section 141(d). The Act specifies the “powers and authority” of the audit committee, which Section 141(d) provides is to be granted by resolution of the board or in the bylaws. If an audit committee’s charter conflicts with Section 301 of the Act, then the issuer will be delisted from the NYSE or Nasdaq. Although existing and proposed listing standards impose requirements on audit committees, the existing standards are accepted by issuers as a condition to being listed on a national securities exchange and are consistent with the freedom-of-contract model of corporate governance that is predominant in the U.S. The Act’s audit committee requirements set new and permanent federal standards for corporate governance. 3. The special responsibilities and duties of audit committee members under Section 301 of the Act raise the question whether audit committee members will be subject to greater liability than non-audit committee members. Traditionally, the extent of a member’s liability depends on whether the board has delegated the responsibilities to the committee – or, for that matter, to any other committee, such as compensation or nominating – or whether the board remained responsible for the committee’s decisions either by ratification or otherwise. Section 301 does not appear to fit this traditional mold. For example, Section 301 does not mention board ratification, but it does acknowledge that the audit committee is acting as a committee of the board of directors. Therefore, the duties established by Section 301 may be capable of being blended with state corporation law to avoid conflicts and avoid increasing the personal liability of members of the audit committee. 4. Section 301 differs from the traditional delegation of board power to a board committee because it requires the audit committee of a public company listed on an exchange to assume responsibility and power with respect to certain board actions – to the apparent exclusion of the full board, management and the shareholders. Therefore, if a plaintiff makes a claim that the engagement or oversight of a registered public accounting firm violated the directors’ duty of care, would non-audit committee members of the board have a stronger defense than audit committee members on the basis that the Act does not permit them to participate in any such decisions? 5. Accordingly, any company that has not already done so may wish to consider amending its charter to include a provision, such as permitted under Section 102(b)(7) of the DGCL, limiting or eliminating director liability for 70

monetary damages for certain breaches of fiduciary duty as a director. This particular statute does not, however, eliminate liability for a violation of the duty of loyalty, lack of good faith, international misconduct, knowing violation of law or improper personal benefit. C.

Practical Points for Audit Committees: 1. Who can be on the audit committee. Section 407 requires the Commission to issue rules with respect to disclosure as to whether the audit committee includes at least one “financial expert,” to be defined by the Commission in accordance with Section 407, and if not, why not. There is a question whether the financial expert can, as a practical matter, be someone who is not a certified public accountant (as opposed to even a CFO or a sophisticated business person). Each audit committee may want to consider having one member who is a certified public accountant. In general, each audit committee should think about how the committee will comply with Section 407, especially with respect to future changes in board or committee composition. 2.

Responsibilities Concerning Outside Accountants. a. Section 301 makes the audit committee directly responsible for appointing, compensating and overseeing the work of the outside auditors. Although this provision will be effective upon issuance of Commission rules no later than April 26, 2003, each issuer should consider operating under these restrictions for the next audit season. The rules, once adopted, are not expected to change the basic principle and operating structure underlying the statute. We believe it is preferable to begin to change practice at this time in the audit cycle (that is, before year end), rather than to change at the end of the next audit cycle. Moreover, the practical experience gained by changing practice at this time can be instrumental in complying when the rules do take effect as well as commenting on the proposals once they are published by the Commission. b. Section 202 requires audit committee pre-approval of all audit and non-audit services by the outside accountants. The audit committee may delegate pre-approval authority to one or members and pre-approvals of audit-related services may be made in connection with the audit engagement. Although the Commission is required to adopt rules implementing these requirements by January 26, 2003, we are recommending that each company: begin to assess what audit and nonaudit services are presently performed; have the audit committee confirm retention for those services; and have the audit committee decide whether to delegate pre-approval authority to one or more members of the audit committee (and if so, to whom such powers will be delegated). If the outside accountant performs tax services, a blanket approval of tax services to the company may be in order, although there is a question of what level of specificity of pre-approval is required. A separate question 71

under Section 202 arises for tax services provided to senior executives by the outside accountant. c. Section 204 requires the outside accountants to timely report to the audit committee on: critical accounting policies and practices; alternative treatments of financial information within GAAP that have been discussed with management; the ramification of the use of alternative disclosures and treatments and the treatment preferred by the outside accountants; and material written communications with management such as the “management letters.” Similarly, Section 401(a)(i) requires each financial report filed with the Commission “reflect” all material correcting adjustments that have been identified by the outside accountants in accordance with GAAP and the Commission’s accounting rules. We believe that “reflect” does not mean “disclose” so that if there are material correcting adjustments, they simply need to be incorporated in the financial statements and do not need to be stated as adjustments made by the outside accountants. d. We believe that Sections 204 and 401(a)(i) effectively give outside accountants more power to determine whatever accounting treatment they desire in any discussion with management, since management may be unwilling to have such discussion come to the attention of the audit committee. Moreover, the audit committee may not be as willing to take management’s side in these matters in the future. Section 401(a)(i) by its terms is effective immediately but it only applies to items identified by registered public accountants (which in turn can only exist after the Board is in place and has registered outside accountants). Section 204 is technically not effective until registration of the outside accountants by the Board. Nonetheless, we believe that an audit committee should consider implementing such procedures as soon as practicable. 3. Internal Controls Review. Although this is technically an issue for the CEO and CFO, a discussion with the audit committee will doubtless be required. As with the other provisions, we believe that companies should start thinking about this issue now. The Section 302 certification requiring the CEO and CFO to certify with respect to their review of the adequacy of internal controls is one of the most demanding aspects of the Act. One alternative to consider to augment the in-house staff is to hire an accounting consultant to review the company’s internal controls. This is not something that a company can assign to its existing auditors. We emphasize that it will be especially important that the internal controls activities under Section 302 be coordinated with the audit committee so that there is consistency between the Section 302 activities and the audit committee’s report in the annual proxy statement. 4. Pro Forma Financial Information. Section 401(b) requires the Commission to issue rules by January 26, 2003 on the presentation of pro forma financial information in Commission reports and also in press releases. We 72

recommend that the audit committee request management to review the use of pro forma financial information and document that review prior to release of the press release for the next fiscal quarter, despite the fact that the Commission’s rules may not be effective until January 2003.134 5. Code of Ethics for Senior Financial Officers. Section 406 requires the Commission to issue rules concerning disclosure in periodic reports as to whether a company has adopted a code of ethics for its senior financial officers, and if has not adopted a code of ethics, why not. While the Act does not explicitly require board oversight of the code of ethics, it is likely that such oversight will fall on the audit committee. D.

Attorney Professional Responsibility 1. In one of the most far-reaching provisions of the Act, Section 307135 grants authority to the Commission to establish federal standards of conduct for attorneys. Specifically, the Commission is required to adopt rules setting forth “minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers.” Not only does the new law conceptually encompass in-house counsel who assist in preparing periodic reports as well as securities lawyers who practice before the Commission every day, but Section 307 represents a reversal of the Commission’s twenty-year policy against attempting to regulate the professional conduct of attorneys, except insofar as that conduct violates the federal securities laws. 2. In the 1970s and early 1980s, the Commission was criticized by the legal profession for bringing administrative proceedings against lawyers based on alleged “unethical or improper professional conduct” on the theory that lawyers are “gatekeepers” to the securities markets. As the Commission itself acknowledged, however, the agency had no legislative mandate nor special expertise to regulate the qualifications of lawyers, nor was there any single national standard of legal ethics. Opponents of regulation argued that Commission action against lawyers interfered with the duty of loyalty that lawyers owe to their clients and may even cause issuers to avoid obtaining legal advice, knowing that it could be colored by the lawyer’s interest in self-

134

See Pro-Forma Release; discussion of Pro Forma Release in Section XVI of this Outline.

135

Chairman Pitt focused on attorney responsibility even before the Act was passed into law. In his remarks at PLI’s SEC Speaks Conference, Chairman Pitt stated that “A core issue arising in Enron’s wake is enhancing existing and planned legal standards with ethical and competency standards, for lawyers, accountants, directors and others. The public cannot be served if professionals who serve as gatekeepers merely follow the letter of the law, but not necessarily its spirit. We need to move away from wooden, rigid, literalism, and encourage all upon whom the present system depends to adopt a bias in favor of the needs of the investing public. And, because the goal is to provide coverage that is broader than mere illegality, the government should not undertake to establish directly standards of professional ethics and competency. On the other hand, the government has to ensure that appropriate standards of ethics and competency are in fact established, and then rigorously implemented and enforced.” See Harvey L. Pitt, Remarks at the SEC Speaks Conference, Feb. 22, 2002 (available at http://www.sec.gov/news/speech/spch540.htm).

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protection. The Commission receded, as reflected in a 1982 speech by Edward Greene, then General Counsel of the Commission: “With respect to attorneys, the Commission generally has not sought to develop or apply independent standards of professional conduct. . . . [T]he Commission, as a matter of policy, generally refrains from using its administrative forum to conduct de novo determinations of the professional obligations of attorneys.”136 3. The Commission’s rules under Section 307 must require that an attorney “report evidence of a material violation of securities law or breach of fiduciary duty or similar violation” by a public company (or any agent of a public company) to the chief legal counsel or the CEO of the company. If the legal counsel or CEO “does not appropriately respond to the evidence,” the attorney must report the evidence to the audit committee or another committee of the Board of Directors comprised solely of independent directors. These rules would appear to apply to both inside and outside counsel advising a reporting company. a. The inclusion of “agent” could greatly expand the scope of the attorney’s obligation under Section 307. b. Model Rule 1.13(b) of the American Bar Association’s Model Rules of Professional Conduct requires lawyers who detect violations of duties owed to the organization to “proceed as is reasonably necessary in the best interest of the organization.” The Model Rule permits the attorney to exercise discretion in how to proceed, while Section 307 does not. 4. These “minimum” rules of conduct are ambiguous. Among other things, it is unclear what the Commission may regard as a “similar violation” to a violation of securities law or breach of fiduciary duty. The rules force attorneys to make judgments about whether evidence reflects a “material violation” which, with hindsight, easily may be second-guessed. Moreover, the rules require attorneys to assess whether the chief legal counsel or CEO has “appropriately respond[ed]” to the reported evidence. As challenging as these judgments may be for in-house counsel, the Act appears to impose them equally on outside counsel who may have no means of knowing how, if at all, matters are resolved in the corporate executive suite or board room. 5.

Section 307 presents interpretative questions and traps for the unwary: a. Is the “breach” of “fiduciary duty” a question of federal or state law? Can an attorney who is not admitted to practice law in a particular state be responsible for advising on that state’s fiduciary duty requirements and discerning violations thereof? b.

136

In the phrase, “breach of fiduciary duty or similar violation,” what

See Release No. 33-6783 (July 13, 1988).

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does “similar” mean? c. Note that almost any violation of law can be recharacterized as a breach of fiduciary duty by commission or omission. For example, could this provision be interpreted to include environmental laws and employment laws? d.

How does it apply to a foreign private issuer?

e. Must an attorney report “evidence” of a material violation without being permitted to weigh the credibility or probity of the evidence? f. What constitutes (and who determines) an “appropriate” response to the evidence? The Act suggests that appropriate responses would include adopting, as necessary, “appropriate remedial measures or sanctions with respect to the violation.”137 6. The Act limits the attorney reporting obligation to the corporate client – and hence preserves the attorney-client privilege in the first instance. The privilege belongs, however, to the company and may be waived in a subsequent malpractice suit, Commission investigation, or any other context in which the company may find it advantageous to do so. These new rules of conduct thereby expose the reporting attorney and the company’s chief legal counsel or CEO to potential liability for malpractice or other breach of duty, as well as Commission regulatory action. 7. In addition, Section 703 of the Act requires the Commission to conduct a study to determine the number of “securities professionals” (defined as accountants, attorneys, brokers and dealers, among others) who, from 1998 through 2001, “have been found to have aided and abetted a violation of the Federal securities laws” but were not punished as primary violators. This provision suggests that Congress may be considering giving private investors a right of action for aiding and abetting violation of Section 10(b) of the Exchange Act, which would mean overturning the Supreme Court case, Central Bank v. First Interstate Bank,138 in which the Court held that a private plaintiff may not sustain an aiding and abetting suit under Section 10(b) of the Exchange Act. 8. The Commission is required to issue final rules implementing this provision by January 26, 2003. VIII. REFORMING THE ACCOUNTING PROFESSION A.

The Public Company Accounting Oversight Board

137

This indeterminate standard will be applied in private litigation, and may prove to be a boon to the plaintiffs’ bar.

138

511 U.S. 164 (1994).

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1. The Act seeks “to further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors,”139 by establishing the Public Company Accounting Oversight Board (the “Board”), a self-regulatory, nonprofit corporation to be incorporated in Washington, D.C. The Board will be subject to Commission oversight and consist of five members, of whom no more than two may be certified public accountants. If the Chairman of the Board is a certified public accountant, he or she may not have practiced for at least five years. The members, all of whom must work for the Board on a full-time basis, will serve staggered five-year terms with a two-term limit. a. Members of the Board must be appointed by the Commission (in consultation with the Chairman of the Federal Reserve and the Secretary of Treasury) by October 28, 2002. The Board must be organized in accordance with, and have the capacity to carry out, the requirements of Title I of the Act by April 26, 2003. 2. All accounting firms auditing the financial statements of an issuer with securities registered under Section 12 of the Exchange Act or required to file reports under Section 15(d) of the Exchange Act, or that has filed a registration statement under the Securities Act, are required to register with the Board. These firms will be known as “registered public accounting firms.” a. Once the Commission has determined that the Board is functional, these firms must register with the Board within 180 days. Foreign public accounting firms are also explicitly subject to the Act (including its auditor independence rules).140 b. Registration will require submission of an initial application and annual reports to the board and payment of registration and annual fees. In addition, all public companies will be required to pay fees to the Board, the amounts of which will be based on their relative market capitalization.

139

Section 101 of the Act.

140

The Act contains a broad assertion of extraterritorial jurisdiction over foreign accounting firms who participate in audits of public companies. Even if a foreign accounting firm is not required to register with the Board because it does not audit public companies, if the foreign firm issues an opinion or otherwise provides material services on which a registered public accounting firm relies in issuing its report, then the foreign firm will be deemed to have consented to supplying its workpapers in response to a request for documents by the Board or the Commission; likewise, a registered public accounting firm, in relying on a foreign firm’s opinion, will be deemed to have consented to supplying the workpapers of that foreign firm in response to a request for documents by the Board or the Commission. See Section 106(b)(1) and Section 106(b)(2) of the Act. The European Commission has called on the United States to exempt European audit firms working for European companies listed in the U.S. from the Act. In an August 29, 2002 letter to the Commission, European Union Tax Commissioner, Frits Bolkestein, stated that “I am deeply concerned about the risk of exposing EU audit firms to a double regulatory regime which would be excessive, inefficient and disproportionate.” See Joe Kirwin, U.S. Accounting Law Exemption Sought for European Audit Firms, Sec. Law Daily, Sept. 9, 2002 (available at http://ippubs.bna.com/ip/BNA/sld.nsf/is/A0A5X9U3F0).

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c. Each application will include a consent executed by the accounting firm to cooperate in and comply with any request for testimony or the production of documents made by the Board in furtherance of its authority. Thus, all public companies, through their auditors, will be subject to the investigative power of the Board. Any documents produced in response to a document request would generally remain confidential and would be exempt from the Freedom of Information Act but could be furnished to the Commission, which has oversight over the Board. 3. The Board will have oversight and disciplinary authority over registered public accounting firms, including subpoena power; the authority to bar individuals from association with a registered firm; the authority to suspend or revoke the registration of a registered public accounting firm; and the authority to establish rules governing audits, conduct inspections and investigations and impose sanctions. The Board will also have the authority to adopt auditing standards. 4. Before the enactment of the Act, on June 26, 2002, the Commission proposed a new system of regulating the accounting profession, which would be known as a Public Accountability Board or PAB.141 We expect the Commission to withdraw this proposal in light of the Act. B.

Auditor Independence 1. In addition to subjecting accounting firms to the oversight and authority of the Board, the Act regulates and redefines the relationship between a registered public accounting firm and its public company audit clients:142 a. Pre-Approval of Services. Section 202 amends Section 10A of the Exchange Act to require audit committee pre-approval of all auditing (including comfort letters issued in connection with securities offerings) and non-audit services provided by the issuer’s outside auditor, with the non-audit services subject to a de minimis exception. The audit committee may delegate pre-approval authority to one or more members of the audit committee, but the decisions by any member must be presented to the full committee. Thus, the delegation provided by the statute is subject to at

141

See PAB Release.

142

The question has arisen as to whether the states could adopt regulation of registered public accounting firms that imposes harsher scope-of-services restrictions than those found in the Act. The answer is most likely no because of the Supremacy Clause, which invalidates state laws that interfere with, or are contrary to, federal law. The Act’s provisions evidence a clear intent by Congress to occupy the field of law regulating the scope of non-audit services that registered accounting firms may (and may not) provide to their clients. Also, state regulation of registered accounting firms that imposes harsher scope-of-services restrictions could frustrate Congress’s goals in two fundamental ways. First, these laws would conflict with the Act’s express provision allowing registered firms to engage in non-audit services not specifically enumerated in the Act. Second, state laws imposing more restrictive scope-of-service prohibitions would also trump the exclusive authority Congress gave the Board to oversee auditor independence issues.

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least a notice to, if not an implicit ratification by, the full committee. (1) The de minimis exception is satisfied if the non-audit services are not prohibited by Section 201 of the Act, as described below, and meet each of a three-part test: (a) the services involve payments to the auditor representing five percent or less of the total payments to the auditor in the year; (b) the services were not recognized by the issuer at the time of engagement as non-audit services; and (c) the services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or any of its delegatees. b. Non-Audit Services. Section 201 amends Section 10A of the Exchange Act to prohibit registered public accounting firms from providing, contemporaneously with any audit, eight categories of nonaudit services to their audit clients.143 Non-audit services not explicitly prohibited – such as tax services – must be approved by the audit committee in advance, subject to the same de minimis exception set forth in Section 202. Any preapproval of non-audit services must be disclosed in periodic reports filed with the Commission. (1)

The prohibited non-audit services are: (a) bookkeeping and other services related to accounting records and financial statements; (b) financial information systems design and implementation; (c)

valuation services;

(d)

actuarial services;

(e)

internal audit outsourcing services;

(f)

management functions or human resources;

143

Prior to the Act, the major accounting firms had voluntarily agreed not to provide internal audit and certain consulting services to their audit clients. See Jonathan D. Glater, Deloitte is Last Big Audit Firm to Revamp Consulting Business, N.Y. Times, Feb. 6, 2002, at C1 (reporting that all of the major accounting firms have announced that they will no longer provide internal auditing services or certain consulting services to their audit clients). Correspondingly, some corporations announced that they will not engage their outside auditor to perform non-audit services.

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(g) broker/dealer, investment advisor or investment banking services; (h) legal services and expert services unrelated to the 144 audit; and (i) any other services the Board determines is impermissible. (2) Tax services have traditionally been allowed to be performed by the outside auditor under the theory that if taxes constitute 40% of the income statement, an outside auditor cannot conduct a competent audit without conducting an examination of the taxes the issuer owes to federal, state, local and foreign governments. Thus, the identification of tax services as a nonaudit service requiring pre-approval in Section 201 may provide continued business for outside auditors even under the Act. However, a number of interpretive questions arise nonetheless. For example, if the accounting firm is providing tax services to executives or employees of the issuer, which services are paid for by the issuer, are those services subject to pre-approval under Section 201 because they are paid for by the issuer or are they outside of Section 201 because they are not a service “for an audit client”? And even if personal tax services are not within Section 201, are they separately covered by Section 202? Given the diversity of non-audit services that are capable of being performed by the auditor and paid for by the issuer, audit committees should conduct a survey of all services being provided and decide whether and under what circumstances services should be provided in the future. While this survey should be conducted in tandem with management and in consultation with the outside auditor, the final decision appears to rest with the audit committee. And, of course, Section 202 requires public disclosure of any non-audit service which is approved by the audit committee. (3) The Board may, subject to Commission review, exempt any person, issuer, accounting firm or transaction from this provision on a case-by-case basis. c. Audit Partner Rotation. Section 203 amends Section 10A of the Exchange Act to require a registered public accounting firm to rotate its lead partner and reviewing partner on audits so that neither role is performed by the same individual for the same company for more than five consecutive fiscal years. Significantly, the effort to rotate audit firms 144

This is really two prohibitions since legal services are separate from expert services unrelated to the audit. While a separate item, the scope of “expert services” is not defined.

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did not become law, but rather, is subject to further study by the Comptroller General.145 d. Communication with Audit Committee. Section 204 amends Section 10A of the Exchange Act to require registered public accounting firms to timely report to audit committees on the following: (1)

Critical accounting policies and practices;

(2) Alternative treatments of financial information within GAAP that have been discussed with management, and the ramification of the use of alternative disclosures and treatments, and the treatment preferred by the registered public accounting firm; and (3) Other material written communications with management, such as management letters. (a) This provision dovetails with the Commission’s proposed rule with respect to disclosing critical accounting estimates in the Management’s Discussion and Analysis section of periodic reports.146 The Critical Accounting Release would require disclosure of whether the development, selection and disclosure of the critical accounting estimates were discussed with the company’s audit committee. Correspondingly, Section 204 of the Act requires the registered public accounting firm to discuss these very same issues with the audit committee. (b) Section 204 may effectively give the outside accountants the power to mandate whatever accounting treatment they desire, as management will often be unwilling to allow such a disagreement to come before the audit committee and the audit committee may be even more unwilling to take management’s side in any disagreement. e. Restrictions on Employment of Auditor Personnel. Section 206 amends Section 10A of the Exchange Act to prohibit registered public accounting firms from providing services on an audit to issuers whose CEO, CFO or chief accounting officer (or any person serving in an equivalent position) was employed by the same firm and participated in the audit of the issuer during the one-year period preceding the date of the initiation of the audit. Note that there is no “grandfather” clause to this provision. 145

See Section 207 of the Act.

146

See Critical Accounting Release. For a full discussion of this release, see Outline at Section XIV.

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f. Possible Mandatory Accounting Firm Rotation. The Act directs the Comptroller General of the U.S. to conduct a study of the potential effects of requiring the mandatory rotation of registered public accounting firms for public companies, to be submitted to the Congress by July 30, 2003. 2. Pursuant to Section 208 of the Act, the Commission is required to issue final regulations to implement these Title II auditor independence provisions by January 26, 2003 as they are not self-executing. The effective date of these provisions, however, is still in question: except for Section 202, these provisions apply explicitly to “registered public accounting firms,” which will not exist until the Commission organizes the Board (by no later than April 26, 2003) and accounting firms have registered with the Board (by no later than 180 days after the Board is organized). Hence, even though the final regulations will be adopted by January 26, 2003, there will be no registered public accounting firm until the Board is organized, which could be as late as April 26, 2003. C.

Principles-Based Accounting Standards 1. Section 109(d) of the Act directs the Commission to conduct a study on the adoption of a principles-based accounting system, which would examine, among other things, the extent to which principles-based accounting and financial reporting exists in the U.S., the length of time required for change from a rulesbased to a principles-based financial system and the feasibility by which a principles-based system would be implemented. The Commission is required to submit a report to Congress on the results of this study no later than July 30, 2003.147 2. There are basically two approaches to setting accounting standards, as there is to law-making in general. One is to create rules that define precisely how to deal with each and every situation. The other is to create principles that set forth policies, which are then applied to the facts and circumstances of the situation at hand. U.S. auditing standards are rule-based, whereas European and many other countries’ auditing standards are principles-based. Post-Enron, many have argued that rules provide a road map for avoidance, with companies gaming the rules to be in technical compliance but nevertheless misleading to investors. Under this view, rules would be replaced with a broader set of guiding principles, which would give management and their auditors greater discretion to make subjective judgments about their financial results. Should this reform effort go forward, Section 108 of the Act may ultimately result in changing U.S. GAAP into a European-style principles-based system. It should be noted, however, that

147

Samuel A. DiPiazza, Jr., the CEO of PricewaterhouseCoopers, stated that “moving to broader accounting principles would be ‘much better than working through a mechanical set of rules or exceptions that . . . frankly are a road map for investment bankers to engineer transactions.’” Management should be responsible “‘to select the most appropriate accounting method . . . that reflects the economics of the transaction.’” David S. Hilzenrath and Kathleen Day, Firm Urges Accounting Rule Shift, Wash. Post, June 18, 2002, at E1.

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recent cases of financial fraud give rise to the observation that sophisticated abuses of generally accepted accounting principles tend to cluster around the more subjective areas of accounting.148 IX.

SECURITIES ANALYSTS A.

Introduction 1. On May 8, 2002, the Commission approved proposed changes to the rules of the NASD and the NYSE to address conflicts of interest that have been raised when research analysts recommend securities in public communications.149 Among other things, the rules prohibit analysts from reporting directly to investment bankers, forbid analysts from receiving compensation for investment banking deals and restrict analysts from personally trading the stocks they follow during specified blackout periods.150 Many believe that conflicts of interest arise from analyst salaries tied to investment banking fees, the ability to invest in companies the analyst is recommending and overly cozy relationships with investment banking, with analysts sometimes going “over the wall.” Nevertheless, analysts can and do play an important informational role in our capital markets.151

B.

Section 501 1. Section 501 of the Act mandates as federal law the content of the rules governing securities analysts; hence, the rules approved by the Commission in May 2002 will need to be revised to reflect the Act’s directives, although many of the areas addressed in Section 501 are already included in the Commission-

148

For a comprehensive article on financial statement fraud, see Richard C. Sauer, Financial Statement Fraud: The Boundaries of Liability under the Federal Securities Laws, 57 Bus. Law. 955 (2002). 149

See NASD and NYSE Rulemaking: Self-Regulatory Organizations; Order Approving Proposed Rule Changes by the National Association of Securities Dealers, Inc. and the New York Stock Exchange, Inc. and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 2 to the Proposed Rule Change by the National Association of Securities Dealers, Inc. and Amendment No. 1 to the Proposed Rule Change by the New York Stock Exchange, Inc. Relating to Research Analyst Conflicts of Interest, Release No. 34-45908 (May 10, 2002)(available at http://www.sec.gov/rules/sro/34-45908.htm); Press Release, Commission, “Commission Approves Rules to Address Analyst Conflicts; SEC Also Requires EDGAR Filings by Foreign Issuers,” May 8, 2002 (available at http://www.sec.gov/news/press/2002-63.htm); Press Release, New York Stock Exchange, “NYSE Board Approves Sweeping Changes in Rules Regarding Research Analysts,” (Feb. 7, 2002) (available at http://www.nyse.com/press/NT00072AA2.html); Press Release, National Association of Securities Dealers, Inc., “NASD Announces New Rules Governing Recommendations Made by Research Analysts,” (Feb. 7, 2002) (available at http://www.nasdr.com/news/pr2002/release_02_009.html). 150

Prior to the Act, some investment banks had already implemented changes to address concerns about analyst independence. For example, on February 19, 2002, the Goldman Sachs Group announced that it would break its research department out of its investment banking operation, thereby creating a stand-alone division, and would ban its analysts from owning stocks in the sectors they cover. See Patrick McGeehan, Goldman Sachs Moves to Tighten Stock Analysts’ Independence, N.Y. Times, Feb. 20, 2002, at C13. 151

See Dirks v. SEC, 463 U.S. 646 (1983)(endorsing the role played by analysts).

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approved rules. 2. Section 501 requires the Commission, or upon the authorization and direction of the Commission, a registered securities association or national securities exchange, to adopt rules to address conflicts of interest and to improve the objectivity of research and provide investors with more useful and reliable information, including the following: a. Restrict the prepublication clearance or approval of research reports by the investment banking division at the broker-dealer firm; b. Mandate that only officials who are not engaged in investment banking activities may supervise an analyst; c. Prohibit those involved in investment banking from retaliating against an analyst for a negative or unfavorable research report that could adversely affect the present or future investment banking relationship with the issuer; d. Set forth periods of time during which a broker or dealer involved in a public offering is prohibited from publishing or otherwise distributing research reports relating to the securities; e. Establish safeguards to ensure that analysts are not pressured by those involved in investment banking; and f. Disclose any conflicts of interest that are known or should have been known by the analyst or broker-dealer. 3. Section 501 requires final rules implementing this section to be effective no later than July 30, 2003. X.

CRIMINAL SANCTIONS, ENFORCEMENT & LITIGATION A.

Criminal Sanctions The Act creates new criminal offenses and substantially increases the penalties for existing offenses. They should, however, be read in context with the other provisions in the federal criminal statute. Recent controversy over the application of these new criminal provisions focuses on the conflict between the Act and existing provisions in the U.S. Code and on interpretations or guidance of the Act offered by the Department of Justice.152 These provisions will require that public companies develop or review

152

See Weisman, supra note 17, at E1 (“Members of Congress from both parties accused the administration of undermining or narrowing the scope of provisions covering securities fraud, whistle-blower protection and punishment for shredding documents.”).

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existing compliance programs and document retention policies, and be prepared to investigate thoroughly any credible evidence of internal wrongdoing. Failing to do so could potentially expose the company and its employees to substantial criminal and civil liability. 1.

Destruction or Tampering of Records a. Section 802 of the Act creates two separate criminal sections, each pertaining to the destruction of records: (1) The new Section 1519 of Title 18 of the U.S. Code provides that any person who knowingly alters, destroys, mutilates, conceals, covers up, falsifies or makes a false entry in any record, document or tangible object with the intent to impede, obstruct or influence the investigation or administration of any matter within the jurisdiction of any department or agency of the U.S. shall be fined under Title 18 or imprisoned not more than 20 years, or both. (2) The new Section 1520 of Title 18 of the U.S. Code provides that any accountant that conducts an audit of an issuer of securities to which Section 10A(a) of the Exchange Act applies will maintain all audit or review workpapers for five years from the end of the fiscal year in which the audit or review was concluded. Whoever knowingly and willfully violates this section, or any Commission rules or regulations promulgated thereunder, shall be fined under Title 18 or imprisoned not more than 20 years, or both. (a) The Commission is required to issue final rules and regulations relating to the retention of such audit or review records by January 26, 2003. b. Section 1102 of the Act amends 18 U.S.C. §1102 – titled “Tampering with a Record or Otherwise Impeding an Official Proceeding” – to provide that whoever corruptly alters, destroys, mutilates or conceals a record, document or other object, or attempts to do so, with the intent to impair the object’s integrity or available for use in an official proceeding, or who otherwise obstructs any official proceeding, or attempts to do so, shall be fined under Title 18 or imprisoned not more than 20 years, or both.

2.

Retaliation Against Informants a. Section 1107 of the Act amends 18 U.S.C. § 1513 – titled “Retaliation Against Informants” – to provide for fines and imprisonment of up to 10 years for anyone who “knowingly, with the intent to retaliate,” takes any action harmful to any person, including interference with the lawful employment or livelihood of any person, for providing to a law 84

enforcement officer any truthful information relating to the commission or possible commission of any Federal offense. (1) The broad, extraterritorial reach of this provision may raise thorny jurisdictional issues in cases involving employees located outside the U.S. Note that the Act does not give the Commission exemptive authority for this provision. b. 3.

This provision is effective immediately.

New Securities Fraud Offense a. Section 807 of the Act creates a securities fraud offense in the federal criminal code, new Section 1348 of Title 18 of U.S. Code, punishable by 25 years’ imprisonment and a fine, for knowingly executing a scheme or artifice “to defraud any person in connection with any security” of a public company, or “to obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of any security” of a public company. b.

4.

This provision is effective immediately.

Penalty Enhancements a. Various provisions of the Act enhance or increase penalties under existing criminal statutes and, correspondingly, direct the U.S. Sentencing Commission to review and, if appropriate, amend the relevant Federal Sentencing Guidelines: (1) Section 902 of the Act creates new Section 1349, Attempt and Conspiracy, to Title 18 of the U.S. Code, providing that those persons who attempt or conspire to commit certain fraud offenses will be subject to the same penalties as those prescribed for the offense; (2) Section 903 of the Act increases the maximum penalties for mail and wire fraud from five years to 20 years’ imprisonment; (3) Section 904 of the Act increases the criminal penalties for violations of ERISA from one year to 10 years’ imprisonment and raises the maximum fine to $500,000; (4) Section 905 of the Act directs the U.S. Sentencing Commission to review and, as appropriate, amend the Federal Sentencing Guidelines to ensure that they reflect the serious nature of the offenses and penalties set forth in the Act, by no later than January 26, 2003; 85

(5) Section 805 of the Act directs the U.S. Sentencing Commission to review and, if appropriate, amend the Federal Sentencing Guidelines with respect to obstruction of justice to ensure that guideline offense levels and enhancements take into account, among other things, the destruction of evidence, the abuse of special skill or position of trust and whether the offense endangers the solvency of a substantial number of victims, by no later than January 26, 2003; (6) Section 1104 of the Act specifically directs the U.S. Sentencing Commission to review the Federal Sentencing Guidelines with respect to securities and accounting fraud and to consider whether there should be new guidelines to provide enhancements for officers and directors of publicly traded companies who commit fraud and related offenses, by no later than January 26, 2003; and (7) Section 1107 of the Act amends Section 32(a) of the Exchange Act to raise the maximum individual penalties from $1 million and 10 years’ imprisonment to $5 million and 20 years’ imprisonment, and to raise the maximum corporate fine from $2.5 million to $25 million. B.

Commission Enforcement 1.

Power to Freeze Payments a. Section 1103 amends Section 21C(c) of the Exchange Act to provide that during the course of an investigation involving possible violations of the federal securities laws by an issuer or any of its directors, officers, partners, controlling persons, agents or employees, if it appears that the issuer will make “extraordinary payments” (which is not defined) to any of its directors, officers, partners, controlling persons, agents or employees, then the Commission can petition a federal district for a temporary order requiring the issue to escrow those payments in an interest-bearing account for 45 days. This change in the law exposes officers and directors to potential lengthy delays in compensation while the issue of liability is being decided. (1) There needs to be notice and opportunity for hearing before a court can issue such an order, which, when issued, would be effective immediately and for not longer than 45 days, unless the court extends the period. The initial 45-day period can be extended to a maximum of 90 days on a showing of good cause. If the issuer or person is charged during this period, then the order will remain in effect until the conclusion of the legal proceedings.

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(2)

This provision is effective immediately.

(3) As with other enforcement provisions, attempts to apply this provision outside the U.S. could be problematic. 2.

Officer and Director Bars a. Before the Act, the Commission was authorized to seek to have an individual disqualified from serving as a public company director or officer, but only through obtaining a court order because it did not have the legislative grant of authority to make such determinations administratively.153 To obtain the order, the Commission was required to establish in a judicial proceeding that the individual violated Section 10(b) of the Exchange Act, or the rules promulgated thereunder, and that the individual’s conduct “demonstrates substantial unfitness to serve as an officer or director” of a public company. The Act now gives the Commission the power to make such determinations administratively, which is effective immediately. b. Section 1105 of the Act amends Section 21C of the Exchange Act and Section 8A of the Securities Act to give the Commission the authority to bar in an administrative cease-and-desist proceeding any individual who has violated Section 10(b) of the Exchange Act or Section 17(a)(1) of the Securities Act (the anti-fraud provisions), or rules or regulations thereunder, from acting as an officer or director of a public company if the person’s conduct demonstrates “unfitness” to serve as an officer or director of a public company. c. Furthermore, Section 305 of the Act lowers the standard governing the judicial imposition of officer and director bars in Commission actions under Section 21(d)(2) of the Exchange Act and Section 20(e) of the Securities Act to be consistent with Section 1105 – from “substantial unfitness” to serve as an officer or director to “unfitness.”

3.

Improper Influence on Audits a. Section 303 of the Act makes it unlawful, under rules or regulations to be issued by the Commission, for an officer or director, or any person acting under their direction, to “fraudulently influence, coerce, manipulate, or mislead” an auditor for the purpose of rendering the financial statements being audited materially misleading. The Commission is given sole civil enforcement authority to enforce this provision, which means that no private cause of action is authorized.

153

Between March 7, 2002 and June 17, 2002, the Commission sought 54 officer and director bars in the federal courts. Letter from Harvey L. Pitt, Chairman of the Commission, to George W. Bush, President of the United States (June 17, 2002).

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b. The Commission is required to propose rules or regulations under this provision by October 28, 2002 and to issue final rules by April 26, 2003. C.

Civil Litigation 1.

Statute of Limitations for Securities Fraud a. Section 804 of the Act amends 28 U.S.C. 1658 by adding subsection (b), which extends the statute of limitations for private rights of action involving claims of fraud, deceit, manipulation or contrivance in contravention of a regulatory requirement concerning the securities laws, to the earlier of (i) 2 years after discovery of the facts constituting the violation or (ii) 5 years after such violation.154 b. This Section does not create a new private right of action. The Act does not always specify which of its provisions can be enforced only by the Commission and which can be enforced by private rights of action. This may be resolved in the courts. c. The new statute of limitations will apply to all such private rights of action commenced on or after July 30, 2002.

2.

Whistleblower Protection a. Section 806 of the Act amends Title 18 of the U.S. Code to add new Section 1514A to provide a private cause of action against public companies and their employees, contractors, subcontractors or other agents who discriminate in the terms and conditions of employment with respect to employees who: (1) Provide information or assist in investigations of securities law violations by Federal regulatory or law enforcement agencies, Congress or company personnel with supervisory or investigatory authority; or (2) File, testify, participate in, or otherwise assist in proceedings (including private actions) filed or about to be filed (with any knowledge of the employer) involving alleged violations of the securities laws or Commission regulations or securities fraud. b. An employee may seek relief under this provision by filing a complaint with the Department of Labor or, if a decision is not rendered

154

Subsection (a) of 28 U.S.C. 1658 is not changed: “Except as otherwise provided by law, a civil action arising under an Act of Congress enacted after the date of the enactment of this section may not be commenced later than 4 years after the cause of action accrues.”

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by the Secretary of Labor within 180 days of the filing, bringing an action for de novo review in the federal district court of jurisdiction. Potential relief includes reinstatement, back pay with interest and compensation for special damages such as attorneys fees and other litigation costs. c. 3.

This provision is effective immediately.

Nondischargeable Debts in Bankruptcy a. Section 803 of the Act amends Section 523(a) of the U.S. Bankruptcy Code and provides that debts resulting from judgments or settlements in civil and criminal securities fraud proceedings, including common law fraud, deceit or manipulation in connection with the purchase or sale of any security, cannot be discharged in bankruptcy. This restriction applies only to individual, not to corporate, bankruptcies. Thus, a corporate officer found liable for securities fraud will not be able to discharge the judgment in bankruptcy and creditors can continue to seek recovery, even after bankruptcy, until the judgment is satisfied. This restriction is a stark exception to the rehabilitation policies underlying the bankruptcy laws. b. This no discharge provision puts individuals at greatest peril who lack the safety net of a solvent employer and/or liability insurance coverage. When corporations or professional partnerships themselves become insolvent, and unable or unwilling to defend or indemnify their individual constituents, those individuals can be left without adequate means to defend themselves against accusations of securities fraud. Now, the end result may be a non-dischargeable settlement or judgment. c.

XI.

This provision is effective immediately.

ACCELERATED REPORTING DUE DATES A.

Introduction 1. The secondary market disclosure system under the Exchange Act requires public companies to file annual and quarterly reports on Forms 10-K and 10-Q, respectively, with limited, specified events required to be reported on Form 8-K on a more current basis. Since 1970, annual reports have been due 90 calendar days after the end of the fiscal year, and quarterly reports due within 45 calendar days after the end of a quarter.155 2. On August 27, 2002, the Commission adopted rules accelerating the due dates for annual and quarterly reports under the Exchange Act to 60 and 35 days,

155

Before 1970, the due date for filing annual reports was 120 days after the end of the fiscal year.

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respectively, with a three-year phase-in period.156 As stated in the proposing release, the Commission believes that these time periods need to be shortened in order to improve the usefulness and timeliness of these reports to investors and to modernize the periodic reporting system.157 3. One of the most controversial proposals in the Commission’s “Aircraft Carrier” release in 1998 was the proposal to shorten the time periods for filing periodic reports.158 Those who opposed the proposal thought that the shortening of due dates would be overly burdensome, particularly for small companies, and would result in less accurate filings. These same concerns apply again here. For a small public company in particular, these shortened time periods may pose a real challenge, especially in light of the additional disclosure requirements set forth in the MD&A Statement and the Critical Accounting Release and the Section 906 and 302 certification requirements. The ability of management, auditors and the audit committee159 to make judgments in a reasoned, deliberative fashion may be reduced. 4. The Commission has acknowledged these concerns, but has concluded that the market’s need for information outweighs the time companies need to prepare that information without undue burden. The Commission has attempted to alleviate the burden on smaller companies by limiting the accelerated due dates to companies that meet the requirements for “accelerated filer.” B.

Applicability

156

The Commission initially proposed these rules on April 12, 2002. The proposed rules would have accelerated reporting dates for annual reports to 60 days and reporting dates for quarterly reports to 30 days, without any phasein period. See Accelerated Reporting Proposing Release. 157

As the Commission dryly observed, the proposition that information included in the reports often is stale by the time the reports are filed has been made since at least 1969, when former Chairman Manuel Cohen said: “because companies need not file the [quarterly] report until 45 days after the end of the quarter, the information is often stale.” Accelerated Reporting Proposing Release, fn. 24. Indeed, in the Commission’s view, advances in communications and information technology since 1970 have made it easier for companies to process and disseminate information swiftly. Indeed, many large companies announce their quarterly and annual financial results well before they file their formal reports with the Commission, which means that investors often make investment decisions based on these results without access to the more extensive disclosure in the company’s Exchange Act reports. Unfortunately, not all public companies are alike, nor do they all announce earnings well before the filing deadline. Despite its surface appeal to the investing public, these rules have the potential to promote the short-term focus of the markets rather than emphasize long-term performance. They could also have the untoward effect of companies, particularly small and mid-size companies, rushing to finalize results to match their competitors, only to have to restate financial statements later on. Finally, they could adversely affect investor confidence when companies are unable to meet the new shorter filing times, particularly for quarterly reports. 158

Release No. 33-7606 (Nov. 3, 1998), as amended by Release No. 33-7606A, 63 Fed. Reg. 67174 (Nov. 13, 1998)(“Aircraft Carrier Release”). 159

Indeed, after increasing the responsibilities and disclosure duties of audit committees, it would be ironic if the Commission now pressured them into making hasty judgments about complex, critical accounting and disclosure policies.

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1. The rule accelerating the filing dates applies only to domestic companies, and not to foreign private issuers, meeting all of the requirements for “accelerated filers”160 as of the end of their first fiscal year ending on or after December 15, 2002. The requirements are: a.

Public float of $75 million or more; (1) This amount is calculated by using the price at which the common stock was last sold, or the average of the bid and asked prices of such common stock, as of the last business day of the issuer’s most recently completed second fiscal quarter;161 (2) Form 10-K is revised to require companies to report on the cover page their public float as computed on the last business day of the company’s most recently completed second fiscal quarter;

b. Subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act for a period of at least 12 calendar months; c. Filed at least one annual report pursuant to Section 13(a) or 15(d) of the Exchange Act; and d. Not eligible to use the Commission’s special forms for small business issuers.162 2. The determination that a company meets the requirements of “accelerated filer” as of the end of its fiscal year governs the annual report to be filed for that fiscal year and the quarterly and annual reports to be filed for thereafter so long as the issuer remains an accelerated filer. 3. Once a company becomes an “accelerated filer,” it remains one unless it becomes eligible to use Forms 10-KSB and 10-QSB for its annual and quarterly reports. In this case, the issuer is not an “accelerated filer” until it subsequently meets the requirements of “accelerated filer” as of the end of its fiscal year. 4. The Commission has used public float and reporting history requirements to identify companies that are the least likely to find the change overly burdensome.

160

“Accelerated Filer” is a new defined term in Rule 12b-2.

161

By looking back to the last business day of the most recently completed second fiscal year, the public float requirement should enable companies to know further in advance whether they will become an accelerated filer at the end of their fiscal year. 162

“Small business issuers” is defined in Rule 12b-2 of the Exchange Act. Eligibility to use forms for small business issuers is defined in Item 10(a) of Regulation S-B, and the primary requirements are: revenues less than $25 million and public float less than $25 million.

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a. These requirements are based primarily on the eligibility requirements for short-form and shelf registration. b. The Commission explained in the proposing release, “As these companies can take advantage of short-form registration, including the resultant benefits of incorporation by reference and quick access to the capital markets through ‘shelf registration,’ a shortening of the deadlines for these companies seems appropriate.”163 C.

Accelerated Dates 1. For accelerated filers, the accelerated filing requirements will be phased in over three years, according to the following schedule: a. For fiscal years ending on or after December 15, 2002, there is no change in periodic reporting deadlines; b. For fiscal years ending on or after December 15, 2003, accelerated filers will have 75 days to file their Form 10-K, with subsequent quarterly reports on Form 10-Q due within 45 days of the end of the quarter; c. For fiscal years ending on or after December 15, 2004, accelerated filers will have 60 days to file their Form 10-K, with subsequent quarterly reports on Form 10-Q due within 40 days of the end of the quarter; and d. For fiscal years ending on or after December 15, 2005, accelerated filers will have 60 days to file their Form 10-K, with subsequent quarterly reports on Form 10-Q due within 35 days of the end of the quarter. 2. For companies that are not accelerated filers, the filing deadlines for annual, quarterly and transition reports will not change.

D.

Consequence of Late Filings 1. If an accelerated filer is late in meeting the new filing requirements, it will lose the availability of short-form registration for at least one year from the date of the late filing.164 2. Being late could also render Rule 144 under the Securities Act temporarily unavailable for security holders’ resales of restricted and control securities and make new filings on Form S-8 temporarily unavailable for resales of employee

163

Accelerated Reporting Proposing Release.

164

Note that the proposed rule to shorten the due date for mandatory Form 8-Ks to two business days could also result in an increase of late filings, with the same consequences as late filings for annual and quarterly reports.

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benefit plan securities.165 E.

Corresponding Changes to Other Commission Filing Due Dates 1. In addition to changing the due dates for quarterly and annual reports, the Commission has adopted conforming amendments to Regulation S-X to ensure that financial statements included in a registration statement or proxy statement will be at least as current as any financial statements filed under the Exchange Act. Also, as the Commission noted, “[p]arallel requirements facilitate the integrated reporting system by simplifying existing rules.”166 2.

Filings within 90 Days of Year-End: a. Under the old Rule 3-01(c) of Regulation S-X, an issuer is not required to include in a filing audited financial statements for its most recent fiscal year if the filing is made after 45 days but within 90 days after the end of the fiscal year, provided it satisfies three conditions: it has filed all required Exchange Act reports; it expects income, after taxes but before extraordinary items and a cumulative effect of a change in accounting principles, for its most recent fiscal year; and it reported income for one of the two immediately preceding fiscal years. Unless these conditions are met, a filing made after 45 days of the fiscal year-end must include audited balance sheets as of the end of each of the two most recent fiscal years. b. Revised Rule 3-01(c) of Regulation S-X now provides that period of time in which issuers will not be required to include audited financial statements for the most recent fiscal year will be changed to conform to the new deadlines for annual reports for accelerated filers. Hence, audited financial statements will not be required if a filing is made after 45 days but within: (1) 75 days for fiscal years ending on or after December 15, 2003 and before December 15, 2004; and (2) 60 days for fiscal years ending on or after December 15, 2004. c. The 45-day deadline for audited financial statements does not change for companies that do not meet the three required conditions of

165

Rule 144 requires that for the resale to be valid, the issuer must have made all filings required under the Exchange Act during the preceding 12 months. Form S-8 requires that an issuer be current in its reporting for the last 12 calendar months (or such shorter period that the issuer was required to file such reports). If a company is late in filing its reports, the company would lose Rule 144 and Form S-8 eligibility during the time that it was not current in its reporting. 166

See Accelerated Reporting Adopting Release.

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Rule 3-01(c); and the 90-day deadline continues to apply to issuers that are not accelerated filers. 3.

Filings within 134 Days of Year-End: a. Rule 3-01(e) of Regulation S-X requires interim financial information in registration statements filed after 134 days subsequent to the end of the registrant’s fiscal year to include a balance sheet as of an interim date within 135 days of the date of filing. For accelerated filers only, the 134-day period will be modified to conform to the phase-in period for periodic reports, as follows: (1) For fiscal years ending on or after December 15, 2002 and before December 15, 2004, the 134-day period will continue to apply, and the balance sheet must be dated as of a date within 135 days of the date of filing: (2) For fiscal years ending on or after December 15, 2004 and before December 15, 2005, the period is 129 days, and the balance sheet must dated as of a date within 130 days of the date of filing; and (3) For fiscal years ending on or after December 15, 2005: the period is 124 days, and the balance sheet must be dated as of a date within 125 days of the date of filing.

4.

Age at Effective Date of Filing: a. Rule 3-12 of Regulation S-X provides that where financial statements in a filing are dated as of a date 135 days or more prior to the date the filing is expected to become effective, or the proposed mailing date in the case of a proxy statement, the financial statements must be updated with a balance sheet dated as of an interim date within 135 days of the date the filing is expected to become effective or the proposed mailing date, with statements of income and cash flows on a comparative basis for the interim period between the end of the most recent fiscal year and the date of the interim balance sheet. b. To conform this updating requirement with the new deadlines, Rule 3-12 is revised as follows with respect to accelerated filers: (1) For fiscal years ending on or after December 15, 2004 and before December 15, 2005, accelerated filers will be required to update their financial statements if they are dated as of a date 130 days or more prior to the expected filing date or proposed mailing date: and (2)

For fiscal years ending on or after December 15, 2005, the 94

accelerated filers will be required to update their financial statements if they are dated as of a date 125 days or more prior to the expected filing date or proposed mailing date. c. Rule 3-12(b) provides that if the anticipated effective date or proposed mailing date falls after 45 days but within 90 days of the end of the fiscal year and the registrant meets the conditions of Rule 3-01 of Regulation S-X, then the filing does not need to be updated with financial statements more current than dated as of the end of the third fiscal quarter of the most recently completed fiscal year. If the registrant does not meet the conditions of Rule 3-01, then the filing must contain audited financial statements for the most recent fiscal year. For accelerated filers, the 90day time period in Rule 3-12(b) will be shortened to conform with the new filing deadlines for annual reports. Hence, for accelerated filers, the new time periods are: (1) 75 days for fiscal years ending on or after December 15, 2003 and before December 15, 2004; and (2) 60 days for fiscal years ending on or after December 15, 2004. 5.

Unconsolidated Subsidiaries and 50% or Less Owned Persons: a. Rule 3-09 of Regulation S-X requires the financial statements of unconsolidated subsidiaries and 50% or less owned persons to be filed in a company’s annual report and as of the same dates and for the same periods as the audited consolidated financial statements required by Rules 3-01 and 3-02. The Accelerated Reporting Adopting Release amends this rule to provide that that separate financial statements of subsidiaries not consolidated and 50% or less owned persons required by Rule 3-09 will not be accelerated for inclusion in an annual report if the subsidiary or 50% or less owned person is not itself an accelerated filer. Hence, the 90day time period will continue to apply to these entities.

XII.

DISCLOSING WEBSITE ACCESS TO PERIODIC REPORTS A.

Introduction 1. As part of the Commission’s effort to modernize the disclosure system, the Commission is encouraging companies to make their Exchange Act filings available to investors free of charge on their Internet websites, if they have one, as soon as reasonably practicable after, and in any event on the same day as, such material is electronically filed with or furnished to the Commission. The Commission is also encouraging companies to disseminate their Exchange Act reports via their websites to promote consistent and relatively uniform access to these reports and to provide website access to all of their filings with the Commission, including their filings under the proxy rules and their Securities Act 95

filings. The ability of the Internet to foster prompt and more widespread dissemination of information means that it could make disclosure more readily available to more investors in a variety of locations, thereby enabling investors to make more informed investment and voting decisions. 2. To further these goals, the Commission has adopted a rule amending Item 101(e), “Available Information,” of Regulation S-K to require accelerated filers to disclose in their annual reports whether their Exchange Act filings are available on their Internet Web sites. The rule concerns disclosure only – and would not require companies to create a website or to provide access to their filings on their websites. a. This rule represents a change from the Commission’s position on websites in its release on Regulation FD,167 in which the Commission stated that “posting of information on an issuer’s website may not now, by itself, be a sufficient means of public disclosure . . . .” The Commission justified this position – taken in August 2000 – because it did not believe that there was sufficient investor access to the Internet to justify websites as the sole means of dissemination of information. The Commission did note, however, that “as technology evolves and more investors have access to and use the Internet . . . some issuers . . . could use such a method [by itself].”168 The rule may signal that the Commission’s position on the Internet and websites may be changing. The Commission has not stated whether websites now constitute a sufficient means of public disclosure under Regulation FD. b. If the Commission were to permit Web sites to satisfy a dissemination requirement, not only would it have to change its positions in Regulation FD, but also many other positions, including with respect to the dissemination of updated information and the New York Stock Exchange rule on dissemination by means of press releases. B.

Disclosure Requirements 1. The new disclosure is applicable only to “accelerated filers,” beginning with annual reports for fiscal years ending on or after December 15, 2002, and includes the following information: a.

The company’s website address, if it has one;

b. Whether the company makes available free of charge on its website, if it has one, its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and all amendments to those 167

Release Nos. 33-7881, 34-43154, IC-24599, 65 Fed. Reg. 51716 (Aug. 24, 2000)(the “FD Release”).

168

FD Release.

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reports, as soon as reasonably practicable169 after such material is electronically filed with or furnished to the Commission; and (1) The Commission encourages companies to provide a hyperlink directly to the company’s reports instead of just to the home page of a third-party service. Hyperlinking to a third-party service is acceptable so long as the reports are made available in the appropriate time frame and access to the reports is free of charge.170 (2) The Commission’s EDGAR system now provides free, real-time access to its database of corporate filings. Company reports filed electronically on EDGAR will be available at www.sec.gov “within minutes of filing.”171 Hence, companies hyperlinking through EDGAR can state that they provide website access as soon as reasonably practicable. (3) Although the Commission encourages companies to provide website access to all of the filings with the Commission, including filings under the proxy rules and the Securities Act, the disclosure requirement covers only annual, quarterly and current reports. (4) The new requirements do not specify how long a company’s report must be available on its website. The Commission recommends at a minimum 12 months. (5) Foreign private issuers are not subject to this new disclosure requirement. c. If the company does not make its filings available in this manner, the reasons why it does not do so (including, where applicable, that it does not have an Internet website) and whether the company voluntarily will provide electronic or paper copies of its filings free of charge upon request. XIII. COMMISSION GUIDANCE ON MD&A A.

Introduction 1.

On January 22, 2002, in response to a petition for interpretative guidance

169

The Commission interprets this standard to mean that the report would be available, barring unforeseen circumstances, on the same day as filing. See Accelerated Reporting Adopting Release. 170

See Accelerated Reporting Adopting Release.

171

Press Release, Commission, “SEC Announces Free, Real-Time Public Access to EDGAR Database at www.sec.gov,” May 30, 2002 (available at http://www.sec.gov/news/press/2002-75.htm).

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from the major accounting firms and the American Institute of Certified Public Accountants with respect to Item 303 of Regulation S-K172 – Management’s Discussion and Analysis of Financial Condition – the Commission published a statement regarding the three areas of concern identified by the petition: • • •

liquidity and capital resources, including off-balance sheet arrangements (one of the key issues at Enron); trading activities involving non-exchange traded contracts accounted for at fair value; and relationships and transactions with persons or entities that derive benefits from their non-independent relationship with the registrant or the registrant’s related parties (one of the key issues at Enron).

2. The MD&A is intended to provide, in one section of a filing, material historical and prospective textual disclosure enabling investors to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant’s prospects for the future. The Commission has long recognized the need for a narrative explanation of financial statements, because numerical presentation, even with footnotes, may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. The MD&A is also intended to give the investor the opportunity to look at the company through the eyes of management by providing both a short- and long-term analysis of the business.173 3. When the current MD&A was adopted in 1980, its requirements were left “intentionally general” to reflect the Commission’s intention of giving management the opportunity and the flexibility to tell their story. It created “a flexible approach would elicit more meaningful disclosure and avoid boilerplate discussions which a more specific approach could foster.”174 4. In addition, the Commission has consistently stated that it “is the responsibility of management to identify and address those key variables and other qualitative and quantitative factors which are peculiar to and necessary for an understanding and evaluation of the individual company.”175 5.

The issuance of the MD&A Statement is at odds with these principles in

172

In addition to Item 303 of Regulation S-K, the MD&A Statement also applies to Item 303 of Regulation S-B, Management’s Discussion and Analysis or Plan of Operations for private foreign issuers, and Item 5 of Form 20-F, Operating and Financial Review and Prospects for private foreign issuers (collectively, “MD&A Rules”). The MD&A Statement applies to any filing with the Commission made after January 22, 2002.

173

See Management’s Discussion and Analysis of Financial Condition and Results of Operation, Release Nos. 336835, 34-26831, 54 Fed. Reg. 22427 (May 18, 1989)(the “1989 Release”).

174

Concept Release on Management’s Discussion and Analysis of Financial Condition and Operations, Release Nos. 33-6711, 34-24356, 52 Fed. Reg. 13715 (Apr. 17, 1987)(the “1987 Release”).

175

Release Nos. 33-6349, 34-18120, 23 SEC Docket 962, 964 at n.5. (Sept. 28, 1981).

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that the MD&A Statement is very specific and directive. It may indicate that the Commission believes, post-Enron, that the language of the MD&A Rules is too general and that rules may be preferable to standards.176 6. The Commission states that the MD&A Statement “does not create new legal requirements nor does it modify existing requirements.” Whether or not it does, for the first time, the MD&A Statement explicitly sets forth the scope of the MD&A with respect to off-balance sheet items and almost-related parties, among others. Significantly, the MD&A Statement would require narrative disclosure in the MD&A for a number of items that are not included in the financial statements. 7. In the Critical Accounting Release, the Commission announced that it is continuing to consider further changes to the MD&A, including revisiting the topics discussed in the MD&A Statement.177 Among other things, it is considering: a. Requiring a summary of the MD&A, which would identify what management considers the most important factors in determining its financial results and condition, including principal drivers, trends and risks; b. Adjusting the focus of the MD&A to a more general discussion of material matters and away from a detailed description of business results that too often recites information that is otherwise available or is not material to investors; and c. Improving disclosure in the MD&A with respect to trends that a company’s management follows and evaluates in making decisions about how to guide the company’s business. B.

Disclosures Concerning Liquidity and Capital Resources 1. Since its adoption in 1980, MD&A has required issuers to discuss liquidity – defined as the company’s ability to generate adequate amounts of cash to meet the company’s needs for cash – and capital resources.178 Since each is likely to be

176

This point alone would require rulemaking rather than interpretation.

177

See Critical Accounting Release.

178

With respect to liquidity, Item 303(a)(1) provides: “Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.” With respect to capital resources, Item 303(a)(2)(i)-(ii) provides: “Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose for such commitments and the anticipated source of funds needed to fulfill such commitments. Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the

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affected by similar facts and circumstances, they can be discussed together. For example, capital expenditure commitments are a part of capital resources; if a company reduces capital expenditures,179 typically that would have a positive effect on liquidity. The MD&A has always required disclosure of internal and external sources of liquidity; material unused sources of liquidity; and disclosure of material deficiencies and the issuer’s plans to address those deficiencies. In addition to disclosure of known trends and uncertainties, the MD&A requirement states that “Liquidity generally shall be discussed on both a long-term [meaning longer than a year] and short-term basis [meaning less than a year].” Often companies will not address long- and short-term liquidity, or if they do, they simply state that it is adequate for both the long- and short-term. 2. The MD&A Statement reinforces and elaborates the general recommendations concerning liquidity and capital resources disclosures. a.

Be more specific; avoid generality and boilerplate. For example: (1) A statement that a registrant has short-term funding to meet liquidity needs provides little useful information. Consider describing the sources of short-term funding and the circumstances that are reasonably likely to affect those sources. (2) If principal source of liquidity is operating cash flow, then disclose the extent of the risk that a decrease in demand for company’s products would reduce cash flow (e.g., change in customer demands). (3) If a company’s liquidity is dependent on its maintaining a particular leverage ratio or credit rating, that fact should be disclosed.

b.

Disclose circumstances “reasonably likely” to occur. (1) The MD&A Statement asserts that the threshold for disclosing circumstances that could affect liquidity is whether or not they are “reasonably likely” to occur. “Reasonably likely” is a lower threshold than “more likely than not.”180 (2) Reasonably likely circumstances that could affect liquidity would include: market price changes; economic downturns;

mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any offbalance sheet financing arrangements.” 179

Item 303(a)(2)(i) requires a description of the registrant’s material commitments for capital expenditures, as of the end of the latest fiscal period, the general purpose of the commitments and the anticipated source of funds to fulfill the commitments. 180

See 1989 Release, at III.B.

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ratings downgrades; defaults on guarantees; and contractions of operations that could have material consequences for the registrant’s financial position or operating results. c.

Identify known trends or uncertainties. (1) One of the key purposes of the MD&A is to provide information to the investor to judge the likelihood that past performance is indicative of future performance. Accordingly, the MD&A requires discussion of “known trends or any known demands, commitments, events or uncertainties [each, a “trend”] that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.” (2) A disclosure duty exists where a trend is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operation. For example: reduction in prices; erosion in market share; changes in insurance coverage; likely non-renewal of a material contract; or planned capital expenditures. (3) In the 1989 Release, the Commission identified two assessments management should make when a trend is known before disclosure is required.181 (a) Is the known trend likely to come to fruition? If management determines it is not reasonably likely to occur, no disclosure is required. (b) If management can’t make that determination, it must objectively evaluate the consequences of the known trend on the assumption that it will come to fruition. If the consequence would have a material effect on financial effect or results of operation, management must disclose the trend. (4) While the MD&A Statement does not modify this analysis, it specifies in great detail how to identify a trend. The considerations for what may constitute a trend are as follows: (a) provisions in financial guarantees or commitments, debt or lease agreements or other arrangements that could trigger a requirement for an early payment, additional collateral support, changes in terms, acceleration of maturity or the creation of an additional financial

181

See 1989 Release, at III.C.

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obligation, such as adverse changes in the registrant’s credit rating, financial ratios, earnings, cash flows or stock price, or changes in the value of underlying, linked or indexed assets; (b) circumstances that could impair the registrant’s ability to continue to engage in transactions that have been integral to historical operations or are financially or operationally essential, or that could render that activity commercially impracticable, such as the inability to maintain specified investment grade credit rating, level of earnings, earnings per share, financial ratios, or collateral; (c) factors specific to the registrant and its markets that the registrant expects to be given significant weight in the determination of the registrant’s credit rating or will otherwise affect the registrant’s ability to raise short-term and long-term financing; (d) guarantees of debts or other commitments to third parties; and (e) written options on non-financial assets (for example, real estate puts). C.

Disclosures Concerning Off-Balance Sheet Arrangements 1. According to the Special Report, one of the key accounting issues at Enron was that company’s use of off-balance sheet financing arrangements. Although this may not be a sensitive area for many companies, where information about off-balance sheet transactions is necessary to understand how significant aspects of the company’s business are conducted, management should consider whether the disclosure of such information in financial statements and published reports is sufficiently transparent to the reader. Correspondingly, if companies do not have off-balance sheet arrangements or special-purpose entities, many are affirmatively stating so in their filings, even though they are not required to do so. 2. Item 303(a)(ii) mentions off-balance sheet financing arrangements only as an aside: the issuer shall “[indicate] any material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.” (emphasis added) In an apparent response to Enron, the MD&A Statement specifies when and how a registrant should disclose off-balance sheet arrangements. Since off-balance sheet financing arrangements are often likely to be integral to both liquidity and capital resources, management should consider discussing them together as well as separately when drafting disclosure. 3.

When to disclose off-balance sheet arrangements: 102

a. If a registrant’s liquidity is dependent on the use of off-balance sheet financing arrangements, such as securitization of receivables facilities or obtaining access to assets through special purpose entities, a registrant should consider disclosure of the factors that are reasonably likely to affect its ability to continue to use these arrangements, under both short-term and long-term planning horizons. (1) For example, many companies fund their trade receivables by selling them on a daily basis through an off-balance sheet arrangement. If the company no longer meets the conditions for those daily sales, it may lose an important source of liquidity. (2) Also, the inability to roll over commercial paper may require bank financing, Rule 144A offerings, sales of assets or more liens on assets. In the case of bank financing and Rule 144A offerings, they would likely be at interest rates higher than that of commercial paper. (3) Similarly, banks and finance companies may depend on the ability to securitize new loans to continue to fund the growth of their businesses. Economic factors that could limit access to securitization markets or cause existing structures to terminate early should be discussed. b. Registrants should consider describing transactions or other arrangements with third parties that could result in exposures to the company that are not reflected in the financial statements. Disclosure may be necessary regarding relationships with unconsolidated entities even where the relationships are narrow in scope. The disclosure may cover a wide range of arrangements, including arrangements with special purpose entities created in connection with receivables facilities or similar asset-backed financing vehicles. c. A registrant’s reliance on off-balance sheet arrangements should be described where those arrangements are a source of financing, liquidity or market or credit risk support for the registrant or expose the registrant to liability that is not reflected on the face of the financial statements. Where contingencies inherent in the arrangements are reasonably likely to affect the continued availability of a material historical source of liquidity or financing, the registrant may have to disclose those uncertainties and their effects. 4. What to disclose with respect to arrangements with off-balance sheet entities: a. Registrants should consider providing basic information about offbalance sheet arrangements, such as: 103

(1)

their business purpose and the nature of the arrangements;

(2)

their economic substance;

(3)

the key terms and conditions of any commitments;

(4) the initial and ongoing relationships with the registrant and its affiliates; and (5) the registrant’s potential risk exposure resulting from its contractual or other commitments involving the off-balance sheet arrangements. The example provided in the MD&A Statement covers all of these: where a company is economically or legally required, or reasonably likely, to fund losses of an unconsolidated, limited purpose, entity; provide it with additional funding; issue securities pursuant to a call option held by that entity; purchase the entity’s capital stock or assets; or the company otherwise may be financially affected by the performance or non-performance of an entity or counterparty to a transaction, the company may need to include information about the arrangements and resulting exposures. b. In addition to basic information, registrants should also consider providing specific information with respect to the effects and risks of offbalance sheet arrangements, including: (1) the total amount of assets and obligations of the off-balance sheet entity, with a description of the nature of its assets and obligations, and identification of the class and amount of any debt or equity securities issued to that entity by the registrant; (2) the effects of the entity’s termination if it has a finite life or it is reasonably likely that the registrant’s arrangements with the entity may be discontinued in the foreseeable future; (3) the amounts receivable or payable, and revenues, expenses and cash flows resulting from the arrangements; (4) any extended payment terms of receivables, loans or debt securities resulting from the arrangements, and any uncertainties as to realization, including repayment that is contingent upon the future operations or performance of any party; (5) the amounts and key terms and conditions of purchase and sale agreements between the registrant and the counterparties in any such arrangements; and 104

(6) the amounts of any guarantees, lines of credit, standby letters of credit or commitments or take-or-pay contracts, throughput contracts or other similar types of arrangements, including tolling, capacity, or leasing arrangements, that could require the registrant to provide funding of any obligations under the arrangements, including guarantees of repayment of obligors of parties to the arrangements, make-whole agreements, or value guarantees. c.

General disclosure principles for off-balance sheet arrangements. (1) Where numerous arrangements exist, similar arrangements can be aggregated but important distinctions in terms and effects between arrangements should also be described. The relative significance to the registrant’s financial position and results of the arrangements with unconsolidated non-independent, limited purpose entities should be clear from the disclosures to the extent material. (2) As with the MD&A generally, disclosure of off-balance sheet arrangements should be clear and individually tailored to describe the risks to the registrant, and should not consist merely of recitation of the transactions’ legal terms or the relationships between the parties or similar boilerplate.

D.

Disclosures About Contractual Obligations and Commercial Obligations 1. Various accounting standards and Commission rules already require disclosure concerning a registrant’s obligations and commitments to make future payments under contracts, contractual obligations and commercial commitments.182 These disclosures are typically located in various parts of a filing. 2. The MD&A Statement suggests that these disclosures should be set forth in tabular form, and in a single location, to provide a total and complete picture of these obligations. One aid to presenting this information (which should include both on- and off-balance sheet entities) would be to include schedules of the registrant’s contractual obligations and commercial commitments183 as of the latest balance sheet date. The MD&A Statement includes examples that could be tailored to the registrant’s particular facts, as follows:

182

See, e.g., Statement of Accounting Standards Nos. 5, Accounting for Contingencies; 13, Accounting for Leases; 47, Disclosure of Long-Term Obligations; and 129, Disclosure of Information about Capital Structure. 183

Commercial commitments would include lines of credit, guarantees, and other potential cash outflows resulting from a contingent event that requires registrant performance pursuant to a funding commitment.

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3. While some of the information in these tables is obtainable from contracts already filed as exhibits to the registrant’s previous filings, the numbers required to be disclosed in relation to the contracts already filed, particularly predictions of numbers going forward, may be difficult to ascertain. The MD&A Statement states that the registrant may use footnotes to describe provisions that create, increase or accelerate liabilities or similar pertinent data. In addition, a footnote describing the assumptions (such as interest rate and volume assumptions or EBITDA predictions) used in making forward-looking calculations should also be included. 4. The registrant may also have other commitments not already filed with the Commission (including any relationships with off-balance sheet entities discussed above) for which information needs to be compiled and included in the MD&A. a. Registrants need to consider whether they have readily available access to consistent and on-going data regarding these commitments that can be included in their periodic reports. b. If this information is not readily available, then the registrant faces a far larger challenge in attempting to establish, within a very short time frame, a system that can produce, on a consistent and ongoing basis, the data set out above in respect of the large range of its commitments now required to be disclosed in the MD&A. 5. Once the data are available, the task of presenting them in comprehensible form for inclusion in the MD&A (such as in the tabular form suggested) remains. The registrant should consult both its financial and legal advisors for assistance with this task. E.

Certain Trading Activities Disclosures 1. The MD&A Statement expresses the Commission’s concern about a lack of transparency and clarity with respect to the disclosure of trading activities involving commodity contracts that are accounted for at fair value but for which a lack of market price quotations necessitates the use of fair value estimation techniques. Companies that are engaged to a material extent in energy trading

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activities,184 risk management activities, weather trading activities185 or nonexchange traded commodity trading contracts that are marked to fair value through earnings and are part of analogous trading activities (such as nonderivative trading contracts on pulp, bandwidth, newsprint, and so on) are already required to provide specific disclosures in financial statements in accordance with applicable accounting standards. 2. The Commission believes that additional statistical and other information regarding these business activities (including any contracts that are derivatives involving the same commodities that are part of trading activities – for example, energy derivatives that are part of energy trading activities)186 may be required to ensure investor understanding and financial reporting transparency. This would be in addition to the general requirement to discuss material trends and uncertainties arising from these activities. a. The registrant should consider disclosing trading activities, contracts and modeling methodologies, assumptions, variables and inputs, along with explanations of the different outcomes reasonably likely under different circumstances or measurement methods and a discussion of how these affect reported results for the latest annual period and subsequent interim period. b. The disclosure should also describe the judgments and uncertainties affecting the application of the registrant’s critical accounting policies to its trading activities, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions.187 In order to provide this range of information, registrants should consider furnishing information that does the following: (1)

disaggregates realized and unrealized changes in fair value;

(2) identifies changes in fair value attributable to changes in valuation techniques; (3) disaggregates estimated fair values at the latest balance sheet date based on whether fair values are determined directly from quoted market prices or are estimated; and 184

“Energy trading activities” is defined in Emerging Issues Task Force Issue 98-10 (EITF 98-10), Accounting for Contracts Involved in Energy Trading and Risk management Activities. 185

“Weather trading activities” is defined in Emerging Issues Task Force Issue No. 99-2, Accounting for Weather Derivatives. 186

Emerging Issues Task Force Issue 98-10 (September 23, 1999) identifies factors that distinguish energy trading activities from other activities that involve the purchase or sale of energy. 187

See December 2001 Cautionary Statement.

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(4) indicates the maturities of contracts as of the latest balance sheet date (e.g. within one year, within years one, two or three, within years four and five, and after five years). (5) The MD&A statement provides an example of this disclosure in the form of a schedule, as follows: Fair value of contracts outstanding at the beginning of the period

xxxxxx

Contracts realized or otherwise settled during the period

xxxxxx

Fair value of new contracts when entered into during the period

xxxxxx

Changes in fair values attributable to changes in valuation techniques

xxxxxx

Other changes in fair values

xxxxxx

Fair value of contracts outstanding at the end of the period

xxxxxx

(6) The fair value of contracts outstanding at the end of the period could also be presented as a separate table, with more specific information provided, as follows:

3. The MD&A Statement further suggests that companies consider disclosing the fair value of net claims against counterparties that are reported as assets at the most recent balance sheet date, based on the credit quality of the contract counterparty (e.g., investment grade; noninvestment grade; and no external ratings). 4. The disclosure should include information about risk management in connection with trading activities, such as the management of risks related to changes in credit quality or market fluctuations of underlying, linked or indexed 108

assets or liabilities, especially where such assets are illiquid or susceptible to material uncertainties in valuation. F.

Effects of Transactions with Related and Certain Other Parties 1. In general, related party transactions are required to be disclosed because “transactions involving related parties cannot be presumed to be carried out on an arm’s length basis, as the requisite conditions of competitive, free-market dealings may not exist.”188 Accordingly, GAAP requires that related party transactions be identified and amounts stated on the face of the balance sheet, income statement or statement of cash flows; and Commission rules189 require factual disclosure of certain relationships and transactions with related parties. In addition, if any related party transactions are material, the MD&A should include discussion of the transactions to the extent necessary to understand the company’s current and prospective financial position and operating results. 2. Notwithstanding compliance with these requirements, the disclosures often are insufficient to explain fully the importance of these relationships to reported financial position and results of operation. Moreover, they also do not include information about parties which are not technically “related parties” but nevertheless have a relationship with the registrant to negotiate terms that are not necessarily at arms’ length and are material to a registrant’s financial condition.190 3. The MD&A Statement addresses both of these weaknesses.191 First, it underscores and further elaborates on existing disclosure requirements. If investors would better understand the company’s financial statements if they clearly discuss arrangements that may involve transaction terms or other aspects that differ from those which would likely be negotiated with clearly independent parties, then registrants should consider disclosing that information. Discussion of the specific elements of these arrangements may be necessary to understand their purpose and effect on the company, such as:

188

Statement of Financial Accounting Standard No. 57, Related Party Disclosures.

189

See Item 404 of Regulation S-K; Item 404 of Regulation S-B; Item 7 of Form 20-F; and Rule 4-08(k) of Regulation S-X.

190

This guidance may be prompted by the dealings of Enron’s chief financial officer. See David Barboza and John Schwartz, The Financial Wizard Tied to Enron’s Fall, N.Y. Times, Feb. 6, 2002, at A1, C9 (“According to an internal report, Mr. Fastow and a group of other top executives secretly invested in a series of partnerships that benefited from swapping assets with Enron. Mr. Fastow used some of those partnerships to conceal losses at Enron.”). 191

In addition to disclosure issues, the MD&A Statement addresses the corporate governance issues raised by related party transactions. The MD&A Statement specifically states that audit committees should review the terms and effects of related party transactions prior to recommending that a company’s financial statements be included in its Form 10-K. See MD&A Statement at footnote 24; see also Item 306 of Regulation S-K. In conducting the review, audit committees should take an expansive view of what is considered a “related party,” focusing on “sweetheart deals” in addition to relationships required to be disclosed under Commission or accounting rules.

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a.

the business purpose of the arrangement;

b. identification of the related parties transacting business with the registrant; c.

how transaction prices were determined by the parties;

d. if disclosures represent that transactions have been evaluated for fairness, a description of how the evaluation was made; and e. any ongoing contractual or other commitments as a result of the arrangement. 4. Second, the MD&A Statement creates, with no specific definition, a new category of disclosure – the “almost related party” transactions. This new category would expand existing requirements to include transactions with any person “with whom the registrant or its related parties have a relationship that enables the parties to negotiate terms of material transactions that may not be available from other, more clearly independent, parties on an arms’ length basis.”192 Examples would include: a. Entities formed or operated by individuals who are former senior management, the purpose for which may be to own assets used by the registrant or provide financing or services to the registrant;193 or b. Entities that have some other current or former relationship with a registrant.194 5. The potential scope of this new guidance is breathtaking. If the Commission is serious, transactions with an almost related party of a related party should be included in a disclosure requirement. Besides the lack of definition in knowing who would be included, how does the company compile this information from people whom it does not know or have access to?195 6. Disclosure for this new category of “almost related party” transactions would include a description of elements of the transactions that are necessary for an understanding of the transactions’ business purpose and economic substance, their effects on the financial statements, and the special risks or contingencies 192

MD&A Statement.

193

For a description of how this type of entity was used at Enron, see Kurt Eichenwald, Deal at Enron Gave Insiders Fast Fortunes, N.Y. Times, Feb. 5, 2002, at A1 (describing how entities formed by a small group of insiders made quick profits). 194

See id. (noting that the chief financial officer’s family foundation, which was set up as a charity, invested in a partnership that did business with Enron – the chief financial officer ultimately converted $25,000 investment into $4.5 million through use of this family foundation). 195

See Rule 12b-21 under the Exchange Act and Rule 409 under the Securities Act.

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arising from these transactions. XIV. CRITICAL ACCOUNTING ESTIMATES A.

Introduction 1. As part of its effort to improve the transparency of financial disclosure, the Commission believes that investors need a clearer understanding about how and where a company’s accounting policies, estimates, assumptions and methodologies materially affect the financial statements when they are prepared196 – reported financial position and results often imply a degree of precision and certainty, which may not, in fact, exist. As the Commission noted in December 2001 when it published its cautionary advice on critical accounting policies, “we believe it is appropriate to alert companies to the need for greater investor awareness of the sensitivity of financial statements to the methods, assumptions, and estimates underlying their preparation.”197 The Commission proceeded to explain the basis for its advice as follows: if investors lose confidence in a company’s financial statements because sudden changes in its financial condition and results occur without any disclosure about the susceptibility of the reported amounts to change, then disclosure about such susceptibility should lead to a stabilization or increase in investor confidence when or if sudden changes occur in the future.198 2. In May 2002, the Commission proposed amendments to Item 303 that would create a new section in the MD&A. The new section would appear in the MD&A of annual reports, annual reports to shareholders, registration statements and proxy and information statements.199 The proposed rule would require disclosure of the critical accounting estimates a company makes in applying its accounting policies, and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation.

196

In the wake of Enron, Chairman Pitt recommended that “[i]nvestors . . . be told, concisely and clearly, how these [accounting] principles are applied, as well as information about the range of possible effects in differing applications of these principles.” Chairman Harvey Pitt, Written Testimony Concerning Accounting and Investor Protection Issues Raised by Enron and Other Public Companies, before the Senate Committee on Banking, Housing and Urban Affairs, Mar. 21, 2002 (available at http://www.sec.gov/news/testimony/032102tshlp.htm)(“Pitt Senate Testimony”). 197

See December 2001 Cautionary Statement.

198

Id.

199

Critical Accounting Release. Note that the proposals do not alter which documents require presentation of an MD&A. MD&A disclosure is required in proxy and information statements themselves only if action is to be taken with respect to: (a) the modification of any class of securities of the registrant; (b) the issuance or authorization for issuance of securities of the registrant; or (c) mergers, consolidations, acquisitions and similar matters. See Items 11, 12, and 14 of Schedule 14A. Otherwise, investors receive MD&A disclosure in the glossy annual report that accompanies or precedes any proxy or information statement relating to an annual meeting at which directors are to be elected, pursuant to Rule 14a-3 under the Exchange Act.

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a. Specifically, the proposals would amend Item 303 of Regulation SK, which covers the requirements for the MD&A, and equivalent MD&A requirements in Regulation S-B and Form 20-F. Accordingly, all U.S. issuers, small business issuers and foreign private issuers would be subject to this new disclosure requirement. b. Upon effectiveness, the proposed requirements would cover the most recent fiscal year and any subsequent interim period for which financial statements are required to be presented. 3. The proposals are part of the Commission’s overall effort to ensure that investors receive higher-quality, more insightful financial information. In the Commission’s view, a focused discussion of critical accounting estimates is well suited to the MD&A because it would further explain to investors the company’s financial condition “through management’s eyes.” Moreover, the MD&A’s emphasis on disclosure of significant uncertainties and trends dovetails with the disclosure of the more subjective aspects used in arriving at critical accounting estimates. 4. Although accounting standards already require information about the accounting principles and methods used and the risks and uncertainties inherent in significant estimates, the Commission believes that communication between investors and public companies can be improved if the MD&A explains the interplay of specific uncertainties with accounting measures in the financial statements. 5. The proposals are intended to promote greater investor understanding of how estimates and the judgments made by management result in the presentation of many amounts that are, in fact, approximate rather than exact. Specifically, the proposals are intended: a. To enhance investors’ understanding of the existence of, and necessity for, estimation in a company’s financial statements; b. To focus investors on the important estimates that are particularly difficult for management to determine and where management therefore exercises significant judgment; c. To give investors an understanding of the impact those estimates have on the presentation of a company’s financial condition and results of operations; d. To give investors an appreciation of how sensitive those estimates are; and e. To give investors an understanding of new material accounting policies as they arise and affect a company’s financial results. 112

6. With this increase in transparency, the Commission believes that investors will be in a better position to assess the quality of, and potential variability of, a company’s earnings. However, the discussion of critical accounting estimates could have the opposite effect of confusing investors. As proposed in the Critical Accounting Release, the MD&A would tell two different narratives. The primary narrative would be the traditional description of the business through the eyes of management that discusses historical results of operation by making period-toperiod comparisons, based on the audited financial statements. The secondary narrative would be the new discussion of critical accounting estimates in the MD&A, which has the potential to deconstruct the primary narrative by showing how the company’s financial condition, results of operations and liquidity are the result of assumptions, estimates and judgments and that a number of different results would have been possible if different assumptions or estimates had been applied. Hence, while the proposals are intended to put the reported financial results into the context of the real-life process in which they are prepared so that investors realize that a penny per share in earnings may not be all that critical, the proposals also have the potential to engender an investor reaction that it’s all just a numbers game and that financial results are in the eye of the beholder.200 7. The Critical Accounting Release’s proposed definition of critical accounting estimates differs from the Commission’s December 2001 Cautionary Statement, which focused on accounting policies, not estimates. A “critical accounting policy” was considered critical because it required management to make difficult, complex and subjective judgments and was “most important to the portrayal of the company’s financial condition and results” in the period being reported. In contrast, while estimates may constitute a policy, they may just as likely be part of an accounting policy or a part of a financial statement line item, such as the net realizable value of accounts receivable. The Critical Accounting Release does not compare or contrast a critical accounting policy with a critical accounting estimate. Nor does the release discuss the Commission’s reaction to the thousands of public companies that voluntarily complied with the December 2001 Cautionary Statement in their 2001 annual reports on Form 10-K. Thus, we do not know what or whether deficiencies in the term, “critical accounting policy,” caused the Commission to propose a different approach to the same objective – a higher level of efficiency and investor confidence in our capital markets through higher quality, more insightful financial information. B.

Determining Critical Accounting Estimates 1.

To determine whether an “accounting estimate”201 involved in applying

200

According to The Economist, Chairman Pitt “wants to end the notion that there is one (and only one) correct version of accounts. ‘There is no true number in accounting,’ he says, ‘and if there were, auditors would be the last people to find it.’” When the numbers don’t add up, The Economist, Feb. 9-15, 2002, at 57, 60. 201

“Accounting estimate” means “an approximation made by management of a financial statement element, item or account in the financial statements.” Proposed Item 303(c)(2)(i) of Regulation S-K. For example, a company will typically estimate the net realizable value of its accounts realizable and of its inventory. Accounting estimates in

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the company’s accounting policies would entail disclosure as a “critical accounting estimate,” under the proposed rule, the accounting estimate must satisfy two requirements. a. First: Did the accounting estimate require the company to make assumptions about matters that were highly uncertain at the time the accounting estimate was made?202 (1)

A matter involves a high degree of uncertainty if: (a) it is dependent on events remote in time that may or may not occur; (b) it is not capable of being readily calculated from generally accepted methodologies; or (c) it cannot derived with some degree of precision from available data.

(2) Hence, as the Critical Accounting Release explains, a matter that is highly uncertain requires management to use significant judgment in making assumptions about that matter. The application of management’s judgment in those circumstances typically results in a range of possible results within which management believes the answer will fall. (3) Since the term, “highly uncertain matters,” is critical to the operation of the proposed definition and is not a commonly used term, it should be defined, so that it does not become a trap for the unwary. For example, if the term “highly uncertain matters” is retained, is the analysis specific or peculiar to the registrant’s management or is it one that the business community generally or the companies in the registrant’s industry or segment would agree is a highly uncertain matter? The Critical Accounting Release implies an analysis that is specific to the registrant, one that is beyond difficult and complex, perhaps knowable only by the registrant’s management. If this interpretation is correct, it would certainly narrow the number of possible critical accounting

historical financial statements measure the effects of past business transactions or events, or the present status of an asset or liability. Accounting estimates are oftentimes used in accounting policies such as revenue recognition; impairment of assets, such as goodwill or product obsolescence; reserves, such as loan loss reserves for a bank; and derivatives. 202

This “highly uncertain” standard creates some tension with the “unable to make a reasonable estimate” standard in existing accounting rules that requires an audit opinion to include an explanatory paragraph. The proposed rule would require management to use significant judgment in making its assumptions, whereas existing accounting rules require special disclosure in the case of matters that are highly uncertain.

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estimates for most public companies.203 b. Second: Would different estimates that the company reasonably could have used in the current period, or changes in the accounting estimate that are “reasonably likely”204 to occur from period to period, have a material205 impact on the presentation of the company’s financial condition, changes in financial condition or results of operations? (1) This requirement focuses on two types of accounting estimates involved in the application of accounting policies. First, it includes estimates for which a company could reasonably have recorded in the financial statements an amount sufficiently different such that it would have had a material impact on the company’s financial statements. (2) Second, it includes any accounting estimate that is reasonably likely to change from period to period to the extent that the change would have a material impact on the company’s financial statements. (3) Thus, whether management’s judgment with respect to the accounting estimate has an impact primarily in the current period or on an ongoing basis (or both), the estimate would qualify as a “critical accounting estimate.” 2. The Commission believes that only a few of a company’s accounting estimates would generally meet the threshold for a “critical accounting estimate.206 While the number of critical accounting estimates will vary by company, the Commission “would expect very few companies to have none at all and the vast majority to have somewhere in the range of three to five critical accounting estimates.”207 Investors would not benefit, in the Commission’s view,

203

Item 305 of Regulation S-K requires quantitative and qualitative disclosures about market risk, which are calculated based on methodologies well known in the marketplace. If Item 305 is not to be redundant, it would appear that the “highly uncertain” language would more likely concern the matters peculiar or specific to management. 204

“Reasonably likely” means “the chance of a future transaction or event occurring is more than remote but less than likely.” Proposed Item 303(c)(2)(iv) of Regulation S-K. 205

In making materiality assessments under the proposed rule, companies would need to bear in mind Staff Accounting Bulletin No. 99, in which the Staff expressed the view that misstatements are not immaterial simply because they fall below a numerical threshold. 206

See Critical Accounting Release.

207

Id. Chairman Pitt testified that every public company has “three, four, or five . . . critical accounting policies upon which [its] financial status depends, and which involve the most complex, subjective, or ambiguous decisions and/or assessments.” Harvey L. Pitt, Testimony Before the Subcommittee on Capital Markets, Insurance and Government sponsored Enterprises, U.S. House of Representatives, Concerning Legislative Solutions to Problems

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from a lengthy discussion of a multitude of accounting estimates in which the truly critical ones are obscured. Examples of critical accounting estimates could include: a.

Net realizable value of accounts receivable;

b.

Net realizable value of inventory;

c.

Property and casualty insurance loss reserves;

d.

Current obligations that will be fulfilled over several years;

e.

Future returns of products sold;

f. Amount of cash flows expected to be generated by a specific group of assets; g. Revenues from contracts accounted for by the percentage of completion method; h.

Pension expenses; and

i.

Warranty expenses.

3. It is difficult to understand how the Commission concludes without any economic analysis that “the vast majority of companies” would “have somewhere in the range of three to five critical accounting estimates.” Rather than rely on impression, to avoid triggering disclosure of a large number of accounting estimates, the Commission could limit the number to the “five accounting estimates with the highest potential to materially affect the financial presentation.” This would be similar to the top five executive officers disclosure requirement in Item 402 of Regulation S-K. Alternatively, the item could impose a percentage threshold such as the potential to change revenue, operating income or net income or assets or liabilities by 20%, similar to the percentage threshold of Item 3-05 of Regulation S-K for the acquisition of a business. Moreover, one way to discern what number should constitute the maximum number of critical accounting estimates would be to survey the number of critical accounting estimates that were included in this year’s Form 10-Ks. These Form 10-Ks represent a test case or experiment that, while not exactly the same as the Critical Accounting Release, may provide valuable, real life experience in arriving at a number or standard. 4. The December 2001 Cautionary Statement defined a critical accounting policy as being “most important to the portrayal of the company’s financial condition and results.” However, a critical accounting estimate would not Raised by Events Relating to Enron Corporation, Feb. 4, 2002 (available at http://www.sec.gov/news/testimony/020402tshlp.htm)(“Pitt Testimony”).

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necessarily be a critical accounting policy because different estimates that could have been used in the current period or changes in the accounting estimate that are reasonably likely can result in a material impact on the company’s financial condition and results in the future, rather than in the current period. C.

Describing Critical Accounting Estimates 1.

The proposed rule would require companies to identify and describe: a.

The critical accounting estimate;

b. The methodology used in determining the critical accounting estimate; c. Any underlying assumption that is about highly uncertain matters and any other underlying assumption that is material; d. Any known trends, demands, commitments, events or uncertainties that are reasonably likely to occur and materially affect the methodology or the assumptions described; disclosure would be required if the trend is currently known, is reasonably likely to occur and is reasonably likely to have a material impact; e. If applicable, why different estimates that would have had a material impact on the company’s financial presentation could have been used in the current period;208 and f. If applicable, why the accounting estimate is reasonably likely to change in future periods with a material impact on the company’s financial presentation. 2. In addition, companies would be required to explain the significance of the critical accounting estimates to the company’s reported financial results, financial condition and changes in financial condition, and, where material, to identify the affected line items. a. Not all estimates are line items in the financial statements. Rather, they could be elements of a line item. Since the existence and effect of an estimate may not be readily apparent to the investor, this disclosure is intended to provide additional information and clarity to investors. 3. Thus, the Critical Accounting Release contemplates four tiers of basic disclosure: the critical accounting estimate itself; the methodology; the 208

For example, a critical accounting estimate related to a significant portfolio of over-the-counter derivative securities may require that a company estimate the fair value of such contracts using a model or other valuation method. In that case, the company would disclose the methods it employs to estimate fair value – e.g., the types of valuation models used and the assumptions such as an estimated price in the absence of a quoted market price.

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assumptions; and the factors that could materially affect the methodology or assumptions. Moreover, given the role that “highly uncertain matters” plays at various levels of the proposed disclosure, registrants could be confronted with the disclosure of uncertainty squared, viz. the highly uncertain matter about which the assumption is made and the uncertainties that affect the highly uncertain matter. a. Note that the Critical Accounting Release has added several new defined terms that are in tension with similar terms used in current Item 303 of Regulation S-K and the interpretive releases published over the past two decades: for example, the term “reasonable likelihood,” which was described in the 1989 Release and first defined in the MD&A Statement, and the term “material,” as it is used in current Item 303 and also in SAB No. 99.209 In order to understand how the proposed disclosure requirement works and what disclosure it is intended to elicit in this new section of the MD&A, the Commission should address the issue of definitions and resolve or reconcile the potentially conflicting terms in the current Item 303, the 1989 Release and the MD&A Statement, and the Critical Accounting Release. b. This four-tier disclosure matrix differs from the typical response to line item disclosure, which requires a registrant to disclose X and the reasons for or the factors that can affect X. In this binary type of disclosure system, the investor is informed of both the registrant’s position and the bases for the position. If there is uncertainty about the position, the registrant is able to disclose the company’s inability to ascertain or assure that X will occur.210 In contrast, the Critical Accounting Release would require disclosure of X, the methodology to determine X, the assumptions to arrive at X and the known trends, demands, commitments, events or uncertainties that are reasonably likely to occur and materially affect each assumption and each methodology. A known trend could materially affect one assumption but not another; or the known trend could be material to one assumption but immaterial when considered in the totality of all the assumptions that underlie the critical accounting estimate – yet, that known trend would be required disclosure under the release. Not only will registrants face a challenge in preparing this disclosure, they will find it difficult to comply with the Plain English requirement of being “clear, concise and understandable” to the average investor. c. The Critical Accounting Release will potentially result in substantially more disclosure. Assume arguendo that a registrant determines it has five critical accounting estimates, one methodology for 209

The Commission endorsed SAB No. 99 in its amicus brief filed in Ganino v. Citizens Utilities Company, 228 F.3d 154 (2d Cir. 2000).

210

This binary disclosure system is commonplace in the Commission’s disclosure requirements, ranging from Item 303(a) of Regulation S-K to Items 1014(a) and (b) of Regulation M-A.

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each estimate and four assumptions for each estimate; and assume further that, in turn, each assumption and methodology has five known trends, demands, commitments, events or uncertainties that are reasonably likely to materially affect the assumption or methodology during the current period or in the future. Simply put, this hypothetical results in 125 new items required to be disclosed in describing the critical accounting estimates, even before those estimates are then subjected to the sensitivity analysis, of which there are two choices, that the Proposing Release would also require. Add to this, the proposed requirements to discuss why different estimates would have had a material impact had they been used; why the estimate itself is reasonably likely to change from period to period; and whether any material changes were made to the estimate in the last three years. D.

Sensitivity Analysis for Critical Accounting Estimates 1. Once the estimates are identified and described, and explanation of their significance is given, the proposal would require a sensitivity analysis of the critical accounting estimates. Registrants would be required to quantify the changes in overall financial performance, and, to the extent material, line items in the financial statements, if the company were to assume that the accounting estimate were changed, either by using reasonably possible, near-term changes in the most material assumptions underlying the estimate or by using the reasonably possible range of the accounting estimate. a. This disclosure is intended to give investors a better understanding of the sensitivity of the reported operating results and financial condition to changes in accounting estimates or their underlying assumptions. Therefore, companies would be required to disclose the impact on overall financial performance regardless of how large or small that impact is. b. For purposes of this sensitivity analysis, companies have two sets of assumed changes to choose from: (1) First, the company can choose to assume that it changed the most material assumptions underlying the estimate and then discuss the results of those changes. (a) Here, the alternative assumption must represent a change that is reasonably possible in the near term, meaning up to one year from the date of the financial statements. (b) The company should alter or change the most material assumptions at least twice – a positive change in the assumption and a negative change in the assumption – in order to reflect reasonably possible, near-term changes. 119

(c) Also, disclose the likelihood of the occurrence of the changes selected, such as estimated probabilities of occurrence or standard deviations, if known or available. (2) Alternatively, the company can choose to assume that the critical accounting estimate itself changes, by using the upper and lower ends of the range of reasonably possible estimates, which the company likely determined in formulating the recorded critical accounting estimate. The company would substitute the upper end of the range for the recorded estimate and discuss the results, and do the same for the lower end of the range.211 c. Under either alternative, the resulting disclosure is intended to demonstrate the sensitivity of the reported results to changes that affect the critical accounting estimates. Consequently, investors would have a better understanding of the extent to which there is a correlation between management’s key assumptions and the company’s overall financial performance – and how a company’s results of operations are susceptible to changes in management’s views relating to critical accounting estimates. 2. Similarly, companies would discuss the impact, if material, on the company’s liquidity or capital resources if any changes being assumed (either by using reasonably possible, near-term changes in the most material assumptions underlying the estimate or by using the reasonably possible range of the accounting estimate) were in effect. 3. The proposal would also require companies to discuss qualitatively and quantitatively any material changes made to the accounting estimate in the past three years, the reasons for the changes and the effect on line items in the financial statements and overall financial performance. a. The Commission would require this information in order to give investors a clear understanding of a company’s recent history of changes in critical accounting estimates. Companies would have to identify how the material changes affected measurements in the financial statements and their overall financial performance. This would enable investors to evaluate management’s formulation of critical accounting estimates over time. b. Small business issuers would be required to discuss changes only during the past two years.

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Companies should note that a disclosure regarding the effect of a more negative estimate might be misconstrued as an assurance that an even more negative outcome could not occur. In light of that risk, these types of disclosures will require special care in drafting.

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4. The underlying premise of the sensitivity analysis is mandated forwardlooking information.212 E.

Critical Accounting Estimates for Each Segment 1. If the company operates in more than one segment, the proposal would require the registrant to identify the segments of the company’s business affected by the accounting estimate. To the extent that disclosure of critical accounting estimates on a company-wide basis only would result in an omission that renders the disclosure materially misleading, companies would have to separately discuss critical accounting estimates on a segment-by-segment basis. a. If the company operates in more than one segment and the estimate affects fewer than all of the segments, the company would have to identify the segments affected by the estimate. This disclosure is important for investors because it would enable them to determine which reported segments’ results are dependent on management’s subjective estimates. b. While the proposal would not require repetition on a segment-bysegment basis of all matters discussed on a company-wide basis, critical accounting estimates that vary by segment in their effect could indeed result in repetition to avoid an incomplete or misleading picture. This could result in such complex disclosure that investors could be more confused than informed. 2. Moreover, this requirement could result in very complicated disclosure. Consider a multi-national conglomerate with operations in 50 countries with seven reportable segments that has a tracking stock. The MD&A for this type of company is already a challenge because the company is presenting two MD&As, one for each tracking stock. Each of the two MD&As presents the segments as they relate to the tracking stock and on a geographical basis. If the segments are truly different businesses, rather than merely reportable under FAS 131, the different dynamics of each segment could result in multiple separate critical accounting estimates that do not relate to another segment and are not meaningful to the holder of the tracking stock.

F.

Discussion of Critical Accounting Estimates with Audit Committees 1. While the “M” in MD&A has always referred to management, the proposal would require disclosure of whether the development, selection and disclosure of the critical accounting estimates were discussed with the company’s audit committee or equivalent. Since the proposal would also require disclosure of the reasons why senior management has not discussed the estimates with the audit committee, it would appear that the Commission is subtly suggesting that audit committees become involved directly in the MD&A. The Commission

212

For a discussion of safe harbors for forward-looking information, see Section XIV.L of this Outline.

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believes, as a matter of policy, that senior management should discuss the company’s critical accounting estimates with the audit committee because, in so doing, the audit committee may seek to understand the estimates, underlying assumptions and methodologies, the appropriateness of management’s procedures and conclusions, and the disclosure about those accounting estimates. The Critical Accounting Release concludes that “[t]his type of oversight would have the potential to improve the quality and the transparency of disclosure.”213 a. Unlike the audit committee report,214 disclosure of whether any critical accounting estimates discussion took place between management and the audit committee would not be limited to proxy and information statements that involve the election of directors. Also, no audit committee report or recommendation in connection with the critical accounting estimates would be required under the proposed rule. b. The substance of the discussions between senior management and the audit committee would not, and should not, be disclosed. 2. This proposed disclosure rule would effectively become a new corporate governance rule, requiring management to discuss critical accounting estimates with the audit committee. Although management would be free to disclose that they decided not to discuss the critical accounting estimates with the audit committee for various reasons (which would also be required to be disclosed), it is highly unlikely that prudent managers would be so inclined. G.

New Requirements on Initial Adoption of an Accounting Policy 1. A company initially adopts an accounting policy when events or transactions occur for the first time, or when events or transactions that were previously immaterial become material, or when events or transactions occur that are clearly different in substance from previous events or transactions. If an initially adopted accounting policy has a material impact on the company’s financial presentation, the Critical Accounting Release states that the impact should be disclosed because it would likely be of interest to investors, analysts and others. a. For example, a company may for the first time enter into transactions involving derivative instruments, such as interest rate swaps, or may begin selling a new product with unprecedented delivery terms and conditions. 2. Under current practice, a company must provide the disclosures required by Accounting Principles Board Opinion No. 22 (“APB No. 22”) when it initially adopts an accounting policy it considers significant. This disclosure is typically

213

See Critical Accounting Release.

214

See Item 306 of Regulation S-K.

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included in the first note to the financial statements. 3. Because the APB No. 22 disclosure may not adequately describe, in a qualitative manner, the impact of the initial adopted accounting policy on the company’s financial presentation, the Commission has proposed that a company include additional MD&A disclosure to further describe the initial adoption of accounting policies where it had a material impact on its financial condition, changes in financial condition or results of operations. Disclosure would not be required if the adoption of the policy resulted solely from new accounting literature issued by a recognized accounting standard setter. 4. The proposed disclosure would be part of the MD&A and would include a description of: a. The events or transactions giving rise to the initial adoption of an accounting policy; b. The accounting principle adopted and method of applying that principle; and c. The impact, discussed qualitatively, resulting from the initial adoption of the accounting policy on the company’s financial condition, changes in financial condition and results of operations. 5. If the company has a choice between acceptable accounting principles when it adopts the accounting policy, the company would also be required to: a.

Explain that it had chosen among acceptable alternatives;

b.

Identify the alternatives;

c.

Describe why it made the choice that it did;

d. If material, provide a qualitative discussion of what the alternative choices’ impact would have had on financial condition, changes in financial condition and results of operations; and 6. If the events or transactions are so unusual or novel that no existing accounting literature governs the accounting, the company would have to explain its decision regarding which accounting principle to use and the method of applying that principle. H.

Presentation of Critical Accounting Estimates in the MD&A 1. The proposed rule would require companies to include a separate section on critical accounting estimates in the MD&A. The separate disclosure is intended to highlight the discussion and better communicate the information. The disclosure must be presented in plain English – i.e., in language and format that is 123

clear, concise and understandable to the average investor. 2. Each critical accounting estimate and each newly adopted accounting policy would be discussed separately in order to facilitate investor understanding of the implications of each one and to avoid confusion, as estimates and policies can materially affect a company’s financial presentation in differing ways. 3. The Commission is considering whether to require a summary of the MD&A, which would identify what management considers the most important factors in determining its financial results and condition, including principal drivers, trends and risks, and registrants can expect to be required to prepare a summary of the MD&A in the near term. 4. Boilerplate disclosure that does not specifically address the company’s particular circumstances and operations would not satisfy the proposed requirements, according to the Critical Accounting Release. Also, disclosure that could easily be transferred from year to year, or from company to company, with no change would, in the Commission’s view, neither inform investors adequately nor reflect the independent thinking that is to accompany the periodic assessment by management intended under the proposal. 5. Disclaimers of legal liability would be prohibited. While companies can, and should, draft disclosure to take advantage of any available safe harbors, disclaiming liability would be, in the Commission’s view, contrary to the disclosure goals underlying the proposal and therefore impermissible. 6. Viewed as a whole, in light of the Critical Accounting Release, the proposed changes to the MD&A could be summarized as follows: TODAY

PROPOSAL

1. Flexible and defers to management’s judgment.

Rules related, and dictates how analysis will be presented.

2. Management’s discussion.

Proposal could have outside auditor review and de facto would involved the audit committee.

3. Fairly straightforward in scope and purpose.

Complex and multifaceted – new discussion on critical accounting estimates focuses on uncertainties and mandates forward-looking information. Summary of MD&A would be required, and MD&A would consist of at least three sections: the critical accounting estimates, the traditional MD&A and the market risk disclosure of Item 305 of Regulation S-K.

4. Must discuss trends, but projections are

Both would be required.

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TODAY

PROPOSAL

not required. 5. Directed at average investor, with emphasis on transparency and understandability for the retail investor.

Requires subtle analysis, running the risk of being understood only by market professionals.

6. Emphasis is on more financial analysis.

More accounting than financial analysis. It’s not going to be the company’s research report.

7. Could be done in the time periods.

When they take effect, the new 60- and 35-day deadlines may be a push for mid-size issuers, and the shorter Form 10-Q filing date may be difficult to meet for a large number of companies.

8. Didn’t increase cost.

The expense could be significant and recurring.

9. Didn’t affect competition.

May affect competition.

10. Trust management to tell their story.

The specificity has a “can’t trust them” approach.

I.

Quarterly Updates 1. The Commission expects that companies would reevaluate accounting estimates and their underlying assumptions and methodologies on at least a quarterly basis and has therefore proposed quarterly updates on critical accounting estimates to reflect any material developments. The Commission also believes that disclosure of material developments made only at the end of each fiscal year may not identify changes quickly enough to inform investors adequately. 2. In a quarterly report on Form 10-Q, registrants would disclose critical accounting estimates that have not been previously discussed as a critical accounting estimate in the MD&A of the registrant’s last Form 10-K or any of its prior Form 10-Qs, and would make any disclosures with respect to any material changes to any prior disclosure on critical accounting estimates necessary to make that disclosure not materially misleading as of the time the registrant files its Form 10-Q for the current fiscal quarter.215

J.

Auditor Examination of Disclosure Relating to Critical Accounting Estimates 1. A company’s auditor is responsible for evaluating the reasonableness of the accounting estimates made by management in the context of the financial statements taken as a whole. In addition, when a company’s audited financial

215

See Proposed Item 303(c)(5) of Regulation S-K.

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statements are included in an annual report filed with the Commission, the auditor is required to read the information in the entire filed document, including the MD&A, and consider whether such information or its presentation is materially inconsistent with the information or presentation appearing in the financial statements.216 2. The Commission is considering whether to require the auditor to take additional steps to ensure the accuracy and reliability of the disclosure on critical accounting estimates: specifically, to subject the MD&A to the auditing process itself by adopting a requirement that an independent auditor examine, in accordance with Attestation Standards, the new MD&A disclosure relating to critical accounting estimates. Thus, in addition to the MD&A having audit committee involvement, it could have auditor association, resulting in the MD&A becoming the MAAC, D&A – the “Management, Auditor, Audit Committee’s Discussion and Analysis.” 3. In general, auditor examinations of MD&A disclosure are rare and expensive, and usually occur in connection with initial public offerings or upon a major restructuring or acquisition.217 The AICPA has established standards and procedures for such an examination.218 The auditor’s goal in such situations is to express an opinion on: a. whether the MD&A includes in all material respects the required elements of disclosure mandated by the Commission; b. whether the historical financial amounts have been accurately derived, in all material respects, from the company’s financial statements; and c. whether the underlying information, determinations, estimates and assumptions of the company provide a reasonable basis for the disclosures contained in the MD&A. 4. To complete an examination, the auditor must examine documents and records and accumulate sufficient evidence to support the disclosures and assumptions and to take other steps to get reasonable assurance of detecting both intentional and unintentional misstatements that are material to the MD&A. To accept an examination engagement, an auditor must have sufficient knowledge about the company and its operations. 216

See Critical Accounting Release, fn. 97, 98.

217

The Critical Accounting Release notes that the MD&A section for the IPO of the Goldman Sachs Group was audited. 218

See Codification of Statements on Standards for Attestation Engagements § 701 (contemplates two levels of service by an auditor with respect to MD&A: an “examination” of the MD&A, and a more limited “review” of the MD&A).

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K.

Application to Foreign Private Issuers 1. The proposed rule would apply to the annual reports and registration statements filed by foreign private issuers. Foreign private issuers are permitted to present their financial statements either in accordance with U.S. GAAP or in accordance with the GAAP of a foreign country or International Accounting Standards and International Financial Reporting Standards issued by the International Accounting Standards Committee and the International Accounting Standards Board (in each case, they would be reconciled with U.S. GAAP). Currently, the MD&A disclosure of foreign private issuers focus on the primary financial statements, and the proposed MD&A disclosure with respect to critical accounting estimates would do the same. 2. If the primary financial statements are not in U.S. GAAP, the company would have to consider critical accounting estimates in connection with the GAAP of its primary financial statements as well as in its reconciliation to U.S. GAAP, for two reasons: a. First, a foreign private issuer could make an accounting estimate under non-U.S. GAAP that would not constitute a critical accounting estimate under non-U.S. GAAP, but in applying U.S. GAAP in the reconciliation, could be required to make different assumptions that involve highly uncertain matters, therefore causing it to be highly susceptible to change. (1) For example, non-U.S. GAAP may permit derivative instruments to be reported at cost, while U.S. GAAP would require the same instruments to be reported at fair value. If the instruments are not traded, assumptions about highly uncertain matters would be required to estimate fair value for purposes of the reconciliation. b. Second, a foreign private issuer could apply different accounting methods under U.S. GAAP than under non-U.S. GAAP, and while both may involve critical accounting estimates, they may do so for different reasons that investors would need to understand. (1) For example, the methodology and assumptions necessary to estimate the liability for environmental claims may be significantly different under the two different GAAPs. Hence, the foreign private issuer would be required to include the proposed disclosure for any critical accounting estimate that is related to the application of U.S. GAAP. 3. Foreign private issuers would also be required to make disclosures with respect to the initial adoption of accounting policies, which would focus on the primary financial statements but also take into account the reconciliation to U.S. 127

GAAP. The proposed rules would require that the foreign private issuer provide the proposed disclosure about the initial adoption in relation to its primary financial statements. In addition, the foreign private issuer would be required to consider the reconciliation to U.S. GAAP, although this would not necessarily present a disclosure issue simply because the company is initially adopting a new policy under non-U.S. GAAP. If it does, however, and it has a material impact on the issuer’s financial presentation, the Commission believes that disclosure would be appropriate. 4. Foreign private issuers are not required to submit quarterly reports to the Commission. Instead, they submit information on Form 6-K, which encompasses only information that the issuer makes public under its home country requirements. Consequently, unless foreign private issuers file registration statements that require interim period financial information and related MD&A disclosure, they will be required to update their critical accounting estimates disclosure only annually. L.

Safe Harbors for Forward-Looking Information 1. The sensitivity analysis undertaken for each critical accounting estimate would require a company to make forward-looking statements.219 a. For example, a company’s disclosure of the reasonably possible, near-term changes in its most material assumptions underlying accounting estimates would qualify as a forward-looking statement, but its quantitative disclosure of changes it made to accounting estimates in the past three years would not. b. Other examples include: a discussion of the assumptions underlying an estimate of projections of future sales; and a discussion of the expected effect if a known uncertainty were to come to fruition and result in a change in management’s assumptions. 2. Since 1980, MD&A has encouraged but not required registrants to discuss forward-looking information. Although trend disclosure is required, projections are not. The proposal would, for the first time, mandate forward-looking information by rule. Thus, Note 6 of Item 303 would be revised to provide that “Your response to this section requires you to make certain forward-looking statements.” 3. In the proposed note, the Commission would underscore that if the conditions of the statutory safe harbors under Section 27A of the Securities Act

219

As defined in the relevant statutory provisions, a “forward-looking statement” generally is a statement containing, among other things a projection of revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items; statement of the plans and objectives of management for future operations, including relating to products and services; statement of future economic performance; and statements of assumptions underlying any such statements. See 15 U.S.C. §§77z-2 and 78u-5.

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and Section 21E of the Exchange Act and the Commission’s safe harbor rules, Rule 175 under the Securities Act and Rule 3b-6 under the Exchange Act, are satisfied, then forward-looking statements would be entitled to safe harbor protection.220 4. Accordingly, companies preparing their disclosure on critical accounting estimates should consider the terms, conditions and scope of the safe harbors in drafting their disclosure. M.

Workshop in Critical Accounting Estimates 1. In anticipation of the adoption of the proposal, companies may want to analyze how they would identify accounting estimates, determine which estimates constitute critical accounting estimates and how the sensitivity analyses would be prepared and presented. One way to develop critical accounting estimates is to begin with management, which identifies the estimates and then proposes them to the outside auditor. After this review, management could propose the critical estimates to the audit committee, which then reviews and discusses them with management and the outside auditor, with and without management present, before recommending them to the board of directors for adoption. 2. Each company’s management and auditor should bring particular focus to the evaluation of the critical accounting estimates used in the financial statements. a. Management should be able to defend the quality and reasonableness of the critical accounting estimates. b. Auditors should satisfy themselves thoroughly regarding the selection of these estimates and their application and disclosure. c. Audit committee members should engage in a candid dialogue with financial management and outside auditors to identify what critical accounting estimates most affect their companies’ financial statements. They should make sure that they understand what these critical estimates are, how they operate, how they affect reported results and how they compare with estimates followed by peer companies. They should also discuss with management the extent to which these estimates are disclosed in the companies’ MD&A. d. If companies, management, audit committees or auditors are uncertain about the application of specific GAAP principles, they should consult with the Staff. 3. In conducting the sensitivity analysis, which would require disclosure of forward-looking information, companies should disclose only those ranges or

220

See Proposed Instruction #2 to Proposed Item 303(c) and similar proposals for Regulation S-B and Form 20-F.

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changes that actually reflect what management has considered in arriving at the reported estimate. Informal processes may need to be formalized in order to provide the assurance that these statements have a proper foundation. XV.

CURRENT REPORTS ON FORM 8-K A.

Introduction 1. The secondary market disclosure system under the Exchange Act requires public companies to report limited, specified events on Form 8-K on a current basis in order to maintain the currency and adequacy of information disclosed by companies. As part of its systemic reform effort to enhance periodic reporting, the Commission believes that the list of events requiring more current reporting needs to be expanded and the time periods for filing those reports shortened. a. President Bush underscored this view. In Proposal #2 in his TenPoint Plan, President Bush stated, “Each investor should have prompt access to critical information.” Under this proposal, the Commission “would expand the list of significant events requiring prompt disclosure between reporting periods.”221 2. Accordingly, the Commission has proposed expanding the types of information that companies must report on Form 8-K.222 The proposed rule would require current disclosure of 11 new items or events, bring the number of mandatory items from six to 17.223 Section 409 of the Act, which requires the Commission to implement rules obligating companies to disclose on a “rapid and current” basis information concerning material changes to financial condition or operations, supports the Commission’s 8-K Release. Indeed, this release may

221

Ten-Point Plan, Proposal #2.

222

See 8-K Release. The Commission made a similar proposal in the Aircraft Carrier Release, in which six new items were proposed to be added to Form 8-K and the filing deadline shortened to five calendar days for some items and one business day of others. Some of the same proposed items from the Aircraft Carrier Release are now being proposed here, and the Commission is again proposing to shorten the filing deadline, but in a different manner than in 1998. Ironically, the present Form 8-K requirements represent a streamlining of the more than 15 items that had been required in Form 8-K before 1980. Therefore, the 8-K Release represents a back-to-the-future movement.

223

In a press release dated February 13, 2002, the Commission announced that it would expand the types of information that companies must report on Form 8-K. See Press Release, Commission, “SEC To Propose New Corporate Disclosure Rules,” Feb. 13, 2002 (available at http://www.sec.gov/news/press/2002-22.txt). Most of those items appear in the 8-K Release. Interestingly, one item mentioned in the press release, but not included in the 8-K Release, is the current disclosure of any waiver of corporate ethics and conduct rules for officers, directors and other key employees. (This item was probably mentioned in the press release because of media reports that Enron’s board waived parts of the company’s code of conduct on at least two occasions to permit the company’s chief financial officer to become involved with private partnerships that did business with Enron. See Special Report at 9.) In the 8-K Release, the Commission states that it is currently reviewing possible changes by the self-regulatory organizations to their corporate governance provisions that would address this issue. For example, the NYSE is considering a requirement that its listed companies adopt and disclose a code of business conduct and ethics for its directors, officers and employees and promptly disclose any waivers of the code for directors or executive officers.

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form the basis of the implementing rules for Section 409. B.

New Item 8-K 1. The Commission’s new items represent, in its view, events that presumptively have, or can have, such significance that timely disclosure is necessary for the market to perform properly and efficiently. In the proposed rule, the Commission has revised and reorganized Form 8-K into five sections of items or events, grouped by subject matter and renumbered to avoid confusion with the old version of Form 8-K. The new disclosure items are: a. Entry into a material agreement not made in the ordinary course of business (Item 1.01); b. Termination of a material agreement not made in the ordinary course of business (Item 1.02); c. Termination or reduction of a business relationship with a customer that constitutes 10% or more of a company’s consolidated revenues during the most recent fiscal year (Item 1.03); d. Creation of a direct or contingent financial obligation that is material to the company (Item 2.03); e. Events triggering a direct or contingent financial obligation that is material to the company, including any default or acceleration of an obligation (Item 2.04); f. Exit activities including any material write-offs and restructuring charges (Item 2.05); g.

Any material impairment to assets (Item 2.06);

h. A change in a rating agency decision, issuance of a credit watch or change in a company outlook (Item 3.01); i. Movement of the company’s securities from one national securities exchange or inter-dealer quotation system of a registered national securities association to another, delisting of the company’s securities from an exchange or quotation system, or a notice that a company does not comply with a listing standard or requirement (Item 3.02); j. Notice to the company from its currently or previously engaged independent accountant that the independent accountant is withdrawing a previously issued audit report or upon the decision of the audit committee or board of directors that previously issued financial statements should no longer be relied upon (Item 4.02); and

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k. Any material limitation, restriction or prohibition, including the beginning and end of lock-out periods, regarding the company’s employee benefit, retirement and stock ownership plans (Item 5.04). 2. In addition, the proposed rule would amend two existing Form 8-K disclosure items, as follows: a. Item 6 of Form 8-K, which requires disclosure about the resignation of a director, would become new Item 5.02, which would add disclosure requirements for the departure of a director for reasons other than a disagreement or removal for cause; appointment or departure of a principal officer; and the election of new directors. b. Item 8 of Form 8-K, which requires disclosure of a change in the fiscal year, would become new Item 5.03, which would add a disclosure requirement for any material amendment to a company’s certificate of incorporation or bylaws if the amendment is not disclosed in a proxy statement or information statement. 3. The proposed rule would also move two disclosure items that currently are required in companies’ annual and quarterly reports to Form 8-K: a. Unregistered sales of equity securities by the company (Item 3.03);224 and b. Material modifications to rights of holders of the company’s securities (Item 3.04).225 4. In general, the Commission expects responses to the Form 8-K items to be as specific as possible, and encourages companies to provide quantitative information, whenever possible. The Commission also advises issuers to take advantage of the safe harbors for forward-looking statements in the Commission’s rules and under Section 27A of the Securities Act and Section 21E of the Exchange Act. 5. Information on Form 8-K would continue to be considered “filed” under Section 18 of the Exchange Act, except for information provided pursuant to Regulation FD under proposed Item 6.01 (the old Item 9). 8-K disclosure has historically been subject to liability under all relevant sections of the Exchange Act, and the Commission believes that subjecting Form 8-K disclosure to liability will promote the dissemination of high-quality, balanced disclosure. C.

New Time Periods

224

This event is current reported under Item 2(c) of Part II of Forms 10-Q and 10-QSB and Item 5 of Part II of Forms 10-K and 10-KSB. 225

This event is currently reported under Item 2(a) and (b) of Part II of Forms 10-Q and 10-QSB.

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1. Given the significance of “real-time” disclosure, the Commission has proposed that companies file Form 8-K reports of these events no later than the second business day following their occurrence, which would mean that an event occurring on Monday would be reported on Wednesday before EDGAR closes.226 Presently, the time periods for filing Form 8-Ks depends on the event being reported – either five business days or 15 calendar days, depending on the event. Hence, the proposed rule would implement a uniform filing period for all mandated Form 8-K disclosure items. 2. The proposed rule does not affect the time periods for filings under Form 8-K to disseminate information in compliance with Regulation FD. Items 5 and 9 of Form 8-K would become Item 7.01 and Item 6.01, respectively. D.

Safe Harbor for Late Filings 1. To accommodate good faith, but unsuccessful, efforts to comply with the proposed deadlines, the Commission has proposed a safe harbor227 from Section 13(a) and Section 15(d) of the Exchange Act for a company that fails to file a required Form 8-K in a timely manner but satisfies these two requirements: a. On the due date, the company maintained sufficient procedures to provide reasonable assurances that the company is able to collect, process and disclose, within the specified time period, the information required to be disclosed by Form 8-K; and b. No officer, employee or agent of the company knew, or was reckless in not knowing, that a report on Form 8-K was required to be filed; and once an executive officer of the company became aware of the failure to file a required Form 8-K, the company promptly (and not later than two business days after becoming aware of its failure to file) filed a Form 8-K with the Commission containing the required information and stating the date on which the report should have been filed. 2. Note, however, that the safe harbor does not affect the company’s liability under any other provision of the securities laws, including Rule 10b-5 under the Exchange Act, and Sections 11, 12 and 17 of the Securities Act. 3. In addition, this safe harbor does not render a late filing timely. Hence, a company that fails to file a Form 8-K within the required time period would not be eligible to use short-form registration statements; and a company could not use Form S-8 and its security holders could not rely on Rule 144 unless the company is current in its Exchange Act filings.

226

Hence, if the event occurs on Monday night, the time period in which to file the Form 8-K is actually less than two business days because EDGAR closes at 5:30 p.m., E.S.T. 227

The safe harbor would be in new paragraph (c) to Rule 13a-11 and Rule 15d-11.

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4. However, the Commission has proposed to amend Rule 12b-25 to add Form 8-K to the filings granted relief by Form 12b-25. The amendment would require a company to file a Form 12b-25 one business day after the Form 8-K is due, and then file the Form 8-K within two business days after the original due date. In short, instead of two business days to file a Form 8-K, a Form 12b-25 would extend that period to four business days. a. In order to file Form 12b-25, the company would need to make the appropriate representations that it was not able to file the Form 8-K in a timely manner without unreasonable effort or expense. b. The filing of a Form 12b-25 would mean that, when filed, the late Form 8-K would be deemed to be filed on the prescribed due date. Therefore, the company would not lose its eligibility to use short-form registration statements as result of the late filing. XVI. PRO FORMA FINANCIAL INFORMATION A.

Introduction

On December 4, 2001, the Commission published a statement to caution issuers on their use of pro forma financial information and an investor alert to instruct investors about the potential dangers of pro forma information.228 In this context, pro forma information is not financials in accordance with Article XI of Regulation S-X or a summary of GAAP financial statements, but rather, information that is prepared on a non-GAAP basis. Since pro forma information can be very useful, perhaps the most important fact for companies that present pro forma information is that it will not be prohibited. Properly presented, it can focus the reader’s attention on the critical components of quarterly or annual financial results in order to provide a meaningful comparison to results for the same period of prior years or to emphasize the results of core operations. Section 401(b) of the Act requires the Commission to issue rules providing that pro forma financial information must be presented in a manner that does not contain an untrue statement of material fact or omit to state a material fact necessary in order to make the pro forma information, in light of the circumstances under which it is presented, not misleading. The new rules may be based upon the Commission’s cautionary statement on pro forma financial information. B.

Cautions about Using Pro Forma Information

228

Pro Forma Release; “‘Pro Forma’ Financial Information: Tips for Investors” (Dec. 4, 2001)(available at http://www.sec.gov/investor/pubs/proforma 12-4htm). See also Robert K. Herdman, Speech by Commission Staff: Critical Accounting and Critical Disclosure, before the Financial Executives International – San Diego Chapter, Annual SEC Update, Jan. 24, 2002 (available at http://www.sec.gov/news/speech/spch537.htm)(“Herdman Speech”).

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1. The Commission is concerned that pro forma financial information because, under certain circumstances, it can mislead investors if it obscures GAAP results. By its very nature, pro forma information departs from traditional accounting conventions, which can make it difficult for investors to compare the results with other reporting periods and with other companies. (Of course, as stated above, pro forma presentation can also clarify results for investors, particularly if there are many one-time events.) Accordingly, the Commission has issued both its Pro Forma Release and an investor alert to investors to remind everyone of the following propositions: a. The antifraud provisions of the federal securities laws apply to a company issuing pro forma financial information. Because pro forma information is derived by selective editing of financial information compiled in accordance with GAAP, companies should be particularly mindful of their obligation not to mislead investors when using this information. b. A presentation of financial results that is addressed to a limited feature of a company’s overall financial results (for example, EBITDA), or that sets forth calculations of financial results on a basis other than GAAP, raises particular concerns. Such a statement misleads investors when the company does not clearly disclose the basis of its presentation. Investors cannot understand, much less compare, this “pro forma” financial information without any indication of the principles that underlie its presentation. To inform investors fully, companies need to describe accurately the controlling principles. For example, when a company purports to announce earnings before “unusual or nonrecurring transactions,” it should describe the particular transactions and the kind of transactions that are omitted and apply the methodology described when presenting purportedly comparable information about other periods. c. Companies must pay attention to the materiality of the information that is omitted from a pro forma presentation. Statements about a company’s financial results that are literally true nonetheless may be misleading if they omit material information. For example, investors are likely to be deceived if a company uses a “pro forma” presentation to recast a loss as if it were a profit, or to obscure a material result of GAAP financial statements, without clear and comprehensible explanations of the nature and size of the omissions. d. The Pro Forma Release encourages public companies to consider and follow the earnings press release guidelines jointly developed by the Financial Executives International and the National Investors Relations Institute before determining whether to issue pro forma results, and before

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deciding how to structure a proposed pro forma statement.229 A presentation of financial results that is addressed to a limited feature of financial results or that sets forth calculations of financial results on a basis other than GAAP generally will not be deemed to be misleading merely due to its deviation from GAAP if the company in the same public statement discloses in plain English how it has deviated from GAAP and the amounts of each of those deviations. 2. In the Investor Alert, the Commission advises investors to ask the following questions: a. What is the company assuming? Be sure to look behind the numbers and find out what assumptions the numbers are based on. b.

What is the company not saying?

c. How do the pro forma results compare with GAAP-based financials? d. Are you reading pro forma results or a summary of GAAP-based financials? The latter can be useful in giving you the overall picture of company’s financial position without the mass of details contained in the full financial statements. C.

Abusing Pro Forma Information 1.

The Trump Case a. On January 16, 2002, the Commission announced its first enforcement action addressing the abuse of pro forma earnings figures, demonstrating the risks involved in mishandling pro forma reporting and not following the cautionary advise proffered in the Pro Forma Release. Enforcement action can result if a company fails to disclose information necessary to assure that investors will not be misled by the pro forma numbers. b. The Commission instituted cease-and-desist proceedings against Trump Hotels & Casino Resorts, Inc. (“Trump Hotels”) for making misleading statements in the company’s third quarter 1999 earnings release. The Commission found that the release used pro forma figures to tout the company’s purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual onetime gain rather than to operations.

229

As Mr. Herdman, Chief Accountant of the Commission, recently stated, “I would encourage each of you to not deviate from the FEI/NIRI guidance and the SEC cautionary advice release as you develop or review an earnings release containing pro forma financial information. In particular, reconcile any pro forma results to, or from, GAAP results with particularity and disclose the amount for each item.” See Herdman Speech.

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2.

Facts of the Trump Hotel Case230 a. On October 25, 1999, Trump Hotels issued a press release announcing its quarterly results for the third quarter of 1999. The press release calculated net income and earnings per share figures on a pro forma basis – i.e., non-GAAP – by expressly excluding a net $81.4 million one-time charge. In the Commission’s view, by stating that this one-time charge was excluded from its stated net income, Trump Hotels implied that no other significant one-time figures were included in stated net income. b. Contrary to this implication, however, the stated net income for the third quarter of 1999 included an undisclosed one-time gain of $17.2 million, the result of the termination, in September 1999, of the lease of a restaurant at one of the casinos owned and operated by Trump Hotels. There was no mention of this gain in the text of the press release, and the financial data provided gave no indication of it because all revenues were reflected in a single line item. c. The misleading impression created by the express exclusion of the $81.4 million charge and the unstated inclusion of the $17.2 million, according to the Commission, was reinforced by the comparison in the release of the stated earnings-per-share figure with the analysts’ earnings estimates and by statements in the release that Trump Hotels was successful in improving operating performance. The release stated that Trump Hotels’ earnings per share exceeded analysts’ estimates, and quoted the CEO as attributing the positive results and improvement from third quarter 1998 to improvements in operations. (1) It was literally true that there was improvement in each area of operation, but they were not responsible for the overall improvement in the quarter-to-quarter results. (2) In short, the CEO’s statement with respect to improvements in operations were misleading because of what he omitted, not because of what he stated. d. In fact, had the $17.2 million one-time gain been excluded from the quarterly pro forma results as well as the one-time charge, those results would have reflected a decline in revenues and net income and hence, Trump Hotels would have failed to meet analysts’ expectations. The Commission found that the undisclosed one-time gain was material, because it represented the difference between positive and negative trends in revenues and earnings, and the difference between exceeding and

230

See Press Release, Commission, “SEC Brings First Pro Forma Financial Reporting Case; Trump Hotels Charged With Issuing Misleading Earnings Release,” Jan. 16, 2002 (available at http://www.sec.gov/news/press/2002-6.txt).

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failing to meet analysts’ expectations. e. On October 25, 1999, the day the earnings release was issued, the price of the stock rose 7.8%. The information about the one-time gain was disclosed in an analysts’ conference call when analysts started to question the CFO on the numbers, and the CFO described the one-time gain. (These events occurred prior to Regulation FD.) When the one-time gain was publicly disclosed, the stock price fell approximately 6%. 3. The Commission found that Trump Hotels had violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and Rule 10b-5 thereunder – through the conduct of its CEO, CFO and treasurer – by knowingly or recklessly issuing a materially misleading press release. The Commission ordered the company to cease and desist from violating those provisions. Trump Hotels consented to the issuance of the Commission’s order without admitting or denying the Commission’s findings. Although no individuals were named, the Commission could have brought enforcement actions against Trump Hotels’ officers. 4.

This case reinforces the Pro Forma Release’s cautions: a. Don’t misdirect the reader by using pro forma numbers on an inconsistent basis. If you state that you are excluding a one-time gain, you are creating the inference that there are no other one-time events. b.

Literal truth is not necessarily a defense.

c. Explain how the pro forma numbers differ from the GAAP numbers. Be specific about what is included and what is not. D.

“Rules of the Road” on Pro Forma Information 1. The Commission is not prohibiting pro forma financial information. In fact, it is saying that properly done, pro forma information can serve useful purposes. 2. Like all information in press releases, the antifraud rules, such as Rule 10b-5, apply to pro forma information. 3. Pro forma information is non-GAAP information. Hence, explain what you mean when you use EBIT or EBITDA, or describe the controlling principles of the pro forma presentation. For example, if you are presenting earnings before unusual or non-recurring transactions, describe what types or kinds of transactions are being omitted. 4. Do not use pro forma information that is literally true but omits material information necessary to understand the entire picture. This is what Trump Hotels did, which resulted in the Commission’s first enforcement action on pro 138

forma information. 5.

Present the GAAP numbers in the press release.

6. Compare the pro forma information to the GAAP numbers and disclose the differences between them. In a recent survey conducted by the National Investor Relations Institute, of the 131 companies providing a clearly disclosed path or reconciliation of pro forma and GAAP numbers, 76% used both narrative and financials to explain the differences.231 7. If pro forma information is important enough to use in your earnings release, consider presenting this information in the MD&A, e.g., EBIT and EBITDA. 8. Be consistent in presenting good and bad items in your pro formas. In Trump Hotels, a bad fact was excluded but a good fact that was in the same category as the bad fact was included. Former Chief Accountant of the Commission Lynn Turner has coined a phrase, “Everything But the Bad Stuff.” Your pro forma information should not have Everything But the Bad Stuff. Also, be consistent between periods: using pro forma information in one quarter and then changing it to suit your presentation for the next quarter is not recommended. 9. Think ahead in terms of whether pro forma information is important to your business and industry. Decide that if you are going to use it, you will do so in good times and in bad. 10. Consider the needs of your debt holders as well as your equity holders. In an apparent response to the criticisms of Bill Gross, the General Electric Company will provide balance sheets in earnings releases, starting with its second quarter earnings report for 2002.232 XVII. THE ANDERSEN RELEASE On March 18, 2002, the Commission issued its requirements for audit clients of Arthur Andersen LLP in light of the single-count indictment announced against Andersen on March 14, 2002.233 Over 2,300 public companies were audited by Andersen in 2001. The Commission’s primary concern is to protect the issuers that are affected by Andersen’s indictment, thereby promoting stability in the capital markets. On June 15, 2002, immediately following the news of the conviction of Andersen for obstruction of justice for impeding the Commission’s investigation of Enron, the Commission 231

See Louis M. Thompson, Jr., Executive Alert, NIRI Releases Survey: An Analysis of Corporate Use of Pro Forma Reporting, Jan. 17, 2002 (available at http://www.niri.org/publications/alerts/EA20020117.cfm). 232

See Gretchen Morgenson, It’s Time for Investors to Start Acting Like Owners, N.Y. Times, Mar. 24, 2002, Section 3, at 1. 233

Andersen Release.

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issued a public statement in which it confirmed that the requirements announced in the Andersen Release will remain in effect after the conviction.234 The Commission also stated that Andersen has informed the Commission that it will cease practicing before the Commission by August 31, 2002, unless the Commission determines another date is appropriate. A.

Overview of the New Requirements 1. In general, the Commission will continue to accept financial statements audited by Andersen in Commission filings; and Andersen-audited companies will have additional flexibility on filing requirements. 2. The Andersen Release is strictly procedural, intended solely to address timing concerns and to provide flexibility for companies as they consider their options.235 The Andersen Release does not affect the liability standards to which an issuer’s filings are subject. 3.

This new framework does not apply to: a. signed audit reports that Andersen issued on or before March 14, 2002;

B.

b.

initial public offerings;

c.

initial registrations under the Exchange Act;

d.

going-private transactions;

e.

roll-up transactions; or

f.

filings or transactions by any blank-check companies.

Procedures for Companies Continuing with Andersen Through August 31, 2002

In the Andersen Release, the Commission provided procedures for companies deciding to continue with Andersen. In light of Andersen’s conviction on June 15, 2002, and its statement to the Commission that it will cease practicing before the Commission by August 31, 2002, such procedures will be applicable only through August 31, 2002. Companies receiving signed audit reports from Andersen after March 14, 2002 must obtain a representation letter from Andersen, to be included in their filings, containing Andersen’s assurances that: 1.

the audit was subject to Andersen’s quality control system;

234

See Andersen Conviction Press Release. According to newspaper accounts, the jurors reached a guilty verdict “because an Andersen lawyer had ordered critical deletions to an internal memorandum, rather than because of the firm’s wholesale destruction of Enron-related documents.” See Kurt Eichenwald, Andersen Guilty in Effort to Block Inquiry on Enron, N.Y. Times, June 16, 2002, at A1. 235

See Andersen Release.

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2. there is reasonable assurance that the engagement was conducted in compliance with professional standards; 3. there was appropriate continuity of Andersen personnel working on the audit; 4.

national office consultation was available; and

5. personnel in Andersen’s foreign affiliates were available, to the extent relevant. With these assurances, the Commission will continue to accept financial statements audited by Andersen through August 31, 2002. C.

Procedures for Companies Not Continuing with Andersen 1. For companies not continuing with Andersen as their auditor, which, after August 31, 2002, will include all companies, the Commission will accept unaudited financial statements for upcoming filing deadlines. However, these companies will be required to amend an annual report with unaudited financial statements within 60 days of the original deadline to include audited financial statements. For example, a Form 10-K that was due to be filed on April 1, 2002, would need to have been amended no later than May 30, 2002 to include audited financial statements. This alternative framework applies to: a. audited financial statements that are included in annual reports or otherwise made available to stockholders; b.

SAS 71 reviews of financial statements for quarterly reports;

c. audited financial statements that are included in registration statements filed by reporting companies; d.

tender offers under the Williams Act;

e.

acquisition proxy statements;

f.

employee benefit plans;

g. and

financial statements of unconsolidated subsidiaries and guarantors;

h. compliance with the disclosure requirements of Rule 144, Rule 144A, Rule 701, or Regulation D. 2.

Annual Reports and Annual Meeting Proxy Solicitations a. Companies whose fiscal year ends between November 30, 2001 and April 15, 2002 may file unaudited financial statements for their annual 141

reports on Form 10-K, provided that audited financial statements are filed by amendment within 60 days of the original filing deadline. Under the requirements of Temporary Note 2T to Article 3 of Regulation S-X, a filing containing unaudited financial statements must prominently state on the cover and immediately before the financial statements that it contains unaudited financial statements because the issuer was unable to obtain from Andersen or elected not to have Andersen issue a signed audit report. Such companies are also encouraged to state when and how they intend to provide audited financial statements and that no auditor has opined that the unaudited financial statements fairly present the condition of the company. When the amended filing is made, it must discuss any material changes from the unaudited financial statements initially filed, as well as any material changes from any other portion of the original filing, such as MD&A. b. Companies whose fiscal year ends between November 30, 2001 and April 15, 2002 and which send out their annual meeting proxy statements on or before September 13, 2002 may use unaudited financial statements in the annual reports that accompany or precede the proxy statement, as required by Rule 14a-3 under the Exchange Act. If the solicitation or corporate action has not been completed by the time the audited financial statements are filed, the issuer must also issue a press release when the Form 10-K is amended to include audited financial statements and must simultaneously post the audited financial statements on its Web site. 3.

Quarterly Reports a. Companies with fiscal quarters ending between January 26, 2002 and June 15, 2002 must meet the existing filing deadlines for their quarterly reports on Form 10-Q, but those reports need not undergo the SAS 71 review required by Rule 10-01(d) of Regulation S-X. Nevertheless, the disclosures regarding the lack of audited financials are required by Temporary Note 2T. (1) If there is a change in the financial statements after completion of the SAS 71 review, the issuer must amend its quarterly report to discuss the specific changes from the unreviewed financial statements and any other section of the quarterly report, such as the MD&A. (2) If there are no such changes after completion of the review, the issuer need only state in its next quarterly report that an auditor, other than Andersen, has reviewed the previous quarter’s financial statements. If this review does not result in any changes to the unreviewed financial statements, the issuer is encouraged to publicize that fact promptly, rather than awaiting the submission of 142

the next periodic report. 4.

Registration Statements a. Reporting companies may file registration statements under the Securities Act using unaudited financial statements if they meet the following requirements: (1) the financial statements relate to an entity with a fiscal year ending between November 30, 2001 and April 15, 2002; (2) the financial statements meet applicable timeliness requirements; (3) Andersen was engaged as the entity’s auditor on or after March 14, 2002; (4) the issuer is unable to obtain from Andersen or elects not to have Andersen issue a signed audit report; (5) the registration statement includes the disclosures regarding the lack of audited financials as required by Temporary Note 2T, described above; and (6) the issuer amends the filing within 60 days of the deadline for audited financials or, if earlier, on the date the audited financials are filed with the issuer’s annual report. b. Already effective Form S-3 shelf registration statements under Rule 415 will remain useable despite the incorporation by reference of unaudited financial statements included in a Form 10-K, provided that the Form 10-K is timely filed and the issuer amends the filing within 60 days of the deadline to include the required audited financial statements. The failure to file audited financial statements on or before the modified deadline described above will be deemed to constitute a fundamental change in the registration statement under Item 512(a)(1)(ii) of Regulation S-K. In that event, no offering off the shelf could be made until all required information was filed by means of a post-effective amendment. c. To accommodate the permitted 60-day delay in the filing of audited financial statements, Temporary Rule 427T extends from 16 to 18 months the age of audited financial information that a company can include in a prospectus that has been used nine months after the effectiveness of the registration statement under Section 10(a)(3) of the Securities Act. d.

In general, eligibility for Securities Act forms that allow 143

incorporation by reference of Exchange Act reports, such as Form S-3, will not be affected for issuers that follow the special procedures adopted for Exchange Act filings. 5.

Rule 437a and the Lack of Andersen’s Consent a. In the Andersen Release, the Commission adopted Rule 437a under the Securities Act in order to dispense with the written consent of Andersen ordinarily required by Section 7 of the Securities Act. By its terms, Rule 437a allows any registrant filing a registration statement with financial statements in which Andersen had been the independent public accountant to dispense automatically with the requirement to file Andersen’s written consent pursuant to Section 7(a) of the Securities Act, where the registrant: (1)

has not already obtained the consent;

(2) and

is not able to obtain the consent after reasonable efforts;

(3) discloses any limitations on recovery by investors posed by the lack of consent under Section 11(a)(4) of the Securities Act. b. Rule 437a follows the approach of Rule 437 by dispensing with the consent, but does so on an automatic basis rather than case-by-case. c. Rule 437a does not change the status of the financial statements as having been certified nor does it exclude Andersen’s audit report from being considered a part of the registration statement prepared or certified by a person under Sections 7 and 11 of the Securities Act, as Rules 436(c) and 436(g)(1) do with respect to an accountant’s SAS 71 review and an NRSRO’s security rating. Thus, Rule 437a, like Rule 437, should not by its terms change the nature of the information included in the registration statement or the status of the person who prepared or certified such information as Rules 436(c) and 436(g)(1) do. d. The question has arisen of whether an underwriter can avail itself of the due diligence defense that applies to “expertised” parts of a registration statement in defending against a Section 11 claim based upon material misstatements or omissions in financial statements certified by Andersen that were included in a registration statement without Andersen’s written consent in compliance with Rule 437a under the Securities Act.236

236

For a detailed analysis of this issue, see John J. Huber, Thomas C. Sadler and Joel H. Trotter, An Underwriter’s Due Diligence in the Permitted Absence of an Expert’s Consent, Insights, Aug. 2002, at 2.

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(1) Research has not identified any judicial precedent or any authoritative pronouncement of the Commission or its staff that directly addresses this question. In the absence of such precedent or a Commission pronouncement, we believe that where the Commission authorizes a registrant to omit an expert’s consent, the parts of the registration statement prepared or certified by that expert should nonetheless remain expertised under Section 11(b)(3)(C) of the Securities Act for purposes of an underwriter’s due diligence defense.237 Our position is based upon: (a) the text of Section 11(a)(4), which makes an accountant liable under Section 11 only with his consent, and the text of Section 11(b)(3)(C), which does not require an expert to consent for another defendant, such as an underwriter, to avail itself of the due diligence defense; (b) the text of Section 7(a), which permits the Commission to dispense with the consent and allows the Commission to require disclosure in such circumstances; (c) the legislative history of the consent requirement, which indicates that Congress intended the requirement to put the expert on notice that he would be liable under Section 11(a), rather than to qualify the nature or meaning of the term “expert”; (d) the English Companies Act of 1929, from which Congress derived Section 11 and under which experts could be relied upon by other defendants but were not required to consent; (e) Rules 436 and 437, which the Commission adopted pursuant to Sections 7 and 19(a) under the Securities Act and which take different approaches to the liability matrix of Section 11; (f) Rule 437a, which specifically addresses Andersen and provides for an automatic dispensation from the consent requirement of Section 7 and Rule 436(a), if certain conditions are met;

237

Despite the substantial reasons supporting their conclusion that an underwriter should not be subjected to the reasonable investigation standard of Section 11(b)(3)(A), they recommend that an underwriter consider taking additional steps, depending on the facts and circumstances involved in each offering, to establish a due diligence defense under Section 11(b)(3)(C).

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(g) Section 19(a), which states that the Securities Act will not impose liability for any act done or omitted in good faith in conformity with any rule or regulation of the Commission; (h) Section 11(c), which imposes a “prudent man” standard to determine what constitutes reasonableness under Section 11(b)(3); and (i) specific considerations regarding an underwriter’s ability to reduce litigation risk related to this issue. e. Ultimately, despite substantial reasons supporting the conclusion that an underwriter should have a due diligence defense under Section 11(b)(3)(C) available to it where the registrant omits Andersen’s consent in compliance with Rule 437a, any underwriter facing this situation must satisfy itself in advance that the risk of litigation can be sufficiently mitigated to proceed with the proposed public offering. One particular cause for concern, in addition to the lack of binding precedent on the specific issue, is that a court could reach a different result. Factors that an underwriter may consider in these circumstances include, but are not limited to, the following: (1) whether the issuer received Andersen’s consent on the most recently audited year’s financial statements with respect to any prior filing with the Commission; (2) the underwriter’s relationship with the issuer prior to the time at which Andersen became unable to provide its consent (i.e., whether the underwriter has conducted multiple offerings for the issuer in recent years, on the one hand, versus whether this is the underwriter’s first offering involving the issuer, on the other); (3) whether the underwriter has research analyst coverage of the issuer and/or the issuer’s particular industry, and the extent of the research analyst’s prior access to the issuer and its accounting team; (4) whether the Andersen engagement partner for the issuer went to the issuer’s new auditor and is available to be interviewed by the underwriter; (5) whether the underwriter has obtained additional representations from the issuer’s chief financial officer, comptroller, treasurer or other members of the issuer’s financial management team; (6)

whether the issuer is a foreign private issuer (because, in 146

the case of foreign private issuers, the entire audit firm that was previously a foreign affiliate of Andersen typically has become a foreign affiliate of a different U.S. audit firm); (7) the availability of a SAS 71 review of the most recent interim financial statements by the issuer’s new auditors; (8) the ability to negotiate agreed-upon procedures between the underwriters and the issuer’s new auditors, which may depend on the new auditor’s ability to issue a comfort letter under SAS 72; (9) the underwriter’s use of a different accountant to conduct a review of one or more critical accounting policies or otherwise examine portions of the financial statements; and (10) whether the underwriter has conferred with other accounting firms with respect to specified accounting issues. 6.

Other Securities Act Filings a. In addition to Rule 437a, relief from the following requirements is available where the issuer cannot obtain the applicable items after using reasonable efforts to do so: (1) The latest signed and dated accountant’s report may be substituted for the accountant’s report required by Rule 2-02 of Regulation S-X; and (2) Under temporary Items 304T and 601T of Regulation S-K, an issuer need not file the auditor’s letter stating whether the auditor agrees with the issuer’s disclosure regarding the auditor’s resignation or dismissal, as otherwise required by Items 304(a) and 601(b)(16) of Regulation S-K, upon the resignation or dismissal of Andersen as the issuer’s auditor. b. In addition, companies that comply with the procedures adopted in the release for Exchange Act filings will be deemed to satisfy the following requirements under certain Securities Act rules: (1)

Rule 144(c)(1) current public information;

(2) Rule 144A(d)(4) financial information that “should be audited”; (3)

Rule 502(b)(2)(ii) reports and registration statements; and

(4)

Rule 701 financial statements.

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XVIII. CONCLUSION This is a time of dynamic, perhaps seismic, change. The bankruptcy of Enron Corp. in December 2001 sparked a process of regulatory and legislative examination. As Chairman Pitt stated in February 2002, “every assumption, every rule and regulation” in our securities regulation system will be reexamined because there are “fundamental, longstanding flaws in our system.”238 Prior to July 30, 2002, this effort resulted in the Commission issuing six proposed rulemaking releases, the NYSE and Nasdaq finalizing proposed changes to their listing standards with respect to corporate governance, and numerous bills being introduced in Congress. Until disclosure of the Worldcom accounting scandal on June 25, 2002, the prospects for federal legislation becoming law were dim. Since then, Senator Sarbanes’s bill, which had little or no chance of passage in June, became law in July. With the passage of the Act, by margins of 99-0 in the Senate and 423-3 in the House and the President’s prompt signature and unqualified support for the Act, rulemaking will now increase239 – mostly, to implement the Act and the Commission’s new disclosure system. The November elections may determine whether the legislative flood crested with the Act or whether more legislation will follow. Even if further legislation is not forthcoming, however, the Act may be changing the federal securities laws as we have known them. It represents the revision that each generation makes to the federal securities laws – a revision that is driven, this time, not to anticipate trends, but to correct “flaws.” Most often this revision is done by Commission rulemaking, like integrated disclosure in the 1980s. This time it is Congress.

238

See Pitt Testimony.

239

In addition to rulemaking by the Commission and the SROs, the Financial Accounting Standards Board is reexamining the accounting for options. See Jackie Spinner, Accounting Board Resuming Date on Option Rules, Wash. Post, Aug. 7, 2002, at E4.

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