- SEC Issues Final Rules on Financial Experts and Codes of Ethics
- July 29, 2003 | Authors: W. Benjamin Barkley; David A. Stockton; Michael H. Trotter; Elizabeth G. Wren
- Law Firms: Kilpatrick Stockton LLP - Atlanta Office ; Kilpatrick Stockton LLP - Charlotte Office
As described in our Securities Legal Alert dated November 11, 2002, the SEC previously proposed rules relating to financial experts and codes of ethics under the Sarbanes-Oxley Act of 2002. The final rules implementing these provisions have now been released. This Securities Legal Alert summarizes the final rules and highlights the changes from the SEC's initial proposals.
Rules Relating to "Audit Committee Financial Experts"
Overview. Section 407 of the Act will require an issuer to disclose in its annual report on Form 10-K whether the issuer has at least one "financial expert" on its audit committee, and, if not, to provide the reason why not. The SEC's final rules implementing that provision require the issuer to disclose whether at least one person qualifies as what the SEC now terms an "audit committee financial expert," the name of that person, if so, and whether that person is independent of management. The final rules allow, but do not require, an issuer to identify additional members of the audit committee that have been determined to be audit committee financial experts. If an issuer chooses to identify additional members as financial experts, the issuer must also disclose if they are independent of management.
Definition. The definition of "audit committee financial expert" in the final rules is significantly broader than the definition of "financial expert" referenced in the proposals. The final rules define an audit committee financial expert as a person who has all of the following attributes:
- an understanding of GAAP and financial statements;
- the ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves;
- experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues than can reasonably be expected to be raised by the issuer's financial statements, or experience actively supervising one or more persons engaged in such activities;
- an understanding of internal controls and procedures for financial reporting; and
- an understanding of audit committee functions.
While these requirements are more stringent than related proposals on financial expertise made by the NYSE and NASDAQ, the final definition is significantly less restrictive than the financial expert definition under the proposed rules. For example, the final rule does not require that an audit committee financial expert obtain all of the above attributes from work with publicly-traded companies, as contemplated under the proposed rules.
Evaluation and Scope of Experience. The final rules require that an audit committee financial expert must have acquired the five attributes referenced above through any one or more of the following:
- education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor, or experience in one or more positions that involve the performance of similar functions;
- experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;
- experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or
- other relevant experience.
The SEC emphasized that "active supervision" will require more than the mere existence of a hierarchical reporting relationship, and that participation, albeit at a supervisory level, in the preparation, auditing, analysis or evaluation of financial statements will be necessary. The SEC also emphasized that a person may acquire expertise in a number of ways, and that a board should have the ability to recognize this expertise. The final rules do require that if a board determines that a person possesses the requisite expertise through "other relevant expertise," the issuer must disclose details of that person's experience. In considering a person's experience, the SEC emphasized that the fact that a person previously served on an audit committee would not, by itself, justify the board of directors in deeming that person an audit committee financial expert.
Standards of Conduct and Safe Harbor. To address concerns surrounding potential liability for persons identified as audit committee financial experts, the SEC included a safe harbor in the final rules that specifies that an audit committee financial expert is not an "expert" for purposes of Section 11 of the Securities Act of 1933. In addition, the final rules state that designation as an audit committee financial expert would not impose any greater duties on the designated person than those of other committee members. Further, the SEC reiterated that the designation would not limit the duties, obligations or liabilities of any other member of the audit committee or the board.
Timing. Issuers, other than small business issuers, must comply with the required audit committee financial expert disclosure in annual reports for fiscal years ending on or after July 15, 2003. Small business issuers must comply in annual reports for fiscal years ending on or after December 15, 2003.
Rules Relating to Codes of Ethics
Overview. Under Section 406 of the Act, issuers will be required to disclose in their annual reports on Form 10-K whether they have adopted a written code of ethics for senior financial officers, and if not, to provide the reason why not. Issuers also will be required to provide immediate disclosure of any change in or waiver of their code of conduct.
The SEC's final rules implementing those provisions are largely unchanged from the proposed rules. As with the proposed rules, the final rules require issuers to disclose whether they have adopted a code that covers their CEO, CFO, chief accounting officer and controller, or persons performing similar functions. The addition of the CEO to the covered officers is an expansion of the scope of executives covered in the Act itself.
While the proposed rules would have required an issuer to file its code of ethics as an exhibit to its annual report, the final rule allows a company to disclose the content of its code of ethics through one of three methods: filing the code as an exhibit to its annual report, posting the code on its Web site, or undertaking to provide a copy of the code to any person upon request without charge. The final rules, like the proposed rules, specifically require disclosure of any amendments or waivers of the code in a current report on Form 8-K or on the issuer's website, within two business days after occurrence.
Code of Ethics Content. Although the rules do not include every subject that the issuer must address in its code of ethics, or prescribe specific language, they do specify the minimum content of the code. The SEC defines the term "code of ethics" to mean a codification of standards that is reasonably designed to deter wrongdoing and to promote:
- honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest;
- full, fair, accurate, timely and understandable public disclosure, in SEC reports or otherwise;
- compliance with applicable governmental laws, rules and regulations;
- prompt internal reporting of code violations to appropriate persons designated in the code; and
- accountability for adherence to the code.
The final rules eliminated the requirement that an issuer establish a system for the centralized monitoring of conflicts of interest, as proposed in the initial rules.
Many issuers previously have adopted codes of ethics or business conduct that apply to a broader group of employees than the persons covered by these rules. Those issuers will not necessarily be required to amend existing codes, but to the extent those codes are not amended as necessary to meet the SEC's standards, issuers will be required to disclose the reasons why they do not maintain a conforming code.
Reporting of Changes and Waivers. As noted, issuers must disclose any change to, or waiver from, the code of ethics for its senior officers within two business days after occurrence, on Form 8-K or by a posting to the issuer's website. Issuers will be required to disclose not only specifically approved waivers, but also implicit waivers resulting from the issuer's inaction with respect to a reported or known violation of the code. The final rules define a "waiver" as a material departure from a provision of the code, and an "implicit waiver" as the issuer's failure to take action within a reasonable period regarding a material departure from a provision of the code that has been made known to an executive officer of the issuer. An issuer may take advantage of the website dissemination option only if it disclosed in its most recently filed annual report on Form 10-K that it intends to disclose these events on its website, and provides its website address. Website disclosure will be required to be maintained for a period of at least 12 months after initial posting, and archived waiver information will be required to be retained for five years.
Timing. Issuers must comply with the required code of ethics disclosure in annual reports for fiscal years ending on or after July 15, 2003.