- SEC Adopts Rules Under Sarbanes-Oxley Act of 2002 Relating to Audit Committee Financial Experts and Codes of Ethics
- June 10, 2003 | Author: Edward C. White
- Law Firm: Donovan Hatem LLP - Boston Office
Although the Sarbanes-Oxley Act of 2002 (the "SOXA"), is intended to govern the manner in which public company audits are conducted, it is likely to become the standard for corporate governance of all business entities. As such, both C.P.A.s and attorneys should be cognizant of the requirements established by SOXA as they are likely to become the "industry standard". The U.S. Securities and Exchange Commission ("SEC") recently adopted final rules relating to audit committee financial experts and codes of ethics. SEC Release No. 33-8177 entitled "Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002" adopted on January 23, 2003 becomes effective on March 3, 2003. Under these rules, reporting companies will be required to provide certain disclosures in their annual reports for fiscal years ending on or after July 15, 2003 (for small business issuers, the financial expert provision is December 31, 2003).
Audit Committee Financial Expert
The rules implementing Section 407 of the SOXA require each reporting company to disclose in its annual report that its board of directors has determined (i) that at least one member of the audit committee is an "audit committee financial expert", or (ii) that no members of the audit committee are audit committee financial experts and the reasons why there are no such experts serving on the committee. If the existence of one or more experts is disclosed, the company must also disclose the relevant names and whether the expert is "independent" of management as described in Item 7(d)(3)(iv) of Schedule 14A. The disclosure standard is not satisfied by the board of directors stating that it has not decided to make a determination or by the board merely disclosing the general qualifications of each member.
In order for a person to be deemed an audit committee financial expert, he or she must possess all of the following five attributes: (i) an understanding of GAAP and financial statements; (ii) the ability to assess the general application of GAAP in connection with accounting for estimates, accruals and reserves; (iii) experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can be reasonably expected to be raised by the company's financial statements, or experience actively supervising one or more persons engaged in such activities; (iv) an understanding of internal controls and procedures for financial reporting; and (v) an understanding of audit committee functions.
An individual may acquire the above-listed attributes through one or more of the following: (i) 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; (ii) experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions; (iii) experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing, or evaluation of financial statements; or (iv) other relevant experience.
In developing the noted attributes, the SEC sought to broaden the pool of candidates who qualify as audit committee financial experts. In addition to persons with technical experience in accounting and auditing, the adopted rules also focus on persons who have the ability to assess, analyze and understand the application of GAAP, financial statements, internal controls and audit committee functions. This effectively allows persons with experience in investment banking, venture capital investing and financial analysis, as well as persons in positions overseeing the financial industries, to become qualified experts. The adopted rules also make clear that a candidate need not have direct experience in the company's industry to be qualified.
The sources for relevant experience described in the adopted rules similarly act to increase the pool of candidates. For example, a person can acquire the necessary attributes through a supervisory capacity of the process of auditing and analyzing financial statements. Likewise, a person may be sufficiently knowledgeable without ever having served as a principal financial officer or any of the other designated financial positions. However, merely having audit committee experience or experience in one or more of the designated financial positions does not, without more, justify a board in deeming such person an audit committee financial expert.
The rules provide a safe harbor by making clear that a person designated an audit committee financial expert will not be deemed an "expert" for any purpose (including Section 11 of the Securities Act of 1933), will not be subject to duties, obligations or liabilities greater than those imposed upon other audit committee members, nor does it affect the duties, obligations or liabilities of such other members.
Codes of Ethics
The rules implementing Section 406 of the SOXA require each reporting company to disclose in its annual report whether or not (and if not, why not) it has adopted a written code of ethics that applies to its chief executive officer, principal financial officer, principal accounting officer or controller, or those performing similar functions.
A "code of ethics" is defined as written standards that are reasonably necessary to deter wrongdoing and promote: (i) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; (ii) full, fair, accurate, timely, and understandable disclosure in reports and documents filed or submitted to the SEC and in other public communications made by the company; (iii) compliance with applicable governmental laws, rules and regulations; (iv) the prompt internal reporting to an appropriate person identified in the code of violations of the code; and (v) accountability for adherence to the code. The SEC chose not to specifically prescribe elements or procedures in order to account for the various circumstances faced by each reporting company.
Once adopted, the code of ethics must be publicly disclosed by the company by filing it as an exhibit to its annual report, by posting it on the company website, or by undertaking in its annual report to provide a copy without charge.
Under the rules, a U.S. company is required to disclose substantive amendments to, or material waivers from, the code of ethics for the chief executive officer and principal financial officers on Form 8-K or its website within 5 business days of the event.
Donovan Hatem LLP urges its clients not to dismiss application of the Sarbanes-Oxley tenets to private and not-for-profit entities. Private companies desirous of becoming publicly traded or the acquisition target of a public company should act early to implement these standards. More importantly, however, we believe that it is only a matter of time before the key disclosure, corporate governance and financial transparency provisions of Sarbanes-Oxley become the de facto standards for private companies in the United States. Compliance may ultimately be mandated by state legislatures, public accounting associations, insurance companies as a condition of coverage, lenders as a condition of funding or by government contractors as a qualification for contracting. We also expect that Sarbanes-Oxley will become the standard of care in shareholder lawsuits.