Public Company Advisory Recent developments governing public companies and their officers, directors and investors

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1 January 29, 2003 Public Company Advisory Recent developments governing public companies and their officers, directors and investors SEC Adopts Disclosure Rules on Audit Committee Financial Experts and Codes of Ethics On January 23, 2003, the SEC published final rules implementing the provisions of the Sarbanes-Oxley Act of 2002 requiring disclosure relating to: audit committee financial experts; and codes of ethics for principal executive officers, principal financial officers, and principal accounting officers or controllers, or persons performing similar functions. Companies Subject to the New Rules. The final rules apply to all domestic and foreign companies that are required to file periodic reports with the SEC. The rules do not apply to registered investment companies; the SEC adopted final rules applicable to registered investment companies in a separate release. The audit committee financial expert rules will apply with some modifications to foreign private issuers. Some requirements for foreign private issuers (such as disclosure of the independence of audit committee financial experts) have been re-proposed for public comment and will not become effective until an unspecified future date. When it proposed these rules, the SEC also proposed rules relating to internal control reports and auditor attestation of these reports. The SEC indicated that it will adopt final rules relating to these matters at a later date; it has previously indicated that it will not require companies to comply with these rules for fiscal years ending before September 15, 2003 in order to permit the Public Company Accounting Oversight Board to adopt standards for these attestations. Compliance Dates. Companies must comply with the new rules as follows: Audit Committee Financial Expert Disclosure: companies must include the new disclosure in their annual reports filed with the SEC for fiscal years ending on or after July 15, 2003 (December 15, 2003 for small business issuers); and Code of Ethics Disclosure: companies must include the new disclosure in their annual reports filed with the SEC for fiscal years ending on or after July 15, Companies should note that the new SEC rules are disclosure rules. Companies that do not have an audit committee financial expert or have not adopted a code of ethics that satisfies the standards provided in the new rules are only required to disclose those facts (and the reasons why not). However, during 2002 the NYSE and Nasdaq proposed to require companies to adopt and publicize codes of ethics. They also indicated that they would consider requiring companies to have an audit committee financial expert, subject to their evaluation of the SEC s final rules. It Boston New York New Jersey Washington DC

2 is currently unclear what action the national securities markets will take on these matters. Audit Committee Financial Expert The final rules requiring disclosure concerning financial experts serving on audit committees differ in several important respects from the rules proposed by the SEC on October 22, We summarized that proposal, as well as the proposed code of ethics disclosure requirements, in our November 4, 2002 Public Company Advisory. Among other changes, the final SEC rules include a broader definition of audit committee financial expert. The SEC also adopted the term audit committee financial expert rather than financial expert because it suggests more clearly that the designated person has characteristics that are particularly relevant to the functions of the audit committee. Despite these changes, the definition of audit committee financial expert will still impose stringent standards for qualification. Disclosure Requirements. The final SEC rules require a company to disclose that its board of directors has determined either that it: has at least one audit committee financial expert serving on its audit committee; or does not have an audit committee financial expert serving on its audit committee. If the company discloses that it does not have an audit committee financial expert, the company must disclose the reasons why it does not. A company cannot satisfy the new disclosure requirements by stating that it has decided not to make a determination or by simply disclosing the qualifications of all of its audit committee members. The SEC did indicate that it would be appropriate for a company that discloses that it does not have an audit committee financial expert to explain which aspects of the definition the various audit committee members do satisfy. If the company discloses that it has at least one audit committee financial expert, then it must disclose the name of the person and whether the person is independent of management. The new rules define independent by reference to the SEC proxy rules, which currently rely on the definition of independent in the rules of the NYSE, AMEX or Nasdaq. The final rules permit, but do not require, a company to disclose that it has more than one audit committee financial expert. Therefore, once a company's board determines that a particular audit committee member qualifies as an audit committee financial expert, it may, but is not required to, disclose whether additional audit committee members also qualify. If the company elects to disclose the names of additional audit committee financial experts, it must also indicate whether they are independent. Definition of Audit Committee Financial Expert. The final rules define an audit committee financial expert as a person who has each of the following five attributes: an understanding of generally accepted accounting principles 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 that can reasonably be expected to be raised by the company 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 2

3 an understanding of audit committee functions. Under the final rules, the person must have acquired the five attributes through at least one 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. Significant Changes in Definition of Financial Expert. The final rules contain many changes in the definition of financial expert. Among the most significant changes to the SEC s proposed definition of financial expert are the following: Changes in generally comparable requirements. The SEC eliminated the requirement that audit committee financial experts must have gained experience with accounting for estimates, accruals and reserves that are generally comparable to those used in the company s financial statements. The SEC also modified the requirement that audit committee financial experts must have experience with financial statements that present accounting issues that are generally comparable to the company s financial statements. Together, these modifications make clear that an audit committee financial expert does not need to have previous experience in the same industry as the company. Commenters had expressed concerns that the proposed rules would sharply limit the pool of potential audit committee financial experts who did not have connections to competitors in the same industry. Changes in experience preparing or auditing requirement. The SEC broadened the definition by permitting an audit committee financial expert to have gained experience by analyzing or evaluating financial statements, rather than only by preparing or auditing them. The SEC indicated that persons who have experience performing in-depth analysis and evaluation of financial statements should not be precluded from being able to qualify as audit committee financial experts if they possess the other four necessary attributes of an expert. Elimination of prior public company experience requirement. The SEC eliminated the proposed requirement that an audit committee financial expert must have gained the relevant experience with a company that, at the time the person held such position, was required to file periodic reports with the SEC. The SEC cited the fact that many private companies are contractually required to prepare audited financial statements that comply with GAAP. In addition, a potential expert may have gained relevant experience at a foreign company that is publicly traded in its home market but that is not registered under the Exchange Act. Addition of other relevant experience. As proposed, audit committee financial experts who had not served in one of the specified positions could have acquired the relevant attributes and experience through a position that resulted in similar expertise and experience. The SEC modified this requirement to permit audit committee financial experts to have obtained the required attributes through other relevant experience. 3

4 Under the revised rules, audit committee financial experts may have acquired the five requisite attributes in many different ways. If the board of directors determines that a person qualifies as an expert by virtue of possessing other relevant experience, the company s disclosure must briefly list that person s experience. In addition, the SEC eliminated the proposed instruction listing several nonexclusive factors for a company's board of directors to consider in evaluating the education and experience of an audit committee financial expert candidate. The SEC indicated that boards should consider all the available facts and circumstances, including but not limited to, qualitative factors of the type that were previously identified, in its determination and expressed concern that the list would simply be used as a mechanical checklist. Grandfathering. The SEC indicated that the board of directors cannot grandfather directors who are serving or have served on the audit committee based solely on that service. Similarly, experience as a public accountant or auditor, or a principal financial officer, controller or principal accounting officer or experience in a similar position does not, by itself, justify the board of directors in designating that person as an audit committee financial expert. In each case, the board of directors must evaluate whether a director satisfies the five attributes listed above and has appropriate education and experience. Safe Harbor from Liability. Because of concerns that directors designated and publicly identified as audit committee financial experts might become subject to greater liability, and to make clear that the other members of the audit committee should not be expected to perform their duties any differently as a result of the designation or identification of an audit committee financial expert, the SEC included a safe harbor in the new audit committee disclosure item to clarify that: a person who is determined to be an audit committee financial expert will not be deemed an expert for any purpose, including for purposes of Section 11 of the Securities Act of 1933, as a result of being designated or identified as an audit committee financial expert; the designation or identification of a person as an audit committee financial expert does not impose on that person any duties, obligations or liabilities that are greater than the duties, obligations and liabilities imposed on that person as a member of the audit committee and board of directors in the absence of the designation or identification; and the designation or identification of a person as an audit committee financial expert does not affect the duties, obligations or liability of any other member of the audit committee or board of directors. Code of Ethics In contrast to the disclosure rules for audit committee financial experts, the final SEC rules concerning codes of ethics are generally similar to the proposed rules. The final rules require domestic and foreign reporting companies to: disclose whether or not they have adopted a code of ethics that covers specified senior officers and ethical issues, and if they have not, why not; file the code of ethics as an exhibit to their annual reports filed with the SEC or, alternatively, make it available on their Web sites or provide copies upon request; and disclose in a Form 8-K report or publicize on their Web sites any material amendments or waivers of the code of ethics. Disclosure Concerning Adoption of Code of Ethics. Companies must disclose each year in their annual reports filed with the SEC (Forms 10-K, 10-KSB, 20-F and 40-F) 4

5 whether or not they have adopted a code of ethics that covers the minimum criteria provided in SEC rules. Companies that have not adopted such a code of ethics must disclose why they have not done so. The final rules define the term code of ethics as written standards that are reasonably designed to deter wrongdoing and to promote: honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; full, fair, accurate, timely, and understandable disclosure in reports and documents that the company files with, or submits to, the SEC and in other public communications made by the company; compliance with applicable laws, rules and regulations; prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and accountability for adherence to the code. The final rules do not include the proposed requirement that the code of ethics promote avoidance of conflicts of interest. The SEC eliminated this element because the first element of the requirements covers the same conduct. In addition, the rules do not specify every detail that must be addressed in the code of ethics or prescribe any specific language, procedures or sanctions that must be included in the code of ethics. Scope of New Rules. To satisfy the new rules, the code of ethics must apply to the principal executive officer, the principal financial officer, and the principal accounting officer or controller, or persons performing similar functions. The code of ethics must also cover the ethical issues specified in the new rules. The rules do not require disclosure concerning codes of ethics applicable to directors or other officers, or other ethical issues. The new rules permit and the SEC encourages companies to adopt codes that apply to additional persons and/or cover additional ethical issues, but they do not require companies to do so. The new rules also permit companies to have separate codes of ethics for different types of officers. Public Availability of Codes of Ethics. If a company adopts a code of ethics that satisfies the disclosure requirements of the new rules, it must make the code of ethics available to the public. Like the disclosure requirement summarized above, this requirement applies only to the portion of a code of ethics that covers the specified officers and ethical issues. If the company adopts a broader or more comprehensive code of ethics, the new rules do not require it to make the entire text publicly available. Under the new rules, a company may make its code of ethics (or the relevant portion) available to the public in one of three ways: filing the code as an exhibit to its annual report filed with the SEC; posting the code on the part of its Web site normally used for investor relations, if the company has previously disclosed its intent to do so (and the Web site address) in its annual report filed with the SEC; or providing an undertaking in its SEC annual report to provide copies of the code on request to any person at no cost. Disclosure of Amendments and Waivers. The new rules require a company to disclose any amendment or waiver, including an implicit waiver, of the required elements of the code of ethics involving a covered officer. The rules permit a company to disclose these amendments and waivers in either of two ways: in a Form 8-K report filed within five business days (or, for foreign private 5

6 issuers, in their next SEC annual report); or on the company s investor relations Web site, if the company has previously disclosed in its most recently filed SEC annual report its intent to post this disclosure there and the internet address. If the company discloses this information on its Web site, it must make the disclosure available for at least twelve months. After the end of that twelve-month period, the company must retain the information for a period of at least five years. Importantly, the new rules define a waiver as the approval by the company of a material departure from a provision of the code of ethics. An implicit waiver is a failure by the company to take action within a reasonable period of time regarding a material departure from the code that has been made known to an executive officer of the company. The new rules do not require foreign private issuers to report amendments or waivers sooner than their next annual report filed with the SEC because they are not currently subject to any interim reporting requirements under SEC rules. However, the SEC has strongly encouraged more rapid disclosure of these events on a Form 6-K or on the foreign company s internet Web site. The Corporate Governance, Securities Litigation and M&A attorneys at Goodwin Procter keep current on these matters. We are available to help advise public companies and their officers and directors on specific issues as well as to provide educational presentations to help them understand and meet their responsibilities under both current and proposed rules and regulations. Please feel free to contact us either directly or through your regular Goodwin Procter contact if we may be of assistance. James A. Matarese, P.C. jmatarese@goodwinprocter.com Eric G. Kevorkian ekevorkian@goodwinprocter.com John O. Newell jnewell@goodwinprocter.com Andrew F. Viles, P.C. aviles@goodwinprocter.com L. Kevin Sheridan, Jr. ksheridan@goodwinprocter.com This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys Goodwin Procter LLP. All rights reserved.