Sarbanes-Oxley Act. The U.S. Sarbanes-Oxley Act of 2002: 2004 Update for Non-U.S. Issuers.

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1 Sarbanes-Oxley Act The U.S. Sarbanes-Oxley Act of 2002: 2004 Update for Non-U.S. Issuers

2 Sarbanes-Oxley REPORT September 1, 2004 The U.S. Sarbanes-Oxley Act of 2002: 2004 Update for Non-U.S. Issuers Alexander F. Cohen D. Jamal Qaimmaqami Introduction...1 Who is Subject to Sarbanes-Oxley?...1 When Does Sarbanes-Oxley Take Effect?...1 Key Provisions of Sarbanes-Oxley, and Related SEC Rulemaking...1 Certification Requirements...1 Section Section Differences Between Section 906 and Section 302 Certifications...3 Section 404 Internal Control Over Financial Reporting...3 Definition of Internal Control Over Financial Reporting...4 Management s Annual Assessment of, and Report on, Internal Control Item 15 of Form 20-F...4 Internal Control Audits Auditing Standard No Non-GAAP Financial Measures...8 Regulation G...8 Regulation S-K Item 10(e)...9 Off-Balance Sheet and Other MD&A Disclosure...10 Off-Balance Sheet Arrangements...10 Table of Contractual Obligations...10 Contingent Liabilities and Commitments...11 Standards Relating to Listed Company Audit Committees...11 Audit Committee Financial Expert...12 Auditor Independence...13 Improper Influence on the Conduct of Audits...14 Auditor Record Retention...14 Material Correcting Adjustments...15 Attorney Conduct Rules...15 Code of Ethics...16 Blackout Trading Restrictions...17 Loans to Executives...17 Forfeiture of Bonuses...18 Reseach Analysts...18 Liability Issues Relating to Sarbanes-Oxley...19 Conclusion and Contacts...20 Annex A Effective Dates for Certain Sarbanes-Oxley Sections and Related SEC Rulemaking...25 Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2004 Latham & Watkins. All Rights Reserved.

3 Introduction This update summarizes the key provisions of the U.S. Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act, Sarbanes-Oxley, or the Act ), and the U.S. Securities and Exchange Commission s (the SEC ) rules under the Act relevant to foreign private issuers (a term that covers most non-u.s. issuers, other than foreign governments). It is current through September 1, Who is Subject to Sarbanes-Oxley? The Sarbanes-Oxley Act applies to all issuers including foreign private issuers that: have registered securities under the U.S. Securities Exchange Act of 1934, as amended (the Exchange Act or the 1934 Act ); are required to file reports under Section 15(d) of the Exchange Act; or have filed a registration statement under the U.S. Securities Act of 1933, as amended (the Securities Act or the 1933 Act ) that has not yet become effective. 1 This means, for example, that any foreign private issuer that has listed its securities in the United States, or issued securities to the public in the United States whether or not listed (such as in a registered exchange offer for high-yield bonds) is subject to the Sarbanes-Oxley Act. A foreign private issuer that has not sold securities to the public in the United States, or that is exempt from Exchange Act registration by virtue of Exchange Act Rule 12g3-2(b) is not subject to the requirements of the Sarbanes-Oxley Act. Accordingly, when we refer below to issuers and foreign private issuers we mean those companies that are subject to Sarbanes-Oxley. Although the Sarbanes-Oxley Act does not generally distinguish between U.S. domestic and foreign private issuers, the SEC has, in its implementing rules, made various exceptions for the benefit of foreign private issuers. When Does Sarbanes-Oxley Take Effect? The Sarbanes-Oxley Act s provisions take effect at different times, ranging from immediately upon enactment to later dates specified in the Act or on which the required SEC implementing regulations come into force. Annex A lists the effective dates for certain key provisions of Sarbanes-Oxley and the related SEC rules. Key Provisions of Sarbanes-Oxley, and Related SEC Rulemaking Certification Requirements Sarbanes-Oxley contains two overlapping certifications that must be provided by an issuer s principal executive officer and principal financial officer, or persons performing similar functions (respectively, the CEO and CFO ): the Section 302 certification, and the Section 906 certification. Section 302 amends the Exchange Act, whereas Section 906 amends the U.S. federal criminal code. Section 302 Section 302(a) of the Sarbanes-Oxley Act directs the SEC to adopt rules requiring CEO and CFO certification of each annual or quarterly report filed by issuers. In response, the SEC has issued new 1934 Act Rules 13a-14 and 15d-14, and the text of a certification for annual reports on Form 20-F. 2 In addition, the SEC has adopted new 1934 Act Rules 13a-15 and 15d-15, as well as new Item 15 of Form 20-F, all dealing with disclosure controls and procedures. 3 These Rules, Item 15 and the certification text took effect on August 29, However, these Rules, Item 15 and the certification text have been further modified by the SEC s internal control rules adopted under Section 404 of the Sarbanes-Oxley Act. 5 As a result, we have summarized below the revised versions of the Rules, Item 15 and the certification text. The revised versions generally took effect August 14, 2003 (with certain exceptions that we note below). 6 Section 302 Certification Text 1934 Act Rules 13a-14, 15d-14; Form 20-F Rules 13a-14 and 15d-14 require a foreign private issuer s annual report on Form 20-F (but not its current reports on Form 6-K) 7 to include separate certifications by the issuer s

4 CEO and CFO. 8 The certifications must state that: 9 the officer has reviewed the annual report; based on the officer s knowledge, the annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading; based on the officer s knowledge, the financial statements, and other financial information included in the annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the issuer; the CEO and CFO are responsible for establishing and maintaining disclosure controls and procedures [and internal control over financial reporting 10 ] 11 for the issuer and have: N designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under their supervision, to ensure that material information relating to the issuer, including its consolidated subsidiaries, is made known to them by others within those entities; N [designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under their supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;] 12 N evaluated the effectiveness of the issuer s disclosure controls and presented in the annual report their conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by the report based on such evaluation; 13 and N disclosed in the report any change in the issuer s internal control over financial reporting that occurred during the period covered by the report that has materially affected, or is reasonably likely to materially affect, the issuer s internal control over financial reporting; and the CEO and CFO have disclosed, based on their most recent evaluation of internal control over financial reporting, to the issuer s auditors and the audit committee: N all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the issuer s ability to record, process, summarize and report financial information; and N any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer s internal control over financial reporting. These certifications must be included as an exhibit to the issuer s annual report on Form 20-F. 14 Except for the portions of the certifications appearing above in square brackets (which do not come into effect until July 15, 2005), the wording of the certifications may not be changed in any respect, even if the changes would appear to be inconsequential. 15 Disclosure Controls and Procedures 1934 Act Rules 13a-15 and 15d-15; Item 15(a) of Form 20-F Under Rules 13a-15 and 15d-15, a foreign private issuer must maintain disclosure controls and procedures. 16 In addition, as of the end of each fiscal year, the issuer s management, with the participation of the CEO and CFO, must make an evaluation of the effectiveness of the issuer s disclosure controls and procedures. 17 Finally, under Item 15a of Form 20-F, the issuer must disclose the conclusions of its CEO and CFO regarding the effectiveness of the disclosure controls and procedures based on their review as of the end of the period to which the report relates. 18 For the purposes of Rules 13a-15 and 15d-15, and Item 15(a) of Form 20-F (as well as the required certifications of Rules 13a-14 and 15d-14), disclosure controls and procedures means controls and other procedures of an 2 The U.S. Sarbanes-Oxley Act of 2002

5 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 Exchange Act is (1) timely recorded, processed, summarized and reported and (2) accumulated and communicated to the issuer s management, to allow for timely decisions about disclosure. 19 not attract liability under Section 18 of the Exchange Act or be incorporated by reference into the issuer s subsequent Securities Act registration statements (unless specifically incorporated by the issuer). 20 As with the Section 302 certification, the Section 906 certification is not required for current reports on Form 6-K. 21 Violations of Section 302 While Section 302 carries no criminal sanctions, false certifications are subject to SEC enforcement action for violating the Exchange Act and also possibly to both SEC and private litigation alleging violations of the anti-fraud provisions of the Exchange Act (e.g., Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5). A false certification also may have liability consequences under Sections 11 and 12(a)(2) of the Securities Act if the accompanying report is incorporated by reference into a registration statement (e.g., on Form F-3) or into a prospectus. Section 906 Section 906, which added new Section 1350 to the U.S. federal criminal code, took effect immediately upon enactment of the Sarbanes-Oxley Act on July 30, Section 906 requires that each periodic report containing financial statements filed by an issuer must be accompanied by a certification by the issuer s CEO and CFO that: the periodic report fully complies with the requirements of Section 13(a) or Section 15(d) of the Exchange Act; and the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer. Although Section 906 is selfimplementing, the SEC has adopted 1934 Act Rules 13a-14(b) and 15d- 14(b) to require that the Section 906 certification (which may be a joint certification of the CEO and CFO) must be provided, and must be furnished as an exhibit to the relevant periodic report. Because the Section 906 certification is not considered filed as a technical matter, it would Violations of Section 906 Under Section 906, an officer who certifies a statement knowing that the periodic report accompanying the statement does not meet the certification can be fined not more than $1 million or imprisoned for not more than 10 years, or both. By contrast, an officer who willfully certifies his or her written statement while knowing that the annual report does not comport with all the requirements of Section 906 can be fined not more than $5 million or imprisoned not more than 20 years, or both. The distinction between knowing and willful certification is not set out in the Sarbanes-Oxley Act, but in other contexts willfully normally requires a showing that the person had specific knowledge of the law he or she was violating, whereas knowingly does not. 22 Differences Between Section 906 and Section 302 Certifications Although the text of the two required certifications overlap, there are some important differences between them. In contrast to the Section 302 certification, the text of the Section 906 certification does not explicitly provide for the officer to certify as to his or her knowledge. The U.S. Department of Justice has, however, confirmed that an officer may qualify a Section 906 certification to his or her knowledge because knowledge would, in any event, be a necessary element of criminal prosecution. 23 Furthermore, whereas the Section 302 certification is required for any amendment to an annual report on Form 20-F, the SEC has stated that Form 20-F amendments do not require a new Section 906 certification. 24 Section 404 Internal Control Over Financial Reporting Section 404 of Sarbanes-Oxley directs the SEC to issue rules requiring an Update for Non-U.S. Issuers

6 Section 404 of Sarbanes-Oxley deals with internal controls over financial reporting. It is one of the most far-reaching aspects of the Act. issuer s annual report to contain an internal control report (1) stating management s responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and (2) containing an assessment, as of the end of the issuer s most recent fiscal year, of the effectiveness of the issuer s internal control structure and procedures for financial reporting. In addition, Section 404 requires an issuer s independent auditor to attest to, and report on, management s assessment, in accordance with standards adopted by the U.S. Public Company Accounting Oversight Board (the PCAOB ). (Section 404 provides, however, that the attestation cannot be a separate engagement of the auditor.) The SEC has accordingly adopted new Rules 13a-15 and 15d-15 under the Exchange Act, and new Item 15 of Form 20-F, and the PCAOB has adopted Auditing Standard No Rules 13a-15 and 15d-15 require a foreign private issuer: to maintain internal control over financial reporting; to evaluate (with the participation of the CEO and CFO) the effectiveness of internal control as of the end of each fiscal year; and to evaluate (with the participation of the CEO and CFO) any change in its internal control that occurred during the fiscal year that has materially affected, or is reasonably likely to materially affect, the issuer s internal control over financial reporting. A foreign private issuer must comply with Rules 13a-15 and 15d-15, as they pertain to internal control over financial reporting, for the first fiscal year ending on or after July 15, In addition to the requirements relating to disclosure controls and procedures, new Item 15 of Form 20-F (discussed in more detail below) also requires an annual report from management on internal control, an attestation report of the issuer s independent auditor and the disclosure of any changes in internal control. A foreign private issuer must comply with these requirements of new Item 15 in connection with its annual report on Form 20-F for the first fiscal year ending on or after July 15, 2005, except with respect to the disclosure of changes in internal control which took effect as of August 14, Definition of Internal Control Over Financial Reporting For purposes of Rules 13a-15 and 15d- 15, and Item 15 of Form 20-F (as well as the required Section 302 certification), internal control over financial reporting is defined as a process designed by, or under the supervision of, the issuer s CEO and CFO, and effected by the issuer s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer s assets that could have a material effect on the financial statements. 27 Management s Annual Assessment of, and Report on, Internal Control Item 15 of Form 20-F In an issuer s annual report on Form 20-F, management must provide a report on the issuer s internal control over financial reporting that contains, among other things: 28 a statement of management s responsibility for establishing and maintaining adequate internal control over financial reporting; 4 The U.S. Sarbanes-Oxley Act of 2002

7 a statement identifying the framework used by management to evaluate the effectiveness of the issuer s internal control over financial reporting; management s assessment of the effectiveness of the issuer s internal control over financial reporting as of the end of the most recent fiscal year, including a statement as to whether or not the issuer s internal control over financial reporting is effective. The statement must also include disclosure of any material weakness in the issuer s internal control over financial reporting identified by management. Management is not permitted to conclude that the issuer s internal control over financial reporting is effective if there are one or more material weaknesses in internal control; 29 and a statement that the independent auditor that audited the financial statements included in the annual report has issued an attestation report on management s assessment of the issuer s internal control over financial reporting. In addition, a foreign private issuer must also include: an attestation report of the independent auditor on management s assessment of the issuer s internal control over financial reporting; and disclosure of any change in its internal control over financial reporting that occurred during the fiscal year that has materially affected, or is reasonably likely to materially affect, the issuer s internal control over financial reporting. 30 With the exception of the disclosure of changes in internal control over financial reporting, which took effect as of August 14, 2003, a foreign private issuer need not comply with the above requirements of Item 15 until its annual report on Form 20-F for its first fiscal year ending on or after July 15, Framework for Evaluation The SEC has not required the use of a particular framework. It has, however, specified that management s evaluation must be based on a recognized control framework established by a body or group that has followed due-process procedures, including a broad distribution of the framework for public comment. 32 The Committee of Sponsoring Organizations of the Treadway Commission s Internal Control Integrated Framework, the Canadian Institute of Chartered Accountant s The Guidance on Assessing Control, and the Institute of Chartered Accountants in England and Wales Turnbull Report are all approved frameworks. 33 The framework must: 34 be free from bias; permit reasonably consistent qualitative and quantitative measures of an issuer s internal control; be sufficiently complete so that those relevant factors that would alter a conclusion about the effectiveness of an issuer s internal controls are not omitted; and be relevant to an evaluation of internal control over financial reporting. Auditor Independence Although management may coordinate its evaluation of internal controls with that of its auditors, it cannot compromise the auditors independence. 35 Auditors may assist management in documenting internal controls, but management must be actively involved in the documentation process. In addition, management cannot delegate its responsibilities to assess internal control to the auditor. Material Weaknesses Management may not determine that an issuer s internal control over financial reporting is effective if it identifies one or more material weaknesses in the issuer s internal control. The term material weaknesses for these purposes has the same meaning as under the auditing standards of the PCAOB Update for Non-U.S. Issuers

8 Method of Evaluation The SEC has not specified a method or procedures to be followed in the evaluation. An issuer must, however, maintain evidential matter, including documentation to provide reasonable support for management s assessment of the issuer s internal control over financial reporting. 36 The assessment must be based on procedures sufficient Management is not permitted to conclude that the issuer s internal control over financial reporting is effective if there are one or more material weaknesses in internal control. both to evaluate design and to test operating effectiveness. Controls that are subject to assessment include: controls over initiating, recording, processing and reconciling account balances, classes of transactions and disclosure and related assertions included in the financial statements; controls related to the initiation and processing of non-routine and non-systematic transactions; controls related to the selection and application of appropriate accounting policies; and controls related to the prevention, identification and detection of fraud. The SEC has cautioned that inquiry alone generally will not provide an adequate basis for management s assessment. Changes in Internal Control There is no explicit requirement in the rules under Section 404 to disclose the reasons for any changes in internal control (as opposed to the existence of those changes). The SEC has noted, however, that an issuer must consider whether the anti-fraud provisions of the U.S. federal securities laws would require that disclosure, together with other information about the circumstances surrounding the change. 37 Certain Internal Control Issues In June 2004, the SEC issued answers to certain frequently asked questions regarding management s report over internal control (the 2004 FAQ ). 38 Under the 2004 FAQ: Equity investees: an issuer must have controls over the recording of amounts related to its investment that are recorded in its consolidated financial statements, although it need not evaluate the recording of transactions into the investee s accounts. 39 Material business combinations: if an issuer consummates a material business combination during a fiscal year and is unable to conduct an assessment of the acquired business s internal control during the period between the consummation date and the date of management s assessment, it may omit an assessment of the acquired business s internal control for not more than one year from the date of acquisition (and must make certain disclosure about the acquired business and the effect of the acquisition on the issuer s internal control). 40 Qualifications: management may not qualify its conclusion about the effectiveness of an issuer s internal control, and may not conclude that internal control is effective if a material weakness exists. Instead, management may state that controls are ineffective for specific reasons. 41 Initial internal control report: management need not disclose changes or improvements made in preparation for the first internal control report, although the SEC cautioned that if the issuer were to identify a material weakness it should carefully consider whether that fact should be disclosed, as well as changes made in response to the material weakness. 42 Subsequent internal control reports: after an issuer s first management report on internal control, it is required to identify and disclose material changes in internal control in its annual report on Form 20-F. This would include discussing a material change (including an improvement) even if it was not in 6 The U.S. Sarbanes-Oxley Act of 2002

9 response to an identified significant deficiency or material weakness. 43 Compliance with law: although general legal compliance is not part of internal control (as opposed to compliance with laws relating to the preparation of financial statements), an issuer must evaluate whether it has adequate controls to ensure that the effect of non-compliance with law is recorded in the issuer s financial statements. An evaluation of compliance with law is instead required as part of management s evaluation of disclosure controls and procedures. In particular, management must evaluate whether the issuer adequately monitors compliance and has appropriate disclosure controls and procedures to ensure that required disclosure of legal or regulatory matters is provided. 44 Disclosure of significant deficiencies: an issuer must identify and publicly disclose all material weaknesses. If management identifies a significant deficiency, it is not obligated to disclose publicly the existence or nature of the significant deficiency. If, however, management identifies a significant deficiency that, when combined with other significant deficiencies, is determined to be a material weakness, management must disclose the material weakness (and the significant deficiency to the extent needed to understand the material weakness). In addition, if a material change is made to either internal control or disclosure controls and procedures in response to a significant deficiency, the issuer should disclose the change and consider whether a discussion of the significant deficiency is needed. 45 Internal Control Audits Auditing Standard No Auditing Standard No. 2 sets out the PCAOB s rules for the independent auditor s attestation report on management s assessment of internal control over financial reporting as required by Section 404, Rules 13a-15 and 15d-15 and Item 15 of Form 20-F. Under Auditing Standard No. 2, the independent auditor s audit (the PCAOB chose to refer to an audit rather than an attestation ) 47 takes the form of an auditor s report which includes two opinions: one on management s assessment of internal control and another on the effectiveness of internal control over financial reporting. The PCAOB stated that the objective of the audit of internal control over financial reporting is to form an opinion as to whether management s assessment of the effectiveness of the issuer s internal control over financial reporting is fairly stated in all material respects. 48 The auditor s conclusion will therefore relate directly to whether the auditor can agree with management that internal control is effective. 49 In this connection, the auditor needs to evaluate management s assessment process (to ensure that management has an appropriate basis for its conclusion) and to test the effectiveness of internal control. 50 Significant Deficiencies and Material Weaknesses Under Auditing Standard No. 2, both management and the auditor may identify deficiencies in internal control over financial reporting. 51 A control deficiency exists when the design or operation of a control does not allow the company s management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. 52 Auditing Standard No. 2 provides that a control deficiency should be classified as a significant deficiency if, by itself or in combination with other control deficiencies, it results in more than a remote likelihood of a misstatement of the company s annual or interim financial statements that is more than inconsequential will not be prevented or detected. 53 In addition, a significant deficiency should be classified as a material weakness if, by itself or in combination with other control deficiencies, it results in more than a remote likelihood that a material misstatement in the company s annual or interim financial statements will not be prevented or detected. 54 Auditing Standard No. 2 mandates that an auditor must communicate in writing to the audit committee all Update for Non-U.S. Issuers

10 Auditing Standard No. 2 does not permit a qualified opinion on the effectiveness of internal control in the event of a material weakness; instead, the auditor must express an adverse opinion. significant deficiencies and material weaknesses of which the auditor is aware. 55 In addition, the auditor must communicate to management, in writing, all control deficiencies of which the auditor is aware that have not previously been communicated in writing to management and to notify the audit committee of such a communication. 56 Identifying Significant Deficiencies Auditing Standard No. 2 identifies a number of circumstances that, because of their likely significant negative effect on internal control are significant deficiencies as well as strong indicators that a material weakness exists. 57 These include: 58 ineffective oversight by the audit committee of the issuer s external financial reporting and internal control. As part of evaluating the control environment, an auditor must assess the effectiveness of the audit committee s oversight and must communicate to the board of directors if it concludes that oversight is ineffective; material misstatement in the financial statements not initially identified by the issuer s internal control. Failure to detect the misstatement is a strong indicator that the company s internal control is ineffective; and significant deficiencies that have been communicated to management and the audit committee, but that remain uncorrected after reasonable periods of time. Auditor s Report Under Auditing Standard No. 2, the auditor s report includes two opinions: one on management s assessment of internal control and another on the effectiveness of internal control. 59 An auditor may express an unqualified opinion if it has identified no material weaknesses. 60 If the auditor cannot perform all of the necessary procedures, the auditor may either qualify or disclaim an opinion. 61 If an overall opinion cannot be expressed, Auditing Standard No. 2 requires the auditor to explain why. 62 The auditor s report may disclose only material weaknesses, although if an aggregation of significant deficiencies constituted a material weakness, then disclosure would be required. 63 Auditing Standard No. 2 does not permit a qualified opinion on the effectiveness of internal control in the event of a material weakness; instead, the auditor must express an adverse opinion. 64 The auditor may express an unqualified opinion on management s assessment (but not on the effectiveness of internal control) so long as management properly identifies the material weakness and concludes that internal control was not effective. 65 If, however, the auditor and management disagree about the existence of the material weakness, then the auditor would render an adverse opinion on management s assessment. 66 Non-GAAP Financial Measures Section 401(b) of the Sarbanes-Oxley Act requires the SEC to issue rules limiting the use of pro forma financial information in various ways. In response, the SEC has adopted both a new disclosure regulation, Regulation G, and new rules applicable to disclosure in filings with the SEC under Item 10 of Regulation S-K. 67 The SEC has chosen to refer in the rules to non-gaap financial measures rather than pro forma financial information, to avoid confusion with existing SEC rules on pro forma financial information (such as Article 11 of Regulation S-X). 68 Regulation G Regulation G applies whenever an issuer, or a person acting on its behalf, publicly discloses material information that includes a non- GAAP financial measure. 69 The term non-gaap financial measure is broadly defined as a numerical measure of financial performance that excludes (or includes) amounts that are otherwise included (or excluded) in the comparable measure calculated and presented in the financial statements under GAAP. 70 For a foreign private issuer, GAAP means the local GAAP under which the financial statements were prepared, unless the measure in question is derived from U.S. GAAP, in which case GAAP means U.S. GAAP for purposes of applying the 8 The U.S. Sarbanes-Oxley Act of 2002

11 requirements of Regulation G to the disclosure of the measure. 71 The term non-gaap financial measure does not include: 72 operating or other financial measures and ratios or statistical measures calculated using exclusively one or both of (1) financial measures calculated in accordance with GAAP and (2) operating measures or other measures that are not non-gaap financial measures; or financial measures required to be disclosed by GAAP, SEC rules or other regulations applicable to the issuer. Regulation G requires that disclosure of this sort be accompanied by the most directly comparable financial measure calculated in accordance with GAAP, and a reconciliation of the differences between the two. 73 In addition, Regulation G prohibits an issuer from making any non-gaap financial measure public if it contains a material misstatement or omits to include information needed to make the included measure not misleading. 74 Regulation G took effect on March 28, A foreign private issuer is exempt from Regulation G if: 76 its securities are listed or quoted outside the United States; the non-gaap financial measure being used is not derived from or based on a measure calculated and presented in accordance with U.S. GAAP; and the disclosure is made outside the United States. Regulation S-K Item 10(e) Distinct from Regulation G, the SEC has adopted limitations on the use of non-gaap financial measures in filings (whether annual reports on Form 20-F, or registration statements in connection with offerings in the U.S. or U.S. listings) as new Item 10(e) of Regulation S-K. For purposes of Item 10(e), the term non-gaap financial measures has the same meaning as under Regulation G. Item 10(e) applies to any SEC filings made in respect of financial years ended after March 28, Item 10(e) requires that whenever an issuer includes a non-gaap financial measure in an SEC filing it must also include: 78 a presentation, with equal or greater prominence, of the most directly comparable GAAP financial measure; a reconciliation of the differences between the non-gaap financial measure and the most directly comparable GAAP financial measure; a statement why management believes the non-gaap financial measure provides useful information for investors; and to the extent material, a statement of the additional purposes for which management uses the non-gaap financial measure. Furthermore, Item 10(e) prohibits in SEC filings, among other things: 79 non-gaap measures of liquidity that exclude items requiring cash settlement, other than EBIT and EBITDA; the adjustment of non-gaap measures of performance to eliminate or smooth items characterized as non-recurring, unusual or infrequent when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years; and the use of titles or descriptions for non-gaap financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures. Item 10(e) contains an exemption from these prohibitions for a foreign private issuer if the non-gaap financial measure relates to the local GAAP used in the issuer s primary financial statements, is required or expressly permitted by the standard-setter that establishes the local GAAP, and is included in the issuer s annual report for its home jurisdiction. 80 The SEC has cautioned that inclusion of a non-gaap financial measure may Update for Non-U.S. Issuers

12 Audit committees are a key area of corporate governance addressed by the Act. be misleading unless accompanied by disclosure as to: 81 the manner in which management uses the non-gaap measure to conduct or evaluate its business; the economic substance behind management s decision to use such a measure; the material limitations associated with the use of the non-gaap financial measure as compared to the use of the most directly comparable GAAP financial measure; the manner in which management compensates for these limitations when using the non-gaap financial measure; and the substantive reasons why management believes the non-gaap financial measure provides useful information to investors. The SEC has also stated that earnings as used in EBIT and EBITDA is intended to mean net income as presented in the statement of operations under GAAP, and that measures that are calculated differently should not be characterized as EBIT or EBITDA. 82 To the extent EBIT or EBITDA are presented as a performance measure, the term should be reconciled to net income and not operating income. 83 Off-Balance Sheet and Other MD&A Disclosure Section 401(a) of the Sarbanes-Oxley Act requires the SEC to implement rules requiring issuers to disclose material off-balance sheet transactions. The SEC s rules go beyond off-balance sheet transactions, however, and also address certain topics covered in its prior MD&A initiatives. 84 The rules take the form of amendments to Item 5 of Form 20-F, and accordingly apply to all registration statements filed by foreign private issuers (whether under the Securities Act or Exchange Act), as well as annual reports. Off-Balance Sheet Arrangements Effective for SEC filings for fiscal years ending on or after June 15, 2003, 85 an issuer must disclose, in a separately captioned section of MD&A, offbalance sheet arrangements that either have, or are reasonably likely to have, a current or future material effect on the issuer s financial condition, results of operations, or liquidity. 86 To the extent necessary to understand these arrangements, the disclosure must include: 87 the nature and business purpose of the off-balance sheet arrangements; the importance to the issuer of the off-balance sheet arrangements in respect of liquidity, capital resources, market risk support, credit support or other benefits; the amount of revenues, expenses and cash flows arising from these arrangements; the nature and amounts of any interests retained, securities issued or amounts incurred by the issuer under these arrangements; the nature and amounts of any other obligations or liabilities (contingent or otherwise) arising from these arrangements that are reasonably likely to become material and the triggering events that could cause them to arise; and any known events or trends that will, or are reasonably likely to, result in the termination or reduction in availability to the issuer of these arrangements and the course of action the issuer proposes to take in response. An off-balance sheet arrangement is defined to include any transaction, agreement or contractual arrangement to which an entity unconsolidated with the issuer is a party under which the issuer has certain obligations or interests. 88 Because the definition of off-balance sheet arrangement incorporates concepts from U.S. GAAP, foreign private issuers will need to refer to U.S. GAAP for some of the disclosure items. 89 However, the MD&A disclosure should focus on the primary financial statements in the document (while taking reconciliation to U.S. GAAP into account). 90 Table of Contractual Obligations For fiscal years ending on or after December 15, 2003, 91 an issuer must also include in its SEC filings a table of contractual obligations as of the end of the latest balance sheet date showing the following items: The U.S. Sarbanes-Oxley Act of 2002

13 Contractual Obligations Payments due by Period Total Less than More than 1 year years years 5 years Long-Term Debt Obligations Capital (Finance) Lease Obligations Operating Lease Obligations Purchase Obligations Other Long-Term Liabilities Reflected on the Issuer s Balance Sheet under the GAAP of the Primary Financial Statements Total The term purchase obligations means an enforceable agreement to purchase goods or services that is binding on the issuer and that specifies key commercial terms (such as quantity and price). 93 With the exception of purchase obligations, the classifications of categories shown in the table are defined by reference to U.S. GAAP. However, an issuer that prepares financial statements in accordance with non-u.s. GAAP should include those items of contractual obligations in the table that are consistent with the classifications used in the GAAP under which its primary financial statements are prepared. 94 Contingent Liabilities and Commitments Although it issued proposed rules with respect to disclosure requirements for contingent liabilities and commitments, the SEC declined to adopt final rules. In the meantime, the SEC s existing guidance on the subject which suggests a tabular format of specified categories 95 is controlling. 96 Standards Relating to Listed Company Audit Committees Section 301 of the Sarbanes-Oxley Act adds new Section 10A(m) of the Exchange Act. Section 10A(m) charges the SEC with creating rules to prohibit the listing of any security in the United States of an issuer that is not in compliance with certain substantive standards for audit committees. The SEC has adopted final rules under Section 301 as Exchange Act Rule 10A-3. Listed foreign private issuers must be in compliance with Rule 10A-3 by July 31, Under Rule 10A-3, audit committee members each have to be a member of the board of directors and otherwise independent. 98 To be independent, an audit committee member is barred from accepting any compensatory fees other than in that member s capacity as a member of the board 99 and may not be an affiliated person of the issuer. 100 The definition of affiliated person includes a person that, directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with the specified person. 101 There is, however, a safe harbor for certain non-executive officers and other persons that are 10% or less shareholders of the issuer. 102 Foreign private issuers are entitled to certain exemptions from the independence prong of Rule 10A-3. For example, the inclusion of a nonmanagement employee representative, 103 a non-management affiliated person with only observer status, 104 or a non-management governmental representative on the audit committee will not violate the affiliated person prong of the independence test. 105 In addition, issuers involved in an IPO are entitled to certain exemptions during a transitional period following their public offering. 106 Rule 10A-3 also requires that: the audit committee must be directly responsible for the appointment, compensation, Update for Non-U.S. Issuers

14 oversight and retention of the external auditors, who must report directly to the audit committee; 107 the audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal controls or auditing matters, and for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters; 108 the audit committee must have the authority to engage independent counsel and other advisors as it deems necessary to carry out its duties; 109 and the issuer must provide the audit committee with appropriate funding for payment of external auditors, advisors employed by the audit committee and ordinary administrative expenses of the audit committee. 110 These requirements are not intended to conflict with local legal or listing provisions (or requirements under the foreign private issuer s organizational documents), and instead relate to the allocation of responsibility between the audit committee and the issuer s management. 111 Accordingly, the audit committee may recommend or nominate the appointment or compensation of the external auditor to shareholders if these matters are within shareholder competence under local law, 112 and it must be granted those responsibilities that the board of directors can legally delegate. 113 Rule 10A-3 contains a general exemption for foreign private issuers that have a statutory board of auditors or statutory auditors established pursuant to home country law or listing requirements, which in turn meet various requirements. 114 A foreign private issuer relying on Rule 10A-3 s exemption from independence, or the general exemption noted above, will need to disclose in its annual report its reliance on the exemptions and an assessment of whether this reliance will materially adversely affect the audit committee s ability to act independently and to satisfy any of the other requirements of Rule 10A Audit Committee Financial Expert Section 407(a) of the Sarbanes-Oxley Act directs the SEC to issue rules requiring an issuer to disclose in its periodic reports whether its audit committee has at least one financial expert or if not, why not. The SEC s final rules implementing Section 407(a) use the term audit committee financial expert instead of financial expert. The SEC has implemented these rules as new Item 16A of Form 20-F. Item 16A applies to annual reports of foreign private issuers for fiscal years ending on or after July 15, Under Item 16A, a foreign private issuer must disclose in its annual report that the issuer s board of directors has determined whether or not it has one audit committee financial expert serving on its audit committee, or if not, why not. 117 If the issuer has a two-tier board of directors, the supervisory or nonmanagement board would make this determination. 118 The issuer must also disclose the name of the audit committee financial expert (if any) 119 and, effective as of July 31, 2005, whether that person is independent from management. 120 An issuer s board of directors must make an affirmative determination whether or not it has at least one audit committee financial expert, and may not simply fail to reach a conclusion. 121 In order to qualify as an audit committee financial expert, the audit committee member must have the following attributes: 122 an understanding of GAAP; the ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves; experience preparing, auditing or analyzing financial statements similar to those of the issuer, or actively supervising others engaged in these activities; an understanding of internal controls and procedures for financial reporting; and an understanding of audit committee functions. 12 The U.S. Sarbanes-Oxley Act of 2002

15 In addition, an audit committee financial expert must have gained those attributes through: 123 education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor, or experience in similar positions; experience actively supervising these 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 term GAAP as used in Item 16A refers to the body of GAAP used by the issuer in its primary financial statements. 124 Accordingly, the audit committee financial expert of a foreign private issuer need only be versed in local GAAP, and not in U.S. GAAP or in reconciliation to U.S. GAAP (although that experience would, of course, be useful). 125 Item 16A also contains a liability safe harbor for the audit committee financial expert, under which: a person who is determined to be an audit committee financial expert is not deemed to be an expert for any purpose, such as Section 11 of the Securities Act; and 126 the designation of a person as an audit committee financial expert does not impose greater duties, obligations or liabilities on the person than on other audit committee and board members, and does not affect the duties, obligations or liabilities of other audit committee and board members. 127 Auditor Independence Title II of the Sarbanes-Oxley Act creates a series of requirements relating to the work of external auditors, grouped under the heading auditor independence. Title II establishes new Sections 10A(g) through (l) of the Exchange Act. The SEC has implemented Title II by the adoption of amendments to Regulation S-X ( S-X ) Rule 2-01, new S-X Rule 2-07, new 1934 Act Rule 10A2, and new Item 16C of Form 20-F. S-X Rules 2-01 and 2-07, and Rule 10A-2, generally took effect on May 6, 2003 (although many of the provisions of these rules have varying transition periods), while Item 16C took effect for annual reports in respect of fiscal years ending after December 15, Rule 10A-2 provides generally that it is unlawful for an auditor not to be independent under certain provisions of S-X Rules 2-01 and S-X Rules 2-01 and 2-07, in turn, track and in some cases expand upon the requirements of Sections 10A(g)-(l), and provide (among other things): an issuer may not employ a former partner, principal, shareholder or professional employee of an accounting firm in a financial reporting oversight role at the issuer if the individual was a member of the audit engagement team during the one-year period preceding the date audit procedures commenced for the fiscal period that included the date of initial employment of the audit engagement team member by the issuer; 129 limitations on the non-audit services that an independent auditor may provide; 130 that an audit partner must not act as the lead audit partner or concurring partner for more than five consecutive years, and must not provide certain other services for more than seven consecutive years; 131 that the audit committee must preapprove the engagement of the auditor to provide audit and nonaudit services to the issuer or its subsidiaries, or for policies or procedures for pre-approval of audit and non-audit services (subject to certain de minimis exceptions); 132 that no audit partner may earn compensation based on the partner s procuring engagements with the issuer to provide any services other than audit, review or attest services; 133 and that an auditor must report to the audit committee on (1) all critical accounting policies and practices to be used, (2) all alternative treatments of financial information within GAAP that have been discussed with the issuer s management (as well as the implications of those alternatives and the auditor s preferred Update for Non-U.S. Issuers

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