In January the Securities and Exchange Commission

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1 February 7, 2003 I NVESTMENT M ANAGEMENT A LERT SEC Adopts Financial Expert Regulations In January the Securities and Exchange Commission (the SEC ) adopted final regulations implementing public disclosure requirements for audit committee financial experts as required by the Sarbanes-Oxley Act of 2002 (the Act ). SEC Release Nos and Investment companies ( funds ) must comply with these new disclosure requirements in annual reports filed for fiscal years ending on and after July 15, In adopting the new regulations, the SEC noted that its proposed definition of financial expert proved to be the most controversial aspect of its proposals more commenters remarked on it than on any other topic. Most of the commenters thought that the proposed definition was too restrictive. In response to these comments, the SEC made several significant changes to broaden its definition. The SEC also changed the term financial expert to audit committee financial expert. The SEC believed that the term audit committee financial expert suggests more pointedly that the designated expert should have characteristics that are particularly relevant to the functions of an audit committee, such as a thorough understanding of the audit committee s oversight role; expertise in accounting matters as well as understanding of financial statements; and the ability to ask the right questions to determine whether a fund s financial statements are complete and accurate. The principal provisions of the new regulations are set forth below in italics, followed by commentary taken from the SEC s releases. As noted in our November 12, 2002 Investment Management Alert, although a fund will not be required to have an audit committee financial expert, a fund will be required to disclose publicly on an annual basis whether or not it has such an expert. Fund boards will want to begin considering these matters now in preparation for the July compliance date. D ETERMINATIONS BOARD A fund s board of trustees must determine whether the fund has an audit committee financial expert. A fund s board of trustees, in its entirety, must determine whether or not it has at least one audit committee financial expert. A fund will not satisfy its disclosure requirement by stating that the board has decided not to make a determination or by simply disclosing the qualifications of all of the audit committee members. Moreover, if a fund s board determines that at least one of the audit committee members qualifies as an expert, the fund must disclose this fact. It will not be appropriate for a fund to disclose that it does not have an audit committee financial expert if its board has determined that such an expert serves on the audit committee. DISCLOSURE OF N AME AND I NDEPENDENCE OF E XPERT If a fund has an audit committee financial expert, then the fund must disclose annually on new SEC Form N-CSR the name of the audit committee financial expert and whether that person is independent. In order to be independent, a member of an audit committee may not, other than in his or her capacity as a member of the audit committee, the board of trustees, or other board committee: Investment Management Alert February 7, 2003

2 1. Accept directly or indirectly any consulting, advisory or other compensatory fee from the fund; or 2. Be an interested person of the fund as defined in Section 2(a)(19) of the Investment Company Act of If a fund s board of trustees determines that the fund has more than one audit committee financial expert serving on its audit committee, the fund may, but is not required to, disclose the names of those additional persons. If these additional persons are named, however, then the fund must indicate whether they are independent. Form N-CSR is a new periodic reporting form that will be filed by funds with the SEC and will be available to the public. The SEC believes that annual disclosure of the name of the audit committee financial expert in Form N-CSR will benefit investors and that omission of the expert s name ultimately would not result in the expert s identity remaining non-public. Once a fund s board of trustees determines that a particular audit committee member qualifies as an audit committee financial expert, it may, but is not required to, determine whether additional audit committee members also qualify as experts. E XPERT DISCLOSURE IF N O If a fund does not have an audit committee financial expert, then the fund must disclose this fact annually on new SEC Form N-CSR and explain why it does not have an audit committee financial expert. As noted previously, if a fund does not have an audit committee financial expert, it must disclose and explain this fact. In this regard, the SEC believes that a fund may not disclose that it has an audit committee financial expert by virtue of the fact that the audit committee members collectively possess all of the attributes of an expert. Rather, the SEC believes that there is no doubt that Congress had in mind individual experts and did not contemplate a collective expert. The SEC believes, however, that it would be appropriate for a fund disclosing that it does not have an audit committee financial expert to explain the aspects of the definition that various members of the committee satisfy. REQUIRED ATTRIBUTES OF E XPERT A person designated as an audit committee financial expert must have all of the following five attributes: 1. An understanding of generally accepted accounting principles and financial statements; 2. The ability to assess the general application of such accounting principles in connection with the accounting for estimates, accruals and reserves; 3. 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 a fund s financial statements, or experience in actively supervising one or more persons engaged in such activities; 4. An understanding of internal controls and procedures for financial reporting; and 5. An understanding of audit committee functions. The SEC adopted Attributes (1) and (5) above substantially as proposed. Investment Management Alert February 7, 2003 Page 2

3 The SEC revised Attribute (2) above to require that an audit committee financial expert have the ability to assess the general application of generally accepted accounting principles in connection with the accounting for estimates, accruals and revenues, rather than experience in applying these principles. In making this change, the SEC recognized that under its proposed regulations the pool of persons possessing highly specialized technical knowledge of accounting principles might be very small. The SEC did not intend this result. Under Attribute (2) as adopted an audit committee financial expert must be able to assess the general application of generally accepted accounting principles in connection with accounting for estimates, accruals and reserves, in contrast to the more industry-specific standard that the SEC originally proposed. In the SEC s view, this more general standard will provide the necessary background for an audit committee when addressing more detailed industryspecific standards or other particular topics. Experience with such detailed standards or topics is not a necessary attribute of an audit committee financial expert. Attribute (3) above has been revised substantially. The SEC was convinced by the comments it received that its proposed requirement that an expert have direct experience preparing or auditing financial statements was too burdensome. The SEC was also persuaded that persons who have experience preparing in-depth analysis and evaluation of financial statements should not be precluded from being able to qualify as audit committee financial experts. The SEC therefore broadened its requirements to provide that an audit committee financial expert must have experience preparing, auditing, analyzing or evaluating financial statements. These revisions are intended to express the intent that an audit committee financial expert must have experience actually working directly and closely with financial statements in a way that provides familiarity with the contents of financial statements and the processes behind them. The SEC specifically recognized that many people actively engaged in industries such as investment banking and venture capital investment have significant direct and close exposure to, and experience with, financial statements and related processes. Similarly, professional financial analysts closely scrutinize financial statements on a regular basis. In the SEC s view, all of these types of individuals often hold positions that require them to inspect financial statements with a healthy dose of skepticism. They therefore would be well prepared, according to the SEC, to diligently and zealously question management and the fund s auditors about a fund s financial statements. In addition, the SEC recognized that a potential audit committee financial expert should be considered to possess Attribute (3) by virtue of his or her experience actively supervising a person who prepares, audits, analyzes or evaluates financial statements. The term active supervision means more than the mere existence of a traditional hierarchical reporting relationship between supervisor and those being supervised. Rather, a person engaged in active supervision must participate in, and contribute to, the process of addressing, albeit at a supervisory level, the same general types of issues regarding preparation, auditing, analysis or evaluation of financial statements as those addressed by the person or persons being supervised. The supervisor should have experience that has contributed to the general expertise necessary to prepare, audit, analyze or evaluate financial statements that is at least comparable to the general expertise of those being supervised. A principal executive officer should not be presumed to qualify. A principal executive officer with considerable operations involvement, but little financial or accounting involvement, likely would not be exercising the necessary active supervision. Active participation in, and contribution to, the process, albeit at a supervisory level, or addressing financial and accounting issues that demonstrates a general expertise in the area, would be necessary. With respect to Attribute (4) above, the SEC has substituted the word understanding for experience. In the SEC s view, it is necessary that the audit committee financial expert understand the purpose, and be able to evaluate the effectiveness, of a company s internal controls and procedures for financial reporting. It is Investment Management Alert February 7, 2003 Page 3

4 important that the audit committee financial expert understand why the internal controls and procedures for financial reporting exist, how they were developed, and how they operate. ATTRIBUTES HOW TO A CQUIRE A person must have acquired the five Attributes listed above through: 1. Education and experience as a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions; 2. Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions; 3. Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or 4. Other relevant experience. An audit committee financial expert may acquire the required Attributes discussed previously through any one or more of the four ways listed above. The SEC believes that a fund board of trustees should make the necessary assessment of the qualifications of an audit committee financial expert based on particular facts and circumstances. The SEC does not believe that familiarity with particular financial reporting or accounting issues, or any other narrow area of experience, should be dispositive. Consistent with this approach, the SEC has eliminated its proposed requirement that an audit committee financial expert must have gained the relevant experience with a company that, at the time the person held his or her position, was required to file reports under the Securities Exchange Act of Similarly, the SEC does not intend that the auditing committee financial expert for a fund must have previous experience in the investment company industry. In addition, the SEC has added a provision that experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements can provide a person with knowledge and experience of accounting and financial issues. For example, individuals serving in governmental, self-regulatory and private-sector bodies overseeing the banking, insurance and securities industries can, in the SEC s view, have very useful backgrounds for an audit committee financial expert. The proposed definition of financial expert included a non-exclusive list of qualitative factors for a fund s board to consider in assessing audit committee financial expert candidates. Some commenters were concerned that some boards would use the list as a mechanical checklist rather than as guidance to be used in considering a person s knowledge and experience as a whole. In light of these comments, the definition, as adopted, does not include this list. Instead, the SEC has stated that the board should consider all available facts and circumstances in making its determination including, but not limited to, qualitative factors of the type that the SEC had identified. The fact that a person previously has served on an audit committee does not, by itself, justify a fund board of trustees in grandfathering that person as an audit committee financial expert. Similarly, the fact that a person has 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 in deeming the person to be an audit committee financial expert. In addition to determining that a person possesses an appropriate degree of knowledge and experience, the board must ensure that it names an audit committee financial expert who embodies the highest standards of personal and professional integrity. In this regard, a board should consider any disciplinary actions to Investment Management Alert February 7, 2003 Page 4

5 which a potential expert is, or has been, subject in determining whether that person would be a suitable audit committee financial expert. Under the final rules, if a person qualifies as an expert by virtue of possessing other relevant experience, the fund must briefly list that person s experience in its disclosures in Form N-CSR, but does not have to disclose the basis for the board s determination that the person is qualified. C OMMITTEE L IABILITY EXPERT AND A person who is determined to be an audit committee financial expert will not be deemed an expert for any purpose, including without limitation 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 liability that are greater than the duties, obligations and liability imposed on such person as a member of the audit committee and board of trustees in the absence of such designation or identification. 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 trustees. The SEC finds no support in the Act or in related legislative history that Congress intended to change the duties, obligations or liability of any audit committee member, including the audit committee financial expert. The SEC believes further that it would adversely affect the operation of the audit committee and its role in the financial reporting and public disclosure system, and systems of corporate governance more generally, if courts were to conclude that the designation and public identification of an audit committee financial expert affected such person s duties, obligations or liability as an audit committee member or board member. In addition, the SEC believes that it would be adverse to the interests of investors and to the operation of markets,and therefore would not be in the public interest, if the designation and identification affected the duties, obligations or liabilities to which any member of a fund s audit committee or board is subject. The regulations adopted by the SEC are intended to codify this position. In adopting this safe harbor, the SEC emphasized that all trustees bear significant responsibility. State law generally imposes a fiduciary duty upon trustees to protect the interests of a fund s shareholders. This duty requires a trustee to inform himself or herself of relevant facts and to use a critical eye in assessing information prior to acting on a matter. The new rules provide that whether a person is, or is not, an audit committee financial expert does not alter his or her duties, obligations or liabilities. The SEC believes this should be the case under federal and state law. * * * If you have any questions or require any further information about the topics discussed above, please contact any of the members of the Investment Management Group listed on the following page. Investment Management Alert February 7, 2003 Page 5

6 Investment Management Group Attorneys Gary D. Stephen T. Jeffrey A. Kenneth L. Stephen D.D. Morgan R. Michael P. Diana E. W. Bruce Mary Jo Audrey C. Joseph J. Joan Ohlbaum Kieran G. Cori E. Joshua B. Michael E. Jonathan M. Michelle M. Kevin M. Nancy P. Michael G. Edward T. Charlotte Anne Emilia P. Administrative Director Christine M. IMG Paralegal Administrator Gino E. Funds Administrator Suzanne C. Fund Production Specialists Stephanie B. Scott J. Sara Frank J. Jane Drinker Biddle & Reath LLP is a full service law firm headquartered since 1849 in Philadelphia, PA, with offices in New York, NY, Washington, DC, Los Angeles and San Francisco, CA, Princeton and Florham Park, NJ, Berwyn, PA, and Wilmington, DE. The firm s more than 450 lawyers represent a broad spectrum of public and private, commercial, financial and educational enterprises, governmental authorities, charities and individuals throughout the United States and abroad. The Drinker Biddle & Reath LLP Investment Management Alert is intended to inform our clients about developments in the investment management field. It is not intended to constitute legal advice regarding any client s legal problems or specific questions and should not be relied on as such Drinker Biddle & Reath LLP Drinker Biddle & Reath LLP A Pennsylvania Limited Liability Partnership One Logan Square 18th & Cherry Streets Philadelphia, PA Investment Management Alert February 7, 2003 Page 6