SARBANES-OXLEY UPDATE. I. Disclosure of Off-Balance Sheet Arrangements... 2

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1 NEWS ALERT SARBANES-OXLEY UPDATE This advisory summarizes the requirements of recent rule proposals that have been made pursuant to the Sarbanes-Oxley Act of 2002 ( Sarbanes-Oxley ). Although the proposed rules will likely be modified to some extent, in many cases final rules are expected to be issued on January 26, 2003, with the annual SEC filing and proxy season following shortly thereafter. Thus, it is not too early to start planning for these changes. Additionally, this advisory summarizes the California Corporate Disclosure Act, which becomes effective January 1, Over a year after the Enron bankruptcy filing last December, the corporate governance scrutiny shows little sign of abating. In this environment, it remains essential that companies keep informed about the latest regulatory developments and remain diligent in their efforts to implement the growing body of requirements. The SEC has released a series of releases that implement additional provisions of Sarbanes- Oxley. These new releases cover issues of immediate importance, including: I. Disclosure of Off-Balance Sheet Arrangements II. III. Conditions for Use of Pro Forma or Non-GAAP Financial Measures and 8-K filing requirements for public announcements of certain financial information... 4 Obligations of Attorneys to Report Evidence of Securities Law, Fiduciary Duty and Similar Violations IV. Audit Committee Financial Experts V. Code of Ethics for Principal Executive Officer and Senior Financial Officers VI. Insider Trades During Pension Fund Blackout Periods VII. Disclosure of Management s Evaluation of Internal Controls VIII. Enhanced Auditor Independence IX. Improper Influence on Conduct of Audits X. Retention of Records Relevant to Audits and Reviews XI. California Corporate Disclosure Act (effective January 1, 2003)

2 I. DISCLOSURE OF OFF-BALANCE SHEET ARRANGEMENTS On November 4, 2002, the SEC released proposed rules governing certain off-balance sheet transactions to implement Section 401(a) of Sarbanes-Oxley. 1 The proposed rules would require a company to provide a thorough explanation of its off-balance sheet transactions and arrangements in a separately-captioned section of its MD&A, with a summary of the company s contractual obligations in tabular format. Contingent liabilities and commitments could be disclosed in either a textual or tabular format. The growing concern over undisclosed liabilities and contingencies, often associated with offbalance sheet arrangements, has been evident and these proposals include many of the suggestions proffered by the SEC in the past. 2 The SEC is required to release final rules by January 26, What is an off-balance sheet arrangement? The proposal seeks to define an off-balance sheet arrangement as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the company is a party, under which the company, whether or not a party to the arrangement, has, or in the future may have: any obligation under a direct or indirect guarantee or similar arrangement; a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement; derivatives to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes). Obligations or liabilities that would not be considered fully reflected on the face of financial statements include: obligations that are not classified as a liability according to GAAP; contingent liabilities that, as of the date of the financial statements, are not probable or, if probable, are not reasonably estimable; and liabilities as to which the amount recognized in the financial statements is less than the reasonably possible maximum exposure to loss under the obligation as of the date of the financial statements. The definitional approach utilized by the SEC contemplates that off-balance sheet arrangements would be contractual in nature, and the SEC s general policy against requiring MD&A disclosure of preliminary negotiations would encompass such arrangements. Disclosure obligations would not be triggered until an unconditional binding definitive agreement, subject only to customary closing conditions, exists or, if there is no such agreement, when settlement of the transaction occurs. Additionally, contingent liabilities arising out of litigation, arbitration or regulatory actions, which are not otherwise related to an offbalance sheet arrangement, would be excluded from the proposed definition. 2

3 What disclosures will be required? To implement 401(a) of Sarbanes-Oxley, the SEC is proposing additional disclosure requirements to Item 303 of Regulations S-K and S-B, as well as amendments to Item 5 of Form 20-F and General Instruction B of Form 40-F, that would require a company to include in MD&A: a separately-captioned section that discusses the company s off-balance sheet arrangements that may have a current or future material effect on the registrant s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources; a tabular disclosure of the company s known contractual obligations categorized by type of obligation (i.e., long-term debt, capital leases, operating leases, or unconditional purchase obligations) and the corresponding amounts of payments due over designated periods of time; and a textual or tabular disclosure of contingent liabilities and commitments, aggregated by type, with either expected amounts, a range of amounts or the maximum amounts that are to expire in designated periods of time. In addition to the above disclosures, a company would be required to disclose, to the extent material to an understanding of the effect of off-balance sheet arrangements on a company s financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures and capital resources, the following: the nature and business purpose of the off-balance sheet arrangements; the significant terms and conditions of the arrangements; the nature and amount of the total assets and liabilities (including contingent obligations and liabilities) of any unconsolidated entity in which the off-balance sheet activities are conducted; management s analysis of the material effects of the off-balance sheet arrangements and resulting obligations and liabilities on the company s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures and capital resources; and information that would provide investors with insight into the importance of the arrangements to the company and the potential risks associated with such arrangements, including: the amounts of revenues, expenses, and cash flows arising from the arrangements; the nature and total amount of any interests retained, securities issued and other indebtedness incurred; and the nature and amount of any other obligations or liabilities (including contingent obligations or liabilities) of the company arising from the arrangements that are or may become material and the triggering events or circumstances that could cause them to arise. 3

4 What is the threshold for disclosure? A company would be required to disclose off-balance sheet arrangements that may have a current or future material effect on the company s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. The SEC s view is that this standard would require disclosure of all off-balance sheet arrangements unless management determines that the likelihood of either the occurrence of an event, or the materiality of the effect, is remote. In reviewing off-balance sheet arrangements in connection with the disclosure threshold, management would need to: identify and carefully review the company s direct or indirect guarantees, retained interests, equitylinked or -indexed derivatives and obligations (including contingent obligations) that are not fully reflected on the face of the financial statements; and assess the likelihood of the occurrence of any known trend, demand, commitment, event or uncertainty that could either require performance of a guarantee or other obligation or require the company to recognize an impairment. Will there be a safe-harbor for forward-looking statements? The proposals would provide for a safe-harbor for forward-looking information within the meaning of Section 27A of the Securities Act and 21E of the Exchange Act. In the proposing release, the SEC urges companies to tailor the required cautionary language to the specific forward-looking statement being made. CONDITIONS FOR USE OF PRO FORMA OR NON-GAAP FINANCIAL MEASURES AND 8-K FILING REQUIREMENTS FOR PUBLIC ANNOUNCEMENTS OF CERTAIN FINANCIAL INFORMATION The SEC also recently published proposed rules to implement Sections 401(b) and 409 of Sarbanes-Oxley. 3 The SEC proposed new Regulation G ( Reg. G ) and amendments to certain existing rules, which would require companies to provide specific disclosure when releasing pro forma or non- GAAP financial information, including reconciling that information to GAAP. The SEC also proposed requiring companies to file a Form 8-K for earnings releases and similar financial announcements containing material nonpublic information concerning period-end financial results, regardless of whether such releases or announcements contain non-gaap financial information. Use of pro forma financial information has been a concern for the SEC and investors for nearly three decades. Less than one year ago the SEC issued cautionary advice regarding the use of pro forma financial information and the potential that such information can mislead investors if it obscures GAAP results. Reg. G will now regulate the use of pro forma financial information. The SEC is required to release final rules by January 26, When would Reg. G apply? Regulation G would apply whenever a company publicly discloses or releases material information that includes a non-gaap financial measure, such as pro forma information. The term non-gaap financial measure in Reg. G would be defined as a numerical measure of a company s historical or future financial performance, financial position or cash flows that: 4

5 excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the comparable measure calculated and presented in accordance with GAAP in a company s statement of income, balance sheet or statement of cash flows; or includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable measure calculated and presented in accordance with GAAP. The SEC provides examples on non-gaap financial measures, which include: a measure of operating income that excludes non-recurring expense or revenue items; EBITDA (earnings before interest, taxes, depreciation and amortization); and a measure of operating margin where either the revenue component or the operating income component of the calculation, or both, were not calculated in accordance with GAAP. The SEC also provided examples of measures that would not be considered to be non-gaap financial measures and, therefore, not subject to Reg. G. Such measures include: operating and statistical measures (such as unit sales, numbers of employees, numbers of subscribers or numbers of advertisers); amounts of expected indebtedness or debt repayments; estimated revenues or expenses of a new product line (so long as such estimates were made in accordance with GAAP); and measures of profit or loss and total assets for business segments required to be disclosed in accordance with GAAP. What would Reg. G do? Reg. G would require a company that chooses to utilize non-gaap financial measures to provide (i) a presentation of the most comparable financial measure calculated and presented in accordance with GAAP and (ii) a quantitative reconciliation for historic measures and, to the extent available without unreasonable efforts, for prospective measures (by schedule or other clearly understandable method) of the non-gaap financial measure and comparable GAAP measures. What disclosures would be required by Reg. G? In order to implement the enhanced disclosures, the SEC has proposed amendments to Item 10 of Regulations S-K and S-B and the incorporation of such amendments into Form 20-F, which would require specific and detailed disclosures. A company that intends to include a non-gaap financial measure in any filing with the SEC would be required to disclose in the filing (1) the information required by Regulation G (the most comparable GAAP measure, a quantitative reconciliation) as well as (2) the following information: 5

6 the purpose(s) for which management of the company uses the non-gaap financial measure; and the reason(s) why management of the company believes the presentation of such non-gaap financial measures provide useful information to investors. Coupled with the above required disclosures, the amended Item 10 would also prohibit a company from certain practices, such as: presenting any non-gaap financial measure with greater authority or prominence than the comparable GAAP financial measure; excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-gaap liquidity measures; adjusting a non-gaap performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur; presenting non-gaap financial measures on the face of the company s financial statements prepared in accordance with GAAP or in the accompanying notes; presenting non-gaap financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; using titles or descriptions of non-gaap financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP measures; or presenting per share measures on a non-gaap basis. When a company releases a non-gaap financial measure orally, telephonically, in a webcast or by broadcast or similar means, the disclosure requirements of Reg. G can be satisfied by posting the required information on the company s website contemporaneously with the release and providing the location of the website in the same presentation in which the non-gaap financial measure is made public. The SEC has also proposed new Item 1.04 ( Disclosure of Results of Operations and Financial Condition ) to Form 8-K. Item 1.04 would require a company to file a Form 8-K within two business days of a public announcement that discloses material nonpublic information regarding results or operations or financial condition for annual or quarterly periods that have ended. A company would be required to file the disclosed information regardless of whether it contains non-gaap financial measures. Unlike disclosures typically made to satisfy Reg. FD, information filed under Item 1.04 would be considered as filed with the SEC. If the disclosure occurs orally, telephonically, by webcast, broadcast or similar means, a company would not be required to file a Form 8-K if: the disclosure occurs within 48 hours of a written release or announcement filed on Form 8-K; the presentation is accessible by the public by conference call, webcast or similar means; 6

7 the information contained in the presentation is posted on the company s website (with any information that would be required under proposed Reg. G); and the presentation was announced by a widely disseminated press release with instructions on when and how to access the presentation and on how to access the information on the company s website. Item 1.04 would not apply to earnings guidance for current or future periods, however, forwardlooking information included in a release also containing material nonpublic information for past periods would necessitate the filing on Form 8-K. II. OBLIGATIONS OF ATTORNEYS TO REPORT EVIDENCE OF SECURITIES LAW, FIDUCIARY DUTY AND SIMILAR VIOLATIONS On November 21, 2002, the SEC proposed rules to implement Section 307 of Sarbanes-Oxley that would establish minimum standards of professional conduct for attorneys who appear or practice before the SEC on behalf of issuers. 4 The proposed rules would create a new Part 205 to 17 CFR that would require an attorney to report evidence of a material violation of the securities laws or breach of fiduciary duty or similar violation by the company or its agents to either the chief legal counsel or the chief executive officer of the company (or the equivalent); and, if the recipient of such report does not respond appropriately, the proposed rules would require the attorney to report the evidence to the audit committee, another committee of independent directors, or the full board of directors. In addition to this up the ladder reporting regime, the proposed rules would provide circumstances in which an attorney may be required to make a noisy withdrawal. Companies are also encouraged to consider forming a legal compliance committee to coordinate and oversee potential internal investigations arising from the proposed rules. The SEC is expected to issue final rules by the January 26, 2003 deadline imposed by Sarbanes-Oxley. Who is considered to appear and practice before the SEC in the representation of an issuer? A broad group of attorneys would be subject to this rule. As proposed, the rule would be applicable to both attorneys employed in-house by an issuer 5 and those retained as outside counsel. Additionally, the proposed rule would apply to attorneys licensed, or otherwise qualified to practice, in foreign jurisdictions who appear and practice before the Commission. Attorneys who do not serve in a company s legal department and do not act in a legal capacity would also be subject to the proposed rule if they participate in preparing or deciding on the content of any document submitted to the SEC. Lawyers retained by a company to investigate apparent material violations and lawyers who supervise a covered subordinate attorney, 6 even if the supervisor would not otherwise be covered, would also subject to the proposed rules. 7 Appearing and practicing before the Commission, as currently proposed, will be defined to include any communication with the SEC on behalf of a company and any conduct relating to the preparation of documents submitted to the SEC. The rule would apply even when materials are not submitted to the SEC, if the attorney s advice causes the materials not to be submitted. 7

8 Certain activities performed by attorneys for non-public subsidiaries would also be encompassed under the proposed definition of in the representation of an issuer. For example, an attorney working for a non-public subsidiary would be subject to the proposed rules if the attorney is retained under an umbrella representation agreement or understanding, whether explicit or implicit, under which the attorney represents the parent company and its subsidiaries and can invoke privilege claims with respect to all communications involving the parent and its subsidiaries. Similarly, an attorney would be considered to represent a company if the work performed is at the direction of the parent and will be incorporated into material submitted to the SEC by the parent (i.e., periodic reports). When is up the ladder reporting required and what is required by up the ladder reporting? New Part 205 would impose a reporting obligation when an attorney becomes aware of information that would lead a reasonable attorney to believe that a material violation has occurred, is occurring or is about to occur. 8 In such circumstances, the attorney would be directed to report the material violation to the company s chief legal officer ( CLO ). 9 It should be noted that the duty to investigate the material violation falls upon the CLO or the CEO, if there is no CLO. Although the attorney cannot ignore evidence of a material violation of which she or he is aware, the attorney is not required to investigate evidence of a material violation or to determine whether in fact there is a material violation. Upon the conclusion of the CLO s investigation into whether the material violation has occurred, is occurring or is about to occur, the CLO shall inform the reporting attorney of the outcome. If the investigation determines that no material violation has occurred, this finding shall be reported to the attorney and no further action is required. On the other hand, a CLO who concludes that a material violation has occurred, is occurring or is about to occur must take reasonable steps to ensure that the company adopts appropriate remedial measures and/or sanctions, including appropriate disclosures. The CLO must also report up the ladder within the company as to what remedial measures have been adopted or sanctions imposed and to advise the reporting attorney of his or her conclusions. Provided the attorney has received an appropriate response within a reasonable time 10 from the CLO to his or her report and further provided the attorney has documented both the report of and response to the report of the material violation, the attorney will have satisfied his or her obligation under the proposed rules. If the CLO fails to appropriately respond to the reported evidence of a material violation within a reasonable period of time, the proposed rules would require the attorney to report the evidence of a material violation to the company s audit committee, or (if the company does not have an audit committee) to another committee of independent directors, 11 or (if the company does not have another committee of independent directors) to the full board. An attorney would be permitted (but not required) under the proposed rules to circumvent the report to the CLO and CEO and to report the material violation directly to the company s audit or other independent committee or its board of directors if he or she reasonably believes that reporting the material violation to the CLO or, if there is no CLO, if reporting to the CEO would prove futile. 12 For purposes of the reporting attorney s requirement to continue reporting the material violation up the ladder, whether the response is appropriate would be determined using an objective reasonableness standard. Thus, if the issuer responds by peremptorily informing the attorney that the reported matter is not cause for concern, and fails to provide any factual or legal basis for the reporting attorney to conclud e there was no violation, such a response may not be reasonably viewed as appropriate by the attorney. 13 8

9 In order to satisfy his or her obligations under the proposed rule, in addition to reporting the material violation, the reporting attorney (and the subordinate attorney, if any) would also be required to maintain a contemporaneous written record of his or her up the ladder reports and the company s responses thereto. Such documentation would be required to be retained for a reasonable period and could be used by the reporting attorney in his or her own defense if the attorney s compliance with this rule is later questioned. When is a noisy withdrawal permitted or required? One of the most controversial provisions of the proposed rules is the noisy withdrawal element. As proposed, the rules would affirmatively state that an attorney representing the company represents the company as an entity rather than the officers of the company. As such, attorneys are obligated to act in the best interests of the company and its shareholders. Therefore, under the proposed rules, an attorney who reports evidence of misconduct but does not receive an appropriate response from the company will be required to withdraw from representation, notify the SEC of his or her withdrawal for professional considerations, and disaffirm any submission to the SEC that is tainted by the violation. 14 An in-house lawyer who has not received an appropriate response to a report of a material violation under the rule would also be required to disaffirm any tainted submissions to the SEC within one business day, however, such attorney would not have to resign. A noisy withdrawal would be mandated only in circumstances in which the reporting attorney does not receive an appropriate response and reasonably believes that the reported material violation is ongoing 15 or is about to occur and is likely to result in substantial financial injury to the company or its investors. A reporting attorney may, but is not required to, make a noisy withdrawal in situations where the material violation has already occurred, has no ongoing effect but is reasonably believed by the attorney to have caused substantial injury to the financial interest of the company or its investors. Regardless of the circumstances under which a noisy withdrawal is made, the attorney need not disclose any evidence of the reported material violation. The company, on the other hand, would be required to disclose to any successor attorney that the prior attorney withdrew based on professional considerations. The proposing rule emphasizes that noisy withdrawals, according to the SEC, would not violate the attorney/client privilege. Critics, however, have expressed particular concern with regard to how this provision could affect the attorney-client relationship, particularly with respect to clients willingness to consult with attorneys about professional misconduct. Are there any alternatives? As an alternative to the previously discussed reporting procedures, the SEC has suggested (but not proposed to require) that companies establish a qualified legal compliance committee ( QLCC ) to investigate reports of material violations made by attorneys. If such a committee is in place, an attorney would fully satisfy his or her reporting obligation under the proposed rules by reporting evidence of a material violation to the QLCC and documenting such report. Any reports made to the CLO may also be directed to the QLCC for investigation. In order for a company to avail itself of this option, as proposed, the committee must be composed of at least one member of the company s audit committee and two or more independent members of the company s board of directors. Such committee must also be responsible for and authorized to conduct any necessary inquiry into the reported evidence, to require the company to adopt appropriate remedial measures to prevent an ongoing, or alleviate a past, material violation, and to notify the SEC of the material 9

10 violation and disaffirm any tainted documents submitted to the Commission. In addition, the QLCC would be required to notify the board of directors, the CLO and the CEO of the results of any inquiry and the remedial measures deemed by the QLCC to be appropriate. Should the company fail to take the recommended remedial measures, each member of the QLCC, the CLO and the CEO would each be required to notify the SEC of the material violation and disaffirm any submissions to the SEC that have been tainted by such material violation. What are the sanctions for failure to follow these rules? Violations of the new rule could result in the imposition of civil penalties including injunctions, cease and desist orders and the barring of individuals to serve as officers or directors. Intentional, including reckless, violations and negligent conduct in the form of a single instance of highly unreasonable conduct or repeated instances of unreasonable conduct that result in a violation are proposed to be the bases of discipline. Furthermore, the proposing release clarifies that an attorney may be subject to discipline and sanctions under Part 205 even if the attorney is not in violation of the professional responsibility laws imposed by the jurisdictions in which the attorney is licensed to practice law. A private right of action against the attorney, however, is not proposed to be created by these rules. III. AUDIT COMMITTEE FINANCIAL EXPERTS NYSE and NASDAQ have rules concerning the composition of the audit committees of listed companies. Both of these rules compel at least one member of the audit committee to have accounting or financial experience or expertise, i.e., to be a financial expert, under NYSE or NASDAQ s particular definitions. As required under Section 407 of Sarbanes-Oxley, the SEC recently proposed rules that are similar in nature. 16 The SEC proposal would require companies to disclose in its annual report whether or not its audit committee members are financial experts under a more rigorous definition than the NYSE and NASDAQ rules. What disclosures are required? Under the SEC s proposed rules, a company s audit committee would be required to disclose in its annual report: the number and names of persons that the board of directors has determined to be the financial experts serving on the company s audit committee; and whether the financial expert or experts are independent, and if not, an explanation of why they are not. 17 Who qualifies as a financial expert? As proposed, a financial expert would be defined as a person who has certain attributes obtained through education and experience as a public accountant or auditor or a principal financial officer, controller or principal accounting officer of a public company that is required to file periodic reports with the SEC, or who has obtained such attributes through experience that involved the performance of similar functions, or, in the judgment of the board of directors, results in similar expertise and experience. These attributes include the following: 10

11 an understanding of GAAP and financial statements; experience applying GAAP in connection with the accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the company s financial statements; experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the company s financial statements; experience with internal controls and procedures for financial reporting; and an understanding of audit committee functions. To qualify as a financial expert, the individual must meet all of the attributes listed above. The board of directors will determine who qualifies as a financial expert by considering such things as the person s education level, whether the person has any professional certifications, whether the person has served as a principal financial officer, controller or principal accounting officer of a public company and the person s duties in that position, the person s experience and familiarity with financial statements and the Exchange Act rules, past experience on audit committees and any other relevant experiences. Possessing one of these attributes alone, such as previously being a member of an audit committee, will not be sufficient to justify qualification. At the same time, however, if an individual has not specifically served as a principal financial officer, controller or principal accounting officer, he or she is not automatically excluded from consideration. The board of directors must look at the director s qualifications and experiences taken as a whole when determining whether or not such director qualifies as a financial expert. This definition is not intended to impose a higher burden or level of responsibility on the financial expert than on other audit committee members and should not be construed to decrease the role of the other members of the audit committee. Additionally, the SEC intends to propose rules requiring the NYSE and the NASDAQ to have as a listing requirement that companies have audit committees that are completely independent. Where should this information be disclosed? As mentioned before, listed companies will now be required to disclose information regarding the existence of financial experts on their audit committees in their annual reports. This information will not need to be included in the quarterly reports. This information, however, may also need to be included in Part III of Form 8-K under the proposed rules when the listed company is required to disclose the arrival or departure of a director. This information may also be incorporated by reference to the proxy statement, as long as the proxy is filed within 120 days of the end of the year covered by the annual report. When will a company first have to make this financial expert disclosure? Section 407 of Sarbanes-Oxley requires that the SEC promulgate final rules by January 26, Accordingly, companies are advised to begin evaluating their audit committee members for qualification under the proposed standards. Companies will be required to make this financial expert disclosure in its first Form 10-K after the rule is implemented. 11

12 It is also important to note that some commentators have expressed concerns about the availability of financial experts to serve on audit committees under this more rigorous definition. First, there are a limited number of individuals that have served as senior financial officers at companies that are now in the current pool of directors and potential director candidates. Second, it is possible that some qualified candidates will be reluctant to serve on audit committees due to the current regulatory climate. As a result, it remains to be seen what percentage of companies will disclose the existence of a qualified financial expert to serve on their audit committee despite the benefits of doing so. IV: CODE OF ETHICS FOR PRINCIPAL EXECUTIVE OFFICER AND SENIOR FINANCIAL OFFICERS Section 406 directs the SEC to issue rules requiring companies to disclose whether or not such company has adopted a code of ethics for its principal executive officer and senior financial officers. The SEC recently published its proposed rules to implement this section. 18 What is required to be disclosed by this code of ethics rule? The proposal would require companies 19 to disclose the following: whether the company has adopted a written code of ethics that applies to the company s principal executive officer, 20 principal financial officer, principal accounting officer or controller or persons performing similar functions; and if the company has not adopted such a code of ethics, the reasons it has not done so. While the proposal does not mandate that a company adopt a code of ethics, most companies will choose to do so because if they choose not to, their decision must be publicly disclosed. This form of regulation, commonly referred to as regulation by disclosure should always be taken seriously, particularly in this post-enron environment. What should be contained in a company s code of ethics? The SEC proposes to define the term code of ethics to mean a codification of standards that is reasonably designed to deter wrongdoing and to promote: honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the code of any material transaction or relationship that reasonably could be expected to give rise to such a conflict; full, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and in other public communications made by the company; compliance with applicable governmental laws, rules and regulations; 12

13 prompt internal reporting to an appropriate person or persons identified in the code of violations of the code; and accountability for adherence to the code. 21 The SEC also notes that a company s code of ethics should be tailored to fit that particular company s needs. For this reason, the proposed rule contains these general requirements instead of a required form such as the forms required for the CEO/CFO certifications. Companies that do not already have a compliant code of ethics should prepare a code of ethics that fulfills the above-described requirements. When will companies be required to implement a code of ethics and disclose it in their SEC filings? Section 406 of Sarbanes-Oxley requires that the SEC adopt final rules by January 26, Accordingly, most public companies will first be required to comply with this new code of ethics disclosure when they file their first Form 10-K after the rule becomes effective. Are there any additional disclosure requirements concerning this rule? The proposed rule would also require a company to file a copy of its code of ethics as an exhibit to its annual report and to disclose on Form 8-K if either of the following occurs: a change to a company s code of ethics that applies to the specified officers; or a grant of a waiver of an ethics code provision to a specified officer. Companies would be required to disclose this information on Form 8-K 22 within two business days after the occurrence of the particular event. Alternatively, the proposed rule would allow public companies to disclose these events on the company s website, so long as the company had previously disclosed its website address, as well as its intention to disclose these events on its website, in the company s most recently filed Form 10-K. The company also would have to provide the disclosure on its website within the two business day time period required for Form 8-Ks. V: INSIDER TRADES DURING PENSION FUND BLACKOUT PERIODS On November 7, 2002, the SEC published proposed rules on the application of Section 306(a) of Sarbanes-Oxley. 23 In the wake of several scandals in which insiders were permitted to liquidate their holdings in company stock while employees were precluded from doing so due to blackout periods in pension plan accounts, the SEC has taken steps to prohibit directors and executive officers of a company from trading in the company s securities during a blackout period with respect to the company s individual account plans. The purpose of this provision is to equalize the treatment of corporate executives and rankand-file employees with respect to their ability to engage, during a pension plan blackout period, in transactions in a company s equity securities that were acquired in connection with their service to or employment with the company. 13

14 Section 306(a) is scheduled to become effective on January 26, 2003, and, in order to clarify the scope and application of the prohibition and implement the mandate of Section 306(a), the SEC has proposed new Regulation Blackout Trading Restriction ( Reg. BTR ). Who would be restricted by Reg. BTR? In general, the blackout period trading restriction would apply to directors and executive officers of all reporting companies, including domestic issuers, foreign private issuers, banks and savings associations, small business issuers and, in rare instances, registered investment companies. Reg. BTR, however, would not apply to entities that do not issue equity securities, such as issuers of asset backed securities. The SEC has proposed varying definitions for directors and executive officers, based solely on whether the company is a domestic issuer or a foreign private issuer. With respect to domestic companies, Reg. BTR would embrace established definitions under the Securities Exchange Act of 1934 (the Exchange Act ). Specifically, Reg. BTR would apply to: any director or any person performing similar functions with respect to any organization, whether incorporated or unincorporated 24 ; and an issuer s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice president of the issuer in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policymaking function, or any other person who performs similar policy-making functions for the issuer. 25 With respect to foreign private issuers, Reg. BTR would modify the above definitions and apply to: directors, as defined by Section 3(a)(7), that are also management employees of the issuer; and executive officers would mean the principal executive officer or officers, the principal financial officer or officers and the principal accounting officer or officers (or, if there is none, the controller) of the foreign private issuer. The definitional variance is the result of foreign private issuers not being subject to Section 16 of the Exchange Act and the fact that many foreign private issuers have lower-level employee representatives on their boards of directors. What securities would be covered? Reg. BTR would apply only to equity securities of a company that its directors and executive officers acquire in connection with their service or employment as a director or executive officer. The SEC again has relied on existing definitions to define equity security, x which encompass options, futures, instruments convertible into equity securities and warrants, as well as derivative securities under Rule 16a-1(c) of the Exchange Act. Securities acquired in connection with service or employment as a director or executive officer would include securities acquired (i) under a compensatory plan or contract (such as under a stock option, or a restricted stock grant), (ii) in transactions between the individual and the company, (iii) as director qualifying shares, (iv) as an inducement to employment, and (v) in connection with a merger, consolidation 14

15 or other acquisition transaction. Securities acquired outside of an individual s service as a director or executive officer (such as shares acquired when the person was an employee but not yet an executive officer) would not be covered, but, in an attempt to simplify the application and enforcement of Reg. BTR, the SEC has established an irrebuttable presumption that equity securities sold by a director or executive officer during a blackout period involved the sale of securities acquired in connection with such individual s service to the company in such capacities (to the extent that the individual holds such securities), without regard to the actual source of the securities sold. What constitutes a blackout period for purposes of restricting insider trading? The Section 306(a) trading restriction would be triggered only if a blackout period (i) continues for a period in excess of three consecutive business days and (ii) suspends temporarily the ability of at least 50% of the participants or beneficiaries under all individual account plans maintained by the company to purchase, sell or otherwise acquire or transfer company securities held in an account plan. Would there be any exemptions or exceptions available? Reg. BTR would exempt various transactions, including: acquisitions under dividend or interest reinvestment plans; purchases or sales conducted in accordance with the conditions of Rule 10b5-1(c) of the Exchange Act; purchases or sales under certain tax-conditioned plans (including 401(k) plans) that do not involve discretionary transactions (as those terms are defined in Rule 16b-3 of the Exchange Act); and increases or decreases in holdings resulting from a pro rata stock split or stock dividend. Additionally, Section 306(a) expressly exempts two categories of blackout periods from the trading restriction. Specifically, (i) a regularly scheduled blackout period in which participants may not engage in transactions of the equity securities if such period is incorporated into the individual account plan and timely disclosed to employees before they become participants (or as a subsequent amendment to the plan) and (ii) any suspension imposed solely in connection with persons becoming participants, or ceasing to be participants, by reason of a corporate merger, acquisition or similar transaction would not trigger the trading prohibitions. With respect to foreign private issuers, a blackout period would occur when participants located in the U.S. subject to the blackout comprise 50% or more of all participants located in the U.S. and plan participants in the U.S. subject to the blackout represent more than 15% of all plan participants worldwide. What steps must affected companies take? Reg. BTR would require a company to provide its directors and executive officers, as well as the SEC, a detailed notice of a blackout period. The notice would require the company to disclose the reason for the blackout, the plan transactions that will be suspended or affected during the blackout, the class of equity securities subject to the blackout, the actual or expected beginning and ending dates of the blackout period and contact information for company designees tasked with responding to inquiries about the blackout period. Notices to directors and executive officers would have to be provided at least 15 15

16 calendar days in advance of commencement of the period, and the company would have to file a current report on Form 8-K containing the above information within two business days of the earlier of notice from the plan administrator and actual knowledge of the blackout period. What are the proposed remedies? Two remedies are available for violations of Section 306(a), SEC enforcement action and a private right of action to recover profits realized by an insider from trading during a blackout period. SEC enforcement action could consist of civil injunctive actions, cease-and-desist proceedings, civil penalties and criminal proceedings. The private right of action would allow the recovery of any profit realized by a director or executive officer. A company can institute a suit to recover the profits and, if the company fails to do so within 60 days after request by a stockholder, a derivative action would be allowed. At this point, the SEC has only outlined alternative methods for calculating profit. What are some strategies for handling the insider trade prohibition? Stagger blackout periods so that fewer than 50% of participants are affected at one time. Schedule compensation committee meetings when options are granted so that they do not coincide with blackout periods. Schedule blackout periods around key executive trading times (e.g., when options may be due to expire or trading windows after earnings announcements and Exchange Act reports). Arrange with brokerage house to permit participants to continue trading company stock during the blackout period. VI: DISCLOSURE OF MANAGEMENT S EVALUATION OF INTERNAL CONTROLS The SEC also recently published proposed rules to implement Sections 404 of Sarbanes-Oxley, which requires annual disclosure of management s evaluation of certain internal controls. 27 What is an internal control report and when will this new rule be effective? The SEC s proposals under Section 404 would add new disclosure requirements to Forms 10-K, 10-KSB, 20-F, and 40-F that would require companies to include in their annual reports an internal control report, tailored to the company s specific circumstances, containing: a statement of management s responsibilities for establishing and maintaining adequate internal controls and procedures for financial reporting; conclusions about the effectiveness of the company s internal controls and procedures for financial reporting based on management s evaluation of those controls and procedures as of the end of the company s most recent fiscal year; a statement that the company s auditors have attested to, and reported on, management s evaluation of the company s internal controls and procedures for financial reporting (with the attestation being filed with the annual report); and the auditor s attestation. 16

17 In addition to the annual internal control report, the proposal would require a company to include the following disclosures in each annual or quarterly report: the conclusions of the company s CEO and CFO with respect to the effectiveness of the company s disclosure controls and procedures and internal controls and procedures for financial reporting based on management s evaluation of these controls and procedures as of the end of the period covered by the quarterly or annual report; and any significant changes to the company s internal controls and procedures for financial reporting made during the period covered by the quarterly or annual report, as well as any actions taken to correct significant deficiencies and material weaknesses in those controls and procedures. This proposed rule will be effective for fiscal years ending on or after September 15, What are internal controls? Internal controls are procedures designed to provide reasonable assurances that transactions are properly authorized, that assets are safeguarded against unauthorized and improper use and that transactions are properly recorded and reported. The proposed definition would mirror that contained in AICPA s Codification of Statements on Auditing Standards Section 319 ( controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with generally accepted accounting principles ). VII: ENHANCED AUDITOR INDEPENDENCE On December 2, 2002, the SEC released proposed amendments to existing auditor independence requirements that would implement Section 208(a) of Sarbanes-Oxley. 28 The proposed rules focus on key aspects of auditor independence, including the provision of certain non-audit services, potential conflicts of interest and the need for effective communication between the auditor and audit committee. The SEC is required to release final rules by January 26, What types of non-audit services would be prohibited? Section 201(a) of Sarbanes-Oxley Act states that it shall be unlawful for a registered public accounting firm that performs an audit of a company s financial statements (and any person associated with such a firm) to provide to that company, contemporaneously with the audit, any non-audit service, including nine services that were specifically identified. While the specific delineation of certain services put forth a bright line of prohibited activity, it failed to fully encompass what the SEC believes are basic principles underlying auditor independence. The SEC s goal is to prohibit any non-audit services provided by an accountant to an audit client during the audit and professional engagement period in situations where it is possible that the accountant would: audit his own work; perform management functions; or act as an advocate for the client. 17