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Audit Committee and Financial Reporting Requirements for U.S. and Non-U.S. Companies under the Sarbanes-Oxley Act

Client Advisory

May 1, 2003

Introduction

Congress enacted the Sarbanes-Oxley Act (the "Act") in July of 2002 to improve corporate governance practices in response to the scandals surrounding a number of corporate executives, independent auditors and other market participants.  The Act creates sweeping corporate disclosure and financial reporting reforms.  Since its enactment, the self regulatory organizations, including the New York Stock Exchange ("NYSE") and the Nasdaq Stock Market ("Nasdaq"), have also reviewed and proposed changes to their own corporate governance standards. In addition, the SEC has proposed and enacted rules under the Act aimed at improving corporate governance practices.

The following is a brief description of the principal provisions of the Act, the SEC's recent implementing rules and the proposed NYSE and Nasdaq rules regarding audit committee and financial reporting requirements. This Advisory also dedicates special sections for non-U.S. public companies.

While the new corporate governance regime and its attendant risks and responsibilities might deter some from serving on audit committees, on further reflection, perhaps the best form of risk control is to be on the audit committee and prevent misconduct at the outset. Certainly public companies are being graded today by their corporate governance standards.  Carter Ledyard & Milburn LLP is dedicated to making sure that while our clients prosper, they are also perceived as good corporate citizens.

As part of our commitment to you, we shall continue to keep you abreast of corporate governance rules and regulations as they unfold.

Audit Committee Responsibilities

Whether or not one volunteers to be an audit committee member, it is clear that companies are obliged to  have one.  If the company does not select one, the Act will deem the entire board to be the audit committee with all this entails. The Act (§ 301) requires that the audit committee (i)  be responsible for the appointment, compensation and oversight of the company's independent accountant; (ii) consist solely of independent directors; (iii) have established procedures for handling employee complaints regarding accounting and auditing matters and  (iv) have the authority to engage independent counsel and other advisors. 

As an enforcement mechanism, the Act and its rules direct the self regulatory organizations ("SROs") including the national securities exchanges and national securities associations, to prohibit the listing of any security of a company whose audit committee does not comply with all of the above requirements.

On April 9, 2003, the SEC published final rules (the "April 9th Final Rules") addressing these audit committee responsibilities.  The April 9th Final Rules require companies to disclose the names of members of the audit committee in the company's annual report. If the company has not picked its own audit committee and has opted, by default, to have its entire board of directors constitute the audit committee, this too must be disclosed in its annual report.   

The April 9th Final Rules make it clear that they apply also to non-U.S. public companies, with some minor adjustments in the case of real conflicts with the laws of certain foreign jurisdictions.  As a gesture to non-U.S. public companies, the SEC has given them extra time to comply by delaying the implementation of the April 9th Final Rules to July 31, 2005.  U.S. public companies, however, must be in compliance with the April 9th Final Rules by the date of their first annual shareholder meeting after January 15, 2004 and in any event, no later than October 31, 2004. 

What are the Audit Committee's Responsibilities for the Relationship with Outside Accountants under the Act?

One of the primary functions of the audit committee is to enhance the independence of the outside accounting firm in the audit function.  Leaving management the power to hire, compensate, supervise and fire the outside accountant risks making them too subservient to management who may be more preoccupied with short-term profitability goals than with the integrity of the audit process.  Accordingly, the April 9th Final Rules shift the responsibility for the relationship with the outside accountants from the company's management to the audit committee.  Now it is the audit committee that is responsible for appointing, compensating, overseeing and terminating the outside accountants.

Included in these new audit committee functions is the requirement that the audit committee resolve accounting disagreements between management and the outside accountants. The outside accountants must report directly to the audit committee which must grill them regarding any differences of opinion they may have had with management over the contents of the financial statements including critical accounting policies used, any elections made between alternative possible accounting treatments that would have different impacts on the bottom line and any estimates or assumptions contained therein. In the event of a difference of opinion between management and the outside accountants as to how the financial statements should be presented, the audit committee must become familiar with the issues and approve the final outcome on the merits.

As part of the drive to make the outside accounting firm that conducts the audit process more independent, the Act and the April 9th Final Rules require the audit committee to take further actions and oversee further matters as follows. It must make sure that the outside accountant is not providing certain prohibited non-audit services, such as internal audit services that might lead the outside accountants to monitor their own activities. The audit committee must pre-approve all permitted non-audit services that could, if not closely monitored, lead to the same self-policing result. The audit committee must ensure that significant members of the audit engagement team are rotated on a periodic basis and that the company observes a cooling off period before employing a former employee of the outside accounting firm. All of these independence-enhancing measures are further described in this Advisory.

The April 9th Final Rules note that the audit committee's responsibility for oversight, appointment and termination of the independent accountant may conflict with certain foreign laws governing a non-U.S. public company.  For example, some foreign laws require shareholder approval or full board approval for the appointment or removal of outside accountants or may require that an independent accountant be removed by court order.  The April 9th Final Rules address these situations by providing that shareholder, full board or court approval for the appointment or removal of the independent accountants pursuant to foreign law will not be in violation of the Act provided that the audit committee is given certain advisory powers which must be taken in to account when  appointing or removing independent accountants. 

What are the Audit Committee's Responsibilities for the Relationship with Outside Accountants under the NYSE and Nasdaq Proposed Rules?

Like the Act, the NYSE and Nasdaq's proposed rules provide that the audit committee must have the sole authority to hire and terminate the independent accountants and to approve any significant, permissible non-audit services. 

What must the Audit Committee do to be "Independent" under the Act?

The investment community will be suspicious of any audit committee which is not independent of management. One cannot be in management's pocket and still be independent under the Act.  Neither can one be so closely aligned with the short-term results of the company as to lose focus on shareholder value. Accordingly, a director cannot qualify as an audit committee member if he or she receives any compensation from the company other than compensation for serving on the audit committee. Neither can the director be so affiliated with the company as to be unable to differentiate between what is good for himself or herself and what is good for the company.

Non-receipt of any compensation other than for audit committee services and non-affiliation with the corporation are the two criteria that constitute independence under the Act.  Accordingly, audit committee members cannot accept any consulting, advisory or other compensatory fees from the company, except in exchange for their service as independent board members or members of the audit committee. This means that an audit committee member who is a partner in a law firm, accounting firm, consulting firm, investment bank or similar entity that receives fees for rendering professional advice to the company, would not be deemed independent. This does not mean that an audit committee member should not be handsomely compensated for his or her services on the audit committee or that he or she may never own stock in the company. It is recognized that the burden of responsibility and the commitment of time involved in acting as an audit committee member today should be adequately compensated, otherwise there may really be nobody ready to do the job.

For independence purposes, the April 9th Final Rules define an affiliated person as a person that controls, or is controlled by, or is under common control with the company and defines control as the possession of the power to direct the management and policies of a company.  The SEC noted that it might be difficult to determine whether an individual controls a company and therefore proposed a safe harbor pursuant to which a person who is not an executive officer or 10% shareholder of any class of voting equity securities of the company would not be deemed to control the company.

Are there any Exceptions to the Independence Requirements under the April 9th Final Rules?  

The April 9th Final Rules created some exceptions from the independence requirements of audit committee members.  First, the SEC recognized that companies coming to market for the first time may face particular difficulty in finding audit committee members that meet the independence requirements.  Therefore, the April 9th Final Rules have relaxed the independence requirements for such companies by requiring that the audit committee need include only one fully independent member at the time of the company's initial listing, as long as it has a majority of independent members within 90 days thereof, and a fully independent committee within one year thereof.  Second, the April 9th Final Rules ease the independence requirements for audit committees members who have certain overlapping board relationships.  Specifically, an audit committee member, who otherwise meets the Act's independence requirements, will not be disqualified merely because he or she sits both on the board of the company and one or more of its affiliates. Third, the April 9th Final Rules recognize that the laws of certain countries like Germany, require non-management employees, who would not be viewed as independent under the Act, to serve on the audit committee of non-U.S. public companies. Accordingly, the April 9th Final Rules provide that non-executive employees can sit on the audit committee of such companies if their presence is required pursuant to home country laws, an employee collective bargaining agreement or other home country legal or listing requirements.  Fourth, the April 9th Final Rules recognize that the Act's non-affiliation component of the definition of independence might interfere with the prevailing custom of certain non-U.S. public companies to appoint to their audit committees, controlling shareholders, including foreign government representatives with significant shareholdings. Therefore, the April 9th Final Rules provides an exception pursuant to which a controlling shareholder of a non-U.S. public company will not be disqualified from being a member of the audit committee if: (i) he or she is the only member of the audit committee to take advantage of this exception, (ii) he or she receives no compensation, other than board compensation, (iii) in the case of a controlling shareholder that is not a government representative, he or she only has observer status on, and is not a voting member or the chair of the audit committee and (iv) he or she is not an executive officer of the company.  Finally, the April 9th Final Rules recognize that several non-U.S public companies are required by home country law to establish committees not necessarily called "audit committees" but, nevertheless, serving equivalent functions to the audit committee. In these situations, the establishment of an audit committee under the Act in addition to the equivalent committee would result in duplicative functions and costs.  Accordingly, the SEC has exempted such non-U.S. public companies from certain of the Act's audit committee requirements, provided such equivalent committees have a degree of independence from the board of directors and management, fulfill outside accountant oversight responsibilities, have procedures for handling whistleblower accounting complaints and have access to outside advisors.

Companies relying on any of the exemptions listed above must disclose such reliance in their public filings and make an assessment whether and the extent to which such reliance might compromise the independence of their audit committee.

What must the Audit Committee do to be "Independent" under the NYSE Proposed Rules?

Under the NYSE's proposed rules, in order for a director of an NYSE listed company to be considered "independent," the board of directors must affirmatively determine that the director has no material relationship with the listed company, and companies must disclose the basis for this determination either in their annual proxy statement or in the company's annual report filed on Form 10-K. Furthermore, the NYSE's proposals preclude directors with the following relationships to the company from being independent. First, a director who receives, or whose immediate family member receives more than $100,000 per year in direct compensation from the listed company (other than director and committees fees, pension and other forms of deferred compensation for prior service) is presumed not to be "independent" until five years after he ceases to receive more than $100,000 per year in such compensation. Other categories of individuals who are precluded from the definition of independence include: (i) a director who is affiliated or employed by, or whose immediate family member is affiliated with or employed in a professional capacity by, a present or former auditor of the company until five years after the end of either the affiliation or the auditing relationship; (ii) a director who is employed, or whose immediate family member is employed, as executive officer of another company where any of the listed company's present executives serve on that other company's compensation committee until five years after the end of such service or the employment relationship; and (iii) a director who is an executive officer or an employee, or whose immediate family member is an executive officer, of another company (A) that accounts for at least 2% or $1 million, whichever is greater, of the listed company's consolidated gross revenues, or (B) for which the listed company accounts for at least 2% or $1 million, whichever is greater, of such other company's consolidated gross revenues, in each case is not "independent" until five years after falling below such threshold. The NYSE proposals define "immediate family member" to include a person's spouse, parents, children, siblings, mothers and fathers in-law, sons and daughters-in law, brothers and sisters-in-law, and anyone (other than employees) who shares such person's home. The NYSE is transitioning in these requirements so that during the five years immediately following the effective date of the listing standard, each five year "look back" period referenced above shall instead be the period since the effective date of the listing standard. The NYSE's proposed rules require listed companies to have a majority of independent directors.

The NYSE's proposed rules also require listed companies to have a minimum three person audit committee consisting entirely of independent directors.  In addition, the NYSE's proposed rules require that audit committee members must comply with the Act's requirements relating to the prohibition from accepting any consulting, advisory, or other compensatory fee from the company.  The NYSE has indicated that because serving on an audit committee imposes significant time commitments, audit committee members may receive reasonable compensation greater than that paid to the other directors. In addition, if an audit committee member serves on the audit committees of more than three public companies, the board of directors must in each case determine that such simultaneous service would not impair the member's effectiveness, and the board must disclose this determination in its proxy statement or in the company's annual report on Form 10-K.

What must the Audit Committee do to be "Independent" under the Nasdaq Proposed Rules?

In order to qualify as an independent director under Nasdaq's proposed rules, the board of directors must determine that a person does not have a relationship with the company that could interfere with his or her exercise of independent judgment.  In particular, the following persons are not considered independent directors: (i) a director employed by the company within the last three years; (ii) a director who accepts or who has a  family member who accepts payments in excess of $60,000 during the current fiscal year or any of the past three fiscal years, other than compensation for board service, payments arising solely from investments in the company's securities, compensation paid to a family member who is an employee of the company, or benefits under a tax-qualified plan or non-discretionary compensation; (iii) a director who is a family member of an individual who has been employed by the company or by any parent or subsidiary of the company as an executive officer within the past three years;  (iv) a director who is a partner, controlling shareholder or executive officer of any organization to which the company made payments that exceed 5% of the recipient's gross revenues for that year, or $200,000, whichever is more, in the current fiscal year or any of the past three fiscal years; (v) a director of the listed company who is employed as an executive officer of another entity where any of the executive officers of the listed company serve on the compensation committee of such other entity, or if such relationship existed during the past three years or (vi) a director who is or was a partner or employee of the company's outside auditor, and worked on the company's audit, within the past three years.

In addition, each company must have an audit committee consisting of three members which: (i) meets Nasdaq's definition of independence; (ii) meets the criteria for independence set forth under the Sarbanes-Oxley Act and (iii) does not own or control 20% or more of the company's voting securities.  Furthermore, the proposed Nasdaq rules permit a person who does not meet the above requirements to be appointed to the audit committee if the board in "exceptional and limited circumstances" determines this to be in the best interest of the company and discloses this in the next annual proxy statement.  However, this director cannot serve on the audit committee for more than two years and cannot be its chair. 

What Procedures must the Audit Committee Establish for Handling Whistleblower Accounting Complaints?   

The April 9th Final Rules require the audit committee to establish procedures for: (i) the receipt, retention, and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters and (ii) the confidential, anonymous submission by employees of the company of concerns regarding questionable accounting or auditing matters.  The April 9th Final Rules do not mandate specific procedures that the audit committee must establish in order to implement this requirement.  Rather, the SEC recommended that each audit committee develop procedures that work best for each company's individual circumstances.  In this connection, many companies have established hot lines on which employees can leave anonymous messages.  The rationale for whistleblower procedures is that the establishment of formal procedures for receiving and handling complaints could serve to facilitate disclosures, encourage proper individual conduct and alert the audit committee to potential problems before they metastasize into serious problems.

What Procedures must the Audit Committee Establish for Handling Whistleblower Accounting Complaints under the NYSE and Nasdaq Proposed Rules?

Under the NYSE and Nasdaq's proposed rules, each listed company must have an audit committee which has established procedures for handling employee complaints on accounting matters.  In addition, under the NYSE and Nasdaq's proposed rules, each listed company's code of business conduct or code of ethics should encourage the reporting of any illegal or unethical behavior.  Further, companies must ensure that employees know that the company will not permit retaliation against employees for reports made in good faith.

Does the Audit Committee have the Right to Hire Independent Counsel and Outside Advisors?

One of the lessons of Enron was that the audit committee's ability to get at the truth might be compromised if they rely upon the company's historical legal counsel or other professional advisors who might be too involved in the matters under investigation to render impartial advice.  Accordingly, the Act (§301) and the SEC rules requires directing the national securities exchanges and national securities associations to prohibit the listing of any security of a company which does not have an audit committee with the independent authority to engage independent counsel and other advisors, paid for by the company.

In addition, the Act requires the company to provide the audit committee with sufficient funding to compensate any advisors it employs.  Further, the April 9th Final Rules provide that, in addition to providing funding for advisors, companies must provide appropriate funding for the ordinary administrative expenses of the audit committee. 

Does the Audit Committee have the Right to Hire Independent Counsel and Outside Advisors under the NYSE and Nasdaq Proposed Rules?

The NYSE and Nasdaq's proposed rules provide that the audit committee must have the authority to engage and determine funding for the independent counsel and other advisors.  The NYSE's proposed rules indicate that the audit committee must be empowered to retain these advisors without seeking board approval.

When must companies comply with the NYSE Proposed Rules?

NYSE's proposals are subject to the approval of the SEC. The proposals relating to audit committee member independence and the requirement to have a majority of independent directors will become effective 18 months after such approval.  During such period, companies that do not already have a majority of independent directors will have time to recruit them. Companies with classified boards who elect directors in a series of staggered elections will have an additional year for such purpose.  Audit committees must amend their charters to specify the audit committees' enhanced responsibilities under the NYSE rules within six months of the date that the SEC approves such rules.  Companies listing on the NYSE in conjunction with their first public offering must comply with the audit committee and director independence requirements within 24 months of listing, and companies listing upon transfer from another market will generally have 24 months from the date of transfer in which to comply with any extra requirement of the new market.

When must companies comply with the Nasdaq Proposed Rules?

Nasdaq's proposed rules relating to audit committee and board composition must be implemented immediately after the listed company's first annual meeting after January 1, 2004.  Companies newly listed on Nasdaq will be afforded two years to comply with the independent director requirements. Companies transferring from other markets with substantially similar requirements would be afforded the balance of any grace period afforded by the other market. Nasdaq's other proposals relating to the audit committee's responsibilities, such as the proposed rules requiring audit committees to update their charters in line with the audit committees enhanced responsibilities, must be implemented within six months of SEC approval.

Pre-Approval of Audit and Permissible Non-Audit Services

In connection with the independence of the outside accountants, §202 of the Act and its related final rules published on January 28, 2003 (the "January 28th Final Rules") distinguish between three categories of services.  The first category is traditional audit services performed by outside accountants.  The second category is non-audit services which outside accountants may have provided in the past but may no longer provide under the Act ("Prohibited Services").  The third category is  non-audit services which the outside accountants may provide if the audit committee pre-approves them ("Permissible Non-Audit Services").  Section 202 of the Act provides that all audit and Permissible Non-Audit Services must be pre-approved by the audit committee.

The January 28th Final Rules define the circumstances under which the audit committee must pre-approve all audit and Permissible Non-Audit Services provided to the company.  Specifically, the SEC's final rules require that before an accountant is engaged by a company or its subsidiaries, the engagement must be: (i) pre-approved by the company's audit committee or (ii) entered into pursuant to pre-approval policies and procedures established by the audit committee of the company, provided the policies and procedures are detailed as to the particular service, the audit committee is informed of each service, and such policies and procedures do not include the delegation of the audit committee's responsibilities to management.  The SEC clarified that audit services, subject to pre-approval by the audit committee, include the issuance of comfort letters, statutory audits and services performed to fulfill the accountant's responsibility under generally accepted auditing standards ("GAAS").

Are there any Exceptions to the Pre-Approval Requirement of Audit Services?

Consistent with the Act, the SEC's rules provide a de minimis exception solely related to the provision of non-audit services for a company. This exception exempts the pre-approval requirements for Permissible Non-Audit Services under the following circumstances: (i) all such services do not aggregate to more than five percent of the total revenues paid by the audit client to its accountant in the fiscal year when services are provided; (ii) the services were not recognized as non-audit services at the time of the engagement and (iii) these services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or one of more of its designated representatives. In addition, the audit committee's policies for pre-approvals should be disclosed by companies in periodic annual reports.

By when must a Company comply with the Approval Requirements of Audit and Permissible Non-Audit Services?

The pre-approval requirements apply to all audit, review and attest services and Permissible Non-Audit Services entered into after May 6, 2003. For Permissible Non-Audit Services entered into prior to May 6th, the accounting firm will have until May 6, 2004 (12 months from the effective date) to complete these services, without regard as to whether these arrangements were pre-approved by the audit committee. For example, an engagement to provide Permissible Non-Audit Services that was entered into in October of 2002, which may not be completed by the effective date of the SEC's rules, is not rendered illegal under the rules provided it is completed by May 6, 2004.

Finally, under the Act, the audit committee of a company may delegate the authority to grant pre-approvals to one audit committee member.  Decisions made by the designated audit committee member must be reported to the full audit committee at each of its scheduled meetings.

Under the January 28th Final Rules, audit committees must disclose the procedures used  to pre-approve audit and Permissible Non-Audit Services provided by the independent accountant and must also disclose the percentage of the total fees paid to the independent accountant where the de minimis exception was used.  Companies may include a copy of these policies and procedures with the information delivered to investors and filed with the SEC.  In addition, the SEC requires that the disclosures be included in a company's annual report, and in a company's proxy statement on Schedule 14A or information statement on Schedule 14C. 

These disclosure requirements are required for annual filings for the first fiscal year ending after December 15, 2003.

What are the Pre-Approval Requirements of Audit Services under the NYSE and Nasdaq Proposed Rules?

The NYSE and Nasdaq's proposed rules similarly provide that the audit committee must have the sole authority to hire and terminate the independent accountants and to approve all audit services and permissible non-audit engagements.

The Nasdaq and the NYSE's proposed rules regarding pre-approval of audit services must be implemented within six months after they are approved by the SEC.

Limits on Non-Audit Services

The January 28th Final Rules clarify the scope of non-audit services that accountants can provide to their audit clients.  The January 28th Final Rules supplement §201 of the Act and provide nine non-audit services that an accountant is prohibited from performing on behalf of a public company client contemporaneously with his or her audit.  An accountant may perform other non-designated services and tax advice only with the advance approval of the audit committee and with appropriate disclosure in the company's SEC reports.

  • The designated non-audit services that an auditor may not perform are:
  • Bookkeeping or other services related to the accounting records or financial statements of the audit client;
  • Financial information systems design and implementation;
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
  • Actuarial services;
  • Internal audit outsourcing services;
  • Management functions or human resources;
  • Broker or dealer, investment adviser, or investment banking services; and
  • Legal services and expert services unrelated to the audit.

The January 28th Final Rules do not restrict the provision of non-audit services by an accounting firm to a client for whom no audit services are being performed.  They only apply to non-audit services provided by independent accountants to clients for whom they are performing audit services.  There are three principal rationales behind the January 28th Final Rules restricting the provision of non-audit services: (i) an auditor should not perform management functions, (ii) an auditor should not audit his or her own work and (iii) an auditor should not act as an advocate on behalf of his client. 

In addition, the January 28th Final Rules permit accounting firms to provide tax services to audit clients, provided that such services are pre-approved by the audit committee. 

By when must a Company comply with the Limits on Non-Audit Services?

The SEC recognized that audit clients may need a period of time to exit existing contracts. Therefore, the SEC clarified that as long as engagements entered into before May 6, 2003 are completed by May 6, 2004 such engagements do no violate the January 28th Final Rules.

Prohibiting Improper Influence on the Conduct of Audits

Pursuant to the Act (§303), on May 20, 2003, the SEC published Final Rules, (the "May 20th Final Rules") which make it unlawful for any director or officer, or any person acting under their direction, to "coerce, manipulate, mislead or fraudulently influence" an accountant engaged in an audit to render the financial statements materially misleading.  For the purposes of this rule, "being engaged in an audit" means any time that the accountant is called upon to make decisions or judgments regarding the company's financial statements. This would cover any time during the accountant's engagement, but could also include coercive conduct during discussions leading up to the accountant's engagement and subsequent to the engagement when the accountant is being asked to issue a consent for the use of prior years audit reports.

In the May 20th Final Rules, the SEC has clarified that persons acting "under the direction" of an officer or director who could potentially be liable under the rule could include customers, vendors, or creditors of the company, who, under the direction of an officer or director of the company, provide misleading information to the company's auditor or who enter into side agreements with management that enable the company to mislead the accountant. Others who might be covered include, partners or employees at accounting firms as well as attorneys, securities professionals or other advisors if they are instructed by officers or directors, for example, to pressure an auditor to limit the scope of the audit, to issue a report on the company's financial statements that is not warranted in the circumstances of the case, not to withdraw an issued report or not to communicate matters to the company's audit committee.

In the May 20th Final Rules, the SEC pointed out that an attorney who negligently provides misleading information or a misleading legal analysis in response to a request by an accountant to provide certain information in connection with the accountant's examination of the company's financial statements, could be in violation of the rule even if there was no fraudulent or bad intent on the part of the attorney. While the SEC does not intend to hold any party accountable for honest and reasonable mistakes or to sanction those who actively debate accounting or auditing issues, the SEC will hold third parties responsible to the extent they do not exercise reasonable attention and care in such communications.

In the May 20th Final Rules, the SEC stated that the rules could be violated by an attempt to influence the accountant even if that attempt did not actually succeed in affecting the audit or the review. 

The types of conduct that the SEC believes might constitute improper influence include the following:

  • Offering the auditor bribes or other financial incentives, including offering continued engagement for audit or non-audit services;
  • Providing the auditor with inaccurate or misleading legal analysis;
  • Threatening to cancel existing non-audit or audit engagements if the auditor objects to the company's accounting;
  • Seeking to have a partner removed from the audit engagement because the partner objects to the company's accounting;
  • Blackmail; and
  • Making physical threats.
The SEC also noted that creating undue time pressure on the accountants, not providing them with information or not making oneself available to discuss matters with them on a timely basis, could under certain circumstances result in a violation of the rules.

The May 20th Final Rules do not exempt non-U.S. public companies or other persons acting under their direction.

Public Accounting Oversight Board

As required by §101 of the Act, on October 25, 2002, the SEC appointed a five-member Public Company Accounting Oversight Board (the "Board") to oversee the auditing of public companies. The Board's mandate is to register, inspect and discipline public accounting firms and establish and enforce auditing, quality control and independence standards, all subject to broad SEC oversight. 

After an initial rocky start, and the resignation of the first appointed chairman, on April 25, 2003, the SEC issued an order determining that the Board was appropriately organized and capable of fulfilling its statutory responsibilities. In order to issue audit reports on U.S. or non-U.S. public companies, U.S public accounting firms must  register with the Board by October 23, 2003 and non-U.S. accounting firms by April 19, 2004.

The Board published its proposed registration rules in March 2003 and its final rules in early May 2003. The rules, which require the registration of audit firms rather than individual accountants, will not be in force until approved by the SEC. The proposed rules require the Board to render its decision on an application within 45 days after the date of its receipt unless further information is required from the applicant in which case the 45 days will run again. The Board plans to be ready to receive applications in late June or early July 2003 and it is recommended that firms apply early to meet the relevant deadlines for registration.

Applications for registration are to be submitted over the internet and will become public unless confidentiality is requested. A registration fee will need to be paid.

Registration with the Board will be expressly required for non-U.S. accounting firms if those firms audit non-U.S. public companies.  Specifically, the Act (§106) provides that if a non-U.S. accounting firm issues an opinion or otherwise performs material services upon which a U.S. public accounting firm relies in issuing all or part of an audit report or opinion contained in an audit report, that foreign accounting firm will be deemed to have consented to (i) produce its audit work papers to the Board or the SEC in connection with any investigation by the Board or the SEC with respect to that audit report and (ii) to be subject to the jurisdiction of the U.S. courts for purposes of enforcement of any request for the production of work papers.

The Board and the SEC may exempt any foreign public accounting firm, as is necessary or appropriate in the public interest or for the protection of investors.

Audit Partner Rotation

What are the Rotation Requirements for the Lead and Reviewing Audit Partner?

Section 203 of the Act requires the rotation of the lead audit partner and reviewing partner on a five year basis.  The January 28th Final Rules require the lead and reviewing partners to take a five year time-out from the audit engagement with the client after each five years of service.

By when must a Company comply with the Audit Partner Rotation Requirements? 

The rotation requirements for the lead audit partner are effective for the first fiscal year ending after May 6, 2003.  In determining when the lead partner must rotate, one must take into account the time that the lead partner served the client before May 6, 2003.  For example, if 2003 was the lead partner's fifth year for that client, he or she would be permitted to complete the current year's audit but must rotate off before the 2004 engagement. 

The rotation requirements applicable to the reviewing partner are effective as of the end of the second fiscal year after May 6, 2003.  Accordingly, a reviewing partner for whom 2003 was his or her fourth or greater year in that role, would be able to complete this engagement for 2004 but must rotate off for the 2005 engagement.

The rotation requirement for "other audit partners" as defined below and for partners of foreign accounting firms are effective as of the beginning of the first fiscal year after May 6, 2003.  However, time served as an engagement partner prior to that first fiscal year will not be taken into account for purposes of the rotation.  Accordingly, for other audit partners or for partners in foreign accounting firms, 2004 would constitute the first year in the applicable rotation period for the audit partner, regardless of whether he or she previously served in that capacity.

How Far Down the Audit Engagement Chain Do the Audit Partner Rotation Requirements Go?

In its final rules, the SEC expanded the scope of the rotation requirements to other audit partners who are not lead partners or reviewing partners.  For this purpose, "other audit partners" to whom the rotation rules apply means decision-making partners on the audit engagement team or those who maintain regular contact with the management and the audit committee of the company including those (i) who provide more than 10 hours of audit, review or attest services in connection with the financial statements of the company, (ii) who serve as the lead partner on an audit or who review the financial statements of a company's subsidiary whose assets or revenues constitute 20% or more of the assets or revenues of the company's consolidated assets or revenues. 

The SEC's final rules provide that other audit partners subject to the rotation requirements must rotate within seven years and are subject to a two-year time-out period.

Do the Audit Partner Rotation Requirements Apply to National Office Partners?

The SEC clarified that partners assigned to "national office" duties, who may be consulted on specific accounting issues related to a client, are not audit partners. The January 28th Final Rules indicated that because these partners are not involved in the audit per se and do not routinely interact with the audit client, these partners are not subject to the rotation requirements.

Do the Audit Partner Rotation Requirements Apply to Small Accounting Firms?

The SEC provided an exemption from the partner rotation requirements for accounting firms with fewer than five audit clients and fewer than ten partners.  The SEC indicated, however, that in order for a small firm to qualify for the exemption, the Public Accounting Oversight Board must conduct a review of all of the firm's engagements subject to the rule at least once every three years. The SEC indicated that this special review should focus on the overall quality of the audit and in particular on the independence and competence of the key personnel on the audit engagement teams

Auditor "Cooling Off" Periods

Alleged accounting improprieties at Enron managed to slip by the supervision of the outside auditors.  This has been attributed to the cozy relationships that existed between audit engagement partners at Enron's outside accountants and recently hired in-house Enron accountants that used to work for Enron's outside accountants.  The fact that in-house auditors of Enron had so recently been employed by the outside accountants led to a situation akin to outside auditors reviewing their own work. 

In response to this situation, the January 28th Final Rules provide that an accounting firm will not be deemed independent in respect of a fiscal year, if a former member of the audit engagement team accepts employment with the client in a "financial reporting oversight" role without first observing a prescribed cooling off period. 

The January 28th Final Rules provide that a company cannot hire a person who was on the audit engagement team during the one year period preceding the date that audit procedures commenced for the fiscal period that included the date on which the audit engagement team member began his or her employment with the company.

The cooling off requirement applies to the lead partner, the reviewing partner and to all other members of the audit engagement team.  It does not apply to other persons affiliated with the audit engagement team who had less involvement, such as persons who spent 10 or fewer hours providing audit services during the relevant fiscal period or other persons employed by the company in an accounting role under emergency or other unusual circumstances.

Restrictions on Audit Partner Compensation

There has been considerable concern that the auditors' independence might be compromised due to the financial interests they may have in the sale of non-audit services to the audit client.  Some auditors may be reluctant to take a position on the financial statements contrary to management because they fear they will lose the compensation paid to them by their firm for the sale of non-audit services to the audit client.  The concern is reminiscent of allegations that analysts cannot render impartial advice regarding companies whose investment banking business they rely upon for their year-end bonus. 

Accordingly, the January 28th Final Rules provide that an accountant is not independent if, at any time during the audit engagement period, any audit partner derives compensation based on the audit partner's procuring engagements with the audit client to provide any services other than audit, review or attest services. 

Reports by the Outside Accountant to the Audit Committee

As part of the need to get the audit committee more involved in ensuring the integrity of the financial statements, the January 28th Final Rules require that the outside accountants report to the audit committee prior to the filing of the audit report with the SEC.  This report should include, among other things, the critical accounting policies to be used in compiling the financial statements and the elections made between alternative accounting treatments within GAAP.  The bottom line of electing such alternative disclosures and treatments should be discussed. 

Disclosure of Audit Fees

The January 28th Final Rules require that a company disclose certain information regarding fees paid to its principal accountant in its Form 10-K, Form 20-F or Form 40-F and proxy statement.  This fee information includes among others: (i) the aggregate audit fees billed for each of the last two fiscal years for audit services provided by the accountant in connection with regulatory filings; (ii) the aggregate audit-related fees billed in each of the last two years related to the audit; (iii) the aggregate tax fees billed in each of the last two years for tax compliance advice and tax planning services and (iv) the aggregate of all other fees billed in the last two fiscal years as well as certain other fee information.

Audit Committee Financial Experts

On January 23, 2003, the SEC published its final rules (the "January 23rd Final Rules") in accordance with §407 of the Act, requiring a company to disclose in its annual reports on Forms 10-K, 10-KSB, 20-F or 40-F whether the board of directors has determined one member of the audit committee to be a financial expert or whether it does not have a financial expert serving on the audit committee.  If a company does not have an audit committee financial expert, it must explain why it does not have such an expert.  Under the January 23rd Final Rules, if a company discloses that it has an audit committee financial expert, it must also disclose the expert's name.  The final rules permit, but do not require, a company to disclose more than one audit committee financial expert serving on its audit committee.  Under January 23rd Final Rules, companies must disclose whether the audit committee financial expert is independent of management. 

In order to qualify as an "audit committee financial expert," the person must have all of the following five attributes:

  • An understanding of generally accepted accounting principles ("GAAP") and financial statements;
  • The ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves;
  • Experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the company's financial statements, or experience actively supervising one or more persons engaged in such activities;
  • An understanding of internal controls and procedures for financial reporting; and
  • An understanding of audit committee functions.

The final rules require a person to have acquired these attributes through any one or more of the following:

  • Education and experience as a principal financial officer, principal accounting officer, controller, public accountant, or auditor, or experience that involves the performance of similar functions;
  • Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;
  • Experience overseeing or assessing the performance of companies or public accountants with respect to preparation, auditing or evaluation of financial statements; or
  • Other relevant experience.

Does the Audit Committee Financial Expert have more Onerous Legal Obligations than Directors who are not the Audit Committee Financial Expert?

The January 23rd Final Rules include a safe harbor to clarify that the audit committee financial expert has no higher degree of  responsibility compared to other audit committee members or members of the board. Under the January 23rd Final Rules, a person deemed an audit committee financial expert will not be considered an “expert” for any purpose, including without limitation for purposes of Section 11 of the Securities Act of 1933, which gives investors the right to sue in connection with misleading statements or omissions. In addition, the January 23rd Final Rules provide that the designation of an audit committee financial expert does not affect the duties, obligations or liability of any other member of the audit committee or board of directors.

Are Non-U.S. Public Companies required to have an Audit Committee Financial Expert?

The SEC’s January 23rd Final Rules clarify that the audit committee financial expert disclosure requirements apply to non-U.S. public companies. Specifically, the SEC’s final rules provide that the audit committee financial expert’s understanding must be of the generally accepted accounting principles used by the non-U.S. public company in preparing its primary financial statements filed with the SEC.  The January 23rd Final Rules require non-U.S. public companies that do not prepare their primary financial statements in accordance with U.S. GAAP to include reconciliation to those principles in the financial statements that they file with the SEC. 

Non-U.S. public companies must disclose whether their audit committee has a financial expert on Forms 20-F and 40-F.  In its January 23rd Final Rules, the SEC deferred deciding on whether non-U.S. public companies must disclose whether their audit committee financial expert is independent.

The SEC revisited the issue in its April 9th Final Rules regarding standards relating to listed company audit committees and determined that, if a non-U.S. public company is a listed company, the non-U.S. public company must disclose whether its audit committee financial expert is independent, as that term is defined by the SRO listing standard applicable to that company.  If the non-U.S. public company is not a listed company, it must choose one of the SRO definitions of audit committee member independence that have been approved by the SEC in determining whether its audit committee financial expert, if it has one, is independent.  The non-U.S. public company must also disclose which definition was used.  Non-U.S. public companies do not need to comply with this independence disclosure requirement until July 31, 2005.

As discussed in our November 2002 Client Advisory entitled The Application of Sarbanes-Oxley to Non-U.S. Companies, under the proposed and final SEC rules, companies are not obliged to actually have financial experts on the board but are only required to disclose if they do and if not, why not.  A non-U.S. public company could comply with the requirements of the Act by stating that it does not have a financial expert because there is no requirement under the law of its home jurisdiction to have one.  Of course, the absence of financial experts on audit committees may cause investor relation problems. One solution that has been recommended for a company that cannot find an audit committee member with the required qualifications is to retain a financial expert as an outside consultant.  This solution would be consistent with §301 of the Act which authorizes audit committees to engage outside advisors.

By when must a Company comply with the Audit Committee Financial Expert Requirements?

Companies must comply with the audit committee financial expert disclosure requirements in their annual reports for fiscal years ending on or after July 15, 2003.  Small business issuers must comply with the audit committee financial expert disclosure requirements in their annual reports for fiscal years ending on or after December 15, 2003. As discussed above, non-U.S. public companies will not be required to comply with the audit committee financial expert independence disclosure requirement until July 31, 2005.

What are the Audit Committee Financial Expert Requirements under the Proposed NYSE and Nasdaq Rules?

Under NYSE’s proposed rules, each member of the audit committee of U.S. listed companies would be required to be financially literate (or become financially literate within a reasonable period of time after his her appointment to the committee), as such qualification is determined by the board of directors in its business judgment.  In addition, the NYSE proposals require at least one member of the audit committee of U.S. listed companies to have accounting or related financial management expertise, as the company’s board of directors interprets such qualification in its business judgment. 

Nasdaq has indicated that it will continue to require companies to comply with the existing Nasdaq listing requirements.  Under Nasdaq’s existing rules, the audit committee of each company must have at least one member with “past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.”

Code of Ethics for Principal Officers

On January 23, 2003, the SEC published final rules implementing §406 of the Act (the “January 23rd Final Rules”) requiring reporting companies to disclose whether or not they have adopted a written code of ethics for their principal executive officers, financial officers, principal accounting officers or controllers or persons performing similar functions.  A company which has not adopted such a code of ethics must explain why it has not done so.

A code of ethics is defined to mean written standards designed to deter wrongdoing and to promote:

  • Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
  • Full, fair, accurate, timely and understandable disclosure in reports and documents submitted to the SEC and in other communications to the public;
  • Compliance with governmental laws, rules and regulations;
  • The 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.

The SEC’s January 23rd Final Rules allow companies to choose between three alternative methods of making their ethics codes publicly available. First, a company may file a copy of its code of ethics as an exhibit to its annual report (on Forms 10-K, 10-KSB, 20-F or 40-F).  Alternatively, a company may choose to post the text of the code on its website, provided that the company also discloses its intention to provide disclosure in this manner in its annual report.  Finally, a company may provide an undertaking in its annual report to provide a copy of its code of ethics to any person without charge upon request.

In addition, the Act (§406(b)) directs the SEC to require a company to make immediate disclosure on Form 8-K or via internet dissemination of any change to, or waiver from, the company’s code of ethics for its senior financial officers.  The SEC’s implementing rules add an item to the list of the Form 8-K triggering events to require disclosure of: (i) the nature of any amendment of a code of ethics applying to the company’s principal executive officer, principal financial officer, principal accounting officer or controller, or person performing similar functions or (ii) any waiver (including an implicit waiver) of a provision of the company’s code of ethics to the specified officers, the name of the person to whom the company granted the waiver and the date of the waiver.  A company choosing to provide the required disclosure on Form 8-K must do so within five business days after it amends its ethics code or grants a waiver.  As an alternative to reporting this information on Form 8-K, a company may use its website as a method of disseminating this disclosure, but only if it previously has disclosed in its most recently filed annual report on Form 10-K or 10-KSB: (i) its intention to disclose these events on the website and (ii) its website address.

Are Non-U.S. Public Companies required to make Disclosures regarding a Code of Ethics?

A non-U.S. public company is required to provide the new code of ethics disclosure in its Exchange Act annual report.  A non-U.S. public company, however, will not have to provide in a current report “immediate disclosure” of any change to, or waiver from, the company’s code of ethics for its senior financial officers and principal executive officers.  Instead, non-US. public companies are required to disclose any such change or waiver that has occurred during the past fiscal year in their Exchange Act annual report. The SEC indicated that non-U.S. public companies may choose to disclose any change or waiver from the code of ethics obligations of its senior officers on a Form 6-K or its website.

By when must a Company comply with the Code of Ethics Disclosure Requirements?

Companies must comply with the code of ethics disclosure requirements promulgated under Section 406 of the Act in their annual reports for fiscal years ending on or after July 15, 2003.  In addition, companies must comply with the requirements regarding disclosure of amendments to, and waivers from, their ethics codes on or after the date on which they file their first annual report in which disclosure of the code of ethics is required.

What are the Code of Ethics Requirements under the NYSE Proposed Rules?

Under the NYSE’s proposed rules, listed companies are required to adopt and disclose a code of business conduct and ethics for directors, officers and employees. The NYSE’s proposals require that any waiver of the code for executive officers or directors must be approved by the board of directors or committee of the board of directors.  Any waiver must be promptly disclosed to shareholders.  This disclosure requirement is designed to inhibit questionable waivers and should help ensure that, where warranted, a waiver is accompanied by appropriate controls designed to protect the company.  Listed companies must post their code of business conduct and ethics on their website.  Further, listed companies should indicate in their annual report that their code of ethics is available on their website and that upon request any shareholder can receive this information in print.  Each code of business conduct and ethics must contain compliance standards and procedures that will facilitate the effective operation of the code.  While all listed companies can determine their own policies, all policies should address the following important topics: (i) conflicts of interest, where an executive, director or employee’s private interest interferes with the interests of the corporation as a whole, (ii) misappropriation of corporate opportunities where an executive, director or employee takes for themselves personally, property or information belonging to the company, (iii) confidentiality of information entrusted to executives, directors and employees by the company, (iv) fair dealing with customers, suppliers, competitors and employees, (v) protection and proper use of company assets, (vi) compliance with laws, rules and regulations and (vii) encouraging the reporting of any illegal or unethical behavior.  NYSE listed companies must adopt a code of ethics within six months of approval by the SEC of the NYSE proposed rules.

What are the Code of Ethics Requirements under the Nasdaq Proposed Rules?

On January 15, 2003, Nasdaq proposed a rule amendment requiring listed companies to adopt a code of conduct for all directors, officers and employees. These codes of conduct must be made available to the public.  Under Nasdaq’s January 15, 2003 proposed rules, the code must comply with the Act and the SEC’s regulations. Nasdaq’s proposal also requires that each code of conduct provide for an enforcement mechanism that ensures the prompt and consistent enforcement of the code, protection for the persons reporting questionable behavior, clear and objective standards for compliance, and a fair process by which to determine violations.  Nasdaq’s proposal requires listed companies to have a code of conduct that applies to all directors, officers and employees, and listed companies can satisfy this obligation by adopting one or more codes of conduct, such that all directors, officers and employees are subject to a code.  Any waivers of the code for directors or executive officers, however, must be approved by the board of directors and disclosed in the company’s public filings, not later than the next periodic report.  Therefore, U.S. companies must make this disclosure in their next quarterly or annual report (whichever is sooner), and non-U.S. listed companies must make this disclosure in their next semi-annual report.  In the alternative, a company may choose to include this disclosure on a Form 8-K filed before its next periodic report.  Nasdaq listed companies are required to have a complying code of ethics six months from the date of approval of the proposed Nasdaq rules by the SEC.

Disclosure of Off-Balance Sheet Transactions

The financial statements of Enron were opaque regarding the impact of its special purpose entities on the financial condition of the company. This finally led to Enron’s implosion.  Accordingly, the Act (§401) and the related final rules of January 27, 2003 (the “January 27th Final Rules”) require disclosure of all material off-balance sheet transactions, obligations, contingencies and other relationships of the company with unconsolidated entities or other persons that may have a material current or future effect on its financial statements.  In the January 27th Final Rules, the SEC clarified that this new disclosure must be located in a separately captioned statement in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) section. 

In the January 27th Final Rules, the SEC defined the term “off-balance sheet arrangement” as any contractual arrangement to which an entity not consolidated with the company is a party, under which the company has: (i) any obligation under a guarantee or similar arrangement; (ii) a retained or contingent interest in assets transferred to such unconsolidated entity or similar arrangement that serves as credit liquidity or market risk support to that entity for such assets; (iii) any obligation under certain derivative instruments or (iv) any obligation under a material variable interest, held by the company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the company, or engages in leasing, hedging or research and development services with the company.

The SEC’s final rules require companies to disclose the material facts and circumstances that provide investors with a clear understanding of a company’s off-balance sheet arrangements and their material effects. In particular, the SEC requires that the following four items must be disclosed to the extent necessary for an understanding of a company’s off-balance sheet arrangements and their effects: (i) the nature and business purpose of the company’s off-balance sheet arrangements; (ii) the importance of the off-balance sheet arrangements to the company for liquidity, capital resources, market risk or credit risk support or other benefits; (iii) (a) the amounts of revenues, expenses and cash flows of the company arising from the arrangements, (b) the nature and total amount of any interests retained, securities issued and other indebtedness incurred by the company in connection with such arrangements and (c) the nature and amount of any other obligations or liabilities of the company arising from the arrangements that are, or are reasonably likely to become, material and the triggering events and circumstances that could cause them to arise and (iv) known events, demands, commitments, trends or uncertainties that are reasonably likely to affect the availability or benefits to the company of material off-balance sheet arrangements and the course of action that it has taken (or proposes to take) in response to a termination or material reduction in the availability of an off-balance sheet arrangement that provides material benefits.  In the January 27th Final Rules, the SEC also indicated that a company should provide further information that it believes necessary for an understanding of its off-balance sheet arrangements and the material effects on the company’s financial condition.  The SEC indicated that companies are not required to make disclosure of an off-balance sheet arrangement until there is an unconditionally binding definitive agreement or a settlement transaction.

In addition, the SEC’s January 27th Final Rules require companies to disclose in tabular format the amounts of payments due under various contractual obligations for specified time periods.  Companies must provide information as of the latest fiscal year end balance sheet date for contractual obligations involving long term debt, capital lease obligations, operating leases, purchase obligations and other long term liabilities reflected on the company’s balance sheet under GAAP.  Companies filing small business reporting forms are not required make these tabular disclosures.   

Are Non-U.S. Public Companies required to disclose Off-Balance Sheet Transactions?

The January 27th Final Rules apply to non-U.S. public companies that file annual reports on Form 20-F or Form 40-F.  Non-U.S. public companies are generally not required to update their MD&A disclosure more frequently than annually. The disclosure regarding off balance sheet transactions and the table of contractual obligations that non-US. reporting companies provide in documents filed with the SEC must focus on the primary financial statements, whether those are prepared in accordance with U.S. GAAP or non-U.S. GAAP.  Non-U.S. public companies should take into account reconciliation to U.S. GAAP.  In the January 27th Final Rules, the SEC indicated that the definition of “off balance sheet arrangement” for non-U.S. public companies encompasses the same type of arrangements as for U.S. companies.  To determine the types of arrangements subject to disclosure, a non-U.S. public company must assess its guarantee contracts and variable interests pursuant to U.S. GAAP. The SEC cautioned that the MD&A disclosure for non-U.S. public companies should continue to focus on its primary financial statements, even though various off-balance sheet arrangements have been defined by reference to U.S. GAAP.

What Protection can a Company Receive Against Allegations of Misstatements in Forward Looking Information in Connection with Disclosure of Off-Balance Sheet Transactions?

Because some of the disclosure required by the January 27th Final Rules in connection with off-balance sheet transactions would require disclosure of forward-looking information and to protect companies against legal actions that are based upon allegations of misstatements, the SEC’s final rules include a statutory safe harbor for forward-looking information.  The statutory safe harbor provides three bases for a company to claim the protection against liability for forward-looking statements. First, a company may choose to identify the statement as a forward-looking statement and include meaningful, cautionary statements that identify important factors that could cause actual results to differ materially from those in the forward-looking statements. Second, a company will be protected from any forward-looking statement that is not material.  Third, a company is protected from private liability if the plaintiff fails to prove that the forward-looking statement was made by or with the approval of an executive officer of the company who had actual knowledge that it was false or misleading.  The statements of reporting companies, persons acting on behalf of the reporting companies, outside reviewers retained by them and underwriters are covered under the statutory safe harbor.

By when must a Company comply with the disclosure requirements of Off Balance Sheet Transactions?

Companies must comply with the off-balance sheet arrangement disclosure requirements in registration statements, annual reports and proxy or information statements that are required to include financial statements for their fiscal years ending on or after June 15, 2003. Companies must include the table of contractual obligations in registration statements, annual reports and proxy or information statements that are required to include financial statements for the fiscal years ending on or after December 15, 2003.

Use of Non-GAAP Financial Statements - Regulation G

Prior to the Act, a practice had developed whereby companies would present financial information in press releases not in accordance with GAAP.  This practice led to conflicting financial results and created confusion for investors.  Accordingly, the Act (§401) and the final rules published on January 22, 2003 (the “January 22nd Final Rules”) provide that pro forma financial information included in any periodic or other report filed with the SEC or included in any public disclosure must be presented in a manner that (i) does not contain any misleading information and (ii) reconciles it with the financial condition and results of operations of the company under GAAP.  According to a new Regulation G, included in the January 22nd Final Rules, whenever a company discloses material information that includes a non-GAAP financial measure, the company must disclose: a presentation of the most directly comparable financial measure calculated in accordance with GAAP and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.  A non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flow that excludes amounts that are included in the most directly comparable measure calculated in accordance with GAAP or includes amounts that are excluded from the most directly comparable measure under GAAP.  Regulation G includes the general disclosure requirement that a company (or person acting on its behalf) cannot make public a non-GAAP financial measure that contains an untrue statement of a material fact or omits a material fact that is necessary in order to make the non-GAAP financial measure not misleading.

How are Non-GAAP Financial Measures to be presented in SEC Filings?

The January 22nd Final Rules amend Item 10 of Regulation S-K and Item 10 of Regulation S-B requiring companies that use non-GAAP financial measures in filings with the SEC to include: (i) a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP, consistent with the requirements of Regulation G; (ii) a reconciliation of the disclosed non-GAAP financial measure, consistent with requirements of Regulation G; (iii) a statement disclosing the reasons why the company’s management believes that the presentation of a non-GAAP financial measure provides useful information regarding the company’s financial condition and results of operations and (iv) a statement disclosing the additional purposes, if any, for which the company’s management uses non-GAAP financial measures that are not otherwise disclosed.  In addition, the amended Item 10 of Regulation S-K and Regulation S-B prohibit the following: (i) excluding charges or liabilities that require cash settlement from non-GAAP liquidity measures, other than the measures EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortization); (ii) adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge is such that it is reasonably likely to occur within in two years or there was a previous gain or charge within the prior two years; (iii) presenting non-GAAP financial measures on the face of the company’s financial statements prepared in accordance with GAAP or in the accompanying notes; (iv) 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 and (v) using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.

Does Regulation G apply to Non-U.S. Public Companies?

Regulation G applies to non-U.S. public companies, subject to a limited exception. The proposed Regulation G would not apply to a non-U.S. public company if (i) its securities are listed or quoted outside the U.S.; (ii) the non-GAAP financial measure is not derived from or based on a measure calculated in accordance with U.S. GAAP and (iii) the disclosure is made outside the United States, or is included in a written communication that is released only outside the United States.  A communication will be considered released only outside the United States even if: (i) U.S. journalists or other third parties have access to it; (ii) the information will appear on company web sites that are accessible from the United States (so long as they are not targeted at persons located in the United States); (iii) a written communication is released in the United States as well as outside the United States, so long as the communication is released in the United States contemporaneously with or after the release outside the United States (and is not otherwise targeted at persons located in the United States) and (iv) the information will be included in a submission to the SEC on Form 6-K.

The SEC amended Form 20-F to incorporate Item 10 of Regulation S-K. The SEC indicated that a non-GAAP financial measure that would otherwise be prohibited is permitted in a Form 20-F filing of a non-U.S. public company if the measure is: (i) required or expressly permitted by the standard setter that establishes the generally accepted accounting principles used in the non-U.S. public company’s primary financial statements and (ii) included in the non-U.S. public company’s annual report or financial statements used in its home country jurisdiction or market.

Non-U.S. public companies do not file Form 8-Ks and therefore are not subject to the additional Form 8-K filing requirement.

By when must a Company comply with Rules regarding the use of Non-GAAP Financial Statements?

The effective date for the SEC’s final rules regarding non-GAAP financial measures is March 28, 2003. Therefore, Regulation G applies to all applicable disclosures as of March 28, 2003.  The requirement to furnish press releases and other announcements to the SEC on Form 8-K applies after March 28, 2003. The amendments to Item 10 of Regulation S-K, Item 10 of Regulation S-B and Form 20-F apply to annual and quarterly reports filed with respect to a fiscal period ending after March 28, 2003.

Rapid Disclosure of Information Concerning Material Changes in Financial Condition or Operations   

The Act (§409) and the January 22nd Final Rules require that companies which file reports with the SEC must disclose to the public on a rapid and current basis information concerning material changes in the financial condition and operations of the company, in plain English.  The January 22nd Final Rules amend Form 8-K by adding Item 12, “Disclosure of Results of Operations and Financial Condition.”  This new Item 12 requires companies to furnish to the SEC a Form 8-K within five business days of any public announcement or release disclosing material non-public information regarding a company’s results of operations or financial condition for an annual or quarterly fiscal period that has ended.  The new Item 12 requires the company to identify briefly the announcement and include the announcement as an exhibit to Form 8-K. 

The SEC has provided an exception to its Item 12 requirements, where non-public information is disclosed orally, telephonically, by webcast, by broadcast or by other similar means in a presentation that is complementary to and occurs within 48 hours after a related, written release or announcement that triggers the requirements of Item 12.  Specifically, a company is not required to furnish an additional Form 8-K if: (i) the related, written release or announcement has been furnished to the SEC on Form 8-K pursuant to Item 12 prior to the presentation; (ii) the presentation is broadly accessible to the public by dial in conference call, webcast or other similar technology; (iii) the financial and statistical information contained in the presentation is provided on the company’s web site, together with any information that would be required by Regulation G; and (iv) the presentation was announced by a widely disseminated press release that included instructions as to when and how to access the presentation and the location on the company’s web site where the information would be available.

In addition, if the information contained in an earnings release or announcement contains a non-GAAP financial measure, companies are required to disclose: (i) the reasons why the company’s management believes that the presentation of the non-GAAP financial measure provides useful information to investors regarding the company’s financial condition and results of operations and (ii) to the extent material, the additional purposes, if any, for which the company’s management uses the non-GAAP financial measure that are not otherwise disclosed.  Companies may satisfy this disclosure requirement by including the disclosure in the Form 8-K or by including the disclosure in the release or announcement that is included as an exhibit to Form 8-K.  Companies can also satisfy this requirement by including the disclosure in the most recent annual report filed with the SEC and by updating those statements no later than the time the Form 8-K is furnished to the SEC.

Obligatory Electronic Filing for Forms 3, 4 and 5.

Section 16 of the Securities Exchange Act of 1934, as amended, requires every person who is a beneficial owner of more than 10% of any class of equity security registered under the Exchange Act and each officer and director of the company to file a report of transactions made by such insider person in the stock of the company. Section 16(a) of the Exchange Act requires the insider to file a Form 3 with the SEC disclosing beneficial ownership of all equity securities of the company. Section 16 also requires insider to update this information by reporting changes in ownership on either Form 4 or Form 5. Before the enactment of the Act, such reports were due within 10 days of the close of the month in which the transactions occurred. The Act amended §16 of the Exchange Act, effective for transactions effected on or after August 29, 2002, to require insiders to file a transaction report before the end of the second business day following the day on which the transaction was executed. Currently, reporting persons may file Forms 3, 4 and 5 either in paper or electronically on the SEC’s Electronic Data Gathering, Analysis and Retrieval System, also known as EDGAR.

By when must Companies comply with the Obligatory Electronic Filing Requirements of Form 3, 4, & 5?

On May 7th, the SEC published final rules, (the “May 7th Final Rules”) which now require, rather than permit, reporting persons filing a Form 3, 4, or 5 on or after June 30, 2003, to file the Form on EDGAR. The SEC will no longer accept paper filings after June 30, 2003. In order to be in a position to comply and not risk untimely filings, action is required now in good time before the June 30, 2003 effective date. In order to file on Edgar, each reporting person will need to become familiar with the EDGAR filing procedure and will require a Central Index Key (“CIK”) and a CIK Confirmation Code for validation of the Forms. Under the May 7th Final Rules, forms will be deemed timely filed on a date if submitted by 10.p.m. Eastern Standard time on that date.

In addition, the May 7th Final Rules require all companies that maintain a corporate website to post on that website all Forms 3, 4 and 5 by the end of the business day after the EDGAR filing.

The purpose of the May 7th Final Rules is to make such filings on Forms 3, 4 and 5 available for public scrutiny the moment they hit EDGAR thereby eliminating the delay that would be caused by the need to procure a copy of the paper filing from the SEC.  Requiring EDGAR filing for changes in insiders’ beneficial ownership is a natural outcome of the SEC Rules adopted on August 27, 2002 requiring insiders to report changes in beneficial ownership to the SEC before the end of the second business day following the day on which the transaction changing the beneficial ownership was executed.  There would be little point requiring insiders to file within 2 days if the public had to wait another two days to access the filing.

Conclusion

The Sarbanes-Oxley Act is the most comprehensive scheme of revised corporate governance in the history of American business. This Advisory has summarized the final and proposed audit committee and financial reporting requirements which are and will come into effect under the latest announcements from the SEC, NYSE, and Nasdaq, and we anticipate that there will be a constant and comprehensive series of additional rules and interpretations as companies endeavor to understand and comply with the new rules.

We will keep you up to date.  We are Partners for Your Business.


Questions regarding Sarbanes-Oxley may be directed to Raphael S. Grunfeld (grunfeld@clm.com), Stephen J. Glusband (glusband@clm.com) or Robert A. McTamaney (mctamaney@clm.com) of our New York Office (212-732-3200).  Christina Gray (New York admission pending) assisted in the preparation of this advisory.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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