SEC Issues Proposed Rules Prohibiting Improper Influence of Auditors and Requiring Disclosures Under Sarbanes-Oxley Act
 
November 6, 2002
 

The Securities and Exchange Commission (the SEC) issued proposed rules on October 18 and October 22, 2002, in accordance with the Sarbanes-Oxley Act (the Act).  The proposed rules prohibit public companies from improperly influencing auditors and require those companies to make certain disclosures relating to (i) internal control reports; (ii) a code of ethics for senior financial and principal executive officers; and (iii) the number and names of the “financial experts” serving on the company’s audit committee and their independence.

Improper Influence on Auditors

Section 303(a) of the Act prohibits officers and directors of a company, and persons acting under the direction of an officer or director, from taking any action to fraudulently influence, coerce, manipulate or mislead the company's auditor for the purpose of rendering the financial statements materially misleading.

The proposed rules would cover not only the direct or indirect activities of officers and directors of the company, but also any other person acting under the direction, but not necessarily the supervision, of the officers and directors. 

Examples of conduct that could, if successful, result in rendering the financial statements misleading include:

• issuing a report on a company’s financial statements that is not warranted in the circumstances (due to material violations GAAP, GAAS or other standards)
• not performing an audit, review or other procedures required by GAAS or other professional standards
• not withdrawing an issued report
• not communicating matters to a company’s audit committee

Conduct that may constitute improper influence includes, directly or indirectly:

• offering or paying bribes or other financial incentives, including offering future employment or contracts for non-audit services
• providing an auditor with inaccurate or misleading legal analysis
• threatening to cancel or canceling 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
• blackmailing
• making physical threats

Management Assessment of Internal Controls

Section 404 of the Act requires companies, other than registered investment companies, to include an internal control report with each annual report filed with the SEC.  The internal control report must:

• state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting and
• contain an assessment by management about the effectiveness of the company’s internal controls and procedures for financial reporting as of the end of the company’s most recent fiscal year

The company’s registered public accountant must attest to, and report on, management's evaluation of the company’s internal controls and procedures for financial reporting.

Under the proposed rules, quarterly evaluations of the company’s disclosure procedures and controls would be required.  Although the Act does not require filing of the attestation report, the proposed rules would require its inclusion in the company’s annual report to stockholders on Form 10-K.

If adopted, the proposed rules would first apply to companies whose fiscal years end on or after September 15, 2003. 

Code of Ethics Disclosure Requirements

Under Section 406 of the Act, every public company must disclose in its periodic reports whether it has a written code of ethics for its principal financial officer and comptroller or principal accounting officer, or persons performing similar functions, and if it does not, the reasons why.  The proposed rules expand this disclosure requirement to include a company's principal executive officer.   

The Act defines “code of ethics” as a set of standards that are reasonably necessary 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 the periodic reports required to be filed by the company, and
• compliance with applicable government rules and regulations

The proposed rules broaden the Act’s definition of code of ethics to include three additional factors:

• 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
• the prompt, internal reporting of code violations to an appropriate person or persons identified in the code, and
• accountability for adherence to the code

Under the proposed rules, a copy of the company’s code of ethics would be required to be included as an exhibit in its annual report to stockholders on Form 10-K.  The proposed rules would also require companies, other than foreign private issuers and registered investment companies, to report any change or waiver of their ethics code within two business days on a Form 8-K or on their Web site.  Alternatively, the company may disseminate information on such changes or waivers on the company’s Web site provided the company discloses its intention to do so in its most recently filed annual report to stockholders on Form 10-K.  Foreign private issuers and registered investment companies would be required to disclose changes and waivers in their periodic reports or on their Internet Web sites.

Financial Experts on Company’s Audit Committee

Section 407 of the Act requires a company to disclose whether the company’s audit committee includes at least one financial expert, as the term is defined by the SEC, and if not, the reasons why. 

Pursuant to the proposed rules, a "financial expert" is defined as a person who, in the opinion of the company’s board of directors has, through education and experience as a public accountant or auditor or a principal financial officer, controller, or principal accounting officer of a public company or experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the company’s board of directors, in the person’s having similar expertise and experience), the following attributes:

• 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 registrant’s financial statements
• experience with internal controls and procedures for financial reporting, and
• an understanding of audit committee functions

To determine if a potential financial expert has all the requisite attributes, the board of directors must evaluate the totality of the individual’s education and experience.  The company should consider a variety of factors described in the proposed rules in making that evaluation.

For a foreign private issuer, the board of directors should also consider the person’s experience with public companies in the foreign private issuer’s home country, generally accepted accounting principles used by the issuer, and the reconciliation of financial statements with U.S. generally accepted accounting principles.

Companies would be required to disclose the new information in their annual reports on Form 10-K.  Any arrival or departure of a director would be disclosed in Form 8-K.

Amendments to SEC Forms

The proposed rules amend the various forms used by companies to file their annual reports.  These amendments are as follows:

• Form 10-K has been amended to include Item 10, Directors and Executive Officers of the Registrant, and Item 15, Audit Committee Financial Experts. 
• Form 10-KSB has been amended to include Item 9, Directors and Executive Officers of the Registrant, and Item 15, Audit Committee Financial Experts.
• Form 20-F has been amended to include Item 15(a), Controls and Procedures, Item 15(b) Audit Committee Financial Experts, and Item 15(c) Code of Ethics.

The SEC is currently soliciting public comment on the proposed rules.

For more information, contact Michael Jamieson at mjamieson@hklaw.com or Steven Sonberg at ssonberg@hklaw.com. They both may be reached through our toll-free telephone number, 888-688-8500.