In a substantial departure from its proposed "financial expert" definition, the SEC has adopted a more realistic final definition of "audit committee financial expert." The SEC final rules adopted pursuant to Sections 406 and 407 of the Sarbanes-Oxley Act of 2002 will require a public company to disclose, for fiscal years ending on or after July 15, 2003:
Whether it has an audit committee financial expert on its audit committee and
- Whether or not the company maintains a code of ethics for its CEO and senior financial officers.
Audit Committee Financial Expert Disclosure
New S-K Item 401(h): Financial Expert Disclosure
In Section 407 of Sarbanes-Oxley, Congress directed the SEC to adopt what is now new Item 401(h) of Regulation S-K to require a public company to disclose in its proxy statement or annual report on Form 10-K whether any member of its board of directors' audit committee is a financial expert.
Each company's board of directors must determine whether or not a director is an "audit committee financial expert." For each audit committee financial expert, the company must disclose:
The expert's (or experts') name(s) and
Whether the expert is (or experts are) independent from management.
"Independence" is determined under the independence requirements of Item 7 of Schedule 14A. Item 7(d)(3)(iv) of Schedule 14A defines "independent" by reference to the definition in the listing standards for NYSE, AMEX and Nasdaq, as applicable. Note that the independence requirements set out in the listing standards for NYSE, Nasdaq and other exchanges/trading markets are currently in the process of being revised in light of the recent SEC proposal regarding audit committee member independence, among other things. See our January 18, 2003 Update.
If a company does not have at least one financial expert on its audit committee, the company must explain why it does not.
The new Item 401(h) disclosure requirements will apply to annual reports on Forms 10-K for fiscal years ending on or after July 15, 2003. A company will generally incorporate the disclosure by reference to its proxy statement. (Incorporation by reference is permitted so long as the company files its proxy statement within 120 days after the end of the fiscal year covered by the relevant Form 10-K.)
Who is an "Audit Committee Financial Expert?"
New Item 401(h) of Regulation S-K defines an "audit committee financial expert" as a person who has all five of the following "attributes":
An understanding of GAAP and financial statements;
- Experience applying GAAP in accounting for estimates, accruals and reserves;
- Experience preparing, auditing, analyzing or evaluating financial statements that present accounting issues "generally comparable" to those that can reasonably be expected to be raised in the company's financial statements, or experience actively supervising someone engaged in those activities;
- An understanding of internal controls and procedures for financial reporting; and
- An understanding of audit committee functions.
Note that these required attributes now include experience evaluating financial statements. The audit committee financial expert must have acquired the above attributes through one or more of the following categories of activities, which now (in a change from the proposed rules) include experience supervising a CFO or principal accounting officer:
Education and experience as a CFO, principal accounting officer, controller, public accountant or auditor, or experience in one or more positions involving the performance of similar functions;
- Experience actively supervising a CFO, principal accounting officer, controller, public accountant, auditor or person performing similar functions;
- Experience overseeing or assessing the performance of companies or public accountants regarding the preparation, auditing or evaluation of financial statements; or
- Other relevant experience.
The SEC intends that a company's board of directors consider all relevant facts and circumstances when determining whether someone is an audit committee financial expert. The final rules specifically eliminated proposed instructions as to how a board should evaluate a potential expert's education and experience. However, if the company's board determines under relevant state law principles (e.g., business judgment) that an individual has the required attributes of an audit committee financial expert through "other relevant experience," the company must provide a brief listing of the person's relevant experience.
Final Definition Less Restrictive Than Proposal
The SEC's final definition of an audit committee financial expert is far less restrictive than the definition that the SEC proposed in October 2002, which would have virtually limited the expert designation to directors with experience as auditors, CFOs or chief accounting officers. One major change is to the third attribute. The original proposal required experience preparing or auditing financial statements that presented accounting issues generally comparable to those raised by the company's financial statements.
Agreeing with public comments that this proposed attribute was too narrow (and would therefore disqualify otherwise qualified individuals), the SEC broadened the focus to include experience preparing, auditing, analyzing or evaluating financial statements presenting a breadth and level of complexity of accounting issues generally comparable to the breadth and complexity of issues reasonably expected to be raised by the company's financial statements, or experience "actively supervising" someone who has been engaged in those activities. By adding the concepts of "analyzing," "evaluating" and "actively supervising," the SEC intends to include a person who has closely scrutinized or actively participated in, and contributed to, the process of addressing financial and accounting issues in a way that demonstrates a general expertise in the area. However, a CEO will not automatically qualify as an audit committee financial expert just because the CFO reports to the CEO.
The SEC also liberalized this attribute by clarifying that the financial expert's background need not be in the same industry as the company's on whose board of directors the financial expert serves. Instead, the SEC focuses on the "breadth and level of complexity" of the accounting issues with which the director has had experience. This stops short of requiring that an audit committee financial expert have had previous experience either in the same industry as the company, or with a Securities Exchange Act reporting company.
Safe Harbor From Liability for Audit Committee Financial Experts
The final rules include a safe harbor for audit committee financial experts to clarify that a company's designation of a person as an audit committee financial expert will not, by itself:
Deem that person an "expert" for any purpose (including for purposes of Section 11 of the Securities Act);
- Impose on that person any further duties, obligations or liability greater than those imposed for regular membership on an audit committee or board of directors; or
- Affect the duties, obligations or liability of any other member of the audit committee or board of directors.
Code of Ethics
New Item 406 of Regulation S-K: Disclosure Regarding Code of Ethics
Pursuant to Section 406 of Sarbanes-Oxley, the SEC adopted new Item 406 of Regulation S-K, which requires a public company to disclose in its Form 10-K whether or not it has adopted a code of ethics for its CEO, CFO, principal accounting officer, controller or persons performing similar functions. If a company fails to adopt a code of ethics, the company must disclose the reasons for this failure. As a practical matter, particularly in the current climate, we expect that most public companies that have not already adopted codes covering the applicable requirements will choose to establish a code of ethics that complies with the final rules.
A company must provide the Item 406 disclosure on Form 10-K for fiscal years ending on or after July 15, 2003.
What Is a Code of Ethics for the CEO and Senior Financial Officers?
Item 406 of Regulation S-K defines the term "code of ethics" to mean written standards that are reasonably necessary to deter wrongdoing and to promote:
Honest and ethical conduct, including 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 that a company files with, or submits to, the SEC and in other company public communications;
- Compliance with applicable laws, rules and regulations;
- Prompt internal reporting of code violations to an appropriate person or persons identified in the code of ethics; and
- Accountability for adherence to the code of ethics.
Availability of Code of Ethics
Item 406(c) of Regulation S-K requires a company that adopts a code of ethics to make the code publicly available by:
Filing the code of ethics as an exhibit to the company's Form 10-K;
- Posting the code of ethics on the company's Web site, and disclosing in the Form 10-K the company's Web site address and the fact that the company has posted its code of ethics on its Web site; or
- Providing a copy of its code of ethics upon request and without charge (if the company's Form 10-K contains an undertaking to do so and an explanation of how a person can make the request).
Disclosure of Waivers Regarding, and Changes to, Code of Ethics
The final rules require a company to report the nature of any waivers regarding breaches of its code of ethics (including implicit waivers due to the company's inaction regarding a reported or known violation of a code provision), the name of any person to whom the company grants the waiver, and the date of the waiver. The company must also disclose changes to its code of ethics. Companies must only report waivers and changes to the code that relate to the specified officers.
Companies must disclose waivers and changes by filing a Form 8-K or by posting the information on the company's Web site within five business days after making the change or granting the waiver.
To utilize the Web site disclosure option, a company must have disclosed its Web site address in its most recently filed Form 10-K and indicated that it intends to disclose these code of ethics waivers and changes on its Web site. In addition, a company utilizing this option must maintain the disclosure on its Web site for at least 12 months after posting the disclosure, retain the disclosure for at least five years and make it available to the SEC upon request.
Text of the Final Rules
You can find the full text of the SEC's final rules regarding disclosures required by Sections 406 and 407 of Sarbanes-Oxley at www.sec.gov/rules/final/33-8177.htm. You can also find further discussion of the Sarbanes-Oxley Act and of recent laws and regulations of interest to public companies on our website.