# Disclosure Required by Sections 404, 406 and 407 of the Sarbanes- Oxley Act of 2002 > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3AX02-11030 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** October 30, 2002 - **Citation:** 67 FR 66208 ## Text Part II Securities and Exchange Commission ----------------------------------------------------------------------- 17 CFR Parts 210, 228, et al. Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002; Proposed Rule Federal Register&thnsp;/&thnsp;Vol. 67, No. 210&thnsp;/ &thnsp;Wednesday, October 30, 2002&thnsp;/&thnsp;Proposed Rules [[Page 66208]] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 210, 228, 229, 240, 249, 270 and 274 [Release Nos. 33–8138; 34–46701; IC–25775; File No. S7–40–02] RIN 3235–AI66 Disclosure Required by Sections 404, 406 and 407 of the Sarbanes- Oxley Act of 2002 AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. ----------------------------------------------------------------------- SUMMARY: We propose to require companies to include a number of new disclosures in their Exchange Act filings. First, companies would be required to disclose the number and names of persons that the board of directors has determined to be the “financial experts” serving on the company's audit committee and whether they are independent of management, and if not, an explanation of why they are not. Second, companies would be required to include an annual internal control report of management stating the following: management's responsibilities for establishing and maintaining adequate internal controls and procedures for financial reporting for the company; management's conclusions 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; and that the company's registered public accounting firm has attested to, and reported on, management's evaluation of the company's internal controls and procedures for financial reporting. Third, companies would be required to disclose whether they have adopted a code of ethics that covers their principal executive officers and senior financial officers, or if they have not, an explanation of why they have not, as well as amendments to, and waivers from, the code of ethics relating to any of those officers. These proposed rules would implement the requirements in sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002. We also propose to make revisions to our recently adopted rules requiring a company's principal executive and financial officers to certify the company's quarterly and annual reports and requiring the company to conduct quarterly evaluations of its disclosure procedures and controls. These rules would be amended to require quarterly and annual certifications and quarterly evaluations of internal controls and procedures for financial reporting. We also would amend the form of the principal officers' certification contained in the quarterly and annual report forms. DATES: Comments should be received on or before November 29, 2002. ADDRESSES: To help us process and review your comments more efficiently, comments should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549–0609. Comments also may be submitted electronically at the following e-mail address: rule- comments@sec.gov. All comment letters should refer to File No. S7–40–02; if e-mail is used, this file number should be included in the subject line. Comment letters will be available for inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549–0102. Electronically submitted comment letters will be posted on the Commission's Internet Web site (http://www.sec.gov).\1\ --------------------------------------------------------------------------- \1\&thnsp;We do not edit personal information, such as names or electronic mail addresses, from electronic submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: Ray Be, Special Counsel, or N. Sean Harrison, Special Counsel, Division of Corporation Finance, at (202) 942–2910, with respect to registered investment companies, Katy Mobedshahi, Senior Counsel, Division of Investment Management, at (202) 942–0721, or with respect to accounting issues, Michael Thompson, Professional Accounting Fellow, Office of Chief Accountant, at (202) 942–4400, U.S. Securities and Exchange Commission, 450 Fifth --------------------------------------------------------------------------- Street, NW., Washington, DC 20549. SUPPLEMENTARY INFORMATION: We are proposing amendments to Form 8–K,\2\ Form 10–K,\3\ Form 10–KSB,\4\ Form 10–Q,\5\ Form 10–QSB,\6\ Form 20–F,\7\ Form 40–F,\8\ Form 12b–25,\9\ Rule 12b–25,\10\ Rule 13a–14,\11\ Rule 13a–15,\12\ Rule 15d–14,\13\ and Rule 15d–15\14\ under the Securities Exchange Act of 1934,\15\ Regulation S–B,\16\ Regulation S–K&thnsp;\17\ and Regulation S–X.\18\ We are also proposing amendments to Form N–SAR&thnsp;\19\ and proposed Form N–CSR&thnsp;\20\ under the Securities Exchange Act of 1934 and the Investment Company Act of 1940,\21\ and Rule 30a–2&thnsp;\22\ and proposed Rule 30a–3 under the Investment Company Act of 1940. --------------------------------------------------------------------------- \2\&thnsp;17 CFR 249.308. \3\&thnsp;17 CFR 249.310. \4\&thnsp;17 CFR 249.310b. \5\&thnsp;17 CFR 249.308a. \6\&thnsp;17 CFR 249.308b. \7\&thnsp;17 CFR 249.220f. \8\&thnsp;17 CFR 249.240f. \9\&thnsp;17 CFR 249.322. \10\&thnsp;17 CFR 240.12b–25. \11\&thnsp;17 CFR 240.13a–14. \12\&thnsp;17 CFR 240.13a–15. \13\&thnsp;17 CFR 140.15d–14. \14\&thnsp;17 CFR 240.15d–15. \15\&thnsp;15 U.S.C. 78a et seq. \16\&thnsp;17 CFR 228.10 et seq. \17\&thnsp;17 CFR 229.10 et seq. \18\&thnsp;17 CFR 210.1–01 et seq. \19\&thnsp;17 CFR 249.330; 17 CFR 274.101. \20\&thnsp;17 CFR 249.331; 17 CFR 274.128. \21\&thnsp;15 U.S.C. 80a–1 et seq. \22\&thnsp;17 CFR 270.30a–2. --------------------------------------------------------------------------- I. Background The strength of the U.S. financial markets depends on investor confidence. Recent events involving allegations of misdeeds by corporate executives, independent auditors and other market participants have undermined that confidence.\23\ In response to this threat to the U.S. financial markets, Congress passed, and the President signed into law, the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”),\24\ which effects sweeping corporate disclosure and financial reporting reform. --------------------------------------------------------------------------- \23\&thnsp;See, for example, John Waggoner and Thomas A. Fogarty, “Scandals Shred Investors” Faith: Because of Enron, Andersen and Rising Gas Prices, the Public Is More Wary Than Ever of Corporate America,” USA Today, May 5, 2002, and Louis Aguilar, “Scandals Jolting Faith of Investors,” Denver Post, June 27, 2002. \24\&thnsp;Pub. L. 107–204, 116 Stat. 745 (2002). --------------------------------------------------------------------------- This release is one of several that the Commission is required to issue to implement provisions of the Sarbanes-Oxley Act. In this release we propose rules to implement the following three provisions of the Sarbanes-Oxley Act: &sbull; Section 407, requiring the Commission to adopt rules: (1) requiring a company to disclose whether its audit committee includes at least one member who is a financial expert; and (2) defining the term “financial expert”; &sbull; Section 406, requiring the Commission to adopt rules requiring a company to disclose whether it has adopted a code of ethics for the company's senior financial officers, and if not, the reasons therefor, as well as any changes to, or waiver of any provision of, that code of ethics; and &sbull; Section 404, requiring the Commission to adopt rules requiring a company's management to present an internal control report in the company's annual report containing: (1) A [[Page 66209]] statement of the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) an assessment, as of the end of the company's most recent fiscal year, of the effectiveness of the company's internal control structure and procedures for financial reporting. Section 404 also requires the company's registered public accounting firm&thnsp;\25\ to attest to, and report on, management's assessment. --------------------------------------------------------------------------- \25\&thnsp;The term “registered public accounting firm” is defined in section 2(a)(12) of the Sarbanes-Oxley Act to mean a public accounting firm registered with the Public Company Accounting Oversight Board (the “PCAOB”) in accordance with the Sarbanes-Oxley Act. --------------------------------------------------------------------------- In connection with our proposed rules to implement the internal control report requirements included in section 404 of the Sarbanes-Oxley Act, we also propose several conforming revisions to our recently adopted certification rules and related requirements.\26\ --------------------------------------------------------------------------- \26\&thnsp;These include Exchange Act Rules 13a–14, 13a–15, 15d–14, 15d–15, Investment Company Act Rules 30a–2 and 30a–3, Item 307 of Regulations S–B and S–K and the forms of certification included in Forms 10–Q, 10–QSB, 10–K, 10–KSB, 20–F, 40–F, N–SAR and N–CSR. --------------------------------------------------------------------------- II. Discussion of Proposals A. Proposed Disclosure About Financial Experts Serving on a Company's Audit Committee Many of the recent corporate scandals have centered on the quality of a company's financial disclosure. These events have, among other things, highlighted problems that can occur as a result of inadequate oversight of a company's management and auditors by the company's board of directors or audit committee. The Commission historically has encouraged companies to establish independent audit committees to oversee the work and independence of auditors. For example, in 1972 the Commission recommended that companies establish audit committees composed of outside directors.\27\ Others have expressed their support for independent audit committees, including the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission,\28\ and the General Accounting Office.\29\ In 1999, we adopted rules requiring companies to disclose whether their audit committee members are independent, as defined by the relevant listing standards.\30\ --------------------------------------------------------------------------- \27\&thnsp;Accounting Series Release (ASR) 123 (March 23, 1972). \28\&thnsp;See the Report of the National Commission on Fraudulent Financial Reporting (1987). This commission, also known as the Treadway Commission, was sponsored by the AICPA, the American Accounting Association, the Financial Executives Institute (now Financial Executives International), the Institute of Internal Auditor and the National Association of Accountants. Collectively, these groups were known as the Committee of Sponsoring Organizations, or COSO. \29\&thnsp;GAO, “CPA Audit Quality: Status of Actions Taken to Improve Auditing and Financial Reporting of Public Companies,” at 5 (GAO/AFMD–89–38, March 1989). \30\&thnsp;Release No. 34–42266 (Dec. 22, 1999) [64 FR 73389]. This release addressed numerous issues related to auditor independence. --------------------------------------------------------------------------- In 1998, the New York Stock Exchange, Inc. (the “NYSE”) and the National Association of Securities Dealers, Inc. (the “NASD”) sponsored a committee to study the effectiveness of audit committees. This committee became known as the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the “Blue Ribbon Committee”). In its 1999 report, the Blue Ribbon Committee recognized the importance of the audit committee in overseeing the corporate accounting and financial controls and reporting of companies.\31\ The Blue Ribbon Committee noted that, because of this important role, an audit committee has “a more recognizable need for members with accounting and/or related financial expertise.” Without some level of financial competence, members of an audit committee may be unable to adequately perform their vital corporate duties. In response to this report, the NYSE, the NASD,\32\ the American Stock Exchange, Inc. (the “AMEX”) and the Pacific Exchange, Inc. (the “PCX”) adopted rules regarding the composition of listed companies” audit committees.\33\ --------------------------------------------------------------------------- \31\&thnsp;See Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999). \32\&thnsp;The NASD rules referred to herein apply to NASDAQ listed companies. \33\&thnsp;NYSE Rule 303.01, NASD Rule 4350(d)(2), AMEX Company Guide §&thnsp;121 and PCX Equities Rule 5.3(b). See also Release No. 34–42233 (December 14, 1999) [64 FR 71529], Release No. 34–42231 (December 14, 1999) [64 FR 71523], Release No. 34–42232 (December 14, 1999) [64 FR 71518], and Release No. 34–43941 (February 7, 2001) [66 FR 10545] respectively. --------------------------------------------------------------------------- The NYSE's and the PCX's rules require at least one member of a listed company's audit committee to have “accounting or related financial management expertise, as the Board of Directors interprets such qualification in its business judgment.”&thnsp;\34\ The NASD and the AMEX have similar rules that require each listed company to certify that it has, and will continue to have, at least one member of the audit committee that has past employment experience in finance or accounting, a professional certification in accounting, or comparable experience or background that demonstrates the individual's financial sophistication.\35\ These rules provide, by way of example, that a person who is or has been a chief executive officer, chief financial officer or other senior corporate officer with financial oversight responsibilities satisfies this criterion. In addition, all four self- regulatory organizations require all members of the audit committee to be independent and to be (or soon become) financially literate, subject to limited exceptions.\36\ While the NYSE and PCX rules permit a company's board of directors to interpret the financial literacy requirements, the NASD and AMEX rules define financial literacy as “the ability to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement.”&thnsp;\37\ --------------------------------------------------------------------------- \34\&thnsp;NYSE Rule 303.01 and PCX Rule 5.3(b). \35\&thnsp;NASD Rule 4350(d)(2) and AMEX Company Guide §&thnsp;121. \36\&thnsp;For example, the NASD Manual states that audit committee members must become able to read and understand fundamental financial statements within a reasonable time after being appointed to the audit committee. Similarly, the NYSE listing standard require such appointees to become financially literate, as that term is interpreted by the board of directors, within a reasonable period of time after appointment. Therefore, these rules do not require that members be so qualified at the time of appointment. Also, in general, with respect to foreign private issuers, the self-regulatory organization rules accommodate differences in home country practices regarding, among other things, audit committee composition. The Sarbanes-Oxley Act does not exempt foreign private issuers from the financial expert disclosure requirements. Our proposed rules similarly do not include an exemption for foreign private issuers. \37\&thnsp;Id. --------------------------------------------------------------------------- Although the NYSE, NASD, AMEX and PCX already have rules regarding the financial expertise of audit committee members, not all companies that are required to file reports under Sections 13(a) and 15(d) of the Exchange Act are subject to these requirements. Furthermore, the Sarbanes-Oxley Act directs us to adopt rules defining the term “financial expert” and specifies several attributes that we must consider in crafting the definition. These attributes are more detailed and rigorous than those reflected in the current self- regulatory organization rules. Therefore, it is possible that a person who previously qualified as a financial expert under the broader guidelines included in the rules of the self-regulatory organizations may not have sufficient expertise and experience to be considered a financial expert under our proposed rules.\38\ In particular, our [[Page 66210]] proposed rules would require a financial expert to have experience preparing or auditing financial statements of a company that files reports with us and experience with internal controls and procedures for financial reporting (or similar expertise and experience in the board of directors' judgment). The proposed disclosure requirements regarding audit committee financial experts are described below. --------------------------------------------------------------------------- \38\&thnsp;The NYSE has indicated that it will await the Commission's interpretation of the definition of the term “financial expert” before proposing amendments to its rules. See File No. SR–NYSE–2002–33 (pending before the Commission). The NASD has indicated that it intends to file rule proposals for the Nasdaq Stock Market with the Commission addressing similar issues. Although we will continue to work with the self-regulatory organizations to reconcile to the extent possible the various definitions of expert. --------------------------------------------------------------------------- 1. Proposed Disclosure Requirements We propose to add new Item 309 to Regulations S–K and S–B. In addition, we propose to add new Item 15(b) to Form 20–F and new Instruction B.(8) to Form 40–F. These proposed items would be identical in substance and entitled, “Audit Committee Financial Experts.” The proposed items would require companies to disclose: &sbull; The number and names of persons that the board of directors has determined to be the financial experts serving on the company's audit committee; and &sbull; Whether the financial expert or experts are “independent,” as that term is used in section 10A(m)(3) of the Exchange Act, and if not, an explanation of why they are not.\39\ --------------------------------------------------------------------------- \39\&thnsp;15 U.S.C. 78j–1(m)(3). The Sarbanes-Oxley Act amended the Exchange Act to add this section. --------------------------------------------------------------------------- If the company does not have a financial expert serving on its audit committee, the company must disclose that fact and explain why it has no financial expert. For purposes of the proposed disclosure, the term “audit committee” would be defined by section 3(a)(58) of the Exchange Act.\40\ --------------------------------------------------------------------------- \40\&thnsp;Section 3(a)(58) of the Exchange Act, as amended by the Sarbanes-Oxley Act, defines the term “audit committee” as “a committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and * * * if no such committee exists with respect to an issuer, the entire board of directors of the issuer.” 15 U.S.C. 78c(a)(58). --------------------------------------------------------------------------- Although the Sarbanes-Oxley Act does not specifically require disclosure of the number or names of the financial experts,\41\ we believe that it is appropriate to propose these requirements. Investors likely would be interested in knowing how many financial experts a company's board has determined are serving on its audit committee, or whether it has determined that all of the audit committee members are financial experts. Furthermore, disclosure of the names of the company's financial expert or experts would assist investors in evaluating the company's annual report and proxy or information statement disclosure that describes the background and business experience of the company's directors.\42\ --------------------------------------------------------------------------- \41\&thnsp;The Sarbanes-Oxley Act only directs the Commission to adopt rules requiring disclosure of whether or not the audit committee has at least one member who is a financial expert and, if not, why. See section 407 of the Sarbanes-Oxley Act. \42\&thnsp;See Item 401(e) of Regulation S–K and Item 401(a)(4) of Regulation S–B [17 CFR 229.401(e) and 228.401(a)(4)]. --------------------------------------------------------------------------- The primary benefit of having a financial expert serving on a company's audit committee is that the person, with his or her enhanced level of financial sophistication or expertise, can serve as a resource for the audit committee as a whole in carrying out its functions.\43\ The mere designation of the financial expert should not impose a higher degree of individual responsibility or obligation on a member of the audit committee. Nor do we intend for the financial expert designation to decrease the duties and obligations of other audit committee members or the board of directors. Furthermore, in order to avoid any confusion in the context of section 11 of the Securities Act,\44\ we do not intend for such a person to be considered an expert for purposes of section 11 solely as a result of his or her designation as a financial expert on the audit committee. The role of the financial expert is to assist the audit committee in overseeing the audit process, not to audit the company. A conclusion that a financial expert is an “expert” for purposes of section 11 might suggest a higher level of due diligence than is consistent with the audit committee's oversight responsibilities. --------------------------------------------------------------------------- \43\&thnsp;See Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999). \44\&thnsp;15 U.S.C. 77k. --------------------------------------------------------------------------- Section 407 of the Sarbanes-Oxley Act does not require disclosure of whether the financial expert is independent. However, we believe that such disclosure may be important to investors. Investors may be interested to know, for example, if the only financial expert on the audit committee is the company's chief financial officer or another individual who is responsible for, or participates in, the preparation of the company's financial statements. Therefore, we propose to require disclosure of whether the identified financial expert or experts on the audit committee are independent, as that term is used in section 10A(m)(3) of the Exchange Act, and if not, an explanation of why they are not. In addition, we intend to propose rules directing the national securities exchanges and national securities association to require a company to have a completely independent audit committee as a condition to listing.\45\ --------------------------------------------------------------------------- \45\&thnsp;See section 301 of the Sarbanes-Oxley Act. --------------------------------------------------------------------------- Some companies do not have boards of directors and therefore do not have board audit committees. For example, some limited liability companies and limited partnerships that do not have a corporate general partner may not have an oversight body that is the equivalent of an audit committee. It may be important to investors to be aware that such entities do not have such oversight bodies. Therefore, we do not propose to exempt these entities from the proposed financial expert disclosure requirements. If a limited liability company or limited partnership does not have a similar oversight body, it must explain that its organizational structure does not provide for such a body and that it therefore does not have an audit committee. We do, however, propose to exempt asset-backed issuers from this proposed disclosure requirement. Because of the nature of these entities, such issuers are subject to substantially different reporting requirements. Most significantly, such issuers are not required to file financial statements like other companies. Therefore, we do not believe disclosure of whether such companies have a financial expert on its audit committee would be of interest to investors. Request for Comment &sbull; Would investors benefit from disclosure of the number of the financial experts serving on the company's audit committee? Or would it suffice to require disclosure only of whether at least one financial expert serves on the audit committee? &sbull; Do investors need to know the names of the financial experts on the audit committee? Would disclosure of the names discourage people from serving as financial experts on an audit committee? &sbull; Should the Commission specifically address the issue of the degree of individual responsibility, obligation or liability under state or federal law of a person designated as a financial expert as a result of the designation? If the Commission should address this issue, how should it do so? &sbull; Should we use a term other than “financial expert”? For example, would [[Page 66211]] the term “audit committee financial expert” be a more appropriate title? &sbull; Is there other relevant information about the financial expert or experts that a company should have to disclose? For example, should we expand the disclosure required under Item 401(e) of Regulations S–K and S–B, as it relates to directors that the company has determined to be financial experts? If so, how? &sbull; Should we require disclosure of whether the financial experts are independent, as proposed? If so, should we define “independent” in the same manner as the term is used in section 10A(m)(3) of the Exchange Act? &sbull; Should we incorporate an independence requirement into the definition of “financial expert” so that any designated financial expert must be independent to qualify under the definition? 2. Proposed Definition of “Financial Expert” The Sarbanes-Oxley Act requires the Commission, in defining the term “financial expert,” to consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, controller,\46\ or principal accounting officer of an issuer, or from a position involving the performance of similar functions: --------------------------------------------------------------------------- \46\&thnsp;The Sarbanes-Oxley Act uses the term “comptroller.” It is our understanding that a comptroller position generally is the position in a government agency or non-profit organization with oversight responsibilities for the agency's or organization's primary accounting function. We believe that for-profit organizations typically use the term “controller” to describe this function. Therefore, throughout this release, we have used the term “controller” instead of the term “comptroller.” --------------------------------------------------------------------------- (1) An understanding of generally accepted accounting principles and financial statements; (2) Experience in: (a) The preparation or auditing of financial statements of generally comparable issuers; and (b) the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) Experience with internal accounting controls; and (4) An understanding of audit committee functions. The “financial expert” definition included in the proposed rules incorporates these four “attributes” with several modifications.\47\ We also propose to require the financial expert's experience to be related to companies that were, at the time he or she held the position, publicly reporting companies. We believe this requirement is appropriate because a person with experience as a principal financial officer or principal accounting officer of a private company may not have been exposed to the reporting requirements of public companies. --------------------------------------------------------------------------- \47\&thnsp;See Instructions 1–4 to proposed Item 309 of Regulations S–K and S–B. In particular, we propose to break the four attributes into five attributes and several changes to clarify that the required attributes include experience applying generally accepted accounting principles in connection with the accounting for estimates, accruals and reserves that are generally comparable to those, if any, used in the company's financial statements, and experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the company's financial statements. --------------------------------------------------------------------------- Moreover, the proposed definition states that the board of directors can conclude that a person is a financial expert if, in lieu of having experience as a public accountant, auditor, principal financial officer, principal accounting officer, or controller, or experience in a position involving the performance of similar functions, the person has experience in a position that results, in the judgment of the board of directors, in the person having similar expertise and experience. If the board makes such a determination, it would be required to disclose the basis for that determination. To qualify as a financial expert, a person would, in all cases, have to possess all of the attributes listed in the proposed definition. The instructions to proposed Item 309 of Regulations S–K and S–B would therefore define the term “financial expert” to mean a person who has, through education and experience as a public accountant or auditor or a principal financial officer, controller, or principal accounting officer of a company that, at the time the person held such position, was required to file reports pursuant to section 13(a) or 15(d) of the Exchange Act, 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: a. An understanding of generally accepted accounting principles and financial statements; b. Experience applying such generally accepted accounting principles 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 registrant's financial statements; c. Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements; d. Experience with internal controls and procedures for financial reporting;&thnsp;\48\ and --------------------------------------------------------------------------- \48\&thnsp;Section 407 of the Sarbanes-Oxley Act states that, among other attributes, the SEC, in defining the term “financial expert,” should consider whether a person has experience with internal accounting controls. This release proposes rules under section 404, which would require an annual report by management evaluating the effectiveness of its internal controls and procedures for financial accounting (a defined term). We believe that this term has substantially the same meaning as “internal accounting controls” in section 407. Therefore, we propose to use the newly defined term for consistency. --------------------------------------------------------------------------- e. An understanding of audit committee functions. In determining whether a potential financial expert has all of the requisite attributes, the board of directors&thnsp;\49\ must evaluate the totality of an individual's education and experience.\50\ The company should consider a variety of factors in making that evaluation, including: --------------------------------------------------------------------------- \49\&thnsp;See section II.A.3., Determination by the Board of Directors of Who Is a Financial Expert, below. \50\&thnsp;This approach is consistent with the approach taken in NASD and NYSE rules. The NASD requires each issuer to have “at least one member of the audit committee that has past employment experience in finance and 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.” NASD Rule 4350(d)(2)(A). Similarly, the NYSE requires at least one member who has “accounting or related financial management expertise.” NYSE Listed Company Manual 303.01. Both of these provisions focus on the level of expertise without providing any mechanical formula for determining whether an individual has the requisite expertise. --------------------------------------------------------------------------- &sbull; The level of the person's accounting or financial education, including whether the person has earned an advanced degree in finance or accounting; &sbull; Whether the person is a certified public accountant, or the equivalent, in good standing, and the length of time that the person actively has practiced as a certified public accountant, or the equivalent; &sbull; Whether the person is certified or otherwise identified as having accounting or financial experience by a recognized private body that establishes and administers standards in respect of such expertise, whether that person is in good standing with the recognized private body, and the length of time that the person has been actively certified or identified as having this expertise; &sbull; Whether the person has served as a principal financial officer, controller or principal accounting officer of a company that, at the time the person held such position, was required to file reports pursuant to section 13(a) or 15(d) of the Exchange Act, and if so, for how long; [[Page 66212]] &sbull; The person's specific duties while serving as a public accountant, auditor, principal financial officer, controller, principal accounting officer or position involving the performance of similar functions; &sbull; The person's level of familiarity and experience with all applicable laws and regulations regarding the preparation of financial statements that must be included in reports filed under section 13(a) or 15(d) of the Exchange Act; &sbull; The level and amount of the person's direct experience reviewing, preparing, auditing or analyzing financial statements that must be included in reports filed under section 13(a) or 15(d) of the Exchange Act; &sbull; The person's past or current membership on one or more audit committees of companies that, at the time the person held such membership, were required to file reports pursuant to section 13(a) or 15(d) of the Exchange Act; &sbull; The person's level of familiarity and experience with the use and analysis of financial statements of public companies; and &sbull; Whether the person has any other relevant qualifications or experience that would assist him or her in understanding and evaluating the registrant's financial statements and other financial information and to make knowledgeable and thorough inquiries whether: &sbull; The financial statements fairly present the financial condition, results of operations and cash flows of the company in accordance with generally accepted accounting principles; and &sbull; The financial statements and other financial information, taken together, fairly present the financial condition, results of operations and cash flows of the company. In the case of a foreign private issuer, the board of directors also should 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. This is not intended to be an exhaustive list of the factors that the board of directors should consider in assessing whether a person qualifies as a financial expert. Moreover, the proposed rules do not specify the number of listed factors that a financial expert should satisfy; satisfaction of any specific number of factors would be neither necessary nor sufficient for a person to be considered a financial expert. Most of these factors require a qualitative assessment of a potential expert's level of knowledge or experience. The fact that a person previously has served on an audit committee would not, by itself, justify the board of directors in “grandfathering” that person as a financial expert under our proposed definition. Similarly, the fact that a person has experience as a public accountant or auditor, or a principal financial officer, controller or principal accounting officer or experience in a similar position would not, by itself, justify the board of directors in deeming the person to be a financial expert. The board of directors would have to confirm that these persons have the requisite attributes and the right mix of education and experience. Some individuals who are particularly knowledgeable and experienced in accounting and financial issues may have the requisite attributes and mix of knowledge and experience to qualify as financial experts, even though they may not have served in one of the specifically identified positions. The board of directors would have to determine whether an individual's qualifications, in the aggregate, satisfy the financial expert definition. Because of the significant role the audit committee plays in the filing of a public company's financial statement, including the preparation and filing of their own report, we would find it hard to believe that an accountant serving as a financial expert on an audit committee would not be practicing before the Commission.\51\ Therefore, any accountant, while suspended or barred from practice under Rule 102(e)&thnsp;\52\ of the Commission's Rules of Practice, generally would not be eligible to serve as a financial expert. --------------------------------------------------------------------------- \51\&thnsp;See 17 CFR 201.102(f). \52\&thnsp;See 17 CFR 201.102(e). --------------------------------------------------------------------------- Request for Comment &sbull; Should we modify the proposed definition of “financial expert” in any way? If so, how? &sbull; Should we require a financial expert to have direct experience preparing or auditing financial statements of reporting companies? Should experience reviewing or analyzing such financial statements suffice? If so, why? &sbull; Should a financial expert have to possess all of the “attributes” listed in the proposed definition? Should we broaden the scope of individuals who may qualify as such an expert? &sbull; Do the five attributes adequately describe the qualities that a financial expert should have? Should we add any attributes? &sbull; Although we do not intend for the list of factors that a company should consider in assessing a potential financial expert's qualifications to be exhaustive, should we add any factors to the list? If so, what other factors should we include? Conversely, should we delete any proposed factors from the list? If so, which factors should we delete? &sbull; Should the proposed rules provide for a different standard or methodology for assessing a financial expert's qualifications? If so, describe the preferred standard or methodology. 3. Determination by the Board of Directors of Who Is a Financial Expert The Sarbanes-Oxley Act does not explicitly state who at the company should determine whether any of the audit committee members is a financial expert. Management is responsible for preparing the financial statements. Therefore, it seems inappropriate for management to assess the qualifications of audit committee members. Similarly, it does not seem appropriate for the members of the audit committee, alone, to assess their own qualifications. We believe that the board of directors in its entirety, as the most broad-based body within the company, is best-equipped to make the decision. Therefore, we propose to require the company to disclose the number and names of the persons that the board of directors has determined to be the financial expert or experts serving on the company's audit committee. Certain foreign private issuers have a two-tier board, with one tier designated as the management board and the other tier designated as the supervisory or non-management board. In this circumstance, we believe that the supervisory or non-management board would be the body within the company that is best-equipped to make the decision. Request for Comment &sbull; Will investors find this information useful? Is there more useful information on how financial experts are determined? &sbull; Should our rules require the company to disclose the persons who are responsible for making the financial expert determination on behalf of the company? Is the board of directors the appropriate body to make such determination? 4. Impracticability of a “Bright-Line” Test We considered, but do not propose, a “bright-line” test for making the financial expert determination that [[Page 66213]] eliminates all elements of subjectivity. We do not believe that such a test would best further the purposes of the statute. Our proposed “financial expert” definition requires a qualifying individual to possess all of the specified attributes, and in that respect, does provide somewhat of a “bright-line” by setting forth several fairly specific and objective standards to limit the pool of potential financial expert candidates. The “factors” also provide guidance to assist the board of directors in making the financial expert determination. Clearly, certain factors such as level of education and years spent in a financial position are important indicia of whether an individual has such knowledge and experience. However, we are not convinced that any bright-line rule or fixed formula that requires a financial expert to have specific academic credentials or a specific number of years of service in a financial or accounting position can ensure that an individual has the level of understanding and experience required by the statute. As the Blue Ribbon Committee stated regarding corporate governance and audit committees, “one size doesn't fit all.”&thnsp;\53\ Indeed, the more complicated the business, the greater the need for a higher threshold of financial expertise. Therefore, we believe that a bright- line test would be inappropriate for such determinations. --------------------------------------------------------------------------- \53\&thnsp;See Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, at 7 (1999). --------------------------------------------------------------------------- Request for Comment &sbull; Should we create a bright-line test for the definition of “financial expert'? If so, what should the test be? 5. Location of Disclosure The Sarbanes-Oxley Act expressly states that companies must include the financial expert disclosure in their periodic reports required pursuant to section 13(a) or 15(d) of the Exchange Act. We propose to require companies to include the new disclosure in their annual reports on Forms 10–K&thnsp;\54\ and 10–KSB.\55\ We do not propose to require companies to also include this disclosure in their quarterly reports because we think that annual disclosure would adequately fulfill investors' informational needs. In this regard, we note that our pending Form 8–K proposals would require a company to disclose the arrival or departure of a director.\56\ This information would be included in part III of those forms. Consequently, the company could incorporate this information by reference from its definitive proxy or information statement that involves an election of directors, if the company voluntarily chooses to include this information in its proxy or information statement and then files such statement with the Commission no later than 120 days after the end of the fiscal year covered by the Form 10–K or 10–KSB.\57\ We also propose to require this disclosure in annual reports filed by a foreign private issuer on Form 20–F&thnsp;\58\ and by a Canadian issuer on Form 40–F.\59\ --------------------------------------------------------------------------- \54\&thnsp;Referenced in 17 CFR 249.310. \55\&thnsp;Referenced in 17 CFR 249.310b. \56\&thnsp;Therefore if, for example, a director who is the audit committee financial expert resigned or was removed from the board one month after the company filed its annual report, the company would have to disclose this event on a Form 8–K filed within two business days after the director's departure. See Release No. 33–8106 (June 17, 2002) [67 FR 42914]. The proposals in that release have not yet been adopted. The proposals do not require disclosure of whether the departing director is a financial expert. We are seeking comment on whether we should require such disclosure. \57\&thnsp;See General Instruction E(3) to Form 10–KSB [17 CFR 249.310b] and General Instruction G(3) to Form 10–K [17 CFR 249.310]. \58\&thnsp;Referenced in 17 CFR 249.220f. \59\&thnsp;Referenced in 17 CFR 249.240f. --------------------------------------------------------------------------- Request for Comment &sbull; Should we also require the proposed financial expert disclosure to appear in the company's proxy or information statement? Is this information relevant to a security holder's decision to vote for a particular director or to elect, approve or ratify the choice of an independent public accountant? &sbull; Should we require the company to also disclose this information in its quarterly reports? &sbull; Should we also require such disclosure in registration statements filed under the Securities Act? &sbull; Should the company have to disclose specifically the arrival or departure of a financial expert promptly after the occurrence of the event? If so, should we modify our Form 8–K proposed item regarding the arrival and departure of a director to also require a company to disclose whether the departing director was, or arriving director will be, a financial expert serving on the company's audit committee? Should a company make appropriate disclosures if: a financial expert leaves the audit committee, but remains on the board of directors; or an existing director joins the audit committee as a financial expert? Should a company only have to file a Form 8–K if it previously disclosed in its annual report that it had a financial expert and now has none? &sbull; A company currently may not have an audit committee member who qualifies as a financial expert under the proposed definition but may intend to seek one. In such a case, the proposed rules would require a company to disclose that it does not have a financial expert on its audit committee. However, the company could explain that it is searching for a qualified individual to serve on its audit committee. Should we provide companies with a transition period to find such a person? If so, what would be an appropriate transition period? 6. Registered Investment Companies We are proposing to implement section 407 of the Sarbanes-Oxley Act with respect to registered management investment companies by adding disclosure requirements similar to those in proposed Item 309 of Regulation S–K to proposed Form N–CSR.\60\ Proposed Item 4 of Form N–CSR would require a registered management investment company to disclose annually: (i) The number and names of persons that the board of directors has determined to be the financial experts serving on the investment company's audit committee; (ii) whether the financial expert or experts are independent, and if not, an explanation of why they are not; and (iii) if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert.\61\ In addition, the investment company would be required to disclose the basis for a determination by its board of directors that a person is a financial [[Page 66214]] expert if, in lieu of having experience as a public accountant, auditor, principal financial officer, principal accounting officer, or controller, or experience in a position involving the performance of similar functions, the person has experience in a position that results, in the judgment of the board, in the person having similar experience and expertise.\62\ We are proposing the same definition of “financial expert” for investment companies as for operating companies, except that we are not including the factor relevant to foreign private issuers.\63\ --------------------------------------------------------------------------- \60\&thnsp;Referenced in 17 CFR 249.331 and 274.128. A management investment company is an investment company other than a unit investment trust or face-amount certificate company. See section 4 of the Investment Company Act [15 U.S.C. 80a–4]. A unit investment trust (“UIT”) is “an investment company which (A) is organized under a trust indenture, contract of custodianship or agency, or similar instrument, (B) does not have a board of directors, and (C) issues only redeemable securities, each of which represents an undivided interest in a unit of specified securities; but does not include a voting trust.” Section 4(2) of the Investment Company Act [15 U.S.C. 80a–4(2)]. A face- amount certificate company is an investment company that engages or proposes to engage in the business of issuing certain face-amount certificates. Section 4(1) of the Investment Company Act [15 U.S.C. 80a–4(1)]. \61\&thnsp;The proposed amendments would add similar disclosure requirements applicable to small business investment companies (“SBICs”) to Item 102P3 of Form N–SAR. Proposed Instruction (b) to Item 102P3 of Form N–SAR (referenced in 17 CFR 249.330 and 274.101). SBICs are investment companies that are licensed as SBICs under the Small Business Investment Act of 1958. We are proposing to add financial expert disclosure requirements for SBICs to Form N–SAR because SBICs would not be required to file reports on proposed Form N–CSR. \62\&thnsp;Proposed Instruction 3 to Item 4 of proposed Form N–CSR; proposed Instruction (b)(3) to Item 102P3 of Form N–SAR. \63\&thnsp;Proposed Instructions 2 and 4 to Item 4 of proposed Form N–CSR. --------------------------------------------------------------------------- A financial expert would be considered to be “independent” if he or she: (i) meets the criteria set forth in section 10A(m)(3)(B)(i) of the Exchange Act; and (ii) is not an “interested person” of the investment company as defined in section 2(a)(19) of the Investment Company Act of 1940.\64\ We have substituted the section 2(a)(19) test for the criteria set forth in section 10A(m)(3)(B)(ii) of the Exchange Act, which would apply to operating companies and require that the audit committee member not be an affiliated person of the issuer or any subsidiary in order to be considered “independent.” The section 2(a)(19) test is more appropriate for registered investment companies because it is tailored to capture the broad range of affiliations with investment advisers, principal underwriters, and others that are relevant to “independence” in the case of investment companies. --------------------------------------------------------------------------- \64\&thnsp;Proposed Item 4 of proposed Form N–CSR. --------------------------------------------------------------------------- The proposed disclosure requirements would apply to all registered management investment companies, regardless of whether they are required to file reports under section 13(a) or 15(d) of the Exchange Act. They would not apply to unit investment trusts, which are unmanaged investment companies that hold specified securities and, unlike managed investment companies, are not required to provide shareholder reports containing audited financial statements. Request for Comment &sbull; Should the definition of “financial expert” be modified for investment companies? Are the factors that are relevant in determining whether someone is a “financial expert” different for investment companies? &sbull; What definition of “independence” should the disclosure requirements apply with respect to financial experts? Should the definition incorporate the criteria set forth in section 10A(m)(3)(B)(i) of the Exchange Act and section 2(a)(19) of the Investment Company Act, as proposed, or a different test, for example, the test used for operating companies? &sbull; Should disclosure with respect to financial experts on an investment company's audit committee be required annually, as proposed? Should this disclosure be required on each report on Form N–CSR or N–SAR, i.e., semi-annually? &sbull; For investment companies that would be required to file reports on proposed Form N–CSR, should the financial experts disclosure be required on Form N–CSR or Form N–SAR? Should small business investment companies, which otherwise would not be required to file proposed Form N–CSR, be required to use Form N–CSR for this purpose? B. Proposed Code of Ethics Disclosure 1. Proposed Rules Compared to Section 406 of the Sarbanes-Oxley Act Section 406(a) of the Sarbanes-Oxley Act directs the Commission to issue rules requiring a company that is subject to the reporting requirements of section 13(a) or 15(d) of the Exchange Act to disclose whether or not the company has adopted a code of ethics for its senior financial officers that applies to the company's principal financial officer and controller or principal accounting officer, or persons performing similar functions. The Sarbanes-Oxley Act states that the rules also must require companies that have not adopted such a code of ethics to explain why they have not done so. The Act defines the term “code of ethics,” as used in section 406, to mean such standards as are reasonably necessary to promote: &sbull; Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; &sbull; Full, fair, accurate, timely and understandable disclosure in the periodic reports required to be filed by the issuer; and &sbull; Compliance with applicable governmental rules and regulations. Section 406(b) of the Sarbanes-Oxley Act further directs the Commission to require a company subject to the Exchange Act reporting requirements to immediately disclose on Form 8–K, or by Internet or other electronic means of dissemination, any change in, or waiver of, a provision of its code of ethics for its senior financial officers. Although section 406 of the Sarbanes-Oxley Act focuses on whether or not a company has adopted a code of ethics applicable to its senior financial officers, we believe that it is appropriate to propose rules that also apply to a company's principal executive officer. Investors not only have an interest in knowing whether a public company holds its senior financial officers to certain ethical standards, but also whether a public company holds its principal executive officer to ethical standards as well. Therefore, we believe that it is consistent with the purposes of the Sarbanes-Oxley Act to extend the scope of section 406 to also include a company's principal executive officer. Specifically, we propose to require a company to disclose whether it has adopted a written code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. We also propose to broaden the definition of the term “code of ethics” used in section 406 of the Sarbanes-Oxley Act to include three additional factors described in more detail below. 2. Description of the Proposed Code of Ethics Disclosure Requirements We propose to add new Item 406 to Regulations S–B and S–K, new Item 15(c) to Form 20–F and new Instruction B.(9) to Form 40–F to require a company subject to the Exchange Act reporting requirements to disclose: &sbull; Whether the company has adopted a written code of ethics that applies to the company's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions;&thnsp;\65\ and --------------------------------------------------------------------------- \65\&thnsp;We expect that many companies already have a code of ethics that applies to these officers, as well as additional officers, directors and employees. We encourage companies to apply the code of ethics to as broad a spectrum of personnel and affiliates as practicable. --------------------------------------------------------------------------- &sbull; If the company has not adopted such a code of ethics, the reasons it has not done so. For purposes of this new disclosure item, we would define the term “code of ethics” to mean a codification of standards that is reasonably designed to deter wrongdoing and to promote:&thnsp;\66\ --------------------------------------------------------------------------- \66\&thnsp;The Sarbanes-Oxley Act section 406(c) definition of the term “code of ethics” does not include the phrase “to deter wrongdoing” that we have incorporated into proposed Item 406 of Regulations S–K and S–B, but we think that it is appropriate to expand the definition in this manner. Although codes of ethics typically are designed to promote high standards of ethical conduct, they also generally seek to instruct those to whom they apply as to improper or illegal conduct or activity and to prohibit such conduct or activity. --------------------------------------------------------------------------- (1) Honest and ethical conduct, including the ethical handling of actual [[Page 66215]] or apparent conflicts of interest between personal and professional relationships; (2) Avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the code&thnsp;&thnsp;\67\ of any material transaction or relationship that reasonably could be expected to give rise to such a conflict; --------------------------------------------------------------------------- \67\&thnsp;Under our proposal, although the company would retain discretion to determine the identity of the appropriate person or persons, such person should not be involved in the matter giving rise to the conflict of interest. Furthermore, we believe the person identified in the code should have sufficient status within the company to engender respect for the code and the authority to adequately deal with the persons subject to the code regardless of their stature in the company. --------------------------------------------------------------------------- (3) Full, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the Commission and in other public communications made by the company; (4) Compliance with applicable governmental laws, rules and regulations;&thnsp;\68\ --------------------------------------------------------------------------- \68\&thnsp;We propose to add “laws” to this prong of the proposed definition. The Sarbanes-Oxley Act section 406(c) definition refers only to compliance with applicable governmental rules and regulations. This language also is intended to ensure compliance with other provisions of the Sarbanes-Oxley Act, including “up-the-ladder” reporting by lawyers, “whistleblower” protection and the enhanced conflict of interest provisions. --------------------------------------------------------------------------- (5) The prompt internal reporting to an appropriate person or persons identified in the code of violations of the code;&thnsp;\69\ and --------------------------------------------------------------------------- \69\&thnsp;The concerns regarding the identification of appropriate persons for the reporting of potential conflicts of interest discussed above would similarly apply to the reporting of violations of the code. --------------------------------------------------------------------------- (6) Accountability for adherence to the code. The second, fifth and sixth prongs of this proposed definition supplement the requirements specified by section 406 of the Sarbanes- Oxley Act. We believe that these items are consistent with the objectives of that section. A comprehensive code of ethics should set forth guidelines requiring avoidance of conflicts of interests and material transactions or relationships involving potential conflicts of interests without proper approval. Moreover, an effective code of ethics should describe the company's system for the internal reporting of code violations.\70\ The code also should state clearly the consequences for non-adherence to code provisions. --------------------------------------------------------------------------- \70\&thnsp;There are a number of provisions in the Sarbanes- Oxley Act that require internal reporting of events. We believe that it is incumbent upon public companies to coordinate these requirements. --------------------------------------------------------------------------- In addition to providing the required disclosure, a company also would have to file a copy of its ethics code as an exhibit to its annual report.\71\ We believe investors would find such disclosure useful. --------------------------------------------------------------------------- \71\&thnsp;See proposed Item 601(b)(14) of Regulations S–K and S–B. Section 406 of the Sarbanes-Oxley Act does not state that our rules must require a company to file a copy of the code of ethics as an exhibit to its annual report, but we think investors may be interested in examining the actual code itself, given that codes are likely to vary significantly from one company to another. --------------------------------------------------------------------------- Request for Comment &sbull; Should the rules address whether a company has a code of ethics that applies to its principal executive officer, as proposed, or should the rules track the language of section 406 of the Sarbanes- Oxley Act and require a company only to disclose whether it has a code of ethics that applies to its senior financial officers? &sbull; Should we expand the definition of “code of ethics,” as proposed, or should the definition adhere to the language in section 406(c) of the Sarbanes-Oxley Act? Are there other ethical principles that should be included in the definition? &sbull; Should the rules cover a broader group of officers? If so, which group of officers should they cover? Should the general counsel be covered? Should all executive officers be covered?&thnsp;\72\ --------------------------------------------------------------------------- \72\&thnsp;Exchange Act Rule 3b–7 [17 CFR 240.3b–7] defines the term “executive officer” as a registrant's president, any vice president of the registrant in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy- making function or any other person who performs similar policy- making functions for the registrant. Executive officers of subsidiaries may be deemed executive officers of the registrant if they perform such policy-making functions for the registrant. --------------------------------------------------------------------------- &sbull; Should the proposed rules require a company to disclose whether it has a code of ethics that applies to its directors? Do most companies have a code of ethics that applies to the board of directors? Does the same code of ethics generally apply to the company's executive officers and its directors? &sbull; Should we require the company to describe its procedures to ensure compliance with the code of ethics? &sbull; Should we require the company to describe its procedures for granting a waiver from a provision of its code of ethics? &sbull; Should we require the company to disclose the date of adoption of its code of ethics and the date of the most recent update or the company's frequency of review of the code? &sbull; Should the company have to file the code of ethics as an exhibit to its annual report as proposed? If not, should we also require the company to describe the principal topics that the code addresses? &sbull; Should we require disclosure regarding the existence of a code of ethics in our other reports and registration statements, including our Securities Act and Exchange Act registration statements? 3. Content of the Code of Ethics The proposed rules do not specify every detail that the company must address in its code of ethics, or prescribe any specific language that the code of ethics must include. They further do not specify the procedures that the company should develop, or the types of sanctions that the company should impose, to ensure compliance with its code of ethics. We believe that ethics codes do, and should, vary from company to company and that decisions as to the specific provisions of the code, compliance procedures and disciplinary measures for ethical breaches are best left to the company. In addition, such an approach is consistent with our disclosure-based regulatory scheme. Many companies already maintain codes of ethics or conduct.\73\ These codes often contain specific policies and restrictions addressing, among other things, such issues as insider trading and conflicts of interest. The proposed rules would not require a company to adopt a code of ethics if it has not already done so, or to amend its existing code of ethics, but they would require a company that does not have a code of ethics that meets the definition in the rule for the specified officers to explain why it does not have such a code. A pre- existing ethics code may satisfy the requirements of proposed Item 406, but a company should review its code upon our adoption of final rules to determine whether the code meets all of the standards included in the rules' definition of a “code of ethics.” If a company has a code, but it does not satisfy all parts of the definition, the company would not be able to affirm that it has the type of code contemplated by the rules. --------------------------------------------------------------------------- \73\&thnsp;On August 16, 2002, NYSE submitted proposed new listing standards that would, among other things, require all NYSE listed companies to adopt a code of business conduct and ethics consistent with the principles enumerated in the listing standards. See File No. SR–NYSE–2002–33. The NASD has indicated that it intends to propose new listing standards that would require a code of conduct for NASDAQ listed companies. --------------------------------------------------------------------------- 4. Types of Companies That Would Be Subject to the Proposed Code of Ethics Disclosure Requirements and Location of the Disclosure All companies that file Form 10–K or 10–KSB reports would be subject to the proposed disclosure requirement.\74\ We [[Page 66216]] also propose to require this disclosure in annual reports filed by a foreign private issuer on Form 20–F and by a Canadian issuer on Form 40–F. --------------------------------------------------------------------------- \74\&thnsp;This disclosure would be required by Item 10 of Form 10–K and Item 9 of Form 10–KSB. --------------------------------------------------------------------------- Request for Comment &sbull; Should we require a company to also provide the proposed code of ethics disclosure in its quarterly reports? Should such disclosure be made in a company's proxy and information statements? Should it be disclosed in Securities Act registration statements? &sbull; Should the requirement apply to foreign private issuers, as proposed? If not, why? 5. Proposed Form 8–K or Internet Disclosure Regarding Changes to, or Waivers From, the Code of Ethics Section 406(b) of the Sarbanes-Oxley Act directs us to require “immediate disclosure” by a company of any change to, or waiver from, the company's code of ethics for its senior financial officers.\75\ As discussed above, we propose to require the basic ethics code disclosure with respect to a company's principal executive officer as well as to its senior financial officers. We therefore also propose to require current disclosure regarding changes to, or the company's grant of a waiver from, a provision of the code of ethics that applies to these same persons. --------------------------------------------------------------------------- \75\&thnsp;Under the proposed rules this would also include an implicit waiver due to inaction on the part of the company with respect to a reported or known violation of a code provision. --------------------------------------------------------------------------- On June 17, 2002, we proposed amendments to Form 8–K that would expand significantly the number of disclosure items triggering a Form 8–K filing requirement and accelerate the Form 8–K filing deadline.\76\ In those proposals, we stated that we were reviewing possible changes by self-regulatory organizations to their corporate governance provisions, including changes that would require a company to promptly disclose any revision that it makes to its code of ethics, or ethics waiver that it grants. --------------------------------------------------------------------------- \76\&thnsp;See Release No. 33–8106 (June 17, 2002) [67 FR 42914]. --------------------------------------------------------------------------- In light of the directive in section 406(b), we propose to add an item to the list of Form 8–K triggering events to require disclosure of the following: &sbull; A change to a company's code of ethics that applies to the specified officers; or &sbull; A grant of a waiver of an ethics code provision to a specified officer.\77\ --------------------------------------------------------------------------- \77\&thnsp;See proposed Item 5.05 to Form 8–K. In Release No. 33–8106, we proposed to reorganize and renumber the Form 8–K items as part of our Form 8–K proposals. The proposed Item 5.05 designation is consistent with the renumbering scheme proposed in that release. --------------------------------------------------------------------------- If choosing to provide the required disclosure on Form 8–K, the company would have to file the report within two business days after it made the change or granted the waiver.\78\ As an alternative to reporting this information on Form 8–K, section 406(b) of the Sarbanes-Oxley Act contemplates a company's use of the Internet as a method of disseminating this disclosure.\79\ Many companies maintain websites to provide information about themselves to the public. A company's website is often an obvious place for investors to find information about a company.\80\ We therefore propose to allow a company to use its own Internet website, if it has a website, as an alternative means of disseminating the proposed required disclosure about changes in, or waivers from, its code of ethics.\81\ Under the proposed rules, a company would be able to take advantage of the Internet dissemination option only if it had disclosed in its most recently filed annual report on Form 10–K or 10–KSB:&thnsp;\82\ --------------------------------------------------------------------------- \78\&thnsp;A two business day filing period is consistent with the accelerated filing deadline that we proposed in Release No. 33–8106. \79\&thnsp;Section 406(b) of the Sarbanes-Oxley Act states that our rules should require a company to report this disclosure on Form 8–K or by “dissemination by the Internet or by other electronic means.” Our proposed rules would permit optional dissemination of the required disclosure through the company's website; it is not clear whether there are “other electronic means” that would result in widespread dissemination of the disclosure that would be accessible by a company's investors and potential investors. This release seeks comment on that issue. \80\&thnsp;We are allowing website disclosure in these limited circumstances consistent with the terms of section 406 of the Sarbanes-Oxley Act. The present proposal does not indicate that the Commission deems website postings as sufficient to broadly and simultaneously disseminate information to the public in other contexts. \81\&thnsp;A company choosing to post proposed disclosure about a change to its code of ethics on its website also would have to post a copy of the amended provision on its website. \82\&thnsp;See proposed Item 406(b) of Regulations S–K and S–B. Because investors may not expect these disclosures to be made on the company's website in lieu of a Form 8–K filing, we are proposing to require a company to provide investors with advance notice that it may choose to use this option. Otherwise, investors may be confused regarding the location of this disclosure. --------------------------------------------------------------------------- &sbull; That it intends to disclose these events on its Internet website, and &sbull; Its Internet website address. If a company elects to disclose this information on its website, it would have to do so within the same two-business day time period that we propose to require for Form 8–K filings. In addition, we propose that a company electing to provide disclosure in this manner would have to make the disclosure available on its website for a period of at least 12 months after it initially posts the disclosure. Although the proposed rules would permit a company to remove information from its website after the 12-month posting period, we propose to require the company to retain this disclosure for a period of not less than five years and to make it available to the Commission or its staff upon request.\83\ We propose a 12-month period because we believe that it would be inappropriate to allow a company to comply with this provision by only briefly posting the disclosure on its website. Reports on Form 8–K are available to the public indefinitely after filing with the Commission. --------------------------------------------------------------------------- \83\&thnsp;Proposed Item 406 of Regulations S–B and S–K. --------------------------------------------------------------------------- Request for Comment &sbull; Are there any privacy concerns that we should consider that would warrant narrowing the disclosure requirements regarding a grant of a waiver from the code? &sbull; Is a “waiver” a sufficiently distinct and formal event that the obligation to disclose will not present any difficulties of interpretation? Should we modify the requirement to ensure that “de facto, post hoc” waivers of codes'granted or acceded to after the occurrence of the “violation” are reported? &sbull; Should companies that use the Internet for these disclosures also be required to have technology that allows investors to be notified by e-mail when new information is posted to the website? &sbull; Should we require the filing of a Form 8–K regardless of whether a company provides the proposed disclosure on its website? Do investors need access to this information for longer than 12 months? How can we permit Internet disclosure and maintain a lasting public record of the information? &sbull; Should we specify where and how this disclosure should appear on a company's website if the company opts for the website method of dissemination? &sbull; Are there other means of electronic dissemination that our proposed rules should permit? &sbull; Should we require a company choosing to disclose information about ethics code changes or waivers through its Internet website to provide advance notice in the company's annual report of its intent to satisfy the disclosure requirements in this manner, as proposed? &sbull; Should we require all Exchange Act reporting companies to disclose their website addresses? If so, should we [[Page 66217]] specify the location of this disclosure? For example, should it have to appear on the front cover of all periodic and current reports, along with the company's street address? Should a company have to disclose its website address in, or on the front cover of, all of its Exchange reports? Proxy and information statements? Exchange Act registration statements? Securities Act registration statements? Foreign Private Issuers Foreign private issuers are not required to file current reports on Form 8–K.\84\ Instead, they are required to file under the cover of Form 6–K&thnsp;\85\ copies of all information that the foreign private issuer: makes, or is required to make, public under the laws of its jurisdiction of incorporation; files, or is required to file, under the rules of any stock exchange; or otherwise distributes to its security holders.\86\ We do not propose to change these reporting requirements. We are proposing changes to Form 20–F and 40–F that would require a foreign private issuer to disclose any change to its code of ethics made during the foreign private issuer's past fiscal year that applies to the foreign private issuer's senior officers. The foreign private issuer additionally would have to file the change as an exhibit to Form 20–F or 40–F. Under the proposals, a foreign private issuer also would have to disclose any grant of a waiver from the code by the company to one of these officers, that occurred during the foreign private issuer's last fiscal year. A foreign private issuer could also make the disclosure under cover of a Form 6–K or on its Internet website. We plan to strongly encourage foreign private issuers to make these disclosures promptly. --------------------------------------------------------------------------- \84\&thnsp;See Exchange Act Rules 13a–11 and 15d–11 [17 CFR 240.13a–11 and 15d–11]. \85\&thnsp;Referenced in 17 CFR 249.306. \86\&thnsp;See Exchange Act Rule 13a–16 [17 CFR 240.13a–16]. --------------------------------------------------------------------------- Request for Comment &sbull; Should we require foreign private issuers to file disclosure about ethics code changes and waivers within two days under cover of Form 6–K? Should we otherwise require a foreign private issuer to promptly disclose ethics code changes and waivers? 6. Registered Investment Companies We are proposing to amend Forms N–SAR and N–CSR to require a registered investment company to: &sbull; Disclose annually whether each of the investment company, its investment adviser, and its principal underwriter has adopted a written code of ethics that applies to the principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions of, respectively, the investment company, its investment adviser, and its principal underwriter;\87\ --------------------------------------------------------------------------- \87\&thnsp;See proposed Instructions (a)(1) and (a)(7) to Item 102P3 of Form N–SAR; proposed Item 3(a) and proposed instruction to Item 3(a) of proposed Form N–CSR. In the case of a UIT, the code of ethics disclosure requirements would apply with respect to the UIT's sponsor, depositor, trustee, and principal underwriter. Proposed Item 133(a) of Form N–SAR. --------------------------------------------------------------------------- &sbull; If the investment company, its investment adviser, or its principal underwriter has not adopted a code of ethics, explain why it has not done so;\88\ --------------------------------------------------------------------------- \88\&thnsp;Proposed Item 133(a) and Instruction (a)(1) to Item 102P3 of Form N–SAR; proposed Item 3(a) of Form N–CSR. --------------------------------------------------------------------------- &sbull; If the investment company, its investment adviser, or its principal underwriter has, during the period covered by the report, amended or granted a waiver from any code of ethics applicable to the investment company's, investment adviser's, or principal underwriter's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, provide a brief description of the amendment or waiver in the investment company's report on proposed Form N–CSR or Form N–SAR, as applicable. In the alternative, the investment company may disclose this information on its Internet website within two business days after the occurrence of the amendment or waiver, if the investment company has disclosed in its most recently filed report on Form N–SAR or N–CSR its intention to provide disclosure in this manner and its Internet address, it makes the information available on its website for a 12-month period, and it retains the information for a period of not less than six years following the end of the fiscal year in which the amendment or waiver occurred;&thnsp;\89\ and --------------------------------------------------------------------------- \89\&thnsp;Proposed Item 133(b) and (c), proposed Instructions (a)(2) and (a)(3) to Item 102P3 and proposed Instruction (c) to Item 133 of Form N–SAR; proposed Item 3(b) and 3(c) and proposed Instruction 3 to Item 3 of proposed Form N–CSR. --------------------------------------------------------------------------- &sbull; Include any written code of ethics and amendment to that code of ethics as an exhibit to the investment company's reports on Form N–CSR or N–SAR.\90\ --------------------------------------------------------------------------- \90\&thnsp;Item 134(b) and proposed Instruction (a)(4) to Item 102P3 of Form N–SAR; proposed Item 6(b) of proposed Form N–CSR. The proposed disclosure requirements would apply to all registered investment companies, regardless of whether they are required to file reports under section 13(a) or 15(d) of the Exchange Act. Management investment companies generally would provide the required disclosure on proposed Form N–CSR, and small business investment companies and unit investment trusts would provide the required disclosure on Form N–SAR.\91\ The proposed amendments would apply the same definition of a code of ethics that we are proposing for operating companies.\92\ --------------------------------------------------------------------------- \91\&thnsp;See proposed Item 3 of proposed Form N–CSR (management investment companies, other than SBICs); proposed Instruction (a) to Item 102P3 of Form N–SAR (SBICs); proposed Items 133 and 134(b) of Form N–SAR (UITs). \92\&thnsp;Proposed Instruction (a)(6) to Item 102P3 and proposed Instruction (b) to Item 133 of Form N–SAR; proposed Instruction 2 to Item 3 of proposed Form N–CSR. See Section II.B.2. above, “Description of the Proposed Code of Ethics Disclosure Requirements.” --------------------------------------------------------------------------- We recognize that Investment Company Act Rule 17j–1 currently requires investment companies, and their investment advisers and principal underwriters, to adopt codes of ethics designed to prevent fraud resulting from personal trading in securities by portfolio managers and other employees.\93\ The amendments we are proposing today would address a broader range of conduct, including disclosure provided in filings with the Commission; compliance with governmental laws, rules and regulations; and ethical conduct generally, including the handling of actual or apparent conflicts of interest. As a result, we believe that the proposals should apply with equal force to investment companies and operating companies. However, to the extent that an investment company, or its investment adviser or principal underwriter, is considering implementing new or changed code of ethics provisions as a result of today's proposals, it may wish to incorporate these provisions, together with its existing code of ethics under Rule 17j–1, into a single comprehensive code of ethics.\94\ --------------------------------------------------------------------------- \93\&thnsp;17 CFR 270.17j–1. \94\&thnsp;Proposed General Instruction D to Form N–CSR would permit a registered management investment company to incorporate its code of ethics by reference from another document, such as the fund's registration statement. See Item 23(p) of Form N–1A; Item 24.2.r of Form N–2; Item 28(b)(17) of Form N–3 (requiring codes of ethics required by Rule 17j–1 to be filed as exhibits to registration statements). --------------------------------------------------------------------------- The proposed disclosure requirements would generally cover the same entities covered by Rule 17j–1 (investment companies, investment advisers, principal underwriters) because these are the entities with respect to which conflicts of interest and other ethical issues are most likely to arise. Like Rule 17j–1, the proposed amendments would cover the code of ethics of an [[Page 66218]] investment company's principal underwriter only if: (i) The principal underwriter is an affiliated person of the investment company or the investment company's investment adviser; or (ii) an officer, director, or general partner of the principal underwriter serves as an officer, director, or general partner of the investment company or of its investment adviser.\95\ Unit investment trusts do not have a corporate- type management structure, but rather are created by a sponsor or depositor that accumulates a portfolio of securities and deposits them with a trustee under the terms of a trust indenture. Therefore, a unit investment trust would not be required to disclose whether it has a code of ethics because it has no officers. Rather, for unit investment trusts, we are proposing to require disclosure with respect to codes of ethics of the trust's sponsor, depositor, trustee or principal underwriter.\96\ For unit investment trusts, the proposed amendments would cover the code of ethics of a principal underwriter only if: (i) The principal underwriter is an affiliated person of the trust or the trust's sponsor, depositor, or trustee; or (ii) an officer, director, or general partner of the principal underwriter serves as an officer, director, or general partner of the trust's sponsor, depositor, or trustee.\97\ --------------------------------------------------------------------------- \95\&thnsp;Proposed Instruction 1 to Item 3 of proposed Form N–CSR; proposed Instruction (a)(5) to Item 102P3 of Form N–SAR. See also Investment Company Act Rule 17j–1(c)(3) [17 CFR 270.17j-1(c)(3)]. \96\&thnsp;Proposed Items 133 and 134(b) of Form N–SAR. \97\&thnsp;Proposed Instruction (a) to Item 133 of Form N–SAR. --------------------------------------------------------------------------- Request for Comment &sbull; Is the proposed definition of a code of ethics appropriate? Are there any modifications that should be made to this definition in the case of investment companies? &sbull; Do the proposed code of ethics disclosure requirements cover the appropriate entities, in addition to the registered investment company itself? Should any entities be removed, or should other entities (e.g., the administrator) be added? &sbull; Do the code of ethics disclosure requirements cover the appropriate individuals at those entities? Should any of these individuals be removed, or should other individuals be added? &sbull; Should we require registered investment companies, like domestic operating companies, to use Form 8–K to disclose amendments to, or waivers of, a code of ethics within two business days? Or is our proposed approach of requiring periodic reporting of this information on Form N–CSR or Form N–SAR appropriate? Should we propose a separate form for prompt reporting of this information? If we require periodic reporting of amendments and waivers on Forms N–CSR and N–SAR, is the proposed alternative option for disclosure of amendments and waivers on the investment company's Internet website within two business days necessary or appropriate? &sbull; For what period of time should we require an investment company to retain information about amendments to, or waivers from, codes of ethics, if it elects to post this information on its website? Should the retention period be not less than six years from the end of the fiscal year in which the amendment or waiver occurred, which would be consistent with the standard retention period for investment company records, or should it be some other period?\98\ --------------------------------------------------------------------------- \98\&thnsp;See Investment Company Act Rule 31a–2 [17 CFR 270.31a–2] (requiring retention by registered investment companies of various types of records for not less than six years). --------------------------------------------------------------------------- C. Management's Internal Controls and Procedures for Financial Reporting 1. Management's Internal Control Report Section 404 of the Sarbanes-Oxley Act directs the Commission to prescribe rules that would require each annual report that a company, other than a registered investment company,\99\ files pursuant to Section 13(a) or 15(d) of the Exchange Act to contain an internal control report: (1) Stating management's responsibilities for establishing and maintaining adequate internal control structure and procedures for financial reporting; and (2) containing an assessment, as of the end of the company's most recent fiscal year, of the effectiveness of the company's internal controls and procedures for financial reporting.\100\ --------------------------------------------------------------------------- \99\&thnsp;Section 404 of the Sarbanes-Oxley Act, and any rules of the Commission under section 404, do not apply to any registered investment company. Section 405 of the Sarbanes-Oxley Act. See section II.C.4 below “Registered Investment Companies.” \100\&thnsp;Section 404 also requires every registered public accounting firm that prepares or issues an audit report for a company to attest to, and report on, the assessment made by the management of a company. --------------------------------------------------------------------------- Twice in the past, the Commission has proposed an internal control report requirement. First, in 1979, following enactment of the Foreign Corrupt Practices Act (“FCPA”),\101\ we proposed rules that would have required a company to annually disclose certain information about its internal accounting controls.\102\ The proposed rules would have required a company's management to state its opinion as to whether the company's systems of internal accounting control provided reasonable assurance that: --------------------------------------------------------------------------- \101\&thnsp;Title I of Pub. L. 95–213 (1977). Partially codified in 15 U.S.C. 78m(b)(2), these provisions require issuers, with securities registered under section 12 of the Exchange Act, to make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer; and to devise and maintain a system of internal accounting control sufficient to provide reasonable assurances that: (i) transactions are executed in accordance with management's general or specific authorization; (ii) transactions are recorded as necessary (a) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (b) to maintain accountability for assets; (iii) access to assets is permitted only in accordance with management's general or specific authorization; and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. \102\&thnsp;Release No. 34–15772 (April 30, 1979) [44 FR 26702]. --------------------------------------------------------------------------- &sbull; Transactions were executed in accordance with management's general and specific authorization; &sbull; Transactions were recorded as necessary: (a) To permit preparation of financial statements in conformity with generally accepted accounting principles (or other applicable criteria); and (b) to maintain accountability for assets; &sbull; Access to assets was permitted in accordance with management's general or specific authorization; and &sbull; The recorded accountability for assets was compared with the existing assets at reasonable intervals and appropriate action was taken with respect to any differences. The proposed rules also would have required an independent public accountant to examine and report on management's statement. Commenters criticized the 1979 proposal for the scope and content of the proposed management statement, and its close correlation to the FCPA requirements. Many commenters viewed the proposal as requiring a report on compliance with the law. Others pointed to the significant voluntary and private-sector initiatives that had been undertaken in this area and urged us not to preempt such efforts by promulgating formal legal requirements. While we did not agree with all of the commenters' concerns, the Commission at that time decided not to proceed with the rulemaking to allow existing voluntary and private- sector initiatives for public reporting on internal accounting control to continue to develop. In 1980, the Commission formally withdrew the proposal.\103\ --------------------------------------------------------------------------- \103\&thnsp;Release No. 34–16877 (June 6, 1980) [45 FR 40134]. --------------------------------------------------------------------------- [[Page 66219]] Following the recommendations of the Treadway Commission, the Commission again proposed rules in 1988 that would have required companies to include in their annual reports a report of management's responsibilities with respect to financial reporting, including its responsibilities for the company's internal control system, and an assessment of the effectiveness of that system.\104\ Our 1988 proposal differed from the 1979 proposal in several respects. Under the 1988 proposal, management's report would have been signed on behalf of the company's principal executive, financial, and accounting officers, and would have contained: --------------------------------------------------------------------------- \104\&thnsp;Release No. 34–25925 (July 19, 1988) [53 FR 28009]. --------------------------------------------------------------------------- &sbull; A description of management's responsibilities for the preparation of the company's financial statements and other financial information included in a document containing the financial statements; &sbull; A description of management's responsibilities for establishing and maintaining a system of internal control directly related to, and designed to provide reasonable assurance as to the integrity and reliability of, financial reporting; &sbull; An assessment of the effectiveness of the company's system of internal control that encompassed material matters; and &sbull; A statement of how management responded to any significant recommendations concerning its system of internal controls made by its internal auditors and its independent accountants. Our 1988 proposal attempted to avoid a direct correlation with the FCPA by including a materiality threshold and focusing on the company's entire system of internal controls, rather than just its internal accounting controls. We received more than 180 comment letters in response to the 1988 proposal, with a majority of commenters supporting it. Many commenters, however, expressed concern over being required to disclose management's response to significant auditor recommendations on the management report. Furthermore, several commenters noted that private sector organizations were working to develop standards for reporting on the effectiveness of a company's internal controls.\105\ The Commission did not act on the proposals. --------------------------------------------------------------------------- \105\&thnsp;Committee of Sponsoring Organizations of the Treadway Commission, Internal Control—Integrated Framework, (August 1992) (the “COSO Report”). --------------------------------------------------------------------------- In light of the mandates of the Sarbanes-Oxley Act, we again are proposing to require companies to include a report on their internal controls and procedures for financial reporting in their annual reports. a. Proposed Disclosure We propose to amend Item 307 of Regulations S–K and S–B, as well as Forms 20–F and 40–F, to require a company's annual report to include an internal control report of management that includes: &sbull; A statement of management's responsibilities for establishing and maintaining adequate internal controls and procedures for financial reporting; &sbull; Conclusions about the effectiveness of the company's internal controls and procedures for financial reporting based on management's evaluation of those controls and procedures in accordance with Exchange Act Rule 13a–15 or 15d–15, as of the end of the company's most recent fiscal year;&thnsp;\106\ and --------------------------------------------------------------------------- \106\&thnsp;A proposed instruction to Item 307 of Regulations S–K and S–B, Item 15(a) of Form 20–F and Instruction B.(7) of Form 40–F states that if the conclusions of the company's principal executive and financial officers are reflected in management's conclusions disclosed in the internal control report, the company does not have to include any separate disclosure required by Item 307(a) (or relevant provision in the foreign forms) regarding the conclusions of those officers about the effectiveness of the company's internal controls and procedures for financial reporting in its report for its fourth fiscal quarter. Another proposed instruction to those provisions states that the company is encouraged, but not required, to include the disclosure required by Item 307(b) (or relevant provision in the foreign forms) for the company's fourth fiscal quarter in the annual internal control report, rather than disclose this information separately. --------------------------------------------------------------------------- &sbull; A statement that the registered public accounting firm that prepared or issued the company's audit report relating to the financial statements included in the company's annual report has attested to, and reported on, management's evaluation of the company's internal controls and procedures for financial reporting. The proposed amendments do not specify the exact content of the proposed management report, as this likely would result in boilerplate responses of little value. We believe that management should tailor the report to the company's circumstances. b. Internal Controls and Procedures for Financial Reporting A key aspect of management's responsibility for the preparation of financial information is its responsibility to establish and maintain an internal control system.\107\ On August 29, 2002, we issued a release adopting new Exchange Act Rules 13a–14 and 15d–14 to implement section 302 of the Sarbanes-Oxley Act. In that release we stated that the term “internal controls”&thnsp;\108\ as used in section 302 of the Sarbanes-Oxley Act is a pre-existing concept that pertains to a company's financial reporting and control of its assets.\109\ However, because there are a variety of different definitions of the term “internal controls” and its meaning has changed over time, there continues to be confusion regarding the meaning and scope of the term. --------------------------------------------------------------------------- \107\&thnsp;See American Institute of Certified Public Accountants (AICPA), Codification of Statements on Auditing Standards (AU) 319.53, “Internal Control in a Financial Statement Audit.” \108\&thnsp;In this release we use the term “internal controls” and “internal control structure” synonymously. \109\&thnsp;See Release No. 33–8124 (August 29, 2002) [67 FR 57276]. --------------------------------------------------------------------------- One of the first attempts to define internal controls was reflected in 1958 in the Statement on Auditing Procedure No. 29, in which the Committee on Auditing Procedure of the AICPA subdivided the definition of internal control into the following two components: “administrative control” and “accounting control.”&thnsp;\110\ This statement explained that the term “accounting control” related directly to the safeguarding of assets and the reliability of financial records. Examples included systems of transaction authorization and approval, physical controls over assets, and the plan of organization for separating duties concerned with record-keeping from duties concerned with operations or asset custody. “Administrative control” was defined as mainly concerning operational efficiency or adherence to managerial policies. Examples included statistical analyses, performance reports, training programs, and quality-control procedures. --------------------------------------------------------------------------- \110\&thnsp;See Committee on Auditing Procedure, AICPA, Statement on Auditing Procedure No. 29, “Scope of the Independent Auditor's Review of Internal Control” (1958). --------------------------------------------------------------------------- In 1972, the Statement on Auditing Procedure No. 54 redefined the administrative control and accounting control concepts.\111\ SAP No. 54 defined administrative control as the plan of organization, procedures, and records concerned with the decision processes leading to management's authorization of transactions. Accounting control was defined as a plan of organization and the procedures and records that are concerned with the safeguarding of assets and the reliability of financial records and consequently are designed to provide reasonable assurance that: --------------------------------------------------------------------------- \111\&thnsp;See Committee on Auditing Procedure, AICPA, Statement on Auditing Procedure No. 54. The FCPA codified the accounting control provisions of SAP No. 54, see note 58. --------------------------------------------------------------------------- [[Page 66220]] &sbull; Transactions are executed in accordance with management's general or specific authorization; &sbull; Transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles; and (2) to maintain accountability for assets; &sbull; Access to assets is permitted only by management's authorization; and &sbull; The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. In 1992, the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) undertook an extensive study of internal control. COSO defined internal control as “a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives' in three categories—effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. COSO further stated that internal control over each of these objectives consisted of the control environment, risk assessment, control activities, information and communication, and monitoring. In 1995, the AICPA's Auditing Standards Board in Statement on Auditing Standards No. 78 codified this definition of internal controls.\112\ --------------------------------------------------------------------------- \112\&thnsp;Auditing Standards Board, AICPA, Statement on Auditing Standards No. 78, “Consideration of Internal Control in a Financial Statement Audit: An Amendment to SAS No. 55” (1995). --------------------------------------------------------------------------- We believe that the purpose of internal controls and procedures for financial reporting is to ensure that companies have processes designed to provide reasonable assurance that: &sbull; The company's transactions are properly authorized; &sbull; The company's assets are safeguarded against unauthorized or improper use; and &sbull; The company's transactions are properly recorded and reported to permit the preparation of the registrant's financial statements in conformity with generally accepted accounting principles. We believe that these objectives are embodied in the definition of the term “internal controls” as the term is defined in AICPA's Codification of Statements on Auditing Standards (AU) section 319 and is consistent with section 103 of the Sarbanes-Oxley Act.\113\ Accordingly, we propose to refer to AU section 319 to define currently internal controls and procedures for financial reporting, pending action by the Public Company Accounting Oversight Board.\114\ The proposed definition would state that the term “internal controls and procedures for financial reporting” means controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with generally accepted accounting principles as addressed by the Codification of Statements on Auditing Standards 319 or any superseding definition or other literature that is issued or adopted by the Public Company Accounting Oversight Board. --------------------------------------------------------------------------- \113\&thnsp;Among other things, section 103 of the Act [Pub. L. 107–204 103] directs the Public Company Accounting Oversight Board to adopt auditing standards that would require all registered public accounting firms to present in each audit report or in a separate report: (1) The scope of the auditor's testing of the internal control structure and procedures of the issuer; (2) the findings of the auditor from such testing; (3) the auditor's evaluation of whether such internal control structure and procedures include maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer, provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and (4) a description, at a minimum, of material weaknesses in such internal controls, and of any material noncompliance found on the basis of such testing. \114\&thnsp;We believe that this definition integrates the various concepts of internal control into a unified concept that is widely understood by the accounting profession and issuers. --------------------------------------------------------------------------- Request for Comment &sbull; Should we propose a definition of internal controls and procedures for financial reporting? If so, is the proposed definition appropriate? &sbull; Should we define the term using AICPA's Codification of Statements on Auditing Standards Section 319 definition? If not, are there any other definitions we should use? &sbull; Should we propose specific disclosure criteria and standards for the management report? If so, what disclosure criteria and standards should we consider? 2. Attestation to, and Report on, Management's Internal Control Report by the Company's Auditor Section 404(b) of the Sarbanes-Oxley Act requires every registered public accounting firm that prepares or issues an audit report for an issuer other than a registered investment company&thnsp;\115\ to attest to, and report on, management's assessment of the issuer's internal controls and procedures for financial reporting. The attestation and report required by section 404(b) must be made in accordance with standards for attestation engagements “issued or adopted” by the Public Company Accounting Oversight Board (the “PCAOB”). --------------------------------------------------------------------------- \115\&thnsp;See section 405 of the Sarbanes-Oxley Act, which states that rules under section 404 of the Act shall not apply to registered investment companies. --------------------------------------------------------------------------- We are proposing amendments to Regulation S–X to reference the attestation report that will be prepared by registered public accounting firms and to require a company to file the attestation in annual reports on Forms 10–K, 10–KSB, 20–F and 40–F.\116\ Section 404(b) of the Sarbanes-Oxley Act does not require filing of the attestation report, but we believe that it is essential in satisfying the purposes of this provision of the Sarbanes- Oxley Act to require a company to file both the internal control report and auditor's attestation report in its annual report. --------------------------------------------------------------------------- \116\&thnsp;See proposed Items 210.1–02(b) and 210.2–02(d) of Regulation S–X. --------------------------------------------------------------------------- Request for Comment &sbull; If we adopt the proposed amendments before the PCAOB is operational, should we delay effectiveness of the rules until such time as attestation engagements standards are issued or adopted by the PCAOB? &sbull; Should the company have to file the attestation report as part of the annual report? If so, should the report have to appear in a particular part of the annual report? Where? 3. Quarterly Evaluation of Internal Controls and Procedures for Financial Reporting On August 29, 2002, we adopted new Exchange Act Rules 13a–14 and 15d–14 to implement section 302 of the Sarbanes-Oxley Act. These rules require the principal executive and financial officers of reporting companies to certify the information in their companies' quarterly and annual reports. Specifically, new Rules 13a–14 and 15d–14 require each of these officers to disclose that: &sbull; He or she has reviewed the report; &sbull; Based on his or her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report; &sbull; Based on his or her knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the [[Page 66221]] financial condition, results of operations and cash flows of the issuer as of, and for, the periods presented in the report; &sbull; He or she and the other certifying officers: (1) Are responsible for establishing and maintaining “disclosure controls and procedures” (a newly-defined term reflecting the concept of controls and procedures related to disclosure embodied in section 302(a)(4) of the Sarbanes-Oxley Act) for the issuer; (2) Have designed such disclosure controls and procedures to ensure that material information is made known to them, particularly during the period in which the periodic report is being prepared; (3) Have evaluated the effectiveness of the issuer's disclosure controls and procedures as of a date within 90 days prior to the filing date of the report; and (4) Have presented in the report their conclusions about the effectiveness of the disclosure controls and procedures based on the required evaluation as of that date; &sbull; He or she and the other certifying officers have disclosed to the issuer's auditors and to the audit committee of the board of directors (or persons fulfilling the equivalent function): (1) All significant deficiencies and material weaknesses in the design or operation of internal controls (a pre-existing term relating to internal controls regarding financial reporting) which could adversely affect the issuer's ability to record, process, summarize and report financial data and have identified for the issuer's auditors any material weaknesses in internal controls; and (2) Any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer's internal controls; and &sbull; He or she and the other certifying officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. For purposes of the Exchange Act Rules 13a–14 and 15d–14, “disclosure controls and procedures” are defined as controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports filed or submitted by it under the Exchange Act&thnsp;\117\ is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms.\118\ “Disclosure controls and procedures” include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in its Exchange Act reports is accumulated and communicated to the issuer's management, including its principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure. --------------------------------------------------------------------------- \117\&thnsp;These reports include quarterly reports on Form 10–Q or 10–QSB, annual reports on Form 10–K, 10–KSB, 20–F or 40–F, current reports, definitive proxy materials filed under section 14(a) of the Exchange Act [15 U.S.C. 78n(a)], definitive information statements filed under section 14(c) of the Exchange Act [15 U.S.C. 78n(c)] and amendments to any of these reports or documents. \118\&thnsp;See Exchange Act Rules 13a–14(c) and 15d–14(c). --------------------------------------------------------------------------- We also adopted new Item 307 of Regulations S–K and S–B&thnsp;\119\ to require disclosure in the company's annual and quarterly reports about the principal officers' evaluation of the company's disclosure controls and procedures and whether or not there have been significant changes to the company's internal controls—disclosure that the principal officers must certify that they have made. --------------------------------------------------------------------------- \119\&thnsp;In addition, we adopted corresponding amendments to Forms 20–F and 40–F for private foreign issuers. See 17 CFR 249.220f and 17 CFR 249.240f. --------------------------------------------------------------------------- Regarding internal controls and procedures for financial reporting, our recently adopted rules require the company's principal executive and financial officers to disclose “any significant changes in the company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with respect to significant deficiencies and material weaknesses.” Despite the reference to an evaluation in this disclosure requirement, our rules currently do not require the company's principal executive and financial officers, or the company itself, to conduct periodic evaluations of the company's internal controls. New Exchange Act Rules 13a–15 and 15d–15 do, however, require a company to conduct a quarterly evaluation of the company's disclosure controls and procedures. As explained above, section 404 of the Sarbanes-Oxley Act directs us to propose and adopt rules that would require management to annually assess the company's internal control structure and procedures for financial reporting. Section 404 contemplates only an annual evaluation of the company's internal controls. A company's officers already must certify to significant changes to internal controls as required by section 302 of the Sarbanes-Oxley Act. To provide a basis for this quarterly disclosure about changes to the company's internal controls and procedures for financial reporting, and to create symmetry between our requirements for periodic evaluations of both the company's disclosure controls and procedures and its internal controls and procedures for financial reporting, we propose to require the company's management to evaluate the effectiveness of the design and operation of the company's internal controls and procedures for financial reporting, as well as its disclosure controls and procedures, with respect to each annual and quarterly report that it is required to file under the Exchange Act.\120\ In addition, we propose to modify the requirement in Exchange Act Rules 13a–15 and 15d–15 that the evaluation be conducted within the 90-day period prior to the filing date of the quarterly or annual report, to require that the evaluation be made as of the end of the period covered by the report.\121\ We are also proposing conforming changes&thnsp;\122\ to Exchange Act Rules 13a–14, 13a–15, 15d–14 and 15d–15 and the form of certification in Forms [[Page 66222]] 10–Q, 10–QSB, 10–K, 10–KSB, 20–F and 40–F. --------------------------------------------------------------------------- \120\&thnsp;Rules 13a–15(b) and 15d–15(b). As originally adopted, Rules 13a–15 and 15d–15 required the company to carry out this evaluation under the supervision of, and with the participation of the company's management, including the company's principal executive and financial officers. To better reconcile this requirement with the proposed rules under section 404 of the Sarbanes-Oxley Act, we propose to revise these rules to state more directly that company's management, rather than the company itself, must undertake the required evaluatio [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AX02-11030. Public record. Not legal advice.