The Latest from the SEC: An Analysis

On October 15, 2003, David Lynn, Chief Counsel of the Division of Corporation Finance for the U.S. Securities and Exchange Commission (SEC), discussed recent rulings in a conference call sponsored by Glasser Legal Works. The call was moderated by Brian Lane, Gibson, Dunn & Crutcher LLP; David Martin, Covington & Burling; and Meredith Cross, Wilmer, Cutler & Pickering. Each of the moderators had formerly been in a significant position with the SEC's Division of Corporation Finance. Mr. Lynn disclaimed any relationship between his views and those of the SEC or any member of the SEC staff.

Introduction

As a result of the Sarbanes-Oxley Act of 2002 (the Act) securities laws and regulations have been changing rapidly, making compliance take longer and cost more. The conference call was a general overview of some of the changes affecting disclosure compliance – including those under Section 404 of the Act — and other new reporting issues at the SEC. A full transcript of the call is available at http://www.realcorporatelawyer.com/programs/cle10-15-03tran.html. What follows is a summary of some parts of that discussion, mixed with some references to the text of the proposed rules.

General Insights

Lynn made several points that highlighted the continuing need to “keep up” with the many changes that are being fashioned from the Act, not the least of which was his confirmation, after consultation with the Department of Justice, that certifications under Section 906 of the Act will not be required for filings on Forms 8-K, 6-K and 11-K. Lynn noted in the course of the call that the SEC would not be issuing any written guidance on that point, leading one of the moderators to comment that “it's hard to do a legal opinion on a CLE conference.”

Lynn also noted that the staff had been extremely busy, and would continue to be so as the Act's provisions become effective. One commentator noted that the Act requires staff review of every issuer at least every 3 years, but that some issuers were receiving comments much more frequently. The SEC is adding staff — 350 to 400 new professionals, mostly accountants — to deal with the additional oversight responsibilities mandated by the Act.

The new proposal for Form 8-K will likely be subject to a new SEC ruling, adding 11 items covering specific events that will now require the filing of a Form 8-K. Lynn discussed additional minor changes in SEC rulemaking. He noted in particular that the SEC would soon issue new guidance to issuers on the preparation of “Management's Discussion and Analysis” sections (MD&A) of SEC disclosure documents. (See below.)

Certification and 404 Issues

The conference call also covered the Public Company Accounting Oversight Board's (PCAOB) proposed standards relating to audits of “internal control over financial reporting.” On Oct. 7, 2003, the PCAOB issued its first proposed Auditing Standard, which related to compliance with Section 404. See http://www.pcaobus.org/rules/Release2003-017.pdf. Section 404(a) of the Act requires each annual report filed by an issuer to contain an “internal control report” which must “1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and 2) contain [management's assessment as to the effectiveness of the] internal control structure and procedures for financial reporting.”

Section 404(b) requires registered public accounting firms to “attest to, and report on, the assessment” made by management. The PCAOB's proposed standards are arguably more comprehensive than the standards used for “internal controls” under the COSO guidelines. The PCAOB standards also require more comprehensive testing, including “walk-throughs,” and testing of controls that “could materially affect financial reporting.” Although the Act and the rules require the audit of internal controls to be integrated with the audit of the financial statements, many companies are hiring a second accounting firm to advise on their internal controls.

Under the PCAOB's proposed standards, an auditor must evaluate both management's assessment and conclusion and the internal controls in order to provide the required attestation under Section 404(b) of the Act. The proposed PCAOB standards establish two new terms for use in evaluating “internal control for financial reporting”:

• “Significant deficiency” is, in essence, a deficiency that results in more than a remote likelihood of a restatement that is more than inconsequential.
• “Material weakness” is, in essence, a deficiency that by itself or in combination with other significant deficiencies “results in more than a remote likelihood that a material misstatement [in the company's] annual or interim financial reports will not be prevented or detected.”

Although the PCAOB report says that the audit is not “absolute assurance,” the report states that an audit committee that does not exercise sufficient oversight is itself an example of a “significant deficiency.” Such a deficiency is in itself likely to be regarded as a material weakness. Audit committees may be reviewed by the auditors they retain – -and the SEC may receive significant comments on this part of the proposal.

The PCAOB Report also states that if the internal control does not uncover a financing reporting error that is later found to have led to a material misstatement, it is a “significant deficiency” – and likely to be a “material weakness.” This was criticized as “20-20 hindsight” – if followed to its logical conclusion, all restatements are indicative of a material weakness. And if there is a material weakness, management may not be able to provide the required certification under Section 302 of the Act. On the conference call, one commentator suggested that the logical conclusion is that if a company has identified a material weakness, it can never file a periodic report. If that is the logical result, then the PCAOB and SEC may well receive comments in opposition.

It is worth noting that most commentators believe that Section 404 of the Act does not require an assessment of all compliance programs, just those that affect “internal control over financial reporting.” Comments on the proposed PCAOB standards were due by Nov. 21 of this year.

New NYSE Standards

Meredith Cross discussed the New York Stock Exchange's proposed corporate governance listing standards. Those standards have been recently modified in a letter to the SEC on Oct. 8, 2003. The SEC has stated that it will not seek additional public comment before accepting the rules, so the rules will likely be effective soon. The rules are slated to be effective as early as each listed company's first annual meeting after Jan. 15, 2004. The NYSE will not likely grant waivers.

The proposed NYSE listing standards set out new “bright line” rules for director independence. It is likely that the NYSE will try to use the same standards for independence that the SEC rules for determining the independence of members of the audit committee. Note that compliance with a stock exchange standard or SEC rule does not necessarily make a director “independent” for all purposes. Under earlier drafts of the NYSE listing standards, a director could be independent as long as he or she had not received payments from the issuer in the past 5 years — that period has been reduced to 3 years. But the standard provides for only a “1-year look-back” in the first year, leading to the “goofy” result that a director who received compensation in 2002 would be independent for calendar year filers in 2004 and 2006, but not in 2005.

The NYSE listing standards propose new procedures as well – including the requirements for new committees, new charters, and a new “self-assessment” regime.

Proposed Shareholder Access Rules

Since the 1970s, the SEC has been concerned with the fact that the election of directors is “more of a coronation than an election.” The drive for greater “shareholder rights” has — rightly or wrongly — become linked with the call for better corporate governance. The SEC may be striking the right balance, but to the extent that corporations cannot be democratic institutions, the rules may be a frustrating compromise. The proposed rules may be found at http://www.sec.gov/news/studies/proxyrpt.htm and http://www.sec.gov/rules/proposed/34-48626.htm. The SEC intends to issue some final rules in time for the 2004 “proxy season.”

Under the proposed proxy rules, material terms of the nominating committee charter must be described, including the independence of members, whether the committee has a policy with respect to director qualifications, whether the nominating committee will consider candidates suggested by shareholders, what skills are necessary, specific standards for composition of the board of directors, disclosure about fees to third parties, etc. If shareholders holding 3% or more suggest nominees for directors and the nominating committee elects not to nominate them, the proxy must include the names of the shareholders who nominated the directors, the names of the nominees, and the specific reasons why the nominating committee decided not to nominate those persons.

After certain “triggering events,” the SEC has proposed permitting shareholders who have held more than 1% of the outstanding stock for more than 1 year to propose nominees to the board. “Triggering events” have not been finalized, but were described on the conference call as being when the corporate governance process has “broken down.” After those events, those shareholders will have “access” to the proxy statement for their candidates. These draft rules are very technical and may be considered controversial at this point.

Disclosure

The SEC has been focused on improving the MD&A disclosure in public filings since at least 1989. In order to obtain more “qualitative” disclosure, the SEC has recently issued a release on the discussion of “critical accounting policies” in MD&A. http://www.sec.gov/rules/proposed/33-8098.htm. The SEC appears to be looking for more “qualitative disclosures” on the company's focus, known trends and uncertainties, cash flows and the need for liquidity. In short, it could be said to be interested in more analysis by the issuers themselves.

Companies frequently use “boilerplate” in their SEC filings to avoid lawsuits, or because an attorney has advised them that the boilerplate will help prevent lawsuits. Rather than analyze the numbers, SEC filings often repeat the facts – “this is going up, and this is going down.” Lynn said that some people have referred to that type of disclosure as “elevator music” and noted that the staff would likely de-emphasize immaterial disclosure. He also referred to the SEC's recent study of “Fortune 500″ disclosure, and noted the study was a “good barometer” of the SEC staff concerns. See http://www.sec.gov/divisions/corpfin/fortune500rep.htm.

On October 15, 2003, David Lynn, Chief Counsel of the Division of Corporation Finance for the U.S. Securities and Exchange Commission (SEC), discussed recent rulings in a conference call sponsored by Glasser Legal Works. The call was moderated by Brian Lane, Gibson, Dunn & Crutcher LLP; David Martin, Covington & Burling; and Meredith Cross, Wilmer, Cutler & Pickering. Each of the moderators had formerly been in a significant position with the SEC's Division of Corporation Finance. Mr. Lynn disclaimed any relationship between his views and those of the SEC or any member of the SEC staff.

Introduction

As a result of the Sarbanes-Oxley Act of 2002 (the Act) securities laws and regulations have been changing rapidly, making compliance take longer and cost more. The conference call was a general overview of some of the changes affecting disclosure compliance – including those under Section 404 of the Act — and other new reporting issues at the SEC. A full transcript of the call is available at http://www.realcorporatelawyer.com/programs/cle10-15-03tran.html. What follows is a summary of some parts of that discussion, mixed with some references to the text of the proposed rules.

General Insights

Lynn made several points that highlighted the continuing need to “keep up” with the many changes that are being fashioned from the Act, not the least of which was his confirmation, after consultation with the Department of Justice, that certifications under Section 906 of the Act will not be required for filings on Forms 8-K, 6-K and 11-K. Lynn noted in the course of the call that the SEC would not be issuing any written guidance on that point, leading one of the moderators to comment that “it's hard to do a legal opinion on a CLE conference.”

Lynn also noted that the staff had been extremely busy, and would continue to be so as the Act's provisions become effective. One commentator noted that the Act requires staff review of every issuer at least every 3 years, but that some issuers were receiving comments much more frequently. The SEC is adding staff — 350 to 400 new professionals, mostly accountants — to deal with the additional oversight responsibilities mandated by the Act.

The new proposal for Form 8-K will likely be subject to a new SEC ruling, adding 11 items covering specific events that will now require the filing of a Form 8-K. Lynn discussed additional minor changes in SEC rulemaking. He noted in particular that the SEC would soon issue new guidance to issuers on the preparation of “Management's Discussion and Analysis” sections (MD&A) of SEC disclosure documents. (See below.)

Certification and 404 Issues

The conference call also covered the Public Company Accounting Oversight Board's (PCAOB) proposed standards relating to audits of “internal control over financial reporting.” On Oct. 7, 2003, the PCAOB issued its first proposed Auditing Standard, which related to compliance with Section 404. See http://www.pcaobus.org/rules/Release2003-017.pdf. Section 404(a) of the Act requires each annual report filed by an issuer to contain an “internal control report” which must “1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and 2) contain [management's assessment as to the effectiveness of the] internal control structure and procedures for financial reporting.”

Section 404(b) requires registered public accounting firms to “attest to, and report on, the assessment” made by management. The PCAOB's proposed standards are arguably more comprehensive than the standards used for “internal controls” under the COSO guidelines. The PCAOB standards also require more comprehensive testing, including “walk-throughs,” and testing of controls that “could materially affect financial reporting.” Although the Act and the rules require the audit of internal controls to be integrated with the audit of the financial statements, many companies are hiring a second accounting firm to advise on their internal controls.

Under the PCAOB's proposed standards, an auditor must evaluate both management's assessment and conclusion and the internal controls in order to provide the required attestation under Section 404(b) of the Act. The proposed PCAOB standards establish two new terms for use in evaluating “internal control for financial reporting”:

• “Significant deficiency” is, in essence, a deficiency that results in more than a remote likelihood of a restatement that is more than inconsequential.
• “Material weakness” is, in essence, a deficiency that by itself or in combination with other significant deficiencies “results in more than a remote likelihood that a material misstatement [in the company's] annual or interim financial reports will not be prevented or detected.”

Although the PCAOB report says that the audit is not “absolute assurance,” the report states that an audit committee that does not exercise sufficient oversight is itself an example of a “significant deficiency.” Such a deficiency is in itself likely to be regarded as a material weakness. Audit committees may be reviewed by the auditors they retain – -and the SEC may receive significant comments on this part of the proposal.

The PCAOB Report also states that if the internal control does not uncover a financing reporting error that is later found to have led to a material misstatement, it is a “significant deficiency” – and likely to be a “material weakness.” This was criticized as “20-20 hindsight” – if followed to its logical conclusion, all restatements are indicative of a material weakness. And if there is a material weakness, management may not be able to provide the required certification under Section 302 of the Act. On the conference call, one commentator suggested that the logical conclusion is that if a company has identified a material weakness, it can never file a periodic report. If that is the logical result, then the PCAOB and SEC may well receive comments in opposition.

It is worth noting that most commentators believe that Section 404 of the Act does not require an assessment of all compliance programs, just those that affect “internal control over financial reporting.” Comments on the proposed PCAOB standards were due by Nov. 21 of this year.

New NYSE Standards

Meredith Cross discussed the New York Stock Exchange's proposed corporate governance listing standards. Those standards have been recently modified in a letter to the SEC on Oct. 8, 2003. The SEC has stated that it will not seek additional public comment before accepting the rules, so the rules will likely be effective soon. The rules are slated to be effective as early as each listed company's first annual meeting after Jan. 15, 2004. The NYSE will not likely grant waivers.

The proposed NYSE listing standards set out new “bright line” rules for director independence. It is likely that the NYSE will try to use the same standards for independence that the SEC rules for determining the independence of members of the audit committee. Note that compliance with a stock exchange standard or SEC rule does not necessarily make a director “independent” for all purposes. Under earlier drafts of the NYSE listing standards, a director could be independent as long as he or she had not received payments from the issuer in the past 5 years — that period has been reduced to 3 years. But the standard provides for only a “1-year look-back” in the first year, leading to the “goofy” result that a director who received compensation in 2002 would be independent for calendar year filers in 2004 and 2006, but not in 2005.

The NYSE listing standards propose new procedures as well – including the requirements for new committees, new charters, and a new “self-assessment” regime.

Proposed Shareholder Access Rules

Since the 1970s, the SEC has been concerned with the fact that the election of directors is “more of a coronation than an election.” The drive for greater “shareholder rights” has — rightly or wrongly — become linked with the call for better corporate governance. The SEC may be striking the right balance, but to the extent that corporations cannot be democratic institutions, the rules may be a frustrating compromise. The proposed rules may be found at http://www.sec.gov/news/studies/proxyrpt.htm and http://www.sec.gov/rules/proposed/34-48626.htm. The SEC intends to issue some final rules in time for the 2004 “proxy season.”

Under the proposed proxy rules, material terms of the nominating committee charter must be described, including the independence of members, whether the committee has a policy with respect to director qualifications, whether the nominating committee will consider candidates suggested by shareholders, what skills are necessary, specific standards for composition of the board of directors, disclosure about fees to third parties, etc. If shareholders holding 3% or more suggest nominees for directors and the nominating committee elects not to nominate them, the proxy must include the names of the shareholders who nominated the directors, the names of the nominees, and the specific reasons why the nominating committee decided not to nominate those persons.

After certain “triggering events,” the SEC has proposed permitting shareholders who have held more than 1% of the outstanding stock for more than 1 year to propose nominees to the board. “Triggering events” have not been finalized, but were described on the conference call as being when the corporate governance process has “broken down.” After those events, those shareholders will have “access” to the proxy statement for their candidates. These draft rules are very technical and may be considered controversial at this point.

Disclosure

The SEC has been focused on improving the MD&A disclosure in public filings since at least 1989. In order to obtain more “qualitative” disclosure, the SEC has recently issued a release on the discussion of “critical accounting policies” in MD&A. http://www.sec.gov/rules/proposed/33-8098.htm. The SEC appears to be looking for more “qualitative disclosures” on the company's focus, known trends and uncertainties, cash flows and the need for liquidity. In short, it could be said to be interested in more analysis by the issuers themselves.

Companies frequently use “boilerplate” in their SEC filings to avoid lawsuits, or because an attorney has advised them that the boilerplate will help prevent lawsuits. Rather than analyze the numbers, SEC filings often repeat the facts – “this is going up, and this is going down.” Lynn said that some people have referred to that type of disclosure as “elevator music” and noted that the staff would likely de-emphasize immaterial disclosure. He also referred to the SEC's recent study of “Fortune 500″ disclosure, and noted the study was a “good barometer” of the SEC staff concerns. See http://www.sec.gov/divisions/corpfin/fortune500rep.htm.