Compliance Hotline

SEC Approves PCAOB Auditing Standard Regarding Audits

On June 18, 2004, the Securities and Exchange Commission announced that it has approved PCAOB Release No. 2004-003: An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.

Previously, on June 5, 2003, the SEC had amended its rules under the Securities Exchange Act of 1934, pursuant to Section 404 of the Sarbanes-Oxley Act. These amendments require a company to include in annual reports a report by management on the company's internal control over financial reporting and an accompanying auditor's report. The auditing standard just approved by the SEC applies to the auditor's involvement and report.

This new auditing standard addresses both the work that is required to audit internal control over financial reporting and the relationship of that audit to the audit of the financial statements. An audit of internal control includes, among other things, evaluating the process management used to perform its assessment of internal control effectiveness, evaluating the effectiveness of both the design and operation of the internal control, and forming an opinion about whether internal control over financial reporting is effective.

Companies considered accelerated filers (seasoned U.S. companies with public float exceeding $75 million) are required to comply with the internal control reporting and disclosure requirements of Section 404 of the Act for fiscal years ending on or after Nov. 15, 2004. Accordingly, auditors engaged to audit the financial statements of such companies for fiscal years ending on or after Nov. 15, 2004, also are required to audit and report on the company's internal control over financial reporting as of the end of such fiscal year. Other companies (including smaller companies, foreign private issuers and companies with only registered debt securities) have until fiscal years ending on or after July 15, 2005, to comply with these internal control reporting and disclosure requirements, and the requirement for audit reporting on internal control is similarly delayed.

The SEC noted that during the new auditing standard's comment period, various implementation questions were identified, and that implementation guidance will be provided shortly for the benefit of issuers and their auditors. Guidance, the SEC stated, will be forthcoming from both the SEC and PCAOB staffs. It will address recent acquisitions, consolidated but non-controlled subsidiaries, and equity investees, as well as concerns raised by issuers surrounding qualification of the report on internal controls, transition periods, disclosure requirements relating to significant deficiencies and material changes made in internal controls, and the timing of assessment of internal control over financial reporting in relation to certain foreign subsidiaries.

The texts of the auditing standard and rules are available at www.pcaobus.org under Rulemaking.

SEC Proposes Rule for Bank Brokers

The Securities and Exchange Commission voted on June 2 to publish for comment proposed Regulation B, which is designed to implement provisions of the Gramm-Leach-Bliley Act of 1999 (GLBA) that set forth the securities activities banks may engage in without registering as brokers with the SEC.

The GLBA replaced banks' complete exception from the definition of 'broker”' with 11 'functional exceptions' and by way of Regulation B, the SEC proposes new rules to implement the GLBA definition by defining some of the statutory terms used in the eleven exceptions. It also proposed a number of new exemptions for some particular bank activities, under conditions that are consistent with investor protections. All of these provisions build off the Interim Rules the SEC adopted in 2001. The proposals would extend many of these provisions to savings associations and savings banks, and also exempt credit unions that engage in certain limited securities activities as long as they are conducted under the terms applicable to certain of the bank exceptions from the definitions of broker and dealer. These proposals include:

A Networking Exception: Allows banks to partner with broker-dealers in offering their customers financial services, including securities brokerage. Under this exception, a broker-dealer offers brokerage services to bank customers and shares the compensation with the bank. The exception also allows unregistered bank employees to receive incentive compensation in the form of a “nominal one-time cash fee of a fixed dollar amount” for referring bank customers to the broker-dealer.

A Trustee and Fiduciary Account Exception: Permits a bank, under certain conditions, to receive 'sales compensation' (eg, commission-type compensation or sales charges and service fees paid out of mutual fund assets pursuant to a distribution plan adopted under rule 12b-1) for effecting transactions for its customers in a trustee or fiduciary capacity without registering as a broker. Under this exception, a bank must effect such transactions in its trust department, or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards. The bank also must be 'chiefly compensated' for any securities transactions, consistent with fiduciary principles and standards, on the basis of 'relationship compensation' (ie, an administration or annual fee, a percentage of assets under management, a flat or capped per order processing fee that does not exceed the cost the bank incurs in executing such securities transactions, or any combination of these fees).

The term “chiefly compensated” is not defined in the statute. The Interim Rules both defined the term to mean that relationship compensation exceeds sales compensation as determined on an account-by-account basis and provided a limited exemption to permit a bank to assess its compliance on an aggregate, rather than an account-by-account, basis using a proportion of 9 to 1 as the ratio for relationship to sales compensation as long as other procedural requirements were met. They also provided a limited exemption for banks acting as indenture trustees.

In addition, the SEC also voted to propose several amendments to the Interim Rules. These amendments are intended to simplify banks' compliance with this statutory requirement through both definitions and targeted exceptions. These amendments would expand the definition of 'relationship compensation,' which is a component of the comparison, to include fees generated by all types of assets. These amendments include:

' A small bank custody exemption that can be used by qualifying small banks in lieu of the “chiefly compensated” comparison and the other requirements of the trust and fiduciary activities exemption.

' A new exemption from the “chiefly compensated” requirement for banks acting as trustees and in other limited capacities (as well as for qualified investors) to be able to make investments in money market funds that pay 12b-1 fees.

' A revision of the 9 to 1 exemption that substantially reduces the procedural requirements and allows the exemption to be utilized on a line-of-business basis, on a bank-wide basis, and for accounts that predate the development of an account-by-account compliance system.

' A personal trust account exemption for personal trust accounts that were established prior to this proposal.

' A conditional safe harbor that allows banks to measure their compensation in one year to determine their status for the next year and provides appropriate cure periods.

' An account-by-account exemption that would give a bank some additional flexibility when evaluating individual accounts that would not meet the 'chiefly compensated' comparison. This exemption would also provide formulas to allocate 'sales compensation' (which goes into the comparison) from sources such as mutual funds that are paid on an aggregate basis.

' An exemption, retained from the Interim Rules, for a bank acting as an indenture trustee

Comments on the proposed rules are due on or before August 1, 2004.

SEC Approves PCAOB Auditing Standard Regarding Audits

On June 18, 2004, the Securities and Exchange Commission announced that it has approved PCAOB Release No. 2004-003: An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.

Previously, on June 5, 2003, the SEC had amended its rules under the Securities Exchange Act of 1934, pursuant to Section 404 of the Sarbanes-Oxley Act. These amendments require a company to include in annual reports a report by management on the company's internal control over financial reporting and an accompanying auditor's report. The auditing standard just approved by the SEC applies to the auditor's involvement and report.

This new auditing standard addresses both the work that is required to audit internal control over financial reporting and the relationship of that audit to the audit of the financial statements. An audit of internal control includes, among other things, evaluating the process management used to perform its assessment of internal control effectiveness, evaluating the effectiveness of both the design and operation of the internal control, and forming an opinion about whether internal control over financial reporting is effective.

Companies considered accelerated filers (seasoned U.S. companies with public float exceeding $75 million) are required to comply with the internal control reporting and disclosure requirements of Section 404 of the Act for fiscal years ending on or after Nov. 15, 2004. Accordingly, auditors engaged to audit the financial statements of such companies for fiscal years ending on or after Nov. 15, 2004, also are required to audit and report on the company's internal control over financial reporting as of the end of such fiscal year. Other companies (including smaller companies, foreign private issuers and companies with only registered debt securities) have until fiscal years ending on or after July 15, 2005, to comply with these internal control reporting and disclosure requirements, and the requirement for audit reporting on internal control is similarly delayed.

The SEC noted that during the new auditing standard's comment period, various implementation questions were identified, and that implementation guidance will be provided shortly for the benefit of issuers and their auditors. Guidance, the SEC stated, will be forthcoming from both the SEC and PCAOB staffs. It will address recent acquisitions, consolidated but non-controlled subsidiaries, and equity investees, as well as concerns raised by issuers surrounding qualification of the report on internal controls, transition periods, disclosure requirements relating to significant deficiencies and material changes made in internal controls, and the timing of assessment of internal control over financial reporting in relation to certain foreign subsidiaries.

The texts of the auditing standard and rules are available at www.pcaobus.org under Rulemaking.

SEC Proposes Rule for Bank Brokers

The Securities and Exchange Commission voted on June 2 to publish for comment proposed Regulation B, which is designed to implement provisions of the Gramm-Leach-Bliley Act of 1999 (GLBA) that set forth the securities activities banks may engage in without registering as brokers with the SEC.

The GLBA replaced banks' complete exception from the definition of 'broker”' with 11 'functional exceptions' and by way of Regulation B, the SEC proposes new rules to implement the GLBA definition by defining some of the statutory terms used in the eleven exceptions. It also proposed a number of new exemptions for some particular bank activities, under conditions that are consistent with investor protections. All of these provisions build off the Interim Rules the SEC adopted in 2001. The proposals would extend many of these provisions to savings associations and savings banks, and also exempt credit unions that engage in certain limited securities activities as long as they are conducted under the terms applicable to certain of the bank exceptions from the definitions of broker and dealer. These proposals include:

A Networking Exception: Allows banks to partner with broker-dealers in offering their customers financial services, including securities brokerage. Under this exception, a broker-dealer offers brokerage services to bank customers and shares the compensation with the bank. The exception also allows unregistered bank employees to receive incentive compensation in the form of a “nominal one-time cash fee of a fixed dollar amount” for referring bank customers to the broker-dealer.

A Trustee and Fiduciary Account Exception: Permits a bank, under certain conditions, to receive 'sales compensation' (eg, commission-type compensation or sales charges and service fees paid out of mutual fund assets pursuant to a distribution plan adopted under rule 12b-1) for effecting transactions for its customers in a trustee or fiduciary capacity without registering as a broker. Under this exception, a bank must effect such transactions in its trust department, or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards. The bank also must be 'chiefly compensated' for any securities transactions, consistent with fiduciary principles and standards, on the basis of 'relationship compensation' (ie, an administration or annual fee, a percentage of assets under management, a flat or capped per order processing fee that does not exceed the cost the bank incurs in executing such securities transactions, or any combination of these fees).

The term “chiefly compensated” is not defined in the statute. The Interim Rules both defined the term to mean that relationship compensation exceeds sales compensation as determined on an account-by-account basis and provided a limited exemption to permit a bank to assess its compliance on an aggregate, rather than an account-by-account, basis using a proportion of 9 to 1 as the ratio for relationship to sales compensation as long as other procedural requirements were met. They also provided a limited exemption for banks acting as indenture trustees.

In addition, the SEC also voted to propose several amendments to the Interim Rules. These amendments are intended to simplify banks' compliance with this statutory requirement through both definitions and targeted exceptions. These amendments would expand the definition of 'relationship compensation,' which is a component of the comparison, to include fees generated by all types of assets. These amendments include:

' A small bank custody exemption that can be used by qualifying small banks in lieu of the “chiefly compensated” comparison and the other requirements of the trust and fiduciary activities exemption.

' A new exemption from the “chiefly compensated” requirement for banks acting as trustees and in other limited capacities (as well as for qualified investors) to be able to make investments in money market funds that pay 12b-1 fees.

' A revision of the 9 to 1 exemption that substantially reduces the procedural requirements and allows the exemption to be utilized on a line-of-business basis, on a bank-wide basis, and for accounts that predate the development of an account-by-account compliance system.

' A personal trust account exemption for personal trust accounts that were established prior to this proposal.

' A conditional safe harbor that allows banks to measure their compensation in one year to determine their status for the next year and provides appropriate cure periods.

' An account-by-account exemption that would give a bank some additional flexibility when evaluating individual accounts that would not meet the 'chiefly compensated' comparison. This exemption would also provide formulas to allocate 'sales compensation' (which goes into the comparison) from sources such as mutual funds that are paid on an aggregate basis.

' An exemption, retained from the Interim Rules, for a bank acting as an indenture trustee

Comments on the proposed rules are due on or before August 1, 2004.