FINAL SEC RULE REGARDING DISCLOSURE OF AUDIT COMMITTEE FINANCIAL EXPERT UNDER SECTION 407 OF SARBANES-OXLEY

By Brent Eller
[February 2003]

Section 407 of the Sarbanes-Oxley Act of 2002 (the "Act") mandates that the Securities and Exchange Commission (SEC) issue rules to require issuers to disclose in their periodic reports under the Securities Exchange Act of 1934 (the "Exchange Act") whether or not their audit committees have at least one member who is a "financial expert" and, if not, the reason why. On January 23, 2003, the SEC issued a final rule regarding audit committee financial expert disclosure that clarifies (and in some cases expands) the requirements of Section 407 in a number of respects.¹ In response to comments, the final rule adopts a less restrictive definition of the term "financial expert" than the proposed rule issued by the SEC on October 22, 2002² and reduces the level of disclosure that the proposed rule would have required.

Section 407

Section 407(a) of the Act requires the SEC to "issue rules, as necessary or appropriate in the public interest and consistent with the protection of investors, to require each issuer, together with periodic reports required pursuant to sections 13(a) and 15(d) of the Securities Exchange Act of 1934, to disclose whether or not, and if not, the reasons therefor, the audit committee of that issuer is comprised of at least one member who is a financial expert, as such term is defined by the [SEC]."

Section 407(b) provides the following guidance regarding who can be a "financial expert":

b. Considerations. In defining the term "financial expert" for purposes of subsection (a), the [SEC] shall consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions--

1. an understanding of generally accepted accounting principles and financial statements;
2. experience in--
   1. the preparation or auditing of financial statements of generally comparable issuers; and
   2. 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.

Disclosure Obligations Under the Final Rule

Under the final rule, an issuer must disclose whether or not its board of directors has at least one "audit committee financial expert" serving on its audit committee.³ An issuer that does not have an audit committee financial expert must explain why it does not. In an expansion of the requirements of Section 407, the final rule requires the issuer to disclose the name of at least one audit committee financial expert. Although the issuer may determine that it has more than one audit committee financial expert on its audit committee, it is not required to make this determination, nor is it required to disclose the names of the additional audit committee financial experts.⁴

In an additional expansion of Section 407 requirements, the final rule requires an issuer to disclose whether its named audit committee financial expert is independent⁵ of management. The SEC noted that this requirement, which was also included in the proposed rule, is necessary even though Section 301 of the Act will require issuers listed on a national securities exchange or association to have audit committees comprised solely of independent directors, because not all reporting companies are so listed. Finally, if an issuer elects to disclose the names of more than one audit committee financial expert, it must also disclose whether or not the additional named audit committee financial experts are independent. The SEC noted that when rules implementing Section 301 are adopted, the Section 407 rules will be revised to be consistent with the independence standard set forth in the Section 301 rules.

Definition of "Audit Committee Financial Expert"

The final rule defines an audit committee financial expert as a person who has the following attributes:

• An understanding of generally accepted accounting principles and financial statements;⁶
  
• The ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;⁷
  
• Experience preparing, auditing, analyzing or evaluating⁸ financial statements that present a breadth and level of complexity of accounting issues that are generally comparable⁹ to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising one or more persons engaged in such activities;¹⁰
  
• An understanding¹¹ of internal controls and procedures for financial reporting; and
  
• An understanding of audit committee functions.¹²

The final rule requires the audit committee financial expert to have acquired these attributes through:

• Education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;¹³
  
• Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;
  
• Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements;¹⁴ or
  
• Other relevant experience.

The issuer is not required, as was proposed, to disclose the basis for its board's determination that an audit committee financial expert qualify as such through "other relevant experience"; however, the person's experience must be briefly listed in the issuer's disclosure. The SEC stated that actual experience, rather than merely education, is required. The SEC also eliminated the lengthy list of factors that the proposed rule would have required an issuer's board to consider in assessing the qualifications of a potential audit committee financial expert, noting that the board should instead consider all the available facts and circumstances, including but not limited to factors of the type listed in the proposed rule. Finally, the SEC noted that prior service on an audit committee or the mere fact that a person has experience as a public accountant, auditor, principal financial officer, controller or principal accounting officer does not, by itself, justify the board in deeming the person to be an audit committee financial expert. The SEC stated that in addition to considering a candidate's knowledge and experience, "the board must ensure that it names an audit committee financial expert who embodies the highest standards of personal and professional integrity."

Safe Harbor From Liability

In response to requests by commenters that it clarify that identification or designation of an audit committee financial expert increase or decrease such person’s duties, obligations or potential liability as an audit committee member, the SEC adopted a so-called “safe harbor” provision stating that:

• A person who is determined to be an audit committee financial expert will not be deemed an "expert" for any purpose, including without limitation for purposes of Section 11 of the Securities Act, as a result of being designated as an audit committee financial expert pursuant to the new disclosure item;
  
• The designation or identification of a person as an audit committee financial expert pursuant to the new disclosure item does not impose on such person any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such person as a member of the audit committee and board of directors in the absence of such designation or identification; and
  
• The designation or identification of a person as an audit committee financial expert pursuant to the new disclosure item does not affect the duties, obligations, or liability of any other member of the audit committee or board of directors.

The SEC noted that because an audit committee financial expert is not an "expert" for purposes of Section 11 of the Securities Act of 1933, he or she is not subject to any higher level of due diligence with respect to any portion of the issuer's registration statement as a result of his or her designation as an audit committee financial expert.

Location and Timing of Disclosure; Applicability of Disclosure Requirements

The final rule provides that the audit committee financial expert disclosure must be made in an issuer's annual reports on Forms 10-K, 10-KSB, 20-F or 40-F. A domestic company may elect to include this disclosure in its proxy or information statement and incorporate it by reference in its Form 10-K or 10-KSB if it files the proxy or information statement with the SEC no later than 120 days after the end of the fiscal year covered by the Form 10-K or 10-KSB.

The disclosure requirements under Section 407 apply to all domestic reporting companies other than asset-backed issuers.¹⁵ The disclosure requirements also apply to foreign private issuers, except that until the Section 407 rules are revised to reflect the independence standard that is eventually adopted and set forth in the rules implementing Section 301 of the Act, foreign private issuers will not be required to disclose whether their audit committee financial experts are independent. The final rule also provides that if a foreign private issuer has a two-tier board of directors, the "board of directors" that is responsible for identifying the issuer's audit committee financial expert(s) is the supervisory or non-management board, and that the term "generally accepted accounting principles" means the body of generally accepted accounting principles used by the foreign private issuer in its primary financial statements filed with the SEC.

Effective Date and Compliance Dates

The final rule is effective March 3, 2003. Companies other than small business issuers must comply with the audit committee financial expert disclosure requirements in their annual reports for fiscal years ending on or after July 15, 2003. Small business issuers must comply with these disclosure requirements in their annual reports for fiscal years ending on or after December 15, 2003.

For More Information, Please Contact the Author:

Brent Eller
brenteller@dwt.com
(206) 628-7786

This Corporate Finance Advisory Bulletin is a publication of the Business Transactions/Corporate Finance Group of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory Bulletin is to inform our clients and friends of developments in business, corporate finance and securities laws. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

Footnotes:

1Final Rule: Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002 (Release No. 33-8177). The text of the release is available at http://www.sec.gov/rules/final/33-8177.htm.

2Proposed Rule: Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002 (Release No. 33-8138). The text of the release is available at http://www.sec.gov/rules/proposed/33-8138.htm.

3The final rule adopted the term "audit committee financial expert" instead of "financial expert" because the SEC believes the term "suggests more pointedly that the designated person has characteristics that are particularly relevant to the functions of the audit committee, such as: a thorough understanding of the audit committee's oversight role, expertise in accounting matters as well as understanding of financial statements, and the ability to ask the right questions to determine whether the company's financial statements are complete and accurate."

4This differs from the proposed rule, which would have required an issuer to disclose the number of the audit committee financial experts on its audit committee and the names of all the audit committee financial experts.

5Independence is currently determined by reference to Item 7(d)(3)(iv) of Schedule 14A, which provides as follows:

A. For registrants whose securities are listed on the New York Stock Exchange ("NYSE") or American Stock Exchange ("AMEX") or quoted on Nasdaq:

1. Disclose whether the members of the audit committee are independent (as independence is defined in Sections 303.01(B)(2)(a) and (3) of the NYSE's listing standards, Section 121(A) of the AMEX's listing standards, or Rule 4200(a)(15) of the National Association of Securities Dealers' ("NASD") listing standards, as applicable and as may be modified or supplemented); and

2. If the registrant's Board of Directors determines in accordance with the requirements of Section 303.02(D) of the NYSE's listing standards, Section 121(B)(b)(ii) of the AMEX's listing standards, or Section 4310(c)(26)(B)(ii) or 4460(d)(2)(B) of the NASD's listing standards, as applicable and as may be modified or supplemented, to appoint one director to the audit committee who is not independent, disclose the nature of the relationship that makes that individual not independent and the reasons for the Board's determination. Small business issuers (Item 10(a)(1) of Regulation S-B) need not provide the information required by this paragraph (d)(3)(iv)(A)(2).

B. For registrants, including small business issuers, whose securities are not listed on the NYSE or AMEX or quoted on Nasdaq, disclose whether, if the registrant has an audit committee, the members are independent. In determining whether a member is independent, registrants must use the definition of independence in Sections 303.01(B)(2)(a) and (3) of the NYSE's listing standards, Section 121(A) of the AMEX's listing standards, or Rule 4200(a)(15) of the NASD's listing standards, as such sections may be modified or supplemented, and state which of these definitions was used. Whichever definition is chosen must be applied consistently to all members of the audit committee.

6This attribute was adopted as proposed.

7This attribute differs from the proposed rule in that the proposed rule would have required the audit committee financial expert to have experience applying such principles in connection with accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the issuer's financial statements. The SEC agreed with commenters' concerns that the proposed attribute would have unduly limited the pool of available audit committee financial experts.
8The proposed rule would have required an audit committee financial expert to have direct experience preparing or auditing financial statements. The SEC acknowledged that people with experience in analyzing or evaluating financial statements, such as investment bankers, venture capitalists, or professional financial analysts, would also have the necessary expertise to serve as audit committee financial experts.

9The SEC retained the proposed rule's requirement that an audit committee financial expert have experience with financial statements that raise accounting issues that are generally comparable to those raised by the issuer's financial statements. However, the SEC clarified that it did not mean to imply that the audit committee financial expert must have experience in the issuer's industry or with a reporting company. Accordingly, the SEC modified this requirement to focus on the breadth and level of complexity of accounting issues raised by the issuer's financial statements.

10The SEC expanded the proposed rule to reflect its agreement with comments that a person who actively supervises a person who prepares, audits, analyzes or evaluates financial statements could possess this attribute. The SEC stated that by "active supervision" it means that the supervisor "participates in, and contributes to, the process of addressing, albeit at a supervisory level, the same general types of issues . . . as those addressed by the person or persons being supervised" and that the supervisor "should have experience that has contributed to the general expertise necessary to prepare, audit, analyze or evaluate financial statements that is at least comparable to the general expertise of those being supervised." The SEC also noted that a principal executive officer should not be presumed to be exercising active supervision.

11The final rule uses the word "understanding" instead of "experience" to make it clear that the focus of this attribute is on the audit committee financial expert's understanding of internal controls and procedures for financial reporting rather than the experience the audit committee financial expert may have had in establishing or evaluating such controls and procedures.

12This attribute was adopted as proposed.

13The final rule eliminated the proposed rule's requirement that the audit committee financial expert must have gained the relevant experience with a reporting company.

14The final rule added this provision, noting that individuals could obtain the requisite in-depth knowledge and experience of accounting and financial issues through engaging in oversight or assessment of the preparation, auditing, or evaluation of financial statements. The SEC commented that certain individuals who serve in bodies that oversee the banking, insurance and securities industries work on financial statement issues on a regular basis and that this experience could constitute a useful background for an audit committee financial expert.

15In a separate rule adopted January 27, 2003, the SEC adopted similar audit committee financial expert disclosure requirements for registered management investment companies. See Final Rule: Certification of Management Investment Company Shareholder Reports and Designation of Certified Shareholder Reports as Exchange Act Periodic Reporting Forms; Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002 (Release No. 37-47262. The text of the release is available at http://www.sec.gov/rules/final/34-47262.htm.

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