Proposed Sarbanes-Oxley Regulations Will Require Internal Complaint Procedures

[March 2003]

Overview

On January 8, 2003, the Securities and Exchange Commission (the “SEC”) voted unanimously to propose new regulations (the “Proposed Rules”) mandating, among other things, that listed companies’ audit committees create anonymous internal complaint procedures.

The rules implement Section 301 of the Sarbanes-Oxley Act of 2002 (the “Act”) and direct the national securities exchanges and national securities associations (collectively, the Self Regulatory Organizations (“SROs”)) to prohibit the listing of any security of an issuer whose audit committee is not in compliance with the five requirements established by the Act. The creation of an anonymous internal complaint procedure is one of these five requirements. The rules also specify required levels of board audit committee independence, including the authority to retain and fund an independent accountant or outside advisors.

Because the Proposed Rules would only affect SRO listing criteria, they will not impose internal complaint procedures on private companies or companies traded over-the-counter or on the “pink sheets.” Nevertheless, as a matter of good corporate practice, issuers should consider establishing procedures relating to the receipt, retention and treatment of internal complaints (confidential or otherwise) regarding accounting, internal accounting controls or auditing matters. This advisory discusses the various alternatives available to audit committees for establishing such procedures.

The SEC must finalize these rules by April 26, 2003. They will be put into effect by the SROs no later than one year after the SEC publishes the final rule in the Federal Register.

Complaint Procedures Required

The Proposed Rules require the board audit committee of a listed issuer (or, if the issuer does not have an audit committee, the full board of directors) to establish procedures for:

(i) [t]he receipt, retention and treatment of complaints...regarding accounting, internal accounting controls, or auditing matters” and

(ii) [t]he confidential, anonymous submission by employees of the listed issuer of concerns regarding questionable accounting or auditing matters.”

They do not, however, specify what specific characteristics of an internal complaint procedure will satisfy these general requirements. Instead, an advisory accompanying the proposed rules states that “[g]iven the variety of listed issuers in the U.S. capital markets, we believe companies should be provided with flexibility to develop and utilize procedures appropriate for their circumstances. We expect each audit committee to develop procedures that work best consistent with its company’s individual circumstances.”

As a practical matter, an employer’s program will most likely evolve from similar policies and procedures that may already be in place for dealing with reports of things like workplace discrimination or harassment, conflicts of interest, complaints of Medicare or Medicaid fraud, or concerns about bribes or kickbacks. The extent of an employer’s resources (including the available time of audit committee members) will also dictate whether the complaint procedure is administered internally, or outsourced through a third-party hotline. As might be expected, vendors providing confidential anonymous hotline services have become dramatically more visible in the wake of the Act.

While neither internally-maintained, nor third-party hotlines are necessarily preferred, the latter do generally make it easier to ensure employee confidentiality and anonymity — two of the general requirements of the Act.

Another general consideration is that, regardless of the procedures developed, the audit committee should retain oversight over the processing of such complaints. In this regard, written procedures should be developed for timely investigating and responding to such complaints.

Finally, employers should make their chosen reporting process known to employees, noting the availability of anonymity. Creating an atmosphere that allows for confidential, anonymous disclosure will go a long way toward ensuring that potentially improper accounting or auditing conduct is exposed in time to stop what could be devastating financial consequences.

Employers are encouraged to consult DWT counsel to determine which procedures best suit their particular circumstances and meet their obligations under the Act.

Determinations of Compliance and Opportunity to Cure Defects

Section 301 of the Act does not impose specific mechanisms to guarantee ongoing compliance by issuers. However, in order to assist the SROs with enforcement of the statutory audit committee requirements, the Proposed Rules would require a listed issuer to notify its SRO promptly after one of its executive officers becomes aware of any material noncompliance with the proposed requirements. The Proposed Rules would require that, once noncompliance was determined, the SROs provide established procedures for an issuer to cure the violation.

Next Steps for Audit Committees

Board audit committees should begin now to consider the alternatives for complying with the Proposed Rules. Although not final, it is likely these rules will be adopted with relatively minor modifications and subsequently acted upon by the SROs. In addition to formal compliance with continued listing criteria, the establishment by an audit committee of effective internal complaint procedures should cultivate open and effective channels of information, encourage proper individual conduct and alert the board’s audit committee to potential problems before serious consequences arise.

This Corporate Finance Advisory is a publication of the Corporate Finance Department of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in corporate finance. 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.

Copyright © 2003, Davis Wright Tremaine LLP. Please do not reprint, or post on your website, without explicit permission.

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