CORPORATE OVERSIGHT AND ACCOUNTING REFORM: AN OVERVIEW OF THE SARBANES-OXLEY ACT OF 2002
By Brent Eller and Susan Preston
[December 2002]

Although many provisions of the Sarbanes-Oxley Act of 2002 were self-implementing or were implemented by SEC regulations shortly after the Act became law, others remain to be implemented or clarified through the regulatory process. Toward this end, the SEC recently proposed rules on the following topics:

• Disclosure of management assessment of internal controls
  
• Code of ethics for senior financial officers
  
• Disclosure of audit committee financial expert
  
• Disclosure in MD&A about off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments
  
• Conditions for use of non-GAAP financial measures
  
• Insider trades during pension fund blackout periods
  

If you need additional information, or guidance about specific issues, please refer to the contact information listed at the end of this advisory bulletin.

DISCLOSURE OF MANAGEMENT ASSESSMENT OF INTERNAL CONTROLS

On October 22, 2002, the SEC issued proposed rules regarding disclosures and attestations under Section 404 of the Act¹. The SEC proposed that these rules would be applicable to companies with fiscal years ending on or after September 15, 2003.

Under the proposed rules, companies that file Forms 10-K, 10-KSB, 20-F or 40-F would be required to include in their annual report an internal control report of management that states management's responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and contains an assessment of the effectiveness of these internal control structures and procedures. The issuer's audit firm would be required to attest to, and report on, management's assessment.

To make the requirements for evaluations of the company's disclosure controls and procedures under Section 302 of the Act consistent with the requirements of Section 404, the proposed rules would modify Exchange Act Rules 13a-15 and 15d-15, as well as the forms of Section 302 certifications that CEOs and CFOs must file with their quarterly and annual reports,² to provide that management's evaluations of disclosure controls and procedures are to be made as of the end of the period covered by the report. Currently, the certifying officers must only certify that these evaluations were made as of a date within 90 days prior to the filing of the report.

CODE OF ETHICS FOR SENIOR FINANCIAL OFFICERS

In the same release, the SEC proposed rules regarding the requirement under Section 406 of the Act that each issuer disclose in its periodic reports under the Exchange Act whether or not it has adopted a code of ethics for its senior financial officers and, if not, why not. The proposed rules would expand on the requirements of Section 406 by requiring the company also to disclose whether its written code of ethics applies to its principal executive officer. In addition to the elements of the code of ethics contained in Section 406, the proposed rules would add the following:

• avoidance of conflicts of interest, including internal disclosure of any material transaction or relationship that reasonably could be expected to give rise to such a conflict;
  
• prompt internal reporting of violations of the code; and
  
• accountability for adherence to the code.
  

Each company would be required to file a copy of its code of ethics as an exhibit to its annual report. Any change in a company's code of ethics that applies to any of the officers specified in the proposed rules, or any waiver of an ethics code provision with respect to such an officer, would require disclosure either on Form 8-K or on the company's website.³ In either case, disclosure would be required within two business days after the change or waiver occurs.

DISCLOSURE OF AUDIT COMMITTEE FINANCIAL EXPERT

The SEC also proposed in this release rules implementing the requirement under Section 407 of the Act that an issuer disclose whether or not its audit committee includes at least one "financial expert" and, if not, why not. In addition to the requirements of Section 407, the proposed rules would require disclosure of the number and names of the audit committee members that are financial experts, and whether they are "independent" within the meaning of Section 10A(m)(3) of the Exchange Act.⁴ This disclosure would be made in the issuer's annual reports.

The proposed rules would define the term financial expert as "a person who has, through education and experience as a public accountant or auditor or a principal financial officer, controller, or principal accounting officer 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 board of directors, in the person's having similar expertise and experience), the following attributes:

(i) An understanding of generally accepted accounting principles and financial statements;

(ii) 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;

(iii) Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements;

(iv) Experience with internal controls and procedures for financial reporting; and

(v) An understanding of audit committee functions."

The proposed rules also list several factors the board of directors should consider in determining whether a potential financial expert has the required attributes.

DISCLOSURE IN MD&A ABOUT OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

On November 4, 2002, the SEC issued proposed rules under Section 401(a) of the Act regarding certain disclosures in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") section of its periodic reports. The proposed rules would require two types of disclosures.⁵ First, detailed information regarding material off-balance sheet arrangements would be required to be disclosed in a separately captioned subsection of the MD&A. The proposed rules define "off-balance sheet arrangement" as "any transaction . . . to which an entity that is not consolidated with the registrant is a party, under which the registrant, whether or not a party to the arrangement, has, or in the future may have:

(A) Any obligation under a direct or indirect guarantee or similar arrangement;

(B) A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;

(C) Derivatives to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or

(D) Any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto)."

In addition, the proposed rules would require tabular disclosure of the company's known contractual obligations (by category, with payments broken down by period) and text or tabular disclosure of contingent liabilities and commitments.

CONDITIONS FOR USE OF NON-GAAP FINANCIAL MEASURES

On November 5, 2002, the SEC issued proposed rules under Section 401(b) of the Act regarding disclosures or public releases of material information that includes a non-GAAP financial measure.⁶ The proposed rules would create a new Regulation G, which would require a registrant to provide the following information as part of the disclosure or release of the non-GAAP financial measure:

• a presentation of the most comparable financial measure calculated and presented in accordance with GAAP; and
  
• a reconciliation (quantitative for historic measures and, to the extent available without unreasonable efforts, for prospective measures) of the differences between the non-GAAP financial measure and the comparable GAAP financial measure.
  

If the non-GAAP financial measure is released orally, telephonically, by webcast or broadcast, or by similar means, the registrant would be permitted to provide its Regulation G disclosure on its website. The proposed rules also would require certain disclosures by registrants that use non-GAAP financial measures in their filings with the SEC and would prohibit certain uses of non-GAAP financial measures in such filings. Finally, the proposed rules would amend Form 8-K to require disclosure within two business days of any public announcement or release disclosing material non-public information regarding a registrant's results of operations or financial condition for an annual or quarterly fiscal period that has ended.

INSIDER TRADES DURING PENSION FUND BLACKOUT PERIODS

Finally, on November 6, 2002, the SEC issued proposed rules under Section 306(a) of the Act regarding insider trades during pension fund blackout periods. The proposed rules would create a new Regulation BTR ("Blackout Trading Restriction") that would clarify the operation of the statute, provide exceptions to the definition of "blackout period," clarify the operation of the private remedy for a violation of Section 306(a), and specify the content and delivery requirements for the notice an issuer is required to provide in connection with a blackout period. Some noteworthy aspects of this proposed rules are as follows:

• Although Section 306(a) includes "executive officers" in the prohibition on trading during blackout periods, the proposed rules would define the term "executive officer" in the same manner as the term "officer" is defined in Exchange Act Rule 16a-1(f). This definition is broader than the definition of "executive officer" provided in Exchange Act Rule 3b-7.
  
• The proposed rules would clarify that the statutory trading prohibition would be limited to either an acquisition of equity securities during a blackout period if the acquisition is in connection with service or employment as a director or executive officer, or a disposition of equity securities during a blackout period if the disposition involves equity securities that were acquired in connection with such service or employment. The trading prohibition would apply to equity securities acquired prior to becoming a director or executive officer if the securities were acquired as an inducement to service or employment with the issuer or a parent, subsidiary or affiliate of the issuer, or as a result of a merger, consolidation or other acquisition transaction involving the issuer and to any equity securities that an individual has acquired to satisfy any minimum ownership requirements the issuer imposed for its directors or executive officers.
  
• To avoid tracing problems and prevent evasion of the trading prohibition, the proposed rules would establish an irrebuttable presumption that any equity securities sold or transferred during a blackout period were acquired in connection with service or employment as a director or executive officer to the extent that the director or executive officer holds such securities.
  
• Certain transactions would be exempted from Section 306(a). These transactions include acquisitions under dividend reinvestment plans; purchases or sales pursuant to a contract, instruction or written plan that satisfies the affirmative defense conditions of Exchange Act Rule 10b5-1(c); nondiscretionary purchases or sales pursuant to certain tax-qualified employee benefit plans; and increase or decreases in the number of equity securities held as a result of certain stock splits or stock dividends.
  

FOR FURTHER INFORMATION, PLEASE CONTACT THE AUTHORS:

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

Susan Preston
susanpreston@dwt.com
(206) 628-7713

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:

1Proposed 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.

2These forms are contained in Exchange Act Rules 13a-14 and 15d-14.

3To disclose this information on its website, the company must have disclosed in its most recently filed annual report both its website address and its intention to disclose these events on its website.

4To be independent under this provision, an audit committee member may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee, accept any consulting, advisory, or other compensatory fee from the issuer, or be an affiliated person of the issuer or any subsidiary thereof.

5Proposed Rule: Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments (Release No. 33-8144). The text of the release is available at http://www.sec.gov/rules/proposed/33-8144.htm.

6Proposed Rule: Conditions for Use of Non-GAAP Financial Measures (Release No. 33-8145). The text of the release is available at http://www.sec.gov/rules/proposed/33-8145.htm.

7Proposed Rule: Insider Trades During Pension Fund Blackout Periods (Release No. 34-46778). The text of the release is available at http://www.sec.gov/rules/proposed/34-46778.htm.

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