How the Sarbanes-Oxley Act of 2002 Applies to Open-End Investment Companies | Publications

Overview

By now, many of you have undoubtedly received numerous memoranda analyzing various aspects of the Sarbanes-Oxley Act of 2002 (the "Act"). This memorandum covers the Act's immediate impact on open-end registered investment companies (i.e., mutual funds). [1]

Effective with the next N-SAR filing, mutual fund CEOs and CFOs (or their equivalents) must certify the accuracy and fair presentation of the report's disclosure. Mutual fund CEOs and CFOs also must establish, evaluate and write-up the results of their evaluation of "disclosure controls and procedures," all in time for the next N-SAR filing. And they must evaluate and report any significant deficiencies or material weaknesses in internal accounting controls to the mutual fund's auditor and audit committee by that time.

CEO/CFO Certification

Section 302 of the Act directed the SEC to adopt rules by August 29, 2002 requiring the principal executive officers and principal financial officers of companies "filing periodic reports under Section 13(a) or 15(d) of the 1934 Act to certify in each annual or quarterly report" as to the: (i) accuracy and fair presentation of the report's disclosure, (ii) establishment and maintenance of internal controls, and (iii) reporting of deficiencies in, and changes to, internal accounting controls.

While it is not entirely clear that investment companies were intended to be covered under Section 302, [2] the SEC has, nevertheless, in new Rule 30a-2 under the 1940 Act, implemented Section 302 and applied it to mutual funds. [3] Rule 30a-2 became effective on, and applies to all annual or semi-annual reports filed by mutual funds on Form N-SAR after, August 29, 2002. Because Form N-SAR is the form on which mutual funds satisfy their Section 15(d) reporting requirements, it is the form that was designated for mutual funds to satisfy their Section 302 obligations. Currently, no certifications are required for shareholder reports themselves, or the financial statements contained therein. [4] Rule 30a-2 recognizes that all mutual funds do not have CEOs and CFOs and, accordingly, allows those persons who perform similar functions for a fund to make the required certification. The rule does not allow the appropriate officers to certify by power of attorney.

The Substance of the Certification

Accuracy and Fair Presentation

A mutual fund's CEO and CFO must each certify that:

he or she has reviewed the report being filed;
based on his or her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which the statements were made, not misleading with respect to the period covered by the report; and
based on his or her knowledge, the financial information included in the report, and the financial statements on which the financial information is based, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the fund as of, and for the periods presented in the report.

This first part of the certification (accuracy and fair presentation) asks for a CEO's and CFO's assurances that the disclosure, including any financial information, reported on Form N-SAR is accurate, complete and consistent with the anti-fraud provisions of the federal securities laws. It also requires a "fairly presents" representation, which seemingly goes beyond confirming that the financial presentation is in accordance with generally accepted accounting principles. The Adopting Release indicates that in the SEC's opinion, a "fair presentation" of a fund's financial condition, results of operations and cash flows encompasses the selection and application of appropriate accounting policies, and the disclosure of financial information that is informative and reasonably reflects the company's material transactions and events. It also presumably encompasses notions of valuation (both market quotations and fair value, as appropriate).

Disclosure Controls and Procedures

A mutual fund's CEO and CFO also must each certify that:

he or she is responsible for establishing and maintaining disclosure controls and procedures for the fund and has:
- designed such disclosure controls and procedures to ensure that material information relating to the fund, including its consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which the periodic reports are being prepared;
- evaluated the effectiveness of the fund's disclosure controls and procedures as of a date within 90 days prior to the filing date of the report (the "Evaluation Date"); and
- presented in the report their conclusions about the effectiveness of the disclosure controls and procedures based on their evaluation as of the Evaluation Date.

This second part of the certification (disclosure controls and procedures) asks for a CEO's and CFO's assurances that their fund has internal disclosure controls and procedures that ensure that information required to be disclosed in the annual or semi-annual report is collected, processed, organized and communicated to fund management. According to the Adopting Release, these controls and procedures must address both the quality and the timeliness of required disclosure

While the Section 302 certification is the responsibility of the CEO and CFO, Rule 30a-2 imposes a complementary obligation on the mutual fund itself to maintain adequate disclosure controls and procedures, so that its CEO and CFO can provide the second part of the certification. Rule 30a-2 does not mandate any specific disclosure controls or procedures, nor does it expressly require that such procedures be written. However, we believe a CEO and CFO should ensure that written guidelines are established so they can be appropriately "evaluated" and records can be maintained to support the certification. And the certification imposes an obligation to include a written report of the conclusions derived from the evaluation in the N-SAR, even if no changes are made following the evaluation. The Adopting Release indicates that a fund's disclosure controls and procedures should cover a broader range of information than is covered by a fund's internal controls related to financial reporting.

Reporting of Deficiencies

A mutual fund's CEO and CFO also must each certify that:

he or she has disclosed, based on their most recent evaluation, to the fund's independent auditors and the audit committee of the board of directors:
- all significant deficiencies in the design or operation of internal controls which could adversely affect the fund's ability to record, process, summarize, and report financial data and have identified for the fund's auditors any material weaknesses in internal controls; and
- any fraud, whether or not material, that involves management or other employees who have a significant role in the investment company's internal controls; and
he or she has indicated in the report whether or not there were significant changes in internal controls or in other factors subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

This third part of the certification (reporting of deficiencies) relates to the fund's internal accounting controls, which are the fund's system for gathering, reconciling and presenting the financial information of the fund. Typically, most mutual fund auditors, with the oversight of the audit committee, already review the adequacy of the fund's internal accounting controls and seek to identify any deficiencies or material weaknesses in such controls. Section 302 apparently directs the CEO and CFO to certify that they have personally done the same, but it is not entirely clear whether they must do so as part of, and as frequently as, the disclosure control and procedure evaluation or do so separately. It also is not clear whether the reference to "changes in other factors" as part of the certification imposes an ongoing monitoring obligation on them.

Form and Location of Section 302 Certification

The SEC has mandated a specific form of Section 302 certification. Rule 30a-2(a) requires that each report filed on Form N-SAR must include the certification "in the form specified [in Form N-SAR]." A CEO or CFO is expressly prohibited from altering the language of the prescribed certification in any manner, and the CEO and CFO must each sign his or her certification (powers of attorney are not permitted). The certification must be attached as an exhibit to the Form N-SAR filing. In addition, according to new Sub-Item 77Q3 of Form N-SAR, the certification must:

disclose the conclusions of the fund's CEO and CFO about the effectiveness of the fund's disclosure controls and procedures based on their evaluation of such controls and procedures as of a date within 90 days of [before] the filing date of the report; and
disclose whether or not there were significant changes in the fund's internal controls or in other factors that could significantly affect such controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

The SEC staff indicated at its open meeting where Rule 30a-2 was adopted that it would be conducting "spot checks" of Form N-SAR filings to determine whether certifications are compliant.

What Steps Must a Mutual Fund CEO and CFO Now Take?

The Adopting Release does not mandate any specific due diligence procedures for a CEO or CFO to follow in preparing to give his or her certification or in developing and overseeing disclosure controls and procedures. In anticipation of giving the certification, a series of "best practices" steps for a CEO and CFO preparing to certify will undoubtedly evolve. Disclosure controls and procedures will have to be tailored to the specific needs of mutual funds and Form N-SARs and a fund's particular service provider arrangements. In light of fast approaching N-SAR filings for many mutual funds, it is crucial to begin a dialogue on these issues as soon as possible.

The Adopting Release indicates that a CEO's and CFO's review of a Form N-SAR report must be a critical one. Such a critical review would necessarily include certain inquiries where appropriate, such as questioning disclosure that they do not understand, or questioning the materiality of information known to them. A CEO and CFO will have to rely primarily on information provided to them from other members of management and their subordinates. In that regard, the Adopting Release specifically recommends that a covered company create a committee with responsibility for considering materiality of information and determining disclosure obligations on a timely basis. The Adopting Release suggests that the committee include the principal accounting officer or controller, in-house counsel, the principal risk management officer, the chief investor relations officer (or an officer with equivalent responsibilities), and such other officers or employees, as the fund deems appropriate. While there may be substantial merit in an operating company deciding to form such a committee, the usefulness of such a committee in a mutual fund setting is less certain.

One potential problem that a CEO and CFO may face when deciding whether he or she can certify as to the accuracy and completeness of the disclosure in a Form N-SAR is that these senior fund officers may not be familiar with the Form in any specific way. The Form, although a required filing, is not typically viewed as a public disclosure document that is available to shareholders in any useable way. Accordingly, the CEO and CFO may need to promptly familiarize themselves with the information that is called for in Form N-SAR.

The Adopting Release and implementing rules also require a mutual fund, under the supervision of, and with the participation of, the CEO and CFO, to conduct an evaluation of the fund's disclosure controls and procedures within 90 days prior to the filing date of every annual and semi-annual report. Therefore, disclosure controls and procedures to address the requirements of the certification should be established as soon as possible by a fund. As mentioned earlier, a mutual fund is already required to have in place internal accounting controls, which a CEO and CFO will also have to critically evaluate in light of the new certification. The rule and form of certification create some ambiguity in that they do not specifically require an evaluation of internal accounting controls but do specifically refer to an evaluation of such controls as part of the foundation supporting the third part of the certification. A mutual fund must state in every report the CEO's and CFO's conclusions as to the evaluations of the company's disclosure controls and procedures, and significant changes in internal controls or corrective action occurring subsequent to the CEO's and CFO's evaluation of such controls.

Liability for a False Certification

A CEO or CFO signing a false certification potentially could be subject to an SEC enforcement action for violating Section 13(a) of the 1934 Act and private actions under Section 10(b) of the 1934 Act and Rule 10b-5 thereunder. A false certification also may have liability consequences under Sections 11 and 12(a)(2) of the 1933 Act where the information from Form N-SAR is incorporated by reference into a registration statement. Penalties in SEC enforcement actions for Section 302 violations, which is a civil penalty provision, could include monetary penalties and/or injunctive actions. Relief in private actions could include monetary damages. Having said that, in egregious cases, where a false certification was "willfully" provided, the SEC may refer the matter to the Department of Justice for possible criminal prosecution under criminal statutes that existed prior to enactment of the Act.

Though there may be an increase in actions against CEOs and CFOs based on the Section 302 certification requirement, any such action is unlikely to prevail if brought solely on the basis that material information was incorrect or missing from a report. Any such action would also have to allege that the officer believed, knew, or should have known that the information was material and incorrect or absent from the report. How effectively CEOs and CFOs document their actions taken in connection with the preparation of an annual or quarterly report may be critical to avoiding liability.

Section 906 Certifications and Criminal Provisions

Section 906 of the Act requires each periodic report containing financial statements filed with the SEC under Section 13(a) or 15(d) of the 1934 Act to be accompanied by a written statement by the issuer's chief executive officer and chief financial officer (or their equivalent). Officers who sign the certification, knowing that the statement does not comply with all of Section 906 can be fined up to $1 million or imprisoned for up to 10 years (or both). Officers who willfully certify false reports can be fined up to $5 million or imprisoned for up to 20 years (or both).

On its face, Section 906 does not currently appear to apply to mutual funds. Even if one assumes that funds file annual reports under either Sections 13(a) or 15(d), rather than filing Form N-SAR in lieu of filing under Sections 13(a) or 15(d), filings on Form N-SAR do not "contain financial statements." However, as part of the new proposals (discussed below), the SEC has proposed to incorporate mutual fund financial statements into certified filings. While the matter is still under consideration by the SEC and the Department of Justice, it appears that Section 906 may, in fact, ultimately be applied to mutual funds.

Expanding the Section 302 Certification -- New Proposals from the SEC

As noted above, new Rule 30a-2 satisfied the Act's immediate statutory mandate that the SEC establish a rule implementing Section 302 no later than August 29, 2002. But because of the tight timing involved, the SEC seemingly adopted a "bare bones" rule that very closely tracked the statutory language.

However, believing that new Rule 30a-2 didn't go far enough in meeting the spirit of Section 302, the SEC proposed, in a companion release to the Adopting Release, a new rule and several rule amendments that among other things proposed to expand the applicability of Section 302. [5] Most notably, the SEC proposed a new Form N-CSR which would contain a copy of the semi-annual or annual shareholder report, a discussion of the disclosure controls and procedures outlined in Rule 30a-2(c) and certifications from the fund's CEO and CFO. The Proposing Release also aims to amend Rule 30a-2 by broadening the term "disclosure controls and procedures" to include not only Form N-SAR or Form N-CSR, but also all filings made under the 1933 Act, the Exchange Act and the 1940 Act, including prospectuses.

The SEC has asked for comments on the Proposing Release no later than October 16, 2002. The most important questions raised by the Proposing Release include the following:

If Form N-CSR is adopted, will there be any reason for CEOs and CFOs to still certify Form N-SAR filings, particularly in light of the fact that Form N-SAR is of little use to the public?
As an alternative to Form N-CSR, which would create additional burdens for mutual funds, should the SEC consider requiring certification of only Form N-SAR filings, but require that Form N-SAR filings include all or a portion of a shareholder report?
Should the certification requirement apply to all or a part of a shareholder report? In particular, should management's discussion of fund performance (MDFP), which includes a subjective narrative, be included as information to be certified?
Should the disclosure controls and procedures be extended to include filings under the 1933 Act, 1934 Act and 1940 Act?

Conclusion

The SEC staff has indicated that the purpose of the certification is to ensure greater participation by CEOs and CFOs in the creation of a fund's periodic reports and to restore investor confidence in the periodic disclosure; however, a legitimate concern is that, regardless of how involved a CEO and a CFO become in the creation of these reports, the certification could lead to a spate of plaintiff's lawsuits against CEOs and CFOs and may create de facto new liability standards for CEOs and CFOs in civil litigation. CEOs and CFOs could end up in the unenviable position of having to demonstrate in court that they were not aware of undisclosed material information at the time of filing of a report in order to escape liability. In addition, it is clear that a CEO and CFO cannot avoid liability in all cases by arguing that they did not know about a material omission or misstatement. Because they must be involved in the creation of a company's reports, some level of critical inquiry will be required. The level of inquiry required may ultimately be a matter for the courts to decide. There are also drafting inconsistencies and ambiguities that the SEC will hopefully attempt to clarify and interpret as time permits.

With respect to the Proposing Release, several of the initiatives discussed there represent, in our view, significant departures from the mandates of Section 302. In particular, asking investment companies to file a new Form N-CSR, in addition to a Form N-SAR, seems duplicative. The problem created by the fact that Form N-SAR filings are not user friendly, could be remedied by requiring that CEOs and CFOs certify the financial statements in the annual or semi-annual report. In addition, requiring that CEOs and CFOs develop and personally evaluate controls and procedures for 1933 Act prospectus filings seems to be penalizing companies, like mutual funds, that continuously offer shares. Even public companies, which were the Act's true focus, would not be subject to these additional and onerous requirements. Accordingly, we encourage our clients and friends to submit comments to the SEC on these proposals.

If you have any questions or would like additional information regarding the above matters, please do not hesitate to contact us.

Prepared by: Marco Adelfio, MoFo DC

Footnotes:

[1] The Act's impact on closed-end funds also is significant, but is made more complex by the interplay among rule proposals by various national stock exchanges (on which most closed-end funds are listed) that seek similar, but not identical, changes as the Act. As these issues are addressed by regulators and exchanges we will provide more information.

[2] Although investment companies are required to file reports under Section 13(a) (closed-end funds listed on national exchanges) and under Section 15(d) (open-end funds), Section 30(a) and Rule 30a-1 under the 1940 Act allow an investment company to satisfy its 13(a) or 15(d) obligations by filing a report on Form N-SAR. Accordingly, investment companies do not technically file their periodic reports under 13(a) or 15(d).

[3] Certification of Disclosure in Companies' Quarterly and Annual Reports, Final Rule, Investment Company Act Rel. No. 25722 (August 29, 2002) ("Adopting Release").

[4] Recognizing this awkward result (i.e., that funds would be certifying information, only some of which is financial in nature, on a form that was intended for the SEC's internal use and is not at all useable by or helpful to investors), the SEC proposed that a new form--Form N-CSR--be adopted and also certified. This form and related proposed rules are discussed later in this memorandum.

[5] Certification of Management Investment Company Shareholder Reports and Designation of Certified Shareholder Reports as Exchange Act Periodic Reporting Forms, Investment Company Act Rel. No. 25723 (August 30, 2002) ("Proposing Release").