Overview

Late last year, the SEC proposed a series of rules to implement various sections of the Sarbanes-Oxley Act of 2002 (the "Act"). Several of those proposals recently were finalized in the adoption of Form N-CSR and related new rules that implement Sections 302 (certified reports), 406 (code of ethics), and 407 (financial experts) of the Act (the "New Rules").

A Form N-CSR must contain: (i) the fund's annual or semi-annual shareholder report; (ii) disclosure as to whether the fund has adopted a code of ethics (which is different in scope from the code of ethics that has long been required); (iii) disclosure as to whether the fund has at least one audit committee financial expert (newly defined); and (iv) certifications by the CEO and CFO of all the information contained therein.

A fund must file Form N-CSR beginning with its first annual or semi-annual fiscal period ending on or after April 1, 2003. For fiscal periods ending on or before March 31, 2003, funds may choose to file a certified Form N-SAR or N-CSR. In either case, funds are not required to comply with provisions mandating code of ethics or audit committee financial expert disclosure until their first filing for a fiscal year ending after July 15, 2003.

Form N-CSR

Annual and Semi-Annual Reports

The New Rules require closed-end and open-end funds to file a Form N-CSR within 10 days after sending each annual and semi-annual shareholder report. The first item included in Form N-CSR is the entire shareholder report itself.

Code of Ethics

The New Rules require funds to disclose on Form N-CSR whether or not they have adopted a written code of ethics for their principal financial officer, principal accounting officer or controller, or persons performing similar functions (collectively, the "senior financial officers") and their principal executive officer. [1] The New Rules require a fund to make its code publicly available, but provide several options as to the manner of doing so, including in Form N-CSR, on its website, or in some other document filed with the SEC on the Edgar system. In addition, the New Rules require funds to publicly disclose amendments made to, or waivers granted from, their code of ethics and to make their code of ethics publicly available. 

The New Rules define the term "code of ethics" to mean written standards reasonably designed to deter wrongdoing and to promote:

• honest and ethical conduct;
• full, fair, accurate, timely, and understandable disclosure in public documents and other communications;
• compliance with applicable laws;
• prompt internal reporting of code violations; and
• accountability for adherence to the code.

In the adopting release, the SEC indicated that codes should vary among funds, and should be broader and more comprehensive than necessary. The SEC has therefore left decisions as to the specific code provisions, compliance procedures, and disciplinary measures to each fund to establish.

The New Code and a Fund's Rule 17j-1 Code

It is important to note that the code of ethics covered by the New Rules addresses a different range of conduct and a different universe of persons than that which has long been addressed by Rule 17j-1 under the 1940 Act. Accordingly, funds may find it more appropriate to adopt a separate code that complies with the New Rules, as opposed to creating one code under both Rule 17j-1 and the New Rules.

Amendments and Waivers

A fund also must disclose amendments made to, or waivers granted from, any provision of the code of ethics that applies to its principal executive officer or senior financial officers. The disclosure must briefly describe the nature of the amendment or waiver, and in the case of a waiver, the name of the person to whom the waiver was granted and the date of the waiver. The disclosure must be made on Form N-CSR or, under certain circumstances, on the fund's website.

Similar Proposal Pending

In addition to the code of ethics requirements set forth in the New Rules, it is important to note that the New York Stock Exchange has submitted similar but not identical corporate governance rules to the SEC for approval (the "NYSE Proposal") that would cover listed closed-end funds. The NYSE Proposal would require a listed fund to: (1) adopt a code of conduct, which would apply to all directors, officers, and employees of the listed fund; (2) make the code publicly available; [2] and (3) promptly disclose any waiver of the code granted to a director or executive officer. [3] In addition, the NYSE Proposal would require that a listed fund's code contain compliance standards and procedures that would facilitate the effective operation of the code. Listed funds will need to comply with the Final Rules and, once approved by the SEC, also any applicable NYSE Proposal as finally adopted.

Audit Committee Financial Expert

Disclosure

The New Rules require the following disclosures:

• if a fund's board determined that the fund has at least one audit committee financial expert serving on its audit committee, the fund must disclose that fact and disclose the name or names of such audit committee financial experts and whether they are "independent"; [4] or
• if the fund's board determined that the fund does not have at least one audit committee financial expert serving on its audit committee, the fund must disclose that fact and explain why.

The disclosure is only required to be made annually (not semi-annually) on Form N-CSR.

Definition of "Audit Committee Financial Expert"

The New Rules define an "audit committee financial expert" as a person with all of the following attributes:

• an understanding of generally accepted accounting principles and financial statements;
• the ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;
• experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable 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; [5]
• an understanding of internal controls and procedures for financial reporting; and
• an understanding of audit committee functions.

Under the New Rules, in order to qualify as an "audit committee financial expert" a person must have acquired the above listed attributes through any one or more of the following:

• 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;
• 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; or
• other relevant experience.

Determination of Audit Committee Financial Expert; Safe Harbor

Notably, the final definition allows directors to conclude that a person may be deemed an audit committee financial expert if, instead of obtaining the required attributes through one of the specific roles identified, the person has "other relevant experience." If the board makes such a determination, it needs to disclose the basis for that determination. The SEC rejected any notion of "grandfathering" a person as an audit committee financial expert on the sole basis that he or she has experience serving on an audit committee. Also, the New Rules permit, but do not require, a fund's board to determine that its audit committee has more than one audit committee financial expert. Further, the SEC stressed the requirement that the full board make the determination and that it consider any disciplinary actions to which a candidate has been subject. The adopting release makes it clear that a board may not decide to not make a determination or to merely list the qualifications of its audit committee members.

Many commenters expressed concern that the requirement that companies identify the audit committee financial expert by name may result in imposing greater duties or potential liability on that member of the board. In order to alleviate those concerns, the SEC incorporated a safe harbor into the New Rules clarifying that:

• a person who is determined to be an audit committee financial expert will not be deemed an "expert" under the Securities Act of 1933 or for any other purpose;
• the new disclosure requirements do not impose on the audit committee financial expert any duties, obligations, or liability that is greater than the duties, obligations, and liability imposed on such person as a member of the audit committee and board in the absence of such designation; and
• the new disclosure requirements do not affect the duties, obligations, or liability of any other member of the audit committee or board.

The adopting release makes it clear that the new disclosure requirements are not satisfied if the fund discloses that its board of directors has decided not to make a determination, or merely lists on Form N-CSR the qualifications of all of its audit committee members.

Different Definitions Used by the NYSE

The definition of "audit committee financial expert" in the Final Rules is substantially different from the current NYSE requirements with respect to financial literacy and expertise, which applies to listed closed-end funds. The NYSE currently requires that each member of a listed company's audit committee be or become financially literate, as such qualification is interpreted by the board in its business judgment. In addition, at least one member of the audit committee must have accounting or related financial management expertise, as the board interprets such qualification in its business judgment. Accordingly, the NYSE already requires at least one audit committee member of a listed company to be a financial expert, but uses a much more subjective definition of the term.

The NYSE indicated at the time that it submitted its new proposed corporate governance rules to the SEC that it would wait until after the SEC issued its definition of "financial expert" before considering whether to modify its own requirements.

As a result of these current differences, a person who qualifies under the listing standards of the NYSE may or may not have sufficient expertise and experience to be considered a "financial expert" under the New Rules. However, the NYSE may reconcile these differences in the future.

Disclosure Controls and Procedures

The disclosure controls and procedures outlined in the New Rules are largely unchanged from the proposed rule. The New Rules require that, within the 90-day period prior to the filing date of a report on Form N-CSR, an evaluation must be carried out under the supervision, and with the participation of, the fund's management, including its CEO, CFO, or officers performing similar functions, of the effectiveness of the design and operation of the fund's "disclosure controls and procedures."

"Disclosure controls and procedures" means controls and procedures of a fund that are designed to ensure that information required to be disclosed by the fund on Form N-CSR is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms. As proposed, the New Rules would have extended the requirement to maintain and evaluate disclosure controls and procedures to filings under the Securities Act of 1933 and the 1940 Act. Recognizing that this extension would impose a much larger burden on funds than on operating companies and that the Act did not compel such an extension, the SEC substantially curtailed this aspect of its original proposal.

Certifications

Accuracy and Fair Presentation

A mutual fund's CEO and CFO must each certify that, after reviewing the report, and 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; and
• 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.

This first part of this certification asks for a CEO's and CFO's assurances that the disclosure, including any financial information, reported on Form N-CSR is accurate, complete, and consistent with the anti-fraud provisions of the federal securities laws. The second part of this certification requires a "fairly presents" representation, which seemingly goes beyond confirming that the financial presentation is in accordance with generally accepted accounting principles. The proposing release indicated 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).

Unlike the proposal of the rules implementing Section 302 of the Act on Form N-SAR, the certification of Form N-CSR will include certification of both a fund's financial statements and management's discussion of fund performance ("MDFP"), which is the required narrative description of the factors that materially affected the fund's performance in the covered period. Although this arguably goes beyond the mandate of Section 302, which speaks only in terms of financial statements, the SEC rejected those arguments and expanded the scope of Section 302 by requiring that all of the information contained in Form N-CSR be certified. While commenters argued that this might have a chilling effect on what fund management states in the MDFP, the SEC believed that the requirement would only encourage funds to include a more complete and accurate discussion of the factors that materially affected fund performance.

Reporting of Deficiencies

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

• he or she has disclosed, based on the most recent evaluation, to the fund's independent auditors and the audit committee of the board:
• all significant deficiencies in the design or operation of the internal controls, and have identified for the fund's auditors any material weaknesses in internal controls;
• any fraud, whether or not material, that involves management or other employees who have a significant role in the internal controls; and
• he or she has indicated in the report whether or not there were significant changes in the 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.

Statements from SEC staff indicate that "internal controls" are in fact different from "disclosure controls and procedures." Disclosure controls and procedures are defined in the New Rules. The term "internal controls" is not defined in the New Rules, but it is generally understood to relate to the fund's internal accounting controls, which are the fund's system for gathering, reconciling, and presenting the financial information.

Form N-SAR

The New Rules replace the certification requirement of Form N-SAR for funds with the certification requirement in Form N-CSR. Accordingly, while Form N-SAR will still have to be filed semi-annually, fund CEOs and CFOs will no longer be required to certify such filings once they begin filings on Form N-CSR. Nor will they be required to maintain and evaluate disclosure controls and procedures relating to the information contained in a report filed on Form N-SAR. However, Form N-SAR will have to include the same code of ethics and audit committee financial expert disclosure that is contained in Form N-CSR.

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