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Section 407 of the Sarbanes-Oxley Act of 2002 (the "Act") directs the Securities and Exchange Commission (the "SEC") to issue rules and regulations requiring public companies to disclose whether they have "financial experts" as members of their audit committees. On October 22, 2002, the SEC issued proposed rules to implement Section 407 (the "Proposed Rules").[fn1] Pursuant to the Act, final rules must be issued no later than January 26, 2003. This update summarizes the Proposed Rules.

We expect that companies that do not currently have an audit committee member who qualifies under the proposed definition of "financial expert" will want to begin the process of seeking out appropriate candidates who can fulfill this role in the future. We would not be surprised if, upon effectiveness of the rules, some companies are forced to disclose that they do not have a member of the audit committee who qualifies as a financial expert, and that they have a pending search to recruit such an expert.

Proposed Disclosure Requirements

The Proposed Rules would apply to public companies that file reports with the SEC, whether or not their securities are traded on a stock exchange or Nasdaq. The proposals will require these companies to disclose in their annual reports and/or their proxy statements for their annual meetings:

• the number and names of the persons that the Board of Directors has determined to be the financial experts serving on the audit committee; and
• whether the financial expert or experts are "independent" (as that term is used in Section 10A(m)(3) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), and if not, an explanation of why they are not.

If the company does not have a financial expert serving on its audit committee, the company must disclose that fact and explain why it has no financial expert. Each of these proposed disclosures would be set forth under the caption "Audit Committee Financial Experts."

A company would have the option of (a) disclosing this information in its annual report on Form 10-K or 10-KSB or (b) including this information in its annual proxy or information statement, if that proxy or information statement is filed no later than 120 days after the end of the fiscal year covered by the Form 10-K or 10-KSB. Foreign private issuers would disclose this information in their annual reports on Form 20-F, and Canadian issuers would do so on Form 40-F. Asset-backed issuers are exempt from this proposed disclosure requirement. The Proposed Rules set forth comparable rules for companies, including some limited liability companies and limited partnerships, that have governing bodies that may be organized differently than the manner in which corporations are organized.

The Release does not indicate when the Proposed Rules will become effective, or whether there will be any transition period for their implementation. We expect that this information will be set forth in the final rules.

Definition of "Financial Expert"

Required Attributes. Under the Proposed Rules, the term "financial expert" would mean a person who has the following five attributes:

• an understanding of generally accepted accounting principles and financial statements;
• experience applying such generally accepted accounting principles in the accounting for estimates, accruals, and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the relevant company's financial statements;
• experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the relevant company's financial statements;
• experience with internal controls and procedures for financial reporting; and
• an understanding of audit committee functions.

Required Experience. The person would need to have acquired these attributes through education and experience as a public accountant or auditor, a principal financial officer, controller, or principal accounting officer, of a company that, at the time the person held such position, was required to file reports with the SEC, or experience in one or more positions that involve the performance of similar functions.

Notably, the proposed definition states that the Board of Directors can conclude that a person is a financial expert if, instead of having experience in one of the specific roles identified, the person has experience in a position that results, in the judgment of the Board of Directors, in the person having similar expertise and experience. If the Board makes such a determination, it would be required to disclose the basis for that determination. The SEC rejected any notion of "grandfathering" a person so as to qualify as a financial expert on the sole basis that he or she previously served on an audit committee or that he or she has experience in one of the specific roles identified. As a result, once the final rules are issued, the Board will have to confirm such persons' attributes under the rules.

Differences from the Act. The required five attributes are the same as those set forth in Section 407 of the Act, with several modifications. In addition to the requirements of Section 407, the Proposed Rules would require a "financial expert" to have (i) experience preparing or auditing financial statements of a company that files reports with the SEC, (ii) experience applying generally accepted accounting principles for estimates, accruals and reserves that are generally comparable to those of the relevant company, and (iii) experience with financial statements that are generally comparable to those of the relevant company. As a result of these provisions, it is possible, for example, that an individual who was CFO or auditor of even a large private company will not necessarily qualify under the Proposed Rules as a "financial expert" for a public company. It is also possible that an individual who was CFO or auditor of a public company in one type of industry (e.g. software development) will not necessarily qualify under the Proposed Rules as a financial expert for a company in another industry with very different accounting issues and policies (e.g. financial institutions).

Factors to Consider. To qualify as a financial expert, a person would, in all cases, have to possess all of the five attributes listed above. In determining whether a potential financial expert has these attributes, the SEC indicated that the Board of Directors must evaluate "the totality of an individual's education and experience." The Proposed Rules set forth a list of non-exclusive factors that the Board should consider in making that evaluation.[fn2] These factors, which should be considered in the aggregate, include:

• the level of the person's accounting or financial education;
• whether the person is a CPA (or the equivalent), and the length of time that the individual has practiced as such;
• whether the person is certified or otherwise identified as having accounting or financial experience by a recognized private standard-setting body in one of those areas, whether that person is in good standing with that body, and the length of time that the person has been actively certified or identified as having this expertise;
• whether, and for how long, the person has served as a principal financial officer, controller or principal accounting officer of a company that, at the time the person held such position, filed reports with the SEC;
• the person's specific duties while serving as a public accountant, auditor, principal financial officer, controller, principal accounting officer or similar position;
• the person's level of familiarity and experience with the laws and regulations regarding the preparation of the financial statements that are included in SEC reports;
• the level and amount of the person's direct experience reviewing, preparing, auditing or analyzing financial statements that are included in reports filed with the SEC;
• the person's past or current membership on one or more audit committees of companies that, at the time the person held such membership, filed reports with the SEC;
• the person's level of familiarity and experience with the use and analysis of financial statements of public companies;
• whether the person has any other relevant qualifications or experience that would assist him or her in understanding and evaluating the company's financial statements and other financial information, and to make knowledgeable and thorough inquiries whether:
• the financial statements fairly present the financial condition, results of operations and cash flows of the company in accordance with generally accepted accounting principles; and
• the financial statements and other financial information, taken together, fairly present the financial condition, results of operations and cash flows of the company.

In the case of a foreign private issuer, the SEC also advised the Board of Directors to consider the person's experience with public companies in the foreign private issuer's home country, the generally accepted accounting principles used by the relevant company (which may be those of a foreign country), and the reconciliation of the company's financial statements with U.S. generally accepted accounting principles.

The SEC noted that these factors are not intended to serve as an exhaustive list of the factors that should be considered in assessing whether a person qualifies as a financial expert. Moreover, the Proposed Rules do not specify the number of listed factors that a proposed financial expert should satisfy; satisfaction of any specific number of factors would be neither necessary nor sufficient for a person to be considered a financial expert.

Different Definitions Used by the NYSE and Nasdaq

The definition of "financial expert" in the Proposed Rules is substantially stricter than the standards of the NYSE and Nasdaq with respect to financial literacy and expertise.[fn3]

NYSE. The NYSE currently requires that each member of an audit committee be financially literate, as such qualification is interpreted by the Board of Directors in its business judgment, or must become financially literate within a reasonable period of time after his or her appointment to the audit committee. In addition, at least one member of the audit committee must have accounting or related financial management expertise, as the Board of Directors interprets such qualification in its business judgment.[fn4] The NYSE indicated at the time that it submitted its proposed rules to the SEC that it would wait until after the SEC issued its definition of "financial expert" before proposing its own requirement.

Nasdaq. Nasdaq currently requires that each member of an audit committee be able to read and understand fundamental financial statements, including a balance sheet, income statement, and cash flow statement, or will become able to do so within a reasonable period of time after his or her appointment to the committee. (Nasdaq's proposed rules will require audit committee members to have such expertise at the time of their appointment.) Additionally, Nasdaq requires that at least one member of the audit committee have past employment experience in finance or accounting, professional certification in accounting, or any other comparable experience or background which results in his or her financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.[fn5]

As a result of these differences, it is possible that a person who otherwise qualifies under the listing standards of the NYSE or Nasdaq may not have sufficient expertise and experience to be considered a "financial expert" under the Proposed Rules. However, we note that the NYSE and Nasdaq are expected to revise several of their corporate governance rules to conform to the Act and the related SEC rules; it is possible that these new corporate governance rules will ultimately be as restrictive as the Proposed Rules.

Disclosure of Independence

The Proposed Rules would require public companies to disclose whether the financial expert or experts on their audit committees are "independent," as that term is used in Section 10A(m)(3) of the Exchange Act. Please note that proposed rules of the NYSE and Nasdaq will disqualify a broader range of individuals from being "independent" than this provision of the Exchange Act.

Section 10A(m)(3) of the Exchange Act. The Act states that, in order to be considered "independent," a member of an audit committee 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, (i) accept any consulting, advisory or other compensatory fee from the company or (ii) be an affiliated person of the company or any subsidiary thereof.

NYSE. The NYSE's proposed rules impose additional requirements for an audit committee member to be deemed independent. No audit committee member would be deemed independent unless the Board of Directors affirmatively determined that the member had no material relationship with the company, either directly or as a partner, shareholder or officer of an organization that has a relationship with the company. In addition, under the NYSE's proposed rules, the following persons would not be considered independent:

• former employees of the company (until five years after the employment relationship has ended);
• persons presently or formerly affiliated with, or employed by, a present or former auditor of the company or an affiliate (until five years after the affiliation or auditing relationship has ended); and
• persons who are, or in the past five years have been, part of an interlocking directorate in which the CEO or another executive officer of the company serves on the compensation committee of another corporation that employs any such person.

In addition, a person who is an "immediate family member" of someone who would not be independent as a result of these provisions would also not be deemed independent under the NYSE's proposed rules. Finally, under the NYSE's proposed rules, directors' fees (including normal equity compensation awards) are the only permitted form of compensation (receipt of deferred compensation for prior services will not preclude a director from satisfying this requirement); fees paid directly or indirectly for services as a consultant or a legal or financial advisor are specifically disallowed.

Nasdaq. Nasdaq provides detailed guidance as to its independence requirements. Under Nasdaq's proposed rules, the following types of directors will not be deemed to be independent, and therefore, would not be permitted to be a member of the audit committee:

• a director who is employed by the company or any of its affiliates during the current year or any of the past three years;
• a director who accepts, or who has an immediate family member that accepts, any payments from the company or any of its affiliates in excess of $60,000 during the previous fiscal year, or in any of the three previous years, other than compensation for Board service;
• a director who is a family member of an individual who is, or has been in any of the past three years, employed by the company or any of its affiliates as an executive officer;
• a director who is a partner in, or a controlling shareholder or an executive officer of, any organization (including charitable organizations) to which the company made, or from which the company received, payments (other than those arising solely from investments in the company's securities) that exceed 5% of the company's or such organization's consolidated gross revenues for that year, or $200,000, whichever is more, during any of the past three years;
• a director who is employed, or who was employed during any of the three previous years, as an executive of another entity where any of the company's executives serve on that entity's compensation committee;
• a 20% or greater shareholder of the company; and
• for a three-year period following their employment, former partners or employees of the company's auditors.

Nasdaq currently permits one non-independent director to serve as a member of the audit committee under exceptional circumstances. Under the proposed Nasdaq rules, a company must limit the time that such director may serve on the audit committee to two years, and such person would be prohibited from serving as the chairperson of the audit committee. As contemplated by Section 301 of the Act, a person who fails to qualify as "independent" under the Act would be barred from serving on the audit committee.

Determination by the Board of Directors of Who Is a Financial Expert

The Proposed Rules require a company's Board of Directors to make the determination as to who are the financial expert or experts serving on the audit committee.[fn6] The Release notes that the mere designation of a person as a financial expert should not impose a higher degree of individual responsibility or obligation on a member of the audit committee, nor should it decrease the duties and obligations of other audit committee members or the Board as a whole. The Release also notes that the designated expert or experts should not be considered "experts" for purposes of the liability provisions of the securities laws solely as a result of this designation.[fn7]

Registered Investment Companies

The Proposed Rules would require a registered management investment company to annually disclose similar information, namely:

• the number and names of the persons that the Board of Directors has determined to be the financial experts serving on the investment company's audit committee;
• whether the financial expert or experts are independent, and if not, an explanation of why they are not; and
• if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert.

In addition, the investment company would be required to disclose the basis for a determination by its Board that a person is a financial expert if, instead of having experience in one of the specified positions, the person has experience in a position that results, in the Board's judgment, in the person having similar experience and expertise. The definition of "financial expert" would be comparable to the definition discussed above, with modifications relating to the independence requirement. These modifications are designed to capture the broad range of affiliations that many registered investment companies have with investment advisers, principal underwriters, and other entities that are relevant to their independence.

The proposed disclosure requirements would apply to all registered management investment companies. However, they would not apply to unit investment trusts, which are unmanaged investment companies that hold specified securities.

Potential Impact of the Rule

Recommended Assessment. The Proposed Rules are disclosure rules only, and do not, in and of themselves, require an audit committee to have any particular composition. However, companies that are listed on the NYSE or Nasdaq will need to comply with the audit committee financial expert requirements that will be set forth in their respective rules. In addition, we anticipate that some public companies that are not subject to the NYSE's or Nasdaq's rules will seek to avoid having to publicly disclose the fact that they do not have at least one financial expert on their audit committees, due to the negative perceptions that might be created as a result. Accordingly, we believe that it is important for public companies to begin to assess the qualifications of their directors under the Proposed Rules.

Potential Shortage of Qualified Candidates. The stringent requirements imposed by the Proposed Rules for qualification as a financial expert may raise concerns as to whether there is an adequate pool of candidates available for public companies. This is likely to be particularly problematic for smaller reporting companies that are not traded on a stock exchange or Nasdaq. In its discussion of "independence," the SEC suggests the possibility that a member of a company's management team, such as the CFO, might serve as the financial expert on the audit committee, so long as the affiliation is disclosed as contemplated by the Proposed Rules. However, this approach would only be appropriate for reporting companies that are not listed on a national securities exchange or Nasdaq, because Section 301 of the Act requires the SEC to prohibit these exchanges and Nasdaq from listing companies that do not have audit committees that comply with the Act's independence requirements.

Anticipated Timeframe for Adoption

The Commission is requesting comments on the Proposed Rules by no later than November 29, 2002. The Act mandates that the final rules be adopted no later than January 26, 2003.

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Footnotes

1: See Release Nos. 33-8138, 34-46701, IC-25775 (the "Release"). The Release also includes the SEC's proposed rules related to Section 404 (relating to the presentation of an internal control report in a company's annual report) and Section 406 (relating to the adoption of a code of ethics for senior financial officers). Please refer to What Public Companies Need to Know about Sarbanes Oxley on our website for client alerts relating to these proposed rules.

2: The SEC refrained from adopting a bright-line test of a person's expertise.

3: For additional comparative information, please see our August 2002 update, NYSE Adopts Changes to its Corporate Governance and Listing Standards; Differences between Current NYSE and Nasdaq Proposals and Sarbanes-Oxley Act Requirements.

4: See NYSE Rule 303.01.

5: See Nasdaq Rule 4350(d)(2).

6: With respect to foreign issuers having a two-tier board, with one tier designated as the management board and the other tier designated as the supervisory (or non-management) board, the Release states that the supervisory (or non-management) board would be the appropriate body that should make the decision.

7: The Release succinctly states: "The role of the financial expert is to assist the audit committee in overseeing the audit process, not to audit the company."