SEC Adopts Rules Governing Determination and Disclosure of Audit Committee Financial Experts

01/28/2003

On January 23, 2003, the Securities and Exchange Commission (the “SEC”) published new rules under Section 407 of the Sarbanes-Oxley Act of 2002 that will require public companies to disclose whether they have at least one “audit committee financial expert” serving on their audit committees.  This Client Alert does not cover the rules recently adopted under Section 407 of the Sarbanes-Oxley Act that apply to registered investment companies.

Summary of New Rules

If the company has an audit committee financial expert, then the company must disclose the name of the expert and whether the person is independent of management.  In determining whether an audit committee member is independent, domestic companies will need to refer to the definition of independence contained in the listing standards of the NYSE, AMEX and the NASD, even if the company’s securities are not listed on the NYSE or AMEX or quoted on Nasdaq.  The SEC has recently proposed rules that would standardize the definition of independence used by the NYSE, AMEX and the NASD.  Foreign private issuers are not required to disclose whether an audit committee financial expert is independent until the proposed independence standard is finalized.

If the company does not have an audit committee financial expert on the audit committee, then the company must disclose that it does not have an audit committee financial expert on the audit committee and explain why it does not have an audit committee financial expert on the audit committee. 

Compliance Dates

The required disclosures must be made for public companies, other than small business issuers, in their annual reports for fiscal years ending on or after July 15, 2003.  Small business issuers (those U.S. and Canadian issuers with less than $25 million in annual revenues and public float) are required to make the disclosures in their annual reports for fiscal years ending on or after December 15, 2003.

Definition of Audit Committee Financial Expert

The board of directors is assigned the task of determining whether it considers the members of the audit committee to be audit committee financial experts.  For an audit committee member to be considered an audit committee financial expert, the board of directors must determine that the director possesses the attributes specified by the new rules.   In response to the significant number of comments the SEC received on the definition of financial expert in the proposed rules, the SEC broadened the definition of audit committee financial expert in the final rules.

To qualify as an audit committee financial expert, a director must possess all of the following five attributes:

  • An understanding of generally accepted accounting principles (“GAAP”) and financial statements (this attribute was revised to clarify that foreign private issuers are to apply the GAAP they used in preparing the primary financial statements filed with the SEC);

  • The ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves (this attribute was revised from the proposed rules, which essentially required that the person have experience making such assessments in the registrant’s industry);

  • 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 (this attribute was revised from the proposed rules, which required that the person have actual experience preparing or auditing such financial statements);

  • An understanding of internal controls and procedures for financial reporting (this attribute was revised from the proposed rules, which required that the person have experience with internal controls and procedures); and

  • An understanding of audit committee functions (this attribute remained unchanged from the proposed rules).

Furthermore, these attributes must have been acquired 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 (if the required attributes are acquired through “other relevant experience”, the company must provide a brief listing of that person’s relevant experience).

The final rules eliminated the instruction in the proposed rules listing several factors that the board of directors should consider in evaluating the person’s education and experience; the SEC believes that boards of directors should consider all available facts and circumstances.  The final rules also eliminated the requirement in the proposed rules that the experience described above must have been obtained with a public company.

The SEC stated that the fact that a person has experience as a public accountant or auditor, or a principal financial officer, controller or principal accounting officer, will not, by itself, cause the person to become an audit committee financial expert.  The SEC emphasized that, in addition to the knowledge and experience  that must be satisfied, the board of directors must ensure that it names an audit committee financial expert who embodies the highest standards of personal and professional integrity.  Accordingly, the board of directors should consider any disciplinary actions to which a potential audit committee financial expert has been subject in making its determination.

Certain Disclosure Issues

A company does not have to name more than one audit committee financial expert even if it determines that it has more than one audit committee financial expert on its audit committee.  A company will not satisfy the new disclosure requirements if it states that the board of directors has decided not to make a determination or by simply disclosing the qualifications of all of its audit committee members.  If the board of directors determines that at least one of the audit committee members qualifies as an audit committee financial expert, the company must accurately disclose this fact.  The SEC noted that a company could not disclose that it has an audit committee financial expert by virtue of the fact that the audit committee members collectively possess all of the attributes of an expert, while no one audit committee member possessed all of the required attributes.  Finally, the SEC stated that it would be appropriate for a company disclosing that it does not have an audit committee financial expert to explain the aspects of the definition that various members of the audit committee satisfy.

The requirement to provide the new disclosure is included in Part III of Forms 10-K and 10-KSB so that a domestic company that voluntarily chooses to include this disclosure in its proxy or information statement may incorporate it by reference into its Form 10-K or 10-KSB if it files the proxy or information statement with the SEC no later than 120 days after the end of the fiscal year covered by the Form 10-K or 10-KSB.

Safe Harbor from Liability with Respect to Audit Committee Financial Experts

In response to concerns that the designation and public identification of an audit committee financial expert would increase such person’s duties, obligations and liability as an audit committee member or board member, the SEC adopted a safe harbor.  Specifically, the safe harbor states that:

  • A person who is determined to be an audit committee financial expert will not be deemed an “expert” for any purpose, including without limitation for purposes of Section 11 of the Securities Act of 1933, as a result of being designated or identified as an audit committee financial expert;

  • The designation or identification of a person as an audit committee financial expert does not impose on such person any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such person as a member of the audit committee and board of directors in the absence of such designation or identification; and

  • The designation or identification of a person as an audit committee financial expert does not affect the duties, obligations or liability of any other member of the audit committee or board of directors.

The SEC stated in the adopting release that the requirements of Section 407 of the Sarbanes-Oxley Act are entirely disclosure-based, and therefore the SEC does not believe that Congress intended to change the duties, obligations or liability of any audit committee member, including the audit committee financial expert, through this provision of the Sarbanes-Oxley Act. 

Actions for Boards to Take to Get Ready for the New Rules

Because the SEC has charged the entire board of directors with determining which directors qualify as audit committee financial experts, the board must evaluate each director in light of the guidelines summarized above.

The following is a sample process the board of directors could use to make its determination:

  • The company would prepare and disseminate to its audit committee members questionnaires that are designed to elicit the necessary information;

  • After the questionnaires are completed and returned, the company’s counsel or another company representative familiar with the new rules would analyze the questionnaires in relation to the five required attributes of an audit committee financial expert and determine whether those attributes were obtained through the means specified in the rule;

  • If any director did not clearly satisfy any of the five required attributes or obtain the required attribute through one of the specified means, the director would be notified and given the opportunity to discuss the company’s conclusion;

  • The names and questionnaires of the directors who appeared to satisfy the five required attributes and the means of obtaining the attributes would be submitted to the board of directors for their consideration; and

  • At the board meeting held to determine whether any audit committee members were audit committee financial experts, the information in the questionnaires would be discussed.  Any discussions concerning legal matters should be held in the presence of company counsel in order to preserve a claim that the communications are protected by the attorney-client privilege.

If the board of directors determines that it does not have an audit committee financial expert, it should start the search process to find a qualified candidate as soon as possible since many other companies will also be searching for qualified candidates that satisfy the required attributes.

Further Information

This Client Alert is a publication of Haynes and Boone, LLP and should not be construed as legal advice on any particular facts or circumstances.  This Client Alert is for general informational purposes only, and may not be quoted or referred to in any other documents or legal proceeding without our prior written consent.  The publication of this Client Alert is not intended to create an attorney-client relationship.

This Client Alert summarizes certain key points of the new and amended rules, as contained in Release Nos. 33-8177; 34-47235.  You are encouraged to review the full text of the rules at http://www.sec.gov/rules/final/33-8177.htm.  If you would like to learn more about audit committee financial experts, please feel free to contact your regular Haynes and Boone attorney or any member of our Corporate/Securities Section.

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