United States: In the Wake of the U.S. Revolution: Don´t Lose Sight of the Big Picture While Sweating the Details

Six months after enactment of the Sarbanes-Oxley Act of 2002, there is good news and bad news. Most officers and directors of public companies, both in the U.S. and abroad, have been inundated with information concerning the Sarbanes-Oxley Act of 2002. That is the good news. The bad news is that the deluge will continue, with many of the rules under the Act and related reform initiatives to be finalized between now and the summer.

In implementing rules under the Act, the SEC has been forced to grapple with many provisions that are unclear in their meaning and scope. For example, much has been written about inconsistencies among the various certification requirements, the scope of the prohibition on non-audit services performed by accountants for audit clients, and the feasibility of expecting public companies to include "financial experts" on their audit committees.

The SEC has indicated in its recent rules releases that it intends to construe the Act broadly. Some believe that the SEC is attempting to cover activities that were not intended by Congress. While the accounting and legal communities have been successful in limiting the scope of certain provisions, the SEC for the most part has held the line on proposed rules relating to issuer disclosure regimes.

Non-U.S. filers are subject to most of the Act's provisions, including its officer certification requirements foreign issuers are, however, afforded some flexibility in complying with specific rules. For example, in certain cases non-U.S. issuers will not be required to disclose certain financial measures in compliance with U.S. GAAP, provided that such disclosure is made outside the United States.

Because of the evolving nature of these provisions, it no doubt will remain critical for senior executives of all public companies to remain abreast of specific rules and interpretations under the Act. At the same time, however, it will be equally important for executives to review the broader surroundings in which they will be operating their businesses going forward - both in terms of assessing the company's internal culture, and in evaluating initiatives being undertaken by the company's competitors and corporate America generally.

Internally, each senior executive should ensure that his or her company maintains the appropriate culture to respond to the new environment of more stringent disclosure requirements and outside scrutiny. As a practical matter, many companies historically- have prepared initial drafts of SEC reports such as Form 10-Ks or 10-Qs by updating information from the prior period's report and making conforming changes. That approach will not suffice in 2003, even absent material developments at the company.

First, as most already know, the new rules require much more rigorous corporate disclosure and transparency at all levels. Second, the SEC is expected to scrutinize periodic reports much closer than in the past, always with the benefit of 20-20 hindsight. Over the past two years, more than 700 companies have been forced to restate their earnings as a result of misleading or outright fraudulent accounting practices. In response, the SEC completed a review of recently filed annual reports of Fortune 500 companies and indicated that based on that review, the financial statements of a "substantial majority" raise questions concerning inaccurate or misleading disclosure, questionable accounting policies or similar concerns. The SEC is required to undertake comparable reviews of reports filed by all other publicly-traded companies, including non-US. issuers, within a three-year period.

In some ways, these trends toward increased transparency and closer scrutiny will impact foreign issuers more than domestic filers. Even where non-U.S. companies are not required to comply with specific provisions of Sarbanes-Oxley; the SEC may nevertheless demand a comparable level of disclosure to allow investors to understand the financial condition of the foreign company. Asian issuers may face particular challenges here in helping investors understand Asian governance practices, which often differ significantly from those in the United States.

Foreign issuers also may receive pressure from auditors to implement practices which become standard in the United States. Sarbanes-Oxley clearly has raised the level of care and competence required by all accountants for services provided to their clients. With increased potential liability under the Act, auditors are likely to more closely scrutinize financial disclosure and corporate governance practices of foreign issuers.

In addressing these increased disclosure demands, all issuers should assess whether they have in place appropriate "disclosure controls and procedures" to ensure that potentially material information is promptly brought to the attention of senior management and others responsible for disclosure in SEC reports. Apart from being required under Sarbanes-Oxley, a review of these controls and procedures can help companies evaluate more generally whether important information is channeled through the organization quickly and efficiently. Before filing SEC reports, CEOs and CFOs also should investigate important issues such as whether there have been disagreements between the company and its auditors during the course of the review or audit of financial statements, or whether there have been any changes in accounting policies since the prior period filing.

Senior executives also should ask themselves: if a lower-level employee has relevant information concerning a company's revenue-recognition practices, for example, would that employee know who to contact? If so, would the information ultimately be delivered to senior management, in a timely manner and in a form most helpful to executives?

In addition to reviewing internal matters, senior executives of public companies also should extend existing communications with other market participants to exchange perspectives on corporate governance practices and initiatives and to learn how others in corporate America are responding to the new reforms. These other participants might include institutional investors, officers and directors of other public companies, and professional organizations such as the National Association of Corporate Directors that are active in the corporate governance arena.

In the upcoming proxy season, public companies should expect that institutional shareholders will be more insistent that companies implement more responsible corporate governance practices.

Organizations such as Institutional Shareholder Services, which provides research and shareholder proposal recommendations to its institutional clients, are in the process of rating the corporate governance practices of public companies, and are evaluating companies individually and within particular industries.

ISS is evaluating companies based on eight core categories: (1) board of directors matters; 2) audit issues; 3) charter and bylaw provisions; 4) laws of the state of incorporation; 5) executive and director compensation; 6) qualitative factors, including financial performance; 7) stock ownership; and 8) director education. ISS will analyze a total of 61 items in determining each issuer's rating, including items such as whether different people hold the Chairman and CEO positions, whether outside advisors are available to the board, and the scope of anti-takeover provisions, such as poison pills, adopted by the company. The data will be obtained primarily- from public disclosure documents, although ISS has indicated that companies will have the opportunity to respond and provide additional information. Companies will be scored individually- and will be ranked relative to their industry peer groups and to companies with comparable market capitalization.

This initiative could have a major impact on shareholder votes beginning this spring, in that funds may decide to vote against proposals specifically because of a company's low corporate governance rating. In turn, this may put pressure on companies to implement reforms that are in, or at least close to, the mainstream, and comparable to those of its competitors. Executive interaction with others in the corporate governance arena will shed light on newly formed national or industry-specific trends in responding to these initiatives, including initiatives undertaken by U.S. issuers in the same industry as particular foreign filers.

At first, Non-U.S. issuers initially could be particularly- impacted by ISS and related ratings, in that certain of their corporate governance practices may not be publicly known in the United States. To the extent ISS does not know of practices implemented by particular foreign issuers, it may initially issue lower ratings than might otherwise be appropriate. Additionally, non-U.S. filers which do not conform to the standards of most U.S. companies may find themselves shut out from certain investment opportunities. For example, several mutual fund companies have indicated that they may establish funds which would invest only in companies with high corporate governance ratings.

Ultimately, if senior executives, particularly those of foreign issuers, do not maintain and communicate the right disclosure environment and philosophy, or do not ensure that their company's actions are appropriate and sufficient in the context of broader movements in corporate America, they risk exposing their company to criticism, if not liability, no matter how diligently they pursue the new rules. On the other hand, if executives understand the contours of the Act and the rules that emanate from it as part of this corporate governance revolution, and take action based on that understanding, they will be far more likely to avoid liability and thrive in the midst of ongoing corporate governance upheaval.