Sarbanes-Oxley Act of 2002 and Related SEC Rulemaking: the Impact on Registered Investment Companies

By Peter T. Fariel, Elizabeth Shea Fries, P.C., Jackson B.R. Galloway, Geoffrey R. T. Kenyon and Philip H. Newman

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act"). The Act is a significant component of a broad series of efforts undertaken by the SEC, NYSE, AMEX and Nasdaq to improve corporate governance and disclosure in response to recent well-publicized accounting scandals. Although primarily focused on auditors and operating companies, many provisions of the Act also apply to registered investment companies. This advisory addresses significant aspects of the Act and related SEC rulemaking affecting open-end funds and closed-end funds traded on exchanges (collectively referred to as "Funds").

Significantly, the Act was drafted with ordinary operating companies, rather than Funds, in mind. As a result, compliance with the Act presents special issues and challenges for the Fund industry. At the conclusion of this advisory, we have highlighted some of the special issues that Funds will need to consider in complying with the Act.

Many provisions of the Act did not become effective immediately upon enactment, but will instead be implemented through rulemaking by the SEC, stock exchanges and other regulatory bodies, subject to deadlines set in the Act. Each provision discussed below includes information on its status of implementation and the timing of any related rulemaking. The SEC’s discretionary rulemaking power under the Act, which it exercised in proposing shareholder report certification requirements, will likely play an important role in determining the eventual scope of requirements applicable to Funds as a result of the Act.

In light of the broad scope of these reforms, this advisory does not attempt to address each provision of the Act or related SEC rules in comprehensive detail. Moreover, it is clear that there will continue to be developments in this area for some time. If you have any questions at any time concerning the current and future application of the Act to your organization, please contact any of the individuals listed at the end of this Alert (or your usual Goodwin Procter contact).

To date, the SEC has engaged in two rulemaking initiatives related to the Act that significantly affect Funds. The SEC has issued final rules requiring (i) the certification of reports on Form N-SAR (N-SARs) by principal executive and financial officers and (ii) the implementation of disclosure controls and procedures addressing compliance with disclosure requirements under the 1934 Act (SEC Release No. 34-46427 (August 29, 2002)). The SEC has also proposed a similar certification for shareholder reports, as well as an expansion of disclosure controls and procedures to include compliance with disclosure requirements under the 1933 Act and 1940 Act in addition to those under the 1934 Act. (SEC Release No. 34-46441 (August 30, 2002)).

Certification of Form N-SAR/1934 Act Disclosure Controls and Procedures – Effective 8/29/02.

The SEC has adopted rules that require a Fund’s principal executive and principal financial officers (or persons performing similar functions) to make specified certifications as part of Fund N-SARs (see Exhibit A for certifications). The rules also require Funds to maintain and periodically evaluate disclosure controls and procedures designed to ensure that information disclosed in N-SARs and other reports under the 1934 Act complies with SEC requirements.

Certification. Exhibit A shows the required N-SAR certification. N-SARs filed for periods ended prior to August 29, 2002 must include only a limited set of certifications that do not require implementation of disclosure controls and procedures (Items 1-3 in Exhibit A). N-SARs for periods ending after August 29, 2002 must include the full certification (Items 1-6 in Exhibit A) and reflect implementation of disclosure controls and procedures. The certification must be in exactly the form specified in Form N-SAR.

Disclosure Controls and Procedures. "Disclosure controls and procedures" are controls and other procedures designed to ensure that information required to be disclosed in 1934 Act reports is recorded, processed, submitted and reported within the required time periods. They include controls and procedures designed to ensure that information required to be disclosed in 1934 Act reports is accumulated and communicated to Fund management to allow timely decisions regarding disclosure. Funds that file N-SARs must maintain disclosure controls and procedures, and the certifying officers must evaluate them within 90 days of each N-SAR filing (see item 4 in Exhibit A). A Fund’s principal executive officer and principal financial officer must supervise and participate in the evaluation of disclosure controls and procedures, and each N-SAR must disclose the conclusions reached in the evaluation.

In adopting these requirements, the SEC highlighted the distinction between internal controls, which relate to an issuer’s financial reporting and control of assets (and are addressed elsewhere in the N-SAR certification (see item 5 in Exhibit A)), and the broader concept of disclosure controls and procedures, which also apply to material non-financial information. In addition, the SEC indicated that disclosure controls and procedures should be designed to ensure compliance with disclosure requirements for proxy and information statements even though those documents are not currently subject to certification.

Certification of Shareholder Reports/1933, 1934 and 1940 Act Disclosure Controls and Procedures – Proposed rules.

The SEC has also proposed rule amendments that would require Funds to provide the same type of certification for their annual and semi-annual shareholder reports (a "Section 302 Certification") as now required for filings on Form N-SAR (see Exhibit A). The rule amendments would designate these certified shareholder reports as periodic reports filed with the SEC under Section 13(a) or 15(d) of the 1934 Act. In addition, the SEC’s proposal would expand the scope of disclosure controls and procedures to apply to filings under the 1933 Act and 1940 Act in addition to those under the 1934 Act. (The SEC’s proposal would also apply N-SAR and shareholder report certification requirements to all registered investment companies, regardless of whether they have 1934 Act reporting obligations or are registered under the 1933 Act, thereby creating certification obligations for "master" funds.)

Form N-CSR Filings. The proposed rule amendments would require a Fund to use new Form N-CSR to file (i) a copy of any shareholder report required under 1940 Act Rule 30e-1 (annual and semi-annual reports); (ii) information regarding the Fund’s disclosure controls and procedures and (iii) a Section 302 Certification with respect to the shareholder report being filed. The Section 302 Certification required as part of Form N-CSR would encompass not only the financial statements included in a shareholder report but also any other information, such as management’s discussion of Fund performance, that might appear in the report, whether or not it is required to be there.

Disclosure Controls and Procedures. Funds would be required to maintain and regularly evaluate the effectiveness of disclosure controls and procedures designed to ensure that information required in filings under the 1933 Act, the 1934 Act and the 1940 Act, including prospectuses, reports to shareholders, proxy and information statements and reports on Form N-SAR, was recorded, processed, summarized and reported on a timely basis. Under related amendments, Funds would be required to evaluate their disclosure controls and procedures within 90 days prior to the filing date of a report on Form N-SAR or Form N-CSR in preparation for the Section 302 Certification and disclosures required in the applicable Form.

Comments on the Proposed Rules. The SEC has requested comment on numerous aspects of its rule proposals, including whether the Form N-SAR certification requirement should be eliminated if the Form N-CSR certification requirement is adopted. Comments are due to the SEC by October 16, 2002.

"Section 906" Certification - Effective if SEC adopts Form N-CSR proposals.

Section 906 of the Act, which requires a specified certification to accompany "each periodic report containing financial statements" filed pursuant to Section 13(a) or Section 15(d) of the 1934 Act, does not currently apply to Funds. N-SARs are reports under the relevant sections of the 1934 Act, but as acknowledged by the SEC when it adopted the Form N-SAR certification requirements discussed above, N-SARs do not contain financial statements. However, should the SEC adopt its proposal to designate Form N-CSR reports (which will contain Fund financial statements) as reports under Section 13(a) or 15(d) of the 1934 Act (as discussed above), those filings will become subject to the certification requirements of Section 906 of the Act as well.

Section 906 Certification. Section 906 requires that an issuer’s chief executive officer and chief financial officer (or their equivalents) certify that (i) the periodic report containing the financial statements fully complies with the requirements of Section 13(a) or 15(d) of the 1934 Act and (ii) information contained in the periodic report fairly represents, in all material respects, the financial conditions and results of operations of the issuer (the "Section 906 Certification").

Criminal Penalties. A knowing misrepresentation in connection with a Section 906 Certification is punishable by a fine of up to $1 million and imprisonment of up to 10 years, and a willful misrepresentation is punishable by a fine of up to $5 million and imprisonment of up to 20 years.

Certification Mechanics. Because of differences from the Section 302 Certification, the Section 906 Certification must be provided separately. The proposed Form N-CSR rules do not address the Section 906 Certification. The SEC has indicated that it may try to work with the Department of Justice to harmonize the Section 302 and Section 906 certification requirements.

The Act includes a number of provisions affecting auditors and audit committees that are designed to improve accounting practices. Clearly the biggest impact of the Act in this area is that it establishes a new Public Company Accounting Oversight Board for the purpose of regulating auditors of public companies and companies offering securities in public offerings, including Funds. The Accounting Oversight Board will be authorized, among other things, to register and inspect auditors’ operations with respect to public companies and Funds, establish rules governing auditing, quality control, ethics, independence and other standards related to the preparation of audit reports and conduct investigations and disciplinary proceedings. The SEC must determine by April 26, 2003 that the Board is capable of carrying out its duties; 180 days after that determination (in no event later than October 23, 2003) auditors must have registered with the Board. Other provisions of the Act discussed below affect the composition and duties of audit committees and auditor conduct. These provisions will also become effective through SEC rulemaking.

– Effective by January 26, 2003 through SEC rulemaking.

Subject to a de minimis exception, a Fund’s audit

committee must preapprove all audit and non-audit services provided to the Fund by its auditor. "Non-audit services" means any professional services provided to a Fund other than those provided in connection with an audit or a review of the financial statements of the Fund. Fund auditors will be prohibited from providing certain non-audit services to the Fund under any circumstances (see "Non-Audit Services" below).

Disclosure of Approvals. Funds that trade on exchanges must disclose audit committee approval of non-audit services in their 1934 Act reports, i.e. N-SARs and if adopted, Form N-CSRs.

Delegation. A Fund’s audit committee may delegate to one or more of its members who are "independent directors" the authority to grant preapprovals. Any preapprovals by an audit committee delegate will be presented to the full audit committee at its next scheduled meeting.

Audit Committees – Effective by April 26, 2003 through SEC rulemaking regarding exchange listing requirements

SEC rulemaking will mandate that exchanges may only list issuers that meet certain requirements relating to audit committee responsibilities, composition and powers. Although the literal effect of these new requirements is limited to Funds that trade on exchanges, e.g., closed-end Funds, it seems likely that these requirements will become best practices for open-end Funds or will become applicable to them through SEC rulemaking (see "SEC Discretionary Rulemaking Power" below), to the extent they are not already.

Audit Committee Responsibilities. Audit committees shall be directly responsible for the appointment, compensation and oversight of the work of any auditor employed by the Fund.

Audit Committee Composition. Each member of the audit committee must be a board member and must otherwise be independent. To be "independent" a director may not, other than as a member of the board of directors (including any of its committees), (i) accept any consulting, advisory or other compensatory fee from the Fund or (ii) be an affiliated person of the Fund. This definition is generally consistent with 1940 Act independence requirements.

Complaint Procedures. Audit committees will establish procedures for handling complaints received by the Fund regarding accounting, internal accounting controls or auditing matters, and the confidential anonymous submission by Fund employees of concerns regarding questionable accounting or auditing matters.

Authority to Engage Advisors. Audit committees must have the authority to engage independent counsel and other advisors as they deem necessary to carry out their duties. A Fund must provide appropriate funding, as determined by its audit committee, to pay the auditor engaged for the purpose of issuing an audit report and any advisors who are employed by the audit committee.

Expert – Effective by January 26, 2003 through SEC rulemaking.

In periodic reports required pursuant to Sections 13(a) and 15(d) of the 1934 Act (i.e., N-SARs and if adopted, Form N-CSRs), Funds must disclose whether or not, and if not, the reasons why not, the Fund’s audit committee includes at least one member who is a "financial expert."

Improper Influence on Audits – Effective by April 26, 2003 through SEC rulemaking. The SEC will adopt rules to prohibit any Fund officer or director or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any "independent public or certified accountant" engaged in an audit of Fund financial statements for the purpose of rendering financial statements materially misleading.

Prohibited Non-Audit Services – Effective by January 26, 2003 though SEC rulemaking. The Act prohibits auditors from providing the non-audit services shown below to audit clients.

(i) Bookkeeping or other services related to the Fund’s accounting records of financial statements;

(ii) Financial information systems design and implementation;

(iii) Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;

(iv) Actuarial services;

(v) Internal audit outsourcing services;

(vi) Any management or human resources functions;

(vii) Broker, dealer, investment adviser, or investment banking services;

(viii) Legal services;

(ix) Expert services unrelated to the auditing services; and

(x) Any other services that a newly-established Public Company Accounting Oversight Board prohibits by rulemaking.

Auditor Reports to Audit Committee – Effective by January 26, 2003 though SEC rulemaking.

Under the Act, auditors must report (in a timely fashion) to audit committees on a number of matters, including the Fund’s critical accounting policies, alternative methods for treating financial information and the reasons for selecting the method used, and accounting disagreements with management.

Audit Partner Rotation – Effective by January 26, 2003 though SEC rulemaking.

The Act prohibits auditors from allowing either a lead audit partner or a lead review partner to provide audit services to a Fund for more than five consecutive years.

One Year Prohibition on Employment of Auditor Personnel – Effective by January 26, 2003 though SEC rulemaking.

The Act prohibits an auditor from providing any audit services to a Fund if the Fund’s CEO, controller, CFO or chief accounting officer was employed by the auditor and participated in any capacity in the audit of the Fund during the one-year period preceding the date of the commencement of the audit.

The Act requires the SEC to review each Fund report under Section 13(a) or 15(d) of the 1934 Act (i.e., each N-SAR and if adopted, Form N-CSR), no less frequently than once every three years. The Act also requires the SEC to promulgate rules (no deadline specified) that will require Funds to disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the Fund, in plain English, which may include trend qualitative information and graphic presentations, as the SEC determines.

Increased Criminal Penalties – Effective.

The Act increases criminal penalties for document destruction, securities fraud, criminal conspiracy, mail and wire fraud, and 1934 Act violations, among other acts. The U.S. Sentencing Commission is directed to review the Federal Sentencing Guidelines to ensure that offense levels and sentence enhancements are adequate with respect to securities and accounting fraud and related offenses.

Whistle Blower Protection in Fraud Cases – Effective.

A Fund and its employees, contractors or agents may not discriminate in the terms and conditions of employment with respect to employees who provide information or assist in investigations of securities law and anti-fraud violations or who file, testify or participate in, or otherwise assist in, proceedings involving alleged violations of anti-fraud laws or any SEC rule or regulation. If these provisions are violated, the employee is entitled to seek reinstatement, back pay and special damages, such as litigation costs.

Officer and Director Bars – Effective.

The SEC may bar an individual who has violated the anti-fraud provisions of the federal securities laws from acting as a Fund officer or director in the future through an administrative proceeding rather than requiring a court order. The Act lowers the standard required to be met in order to impose such a bar; the SEC must now show only that the individual’s conduct demonstrates "unfitness" to serve as a Fund officer or director, rather than the prior standard of "substantial unfitness."

Expedited Section 16 Disclosure – Effective.

Section 16 filers must report transactions in Fund stock to the SEC by the second business day after the transaction in accordance with SEC rules. In addition, effective by July 30, 2003, Section 16 reports must be filed with the SEC electronically and must be publicly posted both on the SEC’s and Fund’s Web sites within one day after the filing date.

Code of Ethics for Senior Financial Officers – Effective by January 26, 2003 through SEC rulemaking.

In accordance with SEC rules, Funds will be required to disclose whether or not, and if not, the reason why not, the Fund has adopted a code of ethics for senior financial officers applicable to its principal financial officer and comptroller or principal accounting officer, or persons performing similar functions. Given 1940 Act Rule 17j-1, the SEC may choose to exempt Funds from these requirements.

Rules of Professional Responsibility for Attorneys – Effective by January 26, 2003 through SEC rulemaking.

The SEC will issue rules that define minimum standards of professional conduct for attorneys appearing and practicing before the SEC in any way in the representation of any Fund. The rules will require that an attorney report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the Fund or any of its agents, to the "chief legal counsel" or the "chief executive officer" of the Fund (or the equivalent thereof); and then, if the counsel or officer does not respond appropriately to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), the attorney must report the evidence to the audit committee or to another committee of the Board comprised solely of directors not employed directly or indirectly by the Fund or to the Board of Directors.

Section 3(a) of the Act grants the SEC considerable discretionary rulemaking power. The SEC has exercised this power in proposing Fund shareholder report certification and may exercise it in other areas to adapt the Act’s operating company tailored provisions to apply more fully to Funds. (Section 3(a) provides that the SEC "shall promulgate such rules and regulations, as may be necessary or appropriate in the public interest or for the protection of investors, and in furtherance of this Act.").

In proposing shareholder report certification, a requirement clearly not mandated by the express terms of the Act, the SEC indicated that it was acting because the N-SAR certification rules it had adopted (as directed by the statute) were insufficient to fully implement the intent of the Act’s certification requirements with respect to Funds.

The certification provisions of the Act are fairly typical of much of the Act in that they are framed in terms of operating company conventions and therefore apply awkwardly to Funds if implemented literally. As a consequence, except for certain provisions of the Act from which Funds are expressly exempted (Sections 401 [Enhanced Disclosures in Financial Reports], 402 [Prohibition on Personal Loans to Executives] and 404 [Management Assessment of Internal Controls]), there exists some likelihood that the SEC may engage in discretionary rulemaking to require Funds to comply with other substantive requirements of the Act that under the strict language of the Act would not apply to Funds or would apply to Funds in some other manner. Examples of provisions that might be the subject of this sort of rulemaking include audit committee requirements nominally applicable only to closed-end Funds and provisions dealing with Fund "employees."

Some issues regarding how the Act and relating rules affect Funds may be resolved in the course of SEC rulemaking. However, if the SEC’s Section 302 rulemaking is any indicator, more complex Fund specific applications and concerns may receive little treatment in the current SEC rulemaking process. The following are among the issues and challenges that many Funds will face in complying with the Act and related rules.

To what extent will certifying officers be required to inquire into the controls and procedures of third-party service providers such as custodians, fund accountants, transfer agents and administrators? Do certifying officers have access to the necessary information under current agreements with these service providers?

Will the new certification and evaluation requirements increase the focus on valuation matters?

What special arrangements may be necessary in more complex Fund structures, such as master/feeder arrangements (including those with third-party masters), Fund-of-Funds, manager-of-manager Funds and subadvised Funds (e.g., to ensure the accuracy of information presented in management’s discussion of Fund performance)?

In the release adopting the N-SAR certification requirements, the SEC recommended that each issuer form a committee reporting to the principal executive and financial officers with responsibility for considering materiality of information and determining disclosure obligations on a timely basis. Is the committee approach a feasible or useful one for Funds? The SEC’s candidates for committee membership, although common for operating companies, generally have no direct Fund analogs. Who would be appropriate committee members for a Fund?

If the SEC adopts the definition of "financial expert" set forth in the Act in rules requiring disclosure of any audit committee financial expert, will Fund audit committees be willing to designate any member who is not a certified public accountant as a financial expert?

What will be the effect of disclosing that a Fund’s audit committee is not comprised of at least one member who is a financial expert?

The SEC has indicated that the representation in item 3 of the Form N-SAR Certification should provide assurance that the financial information and financial statements in question meet a "standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principals." What is this standard? What is the relationship between the evaluation of internal controls referred to in items 5 and 6 of the N-SAR Certification and the evaluation of disclosure controls and procedures referred to in item 4 of the N-SAR Certification?

Are the persons currently designated as a Fund’s principal executive and principal financial officers for purposes of signing the Fund’s registration statement the appropriate persons to provide the necessary certifications? Are changes in the Fund’s governing documents necessary to designate others to perform these duties? May a series company have multiple principal

executive and principal financial officers?

I, [identify the certifying individual], certify that:

1. I have reviewed this report on Form N-SAR of [identify registrant];

2. Based on my knowledge, this 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 such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial information included in this 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 registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in rule 30a-2(c) under the Investment Company Act) for the registrant and have:

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

6. The registrant’s other certifying officers and I have indicated in this report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

[Date] _______________