SEC Adopts Final Rules Requiring Disclosure of Audit Committee Financial Experts Pursuant to the Sarbanes-Oxley Act

On January 22, 2003, the Securities Exchange Commission ("SEC") adopted final rules requiring public companies to disclose in their annual reports whether the Audit Committee of their Board of Directors has at least one "audit committee financial expert" as a member. If so, the public company must disclose the name of the audit committee financial expert and whether the expert is independent of management. A public company that does not have an audit committee financial expert will be required to disclose this absence and explain why the company has no such expert. This disclosure requirement will generally apply to public companies’ annual reports for fiscal years ending on or after July 15, 2003. See Release 33-8177 34-47235 (January 23, 2003). The Release was adopted pursuant to Section 407 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), and is generally implemented through amendments to Item 401 of Regulation S-K.

New item 401(h)(2) of Regulation S-K defines an "audit committee financial expert" to mean a person who has all five of the following attributes:

1. an understanding of generally accepted accounting principles and of financial statements;
2. an ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;
3. experience in 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 company’s financial statements, or experience actively supervising one or more persons engaged in such activities; SEC Adopts Final Rules Requiring Disclosure of Audit Committee Financial Experts Pursuant to the Sarbanes-Oxley Act 2 Securities Update
4. an understanding of internal controls and procedures for financial reporting; and
5. an understanding of audit committee functions.

To qualify as an audit committee financial expert, a single member of the Audit Committee must have all the attributes required by the SEC’s rule. The audit committee financial expert role cannot be met collectively by the various members of the audit committee.

New item 401(h)(3) of Regulation S-K explains that a person can acquire the attributes of an audit committee financial expert through any one or more of the following means:

1. 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;
2. experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;
3. experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or
4. other relevant experience.

A company must disclose whether the audit committee financial expert is independent of management of the company, as defined in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934, as amended ("Exchange Act") (with a limited exception for foreign private issuers, as discussed below). However, Audit Committee independence is contemplated for listed companies by Section 301 of Sarbanes-Oxley, as well as under the current listing standards and the pending corporate governance proposals of the New York Stock Exchange ("NYSE") and the Nasdaq Stock Market, Inc. ("Nasdaq"), so practically speaking, this independence requirement will only create an incremental requirement for companies that are subject to reporting obligations under Sections 13(a) or 15(d) of the Exchange Act, but not listed on the NYSE or Nasdaq.

The final rules require the company’s entire Board of Directors (i.e., not just its Audit Committee) to make the determination of whether or not any member of its Audit Committee meets the definition of audit committee financial expert. Past service on a company’s Audit Committee will not by itself qualify or grandfather a member as an audit committee financial expert.

The Release requires that a public reporting company makes its disclosures regarding its determinations as to its audit committee financial experts in its annual reports filed on Form 10-K, 10-KSB, 20-F or 40-F, as applicable, or to make such disclosures in its proxy statement and incorporate them into their annual report. If the Board determines that it has more than one such expert, however, it need only disclose the name of one of the experts.

The SEC initially proposed its rules relating to audit committee financial experts in Release 33-8138; 34-46701 (October 22, 2002). This proposal release generated extensive concern about the very demanding proposed standards for financial experts, which were viewed by critics as going beyond the requirements of Section 407 of Sarbanes-Oxley and being so restrictive that, practically speaking, very few people could qualify with certainty as such an expert. The final rules included the following changes from the proposal:

• The term "audit committee financial expert" in the final rules differs from the broader term "financial expert" in the proposed rules in order to emphasize that the designated person should have characteristics that are relevant to an Audit Committee.

• The degree of familiarity of the audit committee financial expert with accounting for estimates, reserves and accruals required by the final rules was expanded to include experience with such estimates, reserves and accruals that are generally comparable with those relevant to the company’s financial statements, as compared to the proposed requirements that would have required such experience in the company’s particular industry or businesses.

• The degree of experience of the audit committee financial expert in the preparation of financial statements was broadened in the final rules to include experience in analyzing or evaluating financial statements or his or her actively supervising persons who prepare, audit, analyze or evaluate financials.

• The final rules eliminate proposed requirements that an audit committee financial expert must have gained his or her experience through prior association with a public reporting company reporting under the Exchange Act.

The final rules seek to avoid expanding the liability of the audit committee financial experts. In the Release, The SEC, emphasizes that the audit committee financial expert rules are disclosure-based, and are not meant to expand the duties, obligations or liabilities of the audit committee financial expert, nor to reduce those of the other members of the Audit Committee. Nevertheless, the SEC implicitly acknowledges the possibility that courts might construe the position of audit committee financial expert as adding to the scope of his or her legal duties and liabilities for a variety of potential Federal, state or other claims. Accordingly, new Item 401(h)(4) of Regulation S-K provides the following "safe harbor" provisions:

1. A person will not be deemed an "expert" for any purpose, including without limitation for purposes of Section 11 of the Securities Act of 1933, as amended ("Securities Act"), as a result of being designated or identified as an audit committee financial expert pursuant to the new disclosure item;
2. The designation or identification of a person as an audit committee financial expert pursuant to the new disclosure item 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
3. 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.

Notwithstanding the SEC’s belief that the designation of a person as an audit committee financial expert should not expand the person’s liabilities, such experts may nevertheless be justified in entertaining some residual concerns that some court would impose incremental degrees of legal responsibility on them by virtue of their designation and specified background. The SEC’s efforts in the Release to provide safe harbors and to avoid duty and liability expansion for designated experts provides comfort about SEC originated actions or claims based on compliance with SEC rules, but may not be binding on courts considering a variety of other claims in private litigation. In looking at the duty of care under state corporate law, as well as due diligence defenses under Section 11 of the Securities Act, gross negligence claims under Rule 10b-5 and fraud claims generally, as well as construing control person defenses under the Securities Exchange Act of 1934 ("Exchange Act") and Securities Act, courts have often applied reasonableness standards on director conduct that took into account the position, competence and experience of director defendants. While it is likely, there can be no assurances that courts confronted with such claims may disregard the SEC’s assurances and effectively impose incrementally more demanding expectations 4 on the audit committee financial experts as compared to other directors.

• Foreign Private Issuers. The disclosure requirements for an audit committee financial expert are applicable to foreign private issuers, although they are provided some relief. First, if the foreign issuer’s financial statements are prepared in accordance with non-US GAAP, then the experience and familiarity of the audit committee financial expert is measured in relation to such non-US GAAP. Second, the SEC determined that foreign private issuers need not disclose whether their audit committee financial experts are independent, although the SEC indicated in the Release that it expected to separately address such independence issues in its upcoming rule-making process required by Section 301 of Sarbanes-Oxley.

• Debt Only Issuers. If an issuer has debt securities that are subject to the registration and reporting requirements under the Exchange Act, but not any publicly traded equity securities, the audit committee financial expert disclosure requirements could nevertheless apply to them if they are required to file reports under the Exchange Act by virtue of Section 13(a) or 15(d) of the Exchange Act (which could cease to be applicable if the company had fewer than 300 security holders of record at the beginning of the fiscal year).

• Asset Backed Issuers. The disclosure requirements follow audit committee financial experts are not applicable to asset-backed issuers.

There is Time for Careful Searches and Deliberations. Because the final rules are generally not applicable to annual reports for fiscal years ending before July 15, 2003, Boards and companies have time to search for audit committee financial experts, and carefully consider the ramifications of not identifying such an expert and disclosing their absence.

Board Determination. The entire Board must make a determination as to whether or not it has an audit committee financial expert. A Board may not refrain from making any such determination. In determining whether a person meets the definition of audit committee financial expert, the Board will presumably be protected by the discretion afforded by the state corporate law business judgment rule. However, in view of the scrutiny that applies to all companies as they modify their corporate governance practices in connection

with Sarbanes-Oxley, Boards would be prudent in documenting their inquiries into the expert status of potential designees. This might include written replies from candidates into inquiries about the specificstandards of being such an expert and the basis and background of the potential designee relevant to the Board’s assessment of their experience as contemplated by Items 401(h)(2) and (3) of Regulation S-K, as well as interviews by or on behalf of the Audit Committee chairman or other Board members into these issues.

Even with the SEC’s efforts to broaden the pool of potential audit committee financial experts, and diminish fears of expanded liability, it is very likely that many companies will not be able to identify the experts or to retain them on agreeable terms, especially in view of the potential liability concerns described above. If, notwithstanding these challenges, companies are able to identify and retain audit committee financial experts, they will confront issues of compensation and liability protection. As to compensation, companies must be mindful of structuring compensation arrangements which are reasonable and do not jeopardize an expert’s independence for purposes of Sarbanes-Oxley and the pending NYSE or Nasdaq corporate governance proposals. In this regard, the pending corporate governance proposals by the NYSE recognize that Audit Committee members may compensated more than other directors, and would countenance compensating the audit committee financial experts on the basis of hours worked, meetings attended or some other objective basis. From the standpoint of liability protection, in addition to the typical director exculpation charter provisions, director indemnity agreements and D&O insurance policies, some companies are considering whether the Audit Committees or should have their own separate directors insurance policy, with a priority claim by the Audit Committee members, and not shared with the balance of the Board or the company’s officers.

Companies should remember that the final rules do not require audit committees to have an audit committee financial expert; rather, it’s only a disclosure requirement. It seems unlikely that a disclosure as to the absence of an audit committee financial expert will be of a sufficiently negative character that would effectively motivate a company to strive to identify one, since many public companies appear to be having some difficulty in identifying audit committee financial experts. A Board should not be viewed as negligent as a corporate law matter, merely by not having someone who qualifies as an audit committee financial expert.

If an Audit Committee is unable to identify an audit committee financial expert, the Audit Committee could determine to retain either, episodically or permanently, a financial and/or accounting advisor that could provide expertise and views on an advisory or consulting basis to the Audit Committee. While not the equivalent of identifying an audit committee financial expert, it would demonstrate the Audit Committee’s commitment to obtaining financial expertise. Under Section 301 of Sarbanes-Oxley and the pending NYSE and Nasdaq corporate governance proposals, audit committees are permitted to retain and consult with external advisors, and reasonable reliance by Board members on outside advisors is permitted by corporate law in connection with establishing the duty of care.

If a company determined not to have an audit committee financial expert, its disclosure in its annual report might appear as follows:

"At the present time no member of our Board of Directors serving on the Audit Committee meets the SEC definition of audit committee financial expert. Our Audit Committee consists of three independent directors, each of whom has been selected for the Audit Committee by the Board based on the Board’s determination that they are fully qualified to monitor the integrity of the financial statements of the Company, the Company’s compliance with legal and regulatory requirements, the public accountants’ qualifications and independence and the performance of the Company’s internal audit function and public accountants and the Company’s compliance with the Sarbanes-Oxley Act and the rules and regulations thereunder. In addition, the Audit Committee has the ability on its own to retain independent accountants, financial advisors or other consultants, advisors and experts whenever it deems appropriate. Our Board believes that the qualifications and experience of its Audit Committee members, and their ability to utilize outside advisors and experts as they consider appropriate, affords them the sufficient background and expertise to fulfill their Audit Committee’s obligations without the necessity of including an audit committee financial expert."

If a company believes that its Audit Committee members, considered together, possess all of the elements of an audit committee financial expert, even if none possess all the attributes, the above disclosure could be expanded to identify more particularly which characteristics each Audit Committee member possesses.

Public companies and their Boards should recognize that, in the coming months, the SEC will be considering and implementing additional rules and regulations that will need to be addressed by Audit Committees:

• Auditor Independence. The SEC adopted final rules on January 22, 2003 relating to auditor independence, including Audit Committee approval of permitted non-audit services and auditor reports to the Audit Committee about critical accounting policies of the company.

• Disclosure of Off-Balance Sheet Arrangements. The SEC adopted final rules on January 22, 2003 relating to public company disclosure of off-balance sheet arrangements, which disclosures will be subject to review by Audit Committees.

• Code of Ethics. The SEC adopted final rules on January 22, 2003 to require companies to disclose whether they have adopted codes of ethics for their chief executive and senior financial officers and waivers therefrom.

• Disclosure of Pro Forma and Non-GAAP Financial Information. The SEC adopted final rules on January 22, 2003 relating to the disclosure of pro forma financial information, which will generally be subject to review by, or discussion with, the Audit Committee.

• Standards Relating to Audit Committees. The SEC proposed on January 8, 2003 rules relating to independence requirements for Audit Committees, as well as the responsibility to select and supervise auditors and to discuss critical accounting policies relating to company accounting services.

• NYSE and Nasdaq Corporate Governance Proposals. Although the NYSE and Nasdaq have proposed a wide range of corporate governance policies, many of which impact Audit Committees, these rules have not yet been published for comment by the SEC.

Mayer, Brown, Rowe & Maw expects to provide additional client advisories as to these developments.

This article addresses the provisions of the Release that are most likely to impact issuers and their Audit Committees. This memorandum is not a complete description of the Release. There are exceptions to the general rules described above, which could significantly affect their application in particular circumstances.