Securities
January 2003
New SEC Rules Implementing the Audit Committee
Financial Expert and Code of Ethics Requirements under
Sections 406 and 407 of the Sarbanes-Oxley Act of 2002
The SEC has released the final Rule, available at
http://www.sec.gov/rules/final/33-8177.htm, required
under Sections 406 and 407 of the Sarbanes-Oxley
Act of 2002 (the “Act”). Under the new Rule, each
company subject to the reporting requirements of
Section 13(a) or 15(d) of the Exchange Act must now
make certain disclosures in its annual report filed
under the Exchange Act with respect to (a) whether it
has at least one “audit committee financial expert”
serving on its audit committee and (b) whether the
company has adopted a written code of ethics
applicable to the conduct of its principal executive
officers and senior financial officers. Each reporting
company must comply with the disclosure
requirements under the new Rule in its annual report
for fiscal years ending on or after July 15, 2003,
except that a small business issuer must comply with
disclosure requirements relating to “audit committee
financial experts” in its annual report for fiscal years
ending on or after December 15, 2003. Although the
SEC proposed implementing requirements under
Section 404 of the Act as part of the proposing
release related to the new Rule, the SEC will release
the final rule implementing Section 404 of the Act at
a later date.
“AUDIT COMMITTEE FINANCIAL EXPERTS”
SERVING ON THE AUDIT COMMITTEE
Each reporting company must disclose in its annual
report for fiscal years ending on or after July 15,
2003 (December 15, 2003 for small business issuers)
filed under the Exchange Act whether it has at least
one “audit committee financial expert” serving on its
audit committee and, if so, the name of the person
and whether that person is independent of
management. If the company does not have any
audit committee financial experts serving on its audit
committee, the company must disclose that fact and
explain the reason it has no audit committee financial
experts on its audit committee.
The definition of “audit committee financial expert”
was the most controversial aspect of the rulemaking.
The final Rule establishes a broader definition than
proposed in response to commenters’ concerns,
including, among other things, that the proposed
definition would too greatly restrict the ability of a
reporting company to attract qualified persons to
serve as an audit committee financial expert on its
audit committee and that the proposed definition was
too rigid with respect to required expertise and the
means by which a person could acquire the required
expertise.
Under the final Rule, whether a person is an audit
committee financial expert is a subjective
determination that the full board of directors makes
based on the totality of an individual’s education and
experience. A financial expert is a person who,
through (a) 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, (b) experience
actively supervising a principal financial officer,
principal accounting officer, controller, public
accountant, auditor or person performing similar
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functions, (c) experience overseeing or assessing the
performance of companies or public accountants
with respect to the preparation, auditing or
evaluation of financial statements or (d) other
relevant experience, has all of the following
attributes: (v) an understanding of GAAP and
financial statements, (w) the ability to assess the
general application of such principles in connection
with the accounting of estimates, accruals and
reserves, (x) 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 reporting
company’s financial statements, or experience
actively supervising one or more persons engaged in
such activities, (y) an understanding of internal
controls and procedures for financial reporting and
(z) an understanding of audit committee functions.
Each reporting company must also disclose whether
each audit committee financial expert on its audit
committee is “independent” as that term is used in
Item 7(d)(3)(iv) of Schedule 14A. In the case of any
listed reporting company, all members of its audit
committee will soon be required to be independent.
Section 301 of the Act requires the SEC to adopt
final rules no later than April 27, 2003 directing the
national securities exchanges and national securities
associations to require that each member of a listed
company’s audit committee be independent as a
condition to listing.
Finally, in response to commenters’ requests for
clarification with respect to whether the designation
or identification of a person as an audit committee
financial expert of a company will alter the duties,
obligations or potential liability of that person as a
member of the company’s audit committee, the SEC
has incorporated a safe harbor as part of the new
audit committee disclosure item. Under this safe
harbor, the designation or identification of a person
as an audit committee financial expert: (a) will not
result in that person being deemed an “expert” for
any purpose, including without limitation for
purposes of Section 11 of the Securities Act, (b) does
not impose on that person any duties, obligations or
liability that are greater than the duties, obligations
and liability imposed on that person as a member of
the audit committee and board in the absence of such
designation or identification and (c) does not affect
the duties, obligations or liability of any other
member of the audit committee or board.
CODE OF ETHICS FOR THE PRINCIPAL
EXECUTIVE OFFICERS AND SENIOR FINANCIAL
OFFICERS
Each reporting company (including a small business
issuer) must disclose in its annual report for fiscal
years ending on or after July 15, 2003 filed under the
Exchange Act whether it has adopted a written “code
of ethics” applicable to its principal executive
officer, principal financial officer, principal
accounting officer or controller, or persons
performing similar functions and, if not, the reason it
has not done so.
The code of ethics should contain the written
standards reasonably designed by a company to deter
wrongdoing and promote, among other things, honest
and ethical conduct (including the ethical handling of
actual or apparent conflicts of interest), appropriate
public disclosure, compliance with applicable laws,
prompt internal reporting of violations of the code
and accountability for adherence with the code. The
SEC contemplates that codes of ethics will vary
among companies and, accordingly, does not
prescribe specific provisions, procedures or
sanctions appropriate for an ethics code.
Each reporting company that has adopted a code of
ethics must disclose the code. The company may
make the disclosure in one of three ways: (a) by
filing a copy of the code as an exhibit to its annual
report, (b) by posting the text of the code on its
website, provided that the company has disclosed its
website address and intention to disclose its code on
its website in its annual report or (c) by providing an
undertaking in its annual report to provide a copy of
its code to any person without charge upon request.
In addition, on or after the date on which each
reporting company files its first annual report in
which disclosure of its code of ethics is required,
each such company must “immediately” disclose the
nature of certain amendments to, or any waivers
granted from, its adopted code of ethics using one of
two disclosure methods: (a) disclosure pursuant to a
newly added disclosure item on Form 8-K or
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(b) disclosure on the company’s website if the
company has disclosed in its most recently filed
annual report that it intends to disclose these events
on its website and disclosed its website address. In
either case, the company must make the disclosure
within five business days after it has made the change
or granted the waiver.
persons performing similar functions. Unlike a
domestic issuer, however, a foreign private issuer
need not provide “immediate” disclosure of certain
changes to, or any waivers from, the issuer’s code of
ethics reflecting the fact that, unlike a domestic
reporting company, reporting foreign private issuers
are not subject to specific current disclosure
requirements under the Exchange Act.
FOREIGN PRIVATE ISSUERS
Generally, each foreign private issuer subject to
Exchange Act reporting requirements is subject to
the new disclosure requirements adopted in the new
Rule. Each reporting foreign private issuer,
therefore, must make the required disclosures with
respect to whether it has an audit committee financial
expert serving on its audit committee. Until the SEC
adopts a standard of independence as part of its final
rulemaking under Section 301 of the Act (addressing
standards related to listed company audit
committees), however, a reporting foreign private
issuer need not disclose whether its audit committee
financial experts are independent. The SEC intends
that the final rule adopted under Section 301 of the
Act will apply to foreign private issuers and will
amend Forms 20-F and 40-F to then require
disclosure concerning the independence of their audit
committee financial experts.
Each reporting foreign private issuer must also make
the required disclosures with respect to whether it
has adopted a written “code of ethics” applicable to
its principal executive officer, principal financial
officer, principal accounting officer or controller, or
ASSET-BACKED ISSUERS
Recognizing the special nature of asset-backed
issuers, including the fact that such entities are
subject to substantially different reporting
requirements than those that apply to other reporting
companies, the SEC has excluded asset-backed
issuers from the new disclosure requirements
adopted in the new Rule.
REGISTERED INVESTMENT COMPANIES
The SEC has set forth rules to implement the
requirements of Sections 406 and 407 of the Act with
respect to registered investment companies in a
separate rulemaking, Release Nos. 34-47262; IC25914; File Nos. S7-33-02; S7-40-02, available at
http://www.sec.gov/rules/final/34-47262.htm, which
K&L will address in a separate client alert.
CARY J. MEER
202.778.9107
cmeer@kl.com
SEAN R. HUNT
202.778.9268
shunt@kl.com
Kirkpatrick & Lockhart LLP
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Stephen L. Palmer 617.951.9211
spalmer@kl.com
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Norman R. Miller
214.939.4906
nmiller@kl.com
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Mark A. Klein
Thomas J. Poletti
310.552.5033
310.552.5045
mklein@kl.com
tpoletti@kl.com
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Clayton E. Parker
305.539.3306
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Stephen A. Timoni 973.848.4020
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John D. Vaughan 212.536.4006 jvaughan@kl.com
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Janice C. Hartman 412.355.6444 jhartman@kl.com
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cparker@kl.com
stimoni@kl.com
WASHINGTON
Alan J. Berkeley
202.778.9050 aberkeley@kl.com
Thomas F. Cooney 202.778.9076 tcooney@kl.com
Cary J. Meer
202.778.9107 cmeer@kl.com
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.