January 23, 2003
SEC Adopts Sarbanes-Oxley Rules Relating To Auditor Independence,
MD&A Disclosure of Off-Balance Sheet Arrangements and Contractual Obligations
and Other Matters
As part of the continuing flow of new requirements resulting from the Sarbanes-Oxley Act of 2002
(Sarbox), the SEC approved yesterday the adoption of several sets of new rules affecting public
companies. The final rules, which implement various provisions of Sarbox, will:
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amend existing requirements regarding auditor independence; and
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require public companies to include in their MD&A a discussion of off-balance sheet
arrangements and contractual obligations.
Although not addressed in detail in this Bulletin, the SEC also approved new rules which would:
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require registered management investment companies to file certified shareholder reports
with the SEC; and
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require auditors to retain records relevant to the audits and reviews of financial statements
filed with the SEC.
The text of the final rules has not yet been publicly released. Accordingly, the description below,
which is intended to alert you to the Commission’s actions, is based on statements made at the
SEC's open meeting and is only preliminary and is subject to change upon review of the final rules.
We will supplement this memorandum with further details and recommended actions after the SEC
makes public the complete text of the rules.
Auditor Independence
On December 2, 2002, the SEC issued proposed rules pursuant to Title II of Sarbox, which directed
the SEC to implement the provisions relating to auditor independence. The proposed rules would:
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revise the SEC's regulations related to the non-audit services that, if provided to an audit
client, would impair an accounting firm’s independence;
Note: This Bulletin is intended solely for general informational purposes and should not be construed as, or used as a substitute for, legal advice with
respect to specific transactions. Such advice requires a detailed analysis of applicable requirements and an evaluation of precise factual information.
We do not undertake to keep recipients advised as to all relevant legal developments. This Bulletin may be construed as an advertisement or
solicitation. © 2003 Bryan Cave LLP. All Rights Reserved.
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define the circumstances whereby an issuer’s audit committee can and should pre-approve all
audit and allowable non-audit services provided to the issuer by the auditor of an issuer’s
financial statements;
prohibit partners on the audit engagement team from providing audit serv ices to the issuer
for more than five consecutive years;
prohibit an accounting firm from auditing an issuer's financial statements if certain members
of management of that issuer had been members of the accounting firm's audit engagement
team within the one-year period preceding the commencement of audit procedures; and
require that the auditor of an issuer's financial statements report certain matters to the
issuer's audit committee, including “critical” accounting policies used by the issuer.
In addition, the SEC also proposed rules defining an accountant as not being independent from an
audit client if any partner, principal or shareholder of the accounting firm who is a member of the
engagement team received compensation based on any service provided or sold to that client other
than audit, review and attest services.
Further, the SEC proposed to amend and require additional disclosures of information related to the
audit and non-audit services provided by, and fees paid by the issuer to, the auditor of the issuer's
financial statements.
For a more detailed summary of the proposed rules, please see our December 17, 2002 Corporate
Finance Bulletin “SEC Proposes New Rules Regarding Auditor Independence.” This bulletin is
available via the direct link to our Web site included at the end of this memorandum.
The proposed rules were adopted with certain modifications, which are discussed below, and will be
effective 90 days after their publication in the Federal Register, with transition periods for various
provisions.
In response to over 200 comment letters, the following provisions of the proposed rules were
modified by the final rules:
Rotation of Audit Partners
Section 203 of the Sarbanes-Oxley Act provides that the lead audit partner and the reviewing partner
may not serve on the engagement in that capacity for more than five consecutive years. The
proposed rules significantly expanded the Act’s requirements by subjecting all partners working on
the audit engagement for five consecutive years to a five-year “time-out” period before they can
return.
As modified, the final rules loosen these rotation requirement for partners other than the lead or
concurring partners, and provide an exception from rotation for small audit firms. The final rules
will require the rotation of those partners that could have a significant impact on the financial
statements and/or those that have a strong relationship to management. The final rules specifically
provide that:
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lead or concurring partners of the issuer, as well as lead partners of major subsidiaries of the
issuer (determined utilizing a 20% of assets or revenue test), will be limited to five years of
service, followed by five-year “time-out” period;
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certain other partners would be limited to seven years of service, followed by a two-year
“time-out” period; and
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as an alternative, small audit firms may choose to be exempt from the rotation requirement
for engagements where rotation would not be workable, provided that the engagement is
reviewed by the Public Company Accounting Oversight Board at least once every three
years. Small audit firms will be defined as firms of ten or fewer partners performing audit
services for five or fewer audit clients.
In response to questions from various commissioners, the Staff acknowledged that, due to the
transition period in effecting the new rules, it was possible for non-lead/concurring partners to be
in place for significantly longer than seven years in the aggregate before rotating, based upon prior
years of service. However, Chairman Pitt noted that nothing in the rules prevented audit
committees, in the exercise of their oversight function, from making judgments concerning
individual partners and where appropriate, imposing shorter rotation periods.
Prohibited and Allowable Non-Audit and Tax Services
Section 201 of Sarbox amended the Securities Exchange Act of 1934 by providing that it shall be
unlawful for a registered public accounting firm that performs an audit of an issuer’s financial
statements, or any associated person, to provide to that issuer, contemporaneously with the audit,
any non-audit service, including nine non-audit services specified in the Sarbanes-Oxley Act. The
nine services specifically prohibited are:
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bookkeeping or other services related to the a ccounting records or financial statements of
the audit client;
financial information systems design and implementation;
appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
actuarial services;
internal audit outsourcing serv ices;
management functions or human resources;
broker or dealer, investment adviser, or investment banking services;
legal services and expert services unrelated to the audit; and
any other service that the Public Company Accounting Oversight Board determines, by
regulation, is impermissible.
The Commissioners discussed specific clarifications or modifications to three categories: tax
services, legal services and expert services:
In response to comments, the final rules will clarify that tax services are generally permissible, such
as tax compliance, tax planning and tax advice services. The only explicitly prohibited service will be
representation of the issuer in the tax courts or other instances of public advocacy. However, with
respect to all other tax services, the final rules will indicate that audit committees should review the
proposed services carefully for independence when making the decision to pre-approve such
services.
Second, the final rules will indicate that, to the extent a foreign jurisdiction treats a particular service
as “legal services” under the laws of that jurisdiction, those services may nonetheless be rendered if
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considered to be permissible non-audit services in the United States. For example, tax services are
considered a legal service in some foreign jurisdictions, but may be a permissible non-audit service in
the United States.
Finally, the Staff clarified the limits of the “expert services” category. Although an auditor cannot
provide expert services, particularly in connection with litigation, administrative or regulatory
proceedings, auditors may perform and report on the factual results of internal investigations or
investigations initiated at the request of the audit committee, so long as the auditor is not engaged by
legal counsel or cast in an advocacy role with respect to any such proceedings.
Small Business/Small Firm Considerations
To foster competition by smaller accounting firms, the final rules will provide that firms with fewer
than five audit clients and fewer than ten partners may be exempt from the partner rotation and
compensation provisions, provided each of these engagements is subject to a special review by the
Public Company Accounting Oversight Board at least every three years.
Foreign Considerations
The SEC recognized that foreign accounting firms or foreign private issuers may face additional
issues in implementing certain rules. Changes to the proposed rule relating to the depth of partner
rotation and the scope of personnel subject to the "cooling off" period apply to foreign accounting
firms. Moreover, additional time is being afforded to foreign accounting firms with respect to
compliance with rotation requirements. The final rules will provide guidance on the provision of
non-audit services by foreign accounting firms, including the treatment of legal services and tax
advice.
Additional Information
The SEC’s press release announcing the final rules may be found at:
http://www.sec.gov/news/press/2003-9.htm.
MD&A Disclosure of Off-Balance Sheet Arrangements, Contractual Obligations and
Contingent Liabilities and Commitments
Section 401(a) of Sarbox requires the SEC to adopt rules to require that 10-Ks and 10-Qs disclose
"all material off-balance sheet transactions, arrangements, obligations (including contingent
obligations), and other relationships of the issuer with unconsolidated entities or other persons, that
may have a material current or future effect on financial condition, changes in financial condition,
results of operations, liquidity, capital expenditures, capital resources, or significant components of
revenues or expenses."
On November 4, 2002, the SEC issued proposed rules to implement Section 401(a) and to codify
recent SEC statements regarding the quality of corporate disclosure. These proposed rules would
generally require each public company, including foreign private issuers, to provide, in a separately
captioned subsection of Management’s Discussion and Analysis of Financial Condition and Results
of Operations (“MD&A”), a comprehensive explanation of its off-balance sheet arrangements. The
proposed rules also would generally require each public company, including foreign private issuers,
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to provide in MD&A an overview of its aggregate contractual obligations in a tabular format and
contingent liabilities and commitments in either a textual or tabular format.
For a more detailed summary of the proposed rules, please see our December 4, 2002 Corporate
Finance Bulletin “SEC Proposes Rules Requiring MD&A Disclosure of Off-Balance Sheet
Arrangements, Contractual Obligations and Contingent Liabilities and Commitments.” This bulletin
is available via the direct link to our Web site included at the end of this memorandum.
As a result of over fifty comment letters, major issues were identified in four areas:
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the scope of the definition of the term “off-balance sheet arrangement” was too vague and
captured unintended activities;
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the disclosure requirements were overly prescriptive;
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the disclosure standard should be the same “reasonably likely” standard that governs the rest
of MD&A, rather than the “remoteness” standard originally proposed; and
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the scope of the required disclosure of contractual obligations/contingent liabilities and
commitments needed greater precision.
Based upon these comments, the final rules have been modified in the following ways:
Revised definition of “Off-Balance Sheet Arrangement”
The definition of “off-balance sheet arrangement” has been revised to focus more clearly on
disclosure of the means through which companies typically structure off-balance sheet arrangements
or otherwise incur risks of loss that are not fully transparent to investors. The revised definition
includes the following categories of arrangements:
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certain guarantee contracts defined by reference to FASB Interpretation No. 45;
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retained interests or contingent interests in assets transferred to an unconsolidated entity;
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derivative instruments that are classified as equity; and
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material variable interests defined by reference to FASB Interpretation No. 46 in
consolidated entities that conduct certain specified activities.
Disclosure by foreign private issuers would be based on US – GAAP. The Staff noted that it
believed that domestic and foreign issuers should address the same “universe of disclosure.”
However, the Staff clarified that this rule did not create a requirement that foreign private issuers
actually disclose in conformity to US – GAAP, but rather that US – GAAP would be used as a basis
to identify matters subject to disclosure.
“Reasonably Likely” Threshold
The final rules require a company to “disclose its off-balance sheet arrangements that either have, or
are reasonably likely to have, a current or future material effect on the company’s financial
condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital
expenditures or capital resources that are material to investors.”
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The Staff noted that this disclosure threshold is consistent with the existing disclosure threshold in
MD&A, and viewed as providing the enhanced disclosure most useful to investors.
Scope of Disclosure
The scope of required disclosure has been narrowed in the final rules. The final rules outline limited
categories of key information which must be disclosed to the extent necessary to an understanding
of the off-balance sheet arrangements and their material effects. The categories are:
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the nature and business purpose of the company’s off-balance sheet arrangements;
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their importance to the company for liquidity, capital resources, market risk or credit risk
support or other benefits;
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the financial impact of the arrangements on the company and the company’s exposure to
risk; and
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known events, demands, commitments, trends or uncertainties that affect the company’s
ability to benefit from its off-balance sheet arrangements.
Consistent with the existing MD&A requirements, the final rules will contain a “principles-based”
requirement that a registrant provide such other information that it believes is necessary for an
understanding of its off-balance sheet a rrangements and their material effects.
Contractual Obligations Table
The proposed and final rules require that registrants (other than small business issuers) disclose, in
tabular format, the amounts of payments due under specified contractual obligations, aggregated by
category of contractual obligations, for specified time periods. The categories of contractual
obligations to be included in the table are defined by reference to the applicable accounting
literature.
In a change from the proposed rules, the final rules will not require tabular or narrative disclosure
regarding contingent liabilities and commitments. The Staff believed that further study of the issue
was needed, particularly in light of new accounting and FASB requirements that also address
contingent liabilities and commitments.
Transition Provisions
Registrants must comply with the disclosure requirements in SEC filings including financial
statements for fiscal years ending on or after June 15, 2003, in the case of off-balance sheet
arrangements, and for fiscal years ending on or after December 15, 2003, in the case of the table of
contractual obligations.
Additional Information
The SEC’s press release announcing the final rules may be found at:
http://www.sec.gov/news/press/2003-10.htm.
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Retention of Records Relevant to Audits and Reviews
The SEC also approved the adoption of Rule 2-06 of Regulation S-X to implement Section 802 of
Sarbox. While the proposed rules would have required retention of records relevant to audits or
reviews for five years, the final rules will require retention for seven years. The final rules will also
make clear that auditors must also retain records that contain information or data that is inconsistent
with their final conclusions, including documentation concerning consultation on, or resolution of,
differences in professional judgment. The SEC’s press release announcing the final rules may be
found at http://www.sec.gov/news/press/2003-11.htm.
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Please feel free to contact your Bryan Cave lawyer with any questions or issues relating to these final
rules. For further information on this topic or other Corporate Finance and Securities issues,
including our other Sarbanes-Oxley Client Bulletins, please contact us through the direct link to our
Web site, http://www.bryancave.com/practice/pubs.asp?csgID=211.
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