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SEC Rules Under Sarbanes-Oxley: Impact Beyond Issuers

Recently, the SEC issued a series of final rules under the Sarbanes-Oxley Act of 2002 (the "Act"). Besides the obvious impact of these rules on accountants and broker-dealers that happen to be public reporting companies subject to the Act, they contain certain provisions that significantly impact non-SEC reporting, broker-dealers, as well as the attorneys who work at such companies or represent them as outside counsel.

Attorney Conduct. The final rule covering professional conduct for attorneys (Release Nos. 33-8185; 34-47276; IC-25929) prescribes minimum standards of professional conduct for attorneys who appear and practice before the SEC, in the representation of issuers. The rule requires attorneys to report evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by an issuer "up the ladder" within the company, to the chief legal officer or the chief executive officer. If the CLO or CEO does not respond appropriately, the attorney is required to report the evidence to the company's audit committee, another committee of independent directors, or to the full board of directors. The SEC is still considering how to implement the so-called "noisy withdrawal" provisions, pursuant to which attorneys would have to notify the SEC if they believe the company is continuing to break securities laws, even after reports have been made to the company's CLO, audit committee or full board.

While most commentators have focused on the impact of this rule on issuers, the final version specifically provides that it is "also intended to reflect the duty of an attorney retained by an issuer to report to the issuer evidence of misconduct by an agent of the issuer (e.g., an underwriter) if the misconduct would have a material impact upon the issuer." This duty is set forth in §205.3(b) of the final rule, which reads in part:

If an attorney... becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney shall report such evidence to the issuer's chief legal officer...

The proposed rule stated that an attorney should act in the "best interest" of the issuer and its shareholders. In response to comments, the final SEC rule recognized that the "client" is the issuer and not any other stakeholders (employees, customers, etc.). However, it is important to recognize that this does not excuse lawyers from their duty to report violations of broker-dealers who serve as "agents" of the issuer. The new rule became effective on August 5, 2003.

Pension Blackout Periods. Another set of final rules that impacts broker-dealers concerns "Insider Trades During Pension Fund Blackout Periods" (Release No. 34-47225). These rules clarify the application of Sectionb306(a) of the Act and seek to prevent its evasion. Under Section 306(a) any director or executive officer of an issuer is prohibited from directly or indirectly buying, selling or transferring any equity security of the issuer during a "blackout period," provided that the director or executive officer acquired the security in connection with his or her service or employment with the company. Section 306(e)(4)(A) defines "blackout period" to mean any period of more than three consecutive business days during which the ability of not fewer than half of the participants or beneficiaries, under all individual account plans maintained by an issuer, to purchase, sell or otherwise acquire or transfer an interest in any equity security held in such an individual account plan is temporarily suspended by the issuer or by a fiduciary of the plan.

These final rules are intended to prevent directors or executives who are buying or selling their equity securities from gaining an unfair advantage over participants in or beneficiaries of an issuer's pension plan where the latter persons cannot engage in equivalent transactions through their plan accounts. To implement this policy, new Regulation BTR prohibits the trading of an issuer's equity securities by a director and executive officer during the blackout period. The SEC pointed out that it will give further consideration to the timing of the blackout period, in order to determine whether three business days or less are or may become a concern. The SEC is likely to take up this issue with the Department of Labor to facilitate agency coordination.

While the focus of these new rules and the specifics regarding the notice requirements and other aspects are aimed mostly at issuers and their employees, it is important for all broker-dealers to understand them and prepare their back offices and update their compliance procedures to address these trading prohibitions.

MD&A Disclosure. Broker-dealers should also review the final rule on "Disclosure in MD&A About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations," (Release Nos. 33-8182; 34-47264; FR-67; IS-1266). Again, while this rule primarily impacts issuers, broker-dealers involved in securities offerings as underwriters on behalf of reporting firms are responsible for the accuracy of the offering information disclosed and will need to comply with this rule's provisions and safe harbors.

Listing Prohibition. The national securities exchanges and Nasdaq have been directed to prohibit issuers that are not in compliance with the audit committee requirements of the Act from listing their securities. The impact of these listing prohibitions on the brokerage industry is obvious.

Under the new rules and amendments (see SEC Release Nos. 33-8220; 34-47654; IC-26001), in order to list its securities an issuer must:

  • have each member of its audit committee be independent, in accordance with the criteria set forth in Section 10A(m) of the Act;
  • have full responsibility for the appointment, compensation, retention and oversight of the work of any registered public accounting firm that has been engaged to prepare or issue an audit report or perform other audits, review or attest services for the issuer, and the accounting firm must report directly to the audit committee;
  • establish procedures for the receipt, retention and treatment of complaints on accounting or auditing matters, including procedures for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters;
  • exercise the authority to engage independent counsel and other advisers, as necessary to carry out its duties; and
  • provide appropriate funding for the audit committee.

Under the final rules, the criteria for the independence of audit committee members bar such members from accepting any consulting, advisory or compensatory fee from the issuer or any subsidiary thereof, other than in the individual's capacity as a member of the board or a board committee. Further, a committee member must not be an affiliated person of the issuer or any subsidiary, apart from membership of the board or any board committee.

Because these rules apply to both domestic and foreign-listed issuers, certain provisions applicable only to foreign private issuers have been included to address their special circumstances. For example, non-management employees are allowed to serve as audit committee members consistent with "co-determination" and similar requirements in some countries. Shareholders are allowed to select or ratify the selection of auditors in order to be consistent with many foreign country requirements. The SEC has split the implementation dates for the rules: generally, listed issuers will be required to comply with the new listing rules by the date of their first annual shareholders meetings after January 15, 2004 but in no event later than October 31, 2004. Foreign private issuers and small business issuers will be required to comply by July 31, 2005.

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