As mandated in Section 407 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules and amendments requiring each Securities and Exchange Commission reporting company to disclose whether it has at least one "audit committee financial expert" serving on its audit committee and, if so, the name of the expert and whether the expert is independent of management. The rules and amendments do not require a reporting company to have an audit committee financial expert. A reporting company that does not have an audit committee financial expert must disclose that it does not and explain why it does not. SEC reporting companies, other than small business issuers, must comply with the audit committee financial expert disclosure requirements in their annual reports for fiscal years ending on or after July 15, 2003. Small business issuers must comply with the disclosure requirements for fiscal years ending on or after December 15, 2003.
Under the SEC rules implementing Section 407 of the Sarbanes-Oxley Act, each reporting company will be required to disclose in its annual report filed pursuant to the Securities Exchange Act of 1934:
- The determination by its board of directors as to whether the company either has or does not have at least one audit committee financial expert serving on its audit committee, and if it does not have such an expert, why not;
- If its board of directors determines that it has one or more audit committee financial experts, the name of at least one of the experts; and
- Whether the audit committee financial expert is independent of management under the independence standards of the New York Stock Exchange, American Stock Exchange or Nasdaq, as appropriate.
In determining whether the audit committee financial expert is independent of management, companies with securities listed on the NYSE, Amex or Nasdaq should utilize the independence standards of the self-regulatory organization on which its securities are listed. Companies that do not have securities listed on the NYSE, Amex or Nasdaq will be required to utilize the independence standards of one of those three self-regulatory organizations applied on a consistent basis in making the independence determination.
A reporting company will not satisfy the disclosure obligation by stating that it decided not to make a determination as to whether or not it has an audit committee financial expert, or by simply disclosing the qualifications of all its audit committee members. Moreover, if the board of directors determines that at least one member of the audit committee qualifies as an audit committee financial expert, the company may not disclose that it does not have an audit committee financial expert.
Audit Committee Financial Expert
To qualify as an audit committee financial expert, an audit committee member must have each of the following five attributes:
- An understanding of generally accepted accounting principles and financial statements;
- The ability to assess the general application of generally accepted accounting principles in connection with the accounting for estimates, accruals and reserves;
- 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 company's financial statements, or experience actively supervising one or more persons engaged in such activities;
- An understanding of internal controls and procedures for financial reporting; and
- An understanding of audit committee functions.
The audit committee financial expert definition adopted by the SEC is less restrictive and less focused on technical accounting or auditing expertise than the definition it originally proposed. Consequently, a greater number of audit committee members should qualify as audit committee financial experts than would have qualified if the SEC had adopted its original proposal.
The recently adopted SEC rules provide that an audit committee financial expert could acquire the five required attributes through any one or more of the following avenues:
- 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;
- Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor, or person performing similar functions;
- Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or
- Other relevant experience; but where the expert is qualified on the basis of having other relevant experience, the company must provide a brief listing of the relevant experience.
As an acknowledgment that an audit committee financial expert may acquire the five required attributes in a variety of ways, the SEC observed, in its adopting release, that the relevant experience does not need to have been acquired from an SEC reporting company. The experience can be gained, for example, at a private company or a foreign company that is publicly traded abroad but is not registered under the Securities Exchange Act. Moreover, the SEC emphasized that the expertise should be the product of experience, not merely education. It noted also that investment bankers, venture capitalists and professional financial analysts may have the requisite knowledge and experience. Similarly, the SEC stated that individuals serving in governmental, self-regulatory and private sector bodies overseeing the banking, insurance, and securities industries may have the requisite knowledge and experience. In addition, the SEC stated that a principal executive officer should not be presumed to qualify as an audit committee financial expert. Instead, the board of directors must determine that he or she actively participated in and contributed to the process of addressing financial and accounting issues.
The SEC's final rules do not include the non-exclusive list of qualitative factors contained in the proposing release for a company's board to consider in assessing audit committee financial expert candidates that had been included in its rule proposal. That list addressed such matters as breadth and level of an audit committee member's understanding and involvement in relevant activities and the types of duties held in those positions. The SEC stated that a reporting company's board of directors should consider all relevant facts and circumstances in its determination, including those qualitative factors the SEC had identified in that earlier list.
Safe Harbor for Audit Committee Financial Experts
The final SEC rules include a safe harbor to clarify that:
- The audit committee financial expert will not be deemed to be an "expert" for any purpose, including liability under Section 11 of the Securities Act of 1933, as a result of being designated or identified as an audit committee financial expert;
- The designation or identification of an audit committee financial expert does not impose on the audit committee financial expert any duties, obligations or liabilities that are greater than those imposed on him or her as a member of the audit committee and board of directors; and
- 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.
Consequently, information in a registration statement reviewed by an audit committee financial expert will not be deemed "expertised" unless that person is acting in the capacity of some other type of traditionally recognized expert. Moreover, the audit committee financial expert will not be expected to exercise a higher level of due diligence with respect to a registration statement as a result of being designated or identified as an audit committee financial expert.
The safe harbor is likely to be tested by the plaintiffs' bar.
Possible Delaware Law Claims
The validity of the safe harbor can be expected to be tested through litigation. In recent conferences, Justice Strine of the Delaware judiciary has remarked that the Delaware Chancery Court may be receptive to taking on cases involving audit committee independence. It would require only a relatively short extension to bring cases involving audit committee financial experts within the purview of the Delaware courts. The jurisdictional nexus for these cases, as described by Justice Strine, could be gained by asserting claims of breach of directors' duties of care and loyalty. A development along these lines would undermine significantly the safe harbor intended by the SEC.
In implementing the audit committee financial expert disclosure rules, SEC reporting companies should consider:
- The audit committee financial expert rule is a disclosure rule, not a legal requirement to have an audit committee financial expert. However, the failure to have an audit committee financial expert could be embarrassing to the company, cause the company to lose or be unable to gain institutional investor support for its securities, or possibly be used as evidence of poor corporate governance in connection with securities or corporate governance litigation against the company.
- The board of directors should consider whether it wishes to search for a new member with more financial expertise and experience than those presently serving on the audit committee.
- The board of directors should consider succession planning with regard to membership on its audit committee to assure continual representation on the committee by individuals with financial expertise and experience.
- If more than one audit committee member might qualify as an audit committee financial expert, the board of directors should consider whether to designate more than one audit committee financial expert. Notwithstanding the regulatory safe harbor for audit committee financial experts, the boards of directors of some companies have elected to designated multiple audit committee financial experts in order to avoid the possibility that one member of the committee has greater potential duties and liability than the other members of the committee and to demonstrate their dedication to good corporate governance.
- If it has not done so already, an SEC reporting company should consider modifying its audit committee charters to require that the audit committee have at least one financial expert. When modifying its charter, the company should review, or consider adding, appropriate disclaimers concerning the scope of the committee's responsibilities. The updated charter can be used as a working draft to be updated as the SEC and self-regulatory organizations implement further corporate governance reforms. The audit committee should use the audit committee charter to develop a meeting agenda and allocate responsibilities to ensure that the committee fulfills its responsibilities under the charter.
Practical Considerations Before You Become the Financial Expert
Be careful, you might get what you wish for. If you have been invited to join the Board of Directors of a public company, you might want to evaluate carefully the company and its Board of Directors. In this era of dynamic changes in corporate governance, the role and responsibilities of the corporate director have been heightened along with the accountability of the corporate director to the investing public. Consequently, before accepting that invitation, you may want to ask yourself and the company a series of questions in order to assure yourself that you are making a wise decision.
Why do they want me? You should evaluate whether you possess special skills, attributes or experience that will be valued by the Board of Directors. Consider how your characteristics contrast with those of the company's senior management and other members of the Board. Ensure that you are not being selected in order to add luster to an otherwise undistinguished Board. In recent years, some prominent members of public company Boards have found their reputations sullied as a result of their association with a company that used poor corporate governance practices.
What is the company's attitude toward disclosure and corporate governance? SEC Chairman William Donaldson recently remarked that the senior management and Board of Directors of a public company must set an appropriate tone from the top that assures employees, shareholders and the public at large that the company is dedicated to principles of strong corporate governance and of upholding strict ethical and legal norms. Through discussions with the company's CEO, CFO, general counsel and the members of senior management as well as with members of the Board, you can assess whether the company meets those standards. During this process, you should request and review copies of minutes of the Board and its committees over the past several years. The minutes should be very revealing about procedural safeguards undertaken by the Board and its committees, and may be informative about the level of communication between senior management and the Board and its committees as well as the use of outside advisors to assist them in making well-informed decisions. Likewise, a review of recent SEC comment letters issued in connection with the review of the company's securities law filings and responses to those comments submitted by the company and its advisors should provide further insights into the adequacy of the company's financial reporting and securities law disclosures and the company's attitude toward compliance with applicable securities laws and regulations.
In addition, a review of the company's SEC filings, financial statements and corporate website as well as of reports of financial analysts who regularly cover the company may shed light on this issue. In particular, the company's Form10-K or proxy statement should disclose certain securities law violations, corporate bankruptcies and related matters to which company directors may have been subject during the past five years, which could reflect unfavorably upon their integrity or competency. Moreover, you should review a copy of the company's code of ethics and inquire as to the circumstances of any code violations or waivers. Similarly, you should examine recent management letters from the company's independent auditor as well as other material communications from the auditor, and undertake a Lexis/Nexis or other database search to glean public views of the company.
What will they want me to do? You should inquire as to what Board committee assignments you are likely to receive. Before accepting a committee assignment, you will want to be comfortable that you have the skill set and the available time to carry out the responsibilities of that position. For example, members of the Audit Committee or a stock exchange or Nasdaq listed company must be at least financially literate, and one member must satisfy the definition of an Audit Committee Financial Expert. As to time availability, Board committees are meeting with increasing frequency in this new era of corporate governance, and committee members are finding that they are spending increased time outside of meetings orienting themselves concerning the company and their committee responsibilities in addition to preparing for meetings. You may want to look into the company's Board policy concerning committee rotations in order to understand whether the more burdensome committee responsibilities are shared over reasonable time periods among all of the Board members.
What is the company's risk exposure? You will want to assess the company's risk exposure and risk management techniques. This will entail discussions with, among others, the company's CFO, risk manager, tax manager and General Counsel. During this process, you will want to be informed of the company's financial risks, including contingent liabilities, off-balance sheet financing arrangements and hedging techniques, insurance coverage and claims history, tax exposure, and pending and threatened litigation and lawsuits. The company's financial statement footnotes and the Management's Discussion and Analysis section of the company's SEC filings also should reveal a number of financial uncertainties encountered by the company. Moreover, you should look into risks faced by other members of the company's peer group to determine whether the company may encounter those risks in the future.
How are Board members protected from potential liability? Many companies have included provisions in their certificates of incorporation that shield Board members from liability to the fullest extent permitted under the law of their states of incorporation. Similarly, many companies provide for the indemnification of Board members, subject to applicable legal restrictions, through provisions in their certificates of incorporation or by-laws or by contract. In addition, state corporation law may afford certain legal protections to directors by allowing them to rely upon the advice and analysis of internal and external experts and advisors, and to consider constituencies other than the shareholders in carrying out their Board responsibilities. These legal, charter, by-law and contractual protections are usually supported by directors' and officers' liability insurance. You will want to receive and review, and have your personal counsel review, all relevant documentation on these matters, obtain information concerning any claims asserted or threatened to be asserted against Board members in recent years, and assess the financial viability of the company to make indemnification payments and of its D&O liability insurance carrier to make payments under the policy.
How do the Board and its committees function? You should try to learn the manner in which the Board functions and deliberates. You should inquire as to whether the Board has an independent chairman (which is not legally required), how it conducts executive sessions of independent directors, and whether there is a designated presiding director for those sessions on the role of presiding director rotates among Board or committee members, as applicable. The review of Board and committee minutes, discussed above, may offer clues as to the level of involvement of Board and committee members in the oversight of the company's business and affairs. By reviewing the company's proxy statement, you should be able to learn the nature of director conflicts of interest, related party transactions and interlocking directorships that might affect the behavior and decision making of the Board and committee members. Equally important, but more difficult to obtain, is information concerning the quality of discussion among Board and committee members, areas of disagreement among them and the methods by which they seek to resolve conflicts. Lastly, since your ability to function effectively as a Board member will be enhanced by being well informed about the company, you should look into the director orientation program offered by the company and opportunities offered by the company for the continuing education of directors.