(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Increased Transparency Object of Sarbanes-Oxley Proposals

The SEC has proposed broad rules to implement the mandates of the Sarbanes-Oxley Act regarding internal controls, financial experts on audit committees, codes of ethics for senior corporate officers, and the improper influencing of audits. In many instances, the proposals go beyond the core dictates of the Sarbanes-Oxley Act in an effort to fully carry out the intent of the historic legislation.

The SEC seeks to achieve the act's goals by providing greater transparency regarding issues such as the competency of audit committee members, compliance of senior officers with ethics codes of conduct, and the adequacy of a company's internal controls and procedures for financial reporting. By increasing transparency regarding key aspects of corporate activities, the proposals are designed to improve the quality of information available to investors.

Improper Audit Influence

As directed by Section 303(a) of the act, the SEC rules would prohibit a company's officers and directors, and persons acting under their direction, from improperly influencing an accounting firm's audit of corporate financial statements. Currently, it could be alleged generally that such conduct violates the antifraud provisions of the securities laws or aids and abets or causes the company's violations of those sections. The proposed rules, along with the statute, will provide the SEC with an additional means to address such conduct. They are also intended to enhance the credibility of financial statements.

The Sarbanes-Oxley Act covers persons acting under the direction of an executive. The SEC interprets Congress' use of the word direction in Section 303 to encompass a broader category of behavior than supervision. Thus, someone may be acting under the direction of an officer or director within the scope of the provision even if they are not under the supervision or control of that officer or director. Such persons might include company employees, as well as customers, vendors or creditors who, under the direction of an officer or director, provide false or misleading information to auditors.

In appropriate circumstances, persons acting under the direction of officers and directors also may include other partners or employees of the accounting firm, such as consultants or forensic accounting specialists retained by corporate counsel, and attorneys, securities professionals, or other advisers who pressure an auditor to limit the scope of the audit or to issue an unqualified report on the financial statements when such a report would be unwarranted.

In the case of an investment company, persons acting under the direction of officers and directors may include, among others, officers, directors, and employees of the fund's investment adviser, principal underwriter, custodian, or transfer agent. Similarly, the SEC proposals give a broad meaning to the statutory phrase engaged in the performance of an audit. Reading legislative intent, the Commission said the phrase should encompass the professional engagement period and any other time the auditor is called upon to make decisions regarding the financial statements, including during negotiations for retention of the auditor and subsequent to the professional engagement period when the auditor is considering whether to issue a consent on the use of prior years' audit reports. In limited circumstances, the proposed rules may even apply before the professional engagement.

In addition, the proposals are not limited to the audit of annual financial statements, but would include, among other things, improperly influencing an auditor during a review of interim financial statements or in connection with the issuance of a consent to the use of an auditor's report. Conducting reviews of interim financial statements and issuing consents to use past audit reports are sufficiently connected to the audit process, and improper influences during those processes are sufficiently connected to the harms that the act seeks to prevent, that they should be within the scope of the proposed rules.

For investment companies and business development companies, the prohibition on improper influence on the conduct of audits would cover not only officers and directors of the company itself, but also officers and directors of the investment adviser, sponsor, depositor, trustee, and administrator.

Code of Ethics

The Sarbanes-Oxley Act requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and, if not, why not. In addition, immediate disclosure is required of any change in, or waiver of, the company's code of ethics. Disclosure may be by filing a Form 8-K, by the Internet or by other electronic means. The act explains that code of ethics means such standards as are reasonably necessary to promote: honest and ethical conduct; accurate and understandable disclosure in periodic reports and other corporate public communications; and compliance with applicable governmental regulations.

The SEC proposals would extend the embrace of the code of ethics beyond senior financial officers to the principal executive officer. They would also add to deter wrongdoing to the legislative definition of code of ethics. Moreover, the proposals would add several additional elements to the three legislative elements of the definition of the code of ethics, including 1) the avoidance of conflicts of interest, including disclosure of any material transaction or relationship that reasonably could be expected to give rise to such a conflict, 2) the prompt internal reporting of violations of the code and 3) accountability for adherence to the code.

Similarly, the SEC would enhance a statutory element by adding the standard to comply with applicable law as well as with regulations. The SEC would require a company to file its code of ethics as an exhibit to its annual report. In addition, a company would have to file a Form 8-K, within two business days, upon a change to its code of ethics or the granting of a waiver from a code provision. Alternatively, the company could post the same information on its website within two business days. Finally, foreign private issuers would be covered by the disclosure requirements.

Audit Committee Financial Expert

The Sarbanes-Oxley Act requires disclosure of whether the company's audit committee includes among its members at least one financial expert. Congress believes that investors may find it relevant in making their investment decisions whether a company's audit committee has at least one member who has relevant, sophisticated financial expertise with which to discharge his or her duties.

In defining financial expert, the SEC was told to consider whether a person 1) understands Generally Accepted Accounting Principles and financial statements, 2) has experience preparing or auditing financial statements, 3) has experience with internal accounting controls and 4) understands audit committee functions.

The SEC proposals incorporate the above standards and would also require a financial expert to have experience preparing or auditing financial statements of a company that files reports with the Commission. Although the act does not specifically mandate it, the SEC would require disclosure of the number or names of the financial experts and whether the financial expert is independent. The Sarbanes-Oxley Act is silent on who should determine whether any of the audit committee members is a financial expert. The SEC reasons that the board of directors in its entirety is best-equipped to make the decision. Therefore, the proposals would require disclosure of the number and names of the persons that the board has determined to be the financial expert or experts. For foreign private issuers with a two-tier board, one tier designated as the management board and the other tier designated as the supervisory board, the supervisory or non-management board would be best-equipped to make the decision.

Internal Controls

The Sarbanes-Oxley Act requires that annual reports filed with the SEC must be accompanied by a statement by company management that management is responsible for creating and maintaining adequate internal controls. Under Section 401(a), management must also present its assessment of the effectiveness of those controls.

The SEC proposals would require the annual report to include an internal control report of management that includes 1) a statement of management's responsibilities for establishing and maintaining adequate internal controls and procedures for financial reporting, 2) conclusions about the effectiveness of the internal controls and procedures for financial reporting based on management's evaluation of those controls and procedures; and 3) a statement that the accounting firm that prepared the audit report relating to the financial statements included in the annual report has attested to, and reported on, management's evaluation of the company's internal controls and procedures for financial reporting.

The proposals do not specify the exact content of the management report since, in the SEC's view , such a mandate would probably result in boilerplate responses. Rather, management should tailor the report to the company's circumstances. Section 404(b) of the act requires accounting firms preparing corporate audit reports to attest to, and report on, management's assessment of the company's internal controls and procedures for financial reporting. The attestation and report must be made in accordance with standards for attestation engagements adopted by the public company accounting oversight board.

The SEC proposals would require a company to file the attestation in its annual report. While Section 404(b) does not require filing of the attestation report, the SEC believes that satisfaction of the statutory provision demands that a company file both the internal control report and the auditor's attestation report in its annual report. Section 404 does not apply to investment companies, and the SEC is not proposing to extend any of the requirements that would implement the statute to registered investment companies.