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SEC Staff Discusses Section 404 Guidance and 10A Investigations

Paul Dudek, head of the SEC’s Office of International Corporation Finance, said the guidance on implementing the reporting provisions of Sarbanes-Oxley Act section 404 is based on the staff’s experience with the more than 2,500 internal controls reports it has already received, 8% of which include disclosure of one or more material weaknesses. He discussed the guidance at the Practicing Law Institute’s recent conference on foreign issuers and the U.S. securities laws.  Dudek said one of the key topics covered by the guidance is communication with auditors. He said that an open dialogue between management and the auditor is critical to the quality of the section 404 reports. He said that another important piece of the guidance is the discussion of how companies can achieve reasonable assurance regarding the reliability of their financial statements.  The guidance includes a section on evaluating internal control deficiencies. Dudek said that companies need to discuss how significant the deficiency is, and whether it is mitigated by other compensating controls. In determining significance, he said that management must examine both quantitative and qualitative elements.

The SEC has received a number of questions about the disclosure of a material weakness, he said. The guidance addresses those questions, and includes a discussion of a company’s need to describe the nature, impact and plans for remediation of any internal controls deficiency.  With respect to foreign issuers, Dudek said that by the time they are required to comply with section 404, the SEC will have two years of experience with reports filed by domestic issuers. That may lead to more guidance from the staff prior to the time that foreign companies must comply, according to Dudek.

He noted that much has been said about the costs and burdens of section 404 compliance. He reminded the audience that section 404 has many benefits, including that it has brought senior management into the internal controls process, which has resulted in an overall improvement of the system.  Wayne Carnall of PricewaterhouseCoopers said that, when considering the cost of section 404 for foreign issuers, it is important to look at the relative cost. If only 10% of a foreign company’s shares trade in the U.S. , he noted, then section 404 compliance will cost 10 times what it costs U.S. companies.  Carnall noted that many people are discussing how filings are being delayed by the requirement that management sign off on section 404 reports.  “From an auditor’s perspective, we find that 10A investigations slow us down much more,” he said.  He said that section 10A investigations have now become common and can be very lengthy. One of the most time-consuming pieces, according to Carnall, is getting the company to acknowledge that an investigation needs to be done.

Michael Mann of Richards Spears Kibbe & Orbe said that once an auditor identifies a section 10A issue, the company must do an independent investigation.  “The company will not get an audit opinion until it conducts an investigation, presents its findings to the auditor and provides a remediation plan,” he said.

Carnall agreed, saying that once a 10A issue arises, there is no way to avoid the investigation.  “As a matter of policy, we never retract a request for a 10A investigation,” he said. Carnall said that counsel should be aware that independent investigators will go through all of a company’s email. He has seen a number of cases where this has raised issues completely unrelated to the original inquiry.

Companies’ filings were delayed and, in a number of cases, CEOs and CFOs were terminated because of these investigations.

Carnall also said that he has seen many instances where the market’s reaction to the announcement of a 10A investigation far exceeded the crime that was committed. It is important to consider whether it was an intentional act before passing judgment, he said. He said that foreign companies also face 10A issues, and that they currently are more prevalent in Europe than in South America .  “Some of the largest companies in the world have done 10A investigations in the last 18 months,” he said. “Culturally, it is more difficult outside the U.S. because it puts a strain on the management/auditor relationship, and there is more emphasis on personal relationships with foreign companies,” Carnall said.