Sarbanes-Oxley Update: New Rules Impact Investment Companies and Investment Advisers

The Sarbanes-Oxley Act of 2002 significantly has changed the regulatory environment for public companies. At open meetings held on January 22 and 23, 2003, the SEC approved new rules and rule amendments implementing some important provisions of the Sarbanes-Oxley Act. Kramer Levin attorneys summarize recent developments as they relate to investment companies and investment advisers.

SEC Actions on January 22, 2003

Funds Must Certify Reports Containing Financial Statements

The SEC approved rules requiring investment companies to file shareholder reports on new Form N-CSR, to be certified by principal executive and financial officers. The rules also require funds to maintain and regularly evaluate internal disclosure controls and procedures, which must be designed to ensure that funds promptly record, process, summarize and report financial and other information.

The SEC approved Form N-CSR, which will now contain the certification previously required by Form N-SAR (except in the case of unit investment trusts and small business investment companies).

SEC Approves Fund Code of Ethics Rule and Defines “Audit Committee Financial Expert”

The SEC approved rules requiring registered management investment companies to disclose whether they have adopted a code of ethics for principal executive officers and senior financial officers.

Also, the SEC defined who qualifies as a fund “audit committee financial expert,” which is similar to the definition it applied to operating companies last week. Funds must disclose whether they have audit committee financial experts. If so, they must disclose the name of the expert, and if not, the reasons why not.

To qualify as a fund “audit committee financial expert,” a person must have all five of the following characteristics:

• an understanding of financial statements and generally accepted accounting principles;
• an ability to assess the general application of such 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 registrant'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.

In response to many industry comments, the SEC scaled back its original proposal. The proposal would have required “financial experts” to have experience preparing or auditing financial statements that present accounting issues “generally comparable” to the accounting issues raised by the registrant’s financial statements. Commenters were concerned that few audit committee members could meet the proposal’s rigid standards. Although the SEC recently suggested that the definition to be applied to funds would differ from the definition applied to operating companies, it opted to use the same definition.

SEC Approves Auditor Independence Rules

The SEC approved new rules designed to ensure auditor independence, as required by Section 208 of the Sarbanes-Oxley Act. The Act required the SEC to:

• require audit committees to pre-approve all audit and non-audit services provided by an auditor;
• prohibit certain audit partners from providing audit services for more than five or seven consecutive years, depending on the partner's role in the audit;
• prohibit a firm from auditing an issuer's financial statements if members of the auditor had been members of the issuer's management team within the year preceding the audit;
• require that the auditor report "critical accounting policies" to the audit committee; and
• require disclosure to investors regarding other services provided to, and fees paid by the issuer to the auditor.
   

Pre-approval of non-audit services means that the audit committee must determine that the auditor can be impartial and objective as to the work. In addition, accountants would not be independent from their clients if members of the client's engagement team receive compensation based on their selling services to that client other than audit, review and attest services.

SEC Approves MD&A Disclosure of Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments

The SEC approved rules requiring public companies to disclose in their “Management’s Discussion and Analysis” section of SEC filings:

• off-balance sheet arrangements, including
  • certain guarantee contracts;
  • retained or contingent interests in assets transferred to an unconsolidated entity;
  • derivative instruments that are classified as equity; or
  • material variable interests in unconsolidated entities that conduct certain activities; and
• a table of payments under specified contractual obligations due in short- and long-term periods.
  
  

Companies must disclose additional information necessary to understand the off-balance sheet arrangements and their material effects.

SEC Approves Audit Record Retention Rules

The SEC approved rules expanding recordkeeping requirements that apply to auditors that audit and review financial statements filed with the SEC. Auditors must now retain the following documents, among other things:

• work papers and other documents that form the basis of the audit or review; and
• memoranda, correspondence, communications, other documents, and records (including electronic records), that they
  • create, send or receive in connection with the audit or review and
  • that contain conclusions, opinions, analyses, or financial data related to the audit or review.

SEC Actions on January 23, 2003

SEC Approves Attorney Conduct Rules; Tables Mandatory “Noisy Withdrawal” Provision

The SEC approved rules setting standards of professional conduct for attorneys “appearing and practicing before” the SEC in any way involving public companies. The SEC deferred action on its controversial “noisy withdrawal” proposal pending further study of an alternative requirement.

“Up the ladder” reporting . The rules require lawyers to report “evidence of a material violation” to a company’s chief legal officer. Lawyers who do not receive an “appropriate response” must report the violation “up the ladder” to the CEO, audit committee or full board of directors.

What triggers “evidence of a material violation?” The triggering standard for reporting up the ladder, designed to be objective rather than subjective, must “involve credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur." The original proposal set the standard as “information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring or is about to occur.”

“Noisy withdrawal.” Acknowledging the controversy surrounding the “noisy withdrawal” provisions, the SEC extended the comment period for 60 days mandatory. The final rule allows but does not require lawyers to effect a "noisy withdrawal." The SEC proposed an alternate rule: If lawyers who report “evidence of a material violation” up the ladder do not receive an appropriate response, then they would be required to withdraw, albeit “quietly.” The new proposal, however, would require the companies, not their lawyers, to notify the SEC of a lawyer’s withdrawal from representation and the reasons for it.

To whom do the rules apply? The rules apply to attorneys “appearing and practicing” before the SEC who:

• provide legal advice or services;
• have an attorney-client relationship; and
• are on notice that documents that they had a role in preparing will be filed with the SEC.
   

The original proposal would have applied the rules to a broader category of attorneys, even if they were involved with a client in non-legal capacities.

What about foreign attorneys? The rules do not apply to foreign attorneys who (1) are admitted to practice law in a foreign jurisdiction, and (2) do not hold themselves out as practicing or giving legal advice regarding U.S. law; and (3) conduct activities that would otherwise be considered “appearing and practicing” before the SEC only (a) incidentally to their foreign practice, or (ii) in consultation with U.S. counsel. To be excluded from the rule, foreign lawyers must meet all three criteria. The original proposal drew no distinction between U.S. and foreign lawyers. Also, lawyers practicing outside the U.S. need not comply with the rules to the extent that foreign law prohibits their compliance.

What is a “qualified legal compliance committee?” Companies may establish a “qualified legal compliance committee” (QLCC), consisting of at least one audit committee member, and two or more independent directors. Lawyers may satisfy their reporting obligations under the rules by reporting violations to the QLCC.

When can lawyers disclose confidential client information? Lawyers may voluntary disclose confidential client information, without the client’s consent, if necessary,

• to prevent the issuer from committing a material violation likely to cause substantial financial injury to the financial interests or property of the issuer or investors;
• to prevent the issuer from committing an illegal act; or
• to rectify the consequences of a material violation or illegal act in which the attorney’s services have been used.
  

Do the federal rules preempt state law? Generally, the federal rules preempt conflicting state laws, unless the state laws impose more rigorous obligations that are not inconsistent with the federal rules.

Is there a private right of action? The rules specify that there is no private right of action against lawyers who violate the rules, and that only the SEC can enforce the rules.

When do the rules become effective? The rules become effective 180 days after their publication in the Federal Register.