July 25, 2007

Enforcing Section 404 of the Sarbanes-Oxley Act

Earlier this month, I blogged about the potential Section 404 delay for non-accelerated filers that could result from the so-called Garrett-Feeney amendment to the Financial Services and General Government Appropriations Act (H.R. 2829). While the appropriations bill (including the Garrett-Feeney amendment) quickly passed in the House and was referred to the Senate, nothing further has apparently happened with the piece of the legislation regarding Section 404.

The Garrett-Feeney amendment specifically provides that “[n]one of the funds made available under this Act may be used by the Securities and Exchange Commission to enforce the requirements of section 404 of the Sarbanes-Oxley Act with respect to non-accelerated filers, who, pursuant to section 210.2-02T of title 17, Code of Federal Regulations, are not required to comply with such section 404 prior to December 15, 2007.” I thought that the language of this legislation was curious, because to date there really has been little evidence of SEC efforts to actually enforce the requirements of Section 404. In fact, I think that the SEC has generally sought to make implementation of Section 404 go as smoothly as it possibly could by not resorting to more drastic measures – such as delistings and Enforcement actions – as the means for compelling companies to finish their internal control assessments on time.

This “honeymoon” period with Section 404 may be coming to an end, as it looks like there is at least one ongoing Enforcement investigation involving a company that may not have completed its Section 404 work when required. In a Form 8-K filed last December, Hawk Corporation announced that the SEC Staff had made an informal inquiry requesting information about: Hawk’s preparations for complying with Section 404; transactions in the company’s common stock on June 30, 2006 by a stockholder not affiliated with the company and the impact of those transactions on when Hawk needed to comply with Section 404 (Hawk notes on its Form 10-K that it is a non-accelerated filer – therefore, it would have to complete its first Section 404 internal control assessment for next year’s 10-K absent any further extension); and communications between Hawk and a third parties regarding Section 404 compliance. Hawk also noted in the Form 8-K that it had been contacted by the Justice Department regarding that agency’s related investigation of the company. At the end of May, Hawk filed another Form 8-K announcing that Enforcement had obtained a formal order to investigate this matter, which was expanded to look at the company’s maintenance and evaluation of effectiveness of disclosure controls and procedures and internal controls over financial reporting, as well as Hawk’s periodic disclosure requirements related to these matters.

There is no telling if the SEC or DOJ will ultimately bring any charges as a result of their investigations, but Hawk’s situation certainly signals that, nearly five years following enactment of Sarbanes-Oxley, any forbearance in actually enforcing the requirements of Section 404 has probably run its course.

PCAOB Proposes Independence Rule Changes

Yesterday, the PCAOB proposed a new ethics and independence rule entitled “Communications with Audit Committees Concerning Independence.” This rule would replace the PCAOB’s interim independence requirement, Independence Standards Board Standard No. 1 (and two related interpretations), and would require independence communications with the audit committee prior to commencement of an engagement and then annually for continuing engagements. The Board also proposed amendments to current PCAOB Rule 3523, “Tax Services for Persons in Financial Reporting Oversight Roles,” as a follow-up to a favorably-received concept release issued earlier this year.

As Edith Orenstein notes in FEI’s “Financial Reporting” Blog, the proposed amendments to the tax services rule “would exclude the portion of the audit period that precedes the beginning of the professional engagement period, from being deemed a ‘prohibited service’ under Rule 3523. As explained by PCAOB Assistant Chief Auditor Bella Rivshin, this will be accomplished by striking the words “audit and’ from the current text of Rule 3523. A number of PCAOB board members said they support this proposal, as it would not unduly limit choice among potential audit firms based on tax services provided to individuals at the company prior to commencing the audit engagement. PCAOB staff noted that registered audit firms would be still need to look at facts and circumstances and determine if independence is impaired under the SEC’s audit independence rules.”

The FEI Blog goes on to note that the proposed new rule on independence communications with the audit committee would “change the threshold of what needs to be communicated from matters which – in the auditors’ professional judgment – could impair independence, to matters that a reasonable investor (i.e. third party) may perceive as impairing the auditors’ independence.” The PCAOB will seek comment on whether there should be a specific look-back period for providing information about services that could impair independence, as well as the extent to which information about the independence of non-affiliated secondary auditors must be included in the communications with the audit committee.

These PCAOB proposals will be out for a 45-day public comment period.

Chuck Nathan on Appraisal Rights

In this podcast, Chuck Nathan of Latham & Watkins provides some insight into a recent Delaware case – In re: Appraisal of Transkaryotic Therapies (Del. Ch. Ct., 5/2/07) – dealing with appraisal rights, including:

– What happened in the recent Transkaryotic Therapies case?
– How might the case impact appraisal rights going forward?
– What might it mean in terms of the strategies that hedge funds pursue?

– Dave Lynn