The interesting aspect of these proceedings is that they were based on alleged anti-fraud and reporting violations under the Securities Exchange Act of 1934 – even though there were no allegations that these directors participated in the fraud. Instead, the directors appear to have been targeted because they neglected to make proper inquiries when there were indications that management was engaged in fraudulent conduct.
As John Olson noted in an email to the ABA Corporate Governance subcommittee, the directors were alleged to have been “reckless” in their lack of due care when they signed SEC annual report filings – and that this is one of the few situations where the SEC has sought a federal scienter-based anti-fraud remedy for what amounts to an abdication of state law duties of care, attention and, possibly, good faith.
Marty Lipton came out with a client alert indicating that the business judgment rule is alive and well and is not affected by these SEC proceedings, even as explicated by SEC Director of Enforcement Stephen Cutler, due to the extreme circumstances of the facts in these proceedings.
For TheCorporateCounsel.net subscribers, we have created a new “Convertible Debt Offerings” practice area, with a September webcast on this topic to be announced soon.
Regarding the SEC staff’s recent FAQs on auditor independence, Gibson Dunn just put out an alert regarding the need to tweak pre-approval policies of audit and non-audit services. The alert specifically addresses Questions 22 through 24 of the FAQs that contain guidance on whether, in the view of the SEC’s Office of the Chief Accountant, particular practices would satisfy the SEC’s pre-approval rules. Gibson Dunn’s analysis follows:
These rules, as set forth in Rule 2-01(c)(7) of Regulation S-K, provide that: (1) a pre-approval policy must be detailed as to the particular service to be provided; (2) the audit committee must be informed about each service; and (3) the policy must not delegate audit committee authority to management. The FAQs state that, although the level of detail that is appropriate in a pre-approval policy depends on a company’s facts and circumstances, the establishment of monetary limits alone is not sufficient because these limits do not, without more, provide sufficient detail or adequately inform the audit committee.
Similarly, policies that use “broad, categorical approvals” (the FAQs use “tax compliance services” as an example), or that call upon management to make judgments about whether proposed services fit within categories of services that the audit committee has pre-approved, are not sufficiently detailed as to the particular services to be provided. In general, a pre-approval policy must be “designed to ensure that the audit committee knows precisely what services it is being asked to pre-approve.”
According to the FAQs, if the audit committee is presented with a schedule or cover sheet describing services to be pre-approved, that schedule or cover sheet must be accompanied by “detailed back-up documentation” regarding the specific services to be provided by the outside auditor. In light of the guidance in the FAQs, Gibson Dunn recommends that companies take a fresh look at their pre-approval policies and particularly, the categories and/or descriptions of pre-approved services included in their policies.
For TheCorporateCounsel.net subscribers, we have posted the transcript of last week’s webcast, “Designing Reporting-Up and Complaint Procedures.”
As evident from the number of emails I received, it looks like yesterday’s blog struck a nerve; the one about a SEC staffer’s comment regarding exhibits listed under Item 7 and disclosed pursuant to Item 12 (i.e. earnings releases) being deemed “filed.” One community member noted that he got what was tantamount to contrary advice from a staffer – so this could be one of those areas where inconsistent guidance is being provided by different members of the staff.
However, I got quite a few emails from members who had gotten the same guidance from staffers that I blogged yesterday – and they were quick to point out the weaknesses of the staff’s approach, including:
1. As I pointed out, Item 7(c) says that “the exhibits shall be furnished in accordance with the provisions of Item 601 of Regulation S-K.”
2. Item 601(b)(99)(i) says that “any additional exhibits which the registrant may wish to file shall be so marked as to indicate clearly the subject matters to which they refer.” If the SEC recommends including the earnings release as an Exhibit 99, this language would question the conclusion that the release was merely “furnished” (under the SEC’s strict reading of the language used).
3. Instruction B.6. to Form 8-K indicates that “information in a report furnished pursuant to Item 12 shall not be deemed “filed” for purposes of Section 18 . . . unless the registrant specifically states that the information is to be considered “filed”under the Exchange Act . . . .” (the same language is used in Instruction B.2. for Item 9 disclosures) Surely the SEC couldn’t be implying that the introductory language in Item 7 alone deems the issuer to have “specifically stated” that the exhibits are to be considered “filed.”
4. All the language used in all of the above pre-dates the SEC’s use of the “furnished” vs. “filed” terminology that was introduced in its Regulation FD release, so the concept of liability for “filed” information existed earlier, but the language used in Item 7 when Form 8-K was adopted was clearly never intended to make these distinctions.
5. Item 601(a)(2) of Reg S-K and Rule 102 of Regulation S-T only contemplate the listing of exhibits “filed” in the exhibit index. So, based on the staff’s position, one would not list exhibits furnished in the exhibit list either.
One member noted that if the SEC is worried about being able to distinguish between “filed” and “furnished” exhibits in an 8-K that includes more than Item 9 and/or Item 12 disclosures, perhaps it could either clarify its position (and clean up the forms) or take its Instructions B.2. and B.6. as literally as it is taking the one use of the word “filed” in Item 7. He notes that the impact of this position is obviously troubling, given that most companies have been listing their Item 9 exhibits under Item 7 for years.
Another member grumbled about how does this staff position help transparency or help investors locate Item 12 information? Investors will pull up filings, look at the exhibit list, and then wonder why the issuer didn’t provide the information contemplated.
We hope that all of the SEC staff will get on the same page and accept something reasonable, like the practice of listing exhibits “furnished,” so long as the company expressly notes in the Item 7 exhibit list that they are furnished rather than filed.
Yesterday, the SEC’s enforcement division settled the first case that relies upon false CEO and CFO certifications provided under Section 302 of Sarbanes-Oxley.
According to the SEC’s Complaint, Rica Foods filed a Form 10-K containing a purported unqualified independent auditor’s report from Deloitte & Touche. The audit report represented that Rica Foods’ consolidated financial statements were presented fairly and in conformity with GAAP. At the time of the filing, however, Deloitte had not provided the company with a signed audit report, and the company’s financial statements contained material classification errors – yet the CEO and CFO included the standard 302 certifications in the 10-K.
For TheCorporateCounsel.net subscribers, we have posted an interview with David Kaufman of Duane Morris with bulleted notes on what transpired at the Recent ABA Annual Meeting.
A member of the community brought this situation to my attention. In tandem with the Reg G rulemaking, the SEC adopted new rules earlier this year that require ’34 Act reporting companies to file an 8-K under new Item 12 to “furnish” any earnings releases as an exhibit to the Form 8-K. As a result, some companies have filed 8-K’s pursuant to the new Item 12 that list the earnings release as an exhibit under Item 7(c) (which is the Item that the Form 8-K suggests should be used to list exhibits).
In recent SEC comment letters, the staff indicates that their position is that listing the earnings release as an exhibit under Item 7(c) results in the earnings release being deemed “filed” as opposed to “furnished” for purposes of ’33 and ’34 Act liability. Recall that information that is “furnished” is not subject to ’33 and ’34 Act liability, but information that is “filed” is subject to such liability. The staff would prefer that the 8-K simply furnish the earnings release as an Exhibit 99 without reference to any Item number (other than Item 12).
Apparently, the staff wants to be able to easily distinguish between 8-K’s that were “furnished” and those that were “filed.” The end result doesn’t seem to make much sense, particularly in light of the fact that Item 7(c) of Form 8-K states that “the exhibits shall be furnished in accordance with the provisions of Item 601 of Regulation S-K” – but it may be wise to follow this guidance (and not list any 8-Ks that were previously “furnished” under Item 7(c) in the list of exhibits in a registration statement – so as to avoid them being deemed incorporated by reference). If you have your own interesting comments from the staff, please share them at broc.romanek@thecorporatecounsel.net.
As bad luck would have it, the power blackout affected the ability of some companies to file their 10-Qs on Thursday, and even Friday. The SEC staff has indicated its willing to adjust the filing date for these companies in certain circumstances – and has provided instructions on how to make a date adjustment request.
We continue to receive a number of questions about CEO/CFO certifications, including what to do with amended 10-Ks. It would appear that the certifications for an amended 10-K could follow the old certification rules if the original 10-K was not “due” on or after August 14th – because the amendment technically does not have a due date and the amendment relates to the original 10-K’s timeframe (when the new controls/procedures requirements were not imposed). So the amended 10-K should be able to use the old language regarding controls/procedures – and have the 302 certification following the signatures and the 906 certification as exhibit 99. However, if you decided to go this route, I recommend calling the SEC staff to confirm that it would be acceptable.
And remember that if you are filing an amendment that doesn’t affect the financial statements, the SEC staff informally has indicated that you only have to include paragraphs 1 and 2 of the certification.
Former SEC trial attorney Gary Goodenow has launched RealityattheSEC.com, which includes some interesting information about his perspective of how the SEC’s Miami office functions. We would be remiss if we did not point out that our own “SEC Enforcement” practice area has a wealth of information about the SEC’s enforcement process, including dozens of FAQs.
After a 9-month vacancy, the SEC finally hired a new Chief Accountant, long-time PricewaterhouseCoopers partner Donald Nicolaisen.
In this era of increased pressure to cooperate with the SEC’s enforcement division, the WSJ reports today that RJR Reynolds has refused to provide certain documents underlying how the company aggregates legal and marketing expenses in its disclosure documents. The company states that it doesn’t want detailed information about its litigation costs to get into plaintiff’s lawyers hands for fear that the data could influence jurors in product-liability lawsuits – and notes that its competitors don’t break out this information. We will watch whether the SEC will sue to enforce the subpoena.
For TheCorporateCounsel.net subscribers, thanks to John Huber and Tom Kim of Latham & Watkins for providing an updated version of their helpful 216 page paper on SOX and SEC Rulemaking.
The SEC posted 35 FAQs about auditor independence today.
Yesterday, the ABA’s House of Delegates voted to approve changes to its model code of conduct – 239 to 147 – to allow lawyers to disclose client confidences to protect a company from harm caused by an employee’s crime. This “reporting out” could go either to a regulator or another party, such as shareholders or creditors.
Now, the SEC will deliberate on whether to proceed with its own “reporting out” proposal. Lucky Item 13 of Form 8-K here we come?
We are hearing that a few companies provide outside counsel with a role as part of their “reporting up” policies (such as providing that if an attorney is not sure she is covered, she can call them to make the determination or to provide guidance on whether a matter is material). This is likely to be done by smaller companies that have limited securities expertise on its staff.
At yesterday’s “internal controls” session at the ABA Annual Meeting, there was much discussion about the PCAOB’s July 29th Roundtable. Based on a review of the transcript of the Roundtable, it is clear that on many topics, companies and the FEI represented the minority viewpoint, while the PCAOB, the SEC staff, the audit firms and institutional investors were unified to advocate broader, deeper engagements for audit firms. However, conclusions were not reached on most issues.
Here are some of the highlights from the transcript:
– Although no specific timetable was mentioned, it has been clear that the PCAOB’s goal is to have final standards approved by the SEC by the end of 2003. As a result, the PCAOB could issue an exposure draft in the late August/September timeframe.
– As for documentation, most participants advocated “principles-based” rather than “rules-based” guidance. Although companies recognized that there is some necessary level of documentation, they largely favored leaving documentation to management’s discretion. By emphasizing the view that documentation is the foundation for controls, the audit firms seemed to be pushing for more documentation.
– There was much discussion on whether an audit committee that fails to comply with listing requirements should raise a presumption of material weakness in internal controls. Investors want this presumption.
– Corp Fin Director Alan Beller noted that there are 3 requirements in the SEC’s SOX 404 rules that work together: (1) Management must assess internal controls and disclose any material weaknesses at year-end; (2) Each quarter, management must assess changes in internal controls and disclose any change in internal control that has materially affected or is reasonably likely to materially affect internal controls; SEC specifically did not refer to “material weaknesses” but noted that if the change is due to the correction of a material weakness, then management must consider the need to disclose; (3) Management must report significant deficiencies and material weaknesses to the audit committee and external auditors that had or are likely to have a material effect on internal controls.
– As for auditor independence (long my pet peeve – see recent “50 Nuggets” webcast), the SEC staff reminded participants that management should direct the work to be done and that it is management’s job to make the assessment on internal controls – and the staff indicated it will soon release FAQs on this topic.
Yesterday, the ABA House of Delegates narrowly approved rule changes to the model confidentiality rules that will allow lawyers to turn in corporate clients that are committing fraud – today is the day that the House considers the “reporting up and out” framework (and based on this, the SEC will decide what to do with its outstanding proposal on “reporting out” sometime this fall).
For TheCorporateCounsel.net subscribers, we have posted an interview with Chris Herzeca on the Process of Board Evaluation.
On Friday, the SEC posted its proposing release regarding disclosure of nominating committee activities and shareholder communications with directors.
A recent phenomenon are companies increasingly asking their outside counsel to sign off on their reporting up policies. This is a tough situation for outside counsel seeking to appease their clients – but not willing to take on unnecessary risk.
Whether outside counsel should indeed sign off probably depends on what the client is asking them to sign. If the client simply wants outside counsel to acknowledge that they have read it and that they will comply, there shouldn’t be a problem with signing. If the client is asking for more – or if the policy contains procedures that counsel doesn’t think they can live with – counsel should think twice before signing.
The bottom line is that it’s unclear what the signing gets the inhouse lawyer. If an inside lawyer gets “hooked” under the attorney conduct rules, that lawyer might have a claim against an outside lawyer who signed – but failed to comply. But this gets into a morass. If there is a contract right, it belongs to the company, not the inhouse lawyer who violated the rules. We shall soon see whether the ABA Task Force addresses this at the ongoing ABA Annual Conference. Tune into Wednesday’s webcast regarding “Designing Reporting-Up and Complaint Procedures” for more on this topic.
The PCAOB has configured its website to now accept registration applications from audit firms.
At the open Commission meeting today, the SEC generally followed the recommendations made in the July 15 Staff Report in proposing changes to what is disclosed regarding the nominating process for directors and about shareholder communications with directors.
The big surprise was the 30-day comment period, particularly with the vacation month looming ahead. The goal of the short comment period is to adopt final rules in time for the 2004 proxy season. At the meeting, the staff stated that the 2nd half of the proposals – regarding actual shareholder access to the ballot – would likely be proposed by the end of September.
