As discussed in our prior client advisory memorandum, the Sarbanes-Oxley Act directs the Securities and Exchange Commission to adopt rules to require disclosure of whether public companies have a financial expert on their audit committees and whether they have adopted a code of ethics for their senior financial officers. The final rules were adopted by the SEC on January 15, 2003. Most companies will be required to provide the new disclosures in annual reports on Form 10-K for fiscal years ending on or after July 15, 2003. Small business issuers will be required to provide the disclosure in annual reports on Form 10-KSB for fiscal years ending on or after December 15, 2003. Alternatively, companies that choose to include these disclosures in their proxy statement may incorporate the disclosures by reference into their annual report on Form 10-K or Form 10-KSB if they file their proxy statement with the SEC no later than 120 days after the end of their fiscal year. These disclosures are as of the date the annual report on Form 10-K or Form 10-KSB or proxy statement was filed with the SEC.

Audit Committee Financial Experts

Most companies with fiscal years ending on or after July 15, 2003 must include the disclosure of whether they have an "audit committee financial expert" on their audit committees and, if so, the name of the individual and whether that individual is independent from management in the Annual Report on Form 10-K or proxy statement filed for their fiscal year ended after July 15, 2003. If a company does not have an "audit committee financial expert," it must disclose the reasons why it does not. Companies may not satisfy the new disclosure requirement by stating that they decided not to make the determination or by only disclosing the qualifications of their audit committee members.

Since companies with fiscal years ending December 31 are now approaching their annual meeting and preparing to elect new directors, their boards of directors should begin to consider whether there is a member of the audit committee (or a member of the board of directors that is not currently serving on the audit committee) who would qualify as an "audit committee financial expert" and whether that individual is independent under the applicable definition. If a company does not currently have such a person on its board, it needs to decide whether one should be recruited or be prepared to disclose that the company does not have an "audit committee financial expert" and explain why it has no such expert.

In the final rules, the SEC expanded the range of experiences that would satisfy the definition of the "audit committee financial expert" from that range of experiences originally proposed. Under the final rules, individuals with each of the following attributes would satisfy the standards:

    • an understanding of financial statements and GAAP;
    • ability to assess the application of such principles in accounting for estimates, accruals and reserves;
    • experience preparing, auditing, analyzing or evaluating generally comparable financial statements;
    • an understanding of internal controls and procedures for financial reporting; and
    • an understanding of audit committee functions.

An important change from the proposed rules states that in addition to satisfying the standards through education and experience as a chief financial officer, accounting officer or auditor, an individual can gain this experience from supervising another person who is engaged in the preparation, auditing or evaluation of financial statements. It should be noted, however, that the SEC views this method of meeting the requirement as one of active supervision. Accordingly, the mere fact that a chief financial officer reports to a chief executive officer on an organization chart would not necessarily qualify the chief executive officer as an "audit committee financial expert." In determining whether an individual qualifies, companies will still need to make a case-by-case determination for each individual whether he or she qualifies as an "audit committee financial expert."

One issue on which the SEC elaborated in the final rules is the possibly liability of an "audit committee financial expert." Many of the more than 200 comment letters the SEC received regarding the proposed rules had expressed concern regarding an increased duty upon such an individual which could expose that individual to increased liability. In an effort to allay these concerns, the SEC included a safe harbor provision under the federal securities laws under which an individual designated as an "audit committee financial expert" would not be deemed an "expert" for any purpose (including Section 11 of the Securities Act) and would not have any duties or liabilities greater than those imposed on members of an audit committee generally. It is important to note, however, that this safe harbor provision does not apply to state securities and corporate laws. While the SEC indicated that it did not believe the designation of a director as an "audit committee financial expert" would increase that individual’s exposure to liability under state law, it is entirely possible that state courts will determine that, given the expert’s knowledge and experience which led to his or her designation as an expert, the individual should be held to a higher standard of care than a director who does not have a similar background.

It should also be noted that the New York Stock Exchange and the Nasdaq National Market have adopted rule proposals regarding the composition and responsibilities of audit committees for companies listed or quoted on those exchanges. For example, both exchanges have proposed to require all members of an audit committee to be independent. While these rule proposals are still pending SEC approval, the final rules adopted by those exchanges could also affect the requirements for an audit committee financial expert.

Code of Ethics

The final rules adopted by the SEC also require that a company disclose in its annual report on Form 10-K or Form 10-KSB or its proxy statement for the fiscal year ended after July 15, 2003 whether it has a code of ethics that applies to its principal executive officer and senior financial officers. If a company does not have such a code, it must disclose the reasons why it does not. The code of ethics addressing the matters set forth in the final rules that are applicable to the company’s principal executive officer and senior financial officers must be made available to the public as an exhibit to its annual report, on the company’s Internet website or upon request if the company has undertaken to provide its code of ethics in its Annual Report on Form 10-K or Form 10-KSB. Additionally, all companies (other than foreign private issuers) must disclose all changes to or waivers (including implicit waivers) of the code of ethics within five business days, to the extent that the change or waiver applies to the company’s principal executive officer and senior financial officers. This disclosure can be made on the company’s website or on a Current Report on Form 8-K. This disclosure is required for any changes or waivers occurring after the date on which the company files its first Annual Report on Form 10-K or Form 10-KSB in which their code of ethics disclosure is required.

Many companies have already implemented a code of ethics in connection with a corporate compliance program. An effective compliance program should mitigate the effects of fines and criminal penalties mandated by the Federal Guidelines for Sentencing of Organizations established by the U.S. Sentencing Commission, which became effective in 1991. In light of the SEC's disclosure requirements with respect to codes of ethics, it is a good time for companies to consider adopting or evaluating and updating compliance programs, in particular whether your company’s current code of ethics addresses each of the mattes set forth in the final rules. The actions necessary to implement and maintain an effective compliance program are different for each company and depend, among other things, on the nature of a company's business, its size and organizational structure, the number of its officers and employees, and the potential areas of criminal liability applicable to its business. It is important for a company to customize, and continuously update once adopted, its compliance program in order for the program to be most effective. In addition, recent court cases suggest that corporate directors and officers may face personal liability if they fail to ensure that their organizations have established adequate compliance programs. We are currently in the process of reviewing various forms of codes of ethics for public companies. Should you need our assistance in preparing or revising a code of ethics for your company, please call your regular Jones Day contact.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.