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September 2002

Congress And The New York Stock Exchange Tackle Corporate Governance And Financial Disclosure

By K. Massing, Esq.

On July 30, 2002, Congress passed the Sarbanes-Oxley Act of 2002 (the "SOA"), officially designated as "An Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes."

On August 1, the New York Stock Exchange (the "NYSE") proposed a series of changes to its corporate governance listing standards applicable to companies with securities listed on the NYSE, and on August 16, 2002, the NYSE submitted the proposed changes to the SEC for approval. The changes proposed by the NYSE are not yet in effect. They are subject to public comment and to amendment during the SEC review process, and even then there will be a six-month phase-in compliance period. Nevertheless, this is a serious initiative by the NYSE, and there is little doubt that the major items will go into effect in some form.

These developments will significantly affect the functioning of Boards of Directors and their committees, as well as senior officers. This Memorandum is intended to alert directors and officers of public companies to the provisions that will most affect them. Some of the NYSE proposed rule changes have counterparts in the SOA. The source of each item below is indicated in brackets. Provisions of the SOA that will mostly affect the public accounting profession are mentioned only briefly, and some are not mentioned at all.

(On August 21, 2002, The NASDAQ Stock Market, Inc., announced that it is in the process of submitting rule filings with the SEC to effectuate proposed corporate governance reforms approved by its Executive Committee. These proposed rules will apply to companies whose securities are listed on NASDAQ; they are not commented on in this Memorandum, but they are in many respects similar to the rule changes proposed by the NYSE.)

1. [SOA §403] The time for filing change of ownership forms (Form 4) under §16(b) of the Securities Exchange Act of 1934, as amended, for all purchases and sales of securities of reporting companies occurring after August 29, 2002, is reduced to two business days following the transaction.

The SEC encourages insiders to file the reports electronically (which will be mandatory by July 30, 2003). The SEC may propose certain narrow exemptions to the two-day requirement where it determines that two-day reporting is not feasible.

2. [SOA §302(a); SOA§ 404] On August 29, 2002, as mandated by the SOA, the SEC adopted rules requiring CEO's and CFO's to certify in each annual and quarterly SEC report containing financial statements, to the best of their knowledge, that the report meets SEC disclosure standards and that the financial statements fairly present the issuer's financial condition and results of operations. The CEO and CFO are also required to certify specified internal control matters in Forms 10-Q and 10-K.

3. [SOA §304] If a reporting company is required to restate financial statements due to material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws, the CEO and CFO must repay bonuses, incentive-based or equity-based compensation received and profits realized from the sale of company securities during a twelve-month period following the public issuance or filing of the document embodying such reporting requirement.

This ties in with the certification requirement under SOA §302(a) above and is one of the ways of making the CEO and CFO pay for the company's non-compliance. It is effective immediately, however, and could apply to restatements of financial statements for quarterly and annual periods that ended before the SOA was adopted.

4. [SOA §306] With certain exceptions, there is a prohibition on trading by corporate insiders during a blackout period of more than three consecutive business days when at least 50 participants in an employee benefit plan are prohibited from trading.

This is directed at situations like Enron's 401(k) Plan; however, the ban does not extend to securities acquired outside the director or officer relationship, such as those acquired in the open market.

5. [SOA §402(a)] Personal loans to directors and executive officers are prohibited, effective July 30, 2002.

Loans in existence on July 30, 2002, are grand-fathered, although any renewals or material modifications (including any waivers) of these loans will be treated as a new extension of credit. Just what constitutes a "loan" will need to be clarified by the SEC; presumably (but no one can be sure yet) reasonable travel and expense advances in the ordinary course of business will continue to be legal. It has been suggested that so-called "split dollar insurance" programs for directors and executives officers, as well as company cooperation with "cashless exercises" of stock options, are loans, and, therefore, illegal (except as constituted on July 30, 2002, without any subsequent change).

6. [NYSE] "Listed companies must have a majority of independent directors."

7. [NYSE] In order to tighten the definition of "independent director" for purposes of these standards:

"No director qualifies as ‘independent' unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must disclose these determinations."

Under the NYSE Rule presently in effect, which defines independence in the context of eligibility to serve on an audit committee, a company director who has a business relationship with the company can be considered independent if the Board of Directors determines that the relationship does not interfere with the director's independent judgment. The proposed new Rule imposes a stricter standard; any "material" relationship between the company on whose Board of Directors he or she serves and the director or a company controlled by the director would disqualify the director from being independent. The basis of determining that a relationship is not material must be disclosed in the company's annual proxy statement.

In addition: a director is not independent until at least five years after certain specified relationships of the director or a member of his or her immediate family have terminated. The disqualifying relationships are: (i) employment with the listed company; (ii) affiliation with or employment by a present or former auditor of the listed company or of an affiliate of the listed company; (iii) employment with another company which has an interlocking directorate with the listed company, in which an executive officer of the listed company serves on the compensation committee of the other company.

8. [NYSE] "To empower non-management directors to serve as a more efficient check on management, the non-management directors of each [NYSE listed] company must meet at regularly scheduled executive sessions without management."

According to the NYSE commentary accompanying this proposed Rule, these three lines carry a lot of content and impose significant burdens on the non-management directors, who include all directors who are not company officers – a more inclusive list than "independent" directors.

Here are some provisions of the NYSE commentary:

• Meetings must be "regularly scheduled," so as "to prevent any negative inference from attaching to the calling of executive sessions."
• There should be a presiding director at each meeting of the non-management directors, which may be the same person at each meeting or a different person at each meeting; in either event, the name or manner of selection of the presiding person must be disclosed in the annual proxy statement.
• "In order that interested parties may be able to make their concerns known to the non-management directors, a company must disclose a method for such persons to communicate directly with the presiding director or with the non-management directors as a group."

9. [NYSE] "(a) Listed companies must have a nominating/corporate governance committee composed of independent directors.

(b) The nominating/corporate governance committee must have a written charter that addresses:

1. the committee's purpose – which, at a minimum, must be to: (1) identify individuals qualified to become board members, and to select, or to recommend that the board select, the director nominees for the next annual meeting of shareholders; and develop and (2) recommend a set of corporate governance principles applicable to the corporation;
2. the committee's goals and responsibilities – which must reflect, at minimum, the board's criteria for selecting new directors, and oversight of the evaluation of the board and management; and
3. an annual performance evaluation of the committee."

According to the commentary accompanying the proposed Rule, the nominating/governance committee is expected to take a leading role in the corporate governance of the company. In addition to recommending director nominees, it is also expected to address and make recommendations concerning the structure and operation of other committees and selection of the independent directors to serve on these committees. This too is a significant responsibility.

10. [NYSE] "(a) Listed companies must have a compensation committee composed entirely of independent directors.

(b) The compensation committee must have a written charter that addresses:

i. the committee's purposes – which, at a minimum, must be to discharge the board's responsibilities relating to compensation of the company's executives, and to produce an annual report on executive compensation for inclusion in the company's proxy statement, in accordance with applicable rules and regulations.

ii. the committee's duties and responsibilities, which, at a minimum, must be to:

(A) review and approve corporate goals and objectives relevant to CEO compensation, evaluate the CEO's performance in light of those goals and objectives, and set the CEO's compensation level based on this evaluation.

(B) make recommendations to the board with respect to incentive-compensation plans and equity-based plans.

iii. An annual performance evaluation of the compensation committee.

Under existing SEC rules, the compensation committee is already responsible for a report on executive compensation that is included in the annual proxy statement. According to the NYSE commentary, if a compensation consultant is used, the compensation committee must be given authority to retain and terminate the consultant, including authority to approve the consultant's fees and other retention terms.

11. [NYSE] "Add to the ‘independence' requirement for audit committee membership the requirement that director's fees are the only compensation an audit committee member may receive from the company."

This does not preclude payment of additional directors' fees "to compensate audit committee members for the significant time and effort they expend to fulfill their duties as audit committee members." Members of other time-consuming committees also may receive additional director fees. An audit committee member, however, may not receive fees paid directly or indirectly for services as a consultant or legal or financial advisor, but this prohibition does not extend to ordinary compensation received in a customer, supplier or other business relationship (assuming that the relationship is not "material").

12. [NYSE] "(a) Increase the authority and responsibility of the audit committee, including granting it the sole authority to hire and fire independent auditors and to approve any significant non-audit relationship with the independent auditors.

(b) The audit committee must have a written charter that addresses:

i. the committee's purpose – which, at a minimum, must be to:

(A) assist board oversight of (1) the integrity of the company's financial statements, (2) the company's compliance with legal and regulatory requirements, (3) the independent auditor's qualifications and independence, and (4) the performance of the company's internal audit function and independent auditors; and

(B) prepare the report that SEC rules require be included in the company's annual proxy statement.

ii. the duties and responsibilities of the audit committee – which, at a minimum, must be to: [subparagraphs (A) through (J) omitted from this Memo]

iii. (an annual performance evaluation of the audit committee.

(c) Each listed company must have an internal audit function.

Most audit committees already have formal charters, which will require some amending to be in line with the new NYSE Rule. Paragraph (a) will entail more audit committee involvement with the auditors, and paragraph (c) which will require a listed company to have an internal audit "function."

Many (particularly smaller) public companies do not presently have an internal auditor. The NYSE commentary goes out of its way to indicate that having an internal audit function "doesn't necessarily mean that a company must establish a separate internal audit department or dedicate employees to the task on a full-time basis...." OK, so what is required?

13. [SOA §301] The SEC is mandated, by April 26, 2003, to direct the national securities exchanges (like the NYSE) and national securities associations (like NASDAQ) to prohibit the listing of any security of a company that doesn't meet six specified requirements, all relating to the makeup, authority and funding of audit committees.

Although we don't know what the SEC's "direction" will look like, it appears that the NYSE proposed rules relating to audit committees are consistent with the goals of SOA §301.

14. [SOA §407] The SEC is mandated, by October 28, 2002, to propose rules and regulations, and, by January 26, 2003, to issue final regulations requiring each issuer, together with its periodic reports, to disclose whether or not, and, if not, why not, the issuer's audit committee has at least one "financial expert."

The SEC's rules will be only disclosure rules. Existing NYSE rules require that at least one member of the audit committee have "accounting or related financial management expertise" and that all members of the audit committee be financially literate. Once the SEC issues its final regulations as required by SOA §407, the NYSE will amend its rules to require that audit committees of listed companies have at least one "financial expert," as defined by the SEC.

15. [SOA §201] SOA §201 established a "Public Company Accounting Oversight Board," to oversee the auditing profession. Once the Board is fully operational (expected within less than one year from July 30, 2002), any person that desires to issue an audit report or participate in the preparation or issuance of any audit report on a public company must register with the Board and become a "registered public accounting firm." Then, the following provisions will apply:

15.1 [SOA §201(a)] A registered public accounting firm is prohibited from rendering non-audit services to audit clients. There are nine prohibited categories. Non-audit services not specified may be performed if pre-approved by the issuer's audit committee.

A similar prohibition already exists under Rule 2-01 of Regulation S-X.

15.2 [SOA §204] A registered public accounting firm must timely report to the audit committee of the audit client on (a) critical accounting policies and practices; (b) alternative accounting treatments discussed with management; and (c) material written communications with management.

15.3 [SOA §206] A registered public accounting firm is prohibited from performing audit services for an issuer whose CEO, CFO, controller or chief accounting officer was employed by the firm and participated in the audit of that issuer within one year prior to "the date of initiation" of the audit.

15.4 [SOA §401(a)] SEC reports containing financial statements are required to disclose "material correcting adjustments" that have been identified by the issuer's registered public accounting firm.

This looks like a new requirement; we are looking to the SEC for clarification.

16. [NYSE] "To increase shareholder control over equity-compensation plans, shareholders must be given the opportunity to vote on all equity-compensation plans, except inducement options, plans relating to mergers and acquisitions and tax qualified and excess benefit plans."

Since NYSE rules already require shareholder approval of equity compensation plans in which management can participate, with limited exceptions, this is just a slight narrowing of the existing rule.

17. [NYSE] "Listed companies must adopt and disclose corporate governance guidelines."

According to the commentary, "disclose" means that each listed company's website must include its corporate governance guidelines, the charters of its most important committees and its code of business ethics (see below), and the company must state in its annual report that such information is available on its website or in print upon request.

The following subjects must be addressed in the corporate governance guidelines: director qualification standards; director responsibilities; director access to management and, as necessary and appropriate, independent advisors; director compensation; director orientation and continuing education; management succession; and annual performance evaluation of the board.

18. [SOA §406] The SEC is mandated, by October 28, 2002, to propose rules and regulations, and, by January 26, 2003, to issue final regulations requiring each issuer, together with its periodic reports, to disclose whether or not, and, if not, why not, the issuer has adopted a code of ethics for senior officers.

This is a disclosure rule obviously intended to encourage companies to adopt codes of ethics for senior officers. The NYSE has taken a more forceful position. See next comment.

19. [NYSE] "Listed companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers."

The NYSE suggests that the following topics should be addressed: conflicts of interest; corporate opportunities; confidentiality of information; fair dealing; protection and proper use of company assets; compliance with laws, rules and regulations (including insider trading laws) and encouraging the reporting of any illegal or unethical behavior.

20. [NYSE] "Each listed company CEO must certify to the NYSE each year that he or she is not aware of any violation by the company of NYSE corporate governance listing standards."

The NYSE commentary states that this CEO certification and any CEO/CFO certifications required to be filed with the SEC regarding the quality of the company's public disclosure must be disclosed in the listed company's annual report to shareholders.

21. [NYSE] "The NYSE may issue a public reprimand letter to any listed company that violates any NYSE listing standard."

22. [SOA §401] The SEC is directed to issue, on or before January 26, 2003, final rules relating to issues raised by (a) off-22. balance sheet arrangements and (b) presentation of pro forma financial information.

23. [SOA §409] Each reporting company is required to disclose "on a rapid and current basis" such additional information concerning material changes in financial condition or operations, which may include trend and qualitative information and graphic presentations, as the SEC shall prescribe by rule by an unspecified date. The SEC has already proposed to add several items to Form 8-K and to require filing within two business days after occurrence.

24. [SOA §408] The SEC is mandated to conduct more frequent (at least once every three years) and enhanced review of reports filed with it.

25. [SOA §806] Issuers are prohibited from retaliating against whistle blowers with respect to financial fraud.

26. [SOA §802] The penalty for company record keeping violations may be a fine, imprisonment for up to 20 years or both. The Act prescribes a 5-year retention period for audit work papers with a penalty for violations of a fine, 10 years imprisonment or both. The SEC is mandated to promulgate, by January 26, 2003, rules and regulations relating to retention of audit records, correspondence, etc.

Bertram K. Massing is the head of the Ervin, Cohen & Jessup LLP's Business and Securities Law Department and has broad and extensive experience in corporate governance. If you have any questions regarding this article, please contact Bertram K. Massing, Esq., at (310) 281-6366 or bmassing@ecjlaw.com

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