Searching for transparency: corporate responsibilities in the wake of the Sarbanes-Oxley Act.

RIORITIES for corporate America are changing.

Companies that want to be successful still care about earnings per share, but regulators now demand more for investors- responsibility and transparency.

The Sarbanes-Oxley Act of 2002 and related SEC rulemaking feature important corporate governance and securities reporting requirements. Companies have just begun to digest the new law and regulations, and we anticipate that compliance practices regarding these requirements will continue to evolve for many months.

AUDIT COMMITTEE MEMBERSHIP

Independence

The Act requires the SEC, by April 26, 2003, to issue rules prohibiting the Nasdaq Stock Market and the New York Stock Exchange from listing any company that does not have an audit committee consisting solely of independent directors. To qualify as "independent," a director may not receive consulting, advisory or other compensatory fees, other than as a board or committee member, and may not be an affiliated person of the company or any of its subsidiaries. The SEC may exempt particular relationships that do not meet these independence standards.

It remains to be seen how Nasdaq and the NYSE will regulate director independence. They already, had proposed new listing standards for their member companies prior to the passage of Sarbanes-Oxley. Nasdaq proposed that audit committee members not qualify as independent if they:

* Control 20 percent or more of the company's voting securities;

* Have a relative who in the past three years has been an executive officer of the company or any of its subsidiaries;

* In the past three years have been part of an "interlocking directorate" in which an executive officer of the company serves on the compensation committee of another company that employs the director;

* Are an executive officer of a charity to which the company makes payments exceeding the greater of $200,000 or 5 percent of the company's or charity's gross revenues for the year in which the contribution is made; and

* Are a former partner or employee of an independent auditor that worked on the company's audit engagement within three years.

The NYSE proposed rules under which a director would not qualify as independent unless the board of directors determines that the director has no material relationship with the company. The basis for that determination must be disclosed in the company s annual proxy statement.

In addition, directors would not qualify as independent if, in the past five years, they, or any immediate family member were:

* A company employee;

* Part of an interlocking directorate; or

* Affiliated with or employed by an auditor of the company or an affiliate.

Furthermore, directors who qualify as "independent," but also beneficially own 20 percent or more of the company's stock, may not chair or be a voting member of the audit committee.

Once these independence standards are approved by the SEC and finalized, each company will be required to assess what action is necessary to realign its audit committee membership.

FINANCIAL EXPERT

The Act requires that the SEC issue rules requiring each company to disclose in its periodic reports whether its audit committee includes at least one "financial expert."

Naturally, many public companies will wish to install at least one financial expert on the audit committee, and many already have initiated searches for qualified candidates.

The term financial expert hasn't been formally defined yet, but Congress has instructed the SEC to consider whether a person has:

* An understanding of GAAP and financial statements;

* Experience with preparing or auditing financial statements of comparable companies and applying such principles in connection with accounting for estimates, accruals and reserves;

* Experience with internal auditing controls; and

* An understanding of audit committee functions.

AUDIT COMMITTEE RESPONSIBILITIES

Overseeing Outside Auditors

The Act requires that the audit committee, rather than management, have direct responsibility for appointing, compensating and overseeing the work of any audit firm employed by the company. While this historically has been standard practice for many companies, it's now mandated for all.

Approval of Audit and Non-Audit Services

The audit committee will be required to pre-approve all audit and non-audit services provided by a company's independent auditors. Pre-approval also may be given by an Audit Committee member to whom the committee has delegated authority.

Under certain circumstances, a very limited exception to this pre-approval requirement is available if the company did not recognize services to be non-audit services at the time of the engagement. In addition, the Act requires disclosure of any approval of non-audit services in a company's periodic reports.

Establish Procedures for Tips and Complaints About Auditing and Accounting Matters

The Act requires audit committees to establish procedures to receive, retain and respond to complaints the company receives regarding its accounting, internal accounting controls or auditing matters, including confidential, anonymous submissions from employees regarding questionable accounting or auditing matters.

Companies still are evaluating how to design these procedures, but it is worth noting that the Act provides strong protection for whistleblower employees.

CEO AND CFO CERTIFICATIONS

The Act mandates two distinct but overlapping certifications of company SEC reports, both of which must be made by the CEO and CFO. These certifications are intended to improve the quality of disclosure by imposing personal responsibility for that disclosure on the principal officers. This clearly will result in a new emphasis on internal accounting and disclosure procedures at public companies.

Sec. 906 Certification

Sec. 906 of the Act requires that each periodic report containing financial statements be accompanied by written statements in which the CEO and CFO each personally certify that:

* The report "fully complies" with the requirements of the Exchange Act; and

* Information contained in the report fairly presents, in all material respects, the company's financial condition and results of operations.

To date, most companies have elected to attach these certifications as exhibits to the periodic report. Others have placed the certification below the signature page of the report or transmitted the certifications with the report as "correspondence" to the SEC.

Certifications provided as correspondence are not part of the periodic report and do not appear on the EDGAR website, which could reduce the officers' exposure in any subsequent securities lawsuit arising from a false statement in the report.

Companies that prefer the certifications to be publicly available typically use either the signature page or exhibit approach, though some using the correspondence approach have disclosed the certification by press release or Form 8-K.

Although the Sec. 906 certification does not contemplate a knowledge qualification, in practice, many certifications have included such qualification.

SEC. 302 CERTIFICATION

Sec. 302 of the Act and related SEC rules require a company's CEO and CFO to certify, with respect to any filed annual or quarterly report, that:

* The officer has reviewed the report;

* Based upon the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading;

* Based upon the officer's knowledge, the financial statements and other financial information included in the report fairly present in all material respects the company's financial condition and results of operations as of, and for, the periods presented in the report;

* The officer:

-Is responsible for establishing and maintaining "disclosure controls and procedures";

-Designed those disclosure controls and procedures to ensure that material information related to the company is made known to the officer by others within the company;

-Evaluated the effectiveness of the disclosure controls and procedures within 90 days of the report; and

-Presented in the report conclusions about the effectiveness of the disclosure controls and procedures based on the required evaluation;

* The officer disclosed to the company's auditors and audit committee:

-Significant deficiencies in the design or operation of internal controls that could harm the company's ability to record and report financial data and material weaknesses in internal controls; and

-Any fraud involving management or employees with a significant role in the company's internal controls; and

* The officer indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of the officer's evaluation, including any corrective actions regarding significant deficiencies and material weaknesses.

Unlike the Sec. 906 certification, the Sec. 302 certification includes a "knowledge" qualification and must be included in the report immediately following the signature page. The SEC has provided the specific text of the certification for each report and deviations from the mandated text are not permitted.

PREPARING FOR THE CERTIFICATION REQUIREMENTS

Companies have begun developing procedures to enable CEOs and CFOs to make the required certifications. In tailoring their certification processes to fit their unique circumstances, companies should consider the following:

Establish Disclosure Controls and Procedures; Regularly Evaluate Their Effectiveness. Sec. 302 requires CEOs and CFOs to evaluate the effectiveness of disclosure controls and procedures within 90 days of the Exchange Act report.

"Disclosure controls and procedures" are the internal controls and other procedures designed to ensure that the information required to be disclosed in the reports is recorded, processed, summarized and communicated to management to allow timely decisions regarding required disclosure.

The SEC does not require specific disclosure controls and procedures, but expects each company to develop processes that are appropriate for its own business and internal management. These procedures may include:

* Reviewing drafts of the report with personnel responsible for its preparation;

* Reviewing disclosure requirements applicable to the report;

* Discussing with independent auditors their review of financial information included in the report;

* Discussing with internal audit personnel their activities in the past quarter;

* Reviewing recent management letters from the independent auditors and management responses;

* Reviewing communications from employees or others regarding the company's accounting or business practices;

* Analyzing recent analyst or press commentary on the company's accounting or business practices; and

* Considering the overall quality oft he disclosure contained in the report, particularly the completeness of MD&A and the clarity of disclosure to non-expert readers.

Establish a Disclosure Committee. The SEC recommends that companies organize a disclosure committee to consider the materiality of information and determine disclosure obligations on a timely basis. The committee should report to the CEO and CFO. The composition of the disclosure committee will differ among companies, but generally would include the chief accounting officer, general counsel, chief investor relations officer, principal risk management officer and other company personnel with an interest in and expertise on disclosure matters. External auditors and securities counsel also should work closely with the committee. The committee should meet as often as necessary to help the company comply with its disclosure obligations and should maintain a record of its review process.

Consider Back-up Certifications. CEOs and CFOs may consider obtaining back-up certifications from senior officers responsible for preparing or reviewing the report. These certifications may be general or specifically tailored to substantive areas of responsibility. Such certifications cannot replace the CEO's or CFO's own careful review of the report, but may instill throughout management a culture of responsibility for accuracy and thoroughness in the company's external reporting.

Meet with Audit Committee. The CEO and CFO, along with disclosure committee members, should meet with the audit committee to review the company's internal controls and decide whether significant deficiencies or material weaknesses exist. The audit committee must be provided adequate time to raise questions, concerns or comments regarding the review process and the disclosures in the report.

ACCELERATION OF FILINGS

Acceleration of Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q 

The SEC recently announced that filing deadlines for quarterly and annual reports will be accelerated. The new deadlines will be phased in over a three-year period. The current 90-day filing deadline for Form 10-K will change to 75 days for fiscal years ending on or after Dec. 15, 2003, and to 60 days for subsequent Form 10-Ks. The current 45-day filing deadline for Form 10-Q will change to 40 days for the three Form 10-Qs to be filed after the initially accelerated Form 10-K, and to 35 days for subsequent Form 10-Qs.

The accelerated filings will be required for public companies, referred to as "accelerated filers," that:

* Have a public float of at least $75 million;

* Have been a reporting company for at least 12 months preceding the filing of the report;

* Have filed at least one annual report under the Exchange Act; and

* Are not eligible to use the SEC's special forms for small business issuers.

Companies that are "accelerated filers" should analyze their existing procedures for preparing periodic reports and determine what changes are necessary to comply with the accelerated filing requirements.

For example, audit committees will need additional time to read and digest increasingly complex reports. They also will need time to review with management and independent auditors MD&A disclosures regarding off-balance sheet transactions, critical accounting policies and related-party transactions.

Acceleration of Section 16 Reports

The Act accelerated the deadline for public company directors, executive officers and 10-percent stockholders to file Form 4 reporting changes in their beneficial ownership of company securities. Form 4s now must be filed two business days following the transaction date. Insiders previously could file reports 10 days after the end of the month in which the transaction occurred.

Many transactions previously permitted to be reported on Form 5, such as stock option grants, exercises and cancellations, must now be reported on Form 4 within two business days. Although the filing of Sec. 16 reports is the responsibility of company insiders, companies commonly assist with these filings. Late filings, regardless of the cause, must be reported in the company's proxy statement and could result in an SEC enforcement action.

The two-day deadline will, in reality, be a one-day deadline for paper filings, since a day will generally be required for transmitting the report by mail or courier to the SEC. Consequently, companies must implement procedures to help ensure compliance with the accelerated deadline.

For example, companies should consider revising their insider trading policies to require transactions by insiders to be pre-cleared. Given the shortened deadline for filing Form 4s, many insiders will grant limited powers of attorney to enable individuals, such as members of the legal department or stock administrative staff, to sign Form 4s on their behalf if they are unavailable.

By July 30, 2003, all Sec. 16 reports must be filed electronically via EDGAR and companies will be required to make Sec. 16 filings available on their websites. The SEC has encouraged early adoption of these provisions. Insiders and the companies assisting them with their filings should consider obtaining EDGAR filing numbers. Enabling filings by EDGAR generally will enhance the likelihood of timely reporting.

PROHIBITION ON PERSONAL LOANS TO INSIDERS

The Act prohibits public companies from making or arranging personal loans to their executive officers or directors, which has raised many interesting interpretive questions. For example, the Act may be interpreted to prohibit cashless exercises of stock options, in which the payment to the company of the option exercise price, including any withholding tax, is deferred until a few days after exercise when funds become available from a simultaneous sale of the exercised shares.

Until Congress or the SEC clarifies this provision, many companies will require directors and executive officers to pay the purchase price immediately upon exercise, personally or by arranging a broker's margin loan.

Loans outstanding as of July 30, 2002, are not subject to this prohibition, provided there is no material modification of the loan, or any renewal of the loan, after July 30, 2002. It's unclear whether this grandfather provision would include a commitment to make an extension of credit entered into before July 30, 2002, even if funds are not transferred until after such date.

Another difficult situation may arise for existing loans to directors or executive officers that were overdue July 30, 2002, or later become due. It seems clear that the Act prohibits a company from forgiving the outstanding loan because that would be a "material modification" of the loan. Consequently, companies must take immediate steps to ensure collection of such loans when they come due.

RELATED ARTICLE: PROHIBITED NON-AUDIT SERVICES INCLUDE

* Services related to the company's accounting records or financial statements;

* Financial information systems design and implementation services;

* Appraisal or valuation services and fairness opinions;

* Internal audit outsourcing services; and

* Legal and expert services unrelated to the audit.

Horace L. Nash is a partner and Scott J. Leichtner and Nicole A. Black are associates in the Palo Alto office of Fenwick & West LLP. Nash can be reached at [e-mail], Leichtner can be reached at [e-mail] and Black can be reached at [e-mail].