March 30, 2007
'
By Wayne Kirk1, David Warburg
Contents
Accountant Registration with the Public Company Accounting Oversight Board
Auditor Independence Provisions
Auditor Reports to Audit Committees
Officer Certification Requirements and Internal Controls Reporting
Prohibition on Loans to Directors and Executive Officers
Audit Committee Independence and Qualification; Majority of Independent Directors
Possible Listing Requirements for a Majority of Independent Directors
Financial Expert and Code of Ethics Disclosure
The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley" or "the Act"), adopted in July 2002, is probably the most sweeping piece of reform legislation covering governance of and disclosures by public corporations in the United States since the 1930s. The lead author of this report, Wayne Kirk, published a paper in March 2003 discussing some of the more significant aspects of Sarbanes-Oxley from the perspective of a foreign company that was considering listing in or accessing the public capital markets in the United States.
Since early 2003, the SEC has adopted further regulations implementing various provisions of the Act, and there has been substantial commentary and criticism, as well as praise, of various provisions of the Act and enabling SEC regulation. Perhaps most important, public companies, including foreign private issuers and their auditors and counsel, have had several years of practical experience in operating under the Act and its associated SEC and stock exchange regulations. The purpose of this revised paper is to provide an updated discussion, in light of the events and experience of the last four years, of some of the more significant aspects of Sarbanes-Oxley, again from the perspective of a foreign company that is considering listing in or accessing the public capital markets in the United States.
Both directly and through mandated SEC and stock exchange regulations,2 the Sarbanes-Oxley Act imposed a significant number of new reporting and corporate governance requirements on "Reporting Issuers," generally comprised of U.S. companies and foreign private issuers3 that have filed registration statements to offer securities to the U.S. public (even if the registration statement has not been made effective and no securities have yet been sold); or that list their securities on U.S. stock exchanges; or that register their shares and become subject to continuing SEC reporting requirements because they have more than U.S.$10 million in assets, 500 or more shareholders worldwide and, in the case of foreign private issuers, 300 or more shareholders resident in the United States.4 Although there are some differences between the treatment of U.S. companies and foreign private issuers, principally relating to the frequency of providing information to the SEC,5 for the most part, with certain exceptions discussed below, Sarbanes-Oxley and the SEC rules adopted to date continue to make no distinction between U.S. and foreign Reporting Issuers.
For a foreign private issuer that has not yet become, but is considering becoming, a Reporting Issuer, Sarbanes-Oxley and the associated SEC and stock exchange regulations continue to require a careful evaluation of and advance planning for the potential impact of the law.
Accountant Registration with the Public Company Accounting Oversight Board
Section 101 of the Act provided for the creation of the Public Company Accounting Oversight Board (the "PCAOB"). It is illegal for any accounting firm to participate in the preparation or issuance of an audit report with respect to any Reporting Issuer unless that accounting firm is registered with the PCAOB. The PCAOB, which has been functioning for over three years (since mid-2003), and has been issuing the results of its periodic inspections of accounting firms since 2005, has disciplinary authority over registered accounting firms, with sanctions that can include temporary suspension or permanent revocation of registration. The registration requirement applies equally to domestic and foreign accounting firms. The PCAOB has the authority to exempt foreign accounting firms, but in May 2003 determined not to offer any general exemption, although it has provided since June 2004 for, and in recent years has engaged in, a cooperative effort with foreign regulatory bodies in conducting its periodic inspections, relying in certain instances and areas on foreign regulatory oversight of foreign accounting firms. Currently, approximately 680 foreign accounting firms from approximately 80 countries are registered with the PCAOB. Oversight by the PCAOB requires an inspection every three years. If a firm works with more than 100 Reporting Issuers, it is required to undergo an inspection every year.
The SEC staff have stated that the foreign accounting firm must be registered with the PCAOB if it performs a "substantial portion" of the audit. Note that the PCAOB has indicated that if the accounting firm takes part in auditing the financial statements of a foreign subsidiary that makes up 20 percent or more of a U.S. company's assets or consolidated financial statements, it plays a substantial role in the auditing process. This is true even if the parent company does not state that it relied on the work or assessment of the foreign accounting firm that worked with the subsidiary. The Act also provides that if a foreign public accounting firm issues an opinion or otherwise performs material services on which a registered public accounting firm relies in issuing all or part of an audit report, that foreign public accounting firm is deemed to have consented to produce its audit work papers in connection with an investigation relating to the audit report.
A foreign private issuer that is considering becoming a Reporting Issuer will want to make sure that its current auditors, and all other accounting firms with a material involvement in auditing and reporting on its financial statements, either register with and stay in good standing with the PCAOB or have the benefit of any future exemption the PCAOB may give to foreign accountants. An accounting firm's registration status can be ascertained by looking at www.pcaobus.org/registration. It would also be advisable to have all the foreign private issuer's accounting firms reaffirm their registered or exempt status every year before beginning an audit, and to have them agree, in advance, to advise the company if they are in danger of losing an exemption or become subject to an investigation that could result in temporary suspension or permanent revocation of their registration with the PCAOB. Finally, the company should consider getting a written agreement from its foreign public accounting firms regarding production of audit work papers if and when the company becomes a Reporting Issuer.
Auditor Independence Provisions
Non-audit Services; Approval of Audit and Non-audit Services. Section 201 of the Act makes it unlawful for a public accounting firm registered with the PCAOB contemporaneously to provide its public audit clients with a variety of non-audit services identified in the Act6 or designated in the future by the PCAOB. The Act goes on to provide that other non-audit services, specifically including tax services, may be provided by a registered public accounting firm if approved in advance by the audit committee of the Reporting Issuer. The SEC implemented the Sarbanes-Oxley prohibition on non-audit services by amending its auditor independence rules to conform to the Sarbanes-Oxley list.7 As contemplated by Section 202 of the Act, the SEC also amended its rules to require a Reporting Issuer's audit committee to approve, in advance, all audit and permitted non-audit services to be provided by the company's auditors, or for engagements to be subject to detailed preapproval policies and procedures established by the audit committee, provided that the audit committee is informed of each service and the policies and procedures do not constitute delegation of the audit committee's responsibilities to management.8 There is no exception or transition period for new Reporting Issuers.
A foreign private issuer contemplating the public offering of its securities in the United States, or otherwise becoming a Reporting Issuer, should conduct a review of all services being provided by its auditors well in advance to be sure that prohibited non-audit services have totally ceased by the filing date. In addition, in light of the requirement for preapproval of auditor services, the audit committee should specifically approve all audit and permitted non-audit services prior to the company becoming a Reporting Issuer.
Audit Partner Rotation. As contemplated by Section 203 of the Act, the SEC adopted regulations9 that prohibit an accounting firm from providing audit services to a Reporting Issuer if certain partners on the audit engagement team have been providing audit services for more than five consecutive years in the case of the lead audit and concurring partners, and seven consecutive years for certain other "audit partners" (as defined). The lead audit and concurring partners also must stay off the account for five consecutive years once they rotate off, while the other audit partners are subject to a two-year time-out period. For lead audit partners and for concurring partners, prior years are considered. For other audit partners, prior years are not considered. There is no separate exception or transition rule for companies that are not yet Reporting Issuers, and consequently service during the years before a company becomes a Reporting Issuer must be considered.10
Therefore, it is important for a company expecting to become a Reporting Issuer in the future to review in advance the service periods for all "audit partners" to ensure that rotations can be handled on an orderly basis once the company and its auditors become subject to the requirement.11
Issuer-Auditor Interlocks. The SEC also has adopted rules prohibiting an accounting firm from providing audit services to a Reporting Issuer if an employee of the Reporting Issuer filling a "financial reporting oversight role" was the lead audit partner, the concurring partner, or provided more than 10 hours of service as a member of the audit engagement team for the Reporting Issuer during the one-year period prior to the date of the initiation of the audit.12 A person filling a "financial reporting oversight role" includes anyone who is in a position to exercise influence, or who, in fact, exercises influence over the contents of financial statements or anyone who prepares them, and may include a director, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, or any equivalent position, whether with the Reporting Issuer or a consolidated subsidiary. The rule sets out beginning and ending times for audit engagement periods based on the dates of filing annual reports on Forms 10-K, 20-F and 40-F. The rule applies to any employment relationship and applies equally to U.S. and foreign Reporting Issuers. There is no separate exception or transition period for new Reporting Issuers.
For a first-time Reporting Issuer, the rule by its express terms prohibits an accounting firm from conducting the audit if an employee of the Reporting Issuer hired for a financial reporting oversight role was one of the specified members of the audit engagement team at any time during the audit period that ends with the date of the filing of the first annual report. In addition, the SEC staff has interpreted the rule, with respect to first-time Reporting Issuers, to prohibit an accounting firm from conducting the audit if an employee of the Reporting Issuer hired for a financial reporting oversight role was one of the specified members of the audit engagement team at any time during any of the audit periods included in the initial registration statement, and that each such audit period ends with the date of the audit report for that period.13 For this reason, a company expecting to become a Reporting Issuer needs to consider this issue well in advance, in determining whether to hire an auditor employee for a financial reporting oversight role during all years (typically three) expected to be subject to the auditor's opinion filed with the SEC with its initial registration statement, as well as the year in which the company expects to become a Reporting Issuer.14
Audit Partner Compensation. At the same time the SEC adopted the above-described rules relating to auditor independence, the SEC amended its independence rules to provide that an accounting firm will not be independent from an audit client if an audit partner receives compensation based on selling services to that client, other than audit, review and attest services, "at any point during the audit and professional engagement period."15 There is no separate exception or transition period for auditors of new Reporting Issuers.
Since the professional engagement period for a Reporting Issuer would include all years subject to the auditor's opinion filed with the SEC, which includes income statements for three full fiscal years, a company expecting to become a Reporting Issuer needs be sure that this requirement has been met for all years prior to its becoming a Reporting Issuer, to the extent financial statements for those years are filed with the SEC. Consequently, planning for this requirement needs to be done several years in advance.
Auditor Reports to Audit Committees
Section 204 of the Act requires that registered public accounting firms "timely report" to the audit committee all critical accounting policies and practices to be used in the course of an audit,16 all alternative treatments of financial information (and ramifications thereof) that have been discussed with management, the treatment preferred by the independent auditor, and other written communications between the auditors and management. The SEC rules adopted to implement this provision17 require that the report be made annually. The SEC rules also provide that the discussion of alternative treatments need only relate to material accounting alternatives.
The SEC release adopting these rules indicates that the discussion of alternative accounting treatments is not to be confined to the adoption of new or changed accounting policies, but also applies to application of existing policies to specific transactions if available alternatives were discussed, and requires a statement of why the auditors' preferred method was not selected by management.18 The requirement that the report identify the treatment preferred by the auditors has contributed, since adoption of the Act, to creating extreme pressure on a Reporting Issuer's management to change to the auditor's preferred accounting treatment in every case where the treatment being used by the company is not the auditor's preferred treatment. This pressure, to some extent, has, in turn, contributed to the recent increase in the number of financial statement restatements. Any company that is considering becoming a Reporting Issuer would be well advised to go through this process of auditor-audit committee communication and dialogue at least once before becoming a Reporting Issuer and, as a part of the process, to include an evaluation of all significant alternative treatments of financial information and the treatments preferred by the independent auditors. If changes in accounting treatments are to be made, it is far preferable to make those changes before rather than after the company has become a Reporting Issuer.
Officer Certification Requirements and Internal Controls Reporting
As required by Section 302 of the Act, the SEC quickly adopted rules19 requiring the principal executive officer and the principal financial officer of each Securities Exchange Act of 1934 (the "Act") reporting company to certify the financial and other information contained in periodic reports filed with the SEC. For a foreign private issuer filing its annual report on Form 20-F or 40-F, the certification must be included in that annual report as an exhibit to the report. The rules also require these officers to certify that:
(a) these disclosure controls and procedures are designed to ensure that material information is made known to them on a timely basis;
*[(b) they have designed such internal control over financial reporting, or caused it to be designed under their supervision, to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP;]*
(c) they have evaluated the effectiveness of the disclosure controls and procedures as of the end of the period covered by the annual report and have included information in the annual report to the SEC about their evaluation of the effectiveness of the disclosure controls and procedures; and
(d) they have disclosed in the annual report to the SEC whether there has been any change in the internal control over financial reporting during the company's fourth fiscal quarter that has or could materially affect internal control over financial reporting;
(a) all significant deficiencies and material weaknesses in the company's internal control over financial reporting, and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the company's internal controls.20
To complement the disclosure requirements, the rules require Reporting Issuers who are foreign private issuers to adopt and maintain disclosure controls and procedures and to evaluate them as of the end of each fiscal year.21
Section 906 of the Act has a similar but separate officer certification requirement as to financial information and compliance with the requirements of the applicable reporting form.
Section 404 of the Act, the section of the Act most commented on since the Act's adoption, required the SEC to provide for an additional provision in annual reports stating management's responsibility for maintaining internal controls and procedures for financial reporting and assessing the effectiveness of the internal controls (the "management report requirement"). The company's independent accountants are required to report on and attest to management's assessments in accordance with standards adopted by the PCAOB (the "auditor attestation requirement").
The SEC initially delayed adoption of these annual report disclosure requirements until the PCAOB had an opportunity to adopt the auditors' attestation rules, and then further delayed required compliance dates for the management report requirement and the auditor attestation requirement, both for smaller domestic U.S. issuers and for foreign private issuers, in a series of extensions issued in 2004, 2005, and 2006. These extensions were, to some extent, regulatory responses to the extensive criticism by both registrants and various capital market participants of the (at least initially) very high costs and burdens, particularly for smaller companies, of complying with the new internal control disclosure requirements, particularly those related to the auditor attestation requirement.
Currently:
The last-mentioned rule would, in theory, permit a company to complete its initial public offering close to its fiscal-year end without having to have procedures in place to support a management report or an auditor attestation as to its internal controls over financial reporting for the fiscal year in which the offering transaction occurs. In practice, underwriters and placement agents in the post-Sarbanes-Oxley environment are not prepared to execute capital markets transactions for issuers without adequate assurances that the Reporting Issuer can meet the management report requirement, and will also meet the auditor attestation report requirement. Moreover, management should be (and usually is) unwilling to provide a management report without reasonable assurance that an auditor attestation on those very controls being reported on by management will, in fact, be obtainable when required.
It should be noted that preparation for compliance with the internal control disclosure requirements for a given fiscal year typically must start not later than the start of that fiscal year, and, more often, several months prior to the start of that fiscal year. In addition, although "internal controls over financial reporting" (as to which management report requirements and auditor attestation compliance may be delayed for new Reporting Issuers) are distinguishable in many ways from "disclosure controls and procedures" (which requirements are currently fully effective for new Reporting Issuers), a deficiency in internal controls may result in a deficiency in disclosure controls and procedures.
Therefore, regardless of the expected compliance dates described above, Reporting Issuers need to establish procedures to collect information, and demonstrate that their internal control over financial reporting and the required disclosure controls and procedures will be effective in accomplishing their intended purposes. Many companies also have developed sub-certification procedures whereby subordinate officers and employees certify the required information within their areas of responsibility in order to assist the principal executive officer and the principal financial officer in meeting their certification responsibilities. Any company contemplating becoming a Reporting Issuer needs to start implementing the necessary controls and procedures, and begin conducting evaluations of internal control over financial reporting and disclosure controls and procedures well in advance of becoming a Reporting Issuer, so that the company will have all required controls and procedures in place once it becomes a Reporting Issuer, and also so that the company will be fully prepared for the required disclosures at the time of the filing of its first (or, if the SEC proposed rule described above is adopted, second) Form 20-F or 40-F Annual Report.
Prohibition on Loans to Directors and Executive Officers
Section 402 of the Act has made it unlawful for any Reporting Issuer to directly or indirectly extend or maintain credit, to arrange for the extension of credit, or to renew any extension of credit, in the form of a personal loan to or for any director or executive officer of that Reporting Issuer. Extensions of credit maintained by a Reporting Issuer onJuly 30, 2002 are excepted from the prohibition, provided that they are not materially modified or extended.
Section 402 has no exception for loans made after July 30, 2002 but before a company becomes a Reporting Issuer. Consequently, companies that become Reporting Issuers in the future cannot continue to maintain loans to directors and executive officers made after July 30, 2002, even though those loans were not illegal at the time they were made.
It is a common practice for international companies to make loans to employees in connection with reassignments from one country to another, including, for example, housing loans to assist employees being asked to move from a lower cost to a higher cost location. Such loans are often forgiven over time if the employee continues to be employed by the employer. This provision might have the effect of making it illegal for Reporting Issuers to make such ordinary course loans to executive officers anywhere in the world, although major U.S. law firms have jointly publicly expressed the view that such arrangements should not be subject to Section 402 if forgiveness is subject to continued employment and the contingent obligation to repay is not represented by a note.
Section 402 does not define "personal loan" or "extension of credit." In December 2005, the SEC initiated and settled enforcement action against two executives of a Reporting Issuer who had obtained 90- and 60-day, interest-free loans from the company, rebutting the executives' arguments that the extensions of credit were "advances" and not prohibited loans. In addition to conventional loans (including relocation loans), the prohibition also may apply to non-conventional arrangements such as split-dollar life insurance. It should not apply to bona fide cash advances for travel expenses or to company-sponsored credit cards, so long as they are not used for personal expenses, reasonable (with no interest), and settled by the employee through documentation. Section 402 also makes it unlawful for any Reporting Issuer to "arrange" for the extension of credit. Similar "arranging" language in the Act, relating to margin loans, has been interpreted as significantly limiting the ability of a registered broker-dealer to arrange for margin loans from other lenders. Notwithstanding a broad consensus among the private U.S. securities bar to the contrary, if a similar interpretation were to be adopted for the "arranging" language in Section 402, it could severely limit the ability of a Reporting Issuer to assist its directors and executive officers in securing loans from regular commercial lenders, and perhaps could even extend to other kinds of loans, such as from an employee savings plan, in which the employer is involved with establishing or administering the plan and arranging for payroll deductions to repay loans. Again, although seasoned securities law practitioners and major U.S. law firms have publicly expressed their views to the contrary, this provision might also apply to the cashless stock option exercise programs that companies frequently establish with securities brokers to aid employees exercising stock options, due to the fact that such programs involve temporary financing by the broker. The absence of any negative SEC staff pronouncements or adverse SEC enforcement action in this area is somewhat encouraging. Nonetheless, in the absence of favorable future guidance in interpreting Section 402, where applicable corporation laws permit it, companies should consider including in their option plans a provision that permits employees to exercise options by tendering previously owned shares of the company's stock.
One of the initial more significant concerns with Section 402 was whether it applies to advances of legal fees to directors and executive officers who have been sued for actions taken in their respective capacities. If Section 402 were to apply to such advances of legal fees, it would significantly increase the financial risk for executive officers and directors of companies that choose to become Reporting Issuers. In the first reported case to consider the issue, a federal district court held in March 2006 that such advances were not prohibited by Section 402, noting that nothing in the legislative history of the Act indicated that the Section addressed advances of such expenses.22
Because the law has no exceptions for loans made before a company becomes a Reporting Issuer, a company that expects to become a Reporting Issuer needs to make sure that any loans made after July 30, 2002 are repaid before the company makes the first filing to become a Reporting Issuer. The company also should conduct a detailed review of all option exercise programs, employee benefit plans, and other related arrangements to determine if they involve loans or extensions of credit.
Audit Committee Independence and Qualification; Majority of Independent Directors
Sarbanes-Oxley contains a number of provisions that address audit committee independence and qualification. Section 301 of the Act required the SEC to direct the U.S. stock exchanges to prohibit listing of the security of any company that is not in compliance with various standards as to the composition and functioning of the audit committee of the board of directors. These standards include requirements that:
(i) The audit committee be directly responsible for the appointment, compensation and oversight of the work of the independent auditor;
(ii) The members of the audit committee be independent (with specified limitations upon receipt of fees and other payments from the company and upon affiliations with the company and its subsidiaries);
(iii) The audit committee have procedures in place for dealing with complaints regarding accounting and related matters, including anonymous submissions from employees regarding questionable accounting or auditing matters;
(iv) The audit committee have authority to engage outside counsel and other advisers; and
(v) The audit committee have adequate funding from the company to engage independent auditors and other advisers. The SEC has adopted rules to such effect.23
Section (c) of Rule 10A-3 adopted by the SEC contains a general exemption for foreign private issuers from the provisions of the Rule relating to responsibilities of the audit committee, independence of members, procedures for complaints, authority to engage outside advisers, and adequate funding, provided the foreign private issuer meets each of the following requirements:
Rule 10A-3 requires that any foreign private issuer availing itself of this exemption must disclose its reliance on such exemption and its assessment of the affect of such reliance on audit committee ability to act. Foreign private issuers may make such disclosures either in their Annual Report on Form 20-F or (if a NYSE-listed company) on their Web site (provided it is in English and accessible from the United States).
Possible Listing Requirements for a Majority of Independent Directors
Sarbanes-Oxley does not impose any requirements regarding director independence in general. However, in the wake of Sarbanes-Oxley, the New York Stock Exchange ("NYSE"), the American Stock Exchange, and NASDAQ each adopted new expanded corporate governance standards, required for both new and continued listing, relating to director independence, including requiring a majority of independent directors (with certain exceptions, described below, for foreign private issuers conforming to home country governance requirements or practices), and independence requirements with respect to auditing, nominating, and compensation functions of boards of directors (with certain exceptions for audit and other committees of foreign private issuers that are similar to the general exemption allowed under SEC Rule 10A-3, and with similar disclosure requirements).
NYSE-listed foreign private issuers are effectively permitted to follow home country practice in lieu of the NYSE's corporate governance requirements, provided they (i) have an audit committee that satisfies SEC Rule 10A-3 (described above); (ii) notify the NYSE after becoming aware of any non-compliance with Rule 10A-3; and (iii) provide a "brief general summary" of the significant ways their governance differs from that followed by domestic Reporting Issuers under NYSE listing standard, either in their Annual Report on Form 20-F or on their Web site (provided it is in English and accessible from the United States).24 AMEX corporate governance listing requirements as applied to foreign private issuers are generally comparable to the NYSE.25
NASDAQ-listed foreign private issuers are allowed to follow home country practice in lieu of NASDAQ's corporate governance requirements, but must nonetheless meet the NASDAQ requirements for independent audit committee members. A NASDAQ-listed foreign private issuer that follows a home country practice in lieu of one or more provisions of the NASDAQ requirements shall disclose in its annual reports filed with the SEC each requirement that it does not follow and describe the home country practice followed in lieu of such requirements. In addition, a foreign private issuer making its initial public offering or first U.S. listing on NASDAQ shall make the same disclosures in its registration statement.26
In addition, under the new listing standards, "controlled" companies-i.e., companies in which more than 50% of the stock is controlled by one person or group or another company-are not required to meet most of the independence requirements, although they are required to meet the independence requirements for audit committees, except to the extent exemptions for foreign private issuers may otherwise apply.
Foreign private issuers contemplating becoming Reporting Issuers need to carefully review their existing audit committee composition and their home country practices and requirements before the auditors are retained, ensure that an appropriately constituted and structured audit committee approves the auditors' engagement, and determine whether they will need a majority of independent directors before they commence their SEC registration process. Moreover, they may need to continue to have annual retention of auditors approved by both the audit committee and shareholders in order to meet both the requirements of the SEC rules and their home country legal requirements.
Financial Expert and Code of Ethics Disclosure
As required by Section 407 of the Act, the SEC-adopted regulations requiring each Reporting Issuer to disclose in its annual reports whether or not (and if not, why not) the audit committee includes at least one member who is an "audit committee financial expert." If there is such an expert, that person must be identified. Foreign private issuers are similarly required to disclose whether the audit committee financial expert is independent of management. The rule defines "audit committee financial expert" in relation to the understanding of and experience with accounting principles and financial statements, internal controls and procedures, and audit committee functions. With respect to foreign private issuers, the expert's understanding must be of the accounting principles used by the company in preparing its primary financial statements filed with the SEC.27
Pursuant to Section 406 of the Act, the SEC also adopted regulations requiring each Reporting Issuer to disclose in its annual reports whether or not (and if not, why not) the company has adopted a code of ethics for the chief executive officer and senior financial officers. The rules define "code of ethics" as written standards designed to deter wrongdoing and to promote: honest and ethical conduct; full, fair, accurate, timely, and understandable disclosure; compliance with law; reporting of violations of the code; and accountability for adherence to the code.28 The ethics code must be publicly available on a company Web site, or in public filings, or be available to any person on request. Reporting Issuers also must disclose any amendments and waivers of the policy with respect to any of the specified persons. For foreign private issuers reporting on Form 20-F or 40-F, that disclosure must be made annually, as compared with "immediate disclosure" for companies filing annual reports on Form 10-K, although earlier, prompt disclosure is "strongly encouraged."
Under the new corporate governance listing standards of the exchanges, all listed companies are required to have audit committee financial experts, and NASDAQ-listed issuers must have a code of ethics. Although non-listed companies are not required to have audit committee financial experts and codes of ethics, the requirements for inclusion by listed companies and for disclosure by all Reporting Issuers (whether or not listed) of their absence has prompted the great majority of Reporting Issuers to adopt these requirements. As a consequence, Reporting Issuers that donot have them are conspicuously in the minority. For this reason, foreign private issuers that become Reporting Issuers should plan to be in a position to meet these requirements by the time of their first annual report on Form 20-F or Form 40-F.29
Endnotes
1 Wayne Kirk, who authored the original version of this article in March 2003, practiced law in the San Francisco office of Thelen LLP (now Thelen LLP) until his retirement in 2004. During 1992-2001 he was the Vice President, General Counsel and Corporate Secretary of Homestake Mining Company (NYSE), until Homestake's acquisition by Barrick Gold Corporation (TSX, NYSE).
2 The requirements relating to stock exchange regulations also apply to the National Association of Securities Dealers Automated Quotation System. In this paper, the references to U.S. stock exchanges or listing on U.S. stock exchanges are intended to include NASDAQ.
3 "Foreign private issuer" is defined in SEC Rule 3b-4, and generally includes any corporation or other organisation incorporated or organised under the laws of any foreign country unless it meets the following two conditions:
(i) The majority of the executive officers or directors are United States citizens or residents;
(ii) More than 50 percent of the assets of the issuer are located in the United States; or
(iii) The business of the issuer is administered principally in the United States.
4 Companies that offer securities to the public file a registration statement under the Securities Act of 1933. Companies that list securities on a U.S. stock exchange or that must register their securities with the SEC because they have more than $10 million in assets and 500 or more shareholders register their securities under the Securities Exchange Act of 1934.
A foreign private issuer with 500 or more shareholders worldwide may not have made a public offering of its shares in the U.S. or listed in the U.S., but could have 300 or more shareholders in the U.S. as a result of private placements to U.S. residents, or U.S. residents purchasing its shares in foreign markets. Such a company would nonetheless have to register its shares with the SEC and become a Reporting Issuer unless it takes advantage of the exemption provided by SEC Rule 12g3-2(b). Several hundred companies have taken advantage of this exemption. The SEC periodically publishes a list of exempt companies. The most recent list, published on June 21, 2005 as SEC Release No. 34-51893, can be found at http://www.sec.gov/rules/other/34-51893.pdf.
5 U.S. companies file annual reports on Form 10-K, quarterly reports on Form 10-Q, and Form 8-K reports to report certain specified events. Most foreign private issuers file annual reports with the SEC on Form 20-K or, in the case of larger Canadian companies, Form 40-K, and do not file quarterly reports or Form 8-K reports (although some foreign companies voluntarily file on Forms 10-K, 10-Q and 8-K, generally in order to provide a body of disclosure documents comparable to those of their U.S. business competitors). Since much of the information to be reported under Sarbanes-Oxley is required to be included in these filed reports, foreign private issuers generally are required to provide information annually, whereas U.S. companies (and foreign private issuers that voluntarily report on U.S. company forms) provide various types of information sooner or more frequently. Form 6-K reports, by which foreign private issuers furnish certain information to the SEC, are not quarterly or periodic reports and are not "filed." Consequently, the various requirements under Sarbanes-Oxley that apply to periodic or quarterly reports filed with the SEC do not apply to reports on Form 6-K.
6 The prohibited non-audit services are (i) bookkeeping and other related services; (ii) financial information systems design and implementation; (iii) appraisal or valuation services, fairness opinions or contribution-in-kind reports; (iv) actuarial services; (v) internal audit outsourcing services; (vi) management or HR functions; (vii) broker or dealer, investment advisor or investment banking services; and (viii) legal services and other expert services unrelated to the audit. Tax services are permitted, probably even if they are regarded by a company's home country law to be legal services. However, rules adopted by the PCAOB and approved by the SEC in April 2006 prohibit providing (i) services to an audit client related to planning or opining on the tax consequences of a transaction that is a listed or confidential transaction under Treasury regulation or that is based on an "aggressive interpretation" of applicable tax laws and regulations; or (ii) tax services to certain members of management who serve in financial reporting oversight roles at an audit client or to immediate family members of such persons.
7 Regulation S-X, Section 210.2-01(c)(4). A number of the specified non-audit services, such as most bookkeeping services, were already prohibited by the SEC's auditor independence rules.
8 Regulation S-X, Section 210.2-01(c)(7). If a Reporting Issuer does not have an audit committee, the audit committee functions are to be performed by the entire board of directors.
9 Regulation S-X, Section 210.2-01(c)(6).
10 There is a limited prior service exception for foreign accounting firms for service for years prior to the first fiscal year beginning after May 6, 2003 (the effective date of the SEC's rule amendments), but this exception will effectively end on May 6, 2008. Accounting firms with fewer than five Reporting Issuers as clients, and with fewer than ten partners, are exempt if the PCAOB conducts a review at least once every three years of the audit client engagements when the rotation rule is not met.
11 After May 6, 2008, a company will need to be sure that it is not in violation on the date it becomes a Reporting Issuer.
12 Regulation S-X, Section 210.2-01(c)(2).
13 To illustrate, assume that a foreign private issuer that is a calendar year company lists on a U.S. stock exchange on November 1, 2008, filing its initial Form 20-F Registration Statementin connection with that listing. Further, assume that the company files its first Form 20-F Annual Report on March 31, 2009. The company would run afoul of the auditor independence rule if-before the Form 20-F Annual Report for the calendar year 2008 was filed in 2009-it hired any person who was a specified member of the audit team at any time during the period April 1, 2008-March 31, 2009. Furthermore, the company would also run afoul of the auditor independence rule with respect to the audited statements to be included in its initial Form 20-F Registration Statement if it hired any person who was a specified member of any of the audit teams for its 2005, 2006, and 2007 fiscal years. This would include any such person hired by the company after May 6, 2003 but before the company listed on the U.S. stock exchange. See the SEC's Office of Chief Accountant: Frequently Asked Questions, found at: www.sec.gov/info/accountants/ocafaqaudind121304.htm.
14 The audit committee of a Reporting Issuer can determine that the rule will not apply in emergency or other unusual circumstances when the relationship is in the interest of investors. The SEC has indicated that it expects this exception to be invoked "very rarely." There also is an exemption when the conflict results from a merger or acquisition of clients and is known to the audit committee.
15 Regulation S-X, Section 210.2-01(c)(8). Accounting firms with fewer than five Reporting Issuers as clients, and with fewer than 10 partners, are exempt.
16 See SEC Release No. 33-8040 (December 12, 2001) for a discussion of what the SEC considers to be "critical accounting policies."
17 Regulation S-X, Section 210.2-07
18 See Release No. 33-8183 (January 28, 2003)
19 Rule 13a-14
20 For foreign private issuers reporting on Forms 20-F or 40-F, this requirement is set out as a part of the instructions to the forms. The certification language indicated by "*[]*" may be deleted until the required compliance dates discussed above for the management report requirement regarding internal control over financial reporting.
21 Rule 13a-15
22 Envirokare Tech, Inc. vs. Pappas (SDNY, March 2006). See also the "25 Law Firm Memo" issued in October 2002; available at: www.realcorporatelawyer.com/loan25firms.pdf.
23 Rule 10A-3
24 NYSE Rule 303A
25 AMEX Listing Guide Sections 110, 801 and 808
26 NASDAQ Marketplace Rule 4350(a)(1)
27 For foreign private issuers reporting on Forms 20-F or 40-F, this requirement is set out as a part of the instructions to the forms.
28 For foreign private issuers reporting on Forms 20-F or 40-F, this requirement is set out as a part of the instructions to the forms.
29 This disclosure is required in Form 20-F and 40-F Annual Reports. The disclosure is not required in a Form 20-F or Form 40-F filed as a Registration Statement.
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©2007 by Thelen LLP. This article is published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. We would be pleased to discuss the information in this article, and its application to your specific situation, in greater detail. We welcome your comments and suggestions.
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