SEC Open Meeting December 13

By: Cydney Posner

Even though it was trimmed a bit, the SEC's agenda for today's marathon open meeting (ended at 5:00 p.m. today) was unusually ambitious. Among the items considered:

Management’s Report on Internal Control Over Financial Reporting

The SEC decided to propose interpretive guidance to assist company management in planning and performing its annual evaluation of internal control over financial reporting. The guidance recognizes that tasks of management and auditors with respect to assessment of internal control are different and that distinct guidance is necessary for management. The guidance assumes the adoption of a new AS2 (expected to be proposed by the PCAOB next week) that no longer requires the auditors to evaluate the efficacy of the methods used by management, thereby allowing management to look to the SEC's guidance for methods. There was no discussion of delaying compliance with the rule for small issuers.

At the meeting, John White reaffirmed that the objective of internal control is to foster preparation of reliable financial statements and to bring information regarding material weaknesses to the attention of the investing public. With that goal in mind, the new guidance is designed to allow management to focus on areas where there are high risks of material misstatements and a reasonable possibility of affecting the financial statements. The new guidance is intended to be scalable and to rationalize the planning and conduct of the evaluation, but is not prescriptive.

The two key principles of the guidance are:

• The exercise of judgment by management to design an evaluation that is tailored to the particular company; and
• Significant flexibility regarding the level of documentation necessary to support the assessment.

• A top-down, risk-based approach. The approach comprises
  • Identification by management, using its judgment, of risks to reliable financial reporting (areas that are likely sources of material risk leading to material misstatement) and related controls; and
  • Evaluation of the adequacy of the controls implemented.
  • It may not be necessary to identify and evaluate all controls, so long as key controls have been identified and are adequate.
• Evaluation of the operation of controls. The evaluation would also involve a consideration of the risks regarding financial reporting and would align the methods of evaluation with the assessment of risk. Smaller companies without multiple levels of management may be able to rely on the results of daily interactions and thus eliminate the need for further testing. It was noted, with respect to timing of testing, that the more high-risk the control, the more evidence that should be required, both over a longer period and in closer proximity to year end.
• Deficiency evaluation and disclosure. The guidance directs management to assess whether deficiencies constitute material weaknesses using a framework with examples of various indicators, such as scope limitations and restatements. (It appears the restatements will continue to be strong indicators of material weaknesses; however, there was some approval voiced that auditors were now using judgment on this point and were not automatically viewing all restatements as reflecting material weaknesses.) If there is a reasonable possibility that a material misstatement would not be detected, the company would have a material weakness. Material weaknesses must be disclosed and described.
• Documentation requirements. The guidance would require reasonable documentation defining those controls that form the basis for the evaluation and conclusions, including the methods and procedures utilized to evaluate evidence. Management would be permitted once again to use its judgment to determine the form and extent of documentation, permitting smaller companies without multiple levels of management to minimize documentation.

Finally, the SEC had received feedback indicating that the auditors' report regarding internal control was not effectively communicating the auditors' responsibilities. As a result, the SEC also proposed changes to its requirements to Reg S-X , Item 202(f), to allow a single report on the effectiveness of internal control that subsumes the currently required separate attestation. (The PCAOB will propose similar changes.)

Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles

The SEC voted to propose a new antifraud rule under Section 206 of the Investment Advisers Act of 1940 to prevent hedge fund advisors and advisors to other pooled investment vehicles from defrauding investors. (There is no private right of action under this section.) The rule is designed to clarify an ambiguity that arose under a recent court of appeals case, Goldstein v. SEC, that invalidated the SEC's prior action to require hedge fund registration.

The SEC also decided to propose new rules under the Securities Act to revise the criteria for natural persons to be considered "accredited investors" for purposes of investing in certain privately offered investment vehicles that rely on section 3(c )(1) of the Investment Company Act, such as hedge funds. The rule would specifically exclude investments in venture funds, although it appeared that there may be some definitional issues. The proposed rule, which contains an inflation adjustment provision, would require that individuals have at least $2.5 million in "investments," as defined, and continue to meet the other accredited investor requirements. Commissioner Atkins and former Commissioner Glassman had previously advocated adjustment of the accredited investor standard in lieu of registration of hedge funds. Commissioner Campos raised concerns about the increasing indirect participation of small investors, through pension or similar funds, in risky hedge fund investing. (A modification of Form D requiring more "census data" is also on the horizon.)

Internet Availability of Proxy Materials; Mandatory Internet Availability of Proxy Materials

The SEC adopted amendments to the proxy rules that will provide a voluntary Internet disclosure alternative for proxy solicitations. Companies conducting proxy solicitations will be able to satisfy the Rule 14a-3 requirement to furnish proxy materials by posting those proxy materials on an Internet website and providing shareholders with notice of the availability of the materials. The effect of the new rule is to move from a system for opting in to electronic delivery to an opt-out system. The new rule has a July 1, 2007 effective date. Voluntary early compliance will not be permitted.

The new rules will require that companies deliver a plain-English notice of availability at least 40 days prior to the meeting. The notice would include the date, time and location of the meeting, the website address where the proxy statement can be found, a toll-free number to call to obtain paper copies of the proxy statement, a description of the matters to be submitted for shareholder approval at the meeting and management's recommendation. No other information will be permitted and no other communications may accompany the notice. Intermediaries, such as banks and brokers, will create their own notices. Other soliciting persons will also be permitted to take advantage of the Internet alternative.

The proxy statement must be posted on a publicly accessible website (not EDGAR), and there was some commentary indicating that the website would need to protect the privacy of the shareholder. Companies will not be able to send a proxy in a different medium (e.g., on paper if the proxy statement is sent electronically) until 10 days after the notice has been sent.

Shareholders desiring to receive paper copies need respond only once, by any means, to receive paper proxy statements in perpetuity. Similarly, shareholders will be able to request that intermediaries furnish paper proxy statements for all securities of any issuer held by that intermediary.

The SEC also voted to propose mandatory Internet disclosure of proxy materials, except in the context of business combinations. In this case, companies would be permitted to mail paper copies of the proxy statement with the notice.

Termination of a Foreign Private Issuer’s Registration of a Class of Securities Under the Exchange Act

The SEC voted to repropose a new rule that would enable a foreign private issuer meeting specified conditions to terminate permanently its Exchange Act Section 12(g) registration and reporting obligations and its Section 15(d) reporting obligations regarding a class of equity or debt securities. The new rule is expected to be considered for adoption before the end of the first quarter of 2007.

Currently, foreign private issuers may deregister only if they have fewer than 300 U.S. shareholders. This rule has come under criticism because it can be difficult to determine whether the threshold has been met. In addition, it has been widely reported that foreign companies have become more reluctant to raise public funds in the U.S. because of the uncertainty of exiting the system. The proposed new rule would allow foreign private issuers to terminate registration if their U.S. average daily trading volume over a one-year period falls below 5% of their average daily trading volume in their primary market. It was estimated that, under the rule proposal, approximately 500 of the 1200 foreign private issuers would be eligible to deregister. Companies that exceed the trading threshold but then delist or terminate a sponsored ADR facility or that conduct a public offering in the U.S. must wait 12 months before they may delist under the proposed rule.

The SEC also voted to repropose a rule amendment that would apply the Rule 12g3-2(b) exemption from Exchange Act registration to a class of equity securities immediately upon the effective date of the issuer's termination of registration and reporting obligations under the reproposed new exit rule. Under that exemption, foreign private issuers that have deregistered must post on their websites, in English, information required to be made public under the law of its domicile or incorporation.

Foreign private issuers that terminate registration prior to effectiveness of the new rule would receive the benefits of the rule. In addition, a foreign private issuer that succeeds to registration as a result of a business combination will be able to deregister shortly after succession. Click here for press release.

Investment Company Governance Request for Comment

The SEC decided to reopen the comment period for its June 2006 request for additional comment regarding amendments to investment company governance provisions, which would require mutual fund boards to have an independent Chairman and a Board composed of at least 75% percent outside directors. In connection with the request, the SEC will publish economic analyses of mutual fund governance and independence issues by the Office of Economic Analysis. You may recall that this measure was a very hot topic during the tenure of former SEC Chairman William Donaldson (see my email of 6/23/04 pasted below), who was a strong advocate of the rule. In June 2005, shortly before Donaldson was scheduled to leave the SEC, a federal appeals court sent the rule back to the SEC for further review of its costs. Donaldson immediately scheduled a meeting to reconsider the matter, and eight Senate Banking Committee Republicans asked Donaldson to reconsider his decision to vote on a mutual fund governance rule the day before he was to step down from his post. The proposal passed with significant dissension. The court then concluded that, while the SEC had authority to adopt the rule amendments, it had violated the Administrative Procedure Act by not affording an opportunity for public comment on the economic data, and on and on…. However, no fireworks at the meeting today--the meeting went so late that there was no time for discussion of this item.

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In other matters, the SEC also voted to propose, jointly with the Board of Governors of the Federal Reserve System, new rules, referred to as Reg R, under the Exchange Act to implement the Gramm-Leach-Bliley Act bank exceptions to the definition of "broker" and extended the temporary exemption of banks from the definition of "broker." In addition, the SEC decided to propose additional related rules, including rules exempting banks from the definition of "dealer" under the Exchange Act.