Conversation With Yaacov M. Gross, Partner, Willkie Farr & Gallagher LLP, With Respect To Sarbanes-Oxley Developments

Sunday, February 1, 2004 - 01:00

Editor: What changes in financial reporting for year-end 2003 statements and for upcoming 2004 quarterly statements should we expect to see?

There are a variety of recent accounting changes the full effects of which are being felt currently, like FIN 46 which I equate with Sarbanes-Oxley's disclosure requirement with respect to "off-balance sheet" obligations, or FAS 141 with respect to the valuation of leases in acquired properties. These have been bedeviling some of our clients, but I would leave it to an accountant to explain these in detail. As an attorney, I can say these changes, coupled with the required acceleration of the filing of certain public company reports, such as the 2003 annual reports, have presented real challenges for public companies. With respect to annual reports, the 10-K report for 2003 is now due by March 15, 2004. The quarterly reports on Form 10-Q are also being accelerated in 2004 and then again in 2005.

As far as what to expect in terms of new substantive accounting rules- the new Public Accounting Oversight Board has been impaneled, has overseen the initial registration of registered auditing firms planning to practice before the SEC, and therefore may now turn its attention to new standards and rules to supplement those that they find unsatisfactory under the general accounting process.

There are a host of financial items that are required to be disclosed in companies' MD&A sections, many of which were adopted in 2003, but are only now being fully felt as companies get ready to file their annual reports. As the stock market has strengthened and companies again began to access the capital markets, they also had to deal with the impact of some earlier financial pronouncements, such as the need to provide reconciliation for non-GAAP financial measures. In some cases, this meant that companies had to amend prior SEC filings before being able to access the capital markets.

Editor: Were there certain grace periods in effect in 2003 before the new requirements began to be triggered in 2004?

Generally, grace periods were rather short, often for only one reporting period. In most cases, we are already out of the grace period with the Sarbanes-Oxley mandated financial reporting requirements. With respect to the accelerated filing requirement, that was a lengthy grace period but that is rapidly coming to an end.

We are still in a transition period with respect to the management report on compliance with internal controls and procedures and the audit arrangements that will have to occur with respect to such report. That grace period expires in mid-2004.

Editor: What are some of the knottiest problems in terms of compliance that your clients face?

We have to distinguish between two types of clients - existing public companies and companies planning to go public. In the past two or three years, the latter category was rather small because the IPO market was dead. Now that the IPO queue has increased dramatically, many companies are confronting the Sarbanes-Oxley changes for the first time. The kind of problems that they face are different and rather dramatic. A case in point: the highly anticipated IPO of Google was delayed to allow for an "audit" to be conducted to ensure that, as a public company, Google would be able to satisfy the Sarbanes-Oxley requirements.

If we focus on IPO candidates, one of their basic problems is being able to attract prospective directors to boards in an environment of fear over directors' personal liabilities. It is increasingly difficult to find truly qualified directors willing to serve on the board of an IPO company. I think many candidates view joining a new company's board as being asked to join a rocket ship crew right before launch- where the launch stage is one of the riskiest parts of the venture. In particular, new companies have difficulty in finding anyone to serve as the audit committee financial expert. Their search for candidates willing to perform that role has become almost frantic. Finding good directors who can meet the stock exchanges' "independence" requirements, and moreover who can satisfy the "pure independence" standards of the corporate governance rating criteria of ISS and others, is also becoming very difficult.

Editor: Are seasoned public companies also having difficulty finding directors who meet the independence standard or have the financial acumen to serve in the various board roles outlined by Sarbanes?

They do not have as big a problem since they have existing directors. Even though the directors may be nervous about some of the regulatory changes being implemented, they are not as likely to abandon their board. They also have had the benefit of watching Sarbanes-Oxley develop under the coaching of corporate and outside counsel; they feel committed to their companies - so they feel the pressure in a less significant way. To keep them happy, all that might be necessary would be a bump in their directors' fees and D&O coverage. All that being said, I know of one or two large public companies that have restructured and/or enlarged their boards, and I have had the unpleasant task of advising their CEOs to abandon a cherished board candidate because of a technical or perceived problem with Sarbanes-Oxley compliance. For example, it is a common practice for CEOs to serve on each others' boards, but that often raises interlocking directorship problems that have been prohibited under the SRO and SEC rules. In one case, the CEO of a public company wanted to bring on his board the CEO of another large public company. It turns out that the first CEO serves on the board and all board committees of the candidate CEO's company, including the compensation committee, which means that the candidate CEO would not be "independent" and therefore couldn't serve on any of the first CEO's major board committees. Moreover, the determination of "independence" must be made affirmatively by a company's board each year, so even if the candidate CEO came on board as a non-independent director, the first CEO's independence might then be challenged by the candidate CEO's board. So these things can get complicated, even for seasoned public companies, once they begin tinkering with their board or board committee memberships.

Editor: What other contrasts do you see between established public companies and those about to go public or recent IPOs?

There are certain peculiar anomalies in Sarbanes-Oxley, such as the prohibition on executive officer loans. There is a "grandfathering" provision for loans extended prior to the enactment of Sarbanes so long as the loans were not subsequently amended. But here's the catch: based on the literal wording of the statute, the grandfathering is only available for loans made by public companies. There is no grandfathering for loans extended pre-Sarbanes by a private company that now wants to go public. So the CEO of a private company seeking to go public may now have to scramble to replace his existing company loan with a bank loan.

Editor: How are seasoned public companies responding to the new listing requirements?

What began as a gradual process to conform stock exchange listing standards to the requirements of Sarbanes-Oxley has become a little bit of a scramble. These provisions were awhile in coming, and public companies had plenty of opportunity to monitor their development. Nonetheless, many companies - very sensibly, in my view - decided to wait before changing their corporate governance arrangements until the amended listing standards were finally approved by the SEC. As it happened, the grace period for compliance once the amended listing standards were finalized was quite short. Consequently, companies have been scrambling to get their compliance in order.

Editor: What has been the impact on "D&O" insurance for both new and seasoned public companies?

This is a real dollar-cost item. I don't believe that the exposure of D&O carriers has been increased by Sarbanes-Oxley; on the contrary, I believe the legislation has been helpful to them. But the D&O business has been a money loser for years, mostly because of mistakes made by the carriers in the wake of the Private Securities Litigation Reform Act in the mid-1990s, and the carriers are using the current environment of fear among directors to raise their premiums. With respect to existing companies, the premiums are increasing at a somewhat more modest rate, albeit significantly from year to year. With respect to companies planning their IPOs, it's become a pure grab for dollars.

Editor: Have there been any modifications to the disclosure requirements for management's MD&A disclosures since we last spoke last April?

No, but I think companies will really be dealing with this in a meaningful way because of the immediate need to file their annual reports which will contain the full panoply of new MD&A disclosures. Companies are struggling with this, given the accelerated time for filing these reports. Some of these disclosures focus on getting companies to reveal more about their off-balance sheet financial arrangements. The SEC has also tried to simplify the presentation of this data so that it can be easily quantified; they've created a special section in the MD&A section so that the discussion can be easily found and there is a tabular presentation listing categories of perceived off-balance sheet arrangements. As we discussed before, there are some problems with this, such as a focus on off-balance sheet liabilities without providing a presentation for off-balance sheet assets. There are anomalies there, valuation issues, etc. The effect of this is to make companies look more leveraged than they may actually be, which may hurt their ability to access the capital markets. The good news is that the SEC read some of the comment letters, and at least some of the worrisome contingent liability items such as law suits, etc. are not deemed "off-balance sheet obligations" and are therefore not required to be quantified and placed on these tables.

Editor: What are companies doing to flesh out their internal controls as required by Section 404 of the Act?

Auditors will simply have to audit their clients' procedures. There is a certain interplay between auditors and companies in trying to develop the right procedures. Companies are expending time and money in working with the auditors in terms of trying to flesh out these internal controls. Keep in mind that company executives are already certifying they have the proper controls. But the difference between today and a few months from now is that there will be a report of these controls that will have to stand up to an audit standard. There has been a wait-and-see approach for the audit standards to be developed before companies have undertaken to impose new control procedures and processes.

Editor: How is it possible to devise a one-size-fits-all set of standards?

Each company is different. It comes down to different roles or functions within a company, how information flows within an organization. Some things can be standardized in making sure that certain procedures are universally followed, certain oversights are in place, and no glaring holes are left open in the information transfer process. Today I dealt with a company where the insiders had acquired shares a few years ago but through an honest slip-up had forgotten to advise the compliance officer that they had done this; consequently, the company's various filings, including its proxy statements, had been inaccurate for prior years in terms of listing the shares that the insiders own. A properly developed internal control system would have implemented steps that would have provided a better method to ensure such ownership was reported. Good controls are meant to be self-executing, reducing the impact of human error, and also adding multiple eyes to the process to ensure no improprieties.

Editor: In summary, what do you think the net effect of Sarbanes-Oxley has been in the eighteen months since its passage?

There are some good things but also some serious negatives - wasted time, money, paper. It's good that a company's officers and directors feel more pressure to do their jobs responsibly. Perhaps some will thus be precluded from going down the path of an Enron or Worldcom-like scandal. On the other hand, I suspect that a CEO who is cooking the books or a CFO who is using creative accounting will continue to do so, notwithstanding the certification requirement of the Act. For example, I love to point out that Sarbanes-Oxley and the stock exchanges have mandated that the major board committees be comprised solely of independent directors - and Enron, Worldcom, Adelphia, etc. all satisfied that requirement. So I don't think we can regulate venality in people, try as we may, but we can eliminate certain loopholes and put up certain warning lights, which Sarbanes has done.

Yaacov M. Gross, a corporate and securities law partner, answers questions relating to recent developments under the Sarbanes-Oxley Act.