Financial Certification and Audit Committee

The Sarbanes-Oxley Act of 2002 (the "Act") has created a brave new world of compliance standards that public companies, particularly small- and micro-cap companies, will be grappling with for a long time. Management teams must wake up to the fact that the stakes for corporate accountability have increased substantially, and that they must move up the learning curve quickly to ensure compliance with the Act.

Financial Certification Requirements

The Act has two separate certification requirements for CEOs and CFOs. Beginning on the Act's effective date (July 30, 2002), all 10-Ks and 10-Qs filed by public companies are required to include a certification by the CEO and CFO that the filing fully complies with the requirements of the Securities Exchange Act of 1934 (the "1934 Act") and that the information contained in the filing fairly presents, in all material respects, the financial condition and results of operations of the company.

By way of rules adopted by the SEC on August 29th, the certification requirements have been expanded. CEOs and CFOs now also are required to certify, among other things, that (1) they have reviewed the filing; (2) to the best of their knowledge, the filing is free of material misstatements and omissions; (3) they are responsible for establishing and maintaining "disclosure controls and procedures" for the company and that these have been designed to ensure that material information is made known to them; (4) they have evaluated the effectiveness of the company's disclosure controls and procedures within 90 days of the date of the filing; (5) they have presented in the filing their conclusions as to the effectiveness of the disclosure controls and procedures based on the forgoing evaluation; and (6) to the extent applicable, they have disclosed to the audit committee and its auditors all significant deficiencies or material weaknesses in the company's internal controls as well as any fraud, whether or not material, involving management or other personnel that have a significant role in the company's internal controls.

Public companies, particularly those with smaller compliance budgets, must start taking steps to address the most pressing compliance issues - that is, those arising out of certifications:

Adopt Disclosure Controls and Procedures - Management teams should thoroughly review their internal disclosure controls and procedures, restructuring them as necessary to ensure that everything that is certified is accurate. It is important to remember that one size does not fit all here. Each company needs to implement controls and procedures that are tailored to it. For example, it may be necessary for some management teams to create a public disclosure committee that will review all disclosure issues raised by any line manager. What management teams must ensure in all cases is that any problem that may develop with internal accounting filter up to the CEO and the CFO.

Dedicate Additional Resources to Public Company Compliance - When evaluating the effectiveness of their controls and procedures, companies also need to factor in to the mix that reporting periods in many cases are being compressed. For seasoned issuers, the time periods for quarterly and annual reporting will be shortened over the next three years in stages. Ultimately, quarterly reports will be required to be filed within 35 days after the end of the quarter, instead of within 45 days at present, and annual reports will be required to be filed within 60 days after year-end, instead of within 90 days at present. In addition, starting August 29th, insiders, directors and executive officers have been required to report most trades within two business days. Previously, most trades were required to be reported by the tenth day of the month following the trade. All of these changes may necessitate a considerable reallocation of internal and external resources to public company compliance.

Audit Committee Responsibilities

The Act requires that, by April 26, 2003, a company must have an independent audit committee that is directly responsible for the appointment, compensation and oversight of the company's auditors, in order to be listed on a stock exchange. This piece of the Act will be given effect through modifications to stock exchange listing requirements. The Act also will require all public companies to disclose whether there is a financial expert on the audit committee, which will effectively force public companies to have a committee member that meets the criteria to be considered a financial expert. Both the independence and financial expert standards will be somewhat different than those currently in place at the exchanges and, like other key standards employed in the new legislation, have yet to be defined clearly. However, what is clear is that the Act is inserting the audit committee squarely between a company's management and its auditors.

For many public companies, these changes, together with other rulemaking under way by the exchanges to increase director independence, demand that steps be taken immediately in order to make the necessary changes in both board and audit committee composition:

Start Recruiting Now - Recruiting independent directors already takes substantially longer than before. Given the enhanced responsibilities of the audit committee and of independent directors generally, this process is likely to stretch out even further. The central role that the financial expert on the audit committee is expected to play could make the process of finding someone with the right qualifications to fill that position especially long and cumbersome.

Make Revisions to Audit Committee Charter - Audit committees need to begin focusing on the development and implementation of new procedures that will allow them to effectively discharge their enhanced oversight role. For example, the Act requires the audit committee to establish procedures to address complaints received by the company with respect to accounting, internal controls or auditing matters. The Act also requires that "whistleblower" procedures be adopted so that the company's employees may confidentially submit concerns regarding questionable accounting, internal control or auditing matters. Members of audit committees must be educated on their new responsibilities.

Establish Access to Independent Experts and Advisors - Given their more pronounced role, audit committees should give thought to retaining separate legal and even accounting advisors to assist them in the discharge of their duties, and many audit committees already have begun to move in this direction. In fact, the Act contemplates that audit committees will, from time to time, look to outside experts for assistance, and provides them with the authority to do so. The theory for having designated advisors on retainer is that they will be available when time-sensitive issues suddenly arise, which may be important not only for Sarbanes-Oxley compliance, but also to satisfy fiduciary duties under state law. For example, interpretive issues under the Act will arise on a periodic basis, whistleblower claims may need to be addressed, or a disinterested advisor may be needed to help sort through an accounting or auditing issue. It is likely to be more cost-effective for audit committees to have independent experts on call than to face SEC enforcement actions or shareholder lawsuits due to non-disclosure issues or non-compliance with the Act.

It is important to note that many aspects of the Act, particularly with respect to certification requirements, will require further rulemaking over the next year. Like other substantial pieces of legislation, the Act has its share of ambiguities and raises unanswered questions that will need to be fleshed out and addressed over time. For example, in reference to certification requirements, the Act applies the standard of materiality throughout, especially in determining the basis for disclosure, yet the definition of materiality is left quite vague. Unfortunately, it is often the case that the materiality of information can only be measured after the fact. Consequently, although the Act should be viewed as a work in process that will continue to grow and evolve, CEOs and CFOs should be aware that they nevertheless will be held ultimately responsible for monitoring and maintaining the transparency of disclosures made in 10-K and 10-Q filings, and that they will no longer be allowed to depend simply on professional auditors.

It is also important to note that the SEC has offered little guidance on procedures for compliance. However, the SEC has stated that the "fair presentation" certification is not limited to financial statements. In fact, it goes beyond generally accepted accounting principles and encompasses "selection [and proper application] of appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and events, and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an company's financial condition, results of operations and cash flows." Thus, it behooves principal executive and financial officers to err on the side of rigorous transparency in financial and operating disclosure, despite the current absence of clear and specific compliance guidelines provided by the SEC or the Act.

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