SEC Issues Interpretive Guidance Regarding Section 404 Internal Controls, Adopts New Rules Regarding Electronic Delivery of Proxy Materials, and Proposes Rules Regarding Foreign Private Issuer Deregistration

December 13, 2006

At a meeting today, the Securities and Exchange Commission (“SEC”) worked through an ambitious agenda and issued a number of significant new proposals and final rules. Specifically, the SEC proposed interpretive guidance for management to use in conducting the annual evaluation of internal control over financial reporting that is required under Section 404 of the Sarbanes-Oxley Act of 2002. The SEC also adopted rules to facilitate the use of the Internet to deliver proxy materials to shareholders and re-proposed rules that are intended to simplify the process by which foreign private issuers may deregister from the SEC’s registration and reporting requirements. Other actions taken by the SEC at today’s meeting included a proposal to implement the exceptions to the definition of “broker” under the Gramm-Leach-Bliley Act; a proposal to adopt a new anti-fraud rule under the Investment Advisers Act of 1940; and the re-opening of the comment period for the SEC’s amendments to its investment company governance provisions.

A summary of the interpretive guidance, rules and rule proposals is set forth below. This summary is based on information provided at the SEC’s open meeting, and therefore may not reflect nuances that will appear in the SEC’s interpretive, proposing and adopting releases, which are expected to be issued shortly.

Section 404 Internal Controls Over Financial Reporting

Interpretive Guidance on Conducting Management’s Evaluation
of Internal Control Over Financial Reporting 

The SEC proposed interpretive guidance at today’s meeting for management to use in conducting its annual evaluation of a company’s internal control over financial reporting, as required under Section 404(a) of the Sarbanes-Oxley Act of 2002. In proposing this interpretive guidance, several Commissioners acknowledged that the absence of prior SEC guidance on this issue caused significant confusion and contributed to high implementation costs, and noted that the proposed guidance is intended to make the Section 404 evaluation process more effective and cost-efficient. Several Commissioners also expressed concern that in the absence of prior guidance, management often turned to PCAOB Auditing Standard No. 2 to delineate the parameters of the required evaluation, which is not what the SEC intended. The Commissioners and the SEC Staff emphasized that they believe the proposed guidance is scalable and can be applied by companies of all sizes and complexities. As presented at today’s meeting, the proposed interpretive guidance is premised on a “top-down, risk-based” approach to evaluation and covers four key areas:

• Identification of Risks – The proposed guidance will state that in its evaluation process, management should focus on identifying areas of material risks to financial reporting and controls for addressing these risks. The guidance will urge management to use its judgment in identifying areas where there could be material misstatements and in evaluating related controls to see if they address these risks. The proposed interpretive guidance also will emphasize that management does not need to evaluate all controls in a process; rather, management should focus on identifying and evaluating those controls that in its judgment address the risk of material misstatements in financial statements.

• Evaluating Operation of Controls – The proposed guidance will provide that once the relevant controls are identified, management should align its evaluation methods so that they are focused on analyzing those areas that present the highest risk to reliable financial reporting. The proposed guidance will include examples of ways that management can substantiate its evaluation; this aspect of the guidance is designed in part to limit the amount of testing that management is required to undertake.

• Reporting the Results of Management’s Evaluation – The proposed guidance will include examples that are viewed as strong indicators of a material weakness. At the meeting, the Staff noted that one such example is the scenario where a company is required to restate prior period financial statements. Commenting on this aspect of the guidance, however, the Staff noted that where the restatement arises from an industry-wide change in accounting policy, such as the lease accounting changes in 2005, management should use its judgment as to whether such a change in fact represents a strong indicator of a material weakness.

• Documentation – The proposed guidance will also note that management should take steps to evaluate whether reasonable documentation is maintained with respect to those controls that form the basis for management’s evaluation. The proposed guidance will express that there is no prescribed form of documentation and that management should use its judgment as to the form and extent of documentation maintained. The Staff noted that the proposed guidance is intended to avoid the occurrence of artificial documentation requirements.

At the meeting, the SEC Staff emphasized that the proposed interpretive guidance is not intended to disrupt or change what companies already have done in terms of implementing Section 404. Rather, the SEC intends that companies that have already complied with the Section 404 requirements can determine whether to use any aspects of the interpretive guidance to make their own evaluation process more efficient. Thus, for companies that have already complied with the Section 404 requirements, the proposed guidance, if adopted, is optional, not prescriptive. Also, if adopted as proposed, the guidance will confirm that management can rely on this guidance, and not PCAOB Auditing Standard No. 2, for purposes of conducting an appropriate evaluation of the company’s internal control over financial reporting. The Staff also noted that while the proposed guidance does not include any direction that is tailored specifically toward the types of issues that foreign private issuers are confronting in implementing Section 404, the SEC is interested in receiving comments as to whether the guidance should include such discussion.

To complement the proposed guidance, the SEC also proposed amendments to Rule 13a-15 and 15d-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). These proposed amendments will clarify that if management follows the proposed interpretive guidance in conducting its evaluation as to the effectiveness of the company’s internal controls, management will be deemed to have satisfied the annual Section 404 evaluation required by those rules.

The SEC also proposed amendments to Rule 2-02 of Regulation S-X to require that a company’s registered independent public accounting firm need only provide one opinion on the effectiveness of the company’s internal controls. Under the proposal, the auditor’s attestation of management’s evaluation, a procedure that is required under Section 404(b) of the Sarbanes-Oxley Act, will be deemed subsumed within the auditor’s opinion on the effectiveness of the company’s internal controls.

Finally, at today’s meeting, the SEC took no action to approve the proposals that were issued in August 2006 to extend the Section 404 compliance deadlines for non-accelerated filers, certain foreign private issuers, and newly public companies. It is unclear at this point when the SEC will take action on those extension proposals.

Comments on the SEC’s proposed interpretive guidance and rule amendments will be due 60 days following the date on which the guidance and rules are published in the Federal Register.

Internet Availability of Proxy Materials

The SEC adopted substantially as proposed amendments to its proxy rules that are designed to facilitate the use of the Internet to deliver proxy materials in order to reduce the time and expense involved in delivering these materials to shareholders. The rules will provide companies and other soliciting persons an alternative, optional method for furnishing proxy materials to shareholders based on a “notice and access” model. Under this model, a company may post its proxy materials on an Internet website and mail a notice to shareholders at least 40 days prior to a meeting informing them of the availability of electronic proxy materials and explaining how to access the materials. Companies choosing to use this model would be required to provide a paper or e-mail copy of the proxy materials within three business days of receiving a request by a shareholder. Shareholders may also request to permanently receive all future proxy materials by paper or e-mail. In addition, under the notice and access model, intermediaries (such as brokers) must prepare and send their own notice to beneficial shareholders and must provide a copy of the proxy materials to beneficial shareholders if requested.

Unlike the rules as originally proposed, the final rules will not permit companies to enclose a proxy card with the notice. Instead, a company may send a proxy card, along with another copy of the notice, 10 days or more after it sends the original notice; this process is designed to give shareholders sufficient time to access the online proxy materials. A company may also send a proxy card if it is accompanied by and delivered with proxy materials. In addition, like the proposed rules, the final rules permit a soliciting person other than a company to solicit only shareholders who have not previously requested paper or e-mail copies of proxy materials. Unlike the rules as originally proposed, however, notice must be sent to shareholders by the later of 40 days before the meeting or 10 days after the company filed its proxy materials. Also, if a soliciting person sends a notice to a shareholder, the soliciting person must provide a copy of the proxy materials upon request by the shareholder. These new rules will become effective on July 1, 2007. The SEC stated that voluntary early compliance is not permitted.

The SEC also proposed rules that would make the optional notice and access model adopted today mandatory in the future for all solicitations not related to business combinations transactions. If these proposed rules are adopted, companies would be required to provide shareholders with the web-based disclosures described above, however, companies and other soliciting persons could include a complete set of proxy materials along with the original notice sent to shareholders. Comments on these rule amendments will be due 60 days following publication in the Federal Register.

During the e-proxy discussion, Commissioner Campos stated that he viewed the move toward web-based disclosure as a first step toward shareholder access, and he expressed his desire that the Commission would move in that direction. Commissioner Nazareth stated that while she was supportive of Internet availability of proxy materials, she wanted further study and evaluation of e-proxy before moving to shareholder access. None of the other Commissioners commented on the interplay between this rule and shareholder access.

Foreign Private Issuer Deregistration

The SEC also voted to re-propose rules governing the process by which foreign private issuers deregister securities registered with the SEC under Section 12(g) of the Exchange Act and terminate corresponding SEC reporting requirements under Section 13(a) or 15(d) of the Exchange Act. Currently, a foreign private issuer, even if de-listed from the U.S. exchanges and experiencing little trading activity in the United States, may only exit from the SEC’s registration and reporting requirements if it has fewer than 300 record holders who are U.S. residents.

Under today’s proposal, a foreign private issuer may deregister and terminate its SEC reporting obligations if its trading volume has been no greater than 5% of the average trading volume for that class of securities in the issuer’s primary trading market during the preceding 12-month period. Specifically, proposed Exchange Act Rule 12h-6 would permit the termination of SEC reporting regarding a class of equity securities under either Section 12(g) or Section 15(d) of the Exchange Act that meets the 5% test.

The SEC explained that today’s action to relax the deregistration requirements is intended to make the U.S. securities markets more attractive for foreign private issuers. The Staff also noted that the trading volume test is being proposed as the sole benchmark for deregistration because in the Staff’s view it presents a clear, consistent standard.

Although the 5% trading volume test in proposed Rule 12h-6 appears straightforward, the SEC’s proposal includes several additional conditions that must be satisfied in order to benefit from the relaxed deregistration rule:

• requiring that an issuer that delists in the United States prior to deregistering under Rule 12h-6 must meet the trading volume standard at the date of delisting or else wait 12 months before it can proceed with deregistration;

• requiring that an issuer that terminates an American Depositary Receipts facility must wait 12 months before seeking deregistration;

• requiring that an issuer of equity securities must have been an Exchange Act reporting company for at least one year, have filed or submitted all Exchange Act reports required for the period, and have filed at least one Exchange Act annual report;

• requiring that an issuer of equity securities must not have sold securities in a registered offering in the United States during the preceding 12 months, other than certain exempted securities offerings; and

• requiring that an issuer of equity securities must have maintained a listing for at least a year in a foreign jurisdiction that, either singly or together with one other foreign jurisdiction, constitutes the primary trading market for the issuer’s subject class of securities.

The SEC also stated that its proposal will clarify that a foreign private issuer that terminated or suspended its Exchange Act reporting obligations under the current exit rules before the effective date of Rule 12h-6 typically will be able to take advantage of the final deregistration rules. In addition, the SEC clarified that following a merger, acquisition or other similar transaction, a foreign private issuer that succeeded to the Exchange Act reporting obligations of another company could take into account the Exchange Act reporting history of its predecessor when determining whether it met the conditions for deregistration. Finally, the SEC proposed an amendment that would permit a foreign private issuer to claim the Rule 12g3-2(b) registration exemption immediately upon its termination of Exchange Act reporting under Rule 12h-6, rather than having to wait 18 months as is currently required.

Comments on the SEC’s proposed rule amendments will be due 30 days following the date on which the guidance and rules are published in the Federal Register.

Other Actions

The Commission also approved the following actions at today’s meeting:

Proposed Rules Under the Investment Advisers Act of 1940 and the Securities Exchange Act of 1933: The Commission proposed a new rule under Section 206 of the Investment Advisers Act of 1940 clarifying that it would be considered fraudulent, deceptive, or manipulative conduct for an investment advisor to make materially false or misleading statements or otherwise defraud investors in the advisor’s pooled investment vehicle. The Commission also proposed a rule under the Securities Act of 1933 that would define a new category of accredited investor with respect to hedge funds and other private investment pools. Under the new rule, accredited investors would include natural persons who both satisfy the net worth or income tests under Rule 501(a) or Rule 215 and who also own at least $2.5 million in investments, as defined by the proposed rules. Comments on the SEC’s proposed rule amendments will be due 60 days following the date on which the guidance and rules are published in the Federal Register.

Proposed Rules Under the Bank Broker Provisions of the Securities Exchange Act of 1934: The SEC proposed, jointly with the Board of Governors of the Federal Reserve System (the “Board”), rules known as “Regulation R” to implement the Gramm-Leach-Bliley Act bank exceptions to the definition of “broker.” The proposed rules would provide clarity with respect to statutory terms under the networking, trust and fiduciary activities, sweep accounts, and safekeeping and custody exceptions. In addition, the SEC published companion rules relating to certain bank dealer activities and other related issues. The SEC also issued rules extending the temporary exemption of banks from the definition of “broker” under the Exchange Act until July 2, 2007. Comments on the SEC’s proposed rule amendments will be due 90 days following the date on which the guidance and rules are published in the Federal Register.

Re-Opening of Comment Period for Amendments to Investment Company Governance Provisions: In a brief statement at the conclusion of today’s SEC open meeting, Chairman Cox also stated that the Commission voted in advance of the meeting to approve the re-opening of the comment period for the SEC’s amendments to the investment company governance provisions. Chairman Cox stated that the Commission approved the re-opening of the comment period to permit public comment on two papers prepared on this subject by the SEC’s Office of Economic Analysis. The SEC did not indicate at the open meeting how long it will extend the comment period.

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.