Status report: Sarbanes-Oxley and high-yield debt issuers

February 01, 2003

Does the Sarbanes-Oxley Act of 2002 apply to private companies with registered debt?

Yes. Sarbanes-Oxley has two kinds of provisions, those with general implications for the capital market (e.g., the creation of the Public Company Accounting Oversight Board) and those directly addressed toward companies. The latter cover any “issuer,” which is a term specifically defined in the Act. A company that places debt securities in a registered offering—whether in an original issuance or in an exchange offer following a Rule 144A offering—is an “issuer,” and thus governed by Sarbanes-Oxley, from the time of filing the registration statement, even if its equity is held privately.

When does the application of Sarbanes-Oxley end?

A company ceases to be an “issuer” when the registration statement is withdrawn before it becomes effective, or, if the registration statement has become effective, when the company is no longer required to file periodic reports (10-K, 10-Q, etc.) under the Securities Exchange Act of 1934.

It was initially unclear whether Sarbanes-Oxley would apply to debt issuers that are no longer required by the Exchange Act to file periodic reports with the SEC, but are required to do so by the reporting covenants in their indentures. The Division of Corporation Finance of the SEC recently clarified that the definition of “issuer” in Sarbanes-Oxley does not include these voluntary filing companies.

How do I know whether a company that files SEC reports is an “issuer” or a voluntary filing company?

Section 15(d) of the Exchange Act provides an automatic suspension of the reporting obligation as to any fiscal year (except for the fiscal year in which the registration statement became effective) if the company has fewer than 300 holders of the registered security at the beginning of such fiscal year. Under Rule 15d-6, a Form 15 should be filed to notify the SEC of the suspension, but the suspension is granted by statute and is not contingent on filing the Form 15. Thus, a company with registered high-yield debt but fewer than 300 bondholders at the beginning of any fiscal year (except for the fiscal year in which the registration statement became effective) is not an “issuer” within the Sarbanes-Oxley definition.

If a company initially places registered debt with fewer than 300 investors, is it ever an “issuer” under Sarbanes-Oxley?

Yes, from the time of filing the registration statement until the end of the fiscal year in which the registration statement became effective.

Should a company with fewer than 300 bondholders file a Form 15?

We believe that it can only be advantageous for the company to go on record that it is not an “issuer” under Sarbanes-Oxley. Companies should select the appropriate format for going on record on a case-by-case basis. The clearest method is filing a Form 15. If the company is concerned that the filing may be misunderstood by its bondholders, the company should consider stating its position in the context of an Exchange Act report (10-K or 10-Q).

What provisions of Sarbanes-Oxley are relevant for those companies that are “issuers?”

See the following summary of those provisions that may be relevant to public companies. Provisions that apply to debt issuers that are “issuers” under the Sarbanes-Oxley definition are checked under the column “Applicable to High-Yield Debt Issuers Required To File SEC Reports.” The checklist assumes that the bonds are not listed on any securities exchange or association.

Are there any provisions that apply to voluntary filing companies even though they are not “issuers” under the Sarbanes-Oxley definition?

Yes. These are provisions that mandate certain disclosures or certifications in the reports filed with the SEC. They are checked under the column “Applicable to High-Yield Debt Issuers Filing SEC Reports Voluntarily.”

Some of the statutory provisions use the term “issuer” and on their face do not seem to apply to voluntary filing companies. They relate to off-balance sheet transactions (Section 401(a)(j)), the code of ethics (Section 406), the audit committee financial expert (Section 407), and financial statement certifications (Section 906). However, it was not the intention of Sarbanes-Oxley to create two different standards for Exchange Act reports and the new SEC rules implementing these provisions clearly impose uniform requirements for all filing companies. Voluntary filing companies should comply with these disclosure and certification requirements the way they are complying with all other applicable 10-K, 10-Q and 8-K items.

Does that mean that a voluntary filing company must have an audit committee financial expert and a code of ethics?

No, but neither does an “issuer.” The new SEC rules are strictly disclosure rules. Companies must disclose in their annual reports whether they have an audit committee financial expert serving on their audit committee and whether they have adopted a code of ethics for their principal executive officer and senior financial officers. A company that does not have an audit committee financial expert or a code of ethics must disclose and explain this fact. As a practical matter, the disclosure requirement will probably cause most companies—whether they are an “issuer” or a voluntary filing company—to have an audit committee financial expert and a code of ethics.

What is an “audit committee financial expert?”

The final SEC rules define an audit committee financial expert as a person who has the following attributes: (1) an understanding of GAAP and financial statements; (2) the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves; (3) experience with comparable financial statements; (4) an understanding of internal controls and procedures for financial reporting; and (5) an understanding of audit committee functions. A person must have acquired such attributes through one or more of certain experience categories, which include “other relevant experience.”

The definition originally proposed by the SEC—which used the term “financial expert”—included more stringent requirements. Private equity funds were concerned that their representatives would not meet the criteria and that they had to reconstitute the audit committees of their portfolio companies if they wanted to be able to state that they included a financial expert. We believe that the final definition will make it easier for boards of directors to determine that a private equity professional is an “audit committee financial expert.”

What is the current status of rule-making by the SEC?

The following summary reflects the status as of January 31, 2003, including several new SEC rules that were required by the January 26, 2003, statutory deadline.

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