B-130961.147,OM, AUG 21, 1980

B-130961.147,OM: Aug 21, 1980

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THE BRIBERY PROVISIONS ARE BEING HANDLED SEPARATELY. OUR RESPONSES TO YOUR QUESTIONS ON THE ACCOUNTING PROVISIONS ARE GIVEN BRIEFLY BELOW. WHAT ARE THE POSSIBLE CRIMINAL PENALTIES? A COMPANY FOUND TO HAVE WILLFULLY FAILED TO COMPLY WITH THE REQUIREMENTS OF SECTION 13(B)(2) IS SUBJECT TO CRIMINAL SANCTIONS. THAT EVERY APPARENT VIOLATION OF SECTION 13(B)(2) WILL RESULT IN A CRIMINAL ACTION AGAINST THE NONCOMPLYING COMPANY. WHAT IS EXPECTED FROM A COMPANY IN ORDER TO BE IN COMPLIANCE WITH THAT SECTION? SECTION 13(B)(2)(B) REQUIRES COMPANIES TO ESTABLISH AND MAINTAIN INTERNAL ACCOUNTING CONTROL SYSTEMS SUFFICIENT TO PROVIDE "REASONABLE ASSURANCES" THAT CERTAIN STATED OBJECTIVES ARE MET. THAT THE NECESSARY CONTROL SYSTEMS WILL HAVE TO EVOLVE.

B-130961.147,OM, AUG 21, 1980

SUBJECT: FOREIGN CORRUPT PRACTICES ACT - ACCOUNTING PROVISIONS (FILE B-130961.147; CODE 908010)

DIRECTOR - FGMSD:

THIS RESPONDS TO A MEMORANDUM FROM MR. J. C. STEINHOFF, GROUP DIRECTOR, FGMSD/SO, REQUESTING OUR LEGAL OPINION ON CERTAIN ASPECTS OF THE ACCOUNTING AND THE BRIBERY PROVISIONS OF THE FOREIGN CORRUPT PRACTICES ACT OF 1977 (FCPA), PUB. L. NO. 95-213, 91 STAT. 1494. THIS MEMORANDUM CONCERNS THE ACCOUNTING PROVISIONS (SECTION 102). THE BRIBERY PROVISIONS ARE BEING HANDLED SEPARATELY.

OUR RESPONSES TO YOUR QUESTIONS ON THE ACCOUNTING PROVISIONS ARE GIVEN BRIEFLY BELOW, WITH MORE DETAILED EXPLANATIONS SET FORTH IN THE ATTACHMENT.

QUESTION 1: CAN A VIOLATION OF THE ACCOUNTING REQUIREMENTS ADDED AS SECTION 13(B)(2) OF THE SECURITIES EXCHANGE ACT OF 1934 BY THE FCPA CARRY WITH IT CRIMINAL SANCTIONS AND, IF SO, WHAT ARE THE POSSIBLE CRIMINAL PENALTIES?

ANSWER 1: THE FCPA DOES NOT CONTAIN ANY SPECIAL CRIMINAL SANCTIONS FOR A VIOLATION OF SECTION 13(B)(2) (E.G., IF A COMPANY IMPROPERLY FAILS TO MAINTAIN ACCURATE BOOKS AND RECORDS OR AN ADEQUATE SYSTEM OF INTERNAL ACCOUNTING CONTROLS). HOWEVER, SECTION 13(B)(2) AS A PART OF THE SECURITIES EXCHANGE ACT OF 1934 CLEARLY FALLS UNDER THE SCOPE OF SECTION 32(A) OF THAT ACT, WHICH PROVIDES THAT:

"ANY PERSON WHO WILLFULLY VIOLATES ANY PROVISION OF (THE 1934 ACT) SHALL UPON CONVICTION BE FINED NOT MORE THAN $10,000, OR IMPRISONED NOT MORE THAN FIVE YEARS, OR BOTH ***."

THUS, A COMPANY FOUND TO HAVE WILLFULLY FAILED TO COMPLY WITH THE REQUIREMENTS OF SECTION 13(B)(2) IS SUBJECT TO CRIMINAL SANCTIONS.

THIS DOES NOT MEAN, HOWEVER, THAT EVERY APPARENT VIOLATION OF SECTION 13(B)(2) WILL RESULT IN A CRIMINAL ACTION AGAINST THE NONCOMPLYING COMPANY. DEPENDING UPON THE CIRCUMSTANCES, THE SEC MAY ALTERNATIVELY INITIATE A CIVIL INJUNCTION ACTION, AN ADMINISTRATIVE DISCIPLINARY PROCEEDING, OR SEEK OTHER ANCILLARY EQUITABLE RELIEF.

QUESTION 2: DOES THE "REASONABLE ASSURANCES" STANDARD IN SECTION 13(B)(2)(B) ADEQUATELY EXPLAIN, FROM A LEGAL STANDPOINT, WHAT IS EXPECTED FROM A COMPANY IN ORDER TO BE IN COMPLIANCE WITH THAT SECTION?

ANSWER 2: YES. SECTION 13(B)(2)(B) REQUIRES COMPANIES TO ESTABLISH AND MAINTAIN INTERNAL ACCOUNTING CONTROL SYSTEMS SUFFICIENT TO PROVIDE "REASONABLE ASSURANCES" THAT CERTAIN STATED OBJECTIVES ARE MET. HOLDING COMPANIES AND RESPONSIBLE COMPANY OFFICIALS TO A GENERAL STANDARD OF REASONABLE CARE AND DILIGENCE HAS SUBSTANTIAL AND LONG STANDING PRECEDENT. THUS, THE REASONABLE ASSURANCES STANDARD APPEARS LEGALLY SUFFICIENT IN TERMS OF PROVIDING GUIDANCE TO COMPANIES FOR COMPLIANCE PURPOSES.

WE RECOGNIZE THAT THERE MAY BE PROBLEMS IMPLEMENTING SECTION 13(B)(2)(B) IN TERMS OF THE PRESENT ACCOUNTING STATE-OF-THE-ART, AND THAT THE NECESSARY CONTROL SYSTEMS WILL HAVE TO EVOLVE. HOWEVER, WE DO NOT REGARD THESE PROBLEMS AS AFFECTING THE VALIDITY OF THE LAW ITSELF.

IN ANY EVENT, THE MANY RECENT EFFORTS IN THE PRIVATE SECTOR TO MORE FULLY DEVELOP SPECIFIC STANDARDS AND TECHNIQUES CONCERNING COMPANY INTERNAL ACCOUNTING CONTROLS, AS WELL AS THE SEC'S RECENT EFFORTS TO PROVIDE ADDITIONAL GUIDANCE TO COMPANIES, MAY SUBSTANTIALLY ALLEVIATE IN THE NEAR FUTURE, THE UNCERTAINTIES AND CONCERNS OVER SECTION 13(B)(2)(B).

QUESTION 3: DO THE RECORD KEEPING AND/OR THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS CONTAIN, EITHER EXPRESSLY OR IMPLIEDLY, A MATERIALITY STANDARD?

ANSWER 3: NO. OUR ANALYSIS OF THE LANGUAGE AND LEGISLATIVE HISTORY OF SECTION 13(B)(2) REVEALS NO INDICATION THAT SUCH A STANDARD, WITHIN THE CONTEXT OF THE TRADITIONAL FEDERAL SECURITIES LAWS, WAS INTENDED TO BE APPLIED TO THE RECORD KEEPING AND INTERNAL ACCOUNTING CONTROL REQUIREMENTS. INDEED, THERE IS STRONG SUPPORT FOR SEC'S POSITION THAT A "REASONABLENESS" STANDARD, AS OPPOSED TO MATERIALITY STANDARD, GOVERNS. HOWEVER, IT IS IMPORTANT TO POINT OUT THAT THE DISTINCTION BETWEEN THESE STANDARDS IS ONE OF DEGREE RATHER THAN KIND.

ATTACHMENT

FOREIGN CORRUPT PRACTICES ACT - ACCOUNTING PROVISIONS

DIGEST:

CONCERNING ACCOUNTING REQUIREMENTS IN SEC. 13(B)(2) OF SECURITIES AND EXCHANGE ACT OF 1934, ADDED BY SEC. 102 OF FOREIGN CORRUPT PRACTICES ACT, (1) COMPANY WILLFULLY FAILING TO COMPLY IS SUBJECT TO CRIMINAL SANCTIONS BUT CIVIL ENFORCEMENT ACTIONS MAY ALSO BE INITIATED BY SEC; (2) "REASONABLE ASSURANCES" STANDARD IS NOT LEGALLY INSUFFICIENT FOR PROVIDING GUIDANCE TO COMPANIES FOR PURPOSES OF DETERMINING COMPLIANCE WITH THE INTERNAL ACCOUNTING CONTROL PROVISIONS; AND (3) RECORD KEEPING AND INTERNAL ACCOUNTING CONTROL REQUIREMENTS DO NOT CARRY "MATERIALITY STANDARD"; INSTEAD "REASONABLENESS STANDARD" APPLIES.

I. BACKGROUND:

THE FOREIGN CORRUPT PRACTICES ACT OF 1977 (FCPA), PUB. L. NO. 95-213, 91 STAT. 1494, WAS ENACTED IN RESPONSE TO A SERIES OF HIGHLY PUBLICIZED DISCLOSURES, MAINLY THROUGH INVESTIGATIONS BY THE SECURITIES AND EXCHANGE COMMISSION (SEC), THAT A NUMBER OF UNITED STATES COMPANIES OR THEIR SUBSIDIARIES HAD A LONGSTANDING PRACTICE OF MAKING BRIBES OR OTHER QUESTIONABLE PAYMENTS TO FOREIGN OFFICIALS. SEC'S REPORT TO THE CONGRESS DETAILING THE RESULTS OF THE INVESTIGATIONS, FN1 RECOMMENDED THE ENACTMENT OF LEGISLATION PROHIBITING SUCH PAYMENTS.

HOWEVER, THE SEC ALSO REPORTED THAT THE MOST DEVASTATING DISCLOSURE WAS THE EXTENT TO WHICH SOME COMPANIES HAD FALSIFIED THEIR BOOKS AND RECORDS. THE SEC FOUND THAT "MILLIONS OF DOLLARS OF FUNDS HAVE BEEN INACCURATELY RECORDED IN CORPORATE BOOKS AND RECORDS TO FACILITATE THE MAKING OF QUESTIONABLE PAYMENTS" AND THAT THE "FALSIFICATION" OF SUCH RECORDS "HAS BEEN KNOWN TO CORPORATE EMPLOYEES AND OFTEN TO TOP MANAGEMENT ***." ONE MEANS OF ALLEVIATING THOSE PROBLEMS, SEC RECOMMENDED THE ENACTMENT OF LEGISLATION REQUIRING COMPANIES TO MAINTAIN "BOOKS AND RECORDS WHICH ACCURATELY AND FAIRLY REFLECT THE TRANSACTIONS AND THE DISPOSITIONS OF THE ASSETS OF THE ISSUER, AND TO DEFINE AND MAINTAIN AN ADEQUATE SYSTEM OF INTERNAL ACCOUNTING CONTROLS SUFFICIENT TO PROVIDE REASONABLE ASSURANCES ***" THAT CERTAIN ACCOUNTING/FINANCIAL OBJECTIVES WERE MET.

A NUMBER OF BILLS WERE INTRODUCED TO IMPLEMENT SEC'S RECOMMENDATIONS EITHER IN WHOLE OR IN PART. AFTER A LONG SERIES OF HEARINGS ON THESE BILLS, CONGRESS ENACTED THE FCPA IN DECEMBER 1977. SECTION 102 OF THAT ACT, AMENDING SECTION 13(B) OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. SEC. 78MB), ESTABLISHED THE SO-CALLED ACCOUNTING REQUIREMENTS, WHICH STATE IN PERTINENT PART AS FOLLOWS:

"(2) EVERY ISSUER WHICH HAS A CLASS OF SECURITIES REGISTERED PURSUANT TO SECTION 12 OF THIS TITLE AND EVERY ISSUER WHICH IS REQUIRED TO FILE REPORTS PURSUANT TO SECTION 15(D) OF THIS TITLE SHALL -

"(A) MAKE AND KEEP BOOKS, RECORDS, AND ACCOUNTS, WHICH, IN REASONABLE DETAIL, ACCURATELY AND FAIRLY REFLECT THE TRANSACTIONS AND DISPOSITIONS OF THE ASSETS OF THE ISSUER; AND

"(B) DEVISE AND MAINTAIN A SYSTEM OF INTERNAL ACCOUNTING CONTROLS SUFFICIENT TO PROVIDE REASONABLE ASSURANCES THAT -

"(I) TRANSACTIONS ARE EXECUTED IN ACCORDANCE WITH MANAGEMENT'S GENERAL OR SPECIFIC AUTHORIZATION;

"(II) TRANSACTIONS ARE RECORDED AS NECESSARY (I) TO PERMIT PREPARATION OF FINANCIAL STATEMENTS IN CONFORMITY WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR ANY OTHER CRITERIA APPLICABLE TO SUCH STATEMENTS, AND (II) TO MAINTAIN ACCOUNTABILITY FOR ASSETS;

"(III) ACCESS TO ASSETS IS PERMITTED ONLY IN ACCORDANCE WITH MANAGEMENT'S GENERAL OR SPECIFIC AUTHORIZATION; AND

"(IV) THE RECORDED ACCOUNTABILITY FOR ASSETS IS COMPARED WITH THE EXISTING ASSETS AT REASONABLE INTERVALS AND APPROPRIATE ACTION IS TAKEN WITH RESPECT TO ANY DIFFERENCES."

THE OVERALL CONGRESSIONAL INTENT OF THE ACCOUNTING REQUIREMENTS WAS EXPLAINED AS FOLLOWS: FN2

"THE COMMITTEE RECOGNIZES THAT THE SEC HAS BROAD AUTHORITY TO PROMULGATE ACCOUNTING STANDARDS FOR COMPANIES SUBJECT TO JURISDICTION UNDER ITS EXISTING AUTHORITY. NEVERTHELESS, THE COMMITTEE BELIEVES THE COMMISSION'S CURRENT PROGRAM FOR ACCURATE ACCOUNTING SHOULD BE SUPPLEMENTED BY AN EXPLICIT STATEMENT OF STATUTORY POLICY. THE ACCOUNTING STANDARDS IN S. 305 ARE INTENDED TO OPERATE IN TANDEM WITH THE CRIMINALIZATION PROVISIONS OF THE BILL TO DETER CORPORATE BRIBERY. S. 305 EXPRESSES A PUBLIC POLICY WHICH ENCOMPASSES A UNIFIED APPROACH TO THE MATTER OF CORPORATE BRIBERY.

"THIS LEGISLATION IMPOSES AFFIRMATIVE REQUIREMENTS ON ISSUERS TO MAINTAIN BOOKS AND RECORDS WHICH ACCURATELY AND FAIRLY REFLECT THE TRANSACTIONS OF THE CORPORATION AND TO DESIGN AN ADEQUATE SYSTEM OF INTERNAL CONTROLS TO ASSURE, AMONG OTHER THINGS, THAT THE ASSETS OF THE ISSUER ARE USED FOR PROPER CORPORATE PURPOSE. THE COMMITTEE BELIEVES THAT THE IMPOSITION OF THESE AFFIRMATIVE DUTIES UNDER OUR SECURITIES LAWS COUPLED WITH ATTENDANT CIVIL LIABILITY AND CRIMINAL PENALTIES FOR FAILURE TO COMPLY WITH THE STATUTORY STANDARD WILL GO A LONG WAY TO PREVENT THE USE OF CORPORATE ASSETS FOR CORRUPT PURPOSES. PUBLIC CONFIDENCE IN SECURITIES MARKETS WILL BE ENHANCED BY ASSURANCE THAT CORPORATE RECORD KEEPING IS HONEST."

II. ANALYSIS:

QUESTION 1: CAN A VIOLATION OF SECTION 13(B)(2) CARRY WITH IT CRIMINAL SANCTIONS AND IF SO, WHAT ARE THE POSSIBLE CRIMINAL PENALTIES?

ANSWER 1: YES. THE FCPA DOES NOT CONTAIN ANY SPECIAL CRIMINAL SANCTIONS FOR A VIOLATION OF SECTION 13(B)(2) (E.G., IF A COMPANY IMPROPERLY FAILS TO MAINTAIN ACCURATE BOOKS AND RECORDS OR AN ADEQUATE SYSTEM OF INTERNAL ACCOUNTING CONTROLS). HOWEVER, THE REQUIREMENTS OF SECTION 13(B)(2) AS A PART OF THE SECURITIES EXCHANGE ACT OF 1934 CLEARLY FALLS UNDER THE SCOPE OF SECTION 32(A) OF THAT ACT, 15 U.S.C. SEC. 78FFA) WHICH PROVIDES THAT:

"ANY PERSON WHO WILLFULLY VIOLATES ANY PROVISION OF THIS TITLE (THE 1934 ACT) *** SHALL UPON CONVICTION BE FINED NOT MORE THAN $10,000, OR IMPRISONED NOT MORE THAN FIVE YEARS, OR BOTH ***."

THUS A COMPANY FOUND TO HAVE WILLFULLY FAILED TO COMPLY WITH THE REQUIREMENTS OF SECTION 13(B)(2) IS SUBJECT TO CRIMINAL SANCTIONS. THIS DOES NOT MEAN, HOWEVER, THAT EVERY VIOLATION OF SECTION 13(B)(2) WILL RESULT IN A CRIMINAL ENFORCEMENT ACTION AGAINST THE NONCOMPLYING COMPANY. DEPENDING ON THE CIRCUMSTANCES, THE SEC MAY INITIATE A CIVIL INJUNCTION ACTION OR AN ADMINISTRATIVE DISCIPLINARY PROCEEDING, OR SEEK OTHER ANCILLARY EQUITABLE RELIEF. IN A CIVIL INJUNCTION ACTION, WHICH SEC HAS RELIED ON PRIMARILY IN RECENT YEARS FOR ENFORCEMENT PURPOSES, THE SEC SEEKS TO ENJOIN A COMPANY FROM COMMITTING FUTURE VIOLATIONS OF A FEDERAL SECURITIES LAW. 15 U.S.C. SEC. 78UD). THE SEC MAY ALSO ISSUE AN ORDER DIRECTING A COMPANY TO COMPLY WITH A SECURITIES LAW. 15 U.S.C. SEC. 78OC)(4).

QUESTION 2: DOES THE "REASONABLE ASSURANCES" STANDARD IN SECTION 13(B)(2)(B) ADEQUATELY EXPLAIN, FROM A LEGAL STANDPOINT, WHAT IS EXPECTED FROM A COMPANY IN ORDER TO BE IN COMPLIANCE WITH THAT SECTION?

ANSWER 2: YES. SECTION 13(B)(2)(B) REQUIRES COMPANIES TO ESTABLISH AND MAINTAIN INTERNAL ACCOUNTING CONTROL SYSTEMS SUFFICIENT TO PROVIDE "REASONABLE ASSURANCES" THAT CERTAIN STATED OBJECTIVES ARE MET. HOLDING COMPANIES AND RESPONSIBLE COMPANY OFFICIALS TO A GENERAL STANDARD OF REASONABLE CARE AND DILIGENCE HAS SUBSTANTIAL AND LONG STANDING PRECEDENT. THUS, THE REASONABLE ASSURANCES STANDARD APPEARS LEGALLY SUFFICIENT IN TERMS OF PROVIDING GUIDANCE TO COMPANIES FOR COMPLIANCE PURPOSES.

WE RECOGNIZE THAT THERE MAY BE PROBLEMS IMPLEMENTING SECTION 13(B)(2)(B) IN TERMS OF THE PRESENT ACCOUNTING STATE-OF-THE-ART, AND THAT THE NECESSARY CONTROL SYSTEMS WILL HAVE TO EVOLVE. HOWEVER, WE DO NOT REGARD THESE PROBLEMS AS AFFECTING THE VALIDITY OF THE LAW ITSELF.

IN ANY EVENT, THE MANY RECENT EFFORTS IN THE PRIVATE SECTOR TO MORE FULLY DEVELOP SPECIFIC STANDARDS AND TECHNIQUES CONCERNING COMPANY INTERNAL ACCOUNTING CONTROLS, AS WELL AS THE SEC'S RECENT EFFORTS TO PROVIDE ADDITIONAL GUIDANCE TO COMPANIES, MAY SUBSTANTIALLY ALLEVIATE IN THE NEAR FUTURE THE UNCERTAINTIES AND CONCERNS OVER SECTION 13(B)(2)(B).

EXPLANATION:

SECTION 13(B)(2)(B) REQUIRES THAT COMPANIES "DEVISE AND MAINTAIN A SYSTEM OF INTERNAL ACCOUNTING CONTROLS SUFFICIENT TO PROVIDE REASONABLE ASSURANCES THAT ***" THE SO-CALLED AUTHORIZATION, ACCOUNTING, AND ASSET SAFEGUARDING OBJECTIVES ARE MET (SEE BACKGROUND SECTION). THE TERM "REASONABLE ASSURANCES" IS NOT DEFINED IN THAT SECTION; NOR ARE ANY ACCOUNTING AND AUDITING REQUIREMENTS (AS OPPOSED TO THE STATED OBJECTIVES SPECIFIED THEREIN) WHICH A COMPANY MUST INCORPORATE INTO ITS INTERNAL ACCOUNTING CONTROL SYSTEM IN ORDER TO BE IN COMPLIANCE WITH SECTION 13(B)(2)(B).

DUE TO THE ABSENCE OF MORE SPECIFICITY IN SECTION 13(B)(2) MANY LEGAL AND ACCOUNTING AUTHORITIES HAVE CRITICIZED THAT SECTION, PARTICULARLY THE INTERNAL ACCOUNTING CONTROL PROVISIONS, AS BEING VAGUE AND HIGHLY SUBJECTIVE. FN3 ON THIS BASIS THESE AUTHORITIES BELIEVE THAT IT IS PRESENTLY IMPOSSIBLE FOR COMPANIES TO UNDERSTAND WHAT IS NECESSARY IN ORDER TO BE IN COMPLIANCE WITH THAT SECTION.

WHILE SECTION 13(B)(2)(B) DOES NOT CONTAIN ANY DEFINITION OF THE TERM "REASONABLE ASSURANCES" OR SPECIFIC INTERNAL ACCOUNTING REQUIREMENTS, ITS LEGISLATIVE HISTORY SHOWS THAT THE INTENDED MEANING AND APPLICATION OF THIS SECTION IS TO BE DERIVED PRINCIPALLY FROM AUTHORITATIVE ACCOUNTING LITERATURE. FN4 THE STATUTORY LANGUAGE CONTAINED IN SECTION 13(B)(2)(B) IS TAKEN ALMOST VERBATIM FROM SECTION 320.28 OF THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA) STATEMENT ON AUDITING STANDARDS (SAS) NO. 1 (1973), WHICH IS SPECIFICALLY IDENTIFIED IN THE PERTINENT SENATE REPORT. THESE STANDARDS WERE DEVELOPED TO PROVIDE BROAD PROFESSIONAL GUIDANCE TO INDEPENDENT AUDITORS IN THEIR STUDY AND EVALUATION OF THE INTERNAL ACCOUNTING CONTROLS OF THEIR CLIENT COMPANIES FOR CERTAIN AUDITING PURPOSES. SECTION 320.28 OF SAS NO. 1 DEFINES A SYSTEM OF INTERNAL ACCOUNTING CONTROL AS "THE PLAN OF ORGANIZATION AND THE PROCEDURES AND RECORDS THAT ARE CONCERNED WITH THE SAFEGUARDING OF ASSETS AND THE RELIABILITY OF FINANCIAL RECORDS ***" DESIGNED TO PROVIDE REASONABLE ASSURANCES THAT THE STATED OBJECTIVES ARE MET. SECTION 320.32 OF SAS NO. 1 DEFINES THE TERM "REASONABLE ASSURANCE" AS FOLLOWS:

"REASONABLE ASSURANCE.

"32. THE DEFINITION OF ACCOUNTING CONTROL COMPREHENDS REASONABLE, BUT NOT ABSOLUTE, ASSURANCE THAT THE OBJECTIVES IN IT WILL BE ACCOMPLISHED BY THE SYSTEM. THE CONCEPT OF REASONABLE ASSURANCE RECOGNIZES THAT THE COST OF INTERNAL CONTROL SHOULD NOT EXCEED THE BENEFITS EXPECTED TO BE DERIVED. THE BENEFITS CONSIST OF REDUCTIONS IN THE RISK OF FAILING TO ACHIEVE THE OBJECTIVES IMPLICIT IN THE DEFINITION OF ACCOUNTING CONTROL. ALTHOUGH THE COST-BENEFIT RELATIONSHIP IS THE PRIMARY CONCEPTUAL CRITERION THAT SHOULD BE CONSIDERED IN DESIGNING A SYSTEM OF ACCOUNTING CONTROL, PRECISE MEASUREMENT OF COSTS AND BENEFITS USUALLY IS NOT POSSIBLE; ACCORDINGLY ANY EVALUATION OF THE COST-BENEFIT RELATIONSHIP REQUIRES ESTIMATES AND JUDGMENTS BY MANAGEMENT. BECAUSE OF THE COST-BENEFIT RELATIONSHIP, ACCOUNTING CONTROL PROCEDURES MAY APPROPRIATELY BE APPLIED ON A TEST BASIS IN SOME CIRCUMSTANCES."

THE LEGISLATIVE HISTORY OF SECTION 13(B)(2)(B) REFLECTS THIS VIEWPOINT AS TO THE INTENDED MEANING OF THE "REASONABLE ASSURANCES" STANDARD:

"THE ESTABLISHMENT AND MAINTENANCE OF A SYSTEM OF INTERNAL CONTROL AND ACCURATE BOOKS AND RECORDS ARE FUNDAMENTAL RESPONSIBILITIES OF MANAGEMENT. THE EXPECTED BENEFITS TO BE DERIVED FROM THE CONSCIENTIOUS DISCHARGE OF THESE RESPONSIBILITIES ARE OF BASIC IMPORTANCE TO INVESTORS AND THE MAINTENANCE OF THE INTEGRITY OF OUR CAPITAL MARKET SYSTEM. THE COMMITTEE RECOGNIZES, HOWEVER, THAT MANAGEMENT MUST EXERCISE JUDGMENT IN DETERMINING THE STEPS TO BE TAKEN, AND THE COST INCURRED, IN GIVING ASSURANCE THAT THE OBJECTIVES EXPRESSED WILL BE ACHIEVED. HERE, STANDARDS OF REASONABLENESS MUST APPLY. IN THIS REGARD, THE TERM 'ACCURATELY' DOES NOT MEAN EXACT PRECISION AS MEASURED BY SOME ABSTRACT PRINCIPLE. RATHER IT MEANS THAT AN ISSUER'S RECORDS SHOULD REFLECT TRANSACTIONS IN CONFORMITY WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR OTHER APPLICABLE CRITERIA. WHILE MANAGEMENT SHOULD OBSERVE EVERY REASONABLE PRUDENCE IN SATISFYING THE OBJECTIVES CALLED FOR IN NEW PARAGRAPH (2) OF SECTION 13(B), THE COMMITTEE RECOGNIZES THAT MANAGEMENT MUST NECESSARILY ESTIMATE AND EVALUATE THE COST/BENEFIT RELATIONSHIPS OF THE STEPS TO BE TAKEN IN FULFILLMENT OF ITS RESPONSIBILITIES UNDER THIS PARAGRAPH. THE ACCOUNTING PROFESSION WILL BE EXPECTED TO USE THEIR PROFESSIONAL JUDGMENT IN EVALUATING THE SYSTEMS MAINTAINED BY ISSUERS. THE SIZE OF THE BUSINESS, DIVERSITY OF OPERATIONS, DEGREE OF CENTRALIZATION OF FINANCIAL AND OPERATING MANAGEMENT, AMOUNT OF CONTACT BY TOP MANAGEMENT WITH DAY-TO- DAY OPERATIONS, AND NUMEROUS OTHER CIRCUMSTANCES ARE FACTORS WHICH MANAGEMENT MUST CONSIDER IN ESTABLISHING AND MAINTAINING AN INTERNAL ACCOUNTING CONTROLS SYSTEM." FN5

THE SEC HAS NOT, TO DATE, ISSUED ANY RULES OR REGULATIONS SETTING OUT PRECISE GUIDELINES AS TO WHEN IT WILL CONSIDER A COMPANY'S SYSTEM OF INTERNAL ACCOUNTING CONTROLS SUFFICIENT, FOR PURPOSES OF DETERMINING COMPLIANCE WITH SECTION 13(B)(2)(B), TO PROVIDE "REASONABLE ASSURANCES" THAT THE STATED OBJECTIVES HAVE BEEN MET. HOWEVER, SEVERAL SEC PUBLIC RELEASES AND OTHER PUBLIC ANNOUNCEMENTS, PROVIDE SOME INSIGHT AS TO SEC'S UNDERSTANDING AND INTENDED APPLICATION OF THE "REASONABLE ASSURANCES" STANDARD. FOR EXAMPLE, IN ITS RECENT ANNOUNCEMENT WITHDRAWING ITS PROPOSED RULES ON REQUIRING COMPANIES TO INCLUDE IN THEIR ANNUAL REPORTS A STATEMENT OF MANAGEMENT ON INTERNAL ACCOUNTING CONTROLS, THE SEC STATED: FN6

"AS DISCUSSED IN THE PROPOSING RELEASE, THE RULE PROPOSALS WERE BASED UPON A CRITERION OF 'REASONABLE ASSURANCE':

"THE CONCEPT OF REASONABLE, AS OPPOSED TO ABSOLUTE, ASSURANCE IS INCORPORATED IN THE PROPOSED RULES IN RECOGNITION THAT IT IS NOT IN THE INTEREST OF SHAREHOLDERS FOR THE COST OF INTERNAL ACCOUNTING CONTROL TO EXCEED THE BENEFITS THEREOF. SUCH BENEFITS, AND IN MANY CASES SUCH COSTS, ARE NOT LIKELY TO BE PRECISELY QUANTIFIABLE. THEREFORE, MANY DECISIONS ON REASONABLE ASSURANCE WILL NECESSARILY DEPEND IN PART ON ESTIMATES AND JUDGMENTS BY MANAGEMENT WHICH ARE REASONABLE UNDER THE CIRCUMSTANCES."

THUS, THE TEST FOR DETERMINING WHETHER A PARTICULAR COMPANY IS IN COMPLIANCE WITH THE "REASONABLE ASSURANCES" STANDARD IN SECTION 13(B)(2)(B) IS TO BE JUDGED ON THE REASONABLENESS OF THAT COMPANY'S ACTIONS OR INACTIONS, THROUGH ITS MANAGEMENT, IN REGARD TO THE ESTABLISHMENT AND MAINTENANCE OF APPROPRIATE INTERNAL ACCOUNTING CONTROLS USING GENERALLY ACCEPTED ACCOUNTING/AUDITING PRINCIPLES. WHAT CONSTITUTES REASONABLE ACTION BY A COMPANY IS TO BE DETERMINED ON THE BASIS OF THE FACTS AND CIRCUMSTANCES OF EACH CASE. THE SPECIFIC CONTROLS WHICH MAY BE ADOPTED AS A RESULT OF MANAGEMENT'S REASONED JUDGMENT AS TO THE NEED THEREFOR (E.G., USING A COST/BENEFIT ANALYSIS), APPEARS TO BE WITHIN MANAGEMENT'S DISCRETION.

HOLDING COMPANIES AND RESPONSIBLE COMPANY OFFICIALS TO A GENERAL STANDARD OF REASONABLE CARE AND DILIGENCE HAS SUBSTANTIAL AND LONGSTANDING PRECEDENT. FN7 ON THIS BASIS THE "REASONABLE ASSURANCES" STANDARD IN SECTION 13(B)(2)(B), AS EXPLAINED IN THE APPLICABLE ACCOUNTING LITERATURE AND LEGISLATIVE HISTORY, AND AS FURTHER INTERPRETED BY SEC, APPEARS LEGALLY SUFFICIENT IN TERMS OF PROVIDING GUIDANCE TO COMPANIES FOR PURPOSES OF DETERMINING WHETHER OR NOT THEIR EFFORTS IN REGARD TO THE MAINTAINING OF INTERNAL ACCOUNTING CONTROLS ARE IN COMPLIANCE WITH THAT SECTION.

IT APPEARS THAT MANY OF THE CONCERNS THAT HAVE BEEN EXPRESSED WITHIN THE PRIVATE SECTOR OVER THE PRESENT UNCERTAINTIES OF SECTION 13(B)(2)(B), ARE ATTRIBUTABLE TO THE SUBJECTIVITY OF INTERNAL ACCOUNTING CONTROLS AND THE CURRENT STATE-OF-THE-ART. AS TO THE FIRST CONTENDED DEFICIENCY, INTERNAL ACCOUNTING CONTROLS ARE NOT SUSCEPTIBLE TO PRECISE AND UNIFORM APPLICATION TO ALL COMPANIES, BUT CALL FOR HIGHLY SUBJECTIVE JUDGMENT DECISIONS BY MANAGEMENT AS TO WHAT CONTROLS ARE APPROPRIATE TO ITS COMPANY UNDER THE CIRCUMSTANCES. THIS SUBJECTIVITY IS CLEARLY CONFIRMED IN THE AICPA SPECIAL ADVISORY COMMITTEE REPORT ON INTERNAL ACCOUNTING CONTROL LAST YEAR CONCERNING THE NEED FOR MANAGEMENT TO IDENTIFY AND SET UP INTERNAL ACCOUNTING CONTROLS. FN8 WE ALSO UNDERSTAND THAT THE STATE-OF-THE-ART REGARDING COMPANY INTERNAL ACCOUNTING CONTROLS IS STILL IN THE EARLY STAGES OF DEVELOPMENT, WITH THE SPECIFIC STANDARDS AND TECHNIQUES STILL BEING DEVELOPED. FN9

JUDGING FROM THE MAGNITUDE OF THE PRIVATE SECTOR CONCERNS OVER THE REASONABLE ASSURANCES STANDARD, AND THE LIMITED STATE-OF-THE-ART AT PRESENT, WE BELIEVE THAT ADDITIONAL ADMINISTRATIVE GUIDANCE IS NEEDED. APPARENT RECOGNITION OF THESE CONCERNS THE SEC HAS RECENTLY PROVIDED COMPANIES WITH FURTHER GUIDANCE AS TO WHAT THEY MUST DO IN ORDER TO BE IN COMPLIANCE WITH SECTION 13(B)(2)(B). IN ADDITION TO FURTHER COMMENTING ON THE INTENDED MEANING OF THE TERM "REASONABLE ASSURANCES" AND THE OBJECTIVES OF INTERNAL ACCOUNTING CONTROLS, THE SEC EXPANDED ON THE SO- CALLED "CONCEPTUAL ELEMENTS" AS FOLLOWS: FN10

"THE COMMISSION CONTINUES TO BELIEVE THAT THE DETERMINATION OF WHETHER A SYSTEM OF INTERNAL ACCOUNTING CONTROL PROVIDES REASONABLE ASSURANCES THAT THE BROAD OBJECTIVES OF INTERNAL ACCOUNTING CONTROL ARE ACHIEVED GENERALLY WILL INVOLVE THE FOLLOWING:

"FIRST, CONSIDERATION OF THE OVERALL CONTROL ENVIRONMENT;

"SECOND, TRANSLATION OF THE BROAD OBJECTIVES OF INTERNAL ACCOUNTING CONTROL INTO SPECIFIC CONTROL OBJECTIVES APPLICABLE TO THE PARTICULAR BUSINESS, ORGANIZATIONAL AND OTHER CHARACTERISTICS OF THE INDIVIDUAL COMPANY;

"THIRD, CONSIDERATION OF THE SPECIFIC CONTROL PROCEDURES AND INDIVIDUAL ENVIRONMENTAL FACTORS WHICH SHOULD CONTRIBUTE TO ACHIEVEMENT OF THE SPECIFIC CONTROL OBJECTIVES;

"FOURTH, MONITORING OF CONTROL PROCEDURES AND CONSIDERATION OF WHETHER THEY ARE FUNCTIONING AS INTENDED; AND

"FIFTH, CONSIDERATION OF THE BENEFITS (CONSISTING OF REDUCTIONS IN THE RISK OF FAILING TO ACHIEVE THE OBJECTIVES) AND COSTS OF ADDITIONAL OR ALTERNATIVE CONTROLS."

ALSO, AS INDICATED ABOVE, THERE ARE MANY PRIVATE-SECTOR INITIATIVES IN THIS AREA FURTHER DEVELOPING SPECIFIC STANDARDS AND TECHNIQUES FOR INTERNAL ACCOUNTING CONTROLS. THESE DEVELOPMENTS, AS WELL AS SEC'S RECENT EFFORTS TO PROVIDE ADDITIONAL GUIDANCE TO COMPANIES, MAY SUBSTANTIALLY ALLEVIATE THE PRESENT UNCERTAINTIES AND CONCERNS OVER SECTION 13(B)(2)(B).

HOWEVER, IT IS UNLIKELY THAT A SOLUTION CAN OR WILL BE FOUND WHICH IS SATISFACTORY TO ALL INTERESTS (I.E., CLEAR AND PRECISE GUIDANCE TO COMPANIES AS TO WHAT IS REQUIRED UNDER SECTION 13(B)(2)(B), WHILE AT THE SAME TIME NOT UNDULY INTERFERING WITH INTERNAL MANAGEMENT DECISIONS). IS DOUBTFUL THAT CONGRESS OR THE SEC COULD DEVISE A PERFECTLY CLEAR DEFINITION OF THE TERM "REASONABLE ASSURANCES," TOGETHER WITH DEFINITIVE REQUIREMENTS FOR INTERNAL ACCOUNTING CONTROLS. THESE CONCEPTS NECESSARILY CALL FOR HIGHLY SUBJECTIVE JUDGMENTS ON THE PART OF MANAGEMENT AS TO WHAT CONTROLS ARE APPROPRIATE FOR THE COMPANY UNDER THE CIRCUMSTANCES (SEE ABOVE). ON THE OTHER HAND, EVEN IF ONE ASSUMES THAT SUCH CONCEPTS CAN BE ADEQUATELY DEFINED AND SEC PROCEEDS TO DO SO, SOME PRIVATE-SECTOR INTERESTS WILL SURELY RAISE OBJECTIONS THAT THE FEDERAL GOVERNMENT IS UNNECESSARILY AND IMPROPERLY INTERFERING WITH INTERNAL MANAGEMENT DECISIONS CONCERNING WHAT CONTROLS ARE APPROPRIATE TO ACCOUNT FOR COMPANY FUNDS AND OTHER ASSETS.

QUESTION 3: DO THE RECORD KEEPING AND/OR THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS CONTAIN, EITHER EXPRESSLY OR IMPLIEDLY, A MATERIALITY STANDARD?

ANSWER 3: NO. OUR ANALYSIS OF THE LANGUAGE AND LEGISLATIVE HISTORY OF SECTION 13(B)(2) REVEALS NO INDICATION THAT SUCH A STANDARD, WITHIN CONTEXT OF THE TRADITIONAL FEDERAL SECURITIES LAWS, WAS INTENDED TO BE APPLIED TO THE RECORD KEEPING AND INTERNAL ACCOUNTING CONTROL REQUIREMENTS. INDEED, THERE IS STRONG SUPPORT FOR SEC'S POSITION THAT A "REASONABLENESS" STANDARD, RATHER THAN A MATERIALITY STANDARD, IS THE GOVERNING STANDARD. HOWEVER, IT IS IMPORTANT TO POINT OUT THAT THE DISTINCTION BETWEEN THESE STANDARDS IS ONE OF DEGREE.

EXPLANATION:

SECTION 13(B)(2)(A) REQUIRES COMPANIES TO MAINTAIN BOOKS, RECORDS AND ACCOUNTS WHICH, IN REASONABLE DETAIL, ACCURATELY AND FAIRLY REFLECT THE TRANSACTIONS AND DISPOSITIONS OF THEIR ASSETS. SECTION 13(B)(2)(B) REQUIRES COMPANIES TO MAINTAIN INTERNAL ACCOUNTING CONTROL SYSTEMS SUFFICIENT TO PROVIDE REASONABLE ASSURANCES THAT CERTAIN STATED OBJECTIVES ARE MET.

THE CONCEPT OF A MATERIALITY STANDARD UNDER THE SECURITIES LAWS REFLECTS THEIR PRIMARY OBJECTIVE OF INVESTOR PROTECTION BY REQUIRING FULL AND FAIR DISCLOSURE OF MATERIAL INFORMATION CONCERNING SECURITIES PUBLICLY OFFERED. MATERIAL INFORMATION GENERALLY IS THAT INFORMATION A REASONBLE INVESTOR WOULD CONSIDER IMPORTANT IN DECIDING WHETHER TO MAKE A PARTICULAR INVESTMENT. INFORMATION THAT IS NOT CONSIDERED MATERIAL NEED NOT BE DISCLOSED TO POTENTIAL INVESTORS. AS THE SUPREME COURT EXPLAINED IN TSC INDUSTRIES, INC. V. NORTHWAY, INC., THE LEADING CASE IN THIS AREA: FN11

"THE GENERAL STANDARD OF MATERIALITY THAT WE THINK BEST COMPORTS WITH THE POLICIES OF RULE 14A-9 IS AS FOLLOWS: AN OMITTED FACT IS MATERIAL IF THERE IS A SUBSTANTIAL LIKELIHOOD THAT A REASONABLE SHAREHOLDER WOULD CONSIDER IT IMPORTANT IN DECIDING HOW TO VOTE. THIS STANDARD IS FULLY CONSISTENT WITH MILLS' GENERAL DESCRIPTION OF MATERIALITY AS A REQUIREMENT THAT 'THE DEFECT HAVE A SIGNIFICANT PROPENSITY TO AFFECT THE VOTING PROCESS.' DOES NOT REQUIRE PROOF OF A SUBSTANTIAL LIKELIHOOD THAT DISCLOSURE OF THE OMITTED FACT WOULD HAVE CAUSED THE REASONABLE INVESTOR TO CHANGE HIS VOTE. WHAT THE STANDARD DOES CONTEMPLATE IS A SHOWING OF A SUBSTANTIAL LIKELIHOOD THAT, UNDER ALL THE CIRCUMSTANCES, THE OMITTED FACT WOULD HAVE ASSUMED ACTUAL SIGNIFICANCE IN THE DELIBERATIONS OF THE REASONABLE SHAREHOLDER. PUT ANOTHER WAY, THERE MUST BE A SUBSTANTIAL LIKELIHOOD THAT THE DISCLOSURE OF THE OMITTED FACT WOULD HAVE BEEN VIEWED BY THE REASONABLE INVESTOR AS HAVING SIGNIFICANTLY ALTERED THE 'TOTAL MIX' OF INFORMATION MADE AVAILABLE."

SOME LEGAL AUTHORITIES BELIEVE THAT A MATERIALITY STANDARD CAN AND SHOULD BE IMPLIED WITH REGARD TO THE RECORD KEEPING AND THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS OF SECTION 13(B)(2)(A), PRIMARILY ON THE BASIS THAT SUCH A STANDARD IS INHERENT IN THE FEDERAL SECURITIES LAWS. FOR EXAMPLE, THE COMMITTEE ON CORPORATE LAW AND ACCOUNTING OF THE AMERICAN BAR ASSOCIATION IMPLIED THIS AS TO THE RECORD KEEPING REQUIREMENTS: FN12

"AN ISSUER WILL NOT BE IN COMPLIANCE WITH SUBSECTION (A) IF AT THE TIME INTERIM AND ANNUAL FINANCIAL STATEMENTS ARE REQUIRED TO BE PREPARED IT IS UNABLE TO PREPARE FROM ITS BOOKS AND RECORDS FINANCIAL STATEMENTS THAT ARE IN ALL MATERIAL RESPECTS IN CONFORMITY WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES APPROPRIATE IN THE CIRCUMSTANCES ***." WITH RESPECT TO THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS, THE COMMITTEE STATED: FN13

"GIVEN THE FACTORS JUST REVIEWED, A PRIMA FACIE VIOLATION OF SUBSECTION (B) WOULD ARISE IF AN ISSUER'S SYSTEM OF INTERNAL ACCOUNTING CONTROLS, AND THE DEGREE OF PRACTICAL COMPLIANCE THEREWITH, DO NOT PROVIDE REASONABLE ASSURANCE THAT MATERIAL IRREGULARITIES OR MATERIAL ERRORS IN INTERIM OR ANNUAL FINANCIAL STATEMENTS EITHER WOULD BE PREVENTED, OR WOULD BE DETECTED AND CORRECTED WITHIN A TIMELY PERIOD BY EMPLOYEES IN THE NORMAL COURSE OF PERFORMING THEIR ASSIGNED FUNCTIONS ***."

IN CONTRAST, THE SEC HAS CONSISTENTLY MAINTAINED THAT NEITHER OF THE ABOVE REQUIREMENTS CONTEMPLATE THE APPLICATION OF THE MATERIALITY STANDARD, BUT INSTEAD IMPOSE A "REASONABLENESS" STANDARD. IN SUPPORT OF THIS POSITION THE SEC HAS POINTED OUT THAT THE SECTION 13(B)(2) REQUIREMENTS ARE THE ONLY COMPONENTS OF THE FEDERAL SECURITIES LAWS WHICH SPEAK DIRECTLY TO INTERNAL CORPORATE PRACTICES UNRELATED TO DISCLOSURE AND TRADING IN SECURITIES. FN14 THE SEC BELIEVES THAT THE APPLICATION OF A MATERIALITY STANDARD WOULD BE INCONSISTENT WITH THE EXPLICIT STATUTORY REQUIREMENTS AND THE LEGISLATIVE INTENT. FN15 THE SEC GENERAL COUNSEL'S OFFICE HAS COMMENTED ON THE INTERNAL ACCOUNTING CONTROL REQUIREMENT IN THIS REGARD:

"IF A MATERIALITY STANDARD WERE TO BE APPLIED TO THE INTERNAL ACCOUNTING CONTROLS REQUIREMENTS, THE STANDARD WOULD IMPLY THAT SYSTEMS OF INTERNAL ACCOUNTING CONTROLS NEED BE DESIGNED ONLY TO RECORD 'MATERIAL' TRANSACTIONS AND DISPOSITIONS OF ASSETS. IN ADDITION, THE STANDARD WOULD IMPLY THAT ANY TRANSACTION THAT IS NOT 'MATERIAL' TO INVESTORS NEED NOT BE RECORDED, IN ANY MANNER, IN THE BOOKS AND RECORDS OF A REPORTING COMPANY. THIS RESULT WOULD BE INCONSISTENT WITH THE PRINCIPLE, STATED IN THE COMMISSION'S REPORT AND ACCEPTED BY THE CONGRESS, THAT 'ALL FUNDS BELONGING TO THE CORPORATION, AND THUS TO ITS SHAREHOLDERS, *** (MUST BE) ADEQUATELY MAINTAINED WITHIN THE CORPORATION'S SYSTEM OF FINANCIAL ACCOUNTABILITY' BECAUSE IT WOULD PERMIT SOME CORPORATIONS TO ENGAGE IN TRANSACTIONS OUTSIDE THE SYSTEM OF FINANCIAL ACCOUNTABILITY. MOREOVER, SUCH A VIEW WOULD BE INCONSISTENT WITH THE EXPLICIT STATUTORY REQUIREMENT THAT SYSTEMS OF INTERNAL ACCOUNTING CONTROLS MUST PROVIDE 'REASONABLE ASSURANCES THAT *** TRANSACTIONS ARE RECORDED AS NECESSARY (I) TO PERMIT PREPARATION OF FINANCIAL STATEMENTS IN CONFORMITY WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR ***' OTHER APPLICABLE CRITERIA AND '(II) TO MAINTAIN ACCOUNTABILITY FOR ASSETS.'"

REGARDING THE RECORD KEEPING REQUIREMENTS, THE SEC GENERAL COUNSEL'S OFFICE HAS STATED:

"*** BUT SECTION 13(B)(2)(A) DOES NOT CONTAIN A MATERIALITY LIMITATION. INSTEAD, IT CONTAINS A DIFFERENT TYPE OF LIMITING STANDARD FOR LIABILITY - THE APPROPRIATE RECORD OF A CORPORATE TRANSACTION MUST BE KEPT 'IN REASONABLE DETAIL.'

"AFTER SUBMISSION OF THE COMMISSION'S REPORT TO THE CONGRESS, A NUMBER OF PERSONS SUGGESTED THAT A PROVISION REQUIRING 'ACCURACY' IN CORPORATE BOOKS AND RECORDS WOULD BE UNREALISTIC AND UNATTAINABLE. MOST OF THOSE PERSONS SOUGHT TO QUALIFY THE PROPOSED LEGISLATION BY LIMITING THE LEGISLATION TO PAYMENTS THAT WOULD BE 'MATERIAL' IN AMOUNT WITH RESPECT TO A REPORTING COMPANY'S FINANCIAL STATEMENTS. DESPITE THESE SUGGESTIONS, THE CONGRESS DID NOT CHOOSE TO INCORPORATE A 'MATERIALITY' LIMITATION IN THE LANGUAGE OF THE RECORD KEEPING PROVISION. MOREOVER, AS SET FORTH ABOVE WITH RESPECT TO SUBSECTION 13(B)(2)(B), A MATERIALITY LIMITATION WOULD BE INCONSISTENT WITH THE LEGISLATIVE HISTORY OF SUBSECTION 13(B)(2)(A), THE CONGRESSIONAL OBJECTIVES UNDERLYING THE RECORD KEEPING PROVISION AND THE LANGUAGE OF THE STATUTE, WHICH DOES NOT EMPLOY 'MATERIALITY' AS A STANDARD OF LIMITATION."

WE HAVE REVIEWED THE ABOVE POSITIONS AND AGREE WITH THE SEC VIEW. OUR ANALYSIS OF THE LANGUAGE AND LEGISLATIVE HISTORY OF SECTION 13(B)(2) REVEALS NO INDICATION THAT A MATERIALITY STANDARD WAS INTENDED TO BE APPLIED TO THE RECORD KEEPING AND THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS. IT IS CLEAR THAT THESE REQUIREMENTS WERE INTENDED TO PREVENT THE USE OF COMPANY MONEYS AND ASSETS FOR CORRUPT OR OTHERWISE WRONGFUL PURPOSES, NOT TO PROTECT INVESTORS.

THE FACT THAT SECTION 13(B)(2) IS A PART OF THE SECURITIES EXCHANGE ACT OF 1934 DOES NOT NECESSARILY MEAN THAT A MATERIALITY STANDARD IS APPLICABLE TO THAT SECTION. MOREOVER, BOTH THE LANGUAGE AND LEGISLATIVE HISTORY OF SECTION 13(B)(2) PROVIDE STRONG SUPPORT FOR SEC'S POSITION THAT A "REASONABLENESS" STANDARD AS OPPOSED TO A "MATERIALITY" STANDARD, GOVERNS. THE PERTINENT LEGISLATIVE HISTORY OF THESE REQUIREMENTS, EXPLAINED IN DETAIL IN OUR ANSWER TO QUESTION 2, STATES: FN16

"THE ESTABLISHMENT AND MAINTENANCE OF A SYSTEM OF INTERNAL CONTROL AND ACCURATE BOOKS AND RECORDS ARE FUNDAMENTAL RESPONSIBILITIES OF MANAGEMENT. THE EXPECTED BENEFITS TO BE DERIVED FROM THE CONSCIENTIOUS DISCHARGE OF THESE RESPONSIBILITIES ARE OF BASIC IMPORTANCE TO INVESTORS AND THE MAINTENANCE OF THE INTEGRITY OF OUR CAPITAL MARKET SYSTEM. THE COMMITTEE RECOGNIZES, HOWEVER, THAT MANAGEMENT MUST EXERCISE JUDGMENT IN DETERMINING THE STEPS TO BE TAKEN, AND THE COST INCURRED, IN GIVING ASSURANCE THAT THE OBJECTIVES EXPRESSED WILL BE ACHIEVED. HERE, STANDARDS OF REASONABLENESS MUST APPLY. ***"

AS FOR THE RECORD KEEPING REQUIREMENTS (SECTION 13(B)(2)(A)), COMPANIES ARE REQUIRED TO MAINTAIN SUCH RECORDS WHICH, IN REASONABLE DETAIL, ACCURATELY AND FAIRLY REFLECT THE TRANSACTIONS AND DISPOSITIONS OF THEIR ASSETS. THE SENATE VERSION OF SUBSECTION (A) DID NOT INCLUDE THE TERMS "IN REASONABLE DETAIL," FN17 BUT THE TERMS WERE INSERTED BY THE SENATE- HOUSE CONFERENCE COMMITTEE. IN ADOPTING THESE TERMS THE CONFERENCE COMMITTEE STATED: FN18

"*** THE CONFERENCE COMMITTEE ADOPTED THE 'IN REASONABLE DETAIL' QUALIFICATION TO THE ACCURATE AND FAIR REQUIREMENT IN LIGHT OF THE CONCERN THAT SUCH A STANDARD, IF UNQUALIFIED, MIGHT CONNOTE A DEGREE OF EXACTITUDE AND PRECISION WHICH IS UNREALISTIC. THE AMENDMENT MAKES CLEAR THAT THE ISSUER'S RECORDS SHOULD REFLECT TRANSACTIONS IN CONFORMITY WITH ACCEPTED METHODS OF RECORDING ECONOMIC EVENTS AND EFFECTIVELY PREVENT OFF-THE-BOOKS SLUSH FUNDS AND PAYMENTS OF BRIBES."

FINALLY, IT IS IMPORTANT TO POINT OUT THAT THE DISTINCTION BETWEEN THE APPLICATION OF A "REASONABLENESS" STANDARD VERSUS A "MATERIALITY" STANDARD IS ONE OF DEGREE RATHER THAN KIND. THAT IS, BOTH STANDARDS ALLOW SOME FLEXIBILITY AND MARGIN FOR ERROR IN RELATION TO THE SIGNIFICANCE OF THE SUBJECT MATTER.

THE LEGISLATIVE HISTORY OF SECTION 13(B)(2) CLEARLY INDICATES THAT THE PRIMARY REFERENCE IN APPLYING THE REASONABLENESS STANDARD IS A COMPANY'S ADHERENCE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (IN THE CASE OF THE RECORD KEEPING REQUIREMENTS) AND AUDITING PRINCIPLES (IN THE CASE OF THE INTERNAL ACCOUNTING CONTROL REQUIREMENTS), AS WELL AS OTHER AUTHORITATIVE ACCOUNTING LITERATURE. FN19 THE COMPANIES ANTICIPATED APPLICATION OF EXISTING AND FUTURE PRINCIPLES/PRONOUNCEMENTS OF THE ACCOUNTING PROFESSION MAY RESULT IN EVEN LESS DISTINCTION BETWEEN A MATERIALITY STANDARD AND A REASONABLENESS STANDARD. THE REASON WE SAY THIS IS BECAUSE THOSE GENERALLY ACCEPTED ACCOUNTING AND AUDITING PRINCIPLES MAY THEMSELVES CONTAIN SOME ELEMENTS OF MATERIALITY. FOR EXAMPLE, AUDITORS IN THE PRIVATE SECTOR PRESENTLY MUST NOTIFY THEIR CLIENTS OF ANY "MATERIAL WEAKNESSES" DISCOVERED IN THE COURSE OF THEIR AUDIT. FN20 WHILE THIS AUDITING PRINCIPLE DOES NOT NECESSARILY APPLY WITH RESPECT TO THE PRESENT LEGISLATION, IT DOES SERVE AS SOME INDICATION THAT CERTAIN ELEMENTS OF MATERIALITY MAY WELL BE DEVELOPED IN THE PRIVATE SECTOR CONCERNING COMPANIES' INTERNAL ACCOUNTING CONTROLS.

SPECIAL STUDIES AND ANALYSIS

BY:RAYMOND J. WYRSCH

FN1 REPORT OF THE SECURITIES AND EXCHANGE COMMISSION ON QUESTIONABLE AND ILLEGAL CORPORATE PAYMENTS AND PRACTICES, SUBMITTED TO THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS (MAY 1976).

FN2 S. REP. NO. 95-114, 7 (1977). THE HOUSE OF REPRESENTATIVES VERSION OF THIS LEGISLATION DID NOT CONTAIN ANY COMPARABLE ACCOUNTING REQUIREMENTS.

FN3 SEE "A GUIDE TO THE NEW SECTION 13(B)(2) ACCOUNTING REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934," 34 BUSINESS LAW 307, 309 (1977).

FN4 S. REP. NO. 95-114, 8 (1977).

FN5 ID.

FN6 SECURITIES EXCHANGE ACT RELEASE NO. 34-16877 (JUNE 6, 1980) AT 332.

FN7 SEE HENN, LAW OF CORPORATIONS, 453-457 (2D ED. 1970).

FN8 AICPA REPORT, AT 9.

FN9 SEE FINANCIAL EXECUTIVE RESEARCH FOUNDATION REPORT, "INTERNAL CONTROL IN U. S. CORPORATIONS. THE STATE OF THE ART," 1 (1980).

FN10 SECURITIES EXCHANGE ACT RELEASE NO. 34-16877 (JUNE 6, 1980) AT 319- 324.

FN11 TSC INDUSTRIES, INC. V. NORTHWAY, INC., 426 U.S. 438, 449 (1976).

FN12 GUIDE, SUPRA, AT 313.

FN13 ID., AT 319.

FN14 STATEMENT OF THE HONORABLE HAROLD M. WILLIAMS, CHAIRMAN OF THE SECURITIES AND EXCHANGE COMMISSION, DATED MAY 28, 1980, AT THE COMMISSION'S CONSIDERATION OF PROPOSED RULES TO REQUIRE A MANAGEMENT STATEMENT ON INTERNAL ACCOUNTING CONTROL, PAGE 3.

FN15 SEE PAGES 20-24 AND 38-39 OF THE SEC OFFICE OF GENERAL COUNSEL'S LEGAL OPINION DATED MAY 20, 1980.

FN16 S. REP. NO. 95-114, SUPRA AT 8.

FN17 AS NOTED EARLIER, THE HOUSE OF REPRESENTATIVES VERSION OF THE LEGISLATION DID NOT INCLUDE ANY ACCOUNTING REQUIREMENTS FOR COMPANIES TO COMPLY WITH.

FN18 H.R. REP. NO. 95-831, 95TH CONG., 1ST SESS. 10 (1977).

FN19 SEE S. REP. NO. 95-114, SUPRA, AT 8.

FN20 SAS NO. 1, SEC. 320.68 DEFINES A "MATERIAL WEAKNESS" AS:

"*** A CONDITION IN WHICH THE AUDITOR BELIEVES THE PRESCRIBED PROCEDURES OR THE DEGREE OF COMPLIANCE WITH THEM DOES NOT PROVIDE REASONABLE ASSURANCE THAT ERRORS OR IRREGULARITIES IN AMOUNTS THAT WOULD BE MATERIAL IN THE FINANCIAL STATEMENTS BEING AUDITED WOULD BE PREVENTED OR DETECTED WITHIN A TIMELY PERIOD BY EMPLOYEES IN THE NORMAL COURSE OF PERFORMING THEIR ASSIGNED FUNCTIONS."